Skin Out of the Game, Socialized Losses and Bag Holders
The Transformation of Wall Street: From Partnerships to Public Companies
The most dangerous four words in finance are "this time is different."
But sometimes, fundamental changes really do alter the game permanently, usually not for the better. The transformation of Wall Street from private partnerships to publicly traded corporations represents exactly this kind of seismic shift. What we got was a financial system drowning in leverage, addicted to risk, and operating with other people's money while privatizing the profits and socializing the losses.
The numbers tell the story with brutal clarity. Partnership era firms typically operated with leverage ratios of 10 to 15:1. By 2007, the major investment banks were running 25 to 35:1 leverage. Lehman Brothers reached 31:1 leverage while Bear Stearns exceeded 30:1. When you're levered thirty times over, a 3% decline in asset values wipes out your entire capital base. That's not banking, that's gambling with loaded dice.
When Partners Had Skin in the Game
Back when Wall Street operated as partnerships, the people making the risk decisions had their own money on the line. Partners faced unlimited personal liability. If the firm blew up, they could lose their houses, their kids' college funds, everything. That's the kind of incentive structure that focuses the mind wonderfully.
Consider Sidney Weinberg, who ran Goldman Sachs from 1930 to 1969. Started as a janitor's assistant at $3 a week, cleaning spittoons and brushing partners' hats. Worked his way up to senior partner and became known as "Mr. Wall Street." When Penn Central went bankrupt in 1970 with $80 million in commercial paper that Goldman had sold, the resulting lawsuits threatened the partnership's survival. The amount of defaulted paper was nearly twice Goldman's capital. These weren't abstract shareholders getting hurt. It was Weinberg and his partners' personal wealth at stake.
Here's the telling part: when Goldman realized Penn Central was in trouble, they demanded the railroad buy back Goldman's $10 million inventory at full price on February 5, 1970, the very day they received Penn Central's latest dismal numbers. They protected themselves while leaving their clients holding the bag. It was sleazy behavior, but at least the partners' own money was at risk. They weren't gambling with other people's capital while collecting bonuses regardless of outcome.
The Penn Central disaster led directly to credit ratings for commercial paper, a system we still use today. The crisis taught painful lessons about due diligence and disclosure. More importantly, it nearly destroyed Goldman Sachs as a partnership, which concentrated the minds of everyone involved on not making similar mistakes.
Partnership capital was also illiquid. You couldn't just cash out when things got rocky. Partners typically couldn't withdraw capital for years, which encouraged thinking beyond the next quarter's results. Senior partners mentored junior partners because the firm's long-term success determined everyone's wealth.
There was genuine collective responsibility because everyone's personal fortune rose and fell together.
The Leverage Monster Awakens
Going public changed everything. Suddenly these firms had access to massive amounts of other people's capital. No more being constrained by how much the partners could personally afford to lose.
Want to lever up 30:1? No problem. It's not your house on the line anymore.
The progression was relentless. In 1970, Goldman's assets were 6.5 times its capital. By the 2000s, this had exploded to 30 times. Off balance sheet assets became a significant fraction of total assets for large investment banks, creating additional layers of risk that were often poorly understood even by senior management.
Take Lehman Brothers. By 2008, Lehman had assets of $680 billion supported by only $22.5 billion of firm capital. From an equity position, its risky commercial real estate holdings were thirty times greater than capital. As one analyst put it, "Lehman had morphed into a real estate hedge fund disguised as an investment bank." With that kind of leverage, a 3% to 4% decline in asset values would wipe out all capital. That's exactly what happened.
The firm's leverage ratio increased from approximately 24:1 in 2003 to 31:1 by 2007. They were using tricks like Repo 105 transactions to temporarily move assets off their balance sheet around reporting dates, making their leverage appear lower than it actually was. It was accounting gimmickry designed to fool regulators, rating agencies, and investors about the firm's true risk exposure.
Bear Stearns was running similar numbers: leverage exceeding 30:1 with massive exposure to mortgage backed securities and collateralized debt obligations. When confidence evaporated, these firms collapsed in days. You can't run a 30:1 leverage ratio and survive even a modest decline in asset values. It's mathematically impossible.
Compare this to the partnership era.
When your personal wealth is on the line, you don't lever up 30 times over. You sleep at night because you know a market downturn won't bankrupt you personally. The partnership model enforced conservative capital structures through the most powerful incentive known to mankind: self-preservation.
The Moral Hazard Machine
The shift to public ownership created what economists politely call "moral hazard," the tendency to take excessive risks when someone else bears the consequences. In plain English, it's the difference between gambling with your own money versus gambling with other people's money.
