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Out of the Frying Pan

And into the line of fire of those keen to constrain Wall Street's free-wheeling ways.
Economist Staff, The Economist
June 11, 2008

"The worst is behind us," proclaimed Dick Fuld, Lehman Brothers' boss, in April. If only. Although the overall financial system may be safer, thanks to extraordinary central-bank interventions before and just after the rescue of Bear Stearns, America's investment banks still make investors nervous, not least in the market that puts a price on the risk of default. The longer this goes on, the more onlookers are tempted to conclude that Wall Street's business model is broken. With tougher regulation on the cards, this crisis may, they fear, be less a cyclical slump than the start of an era of less risk-taking and lower returns — in effect, the neutering of Wall Street's finest.

All the investment banks have taken a thumping this year, but Lehman looks the most vulnerable, as it did just after Bear's near-implosion in March. Despite putting itself on a firmer footing by raising capital, it still has more than $60 billion of hard-to-sell securities. Its hedging attempts have gone awry, leaving the bank facing its first quarterly loss as a public company when it reports in mid-June. Lehman's shares tumbled this week to a five-year low after its debt was downgraded, amid reports that it is looking for a deep-pocketed partner. This prompted Lehman to rush out the news that its liquidity position had risen to "well above" $40 billion. It also said that it had not needed to borrow from the Federal Reserve since mid-April.

This financing window was opened to investment banks the day after JPMorgan Chase bought Bear—the first time non-deposit-takers have had access to central-bank money since the 1930s. It means that, although doubts about Lehman's health linger, it is unlikely to run out of short-term funds. Even if the window is shut in September as planned (most bankers assume it will be kept ajar), no one doubts that the investment banks are now considered too systemically important to fail, thanks to their labyrinthine derivatives books.

They all accept the inevitability of greater scrutiny in exchange for acquiring a lender of last resort. Bankers say Fed officials are checking their books much more closely than their Securities and Exchange Commission supervisors ever did.

Commercial banks argue that investment banks should now face the same capital constraints as they do, because of the Fed window. The strength of opposition to this varies: Lehman seems prepared to accept tight shackles, whereas more self-confident firms, such as Goldman Sachs, believe they deserve less regulation because they are funded in wholesale markets, not by government-guaranteed deposits. "[Goldman's] approach is still ‘Screw you, don't hold us back. We're the world's best traders’," says one rival.

With the situation still fluid, there is plenty of scope for lobbying against rules that could hurt profits—though banks say they are not yet at that point. Sheila Bair, head of the Federal Deposit Insurance Corporation, has come out in favour of tighter oversight of capital and risk management. Ben Bernanke, the Fed's chairman, seems to be leaning in that direction. But there is, as yet, no consensus. It is not even clear whether the preference is for firm rules or general guidelines. Congress is unlikely to debate an overhaul of financial regulation until next year, after the election.

One possibility is to limit the sort of overnight funding in repo markets that caused Bear such distress. Don Kohn, the Fed's vice-chairman, has proposed that investment banks be forced to cut such funding in favour of longer-term, more expensive finance, reducing both their incentive to jack up leverage and the risk of liquidity draining away in the blink of an eye.

The banks have already made headway on this front. Lehman has been grabbing whatever long-term financing it can, and only a tiny fraction of Goldman's funding comes through repos or commercial paper. Goldman is thought to be happy to see tougher rules on funding, because it would reduce the risk of counterparties—including its rivals — going pop.

Leverage is thornier. A self-imposed reduction is under way, from levels above 30 times capital to nearer 20. And the banks are taking seriously the possibility of regulators setting a low ceiling: at least one of them is calculating how it would perform if it were subject to commercial-bank-like requirements. Any such restriction would eat into their profitability, since leverage supercharges returns when bets pay off.

But dictating a lower leverage ratio would not cure all ills, the banks argue. Take a bank that invests $200m in Treasuries, mostly with borrowed funds. It sells them, pays off the debt, and invests the remaining $5m—its own money—in mortgage exotica. Its leverage has fallen, but its risk profile has increased. Straightforward leverage ratios "tell you nothing about the underlying quality of the assets", says Paul Calello, head of Credit Suisse's investment bank. Bear's capital levels, remember, looked adequate just before it capsized.

How will investment banks make up for the lower returns that come with less borrowing? One option is to turn their assets over more quickly. They might also be tempted to push deeper into risky areas that offer big margins even without leverage, such as the most exotic emerging markets. But this would simply substitute one gamble for another.

Some may also have more breathing room than they admit to. They can always move proprietary trading off the books and into their hedge funds, which can borrow as much as their investors will tolerate. Their revenue would then be limited to management and performance fees, but such an arrangement could leave the parent with a higher debt rating and lower cost of funds. It may even raise the industry's earnings multiple above the paltry ten or so that has been the norm on account of "black box" risks, thinks Roy Smith of the Stern School of Business.

As it becomes harder for investment banks to finance their own inventory of assets, some will refocus on client businesses, such as merger advice and securities underwriting. But these markets have shrunk, albeit less dramatically than securitisation and leveraged loans have.

Times may get harder in derivatives, too. Pressure is growing for more regulation in the booming credit-default-swap market, and for more trading to move to exchanges. This would eat into the margins of dealers who arrange bilateral trades, mostly American investment banks. In a sign of changes to come, this week InterContinental Exchange bought Creditex, a credit-derivatives broker, for $625m.

As the regulatory noose tightens, some are likely to conclude that a partner with a stable deposit base would be handy. In prime brokerage (lending to hedge funds), clients that a year ago did not differentiate between universal and investment banks are now leaning towards the former, viewing them as more robust. "The banks are taking the markets back," says Dick Bove of Ladenburg Thalmann, a broker.

Whether this lasts will depend on the strength of the shackles placed on investment banks, and their dexterity in wriggling out of them. In the past they have proved adept at killing off proposed rules or circumventing them. But regulators and politicians seem in no mood, for the moment at least, to let that happen this time. For Wall Street's free-wheelers, the worst may indeed be yet to come.

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