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    Chasing Goldman Sachs by Suzanne McGee - Excerpt

    Written by

    Suzanne McGee
    You know what happened during the financial crisis … now it is time to understand why the financial system came so close to falling over the edge of the abyss and why it could happen again. Wall Street has been saved, but it hasn’t been reformed. What is the problem? Suzanne McGee provides a penetrating look at the forces that transformed Wall Street from its traditional role as a capital-generating and economy-boosting engine into a behemoth operating with only its own short-term interests in mind and with reckless disregard for the broader financial system and those who relied on that system for their well being and prosperity. Primary among these influences was “Goldman Sachs envy”: the self-delusion on the part of Richard Fuld of Lehman Brothers, Stanley O’Neil of Merrill Lynch, and other power brokers (egged on by their shareholders) that taking more risk would enable their companies to make even more money than Goldman Sachs. Through probing analysis, meticulous research, and dozens of interviews with the bankers, traders, research analysts, and investment managers who have been on the front lines of financial booms and busts, McGee provides a practical understanding of our financial “utility,” and how it touches everyone directly as an investor and indirectly through the power—capital—that makes the economy work. To read more about Chasing Goldman Sachs and Suzanne McGee please visit Random House at www.randomhouse.com.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd

    Chasing Goldman Sachs by Suzanne McGee - Excerpt

    Written by

    Suzanne McGee
    2K views66 pages
    You know what happened during the financial crisis … now it is time to understand why the financial system came so close to falling over the edge of the abyss and why it could happen again. Wall Street has been saved, but it hasn’t been reformed. What is the problem? Suzanne McGee provides a penetrating look at the forces that transformed Wall Street from its traditional role as a capital-generating and economy-boosting engine into a behemoth operating with only its own short-term interests in mind and with reckless disregard for the broader financial system and those who relied on that system for their well being and prosperity. Primary among these influences was “Goldman Sachs envy”: the self-delusion on the part of Richard Fuld of Lehman Brothers, Stanley O’Neil of Merrill Lynch, and other power brokers (egged on by their shareholders) that taking more risk would enable their companies to make even more money than Goldman Sachs. Through probing analysis, meticulous research, and dozens of interviews with the bankers, traders, research analysts, and investment managers who have been on the front lines of financial booms and busts, McGee provides a practical understanding of our financial “utility,” and how it touches everyone directly as an investor and indirectly through the power—capital—that makes the economy work. To read more about Chasing Goldman Sachs and Suzanne McGee please visit Random House at www.randomhouse.com.

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    You know what happened during the financial crisis … now it is time to understand why the financial system came so close to falling over the edge of the abyss and why it could happen again. Wall Street has been saved, but it hasn’t been reformed. What is the problem? Suzanne McGee provides a penetrating look at the forces that transformed Wall Street from its traditional role as a capital-generating and economy-boosting engine into a behemoth operating with only its own short-term interests in mind and with reckless disregard for the broader financial system and those who relied on that system for their well being and prosperity. Primary among these influences was “Goldman Sachs envy”: the self-delusion on the part of Richard Fuld of Lehman Brothers, Stanley O’Neil of Merrill Lynch, and other power brokers (egged on by their shareholders) that taking more risk would enable their companies to make even more money than Goldman Sachs. Through probing analysis, meticulous research, and dozens of interviews with the bankers, traders, research analysts, and investment managers who have been on the front lines of financial booms and busts, McGee provides a practical understanding of our financial “utility,” and how it touches everyone directly as an investor and indirectly through the power—capital—that makes the economy work. To read more about Chasing Goldman Sachs and Suzanne McGee please visit Random House at www.randomhouse.com.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    2K views66 pages

    Chasing Goldman Sachs by Suzanne McGee - Excerpt

    Written by

    Suzanne McGee
    You know what happened during the financial crisis … now it is time to understand why the financial system came so close to falling over the edge of the abyss and why it could happen again. Wall Street has been saved, but it hasn’t been reformed. What is the problem? Suzanne McGee provides a penetrating look at the forces that transformed Wall Street from its traditional role as a capital-generating and economy-boosting engine into a behemoth operating with only its own short-term interests in mind and with reckless disregard for the broader financial system and those who relied on that system for their well being and prosperity. Primary among these influences was “Goldman Sachs envy”: the self-delusion on the part of Richard Fuld of Lehman Brothers, Stanley O’Neil of Merrill Lynch, and other power brokers (egged on by their shareholders) that taking more risk would enable their companies to make even more money than Goldman Sachs. Through probing analysis, meticulous research, and dozens of interviews with the bankers, traders, research analysts, and investment managers who have been on the front lines of financial booms and busts, McGee provides a practical understanding of our financial “utility,” and how it touches everyone directly as an investor and indirectly through the power—capital—that makes the economy work. To read more about Chasing Goldman Sachs and Suzanne McGee please visit Random House at www.randomhouse.com.

    Copyright:

    © All Rights Reserved
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    of 66

    —CHASING—

    GOLDMAN
    SACHS
    HOW THE MASTERS OF THE UNIVERSE

    MELTED WALL STREET DOWN . . . AND WHY

    THEY’LL TAKE US TO THE BRINK AGAIN

    Suzanne McGee

    Mcge_9780307460110_6p_00_r3.indd iii 5/6/10 7:20 PM


    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.
    www.crownpublishing.com

    CROWN BUSINESS is a trademark and CROWN and the Rising Sun colophon are
    registered trademarks of Random House, Inc.

    Library of Congress Cataloging-in-Publication Data

    McGee, Suzanne.
    Chasing Goldman Sachs/Suzanne McGee.—1st ed.
    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

    ISBN 978- 0-307- 46011- 0

    Printed in the United States of America

    Design by Philip Mazzone

    10 9 8 7 6 5 4 3 2 1

    First Edition

    Mcge_9780307460110_6p_00_r3.indd iv 5/6/10 7:20 PM


    In memory of my grandfather
    James R. Burchell

    Mcge_9780307460110_6p_00_r3.indd v 5/6/10 7:20 PM


    CONTENTS

    Foreword ix
    Dramatis Personae xiii
    Introduction: The Chase 1

    PART I
    Dancing to the Music 13
    1 From Utility to Casino: The Morphing of Wall Street 19
    2 Building Better—and More Profitable—Mousetraps 53
    3 What’s Good for Wall Street Is Good for . . . Wall Street:
    How Wall Street Became Its Own Best Client 89
    4 To the Edge of the Abyss—and Beyond: Flying Too
    Close to the Sun 130

    PART II
    Greed, Recklessness, and Negligence: The Toxic Brew 167
    5 “You Eat What You Kill” 175
    6 The Most Terrifying Four-Letter Word Imaginable 213
    7 Washington Versus Wall Street 252

    PA RT III
    The New Face of Wall Street 299
    8 Too Big to Fail, Too Small to Thrive? 307
    9 Chasing Goldman Sachs? 346

    Notes 379
    Acknowledgments 389
    Index 391

    Mcge_9780307460110_6p_00_r3.indd vii 5/6/10 7:20 PM


    FOREWORD

    O n the same morning that I delivered the final page proofs of this
    book to my editor’s offices in midtown Manhattan, fact-checked,
    proofread, and ready for the printer, the Securities and Exchange
    Commission charged Goldman Sachs & Co. and one of its execu-
    tives with fraud.
    The announcement came as a bombshell. It had been nearly two
    years since the SEC began investigating the “Abacus” mortgage-
    backed securities transactions at the heart of the fraud allegations. In
    its letter to shareholders contained in its 2009 annual report, Goldman
    Sachs’s CEO, Lloyd Blankfein, described 2009 as “a year of resiliency”
    for the bank. It was also an extraordinarily profitable one for Wall
    Street’s most famous and most envied institution: Goldman pock-
    eted $45.17 billion in revenues and $13.4 billion of profit in 2009
    and, even as the SEC was preparing to fi le its lawsuit, it was closing
    the books on a very profitable first quarter of 2010, during which it
    generated twice the profits that it had a year earlier, or $3.46 billion.
    Once again, the rest of Wall Street was left trying to figure out how
    to keep their shareholders happy in light of the astonishing return on
    equity that Goldman Sachs had delivered to its own investors—22.5
    percent in 2009.
    But what had Goldman Sachs done to earn that return on equity
    and those profits? Within hours, that was what everyone was buzz-
    ing about. Certainly, the dealings spelled out in the SEC lawsuit
    seemed to have little to do with the idea that Wall Street exists to
    connect those individuals, entrepreneurs, businesses, and govern-
    ments in need of capital with investors hoping to find a way to put

    Mcge_9780307460110_6p_00_r3.indd ix 5/6/10 7:20 PM


    x FOR EWOR D

    their capital to work in search of a return. Rather, the Abacus deal


    structured on behalf of hedge fund manager John Paulson was little
    more than a big bet on the future direction of the U.S. housing mar-
    ket and the credit quality of some of the country’s most financially
    distressed home buyers. Paulson believed that the mortgage-backed
    securities market was about to blow up, and wanted his bankers at
    Goldman Sachs to find a way to let him bet on that scenario. To earn
    a hefty fee, all Goldman had to do was find someone willing to take
    the other side of that bet. And that’s where the SEC claims that the
    blue-chip investment bank stepped over the line.
    In the lawsuit, the regulatory agency claims that in order to at-
    tract buyers to the transaction, Goldman conspired to keep them
    from learning that Paulson not only wanted to “short” the new col-
    lateralized debt obligation (CDO) it was creating on his behalf, but
    took an active role in structuring it, hand-picking some of the securi-
    ties on which the CDO would be based. It will take months, and
    possibly a year or more, before it can be established whether the SEC
    can prove that Goldman violated its obligation to disclose all this
    information to IKB, the German bank that bought a big chunk of
    the deal, taking the opposite side of the bet from Paulson. But what
    is already clear is that Wall Street is a world in which, for all the pro-
    fessed commitment to serving clients in need of financial services,
    some of those customers are more equal than others. Ultimately,
    Wall Street is no longer run in the interests of its clients, but in the
    interests of Wall Street entities themselves. The value of the Street
    may lie in its role as a financial utility or intermediary, but as the fi-
    nancial results of Goldman Sachs and most of its rivals clearly dem-
    onstrate, that’s not what generates the lavish profits. And profits are
    what Wall Street’s own investors demand.
    For more than a decade, Goldman played the game better than
    anyone else on Wall Street. It earned returns on equity that were
    the envy of all its peers; its bankers were considered the crème de la
    crème and increasingly earned bonus packages reflecting that status.
    Top bankers at Merrill Lynch & Co., for instance, knew to steer clear
    of their temperamental CEO Stan O’Neal on the days that Goldman
    released its earnings. “Why can’t we earn numbers like that?” he de-
    manded of one subordinate on one occasion in mid-2005. O’Neal’s

    Mcge_9780307460110_6p_00_r3.indd x 5/6/10 7:20 PM


    FOR EWOR D xi

    underlings set out to try to do just that—and ended up wiping out a


    decade’s worth of profits by taking gargantuan risks in subprime
    mortgage CDOs. Even in the wake of the crisis, as it became clear
    that Goldman had generated some of those fees by creating risk for
    the financial system—by, for instance, helping Greece structure its
    debt in such a way that the magnitude of its budget deficit was hid-
    den from the other member nations of the European Union—the
    envy remained.
    Goldman’s bankers knew that in being “long,” subprime real es-
    tate in the spring of 2007 was likely to be a risky bet for anyone who
    agreed to take the other side of the trade that Paulson wanted to do.
    In an e-mail to a friend, Fabrice Tourre, the banker who structured
    the deal (and who is named alongside his firm in the SEC action)
    wrote, “the whole building is about to collapse any time now . . . Only
    potential survivor, the fabulous Fab . . . standing in the middle of all
    these complex, highly leveraged, exotic trades he created without
    necessarily understanding all of the implication of those monstru-
    ousitieis!!! [sic]” In another e-mail, the head of Goldman’s struc-
    tured products correlation trading desk warned Tourre that “the cdo
    biz is dead” and that “we don’t have a lot of time left.” Nonetheless,
    Goldman Sachs, the SEC alleges, did whatever they could to per-
    suade IKB to do the deal. As Lloyd Blankfein has explained re-
    peatedly, clients like IKB are really no more than “counterparties,”
    sophisticated investors willing to take risks and able to do their own
    due diligence. But even if Goldman is correct in arguing that it didn’t
    actively mislead IKB—which later required a bailout from the Ger-
    man government to avoid collapsing under the weight of billions of
    dollars of losses on Abacus-like subprime bets—didn’t it have some
    kind of moral obligation to warn either the client or the system?
    The answer is no. On Wall Street today, clients need to be able
    to look out for themselves. The perception among the American
    public is that the game is rigged; that Wall Street is dealing cards
    from the bottom of the deck to its friends while saving the low-value
    cards for their other clients. The SEC lawsuit simply reinforces that
    perception, and damages any remaining confidence Main Street has
    that Wall Street’s “financial grid” operates in their interest or serves
    as a de facto financial utility, through which capital flows from those

    Mcge_9780307460110_6p_00_r3.indd xi 5/6/10 7:20 PM


    xii FOR EWOR D

    that have it to those that need it. Today’s Wall Street is far from being
    a utility, and restoring public confidence that it can still act in the in-
    terests of all those that rely on it is the challenge that confronts all of
    us, from the regulators and legislators in Washington to the bankers
    on Wall Street. As of this writing, a host of regulatory reform pro-
    posals are making the rounds, all of them hotly debated and all of
    them focusing squarely on the structure of Wall Street. It remains to
    be seen, however, whether any of these will succeed in getting Gold-
    man Sachs and its rivals to reconsider their raison d’être and redefine
    their responsibilities to both their clients and to the financial system
    itself. They can’t keep chasing Goldman Sachs if what Goldman
    Sachs is doing to earn its hefty profits is damaging the integrity of
    the financial system, as the SEC lawsuit implicitly claims.

