The Decline of Investment Banking: Preliminary Thoughts on the Evolution of the Industry 1996-2008, 5 J

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The eclineD of Investment Banking: Preliminary Thoughts on the Evolution of the Industry 1996-2008 Robert J. Rhee

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This Articles & Essays is brought to you for free and open access by the Academic Journals at DigitalCommons@UM Carey Law. It has been accepted for inclusion in Journal of Business & Technology Law by an authorized editor of DigitalCommons@UM Carey Law. For more information, please contact [email protected]. 27675 mlb_5-1 Sheet No. 41 Side A 02/18/2010 11:56:44 I noted that it was that I noted 1 financial crisis, This was only a few years before the before This was only a few years 2 2009 was shocking in many ways. For me, a major shock was the a major shock me, For ways. in many 2009 was shocking – 2008 – * Washington J.D., George of Maryland of Law; School University of Law, Professor Associate 1.“Corporate Governance discussion, a roundtable hosted of Law of Maryland School The University 2. Securities International (summer at Citicorp banker During as an investment this period, I worked In this paper, I provide a preliminary financial analysis of the five major inde- this paper, major In I provide a preliminary of the five financial analysis 2010 Robert J. Rhee. 2010 Robert © former I thank my of Chicago. B.A., University (Wharton); of Pennsylvania M.B.A., University University; staff of and symposium and issue. I also thank the editors colleague Lisa Fairfax for organizing Roundtable this journal work, dedication, and service.hard for their our fine law 17, 2009. April on the Financial Crisis,” to Responses and Securities Law (New Kelton and Fox-Pitt, (Baltimore), Brown Alex. Deutschebanc (London), Seoul), UBS Warburg associate, and mergers and acquisitions. finance in corporate I mostly worked York). & technology of business lawjournal 75 During the Roundtable discussion on the the Roundtable During robert j. rhee* robert Preliminary Banking: of Investment The Decline the Industry of Thoughts on the Evolution 1996 \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 1 10-FEB-10 8:10 crisis, the industry yet and me to that nearly collapsed in 2008 seems very different on the industry. myself an intuition based on anecdotal as I update This was more empirical thought developed confirmed by evidence. than a media accounts Morgan the crisis: before Goldman Sachs, banks that existed pendent investment The period and Bear Stearns. examined Brothers, Lehman Stanley, Merrill Lynch, is nothing particularlyThere 2008. is 1996 to significant about 1996 other here the and, as a result, banking career investment that I startedthan this is the year my important to understand finance and the financial industryimportant understand finance to as a part of legal dis- of that thought. The financial education. This paper and is a continuation course crisis of 2008 the competitive banks from investment “bulge bracket” three sudden collapse of landscape From in an industry an oligopoly. starting look like that was already to poor risk due to management and/or mal- banks implode time, investment time to Burnham Lambert in the United Drexel collapses were The last such feasance. implo- in the U.K. in 1995. These occasional in 1990 and BaringStates Brothers and Brothers, not surprising. of Bear Stearns, Lehman sions are the collapse But disappear- within in the months in 2008, resulting of a few a matter Merrill Lynch prior my In inconceivable. knew it, was Street as we of a large partance of Wall sector) financial Street and the City (London’s on Wall life, I worked professional 2001. 1996 to from banker as an investment 27675 mlb_5-1 Sheet No. 41 Side A Side No. 41 Sheet mlb_5-1 27675 27675 mlb_5-1 Sheet No. 41 Side B 02/18/2010 11:56:44 A Year of A Year Rather, 4 note 12. The sector also 12. The sector note Before the crisis, Before there 5 See infra Kevin Quealy & Dylan Loeb McClain, McClain, Quealy & Dylan Loeb Kevin the products and services, primarily the firms. The survivinginvestment See qua qua i. William J. Wilhelm, Jr., Investment Banking: Institutions, Banking: Jr., Investment J. Wilhelm, William & 27675 mlb_5-1 Sheet No. 41 Side B Side No. 41 Sheet mlb_5-1 27675 The Decline of Investment Banking Investment of Decline The , Sept. 15, 2008, http://www.nytimes.com/interactive/2008/09/15/business/20080916- Alan D. Morrison (2007) (discussing the business of investment banking and historical industry trends). (2007) (discussing the business of investment Although the data analysis here is basic, it still Althoughan interesting tells analysis here the data 3 N.Y. Times , See generally 5. 3. with spreadsheet the author. on file in an Excel are The data analysis and outputs 4. Bear Stearns The industry Lynch, Merrill got smaller of competitors. sector in terms of the number The investment banking industry evolved significantly in the twelve-year period significantly banking industry in the twelve-year evolved The investment treemap-graphic.html. Politics, and Law Politics, Heavy Loses Heavy got smaller in terms of lost market capitalization, not counting any equity contribution through the Troubled any capitalization, not counting got smaller in terms of lost market federal or other bailout measures. Program Relief Asset and certain assets of Lehman Brothers were absorbed by their competitors. absorbed their competitors. by were and certain Brothers assets of Lehman 76 & technology law of business journal \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 2 10-FEB-10 8:10 and universal banks have benefitted from the unprecedented cheap public capital public cheap the unprecedented from benefitted banks have and universal and they the financial system, willbeing pumped into benefit in the long-term of the industry, crisis-caused the unexpected, consolidation from which has re- in an industry competitors in fewer underwent significant con- sulted that already following the repeal of Glass-Steagall.solidation in the 1990s and the years narrative of the evolution and business cycle of the investment banking industry. the investment of and business cycle of the evolution narrative major of the three mix banks had a balanced the mid-1990s, 2008. In 1996 to from product and service banks: trading, lines of full-service asset manage- investment the trading the past few years, In overshadowed banking. ment, and investment and became the primaryother product lines activity business of major investment the not to refers banking,” “decline of investment the article,banks. The title of this banking marginalization of investment year I actively observed the industry observed actively I also marks year the mid- The year insider. as an ulti- which bubble, technology the Internet boom, of economic a decade 1990s, indus- banking crashed of the investment rapid in 2000, and mately consolidation try. products by I provide the following data: (1) segmentation basic of net revenue and services, ratio, (3) leverage ratio,(4) debt-to- and return-on-average-equity (2) equity ratio. the decline refers to investment banking investment to refers the decline securities underwriting advisory finance and corporate services. During this pe- highly leveraged pro- their business model toward banks changed riod, investment prietary The investment trading and profit. as the principal means of revenue banking industry a big risk. The managers at these firms in was primed take to type profitability, and boost revenue decisions; to “bet the company” made essence they heavily on proprietary relied trading with balance coupled a highly levered especially vulnerable banks were in investment hindsight, see that pure sheet. In we industry of the ago. The evolution not only a few years and that they were a way for a majoritybrew of the be a witches’ to proved the strategic ultimately choices banks. independent investment For those unfamiliar with the organization of Wall Street investment banks, I pro- Street investment those unfamiliar withFor the organization of Wall the broad industry of vide a rough sketch organization. 