The Battle for Wall Street E-Book

Richard Goldberg

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 379

Veröffentlichungsjahr: 2009

Beschreibung

An insider's look at the changing balance of power on Wall Street

The Battle for Wall Street follows the struggle for power between two giants: the sellers, traditional commercial and investments banks; and the buyers, upstart hedge funds, private equity firms and the like. The battle is about winning the hearts, minds, and – yes, the wallets – of global investors. This battle is still running its course, and with the insights of industry veteran Richard Goldberg, who has had a front row seat, readers will gain a detailed understanding as to what, exactly, is going on within this dynamic arena, specifically the forces behind the shift of power from the old sell side gatekeepers to the new buy side players.  The book will play out in three acts: Act One will examine the instruments of change – liquidity and financial technology – along with their influence on the sell and buy sides. Act Two will look at the agents of change – hedge funds, private equity, financial entrepreneurs, endowments, exchanges and sovereign wealth funds – and their impact on the sell and buy sides. In Act Three, Goldberg will take out his crystal ball and walk through the strategic implications for the winners and losers in this battle, against the dramatic backdrop of the subprime mortgage crisis and the resulting shakeup of global firms like Bear Stearns.

But Wall Street isn't simply about institutions or corporate battles. It’s a landscape dominated by personalities. Goldberg's unique access to major players will bring this book to life with amazing anecdotes and stories about the financial generals who have left their mark in The Battle for Wall Street.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Acknowledgements

Introduction

How the Battle Lines Were Drawn

The Generals Leading the Battle

The Battle Plan

Part One - INSTRUMENTS OF CHANGE

Chapter 1 - Sea of Liquidity

Overplaying Your Ammunition

The King

Long Live the King

Case Study: BlackRock—Liquidity as Friend

Case Study: AIG—Liquidity as Foe

Implications

Chapter 2 - Financial Information in a Digital Age

Broader, Cheaper, Faster

Both Sides of the Battlefield

Front-End Sale, Back-End Execution

Case Study: Michael R. Bloomberg—Democratization of Information

Research Goes Buy Side

Individual Investor Goes Buy Side

Case Study: Barclays—Ahead of the Curve in Financial Technology and Information

Case Study: Société Générale Group—Behind the Curve in Financial Technology and Information

Implications

Chapter 3 - Prime Brokerage Meeting Hall

That Was Then: Back-Office Money Machine

This Is Now: The Pendulum Shifts

Case Study: Deutsche Bank—The Accidental Prime Broker

Implications

Part Two - AGENTS OF CHANGE

Chapter 4 - Hedge Funds: Buy-Side Player, Sell-Side Foe

The Analysts Are Coming

2 and 20

Problem of Large Numbers

Case Study: Citadel Investment Group—The Demand Side of the Equation

Case Study: CalPERS—The Supply Side of the Equation

Implications

Chapter 5 - Private Equity: Buy-Side Player, Sell-Side Friend

Profitable Partnership

Liquidity and Leverage

Losing Old Ground, Gaining New Territories

Battle Lines Converge

The Lehman Incubator

Case Study: Blackstone—From Sell-Side M&A to Private Equity

Case Study: Fortress Investment Group—From Sell-Side Traders to Private Equity

Implications

Chapter 6 - Entrepreneurs to Endowments: Buy-Side Catalysts

Only the Buy Side Need Apply

Here Comes the Cavalry—The Entrepreneurs

Entrepreneurs Are Created, Not Born

Case Study: Lava Trading—Comprehensive Market Information

Case Study: Markit Group—Fair Value Pricing

Case Study: G-Trade—Electronic Execution

More Reinforcements—The Endowments

Implications

Chapter 7 - Exchanges: Sell-Side Voice, Buy-Side Electronics

Buy-Side Ally

One Man’s Vision of Exchanges

Electronic Version of Exchanges

Case Study: New York Stock Exchange—Voice, Domestic to Electronic, International

Implications

Chapter 8 - Sovereign Wealth Funds: Sell Side Today, Buy Side Tomorrow

A Powerhouse Player

Financial Institutions: Have Needs, Will Travel

Sovereign Wealth Funds: Have Advantages, Will Travel

Case Study: Citigroup—Can You Spare a Few Dollars?

Implications

Part Three - IMPLICATIONS OF CHANGE

Chapter 9 - Sell-Side Casualties, Buy-Side Implications

From Main Street to Wall Street

Three-Act Demise: Bear Stearns

Shotgun Wedding

Case Study: JPMorgan—Winning on the Battlefield

Case Study: Lehman Brothers—Falling on the Battlefield

Implications

Chapter 10 - Buy-Side Casualties, Sell-Side Implications

Cracks in the Buy-Side Dam

Future of the Buy-Side Dam

Case Study: Morgan Stanley—A Believer in the Buy Side

Case Study: D. E. Shaw—A Believer in the Sell Side

Implications

Chapter 11 - Regulatory Implications

The Blame Game

The Fall of the Rating Agencies

The Uneven Past

Undoing the Present

Implications

Chapter 12 - Future Implications

Financial System—Next Shoe to Drop

Sell-Side Commercial Banks—A New Battlefield

Sell-Side Investment Banks—A Reconfigured Battlefield

Buy Side—A Shifting Battlefield

The Bottom Line on the Battle

Notes

About the Author

Index

Copyright © 2009 by Richard Goldberg. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Goldberg, Richard (Richard S.)

