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

by Ron Chernow

  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.

  CHAPTER THIRTY-SIX

  SKYSCRAPER

  IN 1989, Morgan Stanley, with sixty-four hundred employees, occupied seventeen floors of the Exxon Building on Sixth Avenue—more than Exxon itself. The building was now owned by a Mitsui unit. Stepping off the elevator into the thirtieth-floor reception area, one was greeted by a portrait of Jack Morgan and glimpses of old rolltop desks salvaged by now-retired partners. In the posh dining room, with its well-spaced tables and leather armchairs, uniformed waiters served Madeira or dry sherry, but (by Morgan tradition) no hard liquor. Such touches aside, the new Morgan Stanley—bold, rich, swaggering—had little in common with the mandarin firm that started life in September 1935 in a flower-banked room at 2 Wall Street.

  Instead of underwriting, Morgan Stanley now stressed takeovers and merchant banking. After the crash, it de-emphasized securities distribution and edged out dozens of managing directors, largely from the sales and trading side. In 1988, Merrill Lynch, once scorned as plebeian, led domestic underwriters for the first time as Morgan Stanley slumped to sixth place. Morgan mostly pursued junk bonds, now the most profitable form of underwriting and an indispensable adjunct to takeover work. When Drexel Burnham lost ground with the investigation into junk bond king Michael Milken, Morgan Stanley briefly emerged as the top junk bond firm in America! Did the ghosts of Pierpont, Jack, and Harry Morgan shudder?

  Morgan Stanley was an undoubted success story, an awesome performer. For over fifty years, it had stood at or near the peak of investment banking—a claim no other firm except First Boston could make. It had survived every competitive threat. Smart, with an uncanny surefire strategic sense, it alone seemed immune to the postcrash blues on Wall Street. In 1987, it was the one publicly traded securities house to boost earnings. As if invincible, it lifted the pay of its five top executives to about the $3-million mark, so that each made more than the chairmen at rival firms; Parker Gilbert was paid $4.4 million in salary and bonus. It registered $395 million in profits for 1988—an extraordinary 71-percent rise in a sluggish trading environment. At the same time, it had avoided the chronic dissension that debilitated many rivals.

  Yet for all its astounding success, the Morgan Stanley story was profoundly troubling. It had followed a flawless instinct for profit into ever-riskier activities with greater potential hazard for the nation’s economy. As the 1980s ended, it resembled an industrial holding company more than a financial services firm. It had stakes in forty companies with over $7 billion in assets and seventy-two thousand employees. Morgan Stanley was suddenly a part owner of food chains and paper mills, textile plants and airplane-engine makers. These investments were reaping 40-percent returns and foreshadowed an even stronger tilt toward merchant banking and away from the trading and distribution of securities in New York, London, and Tokyo that had been the firm’s salvation in the 1980s.

  In the 1970s, LBOs had been small, largely friendly deals involving stable, recession-proof companies. Now the sheer scale of institutional money mustered by LBO funds—$25 billion in 1988, or enough to acquire $250 billion worth of companies—created irresistible pressure to take over all kinds of companies. In striking testimony to the speculative bent of American finance, 40 percent of the loan portfolios at large Wall Street banks were going to LBOs. Through pension fund stakes in such activity, corporate America was cannibalizing itself. With so much easy money at their disposal, LBO funds turned to hostile raids and now operated by the same ruthless logic as merger work.

  The reductio ad absurdum was the $25 billion RJR Nabisco deal, the largest LBO ever. In 1985, Morgan Stanley had represented Nabisco Brands when it was being acquired by R. J. Reynolds; everybody lauded the diversification. Now, three years later, the same people spotted hidden values in busting it up. Along with Drexel Burnham, Merrill Lynch, and Wasserstein, Perella, Eric Gleacher of Morgan Stanley advised Henry Kravis, who defeated an investor group led by RJR Nabisco chief executive F. Ross Johnson and his investment banker, Shearson Lehman.

