It's the end of an era. The big Wall Street investment banks that survived two World Wars, the Great Depression and the Asian financial crisis were taken down by single-family housing. Lehman Brothers is bankrupt, Bear, Stearns & Co. had to be rescued, Merrill Lynch sold itself to Bank of America and Morgan Stanley and Goldman Sachs converted to bank holding companies.
From residential and commercial mortgage-backed securities (CMBS) to collateralized debt obligations the big five investment banks sliced, diced, and packaged, making a lot of money for themselves and investors — until everything went haywire. At the apex the investment banks were voracious in originating or buying loans and then pushing them out the door in securitizations. The bounty for them was the fees they reaped. When the whole thing came crashing down, banks were sitting on billions in toxic loans they had not yet been able to put into new securities.
Most of these loans — now rotting as delinquencies and defaults rise — remain stuck on bank balance sheets. CMBS originations are down 98 percent. At the end of the third quarter, Goldman sat on $14.6 billion in commercial real estate assets including securities and whole loans, Lehman on $24 billion, Merrill on $19.2 billion and Morgan Stanley on $19.5 billion, according to research by Sanford Bernstein and Co., Inc.
A year ago, the entire industry thought the freeze on the securitization machine was just temporary. Today, however, there are real questions about whether the CMBS industry will ever again grow to be a $230 billion domestic business as it was in 2007.
The more optimistic analysts believe the movers and shakers will create new investment banks. And, these newcomers will be smarter, faster, and produce better-looking securities, says Ryan Krauch, principal of Mesa West Capital, a Los Angeles-based lender. “Investment banking and securitization are both viable models — they just need to be tweaked,” he says. Others aren't as sure.
In a best-case scenario, the new investment banks will hopefully know that being over-leveraged is a death wish and won't make the same mistakes of gambling $30 for every $1 they had, says Bill Conerly, president of Conerly Consulting, a Portland, Ore.-based financial consulting firm. However, the danger of over-leverage has cropped up repeatedly during the past two decades from the corporate raiders of the 1980 to notorious hedge fund Long-Term Capital Management in 1998. Despite these near misses in the past, investment banks got drunk on debt.
One idea that's being bandied about is that if investment banks get back into securitization, they should be required to hold equity in the issuances they produce. This will force a greater level of scrutiny on the assets. This will also mean investment banks will be held accountable and can't just wash their hands of the securitizations once they've made their fees, says Elizabeth Corey, chair of law firm Foley & Lardners' Real Estate Practice.