Investment banking and the future of Wall Street
The current economic crisis has changed the face of Wall Street, possibly forever. For decades the energy in the market had been fueled by high-end investment bankers, but look what happened in the last eight months. Lehman Brothers went bankrupt. Bear Stearns was bought by JPMorgan Chase, Merrill Lynch was bought by Bank of America, and Goldman Sachs and Morgan Stanley had to become bank holding companies just to stay in business. Five big investment banks. . .And then there was none.
Earlier this year, those five companies had a combined market value of about $250 billion with the parent firm, Goldman Sachs, valued at nearly $90 billion. Now the major banks, which are comparatively small boutique firms (Raymond James, Jefferies & Co, Greenhill & Co, Keefe Bruyette & Woods, and Piper Jaffray) have a combined market value of $12 billion, a number that has dropped by a factor of 20.
Essentially, the global economic crisis has ushered in the age of universal banking in which big financial firms offer every type of investment product and service imaginable. Even the smallest brokerage firms face being cornered under the umbrellas of the big banks, or risk becoming irrelevant.
Historic Industry Realignment
When Goldman Sachs and Morgan Stanley chose to become bank holding companies, it marked a historic realignment of the financial services industry and the end of a securities firm model that had prevailed on Wall Street since the Great Depression. But why did they make the change? In part because it has given both companies access to the Fed’s discount window, the same line of credit that is open to other depository institutions at a lower interest rate.
As bank holding companies, they can also tap into deposits from retail customers. The two firms had already received a temporary financial lifeline from the Fed, the Senior Dealers Credit Facility, the special reserves set up to bail out Wall Street stockbrokers like the Bear Stearns deal in March 2008.
Although Goldman Sachs and Morgan Stanley are now classified as bank holding companies and are part of the universal banking model, they will still be able to engage in investment banking activities. But after years of lax oversight by the Securities and Exchange Commission, they now face tougher regulations imposed by the Federal Reserve and are subject to oversight by the Federal Deposit Insurance Corporation.
The golden years of investment banking
A quick historical review of investment banks will serve as a backdrop to the events that led to their downfall.
Independent investment banks have been around for a long time, but they were originally small private companies that made most of their money by offering corporate finance and investment advice, as well as some brokerage and other services. If you had walked into one of their offices and looked around, you might have mistaken it for a large law firm.
The success of their business model depended on trust built through long-term relationships. There wasn’t a lot of money at risk in the early days because the companies operated mostly with the partners’ own money. That meant there were no large sums available to bet on risky companies with excessive leverage. But a lack of working capital and a desire to orchestrate more ostentatious deals prompted the companies to go public in the late 1990s.
the fall begins
With more capital in the coffers and increasing access to low-cost, short-term debt, managers began making bigger and riskier capital bets, most recently on troublesome and toxic mortgage-backed securities.
The regulations that once separated investment banks from traditional banks no longer existed. That paved the way for big global banks like Citigroup and JP Morgan to start competing with Wall Street for what had traditionally been the domain of the investment banking business. This forced Wall Street firms to expand their services, use more leverage and take on even greater risks.
When those risks paid off, traders were rewarded with extravagant bonuses and the wheels turned for greater risk taking. Add erratic government regulation to the mix and you have, as the saying goes, a recipe for disaster.
Before long, the major Wall Street firms were three to four times more leveraged than conventional banks, but still operating under far less stringent regulations than banks.
It wasn’t until the financial crisis reared its ugly head in mid-2008 that the US Federal Reserve stepped in and, for the first time, allowed investment banks to access its funds at a discount. Then, when the credit crunch hit, highly leveraged Wall Street firms like Bear Stearns and Goldman Sachs found themselves in even deeper trouble. They had already suffered huge losses with their hedge funds and subprime companies, but their excessive leverage compounded their problems when the credit crunch robbed them of the ability to raise the additional capital they needed to survive.
Wall Street prospects
What is the outlook for those who work on Wall Street now? There will certainly be less excitement and no more of the huge bonuses that traders have become accustomed to. But there are bigger concerns about whether the US will lose its competitive edge and ability to maintain its power status in the global financial system.
Some of the best and brightest could back off and look for better opportunities in burgeoning Asian markets, or move into the unregulated hedge fund market, at least as long as those funds survive. Thousands of hedge funds are closing, raising serious complaints from investors like the huge public pension funds, foundations and endowments that have invested billions of dollars in these private companies.
If there is any good news in this economic fiasco, it is this: Main Street will eventually benefit from a better regulated Wall Street. With a more transparent financial system, a firmer foundation and a stronger business model, there could be a promising outlook for more stable and consistent growth.