The bailout: Consolidation at the top


Richard Moore

September 18, 2008

As Fears Grow, Wall St. Titans See Shares Fall


Editors’ Note Appended

Correction Appended

Even Morgan Stanley and Goldman Sachs, the two last titans left standing on Wall Street, are no longer immune.

To the surprise of executives within those firms, and their rivals, the stocks of these powerful companies were drawn into the crisis of investor confidence on Wednesday. Morgan Stanley, whose stock fell almost 25 percent, was considering a merger with Wachovia or another bank to help shore up its finances. Goldman Sachs’s stock fell almost 14 percent, and it had to rebuff rumors that it was seeking a capital infusion.

The assault on these two companies underscored how quickly a sense of fear is spreading through Wall Street. Both firms just reported respectable profits on Tuesday, and were considered in a separate class from weaker banks like Bear Stearns and Lehman Brothers that saw the value of their businesses evaporate.

“Stop the Insanity,” wrote Glenn Schorr, a brokerage analyst at UBS, in an e-mail message to clients on Wednesday.

A tie-up with a bank would restore Morgan Stanley to its structure during the Depression, when the firm split from the Morgan banking empire. It would also leave Goldman Sachs as the last major American investment bank after a global financial crisis that has gripped markets for more than a year snowballed last week, forcing the most risk-taking industry in the world to get back to basics.

Only a day earlier, Morgan Stanley defended itself from growing doubts about its future, issuing a fairly positive earnings report to ward off concerns about its health.

But as the fear that gripped markets after Lehman Brothers failed also enveloped the firm, John J. Mack, Morgan Stanley’s chief executive, spoke Tuesday evening with Citigroup’s chief executive, Vikram S. Pandit, about a possible combination, according to people briefed on the talks.

On Thursday, however, Morgan Stanley vigorously denied a report in The New York Times that Mr. Mack had said that Morgan needed to seek a merger in order to remain in business.

Mr. Mack was said to have made the comment in the conversation with Mr. Pandit. Citigroup, which had declined to comment on Wednesday night, also denied Thursday that such a comment had been made during the conversation.

Citigroup is thinking of deals it can strike with consumer banks, like buying the struggling Washington Mutual out of bankruptcy if its reported efforts to auction itself should fail, that would provide it with cheaper deposit funding.

Mr. Mack also entered into discussions on Wednesday with Wachovia and several other banks, people briefed on those discussions said. The talks with Wachovia are preliminary and a deal may not emerge. The banks declined to comment.

Goldman Sachs may be under less pressure given its recent history of outperforming its peers. The bank made $11.6 billion last year and has not posted a loss during the credit crisis. Morgan Stanley has also performed well, but has suffered more write-downs and had a loss of $3.6 billion in the fourth quarter of last year.

Still, many specialists say they believe that the monumental events of the last four days herald a new period of painful change for the American financial industry — one that speculators are rushing to pounce on. While Wall Street has gone through tough times before, only to emerge bigger and stronger, some financial specialists question whether the industry can rebound quickly after using high levels of leverage, or borrowed money, to binge on risky investments. Those investments have proved to be disastrous. Worldwide, financial companies have reported more than $500 billion in charges and losses stemming from the credit crisis — a figure some specialists say could eventually exceed $1 trillion.

Merrill Lynch rushed into the arms of Bank of America this week in a deal that in some ways harked back to the past. During the Depression, Congress separated commercial banks, which take deposits and make loans, from investment banks, which underwrite and trade securities. The investment banks were allowed to do business with less oversight, while commercial banks operated with tighter supervision.

But after Congress repealed those Depression-era laws in 1999, commercial banks began muscling in on Wall Street’s turf. As the new competition whittled down profit margins, investment banks used more of their capital to trade securities and also began developing financial derivatives to fuel profits.

Now, executives like John A. Thain, the chief executive of Merrill and a former Goldman executive, say investment banks will need large bases of deposits to shore up their capital.

