CNBC Business | Gamblers Unanimous

Gamblers Unanimous

World markets were brought to their knees by the collapse of US investment  banks. Chris Owen looks at the casino culture that brought the house down.

At 21:30 hours on 21 September 2008, at the end of the most tumultuous week in the financial markets since the Wall Street Crash of 1929, the US Federal Reserve Board announced that it had approved the applications of Goldman Sachs and Morgan Stanley to become  bank holding companies.

In this bland statement, rushed out on a Sunday night before the start of trading in Asia, the Fed had, in effect, called time on the last two major bulge bracket broker-dealers on Wall Street. The full-service investment bank model – buying and selling shares and bonds for customers, as well as advising companies and trading with their own capital – was declared extinct. 

Whereas universal banks raise their money by taking deposits from investors, the US  investment banks relied on short-term funding through the money markets and on leverage to grow their return on equity. Their growth was fuelled by the low cost of capital in recent years, as Wall Street engaged in  one of the largest carry trades in history, borrowing more cheaply than they could lend. When this funding dried up they were left ruthlessly exposed. 

By waiving the normal five-day waiting period for approval, the Fed was attempting to shield Goldman Sachs and Morgan Stanley from the financial storm that had already engulfed their former peers – Lehman Brothers, Bear Stearns and Merrill Lynch – and, at the same time, to assist them to transition to another business structure following the sudden collapse of confidence in their stand-alone broker-dealer model. 

In the short term, relinquishing their cherished status will afford them greater access to emergency funding from the US Federal Reserve’s lending facility. In March, the Fed opened its discount window to investment banks for the first time since the Great Depression – but this was only ever designed to be a temporary measure. In the longer term it will also make them subject to far tighter regulation by the US central bank, which will mean yet more capital, lower leverage and more disclosure. 

“When Goldman Sachs was a private partnership, we made the decision to become a public company, recognising the need for permanent capital to meet the demands of scale,” said Lloyd Blankfein, its chairman and chief executive. “While accelerated by market sentiment, our decision to be regulated by the Federal Reserve is based on the recognition that such regulation provides its members with full prudential supervision and access to permanent liquidity and funding.”  

John Mack, his Morgan Stanley counterpart, stuck to the same script. “This new bank holding structure will ensure that Morgan Stanley is in the strongest possible position – with the stability and flexibility to seize opportunities in the rapidly changing financial marketplace. It also offers the marketplace certainty about the strength of our financial position and our access to funding,” he said.  

For these colossi it was a humbling moment; for decades they had occupied the commanding heights of Wall Street. But of the five independent US investment banks open for business at the start of this year, these two were the last – and confidence in their business model was ebbing fast. Banks from Iceland to Germany were creaking and the global financial system had started tearing itself apart. It was time to go down into  the valley. And fast. 

How did all this come to pass? Stockbrokers such as Morgan Stanley were pushed out on their own by the 1933 Glass-Steagall Act, which enforced the separation of commercial and investment banking activities after the Wall Street Crash. But when fixed commissions for trading securities were abolished in 1975, they were obliged to look elsewhere for their profits. 

In the 1990s, M&A was the cornerstone of investment banking. The big Wall Street firms grew rapidly, hiring thousands of employees and expanding around the world. At the same time they started to gamble more with their own capital. Salomon Brothers (which was subsumed into Citigroup late in the decade) pioneered the concept of a proprietary trading desk – a trading group that risks the bank’s own money on movements in markets – at the same time as the bank bought and sold securities on behalf of its customers. 

But after the US Congress repealed Glass-Steagall in 1999, commercial banks began muscling in on Wall Street’s turf. As the new competition whittled down profit margins, investment banks used more of their capital to trade securities and also expanded into the underwriting and selling of complex financial securities, such as collateralised debt obligations (CDOs). In this they were aided by the Federal Reserve’s decision to cut US interest rates sharply after 11 September 2001, which sparked a boom in housing and mortgage-backed securities. 

Wall Street became ravenous to buy in loans from US mortgage lenders, many in the subprime category, which could be sliced up to create the investment grade bonds needed to satisfy the huge demand from income-starved and regulation-bound fund managers. Higher risk debts were therefore stripped out and concentrated into lower grade instruments that were more difficult to sell on. 

