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FINCGB.2334.20,30; FINCUB.45.001,002: Investment Banking

Charles Murphy
New York University
Spring 2013

FINCGB.2334.20,30; FINCUB.45.001,002:
Investment Banking, Murphy, Spring 2013
New York University

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FINCGB.2334.20,30; FINCUB.45.001,002: Investment Banking,

Murphy, Spring 2013
Table of Contents
"JPMorgan Chase & Co: 2011 Annual Report, Shareholder Letter" by
JPMorgan Chase & Co

"JPMorgan Chase & Co: Financial Results, 3Q12" by JPMorgan Chase &
Co

39

"Morgan Stanley: 2012 Shareholder Letter" by Morgan Stanley

65

"The Economics of the Private Equity Market" by Stephen D Prowse

73

"David Rubenstein And The Carlyle Group: The Kings Of Capital" by

Vardi, Nathan

87

"Profits for Buyout Firms Company Debt Soared" by Julie Creswell

93

"Wasserstein's Spoiled Fruit" by Effinger, Anthony

101

"The Operators" by Kelly, Jason

109

"Hedge Funds: Past, Present, and Future" by Stulz, Rene M.

115

"Overview of the Securities Act of 1933 and the Integrated Disclosure

System" by Johnson, Charles J., Jr.; McLaughlin, Joseph

135

"Inside the Deal that Made Bill Gates $350,000,000" by Uttal, Bro

155

"Shelf Registration (Rule 415)"

167

"Stars of the Junkyard"

171

"Bankers of the Apocalypse" by RoseSmith, Imogen

177

"Encouraging Signs of Distress" by Ji, Xiang

185

"Securitization: The Tool of Financial Transformation" by Fabozzi, Frank

J; Kothari, Vinod

189

"Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of

Mortgage Finance" by Acharya, Viral; Richardson, Mathew,
Nieuwerburgh, Stijn Van; White, Lawrence J.

203

"What Traders Do" by Silber, William L. and Smith, Roy C.

217

"Inside the Machine" by Peltz, Michael

225

"The Deal of the Century; Esquire" by Junod, Tom

233

"The Bull Whisperer" by Farzad, Roben; Son, Hugh

251

"Game Changer" by Segal, Julie

257

"Global Banking After the Cataclysm" by Smith, Roy C

267

"Rethinking Bob Rubin" by Cohan, William D

291

ii

Dear Fellow Shareholders,

Your company earned a record $19.0 billion in 2011, up 9% from the record
earnings of $17.4 billion in 2010.
Our return on tangible equity for 2011 was 15% the same as last year.
Relative to our competitors and given the prevailing economic environment,
this is a good result. On an absolute and static basis, we believe that
our earnings should be $23 billion $24 billion. The main reason for the
difference between what we are earning and what we should be earning
continues to be high costs and losses in mortgage and mortgage-related
issues. While these losses are increasingly less severe, they will still persist
at elevated levels for a while longer. Looking ahead, we believe our earnings
power should grow over time, though we always expect volatility in our
earnings it is the nature of the various businesses we operate.
2011 was another year of challenges for JPMorgan Chase, the financial
services industry and the economies of many countries around the world.
In addition to the ongoing global economic uncertainty, other traumatic
events such as the earthquake and tsunami in Japan, the debt ceiling
fiasco in the United States, revolutions in the Middle East and the European
debt crisis have impeded recovery. In the face of these tragic events and
unfortunate setbacks, the frustration with and hostility toward our
industry continues. We acknowledge it and respect peoples right to express
themselves. However, we all have an interest in getting the economy and job
creation growing again.
In the face of many difficult challenges, JPMorgan Chase is trying to do its
part. We have not retrenched. Just the opposite we have stepped up.
Over the past year, our people demonstrated once again that the work we
do matters. We positively impact the lives of millions of people and the
communities in which they live. Our duty is to serve them by stepping into
the arena each day and putting our resources and our voices to work on
their behalf. For us, standing on the sidelines simply is not an option.

During 2011, thefirmraised capital and provided credit of over $1.8 trillion
for our commercial and consumer clients, up 18% from the prior year.
We provided more than $17 billion of credit to U.S. small businesses, up
52% over last year. We raised capital or provided credit of $68 billion for
more than 1,200 not-for-profit and government entities, including states,
municipalities, hospitals and universities. We also issued new credit cards
to 8.5 million people and originated more than 765,000 mortgages. To
help struggling homeowners, we have offered over 1.2 million mortgage
modifications since 2009 and completed more than 450,000.
We also bought back $9 billion of stock and recently received permission
to buy back an additional $15 billion of stock during the remainder of 2012
and the first quarter of 2013. We reinstated our annual dividend to $1.00 a
share in April 2011 and recently announced that we are increasing it to $1.20
a share in April 2012. And we continued to build our business by heavily
investing in infrastructure, systems, technology and new products and by
adding bankers and branches around the world.
3

New and Renewed Capital and Credit for Our Clients

The best way to build shareholder value is to build a great company, with
exemplary products and services, excellent systems, quality accounting and
reporting, effective controls and outstanding people. If you continually build
a great company, the stock price will follow. Normally, we dont comment on
the stock price. However, we make an exception in Section VIII of this letter
because we are buying back a substantial amount of stock and because
there are many concerns about investing in bank stocks.
We believe you own an exceptional company. Each of our businesses is among
the best in the world, and record earnings were matched by increased market
share in most of our businesses. Most importantly, we have outstanding
people working at every level in every business across the economic
spectrum and around the world. This is no accident we work hard to bring
people with character, integrity and intelligence into this company.
There is always room for improvement, but the strengths that are embedded
in this company our people, client relationships, product capabilities,
technology, global presence and fortress balance sheet provide us with a
foundation that is rock solid and an ability to thrive regardless of what the
future brings.

In this letter, I will focus my comments on the important issues affecting

your company, including some of the regulatory and political issues
facing us.
The main sections of the letter are as follows:
I.

Our mission and how we operate to fulfill our role in society

II.

A brief update on our major initiatives

III.

The new One Chase strengthening the customer experience

IV.

An intense focus in 2012 on adapting our businesses successfully to the

new regulatory framework

V.

Comments on global financial reform

VI.

The mortgage business the good, the bad and the ugly

VII.

Comments on the future of investment banking and the critical role

of market making

VIII. Why would you want to own the stock?

IX.

Closing

I. OUR MISSION AND HOW WE OPERATE TO FULFILL OUR

ROLE IN SOCIETY

We are constantly asked the question of what

comes first in your company customers,
employees, shareholder value or being a good
corporate citizen which implies a need to
favor one over the other. We disagree with
this view. We must serve them all well. If we
fail at any one, the whole enterprise suffers.
Our customers, employees, shareholder
value and communities all come first
Many people seem to think that shareholder
value means profit and that a company
earns more profit by giving customers or
employees less. This has not been our experience. Our job is to build a healthy and
vibrant company that satisfies clients, invests
in its people through training, opportunity
and compensation and rewards its shareholders. When this is done well, everyone
benefits. At the same time, a company needs
to be successful financially because if it isnt,
it ultimately will fail. And when a company
fails, everyone loses.
How we view our customers we wouldnt
be here without them
There would be no company but for our
customers. Without our consumer or corporate clients and satisfied ones at that
there would be no profits, no bankers, no
staff and no CEO.
At JPMorgan Chase, we believe that
customers should be treated like we would
want to be treated ourselves. Customers
usually dont mind paying a fair price for
a product or service they need, particularly
if it is delivered well and accompanied
with a smile. We are constantly looking for
better ways to provide, combine and deliver
products that meet or exceed our customers
expectations. And we try to listen closely to
our customers even when they complain
because they are doing us a service by telling
us how we could do better. It means a lot to
a customer when we respond not only by
listening but also by actually changing.
6

How we view our employees they do it all

Doing a great job starts with great
employees. We look for high-quality people
with the capability to do a great job and
grow with the firm. Then we train and
empower them to do the right thing as best
they can; to understand and anticipate their
customers needs; and, in effect, to be their
advocate. To do this, each employee needs
help from the rest of the company.
There are many employees who work behind
the scenes that the customers do not see
such as programmers, assistants, network
engineers, operations clerks and others. But
these are the professionals we depend upon
to help us seamlessly deliver integrated and
complex products.
And all of our employees drive innovation.
They have the knowledge and the deep
understanding to find ways large and small
to improve a system, streamline a process,
and save time and money by making things
work better for everybody.
How we view our communities they are
our hosts, our customers and our future
Doing the right thing for shareholders also
means being a good corporate citizen.
If you owned a small business (e.g., the
corner grocery store in a small town), more
likely than not, you would be a good citizen
by keeping the snow and ice off the sidewalk
in front of your store or by contributing to a
local Little League team, school or community center. You would participate in the
community, and everyone would be better
off because of your contributions. As a large
company that operates in 2,000 communities
around the world, we should act no differently. We participate at the local level by
providing corporate support and by asking
our associates to get involved in the towns
where they live. We also participate in largescale, country-wide and sometimes global
projects, but the intent is the same to
improve the world in which we live.

In 2011, JPMorgan Chase contributed more

than $200 million directly to community
organizations and local not-for-profits. Our
employees also provided nearly 375,000
hours of volunteer service through our Good
Works program in local communities.
However, our efforts go well beyond philanthropic works. We finance and advise cities,
states, municipalities, hospitals and universities not just about financial affairs but
also in related areas of governance, growth
and sustainability. In 2011, we launched
The Brookings JPMorgan Chase Global
Cities Initiative with a $10 million commitment to help the 100 largest U.S. metropolitan areas become more competitive in the
global economy.
Our business also provides dedicated expertise and financing for economically challenged areas of the world. For example, we
partner with multiple global institutions,
such as the U.S. Agency for International
Development and the Bill & Melinda Gates
Foundation, to help launch and support
businesses that directly benefit small and
rural farmers in Africa. Additionally, we are
able to bring private capital to bear on scale
solutions to global health problems such as
tuberculosis and malaria. And we have just
launched a philanthropic program focusing
on entrepreneurship in South Africa.
I would like to mention one initiative of
which we are particularly proud. After making
some embarrassing mistakes with active
military personnel, we redoubled our efforts
to help military personnel and veterans men
and women to whom we owe a tremendous
debt of gratitude for the sacrifices they have
made get jobs and transition out of active
service to civilian life. Our efforts are working
over the past 12 months we have hired more
than 3,000 veterans.
In short, we are part of our communities in
every way possible from the largest countries to the smallest towns.
Its a big responsibility to be a bank and
communities are better of if we do it well
If the financial crisis has taught us anything,
it has taught us that being a strong bank
in good times and, more important, in bad
times is critical to the customers, communi

ties and countries we serve around the world.

Every day, our customers need us to deliver
cash of $600 million and to reliably and
quickly move $10 trillion around the world,
where and when it is needed. Our customers
trust us to safeguard $17 trillion of their
assets under custody, manage $1.9 trillion of
assets under supervision and protect $1.1 trillion of their deposits.
We provide our consumer and business
customers with more than $700 billion
outstanding of loans. We also are prepared to
lend them an additional $975 billion, under
committed lines, if they need it. Customers
count on us to be there for them. And if
we fail to do our job, they may fail as well.
Money and credit are like oxygen for the
economy. And like the oxygen you breathe,
you really notice it when it is not there.
Unfortunately, sometimes we have to decline
a customer request. Extending credit is
important, but avoiding making bad loans
as we all learned again in this crisis also is
important. It is hard to turn down a customers request and then try to explain why: We
may think the loan represents too much risk,
not only for us but also for the customer. We
dont always make friends doing this but it
is the right thing to do.
Conversely, we cannot be a fair-weather
friend. Clients, communities and countries
want to know that we are going to be there
particularly when times are tough. And when
times are tough, we focus more on helping
clients survive than on generating profits.
That is in their and our long-term interest.
Europe is one ongoing example where we
currently are applying this philosophy. When
Greece, Ireland, Italy, Portugal and Spain got
into trouble, we decided to stay the course.
Our exposures, as reported last year, to those
countries (primarily Italy and Spain) were
maintained at approximately $15 billion.
And we estimated that, in a bad outcome, we
could lose $3 billion, after-tax. (Under really
terrible circumstances; i.e., large countries
exiting the euro where the currency at settlement is uncertain for the assets, liabilities
and contracts at issue those losses could be
even larger.) These exposures are primarily
loans to businesses and sovereign nations,

as well as some market making. Even if the

worst outcome occurs, we believe that we still
made the right decision by being there for our
clients. We hope to be doing business in these
countries for decades to come.
We focus on quality profits not
quarterly profits
If we wanted to increase this quarters
or next quarters profits, we could and
we could do it easily. How? By cutting
marketing expenses by $500 million or eliminating another $500 million of investments
in technology, training or systems upgrades.
We also could add another $1 billion to
our profits by increasing our interest rate
exposure or credit risk. But this is not the
way to build a healthy and vibrant company
for the future or to produce what we would
call quality profits. In actuality, our profits
reflect decisions made over many years. The
breadth and depth of our client relationships today have been built over decades.
Our people have been hired and trained over
decades. Our branches whether retail or
wholesale have been serving our clients
for decades. Our investments in technology
and product innovation typically are multiyear in nature. Our institutional knowledge
and experience have been passed along
generationally for more than 200 years. And
the JPMorgan Chase reputation that we,
and our predecessors, have worked hard to
earn every day has endured for more
than two centuries.
All revenue isnt good; all expenses
arent bad
It always surprises me when people assume
that all revenue is good and that all
expenses are bad. Low-quality revenue is
easy to produce, particularly in financial
services. Poorly underwritten loans represent income today and losses tomorrow.
And an efficiently run company is not
the result of indiscriminate cost cutting.
All expenses are not equal, which is why
I always refer to waste cutting and not
expense cutting. Many expenses actually
are good expenses. If you are reading
this letter on an airplane, you easily can
understand my meaning a good expense

would focus on properly maintaining that

airplane. In the same way, you want to
see your company continuing to invest in
innovation and technology, marketing new
products, hiring employees and opening
branches. Our ability to distinguish
between good and bad expenses should
lead to higher profits in the future.
The reason we generally have been able
to avoid major expense-cutting initiatives
is because we continuously try to avoid
wasteful spending. And much of our efficient cost structure comes from ongoing
investment in technology and operations
and from rigorous attention to detail. We
strive to become an increasingly efficient
company. Efficiency is a virtuous cycle
we can continuously invest more, save
more, give our clients more and still have
healthy margins.
We build our operating company at a
detailed level
While JPMorgan Chase has six lines of business that we report publicly, we essentially
operate 60-70 businesses within and across
the six lines of business. Each of these businesses is expected to attract great management, deliver best-in-class products and
services, and earn a good margin while
making proper investments in its future.
We want each of these businesses to build
quality assets (i.e., well-underwritten loans
and books that are properly marked) and to
account properly for all liabilities. We believe
appropriately conservative accounting at a
granular level leads to quality earnings and
helps prepare each of our businesses to withstand tough challenges and to be there in
tough times for our clients.
JPMorgan Chase builds its business on the
credo first-class business in a first-class
way, and we stick to that credo even when
it means forgoing fees or declining a deal
that we do not think is in the best interest
of our client. And rigorous client selection
ensuring a high-quality clientele is the
foundation of a strong bank.
If we keep doing what I have described
above, you will not only be proud of
this company, but, we hope, happy with
your investment.

ITS NOT SMALL BUSINESS VS. BIG BUSINESS THEY ARE SYMBIOTIC AND
ENGINE OF AMERICAS GROWTH

THE

In our vibrant, extremely powerful and

Even Fortune 500 companies fail or are

complex economic ecosystem, there are 27

bought out or merged with another. Small

businesses often have benefited from strong

million U.S. businesses. Some facts:

companies sometimes morph into big ones

collaboration with the government in making

- just think of Apple, Google and Facebook.

certain types of investments. The American

All but 17,000 of the 27 million are small

businesses; i.e., they have under 500
employees.

Twenty-one million have only one

It is worth noting that both large and small

This is part of a healthy, constantly changing

people started and paid for the Hoover

economic dynamic. Failures are caused by

Dam, the interstate highway system and the

recessions, lack of innovation and bad

landing on the moon. But the Hoover Dam

management, among other things. The alter-

was built by a consortium of six American

employee - they are sole proprietorships.

native to this "creative destruction" would

businesses, the interstate highway system

Five million have fewer than 20

be a stultifying lack of change, inability to

was built by American construction compa-

employees.

adopt new technologies, inflexibility and,

nies spanning the nation and the Apollo

ultimately, lower growth.

spacecraft was built by American aerospace

Over half a million have between 20 and

500 employees.

We often read that small business is the

companies - and all of these projects were

supported by small business.

These "small businesses" account for 56

primary driver of new jobs - this is both

million jobs, or 49% of U.S. payroll employ-

incorrect and overly simplistic. Sometimes

ment. The remaining 17,000 firms with more

those net new jobs appear in small busi-

big business are pitted against each other or

than 500 employees account for the other

nesses, and sometimes they appear in large

are not good for each other, dont believe it.

51% of private sector jobs - and the largest

businesses. In fact, recent studies show that

They are huge customers of each other, they

1,000 companies alone employ over 31

large companies generally are more stable

help drive each others growth and they are

million people. (Outside the private sector,

over time and that their employment goes

completely symbiotic. Business, taken as a

another 21 million work for the government,

down less during recessions.

whole, is where almost all of the job creation

85% for state and municipal governments

- jobs that include our teachers, postal
workers, police officers and firefighters.)

One thing we know for sure is that capital

expenditures and R&D spending drive productivity and innovation, which, ultimately, drive

So when you read that small business and

will come from. And without the huge capital

investments made by big business, job
creation would be a lot less.

There are huge misunderstandings about job

job creation across the entire economy. In

Small businesses of all types are essential,

creation in the United States - and these

the United States, the 17,000 large firms

dynamic and innovative, and they are a

misunderstandings frequently lead to

account for 80% of the $280 billion business

uniquely entrepreneurial part of our

misguided policy. We often talk about the

R&D spending - and the top 1,000 firms

U.S. economy. We wouldnt be the same

net change in employment (clearly an

alone account for 50% of this amount. U.S.

without them.

important number); that is, the number of

companies also spend more than $1.4 trillion

net new jobs created. But it masks the fact

annually on capital expenditures, and the top

that the numbers change enormously

1,000 firms account for 50% of that amount.

underneath. On average, over 20 million jobs

Big businesses are capable of making huge

are "lost" every year as companies adjust

investments. A typical semiconductor plant

payroll or people quit or move. Fortunately,

costs $1 billion, and a typical heavy manufac-

more jobs than that are created most years.

turing plant costs $1 billion. These types of

In our economy, businesses continuously

investments create lots of jobs. Many studies

morph and change; they outsource or

have shown that for every 1,000 workers

insource jobs; some grow, some shrink and

employed by a big business' new plant, 5,000

some merge. New companies - big and small

jobs are generated outside the plant - from

- are created, and, unfortunately, some of

high-tech to low-tech positions (all to support

those companies - big and small - fail.

the plant and its employees); most of these

jobs appear in small businesses.

But that does not diminish what big businesses do. Large companies are very stable,
and they make huge investments for the
future. On average, they pay their people
more, and they provide health insurance and
benefits for their employees and their families. Big businesses are an essential part of a
country's success. Many American big businesses are the envy of the rest of the world.
Show me a successful country, and I will show
you its successful big businesses. Like small
businesses, big businesses are philanthropic,
patriotic and community minded. We are
lucky to have them both.

II. A BRIEF UPDATE ON OUR MAJOR INITIATIVES

The opportunities for JPMorgan Chase over

the next 20 years will equal or maybe even
surpass those of the last 20 years.

The expansion of our international

wholesale businesses, including progress in
our Global Corporate Bank

In last years letter, we discussed several

specific initiatives were undertaking in addition to the normal growth opportunities
that we pursue every day. Each one of these
initiatives involves a sustained, full-fledged
effort of investment in people, branches
and systems over a long period of time. And
while we know that these efforts may not
turn a profit in the first year, we expect each
one to add $500 million or more in profits
annually by the fifth to seventh year.

Last year, we described our international

expansion plan in detail. It involves building
out our global presence across our wholesale businesses (Asset Management, the
Investment Bank and Treasury & Securities
Services) in the rapidly expanding markets
of Asia, Latin America, Africa and the Middle
East, as well as in emerging and even frontier markets.

The following segments provide an update on

how each of these initiatives is progressing.

As our clients multinational corporations,

sovereign wealth funds, public or quasipublic entities expand globally, we intend
to follow them around the world.

We Are Expanding Our Global Platform

1C

We have made good progress:

Five years ago, we served approximately
200 clients in Brazil, China and India
combined. Today that number has grown
to approximately 800 clients. Five years
from now, we expect to serve 2,000 clients
- including locally headquartered companies (about 50%) and foreign subsidiaries
of international companies (about 50%).
In 2011, we opened offices in the following
new locations: Harbin, China; Panama
City, Panama; and Doha, Qatar. Thats in
addition to the offices we opened in 2010
in Bangladesh, Bermuda, Guernsey, Saudi
Arabia and the United Arab Emirates. A
quick glance at the map on the previous
page shows the offices opened over the past
two years in new and existing locations
and the cities around the world where we
plan to add locations in 2012-2013.
When we started the Global Corporate Bank
(GCB), we had 98 bankers. By the end of
2011, we had more than 250 bankers in 35
countries. We plan to have approximately
320 bankers in 40 countries by the end
of 2013, who will provide approximately
3,500 multinational corporations with
cash management, global custody, foreign
exchange, trade finance and other services.
This strategy has led to a 73% rise in our
trade finance loans, a total of $37 billion
in 2011. We also increased other business
with these same multinational corporations, including rates, foreign exchange and
commodities, by 30%.
Commodities
In 2011, we completed the integration of
assets acquired from Sempra. We now are
one of the top three firms in commodities - i.e., global sales and trading, as well
as advisory services and market making in
metals, oil, natural gas, power and others.
Our global franchise includes approximately

600 employees and 10 main office locations

around the world. Over the course of last
year, we grew our client franchise by more
than 10% to serve over 2,200 active clients.
And we increased the selling of commodities products to already existing clients
so that hundreds of clients now come to
us for multiple products across different
commodity asset classes.
Small business growth
In 2011, we provided more than $17 billion of
new credit to U.S. small businesses in 2011, up
52% from 2010. We are the #1 Small Business
Administration (SBA) lender nationwide
for the second year in a row. In 2011, we also
became the #1 SBA lender to women-owned
and minority-owned businesses.
Since 2009, we have added 1,200 new relationship managers and business bankers, and
that includes adding 600 business bankers
in the heritage Washington Mutual (WaMu)
states of California and Florida. And we plan
to continue aggressively hiring bankers who
are meeting the needs of small businesses.
Commercial Banking expansion
particularly in WaMu states
Our Commercial Banking business has
performed well in the recession, earning
returns of more than 20% during the past
two years and over 15% in the most difficult
years. We continue to invest in additional
bankers and offices to support growth. In
2011, Commercial Banking added 60 new
bankers, placing 21 of them in states where
WaMu had a presence. Our expansion efforts
have made great progress in California and
Florida alone, deposits increased to $1.8 billion
and loans to $2.0 billion by the end of 2011.
Since the WaMu acquisition, our Commercial
Banking business has continued to add 200+
new clients a year in the WaMu states.
Commercial Bankings International Banking
business unit also has experienced significant
growth. In the six years since the unit was

Small Business Growth

11

10

Our Branch Network Provides Continued Opportunity to Grow

launched, International Banking has increased

the number of U.S. Commercial Banking
clients using our international treasury and
foreign exchange products to 2,500 clients
at a rate of approximately 20% per year, and
we expect this trend to continue.
As we strive to better and more fully meet
the needs of our Commercial Banking clients,
we are increasing their access to a broader
range of products. Today, our average
Commercial Banking client uses more than
eight of our products and services, and this
number continues to increase.
The growth of our branch network

For years, some have predicted the demise

of the physical branch as more customers
choose to transact banking business online
and on their mobile devices. However, our
experience shows that instead of choosing
between a branch and a website, customers
actively use both. More than 17 million of
our customers are paying bills online. But
when its time to take out a mortgage, apply
for a credit card or seek personal financial

advice, customers often prefer to meet face

to face with a banker. These activities will
take place in physical branch locations for
the foreseeable future. Our small business
and middle market customers also are more
comfortable discussing business needs such
as cash management in person rather than
online. In fact, our middle market business
wouldnt exist without the branch network.
Our branch presence also is a competitive
advantage for many of our other businesses:
For example, when we open a Chase branch,
it provides our Card Services and Mortgage
Banking businesses with the opportunity to
offer more credit cards and retail mortgages.
Today, about 45% of our Chase-branded
credit cards and about 50% of our retail
mortgages are sold through our branches.
Today, our consumer banking household
uses, on average, seven Chase products
and services. Increasingly, our customers
require and appreciate having the option
to transact their business with us virtually
and personally. Our network of branches
gives consumers that choice.

12

11

The map on the preceding page shows our

current branch footprint. Since 2009, we have
built more than 525 new branches. In 2011, we
opened 260 new branches and added more
than 3,800 salespeople in the branches. We
expect we will add approximately 150 -200
branches a year for the next five years, which
is fewer than we previously had planned. We
are taking a more measured approach because
regulatory changes have affected our ability to
profitably operate some of our branches.
That said, and despite slight reductions in profit
due to an abnormal interest rate environment,
our average retail branch still earns approximately $1 million a year. And the right type of
branch in the proper location is profitable not
only on its own but is enormously beneficial
to the rest of the company. We believe interest
rates and spreads will return to normal levels,
and we are building our branches accordingly.
The map shows we are building branches
where we already currently reside. It always
has been more valuable to increase your market
share in an existing market than it is to go to a
new market.

Chase Private Client business continued

growth

In 2011, we opened approximately 250

Chase Private Client (CPC) locations
branches dedicated to serving our affluent
clients investment needs and we plan to
open another 750 CPC locations in 2012.
Chase Private Client is quickly making an
impact in deepening our relationships with
the 2 million affluent clients that already
bank with Chase. Today, more than 500
Chase Private Client bankers and advisors
serve private clients, and we plan to add
more than 1,200 private client bankers and
advisors in 2012. Since we launched the first
phase of CPC expansion in July of 2011, the
number of CPC households we serve has
nearly quadrupled, and each of those households has grown deposit and investment
balances by $80,000 on average.

WHEN YOU HIRE JPMORGAN CHASE, YOU GET ALL OF US ONE

GREAT EXAMPLE OF OUR BROAD, ORCHESTRATED EFFORTS WITH
ONE GREAT CLIENT
At JPMorgan Chase, we are privileged to work with

Fund the manufacturing and finance company

Caterpillar across our markets and services -

operations by underwriting some of their bonds

from community banking in Caterpillar's hometown

and other forms of financing.

in central Illinois to strategic advice on Caterpillar's largest-ever acquisition. The relationship spans

decades and multiple continents, with constant

critical trade finance around the world.

dialogue at many levels of our respective companies.

We helped Caterpillar:

Support the sale of Caterpillar's products into

developed and emerging markets by providing

Fund a portion of Caterpillar's global supply

chains working capital requirements in more than

Efficiently manage its cash through our Treasury

10 countries.

Services team.

Serve its current and future retirees by investing

more than $2 billion of the company's 401(k) and

Finance several of Caterpillar's independently

owned dealers who sell and service its products
around the world.

defined benefit plan assets.

More than 100 JPMorgan Chase banking profes

Evaluate and execute strategic acquisitions by

working closely with the companys strategic
investments team.

sionals around the world touch Caterpillar directly

at many levels. This is a great relationship for all
parties involved.

Provide interest rate, foreign currency and

commodity risk management services
through Caterpillar's work with our exposure
management teams.

13

12

III. THE NEW ONE CHASE STRENGTHENING

THE CUSTOMER EXPERIENCE

The Chase consumer businesses Retail

Banking, Credit Card, Auto Finance and Mortgage historically ran as independent companies. Now we are coming together to run all
of these companies as one consumer business
and one brand to focus, first and foremost,
on serving our customers in the ways they
want and with the products they choose.
This includes developing common strategies,
delivering a consistent customer experience,
designing a seamlessly integrated product
offering and continually innovating for our
customers. We call this effort One Chase.
Doing a better job serving our consumer
and small business customers
What does One Chase mean for our
customers? It means being known and
appreciated for all the business they do with
us across all product lines and feeling
as if they are dealing with one company.
It means customers will be treated with
consistently great service every time, any
way and anywhere they connect with us. It
means when customers call Chase, they will
get an answer from the Chase representative
answering the phone whether the question is about their mortgage, credit card fees
or banking account. It means customers can
have more needs met at the Chase branch
including not only being able to get a credit
card, mortgage or checking account but also
being able to talk with branch professionals
about any problems they may be having with
any of our products.
Here are some of the things were doing
to serve our consumer and small business
customers better:
Making our communications clear and simple

Our customers have told us that the fine

print on our disclosures was confusing and
wordy. Of course, that was not our intent.

When we speak, email or send a letter to a

customer, we aim to foster confidence, not
confusion. So we have undertaken a number
of initiatives designed to simplify the way we
communicate with our customers.
At the end of last year, we unveiled a revised
summary guide for Chase Total Checking
that makes its terms and conditions easier
to understand. We developed a simple
disclosure form that uses everyday words
in a consumer-friendly format. Instead
of saying transaction posting order, our
new disclosure now says how deposits
and withdrawals work, using words that
customers understand. Consumers now can
more plainly see a description of fees and
services and learn how to avoid certain fees,
determine when deposits are available, and
track when withdrawals and deposits are
processed on three pages (instead of 40).
In addition to streamlining and clarifying
our written disclosures, we also are proac
tively reaching out to customers with an
email or a phone call when we think they
should know something about their account.
For example, if there are suddenly several
unusual transactions in a customers account
that could indicate fraud, we immediately
send an email alert or make a phone call to
let them know.
Focusing more on customer complaints

Every week, and sometimes every morning,

the senior managers in our consumer businesses listen to or read customer complaints
to get to the root of problems and to identify options to solve them. These issues
are discussed, and the follow-up and feedback are shared with the broader customer
support teams.
We know every company makes mistakes.
But if you dont acknowledge mistakes, its
unlikely you canfixthem. No one should
be afraid to make a change because it might
imply that something we did in the past was
wrong. Instead, every employee at the firm

14

13

including me should take responsibility for

mistakes and take the initiative to fix them
and prevent them from occurring in the
future. We must continually make changes
that make us better.
Empowering our employees to own customer
issues

When customers contact Chase, they expect

and deserve to have us understand
and assist them with their entire relationship, regardless of which line of business
is involved. To ensure this happens, we
increasingly have empowered our frontline employees to better handle customer
requests and issues.
For example, we have authorized branch
managers to use their judgment in waiving
fees for customers they know personally
in order to get them a quicker response or
expedite a transaction. We are providing realtime information to our bankers and advisors, eliminating the need to transfer many
customer calls. These initiatives have helped
drive customer complaints down 25% over
the last six months.
One Chase means one customer. So when
making decisions, we consider the entire
relationship our customers have with us. For
example, when making a decision about a
credit card application, we now more fully
consider what type of customer the applicant
has been and how long that person has been
a customer.
Learning from our bus trips and other feedback

Following a terrific bus trip last summer

along the West Coast, we hopped on a
bus again in February 2012 and took a
week-long, 550-mile journey through the
Sunshine State. We visited branches and
operations centers throughout Florida,
many of which are in off-the-beaten-path
locations, like our credit card operations
center in Lake Mary. We met face to face
with approximately 5,000 employees and
hundreds of clients across all our lines of
business from consumer customers to
Fortune 500 CEOs. We also met with elected
officials and community leaders to talk
about how much were expanding, lending
and adding jobs in Florida.

It was an incredible trip that gave us the

opportunity to see firsthand how vibrant our
business in Florida is: We have become the
# 1 SBA lender, and our branch count, which
was 261 when we bought the WaMu business
in 2008, is nearly 300 today we expect it to
grow to 500 in three to five years. Five years
ago, we had 6,700 employees in Florida, and,
including the 4,500 people we hired last year,
we now have 17,550.
One of the most rewarding parts of the
trip for us was riding the bus with some of
our front-line employees tellers, branch
managers, personal bankers and others.
Their perspective and advice on how we
could do a better job were invaluable. And,
boy, did we get a lot of advice 160 specific
recommendations, which we are in the
process of implementing as we speak.
We want to make this drive toward continuous improvement a part of the fiber of
every person at our firm.
A new internal tool called What Do You
Think? is giving our employees throughout
the firm a chance to evaluate the products
we offer customers, as well as the services we
provide internally, from accounts payable to
our online benefit enrollment and internal
travel services. Some of us predicted these
internal services were going to receive the
worst ratings we werent wrong. But we
know that while we wont always like what
we learn in fact, sometimes it is embarrassing it will help us become better.
Providing best-in-class services internally is
just as important as providing them to our
customers because better services make our
colleagues lives easier so they can spend
more time with customers in helping to solve
their problems.
Continually innovating for our customers
A culture of speed and innovation is imperative. Sometimes people come up with
great ideas on their own, but, more often, it
happens through informal networking and
brainstorming. Also, small improvements,
over time, cumulatively may lead to major
breakthroughs.

15

14

The financial services industry has been

highly innovative over the past 20 years,
from ATMs to online bill payment and a
variety of mobile banking applications.
Chase mobile customers increased 57% over
the past year to more than 8 million active
users at the end of 2011. These customers
transact online by paying their bills,
checking their balances and transferring
money between accounts. Some of our new
consumer innovations include:
Chase QuickDeposit SM , part of the Chase
Mobile applications that allow customers
to make deposits from their smartphones
(by taking a picture of the check). Our
customers have deposited 10 million checks
in 2011. Over the past year, our total deposit
volume increased to $2.6 billion - with
$481 million deposited by QuickDeposit in
January 2012 alone.
We added "pay with points" functionality
to our Amazon.com Rewards Visa card,
allowing customers to use their rewards
instantly as cash.

We introduced Chase Sapphire SM for the

affluent market in late 2009 and generated
more than 1.8 million accounts in about
two years. In 2011, we launched Chase
Sapphire Preferred SM , an enhanced affluentoriented product that rewards customers
with two points for every dollar spent on
dining and travel.
We continue to roll out new products. Soon
after this letter goes to press, we will be
launching an exciting new banking product
that will have innovative features and broad
appeal. I believe this could be a breakthrough product for consumers in terms
of pricing transparency, convenience and
simplicity - and we hope you agree when
you see it. The management team doesnt
want me to get too excited in case it doesnt
work. I told them that even if its a flop, I
will be proud of their innovative spirit. You
cant succeed if you dont try.

We pioneered JotSM, a new mobile application for organizing and tracking expenses,
which currently ranks in the top 5% of all
financial applications (Apple App StoreSM
ranking) and works exclusively for our
InkSM from Chase small business cards.
We continued to partner with some of the
worlds best brands, launching new cards
with The Ritz-Carlton Hotel Company and
United Airlines.
Chase QuickPaySM, our person-to-person
payment service that allows our checking
customers to use a phone or computer
to send or receive money using an email
address (money is either taken out or
deposited into checking or savings
accounts), increased by more than 200% to
2.6 million users in 2011.

16

15

IV. AN INTENSE FOCUS IN 2012 ON ADAPTING

OUR BUSINESSES SUCCESSFULLY TO THE NEW
REGULATORY FRAMEWORK

The extensive requirements of regulatory

reform which we must meet demand
enormous resources. While we are going to
continue the initiatives in all of our businesses in 2012, it is unlikely that we will
undertake significant acquisitions due to
these regulatory demands and other regulatory constraints. We need to meet these regulatory demands properly while ensuring that
our clients are not adversely affected and
that we are not creating excessive, stifling
bureaucracy. We are totally focused on what
is in front of us. It is a new world, and we are
going to adjust to it very quickly whether
or not we like it or think it is all needed.
Meeting new regulatory requirements will
be a large, costly and complex endeavor
and we must get it right. Therefore, we
need to devote enormous attention and
resources to it
It has been estimated that there are 14,000
new regulatory requirements that will be
implemented over the next few years. Three
hundred out of the 400 Dodd-Frank rules still
need to be completed. We need to meet the
new Basel II, Basel 2.5 and Basel III requirements. We need to meet the new liquidity
requirements, the new global systemically
important banks (G-SIB) rules, the new
requirements due to Resolution Authority
and living wills, and any new requirements
from two new regulators, the Consumer
Financial Protection Bureau and the Office
of Financial Research. We need to meet the
new derivatives, clearinghouse and Volcker
trading rules. We also must complete
periodic Comprehensive Capital Analysis
and Review (CCAR) stress testing for the
Federal Reserve. And, finally, we have major
new rules and requirements from Brussels,
London and other global jurisdictions.
These new rules will affect virtually every
legal entity, system (we have 8,000 of these),
banker and client around the world. It will
take an enormous amount of resources across
all of our disciplines people, systems, tech-

nology and control functions (finance, risk,

legal, audit and compliance) to get it done
right. Over the next few years, we estimate
that tens of thousands of our people will
work on these changes, of whom 3,000 will
be devoted full time to the effort, at a cost of
close to $3 billion.
We must not let regulatory reform and
requirements create excessive bureaucracy
and unnecessary permanent costs
There are so many new rules that they
inevitably create more opportunities to
build unnecessary bureaucracy within the
company. It is incumbent upon us to make
sure that we do it right for the regulators,
our clients and our own efficient internal
functioning. So we are trying to build
streamlined systems to meet the needs of
all the regulators in an efficient way. For
example, different regulators have asked
for different reports on some very complex
issues such as global liquidity. We are
going to try to build one report that meets
all their needs and ours, too as opposed
to preparing three completely different
liquidity reports every day or every month.
Three reports lead to more mistakes, less
understanding and more work.
We must do this in a way that minimizes
cost and disruption to our clients
Most clients hope they will not see much
change as a result of these new regulations. But for certain clients and certain
products, the change will be significant. For
example, the cost of credit, in general, will
go up modestly, essentially due to the banks
higher capital and liquidity requirements.
The cost of credit for some likely will go
up substantially for example, we expect
larger increases in trade finance; consumer
credit (particularly for consumers with FICO
scores below 660); and backup lines of credit

17

16

that support commercial paper issuance.

Because of the Durbin Amendment, the cost
of banking services will go up modestly,
but this will likely affect certain clients far
more than others - e.g., customers with low
account balances.
We also are trying to get ahead of the change
and be proactive. We have canceled products
and services and will continue to do so when
we believe we no longer can adequately
provide them, given the new regulatory
requirements. We also are exiting products
that we think create too much reputational
risk for the firm. For example, we no longer
bank certain types of clients, we no longer
offer tax refund anticipation loans, we
essentially have exited the subprime lending
business and we no longer offer certain
types of complex derivatives. We also have
modified our overdraft procedures to be
more consumer friendly and are trying to be
very responsive to complaints about product
disclosures, as we have mentioned previously. We will adjust to all of the new rules
very quickly.
We have extensive processes in place to try
to do business the right way
We have extensive processes to protect the
company and conduct business the right
way. We have strong audit, compliance and
legal staffs (these groups total more than
3,600 employees). Some of these employees
sit in specialized units that cut across the
company focusing on the requirements of
the Anti-Money Laundering, Bank Secrecy
and Privacy acts, and other requirements
(these units, which also include dedicated line
of business employees, total approximately
1,400 employees). We know we wont always
be perfect, but it wont be for lack of trying.
Listed below are examples of how each business tries to properly conduct its affairs:

New Product Committees vet all new

products to make sure that we can handle
them operationally and, more important,
that they meet our ethical standards for
conducting business.
The Capital and Credit Committees review
all extensions of credit and uses of capital
in the company to make sure we have the
right limits, the right structures, the right
clients and adequate returns.
The Commitment Committees review
underwritings of stocks, bonds, loans, etc.,
to ensure that each is properly structured,
that we want to do business with the client,
that we can meet our commitments and
that due diligence is properly done, etc.
The Operational Risk Committees review
the potential errors in processing, legal
agreements and others that can lead to any
form of operational risk to the company
from settlement to clearance, including litigation and processing errors.
The Reputational Risk Committees review
new types of business and out-of-the-ordi
nary transactions that entail risks relating
to the environment, taxes, accounting,
disclosures and know-your-customer rules
to try to ensure that business is being
done appropriately.
We operate in a complex business with high
and increasing regulatory demands and
risk. Whether or not we agree with all the
new rules and business processes, we want
you to know that we will strive to meet
or exceed every regulatory requirement
around the world. This simply is the way we
run our business.

Our Risk Committees provide general

oversight into any and all risk in the business and set overall risk limits from credit
extensions to any market-making activities.
Risk limits are set by product, by counterparty and by type of specific risk (for
example, liquidity risk, interest rate risk,
credit risk, country risk, market risk, private
equity risk, and legal and fiduciary risk, etc.).

18

17

V. COMMENTS ON GLOBAL FINANCIAL REFORM

We have written extensively about the

crisis and the need for financial reform in
previous letters. Many of the issues we have
discussed have not changed. It is very important, however, that we get this right so I will
comment in this section on some of the more
critical and recent developments.
We always have acknowledged the need
for reform and we agree with most, but
not all, of it. And we all have a huge vested
interest in having a strongfinancialsystem
Most banks and bankers have acknowledged
the need for strong reform. JPMorgan Chase
has consistently supported higher capital
standards, more liquidity in the system, a
Resolution Authority to better manage and
unwind large financial firms, better regulation of the mortgage business, the clearing
of standardized derivatives through wellstructured clearinghouses and even stronger
consumer protection (however, we thought
this should have been a strengthened department inside the bank regulator). We also
supported most of the principles of compensation reform though you should know
that our company, for the most part, had
already practiced them.
In addition, we supported the ideas behind
the creation of the Financial Stability Oversight Council (FSOC), recognizing that one
of the flaws of our financial system was
that we did not have strong oversight of
the whole system or adequate coordination
among many different regulators. We actually believe the FSOC should have even more
authority than it has been given so that it can
force coordination among the 11 regulatory
authorities of the FSOC, adjudicate where
necessary, and properly assign responsibility
and authority.
While we agree with much of the reform
that has been put in place, we do not agree
with all of it. Specifically, we disagree with
the Durbin Amendment which had nothing
to do with the crisis and was the adjudication of a dispute between retailers and banks

18

when the banks were unable to effectively

respond. (It essentially is price fixing by the
government that will have the unfortunate
consequence of leaving millions of Americans unbanked.) Three other specific rules
with which we do not completely agree
include the G-SIB restrictions and surcharge,
the Volcker Rule and some of the derivatives
rules. You may be surprised to know that we
dont actually disagree with the stated intent
of these rules. We, however, do disagree with
some of the proposed specifics because we
think they could have huge negative unintended consequences for American competitiveness and economic growth. As Albert
Einstein said, In theory, theory and practice
are the same. In practice, they are not.
The United States has the best financial
system on the planet. We have the deepest,
widest, most transparent and most innovative capital markets. These markets have
helped fuel the great American economic
machine from small businesses to large.
And while we need reform, we must be very
careful not to throw the baby out with the
bathwater. Clear, fair and consistent rules
need to be put in place as soon as possible so
that our economy, once again, can grow and
meet its potential.
But the result offinancialreform has not
been intelligent design simplicity, clarity
and speed would be better for the system
and better for the economy
A robust financial system needs coordinated
and consistent regulation that is strong,
simple and transparent. The regulators
should have clear authority and responsibility. Just one look at the chart on the next
page shows that this is not what we now
have. Complexity and confusion should have
been alleviated, not compounded.
As a result of Dodd-Frank, we now have
multiple regulatory agencies with overlapping
rules and oversight responsibilities. Although
the FSOC was created, it is proving to be too
19

weak to effectively manage the overlap and

complexity. We have hundreds of rules, many
of which are uncoordinated and inconsistent
with each other. While legislation obviously
is political, we now have allowed regulation
to become politicized, which we believe will
likely lead to some bad outcomes.
And we have been very slow in finishing rules
that are critical to the health of the system.
The rules under which mortgages can be
underwritten and securitized still have not
been completed three and a half years
after the crisis began. This is unnecessarily
keeping the cost of mortgages higher than
they otherwise would be, slowing down the
recovery. Basel III created additional capital
confusion as banks did not know what the
specific capital rules would be going forward
the banks still dont know exactly how
much capital they will be required to hold,
when the regulators would like the banks to
get there and how they will be able to use
their excess capital when they do get there.
The Commodity Futures Trading Commis

sion (CFTC) and the U.S. Securities and

Exchange Commission (SEC), responsible for
different parts of the swaps business, have
not yet come up with common rules. And the
several agencies claiming jurisdiction over
the Volcker Rule have proposed regulations
of mind-numbing complexity. Even senior
regulators now recognize that the current
proposed rules are unworkable and will be
impossible to implement.
The rules also will create unintended consequences. Nearly 40% of all Americans have
FICO scores below 660. Many of the new
capital rules make it prohibitively more
expensive to lend to this segment (if you are
a bank). And the Federal Deposit Insurance
Corporation (FDIC) now charges us approximately 10 basis points on all assets (not just
the deposits it insures we now are paying
the FDIC approximately $1.5 billion a year),
making all lending more expensive and, in
particular, distorting the short-term money
markets that lend large sums of money over
short periods of time at low interest rates.

2C

19

The chart above assumes these

activities are conducted in a
systemically important bank
holding company (BHC)

1 The Council, through the Office

of Financial Research, may
request reports from systemically important BHCs
2 The FDIC may conduct exams of
systemically important BHCs for
purposes of implementing its
authority for orderly liquidations
but may not examine those in
generally sound condition
3 The Dodd-Frank Act expanded
the FDIC's authority when
liquidating a financial institution
to include the bank holding
company, not just entities that
house FDIC-insured deposits

No one has considered the cumulative effect

of all these changes taking place all at once.
And there is little question in my mind that
credit contracted globally (particularly in
Europe) as a response. Some analysts estimate
that even after the European Central Banks
special three-year lending facility to banks,
European banks will need to shed another
$3 trillion in assets in the next few years, and
thats assuming that banks dont try to meet
their new Basel III guidelines ahead of time.
This cant possibly help the recovery of an
already weakened Europe. With all the new
rules, it is unlikely that credit availability
will be replaced by new lenders. Even small
banks that are exempt from many of the new
rules are complaining that these rules will
have a substantially negative effect on their
businesses again, not the intended but the

unintended consequence. And certainly the

new regulatory burdens for large and small
banks have become enormous, but it will be a
disproportionate burden on smaller banks.
Recently, we have begun to achieve modest
economic growth around the globe, somewhat
held back by certain natural disasters such as
the tsunami in Japan. But I have no doubt that
our own actions from the debt ceiling fiasco
to bad and uncoordinated policy, including
the somewhat dramatic restraining of bank
leverage in the United States and Europe at
precisely the wrong time made the recovery
worse than it otherwise would have been. You
cannot prove this in real time, but when economists 20 years from now write the book on
the recovery, it may well be entitled, It Could
Have Been M u c h Better.

CIVIC ENGAGEMENT AND LOBBYING

You read constantly that banks are lobbying regulators

Our engagement with public officials includes:

and elected officials as if this is inappropriate. We dont

look at it that way. We view it as our responsibility to

Executives and employees from around the world

who visit federal, state and local capitals to provide

stay actively engaged in policy debates that will affect

lawmakers with perspectives on economic condi-

our company, our communities and the global economy.

tions in their communities and countries.

Not only is petitioning the government a constitutional
right, we have a responsibility as part of our firm's

Market participants who respond to requests from

policymakers to provide our views on how new

mission to be actively engaged in the political process

regulations or legislation will affect businesses,

in the communities and countries where we operate.

markets and consumers.

Governments are debating issues critical to the financial markets, our company, our shareholders and our

customers. It is vital for officials and regulators to have

the country.

input from people within our businesses who understand the intricacies of how financial markets operate

Small business lenders who offer perspectives

on the lending needs of small businesses across

Analysts and economists who share information

and the consequences of certain policy decisions.

on specific industries and economic performance

Contrary to what you might hear, our input, as often as

around the world.

not, is at the request of government officials who want

to draw upon the expertise of our executives who work

Our Military and Veterans team, which provides policymakers with real-world information on practices

in the markets every day.

that work to employ more veterans and support

Engagement with government officials and regulators

their financial needs.

is not only the responsibility of our Government Relations and Regulatory Policy teams, it also has become

Finally, we should recognize that thousands of groups

an important part of the fabric of our entire company.

- including unions, veterans, teachers, municipal

Employees across our company spend time meeting

workers and others - are reasonably engaged in

with and briefing government officials and regulators -

exercising their constitutional rights. We will continue

from Washington to Brussels to Beijing to Sacramento

to do so as well.

to Albany - about what they are seeing in their local

markets, as well as global markets, and how policymaking
affects the financial and economic issues of the day.
21

20

The United States needs more conversation,

collaboration, coordination and confidence
More collaboration would be a good thing.
Why should anyone be surprised that financial reform, which is so important to our
country, is being rethought and refought
(through the courts and otherwise) since it
was passed in a partisan way without sufficient collaboration and without adequate
input from experts in the field?
Even with many of the rules and reforms that
we support, the details (which are critical) are
far from perfect. Were left with hundreds of
rules and thousands of pages, that even the
regulators are now struggling to make sense
of. These are very complex systems that need
to be carefully thought through and analyzed,
particularly by people who know the subjects
best both academics and practitioners.
These issues are not Democratic or Republican, and the solution is not political. Many
bankers would have loved to support proper
reform. But it is hard to support something
when you were not involved in the process
in a meaningful way. In fact, at a bankers
meeting with 100 bank CEOs in the room,
70%-80% said they were afraid to speak
up because of potential retribution from
the regulators and examiners. This is not a
healthy process for policymaking.

I am struck that so many of our leaders

in the United States forget how strong
our country can be. The United States of
America has the worlds best military, and
it will have for decades. It has the worlds
best universities and the best rule of law. We
are known for having some of the hardest
working, most entrepreneurial and innovative workforces anywhere. The United States
has the widest, deepest and most transparent
capital markets in the world and the best
businesses on the planet small to large.
These businesses are an essential part of
Americas strength they are the engine of
the economy. They create the wealth that
we have today to enable all of the things we
do as a nation. If it werent for the capital
investment, innovation and productivity
of American business, we all still would be
living in tents and hunting buffalo.
The need for honest dialogue and collaboration goes way beyond the financial system.
We need it in fiscal reform, health policy,
energy policy, immigration, education and
infrastructure. If we dont start working
together, we wont get it right. It is critical
that we get it right to ensure America has the
best possible future.
As Benjamin Franklin said, We must,
indeed, all hang together, or assuredly we
shall all hang separately.

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21

We firmly believe in strong capital

requirements, but the G-SIB surcharge
goes too far - as proved by the recently
completed Federal Reserve stress test
The Federal Reserve recently completed
its CCAR stress test. The stress case makes
some pretty severe assumptions for the next
two years:
Unemployment goes to 13%.
Gross domestic product drops 8% (in the
real recent recession it dropped only 5%).
Home prices drop 20% from today's levels
(they already are reduced 34% from peak
2006 levels).
Trading, capital and credit markets perform
even worse than they did in the last crisis.
The Federal Reserve requires all banks to
show that throughout this high-stress environment, they can maintain Basel I capital of
over 5% (at all times), while it also assumes
banks should continue their capital, dividend and repurchase plans as if there were
no crisis (there virtually is no way we would
continue to buy back a substantial amount of
stock if this stress scenario began to unfold).
The chart on the previous page shows what
our capital ratios were over the last several
years and what analysts are forecasting they
will be over the next two years. Recent stress
test results conclude that we can increase the
dividend, buy back $12 billion of stock and
still have capital in the worst quarter (the
Feds stress test assumes that a huge amount
of losses all happen in the same quarter) of
no less than 5%. We believe that even if the
Feds severe stress scenario actually happens,
our capital ratios will drop only modestly
since we will very actively manage our risk
exposures, expenses and capital. Keep in
mind that during the real stress test after
the collapse of Lehman Brothers, our capital
levels never went down, even after buying
$500 billion of assets through the acquisitions of Bear Stearns and WaMu.

Lehmans collapse and the recent severe Fed

stress test make eminently clear - we have
plenty of capital.
There also should be recognition that the
whole system is stronger. Accounting and
disclosure are better, most off-balance sheet
vehicles are gone, underwriting standards
are higher, there is much less leverage in the
system, many of the bad actors are gone and,
last but not least, each remaining bank is
individually stronger.
The G-SIB is contrived, artificial and
duplicative and doesnt recognize that
while some companies were too big to
fail during the financial crisis, some also
were ports in the storm
Once again, very complex regulations are
being overlaid on already complex regulations. Under the new Basel III rules, all
banks will be required to have 7% Basel III
common equity (this translates to approximately 10% Basel I). The new G-SIB requirements mandate for a company our size
approximately 2.5% more capital, totaling
9.5% Tier 1 common equity (this equates to
approximately 13% Basel I). This is capital
that we simply dont need. The G-SIB calculations focus only on the negatives of size and
dont recognize the positives of size - diversification of earnings and capital strength
- which kept several large companies safe
during the storm. In fact, diversification of
earnings and even high market shares, which
often is a sign of a companys strength, are
treated as negatives in these calculations.
The G-SIB rule has 12 metrics to determine how much extra capital a bank needs.
I wont bore you with all 12, but I will
describe a few to show how arbitrary and
contrived the rule is:
Many of the measures simply look at gross
numbers - assets, gross derivatives exposure, cross-border lending, etc. - without
any regard for the risk of the credit,
whether the risk is collateralized or whatever the tenor of the loan.

We deeply believe in stress testing, and

we even think that a severe stress test like
this, properly calibrated, is appropriate. But
we also know - as the real stress test after

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22

 One category is substitutability - an assess

ment of how easily clients can replace the
important services provided by the bank.
One of these measures looks at market
share in debt and equity underwriting.
We believe this is a flawed measure since
any given debt or equity transaction
usually involves multiple underwriters - so
replacement usually isnt even necessary.
And if it were, it could be done easily.
Another measure looks at "risky" wholesale
funding. This clearly is a legitimate risk
measure for banks, but the G-SIB calculation
treats any funding other than retail deposits
as equally risky. Your company, which
effectively has no wholesale money market
funding, is viewed to be just as risky as a
company that mostly is wholesale funded in
the notoriously fickle money markets. And
no credit is given for deposits from companies (most of which are rather sticky), secure
funding sources or long-term funding.
Another factor in the G-SIB calculation is
whether a bank holds assets under custody.
This is a business where the assets are
completely separated from the rest of the
company; i.e., already fully safeguarded.
We do not understand why the custody
business is in the calculation at all.
We could go on and on - the rule penalizes
diversification, it treats liquid securities as
being worse than loans, it gives no credit to
the newly established Resolution Authority
to dismantle a big bank and it is inconsistent
with parts of Basel III, particularly around
the value of operational deposits.
We dont disagree with all of the intent
of the G-SIB - it includes some logical
approaches to reducing the complexity of the
financial markets and the interconnected
ness between financial companies. But the
way some of these measures are calculated is
contrived and artificial. They are duplicative
and completely violate the principles of riskweighting assets. We believe that while the
G-SIB rule will cause bigger banks to hold
more capital and give them some incentive
to shrink, it will not end up working the way
regulators envisioned.

24

We believe banks will be forced to increase

their capital levels in order to cluster
around their major competitors. Even if a
bank could run at 7% capital, it probably
will have to run at the higher number to be
perceived as strong competitively. Additionally, the rule will create unintended, anticompetitive market-distorting arbitrage. Big
banks that have a lot of capital will more
easily win certain types of business, such as
processing, from smaller competitors. Big
banks that need to hold 9.5% capital against
mortgages simply will syndicate them out
to smaller banks that need to hold only 7%
capital against the same specific assets.
Regardless of how we feel about the G-SIB
surcharge, we, of course, will meet all the
requirements and currently believe we can
do so and still earn adequate returns for our
shareholders. We just dont think it is the
right way to regulate banks or operate a
financial system.
Resolution Authority essentially
bankruptcy needs to be made real.
We must eliminate too big to fail
One of the most important provisions of
the Dodd-Frank legislative reforms is the
creation of a robust Resolution Authority,
which empowers the FDIC to take over a
failing systemically important financial
institution, including us, and resolve its
operations and businesses in an orderly
manner, without causing systemic risks
to the financial system or excessive risks
to the economy as a whole. Shareholders
and creditors would bear all the losses (in
a predictable and consistent way), with no
exposure to taxpayers or damage to innocent
bystanders. The management responsible
for the failure would be replaced, and prior
compensation to directors and senior officers
would be clawed back. Ideally, the name of
the failed institution also would be buried,
memorialized only in the hall of shame of
failed institutions.
The FDIC would manage this process,
including providing operational liquidity
if necessary, so that resolution would occur
without a lengthy period of government
intervention. Properly executed, there would
be minimum value destruction and contagion effects inherent in fire sales or disorderly
liquidations (this also would preserve as much
23

value as possible for unsecured debt holders

just as in an ordinary bankruptcy proceeding).
Those responsible for causing the problem
would bear the losses. If losses exceeded the
amount of shareholder equity and debt, the
banking industry, as a whole, would pay for
the losses. This essentially is the way the FDIC
has operated since its creation in 1933. There
would be no cost to taxpayers, and there
would be no bailout by the government.
As a result, critical operations that are important to the economy and the functioning of
the financial markets would continue uninterrupted. Credit card processing, ATM networks,
checking accounts and debit cards would
continue to function, but under the control
of new owners and management. Similarly,
custody services of client assets, payments
processing, asset management, and securities and derivatives clearing would continue
without economy-damaging interruption.
Although Dodd-Frank calls this process
orderly liquidation, it really is comparable
with a bankruptcy. Implementing this process
for financial institutions operating in many
jurisdictions around the world brings added
complexity. We are working closely with regulators to clearly identify how critical operations in local jurisdictions would continue
under a resolution process. Close cooperation
is required by multiple regulators. We believe
this can best be achieved by actively working
together well before any such event occurs
and carefully (perhaps legislatively) agreeing
on how such an orderly liquidation would be
pursued across international borders.
We certainly hope that a large systemically
important financial institution never has to
go through this process. Certainly, higher
capital and liquidity standards, better loan
quality and more disciplined underwriting
make such a failure significantly less likely.
However, the availability of this controlled
bankruptcy process is critically important
for forcing managements and creditors of
such institutions to understand that they are
NOT too big to fail and to understand that
they are NOT so important that the taxpayers
will bail them out and that they are NOT
immune to the consequences of excessive
risk taking. This type of bankruptcy for
failed financial institutions is essential for
management to maintain market discipline
and for risk taking of financial firms.
24

We need to ensure that Americas large

global banks can effectively compete
Many of the new rules potentially affect
U.S. global banks more significantly than
they affect non-US. banks. This is not to
say that other countries (for example, the
United Kingdom and Switzerland) arent
doing things to make it harder for their
banks to compete. But we need to ensure
that the rules, which affect only American
banks, dont hurt - in their cumulative
effect - American banks ability to compete.
Following is a list of regulations that are
unique to American banks. (Many of these
rules did not emanate from Basel but from
the U.S. legislative and regulatory process.)
The Volcker Rule - and we don't know
its final effect yet - will affect only U.S.
companies, including, possibly, American
banks activities outside the United States.
The derivatives rules - still not complete may require American banks to follow U.S.
regulations outside the United States and
effectively could eliminate our ability to
offer derivatives to our corporate clients.
The Collins Amendment eliminates taxefficient Tier 1 capital, effectively increasing
the cost of capital.
Concentration limits restrict the ability of
U.S. banks to acquire institutions outside
the United States with no similar limitations on our foreign competitors.
High Mortgage Servicing Rights capital
charges (a uniquely U.S. asset) increase our
cost of doing business.
Proposed accounting changes are more
punitive for U.S. banks when they hold
marketable debt securities. Foreign banks
will be able to hold many of these securities at cost, but American banks will have to
deduct any unrealized losses from capital.
US.-specific liquid asset classes are given
less credit or excluded. Amazingly, covered
bonds in Europe count as 100% liquid assets,
but U.S. government-guaranteed mortgagebacked securities count only as 85%.
The G-SIB capital charge gives no credit for
U.S. Resolution Authority in Dodd-Frank.

25

 U.S. companies that have earned high

market shares over time in the investment
banking and custody businesses (usually a
sign of having a strong business) are specifically penalized with higher capital charges.
Ironically while the U.S. banking system is
far less consolidated than all other developed nations (currently only six of the
50 largest financial firms in the world, by
market capitalization, are American - they
were 44 of the 50 in 1989 - this should give
U.S. policymakers pause), the G-SIB charges
and some of the other rules penalize American banks more than non-US. banks.
Suffice it to say, the negatives are adding up
and bear close watching. While we strongly
prefer to have common global rules for
everyone, it may not be turning out that
way. It is incumbent upon American policymakers to make sure that the final outcome
is fair to American banks and that they are
fully free to compete in the face of increasingly tough global competition.
Basel III, procyclicality, group think and the
role of judgment

Quantitative easing may be good policy to

help the economy recover, but it does artificially increase the value of government
and government-guaranteed securities. The
new Liquidity Coverage Ratio gives government and government-guaranteed securities
credit only for being liquid - no other assets,
including gold, equities or corporate bonds
have any liquidity value. This also creates
higher demand and, therefore, a higher artificial value for government securities. The
Volcker Rule, as it currently is written, also
allows unimpeded trading and liquidity for
government securities and a lot less liquidity
for everything else. Pension accounting is
forcing pensions to hedge their liabilities
by buying fixed-rate securities at precisely
the wrong time. Banks hold large available
for-sale securities portfolios to manage their
assets and liability risk management. And
if rates ever go up (and they will) and there
are losses in these portfolios, the losses will
have to be deducted in capital - even though
the liabilities that they are hedging are not
being marked-to-market. All the items we

just mentioned could be looked at as one

large crowded trade. If things ever start to
go wrong, everyone could head to the exit
door at the same time. Your company has
positioned itself to be protected against
rapidly rising rates in fact, the company
would benefit if either short-term or longterm rates went up.
Markets already are naturally procyclical,
and Basel III makes it worse. In a crisis, Basel
III demands that even more capital be held
against risky assets. We estimate that the
swing in Tier 1 common capital from benign
times to crisis times could be as much as
a 20% difference in the capital ratio. We
should try to make Basel III countercyclical
but certainly not more procyclical.
Finally, the ultimate goal, with which we
mostly agree, is to have Basel III applied
fairly and evenly around the world. But
this leads to another potential set of issues.
Everyone will start to have an increasingly
more common view of the risk of a certain
type of asset. This is what happened in
the United States when everyone thought
mortgages were completely safe. Models
eventually will replace judgment and this
is a terrible idea. Models always are backward looking and dont capture true underlying shifts and changes that affect credit
or markets; e.g., increasing or reducing
liquidity, structural changes in industries
that dramatically change the riskiness of an
industry (think of what the Internet did to
newspapers) or real quality underwriting vs.
lax underwriting. And models have a hard
time capturing concentration and correlation of risks (think of oil and real estate in
oil regions). Many years ago in the United
States, there were approximately eight large
banks in Texas. Within five years after the
oil crisis, only one survived as an independent bank. The others were either sold under
duress or went bankrupt not because of
their oil exposure but because of their real
estate exposure. Models cannot replace judgment, and judgment helps to balance and
diversify the global financial system.

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VI. THE MORTGAGE BUSINESS THE GOOD, THE BAD

AND THE UGLY

Many of the financial crises of the past

hundred years around the world were
related to real estate. Real estate was not
the only culprit in the recent crisis, but
it certainly was at the eye of the storm. I
suspect that the mortgage crisis will be the
worst financial catastrophe of our lifetime.
What the world experienced was almost a
collective brain freeze traditional mortgage
underwriting loosened over time (actively
supported by the U.S. government) such that
we got Alt-A mortgages, subprime mortgages and option-adjustable rate mortgages
(option-ARM). These mortgages were packaged into securities (sometimes guaranteed by government entities and insurance
companies), and home ownership was going
up it all seemed to be working. But as the
process unfolded, unscrupulous mortgage
officers were mis-selling mortgages, some
borrowers were lying on mortgage documents and speculation was rampant. It was
a disaster hidden by rising home prices
and false expectations, and once that price
bubble burst, we all were in trouble.
We need to write a letter to the next generation that says, Never forget: 80% loan to
value and verify appropriate income.
Clearly, it was not our finest hour
We were one of the better actors in this
situation but not good enough; we made
too many mistakes. We generally were a
better underwriter. We did not originate
option-ARMs. Many of our problems were
inherited from Bear Stearns and WaMu.
Even our subprime mortgages outperformed
most other subprime mortgages. Early in the
crisis, we also stopped dealing with mortgage brokers, some of whom underwrote the
worst of the mortgages and probably missold mortgages more than most.

But we did participate in this disaster by

originating mortgages that wouldnt have
been given a decade earlier (and wont be
given a decade later). And when delinquencies and foreclosures grew dramatically, we
were ill-prepared operationally to deal with
the extraordinary volume of troubled mortgages and upset borrowers. Our servicing
operations left a lot to be desired: There were
too many paperwork errors, including affidavits that were improperly signed because
the signers did not have personal knowledge
about what was in the affidavits but, instead,
relied on the companys processes. However,
the information in the affidavits was largely
accurate i.e., the borrower, in fact, was in
default, we did have the mortgage and so on.
Gearing up to deal with this problem meant
overcoming the multiple and poor systems
we inherited from our acquisitions of Bear
Stearns and WaMu. In addition, there
were numerous government modification
and refinancing programs and multiple
changes to these programs to contend with,
some of which involved extensive and
hard-to-complete paperwork. We now have
23,000 people servicing delinquent loans
or dealing with foreclosures up from
6,800 people in 2008.
These problems, as one might expect, led to a
myriad of lawsuits from various U.S. government agencies, attorneys general from the 50
states and private investors.
We have settled with the U.S. government
and state attorneys general and implemented strong new policies for the good
of all. In February 2012, JPMorgan Chase
and four other top mortgage servicers
agreed to a global settlement with the U.S.
Department of Justice, the U.S. Department
of Housing and Urban Development, the
Consumer Financial Protection Bureau and
the state attorneys general. The settlement
relates to the servicing and origination problems mentioned above.
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26

For us, the settlement will consist of the

following:
Making cash payments of approximately
$1.1 billion (a portion of which will be
set aside for payments to borrowers) to
50 states.
Offering approximately $500 million of
refinancing relief to certain underwater
borrowers whose loans are owned by
the firm.
Providing approximately $3.7 billion of
additional relief for certain borrowers,
including reductions of principal on first
and second liens, payments to assist with
short sales, deficiency balance waivers
on past foreclosures and short sales, and
forbearance assistance for unemployed
homeowners.
Agreeing, along with the other banks, to a
new set of enhanced nationwide standards
for mortgage servicing, including requirements around single point of contact,
staffing levels and training, communication
with borrowers and document execution in
foreclosure cases. The standards also will
require banks to offer modifications and
other foreclosure alternatives for borrowers
before pursuing foreclosure - a practice
in which we have and will continue to be
actively engaged. We support these new
standards - they will help establish a higher
level of transparency and clarity for servicer
activities and, ultimately, will strengthen the
stability of the industry as a whole. (I will
talk later in more detail about all the things
we are doing, in addition to the things
mentioned above, to help homeowners.)
The global settlement releases JPMorgan
Chase from further claims related to
servicing activities, including foreclosures
and loss mitigation activities, certain origination activities and certain bankruptcy
activities. Not included in the settlement
are claims from investors in private label
securities who are making claims both on
representations and warranties (i.e., that the
underwriting wasnt done according to the
standards in the securities contracts), as well
as lawsuits claiming there were misstatements in the underwriting of the securities.

We have substantial reserves for mortgage

litigation. One of the challenges our firm
continues to face following the economic
crisis is litigation relating to mortgage-backed
securities issued by JPMorgan Chase, Bear
Stearns and WaMu. Investors have brought
securities litigation, trustees have demanded
loan repurchases and regulators continue to
scrutinize these transactions. As I always have
said, we will honor our obligations. However,
we also will defend against demands that are
not reasonable. Securities claims brought by
sophisticated investors who understood and
accepted the risks associated with their investments which, in some cases, are current and
still paying face substantial legal hurdles.
Likewise, we are going to fight repurchase
claims that pretend the steep decline in home
prices and unprecedented market conditions
had no impact on loan performance or that
seek to impose liabilities on us that we believe
reside with third-party originators (or, in the
case of WaMu securitizations, with the FDIC).
These plaintiffs face a long and difficult road,
and, as a result, litigation over these issues
could take many years. Nonetheless, we have
set aside significant reserves to handle these
exposures.
How we are trying to properly and fairly
deal with delinquencies, modifications and
foreclosures
First, some facts: Of 76 million owned homes
in America, 24 million do not have a mortgage. Of the remaining 52 million homes
with mortgages, approximately 4.7 million
have a delinquent mortgage. And approximately half of those that are delinquent are
on homes where the value of the home is
worth less than the mortgage. Another 10+
million homeowners are current on their
mortgages, but their houses are worth less
than their mortgages. (We estimate that
approximately 25% of these mortgages ultimately will go into default homeowners for
the rest will continue to pay and, it is hoped,
will recover the value of their homes.)

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27

Here is where we stand and how we are

trying to deal with the situation:
If we treated a homeowner improperly,
we should make it right. Anyone who
was mis-sold a loan or was foreclosed on
improperly deserves redress. Mis-selling
a loan is where the borrower was misled
about significant loan terms or fees or
interest rates that were higher than they
should have been. An improper foreclosure is one in which the homeowner did
not owe the money or was not in default.
If it comes to our attention that we participated in any of these situations, we will
fix them immediately. That said, however,
many loans were taken out by unscrupulous borrowers, individuals who either
lied about their income or lied about their
intention to live in the home - they clearly
were speculating that they could flip
the real estate for a profit on rising home
prices. These individuals should not receive
help for any reason.
If a homeowner can afford to pay the
mortgage - whether or not the home is
underwater - the mortgage should be
paid. A mortgage is a loan collateralized by
the house. It is not a loan that one should
feel free to walk away from if the house
goes down in value. Most of the people in
this situation can, and do, pay their mortgages. Some attempt a strategic default
- even if they can afford to pay, they just
walk away. Even though they still owe
the difference, it is hard for the lender to
collect. It is hoped, as the housing market
recovers, these underwater homeowners
will get equity back in their homes.
If a homeowner cannot afford the m o r t
gage b u t can afford a reduced payment,
we try to modify the loan. W h e n a mort
gage becomes delinquent, we make a very
concerted effort to contact the person. We
start reaching out as early as 15 days after
a loan becomes delinquent and, for some
homeowners, make a hundred or more
attempts before foreclosure. We are sympathetic with these borrowers because most
of them are unable to make their payments
for legitimate reasons - someone lost a
job, someone got sick or a persons income
level dropped precipitously. In these cases,

we try to modify the mortgage - both

under a government initiative called Home
Affordable Modification Program (HAMP),
which has strict requirements, and through
our Chase Home Affordable Modification Program (CHAMP), where we can be
more flexible. We often can reduce the
interest rate to as low as 2% and, in some
cases, reduce the principal. Since 2009,
we have offered over 1.2 million modifications and completed more than 450,000.
We have reduced payments to borrowers
by a current run rate of $1 billion annually.
Ultimately, we expect to reduce payments
over the years by more than $10 billion.
For loans owned by JPMorgan Chase, we
already have deferred principal of $1.5
billion, forgiven over $2.1 billion in principal and reduced interest payments by
$1.2 billion. And by the end of the process,
we expect to have forgiven principal of
approximately $4.5 billion and reduced
interest payments by a total of $3.5 billion.
We treat loans to investors (i.e., loans in
private label securities) the same way we
treat loans that we own. It is important
to note that all modifications are done
according to specific contracts. These
contracts stipulate that you can modify
a mortgage only when it is better for the
lender than foreclosing, all things considered (i.e., the net present value of a modified loan is worth more than going through
a foreclosure process, with all its expense,
and ultimately selling the home at a very
distressed price).
If a homeowner cannot afford the home,
even with the modification, we still try to
avoid foreclosure. If someone cant afford
a mortgage at 2%, even using a reduced
valuation on the house, foreclosure is the
last option. Since 2009, we have prevented
approximately 750,000 foreclosures
through our various programs, including
modifications - twice as many as have
been foreclosed.

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Programs designed to prevent foreclosures

include short sales or deeds-in-lieu situations in which the homeowner agrees to
sell the house or lets us sell the house. In
some cases, we pay homeowners to sell their
homes, and we waive deficient loan balances
(waiving deficient loan balances represents
debt forgiveness to these borrowers). These
foreclosure programs have cost us $6 billion
so far, including direct payments of $150
million and balance waivers of $5.8 billion.
When these programs conclude, we expect
to have paid a total of $650 million in direct
payments and more than $12 billion in
balance waivers.
Foreclosure. While foreclosure is a terrible
option, it sometimes is the only option.
While it is awful for the homeowner, it
does allow an individual to get a fresh start
and more affordable housing - and relief
from a crushing debt burden. Foreclosure is
the worst option for the bank, too, because
the house usually is left in poor condition
and sold for substantially less than the
outstanding balance on the loan, resulting
in a loss. (We even, from time to time,
make payments to people to help them
leave the home in good condition and be
able to afford to relocate.) By the time we
actually foreclose on someone, we generally have not received a payment for 17+
months; and in 54% of the cases, the house
was either vacant or occupied by someone
other than the owner. The loss to the bank,
in effect, becomes loan forgiveness to the
individual - but this forgiveness, it is
hoped, is going only to people who really
need it: people who truly are unable to pay
and really need the debt relief. Since 2007,
JPMorgan Chase has recognized losses on
first mortgages of more than $21 billion due
to foreclosures and charge-offs. Ultimately,
we will have recognized more than $27
billion in foreclosures and charge-offs.
Home equity loans generally are modi
fied if we modify the mortgage loan and
almost always are written off if there is a
short sale or foreclosure. We treat home
equity loans that we own exactly the same
whether we own the first mortgage or
service it for someone else. W h e n the first
mortgage is modified, the home equity loan
generally is modified, and the modification

terms typically are at least as generous to

the borrower as the terms of the first mortgage. The home equity loan essentially will
pay off only if the first mortgage ultimately
pays off. Importantly, if the first mortgage
is ever foreclosed on or written down due
to a short sale, the second mortgage almost
always is written off. Since 2007, we have
recognized losses of more than $16 billion
in home equity loans and expect as much as
another $5 billion over the next few years.
This is a miserable situation all around, but
we want our shareholders to know that we
are trying to treat every borrower fairly and
properly based on the individuals situation
and circumstances.
But it also will be the best of
JPMorgan Chase
We have brought enormous resources to
bear on fixing our mortgage business. Many
of our top executives volunteered to help and we now have some of our best people
from finance, risk, technology and operations
devoted to this effort. As a result, we are
responding rapidly and are improving across
the board. For example:
In early 2009, Chase opened the first
Chase Homeownership Center to help
customers under financial stress stay in
their homes. We now have 82 brick-and-
mortar centers located in 28 states and
the District of Columbia, regions hardest
hit by the housing crisis. Six of the 82
are near military bases, and the mortgage
counselors at these centers receive special
training to understand general military
issues, special military programs and the
Servicemembers Civil Relief Act. Over
the past two years, our Borrower Assistance employees have met with more than
273,000 customers who are behind in their
payments or are likely to be, and Chase has
held 1,800 outreach events for homeowners
who need assistance.
On October 4, 2011, our mortgage
servicing platform, which, in fact, was
three legacy technology systems from
Chase, Bear Stearns and WaMu, was
consolidated. This was a huge 13-month
effort that resulted in one Chase system,
one way to serve customers, and a better
and more consistent customer experience.

3C

29

 Our customer satisfaction scores in

both external and internal surveys have
improved considerably. In the 2011 J.D.
Power Mortgage Origination survey Chase
jumped to # 5 from #12 in customer satisfaction among lenders nationwide - the
largest improvement of any company.
(Were still not satisfied with being #5.) At
the same time, customer complaints have
declined more than 60% from a high point
in May 2011.
The mortgage business is important thats why we are going to stay in it
Providing a mortgage - helping our
customers own and stay in their homes - is
one of the most important and emotional
connections we have with our customers.
It also is a product that has the potential
to deepen our relationship with customers.
Our Retail branch franchise and brand give
us an enormous competitive advantage in
the mortgage business. There are 5.7 million
customers who have an existing Chase
mortgage. But with a base of 50 million
customers, we think we could double the
number of mortgage customers.
Once we finish fixing it, the mortgage business will be a great one for JPMorgan Chase.
The winners in the business will be those
who have good customer relationships
and are good at large-scale servicing and
processing - right up our alley. Normalized
earnings for this business should be about
$2 billion, with a through-the-cycle return on
equity (ROE) of about 15%. We continue to
invest in this business by growing our sales
force and introducing technology applications to improve the customer experience.
Over the past year, we added 700 loan officers - bringing our total to 3,800 - and we
are serving more customers as a result. Plus
we plan to hire an additional 1,000 loan officers in 2012.
Housing is getting better - there, I said it
There has been a tremendous focus on the
fact that housing prices remain depressed
and, in fact, are still going down some. The
large shadow inventory of homes in delinquency or foreclosure that has not yet hit
the sale market adds to the fears that this

will continue for a long time. New home

construction still is very depressed - so, to
most, the future looks bleak. However, if one
looks at the leading indicators, all signs are
flashing green - the turn is coming if it is
not here already. We dont want to be blindly
optimistic, but the facts are the facts:
America has never stopped growing. The
United States has added 3 million people a
year since the crisis began four years ago.
We will add 30 million people in the next
10 years.
This population growth normally would
create a need for 1.2 million additional
housing units each year. Household formation has been half of that for the past four
years. Our economists believe that there is
huge pent-up demand and that household
formation will return to 1.2 million a year
as job conditions improve.
Job conditions have been improving, albeit
slowly. In the last 24 months, 3.45 million
jobs have been created.
On average, only 845,000 new U.S. housing
units were built annually over the last four
years - and the destruction of homes from
demolition, disaster and dilapidation has
averaged 250,000 a year. The growth of
new households, even at a reduced rate, has
been able to absorb all of this new supply,
and more.
The total inventory of single-family homes
and condos for sale currently is 2.7 million
units, down from a peak of 4.4 million
units in May 2007. It now would take
only six months to sell all of the houses
for sale at existing sales rates, down from
12 months two years ago. (This low of
an inventory number normally would
be considered a positive sign for future
housing prices.)
While the shadow inventory mentioned
above still is significant, it has shown a
visible declining trend since peaking at the
end of 2009, when the number of loans
delinquent 90+ days or in foreclosure was
5.1 million homes. It now totals 3.9 million,
and we estimate it could be 3 million in 12
months. The shadow inventory also may

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30

move more quickly as mortgage servicers

get better at packaged sales and short
sales and as real money investors start to
buy foreclosed homes and rent them out
for a good profit. Home prices still are
going down a little bit, and they will stay
depressed for a while. Distressed sales (short
sales, foreclosure sales, real estate-owned
sales) still are 25% of all sales, and these
sales typically are priced 30% lower than
non-distressed sales. As the percentage
of distressed sales comes down over the
next 12-24 months, their negative effect on
housing prices will start to diminish.

Over the last two years, $2 trillion of mort-

gages have been refinanced, substantially
aiding homeowner burdens. We expect
another $2 trillion to refinance over the
next two years, with approximately 10%
coming from recently announced government programs, and, at that point, we estimate that only 15%-20% of Americans will
be paying interest rates over 6%.
More jobs, more households, more Americans, good value - its just a matter of time.

Housing is at an all-time high level of

affordability due to both low home prices
and low mortgage rates.
It now is cheaper to buy than to rent in
half of the markets in America - this has
not been true for more than 15 years. Relatively high rental prices can be a precursor
to increasing home prices.
At the same time, American consumers
are finding more solid financial footing
relative to their debt. The household debt
service ratio, which is the ratio of mortgage
plus consumer debt payments to disposable personal income, stands at its lowest
level since 1994. This is a result of rapid
consumer deleveraging - household mortgage debt now is down $1 trillion from its
2008 peak. (Reported U.S. mortgage data
do not remove mortgage debt from an
individuals debt obligations until there is
an actual foreclosure. It is estimated that
$600 billion of the $9 trillion in currently
outstanding mortgage debt is not paying
interest today and effectively could be
removed now from these numbers.)
Recent senior loan officer surveys by the
Federal Reserve show that, while there are
not yet clear signs of credit loosening for
new mortgages, at least the rush to tighten
mortgage lending standards has abated.

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31

VII. COMMENTS ON THE FUTURE OF INVESTMENT BANKING

AND THE CRITICAL ROLE OF MARKET MAKING

We believe that investment banks provide a

critical role in facilitating theflowof capital
to meet client needs and that those needs
will grow dramatically in the next 10 years
It is important to look at any business from
the point of view of the client. Our 5,000
issuer clients and 16,000 investor clients will
have large and growing needs in the future.
Corporate clients need for equity and debt
issuance, M&A and other advice, and balance
sheet management is projected to almost
double over the next 10 years. Global infrastructure investment will more than double
over a two-decade period it is projected to
reach $3.7 trillion by 2030.(a) Total global
financial assets of consumers and businesses,
which now total $198 trillion, are projected
to nearly double to $371 trillion by 2020.(b)
Clearly, these huge capital and investing needs
of clients will drive real underlying growth of
the investment banking business. And
JPMorgan Chase is in the sweet spot because
much of the growth will be with our clients
large, often multinational companies,
government-related entities and large global
investors. And our role as an issuer of
securities and as a market maker places us
right in the center of key money flows.

(a) According to McKinsey Global

Institute Study, Farewell to cheap
capital? The implications of longterm shifts in global investment
and saving, December 201C
(b) According to McKinsey Global
Institute Study, The emerging

Of course, these business volumes, while

they will grow over time, frequently have
volatile swings within months, quarters and
years. Not only can volumes easily move
50% by quarter or year, but spreads and fees
also can move dramatically, affecting our
revenue. The facts above convince us that
the large slowdown we saw in the second
half of last year was cyclical, not secular. And
volatility does not make the business bad it
simply means you have to manage the business, knowing that it can happen at any time.
In 2011, a tough time for many investment
banks, your J.P. Morgan Investment Bank
earned a 17% ROE.

equity gap: Growth and stability

in the new investor landscape,

Demystifying market making (trading)

why it is so important
While most people understand corporate
finance fees are earned for stock or bond
issuance or advice, market making is a
mystery to most people it remains a black
box. We need to do a better job of describing
the important role of market making and
explaining how it can be done safely. Before
I talk about our market-making business, it is
important to recognize that market making is
a normal function of any economy. While we
make markets in general in financial instruments, others make markets in just about
everything, everywhere farmers markets,
all types of food and commodities markets,
lumber, paper, ink, advertising, steel, etc.
Markets are simply where buyers and sellers
meet to exchange products and services, and
market makers facilitate the process.
Sixteen thousand investor clients use our
market-making services. These clients
include mutual funds, corporations, pension
plans, states, municipalities, hospitals,
universities, etc. The services we provide are
research, advice and execution. Clients come
to us when they want to buy or sell securities
(in this section, when I refer to securities, I
mean stocks, bonds and loans of companies,
bonds of government entities, mortgage securities of all types, commodities of all types,
currencies of all types and derivatives on all
of the aforementioned securities, including
swaps, options, etc.).
It takes substantial resources to provide these
services properly. We have more than 800
professionals carrying out research on 4,300
companies, 1,000 government entities (states,
municipalities, etc.) and 80 countries at a
cost of approximately $600 million a year. We
analyze securities, markets and economies
around the world. Our job is to educate our
investors and issuers and help them accomplish their global financial objectives.

December 2011

33

32

To execute trades, J.P. Morgan has more than

110 trading desks around the world 2,000
traders making markets and executing
trades in securities, broadly defined. And
2,500 salespeople call on our 16,000 investor
clients, offering ideas and advice. Supporting
our research, sales and trading are approximately 13,000 technology and operations
specialists and 4,000 control, finance and risk
management professionals across the Investment Bank. In addition, we hold an average of
$400 billion in inventory (securities, broadly
defined), which we turn over constantly,
and we provide, on average, more than $250
billion of securities financing for clients. Our
market-making operations also help our issuer
clients sell or raise approximately $430 billion
of capital a year.
We trade over a trillion dollars of securities,
broadly defined, every day for example,
approximately 90,000 separate trades a day
in our fixed income business alone. While we
do business with 16,000 clients, the top 1,000
clients account for a large portion of the business. These investors are smart and sophisticated we want their repeat business, but we
have to earn it. Presumably, they keep coming
back to us because they value the services we
provide; but if we did not give them great
value and great prices, we probably would not
get their business they have lots of other
options and there is a lot of competition for
their business.
Our aim is simple to provide our clients
with sound investment ideas and valueadded, world-class execution at increasingly
lower cost.

is being done at an increasingly lower cost

of execution, which is a benefit to investors
and issuers, buyers and sellers. Reducing
spreads, or the cost to do a trade, means that
the buyer gets to buy at a better price, and
the seller gets to sell at a better price. This
is no different from Wal-Mart Stores, Inc.
offering you great products at lower prices.
Innovation in products, systems and markets
has driven down these costs, and the investor
and issuer are the beneficiaries.
Profitability is driven by serving many
clients well at a low cost to them we
take on risk, which we manage carefully,
to serve our clients. A few examples will
suffice. We have huge volumes of business,
allowing us to offer good prices. For example,
in North America Cash Equities, we buy and
sell approximately 160 million shares a day
at 1.5 cents per share. In foreign exchange
trading, we do approximately 80,000 spot/
forward trades a day, netting only $70 a
trade (75% is done electronically). In credit
trading, we do 4,000 trades a day (mostly
bonds), making $1,500 per trade. We also
trade, on average, approximately 500 interest
rate swaps a day. Certain products have
higher fees associated with them, but fees
generally are consistent with the risk and
cost we need to take to execute the trade. In
all of these examples, revenue obviously is
offset by the cost of operating the business,
including the cost of hedging. And when
volumes drop or spreads tighten, the business clearly becomes less profitable.

The revenue on 98% of our trades averages

$50,000 or less per trade. But on a handful
of trades, we do make much larger fees
The cost of these services to clients has
because we serve our clients by taking on
been coming down dramatically over time
substantially more risk. Two examples will
benefiting both investors and corporate
help explain. In one instance, we executed
issuers. Thirty years ago, it cost, on average,
a multibillion dollar interest rate swap for
15 cents to trade a share of stock, 1% (100
a leading real estate company. In another
basis points) to buy or sell a corporate single-
trade, we executed a multiyear, half-billion
A bond and $100,000 to do a $100,000,000
dollar oil hedging program for a leading
interest rate swap. Today, it costs, on average,
transportation firm. On some of these large
1.5 cents to trade a share of stock, 10 basis
trades, we can make revenue of millions of
points to buy a corporate single-A bond and
dollars, but to do so, we take on large risks,
$4,000 to do a $100,000,000 interest rate
which we prudently try to hedge an underswap. Market making creates great liquidity
taking that frequently cannot be completed
in the market, giving investors confidence
immediately. On occasion, after all is said
that they can buy and sell securities often
and done, we may not make any revenue at
at a moments notice. Market making also
all. However, our clients are happy they
have paid us to take on risks that they dont
34

33

want. And when we assume the risk, it is our

job to manage it so that we are paid fairly, on
average, for the risk we took.
In the market-making business, we actively
try to hedge our positions to protect the firm
from violent price swings. But all hedges are
not perfect, and some things simply cannot
be hedged. So we do take risk by holding
inventory, but that is the cost of doing business a cost not much different from the
inventory a retailer or wholesaler holds in
stores to serve their customers. (When they
lose money on their inventory, its called
markdowns or sales.) Holding inventory at
appropriate levels is a cost of doing business
it is not speculating.
Many clients have a large need for derivatives to manage their exposures. Even more
misunderstood than market making in stocks
and bonds is derivatives. Ninety percent of
the global Fortune 500 companies actively
use derivatives. They dont use them because
we want them to do so. They use them to
manage their own exposures. Ninety percent
of what they do, and what we do, is pretty
basic they use interest rate or foreign
exchange (FX) derivatives to manage interest
rate or FX exposures. In addition, clients use
derivatives to manage commodity exposures,
credit exposures and other risk exposures.
Many companies have huge exposures that
they need to hedge so that they are not badly
hurt or even bankrupted by violent moves
in prices. Farmers have been doing hedging
for a long time, and, in the modern world, it
also applies to airlines, banks, investors and
others who have exposures to oil, interest
rates, foreign exchange rates, etc.
We tightly manage our risk in derivatives
by limiting our risk to each counterparty,
by limiting the type of risk we take within
each counterparty and by taking substantial
collateral against existing credit exposures.
Today, our net credit exposure to all counterparties, net of collateral in essence, what
we are owed by our various counterparties
is approximately $70 billion. Most of our
unsecured exposure is to government entities
or corporate clients where we deliberately
dont ask for collateral, which essentially is a
way to extend credit to them. With all of our
major global market counterparties think

of all the other major financial institutions

- we dont leave any material unsecured
derivatives exposure at all - we post collateral to each other every day.
One other great fear about derivatives is their
lack of transparency. If by transparency
people mean transparent prices, derivatives
actually are very transparent. Computer
screens provide immediate pricing and very
accurate spread information on the majority
of derivatives, and many dealers can respond
with actual bids, in size and with very tight
spreads, to anyone who calls. If by lack of
transparency people mean that the regulators
cannot access the information they need to
evaluate the risks, then that is incorrect - they
can and do see everything we can see. Finally,
if by transparency they mean that investors
(our shareholders and debtholders) cant see
or understand the risks - thats kind of true
even though we make extensive disclosures.
But you can look at any large companys
public disclosures, and there will be some, not
deliberate, lack of transparency. For example,
its not transparent what newspaper companies pay for print or paper or how various
companies have their inventory marked or
what insurance companies true exposures
are. We try to be as transparent as we can
meaningfully be, without overwhelming our
investors. We welcome any suggestions on
how we can get even better at this.
A liquid secondary market is critical to the
primary market - where corporate and
government-related entities issue securities.
Because America has such deep secondary
markets, corporate and government-related
entities can issue large quantities of securities quickly and at a low cost. When a
corporate bond issuer comes to market with
a multibillion dollar issue, the world already
has been educated on the company, the
bonds usually are traded actively and the
issue usually can be placed fairly quickly at
low cost to the issuer.
This would not be possible if we did not
have a high level of efficiency, activity and
liquidity in the secondary markets where
existing issues constantly are bought and
sold. If secondary markets were traded with
less frequency, then spreads - or costs -

35

34

would increase, thereby making it far more

expensive for entities public and private
to raise capital by issuing new securities.
America has the widest, deepest and most
transparent capital markets in the world at
the lowest prices for both issuer and investor.
While we clearly had some issues with
parts of these markets and believe reform is
needed lets not destroy the worlds best
capital markets.
We do not disagree with the intent of the
Volcker Rule. If the intent of the Volcker
Rule was to eliminate pure proprietary
trading and to ensure that market making is
done in a way that wont jeopardize a financial institution, we agree. And we believe
there are many ways to accomplish this: by
holding proper capital, by insisting on proper
liquidity, by proper marking of positions,
by proper reporting of risk, by constantly
turning over the risk in inventory positions
as appropriate for the type of security
trading in illiquid securities will have less
turnover than trading in government securities and by making sure that most trading
is customer driven much of the trading the
Street does with itself is effectively to syndicate out unwanted risk, which is no different
from loan syndication. But by its nature,
market making requires that traders, in order
to facilitate client business, take positions in
inventory that they hope to sell later.
The reader should understand that loans, a
traditional bank function, are proprietary,
illiquid and risky by their nature but that
doesnt make them bad. And most banks
that have gone bankrupt did so by making
bad loans not by trading. Loans and
market making both serve a critical function:
financing the American business machine.

The Volcker Rule and derivatives rules

need to be formulated in such a way as not
to severely inhibit American banks ability
to compete and serve clients. If the Volcker
Rule or the derivatives rules are written in
a way that constrains our ability to actively
make markets or to competitively provide
derivatives to our clients, our future will not
be as bright as it could be. For both rules, one
of the key questions is how they will apply
to business conducted outside the United
States. We cannot and should not be in a
position where the rule affects U.S. banks
outside the United States but not our foreign
competition. Not only would we be unable
to compete effectively in Europe, Asia and
Latin America, but much of the business that
we currently do in America (with investors
or corporations) likely will move to foreign
jurisdictions because our competitors will
be able to offer a better deal. No matter how
much our clients may like us, they will (and
should) move their business if they get better
pricing elsewhere.
In any case, we are well-positioned to be a
winner in the investment banking business.
While we do believe that there will be some
large-scale changes affecting the business
driven by both regulation and innovation
J.P. Morgan has the breadth we are one of
the top players in almost all of the markets
that we deal in and necessary economies of
scale to emerge as a winner.

