This was a neat move by the Fed. But in order to make sense of this and what it means, it is important to understand the current business model of Goldman Sachs and how it got here.
Originally, Investment Banks such as GS had a simple purpose - they helped companies sell their stock to the public. In return for a fee, they brought sellers and buyers of new issues together. They provided independent estimates of the price of new securities. After the stock was issued, they helped make a market for that security.
This business model was fee based. The company issued no debt and held no assets. Things were simple.
Then they got greedy.
First, they noticed that some of the stocks they were helping to place rose sharply in value in the secondary market. We all saw that in extreme form during the dot com boom, but this was going on even in the early 1980s.
So, GS started wondering - why can't I keep some of the stock for myself? I can then sell it in the secondary market and make a killing.
But there was a snag: in order to actually buy and hold a stock, one needs capital. As an investment banker, GS needed no capital (nothing much anyway). But if they wanted to own some of the stuff they were selling, they needed capital to fund the purchase.
As a partnership, raising capital meant the partners had to pony up their personal money. Or they could do what every other american does - borrow it.
Which they did. In spades.
For every dollar of capital supporting the firm, they borrowed over 30 dollars. In marketspeak, they were levered 30:1. They then invested this in anything and everything. Real estate. Mortgage Backed Securities. Private Equity. Hedge Funds.
The 'Prop Desk' was born.
A normal commercial bank could not do this. They were regulated tightly and had very strong capital requirements - with a required capital ratio of at least 6% the maximum leverage they could take on was only 16%. A good commercial bank is expected to have 1 dollar of capital supporting 12 dollars of assets.
With Investment Banks, the sky was the limit. Being completely unregulated, they had no qualms about borrowing more and more and using that to buy riskier assets. As long as the market was willing to lend them money at low interest rates, they could lever up and make enormous profits.
Then came 2007.
People started defaulting on mortgages. The market started to see losses creep up on tranches of debt that they never thought likely. Investment Banks, such as Bear Stearns who were buying this stuff like crazy for their prop desks suddenly started reporting losses.
If you are levered 2:1, you can support 50% losses before your capital is all gone. When you are levered 30:1, it only takes a 3% loss to wipe out the shareholder and shut the firm down.
The other problem for the Investment Banks was their funding model (or more precisely the pattern of their borrowing). They borrowed short (ie for 2 years, for example) and lent long (bought a mortgage security with a 10 year maturity) and kept pocketing the difference.
But GS' (and Lehman and Bear ...) lenders were a skittish lot. As they started to see losses eat deep into the equity capital, they stopped funding for the short term.
The mad scramble for capital started. We all know how it turned out. Bear was burned, Lehman followed suitand an unlikely player - AIG - had made similar bets and collapsed.
Banks, meanwhile were thanking their lucky stars that they were so tightly regulated. Their capital came from depositors who were insured by the FDIC and therefore unlikely to disappear at the first sign of trouble. But the quid pro quo for that insurance was very tight regulation.
Now we bring it all together.
GS needs funding. Its traditional sources of funding have dried up. Without that funding, GS will die.
Becoming a bank enables GS (and Morgan Stanley) to tap into the rich source of deposits insured by the FDIC. But as a bank, they cannot hold a 30:1 leverge.
So, they become bank holding companies.
The immediate result of this is to allow them to accept deposits -that precious source of uncomplaining funding.
Now, the crucial question is this: how soon do they have to delever? Will the market give them time?
But this move by the Fed buys them time from being on the chopping block. This allows them to explore buying a bank with a solid balance sheet and then delevering over time.
Look for relatively strong players like KeyBank or National City become immediate takeover targets.
In the meantime, they are probably off the deathwatch.