WALL STREET MODEL CRUMBLES
After a breather, let us discuss the greatest problem, the world is facing today. Financial Crisis. I think this is the biggest crisis, specially for USA after 1930's depression, which has propped up again. It has encircled almost the entire world. Financial markets as on today are inter-linked. If America fails, it sends jitters all round the globe. All the stock markets in the world today, are in shambles.
Three of America's top 5 investment banks have disappeared over the past 6 months. Two of them recently, Bear Stearns and now Lehman Brothers and Merrrill Lynch have followed.
Atleast Bear and Merrill found a buyer, the former with support from the Fed. Lehman had to file for bankruptcy. Only Goldmam Sachs and Morgan Stanley are left standing. Many will wonder, for how much longer ?
These are ( or were ) no ordinary firms. They represented the pride of America's financial system. They attracted the brightest, from the top business schools. They were held up as models of good management, producing returns on equity that were the envy of their counterparts in other sectors.
Today Wall Street's reputation is in tatters. It is legitimate to ask: how on earth did the boards, the top management and the collection of brains down the line manage to bring 3 of the top firms to their knees ? As somebody who worked for one of these defunct investment banks, i will 1st let out a little secret : I was'nt bowled over by the talent at these places. Much of the research was mediocre---no more than a rehash of numbers and arguments provided by the firms themselves. Investments were made or recommended with a casualness that took one's breath away, considering the sums involved.
Most of the blame being laid is, at the doors of the CEO's. Others subscribe the investment bank's collapse to the autocratic styles of their CEO's. This too is glib. If the CEO's autocratic style is indeed the problem, most corporations the world over should be failing.
No, with Wall Street, the cause of failure has elsewhere : the basic business model had come to be seriously flawed. Investment banks started off as brokerages and then branched off into underwriting of securities and advisory services. None of thse businesses requires large amounts of funding. When commissions on these businesses declined, investment banks started setting aside bigger and bigger sums gor proprietary trading. From proprietary trading, investment banks moved on to private equity. They started betting their own capital on risky assests---and illiquid assests. Worse they chose to increase leverage to very big heights. Lehman Brothers had one deal that killed Lehman, was the acquisition of a property investment co. at the height of the property bubble.
The investment banks thought that they had the expertise to manage asset risks. The moment their is uncertainty about the value of assets, access to high funds is cut off--- and this triggers collapse.. Two, in the presence of high leverage, managers have very high incentive to take huge risks, If the gamble works out, managers get big rewards. If they fail it is shareholders who get wiped out.
The demise of 3 top investment banks has several implications. 1st it calls into question the standalone model of investment banking. For most capital market activities, a stable base of funds makes sense. Banks with their access to deposits are better placed to succeed.
Secondly, leverage in banking itself may have to fall from the present levels. Thirdly, when investment bank comes to be part of banks, investment banking too comes under the purview of central bank regulations..
Wall Street, they say, reinvents itself every few decades. This time around it's its not so much reinvention as disappearance.
Three of America's top 5 investment banks have disappeared over the past 6 months. Two of them recently, Bear Stearns and now Lehman Brothers and Merrrill Lynch have followed.
Atleast Bear and Merrill found a buyer, the former with support from the Fed. Lehman had to file for bankruptcy. Only Goldmam Sachs and Morgan Stanley are left standing. Many will wonder, for how much longer ?
These are ( or were ) no ordinary firms. They represented the pride of America's financial system. They attracted the brightest, from the top business schools. They were held up as models of good management, producing returns on equity that were the envy of their counterparts in other sectors.
Today Wall Street's reputation is in tatters. It is legitimate to ask: how on earth did the boards, the top management and the collection of brains down the line manage to bring 3 of the top firms to their knees ? As somebody who worked for one of these defunct investment banks, i will 1st let out a little secret : I was'nt bowled over by the talent at these places. Much of the research was mediocre---no more than a rehash of numbers and arguments provided by the firms themselves. Investments were made or recommended with a casualness that took one's breath away, considering the sums involved.
Most of the blame being laid is, at the doors of the CEO's. Others subscribe the investment bank's collapse to the autocratic styles of their CEO's. This too is glib. If the CEO's autocratic style is indeed the problem, most corporations the world over should be failing.
No, with Wall Street, the cause of failure has elsewhere : the basic business model had come to be seriously flawed. Investment banks started off as brokerages and then branched off into underwriting of securities and advisory services. None of thse businesses requires large amounts of funding. When commissions on these businesses declined, investment banks started setting aside bigger and bigger sums gor proprietary trading. From proprietary trading, investment banks moved on to private equity. They started betting their own capital on risky assests---and illiquid assests. Worse they chose to increase leverage to very big heights. Lehman Brothers had one deal that killed Lehman, was the acquisition of a property investment co. at the height of the property bubble.
The investment banks thought that they had the expertise to manage asset risks. The moment their is uncertainty about the value of assets, access to high funds is cut off--- and this triggers collapse.. Two, in the presence of high leverage, managers have very high incentive to take huge risks, If the gamble works out, managers get big rewards. If they fail it is shareholders who get wiped out.
The demise of 3 top investment banks has several implications. 1st it calls into question the standalone model of investment banking. For most capital market activities, a stable base of funds makes sense. Banks with their access to deposits are better placed to succeed.
Secondly, leverage in banking itself may have to fall from the present levels. Thirdly, when investment bank comes to be part of banks, investment banking too comes under the purview of central bank regulations..
Wall Street, they say, reinvents itself every few decades. This time around it's its not so much reinvention as disappearance.
posted by vaneet kundra at
Saturday, September 27, 2008
4 Comments:
I read your page on wall street. how is has influenced the indian stock market ? can you please let me know...
Dear Anonymous,
Thanks for your comments. Let me request you to identify yourself. Becomes much easier to commnicate.
Regarding your question, about the indian stock market, all stock markets are in the world are co-related. The biggest factor being FII money or hedge fund money involved in it. FII's are Foreign Institutional Investors, mostly based in America. Since our stock market has been getting billions of dollars each year from these FII's, which has stopped now, the tap of liquidity has dried up, thus the crash in indian stock market. FII's for the last 5 years have been net buyers contributing about 50% of the shares bought by them, pouring billions of dollars each year. Since they have gone bust, this year, for the ist time they have been net sellers of indian stocks. They have been net sellers for the reason, because they need money in America to meet their financial needs, which has been cut off from the American investors and American banks. To pay them back, they are encashing Indian shares. The same is the case in other countries. This the reason of crash of stock markets all over. The liquidity provided by them has vanished totally.
Whatever happens in the USA economy directly or indirectly reflects on the world economy.With the Wall street crumbling, what is going to happen to the number of MBA's eyeing USA to join prestigious banks.
What is the status of banks in Switzerland etc?
Dear Dr. Manchanda,
This is the 3rd time. What a coincindence again ? As soon as finish replying to the earlier comments, i see your comments. Thanks again. I agree with you Indian MBA students are in for a tough time both in USA and India. Financial Crisis is quite secular that way. No boundaries or geographical differences. It takes its tole and spares nobody wherever you are
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