We're suddenly getting a lot of talk about deleveraging Wall Street -- even, as Jones Day's Robert Profusek told Deal Journal Tuesday -- taking the "L" out of LBO. That's a nifty line that prompts a few skeptical thoughts. Given how confused we seem to be, predicting the long-term future is a pretty risky thing to do. It's true, the run on Bear Stearns Cos. was destabilizing and paradigm-busting, if that means anything. Wall Street has had an entire year to contemplate deficiencies of its business model and the possibility of cosmic retribution for past sins. And the Federal Reserve (as opposed to the Securities and Exchange Commission) will be keeping a tighter grip on leverage through its use of the discount window, however that works out.
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But say leverage went poof. What would that mean? First, you'd remove any reason on earth to invest in a Wall Street firm rather than a more traditional bank or for that matter some mature software giant. A Wall Street firm is not a Wall Street firm without leverage. Without leverage, the game becomes grindingly commoditized, with the advantage going to the entity with the greatest capital. Relatively cheap and "sticky" capital like consumer deposits suddenly get very appealing. Bring retail brokerage back! Cost issues and economies of scale loom large. There's a disincentive to innovate, or to offer cutting-edge complex synthetic instruments, all of which run on fumes of leverage, which really means risk. Even now, it's a little hard to see how Wall Street firms can support their capital and infrastructure without structured finance. This is the box Lehman Brothers Inc. finds itself in: To calm the markets in the short run (maybe to please the new masters at the Fed), it's ratcheted down its leverage. But that may not be enough for it to climb out of its hole. Beyond the we-have-to-save-ourselves game at Lehman, Dick Fuld and the gang have to be worrying about what it will do when they get to higher ground. That applies as well to the rest of Wall Street.
In private equity, the situation is not as dire. Profusek's comment that we won't deleverage, but unleverage, seems a little extreme. If the financial economy as a whole reduces leverage, there will be lower returns across the board. If that happens, PE and hedge funds might retain their marginal advantage over competitive asset classes. The question is: What happens to stocks? The natural arbitrage in PE is with stocks, that is, corporate performance. It's true, if corporate performance and its equity proxy soars, and PE returns fall, then we might see a shift back to public equities by institutions. This would be not only a major reversal of trend, but an indictment of the last four decades of finance, which has argued that complexity and leverage was essential to the efficiency of the real economy.
A further complication: our flat-as-a-pancake (if a bit lumpy) world. Are we talking a global reduction in leverage? That might be nice, but why would anyone who's not in our situation follow along, voluntarily reducing returns? We might live in a global village, but we compete like crazy. It seems like just yesterday that Hank Paulson was ready to dismantle regulation (ha!) because of a few extra IPOs in London. Has that mindset just gone poof too? Are we just going to financially disarm unilaterally? Don't think so.
And why would we be in for such a permanent change of sentiment? The crisis has been wrenching and painful -- and it's not over. Recession may be deep and long-lasting. But for all the legitimate hand-wringing, whether it's David Brooks in The New York Times Tuesday worrying about our debt-addled consumer culture or brave declarations that Wall Street needs to get off its leverage drug, we are talking about behavior patterns that really go back to just after World War II and are rooted deeply in the institutions and instincts of the society. One of those key institutions is the markets, which produces leverage and liquidity, risk and reward (which Deal Journal happily discovered recently). The markets change like the weather. They are never settled; they are always in the process of changing their minds. It's always good to remember that in 1990 those infamous junk bonds were declared dead dead dead, and that that buccaneering experiment called LBOs was close behind. In the immortal words of the late (and only occasionally great) Kurt Vonnegut: And so it goes. - Robert Teitelman
