Bypassing Wall Street
The Harm that Wall Street Causes
We don’t need Wall Street anymore. We have all the tools we need to bypass the financial intermediaries and take charge of raising and investing money. Today’s technology allows the suppliers and users of capital to communicate directly with each other. Later sections of Bypassing Wall Street describe how those direct relationships are happening now and how they can be developed as an alternative to the Wall Street intermediaries.
It isn’t just that we have the ability to bypass Wall Street—that we should do it just because we can. We urgently need to free ourselves of the grip that Wall Street has over finance. The harm that Wall Street causes is intolerable. This chapter takes us into some of the most egregious penalties inflicted on us all by Wall Street. As Nobel laureate economist Joseph Stiglitz said in addressing his peers, the purpose of a financial system is "to manage risk and allocate capital at low transaction costs." What has Wall Street actually done? "They misallocated capital. They created risk. And they did it at enormous transaction costs." [http://economistonline.blogspot.com/2010/01/report-from-aea-meeting-part-i.html]
Wall Street Causes Our Economy to Crash
A few days after the Crash of 2008 began, Robert Samuelson wrote, “Greed and fear, which routinely govern financial markets, have seeded this global crisis. Just when it will end isn't clear. What is clear is that its origins lie in the ways that Wall Street -- the giant investment houses, brokerage firms, hedge funds and ‘private equity’ firms -- has changed since 1980.” [Robert J. Samuelson, “Wall Street’s Unraveling,” Washington Post, Wednesday, September 17, 2008; Page A19] Eric Hovde added at the same time, “Looking for someone to blame for the shambles in U.S. financial markets? As someone who owns both an investment bank and commercial banks, and also runs a hedge fund, I have sat front and center and watched as this mess unfolded. And in my view, there's no need to look beyond Wall Street -- and the halls of power in Washington. The former has created the nightmare by chasing obscene profits, and the latter have allowed it to spread by not practicing the oversight that is the federal government's responsibility.” [Eric D. Hovde, “Calling Out the Culprits Who Caused the Crisis,” Washington Post, Sunday, September 21, 2008; Page B01. See John Lanchester, I.O.U.: Why Everyone Owes Everyone and No One Can Pay, Simon & Schuster, 2010]
[See the 553-page Financial Crisis Inquiry Report, January 2011, at http://c0182732.cdn1.cloudfiles.rackspacecloud.com/fcic_final_report_full.pdf. Books published about the 2008 Wall Street debacle include: John Cassidy, How Markets Fail; William D. Cohan, House of Cards; Charles Ellis, The Partnership; Greg Farrell, Crash of the Titans; Gary Gorton, Slapped by the Invisible Hand; Alan C. Greenberg, The Rise and Fall of Bear Stearns; Simon Johnson and James Kwak, 13 Bankers; Kate Kelly, Street Fighters; Paul Krugman, The Return of Depression Economics and the Crises of 2008; Michael Lewis, The Big Short; Roger Lowenstein, The End of Wall Street; Susanne McGee, Chasing Goldman Sachs; Bethany McLean and Joe Nocera, All The Devils Are Here; Charles R. Morris, The Trillion Dollar Meltdown; Scott Patterson, The Quants; Henry M. Paulson, On the Brink; Yves Smith, ECONned; Robert J. Shiller, The Subprime Solution; Andrew Ross Sorkin, Too Big to Fail; Joseph E. Stiglitz, Freefall; Matt Taibbi, Griftopia; Gillian Tett, Fool's Gold; Vicky Ward, The Devil's Casino; Gregory Zuckerman, The Greatest Trade Ever.
Of course, many factors contributed to the Panic of 2008, as well as the earlier panics that were triggered by Wall Street abuses. Some causation can be laid to crowd psychology and mass mania. [Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds, Richard Bentley, 1841, Farrar, Straus and Giroux, 1932] Classical economists since John Stuart Mill have applied this theory to economic bubbles, or manias, and the following panics and crashes. The theory is defined in a model developed by Hyman Minsky. It describes the cyclical flows of optimism and pessimism among investors and lenders. But the cycles, beginning with the mania, and followed by the panic and later crash, “start with a ‘displacement’ some exogenous shock to the macroeconomic system.” The result is that “the anticipated profit opportunities would improve in at least one important sector of the economy.” People “would borrow to take advantage of the increase in the anticipated profits.” [Charles P. Kindleberger and Robert Z. Aliber, Manias, Panics, and Crashes: A History of Financial Crises, fifth edition, John Wiley & Sons, Inc., 2005. Carmen M. Reinhart and Kenneth Rogoff, This Time is Different: Eight Centuries of Financial Folly, Princeton University Press, 2009 and J. Bradford DeLong, "Notes on Bubbles," http://issuu.com/delong/docs/delong---notes-on-bubbles---april-21--2009-]
The Minsky model, with its "exogenous shock," certainly described what happened in the Panic of 2008. Wall Street created the “displacement” that came from the anticipated profit opportunities in real estate ownership and financing. The changes in the way real estate was financed, created by mortgage securities and credit default swaps, were a primary cause of the liquidity and credit crunch. [Markus K. Brunnermeier, "Deciphering the Liquidity and Credit Crunch 2007-08, In September 2008, when the mania suddenly stopped, we went into a panic and had the resulting crash. Wall Street was the instigator and the driving force behind that displacement. “By increasing leverage — that is, by making risky investments with borrowed money — banks could increase their short-term profits. And these short-term profits, in turn, were reflected in immense personal bonuses. If the concentration of risk in the banking sector increased the danger of a systemwide financial crisis, well, that wasn’t the bankers’ problem. [Paul Krugman, “Bubbles and the Banks,” The New York Times, January 7, 2010, www.nytimes.com/2010/01/08/opinion/08krugman.html?scp=1&sq=Paul Krugman, Next up: Financial system reform&st=cse] Canada, by contrast, maintained regulatory controls over banks’ borrowings and risky investments. It largely prevented a breakdown of its financial system. [Paul Krugman, “Good and Boring,” The New York Times, January 31, 2010, www.nytimes.com/2010/02/01/opinion/01krugman.html?emc=eta1]
This wasn’t the first time Wall Street ruined our economy. There has been a repeated pattern of financial manipulation that created bubbles. When the bubbles burst, innocent people lost their lifes’ savings, their jobs and their homes. Since 1792, Wall Street has perpetrated the “Panics” that burst price and credit bubbles and led to recessions and depressions. In that first Panic, it was stock market insider trading that created the bubble. Discovery of the frauds burst the bubble, causing an economic decline. The government, in that first year of our Constitution, also set a pattern with token punishment and toothless reform. We were promised something different this time. “My job is to help the country take the long view — to make sure that not only are we getting out of this immediate fix, but we’re not repeating the same cycle of bubble and bust over and over again . . ..” [President Barack Obama, in an interview with columnists on Air Force One, reported by Bob Herbert, New York Times, February 16, 2009.]
In later Panics, it was generally more complex manipulation, selling newly created securities that made promises that couldn’t be met. The first players in those games would do spectacularly well, creating an urgent demand for more—the Minsky model “displacement.” Then some event would trigger discovery, followed by a collapse which brought down the entire economy. England has had the same consequences from games played by the City, its equivalent of Wall Street. This description of Britain’s South Sea Bubble of 1825 could as well apply to what happened with mortgage securities and derivatives nearly two centuries later: “Popular imitativeness will always, in a trading nation, seize hold of such successes, and drag a community too anxious for profits into an abyss from which extrication is difficult.” [Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds, 1841, reprinted by Farrar, Straus and Giroux, 1932]
One of the most damaging of Wall Street’s abuses came with the Panic of 1873, when Wall Street “had crafted complex financial instruments that promised a fixed return, though few understood the underlying object that was guaranteed to investors in case of default. (Answer: nothing).” When the bubble burst, “the stock market crashed in September, closing hundreds of banks over the next three years. The panic continued for more than four years in the United States and for nearly six years in Europe.” [Scott Reynolds Nelson, professor of history at the College of William and Mary “The Real Great Depression,” The Chronicle of Higher Education, October 17, 2008, http://chronicle.com/temp/reprint.php?id=477k3d8mh2wmtpc4b6h07p4hy9z83x18]
Another source of Panics was created in the 1890s, when Wall Street found a new line of business—mergers and acquisitions. In addition to the harm caused by eliminating competitors and creating industry monopolies, the takeover battles could lead to Panics. One war between investment banks, for control of the Northern Pacific Railroad, led directly to the Panic of 1901. Two Wall Street groups launched and reacted to raids, by placing orders for huge purchases of the railroad’s shares. As the stock price soared, short sellers sold heavily, betting that they would cover their short sales after the price dropped back down. Instead, Northern Pacific shares kept going up. As the short sellers were forced to sell other stocks to raise cash for covering their shorts, the rest of the market sank. Ron Chernow described the result as “the biggest market crash in a century,” with this New York Herald headline for May 9, 1901: "GIANTS OF WALL STREET, IN FIERCE BATTLE FOR MASTERY, PRECIPITATE CRASH THAT BRINGS RUIN TO HORDE OF PYGMIES." [Ron Chernow, The House of Morgan, Simon & Schuster, 1990, pages 92,93] According to Chris Farrell: “The takeover struggle for the northwestern rail is a convoluted tale of market manipulations, ruthless maneuvers, corners and shorts, soaring and plunging prices. . . . However, like so many struggles on Wall Street to this day, it was really a fight for power and dominance, of outsized ego and overheated rivalry.” [Chris Farrell, “Wall Street: Is It Good to Apologize for Greed?”, Business Week, November 22, 2009, www.businessweek.com/investor/content/nov2009/pi20091120_387385.htm?link_position=link19]
After each Panic, Wall Street has had its defenders. Following the Panic of 1907 came a book titled The Stock Exchange from Within, by William C. Van Antwerp, a self-described “busy stockbroker.” [William C. Van Antwerp, The Stock Exchange from Within, Doubleday, Page & Co., 1913, preface. The book was reprinted by Kessinger Publishing, LLC, 2006 and is available online at www.archive.org/stream/stockexchangefro00vana/stockexchangefro00vana_djvu.txt. Mr. Van Antwerp was also a collector of rare books and an alternate delegate to the 1936 Republican National Convention.] He first tells us who really caused the Panic: “We, as a people, have brought the disaster upon ourselves by reason of our indiscretions. We have lost our heads and entangled ourselves in a mesh of follies.” Then Mr. Van Antwerp goes on to explain that an individual will “not admit such reproaches, even in our communings with self. . . . He says Wall Street did it. His fathers said the same thing, and his children will follow suit.” [pages 186-187]
Besides, Mr. Van Antwerp wrote, panics are not really so bad. In fact, the recessions that follow do some necessary good chores: “Moreover, panics are rarely such unmitigated calamities as they are pictured by those who experience them. At least they serve to place automatic checks upon extravagance and inflation, restoring prices to proper levels and chastening the spirit of over-optimism.” [page 185 in the 1914 edition] A couple months after the Crash of 1929, which led to the Great Depression, Mr. Van Antwerp gave a speech to San Francisco’s Commonwealth Club: “In 1929, we merely suffered a case of nerves following a debauch. It is not to be expected that sound and conservative industry will be shaken this time.” He placed the blame for the Crash of 1929 squarely on the middle class: “This present panic had its roots back in 1917, when our masses found that they could invest money in bits of paper called Liberty Bonds. From investing to speculating was an easy step.” [http://vanantwerpfamily.wordpress.com. The role of "finance capital" in economic cycles is described by William Greider in One World, Ready or Not, Simon & Schuster, 1997, pages 227-258.]
In each of the Panics, there has been a particular player who took the game to its ultimate escalation, often getting out before the resulting collapse. Matt Taibbi laid out a chronicle of how just one Wall Street firm, Goldman Sachs, had caused five boom and bust cycles, beginning with the Crash of 1929. Taibbi claims that the firm’s investment trust, Goldman Sachs Trading Corporation, was a manipulation that collapsed and led to the Great Depression. Others were the tech bubble of the late 1990s, the oil price up and down, the housing price inflation/collapse and the federal bank bailout. He predicted the next would be the cap-and-trade game. [Matt Taibbi, “The Great American Bubble Machine: From Tech Stocks to high gas prices, Goldman Sachs has engineered every major market manipulation since the Great Depression--and they’re about to do it again,” Rolling Stone, July 9-23, 2009, page 52, available on SCRIBD at www.scribd.com/doc/16763183/TaibbiGoldmanSachs and scanned at http://zerohedge.blogspot.com/2009/06/goldman-sachs-engineering-every-major.html] One harm from the boom and bust cycles is the increase in frauds. "Swindling increases in economic booms because greed appears to grow more rapidly than wealth . . . Swindling also increases in times of financial distress . . . to avoid a financial disaster." [Charles Kindleberger and Robert Z. Aliber, Manias, Panics, and Crashes: A History of Financial Crises, John Wiley & Sons, Inc., Fifth Edition, 2005, page 189]
These Wall Street-caused panics bring their greatest harm to small businesses and their employees, America’s middle class. During the Great Recession started by Wall Street’s 2008 collapse, "Wall Street banks cut back small business lending by 9 percent, more than double their 4 percent cutback in overall lending." [Elizabeth Warren, interviewed by John Tozzi, Bloomberg Businessweek, June 28-July 4, 2010, page 46]. Job losses consistently were far greater for businesses with fewer than 50 employees than for larger employers. [For instance, see the ADP National Employment Report for September 2009, http://bizbox.slate.com/blog/FINAL_Release_September_09.pdf]
A more subtle but disruptive harm from Wall Street's monopoly over the movement of money for investment is its tendency to concentrate vast sums into a small segment of the economy. In 2011, for instance, Wall Street postponed doing IPOs and, instead, raised huge amounts of money from money managers for "private placements" of securities for Facebook, Twitter and other social media businesses. Those ventures spent much of the money hiring technical staff. The result was a shortage of these trained individuals and an increase in their compensation beyond the ability of smaller competitors to pay. [Pui-Wing Tam and Stu Woo, "Talent War Crunches Start-Ups," The Wall Street Journal, February 28, 2011, page B1] Another example is international: As Wall Street has globalized its business, it moves billions into a developing country and then suddenly takes it out. The resulting panics and recessions are left behind, to be worked out--or not--by the local government, the International Monetary Fund and World Bank, or by revolution.
At the macroeconomic level, letting Wall Street control raising money for business and investing has allowed the money monopoly to tamper with the balance between consumption and investment. The theory is that businesses choose to expand plant and equipment based upon their expectation of sales of the additional products and services they could provide. The easy access to money on very favorable terms will not persuade prudent managers to issue more shares or bonds, when they can't see making a profit on the new investment. A 1935 Brookings Institution study concluded that "the growth of new capital is adjusted to the rate of expansion of consumptive demand rather than to the volume of savings available for investment. Between 1923 and 1929, for example, the volume of securities floated for purposes of constructing plant and equipment remained practically unchanging in amount from year to year, despite the fact that the volume of money available for investment purposes was increasing rapidly. . . . The excess savings which entered the investment market served to inflate the prices of securities and to produce financial instability. [Harold G. Moulton, The Formation of Capital, The Brookings Institution, 1935, pages 158, 159]
Wall Street Sacrifices Everything for Short-Term Profits
The original purpose of a trading market was to assure investors that they would be able to resell securities they purchased. The businesses and governments that issued the securities needed money they could use for the long term. Their securities would either be bonds, to be repaid after several years, or shares of ownership, without any repayment date. Investors wanted the ability to cash out the securities they bought, at any time and for any reason. Availability of this liquidity encourages people to invest, even if they may need to get their cash back on short notice—or if they want to earn a profit and turn their money over to something else. Other investors will be interested in buying these previously issued securities, if the price is right and the process is simple and trustworthy. A trading market provides the mechanics to match sellers and buyers.
However, in a classic “tail wagging the dog,” raising capital from new securities issues has become an almost insignificant part of Wall Street. The focus changed from selling new securities to raise money for businesses; it shifted into earning commissions from getting customers to buy and sell existing securities. [As described in Chapter 1] Then, the central focus moved again, and became trading for Wall Street’s own profits, rather than for its customers. The bonds and shares, and all the derivative securities based on them, became markers for trading. Once short-term trading gains were the objective, rapid turnover became the strategy. Take the profit and get on to the next trade. At the extreme, “naked access” computer program trading can buy and sell a position in less than a second.
Wall Street’s trading mentality has infected management of the businesses which have publicly traded securities. Wall Street firms take huge positions in a company’s shares or bonds or, more likely, options or other derivatives. These trades are based upon what a trader for the firm expects about the company’s next quarter’s results, about a possible merger or other event. The trader may act on a tip about what a customer or another trader expects for the company. Businesses whose managements deliver on these short-term expectations are rewarded by more buying than selling, translating into price increases for their securities and greater management compensation.
Wall Street’s buy side, the money managers, are focused only on quarter-to-quarter performance. They demand inordinate amounts of time from chief executives and chief financial officers in their attempts to learn something that will give them a few hours jump on the next quarter’s results, so they can trade in or out. As more and more corporate ownership is concentrated in institutions, Wall Street money managers "can directly demand that the existing management of the companies whose shares they hold plunder them for the instant returns expected by an extractive financial system." [David C. Korten, When Corporations Rule the World, Berrett-Koehler Publishers and Kumarian Press, 1995, page 244]
Wall Street’s analysts came to have more influence over the decisions of CEOs than their own boards of directors. On both the buy side and sell side of Wall Street, analysts are employed to rate the investment quality of a company’s securities. The rating labels fluctuate but they are basically “buy,” “hold” or “sell.” An academic study of Fortune 500 companies from 1996 to 2000 showed that, when analysts reduced the rating, it became 50% more likely that the company’s board of directors would dismiss its president within six months. Where even one analyst stopped rating a company, the chance of the board firing the president within a year went up by nearly a 40%. According to the study’s author: “Our findings suggest that boards are not focused enough on fundamentals and too focused on Wall Street.” [Professor Margarethe Wiersema, The Paul Merage School of Business, University of California, Irvine, “CEO Dismissal: The Role of Investment Analysts as an External Control Mechanism.” Proceedings of the sixty-eight Annual Meeting of the Academy of Management, 2008. (with Y. Zhang)]
Managers can get huge rewards for playing to Wall Street’s short term trading. They can divulge “whisper” earnings predictions for a quarter, then bring in the reported earnings on target. The analysts who were favored with the selective expectations will have been able to make a profit by trading between the whisper and the formal releases. When traders become confident that they will be able to consistently make money on a company’s securities, they will favor it with a higher trading price range than other companies in the same industry. This in turn justifies increased salary and bonuses for the managers. When those managers get their compensation in the form of options to buy their company’s shares, they can vastly multiply their income. It is in the managers’ interest to receive options pegged to a temporary dip in the share price, then exercise the options and sell the shares at a peak price. Managers and traders together have the power to manipulate those trading prices.
The Aspen Institute issued a statement in September 2009, on the harm done by short-term investment objectives, signed by some of America’s most prominent names in business and finance. Among the harms the signers said “have eroded faith in corporations continuing to be the foundation of the American free enterprise system” were that short-term traders “have little reason to care about long-term corporate performance . . .,” with the result that “managers and boards pursue strategies simply to satisfy those short-term investors.” [“Overcoming Short-termism: A Call for a More Responsible Approach to Investment and Business Management,” a statement issued by the Aspen Institute Business & Society Program’s Corporate Values Strategy Group and signed by 28 additional leaders representing business, investment, government, academia, and labor, www.aspeninstitute.org/sites/default/files/content/docs/business and society program/overcome_short_state0909.pdf]
The harm from short-term investment objectives perverts entire business segments. For instance, this from a book publisher’s website: “It used to be that publishing houses would invest much of their profits from bestsellers into promoting new and talented authors. It used to be that the large publishing houses would also use these profits to provide an assortment of valuable titles that might not all sell at a profit, but that would be of great benefit to the public. . . . We now see CEOs and stockholders insist on a formula production line that says, ‘This title was on the bestseller list for 32 weeks, therefore we want to make the next book that we publish as similar as possible to the last one.’ They want to repeat the former book’s sales performance. Their philosophy: ‘Don’t reinvent the wheel; duplicate it!’ Due to that mentality, we now have only 40 authors or so that dominate more than 80 percent of the book market!”
Fixation on short-term takes away jobs and harms our domestic economy. Consider robotics, the use of computers and machines to perform tasks done by humans. There are about nine million robots being used today. [International Federation of Robotics, http://www.ifr.org/, http://www.worldrobotics.org/index.php]Growth in use of robots is inhibited because managers will forego the large current expense. Instead, they will move the work to a country which currently has low-cost human labor. Our experience has been that robotics generally creates more jobs than it displaces. By contrast, outsourcing jobs and importing products takes U.S. jobs away. The Economic Policy Institute "calculates that the growth in the U.S. trade deficit in 2010 created 1.4 million jobs overseas in 2010 and that many of those jobs were outsourced by American companies. 'But for the growth in the U.S. trade deficit, we would have created about 2.5 million jobs last year, enough to drive down the unemployment rate well below 9%.'” [Robert E. Scott, Senior International Economist and Director of International Programs, Economic Policy Institute, http://www.epi.org/pages/epinews/]
Jim Collins co-authored the very popular 1994 book, Built to Last: Successful Habits of Visionary Companies. [Co-authored with Jerry I. Porras, HarperBusiness, 1994] Just six years later, his article, “Built to Flip,” started with this report from one of his former students about dealing with Wall Street’s venture capitalists: "I developed our business model on the idea of creating an enduring, great company -- just as you taught us to do at Stanford -- and the VCs looked at me as if I were crazy. Then one of them pointed his finger at me and said, 'We're not interested in enduring, great companies. Come back with an idea that you can do quickly and that you can take public or get acquired within 12 to 18 months.' “Collins and Porras see a rise in social instability as a result of the Built to Flip short-termism: “Not only is there an increasing sense that the social fabric is fraying, as the nation's wealth engine operates for a favored few; there is also a gnawing concern that those who are reaping more and more of today's newly created wealth are doing less and less to ‘earn’ it.” [Fast Company, February 2000, issue 32 page 131 www.fastcompany.com/magazine/32/builttoflip.html]
Wall Street Starves Entrepreneurs
The course of our nation is set by how our money is allocated. If we had a direct relationship between the individuals who invest money and the business managers who use their money, our dollars would be like votes cast for our beliefs and our desires for the future. Instead, our investment choices are limited to the products Wall Street is selling. Most of those products are nothing more than bets on some short-term future event. We are sold shares that were issued forty years ago. They have nothing to do anymore with supplying capital. We’re just buying from someone else who is selling. We’re betting that the trading price will go up and the sellers are betting it won’t. None of our money will actually get to the business that once issued the shares. It’s likely that it isn’t even shareownership that we’re buying. We may be sold options, futures, swaps or other derivatives, which are even more remote from any business use of capital.
Wall Street makes commissions by selling and buying previously owned securities and the derivatives that are based upon those securities. Much more important to Wall Street are the huge trading profits made from using computer programs and inside information. This recycling of gambling symbols, where one side of a trade wins and the other side loses, has become the “capital market.” Being drawn into that win/lose game keeps us from even considering the opportunities of investing in new business activity. All the money is going to sellers, buyers and commissioned intermediaries. Unlike new securities issued by operating businesses, none of that trading money goes to finance business growth, or pay employees and suppliers. With all of the “investors” having become traders, there is no money for early stage companies.
Yet it is young businesses that are most important to our economy. A November 2009 study by The Kauffman Foundation, from U.S. Census Bureau data, showed that two-thirds of the net new jobs created in 2007 came from businesses less than five years old. "This study sends an important message to policymakers that young firms need extra support in the early years of formation so they can grow into viable job creators. Sometimes a single barrier, such as limited access to credit for business growth, can mean the difference between survival and failure. We must create an environment that aids firm formation and growth if we are going to turn employment around." [Robert Litan, vice president of Research and Policy at the Kauffman Foundation, http://www.kauffman.org/newsroom/kauffman-foundation-analysis-emphasizes-importance-of-young-businesses-to-job-creation-in-the-united-states.aspx. The work most often cited for the correlation between young businesses and job creation has been that of David L. Birch in “Who Creates Jobs.” [The Public Interest, Number 65, Fall 1981, page 3, www.nationalaffairs.com/public_interest/detail/who-creates-jobs. He described small companies with rapid revenue growth as “Gazelles.” However, the Gazelle theory was largely contradicted by a 2008 study called “High-Impact Firms: Gazelles Revisited.” It analyzed businesses with significant revenue growth and expanding employment, ones which “account for almost all of the private sector employment and revenue growth in the economy.” The study found that these firms average 25 years old, with less than three percent under four years. Only half of the companies have fewer than 500 employees. “Job creation is almost evenly split” between the two size categories. U.S. Small Business Administration, Small Business Research Summary, number 328, June 2008, page 1 and page 44, www.sba.gov/advo/research/rs328tot.pdf ]
It is precisely the young businesses that need to raise money by selling shareownership—money that is permanent, that never has to be paid back and has no interest payments. But once young businesses have exhausted their founders’ resources, and what they can raise from family and friends, they need to sell shares to the public. Wall Street investment bankers have a legal monopoly on being the intermediary between business and investors. By ignoring young businesses, Wall Street is starving entrepreneurs. As a result, they are preventing jobs being created. Their reasoning is simple: they make more money, in the short term, by focusing on trading, especially in products other than shareownership. They are interested only in very large public offerings of new shares and bonds.
Consider just one example of the great harm from Wall Street's choice to all but ignore small business: Solar energy. Scores of entrepreneurial businesses became the photovoltaic industry in the 1970s. [Robert Carbone left his job as a Bank of America securities analyst to focus exclusively on these new businesses and technology.] By the 1980s the capital-starved companies had either been acquired by major oil companies or given up. Three decades later, solar energy is dominated by huge installations that feed into the existing electric grid operated by major power companies. "Only 6 to 7 percent of solar panels are manufactured to produce electricity that does not feed into the grid. . . . A $300 million solar project is much easier to finance and monitor than 10 million home-scale solar systems . . .." [Elisabeth Rosenthal, "African Huts Far From the Grid Glow With Renewable Power," The New York Times, December 25, 2010, http://www.nytimes.com/2010/12/25/science/earth/25fossil.html
Small businesses need to sell shares to raise money for growth. But Wall Street has all but abandoned serving as an intermediary for new stock issues for young businesses, turning instead to quick turnover products. The New York Stock Exchange, where Wall Street began, is still an indicator of what Wall Street considers important. Under the Big Board’s new name and scope, NYSE-Euronext, only 16% of its 2009 third quarter revenue came from listing securities. The rest:
· 30% derivatives trading
· 22% cash trading
· 16% market data
· 8% software and technology services
· 8% other [www.nyse.com/press/1256810868304.html]
Even the Exchange president, Duncan Niederauer, acknowledges that small companies are “the economic engine to this country, certainly after every recession. That’s where most of the new job creation comes from.” [Mary Anastasia O’Grady, “Is the Stock Exchange Obsolete?” The Wall Street Journal, October 31, 2009, page A17]
Many of the challenges facing the United States today can be met in ways that would generate earnings for workers and investors. Rising to those opportunities has historically been the role of entrepreneurs, the founders of new businesses aimed at market solutions to current human needs and desires. Wall Street and government propaganda would have us believe that the free market actually operates to decide which entrepreneurs gather money to develop their businesses. The reality is that Wall Street has a government-enforced monopoly on the flow of money from individuals into securities—and it has more profitable games to play with our money. The great harm comes from Wall Street’s lack of interest in providing that capital to entrepreneurs. Entrepreneurship in the United States is in a long decline. [Barry C. Lynn, Cornered: The New Monopoly Capitalism and The Economics of Destruction, John Wiley & Sons, Inc., 2010, pages 130-131]
How are we ever to provide new businesses with the money they need to develop opportunities, if Wall Street is the only road and it’s closed to the traffic of money that could be coming from individuals and going to entrepreneurs? As George Gilder put it, "the crucial source of creativity and initiative in any economic system is the individual investor." [Wealth and Poverty, Basic Books, page 39] The capital needs of small business are just not going to be met by the intermediary structure. On the buy side, where money managers are choosing investments, the economies of scale are weighted toward securities based on big business. It takes as much time to evaluate a small business as it does a large one—actually more, because the information is more difficult to find. Time spent investigating small business is even harder to justify, because it results in a small investment. For the buy side money manager, it takes more investments in small business to put all of a fund’s money to work in a diversified portfolio than it does with big business investments.
A further deterrent to Wall Street money getting to small business is that buy side managers consider small business investments to have a higher liquidity risk. That is, there is more of a chance of not being able to sell without forcing the price lower.
Big business has securities listed on an SEC-registered stock exchange, where trades can be made by going through an SEC-registered securities broker-dealer, who is a member of that exchange. Small businesses either have no trading market at all, or they are bought and sold in the interdealer, “over-the-counter” market. These broker-dealer markets are the only place to buy and sell these small business shares.
It would be a crime for anyone but an exchange or broker-dealer to be in the business of providing a market for buying and selling securities. Often, there is only one broker-dealer making a market in a small company’s shares. That’s what one securities regulator called “an invitation to manipulation.” It’s hard to fault buy side money managers for avoiding securities not on an exchange, ones which are traded by a broker-dealers, since they have a long and deep history of manipulation and nondisclosure.
Even if Wall Street’s buy side were open to investing in small business, it can only happen if the sell side is willing to originate and sell new issues of small business securities. That is not happening. The big investment banking firms, with the help of the SEC and Congress, continue to squeeze out competition. They are still the principal path to an underwritten initial public offering. But they allocate their IPO time and attention to whatever will generate the most fees—either in the initial public offering or in the trading and other activities that will follow it. Today, Wall Street investment bankers are mostly wrapped up in creating and selling derivative securities, which don’t raise capital for anyone.