The battle for Wall Street : behind the lines in the struggle that pushed an industry into turmoil / Richard Goldberg. p. cm. Includes bibliographical references and index.

eISBN : 978-0-470-44681-2

1. Investment advisors—United States. 2. Investments—United States. 3. Finance—United States. 4. Stock exchanges—NewYork (State)—NewYork. I. Title. HG4928.5.G65 2009 332.64’273—dc22 2008038662

To my wife, Jill, and my children, Brett and NikkiFor their love, encouragement and endless patience.

Acknowledgments

My ineffable gratitude to James Mossman, a brilliant tactician and a better friend, Michael Kraines, an instrumental colleague in bringing this book to life, and Ed Hajim and Bruce Wasserstein, the driving influences of my Wall Street career.

I will always be indebted to Dean John Coatsworth, Rob Garris and Katharine Morgan from Columbia University; Dean Andy Boynton, Edie Hotchkiss, and Hassan Tehranian from Boston College; and Edward Bayone from Brandeis University for making my dream of a “second act” come true.

My deepest appreciation to Kelly O’Connor, the hardest-working development editor; Dave Pugh, a reassuring senior editor; Stacey Fischkelta, a patient senior production editor; and Alan Horowitz and Neil Plakcy for their guidance in navigating me through the rocky terrain of pushing a book forward. Matthew Berninger, Jessica Hunt, and Christopher Kaminker also provided invaluable assistance in research.

I am humbled and inspired by Steve Begleiter, Buzzy Geduld, Jeff Lane, Greg Meredith, Ben Phillips, Lou Ricciardelli, Gary Talarico, Catherine Taylor, and Mark Utay for sharing their financial pearls of wisdom which substantially increased the book’s intellectual heft.

My loyalty and admiration to a cadre of friends who endured my obsessing over writing and rewriting this continually evolving drama: Ricardo Gomez Acebo, Reuben Auspitz, Joe Carson, Steve Feldman, Phil Friedman, David Goldhill, Matt Kissner, Barry Klein, Sherri Mahne, Bill Manning, Peter Marber, Jeff Silver, Joe Stein, and Joe Yurcik.

I would be remiss to exclude a special thanks to my wife, Jill, for being an invaluable set of eyes and ears, John Prior for his time and practical expertise, Chris Toro for her kind gestures, and Father James Woods for making the world a better place.

Finally, my parents and my in-laws instilled in me the value of a good education, specifically the importance of studying history and learning from it. To the above mentioned and many more, thank you for helping lead the charge of The Battle for Wall Street.

Introduction

Let the Battle for Wall Street Begin

The Battle for Wall Street.

I chose this phrase as the title for my book because, over the past two decades, a battle of major financial proportions has commenced on Wall Street, and as everyone is all too aware, it continues to rage as I write.

The battle is primarily between two giant armies—the buyers, whose soldiers come from such places as hedge funds; and the sellers, whose armed forces come from such places as hybrid commercial/ investment banks. In addition, other participants—like exchanges, sovereign wealth funds, endowment funds and financial entrepreneurs—have joined the battle along the way.

In 2008, the battle for the Street found its way into my classroom. Just as the rise of the free agent changed the game of baseball, the new roles that aspiring Wall Street types are interested in today are very different than the ones I used to play when I was firmly planted as an investment banker.

In class, I discuss the theories behind global markets and financial institutions, along with the practical applications I’ve learned during my 25-year career. I share personal anecdotes and war stories and try to narrate the excitement of a career spent on the front lines of finance.

My students, though, are interested in something else entirely—it’s as though I’m recounting tales of what it was like when the World Series was played during the daytime. However, all they care about is how the New York Yankees are financing their new stadium in 2009. They also wonder what the playing field will look like now that the credit crisis of 2007-2008 has forever altered the lay of the land.

They want to know what’s going on behind today’s headlines—not the traditional or new roles of investment bankers.

“Tell us about the buy side.Tell us about alternative asset managers, hedge funds and private equity groups,” they ask. “What’s happening to the stock exchanges? What’s up with sovereign wealth funds? Who are these financial entrepreneurs we’re seeing? Who’s going to survive the shakeout between the nimble and the flatfooted?”

My students want to know where the action is today, and where it will be tomorrow. Hmm, I wonder. Am I a dinosaur?

