Business | Investment
Financing model now holds key to the future
Only the paranoid survive, according to Andy Grove, one of the founders of Intel.
- By Tracy Corrigan, The Telegraph Group Limited, London 2008
- Published: 23:42 September 19, 2008
Only the paranoid survive, according to Andy Grove, one of the founders of Intel. He was writing about the technology industry, where new gadgets can displace best-selling products at lightning speed.
But just how paranoid would you need to have been to foresee quite how difficult it would prove to survive in the world of investment banking right now? By comparison, the IT business looks rather tame.
In the space of a week, Lehman Brothers has collapsed, Merrill Lynch has rushed into the arms of Bank of America, AIG needed a huge Federal Reserve support, while Morgan Stanley has started shopping itself around and is now in talks with Wachovia.
What is so scary about all this is that cause and effect have become increasingly hard to untangle. It is all very well to say that the current crisis is the result of a boom in cheap money which encouraged consumers to borrow too much and banks to gear themselves up excessively.
The resulting correction, as asset prices fell and banks were forced to write down bad debts, revealed that banks were not holding sufficient capital to cope with the downturn. But that is a bit like saying that there are a lot of people dying because we are at war and we are at war because our enemies fired the first shot: it doesn't help reduce the number of casualties, nor bring the war to an end.
Lack of capital, as such, no longer seems to be the immediate problem. Rather, there is now a full-blown crisis of confidence that has caused wholesale markets to dry up.
Quite simply, banks won't lend to each other. And investment banks, which by definition are reliant on wholesale funding, since they have no base of retail depositors, have come under heavy fire, even though some of them, at least - Goldman and Morgan Stanley - look perfectly well-capitalised.
There is a vicious circle which works roughly like this: The share price falls, because there are worries about the business model; the cost of insuring against default in the credit default swap market balloons; lenders observing these market movements infer that these are risky borrowers and cut credit lines; as a result, the share price comes under further pressure and the cycle continues.
Sound logic
The logic underpinning the falling value of investment banks is sound enough, but the market appears to have decided, at some point last week, to write off the entire model.
The market, of course, is in part the banks themselves. The brotherly love that was kindled at last week's meetings arranged by Treasury Secretary Hank Paulson, appears to have lasted about five seconds after the bankers left the building. Despite an outbreak of rabies, the dog-eat-dog mentality of Wall Street has become, if anything, more ferocious, as banks try to poach each others' clients or cut off credit lines, and the complex derivatives they designed are not used against them.
The pecking order of investment banks is closely scrutinised and well understood by all concerned. Goldman Sachs stood, as The Economist wrote, on top of the world, followed by Morgan Stanley, Merrill, Lehmans and, at the less respectable end, Bear Stearns. They appear to be being picked off in reverse order.
Self-fulfilling view
The trouble is that if the group-think referred to as "the market", holds that the model of the standalone investment bank has no future, that view will become self-fulfilling, and it may be too late for any curbing of short-selling to make any difference.
Three down, two to go. If Morgan Stanley enters a marriage of convenience with Wachovia, is Goldman next, or does it have a plan up its sleeve?
The irony is all the richer, because the Goldman diaspora is central to efforts to sort out the mess. Steel and Paulson worked together at Goldman before arriving at the Treasury and Paulson recently co-opted Ken Wilson from the old firm to help sort out the crisis. John Thain at Merrill and Robert Rubin at Citigroup are also alumni.
After Goldman, who would be the next target? Since two weeks ago it seemed unthinkable that the future of Goldman, which has not made a loss since the start of the crisis, would be in doubt, there is no reason to believe that it would be the last victim.
No investment banks left? So what? There are still plenty of commercial banks which rely on wholesale markets as well as deposit-taking. Just look at HBOS, which ran to Lloyds TSB.
Financing model, rather than business model, is now the key.
If confidence returns, all these stocks will suddenly look cheap. The market seems to have overshot on the way down, just as it did on the way up. But it kept on rising for a long time after it appeared to be defying gravity. That makes it hard to know just how many banks will be left standing when calm is restored.
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