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You know what happened during the financial crisis ... now it is time to understand why the financial system came so close to falling over the edge of the abyss and why it could happen again. Wall Street has been saved, but it hasn’t been reformed. What is the problem?
Suzanne McGee provides a penetrating look at the forces that transformed Wall Street from its traditional role as a capital-generating and economy-boosting engine into a behemoth operating with only its own short-term interests in mind and with reckless disregard for the broader financial system and those who relied on that system for their well being and prosperity.
Primary among these influences was “Goldman Sachs envy”: the self-delusion on the part of Richard Fuld of Lehman Brothers, Stanley O’Neil of Merrill Lynch, and other power brokers (egged on by their shareholders) that taking more risk would enable their companies to make even more money than Goldman Sachs. That hubris—and that narrow-minded focus on maximizing their short-term profits—led them to take extraordinary risks that they couldn’t manage and that later severely damaged, and in some cases destroyed, their businesses, wreaking havoc on the nation’s economy and millions of 401(k)s in the process.
In a world that boasted more hedge funds than Taco Bell outlets, McGee demonstrates how it became ever harder for Wall Street to fulfill its function as the financial system’s version of a power grid, with capital, rather than electricity, flowing through it. But just as a power grid can be strained beyond its capacity, so too can a “financial grid” collapse if its functions are distorted, as happened with Wall Street as it became increasingly self-serving and motivated solely by short-term profits. Through probing analysis, meticulous research, and dozens of interviews with the bankers, traders, research analysts, and investment managers who have been on the front lines of financial booms and busts, McGee provides a practical understanding of our financial “utility,” and how it touches everyone directly as an investor and indirectly through the power—capital—that makes the economy work.
Wall Street is as important to the economy and the overall functioning of our society as our electric and water utilities. But it doesn’t act that way. The financial system has been saved from destruction but as long as the mind-set of “chasing Goldman Sachs” lingers, it will not have been reformed. As banking undergoes its biggest transformation since the 1929 crash and the Great Depression, McGee shows where it stands today and points to where it needs to go next, examining the future of those financial institutions supposedly “too big to fail.”
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SUZANNE McGEE, is a contributing editor at Barron’s. She has written about the financial markets for the New York Post, Institutional Investor, Portfolio.com, and the Financial Times and is a Loeb Award winner for a multimedia series on consumer culture in China. Earlier in her career she was a staff reporter for the Wall Street Journal.Excerpt. © Reprinted by permission. All rights reserved.:
From Utility to Casino: The Morphing of Wall Street
Alan “Ace” Greenberg’s firm may have collapsed underneath him, but even in the darkest days of 2008, the eighty-one-year-old investment banker’s legendary chutzpah was visible on Bloomberg’s business television network. “There’s no more Wall Street,” Green-berg, the former CEO of Bear Stearns, declared, adding that it had vanished “forever” in the rubble.1
It’s fashionable on Wall Street today to talk wistfully—or in a tone of reverential awe—about investment banking as it was practiced during what is now seen as a kind of golden era. Greenberg’s comments, though more hyperbolic than most, are one example.
The changes over the course of 2008 were so dramatic that Green-berg believed the Wall Street he helped forge no longer existed in any kind of recognizable fashion. Some nostalgic Wall Streeters view the investment banking landscape of the 1960s, ’70s, and early ’80s as a kind of utopia: investment banking as its purest, before the 1987 stock market crash, the collapse of the junk bond market, and Gordon Gekko made Wall Street seem slightly reckless and disreputable. To others, Greenberg among them, the golden era is the more recent past, when investment banks such as Bear Stearns saw their revenues and profits soar as they catered to the emerging powers on the Street, hedge funds and giant buyout funds, and watched their bonus payments and personal wealth climb even more rapidly.
The balance of power has certainly shifted on Wall Street, and new products, players, and technologies have transformed it. But Greenberg’s comments were directed at the collapse of specifi c institutions: the shotgun wedding of his own firm with JPMorgan Chase, the bankruptcy filing of Lehman Brothers, and, the same weekend, the flight of Merrill Lynch into the arms of Bank of America. Greenberg most likely knew about the behind-the-scenes wheeling and dealing orchestrated by Ben Bernanke and Hank Paulson that involved every conceivable combination of every Wall Street firm with every one of its rivals ( J.P. Morgan and Morgan Stanley? Goldman Sachs and Citigroup?). The desperate rush to save the financial system from utter collapse had resulted in the kinds of merger negotiations—however short-lived—that would have seemed laughable only weeks earlier. To Greenberg, still reeling at the collapse of his own firm (which had, after all, survived even the 1929 market crash and the Great Depression), that must indeed have felt like the end of Wall Street.