    Mcge_9780307460110_6p_00_r3.indd xii 5/6/10 7:20 PM


    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 the largest
    asset management fi rms 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 on invest-
    ing in financial stocks
    Sheila Bair: chairman of the Federal Deposit Insurance Corporation
    Ben Bernanke: chairman of the Federal Reserve
    Lloyd Blankfein: CEO of Goldman Sachs
    Peter Blanton: veteran investment banker who has worked at a variety of
    large Wall Street firms and now works for a boutique firm
    Brooksley Born: Washington securities lawyer and former head of the
    Commodity Futures Trading Commission; now a member of the FCIC
    Richard “Dick” Bove: banking analyst at Rochdale Securities; a veteran
    research analyst
    Lise Buyer: has worked on almost every part of Wall Street as an analyst,
    banker, and investor; served as director of business optimization at
    Google; and now has her own firm that helps coach companies through
    the financing process
    Tom Caldwell: chairman of Caldwell Financial, a Toronto-based invest-
    ment and trading firm; one of the largest shareholders of the New York
    Stock Exchange’s parent company
    Marshall “Marsh” Carter: deputy chairman of NYSE Euronext, former
    chairman of State Street Corporation, and a veteran commercial
    banker

    Mcge_9780307460110_6p_00_r3.indd xiii 5/6/10 7:20 PM


    xiv DR A M AT IS PER SONA E

    Tom Casson*: a former Bear Stearns investment banker; since that firm’s
    collapse, he has worked for two other Wall Street institutions
    Jimmy Cayne: former CEO and chairman of Bear Stearns; he spent his
    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 art collector
    Gary Cohn: president and COO of Goldman Sachs
    Leon Cooperman: former Goldman Sachs partner; now runs a large hedge
    fund group, Omega Advisors
    John Costas: rose to head UBS’s investment banking; after briefly running
    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 of Bar-
    clays PLC; Diamond orchestrated the purchase of many of Lehman
    Brothers’ investment banking operations after Lehman’s bankruptcy fi l-
    ing; formerly worked for Credit Suisse, among other firms
    Jamie Dimon: CEO of JPMorgan Chase, a former protégé of Sandy Weill
    whom the latter fired at Citigroup and who went on to have the last laugh
    as the heir to JPMorgan himself during the crisis
    Mike Donnelly*: former Wall Street investment banker who spent most of
    his career at Morgan Stanley
    Glenn Dubin: cofounder of Highbridge Capital, a large hedge fund group
    now owned by JPMorgan Chase
    James “Jimmy” Dunne: CEO of Sandler O’Neill, a smaller investment
    bank that specializes in serving financial institutions
    Ira Ehrenpreis: a general partner at Technology Partners, a Silicon Valley
    venture capital firm
    Gary Farr: former Citigroup banker hired by KKR to build an in-house
    investment banking division to assist its portfolio companies
    Niall Ferguson: professor of history and business at Harvard University and
    Harvard Business School; specializes in economic and financial history
    Jim Feuille: partner at Crosslink Capital, a venture capital firm
    Richard “Dick” Fisher: late CEO of Morgan Stanley; his name often
    surfaces when people talk about competitive yet principled Wall Street
    executives

    * Indicates a pseudonym.

    Mcge_9780307460110_6p_00_r3.indd xiv 5/6/10 7:20 PM


    DR A M AT IS PER SONA E xv

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


    of FridsonVision
    Richard Fuld: former CEO of LehmanBrothers; a Lehman “lifer”
    Timothy Geithner: Treasury secretary; formerly head of the New York Fed
    Mike Gelband: former co-head of fixed income at Lehman Brothers
    Lou Gelman*: former investment banker specializing in equity sales and
    trading at Morgan Stanley
    James Gilleran: former head of the Office of Thrift Supervision who bragged
    about his willingness to cut red tape and make it easier to take risk
    Lew Glucksman: Wall Street trader and briefly chairman and CEO of
    Lehman Brothers
    Alan C. “Ace” Greenberg: former chairman of Bear Stearns, whose vision
    propelled it to the ranks of the “big five” investment banks
    Robert “Bob” Greenhill: founder of Greenhill & Co., a merger advisory
    boutique firm, in 1996 after leaving Morgan Stanley, where he had run
    that firm’s merger business
    Ken Griffin: founder of Citadel Investment Group, one of the largest
    hedge fund groups in the world; now making a push into investment
    banking
    Tony Guernsey: chief client officer at Wilmington Trust; has worked with
    many Wall Street figures over the last three decades
    William R. “Bill” Hambrecht: former CEO of one of the “four horse-
    men” (boutique banks that played a decisive role in financing start-up
    companies), Hambrecht & Quist; since that fi rm was sold to Chase
    Manhattan in the late 1990s, has undertaken a variety of quests, all in-
    volved in improving fi nancing access for fledgling fi rms
    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 at the
    Harvard Business School; has been writing case studies about Wall 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 its predecessor institutions
    Fred Joseph: late founding partner of Morgan Joseph, a boutique invest-
    ment bank; formerly CEO of Drexel Burnham Lambert
    Rob Kapito: president of BlackRock

    Mcge_9780307460110_6p_00_r3.indd xv 5/6/10 7:20 PM


    xvi DR A M AT IS PER SONA E

    Todd Kaplan: veteran Wall Street banker recruited by Ken Griffin at Citadel
    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 prominent economist at
    Salomon Brothers; now president of Henry Kaufman & Co.
    Dow Kim: briefly headed the fixed-income investment banking operations
    at Merrill Lynch; tried but failed to launch his own hedge fund after Mer-
    rill began to take write-downs
    Michael Klein: one of the first architects of a sponsor group of bankers
    catering to private equity clients; a former Citigroup banker
    Bill Kohli: fixed-income portfolio manager at Putnam Investments in Boston
    Richard “Dick” Kramlich: cofounder of New Enterprise Associates, a
    large Silicon Valley venture capital partnership
    Henry Kravis: cofounder of KKR, one of the first large buyout firms
    Sallie Krawcheck: former banking analyst and Citigroup chief financial
    officer; now runs the wealth management business at Bank 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 was ousted after reve-
    lations of large losses at Merrill and agreements to pay Merrill bankers
    big bonuses
    Michael Lipper: architect of data and analysis firm Lipper Advisory Ser vices
    (now part of Thomson Reuters, named Lipper Inc.)
    John Mack: veteran investment banker who has worked at many of Wall
    Street’s most significant firms; until 2010, CEO of Morgan Stanley; re-
    mains the firm’s chairman
    Jake Martin*: partner at a large New York–based buyout firm
    Mike Mayo: veteran banking analyst and managing director at Calyon
    Securities (USA) Inc.
    Larry McInnes*: veteran technology and telecommunications banker
    Tom McNamara*: investment banker who works within a sponsor group
    at a Wall Street firm, putting together financing packages for private eq-
    uity buyouts
    Seth Merrin: founder of LiquidNet, a Wall Street trading fi rm
    Michael Milken: at Drexel Burnham Lambert in the 1970s and 1980s, de-
    veloped the high-yield/junk bond market into a real asset class, but viola-
    tions of securities laws led to his being banned from the industry for life;
    now a philanthropist

    Mcge_9780307460110_6p_00_r3.indd xvi 5/6/10 7:20 PM


    DR A M AT IS PER SONA E xvii

    Eric Mindich: youngest partner in Goldman Sachs history; left the firm to
    found a hedge fund, Eton Park Capital
    Ken Moelis: began his career at Drexel Burnham Lambert; ultimately be-
    came president of UBS’s investment banking division; left in 2007 to
    launch his own boutique firm, Moelis & Co.
    Angelo Mozilo: chairman and CEO of Countrywide Financial until 2008;
    cofounder of IndyMac Bank; a symbol of the credit bubble, Countrywide
    is now owned by Bank of America; IndyMac collapsed
    Duncan Niederauer: former partner of Goldman Sachs & Co., CEO of
    the New York Stock Exchange, and a pioneer in the world of electronic
    trading
    Stanley “Stan” O’Neal: former CEO of Merrill Lynch & Co.; behind the
    firm’s push into CDOs structured with subprime mortgages
    Vikram Pandit: veteran banker and later a hedge fund manager; joined
    Citigroup and quickly became its CEO
    Richard “Dick” Parsons: chairman of the board of Citigroup
    Henry “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 that the hous-
    ing bubble would burst; now betting on a turnaround in financial stocks
    Pete Peterson: cofounder of Blackstone Group; previous posts included
    CEO and chairman of Lehman Brothers between 1973 and 1984
    Anna Pinedo: partner at Morrison & Foerster specializing in corporate fi-
    nance
    Charles E. “Chuck” Prince: former CEO of Citigroup
    Phil Purcell: former chairman and CEO of Morgan Stanley; ousted by fi rm
    dissidents unhappy with the company’s lagging stock price, a reflection of
    its lack of risk taking
    Leslie Rahl: founder of Capital Markets Risk Advisors LLC, a risk manage-
    ment firm that has handled a lot of derivatives debacles
    Lewis “Lew” Ranieri: mortgage bond and securitization pioneer at Sa-
    lomon Brothers
    Clayton Rose: former banker at JPMorgan Chase; now an adjunct profes-
    sor at Harvard Business School
    Wilbur Ross: former investment banker and “workout specialist” at Roth-
    schild Investments; founded his own private investment fi rm, WL Ross &
    Co. LLC, in 2000

    Mcge_9780307460110_6p_00_r3.indd xvii 5/6/10 7:20 PM


    xviii DR A M AT IS PER SONA E

    Nouriel Roubini: economist and professor at New York University’s Stern


    School; known as “Dr. Doom” for his pessimistic economic forecasts
    Jeff Rubin: director of research at Birinyi Associates; has studied the way
    financial markets function
    Robert “Bob” Rubin: former Goldman Sachs partner and Treasury secre-
    tary during the Clinton administration; went on to work as a director 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 Brothers
    alumnus; now runs his own boutique investment bank, Peter J. Solo-
    mon Co.
    Larry Sonsini: chairman of Wilson Sonsini Goodrich & Rosati, a Silicon
    Valley–based national law firm that advises start-ups and Fortune 500
    companies
    Mike Stockman: former risk management officer at UBS
    Richard “Dick” Sylla: Henry Kaufman Professor of the History of Finan-
    cial Institutions and Markets, Stern School of Business, New York Uni-
    versity
    James “Jim” Tanenbaum: partner at Morrison & Foerster specializing in
    corporate finance
    John Thain: former CEO of Merrill Lynch; previously CEO of the New
    York Stock Exchange and a partner at Goldman Sachs
    Leo Tilman: president of L. M. Tilman, a risk advisory firm; contributing
    editor of The Journal of Risk Finance, and former executive at BlackRock
    and Bear Stearns
    Mark Vaselkiv: fixed-income manager at T. Rowe Price in Baltimore
    David Viniar: chief financial officer of Goldman Sachs
    Paul Volcker: former Federal Reserve chairman; named chairman of Eco-
    nomic Recovery Advisory Board by President Barack Obama; championed
    the idea of re-creating a division between risk-taking and deposit-taking
    institutions on Wall Street
    Sandy Weill: financier who combined risk-taking and deposit-taking insti-
    tutions on Wall Street with the formation of Citigroup; his view of a fi-
    nancial supermarket was largely responsible for the repeal of the 1933
    Glass-Steagall Act that separated investment and commercial banking

    Mcge_9780307460110_6p_00_r3.indd xviii 5/6/10 7:20 PM


    INTRODUCTION

    The Chase

    D oes Wall Street owe the American people an apology?”


    Tom Casson* heard the question—the one on the minds of every
    American taxpayer furious at the very idea of footing the bill for
    Wall Street’s excesses in the shape of the $700 billion bailout package
    under debate in a Senate hearing room—from the television on the
    trading floor just outside his office. He saw himself as part of Wall
    Street—it was where he had spent nearly all his working life— so the

    * Here and throughout the book, a name followed by an asterisk is a pseudonym for
    a Wall 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 au-
    thors about what they see happening around them; while their CEOs do, it’s rare to
    find 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 difficult 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 first appear. When senior Wall Street officials declined to be quoted on

    Mcge_9780307460110_6p_01_r3.indd 1 5/6/10 7:22 PM


    2 CH A SING G OLDM A N SACHS

    very idea that some senator from who knows where thought he
    should apologize to the country piqued his curiosity immediately.
    “Why would I and the rest of my guys do that?” he wondered. Still,
    listening to either Treasury secretary Henry “Hank” Paulson or Fed-
    eral Reserve chairman Ben Bernanke struggle to answer the ques-
    tion in a way that would keep the members of the Senate Banking
    Committee happy had to be more fun than just watching the lines on
    his Bloomberg terminal that signaled stock and bond market index
    levels inching their way lower and lower with every passing minute.
    In search of distraction, Casson got up from behind his desk and
    ambled toward the trading floor. Leaning against the glass wall that
    separated his small fiefdom 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 and
    hawing, Ben Bernanke finally replied that to most of America, “Wall
    Street itself is a . . . is a . . . is an abstraction.” Casson felt as if he’d ac-
    cidentally stuck his finger in an electrical socket. He stood upright,
    staring at the television in astonishment. What did Bernanke just say?
    Can he really have just described Wall Street as an abstraction? In Casson’s
    eyes, Wall Street couldn’t be less abstract—it’s where businesses find

    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 fi 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 reflects 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.

