The manic gambling machine

It wasn't that Wall Street's leaders deceived customers or lenders into taking risks that were known to be hazardous. Instead, they concluded that risks were low or nonexistent. They fooled themselves, because the short-term rewards blinded them to the long-term dangers. -- Robert Samuelson

Robert Samuelson traced some of “Wall Street’s Unraveling” on 17 September.

First, financial firms have moved beyond their traditional roles as advisers and intermediaries. Once, major investment banks such as Goldman Sachs and Lehman worked mainly for their clients. They traded stocks and bonds for major institutional investors (insurance companies, pension funds, mutual funds). They raised capital for companies by underwriting -- selling -- new stocks and bonds for the firms. They provided advice to corporate clients on mergers, acquisitions and spinoffs. All these services earned fees.

Now, most financial firms also invest for themselves. They use partners' or shareholders' money to place bets on stocks, bonds and other securities -- so-called "principal transactions." Merrill and other retail brokers, which once served individual clients, have ventured into investment banking. So have some commercial banks that were barred from doing so until the repeal in 1999 of the Glass-Steagall Act of 1933.

Second, Wall Street's compensation is heavily skewed toward annual bonuses, reflecting the profits traders and managers earned in the year. Despite lavish base salaries, bonuses dominate. Managing directors with 15 years' experience can receive bonuses five to 10 times their base salaries of $200,000 to $300,000.

Finally, investment banks rely heavily on borrowed money, called "leverage" in financial lingo. Lehman was typical. In late 2007, it held almost $700 billion in stocks, bonds and other securities. Meanwhile, its shareholders' investment (equity) was about $23 billion. All the rest was supported by borrowings. The "leverage ratio" was 30 to 1.

Leverage can create huge windfalls. Suppose you buy a stock for $100. It goes to $110. You made 10 percent, a decent return. Now suppose you borrowed $90 of the $100. If the price rises to $101, you've made 10 percent on your $10 investment. (Technically, the price has to exceed $101 slightly to cover interest payments.) If it goes to $110, you've doubled your money. Wow.

Once assembled, these components created a manic machine for gambling. Traders and money managers had huge incentives to do whatever would increase short-term profits. Dubious mortgages were packaged into bonds, sold and traded. Investment houses had huge incentives to increase leverage. While the boom continued, government remained aloof. Congress resisted tougher regulation for Fannie and Freddie and permitted them to run leverage ratios that, by plausible calculations, exceeded 60 to 1.

It wasn't that Wall Street's leaders deceived customers or lenders into taking risks that were known to be hazardous. Instead, they concluded that risks were low or nonexistent. They fooled themselves, because the short-term rewards blinded them to the long-term dangers. Inevitably, these surfaced. Mortgages went bad. The powerful logic of high leverage went into reverse. Losses eroded firms' tiny capital bases, raising doubts about their survival.

On its face, it strikes one as a sly attempt at blaming this mess Gramm-Leach-Bliley, which permits investment banks to invest for themselves. What Samuelson really gets at is the foolishness of the investing, not the legality of it. The problem isn’t that investment banks are permitted to invest for themselves. The problem is that they invested foolishly.

Yes, the law permits foolishness.