Broadly, these so-called “toxic bonds” were disposed of these in three ways: by setting up hedge funds to trade in the high-risk CDO instruments; by selling them on to institutional funds; or by retaining them but disposing of the default risk by paying a premium to another investment institution through a Credit Default Swap (CDS). To complicate matters further, these CDSs could be packaged into “synthetic CDOs”, with cash flows based exclusively on insurance premiums, which were also sold on to the market. All this activity generated vast sums for the Wall Street banks, helping them to post a run of record profits in recent years, leading to record bonus payouts. But when the US property market dipped and borrowers began to default on mortgages, this spiral  of complex securities began to unravel. 

When the music stopped no one could be certain who was left holding the toxic waste, and the lack of transparency resulted in liquidity drying up, making the assets almost impossible to value. Fear gripped the market and banks stopped lending to each other. The credit crunch kicked in and the stand-alone model of the Wall Street banks left them uniquely exposed – they were shorn of both capital and confidence. Most  importantly, the assets they held and had previously pledged as collateral to other banks in order to fund themselves were as good as worthless; no one would lend them funds against them. 

The first to succumb was Bear Stearns, then the smallest of the Wall Street five but the second-largest underwriter of mortgage-backed securities. In August 2007, two Bear Stearns’ hedge funds that were highly leveraged in mortgage-backed securities filed for bankruptcy protection having lost nearly all of their value. Bear Stearns itself soldiered on for another six months but the game was up. Rumours spread about a liquidity crisis, which in turn eroded investor confidence in the firm. Bear Stearns’ liquidity pool plummeted from $18.1bn on 10 March 2008, to just $2bn on 13 March. 

On 14 March 2008, JPMorgan Chase, in conjunction with the Fed, stepped in with an emergency loan to prevent Bear Stearns becoming insolvent. Two days later, Bear Stearns signed a merger agreement with JP Morgan Chase in a stock swap worth $2 a share. When shareholders challenged these terms, JPMorgan Chase upped its offer to $10 a share and the sale was finally approved on 29 May. Bear Stearns stock had traded at $172 a share as recently as January 2007, and $93 a share as late as February 2008. 

The Fed assisted the takeover with a $29 billion loan to JP Morgan Chase to assume the risk of Bear Stearns’s less liquid assets because, said Fed chairman Ben Bernanke, bankruptcy would have caused a “chaotic unwinding” of investments across the US markets. It was a decisive intervention but, if the Fed believed it had staunched the flow, it was mistaken. Rather it shifted the focus higher up the food chain. No firm that was reliant on secured funding and short-term borrowings was immune to a crisis of confidence. It was a lesson that Bear Stearns’ Wall Street rivals were not ready to take on board – yet. It was one down, four to go. 

Next up was Lehman Brothers, founded in 1850 and the fourth-biggest US securities company. Under the management of Dick Fuld, chief executive since 1993, the firm had grown into the largest trader of stocks on the London Stock Exchange and on the pan-European Euronext exchange, and had a role in a fifth of all corporate takeovers. Lehman also expanded its asset management business through the Neuberger Berman unit, bought in 2003 for $3bn. 

Then it joined the rush into the mortgage market. In 2004, Lehman acquired two California-based lenders to provide the flow of debt to package into bonds. Record revenue from Lehman’s real estate businesses helped sales in the capital markets unit jump 56% from 2004 to 2006. Lehman reported record earnings in 2005, 2006 and 2007. And, even as the housing market fell, Lehman kept making loans. Last year, it underwrote more mortgage-backed securities than any other firm, accumulating an $85bn portfolio, almost four times its $22.5bn of shareholder equity. “Our global franchise and brand have never been stronger, and our record results for the year reflect the continued diversified growth of our businesses,” Fuld said in a statement on 13 December. 

That was then. Lehman racked up huge losses in lower-rated mortgage-backed securities throughout 2008, apparently a result of its having retained large positions when securitising the underlying mortgages. In the second fiscal quarter, Lehman reported losses of $2.8bn and, as the credit market continued to tighten, Lehman stock lost 73% of its value. 

