New York: The old Wall Street is giving way to a new one. As the tectonic shifts within the American financial industry shook the world’s markets on Monday, many experts predicted that events of the previous 72 hours heralded a new period of painful change for Wall Street.
Under the hammer: A pedestrian stops to read a sign set up on a sidewalk in New York’s financial district on Monday. A late afternoon sell-off sent the stock market to its worst daily loss in seven years. Fred R Conrad / NYT
The predictions were sobering. Investment banks will be smaller. Their profits will be leaner. Jobs in finance will be scarcer. And the outsize role of Wall Street in the US economy will shrink.
That is the extreme case. But as investors tried to comprehend the abrupt downfall of two of Wall Street’s mightiest firms—Lehman Brothers Holdings Inc., which spiralled into bankruptcy, and Merrill Lynch and Co., which rushed into the arms of Bank of America Corp.—even optimists said the immediate future would be difficult. Treasury secretary Henry M. Paulson Jr and the Federal Reserve are paving the way for the few strong survivors to lead an industry turnaround, while letting the weaker ones fail, or be subsumed by larger rivals.
“We’ve gone from a golden era of banking and financial services,” Kenneth D. Lewis, chief executive of Bank of America, said in a press briefing on Monday, as the bank he heads prepared to buy Merrill Lynch. “It’s going to be tougher,” Lewis said. “There are going to be fewer companies, and we are going to have to be better at what we do.”
A debate is raging over what lies ahead for Wall Street now that only two major American investment banks, Goldman Sachs Group Inc. and Morgan Stanley, remain independent.
While Wall Street has gone through tough times before only to emerge bigger and stronger, some question whether the industry can rebound quickly after using high levels of leverage, or borrowed money, to binge on risky investments. Those investments have proved to be disastrous. Worldwide, financial companies have reported more than $500 billion (Rs23.3 trillion) in charges and losses stemming from the credit crisis—a figure some experts say could eventually exceed $1 trillion.
Missteps in the mortgage market cost Merrill Lynch, a brokerage that is synonymous with Wall Street to many people on Main Street, more than $45 billion over the last year. Its sale could be a step towards the broader consolidation within the industry.
“We are all in this business conditioned to cycles in crises and we’re also conditioned to markets snapping back relatively quickly because the crisis can be identified and measured,” said Donald B. Marron, chief executive of the financial services-focused private equity firm Lightyear Capital and former chief of PaineWebber Group. “What’s different now is you can’t do either.”
The marriage of Bank of America and Merrill Lynch, if completed, in a sense would hearken back to the past. During the Depression, Congress separated commercial banks, which take deposits and make loans, from investment banks, which underwrite and trade securities. The investment banks were allowed to do business with less oversight, while commercial banks operated with tighter supervision.
But after Congress repealed those Depression-era laws in 1999, commercial banks began muscling in on Wall Street’s turf. As the new competition whittled down profit margins, investment banks began using more of their capital to trade securities and also began developing financial derivatives in order to fuel profits.
Now, executives such as John A. Thain, CEO of Merrill and a former Goldman Sachs executive, say investment banks will need large bases of deposits to shore up their capital for times of trouble. “As we go forward, size is going to matter,” Thain said on Monday.
Paulson has told Wall Street executives that he isn’t happy about the shrinking number of investment banks, even though his own former firm, Goldman Sachs, is one of the two big investment banks that is likely to benefit from the industry shakeout.
He has told executives that greater consolidation on Wall Street could increase risk in the financial system, because the risks will be concentrated in a smaller number of firms. But treasury officials view risk as the lesser of two evils, if the alternative is to prop up sick firms and increase instability. Meanwhile, the Fed is expanding its backdoor channel for financing what officials hope is an orderly shakeout on Wall Street.
But the Fed, and ultimately taxpayers, could get left holding the bag. In allowing borrowers to post collateral that includes stocks, junk bonds and subprime mortgage-backed securities, the Fed said it would be mirroring the rules of two industry-operated overnight lending systems, known as tri-party repo systems, operated by JPMorgan Chase and Co. and Bank of New York Mellon Corp.
Fed officials have themselves expressed concern that the tri-party lending programmes needed to reassess their practices because lenders were holding collateral that might prove difficult to sell. In recent years, market participants have been funding growing volumes of relatively less liquid assets, warned Donald Kohn, vice-chairman of the Fed, in a speech last May. But if liquidity evaporates, borrowers, whose creditworthiness is questioned, can suddenly encounter difficulties financing now-illiquid collateral.
What seems to be clear to almost everyone on Wall Street is that the era of high-octane trading profits and deals fuelled by extreme bank borrowing is over, at least for now. That will clamp down profits across the industry for some time. Just as Americans are finding it harder to borrow to build a new room on their house, or to buy a new car, the biggest players on Wall Street are being forced to rein in the amounts they borrow. Borrowed money kept the lights on at investment banks such as Lehman, because such pure investment banks do not have the consumer deposit base.
Wall Street has always used other people’s money to amplify its profits, but in recent years, the use of debt ballooned. The finance industry’s credit market instruments increased more than one-and-a- half times in the last decade to $15 trillion last year, according to Moody’s Economy.com, and climbed at a pace that was two times faster than the growth of the broad economy.
At its peak last year, investment banks had borrowed $32 on an average for every dollar of their assets, according to research from Ladenburg Thalmann. The borrowing helped the industry turn record profits, hire more people and pay out eye-popping bonuses. And it pumped up financial stocks, making them the largest segment of the Standard and Poor’s 500-share index from 2001 until this spring.
Already, Wall Street firms are reducing their debt levels, and regulators are widely expected to create new rules about leverage, liquidity and capital levels. The new rules, if strict, could force the hand of Goldman and Morgan Stanley to merge with a bank that has customer deposits, a steady source of capital and buffer from collapse.
Wall Street veterans are divided over the extent of the industry’s problems. Some point out that Wall Street tends to go through a downturn, or outright crisis every four, or five years, and that it usually recovers quickly. But others argue that what is happening now marks the end of a 30-year credit “super-bubble” that affected the financial sector just as much as it did consumers.
Whatever the case, the financial sector seems poised for lower paydays across the board. “They can’t borrow, so they’re going to have (to) cut down,” said Peter J. Solomon, chairman of an independent investment bank that bears his name. “As they cut down, they will have to fire people.”
This past weekend’s events already increased analyst expectations of job losses. Most of Lehman’s 24,000 employees could lose their jobs, and Bank of America, the new owner of Merrill, is known for cost-cutting. Moody’s Economy.com raised its New York area job-loss figures on Monday by 20,000 people, to 65,000 by 2010.
As Wall Street firms of all sizes reduce their borrowings to reduce risk, it comes in some cases at the cost of higher profits. The shift has forced senior executives to rethink their business models, and more firms are focusing on the tried and true asset management units of their companies. In a sense, industry observers say, the firms are grappling with the loss of relationship banking that occurred 30 years ago.
“Wall Street for a number of years has been gripped by a quiet crisis, beneath all the financial wizardry and mathematical formulas, beneath all the financial engineering, there has been an increasingly desperate search for new sources of profit,” said Ron Chernow, the author of a book about JPMorgan’s empire, called The House of Morgan.
Wall Street, of course, reinvents itself all the time. Many executives say it will do so again, even as storied firms such as Lehman and Merrill falter and others, such as Goldman and Morgan Stanley, face questions about their futures.
“This industry is a dynamic industry that has evolved in unanticipated ways in the last 30 years and created pools of earnings that previously did not exist,” said James P. Gorman, co-president of Morgan Stanley.