Source: WSJ
1973 was a terrible year on Wall Street. An unexpected crisis in the Middle East led to a quadrupling of oil prices and a serious global economic recession. The president was in serious trouble with Watergate. The S&P 500 index dropped 50% (after 23 years of rising markets), and much of Wall Street fell deeply into the red. There were no profits, and therefore no bonuses.
I was a 35-year-old, nonpartner investment banker then and was horrified to learn that my annual take-home pay would be limited to my small salary, which accounted for about a quarter of my previous year's income. Fortunately the partners decided to pay a small bonus out of their capital that year to help employees like me get by. The next year was no better. Several colleagues with good prospects left the firm and the industry for good. We learned that strong pay-for-performance compensation incentives could cut both ways.
Many wondered if that was still the case last week, when New York State Comptroller Thomas DiNapoli released an estimate that the "securities industry" paid its New York City employees bonuses of $18 billion in 2008, leading to a public outcry. Lost in the denunciations were the powerful benefits of the bonus system, which helped make the U.S. the global leader in financial services for decades. Bonuses are an important and necessary part of the fast-moving, high-pressure industry, and its employees flourish with strong performance incentives.
There is also a fundamental misunderstanding of how bonuses are paid that is further inflaming public opinion. The system has become more complex than most people know, and involves forms of bonuses that are not entirely discretionary.
The anger at Wall Street only grew at the news that Merrill Lynch, after reporting $15 billion of losses, had rushed to pay $4 billion in bonuses on the eve of its merger with Bank of America. Because Merrill Lynch and Bank of America were receiving substantial government funds to keep them afloat, the subject became part of the public business. The idea that the banks had paid out taxpayers' funds in undeserved bonuses to employees, together with a leaked report of John Thain's spending $1 million to redecorate his office, understandably provoked a blast of public outrage against Wall Street. The issue was so hot that President Barack Obama interrupted his duties to call the bonuses "shameful" and the "height of irresponsibility." Then, on Wednesday, he announced a new set of rules for those seeking "exceptional" assistance from the Troubled Asset Relief Program in the future that would limit cash compensation to $500,000 and restrict severance pay and frills, perks and boondoggles.
Lindsay Holmes
In the excitement some of the facts got mixed up. Mr. DiNapoli's estimate included many firms that were not involved with the bailout, and only a few that were. Merrill's actions were approved by its board early in December and consented to by Bank of America. But the basic point is that, despite the dreadful year that Wall Street experienced in 2008, some questionable bonuses were paid to already well-off employees, and that set off the outrage.
Many Americans believe that any bonuses for top executives paid by rescued banks would constitute "excess compensation," a phrase used by Mr. Obama. But no Wall Street CEO taking federal money received a bonus in 2008, and the same was true for most of their senior colleagues. Not only did those responsible receive no bonuses, the value of the stock in their companies paid to them as part of prior-year bonuses dropped by 70% or more, leaving them, collectively, with billions of dollars of unrealized losses.
That's pay for performance, isn't it?
"Wall Street" has always been the quintessential, if ill-defined, symbol of American capitalism. In reality, Wall Street today includes many large banks, investment groups and other institutions, some not even located in the U.S. It has become a euphemism for the global capital markets industry -- one in which the combined market value of all stocks and bonds outstanding in the world topped $140 trillion at the end of 2007. Well less than half of the value of this combined market value is represented by American securities, but American banks lead the world in its origination and distribution. Wall Street is one of America's great export industries.
The market thrives on locating new opportunities, providing innovation and a willingness to take risks. It is also, regrettably, subject to what the economist John Maynard Keynes called "animal spirits," the psychological factors that make markets irrational when going up or down. For example, America has enjoyed a bonus it didn't deserve in its free-wheeling participation in the housing market, before it became a bubble. Despite great efforts by regulators to manage systemic risk, there have been market failures. The causes of the current market failure, which is the real object of the public anger, go well beyond the Wall Street compensation system -- but compensation has been one of them.
The capital-markets industry operates in a very sophisticated and competitive environment, one that responds best to strong performance incentives. People who flourish in this environment are those who want to be paid and advanced based on their individual and their team's performance, and are willing to take the risk that they might be displaced by someone better or that mistakes or downturns may cause them to be laid off or their firms to fail. Indeed, since 1970, 28 major banks or investment banks have failed or been taken up into mergers, and thousands have come and gone into the industry without making much money. Those that have survived the changing fortunes of the industry have done very well -- so well, in fact, that they appear to have become symbolic of greedy and reckless behavior.
The Wall Street compensation system has evolved from the 1970s, when most of the firms were private partnerships, owned by partners who paid out a designated share of the firm's profits to nonpartner employees while dividing up the rest for themselves. The nonpartners had to earn their keep every year, but the partners' percentage ownerships in the firms were also reset every year or two. On the whole, everyone's performance was continuously evaluated and rewarded or penalized. The system provided great incentives to create profits, but also, because the partners' own money was involved, to avoid great risk.
The industry became much more competitive when commercial banks were allowed into it. The competition tended to commoditize the basic fee businesses, and drove firms more deeply into trading. As improving technologies created great arrays of new instruments to be traded, the partnerships went public to gain access to larger funding sources, and to spread out the risks of the business. As they did so, each firm tried to maintain its partnership "culture" and compensation system as best it could, but it was difficult to do so.
In time there was significant erosion of the simple principles of the partnership days. Compensation for top managers followed the trend into excess set by other public companies. Competition for talent made recruitment and retention more difficult and thus tilted negotiating power further in favor of stars. Henry Paulson, when he was CEO of Goldman Sachs, once remarked that Wall Street was like other businesses, where 80% of the profits were provided by 20% of the people, but the 20% changed a lot from year to year and market to market. You had to pay everyone well because you never knew what next year would bring, and because there was always someone trying to poach your best trained people, whom you didn't want to lose even if they were not superstars. Consequently, bonuses in general became more automatic and less tied to superior performance. Compensation became the industry's largest expense, accounting for about 50% of net revenues. Warren Buffett, when he was an investor in Salomon Brothers in the late 1980s, once noted that he wasn't sure why anyone wanted to be an investor in a business where management took out half the revenues before shareholders got anything. But he recently invested $5 billion in Goldman Sachs, so he must have gotten over the problem.
As firms became part of large, conglomerate financial institutions, the sense of being a part of a special cohort of similarly acculturated colleagues was lost, and the performance of shares and options in giant multi-line holding companies rarely correlated with an individual's idea of his own performance over time. Nevertheless, the system as a whole worked reasonably well for years in providing rewards for success and penalties for failures, and still works even in difficult markets such as this one.
At junior levels, bonuses tend to be based on how well the individual is seen to be developing. As employees progress, their compensation is based less on individual performance and more on their role as a manager or team leader. For all professional employees the annual bonus represents a very large amount of the person's take-home pay. At the middle levels, bonuses are set after firm-wide, interdepartmental negotiation sessions that attempt to allocate the firm's compensation pool based on a combination of performance and potential.
Saturday, February 07, 2009
From Awful to Merely Bad: Reviewing the Bank Rescue Options
Source: WSJ, Authors: Hubbard, Scott, and Zingales
When Henry Paulson, President Bush's Treasury secretary, first introduced the Troubled Asset Relief Program (TARP) in Congress last September, we cautioned against using government funds to buy mortgages and mortgage-related securities from banks. After the Emergency Economic Stabilization Act was signed into law in early October, the Treasury decided not to buy these assets. Instead, it used the first $350 billion of TARP funds to inject capital first into nine systemically important troubled banks, and later into insurer AIG (as part of a refinancing) and auto makers General Motors and Chrysler.
This approach seems to have achieved (albeit at a high cost for taxpayers) its principal objective of avoiding a massive collapse of the financial system. But it has not yet resulted in an increase in bank lending or the attraction of new private equity to the banking system, both of which are important to reviving the economy. There now appears to be active consideration of using TARP funds to buy "bad assets" from the banks. Major problems with so doing remain.
The central issue is how to price the assets. When the subprime crisis hit in the summer of 2007, the Treasury's first response was to encourage the private sector to create a fund -- the so-called Super SIV (structured investment vehicle) -- to buy mortgage-related assets. This proposal foundered due to the difficulty of setting a price for these assets, which come in complex and incomparable varieties. If Treasury pays close to par, it is paying far too much. If it pays current prices, no one will sell because of the adverse impact on their capital. If it pulls a price out of a hat, it will be acting arbitrarily.
Initial discussions focused on using a reverse auction with asset holders "bidding" to sell their mortgage-related securities to the Treasury. Such an approach raises significant problems -- most significant is the risk posed by asymmetric information regarding the value of these securities. Because the holders of complex and incomparable mortgage-related securities have more information regarding their worth than does Treasury, Treasury is at a huge disadvantage and will likely overpay. Moreover, there will have to be many auctions of very different securities. All of this will take months to execute.
Reportedly, thought is now being given to only buying "bad assets" and putting them in a fund (called a "bad bank") owned by the government. This new variation raises additional problems. First, how should "bad assets" be defined? As the recession deepens, bad assets have multiplied and will continue to multiply from mortgages and mortgage-related securities to many other assets classes, including credit-card portfolios. We see little sense in defining bad assets simply as those that have been already significantly written down. The bank may be more exposed to losses from assets that have not been significantly written down, but could well be.
Further, as the potential class of bad assets expands so does the cost of purchase. Total mortgage-related securities and mortgages held by banks alone are estimated to be $6 trillion, of which mortgage-backed securities are $1.3 trillion. Total bank assets are $16.5 trillion.
Another proposal is to guarantee the value of bad assets rather than buy them. This outcome could be accomplished by a direct guarantee of assets that remained on the balance sheet of banks (or were brought in from outside conduits or SIVs), or into one government-run bad bank.
A version of this approach was used in the second round of TARP financing for Citigroup and Bank of America. In the case of Citigroup, a $306 billion asset pool was created in which Citigroup absorbs the first $29 billion of losses, the Treasury and FDIC jointly fund 90% of the next $15 billion ($5 billion from the Treasury through TARP, and $10 billion from the FDIC), and the Fed finally funds 90% of the remaining losses. In return, the government received $7 billion in preferred stock (with an 8% yield) -- $4 billion to Treasury, $3 billion to FDIC. Under this approach, the problem of valuing the assets has been finessed into a problem of valuing the stock.
With more transparency, which Congress and its Oversight Panel would surely demand, that finesse would not work. A conservative estimate puts the value of the Citigroup option -- i.e., the potential cost to taxpayers -- at $60 billion, taking account of the stock warrants the government received. If one were to repeat this approach for all banks the cost would be as much as TARP. And, if the market for toxic assets were to fall further, the government could easily be responsible for trillions of dollars of losses. Last but not least, having the Fed become the residual risk bearer further undermines the Fed's financial stability and its ultimate independence, a concern recently voiced by the Committee on Capital Markets Regulation.
A more reasonable alternative would be to encourage banks to spin off the toxic assets into separate affiliated bad banks (as under a new reported German initiative). Ownership of these two entities would be allocated pro rata to all the financial investors as a proportion of the most updated accounting value of these assets. So a bank with $30 billion of bad assets and $70 billion of good assets will see its debt divided 30%-70% and its equity divided 30%-70%. Each $100 debt claim will become a $30 debt claim in the bad bank and a $70 debt claim in the good bank. The same would be true for equity. To limit the exposure of the FDIC to the bad bank, insured deposits and FDIC-guaranteed debt should remain in the good bank to the extent there are sufficient matching good assets. In addition, off-balance-sheet derivative contracts remain off balance sheet for the good bank to avoid the possibility that the failure of the bad bank would create systemic risk. Furthermore, convincing evidence would be needed before guaranteeing any of the liabilities of a bad bank because ordinarily a bad-bank failure should not result in systemic risk.
An alternative would be for the government to facilitate the injection of new, private-equity capital into banks by eliminating regulatory restrictions, such as bank ownership by private-equity or commercial firms, and providing protection against loss or dilution if there were to be subsequent government intervention. A subsidy for this private risk capital could even be given. As long as private capital holds most of the risk, it will certainly be allocated more efficiently than government money, minimizing the taxpayer cost of any subsidy. This idea would have to be more fully explored.
Whatever is done with respect to still solvent institutions, banks with dangerously low, or no or negative capital, should be taken over by the government through already established FDIC procedures, such as bridge loans. Just as with the Savings and Loan crisis of the 1980s, there is a significant risk that shareholders (and managers) with nothing to lose will roll the dice and lose even more. Existing shareholders with no equity should not benefit by government support. Further, a government takeover (just like a corporate bankruptcy) permits the restructuring of bank debt. As the S&L debacle shows, a decision worse than a nationalization of the banking sector is a nationalization of the losses, which still leaves the gains in private hands.
With still solvent institutions, there is no affordable and workable plan that will by itself assure that these banks will start lending and that private capital will return. We have stabilized the financial system against massive collapse, which is probably all the government can do. While we hope some more improvement may come from the bad bank or private-equity solutions outlined above, the road to further recovery of the financial system now lies principally with the economy's recovery and the success of the fiscal stimulus.
When Henry Paulson, President Bush's Treasury secretary, first introduced the Troubled Asset Relief Program (TARP) in Congress last September, we cautioned against using government funds to buy mortgages and mortgage-related securities from banks. After the Emergency Economic Stabilization Act was signed into law in early October, the Treasury decided not to buy these assets. Instead, it used the first $350 billion of TARP funds to inject capital first into nine systemically important troubled banks, and later into insurer AIG (as part of a refinancing) and auto makers General Motors and Chrysler.
