The current economic crisis has changed the face of Wall Street, possibly forever. For decades the energy in the market had been driven by senior investment bankers, but look at 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 were none.
At the beginning of this year, those five companies had a combined market value of about $ 250 billion and the leading company, 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 figure that has been reduced by a factor of 20.
Essentially, the global economic crisis has ushered in the age of universal banking, in which massive financial firms offer every conceivable type of investment product and service. Even the smallest brokerage firms face being bundled under the umbrella of the big banks, or else they risk becoming irrelevant.
Historic realignment of the industry
When Goldman Sachs and Morgan Stanley opted 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? Partly because both firms have access to the Federal Reserve’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 access deposits from retail clients. The two firms had already received a temporary financial lifeline from the Fed, the Credit Line for Primary Distributors, 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 flexible supervision by the Securities and Exchange Commission, they now face stricter 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 for the events that led to their downfall.
Independent investment banks have been around for a long time, but originally they were small private associations that made most of their money offering corporate investment and financial advice, as well as some brokerage and other services. If I 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 the trust generated through long-term relationships. There was not much money at risk in the early days because the companies operated mainly with the partners’ own money. That meant there were no large sums available to bet on risky companies with excessive leverage. But the lack of working capital and the desire to organize more flashy deals motivated 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 to place bigger and riskier capital bets; more recently, toxic and troubled mortgage-backed securities.
The regulations that had once separated investment banks from traditional banks were no longer in effect. 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 companies to expand their services, use more leverage and take even greater risks.
When those risks paid off, traders were rewarded with outrageous bonuses and the wheels for increased risk-taking were turned on. Add spotty 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 operated under far less strict regulations than banks.
It wasn’t until the financial crisis reared its ugly head in mid-2008 that the US Fed 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 companies like Bear Stearns and Goldman Sachs found themselves in even more serious trouble. They had already suffered huge losses with their hedge funds and hedge funds, but their excessive leverage compounded their problems as the credit crisis robbed them of the ability to raise the additional capital they needed to survive.
The Wall Street perspective
What’s the outlook for those who work on Wall Street now? To be sure, there will be less excitement and no more of the huge bonuses negotiators have grown accustomed to. But there are greater concerns about whether the United States will lose its competitive advantage and the ability to maintain its power status in the global financial system.
Some of the best and brightest could bet and seek better opportunities in burgeoning Asian markets, or they could move onto the unregulated hedge fund market, at least as long as those funds survive. Thousands of Hedge Funds are failing, causing serious problems for investors such as the huge public pension funds, foundations and endowments that have invested billions of dollars in these private associations.
If there is any good news in this economic fiasco, it is this: Main Street will eventually benefit from better regulated Wall Street. With a more transparent financial system, a stronger foundation, and a stronger business model, there could be a promising outlook for more stable and consistent growth.