IN THIS CHAPTER

Seeing where investment bankers have suffered some big black eyes

Finding out how mistakes lead to blunders that hurt investors and the financial markets

Grasping how investment bankers can feed into manias that end badly

Recalling lessons learned from big investment banking mistakes

Investment bankers are supposed to be among the smartest people in the room. Many have trained at the top business schools, hired at high salaries, and live a life of great access to not only capital but knowledge.

But despite their collective brainpower, along with the talent and tools available to investment bankers, the industry has suffered some of the most egregious blunders ever witnessed in modern business. Because investment banking operations are so tightly woven with the financial system, even a minor misstep can have major ripple effects through the entire economy. A bad bet by an investment bank on an obscure financial instrument tied to home loans in Alabama can flow through the system and cause an investor in seemingly unrelated securities in California to lose money.

Such interconnectedness of investment banking with the rest of the economy is a big reason why it’s so closely regulated and why the term too big to fail was coined. The importance of investment banking to our financial system and our economy as a whole is why investors need to not only remember some of the profession’s darkest days, but learn from them as well.

The Dot-Com Boom and Bust

When it comes to the biggest black eyes ever suffered by the investment banking industry, the Internet stock bubble certainly makes the Hall of Shame as a first ballot inductee. During the late 1990s and in early 2000, demand for shares of Internet companies was raging. Investors, many of whom had never bought stocks before, saw the Internet as being the biggest engine of wealth creation since the Industrial Revolution. Investors didn’t want to get left out, so they bought stock in virtually any firm with dot-com in the name.

The problem was many of the investors buying into these fledging companies, many of which didn’t have any revenue — much less earnings — didn’t understand what they were buying. Many investors simply didn’t take the time to read the prospectuses and just piled in hoping to ride these stocks for short-term gains and then unload the shares to someone else. It truly was “the greater fool theory” in action.

Meanwhile, investment bankers were happy to keep shoveling out the Internet IPOs. Shares of companies with dot-com after their name dominated the IPO market. Many of these companies coming public had no business being public, because many of their operating models were flawed and wouldn’t stand the test of time.

A vast majority of the Internet companies that went public during the late 1990s and 2000 crashed and burned in spectacular fashion. Perhaps the most dramatic way to see how much demand there was brewing for Internet stocks was by examining the massive first-day gains realized by these issues. The IPOs were priced and sold to the lucky investors at the offering price. But then, when the shares hit the stock market for the first time, investors poured in, sending the shares skyrocketing. You can see the biggest first-day run-ups in Internet IPOs in Table 19-1.

Tainted Research Scandals

There was plenty of blame to go around for the Internet bubble of the late 1990s and 2000. Certainly, overenthusiastic and under-informed investors who piled into shares of untested and often unprofitable companies created a mania that ended very badly.

But the dot-com boom and bust also highlighted a problem with investment bankers’ stock research teams. Investment bankers that provide research reports to clients are supposedly objective analysts who assess a company’s prospects and advise clients on whether to buy the shares or avoid them.

It turns out, though, that in some cases the investment bankers’ research divisions were doing more salesmanship than unbiased analysis. It was routine for the research arms of investment banking firms to provide glowing research on many of the same Internet companies that their firm was taking public. Outlandish price targets and earnings projections helped feed the Internet mania.

A series of investigations by the Securities and Exchange Commission (SEC) and other regulators found that securities analysts paid and encouraged investors to use their reports to help the investment bankers win lucrative investment banking business. These allegedly tainted reports lured in investors with trumped up research, just to line the pockets of the investment banks, regulators found.

And the penalties were severe, resulting in what’s called the Global Analysis Research Settlements. Ten investment banks, including the giants at the time — Goldman Sachs, Merrill Lynch, and Morgan Stanley — were charged disgorgement and civil penalties of $875 million. Meanwhile, former investment bankers Jack Grubman and Henry Blodget agreed to pay $7.5 million and $2 million penalties, respectively, as part of the settlement and were both barred from working in investment banking again. Neither Grubman nor Blodget admitted or denied guilt.

Enron and the Accounting Scams

Accountants aren’t known for being on the front pages. But accounting news dominated the front pages in 2001 and 2002 as bad bookkeeping and outright financial fraud were unearthed early in the decade. But investment banking got pulled down a notch, too.

Enron and WorldCom still rank among some of the biggest debacles in the financial world. These two companies ended up declaring some of the largest bankruptcy filings in U.S. history, as you can see in Table 19-2.

