chasing goldman sachs (2010)

Rowe Price with a focus oninvesting in financial stocks Sheila Bair: chairman of the Federal Deposit Insurance CorporationBen Bernanke: chairman of the Federal Reserve Lloyd Blankfein: C

Copyright © 2010 by Suzanne McGee

All rights reserved.

Published in the United States by Crown Business, an imprint of the Crown Publishing Group, a division of Random House, Inc., New York.

Library of Congress Cataloging-in-Publication Data

McGee, Suzanne.

Chasing Goldman Sachs/Suzanne McGee.

p cm.

1 Goldman, Sachs & Co 2 Investment banking—United States—History—21st century.

3 Financial crises—United States—History—21st century 4 Finance—United States— History—21st century I Title.

HG4930.5.M38 2010

332.660973—dc22 2009053440 eISBN: 978-0-307-46012-7

Cover design by Pete Garceau

Cover photographs: Reuters/Landov (building); Getty Images (sky)

v3.1

In memory of my grandfatherJames R Burchell

1 From Utility to Casino: The Morphing of Wall Street

2 Building Better—and More Profitable—Mousetraps

3 What’s Good for Wall Street Is Good for … Wall Street: HowWall Street Became Its Own Best Client

4 To the Edge of the Abyss—and Beyond: Flying Too Close to theSun

PART II Greed, Recklessness, and Negligence: The Toxic

Brew

5 “You Eat What You Kill”

6 The Most Terrifying Four-Letter Word Imaginable

7 Washington Versus Wall Street

PART III The New Face of Wall Street

8 Wanted: A New Model for Wall Street

9 Chasing Goldman Sachs?

FOREWORD

We think we’re number one, but we’ll leave that for others todecide.” Back in 1983, when John Whitehead, then cochairman ofGoldman Sachs & Co made that statement to a reporter from NewYork magazine, the investment bank was already well on the way

to becoming one of Wall Street’s iconic rms Its bankersproclaimed that they were “long-term greedy”; the denizens ofGoldman weren’t the type, they declared regally, to try to captureevery fraction of a penny of fees and pro ts, particularly if therewas even a question that they might be doing so at the expense of aclient relationship Goldman Sachs even felt itself to be above somebusinesses—no advising hostile bidders on takeover strategies, forinstance; that was far too messy Then there were some potentialclients that a Goldman Sachs banker didn’t want to be seenlunching with, much less transacting business with Goldman’sclients were the crème de la crème; preserving the rm’s name andreputation by choosing who to deal with and what deals to do wasmore critical than grabbing at an extra few thousand dollars in fees.Occasionally, something unpleasant would happen to remindGoldman bankers of the solid business reasons behind those loftyprinciples, such as the rm’s brief but damaging relationship withRobert Maxwell Many Goldman partners had felt skittish aboutaccepting the media tycoon as a client; his checkered past includedhis being dubbed by a British government inquiry as “not a personwho can be relied on to exercise proper stewardship” of a publiccompany But the allure of earning big fees overrode those concerns

—that is, until Maxwell vanished o his yacht into the sea near theCanary Islands and a new investigation revealed that he had looted

a billion pounds from his employees’ pension funds Britishregulators hit Goldman with a ne for its role in the asco in 1993;the size of the ne was somewhat less important than the publichumiliation, however Partners vowed that never again wouldGoldman Sachs be named and shamed in such a manner

Goldman Sachs be named and shamed in such a manner.

And yet, in the summer of 2010, Robert Khuzami, head of theenforcement division of the Securities and Exchange Commission,stood triumphantly in front of a group of reporters and an array oftelevision cameras broadcasting his words globally He announcedthat Goldman Sachs had agreed to pay a ne of $550 million—thelargest penalty the SEC had ever imposed on a Wall Street rm—tosettle a civil fraud case the agency had led only months earlier.But Khuzami and the SEC had won more than their $300 millionshare of that settlement: Goldman had agreed to acknowledgepublicly that the “fundamental basis” of the agency’s lawsuit wasaccurate Goldman had failed to live up to its own standards anddisclose everything that German bank IKB might have wanted toknow about the mortgage securities deal, dubbed Abacus, that lay atthe heart of the suit Speci cally, the SEC had claimed Goldmanhadn’t fully explained to IKB and other potential investors buyingthe Abacus package of synthetic mortgage-based securities thathedge fund manager John Paulson had played a key role selectingthe speci c securities in that transaction—indeed, that the deal wasbeing done at his initiative because he wanted to nd a way toprofit from what he expected would be a big decline in the value ofthe securities he chose That’s precisely what happened: Paulsonwalked away a billion dollars richer, while IKB became one of therst nancial institutions to fall victim to the global nancial crisisand require a bailout

Goldman Sachs, the envy of Wall Street, now found itself underscrutiny for all the wrong reasons Instead of its peers and rivalstrying to gure out what it was doing to earn the astonishing rates

of return it delivered like clockwork to its investors, regulators andlegislators were putting its business under a microscope Toinsiders, it seemed as if everything for which Goldman was oncefamous and lauded—its creativity in devising and structuring newproducts; its risk management prowess; the market insightdisplayed by traders deploying the rm’s own capital to generatereturns; the rm’s ability to develop relationships with powerplayers in Washington as well as on Wall Street—now rendered itinfamous Suddenly, everyone was asking what Goldman Sachs had

infamous Suddenly, everyone was asking what Goldman Sachs haddone to earn the gargantuan pro ts in recent years; pro ts that hadleft other Wall Street CEOs green-eyed with envy and fuming attheir own inability to measure up.