The rare new issues of stock or bonds actually do channel money from investors to businesses. Not so for trading in previously-issued securities. Especially not so for derivatives, like options, futures, swaps, structured investment vehicles and other devices. They are all “zero sum games” where one person’s wins are offset by another’s loss. And, like other forms of legalized gambling, the only one consistently taking money out is the one operating the game, or the one with some private information or tool. A consistent winner at securities trading can be like the poker player who knows what cards are held by other players, or the blackjack player who can count the cards played and know what remains in the deck.
When investment bankers actually do underwrite a public offering of newly issued securities, it is probably not going to be for a young, growing business. More likely, it will be something created by the same investment banker or one of its affiliates. It might be a company purchased by a private equity fund and then going public again, so the fund can get back what it paid and a profit. Or it could be a “special purpose acquisition fund,” which is a newly-formed shell corporation that raises money in an IPO and then uses it to pay the owners of an existing business it buys. These are ways of recycling money from one group of investors to another. Nothing is put into the stream of creation or expansion.
In the few times that an investment banker does act as an IPO underwriter for a young business, raising money for growth, it is usually for a venture capital fund client. By the time of the IPO, the VCs will have set the business exclusively on the path to maximize return to investors over a two to ten-year term. The VCs objective will be either to maximize the share trading price while insiders sell out or to have the whole business acquired.
Back in 1961, and again in 1969, more than a thousand entrepreneurial businesses were marketed in initial public offerings. After one of the periodic collapses in the new issues market, there were fewer than fifty IPOs in any of the years from 1974 until 1980. Those were the years when Wall Street was going through upheaval from the end of fixed commissions on trading. After that, the number of IPOs averaged about 530 a year in the 1990s. [Drew Field, Direct Public Offerings, Sourcebooks, 1997] However, from 2001 through 2008, the average was only 134 a year. [David Weild and Edward Kim, "Why are IPOs in the ICU?" Grant Thornton, undated, available at www.grantthornton.com/staticfiles/GTCom/files/GT Thinking/IPO white paper/Why are IPOs in the ICU_11_19.pdf]
Not only are there far fewer underwritten initial public offerings these days, but those that do get through must be for companies much larger than the typical entrepreneurial business. Through 1998, about 75% of the IPOS were for less than $50 million each, while the last ten years have had fewer than 25% that size. For IPOs of under $25 million each, the number averaged nearly 300 from 1992 through 1997, when they began a sharp decline. Initial public offerings of that size have been fewer than 25 a year from 2000 through 2008. [David Weild and Edward Kim, Why are IPOs in the ICU?, Grant Thornton, undated, available at www.grantthornton.com/staticfiles/GTCom/files/GT Thinking/IPO white paper/Why are IPOs in the ICU_11_19.pdf] “To stage a successful IPO today,” according to the managing director of tech banking at J.P. Morgan Securities, “companies need close to $100 million in annual revenue and a potential stock-market value of at least $250 million—and preferably much more. [Rebecca Buckman, “Tougher Venture: IPO Obstacles Hinder Start-Ups,” The Wall Street Journal, January 25, 2006]
Just as businesses have to be larger to do an IPO, size requirements have been introduced for purchasers at first time public offerings, excluding all but the wealthiest individuals with brokerage accounts. At broker-dealers with middle class customers, IPOs are still reserved for larger investors. Fidelity Investments, for example, had a rule that clients must have $500,000 with the firm or place 36 trades in a 12-month period to qualify to buy traditional IPOs. [Eleanor Laise, “More IPO Entryways for Small Investors,” The Wall Street Journal, April 8-9, 2006, page B4]
After 2008, Wall Street's sell side and its buy side have simply skipped the IPO and kept the financing within their coterie of investment banks and fund managers. They arrange huge "private placements," which are then traded by "transaction specialists" like SecondMarket, SharesPost or Felix Investments. [Liz Rappaport and Jean Eaglesham, "Private-Share Trades Probed," The Wall Street Journal, February 23, 2011, page C1] The SEC is looking into whether there is a violation of the securities laws, over the objection that these pre-IPO transactions are necessary. " http://www.businessweek.com/smallbiz/content/mar2011/sb20110316_323210.htm?link_position=link8] In other words, let Wall Street buy up shares issued to employees and angel investors. That postpones the IPO, when anyone at all, even the middle class, could buy shares in the aftermarket. Keeping investments among investment bankers and money managers means the IPO will happen at a time when the insiders feel the big increases in value have all taken place.
The decline in IPOs, along with the disappearance of publicly traded companies through acquisitions, has sharply reduced the number of companies listed for trading on exchanges. From 1991 to 2008, the number of New York Stock Exchange listings remained at just under 2,000. But adjusting for growth in Gross Domestic Product, this represents a 40% decline. During the same period, listings on NASDAQ, the home of smaller companies, declined from over 4,000 to under 3,000. With the GDP adjustment, this was a 56% drop. [David Weild and Edward Kim, “A Wake-up Call for America,” Grant Thornton, November 2009, www.gt.com/staticfiles/GTCom/Public companies and capital markets/gt_wakeup_call_.pdf]
It’s hard to call initial public offerings a path for small business. It is also hard to call them “public offerings.” In fact, most IPOs are sold to money managers for hedge funds, pension funds and other institutions, who are clients or prospective clients of the IPO underwriting firm. The underwriter, in setting the offering price, has a conflict between serving the interests of the company selling shares and the money managers who buy them. The conflict gets resolved in favor of the money managers. During the 1980s and 90s, in "99.46 percent of the cases, the share price at the end of the first day of trading was significantly higher than the IPO price, and those fortunate enough to be able to buy at the share price would make a significant capital gain. . . . The investment bankers appeared to set the price for the IPOs so as to maximize the price pop on the first day of trading . . .." [Charles Kindleberger and Robert Z. Aliber, Manias, Panics, and Crashes: A History of Financial Crises, John Wiley & Sons, Inc., Fifth Edition, 2005, page 160.] The nonwealthy individual investor will probably be able to buy an IPO only in the few hours or days after the offering, when the money managers and wealthy broker clients “flip” their allotment from the underwriters, for a quick trading profit. Even these second and third round individuals only get to buy shares if they are active investors with brokerage accounts.
Yet it is the “public” that most believes in small business. According to Gallup’s survey of public confidence in U.S. institutions, small business gets the second highest ranking, between the military and the police, with 67% of the public having a “great deal” or “quite a lot” of confidence in small business. In last place, at 16%, was big business, just below Congress, at 17%. [www.gallup.com/poll/121214/Americans-Confidence-Military-Banks-Down.aspx]
One big impediment for initial public offerings of smaller businesses is that Wall Street firms employ fewer stock analysts these days. The huge losses and closures of Wall Street brokerage firms in 2008 eliminated half of the senior analysts. [Aaron Pressman, “In Search of Stock Research,” Business Week, January 19, 2009] Publicly traded companies thrive on analysts’ attention because their reports trigger buying and selling, creating robust marketplaces for their shares. That makes coverage by analysts crucial for start-ups considering stock offerings, since it is the Wall Street buy side money managers who speculate on short-term price movements. They insist on the prospect of an active trading market, spurred on by securities analysts.
The harm from Wall Street abandoning small business IPOs isn’t just that the public has confidence in small business and yet is largely closed out from investing in it. The harm is also greater than loss of businesses that create the greatest number of jobs. The most dangerous harm may come from the role of small business as the best defense against the excesses of big business. If a big business, by itself or acting in concert with its big competitors, is making unconscionable profits, some entrepreneur will want to seize the opportunity to enter the field. By starving entrepreneurs, Wall Street takes away our best defense from being abused by big business. It impedes the process of “creative destruction” that Joseph Schumpeter said “is the essential fact about capitalism.” [Joseph A. Schumpeter, Capitalism, Socialism and Democracy Harper, 1975, originally published in 1942, pp. 82]
Wall Street Has Caused a Disconnect Between People and Our Economy
Wall Street has refused to market new securities issues to the middle class. Instead, investment bankers have chosen to earn their fixed commissions on “public offerings” by selling them to Wall Street’s buy side money managers. New issues of securities are selected, packaged and sold to attract professional investors looking for short-term profits. These buyers may “flip” the securities within minutes, to be resold to other speculators who didn’t make it into the favored first buyer list. Those second level buyers will mostly resell again whenever they can show a quick gain. Not many of the early owners will have any interest in the long-term direction of the issuing business. In the boom IPO market that ended in 2000, Wall Street did bring in middle class individuals, usually in the second or third round after the investment bankers’ friends had flipped the initial offering. When the bust came, it was these individuals who were left holding the bag, many of them vowing never to try shareownership again.
Middle class individual investors are left with buying securities in the trading markets or, more likely, owning shares in mutual funds. Wealthy individuals may invest in hedge funds that are let in on initial public offerings. Either way, any relationship between the middle class individual investor and the underlying business is remote. There is certainly no direct communication between individuals and business managers. Investing is focused on what the stock price may do in the near future, rather than on the business behind the securities.
As late as the 1970s, academics and policy makers seemed unconcerned about individuals being replaced by institutions as the owners of American business. The Twentieth Century Fund, a nonpartisan foundation since 1919, published a study about the change from individuals owning most of the corporate shares in America to the dominant ownership by institutional money managers. After chronicling the shift, the study concluded that, “on the basis of available information, economic, equity, and social-policy considerations do not provide sufficient justification for encouraging the shift of individuals’ assets into stock and institutional assets out of stock.” [Marshall E. Blume and Irwin Friend, The Changing Role of the Individual Investor: A Twentieth Century Fund Report, John Wiley & Sons, 1978, page 199] As an aside, the study found: “However, if it is desired to stimulate investment by small new firms for reasons other than those analyzed in our study, encouraging stock purchases by individuals, who have traditionally been most active in this market, might prove effective.” [page 197] Peter F. Drucker put in more succinctly: "The capital market decisions are effectively shifting from the 'entrepreneurs' to the 'trustees,' from the people who are supposed to invest in the future to the people who have to follow the 'prudent man rule,' which means, in effect, investing in past performance. But this is happening at a time when the need for new businesses is particularly urgent, whether they are based on new technology or engaged in converting social and economic needs into business opportunities." [The Unseen Revolution: How Pension Fund Socialism Came to America, Harper & Row, 1976, page 71] As individuals began abandoning investment in individual companies, Wall Street's buy side used pension fund money "to subsidize an equity market that might otherwise have long since collapsed," according to Jeremy Rifkin and Randy Barber of the Peoples Business Commission. [The North Will Rise Again: Pensions, Politics and Power in the 1980s, Beacon Press, 1978, page 92] It also had the effect of giving Wall Street
ownership control over management of major businesses.
Wall Street’s recycling of gambling symbols keeps us from even considering the opportunities of investing in new business activity. If we could stand back and think about the future of American business, we could have a very different approach to investing. Many of the challenges facing the United States today can be met in ways that would generate earnings for workers and dividends or capital gains for investors. If individuals were choosing where to place their capital based on these long-term views, we’d have a very different, and democratic flow of capital into business. Otherwise, we’ll have to follow Japan and other countries in having the government allocate capital to selected technologies and innovations. Even government/private cooperation, like the space program, still leaves an elite group deciding how our money will be directed. [Richard J. Elkus, Jr., Winner Take All: How Competitiveness Shapes the Fate of Nations, Basic Books, 2008.] “The current financial system is choking off funds for innovation. . . . Excessive resources are allocated to proprietary trading, to lending to overleveraged consumers, to regulatory arbitrage, and to low-value-added financial engineering. Financing the development of innovation takes a backseat. . . . Unfortunately, most financial firms lack the expertise to invest in business ventures on a sufficient scale, now that a generation of financial professionals has been trained to focus elsewhere. Unless something changes, the gap in funds for business innovation will keep widening.” [Edmund S. Phelps and Leo M. Tilman, “Wanted: A First National Bank of Innovation,” Harvard Business Review, January-February, 2010, http://hbr.org/2010/01/wanted-a-first-national-bank-of-innovation/ar/1]
Our economy is as important to each one of us as our government. It is our economy that makes it possible for us to get paid money for our work. It allows us to buy the things and services we need and want. When our economy gets out of whack, with a recession or inflation, we experience discomfort, fear and even misery. For nearly all of us, however, we have a feeling of powerlessness over the course of our economy. This lack of participation leads to alienation from our nation and a lack of state security. “The ultimate (root) causes of disharmony between state security and human welfare result from failures of the social contracts that bind countries and populations together in cooperative activity.” [Maurice D. Van Arsdol, Jr., Stephen Lam, Brian Ettkin and Glenn Guarin, Crossing National Borders: Human Migration Issues in Northeast Asia, United Nations University Press, 2005, page 11]
With our government, most of us feel we have at least some say in what it does and who makes decisions that affect our lives. However imperfect the process, we have a sense of democratic participation in a republican, representative structure. Politicians can be voted out of office. We citizens can sometimes cause laws to be repealed and new ones enacted. Our economy gives us no such sense of participation. We’ve let it come under the control of Wall Street, with limited restraint by a government that is itself largely responsive to Wall Street. Elizabeth Warren described it this way: "For three decades, the once-solid, once-secure middle class has been pulled at, hacked at, and chipped at until its very foundations have started to tremble. Families have done their best to adjust — sending both mom and dad into the workplace, cutting back flexible spending on food, clothing and appliances, and spending down their savings. When they learn that they have been tricked . . . they start to wonder who wrote the rules that allow that to happen. Distrust spreads everywhere — to industry, to politics, to the institutions that were supposed to make us a stronger country." [Lynn Parramore interview, July 13, 2010, www.newdeal20.org/2010/07/13/nd20-interview-elizabeth-warren-says-big-banks-must-stop-blocking-reform-14233/]
The concept of a free market economy is that we vote with the ways we acquire and spend our money. We can offer our services where we decide we’ll be most useful, fairly paid and well treated. In a free market, we can put the money we save into channels that will support worthwhile activities and pay a fair return. As a result, our collective decision making could influence businesses to grow or to wither, to the general benefit of us all. In practice, however, Wall Street has created a disconnect between us and our economy. There is no direct relationship between our economic decisions and what influences business decisions.
Wall Street’s political power means that government decisions about our economy are made to help Wall Street. Those decisions ignore the rest of us and often harm us. For instance, Wall Street is largely in the business of using other people’s money to leverage much larger bets than it could make using only its own money. The lower the cost of renting other people’s money, the greater the return can be from risking that money. The Federal Reserve, which is actually owned by banks, is largely able to set interest rates. Keeping those rates low favors Wall Street banks, which are in the business of borrowing and employing money.
The people who are hurt by keeping rates low include middle class retirees, who receive interest income from deposits and bonds. The government has accommodated Wall Street, to the detriment of individuals trying to live off income from our savings. In the name of saving the economy, the Federal Reserve and the U.S. Treasury have forced interest rates down in recent years and provided Wall Street with taxpayer funds, so that the cost of money to the money industry has been around two percent.
Everyone in politics and the media seem to look at interest rates from the perspective of the people who borrow money. From that vantage point, the government gets kudos for keeping the cost of borrowed money low. But what about the providers of that money? When the government manipulates interest rates down, that means that bank certificates of deposit and money market funds pay a much lower rate. Retirees who depend on CDs and other fixed income securities have seen their incomes cut by half or more. In an article titled “Taxing Grandma to Subsidize Goldman Sachs,” Peter Morici wrote: “Having fed the campaign machines of both political parties and lavished speaking fees on future White House economic advisors, these financial wizards have managed to purchase preferred treatment in our capital.” [Peter Morici, University of Maryland professor and former Chief Economist for the U.S. International Trade Commission, “Taxing Grandma to Subsidize Goldman Sachs,” Business Week, April 14, 2009, www.businessweek.com/investor/content/apr2009/pi20090414_041627.htm?link_position=link20]
If Wall Street blunders in playing the casino with borrowed money, the government bails it out and gives it a grubstake to get back in the game. Despite the public and media outrage after the 2008 bubble burst and outflow of trillions in taxpayer dollars, the government has done virtually nothing to prevent a replay of the tragedy. As individuals, we have been disconnected from our economy. All the power and influence is with Wall Street and the government it has purchased.
Wall Street Excludes the Middle Class from Share Ownership
The United States has set the pattern for developing a middle class. “In its earliest decades, the makeup of the United States was similar to that of many European nations: a small, wealthy class of aristocrats and merchants, and the rest of society, whether farmers or landless workers, all scraping to get by. . . . It was government policy in the early years of our history that turned a land of largely poor people into the middle-class nation of today. Despite the lingering image of strong-willed, hard-working, self-made men, America’s comfortable middle class was made possible by concerted government policies.” [J. Larry Brown, Robert Kuttner and Thomas M. Shapiro, Building a Real “Ownership Society”, The Century Foundation Press, 2005, page 7] In the last thirty years, however, the trend has reversed. As Wall Street star Felix Rohatyn said, there has been "a huge transfer of wealth from lower-skilled, middle-class American workers to the owners of capital assets and to a new technological aristocracy." ["Requiem for a Democrat," a speech at Wake Forest University, March 17, 1995, quoted in Richard Sennett, The Corrosion of Character: The Personal Consequences of Work in the New Capitalism, W.W. Norton & Company,1998, page 89]
Before the first World War, fewer than 100,000 Americans owned securities listed on the New York Stock Exchange. After the War, individual investors were courted by Wall Street, because so many of them had purchased Victory Bonds. Nearly all of these war bond investors had purchased a security for the first time. A big change in attitude and behavior had occurred when individuals became willing to exchange their money for a piece of paper. After that, Wall Street just had to sell another piece of paper to the bond buyers and the observers they influenced. “By the late 1920s, there were over 3 million shareholders, with half of them buying and selling shares through brokerage accounts, while six hundred thousand were doing so on margin—borrowing money to purchase shares, and using the stock to collateralize the loan.” [Robert Sobel, Inside Wall Street, W.W. Norton, 1977, page 101]
That all but ended with the Crash of 1929 and the Depression. Half the brokerage firms were gone by 1932. Of the survivors, only half of those were still in business by 1937. Commercial banks had been the major marketers of securities to individuals and they were forced out of the securities business by the Banking Act of 1933. Those that remained on Wall Street had little interest in doing business with individuals, except for the very wealthy or the professional traders.
In 1940, the New York Stock Exchange commissioned a public opinion poll by Elmo Roper. It showed that the public had an “image of the stock broker as a polished crook, and the N.Y.S.E as a nest of thieves.” ["What Does the Public Know about the Stock Exchange? Roper Survey Reveals Extent of Misconceptions and Misinformation about the Services of the Exchange," Exchange Magazine, (January 1940)] While it was still business as usual for others on Wall Street, Charles Merrill saw this public perception as an opportunity. He had started a brokerage partnership, Merrill Lynch & Co. in 1914 and sold out just before the 1929 Crash. He came back in 1940, merging three firms into Merrill Lynch, Pierce, Fenner & Beane. Most of the old offices were replaced with cheerful, efficient spaces for brokers to meet with clients. [Edwin J. Perkins, “Market Research at Merrill Lynch & Co., 1940-1945; New Directions for Stockbrokers,” University of Southern California, www.h-net.org/~business/bhcweb/publications/BEHprint/v025n1/p0232-p0241.pdf] "
According to Martin Mayer, Merrill started the new business "because he felt the need to make a political statement. His was the brokerage firm that would serve the ordinary customer." [Martin Mayer, The Money Bazaars: Understanding the Banking Revolution Around Us, E.P. Dutton, Inc., 1984, page 35] Merrill began a major educational advertising effort to explain how investments worked. The brokers were called “account executives” and they were trained not to give investment advice. Instead, they were to recommend securities approved by the firm’s research department, with separate lists for aggressive, conservative and moderate investors. Free research reports were sent to clients and prospects. The biggest innovation that Merrill made was in how the brokers were paid. They got a salary and bonuses—no commissions. “Let others take care of the very wealthy and the gamblers, Merrill seemed to be saying; our firm will cater to the middle class.” [Robert Sobel, Inside Wall Street, W.W. Norton, 1977, page 104]
Other brokerage firms copied the Merrill approach. The New York Stock Exchange, under President Keith Funston, advertised “Own Your Share of America,” “People’s Capitalism” and “A regular dividend check is the best answer to communism.” [Robert Sobel, Inside Wall Street, W.W. Norton, 1977, page 107] The results? Trading volume went from 655 million shares in 1950 to over 3 billion in 1968. Within 20 years, the number of shareowners increased from fewer than 6.5 million to more than 33 million, the number of brokers jumped from 11,400 to 53,000.
However, there’s an old Wall Street saying, “Don’t confuse brains with a bull market.” When the market turned in 1969, the momentum vanished. Bringing in the middle class was suddenly out of favor on Wall Street, losing out to wooing institutional money managers and trading for the brokerage firm’s own account. Wall Street’s buy side, trading in thousands of shares at a time, had been paying the same cost per share as the individual buying a hundred shares. Of course, Wall Street sell side brokers wanted only to do business with the customers who made them far more money for the same amount of work.
Interest in the middle class returned after fixed commissions were abolished in 1975. Wall Street’s buy side had won a major victory over the sell side when Congress took away the fixed rates for buying and selling stocks. Now the money managers could negotiate openly with brokers, forcing them to compete on the basis of what they charged for executing an order to buy or sell. Many of the old Wall Street firms were very slow to adapt to the new rules of the game. They just weren’t willing or able to reduce costs, streamline operations and change their compensation structure. Merrill Lynch moved far away from its founder’s concept. Its strategy was “to focus the firm’s brokerage business on attracting wealthy investors with at least $1 million in assets. The move away from small investors is part of a broader plan to boost profits at the big securities firm.” [The Wall Street Journal, November 2, 2001, page A1]
As a result, a new breed of securities firm sprung up, the discount broker. The most successful of the discount brokers has been Charles Schwab & Co., which was started right after the end of fixed commissions in 1975. At the beginning, the business was aimed at providing execution of individuals’ orders for buying and selling stocks and a few other securities. Schwab has expanded in many ways over the years, such as owning a bank and a securities trading firm, making mortgage loans and providing support for independent investment advisers. It has made a few skirmishes into distributing new issues of securities but has never really tried to become an investment banker.
(A partner and I met with Charles Schwab in the late 1970s, about a joint venture in marketing “negotiable certificates of deposit,” which savings banks had been allowed to issue. The certificates worked like bonds and would have a trading market. We suggested that the banks offer the CDs directly to Schwab’s customers and that Schwab would handle the market for resales. Other priorities got in the way, but we did learn about Charles Schwab’s personal view of his place in the financial markets.)
Except for the discount brokers, Wall Street’s sell side has continued to downplay any relationship with America’s middle class. Registered representatives are discouraged from providing services to individuals with less than, for instance, a million dollars to invest in securities. Wall Street underwriters exclude retail brokers from recent initial public offerings, like General Motors and Tesla Motors, while Goldman Sachs creates a "special purpose vehicle" for their customers who can invest at least $2 million in a "private" offering of Facebook shares. [Roben Farzad, "Initial Private Offering," Bloomberg Businessweek, January 6, 2011, http://www.businessweek.com/magazine/content/11_03/b4211004007471.htm; Anupreeta Das and Amir Efrati, "Cash Keeps Facebook's Status Private, The Wall Street Journal, January 4, 2011, page B1; Jean Eaglesham and Aaron Lucchetti, "Facebook Deal Spurs Inquiry, The Wall Street Journal, January 5, 2011, page A1. Goldman Sachs further limited the sale to foreign investors, saying that " http://www.investmentnews.com/article/20110117/FREE/110119939/0/INDaily01&dailycount=6&issuedate=20110117] The middle class is shunted off by suggestions that they buy mutual funds, which pay significant commissions to the brokers and require very little of the broker’s or firm’s time in picking stocks and deciding when to sell and how to reinvest. For middle class customers who want to own securities that were once actually issued by a business, Wall Street’s sell side will charge a flat fee, of up to three percent, for maintaining an account managed according to the firm’s investment formula. Meanwhile, registered representatives who fail to achieve a minimum amount of revenue from their accounts are severed. Wall Street tolerates the middle class so long as it pays for itself in the very short term and doesn’t interfere with its other businesses.
Wall Street Rations Money for Local Governments and Nonprofits
Ralph de la Torre, CEO of Caritas Christi Health Care, lamented in late 2008: “Health care has been holding its breath. We live and die on the tax-free bond market, and right now we’re dying. Projects are being postponed. All the commodities that health care buys and the companies and people it touches—from imaging to pharma to physicians—are about to dive off the cliff. The bond markets are closed tight. Until they reopen, we’re going to have a big problem. I think there’s going to be a pretty substantial consolidation in health care. As many as 20% of hospitals could close. There’s going to be no capital spending for at least the next year or two.” [“The Recession: What Top CEOs are Thinking,” Business Week, December 15, 2008, page 064]
The infrastructure, health care and other public needs have been starved for funding because local government decision makers are locked into an archaic system of selling bonds through Wall Street underwriters. The 2009 economic stimulus plan would have the federal government sell bonds to the Chinese, then send the money to states for funding infrastructure projects. The common sense way would be for the state and local agencies to market bonds directly to the communities most affected by the infrastructure.
Government could require that infrastructure projects be set up for payment by their users, like toll bridges with fast passes. Then the agencies could market revenue bonds to people who benefited from the project.
Instead of these common-sense ways of raising money for local services, the government and nonprofit officials follow the century-old ritual of going to Wall Street, where bonds are sold in $5,000 minimum amounts, mostly to mutual funds, banks and insurance companies. The Wall Street underwriter often places a small offering entirely with one money manager, collecting the customary percentage fee for a “public” offering. Even if an individual investor learned about an offering and was willing to buy the $5,000 minimum, there remains the problem of whether the bond could be resold before its maturity. Broker-dealers who acted as underwriters might or might not be willing to repurchase the bonds. If they did repurchase, they would set the price low enough to assure a big profit from reselling the bond. There would be no reported source of pricing information or history of trades in the bonds, no way to find out how much a bond is worth in today’s market.
Most government procurement programs, like buildings and equipment, require competitive bidding. Not so with procuring money. Sales of about 85 percent of local government bonds have prices, interest rates and selling commissions which are negotiated with one selected investment banker. That's "because local politicians don't want to alienate investment bankers who donate to charities and political campaigns. . . . 'Firms get chosen to be negotiated underwriters as payback.'" [Darrell Preston and John McCormick, "Chicago Pays for Selling Bonds Without Bids," Bloomberg Businessweek, May 17-23, 2010, pages 46, 47, quoting J.B. Kurish, associate dean, Emory University, Goizueta Business School] Even when competitive bidding is required, bond issues of under $1 million usually receive only one bid. [Comment by Robert C. Pozen in The Deregulation of the Banking and Securities Industries, Lawrence G. Goldberg and Lawrence J. White, editors, Lexington Books, 1979, page 337]
One indication of how profitable it is for investment banks to underwrite local government bonds is the continuing story of “pay to play” scandals. The temptation for scandal comes because government officials choose the underwriter. The decision factors are rather subjective, such as, which underwriting firm has the better relationships with Wall Street’s buy side. [John Tepper Marlin, “Muni Bonds Pay-to-Play,” The Huffington Post, January 12, 2009, www.huffingtonpost.com/john-tepper-marlin/muni-bonds-pay-to-play_b_156620.html; Rajesh Misra, Pay to Play in the Municipal Bond Industry, [www.business.uiuc.edu/broker/pdf/muni.pdf]
“Three federal agencies and a loose consortium of state attorneys general have for several years been gathering evidence of what appears to be collusion among the banks and other companies that have helped state and local governments take approximately $400 billion worth of municipal notes and bonds to market each year. E-mail messages, taped phone conversations and other court documents suggest that companies did not engage in open competition for this lucrative business, but secretly divided it among themselves, imposing layers of excess cost on local governments, violating the federal rules for tax-exempt bonds and making questionable payments and campaign contributions to local officials who could steer them business.” [Mary Williams Walsh, “Nationwide Inquiry on Bids for Municipal Bonds,” The New York Times, January 8, 2009] The recently retired manager of tax-exempt bond field operations for the Internal Revenue Service, Charles Anderson, said that “Pay-to-play in the municipal bond market is epidemic.” He estimated the cost at $4 billion a year.
What has the government done about "pay-play?" The SEC used the occasion to protect Wall Street's monopoly, by saying it is OK for a fund's investment adviser to hire a placement agent, but only if it is an SEC-registered broker-dealer or investment adviser. [Release No. IA-3043; File No. S7-18-09, www.sec.gov/rules/final/2010/ia-3043.pdf] The Internal Revenue Service has a potent tool for dealing with the “pay-to-play” problem. The IRS can revoke the government agency’s tax-exempt status. Unfortunately, that punishes the investor who purchased the bonds and the government agency that issued them. It doesn’t touch the broker-dealer or the officials who selected it as underwriter. The effect of the IRS sanction is to make the interest paid suddenly taxable, retroactive to their first payment. This possibility then becomes a further source of uncertainty and fear for the individual investor.
The American Recovery and Reinvestment Act of 2009, the “stimulus,” included a gift to Wall Street dressed up as a way to finance local governments. Called “Build America Bonds,” they pay interest rates comparable to corporate bonds, rather than the much lower rates typical for government debt. The federal government pays 35% of the interest cost. Conventional local government bonds are marketed as exempt from individual’s federal income tax and from income tax to bondholders in the same state as the local government. The problem for Wall Street is that it doesn’t market to many individuals. The easy sell for a Wall Street investment banker is to institutional money managers. Most institutions are themselves exempt from federal and state income taxes, so they have no interest in conventional local government obligations paying only two-thirds of the rate on corporate bonds. With Build America Bonds, the investment bankers can get corporate bond rates for an entire issue of bonds, allocating them to a few of their favorite customers. The interest cost to the local government is about the same, because the federal government subsidizes a third of the amount paid to investors.