    Mcge_9780307460110_6p_01_r3.indd 2 5/6/10 9:24 PM


    INT RODUC T ION 3

    capital, where investors with capital find places to put it to work in


    hopes of earning a return. Over the decade that he had toiled on the
    Street, Casson had raised money for some of those companies and
    helped others to negotiate multibillion-dollar mergers. Now the
    politicians were demanding that he and his colleagues apologize for
    what they spent their lives doing? Even worse, the head of the Fed-
    eral Reserve—the individual who was the public face of banking
    regulation and monetary policy making— couldn’t find a better word
    to describe Wall Street than abstraction. Months later, Casson was still
    bemused. “How could anyone say that Wall Street was an abstrac-
    tion?” he wondered aloud. What had happened to make even the
    Fed chairman blind to Wall Street’s real value?

    The details of what happened during the weekend in September that


    preceded those Senate hearings, the weekend of frenetic deal mak-
    ing, hectic negotiations, and never-ending meetings within the Fed’s
    fortress-like New York headquarters involving nearly every top fig-
    ure on Wall Street, have by now been told and retold. We know that
    Merrill Lynch held its board meeting to approve the sale of the firm
    to Bank of America at the St. Regis Hotel in Manhattan; that Securi-
    ties and Exchange Commission (SEC) chairman Christopher Cox
    accused a British counterpart of being “very negative”; that Hank
    Paulson commuted to the negotiations downtown from a suite at the
    Waldorf Astoria in midtown Manhattan. We even know the favorite
    route for the dawn runs by Timothy Geithner (then head of the New
    York Fed, who would succeed Paulson at the Treasury Department
    in the New Year) along the southern tip of Manhattan.1 We know
    what happened—the names of the firms that failed, and those that
    rapidly returned to making money hand over fist. (We still don’t know
    the names of those institutions saved from disaster by last-minute
    help from the Treasury Department, but if media organizations

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    4 CH A SING G OLDM A N SACHS

    make a compelling freedom-of-information case to the courts, that


    information won’t be long in coming.) We know the proximate causes
    of the crisis: too much leverage, too much risk, and too much sub-
    prime lending.
    This book will take you on a different journey. Instead of rehash-
    ing every detail of what happened to Wall Street, I’ll take you behind
    the scenes and show you just why our financial system came so close
    to falling over the edge of the abyss. How did we reach the point
    where Wall Street was in so much jeopardy that the staid and some-
    what self-important Paulson was willing to go down on one knee in
    front of House of Representatives Speaker Nancy Pelosi— a Demo-
    cratic politician most investment bankers distrusted and even
    roundly disliked—to beg for her assistance in passing a financial aid
    package for the surviving firms, including his own alma mater,
    Goldman Sachs? Above all, what had happened to Wall Street that
    Bernanke could describe it as an “abstraction” and be greeted not
    with howls of outrage or confused questions by his audience but
    rather with nods of acknowledgment and understanding?
    Truth is, Wall Street isn’t an abstraction but a kind of public util-
    ity. That’s a characterization liable to make those who work on the
    Street bristle in indignation. But in many ways, the financial system
    of which Wall Street is a critical part bears an uncanny similarity to
    any power company or water system. When you come home at the
    end of the day, you count on being able to flick a switch and see your
    lights come on; in the morning, you rely on being able to turn on a
    tap and get clean running water for your shower. You almost cer-
    tainly rely on Wall Street in the same unconscious way. Wall Street
    offers us an array of investment ideas for our retirement portfolios;
    Wall Street institutions finance our entrepreneurial dreams and lend
    us the capital we need to help us buy homes, cars, and even birthday
    gifts for friends and family. (Sure, they make money doing that—but
    so do the power company and the water company.)

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    INT RODUC T ION 5

    From its inception Wall Street had been there to serve Main
    Street, and it took that role seriously. “It was valued; serving your
    corporate clients, if you were an institutional firm like Morgan Stan-
    ley, or investors, if you were a retail-oriented firm like Merrill Lynch,
    exceedingly well was the ticket to success on Wall Street,” says Sam-
    uel Hayes, professor emeritus at the Harvard Business School. The
    problem is that from the 1970s onward, serving as a public utility and
    performing these intermediary functions for the people on both
    ends of the “money grid” (investors and companies needing capital)
    just wasn’t as profitable as it used to be.
    That’s the starting point for this book, which will explain just
    how and why Wall Street drifted away from its core intermediary
    function and morphed from utility to casino, under pressure from
    those running Wall Street firms and from their investors. Both of
    those groups put a priority not on fulfi lling Wall Street’s role as a
    utility but on finding the most profitable products and business strat-
    egies, of which subprime lending and structured finance were only
    the latest— and, so far at least, the most toxic—manifestations.
    Eventually, these insiders came to treat Wall Street as if it were any
    other business, only as valuable as the profits they could extract from
    it. Instead of turning to proprietary trading or structured finance only
    to supplement their returns from the less profitable utility-like or in-
    termediary operations, many Wall Street firms deemphasized Main
    Street in favor of catering to Wall Street clients: hedge funds, private
    equity funds, and their own principal investing and proprietary trad-
    ing divisions. Nor were there any incentives for Wall Street residents
    to question their collective transformation from quasi-utility to self-
    serving, risk-taking, profit-maximizing behemoth. Compensation pol-
    icies across the Street rewarded bankers and traders for turning a blind
    eye to the needs of the money grid; regulators—agencies charged with
    ensuring that utilities operate in the public interest— ended up cater-
    ing to Wall Street rather than trying to rein in its worst excesses.

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    6 CH A SING G OLDM A N SACHS

    When utilities come under too much systemic stress, they fail.
    Think of the electricity system, and what happens when its managers
    fail to plan for the hottest summer days, when everyone turns on the
    air conditioner full blast and the demand for power peaks. Like mil-
    lions of others living in the northeastern United States, I experienced
    that firsthand one muggy August afternoon in 2003, when the power
    to everything from elevators in high-rise office buildings to street-
    lights on Manhattan’s busy roadways flickered off— and stayed off
    for much of the next twenty-four hours. Suddenly, I realized just how
    important the power grid was to my life. I joined thousands of others
    who had to walk home along the darkened New York streets, through
    the heat and humidity. Eight miles and many hours later, there was
    no cold water to ease the pain from my blistered feet (the lack of elec-
    tricity had caused a plunge in water pressure) and no food (there was no
    way to cook anything); I couldn’t even find a cold drink to revive me.
    Thankfully, the reasons for the blackout were relatively straight-
    forward. Someone had decided to take a power plant offline, mean-
    ing that its output wouldn’t be available to customers on one of the
    hottest days of the year. A bad call. When electricity demand spiked,
    that put a strain on the high-voltage power lines. Since electricity
    companies know that can happen, causing power lines to sag dan-
    gerously low, they make an effort to keep trees and foliage trimmed
    back. That didn’t happen at one utility— another bad call— and the
    power lines brushed against some overgrown trees, triggering a se-
    ries of failures that cascaded throughout the region’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 had
    been overrun by a new breed of managers, extremely bright and
    imaginative engineers armed with MBAs. Imagine that they had been
    given a completely different 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 profits too much, don’t bother

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    INT RODUC T ION 7

    with it. And imagine that those engineers, in order to maximize prof-
    its, decided to use all the money they had saved by not investing in
    backup capacity and maintenance to build and operate a casino, or
    some other business that would generate a much higher return in the
    short run. Finally, imagine that regulators were asleep at the switch
    and let them do it. Happy shareholders would have richly rewarded
    the engineers for their efforts right up until the last minute. And even
    after the blackout (which would have been far more catastrophic and
    longer-lasting than that of 2003), while all of us were struggling in the
    dark, those investors and the engineers would have had more than
    enough money to buy their own generators to provide power to their
    mansions.
    In a nutshell, that’s what happened to Wall Street as it morphed
    from being an intermediary to being a self-serving, risk-taking machine
    for generating profits. As long as times were good, few participants
    stopped to ask questions about this transformation, including those
    who have today become some of the Street’s harshest critics. And
    even now that we’ve experienced the near blackout of the financial
    system, the fingers of blame are pointing to individuals—Richard
    Fuld, at the helm of Lehman Brothers, for instance, or Christopher
    Cox, the chairman of the SEC, who looked the other way as Bernie
    Madoff ran his Ponzi scheme and as the investment banks his agency
    regulated teetered on the edge of disaster. If we ever are going to be
    able to devise wise policies for Wall Street and ensure the future
    health of the financial system, we have to take a hard look at more
    than just the proximate causes of the debacle, such as subprime lend-
    ing or the activities of pot-smoking, bridge-playing Jimmy Cayne at
    Bear Stearns. We need to understand how to make the money grid
    work properly. Maybe just being an intermediary doesn’t generate
    enough in profits to sustain the system anymore—but that doesn’t
    mean that people running the utility should feel free to toss caution
    to the wind and start speculating on a host of new and risky businesses.

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    8 CH A SING G OLDM A N SACHS

    Bankers are trying to clear up the mess they have made, while in
    Washington, regulators and policy makers are running around in
    circles trying to analyze what went wrong and to put in place a new
    set of rules that will prevent the financial system from coming so
    close to the brink ever again. But none of these very smart people is
    either admitting or acting on the biggest problem of all: the fact that
    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 Morgan Stanley
    decided, as a result of the events of the last two or three years, to pare
    back the amount of risk it is willing to take. It shuts down its propri-
    etary trading desk, says it won’t act as a principal and invest alongside
    its clients in businesses, and limits its involvement in risky products
    such as synthetic credit default swaps. It even decides to turn away
    underwriting assignments if its bankers conclude that the stocks or
    bonds the firm would be underwriting would add to the level of risk
    in the system. Instead, Morgan Stanley focuses on wealth manage-
    ment, on building a commercial banking franchise, or on market
    making (facilitating the two-way flow of trading in stocks or bonds).
    What would happen next?
    Well, none of these is a high-growth business that will lead to big
    annual jumps in profitability. Before long, the impact of this decision
    would show up in the bank’s quarterly earnings; with each fiscal
    quarter, the gap between Morgan Stanley and its rivals would widen,
    in both absolute levels of profitability and the rate of growth in prof-
    its. The bonus pool would shrink, and if this risk-conscious move
    was one that only Morgan Stanley had made on its own initiative (and
    not part of a government-mandated change affecting the entire in-
    dustry), the bank’s most talented and skilled employees would be
    lured away to work for competitors. Ultimately, the investors in Mor-
    gan Stanley, those who have purchased its stock in hopes of seeing
    the value appreciate, would stage a rebellion. It wouldn’t take long
    before they’d protest to the bank’s management team and demand

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    INT RODUC T ION 9

    that the managers do whatever it takes to keep up with the returns


    being posted by their peers. If those managers stick to their guns, the
    investors’ next stop would be the offices of the company’s directors.
    It’s pretty easy for anyone to imagine what would happen next to the
    executives who had decided that shunning high-risk but profitable
    businesses was a good idea. “Give us a new management team, with
    some guts, that’s willing to go out and do what it takes to capture
    whatever profits are going!” shareholder A would demand. Since the
    board’s absolute duty is to maximize value for shareholders, it wouldn’t
    take 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 firm seemed to
    have a Midas touch: in the decade leading up to the financial crisis, it
    generated an average annual return of 25.4 percent on shareholders’
    equity, while the four other large investment banks earned an aver-
    age return on equity (ROE) of 15 percent annually in the same time
    frame. No wonder Goldman’s rivals were furious as they fended off
    complaints from their own shareholders. It was clear to every other
    Wall Street CEO that chasing Goldman Sachs was the only way to
    boost their personal wealth and simultaneously keep their cantanker-
    ous shareholders pacified.
    What Goldman was doing, however, was something very differ-
    ent from the traditional business of Wall Street. By 2007, the year that
    it posted record profits of $11.6 billion and distributed a bonus pool
    that was even larger ($12.1 billion) among its employees, Goldman
    was getting only about a third of those earnings from serving Main
    Street clients; the rest came from investing and trading for its own
    account. It had become commonplace for Goldman’s rivals to refer
    to the fi rm, scornfully, as a hedge fund disguised as an investment
    bank, even as they scrambled to mimic the strategy. The problem was
    that they weren’t moving into these businesses because they believed

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    10 CH A SING G OLDM A N SACHS

    they had a competitive advantage or the most talented bankers and


    traders. They were doing it just to keep pace with the market leader.
    And while Goldman Sachs, as we’ll see, managed to steer clear of
    some of the subprime mess, those firms that were just trying to chase
    Goldman Sachs didn’t have the tools or the people to help them
    properly manage the new risks they were taking.
    During those years, when everyone was chasing Goldman Sachs,
    there was every incentive to just keep doing so and not much encour-
    agement to stop and rethink the strategy. John Costas, former head
    of investment banking at UBS and one of the Swiss bank’s most
    powerful deal makers, says the system worked in such a way that
    everyone was under pressure to do whatever it took to grab the extra
    percentage point of market share or return on equity and to ride
    roughshod over naysayers. “For a decade, from 1999 through the mid-
    dle of 2007, anytime you stopped participating, by not adding more risk
    or by not aggressively pursuing more transactions, you were wrong.”
    In other words, chasing Goldman Sachs was a strategy that paid off
    for so long that Wall Street’s leaders were ill equipped to recognize
    that it might not always continue to do so.
    Nor was it possible to sit out the dance, to not try to emulate Gold-
    man’s golden touch. With the benefit of twenty-twenty hindsight, de-
    ciding back in 2003 or 2004 not to get caught up in the business of
    repackaging subprime mortgages into collateralized debt obligations
    (CDOs) looks great. At the time, it would have been untenable, says
    one former senior banker. “What was happening at the bank that did
    that? The investment analysts are downgrading it, the shareholders
    are unhappy, and the employees are unhappy because the bonuses
    aren’t as fat as those their friends are earning. The press is all over
    the bank, saying it’s not as well run as the other bank.” That, he ar-
    gues, is the kind of thinking that sealed the doom of some of Wall
    Street’s most venerable names.
    That kind of thinking is still alive and well on Wall Street today,

