“The Collapse”

Mark Beasley (30 March 2010)

Extract: Bill Wrinkle had it all; he was the leader of one of the most powerful financial institutions in the world, he had the respect (and some might say fear) of his rivals and colleagues and he had the beautiful wife and house. Bill had come from the tough streets of New York armed only with what many competitors called “cunning street smarts” and a propensity to bully and intimidate. He was lauded by the press as a pioneer in the “new economy” expanding his company into new exotic financial products and business lines as well as moving his firm into geographic locations not entered by foreigners before. However, that was all about to change as his life’s work began to crumble and fall all around him in the autumn of 2008. His days of enormous risk-taking and swaggering bravado was about to lead him and some 50,000 employees down a precipitous path to eventual destruction.

“How had it come to this?” It was an unseasonably warm evening on the 5th of September 2008 when the lights of Bill Wrinkle’s midnight blue Mercedes lit up the forecourt of his expansive Greenwich, Connecticut home. Of all the palatial mansions that lined the treehugged streets of this part of the world, Bills was by far the most spectacular – a 12 bedroom oasis with tennis court, indoor squash court (which the talented player used almost daily), a 50metre infinity pool, and, enough land to host some of the more grander social gatherings of New Yorks financial elite, which his wife Kitty was famous for. This was now the furthest thought on the mind of one of Wall Street’s Kings, all those “friends” had now deserted him and the light laughter on his freshly cut lawn was now replaced with the deafening silence of isolation and Bill felt, abandonment. The 120 year old financial brokerage house he had helped engineer to be one of the worlds most powerful was now on its knees and facing collapse. As the company car crackled along the pebbled driveway Bill thought about how far he had come from the working class streets of Hoboken, New York, where he and his buddies would stare enviously across the small slip of water to the steel columns of Manhattan to a world that seemed a million miles away, to now actually running a major institution dominating that same small island (and to some extent, the rest of the globe). Most young men from his neighbourhood dreamt of marrying their high school sweethearts and settling down in the nearby suburb of New Jersey to raise a large brood and land a steady job at the local ship-building factory, but not Bill, he saw a much brighter future and the great promise that lay ahead on a gilded street called Wall, that is where he wanted to be. Bill was a gifted student, especially in Math and Science, receiving mainly A’s. However, he was known to have a quick temper that would explode with little warning, this was usually set off after Bill lost patience with fellow students who dared challenge his intellect or question his judgement. Being a good foot taller than the other kids in his year at Franklin D Roosevelt High School, most chose to agree with Bill rather than tempt receipt of his wrath.

He was also a talented athlete who excelled at track and field. He held the United States AllPublic Schools 400m hurdles record for some years until it was only bettered by a young African American athlete named Carl Lewis in 1979. Bill was the schools star quarterback who received several offers to play for such illustrious schools as Brown and Yale on full athletic scholarships, but Bill wasn’t interested, he was too eager to begin his career in the fast-paced world of high finance. How long ago that all seemed as he thumbed the scroll ball of his blackberry checking the latest alarming email from his long time colleague and co-chairman Jack Sykes, who had just received another worrying call from a large prime brokerage client who was concerned about the safety of their assets held with the bank. Again, he heard the words pass through his head: “How had it come to this?”.. As Bills eighteen-hour workday was just about to come to an end, (where he checked, as he did every night, the large bank of monitors in his expansive study to view the latest news and market updates from CNBC Europe and Bloomberg), he saw it... Flashing in the “newsalert” screen was the announcement that a major German bank was now considering halting all business dealings with the firm because they felt it was unable to fund ongoing activities. “How dare they make such an unjustified and invective statement!”... As Bill, and the rest of the street knew, confidence was everything, banking was a proverbial house of cards that once the first client made a move the pack was sure to soon follow.. “Those Bastards!!” his infamous temper exploding as he struck his fist on the antique mahogany writing desk in front of him, the same one that Thomas Jefferson, John Adams and co had signed Americas Declaration of Independence some two centuries ago. The irony was not lost on Bill as he recalled how he came into possession of this most treasured of historical items. It was almost 6 years ago to the day when Bill and most of Wall Street’s privileged elite had assembled at the historical Carnegie Hall to raise money for the less fortunate of New York.

