The end of Wall Street’s business model

Economics columnist Robert J. Samuelson says that what we are witnessing is the collapse of Wall Street’s entire business model, as developed since the 1980’s:

First, financial firms have moved beyond their traditional roles as advisers and intermediaries. Once, major investment banks such as Goldman Sachs and Lehman worked mainly for their clients. They traded stocks and bonds for major institutional investors (insurance companies, pension funds, mutual funds). They raised capital for companies by underwriting — selling — new stocks and bonds for the firms. They provided advice to corporate clients on mergers, acquisitions and spinoffs. All these services earned fees.

Now, most financial firms also invest for themselves. They use partners’ or shareholders’ money to place bets on stocks, bonds and other securities — so-called “principal transactions.” Merrill and other retail brokers, which once served individual clients, have ventured into investment banking. So have some commercial banks that were barred from doing so until the repeal in 1999 of the Glass-Steagall Act of 1933.

Second, Wall Street’s compensation is heavily skewed toward annual bonuses, reflecting the profits traders and managers earned in the year. Despite lavish base salaries, bonuses dominate. Managing directors with 15 years’ experience can receive bonuses five to 10 times their base salaries of $200,000 to $300,000.

Finally, investment banks rely heavily on borrowed money, called “leverage” in financial lingo. Lehman was typical. In late 2007, it held almost $700 billion in stocks, bonds and other securities. Meanwhile, its shareholders’ investment (equity) was about $23 billion. All the rest was supported by borrowings. The “leverage ratio” was 30 to 1.

Leverage can create huge windfalls. Suppose you buy a stock for $100. It goes to $110. You made 10 percent, a decent return. Now suppose you borrowed $90 of the $100. If the price rises to $101, you’ve made 10 percent on your $10 investment. (Technically, the price has to exceed $101 slightly to cover interest payments.) If it goes to $110, you’ve doubled your money. Wow.

Once assembled, these components created a manic machine for gambling. Traders and money managers had huge incentives to do whatever would increase short-term profits. Dubious mortgages were packaged into bonds, sold and traded. Investment houses had huge incentives to increase leverage. While the boom continued, government remained aloof. Congress resisted tougher regulation for Fannie and Freddie and permitted them to run leverage ratios that, by plausible calculations, exceeded 60 to 1.

It wasn’t that Wall Street’s leaders deceived customers or lenders into taking risks that were known to be hazardous. Instead, they concluded that risks were low or nonexistent. They fooled themselves, because the short-term rewards blinded them to the long-term dangers. Inevitably, these surfaced.

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  • Kirk

    At its core, the current culture of Wall St. seems remarkably similar to the culture of the 1920’s. Wasn’t borrowing to buy and building financial structures on loans what lead us into the great depression? I’m not saying that we’re headed for financial oblivion, but the more I read about the state of the banks and financial firms in this country, the more worried I get. I think I may convert my money to Francs and open a Swiss account.

  • fw

    this MESS is at multiple levels.

    CPAs and auditors used to be one of the most incorruptable and honest professions.

    they realized they could make ALOT more money from consulting than auditing, and their consulting then corrupted their ability to be independent.

    ok. so now there is no truly independent audits of corporations. I have ready that Moodys and the other entitites that rate bonds and stocks as AAA or junk often merely accepts what companies tell them….

    so this is a deeply systemic problem that has existed for some time.

    I would lay the blame with people who claim to have dismantled alot of controls in the name of “free markets”.

    this is the EXACT equivalent of eliminating the police department in favor of allowing people to raise a civil suit for damages if a loved one is killed. Police action after the horse are already outta the barn.

    It is worse than my analogy actually. No rule of law because there are really no laws except “buyer beware.”

    At least in the 20s there was a gold standard. the basis for economic activity now is PURE trust in the system, that paper, and now electronic, money is real and has value….

    think of the dot com bubble…. no one was asking where the “bricks and mortar” was. there was no “there” there. In the current events, think “where are the real tangible things of value?” and what does all this mean in respect to them?

    Accountants say “income is a matter of opinion. Cash is real” as much as to say, accountants are able to twist around reality. but at the end, there are things that cannot be lied about or twisted. Look for those things to frame your opinion.

  • What this also shows is that an absolute free, ie unregulated market, does not work. You need law and order there as much as in the rest of society. We do not loose our sinful nature when we step into commerce / onto the trading floor.

    Maybe the US needs to rethink its opposition to Third-Way Economics?

  • Don S

    There is no way that the U.S. has an absolutely free, unregulated market, so your observation, The Scylding, does not apply to the current Wall Street problems. The real problem is that our regulations are inconsistent and oppressive in the wrong areas, while ignoring other areas. In particular, most of the current Wall Street problems derive from the recent overheated real estate market. This overheated market, in turn, was driven by the recent practice of bond securitization as a means of funding mortgages to people who, under old bank underwriting standards, couldn’t get them. In turn, a substantial part of this practice came about because of anti-discrimination regulations (this is the inconsistent part), which forced banks and investment houses to fund loans in economically disadvantaged areas, for people who did not have anywhere near the income or means to service those loans in the event the market inevitably corrected. So, at first, this practice caused the real estate market to overheat, because it created a lot of dollars to chase the available properties. Then, when the market inevitably paused, panic set in. With no intrinsic equity in the homes, and the loans underwater because of a paper decline in value in the underlying properties, folks began walking away from homes they had no stake in.

