FINANCE 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 But after the US Congress repealed GlassSteagall in 1999, commercial banks began muscling in on Wall Street’s turf.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 mortgagebacked 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 incomestarved 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 an-
INVESTMENT BANKING other 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
NO ONE COULD BE CERTAIN WHO WAS LEFT HOLDING THE TOXIC WASTE 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 secondlargest 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
24 CNBC EUROPEAN BUSINESS I NOVEMBER 2008
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