The House of Morgan

by Ron Chernow

  On May 10, 1988, in a splashy coordinated effort, Morgan Stanley, Salomon Brothers, Bear Stearns, Paine Webber, and Kidder, Peabody announced they would stop the practice. Morgan Stanley had apparently orchestrated the move by alerting the others to its plans. Blocked from program trading in the United States, Morgan Stanley then went to Japan that December and caused a furor by introducing the practice there, spurring the Tokyo exchange to a record high. In 1989, it unabashedly led the resumption of program trading among the major firms after only a nine-month hiatus. The question of whether program trading increases volatility is complex and unresolved. What is worth noting is Morgan Stanley’s apparent disregard of public opinion and greater willingness to defy financial authorities—behavior conspicuously at odds with Morgan Guaranty’s strong sense of corporate citizenship.

  If Main Street hoped that Black Monday would throw a cautionary fear into Wall Street, it was dead wrong. It only prodded the Street into more assertive, reckless behavior. Securities firms had already lost many safe, reliable businesses. Brokerage commissions dropped after Mayday in 1975 and underwriting margins shrank after Rule 415 in 1982. Now trading profits plunged with the crash, creating a large contraction in Wall Street and City employment. Mergers already accounted for half of Wall Street’s profits, and with the decline of other opportunities, the attraction to such business became irresistible. To help things along, the crash and a weaker dollar created bargain prices for takeovers. And if raiders didn’t materialize, Wall Street was prepared to do the raids itself through its new merchant-banking departments and junk bond syndicates.

  So many companies had already passed through the merger mill that it was becoming harder to find suitable candidates. Everybody was scrutinizing the same lists, often with the same techniques. One solution was to target industries that by law or custom had been immune to hostile takeovers. Eric Gleacher, and all of Morgan Stanley, now overturned a sacred financial taboo: thou shalt not mount a hostile raid against a bank. It was always thought such raids might shake depositor confidence or jeopardize the dividends of the proverbial widows and orphans who held bank stock. So in the past, bank mergers were either friendly or forced on troubled banks by regulatory authorities.

  Shortly before the crash, this etiquette was shattered when the Bank of New York launched a $1-billion raid against Irving Trust. It was a clash of two hoary institutions steeped in history. The Bank of New York was founded by Alexander Hamilton and his associates in 1784—no other bank had operated so long with the same name—while Irving was named after Washington Irving and dated from the mid-nineteenth century. The Bank of New York was advised by Eric Gleacher of Morgan Stanley and H. Rodgin Cohen of Sullivan and Cromwell and Irving Trust by Goldman, Sachs and Morgan Guaranty.

  The year-long battle showed just how vicious and merciless Wall Street had become. These were genteel, old-line banks, the sort that pampered rich, elderly clients. Irving was so sleepy that it had sat out the trend for foreign-exchange trading that was a boon to other commercial banks. It seldom fired people and usually gave everybody a fat Christmas bonus equal to 15 percent of salary.

  Bank of New York chairman J. Carter Bacot initiated the Irving raid because he feared his own bank would be swallowed by another firm. In their gorgeous art deco headquarters at 1 Wall Street, Irving executives first scoffed at the bid, sure the Fed would never countenance a hostile bank takeover. Gleacher and Cohen correctly predicted that Fed chairman Alan Greenspan would break the precedent. The Bank of New York stalked Irving with lawsuits, proxy fights, and strident exchanges of press releases. After the Bank of New York won, Gleacher quickly threw fear across the economic landscape, telling the press the hostile fight was “a precursor of things to come.”21 The Bank of New York had promised to pay for the takeover through normal attrition. By early 1989, it had begun to fire one hundred people from the foreign side. As an Irving executive said: “The bloodbath has begun.”22 No form of financial marauding was any longer off-limits to Morgan Stanley.

  IN the wake of Black Monday, a new spirit was also blowing through 23 Wall. As it evolved from a purely commercial bank into a novel hybrid with many investment banking activities, its character changed. At an opulent postcrash Christmas party, Lew Preston said he was pleased to see so many spouses present, because now they would know that their husbands and wives would be working late over the coming year. At a second reception the next evening, he said he wanted to make sure everyone could hear him because the night before “some people didn’t hear me and went home happy.”23 As if to underscore new perils facing the bank, Moody’s Investors Service dropped its triple-A rating for J. P. Morgan and Company, the holding company of Morgan Guaranty. Standard and Poor’s kept its triple-A rating for the holding company, and both still honored Morgan Guaranty Trust with the only triple-A rating for a large American bank. Moody’s action was a small, but noticeable dent in Morgan’s shining armor.