It all started as a little bit of friendly competition with each “Master of the Universe” bidding a thousand dollars here and a thousand dollars there for items such as Derek Jetters baseball glove (the New York Yankees famed short stop), the last two tickets on the famed Concorde super jet to London and Tiger Woods golf bag, signed by the great man himself. However, as the night wore on Bill’s and the rest of the streets testosterone levels began to rise as the final item came up for sale. Frenzied bidding began in earnest as the chance to own a piece of American history was too far too strong a temptation.. After thirty minutes the bidding finally came down to Bill and Stan Weinstein, the CEO of a fierce rival firm, one whom Bill personally detested. As the price reached six figures Bill screamed out $1,000,000!! A hush immediately came over the room as the figure resonated throughout the hallowed nineteenth century music hall, “I’m out” was Weinstein’s response, as all eyes stared disbelieving in Bill’s direction. So it was his, he had outlasted them all and had triumphed to take ownership of a rare piece of America’s symbolism of economic and social freedom. Thinking quietly to himself, “It is worth twice as much as that – this is a bargain – don’t those fools know anything?!” (See Appendix A for a list of Sotheby’s recent auction sales of American Independence items) Just then his private line rang, bringing him back into the present with a startling jolt; it was Maria Sanchez, his trusted CFO of nearly 15 years. “Bill, more bad news I’m afraid, our euro credit lines with Banco Sabadell have been called in and Sir Maxwell from the Bank of London wants us to pledge more collateral or they will be forced to call in their pound denominated trades.” Bill by now was turning crimson with rage and barely could contain himself from letting fly with expletives.. “I can’t believe this. Leave it with me Maria, I will call our friends now and get an explanation!”

It wasn’t always like this, not even 12 months ago Bill Wrinkle was being hailed in Business Week and Forbes as the most admired CEO on Wall Street. He had helped guide his firms share price from $8 to $150 in the space of 15 years and had engineered two of the largest takeovers the banking world had ever seen; the first making it the third biggest American investment bank after it swallowed up a major competitor and the second, the historymaking acquisition of a major Chinese bank by a foreigner. Interestingly, the decision making process on both acquisitions, was one of intuition rather than detailed valuation or analysis. Bill was fond of saying: “If it feels right, let’s do it, you can run all the models and simulations you like but from my experience you never know the potential benefits until you roll the dice”. It appeared Bill Wrinkle could do no wrong. When the Asian currency crisis hit in the late 1990’s he had already bet, correctly this time, that it would be a short-term phenomena. He, as opposed to his contemporaries, used the period to consume companies aggressively, opening up offices in Australia, Kuala Lumper and Singapore. The firm now had a real global footprint, with interests not simply in traditional investment banking but in real estate, gambling (they co-funded a joint venture in Macau with Steve Wynn to open up the largest Casino in Asia) and insurance. Many analysts had questioned the thinking behind the firms move out of the traditional areas of banking and into fields where they had little if any expertise. Bill made his feelings quite clear when he said the gaming industry was very similar to the banking industry; “It is part strategy, part skill and mostly luck”. Reporters at the time thought this was a cocky remark, however, his investment appeared to pay dividends when Macau became the gaming capital of the world turning over $65billion a year. Bills casino investment alone made a very healthy profit of $150m in its second year of operation.

