Risky Business
Goldman Sachs and other big banks are taking a beating. But have they learned any lessons at all from the financial crisis?
BY WILLIAM D. COHAN
SEPTEMBER 29, 2011
With Europe on the verge of a financial meltdown and many of Wall Street's biggest banks trading at or near their 52-week lows and at a fraction of their book value -- take for instance, Goldman Sachs, which is trading at about 75 percent of its book value, staring down a rare quarterly loss, cutting compensation, and firing thousands of employees -- is it possible that the turmoil in the global financial markets is finally accomplishing what regulators the world over have not been willing or able to do: force these financial beasts to rein in their excessive risk-taking and act more like the dull, boring utilities we need them to be for our own safety?
If so, the change would be both welcome and long overdue. Since 1970, when Donaldson, Lufkin & Jenrette (DLJ), a small but well-regarded investment bank, bucked the conventional wisdom on Wall Street by deciding to sell shares in its partnership to the public, one private securities firm after another has followed suit, substituting other people's money for that of their own partners. That fateful decision has caused the rest of us nothing but heartache for the past 40 years.
It's not hard to see why Wall Street firms made the choice. First, by going public, the firms were able to have regular, steady access to a nearly bottomless supply of inexpensive capital with which to expand their products and offices around the world. This capital allowed them to make big, proprietary trading bets knowing that if the bets worked out they would make a financial windfall -- and if they didn't, the chances were low that the losses would sink their firms, because losses would be absorbed by the corporate till rather than by the individual partners whose capital was formerly at risk. With the new capital, they could also help their clients -- for large fees, of course -- underwrite massive debt and equity financings, allowing those clients to build new plants and equipment and expand their global reach.
Needless to say, going public also allowed a firm's partners to become very rich; it gave them a way to turn their long-held private equity into cash without depleting the firm's limited capital when they retired, as was formerly the case. With the firm public, if a partner wanted to sell his stock, he just turned to investors in the market and sold it; the risk of the firm's future financial performance shifted from individual partners to an amorphous group of outside investors.
Naturally, this prospect was too good for Wall Street bankers and traders to pass up, and after first expressing profound disapproval of DLJ's decision, the rest of Wall Street quickly fell into line. Merrill Lynch followed DLJ to the public markets in 1972. Bear Stearns and Morgan Stanley went public in the mid-1980s. Lehman Brothers did an IPO in 1994 as a way to leave the American Express fold. Goldman Sachs, the most prestigious Wall Street firm, did its IPO in May 1999, raising nearly $3.7 billion. The firm's value at the end of its first day of trading was more than $33 billion, nearly four times its book value.
The consequence of these public offerings on recent financial history has been nothing short of profound. Goldman, for instance, which had capital of around $45 million in 1970, when DLJ went public, has capital of around $75 billion today. When capital at these firms was limited and scarce, tough choices needed to be made about how and when to use it. Much care was taken to analyze the associated risks of a large trade or underwriting. Partners were prudent with risk-taking.
But with the capital spigot turned on full blast, risk-taking knew no bounds. What's more, Wall Street's partnership culture -- in which partners were paid from firms' pretax profits and were liable for their entire net worth for losses -- was replaced by a bonus culture in which their risk-taking was rewarded with large, multimillion-dollar bonuses while losses were absorbed by public shareholders -- or as we discovered in 2008, by taxpayers, the poor saps. Worse, there has been little or no financial or legal accountability for the Wall Street bankers and traders who brought the Great Recession to the world's doorstep.
Indeed, it is fairly safe to conclude that each and every one of the financial crises that the world has suffered through in the past generation -- from the crash of 1987 and the credit freeze that followed, to the Asian, Russian, and Mexican crises, to the collapse of hedge fund Long-Term Capital Management in 1998, to the puncturing of the Internet bubble in 2000 -- has in one way or another been caused by an incentive system on Wall Street that encouraged bankers and traders to take large risks with other people's money and where the rewards were in the millions of dollars of annual compensation and the penalties were far and few between. There is no getting around this fact. Because this aspect of the finance life remains virtually unchanged in the wake of the collapse of the housing bubble, chances are high that Wall Street will have a heavy hand in causing the next financial crisis, too, notwithstanding the fact that the losses many firms are suffering these days should make them more cautious.
The promise of the recent wave of regulatory theatrics in Washington, London, and Basel has been to try to break this dangerous cycle in which bankers and traders get very rich while the rest of us suffer from their mistakes. The so-called Volcker Rule, introduced with much fanfare by former Federal Reserve Chairman Paul Volcker in January 2010 and quickly endorsed by President Barack Obama, became one of the cornerstones of the Dodd-Frank law, the 2,200-page Wall Street reform legislation, and was supposed to prevent Wall Street firms from engaging in large proprietary trades and other risky bets with their own capital. Forgetting for a moment that proprietary trading didn't cause the mortgage meltdown -- and, in fact, Goldman's proprietary trade in the first half of 2007 against the mortgage market made the firm close to $4 billion in profit and helped it navigate the financial crisis in much better shape that its less clever competitors -- we are now discovering that even the Volcker Rule is in the process of being watered down. The latest draft of the rule, according to observers cited in the Wall Street Journal, "opens the door for banks to make all manner of bets on the market ... because a bank might define the risk to its portfolio broadly, such as the risk of a U.S. recession. If the language is confirmed in the final rule, expected by late October, it would be a victory for Wall Street firms that have lobbied to relax the ban on proprietary trading."
Similar efforts by Wall Street lobbyists are under way to weaken other still-to-be-written regulations mandated by Dodd-Frank. For instance, the Commodity Futures Trading Commission, which must craft the rules that will require many derivatives for the first time to be traded on an open exchange so that price discrepancies can be more easily discovered and then resolved, has only completed a handful of the new rules it was supposed to have approved by now. Deadlines keep getting postponed. As a result, some derivatives at the heart of the mortgage mess, such as credit-default swaps -- the infamous bets that certain debt securities will or won't retain their value -- still trade by appointment and in secret, meaning nothing has changed some three years after the most acute moment in the financial crisis.
Meanwhile, Jamie Dimon, CEO of JPMorgan Chase, has roundly criticized the proposed Basel III capital-requirement rules as being "blatantly anti-American" because the rules require that banks increase the capital they hold in reserve, making it harder for them to earn a respectable return on that money On Sept. 26, Dimon continued his anti-regulatory tirade -- this time against Canada's central bank -- even as the stunning loss of $2.4 billion by a rogue trader at UBS, in London, underscored how little these big firms really understand about the risks they continue to take and how badly they are in need of serious oversight.
The vacuum created by the lack of regulatory reform on Wall Street seems to be getting filled by the prevailing sluggishness in global markets. The persistent lack of demand for Wall Street's services -- from trading (at Goldman, for instance, revenue from this business line is down one-third from 2010 through the first six months of this year) to underwriting to providing M&A and investment advice -- is forcing Wall Street's executives to do what they should have done long ago. Risk-taking is being greatly curtailed, underwriting standards are getting more exacting, superfluous employees are being axed, and those who remain are finally going to have to make do with far less of the obscene compensation that they have been accustomed to receiving.
Some 40 years after the first Wall Street firm went public through an IPO, the big Wall Street banks might finally be getting the message that in order to restore the mutual trust they have so utterly squandered, they may have to return to a simpler time when their focus was on their clients' needs, their pay was far more modest, and rock stars were people who made music -- not pushed paper around.
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William D. Cohan, a former managing director at JPMorgan Chase, is a contributing editor at Vanity Fair, a columnist for Bloomberg View, and the author, most recently, of Money and Power: How Goldman Sachs Came to Rule the World.
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