By: Carrick Mollenkamp and Mark Whitehouse
The Wall Street Journal
September 16, 2008
More than 200 years after it was born at the base of a buttonwood tree, Wall Street as we have known it is ceasing to exist.
The rapid demise of 158-year-old investment bank Lehman Brothers Hodlings Inc., together with the takeover of 94-year-old Merrill Lynch & Co., represent a watershed in the banking industry's biggest restructuring since the Great Depression.
For decades, the world of banking was divided largely into two kinds of businesses. Commercial banks took deposits and made loans, eking out a decent return under the burden of heavy regulations designed to protect depositors. Standalone securities firms such as Lehman, Merrill and the now-defunct Bear Stearns Cos. took no deposits and were lightly regulated, freeing them to take big risks and make fat profits at the cost of occasional losses. More recently, some of the biggest institutions, such as UBS AG and Citigroup Inc., combined the two.
Now, as many securities firms are consumed in the wake of a disastrous foray into financial wizardry, the balance of power is shifting. On the wane are the heavy borrowing and complex securities that financiers embraced in recent years. On the rise is a more old-fashioned business of chasing customer deposits and building branch networks, conducted with the backing of federal insurance programs to keep depositors from pulling out en masse.
Of the five major independent investment banks that existed a year ago, only two -- Goldman Sachs Group Inc. and Morgan Stanley -- remain standing. Two others, Merrill and Bear Stearns, have been acquired by big deposit-taking institutions, Bank of America Corp. and J.P. Morgan Chase & Co. Other giant commercial-banking players, such as Wells Fargo & Co. in the U.S., as well as Germany's Deutsche Bank AG and Spain's Banco Santander SA, have emerged as some of the most powerful players in an industry that is likely to be safer but less lucrative for shareholders.
Banks are heading "back to basics -- to, if you like, the core purpose of the system with less bells and whistles," says Douglas Flint, finance chief at HSBC Holdings PLC and co-chair of the Counterparty Risk Management Policy Group, a task force of finance executives working on a framework to prevent systemic financial shocks. "There is a recognition that when the dust settles...the construct of the industry will be different."
Evidence of the new importance of bread-and-butter banking is appearing around the globe. Deutsche Bank, which had been focused on building its global investment-banking business, last week agreed to pay nearly €3 billion ($4.3 billion) in a two-stage deal to acquire the 850 domestic branches of Deutsche Postbank AG, the retail banking arm of the German postal system. Santander, which also wooed Postbank, paid £1.26 billion ($2.26 billion) in July for troubled U.K. mortgage lender Alliance & Leicester.
The shift reflects a broader reassessment of how best to do the essential business of banking, which plays a crucial role in the economy by turning their short-term liabilities -- savers' cash and deposits -- into longer-term investments such as mortgages and corporate loans. In recent years, commercial banks moved a lot of that business off their heavily regulated balance sheets and into the realm of securities firms.
The investment banks packaged the loans into an array of ever more complex securities, which they kept on their books or sold to a broad range of investors -- including hedge funds and bank-affiliated funds known as conduits and structured-investment vehicles, or SIVs. To fund their activities, the securities firms and investors borrowed heavily in the commercial-paper market and the so-called repo market, where borrowers put up securities as collateral for short-term loans.
This alternative banking system proved profitable, in part because participants weren't required to meet commercial banks' more rigid reserve requirements against potential losses. But these banks' strategies backfired with the onset of the credit crunch last summer, as heavy losses on mortgage and other investments in some cases proved too much for their thin capital bases, and the markets on which they relied for funding dried up.
A federal bankruptcy-court filing by Lehman on Monday in New York highlights the quick spiral. As of May 31, Lehman depended on repo loans for $188 billion in borrowings. But as the value of the securities Lehman had put up as collateral for the loans fell amid the broader market turmoil, its lenders started demanding extra collateral.
Because the amount it could borrow against its securities kept falling, Lehman was forced to dip ever deeper into its cash reserves, prompting ratings firms to consider cutting its credit ratings, according to the filing. Lehman's efforts this month to raise money by selling an investment-management firm proved too late.
As repo loans and other market-based funding on which investment banks rely becomes more expensive, the question becomes whether independent broker-dealers, unattached to big banks with ample deposits, will survive. "In the coming months, we expect a significant overhaul of all the brokers' business models," wrote Matt King, a credit strategist at Citigroup in London, in a recent report.
The new financial order also highlights the lasting impact of the elimination of the Glass-Steagall Act, a Depression-era law that prevented U.S. commercial banks from doing investment-banking business. The repeal of Glass-Steagall, in 1999, allowed commercial banks to break into the securities business and ultimately gain the heft to compete with the likes of Bear Stearns and Merrill.
This universal banking model has proved hard to manage, with the likes of Citigroup and UBS knitting together a vast empire of operating units. Even so, these and other big deposit-taking banks that are required by regulators to maintain bigger cushions against losses, such as Bank of America, have so far survived the credit crunch better than some of the stand-alone securities firms.
Thanks in large part to government programs that insure them, deposits have been a rare bright spot during the credit crunch. In the U.S., savings and small time deposits -- two important classes of customer money -- stood at $6.9 trillion at the end of August, up 7.6 % from a year earlier, according to the Federal Reserve. In the euro area, total deposits stood at €6.3 trillion as of the end of July, up 12.8% from a year earlier, according to the European Central Bank.
Meanwhile, the U.S. market for the IOUs known as asset-backed commercial paper, a key source of short-term funding for the bank and brokerage industry, has shrunk by more than a third since the crisis began last year, to $780 billion as of Sept. 10.
Sticking to the basic banking model hasn't worked for everyone. Smaller banks in the U.S. and Europe have suffered, in part because they lack the scale and diversification to absorb heavy losses generated by growing defaults on mortgage and corporate loans.
To be sure, some stand-alone investment banks, such as Goldman Sachs Inc., are well funded. And some innovations and markets will rebound when the credit crunch fades. Consumer debts such as mortgages, credit-card balances and student loans will still be packaged into securities.
But such securitization, analysts say, will likely happen in smaller volumes and in more conservative forms, such as so-called covered bonds. Many of the instruments central to the current crisis were created and sold by banks with no stake in their performance. In contrast, covered bonds have payments that are bank-guaranteed regardless of how poorly the packaged loans perform. Covered bonds are the main source of mortgage-loan funding for banks in Europe, where a $2.75 trillion market has long thrived. Some analysts predict a U.S. market could grow to $1 trillion over the next few years.
"Securitization will play a lesser role for the well-capitalized, highly rated banks," says Ganesh Rajendra, a researcher at Deutsche Bank in London. "But it will still help them manage their capital and risks in many cases."
Internationally, banks that haven't been disabled by write-downs are moving aggressively to buy deposit-rich lenders. Deutsche Bank, which declined the opportunity to bid for Postbank a few years ago, chose to outbid Santander last week in part because it didn't want to see the large retail operation fall into the hands of a foreign rival.
