Monday, September 22, 2008

The end of investment banking?

The big news of the morning is that Goldman Sachs and Morgan Stanley will reorganize themselves as bank holding companies, thus ending a decades-long experiment with stand-alone public investment banking. Before we buy into the hyperbole that this represents the end of of investment banking as we know it, it behooves to us to look both back in time and into the future and examine the implications.
Independent investment banks have been in existence for a long time, but for much of their existence, they were private partnerships that made the bulk of their profits from transactions and as advisors. They seldom put their own capital at risk, largely because they had so little to begin with and it was their own money (partners). Part of the impetus in their going public was the need to raise more capital, which in turn, freed them to indulge in more capital-intensive businesses including proprietary trading. That model worked well for much of the last two decades, but three things (in my view) destroyed it. The first was that it became easier to access low cost, short term debt (especially in the last few years) to fund the capital bets that these firms were making, whether in mortgage backed securities or in other investments. The second was that the compensation structure at investment banks encouraged bad risk-taking, since it rewarded risk-takers for upside gains (extraordinary bonuses tied to trading profits) and punished them inadequately for the downside (at worst, you lost your job but you were not required to disgorge bonuses in prior years... in many cases, finding another trading job on the Street or at a hedge fund was not difficult to do even for the most egregious violators). The third was a patchwork of government regulation that was often exploited by investors to make risky bets and to pass the risk on elsewhere, while pocketing the returns. The combination worked in deadly fashion these last two years to devastate the capital bases at these institutions. Lehman, Bear Stearns and Merrill have fallen...
So, what will change now that Goldman and Morgan Stanley have chosen the bank route? The plus is that it opens more sources of long term capital since they can now attract deposits from investors. Having never done this before, they start off at a disadvantage. The minus is that they will now be covered by banking regulation, where the equity capital they be required to have will be based upon the risk of their investments. This will effectively mean that they will need more equity capital, if they want to keep taking high risk investments, or that they will have to bring down the risk exposure on their investments. My guess is that they would have gone down one of these roads anyway. In pragmatic terms, it will also mean that their returns on equity at investment banks will drop to banking levels - more in the low teens than in the low twenties. I think the stock prices for both investment banks already reflects this expectation.
Ultimately, Goldman and Morgan Stanley have sent a signal to the market that they are willing to accept a more restrictive risk taking system. In today's market, that may be the best signal to send. There will be times in the future, where I am sure that they will regret the restrictions that come with this signal, but they had no choice.

13 comments:

Johnathan So said...

Professor,

Would you say that the move toward proprietary trading and the Goldman Sachs model was more of a management miscalculation at most of these investment banks or more of a mismatch between returns and the cost of capital?

Charles said...

This move somewhat explains Warren Buffett's $5bn investment in Goldman Sachs. Despite being the new bank in town, GS employees are no slouches and would no doubt be successful in their new roles. Hopefully Warren's oversight will add value now the risk profile has changed. No more weapons of mass destruction!

2jaipm said...

Dear Sir,
Thanks for starting the blog...
Thank you.

D-bakarazzzzzz said...

Dear Professor,

Up to certain limit I agree that all these things are happening due to credit crisis and mortgage based securities etc.
But I think from GS part, it is all planned, I would like to give it some other direction, may be wrong but there are chances of being right also.
As we all saw the picture of investment banking on news and interviews everywhere, but don’t you think those people who are seating at the top of the position are much more aware of all these tragedies long time before, I would say here GS has planned for becoming an universal bank rather than being a concentrated segment of investment banking in the world as a niche market player.
Here if we see warrant buffet has invested $5 bn into the company, where the same person who has take out his all investments from all these banks in year 1997 only due to all these credit crisis and all.
Why GS for warren buffet, why not Morgan Stanley?
In another two years world economy going to be open for all the banks at that time if GS is having an Universal Bank tag with his brand then he can have much more market exposure rather than being an investment banking firm.
I hope this may put a different direction to this discussion.
And if I am wrong at any part of this comment let me know.

Salil said...

Hi Ashwath:

It is indeed interesting to hear your view on the current crisis. I am sure the investment banking community will come back strongly. Every unsustained levels of growth meets a sudden reality check.

I found this article very interesting : http://www.domain-b.com/finance/financial_services/20080924_wall_street.html

I read somewhere that until 2003, all investment banks were allowed only 12 to 1 leverage. Then in 2004, the SEC gave five banks the ability to lever up 30 or even 40 to 1 - Bear, Lehman, Merrill, Morgan and Goldman. Would like to know if this is indeed true.

Also would appreciate if you could write on the implications of the government bailout of $1 trillion dollar in the current economic scenario with increasing fiscal deficit, and the impact of dollar value, inflation, taxes, etc.

Regards,
Salil

dharma said...

its a good sign for the banking world that we have some extent of deleveraging happening to bring down debt equity ratios to reasonable levels

Sanjiv Barve said...

Dear Prof Damodaran,

Does this marks another big set back to Modern Finance Theory, Black-Schole-Merton orderly markets?

Should we consider that every decade, the free world financial markets will witness such aberrations? In 1980s it was portfolio insurance, 1990s it was LTCM and now it is a tsunami?

Marked to market accounting - Is it proving to be too slippary and volatile? As markets move from wild optimism to caution, marked to market profits can fluctuate widely. People receiving fat bonuses might have moved to greener pastures and investors are left with the consequential losses.

Chrysler bail out few decades back was petty cash compared to this.

The main question is still unresolved - who and how, investment banking will be regulated.

Sanjiv Barve said...

Dear Prof Damodaran,

Does this marks another big set back to Modern Finance Theory, Black-Schole-Merton orderly markets?

Should we consider that every decade, the free world financial markets will witness such aberrations? In 1980s it was portfolio insurance, 1990s it was LTCM and now it is a tsunami?

Marked to market accounting - Is it proving to be too slippary and volatile? As markets move from wild optimism to caution, marked to market profits can fluctuate widely. People receiving fat bonuses might have moved to greener pastures and investors are left with the consequential losses.

Chrysler bail out few decades back was petty cash compared to this.

The main question is still unresolved - who and how, investment banking will be regulated.

evileconboy said...

Professor:

You did an S&P valuation with the Equity class a year ago and showed the implied growth rate through the dividend discount model. Any chance you could run through that now?

SMC Global said...

I like your insightful information about Investment Banking.Thanks for sharing all Details. To know more about Investment Banking, Kindly visit:http://www.smccapitals.com

Dean said...

greetings to all.
I would first like to thank the writers of this blog by sharing information, a few years ago I read a book called costa rica investment in this book deal with questions like this one.

niz said...

Hello .. firstly I would like to send greetings to all readers. After this, I recognize the content so interesting about this article. For me personally I liked all the information. I would like to know of cases like this more often. In my personal experience I might mention a book called Generic Viagra in this book that I mentioned have very interesting topics, and also you have much to do with the main theme of this article.

costa rica real estate said...

If you want to buy property for investment and capital growth potential, then you need to consider investing in Costa Rica real estate.

Costa Rican real estate prices have been rising for years, and as more foreign buyers look at investing in Costa Rican real estate, prices look set to soar. Already prices in some areas are booming - and many properties have doubled in value in just two years! Costa Rica real estate