Inside the New World of Finance and Business
By David Snider, Chris Howard
Palgrave Macmillan Copyright © 2010 David Snider and Chris Howard
All rights reserved.
THE BILLION-DOLLAR BROKERS AND TRADERS OF INVESTMENT BANKING
Banking has created more success stories and millionaires than probably any other profession.
—A former Lehman Brothers banker
A HISTORY AND DESCRIPTION OF INVESTMENT BANKING
On Saturday, March 15, 2008, a team of investment bankers from J. P. Morgan was analyzing the financial documents of a business that the bank was considering purchasing. It was not uncommon for the bankers to be working on a weekend. The demands of advising on mergers and acquisitions often involved long days and weeks that lacked the punctuation of relaxing weekends. The diligence had begun late Thursday night, when CEO Jamie Dimon called the heads of J. P. Morgan's investment-banking division about the deal. Immediately afterward, executives and analysts began receiving urgent calls and BlackBerry messages. They quickly hailed cabs or called town cars and returned to work. Steve Black, J. P. Morgan's co-head of investment banking, arranged for a chartered plane to fly him to New York from the Caribbean island of Anguilla. By 11 P.M., a team was assembled.
As with many such deals, there were other potential buyers examining the same documents in order to determine whether they would make bids and, if so, for what amounts. In this case, the other serious potential buyers were two private equity firms: Kohlberg, Kravis, Roberts & Co. and J. C. Flowers. There was a great deal of bustle in the executive suite at the target company's offices at 383 Madison Avenue. The J. P. Morgan bankers were trying to determine the true value of the target company's $400 billion in assets and operating businesses as well as the risks posed by the financial products held on its balance sheet. There was palpable anxiety among both analysts and senior bankers as they tried to understand the business and its current financial state. The analysts were creating Excel models to value elements of the business based on current market prices and to evaluate what would happen if the market eroded further. Senior bankers were using their knowledge to inform the assumptions underlying the financial models.
Like most deals on which the bankers worked, absolute confidentiality was required, as leaked news of a deal could move stock markets or pose issues of insider trading (a type of securities fraud that occurs when someone buys or sells a stock with company information not available to the public). However, this deal was, in many ways, unlike anything the bankers had ever seen and required extreme secrecy. The potential acquisition target was one of J. P. Morgan's competitors, Bear Stearns. The imminent timing was not a result of the normal pressures of a competitive process but of a fear that, without a buyer, Bear Stearns might be forced into bankruptcy, which could incite a global financial panic. It was not only the CEOs of Bear Stearns and J. P. Morgan, Alan Schwartz and Jamie Dimon, who were closely following the deal, but also U. S. Treasury Secretary Hank Paulson, Federal Reserve Chairman Ben Bernanke, and the president of the New York Federal Reserve Bank, Tim Geithner.
On March 16, J. P. Morgan rejected the potential acquisition, seeing it as too risky because of the potential losses from some of Bear Stearns's investments—notably its mortgage-related holdings. Yet strong encouragement from the Treasury Secretary and the Federal Reserve's guarantee to finance and assume roughly $30 billion of Bear Stearns's mortgage assets led to the unprecedented acquisition. Many in the industry believed that the deal represented the avoidance of a major financial crisis. In fact, it was just the beginning of one.
IN 2008, the investment-banking industry lost hundreds of billions of dollars, saw many of its institutions disappear, laid off thousands of employees, and—in its own demise—precipitated a global recession. How could one industry nearly cause a worldwide depression? Why did the U. S. government believe that stabilizing U. S. banks merited allocating $700 billion to the industry? The answers to these questions are found in this chapter.
THE HISTORY OF INVESTMENT BANKING
The U. S. investment-banking industry dates from before the Civil War, when Jay Cooke sold shares of government bonds to individual investors through a network of salesmen. In the late 1800s, J. P. Morgan and other investment houses played a large role in the industrial mergers and restructurings of the railroad and steel industries. The prosperity of the 1920s led to a massive expansion of investing and financial services, and average Americans began to invest (or speculate) in the stock market. Although the period culminated with a run on the banks, a stock-market crash, and the Great Depression, in the following decades the investment banks that survived expanded along with American business. As companies grew larger, so did their initial public offerings (IPOs), debt issuances, and other financial needs. With those increased capital demands came greater profits for the investment banks.
Banking firms continually sought to take advantage of new markets and changes in regulations, such as a 1981 law that, for the first time, permitted savings and loan (S&L) banks to sell the loans they issued to other financial institutions. This legislation laid the groundwork for much of the housing mess that boiled over twenty-six years later. Prior to 1981, S&L banks carefully evaluated potential borrowers, knowing that they were on the hook if those borrowers defaulted on their loans. The change in the law allowed the banks to sell the loans (and the interest those loans generated). Although not an intention of the regulatory change, S&L banks suddenly had less incentive to conduct thorough diligence on loan applicants, because they did not carry all the risks if the borrowers defaulted. Investment banks could now convert the loans they purchased into mortgage-backed securities and sell them to other investors.