This approach seems to have achieved (albeit at a high cost for taxpayers) its principal objective of avoiding a massive collapse of the financial system. But it has not yet resulted in an increase in bank lending or the attraction of new private equity to the banking system, both of which are important to reviving the economy. There now appears to be active consideration of using TARP funds to buy "bad assets" from the banks. Major problems with so doing remain.
The central issue is how to price the assets. When the subprime crisis hit in the summer of 2007, the Treasury's first response was to encourage the private sector to create a fund -- the so-called Super SIV (structured investment vehicle) -- to buy mortgage-related assets. This proposal foundered due to the difficulty of setting a price for these assets, which come in complex and incomparable varieties. If Treasury pays close to par, it is paying far too much. If it pays current prices, no one will sell because of the adverse impact on their capital. If it pulls a price out of a hat, it will be acting arbitrarily.
Initial discussions focused on using a reverse auction with asset holders "bidding" to sell their mortgage-related securities to the Treasury. Such an approach raises significant problems -- most significant is the risk posed by asymmetric information regarding the value of these securities. Because the holders of complex and incomparable mortgage-related securities have more information regarding their worth than does Treasury, Treasury is at a huge disadvantage and will likely overpay. Moreover, there will have to be many auctions of very different securities. All of this will take months to execute.
Reportedly, thought is now being given to only buying "bad assets" and putting them in a fund (called a "bad bank") owned by the government. This new variation raises additional problems. First, how should "bad assets" be defined? As the recession deepens, bad assets have multiplied and will continue to multiply from mortgages and mortgage-related securities to many other assets classes, including credit-card portfolios. We see little sense in defining bad assets simply as those that have been already significantly written down. The bank may be more exposed to losses from assets that have not been significantly written down, but could well be.
Further, as the potential class of bad assets expands so does the cost of purchase. Total mortgage-related securities and mortgages held by banks alone are estimated to be $6 trillion, of which mortgage-backed securities are $1.3 trillion. Total bank assets are $16.5 trillion.
Another proposal is to guarantee the value of bad assets rather than buy them. This outcome could be accomplished by a direct guarantee of assets that remained on the balance sheet of banks (or were brought in from outside conduits or SIVs), or into one government-run bad bank.
A version of this approach was used in the second round of TARP financing for Citigroup and Bank of America. In the case of Citigroup, a $306 billion asset pool was created in which Citigroup absorbs the first $29 billion of losses, the Treasury and FDIC jointly fund 90% of the next $15 billion ($5 billion from the Treasury through TARP, and $10 billion from the FDIC), and the Fed finally funds 90% of the remaining losses. In return, the government received $7 billion in preferred stock (with an 8% yield) -- $4 billion to Treasury, $3 billion to FDIC. Under this approach, the problem of valuing the assets has been finessed into a problem of valuing the stock.
With more transparency, which Congress and its Oversight Panel would surely demand, that finesse would not work. A conservative estimate puts the value of the Citigroup option -- i.e., the potential cost to taxpayers -- at $60 billion, taking account of the stock warrants the government received. If one were to repeat this approach for all banks the cost would be as much as TARP. And, if the market for toxic assets were to fall further, the government could easily be responsible for trillions of dollars of losses. Last but not least, having the Fed become the residual risk bearer further undermines the Fed's financial stability and its ultimate independence, a concern recently voiced by the Committee on Capital Markets Regulation.
A more reasonable alternative would be to encourage banks to spin off the toxic assets into separate affiliated bad banks (as under a new reported German initiative). Ownership of these two entities would be allocated pro rata to all the financial investors as a proportion of the most updated accounting value of these assets. So a bank with $30 billion of bad assets and $70 billion of good assets will see its debt divided 30%-70% and its equity divided 30%-70%. Each $100 debt claim will become a $30 debt claim in the bad bank and a $70 debt claim in the good bank. The same would be true for equity. To limit the exposure of the FDIC to the bad bank, insured deposits and FDIC-guaranteed debt should remain in the good bank to the extent there are sufficient matching good assets. In addition, off-balance-sheet derivative contracts remain off balance sheet for the good bank to avoid the possibility that the failure of the bad bank would create systemic risk. Furthermore, convincing evidence would be needed before guaranteeing any of the liabilities of a bad bank because ordinarily a bad-bank failure should not result in systemic risk.
An alternative would be for the government to facilitate the injection of new, private-equity capital into banks by eliminating regulatory restrictions, such as bank ownership by private-equity or commercial firms, and providing protection against loss or dilution if there were to be subsequent government intervention. A subsidy for this private risk capital could even be given. As long as private capital holds most of the risk, it will certainly be allocated more efficiently than government money, minimizing the taxpayer cost of any subsidy. This idea would have to be more fully explored.
Whatever is done with respect to still solvent institutions, banks with dangerously low, or no or negative capital, should be taken over by the government through already established FDIC procedures, such as bridge loans. Just as with the Savings and Loan crisis of the 1980s, there is a significant risk that shareholders (and managers) with nothing to lose will roll the dice and lose even more. Existing shareholders with no equity should not benefit by government support. Further, a government takeover (just like a corporate bankruptcy) permits the restructuring of bank debt. As the S&L debacle shows, a decision worse than a nationalization of the banking sector is a nationalization of the losses, which still leaves the gains in private hands.
With still solvent institutions, there is no affordable and workable plan that will by itself assure that these banks will start lending and that private capital will return. We have stabilized the financial system against massive collapse, which is probably all the government can do. While we hope some more improvement may come from the bad bank or private-equity solutions outlined above, the road to further recovery of the financial system now lies principally with the economy's recovery and the success of the fiscal stimulus.
The weekend that Wall Street died
Source: WSJ
Lehman Brothers Holdings Inc. Chief Executive Richard S. Fuld Jr., wearing tie, is heckled by protesters in October as he leaves Capitol Hill in Washington after testify before the House Oversight and Government Reform Committee on the collapse of Lehman Brothers.
With his investment bank facing a near-certain failure, Lehman Brothers Holdings Inc.'s chief executive officer, Richard Fuld Jr., placed yet another phone call to the man he thought could save him.
Fuld was already effectively out of options by the afternoon of Sunday, Sept. 14. The U.S. government said it wouldn't fund a bailout for Lehman, the country's oldest investment bank. Britain's Barclays PLC had agreed in principle to buy the loss-wracked firm, but the deal fell apart. Bank of America Corp., initially seen as Lehman's most likely buyer, had said two days earlier that it couldn't do a deal without federal aid -- and by Sunday was deep in secret negotiations to take over Lehman rival Merrill Lynch & Co.
Desperate to avoid steering his 25,000-person company into bankruptcy proceedings, Fuld dialed the Charlotte, N.C., home of Bank of America Chairman Kenneth D. Lewis. His calls so far that weekend had gone unreturned. This time, Lewis's wife, Donna, again picked up, and told the boss of Lehman Brothers: If Lewis wanted to call back, he would call back.
Fuld paused, then apologized for bothering her. "I am so sorry," he said.
Associated Press File Merrill Lynch Chairman and CEO John Thain, left, and Bank of America Chairman and CEO Ken Lewis shake hands following a news conference in New York.
His lament could also have been for the investment-banking model that had come to embody the words "Wall Street." Within hours of his call, Lehman announced it would file for bankruptcy protection. Within a week, Wall Street as it was known -- loosely regulated, daringly risky and lavishly rewarded -- was dead.
As Fuld waged his increasingly desperate bid to save his firm that weekend, the bosses of Wall Street's other three giant investment banks were locked in their own battles as their firms came under mounting pressure. It was a weekend unlike anything Wall Street had ever seen: In past crises, its bosses had banded together to save their way of life. This time, the financial hole they had dug for themselves was too deep. It was every man for himself, and Fuld, who declined to comment for this article, was the odd man out.
For the U.S. securities industry to unravel as spectacularly as it did in September, many parties had to pull on many threads. Mortgage bankers gave loans to Americans for homes they couldn't afford. Investment houses packaged these loans into complex instruments whose risk they didn't always understand. Ratings agencies often gave their seal of approval, investors borrowed heavily to buy, regulators missed the warning signs. But at the center of it all -- and paid hundreds of millions of dollars during the boom to manage their firms' risk -- were the four bosses of Wall Street.
Details of these CEOs' decisions and negotiations, many of them previously unreported, show how they sought to avert the death of America's giant investment banks. Their efforts culminated in a round-the-clock weekend of secret negotiations and personal struggles to keep their firms afloat. Accounts of these events are based on company and other documents, emails and interviews with Wall Street executives, traders, regulators, investors and others.
Summer Clouds
Earlier this year, when the financial crisis claimed its first victim, Bear Stearns Cos., the surviving masters of Wall Street thought the eye of the storm had passed. Bear Stearns, the smallest of Wall Street's big five stand-alone investment banks, imploded just months after bad subprime bets sunk two internal hedge funds. In March 2008, the government brokered Bear Stearns's sale to J.P. Morgan Chase & Co.
After Bear Stearns's brush with death, the Federal Reserve for the first time allowed investment houses to borrow from the government on much the same terms as commercial banks. Many on Wall Street saw investment banks' access to an equivalent of the Fed "discount window" as a blank check should hard times return. But it would also be the first step in giving the government more say over an industry that had until then been lightly regulated.
Associated Press File Lloyd C. Blankfein, of Goldman Sachs,
In April, Morgan Stanley's CEO, John Mack, told shareholders the U.S. subprime crisis was in the eighth or ninth inning. The same month, Goldman Sachs Group Inc.'s chief executive, Lloyd Blankfein, said, "We're probably in the third or fourth quarter" of a four-quarter game.
Mack and Blankfein had some reason to be confident. Mack had been late to steer Morgan into mortgage trading, and relatively early to sell assets and raise cash. Goldman, under Blankfein, had even less direct exposure to subprime investments. Blankfein also took comfort in a stockpile of government bonds and other securities his firm held in case it ran into deep funding problems. By the second quarter, Goldman had increased this store of funds more than 30 percent from earlier in the year, to $88 billion.
Problems were more acute at Merrill Lynch and Lehman.
John Thain, a former Goldman Sachs president and New York Stock Exchange head, had arrived at Merrill Lynch in December 2007. He moved quickly to cut costs, putting the corporate helicopter up for sale and replacing the fresh flowers on a Merrill floor used by nine or so executives -- an estimated annual expense of $200,000 -- with fakes
More monumentally, Thain faced $55 billion in soured mortgage assets that Merrill had acquired under his predecessor. Within weeks of his arrival, he had raised more than $12 billion in much-needed capital, including $5 billion from Singapore's state investment company, Temasek Holdings, at $48 a share.
Some of those early deals would end up being costly. With his would-be investors driving a hard bargain, Thain promised Temasek and others that if Merrill sold additional common stock at a lower price within a year, the firm would compensate them. Within months, after taking a big write-down on a portfolio of mortgage debts that Merrill sold for pennies on the dollar, the firm had to raise more cash at $25 a share. Merrill issued additional shares to pay off its earlier investors, diluting its common shares by 39 percent. The dilution essentially cost shareholders about $5 billion, well above the previously reported $2.5 billion cost of shares issued to Temasek.
Lehman, now the smallest of the major Wall Street firms, also faced billions of dollars in write-downs from bad mortgage-related investments. In June, Lehman reported the first quarterly loss in its 14 years as a public company. Under Fuld, Lehman raised capital. But critics say Fuld was slow to shed bad assets and profitable lines of business. He pushed for better terms with at least one investor that ended up driving it away.
Fuld had faced challenges to his firm before. Since taking Lehman's reins in 1994, he expanded the 158-year-old bond house into lucrative areas such as investment banking and stock trading. Over the years, he had tamped unfounded rumors about the firm's health and vowed to remain independent. "As long as I am alive this firm will never be sold," Fuld said in December 2007, according to a person who spoke with him then. "And if it is sold after I die, I will reach back from the grave and prevent it."
In the summer of 2008, Fuld remained confident, particularly given the security of the Fed's discount window. "We have access to Fed funds," Fuld told executives at the time. "We can't fail now."
Friday, Sept. 12
By Friday, Sept. 12, failure appeared to be an option for Lehman.
Over that week, confidence in Lehman plunged. The firm said its third-quarter losses could total almost $4 billion. Lehman's clearing bank, J.P. Morgan, wanted an extra $5 billion in collateral. Lehman's attempts to raise money from a Korean bank had stalled. Credit agencies were warning that if Lehman didn't raise more capital over the weekend, it could face a downgrade. That would likely force the firm to put up more collateral for its outstanding loans and increase its costs for new loans.
If Fuld couldn't find an investor for Lehman by Sunday night, the fiercely independent boss could be forced to steer his firm into bankruptcy proceedings.
Earlier that week, Fuld had approached Bank of America's Lewis about buying Lehman. A U.S. Treasury official, meanwhile, had contacted Barclays of Britain to suggest it consider taking a stake in Lehman. Fuld's top executives spent Friday shuttling between the two suitors' law firms.
Lehman was also exploring a third option: The night before, veteran bankruptcy lawyer Harvey Miller of Weil, Gotshal & Manges had secretly begun cobbling together a bare-bones bankruptcy filing for the firm.
Lehman's troubles were putting the rest of Wall Street on notice.
In a Merrill Lynch conference room in downtown Manhattan that morning, Thain was on a call with Merrill's board of directors, discussing how to address the chaos. "Lehman is going down, and the [short sellers] are coming after us next," warned Merrill director John Finnegan. "Tell me how this story is going to end differently."
Merrill would be fine, Thain said. "We are not Lehman," he responded, noting the firm held valuable assets, including its stake in BlackRock, a profitable asset-management firm.
But Merrill's clients, too, were beginning to pull out money. The firm's stock was sinking. Executives, including Merrill President Gregory Fleming, were nervous.