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35

VIII. WHY WOULD YOU WANT TO OWN THE STOCK?

With record earnings, top three positions in

each of our major businesses and clear paths
to growth, why hasnt the stock done better?
There are many issues that are causing investors concern, creating legitimate reasons for
why bank values are depressed. Our stock
closed the year at $33.25, lower than it was
five years earlier. Over that time period, we
underperformed the Standard & Poors Index
by 22% although we outperformed the Bank
Index* by 41%. (As of March 15, 2012, at
the time I am writing this letter, the stock
has recovered to $45 a share, and these two
numbers would be a 7% underperformance
and a 60% outperformance, respectively).
In the beginning of this letter, I mentioned
that we are buying back a substantial
amount of stock despite all the issues facing
our company. Given these issues, we feel we
owe you an explanation about why we are
doing this and how we view the stock.
There are significant issues affecting
the stock valuation - but they will resolve
over time
Banks do face a plethora of difficult and
potentially damaging issues. Since the crisis,
we have met with many bank investors who
have said, Bank stocks are uninvestible, and
they cite the following reasons:
High economic uncertainty, a weak
recovery in the United States and large
potential problems in Europe
A low interest rate environment causing
reduced margins
The continued poor housing market in the
United States
Ongoing litigation around mortgage securities
The large amount of regulation, including
much higher capital and liquidity standards
and the fear that given so much capital and
regulatory constraints, we wont be able to
earn an adequate return on our capital

Ongoing anger at banks, which can lead

to even more regulation and litigation
Increasing global competition from
large banks and from less regulated
shadow banks
These issues are real and substantial.
Regarding the first three issues, we have
an abiding faith that the United States will
recover, interest rates will normalize and
housing will get better. Were already starting
to see some hopeful signs. We also believe
we are reserved substantially for mortgage
litigation (as weve already described).
Much of the uncertainty around regulation
will be resolved over the next 12-24 months.
In my opinion, only two regulations materially can hurt our competitive ability (the
Volcker Rule and the derivatives rules, which
I spoke about in the last section). We believe
they both will be properly resolved in a way
that will allow us to compete fairly. We also
believe there will be a lot of unintended
consequences as a result of the complexity
and interplay of all the regulations. And
- while I have expressed my concerns on
behalf of the consumer, the industry and the
country - my sense is that JPMorgan Chase
could benefit from as many unintended
consequences as we will be hurt by them.
This, however, may not be true for some of
our competitors.
Finally, it is possible that we may be required
to hold more capital than our main competitors, but we still believe we will find ways to
manage both our capital and our businesses
such that we earn adequate returns.
As all of these issues are resolved, we will
be left with a stronger and more competitive company, our earnings will be higher,
our industry will be growing and our future
will be bright.

* Excluding
Chase
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36

Why we bought back the stock and how we

look at stock value
Our tangible book value per share is a
good, very conservative measure of shareholder value. If your assets and liabilities
are properly valued, if your accounting is
appropriately conservative, if you have real
earnings without taking excessive risk and if
you have strong franchises with defensible
margins, tangible book value should be a
very conservative measure of value.
And we have substantial, valuable
intangibles. Our brand, our clients, our
people, our systems and our capabilities are
not replicable even if I gave you hundreds
of billions of dollars to do it. We have many
businesses that earn extraordinary returns
on equity because there is very little equity
involved; e.g., much of our asset management business, our advisory business, parts
of our payments businesses and others.
Many of our assets would sell at a substantial
premium to what currently is on the books;
e.g., credit card loans, consumer branches
and others. To be honest, some also would
sell at a discount vs. what theyre on the
books for - though many of these assets or
loans will give us the cash flow return we
expect and which normally are attached to
a client where we earn a lot of non-loanrelated, highly profitable revenue (i.e., cash
management, etc.). The loan itself might
sell at a discount, but the whole relationship
would not. And, certainly, most of our businesses, if we sold them whole, would sell at a
substantial premium to tangible book value.
Our best and highest use of capital (after
the dividend) is always to build our business organically - particularly where
we have significant competitive advantages and good returns. We already have
described many of those opportunities in
this letter, and I wont repeat them here. The
second-highest use would be great acquisitions, but, as I also have indicated, it is
unlikely that we will do one that requires
substantial amounts of capital.

We have huge capital generation. When

you look out many years into the future,
JPMorgan Chase should generate huge
amounts of capital, and much of it will be
hard to deploy. Unfortunately, the CCAR test
restricts our ability to buy back stock because
it looks at just two years of capital generation. So while we have less capital than the
9.5% that we currently believe we will need
under Basel III, once we get there, we will
be generating extreme amounts of excess
capital. And our organic growth and acquisitions unlikely will be able to use it all.
So buying back stock is a great option
you can do the math yourself. Haircut our
earnings numbers that analysts project and
forecast buying back, say, $10 billion a year
for three years at tangible book value. With
these assumptions, after four years, not only
would earnings per share be 20% higher than
they otherwise would have been, but tangible
book value per share would be 15% higher
than it otherwise would have been. If you like
our businesses, buying back stock at tangible
book value is a very good deal. So you can
assume that we are a buyer in size around
tangible book value. Unfortunately, we were
restricted from buying back more stock when
it was cheap below tangible book value
and we did not get permission to buy back
stock until it was selling at $45 a share.
Our appetite for buying back stock is not as
great (of course) at higher prices. If you run
the same numbers as above, but at $45 per
share, buybacks would be accretive to earnings and approximately break even to tangible
book value still attractive but far less so.
Currently, above $45 a share, we plan to
continue to buy back the amount of stock that
we issue every year for employee compensation we think this is just good discipline.
As for the excess capital, we will either find
good investments to make or simply use it
to more quickly achieve our new Basel III
targets. Rest assured, the Board will continuously reevaluate our capital plans and make
changes as appropriate but will authorize a
buyback of stock only when we think it is a
great deal for you, our shareholders.

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37

The tables above show our earnings per

share and tangible book value per share
over the last six years. Id like to make
one last comment about our stock and
your company. I view it as a great sign of
strength that, in the worst financial markets

since the Great Depression, your company

could earn money, grow tangible book
value, buy Bear Stearns and WaMu and
expand our franchise.

CLOSING

Let me close by thanking our 260,000 employees. Day in and day

out, they are the people who serve our clients, communities and
shareholders with distinction and dedication. They make me very
proud, and I am honored to be their partner.

Jamie Dimon
Chairman and Chief Executive Officer
March 30, 2012

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38

39

October 12, 2012

3Q12

FINANCIAL RESULTS

40

FINANCIAL RESULTS

note 1 on slide 23
a tax rate of 38%
3 See slide 8, Charge-offs of post-bankruptcy consumer loans
4 See note 4 on slide 23, and the Basel I Tier 1 capital and Tier 1 capital ratio on page 43 of the Firms third quarter 2012 earnings release financial supplement
5 Reflects estimated impact of final Basel 2.5 rules and Basel III Advanced NPR

2 Assumes

1 See

(424)

551

(512)

$558

Net income

(0.11)

0.14

(0.13)

$0.14

EPS

Estimated Basel III Tier 1 common ratio of 8.4%, after impact of final Basel 2.5 rules and NPR5

Basel I Tier 1 common4 of $135B; ratio of 10.4%4

Fortress balance sheet strengthened

(684)

Corporate Expense for additional litigation reserves

(825)
888

$900

Pretax

Corporate Extinguishment gains on redeemed TruPS

Real Estate Portfolios Incremental charge-offs due to regulatory guidance

Real Estate Portfolios Benefit from reduced loan loss reserves

$mm, excluding EPS

3Q12 results included the following significant items

Strong performance across all businesses

3Q12 record net income of $5.7B; record EPS of $1.40; revenue of $25.9B1

3Q12 Financial highlights

41

FINANCIAL RESULTS

2 Actual

note 1 on slide 23
numbers for all periods, not over/under
3 See note 3 on slide 23

16

ROTCE2,3

1 See

12%

ROE2

$1.40

$5,346

Net income applicable to common stock

Reported EPS

$5,708

15,371

1,789

$25,863

3Q12

Reported net income

Expense

Credit costs

Revenue (FTE)1

$mm, excluding EPS

3Q12 Financial results1

15

11%

$0.19

$712

$748

405

1,575

$2,971

2Q12

3Q11

13

9%

$0.38

$1,410

$1,446

(163)

(622)

$1,495

$ O/(U)

42

FINANCIAL RESULTS

Fixed Income and Equity Markets revenue of

32

Comp/revenue, excl. DVA 4

122

VaR ($mm)6

70

$40

16

41

60

2.30

(1.16)%

1.4

1.3

$60.5

notes 1 and 6 on slide 23

Actual numbers for all periods, not over/under
3 Loans held-for-sale and loans at fair value were excluded when calculating the loan loss coverage ratio
and net charge-off/(recovery) rate
4 Comp/revenue excludes the impact of DVA. As reported, comp/revenue for 3Q12, 2Q12 and 3Q11 of
33%, 30% and 29%, respectively
5 Calculated based on average equity of $40B
6 Average trading and credit portfolio VaR at 95% confidence level. See page 12, footnote (i), of the
Firms third quarter 2012 earnings release financial supplement

75

$40

$40

1 See

19

16

33

56

1.97

(0.06)%

0.8

1.4

$74.4

ROE
EOP equity

62

2.06

ALL/loans 3

Overhead ratio

(0.09)%

0.8

Nonaccrual loans

Net charge-off/(recovery) rate 3

1.4

Allowance for loan losses

$71.2

Comp/revenue, excl. DVA of 32%

compensation

Expense of $3.9B, up 3% YoY, driven by higher

Credit Portfolio revenue of $289mm excl. DVA

Equity revenue of $1.0B, flat YoY

reflecting broad-based strength this quarter

Fixed Income revenue of $3.7B, up 33% YoY,

($64)

Ranked #1 in YTD Global IB fees

results in debt underwriting products

IB fees of $1.4B, up 38% YoY, with stronger

DVA in 3Q11

ROE of 16%, 17% excl. DVA, up from 5% excl.

EOP loans

($341)

108

($102)

(488)

(351)

357

390

3Q11
($92)

DVA loss of $211mm

$4.8B. Excluding DVA:

$1,572

105

($69)

(454)

(170)

(49)

184

2Q12
($489)

$ O/(U)

Net income of $1.6B on revenue of $6.3B

Key statistics ($B)2

Net income

($48)

90

Credit portfolio
3,907

1,073

Equity markets

Expense

3,685

Fixed income markets

Credit costs

1,429

3Q12
$6,277

Investment banking fees

Revenue

$mm

Investment Bank1

43

FINANCIAL RESULTS

ROE excl. Real Estate Portfolios

36%

$1,348

$26.5

42%

($202)

$26.5

34%

($859)

1,186

($235)

313

$78

107

($29)

2Q12

$ O/(U)

34%

$120

$25.0

18%

$247

(396)

$4

474

$478

668

($190)

3Q11

3 Calculated

See note 1 on slide 23

Actual numbers for all periods, not over/under
based on average equity; average equity for 3Q12, 2Q12 and 3Q11 was $26.5B, $26.5B and $25.0B,
respectively
4 Calculated based on average equity; average equity for 3Q12, 2Q12 and 3Q11 was $14.8B, $14.8B and $14.5B,
respectively
5 See slide 8, Charge-offs of post-bankruptcy consumer loans

2,4

RFS net income excl. Real Estate Portfolios

EOP equity ($B)2

Memo:

21%

$1,408

Net income

ROE2,3

631

Credit costs

$2,974

5,039

Expense

Pre-provision profit

$8,013

4,141

Noninterest revenue

Revenue

$3,872

3Q12

Net interest income

$mm

Retail Financial Services1

Expense of $5.0B, up 10% YoY

$825mm based on regulatory

guidance5

Net charge-offs included incremental

allowance for loan losses

Reflected a $900mm reduction in the

Credit costs of $631mm

Revenue of $8.0B, up 6% YoY

$1.2B in the prior year

Net income of $1.4B, compared with

44

FINANCIAL RESULTS

27.7

1 Actual

numbers for all periods, not over/under

# of active mobile customers (mm)

Client investment assets (EOP)

9.8

154.6

6.3

18.6

Business Banking loans (EOP)

Investment sales

$1.7

Business Banking originations

5,596

Checking accounts (mm)

# of branches

2.56%

Deposit margin

Average total deposits

$393.8

$785

Net income

Key drivers 1 ($B)

107

Credit costs

$1,422

2,916

Pre-provision profit

$4,338

Expense

1,653

Revenue

$2,685

Noninterest revenue

3Q12

Net interest income

$mm

Consumer & Business Banking

Retail Financial Services

9.1

147.6

6.2

18.2

$1.8

5,563

27.4

2.62%

$389.5

($161)

109

($162)

174

$12

$5

2Q12

$ O/(U)

7.2

132.3

5.1

17.3

$1.4

5,396

26.5

2.82%

$362.2

($238)

(19)

($418)

74

($344)

(299)

($45)

3Q11

Client investment assets up 17% YoY and 5% QoQ

Investment sales up 23% YoY and 2% QoQ

QoQ

Record Business Banking loans up 8% YoY and 2%

down 6% QoQ

Business Banking originations up 17% YoY and

Checking accounts up 4% YoY and 1% QoQ

2.82% in the prior year

Deposit margin was 2.56%, compared with

1% QoQ

Average total deposits of $393.8B, up 9% YoY and

Key drivers

force and new branch builds

Expense up 3% YoY, driven by investments in sales

the prior year

Credit costs of $107mm, compared with $126mm in

impact of the Durbin Amendment

Net revenue of $4.3B, down 7% YoY, reflecting the

$785mm, down 23% YoY

Consumer & Business Banking net income of

Financial performance

45

FINANCIAL RESULTS

1,063

$563

Net income

73.2

Mortgage application volume

numbers for all periods, not over/under

Headcount for total Mortgage Banking

1 Actual

Headcount2
47,412

814.8

25.5

Retail channel originations

3rd party mtg loans svc'd (EOP)

$47.3

Mortgage loan originations

Key drivers 1 ($B)

($159)

150

Income/(loss) before income tax expense/(benefit)

MSR risk management

($309)

Servicing expense

Income/(loss), excl. MSR risk management

(290)

$1,044

Servicing
Servicing-related revenue

MSR asset amortization

$1,087

(13)

$1,100

678

$1,778

3Q12

Income before income tax expense

Repurchase losses

Income excl. repurchase losses

Production expense

Production
Production-related revenue excl. repurchase losses

$mm

Mortgage Production and Servicing

Retail Financial Services

49,535

860.0

66.9

26.1

$43.9

($41)

($224)

(83)

($141)

110

37

($68)

$156

(3)

$159

58

$217

$ O/(U)
2Q12

46,374

924.5

58.1

22.4

$36.8

$358

($6)

134

($140)

197

167

($110)

$594

301

$293

182

$475

3Q11

26% YoY and 9% QoQ

Mortgage loan application volumes of $73.2B, up

8% QoQ
Retail channel originations (branch and directto-consumer) up 14% YoY, down 2% QoQ

Mortgage originations of $47.3B, up 29% YoY and

Key drivers

Servicing expense of $1.1B, up 23% YoY

amortization, of $754mm, up 8% YoY

Net servicing-related revenue, after MSR asset

Reduction of repurchase liability of $218mm

Realized repurchase losses of $231mm

$594mm YoY, reflecting wider margins and higher

volumes

Record production pretax income of $1.1B, up

$563mm, up $358mm YoY

Mortgage Production and Servicing net income of

Financial performance

46

FINANCIAL RESULTS

4.76

1.08

5.27

1.48

2.82

2.57%

146

172

581

899

$6,327

7.12%

136.5

101.1

$104.9

$127

(379)

(900)

521

($168)

23

($145)

3Q11

numbers for all periods, not over/under

Includes purchased credit-impaired loans acquired as part of the WaMu transaction
3 Excludes the impact of purchased credit-impaired loans acquired as part of the WaMu transaction. Allowance for loan
losses of $5.7B, $5.7B and $4.9B for these loans as of 3Q12, 2Q12 and 3Q11, respectively. To date, no charge-offs have
been recorded for these loans
4 See slide 8, Charge-offs of post-bankruptcy consumer loans

6.62

1 Actual

1.37

2.53

Subprime mortgage and other

2.21%

6.22

116

4.60%

Prime mortgage, including option ARMs

Net charge-off rate

Home equity

157

466

1,120
114

696

Subprime mortgage and other

3,4

5.20%
$6,725

1,420

$8,096

4.63%

124.5

120.3

143

92.9

$96.1

($657)

1,074

350

724

($8)

(26)

($34)

2Q12

$ O/(U)

90.5

Prime mortgage, including option ARMs

Net charge-offs ($mm)4

Home equity

Nonaccrual loans ($mm)

ALL/ EOP loans

Average mortgage loans owned 2

EOP NCI owned portfolio

Average home equity loans owned

$93.2

$60

Net income

Key statistics 1 ($B)

520

(900)

Change in allowance

Credit costs

$620
1,420

Net charge-offs

386

Pre-provision profit

$1,006

Expense

3Q12

Revenue

$mm

Real Estate Portfolios

Retail Financial Services

$600mm +/-

Total quarterly net charge-offs likely to be

losses of $900mm

Reduction in allowance for loan

incremental $825mm based on

regulatory guidance4

Net charge-offs of $595mm before

Credit costs of $520mm

driven by a decline in net interest income

resulting from portfolio runoff

Net revenue of $1.0B, down 13% YoY,

$60mm, compared with a net loss of

$67mm in the prior year

Real Estate Portfolios net income of

47

FINANCIAL RESULTS

affected small population of Auto loans in Card Services & Auto resulting in $55mm of
incremental charge-offs

1 Also

Mean current CLTV: 83

Mean current FICO: 666

~85% of loans are currently paying principal

since bankruptcy; up ~75 FICO points on average

85% of the portfolios FICO scores have improved

for at least 2 years since bankruptcy; ~80% for

at least one year

~50% of population has been making payments

~97% of loans are current

Mortgage characteristics

Note: 3Q12 Adjusted and 2Q12 Adjusted nonaccrual loans exclude performing junior liens that are
subordinate to nonaccrual senior liens of $1.3B and $1.5B, respectively. 3Q12 Adjusted nonaccrual loans
also exclude $1.7B nonaccrual loans in accordance with regulatory guidance requiring loans discharged
under Chapter 7 bankruptcy and not reaffirmed by the borrower to be reported as nonaccrual loans,
regardless of their delinquency status. 3Q12 Adjusted net charge-offs and net charge-off rates exclude the
effect of the incremental charge-offs of $825mm resulting from the regulatory guidance noted above

3Q12
3Q12
2Q12
3Q11
Reported Adjusted Adjusted Reported
Nonaccrual loans ($mm)
$8,096
$5,130
$5,271
$6,327
Net charge-offs ($mm)
1,420
595
696
899
Home equity
1,120
402
466
581
Prime mortgage, including option ARMs
143
97
114
172
Subprime mortgage and other
157
96
116
146
Net charge-off rate
4.60%
1.93%
2.21%
2.57%
Home equity
6.22
2.23
2.53
2.82
Prime mortgage, including option ARMs
1.37
0.93
1.08
1.48
Subprime mortgage and other
6.62
4.05
4.76
5.27

Pro-forma trend analysis

Reserve coverage of the Real Estate Portfolios remains strong

3Q12 nonaccrual balances of $5.1B adjusted for regulatory guidance during 2012

Expect to recover significant amount of losses over time as principal payments are received

A significant number of these borrowers continue to make payments to stay in their homes

$825mm of incremental charge-offs1; $1.7B of incremental nonaccrual loans

Assumes 100% default rate; loans written down to collateral value

$2.8B of Mortgage UPB, largely home equity

bankruptcy loans to the value of underlying collateral

Firms required to charge off current and early stage delinquency (i.e., <60 DPD) post-Chapter 7

Regulatory guidance affecting JPM and the industry

Charge-offs of post-bankruptcy consumer loans

48

FINANCIAL RESULTS

6.3

12.0

$48.4

7.4

$163.6

2.15

5.8

12.9

$48.3

7.1

$160.2

2.13

4.32%

$1.3

11.91%

1.6

96.0

$125.2

$16.5

25%

5.9

13.9

$46.5

6.1

$138.1

2.89

4.70%

$1.5

12.36%

2.0

87.3

$126.5

$16.0

21%

$105

(195)

(33)

($52)

3Q11

note 1 on slide 23
2 3Q12 includes an increase in net charge-offs of $55mm in accordance with regulatory guidance
requiring loans discharged under Chapter 7 bankruptcy and not reaffirmed by the borrower to be
charged off to their collateral value, regardless of their delinquency status
3 2Q12 included $91mm in net charge-offs based on a policy change on restructured loans that do not
comply with their modified payment terms
4 Calculated based on average equity; average equity for 3Q12, 2Q12 and 3Q11 was $16.5B, $16.5B
and $16.0B, respectively
5 Actual numbers for all periods, not over/under
6 Excludes Commercial Card
7 See note 5 on slide 23

1 See

Auto originations

Avg outstandings Student

Avg outstandings Auto

Auto Key drivers 5 ($B)

# of total transactions

Bank card volume

Merchant Services Key drivers (B)

30+ Day delinquency rate

3.57%

Net charge-off rate 7

7

$1.1

Net charge-offs 3

1.6
12.46%

96.6

$124.3

$16.5

23%

Net revenue rate

New accts opened (mm)

Sales volume 6

Avg outstandings

Card Services Key drivers 5 ($B)

EOP Equity ($B)

ROE

$954

Net income

($76)

(176)

1,920

4,5

497

$198

2Q12

1,231

$4,723

3Q12

$ O/(U)

Credit costs 2,3

Expense

Revenue

$mm

Card Services & Auto1

Auto originations up 7% YoY and 9% QoQ

Average auto outstandings up 4% YoY and flat QoQ

Auto

off policy for TDRs3

2Q12 rate of 4.03%, adjusted for change in charge-

prior year and 4.32% in the prior quarter

Net charge-off rate7 of 3.57%, down from 4.70% in the

Sales volume6 of $96.6B, up 11% YoY and 1% QoQ

1% QoQ

Average outstandings of $124.3B, down 2% YoY and

Card Services

Key drivers

marketing expense

Expense of $1.9B, down 9% YoY, driven by lower

Credit costs of $1.2B2, down $33mm YoY

Revenue of $4.7B, down 1% YoY

for loan losses7, up 48% YoY

Net income, excluding the reduction to the allowance

Net income of $954mm, up 12% YoY

Card Services & Auto

49

FINANCIAL RESULTS

2.7
0.9

Allowance for loan losses

Nonaccrual loans

28
$9.5

29

35

35
$9.5

2.20

2.15

(0.03)%

0.9

2.6

193.3

120.5

$118.4

$17

10

$1

10

(8)

27

$41

$ O/(U)
2Q12

$8.0

28

36

2.50

10

0.06%

1.4

2.7

180.3

107.4

$105.3

$119

28

($83)

30

64

47

$144

3Q11

notes 1 and 7 on slide 23

numbers for all periods, not over/under
deposits and deposits swept to on-balance sheet liabilities
4 Loans held-for-sale and loans at fair value were excluded when calculating the loan loss coverage
ratio and net charge-off/(recovery) rate
5 Calculated based on average equity; average equity for 3Q12, 2Q12 and 3Q11 was $9.5B, $9.5B
and $8.0B, respectively

3 Includes

2 Actual

1 See

ROE5
EOP equity

ALL/loans
Overhead ratio

(0.06)%

190.9

Average liability balances 3

Net charge-off/(recovery) rate 4

123.7

$122.1

EOP loans and leases

Average loans and leases

Key statistics ($B)2

$690

601

Expense

Net income

($16)

120

Other

Credit costs

298
106

Real Estate Banking

370

Corporate Client Banking

Commercial Term Lending

838

$1,732

3Q12

Middle Market Banking

Revenue

$mm

Commercial Banking1

prior year

Overhead ratio of 35%, down from 36% in the

related expense

Expense up 5% YoY, reflecting higher headcount-

Excluding recoveries, charge-off rate of 0.09%

Net recovery rate of 0.06%

Credit cost benefit of $16mm

and down 1% QoQ

Average liability balances of $190.9B, up 6% YoY

balances; 10th for Middle Market

9th consecutive quarter of increased loan

QoQ; record Middle Market loans up 15% YoY

Record EOP loan balances up 15% YoY and 3%

Record revenue of $1.7B, up 9% YoY

Net income of $690mm, up 21% YoY

50

FINANCIAL RESULTS

542.3

TSS firmwide average liab bal ($B)4

2,823
541.4

1,745

521.4

1,609

2,548

$7.0

17

24%

30.1

16.3

$341.1

$115

45

(27)

26

95

$121

3Q11

2 IB

notes 1, 8 and 9 on slide 23

and TSS share the economics related to the Firms GCB clients. Included within this allocation are
net revenue, provision for credit losses as well as expense
3 Actual numbers for all periods, not over/under
4 Includes deposits and deposits swept to on-balance sheet liabilities
5 Calculated based on average equity; average equity for 3Q12, 2Q12 and 3Q11 was $7.5B, $7.5B and
$7.0B, respectively

1 See

2,705
1,740

TS firmwide revenue

25
$7.5

22
$7.5

TSS firmwide revenue

ROE
EOP equity ($B)

34%

35.3

35.1

EOP trade finance loans ($B)

32%

17.7

Pretax margin

$348.1

18.2

(14)
($43)

54
$420

(20)

(48)

(113)

(10)

($123)

$351.4

(12)

1,443

965

1,064

$2,029

3Q12

$ O/(U)
2Q12

Average liability balances ($B)4

Assets under custody ($T)

Key statistics 3

Credit allocation income/(expense)

Net income

Credit costs

Expense

Worldwide Securities Services

Treasury Services

Revenue

$mm

Treasury & Securities Services1

11

Expense down 2% YoY and 3% QoQ

12% YoY

Record assets under custody of $18.2T, up

Liability balances up 3% YoY

WSS revenue of $1.0B, up 3% YoY

TS revenue of $1.1B, up 10% YoY

Revenue of $2.0B, up 6% YoY

securities lending and depositary receipts in

the prior quarter

QoQ decrease reflecting seasonal activity in

9% QoQ

Net income of $420mm, up 38% YoY and down

51

FINANCIAL RESULTS

74.9

$7.0

$7.0

$6.5

24

2 Actual

12

21%

111.1

54.2

52.7

1,806

$1,254

$58

(65)

($12)

(9)

85

67

$143

3Q11

note 1 on slide 23
numbers for all periods, not over/under
3 See note 9 on slide 23
4 Calculated based on average equity; average equity of $7.0B, $7.0B and $6.5B for 3Q12, 2Q12 and
3Q11, respectively

1 See

22

25

ROE4
EOP equity

27%

29%

128.1

70.5

67.1

1,968

$1,347

$52

30

($20)

45

26

24

$95

$ O/(U)
2Q12

Pretax margin3

127.5

EOP loans

Average deposits

71.8

2,031

Assets under supervision

Average loans

$1,381

$443

Net income

Key statistics ($B)2

Assets under management

1,731

Expense

$14

531

Retail

Credit costs

563

1,365

$2,459

3Q12

Institutional

Private Banking

Revenue

$mm

Asset Management1

Expense down 4% YoY and up 2% QoQ

2nd quartiles over 5 years

77% of mutual fund AUM ranked in the 1st or

Strong investment performance

YoY and 6% QoQ

Record EOP loan balances of $74.9B, up 38%

and 3% QoQ

Assets under supervision of $2.0T, up 12% YoY

net inflows of $21B to long-term products,

predominantly offset by net outflows of $17B
from liquidity products

AUM net inflows for the quarter of $4B due to

YoY

Assets under management of $1.4T, up 10%

Revenue of $2.5B, up 6% YoY

Net income of $443mm, up 15% YoY

52

FINANCIAL RESULTS

(59)

Other Corporate

1 See

note 1 on slide 23

$221

369

Treasury and CIO

Net income/(loss)

($89)

3Q12

Private Equity

Net income/(loss) ($mm)

Corporate/Private Equity1

$1,998

(163)

2,447

($286)

2Q12

13

$866

145

463

$258

3Q11

$ O/(U)

Included a $449mm loss related to a portion of

SCP retained in CIO; these positions were
effectively closed out this quarter

$100mm +/-; likely to vary each quarter

Expect Other Corporate quarterly net income to be

adjustments

Largely offset by other items, including tax

reserves of $684mm (pretax)

Noninterest expense includes additional litigation

Other Corporate

decisions

Driven by implied yield curve and management

May vary by +/- $100mm

approximately $300mm next quarter

Expect Treasury and CIO quarterly net loss of

Negative NII due to low rates

Principal transactions loss of $247mm

Securities gains of $459mm

$888mm of extinguishment gains on redeemed TruPS

Treasury and CIO net revenue of $713mm

Treasury and CIO

equity less goodwill)

Private Equity portfolio of $8.1B (5.3% of stockholders

Private Equity net revenue was a loss of $135mm

Private Equity

53

FINANCIAL RESULTS

1Q10

2Q10

1.47%

3.06%

3.66%

3Q10

1.42%

3.01%

3.66%

2Q11

1.35%

2.72%

3.33%

4Q11

1.42%

2.70%

3.19%

1Q12

1.29%

2.61%

3.10%

JPM NIM

2Q12

1.07%

2.47%

3.00%

3Q12

1.11%

2.43%

2.92%

Increase in deposits with central banks

with partial offset in deposit costs

Lower rates impacting floating rate assets,

Limited reinvestment opportunities

(2.11% in 3Q12; 2.42% in 2Q12)

largely offset by hedge accounting

Rate benefit related to above items was

trust preferred securities redemption and

debt maturities

Balances and interest expense lower post

Faster mortgage prepayments

Long-term debt (2.51% in 3Q12; 2.47% in

3Q11

1.45%

2.66%

3.14%

Market-based NIM

2Q12)
Investment securities

1Q11

1.43%

2.89%

3.54%

Core NIM

(4 bps and 8 bps, respectively) QoQ

4Q10

1.42%

2.88%

3.51%

Market-based NII

14

note 1 on slide 23
The core and market-based NII presented for 2009 represent the quarterly average for 2009 (total for 2009 divided by 4); the yield for all periods represent the annualized yield

1 See

1.77%

3.32%

3.85%

Core NII

Both Firmwide and Core NIM lower

Comments

FY2009

1.92%

3.42%

3.91%

Net interest income trend

Core net interest margin1

54

FINANCIAL RESULTS

0.9

1.0
1.7%

Return on Basel I risk-weighted assets

15

We consider return on
RWA to be more
relevant for JPM and
comparisons to peers

~+100bps after the

impact of run-off and
mitigants through 20146

2 Reflects

note 4 on slide 23, and the Basel I Tier 1 capital and Tier 1 capital ratio on page 43 of the Firms third quarter 2012 earnings release financial supplement
estimated impact of final Basel 2.5 rules and Basel III Advanced NPR
3 See note 3 on slide 23
4 See note 2 on slide 23
5 The Global Liquidity Reserve represents cash on deposit at central banks, and the cash proceeds expected to be received in connection with secured financing of highly liquid, unencumbered securities (such
as sovereigns, FDIC and government guaranteed, agency and agency MBS). In addition, the Global Liquidity Reserve includes the Firms borrowing capacity at the Federal Reserve Bank discount window and
various other central banks and from various Federal Home Loan Banks, which capacity is maintained by the Firm having pledged collateral to all such banks. These amounts represent preliminary estimates
which may be revised in the Firms 10-Q for the quarter ending September 30, 2012
6 Includes the effect of bringing forward run-off and data/model enhancements
Note: estimated for 3Q12
Note: firmwide level 3 assets, reported at fair value, are estimated to be 4% of total Firm assets as of September 30, 2012
Note: NPR in comment period until 10/22/12; estimates subject to change based on regulatory clarifications, further analysis, confirmation of netting assumptions, and timing
of model approvals

1 See

Global Liquidity Reserve of $449B5

1.4%

0.8

13

9%

$2,289

9.9%

1,218

$120

3Q11

Firmwide total credit reserves of $23.6B; loan loss coverage ratio of 2.61%4

1.5%

15

16

Return on tangible common equity3

Return on assets

11%

$2,290

7.9%

12%

$2,321

8.4%

1,664

Return on equity

Total assets

Basel III Tier 1 common ratio with Basel 2.5 and NPR 2

1,663

Basel III Risk-weighted assets 2

$132

8.8

9.5
$139

9.9%

1,319

1,298
10.4%

$130

2Q12

$135

3Q12

Basel III Tier 1 common capital2

Basel I Tier 1 common ratio 1

Basel I Tier 1 common ratio (with B2.5)

Basel I Tier 1 common capital1

Basel I Risk-weighted assets

$B, except where noted

Fortress balance sheet and returns

55

FINANCIAL RESULTS

16

Expect 2H12 operating expense comparable to 1H12

Expect reserve releases are near the end

Continued modest pressure on NIM

Firmwide guidance

$100mm +/-; likely to vary each quarter

Expect Other Corporate quarterly net income to be

decisions

Driven by implied yield curve and management

May vary by +/- $100mm

Card Services

Estate Portfolios run-off

Expect annual reduction in NII of $500mm +/- from Real

reductions based on current trends

Realized repurchase losses may be offset by reserve

there will be continued reserve reductions

If charge-offs and delinquencies continue to trend down,

Total quarterly net charge-offs likely to be $600mm +/-

Mortgage Banking

negatively impact annual net income by over $400mm,

but this may be offset by strong deposit balance growth

approximately $300mm next quarter

Expect Treasury and CIO quarterly net loss of

Consumer & Business Banking

Deposit spread compression, given low interest rates, will

Corporate / Private Equity

Retail Financial Services

Outlook

56

FINANCIAL RESULTS

Agenda

Appendix

17

17

Page

57

APPENDIX

$0.8

0.0

0.3

$0.3

0.1

0.0

$0.1

0.0

0.4

$0.4

AFS
securities

$16.2

1.3

0.5

$1.8

0.4

9.5

$9.9

3.9

0.6

$4.5

Trading

Securities and trading

($7.0)

(1.3)

0.0

($1.3)

(1.1)

(1.3)

($2.4)

(3.3)

0.0

($3.3)

Derivative
collateral

($6.0)

0.0

(0.7)

($0.7)

(0.3)

(4.7)

($5.0)

(0.3)

0.0

($0.3)

Portfolio
hedging

$11.7

1.0

0.1

$1.1

2.4

3.5

$5.9

3.7

1.0

$4.7

Net
exposure

18

Exposure is a risk management view. Lending is net of liquid collateral. Trading includes net inventory, derivative netting under legally enforceable trading agreements, net
CDS underlying exposure from market-making flows, unsecured net derivative receivables and under collateralized securities financing counterparty exposure

Continue to be active with clients in the region

positions, as well as client transactions

Net exposure increased primarily due to the impact of index/credit tranche

~$12B total firmwide net exposure as of 3Q12, up from $6.2B as of 2Q12

$7.7

1.0

Non-sovereign

Total firmwide exposure

0.0

Sovereign

$1.0

3.3

Non-sovereign

Other (Ireland, Portugal,

and Greece)

0.0

Sovereign

$3.3

3.4

Non-sovereign

Italy

0.0

$3.4

Lending

Sovereign

Spain

As of September 30, 2012 ($B)

Peripheral European exposure1

58

APPENDIX

M ar-09

Sep-09

M ar-10

Sep-10

M ar-11

Sep-11

M ar-09

Sep-09

M ar-10

Sep-10

30 149 day delinquencies

M ar-11

Sep-12

Sep-11

M ar-12

19

Sep-12

150+ day delinquencies

M ar-12

Note: Prime Mortgage excludes held-for-sale, Asset Management and Government Insured loans
1 Excluding purchased credit-impaired loans
2 See note 1 on slide 23
3 Payment holiday in 2Q09 impacted 30+ day and 30-89 day delinquency trends in 3Q09

Sep-08

$0

$1,000

$2,000

$3,000

$4,000

$5,000

Subprime Mortgage delinquency trend ($mm)

Sep-08

$0

$1,000

$2,000

$3,000

Sep-08

M ar-09

Sep-09

M ar-10

Sep-10

$1,000
Sep-08 Mar-09

$2,650

$4,300

$5,950

$7,600

$9,250

$10,900

$12,550

Sep-09 Mar-10

Sep-10

30+ day delinquencies

Sep-11

M ar-12

Sep-12

150+ day delinquencies

Mar-11

Sep-11

Mar-12

Sep-12

30-89 day delinquencies

M ar-11

Credit card delinquency trend2,3 ($mm)

$0

$1,300

$2,600

$3,900

$5,200

30 149 day delinquencies

$6,500

150+ day delinquencies

$4,000

30 149 day delinquencies

Prime Mortgage delinquency trend ($mm)

Home Equity delinquency trend ($mm)

Consumer credit Delinquency trends1

59

APPENDIX

1Q10

2,075

4,512

2Q10

1,372

3,721

3Q10

1,214

3,133
2,671

4Q10

1,157 5

1Q11

1,076

2,226

2Q11

954

1,810

Real Estate Portfolios

123%

$5,503

3.57%

$1,116

3Q11

899

1,499

4Q11

876

1,390

Card Services

110%

$5,499

4.03%

$1,254

232%

$6,468

2.21%

$696

1Q12

808

1,386

126%

$7,528

4.70%

$1,499

270%

$9,718

2.57%

$899

3Q11

2Q12

696

1,254 2

3Q12

595

1,116

($2,025)

(113)bps

($383)

($4,150)

(64)bps

($304)

3Q11

O/(U)

2 2Q12

adjusted net charge-offs and adjusted net charge-off rate for Real Estate Portfolios exclude the effect of an incremental $825mm of net charge-offs based on regulatory guidance
adjusted net charge-offs for Card Services were $1,254mm or 4.03%; excluding the effect of a change in charge-off policy for troubled debt restructurings, 2Q12 reported net chargeoffs were $1,345mm or 4.32%
3 Net charge-offs annualized (NCOs are multiplied by 4)
20
4 See note 5 on slide 23
5 4Q10 adjusted net charge-offs exclude a one-time $632mm adjustment related to the timing of when the Firm recognizes charge-offs on delinquent loans

1 3Q12

$0

$1,000

$2,000

$3,000

$4,000

$5,000

NCOs ($mm)

Allowance for loan losses ($)

LLR/annualized NCOs 3

Net charge-offs ($)

NCO rate (%)4

Card Services

234%

$5,568

1.93%

NCO rate (%)

Allowance for loan losses ($)

LLR/annualized NCOs 3

$595

Net charge-offs ($)

RFS Real Estate Portfolios (NCI):

2Q122

3Q12

Adjusted

Adjusted

Real Estate Portfolios and Card Services credit data ($mm)

Real Estate Portfolios and Card Services Coverage ratios

60

APPENDIX

3Q10

15,503

34,161

154

183

2.74%

241

1.46%

170

3.79%

JPM

2Q12

1Q11

13,441

29,750

144

3.06%

89

1.31%

161

4.17%

Peer avg.

2Q11

11,928

28,520
28,350

4Q11

9,993

27,609

Nonperforming loans

1Q12

10,605

25,871

2Q12

10,068

23,791

3Q12

11,370

22,824

Loan loss reserve/NPLs1

~$5.6B from $28.4B one year ago reflecting

improved portfolio credit quality; loan loss
coverage ratio of 2.61%1

$22.8B of loan loss reserves in 3Q12, down

3Q11

11,005

Loan loss reserve

0%

100%

200%

300%

400%

500%

600%

21

note 2 on slide 23
The current quarter NPLs include $1.7B of loans in accordance with regulatory guidance requiring loans discharged under Chapter 7 bankruptcy and not reaffirmed by the borrower, regardless of their
delinquency status to be reported as nonaccrual loans. In addition, 3Q12, 2Q12 and 1Q12 NPLs include performing junior liens that are subordinate to nonaccrual senior liens of $1.3B, $1.5B and
$1.6B, respectively; such junior liens are now being reported as nonaccrual loans based upon regulatory guidance issued in 1Q12. Of the total, $1.2B were current at September 30, 2012
3 Peer average reflects equivalent metrics for key competitors. Peers are defined as C, BAC and WFC

1 See

LLR/NPLs

LLR/Total loans

2.61%

261

Firmwide

1.46%

LLR/NPLs

135

3.57%

JPM

LLR/Total loans

Wholesale

LLR/NPLs

LLR/Total loans

Consumer

3Q12

4Q10

14,841

32,266

Loan loss reserve/Total loans1

Peer comparison

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

$mm

Firmwide Coverage ratios

61

APPENDIX

7.2%

7.7%

7.1%

7.8%

9.8%

1 18.0%

2 21.0%

2 19.8%

4 10.5%

1 11.3%

1 11.2%

21.2%

10.8%

26.7%

18.3%

12.5%

6.8%

11.2%

6.7%

11.1%

6.7%

8.1%

YTD12
FY11
Rank Share Rank Share

Source: Dealogic. Global Investment Banking fees reflects ranking of fees and
market share. Remainder of rankings reflects transaction volume rank and market
share. Global announced M&A is based on transaction value at announcement;
because of joint M&A assignments, M&A market share of all participants will add up
to more than 100%. All other transaction volume-based rankings are based on
proceeds, with full credit to each book manager/equal if joint
1 Global Investment Banking fees rankings exclude money market, short-term debt
and shelf deals
2 Long-term debt rankings include investment-grade, high-yield, supranational,
sovereigns, agencies, covered bonds, asset-backed securities (ABS) and
mortgage-backed securities; and exclude money market, short-term debt, and U.S.
municipal securities
3 Global Equity and equity-related ranking includes rights offerings and Chinese AShares
4 Announced M&A reflects the removal of any withdrawn transactions. U.S.
announced M&A represents any U.S. involvement ranking

US Loan Syndications

Global Loan Syndications

US M&A Announced

Global M&A Announced

US Equity & Equity-related

Global Equity & Equity-related3

US Long-term Debt

Global Long-term Debt

'2

US Debt, Equity & Equity-related

Global Debt, Equity & Equity-related

Based on volumes:

Global IB fees1

Based on fees:

League table results

IB League Tables

22

#1 in Global Loan Syndications

#2 in Global M&A Announced

#4 in Global Equity & Equity-related

#1 in Global Long-term Debt

#1 in Global Debt, Equity & Equity-related

#1 in Global IB fees

For YTD Sept. 2012, JPM ranked:

62

APPENDIX

The ratio of the allowance for loan losses to end-of-period loans excludes the following: loans accounted for at fair value and loans held-for-sale; purchased credit-impaired (PCI) loans;
and the allowance for loan losses related to PCI loans. Additionally, Real Estate Portfolios net charge-off rates exclude the impact of PCI loans. The allowance for loan losses related to
the PCI portfolio totaled $5.7 billion, $5.7 billion and $4.9 billion at September 30, 2012, June 30, 2012, and September 30, 2011, respectively.

Tangible common equity (TCE) represents common stockholders equity (i.e., total stockholders equity less preferred stock) less goodwill and identifiable intangible assets (other than
MSRs), net of related deferred tax liabilities. Return on tangible common equity measures the Firms earnings as a percentage of TCE. In managements view, these measures are
meaningful to the Firm, as well as analysts and investors, in assessing the Firms use of equity, and in facilitating comparisons with peers.

The Basel I Tier 1 common ratio is Tier 1 common capital divided by Basel I risk-weighted assets. Tier 1 common capital is defined as Tier 1 capital less elements of Tier 1 capital not in
the form of common equity, such as perpetual preferred stock, noncontrolling interests in subsidiaries, and trust preferred capital debt securities. Tier 1 common capital, a non-GAAP
financial measure, is used by banking regulators, investors and analysts to assess and compare the quality and composition of the Firms capital with the capital of other financial services
companies. The Firm uses Tier 1 common capital along with other capital measures to assess and monitor its capital position. On December 16, 2010, the Basel Committee issued its
final version of the Basel Capital Accord, commonly referred to as Basel III. In June 2012, the U.S. federal banking agencies published final rules on Basel 2.5 that will go into effect on
January 1, 2013 and result in additional capital requirements for trading positions and securitizations. Also, in June 2012, the U.S. federal banking agencies published for comment a
Notice of Proposed Rulemaking (the NPR) for implementing Basel III, in the United States. The Firms estimate of its Tier 1 common ratio under Basel III is a non-GAAP financial
measure and reflects the Firms current understanding of the Basel III rules and the application of such rules to its businesses as currently conducted based on information currently
published by the Basel Committee and U.S. federal banking agencies, and therefore excludes the impact of any changes the Firm may make in the future to its businesses as a result of
implementing the Basel III rules. The Firms estimates of its Basel III Tier 1 common ratio will evolve over time as the Firms businesses change, and as a result of further rule-making on
Basel III implementation from U.S. federal banking agencies. Management considers this estimate as a key measure to assess the Firms capital position in conjunction with its capital
ratios under Basel I requirements, in order to enable management, investors and analysts to compare the Firms capital under the Basel III capital standards with similar estimates
provided by other financial services companies.

In Card Services & Auto, supplemental information is provided for Card Services, to provide more meaningful measures that enable comparability with prior periods. The change in net
income is presented excluding the change in the allowance, which assumes a tax rate of 38%. The net charge-off rate and 30+ day delinquency rate presented include loans held-for-sale.

In the Investment Bank, the following metrics are provided excluding the impact of debit valuation adjustments (DVA): net revenue, net income, compensation ratio and return on equity.
These measures are used by management, investors and analysts to assess the underlying performance of the business.

2.

3.

4.

5.

6.

Treasury & Securities Services firmwide metrics include certain TSS product revenue and liability balances reported in other lines of business related to customers who are also
customers of those other lines of business. In order to capture the firmwide impact of TSS products and revenue, management reviews firmwide metrics such as liability balances,
revenue and overhead ratios in assessing financial performance for TSS. Firmwide metrics are necessary, in managements view, in order to understand the aggregate TSS business.

Pretax margin represents income before income tax expense divided by total net revenue, which is, in managements view, a comprehensive measure of pretax performance derived by
measuring earnings after all costs are taken into consideration. It is, therefore, another basis that management uses to evaluate the performance of TSS and AM against the performance
of their respective peers.

Credit card sales volume is presented excluding Commercial Card. Rankings and comparison of general purpose credit card sales volume are based on disclosures by peers and internal
estimates. Rankings are as of 2Q12.

The amount of credit provided to clients represents new and renewed credit, including loans and commitments. The amount of credit provided to small businesses reflects loans and
increased lines of credit provided by Consumer & Business Banking, Card Services & Auto and Commercial Banking. The amount of credit provided to not-for-profit and government
entities, including states, municipalities, hospitals and universities, represents that provided by the Investment Bank.

8.

9.

10.

11.

23

Headcount-related expense includes salary and benefits (excluding performance-based incentives), and other noncompensation costs related to employees.

7.

Additional notes on financial measures

In addition to analyzing the Firms results on a reported basis, management reviews the Firms results and the results of the lines of business on a managed basis, which is a non-GAAP
financial measure. The Firms definition of managed basis starts with the reported U.S. GAAP results and includes certain reclassifications to present total net revenue for the Firm (and
each of the business segments) on a fully taxable-equivalent (FTE) basis. Accordingly, revenue from tax-exempt securities and investments that receive tax credits is presented in the
managed results on a basis comparable to taxable securities and investments. This non-GAAP financial measure allows management to assess the comparability of revenue arising from
both taxable and tax-exempt sources. The corresponding income tax impact related to tax-exempt items is recorded within income tax expense. These adjustments have no impact on net
income as reported by the Firm as a whole or by the lines of business.

1.

Notes on non-GAAP financial measures

Notes

63

APPENDIX

24

This presentation contains forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995. These statements are based on the current beliefs and expectations
of JPMorgan Chase & Co.s management and are subject to significant risks and uncertainties.
Actual results may differ from those set forth in the forward-looking statements. Factors that could
cause JPMorgan Chase and Co.s actual results to differ materially from those described in the
forward-looking statements can be found in JPMorgan Chase & Co.s Annual Report on Form 10-K
for the year ended December 31, 2011, Quarterly Report on Form 10-Q/A for the quarter ended
March 31, 2012, and Quarterly Report on Form 10-Q for the quarter ended June 30, 2012, which
have been filed with the Securities and Exchange Commission and are available on JPMorgan
Chases website (http://investor.shareholder.com/jpmorganchase) and on the Securities and
Exchange Commission's website (www.sec.gov). JPMorgan Chase & Co. does not undertake to
update the forward-looking statements to reflect the impact of circumstances or events that may
arise after the date of the forward-looking statements.

Forward-looking statements

64

DE A R F E L L OW SHAREHOLDERS:

The global nancial crisis has had a profound and lasting impact on Morgan Stanley and
every institution in our industry. Governments, seeking to restore economic equilibrium and
reduce systemic risk, have raised capital standards and redrawn the regulatory boundaries
determining what business activities are allowed and how they are to be conducted. At the
same time, our society-at-large has an undiminished need for the core services we provide:
the formation, distribution and management of capital.
Morgan Stanley anticipated many of the changes affecting nancial services rms, seizing
the strategic imperative to fundamentally change our business model. Forging the
Morgan Stanley Smith Barney joint venture in 2009 was key to transforming our revenue
prole. We also reduced risks in our institutional businesses by exiting proprietary
trading and refocusing on the needs of clients. In addition, we meaningfully strengthened
capital and liquidity. Today, the groundwork is in place for us to deliver stronger, more
sustainable returns.
For the full year, Morgan Stanley reported net revenues of $32.4 billion and earnings from
continuing operations applicable to shareholders of $4.2 billion, or $1.26 per diluted share.
These results fell short of expectations, reecting muted market activity and the negative
impacts associated with two signicant actions to further strengthen our nancial foundation.
Nevertheless, Morgan Stanley ended 2011 in a much better position than where we started
with the Firms common equity and liquidity at the highest levels of our history. We also
made signicant progress toward our business objectives.

65

Against the backdrop of the European sovereign debt crisis and scal policy gridlock in
the U.S., the Firm outperformed peers in our core businesses, gaining market share across
Institutional Securities and attracting signicant client asset ows into Global Wealth
Management and Asset Management. We also remain focused on expense management
across the Firm, with the Ofce of Reengineering on track to realize $1.4 billion in annual
run rate cost savings by 2014.
The investments we have made in our people and building out our businesses are yielding
results. I am grateful to the men and women of Morgan Stanley for their dedication and
continued commitment to serving clients. Clients tell me they are eager to hear from us
and our relationships have never been more productive as our talented professionals helped
navigate a volatile environment. I am condent that our strategy, less burdened by legacy
issues, will deliver for both clients and shareholders.
Institutional Securities: Refocused on Clients and Building on Strength
We have remade our institutional businesses to reduce risk and reemphasize clients,
investing to enhance our leadership positions in Investment Banking, build out our client
ow businesses in Sales and Trading and restore the prominence of our Research group.
Investment Banking is now unambiguously #1 or #2 in M&A and Equity Underwriting.
In 2011, the Firm ranked #1 in completed M&A, advising on eight of the top 10
transactions. We continue to be the underwriter of choice for equity offerings and initial
public offerings and led the largest U.S. equity offering and largest global IPO of the year.
Additionally, we raised critical strategic debt capital for corporates and nancial institutions
and established a leading market position in acquisition nance.
Equity sales and trading surged, driven by market share gains in cash, nancing and
derivatives across all regions, while our largest global peers experienced relatively at or
declining revenues. Investment in Morgan Stanley Electronic Trading (MSET) also
contributed to positive results. Excluding the positive impact of changes in Morgan Stanleys
debt-related credit spreads (DVA) and the MBIA settlement loss, Fixed Income sales
and trading delivered among the best revenue performances relative to peers while
transitioning to more stable ow businesses in rates and currencies.

2
66

We see opportunities to expand wallet share with existing clients in addition to serving
smaller companies. Investment in our global network is providing cross-border opportunities
serving multinational corporations doing business in emerging markets. For example,
in June we announced the launch of our China securities joint venture, Morgan Stanley
Huaxin Securities Company Limited. In addition, in November we reached an agreement
subject to regulatory approval to launch an equities business in Indonesia, a country we
see as a strategic priority as Southeast Asias largest economy with one of the regions most
dynamic nancial markets.
Wealth Management and Asset Management: Scale and Synergies
Creating a leading wealth management platform through Morgan Stanley Smith Barney
provides a stable source of revenues with low capital intensity that balances our Institutional
Securities franchise. Importantly, we are able to leverage best-in-class origination with
unrivaled distribution power to provide a wide range of opportunities to clients.
Global Wealth Management saw global fee-based asset ows of $43 billion in 2011 the
highest since the inception of Morgan Stanley Smith Barney and is a clear industry leader
with nearly $500 billion in fee-based assets. We have set goals of doubling fee-based assets
to $1 trillion in ve years and building out our private banking platform to meet client
lending needs, both of which also provide stable and growing revenues.
We improved margin for the year, albeit modestly, to 10 percent from 9 percent, as the nal
groundwork was laid for full integration in 2012 of the technology and operations platform.
The integration of all 17,000 U.S. nancial advisors onto a single operating platform is
an important step in our plan to ensure all clients are offered our full range of capabilities,
while also improving margins by increasing productivity and reducing costs.
We have restructured Morgan Stanley Investment Management to focus on our core
institutional client franchise, exit peripheral businesses and reorient our merchant banking
activities toward clients and away from proprietary positions. We also have invested in
growth platforms and recruitment of outstanding talent to drive investment performance,
net ows and growth in assets under management. Solid performance provides the
opportunity to raise new funds.
3
67

After several years of outows, Asset Management delivered positive ows of $26 billion
in 2011. Flows ended the year with strong momentum in alternatives and liquidity funds.
Seventy-ve percent of our Long-Only strategies outperformed their benchmarks on a
3-, 5- and 10-year basis.
Continuing to Strengthen Our Sound Financial Foundation
Underpinning our focus on serving clients are the many strategic steps we have taken to
further strengthen our capital levels, enhance liquidity and resolve legacy issues. Our capital
is solid, with a Tier 1 common ratio of 13.0 percent under Basel I among the highest in
the industry. We have also increased the size of our global liquidity reserve to $182 billion
at year-end. Although the safety and stability that comes with this incremental capital and
liquidity reduces return on equity in the near term, the net result is additional capacity to
deliver for clients in all environments.
In 2011, we negotiated two signicant transactions that further strengthened our balance
sheet. I am particularly pleased with the conversion by Mitsubishi UFJ Financial Group,
Inc. (MUFG) of its preferred investment, which meaningfully increased our common
equity capital by $8 billion. Our unique strategic alliance has been highly underappreciated
in the marketplace, in my view.
The interests of our two companies are now more closely aligned with MUFG having
Board representation and sharing in our earnings through equity accounting. These provide
further incentives to enhance our relationship over the decades to come, demonstrated
already by establishing our securities joint venture and integrated investment banking
operations in Japan as well as a loan marketing joint venture in the Americas. Our joint
initiatives to deepen client relationships and leverage our balance sheets to deliver nancial
solutions are proving benecial. For example, if combined, MUFG and Morgan Stanley
would constitute one of the largest lenders to major U.S. corporations with total loan
commitments of more than $210 billion in 2011. We also collaborate through regional
business referral agreements and continue to develop additional mutually attractive
opportunities with global scope.

4
68

We also eliminated our largest remaining legacy exposure through a comprehensive

settlement with MBIA. This settlement meaningfully reduced risk-weighted assets and
released the equivalent of approximately $5 billion of capital under the proposed
Basel III framework.
The steps we have taken successfully position the Firm to achieve the required Basel III
capital levels well in advance of implementation. While these actions reduced returns in
2011, we have eliminated an annual earnings drag of nearly $800 million in preferred
dividend payments to MUFG as well as the volatile hedging risks associated with MBIA.
A more durable funding base and lower risk prole also give us greater exibility to
deploy capital as we pursue our client strategy.
Constructively Engaging on Regulation and Reform
We are actively engaged with regulators around the world to achieve reforms that increase
certainty in the markets and restore trust to our industry. Consistent with the main intent
of the Volcker Rule enacted in the Dodd Frank legislation, we have signicantly reduced
the capital we invest within our Merchant Bank while exiting proprietary trading.
In the nal drafting of regulations, care must be taken not to inhibit the ability of nancial
intermediaries to provide global liquidity by putting capital at risk as market makers.
Governments around the world already have raised an alarm about any actions that would
impair a global, liquid market for sovereign debt. Among other risks are rules that would
make U.S. markets uncompetitive, shift activity to the unregulated shadow banking system
or disrupt the ability of issuers to raise capital. Such unintended consequences were surely
not the legislative intent of Congress.
On the question of compensation, we are determined to balance adequate returns for
shareholders with practices that encourage responsible behavior while appropriately
rewarding talented, hardworking professionals in a market where competition for the
best talent remains intense.

5
69

Confident in Our Future

I am cautiously optimistic about 2012, as our prospects today look better than they have at
any point in the last two years. Our to-do list no longer looks backward to x problems; it
looks ahead to capitalize on opportunities while continued economic challenges cause some
peers to withdraw from businesses where we are leaders.
Some 75 years ago, Morgan Stanley was created in the aftermath of an earlier economic
upheaval, when the nancial industry was also being remade by regulation. Its founding
partners had a single objective: to help new industries made possible by modern advances
in science and technology come into being. Through access to capital in the public markets,
these industries could create employment and contribute to economic growth. Investors,
in turn, could share in that prosperity.
The new Morgan Stanley is increasingly looking like the old Morgan Stanley in how we value
collaboration to deliver all our resources to the client. Our dedication to helping clients
realize their vision in a changing world was behind our success then, as it will be tomorrow.
We look forward to demonstrating our ability to create value for clients and shareholders
this year and across the cycle.

J A M E S P. G O R M A N
CHAIRMAN AND CHIEF EXECUTIVE OFFICER
APRIL 5, 2012

6
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 2012 Morgan Stanley

71

72

The Economics
of the Private
Equity Market
Stephen D. Prowse
Senior Economist and Policy Advisor
Federal Reserve Bank of Dallas

ibis article examines

the economic foundations
of the private equity market
and describes its
institutional structure.

The private equity market is an important

source of funds for start-ups, private middlemarket companies, firms in financial distress,
and public firms seeking buyout financing1.
Over the past fifteen years, it has been the
fastest growing market for corporate finance, far
surpassing others such as the public equity and
bond markets and the market for private placement debt. Today the private equity market is
roughly one-quarter the size of both the market
for commercial and industrial bank loans and
the market for commercial paper in terms of
outstandings (Figure 1). In recent years, private
equity capital raised by partnerships has
matched, and sometimes exceeded, funds raised
through initial public offerings and gross
issuance of public high-yield corporate bonds.
Probably the most celebrated aspect of the private equity market is the investment in small,
often high-tech, start-up firms. These investments often fuel explosive growth in such firms.
For example, Microsoft, Dell Computer, and
Genentech all received private equity backing
in their early stages. In addition, the private
equity market supplied equity funds in the huge
leveraged buyouts of such large public companies as Safeway, RJR Nabisco, and Beatrice in
the 1980s.
Despite its dramatic growth and increased
significance for corporate finance, the private
equity market has received little attention in the
financial press or the academic literature.2 The
lack of attention is due partly to the nature of
the instrument itself. A private equity security is
exempt from registration with the Securities and
Exchange Commission by virtue of its being
issued in transactions "not involving any public
offering." Thus, information about private transactions is often limited, and analyzing developments in this market is difficult.
This article examines the economic foundations of the private equity market and
describes its institutional structure. First, I briefly
discuss the growth of the limited partnership
as the major intermediary in the private equity
market over the last fifteen years. Next, I
explain the overall structure of the market,
focusing in turn on the major investors, intermediaries, and issuers. I men look at returns
to private equity over the last fifteen years.
Finally, I analyze the role of limited partnerships and why they are a particularly effective
form of intermediary in the private equity market. This entails a detailed examination of the
contracts these partnerships write with their
investors and the companies in which the partnerships invest.

73

THE GROWTH OFLIMITEDPARTNERSHIPS

IN THE PRIVATE EQUITY MARKET
The private equity market consists of professionally managed equity investments in the
unregistered securities of private and public companies.5 Professional management is provided
by specialized intermediaries called limited partnerships, which raise money from institutional
investors and invest it in both publicly and privately held corporations. Private equity managers acquire large ownership stakes and take
an active role in monitoring and advising companies in which they invest. They often exercise
as much or more control than company insiders.
The growth of private equity is a classic
example of how organizational innovation,
aided by regulatory and tax changes, can ignite
activity in a particular market. In this case, the
innovation was the widespread adoption of the
limited partnership as the means of organizing
private equity investments. Until the late 1970s,
private equity investments were undertaken
mainly by wealthy families, industrial corporations, and financial institutions investing directly
in issuing firms. By contrast, most investment
since 1980 has been undertaken by intermediaries on behalf of institutional investors. The
major intermediary is the limited partnership;
institutional investors are the limited partners,
and professional investment managers are the
general partners.
The emergence of the limited partnership
as the dominant form of intermediary is a result
of the extreme information asymmetries and
incentive problems that arise in the private

equity market. The specific advantages of limited partnerships are rooted in the way in which
they address these problems. The general partners specialize in finding, structuring, and managing equity investments in closely held private
companies. Limited partnerships are among the
largest and most active shareholders with significant means of both formal and informal control
and thus can direct companies to serve the
interests of their shareholders. At the same time,
limited partnerships employ organizational and
contractual mechanisms that align the interests
of the general and limited partners.
Limited partnership growth was also fostered by regulatory changes in the late 1970s
that permitted greater private equity investment

74

by pension funds. The results of these changes

are telling: from 1980 to 1995, the amount of
capital under management in the organized private equity market increased from roughly S4.7
billion to over $175 billion. In addition, limited
partnerships went from managing less than 50
percent of private equity investments to managing more than 80 percent (Figure 2).- Most of
the remaining private equity stock is held
directly by investors, but even much of this
direct investment activity is the result of knowledge that these investors have gained investing
in and alongside limited partnerships.
THE STRUCTURE OF THE ORGANIZED
PRIVATE EQUITY MARKET

The organized private equity market has

three major players and an assortment of minor
ones. Figure 3 illustrates how these players
interact with each other. The left-hand column

lists the major investors, the middle column lists

major intermediaries, and the right-hand column lists the major issuers in the private equity
market. Arrows pointing from left to right indicate the flow of dollars and other services;
arrows pointing from right to left indicate the
flow of private equity securities or other claims.
The bottom of Figure 3 lists an assortment of
agents and investment advisors that help issuers
or intermediaries raise money or advise investors on the best intermediaries in which to
invest. The role of each of these players in the
private equity market is discussed below.
Investors
Figure 4 illustrates the total estimated private equity outstanding at year-end 1996 and
the portions held by the various investor
groups. Public and corporate pension funds are
the largest groups, together holding roughly 40
percent of capital outstanding and currently

75

supplying close to 50 percent of all new funds

raised by partnerships. Public pension funds
are the fastest growing investor group and recently overtook private pension funds in terms
of the amount of total private equity held. Endowments and foundations, bank holding companies, and wealthy families and individuals each
hold about 10 percent of total private equity.
Insurance companies, investment banks, and
nonfinancial corporations are the remaining
major investor groups. Over the 1980s the
investor base within each investor group broadened dramatically, but still only a minority of
institutions within each group (primarily the
larger institutions) hold private equity.
Most institutional investors invest in private equity for strictly financial reasons, specifically because they expect the risk-adjusted
returns on private equity to be higher than
those on other investments and because of the
potential benefits of diversification.6 Bank holding companies, investment banks, and nonfinancial corporations may also invest in the
private equity market to take advantage of
economies of scope between private equity
investing and their other activities. Commercial
banks, for example, are large lenders to small
and medium-sized firms. As such, they have
contact with many potential candidates for private equity. Conversely, by investing in a private equity partnership, banks may be able to
generate lending opportunities to the firms in
which the partnership invests. Nonfinancial

firms typically invest in early-stage developmental ventures that may fit with their competitive and strategic objectives.
Intermediaries
Intermediariesmainly limited partnershipsmanage an estimated 80 percent of private equity investments. Under the partnership
arrangement, institutional investors are the limited partners and a team of professional private
equity managers serves as the general partners.
Most often the general partners are associated
with a partnership management firm (such as
the venture capital firm Kleiner Perkins Caufield
& Byers or the buyout group Kohlberg Kravis
Roberts & Co.). Some management companies
are affiliates of a financial institution (an insurance company, bank holding company, or investment bank); the affiliated companies generally
are structured and managed no differently man
independent partnership management companies.
Investment companies not organized as
limited partnershipsSmall Business Investment Companies (SBICs), publicly traded
investment companies, and other companies
today play only a marginal role as intermediaries in the private equity market.7 SBICs,
established in 1958 to encourage investment in
private equity, can leverage their private capital
with loans from, or guaranteed by, the Small
Business Administration." In the 1970s they
accounted for as much as one-third of private
equity investment, but today they account for

Figure 4

Investors in the Private Equity Market, by Holdings of Outstandings at Year-End 1996

Billions of dollars

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76

less than $1 billion of the $176.5 billion market.

The reduced role of SBICs has resulted in part
from their inability to make long-term equity
investments when they themselves are financed
with debt. Publicly traded investment companies also played a role in the past, but today
fewer than a dozen such companies are active,
and together they manage less than $300 million. Apparently the long-term nature of private
equity investing is not compatible with the
short-term investment horizons of stock analysts
and public investors.'
The dramatic growth of the limited partnership as the major intermediary in the private
equity market is a result of the limited partnership's success in mitigating the severe information problems that exist in the marketboth for

institutional investors looking for appropriate

partnerships in which to invest and for partnerships looking for appropriate portfolio company investments. The mechanisms the limited
partnerships use to control these problems are
explored in detail in a following section.
Issuers
Issuers in the private equity market vary
widely in size and their motivation for raising
capital, as well as in other ways. They do share
a common trait, however because private equity
is one of the most expensive forms of finance,
issuers generally are firms that cannot raise
financing from the debt or public equity markets.
Table 1 lists six major issuers of private
equity and their main characteristics. Issuers of

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77

traditional venture capital are young firms, most

often those developing innovative technologies
that are predicted to show very high growth
rates in the future. They may be early-stage
companies, those still in the research and development stage or the earliest stages of commercialization, or later stage companies, those
with several years of sales but still trying to
grow rapidly.
Since 1980, nonvenrure private equity
investmentcomprising investments in established public and private companieshas outpaced venture investment, as illustrated in
Figure 5. Nonventure investments include those
in middle-market companies (roughly, those
with annual sales of $25 million to $500 million), which have become increasingly attractive
to private equity investors. Many of these companies are stable, profitable businesses in

low-technology manufacturing, distribution, services, and retail industries. They use the private
equity market to finance expansionthrough
new capital expenditures and acquisitions
and to finance changes in capital structure and
in ownership (the latter increasingly the result
of private business owners reaching retirement
age).
Public companies also are issuers in the
nonvenrure sector of the private equity market.
Such companies often issue a combination of
debt and private equity to finance their management or leveraged buyout. Indeed, between
the mid- and late 1980s such transactions
absorbed most new nonventure private equity
capital. Public companies also issue private
equity to help them through periods of financial
distress, to avoid registration costs and public
disclosures, and to raise funds during periods
when their industry is out of favor with public
market investors.
Agents and Advisors

Also important in the private equity market is a group of "information producers" whose
role has increased significantly in recent years.
These are the agents and advisors who place
private equity, raise funds for private equity
partnerships, and evaluate partnerships for
potential investors. They exist because they
reduce the costs associated with the information
problems that arise in private equity investing.
Agents facilitate private companies' searches for
equity capital and limited partnerships' searches
for institutional investors; they also advise on
the structure, timing, and pricing of private
equity issues and assist in negotiations. Advisors
facilitate institutional investors' evaluations of
limited partnerships; they may be particularly
valuable to financial institutions unfamiliar with
the workings of the private equity market.
RETURNS IN THE PRIVATE EQUITY MARKET

A major reason for the explosive "growth

of the private equity market since 1980 has been
the anticipation by institutional investors of
returns substantially higher than can be earned
in alternative markets. Of course, private equity
investments are regarded as considerably more
risky and more illiquid than other assets. For
those institutional investors that can bear such
risk and illiquidity, however, the high expected
returns are a major attraction.
Available data indicate that returns to private equity have at times far exceeded returns
in the public market. Table 2 shows internal

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rates of return on venture and nonventure

private equity partnerships during the period
in which the partnership was formed. These
returns are those experienced by the limited
partners; they are measured net of management
fees and other partnership expenses. Returns
to partnerships that have not yet been liquidated reflect the valuation of a residual component comprising investments whose market
values are unknown but are often reported at
cost. This may bias downward the returns reported for the funds formed from the mid-1980s
onward.
Overall, Table 2 suggests that returns to
private equity have generally been above those
experienced in the public equity market. The
fourth column of Table 2 shows the annual
average returns on a portfolio of public smallcompany stocks over various periods. These
periods are intended to be roughly comparable
with the ones during which the partnerships
listed were earning the bulk of their returns.10
Except for the early 1980s, returns to both venture and nonventure private equity are greater
than returns to public small-company stocks,
sometimes substantially so. Whether this is
enough to compensate investors for the increased risk of such investments is, of course,
another matter. However, as mentioned above,
returns for more recent partnerships may be
biased downward.
Table 2 also suggests that returns have
been higher for nonventure than for venture
partnerships. This pattern may partly explain
the faster growth of the later stage and, particu-

larly, nonventure sectors of the private equity

market over the past fifteen years.
To a certain extent, returns are driven by
capital availability. For venture investments, for
example, returns have been greatest on investments made during periods when relatively
small amounts of capital were available (.Figure
6). Conversely, there is concern, if not a large
amount of evidence, that periods of greater
capital availability depress future returns.
THE ROLE OF LIMITED PARTNERSHIPS IN THE
PRIVATE EQUITY MARKET
Accompanying the rapid growth of the
private equity market in the 1980s was the rise
of professionally managed limited partnerships
as intermediaries, as illustrated in Figure 2. In
certain respects, the success of limited partnerships is paradoxical. Funds invested in such
partnerships are illiquid over the partnership's
life, which in some cases runs more than ten
years. During this period, investors have little
control over the way their funds are managed.
Nevertheless, the increasing dominance of limited partnerships suggests that they benefit both
investors and issuers.
Table 3 provides an overview of the mechanisms that are used to align the interests of
(1) the limited and general partners and (2) the
partnerships and the management of the companies in which they invest. These mechanisms
can be categorized under the broad headings of
performance incentives and direct means of
control.
As shown on the left-hand side of Table 3,
performance incentives that align the interests
of the limited and general partners are twofold.
First, the general partners must establish a favorable track record to raise new partnerships.
Second, they operate under a pay-for-performance scheme in which most of their expected
compensation is a share of the profits earned on

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79

investments. These provisions are the principal

means by which the interests of the general and
limited partners are harmonized. Of secondary
importance are direct control mechanisms such
as partnership agreements and advisory boards
composed of limited partners. Partnership
agreements give limited partners restricted
direct control over the general partners' activities. These agreements consist mainly of restrictions on allowable investments and other
partnership covenants, which the advisory
board can waive by majority vote.
In contrast, the direct means of oversight
and control are the principal mechanisms for
aligning the interests of the partnership and
portfolio company management. The most
important of these mechanisms are a partnership's voting rights, its seats on the company
board, and its ability to control companies'
access to additional capital. Performance
incentives for company management, including managerial ownership of stock, are also
important but are secondary to direct partnership control.
Information Problems in Private Equity Investing
Two types of problems frequently occur
when outsiders finance a firm's investment
activitysorting problems and incentive problems. Sorting (or adverse selection) problems
arise in the course of selecting investments.
Firm owners and managers typically know
much more about the condition of their business than do outsiders, and it is in their interest
to accent the positive while downplaying potential difficulties (see Leland and Pyle 1977; Ross
1977). Incentive (or moral hazard) problems
arise in the course of the firm's operations.
Managers have many opportunities to take
actions that benefit themselves at the expense of
outside investors.
Private equity is used in financing situations in which the sorting and incentive problems are especially severe." Resolving these
problems requires that investors engage in intensive preinvestment due diligence and postinvestment monitoring. These activities are not
efficiently performed by large numbers of investors; there can either be too much of both
types of activities because investors duplicate
each others' work, or too little of each owing
to the tendency for investors to free ride on the
efforts of others. Thus, delegating these activities to a single intermediary is potentially efficient.
The efficiency of intermediation depends
on how effectively the sorting and incentive
problems between the ultimate investors and

intermediaries can be resolved.12 In the private

equity market, reputation plays a key role in
addressing these problems because the market
consists of a few actors that repeatedly interact
with each other. For example, partnership managers that fail to establish a favorable track
record may subsequently be unable to raise
funds or participate in investment syndicates
with other partnerships.13
Overview of Private Equity Partnerships
Private equity partnerships are limited
partnerships in which the senior managers of a
partnership management firm serve as the general partners and institutional investors are the
limited partners. The general partners are
responsible for managing the partnership's
investments and contributing a very small proportion of the partnership's capital (most often,
1 percent); the limited partners provide the balance and bulk of the investment funds.
Each partnership has a contractually fixed
lifetimegenerally ten yearswith provisions
to extend the partnership, usually in one- or
two-year increments, up to a maximum of four
years. During the first three to five years, the
partnership's capital is invested. Thereafter, the
investments are managed and gradually liquidated. As the investments are liquidated, distributions are made to the limited partners in the
form of cash or securities. The partnership managers typically raise a new partnership fund at
about the time the investment phase for an
existing partnership has been completed. Thus,
the managers are raising new partnership funds
approximately every three to five years and at
any one time may be managing several funds,
each in a different phase of its life. Each partnership is legally separate, however, and is
managed independently of the others.
A partnership typically invests in ten to
fifty portfolio companies (two to fifteen companies a year) during its three- tofive-yearinvest-mentment phase. The number of limited partners is
not fixed: most private equity partnerships have
ten to thirty, though some have as few as one
and others more than fifty.14 The minimum commitment is typically S1 million, but partnerships
that cater to wealthy individuals may have a
lower minimum and larger partnerships may
have a $10 million to $20 million minimum.
Most partnership management firms have
six to twelve senior managers who serve as
general partners, although many new firms
are started by two or three general partners
and a few large firms have twenty or more.
Partnership management firms also employ

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associatesgeneral partners in trainingusually in the ratio of one associate to every one or

two general partners. General partners often
have backgrounds as entrepreneurs and senior
managers in industries in which private equity
partnerships invest and, to a lesser extent, in
investment and commercial banking.

investigation varies with the type of investment.

With distressed companies, efforts are focused
on discussions with the company's lenders; for
buyouts of family-owned businesses, management succession issues will warrant greater
attention; and for highly leveraged acquisitions,
efforts will focus on developing detailed cashflow projections.
Extensive due diligence in the private
equity market is needed because little, if any,
information about issuers is publicly available
and in most cases the partnership has had no
relationship with the issuer. Thus, the partnership must rely heavily on information that it can
produce de novo. Moreover, the management of
the issuing firm typically knows more than outsiders do about many aspects of its business.
This information asymmetry, combined with the
fact that issuing private equity is very expensive,
has the potential to create severe adverse selection problems for investors. In the private equity
market, this problem is mitigated by the extensive amount of due diligence and by the fact
that alternative sources of financing for private
equity issuers are limited.
Information asymmetries between investors and managers of the issuing firm give rise
to a potential moral hazard problem, whereby
management pursues its own interests at the
expense of investors. Private equity partnerships
rely on various mechanisms to align the interests of managers and investors. These mechanisms can be classified into two main
categories. The first category comprises mechanisms that relate to performance incentives,
including the level of managerial stock ownership, the type of private equity issued to
investors, and the terms of management
employment contracts. The second comprises
mechanisms that relate to direct means of control of the firm, including board representation,
allocation of voting rights, and control of access
to additional financing. These mechanisms are
examined in turn.

RELATIONSHIP BETWEEN A PARTNERSHIP

AND ITS PORTFOLIO COMPANIES

Partnership managers receive hundreds of

investment proposals each year. Of these proposals, only about 1 percent are chosen for
investment. The partnership managers' success
depends upon their ability to select these proposals efficiently. Efficient selection is properly
regarded as more art than science and depends
on the acumen of the general partners acquired
through experience operating businesses as
well as experience in the private equity field.
Investment proposals are first screened to
eliminate those that are unpromising or that fail
to meet the partnership's investment criteria.
Private equity partnerships typically specialize
by type of investment and by industry and
location of the investment. Specialization reduces the number of investment opportunities
considered and reflects the degree of specialized knowledge required to make successful
investment decisions.
This initial review consumes only a few
hours and results in the rejection of up to 90
percent of the proposals the partnership
receives. In many cases, the remaining proposals are subjected to a second review, which
may take several days. Critical information
included in the investment proposal is verified
and the major assumptions of the business plans
are scrutinized. As many as half the proposals
that survived the initial screening are rejected at
this stage.
Proposals that survive these preliminary
reviews become the subject of a more comprehensive due-diligence process that can last up
to six weeks. It includes visits to the firm; meetings and telephone discussions with key
employees, customers, suppliers, and creditors;
and the retention of outside lawyers, accountants, and industry consultants. For proposals
that involve new ventures, the main concerns
are the quality of the firm's management and
the economic viability of the firm's product or
service (Gladstone 1988). For proposals involving established firms, the general objective is to
gain a thorough understanding of the existing
business, although the precise focus of the

Performance Incentives
Managerial Stock Ownership. Private equity
managers usually insist that the portfolio firm's
senior managers own a significant share of their
company's stock, and stock ownership often
accounts for a large part of managers' total compensation. In venture capital, management
stock ownership varies widely depending upon
the management's financial resources and the
company's financing needs and projected future
value. It also depends upon the number of
rounds of financing, as dilution typically occurs

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with each round. Even in later stage companies,

however, management ownership of 20 percent
is not unusual. For nonventure companies,
managerial share ownership usually ranges
between 10 percent and 20 percent.
A common provision in both venture and
nonventure financing is an equity "earn-out"
{Golder 1983). This arrangement allows management to increase its ownership share (at the
expense of investors) if certain performance
objectives are met.
Type of Private Equity issued to investors.
Convertible preferred stock is the private equity
security most frequently issued to investors. The
major difference between convertible preferred
stock and common stock is that holders of preferred stock are paid before holders of common
stock in the event of liquidation. From the partnership's standpoint, this offers two advantages.
First, it reduces the partnership's investment
risk. Second, and more important, it provides
strong performance incentives to the company's
management because management typically
holds either common stock or warrants to purchase common stock. If the company is only
marginally successful, its common stock will be
worth relatively little. Thus, the use of convertible preferred stock mitigates moral hazard
problems. Subordinated debt with conversion
privileges or warrants is sometimes used as an
alternative way of financing the firm: it confers
the same liquidation preference to investors as
convertible preferred equity and, thus, the same
performance incentives to management.
Management Employment Contracts. In
principle, management's equity position in the
firm could induce excessive risk taking.
However, management compensation can also
be structured to include provisions that penalize
poor performance, thereby offsetting incentives
for risk taking. Such provisions often take the
form of employment contracts that specify
conditions under which management can be
replaced and buyback provisions that allow the
firm to repurchase a manager's shares in the
event that he or she is replaced.
Mechanisms of Direct Control
Although managerial incentives are a very
important means of aligning the interests of
management and investors, a private equity
partnership relies primarily on its ability to exercise control over the firm to protect its interests.
Board Representation. In principle, a firm's
board of directors bears the ultimate responsibility for the management of the firm, including
hiring and firing the CEO, monitoring and eval-

uating the firm's performance, and contributing

significantly to the firm's business and financial
planning process.
General partners can be extremely influential and effective outside directors. As large
stakeholders, they have an incentive to incur the
expense necessary to monitor the firm.
Moreover, they have the resources to be effective monitorsin the form of their own staff
members, information acquired during the duediligence process, and the expertise acquired
while monitoring similar companies.
Private equity partnerships in many cases
dominate the boards of their portfolio companies. Lemer (1994) reports that general partners
hold more than one-third of the seats on the
boards of venture-backed biotechnology firms,
which is more than the share held by management or other outside directors. Even if it is a
minority investor, a private equity partnership
usually has at least one board seat and is able to
participate actively in a company's management.
Allocation of Voting Rights. For early-stage
new ventures, leveraged buyouts, and financially distressed firms, the investment is often
large enough to confer majority ownership. In
other situations, the partnership may obtain
voting control even if it is not a majority shareholder. Even if the partnership lacks voting
control, however, it is generally the largest nonmanagement shareholder. Thus, it has a disproportionate degree of influence on matters that
come to a shareholder vote.
In general, a partnership's voting rights
do not depend on the type of stock issued.
For example, holders of convertible preferred
stock may be allowed to vote their shares on
an "as-convened" basis. Similarly, subordinated
debt can be designed so that investors have
voting rights should a vote take place. The issue
of voting control can also be addressed by
creating separate classes of voting and nonvoting stock.
Control of Access to Additional Financing.
Partnerships can also exercise control by providing a company with continued access to
funds. This is especially the case for new ventures. Venture capital is typically provided to
portfolio companies in several rounds at fairly
well-defined development stages, generally
with the amount provided just enough for the
firm to advance to the next stage of development. Even if diversification provisions in the
partnership agreement prevent the partnership
itself from providing further financing, the general partners have the power, through their
extensive contacts, to bring in other investors.

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Conversely, if the original partnership is unwilling to arrange for additional financing, it is

unlikely chat any other partnership will choose
to do so; the reluctance of the original partnership is a strong signal that the company is a
poor investment.
Nonventure capital is also provided in
stages, though to a lesser extent. For example,
middle-market firms that embark on a strategy
of acquisitions periodically require capital infusions to finance growth; that capital is not provided all at once. Similarly, companies that
undergo leveraged buyouts are forced to service
debt out of free cash flow and subsequently
must justify the need for any new capital
(Palepu 1990).
Other Control Mechanisms. Other mechanisms by which partnerships control and monitor the activities of the companies in which they
invest include covenants that give the partnership the right to inspect the company's facilities,
books, and records and to receive timely financial reports and operating statements. Other
covenants require that the company not sell
stock or securities, merge or sell the company,
or enter into large contracts without the
approval of the partnership.
RELATIONSHIP BETWEEN THE LIMITED PARTNERS
AND THE GENERAL PARTNERS

By investing through a partnership rather

than directly in issuing firms, investors delegate
to the general partners the labor-intensive
responsibilities of selecting, structuring, managing, and eventually liquidating private equity
investments. However, limited partners must be
concerned with how effectively the general
partners safeguard their interests. Among the
more obvious ways in which general partners
can further their own interests at the expense of
the limited partners are spending too little effort
monitoring and advising portfolio firms, charging excessive management fees, taking undue
investment risks, and reserving the most attractive investment opportunities for themselves.
Private equity partnerships address these
problems in two basic ways: by using mechanisms that relate to performance incentives and
mechanisms that relate to direct means of control. Performance incentives are the more
important means of aligning general partners'
interests with those of the limited partners.
These incentives involve the general partners'
need to protect their reputations and the terms
of the general partners' compensation structure,
such as their share of the profits. These incen-

tives can significantly curtail the general partners' inclination to engage in behavior that does
not maximize value for investors. Direct control
mechanisms in the partnership agreement are
relatively less important means of controlling
the moral hazard problem between general and
limited partners.

Performance Incentives
Reputation. Partnerships have finite lives.
To remain in business, private equity managers
must regularly raise new funds, and fund raising
is less costly for more reputable firms. In fact, to
invest in portfolio companies on a continuous
basis, managers must raise new partnerships
once the funds from the existing partnership
are fully invested, or about once every three to
five years.
Raising partnership funds is time consuming and costly, involving presentations to institutional investors and their advisors that can
take from two months to well over a year,
depending on the general partners' reputation
and experience. A favorable track record is
important because it conveys some information
about ability and suggests that general partners
will take extra care to protect their reputation.
Also, experience itself is regarded as an asset.
To minimize their expenses, partnership managers generally turn first to those who invested
in their previous partnershipsassuming, of
course, that their previous relationships were
satisfactory.
Certain features of a partnership enhance
the ability of the general partners to establish a
reputation. These features essentially make both
the partnership's performance and the managers' activities more transparent to investors
than might be the case for other financial intermediaries. One such feature is segregated
investment pools. By comparing one partnership's investment returns with those of other
partnerships raised at the same time, it is easier
to account for factors that are beyond the control of the general partners, such as the stage of
the business cycle or the condition of the market for initial public offerings, mergers, and
acquisitions. By contrast, if private equity intermediaries did not maintain segregated investment pools, earnings would represent a blend
of investment returns that occur at different
stages of the business cycle or under different
market conditions.
Another feature is the separation of management expenses and investment funds. In a
limited partnership, management fees are specified in the partnership agreement (described

73
83

below). Thus, the amount of investment capital

that can be consumed in the form of manager
salaries and other perquisites is capped. Moreover, because such expenses are transparent, it
is easier to compare expenses across partnerships. Other types of financial intermediaries
pay expenses and finance investments out of
the same funds raised from investors; although
expenses are reported, they are difficult to control before the fact and are not always transparent after the fact.
Compensation Structure. General partners
earn a management fee and a share of a partnership's profits, the latter known as carried
interest. For a partnership that yields average
returns, carried interest may be several times
larger than the management fees (Sahlman
1990). This arrangementproviding limited
compensation for making and managing investments and significant compensation in the form
of profit sharinglies at the heart of the partnership's incentive structure.
Management fees are frequently set at a
fixed percentage of committed capital and
remain at that level over the partnership's life.
Fee percentages range from 1 percent to 3 percent. Carried interest is most often set at 20
percent of the partnership's net return.

Partnership covenants also limit deal fees

(by requiring that deal fees be offset agains
management fees), restrict reinvestment withthe general partners' earlier or later funds, and
restrict the ability of general partners and their
associates to coinvest selectively in the partnership's deals.
Finally, partnership agreements allow limited partners some degree of oversight over the
partnership. Most partnerships have an advisory
board composed of the largest limited partners.
These boards help resolve conflicts involving
deal fees and conflict-of-interest transactions.
They do so by approving exemptions from partnership covenants. Special committees are also
created to help determine the value of the partnership's investments. However, these two
types of bodies do not provide the kind of management oversight that a board of directors can
for a corporation; indeed, their power is limited
by the legal nature of the partnership, which
prohibits limited partners from taking an active
role in management.
CONCLUSION

This article has presented an economic

analysis of the private equity market. In particular, it has detailed how the contracts that
limited partnerships write with investors and
portfolio firms address many of the adverse
selection and moral hazard problems that face
investors considering investments in small and
medium-sized firms.
The private equity market's success in
addressing these problems is evidenced by the
large number of successful firms that received
initial financing in this market. This success has
been much admired in the rest of the industrialized world, particularly in Japan and
Germany. In these countries, private equity markets of the U.S. kind do not exist, primarily due
to the heavily regulated nature of their securities
markets, and so firms rely much more on bank
financing. While such bank-centered systems
may have had advantages in the past, there is
an increasing feeling that such systems may
not adequately provide funds for small and
medium-sized firms that are the engine of future
economic growth and innovation. Both Japan
and Germany have recently taken steps to
deregulate their financial markets. By fostering
the growth of U.S. private equity market practices, these countries hope to solve the informational and governance problems of small firms
looking for capital.

Direct Control Mechanisms

Partnership agreements also protect limited partners' interests through covenants that
place restrictions on a partnership's investments
and on other activities of the general partners.
Restrictions on investments are especially important because a considerable portion of the
general partners' compensation is in the form of
an option-like claim on the fund's assets. This
form of compensation can lead to excessive risk
taking. In particular, it may be in the interest of
the general partners to maximize the partnership's riskand hence the expected value of
their carried interestrather than the partnership's risk-adjusted expected rate of return.
To address the problem of excessive risk
taking, partnership covenants usually set limits
on the percentage of the partnership's capital
that may be invested in a single firm. Covenants
may also preclude investments in publicly
traded and foreign securities, derivatives, other
private equity funds, and private equity investments that deviate significantly from the partnership's primary focus. Finally, covenants
usually restrict the fund's use of debt and in
many cases require that cash from the sale of
portfolio assets be distributed to investors
immediately.

74
84

NOTES
' This article draws selectively from a longer, more
comprehensive research paper on the private equity
market by Fenn, Liang, and Prowse (1997).
7

Some studies have been made of particular market

sectors, such as venture capital and leveraged buyouts (LBOs) of large public companies. On venture
capital, see Sahlman (1990) and special issues of
Financial Management (1994) and The Financier
(1994). For a summary of the LBO literature, see
Jensen (1994).

' An equity investment is any form of security that has an

equity participation feature. The most common forms are
common stock, convertible preferred stock, and subordinated debt with conversion privileges or warrants.
' The emergence of limited partnerships is actually
more dramatic than these figures indicate. As recently
as 1977, limited partnerships managed less than 20
percent of the private equity stock.
5
These and other figures in this section are my estimates based on information from a variety of sources.
See Fenn, Liang, and Prowse (1997) for details on how
these estimates are constructed.
6
Private equity is often included in a portfolio of "alternative assets" that also includes distressed debt.
emerging market stocks, real estate, oil and gas,
timber and farmland, and economically targeted
investments.
' Two other types of private equity organisations are
SBICs owned by bank holding companies and venture
capital subsidiaries of nonfinancial corporations. Both
types were extremely important in the 1960s, and they
still manage significant amounts of private equity. However. these organizations invest only their corporate
parent's capital. In this sense, neither is really an intermediary but rather a conduit for direct investments.
I treat the investments by these organizations as direct
investments, not as investments by intermediaries.
8
9

10

See the Venture Capital Journal, October 1983.

This, of course, raises the question of why private
equity investments haven't proven to be ideal for
closed-end mutual funds, wherein the fund invests
money for the long term but investors can get out in
the short term.
For example, partnerships in the first row were formed
between the years 1969 and 1979. These funds would
have invested and earned returns on their capital
between the years 1969 and 1988. The first row/fourth
column thus shows the annual average return to public
small companies over this 20-year period. Returns tor
small-company stocks for the other periods are similarly calculated. Returns for small-company stocks are
after transactions costs (Ibbotson 1997).

" In venture investing, for example, the firm is often a

start-up with no track record. In a leveraged buyout,
while there may be ample information about the firm,

management may have little or no incentive to act in

equityholders' best interests.
17
If. for example, investors must investigate the intermediary to the same extent that they would investigate
the investments that the intermediary makes on their
behalf, using one may be less efficient (Diamond 1984).
13

Intermediaries are also important because selecting,

structuring, and managing private equity investments
-require considerable expertise. Gaining such expet Use requires a critical mass of investment activity that
most institutional investors cannot attain on their own.
Managers of private equity intermediaries are able to
acquire such expertise through exposure to and
participation in a large number of investment opportunities. Although institutional investors could also

- specialize in this way, they would lose the benefits of

diversification. Finally, intermediaries play an important
role in furnishing business expertise to the firms in
which they invest. Reputation, learning, and specialization all enhance an intermediary's ability to provide
these services. For example, a reputation for investing
in well-managed firms is valuable in obtaining the services of underwriters. Likewise, specialization allows
an intermediary to more effectively assist its portfolio
companies in hiring personnel, dealing with suppliers.
and helping in other operations-related matters.
14
Many partnerships that have a single limited partner
have been initiated and organized by the limited partner rather than by the general partner. Such limited
partners are in many cases nonfinancial corporations
that want to invest for strategic as well as financial
reasonsfor example, a corporation that wants exposure to emerging technologies in its field.

REFERENCES
Diamond. Douglas W. (1984). "Financial Intermediation
and Delegated Monitoring," Review of Economic Studies
51 (July): 393-414.
Fenn, George, Nellie Liang, and Stephen D. Prowse
(1997), "The Private Equity Market: An Overview." Financial Markets. Institutions and Instruments 6 (4): 1-105.
Financial Management 23 (1994). May.
The Financier 1 (1994), Autumn.
Gladstone. David (1988). Venture Capital Handbook
(Englewood Cliffs. N.J.: Prentice Hall).
Golder. Stanley (1983), "Structuring and Pricing the
Financing," in Guide to Venture Capital, ed. Stanley Pratt
(Wellesley, Mass.: Capital Publishing Corp.).
Ibbotson, Roger (1997), Stocks, Bonds, Bills, and
Inflation 1997 Yearbook (Chicago: Ibbotson Associates).

