Can Wall Street Re-Invent Itself Again?
Much of the discussion about the financial system’s woes has revolved around strategies to get out of the current mess—from government help for homeowners holding mortgages they can’t re-pay, to takeovers of Fannie Mae and Freddie Mac, to government-arranged marriages like the Bear Stearns-J.P. Morgan deal.
But at some point when all the bad mortgages have been washed out of the system and all the slumping mortgage-backed bonds have been written off or bought at a steep discount, we’ll look up and realize that something else has happened. Wall Street’s profit paradigm has largely disappeared, and unless it can find a new one quickly we’re facing an extended period of retrenchment that will have enormous consequences for the Street itself, for those who do business with it, and for those who have lived on Wall Street’s outsized profits for years, including governments like New York City and State.
Starting in the early 1980s, Wall Street entered into a period of unprecedented growth that has been interrupted by only a few short blips in the late 1980s and in the early part of the new century. The Street had foundered in the tumultuous 1970s when high interests rates helped discourage foreign investment in the U.S. and kept inflation-adjusted housing prices here at home flat (does anyone remember 14 percent fixed-rate mortgages?). But when the U.S. tamed inflation in the early 1980s, just as a generation of baby boomers were entering their prime earning, spending and investing years, Wall Street went on a long boom. During the first phase of that boom, the Dow Jones Industrial Average tripled from the opening of 1980 through the market’s peak in 1987, while securities industry employment in New York’s financial center, which had declined throughout the 1970s, more than doubled between 1980 and 1987.
Wall Street has proved remarkably good at re-inventing itself during this 25-to-30 year period, even when times seemed as bad as today. After the junk-bond market—whose rise had fueled a buyout binge that produced big investment banking profits—tanked in the late 1980s, Wall Street seemed headed for an enormous pullback. The decline of the high-yield market, accompanied by the infamous insider trading scandals, ultimately provoked the complete collapse of Drexel Burnham Lambert, which at its height was the nation’s fifth largest investment bank—employing some 11,000 people. A number of other venerable names also disappeared during those tumultuous years, including E.F. Hutton, weakened so that it had to seek a merger with Shearson Lehman.
But by the early 1990s, Wall Street was already on to new things, including an investment banking and public offering boom fueled by new technologies, and especially by this funny thing we called the information super-highway, or the Internet, for short. The technology-heavy NASDAQ composite index soared some ten-fold in the 1990s before peaking at above 5,000 in March of 2000, while employment on Wall Street increased 40 percent. By the end of the decade, the average annual pay on Wall Street was an exhilarating $250,000 per worker.
Although Wall Street’s profits, employment rolls and pay levels slumped following the bursting of the tech bubble in 2000 and then the attacks of 9-11, it didn’t take long for the firms to turn the low-interest rates of that period, and the housing boom they produced, into a profit-making machine in the form of mortgage-backed securities. What had once been a nice little business became the business of much of the Street in the last few years.
It was unexpected. After the tech bubble burst I remember an investment strategist for one of the big firms telling me that Wall Street had lost the confidence of its customers and it would be years before investment banks earned it back. His prediction sounded a lot like what critics of Wall Street envisaged after the junk-bond and insider trading scandals. But customers quickly returned to the firms in the very low-interest rate environment of post 9-11, snapping up collateralized debt obligations just as they had returned in the mid-1990s to snap up tech stocks. Even sophisticated institutional investors seemed unable to resist jumping into a risky but rising market, perhaps because they couldn’t afford to post investment returns that lagged behind their competitors by ignoring the hot new investment product.
But being burned for a third time may break the spell. With financial markets emerging around the world and new opportunities rising in developing countries, international investors who have been torched once too often may finally come to distrust what American investment banks peddle. The Wall Street firms that remain standing, moreover, may find their own balance sheets so weakened that it is years before they have the capital to make big, risky bets with their own money, which has been another source of profits on Wall Street. If that scenario plays out, Wall Street may find itself relying on the plain vanilla business of earning money on buying and selling stocks for customers—a low margin business—and arranging the occasional merger or public offering. Don’t look for the kind of hiring, bonuses or profits from that world that Wall Street has gotten used to.
Trying to predict the series of dominoes that would fall if investors around the world lose confidence in American finance is a speculative game that’s impossible to play accurately. Suffice it to say that the hundreds of billions of dollars that have already disappeared from portfolios worldwide are funds that are not going to be invested in American companies. The returns on a generation of IRAs and 401k accounts from baby boomers just starting to retire look ugly.
Meanwhile, governments which have expanded for years on the tax monies thrown off by Wall Street will face fiscal strains reminiscent of the 1970s. New York City, led by a mayor right off of Wall Street, has been spending money since 9-11 at twice the rate of inflation, so that the city’s surpluses of the last few years will provide only the briefest of cushions in a long downturn, while the subsidy that a thriving Wall Street has provided to the rest of a foundering New York State economy will disappear. Expect soon to hear calls from both the city and the state for federal help.
I can hear the optimists telling me that this is too bleak a scenario. The very fact that Wall Street has found its way out of previous crises is evidence it will come up with something novel and irresistible for a new generation of investors.
But I’m not so sure the world is waiting anymore to be wowed by Wall Street.