Average underwriting fees on Build America Bonds are 8.2%, compared to about 5% on conventional local government bonds, or less than 1% on most corporate bonds, Neither issuer nor investor really cares that the investment bankers are taking much more than their usual cut. The program is designed for Wall Street investment bankers to make “surprisingly high” fees. [Edward Prescott, Nobel prize economist at the Federal Reserve Bank of Minneapolis and Arizona State University professor, quoted by Ianthe Jeanne Dugan, “Build America Pays Off on Wall Street,” The Wall Street Journal, March 10, 2010, page C1] The program was to last only through 2010 but is being talked up for becoming permanent.
Wall Street Uses Complexity to Maintain an Impenetrable Mystique
How does Wall Street hold onto its control over the use of securities? Why hasn’t its government-protected monopoly been penetrated? We know they’re greedy, overpaid, that they cause harm—but we haven’t tried to get along without them. They seem to have the keys to the vault. Only they understand what they’re doing. “Wall Street is a very seductive place, imbued with an air of power. Its executives truly believe that they control the levers that make the world go round.” [Simon Johnson, “The Quiet Coup,” The Atlantic, May 2009, www.theatlantic.com/doc/200905/imf-advice. Professor Johnson is a former International Monetary Fund chief economist and now an MIT professor. His blog is http://baselinescenario.com]
Part of Wall Street’s mystique is the myth that investing is too complex for us to do ourselves, so we need the wizards of Wall Street to do it for us. Not so, says Peter Lynch, one of the most successful buy side professionals. He managed Fidelity’s Magellan Fund from 1977 to 1990, as it grew from $18 million to $14 billion. In his book, One Up on Wall Street, he said, “Twenty years in this business convinces me that any normal person using the customary three percent of the brain can pick stocks just as well, if not better, than the average Wall Street expert.” [Peter Lynch, with John Rothchild, One Up on Wall Street, Penguin Books, 1989, page 13] Instead, he says, “People seem more comfortable investing in something about which they are entirely ignorant. There seems to be an unwritten rule on Wall Street: If you don’t understand it, then put your life savings into it.” [page 24]
On the buy side, the performance record is well-documented. Whatever the reasons, most money managers who make investment decisions consistently turn in poorer results than the comparable indices of all securities in the same category. Once an investor decides to invest in a particular kind of security, like shares in large corporations, history shows that better results would come from buying a little interest in all of them than to have a professional pick individual companies. A 2009 study by Standard & Poor’s showed that most managed mutual funds failed to do as well as their comparable S&P indices. [Sam Mamudi, “Managed Funds Take Beating from Indexes,” The Wall Street Journal, April 22, 2009, page C13] For the five years 2003-2008, the index for the largest 500 companies had better returns than 72% of funds investing in shares of large businesses. For smaller companies, where stock picking is often said to require extra skill, more than 85% of the fund managers did worse than the small capitalization index. For emerging market funds, results were below the index for 90% of the managed funds over the five-year period. Even 80% of the bond funds were behind bond benchmarks, not counting junk bonds.
(From our experience in advising direct public offerings, we found that nine out of ten investors had never before owned securities in an individual company. Nor had they ever been a customer of a securities broker-dealer. Nevertheless, they went through a risk/reward analysis as rigorous as most reports from Wall Street’s sell side or buy side. In fact, their investigation was often much broader. They went beyond the financial data for the company and its industry and into the personality of management, the characteristics of customers and their feel for the life cycle of the company’s products.)
The myth of complexity has worked as a marketing strategy for Wall Street’s investment bankers and brokers. Until Madison Avenue was hired to remake Wall Street’s image, the sell side registered representatives were commonly called stockbrokers. The names have been changed, to financial consultants, financial advisors, wealth management advisers and the like. This more obscure naming has coincided with the increased complexity of the products they sell. The new titles and new instruments say to us, “You need me because you couldn’t possibly understand.” That statement is at least half true: most of us do not understand the products that are being sold to us. For instance, to pick just one of these products, the “portable alpha” was sold to middle class individuals shortly before the 2008 Panic. The “alpha” stands for the sophisticated judgment that brings above-market returns on investment. The concept was to use part of the money invested to buy futures and swaps contracts on the market, getting the benefit of how an index fund operates, without having to put up the full amount those funds require. The rest of the investment goes into hedge funds, which are supposed to beat the market. (I may not have described this correctly. That illustrates the problem of complexity.) The portable alpha strategy caused huge losses to middle class investors when the stock market dropped in 2008. [Randall Smith, ‘Alpha’ Bets Turn Sour, The Wall Street Journal, December 1, 2008, page C1.] Back at it again in 2009, Wall Street’s new products included “long-short” funds and “replicators,” marketed as providing the winning strategies of hedge funds in packages for the middle class.
Complexity makes it easier for Wall Street to get away with price-fixing conspiracies, like one uncovered by a whistleblower trader at Bank of America. "It involves a vast bid-rigging and kickback conspiracy, implicating every major Wall Street bank and an assortment of brokers, dealers, and con artists. The perps allegedly manipulated the bidding for short-term investments [of] the proceeds from the sale of municipal bonds--an arcane but lucrative practice that violated the Sherman Antitrust Act and cheated bond issuers out of billions of dollars." [Thomas Brom, "When Thieves Fall Out," California Lawyer, July 2010, page 10] To BofA's credit, it had outside lawyers confirm the whistleblower's account and then turned itself in to the Justice Department under the Antitrust Criminal Penalty Enhancement and Reform Act. That law provides leniency for the first conspirator to admit an antitrust violation. The dozens of others involved included JP Morgan Chase, Morgan Stanley, Citigroup, Wells Fargo and Goldman Sachs. Evidence included more that 600,000 audiotapes of derivatives traders.
Wall Street Uses Complexity to Hide Risk
The history of mortgage securities shows the path from an understandable security into instruments that are too complex for analysis, and thus just right for deception. The first mortgage security, the Mortgage-Backed Bond, was a promise by a bank to pay fixed interest amounts and return the principal at the bond’s maturity date. In addition to the bank’s credit supporting the obligation, the bank deposited a pool of its mortgages with a trustee. The amount of the mortgages totaled 150% of the amount of the bonds and the bank was required to replenish the pool to maintain that level. An investor could rely on the solvency of the bank and also know that, if the bank failed, there was plenty of cushion in the mortgages held by a trustee.
Wall Street saw real limits to its own profitability with Mortgage-Backed Bonds. First, the only revenue was the one commission investment bankers took when the bonds were sold and nothing else for the thirty years the investor might hold the bonds. Second, using $150 of mortgages for each $100 of bonds “wasted” the extra 50% by making them unavailable for packaging into more securities. So, the next mortgage security was the Pass-Through Certificate. Investors were sold a fractional share of a pool of mortgages. They received interest and return of principal as the homeowners made their monthly payments. The Pass-through Certificate allowed 100% of the mortgages to be packaged and sold. If the buyers reinvested the money passed through from mortgage payments, more commissions were generated.
The deterioration in quality that led to the 2008 debacle in mortgage securities began with this change from Mortgage-Backed Bonds to Pass-Through Certificates. The bank that originally made the loans was no longer responsible for anything other than collecting mortgage payments and passing them through to investors. Even that responsibility was often transferred to another servicing agent, so the originating banks were off the hook for loan quality as soon as the loans were bundled and sold as Pass-Through Certificates. The risk had been entirely transferred from the people who made the loan decisions and onto people like those who had put their money into retirement funds.
Wall Street learned that buy side money managers would purchase Pass-Through Certificates, even though they were more complicated and their repayment timing was uncertain. Pass-Throughs were still relatively simple and the buy side felt they could make investment decisions without having to rely completely on the sell side. This changed when Wall Street quickly moved on to the Collateralized Mortgage Obligation, with its segments, called “tranches,” based upon relative risk. CMOs were packaged by computer programs, sorted by characteristics that predicted likelihood of default. One tranche would get a triple-A rating for conservative investors and, several tranches later, the “toxic waste” would be sold to the most gullible. Wall Street looked at their huge profits from CMOs and decided that they could package credit card balances, auto loans, music royalties and other payment streams into Collateralized Debt Obligations, or “CDOs.” In describing this history, Charles Morris commented: “The complexity of the instruments spiraled into absurdity.” Wall Street “gleefully spewed out phantasmagorical 125-tranche instruments that no one could possibly understand.” [Charles R. Morris, The Trillion Dollar Meltdown, PublicAffairs, 2008] Since the destruction of 2008, there has been an effort to start over, with “covered bonds,” marketed as having come from a European model. These are like mortgage-backed bonds, except that the collateral pool of mortgage loans is retained by the lender, rather than placed with a trustee. [Richard Barley, “Covered Bonds Set to Roar?”, The Wall Street Journal, January 8, 2010, online.wsj.com/article/SB10001424052748703481004574646001320191782.html]
(We tried a very different approach, with the Mortgage Trust Certificate. My client was a very large savings bank with a few billion dollars of home mortgages it had originated. With a firm of mathematician consultants, we would analyze a portion of a pension fund’s payment obligations over the next 30 years and then select a pool of mortgages that would generally provide cash flow to match the projected payouts. The lending bank was obligated to have the mortgage pool maintain the cash flow stream, supplying additional mortgages when necessary. No securities broker-dealer was involved. There was to be a direct and ongoing relationship between the bank and the pension fund. We explained the mechanics to rating agencies and to third-party insurance companies who would guarantee the bank’s obligation. The concept was easily understood by everyone involved. Unfortunately, other priorities got in the way and the project was never finished. In retrospect, it seems like a quixotic venture.
(Earlier, before mortgage securities became a huge market, I worked with a client on a computer-based market for selling mortgages directly. Sponsored by Fannie Mae, Freddie Mac and other government-sponsored entities, it was called AMMINET, for Automated Mortgage Market Information Network. It was modeled basically on the original NASDAQ, the automated quotation market for stocks. Lenders would make packages of mortgages available for pension funds and others to buy, leaving Wall Street out of the flow. My client was to design and operate the computer program. The effort never made it to market. Its basic, simple approach was the exact opposite of the complexity that furthers the Wall Street mystique. Instead, mortgage lenders were forced into supplying mortgages for off-the-shelf products designed by Wall Street for maximizing its own take from transactions.)
An awful lot of the bad stuff that occurred in our financial system has happened because a proposed transaction was never explained in plain, simple language. Financial innovators were able to create new products and markets without anyone thinking too much about their broader financial consequences — and without regulators knowing very much about them at all. It doesn’t matter how transparent financial markets are if no one can understand what’s inside them. [Michael Lewis and David Einhorn, “How to Repair a Broken Financial World,” The New York Times, January 3, 2009] An early warning about complexity came from a most unlikely source. On November 17, 1970, the President of the New York Stock Exchange, Robert W. Haack, delivered an address to the Economic Club. It included lines like: “Bluntly stated, the securities industry, more than any other industry in America, engages in mazes of blatant gimmickry.” [As quoted in Chris Welles, The Last Days of the Club: The Passing of the Old Wall Street Monopoly and the Rise of New Institutions and Men Who Will Soon Dominate Financial Power in America, E.P. Dutton & Co., Inc., 1975, page 18]
Borrowing from academic papers on quantifying risk, and hiring the academicians themselves, Wall Street has presented investment schemes and invented securities that used theoretical diversifications and hedging structures to create the appearance of no risk, or very limited risk. For instance, an article by David X. Li, then working at JPMorgan Chase, appeared in The Journal of Fixed Income in 2000. It bore the academic title, "On Default Correlation: A Copula Function Approach." (In statistics, a copula is used to couple the behavior of two or more variables.) Wall Street used the approach to build a way around the difficult task of analyzing the risk of each mortgage or other asset placed in a CMO pool. They could use Li’s correlation number. Rating agencies also began using the shortcut analysis, rather than the arduous task of understanding and quantifying the variables.
For an even riskier game, Wall Street creates options, swaps and other derivatives from these new securities, to both stimulate and serve the mania for greater risk-return ratios. The giant of these new made-up securities was the Credit Default Swap, which is a bet that a particular borrower or package of debt securities would or would not fail to pay. Like most options, it could be used by the owner of the security to hedge its credit risk. For most players, however, it was a way to bet on the economic future of a debt instrument. “The CDS [credit default swap] and CDO [collateralized debt obligation] markets grew together, feeding on each other. At the end of 2001, there was $920 billion in credit default swaps outstanding. By the end of 2007, that number had skyrocketed to more than $62 trillion. The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by 2006.” [Felix Salmon, “Recipe for Disaster: The Formula That Killed Wall Street,” Wired, February 23, 2009, www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=1]
Securities derived from mortgages are only one part of the complexity devastation wreaked by Wall Street. [For a description of "how close the financial system had come to a catastrophic seizure" in October 1987, see Scott Patterson, The Quants, Crown Business, 2010, pages 47-53.] The tax exempt bond market, used to finance state and local governments, has been badly damaged by Wall Street’s practice of inventing and selling complex financial contracts. This market once moved rather predictably with changes in interest rates. Then, in 2008, municipal bond funds lost an average 9.4% and some of them were down over 30%. One cause was Wall Street’s marketing of “tender option bonds” or “inverse floating rate obligations.” These instruments split the income from a municipal bond into a short-term fixed rate and a long-term variable rate. [Jason Zweig, “Muni-Bond Bargains: Devil’s in Details,” The Wall Street Journal, January 31, 2009, page B1] Wall Street uses credit default swaps to bet against the very local government bonds it underwrites. At the same time that Wall Street is selling the bonds to one group of its customers, it also sells another set of customers on bets that the price of those bonds will go down. [Ianthe Jeanne Dugan, "Scrutiny for Bets on Municipal Debt," The Wall Street Journal, May 14, 2010, page C1]
Hospitals were sold interest rate swaps and auction-rate securities, incurring huge losses. [Ianthe Jeanne Dugan, "Hospitals Claim Wall street Wounds," The Wall Street Journal, July 8, 2010, page C1]
Wall Street is still using the disaster it created to extract more money from local governments and university endowments. Before the Panic of 2008, Wall Street sold them instruments that would swap their fixed-rate long-term debt for a variable-rate obligation. With names like "constant maturity swaps, swaptions and snowballs, they lowered the amount of interest borrowers had to pay, for a brief period. [Randall Dodd, "Municipal Bombs," Finance and Development, International Monetary Fund, June 2010, http://www.imf.org/external/pubs/ft/fandd/2010/06/dodd.htm] When the variable rates went up, Wall Street offered to terminate the swap agreement--for a fee. "In all, borrowers have made more than $4 billion of termination payments . . .. In addition to getting termination payments, Wall Street is finding another way to profit--underwriting bonds that borrowers are selling to raise money for the termination fees and to refinance their variable rate debt." Michael McDonald, "The Wall Street Product That Soaks Taxpayers," Bloomberg Businessweek, November 15-21, 2010, page 53, 54. Nonprofit organizations were hit by the same Wall Street tactic, which could include buying a letter of credit from the Wall Street bank "assuring that the bonds were a safe investment' but expiring without renewal. Justin Scheck, "Money Woes Threaten Museum," The Wall Street Journal, November 19, 2010, page A8]
Out of the complexity of using securities comes a mystique surrounding the investment bankers who appear to know how it all works. Wall Street maintains its monopoly of the money flow by perpetuating the illusion that it knows all the whos and whats and how-tos and that no outsider will ever know them. To have some sort of common language with investors, Wall Street grabs onto shorthand concepts that can seem to make some sense. One of the most common is the earnings multiple, the concept that a company’s shares trade at a multiple of its earnings, divided by the number of shares it has issued. The multiple is explained as depending upon the industry, the company’s growth rate and future prospects. A big problem with this is the pressure it puts upon each quarter’s earnings per share. It has lead to a lot of “creative accounting,” which Andrew Tobias describes in The Funny Money Game. [Andrew Tobias, The Funny Money Game, Playboy Press, 1971, pages 134 to 152]
Robert J. Ringer self-published his 1973 book, Winning through Intimidation and sold 1.7 million copies in the next four years. [www.trivia-library.com/b/self-help-advice-est-by-winning-through-intimidation.htm. A later edition was published by Fawcett in 1984.] His advice was geared to his own business experience as a broker for apartment buildings. The techniques he suggested are pretty gross, compared to the sophistication of the investment banker. But the underlying premise is the same: Success in business comes from creating illusions, not from the quality of the product or service offered. The intimidation game on Wall Street does include high-end variations of the tricks Ringer suggests. There are the limousines, breakfasts in the private dining rooms, hard-to-get tickets to events, introductions to famous people, being included among those who wear clothes and watches seen in slick New York magazines. But more effective is the aura created, that these Wall Street people are the ones who understand how high finance really works, that it is not something the rest of us could ever learn, that it’s a combination of breeding and immersion.
A story is told that James Carville, while working for President Clinton, would be in White House meetings with Robert Rubin and others, discussing the national economy. Every issue seemed to be resolved when Rubin or someone else from Wall Street would say how the bond market would react. Carville would remark: “If there is reincarnation, I want to come back as the bond market. Nobody gets more respect.” [In another version, Carville said that, reincarnated at the bond market, "You can intimidate everybody." Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, Pantheon Books, 2010, page 98, citing Louis Uchitelle, "The Bondholders Are Winning: Why America Won't Boom," The New York Times, June 12, 1994, www.nytimes.com/1994/06/12/weekinreview/ideas-trends-the-bondholders-are-winning-why-america-won-t-boom.html] The message seems to work: We work on Wall Street and understand it. You don’t, so you can’t.
Nothing so demonstrates the power of the Wall Street mystique as the bailouts of 2008. Within a week of the request by the Treasury Secretary, himself a former CEO of an investment bank, Congress gave him authority to spend $700 billion of taxpayers’ money buying toxic mortgage securities that investment banks had manufactured but couldn’t sell. Over the same period, politicians and the media were startlingly unconcerned when the Federal Reserve Board bought or guaranteed over a trillion dollars of securities from investment banks and commercial banks which had caused the credit market crisis. All of this was done without any real conditions on how our money was to be used, how the banks would behave in the future and who should bear responsibility for all the pain caused people all over the world.
The academic support for encouraging complexity may have begun changing, back to accepting that some risks cannot be quantified, predicted or even imagined. [See Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable, Random House, 2007] There are even academicians suggesting that commercial banks should no longer provide money for buying complex derivatives. [Amar Bhidé, Glaubinger professor at Columbia Business School, “In Praise of More Primitive Finance,” www.bhide.net] World political opinion may also be shifting from holding Wall Street in awe. French President Nicolas Sarkozy gave the keynote address at the 2010 World Economic forum in Davos, in which he said: “There is indecent behavior that will no longer be tolerated by public opinion in any country of the world. That those who create jobs and wealth may earn a lot of money is not shocking. But that those who contribute to destroying jobs and wealth also earn a lot of money is morally indefensible.” [Marcus Walker and Emma Moody, “At Davos, Bankers Are On The Run,” The Wall Street Journal, January 30-31, 2010, pages A-1, A-11]
Wall Street has Concentrated Power in the Few
Wall Street has gathered for itself a great concentration of power in finance. Through exercise of that power, it has fostered the concentration of American business into a few huge corporations in each industry. In perhaps its most pernicious effect, Wall Street has forced a concentration of business ownership in wealthy individuals and institutions. As Wall Street’s buy side has grown, it has led to a great concentration of ownership in professional money managers for huge funds and other institutions.
Concentration of power in finance.
Perhaps the most obvious and disturbing concentration of power in Wall Street is that 100 financial institutions own over half of all corporate shares, “constituting majority control of corporate America.” Institutional investors of all types own about two-thirds of all U.S. stocks. [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, page 69, 74]
Wall Street personalities are extremely competitive, in the “mine is bigger than yours” syndrome. Size seems to be more important than profitability, innovation or a reputation for integrity, good relationships or other standard. As a result, many of the players on Wall Street have become “too big to fail.” The United States and Britain have considered a “too big to fail tax,” to pay for the increased regulatory scrutiny they require. The big ones would be held to higher capital ratios and other standards intended to keep them out of financial trouble. Despite a lot of talk about forcing these financial conglomerates to split into smaller pieces, there seems to be little chance of that happening.
One effect of "too big to fail" is that everyone now believes that credit of the United States government stands behind the huge institutions, while smaller ones must stand on their own. As a result, the big ones can borrow money at a lower cost and take bigger risks for extra profit. [Dean Baker and Travis McArthur, "The Value of the 'Too Big to Fail' Big Bank Subsidy," Issue Brief, Center for Economic and Policy Research, September 2009, http://www.cepr.net/documents/publications/too-big-to-fail-2009-09.pdf and Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, Pantheon Books, 2010, pages 204-205]
Another example of the concentration of power in Wall Street is the market for U.S. Treasury obligations, from 30-day Treasury bills to 30-year Treasury bonds. The Federal Reserve Banks handle the initial distribution of these securities, through a few investment and commercial banks, chosen by the Federal Reserve Bank of New York. Before each auction of Treasury securities, government officials meet with the primary dealers for advice on how to price them. Then the dealers purchase securities at the auction, as agents or for their own account. These primary dealers were the private contractors chosen by the Federal Reserve and the Treasury to lend government money to purchasers in the Term Asset-Backed Securities Loan Facility. The TALF bailout finances purchases of securities from the banks and others caught when the markets froze. The primary dealers, as you might guess, went to the hedge funds with this minimal down payment, low interest rate deal.
There were 40 of these “primary dealers” twenty years ago and only 18 by 2010, of which 7 were U.S. banks or broker-dealers and 11 were foreign banks or broker-dealers. The Federal Reserve Bank of New York recently tripled the minimum net capital required for primary dealers from $50 million to $150 million. “The message is clear: the New York Fed does not want a bunch of new start-up dealers knocking at their door.” [Chris Bury of primary dealer Jefferies & Co., quoted by Min Zeng, “Cost to Primary Dealers Goes Up,” The Wall Street Journal, January 12, 2010, page C8]
(During 1984 and 1985, I purchased call options on Treasury futures. For a modest option price, I could gamble on the price of 30-year bonds having a short-term rise. My theory was that the primary dealers would manipulate the market down as they advised the government on the next auction’s price. I figured the price would go up right after the dealers had purchased at the auction. The dealers could then sell to their customers at the higher price and pocket the difference. Coincidence or not, using the theory worked well for a few auctions. Then friends, knowing I didn’t have a gambler’s temperament, insisted that I stop. I’m glad to be out of it and know I would have ultimately lost everything, but I got a real taste of the mania that comes from playing rigged games.)
Henry Kaufman was the most-quoted securities analyst/economist of the 1980s, when he worked for Salomon Brothers, now part of Citigroup. His dour outlook led to the nickname, “Dr. Doom.” In a December 2008 opinion editorial, Kaufman noted how the ownership of debt securities had become concentrated in just 15 financial conglomerates. “These were the very firms that played a central role in creating an unprecedented amount of debt by securitization and complex new credit instruments. They also pushed for legal structures that made many aspects of the financial markets opaque.”
Kaufman’s gloomy prediction: “In the years ahead, the influence of these financial conglomerates will be overwhelming—and they will limit any moves toward greater economic democracy. These conglomerates are and will continue to be infused with conflicts of interest because of their multiple roles in securities underwriting, in lending and investing, in the making of secondary markets, and in the management of other people’s money. . . . Through their global reach, these firms will transmit financial contagion even more quickly than it spread in the current credit crisis. When the current crisis abates, the pricing power of these huge financial conglomerates will grow significantly, at the expense of borrowers and investors.” [Wall Street Journal, December 6-7. 2008, page A11. Kaufman is the author of On Money and Markets: A Wall Street Memoir, McGraw-Hill, 2001.] The future that Kaufman forecasts in this Wall Street Journal article is not far from this 1937 report to the Communist Party: “A very important contributing factor to the decline of the stock market, and the uneven recession in various branches of industry is this: that big capital, the reactionary monopolists, may be considered as being on a sort of political strike. . . . It is not excluded that in expectation of this Congress [the special session of Congress called by Roosevelt] and what it may do, the monopolists seek to produce or hasten the aggravation of economic conditions, in order to terrorize Congress and keep it from adopting progressive political measures.” [Economic Trends Today, Monopoly Sabotage, and Tasks of Our Party – A Report to the Political Bureau of the Communist Party on the Present Economic Situation, by Alex Bittelman. Daily Worker, October 28, 1937, as quoted by Dave Cowles, “Strike of Capital,” The New International: A Monthly Organ of International Marxism, Volume IV, No. 4, April 1938, page 107, http://marxists.kgprog.com/history//etol/newspape/ni/vol04/no04/cowles.htm#n1] Kevin Phillips warns that the United States is headed for decline when it "lets itself luxuriate in finance at the expense of harvesting, manufacturing, or transporting things." [Kevin Phillips, Bad Money: Reckless Finance, Failed Politics, and the Global Cdrisis of American Capitalism, Viking, 2008, page 20]
Concentration of power in big business
Nearly every business needs a source of permanent money, in addition to the temporary funding that meets seasonal or occasional needs. Small businesses usually raise their permanent money from savings, personal borrowings, family and friends. They get their temporary funding through bank borrowings, with or without government support. There is no real place for Wall Street in small business financing, with the exception of the fast-track, venture capital-supported “the next Apple,” or Google or other latest hot IPO.
Wall Street makes its real money on big business. Much of it comes from taking a percentage as money changes hands in transactions. The percentage take is about the same on large transactions as on small ones. So, the incentive is always toward doing large securities offerings, large mergers and acquisitions. Big businesses have huge underwritten issues of securities. They generate merger and acquisition fees while gobbling up competitors and expanding into related arenas. It is big business that provides the raw material for stock options, credit default swaps and other derivatives. Big business also creates the opportunities to trade on information that gets leaked to favored Wall Streeters before it is public. Since virtually all money for investment has to flow through the Wall Street monopoly, it is made available to big business only--just the opposite from what is needed. "Rather than reinvest in the industries that once made us great, we must move beyond the industrial tasks of the past, toward the great new enterprises of the future." [John Naisbitt, Megatrends: Ten New Directions Transforming Our Lives, Warner Books, 1982, page 58]
One harmful result is that small business is largely ignored by Wall Street. Investment banking had its beginnings as a service to entrepreneurs—finding sources for growth capital and sheparding a transaction through to closing. The objective was to provide money to build a business. That changed in the 1890s in America, when investment bankers developed a way to do much larger financings, by consolidating small businesses into a few giant businesses. They began doing mergers and acquisitions. Key to this new business was raising money to pay off the sellers, as their companies disappeared into the consolidated structure.
Louis Brandeis, who went on to a lengthy term as United States Supreme Court Justice, wrote a series of magazine articles which were published in 1914 as the book, Other People’s Money: And How the Bankers Use It. [Louis D. Brandeis, Other People’s Money: And How the Bankers Use It, Frederick A. Stokes Company, 1914, republished by National Home Library Foundation, 1933, Kessinger Publishing’s Rare Reprints] Brandeis describes how the great American industries, like railroads, steel, machinery, automobiles and telephone were all initially financed by individuals and the government. It was only after 30 to 80 years of business development that investment bankers added them as clients. He goes through each of the major industries of the time, detailing how the hundreds of competitors were initially financed without any Wall Street participation and then how, decades later, Wall Street engineered their consolidation into a single industry-dominant corporation. This is a brief summary of his chapter, “Where the Banker is Superfluous,” with page references to the republished book:
Railroads. Before the 1890s, Wall Street investment bankers’ major clients were the railroads. But the bankers were definitely not there to help the pioneers of railroad transportation. “The necessary capital to build these little roads was gathered together, partly through state, county or municipal aid; partly from business men or landholders who sought to advance their special interests; partly from investors; and partly from well-to-do- public-spirited men, who wished to promote the welfare of their particular communities. About seventy-five years after the first of these railroads was built, J. P. Morgan & Co. became fiscal agent for all of them by creating the New Haven-Boston & Maine monopoly.” [page 93]
Steamships. Robert Fulton, the inventor, built the first steamship with financing from a friend who was a judge. Funding for the first steamship to cross the Atlantic came from an 1833 direct offering to the three Cunard brothers and over 200 other shareowners. “In 1902, many years after individual enterprises had developed practically all the great ocean lines, J. P. Morgan & Co. . . . organized the Shipping Trust.” [page 93]
Telegraph. The telegraph was invented by Samuel F. B. Morse, with the financial support of his partner, Alfred Vail. When it came to paying for the first telegraph line, Congress appropriated $30,000 for an installation from Washington, D.C. to Baltimore. The telegraph business, as Western Union, operated without investment bankers until it was purchased in 1909 by American Telephone & Telegraph Company. That purchase was financed through J.P. Morgan & Co. [page 94]
Farm Equipment. When Cyrus McCormick invented the mechanical reaper, an ex-Mayor of Chicago put up $25,000 to build the first factory there in 1847. McCormick bought back the investment for $50,000 and the business was entirely owned by his family when he died in 1884. In 1902, “J. P. Morgan & Co. performed the service of combining the five great harvester companies, and received a commission of $3,000,000.” [page 94]
Steel. Andrew Carnegie was already wealthy by 1868, when he introduced the Bessemer process, which propelled the American steel industry to world leadership. It wasn’t until 1898 that Wall Street, particularly J. P. Morgan & Co., began the consolidation of the steel industry. By 1901, all parts of the business had been combined and United States Steel was capitalized at $1.4 billion. Brandeis describes the formation of United States Steel, “combining 228 companies in all, located in 127 cities and towns, scattered over 18 states. Before the combinations were effected, nearly every one of these companies was owned largely by those who managed it, and had been financed, to a large extent, in the place, or in the state, in which it was located. When the Steel Trust was formed all these concerns came under one management. Thereafter, the financing of each of these 228 corporations (and some which were later acquired) had to be done through or with the consent of J. P. Morgan & Co. That was the greatest step in financial concentration ever taken.” [page 104. Italics in the original.]
