Rearranging the towers of gold
Sep 10th 2009 NEW YORK
From The Economist print edition
Wall Street has staged a surprisingly strong recovery from its meltdown a year ago. But it will not return to business as usual
Illustration by Ian Whadcock
AT THE press of a button, the double doors sweep open. Welcome to the office in downtown Manhattan of Lloyd Blankfein, chief executive of Goldman Sachs. A couple of years ago, such smooth gadgetry would have seemed a fitting symbol of the power of Wall Street. These days it stirs more sinister thoughts: of a screen villain rather than a hero of high finance. As it happens, it is rumoured that an institution not unlike Goldman will appear unflatteringly in Oliver Stone’s sequel to “Wall Street”, due in cinemas next spring.
Economists continue to debate the ultimate causes of the collapse of Lehman Brothers, Wall Street’s fourth-biggest firm, a year ago on September 15th, and of the havoc that followed. The public and most politicians, however, are clear: the blame lies with bankers, venal and incompetent in equal measure. “It’s like pre-Thatcher Britain out there,” sighs the head of a New York bank. At a hearing in February a congressman addressed JPMorgan Chase’s boss, Jamie Dimon, as “Mr Demon”. Deliberate or not, it captured the mood.
The name-calling may have died down a bit lately, but the Street will struggle to regain its swagger. Reforms proposed by Barack Obama’s administration would, if passed, introduce an array of penalties for bigness and boldness. Regulators, too, are determined to clip finance’s wings, even musing about reducing the “swollen” financial industry to a more acceptable size, a sentiment echoed by self-flagellating bankers. This week the arch-capitalist Mr Blankfein chastised Wall Street for letting “the growth and complexity in new instruments outstrip their economic and social utility”. Reducing banks’ leverage and their leeway to splash out on star traders will be a priority at the G20 summit in Pittsburgh this month.
The politicians are driven in part by populist urges and in part by a genuine wish to avoid a repeat of the week in which global finance suffered a near-fatal heart attack. In the space of two days Merrill Lynch fell into the arms of Bank of America (BofA), Lehman went bust and American International Group (AIG), a mighty insurer, buckled under suicidal derivatives bets and had to be bailed out. Lehman’s demise marked the onset of the worst financial crisis and global recession since the 1930s.
To be sure, the seeds of trouble had been sown years earlier, with the relaxation of lending standards in mortgages, corporate buy-outs and much more, and with the enthusiasm for using borrowed money to enhance returns. The debts of American financial firms rose steadily from 39% to 111% of GDP in the 20 years to 2008. But many of the subsequent policy choices—not least the $700 billion Troubled Asset Relief Programme—stemmed from Lehman’s demise.
Some believe there would have been less pain had Lehman been bailed out. Others think it was coming anyway. Either way, the episode shattered market expectations that large firms would not be allowed to fail—a few months before, the stricken Bear Stearns, New York’s fifth-biggest investment bank, had been forcibly married to JPMorgan. With no one sure who could be trusted, lending froze most abruptly in short-term markets, such as that for commercial paper, that many had come to rely on to support long-term assets. Such was the panic that the government was forced to backstop supposedly rock-solid money-market funds. By October the large, free-standing investment bank, the pride of Wall Street little more than a year earlier, was extinct.
Among the most important decisions was that no other big financial firm would be allowed to suffer Lehman’s fate. The consequences were too frightening. This approach extended to the stress tests for 19 “systemically important” institutions, completed in May. Those found wanting were promised capital from taxpayers if they could not tap private sources.
The aftershocks of September 2008 are still being felt, not least by the firms at the centre of it. Although chunks of Lehman were sold quickly to Barclays of Britain and Nomura of Japan, tens of billions of dollars of clients’ cash, much of it belonging to hedge funds, is still trapped in the world’s biggest bankruptcy. AIG is part way through a tortuous dismemberment.
America’s financial-services industry has shed record numbers of jobs as firms have failed, been sold or retrenched (see chart 1). Life has become less gilded for those still at their desks: Wall Street bonuses fell by 44% last year (chart 2). For the first time in living memory, investment bankers are having to pinch pennies: taxi firms in Bedford, a wealthy New York suburb, say business at local railway stations has evaporated because Wall Street commuters are walking, cycling or being picked up by their spouses instead.
