Wall Street’s new world order

It took 10 days for Russian revolutionaries in 1917 to overturn centuries of Czarist rule but capitalism works even faster.

In just six days last week, the U.S. financial system was turned on its head. Events are still unfolding, and a domestic financial crisis that’s generated worldwide chaos is — like the Russian Revolution — likely to resonate for awhile.

For financial advisers, questions range from how to reassure clients that their investments are safe — and where in the world to find positive returns — to figuring out whether their own firms or custodians or banks (or all three, in a scenario that’s no longer farfetched) will be standing in the same form tomorrow.

Two giants of Wall Street vanished over the Sept. 13 weekend (farewell, Lehman Brothers, adieu, Merrill Lynch as we now know it), and over the next few days the world’s biggest insurer was all but federalized (adios AIG, may your asset sales benefit taxpayers). On Tuesday, New York-based Reserve Management Corp., the company that invented money-market funds, astoundingly announced that one of its hallmark funds broke the buck because of its debt holdings from Lehman Brothers Holding Inc. of New York (regrets Reserve Primary Fund).

As of this writing, the sustainability of the nation’s biggest thrift was in doubt (hang by your thumbs, Washington Mutual Inc. of Seattle) while concerns mounted that the two remaining giants of Wall Street will take a lead from New York-based Merrill Lynch & Co. Inc.’s match with Charlotte, N.C.-based Bank of America Corp. and fall into the arms of big commercial banks that can finance their daily cash-hungry trading needs (hang in there, Goldman Sachs Group Inc. and Morgan Stanley). In June, The Bear Stearns Cos. Inc. of New York, of course, was drummed by the U.S. government into the embrace of JPMorgan Chase & Co., also of New York.

“Can we stay independent?” one veteran Morgan Stanley broker in the Southeast asked rhetorically last Monday morning. “The short answer has to be if the rest of them couldn’t make it, how can we?”

The chief financial officers of Morgan Stanley and The Goldman Sachs Group Inc., both of New York, vehemently defended their independence last week, claiming their cash reserves were strong and their funding more than adequate. But without the leverage (billions in borrowed money that hedge funds, money market funds and rival banks will no longer lend), it’s hard to imagine how the New York investment banks will maintain the fraying golden threads in their bankers’ pinstriped suits.

The markets are certainly worried, and the government’s schizoid responses to each day’s crisis don’t help restore confidence. (We won’t bail out AIG, we will bail out AIG, Treasury Secretary Henry Paulson said, evoking images of a kid picking she-loves-me, she-loves-me-not daisy petals.) Even after Goldman and Morgan Stanley reported third-quarter profits last week that exceeded expectations, their stocks were brutally battered.

As we pen these words, the two financial icons were said to be discussing marriages with big commercial banks such as Charlotte, N.C.-based Wachovia Corp., the banking giant that is struggling with its own credit card- and real estate-related woes. All rumors can be justified. A Wachovia-Morgan Stanley marriage? Sure, because John Mack, Morgan Stanley’s chief executive, is a dyed-in-the-wool Tar Heel, owns a beachfront North Carolina estate and is a Duke University alumnus. A Morgan Stanley-JPMorgan match? Sure, because Mr. Mack, 63, would love to retire with a bang, reuniting the House of Morgan that the Glass-Steagall Act ignominiously destroyed 75 years ago.

A Goldman-Wachovia deal: Of course. New Wachovia chief executive Robert Steel, an ex-Goldman executive and more recently Treasury undersecretary, would love to reunite with his old friends, prop up his Goldman holdings and help out Hank Paulson.

Bottom line (pardon me for bringing that up): It’s hard to imagine how the investment banks can profit in today’s credit-scarred world. Their trading and arbitrage machines are rusting, and they certainly can’t compensate with advisory and underwriting fees when corporations have stopped calling.

It’s just as difficult to imagine how Bank of America, Wachovia and other banking giants can profitably integrate these complex Wall Street enterprises into their already vast structures. Has anyone looked at the earnings statements and loan-loss reserves at New York-based Citigroup Inc. lately? You’ve heard of too big to fail, but how about “too big to manage?”

It’s tough to explain all this to clients, when the credit-linked roots of the problems are so complex and the government response so understandably inconsistent. Here’s a try.

For several golden years, commercial and investment banks happily minted mortgages and loans to borrowers of all stripes — credit quality be damned — and were content that they wouldn’t be holding the loans because the loans had been parceled off to investors as securities. The music stopped when the short-term lenders that had financed the debt lost confidence in the credit juggernaut, and skeptical hedge funds jumped on the bandwagon.

The regulators were handcuffed. A Morgan Stanley official whispered to me last February that his buddy — a Federal Reserve governor — said Fed chairman Ben Bernanke’s priority was to avoid any perception that he was bailing out Wall Street and its stockholders. And no one could accuse Mr. Paulson, erstwhile leader of Goldman Sachs, of wanting to interfere with the free markets.

But as Bear Stearns collapsed and regulators analyzed its worldwide network of credit relationships, they knew that things at the center were falling apart. So they rushed in with a $29 billion guarantee to JPMorgan to convince it to absorb the Wall Street firm and its bad assets. Then came last month’s rescue of crippled mortgage agencies Fannie Mae of Washington and Freddie Mac of McLean, Va. And last week, it was another $85 billion to support New York-based American International Group Inc.

So what do you tell your clients? Morgan Stanley co-president James Gorman and global wealth management group chief Ellyn McColgan took a stab in a Sunday-night missive eight days ago to the firm’s 8,500 advisers. “As always during periods of severe market volatility, we can be of enormous value to our clients by helping them avoid emotional overreactions and stay mindful of the benefits of portfolio balance, diversification and sticking to the long-term plan,” they advised in an internal alert to brokers.

In other words, stay cool.

That may be a cliché when the walls are crumbling, but what else can they say? Well, they did have another thought.

Remind clients that Morgan Stanley is strong, profitable and highly respected, they wrote. And, don’t forget that client accounts are held in custody far from the firm’s balance sheet. “If the concern arises, you can assure them that their assets are safe and sound at Morgan Stanley,” they counseled.

The message was cold comfort, said one adviser who shared the memo with InvestmentNews and expressed concerns about Morgan Stanley’s fiscal health.

One thing that has changed is that his bosses at Morgan Stanley and at competitors like UBS Financial Services Inc. of New York, Merrill Lynch of New York and Smith Barney, a unit of Citigroup, are no longer urging brokers to push derivatives and other complex products fashioned by their investment bankers to wealthy investors. “You can bet clients are insisting on transparency, and we are becoming a much more simple firm,” the adviser said. “We won’t be offering complex structured investments and pushing them down their throats,”

E-mail Jed Horowitz at [email protected].