Even the mighty are falling. The last two major independent investment banks on Wall Street, Goldman Sachs (GS) and Morgan Stanley (MS), have received permission from the Federal Reserve to convert from traditional investment banks into commercial banks or bank holding companies. Plenty of ink, digital or otherwise, has been spilled about the disappearance of investment banks so I won’t dwell much on that. We’ve seen the collapse of Lehman Brothers (LEH) and Bear Stearns. Still somehow, I’m sure there were some who sentimentally held out hope that the two shiniest of white shoe firms in investment banking would survive relatively unchanged. Disappointingly, Goldman Sachs and Morgan Stanley will now join the ranks of Bank of America (BAC) and Wachovia (WB) as large commercial money center banks serving the retail masses.

It remains to be seen what will happen to the investment banking businesses of Goldman and Morgan. Other commercial money center banks like Bank of America and Citigroup (C) have been able to operate smaller investment banking divisions within the corporate umbrella. While the market is caught up in short-term financial myopia (worthwhile because some fear a total meltdown), I’m more interested in the long term strategic implications.

Survival – It is clear that the decision to convert to a commercial bank was spurred in part by a need to raise capital and survive. Becoming commercial banks allows Goldman and Morgan to tap the emergency funds that the Fed has made available. Goldman has also reached an agreement to secure private funding as well from Warren Buffett, the head honcho at Berkshire Hathaway (BRK-A). Morgan has agreed to sell a piece of itself to Mitsubishi UFJ Financial Group (MTU), in a move reminiscent of the Japanese shopping spree of the 1980s. In the panicked rush to shore up our faltering financial system and institutions, have we given enough thought to these combinations and their future implications?

Initial Public Offerings – Goldman Sachs and Morgan Stanley consistently topped the league tables as the best bulge bracket firms with the power and reach to handle large IPOs. No one is thinking of going public in this market environment but there will come a time when all is right again and innovative businesses will want to go public. Who will be there to sell the hype and coordinate the logistics?

Pure Investment Banks – Will there be a changing of the guard? The investment banking divisions within commercial bank holding companies have never been able to win more business than the Goldmans and Morgans and Lehmans that focused deeply on investment banking and merchant banking. Is it reasonable to assume that Goldman and Morgan will maintain their dominance of investment banking while converting into commercial banks? I think there is merit in the focus of pure investment banking. It will be interesting to watch if other players like Jefferies Group (JEF), Greenhill & Company (GHL), and Stifel Financial (SF) can aggressively move to fill the void. I think these stocks will perform well over the long term as they jockey to become the next white shoe firm (so long as they haven’t gotten involved with all the toxic financial instruments floating out there).

Talent Exodus – Look to the Yahoo! (YHOO) saga to see that Talent (with a capital T) goes where the opportunity is best and where it can operate with the least restraint. Goldman and Morgan will see their cream of the crop flee to hedge funds or the remaining smaller, albeit pure play, investment banks to ply their trade. Goldman’s proprietary traders generated a majority of the firm’s profits so I expect those guys will find happy homes at hedge funds. Why would any truly good trader want to be a part of Goldman Sachs now? On the other hand, I’ve rarely seen a guy from the sell side of investment banking be able to withstand the ruthless performance pressures of the buy side though so I expect there will be a ton of unemployed investment bankers. My how MBA programs will be flooded with applications. Brush up on those GMATs cause you’re going to be competing against a horde of former ibankers. Why would any truly good trader want to be a part of Goldman Sachs now?

There is a lot of knee-jerk anger and many hyperventilating voices calling for change and placing blame on government, government officials, greedy business executives, mindless consumers, etc. I’m over that already, in fact, I’ve never been there in the first place. I’m only interested in profiting from what the future will bring and what we can learn from history. In that light, let me end by quoting one of the great Founding Fathers.

“All human situations have their inconveniences. We feel those of the present but neither see nor feel those of the future; and hence we often make troublesome changes without amendment, and frequently for the worse.” – Benjamin Franklin (1706 – 1790)

Patents are notoriously difficult to value but it is clear that patents are becoming a viable asset class in themselves. Taking the cue from many other asset classes, could there be a way to “securitize” a portfolio of assets? This could be a fun and challenging opportunity to address. One approach is Nathan Myhrvold’s Intellectual Ventures, a “venture fund” that invests in patents by acquiring those invented by others and developing some internally. There are many in the technology industry who fear Intellectual Ventures will evolve into the best funded and organized patent troll.

