Cezary Salad

On April 27th, the US Senate, power of subpoena in hand, brought to its chambers executives from the world’s most powerful financial firm, Goldman Sachs, to testify on the cause of the biggest financial meltdown in decades – and their role in contributing to the disaster.

Eleven hours of testimony later, comedians had much more material for late night jokes and the Democrats had much more momentum for their financial reform bill.

But key questions about the financial crisis and Goldman’s activities remained unanswered, and solid financial reform is still far from certain.

It’s easy enough to see why. Take a look at the video from the hearing and you’ll hear Senators trying over and over again to get Goldman chief Lloyd Blankfein and other executives to admit that the firm had a conflict of interest vis-à-vis its clients. Reams of documents, hand-picked by the Senate’s Permanent Subcommittee on Investigations, were designed to show that the firm had shorted, or bet against, the US’ residential mortgage market, even though it was helping clients structure the opposite bet.

“You went short – big time,” Democrat Carl Levin of Michigan, the committee chairman, told Blankfein in his concluding remarks. “You don’t want to acknowledge it, I know. But that’s what your documents show.”

Now, why couldn’t Chairman Levin just get Blankfein to say as much? Or to just give up and say, “you’re right - we’re conflicted?” After all, the SEC had just accused the firm of committing fraud by not disclosing to one of its clients, German bank IKB, that Goldman had let another client influence the selection of a portfolio of mortgage-backed securities that IKB had bet on. IKB suffered heavy losses when the so-called “Abacus” portfolio went bad, while the other client, hedge fund Paulson & Co., got $1 billion off its short position and paid Goldman a $15 million fee in exchange for structuring the deal.

I think the reason Goldman was so coy – and why the committee wasted its time trying to corner the firm into admitting conflicts – boils down to something simple I heard a hedge fund manager say on the same night of the Goldman testimony.

I was at an event in New York (“Forgotten Lessons of Finance 101” put together by Ed Grebeck, a structured finance lecturer at the NYU School of Continuing and Professional Studies) where James Chanos, the short hedge fund manager famous for spotting the Enron collapse in 2001, was sharing his views.

I asked him what he thought about the SEC’s lawsuit against Goldman; he declined to comment on Goldman or the lawsuit, but he did make one remark that really put the hearing in perspective:

“I think Wall Street generally has a real, inherent problem . . . with conflicts of interest,” he said.

He pointed to equity underwriting as an example. “At its basic heart, in equity underwriting, is a conflict of interest because on the one hand you’re telling your corporate client, ‘this is a good time to raise equity money, it’s cheap, the ducks are quacking, feed them’ . . . on the other hand, you’re then telling your investment clients that this is a good deal.”

That doesn’t mean it’s all hopeless: “we build upon that and we have Chinese walls and we deal with it,” Chanos said. But it doesn’t take away from the basic fact that big investment banks of any stripe face very serious and real conflicts of interest that they have to work real hard to mitigate.

Which is why Goldman wasn’t going to go before the Senate and say anything that would indicate that it’s different from the rest of the pack by being conflicted with its clients. Democratic Senator Claire McCaskill of Missouri at least acknowledged that it wasn’t fair to single out the firm. But she still proceeded to ask the same leading questions aimed at cornering the firm’s executives into admitting conflicts of interest as all the other Senators.

Instead, here are three hard-hitting questions the Senators could have asked which, rather than trying to expose conflicts which are endemic to investment banking, could have given us a much better understanding of how to regulate the industry (fair disclosure - I used to work in investment banking and once interviewed with Goldman for a position):

1) Goldman said in response to the SEC lawsuit that it actually lost money on the Abacus deal with Paulson and IKB. Sure – they got $15 million, but lost $90 million on the transaction overall.

But how much money did the firm really make on the transaction?

Investment banks are very crafty when it comes to fees. Various divisions of an investment bank will work on one deal together and book fees from their individual contributions, though the bank may not (and often does not) disclose all the fees. Why? Because investment banks don’t have to. And if they did, telling their clients that they actually made many multiples more money than they said they did wouldn’t exactly make them look good.

Now, flip through the sales document for the Abacus deal (available here) and you’ll note on page 50 that different parts of Goldman provided interest rate hedges and collateral services for the transaction – fees that may not be included in the $15 million Goldman earned from Paulson.

So one thing the Senate could do to make the industry more transparent would be to require more transparency on fee disclosure and income reporting from all divisions working on a particular deal. Once investors see where the money is, they can make better choices about who to invest with and how to align interests.

2) Goldman’s lawyers said that ACA Capital, the third party it had contracted to select the securities in the deal, ended up not picking many of the mortgage securities Paulson suggested for inclusion in the Abacus pool. Paulson suggested 123 mortgage-backed securities but “ACA rejected more than half of the securities, and sent Goldman Sachs a revised spreadsheet listing 86 securities, including 55 from the list of 123,” the lawyers wrote in a letter to the SEC last year.

