The House of Morgan: An American Banking Dynasty and the Rise of Modern Finance

by Ron Chernow

  In 1986, to raise capital for these new activities and strengthen its position in world capital markets, Morgan Stanley sold 20 percent of its shares to the public. There was a wonderful irony here: it went public so it could take other companies private. To give these shares global distribution, a third of them were sold to buyers outside North America. The shares were offered in-house at $15.33, with the allotted number per person determined by a complex formula based partly on the amount an employee already had invested in the firm. On its inaugural day, the Morgan Stanley stock jumped from $56.50 a share to $71.25. This netted over $250 million for the firm and created instant fortunes for those irrevent young men who had transformed the firm in the early 1970s. Parker Gilbert had 772,133 shares worth $57.3 million by day’s end (a rich reward for a compromise chairman); Dick Fisher had 729,574 shares ($54.1 million); Bob Greenhill, 710,275 ($52.7 million); and Lewis Bernard, 673,521 ($50 million). With its public offering, Morgan Stanley lost one of its last links to the past. It was now a vast, publicly traded company, with 114 managing directors (including its first female), 148 limited partners, and 4,000 employees worldwide. The firm now employed an astonishing number of multimillionaires. Only Goldman, Sachs remained an old-fashioned Wall Street partnership, and even it sold a stake to Sumitomo of Japan.

  Bolstered by its public offering, Morgan Stanley pushed ahead with merchant banking. The next year, it launched the Morgan Stanley Leveraged Equity Fund II, with Tom Saunders eventually rounding up a $2.2 billion war chest, the largest ever assembled by a major investment bank and second in the world after that of Kohlberg Kravis Roberts. In its new dual role, Morgan Stanley would both manage the fund and invest $225 million of its own capital in it. As with hostile takeovers and junk bonds, Morgan Stanley took an activity of questionable benefit and made it acceptable in elite circles. It enlisted sixty institutions for its fund, including the General Motors and AT&T pension funds, Japanese trust companies, Middle East government agencies, Volvo, Barclays Bank, and several American commercial banks. Not only would Morgan Stanley receive about a third of the capital gains from the fund, but it would also skim off a 2-percent fee for managing the money. This was only the beginning, as the huge leveraged buyout of Burlington Industries would show.

  In early April 1987, reports surfaced that raider Asher B. Edelman was accumulating stock in Burlington, the largest textile company in America, based in Greensboro, North Carolina. Frank Greenberg, Burlington’s chief executive, cast about for a “white knight” to ward off Edelman and his partner, Dominion Textile of Canada. In a meticulous reconstruction of events published in an August 1987 issue of Barron’s, Benjamin J. Stein chronicled what happened next. On April 15, thirty-two-year-old Alan E. Goldberg of Morgan Stanley telephoned Greenberg and said Morgan would be interested in buying Burlington while retaining current management. In a follow-up letter of April 21, Bob Greenhill reinforced the naked appeal to Greenberg’s self-interest, saying, “We would have no interest in proceeding except upon a basis agreed to by your management.”10 At an April 29 meeting with Greenberg, Morgan Stanley laid out plans to give management a 10-percent stake in the buyout, plus another 10 percent if certain performance standards were met.

  Facing a clear-cut choice between a hostile raider, who threatened his livelihood, and the Morgan LBO fund, enticing him with lucrative incentives, could Frank Greenberg render a fair, impartial judgment for his shareholders? As Benjamin Stein noted, Morgan Stanley customarily dangled before management promises of salary increases ranging from 50 percent to 125 percent after a buyout. In this tempting situation, Greenberg granted some exceptional concessions to Morgan Stanley. He agreed to give Morgan a $24-million “break-up” fee in the event it failed to acquire Burlington. Morgan Stanley justified this princely fee by citing interest it would allegedly forgo by locking up capital during the talks. Yet, as Stein noted, Morgan Stanley had no capital at risk until the takeover’s completion—and then only $125 million of its own money. The break-up fee, however, worked out to interest that would have accrued on $7 billion over a two-week period. As Stein concluded, “The ‘breakup’ fee could be understood only as a form of payoff to Morgan from its partners on the Burlington board for being included in the deal in the unlikely event that the deal cratered. It simply made no sense otherwise.”11 Greenberg waited until mid-May before disclosing his secret talks with Morgan Stanley, which was privy to company secrets denied Asher Edelman and Dominion. It was hard to see how both bidder groups were being accorded equal treatment.