27675 mlb_5-1 Sheet No. 42 Side A 02/18/2010 11:56:44 one can 8 7 2 (Jan. 26, 2008); Morgan Stanley, 26, 2008); Morgan 2 (Jan. – 14. – erale. Additionally, the industryerale. Additionally, has en´ 08, 311 – e G´ et´ Robert J. Rhee J. Robert note 5, at 304 note supra supra , Wilhelm & Morrison Gramm-Leach-Bliley Act, Pub. L. No. 106-102, 113 Stat. 1338 (1999) (codified in scattered sections in scattered 106-102, 113 Stat. 1338 (1999) (codified L. No. Pub. Act, Gramm-Leach-Bliley See See Before the financial crisis, major investment banks acquired by and affiliated by banks acquired financial crisis, the major investment Before 6 8. 10-K), at 1 (Form Report Annual Inc., Group, The Goldman Sachs 6. 7. I analyze here the data for the five independent investment banks that were regu- banks that were independent investment for the five the data here I analyze With respect to products and services, respect to the activitiesWith of full-service investment Annual Report (Form 10-K), at 1 (Jan. 28, 2008). 10-K), at 1 (Jan. (Form Report Annual of 12 U.S.C.). 5 no. 1 2010vol. 77 lated as broker-dealers by the Securities and Exchange Commission (SEC). These Commission the Securities by and Exchange as broker-dealers lated with unaffiliated a larger commercial selected because they or were firms are were bank- look at the business of investment bank. Their financial data provide a pure Stanley surviveding. Obviously, and Morgan the financial crisis, Goldman Sachs became the most identifi- and Merrill Lynch Brothers, and Bear Stearns, Lehman able victims crisis also fall this of the financial into (arguably, AIG and Citigroup Goldman Since list of victims today). operate although to as well, they continue in 2008, companies bank holding to Stanley converted and Morgan Sachs \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 3 10-FEB-10 8:10 with larger commercial banks were the securities unit of Citigroup (formerly the securitiesunit of Citigroup Salo- banks were with larger commercial In and J.P. Morgan. First Boston, Suisse Credit Barney), mon Smith UBS Warburg, banking firms,large financial in- several other these major investment addition to banking operations through global also built large-scale, investment stitutions have Bar- Bank, Deutsche and internal growth. These firmssmaller include acquisitions Soci´ CIBC, Bank of America, and clays, numerous niche players that specialize in certain or industry products players niche groups, for numerous (M&A) advisory and acquisitions which specializes in mergers Lazard, example ser- equity which specializes in private investment. vices, Blackstone, and were only five major, pure investment banks, sometimes called “bulge bracket” called sometimes banks, investment major, pure five only were Sachs, Goldman in the 1990s: place that took of the consolidation as a result banks, the last two and Bear Stearns, Brothers, Lehman Stanley, Lynch, Merrill Morgan These firmsbeing somewhat a provided larger competitors. smallerthan the three full and services array of products primarily and had large- to institutional clients in- “pure” various internationally. degrees to Theyscale operations were extending with not affiliated financial institutions, larger they banks because were vestment bank- and investment typically of commercial banks. The combination commercial withing was made possible the gradualand repeal of the Glass-Steagall demise Act. plausibly argue that the era of pure investment banking ended with these conver- plausibly argue that the era investment of pure of banks irrespective investment that these firms pure it is clear are sions. However, fall under. the regulatory they to scheme choose which is pri- banking, (1) investment three: banks can be broadly into categorized marily advisory and acquisitions mergers (“in- services, securities and underwriting (“asset vestment banking”); (2) asset management and other securities services broker/dealer including trading and principal(3) investments, and management”); activities(“trading”). and proprietary The 10-Ks of these firmstrading roughly 27675 mlb_5-1 Sheet No. 42 Side A Side No. 42 Sheet mlb_5-1 27675 27675 mlb_5-1 Sheet No. 42 Side B 02/18/2010 11:56:44 Wall , , The Goldman Sachs Group, , The Goldman Sachs See, e.g. Firm DisclosesFirm Planned Details Its IPO of — Investment banking and asset manage- and banking Investment 9 ). Four measures were calculated. First, I provide the calculated. were measures ). Four 10 27675 mlb_5-1 Sheet No. 42 Side B Side No. 42 Sheet mlb_5-1 27675 were combined as the “survivingthe as combined were firms”crisis. of the financial The Decline of Investment Banking Investment of Decline The Goldman’s Results Hits a Record Hits Results Goldman’s 11 The Goldman Sachs Group, Inc., Prospectus (Form 424B4) (May 4, 1999) (detailing Goldman 424B4) (May (Form Prospectus Inc., Group, The Goldman Sachs See Charles Gasparino, Charles , Mar. 17, 1999, at C1. , Mar. 9. banking, or asset not specifically or costs identified as trading, investment miscellaneous revenues Any Based on the data from individual firms, I created composite data. The five firms data. The five individual composite Based on the data from firms, I created The data are from each firm’sThe each data from initial public offering 10-K, or the are (IPO) prospec- 11. 24, 2009. Morgan August in an 8-K filing dated its 2008 financial statements Stanley restated Morgan 10. 78 & technology of business law journal management were included in the asset management category for convenience. Generally, these other sources in the asset management category for convenience. included management were products. major the three to minor compared were or cost of revenue J. St. 2009). 24, 8-K), at 1 (Aug. Report (Form Stanley, Current Inc., Annual Report (Form 10-K), at 56 (Jan. 26, 2009) (identifying investment banking, trading and principal 26, 2009) (identifying investment 10-K), at 56 (Jan. Report (Form Annual Inc., segments). three and asset management and securities servicesonly as Goldman Sachs’ investments, region); and the Asia/Pacific Canada, States, in the United shares stock offering of common public initial Sachs’ see also \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 4 10-FEB-10 8:10 Bear Stearns, Lehman Brothers, and Merrill Lynch were combined as the “failing the as combined were and Merrill Lynch Brothers, Bear Stearns, Lehman break out net revenue into these categories. into net revenue out break net revenues by the three major product lines: investment banking, trading banking, and major product lines: investment the three by net revenues is and asset management and securities services. revenue principal investment, Net and expense attributable trading to activities. revenue The financial net of interest I pro- product lines. Second, by provide segmentation revenues statements of net ratio, as the net in- which is calculated (“ROE”) vide the return-on-average-equity equity.shareholder of the prior year’s and current divided the average come by ratio I provide the leverage ratio, as the is simply calculated of total Third, which equity. shareholder Last, I provide the debt-to-equity ratio, which is calcu- assets to equity. evident, as the ratio shareholder As lated of long-term debt to the analysis manipulation or calculation was required. is ratherhere basic and not much data. Goldman Sachs of the financial average a weighted creating combined, were Stanley and Morgan ment are primarily can be banking are ment activity The businesses. fee-based investment of a firm as whenrisky, underwriting. commitment a bank agrees to such Generally with the risk is commensurate M&A advisory the return. speaking, however, work risks capital, and the minimal of underwriting requires through can be managed bank generates respect trading, to an investment and pricing.syndication With for on trades primary commissions in two executed it charges first, ways: revenue proprietary it takes trading second, a positions as capacity in its as a broker; clients a large portion of net constitutes The latter dealer and principal in investments. trading, from and its activityrevenues is only possible with