Investment Banking in 2008 - Essay Example

INVESTMENT BANKING IN 2008 Table of Contents Deregulation & the Crisis 3 Remaining Competitive Against the Trend 4 Collapse of Lehman Brothers but Bear Stearns Saved 4 Compensation, Risk & Profit 6 Performance, Panic & the Crisis 6 Bail Out of Proprietary Hedge Funds 7 Bank Holding Companies: Goldman Sachs and Morgan Stanley 7 Too Big To Fail: Merits, Demerits and the Way Out 8 Allan Greenspan and the Concept of Too Big To Fail 9 Bibliography 11 Deregulation & the Crisis There were a number of deregulatory measures initiated by the authorities of United States in the decade of 1990s. The reason for such hype of the deregulatory measures has been primarily the universal bank model. The deregulatory measures allowed the investment banks to participate in the depository functions. The supporters of the deregulations believed that modern day clients preferred to do all of their business ranging from life insurance to commercial lending, from mergers and acquisition advisory to retirement planning, under one roof. And only a deregulated market could allow this to happen. Therefore, replacement of Glass-Steagall Act of 1933 (which prevented depository and brokerage functions) by the Gramm-Leach Bliley in 1999 opened a whole lot of opportunities for the bankers. With the approval to the Gramm-Leach-Bliley Financial Services Modernization Act in 1999, investment banks, insurance companies and commercial banks were equally placed in respect to the products and the markets. This led to the concentration of financial power in fewer hands and soon the investment banks were being absorbed by the commercial banks. The Commodity Futures Modernization Act of 2000 weakened the control of law on future contracts and the high risky credit default swaps, which enabled the companies to leverage their risk to an unlimited extent which ultimately led to the meltdown. The government could have prevented the domino effect (chain reaction) by not allowing the investment banks to deviate from its core competencies. The deviation led to the rise in pressure on investment banks to create return on equity compared to the universal banks like Duetsche Bank and as a result investment banks laid more emphasis on the traditional services like M&A, underwriting, sales and trading. Also, the intense competitive pressure led to the withdrawal of Net Capital rule and SEC allowed unlimited and unregulated leverage (in way of debts) to their brokerage units which proved to be fatal in the long run. Remaining Competitive Against the Trend From the analysis of the case, it appears that Goldman Sachs (and also Morgan Stanley, if not others) could have surely remained competitive without increasing its leverage to boost its return on investment. In fact, Goldman Sachs and Morgan Stanley were honest enough at the outset and had written down the losses in residential mortgages and leveraged loans and tried to avoid the excessive exposure to the mortgage industry. But as Lehman Brothers declared bankruptcy, Goldman Sachs and Morgan Stanley faced increasing pressure from the investors as their profits eroded and return on equity subsided. Consequently, they decided to be the bank holding companies (under FED regulations) and initiate the depository functions which would allow them to play as commercial banks and have diversified banking operations apart from invest banking functions, which in turn would help them to stay competitive. Collapse of Lehman Brothers but Bear Stearns Saved For the purpose of bail out of Bear Sterns , Federal Reserve lent JP Morgan Chase $ 30 Billion out of which JP Morgan Chase agreed to assume responsibility for $ 1 Billion leaving the charge of other $ 29 Billion to the U.S. tax payers. But when the Lehman Brothers, which had almost 75% higher valuation of the assets (compared to Bear Sterns as on 30/11/2007) approached Federal Reserve they did not get the nod. The prime reason of such a decision by Fed is believed to be the political dominos. The decision makers hesitated to take another bail-out measure just weeks before the US presidential election as the public outcry for $ 29 Billion bail-out of Bear Sterns was still in place. Also, Lehman Brothers were provided with discounts by Fed's emergency lending programmes earlier in the summer which Bear Sterns missed. So, it is also supposed that government did not want to assist the same invest-banker for the same mistake twice. Compensation, Risk & Profit Return is said to be the reward for taking risks. More the risk taken more is the return earned, since in any kind of risk, the person has a possibility to either gain or lose. And the excessive risk in the financial industry of invest banking was no different. As the invest bankers (the top talents from the reputed business schools) got involved in developing complex financial engineering models, it was assumed that by these means the investment bankers can avoid risks and can earn huge returns which in turn will benefit their shareholders. The compensation of the executive and employees had provision for huge bonuses which depended upon the earnings of the companies. So, the more the employees tried to boost short term profits (by way of accepting excessive risks, the only way), their earnings also took an upward move in the way of bonuses and incentives. Performance, Panic & the Crisis There is absolutely no doubt that the performances of the investment bankers were dismal since 2007. Investment bankers of repute like Merrill Lynch registered more than 20% loss in 2007 on year-on-year basis (compared to 2006). Profitability of Goldman Sachs, Lehman Brothers and Morgan Stanley also deteriorated. All the leading investment bankers were exposed to high mortgage risks and the total liabilities of the investment bankers in 2007 increased by a huge margin (except Morgan Stanley, as per the case study) compared to 2006. US Federal Reserve had to come up with bail-out measures for the leading investment bankers and also for the largest reinsurer of the world, AIG, Inc. All these contributed to the rise in the fear-factor among the retail investors. The earning per share of Merrill Lynch was in the negative in 2007. The prime strength of the market (the investors) decided to stay away from it. It so happened that 150 year old Lehman Brothers ran out of bidders after Fed decided against bailing it out. Also, most of the companies resorted to measures like lay-offs and retrenchments which increased the panic. The credit crunch leading to global meltdown seemed inevitable. So, it can be said that the panic that caused the lack of liquidity in the market had its roots in the performance of the investment banks and so both are inter-related. Bail Out of Proprietary Hedge Funds With due considerations to the scheme of things happening around the financial industry, it seems that Bear Sterns and Lehman Brothers had to bail out the proprietary hedged funds. If they would not have done so, the investors of the hedged funds would have succumbed