• Always Be a Player-Coach. Stay connected to the business on the ground even as you keep your eye on the big picture.
• Incentives Matter. Understand the importance of employee incentives and build compensation to match. Employees who have skin in the game tend to be more engaged with the success of the whole enterprise.
Chapter Nine
Blood on the Tracks
Wall Street’s Fears on Lehman Bros. Batter Markets
New York Times, September 9, 2008
Where were you when Lehman failed?
On Wall Street, that question will likely be asked for many decades to come. After all, the collapse of Lehman Brothers, one of the leading investment banks, was the biggest bankruptcy in U.S. history and the critical inflection point of the financial crisis that swept across global markets in September 2008.
I was at a party. My host, Maggie Wilderotter, was the dynamic CEO of Frontier Communications, a significant telecommunications company that I was soliciting to switch its public listing to Nasdaq. (I would eventually succeed, though it took several years.) We had become acquaintances, and I was subsequently invited to a gathering at her Westchester, New York, home on Sunday, September 14, 2008. Her husband was a winemaker, and together they owned a vineyard in the Sierra Foothills region of Northern California. On this particular day, he was sharing his wines, and she was a gracious hostess, entertaining guests in the grounds of their beautiful house, when the pleasant hum of conversation was abruptly punctuated by multiple phones buzzing. The breaking news rippled through the party: Lehman Brothers, one of the oldest institutions on Wall Street, was rumored to be going bankrupt. Looking around at the Gatsbyesque scene—the manicured lawn, the well-dressed guests, the dappled sunlight reflecting off the wineglass in my hand—I had the sudden sense that it was all precarious, the calm before a gathering storm. Was this how people felt at the end of the Roaring Twenties, just as the Great Depression was about to hit?
Before I could reflect any further, I found myself the center of attention. Everyone seemed to want my opinion about what this meant. It was largely a New York crowd, but not necessarily from the finance industry, so I became the de facto expert. I didn’t have much to offer by way of reassurance. The markets already seemed to be hanging by a thread, and this was not the good news we were hoping for.
I generally consider myself to be a reliable person in a crisis—the one who stays calm as others start to panic. But in this situation, my mind was racing. What were the ramifications? What would it mean to the financial markets? How would it affect the equity exchanges? Lehman Brothers was a huge player in investment banking, with tentacles in every corner of the industry. Compared to Bear Stearns, Lehman was a much bigger institution—and an important player in derivatives, which would be challenging to unwind in an orderly fashion. I knew Lehman’s size would likely mean that its impact and contagion risk would be many orders of magnitude greater than Bear Stearns’s. How would that affect the psychology of Wall Street? What would it mean to Nasdaq? Amid all of the unanswerable questions, there was one thing I was quite clear about—all hell was going to break loose the following morning. There was going to be blood in the streets.
Eventually, my racing mind settled on a simple truth. The one thing I could do was to take care of Nasdaq’s particular corner of the financial markets and ensure that it functioned superbly. That wasn’t a simple matter, because I knew we were about to see a flood of orders hitting our servers. For equity exchanges like Nasdaq, moments of crisis are always times when transaction volumes spike. Volatility attracts trading activity, and a precipitous event like the Lehman collapse was bound to spark a panicked sell-off. Could we handle the trading volume?
Thankfully, Nasdaq systems were up to the task. My CIO, Anna Ewing, and her team did a fantastic job of keeping everything up and running. Admittedly there were a few scary moments—times when our systems seemed to be bending like a sapling in a November nor’easter. Our transaction technology was pushed to the very edge over the days and weeks following the Lehman bankruptcy. We bent but didn’t break. We regularly test transaction volumes in our laboratory that exceed normal operations by two or three times. But in that period we were far exceeding even our test volumes. Every day I was relieved when we successfully processed the morning rush of orders. It was a testimony to the investment we had made in our transaction services over the previous years, beginning with the purchase of Instinet, and the subsequent consolidation and improvements we had made around that core technology.
The increase in transaction volume also meant a large increase in associated revenue. This created an incongruous situation: While everything else was crashing around us, Nasdaq revenue was going through the roof. But I knew that it was temporary. Like a drug-induced high, the crisis-driven revenue surge never lasts very long, and the eventual hangover is brutal. Indeed, the backside of any crisis in the economy is usually a significant recession, entailing a painful drop in transaction volumes, which can linger for some time, compounded by other knock-on effects, like the inevitable disappearance of the IPO market. So I had no illusions about the significant but short-lived profits suddenly appearing on our income statement.
The Great Credit Ice Age
Trust is essential in the development of any well-functioning society or economy. The political scientist Francis Fukuyama points out that successful societies are characterized by wide and efficient networks of trust that allow them to develop the social, political, and economic institutions that are critical to long-term thriving. The social capital that flows out of those trust networks is, like economic capital, an important part of what makes an advanced economy truly work. Trusting and being trustworthy tend to beget more of themselves in a win-win virtuous circle, but the opposite is true as well. Distrust can feed on itself, in a lose-lose deal that ultimately leaves everyone worse off. A circle of distrust was exactly what was set in motion when Lehman failed. Suddenly no one on Wall Street seemed trustworthy. And when trust fails in an economic system that runs on social capital as well as financial capital, the results are disastrous.
