It looks like the independent investment bank is a thing of history. Or a thing of Goldman Sachs, since they'll probably be the only one left shortly.

It's a fascinating story, which I'm working on for tomorrow's All Things Considered.

My current hypothesis (which I'm checking out assiduously) is that investment banks were always like a casino.

They were the House. They set the table for other players to place bets. They served as match-makers between companies with money and companies that wanted to borrow money. They came up with all sorts of complicated ways of getting money from one group to another.

But at the end of the day, the investment bank could only profit.

That's because they didn't put their own money at risk. They let other people take the risk. The investment bank just took a cut of every transaction.

No matter what happened--stocks go up, stocks go down; bonds default, whatever--the investment bank was able to end each day by grabbing a few chips off the table and waving goodbye to the winners and losers.

Then, for complicated reasons, starting around 10 years ago, the investment banks decided to sit down at the table and put their own money at risk. They became the suckers. Which, any casino manager will tell you, is the last thing you want to do.

Why did this happen?

That's what I'm putting together now. I have some theories. Some tips. I'm looking to flesh this out.

If you happen to know, if you worked at an investment bank or are a historian of investment banks, please, please, please: send an email to planetmoney@npr.org.

Here is my rough sense at this point. Consider these tentative and not bearing the full weight of an NPR report:

- The easiest way to make money on Wall Street is to be an intermediary. You take money from one group of people and lend it to another group. You take a cut off each transaction.

- That's the easiest way. But you don't get a huge payout. That's because every other investment bank is doing the exact same thing. So, you all start competing by charging a smaller and smaller cut each time.

- If you come up with some new invention, some new way of transferring money from one group to another, then you can charge a lot more. That's because you have no competition in that area. (It's a lot like how Apple converted the commodity mp3 player into the unique and high-margin iPod. Same principle exactly, actually.)

- Investment banks have always tried to invent new financial products. They took boring old mortgages and turned them into complex mortgage backed securities--a way of changing a mortgage into a bond. They came up with junk bonds (remember that?) and interest rate swaps and all sorts of fancy new products.

- In the 1990s, a whole bunch of things came together to speed this process up. Computers allowed investment banks to do more of the complicated calculations needed to produce new products. This encouraged banks to hire PhD physicists from Harvard to apply advanced math and science to creating more products, faster.

- The repeal of the depression-era Glass-Steagall Act (actually, technically, the Second Glass-Steagall Act) allowed regular old banks--Bank of America, etc--to compete with investment banks. This created a very particular competition, in which the investment banks and commercial banks competed.

- Commercial banks had one major, sweet advantage: they had all that government-guaranteed depositor money to back up any speculative action.

- The Investment Banks had no government guarantee (at least, nobody thought they did until this year) but had less government oversight. So, they had an incentive to take bigger risks--the surest way to make (or lose) more money.

- So, you had new laws encouraging investment banks to take big risks and you had new technology that allowed investment banks to create all sorts of new and riskier products.

- The investment banks were creating so many new products, so often, that they couldn't sell them all. They had to hold some on their own books. That means they had to take risk, themselves. Not just pass the risk on to their customers.

- Somewhere around 2002, the investment banks saw that those risks kept paying off, so they took more risks and more risks.

- From 2002 to early 2007, they were making a fortune. It's like the casino manager who kept hitting the jackpot again and again.

- Ooooopsy. Like any casino manager will tell you, every good run eventually runs out.

- Suddenly, the investment banks saw their risky bets lose and lose and lose.

- Since finance isn't actually random--like casinos tend to be--bad luck actually does bring more bad luck.

- After a century and a half, the investment bank model may have met its end. It might turn out that it's just too hard for Wall Street managers (pit bosses?) to stand by and watch the suckers make a fortune while they just get a steady cut.

- In conclusion: the mob has much better risk managers than Wall Street investment bankers.

categories: Wall Street

6:24 - September 18, 2008

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