Fleming believed he'd identified the ideal partner for Merrill. Bank of America, with a strong balance sheet and retail operations, would mesh well with Merrill's securities franchise and 16,000-strong brokerage force. Fleming worried that Bank of America could buy Lehman instead.
Fleming called a long-time lawyer for Bank of America, Edward Herlihy of Wachtell, Lipton, Rosen & Katz. "You have to talk to us," Fleming said. He was told that Merrill's Thain would have to approach Bank of America's Lewis. "I know," Fleming responded. "I'm gonna try."
At 5 p.m. Friday, after a day of massive client withdrawals at Lehman, Thain's phone rang. It was the Treasury. "Be at the Fed at 6 p.m.," Thain was told.
Soon after, Thain gathered along with Morgan's Mack and Goldman's Blankfein at the New York Federal Reserve in downtown Manhattan, in a room once used to cash coupons on Treasury bills. The three men were greeted by the masters of the world's biggest economy -- Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson, New York Fed Chief Timothy Geithner and Securities and Exchange Commission chief Christopher Cox. It was a signal moment for the Wall Street firms, which after years of being monitored by the SEC would all soon come under the regulatory watch of a newly powerful Fed.
The federal officials told the Wall Street chiefs to return in the morning. If the mess at Lehman could be fixed, it would be the job of the Wall Street bosses. There would be no public bailout.
An industry-led solution wouldn't be without precedent. In the market panic of 1907, financier J.P. Morgan persuaded fellow bankers to help fund a bailout for failing rivals. Competitors united again in 1998, putting up money to insulate the financial system from the failure of hedge fund Long Term Capital Management.
But now, Fuld's problems at Lehman were possibly beyond repair.
By that night, Bank of America's team had concluded that Lehman's real-estate portfolio was worse than expected -- and as a result, the firm's liabilities likely exceeded its assets. "We need government assistance, and we are not getting it," the bank's top deal maker, Greg Curl, told his group. Some of the negotiators prepared to fly back early the next morning to headquarters in Charlotte.
Lewis hadn't come to New York for the Lehman talks. He called Fuld from Charlotte, telling him that Bank of America couldn't do a deal without federal help. "We will keep a team in New York in case things change," Lewis told him.
Saturday, Sept. 13
Fuld arrived at Lehman's office at 7 a.m. on Saturday, wearing a blue suit and tie. The talks with Barclays were still moving. If the government could be moved, there could also be hope for a Bank of America deal.
Merrill, meanwhile, was beginning its own pursuit of Bank of America.
At his home in Rye, N.Y., Thain was getting dressed for a day at the New York Fed when his phone rang. It was Merrill's president, Fleming.
"John, you really need to call Ken Lewis," Fleming said.
"Get me his number," said Thain, who added it to his papers for the day.
Thain's black SUV pulled up in front of the New York Fed just before 8 a.m. Top executives from all four investment banks -- minus Lehman's Fuld -- were there.
Federal officials broke Thain, Mack and Blankfein and their top aides into groups. One studied the potential fallout from a Lehman failure. Another was charged with putting a value on Lehman's controversial real-estate investments. A third group, which included Thain and Morgan's Mack, was supposed to discuss an industry-led bailout for Lehman.
Lehman's president, Bart McDade, walked the group through the embattled firm's books. McDade did not respond to requests for comment for this article.
Mack questioned Wall Street's ability to repair markets. The firms could try to backstop Lehman, he argued, but there was no guarantee they wouldn't have to rescue another rival later. "If we're going to do this deal, where does it end?" he said.
As McDade discussed Lehman's position, Thain had an epiphany: "This could be me sitting here next Friday."
Thain pushed his chair back and left the group to caucus with top Merrill officers. "Lehman is not going to make it," he told them.
Thain stepped to a sidewalk behind the New York Fed and called the Bank of America chief at his home in Charlotte. "I can be there in a few hours," Lewis said.
Members of Bank of America's deal team, exhausted from scrutinizing Lehman's books, had just landed in Charlotte. Lewis ordered them back to New York.
Up in Lehman's midtown office, Fuld was also dialing Lewis's North Carolina home. His calls went unreturned. "I can't believe that son of a bitch won't return my calls," he told a top adviser.
Lehman's bankruptcy team, meanwhile, was rolling into action. Shortly before noon, Miller, the Weil Gotshal bankruptcy head, sent an email to several partners. Lehman's name didn't appear in the email. Its subject line read: "Urgent. Code name: Equinox. Have desperate need for help on an emergency situation."
Throughout the day, Miller's attorneys, working with Federal Reserve officials and their attorneys, began seeking information from Lehman. But with Lehman's top officials tied up at the Fed and in Barclays negotiations, the lawyers were hard-pressed to get the details they needed.
"We were a distraction to the Lehman people," said Lori Fife, a Weil partner. "It felt like it was just a fire drill."
Later that afternoon, Merrill's chief executive met Bank of America's CEO, Lewis, in the bank's corporate apartment in the Time Warner Center. In a one-on-one meeting overlooking Central Park, the two men agreed that it looked like Lehman would be forced into bankruptcy.
Thain made his opening offer. "How about buying a 9.9 percent stake" in Merrill, he proposed.
Lewis said the bank doesn't tend to buy minority stakes. He suggested Bank of America could buy the whole firm.
"I am not here to sell Merrill Lynch," Thain responded.
"Well, that is what I want," Lewis countered.
The two parted with an agreement to keep talking.
Lehman's talks with Barclays, meanwhile, were moving forward at the New York Fed, under the eye of government officials. "Shouldn't I be there?" Fuld said to Lehman President Mr. McDade and to attorney Rodgin Cohen of Sullivan & Cromwell LLP, a longtime adviser.
What Fuld appeared not to know was that some top government officials had instructed key Lehman representatives at the Fed building to keep Fuld away that weekend. The federal officials had explained that Fuld -- not only Wall Street's longest-serving boss, but a director of the New York Fed -- could be an unnecessary distraction and a lightning rod for criticism.
At the Fed meetings, much of the talk was on the sidelines. When Thain returned to the New York Fed from his discussions with Lewis, Merrill advisers told him they had been approached by top Goldman executives. The rival house was interested in taking a 9.9 percent stake in Merrill and offered to extend a $10 billion line of credit.
Thain was digesting the news when he was approached by Mack of Morgan Stanley. "We should talk," Mack said. The bosses of Merrill and Morgan agreed to meet that evening. Soon, Thain and two advisers were en route to the Upper East Side apartment of a Morgan co-president.
Thain drank a Diet Coke as the Morgan and Merrill executives talked. Both sides felt there were benefits to merging. Thain indicated he needed a deal quickly. The meeting ended without a firm plan. "We have a board meeting Tuesday and can get back to you soon," Mack said before the group broke up.
As Thain and his advisers left the apartment, the Merrill chief suggested he had faint hopes for a deal with Morgan Stanley. "I don't think they share our sense of urgency," he said.
Merrill's talks with Bank of America, however, were on track at the bank's law firm, Wachtell Lipton. Merrill's team was camped out on Wachtell's 34th floor. Bank of America's team was on the 33rd. Around midnight, Lewis left the law firm for his apartment in the Time Warner Center. Pizza arrived at Wachtell at 3 a.m.
At Lehman's offices that evening, Fuld still hadn't heard back from Lewis. Attorneys from Weil were poring through documents, drawing up what would be the largest bankruptcy in U.S. history.
But in a rare piece of good news for Lehman, Barclays had agreed to buy Lehman, as long as it didn't have to take on its soured real-estate assets. Lehman's asset-management division would also be spun off. The Fed indicated that a syndicate of banks and brokers had agreed in principle to put up enough capital to support a separate company that would hold Lehman's bad real-estate assets.
Sunday, Sept. 14
A few hours later, at 8 a.m., Thain arrived at the Time Warner Center for a second one-on-one meeting in Lewis's corporate apartment. Over coffee, Thain made his case for a strong price for Merrill despite its stock's recent fall.
At the same time, Merrill officials were huddled with Goldman bankers. Some members of Merrill's team doubted that Goldman could save their firm by taking a 9.9 percent stake. Pete Kelly, a top Merrill lawyer, also had his reservations about letting rival Goldman see his firm's books. Still, the sides set a late-morning meeting at Merrill's offices.
At 9 a.m., the chiefs of finance arrived again at the New York Fed for a second day of meetings. By the time Thain arrived, the Merrill chief had a number of options in his back pocket.
Rolling up to the meetings at around the same time was Goldman's chief, Blankfein. A Goldman aide, referring to days of meltdowns and meetings, carped to Blankfein: "I don't think I can take another day of this."
Blankfein retorted: "You're getting out of a Mercedes to go to the New York Federal Reserve -- you're not getting out of a Higgins boat on Omaha Beach," he said, referring to the World War II experience of a former Goldman head. "So keep things in perspective."
At Lehman that morning, Fuld told his board of directors to gather at the firm's offices. By noon, he expected, the board would be able to approve Lehman's sale to Barclays.
One hurdle remained: To ink a Lehman deal, Barclays needed a shareholder vote. There was no way to get one on a Sunday. Barclays would need the U.S. or British government to back Lehman's trading balances until a vote could be held.
Government approval never came, though there are diverging views on why. Some blame the U.S. government for refusing to commit resources. Others say the British government refused to entertain a deal they worried would expose England to unnecessary risk.
Lehman's president, McDade, and Cohen, the attorney, called Fuld from the New York Fed. Passing McDade's cellphone back and forth, they broke the Barclays news.
Fuld postponed his board meeting. He made one more call to Charlotte, answered by Lewis's wife.
By midafternoon, word emerged that Bank of America was in talks with Merrill Lynch. Cohen, the attorney, broke the news to Fuld. "I guess this confirms our worst fears," Fuld said.
At the Fed, the Lehman executives and their bankruptcy attorneys faced roughly 25 officials from the Fed, Treasury and SEC. The Lehman officials pleaded for federal aid to keep Lehman afloat. But with Barclays and Bank of America off the table, Federal officials wanted a plan in place to soothe markets before trading opened in Asia.
A senior Fed official asked Miller, the Weil veteran who'd been involved in bankruptcy filings of companies including Bethlehem Steel and Marvel Entertainment, if Lehman was ready to file.
"No," Miller answered.
"You need more of a plan to prepare to do this," Miller continued. Lehman had tens of billions of dollars in derivative positions with countless parties. Unless these trades were unwound in an orderly way, it could shock all corners of the financial market. "This will cause financial Armageddon," he said.
Now, Merrill's Thain needed his own deal more than ever. With a Morgan tie-up looking like a long shot, Merrill focused its attentions on Goldman and Bank of America.
Tempers at Merrill flared as two rival teams pored over the firm's records. Merrill's head of strategy Peter Kraus, a Goldman alumnus hired by Thain, wanted to pull some of the firm's due-diligence staff away from the Bank of America project to look at Goldman's offer. "We need some people down here," Kraus said.
"We have a great deal in hand, and need to finish doing this deal," retorted Fleming, Merrill's president. A few minutes later, Thain called Fleming, telling him to send some people to work on the Goldman offer.
Fleming and Bank of America's lead negotiator, Curl, hammered out a price. Bank of America would buy Merrill for $29 a share.
Fleming informed Thain. At 6 p.m., Merrill's top managers and directors gathered in person and by phone.
"When I took this job this was not the outcome I intended," Thain told directors. After the board meeting broke up after 8 p.m., Thain called the chief of Bank of America. "The decision was unanimous," Thain told Mr. Lewis. "You have a deal."
A more somber scene was playing out at Lehman. Directors, who had been camped at the Midtown offices all day, gathered at around 8 p.m. in the firm's board room. Weil lawyers and Lehman executives summarized the Fed meeting to the frustrated board.
"They bailed out Bear," said Roland Hernandez, the former CEO of Spanish-language TV network Telemundo and a longtime Lehman board member. "Why not us?"
One of Fuld's assistants broke in to hand him a note: The SEC chairman wanted to address Lehman's board by speakerphone.
Cox, criticized for his allegedly minor role in the government's bailout of Bear Stearns, had been reluctant to call Lehman. The SEC chief finally called from the New York Fed, surrounded by several staffers, at the urging of Mr. Paulson, the Treasury secretary.
"This is serious," said Cox. "The board has a grave matter before it," he said.
John D. McComber, a former president of the Export-Import Bank and a Lehman director for 14 years, asked: "Are you directing us to authorize" a bankruptcy filing?
The SEC chief muted his phone. A minute later, he came back on the line. "You have a grave responsibility and you need to act accordingly," he replied.
As the meeting wrapped up around 10 p.m., Fuld, his suit jacket now off, leaned back in his chair. "I guess this is goodbye," he said. Lehman would file about four hours later.
Just a few blocks away, Merrill and Bank of America executives met to toast their deal. "I look forward to a great partnership with Merrill Lynch," Lewis said around midnight, a glass of champagne in hand.
The End
Rather than soothing markets, Lehman's bankruptcy filing roiled them -- slamming trading partners that had direct exposure to the firm and sowing fears that Wall Street's remaining giants weren't safe from failure. Shares of Morgan and Goldman plunged. In the credit-default swap market, the price of insurance against defaults of Morgan and Goldman soared.
Hedge funds sought to withdraw more than $100 billion in assets from Morgan Stanley. The firm's clearing bank, Bank of New York Mellon, wanted an extra $4 billion in collateral.
Morgan's chief, Mr. Mack, negotiated a cash infusion from Japan's Mitsubishi UFJ Financial Group. Fed and Treasury officials, concerned that a deal could be derailed by a declining Morgan share price, asked if Mack had other options. One regulator suggested Morgan Stanley consider selling itself to J.P. Morgan -- from which it had been famously split, 73 years earlier, amid post-Depression banking reform laws.
"We're going to get Mitsubishi done. There is no Plan B," Mack told one regulator.