Telephone. Over 90 percent of the money spent by Alexander Graham Bell to build the first 5,000 telephones came from Thomas Sanders, who had a business cutting soles for shoe manufacturers. From 1874 through 1878, Sanders borrowed and invested $110,000, although the shoe business he owned was valued only at about $35,000. Sanders was motivated by a debt of gratitude, because Bell had “removed the blight of dumbness from Sanders’ little son.” [page 96] When Western Union Telegraph Company began to sell telephone service in 1878, it was individual investors who came up with the money to keep alive the Bell Telephone Company. [page 96, quoting from H. N. Casson, “History of the Telephone.”] It was twenty years later that J. P. Morgan gained control of the business and formed the American Telephone & Telegraph Company. Between 1906 and 1912, Morgan and Wall Street syndicates marketed about $300 million in bonds, using the money raised to buy other telephone companies, including control of Western Union. Brandeis commented that this consolidation was, “in large part, responsible for the movement to have the government take over the telephone business.” [page 99]
The point is not just that investment bankers failed to provide growth capital for new industries. What Brandeis shows is that investment bankers raised money to buy up and consolidate entire industries into one dominant company. They created monopolies where there had been lively competition.
Another harm follows from Wall Street’s focus on big deals, especially when combined with its trader mentality. In most businesses, the lure of a short-term profit opportunity can be overcome by the vision of greater long-term prospects. Not so with Wall Street. We’d like to think of financiers as nurturing small businesses into large businesses, investing early for modest returns so they would grow into loyal mature businesses as profitable clients. Instead, one of Wall Street’s first accomplishments was to create big businesses out of small businesses. This was like a farmer selling the seed corn, getting a little more money this year but giving up the source of future crops.
The companies of America’s industrial revolution were generally small and funded without any financial intermediaries. “The businesses of the industrializing nineteenth century were, more often than not, organized as partnerships or closely held corporations.” [Lawrence E. Mitchell, The Speculation Economy, Berrett-Koehler Publishers, Inc., 2007, page 9] There was little room for investment bankers to earn fees or trade in securities. Wall Street’s solution was to gather up scores of small businesses and consolidate them. “The giant modern corporation was created for a new purpose, to sell stock, stock that would make its promoters and financiers rich. It took only seven years. In the space of that explosive period, from 1897 to 1903, the giant modern American corporation was created by the fusion of tens, and sometimes hundreds, of existing business.” [Lawrence E. Mitchell, The Speculation Economy, Berrett-Koehler Publishers, Inc., 2007, page 9] It was in this climate that President Rutherford B. Hayes, said that “This is a government of the people, by the people and for the people no longer. It is a government of corporations, by corporations and for corporations.” [John Micklethwait and Adrian Wooldridge, The Company: A Short History of a Revolutionary Idea, The Modern Library, 2003, page xiv]
Laws were changed to facilitate this consolidation into big businesses. New Jersey was gathering significant revenues by attracting the franchise fees and taxes from businesses choosing to incorporate under its charter provisions. Because Americans were distrustful of corporations, the early state laws had limited them to specific business activities and a set period of years for their existence. New Jersey loosened that, allowing corporations to engage in “any lawful business,” including buying shares in other corporations, paying for them with its own newly-issued stock. Corporations were granted perpetual life.
The bonanza for Wall Street was far greater than the huge fees received from transactions and new stock issues. A trading market for millions of corporate shares was created. In 1890, there were less than ten manufacturing companies with shares traded on the stock exchanges, with total market capitalization of $33 million. By 1903, with the consolidations into new giant corporations, that became over $7 billion. [John Micklethwait and Adrian Wooldridge, The Company: A Short History of a Revolutionary Idea, The Modern Library, 2003, page 69]
Concentration of power in wealthy individuals
Wall Street investment bankers have functioned as gatekeepers, keeping ownership of the instruments of production in the hands of the wealthy and their servants.
Wall Street has made no secret of its focus on wealthy individuals. Making the rich richer is seen as the fastest way to those multimillion dollar bonuses. So long as Wall Street remains the channel for investing discretionary money, then its business model will continue to cause wealth to concentrate. The strategy has paid off for Wall Street, as the income and proportion of wealth held by the richest continues to increase. Even during the market crash of 2008 and the recession that followed, the wealthiest one percent increased their share of U.S. wealth from 34.6% to 35.6%. The share of the wealthiest ten percent increased from 73% to 75%. [Robert Frank, "The Wealth Report," www.wsj.com/wealth] The Spectrem Group issues annual reports on the “affluent market,” which tallies U.S. household net worth, not including primary residences. They reported 1,061,000 households over $5 million in 2010, up from 230,000 in 1997 and just below the 1,160,000 peak of 2007. At $1 million, it was 8.4 million in 2010, versus 5.3 million in 1997 and 9.2 million in 2007. The startling numbers were for households with a net worth of over $25 million, which went from 12,500 in 2007 to 105,000 in 2010.
[http://www.spectrem.com/ProductInfo.aspx?productid=AFFLUENTMARKETINSIGHTS2011. For continuing information, see www.millionairecorner.com. For information on the disparity of wealth distribution, see the work of Emmanuel Saez, http://elsa.berkeley.edu/~saez, particularly “Striking It Richer: The Evolution of Top Incomes in the United States,” http://elsa.berkeley.edu/~saez/saez‐UStopincomes‐2008.pdf, as well as www.inequality.org and www.demos.org/inequality/numbers.cfm]
To gather funds from rich individuals and institutions, Wall Street added complex, fast-moving games to stocks and bonds. It was the year 1973 when options were permitted to trade on an exchange and when Black and Scholes published their formulae for pricing options. Not so coincidentally, 1973 was also when the average income per taxpayer, adjusted for inflation, was at its high of $33,000. By 2005, it had gone down by nearly $4,000. [Bob Herbert, “Reviving the Dream,” The New York Times, March 9, 2009, www.nytimes.com/2009/03/10/opinion/10herbert.html?emc=eta1] The concentration of power in wealthy individuals has continued through the Great Recession, according to The Boston Consulting Group’s report on distribution of the world’s wealth for 2009: “Less than 1 percent of all households were millionaires, but they owned about 38 percent of the world’s wealth, up from 36 percent in 2008. Households with more than $5 million in wealth represented 0.1 percent of households but owned about 21 percent, or $23 million, of the world’s wealth, up from 19 percent in 2008. [Press Release, June 10, 2010, www.bcg.com/media/PressReleaseDetails.aspx?id=tcm:12-49877] From a 2011 Briefing Paper, "The wealthiest 1% of U.S. households had net worth that was 225 times greater than the median or typical household’s net worth in 2009. This is the highest ratio on record." In 1962, the ratio was 125 to 1. As to ownership of corporate shares, "Even at the 2007 economic peak, half of all U.S. households owned no stocks at all—either directly or indirectly through mutual or retirement funds." [Sylvia A. Allegretto, "The State of Working America's Wealth 2011: Through volatility and turmoil, the gap widens," Economic Policy Institute, March 23, 2011, page 2 and Figure C on page 7, http://epi.3cdn.net/2a7ccb3e9e618f0bbc_3nm6idnax.pdf, ]
Americans seem to be unaware of our extreme concentration of wealth. A random sample drawn from a national panel of over a million Americans showed that "All demographic groups – even those not usually associated with wealth redistribution such as Republicans and the wealthy – desired a more equal distribution of wealth than the status quo. . . . First, respondents dramatically underestimated the current level of wealth inequality. Second, respondents constructed ideal wealth distributions that were far more equitable than even their erroneously low estimates of the actual distribution." These "regular Americans" were shown three pie charts of wealth distribution, without disclosing that they represented the United States, Sweden and an equal distribution. While 92% preferred the Sweden distribution over the American one, a slight majority chose Sweden over the equal distribution. When asked to construct their ideal distribution, they had the top quintile owning 32%, compared to their belief that ownership was 59% and to the actual 84% of wealth held by the richest 20%. [Dan Ariely and Michael I. Norton, Building a Better America--One Wealth Quintile at a Time, 2010, http://www.people.hbs.edu/mnorton/norton%20ariely%20in%20press.pdf, pages 2, 6]
Is concentration of wealth harmful? Is anyone really hurt when the rich get richer? One answer is that accumulating wealth in the few leads to depressions, which definitely harm most of us. The theory is that rich people put far more of their discretionary cash into investment than consumption. As a larger proportion of society’s wealth is concentrated at the upper end, investment in productive capacity gets ahead of our ability to consume the resulting output. By itself, that could adjust in time without creating a severe slowdown in the economy. If, however, as the theory goes on, banks and investors take on more risk, an economic slowdown can lead to a sudden aversion to risk. Banks and investors try to sell their marginal assets and put their money into short-term U.S. Treasuries or other safe and liquid vehicles. Financial intermediaries are unable to meet their obligations, stop making new commitments and call in everything due from their customers. Businesses lose their credit lines and can’t meet payrolls or pay creditors.
According to the Joint Economic Committee of Congress: “Peaks in income inequality preceded both the Great Depression and the Great Recession, suggesting that high levels of income inequality may destabilize the economy as a whole.” The Committee reported that “the share of total income accrued by the wealthiest 10 percent of households jumped from 34.6 percent in 1980 to 48.2 percent in 2008,” while the top 1 percent “rose from 10.0 percent to 21.0 percent, making the United States as one of the most unequal countries in the world. . . . In short, the evolution of income inequality in the United States is largely driven by the trends at the very top of the income distribution, as very wealthy households have continued to accrue an ever greater share of the nation’s total income. [Report by the U.S. Congress Joint Economic Committee, “Income Inequality and the Great Recession,” September 2010, pages 1, 2 http://jec.senate.gov/public/?a=Files.Serve&File_id=91975589-257c-403b-8093-8f3b584a088c]
The claimed correlation between increased concentration of wealth and economic downturns goes back at least to a paper published just before the Great Depression. [Mentor Bouniatian, The Theory of Economic Cycles Based on the Tendency Toward Excessive Capitalization, The MIT Press, 1928.] Another explanation comes from the technical analysis of economic cycles by Professor Ravi Batra, who missed the timing with his book, The Great Depression of 1990. If he had only waited 20 years to predict “that the rising concentration of wealth would create a shaky banking system and a speculative fever in the U.S. stock market, which would then crash, leading to a major U.S. depression, and then, with a domino effect, culminate in a global depression.” [The Great Depression of 1990, Liberty Press, Venus Books, 1985, page 6. For an update on Professor Batra, see www.ravibatra.com] Professor Batra charted the percentage share of wealth held by the richest one percent of U.S. adults. [page 133] It peaked in 1929 at 36% and had dropped to 21% by 1949. It was up to 34% in 1983, the last year in Batra’s chart. [page 133] Since then, the share owned by the richest one percent went to 35% in 1998, [ Edward N. Wolff, Poverty and Income Distribution, Wiley-Blackwell, 2nd edition, 2009, page 151] and back to 34% in 2004. [www.faculty.fairfield.edu/faculty/hodgson/Courses/so11/stratification/income&wealth.htm]
Batra claimed that a recession is caused by a decline in demand for goods and services, and will end when demand increases again, whether by the passage of time or by stimulation from government spending. A depression occurs “when a recession is accompanied by a collapse of the financial system . . ..” [page 134] So, the next question Batra asks: “What causes a financial panic?” We can revise his answer to reflect experience of the last 20 years. As the rich get richer and the middle class gets poorer, there is less borrowing done by the rich, while the middle class borrows more. Part of the middle class borrowing is to make up for declining real income from their jobs. Another part is to emulate what they see the rich doing with their money. [The “social comparison theory of happiness.” See Jerry Suls and Ladd Wheeler, The Handbook of Social Comparison, Springer, 2000 and the film, "The Economics of Happiness," ] Wall Street reacts by serving up ever more risky games to play, because acceptance of risk increases with wealth. [Arrow-Pratt Measure of Relative Risk-Aversion, part C of The Theory of Risk Aversion, http://cepa.newschool.edu/het/essays/uncert/aversion.htm#pratt]
The peak concentrations of wealth in recent U.S. history were in 1929 and 2008, when the richest one percent of its residents received nearly 24% of its income. Both years were followed by market crashes, unemployment and severe economic distress. According to Robert Reich: “This is no mere coincidence. When most of the gains from economic growth go to a small sliver of Americans at the top, the rest don't have enough purchasing power to buy what the economy is capable of producing. . . . Under these circumstances the only way the middle class can boost its purchasing power is to borrow, as it did with gusto. . . . When the debt bubble finally burst, vast numbers of people couldn't pay their bills, and banks couldn't collect.” [Robert Reich, “Unjust Spoils,” The Nation, June 30, 2010, www.thenation.com/article/36893/unjust-spoils
It is just a theory that increasing concentration of wealth leads to an economic depression. Perhaps the studies of what happened in 2008 will shed some light on its validity. In the meantime, we can each imagine what might have happened if Wall Street had not been so single-minded about selling speculative games to the rich and instead had extended credit to the middle class. What if they had promoted broad ownership of business and government debt, if Wall Street had helped each of us select shares and bonds of companies we thought would bring us a good return, and if the money managers did not have their vast pools of money to play with derivatives, arbitrage trading and the other games?
Concentration of financial power and wealth leaves the middle class out of society’s increasing wealth and makes us all victims of the periodic collapse of Wall Street. By separating the ownership of business from the workers, the benefits of greater productivity have mostly gone to the owners, leaving the workers behind. Since 1973, “the typical family’s income has grown at about one-third the rate of productivity. . . . Had the median household income continued to grow with productivity, it would now be in the $60,000 range instead of the $40,000 range.” [Jared Bernstein, All Together Now: Common Sense for a Fair Economy, Berrett-Koehler Publishers, Inc., 2006, page 57] Hardest hit are minority families, where the disparity in wealth is far greater than the difference in income. While Blacks earn 62 cents for every dollar of white income, Blacks have only 10 cents for every dollar of net worth whites have. While Latinos earn 68 cents for every dollar of white income, Latinos have only 12 cents for every dollar of net worth whites have. [“State of the Dream 2010: Jobless and Foreclosed in Communities of Color,” United for a Fair Economy, http://faireconomy.org/files/SoD_2010_Drained_Report.pdf]
A recent book has confirmed one of the greatest harms caused by having the rich get richer while the rest stay about the same or get poorer. Richard Wilkinson and Kate Pickett studied comparisons among the richer nations, as well as comparisons of states within the USA. Their book shows consistent correlation between inequality of wealth and such measures as life expectancy, ability to improve economic condition, educational achievement, prison population, teenage pregnancies and murders. The nations and states that have better life qualities all have less income and wealth inequality than their peer nations or states. The nation with the lowest life quality scores, and greatest inequality is the United States. [Richard Wilkinson and Kate Pickett, The Spirit Level: Why More Equal Societies Almost Always Do Better by, Penguin, March 2009 (UK), Bloomsbury Press, December 2009 (USA). See www.equalitytrust.org.uk and Richard Wilkinson, The Impact of Inequality: How to Make Sick Societies Healthier, New Press, 2006 and Unhealthy Societies: The Afflictions of Inequality, Routledge, 1996] Michael Harrington has argued that we must "be concerned not simply with the static inequity of the maldistribution of wealth, but with the dynamic power of elite decision making that goes with it." [The Next Left: The History of a Future, Henry Holt and Company, 1986, page 69]
The subject of wealth and income inequality suggests the uncomfortable thought of taking from the rich to giving to the poor. Of course, it doesn’t have to work that way. Simply alleviating extreme poverty, while leaving the rich alone, substantially narrows inequality. But Wall Street’s emphasis on building wealth for the wealthy does nothing to relieve poverty. About the only positive effect could be that a few who have become very rich on Wall Street will contribute their time and money to charities that help the poor. Mostly, however, people who do that have come from successes outside Wall Street. Wall Street's control over the mechanics of international finance, moving "hot money" from one developing nation to another, can be blamed for causing greater inequality and the resulting violence and revolts. [See Amy Chua, World on Fire: How Exporting Free Market Democracy Breeds Ethnic Hatred and Global Instability, Doubleday, 2003, page 9]
Wall Street's focus on selling investments to the already wealthy has left the middle class to be lured by the persuasive powers of borrowing and spending. This means that earnings from work continue to be the only source of significant income for nearly all of us. We have very little chance of ever having a financial return on money we've kept from spending. Government-promoted lotteries, with their dismal odds, are the only hope we have of breaking free of relying on our ability to find and perform a job. [Jeremy Rifkin, The End of Work, G. P. Putnam & Sons, 1995]
The problems created by wealth and income
inequality can arguably be offset by increased mobility—making it
possible for people to gain wealth.
[Jonathan D. Fisher and David S. Johnson, “Consumption Mobility in the
United States: Evidence from Two Panel Data Sets,” Topics in Economic
Analysis & Policy, Volume 6, Issue 1, Article 16, The Berkeley
Electronic Press, page 27,
Mobility upward into the middle class can begin to alleviate poverty.
Professor C.K. Prahalad, author of The Fortune at the Bottom of the
Pyramid, [Wharton 2004] has said:
“to ‘make poverty history,’ leaders in private, public and civil-society
organizations need to embrace entrepreneurship and innovation as
antidotes to poverty.’” [C.K. Prahalad, “Aid
is Not the Answer,” The Wall Street Journal, August 31, 2005, page A8.
See, also, Gene Sperling, The Pro-Growth Progressive: An Economic
Strategy for Shared Prosperity, Simon & Schuster, 2005] That
will not happen under Wall Street’s monopoly over the movement of money
Concentration of power in institutions
After the Roaring 20s, millions of Americans owned shares directly in American business. By 1931, AT&T had 642,000 shareowners, Pennsylvania Railroad had 241,000 and United States Steel 241,000. An AT&T advertisement showed a grandmotherly woman with her hands in a mixing bowl, with the caption "She's a Partner in a Great American Business." Ad copy called AT&T "a democracy in business--owned by the people it serves.. . . More than half of them have held their share for five years or longer. . . . More than 225,000 own five shares or less. Over fifty per cent are women. No one owns as much as one per cent . . .." Included in Roland Marchand, "AT&T: The Vision of a Loved Monopoly," adapted from his book, Creating the Corporate Soul, University of California Press, 1998 and included in Jack Beatty, Colossus: How the Corporation Changed America, Broadway Books, 2001, page 200] (A friend told me that his father, a lifetime AT&T employee, was encouraged to call upon shareowner families as he traveled the country.)
When the Securities Act of 1933 was adopted, institutions owned less than ten percent of the shares listed on the New York Stock Exchange. [Louis Lowenstein, What’s Wrong With Wall Street: Short-term Gain and the Absentee Shareholder, Addison-Wesley Publishing Company, Inc., 1988, page 58] The relative ownership by individuals and by institutions has dramatically reversed since then. By 2007, institutional ownership was over 76%. [Institutions are defined as “pension funds, investment companies, insurance companies, banks and foundations.” http://www.conference-board.org/utilities/pressdetail.cfm?press_id=3466]
A huge gift to Wall Street has been government encouragement of employer-sponsored retirement plans, through tax deductions for employer contributions and the investment standards and government insurance of ERISA, the Employee Retirement Income Security Act of 1974. The employer tie to accumulating assets for retirement is an anachronism, an accident of history. During World War II, the government set controls on wages, but benefits were not counted. Employers could compete to attract and keep the scarce employee candidates by offering a pension, as well as health benefits. Our national habit of employer-paid pensions and health care was just an unintended consequence of wartime wage and price controls. Other avenues for wealth accumulation may have never been tried, because the combination of social security and corporate pensions was expected to take care of the retirement needs.
Most employers, except the government, have already stopped providing “defined benefit” pension plans. These were the programs that promised to pay retirees a percentage of what they had been earning. Instead, businesses switched to “defined contribution” plans, which paid a percentage of an employee’s current earnings into a fund. The retirement benefits were then measured by what the employer had paid in for the employee, together with proportionate investment earnings. The change has taken the open-ended liability away, but it still ties asset-building to a particular employer. From company-wide plans, many employers have gone to sponsoring individual retirement programs, the IRAs and 401ks. These severely limit the individual’s choice of investments, often to a few selected mutual funds or the employer’s own shares. The conditions of employer plans mean that Wall Street buy side firms are paid fees to make investments. They do this mostly by investing in mutual funds, which get a fee for investing in securities. The mutual fund managers buy the securities through Wall Street sell side firms, which almost never invest in small businesses.
This institutional concentration of investment money has been mirrored by a constant decline in ownership of public companies by individuals. We often are told that some large percentage of Americans are stockholders. What is seldom mentioned is that this includes shares of mutual funds owned by individuals or, more likely, their retirement accounts. It is the money manager for the fund that is making investment decisions and actually owning and voting the shares in an operating company.
This institutional ownership puts at least one financial intermediary between the individual and management of a company. One effect is the disconnect between managers and the ultimate economic owner. Very few individuals know what companies are owned by their funds. They certainly don’t have any voice for shareowner voting.
Institutions have minimum size requirements for the companies in which they invest. Almost none of them ever puts the fund’s money into small businesses. Even initial public offerings are generally for $50 million or more, so the company has to be quite large before it ever goes public. It will have had many millions of dollars invested by institutional venture capital funds, or it will be a spinoff of a large business from an even larger conglomerate. All of this tends to direct capital into the largest corporations, while starving our younger, entrepreneurial businesses. In the final paragraph of his1914 book, Louis Brandeis quotes President Woodrow Wilson: “No country can afford to have its prosperity originated by a small controlling class. The treasury of America does not lie in the brains of the small body of men now in control of the great enterprises. . . . Every country is renewed out of the ranks of the unknown, not out of the ranks of the already famous and powerful in control.” [Louis D. Brandeis, Other People’s Money: And How the Bankers Use It, Frederick A. Stokes Company, 1914, republished by National Home Library Foundation, 1933, Kessinger Publishing’s Rare Reprints, page 152]
Wall Street Has Made Capitalism a Casino Game
Whatever faults we may find with the investment bankers of a century or so ago, they did channel money from Europe into American railroads, factories and other industries that employed people and built infrastructure. For the last thirty years, Wall Street has chosen to direct money into speculative stock trading, derivatives, takeover plays and other betting games that serve no productive use. [See Harold Meyerson, “Wall Street’s Just Desserts,” Washington Post, September 18, 2008, page A21] As Nobel-prize winning economist Paul Krugman wrote: "For the fact is that much of the financial industry has become a racket — a game in which a handful of people are lavishly paid to mislead and exploit consumers and investors." [Paul Krugman, "Looters in Loafers," The New York Times, April 18, 2010, www.nytimes.com/2010/04/19/opinion/19krugman.html?emc=eta1] For a table showing "The Evolution of Critical Derivatives, 1972-2005, see Kevin Phillips, Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism, Viking, 2008, page 35.
Wall Street has a government-enforced monopoly on selling new issues of securities. Entrepreneurs have to go through venture capital firms or investment bankers to grow beyond the start-up phase. Investors must turn money over to broker-dealers or fund managers, who limit the businesses which will ever get to use that money. Nearly all of the savings by individuals will only go to trading in "previously-owned" securities and their derivatives. "The potential of our economy to underwrite a society of broad prosperity is being sacrificed to financial speculation. . . . The real economy of enterprises and workers is hostage to a casino of financial speculation. . . . Every category of gatekeeper who had a fiduciary relationship with small shareholders was corrupted." [Robert Kuttner, The Squandering of America: How the Failure of Our Politics Undermines Our Prosperity, Alfred A. Knopf, 2007, pages 4,5, 74.]
One Wall Street brokerage firm has even crossed over from betting on securities prices to betting on sports. Cantor Fitzgerald, a major Wall Street bond broker, started Cantor Gaming in March 2009. It operates in a trading room located within a Nevada casino, where a player has four computer screens of data. Branches at other Las Vegas casinos use mobile devices. The gamblers place bets on individual plays in seven different sports. The Cantor Gaming CEO http://www.businessweek.com/magazine/content/10_41/b4198041715162.htm?link_position=link5]
Wall Street Promotes Speculative Trading Instead of Long-Term Investing
Most of Wall Street’s revenue has come from two sources, one from acting as a broker in executing trades in existing securities and the other from being a dealer, buying and selling securities for its own account. Federal securities laws, and the laws in every state, give broker-dealers a monopoly over both of these businesses. Anyone trying to cut in on the business, without first getting a broker-dealer license, can be sent to prison.
Since competition isn’t a challenge to monopolists, Wall Street broker-dealers concentrate on increasing the volume of transactions on which they take a broker’s commission or a dealer’s markup. “Churning” is the basic tool. Keep pushing sales of securities and recycling the proceeds back into the market. Just one example of how this is carried out is the concept of “Rotation,” meaning how industries come and go in favor, such as from “growth” stocks to “value” stocks and then from one industry segment to another. This generates commissions for the brokerage side of Wall Street, as investors sell one group and buy another. Even greater income comes from trading on inside information as to which sector will be coming into favor and which will be leaving, as well as underwriting commissions doing IPOs in the hot new industry.
For businesses seeking growth capital, the rotation game can mean being closed out of the IPO market for years and then having a few months in the “window of opportunity,” when investment bankers come calling. As an industry rotates into favor, investment bankers start with underwriting the most attractive businesses and work their way down to the riskier ones. They usually overdo the quality downgrade, until there are failures and frauds, poisoning the whole pool for years. Meanwhile, they have moved on to a new fad.
(In my years of doing securities law work, my clients went through several of these cycles. One of them led to pioneering a Direct Public Offering. We were hired in 1973 to help a savings and loan with an IPO. It signed a “letter of intent” with Wall Street underwriter G.H. Walker. (As in George Herbert Walker Bush, whose family founded and owned the investment banking firm.) But the IPO market for our client’s industry dried up in late 1973. By 1976, when there was some renewed activity, G.H. Walker had merged with William Staats, which was then acquired by White Weld, soon to be taken over by Merrill Lynch. Our client was too small to interest the giant. We met with all the investment banking departments of securities firms that might have the interest and ability to do the IPO. None was willing to take it on. Our client needed investor capital to support its growth and a Direct Public Offering was born out of this necessity. It marketed shares directly to its customers and other communities, in a public offering registered with the SEC and state securities regulators.)
Wall Street Has Turned to Derivatives and Other Nonproductive Games.
What caused the 2008 financial catastrophe? Perhaps we can blame it on the rock and roll. Savings and investments were not very complicated, right up to the late 1960s, the Summer of Love and Woodstock. Banks took deposits and paid interest at rates fixed by law. Governments and businesses sold bonds, which paid interest and had a date for paying back the amount invested. Businesses sold shares of ownership which never came due but could be resold in a trading market. Securities brokers handled the trading market, for which they were paid fixed commission rates.
It was as if the unrest of the 1970s hit Wall Street. In 1972, money market mutual funds were created, to pay higher interest rates than the banks. The next year, the SEC allowed stock options to be traded on the Chicago Board of Trade. There was suddenly a whole different perspective on financial instruments. Our minds were expanded from the “buy and hold,” “put money into growing, profitable businesses” concepts. We were swept away with finding a fast-moving game and playing it to the hilt.
In this alternate reality, stocks and bonds were not enough. There is a limit to the volume of trading that can be generated by churning existing securities that were originally issued by businesses to raise money for operations. Fewer than 7,000 stocks are listed on the two significant U.S. Exchanges. Adding in the stocks traded over-the-counter reported on Nasdaq’s Bulletin Board brings the total publicly traded issues to just over 10,000. Only a few of the 5,000 or so securities with Pink Sheet data are being traded with any regularity. But even if we included all of them, there would be 15,000 stocks available for turning over.
To build more activity, with commissions and trading profits, Wall Street needed more products, more markers in the casino games. An early step was to impose another layer of financial intermediaries between the individuals who provide money and the businesses that use the money. What Wall Street had to do was create other securities, using stocks and bonds as the basic building blocks. Mutual funds, which issued their own shares and used the money raised to buy securities, have provided new securities and greatly enhanced trading volume. There are over 16,000 mutual funds reported by the Investment Company Institute, including closed-end funds, exchange traded funds and unit investment trusts. [www.icifactbook.org/fb_sec1.html#number] That’s more than the 15,000 operating company stocks which could be traded. Then there are the hedge funds, which grew from 3,000 in 1998 to more than 9,000 by 2007, according to the Government Accounting Office. [www.gao.gov/new.items/d08200.pdf] A private consulting firm reported the number of hedge funds in 2007 at about 22,650, including funds that invested in other hedge funds. [www.pertrac.com/PER0020/WEB/me.get?web.websections.show&PER0020_1265]
Why would there be three or four times as many funds as there are companies with traded securities?
In addition to all the mutual funds and hedge funds, Wall Street started inventing new instruments, derivative securities which moved faster and farther. A derivative security is one derived from another security. Like avatars in a virtual reality game, derivative securities are just made-up icons measured by the performance of a real security. Derivatives are not new, nor is their involvement in financial disasters: it was tulip derivatives that were behind the Dutch crash of 1637. [John Lanchester, “Cityphilia,” London Review of Books, January 3, 2008, www.lrb.co.uk/v30/n01/lanc01_.html] In the last decades, stocks, bonds and other “real” securities have largely become just markers for options and other derivatives.
News about derivatives would never have made it into the general media, except for their devastating effect upon our personal economics. The derivatives games have drastically influenced whether we can keep our jobs and afford to stay in our home. In 2008, derivatives based on home mortgage loans were even the subject of “instant history” books, like The Big Short: Inside the Doomsday Machine, [Michael Lewis, W. W. Norton & Company, 2010]; Freefall [Joseph E. Stiglitz, W.W. Norton & Company, Inc., 2010] and Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis. [Paul Muolo and Mathew Padilla, Wiley, 2009]
Since the 1970s, Wall Street has diversified away from raising capital for business and into inventing derivatives and trading for their own accounts. They could have kept to their primary mission and improved the markets and instruments for companies to use for raising money for growth. They could have designed instruments that would fit the new pools of capital, such as retirement accounts for individuals. They could have developed marketing tools that would persuade individuals to buy corporate shares instead of more expensive cars and larger homes.