Hence the relief at recent signs of stabilisation. Stockmarkets have rebounded. Investors have regained their appetite for junk-rated debt: the amount issued hit a two-year high in the week to August 14th. The interest rate at which banks lend to each other has fallen back to near pre-crisis levels. Large-scale bank nationalisation is off the table. Though hundreds of smaller banks face extinction, big banks have thickened their buffers against loss by raising common equity. The healthiest have repaid public capital (at a profit to taxpayers). Confidence is growing among discerning investors: hedge funds, the bane of wobbling banks last year, have lately been buying their shares, not shorting them.
Fuelling this optimism is a partial revival of capital markets. Overall activity remains muted, private securitisation markets all but shut. But trading and underwriting have picked up as capital- and credit-hungry firms tap into the thawed market—though volume has fallen since July (see chart 3).
Survivors prepared to take risks have done very well from trading in currencies, commodities and so forth as clients adjust their portfolios to new market realities, such as higher volatility. Bill Winters, co-head of JPMorgan’s investment bank, calls it “the most profitable period ever for continuing operations”. Banks have begun adding staff in hot areas, notably commodities. Some are even offering guaranteed bonuses, believed only months ago to have vanished with the go-go years.
These trading profits look unsustainable. Indeed, dealers’ spreads are already coming down as shell-shocked rivals recover their poise. Moreover, the financial system continues to be underpinned by federal programmes. Issuance of securities backed by consumer assets, such as car loans, has come back from the dead, to roughly $100 billion since March, but only thanks to a financing facility run by the Federal Reserve. “I still think in terms of parachutes rather than green shoots,” says Rodgin Cohen, chairman of Sullivan & Cromwell, a law firm.
This support means that the minting of money this year in banking’s top tier—the latest quarter was Goldman’s most profitable ever—leaves a bad taste. “Wartime profiteering,” harrumphs an industry consultant. Kenneth Rogoff, a Harvard economist and an authority on financial crises, argues that Wall Street’s resurgence merely reflects a temporary arbitrage: systemically important banks can make big profits taking big risks with cheaply borrowed funds, thanks to the taxpayer’s “invisible wallet” in the form of guarantees, while the authorities turn a blind eye.
Some may even be gambling for salvation. The banks that lost most, such as Merrill and Royal Bank of Scotland, have been offering the keenest terms in several areas, such as leveraged lending and rights issues, say rivals. This jostling for custom is benefiting some clients. BofA Merrill Lynch, Deutsche Bank and Credit Suisse recently agreed to delay part of their fees for initial public offerings by two property trusts. The balance will be payable only if the trusts make a minimum return on equity for a set period.
Swallow and hope
Survivors prepared to take risks have done very well from trading in currencies, commodities and so forth as clients adjust their portfolios to new market realities, such as higher volatility. Bill Winters, co-head of JPMorgan’s investment bank, calls it “the most profitable period ever for continuing operations”. Banks have begun adding staff in hot areas, notably commodities. Some are even offering guaranteed bonuses, believed only months ago to have vanished with the go-go years.
These trading profits look unsustainable. Indeed, dealers’ spreads are already coming down as shell-shocked rivals recover their poise. Moreover, the financial system continues to be underpinned by federal programmes. Issuance of securities backed by consumer assets, such as car loans, has come back from the dead, to roughly $100 billion since March, but only thanks to a financing facility run by the Federal Reserve. “I still think in terms of parachutes rather than green shoots,” says Rodgin Cohen, chairman of Sullivan & Cromwell, a law firm.
This support means that the minting of money this year in banking’s top tier—the latest quarter was Goldman’s most profitable ever—leaves a bad taste. “Wartime profiteering,” harrumphs an industry consultant. Kenneth Rogoff, a Harvard economist and an authority on financial crises, argues that Wall Street’s resurgence merely reflects a temporary arbitrage: systemically important banks can make big profits taking big risks with cheaply borrowed funds, thanks to the taxpayer’s “invisible wallet” in the form of guarantees, while the authorities turn a blind eye.
Some may even be gambling for salvation. The banks that lost most, such as Merrill and Royal Bank of Scotland, have been offering the keenest terms in several areas, such as leveraged lending and rights issues, say rivals. This jostling for custom is benefiting some clients. BofA Merrill Lynch, Deutsche Bank and Credit Suisse recently agreed to delay part of their fees for initial public offerings by two property trusts. The balance will be payable only if the trusts make a minimum return on equity for a set period.
