Non-Breaking News On Tom Keene's Bloomberg Program

Sometimes I think Tom Keene purposely acts stupidly in order to make his guests feel smart. Other times, I think he really is as clueless as he periodically makes out.

Take this afternoon's closing segment on Keene's noontime program.

Keene's guest used the UBS announcement that it is simplifying its business model by shedding a few thousand investment banking employees. After a few minutes of discussion, Keene had his 'gee whiz, I'm surprised' moment regarding the rise of privately-held financial services boutiques. Then he let on that he knew Blackstone has a very healthy and large M&A advisory business.

Subsequently, the term 'brain drain' was used to describe the movement of talent from publicly-held formerly investment banks, now commercial banks (Goldman Sachs, Morgan Stanley & the IB divisions of legitimate commercial banks such as Chase, Citi and BofA/Merrill Lynch).

Except this isn't news. It's been going on for over a decade.

Ever here of a little outfit called Long Term Capital Management, Tom? That was 1998 when it imploded.

I've written a handful of posts dating back over several years observing the history of Wall Street- the real Wall Street, not the commercial money center banks outsiders incorrectly call by that term.

Hutton, Shearson, Lehman Brothers, Kidder Peabody, First Boston, Salomon, Morgan Stanley, Bear Stearns, et.al., rushed to go public in the first big hoodwink of investors back in the 1970s and '80s. I've argued that since then, investment bankers discovered how to get a one-time huge windfall for dumping risk onto public shareholders at a premium.

Some former partners hung around for the lush paychecks and options. Others quickly moved back into private partnerships. That's how Blackstone, BlackRock and other private shops were founded. Add in hedge funds for the veterans of the formerly-private firms' trading desks, and you pretty much have the recreation of the old, old Wall Street of the partnership era.

Then there's Dillon Read, which has sold itself at a market top, then gone private at the bottom, so many times that it makes your head spin.

Schwarzman's Blackstone has even initiated round two of the big bilk, selling a slice of the private equity firm a few years ago, at what astutely proved to be a market top. You gotta love these equity mavens- convincing investors to buy shares of their own firm, while forgetting they were putting themselves on the other side of the trade from the sharpest equity valuation guys around.

What passes for the public face of it has been run by mediocre talent for some time. Even Goldman let itself get tangled up in seamy, public messes rising from originating, then betting against mortgage-backed structured instruments.

Meanwhile, the new barons of the financial sector are people like BlackRock's Larry Fink, Wilbur Ross, and Blackstone's Stephen Schwarzman, along with hedge fund titans like Steve Cohen and James Simons.

How this has escaped Keene for over a decade is beyond me.

Even in commercial banking, two of the nation's largest, old money centers Citi and BofA, are headed up by inexperienced, inept seat-warmers Vik Pandit and Brian Moynihan. A failed hedge fund manager and a lawyer. Some talent, eh?

As nearly the entire publicly-held US financial sector had to be rescued in 2008, thanks to poor risk management, it should tell you where the real brains of finance were- in private practice. Where they've been moving since the first wave of mergers after the original going-public wave of the '70s and '80s.

Mike Mayo's Book & Essay In The Weekend WSJ

I read Mike Mayo's extended article/book excerpt in this past weekend's edition of the Wall Street Journal. Sad to say, I was underwhelmed.

My memory of Mayo as a capable bank analyst goes back to my days with Chase Manhattan Bank in the the early 1980s. Back when Dick Bove, Bob Albertson, Tom Brown and Sally Pope were frequently on page one of the daily American Banker.

Despite taking two pages to write it, Mayo's point boils down to one he doesn't actually state, and apparently doesn't choose to acknowledge, i.e., equity research shouldn't be housed in the same firm as underwriting or other services bought by the banks and non-bank financial firms being evaluated by the analysts.

We already learned this in the late 1900s when technology analysts fawned over the companies that their firms brought to market via IPOs. It's not a new revelation.

Mayo tells the same story over and over. How he virtuously made tough 'sell' calls, only to be reprimanded, gagged, taken aside and 'talked to,' cut off from contact with management of the firms he followed, etc.

I don't doubt that Mike made those tough calls. Somehow, I don't think he's so naive as to be ignorant of what would happen when he did. He is evidently still and MD these days, but now has slipped to being one at Credit Agricole Securities.

Perhaps he should note that Tom Brown and Meredith Whitney finally just struck out on their own. Brown runs a financial sector portfolio, and, thus, is suspect every time he opens his mouth to tout the shares his fund owns. Whitney went the pure research route, and appears to be keeping her firm afloat.

It's no secret that analysts who truly have conviction eventually want to, or ought to, run portfolios. Mayo would have been able to have achieved legendary status, according to the article, had he shorted massively in late 2007, when he went on CNBC to predict the coming financial crisis.

Of course, one problem with the transition from analyst to portfolio manager is that the former are industry-focused. So when they run sector portfolios, they necessarily are exposed to sector cycles, which I would think could make for some pretty lean times. Not to mention the tendency to hype positions which are losing money, as Tom Brown now does with sickening regularity concerning BofA.

Still, I expected more, and better, from Mike Mayo. If all he has to tell us is whining about a conflict of interest that's existed since the dawn of sell-side analysis, well, that's not news.

When Salomon Brothers Was King

I had the occasion to reread Michael Lewis' 1989 classic book about investment banking and the first mortgage crisis, Liar's Poker.

A good friend had recently finished Lewis' Moneyball, the book he wrote about baseball team managements' use of key statistics to select and pay players. Somehow we got onto the subject of his first book, and I lent him my copy.

Upon his returning it to me last Thursday, I began to selectively reread it. Not being the sort of book that I reread often, I hadn't actually opened it, to my knowledge, in 22 years. Thus, many of the passages were quite surprising.

To give some perspective regarding some of what I recalled, thanks to the aid of Lewis' book, let me recount a story from my business youth. Back when I was in Corporate Planning at Chase Manhattan Bank, troubleshooting businesses as one of a few elite internal consultants working for Gerry Weiss, I would often be immersed in a project for months. After its completion, I'd tackle the mountain of BusinessWeeks, Fortunes and Forbes magazines which were routed through the group. What I found typical at that time was that headline issues and stories, read several months later, invariably had developed almost completely opposite of the then-breaking stories. Headlines, read 3-4 months later, often seemed ridiculous.

And so it is with the recent mortgage-originated financial debacle, thanks to Lewis' book.

First, it surprised me to relearn that Lew Ranieri's mortgage research department at Salomon was novel at the time. And that, given the prepayment option embedded in every mortgage, they had been shunned by investment banks for their unreliable duration characteristic.

Second, there had been just one CMO originated and sold before the guy who actually authored the mortgage-backed origination and trading business, Bob Dall, got the green light from Gutfreund & Co. to open for business.

Third, Salomon spent large sums on lobbyists to get Congress to enact federal legislation, overriding state laws, making it legal to issue bonds collateralized by mortgages. Further, Salomon persuaded Congress to allow government-backed mortgages to be so used. This was supremely important, because with FNMA insurance, buyers were assured that defaulted mortgages would be made good by the federal government.

