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Tails, I Win; Heads, You Lose

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Illustration by Mark AndresenAbout a decade ago, in the advent of the Internet era, Wall Street was consumed with the “paradigm shift” occurring in the “New Economy,” where earnings no longer mattered and all that counted were “eyeballs.” Remember that drivel? Based on this flimsy, overweening logic, many investment bankers managed to convince successive waves of investors to buy the IPOs of companies that were little more than a few recent college graduates holed up in quasi-loft spaces south of San Francisco’s Market Street or in the shadow of Manhattan’s Flatiron building. Who can forget such spectacular flameouts as Globe.com and Pets.com? For a while, though, the ruse worked and many people got rich. 

But then, as ever, the Internet bubble burst and—as Warren Buffet likes to say—low tide set in. It became painfully obvious who wasn’t wearing any clothes. Investors lost their shirts, as did those venture capitalists and private-equity dons who continued to believe the world had really changed. The only ones—yet again—who made out like bandits were the investment bankers: they raked in billions of dollars in fees for underwriting deal after deal. And the most senior bankers among them, the very people who inflated the bubble in the first place, were paid millions of dollars in annual compensation. They were not held accountable in any way for their actions. And, in many cases, were promoted for playing so expertly Wall Street’s favorite parlor game.Tails, I win; heads, you lose.

This is hardly the first time that investment bankers have hoodwinked the marketplace. In the past thirty years—since the first Wall Street firm, Donaldson, Lufkin & Jenrette, ceased to be a private partnership in which the liability for partners’ behavior was shared ratably, and became a public corporation in which managing directors made use of shareholders’ money to take all the risks while they themselves reaped all the rewards—there has been a rash of boom-and-bust cycles perpetrated to a great degree by the investment-banking profession. The crash of 1987 had its origins in the leveraged-buyout boom of the previous four years, when cheap debt helped to drive up the price of equities, based on the fantasy that a buyout offer was looming for any and every public company. Not only did bankers incorrectly price the debt used to fund the LBOs, they also failed to account for its risk. The subsequent credit crisis was the four-year-long hangover from that shindig.

Then, in short order, came Long-Term Capital Management in 1998, the Internet bubble in 2001, and the emerging telecom bubble in 2002. These crises have been served up with increasing velocity and peril, culminating—for the time being—in the current credit paralysis, in which the only thing undervalued was risk, and which is proving to be the most intractable and shattering since the Great Depression. Each and every time, the bankers get rich and investors get burned.

Now the worm has turned. Wall Street is the one experiencing a massive paradigm shift. And the once supremely confident bankers do not have the faintest idea how to respond. The credit crisis has caught Wall Street in a web of its own making. Suddenly, all that “structured product,” which since 2002 has generated billions in revenue and billions in bonuses for the bankers and traders, has come back to haunt the very firms that packaged all those securities and shoved them out the door in the first place.


The detritus of a formerly noble profession is strewn everywhere. Witness the calamitous demise of the 85-year-old Bear Stearns, which survived the Depression, World War II, and the crash of 1987 only to be taken down over the Ides of March by its reliance on overnight financing and the waning profits from its broken mortgage-securitization business. Witness the ongoing bankruptcy and liquidation of Lehman Brothers, a firm nearly twice as old as Bear Stearns and once the proudest and most venerable of all the private partnerships. Witness the recognition by Merrill Lynch CEO John Thain that, incredibly, his firm would be next to succumb to the crisis of confidence. Thain wisely chose to set aside his ego and consider what would be best for his shareholders, opting to sell out to Bank of America for $50 billion in stock rather than risk ending up like Lehman.

Witness the languid third-quarter results of the two remaining publicly traded securities firms (to say nothing of their bleak outlook for the fourth quarter of the fiscal year). Witness the ever louder drumbeat for expanding regulatory oversight of the remaining independent investment banks, led by Treasury Secretary Hank Paulson, Federal Reserve Chairman Ben Bernanke, and Tim Geithner, the president of the Federal Reserve Bank of New York, and reaching a crescendo in the Fed’s extraordinary decision on September 21 to convert Goldman Sachs and Morgan Stanley into traditional bank holding companies, which will vastly reduce the amount of leverage they can use to generate revenue and profit in the future. Witness the growing fear of bankers and traders wondering whether their formerly impenetrable firms will survive and, even if the companies make it, whether they’ll be among the 20% or more of the Wall Street workforce to be fired.

Piece the shards together and the picture is clear: Wall Street no longer has the faintest idea how to make money in its core securities businesses.

