The Role of Investment Banking in the 2008 Financial Crisis

(originally posted September 3, 2012)

An investment bank is generally a special type of financial institution that help companies access the capital markets such as stock market and bond market to raise money for expansion and other needs. If a company wanted to sell billions worth of bonds for project use, investment banks would help them find buyers for bonds and handle paper works. Today, investment banks also provide other financial activities such as offer broker-dealer and investment advisory services, and trading derivatives and commodities.

Investment banks play an important and active role in the economic development of a country. When investment banks act properly, they bring together investors and businesses to help channel the nation’s wealth into productive activities that create jobs and bring a possible growth in various sectors of economy. But that is when investment banks act properly. Looking back at the 2008 crisis, the senate found that the results of unregulated activities of the investment banks were the reasons for the collapse of economy. Investment banks turned bad mortgage loans into economy-wrecking financial instruments fuelled the downfall of market.

Before the crisis, the mortgage market experienced a real boom in United States. Interest rates were low and rising house prices led many people believe they could buy a home with little capital on hand. Mortgage lenders loaned money to home buyers and then sought to move those loans off its books. Investors demand for high-yield securities in a phase of high liquidity surpluses and low returns further encourage this trend with the result of the sub-prime market grow to an unprecedented 800% between 2000 and 2005. Highly complex securitization put risk in hands of banks which employed inadequate resources to analyze the remaining risk. When the situation turned upside down, interest rose and house prices fell, investors having second thoughts about the mortgage backed securities investment banks was churning out. In July 2007, two Bear Stearns off shore hedge funds specializing in mortgage securities suddenly collapsed. The credit rating agencies downgraded hundreds of sub-prime mortgage backed securities and the market went cold. Banks and other investors were left with plummeting value of unmarketable mortgage backed securities.

In order to properly illustrate the role of investment banks during the crisis, let us take the case of investment bank Goldman Sachs. Goldman Sachs is one of the United States’ largest banks. It was founded by Marcus Goldman and his son-in-law Samuel Sachs in 1869. The firm is known for pioneering the use of commercial paper, and entered the New York Stock Exchange 27 years after its creation. Its primary activities include investment banking, trading and financial advisory.

Leading to the financial crisis, allegedly, Goldman Sachs fraudulently designed a securities pool to fail. The securities pool being referred to here is one made up of “toxic” mortgage securities. In the year 2006, Goldman Sachs created mounts of Residential Mortgage-Backed Securities and Cash Collateral Debt Obligations, and bought and sold them in behalf of their clients. These securities were marketed wrongly as Goldman Sachs thus leading to their credit ratings being AAA despite its poor quality. These securities looked really attractive so they had no problem with convincing clients to take part in this investment pool. It was during this time when house prices were on the rise, hence the demand for mortgage securities and other financial products were on the rise as well.

The Securities & Exchange Commission has filed a civil complaint alleging that in another transaction, involving a product called Abacus 2007-AC1, Goldman violated securities law by misleading investors about a mortgage-related financial instrument.

The SEC’s complaint alleges that Goldman Sachs in effect helped stack the deck against the buyers of the instrument it sold. The hedge fund that bought the short position in the transaction – in other words, that bet that the product would not perform well – helped select the mortgages that were to be referenced in the product that Goldman sold to investors. The SEC also alleges that Goldman Sachs knew of the hedge fund’s selection role and failed to disclose it to the other Abacus investors, who thought the package had been designed to succeed, not fail. We also have learned that Goldman also failed to disclose the hedge fund’s role to the credit rating agency that rated the Abacus deal. Eric Kolchinsky from Moody’s Investor Services, who oversaw the ratings process at Moody, testified, “It just changes the whole dynamic on the structure, where the person who is putting it together and choosing it, wants it to blow up.”

These types of securities Goldman Sachs created amounted to around $40 billion and according to McClatchy, were backed by 200,000 risky home mortgages. However as 2006 was drawing to a close, Goldman Sachs saw that due to high risk these invested securities were having accelerating rates of default and delinquency. Instead of informing their clients about this and trying to fix the problem, they did not disclose this information and bailed out by quietly took the opposite position against their clients and the mortgage market with a large number of short net positions. With this, Goldman Sachs earned a huge profit the following year when the mortgage market crashed at the expense of their clients’ interests and the financial market as a whole as well. With the facts presented, financial analysts declared that this was Goldman Sachs’ plan all along, to wait for prices to plummet and then bet against it protect itself from loss and actually earn as the market falls.

But Goldman Sachs didn’t just make money. It profited by taking advantage of its clients’ reasonable expectation that it would not sell products that it didn’t want to succeed, and that there was no conflict of economic interest between the firm and the customers it had pledged to serve. Goldman’s actions reveal that it often saw its clients not as valuable customers, but as objects for its own profit. This matters because instead of doing well when its clients did well, Goldman Sachs did well when its clients lost money. Its conduct brings into question the whole purpose of Wall Street, which traditionally has been seen as an engine of growth, betting on America’s successes and not its failures.

The SEC and the courts will resolve the legal question of whether Goldman’s actions broke the law. The question for us is one of ethics and policy: Were Goldman’s actions in 2007 appropriate, and if not, should we act similar in the future?

Most investors make the assumption that people selling them securities want those securities to succeed. That’s how our markets ought to work, but they don’t always.

Investors must believe that their investment banker would not offer them the bonds unless the banker believed them to be safe. This throws a heavy responsibility upon the banker. He may and does make mistakes. There is no way that he can avoid making mistakes because he is human and because in this world, things are only relatively secure. There is no such thing as absolute security. But while the banker may make mistakes, he must never make the mistake of offering investments to his clients which he does not believe to be good.

Investment banks have the capability to create securities to help economic growth, however the opposite happened during the 2008 financial crisis as these banks are one of the major causes of why this crisis occurred in the first place. Senator Carl Levin of Michigan summed this up accordingly in his report on the financial crisis- “Investment banks were a major driving force behind the structured finance products that provided a steady stream of funding for lenders to originate high risk, poor quality loans and that magnified risk throughout the U.S. financial system. The investment banks that engineered, sold, traded, and profited from mortgage related structured finance products were a major cause of the financial crisis.”

Written by:

Ayroso, Ysabel
Sy, Deborah
Wagas, Sharie

References:

Gordon, G. (2009 November 1) How Goldman secretly bet on the U.S. housing crash. Retrieved on September 2, 2012 from http://www.mcclatchydc.com/2009/11/01/77791/how-goldman-secretly-bet-on-the.html#storylink=cpy

Rushe, D. (2011 June 2) Goldman sachs ‘issued with subpoena’ over actions during credit crisis. Retrieved on September 2, 2012 from http://www.guardian.co.uk/business/2011/jun/02/goldman-sachs-gets-subpoena-over-credit-crisis-acitivity

Levin, C. (2010 April 27) Wall street and the financial crisis: the role of investment banks. Retrieved on September 1, 2012 from
http://www.huffingtonpost.com/sen-carl-levin/wall-street-and-the-finan_b_553339.html

Photos: Google Images

 

 

 

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