Bringing down the houses that built America's economy
How convoluted financial products and misguided government policy crippled the Big Five investment banks
SINCLAIR STEWART
From Saturday's Globe and Mail
September 20, 2008 at 1:09 AM EDT
On the eve of the Second World War, as the Great Depression lingered and Americans nurtured their deep-seated grievances with the country's financial elite, Charles Merrill had an unlikely idea: He wanted to bring Wall Street to Main Street, a democratizing push aimed at erasing the public's misgivings and encouraging mass participation in the markets.
“America's industrial machine is owned at the grass roots, where it should be,” Mr. Merrill pronounced. “Not in some mythical Wall Street.”
Now, 70 years after Good Time Charlie revolutionized the face of American capitalism by bringing stocks to the masses, his populist vision lies in tatters, alongside the carcass of the eponymous firm, Merrill Lynch & Co., that he transformed into the world's most powerful brokerage.
One of the most devastating crises in U.S. history is laying waste to the pillars of Wall Street with a swiftness that has tested the limits of incredulity, if not dire superlative: Lehman Brothers, a 158-year-old firm that weathered the Civil War and the Panic of 1907, among other calamities, has crumbled in an inglorious heap. Ditto Bear Stearns, which famously sailed through the Crash of 1929 without firing a single employee. There is now persistent talk that Goldman Sachs and Morgan Stanley, those twin fortresses of impregnability, may have to abandon their independence if they are not spared first by an unprecedented government bailout effort.
And, of course, there is Mr. Merrill's firm, the “thundering herd,” which was tamed this week in a humbling sale to Bank of America, forestalling an almost certain collapse.
The collective failure here has been monumental, not just in monetary terms – half a trillion dollars has vaporized since the mortgage-fuelled meltdown erupted last year, and we're still counting – but in symbolic ones as well.
These were among the founding fathers of the “financial system” as we know it, a group that underwrote governments, financed the creation of the country's blue-chip companies and helped power the notion that the 20th century was America's century.
And yet, to varying degrees, each proved inept at the very task that has been central to their business model, if not their longevity, over the past century: managing risk.
Now, amid a massive restructuring of the financial landscape, there may also be a re-evaluation of Mr. Merrill's gospel: Main Street has been left to wonder whether an anchor was not at the other end of the ties that bound it to Wall Street.
“Merrill Lynch helped create a culture in the last half of the century that really flourished – that Wall Street is a place for us, too,” said Steve Fraser, an economic historian and author of Wall Street: America's Dream Palace. “To see them go down is a shocking loss of the sense that Wall Street is a common place where we can all find our fortune.”
The obvious question is how did this happen? How could these venerable brokerages miscalculate so badly, threatening not merely their own financial health, but that of the entire economy as well?
The tempting answer is greed. Wall Street has long been viewed as a haven for coddled fat cats, but in recent years, compensation levels have reached obscene levels. These flawed bonus models rewarded bankers for pumping out increasingly toxic and esoteric products, with little regard for the havoc they would wreak.
But that is only part of the story, and it neglects the role of government policy, much of it misguided in hindsight, that abetted Wall Street's reckless binge.
During the Reagan era, and the ascendancy of the laissez-faire economic theories laid down by Milton Friedman, the banking industry lobby found a sympathetic ear in Washington. U.S. lawmakers began to loosen market regulation, believing the system would function more effectively by removing as many hindrances as possible to the flow of capital.
For decades, the Big Five investment banks had earned their money by supporting the war effort, selling bonds and stocks, and underwriting public offerings. In fact, that's all they could do, thanks to the Glass Steagall Act of 1933, a law designed to stem the wild speculation that helped fuel the market crash of 1929 by ensuring that banks could not make risky gambles with customers' deposits.
Universal banks such as J. P. Morgan were forced to split into separate companies: the commercial bank, J. P. Morgan, would offer loans and take deposits; the investment bank, the newly minted Morgan Stanley, would provide advisory services and sell stocks and bonds.
Yet in the 1990s, with the derivatives market in full swing, investment banks began straying from their roots. They became more reliant on aggressive trading strategies, often with borrowed money, and devised complex products, such as securitized mortgages, that were essentially loans.
By 1999, when President Bill Clinton scrapped Glass Steagall, it was merely a reflection that the lines separating these two divisions of the banking world were already beginning to blur.
All of this helped set the stage for the current financial crisis, which, like most others, can trace its roots to the credit markets.
In 2001, under former Federal Reserve chairman Alan Greenspan – also a monetarist in the Friedman mould – the central bank began cutting interest rates to precipitously low levels. This incited a tidal wave of new home-buying – and a monstrous credit bubble.