So don’t you think that the Abacus portfolio was doomed fail from the beginning?

The reason this is important is because Paulson wanted to take a short position on the deal. So obviously, the more of these securities they packed into the Abacus transaction vehicle, the better. But the structure of deals like Abacus – called synthetic collateralized debt obligations – is such that it doesn’t take many homeowners to stop paying before the equity in the transaction becomes worthless. Those 55 securities were most likely more than enough to poison the whole transaction for IKB from the outset. So Paulson’s influence on the deal may not be as small as Goldman claims it is.

The larger point:  investment banks who participate in these types of transactions can simply hide behind the fact that they are dealing with “big boys” – large, sophisticated institutional investors who know what they’re doing. But as the Abacus deal clearly shows, investors like IKB aren’t as sophisticated as they’re made out to be. Perhaps there’s a need to revisit this defense and require more disclosure where needed.

3) Goldman’s co-general counsel, Greg Palm, said on a conference call with reporters after the SEC filed its lawsuit that if Goldman “had evidence that someone here was trying to mislead someone, that’s not something we’d condone at all and we’d be the first to take action.”

But did Goldman notice the activities of the investment banker in question, Fabrice Tourre, and simply not think they were misleading or did it not notice his activities at all?

The latter option doesn’t seem like a big possibility since there are two ways to get noticed by your superiors in the world of investment banking: make a lot of money, or make very little money. If you make very little money, you’ll likely get fired. But if you make a lot of money, clearly, there is an incentive to keep you on and let you keep doing what you’re doing.

And Tourre was doing well. Anyone who brings in a $15 million fee on a single deal at the age of 27 is going to get noticed, whether it’s at Goldman or any other investment bank. And superiors will have an inherent incentive to overlook questionable dealings if overall they come out ahead on the deal. With each deal, you stretch a little more and take another step into whatever activity is minting the gold, until – like Lehman Brothers or Bear Stearns – you end up going under and are mired in lawsuits for ethical breaches.

Luckily, Goldman was able to escape that fate and is now going to re-examine its business practices. But that’s as clear an indication as any that there is a need for more accountability in investment banking from the top down and better supervision of twenty-somethings inking complex, billion-dollar deals.

With that in mind, none of the panelists at the “Finance 101” event were happy with the structure of the current financial industry reform package being championed by Democratic Connecticut Senator Chris Dodd.

“It doesn’t go far enough,” Chanos said, referring to the Dodd bill.

With hearings like these, I don’t wonder why.

Way down in New York’s financial district, tucked away inconspicuously on the southern end of Wall Street, there’s a little gem of a museum - the Museum of American Finance - filled with all kinds of goodies from 200+ years of booms and busts on, well, Wall Street.

With $8 admisson and a new exhibit about the credit crisis that just opened up this week, it is well worth a Saturday afternoon visit - followed up with a beer at Ulysses down the street.  

The museum’s been around since 1987 but it is only in the last two years that it’s held its current spot on Wall Street - an old Bank of New York branch converted into a giant exhibition hall.

Below are some of my highlights - enjoy.

Obscure monies

My favorite exhibit was the museum’s collection of obscure coins and notes spanning the pre-colonial era to the latest money coming out of the US mint.

We used to have a lot of higher-denomination notes in circulation but Nixon apparently axed them in 1969 in an effort to fight organized crime. McKinley graces the $500 bill and Grover Cleveland landed himself a sweet spot on the $1,000 bill.

You can still use them as legal tender but if you come across one, might as well sell to a collector: they sell for multiples of their face value these days.

I had no idea that these people sat on dollar bills:

$5,000 bill - James Madison

$10,000 bill - Salmon Chase (the banker who puts the “Chase” in JPMorgan Chase)

$100,000 bill - Woodrow Wilson (the president who created the Federal Reserve)

The Wilson note was only used in circulation among Federal Reserve Banks. It makes you wonder, though: if we’re so into putting obscure presidents on our higher-denomination bills, why isn’t there a Millard Fillmore note? It’s about time he got a seat on US currency.

The museum also has a fascinating selection of Depression-era currencies created by localities suffering cash shortages. My favorite was the hand-writtten 50 cent scrip (upper left hand corner in picture above) from Albany County, Wyoming.

Stock and bond certificates

They also have on display some famous stock and bond certificates that have been issued in the US, going back to an IOU signed by George Washington. My favorite, though, was this stock certificate for the Erie Railway, company:

The Erie was the focus of the legendary showdown between industrial tycoons Cornelius Vanderbilt and Jay Gould. Gould spurned Vanderbilt’s takeover of the Erie by issuing watered-down stock that was worth more than the value of the company - which, apparently, was legal back in those days.