It’s hard to pinpoint the single source of blame for the accounting crises at Enron and WorldCom. But investment banking certainly played a role, especially in the Enron case. Part of Enron’s downfall had to do with the company morphing from being a stable energy company to getting involved in riskier business activities, but without having the proper controls.

The Mortgage Debacle and Collapse of Lehman

Do you have a pulse? If the answer is yes, you had all it took to get a mortgage in 2006. Investment bankers, tired of the deal market for IPOs and stocks, saw the housing market getting red hot. Suddenly, investment bankers got very interested in real estate. The result was disastrous for the economy and the housing industry and proved fatal for some investment banking firms like Lehman Brothers.

The ultimate bankruptcy of Lehman (also appearing in the list of big companies filing for bankruptcy in Table 19-2) not only spooked the financial markets and helped spark the financial crisis of 2007, but killed off one of the oldest and most prestigious U.S. investment banks.

At the core of the issue was the explosion of subprime mortgage loans. In the old days, homebuyers would visit a local bank and get a loan. That bank would hold the loan and collect the interest on it. But investment banks revolutionized the mortgage business with securitization. The investment banks would make or buy mortgages and bundle them into securities that would be sold to outside investors looking for higher yields than were available for U.S. government bonds.

Lehman was especially aggressive in the area, and was focused on making loans to buyers with shakier credit, called subprime loans. Lehman would bundle these risky loans up and hope to sell them in a financial game of hot potato. The models used to value these securities had many faulty assumptions — the most important assumption being that large numbers of borrowers would not default at once. But when the housing market stopped rising, the music stopped, many borrowers couldn’t service their loans, and Lehman was left holding the bag.

The Flash Crash

May 6, 2010, was a regular trading day when all of a sudden crisis hit. In just a matter of minutes, the Dow Jones Industrial Average plunged a jaw-dropping 1,000 points, only to recover just as quickly. The markets were already jittery over the European debt crisis at the time, which was accompanied with civil unrest in Greece.

It took months before regulators could even begin to explain what happened to seriously rattle investors on the day of the Flash Crash. Some of the culprits included high-frequency trades (buys and sells entered, usually by computer programs, to take advantage of short-term swings). But the reasons for the crisis are debated even to this day.

The London Whale at JPMorgan Chase and Barings Bank

Proprietary trading represents a significant source of revenue for most investment banks during most time periods. However, sometimes investment banks have losing streaks from proprietary trading, and it costs the firms. Large trading losses are embarrassing episodes for investment banks. After all, how can investment bankers say they’re the smartest people in the room, and charge a fee to advise others on trading strategies if they lose money on their own trades? But in extreme cases, trading losses can even be so severe as to destroy a firm.

The so-called London Whale case at JPMorgan qualifies as an embarrassing episode. One of the firm’s traders, Bruno Iksil with the cool nickname “London Whale,” made a number of bad bets on credit default swaps, or financial instruments that allow investors to buy and sell risk. (For more on credit default swaps, see Chapter 16.) The bad bets resulted in JPMorgan having to report a loss of $2 billion at its original estimate, which got even bigger after all the trades were unwound. The bad moves also resulted in an investigation into the company’s risk controls.

The trading losses at Barings Bank were much more severe, so severe, that they put an end to the storied banking firm that traced its roots to the mid-18th century. Barings fell apart again at the hands of a rogue trader by the name of Nick Leeson, who was making aggressive bets on the speculative future market out of the bank’s Singapore office.

Long-Term Capital Management

Investors have had their fair share of scares through the years. But when it comes to one of the biggest “uh-oh” moments, the collapse of asset management firm Long-Term Capital Management comes to mind.

Long-Term Capital Management was a hedge fund founded by John Meriwether, formerly a legendary bond trader at Salomon Brothers. The board of directors at Long-Term Capital Management was composed of some of the best and brightest minds in finance and included among its ranks Noble Prize winners in finance.

These high-powered financiers thought they’d found a way to outsmart the market. They used complicated trades that capitalized on differing prices of U.S., Japanese, and European bonds. The strategy relied on the relationships between the securities reverting to the mean and worked fantastically in the early years, and investors poured money into the firm.

