Two and a half years after the crash, Wall Street ought to be feeling pleased with itself. It lost billions of dollars, devastating the world’s economy in the process, the federal government had to put up $700 billion of taxpayers’ money to prevent an even worse disaster, and otherwise reasonable politicians began using epithets like “fat cats” and “robber barons” for the first time in decades. And yet now the financiers are firmly back in business. Bonuses are flowing again—JPMorgan Chase CEO Jamie Dimon got a 51 percent raise in 2010, to $23 million—and Bernie Madoff is the only chief executive to end up in jail. It’s almost as if nothing had happened.
“No one has laid a glove on them,” says Janet Tavakoli, a derivatives expert. “There was massive fraud, and nothing was done. If you are a banker, you are slapping high fives at the moment.” Michael Mayo, an analyst at Crédit Lyonnais Securities, adds, “Wall Street is back, to a far greater degree than many people, including me, would have expected during the crash. Investment banks are alive and kicking.”
Nonetheless, despite all the reasons for celebration, the mood inside many banks is downbeat, even paranoid. Bankers, while not exactly overly sensitive to others’ perceptions of them (hence the goal of “fuck-you money”), still find it a shock to be so publicly despised. More important, many fear that the twenty-year bull run that led up to the crash, when bonuses, debt, and leverage all grew to what turned out to be unsustainable levels, may turn out to be a golden age that will never return. Wall Street feels not only loathed but also fearful.
Even if investment banks find new ways to make money after the previous methods ended in a crash and scandal—their age-old pattern of behavior—many wonder if any newfangled proposition can rival mortgage securitization. It just made so much money. “We always seem to find the next thing; that’s part of our DNA. But nothing else feels as large as that. It was just so enormous,” says one executive.
There is a deeper worry: that the only way banks can make the megaprofits they need to support their vast staffs and infrastructure is in operations that are at best opaque and impossible for outsiders to understand and at worst unethical and possibly illegal. Wall Street’s history is that, at the peak of bubbles, sensing that the end is coming and the profit opportunity disappearing, it degenerates into shocking behavior.
That was the story of the Internet initial-public-offering boom of the late nineties, which culminated in Eliot Spitzer’s uncovering the research scandal as attorney general of New York. It was even more the case with the mortgage bubble. Banks were able to make huge profits because the market was extremely opaque. That allowed them to charge investors big fees compared with a fraction of a cent on public-stock-exchange trades. Ultimately, it also provided cover for the unscrupulous.
“I am charitable enough to say that 80 percent of the time, banks try to identify clients’ needs and innovate in a healthy fashion to meet them,” says one executive. “Then there is fraud, an activity that ought to be illegal if people were smart enough to write laws that made sense. Do you admit to your boss that your business no longer makes sense, or do you start to cheat? Or, as your margins decline, do you raise the leverage to make up for that? It’s insidious.”
This spring has brought a coda with the trial of Raj Rajaratnam, the founder of the Galleon Group hedge fund, on charges of insider trading. Rajaratnam denies the charges, but the jury in lower Manhattan was played long, damning wiretaps of his conversations with two former McKinsey & Company partners, Anil Kumar and Rajat Gupta. Kumar says Rajaratnam paid him $500,000 a year for information.
Gupta actually used to run the management consultancy—about as respectable a job as exists—yet he has been accused by the Securities and Exchange Commission of leaking tidbits to Rajaratnam while on the board of directors of both Goldman Sachs and Procter & Gamble. Whatever the outcome, the trial at the very least raises the question: Is this how members of elite financial circles actually operate?
Lloyd Blankfein, the former trader who is now chairman and chief executive of Goldman, testified at the Galleon trial against Rajaratnam. Goldman had had its reputation tarnished by how it behaved during the credit boom, having paid a $550 million fine to settle SEC charges that it misled investors in its Abacus collateralized-debt-obligation deals.
