Published February 23, 2011
A little more than a decade before Lehman Brothers' tragic implosion, the word from the firm's CEO, Richard Fuld, was unambiguous: "Add fiscal discipline to Lehman." Fuld said he didn't want Lehman to remain a one-trick pony that made its money bond trading during periodic market booms but lost tons of cash when its trading strategies failed, as they did in 1994, when crushing losses in the bond market nearly tanked the firm. He planned to grow more stable lines of business, like mergers and acquisitions, private equity, equity underwriting and asset management, and as such he needed more capital and much stronger credit ratings.
And that's what the firm's then-CFO, Brad Hintz, did -- or at least tried to do, as he began implementing Fuld's edict by ordering traders to begin pulling back on their risk taking. He had them slash "average leverage," or the amount they borrowed to finance their trades, which in good times inflates profits but when the markets turn sour can lead to crushing losses as it did in 1994. With that, Lehman's balance sheet became less risky and smaller. Traders made less money, but the firm itself was stronger and better able to withstand market swoons.
But reducing risk came at a cost for Hintz even as it was making Lehman stronger; the traders missed the good-old days of unlimited risk and the bonus checks it created. They began complaining to management that Hintz's controls were constraining Lehman's once-high-flying bond trading department, the economic engine of the firm.
The trading desks "asked for my head," Hintz recalls. And that's what they got. In July 1998, Lehman announced that Hintz was stepping down to go on "medical leave." He didn’t return to the firm, but risk-taking did, and the timing couldn’t have been worse. As the firm loaded up on leverage and risk taking, bond prices started to tank as fears mounted about whether Russia would continue to service its debt. What began as a hurricane centering on emerging markets debt soon spread to take out hedge fund Long-Term Capital Management, causing widespread losses among Wall Street firms that copied the hedge fund's trades.
For Lehman, it was a replay of 1994 -- but only worse; in September 1998, S&P placed the ratings of Lehman Brothers back on CreditWatch with negative implications, alerting the markets of Lehman's dire situation. The firm survived, but just barely, and only after the Federal Reserve and the US Treasury came to the rescue by cutting interest rates, thus flooding the markets with cash and liquidity.
Hintz learned a valuable lesson from his experience at Lehman: Wall Street has a short memory when it comes to the folly of excessive risk taking and that CFOs who impose risk controls are never popular. Nor do they have much job security. "The average lifespan of the last five Lehman CFOs was 540 days," he says.
In 2000, Hintz returned to Wall Street, joining Sanford C. Bernstein as an analyst covering the financial firms and as a new and ultimately more severe financial crisis began to sweep Wall Street in 2007 and 2008, he was among the first to issuing warnings about the problems his old firm would face. Hintz didn't predict that Lehman would fail in September 2008, the event that would touch off an implosion of the entire banking system, but his warnings about the firm's shaky funding base and risk controls proved prescient enough for institutional investors who consider him among the best analysts covering the banking industry.
Now, almost three years after the 2008 failure of Lehman and the massive federal bailout prevented the rest of Wall Street, including the mighty Goldman Sachs (GS) from following Dick Fuld’s firm into bankruptcy, the FOX Business Network sat down with Hintz to get his perspective on the new post-bailout Wall Street.
Q: What's the best run firm on the street?
Goldman Sachs. It’s derived from a partnership culture (before going public in 2000, Goldman was one of the last partnerships on Wall Street). You have 350 very bright minds working together as they do in a partnership and that is better than one bright CEO mind. The collective knowledge all of them keeps Goldman from making any major bad moves. We’ve seen the result of bad decisions at other firms.
Q: How would you rank the firm’s chairman and CEO, Lloyd Blankfein, and his No. 2, Gary Cohen?
I don’t know them that well. Goldman is a firm that avoided many of the problems of the crisis. Though it came out of the crisis to face a public relations blood-bath, Goldman remains Goldman, whether you like it or not, the most powerful firm on the Street. They addressed the regulatory issues (the SEC filed a civil fraud case against the firm that has since been settled). When you are the number one firm on the Street, they throw tomatoes at you.
Q: Should Goldman divide its chairman and CEO positions as they do at Morgan Stanley?
The chairman and CEO should be divided at every company because it provides a role for someone to act as the senior statesman and gives the CEO someone to directly report to. It also gives the board someone to discuss issues inside the firm who isn’t running the day-to-day aspects of firm. It’s good for corporate governance. So yes, I think they should.
Q: How poorly did Goldman Sachs handle the recent deal involving Facebook, where it appeared the firm was trying to circumvent regulators by offering shares to customers without actually going public, only to be forced to do the deal outside the US and away from their US clients because of concerns from the Securities and Exchange Commission?
Could they have done the deal in the U.S.? Technically, yes, but they made a belt and suspenders policy decision regarding legal risk, and having been in the SEC penalty box, they certainly didn’t want to go back in. Unfortunately, U.S. investors may not be happy about it but the deal got done (the private placement of shares valued Facebook at around $50 billion). In the end, Goldman is doing the right thing for Goldman and that is the Goldman way.
Q: Based on your research, you seem to like the most bailed-out bank on the Street, Citigroup (C) and its CEO, Vikram Pandit, who was running Citi during the bailouts. Why?
Citi is a bet on the emerging markets and I worked with Vikram for 10 years at Morgan Stanley (MS). He’s a brilliant strategist and one of the most capable managers I have ever been around.
Q: How about Goldman?
