New York: The brokers’ customers did reasonably well. The brokers did not.
That is not the usual way of Wall Street. Two-thirds of a century ago, a best-seller asked, “Where are the customers’ yachts?” It noted that somehow the brokers always made money, even when their customers suffered. And so it has been for most of the years since then.
Tough time: Merrill Lynch headquarters in New York. The biggest issue for banks and Wall Street in 2008 will be assessing the damage.
But not in 2007.
How could that happen? In recent years, Wall Street came up with what amounted to parallel markets. Ordinary investors could buy and sell stocks and bonds, but the favoured insiders could partake in a host of investments not available to the rest. There were specialized securities and complex derivatives, and instruments known by their initials: CDOs, MBSs and SIVs.
In 2007, the Standard and Poor’s index of 500 (S&P 500) stocks rose a respectable 3.5%, and high-quality bonds performed well as long-term interest rates fell —at least for those with good credit.
Commodity prices continued to boom, and many foreign stock markets also did very well, particularly when viewed from the US, land of the declining dollar. By and large, the customers of the big financial firms had reason to be pleased.
But not the bosses. The chief executives of Citigroup Inc. and Merrill Lynch & Co. Inc. were forced out, while Morgan Stanley’s CEO will go without a bonus for the first time anyone can remember. Those three companies, and some of their competitors, had to go looking for capital infusions to make up for losses in those exotic markets that the public had been kept away from.
Some of the biggest profits earlier in this decade went to those who invested in private equity firms, which could take companies private and then get their money back almost immediately, often by having the companies borrow it.
But in 2007, the credit markets seized up, and suddenly it was not as much fun to be in the private equity business. The ones who enjoyed it the least were those newly admitted to the club. The Blackstone Group went public in June, just weeks before the credit markets began to turn hostile. Among the unhappy customers last year were the ones who got in on that deal. The shares, sold to the public at $31, ended the year at $22.13.
Overall, financial stocks did the worst of all in 2007. Of the 10 economic sectors that make up the S&P 500, eight showed gains, with the best performances turned in by energy and materials stocks —sectors that were helped by surging growth in developing economies.
Among the historic names that rose more than 20% were Exxon Mobil Corp., United States Steel Corp. and Alcoa Inc.
But the financial shares in the S&P 500 fell 21% as a group. Among the big names that lost at least one-third of their value in 2007 were Fannie Mae, Freddie Mac, Bear Stearns Cos Inc., Moody’s and Citigroup. MBIA Inc., a company that specializes in guaranteeing the financial health of others, lost nearly three-quarters of its value.
Financial scares tend to arrive every decade or so, and the US economy and financial system have always bounced back, confounding the sceptics—although in some of those crises there were more than a few financial fatalities. Many of the biggest banks of the 1970s are no longer around. They vanished into mergers with what had been smaller rivals that did not make the mistakes of earlier eras—notably lending to Latin American countries and overinvesting in commercial real estate.
The survivors of that wave of mergers, by and large, were regional banks. Two of the country’s largest banks, Bank of America Corp. and Wachovia Corp., have their headquarters in Charlotte, North Carolina (whether it is a coincidence or not, Charlotte is now the strongest major housing market in the country, according to one index).
On a relative basis, 2007 was the worst year for financial stocks since at least 1970—the earliest year for which S&P could provide comparable records. (The financials suffered larger falls in 1974 and 1990, both years of crises on Wall Street, but those were years when most stocks fell. By contrast, 2007 was a year when most non-financial stocks rose.)
The most recent period of severe underperformance of financial stocks was in some ways the opposite of this one. In 1997 and 1998, financial markets were shaken first by the collapse of some Asian currencies, then by Russia’s default on its debt. A weak world economy sent commodity markets plunging, with oil falling almost to $10 (Rs394) a barrel.
Now, commodities are strong, with gold topping $800 an ounce for the first time since 1980 and oil almost reaching $100 per barrel. Russia is riding high, and the government of Singapore, which suffered along with its neighbours a decade ago, bailed out Merrill Lynch.
The crisis of the late 1990s caused consternation in financial circles, and led to the rescue of a big hedge fund, Long-Term Capital Management. But it had little effect on the US economy, particularly on consumers. House prices, to cite one example, rose steadily during the period.
In this cycle, a decline in home prices helped to reveal financial excesses in the subprime mortgage market, where lending standards seemed to have all but evaporated in 2006 and the first half of 2007.
The results of that did spread, but not yet to the entire economy. The other economic sector where stocks fell in 2007 was consumer discretionary companies, a group that includes retailers and home builders. An index of department store stocks fell 35%, as forecasts of poor holiday sales came true. But those stocks did better than those of home builders, which were down 42%.
Many of the subprime mortgages had been financed through the securitization market, where a wondrous financial alchemy enabled risky investments to be transformed into supposedly safe investments rated AAA by the bond rating agencies, whose calculations of maximum possible losses turned out to have been woefully low.
In 2008, the biggest issue for Wall Street and the banks will be assessing the damage. Can the securitization market recover, and continue to provide financing for everything from credit cards to corporate loans? Or will its failure in the area of subprime loans spread, leaving it discredited and other parts of the economy desperate for cash?
On the answer to that question may hinge the answer to whether the latest financial crisis will pass with little impact on the real economy, or whether it will pull down all the parts of the economy that enabled most investors to have a good year while their brokers were suffering. If the former, the banks and brokers will recover, and the bailouts from China, Singapore and UAE will appear brilliant, proving that governments can identify bargain investments.
But picking bottoms is not easy, as Bank of America found. Its $2 billion rescue of Countrywide Financial in August was hailed as a bold move at the time, but the price it paid looks very high now.
There was, it turned out, a lot more bad news about Countrywide that was yet to emerge when Bank of America acted. If that is true for the banks and brokerage firms that received bailouts in late 2007, neither the rescuers nor the customers of those financial firms are likely to find much to enjoy in 2008.
©2008/THE NEW YORK TIMES