  For a takeover that promised no economic benefit for the company, the RJR Nabisco deal showered bankers with huge rewards—almost $1 billion in fees and expenses. Morgan Stanley came away with a cool $25 million. Like most LBOs, it was executed almost entirely with borrowed money. In return, RJR Nabisco was burdened with over $20 billion in debt. Before it sold a cigarette or a biscuit each year, it was already in the hole for $3 billion in interest payments. It was forced to shoulder debt equal to the combined national debt of Bolivia, Jamaica, Uruguay, Costa Rica, and Honduras. Only ten countries in the world were more indebted. In more innocent days, investment bankers had put companies on a sound footing and jealously guarded their credit rating. Now, even as the Kravis forces toasted their victory, RJR Nabisco bondholders saw their A-rated bonds deteriorate into junk bonds, with $1 billion in value wiped out overnight. And by the summer of 1989, the company had announced plans to fire 1,640 workers as a way to save money to service the oppressive debt burden. That fall, a collapse in the junk bond market suggested that RJR Nabisco had indeed been the era’s crowning folly.

  In Morgan Stanley’s high-risk, high-reward LBO strategy, some observers saw the prelude to a final deal—the firm would sell out to the highest bidder. Its executives had already profited royally from the 1986 public offering, earning tens of millions of dollars apiece; now they would gain a second bonanza. According to one theory, this ultimate deal would await S. Parker Gilbert’s stepping down as chairman. As son of a J. P. Morgan partner and stepson of Harold Stanley, the prediction went, he didn’t want to be Morgan Stanley’s last chairman. The firm was also being rent by turf battles, especially between Dick Fisher and Bob Greenhill, and top people wearied of the infighting.

  In another sign of the times, Morgan Stanley ended up in an insider trading scandal second in size only to Ivan Boesky’s. In June 1986, Morgan Stanley hired Stephen Sui-Kuan Wang, Jr., who had recently left the University of Illinois, evidently without graduating. Wang, twenty-four, was first assigned to the LBO division, then in March 1987 was moved over to mergers.

  In mid-1987, Wang was coaxed into an insider trading scheme by a Taiwanese investor named Fred Lee. From July 1987 to April 1988—undeterred by the crash—Wang fed Lee tips on twenty-five pending deals in exchange for a modest $250,000. Within a year, Wang—young and green—had obtained information on twenty-five proposed takeovers despite his personal lack of involvement in many of them. He started his criminal career right after the extensive publicity generated by the Dennis Levine and Ivan Boesky insider trading scandals. Armed with Wang’s tips, Lee earned $16.5 million in ten months—while Boesky had taken five years to earn $50 million and Levine had taken five years to make a scant $12.6 million.

  Though Morgan Stanley had no criminal involvement, it didn’t escape criticism. U.S. District Attorney Rudolph Giuliani said, “You would think there would have been better controls, better procedure
s.”1 According to affidavits, junior analysts sat in a big space called the bull pen, where they openly discussed their deals. More embarrassing, the brazen Fred Lee had five trading accounts at Morgan Stanley and routed many trades through the firm itself. His account there showed over $2 million in profit. He frequently visited Morgan Stanley and had even developed an in-house reputation for pestering LBO fund analysts with calls. Morgan Stanley’s computers had flagged Lee’s trades, but when investigators challenged him on nine of them, he attributed his extraordinary luck to rumors and newspaper stories. The Morgan Stanley investigators swallowed this story, even though the trades occurred right before public announcements and tallied with Morgan Stanley’s own deals. Among others, SEC commissioner David Ruder was puzzled by the firm’s failure to detect such shameless operators.

  In October 1988, Stephen Wang was sentenced to three years in federal prison, Federal District Judge Kevin T. Duffy telling him, “You had a brilliant future and you blew it on greed. . . . The first time you could have been a crook, you were.”2 Lee remained a fugitive from justice. Public reaction to the Wang case differed markedly from that to the Adrian Antoniu case early in the decade. Once again, the press noted the prestige of Morgan Stanley, but without the same sense of disbelief, the mournful sense of a smashed idol, that accompanied the earlier news. The firm had squandered its moral franchise. Morgan Stanley was now another big, wealthy Wall Street house out to make a buck and was distinguished only by the fact that it did so better than anybody else.

