This is the peak of the hurricane season – and in its financial markets. Just as Hurricane Katrina devastated New Orleans a few years ago and Hurricane Ike recently swept over the Texas coast, Hurricane Mortgage-Debt has done a job on Wall Street, causing more damage and dislocation than anything experienced in seventy-five years.
The damage has principally affected the world’s market for wholesale finance, which last year accounted for around $25 trillion of transactions originated by the leading commercial and investment banks (with generous allowances for double-counting). Ten firms accounted for about 65% of these transactions – they are the clear market leaders, most of them with balance sheets in excess of $1 trillion and each with ambitions to use leverage, risk-taking skills and global client contacts to earn returns with growth rates of 20% annually. As in all bubbles, people were asked to believe that 20% growth in returns of financial firms was quite consistent with growth in the real economy of perhaps one-fourth that pace. As Wiley E. Coyote likes to point out on the Sunday morning cartoons on television after hurtling to the canyon floor, “watch out for gravity.”
So these same ten firms have now had to absorb close to $200 billion in write offs on illiquid securities that were either warehoused by them or were in the pipeline for sale to investor clients. Consequently, their share prices have been decimated, and they have been forced to raise approximately that amount in new equity capital to survive the financial “storm of the century” – one of three such financial hurricanes in the last ten years. Five of the ten major wholesale firms (Citigroup, UBS, Merrill Lynch, Morgan Stanley and Lehman Brothers) have made dramatic leadership changes at the very top. One of them (Bear Streans) collapsed into the arms of another (JP Morgan Chase) with massive government help and another (Lehman Brothers) at this writing is on the ropes despite severe actions to jettison assets and scale-down to weather the blast, and despite unprecedented lifelines extended by the Federal Reserve.
All of the surviving wholesale banks would surely be on their regulators’ list of banks that are classified as “too big to fail” and therefore eligible to be taken over or otherwise bailed out by their regulators to rescure their creditors if not their shareholders.
Wall Street is known as a blustery place, with dangerous coastlines where many ships have foundered over the years. But the robust and resilient characters who inhabit this world are accustomed to picking themselves up after periodic storms and getting back into things. This time around, though, there are likely to be at least two major changes that will affect the way Wall Street is able to put itself back together again – and that will affect the conduct of business in years to come.
The first is the reaction of the regulators: Backed by public outrage at socialization of risks taken on by private businesses (including the bailouts of Fannie and Freddie) they now think that enough is enough. The tendency of big investment banks to create havoc in the markets through their ability to turbocharge the use of leverage and financial innovation to create or magnify speculative bubbles somehow needs to be constrained. Sure, their shareholders are going to lose heavily if they slip-up, but the massive bonus-pools created along the way have long since been taken off the table by professionals who don’t have to give anything back. Financial firms and their high-performance employees, acting in their own best interests under the existing rules of the game, have created a financial architecture virtually unprecedented in its fragility and potential for inflicting massive damage on the broader economy and society.
So it is inevitable that the government is going to have to act as the involuntary guarantor of these firms’ liabilities under a too-big-to-fail safety net, and this will inevitably come with strings attached. Politically it cannot be otherwise. Those who hold up the safety net get to call the shots. The government now gets to set the terms of new constraints on the major financial firms in order to protect the public from the banks. The specifics won’t be known until next year when the next US administration takes up the matter and international consensus has been sought, but it is quite likely that much tougher constraints will be imposed – constraints that will take their toll on market efficiency and creativity (including some unintended consequences) in a well-justified search for greater financial stability.
The second sea-change is the attitude of the banks’ own investors: Stockholders of the big global wholesale banks have been horrified by what has happened to their investments – at its 2008 annual shareholders meeting, an elderly shareholder of a top European bank whose stock price had collapsed told the board “you have turned our bank into a casino.” Most bank shareholders, of course, are not elderly gentlemen but rather large “sophisticated” institutional investors (pension funds, mutual funds, hedge funds, sovereign wealth funds) who are supposed to manage client assets and have a powerful fiduciary responsibility to them.
These institutional investors in bank stocks have been essential for the dominant global wholesale banks to promote high market values for their stock. But these same institutional investors are surely going to rethink the wisdom of investing in corporate structures that appear to be not only highly risky in their business models, but at the same time take the form of huge, hard to manage global enterprises which – if their mistakes are big enough and certainly if they ultimately have to be taken over by the regulators – automatically wipes-out their investments.
So institutional investors in large universal banks and financial conglomerates, many of whose businesses are both solid and profitable, are unlikely to be pleased at the prospect of some of their worst-performing businesses doubling-up by absorbing failed investment banks. And lurking in the background is plenty of evidence that stock prices of financial conglomerates tend to perform poorly compared to more specialized financial firms.
We think it is doubtful that big banking conglomerates are going to be able to go back to business as usual when the current financial hurricane abates, possibly having swallowed a failed investment bank or two. Their angry stockholders are going to expect a different business model. Several activist shareholder groups have already made this clear to the boards and managements of several major global banks, and at least four of them are being forced by their shareholders to conduct top to bottom strategic reviews to consider their future in the riskier parts of their business.
As a result, rather than see most of the remaining investment banks swallowed by big commercial banks (except under extreme distress and guaranteed by regulators), we might in fact see more dispositions of investment banking businesses by commercial banks and financial conglomerates. Recent pressure on Citigroup, UBS, Allianz, RBS and others suggests that this is not impossible. This “new generation” of independent investment banks – comprising the survivors among the legacy firms plus the spun-off newcomers – would streamline themselves into smaller, simpler businesses that are more reliably managed so as to justify the confidence of the institutional asset managers who hold their stock and vote their proxies. This could lead to a fairly large field of “new-gen” global investment banks that are highly competitive, highly focused and well-managed, operating within sensible and carefully monitored leverage limits, and concentrating on their traditional role of wholesale financial intermediation. The new-gen firms would then proceed to compete with wholesale divisions of financial conglomerates who think they can effectively manage these turbulent businesses and whose shareholders believe they have a reasonable chance of succeeding.
“Not a bad solution for the global wholesale banking architecture,” a dispassionate observer of the world financial scene might say a decade from now, “and maybe an unintended dividend from the hurricane season.”