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What the Abacus Deal Says about Investment Banks

e21 | May 3, 2010
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Their experiment with public status has failed.

The last few weeks have seen stunning revelations of the behavior of investment banks in mortgage-backed securities deals. In the case of Abacus – a deal underwritten by Goldman Sachs – it appears that Goldman may have misled investors about the presence of a first-loss tranche – the equity position that is forced to pay out any losses before more senior investors. Whatever the SEC does with this information, it’s clear that this news has damaged Goldman’s reputation. Their stock has plummeted.

Typically, however, investment banks played a critical role in making the market for collateralized debt obligations (CDOs) by holding the senior-most trenches of debt. Other investors in these deals were not planning to make one-sided bets on the housing market. Rather, a dearth of safe investment opportunities globally led to a demand for new securities that would offer close to risk-less returns with moderate yields. The so-called “shadow banking” system composed of various investment banks did their best to satisfy this demand; and by assuming the riskiest bits of deals they were able to create a market for mortgage debt.

On this role, Macroeconomic Resilience points out:

“But the moral hazard trade was only possible because there was sufficient investor demand for the rated tranches of the CDO and even more crucially, because the originating bank was willing to hold onto the super-senior tranche. As I have discussed many times earlier in detail, bank demand for super-senior tranches is a logical consequence of the cheap leverage that they are afforded via the moral hazard subsidy of the TBTF doctrine. If banks were less levered, many of these deals would not have been issued at all. [Emphasis in the original]”

That is, the CDO market could only take off with someone willing to assume extremely risky bets – bets which investment banks were happy to take in ways consistent with what you’d expect if they were backed by government guarantee.

But why did investment banks suddenly decide to assume enormous quantities of risk? Part of the answer lies in changes in their corporate governance structure.

A few decades ago, all of the major investment banks – like most law and consulting firms still are today – were limited liability partnerships. When the partners’ own capital was at risk, they exercised strict control over the risk, compensation, and underwriting at their firms. Just as home borrowers traditionally placed a down payment to ensure that they had “skin in the game”; similar requirements from the owners of banks encouraged prudential corporate governance.

All of this changed as investment banks gradually went public over the last few decades. The boards of directors that assumed managerial control over investment banks performed abysmally in their role. Few members had the time or background to understand the complex financial trades companies like Lehman Brothers or Bear Stearns were making, and they frequently deferred to the wishes of the CEO. Profits, after all, were soaring – at one point the financial sector contributed over 40% of corporate earnings. Shareholders were too small and diffuse to exercise meaningful control; and those who were concerned about risk were content to short company stock. The financial collapse of most investment banks in 2008 can be seen as a crisis in internal corporate governance at least at the level of Enron or Worldcom.

Shifting to public status had other knock-on effects on firm performance. As CEOs staffed boards with their allies, their compensation skyrocketed, as it did for their employees. This was not, by itself, a bad thing. The trouble came when compensation was awarded for as-yet-unrealized profits. This encouraged accepting risks that executives did not understand but profited from immediately. As these risks turned sour, losses could be and were shunted to shareholders and taxpayers. But by then bank executives had already profited.

Stock prices also magnified financial stress by acting as a barometer of trust. Investment banks are particularly vulnerable to liquidity shocks because they fund long-term assets with very short-term debt. They must roll-over such debt to remain solvent; and so require a certain degree of trust from their counterparties. Falling stock prices indicate a loss of trust, which lowers the ability of the bank to continue operations, which further lowers the stock price in a destructive spiral. To this day, Bear Stearns executives insist that their firm was “fundamentally sound.” Whether or not this is true, it doesn’t really matter – they lost the trust on which their company depended, and their stock price reflected it.

Turning investment banks back into limited liability partnerships may be like putting the genie back in the bottle. Yet without addressing the problem of corporate governance, bankers will again be able to outsmart regulators and pile on additional risk. The government has already resumed the policies of cheap credit and implicit subsidies that encouraged risk-taking in the past, and newly recapitalized investment banks are again seeking profits.