High leverage wiping off anything

In addition to a lack of risk management, highly leveraged bets were also widely blamed. Many economists and analysts emphasized that investment banks depended too much on leverage, or the use of borrowed money, and declined to set aside enough cash against the assets they held.

In 2007, the leverage ratio -- a measure of a firm's risk in relation to the equity on its balance sheet -- soared to 28 from 15 in 2003 at Merrill Lynch, according to UBS. Morgan Stanley's leverage ratio climbed to 33, while Goldman's hit 28. In contrast, leverage ratios at commercial banks such as Bank of America are pretty low, staying at about 11. Less leverage means less profit, but the loss is also less than that of investment banks.

In a market with excess liquidity, investment banks posted huge profits with high leverage. However, once the market encountered a liquidity shortage, the weaknesses of the high leverage were exposed.

Firstly, losses are likely to increase rapidly. Once the prices of subprime mortgage-related securitized products and other securities began to fall, investment banks' efforts to reduce leverage led to more assets being sold. Thus prices further decreased and losses were magnified. Moreover, It is difficult to find buyers to deal with devaluating assets.

In addition, little equity capital in hands characterized investment banks relying on high leverage. Therefore, investment banks are more fragile than commercial banks in the face of losses. They would likely to plunge into the red because investment banks have no access to deposits as commercial banks do.

Given the escalating credit crisis, HSBC chairman Stephen Green said, "we are entering an era in which the industry's recent propensity for high leverage, together with the extreme complexity of some investment vehicles, will no longer be acceptable."

Short selling

Traditional short sellers borrow stock with the aim of selling it, then buying it back at a lower price, hoping to pocket the difference. In a "naked" short sale, however, investors short the stock without actually borrowing it, making it much easier to drive down the share price of a company.

Investment banks targeted by naked shorting complained that the practice dilutes their shares and their market values evaporated. Meanwhile, the practice, which depresses share prices, has kept investors from buying stocks and makes financing more difficult.

In an effort to address continuing market volatility, the US Security and Exchange Commission (SEC) issued a series of emergency orders to limit short sales and require reporting short positions.

On September 18, the SEC issued an emergency order prohibiting short selling, as opposed to "naked short selling" of the public traded securities of 799 companies.

However, traders thought the ban on short selling was ridiculous. Teddy Weisberg from Seaport Securities pointed out that the market is global, so short sellers will always find a place to sell.

New era

From October, the major investment banks, which have survived the crisis, will come under close supervision of regulators and have far less profitability than they have historically enjoyed.

Instead of being overseen just by the SEC, Goldman Sachs and Morgan Stanley will now face more scrutiny from numerous federal agencies, including the Federal Reserve, the Treasury Department's Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp.. Meanwhile, they will have to reduce the amount of borrowed money, which will significantly slash their profitability.

In a word, the move effectively returns Wall Street to the way it was structured before the US Congress passed a law during the Great Depression separating investment banking from commercial banking, known as the Glass-Steagall Act.

(Xinhua News Agency December 3, 2008)