Shares of Goldman Sachs GS and Morgan Stanley MS plunged on Wednesday, a sign that investors fear they can't survive in their present form as the last two major independent investment banks.
Executives of both companies insisted a day earlier, when they were reporting profits for the most recent quarter, that they do have the financial wherewithal to go it alone.
But analysts said the question increasingly is whether continued market turmoil could force them to acquire or be acquired by commercial banks, whose deposit-taking operation would provide a stable source of funding. The upheaval in the U.S. financial system has driven Merrill Lynch and Bear Stearns into emergency sales, and Lehman Brothers Holdings into bankruptcy.
Anxious investors also bid up the price of protecting against a default of debt issued by the two investment banks. The spike in credit default swaps has fanned fear gripping Wall Street that the investment banking model is in jeopardy of extinction.
John Mack, Morgan Stanley's chief executive, struck back on Wednesday. He told employees in an e-mail that the No. 2 U.S. investment bank was "in the midst of a market controlled by fear and rumors."
"I know all of you are watching our stock price (Wednesday), and so am I," he said in the e-mail. "After the strong earnings and $179 billion in liquidity we announced — which virtually every equity analyst highlighted in their notes this morning — there is no rational basis for the movements in our stock or credit default spreads."
Shares of investment banks have been sideswiped by a wave of short selling, which can cause big swings as investors bet that a stock's price will fall so they can profit from it.
Morgan Stanley shares dropped $6.95, or 24%, to close at $21.75 after plunging as low as $16.08 earlier in the day. Goldman shares fell $18.51, or 14%, to $114.50, after dropping as low as $97.78.
The Securities and Exchange Commission on Wednesday took measures to rein in aggressive forms of short-selling that were blamed in part for the demise of Lehman, which filed for bankruptcy protection on Monday. The regulator adopted more restrictions on such trades, and tightened anti-fraud regulations.
"This may be the most panicky the market has been in since this credit crisis began," said Roy Smith, a professor of finance at New York University's Stern School of Business. "People are running for high ground at any cost. The question is, can they stay solvent longer than the market is irrational."
Smith believes the companies can survive on their own, but remains concerned about the current environment in which they operate. Global banks and brokerages have written down more than $350 billion from wrong-way bets on mortgage investments and other risky securities during the past year.
Morgan Stanley had hoped to stem investor panic about its financial health by releasing third-quarter results a day earlier than planned. On Tuesday, the company posted better-than-expected profits, and while Goldman Sachs' profit slumped 70%, it did finish the quarter in the black.
Goldman Sachs Chief Financial Officer David Viniar and Morgan Stanley CFO Colm Kelleher both said their firms were able to navigate through the market dislocation, and vowed to remain independent. The CFOs said their firms have enough cash on hand and no need to raise more.
Spokesmen for both investment banks declined to comment Wednesday about the plunge in their shares.
Those in favor of such combinations believe that the sale of Merrill Lynch and collapse of Lehman Brothers might force the remaining investment banks to pursue some kind of transaction to stabilize results. The steady funding base of deposits held by banks would go a long way in assuage investors concerned about volatility.
There have been numerous reports in the past year that Goldman could buy a retail bank, with Charlotte-based Wachovia mentioned the most. On Wednesday, The New York Times reported that a representative from Wachovia called Mack about a possible deal, citing people briefed on the conversation.
Both Morgan Stanley and Wachovia declined to comment.
Regardless, the feeling on Wall Street remains that these firms — at least fundamentally — can emerge from the credit crisis in a position of strength. Both Viniar and Kelleher told analysts on Tuesday that they can take advantage of the market's dislocation by scooping up undervalued assets.
They also will benefit from less competition. During the third quarter, both companies reported a surge in profit from their prime brokerage businesses that trades securities for institutions.
Glenn Schorr, an analyst with UBS, said on Wednesday that the market reaction was "insanity." He said Goldman and Morgan Stanley aren't running out of money and remain profitable.
"The world should really be concerned about this because if we continue to squeeze the financial system's balance sheet and see fewer players in the business, the available credit to corporations and hedge funds will shrivel up and the cost of capital will continue to skyrocket across the board," he said. "A lack of confidence and forced consolidation into firms that are 'too big to fail' can't be the final solution."