Wall Street's business model has collapsed

Wall Street as we know it is kaput. It's not just that Merrill Lynch agreed to be bought by Bank of America or that Lehman Brothers filed for bankruptcy or that insurance giant AIG is floundering or that these events followed a government takeover of Fannie Mae and Freddie Mac, the largest mortgage lenders. What's really happened is that Wall Street's business model has collapsed.

Greed and fear, which routinely govern financial markets, have seeded this global crisis. Just when it will end isn't clear. What is clear is that its origins lie in the ways that Wall Street – the giant investment houses, brokerage firms, hedge funds and “private equity” firms – has changed since 1980. Its present business model has three basic components.

How Wall Street works

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.” 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 a stock you buy for $100 goes to $110. You made 10 percent, a decent return. Now suppose you borrowed $90 of the $100. If the price rises to $110, you doubled your money. Wow.

A gambling machine

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. They concluded that risks were low or nonexistent. The short-term rewards blinded them to the long-term dangers. Inevitably, these surfaced. Mortgages went bad. The powerful logic of high leverage went into reverse. Losses eroded firms' tiny capital bases, raising doubts about their survival.

How Wall Street restructures itself is unclear. Companies need more capital. Merrill went to Bank of America because commercial banks have lower leverage (about 10 to 1). Many thinly capitalized hedge funds may be forced to reduce leverage. Ditto “private equity” firms. In time, all this may prove beneficial. Financial firms may take fewer stupid and wasteful risks – at least for a while.

But the immediate effect may be to damage the rest of the economy. People have lost their jobs. Banks and investment banks may tighten lending standards again and impede any economic recovery. The stock market's swoon may deepen consumers' pessimism, fear and reluctance to spend. More financial firms may fail. It's hard to know, because financial crises resemble wars in one crucial respect: They result from miscalculation.