Online Extra: Spending Other Peoples' Money
John Gutfreund knows a lot about investment banks taking risks. As the former CEO of Salomon Brothers (SBF ), Gutfreund was one of Wall Street's first chiefs to imagine building an investment bank based on putting huge sums of money at risk for clients in a wide variety of complex markets around the globe. That strategy earned Gutfreund the title "The King of Wall Street," in a BusinessWeek cover story in 1985.
The article dubbed Salomon "the prototype of the thoroughly modern investment bank." Gutfreund resigned in 1991, after a treasury bond trading scandal rocked Salomon Brothers. Now a senior adviser at CE Unterberg, Towbin investment bank, Gutfreund recently talked with BusinessWeek Associate Editor Emily Thornton about why banks have a tendency to take bigger risks after their private partnerships go public. Below are edited excerpts from their conversation.
What's your view of the rising risk appetite on Wall Street?
The risk profile started changing about 25 years ago. It changed as the ownership of Wall Street firms became no longer small partnerships or private corporations, but public companies. The appetite for risk increases when you're using other people's money, that is public capital, which all the Wall Street firms now do because of the restructuring, or destructuring, of commissions. The incentive to make money moved to proprietary, high-risk businesses.
Salomon was the first to take risks using other peoples' money for proprietary trading. Then Goldman Sachs and others followed. Over time, this private capital integrated into what became known as hedge funds. The hedge funds, again, with a small ante of their own -- perhaps 10% to 20% of the capital, and 80% or 90% of public capital, with a lock up and attractive return involved -- propelled people into taking more and greater risks.
What you have over the years is experimentation, improving the formula for risk taking, and the constant flow was exacerbated by the persistent [former Federal Reserve Chairman Alan] Greenspan easy-money policy. You now have the world afloat with liquidity. They're belatedly trying to raise rates to snuff it out, but it hasn't had any effect yet. The extreme liquidity, and the fact that it's other people's money, leads you to that conclusion [that there is greater risk-taking on Wall Street than in earlier times].
Are we going back to the '80s, or are we on a different plane in terms of the Street's risk taking?
We're not going back to the '80s. At some point, there are going to be some major adjustments. The cry for the last year or so has been to diversify risk by going into foreign markets, equity, currency, and debt. I would guess that as interest rates rise, the risk-free rate works against the high risk strategies. That means people will stretch even further and take greater risks.
If you have the risk-free rate at 5% or 6%, it will mean that modest returns above that aren't satisfactory to the big risk takers. They're already beginning to search the world to offset the high cost of money and the risk-free rate. I guess that in the proprietary business, as long as you have the cheap cost of capital that the hedge funds and investment banks have, then they will continue to play the game and lever and lever and lever.
What do you make of the argument that since banks have much larger balance sheets today they can take much larger risks than ever before?
I make two things of this. It's hard to imagine the excess greed that persists in the financial industry through cycles. If you'll recall, [at one point in the 1980's] there were thoughts that Citibank, Bank of America, and Chase were all, if not on the verge of bankruptcy, in deep, deep trouble. The belief then, and it's more so today, is that they were too big to fail. That puts the government in the position of a guarantor, or insurer.
Even with huge balance sheets, two things occur to me. One, the excess of greed. Number two, historically the inability [of banks] to manage a whole new set of businesses. They used to be able to borrow money cheaply and lend money and make a spread. That's what they were good at. They're now attempting to be all things to all people at all times. My view of that is at some point that will lead to crises, and subsequent bailouts by governments. Because now, it won't just be the government in the U.S. It will be the governments [in other countries such as] China and Russia.
Banks are taking so many risks on so many fronts. Where will it lead?
This will lead to modest dislocations at some time. That's the gentle way of putting it. I'm not an alarmist. But I think it's almost inevitable.