Dude, Where's My Leverage?

The numbers still make my head hurt. Citigroup (NYSE: C  ) coughed up $10 billion in losses in the fourth quarter alone. Morgan Stanley (NYSE: MS  ) had to scratch $9.4 billion. Even Goldman Sachs (NYSE: GS  ) , that formidable Wall Street powerhouse, saw its net income fall by 52%.

While some contend the recent wobbles in bank stocks open up chances to buy good companies at bargain prices, I've taken the view that banks have been materially injured for good and won't regain their strut any time soon. The days when investment banks were free to employ huge amounts of leverage have almost certainly left the building.

After releasing his widely read monthly commentary on the economy, famed bond guru and PIMCO managing director Bill Gross -- who oversees some $746 billion in assets -- thinks banks have a tough road ahead, too. 

Gross thinks the days of the debt market operating free as a bird are all but over. "In my opinion, the private credit markets have forfeited their privileged right to operate relatively autonomously because of incompetence, excessive greed, and in minor instances, fraudulent activities," Gross stated.

The real impairment investment banks in particular will undergo is this: If it looks like a commercial bank and quacks like a commercial bank, it has to be regulated like a commercial bank.

One nation, under Bernanke
Soon after Bear Stearns (NYSE: BSC  ) was gobbled up by JPMorgan Chase  (NYSE: JPM  ) , the Fed took the drastic route of lending money to investment banks through its "discount window" under the same terms as commercial banks such as Washington Mutual (NYSE: WM  ) and Wells Fargo (NYSE: WFC  ) .

Under normal circumstances, only commercial banks (that take deposits in the form of checking and savings accounts) borrow from the Fed when money gets thin. Having Bernanke and his pals around as a "lender of last resort" gives the commercial banking sector credibility and helps to stymie bank runs that can bring an economy to its knees.

In return for the government safety net, federal regulators watch commercial banks vigilantly and require them to keep specific amounts of liquid assets to keep them healthy and relatively free from widespread meltdowns.

Welcome to the club; here are your handcuffs
Now that investment banks are under the same obligations, you better believe they'll be subject to the same regulatory scrutiny as their commercial brethren.

What changes? For starters, it requires once-ambiguous investment banks to hold more reserve capital on their balance sheets than they've been used to. At first glance that might sound beneficial for everyone, but it means investment banks must forgo some of the incredible profit engines that propelled their numbers into the stratosphere over the past decade.

Adios, leverage
According to Gross, investment banks on average hold just half the capital base of commercial banks. The extra leverage allowed investment banks to reap huge profits and maintain impressive returns on equity over the years, particularly by trading with their own money.

Goldman Sachs, for example, derived 68% of its 2007 revenue from trading. Now that taxpayers' money is entering into the loop, investment banks will undoubtedly be forced to pare back their exposure to risky bets that juiced shareholder returns. You can't buy caviar with food stamps, and banks can't make exorbitant bets with government money.

Raising the needed capital to shore up balance sheets won't be easy, either. After Bear Stearns flat-lined last month, the market has been weary of nearly every financial institution. Banks trying to raise capital in the open market have two options: Sell their own stock, which, for most banks, has already been severely battered, or issue bonds which currently demand higher interest rates than even a few months ago. Either way, financing the road to safety will come at a hefty price. If you're looking for bank profits to rebound anytime soon, that isn't welcome news.

Final foolish thoughts
The new regulations will likely prevent another investment bank from croaking as Bear Stearns has. With the increase in oversight, there will be serious changes in how the banks will be able to generate profit, which, until now, have had the privilege of vast amounts of leverage. 

From a risk perspective, this is all great news. Whether you're a homeowner, hedge fund, or bank, the amount of leverage employed correlates directly with the odds you'll end up with your tail between your legs.

If you're a shareholder hoping the bonanza of happy days will continue, however, remember Yogi Berra's famous words, "The future ain't what it used to be."

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