The current monumental changes on Wall Street. although shocking to some, are quite familiar to students of history. Following the stock market crash of 1929 and the bank failures of 1930/31, money center banks became heavily-regulated and the resulting Glass-Steagall act separated deposit taking banks from investment banks. Traditional banks could no longer risk deposits in the financial markets. This system worked (for the most part) for the next 70 years.
The repeal of the Glass-Steagall act in 1999 permitted the combination of money center banks and investment banks. The argument was that traditional banks were at a disadvantage compared to investment banks and that the resulting efficiencies would result in lower borrowing costs and lower fees for consumers. For the most part, this was correct. Although the repeal of Glass-Steagall did not cause the current financial crisis, it did make it more widely felt.
The problem started with low Fed Funds rates. Low short-term borrowing costs and a steep yield curve made it profitable for institutions to borrow short and lend long (the carry trade). The carry trade itself is not a bad thing, but the wide spread between short-term and long-term yields desensitized institutions from risk. There was enough spread to cushion institutions from losses on some loans.
The next step was to find more borrowers. If the carry trade is very lucrative, more loans will equal more profits. But how can one lend money to shaky borrowers without taking on excessive risk? Securitize them and get them of the balance sheet. Now there was a second problem. Speculative investors who would purchase high-risk mortgages are limited in number. Here is where the quants came in.
Rocket scientists (literally) developed used a structure known as a CDO to carve up pools of risky (being kind here) loans into tranches which ranged from very risky to very safe. How can risky assets back a safe security? Structure the safest (super senior) tranches so that they have the first claim on assets and cashflows. As we know now, a large number of this collateral failed and the safe tranches were no such thing. This is how we got here (in VERY simplified terms).
What happens now? The days of 20 or 30 times leverage are over! Banks usually lever 10 times, but even that may be too much for the immediate future. Although this reduces balance sheet risk, it reduces profit potential. Financial institutions will now be the boring entities they had been through much of history. This is not good for shareholders. Banks will generate modest profits (for the most part) in the near future.
Fixed income investors also have to be concerned as there will be less revenue to pay debt. Thus could keep credit spreads wide. Combine this with higher long-term treasury rates resulting from printing money to rescue the financial system. Although long-term rates may rise, upward pressure may be limited by a weakening economy which should crimp consumer demand.
If my synopsis and forecast of the financial system sounds gloomy, that's because it is gloomy. The rescue plan, although necessary in the long run, will not prevent bank losses in the near term. The government's Troubled Asset Relief Program (TARP) will not buy troubled assets at par. In fact it may set prices below where banks have troubled assets marked (assuming they have been marked at all).
Could the government make money by purchasing assets as significant discounts? Sure, but optimists may wish to contain their joy. Optimists note that the underlying loans (and properties) are not worthless and, in many cases, are being valued below historical recovery values. Please, do not make the same mistake the quants made.
This credit dislocation is very different than any which have preceded it. Home prices inflated farther and faster than at anytime in our history. Simultaneously, mortgages were given to borrowers with poorer creditworthiness than every before. This leads me to believe that recovery on these loans will be lower than ever before.
How do we make credit more available? We reign in lending practices and provide more transparency to increase investor confidence. This will not result in a return to the credit boom of a few years ago, nor should it. However, it should result in a healthy credit environment in which those who can pay their debts receive credit.
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