Morgan did the deal. But investor fears remained. By Thursday, Fed officials were urging Morgan to become a commercial bank. Such a move would require Morgan to scale back its bets with borrowed money, run the risk of selling lucrative business lines and accept new onsite regulation from the Fed.
Mack consented, and the following weekend, Morgan Stanley formally ceased to be a securities firm.
The same weekend, Blankfein convened top lieutenants on his 30th-floor office. After 139 years as a securities firm, he said, Goldman, too, would also reshape itself as a commercial bank. Within hours, the era of Wall Street's giants was over.
Lehman Brothers Holdings Inc. Chief Executive Richard S. Fuld Jr., wearing tie, is heckled by protesters in October as he leaves Capitol Hill in Washington after testify before the House Oversight and Government Reform Committee on the collapse of Lehman Brothers.
With his investment bank facing a near-certain failure, Lehman Brothers Holdings Inc.'s chief executive officer, Richard Fuld Jr., placed yet another phone call to the man he thought could save him.
Fuld was already effectively out of options by the afternoon of Sunday, Sept. 14. The U.S. government said it wouldn't fund a bailout for Lehman, the country's oldest investment bank. Britain's Barclays PLC had agreed in principle to buy the loss-wracked firm, but the deal fell apart. Bank of America Corp., initially seen as Lehman's most likely buyer, had said two days earlier that it couldn't do a deal without federal aid -- and by Sunday was deep in secret negotiations to take over Lehman rival Merrill Lynch & Co.
Desperate to avoid steering his 25,000-person company into bankruptcy proceedings, Fuld dialed the Charlotte, N.C., home of Bank of America Chairman Kenneth D. Lewis. His calls so far that weekend had gone unreturned. This time, Lewis's wife, Donna, again picked up, and told the boss of Lehman Brothers: If Lewis wanted to call back, he would call back.
Fuld paused, then apologized for bothering her. "I am so sorry," he said.
Associated Press File Merrill Lynch Chairman and CEO John Thain, left, and Bank of America Chairman and CEO Ken Lewis shake hands following a news conference in New York.
His lament could also have been for the investment-banking model that had come to embody the words "Wall Street." Within hours of his call, Lehman announced it would file for bankruptcy protection. Within a week, Wall Street as it was known -- loosely regulated, daringly risky and lavishly rewarded -- was dead.
As Fuld waged his increasingly desperate bid to save his firm that weekend, the bosses of Wall Street's other three giant investment banks were locked in their own battles as their firms came under mounting pressure. It was a weekend unlike anything Wall Street had ever seen: In past crises, its bosses had banded together to save their way of life. This time, the financial hole they had dug for themselves was too deep. It was every man for himself, and Fuld, who declined to comment for this article, was the odd man out.
For the U.S. securities industry to unravel as spectacularly as it did in September, many parties had to pull on many threads. Mortgage bankers gave loans to Americans for homes they couldn't afford. Investment houses packaged these loans into complex instruments whose risk they didn't always understand. Ratings agencies often gave their seal of approval, investors borrowed heavily to buy, regulators missed the warning signs. But at the center of it all -- and paid hundreds of millions of dollars during the boom to manage their firms' risk -- were the four bosses of Wall Street.
Details of these CEOs' decisions and negotiations, many of them previously unreported, show how they sought to avert the death of America's giant investment banks. Their efforts culminated in a round-the-clock weekend of secret negotiations and personal struggles to keep their firms afloat. Accounts of these events are based on company and other documents, emails and interviews with Wall Street executives, traders, regulators, investors and others.
Summer Clouds
Earlier this year, when the financial crisis claimed its first victim, Bear Stearns Cos., the surviving masters of Wall Street thought the eye of the storm had passed. Bear Stearns, the smallest of Wall Street's big five stand-alone investment banks, imploded just months after bad subprime bets sunk two internal hedge funds. In March 2008, the government brokered Bear Stearns's sale to J.P. Morgan Chase & Co.
After Bear Stearns's brush with death, the Federal Reserve for the first time allowed investment houses to borrow from the government on much the same terms as commercial banks. Many on Wall Street saw investment banks' access to an equivalent of the Fed "discount window" as a blank check should hard times return. But it would also be the first step in giving the government more say over an industry that had until then been lightly regulated.
Associated Press File Lloyd C. Blankfein, of Goldman Sachs,
In April, Morgan Stanley's CEO, John Mack, told shareholders the U.S. subprime crisis was in the eighth or ninth inning. The same month, Goldman Sachs Group Inc.'s chief executive, Lloyd Blankfein, said, "We're probably in the third or fourth quarter" of a four-quarter game.
Mack and Blankfein had some reason to be confident. Mack had been late to steer Morgan into mortgage trading, and relatively early to sell assets and raise cash. Goldman, under Blankfein, had even less direct exposure to subprime investments. Blankfein also took comfort in a stockpile of government bonds and other securities his firm held in case it ran into deep funding problems. By the second quarter, Goldman had increased this store of funds more than 30 percent from earlier in the year, to $88 billion.
Problems were more acute at Merrill Lynch and Lehman.
John Thain, a former Goldman Sachs president and New York Stock Exchange head, had arrived at Merrill Lynch in December 2007. He moved quickly to cut costs, putting the corporate helicopter up for sale and replacing the fresh flowers on a Merrill floor used by nine or so executives -- an estimated annual expense of $200,000 -- with fakes
More monumentally, Thain faced $55 billion in soured mortgage assets that Merrill had acquired under his predecessor. Within weeks of his arrival, he had raised more than $12 billion in much-needed capital, including $5 billion from Singapore's state investment company, Temasek Holdings, at $48 a share.
Some of those early deals would end up being costly. With his would-be investors driving a hard bargain, Thain promised Temasek and others that if Merrill sold additional common stock at a lower price within a year, the firm would compensate them. Within months, after taking a big write-down on a portfolio of mortgage debts that Merrill sold for pennies on the dollar, the firm had to raise more cash at $25 a share. Merrill issued additional shares to pay off its earlier investors, diluting its common shares by 39 percent. The dilution essentially cost shareholders about $5 billion, well above the previously reported $2.5 billion cost of shares issued to Temasek.
Lehman, now the smallest of the major Wall Street firms, also faced billions of dollars in write-downs from bad mortgage-related investments. In June, Lehman reported the first quarterly loss in its 14 years as a public company. Under Fuld, Lehman raised capital. But critics say Fuld was slow to shed bad assets and profitable lines of business. He pushed for better terms with at least one investor that ended up driving it away.
Fuld had faced challenges to his firm before. Since taking Lehman's reins in 1994, he expanded the 158-year-old bond house into lucrative areas such as investment banking and stock trading. Over the years, he had tamped unfounded rumors about the firm's health and vowed to remain independent. "As long as I am alive this firm will never be sold," Fuld said in December 2007, according to a person who spoke with him then. "And if it is sold after I die, I will reach back from the grave and prevent it."
In the summer of 2008, Fuld remained confident, particularly given the security of the Fed's discount window. "We have access to Fed funds," Fuld told executives at the time. "We can't fail now."
Friday, Sept. 12
By Friday, Sept. 12, failure appeared to be an option for Lehman.
Over that week, confidence in Lehman plunged. The firm said its third-quarter losses could total almost $4 billion. Lehman's clearing bank, J.P. Morgan, wanted an extra $5 billion in collateral. Lehman's attempts to raise money from a Korean bank had stalled. Credit agencies were warning that if Lehman didn't raise more capital over the weekend, it could face a downgrade. That would likely force the firm to put up more collateral for its outstanding loans and increase its costs for new loans.
If Fuld couldn't find an investor for Lehman by Sunday night, the fiercely independent boss could be forced to steer his firm into bankruptcy proceedings.
Earlier that week, Fuld had approached Bank of America's Lewis about buying Lehman. A U.S. Treasury official, meanwhile, had contacted Barclays of Britain to suggest it consider taking a stake in Lehman. Fuld's top executives spent Friday shuttling between the two suitors' law firms.
Lehman was also exploring a third option: The night before, veteran bankruptcy lawyer Harvey Miller of Weil, Gotshal & Manges had secretly begun cobbling together a bare-bones bankruptcy filing for the firm.
Lehman's troubles were putting the rest of Wall Street on notice.
In a Merrill Lynch conference room in downtown Manhattan that morning, Thain was on a call with Merrill's board of directors, discussing how to address the chaos. "Lehman is going down, and the [short sellers] are coming after us next," warned Merrill director John Finnegan. "Tell me how this story is going to end differently."
Merrill would be fine, Thain said. "We are not Lehman," he responded, noting the firm held valuable assets, including its stake in BlackRock, a profitable asset-management firm.
But Merrill's clients, too, were beginning to pull out money. The firm's stock was sinking. Executives, including Merrill President Gregory Fleming, were nervous.
Fleming believed he'd identified the ideal partner for Merrill. Bank of America, with a strong balance sheet and retail operations, would mesh well with Merrill's securities franchise and 16,000-strong brokerage force. Fleming worried that Bank of America could buy Lehman instead.
Fleming called a long-time lawyer for Bank of America, Edward Herlihy of Wachtell, Lipton, Rosen & Katz. "You have to talk to us," Fleming said. He was told that Merrill's Thain would have to approach Bank of America's Lewis. "I know," Fleming responded. "I'm gonna try."
At 5 p.m. Friday, after a day of massive client withdrawals at Lehman, Thain's phone rang. It was the Treasury. "Be at the Fed at 6 p.m.," Thain was told.
Soon after, Thain gathered along with Morgan's Mack and Goldman's Blankfein at the New York Federal Reserve in downtown Manhattan, in a room once used to cash coupons on Treasury bills. The three men were greeted by the masters of the world's biggest economy -- Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson, New York Fed Chief Timothy Geithner and Securities and Exchange Commission chief Christopher Cox. It was a signal moment for the Wall Street firms, which after years of being monitored by the SEC would all soon come under the regulatory watch of a newly powerful Fed.
The federal officials told the Wall Street chiefs to return in the morning. If the mess at Lehman could be fixed, it would be the job of the Wall Street bosses. There would be no public bailout.
An industry-led solution wouldn't be without precedent. In the market panic of 1907, financier J.P. Morgan persuaded fellow bankers to help fund a bailout for failing rivals. Competitors united again in 1998, putting up money to insulate the financial system from the failure of hedge fund Long Term Capital Management.
But now, Fuld's problems at Lehman were possibly beyond repair.
By that night, Bank of America's team had concluded that Lehman's real-estate portfolio was worse than expected -- and as a result, the firm's liabilities likely exceeded its assets. "We need government assistance, and we are not getting it," the bank's top deal maker, Greg Curl, told his group. Some of the negotiators prepared to fly back early the next morning to headquarters in Charlotte.
Lewis hadn't come to New York for the Lehman talks. He called Fuld from Charlotte, telling him that Bank of America couldn't do a deal without federal help. "We will keep a team in New York in case things change," Lewis told him.
Saturday, Sept. 13
Fuld arrived at Lehman's office at 7 a.m. on Saturday, wearing a blue suit and tie. The talks with Barclays were still moving. If the government could be moved, there could also be hope for a Bank of America deal.
Merrill, meanwhile, was beginning its own pursuit of Bank of America.
At his home in Rye, N.Y., Thain was getting dressed for a day at the New York Fed when his phone rang. It was Merrill's president, Fleming.
"John, you really need to call Ken Lewis," Fleming said.
"Get me his number," said Thain, who added it to his papers for the day.
Thain's black SUV pulled up in front of the New York Fed just before 8 a.m. Top executives from all four investment banks -- minus Lehman's Fuld -- were there.
Federal officials broke Thain, Mack and Blankfein and their top aides into groups. One studied the potential fallout from a Lehman failure. Another was charged with putting a value on Lehman's controversial real-estate investments. A third group, which included Thain and Morgan's Mack, was supposed to discuss an industry-led bailout for Lehman.
Lehman's president, Bart McDade, walked the group through the embattled firm's books. McDade did not respond to requests for comment for this article.
Mack questioned Wall Street's ability to repair markets. The firms could try to backstop Lehman, he argued, but there was no guarantee they wouldn't have to rescue another rival later. "If we're going to do this deal, where does it end?" he said.
As McDade discussed Lehman's position, Thain had an epiphany: "This could be me sitting here next Friday."
Thain pushed his chair back and left the group to caucus with top Merrill officers. "Lehman is not going to make it," he told them.
Thain stepped to a sidewalk behind the New York Fed and called the Bank of America chief at his home in Charlotte. "I can be there in a few hours," Lewis said.
Members of Bank of America's deal team, exhausted from scrutinizing Lehman's books, had just landed in Charlotte. Lewis ordered them back to New York.
Up in Lehman's midtown office, Fuld was also dialing Lewis's North Carolina home. His calls went unreturned. "I can't believe that son of a bitch won't return my calls," he told a top adviser.
Lehman's bankruptcy team, meanwhile, was rolling into action. Shortly before noon, Miller, the Weil Gotshal bankruptcy head, sent an email to several partners. Lehman's name didn't appear in the email. Its subject line read: "Urgent. Code name: Equinox. Have desperate need for help on an emergency situation."
Throughout the day, Miller's attorneys, working with Federal Reserve officials and their attorneys, began seeking information from Lehman. But with Lehman's top officials tied up at the Fed and in Barclays negotiations, the lawyers were hard-pressed to get the details they needed.
"We were a distraction to the Lehman people," said Lori Fife, a Weil partner. "It felt like it was just a fire drill."
Later that afternoon, Merrill's chief executive met Bank of America's CEO, Lewis, in the bank's corporate apartment in the Time Warner Center. In a one-on-one meeting overlooking Central Park, the two men agreed that it looked like Lehman would be forced into bankruptcy.