Swallow and hope
One threat the big names face is from boutiques and others looking to capitalise on the turmoil. Merger and restructuring shops have been hiring, touting their independence and freedom from regulatory interference. KKR, a private-equity firm, is expanding its capital-markets unit and has begun underwriting share offerings, starting with firms in its own portfolio. Private-equity groups should also benefit from the planned easing of restrictions on their ownership of banks. Several former rainmakers and star analysts have set up broker-dealers.
There is a big vacuum to fill, argues John Costas, a former UBS bigwig who has just co-founded PrinceRidge, a boutique focused on debt markets. Some $15 trillion of financing capacity has been taken out as banks have shrunk balance-sheets and the “shadow” network of non-bank credit has crumbled, he estimates. Demand has fallen too, but not by that much.
The newcomers could yet struggle. Far from ceding ground, the big banks have grown even bigger, aided by government-brokered mergers. Rules have been bent or broken: JPMorgan breached the 10% market-share ceiling for deposits when it took over Washington Mutual, for instance. According to Inside Mortgage Finance, a newsletter, nearly half of American mortgages made in the first half of the year came from Wells Fargo, which took over Wachovia, or BofA, which swallowed Countrywide.
Increased concentration is vexing for regulators. Because systemically important firms can borrow more cheaply thanks to implicit state backing, small and medium-sized banks struggle to compete. A recent Fed study put big banks’ funding advantage at more than 30 basis points. That leads to another possible problem: indiscipline. Private firms with a low cost of funds and the taxpayer behind them are prone to recklessness: just look at Fannie Mae and Freddie Mac. America’s leading banks were too big to fail before the crisis. Now they are bigger still.
On closer inspection, however, the giants are taking divergent paths. In one camp are those at the top of Wall Street’s new pecking order, Goldman Sachs and JPMorgan. With them are other “flow monsters”—firms with a big share of high-volume markets, such as currencies, fixed income and equities—including Barclays and Credit Suisse. Like others, these giants have been forced to reduce their leverage, but they see a future that is not so different from the past. Goldman has been boldest, taking record amounts of risk last quarter—though mostly for client trades, not its own book, it insists. Mr Blankfein believes his firm will be able to continue making markets, financing deals and co-investing with clients. “Being both a principal and an agent is mutually reinforcing,” he says.
Perhaps, but these days making a fortune can be as invidious as losing one. Goldman’s bumper profits and earmarking of $11.4 billion for staff in the first half of 2009—not a record, but close—have turned the media as well as the mob against it.
Illustration by Ian Whadcock
The firm’s chutzpah has not helped. It declared that it could have survived without federal assistance, and that it did not need the taxpayers’ cash it received as a derivatives counterparty of AIG because its positions were hedged. Goldman has been put on the back foot by a spate of negative stories, including one that compared it to a vampire squid. (These creatures, which grow to only six inches, are “small and harmless rather than carnivorous,” says an exasperated Mr Blankfein.) Keen to deflect criticism, Mr Blankfein this week attacked some of the industry’s pay practices and accounting shenanigans, even calling for a ban on multi-year guarantees, which Goldman insists it does not offer.
Goldman’s arch-rival, Morgan Stanley, takes a markedly different view of Wall Street’s future. Having ramped up its risk-taking in the boom—John Mack made higher leverage an explicit goal after becoming its boss in 2005—Morgan Stanley has spent the past year scuttling in the opposite direction. The firm has hired traders in some areas to take advantage of the rally after the dramatic cutbacks of last year, but it now sees its future primarily in conventional “agency” businesses that require relatively little capital, picking up fees for arranging mergers, underwriting securities offerings and broking—to which end it bought a controlling stake in Smith Barney from Citigroup.
Citigroup, too, is returning to its roots. Forced by regulators to shrink after losing tens of billions on collateralised-debt obligations, it is well on the way to shedding 40% of its assets. The new, more modest model, centred on things like retail banking and managing companies’ cash, is essentially the Citicorp that existed before its mammoth merger with Travelers in 1998, with a few exceptions, says Vikram Pandit, Citigroup’s boss.