  As J. P. Morgan and Company grew into a fifteen-thousand-person conglomerate, it tried to preserve the old partnership flavor. New management trainees underwent a rigorous six-month training program meant to acculturate them to the bank. Rarely did 23 Wall recruit from outside, and it spent millions annually on free lunches to promote camaraderie. There remained an ethic of not stealing credit or upstaging colleagues. “The Morgan feeling of collegiality is the most important thing we’ve got,” said former Morgan president Rod Lindsay. Preston regularly sent memos admonishing employees that they worked for clients and the bank, not for themselves. In Lindsay’s words, “We don’t want people if they’re going to be by themselves at the top of the list all the time.”24

  Morgan Guaranty had been much more respectful of tradition than Morgan Stanley or Morgan Grenfell and was recognizably the heir of the old, aristocratic House of Morgan. Yet its unique civility was threatened. The bank was engaged in a full dress rehearsal for the day when it would again be a “universal” bank, like the old House of Morgan. At home, it fused commercial lending and capital market activities into a corporate finance group that was an embryonic investment bank. It specialized in “deals that are sufficiently complex that they don’t lend themselves to the commercial paper market,” according to Preston.25 It milked every legal securities business. It dealt in Treasury bonds, underwrote municipal bonds, advised cities, provided stock research and brokerage, and traded in gold bullion, silver, and foreign exchange. It continued to have the fanciest private banking operation, wooing rich customers with ads that promised to relieve their anxiety about possessing $50-million portfolios.

  Abroad, Morgans stepped up capital market activity, specializing in interest-rate swaps, currency swaps, and other financial esoterica. It had merchant banks in Japan, Hong Kong, Belgium, and Germany. In London, the headquarters of its global capital markets operation, it spent $500 million to outfit two historic buildings near the Thames—the vacant Guildhall School of Music and Drama and the City of London School for Girls—with vast trading floors. Eventually fifteen hundred employees would work beneath stained-glass windows and timbered ceilings, flanked by busts of Shakespeare and Milton. As Preston noted ruefully, “We may be in the ironic position of becoming a global securities firm without being able to underwrite in our own market.”26

  To mark its emancipation from commercial banking, the House of Morgan increasingly substituted J. P. Morgan in its advertising for Morgan Guaranty, the old—and now shrinking—bank core. Morgan Guaranty Limited in London was rechristened J. P. Morgan Securities. Morgans had to reconstitute commercial bankers as deal makers and market men. It probably spent more on educating employees than any other bank. “We run almost a small university here,” said group executive Robert Engel.27 The bank hoped to maintain its gentlemanly culture by being brainy and innovative. Yet it wasn’t clear that new products could be peddled with the old style. A lending officer could be a gentleman or a lady. But what about a currency trader? A takeover artist?

  Takeover work was the acid test of the
new Morgans. Until the late 1960s, it had provided such advice gratis as part of a total package. This informal operation—just a file on buyers and sellers—was offered to clients in exchange for million-dollar deposits. As early as 1973, Morgans had tried to systematize this and even picked up a $600,000 fee for arranging the takeover of Gimbel Brothers by British-American Tobacco. But the operation never got off the ground. As with Morgan Stanley, the bank was hampered by its long client list and found it hard to represent one client without injuring another. As a commercial bank, it still wanted to please everybody.

  The problem was glaringly exposed in 1979, when American Express attempted to take over the McGraw-Hill publishing empire. AmEx chairman James D. Robinson III—a Morgan alumnus who’d been an assistant to Tom Gates when he was chairman in the 1960s—turned to the bank to finance the takeover. At first, Robinson thought he could arrange a friendly merger. Instead, he touched off a furious reaction from Harold W. McGraw, Jr., who called in Yerger Johnstone of Morgan Stanley and defense lawyer Martin Lipton and unleashed a blistering counterattack.