Limited liability for shareholders meant that management operated with "other people's money" rather than their own personal wealth. This separation of ownership and control created incentives for excessive risk taking that simply didn't exist in partnership structures. If a bet paid off, management collected huge bonuses. If it blew up, shareholders and taxpayers took the losses.
The cultural transformation was profound. Goldman Sachs provides the clearest example. Partner ownership dropped from 60% at the 1999 IPO to less than 10% by 2008. The firm's traditional "long-term greedy" philosophy, emphasizing sustainable profits over short-term gains, came under pressure from quarterly earnings expectations and stock price performance.
Steven Mandis, a former Goldman portfolio manager who wrote about the firm's "organizational drift," documented how the 1999 IPO accelerated cultural changes. Partnership profit sharing gave way to stock based compensation, individual performance bonuses, and complex incentive structures tied to stock price performance rather than firm fundamentals. The partnership track, which had provided powerful incentives for long-term commitment, was replaced by more liquid stock options that could be exercised and sold relatively quickly.
Academic research confirms these effects. A surprising study of the 1960s "back office crisis" found that partnerships weren't necessarily more risk averse than corporations in practice. Both organizational forms experienced similar failure rates during that crisis. But this was before the modern era of extreme leverage and complex derivatives. Today's risks are exponentially larger and more interconnected than anything Wall Street faced in the 1960s.
When Business Was Still Business
The partnership model fostered a different approach to client relationships and business practices. Partnership firms prioritized long-term client relationships over transaction volume, with senior partners personally involved in key client relationships. Reputation was everything because partners' personal wealth depended on maintaining the firm's standing in the market.
Sidney Weinberg exemplified this approach. He served on 35 corporate boards simultaneously, using his position to generate investment banking business for Goldman Sachs. When he advised clients, his personal reputation was on the line. Screw up a client relationship, and it directly affected his personal wealth and standing in the business community. This created powerful incentives for honest dealing and competent advice.
Weinberg's network was legendary. His relationships with titans like Henry Ford II, built during his service on the War Production Board during World War II, led directly to Goldman winning the Ford Motor Company IPO in 1956, then the largest IPO in U.S. history at $657 million. These weren't transactional relationships built on quarterly fee generation. They were decades long partnerships built on trust and mutual benefit.
Public companies faced different pressures. Quarterly earnings guidance created short-term pressure that often conflicted with long-term client relationship building. The need to meet analyst expectations and maintain consistent growth rates influenced strategic decisions in ways that partnership structures avoided. Cross selling became more aggressive, and there was increased pressure to generate fees and expand into new, potentially riskier business lines.
The transformation also enabled massive expansion in complex financial products. Access to capital markets allowed firms to become major players in proprietary trading, mortgage securitization, and derivatives trading.
While this expansion generated enormous profits during good times, it also created systemic risks and interconnectedness that contributed to the 2008 financial crisis.
Instead of being paid to provide advice and execute transactions, these firms became massive hedge funds using other people's money to place increasingly complex bets. They weren't serving clients. They were competing with them.
The Regulatory Enablers
The transformation from partnerships to public companies was facilitated by regulators who seemed determined to remove every constraint on risk taking. The gradual erosion and eventual repeal of Glass Steagall Act restrictions removed barriers between commercial and investment banking, creating opportunities for larger, more complex financial institutions. The Gramm Leach Bliley Act of 1999 formally repealed Glass Steagall's affiliation restrictions, enabling the creation of financial behemoths that combined various financial services.
The Securities and Exchange Commission's creation of the Consolidated Supervised Entity (CSE) program in 2004 was regulatory malpractice disguised as supervision. This voluntary program allowed five major investment banks (Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns) to operate with reduced regulatory capital requirements in exchange for comprehensive supervision. In practice, this meant higher leverage ratios and less oversight. The program was terminated in September 2008 after it had enabled the very leverage that destroyed the financial system.
Think about the perverse incentives here. Regulators essentially told the biggest investment banks: "We'll let you lever up to dangerous levels as long as you pinky promise to supervise yourselves." It was like letting teenagers regulate their own drinking at a keg party.
International regulatory competition also played a role. Competitive pressure from European universal banks and the need for regulatory equivalence in global markets pushed U.S. regulators to create frameworks that allowed American investment banks to compete internationally by taking more risk. This regulatory arbitrage created opportunities for firms to optimize their capital structure and avoid traditional banking regulations.
The Dominoes Fall
The transformation occurred in waves, with each conversion making the next one inevitable. Merrill Lynch broke the dam in 1971 with its groundbreaking IPO, raising approximately $60 million and achieving a $400 million market capitalization. Wall Street was horrified. Going public was seen as selling out the partnership culture that had built these firms.
