MORE than two years ago, I wrote: “Invest ment banks must de pend to a much greater extent on the money generated from risk-taking ventures” rather than collecting fees for services performed. Between ’02 and the first half of ’07, we saw the fun side 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. Today, we’re seeing the bad side.
Recently, Morgan Stanley announced that $9.4 billion in its shareholders’ assets had vanished during the previous quarter, in large part due to the firm’s poor assessment of the risk one of its trading desks was taking. The quarterly performance meant the firm’s first loss in its more than 70-year history. The CEO, John Mack, said that he’d cut the firm’s risk-taking from “sprinting” to “jogging,” but that “we are in a risk business, and we will [still] be in the market taking risk.”
The same situation held across the industry. The Securities Industry and Financial Markets Association has reported that earnings, or the lack thereof, for the third quarter of last year were the worst on record since the group started keeping track in 1980.
Everyone blames the mortgage crisis – but if it wasn’t mortgages, it’d be something else. And it might be something else anyway, soon enough. Banks and other institutional investors have loaned money to optimistic commercial real-estate owners and to less-than-stellar companies at the same rate they loaned it out to low-income Americans with bad credit and no savings who couldn’t afford half-million-dollar houses.
The real story is that until the last decade or so, banks didn’t have to risk so much of their own shareholders’ – and lenders’ – money to make hefty returns. They could make decent money trading stocks or floating bonds for other people and institutions, among other services, without taking much risk themselves. But due to deregulation and competition, profit margins from such activities have only shrunk over the last few decades. These structural changes have come gradually – but they’ve finally arrived.
So the firms that mostly used to help others take risks have had to jump in and take huge risks on their own. They thought they could spread those risks around, but this strategy doesn’t seem to have worked too well.
For example, banks and other institutional investors theoretically transferred some massive risks to companies called “bond insurers,” which supposedly do just that: If a bond you hold defaults, they’ll pay you at least some of the money back. Now that the bond insurers themselves are weakened, the big banks reportedly are pondering pumping cash into them so that one of them doesn’t fail and force the banks to take even more losses. But the problem with this idea is that if the banks might have to bail out their own insurers, they didn’t really transfer any risk to those insurers.
Theoretically, the possibility of big losses already should have been “priced” into the shares of these companies’ stock before the news of the last six months, as well as in the cost of their debt. Shareholders knew, or should have known, from reading banks’ quarterly reports since they started recovering from the tech bubble, that banks were taking huge risks in pursuit of huge profits and that such an event was thus inevitable.
But shareholders and lenders seem stunned instead, fleeing bank stocks in droves and cutting share prices of such companies as Citigroup and Bear Stearns nearly in half over the last several months. Banks are terrified to lend to one another (which really should tell you something). Citigroup as well as other banks have been so starved of capital that they’ve been forced to go hat in hand to new government investors in the Middle East and Asia and pay huge premiums to replenish their depleted cash.
What does that mean for New York? It means that in one way, the huge budget surpluses we’ve seen in the last few years have been in part an illusion: Remember that the investment banks are now having to give back some of the profits upon which those surpluses were largely based.
It also means recovery for the city (in terms of jobs, economic growth and tax revenues) could be longer than it was after 2000, when the banks could just sit and wait for share-trading and bond-underwriting volume to increase again. Because the largest spigot of the economy’s cash generator has slowed to a trickle, it likely means lower prices for everything from Manhattan co-ops to retail rents and less tax revenue for the city.
Mayor Bloomberg knows all this – and likely already realizes that while his first two years were a challenge, it might have just been preparation for his final two.
Nicole Gelinas is a contributing editor to the Manhattan Institute’s City Journal (from city-journal.org).