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| Home Front Economy |
| Wall Street's Unraveling |
| 2008-09-18 |
| WASHINGTON -- Wall Street as we know it is kaput. It is not just that Merrill Lynch agreed to be purchased by Bank of America or that the legendary investment bank Lehman Brothers filed for bankruptcy or that the insurance giant AIG is floundering. It is not even that these events followed the failure of the investment bank Bear Stearns or the government's takeover of Fannie Mae and Freddie Mac, the largest mortgage lenders. What's really happened is that Wall Street's business model has collapsed. Greed and fear, which routinely govern financial markets, have seeded this global crisis. Just when it will end isn't clear. What is clear is that its origins lie in the ways that Wall Street -- the giant investment houses, brokerage firms, hedge funds and "private equity" firms -- has changed since 1980. Its present business model has three basic components. First, financial firms have moved beyond their traditional roles as advisers and intermediaries. Once, major investment banks such as Goldman Sachs and Lehman worked mainly for their clients. They traded stocks and bonds for major institutional investors (insurance companies, pension funds, mutual funds). They raised capital for companies by underwriting -- selling -- new stocks and bonds for the firms. They provided advice to corporate clients on mergers, acquisitions and spinoffs. All these services earned fees. Now, most financial firms also invest for themselves. They use partners' or shareholders' money to place bets on stocks, bonds and other securities -- so-called "principal transactions." Merrill and other retail brokers, which once served individual clients, have ventured into investment banking. So have some commercial banks that were barred from doing so until the repeal in 1999 of the Glass-Steagall Act of 1933. Second, Wall Street's compensation is heavily skewed toward annual bonuses, reflecting the profits traders and managers earned in the year. Despite lavish base salaries, bonuses dominate. Managing directors with 15 years' experience can receive bonuses five to 10 times their base salaries of $200,000 to $300,000. Finally, investment banks rely heavily on borrowed money, called "leverage" in financial lingo. Lehman was typical. In late 2007, it held almost $700 billion in stocks, bonds and other securities. Meanwhile, its shareholders' investment (equity) was about $23 billion. All the rest was supported by borrowings. The "leverage ratio" was 30 to 1. Leverage can create huge windfalls. Suppose you buy a stock for $100. It goes to $110. You made 10 percent, a decent return. Now suppose you borrowed $90 of the $100. If the price rises to $101, you've made 10 percent on your $10 investment. (Technically, the price has to exceed $101 slightly to cover interest payments.) If it goes to $110, you've doubled your money. Wow. Once assembled, these components created a manic machine for gambling. Traders and money managers had huge incentives to do whatever would increase short-term profits. Dubious mortgages were packaged into bonds, sold and traded. Investment houses had huge incentives to increase leverage. While the boom continued, government remained aloof. Congress resisted tougher regulation for Fannie and Freddie and permitted them to run leverage ratios that, by plausible calculations, exceeded 60 to 1. It wasn't that Wall Street's leaders deceived customers or lenders into taking risks that were known to be hazardous. Instead, they concluded that risks were low or nonexistent. They fooled themselves, because the short-term rewards blinded them to the long-term dangers. Inevitably, these surfaced. Mortgages went bad. The powerful logic of high leverage went into reverse. Losses eroded firms' tiny capital bases, raising doubts about their survival. This year, Lehman lost nearly $8 billion in "principal transactions." Otherwise, it was profitable. How Wall Street restructures itself is as yet unclear. Companies need more capital. Merrill went to Bank of America because commercial banks have lower leverage (about 10 to 1). It seems likely that many thinly capitalized hedge funds will be forced to reduce leverage. Ditto for "private equity" firms. In time, all this may prove beneficial. Financial firms may take fewer stupid and wasteful risks -- at least for a while. Talented and ambitious people may move from finance, where they were attracted by exorbitant pay, into more productive industries. But the immediate effect may be to damage the rest of the economy. People have already lost their jobs. States and localities, particularly New York City and New Jersey, that depend on Wall Street's profits and payrolls will face further spending cuts. Banks and investment banks may tighten lending standards again and impede any economic recovery. The stock market's swoon may deepen consumers' pessimism, fear and reluctance to spend. There may be more failures of financial firms. It's hard to know, because financial crises resemble wars in one crucial respect: They result from miscalculation. |