But this book—conceived in early 2008, as Bear Stearns collapsedand Wall Street waited, holding its breath, for the next shoe to fall

—is not the story of the transformation of Goldman Sachs from WallStreet’s most envied to its most reviled power Rather, it’s the tale

of the ways in which Goldman and the other Wall Street rms thatsought to emulate its success underwent a fundamentaltransformation, and the impact of those changes for Wall Street, itsclients, and the nancial system as a whole That transformation—which led to Wall Street being run solely in the interests of WallStreet entities themselves, with clients now viewed ascounterparties—paved the way for the nancial crisis whose ripple

e ects continue to reverberate on both Wall Street and Main Street.For the latter—indeed, for most of us—Wall Street’s value lies in itsrole as a nancial utility or intermediary But as the nancial results

of Goldman and its rivals demonstrated all too clearly, that’s notwhere the pro t lay And ever-bigger pro ts were what WallStreet’s own investors—the shareholders who bought stock inGoldman Sachs, Merrill Lynch, Lehman Brothers, and other rms—demanded, loud and clear

The SEC’s fraud lawsuit against Goldman Sachs simply madepublic what many Wall Street insiders had long known: clients need

to be able to look out for themselves Wall Street rms are dealingcards from the bottom of the deck to their friends, while saving thelow-value cards for other clients In case there was any doubt ofwhat Goldman bankers really thought of the deals they were taking

to their clients, investigators rapidly made public a series ofembarrassing e-mails and other documents In one, top Goldmanbanker Tom Montag wrote of another mortgage-backed securitiestransaction—Timberwolf—that it was “one shitty deal.” Certainly bythe time John Paulson came knocking on its door, Goldman knewthat being “long” subprime real estate in the spring of 2007 waslikely to be a risky bet for anyone agreeing to take the other side ofthe trade that Paulson wanted to do; after all, the rm was pushing

the trade that Paulson wanted to do; after all, the rm was pushingits team to unload their own exposure to others as rapidly aspossible In an e-mail to a friend, Fabrice Tourre, the banker whostructured the deal (and who has not yet been able to settle theSEC’s charges against him) wrote of the CDO transactions he wascrafting, “the whole business is about to collapse any timenow … Only potential survivor, the fabulous Fab!” In another e-mail, the head of Goldman’s structured products correlation tradingdesk warned Tourre that “the cdo biz is dead” and that “we don’thave a lot of time left.” None of that gave Goldman Sachs bankers areason to stop, it seems Even Bear Stearns had turned away JohnPaulson, concerned at the ethical implications of allowing a hedgefund manager to choose which securities he would bet against andthus which securities Bear would have had to coax a client to buyoutright.

“In the old days, we would never have done business with justanyone who showed up on our doorstep,” insists one formerGoldman Sachs partner, who says the revelations left him “shockedand dismayed.” In the old days, before Goldman Sachs sold stock tothe public and its culture began to change irrevocably, “the questionwould have been ‘John Who? Do we know this guy? What is heasking us to do? What are the consequences of this? Is this someone

we want and need a relationship with?’ Above all, we were alwaysprepared to say ‘no.’ ”

But by the dawn of the twenty- rst century, saying “no” to dealswasn’t how Wall Street worked anymore From the mortgagebrokers who underwrote the now-notorious “no income, no-docs”home loans all the way up to the investment bankers who justcouldn’t turn away a John Paulson, even when they had ethicalreservations or, as Fabrice Tourre admitted, the securities that theywere creating for their investors were “monstrosities”; the veryword “no” seemed to have vanished from the lexicons of thosetoiling within the nancial system And the pressure was on to say

“yes” to any deal that could generate a few pennies a share inquarterly earnings, because each and every investment bank andcommercial bank was well aware of the extent to which its ownreturn on equity fell short of that being generated by the Midas-like

return on equity fell short of that being generated by the Midas-likebankers at Goldman Sachs Swiss banking giant UBS hired aconsulting rm to advise it on the best way to generate pro ts;Goldman alumnus Robert Rubin, who had moved on to work forCitigroup, only reluctantly acknowledged to colleagues that his newfirm had neither the trading skills nor the risk management prowess

to beat Goldman at its own game (That didn’t stop Citigroup fromtrying, of course.) Top bankers at Merrill Lynch & Co knew to steerclear of their temperamental CEO Stan O’Neal on days thatGoldman Sachs released its earnings “Why can’t we earn numberslike that?” he demanded of one subordinate in mid-2005

The problem for Wall Street wasn’t what Goldman Sachs did Itwas the attitude that lay behind those actions, combined with thefact that its rivals and eager imitators tried to beat Goldman at itsown game When O’Neal’s underlings set out to beat Goldman’sreturn on equity, they succeeded in wiping out a decade’s worth ofpro ts by taking gargantuan risks in collateralized debt obligations(CDOs) made up of subprime mortgages The fallout from UBS’seffort to chase Goldman Sachs cost the Swiss bank billions of dollars

in losses and writedowns So far, much of the scrutiny of thenancial crisis has been devoted to identifying and analyzing itsproximate causes: the boom in risky, subprime lending; the rolethat securitization and derivatives played in amplifying that riskand spreading it throughout the nancial system; and theinadequate risk management methodologies that were exposed bythe crash These are easier to understand and to grasp—but theyalso create the illusion that since we can name them so readily, theycan be xed with a few well-considered and carefully designedreforms

There are deeper-seated causes, however, that are far moresigni cant systemic issues that both Wall Street and Washingtonhave yet to address What purpose does Wall Street serve? What do

we have to do to restore public con dence that it can act in theinterests of all its stakeholders, not merely those who run it andview it as a way to generate vast pro ts for themselves? Certainly,Goldman Sachs envy hasn’t abated on Wall Street, even if most ofits rivals admit that they’d prefer to be known for its Midas touch

its rivals admit that they’d prefer to be known for its Midas touchthan the Abacus transaction And as long as they keep chasingGoldman Sachs, and what Goldman is doing to earn its hefty pro ts

is weakening the integrity of the nancial system, then real reform

is still far distant The Financial Crisis Inquiry Commission’s nalreport touched on this when it noted that both bankers andregulators “ignored warnings and failed to question, understand andmanage evolving risks within a system essential to the wellbeing ofthe American public Theirs was a big miss, not a stumble.” Norwere those members of the FCIC who signed on to the reportoptimistic about the future “Some on Wall Street and inWashington with a stake in the status quo may be tempted to wipefrom memory the events of this crisis.”

