Investment Banking and the Future of Wall Street

The current economic meltdown has changed the face of Wall Street, possibly forever. For decades the energy in the market had been fueled by high-rolling investment bankers, but look what's happened in the last eight months. Lehman Brothers went bankrupt. Bear Stearns was snapped up by JPMorgan Chase, Merrill Lynch got bought out by Bank of America, and Goldman Sachs and Morgan Stanley had to convert to bank holding companies just to stay in business. Five major investment banks . . .and then there were none.

At the beginning of this year, those five firms had a combined market value of around $250 billion with the top firm, Goldman Sachs, valued at nearly $90 billion. Now the top banks, which are comparatively small boutique firmsRaymond James, Jefferies & Co, Greenhill & Co, Keefe Bruyette & Woods and Piper Jaffrayhave a combined market value of $12 billion, a number that has shrunk by a factor of 20.

Essentially, the global economic crisis has ushered in the era of universal banking where massive financial firms offer every conceivable kind of investment product and service. Even smaller brokerage firms face being herded under the umbrellas of big banks, or else risk becoming irrelevant.

Historic Realignment of the Industry

When Goldman Sachs and Morgan Stanley opted to become bank holding companies it marked an historic realignment of the financial services industry and the end of a securities firm model that had prevailed on Wall Street since the Great Depression. But why did they make the change? Partly because it's given both firms access to the Federal Reserve's discount window  the same line of credit that is open to other depository institutions at a lower interest rate.

As bank holding companies, they can also tap into deposits from retail customers. The two firms had already received a temporary financial lifeline from the Fedthe Primary Dealer Credit Facilitythe special reserves established to bail out Wall Street broker-dealers like the Bear Stearns deal in March 2008.

Even though Goldman Sachs and Morgan Stanley are now classified as bank holding companies and are part of the universal banking model, they'll still be able to engage in investment banking activities. But after years of loose oversight by the Securities and Exchange Commission, they're now faced with tighter regulations imposed by the Federal Reserve and they are subjected to Federal Deposit Insurance Corporation oversight.

The Golden Years of Investment Banking

A quick historical review of investment banks will serve as a backdrop to the events that led to their downfall.

Independent investment banks have been around for a long time, but originally they were small private partnerships that earned most of their money from offering corporate finance and investment advice, as well as some broking and other services. If you had walked into one of their offices and looked around, you might have mistaken it for a large law firm.

The success of their business model depended on the trust built through long-term relationships. There wasn't much money at risk in the early days because the firms operated primarily with the partners' own money. That meant there weren't vast sums available to gamble on risky ventures with excessive leverage. But the lack of working capital and a desire to orchestrate splashier deals, motivated the firms to go public in the late 90s.

The Downfall Begins

With more capital in the coffers and a growing access to low cost, short-term debt, managers started to make larger, riskier capital betsmost recently those troubling and toxic mortgage-backed securities.

The regulations that had once separated investment banks from traditional banks were no longer in place. That opened the way for big global banks like Citigroup and JP Morgan to start competing with Wall Street for what had traditionally been the domain of the investment banking business. This forced Wall Street firms to expand their services, to use more leverage and to take even bigger risks.

When those risks led to profits, the dealmakers were rewarded with outlandish bonuses and the wheels were set in motion for bigger risk-taking. Throw patchy government regulation into the mix and you have, as the saying goes, a recipe for disaster.

Before long, major Wall Street firms were leveraged three or four times more than conventional banks, yet they still operated under far less stringent regulations than the banks.

It wasn't until the financial crisis reared its ugly head in mid-2008 that the U.S. Fed stepped in and for the first time, allowed investment banks access to their discounted funds. Then when the credit crisis hit, highly leveraged Wall Street firms like Bear Stearns and Goldman Sachs found themselves in even deeper trouble. They'd already suffered huge losses with their hedge funds and high-risk ventures, but their excessive leverage compounded their problems as the credit crisis stripped them of the ability to raise the additional capital they needed to survive.

The Outlook for Wall Street

What's the outlook for those working on Wall Street now? No doubt there will be less excitement and no more of the huge bonuses that dealmakers had grown accustomed to. But there are bigger concerns about whether the U.S. will lose its competitive edge and the ability to maintain its power status in the global financial system.

Some of the best and brightest might pull up stakes and head for better opportunities in the burgeoning Asian Markets, or they could flip over to the unregulated Hedge Fund marketat least for as long as those funds manage to survive. Thousands of Hedge Funds are going out of business, bringing serious grief to investors like the huge public pension funds, foundations and endowments that have poured billions of dollars into these private partnerships.

If there is any good news in this economic fiasco, it's this: Main Street stands to eventually benefit from a better regulated Wall Street. With a more transparent financial system, a firmer foundation and a stronger business model, there might be a promising outlook for more stable and consistent growth.