Running Down Wall Street

Bear Stearns. Lehman Brothers. Merrill Lynch. Three of Wall Street's venerable names failed to persuade the markets that they would survive as independent banks. Yesterday the last two of the independent titans of Wall Street came under fire.
Both Goldman Sachs and Morgan Stanley are were battered yesterday by the stock market. At its lowest point, Goldman was down 25 percent, with its stock trading below $100. Morgan Stanley was hit even harder, plunging 40 percent in intraday trading. By the end of the day, the question was which commercial bank would combine with Morgan Stanley, and whether Goldman might go private or also merge with a commercial bank.
Behind the scenes things were even worse. Hedge fund clients were in full flight from Morgan Stanley and Goldman Sachs, according to a person familiar with the matter. The larger commercial banks found themselves inundated with new clients for their prime brokerages. As many as twenty hedge funds approached one large commercial bank with a prime brokerage. It looked like a run on the banks might get started.
The process of watching an investment bank rapidly implode can be perplexing. Why should even a dramatic decline in its stock price force an investment bank out of business? Even if investors lost confidence in the investment bank, wouldn't it still have a strong team in place that could continue serving its customers? As with Bear Stearns, Lehman and Merrill Lynch, however, the customers of Morgan Stanley and Goldman Sachs apparently began to pull their business while the share price faltered, according to our source. It looked as if the stage was being set for another run on the bank.
Scholars looking at the old-fashioned bank runs of the 1930s, when customers raced to withdraw their deposits from faltering banks, have come up with an explanation for bank runs that sheds light on what happened to Lehman Brothers last week. As it turns out, shareholders unknowingly provide an important service for a bank's customers, providing outside oversight of a bank's activities. In particular, scrutiny by sophisticated institutional shareholders can act as a check against abusive or overly risky activity. A sell-off by these shareholders signals two things: risk at the bank has increased and the shareholder oversight mechanism is no longer in place.
The customers of investment banks, like depositors at commercial banks, depend on shareholder scrutiny, and withdraw their business from the banks when a dropping stock price signals this has broken down. Yesterday, enough shares traded hands to replace nearly every third owner of Goldman Sachs and Merrill Lynch. It hadn't reached the Lehman stage yet, where the volume over a few days amounted to every share of the companies stock. Still, customers watching could conclude that the shareholders who had been watching the shop had fled for the exits.
Until last week, many believed that Lehman couldn't fall prey to a Bear Stearns style bank run because it had something Bear never had: access to the primary dealer lending facility, a special program that allows investment banks to borrow from the Federal Reserve's emergency discount window. Opened after the collapse of Bear, the discount window should have guaranteed Lehman wouldn't ever lack the funds it needed to run its business. But according to people familiar with the matter, Lehman's customers last week started moving their funds from margin accounts, which Lehman could tap for liquidity, to segmented custodial accounts, where the money is out of Lehman's reach. As the process played out, Lehman would quickly find itself grasping for funds. If customers and investors don't regain confidence in Morgan and Goldman, the same process could well get underway.
Just as banks' depositors occasionally make runs on banks despite the existence of deposit insurance, investment banking customers of Lehman began a bank run despite the emergency backstop. They may be preparing to do the same to Goldman and Morgan. In the end, the Fed's backstop is no substitute for trust and scrutiny by the markets.