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Investment banking and the economy

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A day after Goldman Sachs reported record profits, JP Morgan declared a US$2.7 bn profit:

The bank’s second-quarter profit rose 36% from a year earlier and 27% from the previous quarter, to $2.7 billion. Investment banking fees, up 29% from a year earlier and 62% from the first quarter to $2.2 billion, were a “record for any investment bank in any quarter,” Chief Financial Officer Michael Cavanagh said during a conference call with reporters. Investment banking profit smashed analysts’ expectations, just as fellow Wall Street titan Goldman Sachs Group Inc. did Tuesday.

Now the question is, if giant investment banks on Wall Street have been doing so well last quarter, why hasn’t the American economy picked up?

The answer lies with how investment banks work.  Unlike the classic and dated picture painted to school children of banks extending loans to businesses and consumers at a higher interest rate than they provide for deposits, investment banks operate significantly differently from commercial banks.  Wikipedia has a page on what they do.

Much of JP Morgan and Goldman’s profits came from trading fixed-income securities such as T-bonds (just think how much these banks benefited from the Obama’s administration’s US$787 bn stimulus package by reselling Treasurys bought at auctions to nervous investors), equities and equity underwriting.  In addition, both Goldman Sachs and JP Morgan Chase are primary dealers who are able to deal directly with the Fed and take advantage of its all-time low discount rate to finance their operations.  It’s not difficult to imagine them using cheaply leveraged Fed loans to buy up bargain stocks during this year’s low of March 2009 and reselling them at higher prices when naive and gullible investors got carried away by Bernanke’s talk of green shoots.   Goldman Sachs in particular converted to a bank-holding company last September as Lehman collapsed which gave it permanent access to the Fed’s lending window.

For those seeking a more detailed breakdown of the two banks’ revenues, Goldman Sachs’ may be found here while JP Morgan’s report is here.

In other words, their profits were due to trades which barely touched the American macro economy at large. Consumer and commercial lending by banks are still at record lows.  Without lending on favourable terms, the economy can never bounce back.  There’s no way production will increase without financing via loans and lines of credit on terms and conditions half as favourable as those enjoyed by Goldman Sachs and JP Morgan from the Fed.  The Fed has been doing its part extending loan and credit (just like commercial banks would normally do) to companies such as automakers etc., but there’re limits to what a single bank can do even if it’s the most powerful bank in the world.

In short, I believe Paul Krugman was right when he said that we may have mislearned the true lesson of Japan’s lost decade.  As I posted earlier, the problem now isn’t with fixing the financial system.  Heck, even Geithner’s PPIP plan appears to have been shelved.  It’s now about propping up the economy directly by increasing demand. That’s what the fiscal stimulus package is meant to do.

Update: CNN has a commentary on how much Goldman Sachs really owe the American public.  It’s more than just the TARP funds.

Written by defennder

July 17, 2009 at 12:00 PM

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