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.