“I see much less boastful pride than there used to be,” says one top executive at a Wall Street firm. “I wouldn’t call it humility, just shame. I am astonished by how many senior people I meet who are ashamed of their own institutions. They are still a bit paralyzed by the shock of realizing how much of their profits came from unsavory practices.”
Of course, pushing the edge of savory was always part of the allure of Wall Street; it’s what made it badass. The popular image of Wall Street, in the eponymous film and Tom Wolfe’s The Bonfire of the Vanities, was never about rectitude, but it was glamorous. It can be fun to be considered rich, powerful, and ruthless, to understand how things really work. Fabrice Tourre, the former Goldman mortgage-bond trader who still faces SEC charges, e-mailed Marine Serres, his “supersmart French girl in London,” that he’d been told by his boss “that business is totally dead and the poor little subprime borrowers will not last so long!!!”
But there was always a way to justify the greed, some faith in the necessity of the larger system. As Tourre put it, “Anyway, not feeling too guilty about this, the real purpose of my job is to make capital markets more efficient and ultimately provide the U.S. consumer with more efficient ways to leverage and finance himself, so there is a humble, noble, and ethical reason for my job ;).”
That explanation began to seem a bit unconvincing, even to bankers, as reality played out over the last three years. Some wonder openly if the profits and bonuses of the mortgage boom were as fanciful as Madoff’s Ponzi scheme—a temporarily self-reinforcing bubble that was bound to end in massive losses. “Lots of the money the banks reported they were making was really an illusion,” says Tavakoli.
One Wall Street executive (few of whom would be quoted by name) admits that it is harder to attract recruits out of business school. “It is hard for people coming out of school now to get a job, so any job is a good one. But there is less enthusiasm and less of a feeling that this is a hot place to be. There is definitely a stigma,” he says.
Each year, Ray Soifer, a veteran bank analyst, monitors what percentage of Harvard M.B.A. graduates choose careers on Wall Street. The figure peaked at a record 41 percent in 2008, just before the crash, and then dropped to 28 percent in 2009. It recovered slightly last year to just over 31 percent. Instead, interest has increased in other professional services, such as consultancy. Engineers and mathematicians are choosing the Internet as a possible route to great fortune over investment banks’ derivatives operations.
This reflects not only ethical qualms but also doubts about the future of the business. “Most people are fairly pessimistic,” says Terry Smith, chief executive of Tullett Prebon, a Wall Street bond brokerage. “When you look back at the last 25 years, there was an extraordinary wave of deregulation and an upsurge in pay. You had the slaying of inflation and then a dot-com bubble that rolled into a credit bubble. People are still getting paid, but they know they are in the last-chance saloon and it won’t be so easy now.”
One could argue that Wall Street has been the last-chance saloon for decades now. The abolition of fixed commissions on bond and equity brokering in 1975 ended the era of partners in white-shoe firms’ being able to live comfortably in a protected industry that could support ranks of traders, brokers, and analysts. Since then, Wall Street’s challenge has been to run fast enough to outpace a relentless squeeze on its old business.
In theory, this should have reduced profits at each investment bank. In practice, it had the opposite effect. The underlying returns fell: Even at the height of the mortgage boom, return on assets (a measure of the margins on each deal) in securities firms was less than a third of the level in 1968, according to figures from Deloitte Consulting. Yet profits and bonuses soared.
Wall Street managed to escape destruction through a wave of mergers (helped by the abolition of the Glass-Steagall Act, which separated banking and securities, in 1999), a rapid increase in leverage and debt, and an astonishing ability to ferret out new ways of making money, from initial public offerings of Internet companies to mortgage securitization. As it did, Wall Street bonuses exploded and the industry loomed ever larger in the New York economy. The securities industry contributed 20 percent of state-tax revenues before the crash.
The banks that survived 2008 didn’t even do so badly in the aftermath. Helped by Treasury and Federal Reserve support in the form of very low interest rates and asset guarantees, Wall Street made profits of $61 billion in 2009 and paid $22.5 billion in bonuses.
