The Gang of Five, and How They Nearly Ruined Us
The little-known reason why investment banks got too big, too greedy, too risky, and too powerful.
The surviving investment banks are bristling at efforts aimed at recouping taxpayer losses and forestalling a repeat of the panic of 2008: congressional proposals to tax bonuses, President Obama's planned tax on large banks' liabilities, and his suggestion that banks be prohibited from using taxpayer-insured funds for proprietary trading. That last proposal would " restrict lending, increase risk, decrease stability in the system, and limit our ability to help create jobs," says Steve Bartlett, CEO of the Financial Services Roundtable, the trade group for megabanks.
But if the banks want us out of their business, they should get out of our business first. We've (barely) lived through a 40-year period in which investment banks have imposed themselves on us. They effectively moved into our house, raided our fridge, and set the joint on fire. Now they're complaining that our renovation efforts are cramping their style.
The genesis of the problem was the transformation of investment banks from private partnerships into publicly held companies. The process began when Merrill Lynch went public in 1971. It was followed by the four other horsemen of the 2008 credit apocalypse: Morgan Stanley (1986), Bear Stearns (1985), Lehman Bros. (1994), and Goldman Sachs (1999). The Gang of Five went public so they could compete with the international banking giants that were encroaching on their core business of underwriting stock offerings and advising firms and so they could boost their activities in risky, capital-intensive businesses like proprietary trading. "In order to have a capital base that would support the funding they needed, they had to be public," says Roy Smith, a former Goldman Sachs partner and a professor of finance at New York University.
Going public allowed investment banks to get bigger, which then gave them the heft to mold the regulatory system to their liking. Perhaps the most disastrous decision of the past decade was the Securities and Exchange Commission's 2004 rule change allowing investment banks to increase the amount of debt they could take on their books—a move made at the request of the Gang of Five's CEOs. Before Lehman crashed, it had amassed more than $600 billion in debt. No partnership or private corporation could have accomplished that feat.
The shift to public ownership also replaced the accountability of partnerships—when there are no profits, there are no partner bonuses—with the dangerous fecklessness of public boards. In theory, boards are supposed to oversee the activities of CEOs. In practice, they act as expensive rubber stamps. "These companies had board members who either weren't paying attention or, at Lehman in particular, were deliberately selected because they were unqualified or out of it," says John Gillespie, a former investment banker at Lehman and Bear Stearns and co-author of the new book Money for Nothing: How the Failure of Corporate Boards Is Ruining American Business and Costing Us Trillions. Gillespie notes that in 2008, Lehman's compensation committee included actress Dina Merrill, an heiress to the E.F. Hutton fortune who was 85 years old.
By the time Lehman ended its 14-year run as a public company with a "bagel" (a stock worth zero), some $45 billion in shareholder value had been destroyed. Shareholders didn't do much better with the other four. Bear Stearns was rescued from bageldom when JPMorgan bought it at a fire-sale price with the help of the Federal Reserve. Morgan Stanley and Goldman managed to remain independent and solvent, but only because huge subsidies were made available to them. In late January, Morgan Stanley's stock stood where it did in early 1998.
Shareholders may have suffered, but employees and executives didn't. At investment-banking partnerships, compensation is contentious—epic brawls would take place each December as partners argued over bonuses. But they would take place in private, and the process essentially involved rich people taking money out of one another's pockets. Now it's a zero-sum game, with executives and employees essentially taking billions from shareholders.
The public—as aggrieved owners, taxpayers, and savers—has every right to question the banks' methods and practices. If they don't want us poking around their businesses, they can shrink their balance sheets, replace government-subsidized debt with market-rate debt, stop relying on the Federal Reserve for funding, and get out of our index funds. As film mogul Samuel Goldwyn once said: "Include me out!"
Daniel Gross is the Moneybox columnist for Slate and the business columnist for Newsweek. You can e-mail him at email@example.com and follow him on Twitter. His latest book, Dumb Money: How Our Greatest Financial Minds Bankrupted the Nation, has just been published in paperback.
Illustration by Rob Donnelly.