WASHINGTON — Big-name investment banks are taking a financial beating this year, leaving many Americans to ask: Just how did all these Wall Street bankers in their $5,000 John Lobb shoes manage to step in you-know-what?
The answer is simple: They made the same mistakes as the rest of us, just with more zeros attached to them and bigger consequences for the U.S. economy, if not for their own $625 John Lobb wallets.
Those mistakes are why the heads of Merrill Lynch and Citigroup have been ousted in recent weeks, why household names such as Bank of America and Wachovia are announcing billion-dollar losses and why more trouble is brewing.
Individual investors frequently lose money by chasing past returns, deciding on future investments by looking at past performance instead of future market conditions. Investment banks did just that amid the booming housing market. They mirrored each other's moves as they raced into ever-shakier lending. Some estimates suggest that collectively they'll lose more than $400 billion.
"They are basically a herd of sheep. They all go into it together," said A. Gary Shilling, a financial consultant and television commentator who warned in 2005 and 2006 of troubles to come. In the 1980s, banks followed each other into massive Latin American debt. Later, he said, they all got burned together by losses in manufactured housing.
In hindsight, the risks from an overheated housing market seem obvious. But in a now-famous July interview with London's Financial Times, then-Citigroup CEO Charles Prince appeared to confirm the sheep metaphor when he shrugged off the imminent danger.
"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing," he said.
Not anymore. Prince resigned on Nov. 4 with a golden parachute worth an estimated $43 million. His resignation came days after Merrill Lynch CEO Stanley O'Neal was forced out, taking with him compensation worth $160 million. Neither man had "dirt under the fingernails" experience in the complex mortgage-finance market.
With the notable exceptions of Goldman Sachs & Co. and Lehman Brothers, most Wall Street investment banks made the same fundamental miscalculation made by many average Americans who bought second homes or vacation properties as investments.
That mistake was assuming that home prices might flatten but wouldn't fall. Individuals believed they couldn't go wrong. Investment banks concluded the same, relying on complicated financial models dating back to the 1930s that showed that home prices defy the laws of gravity.
"They didn't realize that with rising house prices, things look very good, but they were lending to people that couldn't afford chicken coops but were in four-bedroom homes," said Shilling, who frequently warned about subprime mortgages given to borrowers with weak credit histories.
Investment banks didn't make the loans. They bought them from loan originators and packaged them together — called securitization — into special mortgage bonds to be sold to investors. The bonds were often mixed into another offering called a collateralized debt obligation (CDO), which blended assets and debt into a financial instrument that offered potentially huge returns to those with the stomach for risk.
This bundling helped many Americans get into their first homes. But in late 2005, according to the Federal Reserve, things went awry. Loan originators, many of them non-bank lenders such as now-bankrupt New Century Financial Corp., lent money without verifying borrowers' incomes. Borrowers inflated what they really earned to get into "McMansions" with exotic loans. And Wall Street asked few questions as it gobbled up loans for bundling.
It was all based on a somewhat irrational premise.
"Subprime credits and risky credits had been good for a long time. The number of defaults from real-estate loans and all that lending had been exceedingly small, and there was this notion by some that anything that is collateralized by real estate is safe because nominal real estate prices never go down," said Jeremy Siegel, the author of "The Future for Investors" and a finance professor at the University of Pennsylvania's Wharton business school.
Furthermore, economists trumpeted that business cycles were now longer and more stable while recessions had grown less frequent and shorter. The perception of risk fell, and so did the risk that premium banks calculated into their lending rates.
"There wasn't anything you could point to say, 'This is a really a bad bet,' like Internet stocks or other equity crazes that occur every so often," Siegel said.
Cheap money added to the missteps.
After the 9-11 terror attacks, the Federal Reserve lowered its benchmark short-term interest rate to 1 percent in June 2003, held it there until June 2004 and didn't bump it back above 3 percent until June 2005. Interest on deposits virtually vanished, and yields on long-term bonds and Treasury bills fell. Investors and investment banks were hungry for anything that seemed to promise higher returns.
The seemingly safe bonds comprised of bundled U.S. mortgages were just the fit.
Historically, the quasi-government company Freddie Mac has bundled mortgages for sale to conservative investors. But that gave way to an explosion of investment-bank bundling of mortgages, especially the bundling of riskier subprime loans.
In 2001, so-called private-label mortgage bonds totaled $95 billion, but by 2005 they surpassed Freddie Mac bundling and in 2006 totaled $450 billion. Subprime loans backed about 38 percent of private-label mortgage bonds, many carrying the adjustable rates that are now exploding.
Why didn't banks foresee problems? Like homeowners, they bet the store on rising home prices. And as Prince suggested in July, nobody wanted to be the first one to leave the dance floor.
Now, no one's quite sure how much worse things could get.
"We don't know whether we are in a freefall or near the bottom of this trough," said Jack Coffee, a law professor at New York's Columbia University and one of the nation's most influential lawyers on stock-market matters.
Investment banks are only now disclosing their real losses, and it echoes the accounting scandal that brought down energy giant Enron Corp. in 2001. Many investment banks sold mortgage bonds with a little-known take-back provision — called a liquidity put — that never appeared on balance sheets. It allowed investors to return the bonds if the market sours. Banks are suddenly writing down the value of their assets to the tune of billions of dollars.
"We thought after Enron that we had put an end to off-balance-sheet financing," said Coffee, who added that even directors of some investment banks were unaware of the take-back provisions. "Just six years after Enron we're seeing some of the same problems surface."
HERE'S A LOOK AT SOME OF THE RECENT MORTGAGE-BOND WRITE-DOWNS:
_ Citigroup: CEO Charles Prince resigned on Nov. 4. Nation's largest bank expected to write down $8 billion to $11 billion this quarter. Rival Goldman Sachs suggests Citigroup may be forced to write down $15 billion over the next two quarters.
_ Merrill Lynch: CEO Stanley O'Neal forced out on Oct. 30. Bank announced $8 billion write-down for the third quarter; analysts warn of a $10 billion write-down this quarter.
_ UBS: Swiss banking giant wrote down $3.4 billion in the third quarter, but reports suggest another $7 billion write-down may come in the fourth quarter.
_ Bank of America: Warned of a $3 billion write-down in the fourth quarter.
_ Bear Stearns: Said it will write down $1.2 billion in the fourth quarter; several funds tied to mortgage loans now closed or bankrupt.
_ Wachovia: Warns of fourth-quarter write-down in the ballpark of $1.1 billion.