When I was sitting in their seats, my professors came from commercial banking. They, too, shared war stories and personal anecdotes. All I wanted to hear about, though, was investment banking, because that was grabbing headlines back then—and I could feel the action shifting in that direction. Did my professors, I wonder, feel like dinosaurs?

It’s not only the students who are feeling the ground shift under Wall Street. I recently spoke with a friend who told me about a retreat that a well-regarded sell-side bank held offsite, away from the clatter and hustle of the trading floor, for the members of its fixed income group. The topic? How a classic sell-side institution like theirs should respond to the rising clout of the hedge funds.

The sell side is seeing what the students are seeing: They’re feeling the action crossing over to the buy side. Not surprisingly, they’re searching for ways to respond. After all, they don’t want to turn into dinosaurs.

How the Battle Lines Were Drawn

This battle, of course, is about power. As the story unfolds, you’ll see that it’s also about winning the hearts, minds, and—yes, the wallets—of the investment community.

For many years—one could say hundreds of years—the sell side held most of the power. Whether you were an individual investor or a major institution, what you knew about the market was largely limited to what the sell side told you.

If, as an individual, you wanted to know the price of a stock or corporate bond—or the direction the market was headed—you asked your broker.You only knew what your broker told you.

If you were a corporate executive considering taking your company public, you consulted with investment bankers, who advised you on what to expect from the market.

What buyers knew came largely, if not entirely, from what sellers told them—they had limited access to independent information.

Sellers created markets, made markets, controlled access to markets, controlled information about markets and largely managed markets. Buyers were participants with limited power or influence—or none at all.

And information wasn’t the only thing in limited supply to the buy side—so was access to money. The market’s liquidity came largely from the sell side. Money—capital—mainly flowed from the spigots of commercial and investment banks.

For a long time, that was just the way things worked.The sell side had the advantage. And then everything began to change. Like so many other revolutions, this change was partly due to technology, which has played a key role in leveling the playing field between the buy and sell sides.

For the first time, buyers, through their computer screens, could see who was making markets and at what prices. All of a sudden, they had access to more information than ever before. Over time, the gatekeepers of information, the sell side, lost much of their power. Others were providing large amounts of data—the very thing that had given them the upper hand for so long.

Technology also put the power of computation at the buy side’s fingertips. Complex algorithmic analyses that looked for exploitable anomalies within the market became possible as computers became more powerful, software become more sophisticated, users became more knowledgeable and the cost of both hardware and software fell.

Another element added to the Wall Street landscape is an over-abundance of green. Money has always been floating up and down the Street, and has always been the key ingredient in the mix. But what I’m referring to here is liquidity: the availability of money, and lots of it.

In the last 10 years, there was more money available to Wall Street’s players than ever before. It used to be that the mention of “a few billion dollars” was a tip-off that something important was being discussed. Over the past five years, however, you heard conversations about tens of billions of dollars. In fact, when discussing how much hedge funds have grown in recent years, people started talking about trillions.

The money available to play with grew as dramatically as the increase in the availability of sand from a backyard sandbox to the beach. It was all sand—and all money—but the increase in scale changed the way the game was being played.

Borrowers could tap into pools of liquidity—from pensions, endowments, wealthy individuals, banks, and, yes, electronic versions of exchanges—that were either nonexistent or largely inaccessible in the past.

And as the pools of liquidity expanded in number and size, more and more wealth was created, which just increased the amount of liquidity even more.This circularity fed on itself.

As we’ve seen during the credit crisis, we are currently in a different part of the liquidity cycle. While there is still money available, those who have it are currently less likely to lend it or will lend it on terms that the borrowers would have turned their backs on not so long ago—witness Warren Buffett’s $5 billion investment in Goldman Sachs in September 2008. While Goldman was no doubt happy to have the cash infusion, it obtained it at a hefty cost. As Oppenheimer analyst Meredith Whitney said in a report to clients: “ . . . the terms of this deal seem exorbitantly expensive and provide insight into how truly challenging current market conditions are.”1

The increase in pools of liquidity caused the rise of new asset classes. Mutual funds may have seemed exotic in the 1960s and 1970s, but by the 1990s they were fully mainstream and quite ho-hum.

The buy side, always aggressive when looking for an edge against the sell side, created new asset classes, including hedge funds and other alternative management funds. The sell side, however, was slow on the draw. The buy side got the jump, an advantage it holds to this day.

With the evolution of asset classes, more new players entered the scene: university endowments and public pension funds. For years, these funds had been relatively small and were run by civil servants. Rare was the university with $1 billion; $100 million seemed like the pot of gold at the end of the rainbow.

Today, the folks running these funds have become a professional match for anyone on Wall Street. And in addition to brains and sophistication, they have more money than ever. For example, at the end of fiscal 2007, Yale’s endowment had $22 billion in the till2—and there are other funds, like the California Public Employees’ Retirement System (CalPERS)—with much, much more. As of September 2008, CalPERS had $223 billion in assets.3 That’s big money—and big power—by any definition.

