It is said that the US crisis is the delayed consequence of the Glass-Steagall Act which was repealed in 1999 and the introduction of Gramm-Leach-Bliley Act which had allowed the functioning of commercial banks to merge with the functioning of the investment bankers. Our research paper covered the issues like when did the crisis start, what are the reasons leading to the crisis, who all were affected and the measures taken by the US government to make things correct. We also tried to cover the aspect of investors’ perspective and why it all went wrong.
It’s a vicious circle between a contracting economy and greater credit and financial losses feeding on the economy. Some believe that investment banks are not going to disappear in the future, but they will be smaller, specialized institutions, like the merchant banks of old. There are plenty of advisory firms, hedge funds and private equity funds and this Wall Street crash will create more. Starting with the fire sale at Bear Sterns earlier this year and culminating this week with the shocking news of the Lehman bankruptcy and rush sale of Merrill Lynch, some people prophesies seem to be coming true before our eyes.
Now, only two of the five largest independent brokers–Morgan Stanley and Goldman Sachs–remain standing. With reports that Morgan Stanley is considering a merger with Wachovia, many in–and out–of the financial world are questioning the future of investment banking. The holy reason to believe that the investment banking is not going to fade away is the deposits made by the public in the commercial bank are sacred. Individuals, corporations, and non-profits place their deposits into a bank and expect it to be safe.
They expect 100% surety, immediate access, and complete transparency with their cash. This is even true with money funds. We had even tried to figure out the role of regulators in the whole thing and focused as well on some of the measures that they can take to improve upon the things. We studied that due to the interconnectivity of the countries to a great extent the crisis could absorb quickly into the market and hopefully, it had done already what had already happened.
Our Perspective: The current condition in the US is mostly a result of greed and poor governance, and there is certainly enough of that to go around. We can blame the speculator who thought real estate only went up; borrowers who took on too much debt; banks that gave loans to virtually anyone who applied; investors who wanted higher interest rates; investment banks that took on too much leverage; or auditors and legislators who applied pressure to banks to make loans to the less financially capable, and regulators who turned a blind eye and should have know better. There is certainly at least $840 billion of blame to go around.
Within the past six months, five of the largest investment banks have either folded,been sold to commercial banks, or have become commercial banks themselves; and two of the top ten commercial banks have had forced transitions. In addition, American International Group (AIG)—one of the largest insurers, has been bailed out by the federal government, and Freddie Mac and Fannie Mae have been nationalized. At least ten European banks have been nationalized or bailed out and there are also rumors that additional financial services firms both in the US and Europe may also not survive to year end.
Hopefully we can assume once the markets stabilize, commercial banks— including Morgan Stanley and Goldman Sachs—will be forced (by regulators, legislators, and boards) to become more conservative. As banks become more conservative, their risk and compensation levels will go down and the more highly compensated and risk tolerant will leave to set up or join new institutions. These new organizations will become the investment banks of the future. The current crisis is compared with the Great Depression of 1929 as it was the biggest modern world fiasco happened ever after.
The European banks were hugely affected because of the fact that they invested in the investment banking model in US as they did in the 1929 depression where they invest in the gold standard because of ludicrous profit in it. The then fiasco was due to the fall in the aggregate demand in US and the now fiasco was related majorly to the rising housing prices where the investment bankers were taking toll in it. We look at the reasons behind the recent fiasco which is combination of various smaller components-historically low interest
January 18, 2009 rates, misaligned incentives, pressure from Washington to lend to the less fortunate, poor corporate governance structures, an incorrect pricing of risk, an incomplete understanding of risk management, conflicts of interest, faulty securitization theory, and of course a faltering US economy. For the last two decades the economy is experiencing historically low interest rate which came down from 15% approximately in 1981 to 4. 5% approximately in 2006.
The effect of crisis started from august, 2007 but the things have started working right from the past itself. High interest rates usually translate to greater risk; they also generally enable banks to enjoy greater interest rate spreads and greater profits on their lending. As rates decline, banks either need to raise and use more capital, reduce their funding cost, increase their investment yield, or employ more leverage in order to keep the same profitability. When leverage is employed the game changes.