Then, in 2010, profits dropped by half,to $27 billion, and the mood is correspondingly deflated. It’s still awaiting (and lobbying fiercely against) a wave of new regulations, both from the central bankers who meet in Basel and from Congress, in the form of the Dodd-Frank bill. The latter passed last year but includes a huge number of new rules that are yet to be drafted in detail by regulators such as the SEC.
“A large number of people cannot get on with their lives and their careers until we know what the rules of the game will be,” says John Coffee, a professor at Columbia Law School. “If you are a bank executive trying to plan for the future, you are not sure of precisely what you will be allowed to do. It is like a giant gin-rummy game where you don’t know which cards to pick up or put down.”
“Trading volumes are pretty low, and equity financings are hard. You add all that up, and you have an anemic top line,” says one private-equity executive. “At the same time, there are new rules bubbling out of Congress and the Basel Committee, and no one knows exactly what they’ll mean. There is going to be a lot of fighting over them and some unpleasant surprises.”
In some ways, Wall Street has fought a strong rearguard action by resisting reforms that would break up “too big to fail” institutions. Although the Volcker Rule has forced some to sell their proprietary trading desks, they remain mostly intact. The new Republican majority in the House of Representatives is trying to squeeze SEC funding and block Elizabeth Warren, the activist Harvard professor, from being confirmed as director of the new Consumer Financial Protection Bureau that she’s been running.
But behind these headline-grabbing events, there is a much bigger threat from the more technical-sounding reforms to derivatives trading contained in Dodd-Frank. These could submit the banks’ largest and juiciest businesses—their bond and derivatives operations that have operated off public exchanges, which makes it easier to charge investors more for each transaction—to public exchanges. There, prices can get forced down by the fact that they are easily compared and transparent. “The 1987 stock-market crash was a walk in the park compared with the credit-market meltdown. It had almost no impact whatsoever, whereas 2008 almost caused the end of the world. The over-the-counter credit markets are so much bigger and more important than the equity markets to large banks,” says Smith.
Whatever happens with any new regulation, there’s the bigger problem that maybe the entire economy, particularly in the U.S., isn’t getting any healthier. Bill Gross, the head of Pimco, the largest U.S. bond manager, recently sold all $150 billion in Treasury bonds he held in Pimco’s Total Return Fund, because of concerns about who would buy Treasuries when the Fed stops doing so to keep interest rates low.
Last month, financier Carl Icahn returned $1.76 billion in cash to investors in his fund, explaining in a letter to them that “while we are not forecasting renewed market dislocation, this possibility cannot be dismissed.” Since then, the uprisings have spread in the Middle East and Japan has experienced one disaster after another.
It’s going to be next to impossible to replace bonds and derivatives as all-you-can-eat revenue buffets for investment banks. At the 2007 peak, for example, Goldman Sachs was making four times as much from trading and principal investments as from its traditional investment-banking businesses such as mergers and acquisitions and equity underwriting. The entire shape of its business had altered since its IPO in 1999.
So what’s going to get the appetite going again? Bankers point hopefully to the $2 trillion of cash on U.S. corporations’ balance sheets. “Companies are sitting on enormous pools of cash, so eventually they have to do something with it,” says one. In fact, there are already signs of their doing so: AT&T’s $39 billion acquisition of T‑Mobile USA this week with $20 billion in financing from JPMorgan Chase cheered a lot of M&A bankers.
Investment bankers can also hope for an IPO revival, probably thanks to tech firms. There were an average of 530 IPOs annually in the U.S. during the nineties, but the figure fell to 61 in 2009, according to accounting firm Grant Thornton. Facebook’s IPO is expected next year—other Internet companies such as LinkedIn have already filed to go public. Both Goldman Sachs and JPMorgan have been trying to crack Silicon Valley by investing in companies such as Twitter and Facebook through private markets on which pre-IPO shares now trade.
