"Financial genius is a rising market," wrote the late John Kenneth Galbraith.
The falling market of 2008, on the other hand, was the year Wall Street died. The collapse of Lehman Brothers, the takeover of Merrill Lynch and the transformation of Goldman Sachs into a regular bank marked the disappearance of the classic American investment bank.
Wall Street was where hugely successful family-held companies came to transform themselves into limited liability public corporations. Investment banks sold newly minted corporate shares to pension funds and wealthy individuals. While the former owners, the family, walked away rich, the investment banker made out like a bandit, taking a portion of the share issue proceeds for itself, then charging the eventual buyers of shares a fee as well.
Figuring out what a company was worth was Wall Street’s job. Investment banks decided what the issue price should be for new shares, and made the "market" for share trading. Wall Street paid itself handsomely to "price" risk and estimate rewards.
The classic Wall Street investment bank was a partnership. Partners put up their own money to fund an investment bank such as Goldman’s. Therefore, when the bank decided to put a new issue of shares on the market, it was the partners’ own money that was at risk. If no buyers emerged at the chosen price, the bank could fail, and the partners lose their capital.
American capitalism changed for good in the 1980s when the old style investment banks themselves decided to "go public," that is, to issue their own shares. In effect the partners where cashing out, taking their money out and turning over the risk of deal making to anonymous shareholders.
The business of pricing risk changed for the worse. Investment bankers, now executives (employees) risking someone else’s money, replaced investment bankers as owners with their own money at risk. Michael Lewis in his book Liar’s Poker laid out what happened next on Wall Street as astronomical salaries and bonuses, paid in good times and bad, became the norm for executives. Bank directors got a cut of the action and colluded with management in establishing a plutocracy.
The Mexican peso crisis, the Asian Financial debacle, the high tech bubble bursting did not limit executive salaries or bonuses. In the executive run Wall Street world, fees were charges and money collected, whether markets tanked or soared. Financial advisors were paid whatever the results of transactions. It was as if capitalists were rewarded while taking no risks.
The secret weapon of Wall Street executives was political influence in Washington. By the time Bill Clinton defeated George Bush père (thanks to a third party candidacy, Clinton only needed 42 per cent of the vote) Wall Street had gotten control over the Democratic party, and led by Treasury Secretary Rubin, formerly an executive of Goldman’s (like current Treasury Secretary Hank Paulsen), managed to undo the prudential legislation governing the banking industry, put in place after the Great Depression.
The severity of the great depression was directly linked to widespread bank failures in the U.S. When banks loans went bad, deposit-taking institutions went bust, and took the bank deposits of regular Americans with them went they went under.
Under President Reagan, U.S. income tax rates had been reduced, and some deductions against income eliminated. The ability to deduct mortgage interest before calculating taxable income remained. So, to this day if an American family needs a new fridge or car, it can remortgage the house and deduct the interest costs. In effect, mortgage lending became the American super credit card.
With the complicity of regulators, credit rating agencies and while official Washington looked the other way, the new, executive-run Wall Street discovered it could bundle mortgages and sell them as "risk free" investments to regular banks, pension funds and other unsuspecting investors. When the bankers used their political influence to change the rules governing who could get mortgages, the sub-prime mortgage was born.
These mortgage investment vehicles with a sub-prime component turned out to be something everyone wanted to sell, and nobody wanted to buy. Panic selling ensued. The viability of the American financial industry itself was suspect. In the subsequent falling market, Wall Street may have died, but financial players have moved to have Washington cover their losses. In a falling market, it turns out financial genius is having political influence.