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The End of Wall Street As They Knew It

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With Hubler’s loss and Dodd-Frank looming, Morgan Stanley announced last January that it was getting out of prop trading entirely. The bank decided to spin off its secretive Process Driven Trading unit, a 70-person desk run by Peter Muller, who was the kind of trader who came to embody Wall Street’s exotic ethos in the aughts. (Muller, who writes New York Times crossword puzzles for fun and plays Cat Stevens–style soft rock at Caffe Vivaldi, recruited MIT Ph.D. “quants,” who helped PDT achieve a remarkable 20 percent return since 1993.) Last March, a few months after disbanding Muller’s group, Morgan Stanley announced it had finished spinning off FrontPoint Partners, a multibillion-dollar hedge fund it had purchased for $400 million near the peak of the bubble in 2006. (Ironically, FrontPoint manager Steve Eisman, who was lionized by Michael Lewis in The Big Short, made hundreds of millions betting against subprime loans.)

And last month, Citigroup announced that it, too, was closing its prop-trading desk. At Citi, trading had become a disastrous problem that symbolized the reckless greed of the boom. Last fall, Citi reached a proposed $285 million settlement with the SEC (though a judge rejected the settlement and the matter may go to trial in July) after it was alleged that traders had taken short positions betting against $1 billion in mortgage securities the bank had packaged and sold to investors (“Possibly the best short ever!” one trader bragged in an e-mail).

As the banks jettison their trading arms, they’re being restrained by rules that force them to retain more capital. In December 2011, the Fed announced it would compel banks over the next few years to effectively double the amount of capital they hold on their books, a move that would curb leverage and, ultimately, profits. At the boom’s peak, banks like Lehman and Bear Stearns levered up 30, even 40, to 1. Under the new rules, banks would only be able to borrow $12 for every dollar they spend. In Europe, the rules are even stricter: British regulators have indicated that banks may have to hold as much as 20 percent on their books. “Everything that happened over the past 30 years comes back to the leveraging of the global economy,” a former Bear Stearns executive said, “and now that’s reversing.”

This means that banks won’t be able to borrow as much money to make loans and sell products to their clients.

And even the basic businesses that banks relied on for steady profits are being battered by new rules. As the Dodd-Frank bill moved through Congress, the banks vehemently protested the Durbin Amendment, a rule proposed by Democratic senator Dick Durbin that would slash fees banks could charge merchants. The rule passed and overnight wiped out $6.6 billion in revenues banks had made on debit cards. In response, Bank of America announced it would charge consumers $5 a month for their debit cards. After being savaged by outraged customers, BofA announced this past November that it would drop the plan. “The Durbin rule was the worst rule,” says an executive at one of the major banks. “Debit cards had nothing to do with the crisis. The fact is, we give free stuff to our customers. Now we’re going to have to be the bad guy.”

Just a couple of years ago, traders faced with hardships like this would simply have jumped over to a hedge fund, and made more money with less hassle. In the boom years, banks had to keep star traders happy or they’d bolt to make even bigger money at a fund.

But recently, hedge funds have fared just as poorly as the banks. The bad economy plays a role in this, of course. But just as important is the fact the hedge-fund industry is almost as overbuilt as the housing and credit markets that drove its profits. In 1990, there were 610 hedge funds in the world. In 2000, there were 3,873; in 2011, there were 9,553, according to a report by Hedge Fund Research. All these funds are chasing fewer surefire trades. “When markets are panicked and there’s global risk fear, the markets move in the same direction,” one analyst at a Manhattan hedge fund says. “It’s just a lot harder to make money.” The easy, obvious plays are oversubscribed, which shrinks margins.

The rising tide of the real-estate and credit markets lifted all boats. But nowadays, while some hedge funds will still make ridiculous money, just as many will lose. One Leon Cooperman fund was down 12 percent over the first three quarters of last year, while a Bill Ackman fund was off 16 percent—not the kind of returns investors pay the hedge-fund premium for.


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