  INSIDE 23 Great Winchester Street, Morgan Grenfell hardly seemed in ferment. With its green carpets and ornately framed portraits on pale yellow walls, it maintained its aristocratic dignity. Yet Morgan Grenfell was fighting for its future. After Guinness, it hired John Craven as chief executive, buying his boutique firm, Phoenix Securities, for $25 million and giving him a 5-percent stake in Morgan Grenfell. He already had several ports of call on his crowded résumé. A protégé of Sir Siegmund Warburg, he had been chairman of Crédit Suisse White Weld and Merrill Lynch International. He had quit Merrill after confronting then-chairman Don Regan over what he saw as meddling from New York. Creating and operating Phoenix Securities from his Chelsea home, he engineered two dozen Big Bang mergers and emerged as the deal maker’s deal maker. Handsome, demanding, and restless, he didn’t pass a full week in England in 1986 and crisscrossed the Atlantic forty times.

  Although Craven envisioned Morgan Grenfell as a global investment bank on the American model, the firm wouldn’t fulfill his goals. Unlike Morgan Stanley and Morgan Guaranty, 23 Great Winchester had gone too long without a carefully conceived strategy. The world of securities trading had been too alien to its former leadership. It hadn’t anticipated change or focused the scattered energies of the firm. In retrospect, it had erred fatally by spurning its Morgan brethren at Bermuda in the early 1970s. It had sacrificed that one inestimable advantage—its association with the American House of Morgan.

  Worst of all, distracted by the casual riches of takeovers, it had moved gingerly in preparing for Big Bang and gotten stuck with bit players. It never established a major presence in trading gilts (British government bonds) or equities. The firm’s takeover clients never broadened their business to the firm’s weak securities side. Craven himself had sounded warnings of disaster in the overcrowded London markets after the drop in share volume that followed Black Monday. Morgan Grenfell’s trading rooms were bleeding the firm.

  On December 6, 1988, Morgan Grenfell abruptly shut its securities operation, ending its chances of becoming an integrated global investment bank. There was a wholesale firing of 450 people, or a quarter of its entire payroll—one of the biggest sackings in City history. Some traders had earned £200,000 a year (about $370,000), and their fate underscored the City’s transient wealth. Even the method of their dismissal was emblematic: by an accidental leak, the news first appeared on their trading screens. To offset the leak, the firm rushed out an announcement as people arrived for work. In this confused situation, some gilt traders continued dealing for an hour, unaware that they were jobless. Though Craven handled the massacre with commendable tact, arranging generous severance packages, it was a terrible blow to Morgan Grenfell. For the City, this biggest firing since Big Bang was a thunderclap that symbolically closed the frantic 1980s. In March 1989, John Craven announced a loss for 1988—perhaps the first in Morgan Grenfell’s 151-year history.

  The modern world wasn’t charitable to capital-short banks, and Morgan Grenfell was stuck in that perilous middle rut. It still had a collection of choice businesses, especially the booming merger and global-asset-management departments. It had bought C. J. Lawrence in New York, an excellent institutional research and brokerage firm, which it merged with its American operation. Thanks to strength in export and project finance, it had over $600 million in government-guaranteed loans to strengthen its balance sheet. Finally, as a specialist in financing trade with the Soviet Union, it was the merchant bank best poised to capitalize on perestroika. And Craven moved aggressively to capitalize on such assets. Yet without a securities operation, these strengths didn’t coalesce into a modern global bank.

  Sheared of its money-losing securities business, Morgan Grenfell suddenly looked like a takeover target. Many City cynics suspected that Craven, an inveterate job hopper and shrewd deal maker, had a mandate to make the investment bank’s strategy work or else auction off the firm. “I think John’s goal is to turn Morgan Grenfell around, get it in shape, and then sell it, probably to Deutsche Bank,” a friend remarked. (Deutsche Bank had bought a 4.9-percent stake in 1984.) “He’s a bulldog—he won’t let anything slip out of his bite.” Morgan Grenfell had long been protected by loyal institutional shareholders. Yet the day after the crash, insurance broker Willis Faber said its one-fifth stake was up for sale. Morgan Grenfell was joining the faithless, rootless world of modern finance.

