The Bear’s Lair: The investment banking down cycle

Goldman Sachs’ (NYSE:GS) second quarter income falling 47% with threats of job cuts is just the beginning of a major downtrend in investment banking, reversing the surge of 1982-2021. This should not be a surprise: it has happened three times before. The most recent occasion was after the 1968 stock bubble; that crash was short. The two longer-term declines were after the 1929 stock market crash and the 1720 South Sea Bubble. The three downturns have interesting lessons for today’s investment bankers now seeking a new line of work.

In a sense, the investment banking surge ended 14 years ago. The financialization of the U.S. economy between 1982 and 2007 was extraordinary; it involved major new product areas such as derivatives and securitization and saw investment banking techniques push into many areas of the economy that had hitherto been immune to them, with industrial companies hedging commodity prices, playing derivatives games, granting copious stock options and indulging in massive stock buybacks, all of which cast a pall of fog over the real returns and profitability of the industrial sector.

The investment banking industry’s creativity largely ended in 2008, when many of its products were shown to be dangerous scams and its risk management was shown to be a travesty, but the funny-money years of the 2010s prolonged the investment banking boom artificially. While trading revenues did only moderately well, deal fees exploded, with the plethora of hedge funds and private equity funds ensuring a steady stream of bumper revenues. Entirely new scams involving Special Purpose Acquisition Companies (SPACs) were devised, boosting fees still further – except that these scams were not really new; they had been equally prominent in the 1690s and the days of the South Sea Bubble.

Now the party is over. Goldman’s income this quarter was propped up by continuing profitability in trading, as the resurgence in inflation has pushed real interest rates even more sharply negative, but “deal” fees are not what they were, with the glorious new world of crypto-currencies collapsing into a mess of bankruptcies and accounting fraud. With interest rates now pushing upwards, and the global economy headed into a massive recession, there simply will not be enough suckers available for the investment banks to reap their usual gluttonous rewards. The prison sentences surrounding the Malaysian 1MDB scam indicate that even emerging markets and China are no longer the panaceas they appeared to be. For investment bankers, it will be a long, dark decade, or possibly generation.

Past patterns are instructive here. The post-1968 investment banking downturn was due primarily to a squeeze on brokerage fees, which had been set in the days of personal service and paper deal tickets and were thus grossly excessive as computers took over trading and settlement. Initially, the New York investment banks coped appallingly badly with computerization, to the extent that several houses failed in 1970 because they had entirely lost track of the tickets they had written in the 1968-69 boom. Then in 1975 brokerage fees were liberalized from the monopoly pricing previously imposed and revenues collapsed. It was only after a massive industry consolidation in the late 1970s and a renewed market upsurge from 1982 that a new dawn appeared for the industry.

It is unlikely that the impending investment banking downturn will resemble the 1970s one. Brokerage fees are an infinitesimal part of investment banks’ income and their computer systems are at least good enough to recognize their positions if not to manage them. In retrospect, the 1970s slump was a consolidation of an industry that had been artificially miniaturized and fragmented by the Glass-Steagall Act; that process seems unlikely to be repeated even though technically it could be.

The post-1929 downturn seems more likely to be relevant. In that case, the markets went into such a deep slump that it was 25 years before they returned to their 1929 level, even in nominal terms. Because of policy mistakes by both the Hoover and Roosevelt administrations, as well as by the Fed, the economic depression in the U.S. was far deeper than any other before or since, and full recovery did not come until after the November 1938 midterm elections, when a loose coalition of Republicans and conservative Democrats took over House and Senate and stymied the New Dealers’ economic policies.

For the markets, matters were made much worse by the Glass-Steagall split between commercial and investment banking, legislated in 1933 which forced the investment banks to be spun off separately, decapitalizing the markets’ underwriting capability. That made debt issue volumes in the late 1930s a small fraction of those in 1927-29 and dried up the equity new issue market almost completely. Investment banking was such a poor business in the 1930s that Merrill Lynch, the largest and most successful house, lost money over the decade and was only kept going by Charles Merrill’s mother’s trust fund.

