Do Investment Banks Lend Anymore? Or is that a Thing of the Past?

The investment banking profession has been given a bad rep the past few years. Today, the public views these professionals as overpaid, greedy bankers – overly concerned with short-term profits and unapologetic for the havoc wrought from risky lending that contributed to the financial crisis. Yet, there was once a time when investment banks did what they were originally intended to do: raise debt and equity for corporations eager to grow. The role of investment banks has always been integral to the expansion of the American economy. In any economic system, some individuals or institutions hold excess capital while others are in need of capital investments. The investment bank serves an absolutely vital outlet where those holding excess capital are matched with those in need of capital. Thus, the investment bank, acting as the intermediary connection between the two, allows capital to be channeled to where it can be used most effectively (the parties in need of capital). In return, the individuals and institutions that borrow capital pay the lenders for the opportunity to borrow (an interest rate). The investment bank adds social value acting as the intermediary. The banks have facilitated immense economic growth as those corporations borrowing money have expanded operations, hired workers, and invested in research and development.

The problem today is that the banks like Goldman Sachs, Morgan Stanley, Deutsche Bank and many others no longer serve the same function they once did. Instead of raising capital and debt for corporations, many banks have shifted their focus to proprietary trading (trading on their own accounts) and commission based trading (creating marketplaces and trading for their clients). What we typically think of as investment banks are no longer investment banks – they are dealers and traders. For example, take a look at the revenue breakdown of Goldman Sachs by business activity. In 1999, investment banking represented 33% of net revenue. Last year, investment banking represented only 11%, and in a dramatic shift trading/dealing accounted for over 76% of Goldman’s net revenue. Why are we still calling Goldman Sachs an ‘investment bank’ when it doesn’t lend money anymore?

Goldman Sachs Revenue by Business Activity, 1999 & 2009

Justice for Securities Fraud Raises Red Flags

For the past two decades high net worth individuals, with the help of Deutsche Bank, avoided U.S. government taxes. From 1996 through 2005 these individuals evaded approximately $6 billion in individual income taxes through tax shelters constructed by Deutsche Bank. Yesterday, Deutsche announced that it would settle the civil investigation for $553 million and admitted its wrongdoing in illicitly aiding clients in tax fraud. The $553 that Deutsche must pay represents the fees that the Bank collected from the transactions it facilitated plus a $149 million civil penalty. No Deutsche Bank executives were prosecuted; no employees are serving jail time.

This year Giuseppe Spera of Middletown, CT was also involved in criminal activities. He was accused of stealing $170,000 in cars from an auto dealership that he worked for. He was arrested by Middletown police, and as part of a settlement, he is expected to spend three years in prison.

The contrast between these two crimes raises concerns about the equity of our justice system. In looking at the Deutsche crimes it is unavoidable to not be alarmed by the absolute scale of the fraud – billions of dollars of fraudulent reporting leading to hundreds of million dollars of revenue for Deutsche. Guiseppe Spera, on the other hand, embezzled $170,000 of cars from his dealership employer. A crime, inexcusable, but also on a very different scale. Think about how society as a whole suffered as a result of these two crimes.

Our justice system’s punishment for the two crimes is also troubling because they create a startling dichotomy. Justice should serve two purposes: 1) Does the punishment fit the crime (i.e. “a proportional response” and 2) Does the punishment deter future criminal activities? In answering both of these questions, financial regulation and enforcement seems to be inadequate.

What can the tax deal tell us about our country and values?

A lot of information can be derived from examining a country’s tax policy. What values and ideals does the country espouse? What are the country’s short and long-term fiscal goals? How does tax policy affect class structure? Last week the President reached a tentative agreement with Republican leaders on a tax deal. Below I highlight two major aspects of the deal focusing on the conclusions we can draw about our government’s societal values.

• 1. A 2% cut in taxes that are used to fund Social Security (FICA). This is one of the more “populist” of the tax policies. It is an across the board tax cut that will give individuals at all income levels a slight boost in take-home pay. The implications, however, are interesting. There is widespread agreement from both parties that our Social Security system is underfunded and in need of reform. This policy, while decreasing federal withholdings, undoubtedly adds pressure to an already fragile public support system. It seems as if the government is in essence undermining the need for Social Security and advocating the use of individual retirement planning (i.e. IRAs, 401(k)s, etc.) in lieu of the public system. Americans do not have a history of responsible savings behavior so it is doubtful that individuals will divert the 2% in social security tax cuts towards private savings. More likely, the result will be an increase in short-term consumption and the deferral of important public policy decisions like social security reform until a later date.

• 2. The estate tax will be lowered to 35% with an exemption on the first five million dollars. This is one of the more troubling of the recent policies: the tax rate is in effect being lowered from 55% to 35% and the exemption is being raised from $1 million to $5 million. The estate tax serves an important purpose in our society, preventing the perpetuation of wealth from one generation to the next. More than ever, income inequality has reached unparalleled levels. Globalization, technological advancements, and stock market rallies have not benefited the country equally. In fact, the richest one percent of Americans now earns 24% of the country’s income. This is a one-sided policy that benefits the rich. It will increase income inequality, add to our deficit, and remove strong incentivized charitable behavior, which previously existed due to a high estate tax.

