Wall Street’s Fears on Lehman Bros. Batter Markets
New York Times, September 9, 2008
Where were you when Lehman failed?
On Wall Street, that question will likely be asked for many decades to come. After all, the collapse of Lehman Brothers, one of the leading investment banks, was the biggest bankruptcy in U.S. history and the critical inflection point of the financial crisis that swept across global markets in September 2008.
I was at a party. My host, Maggie Wilderotter, was the dynamic CEO of Frontier Communications, a significant telecommunications company that I was soliciting to switch its public listing to Nasdaq. (I would eventually succeed, though it took several years.) We had become acquaintances, and I was subsequently invited to a gathering at her Westchester, New York, home on Sunday, September 14, 2008. Her husband was a winemaker, and together they owned a vineyard in the Sierra Foothills region of Northern California. On this particular day, he was sharing his wines, and she was a gracious hostess, entertaining guests in the grounds of their beautiful house, when the pleasant hum of conversation was abruptly punctuated by multiple phones buzzing. The breaking news rippled through the party: Lehman Brothers, one of the oldest institutions on Wall Street, was rumored to be going bankrupt. Looking around at the Gatsbyesque scene—the manicured lawn, the well-dressed guests, the dappled sunlight reflecting off the wineglass in my hand—I had the sudden sense that it was all precarious, the calm before a gathering storm. Was this how people felt at the end of the Roaring Twenties, just as the Great Depression was about to hit?
Before I could reflect any further, I found myself the center of attention. Everyone seemed to want my opinion about what this meant. It was largely a New York crowd, but not necessarily from the finance industry, so I became the de facto expert. I didn’t have much to offer by way of reassurance. The markets already seemed to be hanging by a thread, and this was not the good news we were hoping for.
I generally consider myself to be a reliable person in a crisis—the one who stays calm as others start to panic. But in this situation, my mind was racing. What were the ramifications? What would it mean to the financial markets? How would it affect the equity exchanges? Lehman Brothers was a huge player in investment banking, with tentacles in every corner of the industry. Compared to Bear Stearns, Lehman was a much bigger institution—and an important player in derivatives, which would be challenging to unwind in an orderly fashion. I knew Lehman’s size would likely mean that its impact and contagion risk would be many orders of magnitude greater than Bear Stearns’s. How would that affect the psychology of Wall Street? What would it mean to Nasdaq? Amid all of the unanswerable questions, there was one thing I was quite clear about—all hell was going to break loose the following morning. There was going to be blood in the streets.
Eventually, my racing mind settled on a simple truth. The one thing I could do was to take care of Nasdaq’s particular corner of the financial markets and ensure that it functioned superbly. That wasn’t a simple matter, because I knew we were about to see a flood of orders hitting our servers. For equity exchanges like Nasdaq, moments of crisis are always times when transaction volumes spike. Volatility attracts trading activity, and a precipitous event like the Lehman collapse was bound to spark a panicked sell-off. Could we handle the trading volume?
Thankfully, Nasdaq systems were up to the task. My CIO, Anna Ewing, and her team did a fantastic job of keeping everything up and running. Admittedly there were a few scary moments—times when our systems seemed to be bending like a sapling in a November nor’easter. Our transaction technology was pushed to the very edge over the days and weeks following the Lehman bankruptcy. We bent but didn’t break. We regularly test transaction volumes in our laboratory that exceed normal operations by two or three times. But in that period we were far exceeding even our test volumes. Every day I was relieved when we successfully processed the morning rush of orders. It was a testimony to the investment we had made in our transaction services over the previous years, beginning with the purchase of Instinet, and the subsequent consolidation and improvements we had made around that core technology.
The increase in transaction volume also meant a large increase in associated revenue. This created an incongruous situation: While everything else was crashing around us, Nasdaq revenue was going through the roof. But I knew that it was temporary. Like a drug-induced high, the crisis-driven revenue surge never lasts very long, and the eventual hangover is brutal. Indeed, the backside of any crisis in the economy is usually a significant recession, entailing a painful drop in transaction volumes, which can linger for some time, compounded by other knock-on effects, like the inevitable disappearance of the IPO market. So I had no illusions about the significant but short-lived profits suddenly appearing on our income statement.
