Wall Street follies
2008 marked the end of Wall Street’s “Masters of the Universe” phase -- roughly three decades of head-spinning financial engineering, astronomic compensation and an intricate global web of deal-making. By year’s end, New York’s five largest investment banks had collapsed, been acquired or been transformed into more tightly regulated entities. A liquidity crisis caused Bear Stearns Cos. to be snapped up in March by bank holding company JPMorgan Chase (with an assist from the Federal Reserve) at a fire-sale price. Lehman Bros. went bankrupt in mid-September, just as Merrill Lynch was finding refuge in the arms of Bank of America. Before the month ended, Goldman Sachs and Morgan Stanley had become bank holding companies{CB72201A-A795-4C78-8F68-E64DAA26398D} to ease concerns about their ability to raise money.
Although some boutique investment banks remain, the changes at the top of Wall Street mean that federal regulators could have much more influence over the way credit is supplied in this country. For example, the Federal Reserve will now cap how much the erstwhile investment banks can borrow against the assets they hold -- in essence, preventing them from using so much borrowed money to make new investments. Such restrictions will limit both the risk they can take on and the profits they can hope to make. It’s a dicey time to clamp down on the borrowing that supplies money for loans; after all, lawmakers have been pressing banks to provide more credit with the aid they received from the Troubled Asset Relief Program, not just to solidify their balance sheets. Yet had these restrictions been in place five years ago, Wall Street wouldn’t be in such deep trouble today. Washington is likely to impose more dictates this year on the banks and Wall Street firms that received billions of TARP dollars -- a rescue effort that made taxpayers a major stakeholder in the financial industry.
There certainly are steps that Congress and state legislatures should take to guard against future boom-and-bust cycles, such as the one in housing that proved so costly to the financial industry. Still, it’s worth bearing in mind that Wall Street’s meltdown was caused largely by financial offerings that were designed to reduce the risk of big losses. In the heyday of the savings and loan industry, lenders issued mortgages in the communities they served, then held onto them as investments. If the real estate market in its community tanked, the lender was in trouble. One way to mitigate that risk was to pool mortgages from multiple communities and sell them to investors. Wall Street came up with numerous variations on this theme, carving up pools into more and less risky tiers for investors seeking higher returns or more stability. It also developed techniques for guarding against losses by selling what amounted to default insurance (“credit default swaps”), as well as offering investors the chance to assume the profits -- and losses -- from this insurance (through “synthetic collateralized debt obligations”).
In theory, these derivatives made credit cheaper and easier to obtain. But in practice, they helped create such a dense web of financial ties that the fortunes of large players became inextricably linked to those of other big firms around the globe and to the credit system as a whole. Just look at Lehman Bros. -- its failure brought the world’s largest insurance company, American International Group, to its knees. But the chilling lesson for policymakers and taxpayers is that powerhouse Wall Street firms seem to have found the ultimate golden parachute: By lending to and borrowing extensively from central banks and other important financial industry players, they all but guarantee a federal rescue in the event that their biggest bets go bad. That’s an untenable position for taxpayers, and it demands a new type of response from Washington. Regulators can’t focus just on individual firms’ practices; they have to develop some means to identify emerging asset bubbles and other risks that threaten a whole system of interdependent entities. Otherwise, it’s just a matter of time before another investing fad becomes the next tail to wag the dog.
Having said that, we also recognize the need for regulators to enforce existing, basic principles to protect against the kind of shortsightedness and misplaced incentives that contributed to the housing bubble. Lenders should be deterred from giving money to people with no reasonable ability to repay it, even if they plan to sell the loans to Wall Street as soon as the borrowers’ signatures are dry. Regulators’ inattention to underwriting practices encouraged risky lending by firms unconcerned about defaults, planting a financial time bomb that detonated when housing prices peaked. Firms selling complex securities must make clear disclosures of what the assets are, both to investors and to the agencies that rate the risk of default. And there needs to be more protection against ratings agencies serving those who sell securities at the expense of those who buy them. Policymakers should consider new approaches to measuring risk, rather than continuing to mandate the use of government-approved ratings companies. The lack of transparency and compliant ratings agencies allowed securities firms to conceal risks so thoroughly that even sophisticated investors were taken by surprise by the poor quality of the assets they’d gambled on.
Washington is moving ahead on several of these fronts. The Federal Reserve has reemphasized underwriting standards, and we look to new leaders at the Securities and Exchange Commission to require fuller disclosures about complex securities. The transformation of Morgan Stanley and Goldman Sachs into bank holding companies should put the Fed in a better position to monitor the health of the entire credit system and discourage the binge borrowing that contributed to the demise of Bear Stearns and Lehman Bros. And Fed Chairman Ben S. Bernanke has been exploring how to guard against systemic risks, as have central bank presidents around the globe. Ultimately, it may be impossible to prevent the public from being caught up in a mania like the housing bubble. And it would be a mistake to crimp Wall Street’s innovation simply because some of the offerings confuse investors. But it would be just as unwise to let the experience of 2008 become a guide for Wall Street firms on how to guarantee themselves a bailout.
