Morgan Stanley (NYSE: MS) has entertained a fierce rivalry with Goldman Sachs (NYSE: GS) for decades. During the credit crisis, Morgan Stanley failed to emulate Goldman's performance and lost ground to its rival. However, there's one form of imitation they would surely have preferred to avoid.

Yesterday, The Wall Street Journal reported that U.S. prosecutors are investigating whether Morgan misled investors in mortgage derivatives; Goldman is facing a similar investigation and civil fraud charges brought by the SEC in relation to a single derivatives deal. What's the potential impact of these developments for Morgan and its competitors?

Are these really the prime culprits?
It seems rather odd that Goldman Sachs and Morgan Stanley have been singled out so far, since they don't appear to have been the most active participants in this market. Here's how the big U.S. banks stack up in terms of their collateralized debt obligation (CDO) issuance in the period 2005-2008:

Rank

Lead Underwriter

2005-2008 Volume, CDOs Comparable to Goldman's ABACUS 2007-AC1

1

Bank of America Merrill Lynch (part of Bank of America (NYSE: BAC))

$16.9 billion

2

UBS (NYSE: UBS)

$15.8 billion

3

JPMorgan Chase (NYSE: JPM)

$9.9 billion

4

Citigroup (NYSE: C)

$9.3 billion

5

Morgan Stanley (NYSE: MS)

$8.3 billion

6

Wells Fargo Securities (part of Wells Fargo (NYSE: WFC))

$6.7 billion

...

...

...

9

Goldman Sachs (NYSE: GS)

$6.1 billion

Source: Credit Suisse.

If regulators and prosecutors are consistent (a brave assumption, perhaps), we should expect more charges and/or investigations -- it's difficult to imagine that Goldman and Morgan Stanley did business in a manner that was significantly different from their competitors.

A perfunctory investigation
Although this isn't good news for Morgan Stanley, I think an investigation of this type is almost a formality at this stage. For federal prosecutors, it's a matter of looking busy and making sure they don't appear to be losing a step to the SEC. There is a wide gap between conducting an investigation and filing criminal charges -- one that I highly doubt prosecutors will cross.

How things will play out
These are my predictions:

  1. Federal prosecutors will ultimately drop their investigations of Goldman Sachs and Morgan Stanley.
  1. The SEC's accusations against Goldman Sachs may play well in the court of public opinion, but legally, their case is extremely weak. SEC lawyers won't come anywhere near a courtroom to argue the (de)merits of the case; instead, Goldman will settle the suit and pay a fine (in fact, preliminary discussions have already begun, although the two sides are reported to be "far apart"). That outcome will be strongly suggestive that the SEC's decision to announce the charges publicly before offering Goldman the opportunity to enter into settlement talks (the standard procedure) was based on public relations calculus that had nothing to do with protecting investors' interests.

Investors: Keep your eye on lawmakers
If I'm correct, pragmatic bank share investors should be focusing on a different constituency, as a multiplication of investigations simultaneously puts pressure on and gives leverage to lawmakers to pass "tough" banking reform measures -- a much greater potential threat to banks' long-term profitability.

The credit crisis has turned the investing landscape upside down, with advanced economies' balance sheets now looking more like that of a banana republic. In that context, Tim Hanson explains how to make more in 2010.

Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.