I first wrote this article back in 2008 and published it on a discussion forum. I expanded and then posted it to this blog. I just never published it. As I was going through my posts, I realized that I have had this gem in draft form since 2008! as I went through and updated some of the information, I could not help thinking that the only thing left of some of these once powerful companies is a Wikipedia page! So here goes!
=============
In all of my 21 years of involvement in the capital markets, I never thought I would live to see the collapse of Lehman Brothers, and the sale of Merrill Lynch (ML), and AIG tottering on the brink of collape! Never in my wildest dreams could I have imagined the collapse of 158 year old bond power house -- Lehman Bros. coming soon after the collapse of Bear Stearns.
The sale of Merrill Lynch, a once proud institution and investment firm that was otherwise known as "Mother Merrill" was unthinkable prior to the sale!
My thoughts go out to my former Merrill Lynch colleagues and the investors that ultimately had to bear the brunt of the effect of capital market debacles. The mantra when I was at Merrill Lynch was -- "No, it has nothing to do with our clients". Not true, it has everything to do with all investors since declines in capital market valuations do affect client portfolios! Hopefully, investors have learned their lessons from past years and now hold diversified portfolios.
In October 2007, Stan O'Neal, the former CEO of Merrill Lynch, angered employees when he approached another bank about a possible merger prior to disclosing $8.0 billion in losses arising from the sub-prime mess. I really liked Stan -- I was proud to be working for a company headed by a brother! However, there was such a deep sense of betrayal that most of the employees felt that the CEO had to go! I recall thinking "Subprime? That's the other guys not us! What does it have to do with us and our clients?" Most employees were not even aware of the extent of the firm’s exposure. Needless to say -- Stan had to resign and he left with a golden parachute that just angered employees some more!
Municipal Bonds: My relationship with Lehman Bros. goes back to 1990 when I worked with one of their investment bankers on the issuance of municipal bonds to finance projects for seven California health facilities. It was an experience of a lifetime! I did most of the work while Joe, the ever so friendly investment banker, conveniently spent most of his time making calls for his next deal! It was not funny then -- but when I look back on it,Joe gave me the chance to learn a lot more about the issuance of municipal bonds than I would have otherwise. Oh yes, he thought I was very sweet until I cut his underwriting fee, and then he was not too happy with me but I was not going to let him get way with too much!
Municipal Analysts: A few years later, I met a group of Lehman Bros. analysts at a Municipal Analysts conference in Seattle in the early 1990s. That was my first visit to Seattle which would later become my home. I subsequently met the Lehman Brothers Analysts again at other conferences and developed a great working relationship with them over the years. They were some of the best analyst in the municipal credit field at the time. I remember overcoming my morbid fear of New York City when I took the train from the Port Authority at 45th Street in Mid-Manhattan to the World Trade Center (WTC) to have lunch with them in the Atrium at WTC. They survived 9-11 -- so I hope they made it through this debacle too!
Broker: Another Lehman Brothers connection was my all-time favorite Lehman broker, Peter B., in San Francisco – a real Scandinavian gentleman -- a fellow who never lost his cool and would go to great lengths to locate specific bonds, in specific maturities to enable me to effectively round out one of the money market portfolios. Yes, believe it or not -- there are some good people on Wall Street!
Credit Derivatives
I have absolutely no problem with the use of derivatives as long as they are used as a hedging tool for purposes of reducing and managing risk and not for speculative purposes! Derivative contracts are part of the Over-the Counter (OTC)) market and they include forward contracts, futures contracts, options and swaps. A derivative is an instrument whose value or price is derived from or linked to the value or price of another instrument or element. Thus credit derivatives are securities whose value or price is linked to credit instruments such as bank loans or mortgage loans.
The fear of derivatives stems from several high profile losses that were related to derivatives. I will discuss most of these cases in this article. Despite the high profile losses, derivatives remain an important part of the capital markets.
Each year, I would ask myself, "What is the next stupid thing that the banks could possibly do?" Before the subprime mess hit the fan, I knew it was credit derivatives that would prove to be the undoing of the market. The exact extent and breath of the credit derivatives market was unknown because the securities are difficult to price. Most firms have their own pricing model. You just knew the credit derivatives market was big and you were only seeing the tip of the iceberg -- just like the Titanic! You could almost see the writing on the wall! To compound the problem, well-thought out risk management systems went out the door as greed took over.