Thain made his opening offer. "How about buying a 9.9 percent stake" in Merrill, he proposed.
Lewis said the bank doesn't tend to buy minority stakes. He suggested Bank of America could buy the whole firm.
"I am not here to sell Merrill Lynch," Thain responded.
"Well, that is what I want," Lewis countered.
The two parted with an agreement to keep talking.
Lehman's talks with Barclays, meanwhile, were moving forward at the New York Fed, under the eye of government officials. "Shouldn't I be there?" Fuld said to Lehman President Mr. McDade and to attorney Rodgin Cohen of Sullivan & Cromwell LLP, a longtime adviser.
What Fuld appeared not to know was that some top government officials had instructed key Lehman representatives at the Fed building to keep Fuld away that weekend. The federal officials had explained that Fuld -- not only Wall Street's longest-serving boss, but a director of the New York Fed -- could be an unnecessary distraction and a lightning rod for criticism.
At the Fed meetings, much of the talk was on the sidelines. When Thain returned to the New York Fed from his discussions with Lewis, Merrill advisers told him they had been approached by top Goldman executives. The rival house was interested in taking a 9.9 percent stake in Merrill and offered to extend a $10 billion line of credit.
Thain was digesting the news when he was approached by Mack of Morgan Stanley. "We should talk," Mack said. The bosses of Merrill and Morgan agreed to meet that evening. Soon, Thain and two advisers were en route to the Upper East Side apartment of a Morgan co-president.
Thain drank a Diet Coke as the Morgan and Merrill executives talked. Both sides felt there were benefits to merging. Thain indicated he needed a deal quickly. The meeting ended without a firm plan. "We have a board meeting Tuesday and can get back to you soon," Mack said before the group broke up.
As Thain and his advisers left the apartment, the Merrill chief suggested he had faint hopes for a deal with Morgan Stanley. "I don't think they share our sense of urgency," he said.
Merrill's talks with Bank of America, however, were on track at the bank's law firm, Wachtell Lipton. Merrill's team was camped out on Wachtell's 34th floor. Bank of America's team was on the 33rd. Around midnight, Lewis left the law firm for his apartment in the Time Warner Center. Pizza arrived at Wachtell at 3 a.m.
At Lehman's offices that evening, Fuld still hadn't heard back from Lewis. Attorneys from Weil were poring through documents, drawing up what would be the largest bankruptcy in U.S. history.
But in a rare piece of good news for Lehman, Barclays had agreed to buy Lehman, as long as it didn't have to take on its soured real-estate assets. Lehman's asset-management division would also be spun off. The Fed indicated that a syndicate of banks and brokers had agreed in principle to put up enough capital to support a separate company that would hold Lehman's bad real-estate assets.
Sunday, Sept. 14
A few hours later, at 8 a.m., Thain arrived at the Time Warner Center for a second one-on-one meeting in Lewis's corporate apartment. Over coffee, Thain made his case for a strong price for Merrill despite its stock's recent fall.
At the same time, Merrill officials were huddled with Goldman bankers. Some members of Merrill's team doubted that Goldman could save their firm by taking a 9.9 percent stake. Pete Kelly, a top Merrill lawyer, also had his reservations about letting rival Goldman see his firm's books. Still, the sides set a late-morning meeting at Merrill's offices.
At 9 a.m., the chiefs of finance arrived again at the New York Fed for a second day of meetings. By the time Thain arrived, the Merrill chief had a number of options in his back pocket.
Rolling up to the meetings at around the same time was Goldman's chief, Blankfein. A Goldman aide, referring to days of meltdowns and meetings, carped to Blankfein: "I don't think I can take another day of this."
Blankfein retorted: "You're getting out of a Mercedes to go to the New York Federal Reserve -- you're not getting out of a Higgins boat on Omaha Beach," he said, referring to the World War II experience of a former Goldman head. "So keep things in perspective."
At Lehman that morning, Fuld told his board of directors to gather at the firm's offices. By noon, he expected, the board would be able to approve Lehman's sale to Barclays.
One hurdle remained: To ink a Lehman deal, Barclays needed a shareholder vote. There was no way to get one on a Sunday. Barclays would need the U.S. or British government to back Lehman's trading balances until a vote could be held.
Government approval never came, though there are diverging views on why. Some blame the U.S. government for refusing to commit resources. Others say the British government refused to entertain a deal they worried would expose England to unnecessary risk.
Lehman's president, McDade, and Cohen, the attorney, called Fuld from the New York Fed. Passing McDade's cellphone back and forth, they broke the Barclays news.
Fuld postponed his board meeting. He made one more call to Charlotte, answered by Lewis's wife.
By midafternoon, word emerged that Bank of America was in talks with Merrill Lynch. Cohen, the attorney, broke the news to Fuld. "I guess this confirms our worst fears," Fuld said.
At the Fed, the Lehman executives and their bankruptcy attorneys faced roughly 25 officials from the Fed, Treasury and SEC. The Lehman officials pleaded for federal aid to keep Lehman afloat. But with Barclays and Bank of America off the table, Federal officials wanted a plan in place to soothe markets before trading opened in Asia.
A senior Fed official asked Miller, the Weil veteran who'd been involved in bankruptcy filings of companies including Bethlehem Steel and Marvel Entertainment, if Lehman was ready to file.
"No," Miller answered.
"You need more of a plan to prepare to do this," Miller continued. Lehman had tens of billions of dollars in derivative positions with countless parties. Unless these trades were unwound in an orderly way, it could shock all corners of the financial market. "This will cause financial Armageddon," he said.
Now, Merrill's Thain needed his own deal more than ever. With a Morgan tie-up looking like a long shot, Merrill focused its attentions on Goldman and Bank of America.
Tempers at Merrill flared as two rival teams pored over the firm's records. Merrill's head of strategy Peter Kraus, a Goldman alumnus hired by Thain, wanted to pull some of the firm's due-diligence staff away from the Bank of America project to look at Goldman's offer. "We need some people down here," Kraus said.
"We have a great deal in hand, and need to finish doing this deal," retorted Fleming, Merrill's president. A few minutes later, Thain called Fleming, telling him to send some people to work on the Goldman offer.
Fleming and Bank of America's lead negotiator, Curl, hammered out a price. Bank of America would buy Merrill for $29 a share.
Fleming informed Thain. At 6 p.m., Merrill's top managers and directors gathered in person and by phone.
"When I took this job this was not the outcome I intended," Thain told directors. After the board meeting broke up after 8 p.m., Thain called the chief of Bank of America. "The decision was unanimous," Thain told Mr. Lewis. "You have a deal."
A more somber scene was playing out at Lehman. Directors, who had been camped at the Midtown offices all day, gathered at around 8 p.m. in the firm's board room. Weil lawyers and Lehman executives summarized the Fed meeting to the frustrated board.
"They bailed out Bear," said Roland Hernandez, the former CEO of Spanish-language TV network Telemundo and a longtime Lehman board member. "Why not us?"
One of Fuld's assistants broke in to hand him a note: The SEC chairman wanted to address Lehman's board by speakerphone.
Cox, criticized for his allegedly minor role in the government's bailout of Bear Stearns, had been reluctant to call Lehman. The SEC chief finally called from the New York Fed, surrounded by several staffers, at the urging of Mr. Paulson, the Treasury secretary.
"This is serious," said Cox. "The board has a grave matter before it," he said.
John D. McComber, a former president of the Export-Import Bank and a Lehman director for 14 years, asked: "Are you directing us to authorize" a bankruptcy filing?
The SEC chief muted his phone. A minute later, he came back on the line. "You have a grave responsibility and you need to act accordingly," he replied.
As the meeting wrapped up around 10 p.m., Fuld, his suit jacket now off, leaned back in his chair. "I guess this is goodbye," he said. Lehman would file about four hours later.
Just a few blocks away, Merrill and Bank of America executives met to toast their deal. "I look forward to a great partnership with Merrill Lynch," Lewis said around midnight, a glass of champagne in hand.
The End
Rather than soothing markets, Lehman's bankruptcy filing roiled them -- slamming trading partners that had direct exposure to the firm and sowing fears that Wall Street's remaining giants weren't safe from failure. Shares of Morgan and Goldman plunged. In the credit-default swap market, the price of insurance against defaults of Morgan and Goldman soared.
Hedge funds sought to withdraw more than $100 billion in assets from Morgan Stanley. The firm's clearing bank, Bank of New York Mellon, wanted an extra $4 billion in collateral.
Morgan's chief, Mr. Mack, negotiated a cash infusion from Japan's Mitsubishi UFJ Financial Group. Fed and Treasury officials, concerned that a deal could be derailed by a declining Morgan share price, asked if Mack had other options. One regulator suggested Morgan Stanley consider selling itself to J.P. Morgan -- from which it had been famously split, 73 years earlier, amid post-Depression banking reform laws.
"We're going to get Mitsubishi done. There is no Plan B," Mack told one regulator.
Morgan did the deal. But investor fears remained. By Thursday, Fed officials were urging Morgan to become a commercial bank. Such a move would require Morgan to scale back its bets with borrowed money, run the risk of selling lucrative business lines and accept new onsite regulation from the Fed.
Mack consented, and the following weekend, Morgan Stanley formally ceased to be a securities firm.
The same weekend, Blankfein convened top lieutenants on his 30th-floor office. After 139 years as a securities firm, he said, Goldman, too, would also reshape itself as a commercial bank. Within hours, the era of Wall Street's giants was over.
Friday, January 30, 2009
Chinese Premier Blames Recession on U.S. Actions
Chinese Premier Wen Jiabao squarely blamed the U.S.-led financial system for the world's deepening economic slump, in the most public indication yet of discord between the U.S. government and its largest creditor.
Leaders in China, the world's third-largest economy, have been surprised and upset over how much the problems of the U.S. financial sector have hurt China's holdings. In response, Beijing is re-examining its U.S. investments, say people familiar with the government's thinking.
Mr. Wen, the first Chinese premier to visit the annual global gathering of economic and political leaders in Davos, Switzerland, delivered a strongly worded indictment of the causes of the crisis, clearly aimed largely at the United States though he didn't name it. Mr. Wen blamed an "excessive expansion of financial institutions in blind pursuit of profit," a failure of government supervision of the financial sector, and an "unsustainable model of development, characterized by prolonged low savings and high consumption."
Chinese leaders have felt burned by a series of bad experiences with U.S. investments they had believed were safe, say people familiar with their thinking, including holdings in Morgan Stanley, the collapsed Reserve Primary Fund and mortgage giants Fannie Mae and Freddie Mac. As a result, the people say, government leaders decided not to make new investments in a number of U.S. companies that sought China's capital. China's pullback from Fannie and Freddie debt helped push up rates on U.S. mortgages last year just as Washington was seeking to revive the U.S. housing market.
To be sure, China's economy now is so closely intertwined with the U.S.'s that major, abrupt changes are unlikely. The U.S.-China economic relationship has become arguably the world's most important. China has been recycling its vast export earnings by financing the U.S. deficit through buying Treasurys, helping to keep U.S. interest rates low and give American consumers more spending power to buy Chinese exports.China now has roughly $2 trillion in foreign exchange reserves, and has continued to buy U.S. government debt -- surpassing Japan in September as the biggest foreign holder of Treasurys, by one official U.S. measure. China must continue to recycle its trade surplus if it doesn't want its currency to appreciate too quickly.
Still, the relatively smooth financial ties between the two powers that underpinned the global economic boom of recent years are being tested. As both sides survey the wreckage of the U.S. housing bubble and credit crunch, mutual recriminations are raising doubts about the relationship.
The Chinese premier's remarks came a few days after Treasury Secretary Timothy Geithner fanned the flames when he accused China of "manipulating" its currency during his confirmation process. That was widely seen as an escalation of long-standing U.S. complaints that China artificially depresses the value of the yuan to bolster its exports, and prompted strong denials from Beijing. The Obama administration has since played down the statement's significance.
More Friction
Frictions between the two countries began to worsen long before Mr. Obama took office. The Chinese central bank last year stopped lending its Treasury holdings for fear the borrowers will go bankrupt, according to people familiar with the discussions -- a decision that disrupted the functioning of the Treasury market. Beijing rejected pleas by Washington to resume its lending of Treasurys, the people said.
Meanwhile, China -- for years the largest foreign investor in bonds from Fannie Mae and Freddie Mac -- has been sharply trimming its holdings of that debt. After making direct net purchases of $46.0 billion in the first half of 2008, China's government and companies were net sellers of $26.1 billion in the five months through November, according to the latest U.S. data.
Weak demand for such debt from China and other foreign investors helped prompt the Federal Reserve to announce in November that it would take the step of buying up to $600 billion in debt from Fannie, Freddie and two other U.S. government-related mortgage businesses.
While Chinese officials have generally been circumspect in public, some Chinese commentators have sharpened their rhetoric in recent weeks. Washington "should not expect continuous inflow of more cheap foreign capital to fund its one-after-another massive bailouts," said a December editorial in the government-owned, English-language China Daily. Officials at the newspaper said the commentary wasn't ordered by the government.
Cash-rich Chinese financial institutions are under withering criticism at home for investments in the West that have lost money, such as a $5.6 billion stake in Morgan Stanley purchased by China's sovereign wealth fund, China Investment Corp., 13 months ago. The U.S. company's shares have dropped around 60% since then. Chinese institutions have rebuffed entreaties to invest in struggling U.S. companies even as investors from Japan and the Middle East have stepped up.
For years, Washington has pushed China to adopt an economic and financial system more like that in the U.S. -- arguing, for example, that China should liberalize capital flows in and out of the country. In many cases, China has moved more slowly than the U.S. desired. Beijing has resisted American pressure to let its currency appreciate in line with market forces, for example, which economists say has helped inflate China's trade surplus.
