The first of the top 5 investment banks to fail was Bear Sterns, in March 2008. Founded in 1923, the collapse of this Wall Street icon rocked the world of high finance. By the end of May, the Bear Sterns finale was complete. JP Morgan Chase bought Bear Stearns for a price of $10 a share, a stark contrast to its 52-week high of $133.20 a share. Then came September. Wall Street and the world watched as, in just a few days, the remaining investment banks in the top 5 list collapsed and the investment banking system went bankrupt.

Investment Banking Basics

The largest investment banks are big players in the realm of high finance, helping large corporations and the government raise money through means such as trading securities in the stock and bond markets, as well as offering professional advice. in the more complex aspects. of high finance. Among these are such things as acquisitions and mergers. Investment banks also handle trading in a variety of financial investment vehicles, including derivatives and commodities.

This type of bank also has stakes in mutual funds, hedge funds, and pension funds, which is one of the main ways that what happens in the world of high finance is felt by the average consumer. The dramatic fall of the remaining major investment banks affected retirement plans and investments not only in the United States, but also around the world.

The High Finance Finagling That Brought Them Down

In an article titled “Halfway Too Smart” published on September 22, 2008 by Forbes.com, Chemical Bank President Professor of Economics at Princeton University and writer Burton G. Malkiel provides an excellent and easy to understand follow breakdown of what exactly happened. While the catalyst for the current crisis was the collapse of mortgages and loans and the bursting of the housing bubble, its roots lie in what Malkiel calls the breakdown of the bond between lenders and borrowers.

What it is referring to is the change from the banking era where a bank or lender made a loan or a mortgage and that bank or lender held it. Naturally, since they clung to the debt and its associated risk, banks and other lenders were quite careful about the quality of their loans, carefully weighing the probability of payment or default by the borrower, against standards that made sense. Banks and lenders have moved away from that model, toward what Malkiel calls an “originate and distribute” model.

Instead of holding mortgages and loans, “mortgage originators (including nonbanks) would hold loans only until they could be packaged into a complex set of mortgage-backed securities, divided into different segments or tranches with different priorities in entitlement to receive payments from the underlying mortgages,” and the same model also applies to other types of loans, such as credit card debt and auto loans.

As these debt-backed assets were sold and traded in the investment world, they became increasingly leveraged, with debt-to-equity ratios often reaching 30 to 1. This handling and trading often took carried out in a murky and unregulated system that was called the shadow banking system. As the degree of leverage increased, the risk also increased.

With all the money being made in the shadow banking system, lenders became less selective about who they gave loans to, no longer holding onto loans or risk, but instead slicing, repackaging, and selling them. in profit. Crazy terms became popular, no money down, no documents required, and the like. Exorbitant exotic loans became popular and lenders explored the depths of the subprime market looking for even more loans to make.

Eventually, the system nearly came to a halt with falling house prices and rising loan defaults and foreclosures, with lenders making short-term loans to other lenders out of fear of lending to ever-increasing entities. leveraged and illiquid. The decline in confidence could be seen in falling share prices as the last of the major investment banks drowned in shaky debt and investor fear.

September saw the bankruptcy of Lehman Brothers, Merrill Lynch chose acquisition over collapse, and Goldman Sacs and Morgan Stanley regressed to bank holding company status, with possible acquisitions on the horizon. Some of these investment banks date back almost a century, and others longer, like Lehman Brothers, 158 years old. A rather embarrassing end for these storied giants of finance, destroyed by a system of high finance shady deals and deceit, a system that, when it collapses, may even end up dragging down the economy of the entire world.