By Brian Perry
A historical understanding of Wall Street will provide a starting place for analyzing the credit crisis that changed the financial landscape forever. Therefore, this first chapter will discuss the evolution of investment banking to provide a context to the remainder of this tutorial.
Under the Buttonwood Tree
Wall Street originated beneath a buttonwood tree, where a group of traders gathered during the late eighteenth century. Eventually, the New York Stock Exchange (NYSE) came to be headquartered on the corner of Wall and Broad Streets in lower
What began in the shade of a buttonwood tree has today evolved into a massive global industry. At the industry's peak before the credit crisis, financial firms made up 22% of the total market capitalization of the Standard & Poor's 500 Index (S&P 500). Even above and beyond its economic impact, the term "Wall Street" has come to symbolize a culture and a way of life that are instantly recognizable around the world.
Investment Banks and Commercial Banks
Commercial banking and investment banking have historically been separated. Commercial banks accepted customer deposits and made loans to businesses and consumers. This was considered a safe and stable business with relatively low profit margins. Investment banks helped raise money for companies and governments through stock or bond sales, advised companies on mergers and acquisitions, and traded securities for customers or their own accounts. These activities were considered riskier than commercial banking, but profit margins were higher.
This separation between commercial and investment banking began during the Great Depression. Previously, individual firms were allowed to conduct both investment banking and commercial banking operations. However, as part of a plan to reform the financial system, the Glass-Steagall Act separated investment banking firms from commercial banking firms. While commercial banking firms grew to be much larger companies, investment banks became the companies most closely identified with Wall Street. Firms such as Goldman Sachs, Lehman Brothers, Merrill Lynch, Salomon Brothers and Morgan Stanley eventually became the most prestigious investment banks on Wall Street. (To learn more, read What Was The Glass-Steagall Act?)
In the 1980s and 1990s, many firms began to merge as the globalization of financial markets and increasing capital requirements prompted the creation of increasingly larger companies. This trend culminated in 1999 with passage of the Gramm-Leach-Bliley Act, which essentially reversed the Glass-Steagall Act. By allowing commercial and investment banking operations to once again occur within the same firm, the Gramm-Leach-Bliley Act facilitated the creation of the so-called "universal bank". Universal banks such as Citigroup (NYSE:C), JPMorgan (NYSE:JPM), Barclays (NYSE:BCS) and UBS (NYSE:UBS) combined commercial and investment banking and use their massive balance sheets to underprice the traditional investment banks. By the onset of the credit crisis, the investment banking "bulge bracket" included not only traditional investment banks such as Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS), but also universal banks like Citigroup, UBS and JPMorgan.
The Ascent of Risk
In the not-too-distant past, the bulk of investment banks' business consisted of advising corporations on mergers and acquisitions, raising capital for companies and governments, and facilitating stock or bond trades for their customers. Over time, though, the profitability of these activities began to decline as the investment banks faced increasing competition from emerging universal banks.
Seeking higher profits, investment banks such as Goldman Sachs increasingly turned to riskier activities such as principal trading and investing to generate the bulk of their profits. Principal trading and investing occurs when a firm uses its own capital to invest in the markets in hopes of generating profits. During good times, these activities can be phenomenally profitable, and many firms posted record profits in the years leading up to the credit crisis. However, principal trading and investing also exposed Wall Street firms to much higher risk. (To learn more about risk, see Financial Concepts: The Risk/Return Tradeoff.)
While investment banks were increasing the amount of risk that they took in their principal trading, they were also becoming increasingly dependent on complicated derivatives and securitized products. The complicated nature of these products allowed firms with an expertise in them to generate large profits. However, derivatives and securitized products are also difficult to value; these difficulties would eventually result in many firms having much higher levels of risk exposure than they had intended. (For more on this, see Valuation Analysis.)
