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How Investment Bankers Contributed to the Financial Crisis

Posted In:  banking  News and Opinion

Investment bankers are essentially the source of the financial crisis and that's why the government is working hard to re-impose strong regulations on the industry. It helps to understand what an investment banker is, what the job entails and how investment banking led to the problem in the first place.

 

What is an Investment Banker?

Simply stated, an investment bank’s purpose is to assist governments and companies to raise their worth, or monetary capital, by acting as the underwriting agent in the disbursement of securities. Securities can be classified as a number of things, for instance; a bond, a structured finance plan, equity, agency security, and a derivative or investment fund. Investment banks are needed to give companies and corporations assistance with acquisitions and mergers. They also help in the trading of commodities (a product for which there is a demand or need), foreign money exchanges and equity securities also known as capital stock.

Investment banking is made up of two divisions; the product coverage group and the industry coverage. The purpose of the product coverage group is to oversee many financial transactions such as; project and structured finance, assistance to asset leasing and finance, acquisitions and/or mergers, equity, debt consolidation, leveraged finance, and the restructuring process. The industry coverage sector’s primary responsibilities are to concentrate on technology and healthcare. Collectively, these two investment banking branches play a large role in negotiating with mergers, securities disbursement, and staying in contact with appraisers and bidders. They also engineer new financial products as ways to create new revenue streams for their employers, which brings use to the source of the problem.

 

What Investment Bankers Did

Wall Street investment bankers bought mortgages from banks and used them to create new derivitive product that could be sold to institutional investors. The derivitives were valued and structured by the "quality" of the mortgages, based on the credit ratings of the borrowers. Lower quality loans were bundled into derivities that paid higher interest rates, just as long as borrowers kept paying their loans. Most investment bankers held onto these low quality bundles to reap the rewards of higher rates.  The high-quality derivatives were insured against default to make them even more attractive to investors. The derivitives would hold and gain in value as borrowers paid their loans and interest. The banks took the capital from the mortgages it sold to make yet more loans, putting more fuel into the real eastate market as banks lowered their lending standards in search of more loans.

 

When it All Hit the Fan

When the market could bear no more, it all went south. Riskier loans started to default, falling like dominoes. First, thousands of homeonwers defaulted on loans that mortgage lenders sold to the investment bankers. The insurance companies (AIG one of the biggest palyers) had to pay up on the default loans and finally, the value of the derivatiuves plummeted for the end investors, who naturally began to reign in spending and investment activities to cut their losses. All this cause a sudden and massive economic retraction.

 

Banking Regulations

There were laws in place to prevent all this, put in place by the government in the wake of the great depression, but Pressident Bill Clinton repealed those laws during his term in office. Now legislators are grappling with the challenge of replacing those laws in today's context. Investment bankers aren't too happy about it either. One J.P. Morgan analyst had this to say about it: “All banks are expected to lose earnings, but relative winners will be banks taking a proactive stance to regulatory proposals." He went on to say that investment bankers will "mainly have to shift employee compensation to shareholders to generate in our view a 15 percent over-the-cycle acceptable return on equity.”

 

 

 

 

 

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