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    INT RODUC T ION 11

    even after the near apocalypse. The quest is already under way for
    the next “new new thing,” the next product or strategy that will help
    firms such as Goldman Sachs and its rivals earn massive profits in
    the short run while creating new risks for the financial system. Per-
    haps it will be something that Goldman Sachs pioneers, or some-
    thing 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 firm will again overlook risk in hopes of gaining a
    dominant market share in that new product. The financial system
    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 Street
    battles to return to business as usual, Goldman Sachs is once again
    the firm that all its rivals want to emulate, at least when it comes to
    financial performance. As David Viniar, the firm’s chief financial of-
    ficer, told a reporter in 2009, “Our model never really changed”3 ; by
    the end of 2009, Goldman was on track to reward its employees with
    one of the biggest bonus pools in its history and had rapidly returned
    to reporting astronomically high earnings. Once again, a relatively
    small proportion of those profits came from serving Main Street.
    Wall Street is still geared toward serving itself—its shareholders and
    employees— and as long as that collective mind-set endures, we run
    the risk of another systemic shock.
    There is no point sitting around and waiting for Wall Street to
    apologize to us, individually or collectively. Nor can we content our-
    selves with the idea that bankers are twenty-fi rst-century cartoon
    villains and demand that they get their just deserts. It’s not even rea-
    sonable for us to indulge in bouts of nostalgia for the banking sys-
    tem of the past. True, in hindsight, the 1960s look like a golden age
    but we can’t just wipe out innovations such as high-speed trading
    based on computer algorithms that didn’t exist then. Nor can we
    force investment banks to return to the days when they weren’t

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    12 CH A SING G OLDM A N SACHS

    large publicly traded corporations but partnerships that valued long-


    term relationships over short-term quarterly profits. We can’t turn
    back the clock to a time when hedge funds and private equity funds
    were a tiny sideshow on Wall Street. What we can and must do is
    understand the way Wall Street functions today and try to align that
    more closely with its special role in our economy and society.
    This book isn’t another anecdotal history of the subprime crisis
    of 2007 and 2008. Rather, it’s the tale of how Wall Street’s metamor-
    phosis from a utility serving Main Street to a business that took ex-
    traordinary risks to maximize its own profits at the expense of that
    utility function set the stage for that crisis. It’s an analysis of where
    we stand today and where we need to go next—to a world where,
    instead of blindly chasing Goldman Sachs in hopes of replicating its
    success, the players that make up Wall Street identify ways to emu-
    late the strengths and avoid the flaws that lie within the business
    model of Goldman Sachs and seek out their own paths to success.
    Above all, those strategies must be based on their own competitive
    strengths and be pursued in a way that doesn’t jeopardize Wall
    Street’s core utility function.
    The story is told through the eyes of those who lived it, such as
    Tom Casson—the bankers, traders, research analysts, and invest-
    ment managers who have spent the bulk of their professional lives
    on Wall Street. Some of them can recall firsthand the events of the
    1970s, when new technologies and new rules began to reshape the
    world they inhabited. It’s the story of how Wall Street came to be seen,
    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.

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    PART I

    DANCING TO THE MUSIC

    Mcge_9780307460110_6p_01_r3.indd 13 5/6/10 7:22 PM


    T he financial markets had begun to feel the first shocks of what
    would become the worst market earthquake since the Great Depres-
    sion 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, making loans to private
    equity funds to help finance the increasingly gargantuan buyout
    deals the latter were trying to structure. Sure, the credit markets were
    rocky, raising fears among some market participants that big banks
    like Citigroup—those that had been the most aggressive lenders to
    the LBO community and the biggest participants in the world of
    structured finance, marketing securitized products and derivatives to
    clients—would get stuck holding too many of those loans if there were
    no willing investors to take them off their hands. Prince, too, may have
    been worried, but he wasn’t going to show it. Instead, he told the Fi-
    nancial 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 months
    later, by which time Prince himself had been ousted as the giant

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    16 CH A SING G OLDM A N SACHS

    bank’s CEO. Citigroup was still paying the price for his philosophy
    years later. In order to prevent collapse, the bank had to accept gov-
    ernment bailout funds, a portion of which was later converted into
    stock that gave the federal government an ownership position in
    Citigroup. Write-downs produced a gargantuan loss—$27.7 billion—
    in 2008; while the bank’s 2009 loss of $1.6 billion was a lot smaller, it
    stood in stark contrast to the big profits 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 to keep
    dancing as long as the music played is one that has its roots back in
    the late 1960s and early 1970s, long before Citigroup existed or Wall
    Street had ever heard of collateralized debt obligations, credit default
    swaps, multibillion-dollar buyout funds, or any of the other instru-
    ments or players now often cited as culprits in the meltdown of the
    financial markets. The story of Citigroup—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 im-
    perceptible; others, like the collapse of the 1933 Glass-Steagall Act
    mandating a strict separation between investment and commercial
    banking, grabbing headlines worldwide—Wall Street could not have
    become as powerful a player in the U.S. economy as it did. Equally, it
    would not have endangered the entire money grid.
    During the opening session of the hearings of the Financial Crisis
    Inquiry Commission (FCIC), Mike Mayo, a veteran banking ana-
    lyst and now a managing director at Calyon Securities (USA) Inc.,
    described Wall Street’s member firms as being “on the equivalent of
    steroids. Performance was enhanced by excessive loan growth, loan
    risk, securities yields, bank leverage and consumer leverage. . . . Side
    effects were ignored, and there was little short-term financial incen-
    tive to slow down the process despite longer-term risks.” But by the
    time the problems became so big that they began to nag at Mayo and

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    DA NCING TO T HE MUSIC 17

    many of his colleagues during the first decade of the new millen-
    nium, the trends that had led to those problems had been in place for
    decades. As I’ll explain, the changes to Wall Street forced its finan-
    cial institutions to rely on the most innovative and most leveraged
    products it could devise, because those generated the greatest profits.
    Similarly, the needs of “insiders”—Wall Street players like hedge funds
    and buyout funds— came to dominate the Wall Street landscape. As
    long as dancing to the music produced the profits that firms like Citi-
    group and its investors craved, they would continue to jig, two-step,
    or even produce a creditable Highland fling, if necessary. The first
    section of this book is the story of how that ethos became central to
    the way Wall Street functioned.

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    CHAPTER 1

    From Utility to Casino:


    The Morphing of Wall Street

    A lan “Ace” Greenberg’s firm may have collapsed underneath


    him, but even in the darkest days of 2008, the eighty-one-year-old
    investment banker’s legendary chutzpah was visible on Bloomberg’s
    business television network. “There’s no more Wall Street,” Green-
    berg, the former CEO of Bear Stearns, declared, adding that it had
    vanished “forever” in the rubble.1
    It’s fashionable on Wall Street today to talk wistfully— or in a
    tone of reverential awe— about investment banking as it was prac-
    ticed during what is now seen as a kind of golden era. Greenberg’s
    comments, though more hyperbolic than most, are one example.
    The changes over the course of 2008 were so dramatic that Green-
    berg believed the Wall Street he helped forge no longer existed in any
    kind of recognizable fashion. Some nostalgic Wall Streeters view
    the investment banking landscape of the 1960s, ’70s, and early ’80s
    as a kind of utopia: investment banking as its purest, before the 1987
    stock market crash, the collapse of the junk bond market, and Gordon
    Gekko made Wall Street seem slightly reckless and disreputable. To
    others, Greenberg among them, the golden era is the more recent

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    20 CH A SING G OLDM A N SACHS

    past, when investment banks such as Bear Stearns saw their revenues
    and profits soar as they catered to the emerging powers on the Street,
    hedge funds and giant buyout funds, and watched their bonus pay-
    ments and personal wealth climb even more rapidly.
    The balance of power has certainly shifted on Wall Street, and
    new products, players, and technologies have transformed it. But
    Greenberg’s comments were directed at the collapse of specific insti-
    tutions: the shotgun wedding of his own firm with JPMorgan Chase,
    the bankruptcy filing of Lehman Brothers, and, the same weekend, the
    flight of Merrill Lynch into the arms of Bank of America. Greenberg
    most likely knew about the behind-the-scenes wheeling and dealing
    orchestrated by Ben Bernanke and Hank Paulson that involved every
    conceivable combination of every Wall Street firm with every one of
    its rivals ( J.P. Morgan and Morgan Stanley? Goldman Sachs and
    Citigroup?). The desperate rush to save the financial system from utter
    collapse had resulted in the kinds of merger negotiations—however
    short-lived—that would have seemed laughable only weeks earlier.
    To Greenberg, still reeling at the collapse of his own firm (which had,
    after all, survived even the 1929 market crash and the Great Depres-
    sion), that must indeed have felt like the end of Wall Street.
    Wall Street, however, is more than just a set of institutions with
    big brand names, however old and venerable. At its heart, it is a set of
    functions, and those functions remained intact even in the midst of
    the crisis. Two days before Greenberg delivered his epitaph for Wall
    Street, a small Santa Barbara company, RightScale, raised $13 mil-
    lion in venture capital backing from a group of investors led by Sili-
    con Valley’s Benchmark Capital.2 RightScale’s secret? It was in the right
    business— cloud computing, a way for customers to reduce their IT
    development costs by using Internet-hosted services— at the right
    time. Despite the dramatic headlines focusing the world’s attention
    on the plunge in the stock market and the deep freeze that hit the credit

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    FROM U T ILIT Y TO C A SINO 21

    markets, parts of Wall Street’s core business were still functioning,


    albeit in a more muted fashion. In the final three months of 2008,
    venture capital firms invested $5.4 billion in 818 different deals,
    bringing the total for the year to $28.3 billion. That was down a bit
    from 2007, when venture firms—partnerships that have made fortunes
    backing companies such as Amazon.com and Google and lost smaller
    amounts backing stinkers such as Pets.com—put $30.9 billion to work.
    But it’s still more than they invested in any year from 2002 through
    2006.3 By the first anniversary of the collapse of Lehman Brothers,
    even the high-risk world of junk bonds was back in business. The sign?
    Beazer Homes, one of the worst-hit home-building companies in the
    entire industry, was battling not only the collapse in the real estate
    market but also a federal fraud investigation. Yet Wall Street found
    enough investors willing to close their eyes to those risks and invest
    $250 million in junk bonds issued by the company to help replenish
    its coffers.4

    What Does Wall Street Do, and Why Does It Exist?


    The reason for the Wall Street bailout—the explanation for Hank
    Paulson being desperate enough to literally drop to one knee in front
    of Nancy Pelosi in the White House and plead for her help passing
    the initial $700 billion rescue package—is that Wall Street’s functions
    are essential to the economy. According to reports that were leaked
    to the media almost immediately, Paulson begged Pelosi not to “blow
    it up” (referring both to the bailout package and the financial system
    itself ) by withdrawing the Democratic Party’s support for the rescue
    effort. “I didn’t know you were Catholic,” Pelosi quipped, referring
    to Paulson’s kneeling before her, in an effort to lighten the atmo-
    sphere before blaming the Republicans for the gridlock.5
    By saving some of Wall Street’s institutions—those viewed as the

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    22 CH A SING G OLDM A N SACHS

    strongest or the most important to the system—the architects of


    the bailout and many of the subsequent reform packages hoped to
    preserve intact the system that enables capital to flow more or less
    smoothly through the economy the way power flows through the
    electrical grid or water through a municipality’s water and sewer sys-
    tem. Regardless of what Main Street was thinking— and communi-
    cating to their members of Congress—Wall Street isn’t incidental
    to what happens in the rest of the economy. Without Wall Street to
    perform its financial grid functions, it would prove almost impossi-
    ble to raise capital to repair bridges, finance new companies such as
    RightScale, and keep others— such as Beazer Homes— afloat.
    What we tend to think of as Wall Street—the stock market, the
    investment banks, and the newer entities such as hedge funds—is
    really only the visible tip of a much larger iceberg that is the entire
    financial system. Collectively, these institutions help ensure that cap-
    ital continues to move throughout the rest of the “money grid.” Some-
    times they do this by providing a market for participants to undertake
    basic buy or sell transactions; on other occasions, they negotiate or
    devise solutions to more complicated capital-related questions, such
    as helping a company go public or sell debt (a process known as un-
    derwriting) or working with it to establish and achieve the best price
    possible in a merger negotiation.
    That intermediary function is alive and well, most visibly at the
    New York Stock Exchange, which occupies not only the epicenter of
    Wall Street at the corner of Broad and Wall Streets but the heart of its
    role as a financial utility. On its sprawling trading floor, traders go
    about their business in much the same way their earliest predecessors
    did in the naves of Amsterdam churches, executing the purchases of
    blocks of shares for their clients, who these days could include an
    individual trying to sell 100 shares of General Electric or Microsoft
    inherited from a grandparent or a mutual fund manager trying to
    reduce his holdings in Amazon.com in order to buy a stake in

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    FROM U T ILIT Y TO C A SINO 23