The need was there to boost the interest rate or lend to reach the same level of interest revenue and there were possibly two ways to do it-Lock in funds for a longer time in US bonds, or lend to less credit quality investors. However, lending to less credit-worthy customers increases your chance of default and generally investors don’t like to lose their principal. Asset securitization strategies were thought to mitigate this risk. Given a stable economy, close to full employment, and increasing asset values (home prices), the rate of default on even lesser-quality credit was not historically very significant—3 to 4%.
So if we make a number of subprime or Alt-A loans, pool them together, and divide them into groups, we can allocate the payments on the performing loans to the top tier, then the next group of performing loans to the second tier, and so on until the non-performing loans all wind up at the bottom tier. Pressure on Fannie Mae and Freddie Mac to expand the ranks of homeowners to a less financially stable population. Fannie Mae and Freddie Mac obliged, and lowered the lending standards they accepted for acquiring mortgages and investment banks were brought in to figure out ways to mitigate risk.
The unfortunate part of this story was its success. The credit agencies were in a position to gauge the financial soundness of many of these structured products. It was their job to both model the credit structures and rate their default probability. There were only two flaws in this process: First, the credit rating agencies were looking at these products through the lenses of recent history, and given a positive economy, increasing housing prices, low unemployment ature of diversification and securitization, they felt the chance of default was low and gave the structures high-quality ratings.
Second, the credit rating agencies were being paid by product underwriters. Giving them a poor credit rating would not be good for customer relations or revenue streams. The credit rating was critical. Without a high quality credit rating, many institutions would not acquire the products. In addition, the misaligned credit rating caused banks, brokers, and investors of all stripes to misjudge the amount of risk associated with these products.
This was a great mistake either. Institutions holding subprime securitized debt either need to get this debt off their books (fully write it off)—which many firms do not have the capital to do—or partner with a bank with large assets to cover any losses. Although banks need to write this debt off, they can’t. When employing this much leverage, a market value decline of less that 6% can wipe out all of the initial capital used to lever this business. The impact of this crisis has been dramatic.
The decrease in market capitalization of the top ten investment banks from 12/31/07 to 10/10/08 adds up to more than $460 billion or 54% of their end-of year value; and that doesn’t include bailouts and write-downs by other institutions. Deleveraging has its own challenges. Without leverage, investment banks have four options: Banks can be satisfied with the returns that traditional investors earn on fixed income assets (minimal). They can migrate from a banking model where they borrow at lower rates than they invest to an agency/commission model such as the equities business that charges transactional fees.
They can link up with a bank that has a less expensive cost of capital. Get out of the fixed income business completely. Investors have been devastated by the subprime/securitization debacle. We believe the current crisis will switch investor focus from customized product to transparent and liquid products. This will force investment banks to curtail the origination of complex and arcane products and force them to focus on simple and more transparent structures. This will be a time when exchange-traded and centrally cleared products will be more desirable than OTC.
Moving toward an exchange/centrally cleared structure will enable banks to reduce risk, lower their balance sheets, and provide more commission income. Investors during this time of volatility and lack of transparency will make fungible, easily valued, traded, and marked products more popular than bespoke and complex products With securitization in retreat and investors demanding more transparency, banks and investment banks will have to significantly change their business model. The traditional commercial/investment bank business model to loan out money, securitize the debt, sell the debt to investors, and use the proceeds to make more loans is either dead or in deep hibernation. This highly leveraged business model is profitable when it works.
The problem is, this model is and will be broken for years. The result is banks and investment banks will need to keep their originated loans on their books until they are either are sold (less likely) or they mature (more likely). Hopefully, this means that banks will get back into the habit of making good loans to reputable borrowers and curtail the process of making loans to folks that have no way of paying them off. While banks will make better loans, each loan they originate will stay on the balance sheet until it is paid off or sold.
It is the basic business model of banks of yore: take deposits, make loans— how boring is that? This business model does not employ significant leverage and subsequently is not as profitable without a very low cost deposit base. It is certainly not the type of business model that supports eight-, or even six-figure bonuses. However, it will probably get firms in less trouble. It will not just be the subprime mortgage securitization business that gets shut down; it will be virtually any securitized debt product—auto loans, home equity loans, credit card receivables, corporate loans, and anything else being securitized.