Reading the evolution of the mortgage-backed business, the first time, through Lewis' telling, it's stunning to recall that from 1981-86, now approaching 30 years ago, the first mortgage boom was largely missed by First Boston (where current BlackRock CEO and founder Larry Fink was merely the head of its mortgage-backed business), Morgan Stanley, Kidder Peabody, Goldman Sachs, et. al. Most of the investment banks which did play a role poached Salomon traders in the latter years of the boom.

Fourth, the sums of money then paid to rising mortgage-backed trading superstars seems laughable now. None of the original trading wunderkinds broke $1MM in compensation for their first few years.

But perhaps the most amazing piece of history is to read Lewis' description of Salomon at its peak. With (don't laugh) a huge equity base of $3B, Salomon was unrivaled among investment banks for its scale, profits and influence. In one of the latter years of its mortgage trading dominance, Salomon's mortgage business had profits which were roughly equal to the rest of Wall Street's investment banks in total!

Here's the funniest part. I mentioned that to a friend on Friday, asking him to guess how much that profit was? He guessed, of course, in the tens of billions. In fact, at the time, around 1985-86, it was about $750-800M.

Since Lewis' book is really about himself, and not just the Salomon mortgage-backed business, it relates much of the story historically. By the time Lewis arrived as a trainee, Ranieri's operation had reached its obese, swaggering, arrogant apogee.

It took Lewis' recounting of the affair to remember how Warren Buffett became involved with Salomon, and the almost perfect parallel with his rescue of Goldman Sachs just a few years ago.

Ronald Perelman, with the backing of Drexel Burnham's Michael Milken, put Salomon into play in September, 1987. Lewis provides an extensive discussion of how Milken's junk bond empire would soon eclipse Salomon's focus on mere mortgage-backed bonds. How Salomon's corporate infighting and inept senior management allowed it to completely miss the junk bond market development until it was too late.

Also woven through the tale is Lewis' explanation of why Bill Simon was passed over for CEO of Salomon when the last family member, Billy Salomon, retired, in favor of Gutfreund, because Gutfreund sided with Billy on never taking the private partnership public. Then Gutfreund sold the firm to Phillips Brothers, a commodity giant, within just a few years. Bill Simon went on to found the LBO movement with a little deal involving Gibson Greeting Cards.

However, back to Buffett. Buffett lent Salmon a large sum to buy out most of the share that Perelman sought from then-holder Minorco, along the same lines as his recent Goldman Sachs loan- a high coupon rate and convertibility to equity at a rather attractive strike price.

That's how Buffett ended up temporarily running Salomon after the Treasury bid-rigging scandal a few years later.

There are many fascinating parallels from investment banking in the early 1980s with the runup to the financial crisis of 2007-08. But there are some important differences, too. Specifically, back in its day, Salomon managed to tower over its less-capable competitors for years as it dominated the first incarnation of the mortgage-banking market. Some twenty-five or so years later, the other investment banks had learned a thing or two, and were much quicker to jump on a developing bandwagon. As were commercial banks.

Thus the wholesale economic disaster that arrived when the federal government, led by Fannie Mae and Freddie Mac, whose involvement in mortgage-backed bonds had been engineered by Lew Ranieri back in the early 1980s, insured the bulk of mortgages, with ever-declining quality standards, which backed bonds sold to investors around the globe.

And, finally, one recalls, after (re)reading Lewis' book, that Goldman Sachs isn't the first and only investment (now commercial) bank which people love to hate. First, there was Salomon. And at the time, nobody could envision Salomon not dominating global investment banking for decades.

It's an instructive and fun reread, or, if you're too young to know of the book, first time read.

Heck, it's only August 9th. Still time to quickly step through Liar's Poker on the beach before Labor Day arrives.

Old News: We Have Too Much US Financial Services Capacity

In a recent Wall Street Journal editorial, frequent, if often misguided contributor Andy Kessler proclaimed,

"There are too many traders, bankers and salesmen to support the new level of business. Thanks to Dodd-Frank, the shrinking of finance will continue."

Duh.

Sorry to break the news, but, as I've written in prior posts on this blog over the past few years, US financial capacity has been excessive, and shrinking, since the 1990s. Even before, really.

In part, the simple applications of computer technology began to create excess capacity as long ago as the 1960s. It hasn't stopped since.

Kessler evidently thinks his insight is a surprise, or at least news.

It isn't.

He's right about the old retail brokerages and investment banks shamelessly inventing new, less efficient, higher-margin products for decades since the Big Bang deregulation of stock commissions in the 1970s. And among the consequences of the recent regulatory legislation will certainly be the elimination of prohibited activities at publicly-owned commercial banks.

But the much larger, more important trends in the sector have been the continuing growth of excess capacity, depressing margins and causing riskier trading and underwriting behavior, coupled with the exit of the best talent to hedge funds and private equity groups.

Put the two together, as Kessler failed to do, and you have your recipe for the recent financial disaster.

Forget "What's the Matter With Wall Street," the title of Kessler's editorial. There's really no Wall Street left, with Goldman Sachs' and Morgan Stanley's conversion to commercial banks.

It's more a matter of US financial services, generally, being over-supplied with capacity that simply can't be afforded. The sooner the capacity is taken out, the better for the nation and its competitive financial institutions.

Just What Is "Proprietary Trading" Anyway?

Much has been made recently of the belief that "proprietary trading" did not actually cause the demise of Bear Stearns or Lehman Brothers, and, thus, is of no consequence in the evolving FINREG bill.

I believe this is wrong. It takes too narrow a view of just what proprietary trading actually entails.

To me, proprietary trading may technically define or describe only those as-principal activities on an investment or commercial bank's trading desks which risk the firm's own capital.

However, the broader notion meant by people like Paul Volcker, in articulating his Volcker Rule is, I believe, that of the risking of a bank's capital on any underwriting, long term investments or high-frequency trading for its own account.

The key common element isn't the duration, which could rule out proprietary trading as the culprit of some now-defunct banks' woes, but, rather, the risking of the bank's own capital in market-valued instruments and activities.

When banks which do this are also in the business of taking insured deposits, then they are implicitly being backed by the FDIC and, ultimately, taxpayers.

Lehman was brought low, in part, by the poor quality of the commercial mortgage assets it chose to hold on its books. That was proprietary investment.

Bear Stearns was believed, by its commercial bank lenders, to have asset quality problems which made those overnight loans too risky.

Were the assets the result of trading, or underwriting, or investment? Doesn't really matter.

They were owned by the firm, and lost more value than there was equity to back them.

Trading...investment.....really, what's in a word, in this case? The time dimension isn't what is important when considering the reform of financial regulations and structure regarding a bank's risk exposure while also taking insured deposits.

The source of the risk capital is.

Is Bigger Really Better In Banking?

As I mentioned in this recent post, Charles Calomiris of the Columbia Business School wrote an editorial defending 'too big to fail' banks in last Tuesday's Wall Street Journal.

