Yesterday two major investment banks suffered a steep fall in their share prices following a continuing slump in investor confidence. To survive, banks need to raise a large amount of cash, something that is extremely challenging at present due to the credit crunch – no-one is prepared to lend money to troubled institutions.

The problem with Goldmans took most by surprise as its trading results have been strong. However rumours about Morgan Stanley’s large bad loan portfolio have been circulating for a while.

The two banks are the only remaining institutions that focus entirely in the investement banking business, with currently no involvement in commercial (retail) banking.

Separation of investment and commercial banking: In the 1930s, the Glass-Seagall act was passed in the USA which separated commercial banks (which take deposits and make loans), from investment banks (which trade securities). The investment banks were allowed to do business with less oversight, while commercial banks were tightly regulated. This law was repealed in 1999, and as the result commercial and investment banks started merging their operations.

Cause of the Credit crunch: It’s a simplified story, but here goes: Increased competition between banks in the last 10 years put pressure on profit margins and forced investment banks to start getting very creative with complex and risky financial instrument strategies. Credit derivatives were born and exploded exponentially as the major growth area in financial markets. At some stage recently they started getting packaged up into complicated bundles of credit instruments, the risk on which was incorrectly assessed by the market. When bad debts on the US mortgage market started mounting up due to customer defaults in the last couple of years, banks started seeing the complex credit instruments sitting on their books turning worthless and becoming bad debts on a major scale. As banks were all exposed and started suffering from the same problem, they all grew reluctant to lend spare cash to each other, preferring to hold onto it in case of further trouble. This effect rippled right through the system and resulted in retail banks being reluctant to lend money to customers like you and I. The Credit Crunch was born.

Morgan Stanley strategy: Both Morgan Stanley and Goldmans, and other investment banks were heavily exposed in their credit investment portfolios. As the result of yesterday’s share price falls of 24%, Morgan Stanley is now seeking a merger to secure its survival. It is now in talks with Wachovia bank and also with Chinese sovereign wealth fund – China Investment Corp (CIC). CIC already owns 9.9% Morgan Stanley. Reportedly, Morgan Stanley has $120bn of “toxic” mortgage assets on its balance sheet. A merger with a retail bank will diversify Morgan Stanley’s pure investment banking focus.

Goldmans Sachs is denying that it is looking for a merger. The FT has some good commentary about Goldman’s opportunity to consolidate its strength in the investment banking sector, if it somehow manages to raise capital and weather the storm without resorting to a merger: see link