Wall Street, however, is more than just a set of institutions with big brand names, however old and venerable. At its heart, it is a set of functions, and those functions remained intact even in the midst of the crisis. Two days before Greenberg delivered his epitaph for Wall Street, a small Santa Barbara company, RightScale, raised $13 million in venture capital backing from a group of investors led by Silicon Valley’s Benchmark Capital.2 RightScale’s secret? It was in the right business—cloud computing, a way for customers to reduce their IT development costs by using Internet-hosted services—at the right time. Despite the dramatic headlines focusing the world’s attention on the plunge in the stock market and the deep freeze that hit the credit markets, parts of Wall Street’s core business were still functioning, albeit in a more muted fashion. In the final three months of 2008, venture capital firms invested $5.4 billion in 818 different deals, bringing the total for the year to $28.3 billion. That was down a bit from 2007, when venture firms—partnerships that have made fortunes backing companies such as Amazon.com and Google and lost smaller amounts backing stinkers such as Pets.com—put $30.9 billion to work. But it’s still more than they invested in any year from 2002 through 2006.3 By the fi rst anniversary of the collapse of Lehman Brothers, even the high- risk world of junk bonds was back in business. The sign? Beazer Homes, one of the worst-hit home- building companies in the entire industry, was battling not only the collapse in the real estate market but also a federal fraud investigation. Yet Wall Street found enough investors willing to close their eyes to those risks and invest $250 million in junk bonds issued by the company to help replenish its coffers.4
What Does Wall Street Do, and Why Does It Exist?
The reason for the Wall Street bailout—the explanation for Hank Paulson being desperate enough to literally drop to one knee in front of Nancy Pelosi in the White House and plead for her help passing the initial $700 billion rescue package—is that Wall Street’s functions are essential to the economy. According to reports that were leaked to the media almost immediately, Paulson begged Pelosi not to “blow it up” (referring both to the bailout package and the fi nancial system itself ) by withdrawing the Democratic Party’s support for the rescue effort. “I didn’t know you were Catholic,” Pelosi quipped, referring to Paulson’s kneeling before her, in an effort to lighten the atmosphere before blaming the Republicans for the gridlock.5
By saving some of Wall Street’s institutions—those viewed as the strongest or the most important to the system—the architects of the bailout and many of the subsequent reform packages hoped to preserve intact the system that enables capital to flow more or less smoothly through the economy the way power flows through the electrical grid or water through a municipality’s water and sewer system. Regardless of what Main Street was thinking—and communicating to their members of Congress—Wall Street isn’t incidental to what happens in the rest of the economy. Without Wall Street to perform its fi nancial grid functions, it would prove almost impossible to raise capital to repair bridges, finance new companies such as RightScale, and keep others—such as Beazer Homes—afl oat.
What we tend to think of as Wall Street—the stock market, the investment banks, and the newer entities such as hedge funds—is really only the visible tip of a much larger iceberg that is the entire financial system. Collectively, these institutions help ensure that capital continues to move throughout the rest of the “money grid.” Sometimes they do this by providing a market for participants to undertake basic buy or sell transactions; on other occasions, they negotiate or devise solutions to more complicated capital- related questions, such as helping a company go public or sell debt (a process known as underwriting) or working with it to establish and achieve the best price possible in a merger negotiation.
That intermediary function is alive and well, most visibly at the New York Stock Exchange, which occupies not only the epicenter of Wall Street at the corner of Broad and Wall Streets but the heart of its role as a financial utility. On its sprawling trading fl oor, traders go about their business in much the same way their earliest pre decessors did in the naves of Amsterdam churches, executing the purchases of blocks of shares for their clients, who these days could include an individual trying to sell 100 shares of General Electric or Microsoft inherited from a grandparent or a mutual fund manager trying to reduce his holdings in Amazon.com in order to buy a stake in Alibaba.com, a Chinese counterpart. Exchanges trading stocks, futures, and options contracts as well as commodities remain one of the most heavily regulated parts of Wall Street because of the essential role they play in a large, geographically scattered, and diverse community.
Not convinced of the value of Wall Street’s functions and processes? Imagine you are a retiree in your seventies, living off your investment portfolio. The wisdom of your decision to invest in Microsoft in the mid-1980s has become clear; now you’re counting on being able to sell some of that stock at its current market value in order to cover your living expenses for the next six months. Wall Street’s processes make that relatively simple—all you have to do is place an order to sell the stock at the market price with your broker or custodian (say, Charles Schwab) and ask for the money to be transferred to your bank account when the trade is settled in three days’ time.
Now, imagine that there was no Wall Street. For starters, you’d have a hard time establishing a fair price for that stake in Microsoft without the stock market, with its countless numbers of buyers and sellers meeting in cyberspace to decide each minute of the day what value they ascribe to Microsoft’s shares and thus what price they are willing to pay for your stock. Even if you thought you knew what your shares were worth, how would you find a buyer and persuade her that your analysis is right? Would you go door-to-door in Miami or Los Angeles? Put up an ad on Craigslist? (In Vietnam’s over-thecounter market, that is exactly what happens; you then arrange to meet the buyer on a street corner to swap the shares for cash.) And if you found a buyer, could you be certain that you would be paid in full and on time, so that you could pay your own mortgage and purchase your groceries?
Money has existed for millennia, ever since people recognized that barter was an inadequate method of exchange. The stock exchange, just a few centuries old, was the next logical step as society’s financial needs became more complex. The first exchanges were established in wealthy trading cities such as Hamburg, Antw...
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