The same analysts were also very critical of Bills decision to enter the South-East Asian and Eastern European commercial property market. With almost no relenting, from the late 1990’s through to the early turn of the century the firm outlaid $2.5billion and snapped up the financial districts of Talin, Riga and Sofia as well as some big shopping malls in Bangkok, Manilla and Kuala Lumper. A controversial move that ran counter to much of the advice from his newly formed property team who felt the locations extremely volatile both politically and economically. To finance the transaction Bills firm listed the properties as REIT’s (Real Estate Investment Trusts) on the Hong Kong and London Stock Exchanges. These investments, again, turned out to be canny, returning substantial dividends to investors and appreciating by over 3 times their initial listing price. This led many other financial institutions to copy the model and apply it to similar projects. As for the Chinese acquisition, this now goes down in banking folklore. The story goes that Bill and some of his lieutenants from the firms Merger and Acquisitions and the International Corporate Legal teams procured the companies private jet from Newark and flew to Shanghai. On arrival they collected a translator, well versed in Mandarin and Cantonese, and proceeded to “door knock” five major domestic banks that were roughly ear-marked as potential joint venture “entry” partners. (At the time foreign finance firms had to partner up with a local and not hold a majority equity share of the enterprise) With an open chequebook Bill would meet the CEO and ask them what they thought their bank was worth, and when he received the answer he would say, “No, you are wrong it’s worth this much”, and would double whatever the figure was. In four of the five meetings Bill would receive a quizzical stare and then a polite: “不，謝謝”(No thanks) However, one particular CEO thought it was an offer to good to pass up and immediately drafted up the JV documentation and shook hands.

In thirteen months new legislation was then passed by Beijing that allowed greater than 49% share in foreign ownership. Bill’s firm immediately exercised their new right and swallowed up the relative minnow. They were now the first non-Chinese bank to open up banking operations under the firm’s own brand. Unfortunately, at the time of writing, the firm had reluctantly divested themselves from China after issues with corruption and insider dealing practices began to tarnish the firm’s image. Around the same period of the Chinese acquisition Bill was part of a very vocal group that strongly lobbied for the Glass-Steagall Act to be repealed and for this he was applauded as one of the few gifted contemporary thinkers of the time. “Now”, he said in a Bloomberg interview in 1998, “we need laws that encourage and embrace the increased dynamism of the new integrated world economy. Due to the increase in globalisation and financial deregulation we can no longer be shackled by the outdated laws of the past, the world has moved on, and if America is to maintain its position as the leader in the twenty-first century we need a regulatory system that does not inhibit financial innovation, expansion and development.” Background to the collapse In the mid-1990’s the United States government set in motion a social agenda that effectively forced the private sector to extend credit to those citizens who were less well off. Thus, the private sector needed to find new ways of making profits out of an unsafe asset. They did this through the process of Securitisation. Very simply securitisation is the practice of creating a liquid marketable security (e.g. Mortgage Backed Securities) out of an illiquid unmarketable security (pool of mortgages).

Below is a diagrammatical flow of how the product is structured and sold:

Trustee

Bank

Assets

SPV

Issue

Investors

Credit Enhancer

Service Manager
Cash Flows (loan pmts) Cash Flows (MBS interest/principal)

(Viney. C, (2009) “Financial Institutions, Instruments & Markets”, McGraw Hill) The complexity of Mortgage Backed Securities (MBS) was multiplied when they were sliced up, based on the on differing risks of default, to produce Collateralised Debt Obligations (CDO’s). These were now sold off to the financial community with effectively greater opaqueness and, thus, more risk. Bill Wrinkles firm was one of the largest holders of these types of securities, as the yields were extremely attractive, especially at the level of assumed risk they presented (usually 200-300 basis points above corporate bonds with the same credit rating). Standard and Poor’s even placed investment grade letters beside many of the issues. The size of the US Sub-Prime market was estimated at $3.5 trillion in 2006. (See Appendix B for a breakdown of the largest investors in sub-prime in 2006) When Bill and the management team were reviewing the final Profit and Loss numbers in 2003, the Securitised Trading desk stood out. The division had gone from $25million the previous year to $125million.