    Alibaba.com, a Chinese counterpart. Exchanges trading stocks, fu-


    tures, and options contracts as well as commodities remain one of the
    most heavily regulated parts of Wall Street because of the essential role
    they play in a large, geographically scattered, and diverse community.
    Not convinced of the value of Wall Street’s functions and pro-
    cesses? Imagine you are a retiree in your seventies, living off your
    investment portfolio. The wisdom of your decision to invest in Mi-
    crosoft in the mid-1980s has become clear; now you’re counting on
    being able to sell some of that stock at its current market value in order
    to cover your living expenses for the next six months. Wall Street’s
    processes make that relatively simple— all you have to do is place an
    order to sell the stock at the market price with your broker or custo-
    dian (say, Charles Schwab) and ask for the money to be transferred to
    your bank account when the trade is settled in three days’ time.
    Now, imagine that there was no Wall Street. For starters, you’d
    have a hard time establishing a fair price for that stake in Microsoft
    without the stock market, with its countless numbers of buyers and
    sellers meeting in cyberspace to decide each minute of the day what
    value they ascribe to Microsoft’s shares and thus what price they are
    willing to pay for your stock. Even if you thought you knew what
    your shares were worth, how would you find a buyer and persuade
    her that your analysis is right? Would you go door-to-door in Miami
    or Los Angeles? Put up an ad on Craigslist? (In Vietnam’s over-the-
    counter market, that is exactly what happens; you then arrange to
    meet the buyer on a street corner to swap the shares for cash.) And if
    you found a buyer, could you be certain that you would be paid in
    full and on time, so that you could pay your own mortgage and pur-
    chase your groceries?
    Money has existed for millennia, ever since people recognized
    that barter was an inadequate method of exchange. The stock ex-
    change, just a few centuries old, was the next logical step as society’s
    fi nancial needs became more complex. The fi rst exchanges were

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    24 CH A SING G OLDM A N SACHS

    established in wealthy trading cities such as Hamburg, Antwerp, and


    Amsterdam. Here, by the early sixteenth century, there was a signifi-
    cant concentration of wealth in the hands of merchants and noble-
    men, all of whom had an interest in putting it to work in new and
    different kinds of enterprises in the hope of diversifying and making
    still more money. These communities traditionally were also home to
    cutting-edge commercial enterprises, ranging from new technologies
    such as printing to global trading ventures to the East Indies.
    Investors willing to back these enterprises—most of which could
    take years to pay off—needed a secondary market: a place where
    people who were interested in buying or selling shares in ventures
    could meet each other or find an intermediary to help them with that
    transaction. For a while, Amsterdam’s church naves served that pur-
    pose, along with the open-air wharves on Warmoesstraat near the
    city’s old church, or Oude Kerk. The first formal stock exchange in
    Amsterdam opened its doors in 1610; between noon and 2:00 p.m.
    each business day, members were expected to show up and buy and
    sell on behalf of the general public—in other words, to provide li-
    quidity to the secondary market.6 By 1688, the Amsterdam exchange
    already looked a lot like the trading floor of the New York Stock
    Exchange in its twentieth-century heyday; seventeenth-century stock
    jobber Joseph de la Vega, in his dissertation on the financial markets
    of the time, entitled Confusión de Confusiones, famously described the
    scene as one in which “handshakes are followed by shouting, insults,
    impudence, pushing and shoving.” (Perhaps it was this familiar at-
    mosphere that led so many former professional football players to
    pursue second careers in the trading pits of the Chicago Board of
    Trade and the Chicago Mercantile Exchange.)
    There probably has never been a time when people didn’t com-
    plain about how the financial system worked— or failed to work. Nev-
    ertheless, the United States, as Alexander Hamilton, the country’s first
    Treasury secretary, realized, would need a smoothly functioning fi-

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    FROM U T ILIT Y TO C A SINO 25

    nancial system as part of its struggle to emerge as a viable nation-


    state.7 Hamilton’s initiatives included creating the country’s first na-
    tional or central bank, the First Bank of the United States, to replace
    myriad institutions within each of the thirteen original colonies, each
    of which had its own monetary policy and issued its own currency.
    Hamilton’s goal was financial order and transparency, necessary if the
    new country was going to be able to repay its war debt and finance its
    growth by investing in new industries.
    Wall Street, the narrow thoroughfare in lower Manhattan that owed
    its name to its former role as the northern border of the sixteenth-
    century Dutch colony of New Amsterdam, benefited from many of
    Hamilton’s efforts to create the infrastructure of a national financial
    system and emerged as the heart of the new country’s financial mar-
    kets. It was here merchants chose to hang out on street corners to
    swap their ownership interests of government debt or the handful of
    start-up companies, such as canal construction ventures, that would
    form the core of the United States’ new economy. (If you wanted to
    trade in the bonds newly issued by Alexander Hamilton’s fledgling
    Treasury Department, you’d have to know which lamppost on Wall
    Street to stand under.) Eventually, the introduction of New York state
    regulations banning curbside haggling as a “pernicious” practice drove
    these early Wall Streeters indoors. Some two dozen dealers gathered
    under a buttonwood tree to sign a pact that served as the foundation
    of the New York Stock Exchange. First housed informally in a Wall
    Street coffeehouse, the exchange moved to a room at 40 Wall Street in
    1817, paying $200 a month in rent, before relocating to the quarters
    it now occupies, just across Wall Street from Federal Hall. Today, the
    original Buttonwood Agreement, a tiny sheet of yellowing paper, is on
    display at the Museum of American Finance a few doors away at 48
    Wall Street, the building that once housed the Bank of New York,
    also founded by Hamilton himself.
    “You know, if Hamilton came back to life, I don’t think he’d be

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    26 CH A SING G OLDM A N SACHS

    all that surprised at the way the financial system has evolved,” says
    Dick Sylla, the Henry Kaufman Professor of the History of Financial
    Institutions and Markets at New York University. A silver-haired,
    slightly built man, Sylla appears unruffled by the dramatic changes
    that have taken place on Wall Street, smiling wryly at a display at the
    museum featuring Citigroup’s now-reviled leaders—Robert Rubin,
    Sandy Weill, and Charles Prince. But then, for him as for Hamilton
    (about whom he is writing a book), America’s financial system was
    never about a single institution, however large. “It’s all about the
    functions that the various institutions perform, rather than what
    names they go by or where their headquarters happen to be,” Sylla
    explains. “Hamilton knew that there would be bubbles and periods
    of chaos. But if over the long run the system as a whole performs its
    function of allocating capital and allowing us as investors to diver-
    sify our portfolio, to not put all our eggs in one basket, it is doing
    what he wanted it to do.”

    The Nature of the Money Grid: The Intermediary


    Wall Street, in its totality, involves more than what happens on the
    floor of the New York Stock Exchange or within the walls of any
    single investment banking institution. It has become a labyrinth of
    many different groups and institutions, all of which have one thing in
    common: they make the whole money grid work more smoothly and
    more efficiently. Many of them work hundreds or thousands of miles
    away from Wall Street itself. In Tacoma, Washington, Russell Invest-
    ments devises stock indexes widely used by mutual funds and other
    big investors; in Kansas City, a firm called TradeBot uses computer-
    generated models to exploit tiny differences in the price of different
    types of securities and trades—in only milliseconds— on that infor-
    mation, making markets more liquid; Chicago’s options exchanges
    make it possible for investors to bet not on the direction of a stock’s

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    FROM U T ILIT Y TO C A SINO 27

    price but on the rate and magnitude of change in that stock price and
    the time frame in which the change will occur.
    All of these players perform functions that link the “buy side,”
    those who have capital and want to invest it profitably, and the “sell
    side,” those entities in need of capital. “At its heart, when it is doing
    what it does best, Wall Street is a superb gatekeeper, making matches
    between investors and businesses, governments, or anyone else who
    needs to finance something,” explains Mike Heffernan*, a former
    Morgan Stanley banker. The sell-side client could be a regional bank
    trying to resell portions of some of the loans it has made, a credit
    card company looking for an investment bank to package up its re-
    ceivables into asset-backed securities for resale, a town in Indiana
    trying to find an underwriter for the municipal bonds it must sell in
    order to finance new hospitals and schools, or a company trying to
    raise capital for expansion or to acquire a rival.
    The sell side wants to get as much capital on the most favorable
    terms possible from the buy side—investors who range in size and
    importance from individuals to mutual fund conglomerates such as
    Fidelity, and include hedge funds, private equity funds, foundations,
    college endowments, pension funds, venture capital partnerships,
    and ultrawealthy individual investors such as Microsoft cofounder
    Paul Allen or financier George Soros. In a perfect world, the sell side
    would love free money—with no interest payable, no specific term
    for repayment, and no promises about increasing the value of the
    investment. It is the myriad institutions that collectively make up
    Wall Street that—in exchange for a fee—bring together the two par-
    ties and negotiate a compromise: the terms on which the buy side is
    willing to invest some of its capital and the sell side is willing to agree
    to in order to get its hands on that capital. Banks have been fulfi lling
    that kind of function in more limited ways for centuries: the Bank of
    Venice issued government bonds back in 1157 to finance its war with
    the Byzantine empire in Constantinople, and by 1347, as the Medicis

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    28 CH A SING G OLDM A N SACHS

    rose to power in Florence, there were no fewer than eighty banks


    making loans and doing business in that city-state; a few years later,
    the Florentine authorities started a special credit fund that would
    give interest-free loans to distressed condottieri, or soldiers of fortune.8
    But as the sums got larger and the members of interested parties
    on the buy side (investors) and sell side (individuals or entities in need
    of capital) expanded in size and number and their needs became more
    complex, the process of bringing them together got tougher, and Wall
    Street–like intermediary institutions arose to facilitate the procedure.
    If you were a former condottiere who had lost an arm fighting for Flor-
    ence against its neighbor and rival city-state Pisa in the fourteenth
    century, you knew which bank to approach for your interest-free loan.
    But what about financing a decade-long voyage to Southeast Asia in
    hopes of finding the mysterious Spice Islands and returning with a
    king’s ransom in the shape of black pepper, cinnamon, and nutmeg
    in the sixteenth century, or funding the development of the latest gene-
    based cancer therapies in the twenty-first century? Both require the
    right kind of buy-side backer, or else the sell-side entity (the merchant
    adventurer or biotech engineer) would squander weeks or months it
    could ill afford trying to raise the capital it needed on its own. And it
    was only logical that these go-betweens—the investment banks and
    their predecessors, who made it their business to be familiar enough
    with all the deep-pocketed members of the buy side to quickly route
    the different investment opportunities to those they believed would
    have the most interest and the right risk appetite— should pocket a
    fee for that knowledge as well as for their skill in negotiating the
    terms of any investment.
    Wall Street exists to help investors and those in need of capital
    fi nd their way through the fi nancing maze. Investment bankers
    still not only link the two sides but also help them sort out what
    terms are fair for the kind of capital being sought. Wall Streeters
    weigh in on the relative merits of different kinds of capital as well,

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    FROM U T ILIT Y TO C A SINO 29

    advising corporate chief financial officers when it will be cheaper in


    the long run to issue debt on which the company will have to pay
    interest periodically, or when it might be a better idea to sell a stake in
    itself to investors in a stock deal. If they opt to issue corporate bonds,
    what kind of debt do investors want to buy, and what interest rate
    will the buy side demand in exchange for capital? Without the pro-
    cesses that Wall Street collectively oversees, it’s hard to see how that
    vital function in our economy would be filled. The U.S. Treasury
    could still issue bonds and sell them directly to citizens, and munici-
    palities might be able to raise at least some of the money they need
    selling muni bonds to their own citizens. But the latter, at least, won’t
    raise all the capital they could at the cheapest possible price without an
    intermediary to help them identify the maximum number of interested
    investors.
    If we were still back in the early 1900s, the prospect of the col-
    lapse of the investment banking system wouldn’t be quite as apoca-
    lyptic as it is today, at least as long as enough of the commercial banks
    remained in business. That’s because well into the 1920s, corporate
    finance was largely a matter of bank loans—if you could persuade
    your local bank manager that your business idea was sound and that
    you were a good credit risk, then he would lend you what you needed
    to get going and perhaps introduce you to some other folks who
    would invest in the fledgling company.
    The earliest backers of auto pioneers Henry Ford and William
    “Billy” Durant (who founded both General Motors and Chevrolet)
    were local businessmen willing to risk some of their own money
    on two of the ambitious pioneers trying to build and sell the new
    horseless carriages. Durant even orchestrated a bidding war between
    Flint and Jackson, two midsized Michigan towns, to decide which
    would become the corporate headquarters of Buick, the company
    that would later become General Motors. Flint won the battle (along
    with the future tax revenue and jobs for its citizens) when its four

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    30 CH A SING G OLDM A N SACHS

    banks and several carriage and wagon businesses, along with hun-
    dreds of other corporations and civic boosters, put up nearly $1 mil-
    lion in cash in exchange for stock in the fledgling company, more
    than double what Jackson’s citizens were able to offer.9
    Financing these entrepreneurs was both risky and nerve-racking:
    two-thirds of the more than five hundred car companies launched
    between 1900 and 1908 had either collapsed or changed their busi-
    ness within a few years.10 Once a bank or a backer had committed its
    capital to a specific venture, there were few exit strategies—the stock
    wasn’t publicly traded. This early version of the money grid was un-
    sophisticated and underdeveloped. Even Durant—far easier to work
    with than the mercurial Ford, and a former stock trader to boot—
    couldn’t penetrate Wall Street’s establishment and get the money grid
    working for the benefit of his company. Discussing the possibility of
    forming a trust made up of the biggest automakers to design and
    build a car for the mass market with J. P. Morgan’s minions, Durant
    couldn’t persuade the great man himself of the virtues of the auto-
    mobile. Much as he loved the idea of an oligopoly, Morgan seemed to
    love his horse-drawn carriage still more, dismissing automobiles as
    toys for the rackety younger generation and Durant as an “unstable
    visionary.”11 Durant was no more enamored of Morgan. “If you
    think it is an easy matter to get money from New York capitalists to
    finance a motor car proposition in Michigan, you have another guess
    coming,” he wrote bitterly to his lawyer. Ultimately, Durant relied on
    local financing to get his new venture, General Motors, off the ground.
    Henry Ford managed to steer clear of Wall Street until the end of his
    life, relying on a steady flow of loans from banks such as Old Colony
    Trust Co.
    Today’s money grid is altogether a far more sophisticated and ef-
    fective entity, having expanded geographically and evolved function-
    ally. Wall Street is no longer a small clutch of giant investment banks,
    but includes a large and diverse network of venture capital funds