75
85

Jensen. Michael C. (1994). "The Modern Industrial Revolution. Exit, and the Failure of Internal Control Systems,"
Journal of Applied Corporate Finance 6 (Winter): 4-23.

Ross. Stephen A. (1977), The Determination of Financial

Structure: The Incentive-Signalling Approach." Be//
Journal of Economics 8 (Spring): 23-40.

Leland, Hayne, and David Pyle (1977). "Information

Asymmetries, Financial Structure and Financial
Intermediation." Journal of Finance 32 (May): 371-87.

Sahlman, William A. (1990). "The Structure and Governance of Venture Capital Organizations," Journal of
Financial Economics 27 (Spring): 473-521.

Lerner, Joshua (1994), "Venture Capitalists and the

Oversight of Private Firms' (unpublished working paper,
Harvard University).

Venture Capital Journal (1983). "SBlCs After 25 Years:

Pioneers and Builders of Organized Venture Capital,"
October.

Palepu, Krishna (1990), "Consequences of Leveraged

Buyouts," Journal of Financial Economics 27
(September): 247-62.

76
86

87

CARLYLE GROUP

ere's a typical David

Rubenstein Wednesday. Waking in Philadelphia, he joins with
Chinese businessmen
to attend a Wharton program set up
jointly by the Chinese government and
the Carlyle Group, the massive Washington, D.C.-based private equity firm
he helps run. Then he hops on a Carlyle
investment committee call to discuss
imminent deals. By midday he's back
in the capital, lunching at the White
House with an oldfriend,National Security Advisor Thomas Donilon, before
returning to the office to prepare with
some of his dealmakers for Carlyle's
upcoming investors conference. In the
evening he'll give a speech to the mutual fund industry's lobbying group. And
the rest of the week continues apace,
from talking with an investment group
in Michigan to interviewing prospective hires and dining with Jamie Dimon
in New York. Come Saturday, Rubenstein has a down day. teaching a Princeton class and hosting a dinner featuring an expert on how pandas reproduce
(Rubenstein pledged $4.5 million to the
National Zoo in 2011 to promote panda
procreation).
At 63, Rubenstein uses his plush
Gulfstream G550 250 days a year. He
says he enjoys the busy lifestyle, but behind almost every Rubenstein dinner,
speech and self-effacing comment is
something more: the prospect of a sale.
This is not the kind of thing they teach
at Harvard Business School, though
Rubenstein, the 250th-richest person
in the U.S., with an estimated net worth
of $1.9 billion, believes it ought to be.
"I am on some 30 nonprofit boards,
which I love and to which I give a lot
of money, but the networking is helpful
to myfirm,"Rubenstein explains. "I
can help build thefirmbecause of the
contacts I make."
With $156 billion under management, Carlyle has more private equity
funds, investors and assets than any
otherfirm,including Blackstone Group,
which manages $190 billion but has

large real estate and fund of funds

operations to complement its private
equity group. Carlyle owns 209 companies, more than any other buyout
shop, rangingfromHertz to Mrs. Fields
cookies, and it has distributed $52 billion to its private equity investors since
inception. Rubenstein and his two longtime partners, William Conway Jr. and
Daniel D'Aniello, all rank near the top of
FORBES' inaugural statistical ranking
of the top private equity dealmakers
(seep. 90), which places a big emphasis on profitable investment exits and
fundraisingtwo things Carlyle does as
well as anyone.
"David is the most prolific fundraiser maybe the planet has ever seen
in anyfield,not just private equity
and Bill Conway is one of the greatest
investors I have ever met," says Jimmy
Lee, the JPMorgan Chase banker who
has played a key role in the proliferation of the leveraged-buyout industry.
"Those are the two businesses of private equity: raising money, because if
you don't raise money there is no business, and investing the money wisely,
because if you don't invest wisely, you
can't raise the money."

More fundamentally, in May their firm

conducted an IPO, part of Rubenstein's
plan to extend Carlyle into products
like funds of funds and credit investment managementand create a more
diversified financial institution that
can survive without him, Conway and
D'Aniello.
And as all this has happened, this
firm, which not too long ago was demonized byfilmmakerMichael Moore
and has been the subject of elaborate
conspiracy theories, largely escaped
the controversies currently dogging the
industry as a whole. Firms like KKR
and TPG have reportedly been subpoenaed by New York's attorney general
as part of an investigation into the conversion of private equity management
fees into more lightly taxed carried
interesta practice Carlyle has never
employed. Private equity titans like
Steve Schwarzman and Leon Black still
carry the stigmas of their million-dollar
birthday parties, while the former became an even bigger lightning rod after
he compared efforts to raise taxes on
private equityfirmswith Hitler's invasion of Poland. And, of course, President Obama has bashed the industry

"DAVID IS THE MOST PROLIFIC FUNDRAISER

MAYBE THE PLANET HAS EVER SEEN IN ANY
FIELD, NOT JUST PRIVATE EQUITY."
And while the three Carlyle cofounders have been at the buyout
game together for 25 years, they're not
slowing down. Carlyle has been buying
companies at afrenziedpace, outbidding and frustrating rivals, striking
$16 billion in deals in 2012, more than
any other private equityfirm.With a
string of recent big announcements,
like a $3.3 billion deal for Getty Images
and a $4.9 billion purchase of DuPont's
car paint business, Carlyle is leading
the private equity business in the biggest barrage of dealmaking seen since
before the 2008 economic meltdown.

80 | FORBES OCTOBER 22, 2012

88

in the course of vilifying Bain Capital,

thefirmstarted by his opponent, Mitt
Romney
By contrast, Rubenstein is pretty
sure Barack Obama likes him. It was
Carlyle that worked with the White
House to buy a Philadelphia oil refinery
in September, saving 850 union jobs
and averting a fuel-price increase in
the Northeast. When an earthquake
cracked the Washington Monument
last year, Rubenstein donated $7.5 million to helpfixthe damage. Rubenstein
was thefirstprivate equity executive
to sign the Giving Pledge, promising

to contribute half his wealth to philanthropy. Unlike other publicly traded

firms like Blackstone and Apollo Global
Management, Carlyle's stock sells above
its IPO price.
Because of all this Rubenstein is
both the industry's friendliest faceand
its best defender. He thinks Romney's
big mistake was trying to argue that
his private equity work created jobs,
instead of just focusing on what private
equity was made to do: manufacture
investment returns.
"People generally don't love investors and people who have made great
wealth in every society," says Rubenstein. "In the past no investor ever
asked me how many jobs I created; they
never cared. But they did say, 'Give me
my rate of return.'" Rubenstein adds:
'We have made a lot of money for our
investors, and most of them, not all, are
big public pension funds who seem to
like the returns."
WASHINGTON IS AN IRONIC
town, and there may be nothing there
more deliciously ironic right now than
this: As the White House pummels the
private equity industry, the most successful private equity firm's roots come
from the White House.

Rubenstein, son of a Baltimore

postal clerk, got his law degree at the
University of Chicago and served as
a policy advisor in the Carter White
House. After Reagan's landslide he had
no interest in fading into some advisory-role career. He wanted to be the man
making big decisions. His inspiration:
William Simon, who served as Treasury Secretary under Nixon and Ford
before investing some $330,000 in the
1982 leveraged buyout of a greeting
card company, Gibson Greetings, that
yielded Simon a $66 million payday.
But Rubenstein was not a finance
guy. For six years he puttered in private
practice in Washington before finding two financial minds, Conway and
D'Aniello, to help him. In 1987 they
raised $5 million with the help of Ed
Mathias, a friend of Rubenstein's who
worked at T. Rowe Price. There were
deals involving Alaskan tax writeoffs
and some early investments that
tanked, and the firm barely survived
that year's stock market crash. But
while D'Aniello, an ex-Marriott finance
executive, kept their new investment
firm running smoothly handling administrative tasks, Conway, a former MCI
Communications chief financial officer,
quietly mastered the art of buying com-

panies, incentivizing the managers with

ownership and working to change them
over a period of time before putting
them up for sale. Carlyle's private equity funds have averaged 18% annual net
internal rates of returns since inception,
consistently ranking in the top quartile
of their peer groups. Like virtually all
private equity shops, Carlyle collected
its "1.5-and-20" fees-1.5% of the assets
plus 20% of profitsmaking the three
cofounders billionaires.
Carlyle also amassed a slew of former government heavyweightsand an
accompanying cloak-and-dagger reputation. Given their location, the partners initially focused on defense deals,
a strategy aided by Rubenstein's hiring
of former Secretary of Defense Frank
Carlucci and by an increase in military
spending after the post-Cold War lull,
spurred by the first Gulf war. "The early
success in defense helped us understand
that we had a core skill of dealing with
businesses that are heavily impacted by
government policy and regulation such
as transportation, health care, telecommunications, etc.," says D'Aniello.
Rubenstein made sure Conway
had plenty of cash to put to work by
pioneering the idea of raising multiple
funds simultaneously. And to impress
all those potential investors he supplemented Carlucci with a former Secretary of the Treasury and State (James
Baker), a former British prime minister (John Major) and then a former
U.S. President (George HW. Bush). "If
I invited you to a dinner 15 years ago
to hear David Rubenstein speak, you
would throw that invitation away," says
Rubenstein. "If I invited you to a dinner with Jim Baker or John Major, you
would go."
All of this took place from the ultimate Washington power location, an
office on Pennsylvania Avenue between
the White House and the U.S. Capitol.
If you have seen the movie Broadcast
News, you've seen Carlyle's relatively
modest second-floor offices, which
Rubenstein leased after the movie
was shot there. He refuses to leave the
OCTOBER 22, 2012 FORBES | 81

89

PRIVATE

EQUITY

CARLYLE GROUP

space, calling it lucky, even though to

visit some of his partners he has to walk
through a hallway that can be seen from
the building's lobby.
After Sept 11, however, these government ties began to backfire. Private
equity firms were rolling in money,
courtesy of Alan Greenspan's low interest rates and alpha-hungry pension
funds desperate for fat returns that
could help them meet their mounting obligations. But Carlyle's cash pile
seemed tainted, even sinister. Carlyle's
ties to the Bush family at the time of
the second President Bush's military
ramp-up didn't look good. Carlyle
investments from prominent Saudis
notably the Bin Laden familylooked
still worse. Cynthia McKinney, then
a member of Congress, called out
Carlyle and said, "Persons close to this
Administration are poised to make huge
profits off America's new war." The
Economist magazine wrote that "the
secretive Carlyle Group gives capitalism a bad name."
Carlyle ended up asking the Bin
Laden family to take back their money,
and eventually the former government
officials retired. "I made a mistake of
having too many of them, and when
George W. Bush got elected I should
have recognized that we would be seen
as a proxy for that Administration if his
father was still here," says Rubenstein.
"Ultimately, they retired, we depoliticized the image, and now we are the
least political firm even though we are
in Washington."
The credit crisis would prove to be
an even bigger challenge. Conway had
an inkling a crash was coming. "I know
that this liquidity environment cannot
go on forever," Conway wrote in a January 2007 staff memo, which admitted
that cheap debt as opposed to Carlyle's
investment genius had been responsible
for much of the firm's fabulous profits
in the period. "I know that the longer it
lasts, the worse it will be when it ends."
After telling his dealmakers to be "careful," Conway instructed Carlyle-owned
companies to secure and draw on their

credit lines early in 2007, helping Carlyle's private equity portfolio weather
the financial crisis relatively unscathed.
There were some losses, like those
stemming from the bankruptcy filing of
portfolio company Hawaiian Telcom.
The Abu Dhabi sovereign wealth fund
that bought 7.5% of the Carlyle partnership for $1.35 billion saw the value of its
investment plummet. But the biggest
crash for the firm occurred outside the
private equity arena in Carlyle Capital,
a highly leveraged credit fund listed in
Amsterdam that purchased residential
mortgage-backed securities and cratered, causing $900 million in investor
losses. The core business emerged in a
strong position just in time for the most
recent run-up.
RUBENSTEIN CURRENTLY is doing
what he does best: raising yet another
buyout funda $10 billion monster.
He'll surely get it done, though all these
money-raising events also create an inevitable (and, for the partners, enviable)
problem. The more assets a firm has
under management, the harder it gets
to find enough attractive targets to pop
an above-market returnand the more

don't want to sell," says Conway. "They

hang on by their fingernails, waiting
for things to get better, and frankly, it
did, so I do think now is a good time to
invest."
In the last year Conway has found
opportunities snapping up assets
from reeling European banks in need
of capital, signing deals to buy bond
manager TCW from Socit Gnrate
and Spain's Telecable from Liberbank.
He bet on industrial companies, inking a $3.5 billion deal to buy Hamilton
Sundstrand with BC Partners from
United Technologies, which needed
cash to buy an aerospace supplier.
Carlyle outmaneuvered others for this
prize by making a simpler single bid
for Hamilton's three pump-and-compressor units, while most other serious
buyers were interested in acquiring
only a single business line separately.
Conway plans to buy more and has
told investors in the $13.7 billion fund
Carlyle raised in the boom years that
he won't have any trouble putting the
$2 billion still committed to the fund to
work prior to a mid-2013 deadline. Carlyle has also found ways to exit out of
investments like Booz Allen Hamilton,

"WHEN YOU WANT TO BUY LOW, PEOPLE

GENERALLY DON'T WANT TO SELL THEY
HANG ON BY THEIR FINGERNAILS."
pressure there is to chase deals.
Conway remains bullish: He thinks
the U.S. economy endured its worst
stretch of the year between April and
June, and will continue to be reasonably good. Encouraged by relatively
cheap financing, Conway has secured
interest rates of about 6% for his most
recent dealsseemingly high in an environment where good returns are rare,
but Conway finds costs like that attractive. He patiently waited for there to be
good deals coming out of the financial
crisis, and now he has pounced. "When
you want to buy low, people generally

82 | FORBES OCTOBER 22, 2012

90

which in August paid Carlyle a $620

million dividend, meaning Carlyle's
$910 million 2008 investment in the
consulting firm is now worth $2 billion.
Carlyle, across all its asset classes, distributed $18.8 billion to its investors last
year, more than ever before. In the first
six months of this year it distributed
$6.7 billion.
With 1,300 employees and offices
from Barcelona to Beijing, Carlyle has
been using a global approach to try to
offset the challenge of managing larger
funds that has historically bedeviled
money managers. At the center of

dominates. On the issue of carried interestthe application

of lower capital gains taxes on
private equity performance
feesRubenstein presents a
nuanced defense. "It's unfair
to single out any one industry
when it comes to tax reformLet's have a comprehensive
look at everything. I am in
favor of a comprehensive
approach, and everyone will
probably have to pay more,"
says Rubenstein. "Don't spend
all your time changing the
private equity rules, because
you aren't going to pick up any
revenue. Maybe that means
increasing capital gains taxes,
maybe marginal rates. Everything should be on the table."
Ironically one of the tough-

COURTESY: JIMMY CARTER PRESIDENTIAL LIBRARY

that approach is a concept developed by D'Aniello called One Carlyle,

which calls for all Carlyle employees
to collaborate across industries and
geographies.
Conway quickly rattles off examples,
like when he took his U.S.-based health
care investors down to Australia to
analyze a hospital deal. Carlyle's deal
for Moncler, maker of the $1,000 ski
jacket, is another example. It only had
stores close to Milan when Carlyle
invested some $200 million in 2008.
Carlyle helped transform the company
into a global brand by getting its staff
in Asia to work with Moncler to open
dozens of global stores, and by the time
Carlyle sold a big chunk of its Moncler
stake last year for $500 million or so,
half of Moncler's sales were in Asia and
its biggest store was in China. Carlyle
still retains stock in the company recently worth $260 million In another
example Conway flew to Brazil to help
Talaris, a British portfolio company that
makes ATMs and other cash-handling
equipment, become a client of Banco
do Brasil, a Carlyle fund partner. Earlier
this year Carlyle sold Talaris to a Japanese company, making $540 million in
profits in less than four years.

Carlyle's global approach comes together fully in China, which is currently

home to one-sixth of Carlyle's workforce. Carlyle raised its first of three
Asia-focused buyout funds in 1999
and has set up two yuan-denominated
funds with Chinese partners. China
has already produced blockbuster deals
for Carlyle, including its investment
in China Pacific Insurance, one of the
greatest private equity deals ever. In
2005 Carlyle essentially made a $738
million bet that the largely uninsured
Chinese population would buy risk
protection as the economy boomed,
resulting in a $5 billion windfall for its
investors. Conway has become more
concerned about the slowing Chinese
economy and thinks it will be harder
to duplicate this kind of success. These
days he sees more opportunities back
in the U.S.
Not surprisingly, Rubenstein argues
that private equity is also a good thing
for America, pointing out it's a massive
financial industry based in the U.S. He
likes to say he is better received in Beijing these days than in Congress, where
he tells skeptical lawmakers to consider
not doing anything to damage one of
the few global businesses the U.S. still

est recent sales jobs for the master

fundraiser was convincing people
to invest in Carlyle's own IPO, even
though all the money raised was slated
to pay off debt. Part of the problem was
that Carlyle's earnings have historically been lumpy, coming more from
episodic performance fees than steady
management fees. Wall Street prefers
the latter and doesn't like the kind of
results Carlyle posted in its last quarter,
when it reported an economic net loss
of $58 million.
Investors are also suspicious of
private equity shops because these
companies are partnerships whose first
allegiance is to the investors in their
funds, not in their firms. Many stock
investors had already been burned by
the IPOs of Blackstone, Fortress Investment Group and Apollo. Carlyle is out
to prove these stocks can work for investors. To sell the IPO, Carlyle cheaply
priced its shares, or units, even cutting
the final price by half a buck on the
demands of a major investor. Rubenstein couldn't believe it when he heard
that same investor bought $1 billion of
Facebook stock at $38 the same month.
As always, though, Rubenstein got
the deal done. <img/>
OCTOBER 22,2012 FORBES | 83

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October 5, 2 0 0 9

Profits for Buyout Firms as Company Debt Soared

By JULIE CRESWELL

For most of the 133 years since its founding in a small city in Wisconsin, the Simmons Bedding Company
enjoyed an illustrious history.
Presidents have slumbered on its mattresses aboard Air Force One. Dignitaries have slept on them in the
Lincoln Bedroom. Its advertisements have featured Henry Ford and H. G. Wells. Eleanor Roosevelt
extolled the virtues of the Simmons Beautyrest mattress, and the brand was immortalized on Broadway in
Cole Porter's song "Anything Goes."
Its recent history has been notable, too, but for a different reason.
Simmons says it will soon file for bankruptcy protection, as part of an agreement by its current owners to
sell the company the seventh time it has been sold in a little more than two decades all after being
owned for short periods by a parade of different investment groups, known as private equity firms, which
try to buy undervalued companies, mostly with borrowed money.
For many of the company's investors, the sale will be a disaster. Its bondholders alone stand to lose more
than $575 million. The company's downfall has also devastated employees like Noble Rogers, who worked
for 22 years at Simmons, most of that time at a factory outside Atlanta. He is one of 1,000 employees
more than one-quarter of the work force laid off last year.
But T'homas H. Lee Partners of Boston has not only escaped unscathed, it has made a profit. The
investment firm, which bought Simmons in 2003, has pocketed around $77 million in profit, even as the
company's fortunes have declined. THL collected hundreds of millions of dollars from the company in the
form of special dividends. It also paid itself millions more in fees, first for buying the company, then for
helping run it. Last year, the firm even gave itself a small raise.
Wall Street investment banks also cashed in. They collected millions for helping to arrange the takeovers
and for selling the bonds that made those deals possible. All told, the various private equity owners have
made around $750 million in profits from Simmons over the years.
How so many people could make so much money on a company that has been driven into bankruptcy is a
tale of these financial times and an example of a growing phenomenon in corporate America.
Every step along the way, the buyers put Simmons deeper into debt. The financiers borrowed more and
more money to pay ever higher prices for the company, enabling each previous owner to cash out
profitably.

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But the load weighed down an otherwise healthy company. Today, Simmons owes $1.3 billion, compared
with just $164 million in 1991, when it began to become a Wall Street version of "Flip This House."
In many ways, what private equity firms did at Simmons, and scores of other companies like it, mimicked
the subprime mortgage boom. Fueled by easy money, not only from banks but also endowments and
pension funds, buyout kings like THL upended the old order on Wall Street. It was, they said, the Golden
Age of private equity nothing less than a new era of capitalism.
These private investors were able to buy companies like Simmons with borrowed money and put down
relatively little of their own cash. Then, not long after, they often borrowed even more money, using the
company's assets as collateral just like home buyers who took out home equity loans on top of their first
mortgages. For the financiers, the rewards were enormous.
Twice after buying Simmons, THL borrowed more. It used $375 million of that money to pay itself a
dividend, thus recouping all of the cash it put down, and then some.
A result: THL was guaranteed a profit regardless of how Simmons performed. It did not matter that the
company was left owing far more than it was worth, just as many people profited from the mortgage
business while many homeowners found themselves underwater.
Investors who bought that debt are getting virtually nothing in the new deal.
"From my experience, none of the private equity firms were building a brand for the future," said Robert
Hellyer, Simmons's former president, who worked for several of the private equity buyers before being
asked to leave the company in 2005. "Plus, the mind-set was, since the money was practically free, why not
leverage the company to the maximum?"
Just as with the housing market, the good times ended when the economy fell into recession and the credit
markets froze. Simmons is now groaning under a huge amount of debt at a time when its sales are slowing.
And this time there is no escaping by finding yet another buyer willing to shoulder its entire burden.
Simmons is one of hundreds of companies swept up by private equity firms in the early part of this decade,
during the greatest burst of corporate takeovers the world has ever seen. Many of these deals, cut in good
times, left little or no margin for error let alone for the Great Recession.
A disproportionate number of the companies that were acquired during that frenzy are now struggling with
the enormous debts. More than half the roughly 220 companies that have defaulted on their debt in some
form this year were either owned at one time or are still controlled by private equity firms, according to
analysts at Standard & Poor's. Among them are household names like Harrah's Entertainment and Six
Flags, the theme park operator.
Executives at THL counter that Simmons was the victim of hard economic times, not mismanagement or
too much debt. As proof, executives point to Simmons's 40 percent growth in sales and its 26 percent climb
in operating income from 2003 through 2007 as well as its 13 consecutive quarters of market share gains
against competitors through March 2009.
Simmons's woes, said Scott A. Schoen, a co-president of the firm who sat on Simmons's board, are entirely

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caused by the "unprecedented and unforeseeable" downturn that has shaken the entire bedding industry.
"We think the work we had done had positioned the company for us to reap the financial rewards that this
economic cycle has taken away," said Mr. Schoen, gazing across a conference table at THL's headquarters
overlooking Boston Harbor.
Still, he acknowledged, "We are clearly disappointed in the outcome of this investment. Make no bones
about it."
Built Over Generations
Like other emerging industrialists of the 19th century, Zalmon G. Simmons, of Kenosha, Wis., had his hand
in numerous businesses the local bank, a telegraph company, a railroad and a cheese-box factory. He was
even, for a time, the mayor of Kenosha.
Around 1876, Mr. Simmons came across a new machine that could mass-produce woven wire mattresses.
The Simmons bedding company was born.
From its humble beginnings on the banks of Lake Michigan, Simmons grew to become one of the country's
largest manufacturers of mattresses. Along the way, it even sprinkled a little Hollywood pixie dust on the
ho-hum mattress business, hiring Dorothy Lamour and Maureen O'Hara to plug its products.
Until the 1970s, Simmons largely prospered. Then the troubles started, and the company was soon buried
deep inside two enormous conglomerates, Gulf & Western and the Wickes Corporation, for a number of
years.
But in the mid-1980s, Simmons caught the attention of a new type of investor. The businesses that stormed
corporate America in recent years under the banner of private equity were not always called private equity
firms. In the 1980s, they were known as leveraged buyout shops. Their strategy is essentially unchanged,
however: they try to buy undervalued companies, using mostly borrowed money, fix them up and sell them
for a fast profit.
Because they pile debt onto the companies they buy, the firms free up their own cash, allowing them to
make additional investments and increase their potential profits.
Simmons's first trip through the revolving door of private equity came in 1986. Like the latest trip, it was
not a pleasant one for employees, but the buyers did just fine.
William E. Simon, a private equity pioneer and a Treasury secretary under President Richard M. Nixon.
was the man with the golden touch. In 1986, his investment firm, Wesray Capital, and a handful of
Simmons's top managers acquired the company for $120 million, the bulk of which was borrowed. After
selling several businesses to pay back some of the money it had borrowed, Wesray cashed out in 1989. It
sold Simmons to the company's employee stock ownership plan for $241 million twice what it paid just
three years earlier.
The deal was a fiasco for the employees. As part of the buyout, Simmons stopped contributing to its pension
plan, since the stock ownership plan shares were meant to pay for the employees' retirements. But then the

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bottom fell out of the housing market and Simmons, with its large debt, stumbled. Its pensions crumbled as
the value of the stock plan shares plunged.
A succession of private equity buyers came and went. Merrill Lynch Capital Partners bought Simmons in
1991 for $32 million for a 60 percent stake in the company and the assumption of its debt. Merrill sold it to
Investcorp, an investment group based in Bahrain, for $265 million in 1996. Two years later, Investcorp
sold the company to Fenway Partners for $513 million.
During Fenway's tenure, Simmons released one of the industry's biggest innovations: the no-flip mattress.
Profits soared. But after five years, Fenway executives decided to cash out. By the fall of 2003, Simmons
was back on the block.
Teddy Bear at the Gate
A longtime figure in investment circles, Thomas H. Lee vaulted into the big leagues of private equity with
what is regarded as one of the legendary deals of all time. After founding Thomas H. Lee Partners in 1974,
he grabbed headlines in 1994 when he sold Snapple, the iced tea maker, for $1.7 billion to Quaker Oats. He
bought the company two years earlier for around $130 million.
But while other captains of the buyout craze like Henry Kravis of Kohlberg Kravis & Roberts chased
giant companies in hostile deals, Mr. Lee focused largely on midsize companies and steered clear of deals
where he was not welcome. The research firm Hoover's describes Thomas H. Lee Partners as "the teddy
bear at the gate."
Mr. Lee, scion of the family that founded the Shoe Corporation of America, left his namesake firm in 2006
to start another investment company. During his 30-year tenure at THL, his firm invested in a series of big
names: Ghirardelli Chocolate, Petco Animal Supplies and General Nutrition Companies, among others. And
by 2003, as the buyout boom began to build, his firm had Simmons in its cross hairs.
The Deal
The fall of 2003 was little more than a blur of meetings and presentations for Robert Hellyer, the former
Simmons president who is among the fourth generation of his family involved in the mattress industry. In
eight weeks, the company was shown to 20 private equity suitors in the corporate version of speed dating.
The list of potential buyers was quickly whittled to three and finally to THL, whose $1.1 billion bid for the
company consisted of $327 million in new equity from the firm and more than $745 million in bonds and
bank loans that had to be raised from investors.
"They were good guys; very smart guys," Mr. Hellyer said. "Their thesis was to buy a good business with
good management and let them get better."
What THL wanted from the deal was a return of two to three times its initial investment.
From the get-go, the lofty price the firm paid for Simmons and the amount of debt raised red flags on Wall
Street.
The "higher debt burden will limit the company's ability to respond to unexpected negative business

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developments, including economic or competitive threats or internal missteps," analysts at Moody's

Investors Service warned at the time.
But nobody, it seems, was listening. Six months after acquiring Simmons, THL set in motion plans to take
the company public. And by December 2004, THL found a way to get part of its initial investment back.
Simmons issued debt that required the company to pay a hefty 10 percent annual interest rate. The
proceeds were used to pay THL a dividend of $137 million. With the company's debt climbing, Simmons
executives had to aim high with new products and pray they were right.
In late 2004, Simmons unveiled the HealthSmart mattress in a blitz of marketing.
It gave away 250 beds to the audience of "The Ellen DeGeneres Show." It began a $15 million advertising
campaign. It put coupons for free HealthSmart beds in celebrity souvenir bags during New York's Fashion
Week.
A mattress line aimed at combating dust mites, mold and germs, the HealthSmart featured a zip-off top that
could be washed or dry cleaned. But in the rush to get the product to market, Simmons did not go through
its normal research and testings, Mr. Hellyer says.
HealthSmart was a flop. Consumers did not like the mattress they thought the zip-on cover was
troublesome. Sales at the company slid nearly 8 percent in the first quarter from the previous year.
"Panic ensued. Thomas H. Lee came in and pulled the national advertising right away," said a former
Simmons employee involved with HealthSmart who declined to be named because he is still involved with
the mattress industry.
THL shelved its plans to take Simmons public, and the company shook up its sales division. By the third
quarter of 2005, Simmons had "one of the best quarters in the company's entire history up to that point," a
spokesman for THL said in an e-mail message. The numbers tell a slightly different story: Net sales
declined 4.8 percent in that quarter from a year earlier, and operating income fell to $25.1 million, from
$25.5 million in the third quarter of 2004. Later, spokesmen for THL and Simmons clarified the statement
by saying that after excluding a one-time reorganization expense, an adjusted earnings figure for the
quarter was the 10th best in the company's history.
Executives at THL say they moved quickly to put Simmons back on track.
"More than a dozen THL professionals have devoted literally thousands of man-hours to Simmons,
including making over 115 visits to company headquarters and site facilities around the country," the firm
said in a statement.
The results, it argued, speak for themselves. In the following years, Simmons's sales and profits climbed,
and the company introduced several new products, including the successful premium-price Beautyrest
Black line of mattresses.
By early 2007, at the very top of the credit market bubble, THL took a bit more out of Simmons. It created a
holding company that it used to issue $300 million more in debt, which paid an additional $238 million
dividend to the private equity firm. With that, THL had recouped its entire $327 million equity investment

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in Simmons and booked a profit of around $48 million. (It made an additional $28.5 million in various fees
over the years.)
THL was hardly alone in undertaking this sort of financial engineering, known as a dividend
recapitalization. From 2003 to 2007, 188 companies controlled by private equity firms issued more than
$75 billion in debt that was used to pay dividends to the buyout firms.
Asked whether the 2007 dividend was too much for Simmons, Mr. Schoen of THL defended the deal.
"That debt financing, which clearly spelled out to the market the use of the proceeds, was extremely well
received. The securities were heavily oversubscribed," Mr. Schoen said. "Not only did we think it was
appropriate, but the market did as well," he added.
As the economy soured in late 2007, so did Simmons's sales. The company slashed costs and cut jobs
throughout 2008. But last fall, unable to meet the terms of its bank loans and debt dating back to the 2003
acquisition itself, Simmons stopped making interest payments to its bondholders. THL began talking to the
banks and bondholders about how to lighten Simmons's debt load, and put the company up for sale.
The Impact on Employees
From the start, Noble Rogers loved working at Simmons.
"There were picnics, March of Dimes walks, Christmas parties, and we always had Halloween parties. It was
a really family-oriented company," Mr. Rogers, 50, recalled. "I told my wife that this was a great place for
me to work. A great place for me to retire, to make a living at."
For a long time, it was. For 22 years, Mr. Rogers worked at Simmons, the bulk of those years at a factory in
Mableton, outside Atlanta. After operating the coiler machine for the company's Beautyrest mattress, he
moved into maintenance and kept all of the plant's machinery humming.
Over the years, as Simmons passed from one private equity firm to another, and as Mr. Rogers became
president of the local union at the plant, he saw little difference on the plant floor. Then, in the spring of
2008, when the slowing economy had begun to hurt sales, Simmons laid off the night shift at the Mableton
plant. And on Sept. 18 that year, it gathered employees in the cafeteria to say that the plant was closing.
"So many people were hurt because they thought this was a great company to work for and they planned on
spending the rest of their lives here. Their families were here. They bought houses and cars here," Mr.
Rogers recalled. "After this happened, people were really struggling."
Between the closings and other cuts, Simmons let go of more than a quarter of its work force last year, said

its chief financial officer, William S. Creekmuir.

Mr. Rogers, who received his union-negotiated severance package of two months' pay, said he and other
union representatives had tried to get a little more for workers, particularly those who would have been
eligible for retirement. Simmons had a long history of giving retiring employees a bonus of $20 for each
year worked and a free mattress set, Mr. Rogers said.
"They wouldn't give us anything," he said.

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In the months after he lost his job, Mr. Rogers nearly lost his home to foreclosure and struggled to pay his
family's bills. Mr. Rogers, who eventually landed a job at an air filter company and picked up part-time
work doing maintenance at an apartment complex, said Simmons bore little resemblance to the company
he once loved.
"They stopped the picnics. They stopped the Christmas parties. They stopped the retirement parties," he
recalled. "That showed you the type of people I was working for. I just didn't realize it until the hard times
came like they did."
For now, the Golden Age of private equity is over, the financiers say. In a speech to an industry gathering
last spring. Mr. Schoen said that bankers and bondholders were reluctant to lend more money to the buyout
kings.
"We're in a brave new world," he said. "We can't go back to where we were, at least not in this investment
cycle, and probably not in my career."
But some private equity investors are searching for profits in the detritus of the buyout bust. Simmons
hopes to emerge from bankruptcy in the hands of two new private equity firms. One is Ares Management,
which owns the mattress giant Serta. Under the plan, Simmons's debt would be more than halved, to $450
million, in part reflecting the losses suffered by its existing bondholders.
Simmons and its remaining employees face an uncertain future. Some in the industry predict Ares will
eventually merge at least part of Simmons with Serta, jeopardizing more jobs.
"Simmons has been a cash cow. It's made a lot of people a lot of money," said David Perry, executive editor
of Furniture/Today. "But there's a growing question in the industry of how many more times can this be
repeated. How much more juice can be squeezed out of the orange?"
Copyright 2009 The New York Times Company

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100

101
119

102
120

Bruce Wasserstein,
dead for two years, still casts a pall
over the Rogue River Valley of southern Oregon.
There, in and around the town of
Medford, more than 2,000 employees of Harry & David Holdings Inc.,
the century-old seller of mail-order
pears and holiday fruit baskets, labor at a company that went bankrupt
in March 2011 after private-equity
firm Wasserstein & Co. loaded it with
$200 million of debt that it couldn't
pay back-even as Wasserstein's firm
took profits for itself.
For decades, Harry & David set the
standard for high-quality fruit. Its
Royal Riviera pears, sold worldwide,
are known elsewhere as Cornice, a
sweet and juicy variety developed in
France that fared even better in southern Oregon, where the soil is volcanic
and the winters are mild. In 2005,
when Harry & David was preparing to

CEO HEYER RILED

REPEAT CUSTOMERS
BY CHANGING THE
PRODUCT LINE. HE
CALLED THE OREGON
WORKERS 'IDIOTS,'
ACCORDING TO TWO
FORMER EMPLOYEES.
sell shares to the public, the company
cited a survey saying that 60 percent of
Americans earning more than $75,000
knew the Harry & David brand.
"Back in the day, they offered a very
distinctive product," says Pamela
Danziger, president of Unity Marketing, a Stevens, Pennsylvania-based
86

BLOOMBERG MARKETS

above, named Ellis

Jones, above right, CEO when he
founded the firm in 20Gl. Jones
named Heyer, right. to run Harry
& David after Wasserstein died.

company that researches luxury

goods. "Overtime, they became less
distinctive. Specialty fruit became
much more available."
Harry & David's journey from an industry standard for holiday gift givingabout 60 percent of sales happen from
Thanksgiving to Christmas-to bankruptcy shows what can happen when a
private-equity investor like Wasserstein freights a small company with
debt, making it more vulnerable to the
ravages of recession and competition.
When Wasserstein took over Harry &
David in 2004, it was the fourth buyer
in 20 years, with three of the new owners paying a substantial premium to the
previous one.
The bankrupting of one of Oregon's
oldest corporations under New Yorkbased Wasserstein riles local officials.
Harry & David is the largest nonhealth-care employer in the region. It
hires 6,000 temporary workers every
year to pick, pack, and ship fruit. Those
jobs are crucial in Medford, a city
where unemployment stood at 11.3 percent in July compared with 9.4 percent

November 2011

121
103

for the rest of the state. "Many people

here see the Wasserstein people lining
their pockets," says County Commis-

sioner Don Skundrick. "There is strong ci

feeling in the community that they are

taking Harry & David down the road g
to ruin."
Former employees are angry, too.
Medford is rife with executives that the
new management fired, and 2,700
workers and retirees had their pensions terminated and shifted to the
government-sponsored Pension Benefit Guaranty Corp. after Wasserstein &
Co. and other bondholders made
dumping the retirement plan a condition for investing $55 million in the
company after it emerged from
bankruptcy.
In the year leading up to the bankruptcy, Harry & David was run by Steve
Heyer, a former president of Coca-Cola
Co. and chief executive officer of Starwood Hotels & Resorts Worldwide Inc.
He riled repeat customers by changing the product line and also pursued
promotions, including one with Oprah
Winfrey, that boosted costs without

lifting sales, according t(

former employees. ThoSE
employees declined to bE Of the five companies the New York firm owns, two have been through bankruptcy and
a third was downgraded by Standard & Poor's.
identified because they
they're concerned that talkENCOMPASS
ing on the record would make
HARRY &DAVID
PENTON MEDIA
HANLEY WOOD
SPORTCRAFT
DIGITAL MEDIA
NAME
other companies wary of em.................. ... ...
BUSINESS
ploying them.

Heyer was a friend of Bruce
Wasserstein, whose firm had
Mail-order
Trade
Construction
Maker of sports
Outsourced
periodicals,
food
publications
equipment
television
sold Odwalla Inc., one of its
trade shows
broadcasting
.........................
portfolio companies, to Coke
ACQUISITION DATE
August 2005
June 2004
April 2008
September 2005
October 2003
in 2001 when Heyer was
PRICE
$253 million
$385 million
$650 million
$110 million
Terms of
running a new venture unit
purchase not
there. Wasserstein invited
disclosed
him onto the board of Lazard
RESULT
Files for
Files for
S&Plowers
Has made two
Firm declines
Ltd., which Wasserstein ran
bankruptcy in
bankruptcy in
rating to CCC
acquisitions
to disclose
from 200l until his death. At
February 2010
March 2011
performance.
on April 28.
Harry & David, Heyer collected a salary of $500,000
a year and was awarded opSource: Wasserstein & Co.
tions to buy 15 percent of
the company's closely held stock.
a job he had while he was running
Harry & David emerged from bankHeyer also got plenty of perks: WasserHarry & David. He declined to comment. ruptcy on Sept. 14. It had sought prostein let him run the company from
Heyer's replacement, restructuring tection from creditors in March after
Atlanta, and his employment contract
expert Kay Hong, commutes from San Heyer sharply cut prices on gourmet
called for him to fly first-class to MedFrancisco. She took the company into pears, fancy fruit baskets and Moose
ford. Early in his tenure, Heyer leased
bankruptcy and was paid $26,000 a Munch caramel corn during the Dea private jet to fly to Seattle to try (unweek to run it in receivership, accord- cember 2010 holidays, former employsuccessfully) to persuade Starbucks
ing to bankruptcy court filings. Cassan- ees say. Revenues had been soft in the
Corp. to sell Harry & David products.
dra Bujarski, a spokeswoman for wake of the financial crisis, and when
Heyer is now chairman of N ext3D
Wasserstein & Co., who is at Sard the 2010 holidays were over, sales for
Inc., an Atlanta-based company that
Verbinnen & Co. in Los Angeles, said the period had fallen 2 percent, to $262
streams 3-D movies to subscribers,
Hong declined to be interviewed.
million, according to company filings.
Heyer's discounting drove net income
down 56 percent, to $13.8 million.
Wasserstein & Co. and another private-equity company, Highfields Capital Management LP of Boston, bought
Harry & David from Yamanouchi
Pharmaceutical Co., then Japan's thirdlargest drugmaker, for $253 million
in June 2004, putting up $82.6 million
in cash and borrowing the rest.
Eight months later, Harry & David
sold $245 million of bonds, some ofthe
proceeds of which went to pay Wasserstein and Highfields a dividend of $82.6

WASSERSTEIN'S BAD DEALS

,'

t)

i)

A Medford pear orchard.

The company started in
1910 when Sam Rosenberg
bought 240 acres.

88

BLOOMBERG MARKETS

November 2011

122
104

million. Months later, the firms took

two more payouts totaling $19 million,
assuring them a 23 percent return no
matter what happened to sales offancy
pears and mixed nuts.
Harry & David fell victim to a practice that's common in the private-equity industry, says Brian Quinn,
assistant professor at Boston College
Law School and a specialist in mergers
and acquisitions. Directing a company
to sell bonds and then taking the proceeds is legal, he says. Whether it's best
for the purchased company is another
matter. "It doesn't pass the smell test,"
Quinn says. "They are running this
company without anything at stake."
Ellis Jones, CEO of Wasserstein &
Co., says Harry & David's debt load was
small compared with other companies
taken over by private-equity firms. "We
bought Harry & David with more equity than you would normally in the
private-equity business," he says. Even
after the bond sale, Harry & David had
less debt than most buyout targets, he
says. Until the 2008 crisis, its average
debt was about 2.5 times Ebitda, or
earnings before interest, taxes, depreciation and amortization, Jones says.
The average multiple of debt to Ebitda

THE DEAL SAVANT

MADE HIS REPUTATION
BY PUTTING

TOGETHER TIME INC.

AND WARNER
COMMUNICATIONS
AND ADVISING KKR
ON HOW TO SWALLOW
RJR NABISCO.
for retail companies owned by privateequity firms from 2005 through 2008
was 1.5 times, according to Bloomberg's
M&A database.
Wasserstein & Co. was a privateequity sideline for Bruce Wasserstein, the deal ,savant who helped
combine Time Inc. and Warner
90

BLOOMBERG MARKETS

A Harry & David fruit-sorting

facility. The company employs
2.000 full-time workers.

Communications Inc. in 1990, a year after advising Kohlberg Kravis Roberts &
Co. on howto swallow RJR Nabisco Inc.
for $25 billion-a drama chronicled in
the best-selling book Barbarians at the
Gate (HarperCollins, 1990).
The former CEO of Wasser stein Perella Group Inc. and then Lazard died
suddenly of heart failure in October
2009 at 61. Wasserstein's namesake
company manages money left to his
heirs through a trust as well as funds
invested by the Pennsylvania Public
School Employees' Retirement System
and other institutions.
Two of the five companies Wasserstein & Co. currently owns- Harry &
David and magazine publisher Penton Media Inc.-have been through
bankruptcy in the past, two years.
A third, Hanley Wood LLC, a publisher of construction periodicals, was
downgraded to CCC this year by ratings firm Standard & Poor's, which
questioned Hanley's ability to comply
with loan covenants because of poor
performance.
Wasserstein investors, however,
have made money on both bankrupt
companies, Jones says: Harry & David

November 2011

123
105

through dividends and Penton when another privateequity firm bought a stake
before it sought protection.
Wasserstein & Co. started
life as the buyout unit of investment bank Wasserstein
Perella. It went independent in January 2001 after
German bank Dresdner
Bank AG bought the rest of
Wasserstein Perella for
$1.56 billion. Much of the
firm's job is managing the
proceeds of that sale for
Bruce Wasserstein's estate.
It has launched two privateequity funds: US. Equity
Partners I & II. The first fund, started
at Wasserstein Perella in 1997, had an
internal rate of return of negative 1.6
percent before it liquidated its investments and shut down in 2009, according to the Pennsylvania retirement
fund, which invested $73.8 million and
got back $67.2 million.
USEP II, which started in 2001 and
still owns companies, including Harry
& David, had an internal return oflO.6
percent as of Dec. 31, the retirement
fund says. The pension fund had put
in $214.6 million and had gotten back
$202.2 million as of the end of 2010.
"They would have trouble raising a
new fund today with that performance," says Steven Kaplan, a professor at the University of Chicago's Booth
School of Business.
Harry & David was launched by an
Oregon business pioneer named Sam
Rosenberg when, in 1910, he bought
240 acres (97 hectares) in the Rogue
River Valley called Bear Creek Orchards. After Sam's death in 1914, his
sons, Harry and David, both Cornell
University-educated agriculturists,
started shipping their pears to upscale
restaurants in Europe. They survived

the Great Depression by persuading

corporate leaders to send the Royal
Rivieras as gifts to customers. The
brothers launched their Fruit-of-theMonth Club in 1938, and sales jumped.
the same time they changed
their last name to Holmes to skirt a
boycott of goods from Jewish-owned
companies by Germany, according to a
history of Harry & David by Portland
State University.
David died in a car crash in 1950, and
Harry left the business three years
later because of a heart condition.
Harry & David continued to prosper
under new managers by selling gourmet foods that at the time weren't
available in supermarkets. By 1961, the
company had sales of $8 million, and it
continued to grow steadily from there,
according to the International Directory of Company Histories (St. James
Press, 2001).
Harry & David sold shares to the
public in 1976. It remained independent until 1984, when R.J. Reynolds Industries Inc., a tobacco company
looking to acquire fast-growing businesses, took it over for $74 million. Two
years later, vitamin maker Shaklee
Corp. paid Reynolds, by then called
RJR Nabisco Inc., $123 million for it.
Then, in 1989, Japan's Yamanouchi

Pharmaceutical swallowed up Shaklee.

Through all these owners, Harry & David kept growing. In 1993, it began supplementing its mail-order business
with a network of retail stores. In 1997,
sales hit $300 million, according to the
International Directory.

HARRY & DAVID WENT

THROUGH FOUR
OWNERS IN 20 YEARS,
WITH THREE PAYING
A BIG PREMIUM OVER
WHAT THE PREVIOUS
OWNER PUT DOWN.

Yamanouchi hired Citigroup Inc. to

help sell the company, and the bankers
reached out to Wasserstein because it
was known as a buyer of mid-sized consumer companies, Jones says. Wasserstein & Co. took over in June 2004.
Harry & David posted record mailorder sales for the year that included
the 2004 holidays. Bruce Wasserstein
then authorized the 2005 bond sale.
Business started going downhill in
September 2008, when markets seized
just before Harry & David's busiest season and many corporate executives cut

back on gifts to customers. "This event

happened before our one selling period," Jones says. "You can imagine that
the Christmas we had was extremely
difficult." During the next two years,
sales continued to fall, hurt in part
by competition from Internet retailers
like Amazon.com Inc., which had begun selling its own fancy fruit baskets
created by other producers. Revenue
fell 13 percent in the year ended in June
2010 to $426.8 million. The year before, it had fallen 10 percent. In February 201 0, four months after
Wasserstein died, the buyout firm
ousted Harry & David CEO Bill Williams, a 21-yearveteran.
Heyer, now 59, immediately shook
things up. He added artisanal cheese to
Harry & David's gift baskets and
opened 16 "pop-up" stores-operations
that occupied rented space for just a
month or two-in cities including Boston, New York and San Francisco.
Harry & David had about 125 permanent stores nationwide at the time.
Heyer also started selling chicken pies
made by two women on Cape Cod who
had won Oprah Winfrey as a booster.
Nothing worked. Heyer spent too
much on expensive fixtures for the
pop-up stores, a former employee says.
And the fancy cheese raised costs,

BARBARIANS IN THE ORCHARD

2011

After decades of independence, the Medford, Oregon-based company became a toy of the dealmakers.

1984

1886

1910

BearCreek
Orchards founded.

Sam Rosenberg
buys Bear Creek.

1934

1I II II IIIIII IIIIIIIIIIIIillll lllll llllllllll lilli lliliI

BLOOMBERG MARKETS

............................. .....
... ............ ...

1938

1976

Rosenberg's
sons, Harry and
David, start
selling Com ice
pears to high-end
hotels and
restaurants
in Europe.

Fruit-of-theMonth Club starts.

Harry & David sells

shares to the public.

1986
RJR Nabisco sells
Harry & David to
: Shaklee Corp. for
$123 million.

November 2011

124
106

Yamanouchi
Pharma buys
Shakleefor
$39Smillion.

1914

Harry and David in 1948

92

R.J. Reynolds buys

Harry & David for
$74 million.

Harry and David

: start selling pears
by mail in the u.S.

Harry & David

declares
bankruptcy in
March, emerges
in September.

1989

Ad circa

1946

. ......... .... ..

2004
Wasserstein & Co.
and Highfields
Capital buy Harry &
David from
Yamanouchi for
$2S3million.

another says. The chicken pies didn't

meet expectations, former employees
say. Heyer then lost interest, says
Kristin Broadley, co-founder of Centerville Pie. "I feel like we were a little
used," she says.
In early 2010, Heyer leased a corporate jet to fly to Seattle to pitch Starbucks CEO Howard Schultz on selling
Harry & David products in his 17,000
coffee shops, according to a former employee familiar with the trip. They met
for about 90 minutes. Schultz was polite but didn't commit to anything, the
person says. Heyer and his team stayed
at Seattle's Four Seasons, the former
employee says.
Heyer was a risky choice for Harry &
David, says Tom Pirko, president of Bevmark LLC, a Buellton, California-based
consultant to the food and beverage industries. Pirko got to know Heyer when
Heyer was at Coca-Cola and Pirko was a
consultant to the company, Pirko says.
"Steve came in with a jackhammer;' he
says. Shortly after his promotion to
Coca-Cola president in 2002, the companyfired 1,000 people. ''He was the mosthated person in Atlanta," says Pirko,
who says he likes and respects Heyer.
In 2004, Heyer was passed over for
the post of CEO. Instead, the company

OPRAH WINFREY
HELPED HARRY
& DAVID SELL
CHICKEN PIES
FROM CAPE COD.
THE PROMOTION
DIDN'T MEET
EXPECTATIONS.
brought Neville 1sdell out of retirement to take the job. Heyer resigned,
collecting $23 million in severance, according to the Atlanta Journal-Constitution, and was soon hired as CEO of
Starwood Hotels. In April 2007, he resigned after losing the support of the
board of directors. "Issues with regard
94

BLOOMBERG MARKETS

Harry & David pop-up stores

in San Francisco and Boston.
The faces in the pears
are Broadley and Bowen.

to his management style have led us to

lose confidence in his leadership,"
board member Stephen Quazzo said in
a statement at the time. Heyer declined
to comment.
Heyer hit Harry & David like ahurricane, according to former executives
there. He fired many of Bill Williams's
managers and brought in his own. He
often called Harry & David workers
"idiots," two former employees say.
Heyer required managers to sign a
one-page "culture contract" laying out
the methods they would use to run the
company. "We give straight and frequent feedback," the contract says. "We
hate long meetings and never have
them without a decision-making purpose. We hate gravity, old thinking and
habits. Our favorite word is NEXTl"
Heyer changed the company slogan
to Happiness Delivered and called himself "chief happiness officer" in at least
one press release.
One of Heyer's biggest blunders, former employees say, was rearranging
the contents of Harry & David gift baskets. He had workers layout samples
of all the baskets in a warehouse, and
he went down the line, adding and removing items, one former worker says.
The changes made it impossible for

November 2011

125
107

returning customers to easily repeat

an order from the year before on forms
that the company sent out, former
employees say, and many customers
didn't buy.
Heyer also closed one of Harry & David's two call centers and hired Cincinnati -based Convergys Corp. to do the
work, with operators taking calls from
their homes. Customers frustrated
with the Convergys salespeople abandoned more orders than they had in the
past, former employees say. Heyer canceled the contract in February, according to a complaint filed by Convergys
against Harry & David in U.S. District
Court in Medford in March, saying that
Harry & David failed to pay $3.1 million
to terminate the contract.
Heyer expected big things from the
Oprah deal, former employees say. The
project got started in August 2009,
when Broadley, who had just started
her Centerville Pie company with longtime friend Laurie Bowen, heard that
Oprah Winfrey was on Cape Cod for
Eunice Kennedy Shriver's funeral.
Broadley found Winfrey's hotel and
dropped off two pies-one peach and

one chicken. Winfrey loved them,

Broadley says.
Months later, Winfrey's producer
called to invite the pie maker to appear
on the show on Sept. 17, 2010. Winfrey
surprised them by announcing a deal
for Harry & David to distribute the
pies as part of her Ultimate Wildest
Dreams program. Viewers ordered
280,000 pies via Harry & David. That
was good for Centerville Pie, but it
missed Harry & David's projections,
two former employees say. At the
time of its bankruptcy, Harry & David
owed Centerville $279,000, Broadley says.
Heyer had been CEO for 10 months
when the 2010 holiday selling season
arrived. It didn't go well. When the
company reported earnings for the
quarter in February, Heyer warned that
it couldn't finance operations without
new capital.
Ten days later, Jones and Wasserstein President George Majoros ousted
Heyer as CEO. They brought in Hong, a
turnaround expert from Alvarez &
Marsal, a New York-based managementfirm.
Heyer worked extremely hard to try
and fix Harry & David, says Jones, who
insists the moves Heyer made were
the right ones. "We think very highly
of Steve," Jones says. "He's extraordinarily smart."
Hong, who had experience reviving
Eddie Bauer Holdings Inc. and Spiegel
Inc., took the company into bankruptcy
a month after arriving. One of her first
tasks was to deal with investor demands that she get $23.6 million in unfunded pension liabilities off Harry &
David's books.
Wasserstein had purchased Harry &
David debt when it fell in price after the
96

BLOOMBERG MARKETS

2008 holidays. It joined other bondholders in an agreement to invest an

additional $55 million after the company emerged from bankruptcy, Harry
& David said in court documents. Wasserstein wouldn't put up the money unless the retirement benefits were
turned over to the U.S. Pension Benefit
Guaranty Corp., a move that a federal
judge would have to bless. U.S. Bankruptcy Judge Mary F. Walrath in Delaware did so in August, and Harry &
David's unfunded liabilities will now be
covered in part by premiums paid by all
companies that have defined-benefit
pension plans.
The PBGC had argued that the move
was unjustified because Harry & David's survival wasn't at issue. "PBGC
fought to keep the Harry & David pension plan going because the agency's
analysis found that the company could

Bloomberg TIps

afford it," PBGC spokesman Marc Hopkins says in an e-mail. "The plan was
terminated largely to increase investor
returns, not out of necessity to emerge
from bankruptcy."
When Harry & David came out of
bankruptcy on Sept. 14, Wasserstein remained an owner. That means Jones
and Majoros will still have a say in how
the company is operated in the future.
For the citizens of Medford, Oregon,
the question remains whether what's
best for Bruce Wasserstein's heirs is
also good for the thousands of people
who depend on Harry & David for jobs.
ANTHONY EFFINGER IS A SENIOR WRITER AT
BLOOMBERG MARKETS IN PORTLAND.
AEFFINGER@BLOOMBERG.NET
WITH ASSISTANCE FROM STEVEN CHURCH
IN WILMINGTON AND TARA LACHAPELLE
IN NEW YORK.

To write a letter to the editor, send an e-mail to

bloombergmag@bloomberg.net or type MAG <Go>.

COMPARING
RETAIL BUYOUTS

You can use the Merger and Acquisition Search function to compare the Harry

& David deal with other retail buyouts. Type MA <Go> and click on Advanced
Search on the red tool bar. Click on Sector/lndustry, then on the plus sign to
the left of Consumer, Cyclical and finally on Retail. Click on the boxes to the
left of Seller and Acquirer to remove the check marks and then on Update.
Click on Deal Type, then on the box to the left of Private Equity and finally on
Update. Click on Deal Status, then on the box to the left of Completed and
finally on Update. Type 1 <Go> for the results. BETH WILLIAMS

November 2011

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February 21 February 27,2011

Bloomberg Businessweek

The
Operators

JPG's CO-FOU
JIM COULTER
"IT'S TIME
FOR US TO
ENTER THE
NARRATIVE"

Can private equity beat the market

again? Mega-shop TPG makes a
$48 billion bet that the answer is
BY JASON KELLY
PHOTOGRAPH BY
GABRIELA HASBUN

It's a late August morning in Jim Coulter's

office on the 33rd floor of one of San
Francisco's tallest buildings, and the view
has cleared. With the fog burned off the
Bay, the Golden Gate Bridge is glittering
in the sunshine. It's a glorious San Francisco moment, but Coulter doesn't seem
to notice. Instead he's at a whiteboard,
diagramming the private equity business
in green marker.
"It's a three-box model," Coulter says,
J drawing boxes and filling them in with
abbreviations-"SP" for "stockpickers,"
"DG" for "deal guys," and "PM" for "portfolio managers."
Coulter, 51, along with David Bonderman, 68, is co-founder of the 19-year-old
J private equity firm TPG Capital, which
has engineered many of the largest and
most visible deals the industry has seen,
including the 1997 purchase of J. Crew for
$475 million and the 2006 initial public
offering, which valued the company at
$1.1 billion; the $43.2 billion acquisition

of Texas utility TXU, renamed Energy

Future Holdings; and the $27 billion takeover of casino company Harrah's, now
known as Caesars Entertainment. TPG,
with 278 employees in 14 offices, controls $48 billion of investments, putting
it at the top of the private equity world,
along with Blackstone, Carlyle, and KKR.
Such success has put Coulter at No. 221
on Forbes' list of the wealthiest Americans, with an estimated net worth of $1.8
billion. (He is tied with Bonderman, also
at $1.8 billion.)
Each player in the buyout industry
uses its own blend of Coulter's three
boxes. TPG, Coulter says, emphasizes
portfolio management and deals. Portfolio management isn't about stocks.
Rather, it's a focus on improving the performance of acquired companies, often
in the tiniest ways. Coulter argues that
it's TPG's operations team-60 fixers
who go into companies and search for
efficiencies-that sets the firm apart, not

109
105

the stockpickers or deal guys, who put

the purchases together. "There is some
secret sauce to what we do," he says.
"Private equity," strictly speaking, describes a business that deploys capital outside of the public markets, but the "private" is often emphasized in its secondary
meaning as well. It's traditionally among
the most secretive of businesses, partly
because a deal is like a poker hand, best
deployed by surprise, and partly because
the fees, and some of the industry methods, such as paying out enormous dividends from overleveraged acquisitions,
work better when no one is watching.
That has changed, to some extent, as
private equity firms have gone public.
Both Blackstone and KKR are now publicly traded, and Carlyle is said to be mulling an offering in 2011. TPG has held out,
and Coulter says there are no plans to
take the firm public.
It's unusual for TPG to invite a reporter into the firm, but these are

110
107

unusual times for TPG, and for private

equity. Returns, in aggregate, are beginning to look a lot like those of the market,
which threatens the rationale for the industry and its eye-popping fees-usually
20 percent of any profit it creates for investors, along with a 2 percent management fee, win or lose.
In general, an investor in private equity
commits money to a fund for 10 years.
Thus, most judge a fund's performance
after it's hadfiveor so years to make investments, grouping them by "vintages," the
year a fund started investing. According to
PitchBook, a private equity deal database,
the average return for funds raised in 2001
was 22 percent, while funds from 2005
were averaging 4 percent. TPG's funds, in
that time, returned similar results. And it's
still lugging around boom-era baggage, including Energy Future and the memory of
losing $1.3 billion in a minority investment
in Washington Mutual.
The profile of its deals and the wider
notoriety of the industry in the public
and political spheres mean TPG can't operate in the shadows anymore, unless it
wants its critics to be the only ones talking. "We're more in the public eye," says
Coulter, who argues that some of the anger
at private equity, from anti-Wall Street politicians, labor leaders, and disappointed
investors, comes from a misunderstanding of what the firms-and his in particular-actually do. "It's time for us to enter
the narrative," he says.
Still, some habits aren't easily broken.
As Coulterfillshis whiteboard with explanations, he's also playing the poker game.
A few days later he'll fly to New York City
for a dinner meeting with J. Crew Chief

Executive Officer Mickey Drexler, setting' over that time, and that's why so much
in motion an offer to purchase J. Crew- money came in." The problem, he says,
again. This time, for $3 billion.
is that as the industry grows and competition for each deal increases, "the excess
Like the rest of the industry, TPG is still returns get competed away."
coping with a buyout boom that was powRight now firms such as TPG are ready
ered by cheap credit-and destroyed by to prove their merit. Private equity firms
its sudden disappearance. The boom collectively emerged from the crisis with
crested in 2006 and 2007, when 9 of more than half a trillion dollars in comthe 10 biggest deals in history were an- mitments they needed to spend, accordnounced. Among them was the acquisi- ing to PitchBook. TPG has $17 billion. The
tion of TXU and the purchase of Harrah's, open question is whether or not they can
both TPG projects.
spend that money.wisely-orat least more
Private equity firms are under scru- wisely than the market overall-when adtiny not just from the public but from justed for their fees.
their investors, who have poured record
The deals getting done now are differamounts into buyout funds. Those insti- ent from those in the boom, and Coulter
tutional players, still tender from the fi- believes that benefits TPG. "We've seen
nancial crisis, are demanding more in- something of a fundamental change,"
formation from firms they already invest says Dartmouth's Blaydon. "There are
in as well as those looking for fresh com- three ways to make money in a leveraged
mitments. They're also questioning how buyout-the capital structure, buying low
much they'll pay for the privilege of in- and selling high, and actually improving
vesting, according to observers such as the cash flows of the company. The last
Colin Blaydon, director of the Center for is the only one that investors think can
Private Equity and Entrepreneurship at actually deliver the returns in the future,
Dartmouth College's Tuck School of Busi- given everything we've gone through."
ness. "Every investment that's being done
Investors "are much more interested
now, the fee issues are right upfront," he today in how you're going to deliver that
says. "This is a big conversation that's value you're promising," Coulter says.
going on everywhere."
"They say, 'Give me examples.'"
As for the investors, "We measure sucPrivate equity's performance vs. the
public markets has been compelling, es- cess by [earnings before interest, taxes,
pecially from 1998 to 2005, says Steven depreciation, and amortization] growth as
Kaplan, a professor at the University of opposed to balance-sheet restructuring,"
Chicago Booth School of Business, who says Alan Van Noord, chief investment of
has done extensive research on private ficer of Pennsylvania's Public School Emequity returns. "This was a period when ployees Retirement System. "Managers
firms like TPG had begun to invest in understand that they have to be more opoperational capabilities," Kaplan says. I erational in nature and that financial
"They did better than the public markets \ engineering only goes so far."

111
108

ILLUSTRATIONS BY C.HOFFMAN

February 21 February 27, 2011

Bloomberg Businessweek

COULTER

ONCE

FOUND

MEAL

ON

CONTINENTAL

February 21 February 27, 2011

SO BAD HE FEDEXED IT BACK TO HEADQUARTERS

TPG is hardly the only firm responding
to criticism by showcasing its operations
skills. Clayton, Dubilier & Rice, a competitor, has former General Electric Chief Executive Jack Welch, who works with the
firm as a special partner. Part of his job
is to keep CEOs motivated. The firm also
has former Procter & Gamble CEO A.G.
Lafley and Gap chief Paul Pressler, a retail
expert. KKR has an internal operations
group called Capstone that has doubled
its head count since 2007, to 60.
Greg Brenneman, now chairman of
private equity firm CCMP Capital Advisors, ran TPG companies that included
Continental and Burger King. Brenneman,
who stays in touch with TPG's Bonder
manat minimum, they have a standing
yearly breakfast in Colorado-says the financial engineering days are over, giving
an advantage to fixers such as his firm
and TPG. "It really is how you're going to
make money in the next five years in private equity," Brenneman says. "The operators are back on top again."
In early September, just weeks after the
still-secret J. Crew meeting with Drexler,
Coulter is in New York and swings by a
small conference room with a view of
Central Park where Richard "Dick" Boyce
has set up for the week. A former Pepsi
vice-president for strategic planning,
Boyce has run TPG's operations group
out of San Francisco for 14 years.
"I'm definitely a process maven," says
Boyce, patting a stack of spreadsheets as
though it were a favorite pet. Charts,
he says, are his mother tongue. At one
point, grasping for a way to explain his
duties, he concedes, "I tend to think in
slides." He'll often grab a piece of paper
and sketch out a timeline or interlocking
circles to illustrate a point.
Coulter, too, with an engineering degree from Dartmouth, is a selfdescribed nuts-and-bolts guy. Like Boyce,
he thinks and speaks in bullet points. You
get the feeling that he likes taking things
apart just to put them back together. If
you had to put the founders in their own
boxes, Coulter might be the portfolio manager, while Bonderman, who will hop on
his private plane at a moment's notice to
have lunch with a CEO, is more of a deal
guy. (Bonderman, a constant world traveler,flieshis used Falcon 900 in excess of
half a million miles in most years.)
These days, 60 people work for Boyce
in operations, up from just one when TPG
bought J. Crew back in 1997. "Before, it
was some guys with some good ideas,"
says Boyce. "It's a business now." His em-

ployees include specialists such as Deb

Conklin, a senior adviser in San Francisco for the operations group who spends
months embedded in TPG-acquired companies, figuring out everything from the
optimal place to store parts on an assembly line to how a casino buffet should be
arranged to maximize profit. Coulter-like
the rest of TPG-calls Boyce's department
the "ops" group and says that from the
beginning he'd hoped it would be a crucial part of the business.
Coulter and Bonderman met during
the late 1980s, working in the office of
Robert Bass in Fort Worth, alongside
such managers as future Colony Capital Chairman Thomas J. Barrack Jr., Lone
Star Fund's John Grayken, and future TPG
partner Kelvin Davis. Lawyer Bonderman
linked up with former investment banker
Coulter, then in his late twenties.
The two spun out of Bass, joining
GE Capital's Bill Price, to pursue a purchase of Continental Airlines in 1993,
pooling their own money along with
cash from other private investors in a
deal that would launch what was then
called Texas Pacific Group, in a nod to
their having had offices in Fort Worth
and San Francisco. The Continental deal
was a coup: TPG made more than 10
times its initial $60 million investment
in about five years, mostly through operational improvements in customer service. Food and baggage handling were a
focus. Coulter, flying coach with Bonderman one day, found the meal so bad that
he FedExed it to headquarters.
Bonderman says the Continental deal
gave birth to the idea of an operationscentered investment firm. "That put us
on the map in the first place," he says.
"In the popular psyche, there's a lot of
respect for Henry Ford being an industrialist but not for those considered financial engineers. There's an undercurrent
of that, and it's important for us to make
it clear that we actually add value."
Emboldened by Continental, Coulter
and Bonderman began to think about
how to build a firm. "It was very important that we build for the long haul," says
Coulter. He and Bonderman were convinced that the messiness of deals such as
Continental was part of the opportunity
and decided they wanted to institutionalize operations. Coulter, then 32, spun
his Rolodex and got in touch with Boyce,
whom he'd first met as a Stanford Business School summer associate at Bain &
Co., where Boyce worked.
Through deals such as Continental's,
TPG posted some of the best numbers in

112
109

Bloomberg Businessweek

the industry during the 1990s and into

the last decade. Its 1994 fund had an average annual return of 36.3 percent, according to data provided by the Oregon
Investment Council, which manages that
state's employees' pensions.
TPG's 2000 fund had an average
annual return of 24.6 percent and returned 2.5 times investors' money, according to the California Public Employees' Retirement System. The average
fund of that vintage in the CalPERS portfolio had a return of 7.9 percent and 1.4
times invested capital. More recent comparisons for TPG haven't been as strong.
The firm's fourth fund, vintage 2003,
is valued at 13.2 percent, about half the
CalPERS average of 23.4 percent that
year. TPG's ability to get back to those historic highs will come down to its ability to
fix what it already owns and to improve
the fortunes of its next purchases.
To better the odds of an operational victory, Boyce and his team work in
tandem with the deal partners on due
diligence, rather than just parachuting
in once the paperwork is signed. "On the
front end, we help the deal team lean forward and see things that are heavily discounted by another buyer," he says.
Boyce keeps a chart of the skills of
each partner in ops. It lists that partner's
strengths, reminding Boyce who's a procurement guru, who knows how to tweak
a supply chain, and who's an expert on
"lean" manufacturing, the art of producing the most with the least effort. Both
Coulter and Boyce stress that operations
can only be successful if the ops guys are
equal to the deal guys in stature-and pay.
So at TPG, ops partners are full partners in
all profits rather than deal-by-deal hires.
Every company TPG acquires is
color-coded red, green, or yellow. Most
start out red and stay that way for a minimum of a year. If all goes well and J. Crew's
shareholders approve the takeover, Boyce
will have the retailer in one of those categories by summer.
Coulter already serves on J. Crew's
board, and while it's far from a company in need of a turnaround-net income
more than doubled in 2010-J. Crew may
benefit from TPG's approach, especially in expanding into markets such as
China. Coulter and Boyce can't speak
about J. Crew in detail yet, as the deal has
not closed, but a person familiar with its
plans suggests that TPG is taking J. Crew
private-just five years after taking it public-to spend heavily on international expansion and to build new brands
such as Madewell. A publicly traded

February 21 February 27, 2011

Bloomberg Businessweek

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February 21 February 27, 2011

Bloomberg Businessweek

To make his route shorter, they moved the

hinge of a refrigerator so he wouldn't have
to walk around to open it and moved the
spice rack so he wouldn't have to take a
step to get to it.
In the end, TPG had the housekeepers
change their routine in seemingly minor
but ultimately productive ways, devising a method for making a bed so each
corner need be lifted only once for all
four sheets and blankets, not individually for each piece of bedding.
The numbers at Caesars have stabiBoyce embodies a type of partner Coulter lized. It's generating profits of about half
likes to find and hire-someone who has a billion dollars a quarter, but this was
worked as a consultant and inside a com- a company whose debt load, combined
pany, actually doing the work the consul- with a vicious drop-off in business that aftants prescribe. That makes an ops guy fected every casino on the Strip, took it to
coming in from a new owner more of a the edge of default in 2009. TPG, having
kindred spirit and less of a Wall Street pared the debt, filed to sell shares to the
shark. Coulter has a bias toward what public to fund expansion in October.
he calls "academy companies" such as The following month the firm pulled the
GE and Pepsi, where Boyce and others IPO, citing market conditions. TPG has
yet to make any announcements about
learned how corporations work.
As for Boyce, he staffs his ops team with a second try.
At J. Crew, TPG's first ride was operapeople such as Deb Conklin, an industrial engineer who ran a division at Stanley tions-heavy. TPG installed Mickey Drexler
Works. At Houston's Valerus Compres- as CEO and rapidly built the then-catalog
sion Services, which makes equipment for company into a retail chain that also had
the natural gas industry, Conklin tromps a significant presence on the Web. The
around the company's facility near Bay first J. Crew deal worked magnificently by
| City, Tex., in steel-toed work boots and top- and bottom-line measures: TPG and
a hard hat, one of the many get-ups she its investors made more than six times
has worn as part of the field operations their money after J. Crew went public.
unit. She walks through the plant shaking
hands like a politician, noting how one op- TPG's acquisition of TXU marked the
erational tweak was inspired by the way peak of the private equity boom. Anweights are stacked in a gym.
nounced in February 2007, the $43.2 bilDuring four years at TPG, Conklin, lion acquisition, made alongside KKR,
40, has also been a casino hostess and of the biggest power producer in Texas
housekeeper at Caesars while serving as broke a still-fresh record set by Blackthe gaming company's vice-president for stone's $34.1 billion purchase of Equity
continuous improvement. She currently Office Properties a month before. For
spends most weeks in San Diego at LPL investors, TXU may stand as a test of
Financial, a brokerage firm TPG also private equity's, and TPG's, ability to
owns. "People like me are bored doing make returns on massive deals. It was
also a chance for Bonderman to push his
the same thing every day," she says.
While Apollo and TPG were renovat- green agenda-he is a board member of
ing Caesars's capital structure-cutting the the World Wildlife Fund-and TXU andebt by about $5 billion through a series nounced soon after that it would set
of exchanges and balance-sheet restruc- about cutting its number of coal plants
turings-Conklin was embedded in the from 11 to three.
company. She spent more than a year at
TPG is still coping with other vestiges
Caesars, visiting almost every property, of the buyout boom, including positions
looking for ways to apply her specialty, in Univision and Freescale Semiconduclean manufacturing methods, to a service tor. The former chip unit of Motorola,
business. To that end, Conklin tracked the Freescale has undergone an overhaul
movements of a short-order cook, creat- that brought it from the brink of failure
ing a "spaghetti chart" illustrating every to an expected IPO this year.
movement during an eight-hour shift; in
While the operations department has
that time the cook traveled more than played a crucial role in reversing the forthree miles. TPG analyzed the data and tunes of Caesars, TXU falls into the stockthen interviewed the cook, tools in hand. pickers box, a bet on energy prices and
company can be averse to sudden large
expansions, which can destroy reported earnings. Privately owned companies
face less quarterly pressure.
"We used to come in and do cost work.
And if you did that, you had a pretty good
exit," says Boyce, an "exit" being the industry term for selling out of a position.
"One evolution is that we know we have
to be more holistic. If you believe in a
challenging economy, you realize you
can't cost-reduce your way to glory."

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the economy, which may explain some of

the results. The outlook for the company,
while better than it was two years ago,
when talk of default loomed, is middling
at best. KKR and TPG each value the company at about 20 on the dollar. The major
concern is TXU's debt, totaling more than
$40 billion, according to Bloomberg data.
A decline in natural gas prices last year
sent the bonds tumbling, deepening concerns that it would be able to service the
debt. Moody's Investors Service says the
utility faces a "very weak financial profile,
untenable capital structure, questionable
long-term business plan, and material operating headwinds."
"For the 2006- and 2007-vintage deals,
you're playing defense with ops," Coulter
says. "The surprise to many people is that
those companies didn't crash. These companies have done much better than the
prognosticators expected." TPG believes
TXU, now Energy Future, will make it and
make money. It'll just take longer than the
firm originally expected.
Months later, in mid-January, the snow is
piling up in midtown Manhattan as TPG
partners gather from around the world
for their annual meeting. This go-round
is held at the Mandarin Oriental Hotel
at a corner of Central Park. The 54 partners, whose interaction throughout the
rest of the year is mostly limited to videoconferences, phone calls, and e-mails,
convene on the 36th floor of the hotel
for two days of sessions and updates. The
J. Crew deal remains on track, even as the
company seeks to settle lawsuits brought
by shareholders over the deal. A special
meeting of stockholders is scheduled for
March to vote on the transaction.
The meeting happens in the conference rooms at the top of a sweeping staircase that leads up from the lobby. A guard
stands by a velvet rope, and Bloomberg
Businessweek is allowed to pass.
Coulter emerges from a room and
notes that the tone of the partners' meeting is the most optimistic in years and a
marked change from even a year earlier.
Then, the partners decided to be aggressive even in the face of broader fears about
a double-dip recession. Now, Coulter says
he's exhorting them to get stuff done. "A
year ago, the financial market was still all
about fighting fires," he says. "The main
theme this year is that this is our type
of economy. We're telling our guys to
ignore the industry noise, focus on creating value, and 'Just go do it.'" With that,
Coulter slips back into the general meeting, behind closed doors.

Journal of Economic PerspectivesVolume 21, Number 2Spring 2007Pages

175-194

Hedge Funds: Past, Present, and Future

Ren M. harStulz

Hedge funds often make headlines because of spectacular losses or spectacular gains. In September 2006, a large hedge fund, Amaranth, reported losses of more than $6 billion apparently incurred in only one
month, representing a negative return over that m o n t h of roughly 66 percent.
Earlier in the year, newspapers focused on the $1.4 billion compensation in 2005
of hedge fund manager Boone Pickens and the 650 percent return that year of his
BP Capital Commodity Fund (Anderson, 2006b). The importance of hedge funds
in the daily life of financial markets does not make the same headlines, but hedge
funds now account for close to half the trading on the New York and London stock
exchanges (Anderson, 2006a).

Chances are that you personally cannot invest in a hedge fund. Most U.S.
investors cannot. Hedge funds are mostly unregulated. These funds can only issue
securities privately. Their investors have to be individuals or institutions who meet
requirements set out by the Securities and Exchange Commission, ensuring that
the investors are knowledgeable and can bear a significant loss. Most likely, however, you personally can invest in mutual funds, which are heavily regulated in how
they can invest their funds, how their managers can be paid, how they are governed,
how they can charge investors for their services, and so on. The typical mutual fund
cannot make the investments that provide the performance of Amaranth or the BP
Capital Commodity Fund.
The economic function of a hedge fund is exactly the same as the function of
a mutual fund. In both cases, fund managers are entrusted with money from
Rene M. Stulz, is the Everett D. Reese Chair of Banking and Monetary Economics, The Ohio
State University, Columbus, Ohio. He is also a Research Associate of the National Bureau of
Economic Research, Cambridge, Massachusetts, and a Fellow of the European Corporate
Governance Institute, Brussels, Belgium. His e-mail address is (Stulz@cob.osu.edu).

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investors who hope that they will receive back their initial investment, plus a healthy
return. Mutual funds are divided into two types. Some funds are indexed funds
(also known as "passive" funds). With these funds, the managers attempt to produce a return which tracks the return of a benchmark index, like the Standard &
Poor's 500. However, most mutual funds and all hedge funds are active funds.
Investors in such funds hope that the manager has skills that will deliver a return
substantially better than passive funds.
Hedge funds have existed for a long time. It is generally believed that Alfred
W. Jones, who was a writer for Forbes and had a Ph.D. in sociology, started the first
hedge fund in 1949, which he ran- into the early 1970s. He raised $60,000 and
invested $40,000 of his own money to pursue a strategy of investing in common
stocks and hedging the positions with short sales. 1 From these modest beginnings,
especially since the turn of the century, the assets u n d e r management of hedge
funds have exploded. At the end of 1993, assets under management of hedge funds
were less than 4 percent of the assets managed by mutual funds; by 2005, this
percentage had grown to more than 10 percent. In 1990, less than $50 billion was
invested in hedge funds; in 2006, more than $1 trillion was invested in hedge
funds. 2
Since hedge funds and mutual funds essentially perform the same economic
function, why do they coexist? Hedge funds exist because mutual funds do n o t
deliver complex investment strategies. Part of the reason mutual funds do not is
that they are regulated. In addition, mutual funds and other institutional investors
can gather a lot of funds from investors by promoting simple strategies. Mass selling
of hedge fund strategies is much harder because hedge fund strategies are too
complex for the typical mutual fund investor to understand. It is therefore not
surprising that the largest mutual funds dwarf in size the largest hedge funds. At the
end of 2006, the largest mutual fund, the Growth Fund of America from American
Funds, had assets u n d e r management of $161 billion and the largest mutual fund
companies managed more than $1 trillion. In contrast, w i t h a few exceptions, the
largest hedge funds managed less than $10 billion. Goldman Sachs managed close
to $30 billion in hedge funds and was apparendy the largest hedge fund manager.
Can hedge funds and mutual funds coexist in the long-run? Will regulators or
market forces make these two vehicles more similar? I will argue that the bulk of the
hedge fund industry will experience some convergence towards the traditional
mutual fund model. First, the prospects for greater regulation of hedge funds,

1
A hedge is a position designed to reduce a risk one is exposed to. To sell a stock short, an investor
borrows the stock and sells it. The investor closes the short sale when he buys the stock back and returns
it to the lender. The investor profits from the short sale if the stock falls in value. If stocks fall in value
and an investor has a hedge of short stock positions, the short positions are expected to gain in value
and to some extent offset the loss of the stocks held in the portfolio.
2
A well-established data, provider on hedge funds, Hedge Fund Research (HFR), estimates assets under
management at $973 billion at the end of 2004 and reported strong increases in assets under management subsequently. However, larger estimates existup to the estimate of $2.17 trillion of assets under
management for 2005 from a survey by Hedgefundmanager and Advent

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177

which will make them more similar to mutual funds, are very real. Second, as hedge
funds acquire more institutional investors, the discretion of hedge fund managers
will decline to satisfy the fiduciary responsibility of institutional investors. As hedge
fund managers become more constrained, they will find it harder to post great
performance. Finally, as hedge fund assets u n d e r management keep growing, some
strategies will become unprofitablewhich has already occurred.
To understand how hedge funds can be expected to evolve, we start by
examining how hedge funds are organized. We then review their evolution. A
critical issue is whether hedge funds perform better than mutual funds. We discuss
why that question is difficult to answer. We then discuss the risks posed by hedge
funds to financial institutions and the broader economy and the extent to which
these risks should be a source of concern. We conclude by summarizing the
implications of our analysis for the future of hedge funds.

What Are Hedge Funds and How Are They Organized?

Hedge funds are unregulated pools of money managed by an investment
advisor, the hedge fund manager, who has a great deal of flexibility. In particular,
hedge fund managers typically have the right to have short positions, to borrow,
and to make extensive use of derivatives (from plain vanilla options to very exotic
instruments). To avoid the regulations that affect mutual funds u n d e r the Investment Company Act, hedge funds must limit the n u m b e r of investors who can invest
and they cannot make public offerings. To bypass registration u n d e r the Securities
Act of 1933, a hedge fund is restricted to having only "accredited investors consisting of institutional investors, companies, or high net w o r t h individuals who can
'fend for themselves"' (Eichengreen et a l , 1998). In contrast, mutual funds generally do not have short positions, do not borrow, and make limited use of
derivatives (Koski and Pontiff, 1999).
A hedge fund is typically a collection of funds managed by the hedge fund
managernormally through a separately organized company, the m a n a g e m e n t
company. It is a collection of funds because the tax status of investors differs and
each fund is designed to optimize taxes for investors. A typical large hedge fund
with a U.S.-based management company will have an offshore fund for foreign
investors and an onshore fund for U.S. investors. The onshore fund is generally a
limited partnership if investors are taxed, so that gains and losses flow through to
investors and there is no taxation at the fund level. The offshore fund is usually
based in a tax haven, such as Bermuda. A common structure is to have the onshore
fund and the offshore fund invest in a so-called master fund. The onshore and
offshore funds are then called feeder funds.
In the United States, investment advisors with less than 15 clients do not have
to register with the Securities and Exchange Commission u n d e r the Investment
Advisers Act of 1940. The m a n a g e m e n t company in the case of a hedge fund has
few clientsonly the funds it manages. Consequendy, the management company

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does not have to register with the SEC u n d e r the traditional interpretation of
"clients." In 2005, the SEC attempted to change this interpretation by making the
hedge fund investors the "clients" of the management company, so that hedge fund
management companies would have had to register with the SEC. The courts struck
down this interpretation. Many management companies register anyway, perhaps
because they believe that registration gives them credibility. Further, hedge funds
in which U.S. pension funds invest must have registered management companies.
The incentives of hedge fund managers differ sharply from those of mutual
fund managers. The compensation contract for mutual fund advisers is restricted
by regulation so that the incentive compensation, if there is any, has to be symmetricessentially, a dollar of gain has to have the opposite impact on compensation as a dollar of loss. As a result, relatively few mutual fund advisers have an
incentive compensation clause in their contracts, and the compensation of mutual
fund managers depends mostly on the amount of assets u n d e r management (Elton,
Gruber, and Blake, 2003). One of the most famous mutual funds is Fidelity's
Magellan fund. The compensation to Fidelity for managing the fund is a fixed fee
(0.57 percent for the year ending March 2006) plus an adjustment depending on
how the fund performs relative to the Standard &: Poor's 500 of up to minus or plus
0.20 percent of assets u n d e r management.
In contrast, almost all hedge fund managers have an asymmetric compensation
contract that specifies that they receive a substantial fraction of the profits they
generate (Ackermann, McEnally, and Ravenscraft, 1999). Alfred Jones reorganized
his fund in 1952 as a limited partnership and instituted the rule that the general or
managing partner would keep 20 percent of the profits generated by the fund.
Typically, hedge fund managers receive a fixed compensation corresponding to
1-2 percent of the net asset value of the fund (or of the limited partners' equity)
and 1525 percent of the return of the fund above a hurdle rate (which can be the
risk-free rate).
The typical compensation contract of a hedge fund manager makes extremely
high compensation possible if the investors experience large returns. In 2005, at
least two managers had compensation in excess of $1 billion: James Simons of
Renaissance Technologies earned $1.5 billion and Boone Pickens, as mentioned
earlier, earned $1.4 billion (Schurr, 2006). The 2005 Hedge Fund Compensation
Report states that "the average take-home pay of the top 25 hedge fund earners in
2004 was over $250 million."
Generally, the compensation of hedge fund managers has a so-called "high
water" markif the managers make a loss in one period, they can get the performance fee only after they have recovered that loss. The high water mark limits the
risk taking of the fund. Without it, the manager gets all the upside from big bets but
suffers little from the downside. With a high water mark, though, the manager may
just close the fund if it makes a big loss. As long as the fund manager does not have
a large investment in the fund, it is not always easy to resist the temptation to take
large risks. As an example, the trader apparently responsible for the large losses at
Amaranth in 2006 is reported to have earned between $80 million and $100 million

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179

there in 2005. As long as no illegal actions took place, the trader will not have to
return his past compensation to the fundin fact, he is planning to start a hedge
fund of his own.
Investors in mutual funds typically can withdraw funds daily. Thus, mutual
funds must have some low-earning cash on hand. It is risky for mutual funds to
invest in strategies that may take time to prove profitable, because adverse developments in the short run may lead investors to withdraw their money. Hedge funds
have rules that restrict the ability of investors to withdraw funds; for instance, a
hedge fund might allow investors to withdraw at the end of a quarter provided that
they give a 30-day notice. Depending on the fund, an investor may not be allowed
to withdraw an initial investment before a period of several years. Eton Park Capital,
a fund l a u n c h e d in 2004 by a star Goldman Sachs trader, Eric Mindich, raised
$3 billion even though investors had to commit to keep their money in the fund for
at least three years.
Mutual funds have to disclose a lot of information to investors. They have to
report their holdings to the Securities and Exchanges Commission (SEC) and must
have audited statements. 3 Hedge funds may agree contractually to disclose some
types of information and to provide audited financial statements, if they decide that
it helps them to recruit investors, but they are not required to do so. For instance,
referring to the Long Term Capital Fund (often referred to as LTCM, which stands
for Long-Term Capital Management, the company which managed the fund).
Lowenstein (2001, p. 32) states: "Long Term even refused to give examples of
trades, so potential investors had little idea of what they were doing." The Long
T e r m Capital F u n d , f o u n d e d in 1994, was spectacularly successful until the
middle of 1998 (in 1995-1997, the fund's average yearly r e t u r n n e t of fees was
33.4 percent). Its managing partners were star traders and academics. It had capital
of $4.8 billion and assets of $120 billion at the beginning of 1998. In the aftermath
of the Russian crisis in August 1998, the fund lost almost all its capital in one
month. Secrecy does help hedge fund managers protect their strategies from
potential imitators; on the other hand, secrecy makes it harder to assess the risk of
a fund.
In the past, investors typically invested in individual hedge funds. Investors who
want to invest in a hedge fund usually have to commit a large amount of money
often at least $1 million ($5 million in the case of the Eton Park fund mentioned
earlier). Since individual hedge funds can be highly risky, diversification can
reduce risk, but diversification across hedge funds for a single investor requires a
very large amount of investable wealth. Further, because hedge funds are unregulated, an investor has to investigate a hedge fund thoroughly before investing in it.
It is quite expensive for funds that are not well-established$50,000 is a frequently

3
Since 1978, all institutions with over $100 million must report stock holdings in excess of $200,000 or
holdings of more than 10,000 shares. Hedge funds are not exempt from this requirement. The
requirement does not apply to derivatives and short positions. Further, institutions can ask that their
positions be kept confidential for one year and hedge funds have been known to do so aggressively.

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heard price tag for due diligence for an investor who ends up investing in the
fund.4 The process starts with the investor asking questions to the fund manager.
Some questions might be answered; some might not. A personal visit might follow-.
The investor will also check through other means whether the manager is reliable.
In some cases, investors hire an investigative firm (BusinessWeek Online, 2005).
Many investors now invest in funds-of-hedge-funds, rather than in individual
hedge funds. A fund-of-funds is a hedge fund that invests in individual hedge funds
and monitors these investments, thereby providing investors a diversified portfolio
of hedge funds, risk management services, and a way to share the due diligence
costs with other investors. The compensation of fund-of-funds managers also has a
fixed fee (typically 1 percent) and a performance fee (typically 10 percent above a
hurdle rate). At the end of 2004, 30 percent or more of funds invested in hedge
funds were managed by funds-of-funds (Fung, Hsieh, Naik, and Ramadorai, 2007).

What Do Hedge Funds Do?

Arbitrage takes advantage of price discrepancies between securities without
taking any risk. Most hedge funds attempt to find trades that are almost arbitrage
opportunitiespricing mistakes in the markets that can produce low-risk profits.
Once hedge funds have identified an asset that is mispriced, they devise hedges for
their position so that the fund will benefit from the correction of the mispricing but
be affected by littie else. To take an example, Long-Term Capital Management
specialized in identifying bonds that were mispriced. It would sell overvalued bonds
short and hedge its position against interest rate risk and, if necessary, other risks.
In principle, the return of the fund would depend only on the corrections in the
mispricing of the bonds, not on changes in interest rates. Of course, not all
positions hedge funds take are hedged, either because of high costs or because of
intrinsic difficulties in hedging against some risks.
Because hedge funds seek inefficiencies in the capital markets and attempt to
correct them, they can play a valuable role in financial markets by bringing security
prices closer to fundamental values. However, litde direct evidence exists on the
extent to which hedge funds have this effect. Several hedge funds are known to
account individually for several percent of the trading volume of the New York
Stock Exchange. Some funds have also been accused of making money in questionable ways: for instance, by exploiting insider information or by late trading in
mutual funds.
Mutual funds cannot contribute to making financial markets more efficient as
effectively as hedge funds can: mutual funds are limited in their ability to hedge
their positions through short-sales and derivatives use; they are subject to diversification restrictions that constrain their ability to exploit perceived opportunities;
4

Due diligence in this context, is an investigation or audit of the hedge fund to establish that the hedge
fund is what it represents itself to be and that the risks of investing in the fund are properly understood.

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Stulz

181

and they must redeem shares on short notice. In contrast, derivatives and short
positions are critical in most hedge fund strategies and enable hedge funds to
reduce mispricings more forcefully than mutual funds. For instance, if a mutual
fund manager concludes that firm A is valued too richly compared to firm B which
is in the same business, mat manager will typically buy more of firm B and less of
firm A. In contrast, a hedge fund manager would react to a belief that firm A is
overvalued compared to firm B by buying firm B and selling firm A short. With this
strategy, the hedge fund portfolio will not be affected by changes in the market as
a wholeor even in the industry. If the stock market drops sharply, the mutual
fund would lose, but the hedge fund would not. Until 1997, the tax code made
short sales extremely expensive for mutual funds, but it no longer does. As a result,
the binding short-sale restriction for mutual funds is a restriction mat funds p u t on
themselves-in 2000, two-thirds of reporting mutual funds prohibited short sales
(Almazan, Brown, Carlson, and Chapman, 2004).
With their focus on arbitrage opportunities, hedge funds in principle pursue
absolute returns rather than returns in excess of a benchmark, such as an index of
the stock or bond markets. In principle, this approach tends to make hedge funds
market-neutral over time: that is, hedge funds are expected to have average
performance whether equity markets have extremely good or bad performance. It
is therefore not surprising that hedge funds performed well when U.S. equity
markets registered sharp losses in the wake of the collapse of Internet stocks. Many
investors tend to extrapolate from past returns (see Barberis and Shleifer, 2003, for
possible reasons and implications), so it is not surprising that investors were
attracted to hedge funds when they performed so well compared to stocks. Also,
hedge funds appear an attractive diversification vehicle for investors who hold
stocks. However, correlations of hedge funds with the broad markets have increased, so that evaluating the diversification benefits of hedge funds has become
trickier (Garbaravicius andD i e r i c k ,2005). Some hedge funds may have effectively
become mutual funds; that is, an investor in such a fund is paying hedge fund fees
for mutual fund risks and returns.
Investment in a hedge fund is a bet on the skills of the manager to identify
profit opportunities. A managers' strategy may be complex and difficult to communicate. In addition, the manager has incentives not to communicate too m u c h
otherwise investors might not need the manager. Further, it is possible for a strategy
to make losses before it eventually pays off. Viewed from this perspective, it is easier
for professional investors than for others to evaluate hedge fund strategies and the
skill of managers. Such investors are less likely to misinterpret short-term losses as
evidence of poor skills on the part of the manager. When investors do not
understand these strategies, they may withdraw their funds when they make losses
and force managers to liquidate their positions at a loss (Shleifer and Vishny, 1997).
Therefore, hedge funds will seek b o t h restrictions on redemptions and investors
who are knowledgeable. It is not unusual for a hedge fund to reject potential
investors, which would be unheard of for a mutual fund.
Hedge fund investment strategies are classified into style categories. O n e way

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to measure the popularity of the styles is to measure the funds u n d e r management

for a style relative to the sum of the funds under management. According to the
T r e m o n t Asset Flows R e p o r t (Second Quarter, 2005), the four most p o p u l a r
styles and their strategies are: long-short equity (31 percent of total); event-driven
(20 percent); macro (10 percent); and fixed-income arbitrage (8 percent).
A long-short equity hedge fund takes both long and short positions in stocks. The
fund started by Alfred Jones was a long-short fund. These funds tend to hedge their
positions against market risks. For example, a hedge fund of this type might have
only long positions in stocks but use options and futures contracts so that fund
returns will be unaffected by changes in the market as a whole. A typical strategy is
to identify undervalued and overvalued stocks.
Event-driven hedge fund strategies attempt to take advantage of opportunities
created by significant transactional events, such as spin-offs, mergers and acquisitions, reorganizations, bankruptcies, and other extraordinary corporate transactions. Event-driven trading attempts to predict the outcome of a particular transaction as well as the optimal time at which to commit capital to it.
Macro hedge fund strategies attempt to identify mispriced valuations in stock
markets, interest rates, foreign exchange rates, and physical commodities and make
leveraged bets on the anticipated price movements in these markets. To identify
mispricing, managers tend to use a top-down global approach that concentrates on
forecasting how global macroeconomic and political events affect the valuations of
financial instruments.
Fixed-income arbitrage hedge funds attempt to find arbitrage opportunities in the
fixed-income markets.
Another 13 percent of the a m o u n t invested in hedge funds is invested in
multi-strategy funds. Other strategies involve emerging markets funds, funds that
trade futures contracts, and convertible arbitrage funds (convertible debt is debt
convertible into stock and these funds exploit mispricings in the debt relative to the
stock).
The arbitrage opportunities identified by hedge funds are often small. As a
partner of Long-Term Capital Management put it before the fund collapsed, their
strategies amounted to vacuuming penniesthough others have described hedge
fund strategies as picking up pennies in front of a steamroller. Many hedge funds
use leverage, both to take advantage of more investment opportunities and to
increase the return on the funds invested. To illustrate, if a hedge fund starts with
equity of $100 million invested in a strategy that earns $5 million, its return on
equity is 5 percent. However, if the fund borrows an additional $300 million to take
advantage of three similar strategies and the cost of borrowing is $2 million per
$100 million, its return on equity becomes 14 percent on the original $100 million
invested (the income becomes $14 million, or $5 million + 3 x $3 million). The
LTCM fund had an extremely high degree of leveragemore than $20 of assets
were supported by a dollar of equity capital. The typical hedge fund has much lower
leveragea dollar of equity supports two or three dollars of assets. Mutual funds do
not have the same ability to use leverage without restrictions.