I would certainly buy Goldman because of its mergers and acquisitions business, equity underwriting, and merchant banking, M&A is up 25% year-to-date vs. last year-to-date. The equity underwriting business is booming. The merchant banking business is being done well.
Q: Same question for Morgan Stanley, JPMorgan and Bank of America?
Morgan Stanley – we are looking at a company that is revamping and restructuring. The payoff is the 2012, 2013 period. In JPMorgan (JPM), (CEO Jamie Dimon) has a very powerful firm, much more domestic firm than Citi. Vikram is rebounding because of a franchise that he has in the emerging markets. Jamie is rebounding because credit conditions are improving in the US. At certain times Citi will do very well, JPM will do well, as well. The U.S. economy is picking up at a slower rate than the emerging markets. (Editors Note: Hintz owns shares of Morgan Stanley.)
Q: How about Bank of America?
Bank of America (BAC) continues to have a number of legacy assets from the crisis, though Merrill Lynch will prove to be a great acquisition. The Merrill Wealth Management business (its massive brokerage operation that sells stocks to small investors) is the jewel in the crown. Merrill has the most productive advisers and the most affluent clients. With the wealth management business integrated into Bank of America, its private banking clients can get banking services ranging from credit cards and accounts to middle-market loans and mortgages. Merrill Lynch Wealth Management and Bank America may prove to be a business school case of successful cross marketing.
Unfortunately, Merrill Lynch is more than just the Wealth Management business. And when Bank of America acquired Merrill's institutional business it likely acquired a large ‘tail’ of underwriters liability related to Merrill’s unfortunate foray into (depressed housing debt). So, at this point Bank of America still does not know the full cost of the Merrill Lynch acquisition.
Q: As the Deutsche Boerse gets ready to complete its purchase of the New York Stock Exchange, explain the new competitive landscape among the various exchanges. As you know, the NYSE was forced to sell out because it was losing ground competitively. And now other exchanges may be in the same boat if this deal goes through. FOX Business was first to report that the Chicago Mercantile Exchange (CME) was considering a hostile bid to kill the deal along with the Nasdaq and the Intercontinental Exchange (ICE).
By merging the NYSE and DB, the managements of these firms will have established the leading European franchise in the trading of derivatives and equities. The merged company will be the world's largest exchange operator by revenue. It will be able to cut expenses. Moreover, because of its increased business scale, it can spread technology costs across more trades, thus boosting profit margins. And we expect that the new merged entity will eventually try to leverage its dominant European rate futures platform to wrest U.S. interest rate futures from the CME. Still, I don't think it forces any action from the CME because it has a commanding market share in U.S. futures volumes. It has 97-98% market share of North American interest rate volumes and 97% share of currency futures volumes, with the remainder belonging to ICE. It has 54% share of equity index futures volumes. Its pretax profit margins are over 50%.
CME is pursuing global growth through a number of joint ventures and partnerships. The CME has an excellent management team with a Washington savvy CEO who has carefully avoided the troubled cash equity market and the regulatory issues that come with it. We don't think the CME wants to enter the equity market.
ICE has stuck to its core business and it is clear that equities is not an area of the market that ICE is interested in. They have also indicated that they are much more focused on winning in targeted areas -- all nine of ICE's previous deals have been focused on derivatives. So an equity exchange linkup of any kind would be a real departure from a long established strategy. In terms of pure head-to-head competition for existing products, the NYSE-DB deal doesn't change the landscape much for ICE. That being said, ICE is a very desirable 'bite size' takeover target as the global roll-up of exchanges continues, with a highly profitable business mix. (Hintz owns shares of the CME and ICE.)
Q: How about the Nasdaq?
The Nasdaq is an equity exchange without a date for the prom. If it does nothing, it will find itself in a highly competitive technology intensive industry. But Nasdaq's options are limited due to its weaker balance sheet. We would anticipate that it will seek a partner in Asia or by joining with other exchanges. In any case, like the NYSE, any move by Nasdaq will not be made out of strength.
Q: Could there be another financial collapse?
Wall Street regulators and the rating agencies always fight the last war. After Drexel Burnham failed in 1990 the Street raised long-term debt and expanded its repo (short-term borrowing) business to provide a safe funding base for the industry. After the Mexican Peso crisis of 1994 the Street built its risk management systems to protect itself. (The 2007 and 2008 financial) crisis taught the Street that whole markets can become illiquid, that in a crisis every market is highly correlated and moves together and that a market crisis can last longer than any liquidity ‘cushion’. It taught regulators that all the major institutions are tied together. We are addressing all these issues. But there will always be cycles and only the Pope claims omniscience. The next crisis will come from something we haven’t anticipated yet.
Q: How would you rate the state of Wall Street now?
The Street is rebounding. M&A is back. Equity underwriting is back. Even the individual investor is returning to the market. The banks are learning to live in a world of more activist regulation. Its adjusting its business mix and its compensation costs to reflect higher capital charges. Markets are changing. Corporate governance is changing. And new competitors are appearing in capital markets; (private equity firms) KKR (Kohlberg Kravis & Roberts) , Blackstone, Gleacher, Jefferies, Knight, Citadel and Apollo. The banking boutiques such as Greenhill, Lazard and Evercore are thriving. And all these firms are expanding at the expense of the large banks. So although we analysts are all focusing our attention on JPM, Barclays, Goldman Sachs, Morgan Stanley and Credit Suisse, a new generation of the industry may be growing up under our noses.