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    FROM U T ILIT Y TO C A SINO 31

    whose specific function is to underwrite risky start-ups of the kind


    that Ford and Durant sought financing for a century ago and that a
    new generation of automotive industry entrepreneurs are trying to
    launch today. “This is what we exist to do,” says Dick Kramlich of
    New Enterprise Associates, one of the venture industry’s veterans.
    “Until the postwar period, and even for a while after that, if you
    wanted to start something completely new, your personal network
    needed to include people who had money or who could vouch for
    you to the bank. Now all you need is a great business plan that you
    can get in front of one of us. We’ve become part of the bigger,
    broader Wall Street system.”
    Indeed, during the Internet boom in the 1990s, Sand Hill Road,
    the long and winding thoroughfare that connects downtown Palo
    Alto, California, with the campus of Stanford University and other
    parts of Silicon Valley, became a kind of Wall Street west as the ven-
    ture capital funds that set up shop there became more important to
    both the economy and the financial markets, financing start-up
    companies and generating big paydays for their own backers when
    some of those— eBay, Amazon.com, Netscape, and Google, to name
    a few—hit it big. Of course, just as many of the ships that sixteenth-
    century merchants financed in their voyages to the Spice Islands of
    Indonesia ended up dashed to pieces against the rocks on the coast
    of Africa, so many of the start-ups that today’s venture capitalists
    back never live up to expectations or go belly-up. But the winners
    have been frequent enough that venture capital investors willing to
    wait five, six, or even ten years for their bet to pay off in their little
    corner of Wall Street can make just as much money as top-flight in-
    vestment bankers or superstar hedge fund managers in theirs.
    At the height of the dot-com boom in 1999, commercial real es-
    tate on Sand Hill Road was more expensive to rent than anywhere
    else in the world (including Manhattan and London’s West End),
    reflecting the triple-digit returns some venture funds were earning.

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    32 CH A SING G OLDM A N SACHS

    That bubble popped in 2000, making it possible once again to find


    affordable office space in Silicon Valley. But the venture capital com-
    munity continues to scour the landscape for the next “new new thing.”
    To many VCs, one of the most exciting of these is green technology,
    with businesses built around environmentally friendly twists on the
    pioneering products of a century ago, such as new kinds of batteries
    and power generation technologies along with—yes, you guessed it—
    new kinds of automobiles. Detroit’s executives might have had to
    grovel for a share of bailout funds after their financial prospects be-
    came so bleak that Wall Street east couldn’t do anything to help. But
    on Wall Street west, some of Sand Hill Road’s venture investors were
    eagerly backing companies such as Tesla Motors, founded by Elon
    Musk, the millionaire creator of electronic payments system PayPal.
    “A few years ago, this was the lunatic fringe of the venture capital
    industry,” explains Ira Ehrenpreis, a general partner at Technology
    Partners, one of Tesla’s financial backers. Today, he estimates, as
    much as $17 of every $100 that venture funds collectively invest goes
    into clean-technology companies as a category, while half of all the
    capital Technology Partners raises is allocated to the industry. Ehren-
    preis waxes rhapsodic about Tesla’s first car, the $109,000 Roadster,
    of which 1,200 were on order by the end of 2008; 937 had been sold
    by December 2009. “It makes a Prius look like a gas-guzzling hog
    and drives like a Ferrari!” he exults. A couple dozen of the brightly
    colored sports cars, which can travel 236 miles on a single charge,
    can sometimes be spotted whizzing silently along Silicon Valley’s
    highways and streets, Musk’s among them. The Roadster, says Ehren-
    preis, shattered the belief that going green meant abandoning style;
    the next step is to take the concept to the mass market, rolling out a
    more affordable Tesla sedan by 2011, and to raise capital for that
    through an initial public offering (IPO) of stock in the company.
    Kleiner Perkins Caufield & Byers is one of Silicon Valley’s most
    venerable venture firms; it has invested in most of the technology

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    FROM U T ILIT Y TO C A SINO 33

    industry’s landmark deals, now runs a $100 million “iFund” jointly


    with Apple in addition to its other portfolios, and has the same status
    in the venture capital universe that Goldman Sachs does on Wall
    Street east. But despite the motto on its website—“In Search of the
    Next Big Idea”—the firm passed up the chance to invest in Tesla.
    “All-electric cars probably aren’t practical for a long time,” argues
    Ray Lane, a partner at Kleiner Perkins and former president of Ora-
    cle Corp., the world’s second-largest software company.
    But Lane’s resistance to the idea of investing in a next-generation
    kind of auto company didn’t last long. Kleiner Perkins is now back-
    ing a more hybrid, less purist company, Fisker Automotive, launched
    by a designer who briefly worked for Tesla. “The Fisker cars are what
    I call a ‘no-compromise’ vehicle—beautiful and with a price point
    as well as features that will compare to a BMW,” boasts Lane, who
    has a gray Fisker prototype in his garage at home that can run for
    fifty miles per battery charge. “To back these electric vehicle compa-
    nies, you have to be as entrepreneurial within the venture world
    as the entrepreneur is within the corporate world—in other words,
    very, very willing to embrace risk.” But, he quickly adds, Fisker will
    build some seven thousand electric vehicles in 2010. “GM can’t seem
    to produce one.”
    By being able to reconceive itself and its role to include venture
    capital, Wall Street has proven itself, in the long run, more entre-
    preneurial than the Detroit-based automakers. It’s not just venture
    capitalists that have spotted the potential of this new breed of auto-
    maker, however. Even with only a few dozen vehicles on the road,
    the fledgling green technology banking teams from Goldman Sachs,
    Morgan Stanley, Credit Suisse, and others were already making the trek
    to San Jose to check out Tesla and its rivals. So what if they are still
    guzzling capital faster than an SUV or Hummer can guzzle gasoline?
    Wall Street today doesn’t need to be persuaded that it needs to be pres-
    ent from the very beginning if it is to capture all the business— and

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    34 CH A SING G OLDM A N SACHS

    profits—it can. Sure enough, early in 2010, Tesla Motors filed to go


    public, with Goldman Sachs selected to lead four blue-chip under-
    writers.

    How the Financing Life Cycle Works


    There may be no better example of Wall Street’s raison d’être than
    the role that venture capital—itself part of the money grid—plays in
    making entrepreneurial dreams a reality.
    The same week that Lehman Brothers collapsed, the major fig-
    ures of the venture capital community assembled at Microsoft’s cam-
    pus in Mountain View, California, a stone’s throw from Sand Hill
    Road. The occasion was the National Venture Capital Association’s
    thirty-fifth anniversary. They listened to presentations by three care-
    fully selected venture-backed companies: Tengion, a firm developing
    biotechnology to build new human organs from cells; Digital Signal
    Corp., which is honing 3-D facial recognition software that can be
    installed anywhere from airports to shopping malls; and Tesla Mo-
    tors. Formalities over, the crowd escaped gratefully to the reception
    room to quaff Napa Valley wines and buzz excitedly about the melt-
    down under way on Wall Street east. One of the most visible of those
    present was former star technology banker Frank Quattrone, who
    had spent the 1990s steering one promising technology company after
    another through the financing process, from the first capital infu-
    sions to the initial public offering (collecting hefty fees for his firms,
    which included Morgan Stanley and Credit Suisse, along the way).
    He became the banker most closely associated with the dot-com boom,
    but years after it burst, he was back helping start-up technology com-
    panies raise capital.
    That evening he was talking up his new quasi-banking venture
    Qatalyst, and debating the impact the turmoil on Wall Street proper
    would have on start-up businesses in Silicon Valley and his own

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    FROM U T ILIT Y TO C A SINO 35

    firm’s prospects. “He was very interested, feeling that this might
    pave the way for a revival of the old West Coast boutique investment
    bank, like the Four Horsemen,” said one venture investor who was
    on the receiving end of his pitch that evening.
    The Four Horsemen were four small to midsized investment
    banks—Hambrecht & Quist, Montgomery Securities, Robertson Ste-
    phens, and Alex. Brown—that individually and collectively carved
    out both a niche and a reputation for themselves as the go-to guys
    for entrepreneurs in need of finance, venture capitalists hoping to
    take their portfolio companies to the next level, and investors hoping
    to get in on the ground floor of the next great business idea. “We
    didn’t go into this wanting to be Goldman Sachs; we knew we’d end
    up as a marginal player trying to compete with them on ground that
    they owned, and that would be dangerous,” recalls Bill Hambrecht,
    who founded the firm that bore his name and who now runs another
    boutique, W. R. Hambrecht & Co. “More than many of those larger
    East Coast firms, our model was very straightforward—we were there
    to help those companies move up the ladder to the next stage in their
    financial life cycle.”
    In 1981, the rest of the investment banking universe woke up to
    what was happening on the West Coast. “In a sixty-day period, we un-
    derwrote [the initial public offerings of stock in] Genentech, People’s
    Express, and Apple,” recalls Hambrecht. “I think we had sixty people
    in the firm; we made about $50 million that year and it changed ev-
    erything.” Hambrecht had attended college with the late Dick Fisher,
    then chairman of Morgan Stanley, who recognized what was brew-
    ing before the rest of the big Wall Street institutions. “He called me,
    then came to visit me, and told me, ‘Okay, I want in on this business.’
    I asked him what companies interested him, and he mentioned Apple
    and a few others—he and his team had done their work and identi-
    fied the best companies, not the biggest ones.” Hambrecht & Quist
    would go on to co-manage multiple deals with Morgan Stanley,

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    36 CH A SING G OLDM A N SACHS

    helping each other earn hundreds of millions of dollars more in fees


    for both firms before Fisher retired and Hambrecht & Quist’s part-
    ners decided to sell their firm to Chase Manhattan in 1999, at the
    peak of the dot-com market.
    The names of the institutions that help Silicon Valley’s most prom-
    ising companies move from one stage of development to the next by
    providing capital directly or introducing the company to potential
    backers are likely to continue to change, but the process itself remains
    intact. The earlier it is in a company’s life cycle, the more informal
    that process is, as was the case with Google, now a corporate behe-
    moth. One of the company’s earliest supporters was David Cheriton,
    a Stanford professor who knew its founders, Sergey Brin and Larry
    Page. Cheriton also knew Andreas “Andy” Bechtolsheim, the cofounder
    of Sun Microsystems, and introduced him to the two would-be en-
    trepreneurs at a gathering at his Palo Alto home. Bechtolsheim wrote
    Brin and Page a check for $100,000 on the spot even though the com-
    pany hadn’t yet been formed. He followed that with another $100,000
    when the first formal venture financing round occurred the next
    month.12 (One firm that passed on Google was Bessemer Venture
    Partners; offered the chance to meet the “Google guys, ” tinkering in
    the garage of a friend’s home, David Cowan asked if there was a way
    out of the house that would enable him to bypass the garage.)
    In the space of those few weeks, the Google guys had rounded up
    another $760,000 in start-up funding after Bechtolsheim introduced
    them to John Doerr, one of Sun’s earliest investors and at the time
    the lead investor at Kleiner Perkins. Where Doerr went, others ea-
    gerly followed: the imprimatur of Kleiner Perkins was as valuable as
    that of Good Housekeeping or Goldman Sachs. Doerr roped in Jeff
    Bezos (he had also provided start-up funding for Bezos’s Amazon
    .com), who in turn brought along Amazon colleague Ram Shriram;
    all invested in the fledgling company long before it was clear that
    Google was going to become, well, Google. At the time, it was just

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    FROM U T ILIT Y TO C A SINO 37

    another speculative “angel” investment, one of scores that each of


    these individuals undertook between 1998 and 2000. But by the time
    the IPO had been sold and Google’s stock was trading on the public
    market, Bechtolsheim’s $200,000 was worth $300 million or so.
    A typical venture firm, such as Kleiner Perkins, raises and pro-
    vides capital at the earliest stages of the financing life cycle. That
    capital comes from other buy-side players, such as college endow-
    ments, pension funds, and very wealthy individuals whom the general
    partners know and trust, often successful entrepreneurs such as
    Bechtolsheim and Bezos. Venture funds make most of their money
    from their share of the profits of their funds (usually 20 percent) but
    also collect a fee from their investor base in exchange for their ser-
    vices bringing together those investors with bleeding-edge invest-
    ment ideas at their earliest (and most potentially profitable) stage of
    development. Without venture funds and their vast networks, how
    would Verizon’s pension fund know that two bright young Stanford
    students were about to put together a company that within a decade
    would dominate the technology landscape? And how would Brin and
    Page have navigated the Wall Street labyrinth in search of financing
    at such an early stage, while still working out of a friend’s garage?
    The next stage in the financing life cycle for venture-backed com-
    panies such as Google is something that will allow those early back-
    ers to realize the value of their investment. People such as Doerr and
    Bechtolsheim, like everyone else on the buy side, don’t want to keep
    their capital tied up in the same companies indefinitely; at some stage
    they want it back, along with a healthy return, in order to put it to work
    somewhere else and repeat the process. In other words, they want
    liquidity, just as any of those sixteenth-century merchants wanted to
    be able to sell part of his stake in the East Indian trading vessel long
    before it returned home with its hold stuffed with nutmeg, cinna-
    mon, and silks so that he could provide his daughters with dowries.
    By the time Google was ready to go public in the spring of 2004, its

