The High Cost of Speeding on Wall Street

Innovation is the hallmark of American finance. But Wall Street also needs to weigh risks, or its next down cycle will come harder still

by Bob Gach

The shipping market is booming, and yet again Wall Street is speeding into the middle of a once-sleepy market. Bankers are rushing in to broker capacity, finance construction of new ships, and link buyers and sellers around the globe. And just as they did in the mortgage-lending business years earlier, traders are creating widespread use of derivatives. In just five years, the Street has introduced shipping derivatives valued at more than $50 billion, dwarfing the $7 billion cash market.

In the shipping business, executives are stunned by the influx of complex and risky instruments and the wave of hedge funds that have shaken their historic way of operating. But on Wall Street, it's merely the latest example of business as usual.

Is the Street rushing toward what Yogi Berra described as déjà vu all over again? Even as the mortgage derivatives fiasco continues, have the banks locked onto yet another target for products with too much risk and at too furious a pace? If financiers are rushing new products to market in shipping just as they have been doing elsewhere for the past two decades, odds are not even the bankers who crafted those instruments know for sure.

Managing Risk

Many have argued that Wall Street's strength is its ability to manage risk innovatively—whether in mortgages, shipping, consumer credit, or any other market. But recent events have undermined that claim. Rather than controlling its risks, the financial services industry has generated massive systemic risks in the short-term pursuit of profits.

While a few innovators have gotten rich quick, the companies they work for—lacking the ability to understand and manage the ever-quickening impact of new financial instruments—are suffering in the long term. The traders who pushed high-yield bonds in the '80s and leaped into leveraging Asian currencies in the '90s made a lot of quick money. But when those big bets ended badly, it was their employers, shareholders, and the public that paid the highest price.

Innovation is the hallmark of American finance. It would be a mistake to stifle it. But if Wall Street doesn't balance its fixation on speed to market with the ability to stay on track, the next down cycle will come harder and faster than the current one.

Recent Track Record

Think of the biggest busts of the past decade, from Long Term Capital Management to Bear Stearns. What do they have in common? A few brilliant traders. New products promising huge profits on the back of leveraged assets. Companies unaware of the risks—or even how to measure them accurately. An idea is hatched, and soon everyone rushes to grab a piece of the pie, because speed to market is not only a key part of doing business, but a badge of honor.

The breathtaking rise and fall of the collateralized debt obligations (CDO) market is a case in point. In the first quarter of 2004, global CDO issuance was $25 billion. A year later it was $50 billion. By 2006 it had doubled again, until in the first quarter of 2007 the number was $186 billion—a phenomenal 644% increase in just three years. This rush to market allowed some people to make handsome profits before the market became commoditized. But one thing was overlooked: the risk, which only became apparent when the bottom fell out.

In the first quarter of 2008, CDO issuance plummeted to just $11 billion. And suddenly, the inability of companies to understand and handle the risk they'd taken began hurting. To date, financial firms have written down more than $150 billion in bad CDOs. Even firms that have avoided Bear Stearns' fate have seen many billions more lopped off of their market caps.

Origins in the 1980s

How did we get to this point? The start came in the '80s, when Salomon Brothers revolutionized the industry, turning away from the investment banking that had been Wall Street's bread and butter toward proprietary trading. Soon everyone saw greater profits in trading their own books.