The first consequence of the Lehman bankruptcy was a freeze in lending activity. As if someone had injected a heavy sludge into a finely tuned machine, the financial industry began to gum up and grind to a halt. The markets absolutely rely on credit. It’s the oil that makes the entire engine run smoothly. And credit depends on trust. We all know that a credit card company will lend money to a consumer only if they calculate that that person is likely to pay the money back. The same goes for the billions of dollars in short-term loans extended every day between institutions in our global financial ecosystem. As with a personal credit card, the moment there is a loss of faith that an institution will repay the debt, credit lines get cut and lending stops.
That was what happened after Lehman—en masse. Trust started to break down. After all, who knew what monsters lurked on other people’s balance sheets? What if more Lehmans were out there, getting ready to implode? Even a business that was perfectly healthy for the moment might have significant exposure to Lehman’s failure. What if it had money owed to it that now would never be paid back? With stock markets going south, assets that were once perceived as rock-solid might suddenly look a lot less valuable. The insurance giant AIG was rumored to be the next institution teetering on insolvency. Maybe Morgan Stanley, whose stock was dropping every day like a stone, wasn’t far behind Lehman—or so people whispered. Perhaps even Goldman Sachs, the gold standard of investment banking, would require capital infusions to stay afloat? The rumor mill went into overdrive, and every counterparty, every trade, and every transaction was subject to heightened scrutiny and suspicion.
As these fears started to metastasize on Wall Street and spread throughout global markets, interbank lending rates soared. The market for commercial paper, an indicator of lending activity, shrunk dramatically. The so-called TED spread (the difference between interbank loan rates and rates on short-term
Treasury bills), a key risk indicator, reached an all-time high. “Credit Markets Frozen as Banks Hoard Cash,” announced one typical headline of the moment. A high-trust network had quickly devolved into a panicked race for survival. Now the only counterparty that anyone truly trusted was the “lender of last resort,” the federal government. The government had to act and provide a backstop to the spiraling crisis. Soon, a massive bailout was on the way.
Should federal regulators have tried harder to save Lehman and prevent the fallout of that bankruptcy? Without question, I think the answer is yes, assuming it was possible. In retrospect, letting Lehman fail was like taking the pin out of a financial hand grenade and hoping it wouldn’t blow up. Clearly, Lehman was only a symptom of the global financial crisis, not the cause, but it was a precipitous decision nonetheless to allow it to collapse. But hindsight is always twenty-twenty, and such decisions are never so simple in the heat of the moment.
Our nation’s economic leaders—individuals like Hank Paulson, Treasury Secretary; Tim Geithner, President of the Federal Reserve Bank of New York; Ben Bernanke, Chairman of the Federal Reserve; Chris Cox, head of the SEC; and Sheila Bair, head of the FDIC—were already operating in ambiguous territory, where the rules were not prescribed precisely and they had to fill in the gaps. They were trying to respond to the unfolding crisis with appropriate speed while acting within their actual legislative authority. There were no finely honed and tested tools to easily unwind an institution like Lehman, only blunt instruments. There was also the issue of moral hazard, the concern that if the government set a precedent of stepping in to rescue a major institution, it could actually set the stage for more risky behavior by institutions that now knew the downsides of that risk could be borne by others.
Among the architects of the crisis response, I interacted on occasion with Geithner, Cox, and Bernanke. Each earned my appreciation and respect, but the individual I knew best was Paulson. My first meeting with him was in his office in Washington, early on in his tenure. I recall him wondering, almost wistfully, what he would be able to accomplish at the Treasury, given the seeming stability of the economy at the time, his truncated term, and the meager bipartisan support for other needed reforms. He mentioned getting rid of the penny as one of his initiatives, which, though a laudable goal (and one that no one has yet achieved), is almost comically insignificant compared to the actual issues that he would be confronted with. I guess the lesson is: Be careful what you wish for!
On a more serious note, I believe that Paulson is a hero for the unprecedented actions he took, along with Bernanke and others, to prop up the national and global economy. I don’t hand out such compliments casually. The country was lucky to have a public servant of his temper and stature in such a critical role during one of the most dangerous periods in our history. Despite his Goldman Sachs roots, he never seemed to be merely a creature of Wall Street. He always struck me as a grounded, everyday man—refreshingly unconcerned with his own position. He wasn’t a natural politician—neither a gifted orator nor a reliable partisan of Left or Right. But clever verbosity is often overrated in business and life. And overt partisanship would have been a disaster during the financial crisis.
After the worst of the crisis was over, and the country was slowly and painfully recovering, I attended a conference at which Paulson, now retired, was a keynote speaker. At the end of his talk, I was the first in the audience on my feet. It was the only time I have ever led a standing ovation, and it wasn’t because of what he had said but because of what he did—for all of us. God help us if there had been someone less suited in the office of Treasury Secretary in late 2008. The moment demanded heroism, and Paulson delivered. He is, in my book, a great American.