These pensions and endowments boosted their returns by investing in buy-side asset classes like hedge funds and private equity firms—something unheard of 20 years ago. The shift toward these unconventional asset classes helped fuel their growth and their wealth. In turn, they fueled the growth of the buy side on one hand, while the sell side had to do battle with them on the other.

Sovereign wealth funds represent another new player shaking up the financial landscape. These funds, such as the Abu Dhabi Investment Authority, are pools of liquidity from a country’s reserves, and they poured money into institutions that found themselves in need of a capital lifeline.When those folks needed a life preserver, who did they call? 1-800-SOVEREIGN-WEALTH-FUNDS.

And I’m not talking about little known, mom-and-pop type institutions that sometimes need a lifeline, but some of the biggest names on Wall Street, including Citigroup, Morgan Stanley, and UBS. Out of seemingly nowhere, sovereign wealth funds have taken a seat at the financial power table.

As the credit crisis has unfolded, we’ve seen the resurgence of another financial power broker—the Japanese sell-side institutions. Ironically, they weren’t involved with the risky asset classes of the 2000s because they were navigating through their country’s own financial crisis during the 1990s.

While these liquidity players were entering the battlefield, the sell side didn’t exactly sit around waiting to be ambushed. While many of the advantages of the Battle for Wall Street have gone to the buy side, the sell side has developed weapons of its own. Prime brokerage and private equity/company buyout financing are examples of how the sell side has provided services to the buy side and profited nicely as a result.

But the sell side has met with mixed results. In 2007-2008, turmoil has been embroiling Wall Street. I’m referring, of course, to the subprime mortgage crisis and the resulting credit crunch, the likes of which hasn’t been seen since the 1930s. In March 2008, Bear Stearns, one of Wall Street’s mainstays, quickly disappeared into the hands of JPMorgan.

It wasn’t just the credit crunch that brought down Bear Stearns; the firm also collapsed due to the weight of its own internal hedge funds, and its reliance on external hedge fund clients. This 85-year-old firm sunk in heavy seas as quickly and completely as a freighter could in a perfect storm: here one minute and totally gone from sight the next, as it drifts downward through the water to a deep, invisible, grave.

Of course, we now know that it was only the first of several major financial freighters to go down or be tossed about in heavy seas. In the fateful months of September and October 2008, the credit crisis escalated to the point where the financial markets capsized, having disastrous effects on three sell-side sectors.

In the investment banking sector, four principal U.S.-based investment banks were meaningfully affected. Lehman Brothers went out of business; Merrill Lynch had little choice but to fall into the arms of Bank of America; and Goldman Sachs and Morgan Stanley were reorganized into bank holding companies in order to weather the crisis.

In the insurance sector, giant AIG required an approximately $85 billion federal bailout; and in the depository sector,Washington Mutual and Wachovia stumbled into the hands of JPMorgan and Wells Fargo, respectively.

As the financial sector was faltering, the U.S. government joined the battle. Congress approved an unprecedented multibillion-dollar bailout of the financial industry in late 2008, aiming to loosen up credit markets that had tightened up severely as the cascade of bad news unfolded.

Casualties in the Battle for Wall Street suddenly became heavier than anyone had imagined.

The Generals Leading the Battle

While I’ve been talking about liquidity, technology, and asset classes, the driving force behind any firm or community is its people.

Therefore, throughout this book, I discuss many of those who have left their mark in the Battle for Wall Street. Some are entrepreneurs who have created electronic markets or information technology or other products or services that have helped change the balance of power on the Street. Others lead firms that were influential or otherwise important to the development of the financial community. As with military battles, where generals play key roles in the outcomes, Wall Street is filled with individuals who play essential roles.You’ll meet a number of these folks during the course of this book, and in particular in the case studies that I include in each chapter.

On the sell side, I would liken these executives to nine position players in baseball, who pitch and hit all the time.

On the buy side, I would compare them to designated hitters, waiting for their pitch and driving the ball.

The Battle Plan

Neither side is capable of a New York Yankees-worthy dynasty (or, in my particular case, a Boston Red Sox-style dynasty), which is why I think this book is so timely. This is not a history book. It is a book about the wrestling for power that is going on today and likely to continue for some time to come.

Join me as we travel through the ever-shifting, always tumultuous world of Wall Street. We’ll track the forces that have swept through this terrain, from rivers of liquidity to crashing waves of risk. We’ll gaze out over the rocky cliffs of the credit crisis of 2007-2008 and visit the uncharted territory staked out by entrepreneurs. As our compass leads us from the sell side to the buy side, from the past to the future, we’ll draw a comprehensive map of the Wall Street landscape and drill down to the bottom line of each battle. And at the end of each chapter, I will discuss the implications of each battle as well as declare which side seems to be gloriously winning.

So buckle your seat belts and get ready for an insider’s journey—you’re about to watch the Battle for Wall Street unfold.