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    38 CH A SING G OLDM A N SACHS

    team didn’t need any help from Bechtolsheim or Doerr in finding an


    investment bank willing to serve as an intermediary between Google
    and its future stockholders. Every investment bank in the United
    States, as well as an array of foreign competitors, wanted a piece of
    the action. Unlike all the dot-coms that had crashed and burned just
    months earlier, this technology company could point to real revenues,
    not just an ambitious business plan. It was a jewel, and every bonus-
    starved banker wanted a place on the list of underwriters—preferably
    as lead underwriter or, even better, the book runner, the guy in charge
    of deciding which equally excited mutual fund managers, brokers,
    and individual investors would win a few Google shares at the IPO
    price and who would get to pocket the bulk of the underwriting fee
    in compensation for all the aggravation. This would be a multibillion-
    dollar offering, and in a typical IPO, the underwriters collectively
    could pocket as much as 7 percent of the proceeds as their fee.
    Every banking team in the world began to chase the deal, and
    they all took it very seriously indeed. Morgan Stanley opened up a Sili-
    con Valley war room, complete with a team of top bankers and ana-
    lysts preparing pitch books and rehearsing answers to questions they
    expected to get from Lise Buyer, then Google’s chief financial offi-
    cer, and the other Google execs who would select the winners. “It
    was just like a presidential election campaign,” recalls Hambrecht.
    Two weeks before the “bake-off ” was scheduled to take place at the
    Palo Alto offices of Google’s law firm, Wilson, Sonsini, Goodrich, &
    Rosati, pitting the finalists against each other, Morgan Stanley’s team
    hired the key analyst that Hambrecht had assigned to prepare his
    own firm’s pitch for the deal. “They wanted to find out what we were
    doing,” Hambrecht says, shrugging. “All’s fair in love and war.”
    And this was war, make no mistake about it. On a Saturday af-
    ternoon in early April, the finalists were scheduled to appear, one at
    a time, to make the final pitch to Google executives and board mem-
    bers, each explaining (with the aid of thick pitch books stuffed full

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    FROM U T ILIT Y TO C A SINO 39

    of charts, diagrams, and other propaganda) why they were the only
    guys for the job. The Google folks knew what they were in for. Buyer
    had helped prepare pitch books herself in a previous life as a top
    technology analyst. Aware of the other tricks that Wall Streeters liked
    to play, she instructed the top bankers to stay home, decreeing that
    only the middle-ranking people who would actually do the grunt
    work on the deal should show up. (Few abided by that rule.) She also
    told them to be creative. “We wanted to be sure we’d be working with
    bankers who got our corporate culture, so I guess we kind of opened
    the door to a lot of the silliness that followed,” she said.
    One banking team brought beer, apparently assuming that a free-
    wheeling culture was synonymous with the liberal consumption of
    alcohol. Another tried to design a PowerPoint pitch incorporating
    Google’s own search engine, which would spit out the firm’s name
    when asked, “What is the best bank to underwrite Google’s IPO?”
    (The technical challenge proved impossible, and the banking team
    resorted to a paper version of the same pitch.) Citigroup’s technology
    bankers designed laminated place mats that spelled out the bank’s
    achievements and creative strategies for marketing Google to the
    public, using Google-like design elements and layout. The place mats
    probably came in useful for the pièce de résistance. The banking
    team from Goldman Sachs, taking to heart Buyer’s quip that, “given
    that we’re all here on a Saturday afternoon, you can damn well bring
    me dessert,” and learning through their own research that Brin and
    Page loved chocolate, ordered up a big chocolate cake, emblazoned
    with the Google logo, to bring to the pitch meeting. Stunts like that
    have been known to work, as Lisa Carnoy, who is now global capi-
    tal markets co-head at Bank of America, knows from her days co-
    managing the same group at Merrill Lynch & Co. Pulling together a
    pitch book for the investment bank’s presentation to Lululemon, a
    yoga clothing retailer seeking to go public, Carnoy included details
    of the favorite yoga positions of each member of the banking team

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    40 CH A SING G OLDM A N SACHS

    in hopes of showing just how much the bankers understood their


    potential client’s business. “They got a kick out of that and we got
    the deal,” she recalled.
    Winning an IPO is one matter; completing it to the satisfaction
    of all parties is something else altogether. However crucial the role
    played by Wall Street in bringing together and reconciling the com-
    peting interests of the buy side and the sell side, there is usually one
    group that feels it has given up too much in the process. A typical
    IPO investor, for instance, wants the largest allocation possible of a hot
    new issue. Many of those investors are also investment bank clients;
    they execute buy and sell orders and generate trading fees for Wall
    Street institutions year-round and aren’t shy about telling the invest-
    ment banks what they expect them to deliver in return. Fidelity, back
    in the days when it routed more than half of its immense trading activ-
    ity through Wall Street trading desks, routinely threatened to “cut the
    wire” and trade with a particu lar investment bank’s rivals if it didn’t
    get an allocation twice that of its nearest competitor for an enticing
    IPO. The investment bank usually obliged.13
    To make the buy side happy, the new stock should be priced at a
    level that will allow it to rise in value—preferably by 20 percent or
    more—in the days immediately following the IPO. That gives any
    mutual fund manager the chance to sell some of his shares at a quick
    profit— and can mean a big boost in trading revenues for the invest-
    ment bank as trading volume in the newly public stock shoots higher.
    When Netscape went public in 1995 at $28 a share, it posted its first
    trade at $71. Those watching the electronic screens were convinced it
    was a typographical error or that they were hallucinating. An entre-
    preneur watching that kind of drama, however, is well aware that he
    may have just lost millions of dollars of new capital for his company
    and is left wondering whether Wall Street has just ripped him off.
    “Everyone was angry about that, and very vocal about” what they
    viewed as giving up that much in potential proceeds, says Buyer.

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    FROM U T ILIT Y TO C A SINO 41

    Google tried to ensure that it would capture as much of the pro-


    ceeds as possible for itself and its backers. In fact, while the deal itself
    turned out to be messier and less profitable than anyone had hoped,
    it did at least leave all three parties—the buy side, the investment
    bankers, and the company itself—feeling equally dissatisfied. Mor-
    gan Stanley and Credit Suisse were told they had won the coveted
    co-lead-underwriting spots but that they would have to use Ham-
    brecht’s new method of capital matchmaking, a kind of auction that
    forces would-be buyers to bid against each other for the stock, dis-
    closing the maximum price they will pay. That approach was anath-
    ema to both bankers and the buy side: it not only involves a much
    smaller fee for the underwriters (about 2 percent of the proceeds rather
    than the traditional 6 percent or 7 percent) but also in theory elimi-
    nates the possibility of a first-day pop in the price of the newly public
    company of the kind that investors cherish but that issuers such as
    Google had learned to loathe. Hambrecht’s new firm, W. R. Ham-
    brecht & Co., which had devised the auction methodology, won a
    co-manager slot due solely to Brin and Page’s fascination with the
    auction idea rather than his four-page stapled pitch, which Buyer
    rated the worst she’d ever seen.
    For their part, potential buyers were disgruntled at being asked to
    relinquish their traditional instant profit. Hambrecht remained un-
    fazed. The auction process, he says, “means that Wall Street is really
    fulfilling its role as the intermediary because the proceeds are going
    to the company, not as instant, nearly risk-free returns to the bankers
    or investors who’ve owned the stock less than seventy-two hours.”
    The rock-bottom fee took a toll on the process, banking analysts
    would later argue. Merrill Lynch walked away from the underwriting
    syndicate outright, unwilling to do all the work for what it saw as a
    measly return. The remaining underwriters later confessed to being
    reluctant to battle as ferociously as they might have done to combat
    buyer apathy, given the low fees. Buyers lowballed the deal, responding

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    42 CH A SING G OLDM A N SACHS

    to the process and the deteriorating climate for technology stocks.


    Google had to settle for a price of $85 a share, instead of the $135 it
    had hoped to make from the deal.

    The Troubled Heart of Wall Street


    The process of underwriting an IPO or raising other kinds of capital
    for companies such as Google and providing exit strategies for their
    venture backers remains one of the core “utility” functions of Wall
    Street’s big investment banks. “It’s really not all that different today
    from the way it was back in the 1960s, when I wrote my first-ever
    case study about the IPO process,” says Samuel Hayes, professor
    emeritus at Harvard Business School. Only the names of the issuers
    and the underwriters are different, while the dollar amounts are larger.
    But as the Google transaction illustrates, the relationships between
    Wall Street institutions and the two groups on either end of the capi-
    tal exchange transaction that develop when a company goes public or
    otherwise raises new debt or equity capital aren’t always smooth and
    straightforward. On the sell side, corporate clients such as Google
    don’t always feel that their investment bankers are looking out for
    their best interests. Meanwhile, parts of the buy side—the investors—
    are just as skeptical.
    The first part of the problem—the increasingly bumpy relation-
    ship between the investment bank and its corporate clients—Hayes
    attributes to changes on Wall Street itself. The mergers that have taken
    place over the last twenty years— all of the Four Horsemen were ab-
    sorbed by national institutions, most of which in turn became part of
    still more massive financial behemoths—mean that doing the kind
    of smaller deal that is characteristic of what most companies need in
    the earliest days of their existence isn’t cost-effective. Venture capital
    investors are well aware of this trend, and it worries them. “Unless I
    have another potential Google, these guys don’t want to know,” says

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    FROM U T ILIT Y TO C A SINO 43

    one Silicon Valley venture capitalist bitterly. “They want the sure
    thing, the big deal that is going to be able to make a visible difference
    to their own profits at the end of the quarter. They are more inter-
    ested in that than in building relationships with corporate clients
    that might generate a stream of fees over the years. They have be-
    trayed our trust.” He points to Goldman Sachs, which shuttered its
    Sand Hill Road outpost (in a building it had shared with archrival
    Morgan Stanley) a few years after the tech bubble burst. “They’ll fly
    people in for things they consider important, but there aren’t as many
    people competing to serve this space, which means that all the com-
    panies that we are starting to fund today are going to have a much
    harder time in the later stages of their corporate lives when it comes
    to getting financing.”
    This venture investor predicts that a greater number of venture-
    backed companies will wither on the vine, unable to get financing
    simply because of their size relative to that of the investment banks.
    That, he argues, may not augur well for the future of both entrepre-
    neurial energy and Wall Street. Will some prospective entrepreneurs
    be deterred or some promising companies derailed? And what hap-
    pens if Wall Street turns its back on its core function of helping
    promising businesses realize that promise by accessing capital? “We
    play our role; we want Wall Street to play theirs.”
    For now, at least, the venture industry is keeping its part of the
    tacit bargain and continuing to invest billions of dollars a year in
    start-up companies. Despite the market chaos, venture funds still
    want to back the companies that they believe have the potential to
    become next-generation versions of Genentech, Google, or Ama-
    zon. These days those companies will range from start-ups offering
    innovative ideas on managing power grids more efficiently to busi-
    nesses based on new medical devices. But by 2009, the signals were
    becoming more mixed. Wall Street’s recent aversion to doing what it
    saw as small-scale underwriting deals had remained, and had been

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    44 CH A SING G OLDM A N SACHS

    exacerbated by the general chaos as banks focused on their own in-


    ternal restructuring. That forced some venture companies to direct
    as much as 40 percent of their investment funds in 2009 toward ex-
    isting, relatively mature companies still languishing in their portfo-
    lios and unable to find an exit.14 In a normal year, says Jim Feuille, a
    general partner at Crosslink Capital, his venture capital firm invests
    in eight or nine new businesses. By late October 2009, they had se-
    lected only three new companies in which to invest, in order to pre-
    serve enough capital to be able to continue supporting those older
    businesses. The National Venture Capital Association reported that
    the same trend was being seen across the industry: by the third quar-
    ter of 2009 only 13 percent of all venture capital investment dollars
    were directed to first-time companies, the lowest percentage on re-
    cord. Venture capital analysts such as Tracy Lefteroff at PriceWater-
    houseCoopers began to fret that if this trend continued, it could cre-
    ate a “hole” in the pipeline of companies going public, doing a
    disser vice to parties at both ends of the money grid.
    This kind of breakdown in the relationship between Wall Street,
    as represented by investment bankers, and its corporate clients isn’t
    confined to Silicon Valley—nor, as I’ll explain later in the book, is the
    breakdown restricted to one part of the money grid. The relationship
    between Wall Street and its partners on both the buy and sell sides
    has been under threat for more than a decade, as Wall Street drifted
    further and further away from its core utility function and those cli-
    ents generated a decreasing proportion of its revenues and profits.

    From Gatekeeper to Casino Croupier?


