The end of Wall Street

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Should Merrill shareholders move to break up the deal, BofA would have the option to buy up to 19.9 percent of the brokerage at $17.05 per share, UBS' Schorr said. Merrill shares rose $7.44, or 33.7 percent, to close at $29.50 Friday.
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The end of Wall Street
As Lehman's demise and Merrill's acquisition make clear, a business model built on ramping up risk and leverage simply doesn't work.
By Shawn Tully, editor at large
Last Updated: September 15, 2008:

NEW YORK (Fortune) -- Rumor has it that Lehman Brothers CEO Dick Fuld recently wanted to turn off the firm's signature Jumbotron, the giant panels that flash the Lehman name day and night at its headquarters in New York's theater district.

Running the lights, the story goes, was costing Lehman (LEH, Fortune 500) $500,000 a year. But New York City rejected Fuld's plea, since buildings in the Times Square area are required to keep their facades aglow to create the arcade effect that dazzles the tourists.

The lights are still on at Lehman HQ, but they're going out both for the 158-year old firm and for the Wall Street business model that it represents.

Now that Lehman has declared bankruptcy, and Bank of America is buying Merrill Lynch for $50 billion, the ranks of Wall Street survivors have shrunk in the space of six months from five to two, Goldman Sachs and Morgan Stanley.

With Merrill, and Bear Stearns before it, being acquired by giant commercial banks, we're witnessing the triumph of the diversified, universal banking model over the Wall Street one that focused on trading securities and advising corporate clients.

Eventually, the trend will probably capture Morgan Stanley and Goldman as well. Even if they skirt the fate of their former peers, their time is past.

The demise of old Wall Street isn't just about bad bets on mortgages or the hubris of Dick Fuld. It's the failure of an antiquated, risky strategy that depended on macroeconomic luck and that grossly overcompensated employees for being in the right place at the right time.

Debt and more debt

The game Wall Street played relied on leveraging up the cash provided by shareholders to enormous levels and using all the debt to accumulate a giant portfolio of securities.

As long as interest rates trend downward, the value of that portfolio swells, yielding gigantic returns on a slim equity base. And, with the exception of a few scary blips caused by the Asian currency crisis and the tech meltdown, that's what happened for most of Lehman's existence since it was spun off by American Express (AXP, Fortune 500) in 1994.

Based on a huge surge in profits, the employees arrange to take compensation in amounts unheard of outside of sports and Hollywood.

This model has an obvious, and fatal, flaw. Earnings on Wall Street no longer come chiefly from recurring businesses but rather from a combination of huge leverage and huge risk. When good luck turns, as it did in the credit crisis that began just over a year ago, the shareholder wealth supporting all that leverage gets wiped out.

That's precisely what happened at Lehman. Its shares are trading today at around 20 cents, meaning that outside of the dividend that the firm slashed last week, Lehman managed to destroy wealth for shareholders. The employees, though, took out tens of billions in excess pay that's parked in mansions, yachts and stock portfolios.

How did such a scenario come to pass? There are four key reasons:

Too much leverage

Between 2004 and 2007, Lehman swelled its balance sheet by almost $300 billion through the purchase of securities often backed by residential and commercial real estate loans. But in the same period, the firm added a miniscule $6 billion in equity.

As a result, assets jumped from an already high level of 24 times capital, to 31 times. So if the total value of the portfolio declined by 3% or so, shareholders' equity would be erased.


Ever riskier products

Over the years, once-lucrative businesses on Wall Street have become commoditized, including trading and underwriting bonds for clients.

So Lehman, along with Merrill Lynch (MER, Fortune 500) and other firms, pushed into higher-margin products, notably the packaging and trading of ever more exotic types of mortgage-backed securities. This allowed Lehman and others to keep profits humming. But the shift radically changed their businesses.

Wall Street became far more dependent on proprietary trading and far less reliant on clients. Before the collapse of Bear Stearns, it along with Lehman, Merrill, Morgan Stanley (MS, Fortune 500) and Goldman Sachs (GS, Fortune 500) derived over 60% of revenues from trading, most of it for their own accounts, versus around 40% in the late 1990s.

Wall Street firms evolved into giant hedge funds. Now they're suffering the same fate as a lot of over-leveraged hedgies.


Big bets, short-term debts

Unlike Bank of America (BAC, Fortune 500) or JPMorgan Chase (JPM, Fortune 500), Lehman and the other independent investment banks don't have a stable base of retail deposits to use for buying securities.

Instead, they rely on short-term debt that needs to be constantly refinanced. That's fine as long as the mortgages and other securities they hold are stable or rising in value and thus easy to sell. But when real estate started to slump, Lehman and its brethren couldn't sell securities they owned except at a big loss.

In the case of Bear, creditors got so nervous about lending money for securities that couldn't be sold that they refused to roll over Bear's commercial paper.