| Posted by:Bobby |
| #14 Correct Mike N., which is why the situation south of the border is fascinating. Some countries are screaming buys needing investment, after centuries of abuse (Brazil/Chile/Peru/Columbia) while others are headed the wrong way in a hurry (Bolivia/Chavezville). A shame if they get shorted in the fallout, but Brazil is likely finally big enough to thrive regardless, and could drag the other well-behaved types along with it. |
| Posted by: Halliburton - Asymmetrical Reply Division 2008-09-18 23:16 |
| #13 BArb: I always thought that Trump was a true American Hero. And today on Larry King, he endorsed McCain. What's your problem? Don't you love McCain? |
| Posted by: General_Comment 2008-09-18 23:14 |
| #12 Nothing wrong with leverage in and of itself. Lending is a neccessary tool for growth. Problem was, money was so cheap that a ton of that leverage went to bad investments because there wasn't enough good ones to keep up with all the money. |
| Posted by: Mike N. 2008-09-18 21:22 |
| #11 ION CNN + FOX AM > seems Wall Street stocks have REBOUNDED APPROXI 410 POINTS + is anticipated to still rise slighlty further as financial markets stabilize??? |
| Posted by: JosephMendiola 2008-09-18 20:27 |
| #10 I'd call it RICO. |
| Posted by: Procopius2k 2008-09-18 19:48 |
| #9 People were borrowing lots of money 50-60 times for each dollar held. I guess they call this leveraging. I call it poor business practices. |
| Posted by: JohnQC 2008-09-18 19:20 |
| #8 Ebbang, I don't see any jumping this time. Perhaps many of them need to be pushed instead, sine they have no honor nor any integrity to make good the results of their dereliction of duty. Defenestration woudl be a proper punishment of the fat cats who demolished the economy. |
| Posted by: OldSpook 2008-09-18 17:15 |
| #7 Bingo, Ebbang. I borrowed money for my house (still paying) and my car (paid off early). I "borrow" money with my credit card each month merely for convenience - I have the money already and the bill gets paid as soon as it comes in - no interest paid. I don't borrow money to buy intangibles, such as a vacation. And I don't borrow money to buy stocks - otherwise known as buying on margin. I'll never be Donald Trump (thank heavens!), but I'll also never cost normal people billions of dollars and damage the country's economy by playing fast and loose with other people's money. **Spit** |
| Posted by: Barbara Skolaut 2008-09-18 15:45 |
| #6 Isn't borrowing money to buy stocks what led to people jumping out of buildings in 1929? |
| Posted by: Ebbang Uluque6305 2008-09-18 15:21 |
| #5 The problem is that they separated the risk from the profit and loss. They made money on origination fees on mortgages and then sold the junk to others. Those who made the loans did not lose the money, they made it and cared not a whip what happened either to the homebuyer or the loan. It was one big Ponzi scheme with the American public left holding the bag. |
| Posted by: Betty Grating2215 2008-09-18 13:38 |
| #4 I wonder how many of these big bank players and 'managing directors' have 'golden parachute' clauses in their contract? I'm thinking that that (any any bonuses) should the the very first thing to be forfit up by any bailout. |
| Posted by: CrazyFool 2008-09-18 12:27 |
| #3 So how about mandatory financial institutional collapse insurance 'tax' upon the players/firms for in the future. Since they're getting us to pay, in devalued inflated spending dollars with the Fed pumping billzions into the market, maybe its time the players fork over sums to finance future cyclic debacles like this. The level of the tax to be graduated by the riskiness of the activity pursued. Since no one 'in charge' is willing anymore to tell them to suck it up and die [because of 'ramifications' or other rationalization], time to get some control on the process. Talented and ambitious people may move from finance, where they were attracted by exorbitant pay, into more productive industries. Preferably making license plates. |
| Posted by: Procopius2k 2008-09-18 11:59 |
| #2 An interesting article from the Sun on how the leveraging occurred. |
| Posted by: Nimble Spemble 2008-09-18 11:48 |
| #1 What we are seeing is the deleveraging of Wll Street, du to the failures of the derivative markets. What it means is that banks are going to be overly-tight with money, which will lead to less money available, therefore less demand for goods, and eventually less goods produced. Its called a deflationary spiral, and can lead to an economic depression if the hoarding of capital and resultant lack of demand (due to lack of cash) eats into production capability. Basically, a lot of the derivative markets and futures, etc that sprung up in the 90's have demolished the banks because they lent those hedge fund investment fat-cats tons of money that has now vaporized. |
| Posted by: OldSpook 2008-09-18 11:42 |