Wall Street Melts Down: The End of an Era
Each had its own particular business model and culture. However, with the advent of deregulation, an equity research scandal, and advances in technology, the traditional Wall Street business of underwriting securities, producing research and trading stocks for customers had come under a major attack and no longer produced significant income for the firms. Instead, securitization (and in particular home mortgage securitization), credit derivatives trading, and increased proprietary trading had taken up the slack to enhance earnings streams. In my day, the rest of the Street liked to accuse Salomon Brothers of being a big hedge fund, but by now everyone knew that type of risk taking was integral to Goldman Sachs’ handsome profitability. In fact, it was widely reported that Merrill’s then CEO, Stanley O’Neill, desperately wanted to emulate Goldman’s trading success.
As such, Merrill and others plowed headlong into a new area of structured finance known as Collateralized Debt Obligations (“CDOs”). CDOs had been around for a while and were not particularly sexy, but one day someone realized that very attractive expected returns could be manufactured from an underlying pool of securities tied solely to sub-prime mortgage securities. In fact, the securities looked so safe and attractive that the blue chip bond rating agencies, such as Moody’s and Standard and Poor’s, blessed them with AAA ratings. Wall Street issued nearly $2 trillion sub-prime CDOs, but then it ran into a problem when investors would not buy all the parts of a given issue.
As the overall profitability was so extreme, the Wall Street firms were happy to “park” these securities on their balance sheets in the expectation of eventually selling them. And even better, in many cases they found that they could convince municipal bond insurers such as MBIA, AMBAC, FGIC, and even insurance giant AIG to write credit default swaps (“CDs”) on the their CDOs to fully protect (or “lock-in”) their profits. Hence, the fat profits were booked and Wall Street was reporting record earnings.
Unfortunately, the basic assumption behind the valuation of these securities was that US residential real estate was not likely to fall in price in the future and if it did, then not very sharply.
Sure enough, just as sub-prime mortgage issuance was reaching its peak in 2006-2007, prices began to weaken and in some overheated markets like Las Vegas and Miami prices have already fallen more than 30%. As a result, these sub-prime mortgage CDOs have declined sharply in value and started a wave of Wall Street write downs now totaling $500 billion. As a result of declining mortgage bond and CDOs prices, in March of this year, on a Sunday night, Bear Stearns was faced with filing for bankruptcy or accepting a $2 a share takeover offer from JP Morgan. In the following months it was rumored that Lehman Brothers and Merrill Lynch were the next to fail and on Monday, September 15th, Lehman filed for bankruptcy while Merrill rushed into the arms of Bank of America at a 75% discount to its 2007 high stock price in order to ensure its survival. Two more bulge bracket investment banks were gone.
As I watched the shares of the two surviving bulge bracket firms of Goldman and Morgan Stanley plummet in price last week, in spite of both having reported better than expected earnings on decreased CDO write down activity, I recall thinking that the market was just plain wrong on this one, as both firms were well capitalized in ways that Bears Stearns and Lehman could have only imagined.
But, then I read the Bloomberg headline that the Federal Reserve had approved extending bank charters to the two firms. In effect, the Glass-Steagall Act had been vacated and the 80-year era of independent Wall Street investment banks was over. In effect, what the Federal Reserve was telling Goldman and Morgan Stanley, was that in order to survive in their current form with trillion dollar balance sheets and exposure to hundreds of thousands of complex derivative contracts, the companies will need permanent access to the “lender of last resort” (the Federal Reserve) and, as such, will need to come under its regulatory auspices as universal banks.
Thus, whether Goldman or Morgan Stanley ever take a single bank deposit from John Q. Public, they will be subject to the Federal Reserve’s regulation and oversight. Let me assure the reader that based on my own experience with a Federal Reserve examination of my trading books in Tokyo, the Fed is very rigorous and understands risk in a way that other Wall Street regulators have failed to do.
The good news is that for now we can be assured that Wall Street balance sheets will not spiral out of control until the next set of arcane securities are invented in five or ten years time.
The sad news for those of us who are nostalgic is that Wall Street will never quite have that same old swagger I first observed on campus in 1986.
The new uptight, commercial bank-centric Wall Street will have to go back to doing business in the way that the actor John Houseman described in the famous ad campaign for Smith Barney: “We make money the old-fashioned way. We earn it.”
The new financial powers-that-be might as well try that approach, since the system in place certainly was not working.
My eyeballs are bleeding, but I made it through to the end. Thanks for the useful history lesson. Perhaps Wall Street could take up selling Amway products.
My eyeballs are bleeding, indeed.
I don’t have the benefit of a “Business School” education, however even the dimmest of us should know you cannot continue to create wealth from thin air. This is called building a pyramid upside down. Sooner or later, someone has to actually make something tangible (widgets?), that can be sold to another someone in the market place looking for bigger and better widgets. It’s called supply and demand, which is the principal which drive capitalist economies.
The smoke and mirrors game has built a house of cards, nothing of substance there. Why are we surprised it is all falling apart now?
What I would like to see is some hard accountability. The Barney Frank’s, the Chris Dodd’s,,, and the Obama’s, who have profited from this scheme should be prosecuted for their criminal complicity. The rules and regulations were put into place to prevent a crisis exactly like this. To prevent another 1929′ish crash. The Democrat leadership starting with Jimmy Carter are up to their eyeballs in dirty money. Of course, all of this is now being trotted out to make G.W. Bush and all Republicans look like incompetent ninnies.
Where are all the Special Prosecutor’s with their armies of accountants to follow the money trail? I suspect at the end of every rainbow they would find a Democrat with his hands in the “Pot ‘o Gold” up to his elbows.
Bad people need to go to jail over this. Pure and simple.
You make it sound like there’s no room for brash new cowboys to ride in and replace the dying breed. But why must that be so? Trading and taking risk will be legal for Joe Citizen, I assume, and there must be some willing to jump into the game while there’s a vacuum. Never say never!
As far as this Main Street guy is concerned, if you make bet that goes bust, you suck it up. These guys got wealthy by not creating wealth but convincing others that what they did somehow was value-added. Tough, but now we get to stablize your gambling losses. Good riddance to bad rubbish.
As they say on the Street, pigs get fat and hogs get slaughtered.
I dunno,,, I got some money by working my a** off. Why should I stand still and get raped by a slick politician? Obama wants to “tax the rich” and give it to the poor. I already pay 35+%, plus self employment tax,,, is that not enough? Should I just roll over and give my business away?
Where do I sign up for welfare?
Recently learned what GSE and MBS are and now they just about dissolved in the thin air of high finance. I attended a shareholders meeting in April. The CEO said the bank wrote off 25m worth of MBS in GSE. Bank still profitable but dividend less and stock price remain low or stagnant but better than Wachovia and on par with Citi.
Thanks for the history lesson of your life in high finance.
They may have lost their swagger, but I’ll bet a bunch have their ill gotten swag.
John: That’s my concern. Theese SOB’s have their $45m pads in Manhatten and all we get is the lousy paper they shilled.
Sorry but the loss of the swagger is due to the all to obvious and painful revelation that for all their top 5 business school talent, the so called masters of the universe didn’t have the financial acumen of my grandmother with her 5th grade education. Grounded in a bit of reality, she understood that the ability to repay was an, or rather the, important factor in borrower.
Now we all have to pay for the fact that brilliant education from a top school only permits you to fool yourself in much grander ways.
If Wall Streeters want to swagger they should, well you know, not let their new and improved methods reveal them as such utter and complete fools when the lies start to collapse.