Wall Street Finally Gets Its Comeuppance

03/22/2012 11:10 am EST


Howard Gold

Founder & President, GoldenEgg Investing

For years, we thought the investment bankers who helped cause the Great Recession would have the last laugh…but the cannons are finally turning on them, and in a big way, writes MoneyShow editor-at-large Howard R. Gold, also of The Independent Agenda.

Stocks are hitting post-crisis highs, unemployment is falling, and even housing sales are putting up their best numbers in years.

On Wall Street, however, it’s still the winter of their discontent. The giant firms that were instrumental in causing the financial crisis (they had plenty of help, of course) were saved from themselves by taxpayers’ money and zero interest rates, courtesy of Federal Reserve chairman Ben Bernanke.

They had spectacular years in 2009 and 2010, and paid out huge bonuses to their undeserving minions, just as if nothing had happened. The public, suffering through the worst recession since the 1930s, was understandably outraged.

But o ye of little faith, justice and retribution are at hand. Market forces and a regulatory tidal wave are bearing down on these Masters of the Universe. The big firms are slashing bonuses, laying off workers, and getting out of markets where they had no business being in the first place.

In coming years, these firms will earn less, and shareholders may put more pressure on managements to improve profitability—the same kind of heat Wall Street puts on everyone else.

It all points to a secular bear market for Wall Street, no matter how the rest of the economy does. In financial speak, “secular” means caused by structural forces rather than the normal ebbs and flows of the market cycle.

Last week’s public resignation by Goldman Sachs Group (GS) vice president Greg Smith in The New York Times was more than just a take-this-job-and-shove-it message—it was a symptom. These things happen in bear markets, when rats jump off sinking ships. In this case, the rat ratted out his employer.

The former Goldman employee called the environment at the firm “toxic and destructive,” and wrote, “It makes me ill how callously people talk about ripping their clients off.”

Read Howard’s previous take on conflicts of interest at Goldman Sachs.

Roy Smith, a former Goldman partner who now teaches finance at New York University’s Stern School of Business, isn’t sympathetic to Greg Smith because “he made it seem like Goldman Sachs could and did rip clients off all the time.”

But, “the clients Goldman serves…have the opportunity and do shop their business around,” he said in an interview.

That aside, Professor Smith acknowledges there have been big changes at Goldman, and throughout Wall Street, as “seat-of-the-pants” traders were replaced by quants and PhDs brandishing sophisticated mathematical models. Competition has intensified across all businesses.

After the dot.com bust and the Eliot Spitzer investigations, Wall Street appeared chastened. But then the Fed’s low interest rates under Alan Greenspan sparked the blow-off stage of the decade-long housing boom.

Firms like Goldman, Morgan Stanley (MS), Merrill Lynch—now owned by Bank of America (BAC)—and others, like the late and unlamented Lehman Brothers and Bear Stearns, jumped in to package, sell, and trade AAA-rated securities backed by rotten mortgages. And with regulators’ complaisance, these firms levered up those bets 30 or 40 to one.

Result: Financial firms’ earnings catapulted from 19% of all US corporate profits in 1986 to a whopping 41% in 2006. It was all based on funny money, though, so when the inevitable crash came, it almost took the rest of us with it.

“This whole business was…in a rocket ride from the 1980s until now, but in doing so, it created a systemic threat to the world,” Professor Smith told me.

But now those markets have been decimated, and the Street has been forced to compete for a shrinking pie. Equities? Individuals have abandoned the stock market, leaving it to high-frequency traders making fractions of a cent per unit on each trade.

NEXT: How Bad Is Business on Wall Street?


Mergers and acquisitions are way down, and so are initial public offerings, traditional paths to big fees on Wall Street.

Even Facebook, the IPO of the decade, won’t be a bonanza for the firms running the offering, who are reportedly taking in only a 1.1% underwriting fee. They usually make 6-7%. Sorry, bankers, it’s grilled cheese sandwiches instead of truffles on this one.

Business is so bad, Smith told me, that the Street’s return on investment has been less than its cost of capital for the past three years, for a negative economic value added (EVA)—a critical metric. I’ve always thought these firms subtracted value, but now it’s official.

“That means we have to admit these firms have structural problems,” Smith said.

And these problems are about to get much worse as regulators tighten their grip.

Are there too many psychopaths on Wall Street? Read Howard’s view at The Independent Agenda.

After the crisis, governments around the world passed new laws and guidelines to control the crazed speculation that nearly wrecked the global economy. The US, UK, EU, and Switzerland all toughened capital requirements, reduced leverage, and put systemically risky institutions on a very short leash.

The most important are Basel III, drafted by the Basel Committee on Banking Supervision, and the Dodd-Frank Act, signed by President Obama in July 2010. These will force banks to hold a lot more capital in reserve against losses, pass periodic stress tests, change compensation practices, and in the case of Dodd-Frank’s Volcker Rule, divest themselves of riskier operations like proprietary trading.

Congress made a mess out of Dodd-Frank, dropping on regulators’ laps the unenviable task of writing dozens of new rules. Banks and securities firms are lobbying furiously to stave off the most draconian of those regulations, but the law already has changed how they do business.

“All these things are going to require banks to hold considerable amounts of capital,” Smith told me. “These guys may as well say goodbye to their business models of 2007, the kind of swashbuckling attitude that’s showing up in the Greg Smith article. My guess is, we will see some of the firms making drastic changes.”

Job one must be cutting the fat bonuses, which analyst Mike Mayo has called an entitlement rather than an incentive. “Compensation follows the economics of these businesses,” Roy Smith said.

Already, New York State Comptroller Thomas DiNapoli has forecast Wall Street compensation will drop 14% this year. Industry profits, however, have been cut in half. I hope shareholders will pressure banks to get their compensation ratios down. What other industry besides Wall Street pays its employees half its revenues before the companies’ owners see a dime?

Firms already have restructured compensation to pay employees over a longer period, and force them to keep more skin in the game. At Morgan Stanley, cash bonuses reportedly have been capped at $125,000. You or I would grab that in a nanosecond, but that’s what Wall Streeters used to spend each year to light their cigars.

Responding to complaints, Morgan Stanley’s CEO James Gorman said: “If you’re really unhappy, just leave.” Nice. Especially when some 200,000 people in the financial industry lost their jobs in 2011.

Read Howard’s piece on why no bankers are in jail after the financial crisis.

Now, I rarely indulge in schadenfreude, the German word for taking pleasure in other people’s misfortunes. And I don’t wish ill for the thousands of office personnel, IT people, and other average folks who work for these firms.

But I can’t help but smile at the angst overpaid Wall Streeter bankers face in this new world. Little by little, they’re getting their deserved comeuppance, and there’s more to come.

“We’re going through a dark, dark tunnel,” said Smith. And there’s no sign of light on the other side. Hallelujah.

Howard R. Gold is editor-at-large for MoneyShow.com and a columnist at MarketWatch. You can follow him on Twitter @howardrgold and catch his political commentary at www.independentagenda.com.

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