“This is fantastic guys, we are kicking some serious butt here, what’s our market share Doug?!” he asked the Head of Finance “36%, up from 15%”, he replied. “Wow, and are we happy with the amount of risk we are taking on Paul?” Bill asked Paul Furzier, the Head of Risk Management. “We are trading below our risk limits, based on what has been set, and our portfolio only contains a small amount of non-investment grade paper, so yes.” “I would stress though that we are moving very quickly into an area of debt that is new, called CDO’s. The opportunities look great, big spreads and big profits but there are potential problems if the domestic housing market begins to get overheated and mortgage defaults start to creep up”. Bill interjected “That’s great Paul, as for property losing value, I don’t think so, I have never seen a property crash here and the economy is so buoyant job loss is not a concern. Anyway these products are now so liquid we can trade out if there is a storm approaching”. “Let’s move the risk limits up, we need to get above 50% and squeeze our competitors” Bill added. “Whatever you say Bill, you’re the boss” Paul replied. Cracks first started to appear in the property market in 2005 when low quality mortgages (called sub-prime loans) began defaulting in the resort states of California, Florida and Nevada. The US Federal Reserve began to tighten monetary policy and the increase in monthly payments could not be met by many households who had obtained the loans with low or no documentation and, in many cases, no employment to repay the obligations. There was a collective panic across all the big financial institutions, who firstly had to examine their own levels of these toxic assets and then to their counterparts who maybe holding them. The attention quickly focused on Bill’s firm as most of the street knew that Bill personally made a point of taking on increased risk and even more leverage, especially in the last five years as cheap money seemed to fall from the sky. At the close of business on the 31 December 2007 Bills firm was over 30x leveraged. The next closest was Stan Weinstein’s firm with 15x leverage. Nervous clients, not surprisingly, worried that their cash was safe!

“Sir Maxwell, is it true that you are concerned your assets are unsafe with us!?” Bill, doing his utmost to remain calm.. “Well, squire! I have spoken to your dear old mate Stan and the rest of your yank pals on Wall Street and they are all telling me the same thing. Your firm is insolvent, you won’t last another month, maybe even week. I am simply trying to protect myself dear sir!”, arrogance pouring from his Etonian-flecked burr. Bill’s jaw dropped and his grip tightened on his ornate old-fashioned French telephone. “You pompous old bastard!” he exploded. “Who stuck by you when Soros almost destroyed your house?!!”, I’ll tell you who..Me!” “Listen, I am one hundred per cent certain we are, and will always, be solvent. We have over $50billion in excess cash and over $125billion in liquid securities”, “Yes”, Sir Maxwell interjected, “but how liquid are those CDO’s you own?”. “Listen”, Bill retorted. “Our firm has never taken on trades that we don’t know the risks inside and out, and I can assure you we are on top of the CDO’s, in fact, we are all over them, it’s not as bad a picture as my colleagues would like to paint”... “I am sorry Bill, sincerely I am…. “All I ask is more collateral and we can move these levels down once this terrible news all blows over...I have an incoming call from the Prime Minister now that I need to take. All the best Bill, speak soon I hope” with that Sir Maxwell hung up. Bill immediately arranged a 6am meeting the following day (a Saturday) at his compound with his CFO, Risk Manager and the Head of Domestic Fixed Income Trading, Jackie Weinberger. It was time to get a precise handle on the size of the damage that had been spiralling out of control all summer as the securitised markets started to capitulate. When the three arrived the following morning they were met by Bill in his dressing gown and slippers, with an almost crazed look in his eye. “He hasn’t slept”. Maria Sanchez whispered to her colleagues.

