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Cohan: Ending the Moral Rot on Wall Street, Part 2
Can it be true that the trillions of dollars we spent bailing out Wall Street only restored the deeply flawed status quo, instead of bringing about the fundamental system overhaul we needed?
One of the unintended consequences of the rescue of the banks in 2008 was to restore many of the most heinous aspects of Wall Street’s culture, thus exponentially increasing the inherent risks in the system. Indeed, while Main Street continues to suffer from high unemployment and plunging home prices, the financial industry is dancing a jig after paying itself about $150 billion in compensation in 2010.
In September and October 2008, as the fear of financial and economic collapse was at its most acute, there was a brief moment when it seemed there was a real chance that Wall Street would be reformed. That didn’t happen.
Since 1970, when financial companies began selling shares to the public, the industry has ensnared the rest of us in repeated crises of its own making. There was the crash of 1987 and the credit freeze that followed, the Asian crisis, the Mexican crisis, the Russian crisis, the collapse of Long-Term Capital Management, the Internet bubble and, most recently, the risky mortgage-related behavior that led to the Great Recession and brought us to the edge of economic devastation. As the past few weeks have shown, we are still suffering its aftershocks.
At the time, each of these crises seemed existential and rendered the capital markets -- the engine room of capitalism -- dysfunctional for long periods. The increasing rapidity and intensity of each of these events is directly correlated with the decisions by Wall Street companies to go public. The consequence is that Wall Street replaced its traditional partnership culture -- where stakeholders shared profit and losses -- with a bonus culture that encouraged accountability- free, asynchronous risk-taking with other people’s money. Rather than accept responsibility for these recurring crises, Wall Street’s defenders resort to the patently false argument that they are the result of normal market vicissitudes.
Wouldn’t such an obviously broken system need repairing? Apparently not. Instead of a genuine fix, in the past two years, Washington has put Wall Street back on its feet without demanding any accountability for the damage caused to the economy and with only modest changes to the way business is done. Although a boon to congressional campaign coffers, such accommodation damages the credibility of markets and does little to rehabilitate an ailing economy.
Worse, the cozy relationship endures, as Wall Street’s lobbyists and executives exert influence over regulators such as the Securities and Exchange Commission and the Commodity Futures Trading Commission. This gives Wall Street sway over the drafting of the new rules governing our financial system that were mandated by the inadequate Dodd-Frank Act.
In June, Jamie Dimon, chief executive officer of JPMorgan Chase & Co. (JPM), expressed his concerns to Federal Reserve Chairman Ben S. Bernanke. “I have this great fear that someone’s going to write a book in 10 or 20 years, and the book is going to talk about all the things that we did in the middle of a crisis that actually slowed down recovery,” he said.
What’s more, for years now, the Fed has kept interest rates artificially low, creating a subsidy to banks that penalizes savers and those on fixed incomes, and encourages investors to put their money in riskier investments. This replicates the policies of Fed Chairman Alan Greenspan after the Sept. 11 attacks that led to the real-estate bubble -- only today interest rates are even lower.
The Wall Street rescue has also effectively replaced the pluralism of yesteryear -- when competition among many banks offered customers many choices -- with a powerful cartel of a few companies with unlimited access to cheap financing from the Fed.
After the failures of Bear Stearns & Co., Lehman Brothers Holdings Inc. (LEHMQ), Washington Mutual Inc. and Wachovia Corp. -- and the travails of Citigroup Inc. (C), American International Group Inc., Morgan Stanley and Merrill Lynch & Co. -- there is almost no pluralism left. Who could have predicted the September 2008 decision that made Goldman Sachs Group Inc. (GS) a bank holding company, allowing it to back up to the Fed window and borrow money at virtually no cost? That change, in turn, supports Goldman’s largely unchanged, risk-oriented business model, which is now free of much of the competition it faced before the crisis. Is the U.S. taxpayer subsidizing Goldman Sachs? Incredibly, the answer is yes.
Here are three suggestions for restoring public confidence in companies that once were the envy of the world:
-- The bonus culture must be revamped. Human beings are pretty simple. They do what they are rewarded to do. On Wall Street, people are rewarded when they take big, short-term risks with other people’s money. Trouble is, they are rewarded not only when the bets pay off, but also when they don’t. There’s probably no practical way to return to the private partnerships that required people to put their net worth on the line, but a way must be found to require bankers, traders and executives to have skin in the game.
But how? We could start by creating a new security that represents the entire net worth of the top 100 executives at the remaining Wall Street companies. These people decide what business lines to be in, how to deploy capital, who to promote and how much to pay. This new security would be at the bottom of the corporate capital structure -- below corporate debt and shareholder’s equity -- and would be the first asset to be wiped out if the company performs poorly. This would ensure that today’s Masters of the Universe are focused on the risks their businesses are taking.
Close the Casino
-- Close the casino. In the early days on Wall Street, banks prospered by helping their corporate clients achieve their goals. Among them, going public, raising debt and equity capital or providing advice on mergers and acquisitions. Now, for the most part, this is a sideshow to the far bigger endeavor of trading, which involves taking huge proprietary principal risks, buying big blocks of stock or debt, buying and selling credit and equity derivatives and making huge bets on the direction of commodities. A generation ago, investment banking generated the majority of Goldman Sachs’ revenue and profit; in 2010, it accounted for just $4.8 billion, or 12 percent, of the bank’s $39 billion in revenue, and a mere 10 percent of its pretax profit.
Banks should no longer be allowed to gamble for their own accounts. Instead, they should return to being the boring, pre- Enron-style utilities that provided capital to clients who needed to expand plants and equipment or hire new employees. They could also provide advice on corporate mergers or asset management. A new version of the 1933 Glass-Steagall Act, which separated investment banking from commercial banking, should be implemented.
At the very least, cheap financing from the Fed should no longer be used to subsidize risk-taking. The business models of companies such as Lazard Ltd., Greenhill & Co. and Evercore Partners Inc. should be emulated.
-- Cut Wall Street pay at least in half. The compensation is obscene and unjustified, especially now that almost every company is publicly traded. What other publicly traded businesses pay out to their employees between 50 and 60 cents of every dollar of revenue generated? None. Do these companies exist for the benefit of the people who work there or for the benefit of their shareholders and creditors? At the moment, they’re for the executives and employees. Drastically cutting pay would immediately reduce the largest Wall Street expense and lift profitability even as revenue and profit are sluggish.
The industry reaction will be outrage, of course. We will be told that the best people will leave or that business will dry up. That’s nonsense. Even after a 50 percent pay cut, bankers and traders will remain among the most overpaid human beings. Furthermore, because Wall Street is now a cartel, it wouldn’t take long for the lower pay to be the new standard, much to the gain of shareholders. That would also benefit other professions that have lost their best and brightest to the draw of Wall Street compensation.
For now, we can pretend that the 2,300-page Dodd-Frank Act and the new regulations that Wall Street and its proxies are busy writing will change behavior and prevent the next crisis. But until we fundamentally overhaul the business model and its incentives, a reckless industry will continue business as usual. After all, human beings are pretty simple; they do what they are rewarded to do.
(William D. Cohan, a former investment banker and the author of “Money and Power: How Goldman Sachs Came to Rule the World,” is a Bloomberg View columnist. The opinions expressed are his own.)
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