By Yang Liu

The year 2008 witnessed the end of an era on Wall Street. Bear Sterns and Lehman Brothers disappeared. Merrill Lynch is being folded into Bank of America. And Goldman Sachs and Morgan Stanley, with few choices left, have changed their status to become bank holding companies. Those moves marked the end of the securities firm model that has dominated Wall Street since the Great Depression.

Collapse of Wall Street

Lehman Brothers, a 158-year-old firm that started as an Alabama cotton brokerage, filed for bankruptcy protection on September 15. And Merrill Lynch, known by its trademark bull logo, was acquired by Bank of America on the same day.

Both Lehman Brothers and Merrill Lynch have been renowned pillars of Wall Street for a long time. But with the demise of Bear Stearns, the fifth largest US securities firm, in March, three of the Street's five major independent brokers disappeared. Only Goldman Sachs and Morgan Stanley remain.

In order to avoid the domino effect rippling through the banking industry and dragging down Wall Street's last two largest independent investment banks, the Federal Reserve took extraordinary measures on the night of September 21 by agreeing that Morgan Stanley and Goldman Sachs could transfer into traditional bank holding companies.

As investment banks, these five giants once amassed enviable wealth. In the past, the core business of investment banks consisted of helping to hammer out big deals and advising companies and governments around the world on mergers, IPOs and restructurings.

However, since the 1990s, investment banks gradually switched to a model of earning revenue by expanding their own balance sheets. They dominated the industry's most lucrative businesses and enjoyed astonishing profits by taking risky bets and using enormous amounts of debt with little outside oversight.

Derivatives bubble blew up

Twenty years ago, the total notional sum of derivatives in the entire world was close to zero. However, derivatives are a perfect way of getting rich while avoiding taxes and government regulations. Wall Street noticed derivatives were a lucrative business. Therefore, investment banks in a time of easy credit created thousands of types of derivatives in the name of financial innovation. As investment banks rushed into the area, derivatives grew into a massive bubble. In 2007, the notional value of all outstanding derivatives contracts rose above 516 trillion US dollars, which is about eight times global GDP.

However, as the derivatives market was unleashed to expand, a lot of risk was being taken and the effects of this expansion as well as the damage in the event of a wave of defaults is practically unclear. Using the mortgage-backed security for example, there are trillions of dollars of securities whose value derives from the housing market. Lenders write a mortgage contract for a homeowner, then with the help of investment banks package and repackage that contract with thousands of others and sell them to investors.

Only seeing the lavish profit brought by derivatives, investment banks decided to ignore potential risk, forgetting the security is backed by a mortgage that is backed by a mortgage payer. During a bull housing market, homeowners are able to pay. However, as the sharp decline in American housing prices and other assets tied to home values took place last year, the derivative bubble blew up and the damage on Wall Street hammered investment banks.