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By Joe Nocera
16 September 2008
How can this be happening?
How can it even be possible that we wake up on a Monday morning to discover that Lehman Brothers, a firm founded in 1850, a firm that has survived the Great Depression and every market trauma before and since, is suddenly bankrupt? That Merrill Lynch, the “Thundering Herd,” is sold to Bank of America the same weekend?
Just months ago, Lehman assured investors that it had enough liquidity to weather the crisis, while Merrill raised some $15 billion over the last year to shore up its balance sheet. Now they’re both as good as gone.
Last week, it was Fannie Mae and Freddie Mac that needed a government bailout. This week, it looks as though American International Group and Washington Mutual will be on the hot seat. We have actually reached the point where there are now only two independent American investment banks left: Goldman Sachs and Morgan Stanley. It boggles the mind.
But it really shouldn’t. Because after you get past the mind-numbing complexity of the derivatives that are at the heart of the current crisis, what’s going on is something we are all familiar with: denial.
Indeed, it is not all that different from what is going on in neighbourhoods all over the United States. Just as homeowners took out big loans and stretched themselves on the assumption that their chief asset - their home - could only go up, so did Wall Street firms borrow tens of billions of dollars to make subprime mortgage bets on the assumption that they were a sure thing.
But housing prices did drop eventually. And when people tried to sell their homes in this newly depressed market, many of them had a hard time admitting that their home wasn’t worth what they had thought it was. Their judgment has been naturally clouded by their love for their house, how much money they put into it and how much more it was worth a year ago. And even when they did drop their selling price, it never quite matched the reality of the marketplace. They’ve been in denial.
That is exactly what is happening on Wall Street. Ever since the crisis took hold last summer, most of the big firms have been a day late and dollar short in admitting that their once triple-A rated mortgage-backed securities just weren’t worth very much. And, one by one, it is killing them.
Take Richard Fuld, the chief executive of Lehman Brothers. Last summer, as the credit crisis first gripped Wall Street, Fuld’s firm, which was fundamentally a bond-trading firm, concluded that the problems would be short-lived - and that those firms willing to take big risks would be the ones that would reap the big rewards once things calmed down. So Lehman doubled down on mortgage-backed derivatives - not unlike a Florida condo owner buying a second one to flip 18 months ago.
Big mistake. Ever since then, Lehman has had a terrible time admitting the magnitude of its mistake - or properly pricing its securities. As mortgage derivatives became increasingly toxic, they also became increasingly illiquid. So firms were left to set their own “mark-to-market” price. And just like so many homeowners, they kept pricing their securities higher than they should have.
Earlier this year, for instance, when a hedge fund manager, David Einhorn, was making his public case against Lehman (he now refuses to talk about the firm), he stressed his belief that Lehman was valuing its securities too high. He turned out to be exactly right.
Every time the market was roiled - especially after the Bear Stearns collapse - every firm on Wall Street had to re-mark their securities to reflect the new reality. That’s why you saw firms taking billion-dollar write-off after billion-dollar write-off, long after they thought they had taken care of the problem. And it is also why the write-offs will continue now that Lehman is bankrupt.
“Selling begets more selling,” said Sean Egan of the independent bond-rating firm Egan-Jones. And yet, even as they lowered the value of their mortgage-backed securities, firms like Lehman had still priced them too high. Back when he was talking publicly about Lehman, Einhorn used to cast Lehman’s mark-to-market pricing as an act of dishonesty. I tend to think it was more like wishful thinking. Either way, the result was the same.
A week ago, even as the U.S. government was bailing out Fannie and Freddie, Fuld went off to seek new capital - something Lehman desperately needed to shore up its decimated balance sheet - from the Korea Development Bank. Why did those talks break down? Because Fuld wanted more for Lehman than the Koreans thought it was worth. He simply couldn’t face the reality that his firm wasn’t worth what he thought it was.
Now look at his next-door neighbour, John Thain at Merrill Lynch. To be sure, Thain owned a better house - although Merrill Lynch also had billions in toxic securities, its bread-and-butter is its brokerage arm. It is fundamentally a gatherer of assets, not a bond-trader.
But there is another big difference between the firms. Unlike Fuld, who had run Lehman since 1993 and is the architect of the modern Lehman, Thain had been at Merrill Lynch just since December, when he was brought in to stanch the bleeding. He didn’t have the same pride of ownership in Merrill that Fuld had in Lehman. That is why he was willing to sell $31 billion worth of mortgage-backed derivatives for 22 cents on the dollar in late July - far lower than many firms had been pricing those securities.
And that is also why, seeing what had happened to Bear Stearns, Fannie and Freddie, and Lehman Brothers, he took the pre-emptive step of selling Merrill Lynch to Bank of America. In the process, he got $50 billion for Merrill’s shareholders. True, that was half of what Merrill was worth a year ago, and a once-proud name is about to be swallowed up by a commercial bank. But he also got $50 billion more than Fuld got for his shareholders - and being sold is a lot better than being liquidated.
It is unlikely that the worst is over. The market Monday dropped more than 500 points, and the government is now trying to keep AIG from going the way of Lehman Brothers, even asking Goldman Sachs and JPMorgan to make some $75 billion in loans available to the struggling insurance giant. And then there’s Washington Mutual. And then ... well, who knows where it will end?
Clearly the government is no longer willing to put the taxpayers’ money at risk to save firms that took on too much risk buying securities that they didn’t understand. As painful as it is to see Lehman employees lose their jobs, that is probably a good thing. That is the final parallel that exists between the housing market and Wall Street: the issue of moral hazard.
For over a year now, many Wall Streeters have complained about government efforts to forestall foreclosures, saying that it would create the expectation that everyone should be bailed out, and that consequently no one would learn important lessons about the dangers of taking more risk than they could handle. Besides, they added, the housing market was never going to improve until housing prices found their natural bottom. And that wouldn’t happen until the government stopped trying to prop up housing prices.
But in truth, you can say the same of Wall Street - it won’t learn any lessons, either, until firms that took foolhardy risks start to fail. One reason Lehman could not find a buyer over the weekend is because potential buyers were insisting on the same kind of taxpayer guarantees that the government had given JPMorgan when it bought Bear Stearns, or when it took over Fannie and Freddie. That’s the essence of moral hazard. When Treasury Secretary Henry Paulson refused to do so, the potential buyers went away.
With the government refusing to prop up Wall Street anymore, maybe now mortgage-backed derivatives will find their natural bottom. Something to look forward to, I guess.