The news today was unsettling. Two of the nation’s largest investment banks, Merrill Lynch and Lehman, are to disappear, along with thousands of high paying jobs. AIG, one of the world’s largest insurance companies, is also on the verge of bankruptcy. All of this seems to have been caused by improper valuation of mortgage-backed securities. The brightest minds on Wall Street sincerely believed, apparently, that an old wooden house in Cleveland was worth $350,000 and that a guy whose job skills were limited to collecting welfare was going to start making big payments on that house just as soon as his one year payment-free grace period elapsed.
Could it be that we need smarter folks working on Wall Street? Let’s compare to 1987.
On Black Monday, October 19, 1987, the Dow Jones Industrial Average fell 22.6%. What were the consequences of this collapse? By today’s standards, there weren’t any. The stock market fell. The same investment banks and funds that had been operating on Wall Street continued to operate. Real estate, which had become a bit of a bubble, especially in condos, started to slide about a year later. Home prices in the Boston area did not return to their 1987 peaks until perhaps 1996, i.e., 9 years later. But by and large people kept their jobs and companies continued to function.
Back in the 1980s the smartest graduates of M.I.T. went to work in engineering and science. In our present decade, the brightest young minds with technical degrees are drawn to Wall Street where they develop elaborate can’t fail schemes to outperform the market. Apparently there were some risks that the bright quants failed to evaluate properly and now their employers are bankrupt.
Perhaps the answer is that we need fewer smart people on Wall Street.
Your post makes it sound like Lehman and Merrill are facing the same consequence. They aren’t. Lehman is declaring BK, Merrill is being bought by B of A. While many jobs will be lost as a result of the Lehman BK, most of Merrill’s employees will continue doing the same things they do today, but will be doing so under the BofA umbrella.
What interests me isn’t the collapse on Wall Street, but rather home valuations. When will housing prices reach historic norms? And then how many years will it be before prices return to the peak levels (2006 was the peak in many areas)?
I think a lot of the blame rests upon the shoulders of employee-compensation schemes. From loan agents who weren’t held accountable for writing bad loans to investment bankers who got paid to buy those loans, it’s clear that the incentives for both management and employees weren’t always geared toward the long-term health of the firm. It’s a lot easier to screw everything up now than it was 20 years ago when bankers were mostly just buying and selling stocks and bonds.
Scott: Merrill was paying its former CEO $50 million per year (reference: http://philip.greenspun.com/blog/2008/04/21/statins-cholesterol-health-fancy-employee-compensation-ebitda-and-c/). They presumably had a lot of other top executives who will be redundant now that Merrill will simply be a division of BofA. Even if the same people stay on, they won’t be able to nominate their friends to BofA’s Board of Directors and set their own salaries. Among the rank-and-file there is probably a lot of overlap between BofA and Merrill and the only way that this acquisition can work is if redundant jobs are eliminated (BofA’s stock is down 15 percent today and they will have to do something to show investors that they can keep Merrill’s revenue while losing Merrill’s expenses).
Now would be a bad time to try to sell a house or a jet to a Merrill or Lehman executive…
If we employ Occam’s principle a simple explanation for the current financial problem can be summed up as follows. Due to pressures from financial lobbyists the fed lowered the standards for underwriting mortgages. When the fed changes the rules that make it ok to grant high risk mortgages, private financial institutions are not going to hesitate on the opportunity to increase profit. So, even when potential mortgage borrower won’t be able to make the payments, as long as the fed says it is ok to lend to that person then the mortgage lender is going to. Its all about the bottom line.
Do you really need smart people to create ponzi scheme.
watch the video on the link to see what I am talking about.
http://www.cbc.ca/sunday/2008/09/091408_1.html
It takes a certain brain to go into engineering and science.
It is not as simple as cramming. There already a glut of lawyers.
May be they go into Energy that needs some bad ideas
to hasten global warming.
