Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

They were supposed to Move Risk, Not Store It...

StorageNot so long ago, the Wall Street investment banking model was based on a simple rule. Investment banks were intermediaries, NOT investors. Investors take on risk.  Investment banks were in the business of moving risk of their balance sheet as quickly as possible.

Investment banks made money by charging fees for creating securities and then bringing buyers and sellers together. They brought sellers and buyers together. I-banks liked to say they were "in the moving business, NOT the storage business."

During the credit/housing bubble, most of the former investment banks made the mistake of getting into the storage business in a big way. Banks like Bear Stearns and Merrill Lynch bought risky mortgage-backed securities, cdos, and related instruments for their proprietary trading accounts.  Then they held mortgage-related securities on their balance sheets for much too long. 

The investment banks drank their own cool aide, ate their own dog food, and so forth and so on. Ultimately, the i-banks got stuck with so much toxic waste that the short-term repo markets stopped lending them money.  For Bear Stearns, of course, that was the end of the road.

Sticking with the Bear Stearns example, another reason the former investment bank wound up with a huge volume of mortgage-backed securities and related products was greed. Bear Stearns was so determined to milk every penny of profit from the bubble that it built up a massive inventory of mortgages to feed into its securitization machine. By having a pipeline always pumping out MBS and CDOs, Bear was sure it would never miss a sale. 

When the market froze, Bear Stearns was stuck with tons of loans and a huge portfolio of mortgages the firm had securitized but could not sell before the bottom fell out of the mortgage-backed securities market. In short, Bear Stearns was left with a whole lot of inventory and nowhere to sell it.

The principle of risk transference requires banks to get rid of risk (i.e, investments other than certain "cash equivalents") as quickly as possible. Once the investment banks got rid of the mortgage-backed securities they produced - and collected fat fees - the risk of default would be fully transferred to investors.  This is how the model was designed to work.

At some point, the returns on CDOs and related investments were too tempting for many Wall Street banks to resist. These banks became investors, violating their cardinal rule. Things may have turned out at least a little bit better for all of us if Wall Street stuck with the "moving business" and stayed out of the "storage business." 

'Disclosure: No Positions'