True, the playing eld has never been a level one for those onWall Street Back in 1940, Fred Schwed wrote what has nowbecome a classic book, Where Are the Customers’ Yachts? In it, avisitor to Manhattan is being shown the sights near Wall Street,including a yacht basin around the Battery “Look, those are thebankers’ and brokers’ yachts,” his guide points out “Where are allthe customers’ yachts?” asked the naive visitor The punchline wasobvious: Wall Street didn’t make enough for its clients for them toown yachts Not much has changed, except that in the wake of thenancial cataclysm, some of Wall Street’s customers have begun tofeel as if they are setting out to sea in leaky rowboats, without theirbankers and nancial advisors being either ready or willing todispatch a life raft in case of emergency

The reason Wall Street exists and the reason it was bailed out bythe American taxpayer is that it plays a vital role in our capitalisteconomy We need Wall Street—and we need Wall Street toremember that function But today’s Wall Street is far from servingthat “utility” role, and it remains to be seen whether the regulatoryreform proposals will convince Goldman Sachs and its rivals toreconsider their raison d’être and rede ne their responsibilities toboth their clients and to the nancial system itself None of thesurvivors can resume chasing Goldman Sachs and lusting after itsprofits if what Goldman Sachs does and the others try to do in order

to earn that rate of return succeeds in undermining the health of the

to earn that rate of return succeeds in undermining the health of thenancial system as a whole If there is one lesson we all, from theOval Office on down, need to learn from the crisis, that’s it.

DRAMATIS PERSONAE

DRAMATIS PERSONAE

Patrick Adelsbach: principal of event-driven strategies at Aksia LLC,

a hedge fund research and advisory firm

Scott Amero: fixed-income fund manager at BlackRock, one of thelargest asset management firms in the world

Phil Angelides: former state treasurer of California; currently head

of the Financial Crisis Inquiry Commission

Jeffrey Arricale: portfolio manager at T Rowe Price with a focus oninvesting in financial stocks

Sheila Bair: chairman of the Federal Deposit Insurance CorporationBen Bernanke: chairman of the Federal Reserve

Lloyd Blankfein: CEO of Goldman Sachs

Peter Blanton: veteran investment banker who has worked at avariety of large Wall Street firms and now works for a boutiquefirm

Brooksley Born: Washington securities lawyer and former head ofthe Commodity Futures Trading Commission; now a member ofthe FCIC

Richard “Dick” Bove: banking analyst at Rochdale Securities; aveteran research analyst

Lise Buyer: has worked on almost every part of Wall Street as ananalyst, banker, and investor; served as director of businessoptimization at Google; and now has her own firm that helpscoach companies through the financing process

Tom Caldwell: chairman of Caldwell Financial, a Toronto-basedinvestment and trading firm; one of the largest shareholders ofthe New York Stock Exchange’s parent company

Marshall “Marsh” Carter: deputy chairman of NYSE Euronext,former chairman of State Street Corporation, and a veterancommercial banker

commercial banker

Tom Casson* : a former Bear Stearns investment banker; since thatfirm’s collapse, he has worked for two other Wall Streetinstitutions

Jimmy Cayne: former CEO and chairman of Bear Stearns; he spenthis professional life at the firm

Steve Cohen: manager of one of the world’s biggest hedge funds;known as a ferocious and secretive competitor and an avid artcollector

Gary Cohn: president and COO of Goldman Sachs

Leon Cooperman: former Goldman Sachs partner; now runs a largehedge fund group, Omega Advisors

John Costas: rose to head UBS’s investment banking; after brieflyrunning a hedge fund group for UBS, he was caught with short-term losses and resigned; launched his own trading and market-making group, Prince-Ridge, in mid-2009

Robert “Bob” Diamond: CEO of Barclays Capital and president ofBarclays PLC; Diamond orchestrated the purchase of many ofLehman Brothers’ investment banking operations after Lehman’sbankruptcy filing; formerly worked for Credit Suisse, amongother firms

Jamie Dimon: CEO of JPMorgan Chase, a former protégé of SandyWeill whom the latter fired at Citigroup and who went on tohave the last laugh as the heir to JPMorgan himself during thecrisis

Mike Donnelly*: former Wall Street investment banker who spentmost of his career at Morgan Stanley

Glenn Dubin: cofounder of Highbridge Capital, a large hedge fundgroup now owned by JPMorgan Chase

James “Jimmy” Dunne: CEO of Sandler O’Neill, a smallerinvestment bank that specializes in serving financial institutionsIra Ehrenpreis: a general partner at Technology Partners, a SiliconValley venture capital firm

Gary Farr: former Citigroup banker hired by KKR to build an

Gary Farr: former Citigroup banker hired by KKR to build an house investment banking division to assist its portfolio

in-companies

Niall Ferguson: professor of history and business at HarvardUniversity and Harvard Business School; specializes in economicand financial history

Jim Feuille: partner at Crosslink Capital, a venture capital firmRichard “Dick” Fisher: late CEO of Morgan Stanley; his name oftensurfaces when people talk about competitive yet principled WallStreet executives

Martin “Marty” Fridson: veteran high-yield bond market analyst;founder of FridsonVision

Richard Fuld: former CEO of Lehman Brothers; a Lehman “lifer”Timothy Geithner: Treasury secretary; formerly head of the NewYork Fed

Mike Gelband: former co-head of fixed income at Lehman BrothersLou Gelman*: former investment banker specializing in equity salesand trading at Morgan Stanley

James Gilleran: former head of the Office of Thrift Supervision whobragged about his willingness to cut red tape and make it easier

Ken Griffin: founder of Citadel Investment Group, one of the largesthedge fund groups in the world; now making a push intoinvestment banking

Tony Guernsey: chief client officer at Wilmington Trust; has workedwith many Wall Street figures over the last three decades

with many Wall Street figures over the last three decadesWilliam R “Bill” Hambrecht: former CEO of one of the “fourhorsemen” (boutique banks that played a decisive role infinancing start-up companies), Hambrecht & Quist; since that firmwas sold to Chase Manhattan in the late 1990s, has undertaken avariety of quests, all involved in improving financing access forfledgling firms

Nick Harris*: manager of a large hedge fund

Jeff Harte: banking analyst at Sandler O’Neill

Samuel Hayes: holds Jacob H Schiff Chair in Investment Banking atthe Harvard Business School; has been writing case studies aboutWall Street since 1970

