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Doomsday on Wall Street  
Last Updated: April 1, 2008: 12:44 PM EDT
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What's wrong with Wall St. - and how to fix it

Bankers fell victim to their love of risk, leverage, and high pay. But after the government moves in to clean up the mess, things will be different - for a while.

By Shawn Tully, editor at large

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Doomsday on Wall Street

(Fortune Magazine) -- Until the recent tempest, Wall Street firms looked like just about the world's best businesses. Year after year they boasted sumptuous profitability, ever-rising share prices, and, if you believed their claims, a new generation of chief executives who had mastered the art and science of risk management. True, it was hard to decipher exactly how they made money. But make it they did, on an epic scale. From 2002 to 2006 the five big independent firms - Goldman Sachs (GS, Fortune 500), Merrill Lynch, Morgan Stanley, Lehman Bros. (LEH, Fortune 500), and Bear Stearns - tripled earnings to more than $30 billion and, at their peak, achieved an average return on equity of 22%, rivaling such royalty as the pharmaceutical and energy industries.

The standard rules of management, a righteous list that includes avoiding excessive debt and shunning excessive pay, didn't apply to Wall Street. So what if investors only dimly understood CDOs, CLOs, and the alphabet soup of arcane instruments that dominated the business, not to mention the super-geek hedging strategies the firm's leaders kept bragging about? Wall Street was the black box on the Hudson that worked its own mysterious magic.

Today the magic is gone, baby, gone. Since last year's historic highs, share prices at the independent securities firms have dropped an average of 42% - and that's excluding the wipeout at Bear Stearns (BSC, Fortune 500). Since mid-2007, Bear, Merrill Lynch (MER, Fortune 500), and Morgan Stanley (MS, Fortune 500) have taken more than $40 billion in pretax write-downs on their investment portfolios. And given the collapse in the mortgage securities they now can't sell, the big write-downs will keep coming.

In this special report, we'll examine the calamity from all sides, starting with a look at the highly flawed business model Wall Street has followed for years. Next, Allan Sloan explains how a problem with shaky home loans blossomed into a crisis that threatens the financial system. Roddy Boyd provides a behind-the-scenes account of Bear Stearns's collapse. We have an interview with Nassim Nicholas Taleb, author of The Black Swan, who argues that regular market meltdowns are inescapable. Columnist Elizabeth Spiers talks about measures - or mismeasures - of inflation. Finally, we have the story of discount broker E*Trade's near-death experience.

The truth is that Wall Street's shocking reversal of fortune was inevitable. Its black box is virtually guaranteed to careen from record riches to deep losses and ensure that employees grab a fat share of the booty. "As margins shrank in traditional businesses like underwriting and brokerage, Wall Street looked for new places to make money," says Louis Pizante, a former investment banker at Goldman Sachs and Nomura who runs Mavent, a leading compliance firm that ensures that mortgages bought by Fannie Mae and other institutions comply with federal and state regulations. "In the process the firms took imprudent risks to make big profits."

Put simply, Wall Street firms used towering leverage to make lottery-like loot in a long-running bull market that blatantly underpriced risk. Now that run is over, and the price of risk is rising dramatically. That's driving down the value of everything from junk bonds to mortgage-backed securities, and Wall Street's addiction to leverage is cutting the wrong way. The Bear Stearns story is a primer on the Wall Street curse: When portfolios are built on a mountain of debt, a firm's capital can vanish overnight.

Redemption won't be easy. The firms' three big weaknesses are deeply embedded in Wall Street culture. The first is that they depend far too heavily on risky trading as opposed to solid, reliable fee businesses favored by commercial banks. Second, Wall Street embraces leverage levels so dangerous that its vaunted risk-management systems can't prevent a collapse. Third, an outsized share of the gains goes out the door to executives and traders when times are good - or rather, when the firms get lucky - leaving shareholders with far less wealth when markets go sour.

The first issue - trading - is complex. Just a few years ago Wall Street garnered most of its revenue from fee-based businesses, including M&A advisory, equity and debt underwriting, and asset management. But from 2000 to 2006 trading jumped from 41% to 54% of revenues for the Big Five, rising to $70 billion a year. That figure includes commissions earned for executing trades for customers, as well as proprietary trading - investments made by the firm with its own money. Proprietary trading has accounted for most of the increase in revenue, but it's problematic in several ways. Wall Street firms occupy a highly privileged position for viewing which investors are buying or selling which stocks and bonds. That's because they fill orders for market-moving mutual funds like Fidelity and T. Rowe Price. They also own large "prime brokerage" arms that clear trades for hedge funds. Wall Street firms have always denied using information from their clients' trades in any way. But anyone who really knows the business will tell you that the firms use that intelligence to trade for their own accounts. Traders even have a name for it: They call it "color." "There's some truth to their having an advantage on information," says Scott Sprinzen, an analyst with Standard & Poor's. Though their fund clients complain about the practice, they put up with it - in part because Wall Street gives them lucrative allocations of initial public offerings.

We're not talking about the notorious - and illegal - activity known as front running, in which a firm takes a mutual fund's order, then buys the stocks or bonds for its own account before executing the customer's trade. Rather, Wall Street operates within the law by exploiting its intimate knowledge of the funds' trading patterns. For example, let's say a big mutual fund that owns no Oracle stock places an order for one million shares, and the broker knows that the fund typically builds a large position in several stages. The firm can profit by buying Oracle shares for its own account or by investing in a software index that will rise with Oracle's stock price.

Ethical issues aside, such activity is relatively low risk. But the firms don't stop there. Wall Street can't resist taking positions in currencies, oil futures, junk bonds, and other speculative vehicles. When investors think the world is getting safer, they demand less and less compensation for risk (and they begin to believe in magical stories, like the one that said that bundles of dubious home loans can be transformed into bulletproof securities). So fixed-income yields drop, raising bond prices, and P/E multiples on equities soar, as they did in the tech bubble. In those periods Wall Street cowboys look like geniuses. But inevitably the markets change direction, inflicting big losses on traders who have been riding the trend. It happened in the late 1990s with the Asian Contagion, the Long-Term Capital Management meltdown, and the Russian debt crisis, and again in 2000 and 2001 with the tech implosion.

Wall Street leaders from Stan O'Neal, former Merrill CEO, to John Mack, chief of Morgan Stanley, boasted that their firms' mastery of risk management would prevent massive losses from trading. But if Wall Street was hedged against a downturn, how could it generate such enormous profits on the way up? The simple answer is that it couldn't, and that should have been a danger signal. When the bull market is roaring, no one wants to trim profits by buying "insurance" against a big drop. On the downward slide, the firms pay dearly for shucking safety.

Company Price Change % Change
Bank of America Corp... 16.15 0.00 0.00%
Facebook Inc 58.94 0.00 0.00%
General Electric Co 26.56 0.00 0.00%
Cisco Systems Inc 23.21 0.00 0.00%
Micron Technology In... 23.91 0.00 0.00%
Data as of Apr 17
Index Last Change % Change
Dow 16,408.54 -16.31 -0.10%
Nasdaq 4,095.52 9.29 0.23%
S&P 500 1,864.85 2.54 0.14%
Treasuries 2.72 0.08 3.19%
Data as of 6:51am ET
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