Death and Resurrection on Wall Street

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Death and Resurrection on Wall Street

As we saw in September and October of 2008, Wall Street's old business model was no longer sustainable. Some of the biggest names in finance, like AIG, Bear Stearns, Merrill-Lynch, Lehman Brothers, Washington Mutual, Wachovia, and others were sold off in whole or piecemeal at fire-sale prices.

Until recently, these companies were some of America's most successful and respected institutions. Unfortunately, their apparent success was built on the shifting sands of excessive leverage and speculation. However, as liquidity disappeared from the system, it was quickly apparent that they weren't viable as independent firms. Even America's two remaining traditional investment banks, Morgan Stanley and Goldman Sachs, had to seek reclassification as "bank holding companies" so they would be eligible for more help from the Federal Reserve.

So, what's going to be different now? What was it about the old business model that led to its demise? As recently explained by economist Robert Samuelson in The Washington Post,1 the vanquished business model had three components that differed from the more stable model that was in place from 1933 until the '80s:

First, investment banks no longer saw themselves primarily as advisers and intermediaries, where they helped clients raise capital and provided advice on mergers and acquisitions. Instead, they took on the role of gamblers, buying and selling stocks, bonds, and other securities. Traditional investment banks, as well as commercial banks, moved from serving individual and corporate clients to trading for their own accounts.

Second, the business model's compensation scheme encouraged excessive risk-taking. While traders could make huge sums if they generated huge gains, the firm itself was stuck with any losses if they occurred. An employee who lost millions could simply walk away. Base salaries for experienced managing directors were in the $200,000 to $300,000 range, but bonuses were often 5 to 10 times higher. The allure of instant riches, with limited downside, encouraged unrestrained risk-taking.

Third, investment banks relied increasingly on maximum leverage to create enormous returns. Leverage was the irresistible temptation. Why? Because extreme leverage creates huge profits, when everything works as planned. In a world where bonuses were the Holy Grail, mega-profits produced eye-popping compensation. Take Lehman Brothers as an example. At the end of 2007, it had equity of about $23 billion...

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