Morgan Stanley followed in 1986, raising $163.8 million. The firm, considered one of the most "clubby" since its 1935 founding, cited the need for outside capital to remain competitive. Bear Stearns went public in 1985, and Lehman Brothers completed its transformation in 1994 as part of its spin-off from American Express.
Goldman Sachs held out until May 1999, making it the last major firm to convert. The firm raised $3.657 billion by selling 15% of the company at $53 per share, with shares closing at $70.38 on the first day. This marked the end of an era. All major "bulge bracket" investment banks had now adopted public company structures.
But Goldman's IPO came at the peak of the dot com bubble and just before the Long-Term Capital Management crisis demonstrated how interconnected and fragile the financial system had become. LTCM was leveraged 25:1 and when Russia defaulted on its bonds in 1998, the hedge fund lost $4.6 billion in a matter of months. The Federal Reserve organized a bailout because LTCM's failure would have brought down half of Wall Street.
Think about that: a single hedge fund with $125 billion in assets nearly destroyed the global financial system. And this was before the investment banks had really cranked up their leverage to 30:1 and loaded up on mortgage backed securities.
Compensation Revolution and Cultural Drift
The transition fundamentally altered compensation structures and created what researchers call "organizational drift." Partnership profit sharing gave way to stock based compensation, individual performance bonuses, and complex incentive structures tied to stock price performance rather than firm fundamentals.
Steven Mandis's research on Goldman Sachs revealed that the 1999 IPO accelerated cultural changes as compensation structures shifted from collective profit sharing to individual stock based rewards. The partnership track, which had provided powerful incentives for long-term commitment, was replaced by more liquid stock options that could be exercised and sold relatively quickly.
Ethnographic research by Karen Ho found that investment banks developed a "culture of liquidity" where job insecurity became normalized and employees were treated as expendable assets. Higher turnover and talent "liquidity" replaced the apprenticeship model that had characterized partnership era firms. The competitive internal culture driven by individual incentives contrasted sharply with the collective identity and shared risk taking of partnership structures.
Case Studies of Transformation
Goldman Sachs represents the most studied conversion, as the firm maintained its partnership structure longest and was viewed as the epitome of Wall Street partnership culture. The firm's transformation was gradual but profound, maintaining the partnership promotion process while adapting to public ownership requirements. However, the decline in partner ownership from 60% to less than 10% within a decade fundamentally altered the firm's power dynamics.
Morgan Stanley's 1997 merger with Dean Witter illustrates the challenges of cultural integration in the public company era. The $10.2 billion merger created the world's largest securities firm but faced significant cultural conflicts. Dean Witter's "control from the top" culture clashed with Morgan Stanley's collaborative approach, leading to years of internal division and ultimately CEO Philip Purcell's departure in 2005.
Merrill Lynch's evolution demonstrates how public company pressures can drive excessive risk taking. The firm's massive exposure to collateralized debt obligations and mortgage backed securities by 2007 reflected a departure from its traditional focus on retail wealth management. The firm's ultimate sale to Bank of America for $50 billion in September 2008 marked the end of its independence.
Bear Stearns and Lehman Brothers maintained strong partnership cultures even as public companies but ultimately failed due to excessive leverage and risk concentration. Bear Stearns' heavy involvement in mortgage securitization and CDO trading, combined with leverage exceeding 30:1, led to its collapse in March 2008. Lehman Brothers' $85 billion mortgage portfolio (four times shareholders' equity) and 31:1 leverage ratio made it extraordinarily vulnerable to market downturns.
Long-Term Versus Short-Term Thinking Transformation
The partnership model inherently encouraged long-term thinking through several mechanisms. Partners' illiquid stakes and unlimited liability created incentives for sustainable profit generation rather than short-term maximization. The annual profit sharing cycle allowed for longer term planning without the pressure of quarterly earnings guidance.
Public companies face fundamentally different incentives. Quarterly earnings calls and analyst expectations create pressure for consistent short-term performance that can conflict with long-term value creation. Stock based compensation aligns management with share price performance, which can encourage strategies that boost short-term stock prices at the expense of long-term stability.
Research on managerial behavior confirms these effects. Managers with investment banking experience in public companies exhibited more myopic behavior, prioritizing short-term financial performance over long-term investments. The pressure to maintain consistent growth rates and meet quarterly guidance influenced strategic decisions in ways that partnership structures avoided.
The Price of Playing with House Money
The inevitable happened in 2008. The failure of Lehman Brothers, Bear Stearns, and the distressed sale of Merrill Lynch demonstrated the "too big to fail" problem that partnership structures had avoided through their smaller scale and conservative capital structures. These weren't orderly business failures. They were systemic explosions that nearly destroyed the global financial system.