  McGraw picked up any brickbat at hand. He sued American Express for libel, said it cooperated with the Arab boycott of Israel, asked the Federal Communications Commission and the Federal Trade Commission to study antitrust problems, chastised American Express as a menace to the First Amendment, and raised a dozen other issues, bogus and legitimate. In the ultimate slap, McGraw chided American Express for not paying interest on the float from its traveler’s checks.

  American Express had planned to borrow $700 million for the merger, with Morgan Guaranty as lead banker. This outraged McGraw, who considered himself a faithful Morgan client. In 1977, Morgan chairman Pat Patterson had thrown a lunch for McGraw to commemorate the fiftieth anniversary of the publisher’s relationship with the bank. In his desk drawer, McGraw still kept a sterling silver cigar box he had received on that occasion.

  Now McGraw wondered aloud whether Robinson had deliberately chosen Morgans to rob him of his banker and whether Morgans had leaked confidential information to Robinson. He denounced AmEx for using “its financial power to cause a bank to violate its relationship with a client.”28 It turned out the Morgan Trust Department held up to 1.8 million shares of McGraw-Hill stock in fiduciary accounts. To vote—or not to vote—the shares would hopelessly enmesh the bank in a conflict of interest. The proposed merger degenerated into such a noisy, unseemly squabble that American Express decided to quit, while Morgan Stanley collected a $1.5-million fee. It was hard to see how the omnipresent Morgan Guaranty could perform hostile takeovers without constantly stirring up a hornet’s nest of lawsuits and client conflicts. At the same time, the bank’s close relations with corporate clients created the potential for a formidable merger department.

  In 1985, the Morgan bank formed a separate merger and acquisitions group, piloted by the Cuban-born, Yale-educated Roberto Mendoza. A big, brooding man with a slightly hooded gaze, he looked tougher and more determined than the average Morgan banker. He was more reminiscent of Morgan Stanley deal makers than of the sedate Morgan Guaranty bankers of old. A high-adrenaline type, he liked furious games of midnight tennis and drove his young charges to devise unorthodox deals. Mendoza thought investment banks were gouging clients and was willing to compete with them on price—perhaps the one taboo Wall Street still held sacred. He also thought high fees sometimes warped the judgment of investment bankers. Morgan Guaranty ran ads for its takeover group that needled the Street: “In M&A, clients who require totally objective advice, research free from conflict of interest . . . can rely on one firm. J. P. Morgan.”29 One ad showed an empty tombstone and said pointedly: “We don’t promote M&A deals just to generate fees.”30 It would soon pay a price for these holier-than-thou ads.

  The bank knew its genteel image hurt in the slash-and-burn takeover game. As Bob Engel said, “When a chairman wakes up in the middle of the night with a phone call from someone saying, ‘We want to buy your company,’ he thinks of Morgan Stanley instead of Morgan Guaranty. It’s going to be a selling job, no question.”31 Besides the image problem, Morgans faced the reluctance of companies to share secrets with large lending institutions, which might have trouble preserving secrecy or might use information to deny future loans.

  By the late 1980s, Preston and Mendoza stated publicly that Morgans would not only back unfriendly raids but might even finance both sides in a takeover, setting up opposing teams. Once J. P. Morgan and Company placed its authority behind hostile raids, Wall Street’s transformation seemed complete. The situation was not unlike 1929, when the bank submitted to the fad of forming holding companies with the Alleghany and United Corporation promotions.

  Before the crash, Mendoza’s department scored small victories but no big, attention-getting deals. Then, in January 1988, Morgans became the first commercial bank to counsel a hostile raider in a billion-dollar deal, advising F. Hoffman-La Roche on its $4.2-billion tender offer for Sterling Drug. The Swiss pharmaceutical company, F. Hoffman-La Roche, did a $6-billion-a-year business. After its Valium patent expired in 1985, it needed new products in order to fill the sales pipeline. Sterling made Bayer aspirin, Phillips milk of magnesia, and many other products. With its cartellike cosiness, the pharmaceutical industry had been ruled by gentleman’s agreements and spared bloody takeover wars. This was the first time a large pharmaceutical firm had made a hostile assault against a healthy competitor. Adding to the shock was that J. P. Morgan and Company had been a banker to Sterling Drug for more than fifty years.