But often, U.S. suggestions had a sympathetic audience among reformers in China's government, and many of China's financial overhauls in recent decades have been inspired by the U.S. model. Now, some of these changes, and their proponents, have lost credibility in China in the wake of the financial meltdown, and recently commentators and officials in China have been increasingly critical about Washington.
Amid high-level Sino-U.S. economic talks in Beijing in early December, Chinese officials admonished the U.S. and Europe for their financial governance.
Vice Premier Wang Qishan, China's top finance official, called on the U.S. to "take all necessary measures to stabilize its economy and financial markets to ensure the security of China's assets and investments in the U.S."
A similar complaint was issued by Lou Jiwei, chairman of CIC, the government fund established in 2007 to seek higher returns on a $200 billion chunk of China's currency holdings. Mr. Lou said in a December speech that he has "lost confidence" because of inconsistent government policies concerning support for Western banks. "We don't know when these institutions will be invested in by their governments," he said.
Fate of U.S. Investments
CIC officials are especially sensitive about the fate of their U.S. investments because they have been under fire for the poor performance of earlier deals. CIC has sustained large paper losses on the $3 billion it invested in Blackstone Group LP in June 2007, as well as the Morgan Stanley stake. Staffed by officials, some western-educated, who have helped promote financial-market liberalization in China, CIC is also viewed by some Chinese as a symbol of the country's close financial ties to the U.S. -- another reason it has been in the crosshairs.
Around October, a lengthy Chinese-language essay began circulating on the Internet excoriating Mr. Lou and other top CIC officials, along with Zhou Xiaochuan, China's central bank governor, for being too close to the U.S. and then Treasury Secretary Henry Paulson. The diatribe quickly gained wide circulation in Chinese financial circles. One passage charged that Mr. Zhou "colluded with Henry Paulson to buy U.S. bonds, forced [Chinese yuan] appreciation, attached China's economy to the U.S. and broke China's economic independence."
Chinese and U.S. interests remain deeply enmeshed. Washington's huge stimulus plans will result in even heavier borrowing, and, while rising savings in the U.S. could create more domestic capital to help fund that, Chinese lending will remain important.
Japan investors, too, have been selling Fannie and Freddie debt and making other moves to limit their U.S. risk. An official at another Asian central bank in charge of managing hundreds of billions of dollars in foreign exchange reserves noted late last year that trading in some derivative instruments had factored in a slightly higher possibility of default by the U.S. government, though that prospect is still viewed by most investors as extremely low.
The alarm for Chinese leaders started ringing loudly in July and August as problems deepened at Fannie and Freddie. Senior Chinese leaders, who hadn't been apprised in detail of how China's reserves were being invested, learned for the first time in published reports that the country's exposure to debt from those two alone totaled nearly $400 billion, say people familiar with the matter.
Fearing that the U.S. government might not fully back the companies, China demanded and received regular briefings throughout the peak of the crisis from high-level Treasury Department officials, including Mr. Paulson, on the market for U.S. debt securities -- especially those of the mortgage giants.
Mr. Paulson and other Treasury officials spoke regularly with Vice Premier Wang and other senior Chinese officials to soothe their concerns.
Hit With Questions
Chinese officials often bombarded their U.S. counterparts with questions, according to people who were present at meetings.
While Mr. Paulson was in Beijing for the Olympics in August, he dined with Mr. Zhou, the central bank chief, at the Whampoa Club, an upscale restaurant that serves modern Chinese cuisine in a traditional courtyard building near the city's Financial Street.
On Sept. 7, Mr. Paulson announced that the U.S. government would seize Fannie and Freddie, but Chinese officials remained concerned.
At one briefing for Chinese officials to explain the change, said people present, they questioned and debated the meaning of nearly every line of the new Treasury plan.
Then Washington allowed Lehman Brothers Holdings Inc. to collapse, further shaking Beijing's faith. One casualty was CIC's nearly $5.4 billion investment in the Reserve Primary Fund, the money-market fund that "broke the buck" in September as a result of the Lehman collapse.
CIC had placed money in the Primary Fund because "money market funds are supposed to be very safe," said a Chinese official in an interview late last year. But on Sept. 16, the Primary Fund's managers announced that they were delaying redemptions.
CIC officials emailed Reserve asking to withdraw all of its money from the fund, and promptly received a reply agreeing to the request, says the Chinese official.
CIC officials believed the agreement meant that CIC had become a creditor to the troubled fund, and therefore was entitled to all of its money.
A Reserve spokeswoman says the company doesn't comment on individual clients.
Later in the day on Sept. 16, Reserve announced that the Primary Fund's net asset value had fallen to 97 cents a share, below the standard $1.00 level.
Reserve initially said redemption requests received before 3 p.m. that day would be honored in full, but has since said that the net asset value already was down to 99 cents a share by 11 a.m.
As Reserve further delayed payments, CIC began to fear that it might not get all of its money.
The Reserve issue "is causing a lot of concern with a lot of financial institutions in China," said the Chinese official.
Some officials expected that the U.S. and its financial institutions would better protect China from loss.
"If the U.S. is treating us this way, eventually that will be enough cause for concern in the stability of the [U.S.] system," the official said.
A CIC spokeswoman declined to comment on the current status of the dispute.
Tuesday, December 23, 2008
Stock Investors Lose Faith, Pull Out Record Amounts
One of the hallmarks of the long market downturns in the 1930s and the 1970s has returned: Rank-and-file investors are losing faith in stocks.
In the grinding bear markets of the past, huge stock losses left individual investors feeling burned. Failures of once-trusted firms and institutions further sapped their confidence. Many disenchanted investors stayed away from the stock market, holding back gains for a decade or more.
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Today's investors, too, are surveying a stock-market collapse and a wave of Wall Street failures and scandals. Many have headed for the exits: Investors pulled a record $72 billion from stock funds overall in October alone, according to the Investment Company Institute, a mutual-fund trade group. While more recent figures aren't available, mutual-fund companies say withdrawals have remained heavy.
If history is any guide, they may not return quickly.
"I don't have any confidence in buying any new stocks," says David Herrenbruck, a 52-year-old New York photographer at the peak of his ability to save and invest. Mr. Herrenbruck was a big believer in stocks in the late 1990s, but he was burned by the tech-stock meltdown. He has since moved much of his money to real estate, and he has recently invested in bonds and certificates of deposit. "If I have some cash lying around, it is going to be in CDs," he says.
Individual investors arguably form the bedrock of the market. It's difficult to pinpoint how much stock they hold, because they own shares through mutual funds, retirement accounts and other vehicles. But once retirement accounts are factored in, individuals likely account for half or more of all U.S. stock holdings, according to data from Birinyi Associates in Westport, Conn.
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David Herrenbruck
Investors' discomfort with stocks has been growing for years, since just after the 2000 selloff of dotcom shares. From 2002 through 2005, investors put an average of $62 billion a year into U.S. stock mutual funds, less than half the annual level of the previous decade. Since 2006, investors have been pulling money out of U.S. stock funds at a rate of about $40 billion a year.
Such skittishness already promises to put a brake on the stock market's recovery, which could make it harder for companies to raise capital and could squeeze financial firms' profits. That, in turn, could delay the economy's emergence from the severe recession that began last year.
Individuals aren't the only ones who have become skeptical of stocks. Many of the buyers who pushed indexes to record levels this decade -- including private-equity firms and hedge funds -- also appear to be increasingly looking beyond stocks. College endowments and hedge funds, for example, have in recent years funneled more money into alternative investments such as real estate, commodities, art, and even farms and timberland.
Lessons Learned
There's no way to know how long individuals could stay away from shares. Their confidence could be restored more quickly than in the past, optimists say, pointing to policymakers' efforts to avoid repeats of the 1930s and 1970s. Federal officials have sought to stabilize financial markets by injecting hundreds of billions of dollars, slashing target interest rates for overnight loans to nearly zero and announcing plans to buy up mortgage-backed securities.
Also, today's individual investors are different than those of past eras. In the 1930s and 1970s, stock investing was the province of a minority of rich Americans. Now, thanks to 401(k) programs and other retirement plans, nearly half of U.S. families have stock holdings.
Some of the biggest nest eggs belong to baby boomers who are reaching retirement age. The market could receive a boost if many sidelined boomers, whose retirements could span decades, decide it is safe to shift sharply back to stocks. But if these investors believe their money will be safer stashed elsewhere for upcoming years, it could slow a market recovery.
Four-Decade Cycles
Peter Lush is among those steering mostly clear of company shares. The 61-year-old retiree in Georgia built up his retirement plan by investing in a fund that owned midsize stocks. Until recently, he says, he had much of his savings in a bond fund, and after corporate bonds took a hit, he moved the money into CDs. "Maybe now would be a good time to buy" stock, says Mr. Lush. "But I am scared, to tell you the truth."
Enthusiasm for shares has waxed and waned in long cycles, with previous flights from stocks occurring eight and four decades ago.
In 1932, the Dow Jones Industrial Average -- in those days a speculative index of relatively young companies -- had fallen 89% from its 1929 high. The 1930s brought bull markets followed by bears, taking back gains and sapping investor confidence.
The sustained troubles of the 1930s exposed scandals in speculative instruments. So-called investment trusts used investor money and borrowed funds to buy high-flying securities, sometimes buying stock in one another. Of the 1,183 investment trusts and other funds that existed from 1927 through 1936, more than half had failed by 1937, a government study showed. Goldman Sachs, which sponsored three prominent funds that lost most of their value, saw its reputation damaged for years.
The Dow didn't return to its 1929 high until 1954. New York University financial historian Richard Sylla recalls that even in the 1950s, some people were so spooked by the Depression that they were storing money in jars in the basement.
The stock recovery of the 1940s and 1950s became a speculative boom in the 1960s, marked by the so-called Nifty Fifty stocks that brokers said would rise for years. They didn't.
In 1966, the Dow flirted with the 1000 level, then shed 25%. That bull-and-bear pattern would repeat for 16 years amid inflation and soaring oil prices. Investor confidence was hammered again. There was scandal, too, including the early 1970s collapse of Bernie Cornfeld's mutual-fund empire, Investors Overseas Services, which at one point had assets of more than $2 billion.
Mutual-fund data from that period show investors reacted much as they have in recent years. After a market peak in 1968, people began putting less money than before into mutual funds, Investment Company Institute data show. By 1971, they were pulling more money out than they were putting in. From May 1972 through March 1980, total dollars in stock funds fell 42%. Mutual-fund executives worried that the industry might not survive.
Money started flowing in again in the 1980s, after the government encouraged broad market participation through 401(k) plans and other retirement programs. Individuals gradually embraced the idea of buy-and-hold investing, helping to usher in the stock boom of the 1990s.
Pax Americana
With the Cold War over and investments flowing across the globe, people believed they were in a long-running Pax Americana of world-wide prosperity and rising productivity. During the 1990s, investors added $1 trillion to mutual funds. The Dow Jones Industrial Average surged above 11000 in 1999, up tenfold from 1982. Owning anything but stocks looked foolish.
That confidence has been shaken by two bad bear markets in less than a decade. Between 2000 and 2002, the Dow fell 38% and the Nasdaq Composite Index shed 78%. This year's market collapse knocked 47% off the Dow in just over 12 months, returning stocks to 1997 levels. As of Friday, the Dow still was 39% off its 2007 record.
"The question is whether this series of very strong bear markets will cause investors to retrench as they did in the '70s," says Brian Reid, chief economist at ICI. "I think there will be some of that," he says, although perhaps not as bad as it was then.
People in the investment business hoped ordinary investors would return in large numbers when the market began recovering late in 2002. But this didn't happen.
In 2001, 53% of U.S. households held stock or stock funds, which turned out to be a peak. Now, about 46% of families own stocks, according to a report published last week by the ICI and the Securities Industry and Financial Markets Association.
The disaffection appears to be deepening. By the end of October, amid the most recent market collapse, retirement savers tracked by consulting group Hewitt Associates were sending 58% of their contributions to stock funds. That was down from 75% at the beginning of this year.
The decade's second bear market also brought big failures and scandals -- the end of venerable investment banks, an alleged $50 billion swindle by Wall Street stalwart Bernard Madoff -- to add to the collapses of Enron and WorldCom from earlier in the decade.
"For many investors, this has been a glimpse into the abyss," says Terrance Odean, a finance professor at the University of California, Berkeley, who has studied the behavior of individual investors. "They have been told that if you save regularly for retirement and buy and hold, you will be fine. Now, people see a possibility that this will not be the case."
Weak Hands
The market has given Karin Kuder a good ride over the past two decades, but now she's through. Starting in 1989, Ms. Kuder contributed as much as she could to her retirement fund, up to 15% of each paycheck. In the 1990s, she chose aggressive stock funds, moving to a more conservative mix after the 2001 terrorist attacks. Early this year, even after she retired as a nurse at a naval air station in Jacksonville, Fla., Ms. Kuder still held 60% stocks and 40% bonds.
In March, she trimmed her stock holdings to 50% of her portfolio. In October, with her account down $40,000, she ran out of confidence. "It was the only money I had," Ms. Kuder says. "I wasn't sleeping."
She phoned her financial adviser and said she wanted to put all her money in a safe place. The adviser persuaded her to leave 20% in stocks and bonds, but the rest went to a five-year fixed annuity, similar to a certificate of deposit, guaranteeing 5.1% a year.
"You put in all those years, and it is just falling right away from you," Ms. Kuder says. "I was so fearful that I was going to lose everything."