A look at the third-quarter numbers at Goldman Sachs, the largest securities firm, reveals the extent of the damage in the basic Wall Street business model since the onset of the credit crisis a year ago. In the quarter that ended August 29, Goldman had $1.29 billion in investment-banking revenue, down 40% from $2.1 billion in the third quarter of 2007. The company’s advisory business, which offers expert advice on mergers and acquisitions, fell to $619 million, nearly a 56% drop from $1.4 billion a year earlier. Revenue from underwriting equity securities fell to $292 million from $355 million a year earlier (an 18% decline), and revenue from debt underwriting was about flat, at $383 million, within the year-earlier period. Notwithstanding an impressive culture of prudent risk-taking and a willingness to rapidly promote new leaders unafraid to challenge the status quo, Goldman reported one of its worst quarters since it went public in 1999.

At Morgan Stanley, the third quarter managed to surpass analysts’ meager expectations but still resulted in a 28% drop in year-over-year investment-banking revenue, including a 40% drop in advisory revenue. (In fairness, Morgan Stanley’s investment-banking revenues were 18% higher in the third quarter of 2008 than in its disastrous second quarter.) Arguably, the third quarter of 2007—during which the painful effects of the global credit crunch were still being revealed—makes for an unfair comparison. Nevertheless, these contractions across nearly every banking segment at Goldman Sachs and Morgan Stanley are breathtaking.

At Merrill Lynch, things were so bad in the run-up to its sale that it could no longer productively tap outside investors for the capital it desperately needed. It had no choice but to sell previously strategic assets to replace the capital lost to write-downs on its inventory of mortgage-related securities. This past summer alone, Merrill sold its valuable 20% stake in Bloomberg, the juggernaut of financial-information services, back to Bloomberg for $4.43 billion. It sold Financial Data Services, an in-house mutual fund administrator, for $3.5 billion; and it tried and failed to unload its 49% stake in BlackRock, the hugely successful money-management firm. In another effort to salve its wounds, on July 28 Merrill took the extraordinary step of selling $30.6 billion of its mortgage-related securities for 22 cents on the dollar and then financed most of the purchase price for the buyer. But at least Thain was willing to take drastic action.

The same cannot be said for Dick Fuld, the longtime CEO of Lehman. Just days before its demise, Lehman announced a poorly received “restructuring,” hoping to sell 55% of Neuberger Berman, the asset-management business it acquired in 2003 for $2.6 billion, to hive off around $30 billion of commercial real-estate assets into a separate, publicly traded entity, and to sell $4 billion of its UK residential-mortgage portfolio. But it was too little, too late. Now Lehman’s pieces will be flung to the four corners of the Earth for pennies on the dollar.


Banking has always been an elaborate confidence game, and banks and bankers have done everything in their power to instill that confidence, from constructing imposing headquarters with air- and water-tight vaults (for instance, the vault at the New York Fed, with its $200 billion of gold bullion, can be locked down in as little as 30 seconds), to dressing and acting like fat cats. But, as the nearly instantaneous meltdown of Bear Stearns and Lehman Brothers proves, once confidence is lost and no one will do business with you, the vaults and suits are revealed as so much stage props and costuming.

For the first time in a generation, Wall Street appears to be experiencing something way beyond a palpable lack of confidence. There is genuine fear in the corridors of power. Steve Schwarzman, the cofounder of the publicly traded buyout firm the Blackstone Group and an investment-banking connoisseur, can already see that significant changes are underway in the industry where he got his start (with Lehman Brothers). The new regulatory regime, he concedes, will rightly prevent investment banks from continuing to pile up mountains of debt on a sliver of equity capital. “No one knows how much the decrease will be, but they’re betting that it will be significant,” he says. “If that’s the case, then logic dictates that the ongoing earnings power of those companies should be less because they have fewer assets upon which to earn money. That has implications for the extension of credit and the deployment of capital by those institutions.”

Jimmy Cayne, the former longtime chief executive officer of Bear Stearns, is even more pessimistic about the future of investment banking. “Tell me where the profit’s coming from?” he demands, referring to the fact that the market for the types of asset-backed debt securities (such as home mortgages, credit-card loans, or automobile loans) that used to be hugely profitable for his firm and most of its competitors has all but dried up. “You think you make any money in investment banking away from this part of it?” he continues. “Investment bankers are loss leaders. You’re paying these very ordinary guys two million, three million, a million and a half—for what? They do one deal a year, maybe. Your balls are on the line with the leveraged-lending part of it. And you don’t get paid for the risk. If you get to the point where that’s your business, your business is flawed.” Cayne believes that Wall Street is going through a “massive sea change. Salvation? I don’t see it. Hope, hope exists. Hope it comes back.”