Part One

INSTRUMENTS OF CHANGE

Chapter 1

Sea of Liquidity

Can you have too much money, so much that you spend it unwisely? Can having less money give you a competitive advantage over those with more?

I think the answer to these questions is “definitely yes.” And before you tell me that I’m crazy, I’ll explain. No, I’m not turning in my Wall Street name tag just yet and taking a vow of poverty.

It’s just that money, in the form of the sell side’s balance sheet and liquidity, can make the sell side act in ways that are open to debate.

One of the strengths of the sell side has been its lofty liquidity position, specifically its access to capital. That’s why the buy side has made many withdrawals from the sell side’s ATM since traders and speculators first negotiated a truce they called the Buttonwood Agreement, which laid the groundwork for the New York Stock Exchange.

The sell side readily financed the needs of the buy side because it enjoyed the transaction fees it was getting in return. What it didn’t fully realize was that it was supercharging the buy side’s growth by providing it with the deadliest weapon—liquidity.With liquidity as their ammunition, hedge funds and private equity funds became formidable competitors.

It was as though the sell side was providing weapons to the buy side, which the buy side used to its advantage to propel its growth. It was a battle the sell side didn’t quite realize it was entering. Today, it’s too late for the sell side to do anything about it—except play its own hand while emulating its progeny.

I saw the sell side from a front-row seat, and a question pops up. Did it act downright “liquidity silly” during the rise of the buy side? If you want to understand the Battle for Wall Street, liquidity is a good place to start.

Overplaying Your Ammunition

The summer of 2000 was filled with news about the presidential election as well as some heavy-hitting stories about sell-side firms merging with each other: UBS merged with Paine Webber;1 JPMorgan merged with Chase;2 and AXA Financial sold its majority stake in Donaldson, Lufkin & Jenrette (DLJ) to Credit Suisse.3 These skirmishes within the larger Battle for Wall Street demonstrated sell-siders duking it out amongst themselves.

These deals filled not only the airwaves, but also the hallways of my old firm.We were involved particularly with AXA, which sold its majority stake in DLJ to Credit Suisse—a timely move, by my calculation.4 By divesting itself of DLJ (which was a major sell-side player), AXA got out of one meaningful sell-side business just as the buy side was starting its ascendancy. It wisely decided to shift its focus toward the buy side.

A few months after AXA sold DLJ, it acquired Sanford Bernstein, a major money management firm, which it subsequently combined with its existing Alliance Capital Management.5 Today, Alliance Bernstein is a major player in the buy-side business of money management.

Looking back at the Credit Suisse/DLJ transaction today, it paid about $13.7 billion for . . . what?6

That transaction—any transaction—is debatable. On one hand, Credit Suisse acquired a number of quality businesses. Three come to mind: a leverage finance business (funding companies with a greater-than-normal debt-to-equity ratio)7 ; a high-yield bond business (offering bonds rated below investment grade)8; and a merchant bank (providing investment bank services to multinational corporations).9

On the other hand, a good deal of what is bought on Wall Street is talent: the human capital at the firms being acquired.Yet, some of the talent Credit Suisse set out to acquire—the people who were part of the DLJ franchise—left after the merger.

And where did they go? A healthy number went to the buy side. After all, the size of a combined organization like Credit Suisse/DLJ may not have been a selling point. Two primary benefits offered by a big organization like Credit Suisse—technology and liquidity—were becoming more available to the buy side just as Credit Suisse was plunking down its billions.

Whereas the AXA buy-side expansion in the early 2000s was timely, the Credit Suisse/DLJ timing in 2000 may have been off from both a technology and a liquidity angle.

Technology was becoming less expensive and more powerful, and the information that could be gleaned from it was better and broader. One of the edges that investment bankers had—information—was being eroded by the technology, which made that information much more readily accessible. (I’ll cover this explosion in technology in the next chapter. Actually, explosion is an understatement—it was more like a line of cannons blasting its way through a crumbling Maginot line.)

And the buy side was building up its liquidity. While the sell side still had an edge, it was quickly being eroded. The folks at the investment banks saw this happening and were heading for the doors. Those investment bankers who stayed home saw that the sell side had more liquidity than it could usefully deploy.

A quote that is often attributed to Wallis Simpson, Duchess of Windsor, says, “You can never be too rich or too thin.” I don’t know about the thin part, but I believe you can be too rich, and it is possible that the sell side was in this position, to its detriment.

For example, did NationsBank (now Bank of America) and General Electric overplay their balance-sheet and liquidity positions in acquiring sell-side firms? NationsBank bought Montgomery Securities,10 while General Electric bought Kidder Peabody.11 Today, both sell-side firms are history.

Let’s look at the sell side’s misusing its liquidity to win business.When giving advice on mergers and acquisitions or capital markets, a number of firms tend to give away liquidity as well. They do this by telling a prospective customer that, if hired to manage a deal, they will provide more attractive funding as well.