Greed
Wall Street's debacles are often fueled by greed and recklessness involving the taking of excessive risk and wrong bets on interest or currency rates or commodities. The market can be so unforgiving for those who take huge bets and are wrong or economic events don’t pan out as expected.
In addition, unfortunately, the ubiquitous "Gordon Gekko" the fictional corporate raider played so brilliantly by Oscar winner Michael Douglas in Oliver Stone's "Wall Street" is still revered by some players on Wall Street. I am not kidding, I know a fellow that has memorized most of Gordon Gekko's speeches and can recite them without reference to a script. He would often strut around the office reciting this particular favorite Gordon Gekko speech –
“The point is, ladies and gentleman, that greed, for lack of a better word, is good. Greed is right, greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind. And greed, you mark my words, will not only save Teldar Paper, but that other malfunctioning corporation called the USA. Thank you very much.”
Who’s to Blame?
I will leave it to Michael Lewis, author of “Liars Poker” and a Bloomberg writer, and others to tell the story. Nobody says it as well as Michael does. Read on:
Cayne
The Decades
Wall street has always had drama and some very interesting characters! Each decade is defined by the people that dominated the news and created change with its attendent drama and debacles!
Big corporations: The 1970s was the era of big industrial and manufacturing corporations – Boeing, Campbell's, Ford, GM, 3M, Johnson & Johnson, Kellogs, McDonnell Douglas, Martin Marietta, Phillip Morris. Mary Cunningham and William (Bill) Agee, CEO of Bendix Corp. epitomized the 1970s era. Their personal drama dominated the news!
Mergers and Acquisitions: The mid to late 1980s was the era of mergers and acquisitions, corporate raiders and leveraged buyouts! Those were some heady times! Most MBA graduates wanted to work for JP Morgan's Mergers and Acquisition Division, and business students scrambled to campus events to listen to Ivan Boesky and T. Boone Pickens.
Junk Bonds: Drexel Burnham Lambert's investment banker Michael Milken, nicknamed the “Junk Bond King”, reigned supreme! It was a period of obscene excesses! Some of my fixed income investment management colleagues recalled the opulent balls that Drexel hosted for portfolio managers and analysts. I just barely missed the spectacles!
A Brief History of Capital Markets Debacles and Other Events Over the Last 20+ years and the Spectacular 2008 Meltdown of the Financial Services Industry!
Folks, after 20+ years in the financial markets, I have seen it all and experienced enough to give me a few grey hairs! For finance students and professionals, you may want to keep this for your records. Just click on the links, if you want to read more. I recall -
1) October 1987 -- "Black Monday" - we stood in stunned disbelief in front of a Bloomberg monitor in the Investments Division of the State Treasurer's Office, trying to assess the impact on investment securities held by the State of California of a 508 point drop (22.68%) on the stock market (DJIA). I was then a young Associate Auditor undertaking my first audit of the State of California's Treasurer's office. This was a real rude awakening to the realities of the capital markets. However, that did not stop me from seeking the thrill of the capital markets a few years later. Lehman analyst Elaine Gazarelli became a star for accurately predicting the stock market crash only to lose fans later for her Hanes “My Way” stockings ads.
2) 1989 – Charles Keating, former Chairman of Lincoln Savings & Loan Association, epitomized the greed of the Savings and Loan Bank crisis of the mid 1980s. A lot of elderly people lost their savings and the Fed increased regulation of the S&Ls, and formed the Resolution Trust Corporation (RTC) to purchase the assets of failed S&Ls. I had an opportunity to visit Lincoln Savings’ headquarters in Scottsdale , Arizona – an ornate Spanish-style mansion that is located on a golf course -- when I interviewed for a position with First Interstate Bank in 1995 before Wells Fargo took over First Interstate. As soon as the limo drove through the ornate wrought iron gate toward the mansion, I knew there was a story to tell. After the interview, I asked the Exec. VP the story about the ornate office, with expensive art, that we were sitting in – turned out it was Charles Keating’s former office! Wells Fargo purchased First Interstate Bank soon after the interview, and, subsequently, closed the infamous Lincoln Savings “Keating” Scottsdale office.
