Web Extra: Read an Excerpt of David Stockman's New Book

The preponderance of their fabled profitability, however, was generated by massive trading operations which scalped spreads from elephantine balance sheets that were not only preposterously leveraged (30 to 1) but also dangerously dependent upon volatile short-term funding to carry their assets. Indeed, perched on a foundation of several hundreds of billions in debt and equity capital, these firms had become voracious consumers of "wholesale" money market funds, mainly short-term "repo" loans and unsecured commercial paper. From these sources, they had erected trillion-dollar financial towers of hot-money speculation.

On the eve of the financial crisis, Goldman had asset footings of $1.1 trillion and Morgan Stanley had also passed the trillion-dollar mark. Much of their massive wholesale funding, however, had maturities of less than thirty days, and some of that was as short as a week and even overnight. When Bear Stearns hit the wall in March 2008, for example, it was actually rolling over $60 billion of funding every morning—until, suddenly, it couldn't.

It goes without saying that these highly liquid wholesale funding markets were dirt cheap because lenders had no rollover obligation and were often fully secured. It is also obvious that on the other side of their balance sheets, these de facto hedge funds held assets which were generally more illiquid, longer term, and subject to credit and market value risk, and which therefore generated substantially higher average yields.

Due to this "duration" and "credit" mismatch, the profit spread per dollar of assets was considerable, and when harvested a trillion times over, total profits were enormous, reaching $18 billion (pre-tax) at Goldman during the year before the crisis. Since this amounted to a half million dollars of profit per employee (including secretaries and messengers) the potency of carrying a giant balance sheet on the back of cheap wholesale liabilities was self-evident.

Yet here is where the foundation of overvalued debt and equity capital came in. There were limits on the extent to which the assets of these giant "investment banks" could be funded on wholesale money. Even the frothy markets of 2008 would have viewed a balance sheet consisting mainly of slow, illiquid assets funded preponderantly with short-term liabilities as a house of cards. So the investment banks' foundation of permanent capital, in fact, was the vital linchpin beneath the whole Wall Street edifice.

Thus, Goldman's balance sheet at the time of the crisis boasted long-term debt and preferred stock of $220 billion and common stock of $60 billion, even as measured by its depressed share prices that week. Likewise, Morgan Stanley had $190 billion of long-term debt and preferred stock, and $25 billion of common stock at the current market prices of its shares. Taken together then, the last two investment banks standing rested on a half-trillion-dollar base of long-term capital.

During the boom years, this long-term capital had earned handsome returns in the form of interest and dividends, with the common stock, the most junior capital, also experiencing substantial price appreciation. Goldman's share price, for example, had peaked in late 2007 at nearly $250 per share, a level five times its May 1999 IPO price.

Yet in the matter of investments, as in the opera, it's not over until the fat lady sings. The crucial economic purpose of each firm's capital was to function as a financial shock absorber. During times of heavy economic weather, therefore, senior wholesale lenders would be spared from any losses incurred on impaired asset accounts; losses would be absorbed by the firms' more junior, permanent capital—the common equity first and ultimately the long-term debt as well.

As events unfolded in the fall of 2008, these shock absorbers were brought into play. In very short order, they had proved wanting when Lehman filed for bankruptcy and Merrill Lynch was carted-off to Bank of America on a financial stretcher. Both firms had failed because their permanent capital had been inadequate to shield the losses, thereby rendering them insolvent.

In the days after September 15, the shock absorbers of the last two investment banks left standing, Goldman and Morgan Stanley, also failed the test. Their most illiquid asset classes—such as securitized mortgages, CDOs, commercial real estate securities, and corporate junk bonds— declined in market value by between 20 percent and 50 percent during the meltdown. Even when blended with holdings of low-risk government bonds and blue chip corporate securities, the blow to capital was devastating, and they would not have survived the ordeal on their own.

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