substantial support that capital at risk. puts Proprietary tradingtherefore and capital the firm’sfrom the primary are activitiesand principal the distress investment that directly led to Street firms. of major Wall for the period Sachs tus in the case of Goldman partnership when it was a private in 1999 (the firm public went 27675 mlb_5-1 Sheet No. 43 Side A 02/18/2010 11:56:44 21 – 713, 716 Geo. Mason L. Rev. Geo. Mason How to Prevent Hard How Emory L.J. Emory , 17 , 58 = = = _~åâáåÖ ^ëëÉí=jÖãí R qê~ÇáåÖ Marcel Kahan & Edward Rock, Rock, & Edward Kahan Marcel See OMMN OMMO OMMP OMMQ OMMR OMMS OMMT OMMU = Robert J. Rhee J. Robert OMMM 21, available at http://ssrn.com/abstract=1447050) the 21, available (recounting – = NVVV = NVVU = Nationalization of Corporate Governance Corporate and Purpose of DuringNationalization Crisis chart 1: net revenue segmentation of all banks segmentation 1: net revenue chart A comparison of the two composites, “surviving” and “failing” firms, pro- “failing” “surviving” and composites, of the two A comparison NVVS= NVVT 12 ======Robert J. Rhee, Robert Charts 1 through 4 provide the composite data for the five investment banks. investment data for the five Charts 4 provide the composite 1 through MB 12. Barclays. actually sold to and certain filed for bankruptcy, Brothers of its assets were Only Lehman UMB TMB SMB RMB QMB PMB OMB NMB NMB OMB R R (forthcoming 2010) (manuscript at 4 in ensuring its consumma- role and the government’s companies the merger of the two surrounding events but for these Brothers Lehman like collapsed have most likely would Lynch tion). Both Bear Stearns and Merrill transactions.rescuing (2009) (describing the circumstances of the sale). Merrill Lynch survived to merge with survived to It Bank of America. Lynch of the sale). Merrill (2009) (describing the circumstances the federal by government. as prompted Bank of America by failed had it not been rescued have would surely See vol. 5 no. 1 2010vol. 79 Bear Stearns and Merrill Lynch were acquired by JPMorgan Chase and Bank of America respectively. Bear respectively. and Bank of America Chase JPMorgan by acquired were Lynch and Merrill Bear Stearns sale. in a fire Chase JPMorgan was sold to Stearns Comity of and the Strategic Bear Bad Law: Stearns, Delaware, Use Cases Making from \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 5 10-FEB-10 8:10 vide interesting insights.vide interesting and Lehman data for Bear Stearns incorporate 2008 not do These composites they before insolvency or filed for acquired firms were these two because Brothers Morgan Goldman Sachs, only 2008 data include 10-Ks. Thus, file their 2008 could Stanley, Lynch. and Merrill firms.” 27675 mlb_5-1 Sheet No. 43 Side A Side No. 43 Sheet mlb_5-1 27675 27675 mlb_5-1 Sheet No. 43 Side B 02/18/2010 11:56:44 27675 mlb_5-1 Sheet No. 43 Side B Side No. 43 Sheet mlb_5-1 27675 The Decline of Investment Banking Investment of Decline The chart 2: leverage ratio of all banks ratio 2: leverage chart chart 3: debt-to-equity ratio of all banks ratio 3: debt-to-equity chart 6 6 6 6 6 6 6 6 6 6 80 & technology law of business journal \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 6 10-FEB-10 8:10 27675 mlb_5-1 Sheet No. 44 Side A 02/18/2010 11:56:44 Eric see http://www.nytimes.com/2008/04/ After the Internet bubble burst in the Internet After available at available 14 Apr. 3, 2008, at C1, Apr. Robert J. Rhee J. Robert Second was the 1999 conversion of Goldman Sachs was the 1999 conversion Second 13 N.Y. Times, , , Apr. 7, 1998, http://www.nytimes.com/1998/04/07/news/07iht-citi.t.html; 7, 1998, http://www.nytimes.com/1998/04/07/news/07iht-citi.t.html; , Apr. Citicorp and Travelers Plan to Merge in Record $70 Billion Deal: A New No. 1: Financial No. $70 Billion Deal: A New in Record Plan to Merge Citicorp and Travelers chart 4: return-on-average equity of all banks 4: return-on-average chart note 10. note N.Y. Times , See supra Citi’s Stormy First Decade First Citi’s Stormy These data tell a compelling story. The business model of investment banks sig- These data tell a compelling story. The business model of investment Q Q 14. 13. Martin, Mitchell R Q Q Q Q Q Q RQ R Q RQ Dash, 03/business/03citi.html (recounting ten-year history of the merger). ten-year 03/business/03citi.html (recounting vol. 5 no. 1 2010vol. 81 Giants Unite nificantly evolved as the industry that Chart 1 shows a business cycle. nificantly evolved underwent management, banking, asset business mix of investment 2000, the 1996 to from a period growth marked stable. These years of economic and trading was relatively banks expected, investment technology bubble. As and the run the Internet up to highly during profitable this period in the range of 25%. were as seen in the ROE in the industry. major events During also two this period, First was the were there which provided the model of post-Glass- and Travelers, 1998 merger of Citicorp services financial Steagalluniversal and cross-selling of various financial products under a single firm umbrella. \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 7 10-FEB-10 8:10 from a private partnership a private from a public company. to 2000 and the September 11, 2001 terrorist attacks, profitability significantly de- 11, 2001 terrorist attacks, 2000 and the September teens, in the range of low hovered and ROE recession, of the as a result clined also see banks. We of commercial the profitability levels resembling investment in terms of net reve- as measured decline banking and asset management steadily activities during the the slowing of investment contribution to nue in response and trading business activity the prominent recession, start become of invest- to its apex in 2006 when tradingment banks. This trend reached contributed 69% of 27675 mlb_5-1 Sheet No. 44 Side A Side No. 44 Sheet mlb_5-1 27675 27675 mlb_5-1 Sheet No. 44 Side B 02/18/2010 11:56:44 , shows § 240.15c3- supra Id. What Went Wrong? A Wrong? What Went Net Capital Requirements for Requirements Capital Net investment banks had investment 16 see the change in the rule the change 19 John C. Coffee, Jr., C. Coffee, John This provided a definite, tangible This provided a definite, See 17 15 (2009) (noting that the SEC assigned staff three – 403, 414 § certain items. capital is net worth by adjusted 240.15c3-1(c)(1). Net 27675 mlb_5-1 Sheet No. 44 Side B Side No. 44 Sheet mlb_5-1 27675 Given that these models were held by the firms them- held by that these models were Given Id. 18 note 5, at 13 fig. 1.4 (showing that by 2000 trading revenue as a percent of as a percent 2000 trading that by 5, at 13 fig. 1.4 (showing revenue note that is, until the industry of its collapsed under the weight The Decline of Investment Banking Investment of Decline The — . U. St. Thomas L.J. Thomas U. St. supra supra , , 6 supra 15 Wilhelm Chart 1, & See The focus on tradingThe focus with coincided dramatically leverage. Charts 2 increasing The increase in leverage was made possible by a crucial in SEC regula- in leverage was made possible by change The increase 15. in the 1990s. increasing exponentially data showing trading provide revenue Wilhelm and Morrison 16. 17. 17 C.F.R. § standard. an alternative (2003). The rule 240.15c3-1(a)(1)(i) also allows 19. One seriously questions whether the agency had the capacity pass judgment to on these mathematical 18. Supervised of Consolidated Part That Are for Broker-Dealers Requirements Capital Net Alternative § 240.15c3-1(c)(2). 82 & technology law of business journal Morrison and 3 show that investment banks were not always so highly levered. The banks so highly levered. always not banks were investment that and 3 show with funding seeking greater short-termwere in the leverage ratios, debt, as seen as with long-term capital well as funding as seen in debt-to-equity leverage, greater 21x to approximately from ratio 2007, the leverage increased 2003 to ratios. From 6x. Al- just under 3x to approximately from increased 30x, and the debt-to-equity highthough in the 1990s as well, the leverage ratios were \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 8 10-FEB-10 8:10 capitalization was approximately 80%). This trend continued in the twenty-first century. Chartcontinued 80%). This trend 1, capitalization was approximately that trading revenue increased substantially from 2001 to 2008. 