Before the crash, and even in its immediate aftermath, traders could dismiss the populist critique by clinging to the notion that Wall Street’s extreme salaries were rewards for steering capital to its most efficient uses. “For every lender, there has to be a borrower” is how a former Bear Stearns executive put it. If Americans wanted to buy plasma TVs and flip McMansions, then, by God, Wall Street would help.
From 1986 to the middle of the last decade, Wall Street’s earnings grew from 19 percent of all U.S. corporate profits to 41 percent. And the talent followed. “The big banks of the world have dramatically outcompeted industry in recruiting top graduates from the top schools,” a Goldman veteran said.
After the big investment banks went public, the sense of restraint that sometimes could hold back private partnerships from taking on too much risk—it was their own money—was removed. Bank earnings and ever-rising asset values allowed them to borrow ever-larger amounts of money, which in turn juiced ever-greater profits. Banks, which had previously made their money advising corporations and underwriting securities, essentially became giant hedge funds (in 2007, Morgan Stanley held $1.05 trillion in assets supported by just $30 billion in equity). The triumph of the Wall Street system was the exploitation of the real-estate boom: Real estate enabled the biggest credit bubble ever conceived—and a bust of similar magnitude, which some shrewd traders also took advantage of. “The mortgage mess is the biggest financial mess we’ll see in our lifetime,” Jamie Dimon told me.
And without real estate to fuel growth, many on Wall Street know it’ll be a long time before there is ever a profit center like it again. “The number of houses being sold is 25 percent of what it was,” a former Lehman trader says. “You don’t have the mortgages behind it. Essentially the pump has stopped working. All the IPOs, the mergers—everything is slowing down. And the number of new homes will never jump back to what it was. If you look at history, the past 50 years have been incredible. Never has there been a period of time of so little disease and so few wars and such growth of such absurd wealth.”
The implosion of the credit bubble destroyed Wall Street’s business model. Now regulations are kicking in that will sap its ability to create the next bubble. Over the past year and a half, the banks have dramatically deconstructed their proprietary-trading desks to comply with the new rules of the game. Among Volcker’s provisions is a rule that mandates that banks can invest just 3 percent of their core capital in hedge funds and private equity, meaning that, in addition to being banned from trading for their own accounts, they can’t take risks in outside funds either. “There’s less money to go around because the revenue business model is changing, and it has to change,” a former Lehman trader says. “You can’t print the cheap money anymore.” And nowhere is this rule more devastating than at Goldman Sachs, where proprietary trading accounts for an astonishing 10 percent of the firm’s revenue.
Goldman’s trading has been a storied part of the firm’s history; its alumni include Bob Rubin, Eddie Lampert, and Eric Mindich. But the new rules mean that Goldman effectively can’t wager its own capital. Months before the Volcker Rule is set to kick in, star traders began to leave in droves. In March 2010, Pierre-Henri Flamand, the London-based global head of Goldman’s Principal Strategies group, quit to start his own hedge fund. A few months later, in September, Goldman revealed it was shuttering its entire desk. In October, the nine traders at Goldman’s U.S.-based desk, run by Bob Howard, decamped en masse for KKR, the private-equity firm. Around the same time, Morgan Sze, one of the highest-paid traders in Goldman history, who was said to have earned a bonus of $100 million in 2006, announced he was leaving to launch his own $1 billion–plus hedge fund.
Goldman was the first of the major banks to announce it was shuttering its internal hedge funds. Morgan Stanley, which like Goldman converted to a bank holding company to tap Fed funds during the post-Lehman panic, is also being forced to abandon its proprietary-trading activities. Morgan, which had been known for its traditional investment-banking prowess—advising companies on mergers and acquisitions, trading for clients, and raising capital—dived headlong into proprietary trading during the boom. It was a huge source of profits, but unlike Goldman, which had ruthless risk management, Morgan was almost completely undefended from the housing calamity. In 2007, Howie Hubler, a Morgan Stanley trader, recorded the biggest loss in Wall Street history when his mortgage fund blew up and took over $9 billion with it. John Mack, Morgan’s former CEO, called the trades “embarrassing for me, for our firm,” a description he’d now consider an understatement.