That blew up in Goldman’s face when it offered to raise $1.5 billion for Facebook with a private placement of shares. Goldman had to close the offer to its U.S. clients, probably under SEC pressure, when the plan became known. Goldman had already upset some by charging hedge-fund-like fees: 4 percent up front and 5 percent of any profits. Jim Clark, a Silicon Valley investor, dismissed it to Bloomberg Markets as “just another way for them to make money from their clients.”
The arrangement was reminiscent of the way in which banks made money by selling shares on behalf of tech companies during the first dot-com bubble. They not only got paid by technology companies for underwriting their IPOs but also could allocate shares to clients who were most likely to give them other business. “There is a mind-set on Wall Street of wanting to gouge fees wherever they can,” says Tavakoli.
Even if the banks pull off such gouging and invade the territory of Silicon Valley’s venture-capital funds, it is unlikely to make up for what they have lost. “They might take stakes in Facebook and clip the ticket several times with banking and investment fees, but the underlying opportunity is still smaller than the mortgage market. Everyone’s got a mortgage,” says one banker.
Which is probably why Wall Street hasn’t entirely given up on mortgages. Many bankers are hoping to play a bigger role in housing finance as the Obama administration tries to rein in Fannie Mae and Freddie Mac, the government-sponsored entities. “The reform of Fannie and Freddie is an enormous opportunity. It is the last brick in the Berlin Wall of official intervention in housing finance,” says one executive.
That may be true in theory, but Wall Street’s record in mortgage securitization is not going to encourage either borrowers or regulators to trust it in the future. Any efforts by Wall Street to offer “innovative” products related to mortgages and housing will be scrutinized very closely by Warren and other financial regulators.
The cynical view: “Leverage pushed up returns and encouraged excessive risk-taking, and then the government bailed everyone out, so why won’t it happen again next time?” asks one financier. “A lot of people think it’ll take time for us to figure out what to binge on next, but we’ll find something.” After all, as former TARP cop Neil Barofsky pointed out in an op-ed on his way out the door, ratings agencies assume that many banks today are just too big to fail and include that in their calculations.
In the meantime, many bankers are looking for a way out. Those who can will move to hedge funds and private-equity firms or to boutique banks such as Evercore and Greenhill that lack the costs, complexities, and regulatory headaches of the big banks.
Banking’s future is in reality not on Park Avenue at all but in emerging markets—especially Brazil, China, and India, where Goldman has been focusing attention. Banks need not scramble to find new revenues there because traditional activities are still flourishing. While the number of IPOs in the U.S. has been falling, for example, there are plenty in Asia. In 2009, the Chinese IPO market was four times the size of those in the U.S. and Europe combined.
Big banks are shifting staff to India and China. “When I started in Asia fifteen years ago, my friends teased me mercilessly for giving up a proper career for this emerging-markets lark,” says Euan Rellie, the New York–based 43-year-old British co-founder of BDA, a boutique bank serving China and Asia. “Asia used to be all young adventurers and spivvy entrepreneurs, but that’s changed. Now everyone tells me, ‘You’re lucky to be exposed to India and China.’ ”
The shift out of what people used to think of as Wall Street—the big investment banks—into hedge funds and emerging markets could be viewed as simply its latest evolution: Wall Street now means something else, but it still has a future. “The alternative investment world is prospering. There is huge demand for all kinds of derivatives and options and exchange-traded funds in every flavor,” says one money manager.
The problem for New York is that a lot of that future lies in other cities. The name on the door may still be Goldman Sachs and JPMorgan, but the bonuses will be paid to residents of Shanghai, Rio de Janeiro, and Mumbai. New York used to worry about London taking over its crown, but that isn’t the big threat now. Deutsche Börse’s bid to acquire the New York Stock Exchange is only an attempt to counterbalance a far bigger shift to the East.
“A lot of friends of my age on Wall Street got a bloody rude shock in the downturn. It was quite profound, and I think that it altered the way they think about the future,” says Rellie. “They realized the old model of the big integrated banks was threatened in a way it never had been before, and they had a very strong sense of not wanting to be there anymore.”
John Gapper is a Financial Times columnist.