Walking Away from Underwater Homes

A phenomenon that we have witnessed with increased frequency lately is the act of homeowners walking away from their mortgaged homes. Not only is this a new phenomenon, but it is also quite disconcerting for the stability of the housing market. 

When a homeowner applies for a mortgage, the banks receive an appraisal on the home as part of the application process, and if accepted, homeowners are given loans for the appraisal amount or some fraction of the appraisal amount. Very commonly, homeowners must put down 10 or 20 percent of the appraised value and take a loan for the rest. During the years leading up to the crisis, however, it was not uncommon for mortgage lenders to give loans with no down payment at all.

In the ensuing years home prices declined at unparalleled rates and unheralded speed.  So what ensued were homeowners that had outstanding mortgages for far more than the home was now worth.  Homeowners were now on the hook for mortgages well exceeding the value of the home.  Understanding this, many homeowners simply walked away from their homes – leaving the home to be foreclosed.  

Two important conditions exacerbated this phenomenon. The first is economic; the less one is forced to down-pay on a home, the greater the chances that the home will go underwater (the home price will fall below the value of the mortgage), creating an incentive to walk away from the mortgage obligation. The second is moral; once upon a time homeowners would go to their local mortgage lender for a loan. It was a local mortgage lender, a small shop, where the homeowner received the mortgage. The in-person connection created an ethical obligation to repay the loan that was given to them. Today, most mortgage loans are made by large banks or even online.  People no longer feel the same moral obligation to repay a personal debt. 

And the Goldman Sachs Shareholders Have Spoken

In an interesting turn of events, Goldman Sachs shareholders have actually asked the bank to scale down bonuses and pass more of the profit to the investors. Although eerily familiar to my previous post on the subject, I doubt my blogging was a major contributory factor in the move.

You can read the story in more detail here.

A Few Words on Bank Bonuses

The issue of Wall Street bonuses is actually very interesting because it is more so a story of the history of Wall Street than anything else. The big investment banks, which are on track to dole out record bonuses just eighteen months after being bailed out on the taxpayers' dime, have long roots dating back to nineteenth century America. Before there were organizations like the SEC or NASDAQ, banks operated very much like law firms; banks were owned and operated by a group of partners. Goldman Sachs, Bear Stearns and Morgan Stanley were once all privately owned. This structure not only allowed the group of partners to have full control of how much money would be retained by the firm, but it also allowed the partners to decide how much to distribute in bonuses. In simplistic (but also quite truthful terms) the banks would decide what percentage of the profits to disperse to partners and what percentage to reinvest in the firm. What did these privately owned banks decide to do? For the most part, they dispersed about 50% as profits to their employees, and the other 50% was reinvested in the firm to help it expand.

Today Goldman Sachs, Bear Stearns and Morgan Stanley are all publicly traded companies. What this means is that they are no longer owned by a small group of partners, but rather, by a vast array of investors, both small and large. Who decides how much bonuses will be given to employees at these banks? Usually, an internal Committee on Compensation decides on bonuses. These Committees, however, are steeped in the old traditions of Wall Street and treat bonuses as though they are partnership disbursements when in fact the owners of these banks are shareholders. Let’s take a look at Goldman Sachs’ SEC filings. What is disturbing is not only the absolute magnitude of compensation, but also the upward trend in 2008 (the year in which Goldman received bailout money from the US Government).

We all know that the banks give out bonuses, but the real question is why do the shareholders of these companies continue to allow these banks to give out these extravagant bonuses – if the shareholders exerted control and vetoed the bonuses, the result would be higher retained earnings for the shareholders – and higher profits for the company. Something shareholders would certainly not be opposed to.

Some Lessons from the Past

Widespread speculation, lack of regulation, and lack of transparency - these were the headlines in 1929. Doesn’t this sound eerily familiar to the present crisis?

In 1929 it was hyped stocks. Today it’s a hyped housing bubble. In 1929 it was the absence of a Securities and Exchange Commission. Today it’s the absence of a competent SEC. The exotic securities that we created in the past decades (MBS, CDOs, CDS) may not have played a role in the crisis of 1929, but the principles are nevertheless the same.

While we may have failed to learn a crucial lesson in preventing future crisis from 1929, what we did learn was how not to aggravate crisis that do occur. I think Milton Friedman, the famed economist of monetarism, sums the crisis of 1929 best:

The Fed was largely responsible for converting what might have been a garden-variety recession, although perhaps a fairly severe one, into a major catastrophe. Instead of using its powers to offset the depression, it presided over a decline in the quantity of money by one-third from 1929 to 1933 ... Far from the depression being a failure of the free-enterprise system, it was a tragic failure of government. —Milton Friedman, Two Lucky People, 233

This time, Ben Bernake, the current Chairman of the Federal Reserve, took more drastic measures and pumped over $800 million. Why did Bernanke take such measures? As we have discussed before, in a nutshell printing more money lowers interest rates, and lower interest rates spur economic expansions – GDP and job growth.

Did the Fed learn its lesson in 1929? It appears so and It’s looking more and more like the current crisis might just be another garden-variety recession. Yes we have high unemployment (though not by historical standards) and the market crashed 50%, but that's still a far cry from what happened in 1929.