WALL STREET RISES AGAIN
Be afraid. Be very afraid.
By William D. Cohandec Jan-Feb 2015 Atlantic
You may not have noticed amidst the continued, public grumbling of its leaders, but Wall Street, indisputably, is back. The flow of complaints from Wall Street executives that post-crisis reregulation has hurt their moneymaking prospects has not abated, but the flow of money itself has long since resumed. In fact, the big banks that survived the events of 2008 have entered a new golden age. As incredible as it may seem, this new age is marked not just by the immense profits and hefty bonuses common to prior times of plenty, but also, because of the sheer size of the banks, by an increase in the power that Wall Street wields in local, state, and national politics.
A quick refresher: In the weeks and months following the bankruptcy of Lehman Brothers, in September 2008—and also following the near-collapses of Merrill Lynch, Morgan Stanley, and Wachovia; the meltdown of Washington Mutual; and the massive bailouts of AIG and Citigroup—there seemed to be a consensus that the basic architecture of the financial industry was deeply flawed and in need of a redesign. Wall Street was both morally and literally bankrupt. If ever a system cried out for reform, this was it. Wall Street’s reliance on short-term financing, leaving it insolvent the moment overnight lenders grew fearful of its prospects, needed a reboot, as did Wall Street’s compensation system, which rewarded bankers, traders, and executives for taking big risks with other people’s money.
But instead of fixing Wall Street’s broken architecture, the Federal Reserve and the Treasury made it their overwhelming priority to reestablish the status quo as quickly as possible. Shotgun marriages were arranged between the failing banks and the surviving banks. The federal government force-fed Wall Street hundreds of billions of dollars of new capital, whether or not Wall Street needed, or wanted, the money. Trillions of dollars of credit were made available to keep operations running and capital flowing. Similar sinecures were not made available to homeowners struggling with underwater mortgages or to Americans thrown out of work by the bad behavior of Wall Street bankers and traders.
Then, after Congress failed to stimulate the economy sufficiently, the Fed designed the so-called quantitative-easing program as its own form of stimulus for those at the top of the pyramid. Under this program, the Fed bought huge amounts of distressed debt and Treasury securities, bidding up their prices and in the process artificially driving down interest rates (the return on a bond moves in inverse proportion to its price). At the peak, the Fed was buying $85 billion in bonds each month, a huge windfall for Wall Street: traders found a ready buyer in the Fed for all sorts of squirrelly securities, at increased market prices. And, because short- and long-term interest rates had been forced down to levels rarely seen before, the big Wall Street banks were able to get their short-term capital essentially for free, and their long-term capital nearly so. The Fed, which expanded its balance sheet from less than $900 billion before the onset of the crash to some $4.5 trillion today, might as well have been paying Wall Street traders’ bonuses directly.
These gifts to Wall Street came without a requirement that it change any of the most fundamental aspects of the way it does business. Yes, regulators demanded that Wall Street banks keep higher capital reserves and abandon certain business lines, such as proprietary trading and investments in private-equity funds. But the flawed architecture of the industry remains intact. As Fed officials admit, the banks’ funding model—giving big institutional investors a daily vote about whether to keep the banks in business—has not meaningfully changed. (In August, Eric Rosengren, the president of the Federal Reserve Bank of Boston, said that the continued prevalence of overnight financing to keep banks solvent is one of the “financial stability issues that still really scares me.”) And of course, the “heads, I win; tails, you lose” compensation system also remains in place. Bankers and traders have every incentive to swing for the fences in order to get multimillion-dollar bonuses. If their bank blows up because of their shortsighted or overly risky actions, their own capital is not on the line.
Consider what all of this has meant in practice:
Competition on Wall Street has been reduced to a bare minimum. Where hundreds of big banks and securities firms once competed against one another for client business, now there are only a handful. And several of the biggest former competitors—Bear Stearns, Lehman Brothers, and Merrill Lynch—are gone. Their remnants, if there are any, are now tucked inside even bigger banks. As a result, Wall Street banking has become an oligopoly. According to The Wall Street Journal, American banks earned $40.24 billion in the second quarter of 2014, the second-highest total profit in at least 23 years (the highest was in 2013). JPMorgan Chase alone earned $6 billion in the second quarter and just a whisker less in the third quarter, even after a $1 billion charge for future litigation. All in all, 2014 looks likely to have been, at an absolute minimum, one of the most profitable years on Wall Street, ever.