This one’s signed by “the Devil of Wall Street” himself:

Also on display: some pretty interesting municipal bonds, like this one issued by New York for bridge repairs:

How Wall Street got its start

One of the coolest things I learned was how Wall Street - specifically, the New York Stock Exchange (below) got its start.

Apparently, back in the early days of the Republic brokers used to trade stocks in the open on Wall Street and would gather under specific lamp posts along the street to deal in specific securities. People would stand on roofs to make announcements and give signals, so it must have been a pretty hectic scene.

In 1792, a group of 28 brokers got tired of this system and organized a brokerage club that served as the beginning of what is today the NYSE.

Old equipment

The museum also has a lot of technological relics from the old days of Wall Street, including an early form of a calculator that belonged to the comptroller of Lehman Brothers - now itself a Wall Street relic. Below are some of my favorites:

A 1981 Quotron - one of the first computer systems used for trading stocks:

And, of course, the first stock tickers. They were invented in 1867 - this one vintage 1875:

Together, the stock ticker and the telegraph revolutionized the speed at which stocks could be traded. The two inventions put the New York Stock Exchange - and with it, American Capitalism - on growth steroids for decades.

Vintage newspapers

As a journalist, I was particularly drawn to the collection of famous editions of newspapers from panics and crises over the ages. To be fair, American printing presses have probably created their own collection of these future museum pieces just within the last 18 months, but it is interesting to look back to see how thoe events were covered.

An edition of the Daily News from 25 October, 1929 read: “Billions lost in Wall St. Debacle”. Much more interesting than the headline, though, is the advice given by the paper’s “Trader” columnist.

Four days before Black Tuesday - when the Dow Jones Industrial Average dropped 12% and officially heralded the beginning of the Great Depression-  his advice read as follows (emphasis added):

If half the suicides which were reported to “TRADER” yesterday had proved true, Wall Street would be a deserted village this morning.

Happily, however, they all turned out to be baseless rumors, although it was amazing how many stories were in circulation as to operators who jumped out of windows at 120 Broadway. The Equitable building certainly got a lot of free advertising, although it wasn’t the kind usually welcomed.

The market today is in the position of a convalescent who has just successfully passed a crisis in an illness which bid fair to be fatal.

Improvement is indicated, with the practical certainty of eventual recovery, but there will be relapses.

“TRADER” therefore advises against speculative purchases, although he expects prices will be materially higher today. If you have money to buy stocks outright, go in and do so, because current prices are bargains which probably will never be sustainable again as long as the United States continues its present prosperity.

Some parallels are clearly visible to today - especially in light of the recent debate sparked by Jon Stewart’s spoof of stock picker Jim Cramer and CNBC coverage of the credit crisis. People routinely call the bottom prematurely, so the only way to know for sure that stocks have hit a bottom is to read about it in a history book - not by reading “Trader” or watching Fast Money on CNBC. However, the sin isn’t calling a bottom too early or voicing an opinion. Stewart had a bone to pick with CNBC - as I’m sure the Stewarts of his day did with “Trader” - because there was so little humility in the way the opinion was being voiced and advertised. At the end of the day, “buy stocks” four days before Black Tuesday and “buy Bear Stearns” a couple of weeks before it collapses are calls that should be heeded as  just another piece of food for thought in deciding where the market might go; slogans like “In Cramer we Trust”, as if he were the god of stock-picking, go against that very important caveat.

It is also useful to point out that Stewart’s criticism of Cramer pales in comparison with what John Kenneth Galbraith had to say about “Trader” in his account of the 1929 crash:

. . . by 1929, numerous journalists were sternly resisting the more subtle blandishments and flattery to which they have been thought susceptible. Instead they were demanding cold cash for news favorable to the market. A financial columnist of the Daily News, who signed himself “The Trader,” received some $19,000 in 1929 and early 1930 from a free-lance operator named John J. Levenson. “The Trader” repeatedly spoke well of stocks in which Mr. Levenson was interested. 

Some progress was made, though. Fast-forward 58 years, and press coverage of the next big stock market debacle was much different:

 

Another noteworthy decaying newspaper was a copy of the very first edition of the Wall Street Journal: July 8, 1989: 

It is amazing how similar it looked in design until the recent face lift post-Newscorp acquisition.

The Journal’s first lead-left article? A laundry list of price movements: 

The second article from the top - ”The Market To-Day” - references a “bear party” that depressed American stocks. One of the videos at the museum explains that the terms “bull market” and “bear market”, used to describe down markets and up markets, respectively, originated from the way those two animals attack. A bear will claw down its prey, whereas a bull will strike up at its prey.

Strange but true or true but strange?

Credit Crisis

On March 25 the Museum of American Finance unveiled a new exhibit on the financial crisis: a giant timeline that organizes all the key events of the last two years into regulatory, financial, foreign policy and other buckets. It is accompanied by a brief video that sheds some analysis on the crisis’s causes and effects. 

