So Wall St. Is to Blame?

As I wrote about in my post the other night, over the past few weeks, as the global financial markets have begun to crumble and the true nature of the crisis we are facing sinks in, the blame game has kicked into high gear. Unsurprisingly there has been an outpouring of politicians, bloggers, journalists and pundits casting blame on "Wall St. greed." This seems particularly absurd to me given the fact that the latest victim of the crisis is Wall St. itself. The independent broker/dealer business model, the cornerstone of Wall St., is dead. Thousands of people working in finance have been lost their jobs and some of America's most renowned institutions have failed. To me blaming Wall St. is akin to blaming the victim for the crime. As I wrote about in the other night's post, the financial sector has fallen victim to the moral hazard of Greenspan's lax monetary policy just as much a the single mother of 3 in Arkansas, who is having her house repossessed, because she was duped by predatory lenders. Had Greenspan been willing to let America endure a recession, the financial innovation that led us to this precipice would likely have been corrected, snuffed out before more serious losses could be incurred.

I can understand the average American's suspicion of Wall St. The name alone connotes so much power and privledge attached to it. When you add in the fact that a measly, 22 year old analyst can make $120,000 a year and a top hedge fund manager can earn in excess of $1 Billion a year, a rural farmer's mistrust is completely understandable. How on earth can they honestly make that much money? Then there are the complex machinations of the stock market, understood in depth by a small minority of Americans. While reading about the debates over the bailout bill, I was struck by the countless errors and inaccuracies made by journalists and politicians, some of the most learned segments of our population. Cheif among them that stand out in my memory was Bernie Sanders, an extremely bright man in his own right, ascertion that we need to regulate complicated financial instruments like credit default swaps and hedge funds. For the sake of brevity I won't explain this one, but suffice it to say, this would be like saying we need to regulate agricultural produce, like jeruselum artichokes and supermarkets, in the wake of an E. Coli outbreak. Anyway, given all of this, it's understandable why most Americans hold a very distrustful view of Wall St. There are trillions of dollars changing hands and no one understands how it is happening.

Nevertheless, I think any conspiracy theories immediately fall apart when you take into a part the size of the Wall St. There are hundreds of thousands if not millions of people working in finance world-wide, representing a broad spectrum of races, religions and political beliefs. One thing people seem to forget is that Wall St. is made up of average people, who, like all of us, are just trying to do their job. Wall St. does not simply consist of a half-dozen cigar-smoking villains out of a Bond movie, but hundreds of thousands of people, who go to work every day and come home to their families at night. I can only imagine the annual meeting of the cabal. Once a year, the overlords of the universe rent out Giant Stadium for a night to discuss how they are going to dominate the world this year and make a fortune on the backs of hardworking Americans. While there is a lot of power concentrated in the hands of a dozen or so institutions world-wide, I think few understand the nature of the business.

Investment banking is the grease that makes the economy function. When a corporation, municipality or even national government needs to raise funds, they rely on investment banks to do so. If a large multinational corporation needed a multibillion dollar loan (or several trillion dollars as in the case with the US government), many traditional commercial banks would be unwilling to lend to them, due to the size of the loan and the risk involved. If a commercial bank were to dedicate a significant portion of their loan portfolio to one individual company, the bank could get wiped out if the company defaulted. As a result any bank would be forced to charge exhobinant interest rates to justify the risk. A cheaper alternative is found in the bond markets. Investment banks effectively hook up companies and governments with the funding they need through equity and bond placements. Since there are more potential investors and thus more competition on the capital markets, investment banks can generally arrange this financing at a cheaper rate, than a company can by going to their local bank. In America, investment banks usually guarantee full placesment of the debt or equity, buying any unsold bonds or shares with their own capital. By selling shares or placing bonds, investment banks facilitate the investments that keep the economy growing and provide jobs, keeping a small cut for themselves. This small cut, however, can be quite large when a transaction is several billion dollars. These bonds and stocks are generally bought by pension funds, insurance companies, mutual funds and more recently hedge funds, helping individuals generate wealth, retire early and ensure that their lives and property are taken care of. In short, investment banking is usually win-win-win for everyone involved. Aside from pure investment banking, Wall St. banks make the majority of their money through investing in these bonds and stocks and providing brokerage services for other investors, facilitating investors and partially supporting the markets for these securities.