This renewed focus on old-fashioned finance is spreading. Consulting firms say they have seen a surge of interest from banks keen to sharpen their service in everything from retail banking to prime brokerage (the financing of trading by hedge funds). Bob Gach, head of the capital-markets practice at Accenture, a consultancy, knows of several that have set aside $400m or more to improve their technology links with customers. “Relationships are back,” he says. Investment banks are also throwing more resources into merger and restructuring advice, neglected by some during the boom as “a mere pimple on the donkey’s arse”, as one veteran puts it, but now seen as a core source of revenue—with limited downside.
Much of this comes in anticipation of new rules designed to curb bankers’ wilder instincts. With Congress fixated on health care, the fate of the Obama administration’s sweeping financial reforms remains unclear. Banks are in anxious limbo, awaiting the fine print on the treatment of securitised mortgages, credit-default swaps and more. But no one doubts that changes are coming.
The most dramatic is likely to be a toughening of capital-adequacy standards, endorsed recently by G20 finance ministers and a group of central bankers and supervisors that oversees the Basel capital rules. The new rules could be ready for adoption by the end of next year. The Basel Committee has already proposed higher capital charges for complex trading and exotic securitisations.
Capital will also be the method of choice to rein in firms big enough to rock the system. American officials are reluctant to go nuclear and break them up, not least because the task of splitting them into pieces small enough to pose no danger would be horribly messy. Instead banks will probably face a sliding scale, with minimum capital ratios rising as they get bigger or embrace more risk. They will also be expected to prepare “living wills”, setting out how they could be liquidated in the event of failure.
“There’s a real risk we end up so laden with capital that we can’t waddle and fart at the same time,” says a Wall Street grandee. Scrutiny from supervisors, increased after Lehman, will remain heavy. Goldman Sachs has no fewer than 40 Fed staffers breathing down the necks of its traders and risk-modellers.
Supervisors may have a valuable role in dealing with excessive pay, too. Britain’s Financial Services Authority may have watered down its pay code after bankers whinged about losing talent, but it has been using moral suasion to good effect, calling bosses to express its displeasure at the re-emergence of guaranteed bonuses. “Only the very bravest ignore a call like that,” says JPMorgan’s Mr Winters.
Supervisors, boards and shareholders (who are finally getting a say on pay in America) are likely to have a more beneficial impact on pay practices than rules crafted by politicians, who tend not to think the consequences through. When Congress increased the tax on bonuses earlier this year, banks predictably began raising fixed salaries to compensate. The compromise on pay reached by the G20 is more measured, but mostly proposes things big banks are already doing, such as paying more restricted stock and clawing back bonuses if performance slumps.
Elsewhere too, re-regulation may have regrettable unintended results. The push to standardise over-the-counter derivatives contracts, for instance, could, if taken too far, leave investors trying to hedge specific risks with blunt instruments, making the system less safe, rather than more.
The eventual size and shape of a re-regulated, rethought Wall Street is hard to predict. The industry has always been a bit like a balloon: squeeze it in one place and it expands in another. Sure enough, banks are making the most of today’s conditions: Credit Suisse, for instance, is structuring mortgage securities that are unrated by credit-rating agencies; it and others have begun securitising life-insurance policies that the old and infirm sell for cash.
Not-so-great expectations
The firm’s chutzpah has not helped. It declared that it could have survived without federal assistance, and that it did not need the taxpayers’ cash it received as a derivatives counterparty of AIG because its positions were hedged. Goldman has been put on the back foot by a spate of negative stories, including one that compared it to a vampire squid. (These creatures, which grow to only six inches, are “small and harmless rather than carnivorous,” says an exasperated Mr Blankfein.) Keen to deflect criticism, Mr Blankfein this week attacked some of the industry’s pay practices and accounting shenanigans, even calling for a ban on multi-year guarantees, which Goldman insists it does not offer.
Goldman’s arch-rival, Morgan Stanley, takes a markedly different view of Wall Street’s future. Having ramped up its risk-taking in the boom—John Mack made higher leverage an explicit goal after becoming its boss in 2005—Morgan Stanley has spent the past year scuttling in the opposite direction. The firm has hired traders in some areas to take advantage of the rally after the dramatic cutbacks of last year, but it now sees its future primarily in conventional “agency” businesses that require relatively little capital, picking up fees for arranging mergers, underwriting securities offerings and broking—to which end it bought a controlling stake in Smith Barney from Citigroup.
