When Merrill Lynch reported solid second-quarter earnings last July, chairman and CEO Stan O’Neal sent employees a memo boasting about the firm’s risk management prowess. Only three months later, Merrill Lynch took its historic $8.4 billion write-down for losses in mortgage-related securities, with Citigroup and others soon reporting unprecedented credit losses as well. O’Neal and Citigroup chairman and CEO Charles Prince were both ousted from their jobs.
If the capital markets are models of efficiency, it is fair to ask, how could such staggering losses happen? Two Wall Street titans — Lloyd Blankfein, chairman and CEO of Goldman Sachs, and Kenneth Moelis of Moelis & Co. — addressed that question at the recent Wharton Finance Conference in New York City. Despite having different perspectives — Blankfein rose through Goldman’s fixed income, currency and commodities divisions, while Moelis is a veteran M&A investment banker — their views were remarkably congruent.
At its most fundamental level, they agreed, risk management is a corporate culture issue. To manage risks effectively over time, employees must put the firm’s welfare and the preservation of important client relationships ahead of everything else. In October, said Moelis, “firms got hit from The Blind Side” — a reference to a recent bestseller by Michael Lewis about professional football — “and a number of Wall Street leaders suffered career-ending injuries.” Said Blankfein, whose firm seems to have emerged from the recent credit implosion relatively unscathed: “Risk is risk, and you can’t be perfect at managing it.”
How Risks Originate
The bulk of Goldman’s risks, Blankfein said, do not result from proprietary trading, but rather from facilitating client objectives. Being an effective M&A advisor, for example, means giving advice that is actionable, which frequently requires the advisory firm to support the client through loans and other balance sheet commitments. Most of Goldman’s current exposure to mortgage risk came about in just this way — through commitments to support client originators.
Moelis, who founded his firm last summer after heading the UBS Investment Bank, ascribes the current Wall Street credit bloodbath to a widespread cultural breakdown — a loss of focus on client relationships and client-centered values. When a firm tries to explain away its losses by saying, “Our risk management broke down,” said Moelis, the explanation won’t wash. “Give an experienced trader a new rulebook on risk, and he will figure out how to game the new rules in minutes…. What you need from employees is a sense of relationships…. You need to have people who want to save the firm… one trader sitting next to another, saying, ‘This doesn’t look right’ instead of saying, ‘I want to join that scam.'”
“We’re at the beginning of a period of massive change,” Moelis predicted, “and, if you’re looking toward a career on Wall Street, the change is going to be good for you. I don’t think you would have liked the Street in recent years…. It will be a much better place to work going forward.”
Blankfein offered a comprehensive overview of Goldman’s risk management approach. Besides the firm’s daily mark-to-market disciplines, the three indispensable ingredients, he said, are “escalation, accountability and culture.” Escalation means communicating risk concerns to higher levels of management, “getting more fingerprints” on potential problem risks and challenging the notion that a business group leader ought to make independent decisions on risks that affect the entire firm. Accountability, of course, means acknowledging that people are responsible for what their business groups do, and, equally important, holding senior management committees responsible for evaluating all aspects of risk, including the quality of the people with whom the firm chooses to do business.
Goldman’s greatest risk protection, however, comes from ascribing as much status, prestige and compensation to those partners engaged in control functions as to those running businesses — and in constantly rotating partners back and forth between risk control and business operations. Goldman has at least 10 people in senior management, he noted, who at one time or another have run its mortgage business. Each of them contributed directly to managing the firm’s recent portfolio losses. Moreover, Goldman’s various risk committees meet constantly, Blankfein said. “It’s like painting a bridge. You go from one end of the firm to the other, and when you finish, you go back to the beginning and start over again.”
