Wall Street's passages

Maybe we should revisit the case of Sandy Weill. For the past few years, Weill, the now-retired and very wealthy Wall Street dealmaker, had been dismissed and derided. His greatest creation, Citigroup Inc., was awash in bad mortgages and losses, and the strategic concept Citigroup embodied, universal banking, was rejected as unwieldy, unmanageable, the result of a kind of dealmaking hubris gone mad.

Of course, that was before Lehman Brothers Holdings Inc., in the mere flash of the eye, plunged into bankruptcy, Merrill Lynch & Co. was acquired by Bank of America Corp., and the Federal Reserve saved American International Group Inc.

But it's not just that Weill's favorite idea had come startlingly back in favor (whether it's a good idea for the ages remains debatable). It's also the fact that Weill's unusual blend of M&A derring-do, obsessive cost-cutting and operating caution -- a style practiced by former protégé Jamie Dimon, CEO of J.P. Morgan Chase & Co. -- suddenly seems prudent, if not wise. Who can tell whether Weill would have piled into mortgages as excessively as his now-fired successor, Charles Prince? But on a Wall Street gripped by the siren call of leverage and liquidity, Weill was always an outlier, opting to restrain leverage and seek greater size and diversity -- the source of the now famous, or infamous, financial supermarket.

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In this market, Weill looks seerlike again. Size is viewed as essential to survival, universal banking is the rage and, apparently, if the Federal Reserve has anything to do with it, reduced leverage and smaller bank-type profits will prevail.

We are living through strange, transformational times when up is down, left is right. A Republican administration finds itself forced to pile up financial assets like a nationalizing potentate run amok. On Wall Street, where deregulated markets are the very dogma of life, firms, urged on by a theoretically independent Fed (which seems to take instructions from Treasury's Henry Paulson), have in their desperation banded together in a kind of socialist brotherhood to save what they can, recreating a pre-1930s banking sector. The collapse of Bear Stearns Cos. was shocking but "explained" in the press by the wayward psychology of Jimmy Cayne. Such an explanation didn't fly at Lehman, which plunged into mortgages and proved too small to survive. But the rapidity with which Merrill Lynch sought out Bank of America, erasing the third of the five "independent" Wall Street firms, shocked even the most hardened of observers. And then there was AIG.

But step back. In truth, the weekend Lehman died represented the final end of the long battle between commercial and investment banks that had its origins in the Great Depression and saw its sharpest conflicts in the '90s. For years, investment banks seemed to more than hold their own; certainly, investment bankers had it all over commercial bankers in terms of prestige, pay, tailoring. The attraction to investment banking was embodied by commercial bank J.P. Morgan & Co.'s desperate drive to turn itself into one. But in the end, size, capital and diversification -- Weill's mantra -- seems to have triumphed. J.P. Morgan disappeared into the maw of Chase Manhattan in 2000. Now only Goldman, Sachs & Co. and Morgan Stanley survive, and, as of press time, that was an open question.

In retrospect, it had been clear since the late '90s that the independents were losing ground to the big banks, all of which had made significant acquisitions of investment banks. Citi, J.P. Morgan Chase, UBS, Credit Suisse Group, Deutsche Bank AG made runs up the league tables, despite their sporadic integration or operating woes. In particular, the big banks used their balance sheets and financing clout to elbow into deals. The independents scrambled to keep up, expanding their capital base and piling into higher risk-reward business, like principal investing, trading or securitization. That evolution, fueled by free-flowing liquidity and leverage, gave these firms the reputation, not undeserved, of acting like hedge funds. In fact, they might well have piled too much risk and too much leverage atop too little capital, all to feed escalating compensation demands from within and public equity market demands for growth from without.

These firms found themselves in a squeeze. Beneath them grew a tangle of hedge funds, private equity shops and hybrids. On top loomed the big banks. Wall Street had always struggled as profitable product lines commoditized under the pressure of competition. But now that cycle accelerated as firms, many private and amply fueled by institutional money, arbitraged away profits, driving public firms out on the risk curve. Talent was also drawn to hedge and buyout funds. In this context, the dominance of a firm like Goldman Sachs was even more remarkable. But the rest of the independents, and a number of banks, were drawn so deeply into the highly profitable mortgage game that they couldn't escape when the tide turned.

The Washington regulatory system was slow to adjust to the changing realities; that's been obvious for a while but a burning crisis only in the past year or so. Now the New Deal regulatory scheme looks as bankrupt as Lehman, with once-powerful agencies like the Securities and Exchange Commission wandering about in search of a mission or a meeting. Time and again, crisis after crisis, Treasury and the Fed teamed up to try to manage the spreading disaster. Lehman got the brushoff, but the feds stepped in to save AIG, putting the Fed and Treasury itself in a fiscal bind.

What is apparent is that every crisis has spawned new sets of unintended consequences. The Fannie Mae and Freddie Mac bailouts seemed to have brought an end to the feds' appetite for what the newspapers piously refer to as "taxpayer" money. But by then the crisis had its own self-generated momentum. The bailout of the Federal Home Loan Mortgage Corp. and the Federal National Mortgage Association may have released shorts to renew their attacks on Lehman, particularly hedge funds that lacked other, more promising strategies, or simply frightened institutions. When Lehman failed, and Merrill jumped into BofA's arms, selling pressures, now well beyond the shorts, swung toward AIG, Goldman Sachs and Morgan Stanley. Other targets, notably Washington Mutual Inc., loom. The market has seemingly decided that Wall Street's independent firms, with their need to finance themselves in the short-term markets, had to go, gas guzzlers in a world suddenly, inexplicably, without oil.

Still, before one leaps to any glib conclusion about the demise of Wall Street, consider a few things. Wall Street is a set of functions as much as a collection of institutions. The markets will not disappear, or even shrink very much. Advisory, research, underwriting, market operations, initial public offerings will still need to be supplied to a large, lively and lucrative corporate sector. The talent exists to fulfill these needs; the question is where will they work? And just because the whirlwind has knocked down some storied institutions, there is no guarantee that the desire to bet high risk for high reward has disappeared. Not only are there many Wall Streeters who remain eager to play that game, there is a proliferating base of institutions, here and abroad, eager to pay for performance. The speculative impulse has also not expired -- it's not even hiding; that impulse still drives change. And so the mantra (which may not be very popular on Main Street) in these anxious days should be: Wall Street is dead. Long live Wall Street.

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