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FINANCE two California-based lenders to provide the flow of debt to package into bonds. Record revenue from Lehman’s real estate businesses helped sales in the capital markets unit jump 56% from 2004 to 2006. Lehman reported record earnings in 2005, 2006 and 2007. And, even as the housing market fell, Lehman kept making loans. Last year, it underwrote more mortgage-backed securities than any other firm, accumulating an $85bn portfolio, almost four times its $22.5bn of shareholder equity. “Our global franchise and brand have never been stronger, and our record results for the year reflect the continued diversified growth of our businesses,” Fuld said in a statement on 13 December. That was then. Lehman racked up huge losses in lower-rated mortgage-backed securities throughout 2008, apparently a result of its having retained large positions when securitising the underlying mortgages. In the second fiscal quarter, Lehman reported losses of $2.8bn and, as the credit market continued to tighten, Lehman stock lost 73% of its value. Fuld, still hoping to remain independent, sold $6bn in shares and sought more capital from Korea Development Bank and other investors. But on 9 September, it was reported that the Korean bank had put talks on hold. Lehman stock fell 45% and the next day it announced a loss of $3.9bn. The stock went into freefall. Fuld was finally now searching for a buyer, but he had left it too late – when Barclays and Bank of America walked away from talks on 14 September, the firm had no option but to file for bankruptcy. It was two down, three to go. This time the lesson was not lost. Among the industry executives and Fed officials huddled in emergency meetings in Manhattan that weekend to contemplate the demise of Lehman Brothers was John Thain, chief executive of Merrill Lynch, Wall Street’s third-largest investment bank and the next in the firing line. Thain had taken over Merrill last December after the ousting of his predecessor, Stanley O’Neal. Merrill had a $19.2bn net loss in the last year, and taken more than $40bn in write-downs. As the Lehman talks proceeded, it became clear that “the funding of independent investment banks was going to come under pressure.” Thain said. He called Kenneth Lewis,

INVESTMENT BANKING his counterpart at Bank of America and the very man who had only just spurned Lehman, to propose a merger. The shotgun marriage was arranged in less than two days. In a $50bn deal, Merrill relinquished its 94-year independence in an all-stock merger that valued its shares at $29 each, a 70% premium on their existing price but a vast discount to their peak of around $99 in January 2007. “This was the strategic opportunity of a lifetime,” said Lewis at a news conference with Thain in Bank of America’s new offices in New York. “This isn’t necessarily the outcome I would have expected when I took this job,” said Thain. Then there were two – Goldman Sachs and Morgan Stanley – but the carnage continued unabated. First, the US government was forced to bail out two of the biggest US

EVEN AS THE HOUSING MARKET FELL, LEHMAN KEPT MAKING LOANS mortgage banks, Fannie Mae and Freddie Mac, to keep the US home loan system from meltdown and, more alarmingly, it stepped in to rescue the desperately illiquid insurer American International Group (AIG) which had provided $441bn backing for Wall Street trades involving CDSs. The Fed agreed to lend AIG up to $85bn in emergency funds in return for a government stake of 79.9%. The rescue of the giant insurer was justified on the grounds that letting it fail would “pose systemic risk to the US and international financial systems”. But it did not halt the bloodletting. On 16 September, Goldman Sachs and Morgan Stanley posted better-than-expected results but still the chief financial officers of both firms were called on to deflect analysts’ questions about their ability to survive as independents. Morgan Stanley’s Colm Kelleher stated that the number two US investment bank remained confident in its

broker-dealer model and dismissed the need to merge with a deposit-taking bank. Likewise, Goldman Sachs’ David Viniar ruled out the possibility of buying a bank in the near future: “We think that the business model we have right now is working quite well and performance is good.” He also hinted that Goldman Sachs stood to gain from the recent contraction of Wall Street’s inner circle, adding: “[With] more opportunities and fewer competitors that will help market share and pricing power.” But the next day the shares of both firms took a hammering. Morgan Stanley’s share price slumped by 24% and Goldman Sachs’ by 14%. It was becoming clear that they risked being sucked into the vortex. Fearing a total evaporation of confidence, John Mack reportedly held talks with several possible partners, including the US commercial banks Citigroup and Wachovia, and Citic of China. Instead, and with the prospect of a $700bn US government rescue package for troubled banks on the horizon, the last two dealer-brokers came down off the hilltop to seek shelter with the Federal Reserve. The move completed the circle for the banking industry, reversing the separation of commercial and investment banks that had been imposed to restore confidence during the Great Depression. The US central bank said it would allow them time to phase in newly applicable regulations, including those covering capital requirements, rather than have to rush to comply with them immediately. But the banks acted quickly. Morgan Stanley agreed to sell a 21% stake to Japan’s Mitsubishi UFJ Financial Group for $9bn, seeking to shore up investor confidence after borrowing costs climbed and its stock fell by half. Goldman Sachs meanwhile raised $5bn from veteran investor Warren Buffett and a further $5bn via an overnight share placement, double the amount initially intended. Goldman Sachs and Morgan Stanley may have ducked the financial disaster that befell their rivals for now – but it remains to be seen whether this is more than a temporary reprieve. What is certain is that these firms will never be the same. The high leverage and financial ingenuity that produced such stellar returns – and bonuses – on Wall Street for years are gone and it is the more heavily regulated universal banks that are likely to dominate investment banking league tables into the future.

26 CNBC EUROPEAN BUSINESS I NOVEMBER 2008

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