Wall Street’s Slow Demise
With breathtaking speed, the world of large Wall Street investment banks has vanished. Fabled firms, some more than a century old, have been merged out of existence (Bear Stearns, Merrill Lynch), gone bankrupt (Lehman Brothers), or sought asylum as commercial bank holding companies (Goldman Sachs, Morgan Stanley). Why on earth did this happen?
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By Ron Chernow
29 September 2008
With breathtaking speed, the world of large Wall Street investment banks has vanished. Fabled firms, some more than a century old, have been merged out of existence (Bear Stearns, Merrill Lynch), gone bankrupt (Lehman Brothers), or sought asylum as commercial bank holding companies (Goldman Sachs, Morgan Stanley). Why on earth did this happen?
The death of Wall Street has been a long-running, slow-motion crisis, barely discernible to participants who had still booked huge profits in recent years. Beneath the razzle-dazzle of trading desks and the wizardry of esoteric finance lay the inescapable fact that these firms had shed their original reason for being: providing capital to U.S. business.
The dynastic power exercised by Wall Street tycoons in the late 19th and early 20th centuries was premised on scarce capital. Only a handful of European countries and their private bankers had surplus capital to finance overseas development. In this cash-poor world, J. Pierpont Morgan and other grandees exerted godlike powers over U.S. railroads and manufacturers because they straddled the indispensable capital flows from Europe. With their top hats and thick cigars, these portly tycoons scarcely qualified as altruists. As Morgan liked to warn sentimental souls, “I am not in Wall Street for my health.” Yet he and his ilk rendered America an invaluable service by reassuring European investors that they would receive an adequate return on their investments, securing an uninterrupted flow of capital.
To safeguard those returns, old-line investment bankers became all-powerful overlords of their exclusive clients. When they issued company shares, they retained a large block for themselves. Some clients chafed at these gilded shackles, while others gloried in their servitude. As the head of the New Haven railroad, a Morgan client, boasted to reporters, “I wear the Morgan collar, but I am proud of it. If Mr. Morgan were to order me tomorrow to China or Siberia in his interests, I would pack up and go.”
In the sunless maze of Lower Manhattan, the old Wall Street houses were miniature temples of finance. Elite, all-male and lily-white, rife with snobbery and bigotry, they didn’t bother to hang a shingle outside, and the tacit message to pedestrians was clear: Keep on walking. This reflected the banks’ patented formula of serving only the most creditworthy clients: industrialized nations, blue-chip corporations and wealthy individuals.
In London, these small partnerships were called “issuing houses” because they issued stocks and bonds but didn’t trade or distribute them. In their risk-averse culture, J.P. Morgan and his breed considered the stock market a faintly vulgar place, better left to Jews and assorted ethnic groups outside the top ranks of investment houses. This bias would later give predominantly Jewish firms like Lehman Brothers and Goldman Sachs a marked competitive edge. Even in the 1920s, patrician Wall Street firms stayed somewhat aloof from the stock market mania.
Laws during the New Deal, mandating fuller disclosure of corporate accounting, eroded the Wall Street moguls’ power. The new transparency reduced the need of many companies for a banker’s imprimatur to certify their soundness. The Glass-Steagall Act of 1933, which forced full-service banks to choose between commercial and investment banking, further shrank the investment houses’ influence.
After World War II, as capital markets revived, investment banks remained tiny partnerships with outsize power. Morgan Stanley demanded exclusive banking relations with the cream of corporate America: AT&T, General Motors, U.S. Steel, General Electric, DuPont, IBM and Standard Oil of New Jersey. The essence of the business was still the traditional underwriting of stocks and bonds. The era’s emblem was the solemn, rectangular “tombstone” ad in newspapers for share offerings, listing the dozens of firms involved, with Wall Street’s rulers in the top tier.
Underwriting bred a sociable culture of “relationship” banking in which a smooth golf swing, Ivy League credentials, glib patter over a martini and family connections counted for more than financial ingenuity. Firms didn’t advertise, and paid publicists to keep them out of the press. They disdained hostile takeovers, stock trading and other activities that might threaten their coveted underwriting business. And they enforced more rules of etiquette than a debutante’s ball. It was considered bad form to poach an employee or raid another firm’s client. Whatever their flaws, these elite firms still played a vital role in the economy, floating stocks and bonds to create new factories and businesses.
The old Wall Street began to die a lingering death in 1979 when IBM told Morgan Stanley that it wanted to have Salomon Brothers co-manage a $1 billion debt issue. Fearing that its stable of captive clients would likewise revolt, Morgan partners insisted on sole management of the issue. They were flabbergasted when IBM sent back word that Salomon Brothers would be lead manager for the issue.
What accounted for this startling shift? For the first time since the heyday of J.P. Morgan, traditional corporate clients had outgrown their bankers. With Europe and Japan devastated by World War II, U.S. companies had enjoyed unrivaled supremacy in world markets.
They had grown big enough to finance expansion from retained earnings and had many more borrowing options than before. Many had developed their own financial subsidiaries with triple-A credit ratings and scarcely needed Wall Street bankers to vouch for their solvency.
Trading firms like Salomon Brothers and Goldman Sachs were using their prowess to cultivate relations with powerful institutional investors like pension funds and insurance companies, eating into the profits of white-shoe houses. Underwriting deteriorated into a low-margin business as traders trumped blue-blooded bankers in the Darwinian struggle.
The demise of traditional underwriting would create in the coming decades a vacuum filled by a host of volatile, risky businesses. The cozy world of relationship banking yielded to the brutal world of “transactional” banking. Stock, commodity and derivatives trading, hostile takeovers, leveraged buyouts and prime brokerage for hedge funds required ever-larger balance sheets, forcing investment houses to become huge, publicly traded companies. Firms that once remained distant from the stock market were now its storm-tossed creatures, as investors demanded ever-higher profits amid cutthroat competition, forcing bankers to take risks that would have horrified their Wall Street ancestors.
Where the old Wall Street stuck to the most prestigious clients, the new Wall Street engaged in an unseemly rush to the bottom. Investment houses that once dealt only in grade-A bonds became swept up in junk bond mania in the 1980s. Firms that once snubbed companies beyond the Fortune 500 flocked to Silicon Valley in the 1990s, eager to take fly-by-night companies public. And, in the final reductio ad absurdum, Wall Street during the past decade gorged on mortgage-backed securities, tying its fate to America’s least creditworthy borrowers. Addicted to colossal amounts of leverage, the onetime arbiter of scarce capital had become the most profligate borrower.
The large investment banks that once allocated precious capital now exist in a world awash with money, crisscrossed by capital flows from many continents, with financial markets deep and liquid as never before. Once the current crisis is past, investment banking services will eventually flourish again inside diversified financial conglomerates. Stripped of excess leverage and more tightly supervised by regulators, investment bankers may even rediscover the old-fashioned virtues of corporate finance. And small boutique firms will continue to offer trusted advice as of old. But the storied investment houses of Wall Street, trailing their glorious past, have now earned tombstone ads of a very different sort.
Ron Chernow is the author of “The House of Morgan” and “Alexander Hamilton.”