2001 to substantially from increased that trading revenue net revenue, as compared to 15% for investment banking and 16% for asset and 16% banking for investment 15% to as compared net revenue, management. Brokers or Dealers, 17 C.F.R. § or Dealers, 17 Brokers 240.15c3-1 (2008). did not. that the firms themselves that it is clear models given Acts in Three Tragedy members to each bank to monitor the implementation of net capital per the firm’s mathematical models, and models, the implementation of net capital permathematical monitor the firm’s bank to each members to 1(a)(1)(ii). was defined as “theAggregate indebtedness total money subject liabilities,” to certain exclusions indebtedness. collateralized including Id. at 17 be codified 21, 2004) (to 34,428, 34,428 (June Reg. 49,830, 69 Fed. No. Release Act Entities, Exchange Requirements]; Capital Net Alternative C.F.R. pts. 200 and 240) [hereinafter selves and the agency merely approves them for use, approves and the agency merely selves limit on leverage. In 2004, the SEC changed the net capital rule and allowed invest- the net capital rule 2004, the SEC changed and allowed limit on leverage. In of this restriction. out opt The agency established a voluntary, alter- ment banks to banks based deductions net capital for investment method of computing to native and de- for market net capital requirements calculate on mathematical models to risk. credit rivatives-related diversified portfolios coming of business activities,diversified revenue with of the net much banking and asset management, re- investment from commissions fees and from and earnings trading.to from leverage Extreme of revenues ducing the volatility fund primarily a firm is proprietary phenomenon. When trading was a recent the be higher. to Chartshows tends 4 its ROE highly leveraged and successful, the which dramatically from ROE, increased leverage on of increasing influence 2001, and 11, of September crash, the terrorist attacks doldrums of the dot-com subsequent recession leverage. that the SEC required by imposed 2004, the net capital requirement tion. Before . . . shall or dealer all permit to other per- broker its aggregate indebtedness “[n]o of its net capital.” 1500 percent exceed sons to 27675 mlb_5-1 Sheet No. 45 Side A 02/18/2010 11:56:44 23 24 , Oct. 2, 2008, at A1 The validity of these 22 at 34,429 (“One commentator, N.Y. Times , see id. This change in the rule, allowing This change U.S. Treasury, Daily Treasury Rate Yield Rate Treasury Daily U.S. Treasury, 20 Robert J. Rhee J. Robert Agency’s ’04 Rule Let Banks Pile Up New Debt New Banks Let Pile Up ’04 Rule Agency’s Stephen Labaton, Labaton, Stephen The agency changed the rule so that it “may monitor better, and act more better, “may monitor it that so the rule The agency changed at 34,435. at 34,428. 21 Id. Id. See , http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml (last vis- , http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml In addition to the change in regulation, high leverage was facilitated by cheaper high by was facilitated in regulation, leverage the change addition to In Chart 2 shows that the leverage ratio of investment banks began to increase dur- began increase banks to leverage ratio that the of investment Chart 2 shows 20. at 34,428; Reg. 69 Fed. Requirements, Capital Net Alternative 21. 22. 23. 24. provides the data. website Department’s The Treasury vol. 5 no. 1 2010vol. 83 concluding that “[i]t was, from the outset, a mismatch. Three young staffers against all young the financial economists Three “[i]t the outset, a mismatch. was, from that concluding reach”). that its CEO needed to the conclusions reach design wished a model that would use to to Lynch Merrill cost of debt. Since the beginning of the new century, rates have trended down- the beginning of the new century, of debt. Since rates have cost which provide the benchmark Chartwards. 5 provides historic yields on Treasuries, risk-free rates (higher yielding instruments). securities longer-term are \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 9 10-FEB-10 8:10 quickly in response to, any risks the broker-dealer.” . . . to any to, in response quickly however, questioned the use of models to the extent that it would lower broker-dealer capital requirements broker-dealer lower that it would the extent to questioned the use of models however, . . . .”). rule in the agency the change and the subsequent effects). surrounding (describing the events Curves Oct. 30, 2009). ited allowed great leeway and discretion in setting the net capital levels. A significant levels. capital the net in setting discretion and leeway great allowed and deductions for market “broker-dealer’s a that the SEC noted, is, as consequence net method of computing the alternative under risk will probably credit be lower rule.” net capital under the standard capital than investment banks to opt out of the fixed net capital restriction, allowed greater net capital restriction, allowed out of the fixed opt to banks investment leverage. also increasingly trading During this time, the firms were ing 2004 and thereafter. obligations debt of and collateralized derivatives securities, as credit such exotic the this regard, In was no liquid market. securities, for which there asset-backed deductions for illiquid se- compute to also be allowed could mathematical models curities. mathematical models dependsmathematical models expected on the underlying assumptions regarding cashflow and adage “garbagevariance (the old in, garbage out”), and these inputs no were that there know now judgment on human for we been based have must hindsight, In this agency view inputs. reliable was terriblybecause it misguided banks themselves. investment the of leverage to delegated the regulation 27675 mlb_5-1 Sheet No. 45 Side A Side No. 45 Sheet mlb_5-1 27675 27675 mlb_5-1 Sheet No. 45 Side B 02/18/2010 11:56:44 27675 mlb_5-1 Sheet No. 45 Side B Side No. 45 Sheet mlb_5-1 27675 The Decline of Investment Banking Investment of Decline The chart 5: yields on one-, five-, and twenty-year treasuries 5: yields five-, on one-, chart Q Q Q Q Q Q Q Q Q The data here is not surprisingThe data here with leverage and reliance respect increasing to bank, Street investment Wall the premier of Goldman Sachs, examination An Chart 5 shows that yields on long-term securities declined steadily, and the yields that yields securities steadily, Chart on long-term shows declined 5 on shorter-term instruments fell sharply in the period other 2004. Among 2000 to Street’s also fueled Wall of debt fueled the housing bubble. It things, cost cheap boost profitability. dependence on leverage to of the fi- theme in the current account boost profitability, a common on debt to of in the broader context be considered must the account nancial crisis. However, the past several de- over place Street that took the evolutionary on Wall changes of the 1990s, the technology boom the economic see a business cycle: cades. We slow- and the economic terrorist attacks, crash 11, 2001 2000, the September of at the turn of the in the general The decline economy 2002. of 2000 to down asset management and invest- from century naturally in revenue a decline led to sharply declined in the period The ROE 2002. 2000 to ment banking. Profitability not the high and insurance companies, banks of commercial levels was reaching also see that same time, we the in the 1990s. At banks saw flying investment levels experiencing a period were yields of declining on credit. the capital markets advan- Street firms took leverage, which Wall incentivized of credit Cheaper cost we and in the subsequent years boost profitability. The factors converged tage of to Street business model. of the Wall experienced the evolution Chartsreflects this narrative. 