When market analysts talk about who's buying and who's selling in times like these, they sometimes speak of "weak hands" and "strong hands." Weak hands bail out when the market declines, seeking what they see as safer havens. Strong hands are committed to the market for the long term, buying shares at what may turn out to be big discounts. Right now, the market is being driven by the exit of these weak hands. Lasting recovery will come when some of these weak hands -- or the next wave of younger investors -- step back in.
There are signs that even younger investors are growing more fearful of stocks lately. Risk aversion has been on the rise this decade among all age groups, according to last week's report from the ICI and SIFMA. Although it will be long before young people need to tap their retirement savings, the losses they've seen in the current bear market could temper their enthusiasm for stocks for years to come.
Bright Future
Harris Cohen, a 25-year-old project manager with Amtrak in Washington, D.C., opened an individual retirement account in 2001, when he was 18, and filled it with stocks he thought had a bright future, including Apple Inc. and Garmin Ltd. He bought mutual funds that invest in alternative energy companies and utilities. He didn't bother with bonds.
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Harris Cohen
"I had a real good track record over five or six years, with increases from 10% to 20% a year," Mr. Cohen says. His portfolio has fallen about 40% over the past 18 months, he says.
In September, he began pulling back from stocks. Now, he has shifted his retirement savings to corporate bonds, a money-market fund and a few utility funds. He says he doubts he ever will view stocks the same way. "Even if the market were to rebound and the economy were to improve, I would be very loath to invest entirely in stocks," Mr. Cohen says.
While investor confidence is low, there are signs that it may have further to fall.
In 2001, people's hopes for stocks were extremely high. Only 5% of those surveyed expected average annual stock returns in the coming decade to be 5% or less, according to University of Oregon Prof. Paul Slovic, whose company, Decision Research, conducts the surveys. Today, nearly one-third of those surveyed expect such stock weakness, reflecting the decline in investor optimism.
But there is a surprising amount of optimism left. More than half of the small investors surveyed still expect annual gains of 10% or more over the next decade -- at, or above, historical averages.
At some point, these optimists may be right. Investors who jumped into the market at the height of the last love affair with stocks are still hurting. A $10,000 investment in 2000, into a fund tracking the S&P 500 with dividends reinvested, would be worth about $7,000, according to Morningstar Inc. Those who put $10,000 into the same index in 1982, at the end of the last decade of disaffection, would have more than $150,000.
—Shelly Banjo contributed to this article.Write to E.S. Browning at jim.browning@wsj.com
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Tuesday, October 28, 2008
A 21st Century Bretton Woods
Source: WSJ
There wasn't much to see in Bretton Woods in July 1944, when delegates from 44 countries checked into the sprawling Mount Washington Hotel for the United Nations Monetary and Financial Conference. Almost a million acres of New Hampshire forest surrounded the site; there were free Coca-Cola dispensers, but few other distractions.
In this scene of rustic isolation, 168 statesmen (and one lone stateswoman, Mabel Newcomer of Vassar College) joined in history's most celebrated episode of economic statecraft, remaking the world's monetary order to fend off another Great Depression and creating an unprecedented multinational bank, to be focused on postwar reconstruction and development.
At the Final Plenary, a sea of black-tied delegates gave a standing ovation to British economist John Maynard Keynes, whose intellect had permeated the three weeks of talks. Lord Keynes paid tribute to his far-seeing colleagues, who had performed a task appropriate "to the prophet and to the soothsayer."
The Bretton Woods conference has acquired mythical status. To economic-history buffs, it's akin to the gathering of the founding fathers at the constitutional convention. To politicians anxious to make their marks upon the world, it's a moment to be richly envied. The recent calls from British Prime Minister Gordon Brown and French President Nicolas Sarkozy for a new Bretton Woods conference, to which the Bush administration has acceded, have caused TV crews to descend upon the old hotel, which has undergone a $50 million facelift. But Bretton Woods revivalism is nothing new. Indeed, it's a long tradition.
After the onset of the Latin debt crisis in 1982, U.S. Treasury Secretary Donald Regan floated the idea of a new Bretton Woods to steady the hemisphere's currencies. The following year, reeling from three devaluations of the franc, French President Francois Mitterrand declared, "The time has really come to think in terms of a new Bretton Woods. Outside this proposition, there will be no salvation." Mitterrand persisted in this grandiloquence over the next two years. He finally quieted down in 1985, when Margaret Thatcher dismissed his proposal as "generalized jabberwocky."
In the wake of the emerging-market crises of 1997-98, Bretton Woods nostalgia broke out again -- this time in post-Thatcher Britain. "We should not be afraid to think radically and fundamentally," Tony Blair opined. "We need to commit ourselves today to build a new Bretton Woods for the next millennium." The precise content of Mr. Blair's millennial ambition was, shall we say, vague. But no fellow leader was rude enough to say so.
Among acts of international economic statesmanship, perhaps only the Marshall Plan has been invoked more frequently. There have been calls for a Marshall Plan for postcommunist eastern Europe, a Marshall Plan for Africa, a Marshall Plan for the inner cities. Indeed, anybody wanting Washington to splurge finds Marshall exceedingly convenient.
But Bretton Woods has a richer and more rarefied cachet. It was about reordering the international system, not just mobilizing money for an enlightened cause. And whereas the Marshall Plan was an example of the unilateralism for which the U.S. is known, the Bretton Woods conference was a triumph of multilateral coordination. It featured countries as diverse as Honduras, Liberia and the Philippines (Keynes spoke disdainfully of a "most monstrous monkey-house"), though it did not include South Korea or Japan, important voices in today's economic summitry.
Both sides of the Bretton Woods achievement seem alluring today, yet both may be chimerical. The conference rebuilt the economic order by creating a system of fixed exchange rates. The aim was to prevent a return to the competitive devaluations best illustrated by the "butter wars." In 1930 New Zealand secured a cost advantage for its butter exports by devaluing its money; Denmark, its main butter rival, responded with its own devaluation in 1931; the two nations proceeded to chase each other down with progressively more drastic devaluations.
This beggar-thy-neighbor behavior added to the protectionism that brought the world to ruin, and the Bretton Woods answer was simple. In the postwar era, the dollar would be anchored to gold, and other currencies would be anchored to the dollar: No more fluctuating money, ergo no competitive devaluation. To undergird this system, the Bretton Woods architects created the International Monetary Fund, which was far more central to their ambitions than their other legacy, the World Bank. If a country's fixed exchange rate led it into a balance of payments crisis, the IMF would bail it out and so avert devaluation.
Today the idea of another monetary rebirth has much to recommend it. The credit bubble that has wreaked havoc on the world's financial markets has its origins in a two-headed monetary order: Some countries allow their currencies to float, while others peg loosely to the dollar. Over the past five years or so, this mixture created a variation on the 1930s: China, the largest dollar pegger, kept its currency cheap, driving rival exporters in Asia to hold their exchange rates down also. Thanks to this new version of competitive currency manipulation, the dollar-peggers racked up gargantuan trade surpluses. Their earnings were pumped back into the international financial system, inflating a credit bubble that now has popped disastrously.
Persuading China to change its currency policy would be a worthy goal for a new Bretton Woods conference. But currency reform is low on the agenda of the summit that the Bush administration plans to host on Nov. 15. (The administration styles this gathering a "G-20 meeting," ignoring the European talk of a Bretton Woods II.) The British and French leaders who pushed for the meeting want instead to talk about financial regulation -- how to fix rating agencies, how to boost transparency at banks and so on. But many of these tasks require minimal multilateral coordination.
If the Europeans shrink from demanding that China cease pegging to the dollar, it's perhaps because they anticipate the concession that would be asked of them. China isn't going to give up its export-led growth strategy for the sake of the international system unless it gets a bigger stake in that system -- meaning a much bigger voice within the International Monetary Fund and a corresponding reduction in Europe's exaggerated influence. When you strip out the blather about bank transparency and such, this is the core bargain that needs to be struck. Naturally, the Europeans aren't proposing it.
It will be up to the two great powers -- the U.S. and China -- to fashion the deal that brings China into the heart of the multilateral system. Here, too, is an echo of the first Bretton Woods, for underneath the camouflage of a multilateral process there was a bargain between two nations. Britain, the proud but indebted imperial power, needed American savings to underpin monetary stability in the postwar era; the quid pro quo was that the U.S. had the final say on the IMF's design and structure. Today the U.S. must play Britain's role, and China must play the American one.
There's a final twist, however. In the 1940s the declining power practiced imperial trade preferences; the rising power championed an open world economy. When Franklin Roosevelt told Winston Churchill that free trade would be the price of postwar assistance, he was demanding an end to the colonial order and the creation of a level playing field for commerce. "Mr. President, I think you want to abolish the British empire," Churchill protested. "But in spite of that, we know you are our only hope."
Today it is the rising power that pursues mercantilist policies via its exchange rate. China's leadership, which sits atop an astonishing $2 trillion in foreign-currency savings, could trade a promise to help recapitalize Western finance for an expanded role within the IMF. But China may simply not be interested. The future of the global monetary system depends on whether China aspires to play the role of Roosevelt -- or whether it prefers to be a modern Churchill.
Monday, October 27, 2008
What History Tells Us About the Market
Source: WSJ
July 9, 1932 was a day Wall Street would never wish to relive. The Dow Jones Industrial Average closed at 41.63, down 91% from its level exactly three years earlier. Total trading volume that day was a meager 235,000 shares. "Brother, Can You Spare a Dime," was one of the top songs of the year. Investors everywhere winced with the pain of recognition at the patter of comedian Eddie Cantor, who sneered that his broker had told him "to buy this stock for my old age. It worked wonderfully. Within a week I was an old man!"
The nation was in the grip of what U.S. Treasury Secretary Ogden Mills called "the psychology of fear." Industrial production was down 52% in three years; corporate profits had fallen 49%. "Many businesses are better off than ever," Mr. Cantor wisecracked. "Take red ink, for instance: Who doesn't use it?"
Banks had become so illiquid, and depositors so terrified of losing their money, that check-writing ground to a halt. Most transactions that did occur were carried out in cash. Alexander Dana Noyes, financial columnist at the New York Times, had invested in a pool of residential mortgages. He was repeatedly accosted by the ringing of his doorbell; those homeowners who could still keep their mortgages current came to Mr. Noyes to service their debts with payments of cold hard cash.
Just eight days before the Dow hit rock-bottom, the brilliant investor Benjamin Graham -- who many years later would become Warren Buffett's personal mentor -- published "Should Rich but Losing Corporations Be Liquidated?" It was the last of a series of three incendiary articles in Forbes magazine in which Graham documented in stark detail the fact that many of America's great corporations were now worth more dead than alive.
More than one out of every 12 companies on the New York Stock Exchange, Graham calculated, were selling for less than the value of the cash and marketable securities on their balance sheets. "Banks no longer lend directly to big corporations," he reported, but operating companies were still flush with cash -- many of them so flush that a wealthy investor could theoretically take over, empty out the cash registers and the bank accounts, and own the remaining business for free.
Graham summarized it this way: "...stocks always sell at unduly low prices after a boom collapses. As the president of the New York Stock Exchange testified, 'in times like these frightened people give the United States of ours away.' Or stated differently, it happens because those with enterprise haven't the money, and those with money haven't the enterprise, to buy stocks when they are cheap."
After the epic bashing that stocks have taken in the past few weeks, investors can be forgiven for wondering whether they fell asleep only to emerge in the waking nightmare of July 1932 all over again. The only question worth asking seems to be: How low can it go?
Make no mistake about it; the worst-case scenario could indeed take us back to 1932 territory. But the likelihood of that scenario is very much in doubt.
Robert Shiller, professor of finance at Yale University and chief economist for MacroMarkets LLC, tracks what he calls the "Graham P/E," a measure of market valuation he adapted from an observation Graham made many years ago. The Graham P/E divides the price of major U.S. stocks by their net earnings averaged over the past 10 years, adjusted for inflation. After this week's bloodbath, the Standard & Poor's 500-stock index is priced at 15 times earnings by the Graham-Shiller measure. That is a 25% decline since Sept. 30 alone.
The Graham P/E has not been this low since January 1989; the long-term average in Prof. Shiller's database, which goes back to 1881, is 16.3 times earnings.
But when the stock market moves away from historical norms, it tends to overshoot. The modern low on the Graham P/E was 6.6 in July and August of 1982, and it has sunk below 10 for several long stretches since World War II -- most recently, from 1977 through 1984. It would take a bottom of about 600 on the S&P 500 to take the current Graham P/E down to 10. That's roughly a 30% drop from last week's levels; an equivalent drop would take the Dow below 6000.
Could the market really overshoot that far on the downside? "That's a serious possibility, because it's done it before," says Prof. Shiller. "It strikes me that it might go down a lot more" from current levels.
In order to trade at a Graham P/E as bad as the 1982 low, the S&P 500 would have to fall to roughly 400, more than a 50% slide from where it is today. A similar drop in the Dow would hit bottom somewhere around 4000.
Prof. Shiller is not actually predicting any such thing, of course. "We're dealing with fundamental and profound uncertainties," he says. "We can't quantify anything. I really don't want to make predictions, so this is nothing but an intuition." But Prof. Shiller is hardly a crank. In his book "Irrational Exuberance," published at the very crest of the Internet bubble in early 2000, he forecast the crash of Nasdaq. The second edition of the book, in 2005, insisted (at a time when few other pundits took such a view) that residential real estate was wildly overvalued.
The professor's reluctance to make a formal forecast should steer us all away from what we cannot possibly know for certain -- the future -- and toward the few things investors can be confident about at this very moment.
Strikingly, today's conditions bear quite a close resemblance to what Graham described in the abyss of the Great Depression. Regardless of how much further it might (or might not) drop, the stock market now abounds with so many bargains it's hard to avoid stepping on them. Out of 9,194 stocks tracked by Standard & Poor's Compustat research service, 3,518 are now trading at less than eight times their earnings over the past year -- or at levels less than half the long-term average valuation of the stock market as a whole. Nearly one in 10, or 876 stocks, trade below the value of their per-share holdings of cash -- an even greater proportion than Graham found in 1932.
