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Robert Teitelman

Robert Teitelman

Posted: July 15, 2009 05:30 PM

Goldman, J.P. Morgan and Wall St.'s Original Sin

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Every high school biology student (if they're awake) knows the story of the famous experiment concocted by Columbia's Harold Urey many decades ago. Urey used a set of basic inputs -- heat, electricity, water, some basic elements -- to simulate the creation of the first organic compounds in a flask. That's what today feels like: a simulation. The question before us is not how life began, but how did we produce the kind of large, conflicted, high-pay firm that was a prime actor in the recent debacle? What is the origin of Wall Street's sin? And, just as importantly, who or what is responsible (the media, Wall Street, regulators, Congress): a Matt Taibbi conspiracy involving Goldman, Sachs & Co. (NYSE:GS), orchestrated deregulation, out-of-control compensation or a far more complex Harold Urey-like evolution?

The evidence for all of this comes from a handful of pieces written for Wednesday's papers, focusing on everything from Goldman's spectacular earnings and return to sky-high comp, to "swaggering" J.P. Morgan Chase & Co. (NYSE:JPM), which is reporting earnings Thursday, to the matter of Wall Street's boutique banks. The thread that runs through all this is that growth is not only good but necessary for survival. The Financial Times surveys Wall Street's suddenly robust collection of boutiques, which seem, given the debility or disappearance of much of bulge-bracket Wall Street, to be picking up advisory market share -- though it doesn't emphasize that they are fighting over scraps of a pretty lousy M&A market. But the theme the FT keeps returning to is the need to grow, following the well-worn path of firms like Goldman and Morgan Stanley (NYSE:MS) from private partnerships to giant, integrated, capital-rich and publicly owned operations.

The FT casts the urge to remain small and private as a naïve pipe dream. "It may be hard," writes the FT, "for boutique bankers' romanticized views to translate into growth unless they expand into other lines of business." M&A is cyclical, and those cycles have to be smoothed with asset management or private equity, argues the paper. They require capital, which means going public. Once you go public, the demands of shareholders drive firms to further growth, complexity and conflict. The FT quotes Peter Solomon, the former Lehmanite and, since 1989, head of his own eponymous and still-private boutique: " 'There's an inevitability about being public. It means you have to get bigger to build more earnings per share. When you go public, you cross over a line that is antithetical to some of our views.' "

Maybe yes, maybe no. Lazard survived for many decades as a private partnership operating with a very thin layer of capital, despite continual predictions of doom. True, that was then, and today, under Bruce Wasserstein, it's public, with balanced restructuring and M&A advisory businesses -- neither of which requires the kind of capital required to buy its way into deals. Inevitability is a word everyone should use a lot less.

That said, the implication of all this is that generally investors reward growth and greater size, which undercuts the notion that shareholders were somehow innocents gulled by opacity and complexity into pumping up shares of the big banks in the bad old days. They liked big then, and they love it now. The Wall Street Journal makes it very clear the merits of a growth equation at J.P. Morgan, quoting a recent report from Sanford C. Bernstein's John McDonald: " 'While some banks have spent the cycle shrinking to survive, J.P. Morgan has been investing, acquiring and expanding.' " That relative health means the big bank can get even bigger, pleasing shareholders as it throws its weight around.

All these themes converge on Goldman Sachs. All the stories today about Taibbi's favorite firm suggest how its size, capital and sheer power allowed it to take advantage of diminished competition in its class. The links between its earnings and compensation are very clear (and the fact that Goldman and J.P. Morgan paid off the TARP is too). A Wall Street Journal editorial draws out other links as well: the advantages that a systemically important institution like Goldman (or J.P. Morgan) has over a relative pipsqueak like CIT Group Inc. (NYSE:CIT). The WSJ may go a bit too far in describing Goldman as a Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE), but the point remains valid: It's difficult to say that the government does not favor the largest institutions in a variety of ways.

The conclusion here may be obvious but its implication may not be: There are powerful forces from all parts of the public and private arena driving firms to grow larger. The crisis has not affected those underlying factors, which involve a remarkable alignment of interests: managers, boards, investors and the government. This pressure to align runs throughout finance. The fact that so few successful firms, even boutiques, have remained private partnerships, suggests how powerful are the forces creating a Wall Street of highly leveraged giants. But was this, as Taibbi argues in his Goldman takedown, a conspiracy of a single firm? Was this structure engineered by senior managers simply to pump up compensation? The evidence doesn't support either of those arguments (that's not to say, however, that great size doesn't generate great influence, as in Simon Johnson's oligarchy thesis, though that's an argument still in search of real evidence).

Growth and gargantuan size seem to be an evolutionary process that probably launched with the first deregulation of markets in the '70s, impelling firms to seek more capital to gain greater market heft. Example: With the freeing of brokerage commissions in 1975, brokerage firms needed greater size to shift toward a volume business. That commodization occurred across various, and proliferating, businesses, and it extended across multiple generations. It was fed, in turn, by pressures like rising technology costs and -- call this a feedback loop -- compensation expenses, both of which required increasing size; globalization also played a huge role. The counterargument to Taibbi and the comp conspiracy crowd is that Wall Street and the banks needed ever-greater droughts of capital and jolts of leverage because their core businesses were rapidly commoditizing. In fact, the very production of leverage and liquidity spawned more competition and more rapid product cycles, another feedback loop. Finally, the massive machine overheated and broke down.

Those forces, however, still exist and are still operating. The crisis has cleared some space around the biggest banks like Goldman Sachs and J.P. Morgan, enabling those lucrative earnings. But as new competitors arise again -- Blackstone Group LP (NYSE:BX), say, or Fortress Investment Group LLC (NYSE:FIG), or other up-from-boutique firms -- that commodization will accelerate again. That's the underlying problem that no one talks about or seems to have a clue about remedying. - Robert Teitelman

The Wall Street Journal Story
The Financial Times Story
J.P. Morgan Earnings Preview
Goldman Sachs Group Earnings

Robert Teitelman is the editor in chief of The Deal.