  In late June, the Morgan Stanley group made a bid of $78 a share, or about $2.4 billion, for Burlington, defeating the Edelman raid. It got about a third of America’s largest textile company for only $125 million and even most of that came from Bankers Trust and Equitable Life Assurance. It also earned $80 million in fees, including profits from underwriting almost $2 billion in junk bonds to finance the deal. Did Burlington profit equally with Morgan Stanley from this financial alchemy? Before the buyout, the firm had a clean balance sheet, with debt less than half the value of common shareholders’ equity. When the LBO went through, the company suddenly struggled with over $3 billion in debt, or thirty times as much debt as equity. It subsequently had to fire hundreds of middle-level managers, sell off the most advanced denim factory in the world (ironically, to Dominion Textile), close its research and development center, and starve its capital budget to $50 million for a five-year period. All this not only upset the lives of Burlington employees, but drastically weakened the firm’s ability to compete in global markets.

  By the last quarter of 1987, Burlington Industries was losing money despite higher earnings from operations. Why? It had to pay $66 million in interest for the quarter. LBO defenders praised these high levels of debt as stimulating management to greater effort—an argument reminiscent of Dr. Johnson’s observation that hanging wonderfully concentrates the mind. Did companies have to stare at the gallows to perform better? Most cost cutting and asset sales that followed LBOs weren’t designed to improve company performance; they were just steps to pay for the LBOs and were often unnecessary without them. Many LBOs were quick bets on the bust-up values of firms rather than serious attempts to run a company for many years.

  LBO supporters claimed that owners were more enterprising than managers and didn’t have to attend slavishly to their stock prices. The claim was parroted at every turn. “An enormous amount of management time in this country is devoted to managing the market price of the shares,” said Tom Saunders of Morgan Stanley. Yet for years, Bob Greenhill, Joe Fogg, and Eric Gleacher had warned companies to get up their share prices—or else. Who created that preoccupation with share prices and quarterly earnings from which companies were now being rescued? Ironically, many LBO specialists were being transferred over from merger work, where they suddenly had to adopt a long-term perspective. This defense also sounded odd coming from a firm that had managed the initial public offering of several companies in the 1980s. Finally, it ignored the simple fact that the objective of taking companies private was to take them public at a later date and reap a quick killing. Presumably, the firms would then tout the benefits of public ownership.

  There were profound political and social issues at stake in the LBO fad. Participants hailed the trend as a return to the “good old days” when bankers put their own capital at risk. They didn’t look closely at that history and the conflicts of interest that had resulted from excessive cosiness between bankers and the companies they financed. As we have seen, it took decades of agitation and reform to fulfill Louis Brandeis’s vision of investment bankers’ having an arm’s-length relationship with companies. This had been the purpose of endless investigations—Pujo, Pecora, and Wheeler—as well as the purpose of the Medina suit and various government measures to mandate competitive bidding in railroads and utilities. Just when the 1982 Rule 415 had seemed to end the problem of banker-company collusion, investment banks reinvented it with merchant banking. It was no coincidence tha
t Morgan Stanley’s entry into merchant banking occurred after the advent of Rule 415, for through LBOs it could restore the exclusive relationships lost in the transactional age. What better hold to have on a company than to own a large piece of it? Three of the five Burlington board members were suddenly Morgan Stanley managing directors.

  The merger of industry and finance had made some sense in the Baronial Age and had given some stability to the American economy. Companies were then weak and had difficulty tapping capital markets, especially abroad. Only the banker’s reputation could reassure skittish creditors. That was no longer the case in the Casino Age, when companies were often better known than bankers. Burlington Industries needed no introduction to investors. The new merchant banking also differed from the old-fashioned relationship banking of the 1950s, when Wall Street firms had a purely advisory role and could provide objective advice. If the old Morgan Stanley had a firm grip on its clients, it also had no built-in temptation to mislead or abuse them.