Gary Parr, Lazard’s deputy chairman and a longtime M&A advisor to financial institutions (including advising Bear Stearns on its shotgun marriage to JPMorgan), is more sanguine about the future of his industry, albeit from the placid comfort of a 63rd-floor office at Lazard’s 30 Rockefeller Center headquarters. Lazard has few of the headaches of its fellow investment banks largely because it couldn’t be more different from them. The company has only two business linen its publicly traded entity: M&A advisory and asset management, neither of which requires much capital to operate. (In the first quarter of 2008, Lazard did take an unexpected $28.5-million write-down on a portfolio of stocks and bonds in its Paris operations, but this is negligible in the context of what its brethren have experienced.)


Since Lazard appears relatively insulated from the current calamities on Wall Street (which does not mean the firm is unaffected by the dearth of M&A assignments or the schizophrenic stock markets), Parr is able to take a long view. “Some people say, ‘The business of Wall Street is forever changed.’ And I scratch my head and say, ‘No.’ Take securitizations, for example. There’s nothing inherently wrong with securitizations. What’s wrong is if you don’t have good information or if you don’t have good underwriting: then you have a problem. The product is fine, subject to doing your homework. This is a time when nobody wants to touch securitizations because they’re afraid and they don’t know what’s in them. But I’ll wager that between four and eight years from now the securitization market will be fine. There’s all the reason in the world for creating securitized mortgages and tranching them. It’s a perfectly logical thing to do to find different investors. In this situation, too many people underwrote risk and didn’t know what they were underwriting.”

Parr does agree with Schwarzman that the days when securities firms massively leveraged their balance sheets are over. “It could be a very long time, if ever, before that kind of leverage returns,” he admits.

It could also be a very long time before securities firms again rely heavily on the market in so-called “overnight repurchase agreements,” or “repo,” to fund their daily needs. The “run on the bank” at Bear Stearns arose from the refusal of nearly every one of its overnight lenders—firms such as Fidelity Investments and Federated Investors—to continue to provide the relatively inexpensive secured financing they had shelled out every day for the previous twenty years or so. Among the ways Bear Stearns financed itself was to use its growing inventory of mortgage-related securities as collateral to secure as much as $50 billion of its financing needs every day. The cost of accessing the repo market for Bear Stearns was relatively low compared to arranging for longer-term financing in the public markets or from a consortium of banks. (Goldman, for instance, relies very little on the overnight repo market and pays hundreds of millions of dollars more each year in interest expense as a result.)

Bear Stearns made itself vulnerable by handing its creditors in the repo market a daily vote on the firm’s efficacy. When the rumors about the company’s viability reached a fever pitch during the week of March 10, these overnight lenders simply said they would no longer provide the requisite financing. This left Bear Stearns no other option but to tap its own quickly dwindling cash reserves—at that time around $17 billion—to try to meet all the cash-withdrawal requests of its hedge-fund and other trading customers. By Friday, March 14, the confluence of the tsunami of withdrawals and the negative vote of the repo lenders meant that les jeux sont faits: the gig was up.

Ironically, Wall Street would never advise its corporate clients to finance themselves this way. But, in truth, few people outside the repo desk or the treasurer’s office had any idea this was how Wall Street was operating. And by the time the current credit crisis forced the senior executives on Wall Street to confront the lunacy of this funding methodology, time was not an ally. It takes months to unwind one financing scheme and replace it with another; it’s like turning around a battleship. There’s no telling what other firms besides Bear Stearns might have disappeared in the days following the Federal Reserve’s decision on the night of March 16 to open its “discount window” to securities firms for the first time since the 1930s. Of course, not even access to the Fed window could save Lehman Brothers from its ignominious fate, or Merrill, Morgan Stanley, and Goldman Sachs from theirs.

“It’s interesting,” Parr reflects. “About seven or eight years ago I had a conversation with [a Wall Street CEO] about how he was considering merging with a bank to get a deposit base. All that is happening now is that everyone is saying, ‘Yep, it’s true, when the wholesale-funding market goes bad, you’ve got a problem.’ As Bear Stearns proved, you can’t tell whether you have enough cash judging only by your balance sheet. Just to be arbitrary about it, if a firm has $160 billion of liquidity on its balance sheet and $200 billion of funding that rolls in the next three days, it’s not enough. And during a run on the bank, if we only get one side of the equation, to me, that means nothing. Tell me about your funding.”

Was it ever a prudent strategy for Wall Street to fund itself this way? To Parr, the answer is crystalline only in hindsight. “Well, it worked for, what, the last 15 years? For three days for Bear Stearns, it didn’t work, but for 15 years it did work, is that a reasonable proposition? I don’t know. But it’s like an insurance policy. That’s why you buy insurance policies, for the three days things don’t work right out of 5,475 days when they do.”