The Great Credit Ice Age
Trust is essential in the development of any well-functioning society or economy. The political scientist Francis Fukuyama points out that successful societies are characterized by wide and efficient networks of trust that allow them to develop the social, political, and economic institutions that are critical to long-term thriving. The social capital that flows out of those trust networks is, like economic capital, an important part of what makes an advanced economy truly work. Trusting and being trustworthy tend to beget more of themselves in a win-win virtuous circle, but the opposite is true as well. Distrust can feed on itself, in a lose-lose deal that ultimately leaves everyone worse off. A circle of distrust was exactly what was set in motion when Lehman failed. Suddenly no one on Wall Street seemed trustworthy. And when trust fails in an economic system that runs on social capital as well as financial capital, the results are disastrous.
The first consequence of the Lehman bankruptcy was a freeze in lending activity. As if someone had injected a heavy sludge into a finely tuned machine, the financial industry began to gum up and grind to a halt. The markets absolutely rely on credit. It’s the oil that makes the entire engine run smoothly. And credit depends on trust. We all know that a credit card company will lend money to a consumer only if they calculate that that person is likely to pay the money back. The same goes for the billions of dollars in short-term loans extended every day between institutions in our global financial ecosystem. As with a personal credit card, the moment there is a loss of faith that an institution will repay the debt, credit lines get cut and lending stops.
That was what happened after Lehman—en masse. Trust started to break down. After all, who knew what monsters lurked on other people’s balance sheets? What if more Lehmans were out there, getting ready to implode? Even a business that was perfectly healthy for the moment might have significant exposure to Lehman’s failure. What if it had money owed to it that now would never be paid back? With stock markets going south, assets that were once perceived as rock-solid might suddenly look a lot less valuable. The insurance giant AIG was rumored to be the next institution teetering on insolvency. Maybe Morgan Stanley, whose stock was dropping every day like a stone, wasn’t far behind Lehman—or so people whispered. Perhaps even Goldman Sachs, the gold standard of investment banking, would require capital infusions to stay afloat? The rumor mill went into overdrive, and every counterparty, every trade, and every transaction was subject to heightened scrutiny and suspicion.
As these fears started to metastasize on Wall Street and spread throughout global markets, interbank lending rates soared. The market for commercial paper, an indicator of lending activity, shrunk dramatically. The so-called TED spread (the difference between interbank loan rates and rates on short-term Treasury bills), a key risk indicator, reached an all-time high. “Credit Markets Frozen as Banks Hoard Cash,” announced one typical headline of the moment. A high-trust network had quickly devolved into a panicked race for survival. Now the only counterparty that anyone truly trusted was the “lender of last resort,” the federal government. The government had to act and provide a backstop to the spiraling crisis. Soon, a massive bailout was on the way.
Should federal regulators have tried harder to save Lehman and prevent the fallout of that bankruptcy? Without question, I think the answer is yes, assuming it was possible. In retrospect, letting Lehman fail was like taking the pin out of a financial hand grenade and hoping it wouldn’t blow up. Clearly, Lehman was only a symptom of the global financial crisis, not the cause, but it was a precipitous decision nonetheless to allow it to collapse. But hindsight is always twenty-twenty, and such decisions are never so simple in the heat of the moment.
Our nation’s economic leaders—individuals like Hank Paulson, Treasury Secretary; Tim Geithner, President of the Federal Reserve Bank of New York; Ben Bernanke, Chairman of the Federal Reserve; Chris Cox, head of the SEC; and Sheila Bair, head of the FDIC—were already operating in ambiguous territory, where the rules were not prescribed precisely and they had to fill in the gaps. They were trying to respond to the unfolding crisis with appropriate speed while acting within their actual legislative authority. There were no finely honed and tested tools to easily unwind an institution like Lehman, only blunt instruments. There was also the issue of moral hazard, the concern that if the government set a precedent of stepping in to rescue a major institution, it could actually set the stage for more risky behavior by institutions that now knew the downsides of that risk could be borne by others.
Among the architects of the crisis response, I interacted on occasion with Geithner, Cox, and Bernanke. Each earned my appreciation and respect, but the individual I knew best was Paulson. My first meeting with him was in his office in Washington, early on in his tenure. I recall him wondering, almost wistfully, what he would be able to accomplish at the Treasury, given the seeming stability of the economy at the time, his truncated term, and the meager bipartisan support for other needed reforms. He mentioned getting rid of the penny as one of his initiatives, which, though a laudable goal (and one that no one has yet achieved), is almost comically insignificant compared to the actual issues that he would be confronted with. I guess the lesson is: Be careful what you wish for!