Mike Heffernan*: investment banker on Wall Street

Jaidev Iyer: managing director, Global Association of Risk

Professionals; former senior risk manager at Citigroup and itspredecessor institutions

Fred Joseph: late founding partner of Morgan Joseph, a boutiqueinvestment bank; formerly CEO of Drexel Burnham LambertRob Kapito: president of BlackRock

Todd Kaplan: veteran Wall Street banker recruited by Ken Griffin atCitadel to launch the hedge fund’s push into investment banking;resigned in early January 2010 for personal reasons

Henry Kaufman: the original “Dr Doom” and a prominenteconomist at Salomon Brothers; now president of Henry Kaufman

& Co

Dow Kim: briefly headed the fixed-income investment bankingoperations at Merrill Lynch; tried but failed to launch his ownhedge fund after Merrill began to take write-downs

Michael Klein: one of the first architects of a sponsor group ofbankers catering to private equity clients; a former Citigroupbanker

Bill Kohli: fixed-income portfolio manager at Putnam Investments

in Boston

Richard “Dick” Kramlich: cofounder of New Enterprise Associates, a

Richard “Dick” Kramlich: cofounder of New Enterprise Associates, alarge Silicon Valley venture capital partnership

Henry Kravis: cofounder of KKR, one of the first large buyout firmsSallie Krawcheck: former banking analyst and Citigroup chieffinancial officer; now runs the wealth management business atBank of America Merrill Lynch

Ken Lewis: former chairman and CEO of Bank of America;negotiated the merger between B of A and Merrill Lynch but wasousted after revelations of large losses at Merrill and agreements

to pay Merrill bankers big bonuses

Michael Lipper: architect of data and analysis firm Lipper AdvisoryServices (now part of Thomson Reuters, named Lipper Inc.)John Mack: veteran investment banker who has worked at many ofWall Street’s most significant firms; until 2010, CEO of MorganStanley; remains the firm’s chairman

Jake Martin*: partner at a large New York–based buyout firmMike Mayo: veteran banking analyst and managing director atCalyon Securities (USA) Inc

Larry McInnes*: veteran technology and telecommunications bankerTom McNamara*: investment banker who works within a sponsorgroup at a Wall Street firm, putting together financing packagesfor private equity buyouts

Seth Merrin: founder of LiquidNet, a Wall Street trading firmMichael Milken: at Drexel Burnham Lambert in the 1970s and1980s, developed the high-yield/junk bond market into a realasset class, but violations of securities laws led to his beingbanned from the industry for life; now a philanthropist

Eric Mindich: youngest partner in Goldman Sachs history; left thefirm to found a hedge fund, Eton Park Capital

Ken Moelis: began his career at Drexel Burnham Lambert;

ultimately became president of UBS’s investment bankingdivision; left in 2007 to launch his own boutique firm, Moelis &Co

Angelo Mozilo: chairman and CEO of Countrywide Financial until

Angelo Mozilo: chairman and CEO of Countrywide Financial until2008; cofounder of IndyMac Bank; a symbol of the credit bubble,Countrywide is now owned by Bank of America; IndyMaccollapsed

Duncan Niederauer: former partner of Goldman Sachs & Co., CEO

of the New York Stock Exchange, and a pioneer in the world ofelectronic trading

Stanley “Stan” O’Neal: former CEO of Merrill Lynch & Co.; behindthe firm’s push into CDOs structured with subprime mortgagesVikram Pandit: veteran banker and later a hedge fund manager;joined Citigroup and quickly became its CEO

Richard “Dick” Parsons: chairman of the board of CitigroupHenry “Hank” Paulson: former Goldman Sachs leader who went on

to become Treasury secretary in the administration of George W.Bush; an architect of the TARP plan

John Paulson: hedge fund manager who made billions betting thatthe housing bubble would burst; now betting on a turnaround infinancial stocks

Pete Peterson: cofounder of Blackstone Group; previous postsincluded CEO and chairman of Lehman Brothers between 1973and 1984

Anna Pinedo: partner at Morrison & Foerster specializing incorporate finance

Charles E “Chuck” Prince: former CEO of Citigroup

Phil Purcell: former chairman and CEO of Morgan Stanley; ousted

by firm dissidents unhappy with the company’s lagging stockprice, a reflection of its lack of risk taking

Leslie Rahl: founder of Capital Markets Risk Advisors LLC, a riskmanagement firm that has handled a lot of derivatives debaclesLewis “Lew” Ranieri: mortgage bond and securitization pioneer atSalomon Brothers

Clayton Rose: former banker at JPMorgan Chase; now an adjunctprofessor at Harvard Business School

Wilbur Ross: former investment banker and “workout specialist” at

Wilbur Ross: former investment banker and “workout specialist” atRothschild Investments; founded his own private investment firm,

WL Ross & Co LLC, in 2000

Nouriel Roubini: economist and professor at New York University’sStern School; known as “Dr Doom” for his pessimistic economicforecasts

Jeff Rubin: director of research at Birinyi Associates; has studied theway financial markets function

Robert “Bob” Rubin: former Goldman Sachs partner and Treasurysecretary during the Clinton administration; went on to work as adirector and advisor at Citigroup

Ralph Schlosstein: CEO of Evercore Partners; cofounded BlackRock,

a major asset management firm

Stephen “Steve” Schwarzman: cofounder of Blackstone Group;formerly an investment banker at Lehman Brothers

Peter Solomon: veteran Wall Street banker and Lehman Brothersalumnus; now runs his own boutique investment bank, Peter J.Solomon Co

Larry Sonsini: chairman of Wilson Sonsini Goodrich & Rosati, aSilicon Valley–based national law firm that advises start-ups andFortune 500 companies

Mike Stockman: former risk management officer at UBS

Richard “Dick” Sylla: Henry Kaufman Professor of the History ofFinancial Institutions and Markets, Stern School of Business, NewYork University

James “Jim” Tanenbaum: partner at Morrison & Foerster

specializing in corporate finance

John Thain: former CEO of Merrill Lynch; previously CEO of theNew York Stock Exchange and a partner at Goldman SachsLeo Tilman: president of L M Tilman, a risk advisory firm;contributing editor of The Journal of Risk Finance, and formerexecutive at BlackRock and Bear Stearns

Mark Vaselkiv: fixed-income manager at T Rowe Price in BaltimoreDavid Viniar: chief financial officer of Goldman Sachs

David Viniar: chief financial officer of Goldman Sachs

Paul Volcker: former Federal Reserve chairman; named chairman ofEconomic Recovery Advisory Board by President Barack Obama;championed the idea of re-creating a division between risk-takingand deposit-taking institutions on Wall Street

Sandy Weill: financier who combined risk-taking and deposit-takinginstitutions on Wall Street with the formation of Citigroup; hisview of a financial supermarket was largely responsible for therepeal of the 1933 Glass-Steagall Act that separated investmentand commercial banking

* Indicates a pseudonym.

