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.
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