Where Investment Banking Actually Came From

You have seen this one even if you have never worked a day near a bank. September 2008, a glass tower on Seventh Avenue, and a slow line of people walking out of the lobby carrying cardboard boxes. A monitor under somebody's arm. A framed photo poking out of the top of a box. News helicopters overhead. It has been in every documentary about the crash since, and Hollywood has staged it twice, in Margin Call and in The Big Short.

The firm those people were walking out of was 164 years old. It had been started in 1844 by a Bavarian immigrant called Henry Lehman, and it was not a bank. It was a shop. A dry goods store in Montgomery, Alabama, selling cloth and tools to cotton farmers who were usually short of cash, so Lehman let them pay in cotton instead.

Once you are taking cotton, you have to sell cotton. Once you are selling cotton you know the cotton market better than most people trading in it. By 1858 the shop had an office in New York, and by 1870 it helped set up the New York Cotton Exchange.

That progression is roughly how it happened everywhere. Nobody sat down and invented investment banking. Merchants who were already moving goods around noticed that moving the money was the better business.

Florence, and the trouble with charging interest

Start in 1397, when Giovanni di Bicci de' Medici set up his own bank in Florence. He had a problem every European lender had. The church banned usury, meaning charging interest on a loan, and it meant it. Lending money at a stated rate was a sin, and a prosecutable one.

The way round it was an instrument called the bill of exchange. A merchant in Florence would hand over florins and receive a bill promising payment in, say, London, in pounds, some months later. The rate was fixed when the bill was written, not when it was cashed. Because currencies moved in between, the deal carried genuine risk, and risk was the thing that made it not usury. It was a loan wearing a currency trade as a costume, and it worked for centuries.

At its height the Medici bank ran around nine branches, in Rome, Venice, Milan, Pisa, Geneva, Avignon, Bruges and London, which made it the largest in Europe. It also shows you the failure mode early. The bank died in 1494 after years of lending to rulers who did not repay, Edward IV of England among them, while Lorenzo de' Medici gave his attention to politics and art. Charles VIII of France invaded and it was finished.

Lending to governments would remain the most profitable and most dangerous thing in the business for the next five hundred years.

Amsterdam invents the share

The next piece arrives in 1602, and it is the one that makes everything modern possible.

The Dutch East India Company needed more capital than any partnership could raise, because sending ships to Asia took years and a lot of them sank. So it raised about 6.4 million guilders from roughly 1,143 investors across six port cities, and it did something unusual with the money. It kept it. There was no winding up at the end of a voyage and dividing the proceeds. The capital stayed in the company permanently.

Which created a problem, and the problem is the invention. If you have put money in and cannot ask for it back, the only way out is to find somebody who will buy your stake. So people did, in the courtyard of the Amsterdam exchange, and a market in second-hand ownership of a company came into existence because it had to.

Everything an investment bank does now sits on that. Underwriting, listing, market-making, the entire idea that a claim on a business is a thing you can price and trade on a Tuesday afternoon, all of it needs a secondary market to exist first.

London and the business of funding wars

By the eighteenth century the centre had moved again, and the money was in war.

Francis Baring founded Barings in London in 1762. Governments fighting each other needed cash faster than taxes could deliver it, and the merchant banks arranged it, taking a cut and carrying the risk. In 1802 Barings, with the Dutch house Hope and Co, financed the Louisiana Purchase, which doubled the size of the United States. Britain was at war with France at the time, and the money went to Napoleon. Baring did it anyway, on the reasoning that a bigger America would be good for business later, which it was.

By 1818 people were calling Barings the sixth great European power, after England, France, Prussia, Austria and Russia. That was not entirely a joke. A firm that could decide whether a government got funded had something close to the leverage of a state.

Selling a war to ordinary people

America's contribution was distribution.

When the Civil War started, the Union needed to borrow on a scale no American government had attempted, and the usual method, quietly placing bonds with a handful of rich men and banks, could not raise it. A Philadelphia banker named Jay Cooke tried something else. He hired around 2,500 sub-agents and sent them through every northern and western state, selling government bonds in small denominations to schoolteachers and shopkeepers and farmers. He bought newspaper advertising through agencies and worked with editors on pieces encouraging people to buy. The pitch was patriotism and a return, in that order.

It worked enormously. Cooke shifted the entire $500 million issue and $11 million more, and in the first half of 1865 alone he placed another $830 million of seven-thirty notes. He had turned government debt into a retail product.

Then he did what bankers do next, which is believe his own run of form. Cooke put the firm into financing railway construction, specifically the Northern Pacific, and overreached. In September 1873 the firm suspended operations, and the failure helped set off the Panic of 1873. The man who had proved that ordinary people would fund a war went bankrupt eleven years later.

