Friday, September 19, 2008

The Fates of WaMu & Morgan Stanley

As of this morning, news stories still report Wachovia considering the purchase of Morgan Stanley, while, somewhat comically, in relation to the reports of Citigroup considering merging with WaMu, the former's CFO, Gary Crittenden, was quoted as saying,

"People view us today as being a source of the solution, instead of part of the problem."

Only in a rapid consolidation like the current one would so badly managed a bank as Citigroup be considered as a 'source of the solution.'

Perhaps it's just a matter of relativity. As inept as Citi's management is, WaMu's was worse.

Would the financial system be worse off with WaMu's assets slapped together with Citigroup's? Probably not. In this environment, it's not clear what WaMu's other options are, besides orderly sale of its non-mortgage consumer business to some other large bank, while shareholders keep the damaged mortgage assets to offset whatever equity remained.

As to Morgan Stanley's China option, one wonders how that would work? A country whose army still employs prison labor in its commercial manufacturing businesses would now also one one of America's larger investment banks? Not to mention a country whose ownership rules for foreigners doing business in country are so restrictive as to be laughable? Where does the issue of trust enter here?

(At this point, I had written substantial additional material which was published earlier this morning, but has now, inexplicably disappeared. I shall attempt to reprise those additional thoughts.)

But, the larger point is this. Most of the publicly-held US investment banks failed to adequately understand the environment in which they were operating for the past twelve months.

Despite the ranting of CNBC financial hothead Jim Cramer to the contrary, most of these banks did, indeed, debauch their own franchise values. Cramer, only this morning, was nearly breaking his arm while attempting to pat himself on the back for calling for an RTC-style entity in July. In the next breath, he alleged that it was unfair that Bear Stearns, Lehman, Merrill Lynch and, probably, Morgan Stanley have or will vanish as independent entities.

He also contended that Morgan Stanley and Goldman, in his opinion, were in danger of going insolvent yesterday.

I disagree. Those two investment banks, as I wrote here, had options. And still do. But that doesn't mean each should remain as a publicly-held, independent entity.

If it takes today's, and the past two weeks' efforts by the Treasury, Fed, SEC, and other Federal regulatory agencies to rescue a raft of large US financial service entities, then it's fair to question how ably these companies were being run in the first place, isn't it?

They all- or almost all- clearly misunderstood the current financial environment, and failed to take adequate steps in sufficient time to avoid bankruptcy or sale to another firm. Their risk management efforts were terrible.

Why should anyone want those managements to continue to operate in our financial services system? Doesn't the existence of such inept management teams- risk and general- put our entire financial services system at risk?

Yes, it does.

You may argue, as Zachary Karabell did in yesterday's Wall Street Journal, that this is all due to the Enron-era Sarbanes-Oxley legislation which mandates 'mark to market' of thinly-traded, poorly-understood structured financial securities.

So be it. But the whiz kids at these Wall Street houses, and AIG, all knew the rules, or should have. What they apparently didn't know, in reality, was what could really happen to complex instruments, and the values of their firms, which held so much of this paper, when markets for such instruments simply vanished.

Ironically, we saw the same miscalculations when the same firms used 'portfolio insurance' approaches to risk management in the crash of 1987. It didn't work.

Wall Street is, in truth, littered with past crises and market crashes during which the predominant risk management solutions of the day failed to anticipate the next risky environment.

Part of the reason, of course, is the concept of the 'fallacy of composition.' I first learned of it in Paul Samuelson's classic text, "Economics," in my undergraduate economics courses.

What the typically-young, inexperienced risk management model-builders on Wall Street usually fail to anticipate is that, when a market is composed of firms operating similarly-run risk management functions, then they will all behave similarly in the face of the same price information. What happens next falls under the fallacy of composition. All desks try to sell at once, and prices plummet even further, triggering even larger sales of even more instruments.

Of course, it has worked on the upside, too, occasionally. But, on the downside is where crippling side effects like margin calls and capital inadequacy appear.

Think what you may, but John Gutfreund recently and sagely noted the inability of firms such as Lehman to come to terms with the new realities of highly-leveraged investment banking operations in a world of overcapacity and too-thin margins.

Thus, as the moderating economy of the US caused the first ripples of doubt among holders of structured financial paper backed by subprime and alt-a mortgages last summer, the die was effectively cast ending either the independence, or existence of most US investment banks.

Poor risk management and the denial of reality by boards and senior management delayed the inevitable recognition of declining value of many assets held by these firms. And by several large commercial banks.

What's happening now, frankly, ought to occur. Everybody knew what SarBox meant for marking balance sheets to market. And everybody knew that the last batch of securitized mortgages were of lower quality than those of five, or even three years ago.

WaMu's and Morgan Stanley's fates are comparatively strokes on a larger canvas of ineptitude of risk and general management by many large, publicly-held US investment and commercial banks in the past few years.

As a society, we own these behaviors. We can't let the them destroy our financial system. Thus, today's governmental actions which have either nationalized some aspects of, or curbed the operation of free markets in US finance, may be temporarily necessary.

In the longer term, some simpler, clearer means of firewalling leveraged activities needs to be developed, so that, with minimal oversight, natural human behaviors to seek to maximize opportunities for profit, and misunderstand concomitant risks, won't bring a repeat of this financial services sector debacle.

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