  The LBO trend ensnared investment banks in another set of potential conflicts of interest. Were they now advisers or investors? Were the roles of principal and agent compatible? LBOs put investment banks into the position of competing against their underwriting clients. After Morgan Stanley added Fort Howard Paper to a portfolio that already included the Container Corporation of America, its paper-industry clients were aghast. David J. McKittrick, the chief financial officer of James River, had used Morgan Stanley to manage a number of stock offerings. “We have looked with concern at Morgan Stanley’s increasing equity position in the paper industry,” he said.12 There were similar problems with takeover clients. If Morgan Stanley’s merger people spied an undervalued company, should they take it to a client or keep it for the firm? And if they recommended an LBO to a company, could they claim objectivity when the firm stood to make windfall profits in advisory fees and junk bond underwritings? According to one report, CIGNA insurance stayed away from the second Morgan Stanley LBO fund from a belief that the firm was chasing “elephant” deals that would generate giant fees.

  People at Morgan Stanley recognized the potential problem but too quickly waved it away. “Our business is full of conflicts,” said Dick Fisher. “In an industry as integrated as ours, I don’t see how they can be avoided.”13 He noted that if Morgan Stanley scouted a company for a client, that client had first crack. But what if the firm spied an opportunity on its own initiative? Was its first loyalty to its clients? Or to its shareholders? Bob Greenhill replied, “The first party that steps forward is the client; we talked to several companies about Burlington, but none were interested. The point is, because of our tradition, we bend over backwards to accommodate our traditional clients.”14 So Morgan Stanley would save the scraps for itself and only take deals rejected by everybody else? Wall Street was now tangled so deep in ethical thickets that it could no longer fight its way out.

  THE parallel with the 1920s had its inevitable sequel on October 19, 1987, when the Dow Jones industrial average fell 508 points. Some $500 billion in paper value—equal to the gross national product of France—vanished, though there were no untoward scenes at the Corner or mobs of ruined investors. No stock brokers executed swan dives from high ledges. Seventy percent of stock trading was now done by institutions—mutual funds, pension funds, and the like—which were averse to theatrics and tracked the market on computer screens. Depression, migraine headaches, even sexual impotence were later reported among investors, but no aerial artistry as in 1929. Aside from a somewhat longer visitors’ queue at the New York Stock Exchange, the Corner betrayed little sense of calamity on this Black Monday.

  The Morgan houses were actually less remote from the 1987 crash than they’d been from the one in 1929. All the banks and brokerage houses were now trading operations. And Morgan Stanley was a major practitioner of stock-index arbitrage—computer-driven trades that exploited small price discrepancies between stocks in New York and stock-index futures in Chicago. Such transactions were blamed for wild market gyrations and even, unfairly, for the crash itself. In a secret, restricted computer room known as the Black Box for its sophisticated software—some programs forced traders to don 3-D glasses—fifty Morgan Stanley traders and analysts pored over information and scanned arbitrage opportunities. They took risks that would have harrowed Harold Stanley’s soul. On September 11, 1986, after the market suffered a steep drop, Morgan Stanley, gambling on an upturn, had bought $1 billion in stock futures and suffered enormous losses. Such futures-related trading reintroduced leverage into the market that the government thought it had stamped out with stiffer margin requirements in the 1930s.

  From 1984 to 1987, stock prices had risen without a 10-percent correction. This cheered bulls, muzzled bears, and blinded people to warning signals. Following exactly the 1929 pattern, the bond market slumped in the spring of 1987, and the Federal Reserve raised the discount rate in September. In early October, Morgan Stanley, fearing clients would miss the next leg of the bull market, exhorted them to be 100-percent invested in common stock. Later, when it sent financial commentator Adam Smith an exuberant buy recommendation, he mused, “You had me one hundred percent invested in October and I lost half my money. How am I supposed to buy something now?”15

  Where 1929 was a home-grown American crash, 1987 was a global panic. Around the world, stocks rose, crashed, then rebounded together. The same financial deregulation that had interlaced markets led to synchronized drops in Tokyo, Hong Kong, New York, London, Paris, and Zurich. “For days everyone just kept passing the bear market around the time clock,” said Barton Biggs of Morgan Stanley. New links among world stock markets seemed to exaggerate movements in both directions, accentuating the instability of the world financial system instead of ironing out fluctuations.