The buy side, however, doesn’t get involved with those types of deals. It doesn’t finance its customers, and can be smarter with decisions regarding its use of capital. As such, it can avoid this liquidity trap.

Bottom Line

In the liquidity race, the sell side should be a step ahead of the buy side, but recently it does not seem to be using this benefit to its advantage. When it stretches the liquidity band and/or the balance-sheet band, and tries to overreach for, say, market share or earnings, either band can snap back. When it does, the sell side stumbles; it falls a step behind the buy side.

I call that a fall from grace.

The King

There is an aphorism in the business world that has become so widely used that it’s now a cliché: “Cash is king.”

While this phrase may sound trite, no one I know on Wall Street disputes its accuracy or relevance. Cash, or should I say capital, is the lifeblood of every business. A company’s growth, even survival, depends on it. This is one of the primary reasons that the sell side was the king of the financial world for so many years: It provided corporations with windows on capital or—to use the more technical term—liquidity.

Liquidity

“Liquidity, in the financial sense, is a measure of the ease with which one asset can be traded for another. Land . . . is usually considered the least liquid of investments. Alternatively, cash is the most liquid.”

Source: John Steele Gordon, The Great Game. New York: Scribner, 1999, p. 186.

Companies are always keen for fresh capital to increase their profits and, ultimately, their valuation—whether it’s their stock price (if they’re publicly traded) or their franchise value (if they’re privately held).

For a long time, it was impossible for companies to go directly to investors for capital because investors were often fragmented and scattered. Sell-side bankers justified their fees, in part, by being the ones who could coax money from investors, gather it all in one place, and make it available to corporations. They were like the generals of mercenary armies, able to bring together men and materiel—for a price. These investment banking generals are navigating through a very different battlefield in 2008, which I will cover later in the book.

They could have said, “We have the sales relationships, we know where those with money are located, we know who likes to invest in autos or aerospace or technology or whichever industry you are in, and we alone have the wherewithal to make your deal happen.”

The investment bankers of the sell side held the keys to the vault—always a good position to be in. In this vault was access to the public and private markets, as well as the sell side’s own capital, which the sell side used to create liquidity that, in turn, was used to hold sway over the buy side.

And these investment bankers had—and have—additional powers at their command. The brains, brawn, and capital to create secondary markets were theirs. They knew, better than anyone else, which investors held which stocks and bonds, and they had relationships with many of them.They understood the markets best, had the skills needed to value companies, and knew how various types of issues were traded. They had the sophistication and institutional structure required to raise money for virtually every type of company, using any type of asset class.

Hedge Fund

“An aggressively managed portfolio of investments that uses advanced investment strategies such as leverage, long, short, and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).”

Source: Investopedia, www.investopedia.com/terms/h/hedgefund.asp.

Sounds good, right? Wrong. And we can thank liquidity for that.

In this Battle for Wall Street, liquidity has played a major role. Historically, the sell side was a bridge to investors’ capital. But with greater liquidity, the buy side has been able to gather an investor capital base that was unthinkable in the past.

For example, a half dozen guys could set up shop in Greenwich, Manhattan, or wherever, pull out their electronic Rolodexes, make some calls to moneyed folk they know, and raise hundreds of millions of dollars or more to start a hedge fund. Not that long ago, such an enterprise would have been impossible.

What was also at one time unthinkable—explosive hedge fund growth—is today a fact. In the last 20 years, the number of hedge funds has grown from 100 to approximately 10,000, and their assets under management have gone from $20 billion to several trillion dollars. 12 That’s a lot of hedge funds and a lot of assets; thank you, liquidity.

As an example of how active—and important—hedge funds have become, there was a time when investment bankers, underwriting securities, refused to allocate part of their offerings to hedge funds because these funds were considered to be hot money, “flippers,” rather than long-term players. Today, the investment bankers are singing a different tune: one of their first phone calls is to the hedge funds.

Bottom Line

The rise of hedge funds to their current pinnacle of prominence is due, in part, to the expansion of liquidity and the buy side’s embrace of it, as well as its ability to use it to its advantage. There’s more to liquidity than just the rise of hedge funds.

Long Live the King

Liquidity creates progeny. Collateralized mortgage obligations (CMOs) are an example. Before CMOs, commercial banks typically handled mortgages. Now, mortgages are sliced and diced into tranches (single stages within a series of staged investments) based on different risk and yield levels.This has had the effect of increasing the variety of risks and yields associated with mortgage investing.13

These new levels led to an expanded number of investors. More investors means more money, which increases liquidity. We’re dealing with circularity here: Liquidity creates new products, and new products create more liquidity.

A second example of liquidity is dark pools. They match buyers and sellers in ways where neither knows the other’s identity. This creates liquidity where it previously didn’t exist. Investors are more willing to become players when they have the shield of anonymity—and the more players, the more liquidity.

Is the expansion of liquidity seen in the past decade or so likely to continue? Well, liquidity has always waxed and waned to some degree.

