Were investment bank IPOs really the problem?

By Dr. Manhattan

Michael Lewis' recent cover story in Portfolio on the end of Wall Street has been justly hailed; the anecdotes about Steve Eisman's housekeeper and baby nurse would themselves be worth the newsstand price...er, if you couldn't access it for free online, that is.  But I have to quibble with Lewis' big conclusion, which he reaches after a tense reunion with his former CEO, John Gutfreund.  After recounting how Gutfreund turned Salmon Brothers from a private partnership into Wall Street's first publicly held investment bank - a step that would be imitated by virtually all major Wall Street institutions in the following two decades - Lewis pronounces:

No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.'s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.'s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit.

So suppose we have an employee-owned investment firm, organized as a private partnership, which aims to become a major financial institution. In Lewis' formulation, it should be the least likely candidate to run excessive leverage and blow itself up with untrammeled risk-taking.  In fact, it might spare no expense on the risk-management side and only use the most highly sophisticated analysis to protect the franchise.

I am thinking, of course, about Long-Term Capital Management.  When LTCM imploded in 1998, they were leveraged about 25 to 1.  And at that point, they were only gambling with their own money, not their limited partners - the year before LTCM's implosion, they returned most of the capital contributed by outside investors.  (As it turned out, those investors made a killing on their LTCM investment - far greater than the LTCM principals, in an inversion of the usual principal-agent problem.  Many of those investors were begging and pleading to get back into the fund - at least until John Meriwether asked for money right before LTCM's collapse, at which point it was obvious that they were in deep trouble.)  In its short history, LTCM had become a major Wall Street player - on a course to rival the major investment banks for importance. For some reason, all these factors did not lead to an excess of prudence on LTCM's part. 

And while LTCM was an extreme case, almost all hedge fund firms are privately owned (only in the last couple of years did hedge fund managers begin offering shares to the public, and I am not aware of any argument that those managers who completed public offering have increased their leverage or generally acted less prudently since they went public) and the managers usually invest a very large amount of money into the hedge funds they manage, so they generally should have enough incentive not to blow themselves up.  Yet they do often enough that it should make us reconsider whether public ownership is really the problem. (And as the Economist recently pointed out, even public firms such as Bear Stearns and Lehman Brothers were largely owned by their employees, and the amount of money both firms' CEOs had in their firms should have given them more than enough incentive to act prudently. Yet they still lost it all.)

By contrast, James Suroweicki has made a different argument against Wall Street firms being publicly traded - basically, that it increases the risk of a self-fulfilling panic to which all financial firms are vulnerable.  His argument is far from foolproof, but it at least makes more measured claims about the consequences of public ownership and thus is more plausible. By contrast, extravagant claims about how Wall Street IPOs were themselves the prime cause of our current economic catastrophe may help sell a 20th anniversary edition of Liar's Poker, but they don't actually explain the mess we're in.

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