Miércoles 1 de Octubre de 2008, Ip nº 249

The great shakeout
Por James J. Cramer

Frank Capra would have loved the ongoing demise of Wall Street as we know it. How could he not? He correctly presaged it 62 years ago in It’s a Wonderful Life. Except in the 2008 sequel, not only does the Bailey Bros. Building & Loan survive, but it vanquishes Potter’s sorry, bloated operation, and the evil banker’s empire gets dismantled and sent to the eponymous field! This time around, George Bailey gets played not by Jimmy Stewart but by another quiet, unassuming individual, Ron Hermance. He’s the CEO of the homegrown Hudson City Bancorp, a modern-day replica of the Bailey Bros. Building & Loan. Never heard of Hermance or Hudson City? Under the avuncular and down-to-earth Hermance, this once-tiny Paramus, New Jersey, savings bank is now the largest savings and loan in the country. Who gets cast as the vicious, scheming Mr. Potter? We’ve got tons of candidates vying for that role these days, but only Richard Fuld, of the bankrupt Lehman Brothers, can truly fill Lionel Barrymore’s wingtips, given his arrogance and greed. How fitting is it that the day Lehman Brothers ceased to trade, because of Fuld’s inability to grasp how truly rotten Lehman had become, Hudson City hit its 52-week high? The cause of Lehman’s death? A mortgage portfolio of deadbeat loans that may prove to be worth even less than Fuld and his minions eventually acknowledged.

Hudson City’s secret is that, just like good old George Bailey in the movie, Hermance never saw the world outside his hometown, never went to exotic places like Santa Barbara, South Beach, or Europe. So unlike Fuld, or the executives at the defunct Bear Stearns, the merged Merrill Lynch, and even the now-seized American International Group, Hermance never lent money, gave mortgages, or promised to pay off on guarantees to anyone outside of his bailiwick. In other words, unlike those other guys, Hermance actually knew his borrowers and has been paid back on virtually every loan he has ever made. Hudson City’s default rate is virtually nonexistent compared with that of every one of these fallen behemoths. That’s how good the firm’s lending standards are. His model couldn’t have been more the opposite of the Potter-like plan, which, at its core, meant crafting mortgage-backed securities together from billions of dollars in residential loans of dubious quality that vastly overstated the value of the property underneath them and had no hope of ever being repaid unless housing continued to appreciate. No wonder Hudson City’s thriving while Potter’s field is filled with the graves of those who worked at Bear, Lehman, and Merrill.

The ascendancy of Hudson City, and the destruction or succumbing of so many of the once seemingly invincible investment banks or insurers, is no coincidence. There’s a fundamental change going on, and Hudson City’s riding it while almost everyone on Wall Street is being swamped by it. The change involves risk and the need to avoid taking it; it involves funding and the need to have a steady source, through sticky deposits, not hot slimy hedge funds; and it involves simplicity, not complexity. A mortal can actually understand how Hudson City makes its money; nobody can possibly even fathom all of the ways that Lehman or Bear or Merrill or AIG found to lose money.

How did we get to the point where some dinky local savings and loan is now the darling of high finance, and the old, storied banks are falling by the wayside, with even the best of the surviving lot—Morgan Stanley, Goldman Sachs and JPMorgan—struggling with weak profitability and layoffs? Is this the end of the old Wall Street, or simply another bust in the Street’s endless up-and-down cycle? Is it possible that something once as profitable as a modern investment bank may not even work as a business by this time next year? Has Wall Street finally fulfilled Marx’s long-held assumption about capitalism, that it would eventually collapse upon itself? Finally, are we, after these bailouts, nationalizations, and confiscations, in a perverse twist on an old Nixon riposte, all communists now?