5) The real estate bubble of the early 1990s -- Donald Trump (“La Donald”) used his bravado to obtain more loans to shore up his empire. He survived and lived to tell about it and became the host of a popular TV show, “The Apprentice”!
6) The 1990s post Iraqi war recession, led to a spate of defaults - notable defaults include Triad Healthcare, a nonprofit health system located in California. The State of California which insured $167 million of revenue bonds issued by Triad sued Goldman Sachs, the underwriter of the municipal bonds, and won the lawsuit.
7) 1994 - collapse of Kidder Peabody: bond trader Joseph Jett's role in the treasury bonds scandal led to the collapse of investment banking firm, Kidder Peabody in 1994. There was an overwhelming feeling of shame among African-Americans on Wall Street. Joseph Jett was then among the highest ranking African-American's on Wall Street. I had never heard of him until the scandal but I remember the pain we all felt!
8) 1994 - up next, another devastating event in 1994 when Calvin Grigsby, founder of the then largest African-American owned investment bank in the US saw his firm, Grigsby Brandford & Co., collapse following an alleged scandal. To add more to the drama, Calvin was defended by the famous O. J. Simpson lawyer, the late Johnny Cochrane. Calvin’s unfortunate experience taught African-Americans on Wall Street that they need to be extremely cautious;
9) 1994 - Ginnie Mae interest-only (IO), principal-only (PO) debacle and the near collapse of some GNMA mutual funds that held the IO/PO securities when Fed Reserve started tightening and interest rates began to rise.
12) 1994 - good old Robert Citron whose trusted Hollywood sage failed to alert him to the rise in interest rates and the ensuing margin calls that created a liquidity crisis and led to the December 1994 Orange County bankruptcy filing. Orange County ran an investment pool that was highly leveraged. Orange County's Treasurer borrowed funds through reverse repurchase agreements (repos) and then invested the repos in US Agency structured notes that were inverse floaters. When interest rates started to rise, Orange County did not have sufficient liquidity to meet margin calls. Investors panicked and the State of California took over the investment pool to stabilize it and prevent further losses. Citron claimed he really did not understand the securities – the investment bankers and brokers were to blame! (I have to say this for the Hollywood sage – she predicted that if everyone would just keep calm things would get back to normal!) Other counties, including Cuyahoga County, OH, Contra Costa County, CA, and San Diego County, CA, also came close to filing for bankruptcy – their saving grace was that they had not opened their investment pools to the whole world and were able to negotiate with their municipal investors and prevented a run on the bank! The bond rating agencies are criticized for maintaining high ratings of the investment pools despite the risky assets held in the pool.
13) 1995 – Baring Bank collapses following rogue trader, Nick Leeson’s unauthorized bets on Nikkei futures contracts.
14) 1995 – longest running Bull market starts and Goldman Sachs equity investment analyst Abby Joseph Cohen became a star for her accurate predictions of stock market highs and was later ridiculed when she continued to predict stock market highs even as the market tumbled!
15) 1997 -- the Japanese bank loan problem and subsequent consolidation of Japanese banks. In addition to other structural reasons – turns out the Japanese had a pesky little problem with underworld types known as “yakuza” that would entice bank executives to visit their clubs for R&R. The "yakuza" would then use incriminating evidence to blackmail the executives to purchase club memberships, and also extend loans to them on favorable terms – not good for the banks! Most of the banks folded or were acquired by other banks in the 1990s leading to a consolidation of the Japanese banking system.
16) 1997 - the Asian financial and currency crisis was attributed to IMF policies that resulted in foreign exchange problems as the US dollar rose and many of the Asian Tigers were unable to pay debts owed in US dollars. The Asian financial crisis had a ripple effect on other markets worldwide;
17) 1998 - the Russian debt crisis! Apparently, a bit of Russian roulette and caviar goes a long way – just kidding! Structural imbalances in the Russian economy – high commodity risk exposure, foreign exchange rate regime, budget deficits and the prolonged Chechnya war were the primary cause of the crisis. Sale of Russian assets by investors put pressure on the ruble and exacerbated an already bad situation. Long-term Capital and Bankers Trust were some of the victims of the Russian debt crisis;
19) 2001 - deregulation of the California electric industry to separate power generation from transmission. Manipulation of the power industry by Enron and inadequate generation capacity to meet rising demand for power during the Dot com era led to the eventual bankruptcy filing of California's electric utilities - Southern California Edison and Pacific Gas and Electric.