Lehman did have access to a newly created Federal Reserve window for short-term financing. But that couldn't save the firm because the basic problem remains: When markets turn nervous, creditors will stop lending, forcing Wall Street to dump holdings at distressed prices.

Big commercial banks, on the other hand, can hold securities until markets rebound. That gives them a big edge and explains why their model will prevail.


Exorbitant pay

The Wall Street playbook calls for taking home the highest pay possible when times are good and giving none of it back when times are tough.

Since the securities business is cyclical, it would make sense for firms to bank their bonuses forward so that if profits are plentiful one year but disappear the next, part of the compensation is returned to shareholders.

But that's not how the Street works. The pay practices at Lehman are highly instructive. When it came to granting stock to employees, Lehman was incredibly extravagant.

Before Lehman raised equity capital this year, grants of options and restricted stock left 30% of shares in employees' hands. To be sure, employees have lost billions in recent months. But they took out plenty over the years.

Fuld, for example, has cashed out almost $500 million worth of stock in his 14 years as CEO, according to Fortune's Allan Sloan; that's four times Lehman's stock market capitalization as of Monday morning.

In fiscal 2006 and 2007, Fuld earned a total of more than $80 million, an astounding sum for a company Lehman's size. Lehman's general counsel Thomas Russo made more than $12 million in each of those years. Top lawyers for much larger U.S. companies make a fraction of that amount.

Given all of this excess, there's no way this business model can last. The best bet is that Morgan Stanley will eventually be absorbed by a big bank that will reduce leverage, shrink pay scales, fund assets with deposits and impose strict risk controls. That's what JPMorgan CEO Jamie Dimon is doing with the old Bear Stearns and what Bank of America CEO Ken Lewis will no doubt do with Merrill.

Goldman, on the other hand, has the financial strength to move in the other direction and buy a bank. Even so, the Wall Street follies will soon end. They were great while they lasted - though mainly for the hired hands.
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Dow Lost 500 points
NEW YORK (CNNMoney.com) -- Stocks tanked Monday, as investors reeled amid the fallout from the largest financial crisis in years after Lehman Brothers filed for the biggest bankruptcy in history and Bank of America said it would buy Merrill Lynch in a $50 billion deal.

Treasury prices rallied as investors sought the comparative safety of government debt, sending the corresponding yields lower. Oil prices tumbled, falling well below $100 a barrel on slowing global economic growth. The dollar rallied versus other major currencies and gold prices spiked.

The Dow Jones industrial average (INDU) lost 500 points, or 4.4%, according to early tallies. It was the biggest one-day point decline for the Dow since Sept. 17, 2001, when the market reopened for trading after having been closed in the aftermath of 9/11 terrorist attacks.

The Standard & Poor's 500 (SPX) index lost 4.5% and the Nasdaq composite (COMP) lost 3.6%.

Global markets tumbled as investors reeled after Lehman Brothers filed for bankruptcy, Merrill Lynch was forced to sell itself to Bank of America and investors awaited AIG's restructuring announcement.

Worries in the afternoon focused around Dow-component insurer AIG, which has been scrambling to raise enough cash to fend off ratings agency downgrades and stay afloat.

In the afternoon, N.Y. Gov. David Paterson said AIG will be allowed to use $20 billion in assets through its subsidiaries to stay afloat, basically providing itself with a bridge loan. AIG has also reportedly asked the Federal Reserve for a roughly $40 billion bridge loan over the weekend.

Meanwhile, Reuters reported that sources say talks with Warren Buffett's Berkshire Hathaway about investing in AIG have ended.

Shares of AIG (AIG, Fortune 500) were down 52%, near where they stood before the announcement.

Still, some analysts said that the stock selloff could have been worse, considering the depth of the problems.

"You have to throw out the history books because there's really nothing to compare this to," said Jim Dunigan, chief investment officer at PNC Advisors.

Art Hogan, chief market strategist for Jefferies & Co., said the magnitude of the financial industry fallout is unprecedented, and could only be compared to the Great Depression of the 1930s or the railroad bankruptcies of the 1800s.

"We've never witnessed this before," said Hogan. "There's no road map for this."

The developments for the three companies cemented for investors that the credit crisis is far from over, six months after the near-collapse and government rescue of Bear Stearns.

"The landscape has changed and a lot of the major players who were are no more, so of course people are panicked," said Stephen Leeb, president at Leeb Capital Management.

"But it's not the end of capitalism," he said. "This may usher in something worse than what we've seen in terms of the economy, but the companies left standing at the end of this will be OK."

Merrill Lynch's buyout was perhaps providing some reassurance to investors, said Dunigan, in that it shows there is still value in the market.

Losses were also tempered by the Federal Reserve's decisions to loosen up its lending restrictions. The central bank could end up cutting the fed funds rate, its key overnight bank lending rate, when it meets Tuesday, analysts said. The fed funds rate currently stands at 2.0%.

Also helping Tuesday: news that a group of 10 banks including Morgan Stanley, Goldman Sachs and Barclays had given up to $7 billion each to create a $70 billion lending pool to help smaller institutions.