Fuld, still hoping to remain independent, sold $6bn in shares and sought more capital from Korea Development Bank and other investors. But on 9 September, it was reported that the Korean bank had put talks on hold. Lehman stock fell 45% and the next day it announced a loss of $3.9bn. The stock went into freefall. Fuld was finally now searching for a buyer, but he had left it too late – when Barclays and Bank of America walked away from talks on 14 September, the firm had no option but to file for bankruptcy. It was two down, three to go. 

This time the lesson was not lost. Among the industry executives and Fed officials huddled in emergency meetings in Manhattan that weekend to contemplate the demise of Lehman Brothers was John Thain, chief executive of Merrill Lynch, Wall Street’s third-largest investment bank and the next in the firing line. Thain had taken over Merrill last December after the ousting of his predecessor, Stanley O’Neal. Merrill had a $19.2bn net loss in the last year,  and taken more than $40bn  in write-downs. 

As the Lehman talks proceeded, it became clear that “the funding of independent investment banks was going to come under pressure.” Thain said. He called Kenneth Lewis, his counterpart at Bank of America and the very man who had only just spurned Lehman, to propose a merger. The shotgun marriage was arranged in less than two days. In a $50bn deal, Merrill relinquished its 94-year independence in an all-stock merger that valued its shares at $29 each, a 70% premium on their existing price but a vast discount to their peak of around $99 in January 2007. 

“This was the strategic opportunity of a lifetime,” said Lewis at a news conference with Thain in Bank of America’s new offices in New York. “This isn’t necessarily the outcome I would have expected when I took this job,” said Thain. 

Then there were two – Goldman Sachs and Morgan Stanley – but the carnage continued unabated. First, the US government was forced to bail out two of the biggest US mortgage banks, Fannie Mae and Freddie Mac, to keep the US home loan system from meltdown and, more alarmingly, it stepped in to rescue the desperately illiquid insurer American International Group (AIG) which had provided $441bn backing for Wall Street trades involving CDSs. The Fed agreed to lend AIG up to $85bn in emergency funds in return for a government stake of 79.9%. The rescue of the giant insurer was justified on the grounds that letting it fail would “pose systemic risk to the US and international financial systems”. But it did not halt the bloodletting. 

On 16 September, Goldman Sachs and Morgan Stanley posted better-than-expected results but still the chief financial officers of both firms were called on to deflect analysts’ questions about their ability to survive as independents. 

Morgan Stanley’s Colm Kelleher stated that the number two US investment bank remained confident in its  broker-dealer model and dismissed the need to merge with a deposit-taking bank. Likewise, Goldman Sachs’ David Viniar ruled out the possibility of buying a bank in the near future: “We think that the business model we have right now is working quite well and performance is good.” He also hinted that Goldman Sachs stood to gain from the recent contraction of Wall Street’s inner circle, adding: “[With] more opportunities and fewer competitors that will help market share  and pricing power.” 

But the next day the shares of both firms took a hammering. Morgan Stanley’s share price slumped by 24% and Goldman Sachs’ by 14%. It was becoming clear that they risked being sucked into the vortex. Fearing a total evaporation of confidence, John Mack reportedly held talks with several possible partners, including the US commercial banks Citigroup and Wachovia, and Citic of China. 

Instead, and with the prospect of a $700bn US government rescue package for troubled banks on the horizon, the last two dealer-brokers came down off the hilltop to seek shelter with the Federal Reserve. The move completed the circle for the banking industry, reversing the separation of commercial and investment banks that had been imposed to restore confidence during the Great Depression. 

The US central bank said it would allow them time to phase in newly applicable regulations, including those covering capital requirements, rather than have to rush to comply with them immediately. But the banks acted quickly. Morgan Stanley agreed to sell a 21% stake to Japan’s Mitsubishi UFJ Financial Group for $9bn, seeking to shore up investor confidence after borrowing costs climbed and its stock fell by half. Goldman Sachs meanwhile raised $5bn from veteran investor Warren Buffett and a further $5bn via an overnight share placement, double the amount initially intended.  

Goldman Sachs and Morgan Stanley may have ducked the financial disaster that befell their rivals for now – but it remains to be seen whether this is more than a temporary reprieve. What is certain is that these firms will never be the same. The high leverage and financial ingenuity that produced such stellar returns – and bonuses – on Wall Street for years are gone and it is the more heavily regulated universal banks that are likely to dominate investment banking league tables into the future. 