Below is an essay I wrote for an investment newsletter published in February 2007 distributed to high net worth clients.

Patent Bridge is Falling Down

Horror of horrors! We almost lost service for our Blackberry communication devices early last year. Also known as Crackberries for their users’ incessant finger-pounding of emails during company meetings, on the subway, and even on vacations, a patent infringement lawsuit filed against parent company Research In Motion (RIMM), threatened to sever the umbilical cord between the gadgets and their addicted users. NTP, Inc., a patent holding company, claimed that RIM infringed NTP’s wireless email patents. Legions of squinty-eyed telecommuters were relieved when RIM finally settled with NTP by paying an extortionary sum of over $600 million.

The Blackberry episode underscores the growing importance of an emergent business model. Disdainfully described as “patent trolls” by detractors, patent holding companies assemble portfolios of patents and wait for other companies to develop infringing products. Profits are then won in the courts and not in the arena of market competition. This form of intellectual blackmail has the potential of drastically altering the economic landscape and the development of innovative new products.

Innovation is the Holy Grail. Harvard Business School professor Clayton Christensen assured us of that universal truth with the publication of a couple of business bestsellers. Large corporations pursue innovation with a newfound zealousness. However, the editors of this publication submit that the innovator’s dilemma is no longer about large corporations’ inability to recognize and take advantage of disruptive technology; it is now about navigating the field of patent landmines.

Who takes the risk? Innovation is inherently a risky endeavor. Impactful advances in technology seldom occur at low cost. Invention, experimentation, testing, and prototyping can require large sums of capital. Furthermore, product evangelism often dwarfs the cost of research and development. Thus, the founding fathers created a patent system to reward the risk taker and incentivize risky behavior resulting in benefits to society in the form of improved goods. They must now be spinning in their graves. Patent trolls are, in essence, excellent risk arbitrageurs, because they have found a way to extract profit without undertaking the bulk of the risk. In the case of NTP v. RIM, although Research In Motion incurred the cost of developing the Blackberry device and bringing it to market, the patent troll almost succeeded in removing a winning product from the marketplace. Who loses? Ultimately, the consumer.

How does one spot a patent troll? Like the monsters of childhood tales, they hide and wait under a bridge until someone attempts to cross. Trolls then exact a toll from the weary traveler for use of the bridge. Only in the real world, the bridge or asset was built or developed by the traveler! Patent trolls are, in the words of the legal cognoscenti, “nonpracticing” patent holders. They have no intention of ever developing and commercializing their patents.

“But we are all patent trolls!” Panglossian defenders of the current patent system point to the huge patent portfolios of large corporations like General Electric (GE), International Business Machines (IBM), Intel Corporation (INTC), and even mundane consumer goods powerhouse Procter & Gamble (PG). In this world of limited resources and talent scarcity, even the most imposing corporate behemoths can ill afford to commercialize all their patents. Yet when the blue chips’ patents are infringed, they pursue legal recourse as vigorously as any litigant. Defenders of the status quo place the burden of diligence on manufacturers. All who aspire to make the next iPod (AAPL), Blackberry, Viagra (PFE), or toaster oven must search the United States Patent and Trademark Office archives for all prior art – just as it has always worked for the last two centuries. They have a point. If manufacturers are not thorough with their homework, why shouldn’t they be sued?

The problem is not whether large or small inventors are practicing or not. The editors submit that the problem is what we call the Goldilocks Paradox. Currently, too many overly broad patents are being awarded. When that occurs, it becomes very difficult to innovate around such widely defined intellectual property. When patents are too narrowly defined, it becomes very easy for competition to design around them.

“Yum yum, these patents are not too broad and not too narrow, they’re just right!” To get to this happy equilibrium, we humbly suggest a remedy. To curb trolling behavior, set a time horizon for making infringement claims. The deliberate strategy employed by patent trolls of waiting for another company to develop a market for a product to then sue for damages is diametrically opposite of the approach taken by most large corporations armed to the teeth with attorneys. After a certain amount of time, claims will either have no merit or will win reduced compensation. We believe this would put a significant chill on trolling behavior and allow everyone to get on with the business of making our lives better.

For all the Blackberry users out there, cling tightly to your beloved devices. On May 1, 2006, Research In Motion was sued by another patent troll, Visto. Ah, as Candide implied, “All is for the best in this, the best of all possible worlds.”