Better times still are very likely around the corner. As the economy continues to recover from the Great Recession, corporate demand for equity and debt financing, and for advice on mergers and acquisitions—all hugely profitable banking functions—is growing steadily. The volume of global M&A activity for the first nine months of 2014—$2.7 trillion—was up $1 trillion from the previous year, and was on pace for the biggest year since the heady days of 2007. And of course, fewer banks are now splitting the massive fees from advising on all these deals.
One principle of economic theory is that when firms make unnaturally large profits, competitors will rush in, stealing market share and cutting those profits down to size. But that doesn’t seem to apply to Wall Street. While high finance is still somewhat competitive for the existing players, new entrants are few and far between. Barriers to entry are immense, thanks partly to the huge amount of capital required to trade and underwrite securities. And the European banks, which once provided a modicum of competition, are in retreat thanks to the scorching they endured during the financial crisis and, in its aftermath, from regulators. Rather than retool, they are more or less walking away.
The market for risky financial products has undergone a great revival. As happened in 2005 and 2006, investors are searching desperately for good returns on their investments—a natural reaction when returns on savings accounts and high-quality bonds are so miniscule. As a result, risk is once again being badly mispriced by the debt markets. The yield on junk bonds—representing the credit quality of the riskiest companies—is typically about 10 percent. These days junk bonds yield about 6 percent, a sure sign that too many investors are chasing dicey securities and not getting properly paid for the risks they are taking. Given these favorable conditions, junk-bond issuances have soared: at the time of this writing, new junk bonds totaling $290 billion had been sold in 2014, on par with 2013 and nearly on pace with the record issuance of $345 billion in 2012.
Wall Street doesn’t always play a huge role in creating demand for risky securities—for the most part, market conditions do that. But Wall Street’s army does get rewarded for trying to come up with creative ways to meet market demand. And that is exactly what this army will keep doing as long as the markets will allow. For various reasons, Wall Street’s cut on transactions involving risky debt securities is higher than on investment-grade debt securities; accordingly, the few remaining big underwriters are unlikely to raise much of a ruckus about the mispricing of risk.
The compensation system on Wall Street, as noted, remains unchanged. Big bonuses are still paid out to the people who generate the most revenue. While these bonuses may not soon be as big as they were prior to the financial crisis, it’s hard to think of any other group of public companies besides Wall Street firms that pays out as compensation between 40 and 50 cents of every dollar in revenue—immediately, based on a single year’s results alone. This ratio has remained remarkably high in the aftermath of the financial crisis. Instead of taking a deep breath, paying less across the board, and reorienting pay to reward safer behavior, Wall Street banks prefer to lay people off, keep the pay as high as possible for those who remain, and base that pay largely on short-term results.
Reduced competition, funding that’s almost free, thriving markets for risky securities, the usual high pay—it’s fabulous to be on Wall Street today. But what is fabulous for the employees of Wall Street firms will spell trouble for the rest of us.
During the inevitable next financial crisis, when the economy again goes into a tailspin, overnight investors will again threaten to stop rolling over the big banks’ short-term debt, and the federal government will once more be faced with the question of whether to bail out the few remaining Wall Street behemoths that caused the problem. The Dodd-Frank Act promises no more bailouts. That feels awfully hollow. The four biggest U.S. banks—now JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo—control a total of $8.2 trillion in assets, an increase of 28 percent from the time before the crash of 2008. The assets of these banks alone are nearly half the size of America’s gross domestic product.
Does anyone really think the federal government would allow any one of these big banks—to say nothing of Goldman Sachs or Morgan Stanley—to fail? The truth is, these banks are too essential to the proper functioning of American capitalism to be allowed to disappear, no matter the reason. (And yes, they are still too interconnected as well.)
In any event, the acid test will come soon enough. In the meantime, Wall Street will be minting money, and the bankers, traders, and executives fortunate enough to work there will continue to see their bank accounts swell. For the rest of us, sadly, the best hope is that the next crisis will be sufficiently existential to finally force fundamental, long-overdue change to the way Wall Street does business.