“Firstly, let me say that I am extremely shocked and disappointed to hear what is being said about our great firm. We are one of the most innovative and pioneering firms the world has ever seen, we are the only bank to have returned 25%+ annual returns to our shareholders since the turn of the century. When the market opens on Monday I want to release a statement assuring the market all is fine and it is business as usual, so just tell me when and how we can clean this mess up!” Bill demanded. “Now, Maria please tell me the good news” Bill announced. “It is not good Bill, actually it’s worse than we could have imagined. Our liquidity is drying up with clients withdrawing funds at break-neck speed, as I mentioned last night a lot of our revolving credit facilities have been with withdrawn or have been frozen indefinitely.” “Stop there Maria, what are you telling me, not less than 3 days ago you said we had $50billion in overnight cash?!” Bill countered. “It’s now $16billion, your favourite hedge fund manager instructed us to transfer his entire balance to Stan’s firm at the close yesterday and made it clear he would be placing shorts on our firm come Monday. He said it wasn’t personal, just business” Maria regrettably replied. “I can’t believe what I am hearing” Bill retorted sounding dismayed. “Are you saying that one of Wall Street’s most powerful firms, a firm that has been in existence since 1905, that has survived two World Wars and a Great Depression might need to file Chapter11?, I refuse to believe we have to even consider this option, not now, not EVER!.” Bill recoiled slamming his fist. What Bill didn’t realise was that many of his underlings and several Hedge Fund managers saw this coming months (even years) in advance. Those within the firm who would try to raise the growing issue of the heightened risk levels were either shouted down in explosive management meetings or simply ignored and told to leave the running of the firm to the man himself.

A well-known Hedge Fund manager, Jack Fink, had been quite vocal in his disapproval of Bill’s investment and financing activities and had been shorting the firm’s stock since the beginning of summer. He famously recounted a story on CNBC’s daily show about a situation that occurred when he was a Fixed Income trader at Bills firm: “I had just started a role as a junior trader on the long-term corporate bond desk, this was in the mid 90’s, and I had heard all of the stories about how Bill liked to come down from the 35th floor on the odd occasion make wages (bets) with the MD’s. On this occasion he approached my boss and asked him what was happening in the markets that morning. My boss replied that it was pretty quiet, not much activity. So to “liven” things up he asked my boss if he wanted to make the morning more interesting and place some bets on the level of the 10-year T-bond yield at 12pm.” “Say $100-$200?” he asked my boss. I assumed this was dollars, but it was $100,000$200,000 dollars!, on a one-off bet!!” “I think this type of behaviour really shaped my opinion of how he approached risk taking, and business for that matter. He was prepared, and obviously able, to make some big bets just to show he was the man. From that moment on I observed him up close, and to be honest he really scared and intimidated me, not only in his aggressive approach but what I believe was an irresponsible and arrogant style of management. Here was a guy that was the head of a corporation of over 40,000 people and had control of $100billion in shareholder funds and he was more interested in beating his chest on the trading floor rather than focus on the long-time stewardship of the firm.” The End in Nigh Just as the meeting was about to blow out of control Bills private line rang, it was Henry Merritt, the esteemed United States Treasury Secretary. “Hi Bill, how are you holding up?” Merritt drawled. “I gotta tell ya, the government is really concerned about what’s been happening this past week. We hear you are in an extremely tight spot and the outlook does not look great.”

“Hi Henry, we have a handle on the situation but my competitors are releasing damning public statements founded on rumour and speculation. This has caused panic in the market and my clients are reacting by withdrawing their assets.” Bill replied “What about these toxic assets I hear are creating a massive hole on your balance sheet?” Are you happy with your exposure?, I need you to be upfront with me here Bill” Merritt demanded. “Listen Henry, I have always run this firm as if it were my baby. If I wasn’t confident we could cover our exposure I wouldn’t get into the position in the first place.” Bill countered indignantly “Bill, listen, I want you to know that I have been speaking with Stan Weinstein and John Max the last few days and we want to put an offer to you. Basically what we are proposing is a government assisted takeover from one of them, and..” Bill interjected “No chance!”, “There is no way in hell I am giving power to this great firm away, no one can run it with the same skill as me, NO ONE. I’ll tell you another thing I would rather this firm by bankrupt than let that degenerate Weinstein buy it. We have been the best bank on the street for one reason and one reason alone and that is my leadership and strategic decision making. If you look at the returns I have brought this firm since being appointed as CEO it is unparalleled in history. To contemplate we would no longer be alive is inconceivable, and I might add, it is not surprising that my major competitors are looking to swoop on us.. I would not be surprised if most of this rumour spreading is coming from the firms you mention.” Bill bawled back. “Ok Bill, if that is how you feel and you think that you can get out of this mess by yourself then fine, best of luck to you. For if you do fail, god help us and god help America!” and the phone went dead.