But as quickly as things ramped up, they unraveled. Long-Term Capital Management took a hit during the 1997 East Asian Financial crisis, when many of its trades went against it. But the wheels came off in the 1998 Russian financial crisis, when the Russian government defaulted on bonds. The event sent investors scurrying to buy U.S. treasuries and dump Japanese and European bonds. That was something the Long-Term Capital Management team didn’t foresee and their fancy models didn’t anticipate. This resulted in the implosion of their trading system. As Long-Term Capital faced big losses, it was forced to sell its positions, putting the market in a tough spot. Long-Term Capital was so interwoven in the financial system, and counted many investment banks as customers and counterparties, that its poor health was a threat to the system.

At one point, several massive investors including Warren Buffett offered to bail out the firm. But those efforts were declined. Things got so ugly that the federal government stepped in to organize a bailout including funds from many of the top investment banks.

Long-Term Capital Management offered an early glimpse at how interconnected the financial system is. Essentially, LTCM was the genesis of the concept of “too big to fail.”

Bankruptcy in Jefferson County, Alabama

Municipal bonds, as described in Chapter 11, are supposed to be among the safest investments around. They’re designed to be decent investments for widows and orphans. Very few municipal bonds have suffered a default.

But the muni bond market suffered a massive shock in November 2011, when Jefferson County, Alabama, filed for bankruptcy. It was one of the biggest ever municipal bankruptcy filings, involving debts of more than $3 billion.

The county’s woes were connected to the construction of a sewer system that was supposed to cost about $300 million, according to the BBC. But it turns out the system ended up costing $3.1 billion due to construction problems and bum investment bets on bonds and derivatives. The SEC wound up charging J.P. Morgan Securities and two of its former directors of “an unlawful payment scheme” that allowed them to profit from Jefferson County’s bond offerings.

Although municipal woes are extremely ugly, they’re not unheard of. The idea that a county the size of Orange County, California, could file for bankruptcy protection was almost unimaginable until 1994. That year the county in Southern California went that way, creating a permanent stain on the once pristine world of municipal bonds. A series of bad bets on risky investment products called derivatives were largely to blame. Yet the prize, if you can call it that, for the biggest municipal bankruptcy occurred on July 18, 2013, with the city of Detroit. Detroit’s bankruptcy filing was estimated to involve debt valued at upwards of $20 billion.

IPO Allocations with CSFB

When companies go public, it’s an exciting time for the CEOs, management teams, and other employees. But it’s also a big win for investment banks and their clients. Investment banks as part of the underwriting process will get shares of the IPO. And during heady times, these shares are like the Golden Tickets in Roald Dahl’s classic book, Charlie and the Chocolate Factory. There have long been investigations into whether investment banks have used their shares of lucrative IPOs to curry favor with other executives to win additional investment banking business.

A landmark settlement in this area arose in January 2002, when the SEC filed charges against Credit Suisse First Boston for “abusive practices relating to the allocation of stock in ‘hot’ initial public offerings.’” The firm paid a $100 million resolution. Among the infractions, according to the SEC, CSFB “extracted” some of the profits its customers gained by quickly selling Internet IPOs like Gadzooks Networks and MP3.com. The SEC said that CSFB gave shares of hot IPOs to more than 100 of its customers, who returned 33 percent to 65 percent of their IPO profits to CSFB. “CSFB wrongfully obtained tens of millions of dollars in IPO profits through this improper conduct,” the SEC found.

Bad Mergers and Acquisitions Like AOL Time Warner

Investment bankers love mergers and acquisitions (M&A). These deals generate huge fees for the investment bankers as companies buy and sell each other in an effort to create value for shareholders.

But while M&A are hugely profitable for investment bankers, and one of their top lines of business, the track record of M&A deals isn’t all that great. Although difficult to quantify, there’s no shortage of mergers that go wrong. When a company announces plans to buy another company, it will generally see immediate destruction of shareholder wealth and a reduction of its stock price.

Even today, the combination of AOL, the Internet content and access company, with media giant Time Warner is a poster child for M&A deals gone wrong. At the time of the deal, AOL was known as America Online. America Online paid an estimated $124 billion to buy Time Warner in the deal announced in 2000, just before the Internet bubble burst.

But the deal failed to produce any significant benefits for either firm. AOL, facing competition for access from telephone and cable companies, saw its cash cow of selling monthly access drop off. On May 28, 2009, Time Warner announced it would spin off AOL into a separate company on December 9, 2009, after failing to find another company to buy it. Time Warner’s 95 percent stake in AOL was worth $6.3 billion based on estimates at the time. That marked a remarkable destruction in value from the price paid.