Wednesday, September 17, 2008

Investment Banking - Financing Problem

The problem with the investment banks is that they've generally financed themselves for the good times, not the bad times. This means an excessive dependence on short-term funding and high leverage. This generated high ROEs in good times, supporting large payouts for employees and shareholders alike. But when times turned bad, compounded by poor risk management and mind-bogglingly stupid investment decisions, such a capital structure has come back to haunt many a firm.

Nouriel says solve the problem by joining investment banks and commercial banks, and using core deposits as a vehicle for extending the duration of the investment bank's liability structure.

Roger Ehrenberg says no.

According to him, Goldman Sachs and Morgan Stanley should materially alter their financing strategy, lengthening duration by issuing different tranches of preferred stock, subordinated debt and term debt, de-levering in order to weather the storm and accept lower ROEs in the process.

This means that these firms, their culture and their employees won't be destroyed. To maintain continuity and survival in bad times, firms must forego some of the liquidity-driven option value, and put in a more conservative, less leveraged, more flexible capital structure in place.

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