6 through 9 provide the essential data. 84 & technology of business law journal \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 10 10-FEB-10 8:10 27675 mlb_5-1 Sheet No. 46 Side A 02/18/2010 11:56:44 `:R1J$ R:J@1J$ V $I Robert J. Rhee J. Robert chart 7: leverage ratio of goldman sachs ratio 7: leverage chart chart 6: net revenue segmentation of goldman sachs goldman of segmentation revenue 6: net chart Q Q Q Q Q Q Q Q Q 6 6 6 6 6 6 vol. 5 no. 1 2010vol. 85 \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 11 10-FEB-10 8:10 27675 mlb_5-1 Sheet No. 46 Side A Side No. 46 Sheet mlb_5-1 27675 27675 mlb_5-1 Sheet No. 46 Side B 02/18/2010 11:56:44 27675 mlb_5-1 Sheet No. 46 Side B Side No. 46 Sheet mlb_5-1 27675 The Decline of Investment Banking Investment of Decline The chart 8: debt-to-equity ratio of goldman sachs goldman of ratio 8: debt-to-equity chart chart 9: return-on-average equity of goldman sachs 9: return-on-average chart The trends shown in these data mirror the broader trends in Wall Street. I note a Street. I note The trends shown in these data mirror the broader trends in Wall Q 6 6 6 6 Q Q Q Q Q Q few additional observations. The move away from a balanced business mix to trad- business mix to a balanced from away few additional observations. The move partner- it was a private When for Goldman Sachs. pronounced more ing is even 86 & technology of business law journal \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 12 10-FEB-10 8:10 27675 mlb_5-1 Sheet No. 47 Side A 02/18/2010 11:56:44 Despite the market the Despite 25 The net effect was that 26 Robert J. Rhee J. Robert QCRI:J :H. V.I:J `Q .V` chart 10: comparative leverage ratios leverage 10: comparative chart at 3. Id. Another aspectAnother that is worth is that as the crisis noting was unfolding in 2008, 25. 26, 2009). 10-K), at 179 (Jan. (Form Report Annual Inc., Group, The Goldman Sachs 26. 6 6 6 6 6 6 vol. 5 no. 1 2010vol. 87 \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 13 10-FEB-10 8:10 ship before 1999, we see that it was highly levered, but the business mix was mix the business but highly it was see that levered, we 1999, before ship services. and lines of products main among three was an The result diversified 50%. around hovering figures firmextraordinarily in the ROE as seen profitable the leverage ratio, of its IPO in 1999, the time ratio, debt-to-equity and Around leverage and greater by higher was achieved profitability A return to declined. ROE 70% of Goldman approximately on trading, constitute came to which reliance net revenue. Sachs’ raised 2008, it $10.75 billion In in quickly. delever was able to Goldman Sachs $10 billion in capital injection through the Troubled equity capital and received sheet. up its balance shore to (TARP) Program Relief Asset Goldman Sachs raised substantial equity capital to protect its balance sheet. Com- its balance raised substantial equity protect Goldman Sachs capital to ratiosleverage and debt-to-equity with of Lehman those Sachs’ Goldman pare Brothers. crash of $2.3 billion. in 2008, it also earned net income 27675 mlb_5-1 Sheet No. 47 Side A Side No. 47 Sheet mlb_5-1 27675 27675 mlb_5-1 Sheet No. 47 Side B 02/18/2010 11:56:44 27675 mlb_5-1 Sheet No. 47 Side B Side No. 47 Sheet mlb_5-1 27675 QCRI:J :H. V.I:J `Q .V` QCRI:J :H. V.I:J `Q .V` The Decline of Investment Banking Investment of Decline The chart 11: comparative debt-to-equity ratios debt-to-equity comparative 11: chart chart 12: comparative trading contribution net revenues to 12: comparative chart The comparison between Goldman Sachs, a success story a success in crisis Goldman Sachs, management, The comparison between 6 6 6 6 6 6 Q Q Q Q Q Q Q and Lehman Brothers, an obvious failure, is interesting. Obviously, cross-com- any is interesting. an obvious failure, Brothers, and Lehman parison in the same industry of firms, competitors even group, is tricky business. 88 & technology of business law journal \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 14 10-FEB-10 8:10 27675 mlb_5-1 Sheet No. 48 Side A 02/18/2010 11:56:44 (2009) (describing The above comparison The above 27 and Themselves — ii. Robert J. Rhee J. Robert %`0101J$ 1Ì :1C1J$ 1Ì Andrew Ross Sorkin, Too Big to Fail: The Inside Story of How Wall of How Inside Story The Fail: Big to Sorkin, Too Ross Andrew See generally chart 13: trading contribution net revenue chart to Data for 2008 are skewed because heavy losses in trading results in negative per- losses in trading in negative because heavy results skewed Data for 2008 are 27. They almost did not survive the crisis. During in peril, the crisis, both firms and they were were Q Q Q Q Q Q Q Q Q Street and Washington Fought to Save the Financial System the Financial Save to Fought Washington and Street centages and dramatic increases in the percentages for investment banking and for investment and dramatic in the percentages centages increases struggling survive. to 5 no. 1 2010vol. 89 how both firms were in peril both firms during were the crisis).how \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 15 10-FEB-10 8:10 Goldman Sachs and Lehman Brothers were different firms, with different business different were Brothers and Lehman Sachs Goldman heavily more relied had always Brothers see that Lehman We and cultures. models 2007 period the crucialto In 2006 levered. more been on trading, and it had always the leverage and debt-to-equity see that crash of 2008, we the market to leading up substantially. firm suggests that the This increase was Brothers ratios for Lehman the same time, calamity. At toward was heading riskmore as the market taking on sheet. balance its delevered and in 2008, it quickly off, was leveling Sachs Goldman survive Stanley the financial crisis and Goldman Sachs while did Morgan Bear Why did not? Lynch and Merrill Brothers, Stearns, Lehman between Goldman Sachs and Lehman Brothers provides a hint. We can get a a hint. We provides Brothers and Lehman Sachs Goldman between surviving the two data from the composite firms examining by broader perspective data. failed firms. Chartsand the three 13 through 16 provide comparative 27675 mlb_5-1 Sheet No. 48 Side A Side No. 48 Sheet mlb_5-1 27675 27675 mlb_5-1 Sheet No. 48 Side B 02/18/2010 11:56:44 :1C1J$ 1Ì %`0101J$ 1Ì :1C1J$ 1Ì %`0101J$ 1Ì 27675 mlb_5-1 Sheet No. 48 Side B Side No. 48 Sheet mlb_5-1 27675 chart 14: leverage ratios 14: leverage chart chart 15: debt-to-equity ratios 15: debt-to-equity chart The Decline of Investment Banking Investment of Decline The 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 6 90 & technology law of business journal \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 16 10-FEB-10 8:10 asset management resulting from trading losses. Thus, 2008 data are not included trading are 2008 data from Thus, losses. resulting management asset in Chart 13. 27675 mlb_5-1 Sheet No. 49 Side A 02/18/2010 11:56:44 See, The 29 28 :1C1J$ 1Ì %`0101J$ 1Ì Robert J. Rhee J. Robert chart 16: return-on-average equity return-on-average 16: chart A composite comparison provides a few interesting observations. provides a few interesting First, Chart comparison 13 A composite Q Q , The Goldman Sachs Group, Inc., Annual Report (Form 10-K), at 131 (Jan. 26, 2009). With that said, it is 26, 2009). With 10-K), at 131 (Jan. (Form Report Annual Inc., Group, , The Goldman Sachs 28. enormous so off they because the losses of the failing banks were were Data for 2008 was not included 29. The largest expense of these firms salaries based on net income. is professional is a measurement ROE R Q Q Q Q Q Q Q RQ e.g. less than their paid any Stanley were and Morgan at Goldman Sachs that the professionals doubtful competitors. the scale of the graph. Their combined ROE was -131% whereas that of the surviving was -131% whereas that the scale of the graph. ROE combined Their banks was approximately 4%. revenue. the firm’s from take employees much how by be affected may net income and thus and bonuses, 5 no. 1 2010vol. 91 shows that the failing firms historically relied more heavily on trading, that the failing firms historically more relied as was the shows Chart 16 Brothers. and Lehman Goldman Sachs case in the comparison between ROE. that the surviving by as measured shows profitable more firms were \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 17 10-FEB-10 8:10 failing firms had greater leverage. Debt-to-equity ratio was always higher, and the ratiofailing firms leverage. Debt-to-equity had greater was always leverage ratio was generally observation higher. is one here The most interesting dur- Brothers: and Lehman Goldman Sachs that is also seen in the comparison of risk taking greater through dra-ing the period 2008, these firms of 2006 to were gambling the failing firms parlance, were proverbial in leverage. In matic increase the probability heavily fa- the time that bets at precisely on their down doubling of risk exhib- management and the failure decision the house. This executive vored investment of the three cause of the failure the efficient proximate it were by ited banks. 