Another financial innovation in the 1980s was the high-yield bond. High-yield bonds were an important development because they allowed companies that were perceived by investors as being somewhat financially risky to have access to debt capital from public markets. The pioneer of the debt instrument was Michael Milken, who built the business for the investment bank Drexel Burnham Lambert. Prior to Milken, Drexel Burnham was a mid-size bank. By "creating," developing, and virtually monopolizing the high-yield debt market, Milken elevated Drexel Burnham to a central role in finance and disrupted the informal rules and hierarchy that had characterized the investment-banking industry for decades. He and the firm left a lasting legacy on Wall Street: pioneering new financial products is critical to rising to the top of investment banking.
In 1990, however, Drexel Burnham was forced into bankruptcy because of losses and criminal charges related to its high-yield practice. Milken pled guilty to securities violations stemming from charges of insider trading and stock price manipulation, and served time in jail. Though particularly high profile, the incident was certainly not the only scandal in the investment banking industry during the last couple decades.
In 1991, Salomon Brothers was tarnished by charges that the head of the government bond-trading department made illegal bids for U. S. Treasury securities, an incident that led to the ouster of the firm's CEO and other members of the senior management. Warren Buffett, who was one of Salomon Brother's largest shareholders at the time, stepped in and ran the company for a few months to ensure that the firm survived the market's brief loss of trust. In 1994, Joseph Jett of Kidder Peabody allegedly manufactured over $300 million in fictitious profits to hide actual investment losses and garner huge bonuses for himself. Nevertheless, in spite of such bumps along the way, the investment-banking industry grew in size and profitability throughout the twentieth century.
In 2001, however, banks began to face a number of difficulties. Most noticeably, the United States was entering a recession on the heels of the tech bubble. Not only was the economy headed downward, but the large pool of IPOs that banks had facilitated for new technology companies dried up. Additionally, Internet technologies made it easier and less expensive to trade securities, which put downward pressure on the transaction fees that banks received from brokering such trades. One of the few bright spots was the low cost of borrowing money. The U. S. Federal Funds rate, which largely determines the cost of borrowing for banks, was set at historically low levels. Banks seized the opportunity and began to borrow more heavily from other banks in order to increase their leverages and, in turn, their profitability. By expanding the amount of money they could trade and lend, banks could boost their profits, as long as the additional uses of money yielded higher returns than the costs of the loans. Many also increased their lending to private equity firms, commercial real estate developers, and hedge funds—all leveraged investors. Furthermore, new banking regulations, under the international Basel II agreement, allowed banks to use more leverage than they previously could. The Basel II rules were reliant on credit ratings, which proved inaccurate mechanisms for valuing the risks of many assets.
Although stocks and bonds decreased in value during the 2001 recession, home prices continued their long upward trajectory. Investment banks saw the U. S. housing market as an area with significant profit potential, given that increasing home values led to a very low default rate on mortgages. The banks increased the amount of resources that were focused on residential real estate, buying up mortgages and expanding the use of financial instruments, such as mortgage-backed securities, which could be bought and sold easily. Aggressive lending, home building, and speculative-investor home buying drove up real estate prices and created millions of new mortgages for banks to purchase and securitize. Banks valued these assets and the risks they posed with complex models based on historical fluctuations in home prices and mortgage default rates. They began to believe—and to act—as if home prices could only go up.
However, in 2006, the U. S. housing market began to experience turbulence. Lenders who issued mortgages to highly risky borrowers (those with bad credit histories) experienced defaults. They began to cut back on risky lending and to increase mortgage rates for existing borrowers. Higher rates meant more defaults, and tighter lending policies decreased demand for new homes. Housing prices started to decline at rapid rates, and property owners who had adjustable-rate mortgages they couldn't afford (often subprime borrowers), as well as real estate speculators, started to default on loans.
The declines in home prices and the increasing default rates were far greater than the financial models had indicated was possible, and the banks found themselves holding trillions of dollars in securities related to the housing market, with prices dropping. Soon after, banks began seeing the values of their investments in commercial real estate decline as well.
Banks' advisory business divisions, which facilitate corporate mergers and acquisitions (companies buying other companies) as well as other capital market transactions (for example, IPOs and debt issuances) also experienced declines. Furthermore, the banks' exposure to private equity transactions created additional pressure on the stability of some institutions. Between 2004 and 2007, private equity firms constituted a large and increasing share of financial deals. Because of the amount of debt that had to be raised for the financing of these transactions, private equity deals were generally more profitable than corporate mergers. However, as a result of the debt used by private equity firms to purchase companies, banks were often left with billions in loans (if the banks did not sell all the debt associated with the deals). As the economy soured in late 2007, the market's expectation of the likelihood of a default on that debt increased, and the market price of the loans fell to only a fraction of their initial value. The banks had to write down the value of the loans, which decreased the strength of their balance sheets.