Dark Pools

“A slang term that refers to the trading volume created from institutional orders, which are unavailable to the public.The bulk of dark pool liquidity is represented by block trades facilitated away from the central exchanges. Also referred to as the ‘upstairs market.’The dark pool gets its name because details of these trades are concealed from the public, clouding the transactions like murky water. Some traders that use a strategy based on liquidity feel that dark pool liquidity should be publicized.”

Source: Investopedia, www.investopedia.com/terms/d/dark_pool_liquidity.asp.

During my career, I’ve seen liquidity go through various cycles. The 1980s had a lot of it, until the stock market crash of October 1987, when liquidity contracted. It recovered, only to be sent into a reversal with the start of the first Gulf War in 1990, when it again went into a restrained mode. It loosened up again, and for the rest of the 1990s, liquidity was quite plentiful. But when the Internet bubble burst in 2000, liquidity went into a contraction phase again, then returned to an expansionary track until the credit meltdown of 2007.

That’s one too many liquidity downturns for an old-timer like me.

Bottom Line

The credit crunch of 2007-2008 showed that liquidity can contract dramatically and swiftly. But, because of the factors I’ve cited above, I have to say that the expansion of liquidity is permanent.

The globalization of the world economy has made it dramatically easier for investors around the world to get in the game.The more participants, the more money floats around, looking for investments to latch onto. This new army of investors is opening the battle to many new fronts.

Case Study: BlackRock—Liquidity as Friend

In 1988, a sell-sider named Larry Fink cofounded a management firm called Blackstone Financial, now called BlackRock. At First Boston (now Credit Suisse), Fink was instrumental in the development of mortgage-backed securities, which were sold to investors. Understanding the value proposition of these securities, he crossed the Street, became a buy-sider, and marketed these securities directly to investors.

Fink also has an eye for human talent, and the BlackRock team that joined him was like the roster of baseball’s annual All-Star game—superstars, every one of them.

Back in 1988, where did that All-Star team come from? One place was Fink’s former sell-side firm. One of them was Rob Kapito from the mortgage trading desk.14 When Fink told Kapito he was leaving Credit Suisse (and had not yet asked Kapito to join his team), Kapito reportedly asked, “Where are we going?” That’s trust. Also on the team was Barbara Novick15 from structured products, and Ben Golub,16 who recognized early the importance of financial technology. One of the keys to BlackRock’s success is that, 20 years later as I write this book, all of these stars are still working alongside Fink.

Closed End Fund

“A fund that has a fixed amount of shares outstanding, unlike mutual funds, which are open-ended (allow new shares to be purchased). Closed-end funds behave more like stocks because they trade on an exchange and the price is determined by market demand after an initial public offering process. Closed-end funds can trade below their net asset value or above it.”

Source:http://mutualfunds.about.com/od/glossaries/g/closed_end.htm

In addition, some members of the original BlackRock team hailed from the sell-side firm Lehman Brothers. (I will discuss a few of those All-Stars later in the book.)

Keep in mind that, when it opened for business in 1988, BlackRock had no assets and no buy-side track record to speak of. Fink and his team went to the sell side to raise investor capital—assets under management—in the form of closed-end funds.

The investment bankers, always hungry for fees, agreed to underwrite a fund for Fink. And then a second fund. And then a third. And more.

Instead of the sell side’s salespeople selling, say, IBM to their customers, they sold the BlackRock family of investment funds. It was a classic case of the buy side’s leveraging the sell side’s liquidity—access to financial markets—to fuel its growth.

All of this was for one asset class: fixed-income mortgages.17 Fink and his team understood the product and the technology behind it—but also understood the value of the sell side.

The result? As of December 31, 2007, BlackRock had over $1.3 trillion in assets under management.18 That’s a lot of money by any definition. I would say that BlackRock’s success is one of Wall Street’s great stories.

Interestingly, the sell side—namely, Merrill Lynch, now owned by Bank of America—sold its disappointing money management business (Merrill Lynch Investment Management) to BlackRock, in return for a 49 percent interest in the combined entity.19 As I write this, the BlackRock investment is one of the truly bright spots in Merrill’s portfolio.

The sell side, Merrill, looking to the buy side, BlackRock, as a partner for investment performance and returns? That’s not the Wall Street I joined in the early 1980s.

Case Study: AIG—Liquidity as Foe

Before the credit crunch of 2007-2008, who would have thought the insurance giant AIG would face liquidity issues? Who would have imagined that given its size (market capitalization of $180 billion), AIG would fall under the knife of the mortgage debacle?

Credit Default Swap

“A swap designed to transfer the credit exposure of fixed-income products between parties.The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the creditworthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed-income security to the seller of the swap.”

Source: Investopedia, www.investopedia.com/terms/c/creditdefaultswap.asp.

But fall they did. They fell into the hands of the U.S. government.