On a more serious note, I believe that Paulson is a hero for the unprecedented actions he took, along with Bernanke and others, to prop up the national and global economy. I don’t hand out such compliments casually. The country was lucky to have a public servant of his temper and stature in such a critical role during one of the most dangerous periods in our history. Despite his Goldman Sachs roots, he never seemed to be merely a creature of Wall Street. He always struck me as a grounded, everyday man—refreshingly unconcerned with his own position. He wasn’t a natural politician—neither a gifted orator nor a reliable partisan of Left or Right. But clever verbosity is often overrated in business and life. And overt partisanship would have been a disaster during the financial crisis.
After the worst of the crisis was over, and the country was slowly and painfully recovering, I attended a conference at which Paulson, now retired, was a keynote speaker. At the end of his talk, I was the first in the audience on my feet. It was the only time I have ever led a standing ovation, and it wasn’t because of what he had said but because of what he did—for all of us. God help us if there had been someone less suited in the office of Treasury Secretary in late 2008. The moment demanded heroism, and Paulson delivered. He is, in my book, a great American.
I watched the unfolding crisis from the relative safety of the stock exchange, where things were less catastrophic. Indeed, the most important thing from my vantage point was how the equity markets as a whole performed in the midst of the chaos. In fact, they performed admirably—an untold story amid all the doom and gloom.
Indeed, it’s worth emphasizing that while Wall Street often gets painted with a broad brush, the equity exchanges were not responsible for the crisis. Rather, it started in the housing market and festered in the over-the-counter, nontransparent, bilateral trading venues where new financial instruments like credit default swaps helped create unseen risk. Nor did stock markets freeze up, like so many other trading venues. Indeed, once Lehman failed and credit markets ground to a halt, the equity exchanges, including Nasdaq, continued to function amid the spreading global panic, day after day after day. Trades were made and cleared, and the system continued to operate. Trust was maintained. People didn’t stop believing that their trade on Nasdaq or NYSE would get properly processed. They didn’t lose trust in the counterparty on the other side of the trade. The federal government never had to step in. That speaks to the resiliency of our model.
Of course, like everyone else, we were deeply concerned about how equity markets were dramatically falling during that period, and the impact on our nation’s economy and the wealth of hard-working Americans. We were constantly reviewing possible changes to our structure to make sure that trading practices like short selling were not fueling negative sentiment or interfering with appropriate price discovery. But ultimately our job is not to make the market go up or down; it is to make sure it doesn’t break down, which would have been its own kind of disaster. That was our responsibility; the one thing we could do in our corner of Wall Street to help. Consider this amazing fact—the primary thing we had to worry about during the crisis was too much volume, while the main concern with many of these other venues was no volume at all. They had broken down completely.
To Short or Not to Short
In my office at Nasdaq, there were a number of monitors playing financial news channels and displaying market data. Most days, they barely received a glance, but in the fall of 2008, my executive team and I were often glued to the drama unfolding in the market. On one particularly brutal day, Chris Concannon was my viewing partner. The market was dropping precipitously, and even as we stood on the fiftieth floor of a Wall Street tower, you could sense the fear in the streets. It seemed to permeate the very atmosphere of the city during those days, as if a massive low-pressure system had just parked itself over Manhattan.
“I’ve never seen the market fall like this.” Chris’s voice wavered slightly, betraying his own concern. Morgan Stanley was just one of the stocks falling, as if there was nothing between it and a fire-sale bankruptcy. Could things really be that bad? As the numbers flashed red on the screen, I turned to him, trying not to look as worried as I felt. “Short sellers are just hammering Morgan. And Goldman. The shorts are going to burn down the market.”
Short selling, for those not familiar with the term, means that an investor essentially bets that a stock price will fall, and seeks to profit off that decrease in price.* At the height of the financial crisis, with prices plummeting, short selling was rampant, and some were concerned that it was contributing to the downward spiral.
“Should we try to do something more?” Chris asked, unable to take his eyes away from the bloodbath on the screen.
Ask me on a normal day if short selling is a positive thing for the markets, and I could give you solid reasons why the answer is a resounding yes. Arguably, the ability to bet on the decline in the share price of a company brings needed discipline to markets, facilitating better price discovery. If you can only bet that the price will rise (by going long), that is an unbalanced situation and stocks will be overvalued. In theory, short selling can keep a certain “irrational exuberance” from taking hold in equities, allowing diverse voices to express their opinion on the direction of a stock price. It can also help root out fraud in markets, making it hard for companies like Enron to hide their duplicitous accounting practices. But during the financial crisis, short selling was like throwing gasoline on a forest fire that was already burning up capital at an alarming rate. So I appreciated Chris’s question. It was one I’d been asking myself. I wondered if maybe we should try to influence the SEC to further curtail short selling, at least temporarily. I also appreciated, however, that this was a step with far-reaching consequences that we currently could not see.