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183

The Growth, Risk, and Performance of Hedge Funds

How does the performance of hedge funds compare to the performance of
mutual funds? A widely used index of the hedge fund industry is the Credit
Suisse/Tremont Hedge Fund index. This value-weighted index begins in January
1994. As Figure 1 shows, an investor in the hedge fund index in January 1994, who
held that investment until the middle of 2006, would have earned 259 percent (net
of all performance fees and expenses), or an average annual return of 10.8 percent.
Since actively managed stock mutual funds as a group do not perform better than
the stock market after fees, hedge funds beat the actively managed stock mutual
funds if they beat the stock market as a whole. A hypothetical investor who would
have invested in the Standard & Poor's 500 would have earned 241 percent for an
annual return of 10.3 percent. An investor invested in the Financial Times World
Index, which captures the performance of stocks across the world, would have
earned less. If the hedge fund index had exactiy the same risk as the S&P 500 index,
the two investments would have similar risk-adjusted performance. However, if risk
is measured by volatility, the hedge fund index is much less volatile than the S&P
500the annualized standard deviation of the hedge fund index is 7.8 percent
versus 14.5 percent for the S&P 500. Per unit of volatility, an investor who could
have invested in the hedge fund index would have done about twice as well as an
investor who invested in the S&P 500.
As Figure 1 shows, the hedge fund index lagged the S&P 500 index from 1994

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until 2000 and then outperformed it. The spectacular growth of the hedge fund
industry took place mostly after 2000. At the end of 2000, $218 billion was invested
in hedge funds (Tremont Asset Flows Report, Second Quarter, 2005). By J u n e
2005, assets u n d e r management were $735 billion. Other industry reports have the
assets u n d e r management exceeding $1 trillion in 2005. During that period of time,
mutual fund assets grew much lessfrom close to $7 trillion at the end of 2000 to
about $8.5 trillion at the end of 2005 (Investment Company Institute, 2005).
However, investing in a hedge fund index from 1994 to 2006 would have been
very difficult. Index funds of the hedge fund universe do not exist Investors can
only put their money in individual hedge funds or in funds-of-funds. Investing in a
portfolio that replicates the Standard & Poor's 500 over that period would have
been straightforward; for instance, Vanguard has offered an S&P 500 index fund
since 1976.
Since investors cannot invest in an index of the hedge fund universe, it is
critical to focus on the performance of individual funds. Do individual hedge funds
beat the market? Do they outperform mutual funds? The academic literature on
hedge funds is young: the first paper, Fung and Hsieh (1997), was published only
ten years ago. After reviewing the four main reasons why it has proven difficult to
answer these questions, I will offer a conclusion.
First, reports of hedge fund performance are based on biased samples. Since
hedge funds are not regulated, they need not disclose their performance. Databases only report the performance of hedge funds that voluntarily send their
returns to the sponsoring organizations. A hedge fund might n o t report its performance for a n u m b e r of reasons: It might be closed to investors, so that it would not
benefit from advertising its performance. It might have forgotten to send in the
form. Or its performance might have been poor. Indeed, for a n u m b e r of years,
some databases dropped the returns of liquidated funds, so that funds with poor
performance disappeared from the database. The range of estimates of these biases
is wide, from less than 100 basis points (1 percent) per year (Ackerman, McEnally,
and Ravenscraft, 1999) to more than 400 basis points (4 percent) at the high end
(Malkiel and Saha, 2005).
Second, a fair estimate of hedge fund returns will need to adjust performance for
market exposure. Suppose you found that a hedge fund's performance mimics the
performance of the Standard 8c Poor's 500 index in both returns and volatility. In
this case, the hedge fund manager did not add value, because you could have
achieved a better net return by investing in an indexed fund which has dramatically
lower fees than a hedge fund. Because hedge funds can go long an d short, can use
derivatives, and can borrow, their exposure to market risks can vary' tremendously
over a short period of time, which makes it difficult to assess these exposures based
on a limited sample of monthly returns. In addition, techniques that work well to
assess risk exposures for mutual funds do not work so well when applied to hedge
funds. An equity mutual fund's return is typically best viewed as the return of a
basket of stocks, plus some component that is unique to the fund. A hedge fund's
return, in contrast, is best viewed as a basket of derivativesand often rather exotic

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derivatives with nonlinear payoffs (for discussion and references, see Fung, Hsieh,
Naik, and Ramadorai, 2007). For instance, a fund might not be exposed to interest
rates when they are low but might be when they are high.
A third difficulty in assessing hedge fund returns is that the past performance
of a particular hedge fund may give a very selective view of its risk. Hedge funds may
have strategies that yield payoffs similar to those of a company selling earthquake insurance, that is, most of the time the insurance company makes no payouts and has a
nice profit, but from time to time disaster strikes and the insurance company makes
large losses that may exceed its cumulative profits from good times. Investors who
usually focus on volatility may conclude that the fund has low risk because they look
at returns before a disaster occurs. The example shows why volatility is a poor
measure of individual hedge fund risk: the hedge fund would appear to have low
volatility compared to a mutual fund, but it also has a much higher probability of
losing all its assets.
The fourth difficulty in calculating hedge fund returns involves problems of
valuation. A mutual fund invested in U.S. stocks can compute the daily value of its
portfolio by using the closing prices of the stocks. In contrast, hedge funds often
hold securities that are not traded on exchanges. For instance, many derivatives are
traded over-the-counter. For securities not traded on an exchange, no closing price
exists. A hedge fund may need to rely on theoretical models to estimate the value
of some securities, or rely on quoted prices rather than actual transaction prices. In
an efficient market, one would not expect the return of a fund during one m o n t h
to have information for the return of the fund over the next month. In general,
mutual fund returns are not serially correlatedbut hedge fund returns are. There
can be valid reasons for hedge fund returns to be serially correlated, but one reason
that such serial correlation can arise is when hedge fund managers use the
flexibility that they have in valuing the securities to massage returns and present a
picture of low risk and consistent performance (Getmansky, Lo, and Makarov,
2004). It is also somewhat disturbing that Santa Claus is so kind to hedge funds
the average monthly return of hedge funds in December is more than twice what
it is for the rest of the year (Agarwal, Daniel, and Naik, 2006).
With these four problems, the performance of hedge fund managers is sure to
be controversial. A common way to evaluate hedge fund investment strategies is to
estimate the "alpha" of the strategy, which is the performance of the strategy that
cannot be explained by beta risk. Beta risk is the risk arising from exposure to
common market movementsin other words, beta risk is a measure of market risk
exposure. T h e skill of a hedge fund manager is required to produce alpha returns,
but not to take beta risk. For instance, a fund that moves on average one for one
with the stock market has a beta of one with respect to the stock market. It should
compensate investors for risk by earning at least the same return as the stock
market. If a fund has an annualized alpha of 5 percent, this means that the fund
earns 5 percent more than the risk-free rate after taking into account the compensation earned through the fund for taking beta risk. Another way to see this is the
following. Suppose that a fund invests all its money in the Standard 8c Poor's 500.

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The alpha before fees of such a hedge fund would be zero, because investors would
earn exactly the compensation for bearing the beta risk of the S&P 500. After fees,
the alpha of such a fund could be substantially lower. If a hedge fund net of fees
outperforms the S&P 500 by 2 percent, but has exactly the same beta risk as an
investment in the S&P 500, it has an alpha of 2 percent for the investor.
The bottom line of hedge fund research is that, at the very least, hedge funds
have a nonnegative alpha net of fees on average. To phrase this conclusion another
way, hedge fund managers earn at least their compensation on average. The debate
in the literature centers on two points: the size of the average alpha and the
persistence of the alpha of individual funds. If alphas are persistent, then it
becomes possible to form portfolios of hedge funds that are expected to have
positive alphas according to their past returns.
Ibbotson and Chen (2005) examine the performance of hedge funds from
January 1999 to March 2004. Their study uses 3,538 funds. After adjusting for
various sample biases, they conclude that the equally-weighted compound average
return of hedge funds is 9.1 percent after fees. T h e average return before fees is
12.8 percent, so that on average investors pay fees of 3.7 percent per year. T h e
net-of-fee return is divided into two components. The first component is the return
earned for exposure to broad markets"beta risk." They find that exposure to
broad market indexes accounts for a return of 5.4 p e r c e n t The return net of fees
of 9.1 p e r c e n t minus the r e t u r n attributable to exposure to market indexes of
5.4 percent equals the average alpha of the funds of 3.7 p e r c e n t This estimated
alpha of hedge funds is particularly impressive when compared with the alpha of
equity mutual funds. Malkiel (1995) estimates the alpha of all equity mutual funds
with continuous data from 1982 to 1991. H e finds that these equity mutual funds
significantly underperformed the Standard 8c Poor's 500 index with a statistically
significant alpha of -3.20 p e r c e n t None of these mutual funds had a significant
positive alpha.
A study by Kosowski, Naik, and Teo (forthcoming) using an extremely large
database concludes that the average alpha across hedge funds from 1994 to 2002 is
0.42 percent per m o n t h after adjusting for the problems in evaluating hedge funds
we discussed. However, the alpha in this study is not statistically significant The
study finds that the funds in the top performance bracket have an average alpha,
depending on the approach used, of between 1 and 1.25 percent per montii; and
this alpha is highly significant.
Fung, Hsieh, Naik, and Ramadorai (2007) investigate the performance of
funds-of-funds. The authors argue that the data is much better for funds-of-funds
than it is for individual hedge funds and does not suffer seriously from the
problems discussed earlier. They consider three separate periods: January 1995 to
September 1998; October 1998 to March 2000; and April 2000 to December 2004.
They find that the average fund-of-funds has a significant positive alpha during the
second period they consider, but the alpha is insignificant in the other two periods.
The study also distinguishes between two different groups of funds-of-funds.
Roughly 20 percent of funds have managers with valuable skills as evidenced by

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their positive and significant alpha; the other managers do not have a positive,
significant alpha.
We now turn to the issue of whether the performance of hedge fund managers
persists. Jagannathan, Malakhov, and Novikov (2006) use a large database of hedge
funds and account carefully for the various problems in estimating hedge fund
performance. The study concludes that about half of the performance of hedge
funds over a three-year period spills over to the next three-year period. Thus, if a
fund has an alpha of 2 percent during a three-year period, it can be expected to
have an alpha of 1 percent during the next three-year period. This paper therefore
suggests that investing in high alpha funds is profitable.
The academic bottom line on hedge fund performance is captured well by
these stuthes. If one picks randomly a hedge fund, it should be expected to have a
positive but statistically insignificant alpha after fees. Such performance appears
better than the performance of a randomly selected mutual fund. Being able to
pick good hedge funds can therefore be highly rewarding. Some evidence suggests
that past history helps to pick good hedge funds. However, remember that it is
much harder to evaluate the performance of hedge funds than to evaluate the
performance of mutual funds. A hedge fund that implements a strategy akin to
selling earthquake insurance and whose risk is n o t captured well by commonly used
risk factors will have a significant positive alphauntil the quake hits.
Mutual funds are rarely closed to investors. However, an investor may not be
able to invest in a winning hedge fund because the manager rejects the investor.
One very successful hedge fund manager told me that he did not want individuals
as investors because they require too much hand-holding when things go poorly.

Do Hedge Funds Pose Significant Risks for the Economy?

Many hedge funds appear at first glance to have low return volatility compared
to an investment in the stock market. For instance, from February 1994 to August
2004, the average annualized standard deviation of the monthly returns of fixedincome arbitrage hedge funds was 7.76 percent, or slighdy more than half the
standard deviation of the Standard & Poor's 500 return over the 1994-2005 period
(Chan, Getmansky, Haas, and Lo, 2006). However, even funds with a history of low
volatility can end up losing most of their money, an outcome that is almost
inconceivable for a mutual fund. The Long T e r m Capital Fund had lower volatility
than the S&P 500 for almost all its existence, but this low volatility did not prevent
it from losing most of its capital in the span of a month.
Regulators are concerned about the risks of hedge funds for at least four
reasons: investor protection, risks to financial institutions, liquidity risks, and excess
volatility risks. We review and evaluate these reasons in turn.
The Securities and Exchange Commission wanted to force registration of
hedge fund managers because hedge fund collapses had generated large losses for
their investors, arguably indicating a need for greater investor protection. Each year,

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roughly 10 percent of hedge funds the. A fund might the because the investors
withdraw funds following significant losses. Some funds disappear because fraud or
misreporting becomes a p p a r e n t However, aggregate losses from hedge fund fraud
seem relatively small. The SEC brought 51 hedge fund fraud cases from 2000 to
2004. The U.S. Securities and Exchange Commission (2003) estimates the damages
in these cases to amount to $1.1 billion.
Banking regulators are concerned that hedge funds may create risks to financial
institutions. Hedge funds create credit exposures for financial institutions in several
ways: they borrow, they make securities transactions, and they are often counterparties in derivatives trades. Because of leverage, a hedge fund might get in trouble
if its assets experience a sharp drop and the market for these assets lacks liquidity
so that the fund cannot exit its positions. The collapse of a hedge fund could have
far-reaching implications if the fund is large enough. When the Long Term Capital
Fund lost more than $4 billion in August and September 1998, the Federal Reserve
Bank of New York organized a rescue by private banks to avoid possible widespread
damage from a possible disorderly liquidation or bankruptcy of the fund. However,
the debacle at the hedge fund Amaranth in late 2006 had only a trivial impact on
the markets. Nonetheless, the Amaranth losses led to calls for regulation of hedge
funds. For instance, the New York Times (2006) published an editorial stating that
"regulators need to act now to translate their various calls for hedge-fund oversight
into enforceable rules and, in some instances, into concrete proposals for Congress
to enact."
Hedge funds rely on their ability to move out of trades quickly when prices
turn against them, which raises an issue of liquidity risk. If too many funds have set
up the same trades, they may not all be able to exit their positions at the same time.
In that case, two adverse developments can ensue: prices may have to overreact and
liquidity may fall sharply. with low liquidity, hedge funds that rely on trading
quickly to control their risks cannot do so. Hence, such hedge funds become more
risk}', which increases threats to financial institutions and can lead to further
overreaction in prices as financial institutions have to reduce their positions as well.
Further, when hedge funds use leverage, they cannot just ride out a serious adverse
shock; instead, they must reduce their exposures to satisfy the banks from which
they borrowed. As a result, adverse shocks could lead hedge funds to dump
securities and cash out precisely when tilings are going poorly, which could make
matters worse.
Finally, hedge funds could lead prices to overreact by making trades that push
prices away from fundamental values and lead to excess volatility risks. T h o u g h hedge
funds have certainly been accused of creating volatility, the case that they have done
so is far from ironclad. For example, hedge funds were net buyers during the stock
market crash of 1987, so that they helped stabilize markets at that time (Presidential
Task Force on Market Mechanisms, 1998). During the Asian currency crisis of 1997,
the prime minister of Malaysia attacked George Soros for causing the crisis.
However, an IMF study concluded that hedge fund positions were too small to have
much of an impact on emerging markets (Eichengreen et a l , 1998). Earlier, the

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same George Soros had apparently taken a $10 billion bet against the British
p o u n d , which effectively forced the British p o u n d out of the European exchange
rate mechanism, and won $1 billion in the process. There is some evidence that
h e d g e funds did not sell Internet stocks when their valuations were high (Brunnermeier and Nagel, 2004), but the evidence is not completely clear because the
data available does not include various hedges that hedge funds might have used.
How concerned should one be about these four types of risks that hedge funds
supposedly create? Investor protection should not motivate the SEC to regulate the
hedge fund industry, because the small investors who are supposedly the focus of
the SEC are already blocked from investing in hedge funds. There is no reason to
believe that the occasional hedge fund losses of savvy and well-to-do investors,
however painful they may be to these investors, have a social cost. These investors
can choose not to invest in a fund, and they also have legal recourse against acts of
fraud.
T h e risks posed to financial institutions are real, though often overstated.
Brokers and banks have gready improved their systems to evaluate their exposures
to hedge funds in recent years. Derivatives contracts are much better designed for
defaults than they were in the past. Financial institutions are already regulated.
Moreover, a bank that takes on too m u c h risk through a hedge fund could also take
on too much risk with an individual or a proprietary trading desk that employs
hedge fund strategies; in either case, the problem is not specifically a hedge fund
issue, but rather involves the regulation of financial institutions.
Liquidity risk is a serious issue. T h o u g h adverse shocks may force hedge funds
to contract, hedge funds have strong incentives not to be caught in a situation in
which they would have to make distress sales of securities. Empirically, hedge funds
d o not have their worst performance when large shocks affect capital markets
(Boyson, Stahel, and Stulz, 2006). It is not clear how well banks monitor concentration risks in the positions of investment managers they deal withbe they hedge
funds or other investors. Regulators could encourage them to monitor more
actively. There is no reason to believe that regulation of hedge funds would be a
more efficient approach.
T h e fact that hedge funds can cause volatility in prices is a potentially valid
concern, but needs to be based on facts and experience. Hedge funds often profit
by providing liquidity to the marketsby buying securities that are temporarily
depressed because of market disruptions. The role of hedge funds in making
markets more liquid and in reducing market inefficiencies makes it necessary for
those who want to restrict their activities to have a compelling case that their
possible adverse impact on market volatility outweighs their positive effects. So far,
this case has not been made. At the same time, one should not overstate the extent
to which hedge funds make markets efficient. Though hedge funds do well at
eliminating small discrepancies in prices that can be arbitraged, the liquidity they
provide may disappear quickly in the presence of a systemic shockand this
liquidity withdrawal may worsen the shock. Further, if asset prices depart systemi-

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cally from fundamentals, one cannot count on hedge funds to bring them back to
fundamentals.

The Future of Hedge Funds

Over recent years, the hedge fund industry has grown sharply and regulatory
concerns about the industry have increased. In this section, we examine the
implications of these developments for the industry. We e x p e c t 1) the hedge fund
industry as a whole will perform less well over the next ten years than over the last
ten; 2) the hedge fund industry will become more institutionalized; and 3) the
hedge fund industry will become more regulated. These changes will reduce the
gap between mutual funds and hedge funds, but not for all hedge funds. Some
hedge funds will choose their investors and how they organize themselves so that
they will be less affected by the increasing institutionalization and regulation of the
industry.

How Will the Hedge Fund Industry Perform Over the Next Ten Years?
As discussed earlier, Ibbotson and Chen (2005) estimate the average alpha of
the hedge fund industry to be above 3 percent per year. Large funds seem to have
performed somewhat better. As a rough estimate, suppose that the value-weighted
alpha for hedge funds is 4 percent, net of fees. During their sample period, the
yearly average size of the hedge fund industry is $262 billion according to one
consulting firm. Thus, the skills of hedge fund managers were contributing on
average $10 billion a year to investors. The industry is now at least three times
as large. For the p e r f o r m a n c e of hedge funds to generate 4 p e r c e n t net of fees
for investors, the skills of h e d g e fund managers have to p r o d u c e an additional
$20 billion of alpha.
However, as more money enters the hedge fund industry, it either funds
existing strategies, new strategies that typically cannot be as good as the ones
already implemented, or new managers. More hedge funds chasing the same price
discrepancies means that these discrepancies get eliminated faster, leading to
smaller profits for the funds. Hence, additional money entering hedge funds in the
future will typically not find average returns as high as in the p a s t
A clear example of this problem is the recent performance of convertible
arbitrage funds. The typical trade for a convertible arbitrage fund is to buy
convertible bonds issued by a firm and to hedge the purchase with short sales of the
stock of the firm. As more funds buy convertible bonds, the strategy becomes less
profitable because the funds push the price up, so that the performance of this
strategy falls. Not surprisingly, the increase in convertible arbitrage funds, from 26
in 1994 to 145 in 2003 according to one database, eventually led to poor performance and a drop in the n u m b e r of such funds.

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How Will the Organization of Hedge Funds and Mutual Funds Change?
Twenty years ago, most of the money invested in hedge funds came from
individuals, who would largely give the m a n a g e r a free h a n d . In 2003, roughly
40 percent of the money invested in hedge funds came from individuals (U.S.
Securities and Exchange Commission, 2003). This percentage has fallen since. As
a larger fraction of the assets u n d e r management of the hedge fund industry comes
from institutional investorsfrom pensions and endowments directly or from
funds-of-fundsthe rules of the game change.
Investors with fiduciary duties cannot give managers a completely free hand.
Institutional investors have to be able to justify their investments and explain the
outcomes. They fear large losses in individual funds, because they could be criticized for having such funds in their portfolio. As a result, hedge funds have to
provide more information to investors if they want investors with fiduciary duties to
invest in them. Some funds-of-funds require and are able to obtain full transparency from the funds they invest in, therefore they know the securities positions of
those funds, sometimes daily. Providing more information is costly, both because it
requires a larger administrative staff and because the information could be used
against the fund. Hedge funds have to make sure that their largest "drawdown" (the
loss a hedge fund makes before the loss is recovered through performance) is
palatable to their investors. Institutions can even pull money because large current
gains make them worried about future riskone large institutional investor reportedly pulled funds after Amaranth reported large gains early in 2006.
Individual investors often seek returns that are high in absolute terms; institutional investors are more likely to measure performance relative to benchmarks
such as hedge fund indices. As benchmarks become more important, it becomes
less advantageous for a hedge fund manager to take risks that could lead to a
performance that greatly exceeds the benchmark if doing so entails a substantial
risk of falling short of the benchmark. As hedge funds are held to a similar standard
of performance, performance will become more similar across funds. As institutional investors become more important, the manager's skills will matter less
compared to the other services provided to investorsreporting, risk management,
transparency, liquidity, and ability to absorb large new investments. Moreover,
many of these services can be obtained by institutions without paying a large
performance fee to a hedge fund. Perhaps most strikingly, there is increasing
evidence that the performance of hedge fund indices can largely be replicated by
machines (Kat and Palaro, 2006), so that investors who want to achieve a hedge
fund benchmark may have an inexpensive alternative to high-cost hedge fund
managers.
As a hedge fund succeeds, it faces pressure to become essentially a diversified
financial institution. To understand this pressure, consider a successful hedge fund
manager who specialized in one strategy. The manager's net worth is largely
invested in the fund. The manager runs an organization with substantial fixed costs
that has access to large-scale investors and that provides services to these investors.

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To maximize the value of the assets the hedge fund manager has builtreputation,
access to investors, organizationthe manager can expand this organization
through diversification. The hedge fund manager can start new products that rely
on different strategies. The manager can also rely on reputation to sell products
that are more similar to actively managed mutual funds. In this way, the managem e n t company not only becomes more valuable, but it also develops a value that is
i n d e p e n d e n t of the initial hedge.fund strategy employed by the manager. As hedge
fund management companies evolve by expanding their range of products, they
will behave more like financial institutions and less like single-strategy hedge funds.
Mutual funds face obstacles in replicating hedge fund strategies. However,
mutual funds can implement some hedge fund strategies, and some mutual funds
will become more like hedge funds. Over the last ten years, the n u m b e r of mutual
funds that implement hedge fund "lite" strategies has grown substantially. These
funds do not perform as well as hedge funds, but their performance is more similar
to the performance of hedge funds than of plain vanilla mutual funds (Agarwal,
Boyson, and Naik, 2006). Institutional investors who cater to the pension fund
industry and to endowments will also develop more strategies involving short
positions and the use of derivatives that will compete with hedge funds but charge
much lower fees. If investors can get hedge fund strategies by paying mutual fund
fees, the demand for plain vanilla hedge funds will drop.

Will Hedge Funds Become More Regulated?

Both Europe and the United States have experienced substantial pressure for
increased regulation of hedge funds, for a n u m b e r of reasons. We earlier discussed
the systemic risk concerns and the investor protection concerns of regulators. In
addition, mutual funds often lobby for more constraints on hedge funds.
As more money is invested in hedge funds, managers have to branch out in
new strategies, some of which may increase pressure for regulation of hedge funds.
For example, over the last few years, more hedge funds have become activist
investors. In some countries, such activism has led to demands for regulation. Some
hedge funds have also specialized in lending. Again, regulatory authorities are
unlikely to allow unregulated hedge funds to compete with regulated banks.
Recently, much concern has arisen from the fact that hedge funds borrow shares to
vote in corporate control contests without bearing the risks of stock ownership (Hu
and Black, 2006)when a fund borrows shares and holds them to vote, it pays a fee
to the lender, but the lender keeps the price risk of the shares. Regulations may be
enacted to prevent such actions. Finally, we saw that as hedge funds succeed, strong
forces will push them to become more like financial institutions. However, as hedge
fund management companies compete with regulated financial institutions, regulated financial institutions seem certain to express concerns about the lack of a level
playing field.

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Conclusion
We still have much to learn about hedge funds. We are not very good yet at
assessing the risk-adjusted returns and the absolute returns of individual hedge
funds. We have yet to understand fully the risks that hedge funds pose to financial
institutions and to financial markets. T h o u g h we know that hedge funds can make
markets more efficient, no analysis has yet reliably quantified the social costs and
benefits of hedge funds. This being said, hedge funds on average have performed
well over the last 15 years compared to mutual funds or to the stock market as
whole.
Indeed, the hedge fund industry may have played more of a role in creating
liquidity and making markets efficient than the mutual fund industry. The hedge
fund industry could do so because it was generally not regulated, so that funds were
free to take whatever positions they wanted and to make full use of financial
innovations. As the hedge fund industry grows, regulation becomes more likely,
and large hedge funds are likely to become more similar to financial institutions.
However, regulation should leave alone financial innovators who dream of new
strategies and find savvy and well-funded investors to bet on them. without such
financial innovators, capital markets will be less efficient.
I am grateful for comments from Joe Chen, Harry DeAngelo, David Hsieh, Ravi Jagannathan, Andrei Shleifer, Jeremy Stein, Timothy Taylor, and Michael Waldma and for
scientific assistance from Jerome Taillard.

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Ibbotson, Roger G., and Peng Chen. 2005.
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and Costs." Yale ICF [International Center for
Finance] Working Paper 05-17, Yale University,
New Haven, CN.

134
104

Investment Company Institute. 2005. "2005 Investment Company Fact Book." Washington, D.C.
Available a t http://www.ici.org/statements/res/
2005_factbook.pdf.
Jagannathan, Ravi, Alexey Malakbov, and
Dmitry Novikov. 2006. "Do H o t H a n d s Persist
A m o n g Hedge F u n d Managers? An Empirical
Evaluation." National Bureau of Economic Research Working Paper W12015.
Kat, Harry M., and Helder P. Palaro. 2006.
"Hedge Fund Returns: You Can Make T h e m
Yourself!" AIRC [Alternative
Investments
Research Center] Working P a p e r 0023, Sir J o h n
Cass Business School.
Koski, Jennifer Lynch, and Jeffrey Pontiff.
1999. "How Are Derivatives Used? Evidence
from the Mutual F u n d Industry." Journal of
Finance, 54(2): 7 9 1 - 8 1 6 .
Kosowslti, Robert, Narayan Y. Naik, and
Mebyn Teo. Forthcoming. "Do H e d g e Funds
Deliver Alpha? A Bayesian a n d Bootstrap Analysis." Journal of Financial Economics. W o r k i n g
p a p e r version available at SSRN: h t t p : / / s s r n .
com/abstract=829025.
Lowenstein, Roger. 2001. When Genius Failed:
The Rise and Fall ofLong-Term Capital Management.
New York, NY: R a n d o m H o u s e .
Malldel, Burton G. 1995. "Returns From Investing in Equity Mutual Funds 1971 to 1991."
Journal of Finance, 50(2): 5 4 9 - 7 2 .
Malkiel, Burton G., and Atanu Sana. 2005.
"Hedge Funds: Risk a n d Return." Financial Analysts Journal, 61(6): 8 0 - 8 .
New York Times. 2006. "Regulating H e d g e
Funds." September 24.
Presidential Task Force on Market Mechanisms. 1998. Report, Washington, DC.
Schurr, Stephen. 2006. "Hedge F u n d Stars
Earn over $1 bn." Financial Times, May 26.
Shleifer, Andrei, and Robert W. Vishny. 1997.
"The Limits of Arbitrage." Journal of Finance,
52(1): 35-55.
Tremont Capital Management. 2005. "Tremont Asset Flow Report." Second Quarter 2005.
New York.
U.S. Securities and Exchange Commission.
2003. "Implications of the Growth of H e d g e
Funds." Staff Report to the Securities Exchange
Commission, Washington, D.C.

OVERVIEW OF THE SECURITIES ACT OF 1933

1.01

1.01

MARKET CRASHES AND SECURITIES LEGISLATION

History has a way of repeating itself.

The bursting of the 1998-2000 "Internet Bubble" was accompanied by a decline in the value of equity securities that may have reached
as much as $7.4 trillion.1 Investor confidence was shaken not only by the
decline in equity prices but by revelations of accounting failures, corporate fraud and malfeasance, and by a failure by some securities analysts
to live up to professional standards.
Congress reacted by enacting in 2002 the Sarbanes-Oxley Act,
which many observers have described as the most significant federal
legislation affecting the securities markets since the 1930s.
Fortunately, the events that produced Sarbanes-Oxley did not lead
to a collapse of economic activity in the United States. By way of
contrast, when Franklin Delano Roosevelt took the presidential oath of
office in March 1933, the country was still reeling from the impact of the
1929 market crash and the ensuing deep depression. The market value of
stocks listed on the New York Stock Exchange (NYSE) had declined
between 1929 and 1932 by $74 billion, a loss for which "the annals of
finance" up to that time "present[ed] no counterpart."2
Initial public offerings (IPOs) accounted for a significant part of the
losses associated with the bursting of the Internet Bubble, but investors
also suffered losses in established companies. By way of contrast, some
$50 billion of new securities had been floated in the United States during
the decade following World War I, of which fully half had proved to be
worthless.3 The House committee report placed much of the blame on
the securities industry:
The flotation of such a mass of essentially fraudulent securities was
made possible because of the complete abandonment by many underwriters and dealers in securities of those standards of fair, honest, and

1
Estimates of market losses vary widely, but the aggregate market value of the securities
in the Wilshire 5000 index declined from $14.7 trillion in March 2000 to S7.3 trillion in
October 2002.
2
S. Rep. No. 1455,73d Cong., 2d Sess., Stock Exchange Practices, Report of the Senate
Banking and Currency Committee Pursuant to S. Res. 84 (72d Cong.) and S. Res. 56 and S.
Res. 97 (73d Cong.) (June 16, 1934), at 7. Oddly enough, $74 billion represented in 1929
about the same percentage of the U.S. gross domestic product as $7.4 trillion did at the end
of the century.
3
H.R. Rep. No. 85, 73d Cong., 1st Sess., at 2 (1933) [hereafter H.R. Rep. No. 85].

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prudent dealing that should be basic to the encouragement of investment in any enterprise. Alluring promises of easy wealth were freely
made with little or no attempt to bring to the investor's attention those
facts essential to estimating the worth of any security.4
Although the 73d Congress only a year later got around to legislation that would improve disclosure about companies whose securities
were trading in the secondary markets, the legislative priority in 1933
was the new-issue market.5
1.02

HISTORY OF THE 1933 ACT

Since 1911, when the first blue sky law was enacted in Kansas,
new-issue securities regulation had been the exclusive province of the
states. In the aftermath of the crash, however, state securities laws were
perceived to be inadequate.
In his speech accepting the presidential nomination of his party,
Franklin Roosevelt promised not only a "new deal" for the American
people but also called for the "letting in of the light of day on issues of
securities, foreign and domestic, which are offered for sale to the investing public." 6 As one of bis first acts as president, Mr. Roosevelt
delivered to the Congress on March 29, 1933 a message proposing
remedial legislation:
. . . I recommend to the Congress legislation for Federal supervision of traffic in investment securities in interstate commerce.
In spite of many State statutes the public in the past has sustained severe losses through practices neither ethical nor honest on the
part of many persons and corporations selling securities.

Id. at 2.
There are two widely used repositories of the legislative history of the Securities Act of
1933 and the Securities Exchange Act of 1934. The first, which is limited to the original
legislation, is the 11-volume compilation prepared by J. S. Ellenberger and Ellen P. Mahar,
librarians at Covington & Burling in Washington, D.C., and published in 1973 for the Law
Librarians' Society of Washington, D.C. by Fred B. Rothman & Co., South Hackensack,
N.J. The second, Federal Securities Laws: Legislative History, was prepared by the Securities Law Committee of the Federal Bar Association and is published by The Bureau of
National Affairs, Inc. It covers each of the federal securities laws in four volumes and
supplements and has been updated through 1990.
6
Quoted in J. Seligman, The Transformation of Wall Street 19 (Aspen Publishers 2003).
5

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1.02

Of course, the Federal Government cannot and should not take

any action which might be construed as approving or guaranteeing
that newly issued securities are sound in the sense that their value will
be maintained or that the properties which they represent will earn
profit.
There is, however, an obligation upon us to insist that every
issue of new securities to be sold in interstate commerce shall be
accompanied by full publicity and information, and that no essentially
important element attending the issue shall be concealed from the
buying public.
This proposal adds to the ancient rule of caveat emptor, the
further doctrine "let the seller also beware." It puts the burden of
telling the whole truth on the seller. It should give impetus to honest
dealing in securities and thereby bring back public confidence.7
The drafting of legislation to carry out this message had been
assigned to Huston Thompson, a former member of the Federal Trade
Commission.8 The bill drafted by Thompson called for more than disclosure. It gave to the federal government extensive powers to control
the issuance of securities. Sam Rayburn, chairman of the House Committee on Interstate and Foreign Commerce, became convinced that the
Thompson bill did not provide a sound basis for federal securities
legislation. In response to Mr. Rayburn's concern, Raymond S. Moley,
the head of the president's "brain trust," turned for help to Harvard
professor Felix Frankfurter who, in turn, called on the skills of James M.
Landis, Benjamin V. Cohen and Thomas G. Corcoran.
This team determined to prepare a draft based on the English
Companies Act, stressing the theme of disclosure expressed in the president's message. The first draft was completed over a weekend. It went
through a number of revisions, with the assistance of Middleton Beaman,
the chief legislative draftsman for the House of Representatives.
By the time the bill was ready to be reported to the full committee,
agitation had built up on Wall Street, and Mr. Rayburn consented to a
meeting between the draftsmen and a delegation of New York lawyers

H.R. Rep. No. 85, supra note 3, at 1-2.

J. M. Landis, The Legislative History of the Securities Act of 1933, 28 Geo. Wash. L.
Rev. 29 (1959) [hereafter Landis). The brief account that follows is taken principally from
this article, which is required reading for anyone interested in the history of federal securitiesregulation.See also Schlesinger, The Coming of the New Deal 440-442 (1959). For a
detailed account of the drafting process, see Seligman, supra note 6, at 50-72.
8

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comprised of John Foster Dulles and Arthur H. Dean of Sullivan &

Cromwell and A. I. Henderson of the Cravath firm. Landis reports that
Dulles launched an inadequately prepared attack to Rayburn's annoyance, but that Dean and Henderson were far better acquainted with the
details of the bill, and that their technical comments had merit. Ultimately, the Securities Act of 1933 became law on May 27, 1933 as part
of the New Deal's 100 days legislation.
The essential elements of the 1933 Act consisted of (a) mandatory
full disclosure in a registration statement filed with the Federal Trade
Commission (later the Securities and Exchange Commission (SEC)), (b)
SEC review during a "waiting period," at the end of which sales could
commence, (c) mandatory delivery of a prospectus at or before the
delivery of the security and (d) civil liabilities for untrue statements
and for certain omissions.
Contemporaneous concern about the 1933 Act9 focused primarily
on the new civil liabilities that were to be imposed on "those who have
participated in . . . [the] distribution either knowing of such untrue statement or omission or having failed to take due care in discovering it." 10
In this connection, Section 11(c) specified that the applicable standard of
"due care" was to be "that of a person occupying a fiduciary relationship." The securities industry understandably opposed the application of
a "fiduciary" standard of "due care" as a measure of underwriters'
responsibility for an issuer's untrue statements or omissions. This opposition, which extended to other provisions of the new statute relating to
underwriters' liabilities, led to amendments in 1934 that provided,
among other things, that the standard of care was to be that of "a prudent
man in the management of his own property." In addition, the Securities
Exchange Act of 1934 created the SEC to administer both statutes.

9
The reactions to the 1933 Act varied. Some thought that it would retard economic
recovery and bring an end to firm commitment underwriting. A. H. Dean, The Federal
Securities Act: I, Fortune 50,106 (August 1933). Some felt that it was of secondary importance in a comprehensive program of social control over finance. A. A. Berle, Jr., High
Finance: Master or Servant, 23 Yale Rev. 20 (1933). Others adopted a more positive
attitude and, recognizing that the principles embodied in the 1933 Act "have become a
permanent and integral part of our legal system," stressed the need to find "ways and means
of accomplishing expeditiously and efficiently their avowed purposes." W. O. Douglas &
G. E. Bates, The Federal Securities Act of 1933, 43 Yale L.J. 171, 173 (1933).
10
H.R. Rep. No. 85, supra note 3, at 9.

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1.03

1.03

THE SECURITIES AND EXCHANGE COMMISSION

The SEC is an independent agency in the executive branch of the

federal government. It consists of five commissioners appointed by the
president with the advice and consent of the Senate. Commissioners hold
office for a term of five years. No more than three may be members of the
same political party.
The SEC is presided over by a chairman who has the sole power to
assign SEC personnel to perform such functions as may have been delegated to them. The chairman sets the tone for the SEC during his or her
tenure.
On the staff level, the SEC is organized into four divisions:
Corporation Finance, which administers the 1933 Act, the Trust
Indenture Act of 1939 and the disclosure-related requirements of the
1934 Act;
Market Regulation, which administers those parts of the 1934 Act that
relate to the regulation of securities markets and broker-dealers;
Investment Management, which regulates investment companies, investment advisers and (until February 6, 2006) public utility holding
companies; and
Enforcement, which initiates formal and informal investigations,
leading in many cases to injunctive actions in the federal courts or to
administrative proceedings before the SEC. In administrative proceedings, the SEC carries out an important quasi-judicial function that
in turn is subject to review in the courts.
Other important SEC staff departments include the Offices of the
General Counsel and the Chief Accountant as well as other staff offices,
including Economic Analysis and Compliance Inspections and Examinations.
Each of the statutes administered by the SEC authorizes it to adopt
rules for the purpose of carrying out the purposes of the statute. In the
case of the 1933 Act, this includes the authority to define accounting,
technical and trade terms used in the statute and to prescribe the forms by
means of which companies file information with the SEC. The SEC's
Rule 130 states that the SEC's "rules and regulations" include the forms
for registration of securities under the 1933 Act and the related instructions to the forms. Since 1996, the SEC's rulemaking power has

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included the authority to grant general or special exemptions from the

requirements of the 1933 Act.
The SEC accounting staff maintains a Codification of Financial
Reporting Policies and has also for many years issued periodic Staff
Accounting Bulletins. These sources are indispensable for the preparation
of the financial statements included in a prospectus. The Division of
Corporation Finance and the Division of Market Regulation publish
"staff legal bulletins" on current topics, and the "Corp Fin" staff publishes guides on accounting and disclosure issues (most recently updated
on December 1, 2005) and on international reporting and disclosure
issues (most recently updated on November 1, 2004). All of these, together with staff comments on companies' 1933 Act registration statements and 1934 Act periodic reports and a wealth of other information
helpful to the preparation of disclosure documents, are included on the
SEC's website at www.sec.gov.
The staffs of the Division of Corporation Finance, Market Regulation and Investment Management also issue "no-action" letters that
assure a requesting party that the staff will not recommend any enforcement action to the SEC if the requesting party proceeds with a
described transaction. Neither the SEC itself nor much less the courts are
bound by the staffs no-action letters, but they are usually accorded
significant respect. No-action letters are issued on a fact-specific basis,
but securities lawyers frequently cite these letters as precedents. From
time to time, the SEC staff also issues interpretive letters that are
intended to be relied on by a broader group of persons and that may have
significantly greater precedential value.
The SEC's principal office is in Washington, D.C. It has regional
offices that are located in major cities throughout the country.
1.04

SECURITIES OFFERING REFORM

As this book will describe, the SEC has used its rulemaking power
on many occasions to accommodate the requirements of the 1933 Act to
the needs of growing and changing U.S. capital markets. Notable
examples include the development of the integrated disclosure system for
public companies (discussed below), the introduction of shelf registration
(discussed in Chapter 8) and the SEC's development of a comprehensive
disclosure regime for asset-backed securities (discussed in Chapter 14).
The SEC's latest dramatic reshaping of the 1933 Act is the enactment in mid-2005 of the series of rules, forms and interpretations

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collectively referred to as Securities Offering Reform.11 Taken as a

whole, Securities Offering Reform represents the most significant development in more than 20 years relating to the public offering of securities
in the United States. Many of its innovations respond to the revolution in
recent years in information technology and communications and the
effect of this revolution on the U.S. securities and capital markets. As
discussed below in this Chapter and elsewhere in this book, some of the
key elements of Securities Offering Reform include:
the introduction of the "free-writing prospectus" (FWP) as a solution
to the "illegal prospectus" problem that formerly arose whenever a
company or an underwriter or dealer sent an email or other written
communication to an investor inadvertently offering registered securities;
other improvements and extensions of rules and policies that permit
communications during the pendency of a public offering;
the introduction of the "well-known seasoned issuer" (WKSI), with the
ability to offer securities at any time and to file automatically-effective
shelf registration statements; and
rationalization and streamlining of the shelf registration process.
As we shall see, some other elements of Securities Offering Reform were
less welcome, and market participants have yet to respond fully to these
innovations.
1.05
[A]

KEY ELEMENTS OF THE 1933 ACT

Disclosure Philosophy

It cannot be emphasized too often that the 1933 Act is a disclosure

statute. Its principal purpose, as set forth in its preamble, is to provide
"full and fair disclosure of the character of securities sold in interstate
and foreign commerce and through the mails...." As explained in 1933
by Professor Frankfurter:
Unlike the theory on which state blue-sky laws are based, the Federal
Securities Act does not place the government's imprimatur upon
11

SEC Release No. 33-8591 (July 19,2005) (SOR Adopting Release). The SEC released
technical corrections in SEC Release No. 33-8591A (February 6,2006), and the Division of
Corporation Finance released Questions & Answers on November 30, 2005.

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securities. It is designed merely to secure essential facts for the investor, not to substitute the government's judgment for his own.12
Sarbanes-Oxley represents a major departure from the 1933 Act's
original emphasis on disclosure, as it thrusts the SEC into areas of
corporate governance that were formerly the responsibility of the states
and the securities markets such as the NYSE and the National Association of Securities Dealers (NASD). It also involves the SEC, as a result
of its oversight authority over the Public Company Accounting Oversight
Board, in the regulation of the accounting profession.
[B]

Definition of Security

An important threshold question under the 1933 Act is whether a

financing vehicle is a "security." The term is broadly defined in Section
2(a)(1) of the 1933 Act, as well as in Section 3(a)(10) of the 1934 Act 13
According to the U.S. Supreme Court's leading decision in Reves v.
Ernst & Young Congress "did not attempt precisely to cabin the scope
of the Securities Acts" but rather "enacted a definition of 'security'
sufficiently broad to encompass virtually any instrument that might be
sold as an investment." In deciding which transactions are covered by
the federal securities laws, "legal formalisms" are less important than
"the economics of the transaction." Some instruments, on the other
hand, are "obviously within the class Congress intended to regulate
because they are by their nature investments." For example, "stock is,

12
F. Frankfurter, The Federal Securities Act: II, Fortune 53, 108 (August 1933). It
cannot be denied that disclosure also has a prophylactic effect. For example, a chief executive officer is less likely to engage in self-dealing with his corporation if he knows that his
conduct will be exposed to public scrutiny. As Louis Brandeis put it, "Publicity is justly
commended as a remedy for social and industrial diseases. Sunlight is said to be the best of
disinfectants; electric light the most efficient policeman." Brandeis, Other People's Money
92 (1914).
13
The U.S. Supreme Court has consistently held that the scope of coverage of the 1933
Act and the 1934 Act, insofar as it depends on the two "virtually identical" definitions in the
two statutes, "may be considered the same." Reves v. Ernst &. Young, 494 U.S. 56, 61 n.l
(1990). In practice, however, attempts to characterize an instrument as a security are more
likely to succeed where the effect is to preserve holders' federal antifraud remedies under
the 1934 Act than where it would lead to rescission rights under the 1933 Act
14
494 U.S. 56(1990).

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1.05[B]

as a practical matter, always an investment if it has the economic characteristics traditionally associated with stock."
In Reves, the Court adopted a rebuttable presumption that all notes
are "securities." To rebut the presumption would require a showing that
the note bears a strong resemblance to those categories of notes held by
lower courts not to be securities, for example, notes delivered in consumer financing, notes secured by home mortgages, notes evidencing
unsecured bank loans to individuals, and short-term notes secured by
business assets. The required "resemblance" would depend on four
factors: the motivations of the parties, whether the instrument is traded,
the expectations of the investing public and the presence or absence of an
alternative regulatory scheme for the public's protection.
The term "security" includes a guarantee of a security. If a subsidiary corporation makes a public offering of debentures guaranteed by
its parent, the guarantee must therefore be registered under the 1933 Act
along with the primary obligations.
Is an orange grove a security? Hardly. But the U.S. Supreme Court
has held that a security was indeed involved in an offer of land sales
contracts covering plots planted with citrus trees along with service
contracts giving the promoter discretion and authority over the cultivation of the groves and the harvest and marketing of the crops.15 The
Section 2(a)(1) definition includes among the types of securities subject
to the 1933 Act a "certificate of interest or participation in any profitsharing agreement," an "investment contract" and "any interest or instrument commonly known as a security." In SEC v. Howey, Justice
Murphy said that an investment contract is "a contract, transaction or
scheme whereby a person invests bis money in a common enterprise and
is led to expect profits solely from the efforts of the promoter or a third
party...." Investments following the Howey pattern appear irresistibly
attractive to some classes of promoters. Pay telephones are a common
medium for recent versions of these arrangements. The Eleventh Circuit
in 2002 rejected the SEC's characterization of pay telephone lease
arrangements as investment contracts, but the Supreme Court had little
difficulty concluding that the SEC was right and the Eleventh Circuit
wrong.16 And the First Circuit held in 2001 that the SEC had alleged

15

SEC v. W. J. Howey Co., 328 U.S. 293 (1946).

SEC v. Edwards, 124 S. Q. 892 (2004), rev 'g SEC v. ETS Payphones, Inc., 300 F.3d
1281 (11th Cir. 2002).
16

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sufficient facts to go to trial on whether an investment contract had been

created from the opportunity to purchase "virtual shares" in "virtual
companies" on an Internet-based "virtual stock exchange."17
Limited partnership interests are generally treated as securities,
while general partnership interests are not; however, the SEC recently
persuaded the Eleventh Circuit that general partnership interests sold to
485 investors were securities under the Howey analysis.18
The Supreme Court has held that a bank certificate of deposit is not
a security.29 However, the Court of Appeals for the Second Circuit,
applying the Howey analysis, concluded that Merrill Lynch's then
existing "CD Program" involving the sale of certificates of deposit selected by Merrill Lynch, including some specifically created for the
program, involved investment contracts and therefore securities for
purposes of the antifraud provisions of the 1933 Act and the 1934 Act
because a significant portion of the customer's investment depended on
Merrill Lynch's managerial and financial expertise.20
In the early days of derivatives, a corporation that was a party to
certain interest rate and currency swaps argued that these were securities
for purposes of the 1933 Act, the 1934 Act and a state's blue sky law. The
court rejected the argument.21 It held that the swaps were not investment
contracts because they lacked the element of a "common enterprise."
Even if viewed as notes, they fell outside each of the four parts of the
Reves "family resemblance" test. Neither were they "evidences of indebtedness" because they lacked the essential element of an obligation to
pay principal, and they were not "options" on securities because they did
not give either counterparty the right to take possession of any security.
The court was careful to point out that it was not holding that all swaps or
leveraged derivative instruments were not securities.
Most swap transactions, at least those between "eligible participants," were excluded from the definition of security by the Commodity
Futures Modernization Act of 2000. The exclusion does not apply for all
purposes, as it preserves the status of swaps as securities for antifraud,
17

SEC v. SG Ltd., 265 F.3d 42 (1st Or. 2001).

SEC v. Merchant Capital LLC, 483 F.3d 747 (11th Cir. 2007), rev 'g 400 F. Supp. 2d
1336 (N.D. Ga. 2005).
19
Marine Bank v. Weaver, 455 U.S. 551 (1982).
Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith Inc., 756
F.2d 230 (2d Cir. 1985).
21
Procter & Gamble Co. v. Bankers Trust Co., 925 F. Supp. 1270 (S.D. Ohio 1996).
18

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1.05[q

antimanipulative and certain other purposes. Also, companies cannot use

swaps to escape the liabilities associated with issuing securities through
underwriters for the purpose of raising capital (except to manage a risk
associated with capital raising). Custody arrangements often raise close
questions as to whether receipts or other evidence of ownership of the related
assets are securities. These arrangements are discussed in Chapter 11.
[C]

Registration and Prospectus Delivery Requirements

At the heart of the 1933 Act are the registration and prospectus
delivery requirements set forth in Section 5. These requirements represent both:
mandates, i.e., securities must be registered, and prospectuses must be
delivered, and
prohibitions, i.e., offers and sales can take place only in compliance
with these mandates, and non-conforming prospectuses may not be
used.
The mandates and prohibitions of Section 5 are the only requirements of the 1933 Act that can be violated, except for the antifraud
prohibitions of Section 17 and (in a loose sense) the disclosure-based
remedies provided by Sections 11 and 12(a)(2). The remainder of the
1933 Act consists of definitions, exemptions and other provisions that
implement Section 5.
Section 5 touches on every offer and sale of securities that is subject
to federal jurisdiction. Unless an exemption is available, Section 5(c)
forbids any offer of securities unless a registration statement is on file
with the SEC. Subject to the same condition,
Section 5(a) prohibits any sale of the securities unless the SEC has
permitted the registration statement to become effective;
Section 5(b)(1) forbids the use of any prospectus not conforming to
the requirements of the 1933 Act; and
Section 5(b)(2) forbids the delivery of a security unless accompanied
or preceded by a prospectus that does conform to the requirements of
the 1933 Act.

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Section 5 requires that its registration and prospectus delivery

requirements be complied with in connection with any offer or sale of a
security in interstate commerce or through the use of the mails. The SEC
vigorously enforces Section 5 through administrative and court proceedings, but the primary reason for complying with Section 5 is that a
violation entitles a buyer to return the security to the sellerno questions
askedat any time during the year following the sale.22 There is nothing
wrong with selling "puts" to customers, but it is a major mistake to do so
inadvertently and without getting paid for them!
Of course, not every transaction in securities must be registered
with the SEC or be the subject of a prospectus. Important exemptions are
available, based either on the nature of the security (Section 3) or the
nature of the transaction (Sections 3 and 4).
An important limitation on the transactional exemptions under
Section 4 is that they are not available, for the most part, to anyone who
is an "underwriter." The scope of this term is discussed below in this
chapter and elsewhere in this book.
In all cases, the burden of proving the availability of an exemption
is on the person who claims it.
[1]

Registration for a Purpose

Before considering in more detail the key elements of the 1933 Act,
a common misconception should be laid to restthe idea that there is
something bad about securities that are not registered and something
good about securities that are registered. A report appears in the business
section of the morning newspaper to the effect that a broker has been
sanctioned by the SEC for selling "unregistered securities." The reader
thereby assumes that, on the one hand, there are nice registered securities
with wings and halos and, on the other hand, there- are bad unregistered
securities with forked tails and horns. Many people, even in the
securities industry, believe that if a person sells unregistered securities he
will go to jail, but that if he can find some good registered securities to
deliver in the transaction he will remain a free man. Or that once

72

Section 12(a)(1) permits a purchaser of securities offered or sold in violation of

Section 5 to put the securities back to the seller, and Section 13 provides for a one-year
period within which to exercise the put See P. Stolz Family Partnership LP. v. Daum,
355 F.3d 92 (2d Or. 2004).

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unregistered securities have been sold, there is something wrong with

them. This is not the way that the 1933 Act works.
Billions of shares of common stock are traded on the NYSE that
have never been the subject of a registration statement. They may have
been issued before the adoption of the 1933 Act; they may have been
issued in a private placement and resold in accordance with Rule 144 (to
be discussed below); or they may have been sold in an offshore offering
or issued as a stock dividend.
Conversely, if a company reacquires for its treasury shares that had
once been the subject of a registration statement, it must register them
again before it may sell them to the public. Similarly, if a person in a
control relationship with a company acquires that company's registered
securities in the open market, the securities must be registered again
before they may be resold through a broker-dealer in a public offering
outside of the limits of Rule 144.
A sale of securities in violation of the 1933 Act cannot be remedied
by filing a registration statement after the fact, except for the purpose of a
rescission offer (and except for certain securities issued by investment
companies). Securities issued in a private placement cannot be made
freely tradable by registering them after the fact, except for the purpose
of resale with the use of a current prospectus. (It is also possible under
certain circumstances, as discussed in Chapter 7, to conduct a registered
exchange offer that gives holders of privately placed securities the opportunity to exchange them for registered securities.)
Although the 1933 Act speaks of registering securities, it is more
accurate to think in terms of registering a transaction, or at least of
registering securities for the purpose of sale in a particular transaction.
This characterization flows from a comparison of Section 5, prohibiting
offers before filing and sales before effectiveness, and Section 6(a),permitting registration only of such specified securities as are "proposed
to be offered." A registration statement is filed and becomes effective not
to place a stamp of approval on the securities but to provide persons
being offered securities in a non-exempt transaction with sufficient information on which to base an informed investment decision. Part of the
ambiguity must be laid to somewhat faulty draftsmanship. As one of the
principal draftsmen of the 1933 Act acknowledged, the bill "came close
to accurately carving out a differentiation between the registration

23

See infra 1.05[E][4].

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of securities and the registration of offerings of securities" but was "far

from perfect on this point as well as in many of its other provisions."24
[2] How the Registration Requirement Works

Assume that a commercial or industrial company (not a bank or

other issuer of exempted securities) proposes to sell to the public 50
million shares of common stock through an underwriting syndicate. The
1933 Act requires such a company to provide potential investors with
extensive information concerning its business and finances. This information is made available by means of a registration statement filed with
the SEC, nearly always in electronic form.25 Once filed, this is a public
document available for examination on the SEC's website through the
EDGAR (Electronic Data Gathering, Analysis and Retrieval) system.
As discussed below, the 1933 Act also requires the principal part of
the registration statementthe prospectusto be delivered to purchasers
of the registered securities.26
[a]

Contents of the Registration Statement

Section 7 of the 1933 Act requires that our hypothetical issuer's

registration statement contain the information specified in Schedule A to
the 1933 Act except as otherwise required by the SEC. Using its extensive rulemaking authority, the SEC has adopted registration forms27
that together with Regulation S-K (narrative disclosure) and Regulation
S-X (financial statements) specify the required contents of the registration statement. These forms and related rules make Schedule A obsolete
for most intents and purposes.28

24

Landis, supra note 8, at 36.

If debt securities are to be offered, in addition to filing under the 1933 Act, it is
necessary to qualify an indenture under the Trust Indenture Act of 1939.
26
The statement in the text is something of an exaggeration. Nothing in the 1933 Act
requires the delivery of a prospectus. As we shall see, however, a sale cannot be legally
completed without delivering a prospectus.
27
Rule 130 provides that the term "rules and regulations" as used in Section 7
includes the forms for registration of securities and the related instructions.
28
Registration statements filed by a foreign government, or a political subdivision
thereof, are governed by Schedule B to the 1933 Act No forms have been adopted for
these registration statements. As described in Chapter 9, however, the disclosures have
become fairly well standardized.
25

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1.05[C]

There are two basic types of registration forms under the 1933 Act.
Thefirst(Form S-l or its counterpart for foreign companies, FormF-1) is a
stand-alone document that contains all the required information, including
a full description of the business and financial condition of the issuer. If our
hypothetical issuer were "going public" for the first time, i.e., conducting
an IPO, it would use Form S-l. The second form (Form S-3 or its counterpart for foreign companies, Form F-3)29 is a document that ' 'incorporates by reference" information from the periodic reports that a "reporting
company" files with the SEC under the 1934 Act.30 As one might expect,
the ability to incorporate by reference is conditioned (among other things)
on me issuer's having a minimum reporting history. This was once 36
calendar months, but the required period is now 12 calendar months. If our
hypothetical issuer had the requisite reporting history and met the other
requirements of Form S-3including the timely filing of required reports
for the last twelve monthsit would undoubtedly use that form.
[b]

Development of the Integrated Disclosure System

From its beginning, the 1933 Act operated on a sporadic basisthat

is, whenever an issuer decided to make a public offering of securities.
29

A third pair of forms, Form S-2 and Form F-2, was rescinded as part of Securities
Offering Reform.
30
The 1934 Act also requires the "registration" of securities, but primarily for the
benefit of persons who purchase securities in the secondary markets. Section 12(b) of the
1934 Act requires registration of securities listed on a national securities exchange.
Section 12(g) extends the registration requirement to any securities traded in interstate
commerce if the issuer has total assets exceeding $1 million (increased by SEC rule to
$10 million) and a class of equity securities held of record by 500 or more persons. (Such
a class can include outstanding employee stock options, but the SEC recently proposed to
exempt certain employee stock options from Section 12(g) registration. SEC Release
No. 34-56010 (July 5, 2007).)
An initial application for registration under the 1934 Act is made on Form 10, and
additional classes of securities are registered on Form 8-A. Section 13 of the 1934 Act
requires issuers of registered securities to keep their Form 10 current through the filing of
annual reports on Form 10-K and quarterly reports on Form 10-Q. Form 8-K is used for
any current updating, including the disclosure of acquisitions. Any issuer that has filed a
1933 Act registration statement that has become effective is required by Section 15(d) of
the 1934 Act to file the same periodic reports as are required of an issuer with securities
registered under the 1934 Act. An issuer can relieve itself of 1934 Act reporting
requirements, generally by certifying to the SEC that fewer than 300 persons are holders
of record of the registered security. The corresponding requirements for foreign private
issuers are discussed in Chapter 9.

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Even after the passage of the 1934 Act, which required issuers of exchange-listed securities to file periodic reports with the SEC, the twostatutes operated independently. A 1933 Act registration statement and
the related prospectus delivered the information considered necessary for
persons buying a particular distribution of securities. On the other hand,
the periodic reports filed under the 1934 Act provided the information
considered necessary for persons buying securities traded on securities
exchanges.
There was never a good reasonother than historicalfor the
differences between the forms and instructions that governed the content
of periodic reports filed under the 1934 Act and those that governed
registration statements filed under the 1933 Act. The information required for a decision to purchase or sell securities on an exchange or in
the over-the-counter market is, after all, substantially the same as the
information required for a decision whether to purchase securities being
distributed in a registered public offering. Even so, the disclosure
requirements on any given subject were likely to vary depending on
whether the document was being prepared for filing under the 1933 Act
or 1934 Act As Milton H. Cohen stated in his seminal article, "Truth in
Securities" Revisited,31 the combined disclosure requirements of the
1933 and 1934 Acts probably would have been quite different if they had
been enacted in the opposite order.
With the extension in 1964 of the periodic reporting requirements of
the 1934 Act to substantial issuers of securities traded over-the-counter,
the "efficient market hypothesis" began to gain legal recognition. For
purposes of the federal securities laws, the efficient market hypothesis is
that all the information that an issuer disseminateswhether by means
of its 1934 Act reports, communications with shareholders or press
releasesis absorbed into the market through the activities of the financial press, securities analysts and other professionals, thereby causing
the market price of the issuer's securities to reflect this information.
Thus, it may be presumed in the case of an offering of new securities by a
widely followed public company that the prospective investors in the new
securities have already received and discounted the information previously made public by the issuer. Accordingly, it should not be necessary
to disclose it to them again.

31

79 Harv. L. Rev. 1340 (1966).

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1.05[C]

The Wheat Report,32 published in 1969, suggested improvements to

the SEC's disclosure requirements that were compatible with the efficient market hypothesis. It recommended expanded periodic disclosure
under the 1934 Act and coordination of the disclosure requirements of
the 1933 Act and the 1934 Act. In accordance with the report's recommendations, the SEC adopted in late 1970 a short form of registration
statement, called Form S-16, which provided for incorporation by reference of reports filed under the 1934 Act.33 As originally adopted, Form
S-16 was available only for securities issued on the conversion of
convertible securities or the exercise of warrants as well as for securities
being sold "in the regular way" on a national securities exchange by
persons other than the issuer. The form was amended in 1972 to make it
available for any kind of secondary offering34 and in 1978 to make it
available for firm commitment primary offerings where issuer's "float"
was at least $50 million.35
In 1977, the SEC adopted Regulation S-K, then consisting of two
items, "Description of Business" and "Description of Property." For the
first time, the principal disclosure items were made uniform for annual
reports on Form 10-K and 1933 Act registration statements. In time, full
consistency was achieved, and the various registration and reporting
forms under the 1933 Act and the 1934 Act now specify the required
information by references to Regulation S-K.
In March 1982, the SEC announced significant changes in the
forms and rules governing registration statements under the 1933
Act.36 This action represented the final stage of the SEC's program to
implement an integrated disclosure system under the 1933 Act and the
1934 Act. New Form S-3 was adopted to replace Forms S-7 and S-16,
and the abbreviated Form S-3 (unlike its predecessor, Form S-16) was
made available for primary offerings of securities even where there was

This report, Disclosure to InvestorsA Reappraisal ofAdministrative Policies Under

the '33 and '34 Acts, was prepared under the direction of Commissioner Francis M. Wheat
33
SEC Release No. 33-5117 (December 23, 1970). Form S-16 had an antecedent in
Form S-7, which for many years allowed qualified issuers to omit from their 1933 Act
registration statements information relating to management compensation and transactions
that was set forth in the issuer's 1934 Act filings.
34
SEC Release No. 33-5265 (June 27, 1972).
35
SEC Release No. 33-5923 (April 11, 1978).
36
SEC Release No. 33-6383 (March 3, 1982).

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no firm commitment underwriting.37 Later in 1982, the SEC adopted an

integrated disclosure system for foreign private issuers, with registratioif
forms (Forms F-l and F-3) that correspond to their domestic counterparts.38
[c]

SEC Staff Review of the Registration Statement

One of the principal original purposes of registration was to give

the SEC the opportunity to review and comment on the registration
statement's compliance with the requirements of the statute, the rules
and the forms. In the case of an IPO, the SEC staff will invariably review
the registration statement In the case of a reporting company using Form
S-3, the staffs focus will likely have been on the company's periodic
reports filed under the 1934 Act and incorporated by reference into the
registration statement. This focus is in part the result of SarbanesOxley's mandate that the SEC review every reporting company's 1934
Act reports at least once every three years.
While the SEC's disclosure requirements are in part quite specific,
and the staff will take exception to a failure to comply with a specific
disclosure mandate, compliance with the disclosure requirements is not a
"check the boxes" exercise. As discussed throughout this book, the
objective is to achieve a full and fair disclosure that will enable an
investor to make an intelligent investment decision.
[d]

Registered Offers and Sales

In exarnining how the 1933 Act governs the offering process for a
public offering, it is important to keep in mind the three stages of the
registration process described below:39 (i) the period prior to the filing of
the registration statement with the SEC, (ii) the period between the time
the registration statement is filed and the time it is declared effective and
(iii) the period after the registration statement is effective. It is also
important to distinguish between sales, including contracts to sell, on
37

See Chapter 3 for a discussion of registration forms for U.S. issuers. As discussed in
Chapter 8, the availability of Form S-3 for primary offerings on a delayed or continuous
basis was the driving force behind the growth of shelf registration.
38
SEC Release No. 33-6437 (November 19, 1982). See Chapter 9 for a discussion of
registration forms for foreign private issuers.
39
See infra 1.05[C][2][d][i] and [ii].

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1.05[q

the one hand, and offers, on the other hand. With respect to offers, it is
important to distinguish between oral offers and written offers.
[i] Pre-Filing Period. Prior to the time that the registration statement is filed, Section 5(c) prohibits any offer of the securities, whether
written or oral.40 The reference to "offer" is not restricted to the law
school meaning of the word. Rather, as discussed below, it means any
communication or activity that in effect conditions the market for the
securities to be registered. Certain communications that might otherwise
be prohibited offers may be made in reliance on exemptions discussed
below. WKSIs may make offers at any time if they meet certain conditions, whether or not they have filed a registration statement.
[ii] Post-Filing or "Waiting" Period. During the so-called
"waiting period" prior to effectiveness, while the SEC staff may be
reviewing the registration statement and the underwriters may be marketing the issue, there is no restriction on oral offers, but Section 5(a)(1)
prohibits any sale or contract to sell the securities until the SEC declares
the registration statement effective. (As discussed in Chapter 3 under
"Online Offerings," the SEC construes this prohibition as extending to
an underwriter's premature receipt of payment from a customer.)
Prior to Securities Offering Reform, no written offering material
was permitted during the waiting period other than the preliminary or
"red herring" prospectus41 permitted by Rule 430 and other material
covered by specific exemptions, even if the material was accompanied
by die preliminary prospectus.42 Thus, during the period between filing
and effectiveness, it would have been a violation of Section 5(b)(1) for
an underwriter to send a preliminary prospectus to a customer with a
cover letter, e-mail or any other written message pointing out the merits
of the proposed investment.43
40

Thanks to the definitions in Section 2(a)(3), the prohibition does not extend to "preliminary negotiations or agreements" among issuers, underwriters and selling shareholders.
On the other hand, the prohibition applies in full to securities firms that will act as dealers
rather than underwriters.
41
So called for the legend (formerly required to be in red ink) that must be printed on the
cover of every preliminary prospectus. Item 501(b)(10) of Regulation S-K.
42
See infra 1.05[E].
4j
Rule 482 permits investment companies to use certain limited supplemental belling
literature during this period. Also, as discussed infra 1.05[D][4] and 1.05[D][5], pertain
communications are deemed under SEC rules not to be offers or prospectuses. '

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Apart from codifying and expanding certain exemptions discussed

below,44 Securities Offering Reform changed the foregoing pattern in
one significant respect: any written offering material may now be used if
it meets the requirements for a Free-Writing Prospectus ("FWP") discussed below45 and in Chapter 3.
The making of pre-filing offers in violation of Section 5(c) is
sometimes referred to as "gun-jumping." After the filing of the registration statement, the term "gun-jumping" is usedsomewhat illogically
to describe the distribution of written offering material in violation of
Section 5(b)(1).
[iii] Effective Date and Thereafter. By the terms of Section 8(a)
of the 1933 Act, a registration statement becomes effective by operation
of law on the 20th day after filing. In practice, it does not become
effective until declared effective by the staff of the SEC under delegated
authority. This works through the magic of a "delaying amendment"
under Rule 473, which prevents the registration statement from becoming effective until the company has responded to SEC staff comments
if anyon the contents of the registration statement and is ready to price
and sell its securities. At that time, the issuer and its underwriters will
request that the staff "accelerate" the effectiveness of the registration
statement. In determining whether or not to grant the request, the staff
considers the conditions specified in Rules 460 and 461.
The registration statement may become effective without pricing
information if the issuer follows the requirements of Rule 430A (discussed in Chapters 2 and 3), thus mitigating somewhat me problem of
being unable to predict exactly when the staff will act. Also, as discussed
in Chapter 8, one of the advantages of shelf registration is that it
eliminates the uncertainty and delay sometimes associated with staff
review and acceleration on a transaction-by-transaction basis. And one
of the major innovations of Securities Offering Reform was that WKSIs
have the ability to file shelf registration statements that become effective
automatically on filing.
44

See infra 1.05[C][3][b].

In Franklin, Meyer & Barnett, 37 S.E.C. 47 (1956), a broker-dealer was sanctioned
because, among other transgressions, a registered representative enclosed with a preliminary prospectus his business card on which he wrote "Phone me as soon as possible as my
allotment is almost complete on this issue." An oral statement to this effect would not have
violated Section 5. See also Diskin v. Lomasney & Co., 452 F.2d 871 (2d Cir. 1971).
45

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Inside The Deal That Made Bill Gates $350,000,000

On the 25th anniversary of Microsoft's IPO, Fortune is featuring our 1986 cover story in
which we followed around a young Bill Gates as he prepared to take his company public.
Here's the story of the birth of a billionaire.

Editor's Note: This story was first published in the July 21, 1986 issue of Fortune. As Bro Uttal
told Fortune's editor, Marshall Loeb, at the time (see Editor's Letter at the bottom of this page), "I
doubt that a story like this has been published before or is likely to be done again."
By Bro Uttal, writer
Going public is one of capitalism's major sacraments, conferring instant superwealth on a few
talented and lucky entrepreneurs. Of the more than 1,500 companies that have undergone this rite
of passage in the past five years, few have enjoyed a more fren- zied welcome from investors than
Microsoft, the Seattle-based maker of software for personal computers. Its shares, offered at $21
on March 13, zoomed to $35.50 on the over-the-counter market before settling back to a recent
$31.25. Microsoft and its shareholders raised $61 million. The biggest winner was William H. Gates
III, the company's co-founder and chairman. He got only $1.6 million for the shares he sold, but
going public put a market value of $350 million on the 45% stake he retains. A software prodigy who
helped start Microsoft while still in his teens, Gates, at 30, is probably one of the 100 richest
Americans.
Gates thinks other entrepreneurs might learn from Microsoft's (MSFT) experience in crafting what
some analysts called "the deal of the year," so he invited FORTUNE along for a rare inside view of
the arduous five-month process. Companies hardly ever allow such a close look at an offering
because they fear that the Securities and Exchange Commission might charge them with touting
their stock. Answers emerged to a host of fascinating questions, from how a company picks

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investment bankers to how the offering price is set. One surprising fact stands out from Microsoft's
revelations: Instead of deferring to the priesthood of Wall Street underwriters, it took charge of the
process from the start.

The wonder is that Microsoft waited so long.Founded in 1975, it is the oldest major producer of
software for personal computers and, with $172.5 million in revenues over the last four quarters,
the second largest after Lotus Development. Microsoft's biggest hits are the PC-DOS and MS-DOS
operating systems, the basic software that runs millions of IBM personal computers and clones. The
company has also struck it rich with myriad versions of computer languages and a slew of
fast-selling applications programs such as spreadsheets and word-processing packages for IBM,
Apple, and other personal computers.
Yet Microsoft stood pat when two of its archcompetitors, Lotus and Ashton- Tate, floated stock
worth a total of $74 million in 1983. Nor did it budge in 1984 and 1985, when three other
microcomputer software companies managed to sell $54 million of stock. The reasons were simple.
Unlike its competitors, Microsoft was not dominated by venture capital investors hungry to harvest
some of their gains. The business gushed cash. With pretax profits running as high as 34% of
revenues, Microsoft needed no outside money to expand. Most important, Gates values control of
his time and his company more than personal wealth.
Money has never been paramount to this unmarried scion of a leading Seattle family, whose father
is a partner in a top Seattle law firm and whose mother is a regent of the University of Washington
and a director of Pacific Northwest Bell. Gates, a gawky, washed-out blond, confesses to being a
"wonk," a bookish nerd, who focuses singlemindedly on the computer business though he masters
all sorts of knowledge with astounding facility. Oddly, Gates is something of a ladies' man and a
fiendishly fast driver who has racked up speeding tickets even in the sluggish Mercedes diesel he
bought to restrain himself. Gates left Harvard after his sophomore year to sell personal computer
makers on using a version of the Basic computer language that he had written with Paul Allen, the
co-founder of Microsoft. Intensely competitive and often aloof and sarcastic, Gates threw himself
into building a company dedicated to technical excellence. "All Bill's ego goes into Microsoft," says
a friend. "It's his firstborn child."
Gates feared that a public offering would distract him and his employees. "The whole process

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looked like a pain," he recalls, "and an ongoing pain once you're public. People get confused
because the stock price doesn't reflect your financial performance. And to have a stock trader call
up the chief executive and ask him questions is uneconomic -- the ball bearings shouldn't be asking
the driver about the grease."
But a public offering was just a question of time. To attract managers and virtuoso programmers,
Gates had been selling them shares and granting stock options. By 1987, Microsoft estimated, over
500 people would own shares, enough to force the company to register with the SEC. Once
registered, the stock in effect would have a public market, but one so narrow that trading would be
difficult. Since it would have to register anyway, Microsoft might as well sell enough shares to
enough investors to create a liquid market, and Gates had said that 1986 might be the year. "A
projection of stock ownership showed we'd have to make a public offering at some point," says Jon
A. Shirley, 48, Microsoft's pipe-smoking president and chief operating officer. "We decided to do it
when we wanted to, not when we had to."
In April 1985 Gates, Shirley, and David F. Marquardt, 37, the sole venture capitalist in Microsoft (he
and his firm had 6.2% of the stock), resolved to look into an offering. But Gates fretted. To forestall
sticky questions from potential investors, he first wanted to launch two important products, one of
them delayed over a year, and to sign a pending agreement with IBM for developing programs. He
also wanted time to sound out key employees who owned stock or options and might leave once
their holdings became salable on the public market. "I'm reserving the right to say no until October,"
Gates warned. "Don't be surprised if I call it off."
By the board meeting of October 28, held the day after a roller-skating party for Gates's 30th
birthday, the chairman had done his soundings and felt more at ease. The board decided it was time
to select underwriters and gave the task to Frank Gaudette, 50, the chief financial officer, who had
come aboard a year before. Gaudette was just the man to shepherd Microsoft through Wall Street.
He speaks in the pungent tones of New York City, where his late father was a mailman, and prides
himself on street smarts. He had already helped manage offerings for three companies, all suppliers
of computer software and services.
Aspiring underwriters, sniffing millions in fees, had been stroking Microsoft for years. They had
enticed the company's officers to so-called technology conferences -- bazaars where
entrepreneurs, investors, and bankers look each other over. They had called regularly at Microsoft,
trying to get close to Gates and Shirley. Gaudette had been sitting through an average of three
sales pitches or get-acquainted dinners a month.
Gaudette proposed that since Microsoft was well established, it deserved to have a "class Wall
Street name" as the lead underwriter. This investment firm would put together the syndicate of
underwriters, which eventually was to number 114. It would also allocate the stock among
underwriters and investors and pocket giant fees for its trouble. Gaudette suggested a "technology
boutique" co-manage the offering to enhance Microsoft's appeal to investors who specialize in
technology stocks.

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Narrowing the field of boutiques was easy. Only four firms were widely known as specialists in
financing technology companies: Alex. Brown & Sons of Baltimore, L.F. Rothschild Unterberg
Towbin of New York, and two San Francisco outfits, Hambrecht & Quist and Robertson Colman &
Stephens. Culling the list of Wall Street names took longer. Microsoft's managers concluded that
some big firms, including Merrill Lynch and Shearson Lehman, had not done enough homework in
high tech. The board pared the contenders to Goldman Sachs, Morgan Stanley, and Smith Barney.
It also included Cable Howse & Ragen, a Seattle firm that could be a third co-manager if Gates and
Shirley decided that pleasing local investors was worth the bother. "Get on the stick," Shirley told
Gaudette. "Keep Bill and me out of it -- we can't spend the time. Give us a recommendation in two
or three weeks."
Early in November, Gaudette called the eight investment bankers who had survived the first cut. "I
need half a day with you," he said. "Take your best shot, then wait for me to call back. I'll have a
decision before Thanksgiving. But remember, it's my decision -- don't try going around me to Bill or
Jon." Gaudette made up a list of questions, ranging from the baldly general -- "Why should your firm
be on the front cover of a Microsoft prospectus?" -- to the probingly particular, such as, "How would
you distribute the stock, to whom, and why?"
After a whirlwind tour of New York, Baltimore, and San Francisco, Gaudette made his
recommendations to Gates and Shirley on November 21. Then he took off for a ten-day vacation in
Hawaii, a belated celebration of his 50th birthday in the 50th state. No decision would be
announced until his return. The investment bankers turned frantic. Theirs is a who-do-you-know
business, and they mobilized their clients, many of them Microsoft customers or suppliers, to
besiege Gates and Shirley.
Gaudette had methodically ranked the investment houses on a scale of 1 to 5 in 19 different
categories. But he also stressed that any candidate could do the deal and that the chemistry
between Microsoft and the firms would finally determine the winners. Among the major houses,
Gaudette had been most impressed by Goldman Sachs, which tightly links its underwriting group
with its stock traders and keeps close tabs on the identity of big institutional buyers. For those
reasons, Gaudette thought Goldman would be especially good at maintaining an orderly market as
Microsoft employees gradually cashed in their shares.

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On December 4, after conferring with Gates and Shirley, Gaudette phoned Eff W. Martin, 37, a
vice president in Goldman's San Francisco office who had been calling on Microsoft for two years.
"I like you guys," Gaudette said, "and Microsoft wants to give you dinner on December 11 in
Seattle. Do you think you can find time to come?" Dinner at the stuffy Rainier Club was awkward.
The private room was large for the party of eight, and one wall was a sliding partition ideal for
eavesdropping. Most of the party were meeting each other for the first time; how well they got along
could make or break the deal. Microsoft's top dogs didn't make things easy. Gates, who had heard
scare stories about investment bankers from friends like Mitchell Kapor, chairman of Lotus
Development, was tired and prepared to be bored. Shirley was caustic, wanting to know exactly
what Goldman imagined it could do for Microsoft.
For nearly an hour everyone stood in a semicircle as Martin and three colleagues explained their
efforts to be tops in financing technology companies. An Oklahoman by birth and polite to a fault,
Martin labored to kindle some rapport. But it was not until talk turned to pricing the company's stock
that Gates folded his arms across his chest and started rocking to and fro, a sure sign of interest.
At the end of dinner, Martin, striving to conclude on a high note, gushed that Microsoft could have
the "most visible initial public offering of 1986 -- or ever."
"Well, they didn't spill their food and they seemed like nice guys," Gates drawled to his colleagues
afterward in the parking lot. "I guess we should go with them." He and Shirley drove back to
Microsoft headquarters, discussing co-managing underwriters. Gaudette leaned toward Robertson
Colman & Stephens. But Alex. Brown had been cultivating Microsoft longer than any other
investment banking house. "Better the whore you know than the whore you don't," Shirley
concluded. Three days later the board quickly blessed the selection of Goldman Sachs and Alex.
Brown.
The offering formally lumbered into gear on December 17 at an "all-hands meeting" at Microsoft. It
was the first gathering of the principal players: the company with its auditors and attorneys as well
as both managing underwriters and their attorney. Some confusion crept in at first. Heavy fog, a
Seattle specialty, delayed the arrival of several key people until early afternoon. One of Microsoft's
high priorities was making its prospectus "jury proof -- so carefully phrased that no stockholder
could hope to win a lawsuit by claiming he had been misled. The company had insisted that the
underwriters' counsel be Sullivan & Cromwell, a hidebound Wall Street firm. Gaudette was miffed to
see that the law firm had sent only an associate, not a partner.
The 27-point agenda covered every phase of the offering. Gates said the company was
contemplating a $40-million deal. Microsoft would raise $30 million by selling two million shares at
an assumed price of around $15. Existing shareholders, bound by Gates's informal rule that nobody
should unload more than 10% of his holdings, would collect the other $10 million for 600,000 or so
shares. The underwriters, as is customary in initial public offerings, would be granted the option to
sell more shares. If they exercised an option for 300,000 additional shares of stock held by the
company, almost 12% of Microsoft's stock would end up in public hands, enough to create the liquid
market the company wanted.
Gates had thought longest about the price. Guided by Goldman, he felt the market would accord a
higher price-earnings multiple to Microsoft than to other personal computer software companies like
Lotus and Ashton-Tate, which have narrower product lines. On the other hand, he figured the

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market would give Microsoft a lower multiple than companies that create software for mainframe
computers because they generally have longer track records and more predictable revenues. A
price of roughly $15, more than ten times estimated earnings for fiscal 1986, would put Microsoft's
multiple right between those of personal software companies and mainframers.
A host of questions came up at the all-hands meeting. Both Shirley and Gates were concerned that
going public would interfere with Microsoft's ability to conduct business. Shirley wondered whether
all three of Microsoft's top officers would be needed for the "road show," meetings at which
company representatives would explain the offering to stockbrokers and institutional investors.
Gates tried to escape the tour by saying, facetiously, "Hey, make the stock cheap enough and you
won't need us to sell it!"
Microsoft's attorney, William H. Neukom, 44, a partner at Shidler McBroom Gates & Lucas -- the
Gates in the title being Bill's father, William H. Gates -- raised another matter. The company would
have to tone down its public utterances, he said, lest it appear to be "gun jumping," or touting the
stock. Press releases could no longer refer to certain Microsoft programs as "industry standards,"
no matter how true the phrase. Neukom would review all the company's official statements, which
came to include even a preface Gates was writing for a book on new computer technologies.
The most tedious part of taking the company public was writing a prospectus. It was a task rife with
contradictions. By law Microsoft's stock could be sold only on the basis of information in this
document. If the SEC raised big objections to the preliminary version, Microsoft would have to
circulate a heavily amended one, inviting rumors that the deal was fishy. However cheerful or
gloomy the prospectus, many investors would fail to read it before buying. Then if the market price
promptly fell, they would comb the text for the least hint of misrepresentation in order to sue. Still,
the prospectus could not be too conservative. Like all such documents, it had to be a discreet sales
tool, soft-pedaling weaknesses and stressing strengths, all the while concealing as much as
possible from competitors.
Even Before Microsoft had picked its underwriters, Robert A. Eshelman, 32, an attorney at Shidler
McBroom, had started drafting the prospectus. That task took all of January. "As usual," says one
of the investment bankers, "it was like the Bataan death march." Neukom, who had just left Shidler
McBroom to join Microsoft, spent the first week of 1986 with Eshelman, sketching in ideas about
the company's products and business. Two days a week for the next three weeks, many of the
people who had been at the all-hands meeting reconvened at Microsoft's sleek headquarters in a
Seattle suburb to edit the prospectus.
At the first sessions, on January 8 and 9, the underwriters brought along their security analysts to
help conduct a "due diligence" examination, grilling the company's managers to uncover skeletons.
Gaudette was mollified that Sullivan & Cromwell had now furnished a partner from its Los Angeles
office, Charles F. Rechlin, 39. Gaudette had met him years before in New York but was bowled
over by how much he had changed. Rechlin was 40 pounds lighter and sported shoulder-length hair
and a fierce sunburn.

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For ten hours Gates, Shirley, and other managers exhaustively described their parts of the
business and fielded questions. Surprisingly, the Microsoft crew tended to be more conservative
and pessimistic than the interrogators. Steven A. Ballmer, 30, a vice president sometimes
described as Gates's alter ego, came up with so many scenarios for Microsoft's demise that one
banker cracked: "I'd hate to hear you on a bad day."
By late January only one major item remained undecided -- a price range for the stock. The bull
market that began in September had kept roaring ahead, pushing up P/E multiples for other software
companies. The underwriters suggested a price range of $17 to $20 a share. Gates insisted on,
and got, $16 to $19. His argument was ultraconservative: $16 would guarantee that the
underwriters would not have to go even lower to sell the shares, while a price of $20 would push
Microsoft's market value above half-a-billion dollars, which he thought uncomfortably high. "That
was unusual," says Christopher P. Forester, head of Goldman Sach's high-technology finance
group. "Few companies fight for a lower range than the underwriter recommends."
On February 1 a courier rushed the final proof of the prospectus to Los Angeles for Sullivan &
Cromwell's approval and continued on to Washington, D.C., with 13 copies. Two days later
Microsoft registered with the SEC, the underwriters sent out 38,000 copies of the prospectus, and
the lawyers began waiting anxiously for comments from the regulators.
Gates coped with concerns of a different sort. Relatives, friends, and acquaintances of Microsoft's
managers -- from Gates's doctor to a high school chum of Gaudette's -- called begging to buy stock
at the offering price. Except for about a dozen people, including Gates's grandmother and his former
housekeeper, who wanted small lots for sentimental reasons, Gates turned most of them down. "I
won't grant any of these goofy requests," he said. "I hate the whole thing. All I'm thinking and
dreaming about is selling software, not stock."
Rehearsals for the road show dramatized how differently Gates and Gaudette approached the
process of going public. Neukom, Microsoft's in-house attorney, had admonished Gates to say
nothing to anybody that deviated from the prospectus or added new information. At Goldman
Sachs's New York offices for a February 7 rehearsal, Gates wondered to himself, "With my mouth
taped, what's the point of giving a speech?" Addressing about 30 investment bankers and

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salesmen, he assumed an uncharacteristic, robotic monotone while covering Microsoft's key

strengths. He became annoyed when one critic commented, "It's a great first effort, but you can put
more into it." Snapped Gates: "You mean I'm supposed to say boring things in an exciting way?"
Gaudette, however, was in his element. He praised and repraised the company's record, studding
his talk with cliches and corny jokes. "When it comes to earnings," he exclaimed, showing a graph
of quarterly changes, "the pavement is bumpy, but the road goes only one way -- up!" Describing
Microsoft's $72 million in stockholders' equity and its lack of long-term debt, Gaudette teased
Goldman Sachs with a competing investment house's slogan: "We made our money the
old-fashioned way: We earned it!"
The road show previewed in Phoenix on February 18, and over the next ten days played eight
cities, including engagements in London and Edinburgh. Halfway through, the pageant took on an
almost festive air. Gates relaxed a bit, having been able to push his products as well as his stock at
various ports of call. In London, Eff Martin of Goldman escorted the party to the Royal Observatory
at Greenwich, found tickets for the smash musical Les Miserables, and arranged admittance to
Annabel's, a popular club. Gates danced the night away with Ruthann Quindlen, a security analyst
for Alex. Brown.
Festivity was appropriate. Every road show meeting attracted a full house, and many big
institutional investors indicated they would take as much stock as they could get. By the end of
February the Dow Jones industrial average had passed 1700. In London, Martin told Gaudette that
Goldman's marketing group considered the Microsoft issue very hot. The $16 to $19 price range
would have to be raised, he said, and so would the number of shares to be sold.
The underwriters had wanted to come to market while euphoria from the road show ran high. But the
SEC held the starting flag. On March 4 and 5 an SEC reviewer phoned in the commission's
comments on the preliminary prospectus to ^ Eshelman. The SEC had picked all sorts of nits, from
how Microsoft accounted for returned merchandise to whether Gates had an employment contract
(he does not). Its major concern appeared to be that the underwriters allocate shares widely
enough to make the offering truly public and not just a bonanza for a handful of privileged investors.
Eshelman was relieved. "It was a thorough review," he says, "but it was nothing to make my
stomach drop."
On March 6 Microsoft's lawyers and auditors called the SEC to negotiate changes. Meanwhile, the
company persuaded two stockholders to sell an additional 295,000 shares. The next day, as the
lawyers pored over proofs of a revised prospectus at the San Francisco office of Bowne & Co., the
financial printers, Gaudette zestfully battled to raise the price. Eff Martin of Goldman, who had flown
up to Seattle that morning, had good news. The "book" on Microsoft -- the list of buy orders from
institutional investors -- was among the best Goldman had ever seen. The underwriters expected
the stock to trade at $25 a share, give or take a dollar, several weeks after opening. A sounding of
big potential buyers showed that an offering price of $20 to $21 would get the deal done.
Gates asked Martin to leave while he conferred with Shirley and Gaudette. This was a different
Gates from the one who two months before thought $20 too high. "These guys who happen to be in
good with Goldman and get some stock will make an instant profit of $4," he said. "Why are we
handing millions of the company's money to Goldman's favorite clients?" Gaudette stressed that

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unless Microsoft left some money on the table the institutional investors would stay away. The three
decided on a range of $21 to $22 a share, and Gaudette put in a conference call to Goldman and
Alex. Brown.
Eric Dobkin, 43, the partner in charge of common stock offerings at Goldman Sachs, felt queasy
about Microsoft's counterproposal. For an hour he tussled with Gaudette, using every argument he
could muster. Coming out $1 too high would drive off some high-quality investors. Just a few
significant defections could lead other investors to think the offering was losing its luster. Dobkin
raised the specter of Sun Microsystems, a maker of high-powered microcomputers for engineers
that had gone public three days earlier in a deal co-managed by Alex. Brown. Because of
overpricing and bad luck -- competitors had recently announced new products -- Sun's shares had
dropped from $16 at the offering to $14.50 on the market. Dobkin warned that the market for
software stocks was turning iffy.
Gaudette loved it. "They're in pain!" he crowed to Shirley. "They're used to dictating, but they're not
running the show now and they can't stand it." Getting back on the phone, Gaudette crooned: "Eric,
I don't mean to upset you, but I can't deny what's in my head. I keep thinking of all that pent-up
demand from individual investors, which you haven't factored in. And I keep thinking we may never
see you again, but you go back to the institutional investors all the time. They're your customers. I
don't know whose interests you're trying to serve, but if you're playing both sides of the street, then
we've just become adversaries."
As negotiations dragged on, Shirley became impatient. Eshelman, the securities lawyer from Shidler
McBroom, was waiting in San Francisco to get a price range so he could send an amended
prospectus off to the SEC. Finally Gaudette told Dobkin, "I've listened to your prayers. Now you're
repeating yourself, and it's bullshit." The two compromised on a range of $20 to $22, with two
provisos: Goldman would tell investors that the target price was $21 and nothing less, and Dobkin
would report Monday on which investors had dropped out.
Monday's News was mixed. Six big investors in Boston were threatening to "uncircle" -- to remove
their names from Goldman Sachs's list. Chicago and Baltimore were fraying at the edges -- T. Rowe
Price, for instance, said it might drop out above $20 -- while the West Coast stood firm. The market
had closed flat, worrying Goldman's salesmen. But their spirits revived the next day as the Dow
surged 43 points. Gaudette, now confident that he and Dobkin could agree on a final offering price,
flew with Neukom to San Francisco to pick up Martin, and the three boarded a red-eye flight for New
York.
Sleepless but freshly showered and shaved, Gaudette reached Goldman Sachs's offices at 11
o'clock on Wednesday, March 12. Neukom walked over from Sullivan & Cromwell, where the other
lawyers were preparing the last revision of the prospectus. After lunch the two Microsoft officers
went to Dobkin's office and patched Shirley and Marquardt into a speakerphone.
The conferees had no trouble agreeing on a final price of $21. The market had risen another 14
points by noon. The reception for a $15 offering that morning by Oracle Systems, another software
company, seemed a favorable omen: The stock had opened at $19.25. About half the potential
dropouts, including T. Rowe Price, had decided to stay in.
The only remaining issue was the underwriting discount, or "spread" -- the portion of the price that

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would go to the underwriters to cover salesmen's commissions, underwriting expenses, and

management fees. Having agreed fairly easily over dollars, the two sides bogged down over
pennies.
Microsoft had always had a low spread in mind, no more than 6.5% of the selling price. That was
before negotiators at Sun Microsystems, where Marquardt is a director, wangled 6.13% on a
$64-million offering. Gates wanted Microsoft to get at least as good a deal on its offering. But he
had gone to Australia, where he was difficult to reach. In theory Gaudette lacked authority to go
above 6.13%, or just under $1.29 a share.
Dobkin opened with an oration. He touched on what other Goldman clients had paid, noting that
Sun's spread was off the bottom of the charts. He suggested that the managing underwriters
deserved healthy compensation; after all, their marketing efforts had raised Microsoft's offering
price 20%. Goldman's best offer, Dobkin said, was 6.5%, or $1.36 a share. But if pushed very hard
and given no alternative, it might, just to keep things amicable, go as low as $1.34. Having given
away $62,000 -- each penny of the spread was worth $31,000 -- Dobkin and his contingent left the
room to let Microsoft's side confer.
When they returned, Gaudette declared that Bill Gates had given definite orders: no more than
$1.28. Besides, he argued, Microsoft was a much easier deal to handle than Sun. As to the
underwriters' marketing efforts, selling more shares at a higher price was its own reward since it
automatically increased the money in their pockets.
At 3:30 the two sides were stalemated, Goldman Sachs now at $1.33 and Microsoft at $1.30. They
were arguing over all of $93,000 in a total fee of more than $4 million, and pressure was building.
The market was turning flat and would close in minutes. Members of the syndicate were clamoring
to know whether the deal was done. Dobkin kept reiterating his arguments. "Eric, you're wasting my
time," Gaudette sighed wearily, donning his coat. "I'm going to visit me sainted mother in Astoria.
When you've got something to say, send a limo to pick me up." With that, the Goldman team left the
room.
Dobkin returned alone and closed the door. "Sometimes these things go better with fewer people,"
he observed. Gaudette insisted he lacked authority to go higher. "All I can do is try to get another
penny from Jon," he said. "But I'm calling him just one more time, so don't screw up." "Make the
call," Dobkin said.
Gaudette caught Shirley as he was leaving a Bellevue, Washington, restaurant to buy a car for his
daughter as a 16th birthday gift. The lowest spread they could get, Gaudette said, was $1.31.
Though it was above Sun's spread, it was way below what any other personal computer software
company had achieved. Shirley approved. Neukom beckoned Dobkin back into the room, and
Gaudette uttered one phrase that betokened his assent to $1.31: "It's a go!" Dobkin hugged
Gaudette. David Miller, a beefy ex-football player who was Goldman's syndicate manager for the
offering, thundered down the stairs to his office bellowing to his assistant, "Doreen, we have a
deal!"