Changing Wall Street Leadership
To Moelis, who began his career at Drexel Burnham Lambert, the current mortgage debacle recalls other catastrophic events of recent decades — events that took years to play out and eventually wrought fundamental changes in the way Wall Street operates. The insider trading scandals and the related savings and loan crisis of the late 1980s finally ended the whirlwind of mergers and acquisitions fueled by high-yield financings. It was fully three years after Ivan Boesky had confessed to illegal insider trading and informed on confederates, including Drexel’s Michael Milken, that the U.S. thrift industry imploded — the result of its addiction to junk bonds and other hot money. Eventually, Congress rode to the rescue with the passage of FIRREA, the Financial Institutions Reform Recovery and Enforcement Act, which brought far-reaching change to U.S. financial services.
A decade later, the dot-com crash of 2000 punctured the Nasdaq stock market bubble, harshly punishing millions of small investors who had imbibed Wall Street’s Kool-Aid. Prosecutors came down on securities analysts for promoting stocks they had known to be of dubious merit, imposing a new Chinese wall between research departments and investment banking. Numerous corporate and accounting scandals followed — Enron, Tyco and WorldCom to name a few. Once again, Congress rewrote the rules by enacting the Sarbanes-Oxley Act, with its strict new corporate governance requirements.
Both the 1980s insider trading scandals and the stock-touting and accounting scandals of the 1990s took years to be resolved, as will the current mortgage crisis, Moelis predicted. Like those earlier catastrophes, the current crisis directly impacts consumers and, therefore, is likely to spawn significant legal and regulatory reform — especially since Wall Street remains a prime target for politically ambitious prosecutors: It is worth noting that Rudy Giuliani was the U.S. Attorney who collared both Ivan Boesky and Michael Milken, and is now a leading candidate for the U.S. Presidency, while Eliot Spitzer, the New York Attorney General who found incriminating emails penned by Wall Street analysts, currently occupies the governor’s mansion. “And Wall Street analysts tend to be literate people,” said Moelis wryly. “Just wait until investigators get hold of emails written by fixed income traders!”
Far from being over, the impact of the mortgage market crisis is just beginning to be felt, Moelis argued, so that, ultimately, it will affect not only rules and regulations, but Wall Street leadership as well. On the heels of Wall Street’s stock-touting scandals of 2000, many firms ousted their leaders whose backgrounds were in investment banking or retail brokerage, turning instead to their fixed income departments for a new generation of leadership. The Street’s fixed income business quickly tripled in size, he noted, as equity businesses receded. Fixed income tends to be “a win/lose business,” said Moelis, “because a bond is a commodity with little value creation…. Every time you trade a government bond, someone wins and someone else loses…. But Wall Street should be a win/win proposition,” one that creates value for issuer and investor alike.
Now it appears that Wall Street is headed back to an operating model centered on relationships and value creation, said Moelis. “Once again, it’s going to be a business of judgment and feel because we can’t go on just leveraging commodity products.” In addition, he predicts, some of the mega-firms will be broken up. “What you need in employees is a sense of relationships,” he repeated, “and you can’t have that with 200,000 to 300,000 employees.”
Taking the Medicine
Blankfein, too, foresees wide-reaching industry change. In the past, U.S. financial institutions have proven resilient in the aftermath of crises — “nimble” in their ability to “take their medicine and move on.” At the moment, however, with the U.S. economy exhibiting signs of a slowdown, it’s questionable when the industry will regain sufficient strength to resume its fundamental job — that of reallocating capital to the right places.
Nonetheless, Blankfein remains fundamentally optimistic about Wall Street’s future, especially in its business outside the United States. For the first time in 2007, Goldman is generating more revenue outside the U. S. than inside it — by a margin that widened in the third quarter. “It’s a tipping point,” he said.
Blankfein once headed Goldman’s emerging markets business in an era of recurring cut-backs as those markets expanded and contracted. “Things have changed,” he noted, especially with regard to the “BRICs” — Brazil, Russia, India and China, the fastest-growing economies in the world. “We no longer ask if we’re making enough in these markets to justify our presence; it’s a matter of how we could maintain a global franchise without them.” These economies are growing and accumulating wealth so quickly that they must constantly invest outside their own borders.
“Our business is to chase growth in GDP all around the world,” Blankfein added, “so we’re opening offices in places like Moscow, Dubai, Qatar and Tel Aviv. It’s a very different strategy.”