  From the standpoint of Morgan history, the significant aspect of Black Monday was the lack of any overt role in a rescue. That was the big script difference from 1929—the absence of a bankers’ rescue. President Reagan, eager to echo Hoover, said, “the underlying economy remains sound.”16 John Phelan, the New York Stock Exchange chairman, played the Richard Whitney role, debating with advisers about whether to close the Exchange. There were again stock buybacks and early Exchange closings to deal with paperwork. But no bankers marched up the steps of 23 Wall. Phelan consulted mostly with William Schreyer of Merrill Lynch and John Gutfreund of Salomon Brothers—not with Morgan Stanley—reflecting the new importance of trading and retail houses, rank outsiders to the club in 1929.

  The Federal Reserve moved with a dispatch that left no doubt as to its resolve. On October 20, Alan Greenspan issued a tersely effective statement affirming the Fed’s “readiness to serve as a source of liquidity to support the economic and financial system.”17 The Fed bought dollars and engineered a sharp drop in interest rates. E. Gerald Corrigan, president of the New York Fed, personally pleaded with banks to continue lending to sound securities firms. Some New York Stock Exchange specialists ended Black Monday with bloated stock inventories as they tried to stem the decline, and they were floated by their chief lenders, including Morgan Guaranty, Manufacturers Hanover, and the Bank of New York. The Fed acted admirably; Wall Street no longer needed a House of Morgan, which couldn’t have coped with a crisis of such magnitude. As Continental Illinois had showed, private rescues were passe in huge, unfettered global markets. There would never be another financier who bulked as large as Pierpont Morgan or Tom Lamont.

  The crash exposed underwriting hazards of a sort forgotten during the bull market. In November 1987, when the British government sold its 32-percent stake in British Petroleum, investors couldn’t absorb this mammoth $13.2-billion issue so soon after Black Monday. Four U.S. underwriters—Morgan Stanley, Goldman, Sachs; Salomon Brothers; and Shearson Lehman—stared at $350 million in paper losses. Disaster was averted when the Bank of England agreed to buy back shares at 70 pence per share. Higher oil prices and a Kuwaiti purchase of a 20-percent BP stake then rescued the Bank of England.
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br />   After the crash, Main Street again prayed that Wall Street had learned its lesson and gloated over its misery. “It’s been a nice week for the have-nots of the world,” said a GM auto worker. Stock brokers retired the haloes they had worn for several years. “Before the Crash,” bemoaned one broker, “everyone wanted you to meet their daughter. Now we’re the scum of the earth.”18 But the hobgoblins of sustained prosperity—consumerism, greed, and speculation—weren’t to be slain so quickly. When a Newsweek cover asked, “IS THE PARTY OVER?” the unrepentant young staffers at Morgan Stanley used a copy of the glossy page as an invitation to a big bash, with the letters NFW—no fucking way—scrawled defiantly across the top.19 Eric Gleacher, whose merger mill was grinding through two hundred deals at a time, asked, “Why shouldn’t it go on?”20 Morgan Stanley was proudly unscathed by the crash—it even offered to extend credit to one thunderstruck commercial bank—but the staff was shaken by a nearly 20-point drop in the firm’s own newly issued stock.

  Because the crash didn’t usher in a recession, the public wasn’t immediately galvanized into reform. Yet financial reform had lagged behind the 1929 crash by three to four years, arising only after prolonged Depression exposed the full economic consequences of the 1920s speculation. The closest analogy to the post-1929 outcry over pools and short selling was the controversy over computerized program trading. Once again there was a tendency to trace the crash to the internal mechanics of the market itself. In January 1988, Merrill Lynch, Shearson Lehman Hutton, and Goldman, Sachs suspended index arbitrage trading for their own accounts. But Morgan Stanley didn’t need to worry about angry small investors and exhibited its new renegade stance, despite the fact that Parker Gilbert was a governor of the New York Stock Exchange. It suspended its own “proprietary” program trading only after pressure from Congressman Edward J. Markey’s Subcommittee on Telecommunications and Finance. It was also notified by Maurice R. Greenberg, chief executive of the American International Group, a New York insurer, that his firm would cease business with houses that persisted in stock-index arbitrage for their own accounts.