Melloy - Behind The Money

John Melloy, Executive Producer, Fast Money

Goldman Sachs and Morgan Stanley may shed the ‘bank holding company’ classification, which made them eligible for emergency Fed lending during the financial crisis, in order to skirt the Volker rule banning propriety trading with the firm’s own capital, according to Susquehanna Financial Group analyst David Hilder.

“The regulators have proposed a massive new compliance burden on banks to prove that their market-making activities are just that and not proprietary trading in disguise,” wrote Hilder in a note to clients. “There will be large additional costs imposed on banks as market-makers that will not apply to market-makers not owned by banks. We would expect that to draw capital to non-bank market-makers, and cause Goldman Sachs and Morgan Stanley to examine whether it makes sense for them to exit the banking system.”

The Dodd-Frank act provision named for former Fed Chief Paul Volker was released Tuesday in a rather lengthy form by the Fed and the FDIC for public comment. Comments can be submitted until January.

“Only in Washington could a simple idea - ban banks that accept insured deposits from short term trading for their own account - become a proposal that runs to 298 pages and asks for comments on 394 specific questions,” wrote Hilder. “We would add to positions in positive-rated names that could potentially exit the banking system, GS and MS.”

This exit may draw the ire of everyone from legislators to the Occupy Wall Street crowd as Goldman and Morgan Stanley changed their status during the height of the financial crisis following the collapse of Lehman Brothers in Sept. 2008 in order to get access to emergency funds not provided for non-commercial banks.

The Fed rushed through these applications on a Sunday, saying in a statement that in order “to provide increased liquidity support to these firms as they transition to managing their funding within a bank holding company structure, the Federal Reserve Board authorized the Federal Reserve Bank of New York to extend credit to the U.S. broker-dealer subsidiaries of Goldman Sachs and Morgan Stanley against all types of collateral that may be pledged at the Federal Reserve's primary credit facility for depository institutions or at the existing Primary Dealer Credit Facility.”

The Volker rule gained popularity as many critics of the banks believe that the monster, levered proprietary trading done by these institutions helped exasperate the crisis and worked against their clients’ best interest.

Goldman and Morgan Stanley are set to report earnings next week and according to analysts the lack of profitable trading will weigh heavily on these results.

“Given third quarter weakness across trading and investment banking that extended through the end of September, further equity market declines and wider credit spreads we reduce our GS EPS estimate from a 10-cent gain to a 65-cent loss,” wrote Citigroup’s Keith Horowitz on Monday.

The analyst went on to cite “regulatory risk” as one of the factors that could derail a comeback by the shares.

“Goldman operates several businesses including financial and physical commodity trading, private equity or derivatives that could face greater regulation, or in a severe case, require Goldman to divest some business units,” the analyst said.