In September 2008, after severe losses and liquidity issues that drove it to the brink of collapse, AIG accepted a federal bailout that would give the company an approximately $85 billion line of credit, and would give the government about an 80 percent equity stake in AIG .20

Why did the Federal Reserve (Fed) step up with a lifeline?

The Fed determined a disorderly failure of AIG could create havoc in the global financial markets. To prevent this chaos and ensure an orderly process, the Fed provided a loan to cover AIG’s liquidity needs until the company could sell enough assets to fill its capital hole.

Why was AIG in this precarious capital position?

AIG was a provider of insurance guarantees on risky credit default swaps tied to the mortgage market. As the credit crisis of 2007-2008 intensified, AIG was caught in a liquidity death spiral.Those spiraling actions played out like this: AIG went one way on credit default swaps, and with the subprime crisis raging, the market went the other way. Not a good scenario for AIG.

As the credit crisis intensified, AIG incurred write-downs and losses. As a result, Moody’s and Standard & Poor’s (S&P) downgraded the company’s credit ratings. Those credit reductions triggered collateral calls, and AIG was forced to post more capital.

Collateral Call

“Collateral is assets provided to secure an obligation.

A more recent development is collateralization arrangements used to secure repo, securities lending, and derivatives transactions.

“Under such arrangement, a party who owes an obligation to another party posts collateral—typically consisting of cash or securities—to secure the obligation. In the event that the party defaults on the obligation, the secured party may seize the collateral. In this context, collateral is sometimes called margin.

“In a typical collateral arrangement, the secured obligation is periodically marked-to-market, and the collateral is adjusted to reflect changes in value.”

Source:www.riskglossary.com/link/collateral.htm.

At this point, counterparties (the other parties to these financial transactions) did not want to take AIG’s risk. They wanted capital. AIG did not have the capital and could not get access to capital in time to offset the impairment of their assets.They had a severe liquidity issue.

Over its fateful last two weeks as an independent company, AIG’s capital issues grew geometrically. According to an industry observer, during that time, AIG’s capital requirements skyrocketed to the tune of tens of billions of dollars.

Why didn’t AIG—an insurance company—recognize the probability of blowing up if the rating agencies downgraded them from AAA to A (S&P) and AAA to A2 (Moody’s)?

I would suspect the answer is that they predicted the probability of a credit downgrade was a low event. But why take even a minimal chance, knowing that it could lead to catastrophic risk?

That risk took their stock down from dinner for two ($70 a share) to less than a Manhattan subway token ($1.50 a share).

The AIG story is rife with ironies. First, the company turned to the Fed after unsuccessful negotiations with the one and only Warren Buffett of Berkshire Hathaway21—the same Warren Buffett who invested in Goldman Sachs and General Electric at the height of the credit crisis of 2007-2008. As I write this book, Buffett may still be interested in “in acquiring a couple of AIG’s assets depending on what the company was willing to sell.”22

The second irony is that has been reported that the former AIG chief executive, Maurice Greenberg, would like the chance to bid on the assets that are going to be sold as AIG repays its multibillion-dollar bailout loan from the federal government.23

The third irony is that going into the credit crisis, AIG was the world’s largest insurer. The AIG left standing at the end of the credit crisis will not be the same—it will be significantly smaller.

AIG—and for that matter, any financial institution falling on the battlefield during the credit crisis—is victim to the bullet called liquidity.

Implications

As I write this, a debate is going on over liquidity. Financing of commercial deals has pretty much come to a stop. Commercial lending has shriveled up. So is the credit crisis due to a lack of liquidity or because the credit window has virtually closed for the time being? This makes for an interesting debate in financial war rooms.

I would suggest it is because the credit window has closed for the time being. To illustrate my point, look no further than at a number of sell-side players, who in early 2008 had aggregate balance-sheet write-downs of approximately $85 billion.24 Yet, in less than six months, virtually all of it had been replaced by raising new capital. Before the growth in liquidity, making up that sort of loss would have taken years. In the early stages of the subprime crisis, it could be done in a matter of months. In battle terms, this was a definite win for the sell-side team.

Most of the money came from players who, in the last half of the 2000s, became large enough to make a difference—sovereign wealth funds (foreign-owned investment entities). In the first part of 2008, we saw how much liquidity was available and how readily financial firms could get their hands on it. That much liquidity—and that kind of access to it—was new.

Shutting down the credit window, for the most part, has led to shocks within the system. Management and shareholders alike have to ask if the best and brightest on Wall Street really know what they’re doing. Do they understand the instruments they’ve created? Do they have proper management systems in place? Do they understand the risks involved?

As we know, history repeats itself. We’ve had liquidity and credit crises before. In the 1980s, Japanese banks went crazy buying things, while the Nikkei average dropped about 65 percent during the 1990s, as a result.25 Too much liquidity led to silly decisions, which led to a major fall. Sound familiar? Who would have imagined that too much liquidity could be your enemy?