Monday, September 22, 2008

The death of i-banks and the future of law firms that served them

It’s a brave new world this Monday morning. The last two large Wall Street investment banks left standing, Goldman Sachs and Morgan Stanley, disappeared over the weekend. And if they didn’t exactly disappear, they’re no longer i-banks either.

On Sunday, Goldman Sachs and Morgan Stanley agreed to become bank holding companies, which are subject to much more stringent regulatory oversight by the Federal Reserve. This oversight will significantly increase their financial transparency. The change will also reduce the banks’ abilities to take big risks and make huge profits. They’ll have to put more of their own money into deals they put together. When borrowing large amounts of money to invest themselves, they’ll likely pay more for that money. Going forward, they won’t be able to invest nearly as much in non-financial companies as before.

What do these changes, effects, and possible unintended consequences mean for Wall Street law firms that evolved to fit i-banks’ needs and benefitted enormously from their success?

To address this very large question, let’s look first at what the changes are likely to include. Under the rosiest scenario, where the Federal Reserve’s actions and interventions have the desired effects, there’s considerable agreement that:

1. Credit will gradually become more available, and financings at all levels will move forward again.

2. No one will use the R word, but thawing credit doesn’t alter the fact that the U.S. is in an economic slump (the S word), a condition that will last who knows how long.

3. The bloodletting in the financial sector is not over; more banks will fail, in the US and abroad.

4. Profits in the financial sector will be down near-term and probably much longer.

5. At some point, investors will begin loosening their grip on record levels of cash and start investing again.

6. US markets are in a bear market, although global markets will reverse sooner.

7. Short-selling has been “temporarily” banned in some markets (I’m keeping the air quotes for now), and it’s rumored these bans may be extended.

8. Consolidation within the financial sector will continue, yielding near-term deal work.

9. Regulatory expansion in the financial sector will be a huge boon to the legal industry.

10. Litigation involving the financial sector and those who work there will be huge, with expected benefits for big litigation shops.

11. Bankruptcy and business reorganization work will be abundant.

One law firm success theorem says firms should serve sectors that are highly profitable. The no-longer-i-banks are not the highly attractive profitability destination they once were. That leaves hedge funds and private equity, and regulators are already headed in those directions. That leaves the big global banks, which, for the next era, will rule.

Sooner rather than later, human ingenuity and greed (in service to the urges humans have to compete and survive) will produce new financing models and instruments that investors will find seductive. Paradigms will shift. I do not believe there is any way regulatory agencies can guard against this kind of creativity. Smarter people will always outplay dumber ones. I’m not saying greed is always good, but I am saying greed (in our lifetime) is inextinguishable.

What is truly astonishing to me is that the intelligence world is relatively quiet about all these events. Why were so many people, companies, industries, and experts of all kinds (including lawyers) caught so flat-footed?

What do you think about all this? What do you think is likely to happen to Wall Street law firms—both near-term and long-term? Which legal practices will profit from these events? Which are endangered? Which new practices might emerge? What kinds of law firm mergers might these events precipitate? Which firms might fail and shockingly so?

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