Instead of improving their own business, Wall Street executives chose to move into other ones. The greatest harm to us all has come from Wall Street’s runaway use of computer technology to create derivatives. To the extent anyone tries to justify the financial futures, options, swaps and the like, they argue that these derivatives help to “manage risk.” For instance, someone with a fluctuating-rate debt instrument can swap it for a fixed-rate payment schedule, to protect against the risk of interest rates going higher. On the other side, a speculator who wants to bet on lower rates can deliver a fixed-rate debt and take back the one that fluctuates. To protect against the risk of default, a bond owner can purchase a credit default swap, from a counterparty that believes it has priced the risk profitably. A stock investor can hedge against falling value by purchasing put options on the same stock or industry segment. However, those beneficial uses just scratch the surface on the games that are played in this casino.
One set of derivatives came from the futures market, which had long traded in bets on what the price would be for wheat, pork bellies and other agricultural products. The buyer of a futures contract is agreeing to deliver the real thing at a specific future date and a set price. The buyer is betting that the price for immediate delivery (the cash or “spot” price) will be lower on the contract delivery date. It is almost unheard of that anyone actually delivers the underlying commodity on the agreed delivery date. What really happens is that the contract either expires as worthless, because the spot price is lower at the delivery date, or the person on the other side of the futures contract pays the difference between the spot price and the contract price. It is a zero sum game, in that all the profits are equal to all the losses, not counting the commissions and fees charged for participating in the market.
Futures markets were intended to serve two types of participants. One is the speculator, who bets on the future price, just like gambling on the results of sporting events or elections. The other is someone in the business of actually using the commodity to be delivered. For these "commodities traders," the futures market provides a hedge against price fluctuations that could cause big losses to the business. Oil refineries buy crude oil for future delivery and sell their products at prices which include that cost. When they purchase oil, they can also sell an oil futures contract at the same price, for the same amount and same delivery date. That way, any price changes will cancel out. It takes the risk away from the refinery and places it on the speculator.
Of course, the futures market has become much more complicated than that. The real activity is among the speculators, those betting the price of a commodity will go up and those betting it will go down. If there are more bettors on higher prices (the bulls) than on lower prices (the bears), the futures contracts will continue to have higher settlement date prices. This will go on until the bulls start dropping out and the bears increase.
Sometimes the rational analysis of speculators is replaced by a mania, a belief that the market price will only go up, never down. Observers will call this “the greater fool theory of valuation.” Even if buyers don’t believe in the fundamentals for the price, they are convinced that someone will come along who is willing to pay an even higher price. This is the “bubble,” that, when it bursts, can cause calamity.
The futures markets were once spread all over the United States, with Chicago having the major ones. The principal players were not really part of Wall Street. As the futures markets expanded, it attracted Wall Street traders and brokers in their unquenchable thirst for new securities games to play. In 1994, the New York Mercantile Exchange and the New York-based Commodity Exchange merged and became the largest center for trading futures on physical commodities. Congress has passed laws purporting to regulate futures markets, but they have really been the results of lobbying by contestants in a turf war between Chicago commodities brokers and Wall Street, and between their respective regulators, the Commodities Futures Trading Commission and the Securities and Exchange Commission. A most recent and painful example of Wall Street’s domination of a futures market has been the one for oil. The futures market in oil was created in 1981, when the executive branch removed price and allocation controls and allowed the New York Mercantile Exchange to begin a trading market in gasoline futures. [Barry C. Lynn, Cornered: The New Monopoly Capitalism and The Economics of Destruction, John Wiley & Sons, Inc., 2010, pages 189-190] Congress separated speculators from “commercial traders," but left the so-called “swaps exemption.” Wall Street firms could purchase some physical assets, as if they were in the oil business, putting them in the commercial trader category. Then they could sell swaps to hedge funds, pension funds and other pure speculators. Bills introduced into Congress to eliminate the swaps exemption seem to have died in committee.
Oil derivatives have taken on a role in financial speculation that has almost nothing to do with the supply and demand for that commodity. It is now part of an arbitrage game, playing off the stock market. Since oil futures first started trading in 1983, their correlation with stock prices has been only about a tenth of one percent. Since 2008, it has been at 34% and reached 70% in 2010. “Crude oil is now influenced more by the stock market than by its own inventory levels or demand patterns.” What happened? Wall Street has overtaken the trading in oil futures, moving in and out on programmed trades. “Oil and stocks are joined up by actual money flows, as more fund managers start to trade in both markets. Many of them are so-called ‘algorithmic traders,’ who trade based on technical signals instead of fundamentals.” [Carolyn Cui, “Oil Gets a New Dance Partner: Stocks,” The Wall Street Journal, August 16, 2010, page C1]
Wall Street speculation in the futures markets for food has been blamed for increased hunger in poor countries. Professor of Economics, Jawaharlal Nehru University, in an interview with Paul Jay:
“From about late 2006, a lot of financial firms—banks and hedge funds and others—realized that there was really no more profit to be made in the US housing market, and they were looking for new avenues of investment. Commodities became one of the big ones—food, minerals, gold, oil. And so you had more and more of this financial activity entering these activities, and you find that the price then starts rising. . . . It sounds incredible, but world rice prices increased by 320 percent between January 2007 and June 2008. So in just 18 months you have tripling of world rice prices. World wheat prices go up by 240 percent, maize prices by 218 percent. Crazy increases in these trade prices of these commodities. . . . This bubble burst in June 2008 . . . because that was when banks had to move their profits back to the US to cover their losses in the subprime market.” from about March/April 2009 is that the prices have started rising again, and more and more of these investors, index investors, as they're called, have now started entering and buying OTC contracts in the forward market. And this is because there is really no reason for them not to do that, because they're getting very cheap interest, they've got a huge moral hazard because they know they'll get bailed out if there's a crisis, and this is a very profitable avenue of investment at the moment."
, in an interview with Paul Jay, http://therealnews.com/t2/index.php?option=com_content&task=view&id=31&Itemid=74&jumival=5067]
Derivative securities, fashioned from subprime home loans, have been especially harmful to communities of racial minorities, according to sociologists at Princeton University. Segregated, low-income areas had formerly been "red-lined" as undesirable by traditional lenders, who held and serviced the loans they originated. When making home loans became separated from continuing to own the loans, it created "geographic concentrations of underserved, unsophisticated consumers that unscrupulous mortgage brokers could easily target and efficiently exploit. . . . In the end, subprime lending not only saddled borrowers with onerous terms and unforeseen risks, but it also reinforced existing patterns of racial segregation and deepened the black-white wealth gap." [Jacob S. Rugh and Douglas S. Massey, "Racial Segregation and the American Foreclosure Crisis," American Sociological Review, Volume 75, number 5, October 2010, pages 629-651, at page 632]
The speculation in oil and food futures has led to a new kind of derivative for other commodities. In December 2009, the Securities and Exchange Commission approved new exchange traded funds (ETFs) for trading in platinum and palladium. Unlike most futures trading, these ETFs actually buy and store the physical commodity. That has the effect of taking supply out of the market, raising the price of the futures. Higher prices also have the effect of “hurting consumers such as car makers, liquid-crystal-display glass makers and medical-device makers.” [Matt Whittaker and Carolyn Cui, “ETFs Drive Up Platinum, Palladium,” The Wall Street Journal, January 20, 2010, page C9] "The holdings create a certain amount of overhang, raising concerns abaout how sharp any correction, whether driven by profit-taking or hedge-fund asset reallocation, would be." [Matt Whittaker, "Palladium Shines in the Glow of Metal-Backed ETFs," The Wall Street Journal, April 16, 2010, page C9]
The same concept and structure were applied to the future price for foreign currencies, then to U.S. Treasury bonds. These “financial futures” are commitments to deliver or to buy a security or currency at a date a few days or months out, at a stated price.
Financial futures came to include the single stock futures contract. They are another way of betting on the future price of a company’s shares, modeled on the futures contracts used for commodities like wheat, pork bellies and oil. When single stock futures contracts were first used, both the SEC and the Commodities Futures Trading Commission claimed jurisdiction over regulating them. To settle the dispute, Congress in 1982 banned the instrument from trading anywhere. When it passed the Commodity Futures Modernization Act of 2000 (tacked on to the “Consolidated Appropriations Act”), it gave the agencies shared jurisdiction. But it also used the 262 page law to create exemptions and exclusions from trading limitations and rules for “eligible contract participants.” These players include individuals or businesses (such as hedge funds) with $10 million in assets and employee benefit plans with $5 million in assets. [see summaries of the Act by Daniel P. Cunningham and Katherine J. Page of Cravath, Swaine and Moore for the International Swaps and Derivatives Association, www.isda.org/speeches/pdf/Analysis_of_Commodity-Exchange-Act-Legislation.pdf, by Glen S. Arden of Jones Day, www.jonesday.com/pubs/pubs_detail.aspx?pubID=1962 and by Dean Kloner, an associate with Stroock & Stroock & Lavan, www.stroock.com/SiteFiles/Pub134.pdf.] This wholesale market is the focus for Wall Street investment banking firms on both the buy and sell side. The Act directed a study of the use of swap agreements for the retail trade.
Then came another derivatives game, options on financial instruments. Options are the right to sell (a put option) or to buy (a call option) a security at a particular date and price. Unlike a futures contract, an option does not commit the holder to do anything other than pay a price for the option. That price is usually a small percentage of what it would cost to buy the underlying, “real” security. You get to play the game of guessing whether a security’s price will go up or down, without having actually to buy or sell the security or even agree to buy or sell it in the future. Options allow you to get the short-term price increase or decrease on a security, while paying only a fraction of the cost of buying the security itself. If you guess right, you can collect the same profit you would have gotten from buying the security on which the option was based, minus only the cost of the option. If you miss the mark, you only lose what you paid for the option.
Some option contracts are indices tied to a group of companies’ shares, like the S&P 500. Participants may use them as legitimate hedging tools, by simultaneously buying an individual company stock and selling an index option. Before long, the stock option concept went from broad market indices to options on stocks in specific industries or company size category or specific countries. Then, stock options were created that are the right to buy or sell a single company’s shares by a certain date at a set price. The option buyer is betting whether the price will move up or down. The option is “settled” without anyone actually buying or selling shares, with the result that trading in options can be done with far less capital. But it still means that capital is being tied up in a zero-sum game among its players, capital that could have been used to actually buying shares from a business that would use the funds to develop a product or service.
(My brief foray into playing the derivatives game was with futures call options on 30-year Treasury bonds. My options gave me the right to buy a futures contract which, in turn, would give me the right to buy the bonds. Having both an option and a futures contract had the effect of multiplying the amount of potential gain. I was betting that the price of the bonds at the delivery date on the futures contract would be higher than the price payable on the futures contract. If the price was below the futures price commitment, I’d be out the cost of the option. The odds looked to me much better than a lottery. Just as other gamblers tell themselves about sports betting, I could fantasize that I had some knowledge and ability in analyzing what the results would be, that it wasn’t really gambling, that it was a game of skill, perhaps even a career. I did OK, but I know that eventually I would have given back all my gains. Friends insisted that I get out and stay out.)
As the 1970s progressed, derivatives, especially options, gained respectability from government and academia. But the trade in derivatives was hampered by one big thing: no one could work out how to price many of them. The interacting factors of time, risk, interest rates and price volatility were so complex that they defeated mathematicians until Fischer Black and Myron Scholes published a paper in 1973. Within the year, traders were using equations and vocabulary straight out of Black-Scholes (as it is now universally known) and the worldwide derivatives business took off like a rocket.
In 1973, the year that the SEC approved options trading on the Chicago Board of Trade, it also allowed operation of the new Chicago Board Options Exchange. After Black’s death in 1995, Scholes and Robert Merton were awarded the Nobel Prize in Economics for this work. In the news release announcing the award, the Royal Swedish Academy of Sciences said: “A new method to determine the value of derivatives stands out among the foremost contributions to economic sciences over the last 25 years.”
Black and Scholes, the academics who created the formula for pricing options, were co-founders of Long Term Capital Management, a hedge fund manager that successfully used the Black-Scholes Formula from 1993 to 1998. But their formula didn’t anticipate what would happen to the financial markets when Russia defaulted on its debt. In a prelude to the 2008 collapse of Wall Street, the Federal Reserve Bank of New York jawboned a bailout by Wall Street banks, which had lent LTCM nearly all the money used in its maneuvers. After the bailout, the banks went back to business as usual.
With support from the SEC and Nobel prizewinning economists, derivatives trading came to dwarf the stock market. There were futures and options on individual stocks and groups of stocks, which led to the simultaneous buying and selling of derivatives for the same underlying securities, using different markets. This brought index arbitrage and program trading. One securities firm marketed its use of the Black-Scholes formula as “portfolio insurance.”
The summer before the Crash of October 19, 1987, when the Dow Jones Industrials dropped 22.5% in one day, institutional money managers had put over $100 million into these arbitrage strategies. [Marshall E. Blume, Jeremy J. Siegel, Dan Rottenberg, Revolution on Wall Street: The Rise and Decline of the New York Stock Exchange, W.W. Norton & Company, 1993, page 159] The flaw in the Black-Scholes equation was the assumption that index futures could always be sold in a down market. It didn’t provide for a panic market, when there were no buyers. That was the end of “portfolio insurance” but only to be replaced by more bets labeled “insurance.”
Futures and options instruments multiplied, with hedges, straddles and portfolio management strategies adding complexities. As Wall Street looked for more marker securities upon which to build more derivatives, real estate loans became the new game in town. First were mortgage-backed bonds, which were debt obligations secured by a pool of mortgages that had a value equal to 150% of the bond amount. Then, in 1977, came the first private Pass-through Certificates. They were fractional interests in a pool of mortgages that collected payments of interest and principal and passed them through to the owners. Both of these instruments were modeled on what was already being done by the government sponsored entities, Fannie Mae, Freddie Mac and Ginnie Mae.
Wall Street grabbed onto the mathematical formulae of the “rocket scientists” it had hired to come up with Collateralized Mortgage Obligations, or “CMOs.” These divided a pool of loans into tranches, based upon the risk involved in each. The lower risk tranches got triple A ratings from the rating agencies, while the high risk, “toxic” tranches got high interest yields and paid large commissions to the brokers who sold them. The appetite for CMOs led to using car loans, music royalties and any other installment payments for Collaterized Debt Obligations, or “CDOs.”
(I stopped doing legal work on mortgage securities in 1985, after completing my first and only Collateralized Mortgage Obligation. Unlike the Mortgage Backed Bonds and Pass-through Certificates I’d done, the CMO was dizzyingly complex. Most important, I listened to the investment bankers laugh about how they marketed the “toxic waste” tranches and the kind of fund managers who could be sold on them. That same year, I got my one and only call from a head hunter. The client was Drexel, Burnham, Lambert, the formerly sleepy Philadelphia broker brought to riches by Michael Milken and his junk bond operation. They were looking for someone to build a parallel business in mortgage securities. I’ve been so glad ever since to have declined any interest in pursuing it.)
As derivatives like futures, options, CMOs and CDOS expanded, the process moved on to inventing derivatives on these derivatives. The most publicly known are the Credit Default Swaps, a form of betting on whether payments on contracts will be made on time. They’re a little like sports betting, such as whether a quarterback will complete the next pass. These Credit Default Swaps grew to unimaginable amounts. “For example, the bets on who might default, called credit default swaps, grew unregulated to now comprise $683 trillion of contracts (Bank for International Settlements December 2008) – while real global production measures only the $62 trillion of global GDP (IMF October 2008).” [Hazel Henderson, “The New Financiers,” Ethical Markets, 2009, www.ethicalmarkets.com/2009/03/05/the-new-financiers]
One of the most difficult derivatives to understand is also the one that has caused some of the greatest losses. The “synthetic collateralized debt obligations” or synthetic CDOs. They are a group of bets on whether a company will default on its bonds. The bets are sold as “insurance” and “credit default swaps.” The groups include a hundred or more companies and the buyers are the banks, hedge funds and others who purchase bonds. They cover their risk of default by paying a premium to the owner of the synthetic CDO. The risk for each company in the pool will have been evaluated and the premium set to reflect the perceived risk of default. Like real insurance, the seller of the bets is protected by having a diverse pool of companies. However, if total losses from defaults comes to more than around 5% of the total debt, investors in the synthetic CDOs could lose the entire amount they paid. [The sad history of one synthetic CDO is chronicled by Mark Whitehouse and Serena Ng in “Insurance Deals Spread Pain of U.S. Defaults World-Wide,” The Wall Street Journal, December 23, 2008, page A1.]
Instead of channeling money from individuals to growing businesses, Wall Street has invented thousands of securities that are nothing more than bets on future events. Increasingly gigantic amounts of money have been sent to Wall Street to play these zero sum, nonproductive games. In late 2009, the global derivatives market had reached $600 Trillion, equal to ten times global gross domestic product. Of that, $204 Trillion was held by U.S. banks, with almost all of it, $197 Trillion, owned by the four largest Wall Street banks. [http://www.occ.treas.gov/deriv/deriv.htm] That’s “up from $106 trillion in 2002 and a relative pittance just two decades ago. Theoretically intended to limit risk and ward off financial problems, the contracts instead have stoked uncertainty and actually spread risk amid doubts about how companies value them.” [Peter S. Goodman, “The Reckoning: Taking a Hard Look at the Greenspan Legacy,” The New York Times, October 9, 2008, www.nytimes.com/2008/10/09/business/economy/09greenspan.html?_r=2&ei=5070&emc=eta1] That half a quadrillion dollars is lost to investing in shareownership or bonds of businesses that could make our lives healthier, safer and more satisfying. “Today we’re awash in capital and literally running out of nature.” [Peter Barnes, Capitalism 3.0, Berrett-Koehler, 2006]
Of course, many participants in these games of greed and fear are not residents of Wall Street. People buy and sell derivatives of their own free will, however ignorant or careless they may have been. “I'm not saying that average Americans were as culpable as Wall Street in creating this financial and economic crisis; our sins were venial, whereas theirs were mortal. Madoff's alleged fraud was at least straightforward. Much worse was the creation of exotic ‘derivative’ investment products -- whose true value turned out to be impossible to ascertain -- that were bought and sold with enormous leverage. As long as real estate values kept rising, it didn't matter what these chimerical investments were worth. What mattered to Wall Street was the ability to collect enormous fees from real people, in real dollars, for trading unicorns and dragons.” [Eugene Robinson, “The Year of Madoff,” Washington Post, December 30, 2008, page A15. Bernard Madoff, a former chairman of the NASDAQ Stock Exchange, confessed to a massive Ponzi scheme fraud in 2009 and began serving a 150-year prison term.] Trading on today's derivatives clearing houses are controlled by nine persons from huge Wall Street firms. Called http://www.nytimes.com/2010/12/12/business/12advantage.html?pagewanted=1&_r=2]
A practice similar to the derivatives markets was made a crime a century ago by New York’s Bucket Shop Law, later followed by other states. Before these laws, securities brokers and others accepted wagers that a company’s shares would go up or down in price. [Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970, page 127, note 62] The Financial Services Modernization Act of 1999 [also known as the Gramm-Leach-Bliley Act, Pub.L. 106-102] preempted these state bucket shop and gambling laws to the extent they might be applied to hybrid instruments, swap agreements and transactions among eligible contract participants. The “Modernization Act” went even further to create an unregulated market for Wall Street’s derivative securities. It set up a legal monopoly for a betting parlor on securities. Only registered broker-dealers could participate.
The 1987 market crash was not the only clear warning of what was to come in the derivatives market. Wall Street continued right after that to sell packages of interest rate swaps and other derivatives related to the debt market. When interest rates rose in 1993, many bond prices dropped by ten percent. Holders of derivatives experienced a much greater loss in value. The treasurer of Orange County, California had invested nearly $8 billion of its own funds and those of 180 other municipalities in bond-based derivatives. The turn in interest rates caused a $1.5 billion loss. In 2001, Enron became the largest bankruptcy in history after exposure of its games with derivatives and accounting. Enron had invented a series of derivatives, including contracts on future weather. It would trade new products at monopolistic profits. But then the investment bankers would copy Enron’s successful derivatives and competition would take away their profitability.
One of the voices about derivatives came from Warren Buffett, in his 2002 annual report to Berkshire Hathaway shareowners: “The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. . .. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” [www.berkshirehathaway.com/letters/letters.html] “Felix G. Rohatyn, the investment banker who saved New York from financial catastrophe in the 1970s, described derivatives as potential ‘hydrogen bombs.’” [Peter S. Goodman, “The Reckoning: Taking a Hard Look at the Greenspan Legacy,” The New York Times, October 9, 2008, www.nytimes.com/2008/10/09/business/economy/09greenspan.html?_r=2&ei=5070&emc=eta1]
When the Panic of 2008 hit, and some Wall Street players were bailed out, it still didn’t fix the crisis. “This is because the credit crisis reflects something more fundamental than a serious problem of mortgage defaults. Global investors, now on the sidelines, have declared a buyers' strike against the sophisticated paper assets of securitization that financial institutions use to measure and offload risk.” [David Smick, “Commentary: Why there's a crisis -- and how to stop it, CNNPolitics.com, October 10, 2008. David Smick is author of The World Is Curved: Hidden Dangers to the Global Economy, Penguin Portfolio, 2008. He is chief executive of Johnson Smick International, a financial market advisory firm based in Washington, D.C., which publishes The International Economy magazine.]
What happened to the credit markets in October 2008 was that banks became afraid to lend money to other banks, a practice that is a major source of bank funding. Bankers didn’t know which of their correspondent banks had loaded up on derivatives, and how many of those derivatives may have become unsaleable. “The reason banks became reluctant to lend money to each other was linked to risks arising from new types of financial instrument. Recent years have seen huge amounts of ingenuity applied to the devising of new types of investment vehicle. Most of these are forms of derivative, in which a product derives its value from something else.” [John Lanchester, “Cityphilia,” London Review of Books, January 3, 2008, www.lrb.co.uk/v30/n01/lanc01_.html]
Government reform proposals have focused on this unsaleability of derivatives, the fact that so many of them are traded privately, without continuous, public bid and asked quotations. The suggestion is that a repeat of the 2008 collapse could be avoided by having “transparency” from exchange trading of derivatives. One prediction is that greater transparency will be required for some, but not all derivatives. “This half-measure will allow new Petri dishes of systemic risk to fester in darkness as Wall Street returns to the “financial innovation” laboratory.” [Paul M. Barrett, “The Crisis Commission’s Missing Witness,” Bloomberg BusinessWeek, January 25, 2010, page 18]
The harm to United States citizens can be clearly seen and measured for at least one part of the derivatives mess. American International Group, Inc., the world’s largest insurance company, had a financial products unit which sold “insurance” against losses that could happen to owners of derivatives. One of the simpler products was a credit default swap, which charged a premium for insurance against a loss caused by a pool of mortgages going bad. It turned out to be a very bad bet by AIG. When AIG begged for its fourth rescue from the Fed, it said, in its February 26, 2009 draft presentation: “What happens to AIG has the potential to trigger a cascading set of further failures which cannot be stopped except by extraordinary means. . . . Insurance is the oxygen of the free enterprise system. Without the promise of protection against life’s adversities, the fundamentals of capitalism are undermined.” [www.bloomberg.com/apps/news?pid=20601103&sid=aijqMQA3JXzs&refer=us]
Credit default swaps and interest rate swaps insured by AIG totaled $440 billion, with less than $40 billion pledged as collateral, at a time when the total market value of all AIG equity was about $200 billion. [Gretchen Mortenson, “AIG, Where Taxpayers’ Dollars Go to Die,” The New York Times, March 9, 2009, www.nytimes.com/2009/03/08/business/08gret.html?em] Yet, Wall Street kept on buying and pushing insurance as protection for its customers. They either didn’t care whether AIG could cover the loss or they believed that widespread losses would never occur. Those on Wall Street who actually thought about AIG’s role in the derivatives game may also have believed that AIG would never be allowed to fail, that the government would bail it out. They were rewarded for taking this moral hazard. [John Carney, “Don't Forget: AIG's Customers Were Running A Scam Too,” The Business Insider, www.businessinsider.com/dont-forget-aigs-customers-were-running-a-scam-too-2009-3]
When AIG didn’t have enough reserves to pay its customers, the Federal Reserve Banks provided what had come to be $173 billion by early 2009 and could go to $400 billion. Why would the Fed do that? Insurance companies are not even regulated by the federal government. Heavy duty lobbying has kept them governed solely by each state’s insurance commission. It would be understandable if AIG’s swap customers were United States commercial banks, members of the Federal Reserve System. But it turns out they were U.S. investment banks, like Goldman Sachs, Morgan Stanley and Merrill Lynch, and foreign banks, like Deutsch Bank, Royal Bank of Scotland and HSBC Holdings. [Serena Ng and Carrick Mollenkamp, “Goldman, Deutsch Bank and Others Got AIG Aid,” The New York Times, March 7-8, 2009, page B1. Editorial, “The Gift That Keeps on Giving,” The New York Times, March 16, 2009, www.nytimes.com/2009/03/17/opinion/17tue1.html?_r=1&emc=eta1]
Rather than deter the use of credit default swaps, the AIG disaster seems to have prompted greater use of these derivatives. In the first half of 2009, some 70% of the credit lines extended to borrowers in good standing had interest rates tied to the price of the borrowers’ credit default swaps. If the swaps became more expensive, the interest rate on the loan would go up. Wall Street’s explanation is that increasing the borrower’s interest cost somehow protects the lender from default. Given that the credit default swap market is used for speculation, an unfounded rumor could send the swap price spiraling up, triggering an increase in the interest rate, causing the borrower to have real financial problems and the bank to have a loss on the loan.
Why did the Federal Reserve bail out those investment bank customers of AIG? One explanation is a rule of bureaucracies: Always increase your turf, your sphere of influence, the scope of your power. A clue for that motive is in what happened to the three investment banks disclosed as receiving bailout money funneled through AIG. As a part of the bailout, Merrill Lynch became part of Bank of America, while Goldman Sachs and Morgan Stanley signed up as bank holding companies. That put all three of them directly under the Federal Reserve’s authority. They took bailout funds directly from the Fed and got billions more of Fed-created money passed through AIG.
The same “increase your turf” motive may explain why foreign banks got so many billions from the Federal Reserve via AIG. The financial crisis that hit in 2008 has been world wide. Europe and other countries with banking systems have been pushing for an international authority over all financial institutions. That could put an international government structure over the Federal Reserve—unless the Fed could grab that job for itself.
The near miss from bankruptcy definitely did not scare Wall Street into staying away from derivatives. Beginning with the first quarter of 2009, SEC-reporting businesses were required to disclose their exposure to derivatives in their financial statements. A study of that quarter’s reports showed that some 80% of the derivative assets and liabilities were on the books of five firms, all of them on Wall Street: Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Bank of America. That five held 96% of the credit default swaps. [CFO.com, as reported in “Executive Summary,” Business Week, August 10, 2009] “The economy hasn’t yet recovered from the implosion of risky investments that led to the worst recession in decades—and already some of the world’s biggest banks are peddling a new generation of dicey products to corporations, consumers, and investors.” [Jessica Silver-Greenberg, Theo Francis and Ben Levisohn, “Old Banks, New Tricks,” Business Week, August 17, 2009, page 020]
Wall Street also went headlong after the Panic into selling “structured” securities to individual investors, in amounts as small as $1,000. These are derivatives for the little people. One of the advantages to Wall Street is that they are each a “proprietary product” to the bank or broker selling it. To get a sense of the amount and complexity of what is being sold, you can go to www.structuredretailproducts.com for a trial subscription to its service. [Jessica Silver-Greenberg, Theo Francis and Ben Levisohn, “Old Banks, New Tricks,” Business Week, August 17 and Ben Levisohn, “Old Banks, New Tricks,” Business Week, August 17, 2009, page 020] One report tells of an 84-year-old retired beautician whose broker sold her a "reverse-convertible note with a knock-in put option tied to Merck stock," for which the brokerage firms get a fee seven times greater than an investment-grade bond. [Zeke Faux, "Individual Investors Duped by Derivatives," Bloomberg BusinessWeek, October 4-10, 2010, page 43, referring to Satyajit Das, Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives, FT Press; Revised edition, 2010]
Wall Street’s “Prime Brokerage” Games with Hedge Fund and Private Equity Firms
Hedge funds have become the preferred structure for gambling in derivatives and other nonproductive games. Wall Street banks have made serving these funds, often managed by their former employees, their highest priority, calling it “prime brokerage.” Wall Street investment banks and commercial banks lend the hedge funds most of the money they use to trade in securities. The banks execute the trades, for commission income, and they pass information back and forth on profitable trading opportunities.
The first hedge fund is said to have begun in 1949, with the strategy of buying undervalued stocks and then hedging the market risk by selling overvalued stocks. [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, page 120] Today’s approximately 10,000 hedge funds are vehicles for any kind of trading strategies with whatever instruments are thought to produce big winnings. Nearly all of them rely on borrowing as much money as they can, to leverage the amount committed by institutional money managers and wealthy individuals.
Private-equity funds are funded in the same way as hedge funds. They buy businesses, often publicly traded ones in distress or underperforming in their industry. The private equity funds drain any available cash out in dividends and fees and then do an “initial” public offering of what’s left, or sell it to another business. [David Henry and Emily Thornton, “Buy It, Strip It, Then Flip It: The quick IPO at Hertz makes buyout firms look more like fast-buck artists than turnaround pros,” Investor beware, Business Week, August 7, 2006, page 28] Of course, the fund managers use maximum leverage—employing borrowed money for 80% or more of the purchase price. Meanwhile, operating businesses, providing products and services, and employing workers, are denied loans and refused IPOs. Wall Street bankers “say lending to hedge funds and private-equity firms can be more lucrative and potentially safer than lending to businesses and consumers.” [Gregory Zuckerman and Jenny Strasburg, “Banks’ Loans to Funds Are Back at Levels Before Crisis,” The Wall Street Journal, January 9-10, 2010, page C-1]
Wall Street’s easy credit to hedge funds and private equity firms fits precisely within the Minsky model for what causes an economy to crash and go into recession, as it did in October 2008. [Charles P. Kindleberger and Robert Z. Aliber, Manias, Panics, and Crashes: A History of Financial Crises, fifth edition, John Wiley & Sons, Inc., 2005, page 25.] Just over a year after that panic, Wall Street was drumming up new prime brokerage business, “boosting their lending to hedge funds and private-equity funds to levels unseen since before the financial crisis, raising their risk levels and adding fuel to the buying power of key players across the stock, debt and buyout markets.” That fits the easy credit/high risk scenario that keeps creating economic crises. [Gregory Zuckerman and Jenny Strasburg, “Banks’ Loans to Funds Are Back at Levels Before Crisis,” The Wall Street Journal, January 9-10, 2010, page C-1]
Program trading, naked access, flash trading, quote stuffing, etc.
