At the year’s onset, five investment banks presided over Wall Street, each bank seemingly a model of attaining staggering profits for employees and investors alike. By October, there were none. The aftershocks of the rapid demise of the five investment banks were felt from small businesses in Toledo to financial markets in Tokyo, as confidence in the world’s banking system vaporized.
The Banks
In the wake of the Panic of 1929, Congress passed the Glass-Steagall Act of 1933, prohibiting commercial banks from engaging in investment banking. Investment banks are responsible for raising funds for companies by selling those companies’ shares to the public; investment banks often engage in asset management, which includes investing in real and financial assets. The separation of the spheres of investment banks and commercial banks enabled investment banks to escape the federal oversight to which commercial banks were subject, but, because of the inherently risky nature of the investment banking, also left investment banks vulnerable to large crashes. Although Congress repealed the Glass-Steagall Act in 1999, allowing commercial and investment banks to merge, five investment banks remained independent: Bear Stearns (the fifth-largest), Lehman Brothers, Merrill Lynch, Morgan Stanley, and Goldman Sachs (the largest).[i] In recent years, the Fed’s loose monetary policy has enabled investment banks to easily obtain funds for investment. Low-cost funds for investment enabled the investment banks to leverage in the high-risk-high-yield Mortgage-Backed Securities (MBS – see post on MBS for more information) market. Leveraging involved taking advantage of high yields on MBS and relatively lower interest rates, investment banks had large incentive to borrow large sums of money and invest in MBS to make profits. Although leveraging allowed investment banks to enjoy great profits between 2003 and 2006, leveraging with MBS was highly risky, as the repayment of the MBS hinged on the mortgage payments of American homeowners.[ii]
The Causes of the Failures
Leveraging only offered great profits as long as the housing market boom of the early 2000s lasted. When the housing bubble burst in 2007, more homeowners defaulted on their loans, substantially diminishing the returns on many MBS. This caused many investors to pull out of their positions in investment banks. Since investment banks often have about half the capital base of commercial banks, high-leverage MBS-holding firms were forced to sell many of their MBS assets, in a process known as deleveraging.[iii] Deleveraging caused asset prices to drop, causing investment banks to write down more and more losses on their balance sheets.[iv] Further exacerbating the problem were CDS losses facing investment banks, particularly Lehman Brothers. Just as investors pulled away from investment banks, further reducing the investment bank capital base, shareholders began to question the profitability and stability of investment banks, leading to a sell-off of investment bank stock. As ratings agencies began to downgrade investment banks for their inability to raise sufficient capital for investment, confidence in investment banks continued to diminish, leading to a uncontrollable downward spiral for investment banks, particularly Bear Stearns and Lehman Brothers (Merrill Lynch appeared to be in the early stages of a similar fall—fears of future losses triggered its sale). Within months, years of profits were turning into devastating losses.
The Consequences
The unexpected subprime mortgage crisis precipitated the downfall of investment banks. After significant losses in 2007, Bear Stearns, Merrill Lynch, and Lehman Brothers collapsed the following year. In March 2008, Bear Stearns was bought out by JP Morgan, forming a universal bank with both commercial and investment banking divisions. On September 14th, 2008, Merrill Lynch was sold to Bank of America. Mired in vast CDS-related debt, Lehman Brothers filed for liquidation bankruptcy in September 2008. A Japanese investment bank, Nomura agreed to buy the European and Asian divisions of the firm. The final two investment banks, Goldman Sachs and Morgan Stanley, converted into bank-holding companies. With the permission of the Fed, they can create commercial banks that will take deposit and bolster the resources of both firms. With this conversion, the age of the standalone investment bank on Wall Street is over.[v]
[i] The Economist, “The financial crisis: Wall Street’s bad dream,” The Economist, 26 Sept. 2008, 85-86.
[ii] Investopedia, ULC, “Leverage,” Investopedia,
[iii] James Saft, “Credit crisis likely to redefine investment banking and cut its profitability,” The International Herald Tribune, 3 Apr. 2008. (Accessed online:
[iv] The Economist, “Deleveraging: A fate worse than debt,” The Economist, 3 Oct. 2008, 90.
[v] Martin Crutsinger, “Last major investment banks change status,” The Huffington Post, 21 Sept. 2008. (Accessed online:
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