“Normally, I would say that’s a bad idea, but…” My voice trailed off. At that moment, despite my position at the top of Wall Street’s machinery, I felt buffeted by forces far beyond my control. Between the two us, Chris and I probably knew as much about market structure as any two people on the planet. But in the whirlwind of that period, it was hard to know how much to trust your own experience. It was the classic dilemma of the philosophical ideal versus the pragmatic reality. None of us had lived through anything like this before. Who were we to play puppet master to the markets, especially at such a delicate point in their history? Maybe it was all going to burn down, despite our elegant theories, hard work, and idealistic motives. I looked at Chris and completed my thought: “… but what the hell do I know?”
Such doubts often swirled around us as we watched the market swoon, flinching at the body blows it was receiving. Sooner or later, it was going to be a knockout punch. We put our heads down and did our jobs amid the gathering gloom, but our usual optimism was in short supply.
Soon after that conversation, I was at home over a weekend when I received a call from Chris Cox just before dinner. He had just been discussing the issue of short selling with Geithner. Already in the summer, they had cracked down on the practice, and attempts had been made to tighten restrictions. They had even banned short selling outright for a period in some financial stocks. Now Geithner was looking to implement further protections. I was sympathetic to the idea.
“Bob, sorry to bother you. But Geithner wants to get this done immediately, if possible,” Cox explained. He sounded exhausted, urgent, and worried—all at the same time.
He wasn’t the only one concerned about the issue. In fact, Cox was also getting pressure from the banks and politicians about it. Both New York Senators, Chuck Schumer and Hillary Clinton, were urging a short-selling ban. At one point, during the crisis, TV personality Jim Cramer went after Cox personally for not reining in short sellers, and then presidential candidate John McCain called for him to be fired. Personally, I found Cox to be hardworking, nonideological, and responsive—all good qualities for running the SEC. But justified or not, he was being held accountable for allowing short sellers, the bogeymen of the moment, to further destabilize markets.
“Chris, I agree,” I told him, “but as you know better than anyone, the SEC is not an organization known for its adaptive agility. It isn’t designed to move fast on anything.” It was a simple fact. The SEC is required to meticulously follow sunshine laws requiring transparency. You can’t even have more than two Commissioners talking to each other at the same time; otherwise, these laws require a full public hearing of all five Commissioners. The public has to weigh in on new regulations. There is a comment period. It’s an orchestrated process. Indeed, I had come to realize an inconvenient truth—when it comes to government institutions, you can have transparency or you can have speed, but you can’t have both.
“Dad, are you ready for dinner?” Katie’s voice rang out as she entered my office. My daughter and I had made plans to go out, and she was hungry. Normally, she would have looked irritated and urged me to hurry up and get off the phone, and like most teenagers shown little concern for her father’s business dealings. This time was different, however. As soon as she entered the room, she got very quiet and still. She suddenly looked concerned—for me. I was amazed at how the very atmosphere of the room and the gravity of the moment cut through all of her teenage self-absorption.
Cox soon explained to me that he had a new plan. “Bob, since the SEC can’t self-propose this, I want Nasdaq and NYSE to join together and do it themselves. That could be approved quickly.”
Cox’s plan was sound, and that was exactly what we did in the following days. The SEC passed a temporary ban on most short selling, which lasted several weeks, and ended in early October 2008. At the time, it felt good to have done something. But of course banning short selling doesn’t stop selling, or prevent the markets from falling. I’ve come to regard it as a cautionary tale about what can happen when one acts too quickly to fix a perceived problem and in the process interferes with natural market forces. Even at the time, the consensus was largely that the ban did little to help stabilize markets, and a number of careful studies afterward came to the same conclusion. If anything, it might have been counterproductive. Before he departed the SEC later that year, Cox also said that he regretted the decision. “Knowing what we know now,” he said, “I believe on balance the commission would not do it again.”1
The Perils of Leverage
“There are only three ways a smart person can go broke. Liquor, ladies, and leverage,” is a saying attributed to legendary investor Charlie Munger.2 There are a lot of smart people on Wall Street, and it’s true that the three Ls have taken down more than a few, but in 2008, one stood out far above the others—leverage. There was no single cause of the crisis; many events came together and conspired to set the system on fire. But the dangers of leverage were at the center of it all, and that stands out to me as a lesson that must be learned if we are to avoid repeat performances.
