Wall Street follies

2008 marked the end of Wall Street's "Masters of the Universe" phase -- roughly three decades of head-spinning financial engineering, astronomic compensation and an intricate global web of deal-making. By year's end, New York's five largest investment banks had collapsed, been acquired or been transformed into more tightly regulated entities. A liquidity crisis caused Bear Stearns Cos. to be snapped up in March by bank holding company JPMorgan Chase (with an assist from the Federal Reserve) at a fire-sale price. Lehman Bros. went bankrupt in mid-September, just as Merrill Lynch was finding refuge in the arms of Bank of America. Before the month ended, Goldman Sachs and Morgan Stanley had become bank holding companies{CB72201A-A795-4C78-8F68-E64DAA26398D} to ease concerns about their ability to raise money.

Although some boutique investment banks remain, the changes at the top of Wall Street mean that federal regulators could have much more influence over the way credit is supplied in this country. For example, the Federal Reserve will now cap how much the erstwhile investment banks can borrow against the assets they hold -- in essence, preventing them from using so much borrowed money to make new investments. Such restrictions will limit both the risk they can take on and the profits they can hope to make. It's a dicey time to clamp down on the borrowing that supplies money for loans; after all, lawmakers have been pressing banks to provide more credit with the aid they received from the Troubled Asset Relief Program, not just to solidify their balance sheets. Yet had these restrictions been in place five years ago, Wall Street wouldn't be in such deep trouble today. Washington is likely to impose more dictates this year on the banks and Wall Street firms that received billions of TARP dollars -- a rescue effort that made taxpayers a major stakeholder in the financial industry.

There certainly are steps that Congress and state legislatures should take to guard against future boom-and-bust cycles, such as the one in housing that proved so costly to the financial industry. Still, it's worth bearing in mind that Wall Street's meltdown was caused largely by financial offerings that were designed to reduce the risk of big losses. In the heyday of the savings and loan industry, lenders issued mortgages in the communities they served, then held onto them as investments. If the real estate market in its community tanked, the lender was in trouble. One way to mitigate that risk was to pool mortgages from multiple communities and sell them to investors. Wall Street came up with numerous variations on this theme, carving up pools into more and less risky tiers for investors seeking higher returns or more stability. It also developed techniques for guarding against losses by selling what amounted to default insurance ("credit default swaps"), as well as offering investors the chance to assume the profits -- and losses -- from this insurance (through "synthetic collateralized debt obligations").