Lehman bankruptcy: Lehman Brothers (LEH, Fortune 500) announced it was filing for bankruptcy, after weekend talks aimed at saving the 158-year old firm failed.

The filing came shortly after midnight Monday, after Bank of America and Barclays pulled out of negotiations to acquire Lehman, which has lost $60 billion in bad real estate bets and the credit market's collapse.

Unlike with Bear Stearns back in March, the government was reportedly not willing to help finance a takeover, bailout or restructuring of Lehman Brothers. This reportedly contributed to the reluctance of other firms to strike a deal with the troubled company.

Speaking in the afternoon, Treasury Secretary Henry Paulson said that he hasn't ruled out additional government bailouts for the future. He also said that the banking system is sound. (Full story).

Lehman shares plunged 94%. (Full story)

Merrill Lynch buyout: After pulling out of the Lehman negotiations, Bank of America (BAC, Fortune 500) announced that it will buy Merrill Lynch (MER, Fortune 500) for $50 billion in stock. The price values the company at more than $29 a share, a more than 70% premium from Merrill's closing price on Friday of $17.05.

The company has posted losses of more than $17 billion over the last four quarters and saw its stock plunge 27% last week.

Shares gained 14% Monday afternoon, while Bank of America tumbled 20%. A variety of other financial shares plunged, including Washington Mutual (WM, Fortune 500), Citigroup (C, Fortune 500), Morgan Stanley (MS, Fortune 500), Goldman Sachs (GS, Fortune 500) and JP Morgan Chase (JPM, Fortune 500).

AIG: Insurer AIG (AIG, Fortune 500) plunged 55% as Wall Street awaited the details of its restructuring plan, expected to be announced Monday.

The company has lost more than $18 billion in the wake of the subprime mortgage crisis and is in desperate need of cash to maintain its credit ratings and investor faith.

Should the company fail to raise cash and see its credit rating cut by the ratings agencies, it may have only two to three days to survive, according to a source close to the firm. (Full story).

AIG stock fell 50%.

Market breadth was negative, with losers beating winners by almost 7 to 1 on volume of 1 billion shares. On the Nasdaq, decliners topped advancers by over three to one on volume of 1.81 billion shares.

10-bank emergency fund: In a bid to calm the markets, the Federal Reserve announced plans Sunday to loosen its lending restrictions to the banking industry. A consortium of 10 leading domestic and foreign banks, including Goldman Sachs (GS, Fortune 500), Citigroup (C, Fortune 500), Barclays (BCS) and Morgan Stanley (MS, Fortune 500), agreed to create a $70 billion fund to lend to troubled financial firms.

The Federal Reserve, meeting Tuesday, could cut the fed funds rate, a key short-term interest rate, from the current level of 2%, analysts said.

Oil: Oil prices plunged as investors continued to bet on a global economic slowdown. Additionally, early reports showed Hurricane Ike didn't do as much damage to oil rigs and refineries in the Texas Gulf region as expected.

Oil prices were down $5.50 a barrel to $95.68. Oil dipped below $100 a barrel on Friday for the first time in five months.

Other markets: In global trade, European and Asian stocks ended lower. Many major Asian markets, including Tokyo and Hong Kong, were closed for holidays.

Treasury prices soared as investors poured money into the relatively safe-haven. The rally sent the benchmark 10-year note tumbling to 3.52% from 3.72% late Friday.

In currency trading, the dollar rallied versus the yen and euro.

COMEX gold for December delivery gained $19.20 to $783.70 an ounce. To top of page


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With thousands of Lehman workers preparing to pack their bags, experts say other Wall Street firms probably aren't done with layoffs either.

Most people are assuming that they're out of a job at Lehman Brothers," said David Schwartz, head of executive search firm DN Schwartz & Co in New York. Schwartz said he wouldn't be surprised if upwards of 20,000 Lehman workers lose their jobs. That would amount to more than 75% of the company's total workforce.

When Bear Stearns was acquired by JPMorgan Chase (JPM, Fortune 500) earlier this year, about 9,000 workers, or more than half of Bear Stearns' employees, lost their jobs - many of whom are still looking for full-time employment.

Through August, financial firms have already eliminated an estimated 65,400 jobs over the past year, according to the latest employment figures from the Department of Labor.

Only 20% to 25% of Lehman employees will eventually land Wall Street jobs," Bernard said. "There are just not that many jobs."

"It's like a game of musical chairs with too many people chasing the jobs that are left," Challenger added. To top of page
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AIG shares plummet as investors await rescue plan

NEW YORK (Reuters) - Shares of American International Group Inc plunged 53 percent on Monday as investors grew increasingly nervous after the insurer, once the world's most valuable insurer by market value, failed to deliver a rescue plan.

AIG, hit by $18 billion in losses over the past three quarters from guarantees it wrote on mortgage derivatives,

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