Ever wonder how Wall Street bankers manage to make tens -- and sometimes hundreds -- of millions of dollars? How do people who really don't produce anything manage to siphon such gigantic sums from the pockets of the people who produce goods and services -- who actually create the wealth?
The answer is that they have managed to gain almost monopolistic control of the keys to world financial markets, to sources of capital that are necessary to finance equity investments and bonds for everyone from the largest international corporations to new start-ups.
But, you may ask, how can this be? In the kind of competitive financial markets envisioned by Adam Smith, competition should create multiple gateways to these capital markets. What's more, price competition should prevent massive overcharges by the underwriters of big financial deals.
On Friday, Aug. 20, Washington Post financial columnist Steven Pearlstein published an insightful article examining the reasons why there is so little price competition on underwriting deals between Wall Street's big banks.
He points out that the big investment banks would normally stand to make almost $450 million in fees on the $15 billion stock offering by General Motors. In this case, though, the federal government owns most of the stock. Goldman Sachs -- convinced that it would never be named lead underwriter because of its legal and PR issues -- decided to do something that is never done on Wall Street: undercut the fee structure. It shocked its rivals by violating an unwritten law of the investment banking world -- it engaged in price competition.
It turned out that Goldman's competitors Morgan Stanley and J.P. Morgan got the opportunity to underwrite the offering. But the Treasury Department insisted that they do so at Goldman's price -- .75 percent of the stock sale -- which is one quarter of the normal fee.
Now even three-quarters of a percent is a huge haul of $112 million -- but it's not $450 million.
The normal fees charged by investment banks are 6 to 7 percent for deals of less than $200 million, 4 to 5 percent for middle range deals, and 3 to 4 percent for those more than a billion. Pearlstein explains that the fee structure is divided into three pots:
Twenty percent is an underwriting fee for the banks' guarantee that they will buy the entire issue even if nobody else will. That was once an important consideration, but in today's markets, the investment banks ensure that no IPO goes forward unless it is pre-sold. As a result, the underwriting fee is now a pure windfall.
Sixty percent of the fee represents a sales commission, which also turns into something of a game, particularly when it involves highly desired shares of well-known companies such as GM. Since all the major relationships with all the major institutional buyers, it's hard to say which sales force actually makes the sale. So once Fidelity or TIAA decide how many shares they want to buy, they can divide the commission among the investment banks any way they choose...
The final 20 percent is the management fee, which goes exclusively to lead underwriters. This is for helping to prepare the prospectus, organizing the 10-day road show to market the issue to prospective buyers, keeping the order book and advising the company on the offering's price and size. For a big deal such as the GM offering, it might involve incredibly intense work by as many as 30 professionals for as long as four months -- let's say generously, 30,000 hours of work. On a $15 billion IPO, that works out to $3 million per banker, or $3,000 per hour worked.
Not bad pay. These "masters of the universe" make more money in six hours than a minimum wage worker makes all year.
But the question is, how can they demand such massive fees? Do they have special skills that are so rarefied and valuable that they can demand such numbers? Are they the intellectual equivalent of precious stones?
Of course not. They do it the old fashion way. They have cornered the market. Pearlstein notes, "A handful of established firms control access to global financial markets and use this power to extract monopoly-like profits and funnel them to their executives and employees."
These firms don't engage in price competition because they have a "gentlemen's agreement" between them not to kill the goose that lays the golden egg. If one of them starts undercutting the other they will drive down these fees and all of them will see less money.
The big Wall Street banks can limit the size of the investment banking club because it is very difficult for upstart firms to establish themselves. Part of the issue is size. And these firms have managed to convince potential clients that if they go around Wall Street's gatekeepers -- say, selling IPO's at auction as Google successfully managed to do with its IPO -- they will not get full price for their offerings.
In addition, with the end of the Glass-Steagall Act that once put a firewall between commercial and investment banking, companies worry that if they cut the investment banks out of the deal, they will be charged higher prices for their loans. Bundling of services is a classic means of fending off market entry from lower-priced competitors.
Pearlstein argues that one way to break through this semi-monopoly pricing structure is for companies themselves to do what the Treasury did -- demand lower prices from their underwriters. But they haven't done it up to now, and there is no reason to expect they will take that risk any time soon.
Why, you might ask, should anyone care if a big corporation pays a huge fee to investment bankers? Because the money they pay really represents the control of a huge quantity of the society's goods and services. For the corporations in question it becomes a cost of doing business that is passed along to the average consumer. And, of course, these fees represent dollars that the corporations might pay to their employees who are paid maybe $25 per hour, instead of $3,000 per hour that goes to the Wall Street bankers. Remember each "Wall Street Banker hour" (at $3,000) represents 120 hours of an employee who makes $50,000 per year.
In either case these are dollars siphoned out of the hands of everyday Americans who work for a living producing the goods and services of the economy -- and concentrated into the pockets of a tiny elite on Wall Street. And mostly they are not paid for adding value to a product or service. They are paid a toll for having gained semi-monopoly control of the gateway to financial markets. They are the sophisticated version of a bunch of bandits who stop you on the road and demand to be paid before you can pass.
The only way to end this oligopoly of corporate finance is government action. It is just one more compelling reason why the big Wall Street banks should be broken up and we should reimpose a strict firewall between commercial and investment banking.
The new Wall Street reform bill went a great distance to rein in the power of the big Wall Street Banks. Now Congress must take the next step.
The government must set up new rules to assure that corporate finance is a competitive marketplace. It clearly isn't today and will never be so as long as a few gigantic players are allowed to maintain "gentlemen's agreements" not to compete on the basis of price. Congress needs to act to break these institutions up, and the Antitrust division of the Justice Department should take action to enforce the antitrust laws.
And that isn't the only reason to break up the big Wall Street banks. There is no real competition in the credit card sector either. The top three issuers control 52.82% of the market (JPMorgan Chase 21.22%, Bank of America 19.25% and CitiBank 12.35%). Add American Express (10.19%) and Capital One (6.95%), and it becomes clear that five firms control almost 70% of American's credit card market.
The new Wall Street reform has gone a long way to prevent the kind of recklessness and financial sector meltdown that collapsed the economy and cost eight million Americans their jobs. Democrats passed that bill over virtually unanimous Republican opposition, on the strength of massive public support. There is plenty of political support among the voters to take the next step and break up the monopoly power of the big Wall Street Banks.
After all, the only way to completely guarantee that no financial institution is ever again "too big to fail" is to invoke the yardstick that if it's too big to fail, it's simply too big.
For a long time a group of sharp guys and gals on Wall Street have run one hell of a game on everyday Americans. We've been played for chumps. Isn't it time for us to wake up and end a system where a few Wall Street Bankers have a license to siphon money out of the pockets of the middle class?
Robert Creamer is a long-time political organizer and strategist, and author of the recent book: Stand Up Straight: How Progressives Can Win, available on Amazon.com.
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