Here comes the credit crackdown

One year into the credit crisis, regulators are hard at work on new laws they hope will prevent history repeating itself. Leading investment banks fear a draconian backlash. By Stephen Foley

You don't lose half a trillion dollars and then go merrily on your way as before. When the dust settles – and we are still stumbling blindly through clouds of the stuff at the moment – the investment banking industry is going to emerge from the credit crisis looking very different. What is difficult is getting an agreement on what it might look like.

The era of the independent investment bank might be over, and the voices that suggest they are ultimately unviable businesses are no longer sounding quite so shrill. Even so, only one thing seems absolutely certain. Investment banking will be smaller.

The industry enjoyed an unprecedented boom, creating and trading a myriad of new financial products, shuffling them between themselves and with a whole new kind of investor, hedge funds with their exotic trading strategies and insatiable appetite for complex ways to lay bets on the financial markets. It was an enterprise that required thousands of new employees on Wall Street and in the City of London, and which generated hundreds of billions of dollars in profits.

It was also inherently unstable. As the trading activities of these banks overwhelmed their more mundane businesses such as corporate advisory work on mergers and acquisitions, jokers used to describe the biggest of them all, Goldman Sachs, as the largest hedge fund on the planet.

In a complex web of transactions, each new financial instrument was laid down as collateral for a raft of investments in other, even more complex derivatives, and in this way banks built enormous businesses on very thin underlying assets. Lehman Brothers, for example, had trading positions open that represented 30 times their underlying assets.

By this miracle of leverage, they reported big profits – but only for a while. Exposed in their folly, all are now scrambling to deleverage and to raise capital. (As an illustration, Lehman is down to gross leverage of 24 times and that number is headed south.)

Even if regulators, shocked by the system-wide failure that the collapse of Bear Stearns threatened in March, don't set new limits on the amount of leverage that can be employed by investment banks, shareholders are doing some of that job already. But with deleveraging comes reduced profitability, and less money for reinvestment.

On top of that, whole swaths of business have disappeared. The fat commissions from creating exotic credit instruments, such as those discredited collateralized debt obligations (CDOs) and auction-rate securities, are likely to be in shorter supply in the future, now that the dangers and limitations of those instruments have been exposed for their hapless investors to see.

The industry itself is considering curbs on the redevelopment of these markets. In a discussion paper earlier this week, a panel of Wall Street grandees, led by the Goldman Sachs managing director and former New York Federal Reserve president Gerald Corrigan, proposed large amounts of new paperwork that should be appended to the sales documents for these instruments, and also suggested a test that would bar all but the most sophisticated institutional investors from buying them. No longer would little municipal pension funds in the US heartland be able to rely on a seal of approval from a credit rating agency, instead they would have to raise an army of risk analysts to examine the instruments they were buying – or, more practically, not buy them at all.

Investment banks will have to "accept changes to market practices, that in the past have generated sizeable revenues but at the cost of weakening the underlying foundation of the markets," Mr Corrigan warned.

The 60 recommendations laid out on Wednesday by Mr Corrigan's policy group are aimed at getting investment banks' house in order so as to prevent a regulatory backlash that could have serious adverse consequences for the industry. The plans also include much stricter oversight of trading desks by risk managers, and a change to the way executives are paid so that much of their compensation is spread over the economic cycle, when the ultimate consequences of their boom-time practices can be judged.

By signing up voluntarily to this industry-wide code of conduct, Mr Corrigan says investment banks can solve their central dilemma: "namely, in a competitive marketplace it is very difficult for one or a few institutions to hold the line on best practices, much less for one or a few institutions to stand on the sidelines in the face of booming markets".

Whistling in the wind, say sceptics. Cutting the size of investment banks is not enough to restore stability, they argue, and these companies are simply too dangerous as standalone entities.

Nouriel Roubini, economics professor at New York University, and one of the most bearish commentators on the credit crisis, says the business model is flawed, since investment banks rely on very short-term funding for their operations, much of it funded in the overnight market, which can dry up.

"The broker dealers that work are those that are part of a bigger conglomerate where there's a commercial bank like JPMorgan or Citigroup and so on, but all the other ones are fundamentally and structurally unstable," Mr Roubini said.

Inevitably, the folk at Goldman Sachs have done more thinking about this than most. In recent closed-door meetings with analysts, its top brass have been dropping clues as to their thinking, and it is clear they have been examining the option of building the investment bank into a wider bank structure, with access to alternative funding sources.

Guy Moszkowski of Deutsche Bank told clients that he would no longer be surprised if Goldman acquired a retail bank, if it could find a cheap one with a substantial depositor base. "These are strange times, indeed," he reported.

Meredith Whitney of Oppenheimer & Co became one of the most feted analysts on Wall Street thanks to her early call that Citigroup would have to cut its dividend and her persistently bearish – and persistently correct – calls that writedowns would continue and emergency refinancings would become common. She too has been in to see Goldman Sachs executives, including David Viniar, the chief financial officer, and John Winkelried, co-president, and she came away believing that the chances of such a dramatic change to the business model are "less than slim". There are simply too many limits on what Goldman could do with any retail bank deposits it acquired.

"With a smile on their faces as to acknowledge the improbability of such a scenario, management stated that the company would be interested in purchasing a bank only if it was able to use the acquired deposits as a funding source for any other part of the business and without additional regulatory scrutiny. Obviously, current regulation makes that scenario impossible."

But there was a caveat, which is that buying a retail bank might be sensible response if the investment banks are slapped with a new regulatory regime that is as onerous as the one under which retail banks operate, with strict capital requirements and oversight. Just such a thing is on the agenda.

So far the Federal Reserve is only "evaluating" the capital positions of the investment banks and"co-operating" with theSecurities and Exchange Commission which is the industry's regulator, but the US Treasury is pushing for the Fed to be given full oversight, since it is on the hook for bailing them out in a crisis.

The shape of a new regulatory regime will determine the shape of the investment banking industry in the future, but we are just at the start of discussions of whether it will be light-touch, or a heavy-handed regime with fixed rules on capital adequacy. For now, the aim is to stumble through the present crisis with no more accidents.

Citi and Merrill in auction-rate securities deals

Tens of thousands of investors left holding impossible-to-sell bonds known as auction rate securities will be able to sell them back to the brokers which sold them, after two Wall Street firms bowed to pressure.

Merrill Lynch said last night it would buy back $12bn of the securities from 30,000 clients, starting in January. Its announcement followed an agreement by Citigroup to refund 38,000 of its retail clients, charities and small businesses, who had bought $7.5bn in auction rate securities. Citi will also pay $100m to settle a lawsuit brought by New York attorney-general Andrew Cuomo, and promised to use its "best efforts" to buy back a further $12bn sold to institutional investors by the end of 2009.

Many investors say they were led to believe that auction-rate securities were the equivalent of cash, only to find they became impossible to sell when the brokers stopped providing liquidity to the market in February.

"Our clients have been caught in an unprecedented liquidity crisis," said John Thain, Merrill Lynch's chief executive. "We are solving it by giving them the option of selling their positions to us."

Yesterday's moves intensify the pressure on UBS, the Swiss bank, to step up settlement talks with Mr Cuomo and with the state of Massachusetts, where it is also being sued for mis-selling auction rate securities. Massachusetts is also pursuing a lawsuit against Merrill Lynch.

Stephen Foley