Calomiris clearly states his contention thus,

"Yet the challenge of coordinating the efforts among different countries' regulators can be met through prearranged, loss-sharing arrangements that assign assets to particular subsidiaries based on clear rules. This would make it possible to transfer control over the assets and operations of a large international financial institution in an orderly fashion, in case of its failure. This process could be handled by the courts for nonbank failures and the Federal Deposit Insurance Corp. for banks. With such arrangements in place, governments will have no reason (or excuse) to bail out large, international institutions.

But is it worth the trouble to preserve large financial institutions? Emphatically, it is."

It's worth noting that Calomiris postulates an entirely new, trans-national financial regulatory and accounting structure, after and on which he then bases his contention.

Realistically, what he envisions would be a good decade away from implementation, never mind that the sorts of accounting data supporting it would be gamed to high heaven by the smart financiers who would have time to discover and exploit the inevitable loopholes.

And, ironically, last year Calomiris claimed, in the Journal piece on which I wrote a post which is linked in that recent post, that the Basel accords' risk management prescriptions were the reason for the recent meltdown!

So, prior international financial regulatory attempts were bad. But now, Calomiris believes, they will magically become good.

Remember, modestly-paid civil servants write these sorts of regulations and procedures, while much smarter, better-educated sector practitioners, with plenty of capital behind them, immediately begin working to subvert, avoid and evade these same regulations.

Calomiris' vision will never be created, much less work as planned.

"This underlying reality is the background factor that helps explain why some financial firms also need to be large.

First and foremost, they need to be large to operate on a global scale—and they need to do so because their clients are large and operate globally.

Second, there are economies of scope when financial firms combine different products within the same firm (lending and foreign-exchange swaps, for example). A financial firm able to offer multiple products to a customer means savings in marketing costs and in the costs of information production (about the creditworthiness of clients, for example). Economies of scope among products also imply economies of scale within finance suppliers, since small financial firms cannot afford the overhead costs of building platforms with many complex products."

This is a rather common fairy tale in banking. The truth is, until the mid-1970s, the business of correspondent banking was alive and well. I didn't happen to include Calomiris' cite of Ollie Williamson's recent Nobel for his work on networks among businesses, but correspondent banking was the original implementation of this notion.

Simply described, regional and local banks across the US would use New York- or California-based money center banks for various financial markets activities, such as securities lending, upstreaming loans for risk layoffs, taking part in large loans from the money center, institutional trust, letters of credit, and so forth. There was no particular need for a regional bank to be everywhere, when it could basically share customer activities with a money center bank.

However, as money centers grew more complex, there was no accompanying increase in the skills of senior management in those banks, and the increased risks began to result in heavy losses. For example, recall Chase Manhattan's Drysdale Securities fiasco in securities lending, and the Penn Square energy lending debacle in the correspondent banking division.

If anything, finance has proven to be a sector where focused execution of fewer functions tends to result in greater wealth creation per invested dollar. Old line investment banks and brokerages were partnerships which only went public when the allure of cashing out to an unwitting public proved too great a temptation for the older partners.

Third, many of the gains of consolidation accrued to customers, not banks, in the form of cheaper and better financial services. For example, my research shows that from 1980 to 1999, after controlling for changes in the mix of firms, the underwriting costs of accessing the public equity market fell by more than 20%. These declining costs encouraged an expanded use of the market particularly by young, growing firms.

One study of bank productivity growth during the heart of the merger wave (1991-1997), by Kevin Stiroh, an economist at the New York Federal Reserve, found that it rose more than 0.4% per year.

This is hilarious. I would just love to know how the Fed's economist's study defined "bank productivity." I worked at Chase Manhattan for quite a few years, in many areas of the bank, including IT. One thing which is nearly impossible to do is provide a meaningful, cross-bank measure of productivity that has any sort of functional meaning.

As for Calomiris' finding of lower equity underwriting costs, this is precisely what my old boss at Chase, Gerry Weiss, predicted. However, Calomiris separates that cause from the effect it triggered on Wall Street, meaning investment banks. This loss of profitability in underwriting is what drove Merrill Lynch, Morgan Stanley, Bear Stearns, Lehman and the capital markets portion of Citibank to pile into mortgage banking and securitization. Thus, the causes of the ensuing bubble of poorly-originated and securitized mortgages by 'too big to fail' investment and commercial banks stemming from the ability of diversified financial institutions to move into product/markets with which they were not well acquainted. And whose risks with which they were inexperienced.

Fourth, global financial institutions also have made stock, bond and foreign exchange markets globally integrated and more efficient. Global financial institutions are the institutions that provide the funds for arbitrage across markets, which ensure global market integration.

But such "integrated and more efficient" "stock, bond and foreign exchange markets" can be accessed by smaller, single- or limited-product line firms, just as well as by financial utilities of unimaginable size and scope. That's the point of exchanges. They require counterparties to post collateral and stand between the counterparties, allowing small and large entities to safely trade with each other.

It was the old telephone markets which allowed large firms, in their day, like the old Salomon Brothers, to dominate specific markets, such as fixed income trading and origination, to the detriment of smaller rivals.

Today, we see thriving privately-owned M&A, hedge fund and private equity concerns. All primarily focused on specific niches in the financial services markets.

Until large commercial banks embarked on their buying spree, of dubious value, of standalone credit card issuers, that segment, too, had its own focused, skilled competitors.

Limiting the size, complexity and global reach of financial institutions is fraught with downsides for the international economy. We can solve the too-big-to-fail problem without destroying global finance. It certainly is worth a try."

As in his piece in October of last year, Calomiris avoids providing empirical evidence for his sweeping contentions. By contrast, merely observing which firms went under last year tells you a lot about how wrong Calomiris' positions are.

Merrill Lynch, Wachovia, WaMu, Bear Stearns and Lehman were all large financial institutions. They were either needlessly diversified, or growing into new areas at their peril. Citigroup and AIG came near dissolution, but were "saved" by government intervention. Morgan Stanley nearly failed, but found a gullible Asian savior just before the feds closed and merged them, as well.

One of the most memorable lessons I took away from my Chase Manhattan Bank experience was the manner in which executives in businesses that are part of a large, diversified financial institution lose a sense of individual risk-taking, assuming that poor performance or outright losses will be borne by the institution and its shareholders, while the near-term profits of risky and/or ill-conceived strategies will drive bonuses for the unit's management.

Financial services skills tend to be focused on and in particular products. Very few senior managers, CFOs and CEOs actually understand the intricacies of all of the businesses which report to them, and for which they are responsible and accountable. Notice how unprepared Vik Pandit was as he was given the CEO job at Citigroup, and how many months he took before claiming to have the slightest idea of what to do with the collection of businesses he inherited from Chuck Prince.

Among the most admired financial service firms, for their ability to generate consistently superior total returns, do not appear large, publicly-owned diversified banks. More often, firms such as Goldman Sachs, Blackstone, Blackrock, and a few hedge funds, are mentioned. Those firms operate in fewer, more focused collections of businesses.

