Gone with the wind

The old way of doing business on Wall Street is now history

It is said a week is a long time in politics. But on Wall Street last week it was like nanoseconds. In less than a fortnight America’s gargantuan financial system changed, for ever. It was like the ‘Old South’ disappearing after the Civil War as shown in Gone With The Wind. The writing on the wall was clear – the old way of doing business is dead. The Wall Street business model of leverage – using borrowed cash to make high-stakes bets on everything from commercial mortgages to non-US stocks trading – has been deemed too risky for the present times. The model is now gone with the wind and the debris from the financial typhoon is too messy and mangled to be cleared too soon.
On Monday the verdict was out. The US central bank, the Federal Reserve, decided enough was enough and converted the last two independent Wall Street investment banks still in business, Goldman Sachs and Morgan Stanley, into traditional bank holding companies. The measure puts a heavy burden on the operating style of the swashbuckling titans. The new terms include closer scrutiny by banking regulators, need for new capital requirements and worst of all, much lesser profitability that has been the hallmark of these brokerages.
The giants of the Street have always used borrowed cash to play the high-stakes game. They were good at it and it showed. They created wealth, a lot of it, and careers. There was nothing like being a banker on Wall Street. Life was an LSD-laced dream. Work hard, party hard with your million-dollar bonuses – that summed up life of on the Street. It was as New York Mayor Michel Bloomberg, a former trader on the Street, said in his autobiography: “Sometimes I thought I had gone through the looking glass into another world…Funny world, funny money.” Mind you, he was speaking of the 1970s.
The leverage ratio of firms, which shows the risk a company takes with borrowed cash compared to its equity capital, has been rising from last year. Merril’s leverage hit 28 from 15 in 2003. For Morgan it was 33 and for Goldman Sachs, 28. For Lehman Brothers it was an astounding 40.
When the going was good nobody bothered about how the titans were going about with leverage, which involved short-term money market funding. For Lehman, as long as the profits were coming in torrents it was okay. But the music stopped when its shares hit 18 cents last week from a year-ago figure of $50. Leverage can be deadly when share prices plummet. Lehman found it was time to shut shop, and questions are now floating around on the Street’s ability to manage risk.
Blue-blooded investment banks such as Merrill, Goldman and Morgan, with a lower capital base compared with general banks, have historically used leveraged cash. Though the three had tried to reduce their levels of leverage by selling bad assets, the plunging values meant there was hardly anything they could do. And last week’s carnage clearly showed it was a one-way street. There were only sellers, no buyers for distressed assets, which is normally the case when markets go into a tailspin.
When assets prices start falling leverage could turn into a death trap. The danger here was that leveraging was based on the principles of mark-to-market accounting. Accordingly, if the current market value of an asset causes the margin account to fall below its required level, the trader will be faced with a margin call. That was what poked the banks in the eye. They blinked as they had not set aside enough less cash to face the eventuality of falling asset prices.
Therefore, when the banks’ stocks fell like ninepins there was hardly anything anyone could do about it. It was a near-death experience, which has made the giants more amenable to reason.
Now that the Fed has moved in, the landscape has changed for ever. Instead of being overseen by Securities and Exchange Commission, Goldman and Morgan will now have to bow before the diktats of a slew of federal agencies. The implosion on the Street had earlier seen Merrill and Bear Sterns merging with larger banks.
The advantages of turning into normal banks are many, particularly now when most people find leveraging a dirty word. Though normal banks have also got entangled in the credit imbroglio, the fact remains that since commercial banks mostly use their depositors money to fund their business the risks are much lower as run on banks are now history, thanks to government insurance.
More than that, it will allow the Street titans to swear off mark-to-market accounting, which value their assets according to the market price and instead allow them to follow normal banking procedure and mark them as “held for investment”. Though these measures will not provide a fool-proof mechanism, it will keep the titans steady, at least till the next crisis, which is always around the corner for if stock market experts were such experts, they would be buying stocks, not selling advice!

This article was first published in Oman Tribune