In your opinion, what caused the crisis in the financial sector? – Marc Lepage, Dudley, Mass.
The list of possible culprits is long indeed: Congress, for zealously promoting homeownership; the Fed, for keeping interest rates so low; predatory lenders, for tricking often illiterate and sometimes vulnerable buyers into profiting from their naivety; and buyers for wanting to own real estate at all costs.
The list goes on: the White House, for letting banking regulations become too loose; the executives of financial firms for selling products they didn’t even understand while earning huge profits; the rating agencies for having failed in their mission by producing studies without depth; and hedge funds for having bet on the day of the market reversal which had the consequence of leading us there.
All of this reminds us of Agatha Christie’s famous novel Murder on the Orient Express. There was just one casualty in the middle of the night, but the abundance of passengers spawned a slew of suspects. And we will also add even another culprit: the transformation of investment banks from private partners into publicly traded commercial companies. This trend, which began in the mid-1980s due to a justifiable need for more capital in an expanding global economy, has spawned what may be its most dangerous consequence.
Here’s what we mean: Investment banks used to be owned and run by associates putting their own wealth at risk. They were rewarded when business was good and personally felt the sting when it didn’t. No doubt these associates have lived and breathed the risk profile of every significant sale, deal, and position.
Then came the parade of investment banks specializing in initial public offerings (IPOs), which began with Bear Stearns in 85 and ended with Goldman Sachs (GS) in 99. At each public offering, a few associates came out. Those who remained continued to run the machine with this time the money of others in greater proportions.
One of us (Jack) got a little taste of the impact when GE (GE) acquired investment bank Kidder Peabody in 1987. Although not technically an IPO, the deal had the same effect because of GE’s huge balance sheet. Less than two weeks after the purchase, a group of excited young i-bankers arrived at Jack’s office brandishing a $400 million bridging loan to fund a high-risk oil and gas deal they probably wouldn’t have dared to propose in their previous company. They got it, and after several more creative uses of GE’s balance sheet, it became apparent that GE lacked the expertise to control an i-bank, and it sold Kidder in 1994.
As shareholder-owned investment banks began to take bigger risks on bigger positions, something else started to get bigger, bonuses. It was like Las Vegas down the street. Working the same hours, at the same intensity, but growing other people’s money instead of their own, the anonymous financial engineers were suddenly bringing home $5 million, $10 million, $20 million a year. To maintain this game, some have taken more risks with ever more exotic instruments. What if a deal or sale goes wrong? A smaller bonus, but with no personal wealth on the table no personal asset drop. Is it any surprise that properly assessing risk has eluded them?
Now, we don’t want to blame the financial crisis alone on i-public banks. They’re just another passenger on the Orient Express. But we mention them so that in the cleanup that is about to take place, all the “culprits” pay for their actions. And arguably, the outstanding clearing system on Wall Street should be partly controlled by government action. There needs to be greater long-term alignment with shareholders.
As for a cleaning, of course there will be one. This crisis is hard to pin down in its complexity and global reach, but previous mergers have shown that broken systems can be fixed by smart people. Hank Paulson, Ben Bernanke, and Tim Geithner and their global counterparts have the job profile. The ideology has not blinded them, and they have proven their speed and flexibility in anticipating the next actions to take when the first ones are ineffective. We don’t know how or where this crisis will end, but we have confidence in the ability of the management teams to get the system back on track.