A worker is seen carrying a box out of the U.S. investment bank Lehman Brothers offices, in the Canary Wharf district of London in this Sept. 15, 2008 file photograph. (Xinhua/Reuters Photo)
The year 2008 witnessed the end of an era on Wall Street. Bear Sterns and Lehman Brothers disappeared. Merrill Lynch is being folded into Bank of America. And Goldman Sachs and Morgan Stanley, with few choices left, have changed their status to become bank holding companies. Those moves marked the end of the securities firm model that has dominated Wall Street since the Great Depression.
COLLAPSE OF WALL STREET
Lehman Brothers, a 158-year-old firm that started as an Alabama cotton brokerage, filed for bankruptcy protection on September 15. And Merrill Lynch, known by its trademark bull logo, was acquired by Bank of America on the same day.
Both Lehman Brothers and Merrill Lynch have been renowned pillars of Wall Street for a long time. But with the demise of Bear Stearns, the fifth largest U.S. securities firm, in March, three of the Street's five major independent brokers disappeared. Only Goldman Sachs and Morgan Stanley remain.
In order to avoid the domino effect rippling through the banking industry and dragging down Wall Street's last two largest independent investment banks, the Federal Reserve took extraordinary measures on the night of Sept. 21 by agreeing that Morgan Stanley and Goldman Sachs could transfer into traditional bank holding companies.
As investment banks, these five giants once amassed enviable wealth. In the past, the core business of investment banks consisted of helping to hammer out big deals and advising companies and governments around the world on mergers, IPOs and restructurings.
However, since the 1990s, investment banks gradually switched to a model of earning revenue by expanding their own balance sheets. They dominated the industry's most lucrative businesses and enjoyed astonishing profits by taking risky bets and using enormous amounts of debt with little outside oversight.
DERIVATIVES BUBBLE BLEW UP
Twenty years ago, the total notional sum of derivatives in the entire world was close to zero. However, derivatives are a perfect way of getting rich while avoiding taxes and government regulations. Wall Street noticed derivatives were a lucrative business. Therefore, investment banks in a time of easy credit created thousands of types of derivatives in the name of financial innovation. As investment banks rushed into the area, derivatives grew into a massive bubble. In 2007, the notional value of all outstanding derivatives contracts rose above 516 trillion U.S. dollars, which is about eight times global GDP.
However, as the derivatives market was unleashed to expand, a lot of risk was being taken and the effects of this expansion as well as the damage in the event of a wave of defaults is practically unclear. Using the mortgage-backed security for example, there are trillions of dollars of securities whose value derives from the housing market. Lenders write a mortgage contract for a homeowner, then with the help of investment banks package and repackage that contract with thousands of others and sell them to investors.
Only seeing the lavish profit brought by derivatives, investment banks decided to ignore potential risk, forgetting the security is backed by a mortgage that is backed by a mortgage payer. During a bull housing market, homeowners are able to pay. However, as the sharp decline in American housing prices and other assets tied to home values took place last year, the derivative bubble blew up and the damage on Wall Street hammered investment banks.
HIGH LEVERAGE WIPING OFF ANYTHING
In addition to a lack of risk management, highly leveraged bets were also widely blamed. Many economists and analysts emphasized that investment banks depended too much on leverage, or the use of borrowed money, and declined to set aside enough cash against the assets they held.
In 2007, the leverage ratio -- a measure of a firm's risk in relation to the equity on its balance sheet -- soared to 28 from 15 in 2003 at Merrill Lynch, according to UBS. Morgan Stanley's leverage ratio climbed to 33, while Goldman's hit 28. In contrast, leverage ratios at commercial banks such as Bank of America are pretty low, staying at about 11. Less leverage means less profit, but the loss is also less than that of investment banks.
In a market with excess liquidity, investment banks posted huge profits with high leverage. However, once the market encountered a liquidity shortage, the weaknesses of the high leverage were exposed.
Firstly, losses are likely to increase rapidly. Once the prices of subprime mortgage-related securitized products and other securities began to fall, investment banks' efforts to reduce leverage led to more assets being sold. Thus prices further decreased and losses were magnified. Moreover, It is difficult to find buyers to deal with devaluating assets.
In addition, little equity capital in hands characterized investment banks relying on high leverage. Therefore, investment banks are more fragile than commercial banks in the face of losses. They would likely to plunge into the red because investment banks have no access to deposits as commercial banks do.
Given the escalating credit crisis, HSBC chairman Stephen Green said, "we are entering an era in which the industry's recent propensity for high leverage, together with the extreme complexity of some investment vehicles, will no longer be acceptable."
Traditional short sellers borrow stock with the aim of selling it, then buying it back at a lower price, hoping to pocket the difference. In a "naked" short sale, however, investors short the stock without actually borrowing it, making it much easier to drive down the share price of a company.
Investment banks targeted by naked shorting complained that the practice dilutes their shares and their market values evaporated. Meanwhile, the practice, which depresses share prices, has kept investors from buying stocks and makes financing more difficult.
In an effort to address continuing market volatility, the U.S. Security and Exchange Commission (SEC) issued a series of emergency orders to limit short sales and require reporting short positions.
On Sept. 18, the SEC issued an emergency order prohibiting short selling, as opposed to "naked short selling" of the public traded securities of 799 companies.
However, traders thought the ban on short selling was ridiculous. Teddy Weisberg from Seaport Securities pointed out that the market is global, so short sellers will always find a place to sell.
From October, the major investment banks, which have survived the crisis, will come under close supervision of regulators and have far less profitability than they have historically enjoyed.
Instead of being overseen just by the SEC, Goldman Sachs and Morgan Stanley will now face more scrutiny from numerous federal agencies, including the Federal Reserve, the Treasury Department's Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp.. Meanwhile, they will have to reduce the amount of borrowed money, which will significantly slash their profitability.
In a word, the move effectively returns Wall Street to the way it was structured before the U.S. Congress passed a law during the Great Depression separating investment banking from commercial banking, known as the Glass-Steagall Act.
(Xinhua News Agency December 2, 2008)