Right now, every financial institution in the United States is struggling. Global financial institutions have reported more than $1. 3 trillion in writedowns and losses tied to the meltdown of the subprime-mortgage market since 2007, according to Bloomberg data (Katz, 2009). The government has taken over AIG, Fannie Mae and Freddie Mac. Citigroup, Bank of America, Goldman Sachs, and JP Morgan Chase have taken bailout money from the federal government and their true financial condition is unclear.
The names Moodys and Standard & Poors have lost their credibility. Former high flyers are feeling the pinch. In 2008, bonuses shrank by 44%, along with profits, for those lucky enough to have survived the job cuts that sent 400,000 financial sector employees packing in the last two years (Bowley & Story, 2009). Main Street had little sympathy for Wall Streets pain and was outraged that the bankers who caused the financial mess were getting any bonuses at all (Bowley & Story, 2009).
Moved by growing anti-Wall Street sentiment, the federal government added insult to injury when it decided to limit executive pay and bonuses at banks that receive aid from the taxpayers (Bowley & Story, 2009). This was undoubtedly politically necessary, considering how much money the government is spending to stave off disaster in the financial system and the intensity of Main Streets anger, where people who earn a lot less than those in the financial sector are facing high levels of unemployment from the recession that followed close on the heels of the credit crisis.
However, the governments action also calls attention to how dangerous it is for the government to directly intervene in the private sector. A lot of time and energy is now being spent on the compensation question which pales in significance next to the real problem in the industry: solvency. It seems inevitable that the government will continue to be involved in our largest financial institutions for some time to come, but I hope this will only be for as long as it takes to gently unwind the companies that are no longer profitable.
This needs to be done very carefully and at a pace that lets the system absorb the shock without panic and the losses without contagion. This causes pain in the short term, but in the long term it is the better option because we need our companies to be in the business of making profits. This is a time proven way to increase our prosperity as a nation. When the economic system falters, as it is now, the appropriate role of government is to provide a social safety net for the people who are unemployed.
There is no particular reason for a company to endure once it is no longer profitable. Better to foster a commercial environment that supports entrepreneurship and innovation so new companies can be started. The seeds of the next generation of Wall Street powerhouses have already been planted. Some of the most talented bankers in the business are leaving their positions at the big banksGoldman Sachs, Citicorp, etc. ”to join start-ups that will not be subject to government oversight (Bowley & Story, 2009). Some of these new companies will turn into tomorrows success stories.
And we may end up with a financial system that is more resilient: If the risk-taking spreads out to these smaller institutions, it is no longer a systemic threat, said Matthew Richardson, professor of finance at the Stern School of Business at New York University. And innovation is spreading out too. This is a good thing (Bowley & Story, 2009). Sensibly, students who once would have automatically headed for Wall Street after college or graduate school are now considering other options (Lohr, 2009). Like these students, I will hedge my bets.
The financial sector will be much smaller for a while. When it comes back, so will the recent graduates. This also means that those who persevere and start careers in finance now will be intensely motivated to succeed. Thats a good thing for any industry. And the sector may bounce back sooner than one might expect: Jesse Riseborough of Bloomberg (2009) reported that workers at the largest financial institutions are likely to earn as much money in 2009 as they did before the financial crisis. The success of companies receiving TARP funds is mixed.
Goldman Sachs forecasts their average pay per employee will be $569, 220 this year, while JP Morgan Chase forecasts $138, 324 (Riseborough, 2009). Wall Street almost certainly faces new government regulation. One possibility is the revival of the Glass-Steagall act, which separated banks that took deposits from commercial banks that underwrote and sold securities. I think this is a sensible regulation for a number of reasons. First, it makes it harder for any financial company to become so large that it jeopardizes the entire system.
Second, institutions that take deposits have special obligations to depositors and taxpayers because the federal government insures deposits. As Gary Cohn, President of Goldman Sachs said recently in an interview with Nikhil Deogun of the Wall Street Journal: I do not think that commercial banks should take retail deposits that theyre empowered to collect and need to protect and lend them into high-risk capital markets. There should be a segregation of the retail deposit base and the capital-markets activity (2009).
.Would such a segregation of activities have prevented the current crisis? I dont think so. As I see it, the chain reaction that caused the current problem happened for two reasons: no one believed that housing prices could ever fall and mortgage lenders no longer expected to hold the mortgage for its full (long) term. Mortgage lenders sold their mortgages to commercial banks that used the mortgages as the basis for securities. This decreased their risk and passed it along to the investors who eventually bought the securities.
This, and the unquestioned belief that home prices would always go up, led to lending practices that would have been unacceptable in another era. Deposit holding banks werent doing something more risky, they were doing something less risky. Or so they thought until residential real estate prices started to drop. In hindsight, it seems incredible that no one would have considered that what goes up, must come down, but this happens in every bubble, from tulip bulbs to tech stocks to real estate. What kind of regulation can protect us from irrational exuberance?
This crisis was further exacerbated by irrational exuberance in another quarter: the OTC derivatives markets. Because this market is unregulated and not in the least bit transparent, no one knows what kind of exposure anyone else has. In such a situation the normal regulating effect of the equity markets is suppressed. Fuller disclosure and capital requirements suitable to each type of investment would seem to be the basic equation for rating any investment or insurance activity. There is one part of the industry that I believe must be regulated: the credit rating agencies.
Moodys, S&P, and Fitch dont just rate securitized debt, they participate in the design of the bonds. And they are paid a percentage of the total offering, as they are with corporate bonds (Tomlinson & Evans, 2007). This seems like a conflict of interest and probably explains why the rating agencies are so late to downgrade credit ratings. Wall Street will emerge from this crisis with smaller companies subject to more regulation, until the next wave of political irrational exuberance takes hold and the regulations are swept away.
Bowley, G. & Story, S. (April 12, 2009). Crisis altering Wall Street as big banks lose top talent. The New York Times. Retrieved April 27, 2009 from www. nytimes. com. Deogun, N. & Cohn, G. (March 30, 2009). Future of finance: Is Wall Street over? The Wall Street Journal. Retrieved April 27, 2009 from www. wsj. com. Katz, I. (April 23, 2009). Soros says Lehman bankruptcy led to financial system collapse. Retrieved April 27, 2009 from www. bloomberg. com.