Before the government stepped in last week, the bodies of financial institutions — Lehman Bros., Merrill Lynch and AIG, with Washington Mutual and even Morgan Stanley threatening to be next — were piling up so fast it seemed possible that Wall Street might simply cease to exist.
The list of blunders that led to the carnage is by now familiar: Firms succumbed to the frenzy of the housing bubble; relied on dubious mathematical models to manage risk; and leveraged bad bets with suicidal amounts of borrowed money. But the impact of these mistakes was made worse by a seemingly harmless decision that these companies made many years ago: the decision to go public. Doing so put the firms at the mercy of the stock market, and last week that mercy evaporated.
Once upon a time, investment banks were private firms, structured as partnerships, and relying on the capital provided by the partners in order to run their operations. In fact, until 1970 the New York Stock Exchange prohibited investment banks from going public. But after that regulation’s repeal there were two big waves of IPOs, one in the 1970s and one in the 1980s, at the end of which nearly every prominent Wall Street firm was public. (The last holdout was Goldman Sachs, which went public in 1999.)
The incentives were obvious. Partners could cash out and other employees could more easily be compensated with stock. More important, going public allowed companies to raise huge amounts of capital, which, in turn, increased the amount of money they could borrow to leverage their bets and the profits they reaped when those bets came off. Between 1995, Lehman’s first full year as a public company, and 2007, its revenues more than sextupled, while its profits grew more than 17 times.
All, then, seemed good. But, for Wall Street firms, going public was a deal with the devil, because it meant exposing themselves to what was, in effect, a minute-by-minute referendum, in the form of the stock price, on the health of their operations.
This was fine as long as things were going well — the higher the stock price, the richer everyone got — but, once things started to go bad, that market referendum started to look like a vote of no confidence. And that made the problems that the companies were already facing much, much worse.
That’s because the entire edifice of Wall Street is built on confidence. Investment banks rely on short-term debt to run their businesses, and their businesses consist of activities — trading, dealmaking, money management — that depend on people’s faith in their ability to honor their obligations. As soon as the customers and creditors of a company like Lehman start to wonder whether it might collapse, they become less willing to lend or to trade, and more likely to demand their money back. The perception of weakness exacerbates the reality of weakness. And although there are myriad measures of a company’s health, nothing looks scarier than a stock price that’s heading toward zero.
All companies, of course, worry about how their stock is doing. But for most the stock price is a product of performance, rather than a cause of it. If Procter & Gamble’s stock plummeted tomorrow, people would still keep buying Tide. By contrast, if an investment bank’s share price tumbles, it not only wrecks people’s confidence but also can lead to credit-rating downgrades, which provoke a further decline in the stock price, and so on.
The downward spiral can be stunningly fast and near-impossible to escape. Lehman’s assets were not significantly more toxic last Monday, when the company filed for bankruptcy protection, than they had been a week earlier. And, technically speaking, the bank may not even have run out of money, since it had access to an emergency liquidity line from the Federal Reserve. What Lehman did run out of was credibility. It couldn’t remain a going concern because creditors and customers no longer trusted it. Why would they, when its stock price had fallen nearly 80 percent in the previous week? The less faith the market had in the possibility of Lehman’s survival, the more remote that possibility became.
This doesn’t mean that stock prices don’t reflect reality — Lehman’s business really was in bad shape — or that Lehman would have survived had it been private. But being publicly traded makes it harder to take the long view and survive market storms. It’s possible that a year or two from now many of the toxic assets that financial firms have written off will turn out to have considerable value. (That, one assumes, is why the private-equity firm Lone Star Funds spent almost $7 billion, in July, to buy such assets from Merrill Lynch, at a steep discount.) However, public companies, in order to satisfy ratings agencies and convince shareholders that they were cleaning up the mess they’d made, had little choice but to dump those assets.
Considering that Wall Street firms spend all day dealing with the market, they have been slow to understand just how vulnerable they were to it. Companies like Lehman and, earlier, Bear Stearns saw going public as an excuse to take on more risk and act more recklessly, when in fact becoming a public company makes caution more important, since the margin for error is smaller, and the punishment for failure swifter.
Now that the government has acted, Wall Street (or what remains of it) may yet be able to regain investors’ confidence. But long-term survival really depends on remembering the fundamental truth about playing with other people’s money: it’s a lot of fun until they suddenly decide to ask for it back.