The End of the Masters of the Universe?

By William Cohan

Amid the turmoil and confusion on Wall Street these days, one serious message is coming through loud and clear: Investment banking is dying.

The evidence is everywhere: in the languid second-quarter results of three of the four remaining publicly traded securities firms, in the ever-louder drumbeat for expanding regulatory oversight of investment banks — led by none other than Treasury Secretary Hank Paulson and Tim Geithner, the president of the Federal Reserve Bank of New York — and in the growing fear of bankers and traders who have nothing to do but wait and see whether they’ll be among the 20 percent of the Wall Street workforce to be fired.

Put it all together and the picture is clear: Wall Street is no longer so sure how to make money in its core securities businesses.

A look at the second-quarter numbers at Morgan Stanley, the second-largest securities firm, reveals the extent of the damage since the onset of the credit crisis a year ago. In the quarter that ended May 31, the firm had US$875 million in investment banking revenue, down 49 percent from $1.7 billion in the second quarter of 2007. The company’s advisory business, which offers expert advice on mergers and acquisitions, fell to $367 million, nearly a 50-percent drop from $725 million a year earlier. Revenue from underwriting debt securities fell to $210 million from $486 million (a 57-percent decline) and income from equity underwriting fell to $298 million from $493 million, a drop of 40 percent.

You could argue that the second quarter of 2007 — before the painful effects of the global credit crunch were revealed — was the peak of the last market boom; nevertheless, these contractions across every banking segment at Morgan Stanley are breathtaking. Merrill Lynch and Lehman Brothers share a similar tale of woe.

Only the mighty Goldman Sachs, with its culture of excellence, prudent risk-taking and willingness to quickly promote new leaders who are unafraid to challenge the status quo, can legitimately claim to be surfing the waves. Goldman’s second-quarter investment banking revenues were $1.69 billion, only 2 percent lower than a year earlier and about 44 percent higher than the first quarter of this year. Like its competitors, though, the firm suffered in the area of debt underwriting in the second quarter, with revenue of $269 million, down from $654 million in 2007.

Banking has always been an elaborate confidence game, and banks and bankers have done everything in their power to instill that confidence, from constructing imposing headquarters with air- and water-tight vaults — the vault at the New York Fed, with its $200 billion of gold bullion, can be locked down in as little as 30 seconds — to dressing and acting like fat cats. But as the recent, nearly instantaneous meltdown of Bear Stearns revealed, these are just stage props that can disappear like rain in the Sahara if confidence is lost and people will no longer do business with you.

For the first time in a generation, Wall Street appears to be experiencing not just a palpable lack of confidence; there’s also genuine fear in the corridors of power. Steve Schwarzman, the co-founder of the publicly traded buyout firm the Blackstone Group, can already see that significant changes are underway in the industry where he got his start (with Lehman Brothers). The new regulatory regime, he concedes, will rightly prevent investment banks from continuing to pile up mountains of debt on a sliver of equity capital. “No one knows how significant the decrease will be, but they’re betting that it will be more significant than less. If that’s the case, then logic should dictate that the ongoing earnings power of those companies should be less because they have fewer assets upon which to earn money,” he says. “That has implications for the extension of credit and the deployment of capital by those institutions.”

Jimmy Cayne, the former longtime chief executive officer of Bear Stearns, is even more pessimistic. “Tell me where the profit’s coming from?” he asked in a recent interview, since the market for the types of asset-backed debt securities — such as home mortgages, credit-card or automobile loans — that used to be hugely profitable for his firm and most of its competitors has all but dried up.

“You think you make any money in investment banking away from this part of it?” he asked. “Investment bankers are loss leaders. You’re paying these very ordinary guys two million, three million, million and a half, for what? They do one deal a year, maybe. Your balls are on the line with the leveraged lending part of it. And you don’t get paid for the risk. You get to the point where that’s your business, and your business is flawed.” Cayne believes that Wall Street is going through a “massive sea change. Salvation? I don’t see it. Hope, hope exists. Hope it comes back.”

When a gallon of gas costs around $4 and a gallon of milk even more, maybe a heaping helping of humble pie is just what Wall Street needs. Besides, why should anyone care what happens to a bunch of overpaid bankers and traders amid a mess that their own greed and carelessness created?

Well, for starters, we taxpayers should care because we have some serious skin in this game. On June 26, the Federal Reserve bet precisely $28.82 billion of our money (about $100 for each American) that Wall Street will come back from the edge of the abyss. That’s the amount of the loan the Federal Reserve Bank of New York used to buy the infamous $30 billion portfolio of assets, consisting mostly of illiquid mortgage-backed securities, once owned by Bear Stearns. (The balance of the money for the purchase came from J.P. Morgan Chase.) But the value of our assets has already fallen by a little more than $1.074 billion. Since J.P. Morgan agreed to absorb the first $1.15 billion of losses — its investment — our loan will start to be impaired if the portfolio decreases by only another $76 million.

We should also care because a thriving economy is based on the proper functioning of the global capital markets. All of those now-crippled debt and equity underwritings raise trillions of dollars in capital each year that companies use, in part, to buy new plants and equipment, take chances on new technologies such as wind power or hydrogen cars, and create new and intellectually engaging jobs. Without capital to grease the gears, our economy will sputter to a halt.

Furthermore, even the much-maligned subprime mortgage did make homeownership possible for millions of Americans. Most of the new homeowners with these mortgages — some say as many as 75 percent or more — make their payments on time. But the bad apples and crashing home values have done in this particular corner of financial innovation for the foreseeable future. And we may not be better off as a result.

Marry all of this — the coming new regulatory regime, the persistent question of whether securities firms can fund themselves without customer checking and savings accounts, and the moribund markets for mergers and acquisitions, debt and equity underwriting and, of course, asset-backed securities — and it’s clear that a brave new world of investment banking is here. And it isn’t pretty.

The short-term fixes are few and far between: Securities firms can try to sell themselves to banks, but since J.P. Morgan can’t buy everyone, that’s a long shot at best. Wall Street can aggressively lengthen the maturity of its borrowing and remove the voting power of the overnight lenders who helped finish off Bear Stearns. While this will increase the cost of capital, a more modest profit profile is better than none at all. Or securities firms can start doing whatever Goldman Sachs is doing, since it alone seems to be weathering the crisis.

Then there’s just old-fashioned ingenuity. Wall Street may be suffering one of its worst financial disruptions in generations and its outlook may be bleak, but “smart people will always find a way to make money,” says Schwarzman. For the sake of our way of life, let’s hope he’s right.

Cohan, author of The Last Tycoons: The Secret History of Lazard Freres & Co., is writing a book about the collapse of Bear Stearns.

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