  By 1989, Morgan Grenfell seemed ripe for the taking by bigger rivals. In shedding the bank’s securities business and swiftly restoring profitability, Craven only added to its allure as a takeover target. And so the bank that had specialized in hostile takeovers found itself in November the object of an unwelcome embrace from Banque Indosuez of France. Craven brought in Deutsche Bank as a white knight and extracted a rich price for the firm: over $1.4 billion, or more than twice its book value. This breathtaking bid settled the contest. Craven, the consumate negotiator, became the first foreigner invited onto the Deutsche Bank board. The hoopla was spiked by the grisly slaying of Deutsche Bank head Alfred Herrhausen by terrorists. The generous settlement also obscured the fact that 151 years of noble independence had been suddenly swept away.

  OVER fifty years later, J. P. Morgan and Company appeared to have erred in its choice of commercial banking in 1935. If it saved Depression-era jobs, it also burdened the House of Morgan with what proved to be a dying business—wholesale lending. Large companies no longer turned to banks for short-term credit or seasonal lending—activities now relegated to the commercial paper market. So Morgans had gradually undone its history and grown into a hybrid investment bank, much like its rival down the block, Bankers Trust.

  The House of Morgan led the fight to repeal Glass-Steagall. Like other banks, it tried to scramble into so many investment bank activities that Congress would have to rubber-stamp the marketplace reality. Lew Preston also believed in making an intellectual case for change, and in 1984 the bank produced a treatise called Rethinking Glass-Steagall. One patron was Alan Greenspan, then a Morgan director, who followed Paul Volcker as Fed chairman. “As a director, Greenspan was very instrumental in getting that document out,” said a Morgan insider.

  Lew Preston knew that after Rule 415, straight blue-chip underwriting was a less lucrative auction business. The Morgan bank wanted to underwrite corporate bonds mainly to offer customers a full line of financial services. It was also necessary to finance takeovers. Although Morgans was dubbed the Fed’s bank, Preston could never budge Paul Volcker on Gla
ss-Steagall. Still worried about banks performing “risky” securities work, Volcker would reply that he didn’t worry about Morgans, but about three or four other banks. Morgans was also reaping the highest return on equity and assets of any American bank during the Volcker years. “Unfortunately, we were having some pretty good earnings,” Preston conceded, “and so there was skepticism on the part of the Fed chairman.”3

  Having helped Volcker at least three times—with the Hunt brothers, Continental Illinois, and the Brazil debt rescheduling—Preston fretted about the lack of a quid pro quo. A friend of Preston’s noted that “Lew was very close to Volcker in pulling acorns out of the firm. He had broken his back on those three cases. I remember Lew saying, ‘I had a lot of chits on Paul, and yet Paul is still against banks going into the debt markets.’ I’m absolutely positive that Preston felt somewhat betrayed by Volcker.” Other Morgan officials felt they had gained little for being such a model of obedience. As one Morgan insider said bitterly, “I’m tired of being the Fed’s pet.”

  As recently as 1984, the New York Times had said it would be “a matter of seconds” before Morgan Guaranty and Morgan Stanley got back together if Glass-Steagall fell.4 Twenty years before, this was indisputable. But as the 1980s progressed, the warmth between the Morgan brethren waned. Young hotshots at Morgan Stanley felt more kinship with the flamboyant Bankers Trust, which specialized in risky trading and merchant banking, than with the austere, circumspect Morgan Guaranty. One could more readily imagine Morgan Guaranty teamed up with Goldman, Sachs than with Morgan Stanley. The two Morgan houses no longer made a natural match and were especially keen adversaries in Tokyo and London.

  Investment bankers were fatalistic about Glass-Steagall’s fall. As Fred Whittemore said of Morgan Stanley’s decision to go public in 1986, “We are taking advantage of a 3-to-5 year window, before the banks become full-fledged competitors, to become as large and powerful as quickly as we can.”5 Morgan Stanley’s LBO war chest and large capital freed it from reliance on commercial banks in financing takeovers. With its new merchant-banking orientation, Morgan Stanley didn’t much care about Glass-Steagall’s demise, which would affect only a small, declining part of its operations. Morgan Stanley managing director Robert A. Gerard warned Congress, in strangely populist tones, that if Glass-Steagall fell, “there will be a vast increase in the concentration of economic power in large banking organizations.”6 But his firm made only perfunctory moves against what it saw as a largely irrelevant law.