Two years ago, I wrote that even the most elite [Wall Street] firms . . . often bet more of their own capital than they once did, and that investment banks must depend to a much greater extent on the money generated from risk-taking ventures than on collecting fees for services performed. Between 2003 and the first half of 2007, we saw the upside of this new world: record Wall Street bonuses, record profits, and tax revenues for New York City that grew at a pace never seen before, in large part the results of the huge bets, explicit and implicit, that Wall Street firms were taking. Today, were seeing the downside.
Just before Christmas, Morgan Stanley announced that $9.4 billion in shareholder assets had vanished during the quarter, mostly because of the firms poor assessment of the risks that one of its trading desks was taking. The quarterly loss was the firms first in its more than 70-year history. How could this happen? one analyst plaintively asked Morgan CEO John Mack. How could one desk lose $8 billion? Bear Stearns also reported its first-ever quarterly loss; neither firms management will take a bonus this year. The same situation held at most of the citys other investment banks and commercial banks. The Securities Industry and Financial Markets Association has reported that earnings across the industry for the third quarter of last year were the worst since the group started keeping track in 1980.
Everyone blames the mortgage crisis, but if it hadnt been mortgages, it would have been something else. And in fact it might be something else soon: banks and other institutional investors have lent money to optimistic commercial real-estate owners and to less-than-stellar companies at the same rate that they made loans to low-income Americans with bad credit and no savings who couldnt afford half-million-dollar houses. The real story is that until about a decade ago, banks didnt have to risk so much of their own shareholders and lenders money to make hefty returns. They could make decent money trading stocks or underwriting and selling bonds for other people and institutions, among other services, without taking much risk themselves.
But because of deregulation and competition, profit margins from such activities have shrunk over the past few decades. In order to adapt, the bankswhich used to help others take riskshad to start taking huge risks of their own. They thought that they could spread the risk around, but as the current crisis shows, that strategy may not have worked. For example, banks and other institutional investors theoretically transferred some massive risks to companies called bond insurers; if a bond that you hold defaults, these companies will pay you at least some of the money. Now the bond insurers themselves are hurting, so the big banks are reportedly thinking about pumping some of their scarce cash into them to stave off any failures, since such failures would force the banks to take even greater losses. But if, when things go south, you wind up bailing out your own insurer, thats a good sign that you never really transferred any risk to it in the first place.
The possibility of big losses should already have been priced into the shares of the banks stock, and into the cost of their debt, long before the news of the past six months. By reading banks quarterly reports since they started recovering from the technology bubble, shareholders knew (or should have known) that banks were taking huge risks in pursuit of huge profits, and that somehow, at some point, big losses were inevitable. But shareholders and lenders seem stunned instead, fleeing bank stocks in droves and slashing share prices of Citigroup and Bear Stearns nearly in half over the past several months. Banks are terrified to lend to one another (which should tell you something). Starved for new capital from outside investors, theyre paying hefty premiums for the money that theyre getting today from cash-flush investment funds owned by Middle Eastern and Asian governments.
The banks poor positions, and investors second thoughts, may mean a slower recovery than after the tech bubble burst in 2000. Back then, the banks biggest problem wasnt their own losses but lawsuits and new regulation spurred by outsiders who had lost money. Repairing their positions this time may be harder. Revamped risk controls at the investment banks may mean more caution and lower profits while the banks try to lure investors back. Another possibility is that banks, desperate to recover, will take on even more ill-considered risks with the money they have left.
Like the banks, New Yorks economy may find recovery slower going this time around. The city shouldnt expect a quick return to record surpluses after a short downturn. The largest spigot of the economys cash generator has slowed to a trickle, which will likely result in lower prices for everything from Manhattan co-ops to retail rents (commercial banks opened their storefront branches all over the city largely to sell mortgages). And Mayor Michael Bloomberg, as he prepares to unveil the citys next budget in late January, probably realizes that while his first two years in office were a challenge, his final two may be even more daunting. When the city isnt creating wealth at a blistering pace, its leaders have far less room for error.
Nicole Gelinas is a Chartered Financial Analyst and a contributing editor of City Journal.