Every once in a while I feel compelled to put my economics degree to use. This is one of those times.
There’s a tremendous amount of pain around the collapse of Lehman Brothers. I don’t want to belittle or take attention away from that pain. I have been in two market collapses myself (Latin American stock markets in 1994 and the internet business in 2001) and it is not fun.
But there is a silver lining in the collapse of Lehman. Lehman’s bankruptcy, along with Bank of America’s purchase of Merrill Lynch and Bear Sterns disappearance are the end a particular type of business: the large scale broker-dealer investment bank. These banks made huge amounts of money in secondary markets for stocks, bonds and financial products derived from other underlying assets. The money in these markets is primarily traded among participants in those markets. It does not directly go to the companies, governments or people whose name might be on those assets.
For example, when somebody buys a share of Coca-Cola, Coca-Cola itself does not get any money from that transaction. It is made between a buyer and seller of that share. The seller gets the money. The buyer gets the share. Coca-Cola gets nothing. Similarly, when another bank buys your mortgage from the company that originally provided it to you, you don’t get any money. It’s simply a transaction between two banks.
To be sure, the secondary market has a role in the ability of companies, governments or people to raise money. A lender or initial buyer is more likely to give you the money to start with if they believe they can easily unload that loan/sell it to someone else at a good price. But ultimately, they are not giving you the money because they think it’s a good place to put money. They are giving you the money because they know they can easily flip it for a decent profit to someone else. In economics, this is called the greater fool theory. There will always be a greater fool to buy it –until there isn’t.
And the broker-dealers became the greatest fools. There was no-one else to sell it to. They were the end of line.
The why’s of what drove the broker-dealers into this kind of risky decision making lay in the deregulation of commissions on stock trades in 1975 and the repeal of a Depression era piece of legislation called the Glass-Stiegel act. Those are for another blog post.
What’s important now is that with the demise of the big broker Wall Street business model, traditional banks can grow the amount of money they have on deposit. And this is good for entrepreneurs and small business in America (the backbone of the US economy). Unlike a broker-dealer, a traditional bank (like Bank of America) makes it money by keeping money for people or companies and lending a percentage of it directly to other companies or entrepreneurs with ideas for real businesses. There’s little room for a greater fool. A company or person’s assets are often directly on the line in these type of loans. It’s money that has to be paid back. It is also a source of financing that is more accessible to a small business person, shop owner or parts manufacturer. That small business person, in turn, needs to put that money to work in something that will directly produce more money –not through flipping it but by turning into a product or service that people will pay for. America is a country full of energetic, creative, hard-working entrepreneurs and business people. The increased availability of bank lending can help unleash their energy.
The stock market and the secondary market of bonds and mortgages have not disappeared and should not. They are important parts of the Economy’s engine for growth. What has changed is certain participants in these markets are no longer there. These participants had a lot of money. But they also had incentives to make bad, unproductive decisions –decisions based on the finding a greater fool.
In the short term, the market for bank financing may tighten as the greater fool based money sources are weeded out of the system. The pain this will cause and how long it will take are going to be affected by the government bailout. Specifically, is $700 billion going to be enough? Will the new regulations protect smaller investors yet still let Wall Street pass away? But in the long term, the demise of Wall Street should be a good thing for bank lending and the investment of capital in truly productive assets which can sustain growth in the US Economy for years to come.