The Real Reason Investment Banks Collapsed

Pundits have blamed the financial crisis on many things: excessive Wall Street greed, failure to manage risk, consumers with lousy credit who couldn’t afford subprime mortgages and more. But they all miss the real reason behind the crisis, according to Jeremy Siegel, professor of finance at Wharton Business School.

Siegel was speaking in Philadelphia to launch a 15-session lecture series that Wharton is offering for MBAs and undergrads. Siegel says the real reason is that large financial firms bought, held onto and insured large quantities of risky mortgage-related assets using borrowed money — instead of “flipping” them as they had in the past, and done with other financial products such as the IPOs during the dot-com era.

Many of these companies were making enormous profits from creating, bundling and selling these products. There was little need to hang onto them. But instead they decided they were good assets to hold. That was their “fatal flaw” according to Siegel, in an article published by Knowledge at Wharton.

Siegel looks at American International Group (AIG) for example. Roughly 95% of its business units were still profitable when the company collapsed. But it was the New Products Division based in London, England, that came up with the idea of insuring piles upon piles of mortgage-backed assets, and nobody at the head office raised a red flag. Basically, 90 employees sank a firm with 125,000 employees.

Siegel discusses other mishaps along the way in a lengthy article that’s worth reading. Yet he remains optimistic about things finally turning around, toward the end of 2009. He even offers some advice for investment bankers with an entrepreneurial bent: it’s a good time to start your own bank. “You won’t have the problems of existing banks, and the federal loans interest rate is near zero,” Siegel said. “Demand for loans is high, and you will face no competition from the private market. You could become very profitable.”

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