Leverage is not all bad, of course. I went deep into debt to acquire some of the assets that were essential to the transformation of Nasdaq, like Instinet. In those days, we were temporarily nine times leveraged. That means, for example, that if our business declined for some reason, it could impair our ability to pay off the debt. We knew that Nasdaq was temporarily in a delicate position, but given the synergies of the deal, we also knew that we could quickly bring it under control. That was a unique circumstance. In general, I was careful to keep our debt well within reasonable limits. I also avoided acquisitions that I felt would have left Nasdaq too highly leveraged, as demonstrated when we walked away from the LSE bid.
Perhaps my most relevant experience with leverage came as the new owner of OMX, which owned a clearinghouse in the Nordics. This was a business I was familiar with but had never overseen operationally, so I had to get up to speed fast. Any CEO worth his or her paycheck needs to understand any business he or she is overseeing and find the right comfort level in terms of the degree of oversight. It can be surprising how many CEOs, especially in large corporations, don’t truly know important details about their own businesses. So I had to learn the essential components of the clearinghouse business—one of which was managing the margin. In the context of clearing, that means knowing how exposed the positions of your member institutions are and how much capital is needed to account for that risk. We employed a number of high-IQ mathematicians to help us do exactly that.
Soon after the acquisition, I met with the team managing risk. This was many months before Bear Stearns and Lehman Brothers made everyone rethink our risk models. This team was using sophisticated mathematical profiles to measure correlations among different assets, and the risks entailed in those relationships. So, for example, if a big institutional client had a $100 million portfolio that was cleared with us, we might demand a $7 million margin at the clearinghouse. However, in this meeting, our team was telling me their models showed that declines in certain assets weren’t historically correlated with declines in other assets. Since the model showed the risk profile was reduced in such cases, perhaps we should relax the margin requirements on those types of portfolios containing these noncorrelated assets.
Thankfully, our team decided not to change our margin requirement based on those calculations. We stayed conservative. I had no idea then how grateful I would be for that decision. In retrospect, it looks prophetic. Now we know that too many such models proved disastrously inaccurate. In a real crisis, everything is correlated. But in those days, I didn’t know the storm that was coming. I decided not to ratchet up our risk, no matter what the smartest guys in the room suggested. A few months later, as we found ourselves closely monitoring our risk levels on a daily basis through the crisis, there were several cases when we were forced to make margin calls on our member firms.
Here is where one of the most important leadership lessons applies: Don’t fool yourself. It’s a hard lesson to learn. There are always ways to convince yourself of things that don’t deserve your conviction. It’s always possible to talk yourself into a conclusion that owes more to the climate of the moment and the temporary incentives of the day than to any independent assessment of the situation. And leverage is one of those matters about which it’s all too easy to fool yourself, assuming that the future will look like the past.
But the reality is that the future doesn’t always look like the past. That may sound obvious, but humans always like to interpret their current experience through the lens of what’s come before. Computers (programmed by humans) often do the same. Just because something has not happened doesn’t mean it won’t. We all learned that critical lesson in the financial crisis. Some models seemed rock-solid until the very day they failed completely. Don’t get caught fighting the last battle. Don’t fool yourself.
“Beware of geeks bearing formulas” is another pearl of wisdom from Warren Buffett, urging investors to be skeptical of history-based models. It’s sound advice, although I might phrase it differently. After all, Nasdaq has built a multibillion-dollar business while relying on many geeks bearing useful formulas and models—likewise with many of our listed firms. But like any sophisticated tool, mathematics can become one more way to fool yourself—like the investment bankers on Wall Street before the financial crisis who somehow convinced themselves that a 30:1 leverage ratio was acceptable. In other words, they were putting up $3.33 in actual capital for every $100 invested, meaning that if their portfolio declined 4 percent or more, they would be insolvent! Yet CEOs armed with formulas talked themselves into thinking such leverage was manageable. I have made plenty of mistakes in my career, but that was one I never would have made. I could not have slept soundly with that kind of risk hanging over my head.