    There were a lot of good intentions in all of the aforementioned regulations, but it turned out that they worked against each other and ultimately contributed to the current difficulties. Ultimately, you can regulate all you want, but you will never plug all of the holes in the system, and in the meantime will cause tremendous costs and complexities to enter the system. So, the reflexive response is to say “we need more regulation”, but what we really need is to take a step back and evaluate the whole system before doing anything. If this measured step is taken, then I suspect we would find that we do need additional regulations in certain areas, and fewer regulations in other areas.

    We also need to realize that if you are going to have a prosperous economy, because it is market-driven, you have to accept risk. No risk, no reward. The Chinese are a classic example of a government that finally came to the realization that you cannot regulate prosperity, and that, ultimately, a free market is the only way to truly economically improve the lives of the average working person. Hopefully, they will soon also realize that an empowered and free population is the greatest guarantor of a country’s ultimate survival and real prosperity.

  • Don S: Maybe I should have said a classical Third Way system instead of one based on the fundamentally impossible ideal of the American Dream for Everyone?

  • Joe

    “American Dream for Everyone” please define. I can give two working and broadly accepted definitions to American Dream. One that I would agree is not possible for everyone and one that is possible for eveyone.

    1. I can get rich during my life time

    2. In America I have a legitmate opportunity to create a better life for my children and they inturn for theirs.

    I submit that number 2 is actually what the American Dream is. I think people have tried to idealize it and turn it into number 1.

  • The article Veith quoted mentioned “the repeal in 1999 of the Glass-Steagall Act of 1933”. This repeal came from the Gramm-Leach-Bliley Act, signed by Clinton, which prohibited bank holding companies from owning other financial companies.

    Anyone wanna guess how our current slate of presidential candidates voted on the Gramm-Leach-Bliley Act?

    Biden: Nay. In fact, every Democratic Senator voted nay except Hollings. McCain: Yea. What a shock. (By the way, the Wall Street Journal got the votes wrong in James Taranto’s article “On a Short Leach”, accusing Biden and Reid of voting yea and McCain of being “absent”. Oh, that liberal media!)

    Hey, where is Phil Gramm* now? He was the McCain campaign co-chair and senior economic adviser until July? And now he’s an unofficial adviser after uttering the memorable phrase “nation of whiners”? Quelle coïncidence!

    *One of the few Senators whose hand I’ve shaken, back when he was my Senator. Oh, Grammbo, how your star has fallen!

  • Joe – no 1, mostly. But at some stage, no 2 will have to morph into no 1, no?

  • TK

    I posted this on yesterday’s thread, but it is dead (hey, that rhymes.) Anyway…

    Regarding AIG, this should have been predictable. Their insurance assets are vast, but recent legislation (by Eliot Spitzer) mandated the separation of various parts of the company (ie, financial and insurance). Therefore, AIG was prevented from using assets on the insurance side to bolster the financial side. (AIG insurance holders have no worries – it is a separate company). More proof of its viability is that the government was even willing to bail out AIG; their overall assets are sound. The loss was more paper-based, due to the implementation of FASB 157 and required loss-taking. The government was not willing to bail out Lehman Brothers because their assets were not sound. This does not get reported; instead, media prefers to sound the alarm and force people into crisis mode. I think that will influence the election, but who will win out? To me, it sounds like McCain has a greater ability to understand Wall Street. He is right that our economy (our workers and their products) are strong. Obama’s message that all is broken is not accurate, I think.

  • Anon


  • Anon

    The federal Constitution requires real money – specie, which means gold and silver; not paper. The current actions by the Federal Reserve State/Corporate bundle established by Democrat Woodrow Wilson, and the Keynsian economics driving it (someone who’s life choices left him without a stake in future generations) is exactly what the framers of the Constitution were forbidding and trying to prevent. They knew how the late Roman Empire resorted to debasing money to increase the ‘money supply’ and how that terribly weakened Rome. They did not yet have the example of Weimar Germany and pushing wheelbarrows full of paper money to the grocery store to buy a loaf of bread.

    I don’t know what you mean by third way, as there are two very different systems that go by that name. One is Chestertonian/Jeffersonian microcapitalism, and the other is Fascism.

    As to the American Dream being allegedly impossible, consider that it is simply the basic picture of shalom in the Bible – every man sitting under the shade of his own olive tree, eating the fruit of his own vine.

  • Joe

    “McCain: Yea. What a shock” yeap your right McCain just never gets the economy right. Except of course when he tried to change the oversight regulations of Freddie and Fannie to, you know, prevent what just happened to them.

    I am linking to a blog that has a pretty pro-McCain bent but it has the text of the bill McCain supported and text of McCain’s statements in the committee that considered the bill. Chris Dodd the then Chairman killed the bill.

    It also contains some other interesting tidbits (not sure if they matter but they are interesting):

    1. According to open secretes Obama is the number 2 all time recipient of cash ($295,198) from Feddie/Fannie since 1998 despite the fact that he has only held elected office for 4 years during that time period. McCain was way down on the list – taking in just over 42,000 over those years.

    2. Franklin Raines and Jim Johnson former Freddie and Fannie execs have been (or still are?) economic advisors to Obama’s campaign.

  • Anon: What I mean by third way is this – .
    I’m not necessarily a supporter, I’m just observing.

  • Anon

    So the Third Way you are advocating, Scylding, is Mussolini’s economics. Ok. But not Hitler’s political system, like another group using “third way”. (and I am really mad at them for using the Celtic Cross, which is a merging of the Labarum with the Cross)

  • Anon

    Sorry, not advocating but observing, I correct my post, sorry about that, Scylding.

  • Anon

    Sorry, not advocating but observing, I correct my post, sorry about that.