It does a good job of objectively laying out what happened when and organizing it in a logical manner. But it doesn’t yet gel together the events into a cohesive narrative that lets you walk away with clear take-aways on what exactly is going on. I don’t think it is the museum’s fault though: perhaps it is just too early yet for us to completely understand all the dimensions of this crisis and how it will play out.

They should, however, update this exhibit - a chart of the DJIA over the years that has not yet taken the huge dive indicated on the crisis exhibit: 

This one could also use an update: a Bank of America family tree, conspicuously missing Merrill Lynch:

Other exhibits still reference Lehman Brothers as a bond trading powerhouse, etc. I’m sure these will all get corrected over time - after all, these days, if they were to wipe out defunct Wall Street names from their exhibits they might not have time for anything else.

These nips and tucks aside, if you’re ever free on a Saturday afternoon and looking for a good time, I nerdily suggest the MoAF. 

 

“. . . I’d build Bear Stearns.”

If there was anything that I remembered from the brief recruiting video that I watched at a Bear Stearns recruiting session as an undergrad at Penn, it was this line. It was uttered by then-CEO Jimmy Cayne as the screen glistened with an overhead view of the octogonal 383 Madison headquarters shot from a helicopter in the Manhattan sunset.

As I sat there watching that video, I scrambled to take notes on anything anyone said. Jimmy likes bridge. Ace Greenberg is legendary. If you join Bear, you will “drink water from a water hose” and “you will be baptized by fire.”

“So if you’re an outdoors type and you like to brave the elements, this might be just the place for you,” I thought.

Two years later, Bear’s collapse and fire sale to JPMorgan for $2 per share – now quintupled to $10 per share – made me think back to the hubris on display at that recruiting session, but not with a sense of schadenfreude but rather with a sense sympathy for Bear’s recruits. Being told you’re joining the “perfect firm” only to have it collapse a few months after joining and be sold for a pittance to a competitor is not exactly the ideal way to start your career.

So what went wrong? Bear’s downfall was precipitated by bad luck but compounded significantly by mismanagement of risk and perception.

The bad luck part seems to have been a good old fashioned bank run that ensued after market rumors started to spread two weeks ago that Bear was having liquidity problems. Then, in the scope of just two days, nervous clients withdrew $17 billion of their money, effectively forcing it to find a well-capitalized buyer or face bankruptcy. Ironically, at the end of its 2007 fiscal year, Bear had actually had a quick ratio that was better than that of its peers: .78x versus an average of .66x for Morgan Stanley, JPMorgan, Goldman Sachs, Lehman Brothers, Citigroup and Merrill Lynch, which I calculated from their respective 2007 10K filings. This only reinforces the point that Bear was – as are all investment banks – trust-based businesses: to lose your counterparties’ trust is to lose your shirt. No bank is immune from such a fate.

Yet while it’s true that this could happen to any bank, Bear sure didn’t help itself by aggressively leveraging its mortgage-backed securities as high as 30-1, making their falling out of favor with investors all the more painful once the CDO market turned sour. Bear did eventually dial-down its CDO exposure after its $1.2 billion write-down in the fourth quarter of 2007. But with the yield curve steadily steepening throughout last year, did they not see the need to reduce their risk exposure earlier, before ARMs reset and foreclosures went up?

Compound this lack of foresight with the management’s inability to manage investor expectations. Despite Bear CFO Sam Molinaro’s insistence that Jimmy Cayne was always readily reachable during critical moments, it doesn’t shore up investor confidence – nor that of your counterparties – to know that the CEO can be counted to be at a bridge tournament when he is needed most. When the news broke on March 14 that Bear will seek emergency funding from the Fed, I jokingly thought, “boy, I hope Jimmy Cayne isn’t out at a bridge tournament.” Wishful thinking; he was out in Detroit at the North American Bridge Championship with former Bear bond chief and fellow bridge aficionado Warren Spector. Talk about fiddling while Rome burns.

Contrast that with how Lehman’s leadership reacted when rumors spread that Lehman Brothers might be the next bank to suffer Bear’s fate. Lehman’s stock tumbled 31% from $45.99 to a low of $31.75 but soon rebounded after CFO Erin Callan pulled all the stops during an excruciatingly detailed earnings call to reassure the market that Lehman was and would remain solvent. CEO Dick Fuld cut short his trip to India and came back to deal with the crisis.

It is still too early to tell who the survivors will be once the credit markets calm down and things return to normal. But two things are certain. First, Bear was certainly not perfect, but it didn’t have to end this way for shareholders and employees. A little less bridge and more risk and perception management would have gone a long way. And second, when this all comes to pass and things return to normal, it will be an all-together different kind of normal – so different that it begs the question: will we even recognize it when it comes?