We have generally considered the difference between investing and trading to be a factor of the time between purchase and sale. Roughly, more than a year is considered investing. Less than a year is called trading or speculating. From Wall Street’s point of view, investing generates only an occasional commission, while trading brings a stream of commissions. When Wall Street firms use their own money to buy and sell, they go for rapid turnover.
Computers have helped drastically accelerate the movement to ever faster trading. The Crash of October 19, 1987, when the Standard and Poor’s 500 stock index fell 23 percent in one day, has been blamed on “program trading,” the computer-based trading for arbitrage among stock prices, options and financial futures. The head of the commission appointed to study the cause of the “market break” said: “If we have learned anything from the events of last October, it’s that the nation’s financial marketplaces are inextricably linked. What historically have been considered separate marketplaces for stocks, stock-index futures and options do in fact function as one market.” [Nicholas Brady, later Secretary of the Treasury, New York Times, February 4, 1988] The only remedy taken after the 1987 panic was to have the exchanges stop trading automatically when prices fell beyond a set trigger. The separate marketplaces were left uncoordinated and largely unregulated. As a result, the “quants” continued to invent their computer algorithms and history repeated itself in October 2008. [For a description of the takeover of Wall Street trading, and the price we’ve all paid, see Scott Patterson, The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It, Crown Business, 2010]
New ways to bet on price movements are constantly being invented. Computer communications technology has led to “high-frequency trading,” where computerized models trade in and out in milliseconds. Participants have moved their operations to be physically near the computers where trades are executed. Even at the speed of light, there can be a competitive advantage to placing a computer close to the equipment used by an exchange. Imagine a poker table where the first to play a card can win. This “high frequency trading” operates entirely through computer- programmed trading strategies. No human has to make any decision. Some programs read everything that goes across the Internet, finding and analyzing words related to a company and then places buy or sell orders. [Graham Bowley, "Wall St. Computers Read the News, and Trade on it," The New York Times, December 21, 2010, http://www.nytimes.com/2010/12/22/technology/22trading.html?_r=2&hpw The trade may not even be in reaction to whatever is happening with the company that issued the securities, the economy or any other events. A program can be all about trading techniques. The stock exchanges registered with the SEC have petitioned to trade stocks in tenths of a penny, instead of a penny. They say they need the change in order for them to compete with the Alternate Trading Systems and Dark Pools, which are not subject to SEC registration. [Jacob Bunge, “Exchanges Want to Take Stock Quotes Below a Cent, The Wall Street Journal, January 26, 2010, page C1]
How much of the buying and selling on U.S. Exchanges is done by high frequency traders? By 2009, over half of all trades on U.S. exchanges were these high frequency trades. “High-frequency trading now accounts for 60 percent of total U.S. equity volume, and is spreading overseas and into other markets.” [Jonathan Spicer and Herbert Lash, “Who’s Afraid of High-Frequency Trading?” Reuters, December 2, 2009, www.reuters.com/article/idUSN173583920091202]
We all became more aware of high-frequency trading after the Dow Jones Industrial average dropped nearly a thousand points during trading on May 6, 2010. " In describing that day, Scott Patterson wrote: "High-frequency firms have in recent years become central to how the market operates, growing to account for about two-thirds of daily market volume, according to industry estimates. . . When the market hits certain levels as it falls, these firms’ computers are programmed to sell automatically as protection against further losses. . . . As the losses accelerated, there were little or no ‘buy’ orders left in many stocks and other assets, causing a plunge that saw some securities spiral to near zero.” [Scott Patterson, “Did Shutdowns Make Plunge Worse?” The Wall Street Journal, May 7, 2010, C1, C3]
The rules of the exchanges are that only member broker-dealer firms may trade. However, to get the speed they want, hedge funds and other trading firms “rent” their brokers’ computer codes. Only brokers who are members of the exchange are allowed to place orders, but some brokers get paid for letting trading customers use their access codes to communicate with the exchange computers. This “sponsored access” occurs when the customer routes orders through the brokers’ computers, where they can be checked for any rule violations. A few brokers’ let customers skip the brokers’ computer system entirely and tie directly into the exchange network, using the brokers’ “market participant ID” computer access codes to interface with the exchange computers. That’s known as “naked access” and it allows a hedge fund or other trader to buy and sell a security in less than a second. [http://aitegroup.com/reports/200912141.php?PHPSESSID=57b191c4e3eb35bfe05c2ff11067be93] No one could be in and out of owning a security in a split second, based upon some change in information about the underlying business. This is speculative trading, based upon computer-programmed instructions that have nothing whatsoever to do with any real world information.
There are several advantages to naked access, over sponsored access. First of all, it is some milliseconds faster, giving participating customers a competitive advantage. [“A firm that uses naked access can execute a trade in 250 to 350 micro seconds, compared with 550 to 750 microseconds for trades that travel through a broker’s computer system by sponsored access . . ..” Scott Patterson, “SEC Aims to Ban ‘Naked Access’, The Wall Street Journal, January 14, 2020, page C1, referring to a report by the Aite Group, www.aitegroup.com/reports/200912141.php] But it also provides anonymity, so that the exchanges and securities regulators don’t know who is making the trades, since the only traceable identity is the broker-dealer who has rented out its access codes. Estimates are that over half of all trading volume in stocks is being done through naked access. [Scott Patterson, “Regulators Target ‘Naked’ Access: Concerns Over Risk Management of Anonymous, High-Speed Trades,” The Wall Street Journal, October 13, 2009, page C1] In November 2010, the SEC adopted a rule ostensibly to bar naked access. What the rule actually does is require the licensed as a broker-dealer to follow "risk management controls" which are "reasonably designed to manage the financial, regulatory, and other risks, such as legal and operational risks, related to market access." [www.sec.gov/rules/final/2010/34-63241.pdf] Some could view the SEC's action as business as usual, with more records generated.
Back at that imagined poker table, what if a player could get a quick glance at the hands held by the others? That is the advantage of “flash trading” in the securities markets. It is a quick view on the computer of orders placed but not yet executed. “The order is ‘flashed’ to a select group of participants who can act on the order before it is routed to other exchanges to be filled.” [Jacob Bunge and Joan E. Solsman, “Direct Edge Rides Citi to Record Trading Share,” The Wall Street Journal, September 4, 2009, page C5] The traders use the flash for "gaming," which is a form of front-running, when "a high-speed firm's computers detect a large buy order for a stock, for instance, the firm will instantly start snapping up the stock, expecting to quickly sell it back at a higher price as the investor keeps buying." [Scott Patterson, "Fast Traders Face Off With Big Investors Over 'Gaming'," The Wall Street Journal, June 30, 2010, pages B1, B3] The principal flash trader is Direct Edge, which is owned by a foreign securities exchange and three Wall Street firms, including Goldman Sachs. A Goldman Sachs alumnus is its CEO. Together with a similar trading system, BATS Exchange Inc., Direct Edge had taken over 22.6% of matched trading in July 2009, compared to 6.3% two years earlier. BATS dropped the practice in September 2009. Senator Charles Schumer has called flash trading “a two-tiered system where a privileged group of insiders receives preferential treatment.” [Randall Smith, “The Flash-Trading Thorn in NYSE’s Side,” The Wall Street Journal, August 31, 2009, page C1] The SEC is still gathering comments on how it might tinker with rules about flash trading. ["Elimination of Flash Order Exception from Rule 602 of Regulation NMS," Release No. 34-62445; File No. S7-21-09 www.sec.gov/rules/proposed/2010/34-62445.pdf]
Wall Street traders are not satisfied with being able to peek at prices for pending trades before placing their own buy or sell orders. Looking at the cards held by other players is not enough--they are finding ways to reshuffle the cards. They are finding ways to go beyond flash trading, and cause price changes by placing orders that they cancel before they are executed. One technique, called "quote stuffing," places a mass of orders, all within a fraction of a second, followed directly by canceling them all. For instance, Nanex, LLC, a data provider, looked at a day in which an average 38 orders were placed every second to buy or sell one company's stock. But in one second, there were 10,704 orders, followed by 5,483 the next second. All but 14 of those orders were cancelled within the next second. This may cause other buyers and sellers to place orders as they conclude the market price is moving. The first round of orders is a feint, intended to deceive other high frequency traders, enticing them to place orders before they see the cancellations. This allows the quote stuffer to purchase and sell at the two different prices--the price in the "real" market and the price of the trade made in reaction to the quote stuffing. [Tom Lauricella and Jenny Strasburg, ""SEC Probes Cancelled Trades: Regulators Looking Into Role 'Quote Stuffing' May Have Played in Flash Crash," The Wall Street Journal, September 2, 2010, page A1, A12] Another gambit is placing large numbers of trades, each in tiny amounts, like a tenth of a cent. These "sub-penny" orders, placed at prices much lower or higher than the real market, are intended to dupe the algorithms of other traders about a stock's price direction or volume of trades.
High frequency trading's wild potential for disruption is described in the Flash Crash series of events, revealed in the September 30, 2010 report by the SEC and the CFTC, "Findings Regarding the Market Events of May 6, 2010," www.sec.gov/news/studies/2010/marketevents-report.pdf] From its Executive Summary: "May 6 started as an unusually turbulent day for the markets. . . . At 2:32 p.m., against this backdrop of unusually high volatility and thinning liquidity, . . . a mutual fund complex initiated an automatic execution algorithm . . ." to sell $4.6 billion of "E-Mini contracts . . . as a hedge to an existing equity position." The buyers included high-frequency traders, who quickly placed orders to resell, and "cross-market arbitrageurs, who transferred this sell pressure to the equities markets by . . . simultaneously selling . . . individual equities in the S&P 500 Index." The high frequency traders "began to quickly buy and then resell contracts to each other--generating a 'hot potato' volume effect as the same positions were rapidly passed back and forth. CBS' 60 Minutes devoted a segment of its October 10, 2010 broadcast to high frequency trading. [ transcript at http://www.cbsnews.com/stories/2010/10/07/60minutes/main6936075.shtml, video at http://www.cbsnews.com/video/watch/?id=6945451n]
Wall Street Recycles Taxpayers’ Money and Reduces Retirees’ Income
A very simple game Wall Street plays is to borrow taxpayer money and then lend that money back to the federal government. In a free market, that game wouldn’t be possible. But this is a government-rigged market, available only to “banks,” which now includes investment banks. The Federal Reserve System, which is owned by the banks but has the power of government, has made it possible for its member banks to “earn a huge spread by borrowing virtually unlimited amounts for nothing and lending that same money back to the Treasury. . . . Rather than giving capital to businesses with real products and services, Wall Street plays a government-backed shell game, enriching bankers’ pockets at everyone else’s expense.” [Ann Lee, adjunct professor at New York University, former investment banker and hedge fund partner, “The Banking System is Still Broken,” The Wall Street Journal, October 16, 2009, page A17]
The cost of this game to the rest of us is many times greater than what is taken from our pockets to pay Wall Street the interest spread between the money borrowed and the return from its purchase of government debt. Artificially low interest rates on Treasury securities forces lower rates to be paid on nongovernment debt as well. That means that bank certificates of deposit and money market funds pay a much lower rate. Retirees who depend on CDs and other fixed income securities are seeing their incomes cut by half or more. The media greets low interest rates as a gift, which they are for banks and others who can borrow, but that gift is bought with a painful loss of income to people relying on interest income for their living expenses. As economists Peter Morici has said, “Having fed the campaign machines of both political parties and lavished speaking fees on future White House economic advisors, these financial wizards have managed to purchase preferred treatment in our capital.” [Peter Morici, University of Maryland Professor and former Chief Economist for the U.S. International Trade Commission, “Taxing Grandma to Subsidize Goldman Sachs,” Business Week, April 14, 2009, www.businessweek.com/investor/content/apr2009/pi20090414_041627.htm?link_position=link20]
Mutual Fund Managers Have Adopted Wall Street Morals and Practices
A new type of financial intermediary spread in the mania of the 1920s—the investment trust. They started out as a fixed group of securities placed in a trust, with shares in the trust sold to investors who wanted income with the stability of a diversified portfolio. Then their managers began selling securities from the portfolio and buying new ones, to increase income, pay management fees and compete with other trusts for investors. Investment banks and commercial banks used their name recognition and reputations to start their own investment trusts, which often purchased securities from their bank sponsors.
The use of investment trusts was a way to attract capital from middle class individuals, without letting them actually own securities of individual companies. Instead, they were sold nonvoting shares in a trust. The trust managers invested their pooled funds in new issues, often distributed by their affiliated investment bank or commercial bank. The management fees and the underwriting commissions were both taken out of the pool of investors’ money. Many of these investment trusts came undone in the Crash of 1929. Goldman Sachs Trading Corporation sold its shares in early 1929 at $104 a share. The price by May 1932 was $1.75.
After the Investment Company Act of 1940, the investment trusts came back to life as mutual funds, operating within that law’s restrictions, which were supposed to prevent the abuses of the 1920s. But greed and the lust for power took over the buy side of Wall Street as surely as it did the sell side. There was the same “My compensation is bigger than yours” and “My fund is larger than yours.” To play the buy side greed and power game, money managers went from investors in businesses to gamblers at the casino. “They all reject the need or feasibility of making company-by-company judgments about price and value, industry structure, managerial competence, or many of the other factors that would affect the selection of one stock over another as a long-term holding. These are the performance game, index fund, portfolio insurance, and other so-called modern strategies. Mostly they inflict on investors heavy costs, and invariably they distract managers from their fiduciary and social responsibilities.” [Louis Lowenstein, What’s Wrong with Wall Street: Short-Term Gain and the Absentee Shareholder, Addison-Wesley Publishing Company, Inc., 1998, page 1]
Institutional investing is all about each quarter’s rate of return. Institutional investment officers are like corporate CEOs. They get multimillion dollar paychecks based on the “peer analyses” made by selected compensation consultants, who are paid big fees. The consultants compare a fund’s size and rate of return with that of similar institutions. “These typically young portfolio managers, who could expect to peak in their early forties, were generally compensated on the basis of their quarterly performance. This gave them powerful incentives to manage their institution’s portfolios to achieve the highest quarterly prices possible.” [Lawrence E. Mitchell, The Speculation Economy, Berrett-Koehler Publishers, Inc., 2007, page 277]
Institutional money management was dramatically changed after passage of the Employee Retirement Income Security Act of 1974, called “ERISA.” The new law was interpreted as directing money managers to look beyond traditional stocks and bonds for entrusting pension fund investments. The leader in this “total return investing” was the Yale University endowment, which consistently and significantly had higher returns through the 1980s than other university and charitable funds. Wall Street’s sell side jumped to provide derivatives and other instruments for this total return investing. Opportunities for investment spread to commodities, derivatives and other products sold by securities broker/dealers. In addition, real estate investment managers, venture capital firms, hedge funds, private equity funds and other intermediaries presented their proposals to money managers. In the Panic of 2008, most of these total return funds lost a quarter of their value.
Jack Bogle, founder of the Vanguard mutual funds, has written that, “The principal instigating factor” for mutual funds going wrong “has been a basic shift in orientation from a profession of stewardship to a business of salesmanship.” [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, page xxii] He points out that, over the period from 1985 through 2004, “fund costs consumed more than 40 percent of the return provided by the stock market itself. . . . Looked at from yet another perspective, the investor put up 100 percent of the capital and assumed 100 percent of the risk, but collected only 57 percent of the profit. The mutual management and distribution system put up zero percent of the capital and assumed zero percent of the risk, but collected 43 percent of the return.” [page 163]
In describing how the mutual fund industry changed, Bogle traced the history of the first one, Massachusetts Investors Trust. Started in 1924, it had a mutual legal structure, that is, the fund shareowners elected a board of trustees which actually managed the fund’s business. In 1969, it converted to having a separate management company. Before that happened, the fund’s expense ratio—the amount of its expenses as a percentage of the amount invested in the fund, was 0.19 percent. By 2003, the expense ratio had gone up to 1.22 percent.
There are basically two types of mutual funds. One is the index fund, where the fund manager simply purchases securities to match the S&P 500 stock index or some other well known index. The other is the actively managed fund, where the fund manager makes decisions about which securities to buy and sell, within some general category, like “growth” or “large capitalization.” The two important differences between these fund types are definitely counterintuitive: (1) actively managed funds charge much higher management fees and (2) index funds consistently have higher returns for the plan beneficiaries. If actively managed funds cost more and return less, why do they have 90% of the $1.5 trillion in 401(k) plans?
Mutual fund money managers market to the corporate sponsors of employee retirement plans. They find ways to convince employers’ plan administrators to offer the funds they manage as the limited options for investment by employees. One of the most convincing marketing techniques is known as “revenue sharing,” which is simply a rebate to the plan administrators from the management fees collected by the fund managers. Those management fees are paid by the employees. In return, fund managers siphon off a portion of what the employees pay and turn it over to the employers’ administrators. Employees pay twice, once in lower investment results and again in higher management fees.
Some of them used Wall Street sell side firms and other “placement agents” to deal with money managers. [Steven Rattner, hedge fund manager and “car czar” in the Obama administration, was one of the early placement agents. In 1989, Rattner got his firm, Lazard Freres, to be placement agent for Providence Equity Partners, a private equity firm. Lazard was paid a one percent commission on the money it helped bring in. In addition, Lazard got a third of the incentive fees the fund earned on that money. “Heard on the Street,” The Wall Street Journal, April 23, 2009, page C12] These placement agents have relationships with money managers, and can get their attention and endorse their client’s proposition. This presents an opportunity for the intermediary to get paid by both sides. Sure enough, scandals have been uncovered. One indictment alleged that the former chief political advisor to the New York State Comptroller had shared fees from hedge funds and private equity firms for investments made by the state’s retirement fund. [www.oag.state.ny.us/media_center/2009/mar/pdfs/FINAL INDICTMENT.pdf and www.sec.gov/litigation/complaints/2009/comp20963.pdf] Calpers, the California Public Employees Retirement System, disclosed that it had paid over $125 million to placement agents, three of whom were retired members of the Calpers board. [Jim Christie and Megan Davies, “Firms paid $125 million in fees for Calpers business,” Reuters, January 14, 2010, www.reuters.com/article/idUSN1419597920100114]
Sell side managers are tempted into unethical and illegal ways to increase their quarterly performance, as compared with their peers. For instance, the comparisons among funds are made as of the end of each quarter, so it is not unusual for managers to sell and buy on the quarter’s last business day. Stepping over the line, some ask themselves if there are ways they could have higher prices shown for their end-of-quarter holdings. One way is to place large orders, just before the market closes, for shares they already own. That sudden increase in demand moves the share price up. The next step past the line is to get the sell side broker to cooperate in putting in orders at prices higher than the market. These practices, known as “marking the close” or “portfolio pumping,” have been illegal for many years but still happen. [http://knowledge.wharton.upenn.edu/article.cfm?articleid=122 or http://knowledge.wharton.upenn.edu/articlepdf/122.pdf?CFID=10862081&CFTOKEN=46722360&jsessionid=a83039153a4af7e9ee6c18282b695611cd54]
The drive for quick profits has created moral hazards for the managers of mutual funds. According to Bogle, “Fund managers have moved away from being prudent guardians of their shareholders’ resources and toward being imprudent promoters of their own wares. They have learned to pander to the public taste by capitalizing on each new market fad, promoting existing funds and forming new funds, and then magnifying the problem by heavily advertising the returns earned by their ‘hottest’ funds, usually highly speculative funds that have delivered eye-catching past returns.” [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, page 164]
Mutual fund managers have largely been left alone by their regulators, the SEC and state securities agencies. The changes that have been forced upon them have come mostly from private litigation. A case brought by mutual fund shareowners is before the United States Supreme Court in its 2009-2010 session. [Jones v. Harris Associates, www.supremecourtus.gov/qp/08-00586qp.pdf] It claims that the boards of directors of mutual funds are loyal to the fund managers and allow management fees that can be twice the rate that the managers charge pensions funds and others who are independent and can negotiate their fees. Mutual fund management fees run nearly $100 billion a year. [Jess Bravin and Jane J. Kin, “Fees Case Strikes at Heart of Mutual Funds,” The Wall Street Journal, October 30, 2009, page C3]
Fund management companies chase flashy short-term returns, so their marketing can showcase a fund’s percentage return and peer group comparison. This has brought a stepped-up pace of buying and selling a fund’s portfolio. Back in the “twenty years from 1945 to 1965, the annual turnover of equity funds averaged a steady 17 percent, suggesting that the average fund held its average stock for about six years. But turnover then rose steadily, and the average fund portfolio now turns over at an average rate of 110 percent annually,” an average holding period of 11 months. [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, page 184]
Mutual fund managers even found a way to participate in stock manipulation and Ponzi schemes. There was a fad for a while called “momentum investing.” The theory was that once the price of a stock was moving in a direction, it would keep moving that way. The fund managers would buy a stock, then keep buying it as other managers did the same. They would appear on television investor shows and talk up the stocks. The positive effect on their funds’ returns would bring in more money from investors, so they could buy more of the chosen stocks. [James J. Cramer, Confessions of a Street Addict, Simon & Schuster, 2002, pages 295-96] Of course, the resulting bubble had to burst. Like a game of hot potato, the last one to buy into the inflated stock took the big loss.
This driving for short-term profits, to justify huge compensation, was protected by ERISA, which ordered money managers to act like other money managers. Copying each other led money managers into “total return investing,” which endorsed investing in derivatives and other alternatives to stocks and bonds. It all caught up with the buy side in the Panic of 2008. The consequences fell upon the beneficiaries of funds with professional money managers, including colleges and charities, as well as retirees who have placed their life’s savings in mutual funds or who are counting on their employer’s pension fund. The California Public Employees’ Retirement System, the largest public pension fund, lost 23.4% of its value in the fiscal year ended June 30, 2009. In the same period, the California State Teachers’ Retirement System was down 25%. Real estate and private equity investments were the big losers in their investment portfolios, while fixed-income investments performed best. The pain from managers using public retirement money for big risks/big compensation gambles has also flowed directly to the state and local governments and their taxpayers. They will have to pay contribution increases of up to 4% of their payroll. [Craig Karmin, “Calpers Has Worst Year, Off 23.4%, The Wall Street Journal, July 22, 2009, page C3]
Wall Street Money Managers Don’t Restrain Corporate Greed
Money managers buy and sell shares for trading profits, not to be long-term shareowners of a business. Wall Street’s buy side focus on short-term trading games has meant that they don’t act as shareowners who care about the prospects for the business. They only care about what will happen to the market price for the shares in the next minutes, hours or days. When they get proxy material for a shareowners’ meeting, they nearly always vote the shares they hold just as the company’s management suggests. One of the two exceptions is the union or public employees pension fund that has a cause to promote. The other is the hedge fund or private equity firm that is trying to maneuver a sale or change in management for the company.
This pervasive go-along-with-management practice is motivated by the money managers’ fear of losing business from the corporations who pay them to manage their pension funds. When an unwanted proposal is coming to a shareowner vote, the threatened CEOs have been known to ask their counterpart CEOs in other companies to put pressure on their pension fund managers to vote against the proposal. If they don’t go along with the CEOs, their firm’s reputation as a trouble-maker may keep them from winning new clients, or cause them to be cut off from the flow of telephone information from a company that feels threatened. “There is almost no dissent from the Wall Street Rule, which says that a shareholder who is not pleased with a company is better off selling the shares than trying to change or influence its direction.” [Louis Lowenstein, What’s Wrong With Wall Street: Short-term Gain and the Absentee Shareholder, Addison-Wesley Publishing Company, Inc., 1988, page 91] They follow the Wall Street Rule: “Vote with your feet.” Sell the shares if you don’t like what management is doing.
The escalation of CEO pay has been one consequence from this go-along practice on Wall Street’s buy side. The amounts taken home by corporate executives have made frequent news stories. Since reporters look for the other side, these stories usually have quotations from corporate defenders that the compensation is necessary to attract talent that will increase value for shareowners. Academic studies show that this claimed justification is not supported by the facts. “It turns out that the bigger the CEO’s slice, the lower the company’s future profitability and market valuation.” One study of the 10% of companies with the highest CEO pay found that: “Each dollar that goes into the CEO’s pocket takes $100 out of shareholders’ pockets.” [Jason Zweig, “Does golden Pay for the CEOs Sink Stocks?” The Wall Street Journal, December 26-27, 2009, page B1]
The SEC has done its part to discourage money managers from exercising the rights of corporate democracy. If shareowners try to communicate with ten or more other shareowners about an upcoming vote, they become subject to the SEC’s proxy rules, a costly and very public process.
Wall Street Changed the Objectives of Business
Of all the economic and political systems that we’ve tried, businesses are still the best structure for meeting most human needs and wants. Governments, charities and cooperatives have their place—we’ve learned that “privatization” can definitely be taken too far. But most of us still believe that private enterprise, including the profit motive, still delivers the best results for most products and services.
Owner-operated businesses and family businesses have proven their sufficiency for smaller, local purposes. For larger businesses, with many owners who don’t work there, the corporate form has many advantages. Those absentee owners never have to worry about losing more than the money they paid for their shares. When they are ready to convert their ownership shares back into cash, there will probably be a ready market for them. That said, how did we get from businesses, serving our needs and wants, to gambling in the markets for stocks and derivatives? What can we do to restore the useful function of the corporation?
As the tech bubble was building in the 1990s, someone said that Silicon Valley changed for the worse when it switched from making products to making stocks. But the financialization of corporate business started long before. Professor Lawrence Mitchell describes the history in his book The Speculation Economy: How Finance Triumphed Over Industry, which deals only with the years 1897 through 1919. At the beginning of that period, American businesses “typically were owned by entrepreneur industrialists, their families and often a few business associates.” The change he describes “might never have come into being if financiers and promoters had not discovered that they could be used to create and sell massive amounts of stock for their own gain. The result was a form of capitalism in which a speculative stock market dominated the policies of American business.” [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2008, page ix]
"The financial crisis has provided us all with a crash course on how much of our economy is based not on the creation of real value, but on speculation. Over the last year, we have learned that the speculative economy — the one that trades in exotic derivatives like credit default swaps and makes short-term, bubble-inducing bets on assets like real estate and tech stocks — is vast and highly rewarded. We have learned that the speculative economy undermines and consumes the productive economy. And we have learned that money made by speculation is often treated much more favorably by tax systems than money earned through real work." [Stacy Mitchell, “A New Deal for Local Economies, Lecture at the Bristol Schumacher Conference at Bristol, England, October 17, 2009, www.newrules.org/retail/article/new-deal-local-economies reprinted at “Making Money Work: How Can We Reconnect Capital with Community? Our investments tend to fund consolidation and speculation. But new models are emerging that allow us to finance the economy we really want,” April 23, 2010, and excerpted in www.yesmagazine.org/new-economy/money-that-works-for-local-communities]
During the term of President Theodore Roosevelt, Congress commissioned a Bureau of Corporations to report on the state of corporate America. Professor Mitchell summarized the 1904 report as concluding that changes had “allowed corporate America to be captured by the financiers, the segment of corporate America that the Report most strongly criticized.” [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2008, page 163] The Bureau recommended federal franchising for corporations, with disclosure requirements and standards of conduct. Congress took no action.
The basic concept of investing is that people who want to earn a return on their money are matched with businesses which need money to grow. By its nature, “investing” is for the long term, money that is put to use for several years, or indefinitely. Lending money for seasonal working capital needs is the business of banks and other short-term lenders. Long-term investing is appropriate for individuals and institutions seeking to build their financial assets for the future.
The line between short-term lending and long-term investing is roughly the border between the commercial banking and securities industries. While the two businesses have very similar products, their business models are sharply different. Banks purchase money for a period of time. In exchange for deposits in a checking account they provide safekeeping, checking, online banking and related services. They may agree to pay a rate of interest on certificates or bonds or interbank loans, which come due on specific dates. Then the bank lends the money at a higher rate, to cover its operating expenses, reserves for loan losses and profit.
Investment in common stock is a very different proposition. Initially, the “joint stock companies” were organized around a particular venture. For instance, when a ship sailed from England to Asia, it needed enough money to last for a couple years. There would be no income until the ship came back, if it did. Anyone putting their money up for use would want something more than a promise to pay it back with interest. The solution was to allocate them a share of the hoped-for profits from the voyage. Investors put their money up before their ship sailed and waited for the day their ship would come in, their money returned and profits distributed. In 1602, The Dutch East India Company was chartered for a 21-year period, spreading investors’ money and risks over many voyages. By 1611, the Dutch had the first stock exchange, followed by the first market crash, triggered by the tulip mania in 1636. [John Micklethwait and Adrian Wooldridge, The Company: A Short History of a Revolutionary Idea, The Modern Library, 2003, page 20] Gradually the concept was expanded to finance canals, railroads and manufacturing businesses.
Einstein reportedly said that compound interest is “the greatest mathematical discovery of all time.” To help its success, he invented the Rule of 72, a shortcut to calculating how long it takes money to double at a particular rate of interest. [www.ruleof72.net/rule-of-72-einstein.asp] The corporation is certainly another great invention. It has made it possible for businesses to gather money from people who don’t have to pay constant attention to how it is being used. Authors John Micklethwait and Adrian Wooldridge of the Economist described “the three big ideas behind the modern company: that it could be an ‘artificial person,’ with the same ability to do business as a real person; that it could issue tradable shares to any number of investors; and that those investors could have limited liability (so they could lose only the money they had committed to the firm).” [John Micklethwait and Adrian Wooldridge, The Company: A Short History of a Revolutionary Idea, The Modern Library, 2003, page xvii]
As people made investments in ongoing businesses, not just voyages and projects, their share of the profits was distributed to them annually or quarterly. The payments were called dividends and were very different from interest on loans or bonds. The business had no obligation to pay dividends. No matter how profitable it was, it was entirely up to the board of directors whether and how much might be paid to shareowners. On the other hand, as the business grew, dividends would usually increase and, after several years, the annual dividends could be more than the amount the shareowner originally paid for the shares.