I watched the unfolding crisis from the relative safety of the stock exchange, where things were less catastrophic. Indeed, the most important thing from my vantage point was how the equity markets as a whole performed in the midst of the chaos. In fact, they performed admirably—an untold story amid all the doom and gloom.
Indeed, it’s worth emphasizing that while Wall Street often gets painted with a broad brush, the equity exchanges were not responsible for the crisis. Rather, it started in the housing market and festered in the over-the-counter, nontransparent, bilateral trading venues where new financial instruments like credit default swaps helped create unseen risk. Nor did stock markets freeze up, like so many other trading venues. Indeed, once Lehman failed and credit markets ground to a halt, the equity exchanges, including Nasdaq, continued to function amid the spreading global panic, day after day after day. Trades were made and cleared, and the system continued to operate. Trust was maintained. People didn’t stop believing that their trade on Nasdaq or NYSE would get properly processed. They didn’t lose trust in the counterparty on the other side of the trade. The federal government never had to step in. That speaks to the resiliency of our model.
Of course, like everyone else, we were deeply concerned about how equity markets were dramatically falling during that period, and the impact on our nation’s economy and the wealth of hard-working Americans. We were constantly reviewing possible changes to our structure to make sure that trading practices like short selling were not fueling negative sentiment or interfering with appropriate price discovery. But ultimately our job is not to make the market go up or down; it is to make sure it doesn’t break down, which would have been its own kind of disaster. That was our responsibility; the one thing we could do in our corner of Wall Street to help. Consider this amazing fact—the primary thing we had to worry about during the crisis was too much volume, while the main concern with many of these other venues was no volume at all. They had broken down completely.
To Short or Not to Short
In my office at Nasdaq, there were a number of monitors playing financial news channels and displaying market data. Most days, they barely received a glance, but in the fall of 2008, my executive team and I were often glued to the drama unfolding in the market. On one particularly brutal day, Chris Concannon was my viewing partner. The market was dropping precipitously, and even as we stood on the fiftieth floor of a Wall Street tower, you could sense the fear in the streets. It seemed to permeate the very atmosphere of the city during those days, as if a massive low-pressure system had just parked itself over Manhattan.
“I’ve never seen the market fall like this.” Chris’s voice wavered slightly, betraying his own concern. Morgan Stanley was just one of the stocks falling, as if there was nothing between it and a fire-sale bankruptcy. Could things really be that bad? As the numbers flashed red on the screen, I turned to him, trying not to look as worried as I felt. “Short sellers are just hammering Morgan. And Goldman. The shorts are going to burn down the market.”
Short selling, for those not familiar with the term, means that an investor essentially bets that a stock price will fall, and seeks to profit off that decrease in price.* At the height of the financial crisis, with prices plummeting, short selling was rampant, and some were concerned that it was contributing to the downward spiral.
“Should we try to do something more?” Chris asked, unable to take his eyes away from the bloodbath on the screen.
Ask me on a normal day if short selling is a positive thing for the markets, and I could give you solid reasons why the answer is a resounding yes. Arguably, the ability to bet on the decline in the share price of a company brings needed discipline to markets, facilitating better price discovery. If you can only bet that the price will rise (by going long), that is an unbalanced situation and stocks will be overvalued. In theory, short selling can keep a certain “irrational exuberance” from taking hold in equities, allowing diverse voices to express their opinion on the direction of a stock price. It can also help root out fraud in markets, making it hard for companies like Enron to hide their duplicitous accounting practices. But during the financial crisis, short selling was like throwing gasoline on a forest fire that was already burning up capital at an alarming rate. So I apprec
iated Chris’s question. It was one I’d been asking myself. I wondered if maybe we should try to influence the SEC to further curtail short selling, at least temporarily. I also appreciated, however, that this was a step with far-reaching consequences that we currently could not see.
“Normally, I would say that’s a bad idea, but…” My voice trailed off. At that moment, despite my position at the top of Wall Street’s machinery, I felt buffeted by forces far beyond my control. Between the two us, Chris and I probably knew as much about market structure as any two people on the planet. But in the whirlwind of that period, it was hard to know how much to trust your own experience. It was the classic dilemma of the philosophical ideal versus the pragmatic reality. None of us had lived through anything like this before. Who were we to play puppet master to the markets, especially at such a delicate point in their history? Maybe it was all going to burn down, despite our elegant theories, hard work, and idealistic motives. I looked at Chris and completed my thought: “… but what the hell do I know?”
Such doubts often swirled around us as we watched the market swoon, flinching at the body blows it was receiving. Sooner or later, it was going to be a knockout punch. We put our heads down and did our jobs amid the gathering gloom, but our usual optimism was in short supply.
Soon after that conversation, I was at home over a weekend when I received a call from Chris Cox just before dinner. He had just been discussing the issue of short selling with Geithner. Already in the summer, they had cracked down on the practice, and attempts had been made to tighten restrictions. They had even banned short selling outright for a period in some financial stocks. Now Geithner was looking to implement further protections. I was sympathetic to the idea.
“Bob, sorry to bother you. But Geithner wants to get this done immediately, if possible,” Cox explained. He sounded exhausted, urgent, and worried—all at the same time.
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