Investors appeared to be questioning whether either Morgan Stanley or Goldman Sachs would be able to survive alone as panic spread through the markets. The cost of protecting against defaults on the debt of both have shot up, a signal that some investors believe one or both of the banks could be next in the growing list of financial companies to either go bust, get sold or require a government bailout. Any institution without a big, stable balance sheet is seen as vulnerable to the kind of rapid collapse in confidence that led to the demise of Bear Stearns and Lehman Brothers.

As Morgan Stanley considered its options on Wednesday, the struggling savings and loanWashington Mutual also put itself up for auction, people briefed on the matter said. Shares of Washington Mutual fell 31 cents, or 13.36 percent, to $2.01; Wachovia shares fell $2.39, or 20.76 percent, to $9.12.

Normally, a declining share price alone should not force a stalwart like Morgan Stanley into a sale. But those declines, which executives blamed on aggressive hedge funds that profit when stocks drop, can increase the firm’s cost of borrowing by forcing it to post more collateral to lenders when its credit default protection prices rise.

Such an event often leads credit rating agencies to downgrade a company’s debt. That, in turn, can quickly deplete even a well-financed bank’s capital and force into sale or bankruptcy. The real end for Lehman Brothers, for example, came when Moody’s, the ratings agency, downgraded the company’s debt last week, forcing it into a corner.

Indeed, with healthy earnings, Wednesday’s relentless downward spiral in shares of both Morgan Stanley and Goldman Sachs made little sense to some.

Mr. Schorr, the analyst at UBS, said the increase in the risk premiums investors are demanding on debt have become self-fulfilling prophecies that now operate almost entirely detached from underlying fact, a thought echoed by people inside both banks and by several investors.

“It’s all confidence, it’s not reality,” Mr. Schorr said.

Morgan and Goldman have some problems, including a parcel of troubled mortgage assets and trading and advisory businesses that are vulnerable to a slowing economy.

“But that is not what is going on here,” Mr. Schorr said. “It is just a flat-out squeeze that should not be able to happen. The negative feedback loop has to be somehow suspended,” he added, “but I don’t know exactly how you do that.” Goldman Sachs declined to comment.

On Wednesday, the Securities and Exchange Commission reinstated a rule curbing the ability of investors to drive the share price of firms down to make a profit. Nearly five days ago, Wall Street chieftans who were gathered for emergency meetings at the New York Federal Reserve bank pleaded for the agency to revive the rule, which expired in the summer.

Mr. Mack has been in contact with regulators about what he views as abusive short-selling of the company’s shares. On Wednesday, he sent a memo to employees assuring them of the bank’s strong capital position and blaming short-sellers for driving the stock down “in the midst of a market controlled by fear and rumors.” He plans to hold a town hall meeting with Morgan employees Thursday morning.

Andrew Ross Sorkin contributed reporting.

Editors’ Note: September 19, 2008
A front-page article on Thursday reported on discussions the investment bank Morgan Stanley has had with possible merger partners. It cited two people who were said to have been briefed on a conversation in which John J. Mack, chief executive of Morgan Stanley, had told Vikram S. Pandit, Citigroup’s chief executive, that “we need a merger partner or we’re not going to make it.”

After the article appeared, Morgan Stanley vigorously denied that Mr. Mack had made the comment, as did Citigroup, which had declined to comment on Wednesday. The two people whom The Times cited now say that because they were not present during the discussions, they cannot confirm that Mr. Mack in fact made the statement. The Times should have asked Morgan Stanley for comment and should not have used the quotation without verifying that the two people had direct knowledge of any comments made by Mr. Mack.

This article has been revised to reflect the following correction:

Correction: September 19, 2008
An article on Thursday about the falling share prices of the investment banks Morgan Stanley and Goldman Sachs misstated, in some editions, the market performance on Wednesday of shares in Wachovia, which is said to be considering a merger with Morgan Stanley. The shares fell 20.76 percent, or $2.39, not 2.39 percent.