Before we answer that, we have to ask ourselves how we got here. The unraveling started with brokers searching for new income streams after the post-dot-com collapse of equities. With the Federal Reserve taking interest rates down to 1 percent to jump-start the economy after 9/11, these firms’ clients were desperate for bonds that could give them a higher return than risk-free Treasury bonds. With low short-term rates available to tease borrowers, as well as what seemed to be endless home-price appreciation and a glut of global cash seeking a home, the brokers decided to package all sorts of arcane mortgages into bonds and sell them to institutions and hedge funds around the world. The whole scheme rested on the underlying value of those homes, which would never decline again—right?

Given that these bonds were proprietary to the firms that issued them, the brokers could charge their clients a huge premium—as much as twenty times the fees they might take for Treasuries or even big corporate bonds. Those markups were perhaps the most profitable streams of revenue these firms have ever seen. A so-so salesperson could make $2 million to $3 million easily selling this paper; a good broker could bring down twice that. All the brokerage houses, led by Lehman, Merrill, and Bear Stearns, jumped into this game, usually with sketchy due diligence and nary a thought of what would happen if homes fell in value. As the housing boom went on and on, and home prices refused to quit, the brokerages dramatically lowered their lending standards to get ever-higher rates for their bonds and generate even-better returns for their customers.

But then the chickens began coming home. The Fed started what proved to be an inexorable rise in interest rates, and the housing market cooled. The borrowers, legions of whom had used adjustable-rate mortgages, began defaulting at record rates. Even though only a small percentage of homeowners actually defaulted when all was said and done, those defaults set off alarm bells that led the major bond-rating agencies to downgrade the mortgage-based bonds. That caused a kind of mortgage-bond reflux. In essence, the billions in mortgage-backed loans were called all the way back up the borrowing chain, and no one had the cash to cover them because they were too heavily leveraged. It was that chain reaction that effectively caused Bear, then Lehman and Merrill, to succumb or merge. AIG, the insurer of much of this kind of paper, could no longer guarantee its worth, either.

All of those firms had one thing in common: They had no deposit base they could use to buy up all of this deflated inventory. They weren’t, alas, banks, like Hudson City; they were just brokers, renting money at ever higher prices to finance their own increasingly worthless investments. Without exception, all of these firms thought they could ride the housing cycle right through rather than dump these bonds, albeit for huge losses. Fortunes were lost (theirs and other people’s) in vain attempts to hold on for a home-price appreciation that never came. The federal government has now lent or spent almost a trillion dollars propping up this mortgage edifice even as institutions worldwide have taken more than a half a trillion in losses on the paper. The storm has overwhelmed almost everyone and everything in its path, Katrina-like, and despite the stock market’s encouraging response to the government’s most recent moves to address the crisis, on Friday, others may yet drown. At the very least, Wall Street will emerge forever changed.

How was all of this allowed to happen? Where were the regulators, the agencies that rate these bonds, the early warnings to the investors that maybe this paper was more dangerous than the brokerages let on? First, not only was there no regulation to speak of at any level—federal, state, or local—but the much-worshipped Alan Greenspan and current Fed chairman Ben Bernanke actually encouraged this kind of securitization even as they raised rates ever higher, seventeen times, to stop the very house-price appreciation these securities depended on to be viable. They shared the Republican ideology that promoted homeownership for everyone—including those who couldn’t afford it—and minimal market regulation.

Second, the ratings agencies, like Standard & Poor’s and Moody’s, blew the call. Failing to take the new risky lending practices into account, they just assumed that as long as employment held up—job losses had always been the trigger for defaults—the mortgage-backed bonds were good. Third, on the off chance of a possible rash of defaults, the issuers purchased insurance from outfits like AIG to make good on potential losses. We now know from the government’s seizure of AIG this past week that the world’s largest insurer could never pay off on all of those policies without selling everything that wasn’t nailed down, which is exactly what the new company, bought by you, courtesy of the Federal Reserve, will now have to do.

So, back to the big questions: Is this the end of Wall Street? What does it mean for the broader economy? And what about all that nationalizing?

