Wall Street's Casino Attitude, Questions and Answers: Wall Street's Business Model Incites Greed, Cowboy Investing, Lack of Risks, Push for more Profits and More Borrowing (Leverage)
Wall Street is not what it used to be. Some of the buildings are still there. However, everybody from company directors to ground crew, traders, brokers and customers is running scared. Wall Street as we knew it is having huge problems. Consisting of giant investment houses, brokerage firms, hedge funds and "private equity" firms, Wall Street business model has come under huge assaults from greedy traders and management directors who thought that risks were to be handled differently in their quest for more and more profits.
Bear Stearns is no more. Venerable Merrill Lynch had to find a purchaser in Bank of America. The Feds could not rescue investment bank Lehman Brothers which had to file for bankruptcy. Insurance giant AIG received an $85 billion bailout from the Federal Reserve. That's after the government took over Fannie Mae and Freddie Mac, the largest mortgage lenders in an effort to shore up the economy and the housing market. Investors have just found out that their funds could be lost if it was not for this late-hour lifeline. Foreign investors also had to be reassured. Anything that happens to our economy ends up having great repercussion in other countries' stock markets.
In the past few years, Wall Street has gone away from its business model. They have long lost their role as advisers and intermediaries. In the past, these investment banks used to work for their clients. They traded stocks and bonds for major institutional investors such as insurance companies, pension funds, and mutual funds. They raised capital for companies by underwriting, selling new pension funds, mutual funds. They provided advice to corporate clients on mergers, acquisitions and spinoffs. That's how they made their money by charging fees.
Wall Street's financial institutions changed their focus. They were in business for themselves. They were investing for themselves by using partners' or shareholders' money to place bets on stocks, bonds and other securities which they called "principal transactions.
If anybody wants to do something about Wall Street's compensation system, he/she will have to lay the groundwork to avoid future chaos. It is not a secret that Wall Street's compensation system is heavily skewed toward annual bonuses which reflect the profits traders and management directors earned in the year. Even when these traders and directors were making base salaries of $200,000 to $300,000, bonuses were their gravy. They used to receive bonuses five to 10 times their base salaries.
Unlike commercial banks, investment banks rely too much on borrowed money which they call "leverage." There were too many windfalls caused by too much borrowing. For a long time, traders and money managers were focusing too much on their own short-term profits. That is why the crash was just around the corner. Wall Street was being severely damaged by these acts. Short-term goals were met, but investors, shareholders and the rest of the country were going to get hurt. Everyone involved had huge incentives to increase borrowing.
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