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The Big Brokers Blew It. They Should Bear the Cost.

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By William D. Cohan
Sunday, April 6, 2008

Once upon a time on Wall Street, in the days when investment banks were small private partnerships, a simple but ingenious idea kept bankers and traders accountable for their actions: the collective-liability clauses in their partnership agreements. A mistaken trade here or bad advice there, and all the partners suffered. Conversely, if things went well -- as they mostly did -- these same agreements rewarded them with lavish compensation that soon included Fifth Avenue apartments, ocean-front estates in the Hamptons and priceless art collections.

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This is worth remembering as Wall Street and Washington take increasingly desperate and historic measures -- even using taxpayers' money -- to stanch the financial meltdown now occurring before our eyes, including the near-bankruptcy of global investment bank and brokerage firm Bear Stearns & Co. Accountability has been absent from Wall Street for too long. Unless we restore it to the equation -- amid all the other proposals for fixing the capital markets now being bandied at both ends of Pennsylvania Avenue -- the chances are high that the cycle of boom and bust will keep churning.

Since 1792, when a group of 24 traders met under a buttonwood tree at 68 Wall Street, various forms of the collective liability clause's legal alchemy have worked magically. Take Lazard Frères & Co., the last major private partnership on Wall Street. For 157 years, its partners became extraordinarily wealthy by spinning their whispered advice about deals into ever-increasing high-margin fees. Among the earliest Lazard partners were Marc Eugene Meyer and his son, Eugene Isaac Meyer, a wealthy financier who bought this newspaper out of bankruptcy in 1933 for $825,000 and who served as chairman of the Federal Reserve and the first president of the World Bank.

Such was the clarity of the partnership agreement's liability clause that when star mergers and acquisitions banker Ira Harris left the Salomon Brothers partnership -- where he had earned his first fortune -- to join Lazard in 1988, he made exemption from the clause an express condition of his employment. ("Not having made my capital there, I didn't want to lose it there," he said after he retired.) But Harris was the only Lazard partner so exempted. When another marched into general counsel Tom Mullarkey's office to ask about Harris's special arrangement, Mullarkey snapped, "It's none of your goddamn business."

Harris was prescient about the potential for rogue behavior among his fellow partners. A few years after he arrived, Lazard found itself at the epicenter of three separate scandals involving a few partners in its municipal finance department. By the end of the 1990s, Lazard's partners had coughed up roughly $100 million to settle the legal actions that resulted. And only because of the senior partners' direct appeals to the U.S. attorney did Lazard narrowly avoid a federal racketeering lawsuit that would have put it out of business. The magnitude of these mistakes was communicated to the Lazard partners (Harris excepted) in a language they understood perfectly: through their diminished bank accounts. That's accountability.

In May 2005, Lazard became a public company, a milestone event for the secretive firm and one that marked Wall Street's final substantive transformation -- begun a generation earlier with the initial public offering of the Donaldson, Lufkin & Jenrette brokerage -- from a clubby world of private partnerships to the global, shareholder-owned, (supposedly) hugely capitalized behemoths that roam the Earth today.

Recapitalizing Wall Street has provided substantial and lasting benefits, from the ability to provide capital wherever in the world it is demanded to employing more than a million people. But something has been lost as well, and that something is the collective accountability for individual actions that was handled so well by Wall Street partnership agreements. Nowadays, senior bankers and traders are paid millions of dollars in annual compensation based on their short-term performance. But there is no longer any corresponding way for these masters of the universe to be held accountable for their actions. Should something go terribly wrong -- say, too big an inventory of illiquid mortgage securities or a hung "bridge loan" on a big leveraged buyout -- the liability for these mistakes now rests with the non-employee shareholders, and even with U.S. taxpayers.

Like Lazard, Bear Stearns was once a private partnership. Founded in 1923, with $500,000, as an equity-trading house, Bear survived the 1929 crash without a loss or a layoff. The firm thrived under the meticulous stewardship of its second- and third-generation leaders, Salim "Cy" Lewis and Alan "Ace" Greenberg. In 1978, after the deaths of Lewis and another senior partner, who together owned 30 percent of the firm, the remaining partners arranged to buy out their families' stakes in the firm over five years. "We had to work like the sheiks to make enough money to pay out those families, which we did, and to survive," Greenberg explained in 2004. That's accountability, too.

Greenberg was said to be so tight with a buck that he ordered that new employees be given a bag of paper clips and rubber bands and told to re-use them. While other Wall Street firms took only the best and the brightest, Greenberg wanted people with "PSD" degrees: "poor, smart and with a deep desire to get rich."

Bear Stearns joined the ranks of the publicly traded Wall Street firms in October 1985. Its initial public offering was priced at $6 per share; the stock peaked at $171.50 in January 2007. The firm did not have a single losing quarter in its history until the one that ended in November 2007, when it incurred a net loss of $854 million after lowering the valuation of its inventory of mortgage securities because of a deterioration in the credit markets.

The extraordinary events of the past several weeks -- with the Federal Reserve Bank and the Treasury pushing a near-bankrupt Bear Stearns into the opportunistic arms of J.P. Morgan Chase over the Ides of March -- show that it is truer than ever that the ongoing lack of accountability on Wall Street is a serious problem for us all. Our tax dollars are being committed to pay for investment bankers' mistakes. As Russell Roberts, a professor of economics at George Mason University, explained to National Public Radio: "What's going on here is that we're in uncharted territory, a world where the Fed and the Treasury are making up the rules as they go along, where accountability is being ignored and a world where the government bails out Bear Stearns and its creditors rather than letting those who have been reckless learn a lesson for the next time."

To be sure, the shareholders of Bear Stearns -- more than 30 percent of whom are Bear Stearns employees -- believe that a collective suffering has been parsed out, given the sickening fall of Bear's stock from its January 2007 high to the $10-a-share deal that J.P. Morgan and Bear's board of directors have now agreed upon.

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