October 27, 2011
Look back on the origin of Investment Banks and you will find people with real money coming together to pool their capital and gamble on commercial opportunities. When the bets were in the black, the partners would share in the gains, and when there were bad investments, the partners would share in the loss.
Fast forward to the time when we began to see a transformation of Investment Banks from private partnerships into publicly held companies.
Most would agree that the beginning of this metamorphosis was the public offering of Merrill Lynch in 1971. That was followed by four other entities which became infamous in the 2008 credit apocalypse: Morgan Stanley (1986), Bear Stearns (1985), Lehman Bros. (1994), and Goldman Sachs (1999) (aka, “the Gang of Five”).
These former partnerships converted to public ownership ostensibly so they could better compete with international banking giants which were encroaching on their core business of underwriting stock offerings and advising firms.
New capital from new shareholders allowed them to increase their involvement in riskier, capital-intensive businesses like proprietary trading.
“In order to have a capital base that would support the funding they needed, they had to be public,” said Roy Smith, a former Goldman Sachs partner and a professor of finance at New York University.
Going public allowed the former Investment Bank Partnerships to become more powerful, with much deeper equity cushions, giving them the gravitas to actively influence significant regulatory change to support their agendas. One clear example of this is the 2004 rule change at the Securities and Exchange Commission which allowed investment banks to increase the amount of debt they could take on their books—a move made at the request of the Gang of Five’s CEOs.
Before Lehman crashed, it had amassed more than $600 Billion in debt. No partnership or private corporation could have achieved that milestone!
The shift to public ownership also replaced the accountability of partnerships—when there are no profits, there are no partner bonuses—with the apparent lemming-like behavior of public boards which some would say are selected for their willingness to rubber stamp recommendations from the COO.
When Lehman failed, $45 Billion in shareholder value disappeared forever. Bear Stearns was rescued from a similar fate when JPMorgan bought it at what some have claimed was a fire-sale price with the help of the Federal Reserve. Morgan Stanley and Goldman managed to remain independent and solvent, apparently because huge subsidies were made available to them.
In the final analysis, shareholders suffered, but employees and executives didn’t. In true Investment Banking partnerships, compensation was contentious: major debates would take place at the end of each year as partners worked to resolve the equitable distribution of bonuses. These debates took place in private, and involved rich people taking money out of one another’s pockets.
Today, it seems to have evolved into a zero-sum game, where the protagonists in the drama have no real skin in the game, yet they are eligible to take Billions from shareholders.
It would seem that the public — as aggrieved owners, taxpayers, and savers — has every right to question the Investment Banks’ methods and practices. If they don’t want the public digging into their businesses, these publicly traded Investment Banks could shrink their balance sheets, replace government-subsidized debt with market-rate debt, stop relying on the Federal Reserve for funding, and get out of index funds that bet against our domestic economy.