As I wrote in that recent post concerning Mervyn King's and Paul Volcker's calls for the effective rebuilding of the Glass-Steagall wall between deposit-taking institutions and risk-taking investment banking institutions, it's simply unwise to allow large, diversified banking concerns to have a conduit into government-insured deposits. This allows them to essentially take risks with taxpayer-insured money, knowing that this will also prevent the firms from failing without some form of government-directed intervention or rescue.

In short, until and unless such insured activities are split from risk-taking ones, the moral hazard against which the two central bankers warn will continue to loom large.

Calomiris simply ignores this fact, provides no persuasive empirical evidence for his contentions, and then dreams up a non-existent international regulatory regime on which to base his conclusion that we need gigantic financial utilities.

Business Odds & Ends

Quite a bit of flap has arisen in business circles over the administrations "pay czar" slapping 90% salary cuts on a number of executives at firms which requested or took government aid, e.g., GM, Citigroup, AIG, BofA.

If anything, this illustrates the point of this post back in April about a lack of boundaries between government and business. I wrote,

"In my opinion, as well as others, such as William McGurn of the Wall Street Journal and even liberal Nobel Economics Laureate Joseph Stiglitz, the bankruptcy option has been avoided far too much in the past twelve months.

Bear Stearns, Lehman, BofA, AIG and Citigroup, upon appealing to the federal government for assistance, should all have been referred to bankruptcy court or the FDIC for closure. GM and Chrysler, too, should be in Chapter 11.

Somehow, corporate executives have come to expect their government to play favorites, pick winners, and temporarily prop up failing companies, rather than admit their own mistakes and close up shop.

By failing to observe the boundaries of responsible corporate behavior, boards of directors and CEOs unwisely opened a Pandora's Box of problems by requesting government financial aid.

This left them open to having their operations and decisions overseen and scrutinized by political officials who have used the excuse of looking after taxpayer money in order to move our economy down the road of fascism.

At the same time, government officials, beginning with the Bush administration, and continuing into the current one, have unwisely consented to helping private corporations, rather than declining, and sending them to their fate in the financial markets or bankruptcy courts.

By failing to observe the clear line between private and public spheres of activity, our government officials have compromised our economic system and given into the temptation to begin manipulating companies for political purposes and pet political agendas."

Right now, the political agenda on display is liberal America's desire to limit executive compensation. And, frankly, the companies involved right now deserve this treatment.

They ran themselves into a condition worthy of bankruptcy court. They begged for government aid. Now, having availed themselves of taxpayer funding, they have no excuse for having compensation become a political weapon to be used against their employees.

But I don't think there is any room for such government intervention in the rest of business.

You don't see the administration suggesting that entertainment or sports figures have their compensation limited, do you?

On another topic, I saw a laughable little piece on CNBC the other day. The topic was women in business, featuring some female MD from Deutsche Bank's derivatives unit.

Hilariously, the woman, whose name I cannot recall, blathered on about how a woman can now take time out of her career to have children, return to the workforce, and still reap substantial corporate success.

Michelle Caruso-Cabrera, a CNBC co-anchor, laughed and retorted that the only truly successful executives of either gender of whom she knew basically slaved like dogs, worked unending hours for years, sacrificed their family lives in order to climb to the top of the executive ladder at an investment bank. The other CNBC on-air personnel bobbed their heads in agreement.

The Deutsche Bank woman protested that this was wrong, and here she was, an MD at DB, to prove them wrong.

Look, let's be honest. DB is no Goldman Sachs, Morgan Stanley, or Blackstone. It's simply not a first-rank US investment bank or asset manager. DB is one of those second-rate-at-best, large European universal banks which bought a US bank, usually in distress. In DB's case, that would be the old, self-crippled Bankers Trust.

I don't think anyone equates rising to MD rank at DB with being a senior executive at Goldman, a first-rate private equity shop, or a hedge fund.

It's not clear just why CNBC even aired this segment. I guess they really wanted to focus on the notion that women can now rise to the top of an investment bank while happily and successfully juggling a family, too.

Unfortunately, I don't think women in senior management at truly first-rate investment banks, private equity groups or hedge funds would waste their time appearing on CNBC to crow about how much time they didn't work while rising to the top.

It seems to be very much a Groucho Marx sort of topic. Anyone foolish enough to self-identify as a successful female financial services exec who has it all probably either a) doesn't have it all, b) isn't that successful, or c) is about to have her career limited by appearing on CNBC to state that she has it all and is successful.

More Regulatory Pressure To Separate Commercial & Investment Banking

Way back in 1996, my friend B predicted that, going forward, US banks would become increasingly like utilities, with core lending and deposit-taking functions eventually separated from riskier investment banking. The former would become federally-insured activities, with lending subject to fairly rigorous standards in order to qualify for federal guarantees.

Otherwise, he noted, the few, large deposit-taking banks would subsidize risky investment banking with insured deposits and a "too big to fail" condition that would only lead to increasingly riskier trading and underwriting activities.

This week, Mervyn King, Governor of the Bank of England, and Paul Volcker, former US Fed chairman, once again called for separation of investment and commercial banking. For pretty much the same reasons B prophesied over a decade ago.

Both central bankers identified the increasingly risky behavior of commercial banks which have bulked up proprietary trading and underwriting activities.

Yet, one only has to look at this week's mortgage loan delinquencies at Wells Fargo to see that my old Chase Manhattan boss, Gerry Weiss, was prescient when he observed that money center banks didn't need to enter investment banking to lose money. They could do that in their regular businesses through the usual abandonment of credit standards in pursuit of market share as various product/markets exhibited strong growth in demand.

Is a return to an era of a Glass-Steagall type of separation of investment and commercial banking possible?

If the current administration and Congress have their way, quite possibly.

Given the quick return to risky trading activities at Chase this past quarter, it's clear that the combination of the two types of banking is going to once again, in time, lead to risk-based profits for shareholders and compensation for employees, while heavy losses will once again tax the FDIC and result in federal rescues.

Just a few days ago, on Tuesday, Columbia finance professor Charles Calomiris authored another flawed editorial in the Wall Street Journal, on the subject of universal banks combining investment and commercial banking. The last one one which I posted, here, was exactly a year ago.

Because Calomiris' piece was so long, and contains a number of fallacies, I'll touch on it in a subsequent post.

But, for me, King and Volcker represent far more objective, reasoned positions on the subject of separating riskier banking activities from those of insured deposit-taking institutions.

Roy Smith On Investment Banking, Compensation & Greed

Former Goldman Sachs partner and current NYU finance professor Roy C. Smith wrote a lengthy piece in the weekend edition of the Wall Street Journal entitled, "Greed Is Good."

In his extensive piece, Smith paints the more complete and fair picture of the old Wall Street, a/k/a investment banks, compensation structure, in order to raise some warnings about the effects of the recent compensation caps, and predict some structural changes.

Among other points, Smith notes that many- perhaps thousands- of well-paid investment bankers at Bear Stearns and Lehman lost assets, jobs and companies. This, too, is part of the risk-taking environment which produced such lavish bonuses over the past few decades.