Scott:
Thanks to to job redundancies and economies of scale, Merrill Lynch will end up with around 24000 jobs eliminated. http://www.reuters.com/article/bondsNews/idUSLF8371520080915?pageNumber=2&virtualBrandChannel=0
In addition, due to their high salaries every job on wall street creates additional 3-4 jobs via trickle down effect. So you are looking at close to 100,000 job losses after this acquisition. Well, the alternative (Merrill going bankrupt) would have been worse.
Joe, you’re half right. Congress’ blessing of Fannie Mae and Freddie Mac divorced mortgage origination from mortgage risk, providing banks with a quick path to get loans off their balance sheets. Imagine being able to buy an orange for $1 and sell it a month later for $1.25.
The GSEs happily bought $1 oranges for $1.25, and would have gladly kept doing so in the name of “expanding home ownership.” Those who thought a government-sponsored, risk-ignorant aftermarket made sense in the 21st century should be shot.
Don’t forget whith whom money thos “smart” guys work. It’s seldom their own. Let’s face it if you earn 1 000 000 (safe) but have to handle 1 000 000 000 other money. How much would you dare?
You “just” face the risk to not earn 1 000 000 all years long but let’s see what happens if you got another 5 000 000 each year variable. How worse can it be to retire after just 3 years?
The smart guys have taken their share and probably started seeking greener grounds next stuff. It would be very interesting to know how large the fluctuation in the investement banking sector hade been. I doubt it’s all to high currently but I may be wrong.
Regards
Friedrich
It’s really simple.
For corporate CEOs, it’s all upside, no downside. With current executive compensation – even base compensation, much less the size of the golden parachutes out there – it only takes a few years for execs to be rich enough that they don’t need more money.
Fuld (CEO of Lehman) took home $466 million from 1993 to 2007. If he’d resigned at the end of january, the 8.6 million shares he holds would have netted him an additional $567 million (assuming he could have disposed of that many at that price). Today, they’re worth a little less than $2 million.
If he ends up terminated, he’s only going to walk away with around $60 million (stock, pension, deferred compensation).
So, what was the downside for him to have done what he did? $500 million over 15 years for taking a thriving company and bankrupting it?
Where do I sign up?
Here’s one question I keep asking myself when we talk about bailouts:
Are Investment banks like carrier battle groups, with massive capital investments and hard-won institutional knowledge and difficult-to-recreate systems, or are they more like law or architectural firms, nice buildings full of smart people with specialized knowledge and the right rolodexes?
I suspect it’s somewhere in-between, but more on the law firm side of things. If that’s the case, then who cares if they fail? Their competitors would be glad to step in and take over their less risky lines of business, their workers remain well-connected dealmakers, and their principals can always start another firm. Sure, it’ll be rough in the Jet and custom pool market for a while, but it looks like aviation is in for a rough ride anyways. (P. Diddy can’t even afford to fly his plane)
When Cantor Fitzgerald was devastated on 9/11, it didn’t destroy the bond market; when Arthur Andersen blew up, it didn’t wreck the accountancy market. I say let ’em fail.
You make a good point, Friedrich. I was about to disagee with Philip and say that these guys aren’t so smart considering all of the losses that they’re racking up. (There’s certainly a lack of creativity on Wall Street. All ofthese institutions appeared to make basically the same mistake.)
On the other hand, maybe they’re actually quite smart. Some of these executives justified their huge paychecks a few years by pointing to the big profits of their institutions. Now that the bubble has burst and the profits have become losses, some of these guys have arranged for the taxpayers to get stuck with the bill. They walk away with their golden parachutes paid for by waitresses and truck drivers in Boise and Wichita.
They may be incredible smart, but for all of them to outperform the market would be a Lake Wobegon situation.
OTOH, I kinda believed back in the day that Doyne Farmer would be able to pull it off, given his casino experiences, his background in chaos theory and his work with the Santa Fe wonks on complex systems. But even that becomes common knowledge, and any engineering undergrad today can avail themself of the knowledge that was bleeding egde in the mid-90s.