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Gaudette saved his cheers for the next morning. At 8 A.M. a courier had delivered Microsoft's
"filing package" to the SEC--three copies of the final prospectus and a bundle of exhibits, including
the underwriters' agreement to buy the shares, which had been signed only hours earlier. The
commission declared at 9:15 that Microsoft's registration was effective. On the trading floor at
Goldman Sachs, Gaudette heard a trader say, "We're going to shoot the moon and open at 25!"
At 9:35 Microsoft's stock traded publicly on the over-the-counter market for the first time at $25.75.
Within minutes Goldman Sachs and Alex. Brown exercised their option to take an extra 300,000
shares between them. Gaudette could hardly believe the tumult. Calling Shirley from the floor, he
shouted into the phone, "It's wild! I've never seen anything like it -- every last person here is trading
Microsoft and nothing else."
The strength of retail demand caught everyone by surprise. By the end of the first day of trading,
some 2.5 million shares had changed hands, and the price of Microsoft's stock stood at $27.75.
The opportunity to take a quick profit was too great for many institutional investors to resist. Over
the next few weeks they sold off roughly half their shares. An estimated one-third of the shares in
Microsoft's offering has wound up in the hands of individuals.
In the wake of Microsoft's triumph, Gates still fears that being public will hurt the company. No
longer able to offer stock at bargain prices, he--finds it harder to lure talented programmers and
managers aboard. On the other hand, his greatly enriched executives have kept cool heads.
Shirley, who cleared over $1 million on the shares he sold, has been the most lavish. He bought a
45-foot cabin cruiser, traded in two cars for fancier models, and may give in to his daughter's pleas
for an exotic horse. Gates used part of the $1.6 million he got to pay off a $150,000 mortgage and
may buy a $5,000 ski boat -- if he finds time. One vice president who raked in more than $500,000
can think of nothing to buy except a $1,000 custom-made bicycle frame; a programmer who
received nearly $200,000 plans to use it to expand his working hours by hiring a housekeeper.
That's just the kind of attitude Gates prizes. Constantly urging people to ignore the price of
Microsoft's stock, he warns that it may become highly volatile. A few weeks after the offering,
strolling through the software development area, he noticed a chart of Microsoft's stock price
posted on the door to a programmer's office. Gates was bothered. "Is this a distraction?" he asked.

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From the July 21, 1986 Editor's Letter:

Taking a company public is usually as private-and erratically emotional-as a love affair
Managers and their underwriters view the federally mandated "quiet period" before and after the
stock sale (designed to discourage hucksterism) as a signal to maintain a nervous
circumspection in the presence of the press. But Microsoft, the Seattle computer maker that is to
yuppies what GM is to middle-aged executives, granted "astounding access" over several months
before and after its offering, say Uttal. Chairman William Gates, whom Uttal calls the "Rabid
Rabbit" for his high-strung competitiveness, took the writer into his confidence. "We got along
because Bill likes intellectual challenges," says Uttal, "and I like to ask questions."
And ask questions he did. Questions of company officers, underwriters, lawyers, and major
investors. Questions in six cities, from San Francisco to Baltimore, where he followed Gates and
his troupe as they spoke to investors and negotiated the deal. Uttal went back to these sources
after the successful stock offering, when many felt more at liberty to talk. Meanwhile, invoking the
Freedom of Information Act, reporter David Kirkpatrick got the Securities and Exchange
Commission to release its normally private comments on Microsoft's prospectus.
Uttal, who joined FORTUNE shortly after earning his Harvard MBA in 1972, has covered
electronics since 1977. "I was bit badly, "says Uttal about his fascination with computers. He now
has four of them, including an ancient Osborne model and a laptop machine for taking notes at
interviews. His favorite stories for FORTUNE have examined subjects as diverse as the office of
the future and corporate "culture vultures." But he views the Microsoft chronicle as one of his
personal best because it is unique. As Uttal says, "I doubt that a story like this has been published
before or is likely to be done again." -Marshall Loeb

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SHELF REGISTRATION (RULE 415)

If a company expects to be making frequent public offerings of its

securities, and especially if it is eligible to use Form S-3 or Form F-3, it
will probably file a shelf registration statement as permitted by Rule 415
under the 1933 Act. A shelf registration statement covers securities that
are not necessarily to be sold in a single discrete offering immediately on
effectiveness, but rather are proposed to be sold in a number of "takedowns" over a period of time or on a continuous basis.
As described in this chapter, shelf registration has been around for
many years, but its use by companies to raise large amounts of capital in
the public markets has steadily increased since the adoption of Rule 415.
The SEC's adoption of Securities Offering Reform in 2005 has improved
the shelf registration process in many ways for the large companies
known as WKSIs as well as for seasoned companies who do not qualify
as WKSIs.
If a qualified company decides to take the shelf route, it will
register a specified dollar amount of securities. Since 1992, U.S. companies eligible to use Form S-3 have been permitted to register both debt
and equity securities on the same registration statement on an unallocated basis, that is, without separately specifying the amount of debt and
equity securities being registered.1 (In 1994, this privilege was extended
to non-U.S. companies eligible to use Form F-3.)2
Companies eligible to use Form S-3 or Form F-3 may offer their
securities either on a continuous or delayed basis. For example, at some
time after effectiveness, when market conditions appear favorable, the
company may request proposals or bids from one or more underwriters
for the sale of, for example, $500 million principal amount of debt
securities of a specified maturity or range of maturities. The company
weighs the various proposals and decides to accept terms that include, by
way of illustration, a 6% coupon, a seven-year maturity and a specific
price to public and underwriting discount. The securities are then "taken
off the shelf': the company and the underwriters sign a terms agreement
that is based on a full-scale underwriting agreement that was previously
filed as an exhibit to the registration statement, and the terms of the
securities and the underwriting arrangements are set forth in a supplement to the basic prospectus that is filed with the SEC under Rule
424(b)(2) by the close of business on the second business day after
pricing. There is no need for the SEC to take any action.
1
2

SEC Release No. 33-6964 (October 22, 1992).

SEC Release No. 33-7053 (April 19, 1994).

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CORPORATE FINANCE AND THE SECURITIES LAWS

A few months later, when the company needs funds or simply

wishes to take advantage of a perceived "market window," it may repeat
the process, this time ending up with an $800 million issue of five-year
notes with a specified coupon, public offering price and underwriting
discount. It may issue additional securities from time to time until all of
the registered securities have been sold, at which time it may file a new
shelf registration statement. With the availability of the unallocated shelf
procedure, the company has the ability to move rapidly with great
flexibility to take advantage of market opportunities.
After several offerings, the amount of securities remaining "on the
shelf" may be insufficienteven taking into consideration the 20%
"cushion" afforded by Rule 462(b)3to meet the company's
anticipated needs in the near term. In that case, the company can
"reload" the shelf by filing a new shelf registration statement. The
newly registered securities, together with the remnant remaining from
the old shelf, can be offered by means of a common prospectus under
Rule 429. The market sometimes assumes that a significant "reloading"
means that the company has acquisition plans, but most new shelf
registrations are regardedas one analyst put it in 2003as being
"like gasoline in the c a r . . . . When the tank gets low, you fill it up,
and you don't know if you're going to use it Saturday morning or three
weeks from now."
The use of Form S-3 or Form F-3 greatly simplifies a shelf registration program because the company can incorporate its future 1934 Act
reports by reference rather than amend or supplement the registration
statement and prospectus each time a material event occurs. The rule
does not require, however, that a company be eligible to use Form S-3 or
Form F-3 in order to take advantage of shelf registration for purposes
other than "delayed" offerings. For example, shelf registration is available to any company for "continuous" offerings of securities such as in
the case of MTN programs, discussed below. And since the adoption of
Securities Offering Reform even seasoned companies required to use
Form S-l can under specified conditions incorporate by reference their
past (but not their future) 1934 Act reports.
Shelf registrations were also used by companies of mortgage
related securities long before Rule 415, and the technique continues to
be used to register billions of dollars of ABS each year. See Chapter 14.
3

See infra 8.06[B][3] "Amount of Securities Registered."

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SHELF REGISTRATION (RULE 415)

8.01

Rule 415 specifically permits shelf registration of secondary offerings by selling securityholders from time to time on a securities
exchange or otherwise at prices current at the time of sale. This technique also predates Rule 415 by many years.
Rule 415 permits shelf registration of securities offered under a
dividend or interest reinvestment plan or an employee benefit plan;
securities to be issued on the exercise of outstanding options, warrants
or rights or on the conversion of other outstanding securities; securities
that have been pledged as collateral; and ADSs registered on Form F-6.
Shelf registration has made it possible for companies to reduce the
cost of capital by ensuring prompt access to the public markets at the
desired time, by reducing transaction costs and by facilitating the use of
efficient methods of distributing securities. But Rule 415 did not come
about without controversy. As will be seen, the SEC did not escape
criticism and opposition as it sought to adapt its rules and policies to
evolving practices in the securities markets.
The process by which the SEC sought to deal with registration "for
the shelf" began in the 1930s. The way that the law has developed in this
area is not unlike that described by Professor Lon Fuller in his jurisprudence classes at Harvard Law School. As an example of how the law
responds to the realities of life, Professor Fuller would point to the
flagstone paths laid out on the Cambridge Common. If the otherwise
law-abiding citizens of Cambridge consistently strayed from the paths
designated for their use, wearing away the grass as they followed a more
convenient route from one point to another, the city fathers simply would
pave over the paths that they had created. The SEC has followed similar
pragmatic principles in coping with shelf registration, and Rule 415 can
be viewed as a pavement that has been laid to widen and improve an
already existing path.

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170

Littler
littler.com

The

Economist
D r e x e l Burnham L a m b e r t ' s l e g a c y

Stars of the junkyard

T w e n t y y e a r s after Michael Milkens j u n k - b o n d firm c a m e c r a s h i n g d o w n , t h e
financial r e v o l u t i o n that it f o s t e r e d l i v e s o n
Oct 2 1 s t 2 0 1 0 | LOS ANGELES

IN JANUARY 2007 Creative Artists Agency (CAA), which manages George Clooney, Julia Roberts,
Brad Pitt and other film-industry luminaries, opened its new offices on Avenue of the Stars in
Century City, Los Angeles. As famous actors and directors file into the marble-lined entrance to
strike lucrative film contracts, even more serious money is being made upstairs.
The 12th floor is occupied by Ares, which has $37 billion of funds invested in private equity, highyield bonds and other corporate debt. One floor down is Canyon Partners, an alternativeinvestment firm that manages $18 billion. The CAA building is also home to Imperial Capital, a
boutique investment bank. All three firms can trace their origins to Drexel Burnham Lambert, an
investment bank that collapsed into bankruptcy in 1990, fatally wounded by an insider-trading
scandal.
Twenty years ago next month Michael Milken, Drexels most talented and best-paid financier, who
was based in Los Angeles, was sentenced to ten years in prison after pleading guilty to six counts
of securities fraud. His sentence was later com muted and he was released in 1992 after serving
22 months. He was also forced to pay much of the huge bonuses he earned at Drexel in fines and
settlements.
It is rare even in Hollywood to find a star that rose and fell so quickly. For much of the 1980s
Drexel was the hottest firm in investment banking, thanks to its dominance of the market for
high-yield corporate bonds, of which Mr Milken was king. These bonds were known a s junk
because they were ranked below investment grade by ratings agencies. Drexel used its muscle in
high-yield bond trading, which Mr Milken had built up in the 1970s, to push into other areas of
investment banking such as mergers and acquisitions and underwriting. By 1986 Drexel, which in

http://www.economist.com/node/17306419/print 171

11/16/2010

it s long hist ory had not previously t hreat ened t o j oin t he financial elit e, was Wall St reet s m ost
profit able firm .
But Drexel slum ped under t he weight of legal bat t les and t he $650m fine it agreed on wit h t he
Am erican governm ent t o set t le an invest igat ion of alleged securit ies fraud. When Mr Milken was
forced out at t he end of 1988, t he firm lost it s biggest source of revenue. His acum en was m issed
all t he m ore as t he j unk- bond m arket st art ed t o im plode at t he end of t hat decade. Rising
int erest rat es, default s on bonds t hat had been issued t oo readily in t he go- go years and new
regulat ions t hat forced t roubled savings- and- loans t o unload t heir high- yield holdings all
conspired t o drive j unk- bond prices down. This seem ed only t o validat e claim s t hat t he j unk- bond
m arket was a Ponzi schem e perpet uat ed by Mr Milkens t ight cont rol of it .
Those claim s t urned out t o be false. Drexel has left t hree enduring legacies: a j unk- bond m arket
t hat has grown at least sevenfold since t he firm s dem ise; t he firm s and indust ries, from
gam bling t o cable t elevision, t hat owed t heir rapid expansion t o t he invest m ent banks j unk
bonds; and t he influence of t he Drexel diaspora , t he young MBA graduat es who worked in t he
1980s under Mr Milken, on t he finance indust ry in Los Angeles and elsewhere.

Bust t o boom
I n 1990 t he out st anding st ock of j unk bonds ( est im at ed by
subt ract ing redem pt ions from new regist ered issues since 1970)
was about $150 billion. Now t he t ot al is over $1 t rillion. Around
t wo- fift hs of all out st anding corporat e bonds in Am erica are rat ed
as speculat ive , or below invest m ent grade ( BB+ or lower) ,
according t o Dealogic, a financial- dat a firm . Even bet t er- class
bonds are not as pukka as t hey once were: m uch of t he non- j unk
issued since 1992 has been rat ed BBB- , t he lowest invest m ent
grade.
Like all ot her credit , t he j unk- bond m arket was badly dam aged
during t he recession. But it has bounced back, j ust as it did in t he
early 1990s and early 2000s. This year new issuance has surged: wit h around $200 billion raised
in Am erica already, t he t ot al for 2010 is sure t o be a record ( see chart 1) . The revival is in part
driven by a renewed search for yield by invest ors disappoint ed wit h t he poor ret urns on cash or
Treasuries: t he int erest prem ium t hey dem and for holding j unk has t um bled ( see chart 2) .
The reopening of t he j unk- bond m arket has also afforded m edium sized firm s access t o credit again. The businesses t hat have
t apped t he m arket are a cross- sect ion of corporat e Am erica:
airlines, clot hing m anufact urers and ret ailers, healt h- care
providers, drug firm s, rest aurant chains, oil- explorat ion firm s and
sem iconduct or m anufact urers. Som e of t he new issuance is by
firm s looking t o lock in long- t erm financing on good t erm s.
The m arket s revival has been helped by fewer default s on highyield bonds. The default rat e on j unk bonds st ayed above 8% for
14 m ont hs in 2009- 10, according t o Credit Sight s, a research firm .
That com pares wit h 20 m ont hs in t he previous t wo recessions.
Junk bonds, once despised, are now m ainst ream . Milken and Drexel t ook high- yield bonds from
a cot t age indust ry t o one of t he cornerst ones of t he financial indust ry, says Howard Marks, one

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of Mr Milkens early cust om ers and now chairm an of Oakt ree, a Los Angeles firm t hat m anages
around $75 billion in funds, m uch of it in high- yield bonds and relat ed invest m ent s.

Ca t ch a fa llin g st a r
I n t he 1970s t he m arket for such bonds was t iny. I t com prised fallen angels , t he securit ies of
form er invest m ent - grade com panies t hat had fallen on hard t im es, which changed hands
infrequent ly and at big discount s t o face value. While a st udent at Berkeley in t he lat e 1960s, Mr
Milken cam e across em pirical support for his hunch t hat a port folio of t hese high- yield bonds
would out perform an invest m ent - grade port folio, even t aking int o account t he higher likelihood of
default . He found it in a st udy by Braddock Hickm an, a cent ral banker and st udent of corporat e
finance, which showed t hat even during t he Depression t here was a high rat e of ret urn on noninvest m ent - grade bonds. The int erest - rat e spread over supposedly safer bonds was m ore t han
enough com pensat ion for t he higher expect ed losses.
When Mr Milken began t o t rade j unk bonds at Drexel from t he early 1970s, his pit ch t o his
growing band of client s and followers was always t he sam e: j unk was a bet t er bet t han
invest m ent - grade bonds, which had only one way t o go: down. High- yield bonds proved t o be
resilient in t he m id- 1970s recession. Such was t he m elt down in financial m arket s t hat in 1974,
when t he value of equit ies fell by half, som e bonds could be purchased for t he price of t heir
coupon. Yet rem arkably few j unk bonds went bad and invest ors achieved high rat es of ret urn.
This set t he st age for t he opening of a sizeable m arket for new j unk issues in 1977. From t hen on
fallen angels would be t raded alongside ascending angels : t he bonds of firm s whose prospect s
were bet t er t han t heir lowly st at us suggest ed. I nt erest rat es were volat ile and firm s want ed t o fix
t heir cost of capit al. They were wary of relying on banks, which had cut lines of credit t o firm s at
t he nadir of t he recession t o preserve t heir capit al.
I n April t hat year Drexel underwrot e it s first j unk- bond issue when
it raised $30m for Texas I nt ernat ional, a sm all oil- explorat ion
com pany. Ot her issues followed t hat year but ot her invest m ent
banks init ially t ook a larger share of t his new m arket . That lead
did not last ( see chart 3) . Mr Milk ens preaching of t he high- yield
gospel secured him a loyal and growing cust om er base, m ost ly
am ong insurers and t hrift s, wit h an insat iable dem and for lowgrade securit ies. He helped his cust om ers m ake m oney. I f t hey
did well, t hey cam e back for m ore and in t im e t hey built t heir
businesses on t he supply of securit ies from Drexel.
The key t o t heir loyalt y was Mr Milkens com m it m ent t o buy or sell
on dem and t he bonds t hat Drexel had underwrit t en: he t hus offered t hem a liquid m arket and a
w ay out of invest m ent s t hey no longer w ant ed. That liquidit y at t ract ed m ut ual funds int o t he j unk
arena. Mr Milkens skill as a m arket m aker was root ed in his knowledge of t he bonds issued ( which
allowed him t o price t hem accurat ely) and his ext raordinary recollect ion of his client s holdings
( which helped him find new buyers for j unk t hat ot hers want ed t o unload) . And he st uck around
when ot her banks ret reat ed from t he j unk m arket during t he early 1980s recession.
This fresh j unk becam e an im port ant weapon for t he corporat e raiders and leveraged- buy- out
( LBO) firm s t hat cam e t o prom inence in t he 1980s. Drexels abilit y quickly t o raise hundreds of
m illions of dollars in m ezzanine debt ( so called because it ranks bet ween secure bank loans and
at - risk equit y in t he capit al st ruct ure) m ade t he t hreat of buy- out s credible and forced m any big
com panies t o slim cost s and increase ret urns t o shareholders t o st ave off t he t hreat of t akeover.

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Drexel found m uch of t he m ezzanine financing in 1989 for t he $25 billion purchase by Kohlberg
Kravis Robert s, a buy- out firm , of RJR Nabisco, a cigaret t e- and- biscuit conglom erat e. I t was an
exam ple of bot h Drexels daring and t he m uscle t he firm had at it s peak. We sat around and said
if every one of our exist ing cust om ers buys t he m axim um am ount t hey have ever bought of one
issue, we could get $3 billion, says Dana Messina, once a high- yield salesm an at Drexel, now t he
chief execut ive of St einway Musical I nst rum ent s. Drexel com fort ably raised $6 billion t o finance
t he deal.

Fe r t ilise d by j u n k
Junk- bond issues also offered a new way for m any sm all but growing firm s, which had been
st arved of capit al by st odgy com m ercial banks and sniffy invest m ent banks, t o finance
t hem selves. The bread- and- but t er business was cat ering t o guys like Craig McCaw or St eve
Wynn or John Malone or Ted Turner, says Mr Messina.
These ent repreneurs saw t he growt h pot ent ial in t heir respect ive indust ries. Mr McCaw was head
of McCaw Cellular Com m unicat ions, an early ent rant t o t he m obile- phone business, which had 2m
subscribers by t he t im e AT&T bought it in 1994 for $11.5 billion. Drexel also funded Bill
McGowans MCI , t he firm which successfully challenged AT&Ts fixed- line t elephone m onopoly.
Drexel financed Mr Wynns Golden Nugget casino in At lant ic Cit y and t he Mirage in Las Vegas,
replet e wit h a fake volcano. His firm now owns several luxury hot els in Las Vegas, a cit y whose
rapid growt h owed m uch t o high- yield finance. Mr Malones Tele- Com m unicat ions I nc becam e t he
biggest cable- TV firm in t he world. I t s growt h was financed by Drexel- issued j unk. Mr Turner
pioneered 24- hour news t elevision at CNN, a channel powered by j unk. Rupert Murdoch was
anot her m edia client .
None of t he firm s we financed were pure st art - ups, says Ken Moelis, who worked in Drexels
corporat e- finance t eam in Los Angeles and who st art ed Moelis & Co, an invest m ent bank, in
2007. Rat her Drexel found m oney for sm all firm s which had enough cashflow t o m eet int erest
paym ent s t o grow bigger. Som e indust ries were not well- suit ed for debt finance: t he m obilephone business did not generat e m uch upfront cash and cable- TV firm s had big st art - up cost s
before subscript ion revenue flowed. One solut ion was t o over- fund firm s, t o raise m ore capit al
t han t hey needed so t hat t hey could m ake t heir init ial int erest paym ent s. Anot her t rick was t o
use zero- coupon bonds, on which int erest paym ent s are deferred unt il t he principal com es due.
Not all Drexels corporat e cust om ers were t hrilled wit h t he price ext ract ed for t his service. Som e
felt t hat Drexel cut t oo good a deal for it self and for Mr Milkens loyal j unk- bond invest ors.
Drexels fees on j unk issues were 3- 4% ; less t han 1% was t ypical for invest m ent - grade bonds.
Drexels bankers oft en dem anded equit y warrant s for t hem selves and t heir buyers t o sweet en t he
deal.
Yet lopsided pricing is a feat ure of t wo- sided m arket s , in which one side benefit s if t here are
lot s of cust om ers on t he ot her side. For inst ance, clubs t hat act as m at chm akers for lonely heart s
oft en levy higher charges on m en t han on wom en, j udging t hat single m en will be keener t o j oin
clubs wit h lot s of fem ale m em ber s. I n a sim ilar way, Drexel was able t o charge an enviable fee
for access t o a scarce invest or base. Most firm s were willing t o pay. For a lot of issuers, it wasnt
t he cost of m oney. I t was t he cost of not having it , says Kyle Kirkland, who was one of t he last
MBA graduat es hired by Drexels Beverly Hills office in t he 1980s.
The desire t o m aint ain Mr Milkens hold on high- yield m arket m aking m ay explain why Drexels
bankers were lot h t o share deals wit h ot her invest m ent banks. I f com pet it ors issued lot s of j unk
bonds, t hat would underm ine Mr Milkens sense of who held what bonds and m ake cont rol of t he

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m arket harder. The firm gloried in t hwart ing rivals and in st ealing business from under t he noses
of a Wall St reet elit e it viewed as snoot y and indolent .
The firm had plent y of enem ies who welcom ed it s downfall. The
firm s abilit y swift ly t o raise vast sum s for LBOs st ruck fear int o
t he heart of corporat e Am erica. The j ob losses t hat oft en followed
a j unk- financed buy- out , as hit hert o inefficient firm s were sweat ed
for cash, creat ed a lot of polit ical fury. ( That far m ore j obs were
creat ed by t he sm all firm s t hat Drexel financed t han were lost in
LBOs is oft en overlooked.) Junk bonds, j unk people was t he
sneer from Wall St reet ers who loat hed t he upst art bank. Drexels
ret ort , t hat it s rivals would prefer t o sell invest m ent - grade bonds
on t heir rat ings, rat her t han put in t he hours of analysis needed t o
hawk j unk, was hardly endearing. Drexel also provided a useful
scapegoat for t he savings- and- loan crisis, because som e t hrift s
were keen buyers of j unk bonds.
Yet unloved as it was, Drexel changed t he face of corporat e
finance and of Wall St reet . These days wit h firm s, such as Google
and Apple, everyone t akes dynam ism for grant ed, says Mr Moelis.
But Mike Milken st art ed out in t he 1970s when capit alism was
st ruggling. I n t hose days, t here was very lit t le innovat ion. Along
com es Drexel, a firm wit h a visionary purpose, and suddenly you
could get capit al. Before 1977, when new j unk- bond issues t ook
off, says Mr Marks, non- invest m ent - grade bonds were t hought of as bad invest m ent s, at any
price. Nowadays a bad credit can be considered a prudent invest m ent if it is available at t he right
price.
Drexels t hird legacy is in t he m ark it left on t he finance indust ry, part icularly in Los Angeles. That
Drexels m ost profit able division was based so far from it s headquart ers in New York is largely
down t o t he accident of Mr Milkens birt h. Born and raised in t he San Fernando Valley, Mr Milken
ret urned t o Los Angeles in 1978 ( t aking 20 or so t raders wit h him ) t o be closer t o his fam ily.
Since he was t he m ain source of t he firm s profit s at t he t im e, his m ast ers could scarcely refuse
him .

D e sce n da n t s of D r e x e l
Wit h Mr Milken at it s cent re, Drexels Beverly Hills operat ion becam e a m agnet for t he best
business- school graduat es in t he lat e 1980s. That cohort of financiers is st ill act ive. Many of t hem
st ayed in Los Angeles aft er Drexel folded. Alm ost all have now m oved t o t he asset - m anagem ent
side of t he business, alt hough t he sell- side skills t hey developed at Drexel are useful in bringing
in m oney t o m anage or in arranging out side co- financing for privat e- equit y deals. Los Angeles no
longer has a big m oney cent re bank or a big broker. What st ayed was an innovat ive st rain of
Drexel- st yle next - st age finance. Local financiers say t hey are free of t he herd m ent alit y t hat
can t ake hold in New York. The weat her and t he qualit y of life help t oo: firm s say t hey find it
harder t o recruit , but easier t o ret ain, good st aff.
Som e Drexel alum ni are found t oday in New York. Rich Handler, a j unk- bond t rader in Drexels
Los Angeles office, m oved wit h 35 or so colleagues t o Jefferies, a local invest m ent bank; t hey
t ook t heir knowledge of high- yield bonds and invest ors wit h t hem . Mr Handler is now Jefferiess
chief execut ive but t he bank has long out grown it s Los Angeles and high- yield root s. I n 1990 it
had 400 em ployees. I t now has around 3,000, of whom 200 are based in Los Angeles: t he

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headquart ers t hese days are in New York. Anot her alum nus is Leon Black, founder of Apollo, a
corporat e- credit firm wit h $55 billion under m anagem ent . Apollo is based in New York, where Mr
Black also spent his Drexel years.
Drexels financiers were not alt ruist s; t hey were dealm akers. But in t heir search for profit t hey
also brought about a dem ocrat isat ion of credit . Firm s t hat previously had t o rely on conservat ive
banks or expensive equit y were given access t o fixed- int erest funds in capit al m arket s by t he
invest ors t hat Mr Milken and his j unk- bond t r aders had cult ivat ed. This was a boon t o t he
Am erican econom y: lim it ing capit al t o invest m ent - grade firm s lim it s econom ic progress. I f a firm
can pay t he rat e for it s risk, it should get t he m oney it needs.
Los Angeles is perhaps a curious hom e for a group of financiers wit h such a focus on high- yield
credit . The Hollywood business m odel is a search for a blockbust er t hat will pay for all t he
t urkeys. High- yield bond invest m ent is a different art : t he t rick is t o avoid t he losers; t hen t he
winners will t ake care of t hem selves.
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11/16/2010
176

Evercore Partners: Bankers of the Apocalypse

22 Sep 20 10
Im ogen Rose-Sm ith
Ev e r co r e 's r e s t r u ct u r in g t e a m h a s h a d a fr o n t -r o w s e a t fo r U .S. co r p o r a t io n s r id e in t o t h e e co n o m ic
aby ss.
On the evening of Decem ber 31, 20 0 8, while hundreds of thousands of people were m aking their way toward New Yorks
Tim es Square to watch the fam ous Waterford crystal ball drop, investm ent banker David Ying was hosting a far less
ebullient gathering in downtown Manhattan. As co-head of restructuring for boutique bank Evercore Partners, Ying was
advising LyondellBasell Industries, the worlds third-largest chem icals com pany, which was on the brink of bankruptcy.
The only way to prevent a com plete shutdown of LyondellBasells operations was to raise $ 4.75 billion of debtor-inpossession financing larger than any DIP loan in history. The sheer size wasnt Yings only problem . The capital m arkets
had been com pletely frozen since investm ent bank Lehm an Brothers Holdings had filed for bankruptcy a few m onths
earlier.
We had to raise $ 4.75 billion of financing at the nadir of the DIP m arket, Ying says.
For New Years Eve, Ying and his team at Evercore invited LyondellBasells m ajor lenders, including banks, private equity
firm s and hedge funds, to the offices of Cadwalader, Wickersham & Taft, the chem icals m akers legal counsel. Also present
was the LyondellBasells biggest equity holder, Access Industries, a U.S.-based industrial holding com pany controlled by
Russian-Am erican billionaire Leonard Blavatnik, whom m any of the creditors blam ed for creating the m ess after his Basell
Holdings paid $ 20 billion in borrowed cash to acquire Lyondell Chem ical Co. the previous year. Yings job was to shuttle
am ong the different constituents, encouraging and cajoling, suggesting and insisting, until an agreem ent could be forged.
[Click here to view Evercore Partners slideshow]
Negotiations dragged on. Afraid to m iss any of the action, Gavin Baiera, a distressed-debt analyst with a LyondellBasell
creditor, $ 23 billion alternative-investm ent firm Angelo, Gordon & Co., didnt go hom e for three days. On Monday,
J anuary 5, Daniel Celentano, the other senior Evercore partner on the deal, led his firm s team as they dialed through the
night to round up support for a crucial standstill agreem ent necessary to prevent any creditors from forcing LyondellBasell
into receivership in a jurisdiction outside the U.S. Baiera rem em bers eventually being woken up by a groggy Celentano at
4:0 0 in the m orning on Tuesday, J anuary 6, to get a signature on a loan agreem ent. The radical solution Ying and
Celentano brokered was an innovative partial roll-up of the first lien debt. The agreem ent m ade $ 3.25 billion of that debt
equal in seniority to the $ 3.25 billion of term -loan DIP financing, but with the important proviso that the rolled-up loan
could be satisfied by issuing new debt, as opposed to cash. Com bined with an addition al $ 1.5 billion to $ 2 billion in assetbacked DIP financing, LyondellBasell had its lifeline.
That sam e day, Lyondell Chem ical and 93 other affiliates of LyondellBassell began the process of filing for bankruptcy.
Though one of the largest and m ost com plex restructurings of all tim e, LyondellBassells $ 27 billion Chapter 11 filing
turned out to be only the sixth largest in 20 0 9. Evercore acted as lead adviser on that years two biggest bankruptcies, the
Chapter 11 filings of carm aker General Motors Corp. and financial services com pany CIT Group.
The past 24 m onths have been an unprecedented white-knuckle ride for corporate Am erica. The credit crisis and the
collapse of the capital m arkets put enorm ous strains on com panies, m any already overloaded with debt they acquired
during the previous decade of easy m oney. The result has been a boom for restructuring, with Evercore right in the thick of
things. To save these broken com panies, the firm s bankers have had to innovate and im provise, som etim es reinventing
the rules as they went along. Now, as the U.S. econom y seeks to right itself, it rem ains to be seen if these fixes, and others
like them , will be enough.

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[Video Caption: Business leaders and W ashington are not seeing ey e to ey e w hen it com es to financial reform , w ith
Roger Altm an, Evercore Partners. Airtim e: W ed. Jul. 21 20 10 | 7:19 AM ET]
After a record boom in leveraged buyouts, the U.S. is facing an im pending wall of debt. According to Credit Suisse
estim ates, $ 985 billion of high-yield bonds and leveraged loans are set to m ature between 20 11 and 20 14 and m uch of
that will need to be refinanced. Every refinancing conversation is a potential restructuring, says Yings fellow co-head of
restructuring, William Repko.
The senior m em bers of Evercores workout team are an eclectic crew. The slightly rum pled Repko, 61, is a self-described
gearhead who worked at one bank for 32 years and loves gadgets and golf. The cerebral Ying, 56, is a Massachusetts
Institute of Technology graduate who could easily have becom e a quant. Before joining Evercore as a senior m anaging
director, the 59-year-old Celentano had to prepare his own com pany for bankruptcy when he was working at Bear Stearns
Cos. Senior m anaging director Qazi Fazal, 37, left his native Bangladesh at the age of 15 for prep school in the U.S. And
Stephen Hannan, 48, the newest m em ber of the team , landed in restructuring after a career that began in accounting and
included a stint at a hedge fund. None of the group conform s to the traditional m old of a financial adviser. But then, as
Repko puts it, restructuring is the dark side of investm ent banking.
By contrast, Evercore founder Roger Altm an, 64, is the quintessential banker tall, well dressed, charism atic and
fam ously connected. Last year the form er Lehm an banker an d two-tim e Treasury Departm ent official brought in Ralph
Schlosstein, 59, a founding partner of $ 3.4 trillion m oney m anagem ent firm BlackRock, to be president and CEO of
Evercore. Altm an and Schlosstein, however, are no strangers to the art of restructuring (see Evercore's Washington Ties
Help The Firm Gain Perspective).
Altm an co-founded Evercore in 1996 as a boutique investm ent bank offering advice free of the conflicts of larger
institutions. In 20 0 6, capitalizing on investors then fondness for financial services com panies, he took the firm public. Net
revenue for 20 0 6 was $ 20 8 m illion, clim bing in 20 0 7 to $ 321.6 m illion, of which $ 295.7 m illion was generated from
advisory work. Although Evercore does not break out restructuring in its financials, it is a safe bet that in 20 0 7 the vast
m ajority of the firm s advisory revenue cam e from m ergers and acquisitions. Global M&A deal volum e, as tabulated by
Thom son Reuters, hit a record $ 4.4 trillion that year. Evercore ranked 12th in total volum e for U.S. deals, second only to
Lazard am ong independent investm ent banks, according to Thom son Reuters.
Then the world changed. As the credit m arkets started showing cracks, the lucrative advisory business began to wither.
Deal volum e fell to $ 2.9 trillion in 20 0 8; Evercore had only $ 181.6 m illion in advisory revenue that year. But am id the
gloom the restructuring business was boom ing. Restructuring accounted for roughly half of Evercores 20 0 9 advisory
revenue of $ 293.3 m illion. Bankruptcy fees are always a sensitive topic, for obvious reasons, but Evercore m ade $ 47
m illion from GMs restructuring, $ 50 m illion from its work for CIT and $ 41 m illion from LyondellBasell.
Boosted by advising to the likes of GM and CIT, as well as counseling GM on the bankruptcy of auto-parts m anufacturer

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Delphi Corp., Evercore was ranked second by Thom son Reuters for worldwide com pleted restructuring deals in 20 0 9. It
finished behind Houlihan Lokey, a Los Angeles based boutique bank that advised CITs creditors on that restructuring and
worked with the creditors of Lehm an Brothers and GM during those com panies bankruptcies. Altm ans goal for the next
few years is for Evercore to be considered one of the top three banks in restructuring. Hell have his work cut out for him .
For the first half of this year, Evercore ranked just fifth for worldwide com pleted restructurings and 18th for announced
deals. Widely regarded as the current king of bankruptcy, Lazard tops the chart for com pleted deals this year (up from No.
7 in 20 0 9). Altm an also has to worry about up-and-com ers like Moelis & Co. Founded in 20 0 8 by Kenneth Moelis, form er
head of UBSs investm ent bank, the New York based boutique ranks fourth in com pleted restructurings this year, one rung
above Evercore. In his firm s defense, Ying says a large percen tage of what we do never ends up in bankruptcy and doesnt
show up in the league tables.
Evercores lim ited global footprint is a challenge for the firm . With so m any European countries facing severe econom ic
shortfalls and Europe-based com panies having taken on leverage, m any U.S. investors believe that the next real action in
the current distressed cycle will occur on the other side of the Atlantic. Altm an and Schlosstein are working to build up
Evercores European franchise on both the restructuring and M&A sides of the business. We need to expand the num ber
of partners [and] senior m anaging directors that we have [in Europe] both on an industry basis and also to have m ore
critical m ass there, Schlosstein told analysts in April. But restructuring presents a particular difficulty in Europe because
the bankruptcy process varies from country to country.
LyondellBasell, a Netherlands-based com pany, chose to file for bankruptcy in the U.S., where the process is unique largely
because of the existence of Chapter 11. That part of the bankruptcy code provides legal breathing room for com panies to try
to fix them selves. There is no equivalent [in Europe] to Chapter 11, says LyondellBasells CFO, Kent Potter. If this had
been a solely European com pany, we would have been in liquidation.
In 20 0 5, Congress legislated the first significant changes to the bankruptcy code in alm ost 30 years. The controversial
legislation, which originally passed the House of Representatives in 1997 and was lobbied for by the credit card com panies,
sought in part to speed up the process of corporations reorganizing through bankruptcy court. The events of the past two
and a half years have put the reform s to the test, and the results have been m ixed. Although com panies like GM and CIT
have been able to em erge from bankruptcy in record tim e, retailers such as Circuit City Stores have struggled to renegotiate
leases quickly enough to avoid liquidation.
The other m ajor change in this distressed cycle is the num ber of different groups now seated at the workout table.
Originally, banks were the only lenders to attend the party, but they are now joined by private equity m anagers, hedge
funds and other distressed-debt investors. Meanwhile, securitization and the boom in the credit derivatives m arket have
created a whole new set of instrum ents specifically, collateralized debt obligations and credit default swaps that
provide a way for investors to bet on com panies.
For creditors that hold both the debt and the CDSs of a com pany, it m ight not always be in their best interest to see that
com pany survive. If a noteholder also has CDSs and you dont know his exact position, it is m uch harder to determ ine his
ultim ate agenda, Celentano says. The result can feel like a never-ending poker gam e. That gam e got especially tense
during the recent credit crisis, when counterparty risk becam e a m ajor issue and m any hedge fund m anagers had financing
problem s of their own that m ay have influenced their decision m aking.
By Roger Altm an's own adm ission, Evercore was late to the restructuring game the last tim e the econom y m elted down,
following the bursting of the stock m arket bubble in 20 0 0 . It took us too long to develop a restructuring group, and that
was m y fault, he concedes. But the Evercore founder and chairm an m ade up for lost tim e with the hiring of Bill Repko and
David Ying in 20 0 5.
Ying and Repko would seem an unlikely pair. Repko is all jowls and jokes, a father of six who epitom izes the word
avuncular, while the tall, angular Ying com es across as icy and aloof. Bill is clearly the m ore gregarious of the two of us,
and I am the m ore intellectual, Ying says. But first im pressions can be wrong. Ying has a sharp, wicked sense of hum or,
and Repko is a cunning tactician. Ying jokes that for m ost of their careers he was always careful not to anger Repko,
because the latter was the one with the checkbook.
Bill Repko m oved around a lot as a kid his father was an executive with Pepsi-Cola Co., as it was then called and he
wanted to design and build sports cars when he grew up. To that en d, he studied engineering at Lehigh University until a
course on theoretical m athem atics sent him to the finance departm ent instead. Graduating with a BS in finance, Repko
joined Manufacturers Hanover Trust Co. in 1973 as a m anagem ent trainee, ending up in the New York based banks
corporate lending division. Back then restructuring wasnt even a cottage industry, he says. Over the next 32 years, while
Repko worked his way up the banking ladder, the world around him was changing. Manufacturers Hanover becam e,
through a series of m ergers, J PMorgan Chase & Co., and corporate credit took off along with the job of restructuring
troubled com panies.
Repkos group was involved in m ost of the m ajor corporate reorganizations of the past three decades, including Adelphia
Com m unications Corp., Enron Corp., Lucent Technologies, United Airlines and WorldCom . He likes to say, No one cares

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how m uch you know until they know how m uch you care, explains Norm a Corio, treasurer at J PMorgan Chase, who was a
protge of Repkos in the restructuring group. Repkos passion for products like cars and airplanes he is never happier
than when he is at an auto show or visiting a factory helps him connect with clients, m aking them com fortable so his
bankers can better do their jobs.
The son of Chinese im m igrants, Ying wanted to be a m athem atician or a chem ist when he arrived at MIT in the fall of 1972,
but he ended up studying m anagem ent. A pupil of Robert Merton, one of the architects of m odern financial theory, who
would go on to becom e a founding principal of hedge fund Long-Term Capital Managem ent, Ying was tapped to join the
professors doctoral program . The New York native, however, was drawn to banking. After graduation he got his MBA from
the University of Pennsylvanias Wharton School, then landed a job in 1978 as a generalist investm ent banker at Shearson
Hayden Stone (which would becom e Shearson Lehm an Brothers).
When you cam e up without contacts in the late 1970 s, you pulled yourself up by your bootstraps, Ying says.
In 1985, Ying joined New York boutique investm ent bank Drexel Burnham Lam bert and wound up in the exchange-offer
group, which handled tender offers. Paul Levy, then head of the group, rem em bers him well. David was an extrem ely
talented generalist, and I was lucky enough that he joined m y restructuring team , Levy says. He adds Ying was m ore
analytical than I am , and I was m ore outgoing, foreshadowing the dynam ic between Ying and Repko. The com bination
worked. We really dom inated the exchange-offer business, Levy says.
Out in Drexels Los Angeles office, another Wharton graduate was busy transform ing the high-yield bond m arket and the
balance sheets of corporate Am erica. During the 80 s, as head of Drexels high-yield and convertible bond departm ent,
Michael Milken had persuaded U.S. com panies and investors to issue and buy lower-rated, higher-risk debt junk bonds
and with that, the leveraged buyout industry had taken off. But by 1990 the high-yield m arket was crum bling, Milken
had been indicted for securities fraud as part of an insider trading investigation, and Drexel was teetering on bankruptcy.
In J anuary of that year, Ying, who by then was heading up Drexels restructuring practice in New York, m oved the m ajority
of his group to Sm ith Barney. Three years later Donaldson, Lufkin & J enrette recruited him to lead that firm s restructuring
business.
During the sum m er of 20 0 5, Repko, who had recently retired from J PMorgan, and Ying, who had just left the boutique
advisory firm Miller Buckfire & Co., bum ped into each other on Manhattans Park Avenue and m ade plans to m eet. During
that lunch they discovered that each of them had been contacted by a headhunter to gauge his interest in becom ing the new
head of restructuring at Evercore. We decided that whatever we did next, we should do it together, Repko recalls. So they
suggested to the headhunter that Altm an hire them both.
Repko and Ying joined Evercore on Septem ber 30 , 20 0 5. From the m om ent he arrived, Ying was struck by the collegial
atm osphere of the firm , which rem inded him of the good old days at Drexel. Still, he and Repko didnt have a lot to do at
first, as corporate bankruptcies were few and far between. The global and corporate default rate for speculative- and
investm ent-grade bonds was at a near all-tim e low of 0 .55 percent, according to Standard & Poors. But that would soon
change.
Repko and Yings first crucial hire was Celentano. The son of a rocket scientist his father, who had a Ph.D. in
biochem istry, worked on nuclear m issile defense contracts Celentano originally planned on being an architect until art
classes at night school convinced him he could not draw. Instead, he earned his MBA in finance from Wharton and began a
career on Wall Street as an account officer covering m etals and m ining in Citibanks World Corporation Group, which
m anaged the bank's relationship with m ultinational com panies. In 1988 he joined Bear Stearns restructuring departm ent.
As a senior restructuring banker, Celentano got a call in early March 20 0 8 from Richard Metrick, a close confidant of Bear
Stearns CEO Alan Schwartz. The firm was in deep trouble, and Metrick asked Celentano to prepare it for a possible
bankruptcy filing a grim task that Celentano had to perform a second tim e when Bear Stearns feared that its
shareholders would not approve J PMorgans agreem ent to purchase the bank for $ 2 a share (the offer was later raised to
$ 10 a share).
The day after the J PMorgan Bear Stearns transaction closed, Celentano joined Evercore. He brought with him an
extrem ely im portant engagem ent. Celentano was GMs adviser on the seem ingly never-ending restructuring of Delphi,
GM's largest auto-parts supplier and form er subsidiary. We stayed with Dan; we trusted him , says Frederick (Fritz)
Henderson, GMs form er CEO. Delphi had filed for Chapter 11 in October 20 0 5; it would em erge in October 20 0 9.
Another key hire was Qazi Fazal. Born in Bangladesh, Fazal wanted to attend university in the U.S., but in the late 80 s,
U.S. schools were reluctant to take students from that country because of concerns over forged academ ic records. So, Fazal
instead applied for and received a scholarship to prep school Phillips Exeter Academ y in Exeter, New Ham pshire. Two
years later he was accepted at Harvard University, where he went on to m ajor in econom ics and study Sanskrit.
In 1994, after graduation, Fazal entered the throng of Wall Street, first as an analyst in the m anagem ent consulting group
of Bankers Trust Co., then as an investm ent banker at Wasserstein Perella & Co. In 20 0 2 he was part of the restructuring
group that spun out to form Miller Buckfire. Thats where he got to know Ying, eventually following him to Evercore in late
20 0 8.

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Few com panies were m ore poorly positioned when the finanical crisis hit than the U.S. car m anufacturers. Detroits Big
Three GM, Ford Motor Co. and Chrysler Corp. had been in peril for decades, struggling with m assive pension and
health care costs, battling im m ovable unions and burdened with debt. Their m ore nim ble non-U.S. com petitors, not
hindered by legacy labor issues, had been handily beating them in the m arketplace. And like m ortgage lenders and credit
card providers, the autom akers, which had large finance arm s and sold m ost of their vehicles through leasing
arrangem ents, were highly leveraged to the U.S. consum er.
Few bankers have closer ties with the carm akers than Repko, whose relationship with GM goes back to 1992, when he
was at Chem ical Bank and helped put together a $ 20 .6 billion credit facility for its lending subsidiary, General Motors
Acceptance Corp. As recently as 20 0 6, while at Evercore, he advised GMs board on its sale of a 51 percent stake in GMAC
to Cerberus Capital Managem ent. That sam e year, Repko also advised Ford, the only m ajor U.S. car com pany not to go into
receivership.
Bill likes cars, and he has an infectious attitude, says Henderson, who was GMACs group vice president of finance in
1992 and served as GMs CEO from March 20 0 8 through March 20 0 9. With Bill, its not sim ply about finance, its about
how finance supports the business.
Despite Repkos reputation as banker to the cars, it was Altm an who got the call in J une 20 0 8 when GM needed to look for
new financing options. In hindsight, it seem s inevitable that GM, which was wobbling under $ 77.1 billion in debt, would
have to be reorganized through a governm ent-assisted Chapter 11 process, but at the tim e, a public bailout on such a large
scale had never been achieved. That sum m er, Evercores m ain task was to try to find private financing but there wasnt
any.
Bill told us point-blank, You arent going to be able to get this done, Henderson recalls.
Once GM entered Chapter 11 in J une 20 0 9, Evercores m ost im portant roles were com ing up with a valuation no easy
task given the highly com plex nature of GMs balance sheet and the m ultiple m oving parts of the bankruptcy as well as
working with Treasury and GM to structure the $ 66 billion in financing. GM was in and out of Chapter 11 in just 39 days,
but for Evercore, as Repko says,GMs bankruptcy was a whole years worth of work.
If GMs bankruptcy was characterized by governm ent involvem ent, the im m ediate cause of CITs 20 0 9 bankruptcy was the
governm ents decision not to intervene. The im proving capital m arkets at the tim e convinced officials that the econom y
could survive such a shock. This was bad news for J effrey Peek.
Peek was the form er head of investm ent banking at Merrill Lynch & Co., which he left in 20 0 1 after losing a battle with E.
Stanley ONeal to becom e CEO. Eventually, he landed at CIT Group, a then-sleepy Livingston, New J ersey based lender.
As CEO, Peek m oved CITs headquarters to Manhattan and began expanding its operations in areas such as subprim e
m ortgages and student loans. During the credit crisis, however, that strategy quickly unraveled. In April 20 0 8, shortly
before Peek hired Evercore to advise the board, CIT stopped m aking student loans. In J uly it sold its hom e m ortgage
business. By J une 20 0 9, CIT had converted itself into a bank holding com pany so it could participate in the Troubled
Assets Relief Program , but the $ 2.3 billion it received from the governm ent wasnt even close to enough to cover its $ 64.9
billion in liabilities. CIT approached the Federal Deposit Insurance Corp. about governm ent backing for a bond sale and
was turned down.
CIT was on the verge of an uncontrolled bankruptcy, just like Lyondell, recalls Ying. Initially, he and his team thought
they had lined up a lender, but at the last m inute, that bank backed out. The failed negotiations had wasted 48 hours
tim e that CIT didnt have. David and I walked into an em pty conference room , Fazal recalls. We looked at each other and
said, What do we do now?
But a potential savior had already em erged. New York based hedge fund Centerbridge Partners was a large CIT
bondholder. This situation was ripe for a rescue, says J effrey Aronson, co-founder of the $ 12 billion firm . He reached out
to Ying and offered to help raise the m oney, but Centerbridge wanted a closed process.
The half dozen invited investors collectively had to com e up with $ 3 billion. In return, they would receive interest
paym ents on the senior secured loan of about 13 percent. As part of the agreem ent, CIT had to present a restructuring plan
to the Group of Six, as the rescue lenders cam e to be known, for approval. Rather than present CITs board with tem porary
financial solutions, Evercore suggested a $ 55 billion debt restructuring, including a $ 35 billion debt-for-equity swap, all
through a prepackaged Chapter 11 process. Getting the com pany and the creditors to agree to what would be the largestever prepackaged bankruptcy put Yings powers of persuasion to the test.
To convince a board of directors and a senior m anagem ent team who were sure, not unreasonably, that if CIT were to
announce bankruptcy that their franchise would be over took som e doing, says J . Gregory Milm oe, head of the
restructuring group at CITs legal counsel, Skadden, Arps, Slate, Meagher & Flom in New York.
David had to explain to the com pany that a Band-Aid doesnt solve the problem , adds Aronson. He told the com pany

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that the right thing to do, not only for the creditors but also for the health of the business, is to fix it through this prepack.
On October 13, 20 0 9, Peek announced that he would be leaving CIT before the end of the year. The com pany filed for
bankruptcy less than three weeks later, but thanks to Evercores plan, it was able to em erge from Chapter 11 in just 38 days.
Like CIT, MGM Mirage (now MGM Resorts International) got neck-deep into the areas hit hardest by the credit crisis. In
August 20 0 7 the hotel-and-gam ing com pany annouced a landm ark 50 -50 joint venture with Dubai World, the investm ent
arm of the wealthy Persian Gulf em irate, to build a project called CityCenter. Sprawling across three Las Vegas blocks, the
16.8 m illion-square-foot com plex was slated to include everything from a high-end resort and spa to ultrachic shopping
and casinos to luxury condom inum s. Dubai World agreed to put up $ 2.7 billion to help pay for CityCenter and to purchase
$ 2.4 billion in MGM shares.
But then the credit crisis hit. By March 20 0 9 both MGM and Dubai were in serious financial trouble, and there were doubts
as to whether the $ 8.5 billion project would ever be com pleted. To finish the job, the two partners needed to raise a further
$ 2.8 billion; Dubai World tried to get out of the deal by suing MGM for breach of contract and refused to m ake a $ 20 0
m illion paym ent required to keep CityCenter on track.
Evercore senior m anaging director Stephen Hannan remembers the events well, as they unfolded during his first week on
the job. The Sunday before, he flew to Las Vegas with Fazal, Repko, Ying and Eduardo Mestre, Evercores vice chairm an,
for a m eeting with MGMs board and m anagem ent. It would be the first of m any trips, says Hannan, who joined Evercore
from $ 5 billion Greenwich, Connecticut, hedge fund Black Diam ond Capital Managem ent.
We had never had to deal with this kind of situation before, says MGM Resorts CFO and treasurer Daniel DArrigo. We
were a little bit of a fish out of water.
MGM had blown through its credit agreem ents with all of its lenders and needed to renegotiate its debt im m ediately. But
Evercore also had to help MGM persuade Dubai World and the banks, which were on the line for about $ 3.5 billion, to
continue with their com m itm ent to CityCenter. Evercores solution was to create a structure where both MGM's and Dubai
World's com m itm ent were supported by bank letters of credit. CityCenter was com pleted in Decem ber 20 0 9; Eduardo,
Hannan, Repko and Ying all flew to Vegas for the opening party.
For com panies like MGM, the next 18 m onths are critical. Will the U.S. econom y continue to im prove, or is it headed
toward a double-dip recession? And if econom ic conditions worsen or interest rates rise, does MGM have a large enough
financial cushion to survive?
We have created a lot m ore liquidity for ourselves, DArrigo says. But this is not going to be the kind of V-shaped
recovery that we have seen in the past.
In early August, MGM Resorts announced that it had taken a $ 1.12 billion write-down on CityCenters value in its secondquarter earnings and that CityCenter had an operating loss of $ 128 m illion for the quarter. But there were som e favorable
m etrics as well. J une was the first m onth since October 20 0 7 that MGMs revenue per available room on the Las Vegas
Strip increased.
Things are definitely looking up for LyondellBasell, which em erged from Chapter 11 with $ 7.2 billion in total debt and
$ 2 billion in cash. After a fraught bidding war over who should provide the exit financing in which Evercore, and in
particular Celentano, played a pivotal advisory role LyondellBasell hopes to soon be filing to list on the New York Stock
Exchange 564 m illion shares that it had issued to creditors.
On August 18, General Motors Co. filed for its long-awaited IPO. The offering, which is being led by underwriters
J PMorgan and Morgan Stanley and is expected to be com pleted som etim e this fall, will be closely watched as an indicator
of the health of the auto industry.
There rem ains plenty for Ying, Repko and the rest of the restructuring team to do. Off the back of its work with MGM
Resorts, Evercore has acted as an adviser to the Marnell fam ily on its M Resort in Las Vegas. It also advised Apollo
Managem ent when the private equity firm was considering acquiring a different struggling resort project, Fontainebleau
Las Vegas. And along with Morgan Stanley, Evercore has been counseling the oil and gas exploration com pany Delta
Petroleum Corp. on its strategic options to help pay down its debt. The firm has also been retained as an adviser to troubled
U.K. oil and gas com pany BP.
There is little doubt that the pendulum is swinging back toward M&A advisory. During Evercores second-quarter
conference call, Altm an said he expects restructuring to account for m eaningfully less than half of Evercores overall
advisory revenue in 20 10 . He went on to say that the firm s restructuring business is quite healthy, but in reality, the cycle
is slowly shifting, and as M&A recovers, the restructuring tends to soften. But the shift is going on slowly.
In preparation for the good tim es ahead, Evercore has been on a hiring spree. In J une, Altm an and Schlosstein brought in
Philip Kassin as a senior m anaging director in the firm s advisory practice. A chem icals and energy specialist, Kassin

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previously worked as head of M&A and financing for, of all com panies, LyondellBasell investor Access Industries. There he
becam e very fam iliar with the chem icals com pany, its travails and the work of Evercores restructuring team . In fact, as
Access representative on the LyondellBasell supervisory board, Kassin was a key player during the long days and nights in
J anuary 20 0 9 when Ying and Celentano were negotiating for the chem icals com panys survival.
Still, Roger Altm an believes that restructuring can be a business for all seasons. This is a good business, he says, and one
wants to be in it in a leadership way every day of the week.

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184

Distressed-Debt Investing Shows Great Prom ise

20 Sep 20 10
Xiang J i
Fo r d is t r e s s e d -d e b t in v e s t o r s , a n in d u s t r y n o t lo n g a g o w r it t e n o ff a s h a lf d e a d is r e g is t e r in g fr e s h v it a l
s ig n s .
When Centerbridge Partners, a New York based private equity an d distressed-debt investor, gained the right this spring to
sponsor the reorganization of bankrupt Extended Stay Hotels, it was m ore than just a corporate coup. For Centerbridge
m anaging directors Vivek Melwani and William Rahm , it was a personal trium ph. For close to two years, Melwani, 38, at
one tim e a bankruptcy lawyer, and Rahm , 31, form erly a private equity specialist for Blackstone Group, had been
painstakingly com bing through the convoluted debt of the 684-hotel, Spartanburg, South Carolina, chain.
Extended Stay had a $ 4.1 billion m ortgage that was securitized and sliced into 18 tranches, along with $ 3.3 billion of
m ezzanine debt divided into ten separate loans, recalls Rahm with a shudder. Som e prospective investors in the efficiencyhotel com pany had thrown up their hands after discovering what a m ishm ash its finances were a situation exacerbated by
the fact that this was the first-ever large-scale corporate bankruptcy involving com m ercial-m ortgage-backed securities, and
therefore posed extra uncertainty. (The num erous holders of CMBSs are presum ably harder to round up to vote on a rescue
plan than a sm attering of banks holding shares of a m ortgage.)
Yet Centerbridge saw opportunity buried beneath the com plexity. Based on our analysis, we recognized that there was a
very good business here struggling under too m uch debt in a com plicated structure, says Rahm . Extended Stay had good
m anagem ent and a low-cost business m odel that produced high m argins but was saddled with a bubble-era balance sheet,
he explains.
Unfortunately for Centerbridge, other private equity operators and distressed-debt investors were arriving at the sam e
conclusion. Thus, when Centerbridge, at Melwani and Rahm s recom m endation, bought a big chunk of Extended Stays
CMBSs at a sizable discount in late 20 0 8, other investors swooped in too. And when Centerbridge and New York hedge
fund firm Paulson & Co. put up $ 450 m illion in February 20 10 in a partial bid intended to give them effective control over
Extended Stays reorganization (and which valued the com pany at about $ 3.3 billion), the offer was topped less than one
m onth later by real estate m ogul and glam our-hotel im presario Barry Sternlicht. His Greenwich, Connecticut based
Starwood Capital Group paired up with Fort Worth,Texas based private equity giant TPG Capital in March to pony up
$ 90 5 m illion in sundry form s (cash, a backstop rights offering and cash alternatives).
Centerbridge m atched Starwoods offer and sweetened it by agreeing to forgo the breakup fee and other expenses that it
would ordinarily be entitled to as a stalking-horse bidder: the one that gets a corporate auction going by creating a floor
price. Moreover, Centerbridge dem anded that an open auction be held before long so that on e of the investor groups could
be picked to im plem ent a reorganization plan to try to salvage the long-suffering Extended Stay.
So after 19 straight hours of bidding and counterbidding, Centerbridge, Paulson and a third partner, Blackstone, declared
victory in the wee hours of Thursday, May 28. Their offer of $ 3.925 billion topped the Starwood groups bid by just $ 40
m illion. The bidding war pushed up the value of Extended Stay by roughly $ 625 m illion. Thrilled at winning the auction,
Melwani and Rahm assert that Centerbridge got a great price, especially considering that the firm s holdings of cheap
Extended Stay CMBSs will be paid back at 10 0 cents on the dollar.
For distressed-debt investors, the epic contest for Extended Stay is both good and bad news a com bination with which
they are intim ately fam iliar. On the positive side, it dem onstrates that an industry not long ago written off as half dead is
registering fresh vital signs. On the negative side, the sheer im penetrability of Extended Stays finances and the fierce
bidding for the insolvent com pany attest both to the unprecedented com plexity of distressed-debt investing today and the
intense com petition for deals.
Distressed-debt investors say that, com pared with the high-yield bond m arkets collapse in the early 90 s or the stock
m arket bubbles bursting a decade later, the recent financial crisis is characterized by considerably m ore-recondite
corporate reorganizations. Creditors of Lehm an Brothers Holdings, for exam ple, are divided into m ore than 10 0 classes,
each with what seem s to be a different repaym ent priority. The freewheeling financial creativity of the past decade has
added to the com plications of m any workouts.
The ferocious rivalry for deals, m eanwhile, is in large part m erely a function of overcrowding. In the downturn of the early
20 0 0 s, som e $ 30 billion of capital was com m itted to distressed debt, according to Chicago-based data provider Hedge
Fund Research. One expert on the subject, New York University Leonard N. Stern School of Business professor Edward
Altm an, gauges the sum at $ 30 0 billion today. The field is awash in deep-pocketed new entrants, such as Blackstone, KKR
& Co., Paulson and Tudor Investm ent Corp.
There is an awful lot of m oney chasing too few opportunities, contends J effry Haber, controller of the $ 558 m illion
Com m onwealth Fund, a New York based private foundation. People m ight pitch buying debt at 60 cents on the dollar.
Then you see them buying things at 90 cents.
Howard Marks, co-founder an d chairm an of one of the largest and m ost venerable distressed-debt firm s, $ 76 billion-in-

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assets Oaktree Capital Managem ent, sees interlopers as the big problem . A lot of m oney can swing into distressed debt that
is not technically allocated to it, he points out. Warren Buffett can be the biggest distressed-debt buyer. Hedge funds can
swing into distressed debt. Kn owing how m uch m oney has been raised by pure distressed-debt funds is only half of the
picture.
Excessive dem and aside, theres also a supply-side issue. Som e insist that as the econom y recovers, albeit haltingly, the great
bargains tossed up by the worst financial upheaval since the Great Depression are growing a little scarce. At the end of 20 0 8,
the distressed-debt ratio the proportion of junk bonds trading at truly distressed levels (1,0 0 0 basis points or m ore above
Treasuries) peaked at 85 percent, according to Standard & Poors. By May the ratio had im proved (or, from a distresseddebt investors perspective, worsened) all the way to 9.4 percent. At the same time, the high-yield default rate, having
peaked at 13.5 percent last Novem ber, had eased to 5.4 percent in J uly, reports Moodys Investors Service.
The upshot, m any were contending this spring, is that the grave dancers ball is well and truly over. The 28 percent average
return on distressed-debt investing in 20 0 9 (according to HFR) will not be repeated for som e tim e, they insist.
Yet m any distressed-debt investors beg to differ. Doom -m ongerers by nature, they see a world of troubles ahead theyre
hardly alone and past surveys have am ply captured this Cassandra streak. According to an annual poll last J anuary by
publisher Debtwire, while one third of distressed-debt investors believed corporate restructurings had peaked, two thirds
didnt expect that to happen until this year, 20 11 or even beyond.
The fact is that over $ 1 trillion of bank loans and junk bonds are m aturing over the next five years, and given the num ber of
com panies that are leveraged north of 5 tim es, the supply of overleveraged credit is as large as it has ever been, contends
Anthony Ressler, co-founder and senior partner of Los Angeles based alternative-investm ents outfit Ares Managem ent.
J onathan Lavine, chief investm ent officer of Sankaty Advisors, the credit affiliate of private investm ent m anager Bain
Capital, adds: We sim ply need to be patient. Our analysis on the m aturity wall suggests that the opportunity is significant
about 15 to 20 percent of m aturing debt is potentially going to need to be restructured, which would be three tim es m ore
than the last cycle.
Credit Suisse was estim ating in m id-J uly that about $ 985 billion of high-yield bonds and leveraged loans will m ature
between 20 11 and 20 14. Thats som ewhat less than the banks Decem ber 20 0 8 estim ate of $ 1.2 trillion reflecting a rush of
refinancing but its still a staggering figure. Whats m ore, the gloom -sayers gleefully note, the average annual default rate
on U.S. speculative-grade corporate debt rem ained below 2 percent from 20 0 5 through 20 0 7 a condition unseen in the 30
years before that. Im plication: A slew of defaults are ready to erupt. On top of all that, the past three years witnessed a
record $ 436 billion in high-yield U.S. bond issues.
We see the default rate as a W pattern with the slanted vertical on the right extending into the future, says Centerbridge
co-founder J effrey Aronson. He figures that m any overleveraged buyouts will hit snags and com e asunder. Am end and
extend deals m erely delayed the underlying com panies day of reckoning with an unsustainable debt load, Aronson asserts.
He points out too that som e buyouts during the precrash boom years relied on floating-rate loans and that the com panies
involved will be squeezed all the harder when rates eventually rise from their current record low. But he adds that overall,
its m uch m ore situational today in distressed debt you have to do the work and focus on special situations.
Gloom is apparently everywhere, though, if you look eagerly enough for it. High-yield bond issuance globally reached $ 178.9
billion last year, only 7 percent below 20 0 6s record volum e. And these latest, postcrash bonds carry tighter covenants,
m eaning com panies wont find it so easy to slither through loopholes to avoid form al default. J itters about European
sovereign debt are a rem inder that the global econom y is not out of the Bretton Woods yet. Sm all wonder that the m ore
optim istically pessim istic distressed-debt investors foresee returns this year ranging from the high teens to 20 percent.
This is a better tim e than a year ago for distressed debt, declares WL Ross & Co.s Wilbur Ross J r., a doyen of investing in
ailing com panies and whole industries. He notes that we have a pillow som ewhere that says, Dont buy anything you can
buy off a Bloom berg screen. Ross is looking in particular at financial institutions. Around 50 0 banks will fail before we are
out of this m ess, he says.
That kind of encouraging news (depending on ones perspective) resonates with Marc Lasry, co-founder and CEO of New
York based, $ 18 billion-in-assets Avenue Capital Group. Im m ore optim istic because there are m ore problem s out there,
he says. The econom y is not growing as fast as people had hoped. Theres a significant am ount of debt and less capital
available. You could end up having a lot of restructuring as com panies choose to work with creditors to avoid bankruptcy.
This could be a perfect storm , and that is great for distressed-debt investors like us. From its inception in 20 0 7 through
March 31, Avenues nearly $ 17 billion Special Situations Fund V has run up a net annual internal rate of return of 11.6
percent.
But no m atter whether they see Arm ageddon com ing or m erely bad tim es, or if they differ on which targets will be the ripest
in the approaching disaster, distressed-debt investors agree on one thing: They are going to have to labor harder than they
did in 20 0 9 to bring hom e alpha. One area a num ber of firm s are looking at closely is the som etim es neglected m iddle
m arket, usually defined by distressed-debt investors as com panies with ebitda (earnings before interest, taxes, depreciation
and am ortization) of anywhere from $ 10 m illion to $ 10 0 m illion. Close to $ 30 0 billion of m iddle-m arket debt is due to

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m ature between now and the end of 20 14, according to S&P. Moreover, these credits havent recovered in price to anywhere
near the debts of large-capitalization com panies. In J uly the spread between the loans of m iddle-m arket and large-cap
com panies was on average 30 0 basis points, com pared with about 80 basis points historically.
We expect m iddle-m arket com panies with enterprise values ranging from $ 20 0 m illion to $ 80 0 m illion to rem ain
underserved by m iddle-m arket lenders for several years to com e, says Michael Parks, head of distressed funds at Los
Angeles asset m anager Crescent Capital Group. These com panies tend to be less followed by Wall Street research, less
liquid and undercapitalized. Parkss fund ordinarily invests $ 20 m illion to $ 30 m illion apiece in m iddle-market com panies.
In a typical such exercise, Crescent spent m ore than $ 30 m illion between 20 0 3 and 20 0 6 buying up the debt of Brown
J ordan International, a Florida m aker of snazzy outdoor furniture. Plagued by m ism anagem ent and overleveraged, the
com pany wound up undergoing an out-of-court restructuring in 20 0 7. Having gained 30 percent of the reorganized Brown
J ordan, Crescent led a turnaround that saw ebitda go from $ 12 m illion in 20 0 4 to $ 43 m illion in 20 0 8.
Everybody wants to do the big-nam e bankruptcies because they are liquid and you can invest a lot of cash, but there are
only a handful of m egadeals, notes another m iddle-m arket enthusiast, Thom as Fuller, senior m anaging director of
alternative-invesm ent specialists Angelo, Gordon & Co. in New York.So what we are focused on are com panies that have
between $ 50 0 m illion and $ 3 billion of debt.
Killings at all target levels are becom ing rarer. The 63-year-old Marks, interviewed in his sun-splashed 28th-floor office at
Oaktrees spalike LA headquarters (m arble floors, California artwork, white roses), is characteristically guarded about the
outlook. You cant find bargains like two years ago, he cautions, adding: Thats okay; we can still m ake good investm ents.
We just have to accept lower returns in order to avoid increased risk.
And work as hard as ever. We will continue to try to find bargains by constantly doing analysis and through close relations
with brokers and debtholders, vows Marks. Its all execution, just like baseball.
Oaktrees conservative investm ent stance has seen it through challenging tim es before. Founded in 1995, the firm has
outlasted such potentially form idable rivals in the distressed-debt arena as Fidelity Investm ents; Goldm an, Sachs & Co.; and
T. Rowe Price Group. All three launched serious distressed-debt operations only to abandon them because of conflicts of
interest or other concerns.
Oaktrees working m otto, in Markss words, is, If we avoid the losers, the winners will take care of them selves. He explains
that the goal is to m atch m arket returns in good tim es and do m arkedly better in bad tim es.
For that, one needs strict discipline. During the 20 0 4-0 6 credit boom , when the default rate stayed below 2 percent,
Oaktree did not raise a batch of m oney, as tem pting as that would have been in a giddy m arket. Nor did it deploy all the
funds at its disposal. Oaktree only invested half of the m oney we com m itted, confides one institutional investor client.
When the opportunities are not there, they dont do deals.
That defensive approach has resulted in pretty reliable perform ance, though Oaktree naturally fares better when com panies
do worse and defaults are abundant. The firm s OCM Opportunities Fund IVb, whose strategy is to influence distressed
debt (that is, it does not aim to take actual control of com panies), was raised in 20 0 2, when m em ories of the tech bubble
bursting were still fresh, and through J une had a net IRR of 46.5 percent. By contrast, OCM Opportunities Fund III, raised
two years earlier during happier tim es, had a m ore m odest IRR of 11.9 percent.
Recent results have been robust. About the tim e the U.S. stock m arket peaked precrash, Oaktree raised its largest-ever
distressed-debt fund the $ 10 .9 billion OCM Opportunities Fund VIIb and the firm invested it aggressively during
volatile 20 0 8 and 20 0 9. From its inception in 20 0 8 through J une 30 , the fund had a net IRR of 23.5 percent.
In February, Oaktree finished raising a $ 3.3 billion fund, OCM Principal Fund V, that will act as a principal in taking control
of com panies and forcibly extricating them from trouble. Marks says he wants to be prepared for opportunities in
overleveraged buyouts and com m ercial real estate if the recovery stalls. However, he also wants to be well positioned in case
the econom y gets better on schedule. Over at $ 12 billion Centerbridge, the 51-year-old Aronson is cheered by the case for
pessim ism .
Last year everyone could buy debt at m aybe around 50 cents, he says. Today it m ay trade at 80 cents. So it m ust be over,
som e people think. In our view it is all about value versus price. The default rate will decline this year, but as this m assive
am ount of buyout-related debt m atures from 20 11 to 20 15, som e of those com panies will be refinanced; others will have to
be restructured. The result, he predicts, will be a default rate trending up sm artly in 20 11 and 20 12. The m acro
environm ent is quite fragile, he notes.
That is halfway good news for Centerbridge. The reason is that this bipolar firm is virtually unique am ong distressed-debt
shops in also doing substantial private equity investing as a way to sm ooth out returns in theory, private equity should
thrive in good econom ic cycles and distressed debt in bad.
What is attractive about Centerbridge is its com bination of buyout and distressed debt, contends J ay Fewel, senior

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investm ent officer at Oregons Public Em ployees Retirem ent System , which m anages $ 53 billion. The firm can take
advantage of whatever econom ic environm ent we are in.
Consider Centerbridges hybrid approach to investing in Dana Holding Corp. When the Maum ee, Ohio, auto-parts
m anufacturer filed for bankruptcy in 20 0 6, Centerbridge was able to form an alliance with the United Auto Workers and
United Steelworkers a process helped, no doubt, by the firm s in-house auto expert at the tim e, Stephen Girsky, once a
special adviser to form er GM CEO Rick Wagoner and since March the autom akers vice chairm an for corporate strategy and
business developm ent. (He was also the top-ranked autom otive and auto-parts analyst in Institutional Investors AllAm erica Research Team while at Morgan Stanley.) With the unions blessing, Centerbridges distressed-debt team
negotiated a recapitalization with Danas creditors. The investm ent firm itself bought $ 250 m illion of the com panys
convertible preferred shares, giving it sway in appointing directors; other debtors bought $ 50 0 m illion of the shares, which
paid a 4 percent dividend.
Once Dana em erged from bankruptcy in February 20 0 8, Centerbridges private equity specialists took over. Centerbridge
co-founder Mark Gallogly and a m anaging director, David Trucano, were installed on Danas seven-m em ber board. A
Centerbridge turnaround expert, Brandt McKee, was brought in to cut costs and shore up the com panys capital structure.
Danas ebitda profit m argin has increased from 0 .3 percent at the end of 20 0 8 to 10 percent in this years second quarter.
Once highly leveraged, the com pany now has $ 1.0 6 billion in cash versus $ 939 m illion in debt.
More than two years after Dana exited Chapter 11, Centerbridge still holds its original com plem ent of convertible preferreds,
which if converted would m ake it the com panys largest shareholder. And Danas shares have risen from $ 0 .23 last year to
$ 11 as of m id-August.
Founded in 20 0 6, Centerbridge has prospered from its baptism by fire in the financial crisis. The firm s $ 3.2 billion Capital
Partners fund, which invests in both buyouts and distressed debt, has a net IRR of 21.5 percent from inception through
March 31. And its $ 6.4 billion Credit Partners Fund, focusing on just distressed debt, returned 62.5 percent in 20 0 9 after
suffering a 23.2 percent loss in 20 0 8. For this year through J une, the funds IRR was 10 .4 percent. Meanwhile,
Centerbridges $ 2 billion Special Credit Partners Fund, which does nothing but buyouts, had an IRR of 76.5 percent from its
inception in J une 20 0 9 through March 31. (All these num bers com e from an investor in Centerbridge funds.)
Scanning the horizon for opportunities, Aronson fixes on com m ercial real estate. Today there are hundreds of billions in
com m ercial real estate debt on banks books, which theyre holding while hoping things will get better, he observes. But as
banks heal them selves and build up equity cushions, even tually they will write down those loans and sell them to
distressed-debt investors like Centerbridge.
Distressed-debt investing requires patience even m ore than capital. People com e and go, says Oaktrees Marks. For those
people who raised funds in 20 0 7, the best ones will survive and the worst ones will disappear. Much like the com panies in
which they invest.

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Yale ICF Working Paper No. 07-07

Securitization: The Tool of Financial

Transformation
Frank J. Fabozzi, Professor in the Practice of Finance, Yale University,
School of Management and International Center for Finance
Vinod Kothari, Independent Financial Consultant and Visiting Faculty,
Indian Institute of Management

This paper can be downloaded without charge from the

Social Science Research Network Electronic Paper Collection:
http://ssrn.com/abstract=997079

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Securitization: the tool offinancialtransformation

Frank J. Fabozzi, Professor in the Practice of Finance, School of Management, Yale University
Vinod Kothari, Independent financial consultant and Visiting Faculty, Indian Institute of Management,
Kolkata, India
Abstract
Securitization as a financial instrument has had an extremely significant impact on the world's financial
system. First, by integrating capital markets and the uses of resources - such as mortgage originators,
finance companies, governments, etc. - it has strengthened the trend towards disintermediation. Having
been able to mitigate agency costs, it has made lending more efficient; evidence of this can be observed in
the mortgage markets. By permitting firms to originate and hold assets off the balance sheet, it has
generated much higher levels of leverage and, though arguably, greater economies of scale. Combination of
securitization techniques with credit derivatives and risk transfer devices continues to develop innovative
methods of transforming risk into a commodity and allow various market participants to tap into sectors
which were otherwise not open to them.

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In its broadest sense, the term "securitization" implies a process by which a financial relationship is
converted into a transaction. A financial transaction is the coming together of two or more entities; a
financial relationship is their staying together. For example, a loan to a corporation is a financial
relationship; once the loan is transformed into a tradable bond, it is a transaction. We find several examples
in the history of the evolution of finance of relationships that have been converted into transactions. The
creation of "stock," representing ownership in a corporation, is one of the earliest and most important
examples of this process because of its impact on the growth of the corporate form of business
organization. The process of converting loans to corporations of high credit quality corporate borrowers,
and in the 1970s expanding that opportunity to speculative-grade corporate borrowers, into publicly traded
bonds is another example of this. Commercial paper is another example of securitization of relationships as
it securitizes a trade debt.
In today's capital markets, the term securitization has acquired a more specific meaning, which for the sake
of distinction is referred to as "asset securitization." Today securitization is understood to mean a process
by which an entity pools together its interest in identifiable future cash flows, transfers the claims on those
future cash flows to another entity that is specifically created for the sole purpose of holding those financial
claims, and then utilizes those future cash flows to pay off investors over time, either with or without credit
support from a source other than the cash flows. A securitization transaction thereby achieves the purpose
of providing financing, but in a unique way - by sale of assets. While the result of a securitization
transaction is that financing is obtained, it is not "financing" as such because the entity securitizing its
assets is not borrowing money but selling a stream of cash flows that was otherwise to accrue to the entity.
The entity could be a corporation (financial or non-financial) or a government entity (nation or municipal).
The purpose of this article is to describe the basic principles of securitization, the reasons for its use by
corporations, and its impact on financial markets.
The securitization process
We will use an example to explain the securitization process. Suppose a company has receivables on its
balance sheet that represent installment loans that borrowers are repaying over time. Because the company
has originated the loans it will be referred to as the "originator company" or simply the "originator." The
originator identifies a pool of receivables that satisfy certain features, described later, that make them
acceptable to be securitized.
This pool of receivables is transferred to a special purpose entity (SPE), also referred to as a special
purpose vehicle (SPV). Generally speaking, the pool of loans, which we will refer to as the "asset pool," is
transferred at par value; that is to say, it is transferred at the outstanding principal of the loans being pooled.
Let us suppose the asset pool has a par value of U.S.$100 million. The rate of return that the SPE would
now receive on the loans is, of course, the weighted average of the interest accruing on the loans. In our
illustration, an 8.55% weighted average rate of interest for that asset pool will be assumed.
The SPE holds the asset pool, paying for it by issuing securities. The credit rating of those securities will be
based solely on the strength of the asset pool. That is to say, the asset pool's cash flows will be used on a
mutually exclusive basis to repay investors of the securities issued by the SPE. By "mutually exclusive" it
is meant that the originator would not have any direct claim on the receivables, nor would the investors in
the securities issued by the SPE or the SPE itself have any claim against the general assets of the originator,
except to the extent of credit support described later.
As for the securities issued by the SPE, they are structured into different classes of securities. Very simply
speaking, these securities may be senior and junior; or they may be senior, mezzanine, and junior; or they
may have various classes such as class A, class B, and so on. These various classes are created in order to
generate differentiated interests in the pool, such that the senior investors have superior rights over the pool
than the subordinated investors. In our illustration, we will suppose that three classes of securities are
created with following interests in the asset pool: class A - 95% (senior bond), class B - 2% (mezzanine
bond), and class C - 3% (junior bond).
Since class A investors are senior, any losses or shortfalls in the asset pool to satisfy the obligations of that
bond class would first be absorbed by class C, and then by class B. Class A would not be affected by losses

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unless those losses exceed 5%. Therefore, class A has a cushion against losses provided by the existence
and size of classes B and C. This allows class A to get a high rating from the rating agencies. In a
securitization transaction, the amount of class B and C (referred to in securitization jargon as the "sizing"
of subordination) is determined so as to obtain a target rating for class A, the target typically being a triple
A rating. Likewise, the sizing of class C is determined so as to ensure the target rating for class B, say, an
investment-grade rating. Typically, class C would be an unrated class, and may not find a buyer and, as a
result, is often retained by the originator.
The three classes of securities in our example will be offered at different coupon rates, class A being the
lowest because it carries the least credit risk and is therefore the cheapest funding source for the SPE; class
C would have the highest coupon rate and therefore the costliest funding source for the SPE because it has
the lowest credit rating. Suppose the weighted average cost of the three coupons is 7%.
As will be explained later, the SPE is almost like a non-substantive shell entity. As such, after it acquires
the asset pool from the originator, it does not have the wherewithal required to collect the receivables, and
therefore cannot perform the collecting and servicing function itself. Generally, the originator company,
who has proximity with the borrowers and typically has an infrastructure and systems in place for doing so,
retains the servicing function; the originator company is now in a servicer role instead of an ownership role,
which it had prior to the securitization transaction. In some cases the servicing function may be transferred
to an independent third-party entity that specializes in servicing loans. The decision as to whether to retain
servicing with the originator company or to have it transferred to an independent third-party entity will be
driven by economics rather than by structural considerations.
Let us assume in our illustration that the servicer is paid a servicing fee of 50 basis points per annum. The
difference between the weighted average interest accruing on the loans of 8.55% and the weighted average
cost of the three coupons plus servicing fee is 1.05%. This difference is referred to as the excess spread.
The SPE may issue residual income certificates or one or more interests that will sweep this residual
income from the SPE. The residual interest may be held either by the originator or sold to willing buyers.
Let us see what each of the parties realized as a result of this securitization transaction:

The originator received immediately after the transaction was consummated funding of U.S.$100
million. Assuming class C with a par value of U.S.$3 million was held by the originator, the actual
funding the originator obtains is only U.S.$97 million. In addition, the originator obtained the residual
interest in the transaction, representing the cash left over after paying the investors in class A and B.

Investors had the choice of three different classes of securities from which to select, each carrying a
different credit rating and coupon rate. These securities might also have other different investment
features beyond the credit rating, such as differences in interest rate risk (i.e., duration and convexity).

The SPE was a creature designed for enabling the transaction; consequently, there are no regrets that
the SPE gets nothing at all.
While the pool is transferred to the SPV, as explained above, it has no infrastructure to actually manage the
collections on the receivables. Logistically, the best party to continue to manage the collections is the
originator company itself, as it has an existing franchise with the customers. Consequently, the originator
company typically continues to manage the collections and render other borrower services1. Of course, the
servicer would expect a servicing fee for doing so. The cash flows collected each month by the servicer are
used to repay the principal, as well as interest, for the securities issued by the SPE, either with or without
their reinvestment.

The services to the borrowers, collection of cash flows, and remittance of cash flows to investors, and
basic investor services, are collectively known as the servicing function.

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What is an asset-backed security?

The securities issued by the SPE are referred to as asset-backed securities2. In our example, classes A, B,
and C are the asset-backed securities. These securities differ from a usual capital market instrument which
is an exposure to the issuer's business. An asset-backed security is simply an exposure to a pool of
specified assets. Returning to our earlier example, the investors who acquire classes A, B, or C are not
concerned with the generic risks of the business of the originator company. Even the bankruptcy of that
company cannot affect investors, though there will be some shock to the servicing function if it is being
performed by the originator company. The servicing will have to be transferred to another servicer, but
assuming that can be done smoothly, the investors will continue to enjoy the cash flows generated by the
asset pool.
The investors are, however, exposed to the risks of the asset pool. These risks may be multifarious - for
example, delays, defaults, prepayments, legal challenges, and so on - and they will be discussed later. What
is critical to understand is that investors in the asset-backed securities are exposed to the risks of the asset
pool not the risks of the originator company's business. Therefore, an asset-backed security is not a claim
on an entity but a pool of assets.
Two important points arise here. Firstly, the distinction between claims on assets and claims on entities is,
to an extent, ephemeral. In the final analysis, the two seem to merge: any claim on an asset is a claim on an
entity as no asset is a value by itself. Secondly, any claim on an entity is also ultimately a claim on the
assets of the entity, as all such claims are paid off from the assets of the entity. The very concept of limited
liability companies makes all financial claims as claims on assets.
To understand the significant difference, and to appreciate the basic indifference, between an asset-backed
security and a traditional bond, let us examine their nature. In our example above, we had three classes of
securities: class A [U.S.$95 million], class B [U.S.$2 million], and class C [U.S.$3 million]. They are all
backed by the common pool of assets of U.S.$100 million. Since class C is the junior-most here, it will be
the first one to absorb losses in the pool of assets. The first dollar of realized loss on the assets will be
allocated to class C, which means class C will suffer a write off of principal to the extent of such realized
loss. Class C continues to absorb losses until it is wiped out, at which point class B starts suffering losses.
In other words, the probability of class B suffering losses is the same as that of the losses in the asset pool
exceeding the size of class C. Likewise, if the losses exceed the combined size of classes B and C, class A
would default.
Let us now look at a corporate bond. Assume an entity having total assets of U.S.$100 million has the
following capital structure: equity of U.S.$3 million, preferred stock of U.S.$2 million, and senior
unsecured bonds of U.S.$95 million. As it might be obvious, we have contrived to put the same numbers
here as in the example of asset-backed security, though it would be rare to see such a highly leveraged
company. Look at the moot question: when do the bonds in our example default? Obviously, when the
losses of the entity exceed the equity and preferred stock, which is the same as the probability of class A
defaulting in our example of asset-backed securities. We can use these parallels to appreciate the
2

There is no uniform name for the securities issued by the SPV, as such securities take different forms.
These securities could represent a direct claim of the investors on all that the SPV collects from the
receivables transferred to it - in this case, the securities are called "pass through certificates" or "beneficial
interest certificates" as they imply certificates of proportional beneficial interest in the assets held by the
SPV. Alternatively, the SPV might be re-configuring the cash flow by reinvesting it, so as to pay the
investors on fixed dates, not matching the dates when the transferred receivables are collected by the SPV.
In this case, the securities held by the investors may be called "pay through certificates." Alternatively, as

these securities are essentially the obligations of the SPV that are discharged by the receivables from the
assets transferred to it, the obligations could be referred to generically as "asset-backed obligations," and
specifically as "asset-backed bonds" or "asset-backed notes." The securities issued by the SPV could also
be named based on their risk or other features, such as senior notes, junior notes, floating rate notes, and so
on. Yet another way of referring to asset-backed securities is based on the term of the paper concerned; if
the paper is short-term commercial paper, it is referred to as asset-backed commercial paper, otherwise
referred to as "term paper."

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indifference between traditional bonds and asset backed-securities. The creation of structured securities of
different classes is not unique to securitization. There is a hierarchy of different financial instruments on the
liability side of a corporate balance sheet which has different levels of priority. All financial instruments are
backed by assets, and therefore, in the ultimate analysis, all securities are asset backed.
However, there is a significant difference between assets of the entire enterprise and those that are isolated
as a specific pool. The bond in question above is a claim on all assets of the entity. The asset-backed
securities are a claim on an isolated pool. The securitized pool is a like a miniature corporation; it came out
of the aggregate assets of the originator company's business. But once the isolation of the pool happens,
investors in the transaction are only impacted by the risks of those specific assets, and not the general
business risks of the mortgage lender. From the open-ended enterprise of the originator company, we are
now focused on a closed-end, deconstructed asset pool.
This discussion leads to an important feature of an asset-backed security: whether asset-backed or entitybacked, there is no value-added merely by securitizing assets. The only source of value-added is by a sort
of inter-creditor arrangement whereby an asset-backed investor is provided two advantages - legal and
structural preferences.
Legal preference refers to the preference that an asset-backed investor enjoys over a traditional investor as
a claimant on the assets of the operator. A traditional investor essentially has a claim against the operator. If
the operator were to run into financial problems, the investor's claim is subject to bankruptcy
administration, which in most countries is a time-consuming process and might be legally preceded by
other statutory claims. An asset-backed operator has a claim over the assets of the operator, as those assets
have been hived off and made legal property of the investors. Therefore, these assets subserve the claims of
the investors before they can be claimed by anyone else. Creating this legal preference is the key to
securitization.
Structural preference refers to the stacking order of mutual rights among the different classes of investors.
In our example earlier, we had three classes of investors, who had so aligned their rights that one becomes
safer at the cost of the other. The senior-most, class A is safest by piggy-backing on classes B and C, and
likewise, class B piggybacks on class C. This structuring of mutual rights is not unique to securitization
since every capital structure of any corporation has some liabilities which are prioritized to others, but the
structuring becomes more meaningful in case of securitization in view of the isolation of entity risks.
We used the term inter-creditor arrangement above as the genesis of the two preferences. That an investor
in an asset-backed security enjoys both a legal and structural preference over the traditional investor is a
matter of mutual arrangement among the various "creditors" (including, for this purpose, the asset-backed
investor) of an entity. A preference is understandably an advantage that one has over the other, and looked
at the other way around, it is only gained by the acceptance of deference by the other creditors. Therefore,
the advantage that asset-backed investors gain is at the expense of the other creditors. Does this mean that
the sum of the parts is no different from the whole?
Legal preference by isolation
As discussed earlier, the legal preference of the asset-backed investor over a traditional investor is key to
the very economics of securitization. Much of the need for the present day methods of securitization would
disappear if it were possible to allow a certain group of investors a bankruptcy-proofing device whereby
certain assets, if not all, of a corporation would first be used to pay them off. One might argue that in
countries such as the United States there are rules for the priority of creditors in the case of bankruptcy
(rules of absolute priority) that can be used to protect different classes of creditors by creating a preference
against a specific asset. However, as has been found in numerous studies [Merton (1977), Meckling
(1977)], the principle of absolute priority is the exception rather than the rule in a Chapter 11 bankruptcy.
Thus, securitization strives at arbitraging the law by ensuring that at least some specific assets are free from
any other claim and can be used to pay off only the asset-backed investors.
3

Covered bonds are generally used in some European countries and have arguably served as an effective
alternative to isolation-type securitization devices.