Smith also does a great job tracing the evolution of investment banking from when all of the firms were private partnerships. He, as I have done, notes the entry of commercial banks into traditional investment banking turf as the beginning of the end of the sector.

My mentor at Chase, Gerry Weiss, had predicted this years in advance. As the less-adept, more ham-handed commercial banks began to underwrite securities, margins shrank, volumes had to increase and instruments had to become more opaque in order to justify spreads and maintain revenues and profits.

Eventually, everybody levered up, and the once-private investment banks, having mostly gone public with the deregulatory "Big Bang" of the 1970s, mostly used other people's money to run much more risky businesses, while paying themselves healthy bonuses in good years.

Smith points out, with which I agree and have also stated, that the logical consequence of the recent vaporization of publicly-held investment banks, is a return to boutique, private partnership investment banking. The compensation caps really won't, by themselves, cause talent to leave the commercial banks for the private investment banks.

But they will set a tone that will probably trickle down. And, anyway, investment banking at a commercial bank simply isn't the same as doing it at a pure investment bank, even with the abolition of Glass-Steagal.

Smith endorses the practice of making large compensation payments vest over some years, in order to make them conditioned on continued profitability. Again, a topic on which I have written, in one form or another, for years. Specifically, I've recommended that large components of senior executive compensation be tied to outperforming the S&P500 over a five year period, in arrears. Thus, if performance lags, the payment in any given year for the prior five-year period shrinks. This is the sort of idea now gaining currency in the remaining publicly-held institutions having to grapple with this dilemma.

I like Smith's sense of history. He notes how the regulatory backlash to the 1920s and market crash of '29 resulted in relatively low financial services compensation until the 1980s. Which, by the way, was about the time the previously-privately-held investment bank partnerships began to swell with public money and pay more lavishly.

On the subject of the systemic risks taken by most, if not all, of these banks, which eventually came home to roost via mortgage-backed CDOs and such, Smith and I agree that, in the future, it's likely that such risk will be minimized only by the existence of many smaller investment banks, rather than a few large ones.

Even now, as I discussed with a Morgan Stanley employee at a social function this past Sunday, quite a few large hedge funds and private equity shops, not to mention the explicitly-identified boutique investment banks, stand ready to re-enter the riskier areas of underwriting and trading in the coming months and years. As private firms, they have no shareholders ranting at annual meetings, need justify their compensation to no external parties, and can only grow at the rate at which their private capital allows, plus judicious borrowing.

As Smith notes, the industry will reinvent itself, and, in fact, already has. My various posts about Blackstone and other private equity shops noted this as far back as the 2007 IPO of that large private equity enterprise.

In truth, as usual, what we see happening with compensation, regulation and risk management of the remaining former-investment banks-cum-commercial banks, Goldman and Morgan Stanley, and the crumbling commercial banks, Citigroup and BofA, is simply the tidying up of the worst-performing, hind-end of the sector. The better players and their capital departed those publicly-held firms over a decade ago, the better to ply their trade in stealth and away from excessive governmental intervention.

Though he didn't write that, I believe Mr. Smith would agree with me on that last point.

Disbelief and Denial On "Wall Street"- Or What's Left of It

I read Dennis Berman's piece in yesterday's Wall Street Journal, entitled "On the Street, Disbelief and Resignation," with great interest, and more than a little surprise.

Berman wrote, in part,

"Inside what's left of Wall Street, investment bankers are doing all they can to cope with a business that is disappearing before their eyes. Yes, there are tens of thousands of people still with jobs. They just don't have much work. Debt and stock markets are virtually shut, merger volume is down by 28%, and whole lines of structured finance are closed for good.

This would appear a moment of natural self-reflection. Perhaps the time to consider a career move out of New York, or pursue an abandoned passion. Oddly, few of the senior bankers seemed to be able to accept the basic reality of their own profession: that an overleveraged world created an excess of bankers, too.

It is a testament to Wall Street's inherent optimism -- and exactly why the boom-and-bust cycles will continue -- that bankers remain so committed. As the Goldman banker summed it up: "People are busy. They're just not getting paid."

Here's what I don't get.

Ten, five, even a year ago, these whiz kids were supposed to be able to out-think corporate CEOs and CFOs, identify mergers, create novel financing approaches, and, generally so it was presumed, add value.

How can a group of largely kids, with a few adults riding herd on them, be so currently misguided, blind, and clueless, yet be in a position to 'assist' US companies with financial consulting and engineering?

We're dealing with global deleveraging. A serious pollution of the world's financial markets by toxic securitized waste. Credit is being retracted, or only extended in rollovers at very high rates of interest.

Underwriting is probably headed back to the stone age, since nothing glitzy will be trusted by most investors for maybe a decade. There is no 'Wall Street' anymore, simply corporate finance and M&A divisions of commercial banks.

I was around in the 1980s, when investment bankers and corporate raiders routinely merged companies, engineered leveraged buyouts, and purged hundreds, sometimes thousands of employees from the affected companies.

Guess whose turn it is now?

Thaaaat's riiiiiight! Investment bankers, M&A mavens, and traders, both buy and sell sides.

The underlying markets and demand for much of what these typically-younger, well-educated, highly-financially aspirational financial service workers are gone. Vanished. Vaporized.

Thus, so are the jobs serving those vanished markets and demands. And they likely will not ever return. Period. It is a new era. Publicly-held investment banks are gone, and will not return.

It's revealing to see how, when it is now apparent to all who understand these markets and sectors, that there has been a one-way sea change in employment opportunities and careers in investment banking and trading, these young worthies still cling to the hope that there will be a dawn following this night.

If this represents their considered business judgment, that's just another reason for the once-vibrant, overheated investment banking sector to have vanished as publicly-held companies.

On Recent Developments At Goldman Sachs

Let me begin by admitting that, in this recent post, I was completely wrong in my prediction of Goldman Sach's fate. I wrote, in part,

"This does not, in our view, alter the fact that Goldman remains the class of the class of investment banks, public or private. So, when everyone else is selling equities, what should the best equity house on Wall Street do? Buy, of course. We believe that, while John Mack's weakened Morgan Stanley runs for cover at a large, mediocre commercial bank, Lloyd Blankenfein and his management team will, in conjunction with selected private equity investors, tender to take Goldman Sachs private again.It makes sense. Goldman's risk management has held up well while all their publicly-held competitors are finally driven from the field. Why should the best managers in investment banking cast their very desirable pearl before the....ah....well, you know....sell to a commercial bank and work for its probably-dimmer CEO?

That's my- our- prediction. It just seems too obvious that when Goldman's price has been unrealistically depressed, due to near-term market conditions, far below its long-term intrinsic value, those who know it best- Goldman's managers- will do a leveraged buyout.You read it here, if not first, early."

Instead of my expected solution, Goldman instead filed to become a commercial bank. Perhaps Lloyd Blankenfein felt that more immediate action was required than that necessary for a tender to take the firm private.

Then again, just what is the firm that is applying for a commercial bank charter? Is it the Goldman Sachs we know, post-Whitehead? The swashbuckling, client-beating, private trading and hedge fund-gone-public?

