Saturday, July 13, 2013

Stockman (2) Investment Banks

David Stockman argues in the Great Deformation that the big investment banks were not worth saving.

Twenty-five years earlier these firms had been undercapitalised white-shoe advisory houses with balance sheets, which were tiny and benign. They had grown into giant ultra-leveraged hedge funds, with just a small side operation in regulated securities underwriting and merger and acquisitions advisory services. This shift followed a transition from partnership to a limited liability companies through IPOs in the 1990s. Their profitability was generated by massive trading operations supported by balance sheets that were leveraged 30 to 1 and dangerously dependent on volatile short-term funding.

Goldman Sachs held assets of $1 trillion, but much of their massive wholesale funding had maturities of less than thirty days, and some of that was as short as a week, and even overnight. When Bear Stearns hit the wall in March 2088, it was rolling over $60 billion of funding every morning. This rollover funding was dirt cheap, because lenders had no rollover obligation and were often fully secured.

On the other side of their balance sheets, these de facto hedge funds held assets, which were generally more illiquid, longer term, and subject to credit and market value risk, which generated substantially higher yields. Due to this duration and credit mismatch, the profit spread per dollar of assets was considerable.

When the crash came, these shonky balance sheets came under attack. The investment bankers complained about short sellers, but they were really undermined by plain sellers. These houses of cards should have been allowed to collapse, as an example for an entire generation of money managers, but Bernanke and Paulson body checked the free market before it could do its work.

They panicked because they were afraid that the crisis would spill over into main street banking. Stockman says this was not a risk, because the run on wholesale funding was mostly confined to Wall Street. During the crisis, there were no runs on well-managed commercial banks and thrifts, because their assets were invested in safe US Treasury debt and government-guaranteed mortgage securities. Other loans were carried on their banking books, rather than trading accounts. The irony was that the Wall Street mortgage securitisation machine had sucked all the worst of the subprime mortgages of the balance sheets of community lending institutions.

The claim that their vestigial capabilities in mergers and acquisitions and in underwriting stocks and bonds should be preserved was ludicrous. Neither of these businesses required meaningful amounts of capital, and there always dozens of pedigreed Wall Street veterans waiting to hang out a boutique investment banking shingle to pick up the slack.

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