Back to the shop in Alabama

The cotton needs saying plainly. Alabama in the 1840s and 1850s ran on forced labour, and the cotton Lehman accepted from farmers and sold on was grown and picked by enslaved people. The firm's first capital came out of that, as did a good deal of the capital of nineteenth-century American finance generally, in New York as much as in Montgomery.

What the Lehmans did after the war is the standard route into the trade. If you broker cotton, you end up handling the paper that finances cotton. From there you finance the railways that carry it and the companies that spin it, and by the twentieth century you are underwriting share issues for anybody who asks.

Goldman Sachs arrived by much the same road. Marcus Goldman set up in 1869 buying merchants' short-term IOUs at a discount and selling them on to banks, which is about as unglamorous as finance gets, and it put the firm in the middle of everybody's cash flow.

1933: a wall down the middle

By the 1920s the two halves of banking had grown into each other. The bank holding your savings was also underwriting and selling securities, and could sell you the ones it was struggling to shift. When the crash came in 1929 and the banks went down with it, that arrangement got the blame.

The Banking Act of 1933, in the four sections known as Glass-Steagall, separated the two by law. A commercial bank taking deposits could not underwrite or deal in most securities, could not hold non-investment-grade paper for itself, and could not affiliate with a firm that did. An investment bank, in exchange, could not take deposits.

Firms had to pick a side. J.P. Morgan and Co chose to stay a commercial bank, so in September 1935 the partners who wanted the securities business walked out and opened their own shop. They called it Morgan Stanley, and in its first year it underwrote $1.1 billion of public offerings and private placements, about a quarter of everything issued in America.

1999: the wall comes out

For most of the century the separation held, and eroded slowly at the edges as regulators granted exceptions. Citibank was allowed to affiliate with Salomon Smith Barney in 1998, before the law changed at all. In 1999 the Gramm-Leach-Bliley Act repealed the separation outright. Bill Clinton signed it eight days after Congress passed it.

What followed is the argument people are still having. Nine years later, the trade that began with a Florentine dodging a ban on interest had produced a firm with $639 billion of assets and $613 billion of bank debt, and on 15 September 2008 Lehman Brothers filed the largest bankruptcy in American history. How much of that the repeal caused is genuinely contested, and anyone telling you it is simple is selling something. The collapse itself had a lot of authors.

Barings did not make it that far. In February 1995 a single trader in its Singapore office, Nick Leeson, ran up £827 million of losses gambling on Japanese futures and hiding it in an error account. The sixth great European power, 233 years old, was sold to ING for one pound. That one got a film too.

The pattern is the same in every case, and it is older than any of the firms. Someone works out how to move other people's money faster than anyone else, and gets rich. The method gets copied until it is ordinary. Then someone pushes it past what it can carry, and the whole thing has to be rebuilt by people carrying boxes out of a lobby.

Sources

• Wikipedia, "Lehman Brothers" (Henry Lehman's 1844 dry goods store, cotton taken as payment from plantations, the 1858 New York office, the 1870 Cotton Exchange, and the September 2008 filing with $639bn of assets and $613bn of bank debt).
• Wikipedia, "Medici Bank" (Giovanni di Bicci's 1397 founding, how bills of exchange sidestepped the usury ban, the branch network, and the 1494 collapse).
• Wikipedia, "Dutch East India Company" (the 1602 charter, the 6.4 million guilder raise from about 1,143 investors, permanent capital, and the secondary market in shares that followed).
• Wikipedia, "Barings Bank" (Francis Baring's 1762 founding, the Louisiana Purchase financing, the "sixth great European power" line, and the 1995 collapse and £1 sale to ING).
• Wikipedia, "Jay Cooke" (the roughly 2,500 sub-agents, small-denomination bonds, newspaper advertising, the $500m plus $11m and the $830m of seven-thirties, and the 1873 suspension).
• Wikipedia, "Panic of 1873" (how the failure of Cooke's firm fed the wider crisis).
• Federal Reserve History, "Glass-Steagall Act" (the 1933 separation and the reasoning behind it).
• Wikipedia, "Glass-Steagall legislation" (sections 16, 20, 21 and 32, what each prohibited, and the 1998 Citibank and Salomon Smith Barney affiliation).
• Wikipedia, "Morgan Stanley" (the September 1935 founding by Henry Morgan and Harold Stanley, and the $1.1bn and 24 percent share in its first year).
• Wikipedia, "Gramm-Leach-Bliley Act" (the 1999 repeal and the eight days between passage and signature).