to huge losses. The way the market was behaving, the investment bankers had no other option but to bail out the funds. The other way of getting out of this vicious circle (apart from bailing out) was to write off the losses. But as said earlier, it would have exposed the hedgers to huge risks. Bear Sterns and Lehman Brothers could have discouraged its investors from hedging upon the high risk instruments at the first place. Also, the Securities and Exchange Commission and the Federal Reserve should have had stringent regulatory norms which could have prevented the entire scenario. Bank Holding Companies: Goldman Sachs and Morgan Stanley According to the United States law, Bank Holding Company can be referred to as an entity which owns and controls (has the voting rights) an U.S. bank. The bank holding companies are registered with the Federal Reserve and are guided by the Bank Holding Company Act of 1956. Bank holding companies enjoy greater financial flexibilities in their operations and decision making than the traditional banks. Also, the BHCs (as the bank holding companies are often referred to as) find it easier to raise capital in comparison to a traditional bank. Being a bank holding company, the firm can acquire other banks and non-bank entities with lesser hassles. Also, it can issue stocks as and when required. A bank holding company also has greater authority to buy back its shares, once issued. On the flip side, a bank holding company has to abide by a larger number of regulations especially when the number of shareholders increases. In such a case, the BHC is forced to get an authorisation from the Securities and Exchange Commission. Also, the expenses of the BHCs are comparatively higher than that of the traditional banks. As the two leading investment bankers, Goldman Sachs and Morgan Stanley, wrote off huge losses related to the mortgage industry, the pressure from the shareholders started to pile up. The scenario worsened in September 2008 after the fall of Lehman Brothers. The investors felt that the credit crisis revealed the untenability of 20X leveraged firms. Consequently, the investment bankers had to decide about their re-organisation. To meet the expectations of the shareholders, it apparently seemed that they had no other way than to be converted into bank holding companies. As bank holding companies, Goldman Sachs and Morgan Stanley would be regulated by Security and Exchange Commission, the Federal Reserve, FDIC and other state or national level regulators of banks at the United States and would be rendered as the deposit taking institutions henceforth. Being a bank holding company, Goldman Sachs and Morgan Stanley could now have diversified investments over a range of products. Too Big To Fail: Merits, Demerits and the Way Out Too-Big-To-Fail (TBTF) can be referred as the situation where a relatively large corporation is believed to be immune to collapse. The idea behind the concept of Too-Big-To-Fail is that the company cannot be allowed to fail as its operation or way of business involves larger stakes of the society or the government or the public at large. The bail-out steps are often taken to prevent such a company from collapse. The recent bail-out of the leading reinsurer, American International Group, by the US government is a contemporary example of bail-out of TBTF companies. As AIG has been reinsurer to a number of insurance companies, it was believed that the collapse of AIG will make the entire system go haywire. So, the tax-payers' money was injected to bail out AIG. Inc. The moral hazard that goes hand in hand with the TBTF concept is that these firms are often allowed undue relaxations in their operations and policies. The regulatory measures are also a bit relaxed for such companies. As a result, because of lack of imposition of discipline, the T-B-T-F firms find greater incentive to take higher risks, as they think the government will take care of them if things go wrong. They tend to take situations for granted. In the process, when they fail, the tax-payers' money is used to bail them out and the resources are lost. The problem of Too-Big-To-Fail concept can be fixed by having stringent regulations and strict adherence to the rules by the corporate houses. It is feared that excessive usage of TBTF and preferential treatments towards the larger companies may render market discipline to come to a standstill. To fix the problem, the firms should be compelled to implement government counsel even when the firm is doing well. It should be so because it is the government which would help them when faced with a crisis. In no way, privatisation of all profits and nationalisation of all losses can be encouraged. Allan Greenspan and the Concept of Too Big To Fail Alan Greenspan is a leading American economist and has been the chairman of the Federal Reserve of United States from 1987 to 2006. He has the credit of successfully handling the 'Black Monday' in October, 1987 and also the dot-com meltdown in 2000. The theory provided by Alan Greenspan has both pros and cons. As the large companies are turning to the government at the helm of their crisis, it means that the tax-payers' money is increasingly used to save the private houses from bankruptcy and the public money is not being used for the utilities that they are actually meant for. On the other hand, if the large companies are not saved, it may hamper the entire system globally. In this regard, the case of AIG, Inc has been discussed earlier. The Too-Big-To-Fail companies should be saved if and only if no other means are available to them. The prior capital requirements can be a good option. Also, the companies should be ordered to follow regulatory measures from the very outset so that they do not expose themselves to the unviable risks and the need of bail-out does not appear at all. The companies are classified as Too-Big-To-Fail based upon factors like market share, impact on society, impact on the entire system apart from the other considerations like the number of countries in which the company is operating, number of shareholders, human capital, stakeholders, asset base, etc. The companies regarded as Too-Big-To-Fail have larger implications when they collapse. So, if the injection of new capital can save them from being bankrupt, then they should be provided with it. But essential measures should also be taken to ensure that the companies are not taking tax-payers' money for granted. They should be bound by regulations so that they do not intentionally expose themselves to high risks. Bibliography Broome L. L., No Date. Redistributing Bank Insolvency Risks : Challenges to Limited Liability in the Bank Holding Company Structure, UC Davis Law Review. [Online], Available at: http://lawreview.law.ucdavis.edu/issues/Vol26/Issue4/DavisVol26No4_Broome.pdf [Accessed 15 May 2009]. Saporito B., 2009. How AIG Became Too Big To Fail. Time, [Internet] 19 March. Available at: http://www.time.com/time/business/article/0,8599,1886275,00.html [Accessed 15 May 2009]. Read More