The concept of sharing in profits worked well for investors, who were willing to exercise their risk/reward judgment in return for a higher expected return than they would get from a fixed-income security--one that paid interest and eventually returned the purchase price. Shares worked well for managers of the business, because they weren’t obligated to pay current interest and never had to pay back the money invested.
However, there were two groups who were less than happy with shares being sold on the basis of expected dividend payments. One was the CEO and top management who would rather retain all money in the business, because they had big ambitions for growth, with the compensation, prestige and power that could bring. The others who weren’t entirely happy with shareowners expecting dividends were the financial intermediaries who made commissions by selling shares in the trading market. If the investors were buying shares to collect dividends over the long term, then Wall Street could only look forward to a one-time commission, at the time the shares were initially issued and sold by the business.
The answer for Wall Street and CEOs was to change the expectations of shareowners, from the dividends they would receive to the increase they could see in the market price for their shares. That way, the profit and resultant cash are kept in the corporation, available to fund the CEO’s ambitions for expansion and acquisitions. These retained earnings can also be used to cover the effects of any mistakes of judgment that the CEO makes. The financial intermediary could induce the investor to take profits (or losses) by selling the shares and using the money to buy different shares, generating commission income on both trades. Wall Street got Congress to change the tax laws to tax gains on the sale of shares at a much lower rate than dividends.
Wall Street began a vast new business when “price appreciation followed as a substitute for dividends.” [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2007, page 196] As investors changed their objectives from dividend income to profit on a sale of shares, Wall Street’s commission income took off. Unlike investors seeking dividends, traders like to borrow money to buy even more shares for short-term profits. Wall Street borrows money from bank loans to lend out again to its brokerage customers, through margin accounts. There is some profit in the interest rate it pays the bank and charges the customers. More profitable is the ability to increase the customer’s volume of business by 50%, from money borrowed in the margin account. Most profitable of all is when Wall Street can steer its customers into using proceeds from stock sales to buy a different financial product, one that generates even more revenue for Wall Street.
The justification for trading is that it makes for a liquid market, one in which all investors can buy or sell at fair prices. But is all that volume of trading really necessary? Professor Lowenstein points out that the real estate market has less than a twentieth of the stock market’s annual turnover “and yet that is enough to support all the new homes and offices that are needed.” [Louis Lowenstein, What’s Wrong With Wall Street: Short-term Gain and the Absentee Shareholder, Addison-Wesley Publishing Company, Inc., 1988, page 27]
There has been a clear long-term trend away from dividends and toward more frequent trading. “Historically, dividends have accounted for almost one-half of the market’s return—about 5 percent of the stock market’s 10.5 percent long-term annual return—with the remainder accounted for almost entirely by earnings growth averaging about 5 percent annually. Yet the dividend yield on U.S. stocks dropped to 1 percent in early 2000 . . .. Turnover in stocks that pay no dividends now runs at an average rate of 175 percent per year; turnover in stocks that pay dividends runs about 85 percent per year . . ..” [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, pages 122-123]
“The shift from investment to speculation, from a time when most Americans saw corporate securities as a way to get a steady return while protecting their principal to a time when Americans saw the stock market as a place to trade on the fluctuations of an increasingly volatile market, took place over the second and third decades of the twentieth century.” [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2007, page 206] By the first decade of the twenty first century, this shift from investment to speculation has led to the extremes of high frequency trading, options and complex derivatives.
The game of buying and selling stocks got an extra boost when Wall Street began earning huge fees by promoting and defending hostile takeovers. “The modern exaggeration of the domination of finance over industry started during the takeover decade of the 1980s, when the hostile takeover became an extreme way to satisfy stockholders’ demands for short-term profit maximization by buying then out at a substantial premium over market. Stockholders began to invest in the hope of finding the next big takeover target.” [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2007, 276]
The use of stocks and their derivatives to speculate on price changes has brought all the attention to short-term results. For corporate officers, the only goal is to keep the stock price up and on a steady rise. Their stock option profits, their very jobs depend upon being able to predict each quarter’s earnings as better than the last, and have those earnings come in as predicted. This “rent-a-stock” culture has destroyed industries, especially those with a dynamic that doesn’t fit the quarter-to-quarter game. Newspapers, for instance, have needed some restructuring to fit the unfolding of media technology. That would mean going through a period of losses and reinvestment. But as soon as management stepped off the quarter-to-quarter treadmill, the stock price would collapse and many newspapers became victims of hostile takeovers.
Wall Street has changed the objectives of business, from serving human needs to generating short-term profits. What can we do to restore business objectives? Government is not the answer. We have watched Japan, after World War II, when its Ministry of Finance influenced the allocation of capital for long-term objectives, before its banking system failed. We are now watching China as its one-party government decides which businesses will be launched and supported. Overwhelmingly, we Americans reject government control. But, so long as we let Wall Street have its monopoly on the investment process, it will be Wall Street bankers and brokers who set objectives for business. Our objectives, as individual investors, will only reach business managers if we deal with them directly.
The IPO is Not About Financing Business, It’s About the Game
The romantic fantasy of Wall Street is dramatized by the initial public stock offering, where a young business has done so well that it is now ready to share ownership with the investing public. Most entrepreneurs have a dream that they will one day take their company public, that money will flow into their business from thousands of people who will want to be a part of their enterprise. They can envision going public as the ultimate recognition of their success. Beyond self esteem, they know that a public offering can be the best way to raise capital for growing their business. The money is permanent capital, it never has to be paid back. No interest payments are ever required, any dividends are entirely up to management. With share ownership spread among many holders, no one really has any power to interfere with management’s business judgment.
In the fantasy, the relationship with an investment banker and Wall Street firm is seen like that of a great novelist with an editor and publishing firm.
Wall Street doesn’t share the entrepreneur’s vision of the IPO process. For the securities firms that handle the underwriting, and sales in the aftermarket, an initial public offering is a one-time opportunity to earn large commission income in many related transactions. They will be able to do favors for others who will reciprocate when it’s their turn. The decision whether to take on a particular IPO will involve questions like, “Is this being presented to us by a venture capitalist or private equity firm that will generate more business for us?” “Can we hold or attract clients by helping them flip the shares we allocate to them, so they make lots of money in a few hours?” “Is this a company that will quickly acquire many other businesses, paying us advisory fees along the way?”
A particularly pernicious consequence of the IPO game is Wall Street’s need for ever-larger stakes. Investment bankers get paid a percentage, generally fixed at 7% for an initial public offering. That motivates the investment bank to have as large an offering as they can sell. The minimum amounts they are willing to do have grown to $50 million for an IPO with major firms. What if a business fits the rest of the picture for a successful offering, but really only needs $20 million? The first subject in discussions with a Wall Street underwriter will likely be how the business plan can be changed to show a need for the higher amount. The investment banker may suggest an acquisition of another business. They may want the company to skip a beta test phase and go right on to full rollout of production and marketing. Perhaps they’ll suggest buying and furnishing a new facility, rather than staying in rented quarters. The huge supply of money on Wall Street’s buy side, with hedge funds and other managed pools, has created the ability to sell ever-larger IPOs. The result is that Wall Street selects IPO candidates based on the size of the offering, and the resulting fees. Say’s law is in force when it comes to money available for buying securities--supply creates its own demand. [www.econlib.org/library/Enc/bios/Say.html]
The need to have a large IPO has a dangerous effect upon earlier stage financing, the private rounds necessary to grow to IPO readiness. For most of the last 30 years, venture capital firms have themselves raised very large amounts of money, from endowments and other institutional funds. Because they are part of Wall Street, they finance most of the businesses that later do IPOs with major investment bankers. In order for them to have a business ready for a $50 million public offering, they need to apply lots of venture funding and hurry up the process toward their exit plan. They even hire consultants, called “VC accelerators,” to get their clients IPO-ready as quickly as possible. The venture firms want to maximize their annual rate of return. If they are going to make 300% on their investment, moving an IPO from three years out to only two means getting a 150% annual return instead of 100%.
The Wall Street monopoly over underwriting IPOs has held firm against repeated efforts by off-Wall Street broker-dealers and others to bring businesses together with investors. The really serious competition has recently come from securities firms and exchanges outside the United States. A study prepared for the London Stock Exchange compared the US underwriting fee of 7% to the range in six European countries of 2.5% to 4%. [www.londonstockexchange.com/companies-and-advisors/main-market/documents/brochures/cost-of-capital-aninternational-comparison.pdf] The London Stock Exchange has marketed itself as a home to IPOs, especially its AIM market for younger companies. “Since its launch in 1995, over 3,000 companies from across the globe have chosen to join AIM. Powering the companies of tomorrow, AIM continues to help smaller and growing companies raise the capital they need for expansion.” [www.londonstockexchange.com/companies-and-advisors/aim/aim/aim.htm]
From the early days of investment banking, the commission method of getting paid created conflicts, with resulting harm to investors. The U.S. Industrial Commission was appointed by the President in 1898 to investigate concentration of economic power for a report to Congress. An economist testified to the Commission that: “These banking syndicates want a profit and the larger the stock issues the larger the commissions.” The Commission’s Report concluded: “Heavy capitalization is, without question, injurious to the interests of investors and the public at large; but to promoters and bankers it opens opportunities for great gains.” [Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970, page 76]
Fitting into the minimum size for an IPO can be just the wrong move. Getting too much money too soon has been the death of many promising ventures. Clayton M. Christensen, Harvard Business School professor and author of The Innovator’s Dilemma [Collins Business, 2003] has said: “93% of all innovations that ultimately become successful started off in the wrong direction; the probability that you’ll get it right the first time out of the gate is very low. So, if you give people a lot of money, it gives them the privilege of pursuing the wrong strategy for a very long time. . . . The breakthrough innovations come when the tension is greatest and the resources are most limited.” [Martha Mangelsdorf, “How Hard Times Can Drive Innovation,” The Wall Street Journal, December 15, 2008, page R2]
Marketing guru Guy Kawasaki gave more reasons why it can be deadly for a business to get too much money. [“Let the Hard Times Roll! Why too much capital can kill you,” The Journal of Private Equity, Summer 1999] For instance, a business that has lots of money will keep tinkering with a business plan that is basically flawed, while the lean business will have to admit it is wrong and change plans. Big money can use promotion to attract customers, rather than developing a product or service that gets customers who will repeat their purchases and excitedly tell others about it. According to Kawasaki: “When companies have too much money, they hire professionals who charge twice as much for half the results and leave the companies with little in-house expertise.” Or, as Orson Welles said, “The enemy of art is the absence of limitations.”
(One of our clients had started the business with a little savings and built it through retained earnings. He decided to do a direct public offering through the SEC exemption for issuances of no more than $1 million a year. Venture capitalists had approached him, wanting to invest much more. But, he said, “I can’t grow this business faster than 25% a year and be profitable. If I had a big investment from a VC, with pressure to grow at 100% plus, it would ruin the business.”)
There are at least eight major profit opportunities for the underwriting firm that lands an initial public offering of shares:
• fees from the client, for the initial underwriting
• fees from quick resales, “flipping” shares when the aftermarket price jumps
• fees in reselling the flipped shares for a third and fourth time,
• fees on business gained in return for allocating IPO shares to flippers
• fees in selling shares for insiders, after the initial six month lock-up
• fees for investing money received by the company and its selling shareowners
• fees for arranging private placements of the public shares (“PIPES”)
• fees for advising on mergers and acquisitions with the now-public client
The initial underwriting fees are pretty well fixed, at seven percent of the amount sold. That’s three and a half million dollars on the recent minimum offering size of $50 million. There are a few smaller broker-dealers left who may handle an offering as small as $10 million, but they charge ten percent, plus options, reimbursements and other items that bring the fee up to the maximum fifteen percent permitted under securities industry rules.
When Wall Street underwriters compete for IPO business, there is no cost comparison, since the underwriting fees are fixed. Getting the highest price in the initial offering is certainly talked about a lot when prospective underwriters make their pitches. So is the ability to get the offering cleared with the SEC and sold to Wall Street’s buy side. Investment bankers rely heavily on the two motivations they acknowledge and manipulate: fear and greed. They will talk about their special ability in making it through the “window of opportunity,” before the market for the shares goes away. There has also been non-price competition, such as reciprocal business promised by the underwriter to the prospective IPO client. [Randall Smith, “Pay to Play? Companies Put a New Squeeze on Their Investment Banks,” The Wall Street Journal, August 26, 2003, page A1]
Conflicts of interest arise when a business is issuing new securities, because Wall Street is an intermediary, serving both sides of the transaction. The investment banker is likely to come down on the side of the buyer in any conflict between the interests of client selling the securities and the money manager buying them. Investment bankers are part of a large broker-dealer business that depends every day on its relationships with the money managers on the buy side. These Wall Street counterparts are far more important to the investment banker’s profits than the transitory relationship they will probably have with the IPO client. Getting the highest IPO offering price for the issuer clearly conflicts with getting a bargain price for the money managers.
(This conflict between issuer and money manager creates what I call the “Pricing Dance.” It begins with the very first handshake between the investment banker and the issuer’s management and continues right through to the final pricing, after orders will have been taken, based upon an estimated price range. The structure of the dance is to convey that the investment banker will work for the client to get the highest price possible, but that it will have to be one which “the institutions” will accept. I was in a meeting once when a founder of the investment bank came in from the golf course to give what I called the “level of greed” speech. It was his inside knowledge of the minds of money managers, their most intimate and even unconscious motivations. To get them to say “yes” to my client’s offering, the price had to appeal to the money managers’ own level of greed. They had to see how, through reselling the shares at a large profit, or showcasing its increased market value in their report of quarter-end holdings, they would look so good that their bonus would increase many thousands of dollars.)
Once the IPO is complete, the “flipping” part of the game begins. Favored persons who were allocated shares in the offering often sell them within minutes or hours. Persons allowed to purchase the once-flipped shares likely resell them quickly as the aftermarket continues to “pop.” The profit opportunities from flipping are based upon the share price increasing significantly in the trading market that begins immediately after the final offering price has been set.
When investment bankers are selling themselves as underwriters for an offering, they stress their superior ability to create demand for the shares, well beyond what it takes to sell the offering. Managers and directors generally must commit to have their shares in “lock-up” for six months or so after the initial offering. Then they can begin selling them. Second in priority only to getting the offering done is boosting the aftermarket price so that these insiders can sell a chunk of their shares. Investment bankers used their securities analysts to convince the client of the firm’s ability to keep the price up long enough to let insiders cash out at maximum profits. This practice led to some racy extremes covered extensively by the media after the tech stock bubble burst in 2000. Perhaps the rawest example is the affidavit filed by the New York Attorney General’s office when it got an order against Merrill Lynch [www.oag.state.ny.us/media_center/2002/apr/MerrillL.pdf] and forced an agreement to change the analyst’s role. [www.oag.state.ny.us/bureaus/investor_protection/pdfs/merrill_agreement.pdf]
Building demand for new shares is, of course, a legitimate and necessary part of the underwriter’s job in a successful offering. But somewhere along the way, the definition of “successful offering” got changed. In the investment banker’s pitch to get the business, a successful offering was talked about as one that got completed on time, at a price that was fair to the issuer and the investors. What came to replace that definition of a successful offering was having a huge increase from the offering price to the trading price in the minutes, hours and days after the initial offering was completed.
CEOs would even brag about the size of the “pop” in price after their company did its IPO. They wouldn’t even pay lip service to the logical conclusion that the business they managed had gotten only a fraction of the amount that buyers were actually willing to pay. To get this price jump, underwriters began by selling many more shares than were actually being offered. When that practice started, it was to accommodate buyers who would renege on their order for shares. It worked like overbooking by the airlines to offset no-shows. Then it became a tactic to build fever in the aftermarket, one that was used long before the boom in tech stocks. In the early 90s, Starbucks and The Cheesecake Factory had buy orders for 50 times the shares available in the IPO. [Gretchen Morgenson with Steven Ramos, “Danger Zone,” Forbes, January 18, 1993]
Securities analysts were not the only ones employed to create demand for new shares. Investment bankers worked with their firm’s sales brokers to find reciprocity deals: “I’ll scratch your back if you’ll scratch mine.” For instance, money managers could buy 10,000 shares in the IPO if they agreed not to sell them for a month or so and to buy another 10,000 a week later in the trading market. Investment bankers would even work with the firm’s stock lending department, which collects a fee for lending shares it holds for customers. The borrowers use the shares to place “covered short sales,” bets that the share price will decline. The investment bankers would get the firm to refuse to lend shares in a recently underwritten IPO, to keep the negative pressure out of the market.
Wall Street Crippled Local Governments
Local government officials have been ideal marks for Wall Street scams. They make decisions involving large sums of money and they aren’t very experienced in the world of finance. Even better, they often make decisions by board or committee, so that responsibility is diffused and no one person is responsible.
The Orange County, California bankruptcy in 1994 came about when Wall Street sold bonds to the County Treasurer, a person with no education or training in securities. Then it sold him reverse repurchase agreements, called “repos,” which were effectively loans secured by the bonds. This borrowed money went to pay for more bonds, which were used for new repos. The big flaw was that the bonds wouldn’t pay off for an average of over two years, while the repos were due within six months. When the Federal Reserve started raising interest rates, bond prices began declining. But Wall Street kept selling repos to the Treasurer. When a repo came due, Wall Street would sell them a replacement. The securities firms eventually panicked and stopped selling the replacements. Orange County could not pay the maturing repos. Wall Street foreclosed on the bonds it held as collateral and the County declared bankruptcy. [Mark Baldassare, When Government Fails: The Orange County Bankruptcy, University of California Press, 1998, pages 90-91, 102]
San Mateo County, California, lost $37 million in complex bonds issued by Lehman Brothers, which could be sold for only about a fifth of what they had cost before Lehman’s 2008 failure. A report to San Mateo County by Beacon Economics put the cost of the loss at $148 million and 1,648 lost jobs. [John Carreyrou, “Lehman’s Ghost Haunts California, The Wall Street Journal, February 24, 2010, page A1, A14]
Local governments are still being made the victims of Wall Street schemes. The problem assumed a much larger scale when derivatives were introduced in the late 1990s. Interest rate swaps, credit default swaps, “swaptions” and other exotic instruments were being bought and sold. Before the 2008 Panic, Wall Street sold them complex derivatives that were supposed to offset borrowing costs or to increase investment returns. Intricate tax structures allowed the governments to get cash for part of their fixed assets. These were in addition to all the alternate investment products, like private equity pools for buying entire companies. Many of the investment contracts called for “breakup fees” or other penalties to be paid the Wall Street firms for technical defaults, such as a downgrade in credit ratings. As a result, local governments have had to lay off workers and charge higher fees to residents. “Many of the transactions shared a striking similarity: provisions that protected the banks from big losses and left the customers on the hook for huge payouts. Now, as many of those deals sour, Wall Street is ramping up its efforts to collect from Main Street.” [Theo Francis, Ben Levisohn, Christopher Palmeri and Jessica Silver-Greenberg, “Wall Street vs. America,” Business Week, November 30, 2009, page 034, 036]
Wall Street Cleaned Out Savings and Loan Associations
Wall Street searches for pools of money and devises ways to get at it, to gather commissions, fees and trading profits. One of those pools was “thrift institutions,” which includes savings banks, savings and loan associations and building and loan associations. Working with Congress and the regulators, Wall Street took billions from the thrift industry, leaving it a much smaller and poorer.
You may remember Bailey Brothers’ Building and Loan, from the 1946 movie, “It’s a Wonderful Life.” The bad banker, Mr. Potter, manipulates a run to get rid of Bailey Brothers’ as a competitor. As the locals crowd in to withdraw their savings, Jimmy Stewart makes his impassioned speech about how their deposits are used to help their neighbors own homes. He effectively explains the Achilles heel of the thrift industry—it borrows short (deposits can be withdrawn at almost any time) and lends long (home loans are paid in monthly installments over 30 years).
Two of the New Deal’s objectives in The Banking Act of 1933 were to encourage savings by individuals and to cause local banks to lend money in their communities. They had been gathering funds locally and then sending the money to Wall Street banks, which paid them interest. The new laws provided government insurance for individual deposits and intensive regulation over how banks used their money. They also established federal savings and loan associations, to gather deposits and make home loans in their communities. They were all in the “mutual” form, meaning that they were owned by their depositors and borrowers, without any shares of stock.
To prevent Wall Street from siphoning off local savings, Congress prohibited the payment of interest on checking accounts and gave the Federal Reserve authority to set rates on savings accounts, with its Regulation Q. The rate set was generally around three percent and worked rather well until 1979, when the Fed allowed market interest rates to rise, in order to stop inflation. Interest levels reached nearly 20 percent. Money market funds were created, which drained funds from the regulated institutions by paying higher rates. It was the beginning of a new takeover by Wall Street of the locally-gathered savings and the home loans held by the savings and loan associations. [B“A Nation in Debt: How we killed thrift, enthroned loan sharks and undermined American prosperity,”
In 1978, the Federal Reserve began making exceptions to Regulation Q interest rate limits for special types of accounts. Under orders from Congress, it eliminated interest rate ceilings entirely by 1986. [R. Alton Gilbert, of the Federal Reserve Bank of St. Louis, “Requiem for Regulation Q: What it Did and Why it Passed Away,” http://research.stlouisfed.org/publications/review/86/02/Requiem_Feb1986.pdf, page 31]
In addition to making thrifts gather deposits at market rates, new laws also put them into investment businesses far beyond making home loans. After Congress had taken away the New Deal structure for thrifts, Wall Street began to lure back the money they held. [Depository Institutions Deregulation and Monetary Control Act of 1980, Pub. L. No. 96-221; 94 Stat. 132, codified as 12 U.S.C. 226; Garn–St. Germain Depository Institutions Act of 1982, Pub. L. No. 97-320; 96 Stat. 1469, codified to 12 U.S.C. 226] Like the officials at the crippled local governments, thrift institution executives controlled lots of money and had very little knowledge of any investments except home loans. They became marks for derivatives and scores of other investment schemes.
One of the ways the federal government reversed the New Deal structures was to allow mutual savings and loan associations to convert into stockholder-owned corporations. The justification given was that they needed a level of risk capital investment to carry them through difficult economic times, like the sudden spurt in interest rates. What actually happened was that some 5,000 local institutions were put “into play” for Wall Street. As mutual associations, responsible only to their local depositors and borrowers, the management philosophy was often described as “We don’t need to make big profits—just stay in the black and serve our community.” S&L managers had no incentive to sign on to Wall Street’s programs of taking more risk for higher profits. They didn’t own shares in the association, there were no stock options, no performance-based big bonuses.
All that changed when the mutual savings and loans converted to stockholder-owned corporations. Wall Street investment bankers appealed directly to the association managers with pitches such as “you’ve built a great business here; now you deserve to build up your own assets, for the sake of your family.” When an association was converted, the sales price for its shares could be appraised at substantially less than what it would trade for after the IPO. Loans could be arranged for the managers to buy lots of shares in the offering and there would be an executive stock option plan. As maximizing profits became the new goal, Wall Street could sell the managers all sorts of new investment products, just as an accommodating Congress had permitted in the 1980 and 1982 laws.
The raid on savings and loans followed the Wall Street pattern of reaping profits from: (1) underwriting fees in the IPO, (2) commissions on the resale of the new shares, as their favored customers flipped them for big, quick gains, (3) commissions and trading profits from putting the offering proceeds, and more, into investment products, (4) merger and acquisition fees from talking managers into acquiring ownership of competitors, or being acquired at big personal gain. The effect on the associations? Over 1,000 failed and were closed by regulators—only half survived. Taxpayers had to pay for a $124 bailout.
Wall Street went on to cripple another financial intermediary that serves the middle class--credit unions. http://www.ncua.gov/About/FAQ.aspx#2, [Liz Rappaport, "Banks Hit for Credit Union Ills," The Wall Street Journal, March 23, 2011, page A1]
Wall Street Trashed Government Sponsored Entities
Since the New Deal, the major competition for Wall Street has come from the federal government. In the Great Depression, Congress created programs to provide money for purchasing homes, growing businesses, operating farms, developing infrastructure. These programs either provided money directly from taxpayer dollars or guaranteed loans funded by banks or other private lenders. The website www.govloans.gov offers a cafeteria of direct and guaranteed loans.
Government guarantees are a way to use the credit of the United States to encourage investors to make loans that would otherwise seem too risky. The Federal Housing Administration, the Veterans Administration and the Small Business Administration and other agencies have guaranteed or insured loans made to their standards. They’re able to be self-supporting from the fees charged borrowers for putting the government’s credit behind the loans. Without the government’s role, lenders would either decline the loan or charge interest and fees that borrowers couldn’t afford.
Agencies that guarantee or insure loans are still, after all, part of the U. S. Government, responsible to the political process. A program that breaks even, with no profit or loss, is a great success to the government if it is meeting the need for which it was established. But there is not much of a place for Wall Street. Securities that carry the full faith and credit of the United States virtually sell themselves. The profit margin to financial intermediaries is narrow and the competition is intense.
Enter the government-sponsored entity, or GSE. These legal creations are shareholder owned but are viewed by investors as government-backed. Often, that backing is implied because it is not in the law creating the entity. Sometimes it is no more than a feeling that “they would never let it fail.”
Largest of the GSEs is the Federal National Mortgage Association, or Fannie Mae. It was created in 1938, to purchase mortgages insured by the Federal Housing Administration. The money to buy those mortgages came from Fannie Mae bonds, carrying the credit of the United States. There was little business for Wall Street in this structure. Government bonds are sold with tiny commissions to any intermediaries.
That began to change in 1954, when lobbyists got Congress to reorganize Fannie Mae, making it partially owned by shareowners. The policy reason given was that its ability to sell government bonds gave it the unfair competitive advantage of raising cheaper money than other lenders. In 1968, Fannie Mae became entirely investor owned. Five of its 18 directors were to be appointed by the President but the other 12 elected by shareowners. At the same time, Congress created an almost identical private corporation, the Federal Home Loan Mortgage Association, or Freddie Mac. Both of them were allowed to buy conventional mortgages, as well as those FHA-insured or VA-guaranteed.
Through all of this restructuring, Fannie Mae and Freddie Mac kept the image that the government would bail them out if necessary. As it turns out, the image was correct. Fannie Mae was placed in a conservatorship on September 8, 2008 and the U.S. Treasury agreed to provide up to $100 billion in funding, whenever Fannie Mae’s liabilities exceed its assets. The Treasury received preferred stock and the right to buy 79.9% of Fannie Mae’s common stock, “for a nominal price”. [Fannie Mae’s Form 10Q for the quarterly period ended September 30. 2008]. Freddie Mac got the same bailout.
In the forty years that they lasted as GSEs, Fannie Mae and Freddie Mac were a feast for Wall Street. Nearly all of the mortgages purchased by the two were securitized and sold by Wall Street firms. The great bulk of the mortgages were “conventional,” rather than VA or FHA, so they could include the high-risk loans that brought down the home loan business and, with it, the economy.
The same process has come to student loans for post-high school education. SLM Corporation, commonly known as Sallie Mae, is the parent company of a number of college savings, education lending, debt collection, and other subsidiaries. “Sallie Mae was originally created in 1972 as a GSE. The company began privatizing its operations in 1997, a process it completed at the end of 2004 when the company terminated its ties to the federal government. [www.salliemae.com/about/]
Competition for Sallie Mae, and other private student loan originators, was presented by the Federal Direct Student Loan Program enacted in 1993. However, funding for loans made directly by the Department of Education was cut from over $7 billion in 2006 to a half billion in 2008, until the private student loan market dried up. After the Crash of 2008, Congress raised the limits and government student loans increased by $3.1 billion, picking up most of the $3.4 billion drop in private loans. Bribery of college loan officers and other scandals in the student loan business contributed to the 2008 drying up of buyer interest for securities backed by student loans. By late 2008, “Hedge funds, endowments, and others are currently sitting on $62 billion in education-related securities, deeply troubled debt trading as low as 20 cents on the dollar.” [“These Lenders May Not be Missed, “Business Week, December 22, 2008, page 040.]
Wall Street Promotes Wasteful Class Action Litigation
Great amounts of money and professional time is expended in lawsuits by shareholders against corporations, their officers and directors. Shareholder litigation law firms need four characteristics for one of these class actions to be started and survive. One is a big, sudden drop in the price of the shares in the trading market. This will create a large loss, so the legal fees will make the case profitable.
The second element needed for a shareholder class action is a group of shareholders that includes institutional money managers and stock speculators. These are people who must explain to the source of their money that they either made a mistake when they bought into the company or that they were cheated. They are very likely to join any class action that is based on someone else doing them wrong.
Third must be some deep pockets that can pay a settlement or a judgment. The corporation itself may not have enough left to be an attractive source of money. This is where insurance comes in. Nearly every publicly-traded corporation buys directors and officers liability insurance. Anyone asked to join a board of directors, or be recruited to senior management, will insist upon it. The irony is that this very expensive product just makes it more likely that the director or officer will be sued. It also means that there will probably be a big fight over whether the claim is covered by the insurance. [“Directors and Officers liability insurance: Paying a premium now for the right to sue your insurance carrier later,” The Curmudgeon’s Guide to Practicing Law, by Mark Herrmann, Section of Litigation, American Bar Association, 2006]
The fourth requirement for shareholder litigation is the easiest: Something that the corporation, its officers and directors did, or didn’t do or say that would create liability. Hindsight being what it is, there is always something.