INTRODUCTION

INTRODUCTION The Chase

Does Wall Street owe the American people an apology?”

Tom Casson* heard the question—the one on the minds of everyAmerican taxpayer furious at the very idea of footing the bill forWall Street’s excesses in the shape of the $700 billion bailoutpackage under debate in a Senate hearing room—from thetelevision on the trading floor just outside his office He saw himself

as part of Wall Street—it was where he had spent nearly all hisworking life—so the very idea that some senator from who knowswhere thought he should apologize to the country piqued hiscuriosity immediately “Why would I and the rest of my guys dothat?” he wondered Still, listening to either Treasury secretaryHenry “Hank” Paulson or Federal Reserve chairman Ben Bernankestruggle to answer the question in a way that would keep themembers of the Senate Banking Committee happy had to be morefun than just watching the red lines on his Bloomberg terminal thatsignaled stock and bond market index levels inching their waylower and lower with every passing minute In search of distraction,Casson got up from behind his desk and ambled toward the tradingoor Leaning against the glass wall that separated his smallfiefdom from the hurly-burly of the floor, he waited for the answer

It wasn’t what he expected to hear After a lot of hemming andhawing, Ben Bernanke nally replied that to most of America,

“Wall Street itself is a … is a … is an abstraction.” Casson felt as ifhe’d accidentally stuck his nger in an electrical socket He stoodupright, staring at the television in astonishment What hadBernanke just said? Can he really have just described Wall Street as

an abstraction? In Casson’s eyes, Wall Street couldn’t be less abstract

an abstraction? In Casson’s eyes, Wall Street couldn’t be less abstract

—it’s where businesses nd capital, where investors with capital

nd places to put it to work in hopes of earning a return Over thedecade that he had toiled on the Street, Casson had raised moneyfor some of those companies and helped others to negotiatemultibillion-dollar mergers Now the politicians were demandingthat he and his colleagues apologize for what they spent their livesdoing? Even worse, the head of the Federal Reserve—the individualwho was the public face of banking regulation and monetary policymaking—couldn’t nd a better word to describe Wall Street thanabstraction Months later, Casson was still bemused “How couldanyone say that Wall Street was an abstraction?” he wonderedaloud What had happened to make even the Fed chairman blind toWall Street’s real value?

The details of what happened during the weekend in Septemberthat preceded those Senate hearings, the weekend of frenetic dealmaking, hectic negotiations, and never-ending meetings within theFed’s fortress-like New York headquarters involving nearly everytop gure on Wall Street, have by now been told and retold Weknow that Merrill Lynch held its board meeting to approve the sale

of the rm to Bank of America at the St Regis Hotel in Manhattan;that Securities and Exchange Commission (SEC) chairmanChristopher Cox accused a British counterpart of being “verynegative”; that Hank Paulson commuted to the negotiationsdowntown from a suite at the Waldorf Astoria in midtownManhattan We even know the favorite route for the dawn runs byTimothy Geithner (then head of the New York Fed, who wouldsucceed Paulson at the Treasury Department in the New Year) alongthe southern tip of Manhattan.1 We know what happened—thenames of the rms that failed, and those that rapidly returned tomaking money hand over st (We still don’t know the names ofthose institutions saved from disaster by last-minute help from theTreasury Department, but if media organizations make acompelling freedom-of-information case to the courts, thatinformation won’t be long in coming.) We know the proximate

information won’t be long in coming.) We know the proximatecauses of the crisis: too much leverage, too much risk, and too muchsubprime lending.

This book will take you on a di erent journey Instead ofrehashing every detail of what happened to Wall Street, I’ll takeyou behind the scenes and show you just why our nancial systemcame so close to falling over the edge of the abyss How did wereach the point where Wall Street was in so much jeopardy that thestaid and somewhat self-important Paulson was willing to go down

on one knee in front of House of Representatives Speaker NancyPelosi—a Democratic politician most investment bankers distrustedand even roundly disliked—to beg for her assistance in passing anancial aid package for the surviving rms, including his ownalma mater, Goldman Sachs? Above all, what had happened toWall Street that Bernanke could describe it as an “abstraction” and

be greeted not with howls of outrage or confused questions by hisaudience but rather with nods of acknowledgment andunderstanding?

Truth is, Wall Street isn’t an abstraction but a kind of publicutility That’s a characterization liable to make those who work onthe Street bristle in indignation But in many ways, the nancialsystem of which Wall Street is a critical part bears an uncannysimilarity to any power company or water system When you comehome at the end of the day, you count on being able to ick aswitch and see your lights come on; in the morning, you rely onbeing able to turn on a tap and get clean running water for yourshower You almost certainly rely on Wall Street in the sameunconscious way Wall Street o ers us an array of investment ideasfor our retirement portfolios; Wall Street institutions nance ourentrepreneurial dreams and lend us the capital we need to help usbuy homes, cars, and even birthday gifts for friends and family.(Sure, they make money doing that—but so do the power companyand the water company.)

From its inception Wall Street had been there to serve MainStreet, and it took that role seriously “It was valued; serving yourcorporate clients, if you were an institutional rm like MorganStanley, or investors, if you were a retail-oriented rm like Merrill

Stanley, or investors, if you were a retail-oriented rm like MerrillLynch, exceedingly well was the ticket to success on Wall Street,”says Samuel Hayes, professor emeritus at the Harvard BusinessSchool The problem is that from the 1970s onward, serving as apublic utility and performing these intermediary functions for thepeople on both ends of the “money grid” (investors and companiesneeding capital) just wasn’t as profitable as it used to be.

