Our Take: Animal Spirits at Work

While balance sheet assets continue to wither, employment at securities firms sits at record highs. That makes a scary combination as Wall Street faces another possible wave of asset markdowns.

As we foresaw at the beginning of December, year-end financial results contained a good deal more poison than banks were then willing to admit. The last quarter's avalanche of sub-prime write-downs propelled the cumulative industry-wide tally past $120 billion, according to The Wall Street Journal.

Now, there are rumblings that sub-prime might be yesterday's battle. Attention is turning to banks' exposure to troubled monoline (bond) insurers, risky mortgages not classed as sub-prime, and bonds backed by commercial mortgage loans. Each category has the potential to cause further losses in the tens of billions, say various equity analysts, rating agencies and other authorities.

To be sure, institutions are starting to hedge some bets. Along with re-pricing and selling troubled assets, investment banks are overhauling their operations and business mix - pulling back from certain activities, or even exiting altogether. Morgan Stanley is eliminating 1,000 jobs, primarily in asset management and wealth management, even while CNBC reports Chief Executive John Mack is determined to stay the course in proprietary trading. Merrill Lynch says it's withdrawing from structured finance and collateralized debt obligations. UBS is doing much the same, and is also getting out of real estate and some commodity markets. Bank of America plans to sell its prime brokerage, and its investment banking unit will cease doing deals in a number of industries, though it will remain active in others where it's thrived.

Bulging Headcounts Spotlight Industry's Vulnerability

Despite all the well-publicized cutbacks, the securities industry's total U.S. headcount ended 2007 at an all-time high of 850,900, according to the Labor Department. During the second half, while the sub-prime meltdown was chewing up earnings and equity, Wall Street added a net 6,500 jobs. In the cyclical downturn that ended in 2003, the industry lost a total of 91,400 jobs.

Apparently, Wall Street's animal spirits are still frisky enough that chief executives smell a dollar of fresh opportunity in some business segment for each dollar they yank out of another in which they've had all the fun they can stand. As long as those spirits hold up, and capital continues to flow in to reload the risk-taking guns, this process of creative destruction can continue. But if economic or market conditions turn truly unfriendly, there will be a lot more cutting to do.

The sudden involvement of sovereign wealth funds removed the immediate impetus for the world's major investment houses to retrench in a big way, as they did in 2001-02. Did the $40 billion sovereign equity injection - with promise of more to come - set the industry on a path to renewed good health? Or, did it merely postpone an inevitable day of reckoning?

Under capitalism, the bedrock measure of health for any industry or company is profitability - or at least, the sound expectation of profitability. Restoring a troubled industry's profit margins usually requires a purge of excess capacity, often spearheaded by deep-value investors. That's why, as soon as the pattern of sovereign investments in bulge-bracket banks emerged late last year, we anticipated the question that 1970s-80s super-dealmaker Felix Rohatyn recently asked the New York Times' Andrew Ross Sorkin: "Why isn't Warren Buffett making an investment in Citigroup when Kuwait is?"

We don't mean to glorify the knife-wielding methods favored by deep-value investors. But if a cyclical downturn is really here, then the financial industry's newfound sovereign partners - and even its army of suddenly surplus employees - may come to wish their managements had shown less animation and greater sobriety once the skies began to darken.