Page FOUR -- The End of Wall Street As They Knew It
How sweet is this ?
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.
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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 Citi 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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