That’s the starting point for this book, which will explain justhow and why Wall Street drifted away from its core intermediaryfunction and morphed from utility to casino, under pressure fromthose running Wall Street rms and from their investors Both ofthose groups put a priority not on ful lling Wall Street’s role as autility but on nding the most pro table products and businessstrategies, of which subprime lending and structured nance wereonly the latest—and, so far at least, the most toxic—manifestations.Eventually, these insiders came to treat Wall Street as if it wereany other business, only as valuable as the pro ts they could extractfrom it Instead of turning to proprietary trading or structurednance only to supplement their returns from the less pro tableutility-like or intermediary operations, many Wall Street rmsdeemphasized Main Street altogether in favor of catering to WallStreet clients: hedge funds, private equity funds, and their ownprincipal investing and proprietary trading divisions Nor werethere any incentives for Wall Street residents to question theircollective transformation from quasi-utility to self-serving, risk-taking, pro t-maximizing behemoth Compensation policies acrossthe Street rewarded bankers and traders for turning a blind eye tothe needs of the money grid; regulators—agencies charged withensuring that utilities operate in the public interest—ended upcatering to Wall Street rather than trying to rein in its worstexcesses

When utilities come under too much systemic stress, they fail.Think of the electricity system, and what happens when itsmanagers fail to plan for the hottest summer days, when everyoneturns on the air conditioner full blast and the demand for powerpeaks Like millions of others living in the northeastern UnitedStates, I experienced that rsthand one muggy August afternoon in

States, I experienced that rsthand one muggy August afternoon in

2003, when the power to everything from elevators in high-rise

o ce buildings to streetlights on Manhattan’s busy roadwaysickered o —and stayed o for much of the next twenty-fourhours Suddenly, I realized just how important the power grid was

to my life I joined thousands of others who had to walk homealong the darkened New York streets, through the heat andhumidity Eight miles and many hours later, there was no coldwater to ease the pain from my blistered feet (the lack of electricityhad caused a plunge in water pressure) and no food (there was noway to cook anything); I couldn’t even nd a cold drink to reviveme

Thankfully, the reasons for the blackout were relativelystraightforward Someone had decided to take a power plant

o ine, meaning that its output wouldn’t be available to customers

on one of the hottest days of the year A bad call When electricitydemand spiked, that put a strain on the high-voltage power lines.Since electricity companies know that can happen, causing powerlines to sag dangerously low, they make an e ort to keep trees andfoliage trimmed back That didn’t happen at one utility—anotherbad call—and the power lines brushed against some overgrowntrees, triggering a series of failures that cascaded throughout theregion’s power grid.2

The 2003 blackout was an accidental phenomenon But imagine

if in the years leading up to the blackout, the power companies hadbeen overrun by a new breed of managers, extremely bright andimaginative engineers armed with MBAs Imagine that they hadbeen given a completely di erent mandate by shareholders:blackouts don’t happen too often (the last big one was in 1965), so

if preparing for one consumes too much capital or limits pro ts toomuch, don’t bother with it And imagine that those engineers, inorder to maximize pro ts, decided to use all the money they hadsaved by not investing in backup capacity and maintenance to buildand operate a casino, or some other business that would generate amuch higher return in the short run Finally, imagine that regulatorswere asleep at the switch and let them do it Happy shareholderswould have richly rewarded the engineers for their e orts right up

would have richly rewarded the engineers for their e orts right upuntil the last minute And even after the blackout (which wouldhave been far more catastrophic and longer-lasting than that of2003), while all of us were struggling in the dark, those investorsand the engineers would have had more than enough money to buytheir own generators to provide power to their mansions.

In a nutshell, that’s what happened to Wall Street as it morphedfrom being an intermediary to being a self-serving, risk-takingmachine for generating pro ts As long as times were good, fewparticipants stopped to ask questions about this transformation,including those who have today become some of the Street’sharshest critics And even now that we’ve experienced the nearblackout of the nancial system, the ngers of blame are pointing

to individuals—Richard Fuld, at the helm of Lehman Brothers, forinstance, or Christopher Cox, the chairman of the SEC, who lookedthe other way as Bernie Mado ran his Ponzi scheme and as theinvestment banks his agency regulated teetered on the edge ofdisaster If we ever are going to be able to devise wise policies forWall Street and ensure the future health of the nancial system, wehave to take a hard look at more than just the proximate causes ofthe debacle, such as subprime lending or the activities of pot-smoking, bridge-playing Jimmy Cayne at Bear Stearns We need tounderstand how to make the money grid work properly Maybe justbeing an intermediary doesn’t generate enough in pro ts to sustainthe system anymore—but that doesn’t mean that people running theutility should feel free to toss caution to the wind and startspeculating on a host of new and risky businesses

Bankers are trying to clear up the mess they have made, while inWashington, regulators and policy makers are running around incircles trying to analyze what went wrong and to put in place anew set of rules that will prevent the nancial system from coming

so close to the brink again But none of these very smart people iseither admitting to or acting on the biggest problem of all: the factthat while Wall Street is as important to our economy and society

as any other utility, it doesn’t work like one Let’s say that MorganStanley decided, as a result of the events of the last two or threeyears, to pare back the amount of risk it is willing to take It shuts

years, to pare back the amount of risk it is willing to take It shutsdown its proprietary trading desk, says it won’t act as a principaland invest alongside its clients in businesses, and limits itsinvolvement in risky products such as synthetic credit default swaps.

