“Bye, bye, Miss American pie…” sang Don McLean in one of my favorite songs of an earlier time. The poignant lyrics, which I never fully understood, talked about the day the music died.
Sunday, September 19, 2008, is the day the music stopped for Wall Street as we’ve known it. As 2008 began, five large investment banks dominated American finance and were major players on the world scene: Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Stearns and Lehman Brothers. Each of these firms made enormous profits for as long as I can remember; each hired the best and brightest college and business school graduates; and each paid kingly salaries and bonuses. While the good times lasted, the times were very good, indeed.
All five major investment banks were able to generate huge profits and pay huge salaries and bonuses for one reason: they were all very highly leveraged. Typically, each maintained debt-to-capital ratios of 20- or 30-to-1 or higher.
To understand how high leverage can generate huge profits, imagine you have $1 million in capital to invest. Suppose you buy a $1 million home and hang on for a year or two while it goes up 10 percent in value. Ignoring the costs of buying and selling, you’ve made a tidy profit of $100,000. Now, instead of buying one home, assume you find a lender willing to let you buy 25 $1 million homes, with $40,000 down and a mortgage of $960,000 on each. Now, when the housing market goes up 10 percent, you’ve made $2,500,000 in profits, all because you’re leveraged 24-to-1. Now you can call yourself an investment bank.
Of course, leverage works both ways. A 10 percent decline in the housing market will not only wipe out your profits but will put you more than $2 million in the hole. And that’s what happened this year to the five major investment banks.
The problem started, as we’ve all heard, with subprime mortgages. Rising delinquencies and defaults led to falling housing prices, causing the value of the mortgage-backed securities issued and held by the investment banks to fall. The problem was especially acute for Bear Stearns, which was forced into a shotgun marriage with banking giant J.P. Morgan Chase in March at a stock price 93 percent down from what it had traded for a year earlier.
Next to fall was Lehman Brothers, which struggled all summer to find a savior. As its financial condition worsened, Lehman’s cost to maintain its leverage soared, accelerating its downward financial spiral. One minute past midnight on Monday, September 15, Lehman filed for bankruptcy protection from its creditors.
Concurrent with the Lehman bankruptcy filing, Merrill Lynch, seeing the handwriting on the wall, announced it had arranged to be bought by Bank of America in a deal worked up in less than 48 hours. Bank of America is paying $28.50 a share for Merrill, almost 65 percent below the 52-week high for the stock. Three down and two to go.
Finally, the following Sunday, the Federal Reserve announced it had approved petitions by Goldman Sachs and Morgan Stanley to become bank holding companies. This will let them access the Federal Reserve System to meet liquidity crises and take deposits, an inherently more stable source of funding than the short-term loans used by investment banks. But the conversion will come with much more regulation from the Fed and from the Federal Deposit Insurance Corporation, including much higher capital requirements. Because their leverage will be significantly restricted, Goldman and Morgan Stanley’s ability to generate profits in the good times will be much more muted. And that means and end to the high salaries and gaudy bonuses.
Where the best and brightest graduates will go now remains to be seen. New York City potentially faces an enormous blow to its economy, which has benefited mightily from the investment banks’ erstwhile success. The City’s vaunted Renaissance since 1990 may be in jeopardy.
Ironically, the independent investment bank concept arose during a prior financial crisis—the Great Depression. Underwriting securities was deemed then to be too risky for commercial banks, so Congress passed the Glass-Steagall Act, forbidding one entity from performing both functions. Now with the repeal of the Glass-Steagall Act in November of 1999, U.S. investment banks will become arms of giant commercial banks, as they are in Europe.
Leverage is like an addictive drug. The high is so pleasurable, the borrower simply can’t stop. Inevitably, when times get difficult, leverage turns back on the investor, wrecking his carefully laid plans. Think of leverage like loading your ship with cargo so the sea is almost to the gunwales. All is fine when it’s calm, but the ship quickly founders in a storm. The wise investor understands that highly leveraged investments suffer first and most when hard times are at hand.