    Harvard Business School’s Sam Hayes has studied the breakdown in
    the relationship between Wall Street and its corporate clients in real
    time. Hayes knows whereof he speaks. He holds the Jacob H. Schiff
    Chair in Investment Banking as a professor emeritus and has studied

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    FROM U T ILIT Y TO C A SINO 45

    Wall Street from the perspective of a scholar (he has published seven
    books and countless research papers and other articles about various
    aspects of Wall Street), a consultant (to the Justice Department, the
    Treasury Department, and the Securities and Exchange Commission,
    as well as many businesses), and even a participant (he chairs the in-
    vestment committee at his alma mater and is a former chairman of
    the Eaton Vance family of mutual funds, making him a member of
    the buy side, while his role as a member of the advisory board of bro-
    kerage firm Edward Jones puts him on the sell side). When in 1970
    he began scrutinizing the way Wall Street worked, it was performing
    its intermediary function adeptly; the relationships with clients, he
    says, were true long-term ties of importance to both parties. When a
    CEO wanted to sell bonds, raise new capital through a stock issue, or
    mull over other strategic issues, he’d pick up the phone and call his
    banker. That banker would be the same person, or at least someone
    at the same firm, year after year.
    But Hayes soon began to detect signs that those relationships
    were crumbling, as they came under siege from both sides through-
    out the 1970s. A new breed of CEOs and chief financial officers with
    MBA degrees felt better equipped to pit one Wall Street firm against
    another in search of a way to cut financing costs. Wall Street firms
    were quite eager to poach their rivals’ investment banking clients,
    adding fuel to the fire. To both groups, this breakdown seemed logi-
    cal and even beneficial—why shouldn’t corporations shop around for
    the best deal and investment banks compete to offer that deal? By
    1978, Institutional Investor magazine had stopped publishing the an-
    nual “Who’s with Whom” list documenting which firms “banked”
    which corporate clients. “Clients didn’t like being labeled as ‘belong-
    ing’ to Kuhn Loeb,” Hayes recalls.
    The turning point came a year later when IBM wanted to add
    Salomon Brothers as a co–lead underwriter to a bond sale it was plan-
    ning. When the company informed its traditional bankers at Morgan

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    46 CH A SING G OLDM A N SACHS

    Stanley of its wish to include Salomon because of the latter’s growing


    importance in the bond markets, Morgan Stanley refused to share
    the spotlight. (At the time, Morgan Stanley, in an attempt to emphasize
    how exclusive it was in the clients it accepted, even insisted on using a
    special typeface in the newspaper “tombstone” ads announcing deals
    it had done.) Instead of backing away from the idea, as Morgan bank-
    ers had expected, IBM awarded the whole deal to Salomon Brothers,
    shutting out Morgan Stanley altogether. It wasn’t until 1984, when
    Morgan Stanley agreed to share the lead underwriting role for Apple
    with Hambrecht & Quist, that the blue-chip New York firm conceded
    that it would have to relinquish part of the limelight on occasion in
    order to participate at all in the deals it wanted to do.
    If IBM’s decision to put its foot down was the turning point in
    the relationship between Wall Street and the sell side, the tipping
    point in ties between the Street and its buy-side clients came in 1995,
    when Netscape went public with the assistance of several leading in-
    vestment banks. The transaction certainly was part of Wall Street’s
    core function—the underwriters were raising money for a corporate
    client—but the company in question had a far riskier and less estab-
    lished business model than those that bankers were accustomed to
    introducing to the buy side. With Netscape, says Lou Gelman*, a for-
    mer Morgan Stanley banker involved in the IPO, Wall Street was
    asking its buy-side clients to adopt a completely different approach to
    investing. Netscape wasn’t earning a profit, and its business model
    was untested, relying on the then-new phenomenon of the Internet.
    “Until Netscape came along, Wall Street used to say a company had
    to have two years of operating profits in order to go public,” Gelman
    says. But Morgan Stanley badly wanted a piece of what promised to
    be a very hot IPO. “Suddenly our top guys were tossing their own
    rules out the window in order to get this business.”
    Above all, the Netscape IPO opened the door to speculation as
    an investment strategy. It was now in Wall Street’s financial interest

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    FROM U T ILIT Y TO C A SINO 47

    to encourage its buy-side clients to toss away their concerns about


    investing in a relatively risky business. “We went from being a gate-
    keeper to [being] a croupier,” says Gelman. Until that time, he argues,
    Wall Street had served its buy-side clients by helping them preserve
    and protect their wealth. Now the ethos seemed to have changed; Wall
    Street was becoming a casino, a place where people could create
    wealth rapidly by speculating. “It was with the Netscape IPO that
    the conviction we have today—that it’s actually possible to get rich
    in a day by owning the right stock—took root,” Gelman says. “It’s
    corrupting.”
    Not only that, but for several years it was also exciting and dramatic;
    that drama would help swell Wall Street’s own coffers as hundreds of
    Internet companies followed Netscape’s lead and paid their 7 percent
    underwriting fee to go public. It all followed the success of the Netscape
    underwriting team, which, after overseeing the production of an IPO
    prospectus containing twenty-plus pages of risk factors, took the fledg-
    ling Internet company’s management team on the road to drum up
    buying interest. The target stock price crept slowly higher, to $12 per
    share and onward, as public awareness grew during that “road show.”
    The battle to acquire stock in the deal ended up bringing Wall Street
    and Silicon Valley to Main Street’s attention; both captured the imagi-
    nation of ordinary investors who until then had never had a brokerage
    account. One caller to Netscape’s headquarters asked what the IPO
    signified. “Essentially that means our company will be trading a cer-
    tain number of shares on the stock market, which will raise capital so
    we can expand our business,” the operator informed him. “What’s the
    stock market?” the caller inquired. Another caller had heard people
    talking about the deal in the grocery store and wanted more informa-
    tion. A third threatened to report Netscape to the San Jose police for
    “insider trading” when he wasn’t allotted shares at the IPO price of $28
    apiece. It’s not surprising he was unhappy: the stock soared as high as
    $75 in its first trading day, before closing at $58 a share.

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    48 CH A SING G OLDM A N SACHS

    The external exuberance wasn’t always matched inside Morgan


    Stanley itself, even after the deal turned into a runaway success story.
    “Some of us pushed back, but the argument came down to the repu-
    tation of our franchise against the potential revenue,” says Gelman
    today. “Were we going to be the firm that doesn’t do early-stage
    IPOs, when this is what the public wants to buy? No one, it turned
    out, was willing to walk away and leave that to our rivals.” By the
    time the dot-com bubble was fully inflated, Gelman was convinced
    that the capital-raising process had undergone a fundamental change.
    “We weren’t there to provide companies with the best long-term
    sources of capital to grow with; we were doing this to help our inves-
    tor clients get richer faster.” In his view, Wall Street had abandoned
    both of its core constituencies in pursuit of its own self-interest.
    That approach gained momentum as the years passed, and ex-
    tended into a variety of products, including higher-risk corporate
    bonds and collateralized debt obligations (CDOs), the bundles of
    mortgages (including those issued to subprime borrowers) that had
    been repackaged in the form of marketable securities. Caveat emp-
    tor, Wall Street declared—buyer beware. “Eighteen or twenty years
    ago, when someone [on Wall Street] showed us a bad product, we
    went crazy; we’d tell them, ‘Don’t ever show us that again,’ ” recalls
    Scott Amero, a portfolio manager at BlackRock, a major buy-side
    asset management firm. “At first we took the time to explain why
    something was a bad product, why it was risky or poorly designed.”
    But eventually Amero found it impossible to provide that kind of
    detailed feedback: either the relationships weren’t strong enough to
    permit it or the banker wasn’t in a position to do anything about
    BlackRock’s concerns, especially since there were other willing buy-
    ers. All Amero could do was go on a buyer’s strike. In 2009, Larry
    Fink, one of BlackRock’s founders and its chairman and CEO, gave
    voice to his fury with Wall Street for abandoning its traditional role

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    FROM U T ILIT Y TO C A SINO 49

    as gatekeeper that took care to funnel only valid and viable products
    to the buy side. In the past, Fink told the Financial Times, firms such
    as BlackRock “relied on Wall Street to be the safety guards to the cap-
    ital markets,” winnowing out the poor-quality deals. Now, he added
    angrily, it seemed as if it was up to his firm and other buy-side institu-
    tions to protect the integrity of the parts of the market.15

    The Core Function Becomes a Sideshow


    The IPO market may be one of the best examples of Wall Street’s
    core function at work, funneling capital from those who have it to
    those who need it. But Wall Street saw underwriting IPOs as less and
    less attractive with each year that passed. Most transactions were far
    smaller than either Netscape or Google, and the amount of work the
    investment bank had to do in order to drum up investor interest in a
    previously unknown company could be time-consuming. When that
    company planned to raise only $15 million or so, the fees were small.
    But being willing to work on an IPO was what a bank had to do in
    an era where relationships alone were not enough to win business.
    Some, such as Morgan Stanley’s Dick Fisher, realized that technol-
    ogy companies weren’t going to generate a lot of banking fees in the
    future. They didn’t need much new equity after an IPO, typically,
    and almost never raised debt capital, since they didn’t have the kind
    of fixed assets that bond buyers like to see. Unless the company
    decided to make acquisitions, the IPO fee might be the only banking
    revenue the underwriter ever earned. “Fisher told me he knew [com-
    panies such as Adobe and Apple] weren’t going to be good invest-
    ment banking clients,” says Hambrecht. “He was right; Adobe had a
    $10 million IPO and then never raised another dime on Wall Street.”
    But Fisher’s ultimate goal was to capture a different kind of busi-
    ness and a more secure stream of fee income for Morgan Stanley: he

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    50 CH A SING G OLDM A N SACHS

    wanted to woo the newly wealthy executives as clients for Morgan


    Stanley’s private banking team. “Sure enough, Morgan Stanley ended
    up managing about 90 percent of the wealth created in the Apple
    IPO, while Goldman Sachs did the same for their Microsoft million-
    aires,” says Hambrecht. And when the $4.4 billion initial public of-
    fering of stock in UPS closed in November 1990, Morgan Stanley
    saw its $50.5 million share of the $191.5 million in fees paid by “Big
    Brown” to the thirty-five-member Wall Street underwriting syndi-
    cate as just the tip of the iceberg.16 That evening, when UPS’s top
    brass sat down to celebrate the first day of trading in their new stock
    (and its 30 percent pop in value), they were sharing their prime rib
    not only with the bankers who had sold the stock but also with the
    Morgan Stanley wealth managers summoned to woo them as clients
    for that side of the company’s business. Yes, Wall Street was changing.
    Some of those who felt as if the new Wall Street was leaving them
    behind as it drifted further away from its core function came from
    within the ranks of Wall Street itself. While one group of Wall Street
    bankers focused on helping companies raise new capital, another spe-
    cialized in advising corporate clients on making a different kind of
    match: negotiating a merger with or acquisition of another business.
    Fees on these transactions may be a smaller percentage (from 1 per-
    cent to 3 percent) of the value of the deal, depending on the complex-
    ity and the players—but the deal sizes can be large. And a satisfied
    client can earn a banking team a series of fees year after year, as a busi-
    ness grows through acquisitions. JDS Uniphase, an optical networking
    company, forked over $30 billion in stock for big-ticket acquisitions
    in just a few years, each of which generated hefty deal fees—mostly
    in cash—for the matchmakers who helped orchestrate them.17
    At any rate, this part of Wall Street tended to see itself as an elite
    group. Other members of their firms underwrote stock and bond
    offerings, handled sales and trading, or devised structured products
    such as CDOs and might generate high fees when their part of

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    FROM U T ILIT Y TO C A SINO 51

    the business enjoyed its moment in the sun. But the mergers and
    acquisitions (M&A) advisory business, in their eyes, was the heart of
    what Wall Street was really about. “In my mind, the really sharp
    minds on Wall Street are not doing IPOs or debt financings; they’re
    doing strategic stuff like M&A advisory work,” says Mike Donnelly*
    bluntly. Donnelly, who lost his own job in the wake of the collapse of
    his firm, hasn’t lost his awe for those he considers to be Wall Street
    artists. “Someone who is really great at this has a knowledge of the
    business, the industry and the company and the strategic issues that
    lie ahead. He has the technical knowledge, he knows the latest twists
    and turns in accounting rules and the law. He has experience and is
    never taken by surprise because he knows the kind of odd things
    that can happen,” explains Donnelly. “And they can present every-
    thing to a board in a lucid and compelling way. I suppose they’re a bit
    like a Pied Piper; people who hear them will end up following them
    anywhere. It’s incredibly hard to find someone like that, and that’s
    why they are so valuable.”
    Robert Greenhill, Morgan Stanley’s president and Fisher’s heir
    apparent back in 1992, has always been that kind of banker. Flying
    his own Cessna from one client meeting to the next, he and his team
    had propelled the firm to the coveted top spot in the league table
    rankings. (These widely scrutinized lists, published quarterly by data
    groups such as Dealogic LLC and Thomson Reuters, told the world
    which investment bank had underwritten the most deals in any spe-
    cific area imaginable; the battle for league table credit and the brag-
    ging rights that went along with a top-three finish was fierce and
    remains so today.) Alas, merger volumes were down overall that year,
    and John Mack—whose own background was in sales and trading,
    the heart of the underwriting function— ended up elbowing Green-
    hill out of his way. Deposed as president in early 1993, Greenhill
    resigned shortly after, first joining Sandy Weill as the latter began to
    construct the behemoth that would become Citigroup and later

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    52 CH A SING G OLDM A N SACHS

    founding his own boutique advisory firm. He left behind him what
    became known as the “Greenhill gap”—there was no one who was
    his equal as a rainmaker for the firm.18
    To Gelman, the former Morgan Stanley banker, Greenhill’s de-
    parture symbolized the final transition of power from the long-term
    strategic thinking characteristic of an M&A advisor to the emphasis
    on speculation and short-term profit maximization symbolized by
    the rising power of the trading desks and their chiefs within the
    power structure of many investment banks. “By the time Netscape
    came along, serving investors who were speculating and trading like
    crazy— and trading for our own account—had become what it was
    all about,” he says. “Even in the IPO business, what had been a craft
    became an assembly line.”
    But by then, there was no way for Wall Street’s investment banks
    to become purists, even when it came to fulfi lling their gatekeeper
    role. Too much had changed in the world around them, and their
    responses to those changes had produced a series of unanticipated con-
    sequences. Long before the Netscape IPO was a gleam in the eye of
    the company’s venture capital backers, it had become clear to invest-
    ment bank CEOs that relying on the basic gatekeeping functions of
    yore was never going to generate enough profit to keep their ever-
    expanding empires afloat.

    Mcge_9780307460110_6p_01_r3.indd 52 5/6/10 7:22 PM


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