Bear Stearns Troubles

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But that started to change in the late 1990s. Stock trading was becoming commoditized, which meant that victory increasingly went to the lowest-cost player. The underwriting fees paid by corporations looked as though they’d be squeezed. The universal banks had more money to work with, which meant that they could use their ­balance sheets to offer commercial loans, enticing companies to the banks’ investment advisers when it came time to do deals. (That such blatant “tying” was against the law seemed beside the point.) Life as a stand-alone investment bank was presumed to be an unhappy one, the thinking went.

Then a surprising thing happened. The big financial supermarkets found that combining hotshot investment bankers with milquetoast commercial bankers flopped. Citigroup and J.P. Morgan languished. Deutsche Bank and Credit Suisse remained Wall Street also-rans. Bank of America retrenched to focus on retail banking.

But as the stock market emerged from the dotcom crash, most of the independents flowered. Their earnings and return on equity soared, as did their stocks. From the end of 2002 to the middle of this year, Goldman’s shares rose about 240 percent. From the end of that year to the beginning of this one, Lehman’s soared about 200 percent, and Bear’s increased a comparatively paltry 175 percent before giving back significant amounts amid the recent problems. All easily outperformed the markets and their peers.

Investors had noticed that the independent investment banks rarely fail and almost always thrive. Bear Stearns, formed in 1923, boasts it has never had an unprofitable year. Lehman had carved out a niche in fixed income and mortgages. Bear financed mortgages as well and served hedge funds. Goldman Sachs, brightest of them all, became the bank that runs the world, not just Wall Street.

How did they do it? Largely by taking more risks with their own money than they had before. Sure, they still do top-notch advisory work and act as dealers. But the growth in revenue and income has come mostly from ­betting with their own capital. They set up in-house private equity firms and spread money around on their own proprietary trading desks. In hindsight, it seems obvious that this couldn’t last.

Inside Trading

It’s become a cliché in recent years to label Goldman Sachs a hedge fund. But that doesn’t mean the cliché is wrong. The percentage of Goldman’s revenue that came from trading for its own accounts and investing its own money rose to 63 percent in 2006, according to Portales. From 1999 to 2003, that percentage never broke 50 percent. The portion of Lehman’s revenue that came from its own investments was 55 percent last year, up from an average of 44 percent between 1999 and 2004.

In the most recent quarter, investors learned how vulnerable these revenues can be. Bear, Lehman, and Morgan Stanley all suffered big drops from such trading. Goldman somehow managed to thrive. We’ll see if that lasts.

As a group, the five independent investment banks got 45 percent of their revenue from investing their own capital last year. In 1999—at the height of the tech boom, when they were generating fees from more-conventional sources—that number was about 30 percent.

The assets on the independents’ ­balance sheets have ballooned since then, and they have become riskier institutions because of it. A recent paper by Tobias Adrian of the New York Federal Reserve and Hyun Song Shin of Prince­ton University makes it clear that the banks aren’t much different from those low-credit borrowers now haunting the housing market. As home prices went up, homeowners borrowed against their houses; as prices have fallen, some have found themselves underwater, having to default.

You might think the investment banks would have been smarter. But they weren’t. When times are good, more investors are willing to lend and take risks. This gives investment banks excess ­capital to invest. Prices on assets rise. A global search for yield begins. The banks load up on assets and increase their leverage. At its core, what the banks are doing is buying high—hardly the stuff of a great business model.

As Adrian and Shin point out, this activity can quickly spill over into the broader market: “There is the potential for a feedback effect in which weaker balance sheets lead to greater sales.”

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