Editor's Note

01/31/2008 12:00 am EST

Focus: MARKETS

Howard Gold

Founder & President, GoldenEgg Investing

January 31, 2008

As the US economy teeters on the brink of recession, some blame Federal Reserve chairman Ben Bernanke for waiting too long to cut interest rates. Others accuse his predecessor Alan Greenspan of creating the real estate bubble by keeping rates too low for too long.

But more and more people recognize who the real culprit is: Wall Street.

Through their recklessness, the big Wall Street firms have driven a strong economy to its knees. They have by and large shown themselves utterly incapable of managing the risk of the new instruments they’ve created. And yet the outrageous bonuses they’ve paid out have enriched their employees at the expense of their shareholders.

Strong words? Maybe, but I'm not the only one saying them. "If the US suffers a recession in 2008 or 2009 it will not be due to an industrial decline or an oil price shock," said a lead editorial in last week's Financial Times. "It will be a recession that began in the financial system."

“The bigger question,” wrote Hugo Dixon in breakingviews.com, “is whether Wall Street has run amok and, as a result, is dragging down the rest of the economy.”

Until late last year, employment growth remained pretty good, and business spending was holding up, too. Consumers continued to spend despite $90-a-barrel oil and $3.00-a-gallon gas. Many economists still expect the housing bust to subtract only one percentage point from gross domestic product (GDP) growth.

Everything changed, however, with last summer's financial panic and the subsequent seizing up of the credit markets. That was due entirely to the unwinding of subprime mortgages, collateralized debt obligations (CDOs), structured investment vehicles (SIVs), and all the other ingenious devices Wall Street's rocket scientists concocted to fob risk off on someone else.

The resulting credit crunch has dampened consumer confidence and may have made recession a self-fulfilling prophecy.

"Everything beyond a mild recession is Wall Street's fault," says market historian Charles Geisst, professor of finance at Manhattan College and author of Undue Influence: How the Wall Street Elite Put the Financial System at Risk.

And every day the hole Wall Street has dug us all into gets deeper and deeper. On Wednesday, UBS announced it would take $4 billion in additional write-offs to cover its losses in subprime and other debt securities, for a total of $18.4 billion, putting the Swiss banking giant right up there with Merrill Lynch and Citigroup in the Hall of Shame (see table).

And this may not be the end of it. Wall Street banks have taken writedowns in shareholders' equity of more than $100 billion from mortgage-related securities, and Standard & Poor's predicts that total could balloon to $265 billion. Other estimates of the ultimate writedowns run much higher.   

"Wait a little bit longer and see what else is hiding," says Professor Geisst.

Can there be any stronger indictment of these firms? All in all, we can safely say that with few exceptions (Goldman Sachs and Lehman Brothers in particular), Wall Street's handling of subprime mortgages and other derivatives has been as monumental a failure as the federal government's response to Hurricane Katrina.

Representatives of Citigroup, Merrill Lynch and Morgan Stanley did not respond to email or phone requests for interviews by deadline. A spokesperson for the Securities Industry and Financial Markets Association wouldn’t comment, but instead referred me to articles and press releases on that industry group’s website.

Justifiably, some heads have rolled in response-Stan O'Neal at Merrill, Chuck Prince at Citi, and Jimmy Cayne at Bear Stearns, along with a whole slew of executives just below the top tier. Other chieftains-John Mack at Morgan Stanley, Marcel Ospel at UBS-unaccountably hang on despite massive losses at their firms.

But beyond that, few appear to be feeling much pain. Wall Street bonuses totaled $33.2 billion in 2007, only about a 2% drop from the previous year, according to New York State Comptroller Thomas DiNapoli. Because of subprime-related losses, the seven largest Wall Street firms made pretax profits of only $11 billion last year-a huge drop from the $60 billion they made in 2006.

Yet total compensation actually increased at the seven firms to 61% of revenue from 45% the previous year.

The firms' rationale for this is twofold: some areas, like equities, investment banking, and emerging markets, did very well last year, so why should those people be penalized for the massive screwups in mortgages and fixed income? And if firms didn't reward talented people, they would promptly jump ship to rivals who were willing to pay top dollar.

This rationale for overpaying top executives looks particularly specious. With rumors about impending layoffs throughout the Street, are there really so many places for this "talent" to go? And since everybody presumably benefited when fees from subprime-mortgage deals produced fat profits for their firms, shouldn't they also "take one for the team" when times are hard?

In fact, the Street's compensation structure may be at the heart of the problem. "Incentives are skewed toward uncontrolled risk taking on the theory that heads, the traders win; and tails the shareholders lose," as Henny Sender of the FT wrote.

Meanwhile, storm clouds are gathering. Several Wall Street firms have been subpoenaed by New York state prosecutors investigating the whole subprime-mortgage debacle. The Securities and Exchange is making inquiries, too, and the FBI has opened a criminal investigation of mortgage fraud which may or may not involve Wall Street firms. Financial regulators question whether the current oversight regime needs to be toughened. And to replace some of their shareholders' money that vaporized in the ether, several firms went hat in hand to their latest saviors in Asia and the Persian Gulf-sovereign wealth funds, which have poured around $20 billion into Citi alone.

As with Eliot Spitzer's investigations in the early part of the decade, the Street is facing yet another black eye. (How many do they have left?) What remains of its public image is already in tatters.

So, let me make a constructive suggestion to Wall Street's beleaguered chieftains: why not ask your overpaid "superstars" to give back those bonuses?

Don't give them to the government, don't give them to me, don't even give them to charity. Give them back to the shareholders. It might give these Masters of the Universe the first glimmer of understanding whose money they're really playing around with.

And it would be a good first step in a long but necessary rehabilitation process for Wall Street, which would make Lindsay Lohan's or Britney Spears' look easy.

Howard R. Gold is executive editor of MoneyShow.com. The views expressed here are his own and not necessarily those of InterShow.

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