During the past few weeks, a consensus has emerged that Wall Street has entered a new era of lower returns on equity, thinner profits, fewer jobs and more federal oversight. The declining fortune of financials since mid-2007 reflects a dramatic paradigm shift from their opulent prospects earlier this century.
In brief, “hogs get slaughtered.”
On June 11, Federal Reserve Bank of New York President Timothy Geithner said that henceforth the nation’s financial system needs tougher regulations and stronger supervision to protect against future crises.
Geithner criticized the existing regulatory structure. He cited an “enormously complex web of rules that created perverse incentives that leave huge opportunities for evasion, and the risk of large gaps in our knowledge and authority.”
Our current regulatory bodies were no more effective than blind, deaf or mute monkeys.
Geithner advocated the insertion of “shock absorbers” inside firms and across the markets to protect the overall economy and financial system against possible systemic failures. As a quid pro quo, the Fed will implement “more exacting expectations” for capital, liquidity and risk management for the largest financial firms. These more stringent guidelines will conversely reduce the ability of financial firms to achieve “outsized profits.”
Opponents of regulation point out that, historically, regulation has not been effective in preventing poor and unethical business practices. They question whether legislators can craft new laws that will establish functional parameters for the many federal and state agencies that will administer these new regulations.
Today’s somber mood starkly contrasts with the euphoria that existed between 2004 and mid-2007. During this period, seven of our country’s largest financial institutions — Bank of America, Citigroup, JPMorgan Chase, Lehman Brothers, Merrill Lynch, Goldman Sachs and Morgan Stanley — achieved on a combined basis $254 billion in profits.
Since the summer of 2007, these same seven firms have hit the proverbial wall. They have written down about $108 billion. Worldwide, the reckoning totals $380 billion. With each new revelation of write- downs, onlookers ask, “When will the pain end?” Sadly, there is no “quick fix” by gulping down some Alka-Seltzer.
The lyric from the biggest musical hit of the 1890s, “After the Ball,” reflects the current mood.
“After the ball is over, after the break of morn,
“After the dancers’ leaving, after the stars are gone
“Many a heart is aching, if you could read them all.”
Historically, business cycles last longer than the biblical Joseph’s seven years of plenty and seven years of famine. For example, the “Roaring Twenties” were followed by the Great Depression that lingered on until World War II.
Paul Volcker, chairman of the Federal Reserve from 1979 to 1987, sharply limited the growth of the money supply in order to eradicate the stagflation that gripped the nation during the 1970s. To stop inflation and reinvigorate the economy, Volcker pushed up overnight borrowing costs to more than 20 percent.
Before the current malaise, investment bankers imbibed heavy doses of conspicuous consumption. For example several years ago at a dinner party, six investment bankers from Barclay Capital ran up a tab of $62,679, mostly on wine. Fast forward, today’s financiers celebrate their continued employment with beer and pretzels.
Federal Reserve officials worry that after taking the following actions, they may have few options left to stop the downward financial spiral:
* Shored up the supply of credit through greater and easier loans to commercial and investment banks.
* Lent directly to the securities industry.
* Slashed the Federal Reserve rate to 2 percent.
In April 2008, Volcker voiced strong criticism of many of the initiatives of the Fed. He said that the Fed “extended to the very edge of its lawful and implied power, and transcended certain long embedded central banking principles and practices.”
In June 2008, Geithner rebuffed Volcker’s criticism, saying the Fed followed “the same general principles” that governed its actions in prior crises. Geithner defended the unusual steps taken by the Fed to facilitate the JP Morgan-Bear Stearns marriage. He asserted that the Fed’s acquisition of $30 billion of assets from Bear Stearns’ subsidiaries was necessary to avoid substantial damage to the financial system and the economy.
Richard Bove, a financial services analyst at Ladenburg Thalmann & Co., prescribed that investment banks would have to build a new financial model: “I do not believe those businesses have the ability to generate the kind of profit they did in recent years without all the leverage.”
The financial phoenix will rise from its ashes to less lofty heights on a date to be determined.
Originally published in the Sarasota Herald-Tribune
