Market Epicurean


The Month I Could Never Forget: A Not-So Happy Anniversary - PART FIVE

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Is Wall Street Dead? The Day Morgan Stanley and Goldman Sachs Looked into the Abyss

If reading our series so far has given you the impression that September 14 (Lehman’s bankruptcy), September 15 (Merrill swallowed up, market down 500 points), or September 16 (AIG bailout, money markets collapsing) were stressful days, then I am not sure what the appropriate adjective would be to describe September 17, 2008.

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My late father, who passed away in 1995 at the age of 47, would have been 60 years old on Sept. 17, 2008. That day always involves a certain degree of emotion. This week and season were obviously producing entirely enhanced levels of emotion and anxiety. And on this particular day, a few things were particularly noteworthy. The stock market dropped 450 points, the second worst day of the year (the Monday, two days earlier, had been worse). This represented the market hitting a 3-year low.

But in addition to living through the onset of this recession (which was growing worse by the day), the macro issues in the U.S. stock market, the clear stress and uncertainty in all aspects of the financial sector, and the pain and fear clients and investors were dealing with, I was, at the time, a Managing Director at Morgan Stanley, one of the leading investment banks on Wall Street. Until a few months earlier, Morgan Stanley had felt reasonably good about how it had held up throughout the crisis. Its stock had declined throughout 2008, as all stocks had, but compared to Bear Stearns and Lehman even before their combustion and even compared to Merrill Lynch and Citibank, it felt relatively better about its positioning versus competitors (it had large mortgage write-downs, but not at the same level that some other firms had). On September 17, the fears moved from the broad boulevard of “Wall Street” to the actual address of “Morgan Stanley.”

In the middle of the day, the stock dropped fully 24% from its opening level, as rumors persisted that Morgan’s demise was next. Goldman Sachs also saw its stock drop over 15%, both around concerns for the firm’s ability to sustain adequate liquidity. The costs of the credit default swaps for Morgan Stanley’s debt had skyrocketed (meaning, the cost to insure the debt was way up, indicating a heightened fear of a big problem). One rumor circulating was that Deutsche Bank had taken away a $25 billion credit line (this ended up being untrue). Short sales skyrocketed (mostly hedge funds betting against the stock price).

A controversy persists to this day – are the shorts betting on an outcome, or creating an outcome? (the accurate answer is neither – they are “betting” on an outcome they genuinely believe is coming, while also potentially facilitating that outcome if the entity is over-leveraged). We received a company-wide email mid-morning that the firm was a victim of vicious and opportunistic attacks by short sellers. We had a conference call later that morning where that same message was reinforced. Clients were panicked about the safekeeping of their own money. And it wasn’t even 10:00 am yet.

We now know that many hedge funds were bidding up the cost of the credit default swaps (signaling distress in the credit quality) while simultaneously shorting the stock (creating a self-fulfilling prophecy). John Mack, the CEO of Morgan Stanley, launched a very public effort to ban short-selling, an effort that would succeed, unfortunately for Morgan Stanley (what I mean is that a few days later when the SEC announced a ban on short sales of certain financial stocks, legitimate financial actors who lacked an ability to hedge risk and exposure they had turned to the bond and CDS market to find their protection, creating a negative feedback loop for Morgan Stanley; it also so angered certain high-profile hedge funds that they pulled money from Morgan’s prime brokerage business, adding to market signals and anxiety).

The level of hysteria and panic and volatility and insanity in the market can best be demonstrated by this: One of the large rumors circulating that day was that Wachovia was looking to buy Morgan Stanley. Within days, Wachovia themselves were on the brink of death (a future issue in the series coming) and would themselves be bailed out. The hunter and hunted were trading each other’s hats every day.

By the end of the week, Morgan Stanley and Goldman Sachs announced that they were becoming “bank holding companies.” Their formal structure as an independent investment bank was over. Like Citigroup, JP Morgan, and Bank of America, this means that Morgan Stanley and Goldman Sachs could now benefit from the capital cushion and funding mechanism of a client deposit base. This move would intensify regulation on the respective firms dramatically and would reduce their leverage levels by over 60% (imagine that!).

The regulatory framework, financial metrics, and culture of the firms would not be the only thing that changed this fateful week. The Wall Street model would be forever altered. The capital structures of the firms, reliance on the repo market for funding, and inter-connectedness to each other for debt funding would all be revealed as a source of monumental systemic risk. Market solutions would not be easy to find due to the lack of understanding surrounding these complex behemoth institutions. A new relationship between government and Wall Street was coming, as was a new relationship between Wall Street and her customers. And her advisors.

Morgan Stanley did end up surviving the financial crisis, and a few months later, were themselves switching hats from hunted to hunter. The days of being “swallowed up” by JP Morgan or Wachovia were gone, and instead, Morgan Stanley was buying Smith Barney from Citi for a tiny fraction of the prestigious wealth management firm’s former value. This would take place in January 2009. Oh, what a difference just a few days makes, eh?

But back to September 17, 2008, months before Morgan was buying other companies on the cheap, they were themselves on the brink of extinction. Reports that the Federal Reserve released years later would reveal that they had borrowed emergency sums of money from the Fed discount window to keep the lights on during this time. They did keep the lights on, and John Mack negotiated a deal to sell 20% of the firm to Mitsubishi, providing $9 billion of desperately needed capital. That phone call from Mitsubishi, coming on CFO Kelleher’s cell phone on a Sunday night at San Pietro restaurant at 54th and Madison in midtown Manhattan, saved the firm.

I will never forget the October Mitsubishi deal that saved Morgan Stanley, but I will really never forget September 17, 2008.

Oh yeah, happy birthday, dad. I assure you, I thought about him a lot that day.

David L. Bahnsen
Chief Investment Officer, Managing Partner
dbahnsen@thebahnsengroup.com

The Bahnsen Group
www.thebahnsengroup.com

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