Historic Wall Street Woes: Building Back from Bust
Three of Nation's Top Five Investment Banks Collapsed With Two More in Merger Talks
September 21, 2008
Watching the conflagration that is consuming Wall Street one is reminded of the famous words of New York baseball manager and philosopher, Casey Stengel: "Can anybody here play this game?"
Casey was describing his 1962 Mets team, arguably the worst baseball team in major league history, but compared to today's Wall Street investment banks the 1962 Mets look like all-stars. 2008 began with five top tier investment banks and less than 10 months later only two are left standing on their own with one of those in merger discussions.
Bear Stearns collapsed in March and was sold for pennies on the dollar to J.P. Morgan. On Sept. 14, Lehman Brothers declared bankruptcy and that same day Merrill Lynch, under duress, accepted a buyout offer from Bank of America for half of its Jan. 1 value.
The two remaining investment banks, Goldman Sachs and Morgan Stanley, have lost 44 percent and 56 percent of their market value respectively.
Add to that carnage the demise of the insurance giant AIG and mortgage titans Fannie Mae and Freddie Mac and you have the biggest bank panic that anyone can remember.
Investment banks have taken the biggest fall in this financial panic but there is plenty of blame and pain to spread around. In short, there has been a systemic breakdown in the fiduciary checks and balances that govern the relationships from borrowers to mortgage brokers to appraisers to underwriters to securitizers to rating agencies to bond insurers to investors.
At the nub of this crisis is a glut in residential real estate and what is now a two-year decline in home prices. The Case-Shiller U.S. home price index peaked in the Spring of 2006 and has declined 18 percent since then.
In the early 1980s a hot political issue was the plight of the homeless. Twenty-five years later, America is the best-housed and, unfortunately, the most over-housed country in the world. Don't let it be said that capitalism can't deliver the goods.
Alas, grand production untethered from prudence and market disciplines can result in gross oversupply and the busts that inevitably follow.
What makes this bust so insidious and seemingly intractable is the large role residential real estate plays as collateral for trillions of dollars of complex pools of debt in bank, insurance and pension portfolios. This is how a housing bust has become a credit calamity.
The genesis of this over-build of residential real estate can be traced back to 2003-2004 when the Federal Reserve, fearing deflation, dropped its key interest rate, the Federal Funds Rate, to 1 percent and kept it there for a year.
Ben Bernanke had presaged this move with a November 2002 speech entitled, Deflation: Making Sure "It" Doesn't Happen Here.
With stocks still suffering from post bear market blues and bonds offering paltry returns, super cheap money gushed into the asset class that was performing best and seemed the most reliable - real estate, especially residential real estate.
This gusher of investment into tangible assets was further supercharged by new levels of clever financial engineering in the form of complex pools of securities with acronyms like CDOs (collateralized debt obligations) and SIVs (structured investment vehicles).
No discussion of today's panic would be complete without mention of the credit rating agencies Standard & Poor's, Moody's and Fitch and the complicit role they have played.
These are public companies compensated by the underwriters to provide ratings on securities being issued but because of rules governing bank and insurance portfolios the rating companies become de-facto regulators.
When the market for CDOs and SIVs took off in 2004 and 2005 the rating agencies gave investment-grade ratings to most of these new structures that included large chunks of junk debt and sub-prime loans.
With yields 4 to 5 percent higher than similar rated corporate bonds, sales of CDOs mushroomed to $500 billion by 2006.
By the end of 2006, CDOs had become the most profitable and fastest-growing portion of the rating agencies business.
The symbiotic relationship between underwriters and rating agencies is an unhealthy one and a major contributor to the proliferation of CDOs in institutional portfolios worldwide. It is fair to say that we are witnessing in real time the end of an era. Investment banks and their bankers have been the castles and crown princes of Wall Street. Need advice for corporate strategy, mergers and acquisitions or how to invest a billion?
It was to investment banks that big companies and big investors turned. Investment bankers have had their detractors as well - portrayed in movies like Wall Street and books like Bonfire of the Vanities as masters of the universe, the egotistical key-masters and gatekeepers to the really big money of capitalism.
As events and companies have unfolded and unraveled over the past eight months it has become clear that investment banks have been pushed to reinvent their business models over the past five years. For some it worked, but mostly it didn't.
Information technologies and especially the Internet have flattened the investment arena, squeezing profits in some areas and allowing hedge funds, private equity and boutique research firms to compete in areas investment banks once dominated.
In a classic response to such disruptive innovation, the investment banks moved up market to more complex products where better profit margins could still be maintained. In retrospect it is clear now that in many cases they were pursuing complexity for complexities sake rather than for improvement in their product or service offering. In so doing they violated the old G.I. axiom "keep it simple, stupid," and they have paid the consequences. Lastly is leverage. Lehman Brothers and Bear Stearns succumbed to the same fatal flaw: making outsized bets with outsized debt.
Both firms morphed into huge hedge funds, at times utilizing 30- to-1 ratios of debt to equity in an effort to juice returns. Markets and leverage mixed with hubris makes for a powerful concoction. But get the recipe wrong and it can wipe you out. Stengel had counsel for such folly: "Been in this game 100 years, but I see new ways to lose 'em I never knew existed before."
Ashby M. Foote III is president of Vector Money Management.
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