27675 mlb_5-1 Sheet No. 49 Side A Side No. 49 Sheet mlb_5-1 27675 27675 mlb_5-1 Sheet No. 49 Side B 02/18/2010 11:56:44 How We Got We How — something the firms and — In the postmortem In crisis, on the financial iii. 30 27 (updated ed. 2009) (arguing that leverage and illiquidity ed. 2009) (arguing that leverage 27 (updated – 123 27675 mlb_5-1 Sheet No. 49 Side B Side No. 49 Sheet mlb_5-1 27675 The Decline of Investment Banking Investment of Decline The leverage and failure of risk management leverage and failure — Mark Zandi, Financial Shock: Global Panic and Government Bailouts and Government Panic Shock: Global Mark Zandi, Financial See The relationship between the demise of these investment banks and complex these investment the demise of between The relationship should put it in the context we however, as the instrumentsInsofar themselves, 30. 92 & technology law of business journal Here and What Must Be Done to Fix It Fix Be Done to Must and What Here significant in the financial crisis). factors were \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 18 10-FEB-10 8:10 The basic data in the above sections confirms two major observations sections confirms two the about data in the above The basic perhaps banks. First, the single important most investment death of the in factor sheet, trig- balance banks was a leveraged major investment bringing three down illiquidity and credit the assets when of in the firm’s gering a crisis in confidence collapse. started market to the housing there has been much talk about how Wall Street created ever more exotic financial exotic more ever Street created Wall talk about how much has been there default swaps, collateralized credit criticize fashionable to instruments. is now It in- But derivatives. debt obligation, mortgage securitization, and over-the-counter the culprit was a rather banks is concerned, the investment sofar as the death of ordinary one the SEC thought could be managed by sophisticated mathematical modeling. This mathematical modeling. sophisticated be managed by the SEC thought could and a decade Management, Capital in the sagastory of Long-Term before was told and Merrill again with it is told Brothers, later demise of Bear Stearns, Lehman the Lynch. is important distinguish the some clarification. It financial instrumentsto requires rationale inherent and function of the securities,financial engineering and for that the underwriting, from matter, and use or abuse of these securities. The marketing, meet their demise at the hands of complex banks did not failed investment three that these securities not be adequately could the extent financial instruments. To a factor in the causality just during they were valued turbulent conditions, market financial instru- as a bullet can be a link in the causality However, of a homicide. not the primary were cause of the as securitization ments such and derivatives bubble bursts with market terrible effects, last saw financial crisis. a stock If as we market stock the in 2000 with severely, the crash or, more the technology market of of or the process stock of the common crash blame the concept 1929, should we of instruments col- that complex were one questions No capital investment? venture industry. of an entire abused by volume and aggregate The complexity lectively risktransactions disguised and made risk management far therefrom resulting a terrible imposing onerous, secondarymore effect the collapse of the housing of have could that the government no one disputes this regard, In markets. and credit the instruments regulated and the industry.far better experienced the largest asset bubble in the history of of the fact that the economy the banks, Ameri- to addition leverage. In This asset bubble was fueled by finance. the wealthiest leveraged. In also heavily were can homeowners and consumers home is typicallyresidential countryone’s the largest portion in the world, of an 27675 mlb_5-1 Sheet No. 50 Side A 02/18/2010 11:56:44 effects secondary M&A and under- — residential mortgage-backed residential — Unlike the issue of leverage, this Unlike 31 03 (discussing the decline of investment banking of investment 03 (discussing the decline – note 5, at 301 note Robert J. Rhee J. Robert supra supra , were tied to the bubble. These bonds were systematically, im- systematically, These bonds were the bubble. tied to were Wilhelm — & Morrison have become ancillary activities. It is ironic that investment banks no ancillary become activities. that investment ironic have is It See — Lehman Brothers, Bear Stearns, and Merrill Lynch fell because of poor risk man- Bear Stearns, and Merrill Lynch Brothers, Lehman The second observation about the demise of the investment banks is that they observationThe second about the demise of the investment 31. requiring reputational capital as compared to trading to capital). requiring financial capital as compared reputational requiring 5 no. 1 2010vol. 93 \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 19 10-FEB-10 8:10 American household’s personal wealth. The housing bubble and collapse is ground collapse bubble and housing The personal wealth. household’s American vanilla of plain crisis. of the bonds The value zero writing, functionsof investment traditionally be the prime to domain considered banks banking activities. These traditional on their core, investment longer depend much activities fee-based services are with moderate risks with associated them, and they mix of in- effect business on the entire historically provided a diversification have pub- like banks became more investment past several years, the banks. In vestment proprietary rather traded bets on the market than licly hedge funds taking massive the time when to Goldman back banks harkening investment capitalized privately banks investment “bulge bracket” partnership was a private Sachs and independent the servicingdominated of the global capital markets. agement in trading and business strategy of one of betting the firm on the success product or activity, ordinary a fairly in an extraordinary explanation historical epi- theory corporate finance sode. Standard informs that leverage can boost profitabil- aspect of the evolution of the investment banking industry has not been promi- aspect of the investment of the evolution banking The business segment of investment nently publicized. securities (RMBS) properly underwritten duringproperly gross irrationality a time of marketed and in both suggests that when sense this entire Common and capital markets. the housing all nation, entire the across price correction severe experiences a pool of assets of complex layers them willother things multiple the to tied adjust, including also financial instruments that wrapped these finan- the bonds. Metaphorically, around a pool of cars racing down congested Angeles-sized a Los like cial instruments were mountain, withoutfog-shrouded which was a col- a speed of limit, at the bottom These financial instruments gorge. a steep nearly became the lapsing bridge over one of the was tied to because (1) their value that killed the economy asteroid write- in financial history their asset bubbles seen and accordingly levered greatest addi- injected their complexity reflect this, and (2) in mass quantities must downs the task of assessing risk making far more by financial system tional risk the into which had highly adverse and regulators, difficult for the market market, of counterpartyon liquidity, overall in the perceptions risk, and confidence instru- financial that somehow however, particularly The notion, market. the credit a deadly virus,ments, like can wreak destruction is nature through their inherent in the public dialogue. one that should be discounted servicesproviding client from and their business away fundamentally pivoted have intermediating functions of the capital markets. 