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The device used for creating this legal preference is simple: transfer of assets, often referred to as a "true
sale." The originator company in our example transfers a stream of receivables (i.e., the loans) to the SPE.
This transfer should be a legally recognized transfer, such that the receivables now become the legal
property of the SPE. Being the property of the SPE, obviously, the receivables are not affected by any
bankruptcy of the operator, or claims of the general creditors of the operator.
In securitization parlance, this legal transfer is often referred to as "isolation." Isolation is only a perfected,
irreversible legal transfer. That the receivables are isolated from the originator company means that the
receivables are beyond the legal powers of either the originator company, or the originator company's
liquidator, or creditors, or for that matter, anyone with a claim against the originator company.
In the United States, a recent legal challenge that the holders of a security in a securitization are protected
from the creditors of the originator company when there is true sale is the bankruptcy of LTV Steel
Company, Inc. (LTV). In this bankruptcy, filed in the United States Bankruptcy Court for the Northern
District Court of Ohio on December 29, 2000, LTV argued that its two securitizations were not true sales
but merely disguised financing transactions, which meant that the creditors of LTV are entitled to the cash
flows of the assets that LTV allegedly merely transferred but did not sell to the SPV. LTV in an emergency
motion to the bankruptcy court in which it put forth this argument asked the court for permission to use the
cash flow from the two securitizations with the provision that LTV provide adequate protection to holders
of the securities issued in the securitization. While in an interim order the bankruptcy court granted LTV
permission to use the cash flow from the asset pools used in the two securitizations, because the case was
settled, the bankruptcy court did not have to rule on LTV's argument of whether there was a true sale of the
assets. As part of a settlement, there was a summary finding that LTV's two securitizations were in fact a
true sale. For investors in the securities issued in a securitization, however, what was troubling about this
case is that the court decided to permit LTV to use the cash flows prior to the settlement4.
Use of special purpose vehicles
The dual objectives of transferring assets to investors and at the same time creating a capital market
instrument can only be achieved by utilizing a transformational device known as an SPV. The legal entity
is created for the single purpose of holding the assets sought to be transferred by the originator and the
subsequent issuance of securities such that the securities are no different from a claim over those assets.
Thus, investors do not have to acquire or hold the assets of the originator directly, but they do so indirectly
through the SPV. The SPV, as an intermediary between the originator and the investors, sits with the assets
as a sort of legalized facade for the multifarious and nebulous body, which are the investors.
Structured finance and securitization
The term "structured finance" refers, very broadly, to financial solutions or products which are structured to
meet specific needs. In a narrow and more common sense, the word is used almost interchangeably with
securitization. We noted in the example above that one of the crucial features of securitization is the
creation of different classes of securities such that they are assigned different ratings. The senior-most of
the securities is quite often rated triple A. The highest rating for the senior-most class is explained by two
factors: isolation of the assets from the bankruptcy risks of the originator and hence originatorindependence and the creation of a credit risk mitigation device by subordination of classes B and C, such
that those lower classes provide credit support to class A. It is possible to say that the size of classes B and
C was so computed as to meet the rating objective for class A. Likewise, the size of class C was so
computed as to have class B accorded the desired rating. In other words, the entire transaction was
engineered, or structured, to meet specific investor needs.
It would be wrong to assume that investors are always interested in triple A rated securities. Quite

obviously, the securities with this rating carry the smallest spread to Treasuries or some other benchmark.
4

It should be noted that while "true sale" is a significant legal issue in securitization, the question is
whether a sale in "true." This implies determination of the truth of what is apparently a sale; the question is
therefore subjective. While market practitioners try to learn from past experience and construct transactions
that abide by certain true sale tests, there cannot be an absolute safe harbour.

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Investors have different risk-return profiles, based on their liability structures, and the objectives of their
respective investors or stakeholders. Hence, there might be yield-hungry investor looking for a triple B
rated security, but with a substantially higher spread. Thus, use of structured finance principles allows the
originator company to create securities that meet investor needs. Rating is not the only basis for structuring
of securities. There are several other features with respect to which securities may differ. Interest sensitivity
(i.e., duration and convexity), maturity or average life, cash flow pattern, and prepayment/call protection
are just a few examples of such features.
Getting into details
In this section we will take a closer look at securitization by reviewing asset pool characteristics, credit
enhancement mechanisms, liquidity support, and others.
Asset pool characteristics
What exactly is an asset pool and what is the relevance of having an asset pool as opposed to a single asset?
One of the essential features of securitization we noted above was the creation of several classes of
securities, and the resulting upliftment of the rating of the senior classes. The whole concept of creating
classes or tranching is based on a probability distribution of default risk, such that the probability of
suffering extreme losses, that is, lots of loans in the pool going bad, is extremely low.
Figure 1 illustrates this point. The probability distribution curve shows the amount of losses and their
respective probabilities. The probability of having no loss at all is about 13.6%. The probability of 1% loss
in the pool is about 27%, and likewise, the probability of 2% of the pool being lost is also about 27%.
However, as we move to the right hand side, the probabilities start declining sharply. The probability of a
7% loss is only 0.3%, and that of losing 10% is 0.003%. With those numbers, an originator company can,
via the SPV, create four classes of securities as shown in the Figure 1 - class D taking the bottom 3% of the
liabilities, class C 2% of the liabilities, class B 2% of the liabilities, and class A the balance 93%. Quite
obviously, losses up to 3 % will be
taken by class D, losses from 3.01 %
to 5% will be taken by class C, from
5.01% to 7% by class B, and losses in
excess of 7% will be taken by class
A.
The probability distribution shown in
Figure 1 is the very crux of structured
finance. If we had just one loan, there
is nothing like a probability
distribution. There will be only two
possible occurrences: either the loan
defaults or the loan survives. If the
loan defaults, most of the loan (1
recovery rate) is lost. If the loan
survives, the loss is zero. Hence, as
may be understandable by a bit of reflection, the whole concept of tranching does not work in the case of a
single asset. It would also be obvious that in order to develop into the kind of probability distribution that is
presented in Figure 1, the pool must be diversified. The more diversified and the more granular the pool,
the more fine will be the right hand side of the probability distribution, making it easy to create the classes
of securities. The feature of a highly concentric pool is very similar to that of a single loan transaction. In
fact, the single loan may be compared to a pool with a correlation of 1 (i.e., all loans are so correlated that
the loans either default together or survive together).
While the guiding principle of diversification is understandable, how exactly is the pool created? In other
words, how do we narrow down from the whole loan book to creating a securitizable pool? Recommended
practice is that a pool is not created by cherry-picking. However, elaborate selection criteria is always set
forth so as to select assets that qualify for the selection criteria. The fixation of the selection criteria itself is
consistent with the desired quality of the pool. For example, a pool of prime loans will not have loans that

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fail the "prime" criteria, but a pool of subprime loans will obviously not have prime loans. Examples of
selection criteria may be the number of months in default at the time of transfer, number of months in
default at any time in the past, minimum and maximum rate of interest, minimum and maximum remaining
maturity, minimum and maximum LTV ratio, minimum and maximum debt-to-income ratios, and so on.
Credit enhancement
Having identified the asset pool, the most significant task is to understand the risks inherent in the pool.
While this will depend largely on the type of collateral, for most financial assets there will at least be the
following risk areas: credit risk, that is, the risk of default; liquidity risk, that is, temporary shortfalls in
collections or cash flows, so that cash falls; interest rate risk; and in case of certain collateral classes,
principally those for long tenures such as residential mortgage loans and commercial mortgage loans, the
risk of prepayment
Credit enhancement refers to the devices put in place to mitigate the risk of default in the asset pool. As we
have mentioned earlier, the sizing of credit enhancement is done so as to achieve a target rating for the
securities. The credit enhancement level for each class of security is different, as might be evident from the
probability distribution in Figure 1.
Excess spread - The most basic and the most natural form of credit enhancement for any pool is the level
of excess spread inherent in the transaction. Excess spread is the difference between the weighted average
rate of interest inherent in the receivables (this is true for loans or loan-type transactions) and the weighted
average funding cost of the transaction. Since the receivables are mostly transferred at par, the loans carry
the same rate of interest at the SPV level as they carried at the originator level. The funding cost of the
transaction is the coupons payable on the different classes, which is obviously lesser than the weighted
average rate of interest on the loans, thus leaving the excess spread.
One of the most basic principles of pricing of loans is that the lender charges a risk premium for credit risk,
that is, the expected losses on the asset pool. Hence, the excess spread is presumably sufficient to absorb
the expected losses from the asset pool, and other forms of enhancement, noted below, are needed
essentially for unexpected losses. However, there are several situations where the excess spread is either
not enough, or is more than enough, due to, for instance, movements in rates of interest, higher origination
profits, presence of subvention or promotional loans, etc.
Excess spread is the most common form of basic credit enhancements in a securitization transaction.
However, excess spread levels are affected by the rate of prepayment, since costlier loans in the asset pool
are expected to have a higher propensity to be prepaid. Hence, excess spread levels may fall over time. In
rare cases, excess spread levels may do just the opposite.
Subordination - Creation of a stacking order of liabilities is also the most common, almost universal,
feature of securitization. In our earlier example, classes A, B, C, and D represent the four different classes.
Class D is the most junior of all and is referred to as the first-loss class; that is, it is the first class of security
to suffer losses if the losses exceed excess spreads. Class C has the benefit of subordination of class D;
therefore, the credit enhancement at class C level is 3% plus the excess spread. Likewise, the credit
enhancement at the class B level is 5% plus the excess spread, and that of the class A level is 7% plus the
excess spread.
Over-collateralization - In appropriate cases, the same impact as in the case of subordination can be
created by over-collateralizing the liabilities. For instance, if the total funding raised is U.S.$100 million
and if assets backing them up are worth U.S.$105 million we have a 5 % over-collateralization. The over-

collateralized assets are a sort of subordinated share of the seller, which is available to offset losses in the
pool.
External credit enhancements - If the repayment of any of the classes of liabilities is guaranteed or
backed by the credit of a third party, that form of credit enhancement is referred to as external credit
enhancement. The most common form of such credit enhancement is the guarantee from a financial
guarantee company, or a monoline insurance company. Monoline insurance wraps or external

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enhancements are most commonly used in transactions which have a strong originator-dependence (for
example, servicing risk is too high), or where the collateral is located in jurisdictions which do not have a
tested history of either securitization or enforcement of claims.
Liquidity support
While credit support is needed to absorb defaults, liquidity support is required to meet temporary shortfalls
in collections such that the expected schedule of payments to investors may be maintained without
disruption. The most common reason for the shortfalls is the monthly arrears in collections, so very likely
in case of retail pools. The most common forms of liquidity support are servicer advances, cash reserve,
and external line of credit. Cash reserve, it may be noted, is both a form of credit and liquidity support. The
cash reserve might either be funded outright or may be created by pooling excess profits until the target
amount of reserve is created.
Prepayment risk mitigation
Prepayments, that is, the repayment of a loan or part thereof prior to its schedule, is quite a common feature
in the case of asset pools backed by retail loans. In case of residential mortgage loans, a loan may be paid
before final maturity either because the house is sold or because the borrower finds it better to repay the
existing loan taken at a higher rate and refinance the property at a lower rate that may prevail in the market.
To the extent prepayment happens for non-economic reasons, such as the sale of the property, it will not
result in an adverse economic outcome for the investor if the prevailing market mortgage rate is less than
the note rate paid by the borrower. However, if the borrower elects to prepay because it is economically
beneficial because the prevailing mortgage rate is less than the note rate paid by the borrower, this will
have an adverse economic consequence for the investor. While prepayment is a risk in all cases where the
borrower is contractually permitted to prepay without mark-to-market losses, it causes the maximum
damage in case of long-tenure collateral classes such as residential mortgage loans and commercial
mortgage loans5. Therefore, prepayment protection devices are mostly limited to securitizations of these
types of assets only.
A common prepayment protection device used in mortgage securitizations is the prepayment-protected
classes such as planned amortization class structures. Similar to the way in which the subordinated classes
provide credit support to the senior classes, there is a support class that sweeps more than the expected
prepayment and thus provides prepayment protection to the planned amortization class. Yet another device
is to differentially allocate prepayment of principal to different classes such that one class is more sensitive
to prepayments than others.
Motivations for using securitization
Securitization appeals to both non-financial and financial corporations. The four primary reasons for raising
funds via securitization are reviewed below.6
Potential for reducing funding costs
The cost of funding depends on the credit rating assigned to a debt obligation issued by an entity. In the
case of a corporate bond, the rating will depend on the credit quality of the corporation. In the case of an
SPV, because of legal preference and deference, the rating agencies will assign a rating to each security in a
securitization based on the expected performance of the asset pool and the priority of a security in the
structure. What is key is that the rating assigned to each security issued by the SPV will be independent of
the financial condition of the originator company. Consequently, the originator company can have a
speculative-grade rating but the SPV can issue one or more securities with a much higher credit rating. The
rating agencies evaluating the securities in the structure will advise the originator company on how the
transaction must be structured in order to obtain a specific rating for each security in the securitization.
More specifically, the issuer will be told how much "credit enhancement" is required in the structure in
5
Unlike residential mortgage loans, commercial mortgages have different forms of prepayment penalties
embedded in the loan agreement.
6
For regulated financial entities there is another reason for securitization. It is a tool for managing riskbased capital requirements (i.e., attaining optimal capital adequacy standards).

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order to achieve a specific credit rating for each bond class. The higher the credit rating sought by the
originator company, the more credit enhancement a rating agency will require for a given collateral.
Even after factoring in the cost of credit enhancement and other legal and accounting expenses associated
with a securitization, the behavior of firms provides support that securitization is less expensive than
issuing corporate bonds. For example, consider the auto manufacturers. In 2001, the rating downgrades of
the firms in this industry pushed Ford Motor, General Motors, and Toyota Motor to issue in early 2002
asset-backed securities backed by auto loans rather issue corporate bonds. Consider the case of Ford Motor
Credit. It issued U.S.$5 billion in the first two weeks of 2002. Since 2000 when there was the first threat of
the parent company's credit rating being downgraded, Ford Motor Credit reduced its exposure from
U.S.$42 billion to U.S.$8 billion, substituting the sale of securitized car loans rated triple A. In feet, from
2000 to mid 2003, Ford Motor Credit increased securitizations to U.S.$55 billion (28% of its total funding)
from U.S.$25 billion (13% of its total funding). It is noteworthy that as the ratings of the auto
manufacturers were downgraded in May 2005, the ratings on several of their securitization transactions
were actually upgraded due to high subsisting levels of credit enhancement.
Diversifying funding sources
Corporations seeking funding in the asset-backed securities market must be frequent issuers in the market
in order to get their name recognized in the asset-backed securities market and to create a reasonably liquid
after-market for trading their securities. Once an issuer establishes itself in the market, it can look at both
the corporate bond market and the asset-backed securities market to determine its best funding source by
comparing the all-in-cost of funds in the two markets, as well as non-quantifiable benefits associated with
securitization. [For a further discussion, see Chapter 9 in Kothari (2006).]
Managing corporate risk
Securitization is one of several corporate risk management tools available to management. When assets are
sold in a securitization, the originating company no longer bears the interest rate or credit risk of those
assets. Ford Motor Credit offers a good example of this. Since 2000, management has employed
securitization to reduce the credit risk of its car loan portfolio.
Achieving off-balance-sheet financing
If properly structured, securitizations remove assets and liabilities off the balance sheet of the originator
company. The argument put forth by those who employ securitization is that the reduction in the amount of
the originator company's on-balance-sheet leverage can help enhance its return on equity and other key
financial ratios. However, it is probably reasonable to assume that today many equity and corporate debt
analysts give recognition to both reported and managed (i.e., reported plus off the balance sheet) leverage
in their analysis of firms that utilize securitization, particularly following the actions by the Securities and
Exchange Commission (SEC) 7 and the Financial Accounting Standard Board (FASB) 8 regarding offbalance sheet financing after the Enron bankruptcy.
It is important to note, however, that SPVs in securitization had nothing to do with how SPVs were used by
Enron to mislead investors. Enron's management used SPVs for a variety of illegal purposes.
Unfortunately, this tainted the view of SPVs in the mind of the public despite the fact that SPVs for
securitizations are used in quite a different way than their abusive use by Enron.
7
More specifically, SEC requirements, Section 401(a) of the Saxbanes-Oxley Act of 2002 (SOX) and its
amendments deal with disclosure in periodic financial reports. With respect to off-balance sheet
transactions, SOX requires that a company in its annual and quarterly filings with the SEC discloses all
material off-balance sheet transactions, arrangements, obligations (including contingent obligations), and
other relationships of the issuer with unconsolidated entities or other persons, that may have a material
current or future effect on financial condition, changes in financial condition, results of operations,
liquidity, capital expenditures, capital resources, or significant components of revenues or expenses.
8
The basic financial reporting issue is whether or not the SPV should be consolidated with the corporation.
The FASB on January 17, 2003 issued FASB Interpretation No. 46 ("Consolidation of variable interest
entities"), a complex set of rules and principles for consolidation applicable to SPVs.

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Securitization and financial disintermediation

With the aid of securitization corporate borrowers can obtain funds directly from the capital market rather
than from financial intermediaries such as banks. In the absence of a public debt market, all financial
transactions involving corporate borrowing are done directly with a lender. Let us assume that the potential
lenders are individual investors and there are no financial intermediaries. In this scenario, there will be a
direct lender-borrower relationship between the individual investor and the corporate borrower. The
individual investor must have the ability to analyze the financial condition of the corporate borrower,
prepare the legal documentation for the loan, service the loan, and, if the borrower fails to perform, institute
legal proceedings against the borrower to recover the outstanding principal and unpaid interest for the loan.
More than likely, an individual investor will not have the capability of performing these services and must
therefore engage third parties to undertake these activities, paying a fee for these services. Moreover, the
lender must have sufficient funds to provide the full amount of the funds requested by the borrower and
agree to accept the entire credit risk. Of course, the lender could ask other individuals to participate as part
of a lending group to obtain a larger pool of funds that can be lent, as well as spread the credit risk and
other costs associated with the loan among the members of the group.
At least three problems arise in a world without public debt markets and financial intermediaries:
transactional difficulty, informational difficulty, and perceived risk. Transactional difficulty arises because
an individual investor may not have sufficient funds to satisfy the amount needed by the borrower, nor
might the tenure of the loan sought by the borrower match what the individual investor is willing to grant.
There is informational difficulty because the individual investor may not be capable of assessing the
creditworthiness of the borrower. Finally, the individual investor's perception of the risk associated with a
loan will be based on only the credit risk of the borrower with no opportunity to diversify that risk over
other borrowers.
It is because of these disadvantages associated with individual investors lending to corporations, as well as
lending to other individuals, that there is a need forfinancialintermediaries. Afinancialintermediary raises
funds from individual investors and then uses those funds to lend to corporations and individuals.
Consequently, it can accommodate the demand for a larger amount of funds than a typical individual
investor. Financial intermediaries provide one or more of the following three economic functions: they
provide maturity intermediation, reduce risk via diversification, and mitigate the costs of contracting and
information processing. Let us look at each of these.
A financial intermediary, such as a bank, can provide loans for a length of time that can accommodate the
needs of a borrower. This is difficult for an individual investor to do. A financial intermediary makes loans
with a range of maturities despite the fact that the claims it issues on itself can be short-term. For example,
a bank can borrow funds by issuing certificates of deposit with maturities ranging from six months to five
years and yet manage its duration risk exposure so as to be able to issue bank loansfromthree months to
say 10 years. This role performed byfinancialintermediaries, referred to as maturity intermediation, has
two implications forfinancialmarkets.
Firstly, it offers borrowers more choices for the maturity for their loans and investors with more choices for
the maturity of their investments. Secondly, it lowers borrowing costs because while an individual investor
may be reluctant to commit funds for a long period of time and thereby charge borrowers a higher cost to
extend maturity, afinancialintermediary is willing to make longer-term loans at a lower cost to the
borrower. Hence, borrowing costs are reduced.
Individual investors who have a small sum to invest would find it difficult to achieve diversification. Yet
by investing in afinancialintermediary, individual investors can attain cost-effective diversification.
Financial intermediaries maintain staff to handle the tasks associated with granting a loan. These associated
costs, referred to as information processing costs, can be done more efficiently byfinancialintermediaries
than by individual investors. The costs of writing loan contracts and enforcing the terms of the loan
agreement, referred to as contracting costs, can also be done more cost effectively by financial
intermediaries, as compared to individual investors. This reduces the cost of borrowing for those seeking
funds.

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Let us see how securitization can fulfill these roles. Consider first maturity intermediation. As we have
explained, a pool of assets can be used to create asset-backed securities with different maturity ranges. For
example, a pool of 30-year residential mortgage loans can be used to create securities with maturities that
are short, intermediate, and long term. Diversification within an asset type is accomplished because of the
large number of loans in a typical securitization. Finally, the costs of contracting and information
processing are provided in asset securitization. The contracting costs are provided by the originator of the
loans. Information processing is provided at two levels. The first is when a loan is originated. The second is
when a rating agency rates the individual asset-backed securities in the transaction.
There is one activity that is performed by some financial intermediaries that is not replaced by
securitization. The asset-backed securities created from a securitization transaction must still be distributed
to the public and a secondary market maintained. Technically, the distribution of securities and the
maintaining of secondary markets is not a role of a financial intermediary. Rather, it is the role played by
investment bankers. As more corporations shift from borrowing from financial intermediaries, the role of
underwriting by investment banks will increase while their role as lenders will decline. Thus, with a
securitization, the types of fees generated by financial intermediaries will change. Fee income from loans
and the corresponding costs charged in granting those loans (which are embedded in the loan rate) will be
replaced by fees for distributing and market making.
A concern with financial disintermediation is that it may reduce the effectiveness of monetary policy
because banks derive more of their funding from capital markets; likewise, disintermediation results in
more direct funding by capital markets rather than through banks. Thus during periods of tight monetary
policy, banks can originate loans and then securitize the loans rather than holding them in their portfolio.
This avoids the need for banks to fund the loans originated. Loutskina and Strahan (2006), for example,
show how securitization has weakened the link between bank funding conditions and credit supply in the
aggregate and as a result has mitigated the real effects of monetary policy. Frame and White (2004) and
Bank for International Settlements (2003), for example, have shown that the mortgage hedging activities of
the two government-sponsored entities, Fannie Mae and Freddie Mac, have at times moved Treasury rates.
Two empirical studies by Federal Reserve economists support the view that based on mortgage loans
securitization has had a significant impact on monetary policy [Estrella (2002) and Kuttner (2000)].
Conclusion
Securitization is as necessary to any economy as organized financial markets. As has been explained in the
article, securitization results in the creation of tradable securities with better liquidity from financial claims
that would otherwise have remained bilateral deals and been highly illiquid. For example, very few
individual investors would be willing to invest in residential mortgage loans, corporate loans, or automobile
loans. Yet they would be willing to invest in a security backed by these loan types. By making financial
assets tradable in this way, securitization reduces agency costs thereby making financial markets more
efficient and improves liquidity for the underlying financial claims thereby reducing liquidity risk in the
financial system.
A concern with securitization is that with lenders able to remove assets that they originate from their
balance sheet and therefore transfer credit risk via securitization, this process has motivated lenders to
originate loans with bad credits. Given the ability of lenders to pass along subprime loans into the capital
market via credit enhancement that we have described in this article, lenders have been viewed by critics of
securitization as abandoning their responsibility of evaluating the creditworthiness of potential borrowers.
References
Bank for International Settlements, 2003, "The role of ratings in structured finance: issues and
implications," The Committee on the Global Financial System, January
Estrella, A., 2002, "Securitization and the efficacy of monetary policy," Federal Reserve Bank of New
York Economic Policy Review, 8, 241-255
Frame, W. S., and L. J. White, 2004, "Fussing and fuming over Fannie and Freddie: how much smoke, how
much fire?" Federal Reserve Bank of Atlanta Working Paper Series, Working Paper 2004-26
Kothari, V., 2006, Securitization: The Financial Instrument of the Future-Third Edition, John Wiley &
Sons, Singapore

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Kuttner, K., 2000, "Securitization and monetary policy," Unpublished paper, Federal Reserve Bank of New
York
Loutskina, E. and P. E. Strahan, 2006, "Securitization and the declining impact of bank finance on loan
supply: evidence from mortgage acceptance rates," NBER Working Paper No. 11983
Meckling, W. H., 1977, "Financial markets, default, and bankruptcy", Law and Contemporary Problems,
41, 124-177
Miller, M. H., 1977, "The wealth transfers of bankruptcy: some illustrative examples," Law and
Contemporary Problems, 41,39-46

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NoW VORX UNIVERSITY

NYU-

lEONARD N

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GUAIRANTEEiD
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FAIL
FANNIE MAE f FREDDIE MAC
and the Debacle of Mortgage Finance

VIRAL ACHARYA
MA.TTHEW RICHARDSON
STIJN VAN NIEUWERBURGH
LAWRE.NCE J. WHITE

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NfW YORl: UNIVERSITY

NYU-

SrERKT
,fONAIHl I' SHRN
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A Blueprint for Mortgage Finance Reform

Executive Summary:
The goal of reforming housing finance should be to ensure economic efficiency, both in the primary
mortgage market (origination) as well as in the secondary mortgage market (securitization). By
economic efficiency, we have in mind a housing finance system that
corrects any market failures if they exist; notably in this case is the externality from originators
and securitizers undertaking too much credit and interest rate risk as this risk is inherently
systemic in nature;
maintains a level-playing field between the different financial players in the mortgage market
to limit a concentrated build-up of systemic risk; and
does not engender moral hazard issues in mortgage origination and securitization.
Motivated from economic theory, we argue that such a mortgage finance system should be primarily
private in nature. It should involve origination and securitization of mortgages that are standardized
and conform to reasonable credit quality. The credit risk underlying the mortgages should be borne by
market investors, perhaps with some support from private guarantors. There should be few
guarantees, if any, from the government.
The question is how does one effectively get to this private system given the current state of mortgage
finance? We call this the "genie in the bottle" problem. A quarter century ago, the proverbial "genie"
was let out of the bottle when mortgage markets were deregulated yet left the government guarantees
and special treatment of Fannie Mae and Freddie Mac (the "government-sponsored enterprises", or
GSEs) in place. Capital markets over the past twenty five years have developed to be reliant on these
guarantees. To wean the system off these guarantees - to put the "genie back in the bottle" - we need
to transition away from a government-backed system to a private-based one. The problem is that the
transitional process will only succeed if private markets are not crowded out, regulatory capital
arbitrage by private guarantors is averted, and systemic risk inherent in mortgage credit and interest
rate risks is managed.
We envision that the initial phase of this process would preserve mortgage default insurance because
such guarantees have been essential for the way that the securitization market for mortgages has
developed. However, the government share of these guarantees would be steadily phased out. To
achieve this, the transition should include a public-private partnership in which the private sector
decides which mortgages to guarantee and sets the price for the mortgage guarantees but insures only
a fraction (say 25 010), while the government is a silent partner, insuring the remainder and receiving
the corresponding market-based premiums. The public sector involvement should be limited to
conforming, tightly underwritten mortgages (for example, to mortgages with loan to value ratios that
are at most 80%). The private sector mortgage guarantors would have to be regulated to be wellcapitalized and subject to an irrefutable resolution authority. This way, the market pricing of
mortgage guarantees will reflect neither explicit nor implicit government guarantees. And, the
government guarantees being offered in passive partnership to private markets, and importantly, at
private market prices, will ensure that the private sector is not crowded out.
2

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We envision that if such a transition plan were followed, then the private sector would be encouraged
to shrug off any regulatory uncertainty and allowed to flourish. Financial innovation in these markets
could return. New investors that are focused on the credit risk of mortgage pools would emerge.
Mortgages would become more standardized and underwriting standards would improve. To help the
transition process along its way to an efficient mortgage market in the long run, reliance on the GSEs'
guarantees should be mandated to end in a phased manner. One example of such a mandate would be
a gradual reduction of the size limit for conforming mortgages; another would be an increase in the
fees that the GSEs charge for their guarantees. These mandates could be implemented sooner if the
private capital market develops more quickly.
Although our book, "Guaranteed to Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage
Finance': was written before the Obama Administration's recently announced plan, there is much
common ground between the two: (a) The GSEs should be wound down; and, (b) Efforts to assure
housing affordability for low- and moderate-income households should be explicit, on-budget, and
primarily the domain of the Federal Housing Administration (FHA). However, the Administration does
not currently have a specific proposal for the long-run future role of government guarantees in the U.S.
housing finance. Instead, the Administration offers three possibilities, without indicating its
preference: (i) a wholly private structure; (ii) a largely private structure, but with an agency that
would provide guarantees to new mortgage-backed securities (MBS) at times of severe stress in the
mortgage markets; or (iii) a largely private structure, with a government agency providing "tail risk" or
catastrophic insurance in the event that a private mortgage guarantor defaulted on its obligations.
We believe that the first of these three possibilities is the appropriate long-term goal; but we believe
that our transition plan offers a superior means of getting there. We believe that the Federal Reserve
is already the agency for dealing with general and severe stress in financial markets, including MBS, so
that any additional effort by a new agency would be duplicative. Further, we believe that the "tail-risk"
government insurance will inevitably be underpriced and thus will likely end up being a "back-door"
means of subsidizing general mortgage borrowing. Our proposal calls for the government providing
side-by-side guarantees - only in the interim - and would explicitly use the market-based pricing of
the private guarantors. Also, our proposal will encourage the private sector to develop tail-risk
insurance capabilities, which can then expand and replace the government; the advocates of option iii
have no such phase-out scenario.

In the following pages, we provide

(I)
(II)
(III)

an exact timeline and implementation plan corresponding to our proposal;

a set of questions and answers relating to our proposal; and,
a detailed evaluation of the Obama Administration's plan.

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I. TIMELINE
.:. Shutter Fannie Mae and Freddie Mac:

Create a Resolution Trust Corporation (RTC) for the GSEs to wind down their $1.7 trillion
portfolio. The preferred structure would be equity partnerships along the lines of those
created to resolve the Savings & Loans (S&L) crisis. Since the typical paydown rate for the GSEs
in normal times is around 25%, this suggests almost 600/0 of the original portfolio could be sold
off within the first three years.

In terms of purchases of new loans, the government would effectively be out of this business.
We see no need for the GSE RTC, or some other government entity, to be an active trader in
these markets. There is a well-developed capital market that can play this role. That said, for
purposes of market stabilization, the GSE RTC could purchase modest quantities of MBS that
have been guaranteed by the GSEs in the first three years. This would delay slightly the
winding down of the portfolio.

Since the GSEs are to be shut down, the GSEs' securitization and guarantor function for
mortgages should similarly be phased out, by reducing the size ofloans that they can securitize
(the "conforming loan limit") and raising their guarantee fees (the "g-fees").

After three years, the GSE RTC would sell the remaining portfolio over the next 7 years or
sooner. The GSE RTC would be mandated to selll/7 ili of the remainder every year, but,
depending on market conditions, might sell a greater amount.
:. Conforming mortgages:
For conforming mortgages (such as those with loan to value less than 800/0, FICO scores above 660,
and to borrowers with measurable income - from labor or asset holdings - that can cover the
interest on mortgages), mortgage originators have three primary choices:

Hold the mortgage loans on their balance sheet and be subject to a K% capital requirement.

Securitize the mortgages, and sell these securities to the capital market at large. Under DoddFrank, banks will be required to retain a 5% interest and must hold at least K% capital against
their 5% interest. Qualified residential mortgages, whose criteria remain to be determined, are
exempt from this retention requirement. Prudentially regulated capital market investors must
also hold at least K% capital on their holdings of these MBS. Of course, market participants that
are considered systemically risky (the systemically important financial institutions", or SIFIs,
determined by the Financial Stability Oversight Council, or FSOC, under the Dodd-Frank Act)
would be subject to even higher capital requirements. If the securities are structured into
various tranches, it must be recognized that the weighted-average capital requirement of the
combined tranches must also be at least K%. The expectation is that a MBS market without
guarantees will eventually dominate as capital markets develop savvy mortgage-credit
investors, and as the transparency of structured products improves.

Securitize the mortgage but purchase a guarantee. Private guarantors would offer insurance on
250/0 of the securitized mortgage pool at insurance rates determined in the market place. As a
silent partner, a newly formed government mortgage insurance company (GMIC) would
provide the remaining 75% insurance at those same rates, backed by the full faith and credit of
the U.S. government. Initially, given their experience in focusing only on interest rate and
prepayment risk and not credit risk, capital market investors might prefer these guaranteed
MBS. The expectation, however, is that because this insurance is priced by the market and
therefore costly, many investors would prefer to take the credit risk themselves and earn
higher yields.
The conforming mortgage limit for provision of guarantees by the GMIC would start at
$625K in the first year (current GSE limits exceed $729K in some high-cost geographic
areas), decline by $75k each year to $400k in the 4ili year, and by $66k each year thereafter
to $0 by the 10 th year. The GMIC would cease to exist after a decade-long period.
The private mortgage guarantors would be subject to rigorous prudential regulation and a
credible resolution authority (see below).
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.:. Non-conforming mortgages

For mortgages that are non-conforming, banks again have three primary choices:

Hold the mortgage loans on their balance sheet and be subject to a K*% capital requirement
(where K* exceeds K, K being the requirement for conforming mortgages).

Securitize the mortgages, and sell these securities to the capital market at large. Under DoddFrank, banks would be required to hold a 5% interest, and, under this rule, they must hold at
least K*% capital to support their 5% interest. Prudentially regulated capital market investors
must also hold at least K*% capital on their MBS holdings with the proviso that systemically
important financial institutions (SIFI's) would be subject to greater capital requirements. And
like above, if the securities are sliced and diced into various tranches, it must be recognized
that the weighted-average capital requirement of the combined tranches must also be at least
K*%.

Private insurance could be offered on 100% of the securitized mortgage pool at insurance rates
determined in the marketplace. There would be no role for the government other than fulfilling
its regulatory function. These private mortgage guarantors would automatically be considered
by the Financial Stability Oversight Council (FSOC) to be systemically important financial
institutions (SIFI's), which in effect means they would be subject to (i) higher capital
requirements, i.e., K**% (where K** exceeds K*), (ii) other forms of enhanced prudential
regulation, and (iii) a credible resolution authority (see below) .

:. Resolution authority:
The private mortgage guarantors and their resolution authority would have the following
properties:

The private mortgage guarantors cannot be financed via short-term (systemically risky)
liabilities as the risks they guarantee are long-term and systemic in nature.

If the private guarantors are housed within a larger, complex financial institution, then the
insurance unit must be ring-fenced and financed separately, again not using short-term
liabilities for funding purposes.

Upon the failure of one of these private insurers, any losses associated with unpaid mortgage
guarantees to capital market investors would be pari passu with the senior unsecured debt of
the guarantor. In other words, capital market investors would now receive payment on only a
fraction of the mortgage balance. This is quite similar to how covered bonds in the mortgage
market in other international jurisdictions are treated. The investors would, however, be
assured of receiving the 75% from the GMIC.
.:.

The bigger picture:

There is tremendous subsidization of homeowners hip in the United States. The Congressional
Budget Office (CBO) estimated that the total cost of tax expenditures - such as the mortgage
interest rate tax deductibility, the tax exemption of implicit income from owned housing, the
exemption from capital gains upon sale of a house, the subsidies to the GSEs, etc. - is alone close to
a staggering $300 billion per year. This number needs to be substantially reduced to enable private
markets to allocate capital more efficiently in the economy. In particular,

There is over-consumption of housing which crowds out more productive economic

investment, such as human capital, social infrastructure and business investment.

The public mission of stimulating home ownership can be debated. While the GSEs may have
had a little impact on increasing housing accessibility for the poor, the GSEs engaged in many
activities that were completely unrelated to this mission. There are many more direct and
effective ways to support housing initiatives at the federal, state or municipal level.
Furthermore, the GSE subsidies applied equally to first and second homes, encouraged
leverage, and benefited the rich substantially more than the poor. The latter is true of several
of the other tax expenditures as well.
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II.

Q&A

1. What does economic theory tell us about government intervention in markets? Regulation is
only necessary when there is a market failure. So the relevant question must be: What, exactly, is
the market failure in mortgage finance that justifies government intervention? The purpose of such
intervention should be to remedy a dearly identified market failure, or, in other words, fill in
where markets do not exist or are unlikely to achieve socially efficient outcomes.

2. Is government intervention necessary in mortgage markets? It is clearly untrue that mortgage

finance necessarily requires heavy government involvement, in particular, guarantees of mortgage
defaults. Looking at the cross-section of mortgage funding models across various developed
countries, no country has any entities that resemble Fannie Mae or Freddie Mac. The majority of
countries rely on a deposit-based system in which the mortgage lender retains the mortgage loans
on their books. These institutions are subject to prudential regulation just like any other bank. And
the argument cannot be that this has a major impact on homeownership rates. Of the 25 most
developed countries, the U.S. lies 17th in ranking. Of particular importance, what is unique about
U.S. mortgage finance is that almost 2/3 of all mortgages are securitized, whereas abroad, the next
largest securitizers - Australia and Canada - are only around 200/0. 1

3. What is the argument then in favor of mortgage-backed securitization? While the depositbased system mentioned above leads to the lender retaining the risk of mortgages ("skin in the
game"), there are reasonable economic grounds for preferring the U.S. mortgage finance system of
securitization. Securitization truly can turn "lead into gold": Securitization takes illiquid mortgage
loans and pools them to form liquid mortgage-backed securities (MBS) that trade on the secondary
market. Because illiquidity commands a risk premium, the more liquid mortgage assets from
securitization command better prices and thus a reduced mortgage rate. An additional benefit is
that the credit risk gets transferred out of the systemically risky banking sector to the capital
market at large. Also, the 30-year fixed-rate mortgage is a difficult financial instrument for banks
to hold, since their deposits and other liabilities are considerably shorter term; the securitization
of these mortgages, however, allows their natural customers - life insurance companies and
pension funds, which have long-lived liabilities - to invest in these long-lived assets. In other
words, if securitization works the way it is supposed to, the banking sector can better share its
mortgage risks with rest of the economy. Finally, MBS provide banks with access to investors
worldwide, which diversifies their funding base. A successful return of securitization, though, will
crucially depend on increased transparency and reduced complexity of the structures. We believe
the reforms proposed by the Dodd-Frank Act, the SEC's regulation AB, the FDIC's new safe harbor
rules for securitization, and the FASB regulations 166/167 go a long way towards ensuring that
securitization will be safer and more transparent in the future.

4. What was the market failure, if any, in this financial crisis that requires government
regulation? The market failure of the financial crisis is by and large that financial institutions
produce systemic risk but do not bear the costs of that risk - we call this a negative externality.
Financial institutions take risks either on the asset or liability side that are aggregate in nature and
can trigger loss of intermediation to households and corporations (a "credit crunch") and
potentially also trigger contagion through inter-connectedness, bank-like runs, and fire sales on
assets leading to downward price spirals. Other financial institutions share the costs of such
events, which can lead to a complete collapse of the financial system. The private markets cannot

1 Denmark's mortgage market relies for 90% on covered bonds, a close cousin of mortgage-backed securities, but
which provides investors with full recourse not only to the mortgage loans but also to the bank's capital. Several
other European countries, such as Germany, the U.K., and Spain, have substantial covered bond market shares.
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solve this problem efficiently because individual firms do not have incentives to deal adequately
with the systemic risk they produce.
If government intervention is required in U.S. mortgage finance, it therefore follows that the
purpose of such intervention should be to reduce or manage the systemic risk that emerges from
mortgage finance.

5. On systemic risk grounds, isn't securitization a better system for mortgage finance than a
deposit-based system? The answer is generally yes - on the assumption that securitization works
as intended. To understand why the U.S. mortgage finance system failed, one has to understand the
source of this failure - the government sponsored enterprises (GSEs), Fannie Mae and Freddie Mac
(see next several points).
6. What was the role of the GSEs, specifically Fannie Mae and Freddie Mac? The GSEs have been
performing two separate functions. Their first function - the guarantee function - is arguably the
most important: guaranteeing the credit risk in conforming (prime non-jumbo) mortgages that the
GSEs securitize. They charge a small fee (recently, around 20 cents per 100 dollars of unpaid
mortgage principal) for this guarantee, and they hold 45 cents of capital for every 100 dollars of
mortgage face value that they guarantee. The second is essentially the proprietary trading
function: purchasing mortgages and both prime and non-prime (Alt-A and subprime) MBS. They
financed these asset purchases almost entirely by issuing debt (so-called lIagency" debt). Because
of the implicit government guarantee (which has now become an explicit guarantee), the GSEs are
able to borrow at below-market rates. The GSEs are required to hold 2.50 dollars of capital for
every 100 dollars of mortgages and MBS that they hold.
7. What was the problem with the GSEs? Given both the implicit guarantee of the u.s. government
(resulting in a below market cost for debt financing) and favorable capital requirements, the GSEs
grew unencumbered for decades. From the last major GSE legislation in 1992, for example, Fannie
Mae and Freddie Mac combined went from holding $153 billion in mortgages and guaranteeing the
credit risk of another $714 billion to holding $1.5 trillion and guaranteeing $3.5 trillion,
respectively by the end of 2007.
8. Were the GSEs systemically risky? Yes, due to their interconnectedness - $1.6 trillion derivative
positions, $3.5 trillion mortgage guarantees (Le., approximately 7 times that of the infamous A.I.G
Financial Products Group), their widely held debt, the possibility of fire sales resulting from
liquidation of their $1.5 trillion portfolio, mortgage finance being at the center of the economy's
financial plumbing, and their failure igniting a run on short-term liabilities of the banking sector
and possibly sovereign U.S. debt.
9. What are the major flaws of the GSE model?
While a number of problems exist, three stand out:
The obvious one is that unpriced government guarantees destroy market discipline and
lead to below-market borrowing rates. This in turn encourages excess leverage and risk
taking. Private profit taking with socialized risk is simply unacceptable as a matter of
public policy.
Less discussed, but equally important, is the fact that the mortgage finance system
essentially ordained the GSEs as the dominant mortgage player. Under capital rules, if a
bank makes a portfolio of loans, the bank must hold 8% capital. If these loans, even of
identical risk, were mortgages, the bank would need to hold only 40/0 capital. If these same
mortgage loans were then sold to the GSEs and bought back as mortgage-backed securities,
the bank would need to hold only 1.60/0 capital. Since the GSEs had to hold only 0.450/0
capital to support their guarantees on these MBS, the lower overall 2.050/0 capital
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requirement basically assured GSE involvement. In fact, over 37% of MBS were held within
the banking sector, which is contrary to the "originate-to-distribute" prediction of the
desired risk-sharing purpose of securitization business model described above.
Starting in the 1990s, and increasing over time, partly due to government mandates and
partly due to risk taking decisions by the GSEs, the GSEs took on mortgages with high
credit risk, such as loan-to-value ratios greater than 80% (Le., down payments less than
20%), borrowers with FICO scores less than 660, and Alt-A loans (Le., those with lower
documentation levels). The light regulatory capital requirements - 2.50/0 for portfolio
holdings and 0.450/0 for their MBS default guarantees - may have seemed reasonable when
set back in 1992, but the mortgage-backed assets of the GSEs of 2007 had a quite different
credit risk profile than those of 15 years earlier.

10. Why did mortgage securitization fail? Securitization failed in mortgage markets because the risk
transfer it promises did not (sufficiently) take place, largely because of regulatory arbitrage of
capital requirements, and because the credit rating agencies massively mis-rated private-label
mortgage-backed securities. The GSEs, as private companies, were essentially mandated to be
front and center of mortgage securitization markets. The mortgages that they guaranteed saw
unprecedented default rates during the crisis of 2007-2009. The GSEs had underestimated and
underpriced that default risk, which combined with the losses on their investment portfolio,
resulted in their insolvency. But non-conforming mortgages securitized in "private-label" MBS
fared even worse. They saw default rates 3-5 times as high as those on conforming mortgages.
The credit rating agencies massively mis-rated these private-label MBS securities, as
witnessed by the fact that in January 2010 less than 10% of subprime MBS were still rated
AAA compared to 80% in January 2008. The ratings problems were even worse for
collateralized debt obligations (COOs) that had tranches of mortgage-backed securities as
collateral.
Other too-big-to-fail financial institutions exploited loopholes in regulatory capital
requirements through private-label securitization to concentrate risky tail bets with little
or no capital. They either directly held MBS on balance sheet or provided guarantees to
MBS that they transferred to off-balance sheet special purpose vehicles (conduits and
SIVs). The future U.S. mortgage finance system needs to prevent such buildups in systemic
risk by tightening the regulatory capital treatment of (tranches of) MBS and guarantees
written to special purpose vehicles. The new FASB 166/167 rules concerning consolidation
of assets in special purpose vehicles for the purpose of regulatory capital calculations, the
SEC's Regulation AB, and the FDIC's new safe harbor rules for securitizations are all steps
in the right direction.
11. If a mortgage finance system has securitization as its anchor, does it require heavy-handed

government involvement, e.g., government guarantees of mortgage defaults? The answer is

NO. There are many securities markets that expose investors to credit risk, which function as
intended. It is certainly true that government guarantees of mortgage defaults remove credit risk
from the pools of mortgages underlying the mortgage-backed securities. This helps standardize
these mortgage pools, allowing for greater liquidity and secondary market trading. But as we have
argued above, these government guarantees come at great cost, not least the distortions that these
guarantees produce in the mortgage market and the crowding out of private markets. The role of
the government in securitization should be limited to set regulations that improve data disclosure,
increase standardization, and reduce complexity of securitized products so that these markets can
flourish again.

12. Your proposed solution for mortgage finance system does, however, involve some form of
government guarantees. Why? The executive summary termed this the "genie in the bottle"
problem. Capital market investors have relied on government guarantees for 25-plus years,
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focusing on the valuation and trading of MBS securities that carry only interest rate and
prepayment risk. There needs to be a transition that allows the private market to develop. In
reality, private markets do not spring up out of thin air. As has been demonstrated through past
financial innovations, such as the emergence of mortgage-backed securities, high-yield bonds, and
leveraged loans, it takes years to develop the investor base and institutional knowledge of the
markets. One of the failures of the current crisis was that, like previous mortgage market failures
(e.g., collateralized mortgage obligations in the early 1990s), the market for subprime
securitization products arose so quickly that when the financial crisis started, there wasn't really
the market or expertise for standby private capital to step in.

13. So how will your proposal work? Since mortgage default guarantees were an essential element of
the development and liquidity of the mortgage market, to the extent possible, mortgage default
insurance should be preserved in the short term as we transition to a fully private market. The
problem is that the private sector cannot be the sole provider, as this insurance is systemic due to
its dependence on macroeconomic events. The negative externalities caused by such aggregate risk
exposure are not fully reflected in the price of insurance. Yet because there is not the right
incentive structure and no accountability (let alone political considerations), the public sector
cannot step into the breach. We argue for a public-private partnership in which the private sector
determines which mortgages to guarantee and at what price to guarantee them, insuring only a
25% fraction, while the government is a silent partner, insuring the majority 75% of the remainder
and receiving the corresponding market-based premiums. It is important that the public sector
involvement be limited to conforming, safe mortgages. And to help the transition along its way, the
loan limit for conforming mortgages would be gradually reduced over time. Market pricing of the
guarantees will ensure that a competing private sector mortgage market (without guarantees) will
not be crowded out. Precedence for such partnerships exists, such as the private-public program
given by the Terrorism Risk Insurance Act (TRIA) of 2007. Most important, and described in prior
pages, the private sector firm/subsidiary would be "well-capitalized" and subject to an irrefutable
resolution authority.

14. Are there any concerns? Most notably, once the GSEs are effectively shuttered, it is hard to believe
that systemic risk in the mortgage finance market will not persist. One can imagine that this risk
will be gradually built up by private sector financial institutions that garner favorable capital
requirements and government guarantees. It is crucial therefore that the external costs of systemic
risk are internalized by each financial institution to prevent private sector "GSEs" from forming.

15. What about the al!ordability of housing? Affordability issues have bedeviled housing policy and
were partly responsible for the demise of the GSEs. In the apparent pursuit of affordability, the
U.S. has had policies (such as the deductibility of mortgage interest against income tax) that are
extremely costly to the federal budget (as much as $300 billion/year), yet mostly favor higher
income households. These policies ultimately made housing less affordable because they pumped
up housing prices by making mortgage debt artificially cheap.

16. What about encouraging home ownership? Many of those same policies have also been
supposed to encourage home ownership. But they mostly encourage upper-income households,
who would buy their homes anyway, to buy larger houses on larger lots, and to take on excessive
debt in doing so. An important consequence is that the U.S. has invested too much in housing and
not enough in other forms of productive capital (including business investment, social
infrastructure, and human capital), so that U.S. GOP is lower than it otherwise could be.

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III.

The Administration's Plan

From a level of 30,000 feet, it is hard to argue against the fundamental premise of the administration's
plan for mortgage finance, and, in particular, for the GSEs. Their various plans all call for effectively
winding down and eventually shuttering Fannie and Freddie and, as a replacement, for a privatized
system of housing finance with little government involvement:
Under our plan private markets - subject to strong oversight and standards for consumer and
investor protection - will be the primary source of mortgage credit and bear the burden for
losses. Banks and other financial institutions will be required to hold more capital to withstand
future recessions or significant declines in home pricesJ and adhere to more conservative
underwriting standards that require homeowners to hold more equity in their homes.
SecuritizationJ alongside credit from the banking system, should continue to playa major role in
housing finance subject to greater risk retentionJ disclosureJ and other key reforms. Our plan is
also designed to eliminate unfair capital, oversight, and accounting advantages and promote a
level playing field for all participants in the housing market. The Administration will work with
the Federal Housing Finance Agency C'FHFA") to develop a plan to responsibly reduce the role of
the Federal National Mortgage Association (IfFannie Mae'] and the Federal Home Loan Mortgage
Corporation ("Freddie Mac'] in the mortgage market and, ultimate/YJ wind down both
institutions."
("Reforming America's Housing Finance Market", Administration Report to Congress.)
II

That said, there is plenty to quibble about in the report itself and, in particular, with respect to the
implementation of the administration's proposals. We separate our remarks into four areas:

1. The causes of the crisis and the GSE's role

We agree with the basic notion that we want to look forward and not back. But the role and
subsequent failure of the GSEs within the U.S. mortgage finance system provide valuable lessons for
how to reform the system.
There is little doubt that the financial crisis was not brought about just by the reckless profit-seeking
incentives of then-private-but-always-implicitly-guaranteed Fannie and Freddie. Private-label
securitization of sub-prime and Alt-A mortgages, which were destined to fail when house prices fell
and which were not guaranteed by Fannie and Freddie, left much to be desired as well. There were
poor underwriting practices and standards; the capitalization of originators and securitizers was
woefully inadequate and many of these also enjoyed explicit or implicit government guarantees; the
private-label MBS were maSSively mis-rated by the credit rating agencies, whose ratings many
investors took on blind faith; and the dispersed owners of sliced-and-diced tranches of risk had little
incentive to pursue efficient renegotiation of defaulted or near-default mortgages. In the end, many
private players became too big to fail, just like Fannie and Freddie.
But the data do not support the idea that the GSE's mortgage portfolio and credit guarantees followed
safe and sound practices prior to the 2005 period. While the quality of the 2005-2007 vintages were
certainly below those of the earlier period, the main determinant of defaults was the collapse in home
prices. If such a collapse had occurred prior to the 2005 period, then the GSEs would have failed then
too, perhaps not as spectacularly, but failed nonetheless. The data from the FHFA (via Fannie Mae and
Freddie Mac) show significant increases in the riskiness of their mortgages starting in the 1990s. It is
not rocket science to understand that high loan-to-value (LTV) ratios and lower FICO scores increase
risk exposure. The fact that national house prices, according to the Case-Shiller index, increased 132
straight months from 1995 to 2005 is the primary reason mortgage defaults were low in this period.
The GSEs, or future variations of the GSEs, need to therefore go back to sound underwriting. We think
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the 900/0 LTV cited in the Administration's report is too high and favor an 80% LTV ratio for first and
second liens combined. That is, a household with 20% equity in its house would not be allowed to take
on a second mortgage or a home equity line of credit, while a household with 30% equity could take on
a second mortgage no larger than 10% of the value of its house.
Also missing from the report, and perhaps most important, is the key problem that the mortgage
finance system placed the GSEs as the heads of u.s. mortgage finance. They received implicit
government guarantees that enabled them to borrow at near-government rates with little or no
capital. If banks involved Fannie or Freddie in the mortgage underwriting and securitization process,
the system allowed for twice the leverage even though the underlying risk was the same. It should not
be surprising that the u.s. banking sector, including Fannie and Freddie, held 37 0/0 of GSE MBS in 2007.
This is the opposite implication of the originate-to-distribute model of securitization: risks remained
on the financial sector's balance sheet rather than being dispersed to capital-market investors and
other intermediaries.
It is important to understand the consequences of this regulatory capital arbitrage. A pool of
mortgages, no matter how these mortgages are sliced and diced in securitization or guaranteed by one
counterparty or another, has the same overall risk. If regulators believe a certain amount of capital
needs to be held against these mortgages, then sound economics suggests this should be similar at the
beginning and end of the securitization process. Moreover, if systemically important financial
institutions hold these mortgages or securitized versions, then the capital requirements should
actually go up to reflect the external costs of systemic risk. In equilibrium, one might expect therefore
that the less systemic institutions would hold these securities, in contrast to what was observed in the
period leading up to 2007.
The importance of this observation cannot be understated. The new and improved mortgage finance
system must be a level playing field or systemic risk will once again be built up within a few financial
institutions: those who can hold the risk at the lowest cost and whose costs are artificially cheap
because of explicit or implicit government guarantees.
2. The unwinding of the GSEs
The report makes four suggestions for unwinding the GSEs. While each of the four recommendations is
reasonable, each lacks specifics:
A.

Increasing guarantee fees to bring in more private capital.

"We support ending the unfair capital advantages that Fannie Mae and Freddie Mac previously
enjoyed and recommend FHFA require that they price their guarantees as if they were held to the
same capital standards as private banks or financial institutions."
("Reforming America's Housing Finance Market", Administration Report to Congress.)

There is no recognition that the government, no matter how well intended, cannot accurately price
default risk. Without accountability, and subject to no market discipline, it is difficult to see how the
pricing will improve under the watchful eye of the FHFA. Without market pricing, it is not clear how
private markets will emerge.
B. Increasing private capital ahead of Fannie Mae and Freddie Mac guarantees.
In addition to increasing guarantee pricing, we will encourage Fannie Mae and Freddie Mac to
pursue additional credit-loss protection from private insurers and other capital providers. We
also support increasing the level of private capital ahead of Fannie Mae and Freddie Mac's
guarantees by requiring larger down payments by borrowers. Going forward, we support
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gradually increasing the level ofrequired down payment so that any mortgages insured by
Fannie Mae or Freddie Mac eventually have at least a ten percent down payment."
("Reforming America's Housing Finance Market", Administration Report to Congress.)

Fannie Mae and Freddie Mac were statutorily required to hold mortgages with at least 20% down
payment. The way the GSEs got around this restriction was to have private mortgage insurance (PMI)
on the mortgages. While PMI provides protection to Fannie and Freddie, it does not change the fact
that mortgages with high LTVs are more likely to default. These defaults lead to deadweight costs that
push the value of the property down. To lower the mortgage risk, 10% down payment is not sufficient.
Encouraging additional credit-loss protection is not a bad idea per se as long as it is structured in a
way that does not reduce the overall capital in the system. Mortgage insurers, by their very nature, are
systemically risky. For example, leading up to the financial crisis, $960 billion of PMI had been written
with 80% of the insurance performed by just 6 companies. In 2007 alone, these companies lost 600/0 of
their market value, effectively causing them to suffer a capital shortfall. The key goal should be to
prevent a systemic risk buildup anywhere in the financial sector, whether public or private.
C. Reducing conforming loan limits.

"In order to further scale back the enterprises' share of the mortgage market, the Administration
recommends that Congress allow the temporary increase in conforming loan limits that was
approved in 2008 to expire as scheduled on October 1, 2011 and revert to the limits established
under HERA. We will work with Congress to determine appropriate conforming loan limits in the
future, taking into account cost-ofliving differences across the country."
("Reforming America's Housing Finance Market", Administration Report to Congress.)

While reverting to a loan limit of $625,000 is a necessary action, it is by no means sufficient. The
implication of the above paragraph is that these limits would remain in place, otherwise why mention
the cost-of-living differences nationwide. A conforming loan limit of $625,000 keeps the government
firmly entrenched in the jumbo segment of the housing market. For the private sector to emerge, and
as long as the GSEs are "alive", there has to be a formal way to eventually choke the life out of these
GSEs. Gradual loan limit reductions all the way down to zero and according to a clear timeline would
seem like a straightforward way to do this.
D. Winding down Fannie Mae and Freddie Mac's investment portfolio.
"The PSPAs require a reduction in this risk-taking by winding down their investment portfolios

at an annual pace of no less than 10 percent."

("Reforming America's Housing Finance Market", Administration Report to Congress.)
While we prefer a more immediate closing of the GSEs, lest they still crowd out the private sector, and
for their portfolio to go into an RTC-like entity, the 100/0 reduction should be quite manageable given
the normal pay-down rate of the mortgage portfolios. We advocate a faster paydown rate if market
conditions permit, and we advocate legislation to that end so that future administrations cannot
renege on this plan.

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3. The Public Mission

The report writes that:
"we should make sure that all Americans who have the credit history, financial capacity, and
desire to own a home have the opportunity to take that step. At the same time, we should ensure
that there are a range of affordable options for the 100 million Americans who rent, whether they
do so by choice or necessity."
("Reforming America's Housing Finance Market", Administration Report to Congress.)
As one path to the above goal, the report calls for a reformed and strengthened Federal Housing
Administration (FHA), which includes (i) a commitment to affordable rental housing, (ii) measures to
ensure that capital is available to creditworthy borrowers in all communities, including rural areas,
economically distressed regions, and low-income communities, and (iii) a flexible and transparent
funding source to support targeted access and affordability initiatives.
A reasonable question to ask is why households that have the "credit history and financial capacity"
cannot access the mortgage market. Where is the market failure that private markets cannot operate
here but can elsewhere?
Is it not mildly worrying that the administration still emphasizes a role for government agencies to
target creditworthy low and moderate income households, in effect, to continue the "American dream"
of homeowners hip? It is taken as a given that these programs are socially optimal. The enormous
subsidies thrown at housing - the mortgage interest rate tax deductibility, the tax exemption of implicit
income from owned housing, the exemption from capital gains upon sale of a house, and the subsidies
to Fannie and Freddie - have not served us well. Many low-income households ended up losing their
little home equity and are left with little but a ruined credit history. As documented in numerous
economic studies, most of these programs involve transfers of wealth to the well-to-do and not to the
poor. More generally, there needs to be serious analysis and debate whether this is the best way to
redistribute wealth to households in need.

4. The Administration IS three plans

The Administration offers three possibilities, all of which involve efforts to assure housing affordability
for low- and moderate-income households -- albeit explicit, on-budget, and primarily the domain of the
Federal Housing Administration (FHA). Putting aside the above discussion on whether this is the
socially optimal goal, returning to the past tighter standards of the FHA and making all of these
programs transparent removes some of the major issues that arose with Fannie and Freddie.
Conditional on a government role through the FHA, the administration presents three plans: (i) a
wholly private structure; (ii) a largely private structure, but with an agency that would provide
guarantees to new MBS at times of general and severe stress in the MBS markets; or (iii) a largely
private structure, with a government agency providing "tail risk" or catastrophic insurance in the
event that a private guarantor defaulted on its obligations. As is clear, we believe that the first is the
appropriate long-term goal; but we believe that our plan is a superior interim means of getting there.
The other two plans offered by the administration allow for the government to slide into the mortgage
market through the backdoor and remain permanent fixtures.
In one option, the government comes in like the Lone Ranger (or should we say "Loan Ranger") and
saves the day in a financial crisis. It is not atypical for government entities to act as a lender of last
resort, but, to keep the mortgage system in check, it should be the case that whatever the government
lends out in a crisis should be at exorbitant rates. In other words, it should really be THE last resort.
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Where to set the threshold for government intervention is difficult and determining the level of
guarantee fees that will adequately compensate the government for the default risk of mortgages
issued during a crisis is even more difficult. Also, isn't this the function that we already expect the
Federal Reserve to perform?
The final option offered by the administration looks a little like what we currently have in disguise.
When mortgages start to default, private mortgage guarantors that sold protection would absorb the
first losses. If defaults continue to mount, and private guarantors are wiped out, the government would
step in and make the MBS holders whole. In this plan, the government assumes the so-called tail (or
economic catastrophe) risk. While such a system brings back some market discipline and tries to address
systemic risk, it nevertheless is a dangerous idea for four reasons.
First, can we think of any instance in which the government does a good job in pricing credit risk, whether it
is deposit insurance for banks or hurricane insurance in Florida? The answer is a resounding no. Even if they
had the very best people working for them, setting the correct price would be virtually impossible. Without
the interaction and competition amongst market participants and resulting information revelation, the prices
of the tail risk will be wrong. And, eventually, moral hazard will rear its ugly head. The problem of pricing
the risk accurately is only aggravated by the fact that this is tail risk. By its nature, tail risk only materializes
rarely. Lack of data thus plagues the pricing process.
Second, markets (and politicians) become impatient if they have to pay for tail risk insurance which (by its
nature) may not materialize for many years. They will call for a reduction in catastrophic risk insurance fees,
often at the very moment that more credit (tail) risk is taken on. This is what happened with FDIC insurance
fees. Banks successfully lobbied to stop contributing to the fund during the quiet time. While its coffers
appeared full at the time by standards of expected losses, the fund experienced a massive unexpected
shortfall when the catastrophic risk materialized in 2008-2009.
Third, if there is one thing the current financial crisis has taught us, regulators are always one step behind
well-paid financiers. The crisis was the poster child for financiers' coming up with clever ways of pushing
risk out into the tails and avoiding capital requirements. It doesn't take much imagination to see how
mortgage financiers will do the same here, given that they in effect control the quantity of tail risk borne by
the government.
Fourth, if private mortgage insurers suffer first losses, and an event occurs that triggers a government payout,
then by construction all the private mortgage insurers go bust. Next, the government takes over the mortgage
market, crowding out private markets from then on. There is a certain "been there, done that" feel to this
plan. And we will be back to solving the "genie in the bottle" problem that we face right now!

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What Traders Do
by William L. Silber and Roy C Smith

There are essentially two types of trading activities: marketmaking and proprietary
trading.
(1) "Marketmaking" involves continuously quoting prices to the market at which the
trader is willing to buy (bid for) or sell (offer) a particular security or commodity. The
marketmaker, sometimes called a dealer, will disclose prices upon inquiry and supply such
prices to the appropriate exchange, over-the-counter (OTC) market or electronic trading
system. Such traders benefit from a large volume of orders on which a (usually) small
"spread" is earned. For example, a marketmaker may bid for securities at 100, and offer at
100 1/2, thereby making a spread of 1/2 of 1% on each trade he or she is able to generate
at these prices. The more trades the better volume is highly important to marketmakers
and directly affects the spreads they quote. In the very high volume U.S. Treasury market,
for example, spreads of 1/16 to 1/32 are normal; in some infrequently traded OTC stocks,
however, the bid and asked spread might be as high as 2-3%.
Most of the world's trading in securities, commodities, foreign exchange and
derivatives occurs over the counter. Some, such as stocks, and certain futures and options
contracts, are traded on exchanges. When traded on exchanges with auction markets, like
the New York Stock Exchange, trades are directed through "specialists," which are firms
obligated to use their own capital to buy and sell the securities allocated to them for
marketmaking. The specialists operate according to the rules of the particular exchange.
One of the obligations imposed by the NYSE on its specialists is to conduct an orderly

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auction for the stocks they are in charge of. Thus, they must represent orders to buy or sell
stock at a specific price (a limit order) left with them by other exchange members. In
addition, the specialist must be prepared to bid and offer if there are no other public orders
for the stock. Thus, specialists are a mixture of auctioneer and marketmaker.
(2) "Proprietary trading" involves taking a position in a security or commodity for
the trader's own account with the intention of selling it at a higher price. Thus, proprietary
traders are what we commonly call speculators. Transactions by proprietary traders are
usually done for a firm's own account and do not require the trader to quote prices or
disclose his or her activities to others. Many proprietary traders attempt to complete quasi
arbitrage transactions: e.g., they will buy US ADRs of a Dutch company in New York and
simultaneously sell an equivalent number of underlying shares of the company in the
Amsterdam market, pocketing the difference in values after all expenses as a profit There
are many forms of arbitrage in all securities, foreign exchange and commodities markets,
though most are complex and highly dependent on getting the various details right.
One popular form of proprietary trading is "program trading" in which transactions
are executed based on price differences between securities "in the cash market and their
equivalent in derivative markets. Usually such transactions are grounded in mathematical
models created by a research team at a firm to take advantage of market anomalies. Other
traders use other forms of quantitative analysis to create trading models. Still others invest
in longer-term situations in which the.trader is, in effect, betting on a certain outcome of
a transaction in progress, e.g., an announced but uncompleted merger, or a change in the

" American Depository Receipts issued in the VS. by foreign companies.

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relationship between, the prices of two or more securities. In all cases, one principle stands
out as crucial for success: Know the details.
How do they make money?
Marketmakers succeed when they, or salesmen working with them, are able to drive
large volumes of trades through the spreads quoted by the trader. Research activities of the
firm are helpful to the salesmen in this respect. Marketmaking should be profitable because
quoted bid prices are always below quoted offer (ask) prices. Thus, if there were roughly
the same volume of buying and selling, the marketmaker would extract a "toll," the bid-asked
spread, from all other traders. Marketmaking is risky, however, because immediately after
the dealer has bought but before he or she has had the chance to sell (or vice versa), the
dealer has inventory which is exposed to the risk that new order flow and/or information
may cause the overall price level to go up or down. Since it is the dealer's business to
accommodate public orders, they often find themselves buying when everyone else is selling
or selling when everyone else is buying. Whether a marketmaker earns a positive return over
time depends upon how well he or she manages inventory risk, that is, whether the bid-ask
spread earned during "normal" periods outweighs the inventory losses incurred during
sustained waves of buying and selling.
Proprietary trading involves a willingness to take risks that certain outcomes will
occur in the future. The firm establishes a position in the instruments involved and waits for
the market to adjust in its favor. Proprietary traders must select the positions they want,
then determine the most efficient way to "put on" the trade, then monitor the position
continually until the position is "taken off," i.e., liquidated or otherwise changed. Most
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proprietary traders change their positions when new information is absorbed by the marke
Although proprietary traders remain flexible, they do not like to alter their positior
frequently because they then squander their profits by paying the marketmakers' bid-aske
spread. More transactions are good for marketmakers, but lead to "overtrading" and losse
to proprietary traders.
Proprietary traders use many different analytical techniques for identifying profitabl
transactions. Two broad categories of approach are: fundamental analysis and technics
analysis. As its name implies, fundamental analysis focuses on the underlying economic an
political environment to determine where interest rates, exchange rates, commodity price":
and stock prices are heading. Traders then identify the specific financial instruments c
relationships among instruments that best captures the expected profit opportunit
Technical analysis ignores the underlying forces and focuses on historical price movemen
to determine whether a pattern emerges that can be exploited. Most successful techniciar
recognize that their craft is more art than science, so that their ability to beat the marks
does not clash with the principles of market efficiency.
What do they trade?
Equities: all foreign and domestic equities, including those from "emerging markets
preferred stocks, convertible debentures, warrants and a variety of equity security
derivatives. Some are traded on exchanges, many OTC, and the same principles c
marketmakmg and proprietary trading can (but do not necessarily) apply all over the worlc
Fixed-income securities: all foreign and domestic government, agency, corporate, ar
municipal bonds, notes and short-term instruments as well as interest rate and currenc
swaps and other fixed-income derivative securities.

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Currencies: Because foreign exchange is the most active market in the world, it has
attracted some of the largest speculators and marketmakers; they focus on the dollar value
of the German Mark, Japanese Yen, British Pound, as well as numerous other currencies,
plus the so-called cross rates: Mark value of the Yen (Mark Yen), Italian Lira versus the
Mark (Mark Lira) and so on.
How do they finance trading positions?
There are many ways to finance a position. All investments must be paid for, i.e.,
either one dips into capital for it, or one finances it by borrowing or otherwise establishing
a liability that offsets the asset Traders may borrow directly from banks, using the asset as
collateral for the loan (a "margin" transaction), or they may borrow in the repurchase
("repo") market from another dealer. In the repo market a dealer sells an asset with a
promise to buy it back after a specified period at a specified price which reflects the
"repurchase rate" which is really an interest rate determined by the market at the time.
Repurchase transactions are accounted for on the books of dealers as "securities purchased
under agreements to resell" (assets) and "securities sold under agreements to repurchase,"
(liabilities).
Dealers may also establish a position in the derivatives market, e.g., using futures or
options contracts, instead of the cash market. Futures do not require any cash outlay and
options require a relatively small up-front payment called a premium.
All securities firms must mark their entire inventory of securities, and their offsetting
liabilities, to their market prices every day. Sometimes when this occurs the firm is required
to increase cash margins to reflect changes in relative market values.
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Those who manage trading positions seek to minimize costs and to maximize credit
facilities available. This can be an extremely complex, challenging and important job when
the firm is trading actively in many different instruments at once. For example, on
November 26, 1993, the end of its fiscal year, Goldman, Sachs & Co. showed total assets of
$115.9 billion. These included S15.6 billion of securities borrowed, $26.8 billion of repos, and
$61.4 billion of inventories of commercial paper, government securities, swaps, corporate
debt and equity securities, municipals, commodities and foreign exchange. These inventories
were financed through direct borrowings, including commercial paper, securities loaned,
repos, and "short sales," or instruments sold but not yet purchased, and about $5.0 billion
of capital, or 4 3 % of total assets.
How do traders manage risk?
Most traders are principally concerned with market risk, that is, a change in market
prices that changes the value of the firm's net, or fully-financed, position. This means a
market change that, for example, lowers the value of an asset but may also lower the value
of its corresponding liability, usually by a somewhat different amount- The net position is
what counts. That is what must be managed by the trader with position adjustments and
nerves of steel.
There are other risks for which the trader (and the firm's central administration) are
responsible: "counterparty" risk (or creditworthiness of the party on the other, side of trades
that have been agreed but not yet delivered) and "daylight" risk (reflecting the different time
zones in which delivery and settlement must sometimes take place).
How do firms manage traders?
There are various actions taken by firms to manage their traders:
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(1) all positions must be marked-to-market daily, and the firm must have a way.of
spot checking these valuations to assure their accuracy.
(2) all traders will be required to stay within maximum .limits on trading positions.
(3) all traders will be supervised by senior traders, with whom they must consult
when positions go awry or increases in limits are sought
(4) all traders and their positions should be subject to inspection by qualified senior
personnel representing the financial controller's department to insure objectivity and
transparency in reporting trading results.
(5) firms must impose limits on aggregate counterparty and daylight exposure which
traders must observe.
(6) the firm must invest in adequate system support to monitor compliance with its
policies and all applicable regulation.
(7) firms, must discipline those violating these rules without regard to seniority.
What are they like?
The overwhelming majority of traders (9 out of 10) at large financial institutions are
marketmakers. Successful marketmaking is a skill that can be taught to individuals with the
proper raw materials people who Eke numbers and are highly disciplined and actionoriented are prime candidates for marketmaking. These characteristics do not, by any
means, guarantee success but they form the best foundation for managing inventory risk
while trying to extract the bid-asked spread from the marketplace.

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224

Inside the Machine: A J ourney into the World of High-Frequency Trading

10 J un 20 10
Michael Peltz
An e d it o r 's jo u r n e y in t o t h e w o r ld o f h ig h -s p e e d t r a d in g a n d p r o p r ie t a r y a lg o r it h m s t h a t m a k e o r
b rea k m a r kets.
At 2:45p.m . on Thursday, May 6, George (Gus) Sauter received a frantic call from one of his traders to get in front of a
Bloom berg term inal. The Dow J ones industrial average, already down 3.9 percent that day on fears about Greece, was in
free fall. In just five m inutes the index plunged 573 points. Less than two m inutes later, the Dow had rocketed back up 543
points, going on to finish the day down 3.2 percent.
It was just crazy, Sauter, chief investm ent officer of m utual fund giant Vanguard Group, told m e a few days later. I had
to go to our fixed-incom e building, about a five-m inute walk from m y office. By the tim e I got there, the m arket had
rallied.
Crazy, indeed. The aptly nam ed flash crash tem porarily wiped out m ore than a
half trillion dollars in equity value, shaking what little faith nervous investors had
in U.S. m arkets. Shares of Dow com ponent Procter & Gam ble Co., the ultim ate
defensive blue-chip stock, dropped m ore than one third in a m atter of m inutes
before recovering alm ost as quickly, all for no apparent reason. A few other large
U.S. com panies, including accounting firm Accenture, saw their stocks trade as low
as a penny a share, only to close not far from where they had begun the day (nearly
$ 42 a share in the case of Accenture) again, on no news. By the tim e the dust
settled, a whopping 19.3 billion shares had changed hands, m ore than twice the
average daily U.S. equity m arket volum e this year and the second-biggest trading
day ever.
But for m e, the single m ost am azing fact about the flash crash was that no one had
a clue as to what had triggered it. Not that I should have been surprised, based on
the conversation Id had two days earlier with Mary Schapiro, chairm an of the
Securities and Exchange Com m ission. Schapiro, whose organization is charged
with m aintaining fair and orderly m arkets, explained to m e how the SEC did a
detailed study after the October 1987 crash to reconstruct what had happened.
Weve lost som e of the capacity to do that given the dram atic volum es of trading
that exist today, Schapiro said. But we need to be able to do that to understand
where are the vulnerabilities in our m arketplace and what are the practices that
have the potential to hurt investors and the m arketplace in the long run.
In 1987 the SEC had a m uch easier task because the vast m ajority of listed U.S. equities were traded in one place on the
floor of the New York Stock Exchange, where specialists em ployed by the Big Boards m em ber firm s m ade a m arket based
on an open-outcry auction system . Today, as a result of a series of regulatory changes designed to increase com petition
and m ake the m arket fairer for m om -and-pop investors, only about one quarter of all U.S. equity trading occurs through
the now publicly held NYSE Euronext. And the m ajority of that trading is done electronically, either by the new NYSE
floor specialists, called designated m arket m akers, or on the fully autom ated NYSE Arca platform . The rest of the trading
in U.S. equities is spread across a wide range of venues, including the three other m ajor exchanges (Nasdaq Stock Market,
BATS Exchange and Direct Edge) and dozens of broker-dealer-operated trading system s, electronic com m unications
networks (ECNs) and dark pools, where buyers and sellers are matched up anonym ously.
[Click here to view the Top 25 Most-Favored Stocks In High-Frequency Trading.]
The past decade of fragm entation and autom ation has given rise to a whole new type of professional trading firm : one that
uses sophisticated com puter algorithm s, often running on servers housed right next to exchanges own m achines, and
high-speed m arket data feeds to buy and sell securities in rapid-fire fashion. Som e of these high frequency traders place
hundreds of m illions, even billions, of buy and sell orders a day, continually canceling and replacing them , and are likely to
be on the other side of your trade. Not that youd know who they are proprietary trading firm s are not required to
disclose their identity or recognize their nam es. The bulge bracket of high frequency trading includes firm s like Allston
Trading, DRW Holdings, Global Electronic Trading Co. (Getco), Hudson River Trading, Quantlab Financial, RGM
Advisors, Sun Trading, Tower Research Capital and Tradebot System s.
High frequency trading has becom e a m ultibillion-dollar business, accounting for an estim ated 50 to 70 percent of the
total U.S. equity m arket volum e on any given day. Since last sum m er it has also been a lightning rod for the populist anger
directed at Wall Street, despite the fact that m ost of the largest high frequency firm s operate far from the canyons of lower
Manhattan, in places like Chicago, Kansas City and Austin, Texas. Critics accuse high frequency traders of being fairweather m arket m akers who, unlike the form er NYSE specialists theyve largely replaced, dont have a legal obligation to
trade during periods of stress. They also say that the growth in high frequency trading has created a two-tiered m arket of
technology haves and have-nots that is unfair to long-term investors and poses potential system ic risks.

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I grew interested in high frequency trading last year when I was writing a feature on hedge fund firm Citadel Investm ent
Group (m ore on that later). As an editor, however, it wasnt until J anuary that I was able to dig into what I soon learned is
an incredibly arcane world. My first stop was a com pany called Pragm a Securities, an agency-only brokerage firm that
aggregates m ore than 40 different dark pools, electronic trading venues and open m arket destinations into a single
liquidity source for clients. Douglas Rivelli and David Mechner, Pragm as co-CEOs, spent two hours at the firm s spacious
New York offices taking m e through that world.
High frequency traders, Rivelli and Mechner explained, generally fall into one of two cam ps: proprietary trading shops that
act as electronic m arket m akers, using com puters to generate and adjust buy and sell orders autom atically throughout the
day, and hedge funds that specialize in statistical arbitrage, seeking to exploit pricing inefficiencies am ong different
securities and asset classes. The distinctions between the two som etim es blur, however, as proprietary trading firm s often
try to capitalize on som e of the sam e buy and sell signals that statistical arbitrageurs use and hedge funds trade on evershorter tim e horizons. High frequency firm s are best known for trading equities, but they also trade futures, options and
foreign exchange basically, anything that can be traded electronically. High frequency trading is also an increasingly
global phenom enon, gaining ground in both Europe and Asia.
One thing is clear: Hedge funds dont like to be called high frequency traders, as I quickly discovered after visiting with
som e of the biggest quantitative m anagers, including AQR Capital Managem ent in Greenwich, Connecticut, and D.E. Shaw
& Co. and Renaissance Technologies Corp. in New York.
In the wake of the flash crash, as people scram bled to determ ine what had triggered the m arket plunge, it didnt take m uch
longer than the 40 0 to 60 0 m icroseconds (m illionths of a second) that high frequency traders typically need to identify and
place a trade for fingers to start pointing at them . The potential for giant high-speed com puters to generate false trades
and create m arket chaos reared its head again today, Delaware Senator Ted Kaufm an said in a statem ent released that
sam e afternoon. When I caught up with the Dem ocratic lawm aker a week later, he was even m ore incensed, pointing out
that regulators still didnt know what had caused the flash crash.
We have a 30 0 -pound gorilla in the room , and were saying that were going to keep it in a cage som ewhere, he told m e.
This thing will be 60 0 pounds.
But isnt part of the problem that there are 30 0 gorillas? I asked, referring to the fact that an estim ated 20 0 to 40 0 firm s
do high frequency trading.
Good point, he replied. We have all these gorillas, and guess what? We put them in zoos where the people running the
zoos dont have enough inform ation and authority to take care of them .
Kaufm ans interest in high frequency trading predates m ine. When he was sworn into office in J anuary 20 0 9 to fill the
Senate seat of his form er boss J oe Biden, Kaufm an was hell-bent on m aking sure that everybody responsible for the 20 0 8
m arket m eltdown paid for their actions. He soon focused on short-selling, urging the SEC to reinstate the uptick rule
requiring short sales to be filled at a higher price; the rule had been elim inated in 20 0 7. He told m e that when he was in
business school in the 1960 s, it was an article of faith that the uptick rule was one of the two or three things that helped
deal with predatory bear raids. As a result of his interest in short-selling, Kaufm an said, his office started getting calls
from som e fairly sophisticated people, including form er Wall Streeters, telling him that if he thought that practice was bad,
he should look at high frequency trading.
Kaufm an likes to draw an analogy between high frequency trading and the swaps m arket. With synthetic derivatives, you
had a lot of m oney at stake, no transparency and then a m ajor m eltdown, he explained to m e. If you look at high
frequency trading, I think the sam e Kaufm an form ula works.
A graduate of the Wharton School of the University of Pennsylvania, the 71-year-old Kaufm an is a quick study and
understands m arkets. If I were a high frequency trader, Id take him seriously.
Kaufm an has been high frequency tradings loudest critic. But hes far from alone. Seth Merrin, founder and CEO of
Liquidnet Holdings, which operates an electronic m arketplace that provides block trading for institutional investors, likes
to com pare high frequency traders to the Am erican arm y during the Revolutionary War. The institutions are the
equivalent of the British arm y, walking down the battlefield wearing bright red, he told m e back in March in his glassenclosed office at Liquidnets sleek m idtown Manhattan headquarters. The high frequency traders are the Am ericans
hiding in the woods in cam ouflage, picking them off. If the British arm y hadnt changed its tactics, they would have lost
every subsequent war.
Even Duncan Niederauer, who as the pragm atic CEO of NYSE Euronext has been retooling his exchange to attract m ore
business from high frequency traders, took a swipe at them . We as an industry have to say how m uch is too m uch of this
technology, he said during an interview on CNBC after the flash crash, undoubtedly causing som e consternation am ong
the folks at NYSE Euronext who are selling space in the com panys new, 40 0 ,0 0 0 -square-foot data center and co-location
facility in Mahwah, New J ersey.

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High frequency traders say that any efforts to rein in technology would be m isplaced. Although speed is im portant to what
they do, the quality of a firm s com puter m odels for analyzing m arkets and identifying where and at what price to buy and
sell securities is what really determ ines success or failure, they argue. In their defense, high frequency traders say that they
increase liquidity, lower trading costs, im prove price discovery and reduce risk by dam pening short-term volatility.
High frequency trading is the liquidity backbone of the equity m arkets, Manoj Narang, the founder, CEO and chief
investment strategist of Tradeworx, told m e when I first m et him , in early March. Long-term investors are the ones who
cause bubbles, as well as liquidity crises when these bubbles burst.
Narang, 40 , is one of only a handful of proprietary traders I found willing to talk openly with a journalist about what they
do. Most prefer to operate in the shadows, both to protect their valuable algorithm s and to avoid regulatory scrutiny. But
Narang, who left Wall Street in 1999 to start Tradeworx, sought m e out when he heard through a public relations contact
this winter that I was working on a story on high frequency trading. His 25-person firm , which operates out of an office
above a Restoration Hardware store in Red Bank, New J ersey, trades about 40 m illion shares a day on about $ 6 m illion in
proprietary capital. Tradeworx also runs a $ 50 0 m illion statistical arbitrage hedge fund (which trades another 40 m illion
shares a day) and owns a subsidiary, Thesys Technologies, which licenses its high-perform ance trading platform to other
investors.
Narang lifted his profile on May 6 when he revealed to the Wall Street J ournal that his firm turned off its high frequency
trading com puters during the flash crash. Tradeworx wasnt the only one to do so. Kansas City based Tradebot, started by
BATS founder David Cum m ings, also stopped trading. Tradebot is one of the worlds two largest high frequency firm s,
reportedly trading as m any as 1 billion shares a day in U.S. equities. Only Chicago-based Getco is thought to be bigger.
Although Getco wont com m ent on its daily trading volum e, a spokeswom an for the firm did tell m e that it continued to
provide a two-sided m arket on all the electronic exchanges during the flash crash.
Most high frequency traders, in fact, kept their com puters running, according to J effrey Wecker, president and CEO of
Lim e Brokerage. Wecker should know. His firm , which accounts for as m uch as 5 percent of the daily equity trading volum e
in the U.S., is the oldest and largest provider of high-speed trading solutions and access to all m ajor U.S. exchanges for
high frequency traders.
The high frequency firm s that did stop trading on May 6 have been criticized for contributing to the decline by pulling
liquidity from the m arket when it was needed m ost. But Narang told m e that his firm had no choice because the exchanges
were likely to cancel, or break, trades that were clearly erroneous (like selling Accenture at a penny a share). If the
exchanges broke all our buys and not our sells, we could have exceeded our capital requirem ents, he explained. We didnt
want to take the risk. The high frequency traders who continued to trade that afternoon m ade a fortune.
IN J ANUARY THE SEC PUBLISHED A CONCEPT RELEASE on equity m arket structure, seeking public com m ent on
everything from high frequency trading strategies and system ic risks to co-location and dark pools. At 74 pages, the report
m ight seem like a real snoozer, but its actually a great prim er on how the U.S. equity m arkets have responded to regulatory
changes, starting in 1996 with the adoption of order-handling rules. These new rules, which were designed to m ake the
m arkets fairer following the Nasdaq price-fixing scandal in the m id-90 s, created ECNs and gave them the power to publish
their stock quotes publicly alongside those of the listed m arkets. In 1999, Regulation Alternative Trading System (ATS)
went into effect, enabling ECNs to operate as m arket centers without having to register as exchanges. By the following year
ECNs like Island and Archipelago had taken about one third of m arket m akers volum e in Nasdaq-listed stocks. But it
wasnt until after April 20 0 1 the deadline the SEC m andated for all U.S. exchanges to switch from fractions to decim als
that electronic trading really started to take off.
As bid-offer spreads shrunk and com petition increased, ECNs and exchanges adopted a m aker-taker pricing schem e to
attract liquidity. Under the m aker-taker m odel, m arket participants that offer to provide, or m ake, liquidity by posting an
order to buy or sell a certain num ber of shares at a particular price receive a rebate. Those that execute against that order
that is, take the liquidity have to pay a fee. Exchanges earn the difference between the rebate they pay and the fee they
charge. The SEC lim its taker fees to 0 .30 cents a share; rebates tend to be lower for econom ic reasons, but for high
frequency firm s trading m illions of shares a day, they can m ake for a pretty good living.
The m aker-taker m odel created an arbitrage that provided incentive for those firm s that could properly blend together
knowledge of trading, financial econom ics and com puters all into a single, scalable system that could handle high volum es
of transactions, Lim e Brokerage CEO Wecker told m e back in April when we m et at his firm s Greenwich Village offices.
The final m ajor regulatory change was Regulation NMS (for National Market System ), which was passed by the SEC in
20 0 5 and went into effect in 20 0 7. One of the key pieces of Reg NMS is the trade-through rule prohibiting any exchange
from executing a trade at an inferior price to one quoted at another trading venue. Trade-through protection is critical for
high frequency traders; it ensures that if they are the first to post the best price for a stock, theyll get the trade.
High frequency trading is a product of Reg NMS, decim alization and technology im provem ents, says J ohn Knuff, general
m anager of global financial m arkets for Equinix, a Foster City, California based com pany that runs 87 data centers in 35
key m etropolitan areas around the world. High frequency traders are the dem ocratic enforcers of Reg NMSs tradethrough rules.

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Under Reg NMS, exchanges are required to handle electronic orders im m ediately or risk having them redirected to other
venues. Once the rule was adopted, the NYSE which even after decim alization had been clinging desperately to its
m anual specialist system had no choice but to em brace autom ation. In 20 0 7 the NYSE switched to a system it called the
Hybrid Market, expanding its autom atic execution facility, Direct+, and giving specialists the power to create their own
algorithm s to quote and trade electronically. The hybrid system included circuit breakers, called liquidity replenishm ent
points, that would be triggered if a stock experienced a large price swing, at which tim e autom ated trading would stop and
hum an specialists would step in.
Thats exactly what happened on the afternoon of May 6, when the NYSE im posed a trading slowdown in Big Board stocks
like P&G and Accenture. Investors who wanted to sell or buy were forced to go to other electronic exchanges or ECNs.
Although Nasdaq OMX Group CEO Robert Greifeld and other com petitors criticized the NYSE on May 6 for m aking the
m eltdown worse, NYSE Euronext CEO Niederauer staunchly defended its actions, pointing out that the exchange did
exactly what it should have under Reg NMS. He was vindicated two weeks later when the SEC proposed instituting sim ilar
circuit breakers for all exchanges that would pause trading in any stock in the Standard & Poors 50 0 index if its price
m oved 10 percent or m ore in a five-m inute period. The new circuit breaker rule, which is likely to be approved by the SEC
this m onth, would go into effect on a pilot basis through Decem ber 10 , at which point the regulator could expand it to other
stocks and exchange-traded funds.
When a stock gets overheated, som e form of stock-specific circuit breaker is a very effective m eans for letting inform ation
repopulate in the m arketplace, Lim es Wecker told m e a few days after the flash crash. He advocates an initial short-term
cooling-off period m easured in seconds or m inutes; if a stock suffers a subsequent steep decline in price, the next halt
would be longer.
Like m any of the people I have interviewed about high frequency trading over the past five m onths, Wecker is concerned
that regulators could try to rein in the practice by putting lim its on technology. After all, his business is built on speed. The
challenge with speed bum ps is that you are slowing down innovation to accom m odate the players who have no interest in
investing in innovation, says Wecker, 47, who spent 11 years at Goldm an, Sachs & Co., including six in its fam ed
quantitative trading group, before eventually m oving to Lehm an Brothers to build its electronic trading group. He left
Lehm an in April 20 0 8, five m onths before the investm ent bank filed for bankruptcy, and was hired by Lim e founder Mark
Gorton that Novem ber.
Lim e handles hundreds of m illions of trade orders a day. This spring it introduced a product called Lim eInside that enables
custom ers to place an order with Nasdaq, NYSE Arca and BATS in less than ten m icroseconds, on average including
real-tim e pretrade risk checks. Thats blazingly fast, confirm s Tradeworx CEO Narang. It takes his group about 20
m icroseconds to do a trade from the m om ent a stock quote enters its system , triggers a signal, determ ines an order and
passes through risk controls. Besides Lim e, the only firm s that are faster than Tradeworx, Narang says, are Tradebot and
Getco.
Trading in the single-digit m icroseconds would be im possible for firm s like Lim e, Tradebot and Getco if they didnt house
their algorithm s near the com puter m atching engines that power exchanges, ECNs and other electronic m arketplaces.
Brokerages, proprietary trading firm s, hedge funds and other asset m anagers can lease co-location space in exchangeowned facilities (such as the NYSEs Mahwah data center) or those owned and operated by third-party providers like
Equinix.
Co-location has been a hot-button issue for critics of high frequency trading. I wonder, however, how m any have actually
visited a co-location facility. In March I got the chance to do just that at Equinixs 340 ,0 0 0 -square-foot NY4 data center in
Secaucus, New J ersey. My host was Brandon Travan, head of the inform ation technology infrastructure, co-location and
cloud-hosting services divisions for Gravitas Technology, one of the growing num ber of com panies that provide turnkey
technology solutions for high frequency traders and one of the first tenants at NY4.
From the outside, the white, two-story, unm arked building, located 11 m iles west of downtown Manhattan in an area
known best for outlet shopping, looks like a suburban m edical office or law firm . (I later learned that it had been an
eyeglass factory.) The lobby is equally nondescript, if not a little odd theres not m uch m ore than a phone, a plain steel
door and a biom etric hand scanner. After dialing in a personal code m atched against the geom etry of his hand, Travan got
us into an inner lobby, where three security guards sat behind bulletproof glass and Kevlar-reinforced walls. I gave them
m y drivers license (which, I was told, Id get back when I left), and after two m ore sets of hand scans and steel doors, we
entered the co-location area.
I was glad that I had decided to wear a light coat over m y suit that day, because Equinix keeps the facility at a cool 65 to 72
degrees Fahrenheit. The design itself is also very cool. Built on a concrete slab with 45-foot-high ceilings, the building is
organized along a rectangular grid system , with rows and rows of servers housed in m etal cages for as far as the eye can see.
Yellow trays snake above the cages, carrying all types of cables. Orange innerducts tran sport fiber-optic connections
within the cages. Giant air-conditioning units, located outside the co-location area in case of a water leak, pum p air through
large green ducts that com e down over the cages, creating a giant convection loop that sends the heat from the servers and
networking equipm ent up toward the ceiling and out through the roof.

