What Happened on Wall Street?

On Sunday, two of the financial institutions that have defined Wall Street for more than a century closed shop — one, Merrill Lynch, staving off financial crisis by accepting a buyout from Bank of America, and the other, Lehman Brothers, filing for bankruptcy protection. The Dow Jones industrial average dropped more than 500 points the following day as investors tried to make sense of the new and still-changing world of finance.

The news of Lehman’s collapse and Merrill Lynch’s rescue came a week after the federal government, in an effort to stabilize lending, took control of the troubled Fannie Mae and Freddie Mac, the country’s two largest mortgage finance companies, leaving many investors wondering if the crisis is only beginning. Mark Williams, an executive-in-residence at the School of Management and a former risk management advisor for Deutsche Bank and Standard and Poor’s, spoke to BU Today about why the economy is in crisis. “Capitalism and bankruptcy,” he says, “go together like religion and sin.”

BU Today: Three of Wall Street’s five major brokerage firms are gone. What’s happening?
Mark Williams: I think what happened in the filing late Sunday night with Lehman Brothers is really sort of a microcosm of a broader risk that actually has enveloped the market in the last four years — that these financial institutions, whether it be Lehman Brothers or Freddie Mac, took greater risks than either they understood or should have taken. And as a result, these mortgages are coming home to roost, and they clearly didn’t have enough capital to cushion against the fall of these bad real estate bets.

In business you have to take risk to get return, but there were excessive risks taken, and excessive returns received in 2004, 2005, and 2006 — to the detriment of understanding what those returns really symbolized. Lehman is a great poster child of that: they collected billions of dollars in revenue in these years, but when it was finally realized that the risks were too great, it was too late for them.

The principle here that these large banks failed to focus on is basic risk management. And that is, diversify your risk, define the risk, understand it before you enter into it. And should the risk be greater than you originally anticipated, then you need to manage yourself out of that exposure very quickly.

Why wasn’t Lehman bailed out by the Federal Reserve, as Bear Stearns was in March?
The first to the trough seemed to get the bailout, so it was really a timing thing. If Lehman were the first to come to the Fed back in March of 2008, then most likely they would have gotten some sort of backstop that would have helped push them into the arms of a stronger suitor, such as JPMorgan Chase. But that wasn’t the case — and Bear Stearns was the fifth-largest bank at the time. It seemed to be much weaker than Lehman.

And also at the time, Lehman fought to remain independent. Dick Fuld, the company’s chairman, was fiercely independent and wanted to keep that identity, and was not interested even in March, or even as of a month ago, in being anything else than independent.

Will Sunday’s events work to slow the industry’s crisis?
We’ll know the answer to that in the next three months — whether Lehman’s bankruptcy is really the mark of the bottom of the market, or whether this punctuates the continuation of a downward spiral. My general sense is that the excessive risk-taking is over at this point. And we’ve had a lot of bloodletting. Bank of America acquiring Merrill Lynch is a good bet, because it’s going to shore up the market, at least for the third-largest investment bank in the country, and get them the capital base that they need to get out of this problem.

Is there any CEO accountability in these failures?
Well, it’s quite interesting — let’s just take Lehman as an example. In 2007, Dick Fuld took $22 million in compensation. But yet, in the last 10 months, the average shareholder has lost all shareholder value, which is a market cap of about $40 billion. So clearly there’s a disparity here. I’m sure there are going to be a lot of people looking very closely into the microscope, saying that we have to reexamine compensation and short-term compensation for executives, when they destroy long-term value.

Are we headed for a 21st century Depression?
Just to make it clear, economists have not said that we’re in a recession, so to jump ahead and talk about a depression is one step too far. But I will say the fact that the D-word is used quite a lot now suggests that we’re really at a low point in banking.

This is the largest fundamental change in Wall Street. In essence, two brand-name shops that represented and epitomized Wall Street are gone. I think it marks a new era, and maybe a reduction in the level of risk that will be taken by Wall Street going forward.

What’s the effect on the average consumer or homeowner?
I think there’s going to be two impacts. Initially, it’s extremely negative in the sense that we’re just showing continual turmoil in the marketplace, and the uncertainty in the marketplace typically increases the cost of capital for the average consumer. But you may also see the Fed pushed very dramatically to reduce interest rates, to try to keep the economy from teetering even further down the precipice.

What’s the best long-term outlook for the economy and these trading shops?
My outlook is a little rosier for these trading shops than where we are now. I think this is clearly a bloodletting, but what it does is reinforces basic concepts: for these shops to go on and take risks and get involved in very risky ventures like mortgage securities, they needed to do a better job with their homework. And I think what we’ve learned from this is that there’s going to be more focus on risk management, which I’m happy about.

In general, I’m optimistic that as the days, and weeks and months unfold, we’re going to learn more about how Lehman Brothers, a venerable shop that’s 158 years old and helped build America, could actually go into bankruptcy. And how Merrill Lynch, an icon of Wall Street, needed to be taken over by a bank — even six months ago, that would have sounded ludicrous. So I think there are lots of lessons to be learned. Hopefully, we’ll learn from these mistakes. I hope we don’t repeat them.

Robin Berghaus can be reached at berghaus@bu.edu. Jessica Ullian can be reached at jullian@bu.edu.