The Iconoclast Investor

A team of reporters from Reuters calculated how much the world’s investment banks had disclosed writing down from derivatives in the past year, from the third quarter of 2007 through the second quarter in 2008, ending July 31. The total? $404 billion. In just four quarters, Wall Street wiped out its previous 10 years of profits. Even the airlines aren’t that bad. And that $404 billion doesn’t include the losses the financial services industry incurred in the last few weeks on those black-box creations of collateralized debt obligations and credit default swaps that blew up in their faces. JP Morgan, for instance, just reported $3.6 billion in additional write-downs on derivatives for its most recent quarter.

The market plunge of recent weeks has destroyed many things: trillions of dollars in stock market wealth, the retirement plans of untold Americans and the myth that the stock market had evolved to become immune to worldwide crashes. It also ended the era of the great “white shoe” investment banks. With the failures of Bear Stearns and Lehman Brothers, Merrill Lynch’s capitulation to a Bank of America purchase, and Morgan Stanley’s and Goldman Sachs’ shift to become commercial banks to shore up their balance sheets, the independent investment banks spawned by the Glass-Steagall Act are all gone.

The reasons for this have been covered extensively, but here’s a quick rundown of what I see as the path to this end. The decision in the 1970s to allow investment banks to go public shifted them from partnership structures, where the long-term health of the banks took highest consideration, to a publicly traded model where turbo-charging quarterly profits became a necessity to meet investor demands.

Capitol Hill’s elimination of Glass-Steagall in 1998 opened the door for the investment banks to start dabbling in ever-riskier ways in consumer insurance, credit cards and mortgages. The decision this decade to increase the amount investment banks could leverage to 30 times their assets meant greater risk-taking and encouraged over-valuing the derivative instruments that investment banks kept on their proprietary trading books.

Then there is the phenomenon of cheap money–at no time since the 1930s were interest rates to financial institutions so low as from 2002 to 2005, which encouraged more wildcatting in the financial markets since, after all, the downside was so low. On top of all of that, add in the laissez-fair approach to regulating the markets, so extreme of late that enforcement staff withered under SEC chairman Christopher Cox; he even rejected an offer by Congress for more enforcement funding. Essentially, the U.S. government stepped aside after the tech bubble to allow a Wall Street bubble to form.

Of course there will be hundreds of banks, led by megabanks Bank of America, JP Morgan Chase, Citigroup and Wells Fargo–but they will be working in a world of greater oversight, more restrictions and, eventually, higher interest rates. Never again will we see such a combination of factors that led to Wall Street firms seeming like such unstoppable profit machines as we did this past decade.