20) 2001 -- auto manufacturers Ford and GM faced a spate of recalls and stiff competition from Japanese auto makers after decades of not responding quickly to producing more fuel efficient cars leading to deterioration in credit outlook and ratings of the US auto makers. Detroit is still reeling while the Japanese auto-makers who started to revamp their products after the Oil Crisis of 1972 and began implementing future car concepts in the 1980s continue to soar. The bond ratings of the US auto makers started a downward slide!
21) 2001 -- Enron's manipulation of the power market post deregulation and its eventual collapse;. The Enron scandal also engulfed accounting and consulting firm, Arthur Andersen, which folded. Global Crossing, HealthSouth, Tyco, WorldCom and other annoying accounting scandals all led to the enactment of the Sarbanes-Oxley Act (SOX) and increased regulation of and disclosure by corporations. SOX also increased the responsibility of corporate Board of Directors.
22) 2001 - the Dot com and telecommunications bubble should not have been a surprise. There have been new technology bubbles since the advent of tulips and the telephone – that is the capitalist system but no one paid any attention to history! Silicon Valley was the place to be -- Fry’s Electronics was the most happening place on Friday nights and one had to put up with Adobe geeks playing roller-derby hockey in our company parking lot when I worked for The Benham Group (now merged into American century Investors). The Dot com bubble burst and many start-up Dot coms were gone in a flash! At least the technology bubble created some great technology products, productivity enhancements, collectors’ refrigerator magnets, and brought Steve Jobs back to Apple, yeah! [Unfortunately, Steve Jobs passed away in 2011. May his soul rest in peace!]
23) 9-11-2001 – The world as we knew it changed forever as we all watched in stunned disbelief as the Twin Towers of the World Trade Center tumbled down following the terrorist attack. Several firms lost scores of employees. I never heard again from a Trustee Officer that was researching a New York Port Authority Bond that had been refunded – I don’t know if she survived or was buried in the rubble with thousands of others who perished in the tragedy. The Fed Reserve acted quickly to provide liquidity to prevent disruptions to the financial markets.
24) 2002 - Salomon Smith Barney telecom analyst, Jack Grubmann, became the “poster boy” for the greedy self-conflicted stock analyst who continued to tout stocks even as the market valuations of telecom stocks plummeted. The SEC and State of New York reached agreement to limit research analysts’ access to corporate management and increase transparency and availability of ratings and research information to investors. Wall Street firms paid fines totaling $1.4 billion to settle the case and agreed to undertake training and implement procedures to eliminate conflicts of interest.
25) 2003 – SEC charged Credit Suisse First Boston (CSFB) with fraudulent behavior in a global settlement with Wall Street firms. CSFB paid $200 million in fines for allowing its investment banking goals to undermine the integrity of its stock research. CSFB investment banker and executive, Frank Quattrone, faced criminal charges in New York due to an alleged attempt to impede a SEC investigation into his IPO activities in 2000.
26) 2004 – Elliot Spitzer, then the State of New York’s Attorney General, investigated AIG for accounting fraud and forced out its Chairman Maurice “Hank” Greenberg who he sued for conflict of interest regarding a Foundation. AIG settled the accounting case for $1.6 billion. Spitzer then sued Marsh and McLennan (Marsh), and other insurance firms for fraud and collusion. AIG and Marsh shares dropped as a result of the investigation and some employees lost most of their retirement assets. Spitzer was later investigated for his involvement with a call girl sex scandal and he resigned from office in disgrace.
27) 2004 - Fannie Mae chief, Franklin Raines – an African-American, retires early amid allegations of accounting errors, overstatement of earnings, and large bonuses. Fannie Mae paid a record fine of $400 million to settle the case. Raines got to keep part of his bonus but gave up a significant portion.
28) 2004 – Collateralized Debt Obligations (CDOs) or Mortgage-Backed Securities (“MBS”) created from securitization of mortgage loans and CDOs became a more important source of lending for mortgages while bank lending declined.