Remember, Goldman was the last private investment bank partnership to go public. And, as the Street's premier equity underwriter, you had to bet that, if they were selling, it was a market top.

So, why would Blankenfein take his much-feared crew off the field of relatively-unfettered trading and, in a minor way, investment banking, to compete in the stuffy, restrictive, unimaginative world of commercial banking?

Maybe it's this. Goldman, the public entity, will become a commercial bank. But what of its talented, highly-paid, innovative staff? Do you think the guy who was trading exotic swaps yesterday will be sitting opposite you to discuss your application for a home equity loan tomorrow?

Doubtful.

No, I think Blankenfein piloted his firm into a safe harbor- commercial banking- in order to let all hands leave the stranded ship for a safer shore, to begin life anew. With their substantial equity stakes in the firm as grubstakes.

Plan on seeing many, if not most, of Goldman's brightest people migrate to existing private equity, asset management and hedge fund firms, and/or start new ones. As I wrote later in the prior post,

"And that will be the finish of the 30+ year-long cycle of Wall Street going public, shearing its clients, then selling the wreckage either to other investment banks, commercial banks, or back to itself. Investment banking will have ceased to be an independent, publicly-held market function.

I'll even predict that, with time, the private investment banks will out-maneuver and -compete the commercial banks which bought the remnants of the poorly-run, remaining publicly-held investment banks. And we'll be back to a de facto version of Glass-Steagal, with a few commercial banks half-heartedly trying to compete with their sharper, better-paid privately-held competitors."

I still believe what I wrote in those two paragraphs. And that Goldman's employees will lead in this remaking of investment banking in the image of the old, legendary days of JP Morgan, the man- not the firm.

It's remotely possible that Goldman's best would hang around to merge with, then takeover and run a larger commercial bank. But I'm just not sure that sort of mind-numbing activity and straitjacketed operation style will be attractive to the best Goldman alums. No matter how large the commercial bank, it's simply not as nimble, nor interesting, as a private equity firm or hedge fund.

And what of Warren Buffett's $5B investment in the firm? Well, as usual, Warren got an exceptionally sweet and unique deal which neither you, nor I could extract. He has locked in a 10% return on $5B. It's really not an equity deal. It's a high-priced private equity loan.

I'm not sure if Buffett feels the firm will be a good equity investment. Sure, he's got warrants, in case it is. But if not, 10% is a good coupon rate for whatever will be left, legally, that Goldman can still do under a commercial banking charter.

But the Goldman we knew is gone forever. There just isn't sufficient wiggle room in a commercial bank charter for the firm to ever return to its heyday of being a publicly-held hedge fund/private equity shop with a few pieces of old investment banking attached- underwriting, asset management and M&A.

However, in truth, the branchless bank model of the old JP Morgan commercial bank and Bankers Trust failed in the 1990s. And they failed, in part, because of a lack of a stable deposit base. So, how will a newly-commercialized Goldman Sachs bank escape that fate?

It's even reasonable, given the excess capacity in the financial system, that, once a sufficient number of top-tier, old Goldman Sachs employees depart for greener pastures, the remaining second-tier staff will merge with some always-commercial bank, e.g., Wells Fargo, Wachovia, or BONY-Mellon.

I doubt the new Goldman will remain unmerged or unacquired for long after its best and brightest have departed.

A Long Term View of the Structure of US Financial Service Sector

As I reflected on yesterday's news that Goldman Sachs and Morgan Stanley, America's two largest remaining publicly-held investment banks, are becoming Federally-chartered commercial banks, there seemed to me to be less about which to be surprised than others seem to believe.

The 'modern,' publicly-held, large US investment bank is not your father's Wall Street investment bank. I have known a few people who were partners in some of the older firms during the 1960s and 1970s. Days when Dillon Read's partners could fit around one table in a boardroom.

Today's investment banks are quite different. As one CNBC guest noted this morning, they had morphed into large trading desks with underwriting, M&A, and asset management units. In fact, I can well recall my days as a Director of Planning and Research at Andersen Consulting, now Accenture, in the Financial Services sector, in 1993. Back then, our own business plans reflected the reported growing use of proprietary capital in trading activities among Goldman Sachs, Salomon and Morgan Stanley. It was news that the firms, with only Goldman still private, were using their larger capital bases to compete with their own clients by trading actively in many securities markets.

Gone were the days of John Whitehead's Goldman, when the firm would not so brazenly face its own clients in the markets and use better risk management and information to get the better of them.

But let's step back in time to the last century's signal financial services event- the Crash of 1929. Starting from that point, our nation's financial sector's history can be described by a surprisingly few turning points.

Before we stroll down this memory lane, let's also be clear on one important behavioral point. Competitors in financial services, like those in other sectors, will, absent governmental prohibitions, act in their own, or their shareowners' short to medium-term profit or return-maximizing interests, heedless of the systemic effects of their behavior. If their trading, underwriting or investment behavior accrued superior total returns, but wrecked the financial system wherein they existed and operated, they would probably still continue such behavior until there were no customers or counterparties left with whom to do business.

Now, to my short course on the modern history of the US financial services sector:

1. In the 1920s, integrated commercial and investment banks, operating with then-allowed 10% margin for customer accounts, contribute to the stock market price bubble by stuffing customer investment accounts with underwritten instruments of their corporate clients, from their own investment banking units.

2. After the Crash, Congress passes the Glass-Steageall Act, separating investment and commercial banking.

3. In the 1970s, many of Wall Street's formerly-private investment banks and retail wire houses- First Boston, Morgan Stanley, EF Hutton, to name a few- go public, reaping windfalls and subtly transferring formerly partner-shouldered risks of the firm's positions and businesses to thousands of retail and institutional investors.

4. In the 1980s, computer- and information-management technology begin to radically change the way trading operations at investment and commercial banks, and their clients. "Baskets" of indexes were traded rapidly by computer-driven models. Risk management models relied on 'portfolio insurance' to rapidly sell positions to reduce risk in the event of sharp market downturns.

5. The Crash of 1987 demonstrates that, left unchecked, the haphazardly-controlled software models for risk management and trading among financial services businesses resulted in steep plunges in equity prices of unheard-of speed and depth. In reaction to this crash, 'circuit breakers' are introduced on the NYSE, halting trading when key indices drop by more than a maximally-allowed number of points. 'Portfolio insurance,' used by all major trading concerns, fails, due to the fallacy of composition, when all the trading desks use similar models to trigger similar sales of like instruments, cascading ever-larger and faster sell orders.

6. In the early 1990s, so-called "Section 20" units of commercial banks are allowed to trade and underwrite equities. This expansion of capital available to equity underwriting and trading adds to the over-capacity in the American underwriting and trading business segment. Investment banks and hedge funds continue their headlong expansion of leverage and risk, as margins in their businesses continue to thin, due to excess capacity and ubiquitous risk management and trading technologies among so many financial service firms.

