The boom years came to a crashing halt with a financial panic. During the early days, as uncertainty peaked, a number of firms went under. Others struggled to find capital that would give them the liquidity they needed to survive. In the weeks that followed, in tense, closed-door meetings, business and government leaders negotiated a path to solvency that pulled Wall Street back from a collapse that could have made the subsequent recession much worse than it ended up being.
Does that sound like a series of events that you lived through? It’s actually a description of the Panic of 1907. John Pierpont Morgan was at the center of the negotiations that helped abate that crisis. He was widely seen as instrumental in stabilizing the financial sector—and shepherding his own firm through the turmoil.
Two decades later, the House of Morgan survived the crash of 1929—but new regulations required it to split in two. After the Glass-Steagall Act forbade banks from doing both commercial and investment banking, the investment banking business of J.P. Morgan became Morgan Stanley, which opened its doors in 1935. In its first year, the new firm managed 25% of the nation’s IPOs.
Like most investment banks, Morgan Stanley remained a small private partnership for years. The inflation-adjusted capitalization of the top 10 investment banks was $1 billion in 1960; by 2000, that number had shot up to $194 billion, according to a paper by Alan D. Morrison, of University of Oxford and William J. Wilhelm, Jr., of the University of Virginia. Regulatory and technological changes, most notably the 1999 repeal of Glass-Steagall, encouraged top firms to expand into full-service financial institutions.
The distinctions between commercial and investment banking largely fell away and, as the Economist explains, “from the mid-1990s [banks] were allowed more and more to use their own internal models to assess risk—in effect setting their own capital requirements. Predictably, they judged their assets to be ever safer, allowing balance-sheets to balloon without a commensurate rise in capital.”
When the housing bubble popped, it became clear how risky the bets were and how highly leveraged financial institutions had been. For Morgan Stanley, surviving a $9.4 billion loss on subprime mortgage investments in just the fourth quarter of 2007 meant scrambling for cash infusions. The firm eventually received $5 billion from the China Investment Corporation, $9 billion from the Mitsubishi UFJ Financial Group, and $107 billion in loans from the Federal Reserve.
Goldman Sachs, the other major investment bank to make it through the crisis, found similar liquidity through investments and government loans. Both became bank holding companies in 2008. Since then, according to an article in the Financial Times, “Goldman Sachs has defiantly hewed to the strategy that made it the most ruthlessly effective Wall Street bank, with risk-taking at the center of its business.” Meanwhile, Morgan Stanley, “which barely emerged in one piece from the crisis, is engaged in a far more drastic transformation. It has bet hugely on wealth management.”
Yale Insights talked with James Gorman, chairman and CEO of Morgan Stanley, about the company’s past and future. He underscored the change the company has gone through since the financial crisis. “It’s transformational at almost every level,” he said. “The amount of change we’ve done in five years is equivalent to what an institution might do in at least 20, 30 years, and maybe 50.” These changes include becoming a bank holding company, acquiring Salomon Smith Barney, ending the firm’s proprietary trading and hedge funds, and doubling capital while reducing leverage.
Gorman believes the next steps will focus on execution. “I think the major strategic changes have taken place,” he said. “Clearly in the new regulatory environment we’re continuing to refine our business model.”
Since the financial sector recovered faster than other parts of the economy, Gorman sees Morgan Stanley as well positioned. “I think a lot of our competitors are still focused on changing their business models post-crisis,” he said. “We’ve done that. We’ve got that behind us, so we’re going to be focusing all of our energy on doing business.”