First, let’s take Wall Street. The good news is, there’s almost no one left to go belly up from the mortgage mess. The bad news is, I said “almost.” A couple of firms are working their way through the storm, for the time being anyway, with their heads above water. Morgan Stanley intelligently slashed its mortgage operation ahead of the others, but still lost billions on mortgage-related trading, and was forced into merger talks with Wachovia last week. Morgan Stanley was also said to be in talks with the Chinese state to shore up ts capital base. Citigroup is mired with who-knows-how-much toxic paper, but because of its worldwide deposit base and salable assets, it hopes to be able to cover the losses and rebuild capital over time. The financial jury’s still out on those companies, although a merger or major cash infusion would certainly make Morgan Stanley safer than it was.

Only two firms appeared to have come out from mortgage-bond hell effectively unscathed: JPMorgan and Goldman Sachs. The former, run by Jamie Dimon, wisely allocated its capital and shrewdly built deposits at Chase Bank. Those deposits give it more wherewithal than any of the other major firms including Citi, which has a bigger deposit base but looser risk controls. Goldman, managed brilliantly by Lloyd Blankfein, made an actual bet against mortgages that started out as a hedge against its own toxic portfolio but ended up being much more profitable than the losses its mortgage bonds sustained.

Still, there are reasons to believe that no one’s entirely safe. Right now, every single kind of merchandise the remaining Wall Street firms have to offer—the underwriting of corporate stocks and bonds, mergers and acquisitions, stock and bond trading, and so on—are all simultaneously in the toilet. Even Goldman, once seen as the blue chip of the blue chips, reported a so-so quarter, but a profitable one, and its stock promptly fell 40 points on the news (though it later recovered). When the best of the best gets clobbered, even though it’s making money, you have to wonder whether things can ever get back to the way they were. When the economy eventually rebounds worldwide, we could see bigger profits for the big financial-services firms simply because there are fewer competitors sharing a shrinking pie. The remaining outfits can survive, perhaps thrive. But it’s hard to imagine, without the huge profits that these kinds of now-disgraced complex mortgage-backed investments can bring, we are going to see a return to what now looks to have been Wall Street’s Golden Age.

For two-plus decades, New Yorkers have been living in a Wall Street–dominated world. Ushered in by Michael Milken and Henry Kravis, popularized by Oliver Stone and Tom Wolfe, and carried to its decadent extreme by hedge-funders with 32,000-square-foot Greenwich mansions and Gulfstreams at every airstrip, it was an era that dramatically changed New York. I don’t care what the stock market did late last week or what it does in the next few days. That age, the Master of the Universe Era, is over. Too many people were too badly burned by taking too much risk to repeat that trick again. That has practical implications for everything from private schools, Range Rover dealerships, and Sotheby’s auctions to SAT tutors, newsstand operators, and shoeshine guys. It will also have an impact on the Zeitgeist. Greed is good? Not anymore. I’m nobody’s innocent, but I think we’ll see a more chaste culture emerge from all of this, on Wall Street, and perhaps beyond. Caution will be the new daring. Safe will be the new sexy.

In terms of the broader economy, we’ve often been able to cordon off Wall Street meltdowns from Main Street. Anyone who lived through the crash of 1987 knows that it turned out to have virtually no economic impact. But this sell-off has more far-reaching roots. It’s jarred the confidence of consumers and lenders in a way that could lead to a severe downturn in consumer spending and a starving of capital for businesses. Any purchase that can be put off, from a home addition to a vacation, is likely to be put off, at least until the economic dust settles. Any project that needs financing, from building skyscrapers and bridges to opening a new restaurant or dry cleaner, could be stopped in its tracks. The $180 billion in liquidity the Fed injected into the system last week was helpful, but it wasn’t the key move. The real difference maker was the government’s decision to buy these toxic bonds for pennies on the dollar, taking them off everyone’s books. The feds could have kept handing these firms money, but if the bad paper kept losing its value, then that money would have gone down the drain too.

