Are the Halcyon Days of Investment Banking Gone for Good?


An article on a Reuters blog caught my eye recently, as it dealt with the subject of Wall Street profits. It seems that Standard & Poor's came out with a new outlook for capital markets for the rest of this year, slightly better than its previous opinion. In addition, the ratings agency also weighed in on the "structural vs. cyclical" argument regarding the depressed earnings of the investment banks over the past few years and has determined that they're here to stay.

By acknowledging that the financial landscape has changed dramatically from four years ago, S&P is essentially saying that this is not just a normal business cycle from which firms will eventually emerge with fat earnings intact. While it's true that issues such as tighter regulations and a negative public image will be a permanent weight on banks' earnings, I think there is something more -- those obscene profits from the pre-2008 days won't recur because they shouldn't have happened in the first place.

Creative banking brought huge profits and enormous losses
Though the tangle of the financial crisis probably won't be sorted out for years, we know enough of its origins to realize that it was not a normal housing boom that preceded the crash. With regulatory restraints peeled away, banks were free to explore the creative side of investment banking. Without the newly minted products dreamed up by Wall Street whiz kids, the outsized expansion and thus the devastating bust could not have happened.

Collateralized debt obligations were not anything new. They were second cousins to asset-backed securities made to order for the savings-and-loan industry way back in the 1980s. These instruments were created by the Wall Street gang to not only move loans off of the S&Ls' balance sheets, but also to inject some nice capital into the mix for the S&Ls to make hay with. Debt magically disappeared, capital is infused, and everybody made money -- until it all came crashing down.

For banks, CDOs were originally made up of things like corporate and Treasury bonds, commercial loans, and other less-risky ingredients, which could then be moved off their books. Then, mortgages began being thrown in, and, once the greed machine really got going, subprime mortgages were, too. The furious rate at which these risky loans were being written allowed the CDOs to become predominately subprime, instead of diversified as they had been previously.

It's easy to see how Wall Street became addicted to the money that CDOs produced. Everyone took a cut, from lawyers to the rating agencies -- but banks made the most money. And there were lots of these products being created: Estimates for CDO sales figures for 2006 are in the range of $535 billion, versus just $69 billion in 2000. Of course, by 2009, the value of CDOs sold fell to $105 billion, as the vehicles were recognized as the empty vessels they truly were.

It's also understandable that the titans of finance would miss those days of big profits and hefty bonuses. The Wall Street Journal has an interesting graphic that shows just how much these financial instruments meant to these banks. For the years 2006 to 2007, Wall Street bonuses were in the $34 billion range, compared with the years 2010 and 2011, which were closer to $20 billion.

What did the banks know, and when did they know it?
But even during the heyday, banks must have known that those profits were unsustainable. More than anyone, the people who put these vehicles together knew that CDOs made up primarily of stated-income, subprime loans would fail at some point. When you lend money to someone without checking income, how do you suppose the loan will be repaid? By 2006, almost half of all loans written were characterized by Credit Suisse as liar's loans -- and the banking industry knew it.

Some banks found out sooner rather than later. Citigroup (NYS: C) , for example, tried out a stated-income loan program in New York back in the 1980s, liked the results, and proceeded to offer it nationwide. When it noticed an avalanche of defaults, it ended the experiment. For Bank of America (NYS: BAC) , whose purchase of Countrywide Financial will be remembered as one of the worst acquisitions in banking history, the learning curve happened much later.

Investors found out too much, too late, as well. Lawsuits against Goldman Sachs (NYS: GS) involving the sale of CDOs in which Goldman did not disclose its involvement in shorting, and Morgan Stanley (NYS: MS) , alleging that the company persuaded Moody's and S&P to give stellar ratings to $23 billion of investments based on subprime mortgages, lends credence to the notion that these banks had more than a passing knowledge of the fact that their products were not the great investments they purported them to be.

Conclusion: The huge profits from 2006 and 2007 won't be back (we hope)
Despite the evidence of malfeasance, bank executives aren't happy just to avoid jail -- they must whine about the fact that they are not making the big, artificially inflated bucks that they used to. Structurally, these kinds of hijinks shouldn't recur because of new regulations and investor wariness. In a history-repeats-itself kind of way, the cyclical argument may hold water, too, since it was barely 20 years between the S&L debacle and the latest financial disaster -- so there's a possibility that it could happen again.

As JPMorgan Chase's (NYS: JPM) recent troubles show, risky behavior and deception of investors are still considered acceptable business practices. Has anything really been learned? I hope so -- but I wouldn't bet on it.

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At the time thisarticle was published Fool contributorAmanda Alixowns no shares in the companies mentioned above. The Motley Fool owns shares of Bank of America, JPMorgan Chase, and Citigroup.Motley Fool newsletter serviceshave recommended buying shares of Goldman Sachs and Moody's. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days. The Motley Fool has adisclosure policy.

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