The Year of Puncturing Wall Street Orthodoxy

By JENNY ANDERSON
December 21, 2007
Source

NEVER in the history of Wall Street have so many who are so senior fallen so fast.

And it’s no wonder. Citigroup, Merrill Lynch, Morgan Stanley and UBS have all lost billions of dollars as the crisis that began in the subprime mortgage market has ripped through the financial markets. There is enough finger-pointing at most major banks to cause carpal tunnel syndrome.

This year the leaders of some of the world’s most respected financial institutions — leaders who are paid first and foremost to manage risk — have been caught either unaware or uninformed about giant risks their companies took. Their financial engineers concocted securities so complex that even the brainiacs cannot figure out what those investments are worth. And the few banks that got it right, like Goldman Sachs, now face a sobering question: Will they be so agile next time?

The landscape on Wall Street is already changing drastically. Firms once known for their savvy risk managers, like Bear Stearns, or for their conservative stockbrokers, like Merrill Lynch, have been crippled by the credit squeeze. Meantime, other firms that have run into trouble in the past, such as Credit Suisse, have emerged relatively unscathed and are now angling for clients and market share.

The credit bubble that is now bursting, like the dot-com implosion before it, was fueled by the fantasy of easy money. Everyone knew the music would stop, but as Charles O. Prince, the former Citigroup chief executive, famously said, until it stopped, the bank would keep dancing. Any smart trader knows that challenging the conventional wisdom is often a sure bet. Here are 10 bits of well-worn Wall Street defenses that many must wish they had questioned this year.

High Pay Means Low Risks

Wall Street chief executives are paid princely sums to manage risks. But not only did these executives pile into tricky, hard-to-value assets, they also seemed incapable of keeping track of their falling value. And those ranks are packed with the best and brightest.

As one chief executive after another was shown the door, it began to feel like a Wall Street version of “And Then There Were None.” The scramble to replace top executives at Citigroup, Merrill Lynch and UBS laid bare the dearth of talent on the Street. Many rising stars have left big Wall Street banks to join hedge funds and private equity firms. Power-hungry chiefs failed to set up solid succession plans.

Morgan Stanley had at least one good reason to leave John J. Mack in place after it reported its first loss ever this week. If the board had sacked him, it would have to hunt for a new leader, and the pickings are getting slimmer.

Spreading Risk Is Good

This makes sense. If big banks load up on risky assets, they cannot make as many loans, which is bad for the economy (witness what is happening today).

But the banks no longer hold the loans they make. Instead, they package them into securities and spread the risk just about everywhere. No one knows who is exposed to subprime home loans, for example. Losses from such investments have turned up in towns in the Arctic Circle, public schools in Florida and big banks in Germany, among other places. What is more, the banks spread the risk but ended up with it anyway, which is why Wall Street has taken more than $40 billion in losses on mortgage-related investments.

Your Board Will Protect You

Unless you are E. Stanley O’Neal and you rack up $5 billion, I mean $8 billion, I mean $12 billion, in losses. At Merrill, Mr. O’Neal announced huge write-downs — and then kept revising them higher. No one has figured out why the Street did not take bigger hits last February, when the floor fell out of the subprime mortgage market. Virginia Reynolds Parker, head of Parker Global Strategies, called it the year of slow confessions. That may be too kind.

Computer Models Will Save Us

Unless they don’t. Despite being packed with Ph.D.’s from around the globe, the Street forgot that algorithm-filled computers could not predict everything. So-called Black Swan events happen more than you think. And in 2007, such completely unexpected events occurred in February, August and November.

Buyouts Will Backfire

Not yet, anyway. For much of 2007, everyone fretted that reckless loans used to finance buyouts would break Wall Street. Instead, the real danger turned out to be complex structured finance investments linked to mortgages.

Judging by fourth-quarter results posted by Goldman Sachs and Lehman Brothers, the leveraged lending market is recovering. But that does not mean the storm has passed. Companies that have been saddled with debt from buyouts may stumble if the economy sinks into a recession.

Banks and buyout firms have tried to weasel out of deals done before the credit markets stumbled, including acquisitions of Sallie Mae, Harman International and United Rental. But the canary in the coal mine ended up being a robin.

Blame the Hedge Funds

No, Wall Street blew up the system. Many hedge funds made a killing. Others went out of business. To be fair, Wall Street banks and hedge funds are starting to look alike. Hedge funds earn fees of 2 percent of assets under management and collect 20 percent of any profits by taking risks (measured risks, they would claim). Wall Street is paid an incentive fee of 50 percent to take risks, sometimes reckless ones — that ultimately are borne by shareholders, not chief executives.

Mr. O’Neal was able to hold onto $161.5 million in stock and benefits by “retiring,” on top of the more than $70 million he took home in the past five years. Mr. Mack said this week that he would forgo a bonus, but he did not have to give back the $41 million he made last year.

This Is a Liquidity Crisis

Not true. There is plenty of money sloshing around: witness the $25 billion that Chinese and Middle Eastern investment funds have spent on stakes in Citigroup, Morgan Stanley and UBS. Parts of the financial markets have seized up because sellers do not want to take big losses on beaten-down assets. There is liquidity, but just not being directed to where it is needed.

Home Prices Never Fall

At least not on a national basis. But never say never. In 2005, Ben S. Bernanke, then an adviser to President Bush and now the chairman of the Federal Reserve, said surging home prices were being driven by economic fundamentals. “We’ve never had a decline in housing prices on a nationwide basis,” Mr. Bernanke said.

It turns out that in 2006, house prices started falling nationally, according to the Standard & Poor’s Case-Shiller index. They have fallen 5 percent so far, and the consensus estimate is that they could fall up to 10 percent.

Hedge Funds Make Money

Sure, for the people who run them. But so far not for public shareholders. Wall Street banks overpriced the buyout and hedge fund companies that have gone public this year, even though these firms are in the same business as the banks. The Fortress Investment Group led the public offering parade, followed by Blackstone and Och-Ziff. Kohlberg Kravis Roberts filed to go public but missed the window. But the shares have plummeted. So why did Wall Street slap such a high valuation — up to 25 times earnings — when their own businesses generate such abysmal multiples?

Big Birthday Parties Are Cool

Stephen A. Schwarzman, who runs Blackstone, thought it was O.K. to throw himself a circus of a birthday party while he was contemplating taking the firm public.

Bad move. Proposed legislation aimed at raising taxes on private equity fund managers soon followed. Congress denies it got interested in slapping private equity managers with higher taxes because of Mr. Schwarzman’s $5 million affair, but no one denies that reports of the party helped drum up support for the measures.

Neither piece of legislation passed, but 2008 is a new year, perhaps one with a recession. And where better to go looking for tax revenue than the guy who threw himself that party?