Last weekend, at the behest of my finance professor, I went on the Business School’s annual New York trip. A friend of mine was also going on the trip, so I figured I’d at least be able to hang out with him for a few days in New York City and check out the New York Stock Exchange and a few banks.
The first Wall Street firm we visited began by serving our group a continental breakfast and talking to us about the financial services industry, new developments at the company, and a bit about their recruiting process. Then we got to speak to some employees. I was chatting up one of their bond traders, and after a few minutes I learned that he worked on a desk that traded mortgage-backed securities—the financial instruments that blew a hole in the economy.
He was a very likeable guy. And he seemed to be doing well—he still had a job, after all—and even laughed about the temporary (multibillion dollar) misfortune of his firm, which he had played a direct role in creating.
But in the books I’ve read about the recession, specifically Michael Lewis’s recently published The Big Short, which details the sub-prime mortgage market bubble and subsequent implosion, one of the major themes is that the people inside Wall Street were too busy looking at the trees and therefore missed the forest. This definitely rang true throughout most of the bank presentations.
So how can these banks, and the people working inside these firms, conduct business as usual—without stopping to take responsibility for the economic havoc they wreaked upon the global economy?
One of the underlying messages in The Big Short is that the corporate structure of the banks is the major reason why the economic crisis affected so many people. Until recently, nearly every Wall Street firm was structured as a partnership, meaning that a group of wealthy people owned and managed the brokerage houses. This small group of partners was well versed in finance, and generally kept a close eye on what kind of bets their traders were making and the amount of risk they were taking.
The foundation for today’s financial woes was laid in 1981, when one firm, Salomon Brothers, decided to sell its shares to the public. This meant a quick payoff for the CEO and upper managers at Salomon, though other Wall Street firms were furious that a brokerage house had “sold out.” While other firms initially protested Salomon’s move, the higher-ups at other firms soon saw the financial gains to be made by going public, and over the following two decades, most large Wall Street banks abandoned their partnership structures for corporate ones.
So, what’s wrong with that? Now anyone, not just rich people, can have a slice of the profits from Wall Street, right?
Well, sort of. When the partners were controlling the firms, the traders were making bets with the partners’ money. The partners, being prudent, wouldn’t allow the traders to make overly risky bets—say, on the subprime mortgage market.
But now that the public owned the firm, the traders didn’t have partners looking over their shoulders and watching their trades, and thus could take giant risks with little fear of repercussion. And since their pay is tied to performance, if traders make big profits for the firm, they take home a big check. But if they lose big, the shareholders absorb the loss.
In the past, dozens of partners could sit around a table and manage the risk of the firm. Today, there is not a table in existence that could allow all the shareholders to keep tabs on what’s happening inside the banks.
One solution, though radical, would be to force banks to privatize, or return to a partnership structure. When the partners are the ones with money on the line, they are more likely to keep track of what the traders are up to and less likely to allow banks to borrow boatloads of money—like how in 2007, Lehman Brothers had borrowed $44 for every dollar it owned—and in turn use that borrowed money to bet on risky assets.
A less radical solution would be to re-implement some form of the 1933 Glass-Steagall Act (repealed fully in 1999), which does not allow a bank holding company to own other financial companies. So, for example, an investment bank cannot own your local bank. That way, at least taxpayers would be largely relieved from bailing out giant firms like Citigroup, which has both consumer and investment banking arms under its umbrella.
I had a great time in New York, and I learned a lot—much of which I couldn’t learn from books. There are real people who sit and trade billions of dollars a day simply by clicking buttons—and these people, like human beings everywhere, are far from perfect in their judgments and motivations. I just can’t help but think that with today’s corporate structure on Wall Street, another similar crash is not far away.