Postscript Monday came and despite a pre-market announcement by Bill on CNBC and Reuters that the firm was in good shape and had plenty of cash to meet immediate demands the firm’s stock sank. It closed trading at $1.98 (a remarkable fall from a high of $150.51 in May 2007). Another phone call from the Treasury Secretary yielded no change in Bills stance or his positive outlook for the firm. When quizzed by a reporter outside his Manhattan office, he remarked that he didn’t believe that his firm was bankrupt and that it was simply rumour and speculation, with his company’s stock being irresponsibly punished by short sellers who had a personal grudge against him and his firm. On Tuesday morning the bank had filed Chapter 11 and after a century in operation was no more. Bill was required to front Congress two months later after an official inquiry was called to investigate how his bank could accumulate over $150 billion in losses and also explain his extremely handsome remuneration package during this time (See Appendix C). When quizzed by the Democrat Senator for Virginia, Jack Warren, about why he thought there was no big problems with his firm only a day before its bankruptcy he had this to say: “I honestly believed we were solvent and could trade our way out of any problems. We had some of the most talented traders on the street when it came to exploiting opportunities and I thought we could make a positive out of a negative, I really did. We had done it before and I thought we could do it again. And might I also add, much of this mess must be attributed to the incompetency of our Credit Agencies and Regulators. Our firm placed large orders on paper that was rated as investment grade, and it simply was not. Our firm was also regulated by an organisation that did not understand the products we traded in. If a finger is going to be pointed then I believe these two groups have a lot to answer”.

Questions to answer. • What, if any, of the psychological phenomena we have studied have led Bill Wrinkle to make errors when making financial decisions? • What could Bill Wrinkle have done to reduce his errors and biases? How could he debias? • If you were on the Board of Directors at the firm what policies would you propose to reduce Bills ability to commit errors and put the firm in peril?

Appendix A: Sotheby’s Auction sales of American Independence Items (2001) 1. The original chair on which each signatory sat to sign the Declaration $185,000 2. The actual signed Declaration of Independence $550,000 (record at the time) 3. John Adams Pen used in the signing $50,000 4. John Hancock’s Pen used in the signing $75,000 5. Paul Reveres Riding Jacket $35,000 6. 1775 Muscat used in War of Independence $68,000 7. Various legal documents $65,000 8. Thomas Jefferson’s waistcoat $89,000

Appendix B: Largest holders of Sub-Prime Securities (2006)

Sub-prime Securities ($) billion
$215
Fannie Mae - GSE Freddie Mac - GSE Bill Wrinkles Firm Stan Weinsteins Firm John Maxs firm

$300 $350 $250

$850

$650

$350
$85 $150

Ginnie Mae - GSE Foreign Investors Calpers Others

Appendix C: Comparison of Bill Wrinkles Yearly Salary Package to the Average (1992-2007)

$300,000,000 $250,000,000 $200,000,000 $150,000,000 $100,000,000 $50,000,000 $0
1992 1998 2007

Bill Wrinkles Salary
Mean Salary of US CEOs

The Firms Stock Price performance and Debt Ratio (1992 – 2007)

160 140 120 100 80 60 40 20 0 Stock Price ($) Debt Ratio (%) X

1992

1998

2007