We felt the ill winds. But few could have
anticipated what has happened since Black Monday, 15
September 2008. Lehman Brothers became history after
filing for bankruptcy on 14 September. John Thain
sold Merrill Lynch lock, stock and barrel to the
Bank of America for $50 billion. With AIG about to
tank, US Treasury Secretary Henry Paulson eschewed
high morals of “no more bailouts” for sensibility,
and extended $85 billion credit to acquire 79.9 per
cent of the company — thus nationalising it in the
short run.
That didn’t help. Washington Mutual was teetering;
Morgan Stanley’s and Goldman’s stocks were being
hammered down. And there was real fear in the air.
So, Paulson announced the mother of all bailouts —
$700 billion to create a ‘bad bank’ that would
sequester ‘toxic’ assets, create liquidity, clean up
dud paper and shrink the financial sector’s balance
sheets. But the US Congress turned down the
proposal. While realising the need for this bailout
to save the system, there were many Congressmen and
Senators who were appalled at sinking such vast sums
of taxpayers’ money to throw a lifeline to
institutions whose employees behaved like fat cats.
Simultaneously, realising that the days of
independent Wall Street institutions are over,
Morgan Stanley and Goldman Sachs have opted to
become bank holding companies instead of investment
banks — thus agreeing to be supervised by the
Federal Reserve as well as the SEC (Securities and
Exchange Commission). This hasn’t helped Morgan,
whose Chairman and CEO John Mack is still
desperately seeking suitors for the battered bride.
Lloyd Blankfein of Goldman, a canny mogul who exited
mortgage-backed paper at the right time with tidy
profits, has been luckier. He has found a groom in
Warren Buffett, who has agreed to invest $5 billion.
In hindsight, it is all too easy to crow, “I told
you so”. Instead, we should be asking two questions:
will being banks help the last three standing — JP
Morgan Chase, Morgan Stanley and Goldman Sachs? And
second, will there be more stringency in
governmental and regulatory supervision?
To understand why these institutions became
investment banks, we need to go back to the Glass
Steagall Act, 1933. Major bankers and brokers were
indistinguishable in the late 19th and early 20th
centuries. With the Great Depression, the US
Congress was convinced of severe conflicts of
interest between banks and their broking arms to the
detriment of ordinary depositors, and passed Glass
Steagall. It created major legal barriers to the
mixing of these activities, separated banks
according to their business, and founded the Federal
Deposit Insurance Company for insuring bank deposits
up to a limit.
Glass Steagall was repealed in November 1999, but
many investment banks chose to remain where they
were because it kept them outside the stricter
regulatory supervision of the Federal Reserve. And
in the heady last nine years, the constraints of
non-deposit financing were overcome by the kind of
astronomical leveraging that no regulator worth his
salt would have permitted any bank to do. Taking on
various forms of debt up to 75 times equity was
considered great business.
Becoming commercial banks will give the Big Three
access to cheaper depositor funds. But that won’t
help unless they learn to discipline themselves.
That’s unlikely. For one, there are no Chinese walls
in the world of integrated finance. For another,
smart, greedy, testosterone injected investment
bankers and brokers, whose compensations depend on
the money they make on other people’s money, will
find myriad ways of using depositor funds for
riskier businesses. Such excess risk taking won’t
happen immediately due to the present milieu and
because there will be stricter US laws and greater
governmental supervision — as it was with the
Sarbanes Oxley Act. Expect tough regulations and
witch hunting in the near future.
History tells us that regulatory toughness
disappears in good times. Smart Wall Street cookies
with their lawyers and rating agencies will find
ways of circumventing regulation to promise gold. We
know that the rating agencies are a joke. A few
years ago, S&P had given Fannie Mae a higher
corporate governance rating than Infosys! Just as it
gave AAAs to funny paper.
So, while the geography of Wall Street will change,
never believe that greed won’t rear its hydra head.
And don’t be taken in by the notion that having both
commercial and investment banks under a holding
structure will mitigate risks. Innate prudence
mitigates risks. Where that doesn’t exist, nothing
does.
Published: Business Standard, October 2008