In the 1980s, two revolutions swept Wall St., sending it on the path, which eventually culminated in this crisis: the development of proprietary trading and the appointment of Alan Greenspan as the Chairman of the Federal Reserve.

The history of proprietary trading is as old as Wall St. itself. Given the nature of their brokerage operations, investment banks have always been required to have a large number of securities on their books at one time, in order to meet their customers needs. Investment banks also often took a proprietary interest in the securities they were holding, acting as direct investors. During the 1980s, computers first started to deeply penetrate Wall St., allowing traders to analyze securities quicker and in greater depth than they had previously. As a result proprietary trading took off and became a central focus for Wall St. firms. Like traditional commerical banks, investment banks also often loaded up on debt to enhance their returns; except rather than giving comsumer or business loans, investment banks tend to invest in stocks and bonds. Additionally, rather than seeking consumer deposits to fund their activities, investment banks were restricted to placing bonds and other forms of direct loans.

Increasing leverage is the easiest way to increase both a firms profitability and risk. Goldman Sach's shareholders have historically expected Goldman to return around 17% a year, making it expensive for the firm to raise equity to fund its operations. By contrast, Goldman Sach's bonds, depending on their term generally yielded between 5-6.5% historically. Thus firms like Goldman increased their leverage throughout the 80s, 90s and 2000s to increase their return. For instance, in 1996, Morgan Stanley's assets stood at 20.4 times equity. By 2006, this ratio had jumped to 31.8 assets-to-equity. This increase in risk was not the result or reckless behavior, rather it was the result of a cultural shift Wall St. underwent as a result of Alan Greenspan's lax fiscal policy.

A whole generation of investment bankers, now finding themselves in senior positions, grew up under Alan Greenspan and his lax monetary policy. As I mentioned earlier, whenever the economy was teatering on the edge of a recession, Greenspan would pump money into the economy by lowering interest rates. More than anyone else, this policy helped at Wall St., as the investment banks were among the first line of beneficiaries. As the general economy soured, loans and stock prices went with it. To compensate for the potential losses, Wall St. firms were given access to funding at extremely low rates, thus reducing their costs and allowing for them to maintain profitable. Over the course of 20 years, this abnormal economic behaviour began to be taken for granted. As a result, many of these bankers had known nothing buy Greenspan's easy money for their entire careers. Due to Greenspan's policies a massive credit bubble built up under his watch. Just as with any asset bubble, it eventually burst, culminating in the crisis we have today.

In search of returns, in the 1990s and early 2000s, investment banks began to get more directly involved in the US housing market. While traditionally, Americans had relied on savings and loans and other local banks for mortgage financing, many of these were wiped out in the early 1990s Savings and Loan crisis. To fill the void left by the loss of over a thousand of these establishments, Wall St. stepped in, buying debt off of small local banks and mortgage brokerages with limited funding capacity and cutting it up into bonds. At the same time, Greenspan's reckless lowering of interest rates encouraged a massive housing bubble in the United States, just as it encouraged investment banks to leverage themselves. To make matters worse, these investment banks bought many of the mortgage-backed securities that they sold to investors. As a result, as this credit bubble is deflating, it is bringing the investment banks with them, who are posting record losses on their already weak, over-leveraged balance sheets.

Wall St. is not to blame for the current crisis we are in. All the bankers did was over-leverage themselves at Greenspan's encouragement, just like the people who bought houses at the height of the boom. Regulation of the financial industry could not have averted this crisis, rather we needed better regulation of our monetary policy.