Monday, September 22, 2008

 

End of the road for investment banking ?

It has been decades now that Wall Street has been run by big investment banks. The exact names may keep changing as some of the smaller firms became bigger, and some of the bigger firms fall (and of course, names keep on changing with mergers and acquisitions), but the basic structure of large investment firms that handled investments for individual depositors as well as large institutions (as distinct from banks who depend on deposits for their cheap source of capital) has more or remained constant for so long that most people do not know of any other mechanism on Wall Street. And then suddenly, in the space of an year, Poof!, it all disappears. It started late last year when reports started coming in of problems in the category of non-collateral high-risk loans known as sub-prime. And these loans were in turn converted by financial magic into a range of investment instruments (explaining at more this level of detail will make this a highly technical discussion !) that were traded by a variety of financial institutions including banks and investment firms. When these sub-prime loans started collapsing, the sheer extent of these loans the subsequent losses caused huge losses for those holding these instruments.
Once people sensed that these investment firms were in danger, further credit to them was slow in coming, people started withdrawing their investments, and then the credit rating agencies started declaring them as various shades of high-risk, junk status. Once this happened, for all practical purposes, these institutions were finished, with the actual spiral of destruction collapsing very fast. And, now with the Administration and Federal Bank of the USA very worried, they have taken steps to prevent some of the more huge ones:


Federal regulators converted Wall Street's remaining stand-alone investment banks - Goldman Sachs and Morgan Stanley - into bank holding companies Sunday night. The move allows Goldman and Morgan to scoop up retail banks and to streamline their borrowing from the Federal Reserve. But it also puts Goldman and Morgan under the Fed's supervision, increasing the agency's regulatory oversight and possibly forcing them to raise additional capital. As banks, Morgan and Goldman will be forced to take less risk, which will mean fewer profits.
And it brings to a close the era of the Wall Street investment bank, a storied institution that traded stocks and bonds, advised mergers and showered lavish bonuses on its executives. In the past eight days, the federal government announced a $700 billion plan to rescue the financial sector by buying up troubled mortgage assets and an $85 billion emergency loan to insurance titan American International Group. Also, Lehman filed for bankruptcy and Bank of America took over Merrill Lynch.


So, even though both these huge huge firms were not in immediate financial danger, they were sensing that they were in grave danger of running afoul of sentiment. In a scenario where investment banks were automatically assumed to be in danger, neither of these firms would have wanted to be the next company picked up for speculation; once in the target of negative public sentiment, even a profitable investment bank could quickly reach the edge of collapse.
This action goes against the normal distance that the US Government would like to maintain from the private market, but politicians of all shades have realized the extreme danger to the economy, and are willing to run with this. Making these investment firms as companies that will act like normal banks will give far more stability.

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