The Depression-Recession: How We Got Here

In a negative feedback loop, job loses and falling corporate profits are creating new loan defaults, hurting banks beyond the original damage caused by the home mortgage crisis. The banks' falling stock prices together with the loan defaults make it harder for them to raise capital and more reluctant to lend. All of this saps spending by consumers (which makes up 70% of the US economy) and business which results in more job cuts, more loan and mortgage defaults, ... and so the negative feedback loop spirals down. The government keeps threatening to step in to save the failing banks, which raises the specter of nationalization which would wipe-out bank stock holders, who become even more reluctant to buy bank stocks and makes it harder again for the banks to raise capital for loans... And so it goes.

Bank Failures - Then and Now

Over 3000 banks failed during the savings and loan crises, and the run up to it, in the '80s and '90s. By comparison, bank failures post the S&L crisis of the '80s have been minuscule by comparison. But the ones of late have been gigantic in size.

Bank Failures during the S&L Crises of the '80s and Now

Source: WSJ

A Brief History of Investment Banking Firms in the US

Goldman Sachs and Morgan Stanley - End of the Line


Source: WSJ

"It Was Leverage Killed the Beast"

Police Lieutenant: Well, Denham, the airplanes got him.
Carl Denham: Oh no, it wasn't the airplanes. It was beauty killed the beast.

--- Last lines, King Kong (1933) ---

Morgan Stanley and Goldman Sachs Group, the remaining independent Wall Street brokerages, threw in the towel today and converted to traditional bank holding companies, placing themselves under the regulatory supervision of numerous federal regulatory agencies. Instead of being overseen just by the Securities and Exchange Commission, Goldman Sachs and Morgan Stanley will now face much stricter oversight from numerous federal agencies. The Federal Reserve will regulate the parent companies, the Comptroller of the Currency will oversee the national bank charters, and the Federal Deposit Insurance Corp. will likely play a bigger role because the companies are expected to seek much higher volumes of federally backed deposits, and the entities may seek to take customer deposits, instead of depending on short-term borrowing to finance their investments.

The firms will reduce their leverage ratios -- a measure of a firm's risk in relation to the equity on its balance sheet -- over the next two years from current levels to something more in line with that at commercial banks. Investment bank ratios now stand above 20, with commercial banks closer to 10. The combination of easy money, interest rates kept lower than the real inflation rate by the Fed after the dot com bust, Fannie Mae and Freddie Mac incentives to make housing affordable to more Americans, and finally the housing bubble burst, at the core of the problems, that all contributed to the rapid deleveraging of investment banks as their underlying assets crashed in value.

Quarterly Leverage Ratios Trend for Morgan Stanley, Goldman Sachs, Lehman Brothers

Morgan Stanley and Lehman Brothers had leverage ratios above 30 in Q1 2008, while Goldman Sachs had a leverage ratio of 27. For comparison purposes, Bank of America has a leverage ratio of 11, giving it far more assets to back up any troubled investments it makes. Having more assets on their balance sheets allowed the commercial banks to ride out the storm, since they had more resources to fall back on, without having to raise more capital, as their investments declined in value. Much of the investments banks out-sized profits came from this leverage - investing borrowed money in the hopes of getting a great return before having to pay it back. This fueled the out-sized returns of the investment banks during their salad day, and fuled their death pyres during the housing crash. They will be safer in the future, but also have smaller returns, as their ability to bet large amounts of someone else's money has now come a'cropper.