10 of the Biggest Debacles in Investment Banking History - dummies

10 of the Biggest Debacles in Investment Banking History

By Matt Krantz, Robert R. Johnson

Investment bankers are supposed to be among the smartest people in the room. Despite this, the industry has suffered some of the most egregious blunders ever witnessed in modern business.

The dot-com boom and bust

The problem was many of the investors buying into these fledging companies, many of which didn’t have any revenue or earnings didn’t understand what they were buying. Many investors hoped to ride these stocks for short-term gains.

Meanwhile, investment bankers were happy to keep shoveling out the Internet IPOs. Many of these companies had no business being public, because many of their operating models were flawed and wouldn’t stand the test of time.

Tainted research scandals

Investment bankers that provide research reports to clients are supposedly objective analysts who assess a company’s prospects and advise clients on whether to buy the shares or avoid them.

A series of investigations by the SEC and other regulators found that securities analysts paid and encouraged investors to use their reports to help the investment bankers win lucrative investment banking business. These allegedly tainted reports lured in investors with trumped up research.

Enron and the accounting scams

Enron and WorldCom still rank among some of the biggest debacles in the financial world. These two companies ended up declaring some of the largest bankruptcy filings in U.S. history.

Company Bankruptcy Date Assets (millions)
Lehman Brothers September 15, 2008 $691,063
Washington Mutual September 26, 2008 $327,913
WorldCom July 21, 2002 $103,914
General Motors June 1, 2009 $91,047
CIT Group November 1, 2009 $80,448
Enron December 2, 2001 $65,503

Source: BankruptcyData.com

It’s hard to pinpoint the single source of blame for these blunders. But investment banking certainly played a role, especially in the Enron case. Part of Enron’s downfall had to do with the company morphing from being a stable energy company to getting involved in riskier business activities, without the proper controls.

The mortgage debacle and collapse of Lehman

The ultimate bankruptcy of Lehman not only spooked the financial markets and helped spark the financial crisis of 2007, but killed off one of the oldest and most prestigious U.S. investment banks.

At the core of the issue was the explosion of subprime mortgage loans. In the old days, homebuyers would visit a local bank and get a loan. That bank would hold the loan and collect the interest on it. But investment banks revolutionized the mortgage business with securitization. The investment banks would make mortgages and bundle them into securities that would be sold to outside investors looking for higher yields.

The Flash Crash

May 6, 2010, was a regular trading day when all of a sudden crisis hit. In just a matter of minutes, the Dow Jones Industrial Average plunged a jaw-dropping 1,000 points, only to recover just as quickly. The markets were already jittery over the European debt crisis at the time, which was accompanied with civil unrest in Greece. The reasons for the crisis are debated even to this day.

The London Whale at JPMorgan

One of the JP Morgan’s traders, Bruno Iksil with the cool nickname “London Whale,” made a number of bad bets on credit default swaps, or financial instruments that allow investors to buy and sell risk.

The bad bets resulted in JPMorgan having to report a loss of $2 billion at its original estimate, which got even bigger after all the trades were unwound. The bad moves also resulted in an investigation into the company’s risk controls.

Long-term capital management

The board of directors at Long-Term Capital Management thought they’d found a way to outsmart the market. They used complicated trades that capitalized on differing prices of U.S., Japanese, and European bonds.

Long-Term Capital Management took a hit during the 1997 East Asian Financial crisis. The big hit came with the 1998 Russian financial crisis, when the Russian government defaulted on bonds. This caused investors to dump Japanese and European bonds. This resulted in the implosion of their trading system. It was forced to sell its positions putting the market in a tough spot.

Things got so ugly that the federal government stepped in to organize a bailout.

Bankruptcy in Jefferson County, Alabama

The muni bond market suffered a massive shock in November 2011, when Jefferson County, Alabama, filed for bankruptcy, involving debts of more than $3 billion.

The county’s woes were connected to the construction of a sewer system that was supposed to cost about $300 million, but ended up costing $3.1 billion due to construction problems and bum investment bets on bonds and derivatives. The SEC wound up charging J.P. Morgan Securities of “an unlawful payment scheme” that allowed them to profit from Jefferson County’s bond offerings.

IPO allocations with CSFB

There have long been investigations into whether investment banks have used their shares of lucrative IPOs to win additional investment banking business.

A landmark settlement in this area arose in January 2002, when the SEC filed charges against Credit Suisse First Boston for “abusive practices relating to the allocation of stock in ‘hot’ initial public offerings.’” The firm paid a $100 million resolution.

The SEC said that CSFB gave shares of hot IPOs to more than 100 of its customers, who returned 33 percent to 65 percent of their IPO profits to CSFB. “CSFB wrongfully obtained tens of millions of dollars in IPO profits through this improper conduct,” the SEC found.

Bad mergers and acquisitions like AOL Time Warner

AOL paid an estimated $124 billion to buy Time Warner in the deal announced in 2000.

The deal failed to produce significant benefits. AOL, facing competition for access from telephone and cable companies, saw its cash cow of selling monthly access drop off. On May 28, 2009, Time Warner announced it would spin off AOL into a separate company, after failing to find another company to buy it.

Time Warner’s 95 percent stake in AOL was worth $6.3 billion based on estimates at the time.