It even decides to turn away underwriting assignments if its bankersconclude that the stocks or bonds the rm would be underwritingwould add to the level of risk in the system Instead, MorganStanley focuses on wealth management, on building a commercialbanking franchise, or on market making (facilitating the two-wayflow of trading in stocks or bonds) What would happen next?Well, none of these is a high-growth business that will lead to bigannual jumps in pro tability Before long, the impact of thisdecision would show up in the bank’s quarterly earnings; with eachscal quarter, the gap between Morgan Stanley and its rivals wouldwiden, in both absolute levels of pro tability and the rate ofgrowth in pro ts The bonus pool would shrink, and if this risk-conscious move was one that only Morgan Stanley had made on itsown initiative (and not part of a government-mandated change

a ecting the entire industry), the bank’s most talented and skilledemployees would be lured away to work for competitors.Ultimately, the investors in Morgan Stanley, those who havepurchased its stock in hopes of seeing the value appreciate, wouldstage a rebellion It wouldn’t take long before they’d protest to thebank’s management team and demand that the managers dowhatever it takes to keep up with the returns being posted by theirpeers If those managers stick to their guns, the investors’ next stopwould be the o ces of the company’s directors It’s pretty easy foranyone to imagine what would happen next to the executives whohad decided that shunning high-risk but pro table businesses was agood idea “Give us a new management team, with some guts, that’swilling to go out and do what it takes to capture whatever pro tsare going!” shareholder A would demand Since the board’sabsolute duty is to maximize value for shareholders, it wouldn’ttake long for it to capitulate

Do you think that couldn’t happen? Well, it did, over the course

of the last two decades Over that period, Goldman Sachs emerged

as the rival to beat, or at least to try to mimic The rm seemed to

as the rival to beat, or at least to try to mimic The rm seemed tohave a Midas touch: in the decade leading up to the nancial crisis,

it generated an average annual return of 25.4 percent onshareholders’ equity, while the four other large investment banksearned an average return on equity (ROE) of 15 percent annually inthe same time frame No wonder Goldman’s rivals were furious asthey fended o complaints from their own shareholders It wasclear to every other Wall Street CEO that chasing Goldman Sachswas the only way to boost their personal wealth and simultaneouslykeep their cantankerous shareholders pacified

What Goldman was doing, however, was something very di erentfrom the traditional business of Wall Street By 2007, the year that

it posted record pro ts of $11.6 billion and distributed a bonuspool that was even larger ($12.1 billion) among its employees,Goldman was getting only about a third of those earnings fromserving Main Street clients; the rest came from investing and tradingfor its own account It had become commonplace for Goldman’srivals to refer to the firm, scornfully, as a hedge fund disguised as aninvestment bank, even as they scrambled to mimic the strategy Theproblem was that they weren’t moving into these businessesbecause they believed they had a competitive advantage or the mosttalented bankers and traders They were doing it just to keep pacewith the market leader And while Goldman Sachs, as we’ll see,managed to steer clear of some of the subprime mess, those rmsthat were just trying to chase Goldman Sachs didn’t have the tools

or the people to help them properly manage the new risks theywere taking

During those years, when everyone was chasing Goldman Sachs,there was every incentive to just keep doing so and not muchencouragement to stop and rethink the strategy John Costas, formerhead of investment banking at UBS and one of the Swiss bank’smost powerful deal makers, says the system worked in such a waythat everyone was under pressure to do whatever it took to grab theextra percentage point of market share or return on equity and toride roughshod over naysayers “For a decade, from 1999 throughthe middle of 2007, anytime you stopped participating, by notadding more risk or by not aggressively pursuing more transactions,

adding more risk or by not aggressively pursuing more transactions,you were wrong.” In other words, chasing Goldman Sachs was astrategy that paid o for so long that Wall Street’s leaders were illequipped to recognize that it might not always continue to do so.Nor was it possible to sit out the dance, to not try to emulateGoldman’s golden touch With the bene t of twenty-twentyhindsight, deciding back in 2003 or 2004 not to get caught up inthe business of repackaging subprime mortgages into collateralizeddebt obligations (CDOs) looks great At the time, it would havebeen untenable, says one former senior banker “What washappening at the bank that did that? The investment analysts aredowngrading it, the shareholders are unhappy, and the employeesare unhappy because the bonuses aren’t as fat as those their friendsare earning The press is all over the bank, saying it’s not as wellrun as the other bank.” That, he argues, is the kind of thinking thatsealed the doom of some of Wall Street’s most venerable names.That kind of thinking is still alive and well on Wall Street today,even after the near apocalypse The quest is already under way forthe next “new new thing,” the next product or strategy that willhelp rms such as Goldman Sachs and its rivals earn massive pro ts

in the short run while creating new risks for the nancial system.Perhaps it will be something that Goldman Sachs pioneers, orsomething that is launched by one of the new boutique institutions.The one certainty is that Wall Street’s mind-set remains unchanged.Left unchecked, every rm will again overlook risk in hopes ofgaining a dominant market share in that new product The nancialsystem has been saved from destruction, but as long as the mind-set

of “chasing Goldman Sachs” lingers, it hasn’t been reformed

As the worst of the crisis recedes into the distance and Wall Streetbattles to return to business as usual, Goldman Sachs is once againthe rm that all its rivals want to emulate, at least when it comes tonancial performance As David Viniar, the rm’s chief nancial

o cer, told a reporter in 2009, “Our model never really changed”3;

by the end of 2009, Goldman was again rewarding its employeeswith one of the biggest bonus pools in its history and had returned

to reporting astronomically high earnings Once again, a relativelysmall proportion of those pro ts came from serving Main Street

small proportion of those pro ts came from serving Main Street.Wall Street is still oriented toward serving itself—its shareholdersand employees—and as long as that collective mind-set endures, werun the risk of another systemic shock.

