Giving Up the Ghost of the Ghost of J.P. Morgan

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While being raised in rural Minnesota, we learned that "giving up the ghost" meant some person or animal had died, was no more and had passed. Today we are learning that this is no longer the case when the phrase is used in conjunction with the animal known as "investing banking" — at least in the minds of those who work on Wall Street in New York City and on Pennsylvania Avenue in our nation's capitol.

The best history of the rise of investing banking in America is Ron Chernow's book, The House of Morgan. This chronology (voted in several polls as one of the 100 best nonfiction books of the twentieth century) of J.P. Morgan and the bank he left behind traces developments for over one hundred years from the late nineteenth century onward.

At the beginning of this financial era, there was a mismatch between America's opportunities to grow its economy and the available capital in this country to finance that growth. Most surplus capital at the time was in Europe and J.P. Morgan took the lead in helping foreigners allocate this scarce capital to America's most worthy railroads, manufacturers and so forth during this timeframe.

Without people like Morgan to pass judgment on America's emerging industries, money from foreigners would simply not have been made available to fund these enterprises. As a result, railroads and manufacturers made repeated visits to America's investment banking houses — as opposed to the bankers seeking them out — to argue why their businesses were worthy of obtaining this capital.

Ron Chernow recently summarized the role played by Morgan and his ilk in an op-ed article he had publish in the September 28, 2008 edition of the New York Times: "They rendered America an invaluable service by reassuring European investors that they would receive an adequate return on their investments, securing an uninterrupted flow of capital" to this country at a time when our economy sorely needed it.

The original House of Morgan and other investment banks originally served only the most creditworthy clients whether they were industrialized nations, blue-chip corporations or millionaire families. The Glass-Steagall Act of 1933 forced the full-service banks of the past to choose between commercial and investment banking. The House of Morgan was split, for example, into two separate entities — a commercial bank (J.P. Morgan which later became Morgan Guaranty) and an investment bank (Morgan-Stanley).

Most of the capital from such splits, however, was retained by the commercial banks. This was in no small part due to fact that the need for investment banking services was so diminished during the Great Depression.

Although only the "ghost of J.P. Morgan" in the form of thinly capitalized investment banks survived World War II, they continued to exert a near mystical influence in American finance far beyond their real worth to the country's leading businesses. Companies like DuPont, I.B.M., General Electric, United States Steel and General Motors thrived in the initial decades after 1945 primarily because of the devastation caused by the preceding war in Europe and Asia.

American companies became so successful that they grew big enough to finance expansion from their own retained earnings. As the United States — and, later, the rest of the industrialized world — boomed, other borrowing options that did not require the services of investment banking firms became at first viable and then commonplace.

In the last three decades prior to 2008, traditional underwriting services at investment banks have been systematically replaced by ever more volatile and risky businesses promoted by the remaining firms. Examples of these enterprises have included increased trading activities (for stocks, commodities and derivatives), hostile takeovers, leveraged buyouts, junk bond issuances and prime brokerage services for hedge funds. Rather than allocate investment capital as they once had, investment banks had ever-greater needs to raise it for themselves to finance one risky venture after another. Chernow says, "Where the old Wall Street stuck to the most prestigious clients, the new Wall Street engaged in an unseemly race to the bottom." How low would they ultimately go? How about the packaging of subprime mortgages (what James Grant of Grant's Interest Rate Observer calls "junk mortgages") into collateralized debt obligations (CDOs) rated AAA by friendly rating agencies?

Why "save" Bear Stearns, Merrill Lynch and Morgan Stanley and/or subsidize commercial banks to take them over? Who needs these clowns anymore? Let them go the way of buggy whip manufacturers. They long ago stopped serving their original useful purposes. Any important remaining services they provide will be assumed by some other parties. Their best talent will surely find employment elsewhere. Why cannot public policymakers like Henry Paulson see these obvious facts? Oops! That's right…Paulson was the head of one of those "leading" investment firms at one time himself. And the fact that the head of Merrill Lynch once worked for him might explain while that firm was bailed out and Lehman Brothers was allowed to fail. So it goes.

November 13, 2008