7. Sandy Weill's insistence, in 1998, on merging his Traveler's Corporation with Citibank, a Federally-chartered commercial bank, forces Congress, at the urging of President Clinton's Treasury Secretary, Robert Rubin, to repeal Glass-Steagall. The regulatory and functional climate of pre-1929 America in financial services is formally recreated. As a footnote, upon his exit as Clinton's Treasury Secretary, Rubin is rewarded for his service in Weill's cause by being named non-executive Chairman of Citicorp, the merged firm's successor, with an annual compensation package ranking among the firm's three largest- a rare practice for non-executive board members.

Several wiser heads, among them former Fed Chairman Paul Volcker, warn against the dismantling of this 60-year old, effective barrier in the US financial services sector.

In the fall of this year, Long Term Capital Management, a hedge fund spinoff of former Salomon Brothers' key fixed income executives, using vast amounts of leverage, several Nobel Economic Laureates to develop and operate risk management, and investment and trading across large numbers of asset classes, make bad bets which nearly wipe out the firm. The resulting effect on global asset prices nearly disrupts the world's financial system.

The next year, "Wall Street's" last remaining large investment bank partnership, Goldman Sachs, goes public, signaling a peak valuation for investment banking assets in the publicly-traded equity markets.

8. As interest rates are lowered to historically low levels by Fed Chairman Greenspan in the wake of the equity market's "Tech Bubble" bursting in 2001, commercial and investment banks begin an unprecedented buildup of leverage to compete in the suddenly-wildly growing residential homebuilding and mortgage finance sectors. As the boom in residential homebuilding peaks, Congressionally-chartered GSEs, Fannie Mae and Freddie Mac, take 'subprime' and 'alt-A' mortgages, of lower quality, into their securitized products sold to investors globally. Private competitors, including Merrill Lynch, Citigroup and Bear Stearns buy or create mortgage origination businesses to further profit from the underwriting and sales of securitized mortgage paper. Prominent credit rating agencies- S&P, Fitch and Moodys- give investment-grade ratings to many of the newly-created, untested securities backed by the new, lowest-quality mortgages.

The practices of the 1920s, wherein commercial and investment bank businesses fed each other and mixed risks between the two functions, return full scale, and more, to the American financial services sector.

In the wake of Enron's collapse, Congress passes the Sarbanes-Oxley law, which, among other regulatory changes, mandates that financial firms must mark securities to market prices, regardless of their economic value as performing assets.

9. In 2007, as a slowing economy begins to dampen growth in residential real estate, homebuilding and mortgage originations slow, and delinquencies and defaults begin to occur in recent subprime mortgages underlying some mortgage-backed securities. Because so many mortgages have been wrapped together as securities, widespread concern over how much of these assets are owned by 'counterparties,' rather than easy identification of individually-affected mortgages, causes a freezing up of trading of these assets, and other fixed income instruments.

Early in the year, private equity investment bank/hedge fund, Blackstone Group, goes public, signaling a peak valuation of private equity asset valuations in the traded equity markets.

Despite lowering of interest rates by the Federal Reserve throughout late 2007, and the opening of the Fed Discount Window to American investment banks in the wake of Bear Stearns' failure in March of 2008, counterparty risk fears continue to cause markets for the mortgage-backed structured finance securities to evaporate, driving valuations to extremely low values. Continuing uncertainty of the 'mark to market' value of such structured finance assets causes Merrill Lynch, Lehman Brothers, Citigroup, Bank of America, Wachovia and AIG to continue quarterly writedowns at multi-billion dollar levels.

10. Capping several weeks of investor and trader panic, beginning with the takeover of Fannie and Freddie by the US Treasury, Lehman Brothers files for Chapter 11 bankruptcy protection, Merrill Lynch sells itself to Bank of America, and AIG barely avoids technical bankruptcy and is taken over by the Treasury. One week later, Goldman Sachs and Morgan Stanley, the two remaining, large, publicly-held US investment banks, both file to become Federally-chartered commercial bank holding companies.

Do you see the overall pattern which I see?

Prior to Glass-Steagall, untrammelled, self-interested behavior by integrated American banks caused a financial disaster, the Great Crash of 1929. Subsequent separation of investment and commercial banking, along with the SEC's policing of strict margin requirements, prevented a repeat of this occurrence for sixty years.

In the interim, there were non-macro-economic based financial debacles involving overheated equity markets and real estate or energy lending by, respectively, brokerages, investment banks and commercial banks. However, nothing remotely akin to the scale of the 1929 Crash occurred.

With the advent of game-changing, computer-based technology for trading and risk management, and the removal of Glass-Steagall, America's financial services sector once again enjoyed little effective prohibitions on its natural proclivity to reap short term gains while saddling customers and counterparties with losses.

Just as in 1929, but with greater speed, thanks to modern technology, integrated finance businesses shifted into high gear, using the then-fastest, most profitable asset class, residential mortgages and their structured financial securities, to maximize short-term profits and total returns.

Thanks to Congressionally-mandated use of 'mark to market' rules, when home values began to drop, the mortgage loans to them, now in the form of tradable securities, rather than loans on commercial bank balance sheets, plunged even faster.

The result is a train wreck in the financial services sector on a par with 1929, in terms of damage to financial service sector competitors.

If two elements of this situation were different- 'mark to market' rules mandated for performing securities, the abolition of Glass-Steagall- it's highly probable that we would not today be facing such a mess in this sector.

Once Congress made those two changes, normal, dependable behavior of firms in the financial sector virtually guaranteed that a form of excess would eventually create more risk, and more 'accounting value' destruction, than the sector could sustain with existing capital.

It would be hopeful to believe that our sense of history of the sector would have prevented this latest situation. But, evidently, we are, as a society, more susceptible to forgetting the lessons of history, and common sense, than we able to remember them, and the fundamental self-interest of firms which operate in the financial services sector.

Modern Risk Management- Time To Return To Yesterday?

Many years ago, mortgage finance was a regional business. Back in those days, pre-1980, the US commercial banking industry consisted of several large 'money center' banks- Chase Manhattan, Bank of America, Citibank, First Chicago, Chemical, Manufacturers Hanover, and Contintental Illinois, to name most of them- and many smaller regional banks. The latter would do business with the former using a model known as 'correspondent banking.'

In a sort of semi-formal partnership, smaller local and regional banks had an explicit relationship with their big-city, money center correspondent bank which allowed them to buy pieces of whole bank loans. Similar to the securities industry's syndication of underwritten listed securities, banks syndicated pieces of loans to their correspondents.

For the most part, due to restrictions on deposit-taking across state lines, money center banks sold loan participations to regional and local banks, thus, in effect, gaining by these sales funding which they could not access as direct consumer deposits in other states.

This correspondent function also had the effect, albeit, in this pre-electronic era, at considerable expense in terms of people and operating expenses, of diversifying loans throughout the US economy, on a loan-by-loan basis.

Particularly prevalent in these correspondent relationships would be business loans. The system was not without risk. Several banks, such as SeaFirst, in Seattle, went bankrupt after buying too much correspondent-originated energy loan volume in the infamous Penn Square Bank debacle of the early 1980s.

