Monday, September 22, 2008

The Death of Wall Street


Since when did weekends become the normal occasion for dumping unprecedented economic news on us? For the … oh, I've lost count … maybe third weekend in a row, financial markets were inundated with news that's bound to shift our economic landscape for ages to come.

Here's the latest:

It's over 
That's right. It's done. It's over. Wall Street as it's been known for decades got a dramatic makeover this weekend as the remaining independent investment banks -- Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS) -- gained approval from the Federal Reserve to be recognized as bank holding companies.  

What's that mean? For starters, both companies will be permitted to form deposit-taking entities, which will allow them to replenish their balance sheets with a more stable source of capital than the short-term funding they had been relying on.

Good news, right? For most, absolutely. The moves should squelch any remaining fear that the last two independent Wall Street banks are on their death beds, and that ought to (cross your fingers) restore a sliver of confidence in the financial system.

But yes, in many ways, this marks the death of Wall Street as we knew it. Under the new regulations, Goldman and Morgan Stanley will be required to meet strict capital requirements and fierce oversight, and that means the days of being allowed to leverage from here to Timbuktu are over -- and good riddance. In short, that means an end to a good chunk of previous profit streams.

Recently, Goldman was leveraged about 24-to-1, while Morgan Stanley was leveraged nearly 30-to-1. Under their new structures, they'll probably have to scale back to become more in line with the likes of Bank of America(NYSE: BAC) and JPMorgan Chase (NYSE: JPM), which were leveraged about 11-to-1 and 13-to-1 last quarter, respectively.

R.I.P., recklessly made profits.

Bailout update 
We're getting our first glimpse of how much the mother of all bailouts could cost taxpayers, and it isn't encouraging: $700 billion -- or about $2,300 per person.

First, an important point that hasn't been brought up enough lately. Whatever the final cost to taxpayers will be, it's bound to be less than the amount of credit extended to the bailout program. Once the Treasury starts buying bad assets from banks, it's of course going to make an attempt to resell what it can back to markets, albeit at some unknown price and an unknown time. And yes, these assets still have value. The bad assets clogging the debt market are worth less, not worthless.

The answers to three very important questions regarding the bailout remain unknown: (1) at what price the Treasury will buy assets from banks, (2) how much the Treasury will be able to re-sell those assets for, and (3) what kind of magic trick the Treasury has planned to raise $700 billion without sending the economy into an inflation-driven bender. Until answers to those three questions are hammered out, there's absolutely no telling what the final cost to taxpayers will be.

Perhaps the worst idea I've ever seen 
Australia took one of the most excessive market-intruding actions a free-market economy has seen in recent memory after banning all short-selling. No, not just a collection of financial stocks like American markets did last week … the Aussies simply abolished short-selling altogether.

Please, oh, please, regulators, if you can hear me, don't follow our friends down under. Sure, eliminating short-selling on financial companies will be a short-term boon for companies such as Washington Mutual (NYSE: WM),Wachovia (NYSE: WB), and Citigroup (NYSE: C), but ask yourself some questions: How much of that increase is artificial? Once the ban ends, what happens? How much of the recent run-up has been caused by short-sellers covering their positions? Doesn't eliminating short-selling reduce liquidity, and, hence, couldn't it exacerbate some of our current problems?

As a fellow Motley Fool contributor joked last night, what's next … a ban on selling stocks altogether? In a week where the unthinkable has become reality, all options are on the table.

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