In autumn 2007, due to housing market financial products and other debt related holdings, investment banks began to take multibillion-dollar write-offs, acknowledging that the assets they held had declined in value. Unfortunately, the write-offs did not solve the banks' problems. Many had used borrowed money to purchase investments; the amount of borrowing (as much as thirty dollars for every one dollar of equity) used to boost gains, ended up magnifying losses. Declines in asset values of only 4 percent wiped out many banks' equity in some investments, exposing them to large potential losses. With little demand for the banks' debt investments, the values of the assets continued to decline, creating further strain on the banks' financial stability. With no buyers, banks could not get liquidity (cash)from their investments. That downward spiral led to concerns that perhaps banks did not have adequate capital to maintain operations.
In March 2008, a rumor began to circulate on Wall Street that Bear Stearns, the smallest of the major investment banks, might be in an unstable position because of its large exposure to the mortgage market. The previous summer, two of its internal hedge funds had been devastated by losses stemming from mortgage-related investments. The hedge funds had purchased mortgage-backed securities and applied huge amounts of leverage; when the investments went down, the funds were nearly wiped out. In March the firm still had $18 billion in cash, an adequate amount to function (although less than one-twentieth of the total amount of the bank's assets). However, Wall Street banks depend on more than cash to function; they rely on the confidence of other Wall Street firms and their customers. Suddenly Bear Stearns lost the confidence of both groups. Investors began to withdraw funds, thereby depleting Bear Stearns's cash supply. Wall Street firms—which Bear Stearns needed to borrow money from and clear trades with—pulled back in order to limit their exposure. In an attempt to stabilize the worsening situation the Federal Reserve and J. P. Morgan provided Bear Stearns with secured lending, but singling it out for assistance unintentionally further eroded confidence in the institution. The firm was left with few options, and the federal government eventually had to step in and broker a merger with J. P. Morgan. The government determined that, given all the interrelated deals and lending between Bear Stearns and other investment banks, Bear's collapse into bankruptcy could pose a systemic risk to the entire U. S. banking system.
Nevertheless, in September 2008, when Lehman Brothers faced similar liquidity issues and a loss of investor confidence, the federal government declined to provide financial backing for a merger deal. Barclays, the British investment bank, was prepared to buy Lehman for $5 billion plus the assumption of $75 billion of debt, but it needed approval from its shareholders before completing the transaction. The U. S. government refused to support Lehman Brothers financially for the three months required for Barclays to close on the transaction, fearing that things would get worse and that, consequently, Barclays would walk away from the deal. Faced with no access to capital and no banks willing to purchase it without guarantees from the U. S. government, Lehman filed for bankruptcy.
Lehman Brothers, the counterparty on thousands of transactions with other banks, was larger and more interconnected than Bear Stearns. Key financial players felt that, if an institution that big could fail, others could too. Investment banks stopped lending, and even the largest and most stable companies could not get short-term loans. Adding to the sense of market chaos was the potential failure of AIG—then the world's largest insurance company—and a forced government takeover of the mortgage-lending institutions Fannie Mae and Freddie Mac. To avoid a full-scale financial meltdown, the secretary of the Treasury and the chairman of the Federal Reserve asked the U. S. Congress for $700 billion to buy the troubled assets that were weighing down the investment banks and inhibiting the ability of the credit markets to function. In the end, the Treasury Department decided to use the money allocated by Congress for the Troubled Asset Relief Program (TARP), in order to make capital injections into the banks. Some banks did not require capital injections to stay solvent. However, Treasury Secretary Paulson felt that it was important for all nine of the major banks to accept the funds to avoid those who voluntarily took government money from being stigmatized. "We did not need the TARP money," notes J. P. Morgan CEO Jamie Dimon. The government "asked the nine banks to take it. Some of those firms may have needed it to survive. Some probably needed it for comfort. We were in neither of those camps, but I think there was a coherent argument that these nine banks take it, in order to help stabilize the system and help those other banks to take it. We didn't think that J. P. Morgan should be partisan or parochial and stand in the way of doing something that was good for the country and, in fact, for the financial system of the world."
To be proactive and avoid further issues, Merrill Lynch sold itself to Bank of America. On September 22, 2008, seven days after Lehman declared bankruptcy, Goldman Sachs and Morgan Stanley became bank holding companies. This change allowed them to raise money by collecting deposits in the same way as traditional banks and to access funding from the U. S. government. Although some institutions were forced to liquidate or sell, a catastrophic collapse of the banking business and the world economy was avoided. (Continues...)
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