Monday, January 9, 2012

How Wall Street emerged stronger than before the crisis

William Cohan wrote an interesting Bloomberg column in which he asserts that as a result of the crisis, Wall Street has emerged as a stronger cartel than it was before the crisis.

Wall Street achieved this as the result of how the regulators responded to the crisis.  The regulators had the choice between breaking up or consolidating the Wall Street firms.  Regulators chose consolidation.

One of the reasons that this blog has pushed for ultra transparency is that a force bigger than Wall Street is needed to discipline and, where necessary, shrink these firms.

As the blog has discussed, ultra transparency achieves this because market participants use the on-going disclosure of each Wall Street firm's current asset, liability and off-balance sheet exposure details to assess each firm's risk.  Based on this risk assessment, market participants adjust the amount and price of their exposure to each firm.

The result is that the riskier a Wall Street firm is, the higher the cost of funds for that firm and the greater the incentive to lower the firm's risk level.

Currently, with the regulators possessing an information monopoly on each Wall Street firm's current asset, liability and off-balance sheet exposure details, market participants are not able to link their exposure to the true underlying risk of each firm.  As a result, these firms are not subject to market discipline, but only regulatory discipline.

Clearly, despite a significant amount of 'sound and fury', regulatory discipline is non-existent.  Look no further than the fact that regulators know that by not requiring Wall Street to provide ultra transparency they are signaling that there is something to hide.

Almost 65 years ago, in 1947, the U.S. government sued 17 leading Wall Street investment banks, charging them with effectively colluding in violation of antitrust laws. 
In its complaint -- which was front-page news at the time - -- the Justice Department alleged that these firms had created “an integrated, overall conspiracy and combination” starting in 1915 “and in continuous operation thereafter, by which” they developed a system “to eliminate competition and monopolize ‘the cream of the business’ of investment banking.” 
The U.S. argued that the top Wall Street investment banks - - including Morgan Stanley (MS) (the lead defendant) and Goldman Sachs -- had created a cartel by which, among other things, it set the prices charged for underwriting securities and for providing mergers-and-acquisitions advice, while boxing out weaker competitors from breaking into the top tier of the business and getting their fair share of the fees. 
The government argued that the big firms placed their partners on their clients’ boards of directors, putting them in the best possible position to know when a piece of business was coming down the pike and to make sure that any competitors were given a very hard time should they dare to try to win it. 
The government was spot on: The investment-banking business was then a cartel where the biggest and most powerful firms controlled the market and then set the prices for their services, leaving customers with few viable choices for much needed capital, advice or trading counterparties. 
The same argument can be made today.
Indeed, following the destruction of Bear Stearns Cos., Lehman Brothers Holdings Inc., Merrill Lynch and countless smaller and foreign competitors during the financial crisis that began in 2007, the investment-banking business is an even more powerful and threatening cartel than it was in 1947. 
Today, there are far fewer than 17 firms in control of the investment-banking business. After Goldman Sachs Group Inc. (GS), Morgan Stanley, JPMorganChase & Co. (JPM)Citigroup Inc. (C)Bank of America Corp. (BAC) and Deutsche Bank AG (DBK), one is pretty much at a dead end. The investment-banking business is now both much, much bigger -- in terms of revenue and profits -- and much, much more concentrated than it ever was close to being in 1947. 
How could that have happened? Unfortunately, in October 1953, Harold Medina, the presiding federal judge in the case, threw the antitrust lawsuit out of court. In an extraordinary 417-page ruling -- a must-read for anyone interested in the history of Wall Street -- Medina decided that the government’s case rested solely on “circumstantial evidence” and that the banks didn’t violate antitrust laws. Yet Medina’s ruling also laid bare the extent to which the 17 Wall Street firms would go to defend their turf and prevent other banks from getting access to lucrative, fee-paying clients. It wasn’t a pretty picture. 
Today, while there is no inkling of an antitrust lawsuit against Wall Street, its cartel-like behavior is very much in evidence. The remaining banks have increased their hold over the marketplace and continue to collude when it comes to pricing their services. 
Although banks will argue that all fees are negotiable, every corporate issuer knows the rules: Initial public offerings are priced at a 7 percent fee; high-yield-debt underwriting is priced at 3 percent; loan syndications are priced at about 1 percent. M&A deals are still priced off the “Lehman formula,” even though there is no more Lehman Brothers....

Sixty-five years late, let’s break up the Wall Street cartel and re-establish the integrity of the capital markets.

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