In an era in which the investment banks were still organized as partnerships and not as public corporations, I find it hard to imagine that such high-risk levels would have been employed. The incentives of the partnership—the skin in the game, so to speak—would surely have exerted greater discipline, and that would have mitigated some of the assumed risk. No crisis on the scale of 2008 has one or even two causes; inevitably, it’s a confluence of many events. But leverage, the failure of leadership, and the different organizational structure of Wall Street investment banks each played a significant role.
What about the SEC? How much blame should they get? Regulatory failure also contributed to the crisis, and the SEC was obviously ground zero of that issue. But rather than point the finger at one person, or even the five-person committee, or home in on specific events leading up to the crisis, I think it is more instructive to examine the regulatory culture of the SEC.
Culture may be destiny, as many have pointed out, but in this case, “charter” is also destiny. The SEC’s charter is explicitly focused on investor protection and maintaining fair and orderly markets. The stability and soundness of the institutions it oversees are not front and center. This mandate is right there in the founding charter, and arguably it worked fairly well for most of the century since it was set up—until it failed completely. Institutional inertia is a powerful force. The SEC was making sure everyone followed the rules, obsessing over every little change that Nasdaq and other institutions made to their business models—in the name of investor protection—while world-destroying amounts of leverage and risk were building up under their noses. Looking back, the lack of oversight would be laughable if it wasn’t so consequential. The SEC simply wasn’t designed to look in the right direction.
During the crisis, the surviving investment banks converted to commercial banks, which gave some regulatory authority to the Federal Reserve, changing the dynamic completely. Nevertheless, the financial crisis signaled that it was time for a major update of our nation’s regulatory structure—which was exactly what happened after the smoke cleared and some stability returned to the markets.
Dodd-Frank and a Big Bank
“You f——k! You f——king ass! Who do you think you are? What do you think you’re doing!?”
The stream of F bombs being hurled at me came as a shock. I had just picked up the phone and was unexpectedly greeted by this tirade before I could even say a couple of words. But it wasn’t just the torrent of invectives that was a surprise. It was the person behind them. It’s not every day you have Jamie Dimon—CEO of JPMorgan Chase and one of the individuals in the business I respect most highly—call up and curse at you like a drunken sailor.
“Jamie, let me speak,” I broke in after about fifteen seconds. But this only seemed to reenergize his rant.
“You don’t speak! You listen!” And this was followed by another thirty seconds of shouting and cursing.
Admittedly, I knew exactly what he was upset about. I could even sympathize with his frustration. It was 2009, and we were in the middle of the discussion around the new legislation package that would come to be known as Dodd-Frank, which promised a full overhaul of our nation’s financial regulatory structure in response to the systemic breakdowns that had occurred. Dimon had just realized that Nasdaq was involved in a campaign to change the way that certain types of trading and clearing would be conducted—a change that would have significant consequences for the big banks.
A few months earlier, Ed Knight, Nasdaq’s legal counsel, had proposed a series of steps we could take to influence the new regulatory structure that would be put in place postcrisis. Every major institution on Wall Street had a stake in it—though Nasdaq’s stake was less direct than others’.
The financial crisis highlighted, for me, certain aspects of our model that had proven critical to our resiliency. Equity markets like Nasdaq function using what is sometimes called an “all-to-all” model, meaning that all buyers and sellers come together in an exchange with a central, independent clearinghouse that mutualizes risk. That latter part is key. A clearinghouse legally settles the trades that happen on the exchange. It provides a standard set of rules that governs those transactions. If a retail investor, John Q. Public, puts in a sell order using his retirement account on TD Ameritrade, he may get a confirmation right away, but that does not mean the trade is complete. The trade is not cleared until it is settled at the clearinghouse, and the contract is finalized and the money moves. In a sense, clearinghouses systematize and institutionalize trust. Every institution that is a participant in that market has to put up some collateral to the clearinghouse. In turn, the clearinghouse monitors the creditworthiness of member firms and provides a fund that can cover losses if those losses exceed any one member’s collateral. Today, the function of a clearinghouse in U.S. equity markets is performed by the DTCC (Depository Trust and Clearing Corporation).
For years, I had been an advocate of open, transparent markets, with competing electronic exchanges and independent clearinghouses. Nasdaq operated that way, and we had pushed regulations that encouraged the evolution of markets in that direction. In the midst of the crisis, the markets that adhered to that model had performed the best, without the hidden risks that had built up in the bilateral, private credit markets. If ever there was a moment when that faith was vindicated, this seemed to be it.