27675 mlb_5-1 Sheet No. 50 Side A Side No. 50 Sheet mlb_5-1 27675 27675 mlb_5-1 Sheet No. 50 Side B 02/18/2010 11:56:44 The 32 200 (6th ed. 2008) (noting , Sept. 16, 2008, http://www.nytimes.com/2008/09/ 300 & fig. 10.1 (describing of the the consolidation – N.Y. Times , note 5, at 294 note 27675 mlb_5-1 Sheet No. 50 Side B Side No. 50 Sheet mlb_5-1 27675 supra supra , The Decline of Investment Banking Investment of Decline The Wilhelm & William W. Bratton, Corporate Finance: Cases and Materials Cases Finance: Corporate W. Bratton, William Morrison See See A globalized economy may be better served by universal banking, a model universal served by be better may A globalized economy 33 Barclays Agrees to Buy Some Lehman Assets Some Lehman to Buy Agrees Barclays Given these missteps, what can be done about the problem? I do not envision the not envision I do about the problem? whatdone these missteps, can be Given the past several decades, the financial industryIn has undergone a transforma- 32. 33. 94 & technology of business law journal that at one time Long-Term Capital Management was levered by as much as 100x, and at the time of its as much by was levered Management Capital that at one time Long-Term 54x). collapse it was levered \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 20 10-FEB-10 8:10 1990s and the trend toward larger investment banks). Among others, these American and British investment banks). Among larger investment toward 1990s and the trend Donaldson First Boston, Brown, Alex. Trust, foreign or non-U.K. banks: Bankers by acquired banks were Baring Brothers, Grenfell, Benson, Morgan Kleinwort SG Warburg, Cowen, PaineWebber, & Jenrette, Lufkin bought Barclays generally These firms firms. smaller- were Recently, or medium-sized Perella. and Wasserstein Thomas & Landon Werdigier Julia Brothers. operations of Lehman banking and capital markets the investment Jr., 17/business/worldbusiness/17barclays.html. ity, but at a certain point bankruptcy risk increases the cost of capital such that ity, such of capital certain but at a the cost risk point bankruptcy increases col- Management Capital earlier, Long-Term A decade is value-destroying. leverage of high and sharpa result leverage lapsed as disruptionbond market. in the demise of Lehman Brothers, Bear Stearns, and Merrill Lynch are just additional are and Merrill Lynch Bear Stearns, Brothers, Lehman demise of engaging increasingly of poor risk These firms management. examples in were activities,highlythey the SEC, and permitted at high volatile did by leverage levels of shocks withstand to sheet severe balance cushion in their the capital not have markets. credit bursting housing and of the merit of Glass-Steagall’s Regardless of the Glass-Steagall Act. reinstitution I banking, and and investment against of commercial the combination prohibition that seems academic. One supposes had merit,statute the issue now the believe be would the wall,legislation but the politics of reinstitution can simply re-erect establish prime firms to several decades European took It insurmountably complex. Suisse, Credit firms banking. These include tier of investment positions in the top large American commercial Bank. Likewise, several and Deutsche UBS, Barclays, the same obsta- and Bank of America, confronted Chase as JPMorgan banks, such banks of their these universal in building their substantial franchises. Divesting cles be no small banking businesses would political and regulatory feat. Any investment pol- of mostly domestic no longer be a matter would divestiture toward movement internationally, absent be coordinated now be something that must icy, but would American firms only. banking by of investment unilateral divestiture substantial capital require tional period may of globalization. finance Globalized not only in bigger gotten and infrastructure a one firm under umbrella. Banks have and York long ago, New that but also internationally. Not States, the United banks the primaryAmerican investment and of finance were London centers of the This is no longer the case. Much in the capital markets. reigned supreme from banks resulted in the 1990s among investment place that took consolidation banking busi- up American investment international financial institutions buying ness. 27675 mlb_5-1 Sheet No. 51 Side A 02/18/2010 11:56:44 7,355 6,575 6,031 10,273 24,253 19,526 35 Citigroup UBS Bank of America CS First Boston CS First Barclays JP Morgan firms firms in 2003 are that 7,355 6,575 6,031 4,069 Edwards AG 2,708 10,273 19,526 20,184 Italicized 34 18. – firms are banks affiliated with firms banks affiliated foreign banks. are bold Robert J. Rhee J. Robert note 5, at 17 note CS First Boston CS First UBS Merrill Lynch Citigroup Lehman Brothers Lehman JP Morgan Bank of America supra supra , Wilhelm & table 1: top 10 equity ($ million) underwriters 1: top table Morrison On a practical the full in the mold banks, service, level, independent investment 35. a in thousands of U.S. dollars, but this is clearly are that these figures indicate and Wilhelm Morrison 34. First BostonFirst 929 Salomon BrothersMerrill Lynch 1,756 BrothersLehman Goldman Sachs 1,013 1,596 14,554 Stanley Morgan Goldman Sachs 14,554 12,116 Stanley Morgan 12,116 1990 BrownAlex. 2,975 2003 2003 Adjusted Goldman Sachs 2,634 Dean Witter 759 Edwards AG 2,708 Paine WebberPaine StanleyMorgan 911 911 Smith Barney 807 typographical be in millions of U.S. dollars. must The figures error. vol. 5 no. 1 2010vol. 95 \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 21 10-FEB-10 8:10 based on providing a broad array of banking servicesof banking array a broad on providing based across available products and various geographic a one firm under umbrella. areas crisis The financial a dying breed. firmsthe 1990s, are of “bulge bracket” the of Stanley stand as and Morgan Sachs and only Goldman banks, such killed three status notwithstand- company banks, their bank holding independent investment not be im- of Glass-Steagall significanting. This is would because the reinstitution require its repeal, but it would as was the case before posing a prohibition bur- banks, an onerous universal of fully integrated operations many of divestitures in the leagues tables the following Consider changes den on financial institutions. banking services, advisory mergers and acquisitions investment key servicesfor two and equity underwriting 2003. 1990 to from are now affiliated with larger commercial banks, including Merrill Lynch (Bank of (Bank Merrill Lynch banks, including with affiliated larger commercial now are of banking assets and the investment Chase), (JPMorgan America), Bear Stearns and (Barclays), Brothers Lehman the forma account a pro adjustment taking into do figures “2003 Adjusted” The their new parents. banks into of these investment 2008 consolidation 27675 mlb_5-1 Sheet No. 51 Side A Side No. 51 Sheet mlb_5-1 27675 27675 mlb_5-1 Sheet No. 51 Side B 02/18/2010 11:56:44 13,222 22,143 34,281 29,838 40,429 Bank of America JP Morgan Boston CS First Deutsche Bank Barclays 13,222 13,832 22,143 30,143 26,773 10,286 29,838 20,449 Stanley Morgan 15,549 Merrill Lynch JP Morgan Citigroup Deutsche Bank Bear Stearns Lehman Brothers Lehman Boston In CS First Boston CS First 27675 mlb_5-1 Sheet No. 51 Side B Side No. 51 Sheet mlb_5-1 27675 In an era of increasing volatility in the markets, the next the in the markets, an era volatility In of increasing 36 The Decline of Investment Banking Investment of Decline The table 2: top 10 m&a advisers 10 m&a ($ million) 2: top table These league tables show the striking banking show transformationThese league tables of the investment Stanley, patri- Morgan and Goldman Sachs a question whether remains even It 36. and invest- The marriage only a few natural of commercial acquirers. are that there One can speculate First BostonFirst 41,009 1990Goldman Sachs StanleyMorgan 48,223 Sachs Goldman 45,820 60,377 Goldman Sachs 2003 60,377 Shearson Lehman BrothersLehman 12,430 10,903 2003 Adjusted Morgan GuarantyMorgan 15,840 Stanley Morgan 15,549 Salomon Brothers 33,163 Dillon ReadMerrill Lynch 22,239 15218 Lazard FreresLazard 25,181 ment banking is tricky. I would not be surprised to see Deutsche Bank acquire one of these firms in the future, Bank acquire not be surprisedment banking is tricky. see Deutsche I would to bank- a prime investment Bank has long coveted Deutsche Bank of America, Stanley. Like Morgan likely more Trust and Bankers Grenfell as Morgan banks such ing franchise, and it has a history of acquiring investment and because it conducts major invest- an acquisition, such make is big enough to It Brown). Alex. (including be for some other commer- be less of an issue than it would integrationment banking activities would already, cial banks. 