Days of Reckoning For Goldman and Morgan

By Cyrus Sanati, contributor

FORTUNE -- Goldman Sachs and Morgan Stanley are facing headwinds like never before. The two financial firms are widely expected to post weak third quarter earnings in the coming days thanks to the spooked capital markets and sour trading environment. Analysts at Citigroup now predict Goldman will report a loss for the quarter -- it would be only its second quarter in the red since becoming a public company.

But the third quarter should be the least of their worries. New regulations are set to roll out in the coming months that threaten to kill off a large chunk of their profits -- most notably, the controversial Volcker Rule. While the specifics of the Volcker Rule are still being debated, the long-term impact on the firms' bottom line could be quite damaging. If the banks fail to engineer satisfactory loopholes to protect their profitable broker-dealer operations, they will then face a daunting choice – to be or not to be a bank holding company.

The first draft of the proposed Volcker Rule was released to the public on Tuesday. At 298 pages, the draft rule is full of questions and comments regarding one of the most esoteric corners of Wall Street.

The Volcker Rule was proposed by President Obama in 2009 as a way of mitigating risk in the financial system. The rule, which was folded into the Dodd-Frank financial regulatory bill, would limit a bank's ability to trade and invest its own capital in an effort to shield their depositors from potentially large trading losses. Banks would be barred from owning and investing in private equity and hedge funds and would be forced to curtail many of their broker-dealer operations.

The implications are significant for the large banks. The rule forces them to shut down a variety of high margin profit centers and focus on safer, lower margin businesses. It would also bar them from engaging in trading schemes that would be considered to be a "material conflict of interest," between the bank and its customers, effectively ending the banks' ability to front run or bet against their client's orders. While core investment banking operations, like deal-making and taking companies public, would be spared, anything in the trading realm could be up for elimination.

The original rule made exceptions that allowed banks to keep their market-making activities in order to help their clients hedge their positions and maintain liquidity in the markets. But to engage in market-making, a bank must take on a certain amount of risk by buying up and selling securities. Many fear that the banks will just lump all their proprietary trading activities under the market-making exception to allow business to go on as normal.

But the government is well aware of that risk and appears to be taking it very seriously. In fact, the majority of the draft is spent on this very topic. One proposed rule would force the banks to report any trading plan used for market making activities. It would require the banks to prove that they were not engaging in a short-term resale of a security and also prove that they were not benefitting from any actual or short-term price movements through trading arbitrage or hedging.

It would then all come down to enforcement. The regulators don't have to catch every prop trade disguised as a market-making trade. Hefty fines for just a few violations will eventually squeeze the profit margin of the business, forcing the firms to eventually comply with the spirit of the law.

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Discussion of the Volcker Rule couldn't have come at a worse time for the banks. High margin capital markets activity at the big U.S. banks has hit a snag amid uncertainty in the world economy. The amount of money raised in IPOs in the third quarter globally was down 49% from the same time last year, while the number of mergers and acquisitions announced globally were down 19%. Global investment banking revenue is expected to fall 37% in the third quarter compared with the previous quarter, according to Dealogic.

It wasn't much better on the trading side of the business. While trading velocity was strong in the third quarter due to all the volatility in the markets, much of the flow seem to be coming from lower-margin electronic trading activity. The once lucrative high yield market went virtually silent as investors shied away from risky credit instruments. Activity in that market was down 75% in the third quarter compared with the previous quarter. Meanwhile, wide spreads and incongruent pricing in the rest of the credit markets led to many banks to take negative inventory marks, which will most likely outweigh broker commissions.

All this bad news is expected to weigh heavily on bank earnings. Analysts have slashed their estimates in preparation for the weak numbers, dragging down the share prices at all the major banks. But this short-term blip in profits pales in comparison to what could happen to the banks' bottom line if the Volcker Rule is fully enforced by the government. While all the major banks will be hit hard, the two investment-banks-turned-bank-holding-companies, Goldman Sachs (GS) and Morgan Stanley (MS), are expected to experience the most pain.

Goldman could see 14% of its total investment banking revenue impacted if the government focuses solely on trades that are proprietary in nature, according to an analysis by JP Morgan (JPM). But if the government clamps down hard on market making as well, that number jumps to 52%.  Morgan Stanley's bottom line would also be eviscerated, with 40% of its investment banking revenue impacted by a strong Volcker Rule.

Both banks have taken steps to close business units that are clearly proprietary in nature. Goldman shuttered several of its prop desks in 2009 and 2010 and is currently winding down its once high-flying Global Alpha hedge fund. Morgan Stanley closed most of its prop trading units after experiencing heavy losses as a result of the mortgage meltdown in 2008. But neither has taken steps to seriously prepare for a strong Volcker Rule where their market-making activities could be seriously impacted. It was always assumed that the government would go easy on them in that regard.

Bank holding companies

But with the draft rule clearly focused on market-making, the banks may need to rethink their strategy. A strong Volcker Rule would clearly be unacceptable to both banks given how important the broker dealer operations are to their bottom lines. That's because they are really not traditional banks. In 2008, the two became bank holding companies so they could have access to the government's bailout programs. The money market and overnight repo funding markets dried up and they needed access to cheap government funds through the discount window in order to resolve what could have been an insolvency crisis. In return, they basically agreed to become boring commercial banks, which would open them up to more regulatory oversight.

Two years later, little has changed for the firms. Goldman and Morgan may be bank holding companies, but it's really in name only. For example, there aren't any Goldman Sachs retail bank branches or ATMs around town and there are no Morgan Stanley debit cards in sight. The firms receive just 10% of their funding needs through customer deposits. That's in contrast to the large commercial banks, like JP Morgan, Bank of America (BAC) and Citigroup (C), which derive around half of their funding needs from deposits.

The Volcker Rule is aimed at the commercial banks, not the broker dealers. Pure play broker dealers and non-bank affiliates appear to be exempt from Volcker and can trade as they like without much government interference. There would be very little switching costs for Goldman and Morgan to go back to being broker dealers. Goldman has said publicly it would not give up its bank charter, but internally there have been discussions about doing just that, according to a person familiar with the firm's thinking. The question is: what's holding them back?

It all comes down to perception. The firms may be afraid to give up cheap funding from the government at a time of severe market stress. The government lifeline allows them to borrow whatever they want, whenever they want it, and in relative secrecy. Pure-play broker dealers are dependent on the fickle money markets to fund their trading activities and don't have access to that government backstop -- a dangerous game in today's volatile markets.

Goldman and Morgan have had two years to figure out what they want to be in the post-financial crisis world. If they want to be banks, they should accept that the government will no longer be backstopping them while they gamble for their own account. If they want to make big trading profits, then they should accept all the risks that go along with that proposal and give up the government lifeline. For now, the firms are hoping to have their cake and eat it too. But a strong Volcker Rule just might take the cake away.

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