To see how regional mortgage finance was at the time, witness how many regional banks failed in the residential mortgage finance crisis of the late 1980s, when the RTC was created to clear the bad loans from the active banking system. Shortly thereafter, Salomon Brothers, First Boston and Kidder, Peabody dove into the private-label securitization of S&L mortgage assets, liquefying the balance sheets of the latter, and expanding capital available to housing finance.

Fast-forward to today.

In the last decade, the regional mortgage finance model was scrapped, as Countrywide Finance, Pulte, Toll Brothers, Centex, and other builders, helped to create a nationally-scoped residential construction and finance industry. With Congressionally-approved increases in the sizes of jumbo-mortgages taken for securitization by Fannie Mae and Freddie Mac, mortgage securitization reached new highs.

Investment banks, including Merrill Lynch and Bear Stearns, actually bought mortgage origination firms to provide a lower-cost supply of the instruments, with which to manufacture, for sale, securities backed by mortgages. Citigroup did likewise. Other firms, such as Morgan Stanley and Lehman, vastly expanded their mortgage securities trading and sales operations.

In effect, rather than restrict mortgage delinquencies and defaults to the regions which were typically economically impaired, and the banks in those regions, the new, securitization model of mortgage finance spread mixtures of mortgages from anywhere in the US into structured finance instruments sold to investors on a global basis.

Thus, when US real estate markets such as California, Las Vegas, and Florida, overheated, stalled, and collapsed, overextended mortgagees in those markets began to default. Instead of a few regional financial institutions being easily identified as affected, insolvent, and removed from the industry, the effects of the defaults were hidden amongst thousands of structured mortgage-backed instruments held in portfolios worldwide.

It doesn't take a genius to see how this insidious spreading of risk, meant to lower systemic risk, actually increased it by causing massive, ubiquitous concerns over counterparty risk.

To use risk management language, default risk of a particular instrument was replaced with counterparty risk involving any other institution suspected of holding mortgage-backed paper that might contain questionable mortgages which were about to default.

Thus, what began as a new idea for spreading and, thus, reducing, systemic risk from mortgage financing, while providing more capital, ostensibly at lower rates, to this sector, has, in fact, created disproportionately more risk, as counterparty risk, to the entire global financial system.

This brings me to a point I made in conversations with my business partner recently.

Way back in the early 1990s, when I was attending CMO conferences sponsored by Salomon, First Boston, et.al., I discussed the phenomenon with my boss, Chase Manhattan Bank SVP of Corporate Planning and Development, Gerry Weiss. How, I asked, could the total risk of a system which was attributed to mortgage finance, be reduced by adding more layers of securitization, with each layer taking a 'haircut' of a few basis points for expenses?

It simply makes no sense that total risk can be reduced. Any one player's risk may be reduced, but only by transferring, i.e., selling it to another party. The benefit to the system would be that each party could lay off excess risk, beyond its ability to afford or, ultimately, bear the consequences of the risk turning into actual loss. Thus, more parties could assume some risks, up to their capacity, in the form of mortgage-backed paper, to which they otherwise would not have had access, while other parties could reduce their risks to match their ability to sustain loss.

But, surely, the system did not reduce its risk.

Now, we see the outcome of this new approach. It doesn't work. Instead of containing losses, due to realized risks, among a few real estate-heavy lending institutions, these losses have spread among countless other institutions, be they underwriters, trading desks, or portfolio managers.

If, as we know from the last few decades of corporate finance teaching and research, an investor can more easily diversify his holdings for himself, than any corporation can for him, could the same be true for investors, with respect to fairly opaque structured financial instruments?

Would it not have been easier, when all is said and done, for institutional investors to pay a bit more to pick and choose the mortgages they wish to hold, rather than hope that someone who is paid for simply 'slicing and dicing' payment streams of mortgages like some financial butcher, without retaining risk in the structured financial paper he has manufactured, has accurately represented the risks therein?

Buying individual, seasoned mortgages directly from portfolios of banks or other financial institutions which underwrote the loans would have probably, in the end, cost less than what the current financial mess is costing us in terms of fear, uncertainty, and extensive counterparty risk.

I think it's time to acknowledge that securitization, as we have seen it for two decades, does not work. Unless the model is scrapped, or somehow modified to require significant shares of any securitization to be held by the structurer, who among us will again trust the party who sells us structured finance paper, being paid for the transaction, without holding it himself?

Maybe returning to the days of more regionally-based residential finance, geographical firewalling of mortgage finance problems consistent with economics of the region, and the buying of individual mortgages, or seasoned securitizations of them, makes more sense.

Lehman's, Merrill Lynch's & BofA's Busy Weekend

What a busy weekend! As CNBC's anchors chortled last night, publicly-held US investment banks shrunk in number from five in January of this year to just two today- Goldman Sachs and an ailing Morgan Stanley.

Over the weekend, Lehman filed for bankruptcy, while John Thain unexpectedly sold Merrill Lynch to Ken Lewis' BofA.

What to make of all this turmoil and change?

First, I'm thankful that Lehman is finally pulling the plug and dissolving itself. It's way past time to do so.

Second, I bet John Thain wishes he'd stayed at the NYSE and never been tempted by the wreckage Stan O'Neal left behind. Too much damage, not enough time. Who'd have guessed that Thain would be out of a job before Vikram Pandit at Citigroup?

I understand why Merrill needed to be sold, albeit with pressure from the Fed. Thain was continually finding more writedowns each quarter, consuming more and more capital, while new investors were understandably reluctant to be his latest pigeons.

What I don't believe is that Ken Lewis is any more able to handle merging the Merrill wreckage with BofA than he has been with Countrywide. In case nobody's noticed, retail brokerage is a dying business. Merrill Lynch's investment banking, via mortgage underwriting, sunk the firm.

What's left that is truly worth having now? Didn't he just finish firing a bunch of his own investment bankers earlier this year?

So, let me get this straight. He was long investment banking, then shortened his exposure, but has now lengthened it again by purchasing the wreckage of one of the Street's worst-run risk-management operations?

Ken Lewis just bought a crippled player in a game whose Schumpeterian dynamics have decreed that excess capacity is now to be eliminated. I wouldn't be a buyer of BofA equity anytime soon. Not with Lewis at the helm, and this new jetsam aboard.

And isn't that how this all came about? If there wasn't excess underwriting and trading capacity, would Lehman, Bear Stearns, Merrill Lynch, Morgan Stanley and Goldman have leveraged themselves up above 25 times equity?

As I've noted in prior posts, all of these firms now exist at the pleasure of some commercial bank's broker loan division.

You won't catch me weeping over any of these corporate departures. Lehman, Bear Stearns and Merrill Lynch all exhibited horrifically bad risk management in a sea of financial excess and excess capacity. That's why capital was leveraged up so highly- to offset razor-thin margins. Guess what those margins, even on higher capital turnover, could not offset?

Risk.

Now the investment bank version of musical chairs has two players left, and, ostensibly, one chair.

I doubt Goldman Sachs is worried. Their risk managers are the best in the publicly-held financial services sector.

Do you think John Mack is worried today?