Bigger, badder, bolder - It's the return of Wall Street

Finance:Wall Street began as a no-risk raiser of capital but then grew into high-risk, high-reward money seeking monster that led to the last crash. Despite promised changes, it is carrying on as it did before, writes WILLIAM COHAN

WELCOME TO a sad story about how the more things change, the more they stay the same. In this instalment, we must confront the unfortunate truth that the very power structure on Wall Street that brought the world to its knees during the financial crisis of 2007 and 2008 has been very much – and deliberately – restored (minus a few sacrificial lambs), without the slightest perceptible change to the status quo, despite all the fanfare in 2010 about new laws, regulations and capital requirements.

As a result, it is now just a matter of time – and not long, either – before Wall Street perpetrates another financial crisis of its own clever making, much as it has been doing repeatedly for the past 25 years.

That this will inevitably happen – unless the serious overhaul of capitalism’s plumbing that seemed likely in the fall of 2008 occurs – is not unlike the reason scorpions sting: it is what they were put on Earth to do.

Once upon a time, Wall Street was a humbler, safer place. Its major purpose was to raise capital – either debt or equity – for corporations so that they could expand to meet the demands of the marketplace.

Armed with the new capital, corporations built plants, bought equipment and hired workers. For their trouble – and their relatively innocuous risk-taking – the small, private, relatively undercapitalised Wall Street firms received success fees as part of the transactions, an acceptable price to pay for finding the capital their clients needed to grow.

Eventually, Wall Street also came up with the idea of providing advice to corporate executives to help them acquire other companies, sell off pieces of their own companies or construct game-changing mergers.

The advice business was an even better business than the capital-raising business because it required virtually no capital commitment from the firms themselves.

As for getting paid for its advice, Wall Street was able to convince its clients to pay fees – not unlike those paid for raising capital – based on a tiny percentage of the size of the completed deal.

As the size of the companies grew, their mergers did, too, and the fees paid to bankers climbed into the tens of millions of dollars, for nothing more complicated than offering risk-free, and liability-free, advice. What a great business!

Wall Street’s argument was: “Who could object to a banker being paid a sliver of a deal that would create an era’s new corporate kingpins?” For instance, in 1967, Lazard Frères Co advised the Douglas Aircraft Company on its sale to the McDonnell Company, creating McDonnell Douglas (now part of Boeing). Douglas hired Lazard in late 1966, when the company was near bankruptcy, and Lazard put together a SWAT team of six partners to work diligently between Thanksgiving and New Year to find a buyer for the company. Six bids for Douglas were solicited, and McDonnell was chosen as the winner. Lazard asked for, and received, the first $1 million merger advisory fee for the McDonnell Douglas deal. “Actually,” recalled Stanley de Jongh Osborne, the Lazard partner in charge of the deal, “we were entitled to twice that, under the terms of the contract. But we thought $1 million was enough. Even so, Mr McDonnell wasn’t particularly pleased.”

The modern era of Wall Street behaviour was ushered in, in 1970, when Dan Lufkin, of the upstart firm, Donaldson, Lufkin Jenrette, known as DLJ, announced at his first meeting of the governors of the New York Stock Exchange that DLJ intended to flout the NYSE rules by selling shares in the partnership to the public. Indeed, he had brought with him – and handed out – copies of the IPO prospectus the firm intended to file that day with the Securities and Exchange Commission. The reaction from Wall Street’s establishment figures – Gus Levy, the senior partner at Goldman Sachs and Felix Rohatyn, the senior partner at Lazard – was one of predictable outrage for challenging the status quo.

But what was even more predictable was that one Wall Street firm after another would follow in DLJ's footsteps, unable to resist the lure of cashing out their partners' capital and then substituting in its place the dumb money of new shareholders and creditors.

It was almost too good to be true: Not only would the IPOs make the Wall Street partners fabulously wealthy, but the new corporate legal structure would shield them from the liabilities – up to their entire net worth – they faced on a daily basis as a general partner.

Merrill Lynch went public in 1972. Bear Stearns went public in 1985 and Morgan Stanley in 1986. Despite years of crocodile tears, Goldman Sachs – the powerhouse of Wall Street – went public in 1999. Even the partners of Lazard, with a business model that requires only the barest minimum of capital, could not resist the chance at unparalleled wealth; the firm went public in May 2005.

The denouement of this unprecedented transformation of Wall Street was the loss of the old partnership ethos – where the fear of financial disaster kept the firms small and the risks by-and-large prudent – and the triumph of a new bonus culture.

Suddenly, instead of being rewarded to generate pre-tax profits – from which the partners would get paid – Wall Street's best and brightest were rewarded to generate revenue, from which they would get paid larger and larger bonuses regardless of how the firm as a whole performed. In the new bonus culture, Wall Street firms paid out between 50 per cent and 60 per cent of every dollar of revenue generated in the form of compensation to its employees.

What other large businesses on the face of the earth pays that high a percentage of revenue out to its employees? Did these firms exist for the benefit of their public shareholders and creditors or for the benefit of their employees?

In the old days on Wall Street, genuine financial innovation was rare. But in the bonus culture era, since bankers and traders were rewarded for generating revenue – not profits – Wall Street promised great rewards to those rare individuals who could come up with new financial products that the Wall Street's massive sales forces could sell to generate revenue.

In short order, Mike Milken created high-yield bonds, or "junk bonds" as they were known. His firm, Drexel Burnham Lambert, dominated in this until the rest of Wall Street copied his innovation. Lew Ranieri, at Salomon Brothers, came up with the idea of collecting together streams of cash flows – be they from credit-card payments, auto-loan payments or monthly mortgage payments – and turning the flows into securities and selling them off to investors around the world.

Another – unknown – Wall Street genius came up with the idea of selling the stock of internet-related start-ups – with few employees and no profits – for massive valuations based on the notions of "eyeballs" and rapid growth. Tulips anyone?

In their way, each of the these innovations have been – correctly – justified on the grounds of offering capital at reasonable rates to people and companies that never before had access to it.

But it is also true that in Wall Street's new-fangled generation of no accountability, these innovations rewarded the armies of salesmen who kept selling and selling and selling until one bubble after another inflated and burst.

Milken's "junk bond" bubble ended with the Crash of 1987. The internet bubble ended with the market collapse of March 2000. Ranieri's securitisation bubble didn't end until 2007 and 2008 when the market could not tolerate one more fatally flawed, overly engineered mortgage-backed security, and nearly took the whole idea of Wall Street with it.

The boom/bust cycle that has characterised the last 25 years on Wall Street will continue unabated unless and until financial accountability – similar to what used to exist when Wall Street was a series of private partnerships – has been restored along with the status quo. Human beings' behaviour is simple to predict: we all do what we are rewarded for.

As long as Wall Street's bankers, traders and executives are rewarded for generating revenue – as they continue to be – not a single aspect of their behaviour will change.

Until, say, the top 100 executives – those that make the decisions about how to deploy capital and who to hire, fire, promote and pay – of the remaining Wall Street firms once again have their entire net worth on the line every day and are held accountable for their actions and those of their colleagues, we might as well just start counting the days until the next – utterly avoidable – financial meltdown takes us all by "surprise".

William D Cohanis author of House of Cards, and a former Wall St former investment banker at JPMorgan Chase and Lazard Ltd. His previous book, The Last Tycoons, won the FT/Goldman Sachs Business Book of the Year