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The facility is kept dark, both to im prove its energy efficiency and to protect the anonym ity of Equinixs tenants. Each cage
has lights that com e on autom atically when som eone enters, I learned when Travan typed in the code to unlock his cage.
Gravitas has about 35 clients operating out of its space, including one large hedge fund firm that spent more than $ 1
m illion on com puter hardware, software and setup costs. The m ajority of Gravitass clients, however, are sm all. The
com pany provides all of its clients with direct high-speed connections to all the m arket data providers and trade execution
networks, including other NY4 tenants, like Direct Edge and the International Securities Exchange.
We m ake the electronic trading com m unity of Equinix available to sm aller players by taking advantage of econom ies of
scale helping them get in with the technology they need with alm ost no up-front capital, Travan told m e. If youve got a
coder and the next best algo for trading equities, currencies or other vehicles, instead of needing a quarter-m illion dollars
to start up, you can sim ply install your code on our hosting platform or send us servers to plug in, and youre ready to go.
Not everybody, however, buys the dem ocratization argum ent. J ames McCaughan, CEO of Principal Global Investors, says
co-location gives high frequency traders an unfair advantage. Co-location creates an inform ational asym m etry that is
fundam entally acting against the interests of long-term investors, McCaughan told m e exactly one week after m y visit to
the Equinix data center. I have no problem with people developing algorithm s for high frequency trading as long as theyre
doing it with the sam e inform ation as everybody else.
McCaughan, whose team m anages $ 215 billion in m ostly 40 1(k) and other retirem ent assets for Principal Financial Group,
considers him self to be a pretty savvy investor. His equity-trading desk has six people at the companys Des Moines, Iowa,
headquarters; two each in London and Singapore; and one in Tokyo, as well as access to state-of-the-art trade-execution
algorithm s offered by all the leading brokerage firm s and third-party vendors. Although theres nothing stopping Principal
from using co-location, McCaughan told m e that for a long-term investor, its probably not worth the effort. As a large,
sophisticated investor, we can com pete, he said. But it is a weaker m arket if you have to be that sophisticated to
com pete.
HIGH FREQUENCY TRADING BURST into the public consciousness last sum m er when news broke that a form er
Goldm an Sachs Group com puter program m er had been arrested by Federal Bureau of Investigation agents at Newark
Liberty International Airport for allegedly stealing software code. According to the FBI, the program m er, Sergey Aleynikov,
transferred thousands of files related to Goldm ans proprietary trading program to his hom e com puters with the intention
of using them to help his new em ployer build a high frequency trading platform . It didnt take long for that em ployer,
Chicago-based Teza Technologies, to cut its ties with Aleynikov. But Tezas co-founders soon landed in hot water
them selves when just six days after Aleynikovs arrest, hedge fund firm Citadel sued them for violating a noncom pete
agreem ent and trying to steal its trade secrets. Last fall Citadel finally got the injunction against Teza that it was seeking,
but by the tim e the judgm ent was rendered, the nine-m onth noncom pete period had nearly expired.
The Citadel-Teza lawsuit provides an illum inating window into the world of high frequency trading. The person at the
center of the dram a is Mikhail Malyshev, a brilliant Russian m igr with a Ph.D. in plasm a physics who joined Citadels
high frequency trading group in 20 0 3. During Malyshevs six years at Citadel, the firm spent hundreds of m illions of
dollars researching and developing high frequency trading m odels and building out the IT infrastructure and systems to
im plem ent them . Its m arket data system , for exam ple, contains roughly 10 0 tim es the am ount of inform ation in the
Library of Congress. Citadel uses this historical data to test its m odels, which attem pt to forecast changes in the prices of
securities by analyzing statistical pricin g patterns, supply and dem and im balances an d other factors. The signals, or alphas,
that prove to have predictive power are then translated into com puter algorithm s, which are integrated into Citadels
m aster source code and electronic trading program .
Malyshev oversaw all aspects of Citadels nearly 60 -person high frequency business, including the approval of trading
strategies. He resigned on February 16, 20 0 9; the next day his top lieutenant, J ace Kohlm eier, left too. By April they had
incorporated Teza. Last fall, while I was reporting m y story on Citadel, Kenneth Griffin, the firm s billionaire founder and
CEO, told m e that before the arrest of Aleynikov, he had no idea what Malyshev and Kohlm eier were doing at Teza. After
all, he said, the two were still on Citadels payroll as part of their noncom pete agreem ents.
Like m ost hedge fund firm s, Citadel is secretive about its investm ent strategies. The fact that Griffin would pursue a very
public lawsuit with Tezas founders says a lot about the im portance of high frequency trading to the $ 12 billion-in-assets
Citadel. In 20 0 8 its high frequency group m ade $ 1.15 billion, com pared with gains of $ 8 92 m illion the previous year and
$ 75 m illion in 20 0 5, according to Malyshevs testim ony. The 20 0 8 perform ance was especially im pressive given how
poorly Citadels large m ultistrategy funds did that year: Its flagship Kensington and Wellington funds were each down
about 55 percent.
Benjam in Blander, who joined the firm in 20 0 4 from Banc One Corp., now leads the high frequency group, which m anages
a portion of Citadels $ 1.8 billion Tactical Trading fund. Citadel, however, was the only large hedge fund firm I could find
that was willing to adm it that it does high frequency trading. Most say they use m any of the sam e tools as high frequency
traders em ploying high-speed com puter program s and co-location services to generate, route and execute orders but
that their strategies have a longer tim e horizon.

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Even the slowest high frequency traders are turning over their portfolios at least a half dozen tim es a day, AQR principal
Michael Mendelson told m e when I m et with him in J anuary at the firm s Greenwich headquarters. We tend to hold things
for at least a day or two, and usually longer.
Mendelson was head of quantitative equity trading at Goldm an Sachs before joining AQR in 20 0 5; he oversees the firm s
statistical arbitrage strategies. He explained to m e that high frequency trading doesnt require m uch in the way of capital
in fact, it would be hard-pressed to put hundreds of m illions of dollars to work. The typical high frequency firm , he added,
is likely to have about $ 5 m illion in proprietary capital and trade a few m illion shares a day through a specialized brokerage
firm like Lim e or Wedbush Securities.
High frequency trading, I learned, is a very low-m argin, low-risk strategy. Traders earn less than a penny a share and rarely
hold overnight positions. Profits are m easured in hundredths of a cent, or m ils, to use the industry parlance. According to
Narang, high frequency traders typically earn about 10 m ils, or 0 .1 cent, a share trading U.S. equities. One of the attractions
of the strategy is its consistency. High frequency traders rarely have losing days. They also tend to do very well during
periods of high volatility. May was likely a great m onth for them .
Narang and other high frequency traders I spoke with gripe about the press, saying that it has often m isrepresented what
they do and grossly inflated the profitability of their business. Theyve got a legitim ate beef. Last sum m er, a few weeks after
the Goldm an software-theft news broke, the New York Tim es ran a front-page story by Charles Duhigg describing how a
handful of traders use powerful com puters to reap billions at everyone elses expense. The article went on to say that
these system s are so fast they can outsm art or outrun other investors, hum ans and com puters alike, using flash orders to
step in front of those investors. (Under Reg NMS, exchanges were given the ability to flash m arketable orders
electronically for a split second to som e professional traders before they are displayed to the broad public.) The article
included the bold assertion that high frequency traders generated som e $ 21 billion in profits in 20 0 8.
The source of the data was TABB Group, a New York and London-based research firm . The problem with the Tim es story,
as I discovered when I m et with Larry Tabb at his Wall Street office in early March, was that the $ 21 billion included a lot
m ore than just high-frequency m arket m aking. That num ber included anybody following an equities-related tim esensitive strategy that doesnt take a significant end-of-day position, the TABB founder and CEO explained. It is pairs
trading, options m arket m aking, futures and cash arbitrage, exchange-traded funds. The profits for the virtual m arket
m akers in U.S. equities, he said, were roughly $ 8 billion in 20 0 8 and $ 7.2 billion in 20 0 9 and likely to be lower this year
because of the drop in volatility and trading volum e. (Tradeworxs Narang says that high frequency trading in U.S. equities
generates no m ore than $ 2 billion to $ 4 billion a year in profits overall.)
New York Senator Charles Schum er probably didnt ask Larry Tabb for clarification after he read the Tim es article. The
very sam e day it appeared, the longtim e lawm aker fired off a letter to Mary Schapiro dem anding that the SEC do
som ething about high frequency traders and their ability to view order-flow inform ation before the general public by using
flash orders. This kind of unfair access seriously com prom ises the integrity of our m arkets and creates a two-tiered system
where a privileged group of insiders receives preferential treatm ent, he wrote. If the SEC failed to curb flash trades,
Schum er threatened to introduce legislation that would.
THE SEC'S NEW HEADQUARTERS IS a m arvel of m odern architecture. Conveniently located next to Washingtons
historic Union Station, the building has a spectacular glass-and-steel atrium where visitors can watch the news on a giant
flat-screen television while waiting to m ake their way into the agencys inner sanctum . Thats exactly what I was doing one
cloudy Tuesday afternoon in late March when J ohn Nester, the SECs director of public affairs, cam e to get m e. Id taken
the train down from New York that day to m eet with J am es Brigagliano, deputy director of the agencys Division of Trading
and Markets, and several other m em bers of his team to discuss high frequency trading. The problem was, I didnt know in
advance who was going to be in the m eeting, and as Brigagliano and three other staffers from the SEC division filed into the
room and quickly introduced them selves, I didnt catch all of their nam es. I handed out business cards to each of them in
hopes of getting them in return, but only one person (assistant director J ohn Roeser) had brought a card.
It took m e about 20 m inutes into the interview to piece together the two m issing names Dan (who I later found out
was m arket structure counsel Daniel Gray) and Dave (associate director David Shillm an). Despite m y initial confusion, I
was im pressed with the SEC staffs knowledge of high frequency trading. We had a wide-ranging discussion, spanning
everything from m arket structure and regulation to Washington politics and financial reform . The SECs interest in high
frequency trading, I learned, long preceded Schum ers fam ous letter to Schapiro last sum m er (and a sim ilar call from
Senator Kaufm an for the SEC to do a com prehensive review of m arket structure). Brigagliano told m e that the SEC began
hearing about high frequency trading not long after it passed Reg NMS and that his group started working on the equity
m arket structure concept release early last year.
The SEC has a tripartite m ission: to protect investors, m aintain fair and orderly m arkets and facilitate capital form ation.
Although the m andates can sometimes be at odds with one another, getting the first two right can go a long way toward
ensuring the third. We see confidence in the m arkets as essential for capital form ation, Brigagliano told m e. Investors
are not going to com m it capital if they think that the system is rigged.
By the tim e I m et with Brigagliano and his team , the SEC had proposed several new rules to help safeguard the m arket,

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including the elim ination of flash orders and a prohibition against broker-dealers providing clients with unfiltered, or
naked, access to exchanges and other alternative trading system s. Naked access has been popular am ong som e speedconscious high frequency traders because it enables them to place buy and sell orders directly with an exchange or trading
venue without being slowed down by pretrade credit and risk checks. The SECs rule proposal, if approved, would require
brokerage firm s to create and m aintain strict risk m anagem ent controls for clients that are given direct sponsored access to
electronic trading venues.
Of course, one of the biggest problem s the SEC and other regulators have faced is that they sim ply havent had the tools or
the data to track the billions and billions of trades that fire across the electronic exchanges and trading platform s each day.
Although several of the largest high frequency players, like Getco, are registered broker-dealers and have the reporting
requirem ents that go along with that, the vast m ajority of firm s operate in anonym ity. In April the SEC looked to change
that when it voted to propose the creation of a large-trader reporting system . If the proposal is approved, any firm or
individual that trades 2 m illion shares or $ 20 m illion in exchange-listed securities in a day, or 20 m illion shares or $ 20 0
m illion in securities in a m onth, will be required to identify itself to the SEC. The agency will then assign that trader a
num ber, which its broker-dealer will use to tag all its transactions, reporting them , upon request, to the SEC.
The large-trader reporting system will be sim ple to put in place, the SECs Shillm an told m e during m y March m eeting at
the agency. Creating a consolidated audit trail is m ore com plicated, and could take several years, because it requires
system s changes at exchanges and broker-dealers.
The SEC began working on a consolidated audit-trail proposal last sum m er, consulting with exchanges and broker-dealers
on what would need to be done and how m uch it would cost. On May 26 the agency unveiled its new rule, which would
create a consolidated order-tracking system that would enable the agency to access in real tim e m ost of the data needed to
reconstruct a m arket dislocation like the flash crash. But progress doesnt com e cheap: The SEC estim ates that it will
initially cost about $ 4 billion to build the system and an additional $ 2.1 billion a year to m aintain it. Taxpayers, however,
wont have to worry about footing the bill; the costs would be borne by broker-dealers, exchanges and other trading venues.
The large-trader tagging and consolidated audit-trail proposals are likely to be approved by the com m ission over the
com ing m onths. Although its wishful thinking to expect the SEC to ever be able to m atch the technological sophistication
of high frequency traders, the new rules should eventually give the regulator the necessary tools to m onitor and police their
activity. Im sure that is going to m ake som e high frequency traders very nervous, but they shouldnt be. Unlike some of the
m ore vocal critics of high frequency trading, SEC chairm an Schapiro knows that the technological clock cannot be turned
back.
While technology has provided benefits to the m arket, it has also created real issues, she told m e in early May. We want
to be very careful and thoughtful about how we approach it. The idea that you can say, Lets just unplug everything or
Lets put something into the m achines that makes everything go slower is probably not realistic.
In other words, in the battle of m an versus m achine, both sides could end up winning.

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232

http://www.esquire.com/features/barclays-deal-of-the-century-1009

Th e D e a l of t h e Ce n t u r y
As our financial syst em ent ered free fall last Sept em ber and t he people who ran Wall
St reet st ruggled t o avert a com plet e econom ic collapse, an epic bat t le for power and,
above all, cash was being waged bet ween Barclays and JPMorgan Chase. The inside
st ory of how Bob Diam ond w alked away w it h everyt hing he want ed.
By Tom Ju n od

On Se pt e m be r 2 3 , 2 0 0 8 , Gerard LaRocca, a senior

execut ive at Barclays Capit al, t he invest m ent bank, got an
em ergency phone call from one of his em ployees in t he
bank's operat ions depart m ent . The em ployee was looking at
Barclays' bank st at em ent from it s account wit h JPMorgan.
There had been $7 billion in t he account , and t he em ployee
had been aut horized t o m ove t he cash from JPMorgan t o t he
Bank of New York, which was Barclays' regular, or cust odial,
bank.
But now t he m oney was gone.
Of course, t here were a lot of ways you could lose m oney
last Sept em ber in t he weeks following t he bankrupt cy of
Lehm an Brot hers. Banks had st opped lending m oney, first
t o one anot her and t hen t o everyone else. The st ock m arket
crashed, and t rillions of dollars were evaporat ing from t he
econom y. Lehm an Brot hers em ployees who had equit y wit h
t he firm were left wit h not hing. But Barclays hadn't lost
m oney in it s dealings wit h Lehm an Brot hers. I t was in t he
process of buying Lehm an Brot hers, t he profit able port ions
of it anyway, in a deal t hat one of it s t raders likened t o
" hit t ing t he lot t ery." I t had done what it had set out t o do
Bob D ia m on d
when it s execut ives had surveyed t he once- in- a- lifet im e
St eve Pyke
wreckage of t he Am erican financial syst em in search of a
once- in- a- lifet im e opport unit y, and t he $7 billion was part of
it s spoils. I t was m ore t han m oney t o Barclays; it was m oney t hat Barclays had won aft er st ruggle
won from bat t le wit h t he dom inant player in banking, JPMorgan Chase and so t he $7 billion's very
exist ence was proof t hat Barclays had what it t ook t o com pet e for preem inence in Am erica and
t herefore around t he globe. The $7 billion also happened t o be in cash at a t im e when Barclays, along
wit h j ust about every ot her bank in t he world, needed it desperat ely.
The only problem wit h t he $7 billion was t hat it was no longer t here in t he account m anaged by
JPMorgan. I t was lost . No, not lost Barclays hadn't lost t he $7 billion t he way ot her banks were
losing t heir billions, t he result of bad bet s, insane risks, overleveraging t hat expressed a feeling of
inst it ut ional im m unit y when in fact it was an indicat ion of syst em ic disease.

233

No, it was sim pler t han t hat , and also infinit ely m ore com plicat ed, given t he sheer size of t he sum .
The $7 billion had been t aken.
I w a s w a it ing in front of a rest aurant in Hell's Kit chen, on t he West Side of Manhat t an, when a hired
car, gleam ing and black but fairly m odest as t hese t hings go a Lexus pulled up t o t he curb. One
of t he back doors opened and out st epped Bob Diam ond, t he CEO of Barclays Capit al, who, upon
seeing m e, t hrust bot h of his arm s up in t he air, fist s closed, in a sudden and awkward expression of
t rium ph.
I had m et Diam ond t wice before, in his office, and he had been wary and const rained, t o t he point of
seem ing genially coiled. He is a t rim and com pact fift y- eight - year- old m an who ident ifies him self as a
Bost onian, as an I rish- Cat holic, as a form er t eacher, and as a banker, and t hough he m eans t o be
approachable, he can com e off as severe as, well, an I rish- Cat holic t eacher- t urned- banker from
Bost on. There is, indeed, som et hing alm ost priest ly about him t he sense t hat he's using his
ebullience t o get you t o m ass. He has a long pink face and a long pink nose upon which he perches
his rim less glasses. Under his gray eyes he shows fat igue wit h colorless dent s inst ead of dark circles.
He has a full head of coarse hair t he color of a railroad spike, j ust now st art ing t o t urn gray at t he
t em ples. His body language is sprawling, aggressively relaxed, unt il it isn't unt il, say, he's asked a
quest ion t hat put s him on t he alert and he cont ract s and snaps t o. His m odest y can appear pained
and his inform alit y st udied. He has a habit of t aking off his suit j acket and slinging it over his shoulder
before sit t ing on t he edge of one of t he t rading desks a habit t hat his t raders describe as his m ove,
as in, " he has t his t hing he does wit h his j acket , when he want s t o t alk t o us, it 's his m ove..." See,
everybody has a m ove, and t hat 's what I was expect ing when Bob Diam ond got out of t he black
Lexus: a m ove, from a m an in dogged cont rol of him self. I nst ead, he pum ped his fist s t o t he sky, and
he looked endearingly goofy and boyish a conqueror som ehow m ade innocent by t he act of
celebrat ion.
Of course, Bob Diam ond has plent y t o celebrat e, start ing wit h his conquest . He is t he m an from an
English bank who bought an iconic Am erican one, aft er Lehm an Brot hers default ed last Sept em ber 15
on $613 billion of obligat ions and becam e t he biggest bankrupt cy in Am erican hist ory. He is t he m an
who st ayed calm in a t im e of chaos, who st ayed am bit ious when dream s were dying, who t hought big
when ot hers t hought only of survival, who viewed Am erica as t he prize when m ost of t he globe was
recoiling from it s cont agion, who cont ended wit h forces vast ly st ronger t han him self and em erged
vast ly st rengt hened, who m ade a $45 billion bet and got everyt hing he want ed, saving t housands of
Am erican j obs in t he process. He won when everyone else was losing, or, t o put it m ore blunt ly, he's
a winner in a hist orical m om ent defined by losers, and his only problem is t hat he is a banker who
lives in a t im e when bankers ar e m ist rust ed, especially t he happy ones.
Diam ond is aware of t his. The first t im e I m et him , I asked him what his answer would be if som eone
sit t ing next t o him on an airplane asked him what he did for a living. " I 'm a banker," he said, before
adding, " which used t o be kind of cool." Was being a banker ever cool? Maybe not , but it was a
profession t hat cert ainly conferred exact ly what Diam ond is at pains t o em body t he st at us of t he
solid cit izen, t he kind of old- fashioned em inence t hat 's root ed in com m unit y and a recognizable set of
values. But t hat was before t he expansion of t he financial m arket s and t he incessant m ovem ent of
global capit al redefined our not ion of what a banker is, what a banker does, and what we m ight
assum e about his values. I t is st ill possible t o sit next t o Bob Diam ond on an airplane, because he is
one of t he few global financiers who will fly com m ercial. But Bob Diam ond is one of t he highest - paid
bankers in t he world, earning $42 m illion in 2007 before forgoing his bonuses in 2008. He becam e a
Brit ish cit izen, in addit ion t o being a solid Am erican one, and is such a regular at Davos t hat his
decision t o skip t he financial sum m it t his year was seen as an indicat or of an era's end. He is no m ore
st ill " a banker" t han he's st ill " a Bost onian" ; rat her he is a m em ber of t he t iny global cast e creat ed in

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t he last fort y years or so by capit alism 's elast ic effect on t he m oney supply and it s acid one on
nat ional sovereignt y. This is not t o say t hat he's a bad guy, or t hat he's being disingenuous when he
shows up t o a phot o shoot in t he sackclot h of a plain navy- blue suit because he underst ands t hat his
preferred pinst ripes m ight m ake him a t arget . No, he's supposed t o be a good guy, as good as a guy
spearheading t he consolidat ion of t he world's banks is likely t o get . Hell, in t he event s t hat begin wit h
t he deat h of Lehm an Brot hers and end wit h Barclays' purchase of it s lucrat ive carcass, he was t he
underdog, t hough probably t he richest and m ost resourceful underdog in t he hist ory of t he world. And
so t his st ory which is t he st ory of Bob Diam ond and Barclays and how capit alist s behave when
capit alism is under siege provides a t est case.
Last year we despised and dist rust ed and derided t he bankers who failed. This year we're in t he
process of doing t he sam e wit h t he ones who succeed. But public opinion, like banking it self, is a zero
- sum gam e, and one of t hese days we're going t o have t o decide whom we can live wit h: t he banker
hauled before Congr ess t o sham efacedly account for his st aggering losses, or t he banker who t ravels
t he world wit h his fist s in t he air.

On Se pt e m be r 1 2 ,
2 0 0 8 , t he t hree
m ast ers of t he Unit ed
St at es econom y
Treasury Secret ary
Henry Paulson, SEC
Chairm an Christ opher
Cox, and New York Fed
President Tim ot hy
Geit hner called t he
half dozen m ast ers of
t he universe t o a
weekend m eet ing at t he
downt own offices of t he
New York Fed. The
m eet ing was, t o say t he
least , not open t o t he
Ta bloid N e w spa pe r s D e pict in g St ock M a r k e t Cr a sh 2 0 0 8
public or t o j ournalist s;
Mario Tam a/ Get t y I m ages
indeed, it was not hing
short of cabalist ic. The m en who were called t o t he m eet ing were t he CEOs and senior execut ives of
Wall St reet banks like JPMorgan Chase, Goldm an Sachs, Morgan St anley, and Cit igroup. These were
m en invest ed wit h t he consciousness t hat t hey knew how t he world worked, and also t hat t hey ran it .
On t his day, t hough, t heir confidence, in t hem selves and in one anot her, was shaken; t he week
before, t here had been a run on t he 160- year- old invest m ent bank Lehm an Brot hers, and t hey had
com e t o t he t errifying underst anding t hat t hey were responsible not j ust for t heir own losses, but for
one anot her's. They had est ablished an em pire of shared power by ext ending an em pire of shared
risk, and now t hey were realizing t hat t he risk t hey'd passed off t o ot hers was in t he pr ocess of
com ing hom e. And so t he m eet ing's local focus was really a global one: They were being asked what
t hey were willing t o do t o save Lehm an Brot hers. But t hey were really being asked what t hey were
willing t o do t o save capit alism and t hem selves.
There were t wo CEOs at t he m eet ing who had m ore at st ake t han anyone else. One was fift y- t hreeyear- old Jam ie Dim on of JPMorgan Chase, arguably t he m ost powerful banker in t he world. He was
t he privat e hand on t he U. S. financial syst em , as Paulson and Cox were t he public ones; and
alt hough his hand had for t he m ost part a st eadying effect , it was also very close t o t he t ill. What was

235

at st ake for Dim on in t he Lehm an cr isis was, quit e sim ply, cash: JPMorgan was Lehm an's bank. I t
cleared Lehm an's t rades, which m eant t hat t he exchange of cash and securit ies arranged by
Lehm an's t raders act ually t ook place at JPMorgan. I f Lehm an failed, JPMorgan was, in Wall St reet
parlance, " exposed" it would be st uck wit h t he securit ies and t he losses. During t he previous week,
Morgan had been advancing Lehm an Brot hers m ore t han $100 billion a day in collat eralized lending
so t hat Lehm an had t he liquidit y t o cover it s debt s and st ay in business, but t he night before
Sept em ber 11 it had frozen $17 billion of cash and securit ies in Lehm an's account and had, in t he
view of Lehm an's execut ives, effect ively finished it off. The execut ion cam e in t he form of phone calls
t o a few key execut ives, and Dim on had earned t heir undying enm it y by being on t hose calls but
saying not hing.
The ot her execut ive wit h a lot at st ake was, of course, Bob Diam ond, and what he had at st ake was
his own am bit ion: He was looking t o buy Lehm an Brot hers and t hereby becom e a Wall St reet player,
a m an who m en like Jam ie Dim on couldn't afford t o ignore. And, indeed, on t he m orning of Sunday,
Sept em ber 14, t he assem bled m ast ers agreed t o adm it Diam ond int o t heir com pany agreed, t hat
is, t o let Bob Diam ond save t he global financial syst em by buying Lehm an Brot hers.
I t didn't work.
The deal did not go t hrough, t he t rade was not closed, and t he bankrupt cy filing of Lehm an Brot hers
Holdings t riggered a st ock- m arket crash, a global bank run, and t he dest ruct ion of t rillions of dollars
of capit al. The m eet ing of m inds and m oney t hat had been called t o save capit alism didn't , and so
people st art ed writ ing capit alism 's epit aph, or least epit aphs for capit alism in it s m ost unfet t ered
form . They even wrot e about t he m eet ing it self and how it proved t hat even t he power of m en like
Dim on and Diam ond has it s lim it s.
What was not writ t en about , however what has never been writ t en about because nobody knew
about it was a m eet ing t hat was held j ust a week lat er, in t he offices of Weil Got shal, t he law firm
providing Lehm an it s bankrupt cy counsel. I t was not so grand a m eet ing as t he m eet ing held at t he
New York Fed, but it had as m uch t o say about capit alism and how it was being reconst it ut ed.
I ndeed, it was eit her t he last m eet ing of capit alism 's expansion or t he first m eet ing of it s cont ract ion,
for it pit t ed JPMorgan against Barclays in a kind of cage- m at ch fight as t he rest of t he world was
collapsing. I n t he seven days bet ween t hose m eet ings, bet ween t he m eet ing at which Barclays failed
t o buy Lehm an and t he m eet ing at which it s t akeover of Lehm an was com plet ed, it becam e apparent
t hat t he t wo banks' prim ary concerns were less t he survival of capit alism t han who walked away wit h
a big pile of cash.

I n Apr il 2 0 0 8 , Bob Diam ond had received a phone call from one of t he undersecret aries of t he U. S.
Treasury. His nam e was Bob St eel, and he was one of Diam ond's friends. He'd worked for Henry
Paulson at Goldm an Sachs and now worked for him at Treasur y, but in bet ween he had served on
Barclays' board. He had st ayed in t ouch wit h Diam ond t hrough t he m arket t urm oil of t he subprim em ort gage crisis as it unfolded early t hat year. Diam ond says, " He m ade it very clear he had no official
capacit y t o ask t hese quest ions, but he had t wo quest ions t o ask m e: I s t here a price at which you'd
t ake Lehm an, and if so, what would you need for us t o do?"
Now, you have t o underst and: Barclays is an old Brit ish nam e and an old Brit ish bank. I t 's been in
business for 320 years. But Barclays Capit al is a new invest m ent bank. I t 's been in business t welve
years, and Diam ond has been running it from t he st art . When Barclays first hired him t o run a new
invest m ent - banking business, 80 percent of it s revenues were from it s ret ail and com m ercial- banking
business in t he UK, which is t o say t he business side of a bank you see at an ATM m achine or a
branch office. He creat ed Barclays Capit al out of a t hreadbare rem nant of corporat e acquisit ion and
am algam at ion called BZW, and t hen aft er BarCap prom pt ly lost hundreds of m illions of pounds in t he

236

Russian debt crisis of 1998, he had t o go before t he

Barclays board and ask if t hey want ed t o st ay in t he
business of invest m ent banking at all. They did and
wound up st rengt hening his hand. Since t hen, he
has m ade a pract ice of building BarCap
" organically" during t im es of st abilit y and
" st rat egically" during t im es of crisis, and by April
2008 he had succeeded in m aking Barclays t he
fast est - growing invest m ent bank in t he world, if not
one of t he biggest . Diam ond lived in London and
becam e not j ust a Brit ish banker but also a Brit ish
cit izen, root ing for Chelsea wit h t he sam e privileged
fervor he displayed for t he Red Sox, Pat riot s, and
Celt ics. But he was st ill an Am erican, and he st ill
dream ed of Am erica.
The subprim e crisis t hat had begun in t he sum m er
of '07 gave him his chance t o cr ack t he Am erican
m arket . When he st art ed Barclays Capit al, he did so
wit h t he int ent ion of com pet ing wit h " Am erican
bulge- bracket firm s," by which he m eant t he six or
seven t radit ional Am erican invest m ent banks t hat
had dom inat ed global m arket s for t he last t hirt y
years Goldm an Sachs, Morgan St anley, Merrill
Bob St e e l
Lynch, and, yes, Lehm an Brot hers. By his own
John D. Sim m ons/ Charlot t e Observer ( via Newscom ) st andard, he had failed " for all our success we
were st ill a second- t ier firm in t he U. S." but he
was convinced t hat he had failed because, while st anding for free m arket s, t he big U. S. invest m ent
banks were in fact " an oligopoly" t hat discouraged com pet it ion. He felt t hat crisis would deliver him
opport unit y, and when t he subprim e crisis fell at his own front door, he did t wo t hings: first , report
his billions of losses t o t he board, and second, ask t he board for m oney t o begin building his business
in Am erica.
" I t is only in t im es like t hese t hat organizat ions can im prove t heir relat ive posit ions," he says. St ill, he
figured t hat he would st art by luring t he m ost t alent ed t raders from banks m ost shaken by t he crisis.
He never t hought he'd be able t o buy a bank out right unt il JPMorgan bought Bear St earns for som e
sm all percent age of it s book value t he week before East er 2008, and t hen a few weeks lat er, Bob
St eel called and asked him t o nam e his price for Lehm an Brot hers. Barclays buying Lehm an Brot hers?
I t was as if Schweppes were being asked how m uch it was willing t o pay for Pepsi- Cola.
And yet Diam ond was not so sure he want ed t he deal at all. There was overlap bet ween t he t wo
banks in Europe, and t here was " absolut ely no t rack record of success" when one invest m ent bank
bought anot her especially when a foreign invest m ent bank bought an Am erican one. Besides, he
had done so m uch right at Barclays, when Lehm an had done so m uch wrong. How could an
invest m ent banker fam ous for inst it ut ing a " no- asshole" rule at Barclays buy an invest m ent bank
whose all- asshole rule was j ust as st rict ly enforced?
" Our first im pulse was no," he says. But when he st art ed looking at t he business Lehm an Brot hers
had in t he Unit ed St at es, he went back t o t he board and rem inded t hem what Bob St eel had asked. " I
said, 'Let 's rem em ber t he quest ion. The quest ion was, What price? So let 's say t he price is a dollar.
Are you going t o t ell m e t hat t his wouldn't be t ransform at ional?' "

237

At t he t im e, his quest ion was hypot het ical. He didn't really

available for a dollar. He also didn't know " I know now,"
was already having conversat ions wit h Henry Paulson, and
paraphrase: Get a deal done we're not going t o bail you

expect t hat Lehm an Brot hers would be

he says t hat Lehm an's CEO, Dick Fuld,
Paulson was t elling him , in Diam ond's
out .

On Th u r sda y,
Se pt e m be r 1 1 , 2 0 0 8 ,
a week t hat began wit h
Henry Paulson's
announcem ent t hat he
was put t ing Fannie Mae
and Freddie Mac int o
federal receivership,
Paulson called Diam ond
t o ask, officially, if he
was int erest ed in buying
Lehm an Brot her s, which
was enduring what one
Je r r y D e l M issie r An d Rich Ricci
of it s form er execut ives
St eve Pyke and Paul St uart
called a " good oldfashioned bank run," couldn't get financing for it s suspect asset s, and had lost 70 percent of it s value
since t he opening of t rading t hat Monday. Diam ond, who was in London for an invest ors' conference,
t ook t he call wit h his boss, John Varley, and wit h his t wo closest confidant es, BarCap COO Rich Ricci
and BarCap president Jerry del Missier. Ricci and del Missier had bot h been wit h Diam ond from
BarCap's inauspicious beginnings. They asked Paulson if t here was an Am erican com pany also bidding
on Lehm an, because t hey were concerned about being used as a foreign st alking horse. Paulson said
he couldn't prom ise exclusivit y but t old t hem t o " com e here and do your work." Diam ond, Ricci, and
del Missier t ook t he last flight s out of Heat hrow for New York. They flew com m ercial.
On Friday, Sept em ber 12, Diam ond went t o t he Barclays building on Park Avenue, where he was
picked up by Dick Fuld's chauffeur in Fuld's car. He was t aken t o t he under ground parking garage and
t hen t ook t he freight elevat or t o Lehm an's executive floor t he t hirt y- first , known as " Club 31" for
it s ext ravagances and m et t he beleaguer ed Fuld in his office. He found out t hat t here was indeed
anot her bank in t he bidding for Lehm an Brot hers, Bank of Am erica. Wit h Ricci and del Missier, he
t hen went t o t he offices of Lehm an's bankrupt cy at t orneys, and even as Tim ot hy Geit hner was calling
t he richest financiers on t he planet t o t he New York Fed's headquart ers and challenging t hem t o com e
up wit h a solut ion t o Lehm an's problem s over t he weekend, t hey wait ed t ill alm ost eleven o'clock
before t hey engaged wit h Lehm an execut ives. As t hey wait ed, t hey had a chance t o look at Lehm an's
books and were am azed by what del Missier calls t he " size and concent rat ion of it s posit ions" in
com m ercial real est at e and privat e- equit y lending. Sim ply put , Lehm an had t aken an ownership piece
in virt ually every deal it had ever done, unt il it had a port folio of $50 billion t hat was t he m ost
radioact ive port folio on Wall St reet . And, as Ricci says, " We decide we don't want it ." What t hey
want ed was " t o t ake Lehm an at a price, wit hout t hose asset s." I t was t he principle t hat would hold
t hem in good st ead in t he week t o com e: Get t he good st uff. Don't worry t oo m uch about who get s
t he bad.
On Sat urday, Sept em ber 13, Diam ond and t he Barclays t eam went t o t he m eet ing at t he Fed. The
m ission was clear: Save Lehm an Brot hers, hence Wall St reet , hence t he world, all in " business
casual." Since he was m aking a bid, Diam ond was off in one room ; since he was also m aking a bid,
Ken Lewis of Bank of Am erica was off in anot her. The rest Jam ie Dim on, Lloyd Blankfein of
Goldm an Sachs, Vikram Pandit of Cit igroup, et al. were all discussing whet her t hey want ed t o pay

238

t o liquidat e Lehm an's radioact ive port folio, it s $50 billion pile of crap. They decided t hey did. They
decided t hey would. Barclays and Bank of Am erica bot h bid for Lehm an. Bank of Am erica wound up
asking for guarant ees t hat Henry Paulson couldn't fulfill, since Paulson m ade it very clear he didn't
want t o do anyt hing t hat sm acked of a Lehm an Brot hers bailout . Ken Lewis went on t o bid for Merrill
Lynch, and Bob Diam ond st ood alone wit h his bid for Lehm an Brot hers. At t he end of t he day, t he bid
was accept ed. A deal had been m ade. Barclays was buying Lehm an Brot hers. The world was saved.
On Sunday m orning, all t hat rem ained was for t he deal t o be sent t o t he Brit ish regulat ory body, t he
Financial Ser vices Aut horit y, for it s approval. But t here was a problem : A purchase of such m agnit ude
required a shareholder vot e. For t hat requirem ent t o be waived, t he FSA had t o provide a waiver. The
FSA declined. The deal was dead. I nst ead of being saved, Lehm an Brot hers was t old t o file for
bankrupt cy by Christ opher Cox, t he chairm an of t he SEC. The m eet ing t hat was designed t o save
Lehm an Brot hers ended wit h Merrill Lynch saved purchased by Bank of Am erica and Lehm an
Brot hers in Chapt er 11.
There is st ill som e suspicion, given what was t o com e, t hat Diam ond never really want ed t o buy a
solvent Lehm an Br ot hers t hat he want ed t o buy t he bankrupt ent it y, and orchest rat ed a piece of
subt erfuge wit h t he FSA. There is, however, not a Barclays execut ive who does not voice regret over
t he deat h of t he deal t hat was on t he t able at t he New York Fed, and Rich Ricci says t hat he and
Diam ond were " absolut ely gut t ed." They went from t he Fed t o t he bar at Sm it h & Wollensky, a m acho
New York st eakhouse, where, Ricci says, " t here was drinking involved." There, Diam ond got a call on
his cell phone. I t was Bart McDade, Lehm an's president . He t old Diam ond t hat Lehm an Brot hers
Holdings, t he bank, was going t o file for bankrupt cy. But Lehm an Brot hers Nort h Am erica, t he brokerdealer, was st ill in business, and it was for sale. He want ed t o know whet her Diam ond was st ill
int erest ed.
" I cam e back t o work," Ricci says. " I cam e back over here [ t o 745 Sevent h Avenue, Lehm an Brot hers'
headquart ers] at about four o'clock in t he m orning. Very lit t le sleep. I st art ed working wit h Bart on
how t his would work. And of course all hell broke loose Monday m orning. The world sort of collapsed.
And it was very odd here, very odd."
The crisis t hey had t ried t o avert was upon t hem , and upon t he whole financial syst em . The Dow
dropped 504 point s t hat day, t he bank- t o- bank lending rat e doubled, and t he run t hat eradicat ed
Lehm an Brot hers began t o spread even t o banks like Morgan St anley and Goldm an Sachs. The next
day, one of t he principal m oney- m arket funds wrot e off it s Lehm an holdings as wort hless, and t he
value of m oney- m arket shares dropped below a dollar for j ust t he second t im e in hist ory. At t he end
of t he day, Henry Paulson announced t he Treasury's $85 billion bailout of AI G.
Even am idst t he chaos on t hose t wo days, Diam ond and Ricci and McDade, t oget her wit h t eam s of
lawyers, bankers, analyst s, and "deal guys," cam ped out on t he t hirt y- first and t hirt y- second floors of
t he Lehm an building. They were served food from t he dining room on t hirt y- t wo; t hey didn't sleep.
They knew, in t he words of Skip McGee, who headed invest m ent banking for Lehm an and now for
Barclays, t hat t he value of Lehm an Brot hers was " m elt ing like ice on a sum m er day. I f we didn't do
t he deal when we did, t here was no deal t o be done."
At around noon on t hat Tuesday, Diam ond left t he building. He showered and grabbed a change of
clot hes. He called London and spoke t o his boss and his board. Around t hree o'clock in t he aft ernoon,
he showed up wit h Bart McDade on one of Lehm an's t rading floors t he fourt h. He was not wearing
his j acket . He t old t he t raders, over t he int ercom , t hat t hey had been bought , t hat t hey would
cont inue t o get paid, and t hat he would t ry t o save t he bulk of t heir j obs. Then, as if t o rem ind t he
gat hered t raders t hat Diam ond was t heir conqueror as well as t heir savior, t he int ercom played " God
Save t he Queen." This was t he first public announcem ent t hat Barclays had purchased Lehm an

239

Brot hers, and it was repeat ed on all seven t rading floors and t hen in t he audit orium . He got st anding
ovat ions and t ears. The world had ended was st ill ending but Lehm an, t he cause of it all, had
not . Diam ond had done exact ly what he set out t o do, buying Lehm an Brot hers "at a price."
No, t he price wasn't a dollar, but it was pret t y close: He got Lehm an's U. S. operat ions and it s
headquart ers building for $1.75 billion, including t he assum pt ion of som e liabilit ies and a $250 m illion
fee. And Diam ond was pret t y dam ned proud of it pret t y dam ned proud of get t ing his price. I asked
him once if, seen in ret rospect , t he Lehm an Brot hers acquisit ion was a " no- brainer," and t his was his
response: " I f it was such a no- brainer, why did no one else bid for it ? We're buying t he U. S. brokerdealer of Lehm an Brot hers for $1.75 billion, which is roughly t he price of t his building, which we
needed anyway. No one else bid. Where was Deut sche? Where was Credit Suisse? Where was
Goldm an Sachs? Where was Morgan St anley? Where was HSBC? This is a U. S. bulge- bracket firm ,
operat ing at t he very t op level, and you're get t ing only t he crown j ewels."
And t hen, on Wednesday aft ernoon, Diam ond heard from t he Fed. There was yet anot her price t o be
paid.
Bob Diam ond was in for t he fight of his life.

Th e r e w a s som e t h in g people said about Bob Diam ond

pret t y m uch universally. Current execut ives, form er
execut ives, t raders, and friends. Bob Diam ond? Good guy,
great wit h people. Charism at ic. Has built a cult ure of
decency at Barclays from t he t op down. Doesn't like t o hear
bad news, t hough. Will som et im es st and up and leave a
m eet ing if t he news is bad. Or will st op som ebody
m idsent ence " Why are you t elling m e t his?" So if you t alk
t o Bob, you bet t er t ell him good news. Because Bob
Diam ond is a good- news guy.
I t seem ed like som et hing t o m ent ion in an int erview t he
kind of soft ball quest ion t hat get s som eone t o t alk about
him self. So I did. And I wat ched Bob Diam ond's face change
as if I 'd am bushed him wit h secret docum ent s. His hands,
which had been poised in his pinst riped lap, closed int o fist s.
He got up and went t o his com put er, t hen sat down again
wit h his arm s crossed. He had his glasses on, and he peered
at m e over t he lenses. By force a sm ile flickered on his face,
t hen went away.
" Who want s t o hear bad news?" he said.
Jpm or ga n s Ja m ie D im on
Chip Som odevilla/ Get t y I m ages

A lot of pe ople t hink governm ent act ion saved capit alism .
I t didn't . Capit alism saved capit alism .

A lot of people t hink t he governm ent didn't have any plans

wit h regard t o Lehm an Brot hers. I t did. The plans j ust didn't work.
The governm ent , in t he form of t he Federal Reserve, had t wo plans, in fact . I t had Plan A and Plan B.
Plan A was t o find som eone t o buy Lehm an Brot hers. When t hat didn't happen when t hat didn't
happen because t he Fed didn't want t o fund t he guarant ees necessary t o m ake it happen t hey
went t o Plan B. Plan B was t he Fed's plan t o deal wit h a bankrupt Lehm an Brot hers. I t was a plan t o
keep order in t he m arket s once Lehm an went out of business. I t called for closing Lehm an Brot hers

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t he holding com pany but keeping open it s broker- dealer t he part of t he operat ion t hat bought and
sold securit ies. That way, t he broker- dealer could close all it s t rades, and all t he people doing
business wit h Lehm an Brot hers could get paid. So on Monday night , Sept em ber 15, t he Federal
Reserve began advancing t he broker- dealer $45 billion a day t o st ay open. The idea was t o keep
people from freaking out .
People freaked out . The bankrupt cy of Lehm an Brot hers was like an eclipse in t he Middle Ages, a
por t ent and a fulfillm ent of port ent all at once. I t was t he darkness t hat had t he power t o burn and
blind. The birds of t he m ar ket place went quiet , and t he dogs howled at t he sun inst ead of t he m oon.
The Fed went from being in cont rol of t he sit uat ion t o being as scared as anyone else. I t was a bank,
aft er all. Banks were scared.
And t hen, on Tuesday, Bob Diam ond played " God Save t he Queen" on t he t rading floors at Lehm an
Brot hers. I t was t he one unalloyed t rium ph in a week of unnat ural disast ers, and t he people at t he
Fed had not hing t o do wit h it . They had not been consult ed when t he dealm akers were holed up on
t he t hirt y- first and t hirt y- second floors of Lehm an Brot her s. They found out about t he deal only about
an hour before everyone else did. They were, in t he words of one Fed official, " surprised."
By Wednesday aft ernoon, t hey'd had som e t im e t o t hink about it , and t he Fed's general counsel
called t he general counsel at Barclays. I f you're going t o do t his, he said, you're going t o have t o st ep
in for us on t he funding. I t was a request of sort s. But it was also a requirem ent . There were a series
of m eet ings bet ween Barclays and t he Fed t hat day, and what was clear t o one of t he part icipant s
was t he role t hat fear had st art ed play. " I t was underst ood t hat t he Fed was desperat e t o get t he
Lehm an t rade off it s books," he says. Anot her says sim ply: " They want ed t o get paid."
Barclays had no obj ect ion t o doing what t he Fed was asking and even saw opport unit y in t aking over
t he funding. The Fed want ed out ? Barclays was in. That was t he good news. The bad news? As
Lehm an Brot hers' bank, JPMorgan was also lending Lehm an Brot hers m oney. And JPMorgan want ed
out , t oo.
Ba r cla ys Ca pit a l and JPMorgan are oft en present ed as heroes of t he crisis. Barclays bought what
was left of Lehm an Brot hers when nobody else want ed t o and saved t housands of j obs. JPMorgan
operat ed as a quasi- public t rust , it s sheer size exert ing a st abilizing force. Their CEOs even had
sim ilar nam es Jam ie Dim on and Bob Diam ond. A few days before, t hey'd agreed on t he proposit ion
t o creat e a liquidat ing t rust for Lehm an's t oxic asset s, wit h Jam ie Dim on urging his Wall St reet
colleagues t o fund it .
But t he m eet ing at t he New York Fed wasn't capit alism . I t was about capit alism , and it was at t ended
by capit alist s. But it was a nearly collect ivist exercise, wit h governm ent inducing capit alist s t o
cooperat e for t heir own good and t he good of one anot her.
Now, what happened lat er in t he week, bet ween Barclays and JPMorgan now t hat was capit alism .

I t w a sn't a de a l, you see. I t was a t rade. The Fed was involved wit h Lehm an Brot hers in t hat it was
lending Lehm an Brot hers billions of dollars in ret urn for collat er al sort of like a pawnshop loan. I t
want ed Barclays t o t ake over t hat t ransact ion t o be t he one lending Lehm an Brot hers t he billions of
dollars in ret urn for t he sam e collat eral. That was t he t rade.
What m ade t he t rade com plicat ed was t he fact t hat JPMorgan was also involved in a pawnshop loan
wit h Lehm an Brot hers, advancing Lehm an Brot hers on average $69 billion a day. I t had a lot of
Lehm an Brot hers collat eral and was looking for som eone t o t ake it . Specifically, it was looking for

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Barclays t o t ake it . And it went int o t he t rade wit h what a

JPMorgan official calls a clear underst anding t hat Barclays
had agreed t o st ep in for it s funding and accept t he asset s it
had on hand.
Barclays went int o t he t rade wit h no idea how JPMorgan
cam e t o such an underst anding. Rich Ricci and Gerard
LaRocca figured t hat t he collat eral t hat Lehm an Brot hers
had pledged t o t he Fed was of good qualit y. They suspect ed
t hat t he collat eral t hat Lehm an Brot hers had pledged t o
JPMorgan was not as good.
They want ed t he good st uff and only t he good st uff.
JPMorgan want ed t o give t hem t he bad st uff.
This was an elem ent al Wall St reet confront at ion, and so,
alt hough Barclays' purchase of Lehm an Brot hers was
supposed t o be good for a Wall St reet in grievous peril, it
ended up a knife fight in an operat ing room .
Th e t r a de w a s supposed t o be sim ple.
Barclays was supposed t o wire $45 billion t o Lehm an
Brot hers. I n ret urn, Lehm an would send $49.7 billion in
Bob D ia m on d
asset s back t o Barclays. The difference in t he value of t he
St eve Pyke
cash and t he asset s is called t he " haircut ," and it rewards
t he sender of cash for t he risk it is t aking.
There were, however, som e problem s.
First , t he Fed was so eager so desperat e t o get it s m oney back t hat it gave Barclays only one
day t o com plet e t he t rade.
Second, t he t rade was so large and put such a st rain on t he Wall St reet infrast ruct ure t hat nobody
knew if it could act ually be com plet ed in a day.
Third, it was not sim ult aneous, as m ost t rades are. I n m ost t rades, cash and asset s are exchanged
sim ult aneously at t he bank where t he m oney is changing hands t he so- called clearing bank. This
t rade was different , because t he world was different . This t rade was a fucking bet . Barclays was going
t o be sending t he cash out first over t he wire and wait ing for t he asset s t o com e back.
And fourt h, t he clearing bank was JPMorgan, which gave it t rem endous power. I m ean, t hink of it :
Morgan was going t o have t he m oney and t he securit ies. So if you were Barclays, you had t o t rust
JPMorgan.
Which leads us t o t he fift h problem :
I t didn't .
Th e t r a de st a r t e d out sim ply enough. On t he m orning of Sept em ber 18, 2008, Barclays wired it s
first $5 billion t o Lehm an Brot hers t hrough JPMorgan. And t hen it wait ed t o receive t he collat eral
back. I t t ook a long t im e. I t t ook six hours t o get $5.06 billion in collat eral. Ricci's plan was t o keep
sending t he cash $5 billion at a t im e and t hen m ake sure he got t he collat eral he want ed in ret urn.
But lat e in t he aft ernoon t here was a phone call from Bill Wint ers, t he co- CEO of JPMorgan's

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invest m ent bank. I t was t o Bob Diam ond. Wint ers had a request , or m aybe a challenge. List en, he
said, at t he rat e we're going, we're never going t o get t his done. Cut t his $5- billion- at - a- t im e crap
and let 's get it over wit h. Send us $40 billion all at one t im e.
Diam ond looked at Rich Ricci. The deal of t he cent ury would require t he risk of t he cent ury. Your call,
Ricci said.
Ricci want ed t o keep sending t he cash out $5 billion at a t im e. Fort y billion dollars was a lot of fucking
m oney. But he knew t hat t his was Wall St reet , t hat t his was som e kind of you- show- m e- yours- I 'llshow- you- m ine m om ent . Wint ers was asking Diam ond if he was in all- in.
Your call, Ricci said.

On W a ll St r e e t , t here are t wo kinds of j obs: back office

and front office. The people who work in t he back office
support t he people who work in t he front office. The people
who work in t he back office are t he analyst s, t he risk
m anagers, t he com put er program m ers. The people in t he
front office are t raders. What separat es t he t wo kinds of
j obs what m akes t he front office so m uch m ore
prest igious and lucrat ive t han t he back office is risk. Risk
is not j ust t he lifeblood of Wall St reet ; it 's t he j uice. I f you
can t ake risks, you get a front - office j ob; if you can't , you
get a back- office j ob. Bot h are fine, but only one allows you
t o be a hero.
Bob Diam ond had st art ed in t he back office.
I n 1979, he t ook his first Wall St reet j ob in Morgan St anley's
I T depart m ent . He did very well at it and becam e assist ant
t o t he CFO. But he could see what was happening on t he
St reet , could see t hat banks like Goldm an Sachs and
Salom on Brot hers were, in his words, " st art ing t o t ake real
risks." He had st art ed his career on Wall St reet j ust as t he
expansion of t he risks banks were willing t o t ake was about
t o change Wall St reet forever, and he want ed t o be part of
Bob D ia m on d
it . So he accept ed t he assist ant CFO j ob only on t he
St eve Pyke
condit ion t hat he'd get a chance t o work in t he front office.
A year lat er, he got a j ob on t he financing desk, as a socalled repo t rader, doing t he very sam e kind of pawnshop loans t hat Barclays was t rying t o do wit h
Lehm an Brot hers. Repo t raders are not heroes; m ost t raders don't regard t hem as real t raders,
because t hey don't t ake posit ions, and t heir t rades sim ply finance t he t rades t hat real t raders m ake.
" We st ill kid Bob about st art ing out on t he repo desk," Ricci says, and if t here's anyt hing Diam ond is
sensit ive about , it 's his abilit y t o t ake risks. He t ells t he st ory of being a young t rader looking wit h
pride at his book of t rades because he'd never m ade a t rade t hat lost m oney, unt il he realized t hat
never losing m oney on a t rade m ade him a loser on Wall St reet , not a winner, because it m eant he
wasn't t aking enough risk. He was short changing his com pany, short changing him self...
At about five m inut es t o seven, on Sept em ber 18, 2008, Barclays Capit al wired $40 billion t o
JPMorgan. I n an inst ant , he had put his bank at risk. Bob Diam ond was all- in.

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Bob D ia m on d doesn't like t o t alk about it . He doesn't like t alking about his role in t he t rade, figuring
t hat t here's no upside t o a CEO com m ent ing on a cont roversy. When he does t alk about it , he's
cagey. He doesn't even com e out and say t hat t here were t alks wit h JPMorgan about assurances wit h
regard t o t aking over JPMorgan's financing of Lehm an; rat her, he says t hat " if t here were t alks wit h
JPMorgan, t hen I was in on t hem ." When he's t old t he st ory of Bill Wint ers calling and challenging him
t o send t he $40 billion all at once, he sm iles shrewdly, while keeping his dead- level gaze, and says,
" Well, if Rich Ricci t old you t hat st ory, t hen it m ust be t rue." I t 's only when JPMorgan, t hrough an
official close t o t he t rade, says t hat JPMorgan received assurances about t he t rade from senior
Barclays execut ives, including Bob Diam ond, t hat Diam ond rouses him self int o an unequivocal denial.
Assurances t o JPMorgan? There were no assurances, not from Diam ond, nor from anyone else at
Barclays.
What 's clear from Diam ond's cloaked adm issions, however, is t he fact t hat execut ives at t he highest
levels of bot h firm s played a part in t he t rade of Sept em ber 18 and 19. And when t he official at
JPMorgan speaks of t he bank feeling deceived, it 's clear he m eans t hat JPMorgan felt deceived by,
am ong ot hers, Bob Diam ond him self.

Th e r e a r e t wo num bers you have t o rem em ber:

The first is $15.8 billion.
The second is $7 billion.
The $15.8 billion is t he loan t hat Barclays ext ended t o
Lehm an Brot hers t he night before, when t he Fed forced t he
t rade on Barclays. The paym ent of t hat loan led JPMorgan t o
believe it was going t o have it s way wit h Barclays t hat
Barclays was going t o t ake over funding for Lehm an
Brot hers, and also t ake t he collat eral JPMorgan was looking
t o get rid of. The bad st uff.
But a loan of t his t ype has t o be renewed every night . And
lat e on Thursday, t he back- office guys at JPMorgan not ice
t hat Barclays has not r enewed t he $15.8 billion loan.
A back- office guy at Barclays says t hat it 's j ust an oversight ,
and t he loan will be renewed. Aft er all, Barclays has m ore t o
worry about t han a $15.8 billion loan.
Barclays has t o worry about t he $40 billion. You see, it
hasn't got t en t he collat eral back for it .
Bob D ia m on d
St eve Pyke

And alt hough t he Fed is working t o keep open t he wire

t he elect ronic conduit for securit ies t ransfers t im e is
running out , and it is clear t hat Barclays is not going t o get

paid, not t onight anyway.

For t he day, Barclays has sent $45 billion cash t o Lehm an Brot hers via JPMorgan.
I t 's supposed t o get $49.7 billion back in collat eral.
I t 's got t en $42.7 billion.
I t 's short .

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Barclays is fucked.
Diam ond, it seem s, has lost his bet .
And t hen, at one in t he m orning, t here's a deal: JPMorgan agrees t hat it owes Barclays a lot of
m oney. A cust odial account is creat ed at JPMorgan for j ust t his purpose. I t 's Barclays' account . I t 's
Barclays' cash: $7 billion.
Som e body w a k e s u p Friday feeling t hey've got t en screwed. Take your pick: I t could be JPMorgan,
when it discovers t hat Barclays didn't pay t he $15.8 billion loan, and Barclays explains t hat it was
under no obligat ion t o do so.
I t could be Barclays, when it discovers t hat JPMorgan has frozen t he account wit h t he $7 billion.
So let 's change our opening proposit ion:
Everybody wakes up Friday feeling t hey've got t en screwed.
And it 's st ill early.
I t 's about 5: 00 A.M., in fact , when Mike Keegan of Barclays t ells Alex Kirk of Lehm an Brot hers t hat
JPMorgan has st art ed t o freeze Lehm an's asset s. Keegan is, like a lot of t he people Diam ond has
brought in t o consum m at e t he Lehm an purchase, som ebody who has been wit h Diam ond a long t im e.
He has, indeed, t he honor of having been one of Diam ond's first hires at Barclays Capit al.
Alex Kirk is a Lehm an m anaging direct or. Like a lot of t he Lehm an people who have been brought in
t o consum m at e t he deal, he has t he honor of being wit h t he com pany only a few m ont hs and of being
bot h a newcom er and a survivor. He has been asked by Lehm an president Bart McDade t o close t he
t rade because Lehm an's original closer, it s m ergers- and- acquisit ions guy, quit t he day before.
When Keegan t ells him about t he frozen asset s, he t ells Keegan, " Call Bob [ Diam ond] and Rich
[ Ricci] . Tell t hem we've got a problem . JPMorgan is not going t o close. They're not going t o sell you
one t hing you want ."
He is a Lehm an person, you see, and like all of t he Lehm an people, he has dealt wit h JPMorgan
before. I n t he week leading up t o Lehm an's bankrupt cy, t he Lehm an people saw how JPMorgan
responded when t hreat ened: like a raging, squat t ing behem ot h, " seizing and freezing asset s left and
right ," in t he words of anot her form er Lehm an m anaging direct or.
" JPMorgan doesn't want t o save t he universe," he says. " JPMorgan want s t o profit from t he
dest ruct ion of t he universe."
To Lehm an guys like Kirk, JPMorgan is not hing but a predat or. And so he warns Keegan and Ricci:
You're going t o have t o rewrit e t he ent ire deal.
The deal, of course, is not a handshake agreem ent . And at t he heart of t he deal is t he list of asset s
t hat Barclays has agreed t o purchase from Lehm an Brot hers, consist ing of t housands of securit ies.
The list , like everyt hing else in t he deal, has t o be approved by t he bankrupt cy- court j udge aft er a
hearing.
And t he hearing is t oday, Friday aft ernoon.
At four o'clock.

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I t 's now seven in t he m orning. Kirk is t elling Keegan and Ricci t hat t hey have t o rewrit e t he asset purchase agreem ent in nine hours. That m eans going back t o Lehm an's books and finding securit ies
t hat m ight act ually be wort h what Barclays is going t o pay.
But t he bigger problem is t he $7 billion. One of t he reasons t he t rade went slowly t he night before
was t hat t he collat eral t hat st art ed com ing over t he wire was not t he collat eral t hat Barclays believed
it was paying for.
I t wasn't t he good st uff, from t he Fed.
I t was, in t he words of a Barclays execut ive, crap. As in, I know crap when I see crap.
Fort unat ely for Barclays, som e of t he Lehm an people on hand recognized it . They should. They'd sold
it . These were asset s t hat bore t he kind of nam e t hat hist orians will decry when t hey writ e of t he last
days of t he Era of Expanding Risk:
RACERS.
Rest ruct ured Asset Cert ificat es wit h Enhanced Ret urns.
They were issued wit h an Aaa rat ing from Moody's.
Now t hey were pract ically wort hless, so wort hless in fact t hat Lehm an people had been warning
Barclays people about t hem . Don't t ake t he RACERS...
So Barclays rej ect ed t he collat eral t hat JPMorgan was sending over.
" I don't know if Barclays knew t hat it was st art ing a holy war when it refused t he collat eral," says t he
form er Lehm an m anaging direct or. "But t hat 's what happened. I t hink t hat JPMorgan got pissed
because t hey're usually so clever at doing t his st uff. Now it was being done t o t hem ."
But JPMorgan has a clever m ove left because it has t he $7 billion $7 billion is st ill a lot of m oney,
and JPMorgan holds it host age. I f Barclays want s it s m oney, it has t o t ake t he RACERS and pay t he
$15.8 billion.
The knife fight in t he operat ing room has begun.

I t 's Su n da y m or n in g, one week aft er t he m ost powerful bankers in t he world t ried and failed t o
save capit alism . That m orning, Alex Kirk t urns t o Bart McDade and says, What are we going t o t ell
people? How are we going t o explain t his?
What Kirk and McDade fear t hey are going t o have t o explain is unusual indeed:
Two days earlier, at a bankrupt cy- court hearing t hat last ed eight hours and ended at close t o one in
t he m orning, Judge Jam es Peck had approved t he rewrit t en deal. He'd approved t he deal because he
deem ed it significant t o t he m arket s, t o " t he nat ional econom y, and t he global econom y."
And now Kirk and McDade fear t hat t hey won't be able t o close it . The deal of t he cent ury is on t he
brink of collapse.
The $7 billion is st ill frozen.
And JPMorgan won't ret urn Barclays' calls.
Because JPMorgan is furious t hat Barclays didn't ret urn it s calls.

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The world is ending in silence.

That night , however, t here is an em ergency m eet ing at t he
offices of Weil Got shal, Lehm an's bankrupt cy lawyers. A
Barclays cont ingent led by Rich Ricci is t here on one side of
t he t able. They don't even know if JPMorgan is going t o
show up. But it does, and t he com m on assum pt ion is t hat
t he Fed prevailed upon it t o do so, at t he highest levels. The
JPMorgan cont ingent is led by it s general counsel, St ephen
Cut ler. He looks at t he assem blage on t he ot her side and
says: You didn't really t hink you could close wit hout us, did
you?
Som e of t he people at t he m eet ing rem em ber it for it s
m ayhem for JPMorgan " t rying t o bully Rich Ricci," and
Ricci showing t hat he " doesn't bully well," and bot h sides
event ually calling each ot her t hieves.
But one of t he lawyers rem em ber s it as a " bunch of bankers
yelling about what bankers usually yell about m oney."
And at t he end, t here was a set t lem ent " well, we t hought
t here was a set t lem ent ," t he lawyer says.

Bob D ia m on d
St eve Pyke

And so it was t hat som et im e early on Monday m orning,

Sept em ber 22, precisely one week aft er Lehm an's
bankrupt cy filing ended t he era of Wall St reet expansionism ,
a t rade was com plet ed t hat began t he era of global financial

consolidat ion.
Lehm an Brot hers NA, t he surviving broker- dealer of t he bankrupt Lehm an Brot hers Holdings, sent a
package of securit ies t o Barclays Capit al. Barclays Capit al wired back cash, t hereby obligat ing
Lehm an Brot hers NA t o pay it back by t he t erm s of t he repo cont ract .
As foreordained, Lehm an Brot hers NA default ed. Barclays forgave t he debt , t aking possession of t he
com pany inst ead.
The t rade was closed, and Bob Diam ond had his prize, for his price.
One day lat er, Gerard LaRocca discovered t hat t he $7 billion he t hought was in t he Barclays account
at JPMorgan was no longer t here.
You ge t t he se nse t hat t hey are st ill t aken aback about what t hey had t o cont end wit h t he furies
t hey unleashed in t heir dealings wit h JPMorgan. They say t hey would never want t o go t hrough
som et hing like t hat again. They say t hat it was Wall St reet hardball at it s best and worst . They say
t hat t hey've gone up against m any Wall St reet t ough guys, but t his was som et hing different . This was
inappropriat e. This was rut hless. This was one firm m aking a bad sit uat ion m uch worse. This was a
Wall St reet giant exacerbat ing t he dist ress of t he m arket s. Sure, t here were t hings t hat JPMorgan
was unhappy about . I t was unhappy about t he deals it had on t he books wit h Lehm an Brot hers and
so it becam e unhappy about it s deal wit h Barclays. But t here was not hing t hat Barclays did t hat could
have possibly j ust ified JPMorgan t aking it s m oney.
I n fact , by t aking t he m oney wit hout warning or aut horizat ion, JPMorgan did som et hing t hat was
unprecedent ed.

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But for all t hat for all of JPMorgan's rut hlessness Barclays won at every t urn.
They won everyt hing t hey want ed t o win. They got t he good st uff. They m ade sure som eone else got
t he bad. They went by t he sim ple if pit iless principle art iculat ed by Rich Ricci:
" What happened was we t hen decided very consciously we were only going t o t ake t hese liabilit ies,
t hese asset s. That 's it . The rest of it is in t he hands of t he bank, of t he court , and of t he receiver...
Now, cert ainly we're worried about t he past and t rying t o help our client s. But we are under no
obligat ion t o set t le t hose t hings because of t he way bankrupt cy works. We have t he advant age of a
clean slat e going forward but t he disadvant age of t rying t o deal wit h Lehm an client s who want t o t alk
about t he past ."
Com pare t hat wit h how JPMorgan fared. JPMorgan went int o t he t rade looking t o unload it s wort hless
Lehm an asset s, and looking t o get Barclays t o fund t he operat ions of t he Lehm an broker- dealer.
I nst ead, an official speaking for JPMorgan adm it s, We kept t he dregs, and didn't get paid. JPMorgan
was not very happy wit h Barclays Capit al.
And so, when t he $7 billion went m issing, perhaps it was inevit able t hat Bob Diam ond's winning
st reak would cont inue. I t was shocking t o Barclays execut ives t hat t he Fed wasn't able t o j ust m ake
JPMorgan give it back wasn't able t o convince JPMorgan t o right such an obvious wrong. But when
t he Fed forensically reconst ruct ed t he t rade and bot h sides were called upon t o set t le, Barclays got
sat isfact ion: $1.3 billion in cash and $5.7 billion in securit ies.
Bob Diam ond got everyt hing he want ed, because he knew what he want ed. He nam ed his price, and
he got it .

" W a s it fu n ?" I asked Bob Diam ond.

I t was one of t hose easy quest ions he didn't like. Hard
quest ions he could answer wit h dignit y, wit h his
com binat ion of priest ly rem ove and priest ly m agnanim it y.
The easy quest ions m ade him look a lit t le queasy. He
blanched a lit t le bit , and his m out h t ight ened, like t he knot
of a skinny t ie.

Bob D ia m on d

" I don't t hink t here's any way you could describe anyt hing
we did over t hat period as fun," he said. " I t hink, in looking
back, t here's definit ely t hings t hat we accom plished t hat we
felt very grat ified about felt , gosh, given t he sit uat ion, we
really execut ed well. But t here was no aspect of it from
t he int ensit y, from vest ed int erest s on so m any sides, from
disagreem ent s wit h people you t rust and know well, t o
being frankly j ust plain t ired t here was no aspect about it
t hat could be described as fun. But we knew t hat when we
st art ed t his process. We got on a plane Thursday night t o
com e t o New York. We underst ood t he seriousness. We
expect ed t his t o be one of t he m ost int ense experiences. We
felt t hat if it wasn't som et hing we were prepared t o do, we
should m ove aside."

St eve Pyke

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They didn't m ove aside, of course. At no t im e did t hey ever m ove aside, and now Diam ond was an
Am erican again. He m oved t o New York and went t o work in t he big building at 745 Sevent h Avenue,
which used t o be t he headquart ers of an Am erican invest m ent bank called Lehm an Brot hers. I t s
facade used t o t hrob wit h t he color of lucre Lehm an green, in honor of all t hose em ployees who
at t est ed t hat t hey " bled green" but now it s pulse was Barclays blue. Dick Fuld used t o go t o work
in t he carved isolat ion of t he t hirt y- first floor, but now Bob Diam ond's office was m ade of glass and it
was locat ed in t he corner of one of his t rading floors. He had int ended t he purchase of Lehm an
Brot hers t o be "t ransfor m at ional" for Barclays, and for evidence of his success he didn't have t o look
m uch fart her t han j ust out side t he walls t hat were his windows and t he windows t hat were his walls.
I t wasn't j ust t hat Barclays Capit al was now an Am erican bulge- bracket firm in it s own right ; it wasn't
j ust t hat out of t he int egrat ion of Barclays and Lehm an Brot hers he had built what Jerry del Missier
called a " flow m onst er" t hat kept capit al m oving wit h incr edible efficiency. I t was t hat in t aking over
Lehm an Brot hers, he had also allowed Barclays t o be t aken over, in what one Barclays t rader called
t he " goddam nedest reverse t akeover you ever saw." The cult ure at Lehm an Brot hers was Am erican
and aggressive, replet e wit h it s " anim als" and it s " killers," not t o m ent ion it s j erks and assholes, and
while Diam ond cherished t he cult ure he had built at Barclays from t he beginning, he was willing t o
put it in play.
And so I asked him if t he purchase of Lehm an Brot hers had been as t ransform at ional for him as it
was for Barclays. Of course, being a j ournalist rat her t han a capit alist , I was t hinking in sent im ent al
t erm s t hinking t hat he m ight answer by speaking of what he'd lost , in t erm s of innocence, rat her
t han what he'd gained, in t erm s of power and prest ige. But his answer was right in front of m e, as
well as all around m e. His j acket was off, slung on a chair. He was wearing a blue- st riped shirt , wit h a
green t ie dot t ed wit h t iny em blem s in t he shape of Nant ucket , where his fat her had once been t he
high school principal, and where he was flying t hat evening in a Net Jet t o spend t he sum m er weekend
at his m ansion. His whole being was t ransform ed and his innocence was t he innocence of acquisit ion.
He was t ransform ed exact ly as Barclays had been, and when, t wo weeks lat er, Barclays Capit al
announced lar gely on t he st rengt h of it s Lehm an acquisit ion a half- year profit of nearly $2
billion, Diam ond's st aid English bank st ood wit h JPMorgan as one of t he biggest invest m ent banks in
t he world... or, as Ricci would have it , as " one of t he big boys, for bet t er or for worse."

http://www.esquire.com/features/barclays-deal-of-the-century-1009

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The Bull Whisperer

Sallie Krawcheck, chief of
the wealth management unit
at Bank of America, needs
her Merrill Lynch brokers to
drive profit to other divisions.
And Merrill's "Thundering
Herd" is snorting mad about it
By Roben Farzad and Hugh Son

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On
a slushy January morning in New York City, Sallie Krawcheck sits at a marble-top table in her corner office on the 50th
floor of the Bank of America tower, the second-tallest skyscraper
in town. Although pedestrians far below are dodging icy splashes from passing cabs and buses, the head of Bank of America's Global Wealth and Investment Management division isn't
dressed for stormy weather. Her cream cardigan is thrown over
a light print dress, and her chin-length hair is tucked behind
one ear, exposing a large diamond earring. In a few hours, she'll
be hosting a charity fundraiser on Park Avenue; for now, she's
arguing that there's no better place for the clients and advisers
of Merrill Lynch-the world's most profitable brokerage-than
Bank of America, the embattled retail giant that swallowed Merrill during the crisis of September 2008.
"In the days and weeks after I got here, it hit me like a blast
furnace: The client comes first," says Krawcheck, who's been
running the wealth unit for nearly two years. "We operate in
the client's interest. We measure client satisfaction down to
the adviser level." She's so on-message that you have to remind
yourself that this is the same person who, as an analyst covering Wall Street a decade ago, told a Fortune reporter she could
tell when management was lying because "their lips move."
As the boss of 15,500financialadvisers at Merrill Lynch and
2,200 more at U.S. Trust, Krawcheck, 46, may be the most powerful woman on Wall Street. In the past two years her divisionone of the best performers inside Charlotte (N.C.)-based Bank
of America-produced $3.1 billion in profits and pushed client
balances to $2.2 trillion while riding a bull market that has seen
stocks double from their 2009 lows. Shares of BofA have gone
nowhere since the Merrill deal closed in early 2009.
Krawcheck's performance is a rebuttal to those who argue
that Bank of America got suckered when it paid $50 billion for
Merrill. It was a "crazy price," Warren Buffett told the Financial Crisis Inquiry Commission last May, because Ken Lewis,
BofA's chief executive officer at the time, "could have bought
them the next day for nothing because Merrill was going to
go when Lehman went." Lewis tried to cancel the deal weeks
before it closed, saying that Merrill-which posted a $15.3 billion loss in its final quarter of independence-was in worse
shape than his team had known. Regulators instructed him to
proceed because Merrill's failure would threaten economic
stability, he told analysts in 2009. The acquisition forced him
to seek $20 billion in federal bailout money on top of the combined $25 billion Bank of America and Merrill had already borrowed. Since then BofA, which also bought subprime home
loan giant Countrywide during the bust, has racked up $25 billion in mortgage and credit-card losses. In 2009, it repaid the
$45 billion in rescue loans.
Krawcheck betrays no doubts about the wisdom of the
acquisition. "The deal has made tremendous sense strategically," she says. "Will the business over time do better?
We certainly hope and expect so." The key to making the

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marriage work lies in what the industry calls "cross-selling"driving business between the wealth management, consumer
banking, and commercial banking divisions. A Merrill client, for
example, may shift his company's 401(k) plan to BofA's retirement unit, or open a personal line of credit at the retail bank.
Bank of America management tracks the number of leads and
referrals-for products such as mortgages, credit cards, and
debt financing-that come from each of the firm's brokers.
Creating those synergies would be easier if Merrill's brokersits so-called Thundering Herd-weren't independent operators,
with their own clients and profit-and-loss statements. Krawcheck
must draw profitable cross-sell opportunitiesfromthem without
driving them away. "A good part of our growth potential," she
says, "is directly linked to our connectivity to the bank." Many
of the seven current and former Merrill brokers interviewed for
this article, most of whom did not want to be named for fear of
undermining their relationship with Bank of America, say they
resent the loss of control the new centralized sales culture has
created. In the two years since BofA acquired Merrill, the combined firms' broker count has dropped from 18,000 to 15,500.
Most of the losses came during and right after the crash.
"Management is not in tune with the brokers," says Carri
Degenhardt-Burke, a headhunter who runs Degenhardt Consulting. Over half of her 230 placements in the last two years
came from Merrill, she says. "They're pushing them to crosssell and to move accounts." She adds that half of her incoming
calls are from Merrill brokers interested in the big signing bonuses being paid out by rivals UBS and Morgan Stanley Smith
Barney. "Sallie Krawcheck has a really tough job," DegenhardtBurke says. "The hardest, I think, of anyone on Wall Street. The
BofA and Merrill cultures just don't mesh well."
Krawcheck cringes at the mention of cross-selling. "There
are certain things that drive me nuts," she says, rolling her eyes.
"'Cross-sell' is one of them. The other is 'retail distribution.'
That means we're thinking about pushing product through
the channel. We avoid these words internally." Yet she proudly offers examples of business from her brokers funneled to
the commercial and consumer divisions, and brags about how
each of BofA's 18,000 ATMs can transfer money in and out of
Merrill brokerage accounts. Her unit's $42 billion in deposit
growth over the last year-it now holds $266 billion in cash and
cash equivalents-makes it a large bank in its own right. "If we
were pulled out of Bank of America," she says, "we'd be either
the top four or top five bank by deposits in the U.S. We're

neck-and-neck with Citigroup for being the No. 4 bank."

There's a special satisfaction in that. Krawcheck worked for
Citigroup before BofA-and her six years there did not end well.
Bank of America represents her second chance to show that
she is up to running a globalfinancial-servicesgiant.
A familiar face on the cover of business magazines since
her days as chairman and CEO of research boutique Sanford
C. Bernstein in 2001 and 2002 (she'd been a star bank analyst
there since 1994), Krawcheck had a reputation for integrity.
After she questioned deal valuations and putative synergies
during the boom in bank mergers, Fortune dubbed her "the
last honest analyst." Then Citigroup CEO Sanford Weill, the
architect of Citi's late-1990s "financial supermarket" merger
binge, hired her to restore the reputation of his Salomon Smith
Barney brokerage unit, which had been tainted by its boosterish tech research and involvement in the Enron accounting
scandal. Two years later, after Charles O. Prince III took over
for Weill, he promoted Krawcheck to chief financial officer of
Citigroup-the top numbers executive for what was then the
world's largest financial institution. People on the Street soon
began to whisper that she was out of her depth.
Investors such as Bill Smith of SAM Advisors criticized Krawcheck for failing to control spending. And like most other big
bank executives, she failed to recognize the gathering storm of
risk and overleverage. In 2006, as Citigroup expanded its balance sheet, she told an interviewer that "the consumer doesn't
seem stretched." By the next year, the press was reporting that
she was unhappy and thinking of resigning. When Prince moved
her out of the CFO job and put her in charge of wealth management, including Smith Barney and private banking, she conceded: "I'm looking forward to returning to an operating role.... One
of our most important strategic priorities is to grow this business
and have it work more closely with our other businesses."
It didn't happen. By the end of 2007, Citigroup'sfinancialsupermarket dreams were dying as the bank wrote down tens of
billions of dollars in bad subprime debt. Prince was out, Vikram
Pandit was in. The crash chewed up the nest eggs of the wealth
management unit's clients as Citi hedge funds that had bought
subprime securities plunged in value. Krawcheck told Pandit
that it was Citi's responsibility to reimburse the clients, according to a person with direct knowledge of the encounter, and
Pandit refused. (A Citigroup spokeswoman declined comment.)
Krawcheck left Citi shortly after Lehman collapsed in September 2008. Less than a year later she joined Bank of America. She

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Bloomberg Businessweek

declined to comment on her years at Citi or on whether her exit

negotiations included a non-disparagement agreement.
F or much of the 20th century, Merrill Lynch Pierce Fenner &
Smith was the quintessential American brokerage, the one that
brought stocks and investor education to Main Street. Merrill was
independent for 94 years, until its investment bank's subprime
mortgage bets crippled the firm and forced it into the arms of
BofA. Formerly NationsBank, Bank of America had been built
during the 1990s and 2000s through the serial acquisitions of
CEO Hugh McColl Jr. and his successor Lewis, who snapped up
a half-dozen financial houses-including MBNA, Fleet, and LaSalle-between 2001 and his exit in 2009. Lewis's $130 billion
in takeovers made BofA the largest retail debit-card issuer and
mortgage servicer in the U.S, with $1 trillion on deposit.
Brokers Jason Purinton and Kent Rains were a typical team
at Merrill, 5- and 13-year veterans, respectively, who worked in
the Kansas City suburb of Leawood. They left Merrill last May,
taking with them $56 million in client assets, because they say
they were frustrated with meddling from above. Today they're
part of a new brokerage called Cetera, with 4,700 advisers and
$80 billion in assets. "There was pressure to get rid of smaller
accounts regardless of what potential they may hold-and corporate objectives that were in contrast to what we wanted,"
says Purinton, alluding to a move by Merrill to funnel low-networth clients into an online service called Merrill Edge. "You
can't just tell a client they're too small and then, once they
have money, expect to go back to them." The team has since
increased its asset base to $105 million and expects to reach
$150 million by the end of 2012. "We're not tied to any one fund
family or product," says Purinton. "We have 100 percent autonomy and discretion to pick the clients we want."
"We're hearing from Merrill guys in record numbers," says
Brian S. Hamburger, an attorney who runs MarketCounsel, an
Englewood (N.J.)firmthat helps brokers with thefiduciarydetails of leaving their employers. "They've got to answer for the
sins of BofA, with clients starting meetings by asking about BofA's
problems. It's bad enough that you have to live and die by the
market. But to have your ownfirm'sbrand work against you..."
Krawcheck agrees that headhunters, the new crop of independent wealth management boutiques, and long-standing
rivals such as Morgan Stanley are all keen to poach Merrill brokers. (Morgan Stanley acquired Smith Barney in 2009-passing
Merrill as the nation's largest brokerage by head count-and is
now run by James Gorman, who previously ran Merrill's brokerage force.) Yet Krawcheck insists that reports of an exodus are
greatly exaggerated. She says her unit's attrition rate has been
running at 10 percent, below the four-year average of 14 percent.
And during a conference call with reporters in January, she said
departures among the most profitable 40 percent of her brokers
were at a record low. "Despite what I read about these big attrition rates" she said, "it's not happening." Fred St Laurent, an
Atlanta-based headhunter, says Krawcheck's competitive drive
is making the task of poaching from Merrill more difficult. "She
is," he says, "a recruiter's worst nightmare."
Elliot Weissbluth, head of independent boutique HighTower,
in Chicago, says Merrill represents the single top source of interest in joining his startup, which targets advisers with at least
$300 million in client assets. "The whole concept of cross-selling
between a North Carolina bank and Wall Street brokerage works
elegantly on a spreadsheet," he says. "But a Merrill adviser ul-

"A Merrill adviser ultimately

rails against the idea
that he needs
to push BofA products,"
says independent brokerage boss
Elliot Weissbluth

timately rails against the idea that he needs to push BofA products." Weissbluth says he has been booking conference rooms
across the country to receive Merrill brokers. "Any reasonable
Merrill manager knows his people are looking around."
Krawcheck is dismissive of the independents, who she says
accounted for just 0.2 percent of Merrill defections last year.
"That almost rounds to zero," she says. Since brokers aren't
a sentimental bunch, she isn't relying on loyalty to stem departures. In a February internal document from U.S. Trust
management obtained by Bloomberg News, brokers at the
unit were told that those who chose to exit would be barred
from contacting clients for eight months. "Your employment
is further conditioned upon your agreeing" to the terms of the
letter. "Should you not comply with these terms, you agree that
the company shall have the right to enforce them" through
court-ordered actions. All of which makes it risky and expensive to move accounts to a rival. "They're sending the message,
'Make no mistake, you will incur our wrath, this is not a place
you want to leave,'" says Mindy Diamond, president of Diamond Consultants, an executive search firm in Chester, N.J. "I
think this could backfire if people view it as draconian."
Another flash point is Merrill Edge, the combination call
center and online platform designed for clients worth $250,000
or less. Now that brokers are being urged to move low-net-worth
clients to Merrill Edge, it means they give up some future fees
along with day-to-day client contact. Lyle LaMothe, who heads
U.S. wealth management for Merrill, says the move is designed
to give brokers the freedom to concentrate on their key customers. "If an adviser is so busy that everything's on autopilot, if
there's not a degree of ongoing communication, the client will
feel shorted," says LaMothe, surrounded by pewter bulls in his
office at Merrill's headquarters, just west of New York's former
World Trade Center. "If you want to deliver a full-service experience, you get somewhere in the neighborhood of a couple
hundred relationships. That's all you can do properly."
To lure customers to Merrill Edge, Bank of America recently started testing videoconferencing kiosks at bank branches
in the Los Angeles and Washington, D.C., areas. Merrill associates in Arizona, Florida, and New Jersey dispense financial advice on the kiosks' monitors. Branches advertise Merrill
Edge on their windows and ATMs, which doesn't sit well with
brokers who don't like seeing the Merrill brand diluted.
In a December 2009 internal memo aimed at dispelling VVi254
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atop Citigroup's wealth management business, lured away Michael Brown, one of Bank of America's's top high-net-worth advisers, to join his startup Dynasty Financial Partners. Brown
managed $5.9 billion when he left Bank of America, according
to a person briefed on his move. "Want to guess how much he's
taken out of his $5.9 billion?" asks Krawcheck. "I'm sure he'll
take, you know, a billion dollars. Clients are allowed to go."
Shirl Penney, CEO of Dynasty, says he's "very confident"
that Brown's clients will come. "For a firm with over $1.5 trillion in assets, it is easy to claim that the loss of any individual's
business is insignificant," he says. "When more and more advisers and assets move to [our] model, the overall impact will
be significant and not easy to dismiss."
"What do they have going for them?" says Krawcheck.
"They say,'We're independent, we're fiduciaries' "-meaning
they agree to place the client's interests above the firm's. "We
said, 'We'll be fiduciaries too. Sign us up!' They just conceded any competitive advantage." Of course, the fiduciary standard is just one factor brokers consider in deciding whether
to jump ship. According to Diamond, some brokers are offered
packages worth up to 350 percent of their 12-month revenue.

F
F or retaining brokers over the long term, the metric that
matters most is the financial health of Bank of America. "The
clock is clearly ticking," says Tony Plath, a finance professor
at the University of North Carolina at Charlotte. "If they don't
find a way to get earnings per share higher.... How long will his
shareholders be complacent?" Plath gives CEO Moynihan "a
year or two to turn it around" amid multiple obstacles, many
stemming from Lewis's acquisition of mortgage lender Countrywide. BofA is spending billions to repurchase its defective
loans, while fending off lawsuits from those who bought or insured the assets. Larry DiRita, a spokesman for Moynihan, says
shareholder value "depends in part on aggressively cleaning
up legacy mortgage issues" as well as on the synergies from
the integration of Merrill and Bank of America.
"Every day that Bank of America trades [this low] is another
day closer to pressure starting to form from big shareholders
and Wall Street to break the thing up," says Greg Donaldson,
chairman of Donaldson Capital Management, an investment
firm based in Evansville, Ind., that holds Bank of America
shares. "You win if Moynihan can pull everybody together and
execute. You also win if he doesn't, because if he doesn't it
swirls out of control and they break the thing up." While Bank
of America has a market value of $142 billion, a breakup would
unlock far greater value, according to Richard Bove, a veteran analyst at Stamford (Conn.)-based Rochdale Securities. "If
one were to value the multiple businesses of Bank of America
based on [individual unit] values, it would be worth $53 per
share," he says. The stock now trades at $14.
All of which makes you wonder what vintage-2002 Sallie
Krawcheck, the last honest Wall Street analyst, would have
to say about Merrill being worth more as a spinoff. She wins
either way-as a star in the BofA empire or as the CEO of a
stand-alone Merrill brokerage. She has no doubt crunched
the numbers and fielded the question from both her brokers
and those she is recruiting. Krawcheck knows it's an inevitable query, and she betrays a small smile and leans forward to
answer it-until one of her corporate PR people objects to the
question and cuts her off.

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fears over the integration of the banking and brokerage operations, Krawcheck had to declare: "No, we're not converting
our wealth management branches into ATMs."
Many brokers interviewed for this story say BofA needs Merrill more than Merrill needs BofA. In the past two years, shares
of investment banks such as Goldman Sachs and Morgan Stanley have far outperformed Bank of America. Where BofA called
the shots during the crisis, it is Merrill's brokers and investment bankers who are profitable now.
Bank of America management is happy to have them. David
Darnell, who runs the commercial banking division, says he
has "waited 30 years" to work with a brokerage like Merrill.
"I'd always heard about the Thundering Herd, but now I know
what the herd is, and it's a powerful team."
Darnell, 58, has been at Bank of America since the late 70s,
when it was North Carolina National Bank. In the past two
years, he says, his division has tallied 10,000 referrals from
brokers. "If I'm a client of a financial adviser and have a great
relationship with the FA, the strength of that relationship transfers over.... It is not cross-selling." Andy Sieg, head of Merrill's
retirement services arm, says his unit won $3.6 billion in business from clients of Darnell's commercial bank unit in 2010,
up from $700 million in 2009. Late last year, the company
snatched Aecom Technology's $1.7 billion 401(k) plan from Fidelity after BofA CEO Brian Moynihan called executives of the
L.A.-based engineering and construction firm. "They wanted
to understand from the top how committed we were," says
Sieg, whom Krawcheck brought in from Citigroup in 2009.
Some brokers appreciate these cross-divisional capabilities.
Jeff Erdmann, afinancialadviser in Greenwich, Conn., who has
been with Merrill Lynch for 27 years, says his $4 billion book
benefits from Bank of America's lending power. In November
a client asked Erdmann for help financing the purchase of a
$43 million private jet. "For the first time in my career," he
says, "I was able to call an aviation specialist at my own firm
and arrange a deal infivedays."
In December, Todd Thomson, Krawcheck's predecessor

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W I T H R A N K COMES PRIVILEGE. NO ONE KNOWS

that better than Laurence Fink, the voluble chairman and
CEO of BlackRock, the world's largest asset management firm.
In September, while one of his lieutenants, Richard Prager,
was meeting with a reporter, Fink hovered near the door of
Prager's office for a few moments before stepping in and asking what they were talking about. Prager, BlackRock's global
head of trading, told his boss that he'd been explaining what
the firm is doing to make sure it continues to thrive in markets that are
undergoing some of the biggest changes in a generation in the wake
of new regulations and the seemingly never-ending financial crisis.
That was all the opening the 59-year-old BlackRock CEO needed.
Fink, whose love ofpower and showmanship is tempered by a child's
wide-eyed curiosity and energy, raced on about the forces shaping
BlackRock's plans. It was a long list: an inexorable macro trend
toward less dollar-based trading, French banks stoking counterparty
fears, investors pushing up costs by demanding more "granularity"
on securities, and the need to create the right asset management
culture to manage all of this. After his five-minute soliloquy, the
indefatigable Fink left as swiftly as he had entered the room.
Fink, who has an outsize grasp on the details of his $9 billionplus-in-revenue business, has reason to be worried. BlackRock is
one of the largest managers of fixed-income securities and relies on
unfettered access to them and to efficient capital markets to manage
its growing portfolios for retail and institutional clients. A lack of sufficient liquidityfinancial jargon that refers to the ease with which
a trade can occur at a given pricehas defined the debt markets off
and on since 2007. In the years since the 2008-'09 crisis, as investment banks have moved to deleverage and governments around the
world have imposed restrictions on banks as a result of the Basel III
accord and the Dodd-Frank Wall Street Reform and Consumer
Protection Act, there has simply been less liquidity sloshing around
in the system. That means firms like BlackRock can't buy and sell
the securities they need as easily and investors aren't getting the
prices they want. Liquidity is likely to continue to be under pressure
as governments debate regulations, the economic environment
remains shaky and banks reduce trading risk.
Prager is only a small part of the story unfolding at BlackRock.
Robert Kapito, the firm's president, is the man behind the charge
to redefine BlackRock's-every interaction with the capital markets,
overseeing one of the biggest structural changes in how buy-side
firms work with their counterparts on the sell side in 30 years. It's
in keeping with Kapito's humble roots that he hasn't broadcast his
plans to the world. IfFink is the public, ubiquitous face of BlackRock,
Kapito has fathered the intense culture within the firm.