The 1930s also do not seem likely to be a pattern for this investment banking down cycle. It is unlikely that the devastating combination of stringent fiscal policy and decapitalization of the market makers will be repeated. It is also likely that inflation will persist, rather than the deflation of the 1930s; thus the decline in nominal stock prices will be less than the 88% of that era. Still, the 1930s were a decade when investment banking jobs almost disappeared, and the industry did not return to health until about 1960. The 1930s decline in investment banking was even more severe than in the U.S. economy as a whole (and far more severe than in other economies such as Britain’s, where policy was much better). Just as the 1970s decline was less severe than can be expected now, so the 1930s fall was beyond the pessimistic end of current likely outcomes.

There remains the third investment banking drop-off, far less known today: that following the collapse of the South Sea Bubble in Britain. The period 1693-1720 had seen a classic investment banking bull market, full of “financial engineering” scams and fraudulent accounting, in which the Whig “monied interest” had rigged both the financial system and the economy in its favor and against the interests of the non-metropolitan predominantly landed Tories without major connections in the generally Whiggish governments.

That boom had included the use of SPACs – the first of which became the Bank of England – in this case used to issue debt rather than make acquisitions. It also used a variety of lotteries, annuities, both of fixed duration and on multiple lives and most notoriously tontines, thereby preventing investors and taxpayers from assessing instruments properly and maximizing their “take” for politically connected insiders. The South Sea Bubble, itself an attempt to use the South Sea Company as a speculative “SPAC” to take control of all the expensive debt issued over the previous quarter-century, was only the culmination of this period.

On the equity side, the bubble had used the all the modern promotion techniques, uninhibited by any reporting or regulatory requirements, to issue stock in a wide variety of companies, some of them solid, like two insurance companies, some of them high-tech, like Puckle’s Machine Gun, the first invention to receive a full patent description, which fired round bullets at Christians and square bullets at Turks, and innumerable scams including the notorious “undertaking of great advantage, but nobody to know what it is.”

The bursting of the bubble bankrupted many of the embryonic broker/investment bankers of the time, and the Bubble Act of 1720, forbidding the creation of new public companies without an Act of Parliament, effectively shut down the new stock issues market for more than a century. However, those brokers who had specialized in government bonds did quite well for the next 35 years, as the market settled down with a long period of peace, while government debt interest rates declined gently from 5% to 3%, thus giving brokers a comfortably profitable existence. The most famous such broker was Sampson Gideon, who took a fortune of £20,000 from the South Sea Bubble and turned it into £500,000 in the next 35 years, ending by becoming the principal investment banker and advisor to Henry Pelham’s government, in 1751 consolidating government debt into the 3% Consols that were to last for 264 years until their foolish redemption in 2015.

The period 1720-1760, still under one-party Whig rule, thus brought a thorough de-financialization of the British economy. Government debt ownership, as yields declined and apparent security increased, was broadened to the Tory squires and provincial tradesmen who had not been involved in the market’s early most profitable years. That would enable the government to finance a succession of immensely expensive wars over the next half-century. Meanwhile banking in London stagnated, while the declining profitability of financial-market investment banking gradually shifted the financial sector away from the “monied interest” and towards provincial centers where the economy was beginning to stir. After 1750 were founded a plethora of provincial “country banks” each with fewer than 6 partners (by the Bank of England Act of 1708) and mostly with capital of under £10,000. The country banks, not being fashionable or well-connected were accessible to local businesses and even working men. Thereby, they provided the critical low-level financial services and networking that were to finance the canals and the Industrial Revolution.

If the world is very lucky, this is the fate investment bankers will see until 2050 or so. Their size and profitability will decline, and the big houses will become uninteresting and bureaucratic places to work, with little innovation and limited profitability. Later in the period, perhaps starting in 2035-2040, if the regulators do not prevent them (let us pray for governments and courts that will quell those regulators) new and much smaller financial intermediaries will emerge, scattered outside the major financial centers, that will focus through direct investment and networking on financing entrepreneurs and small businesses, thereby returning the U.S. and global economies to the micro-innovation that is the seed of true wealth creation.

That is the hope, anyway. Meanwhile, Goldman Sachs and its brethren are shorts!

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)