Bilateral, private markets have a tendency to fail; not because of nefarious behavior, but simply because trust is more delicate in those relationships. Without the firewall of a clearinghouse, they are only as strong as their weakest link, and contagion is more of a danger. The rumor mill has more power. A breakdown in trust can quickly infect the whole system. Indeed, failures of trust can more easily infect whole interconnected webs of bilateral relationships. That’s why many of those over-the-counter (OTC) trading venues ground to a halt in 2008. Clearinghouses provide an institutional firewall and help inoculate against exactly the type of contagion that attacked our system in the crisis.
Ed’s proposal was that we initiate a grassroots campaign to lobby for the inclusion of our proposed changes in the Dodd-Frank rules that were currently being negotiated in Congress. We invested some money in that lobbying campaign, distributing it to civic-minded organizations that were aligned with our goals. We felt it was for a good cause, and we hoped to have a real influence on policy.
During that campaign, one of the more memorable meetings we had was a conversation in the West Wing of the White House with Larry Summers, head of the National Economic Council under Obama. It was exciting to set foot in that iconic building, not as a tourist but on official business that would affect the nation. As we launched into our sermon on clearinghouses, Summers, who is one of the smartest individuals I’ve been privileged to know, leaned back in his chair and closed his eyes. My heart sank. Was he concentrating? Was he sleeping? I wasn’t sure, but I knew he had a reputation for working long hours. Perhaps they had caught up to him (a few days later, the press would actually circulate a photo of him sleeping in a meeting with the President). After a few moments, however, his eyes popped open and he exclaimed, “Clearinghouses, I get it! Basically, that’s the reason we invented money.”
Puzzled by his statement, I thought, He must have been asleep. Then I realized he was right. It was a wonderful leap of logic. Money gives people the confidence to exchange goods and services independent of needing to personally trust each other’s creditworthiness. In the same way, a clearinghouse gives investors confidence to exchange securities independent of having to personally trust and verify the creditworthiness of the counterparty. Money may just be pieces of paper (or numbers in an account), but because we’re all invested in that medium of exchange and it is backed by the full faith of the federal government, it becomes a way to clear hundreds of billions of transactions every day. A clearinghouse performs the same critical function in trading securities, as Summers quickly grasped during our conversation. No one else we’d spoken to had made this unique connection. It’s always interesting to see a great mind at work.
In due course, on December 11, 2009, a bill passed the House of Representatives that would mandate the use of independent clearinghouses in many over-the-counter derivatives and take those functions out of the hands of the banks.
When it passed the House, the banks woke up. Suddenly, they realized that there was a possibility they might lose the clearing and trading function in certain derivative markets given the proposed regulatory structure. That hit the bottom line directly, as they would potentially lose significant streams of revenue, like the billions of dollars in profit they earned from trading over-the-counter interest rate swaps for large companies and institutions. In 2008, Chase reportedly earned $5 billion in profit on this one business alone! It’s no accident that the internal nickname for the leader of this trading business for JPMorgan Chase was “Matt the Mint.”
The House bill threatened to lower the boom on this type of trading and clearing and move it out of the private markets controlled by banks like Chase. When it passed, warning bells went off in executive suites all over Manhattan. In a tough banking environment, that revenue stream was critical. They started asking, “Who is pushing this legislation?” All of which led to that irate phone call from Dimon.
For JPMorgan Chase, the issue was particularly relevant. With one of the biggest balance sheets on Wall Street, they could offer customers a security and certainty that few others could match. They could make trades on derivatives—interest rate swaps, for example—that few others could handle. Bilateral trading venues cleared by specialized, custom-made contracts tend to give an advantage to the person with the biggest balance sheet in the room. In contrast, a mutualized clearinghouse is all about the collective strength of the group, not the individual strength of a particular player. Everyone is treated roughly the same: no sweet deals, no special rates. Everyone puts up collateral. The rules are more transparent and standardized.
In thinking about Dimon’s tirade, I could see it from his perspective. JPMorgan Chase had made real sacrifices during the financial crisis, taking on Bear Stearns and Washington Mutual and the liabilities associated with those two troubled institutions. Furthermore, Chase had not been involved in the nefarious activities that led to the crisis. Dimon was fending off politicians out for blood on one end and an outraged public on the other. But if I wasn’t going to be an advocate for all-to-all electronic markets with mutualized clearinghouses, who exactly was going to? That’s what Nasdaq does! JPMorgan lends money; Nasdaq runs fair markets.