96 & technology law of business journal industry. Glass-Steagall periods the and post-repeal eras. two These In represent banking was performed1990, the activity independent by investment of investment that only Goldman of 2008, show for the events 1 and 2, as adjusted banks. Tables that the business Stanley independent. remain They and Morgan also show Sachs also banking has been truly globalized and that foreign firms have of investment banking has changed The landscape leaders. market of investment become permanently. not banking, can maintain their independence, and one would cians of investment sufficiently high incen- are to valuations once be surprised see them be acquired to tivize a voluntary sale. \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 22 10-FEB-10 8:10 financial storm could be the last for a thinly capitalized investment bank, absent investment be the last for a thinly capitalized financial storm could capital and perhaps Soon regulatory on minimum mandates other safeguards. be a thing of the past, either because theyenough, securities the pure firm may withmeet their demise or because they combine larger financial institution. a the internationalization of investment consolidation, of market level the Given the practical a banking, and the globalization of finance, of reinstituting hurdles high. seems that be too It banking may and investment wall commercial between the genie is out of the bottle. 27675 mlb_5-1 Sheet No. 52 Side A 02/18/2010 11:56:44 The agency removed 37 * * * Robert J. Rhee J. Robert note 19, at 416 (“In combination then, the investment banks were motivated to raise to motivated banks were then, the investment (“In combination 416 at 19, note supra Coffee, Coffee, See Obviously, the industry must be better regulated. This topic is best left for an- best left is Obviously, This topic the industry regulated. better be must The basic analysis presented here suggests that one such cause is the way Wall cause is the way suggests that one such here The basic analysis presented 37. their leverage levels and abandon diversification at the same time as the SEC was inclined to pursue deregula- to at the same time as the SEC was inclined diversification and abandon levels their leverage was deadly.”). tion. The combination vol. 5 no. 1 2010vol. 97 \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 23 10-FEB-10 8:10 other day, except to suggest that, as we have seen, leverage is clearly an issue. It is It an issue. is clearly leverage seen, have we that, as suggest to except day, other bright-line fail- to prominent limits. The most susceptible measurable such, and, as banks with regulation of the investment respect the demise to of government ure banks. This investment for pure limits on capital loosen to decision SEC’s the was on the industry,regulatory had disastrous consequences decision SEC must and the investment the properly regulate to the blame for its failure of share bear a large banking industry models of investment and its misguided belief that mathematical capital limits. their be the basis for regulating banks could the capital safeguard, the external limitation that could have tamed the urgency of tamed the urgency have that could limitation the external the capital safeguard, just eye-balling example, and self-destructive behavior. For bubble psychology Charts a leverage ratio other analysis, it seems that 2, 3, 14, and 15, without any the firmplace in a 3x may ratio 30x and a debt-to-equity at or exceeding exceeding Certain systemically important upon a stressful event. firms of danger are zone to one will Goldman Sachs No seriously argue that firmsthe financial markets. like the carnage not Stanley, firms of 2008, are the two left standing after and Morgan systemically important firms. of these types The collapse impose of firms would riskgreater of secondary and tertiaryof these kinds make effects. is possible to It firms capital structure. risky regulating less by of the This paper some preliminary presents the evolution thoughts as I consider banking industry the thoughts concern here its current form. My investment to banking industry, the broader causes of the financial crisis.investment and not I stress the preliminary of the inquiry nature which is based on rather elemen- here, with fairly consistent the pre- are tary conclusions my information. Nevertheless, on the financial crisis. This papervailing narrative provides a broader perspective on the demise of the majority full-service banks. A histori- of the pure, investment under- to banks is needed of investment cal perspective showing the business cycle houses fell banking so suddenly and major investment why completely stand more in the dark months of summer and fall of 2008. collectively at the turnStreet organized itself in the 1990s and of the new century, and the way fortunes with associated the eco- the adverse the industry reverse to attempted of an erosion profitability and declining 2002. With nomic downturn in 2000 to banking business, the firms on trading of increasingly relied as a source investment the rules of this, they change also lobbied the SEC to doing In and profit. revenue SEC loosened the regula- A compliant capital requirements. leverage and minimum 27675 mlb_5-1 Sheet No. 52 Side A Side No. 52 Sheet mlb_5-1 27675 27675 mlb_5-1 Sheet No. 52 Side B 02/18/2010 11:56:44 27675 mlb_5-1 Sheet No. 52 Side B Side No. 52 Sheet mlb_5-1 27675 The Decline of Investment Banking Investment of Decline The Knowing the past and the present is essential for formulating the policy prescrip- for formulating the is essential past and the present the Knowing \\server05\productn\M\MLB\5-1\MLB106.txt unknown Seq: 24 10-FEB-10 8:10 98 & technology of business law journal tory constraints. By 2007, some of these banks were essentially toryhedge funds, public banks were of these 2007, some constraints. By to susceptible They were housing market. on the bets highly levered massive, taking ago. not only a few years they that were in a way market a volatile have whether will would limits on leverage know never We the future. tions for outcome alternative but an or Merrill Lynch, Brothers, Lehman Bear Stearns, saved happened had have would is certainly What and perhaps plausible probable. even been have in 2004? These firms may the capital requirements the SEC not lifted from on their bets or had they precluded down been had they not doubled saved about regulation, thinking regulatory limits on leverage. In appropriate so by doing of the firms and their right the profitability concerns should weigh freely we to engage public and in financial enterprise the greater againstdangers posed to the risk. habit to of systemic Lastly, it is good the realization from the capital market with the law the goal retrofit of preventing to regulations counterfactual institute the foresight to lack that we and recognize also be humble last crisis, should but we of prudential lim- philosophy or crash. catastrophe A conservative predict the next type“bet for some financial be needed the firm” risk-taking financial may on its the fabric markets. systemically integrated into of the capital institutions that are