29) 2006 - Defaults on mortgage loans rose and the subprime implosion began. Subprime mortgage lenders began to collapse – a total of 283 mortgage lenders were then listed on the mortgage lenders implosion list.
30) 2007 - bond insurers MBIA, AMBAC, and FGIC disclosed large exposures to subprime loans raising questions about whether they are adequately capitalized and leading to downgrades of the bond insurer’s venerable AAA ratings. Again, the bond rating agencies are criticized for maintaining high ratings of the bond insurers even as their risk expose to credit derivatives increased.
31) 2007 – Concerns begin to mount about Fannie Mae and Freddie Mac’s exposure to subprime mortgage loans.
32) 2007 – UBS' CEO stepped down due to writedowns related to subprime and other debt.
33) 2007 Merrill Lynch, Citibank and Bear Stearns disclosed large writedowns related to subprime obligations leading to the ouster of their CEOS – Stan O’Neal, Charles Prince and Jim Cayne.
34) 2007 Bank of America acquired mortgage lender Countrywide which was close to failure.
35) 2008 - Wall Street firms paid record bonuses amidst writedowns from subprime losses.
36) 2008 - Societe General trader, Jerome Kerviel, caused losses estimated at 4.9 billion Euros due to unauthorized and fictitious trades.
37) 2008 – UBS reported the largest loss ever recorded by a bank following the ouster of its CEO.
38) 2008 - Bear Stearns nearly collapsed from writedowns arising from subprime losses and was purchased by JP Morgan;
42) 2008 - Washington Mutual’s CEO Kerry Killinger resigned following pressure from shareholders and a new CEO was appointed.
43) 2008 - the Federal government bailed out federal mortgage lenders - Fannie Mae and Freddie Mac
46) 2008 - Federal Reserve takes over AIG – the world’s largest insurer to prevent market disruption and protect assets. AIG is also the largest issuer of Guaranteed Insurance Contracts (GICs) for the municipal market. Questions abound about whether the Fed ought to use taxpayer funds to bailout companies like AIG. The implications of “too big to fail” may have been at play here. The move definitely helped to protect and prevent a run on Money Market Funds which are the first in line to feel the impact of failure of major financial institutions.
48) 2008 – Federal Reserve announced a plan to create a temporary guaranty program for the U.S. money market mutual fund industry to prevent a run on the bank and assure money market investors about the safety of their investments.
49)2008 - Which bank or financial institution will be the next to fail? I have a clue but I am not saying! [Actually, I was thinking of Washington Mutual which was acquired by JP Morgan Chase.]
50) Partial list of trading losses including some losses that I have not detailed above - compiled by Wikipedia
Will it happen again?
Recounting all these debacles makes it seem like people on Wall Street have very short memories. Believe me, they do -- and it will happen again. It seems like a three to four year cycle! The “performance is everything” and “winning at any cost” mentally is still very pervasive among some investment bankers, traders and advisors.
Even as we speak, some financial engineering guru is probably busy trying to figure out how to profit from the current debacle. Some advisors are also probably busy trying to get more commissions so they can buy the latest model Mercedes Benz for their wife or girlfriend at Christmas.
However, I don’t blame them entirely because the greed is on both sides. Some investors are just as greedy and want to reach for high yields so they can feel good that they outperformed the market. Such greedy investors are just ripe for the picking or taking!
“Reversion to Mean”
Historically, ultimately the US stock market’s return has always reverted to mean (average) but most investors believe they can still outperform the market! Good luck!
Regulation
There will definitely be more regulation of the capital markets. Fed Reserve Chairman Bernanke wants more integrated regulation but will it be sufficient? I doubt it, so let's hold our collective bated breath until the next capital markets debacle hits the fan!
Follow-up:
Congress has enacted the "Dodd–Frank Wall Street Reform and Consumer Protection Act"; however, some financial industry participants oppose it and the Republicans plan to repeal it. Second, we did not have to hold our collective bated breath for too long -- oops, they did it again! So will Wall Street ever learn? Just don't bet on it!
Disclaimer: this is intended for information purposes only and not intended to constitute investment advice! Please contact your own personal financial advisor for investment guidance.
Copyright 2008: Audrey Quaye
Read more or see:
Posts