Still, a recovery from a storm this big is going to take time. I don’t see the current recession ending until the second half of 2009. Ironically, housing, which got us into this mess, could be one of the first sectors to recover, as cheap mortgage money and a dearth of new supply should lead to a bottom by June of next year.

New York is insulated somewhat—especially the housing market—by the flood of foreign money that’s been pouring into town because of the weak dollar. The city’s economy is also far more diversified than it once was, and many of the area’s big non-financial companies—IBM, Honeywell, United Technologies, and the like—are flush. And an awful lot of the Wall Street people who are now out of work made an awful lot of money before they got the boot.

What about all that nationalizing? I know there’s been a lot of hand-wringing about the government’s takeover of AIG and Fannie Mae and Freddie Mac, and about the inconsistency of bailing out one firm, Bear Stearns, while leaving another, Lehman, hanging out to dry, and, not least of all, about taxpayers footing the bill for greedy Wall Street executives’ incompetence. And don’t get me wrong: I’m no fan of Greenspan or Bernanke or Hank Paulson, either. They helped steer us into this mess. But the fact is, they had no choice but to do what they did. Am I worried about setting a dangerous precedent of bailouts? Sure. Do I resent my tax dollars being spent this way? Yes. But had the government looked the other way, the stock market would have truly crashed—another 2,500 points at least—and we would have been in far deeper trouble. In a sense, the system worked. Your tax dollars provided insurance against a far bigger calamity. As it is now, I see more turbulence for investors in the short run—that’s Wall Street gibberish for volatile stock prices—but one thing I don’t see is a disaster. In fact, I believe we will come out of this mess healthier and more risk-averse, which is good for everyone in the long run.

Which brings us all the way back to Hudson City Bancorp. What we learned during this period is that funding—steady funding—is the real lifeblood of a bank, or any corporation’s, growth. We learned that the only banks that don’t have to go hat in hand and throw themselves on the mercy of strangers, as Bear and Lehman and Merrill did, are the banks with gigantic deposit bases that can be used to loan and borrow against.

Of course, Hudson City doesn’t aspire to be the nation’s largest financial institution. But JPMorgan and now Bank of America, with its acquisition of Merrill, sure do. Because of their huge deposit bases, those two multiheaded giants will most likely become the dominant players in American finance. They can issue mortgages and have enough money in their coffers to own the mortgages outright, which can be very lucrative if you underwrite safely. That’s something institutions without billions in huge deposits at their disposal, like Goldman and Morgan Stanley, simply can’t do. It’s why Goldman’s executives were asked repeatedly last week if the firm needs to merge with a savings bank in order to survive and become more profitable (even though I believe Goldman is still the traditional investment bank best positioned to go it alone). It’s why Morgan Stanley was talking to Wachovia and the Chinese. And it’s why the Street loves the Bank of America–Merrill hookup—because the brokerage operation can now benefit from the deposits. The new Bank of America “looks like” JPMorgan, which, thanks to its federally arranged shotgun marriage with Bear, is now the most revered financial institution in America. Coming up behind JPMorgan and Bank of America will be Wells Fargo and US Bancorp, two other deposit institutions that are now set to capitalize on a new world where there they can afford to make and keep mortgages on their books. (Washington Mutual, for the record, was subject to doomsday rumors last week not because it’s a savings and loan but because it’s a badly managed savings and loan. Its reckless lending practices have been among the worst in the business.)

If you want to be in the incredibly lucrative mortgage game going forward, you are going to have to mimic the Hudson Cities of the world—banks that know their customers and demand down payments and don’t risk giving loans to those who could turn out to be deadbeats. That’s right, what we’re seeing is a return to the era of good, clean, old-fashioned banking, an era in which the winners will be those banks that look just like the Bailey Bros. Building & Loan, or at least have an old-school deposit component at their core. Their owners and operators may not make as much money as the Potters once did, but at the end of the day they get to keep their jobs. And they’re still the richest men in town.


  21/09/2008. New York Magazine.


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