Bear Stearns collapsed first in March 2008, sold to JPMorgan for $2 per share (later raised to $10). The firm's heavy involvement in mortgage securitization and CDO trading, combined with leverage exceeding 30:1, made it extraordinarily vulnerable to market downturns. When confidence evaporated, the firm had days, not weeks, to find a buyer.
Lehman Brothers followed in September 2008 with the largest bankruptcy in U.S. history. The firm's $85 billion mortgage portfolio (four times shareholders' equity) and 31:1 leverage ratio made it a mathematical certainty that even a modest decline in real estate values would wipe out all capital. Close to 100 hedge funds used Lehman as their prime broker, and when it filed for bankruptcy, $22 billion of client assets had been re-hypothecated, creating systemic risk throughout the financial system.
Merrill Lynch, seeing the writing on the wall, sold itself to Bank of America for $50 billion in an emergency weekend deal. The "thundering herd" that had pioneered retail wealth management ended its independence because of massive exposure to collateralized debt obligations and mortgage backed securities.
The Federal Reserve's research confirms that leverage ratios became procyclical for investment banks, increasing during boom periods and creating vulnerability during downturns. The complexity of off balance sheet vehicles and derivatives positions made risk assessment difficult even for regulators and firm management.
Compare this to the partnership era. When Sidney Weinberg nearly lost Goldman Sachs in the Penn Central bankruptcy, the firm learned its lesson and became more conservative. The partners' personal wealth was at stake, so they had every incentive to avoid repeating the mistake. But when you're gambling with other people's money and getting paid regardless of the outcome, why would you exercise restraint?
Cleaning Up the Wreckage
The 2008 crisis prompted fundamental regulatory changes designed to address the risks created by the partnership to corporation transformation. Goldman Sachs and Morgan Stanley became bank holding companies, subjecting them to enhanced capital requirements and Federal Reserve supervision. The Dodd Frank Act imposed comprehensive regulation on systemically important financial institutions, including stress testing and capital planning requirements.
The Volcker Rule restricted proprietary trading, attempting to separate customer serving activities from speculative risk taking. Enhanced capital and liquidity requirements aimed to recreate some of the risk discipline that partnership structures had provided through personal liability. However, these regulatory solutions attempt to impose external constraints rather than internal incentives.
But here's the problem: you can't regulate away incentive structures. As long as management can collect huge bonuses for taking risks with other people's money while facing limited downside if those risks go bad, they'll find ways around the regulations. The fundamental incentive misalignment between limited liability shareholders and unlimited liability partners remains unresolved.
We've also made the "too big to fail" problem worse, not better. Today's banking behemoths are larger than the institutions that nearly destroyed the financial system in 2008. Bank of America, JPMorgan Chase, and Wells Fargo each have over $2 trillion in assets. When institutions are that large, their failure isn't just a business problem. It's a threat to the entire economy.
The partnership model wasn't perfect, but it had one crucial advantage: the people making the risk decisions had their own money on the line. That's the most powerful risk management tool ever created. Everything else is just regulatory theater.
The Lesson We Refuse to Learn
The transformation from partnerships to public companies illustrates a fundamental truth: incentive structures matter more than regulations, oversight, or good intentions. When Sidney Weinberg was running Goldman Sachs, he couldn't afford to blow up the firm because it would have destroyed his personal wealth. When Dick Fuld was running Lehman Brothers, he collected hundreds of millions in compensation while driving the firm into bankruptcy.
Guess which system produced better risk management?
The evidence is overwhelming that organizational form matters crucially for financial institutions. While public ownership enabled massive growth and innovation, it also created moral hazard problems that contributed to excessive risk taking and systemic instability.
The partnership model's alignment of personal wealth with firm performance created risk discipline that has proven difficult to replicate in public company structures.
The challenge for modern investment banking is maintaining the growth and innovation benefits of public ownership while recreating the risk discipline and long-term thinking that characterized successful partnerships. Current regulatory approaches attempt to achieve this through external constraints, but you can't regulate away bad incentives.
We now have a financial system where profits are privatized and losses are socialized. When things go well, management and shareholders collect enormous profits. When things go badly, taxpayers bail out the system.
This isn't capitalism. It's crony capitalism designed to enrich insiders at the expense of everyone else.
The partnership era had its problems, but at least the people taking the risks bore the consequences of their decisions. That's the essence of a free market: profits and losses should accrue to the same people making the decisions. What we have now is a system designed to encourage reckless risk taking because the downside is borne by others.
Until we restore the principle that the people making the bets should be the ones losing their own money when those bets go bad, we'll continue to lurch from crisis to crisis. The next one is coming. The only question is whether we'll be smart enough to see it in advance or whether we'll once again be surprised that gambling with other people's money eventually leads to disaster.