Disappearance of Investment Banks
At the start of 2008, Goldman Sachs, Morgan Stanley, Merrill Lynch (NYSE:MER), Lehman Brothers (OTC:LEHMQ) and Bear Stearns were the five largest stand-alone investment banks. The companies had existed for a combined total of 549 years, but within the span of six months, they would all be gone.
In March 2008, Bear Stearns teetered on the edge of bankruptcy. J.P. Morgan purchased the bank for $10 a share, a fraction of its all-time high of $172 a share. The purchase was facilitated by the Federal Reserve, which guaranteed a large portion of Bear's liabilities as part of an effort to mitigate the potential impact of a Bear Stearns bankruptcy. Following a tumultuous summer, Lehman Brothers succumbed to the credit crisis on September 15, 2008, when it filed for the largest bankruptcy in
At the same time that Lehman Brothers filed for bankruptcy, Merrill Lynch was struggling for survival. Unsure of its ability to continue as a stand-alone entity, Merrill chose to sell itself to Bank of America (NYSE:BAC), ending 90 years of independence.
Following the disappearance of Bear Stearns, Lehman Brothers and Merrill Lynch, the only two remaining independent investment banks were Goldman Sachs and Morgan Stanley. These firms were the two largest and most prestigious of the investment banks. As the credit crisis intensified, it became apparent that both of these firms were also in a struggle for survival. With confidence in the investment banking business model evaporating, Goldman Sachs and Morgan Stanley chose to convert to bank holding companies, thus ending their existence as stand-alone investment banks.
|Goldman Sachs||1869||Converted to bank holding company September 21, 2008|
|Morgan Stanley||1935||Converted to bank holding company September 21, 2008|
|Merrill Lynch||1914||Acquired by Bank of
|Lehman Brothers||1850||Filed for bankruptcy September 15, 2008|
|Bear Stearns||1923||Acquired by JPMorgan March 16, 2008|
|Figure 1: The disappearance of investment banks|
While several much smaller investment banks still exist, the dramatic reshaping of the financial landscape means that the bulge bracket of investment banking now consists entirely of universal banks. Seventy-five years after the Glass-Steagall Act originally separated commercial and investment banking, events have come full circle and these activities are once again performed by the same firms.
From its origins under a buttonwood tree, Wall Street developed into a global industry that generated huge profits. For decades, investment banks dominated Wall Street and relatively low-risk investment banking activities were extremely profitable. However, margins in these traditional businesses steadily declined - a trend that was exacerbated after the turn of the millennium, when investment banks increasingly were forced to compete with much larger universal banks. As these firms competed with one another, they increasingly turned to higher-risk activities to generate record profits. In doing so, they also assumed ever-higher risk levels in the years leading up to the start of the credit crisis. (To learn about how to predict bank failures, read Texas Ratio Rounds Up Bank Failures.)
Credit Crisis: Historical Crises
Personal FinanceRetail banking is the visible face of banking to the general public. Corporate banking, also known as business banking, refers to the aspect of banking that deals with corporate customers.
InvestingTake a closer look into the most noted rivalry on Wall Street between Morgan Stanley and Goldman Sachs, the last two standalone investment banks.
InsuranceGet to know a little bit about the institutions whose actions help to guide free markets.
Managing WealthAn investment bank is a special type of bank involved in a variety of large and complex financial services for major institutions.
InvestingRead a Porter's Five Forces breakdown of America's largest stand-alone investment bank, Goldman Sachs, including how the bank is protected from competition.
InsightsTrump has called for reinstating Glass-Steagall, which could drastically reshape the industry and Wall Street's big banks. Will it happen?
InvestingFind out about some of the popular financials stocks in 2015, why they have become popular and whether they will remain popular going forward.
Personal FinanceFederal banking regulators are seeking curbs on merchant banking and commodities trading that may have a severe impact on leading Wall Street firms.
Managing WealthThe easiest way to rank investment banks is through figures such as revenue numbers and employee headcount.
InvestingA commercial bank is a type of financial institution that accepts deposits, offers checking account services, makes business, personal and mortgage loans; and offers basic financial products ...