Citigroup, too, is returning to its roots. Forced by regulators to shrink after losing tens of billions on collateralised-debt obligations, it is well on the way to shedding 40% of its assets. The new, more modest model, centred on things like retail banking and managing companies’ cash, is essentially the Citicorp that existed before its mammoth merger with Travelers in 1998, with a few exceptions, says Vikram Pandit, Citigroup’s boss.
This renewed focus on old-fashioned finance is spreading. Consulting firms say they have seen a surge of interest from banks keen to sharpen their service in everything from retail banking to prime brokerage (the financing of trading by hedge funds). Bob Gach, head of the capital-markets practice at Accenture, a consultancy, knows of several that have set aside $400m or more to improve their technology links with customers. “Relationships are back,” he says. Investment banks are also throwing more resources into merger and restructuring advice, neglected by some during the boom as “a mere pimple on the donkey’s arse”, as one veteran puts it, but now seen as a core source of revenue—with limited downside.
Much of this comes in anticipation of new rules designed to curb bankers’ wilder instincts. With Congress fixated on health care, the fate of the Obama administration’s sweeping financial reforms remains unclear. Banks are in anxious limbo, awaiting the fine print on the treatment of securitised mortgages, credit-default swaps and more. But no one doubts that changes are coming.
The most dramatic is likely to be a toughening of capital-adequacy standards, endorsed recently by G20 finance ministers and a group of central bankers and supervisors that oversees the Basel capital rules. The new rules could be ready for adoption by the end of next year. The Basel Committee has already proposed higher capital charges for complex trading and exotic securitisations.
Capital will also be the method of choice to rein in firms big enough to rock the system. American officials are reluctant to go nuclear and break them up, not least because the task of splitting them into pieces small enough to pose no danger would be horribly messy. Instead banks will probably face a sliding scale, with minimum capital ratios rising as they get bigger or embrace more risk. They will also be expected to prepare “living wills”, setting out how they could be liquidated in the event of failure.
“There’s a real risk we end up so laden with capital that we can’t waddle and fart at the same time,” says a Wall Street grandee. Scrutiny from supervisors, increased after Lehman, will remain heavy. Goldman Sachs has no fewer than 40 Fed staffers breathing down the necks of its traders and risk-modellers.
Supervisors may have a valuable role in dealing with excessive pay, too. Britain’s Financial Services Authority may have watered down its pay code after bankers whinged about losing talent, but it has been using moral suasion to good effect, calling bosses to express its displeasure at the re-emergence of guaranteed bonuses. “Only the very bravest ignore a call like that,” says JPMorgan’s Mr Winters.
Supervisors, boards and shareholders (who are finally getting a say on pay in America) are likely to have a more beneficial impact on pay practices than rules crafted by politicians, who tend not to think the consequences through. When Congress increased the tax on bonuses earlier this year, banks predictably began raising fixed salaries to compensate. The compromise on pay reached by the G20 is more measured, but mostly proposes things big banks are already doing, such as paying more restricted stock and clawing back bonuses if performance slumps.
Elsewhere too, re-regulation may have regrettable unintended results. The push to standardise over-the-counter derivatives contracts, for instance, could, if taken too far, leave investors trying to hedge specific risks with blunt instruments, making the system less safe, rather than more.
The eventual size and shape of a re-regulated, rethought Wall Street is hard to predict. The industry has always been a bit like a balloon: squeeze it in one place and it expands in another. Sure enough, banks are making the most of today’s conditions: Credit Suisse, for instance, is structuring mortgage securities that are unrated by credit-rating agencies; it and others have begun securitising life-insurance policies that the old and infirm sell for cash.
Not-so-great expectations
However, the days when finance accounted for 40% of corporate America’s profits are over. Mr Winters thinks investment banks’ average return on equity will settle at a hardly dazzling 10-12% (though the best firms will do much better than that). At leverage of 15 times equity—the reduced level at which investment banks now typically operate—large parts of the fixed-income business fail to cover their cost of capital, reckons Brad Hintz, an analyst with Alliance Bernstein.
Rising interest rates will provide further drag—and probably ensure that credit grows more slowly than the economy for some years. “Everyone was running downhill for 15 years,” says Michael Poulos of Oliver Wyman, a consultancy. “Now we’ll see who the real athletes are.”
Copyright © 2009 The Economist Newspaper and The Economist Group. All rights reserved.
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