Those numbers testify to the wholesale destruction of the stock market's faith in the future. And, as Graham wrote in 1932, "In all probability [the stock market] is wrong, as it always has been wrong in its major judgments of the future."
In fact, the market is probably wrong again in its obsession over whether this decline will turn into a cataclysmic collapse. Eugene White, an economics professor at Rutgers University who is an expert on the crash of 1929 and its aftermath, thinks that the only real similarity between today's climate and the Great Depression is that, once again, "the market is moving on fear, not facts." As bumbling as its response so far may seem, the government's actions in 2008 are "way different" from the hands-off mentality of the Hoover administration and the rigid detachment of the Federal Reserve in 1929 through 1932. "Policymakers are making much wiser decisions," says Prof. White, "and we are moving in the right direction."
Investors seem, above all, to be in a state of shock, bludgeoned into paralysis by the market's astonishing volatility. How is Theodore Aronson, partner at Aronson + Johnson + Ortiz LP, a Philadelphia money manager overseeing some $15 billion, holding up in the bear market? "We have 101 clients and almost as many consultants representing them," he says, "and we've had virtually no calls, only a handful." Most of the financial planners I have spoken with around the country have told me much the same thing: Their phones are not ringing, and very few of their clients have even asked for reassurance. The entire nation, it seems, is in the grip of what psychologists call "the disposition effect," or an inability to confront financial losses. The natural way to palliate the pain of losing money is by refusing to recognize exactly how badly your portfolio has been damaged. A few weeks ago, investors were gasping; now, en masse, they seem to have gone numb.
The market's latest frame of mind seems reminiscent of a passage from Emily Dickinson's poem "After Great Pain a Formal Feeling Comes":
This is the Hour of Lead --
Remembered, if outlived,
As Freezing persons recollect the Snow --
First -- Chill -- then Stupor -- then the letting go.
This collective stupor may very likely be the last stage before many investors finally let go -- the phase of market psychology that veteran traders call "capitulation." Stupor prevents rash action, keeping many long-term investors from bailing out near the bottom. When, however, it breaks and many investors finally do let go, the market will finally be ready to rise again. No one can spot capitulation before it sets in. But it may not be far off now. Investors who have, as Graham put it, either the enterprise or the money to invest now, somewhere near the bottom, are likely to prevail over those who wait for the bottom and miss it.
Corrections & Amplifications:
Charles Schwab Corp. had $600 million of cash freely available at the parent-company level as of June 30. An earlier version of this story incorrectly said the total was $27.8 billion.
Friday, October 17, 2008
Fed Rethinks Stance on Popping Bubbles
Source: WSJ
The Federal Reserve and academics who give it advice are rethinking the proposition that the Fed cannot and should not try to prick financial bubbles.
"[O]bviously, the last decade has shown that bursting bubbles can be an extraordinarily dangerous and costly phenomenon for the economy, and there is no doubt that as we emerge from the financial crisis, we will all be looking at that issue and what can be done about it," Fed Chairman Ben Bernanke said this week.
The bursting of this decade's housing bubble, which was accompanied by a bubble of cheap credit, has wrought inestimable economic damage. The U.S. economy was faltering before the crisis in credit markets recently intensified, rattling financial markets and sending home prices down further. Even if the government's decision to take stakes in major banks works, it could take weeks for money to flow freely again.
"A recession at least of the magnitude of 1982 is quite likely," said ITG economist Robert Barbera. The recession that ended in 1982 lasted 16 months -- twice as long as the 1991 and 2001 recessions -- and saw the unemployment rate rise to 10.8% from 7.2%.
While it is too soon to pronounce an about-face in Fed thinking, policy makers' views clearly are evolving. The Federal Reserve's longtime line on financial bubbles has been that they were impossible to identify. Even if the central bank could identify a bubble, policy makers said, trying to lance it would be far worse for the economy than letting the bubble run its course and dealing with the consequences.
Economists' view that central banks shouldn't meddle with financial bubbles was informed by the Fed's disastrous efforts to pop the stock-market bubble in the late 1920s, which led to the 1929 stock-market crash and contributed to the Great Depression. That view was reinforced when the Bank of Japan's pricking of the late 1980s' stock-market bubble shepherded in a decade of economic stagnation.
"[T]he degree of monetary tightening that would be required to contain or offset a bubble of any substantial dimension appears to be so great as to risk an unacceptable amount of collateral damage to the wider economy," former Fed Chairman Alan Greenspan said in 2002.
The Fed's view on bubbles helped fuel what became known as "the Greenspan put" -- the conviction among investors that the Fed would let them take excessive risks and step in as custodian if the bets they made went awry. By giving market participants an incentive to assume greater risk than they would have otherwise, the Fed's laissez-faire position on bubbles may have contributed to the surge in credit that helped push housing prices skyward in the first half of this decade.
Part of the problem was that the Fed applied the lessons of the dot-com bubble to housing and credit, says Harvard University economist Jeremy Stein. When Internet stock prices collapsed in 2000, the economic fallout was contained, because the use of leverage -- borrowing money to magnify bets -- was limited. The housing market is far more dependent on credit, and therefore leverage. As the issuance of mortgages expanded, and investors plunged money into complex securities based on those loans, matters got dangerously out of hand.
Identifying bubbles is tricky, with some seemingly irrational price spikes turning out to be justified. Policy makers need to be careful of valuing their judgment over the collective judgment of the market, because efforts to quash prices could interfere with the crucial role markets play in relaying information and allocating capital.
In recent years, economists have made headway in identifying incipient bubbles. Princeton University's Jose Scheinkman and Wei Xiong have shown how bubbles lead to overtrading -- whether day trading dot-com stocks or flipping condos -- and this might be a useful alert. Researchers at the Bank for International Settlements have flagged excessive credit growth signaling a bubble.
Once authorities identify a bubble, the next step is figuring out how to deal with it. Fed officials appear uncomfortable with the idea of raising interest rates to prick a bubble, because rates affect a wide swath of economic activity, and a bubble may be confined to just one area.
"Monetary policy, for which we in the Federal Reserve are responsible, is a blunt instrument with economy-wide effects," said Federal Reserve Bank of Minneapolis President Gary Stern. "We should not pretend that actions taken to rein in those asset-price increases, which seemingly outstrip economic fundamentals, won't in the short run curtail to some extent economic growth and employment."
Fed officials are leaning toward regulating financial firms with more of a focus on how they are contributing to risk throughout the financial system. This approach could also have drawbacks, said Princeton economist Hyun Song Shin.
"These Wall Street people are very intelligent, and their incentives are so vast that they're going to find a way to go around the rules you set down," he said. "Leaning against the wind by raising interest rates in the face of what seems like a credit boom is one way of at least damping down on potential excesses."
Wednesday, October 15, 2008
A Short Banking History of the United States
Source: WSJ, by John Steele Gordon
We are now in the midst of a major financial panic. This is not a unique occurrence in American history. Indeed, we've had one roughly every 20 years: in 1819, 1836, 1857, 1873, 1893, 1907, 1929, 1987 and now 2008. Many of these marked the beginning of an extended period of economic depression.
![[Opinion]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_uYy2hWUDNkW9n6WAmmz1r8GhZgf6rQgaNqVC2JkJ-2jgy0J81prK3zEosIlXZq5u6vmEnb-yG2wJinBbHwpF_MOw0eBr_pq3Cp7FqWw5JjRj7rtj5aR1nrRqr-NcIob6ch7autovAArJSfBXCPATY=s0-d)
The Granger CollectionPresident Andrew Jackson destroying the Bank of the United States. Lithograph, 1828.
How could the richest and most productive economy the world has ever known have a financial system so prone to periodic and catastrophic break down? One answer is the baleful influence of Thomas Jefferson.
Jefferson, to be sure, was a genius and fully deserves his place on Mt. Rushmore. But he was also a quintessential intellectual who was often insulated from the real world. He hated commerce, he hated speculators, he hated the grubby business of getting and spending (except his own spending, of course, which eventually bankrupted him). Most of all, he hated banks, the symbol for him of concentrated economic power. Because he was the founder of an enduring political movement, his influence has been strongly felt to the present day.
Consider central banking. A central bank's most important jobs are to guard the money supply -- regulating the economy thereby -- and to act as a lender of last resort to regular banks in times of financial distress. Central banks are, by their nature, very large and powerful institutions. They need to be to be effective.
Jefferson's chief political rival, Alexander Hamilton, had grown up almost literally in a counting house, in the West Indian island of St. Croix, managing the place by the time he was in his middle teens. He had a profound and practical understanding of markets and how they work, an understanding that Jefferson, born a landed aristocrat who lived off the labor of slaves, utterly lacked.
Hamilton wanted to establish a central bank modeled on the Bank of England. The government would own 20% of the stock, have two seats on the board, and the right to inspect the books at any time. But, like the Bank of England then, it would otherwise be owned by its stockholders.
To Jefferson, who may not have understood the concept of central banking, Hamilton's idea was what today might be called "a giveaway to the rich." He fought it tooth and nail, but Hamilton won the battle and the Bank of the United States was established in 1792. It was a big success and its stockholders did very well. It also provided the country with a regular money supply with its own banknotes, and a coherent, disciplined banking system.
But as the Federalists lost power and the Jeffersonians became the dominant party, the bank's charter was not renewed in 1811. The near-disaster of the War of 1812 caused President James Madison to realize the virtues of a central bank and a second bank was established in 1816. But President Andrew Jackson, a Jeffersonian to his core, killed it and the country had no central bank for the next 73 years.
We paid a heavy price for the Jeffersonian aversion to central banking. Without a central bank there was no way to inject liquidity into the banking system to stem a panic. As a result, the panics of the 19th century were far worse here than in Europe and precipitated longer and deeper depressions. In 1907, J.P. Morgan, probably the most powerful private banker who ever lived, acted as the central bank to end the panic that year.
Even Jefferson's political heirs realized after 1907 that what was now the largest economy in the world could not do without a central bank. The Federal Reserve was created in 1913. But, again, they fought to make it weaker rather than stronger. Instead of one central bank, they created 12 separate banks located across the country and only weakly coordinated.
No small part of the reason that an ordinary recession that began in the spring of 1929 turned into the calamity of the Great Depression was the inability of the Federal Reserve to do its job. It was completely reorganized in 1934 and the U.S. finally had a central bank with the powers it needed to function. That is a principal reason there was no panic for nearly 60 years after 1929 and the crash of 1987 had no lasting effect on the American economy.
While the Constitution gives the federal government control of the money supply, it is silent on the control of banks, which create money. In the early days they created money both through making loans and by issuing banknotes and today do so by extending credit. Had Hamilton's Bank of the United States been allowed to survive, it might well have evolved the uniform regulatory regime a banking system needs to flourish.
Without it, banking regulation was left to the states. Some states provided firm regulation, others hardly any. Many states, influenced by Jeffersonian notions of the evils of powerful banks, made sure they remained small by forbidding branching. In banking, small means weak. There were about a thousand banks in the country by 1840, but that does not convey the whole story. Half the banks that opened between 1810 and 1820 had failed by 1825, as did half those founded in the 1830s by 1845.
Many "wildcat banks," so called because they were headquartered "out among the wildcats," were simple frauds, issuing as many banknotes as they could before disappearing. By the 1840s there were thousands of issues of banknotes in circulation and publishers did a brisk business in "banknote detectors" to help catch frauds.
The Civil War ended this monetary chaos when Congress passed the National Bank Act, offering federal charters to banks that had enough capital and would submit to strict regulation. Banknotes issued by national banks had to be uniform in design and backed by substantial reserves invested in federal bonds. Meanwhile Congress got the state banks out of the banknote business by putting a 10% tax on their issuance. But National banks could not branch if their state did not allow it and could not branch across state lines.
Unfortunately state banks did not disappear, but proliferated as never before. By 1920, there were almost 30,000 banks in the U.S., more than the rest of the world put together. Overwhelmingly they were small, "unitary" banks with capital under $1 million. As each of these unitary banks was tied to a local economy, if that economy went south, the bank often failed. As depression began to spread through American agriculture in the 1920s, bank failures averaged over 550 a year. With the Great Depression, a tsunami of bank failures threatened the collapse of the system.
The reorganization of the Federal Reserve and the creation of the Federal Deposit Insurance Corporation hugely reduced the number of bank failures and mostly ended bank runs. But there remained thousands of banks, along with thousands of savings and loan associations, mutual savings banks, and trust companies. While these were all banks, taking deposits and making loans, they were regulated, often at cross purposes, by different authorities. The Comptroller of the Currency, the Federal Reserve, the FDIC, the FSLIC, the SEC, the banking regulators of the states, and numerous other agencies all had jurisdiction over aspects of the American banking system.
The system was stable in the prosperous postwar years, but when inflation took off in the late 1960s, it began to break down. S&Ls, small and local but with disproportionate political influence, should have been forced to merge or liquidate when they could not compete in the new financial environment. Instead Congress made a series of quick fixes that made disaster inevitable.
In the 1990s interstate banking was finally allowed, creating nationwide banks of unprecedented size. But Congress's attempt to force banks to make home loans to people who had limited creditworthiness, while encouraging Fannie Mae and Freddie Mac to take these dubious loans off their hands so that the banks could make still more of them, created another crisis in the banking system that is now playing out.
While it will be painful, the present crisis will at least provide another opportunity to give this country, finally, a unified banking system of large, diversified, well-capitalized banking institutions that are under the control of a unified and coherent regulatory system free of undue political influence.
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