  Advised by Mendoza, Hoffman-La Roche followed a frenzied raiding strategy known as a bear hug. It made an opening bid of $72 a share for Sterling, then twice stepped up the bid in rapid succession without any formal rejection of the earlier offers. Sterling chairman John M. Pietruski had jolted his firm from its former lethargy and lifted its earnings to healthy double-digit levels. He was consequently irate at Hoffman-La Roche’s overture and called in Joe Fogg of Morgan Stanley and Joe Flom of Skadden, Arps as advisers.

  Taking a leaf from Harold McGraw, Pietruski let loose a blast that Morgan Guaranty wouldn’t soon forget. In an open letter, he said he was “shocked and dismayed by what I consider to be Morgan bank’s unethical conduct in aiding and abetting a surprise raid on one of its longtime clients.” The bank, he said, was “privy to our most confidential financial information.”32 He laid out their ties of recent years, including borrowing, Morgan work as Sterling’s registrar and transfer agent, and Morgan’s management of Euromarket issues for Sterling. It was a clever broadside, for Pietruski echoed the language of the old Wall Street, as if shaming the bank with recollection: “How many relationships of trust and confidence do you have to have with a client before you consider not embarking on a course of action that could be detrimental to [his] best interest?”33

  In an unusual public rejoinder, Lew Preston hinted that the letter was hypocritical bluster crafted by a publicist. “It’s kind of interesting that we’re still their transfer agent,” he said afterward. When the battle was over, Preston elaborated: “That wasn’t a letter from the chairman of Sterling. That was a letter written by the investment bankers to embarrass this firm.”34 He disputed the notion that Morgan betrayed a deeply loyal client, noting that Sterling’s principal banker was Irving Trust and that 23 Wall had only performed “mechanical functions” for Sterling. For Preston, the surprise was less in the raising of the betrayal issue—obviously anticipated in planning for the takeover—than in the way that Wall Street ganged up to bad-mouth Morgan’s handling of the deal.

  Indeed, investment bankers believed that Hoffman had made too low an initial bid and only ended up drawing other sharks into the water. Morgan Stanley brought in Kodak as a friendly suitor, and it snatched Sterling away for $89.50 a share. Although Wall Street crowed that Morgan Guaranty had bungled the deal—the glee was scarcely disguised—the bank hinted that Kodak had overpaid. The price was high—twenty-two times Sterling’s estimated 1988 earnings. The investmen
t banks, of course, had a vested interest in denigrating the performance of Morgan Guaranty, which was poaching on their territory. They were especially incensed when Mendoza charged a paltry $1 million for the losing effort, surely the most unforgivable sin of all.

  Clearly, Morgans considered Hoffman-La Roche a much closer and more profitable client than Sterling Drug. But was this to be the new standard for choosing targets? Would the bank feed off stronger clients at the expense of weaker ones? Would it sacrifice those deemed less important? Then who would trust the bank in the future? The controversy also highlighted the multiple possibilities for conflicts of interest as big banks conducted raids. For instance, as transfer agent for Sterling Drug, Morgan Guaranty held its confidential shareholder list—information invaluable to any raider. (Later that year, the Morgan bank sold its shareholder service operation to First Chicago, terminating a corporate trust business over a century old. Preston denied a Sterling link, although such shareholder work was clearly incompatible with merger activity.) Even as the bank invoked its internal controls for protecting confidential information, it was encouraging loan officers to pass along ideas to the Mendoza team in its “one bank” concept of teamwork.

  Lest McGraw-Hill or Sterling seem a freak, the bank again ran into trouble in April 1988. James R. Houghton, chairman of Corning Glass, announced an agreement to acquire International Clinical Labs, Incorporated, for $26 a share. A stout opponent of hostile deals, Houghton thought this deal was done and used Morgan Guaranty as his depository and lender. Then Smithkline Beckman unveiled a surprise bid, quickly kicking up the price to a winning $37 a share. The defeated Houghton was stunned: Smithkline’s adviser was his own stalwart banker, Morgan Guaranty. More shocking was that Houghton sat on the Morgan board! On the eve of Morgan’s annual meeting, Houghton threatened to resign and was pacified only after a talk with Lew Preston. Again, Morgan earned more by advising Smithkline than by being depository for Corning. But was this short-term calculus to be the new operating standard? Would the bank auction itself off to the highest bidder? It was moving toward a two-tier structure in which it coddled the larger clients and sacrificed the smaller. And in this, it was beginning—just beginning—to resemble the rest of Wall Street, which had now operated that way for many years.