In 2010, Dodd-Frank passed with a version of our proposed regulated structure for derivative markets. We did get clearinghouses overseeing the derivatives market trades, an important step forward, though it would take many years to fully implement. Moreover, all interest rate swaps now must be reported to a public database at the DTCC clearinghouse—a move toward greater transparency, which is also positive. While the OTC markets are still a big step short of where the equity markets are today, I do believe that they are stronger and better today because of our and others’ efforts, and I take some pride in having helped them to evolve.
The Madoff Mess
The final coda to the lesson we all learned about trust in the financial crisis was an event that, for many, personified the greed and corruption that led our economy to the brink of disaster—the Bernie Madoff affair.
I had been involved in a few dealings with the Madoff brothers, Bernie and Peter, over the years. When I was at ASC representing our software platform, BRASS, I ended up negotiating with both of them on the price structure of that contract (which in practice meant negotiating with Peter, as Bernie didn’t seem to be a detail person). He argued incessantly for every extra cent that they could get from me, even though he had no real leverage in the discussions. Generally, I’m not one to disparage good negotiating tactics. But it was, frankly, overwrought. In the early days at Nasdaq, I would find myself in another difficult negotiation with the Madoffs as I sought to unwind a horrible contract my predecessors had signed with the brothers for a joint initiative that went nowhere. While Bernie was never Chairman of the Nasdaq Board, as some news outlets have reported, before my arrival he was Chairman of an advisory board, a much more ceremonial position, but one that still speaks to his connections at the stock market. I reluctantly settled the contract for more than I thought we should have paid, but I was glad to end Nasdaq’s dealings with the brothers.
Still, when I heard the news about the Ponzi scheme, I was as shocked as everyone else. For several days, the news dominated my thoughts and every conversation on Wall Street, although no one I knew was affected personally. Madoff’s targets were not professionals in the industry, who would be more inclined to a high level of due diligence.
After the initial shock had passed, everyone in the industry was suddenly a confident Madoff expert. “I knew something was wrong with those guys.” “They always seemed dishonest.” “It’s obvious there was something unsavory about their operation.” And yet, right under the noses of all of these self-appointed experts with their perfect, retrospective knowledge, somehow the Madoff Ponzi scheme had lasted for well over a decade, defrauding a whole community of billions and billions of dollars.
If good markets, successful economies, and healthy societies are built on high levels of trust, the Madoff scandal was the polar opposite—an event that degraded our trust in each other and in the markets that support our financial dealings. As with the larger financial crisis that was ultimately Madoff’s undoing, it was a moment to appreciate that markets are not abstractions but dynamic systems that are fallible, sensitive, and continually in need of improvement. They exist to allocate precious capital and facilitate its free flow, allowing the entire economy to function better. Like the movement of water in an ecosystem, the functional circulation of capital plays an irreplaceable role in the health of the system it supports. When that circulation breaks down, as it did in the greatest financial crisis of my lifetime, our economies dry up, and we all suffer the consequences.
We are all children of the great recession. It’s no exaggeration to say that we will never be the same. A generation of Wall Street bankers and executives had been lulled to sleep by decades of relative stability; it had been several generations since we’d seen a crisis on this scale. When one finally came, after so long, it came with a vengeance. Before 2008, we had risk models and disaster-scenario planning—but let’s be honest, it was mostly theoretical. All of our existing models about what could go wrong were swamped in that wave of contagion. The existential threat was real, and we all felt it—the knowledge that we might all go down with the ship.
It changed us. I think about risk today very differently than I did prior to 2008. And I see the same every day on Wall Street—the level of awareness, attention, and concern about what could happen is entirely different than it was prior to the crisis. People are less inclined to underreact. I’m not pretending that our financial system has somehow been derisked. Finance inevitably involves risk, as does all business. It is part of the capitalist endeavor. Nor have the incentives of human nature evolved that much in the last decade. Yet, something has shifted. We all stared into the collective abyss in 2008. Anyone who took a good look into that dark and deep chasm, and came back from the brink, has not forgotten the view.
LEADERSHIP LESSONS
• The Future Doesn’t Always Look Like the Past. Beware the trap of predicting what’s likely to happen only through the lens of what’s come before.
• Trust Is Delicate. Business is fueled by competition, but it also depends on trust and cooperation. It’s too easy to take that for granted—until it fails.