For investment banks, the temptation to cash in on the borrowing craze proved irresistible. Because of the cheap credit, they could borrow huge sums of money to buy mortgages of varying quality, repackage them as mind-bogglingly complex securities, and then sell them to investors who wanted a safe product with better returns than government bonds.
So great was the demand for these securities that banks began scraping the bottom of the credit barrel, and extending mortgages to many people who couldn't afford them.
This was a fantastically enriching business for a time – profit for the Big Five tripled to more than $30-billion between 2002 and 2006 – but only as long as the housing market didn't crater. Oddly, for all its vaunted risk systems, Wall Street never seemed to view this as a possibility.
“I don't think anyone realized how much their survival could be put at risk,” said Aswath Damodaran, a professor of finance at New York University. “You can't just let people run off as Lone Rangers.”
Of course, there was a reason investment banks didn't historically play in this arena – they weren't really equipped to do so. Unlike more tightly regulated commercial banks, which can tap their deposits as an inexpensive source of financing, firms such as Merrill and Lehman have no such cushion. They depend upon regular, short-term loans from other institutions, which they secure by using their assets as collateral.
In the days of Charlie Merrill, these assets would likely have consisted of highly liquid securities such as treasury bills, which could be sold immediately if there was a funding panic. But not this time around.
When home prices began to tumble last summer, the investment banks were left clutching sketchy mortgage assets that no one wanted to buy. As the value of these assets plummeted, causing hundreds of billions of dollars in writedowns, so too did the amount of money investment banks could borrow. In some cases, as with Bear and Lehman, the credit dried up completely, leaving them without enough cash to remain in business.
Such is the level of carnage that many observers are sounding the death knell for the investment banking model as we know it; the capital crunch is so severe, they say, that even Goldman and Morgan will eventually have to merge with a commercial bank. Indeed, the one reason why universal banks such as Citigroup, which boast investment-banking and commercial divisions, survived the mortgage crisis is because of their broad deposit bases.
Both Goldman and Morgan were hammered in the market over the past week, but rebounded sharply yesterday amid the government's plans to stage a record bailout.
Never mind that both of these firms insist their capital position is sufficient: Confidence is what lubricates the markets, and when it disappears, the gears seize and money stops flowing.
One hundred and one years ago, almost to the month, Wall Street was besieged by a similar crisis: the Panic of 1907.
When nervous depositors began pulling their money out of trust companies, inciting mayhem in the markets, J. P. Morgan rallied a group of bankers to raise $25-million in a mere 12 minutes, ending a run on the banks that may have resulted in the failure of 50 institutions.
Mr. Morgan's rescue effort prompted the U.S. government to create the Federal Reserve, a backstop that could be counted on to help contain future crises. But the problems facing today's Fed are much more vexing than the ones Mr. Morgan and his peers confronted a century ago.
The financial products involved in the current mortgage crisis are so convoluted that many of the firms that peddled them didn't quite grasp their intricacies. The interconnectedness of global markets, meanwhile, presents another quandary – each time one major firm fails, it is as though a linchpin is being removed, threatening to unleash a cascade of peril throughout the system.
Right now, the most pressing priority for the Fed and the Treasury Department is building a levee around Wall Street, before its tide of problems overwhelms the greater economy.
Already, as banks move to conserve their capital, corporations and consumers are finding it difficult to access credit – a problem that, if it deepens, could be catastrophic since U.S. growth has always been fuelled by easy access to debt.
But that is merely a palliative action. The next step, once the markets stabilize, will undoubtedly be remedial. “The days of Wild West risk-taking and throwing caution to the wind are gone,” said Michael Holland, a veteran of Wall Street who heads his own money-management firm, Holland & Co. “Every one of these crises is different in specifics, but consistent in its outcome: The regulatory landscape shifts, and it will this time as well.”
Industry officials say they expect a new frontier of regulation, one that will crack down on financial alchemy, stiffen capital requirements, scrutinize hedge funds and overhaul the flawed credit-rating industry, among other things.
If Washington goes that far, it will amount to a rebuke of a government policy that in recent decades has been rooted in market fundamentalism – the secular faith that unfettered markets, left to their own devices, will offer the quickest path to prosperity.
A Merrill associate, describing the differences between Charlie Merrill and his partner, Edmund Lynch, once famously remarked that “Merrill could imagine the possibilities; Lynch imagined what might go wrong in a malevolent world.”
Wall Street, as it turns out, had plenty of Merrills in the past decade. In the future, it could do with a few more Lynchs.