BlackRock, with $3.3 trillion in assets under management, more

than three times the size of its nearest competitor, is retooling the
long-standing relationship among asset managers, investors, Wall
Street and companies looking for capitaland changing the value
proposition for its industry in the process. To combat the growing problems in fixed-income markets and the changing market
structure ofWall Street, BlackRock is taking a seat at the table with
banks and issuers, helping them design bond offerings and advising them on deals. The firm has launched a global capital markets
desk, as well as a syndicate desk, hiring executives from Wall Street
banks with the promise of bigger opportunities and greater riches.
At the same time, BlackRock is aggressively expanding its electronic
trading capabilities developing another way to get the liquidity
it needsand building a securities crossing network to match buy
and sell orders within the firm so it can bypass the Street altogether
and save its clients millions of dollars in trading costs. By building a
capital markets desk, BlackRock will be able to get better terms on
the securities it buys and sells, larger allocations when it wants them
and deeper information about the primary markets.
For the 54-year-old Kapito, one of the firm's founders, BlackRock
has no choice but to build these new capabilities. "Yields are low,
interest rates are low, liquidity has changed," he says. "We have to
think differently to produce results for clients."
Historically, the interactions among investment banks, corporate issuers, money managers and investors have followed a
standard script. A bank would advise a company say, Kraft
Foods on its capital structure; when it should issue debt and at
what rate; and whether it should buy back stock or shore up the
equity on its balance sheet. The bank would then structure and
offer securities to money managers, which in turn would buy them
for individual investors and institutions.
But Wall Street doesn't have the resources it once did, and BlackRock doesn't necessarily want to wait for banks to come to it with the
choices on the menu. Instead, it wants to have a hand in designing the
menu itself, helping to advise companies on their capital structure
and how securities might be constructed. To do that, BlackRock
has had to build capabilities that were once the sole province of
investment banks. But Kapito and other senior executives at the firm
are careful to point out that they are not trying to eliminate brokerdealers from the capital-raising process. They contend that it would
be a mistake to try to replicate Wall Street's high-cost infrastructure.
"We pioneered a capital markets capability not because we're
getting into the underwriting business; we're not," says Peter Fisher,
55, head of fixed-income portfolio management at BlackRock and
former undersecretary for domestic finance at the U.S. Treasury.
"But we do want to buy and hold the assets with the risk-return
profile that we're looking forrather than just the ones on offer."
BlackRock is the first mover in what will emerge as a new model
for how business gets done between Wall Street and the rest of the
financial industry, including money managers, which oversee trillions of dollars for retail investors and institutions such as public
pension funds. Other asset managers ultimately will be forced to
institute similar changes or risk losing ground.
"The big buy-side firms are displacing Wall Street," says David
Weild IV, who heads capital markets research at U.S.-based accounting and business advisory firm Grant Thornton.
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BlackRock has grown substantially since Fink, Kapito and the six
other founding partners spun out their business from private equity
firm Blackstone Group in 1994 with $53 billion in mostly fixedincome assets under management. BlackRock now boasts more
than 10,000 employees, operates in 27 countries and has expanded
well beyond fixed income, which represents a little more than one
third of its assets. The rest are spread among equities (44 percent),
multiasset and advisory portfolios (10 percent), cash (7 percent)
and alternatives (3 percent).
What hasn't changed is BlackRock's raison d'tre: to build a firm
whose interests would be aligned with those of its investors. Fink
and company have maintained that mission through a series of
acquisitions capped off in 2009 by the purchase of Barclays Global
Investors, which made BlackRock the largest asset management
firm in the world and put it neck and neck with Newport Beach,
California-based Pacific Investment Management Co. in the race
for the crown of biggest bond manager.
"Rob and Larry have taken a firm from a handful of partners to
more than 10,000 employees," says Gregory Fleming, who runs
the brokerage and asset management businesses at Morgan Stanley.
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"There are not many founder-entrepreneurs who have

the skills to transitionfromlaunching a start-up to leading a global firm."
In the wake of the 2008 market meltdown, global
regulators have imposed higher capital requirements.
Basel III, the global banking standard, increases the
common equity that banks must hold and defines
risk-weighted assets more onerously. It also dramatically increases capital requirements for banks' trading books. The Dodd-Frank Wall Street Reform and
Consumer Protection Act imposes additional burdens
on banks' business models and requires clearing of
derivatives contracts. As banks are being forced to
increase capital and reduce leverage and risk exposure,
they have less desire to hold positions that their clients
are buying and selling. As a result, big investors looking
to sell anything from a corporate bond to a mortgagebacked security are driving down prices.
"In the current regulatory environment and
because of the excesses, that pool [ofWall Street capital] has shrunk," Kapito says. "So the leverage is going
from 30-to-l on its way to 8-to-1. The amount of
balance sheet those firms have available to do those
trades and to put positions on their books is just less."
Primary dealer holdings of corporate bonds
peaked before the credit crisis at about $240 billion.
That number fell to about $55 billion during the
crisis, recovered some in 2009, then dropped again,
to about $65 billion recently, more than 70 percent
off its high. "This pressure on primary dealer balance sheets becomes a strategic issue for investment
managers because they aren't seeing the same level
of liquidity from the dealers that they did prior to
the crisis," says Richard McVey, CEO and chairman
of MarketAxess, one of the dominant electronic
trading networks for U.S. high-grade corporate,
high-yield and other debt securities.
BlackRock, though, has plans to get around a tightened Wall Street.
Kapito is retooling the firm with the help of Prager; Fisher; Steve
Sterling, who was recruited from private equity firm Carlyle Group
to run the new capital markets desk; and Robert Goldstein, who heads
BlackRock Solutions, which offers sophisticated risk analysis, technology and advice to institutions, money managers and other investors.
BlackRock is turning some traditional practices on their head,
taking a microscope to the securities in which it invests. As a result,
Prager says, it has implemented a practice called "originate to manage," in which it partners with Wall Street firms to work with issuers to sculpt new securities offerings. "We believe the future is an
originate-to-manage model," says Prager, 51, who was global head of
rates, currencies and commodities at Bank ofAmerica Corp. before
joining BlackRock in 2009. "So if the Street used to warehouse risk
and then distribute it, Basel III makes that a very unattractive proposition. In the new model we're the balance sheet. If we're ultimately
going to end up owning these assets on behalf of clients, why not
bring us into the economic equation sooner?"
Another consequence of the changes emanating from Basel III,

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COVER STORY

Dodd-Frank and other new regulations: The fixed-income markets

are now ripe for automation. BlackRock has taken the best practices
from its equity-trading capabilities which are highly electronic
and extended those to fixed income, money markets and securities lending. The firm has taken another radical step by building its
own crossing network to bypass Wall Street when it has a buyer and
a seller of the same security in-house. Clients keep the spread a
substantial way to reduce costs, which is especially important when
markets are as inefficient as they are now, with returns projected to
be skimpy going forward. Goldstein is even planning to establish a
crossing community within BlackRock Solutions.
"It's really very simple," he says. "We have many clients who could
execute trades with each other right on our platform."
The changing fixed-income markets are a thorn in all investment
managers' sides. "The buy side is exploring the alternatives," says
Robert Gasser, CEO of Investment Technology Group, a New
York-based independent agency research brokerage. "If these guys
[the banks] are not carrying inventory, markets still have to function,
and investors still have to buy and sell."
Other big asset managers, such as Valley Forge, Pennsylvaniabased Vanguard Group, which has $627 billion in fixed-income
assets, have worked with Wall Street syndicate desks and issuers to
source public securities. Such asset managers have long done reverse
inquiries, going directly to dealers with a request for specific terms
from an issuer. But BlackRock's moves go many steps further, forcing huge changes among money managers, many ofwhich don't have
the scale, power or desire to implement similar initiatives. Some have
reservations about the practice. A trader at Boston-based Loomis,
Sayles & Co., which manages $120 billion infixedincome, says the
firm is concerned about getting too involved with issuers and bankers given the confidential nature of information gleaned from such
conversations. And Newark, New Jersey-based Prudential Fixed
Income, which has $327 billion in assets under management, prefers
not to cross trades, in part because it doesn't want the appearance of
conflicts of interest that could arisefrommatching trades inside the
firm. "We favor the transparency of finding the best possible price
from an independent broker-dealer," says Prudential Fixed Income
CIO Michael Lillard.
BlackRock, however, has a long history ofprotecting confidential
client information. BlackRock Solutions' very premise relies on its
practice of partitioning offrivals' investment information.
BLACKROCK IS WELL AWARE THAT IT IS REWRITING
the rules. Kapito starts out a conversation on the effort with a long
prelude explaining record low interest rates, how mom-and-pop
investors have been suffering and subsidizing Wall Street banks, the
changing demographics that are pushing people toward less risky
fixed-income products and how much harder it is to do business in
such an environment. But it doesn't take long for Kapito to show his
Street smarts, wondering aloud why his partners had agreed to talk
at all about what he considers corporate secrets. He says he doesn't
want to draw a road map for his competitors. During a second
interview Kapito softens. His large rivals will have little choice but
to do the same thing as BlackRock, he says.
Rob Goldstein's BlackRock Solutions is a major change agent

/53\

Kapito grew up in Monticello, New York, a small, working-class

town about 90 miles northwest ofManhattan. His father, aunt and two
brothers ran a tire and auto repair shop there for 50 years. His father
suffered a debilitating stroke when Kapito was 13 but continued to
work in the office. Kapito put himselfthrough college, taking a thrifty
approach to his higher education. He spent hisfirsttwo years at the
state-run University ofBuffalo before transferring to the more expensive Wharton School of the University of Pennsylvania, where he is
now a trustee. AtPennhe met his wife, Ellen, who was in the school of
nursing and has been an oncology nurse for 30 years. Kapito, who has
four children, regrets that his parents never got to see his success. (His
father died in 1986; his mother in 1997.) He expects long hours and
complete loyaltyfromhis employees, but he treats them like family.
After graduating from Wharton with a BS in economics in 1979,
Kapito began his career on Wall Street in the public finance department of investment bank First Boston. He left two years later to get
his MBA from Harvard Business School. In 1983 he rejoined First
Boston on the mortgage desk after the firm's head of sales and trading told him the best opportunity would be to work for Fink.
Fink helped develop the mortgage-backed security and other debt
securitization products that bundled mortgages into one instrument,
diversifying the risk and allowing banks to get loans off their books
and write more mortgages. Though structured products ultimately
turned into many ofthe toxic securities at the heart ofthe 2008 crisis,
they would also dramatically lower the cost of credit, especially the
30-year mortgage, and expand home ownership. Fink and Kapito,

"Larry and Rob have created

a fabulous partnership. Larry
spends more time in the public
arena, and Rob keeps the
engine going."
David Nadler, Marsh & McLennan Cos.

who still talk as often as 15 times a day, grew the group into the most
profitable area of the firm.
In 1986, Fink lost 8100 million on an interest rate bet and the
mortgage department went from darling to loser overnight. Kapito
says the importance of the loss has been overstated in Wall Street
lore about the founding of BlackRock. "We made money and we
lost money over the years," he says. The work had become less fun,
Kapito explains, as the mortgage market changed and Wall Street's
focus shifted from client service to proprietary trading.
Fink came up with the idea of setting up an asset management
firm that would use risk tools that previously had been available
only on the sell side, and he started talking to Kapito about it. Fink
introduced Kapito to Susan Wagner and Ralph Schlosstein from
Lehman Brothers, and the four refined Fink's concept. Kapito
recruited Keith Anderson, whom he had hired on the First Boston
mortgage desk, as well as Barbara Novick and Bennett Golub, who
were mortgage specialists. They were joined by Hugh Frater, an
investment banker in the mortgage finance department at Lehman.

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COVER STORY

In 1988 the group of eight formed Blackstone Financial Management under the umbrella of Blackstone Group. They realized that
to analyze risk they needed to build sophisticated systems. The task
was left to Golub, who has a Ph.D. in applied economics and finance
from the Massachusetts Institute ofTechnology, and Charles Hallac,
the firm's first employee, who had worked for Golub at First Boston
and is now chief operating officer of BlackRock. The two bought a
Sun Microsystems workstation and stuck it between the refrigerator
and coffee machine. From that computer they constructed models
to track collateralized mortgage obligations. They built a portfolio
management system after one ofthe portfolio managers complained
that he couldn't keep track of his positions in Lotus 1-2-3 , a popular
spreadsheet program at the time. Hallac and Golub printed out
reports from the portfolio tracking system on green paper, the only
available paper in the building one night. (The "green package" is
still available to BlackRock Solutions clients.) The technology that
Golub and his team created helped the firm generate impressive 40
percent-plus margins.
Experienced at sales and trading, Kapito and Anderson took
charge ofportfolio management. Kapito was always on the markets
side, building portfolio management and performance from scratch,
maintaining the firm's relationships with Wall Street and running
day-to-clay risk oversight and operations. He continues to work in
an office 20 feet away from the trading floor.
By 1993 the group, which had changed its name to BlackRock to
differentiate itselffromits parent, had $23 billion in assets. The next
year the group split offfrom Blackstone. Fink wanted to entice talent
to his business by offering equity, but Blackstone co-founder Stephen

"If we're ultimately going

to end up owning these assets
on behalf of clients, why not
bring us into the economic
equation sooner?"
Richard Prager, BlackRock

Schwarzman didn't want to dilute his ownership, saying Fink should

instead dilute his own. Blackstone ended up selling its 32 percent share
to PNC in Pittsburgh for $240 million. The PNC deal closed in 1995,
and four years later BlackRock went public at $14a share.
BlackRock had had third-party clients since it advised General
Electric Co. on what to do with subsidiary Kidder Peabody's
$7 billion portfolio in 1994 amid a bond-trading scandal and
plummeting bond markets. In 2000, BlackRock formalized BlackRock Solutions as a separate brand and unit, selling its services to
competitors, pension funds and others. In addition to technology,
BlackRock Solutions also offered advisory services, acting as a
fiduciary for client portfolios. The advisory service would prove
to be a godsend during the financial crisis, as many banks sought
BlackRock Solutions' services. The firm realized it could both
cover the costs of its expensive technology endeavors and learn
from the challenges of processing others' work by formally going
after external business.

In 2005, BlackRock, still largely an institutional fixed-income

shop, wanted a more meaningful presence in equities. That year it
purchased State Street Research & Management. The $375 million
acquisition was small, but the success the firm had in transferring
State Street's portfolios to its technology platform gave management
the confidence to do more. A year later BlackRock purchased Merrill
Lynch Investment Managers from Merrill Lynch & Co. The deal
gave Merrill a 49 percent stake in the company, and BlackRock got
equity capabilities as well as retail business and a global footprint.
The deal doubled BlackRock's assets under management, from
$425 billion in 2005 to $1 trillion.
Things were calm in 2006 as BlackRock integrated MLIM.
Then came 2007, when the market got some of its first hints of the
mortgage crisis. By 2008, CEO after CEO was calling BlackRock
for advice on the contents of what would turn out to be catastrophic
portfolios filled with little-understood structured securities.
BlackRock assessed Bear Stearns Cos.' mortgage portfolio before
JPMorgan Chase & Co. CEO Jamie Dimon decided to buy the firm
with the Federal Reserve's assistance. As part of that deal, the Fed
took on Bear's riskiest assets; BlackRock helped manage the portfolio. Later, BlackRock advised the Fed on American International
Group's credit-default-swap portfolio and counseled UBS about
its asset troubles. Fink spent the crisis shuttling between New York
and Washington, advising the Treasury and honing his very public
personality. Kapito minded the shop back in New York. Friends
and colleagues say that although Fink loves the attention he has
gotten as CEO of BlackRock, Kapito is perfectly happy keeping
a low profile.
"Larry and Rob have created a fabulous partnership where they
have divided up the work," says David Nadler, vice chairman of
Marsh & McLennan Cos. "Larry spends more time in the public
arena, and Rob keeps the engine going. But it would be a mistake to
underestimate Rob's strategic vision and innovation for the firm."
In 2009, BlackRock bought BGI from Barclays Bank. Not only
did BGI have a huge institutional index business, it owned IShares,
the powerful exchange-traded-funds brand. Today, BlackRock's
$3.3 trillion in assets is bigger than the Fed's balance sheet. In
fact, the Financial Stability Oversight Council has not yet decided
whether BlackRock should be deemed a nonbank systemically
important financial institution (SIFI)one that is too big to fail.
STEVE STERLING WAS RUNNING THE CREDIT BUSI
ness at Carlyle Group when he got a call in November 2009fromRick
Rieder, CIO of activefixedincome at BlackRock. Kapito had asked
Rieder, Sterling's longtimefriendfromtheir days together at Lehman,
to place the call. Sterling had spent 20 years on Wall Street, starting
out at Bank of America in leveraged finance and loan syndication,
then working at Lehman running leveraged loan capital markets,
then finally going to Bear Stearns, where he oversaw high-yield capital
markets. Rieder wanted to knowif Sterling was interested in managing
a capital markets desk at an unlikely place: BlackRock.
Sterling took his time before saying yes. He wanted to make sure
that the changes BlackRock was anticipating were inevitable and
long term. "I spent a lot of time with folks at BlackRock, thinking hard about whether there had been sufficient structural change in
continued on page 93
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COVER

GAME
CHANGER
the markets to create sustainable capabilities
for something like this, or was this more temporal?" says Sterling, 48. H e decided that
the structural changes were indeed real and
that the key revenue drivers for investment
banks, including proprietary trading, were
going away. That would force them to change
in ways they would never have voluntarily.
Banks would also need to figure out a way to
sustain revenue on a smaller balance sheet.
T h e latter is where BlackRock's capital
markets desk would come in. If banks have
to turn over their capital much more quickly
and aggressively, then BlackRock can insert
itself into the capital markets process in a
m u c h more meaningful way. Sterling, who
chooses his words carefully, notes that he
n e e d e d to know that BlackRock, despite
its size, retained an entrepreneurial spirit
a n d t h a t executives like K a p i t o w e r e n ' t
figureheads b u t instead deeply involved
in the day-to-day running of the business
and obsessed with the details. Convinced
of BlackRock's logic a n d c o m m i t m e n t ,
Sterling took the job.
Less than two years after joining BlackRock, Sterling has had success with his team.
T h e firm established a Chinese wall between
the new, private capital markets group and the
public securities group. This gave the capital
markets group unfettered access to information that the Street would share about issuers'
potential deal making, securities offerings and
the like. T h e Chinese wall is there to ensure
that the information can't leak to BlackRock
portfolio managers who may have positions in
the companies or other companies that would
be affected by those changes.
BlackRock is trying to make sure that
banks think of it first and that it gets the best
allocation of any securities they are distributing. To do that, Sterling has created a syndi-

cate desk, now one year old. Traditionally, a

syndicate desk at an investment bank talks
to investors around the world about a deal.
BlackRock's desk is designed for the firm's
internal needs.
Wall Street now has one central point at
BlackRock for new-issue offerings. When a
bank comes to the firm with an idea, Sterling's team shares it globally with the firm's
portfolio managers. "That ensures that there
is a gateway to BlackRock through which all
the capital of BlackRock has the opportunity
to see the idea, with the notion that we can
concentrate our buying power and we can
concentrate information," Sterling says.
Even more important is the new inform a t i o n that the syndicate desk is giving
BlackRock. Once again the firm is using the
power of technology to give it a leg up. T h e
syndicate desk uses BlackRock's systems
prowess to capture the flow of information
from the primary markets to better understand its own portfolio managers' behavior
as well as how certain broker-dealers are
performing in the market with new issues
and other secondary offerings. For example,
BlackRock can assess the volatility ofthe market by sector, duration and credit quality;
the performance of a product and how well
it is trading over time; what concessions to
the market have been made by the brokerdealer; and other factors. If a broker-dealer
is not pricing transactions appropriately,
Sterling will take his business elsewhere.
In a sense, BlackRock is creating a m i n i investment bank to protect itself from what
it believes is the future decline of the investment banking industry. Its syndicate desk is
responsible for the distribution of risk in an
offering. T h e last thing BlackRock wants is
for its clients to participate in transactions
that don't perform well.
Historically, some asset managers have
initiated discussions with b a n k s a b o u t
what they might want to buy or the a m o u n t
of money they want to put to work. Asset
managers have never been good at reverse
inquiries because those deals are one-off
a way to help finance a troubled company,
for instance.
BlackRock is doing reverse inquiry on
steroids. T h e firm is institutionalizing the
practice by pairing an in-house capital markets professional with a portfolio manager
on a specific investment idea. T h e two work
together to put specific terms and pricing

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STORY/93

around the idea and then take it to a brokerdealer. BlackRock gets to influence the terms
ofthe deal and how much it receives for client
portfolios. T h e broker-dealer takes the idea
to the issuer, who knows that BlackRock is
behind it and that there will be meaningful
capital to back it up.
BlackRock also provides strategic capital when a broker-dealer comes to it on a
restricted basis. For example, BlackRock
could provide capital for mergers and acquisitions that haven't been announced. Recently,
the firm was brought in on an M&A deal for a
major health care company. BlackRock had
input on the blend of debt and equity, and
the senior and subordinated debt mix. For
providing the bridge capital, it was paid a fee
100 to 150 basis points that was rolled
into its funds. BlackRock did 50 transactions
in the first 11 months of 2011 on its capital
markets desk, with about 40 percent being
strategic capital trades. In fact, 20 percent of
the capital deployed by BlackRock in U.S.
corporate credit in 2011 came from the capital markets group. T h e firm plans to launch a
European capital markets debt capability in
the first quarter of 2012.
Ultimately, BlackRock plans to expand its
capital markets desk to equities, which it is
now only doing on a one-offbasis. T h e firm
has done cornerstone capital commitments
to anchor initial public offerings, primarily in
Asia. T h e commitments give offerings more
certainty of execution. BlackRock plans to
do more of these types of deals in Europe
and the U.S. as well. Sterling will formalize
the European and U.S. equity efforts in the
first quarter and will expand to Asia for both
equity and debt by early 2013.
Sterling is careful to point out that BlackRock is not going around the banks. First,
it doesn't want to replicate the banks' cost
structure, which includes hiring teams to call
on issuers. Second, BlackRock's funds are
limited in the number of private placements
they can hold and the firm wants secondary liquidity in issues that only a bank can
provide. But most important, BlackRock
doesn't believe it has to go direct. "We can
create what we have today through a partnership by leveraging their resources, not
replicating them here," Sterling says.
R O B GOLDSTEIN J O I N E D BLACK
Rock as an analyst in 1994, two weeks after
graduating from Binghamton University

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COVER STORY

with a BS in economics, when the firm had

just 80 people. His job was to do quality
control for the green package, which meant
that he analyzed the numbers the computers
were spitting out and made sure no one relied
solely on the mathematical models or some
magic number to assess a portfolio's risk. Five
months after joining, the now-37-year-old
Goldstein was part of a group brought into a
conference room where Fink announced that
G E had retained BlackRock to liquidate the
mortgage portfolio of Kidder. A G E banker
h a n d e d a disc with the portfolio information to the group at 10:00 that night. By the
next day BlackRock had started to produce
reports, the transparency of which amazed
the G E and Kidder executives.
His b a c k g r o u n d in BlackRock's technology business has given Goldstein the
confidence to be excited about the benefits
of electronic trading, central clearing and
crossing. It's all about liquidity, he says. To
combat liquidity problems, BlackRock is
crossing as many trades as it can internally.
T h a t means if the portfolio manager of one
fund or account is selling a security and
another manager wants to buy it, BlackRock
can simply cross the two trades and bypass
Wall Street altogether.
BlackRock's ambitions go well beyond
internal crossing. T h e firm is creating a
crossing c o m m u n i t y within BlackRock
Solutions that will include BlackRock and
all its other clients. BlackRock Solutions
processes $10 trillion worth of positions a
year, giving it a huge community in which
to find crossing opportunities. Goldstein
says the offering will be available in early
2012, emphasizing that the capabilities are
completely optional and will be tracked
and settled like any other trades that r u n
through BlackRock's system.
Crossing fits into the larger puzzle of
electronic trading, for which BlackRock is
preparing in a massive way. D o d d - F r a n k is
changing the equation by requiring clearing
of over-the-counter derivatives contracts.
To do that, instruments need standard features; once instruments are standardized,
they can be traded electronically. That's all
BlackRock needed to know before it put in
place an electronic tradingplan. Of course,
BlackRock's executives have been watching what has h a p p e n e d with equities for
years as h u m a n traders have been replaced
by h u n d r e d s of electronic venues where

market participants can get liquidity. It was seminating trade information. BlackRock
just a matter of time before fixed-income is c o n c e r n e d that bid-ask spreads could
t r a d i n g was a u t o m a t e d , with or without widen if there isn't sufficient time given
before disclosure is required. T h e firm is
Dodd-Frank.
Still, BlackRock is early. T h e majority of also watching rules about swaps execution
fixed income is still executed when a trader facilities, where derivatives will be required
picks u p the phone and calls a dealer. " T h e to trade, to make sure that these new entities
catalyst for doing it now is that there will be aren't introduced too soon into the market.
a paradigm shift; maybe it's five years out
BlackRock's moves are the first volley in
there," Goldstein says. "It will look like what a larger game that will play out over the next
equities did ten to 15 years ago."
decade as the financial industry reorganizes
Goldstein has been studying what h a p - itself in the face of politics and populism,
pened in the equity markets and trying to massive government debt in the developed
apply those lessons to fixed income. He's world and a continued paucity of economic
connecting BlackRock's Aladdin trading growth. As recession has stalked the U.S.,
platform to more and more liquidity pools. some think a shrinking Wall Street has a lot to
Already, BlackRock sees fixed-income vol- do with it. Kathleen Gaffney, who has been
umes rising and average trade sizes getting managing fixed-income investments for 27
smaller. "Because of the liquidity challenges years and is co-portfolio manager, with Danpeople are facing, the 'science of trading' iel Fuss, of the Loomis Sayles Bond F u n d ,
has become m u c h more complex," he says. believes the dysfunctional fixed-income
Outside of BlackRock Solutions, Kapito markets are preventing companies from
has combined the electronic trading team getting access to capital to expand, despite
in BlackRock's global trading area u n d e r historically low interest rates.
co-heads for fixed i n c o m e a n d equities.
"We b l a m e Wall S t r e e t , t h e n c l a m p
" D o d d - F r a n k is the catalyst, but there has down, but we've lost sight of how liquidity
also b e e n t r e m e n d o u s a d v a n c e m e n t in is positive for the economy," says Gaffney.
technology capabilities," says SupurnaVedN o sector of the financial industry will
Brat, co-head of the market structure and be left untouched by Wall Street's efforts
electronic trading team for fixed income. to rightsize. Investment managers are now
" T h e market has pushed us to execute faster thinking through how to take on some of the
and smarter and to be more streamlined in tasks that Wall Street once did or risk getting
order for us to have access to liquidity. It's left in the dust. "As Wall Street retrenches,
the right time for us to be innovative and why wouldn't I want my money manager
disruptive, so we can incorporate e-trading to have more of a say in how securities are
at the center of our trading strategy."
designed?" asks Christopher Li, president
Although BlackRock plans to start hiring and C E O of Lockheed Martin Investment
for its e-trading fixed-income effort in early Management Co., which manages the com2012, right now that's still in the design stage. pany's pension assets. "If BlackRock is going
T h e firm wants to connect to as many liquid- to be at the table with issuers and banks, it
ity pools as possible. "If you want the best seems that every money manager will have
access to liquidity, then you want a frame- to do something similar so they also have a
work that can allow you to pick which trading say in future offerings," he adds.
channel you want at what time," says VedStill, Fink Mr. Outside has reason
Brat, a computer scientist and theoretical to be worried. With or without the benefits
mathematician who started at BlackRock in of capital markets expertise, investment
2010 as a strategic business adviser to Prager. managers' fees are inextricably linked to
But BlackRock can't operate in a vacu u m ; it depends on the industry at large. As
such, it's been active in lobbying for changes
in some of the D o d d - F r a n k proposals for
electronic trading of OTC-cleared derivatives. For one, while it is supportive of central clearing, it has written to regulators
that liquidity providers should have time to
hedge their positions before publicly dis-

the health of the markets, which, with the

future of the euro hanging in the balance,
doesn't look particularly good these days.
But Mr. Inside has reason to be optimistic.
With $3.3 trillion in assets, BlackRock is still
innovating. "We're reinventing how money is
managed, and in order to do that, you can't
be afraid to change, to reinvent, to retool the
factory," Kapito says.

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266

Global Banking After the Cataclysm

By Roy C. Smith1

After many years beginning in the 1970s of continuous, incremental deregulation,

global market integration and major advances in telecommunications technology,
world financial markets became vast and efficient. The markets were efficient in
the sense that they lowered the cost of capital, and improved returns on
investment to market users to such an extent that funds around the world were
being transferred from the balance sheets of local institutions into tradable
instruments in capital markets.

Global Capital Markets

At the end of 2007, the last year before the financial system collapsed, the
market value of all tradable securities and loans in the world amounted to $202
trillion, up from $54 trillion in 1990 (see Exhibit 1). The market value in 2007 was
about ten times greater than the GDP of the United States and the European
Union combined. Changes in investor preferences, caused by fear, greed or
other more rational impulses, could create enormous market forces, which would
prove to be well beyond the control of governments seeking to stabilize them.

Kenneth Langone Professor of Finance, NYU Stern School of Business

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Investment banks are the intermediaries in capital markets, acting as

underwriters, brokers and dealers (traders), and advisors in merger and other
transactions. They used their own capital as market makers and for "proprietary"
trading opportunities. This was a business that sustained high rates of returns on
capital for the bankers, especially in the rising markets for debt and equity
securities of the 1980s and 1990s. The investment banks of that period,
however, were relatively small and did not have the capacity to support the sort
of volumes that developed in the markets later on.
Increased Competition
For several large commercial banks focused on servicing corporate or
government clients, the investment banking business had not only become
attractive for its returns, it was also thought to be essential to their long-term
business strategies as capital markets displaced traditional lending businesses.
In the US, banks lobbied extensively to remove the 1933 Glass-Steagall law that
the separated banking and securities businesses. After years of incremental
lifting of the barriers, the old law was repealed - a year after the otherwise illegal
Traveler-Citicorp merger was announced in 1998. In Europe, "universal banks"
were never restricted in their investment banking activities, though most were not
as aggressive as their American counterparts were to become after 1999.
Not only were US banks allowed to cross over into the riskier and, for most,
unfamiliar territory of capital markets, they were also permitted to expand rapidly
across state lines, with the repeal in 1994 of the McFadden Act of 1927.2
By 2007, the dozen or so "money center" banks of the 1990s had been
consolidated into just three very large Bank Holding Companies (Citigroup, JP
Morgan Chase, and Bank of America) that engaged in a wide variety of financial
services. These banking institutions, both the result of numerous merger and
acquisition transactions, had become "too-big-to-fail" - i.e., because of their size
and importance it was assumed that the government would have to intervene to
protect depositors and other liability holders from any sort of run on the bank.
This feature was soon reflected in the relatively low rates at which these banks
2

An earlier banking crisis occurred in the US after the collapse of Continental

Illinois Bank, which was deemed to be too-big-to-fail by the Federal Reserve and
the FDIC, which took it over in 1984 after guaranteeing all depositors, lenders
and bond holders. This action preceded the failure of other large banks, many of
which were rescued by acquisition by banks from other states, which received
waivers from applicable law preventing inter-state banking. As banks recovered
from the banking crisis of 1984-1994, they asked for relief from Glass Steagall to
be able to compete more effectively. Paul Volcker chaired the Federal Reserve
until 1987 when Alan Greenspan, who favored a more open, competitionenhancing regulatory structure for banks, replaced him.
2

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(and others thought to share the designation) were able to fund themselves in the
markets.
By 2007, Citigroup and JP Morgan Chase occupied the top two market share
positions among investment banks. As a result, US investment banks and those
Europeans interested in capital markets, had to adapt to the rapidly increasing
footprints of these giant US banks - which they did mainly by leveraging their
balance sheets, but also through innovation in new products (such as more
sophisticated forms of mortgage-backed securities), and by a willingness to
accept risk in transactions they undertook.
Ten Banks Dominate Markets
The result was that market capacity increased significantly - though this may
have been a supply-side phenomenon. In 2006, the volume of global capital
market new issues reached a record of $14.7 trillion ($10.2 trillion of securities
new issues, and $4.5 trillion of syndicated bank loans). The top ten global capital
market banks accounted for 94% of these transactions (the top 5 had 57%). The
banks comprised the 3 large US banks, 4 large stand-alone US investment
banks (Goldman Sachs, Morgan Stanley, Merrill Lynch and Lehman Brothers),
and 3 European universal banks (UBS, Deutsche Bank, Credit Suisse). (See
Exhibit 2).

The Build Up

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The market avalanche that commenced in September 2008, was preceded by a

more than year-long decline in market prices of securities backed by real estate.
But even before then, the seeds of this crisis were planted in the government's
response to the earlier one of 2000-2002 that followed the collapse of the
Internet and related technology "bubble" of the late 1990s. This was the most
significant financial crisis since the 1930s - stock prices declined for three
consecutive years involving market losses of $8 trillion, or 80% of GDP in 2000;
record bankruptcy filings occurred in each of the three years; many corporate
officials were arrested or sued for misconduct; and the real economy fell sharply
into recession
The chief response to the 2000-2002 crisis was the Federal Reserve's - to lower
interest rates to virtually nothing to stimulate recovery. This ultimately occurred,
but it also led to an abnormal rise in certain asset prices, particularly of securities
backed by mortgages on real estate, originally developed in the 1980s.
Institutional investors, especially pension funds, had suffered low returns (often
losses) from equity markets since 2000, and the market value of their liabilities
(subject to Fair Value accounting) rose appreciably due to the drop in the level of
interest rates, leaving many with greatly diminished (or negative) capital
accounts. To turn this situation around, many such institutions allocated
substantial amounts of assets to hedge funds and to investments in relatively
high-yielding AAA-rated asset-backed securities. Exhibit 3 illustrates the rapid
growth in the new supply of such securities, from $100 billion per quarter in 2002
to $280 billion in 2007, of which subprime issues increased from about $30 billion
per quarter to over $130 billion.

Many investors then saw themselves in similar positions to US pension funds.

Over the next few years, a modest shift in allocation of investment assets
resulted in a rush of demand for a few favored investment strategies. Equally,
when the favoritism is lost, a rapid rush for the exits can develop.

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Cataclysm
The crisis of 2008 began with the nationalization of failing FNMA and FMAC, two
enormous federal mortgage institutions that for many years had been subjected
to political wheeling-and-dealing, aggressive and short-sighted lending practices,
shoddy management, and myopic regulatory oversight. The failure of these two
firms accelerated the collapse of the mortgage-backed securities market, and
pressure was transferred suddenly to the next most likely victim, Lehman
Brothers, a firm that had leveraged itself dangerously to invest in real estate and
similar securities. But, after the assisted merger of Bear Stearns (the fifth largest
investment bank) into JP Morgan Chase several months earlier, the market
assumed that similar treatment would be afforded to Lehman, the fourth largest
investment bank. When it wasn't, an avalanche of market forces began as funds
were withdrawn from all firms having major capital market businesses.
By the end of 2008, two of the largest US banks (Citigroup and Bank of America)
and the largest US insurance company (AIG) had been bailed out by the US
government, Merrill Lynch was driven into an acquisition by Bank of America,
and the two surviving investment banks (Goldman Sachs and Morgan Stanley)
had been converted into bank holding companies. Further, one of the largest
regional banks (Wachovia) had been rescued by acquisition by Wells Fargo and
one of the largest savings-and-loan organizations (Washington Mutual) had been
taken over by the FDIC and resold to JP Morgan Chase. Eight major US
financial institutions, with assets of more than $8 trillion had either failed outright
or had been rescued by government action, all within a space of four months.
In Europe, to which capital markets were integrated with those of the US, similar
bailouts occurred: the largest banks in the UK, The Netherlands, Belgium and
Switzerland were taken over by their governments. Many other European banks
also had to be assisted by their governments. Banks in Ireland, Portugal, and
Greece were flattened by the crisis and became wards of their states; these were
so large and numerous that they were thought to be capable of bringing their
governments down. The Euro-zone sovereign debt crisis involving these
countries developed a few years later, in 2010-2011.
These events together constituted the worst and largest global systemic financial
collapse the world had ever known. The loss of market value alone in 2008 was
$27 trillion. The US and Europe plunged into what has since been called the
Great Recession, that lingered for at least four years.

Bailouts and Government Support

In the US, government assistance to banks began in September 2008 with the
passage of the Troubled Assets Relief Program (TARP), to be directed by the
Treasury with initially authorized expenditures of $700 billion. The funds were
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intended to be used to purchase subprime and other mortgage backed securities

in the markets, to provide a pricing floor for them. Soon after its passage,
however, the Treasury changed its mind and decided to use the funds to
purchase preferred stock of troubled and not-so-troubled banks and for a number
of other programs to assist other financial institutions and the automobile
industry. The Dodd-Frank Wall Street Reform and Consumer Protection Act
(Dodd-Frank), passed in August 2010, reduced the amount authorized for TARP
to $475 billion.
Two of the top ten global banks received substantial assistance from TARP both Citigroup and Bank of America received additional rounds of financing after
the initial one (all major banks were required by the Treasury to participate in this
round) leaving TARP with $45 billion or more invested in each. Altogether, TARP
invested $245 billion in the banking industry; by Sept. 30, 2011, it had collected
$258 billion in repayments, dividends and other income, while still holding only
$17 billion of securities of 390 banking institutions. The capital market banks had
all fully repaid their investments from TARP by the end of 2011. 3
The banks, which wrote off enormous amounts of capital during the crisis, had to
replace it. Because the market for mortgage-backed securities had become panic
stricken, fearing the securities were all filled with non-performing loans, there
were virtually no buyers for the huge supply of bonds offered. Market prices
dropped well below the securities' risk-adjusted valuation levels, and banks had
to write the unrealized losses off against profits and capital.
Altogether, banks worldwide (according to Bloomberg data) wrote off $1.8 trillion
in 2007-2009, but issued $1.6 trillion of new capital to replace it. The top ten
global capital market banks wrote off $605 billion during this time and raised
$536 billion in rights offerings to shareholders, other public offerings and private
sales to sovereign wealth funds and other large institutional investors. See
Exhibit 4.
(Insert Exhibit 4 about here)
The stock prices of these banks and other major financial institutions affected by
the crisis suffered considerably. Based on early 2008 market values, FNMA,
FMAC, AIG, and Lehman Brothers lost virtually all of their market value over the
four years to January 2012; Citigroup and Bank of America experienced losses of
80% or more; Morgan Stanley lost 60%; Goldman Sachs, 30%; and JP Morgan
Chase, 10%. All of these institutions, except Goldman Sachs and JP Morgan,
experienced crisis-related CEO and other management changes.
The five Europeans among the top ten global banks (UBS, Deutsche bank,
Credit Swiss, Barclays and BNP-Paribas) suffered similar results: their average
stock price decline over the four years was 50%; UBS, the only bank among this
3

US Treasury Dept., Citizens Report on Trouble Assets Relief Program, Fiscal

Year 2011
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group to receive bailout assistance from its government, also experienced two
crisis-related CEO changes.

Regulatory Responses
Two large investment banks, Goldman Sachs and Morgan Stanley, were
encouraged by the Federal Reserve to become Bank Holding Companies (with
access to the Federal Reserve discount window) in September 2008 to assist
them in overcoming a surge of selling activity in their common stock, which
threatened to disrupt their ability to roll over their maturing debt obligations. Both
investment banks took advantage of the offer, which was speedily implemented.
A much greater amount of support was given to banks by the Federal Reserve in
its market intervention activities, than was provided by TARP. A Bloomberg
report, based on a Freedom of Information Act request, reveals that the Fed
committed an historically unprecedented $7.8 trillion in its various efforts to
stabilize and support interbank lending, repo, commercial paper markets and
money market funds, and mortgage-backed securities during the crisis.4 These
transactions netted out to an increase in the Fed's balance sheet to
approximately $2.1 trillion at the end of 2010, from less than $1 trillion before the
crisis. Gains on these investments led to net income for 2010 of $76 billion. The
Fed's actions, little noticed at the time, constituted the largest financial
intervention effort by any government ever to take place.
Basel III
Soon after the crisis began, the Basel Committee on Banking Supervision, an
organization of central bankers from 27 subscribing countries, met to examine
their standards on risk-adjusted capital adequacy standards for banks. The
committee was formed in the 1980s to agree a common standard of minimum
capital adequacy for banks competing in global markets. These standards had
been revised prior to the crisis, but had not been adequate to prevent the
systemic collapse that occurred. Hurriedly the committee met (in 2010 and 2011)
to revise the standards again (Basel III) to toughen them up. Risk adjustments
would be more severe, and the percent of risk-weighted assets to be covered by
capital would be increased significantly. Further, additional new standards would
be introduced to limit leverage and liquidity risks. These measures would be
implemented gradually over a seven year period ending on January 1, 2019
when total capital requirements (in two "tiers") would increase from 8.0% of riskweighted assets to 10.5%. At least 6% of the 10.5% would have to be in the form
of tier 1 equity.

Thomas R. Eddlem, "Another Secret Federal Reserve Bailout, $7.7 trillion this
Time," Bloomberg Business Week, 29 November, 2011.
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Some banks have calculated that a 6% Basel III ratio is the rough equivalent of a
Basel I tier 1 ratio of 9% or 10%.
As of December 31, 2011, the top ten capital market banks had tier 1 capital
ratios - scored according to Basel I - of 13.8% (all but one had ratios above
12%). These ratios were roughly equivalent to 9%-10% under the stricter
standards of Basel III. All of these banks wanted to demonstrate that they were
fully capitalized under current and expected regulations, and to satisfy debt
markets that the remained good credit risks, despite the difficult circumstances
they were in.
G20 Bank Standards
In 2010, the G20 group of nations (of which the US and the largest European
countries are members) created a Financial Stability Board. In November 2011,
the Board designated 29 global banks as being so important to the global
financial system that they must hold more capital than rivals and must put in
place a plan to allow them to be wound up without taxpayer help ("living wills"
due to be in effect by the end of 2012) if they should get into trouble. Of the
banks listed, 17 are from Europe, 8 are U.S. banks5, and 4 are from Asia.
The G20 also endorsed a core capital requirement surcharge (over the Basel III
requirement) - starting at 1 percent of risk-weighted assets and rising to 2.5
percent for the biggest banks - which must be phased in over three years from
2016. This surcharge is called "Basel 2.5."
Dodd-Frank
Dodd-Frank was signed into law in August 2010. It is a massive undertaking (848
pages, Glass-Steagall was 37 pages) that has been described as reflecting the
opinions of outraged members of Congress more so than those of the Treasury
or Federal Reserve. It was intended to address and contain systemic risk in the
financial system, but the bill went well beyond that. The law essentially was a set
of instructions to regulatory agencies to write about 400 new rules for financial
markets. Eighteen months after the bill was passed, only about 90 of the new
rules had been completed and the process of implementing the law was way
behind schedule. The new rules will replace or extend existing ones, add
additional regulations and overlap extensively with the other financial regulatory
bodies. (See Exhibit 5). By all accounts Dodd-Frank will take several additional
years to implement in full, and the cost to the banks of both implementing and
complying with it will be very high, though how high no one presently knows.6

From the US: Bank of America, Bank of NY-Mellon, Citigroup, Goldman Sachs,
JP Morgan Chase, Morgan Stanley, State Street, Wells Fargo
6
"Too Big Not to Fail," The Economist, Feb. 18, 2012
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Dodd-Frank addresses systemic risk in several ways. It designates all US banks

with assets of more than $50 billion (about 30) as "systemically important" and
requires the new Financial Stability Oversight Council (FSOC, to which all other
financial regulators are meant to report) to designate those nonbanks that are to
be regarded as systemically important.
As of February 2012, these designations had not been made. All systemically
important banks and nonbanks are to be subject to a requirement to hold more
capital against losses than nonsystemically important banks, though how much
this premium would be had also not been released. Further, systemically
important institutions will be subject to the Volcker Rule (a part of the law which
prohibits "proprietary trading" and related activities); the actual rules governing
the Volcker Rule had also not yet been released. The Volcker Rule is scheduled
by Dodd-Frank to become effective in July, 2012, though there is broad
expectation that it may be deferred. This provision has involved extensive efforts
by the banks to persuade the Federal reserve and other regulators to moderate
its terms so as not to prevent the banks from performing their traditional marketmaking functions.
Similarly rules requiring the trading of derivative contracts on exchanges or
clearing house platforms were still under development in February 2012, though
these too are scheduled to become effective later in the year. These rules most
likely will subject banks to margin requirements they did not have to meet while
dealing entirely over-the-counter.
Dodd-Frank did not seek to break up the largest banks (though that would have
been difficult with these banks on average holding assets of $1.6 trillion; how
many banks would they have to be broken up into?), or to reimpose the GlassSteagall limitations on dealing in securities, which also would be difficult to do
when banks can operate freely outside the US. But it does impose a system for
intervention and "risk mitigation" to be undertaken by the FSOC, though bailouts
as practiced in the past are no longer permitted. This process is cumbersome at
best - it requires an official designation of a bank as being a "grave threat" to
financial stability (achieved by a majority vote of the FSOC), which can be
challenged in court and appealed, followed by one or more mitigation efforts

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imposed by the FSOC to be implemented when and as possible. The whole

process could take many months, but once a bank has been designated as a
"grave threat," investors in the designated bank (and others like it) will
immediately take flight, fearing they will not be protected. In other words, the
mitigation process may actually create the run on the bank that the FSOC is
trying to prevent. But once the run comes, what can it do but take over the bank
through the FDIC? 7
The Swiss "Finish"
After bailing out UBS, which it did very reluctantly, the Swiss government formed
a "Committee of Experts" to advise it on the "too big to fail" problem. The
government, as in the UK, was concerned that the country's largest banks had
assets well in excess of the national GDP and Swiss taxpayers were unwilling to
guarantee such a large and disproportionate amount under too-big-to-fail
conditions. Made up of top regulators, bank executives and other industry
experts, the Committee announced in October 2010 that UBS and Credit Suisse,
its two largest banks, must hold almost twice as much capital as set out in the
new international Basel III standards. The two banks must hold at least 10% of
risk-weighted assets in form of common equity and another 9%, which could be
contingent convertible ("CoCo") bonds, taking the current total capital
requirements to 19%.
CoCo bonds are fixed income obligations that are required to be converted into
common stock if the issuer's tier 1 ratio falls below a pre-set limit. Several billion
euros of such bonds were issued after 2009 by Credit Suisse, Lloyds Bank,
Rabobank and others, usually with conversion triggers of tier 1 capital dropping
below 5% or so. In February 2012, UBS issued $1 billion of "contingent debt" as
tier 2 capital - this debt does not convert to equity, but must be written off if UBS'
tier 1 capital falls below 5%.
European Banking Authority
In November 2010, the European Union established its own financial regulatory
system, creating different units for banking, securities and insurance. The
European Banking Authority sprang to life quickly, first organizing "stress tests"
and then, much to the surprise of many, imposing its own minimum capital rules
for the largest banks in the EU. These rules require banks to meet and maintain
a 9% "core capital" requirement (relative to risk-weighted assets) by July of 2012.
These are higher standards, that go into effect much sooner, than Basel III.

Roy C. Smith, "The Dilemma of Bailouts," The Independent Review, Summer

2001. In January 2012, seeking to test the law, The Public Citizen, a public
interest group, petitioned the FSOC to declare Bank of America, which it
described as being in very tenuous condition for such a large bank, a "grave
threat" and begin mitigation steps. The FSOC has not responded to the petition.
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The EBA said the raised capital buffers were intended to provide reassurance to
markets about the ability of European banks to withstand a range of shocks and
still maintain adequate capital, and stressed the move was not done explicitly to
cover losses from sovereign debt holdings.
On December 8, 2011 the EBA announced that the largest European Union
banks would be required to raise 115 billion of additional core tier 1 capital by
July 2012. Of this amount26 billion would have to be raised by Spanish banks,
15 billion by Italian banks, and 13 billion by German banks.
UK "Ringfencing"
The UK also appointed an independent banking commission to advise the
government on its exposures to too-big-to-fail situations. The combined assets of
the four largest UK banks were several times the size of the GDP of the UK,
according to the Commission's chairman, Sir John Vickers. The Vicker's
Committee issued its report (which the government said it would adopt) in Sept.
2011. Banks should be forced to ringfence their domestic retail businesses to
separate them from their "casino" investment banking arms. Business inside the
fence will be eligible for financial assistance from the government if needed, but
those outside will not be. The commission suggested that between one-sixth and
a third of the 6 trillion of UK bank assets should be inside the fence, the rest not.
The Commission described the ringfence as "high" and said that the ringfenced
part of the bank should have its own board and be legally and operationally
separate from the parent bank, and or any global or wholesale units. Similar to
the Swiss rules, ringfenced banks are to have a capital cushion of up to 20%
comprising equity of 10% together with an extra amount of other capital such as
Co-Co bonds. The largest ringfenced banks should have at least 17% of equity
and bonds and a further loss-absorbing buffer of up to 3% if "their supervisor has
concerns about their ability to be resolved without cost to the taxpayer." Capital
could be moved from the ringfenced bank to the investment bank only if the tier 1
capital ratio of the ringfenced bank did not fall below the 10% minimum.
Operations outside the ringfence will not be eligible for government assistance,
and will have to secure financing for their activities solely on their own credit. It is
likely that such financing, if available at all, would depend on the nonringfenced
business being very well capitalized itself.
In addition to ringfencing, the UK government has actively campaigned to reduce
high levels of compensation paid to bankers, including a one-time bonus tax in
2010, and has supported efforts to persuade Royal Bank of Scotland Group
Chairman Philip Hampton and Chief Executive Stephen Hester to waive bonuses
of approximately 1 million in shares, as criticism swirled over payouts to the
chief officers executive of the taxpayer-owned institution. In January 2012, both
men did waive their bonuses.

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Therefore, the Basel III standards apply to all banks within the 27 countries
signing on to the Basel Accord; Basel 2.5 applies to the G20's 29 globally
systemic banks; and the largest banks in Switzerland and the UK will be subject
to further additional capital charges. The US FSOC has not announced its capital
surcharge for systemically important banks, but as it is a signatory to both the
Basel Accord and the G20 agreement it must be assumed that these
arrangements apply to the US banks named in the G20 report.
Financial Transaction Taxes
In January 2012, French president Nicholas Sarkozy said a new 0.1% financial
transaction tax8 would come into force in August regardless of whether or not the
European Union agrees to impose a similar tax applicable to the entire EU.
Sarkozy said he hoped his move would push other countries into taking action.
"What we want to do is create a Shockwave and set an example that there is
absolutely no reason why those who helped bring about the crisis shouldn't pay
to restore the finances," Sarkozy said. "We hope the tax will generate 1bn
(800m) of new income and thus cut our budget deficit."
The country's national bank, the Bank of France, has already questioned the
feasibility of a tax that will only be imposed in France and the nation's financial
sector has been very vocal in its opposition. "A tax that's limited to France would
weigh on growth, lead to a loss of competitiveness, and create a heavy handicap
for the financing of the French economy," the French Banking Federation said
after the announcement.
In September 2011 the European Commission suggested a tax of 0.1% on equity
and bond transactions and 0.01% on derivatives, which it said could raise 55bn
a year. European Union finance ministers are due to discuss the tax in March
2012. Several countries, including the UK, oppose the proposal that requires
unanimous consent to adopt.

Market and Other Responses

The consequences of the financial crisis and the Great Recession that followed
were felt in several different ways by global banks.
Reduced Capital Market Activity
First there was a sharp reduction in demand for capital market services: global
new issues of debt and equity declined 28% from the peak year of 2006 (total
8

Often called a 'Tobin tax' after 1981 Nobel laureate James Tobin, who first
proposed it. A Tobin tax was also floated in the UK but not taken up by
government.
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volume of activity was $14.7 trillion) to 2011 in which $10.6 trillion of new issues
occurred. See Exhibit 6. Also, global merger and acquisition activity declined by
44% from its peak year of 2007 ($2.7 trillion of completed transactions) to 2011
($1.5 trillion). See Exhibit 7.
Part of the reduction in both sectors of capital market activity was the decline in
transactions involving banks and other financial services organizations as
principals, and part by the 78% decline in new issues of collateralized debt in
2011, as compared to its peak year in 2006 in which $3.3 trillion were floated.
(Insert Exhibits 6 and 7 about here)
Increase in Bank Funding Spreads
The funding costs for global banks increased considerably after 2008. This is
indicated by the widening of five year credit default swap (CDS) spreads from 10
to 20 basis points in 2007 to a peak of over 1,200 basis points in late 2008, after
which they settled in the area of 375 basis points at the end of 2011, reflecting
much greater disbelief in the future of federal support that would bailout bank
creditors. See Exhibit 8)

Liquidity Squeeze in Europe

As a result of growing concerns about exposures to European sovereign credits
and to other banks similarly exposed, interbank credit markets began to resist
European bank paper. Also, money market funds in the US that typically rolled

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over substantial quantities of European bank CDs (which paid a higher yield than
comparable US banks) began to liquidate their positions. European banks keenly
felt these market pressures. Accordingly, Mario Draghi, who replaced JeanClaude Trichet as President of the European Central Bank on November 1, 2011,
declared an unlimited access to ECB funds by European banks for up to threeyears at low rates. This action, consider bold and controversial because of the
open ended nature of the commitment, clearly established the ECB as Europe's
lender of last resort for banks. On December 21, 2011 an auction was held in
which 523 banks borrowed 489 billion; a second auction was held on February
29, 2012 and 800 banks borrowed 530 billion. These actions substantially
reduced the borrowing pressures for banks in Europe, but increased the assets
on the balance sheet of the ECB from 1.3 trillion in January 2008 to 3 trillion in
February 2012.
Downgraded Credit Ratings
This concern was also reflected in the credit rating issued for banks by the major
credit rating agencies. These agencies progressively downgraded the ratings of
the largest banks after the crisis, and on February 15, 2012, Moody's announced
that it may cut ratings of 17 capital market banks by from 1 to 3 notches because
of "more fragile funding conditions, wider credit spreads, increased regulatory
burdens and more difficult operating conditions... that together with inherent
vulnerabilities...and opacity of risk, have diminished the longer term profitability
and growth prospects of these firms."9
If the rating downgrades occur as indicated (during the Spring of 2012), the
highest rated global capital market bank (BNP) will be A1; four banks (Credit
Suisse, Barclays, Deutsche Bank and JP Morgan Chase) will be A2; two (UBS
and Goldman Sachs) will be A3, and the rest of the top ten (Morgan Stanley,
Citigroup and Bank of America) will be dropped to Baa2, only two notches about
junk status. For most of the banks such ratings would be far lower than at any
time in the their history, and would likely further increase their funding costs from
their present levels.
Decline in Stock Prices
The stock prices of the major capital market banks were shattered by the
financial crisis and very slow in recovering during its aftermath. For the five year
period from February 2007 until February 2012, three US banks (Citigroup, Bank
of America and Morgan Stanley) saw their stock prices drop by an average of
82%; of the other two, Goldman Sachs dropped 50% and JP Morgan Chase,
25%. The stocks of the five largest European capital market banks (Deutsche
Bank, UBS, Credit Suisse, Barclays and BNP) were closely packed around an
average 70% decline. See Exhibit 9.

Moody's Investor Service, "Announcement: Moody's Reviews Ratings for Banks

and Securities Firms with Global Capital Market Operations," Feb. 15, 2012.
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A partial recovery in stock prices occurred in 2009, but even so, the market
capitalization of the top ten global capital market banks (reflecting some
considerable amount of new capital raised) declined $270 billion, or 33%, from
$800 trillion in December 2009 to $530 billion in December 2011.
Exhibit 10 illustrates the extent to which the markets had turned against capital
market banks three years after the crisis. The market price-to-book value ratio of
the top ten banks declined during this period to 0.58 from 1.08. The banks had
been forced to raise tier 1 capital to 13.8% (well above required levels), which
together with protracted weak conditions in trading markets, contributed to a
sharp decline in ROI to an average of 10.4%, or 5.9% below the average cost of
capital of these banks. This differential (ROI less cost of capital) is known as
"economic value added" (EVA). The average EVA for these banks has been
negative since 2009, when it was -4.0%. Only one bank among the top 10 global
capital market banks reported positive EVA in 2011, JP Morgan Chase (1.65%).

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Litigation, Public Relations and Reputation Loss

Following the peak of the crisis in the fourth quarter of 2008, a public sentiment
developed in the US and Europe that the market collapse and the ensuing
recession was principally the fault of the largest global banks, whose managers
had been driven by excessive compensation incentives and a disregard of the
law and ethical standards. Elected officials in the US and the UK drove this
message home repeatedly and made a number of attempts to limit bonuses at
banks, particularly those that had received government assistance.
The public anger at banks was widely covered by the media and even the most
highly regarded banks before the crisis were subject to intense investigations by
journalists whose reports were well read. Government regulators were active on
many fronts, especially in the US, and brought civil charges of securities fraud
against all the banks, most prominently resulting in a $25 billion settlement with
five largest US mortgage servicers (Bank of America, Citigroup, JP Morgan,
Wells Fargo, and Ally Financial, formerly General Motors Acceptance Corp.). In
addition the SEC secured settlements from Goldman Sachs ($550 million),
Citigroup ($230 million) and JP Morgan ($154 million) of civil charges of fraud in
connection with selling mortgage-backed securities to hedge funds and other
institutional investors. Additional charges for misrepresentation in the sale and
underwriting of mortgage-backed securities are pending against several bankers.
Altogether, these various charges are expected to result in legal charges to the
banking industry of additional billions of dollars.

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European banks were exposed to some of these charges related to activities in

the US. In addition, Barclays faced charges related to its acquisition of Lehman
Brothers assets and several banks were involved in investigations of rate rigging
in the LIBOR and foreign exchange markets. UBS settled a criminal complaint
related to encouragement of its client to evade US taxes with the US Department
of Justice for $780 million_in 2009 and the DOJ then turned its attention to Credit
Suisse and other Swiss banks which it claimed did the same thing as UBS.
In his State of the Union address in January 2012, President Obama announced
the formation of a special task force in the Department of Justice to pursue as
diligently as possible those banks and others involved with financial fraud during
the crisis.
At no time since the 1930s had large banks been held in lower esteem by the
general public, nor been required to pay so much for the adjudged misconduct.

Diagnostics
There were two maladies affecting the global banking industry in early 2012,
nearly five years after the financial crisis first began to form:
Cyclical Factors
One of these is the cyclical nature of financial markets, which in recent years
have levels of volatility that was unfamiliar before 2008. Indeed the markets have
endured three separate storms since then - the melt-down of late 2008, and the
subsequent effects of the Great Recession and the European sovereign debt
crisis. Considering that the value of securities outstanding in global markets
exceeded $200 trillion in 2007, the volume of financial assets subject to fear and
panic was never higher. A sudden change in investor attitudes of just 5% would
release financial flows of $10 trillion that could be forced onto secondary
markets, limiting liquidity severely.
Capital market transactional activity is still near the bottom, five years after
peaking due mainly to a sharply reduced demand during a period of slow
economic growth.
The markets, however, have been damaged by the loss of confidence, still not
restored, in the mortgage-backed securities sector (which continues to be
hampered by a glut of foreclosures still overhanging the market, the absence of
any private sector alternative to relying upon the US government sponsored
mortgage financing entities (FNMA, FMAC), and the poor condition of these
firms, both of which been taken into "conservatorship" by the US government. It
is very difficult to foretell when this important but ailing sector of US financial
markets may be returned to normal.

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Banks are also still processing some of the adjustment costs (such as litigation
expenses) associated with their mortgage-related activities prior to the crisis.
Structural Factors
The other malady is the need for structural reform before the global capital
markets industry can fully return to normal. The most apparent indicator of this
need lies in the increasingly negative EVA generated by the top ten capital
market banks since 2008. The banks also suffer from substantially downgraded
credit ratings and an investor reluctance to assume their paper might be bailed
out in future crises.
These banks are burdened by the prospects of complying with Dodd Frank,
Basel III (and the accelerated EBA requirements) and special rules adopted by
Switzerland and the UK. These will require considerably higher capitalization
ratios than before the crisis; restrictions on certain previously important trading
activities (proprietary trading, derivatives - both of which new rules are still
pending); and the need to comply with compensation restrictions and other
regulatory requirements (which in the US under Dodd-Frank are very extensive and expensive).
Global banks prior to the crisis often promised investors growth rates in the area
of 15% or more based on both organic growth from a wide range of different
revenues platforms, and from mergers and acquisitions. Much of the growth of
most large global banks over the past 15 years was the result of strategic
acquisitions. Dodd-Frank places significant restrictions on future mergers or
acquisitions of systemically important banks, thus limiting future growth rates for
these banks.
Altogether, changes in regulation for the top ten banks has caused returns to be
reduced, thus sharply lowering their expected returns on equity to levels well
below the 15%-20% they were before the crisis. Cyclical improvements may
improve returns somewhat, but compliance with approved by not-yet effective
capital and other capital requirements will still hold back improvements in ROE.

Alternative Structures
Banks can adjust their structural situations in three different ways.
Shifting Regulatory Jurisdiction
They could seek a more favorable regulatory regime, by relocating to a different
jurisdiction. HSBC relocated to London after the reversion of Hong Kong to the
Peoples Republic of China in 1997; conceivably Barclays Bank may want to
avoid the burden of UK ringfencing of its substantial nonUK businesses (more
than half of its profits being outside the fence) by relocating to New York, or

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Goldman Sachs might want to avoid the many constraints of Dodd Frank (and
US taxes) by merging itself into a Bermuda corporation.
There are substantial costs to jurisdiction shopping, including the reluctance of
markets to approve of large risk-taking entities moving themselves beyond the
reach of safety and soundness regulation. None of the top ten capital market
banks have suggested they might relocate to another location, and Barclays, in
particular, has denied that it would.10
Retreat from Wholesale Banking
Banks, especially those with a relatively short (and painful) history in capital
markets, could move to divest themselves of all or most of their investment
banking units. They would be guided by the experience of the seven largest
global commercial banks by market capitalization11, also suffering from a cyclical
downturn, which averaged in 2011 a positive economic value added of 1.00%
and a market to book ratio of 1.15. These banks had only modest commitments
to investment banking. The two largest of these banks, Wells Fargo and HSBC,
had market capitalizations at December 31, 2011 of $145 billion and $136 billion,
respectively, as compared to $126 billion for JP Morgan Chase, which had the
largest market capitalization among the capital market banks. See Exhibit 11.
Indeed, prior to its merger with Travelers in 1998, Citicorp had announced that it
would substantially scale back its wholesale lending and capital markets
activities, which had caused it so much trouble during the US banking crisis of
1984-1994. Only after the merger and the departure of John Reed, Citicorp's
prior CEO, did Citigroup return to aggressive wholesale financing activities, which
proved for a second time to be nearly fatal for the bank. At December 31, 2011,
investment banking comprised 34% of Citigroup's revenues. Its stock was trading
then at 0.43 of book value, with economic value added of-9.45%.

10

Julia Werdigier, "Could Barclays Move to New York?" New York Times, March
30,2011
11

HSBC, Wells Fargo, Royal Bank of Canada, Toronto Dominion, Santander,

Standard Chartered, and BBVA. The two Spanish banks reported negative EVA,
the rest reported EVA ranging from 1.1% to 8.5%.
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Bank of America emerged through many mergers during the 1990s and 2000s
into the nation's largest commercial bank, with only limited investment banking
activity. Its stock price performed better than all other major banks in 2000-2007.
It became a major capital market bank after acquiring Merrill Lynch under duress
in 2008. Merrill's retail brokerage business may be appropriate for Bank of
America to retain, but it may be better off spinning off the large, capital-intensive
investment banking component. Doing so would free Bank of America from
having to cope with capital market risk management under intense competitive
conditions while trying to "right size" the business as a while and return it to
sustainably profitable operations. The stock market, which at December 31, 2011
valued Bank of America at 0.28 of book value, with economic value added of 15.1%, and might see such a move as a positive step. Its chief rival, Wells Fargo,
then traded at 1.12 times book and an economic value added of 2.08%.
Barclays Bank also has a relatively short history in investment banking, dating
from its acquisition of the US business of Lehman Brothers in 2008. Before then,
Barclays had operated a mainly fixed-income and currencies business based in
London which was retained after Barclays decided to retreat in the 1990s from
the investment banking business it had entered through its BZW subsidiary in
1986. An American executive, Robert Diamond, was hired from Credit Suisse
First Boston in 1996 to build up the bank's capital market activities and he
became Group CEO in January 2011. In 2011, investment banking comprised
53% of the consolidated profits of Barclays Bank.
Barclays now must face the ringfencing difficulty, which essentially requires it to
separate its nonUK and capital market activities from its UK business and run it

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as a stand-alone operation. This may be difficult to do as sizeable trading

operation dependent of markets to provide funding - with no assurance of
support from either Barclays or the UK government. This may prove to be
something that Barclays could do better by spinning it off entirely, perhaps
relocating it to New York where it might even be downsized enough not to
constitute a systemically important nonbank under Dodd Frank. Doing so might
enable Barclays' stock price to recover - at year-end 2011 it was trading at 0.33
times book value with an economic value added of -11.46%.
Similar to Barclays, the two largest Swiss banks, UBS and Credit Suisse face
regulatory pressures (Swiss Finish) so strong as to render a major investment
banking business as unviable. Both Swiss banks have announced that, in order
to comply with much tougher capitalization ratios, they will be substantially
reducing their risk-weighted assets, most of which are in the investment banking
units, by 50% or more. This will essentially leave the banks as underwriters and
advisers in the market, after giving up proprietary trading and market making.
Doing so will substantially reduce the wholesale banking revenue flows (but also
its risk) and protect and increase the relative value of the banks' crown jewels,
their wealth management businesses. Such adjustments should in time enable
the stock of these banks to be valued much more highly as asset managers
rather than as capital market banks.
Reengineer the Business Model
For JP Morgan, Deutsche Bank and BNP-Paribas, the task ahead is to
reengineer their businesses to balance their riskier wholesale commitments with
the rest of their retail and service businesses.
For JP Morgan market making and accommodation of client demands is key to
its market-leading business model based on its "fortress balance sheet." JP
Morgan is eager to organize and lend large sums to clients on short notice, and
to receive in return mandates for subsequent refinancing, underwriting and
merger advisory assignments. In 2011, investment banking comprised 35% of JP
Morgan's net income of $19 billion and maintained the largest market share. It
does not want to give up much of anything it presently does, and believes that
structural problems are less problematic for it and the cyclical downturn.
This may be true, but the bank needs to reduce the risk of its capital market
activity even as it expands it - by accommodating client wishes for it to hold
positions, but not to hold them for very long. Essentially this means strictly pricing
positions to be taken at market rates so that can be resold through the bank's
distribution system. As the least damaged bank from the crisis, JP Morgan
stands to benefit the most from the recovery of the markets amidst the weakness
of many of its rivals.
Deutsche Bank recently appointed - for the first time in its history - two co-CEOs
to replace long-serving CEO Josef Akermann. One, Jurgen Fitschen, a German
national whose roots are in the domestic business, the other, Anshu Jain, an

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Indian national, has been tied to the capital markets business conducted out of
London. The domestic business was expanded after 2010 by a series of
investments in the former postal savings bank, Deutsche Postbank, culminating
in the acquisition of a majority stake, which led to ownership of 94% in February
2012. Prior to this, investment banking activities comprised 55% of Deutsche
Bank's net revenues, and all indications are that the new management team
wants to preserve the business. In November 2011, Deutsche Bank announced
that its entire asset management business would be sold for 1-2 billion in an
effort to streamline and simplify Deutsche bank's business.
Goldman Sachs, like JP Morgan, emerged from the crisis in relatively good
condition. Indeed, 2009 was a record year in which it earned $13.4 billion in
profits, 79% of which were derived from Institutional Client Services (sales and
trading) and Investing and Lending (proprietary investing). Goldman is
substantially committed to a "flow trading" business model, in which attempts to
integrate all the market information from all its activities into trading decisions and
client services. It is also the most committed of all the top ten banks to alternative
asset management activities in hedge funds, private equity and real estate which
are effectively to be disallowed by the Volcker Rule, though it will have several
years to disengage. Goldman Sachs certainly needs to reduce risk-weighted
assets to improve its ROE, which like JP Morgan it can do by distributing
securities acquired in market-making rather than holding them. It may also
decide that its extensive alternative asset management business, which is larger
than Blackstone, an industry leader, may be better off distributed to shareholders
where it might be permitted to operate as a nonsystemic nonbank without the
regulatory burdens that Goldman Sachs cannot escape.
Morgan Stanley is the smallest of the top ten banks, with market capitalization at
December 31, 2011 of $29 billion, reflecting a market to book value ratio of 0.48
and EVA of -7.3%. In 2009, Morgan Stanley made a major strategic change in
forming a joint venture with Salomon Smith Barney (of which it would hold 51%
and CitiHoldings 49%), committing itself to acquiring the portion still held by
Citigroup within a few years. Doing so would make Morgan Stanley the largest
retail brokerage firm in the world. In 2010 James Gorman, a retail brokerage
executive, succeeded John Mack, a long-term Morgan Stanley executive as
CEO. The retail brokerage business is not as capital intensive as investment
banking, so absorbing the joint venture could beneficial to Morgan Stanley, but
continuing to be under the systemically important regulatory requirements could
offset the benefits. Possibly Morgan Stanley could give up its status as a Bank
Holding Company, though this alone might not enable it to escape the capital
requirements if Morgan Stanley was designated as a systemically important
nonbank. If the burden of being systemic is too great, Morgan Stanley may
decide to separate the brokerage and investment banking businesses, though
this would be a complex and expensive process.

Adapting to Survive
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The investment banking business is quite old. It certainly goes back to the 19th
century when some of the present leaders were formed, but the industry existed
long before then in one form or another. Industry observers have noted that over
time, the industry persists - capital has to be raised and invested - but individual
firms come and go. In the 1930s, US banks were required by law to divest their
securities units and the industry was changed as adaptations were made. In the
1960s and 1970s important regulatory changes and technology developments
occurred that forced firms to adapt again. The pattern has continued until now;
today's firms will have to adapt to regulatory changes as profound as those of the
1930s amidst global markets of enormous size and volatility.
Adaptations are uncertain events. Some first movers set the stage for others to
follow, even though the success of the moves may be uncertain or even doubtful.
Some firms will hesitate to change, either out of inertia or indecision, and they
may suffer from their caution, or not as only the future can reveal. But all have to
think about how they might best adapt their particular businesses to the new
conditions.
It may be possible to sustain negative EVA during a period - even an extended
period - of transition, but negative numbers point to nonviabliity in the long run
and thus they must be addressed. A more optimistic outlook for Improving
economic conditions has lifted all bank stock prices since the end of 2011 by
almost 20%, but the structural part of the weight on bank stocks has to be
respected too. All of the major banks are considering how they might adjust some are waiting for improved markets to sell or spin off parts of their
businesses, other are waiting for a more definitive understanding of the new rules
before acting. There are indeed quite a few important rules we are waiting for.

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290

Bloomberg
Rethinking Bob Rubin From Goldman Sachs Star to
Crisis Scapegoat
By William D. Cohan - Sep 20, 2012

Bill Clinton has a favorite Robert Rubin story.

It's 1999, and the Cabinet has gathered to discuss the business of the American people. Except no
one can focus because the impeachment crisis is raging, and even the most veteran Washington
power players are, for lack of a better term, freaking out.
"It was amazing what he did," says Clinton of Rubin, his then-Treasury Secretary. "He often didn't
say much, and I was stunned when he wanted to speak. He just sat there and in about three
minutes summed up the whole thing in a very calm way, and had an incredibly positive impact on
the attitude of the Cabinet," as reported in Bloomberg Businessweek's Sept. 24 issue.
He said, 'What we've got to do is get up tomorrow and go back to work, just like we did today,
make good things happen, and trust the system and trust the American people. It's going to be
fine.' And oh my God, you would've thought that somebody had gone around and lifted a rock off
everybody's shoulders."
Rubin's knack for spreading wisdom and tranquility has been the defining trait of his professional
life. Whether economies across Asia are contaminating each other like kids on a school bus or the
Mexican government rises one morning and decides to devalue the peso, Rubin's hooded eyes and
perpetually mussed gray hair give him the air of an ancient Galapagos tortoise. Whatever
nastiness politics or the global economy may throw at him, he abides.

Constant Demand
This legendary stillness, combined with decades of economic and market expertise, keeps Rubin in
constant demand. Since 2007 he's been the co-chairman of the Council on Foreign Relations,
where he maintains a disheveled office and employs his longtime assistant. He's considered the
intellectual father of the Hamilton Project at the Brookings Institution, which examines the
relationship between government spending and unemployment. He's a regular participant at the
annual Bilderberg Meetings (so secretive they make Davos look like an American Idol taping) and
a member of the Harvard Corporation, the discreet board that runs his alma mater. He also meets

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regularly with congressmen and foreign leaders and has access to the Obama administration
through Timothy Geithner and other proteges. In 2010 he joined Centerview Partners, an advisory
investment banking boutique, as a counselor to founders Blair Effron and Robert Pruzan.

Pivotal Role
It's enough to keep a 74-year-old plenty busy. But not enough to shake questions about just how
wise and thoughtful Robert Rubin really is, especially on the fourth anniversary of a financial
crisis in which he played a pivotal, under-examined role. Rubinomics -- his signature economic
philosophy, in which the government balances the budget with a mix of tax increases and
spending cuts, driving borrowing rates down ~ was the blueprint for an economy that scraped the
sky. When it collapsed, due in part to bank-friendly policies that Rubin advocated, he made more
than $100 million while others lost everything. "You have to view people in a fair light," says Phil
Angelides. co-chair of the Financial Crisis Inquiry Commission, who credits Rubin for much of the
Clinton era prosperity. "But on the other side of the ledger are key acts, such as the deregulation of
derivatives, or stopping the Commodities Futures Trading Commission from regulating
derivatives, that in the end weakened our financial system and exposed us to the risk of financial
disaster."

Taxpayer Money
After he stepped away from Treasury in 1999, Rubin moved to Citigroup, and until 2009 he served
as chairman of the executive committee and, briefly, chairman of the board of directors. On his
watch, the federal government was forced to inject $45 billion of taxpayer money into the company
and guarantee some $300 billion of illiquid assets. Taxpayers ended up with a 27 percent stake in
Citigroup, which was sold in 2010 at a cumulative profit of $12 billion. Rubin gave up a portion of
his contracted compensationand was still paid around $126 million in cash and stock during a
tenure in which his serenity has come to look a lot more like paralysis. "Nobody on this planet
represents more vividly the scam of the banking industry," says Nassim Nicholas Taleb. author of
The Black Swan. "He made $120 million from Citibank, which was technically insolvent. And now
we, the taxpayers, are paying for it."
Evaluating Rubin's role in the financial crisis is a tough task made tougher by the fact that the
tortoise has retreated into his shell. Once famously adept at working the press the author of a
2007 American Prospect profile noted that he "literally could not find a single feature piece that
was, on balance, unflattering" Rubin has turned down countless interview requests over the past
four years, including several for this piece.

Declines Interview

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Which is not to say he dismissed the idea lightly. After an April event at the Council on Foreign
Relations, Rubin appeared in the building's Park Avenue lobby. His white Brooks Brothers shirt
was fraying, and his gray suit looked rumpled enough that he might well have slept in it the night
before. He was carrying an old-fashioned Redweld legal folder, filled with papers, when he pulled
me aside. "I have been working hard to try to balance my work-life issues," he said, explaining why
he'd deliberated for months about whether to talk on the record. "I have been really busy, and I am
not sure I have the right balance." A few weeks later a representative conveyed that it was a close
call, but Rubin would be heeding advisers who urged him not to speak. Instead, he dispatched his
friends to speak for him.

Goldman Sachs
During his 26 years at Goldman Sachs (GS), Rubin rose from trader to the corner office, and along
with his partner, Stephen Friedman, helped transform Goldman from an investment bank into
shorthand for financial dominance. Goldman has made thousands of people, including Rubin, very
rich. But the firm's reputation for avarice has also created a cloud that follows its all-star alumni
into civic life. The case against Rubin's performance as a public servant is mainly about that cloud.
As Treasury Secretary, was he motivated by a desire to serve the people, or an opportunity to serve
himself and his friends?
"Most people see him as your sort of archetypical buttoned-down Wall Street guy," says President
Clinton, acknowledging the perception that Rubin favored the financial sector. Clinton, for one,
doesn't buy it, and cites numerous examples of Rubin advocating for policies that ran counter to
his own economic interest. "When we had to give up the broad- based middle-class tax cut to reach
our deficit reduction targets, he was one of the strongest supporters I had in not giving up the
proposal to double the Earned Income Tax Credit. He said, 'We can't do that. It'll move millions of
poor people who are working out of poverty.' You wouldn't expect somebody who had spent a
career on Wall Street, making and helping other people make millions and millions of dollars, to
be in there arguing. But he was just as strong as [Secretary of Labor Robert] Reich was. He said,
'We've got to keep that.' And we took a lot of heat for it."

Selfless Attitude
Rubin's selflessness, whether in economic policy or the day-to-day management of the Treasury, is
a frequent theme of his admirers. Sheryl Sandberg, the chief operating officer of Facebook, worked
at Treasury after she graduated from Harvard Business School in 1995. In her first meeting with
Rubin and a dozen senior staffers, she hid in the back of the room, hoping to turn invisible. "I'm
young and brand new at Treasury, and I did not know much," says Sandberg, now 43. Rubin called
on her anyway. "He said, 'You're new. You may see things we're missing.' And it was a really
powerful lesson, because he was showing everyone that you take opinions and you get feedback

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from everyone. He wasn't going to be curtailed by hierarchy or titles."

Encourage Questions
She says Rubin was spectacularly self-aware, and taught her that people will "overreact to things
you do when you are senior," especially in places like Goldman Sachs and the U.S. Department of
Treasury. "He'd start, I'm going to say this really carefully. Here's what I mean. Here's what I
don't mean,'" recalls Sandberg. "More importantly, he encouraged everyone to ask questions. He
said, 'If you have questions, come to me.'"
Peter Orszag, another Rubin protege who later became President Obama's director of the Office of
Management and Budget (and is now a managing director at Citigroup and a contributor to
Bloomberg View), had a similar experience as a junior White House staffer. In a meeting with
Rubin, the Secretary bungled a calculation, transposing a billion dollars for a trillion. Orszag
scribbled a correction on a note in an attempt to help Rubin save face. A week later, Orszag's
phone rang. "[Rubin] was abroad, like in Italy or somewhere," Orszag says. "He called to tell me he
was going through his briefcase and he came upon my note, and I was right. He just wanted to tell
me that I was right. Most Treasury Secretaries would not do that."

Riles Critics
It's not his personality that riles critics of Rubin's four-and-a-half-year tenure at Treasury. It's his
failure to tame the 1999 repeal of Glass-Steagall and the wild expansion of over-the-counter
derivatives, which were traded between banks, out of the public eye. "The changes that Robert
Rubin drove through in the 1990s certainly helped plant the seed for [the] collapse," says
Angelides.
Rubin's legion of defenders stir at any mention of Glass- Steagall, the 1933 law that separated the
activities of commercial and investment banks. "There is an assumption that Bob was pushing
hard for the repeal," says Michael Schlein, a former chief of staff at the Securities and Exchange
Commission and a former Citigroup executive. "I was there. That's not the way it happened."

No Restrictions
In testimony before the Financial Crisis Inquiry Commission in March 2010, Rubin conceded that
he "was an advocate of rescinding Glass-Steagall." But: "By the time we rescinded it, there were no
restrictions left in it at all except for the insurance underwriting, which had no relevance to
anything that has happened since then." What Rubin meant was that commercial banks had long
been able to underwrite debt and equity and advise on mergers and acquisitions, and they had
been buying investment banks through much of the 1990s. Rubin told the FCIC that ditching
Glass-Steagall removed the "cumbersomeness" experienced by banks already in those businesses.

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In other words, he argued, he pushed for the removal of a law that was a phantom.
"Of course, it would have been better if we'd had the foresight and political strength to put in place
the protections that were put in place in 2010 after the financial crisis occurred," says Larry
Summers. Rubin's friend and successor as Treasury Secretary. "But this does not relate to the
repeal of Glass-Steagall. There were virtually no restrictions on the investment banking activities
of the major banks after the Federal Reserve's undertakings during the decade before GlassSteagall was repealed." Speaking at a CNBC forum on July 18, Rubin said simply, "It is a myth
that the repeal of Glass- Steagall contributed to the financial crisis."

Not Consensus
This is no longer the consensus. Aside from Paul Volcker. several of Rubin's ex-Citigroup
colleagues have recently revised their opinions. In an October 2009 letter to the New York Times,
John Reed, the co-chief executive officer of Citigroup from 1998 to 2000, wrote: "As another older
banker and one who has experienced both the pre- and post-Glass-Steagall world, I would agree
with Paul A. Volcker (and also Mervyn King, governor of the Bank of England) that some kind of
separation between institutions that deal primarily in the capital markets and those involved in
more traditional deposit-taking and working- capital finance makes sense." Richard Parsons, the
former Citigroup board chairman, told a Washington audience this past spring that "to some
extent, what we saw in the 2007-2008 crash was the result of the throwing off of Glass-Steagall."
Most famously, Sandy Weill told CNBC in July 2012 that the law's reinstatement in some form is
necessary to restore confidence in the financial system. "Have banks be deposit takers, have banks
make commercial and real estate loans," Weill said. "And have banks do something that will not
risk taxpayer dollars."

Political Convenience
Summers dismisses this as revisionism, warped by hindsight and political convenience. Instead,
he offers a syllogism: If permitting the combination of commercial and investment banks caused
the financial crisis, why was fixing it so dependent on commercial banks buying investment
banks? True enough, many companies that took advantage of Glass-Steagall's repeal (Citigroup,
JPMorgan Chase, Bank of America) still exist. Souvenirs from the standalone investment banks
(Bear Stearns, Lehman Brothers, Merrill Lynch) are available on EBay.

Derivatives Regulations
In part because of its complexity, less attention has been paid to Rubin's role in the unleashing of
the over-the-counter derivatives market. In March 1998, Brooksley Born, chairman of the CFTC,
wanted to release a "concept paper" that would raise a series of questions about the possible

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regulation of derivatives. "I was very concerned about the dark nature of these markets," Born told
the Washington Post in 2009. "I didn't think we knew enough about them."
Born's plan was to have the CFTC oversee these new, often inexplicable financial products. Rubin,
Summers, Federal Reserve Chairman Alan Greenspan, and Securities and Exchange Commission
Chairman Arthur Levitt countered that Born was out of her depth. (Levitt is a board member of
Bloomberg LP, which owns Bloomberg Businessweek.) They argued that the CFTC, created in the
1970s to regulate futures contracts bought by farmers, didn't have the authority or expertise to
regulate complex derivatives in a fast-expanding market. Born was no match for their firepower.
They persuaded Congress to ignore her.

Fed Bailout
In his 2003 memoir, In an Uncertain World, Rubin wrote that he favored making derivatives
"subject to comprehensive and higher margin limits." He just didn't support doing it Born's way,
which he called "strident." But if Rubin and others had an alternative plan, they didn't offer it up
quickly enough. In September 1998 the Long Term Capital Management hedge fund melted down,
thanks in part to $1.6 billion in losses on interest rate swaps. The Federal Reserve Bank of New
York had to organize a $3.6 billion bailout by its major creditors to avoid infecting the rest of the
market. Then-House Banking Chairman Jim Leach (R-Iowa), who opposed giving the CFTC
regulatory authority, introduced Born at a hearing by saying, "You're welcome to claim some
vindication if you want."
Even now, Summers thinks he and Rubin were right to fight Born's power grab. "Our concerns
were not with respect to the desirability of derivatives regulation," Summers says. "Career lawyers
at the Fed, the SEC, and the Treasury insisted that the CFTC's proposed approach would raise
potentially grave questions about the enforceability of existing contracts." Born, Summers adds,
didn't know what she was attempting to regulate, making it as much of a reach to credit her with
prophesizing the financial crisis as it is to hold Rubin or Summers responsible for failing to
prevent it. "It should be noted," adds Summers, "that the credit-default swaps and the
collateralized-debt obligations that were central to the crisis barely existed at the end of the
Clinton administration." Born declined to comment for this story.

Judgement Errors
Greenspan, Levitt, and others have conceded errors in judgment that, upon reflection, may have
created conditions that led to the crisis. Clinton, too, wishes he had a few mulligans. The president
says he raised concerns about derivatives and their lack of regulation to Greenspan, though not to
Rubin. "I should have aired the debate we had in private in public," Clinton says, "and at least
raised the red flag."

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Rubin hasn't looked back, at least not publicly. Those close to him say that he dealt with the facts
of the financial markets as they presented themselves and was without outside influences. If Rubin
failed to focus on the future ramifications of a few key policy decisions, it might be because he was
fighting global crises in the present. He was also persuading a president under constant political
attack to implement Rubinomics. Having your name attached to the policy that led to the largest
postwar expansion in American history is a pretty effective way to obscure other controversies.
"Bob has been acclaimed as the most effective Treasury Secretary since Alexander Hamilton," said
Clinton on July 2, 1999, the day Rubin departed as Treasury Secretary. "And I believe that acclaim
is well deserved."

Courted Relentlessly
In September 1999, after stepping down from Treasury, Rubin and his wife, Judith Oxenberg,
threw a return-to-New-York party for themselves at the Metropolitan Museum of Art. Already,
Rubin was being pursued by Sandy Weill to join Citigroup. Weill couldn't stand the thought of the
ex-Treasury Secretary landing with a competitor. "He had the best reputation of anybody in the
financial industry," Weill says. "Here we were putting together a company that was the biggest,
most important financial company in the world, and he [could] really be helpful if he accepted."
Weill courted Rubin relentlessly for five weeks and promised that Rubin would join him and Reed
in a three-person office of the chairman. Rubin's responsibilities would be to craft Citigroup's
management and strategic decisions. He would have no direct reports. "Bob has the best job in the
company: no line responsibility, but he will be a full partner," Reed said in announcing Rubin's
role. Rubin would also receive $15 million a year and unlimited use of the company's fleet of
corporate jets.

Public Intellectual
When he began at Citigroup, Rubin made it clear that he wasn't looking for a quiet and
remunerative third act. In various contemporaneous interviews he expressed his intent to be a
bank officer and a public intellectual, someone perched at the intersection of markets and
government who would serve the best interests of both. "One reason I wanted to come to
Citibank," Rubin told the New York Times in 2002, "is that being immersed in what is going on
the financial issues, the economic issues would keep me current in a way that would make me
better equipped to be useful in public policy. It puts me more at the center of things."

Bank Reform
For a while he was just where he said he wanted to be, advising Senate Majority Leader Tom
Daschle (D-S.D.) on economics and debating Chinese Prime Minister Zhu Rongji on bank reforms,

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while running the company with Weill and Reed and attending to Citi's clients and prospective
clients around the world. There was an early and foreboding misstep, though. During the Enron
scandal in 2001, Rubin called Peter Fisher, under secretary of the Treasury for domestic finance,
and asked if the Bush administration might find a way to intervene and avoid a downgrade of
Enron's credit rating. Later, Rubin said that even though Citigroup faced huge losses the bank
ultimately paid $3.66 billion to settle legal claims against it and lost billions more when Enron
cratered -- he had placed the call as both a bank executive protecting a financial position and a
concerned former Treasury official. "I'd do it again," he told the New York Times, brushing off even
the perception of a conflict of interest.

Shareholders, Public
The idea that a bank official can serve shareholders and the interests of the American public
simultaneously might have been naive. It might have been monomaniacal. Either way, it would
prove impossible.
In the runup to the financial crisis, Citigroup was a leader in packaging risky mortgages by the
billions and selling them to investors in the form of mortgage-backed securities and
collateralized-debt obligations, as well as leveraged-buyout loans, and tried to hide much of what
it was doing by packaging the securities into off-balance-sheet investment partnerships. In a
November 2008 story, Eric Dash of the New York Times reported that, starting in late 2002,
Rubin and Chuck Prince, then the head of Citi's investment bank (and later its CEO), advocated
ratcheting up the risk-taking at Citigroup, using strategies from Rubin's days as head of risk
arbitrage and co- head of fixed income at Goldman Sachs. In the end, bank losses totaled more
than $65 billion ~ at least half of which came from mortgage-related securities.

Fixed Income
Michael Schlein, whose office at Citigroup was next to Rubin's, says he attended a 2005 meeting
in which Tom Maheras, then head of Citigroup's fixed-income division, along with consultants
from the firm Oliver Wyman, recommended that the division should be taking more risk, given the
size of its balance sheet. Schlein recalls that after the presentation, Rubin concurred, but was
unequivocal about the need for proper risk management and compliance if the firm was going to
take on more risk. "That's what Eric Dash got wrong, and now it has taken on a life of its own,"
Schlein says. "Eric paints a picture of Bob banging on the table, demanding that Citi take more
risk. It's not even close to who Bob is. It's just wrong." Dash, now a senior adviser for policy and
communications at Treasury, stands by his story.

'Force Majeure'

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Rubin has said that Citigroup's losses were the result of a financial force majeure. "I don't feel
responsible, in light of the facts as I knew them in my role," he told the New York Times in
April 2008. "Clearly, there were things wrong. But I don't know of anyone who foresaw a perfect
storm, and that's what we've had here."
In March 2010, Rubin elaborated in testimony before the Financial Crisis Inquiry Commission.
"In the world of trading, the world I have lived in my whole adult life, there is always a very
important distinction between what you could have reasonably known in light of the facts at the
time and what you know with the benefit of hindsight," he said. Pressed by FCIC Executive
Director Thomas Greene about warnings he had received regarding the risk in Citigroup's
mortgage portfolio, Rubin was opaque: "There is always a tendency to overstate ~ or overextrapolate ~ what you should have extrapolated from or inferred from various events that have
yielded warnings."

Defective Mortgages
Richard Bowen, a former senior banker at Citigroup, says that in 2006 he repeatedly warned
senior management, including Rubin, that he believed 60 percent of the mortgages the firm was
buying and stuffing into mortgage-backed securities were defective. "Obviously it's very tragic that
my warnings were ignored," says Bowen, who was relieved of his duties in January 2009 and now
is a senior lecturer at the University of Texas, Dallas. "Rubin was the primary contact as well as
the other executive officers. He was on the board of directors. He was chairman of the executive
committee. He was about to be named chairman of the board. Who better to alert about the
situation?"
Angelides, the FCIC's co-chair, was "disappointed" by Rubin's testimony. "I didn't see him
stepping forward and accepting the responsibility of the disaster that Citigroup was," he says, "and
for the impact it had on the taxpayers and our financial system. Citigroup required massive federal
assistance to save it~$45 billion of Troubled Asset Relief Program funds, $300 billion in
ring-fencing of its assets. I just don't think you can be in that kind of leadership position, get paid
more than $115 million, and ultimately disclaim any responsibility for the fate of the ship you
helped captain." If Rubin disavowed any role in enfeebling Citigroup, he was nearly invisible in
the frantic year between November 2007, when Chuck Prince resigned in the wake of billions of
dollars in Citigroup losses, and November 2008, when the federal government bailed out
Citigroup.

Board Chairman
Between Prince's departure and the appointment of Win Bischoff, Rubin served five weeks as
chairman of the board. He accompanied investment banker Michael Klein to Abu Dhabi to raise a

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$7.5 billion investment in Citigroup from the Abu Dhabi Development Authority, but wasn't
involved in the fund's due diligence for the investment or in the negotiation of the deal. In
testifying to the FCIC about those five weeks, he made it sound as if he was as ceremonial as the
groom atop a wedding cake.
Even though he remained a senior executive and sat on the board of directors after stepping down
as chairman, Rubin did not attend meetings at Bear Stearns during the firm's collapse in
March 2008, nor was he at any of the infamous September New York Federal Reserve sessions
when Merrill Lynch, Lehman Brothers, and AIG each went down the tubes, or nearly did. Rubin is
mentioned only in passing in the 624 pages of Andrew Ross Sorkin's Too Big to Fail, a 2009
narrative of the crisis. "He was a sounding board for Vikram [Pandit] and a voice of calm for
employees and clients," explains Steven Lipin, Rubin's spokesman at the public-relations company
Brunswick Group. "He played a stabilizing role within Citigroup. Clients and internal executives
looked to Bob for guidance and to broadly help stabilize the bank during this very scary period."

Assert Control
Citigroup's new CEO, Pandit, may have wanted to assert control over the company's perilous
future, but there was one errand Rubin was asked to handle. On Nov. 19, 2008, as Citigroup's
prospects were deteriorating rapidly, Rubin called Treasury Secretary Hank Paulson. According to
Paulson's memoir, On the Brink, Rubin "put the public interest ahead of everything else" and
"rarely called me," so the "urgency in his voice that afternoon left me with no doubt that Citi was
in grave danger." Rubin told Paulson that "short sellers were attacking" Citigroup's stock, which
had closed the day before at $8.36 per share and was "sinking deeper into the single digits."

Represent Stocks
In his testimony to the FCIC, Rubin disputed Paulson's recollection. "I don't think that mine was a
Citi-specific call," Rubin said. He claimed his intent was to represent all the bank stocks being
pecked to death by short sellers, and to alert Paulson to the severity of the problem. "I think mine
was a general call."
Paulson's call log from those months is filled with bank CEOs asking for help, and it wouldn't have
been strange for Rubin to do so, too. Rubin's insistence that his was "a general call" seems a last
attempt to reinforce his role as the ethical colossus linking banking and the public, or a final
statement of detachment from Citi. Whatever the case, he didn't appear to be willing to put his
credibility as a wise man on the line at a moment of reckoning.

Crucial Moment
It's a mystery why Rubin vanished at such a crucial moment in the nation's financial history, but

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there were distractions. In October 2007, as Citigroup was imploding, Rubin went to South Beach
to visit his father, who died a year later at 101. In line at an upscale grocery, he met Iris Mack. One
of the first African American women to get a Harvard Ph.D. in applied mathematics, Mack also
worked at Enron and the Harvard Management Co. Over the next 14 months, Rubin pursued her
romantically. They would meet, according to Mack, in his Ritz- Carlton Hotel suite, where he
would stay after flying in on the Citigroup corporate jet. "It's one of the perks," Mack says Rubin
told her.
This is not news, but it does call into question how hard Rubin was working for his $15 million
annual salary. Mack, who is single and 46, wrote about her relationship with Rubin in an
April 2010 Huffington Post article. She decided to go public after watching Rubin testify before the
FCIC. "I really think he was in a vacuum, a little bubble," Mack says now. "I don't think all these
people start out as evil creatures, but you get in this environment, like we were in Wall Street and
Enron, and it's so much stuff thrown at you...If you don't have your head on straight, you can get
totally screwed."

'Good Liar'
Mack enjoyed Rubin's company. "But the more I talked to him, I realized he was a good liar," she
says. "I point-blank asked the guy if he was married. He never did answer a simple damn question.
He would say stuff like, 'Well, are you married? Have you ever been married?' So it got to the point
where I would still talk to him, but eventually I started ignoring him, or he would come down
[and] I would lie and tell him I was out of town. I just felt like the guy had a double personality."
"Listen, nobody's perfect," says Sandy Weill. "I'm sure you've heard all sides." Weill says that
Rubin was "extremely" helpful to him during his years at Citi, but that he can't account for what
happened after his departure in October 2003. (Weill remained non-executive chairman of the
Citigroup board until April 2006.) "Unfortunately, something happened that was not very pleasant
for a lot of people and not very pleasant for a lot of people that worked for the company. It was very
sad."
Like many Rubin defenders, Sheryl Sandberg suspects that her mentor has become a scapegoat for
events beyond comprehension. "My own view is that, look, these have been hard times, and people
need people to blame," she says. "It doesn't mean they blame the right people."

'Teflon Don'
Nassim Nicholas Taleb doesn't know Rubin personally. He admits that his antipathy, like that of
so many Rubin critics, is fueled by symbolism. "He represents everything that's bad in America,"
he says. "The evil in one person represented. When we write the history, he will be seen as the

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John Gotti of our era. He's the Teflon Don of Wall Street." Taleb wants systemic change to prevent
what he terms the "Bob Rubin Problem" -- the commingling of Wall Street interests and the public
trust --"so people like him don't exist."
People like Rubin brilliant, powerful, and fueled by certainty will always exist. They'll act
selfishly and selflessly. They'll advance whole societies and their own interests, and their
paradoxes will be endlessly debated. "This is a guy who is as controlled as any human being I
know," says Sandy Lewis, who as an arbitrageur worked with Rubin at Goldman Sachs. "He's
pleasant company. He's compulsively dishonest in a certain way, and compulsively honest in other
ways." Nobody's perfect. But for $126 million, they ought to show up.
To contact the reporter on this story: William D. Cohan at wdcohan@yahoo.com.
To contact the editor responsible for this story: Josh Tyrangiel at jtyrangiel@bloomberg.net
2012 BLOOMBERG L.P. ALL RIGHTS RESERVED.

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