GUEST COMMENT: Forget this year's bonuses, the US investment banking model is dead
With banks making record profits and bonuses expected to be at record levels, it's easy to overlook the enormous changes that have taken place over the past 24 months. One of these, the demise of the "originate to distribute" model has yet to make itself properly felt. When it does, nothing will be the same again.
At the turn of the century, the Wall Street model was a pure "originate to distribute" model with little to no residual risk on behalf of the originators or underwriters. When there's no residual risk, those who "WIN" are the players that can purely process the most volume. Well, how does one get volume? Lower the credit standards, put fewer restrictions on borrowers, little to no covenants (NINA Loans: no income, no asset check). WOW!!! What were we thinking?? Well, Wall St. felt, "let's worry about it tomorrow or maybe not at all because we are making too much money today."
Tomorrow has arrived and Wall Street must now deal with the concept of retaining risk in their loan originations. The topic of 'risk retention' has been bandied about over the course of the year, but it was ratcheted up dramatically in a recent meeting of the House Financial Services Committee and U.S. Treasury on October 27th.
What came out of that meeting has potentially dramatic implications for the entire spectrum of loan origination, securitization, and distribution businesses on Wall Street and their subsequent impact on Main Street.
The Financial Services Committee doubled the amount of risk retention that would be required. If the law comes to pass, banks will be required to keep as much as 10% of the credit risk associated with a transaction on their balance sheet (Obama had initially suggested this be set at 5%).
Most significant, however, is the scope of the risk retention requirement itself. The draft legislation would apply the 10% rule not only to securitized loans-but to all loans that are sold on in the secondary market. Taking it to an extreme, if a loan were to be sold from the Originator to Purchaser A, who then sold to Purchaser B, who then sold to Purchaser C, ...when we get to Purchaser I, has 100% of the credit risk been accounted for and we're all good?
What are the immediate implications of this risk retention policy? Banks originating loans will need to set aside more capital in reserve against the loans originated. This will hit profitability. It will also require an army of people to manage the retained risk. Wall Street's model is dead. Something new is emerging from the flames.
Larry Doyle has worked as a senior banker at Bear Stearns, JP Morgan, UBS and Bank of America. He is author of the financial services blog, Sense on Cents.