The only product that may survive this would be whole loans as those are sold off whole and are not aggregated, sliced, and diced into a series of tranches. Banks will return to the similar institutions they were 30 years ago, deposit taking organizations that lend money in fairly innocuous ways, unless investment banks develop a more creative transparent way of financing this debt. A major problem arising is the mismatch between business model and governance structure.
Historically, investment banks have been partnerships. These partnerships eventually transitioned during the ’80s and ’90s into public corporations as greater leverage, increasing investment, and increasing pressures to be global drove the need for greater capital. A major problem arising is the mismatch between business model and governance structure. Historically, investment banks have been partnerships. These partnerships eventually transitioned during the ’80s and ’90s into public corporations as greater leverage, increasing investment, and increasing pressures to be global drove the need for greater capital.
An investment banker’s incentive structure was typically a multiple of his or her salary. It was not odd for the average bonus at a top investment bank to be over $350,000 annually; and this calculation included secretaries, operational staff, and technologists whose bonuses were much less. Seven digit bonuses were not odd, and top performers could earn eight digits. In addition, annual compensation was significantly more valuable than many individual’s ownership positions. When this ompensation structure exists, it becomes much more important for the individual to maximize his or her short-term contribution, even if it conflicts with the long-term goals of the firm.
The shutdown of many hedge funds may play into this factor as well. While the Glass-Steagall Act mostly split investment and commercial banking across equity/corporate underwriting (investment banking only) and fixed income (both investment and commercial banking) lines, most if not all of the challenges stemming from the subprime crisis occurred on the commercial banking side.
It was not the equity side of the business that blew up, it was the fixed income side, which has historically been thought of as the safer side. While I don’t think the government would split out the mortgage or the loan business from the commercial banking side, besides better managing the amount of leverage implemented on commercial banks, we could easily see that various risk-type businesses being split from these US Universal Banks.
This may mean that while the new Universal Banks have both equity and fixed income businesses, they may be prohibited from proprietary trading, taking sizeable risk positions or underwriting corporate securities (both equity and corporate debt), leaving the Universal Bank’s role in capital market as more of a processor, custodian, and agency trading operation rather than proprietary desks using retail deposits and naive investor capital.
They usually run profitable business whose margins fund other underperforming units, which is one of the reasons why investors put a discount on their share price. But financial conglomerates also involve additional problems related to risk management, conflicts of interest and capital allocation, which create huge challenges for regulators and banking stability as a whole.
The first basic problem that universal banks face is risk management. On the one hand, these banks offer low-risk, traditional banking services – such as deposit-taking and commercial lending – with guaranteed deposits and an insurance mechanism set up by governments. Yet they also run trading units, lend money for mergers and acquisition, manage individuals’ portfolios, invest their savings in exotic products and design complex structured loans. These banks look more stable because they are more diversified, but in this diversification lies the problem.
There are a few universal banks in the US, such as Bank of America and JPMorgan that have weathered the storm so far reasonably well. It is also true that European banks such as Santander or BBVA have been successful with a universal model, although they are strong retail banks and not as diversified as their US competitors. If one leaves these exceptions aside, managing the traditional banking business together with risky financial operations not only makes the basic banking function riskier, but also puts pressure on the whole bank.
This is one of the reasons for the huge problems at the heart of the financial woes of Merrill Lynch, UBS, Fortis and Wachovia. In universal banks, conflicts of interest are ubiquitous. This is an old story that often comes back. It happened during the internet bubble, when some banks played different roles for different parties: advising on M&A, lending to fund some acquisitions, leading initial public offerings or managing portfolios.
Chinese walls were torn down and some bankers exploited unethically those conflicts of interest. Public uproar and some regulatory changes calmed the storm, but did not eradicate the intrinsic problem. Disclosure and shareholders’ protection is another important issue. By definition, capital allocation in conglomerates is complex to make and complex to discern.
Unless banks make a huge effort to explain it in a clear way, neither investors nor regulators really understand where their risk lies, as the recent crisis has shown. The conflicts of interest inherent in universal banks are not enough to forbid their existence or to go back to the US Glass-Steagall Act. Thus, we say that there is a lot to go for the investment banking model in the world, may be as there was a shift from Europe to United States Of America and may be now it is the turn of Asia to become the next big thing.
