GOLDMAN SACHS and MORGAN STANLEY DECIDE TO REGULATE THEMSELVES !

How often does THIS sort of thing happen ?

Today the NEW YORK TIMES announces that Goldman Sachs (GS) and Morgan Stanley (MS), America's last two independent investment banks, are going to reorganize as bank holding companies -- thereby subjecting themselves to all the Treasury (and Comptroller of the Currency) regulation & oversight that they did NOT have to endure as investment banks.

Clearely GS and MS are doing this because investor confidence in their investment-bank business model has vanished. So far, so good: "the customer is always right," and thus you please the customer, whatever it takes. The even better news is that, as bank holding companies, GS and MS will be required to limit their LEVERAGE to about 11 to 1 -- which, as the NY TIMES points out, is the present leverage ratio maintained by Bank of America. (Actually, Treasury regulations require banks to reserve for at least 8 % of their debt obligations, but there's no harm in a bank reserving more than the minimum, is there ?) Reaching this level of reserves will require GS and MS to retrench substantially: the TIMES reports that GS's leverage ratio is 22 to 1, MS's 25 to 1. Amazingly, in the workd of U.S. investment banking, these leverage ratios are conservative. Lehman Brothers's leverage ratio on its bankruptcy day was repoorted to be 40 to 1...

I am unable to comprehend how a banking institution can rationally maintain a leverage ratio of 40 to 1. Even the merest fluctuation in the quality of its debt holdings would wipe out such a pittance of capital. Why so ? Let's do the math:

The Fed requires a bank to reserve 8 % of its debt holdings but 100 % of its NON PERFORMINMG debt holdings. Thus if 1 % of a bank's debt holdings are non performing, 1/8 th of all of its capital is used up, reducing its reserve on debts not in default down to 7 % and thus forcing the bank to raiuse some new capital.

Now suppose that a bank has $ 100 billion of debt holdings and $ 8 billion -- the minimum -- of cash reserves. Suppose that THREE percent of its $ 100 billion debt portfolio is in default. The bank must now set aside $ 3 billion of its $ 8 billion reserve, leaving only $ 5 billion to cover its other $ 97 billion debt portfolio: the bank must now raise about $ 2.8 billion in capital to not be in violation of Treasury rules.

That is bad enough; but for Lehman, with a reserve ratio of 40 to 1, even a 2 % default rate on itws debt would wipe out its capital entirely. And the mortgfage-related debts that Lehman was heavily committed to was at least 20 % in default !

If a bank with $ 100 billion in debt holdings has 20 % of them in default, its reserve requirement just for its defaulted loans equals 250 % of its minimum Treasury reserve minimum !

I think you see the problem now. Which is why GS and MS have a TON of work to do. Raising capital, selling off bad debt, reetreating from the outer reaches of risk to something like rational risk assessment. No wonder that they have, by becoming bank holding companies, FORCED themselves to change their ways -- and FAST.

This is a good move. It lets us know that the folks on Wall Street recognize that they have been smokin' an awfully goofy brand a financial weed and that they feel strongly the need to GET STRAIGHT -- before Secretary Paulson and the Coingress impose straightness painfully on them.

As JOHN McCAIN so beautifully put it in his Acceptance Speech, "my friends, CHANGE IS COMING!"