Given the ongoing paralysis gripping Wall Street, what is the prognosis for the securities industry? In the short term, Wall Street will pay for having had access to the Fed’s discount window by suffering under a far stricter regulatory and oversight regime. Already, representatives of the SEC, the New York Federal Reserve, and the Treasury are becoming fixtures inside investment banks. And after the Fed’s September 21 decision, it appears the traditional broker–dealer configuration is all but dead. As Schwarzman observes, these supervisors are insisting that Wall Street operate with less leverage and more equity capital. That approach will drive down the risk on balance sheets, but also risk’s return on equity, one of the measures firms use to compensate their top executives. (That correspondence was especially pertinent at Bear Stearns, where intraquarter leverage got as high as 50–1. Right up to the bitter end, members of the executive committee repeatedly turned down offers for more equity to avoid lowering their compensation.)

Without question, the cost of financing day-to-day operations will increase. No firm—one hopes—will ever again make itself as vulnerable to the whims of its repo lenders as Bear Stearns, even if self-protection involves shelling out tens of millions of additional dollars in interest expense annually to lengthen the terms of its financing. Ideally, Wall Street’s two remaining global securities firms could both find a cheaper source of financing (along the lines of what Parr’s anonymous CEO alluded to) by buying a bank and using customer deposits. But now is hardly the time for such a move, since no firms are in a position to buy and no banks are in a position to sell, given their depressed stock prices and the still unknown toxicity of their balance sheets. Nor, of course, is it viable to hope that either JPMorgan Chase, the firm that rescued Bear Stearns, or Bank of America, which bought Merrill, will step up and buy Morgan Stanley or Goldman Sachs.


Increasingly zealous regulation, higher financing costs, and significantly lowered revenue in investment banking: this unfortunate troika means a period of extended misery whether you are independent—like Goldman Sachs or Morgan Stanley—or part of a depository institution, like the remains of Merrill Lynch, Bear Stearns, and Lehman. One way to ameliorate shareholder pain and boost short-term profits would be to cut the compensation of bankers and traders severely, which may end up being part of the price the profession pays for Paulson’s proposed bailout of $700 billion. After all, there is scarcely another profession on the planet where 50% or more of each dollar of revenue slips into the pockets of employees. And no serious effort to hold bankers and traders accountable for their actions has been made to date. They get paid based on the revenue they generate, regardless of the losses that result from the products they manufacture and sell. Now that the industry is on its back, it’s the ideal moment to cut overall pay and create an escrow account to hold a portion of that compensation until any resulting losses or litigation have been determined. Wall Street would immediately be more profitable, and would operate more like other corporations—for the benefit of shareholders, rather than employees.

A move like that would raise a hue and cry about how lower compensation levels on Wall Street would result in a loss of the best talent. In response to that, the question must be asked, unflinchingly and with a nod to Jimmy Cayne: Where is it written that bankers and traders must make millions of dollars a year? If their current paychecks were halved, they’d still be earning far more than they could hope to make in another profession. And they know it.

A gallon of gas costs around $4, a gallon of milk even more. Perhaps a heaping helping of humble pie is exactly the right medicine for what ails Wall Street. And besides, why should anyone care what happens to a bunch of overpaid bankers and traders floundering in a mess that they created with their own greed and carelessness?

Well, for starters, healthy global capital markets are a prerequisite for a thriving economy. All those now-moribund debt and equity underwritings raise trillions of dollars in capital each year that companies use, in part, to buy new plants and equipment, to create new and intellectually engaging jobs, and to take chances on new technologies such as wind power and cars that run on hydrogen instead of fossil fuel. Without capital to lubricate the gears, our economy will sputter to a halt. Even the much-maligned subprime mortgage did make home ownership possible for millions of Americans who otherwise could never have dreamed of it. Most of the new homeowners with these mortgages—some estimate the number at 75% or more—still make their interest and principal payments on time. But bad apples and crashing home values have done in that particular financial innovation for the foreseeable future. And we may not be better off as a result.

Perhaps the best answer for a happy ending to the current crisis on Wall Street is a return to old-fashioned ingenuity. Investment banking is suffering through one of the worst financial disruptions in generations, and the outlook is bleak. Still, “smart people will always find a way to make money,” says Schwarzman. For the sake of our way of life—however flawed it may be—let’s hope he’s right.

–William D. Cohan is a former senior Wall Street investment banker, whose first book, The Last Tycoons: The Secret History of Lazard Frères & Company, won the 2007 Financial Times/Goldman Sachs Business Book of the Year Award. He is also the author of House of Cards, a book about the collapse of Bear Stearns & Company.

Illustration by Mark Andresen.

This article was originally published in the Fall 2008 Issue of the Investment Professional.

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