There is no point sitting around and waiting for Wall Street toapologize to us, individually or collectively Nor can we contentourselves with the idea that bankers are twenty- rst-century cartoonvillains and demand that they get their just deserts It’s not evenreasonable for us to indulge in bouts of nostalgia for the bankingsystem of the past True, in hindsight, the 1960s look like a goldenage but we can’t just wipe out innovations such as high-speedtrading based on computer algorithms that didn’t exist then Norcan we force investment banks to return to the days when theyweren’t large publicly traded corporations but partnerships thatvalued long-term relationships over short-term quarterly pro ts Wecan’t turn back the clock to a time when hedge funds and privateequity funds were a tiny sideshow on Wall Street What we can andmust do is understand the way Wall Street functions today and try

to align that more closely with its special role in our economy andsociety

This book isn’t another anecdotal history of the subprime crisis of

2007 and 2008 Rather, it’s the tale of how Wall Street’smetamorphosis from a utility serving Main Street to a business thattook extraordinary risks to maximize its own pro ts at the expense

of that utility function set the stage for that crisis It’s an analysis ofwhere we stand today and where we need to go next—to a worldwhere, instead of blindly chasing Goldman Sachs in hopes ofreplicating its success, the players that make up Wall Street identifyways to emulate the strengths and avoid the aws that lie withinthe business model of Goldman Sachs and seek out their own paths

to success Above all, those strategies must be based on their owncompetitive strengths and be pursued in a way that doesn’tjeopardize Wall Street’s core utility function

The story is told through the eyes of those who lived it, such asTom Casson—the bankers, traders, research analysts, and investmentmanagers who have spent the bulk of their professional lives onWall Street Some of them can recall rsthand the events of the

Wall Street Some of them can recall rsthand the events of the1970s, when new technologies and new rules began to reshape theworld they inhabited It’s the story of how Wall Street came to beseen, even by one of its devotees, as an “abstraction.” With any luck,the next time Bernanke uses that phrase to describe the money grid,he’ll be met with howls of outrage.

* Here and throughout the book, a name followed by an asterisk is a pseudonym for a all Street professional Casson, as is true of many of his colleagues still working on Wall Street, does not have permission to speak openly to the press or book authors about what they see happening around them; while their CEOs do, it’s rare to nd them frank and forthcoming In cases such as that—where speaking openly and honestly about what individuals on Wall Street witnessed and experienced would have caused trouble for my sources with their employers or investors, and where simply using an anonymous source would have made following the narrative unnecessarily di cult for the reader—I have chosen instead to gives these sources a pseudonym In cases where that is done, their name is followed by an asterisk when they rst appear When senior Wall Street o cials declined to be quoted on the record for this book, I have not given them pseudonyms, but simply cited them and referred to their roles on the Street, but not their rms Reporting this book at the height of the crisis in the winter of 2008 and spring and early summer 2009 proved particularly challenging, as many of these individuals were focused on what was going to happen in the next twenty-four hours or the following week, not what happened in past decades or what might happen over the next decade “How can you ask us to predict that?” said Fred Joseph, former boss of junk-bond king Michael Milken, who went on to cofound a boutique investment bank but who, sadly, died in late 2009 “We can’t predict what we’ll have to deal with in a month or two, and how that will change our options.” This book re ects the views and thoughts of some two hundred individuals whose lives are tied to Wall Street in one way or another and who, like Joseph, made that effort.

PART I DANCING TO THE MUSIC

The nancial markets had begun to feel the rst shocks of what

The nancial markets had begun to feel the rst shocks of whatwould become the worst market earthquake since the GreatDepression when, in July 2007, then–Citigroup CEO Charles

“Chuck” Prince came up with an unusual metaphor to explain why

he and his team were forging ahead with business as usual, makingloans to private equity funds to help nance the increasinglygargantuan buyout deals the latter were trying to structure Sure, thecredit markets were rocky, raising fears among some marketparticipants that big banks like Citigroup—those that had been themost aggressive lenders to the LBO community and the biggestparticipants in the world of structured nance, marketingsecuritized products and derivatives to clients—would get stuckholding too many of those loans if there were no willing investors

to take them o their hands Prince, too, may have been worried,but he wasn’t going to show it Instead, he told the Financial Times,

“as long as the music is playing, you’ve got to get up and dance.”And, he added, Citigroup was “still dancing.”1

That music came to a sudden and discordant end only monthslater, by which time Prince himself had been ousted as the giantbank’s CEO Citigroup was still paying the price for his philosophyyears later In order to prevent collapse, the bank had to acceptgovernment bailout funds, a portion of which was later convertedinto stock that gave the federal government an ownership position

in Citigroup Write-downs produced a gargantuan loss—$27.7billion—in 2008; while the bank’s 2009 loss of $1.6 billion was alot smaller, it stood in stark contrast to the big pro ts being earned

by the likes of JPMorgan Chase and Goldman Sachs

How and why did one of Wall Street’s premier institutions end

up in such a pickle? The story of why Prince felt it necessary tokeep dancing as long as the music played is one that has its rootsback in the late 1960s and early 1970s, long before Citigroupexisted or Wall Street had ever heard of collateralized debtobligations, credit default swaps, multibillion-dollar buyout funds,

or any of the other instruments or players now often cited asculprits in the meltdown of the nancial markets The story of

culprits in the meltdown of the nancial markets The story ofCitigroup—both its rise and near collapse—hinges on the changes

to Wall Street’s very structure Without those transformations—some

of them slow and almost imperceptible; others, like the collapse ofthe 1933 Glass-Steagall Act mandating a strict separation betweeninvestment and commercial banking, grabbing headlines worldwide

—Wall Street could not have become as powerful a player in theU.S economy as it did Equally, it would not have endangered theentire money grid

During the opening session of the hearings of the Financial CrisisInquiry Commission (FCIC), Mike Mayo, a veteran banking analystand now a managing director at Calyon Securities (USA) Inc.,described Wall Street’s member rms as being “on the equivalent ofsteroids Performance was enhanced by excessive loan growth, loanrisk, securities yields, bank leverage and consumer leverage.… Side

e ects were ignored, and there was little short-term nancialincentive to slow down the process despite longer-term risks.” But

by the time the problems became so big that they began to nag atMayo and many of his colleagues during the rst decade of the newmillennium, the trends that had led to those problems had been inplace for decades As I’ll explain, the changes to Wall Street forcedits nancial institutions to rely on the most innovative and mostleveraged products it could devise, because those generated thegreatest pro ts Similarly, the needs of “insiders”—Wall Streetplayers like hedge funds and buyout funds—came to dominate theWall Street landscape As long as dancing to the music produced thepro ts that rms like Citigroup and its investors craved, they wouldcontinue to jig, two-step, or even produce a creditable Highlanding, if necessary The rst section of this book is the story of howthat ethos became central to the way Wall Street functioned

CHAPTER 1