Wall Street creates the price volatility and short-term speculation that promotes shareholder litigation. The “herd instinct” is emphasized by having professional traders, advised by securities analysts, taking large positions and expecting a short-term profit. These traders are playing with other peoples’ money and need a scapegoat when they lose. The resulting lawsuits waste resources and harm the underlying business. The best protection from stockholder class action litigation is a large group of long-term investors, each having invested a relatively minor amount of their own money.
The Way Wall Street Works Creates Moral Hazards That Infect Us All
The term “moral hazards” pops up in a lot of current commentary. I think it means temptation. The temptation becomes greater as the payoff amount goes up and the risk from getting caught goes down. For Wall Street, the moral hazard is greatest when success means keeping big winnings, while losses may be passed off to someone else.
Any time money is being exchanged, there is temptation, a moral hazard, a conflict between what’s right and what’s self-serving. Every business, and most nonprofit entities, are receiving money for what they sell or do, and paying money for materials and services they use. It is just more so with Wall Street, because it is in the money business. It is constantly moving money from one person to another. Working on Wall Street is like being stationed on a conveyor belt, where money is the commodity and the objective is to get a piece of it as it flows by. The moral hazards for Wall Street are intensified by the sheer amounts of money involved in transactions, the size of the rewards that get handed out at the top and the way compensation is figured. Not a lot can be done about the large amounts of money that get transferred in a Wall Street transaction. But it puts more emphasis on the way people get paid.
The amounts paid to Wall Street, just in fees alone, are huge. In the five years before 2005, “revenues of investment bankers and brokers came to an estimated $1.3 trillion; direct mutual fund costs came to about $250 billion; annuity commissions to some $40 billion; hedge fund fees to about $60 billion; fees paid to personal financial advisers maybe another $20 billion. Even without including, say, banking and insurance services, total financial intermediation costs came to nearly $2 trillion, an average of $400 billion per year, all directly deducted by the croupiers from the returns that the financial markets generated before passing the remainder along to investors.” [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, page 231]
The amounts of money involved can overcome such other values as loyalty. According to James Cramer, “There are no loyalties on Wall Street. When you smell blood in the water, you become a shark.” [James J. Cramer, Confessions of a Street Addict, Simon & Schuster, 2002, page182] In describing how his fellow hedge fund managers responded to troubles at Long Term Capital Management: “Put simply, when you know that one of your number is in trouble, you don’t lend him a hand, you try to figure out what he owns and you start shorting those stocks to drive them down. . . . You could feel the whole Street collectively buying long-term U.S. bonds to squeeze Long-Term Capital into buying back those bonds at the highest possible price.”
A prominent Wall Street adage is that “securities are not bought—they are sold.” The decision about which securities to sell has often been made on the basis of “what’s in it for me.” The questions asked by the broker, and the firm’s analyst, are ones like: “What will earn me the largest commission? What will help me get a bigger bonus? How can I earn favors from management?” According to a pair of former investment bankers: "Greed, Fear, and Abandon. Those are the three steps.. . .Greed and the pursuit of money is the banker's ultimate aphrodisiac. . . . If this doesn't work, move to the second stage of the process--fear. . . . Finally, if this doesn't work the banker will abandon in an unusually rapid fashion." [John Rolfe and Peter Troob, Monkey Business: Swinging Through the Wall Street Jungle, Warner Books, 2000, page 261. One former stockbroker, Donald E. Kendrick, warned of the moral hazards in The Average Investor's Rage, Vantage Press, Inc., 1990]
The moral hazard on Wall Street has been exacerbated by the role of government in preventing a collapse of schemes that could “bring down the entire financial system,” as the phrase was used after the Panic of 2008. For a while, the silent assurance of a bailout by the Federal Reserve Banks was known as the “Greenspan put,” meaning that a disastrous loss position could ultimately be put to the Fed for transferring a loss onto others, including the taxpayers.
There have been pioneers on Wall Street who have set out to do business in ways that reduced the moral hazards. When Charles Merrill started Merrill Lynch in 1940, he told the world that its broker representatives would receive a salary, rather than a percentage of commissions on the trades they generated. The firm would not participate in underwriting new issues of securities. That all changed long ago. Before it was acquired by Bank of America in 2008, Merrill Lynch was a broker, dealer, underwriter, traded for its own account and did business the same way as all the other giant Wall Street sell side firms.
(My own observation is that most harm comes from incompetence, masked by arrogance, rather than criminal conspiracies. Near the end of the Great Depression, a popular book was published, called Where Are the Customers’ Yachts? Or a Good Hard Look at Wall Street. [Fred Schwed, Jr., Where Are the Customers’ Yachts? Or a Good Hard Look at Wall Street. Simon & Schuster, 1940, second printing 1955.] The title was from an old story about a tourist’s question, when the guide pointed out the bankers’ and brokers’ yachts. The author had been a Wall Street trader since 1927. He observed that “The crookedness of Wall Street is in my opinion an overrated phenomenon.” “They involve vastly greater sums, and they make more interesting reading. Best of all, they suggest to the public and excuse for the public’s own folly.” “The burnt customer certainly prefers to believe that he has been robbed rather than that he has been a fool on the advice of fools.” [page 196 in the 1955 printing])
When entrepreneurs need more money than they can raise from family and friends, they naturally turn to wealthy individuals. Beginning in the 1950s, groups of wealthy individuals would pool their money and have one of them select and manage investments in early stage businesses. During the 1960s and 1970s, these venture capital funds made total investments of no more than $300 million a year. [Robert J. Kunze, Nothing Ventured: The Perils and Payoffs of the Great American Venture Capital Game, HarperBusiness, 1990, p.6] As VCs grew, they began having full-time managers, who were paid annual fees of about two percent of the amount in their fund, as well as success fees equal to 20 percent of the gains from disposition of an investment. No longer were the managers co-investors, handling administrative duties so that they and their friends could make money on their pooled investments. They became MBA-schooled managers.
Myth has it that venture capital got its big boost when the capital gains tax rate was cut significantly in 1978. In fact, it was changed when VC managers used their historical performance records to get huge chunks of money from institutional money managers. [Charles R. Morris, The Trillion dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash, Public Affairs, 2008] With their percentage fees, VC managers became full-blown financial intermediaries. Income from their percentage compensation became their prime motivation. Since the percentage was generally set the same among VC firms, regardless of their performance, the way to make more money for the VC managers was to bring in new investors, preferably ones with deep pockets. Along came the Employee Retirement Income Security Act, or ERISA, and related rules, which changed the standard for investments by pension and other funds. Fund managers tapped into these institutions and the investment levels jumped to $2.5 to $5 billion a year in the early 1980s, with 300 new funds formed from 1981 to 1984 [Robert J. Kunze, Nothing Ventured: The Perils and Payoffs of the Great American Venture Capital Game, HarperBusiness, 1990 p.11]. Venture capital went from partnerships of investors to a financial intermediary business.
Venture capitalists need to have an “exit plan” before they ever commit to investing. How are they going to recover the cash they put in, plus or minus their gain or loss? Their preferred route is an underwritten initial public offering and they work closely with investment bankers, referring business to each other. The other “liquidity event” is to have the portfolio company acquired, for cash or marketable securities. But the IPO usually provides a higher valuation. It also lets the VC choose whether to sell in the IPO or pick times in the aftermarket. An IPO could allow the venture investor to cash out at least a portion of their ownership. Even better, the public offering would be followed by a trading market in the shares. The brokerage firms who acted as underwriters would act as a market maker and issue analyst reports to build ongoing interest in buying into the company. Between 1980 and 1984, these broker-dealers earned over $1.5 billion from commissions as IPO underwriters and aftermarket traders. [Robert J. Kunze, Nothing Ventured: The Perils and Payoffs of the Great American Venture Capital Game, HarperBusiness, 1990, p.14]
Venture capitalists measure their success in the price they get on cashing out an investment. They also look at how long it takes from investment to return. The VC to IPO path travels well in “hot new issues” markets, when underwriters are hungry for venture-backed companies they can sell to the institutional money managers. At those times, the VCs hire “VC accelerators,” consultants who show how a company can be dressed up for the quickest possible disposal. When the new issues markets turns cold, VCs must either continue to hold their investment in a private company or have it acquired. In the hot market of 1999, the average venture-backed company had its IPO just over four years after the business began. By 2008, it was taking nearly nine years. [Rebecca Buckman, “As High-Tech IPOs Dwindle, Start-Ups Look to Private Money for More Backing,” Wall Street Journal, July 1, 2008, C3.] Even in the 2008 “capital markets crisis,” there is no sign of VCs trying to find an alternate route to the investment dollars of nonwealthy individuals. Instead, they are raising the needed growth capital from investment bankers who specialize in private placements with institutional investors.
(I was asked to speak to a meeting of the International Venture Capital Association (?). My subject was what a great tool direct public offerings would be for venture capital investors, how raising money from the company’s communities would increase the value of the VCs investment. While speaking, I could sense that unmistakable glassy-eyed stare of the person who is deciding what to have for lunch, replaying the last game of golf or taking a fantasy trip. However badly I may have been presenting the subject, it was just not within their frame of reference.)
Venture capitalists were presented with a set of moral hazards when they went, from groups of individuals pooling investments, into funds with managers, who were paid a percentage management fee. As financial intermediaries, their eye was on maximizing their compensation, both the percentage of the fund amount and the percentage of profits. This first percentage tempted VC managers to keep the total in the fund as high as possible, often through decisions harmful to the investors. One way to inflate the fund amount, and the percentage compensation, was to value companies in the investment portfolio at higher than realistic amounts. Until there is an IPO or sale of an investment, the value is a matter of judgment. Comparisons are made to similar companies that are already publicly traded, or were recently purchased for a disclosed price. Estimates of future income and cash flow from the business are discounted to reflect a present value, considering the likely risks of achievement. The process can be influenced by choices and judgments, even if outsiders are hired to make a valuation.
To increase their take from profits, VC managers can also be influenced to drive particularly harsh terms on the young companies seeking capital to develop their business. Entrepreneurs are particularly vulnerable to agreeing to conditions when they are obsessed with their dream. Some of the nicknames for these provisions tell the story of the fear and greed behind them, such as “full-ratchet” clauses that increase the VC’s ownership percentage as the business stumbles, or the “drag-along rights” that force the business founders to join in a sale of the business dictated by the VC managers.
Another moral hazard comes with investment in a company that is looking like a loser. The manager can keep a higher base for percentage pay by having the fund invest more money into the poor-performing company. This keeps it in the portfolio when to write it off would mean a cut in the manager’s profit sharing. A subtler variation of avoiding a writedown in compensation base occurs when another VC offers to invest in the needy company, but at a lower price than the first investor. If the new funding were accepted, it would set a reduced value for the initial investment. Under the adage, “a problem postponed is a problem solved,” the manager could cause the investment offer to be refused. This could keep the original investment cost as the valuation for management’s fee.
Winning investments present another set of moral hazards for VC managers, especially when an underwritten initial public offering is the expected “liquidity event,” when their investment is transformed into cash and marketable stock. The manager has a lot to gain from a successful IPO. The VC managers typically have gotten 20 to 30 percent of the net gain from investments. In addition, the proceeds to the VC from a public offering are often left in the fund to reinvest. That success can be the result of having the right managing underwriter. To attract the right broker-dealer firm to underwrite the offering, VCs began offering them so-called “mezzanine round” investments in the IPO candidates. By buying in at a pre-IPO price, the broker-dealer could turn a quick profit.
Wall Street’s emphasis on speculative trading, rather than long-term gains and dividends, has created moral hazards for corporate managers. The CEOs and CFOs are under great pressure to tell Wall Street what the current quarter’s earnings are expected to be, so that trades can be made before the public finds out. Especially when these executives have stock options tied to the current market price, they look for any way to pass on good news. “When our financial markets are driven by speculative trading, there is overwhelming pressure to cook the books in order to sustain artificial prices in the stock market . . .. If the money manager focuses almost exclusively on the price of the stock rather than on the intrinsic value of the corporation, we should not be surprised when the corporate manager, in an attempt to ‘game’ the system, focuses on the stock price, too.” [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, page
Even those of us far away from Wall Street are infected by the response it makes to moral hazards. We come to believe that “everybody does it,” and even that we’re chumps and losers if we don’t get on the bandwagon. “Most Americans believe that investment fraud like the recently revealed Ponzi scheme run by Bernard Madoff happens regularly on Wall Street, according to a recent survey. In a CNN/Opinion Research poll, 74% of those surveyed said they think Madoff's behavior is common among financial advisors and institutions.” [David Goldman, “Americans think Madoff's behavior is common – poll,” December 23, 2008, http://money.cnn.com/news] In a chapter called "The Case for Eliminating Wall Street," David Korten has written: "Even more damaging in some ways than the economic costs are the spiritual and psychological costs of a Wall Street culture that celebrates greed, favors the emotionally and morally challenged with outsized compensation packages, and denies the human capacity for cooperation and sharing." [David C. Korten, Agenda for a New Economy: From Phantom Wealth to Real Wealth, Berrett-Koehler Publishers, 2009, page 45]
Wall Street Promotes Monopolies
Wall Street makes money when small companies are acquired by big corporations. The merger & acquisition investment bankers get a percentage of the acquisition price for bringing the acquisition candidate to the prospective acquirer and pushing to get the deal done. Then the underwriting or private placement investment bankers get a percentage of the money they raise for the acquirer, to finance the acquisition. This ties the investment bankers closer to management of the large corporation, to help it grow even larger through more acquisitions and financings.
The fact that the smaller company that was acquired is lost to the economy is of no significance to Wall Street. The money to be made right now comes from doing business with large corporations. Nourishing young enterprises toward maturity, teaching their management about “high finance,” is time-consuming and the percentage fees on their early transactions is not big-bonus-making material. Better to lure the entrepreneurs into selling out, with appeals to their greed and promises about how their new owner will help them fulfill their dreams. The greatest threat to monopoly businesses is the adequately financed new entrant with the creativity and agility to exploit gaps and weaknesses. The harm to us all from monopolies is described in Barry Lynn’s new book. [Barry C. Lynn, Cornered: The New Monopoly Capitalism and the Economics of Destruction, Wiley, 2010] Wall Street controls nearly all of the money available and allocates it to the existing monopolies. This leaves little opportunity for new ideas and energy to improve products and services, to make capitalism work. To quote from two icons of economics: "This process of creative destruction is the essential fact of capitalism." [Joseph Schumpeter, Capitalism, Socialism and Democracy, Harper & Brothers, 1942, page 83] "WE need decentralization because only thus can we insure that the knowledge of particular circumstances of time and place will be properly used." [Friedrich Hayek, "The Use of Knowledge in Society," http://www.econlib.org/library/Essays/hykKnw1.html, page H.17]
(Entrepreneurs we advised on direct public offerings were enthusiastic about the independence they would have after their first sale of securities. Some of them went on to a series of direct public offerings, raising money for rapid growth. Nevertheless, many of our most successful direct offering clients were acquired by large corporations. After years of struggling with a young business, becoming independently wealthy—right now—can be hard to pass up, especially when that is the definition of success. As Wall Street becomes less important as a source of funding, I hope the culture of quick money, and the status it provides, will subside.)
Wall Street Entices Some of Our Best Minds Away from More Useful Work
The irony is that the very minds that can get rich and powerful on Wall Street are the minds that could finally alleviate poverty. Paul Polak is a psychiatrist and entrepreneur who has spent the second part of his life helping the world’s poorest farmers increase their income. He came to that work because “I became convinced that the most significant positive impact I could have on world health was to work on finding ways to end poverty.” [Paul Polak, Out of Poverty: What Works When traditional Approaches Fail, Berrett-Koehler Publishers, Inc., 2008, page 5.] “I have no doubt that the most important low-cost, high-leverage solution to the complex issue of poverty is helping poor people increase their income.” [page 55] Muhammed Yunus, the founder of Grameen Bank and the microfinance movement, was an economics professor when he experimented with lending very small amounts to his Bangladesh neighbors for acquiring tools and methods to increase their incomes. If a physician and a professor could make such contributions to alleviating poverty, imagine what experienced Wall Streeters could accomplish.
A study by three economists was based upon the proposition that “the ablest people” choose occupations with the highest “returns to being a superstar.” Where will individuals choose to work if they are particularly good at applying mathematics or physics to solve extremely complex issues? The professors say they’ll go where the few who really excel are paid the greatest compensation. In academic language, their analysis “suggests that private incentives governing the allocation of talent across occupations might not coincide with social incentives. Some professions are socially more useful than others, even if they are not as well compensated.” [Kevin M. Murphy, Robert W. Vishny, Andrei Schleifer, “The Allocation of Talent: Implications for Growth,” The Quarterly Journal of Economics, Harvard University, May 1991, pages 503, 529. www.economics.harvard.edu/faculty/shleifer/files/allocation_talent.pdf]
This academic conclusion was applied to jobs on Wall Street in a feature article by Lisa Bannon. “The earnings of an engineer and someone in finance with the same level of postgraduate degree were roughly the same in 1980, but by 2005, the finance professional earned 30% to 40% more, on average . . ..” [Lisa Bannon, “Beyond the Bubble: As Riches Fade, So Does Finance’s Allure,” The Wall Street Journal, September 18, 2009, page 1, 20, citing Thomas Philippon, New York University finance professor, http://sternfinance.blogspot.com/2008/11/are-banker-over-paid-thomas-philippon.html] Of course, Wall Street superstars earned many times more. The culture of Wall Street appeals to and enforces the “Winner-Take-All Society.” [Robert H. Frank, The Winner-Take-All Society: Why the Few at the Top Get So Much More Than the Rest of Us, Penguin, 1996, pages 7-8, hardcover, The Free Press, 1995, subtitled: How more and more Americans compete for even fewer and bigger prizes, encouraging inequality and an impoverished cultural life]
Professor Louis Lowenstein noted that over half of the 1986 graduates of the Columbia School of Business took jobs at investment banks and commercial banks. Over 85 percent of the Columbia Law School graduates were hired by the big city law firms who do financial transactions and litigation. “We seem to forget that corporate finance is, or at least ought to be, a relatively minor pursuit, one whose principal purpose is simply to see that those who design, produce and distribute goods and services have sufficient capital.” [Louis Lowenstein, What’s Wrong With Wall Street: Short-term Gain and the Absentee Shareholder, Addison-Wesley Publishing Company, Inc., 1988, page 86] The Great Recession may have reversed that, at least for a while. Of Harvard’s 2008 graduates, 41% took jobs in investment banking, private equity firms or hedge funds. That dropped to 28% in 2009. The lowest ever was in 1937, when only one percent went to Wall Street. [http://bx.businessweek.com/harvard-business-school/view?url=http%3A%2F%2Fwww.hbs.edu%2Frecruiting%2Fmba%2Fresources%2Fcareer.html]
(My first job out of law school was with one of the Big Four accounting firms, where I ended up in the tax department. I spent the next few decades trying to avoid tax work. But I met scores of very intelligent, capable people who spent their entire work lives dealing with tax issues. Clients were willing to pay them large hourly rates in the hope of saving even more in payments to their governments. It has always seemed sad that these talented, productive professionals were figuring out ways to avoid paying taxes, rather than working on issues I thought would be more useful. Later, when Wall Street began inventing and selling derivatives, I saw an even greater diversion of talented people.)
There is a much greater, but more indirect waste of human talent that comes from leaving Wall Street in control of distributing securities. Its monopoly focus on financial intermediaries and wealthy speculators has kept the middle class from direct ownership of business. This means that corporate profits are taken mostly by managers—CEOs and their lieutenants, as well as the money managers at mutual funds, pension funds and other intermediaries. One result is that businesses are run to generate income for these managers and short-term profit-takers, not for long-term shareowners. Net income after payments to management is spent to make the business larger, to justify even greater compensation. Corporate executives, intermediaries and speculators all make money buying and selling the shares. Not much of the earnings of the business are paid out in dividends.
Because we don’t participate in the Wall Street insiders’ games, the rest of us are left with our income tied to our work. Our ability to pay our living expenses is dependent upon businesses having jobs available for us to do. But those corporate executives and financial intermediaries are doing everything they can to eliminate jobs. The corporations raise money from borrowings, in order to automate the work done by humans. This means the businesses pay out interest and fees on the money they use to eliminate labor expense. Our only chance to participate is in holding onto our jobs.
The result is not only unemployment because of the loss of jobs paying a middle class income. It also means underemployment as we take low-paying work, doing tasks that can’t yet be profitably automated. All of us lose the contributions that could have been made by the inventors, entrepreneurs and other talented roles for people who are instead just making do with unchallenging work.
Wall Street’s Morality Harms Our National Psyche
Wall Street has callously announced that we are all governed by only two emotions: fear and greed. All marketing of securities is a manipulation of one or the other, or both. Throw in a bit of mob psychology and we have the manias and panics that make for market volatility, the mass buying and selling that generates commissions and insider trading profits. Two Wall Street veterans described the “three-step banking process.” First: “Greed and the pursuit of money is the banker’s ultimate aphrodisiac.” “If this doesn’t work, move to the second stage of the process—fear.” “Finally, if this doesn’t work the banker will abandon in an unusually rapid fashion.” [John Rolfe and Peter Troob, Monkey Business: Swinging Through the Wall Street Jungle, Warner Books, 2000, page 261.] Michael Lewis will show you Wall Street morality in shocking dark humor. [Michael Lewis, Liar's Poker: Rising Through the Wreckage on Wall Street, W. W. Norton & Company, 1989, The Money Culture, Penquin 1992 or The Big Short: Inside the Doomsday Machine, W.W Norton & Company, 2010.]
During Alan Greenspan’s long tenure as Chairman of the Federal Reserve Board, he coined two phrases that captured what Wall Street was doing to our national psyche. The first came as the bubble in technology stocks was early in its run-up, when he attributed it to “irrational exuberance.” As the bubble inflated more and more, he called it “infectious greed.” Whatever else we may think of Greenspan, he captured the pathology in these four words. A much longer and older description is in the 1841 book, Extraordinary Popular Delusions and the Madness of Crowds. Describing John Law’s Mississippi Scheme of 1719: “He did not calculate upon the avaricious frenzy of a whole nation; he did not see that confidence, like mistrust, could be increased almost ad infinitum, and that hope was as extravagant as fear.” [Charles Mackay, Memoirs of Extraordinary Popular Delusions, Richard Bentley, 1841, reprinted by Farrar, Straus and Giroux, 1932, page 1]
There’s more to greed than just making and keeping wealth. The strongest motive can be the “chump factor.” Paul Krugman has said that we find “it hard to resist getting caught up in the momentum, to take a long view when everyone else is getting rich.” [Paul Krugman, The Return of Depression Economics and the Crisis of 2008, W.W. Norton & Company, 2009, page 61The Fortune at the Bottom of the Pyramid" (Wharton, 2004)] If we don’t get in there, it will pass us by. We’ll look like a wimp, a chump to ourselves and others. “To a substantial extent, we no longer admired those who were merely hard workers. To be truly revered, one had to be a smart investor as well.” [Robert J. Shiller, The Subprime Crises: How Today’s Global Financial Crisis Happened, and What to do about it, Princeton University Press, 2008, page 57.] The investment banker has had the same effect upon a generation of young people as drug dealers. They’re both a role model of seemingly easy big money.
(We’ve watched this infect the entrepreneurs who came to us for direct public offering advice. Consciously or not, they were aware of all the get-rich-overnight stories about underwritten IPOs. At first, our talk would be about the mission of their business, how they were meeting a human need, how their products and services were benefiting customers. They were doing well by their employees and other communities. Somewhere along the way, questions would turn to the expected trading market for the securities to be sold. Then it would be about the percentage of the business to be sold for the amount of money to be raised. At that point, we’d often see the glazed-eye clue that their thoughts were no longer on what we were saying. They were doing the arithmetic about how rich they would be and how that compared with others they knew.)
Fear and greed govern the way Wall Street sells to its customers. They’re also the only motivational tools Wall Street uses to hire and retain employees. Much of the criticism after the 2008 crash was directed to the huge bonuses paid to people who successfully took great risks. The government tried to limit the bonuses, calling them part of a “heads I win, tails I don’t lose” compensation scheme. The employees taking the risks would get great personal gain if they bet right, but didn’t lose their jobs, or have pay cuts, if they bet wrong. By restricting the bonus amounts, the government figured it could cut down on the risks that were causing banks to fail and be bailed out with taxpayer money.
Perhaps a greater harm was the perpetuation of a value that infects us all. Other businesses follow Wall Street, since that’s where the fabulous riches are made. The fact is, however, that studies show that financial incentives don’t work. If fact, they are often counterproductive. Barry Schwartz, a Swarthmore College psychology professor, mentioned three of the studies in an essay, “The Dark Side of Incentives.” [Business Week, November 23, 2009, page 084] One study was of people living around a proposed toxic waste dump. Offering them a significant cash amount cut in half their willingness to have the dump in their community. Another was a day care center that began fining parents when they were late to retrieve their children, only to have lateness increase. In the third study, people walking by strangers unloading a sofa were less likely to help if they were offered payment. The professor’s conclusion: “Despite our abiding faith in incentives as a way to influence behavior in a positive way, they consistently do the reverse.” [Business Week, November 23, 2009, page 084. Professor Schwartz mentions the sources for each study.]
The current epitome of the Wall Street psyche is Goldman Sachs. The Sunday Times of London printed an interview by its reporter, John Arlidge, in which the CEO of Goldman Sachs, Lloyd Blankfein, candidly described that mindset. [John Arlidge, “I'm doing 'God's work'. Meet Mr. Goldman Sachs: The Sunday Times gains unprecedented access to the world's most powerful, and most secretive, investment bank,” The Times of London, November 8, 2009, www.timesonline.co.uk/tol/news/world/us_and_americas/article6907681.ece] Some of the article’s quoted excerpts:
1. "We help companies to grow by helping them to raise capital. Companies that grow create wealth. This, in turn, allows people to have jobs that create more growth and more wealth. It’s a virtuous cycle." To drive home his point, he makes a remarkably bold claim. "We have a social purpose." The facts, of course, are that very little of what Wall Street does has anything to do with raising capital for business.
2. Of the $20 billion to be paid by Goldman in 2009 salaries and bonuses, equivalent to $700,000 for each employee but heavily skewed toward those at the top: “If you examine our practices on compensation, you will see a complete correlation throughout our history of having remuneration match performance over the long term. Others made no money and still paid large bonuses. Some are not around any more. I wonder why."
3. On any government interference with Wall Street: “’I’ve got news for you,’ he shoots back, eyes narrowing. ‘If the financial system goes down, our business is going down and, trust me, yours and everyone else’s is going down, too.’"
4. In response to angry name-calling: “He is, he says, just a banker ‘doing God’s work.’"
In 2007, the Goldman Sachs boss Lloyd Blankfein earned $68m, a record for any Wall Street CEO. A good investment banking partner at Goldman will make $3.5m a year, a good trading partner $7-10m a year, and a management committee member $15-25m.
For even more colorful language describing Wall Street’s attitude toward its business and customers, you can read the affidavit filed by the New York Attorney General’s office in its action against Wall Street’s use of securities analysts. [AFFIDAVIT IN SUPPORT OF APPLICATION FOR AN ORDER PURSUANT TO GENERAL BUSINESS LAW SECTION 354] The accompanying news release is at www.oag.state.ny.us/press/2002/apr/MerrillL.pdf.
Wall Street has become the career choice for young people caught up in the winner-take-all value system. It has had the same draw for college students that drug dealers have for high school dropouts—a seemingly quick way to have all the flashy symbols of big money.
Wall Street has corrupted our political system, directly by bribing elected officials and indirectly by perpetuating ever-larger businesses with its financing power, starving the competition that might have come from new businesses.
(Remember the 1990s bumper sticker, “The one who dies with the most toys wins?” I’ve heard many CEOs, financial types and professionals say things like, “For me, money is just the way of keeping score.” One observation is clear, “if you think money is the answer, there will never be enough.” Wall Street’s single-minded pursuit of scoring money infects us all. No matter whether the love of pursuing money was already there before the Wall Street career, or was developed on the job, it is the primary value, governing every decision and action. However, study after study has shown that money does not bring happiness. Once above the basic poverty level, there is no correlation. [The World Database of Happiness, directed by Professor Ruut Veenhoven of Erasmus University, Rotterdam, correlation by nation between happiness and wealth, http://worlddatabaseofhappiness.eur.nl/statnat/statnat_fp.htm. Also, see www.happyplanetindex.org/public-data/files/happy-planet-index-2-0.pdf] Yet, Wall Street perpetuates the myth that getting money—lots of it and quickly—is what life is all about. That harms us all. Some of our most capable people are ignoring community, service, family and other values, while they chase making more money than anyone else.
The Wall Street Capital Formation Myth
Our government and other governments around the world have sacrificed billions of dollars and immense political capital to save investment bankers. Few of us even asked why this effort was necessary. If we did ask, the answer was something like, “the credit markets are frozen and money won’t be there for Main Street businesses to pay their employees and suppliers.” This justified taking money from present and future taxpayers and giving it to the investment banks. Few of us asked, “Why not make alternative financing available directly to those businesses?”
It turns out that investment bankers no longer do much to provide money to grow and sustain businesses. Nearly everything they do is based on reshuffling ownership of securities or using derivatives to place bets on the future price of securities. Only a tiny fraction of their activities is actually raising money from investors for growing businesses. Money they raise in IPOs, initial public offerings, is mostly just part of the recycling of ownership by Wall Street’s buy side. Many of the “initial” offerings are of mature businesses that “private equity” funds have purchased from their public shareowners, sold off divisions and drained of all cash. Investment bankers dump the remains back onto the public, calling it an IPO. The sales that are really “initial” are generally businesses that have been built by institutional venture capitalists, with the IPO being the exit plan for cashing out their investment.
When Wall Street does do an “Initial Public Offering,” it usually has nothing to do with early stage businesses and nothing to do with financing new products or industries. Just look at the prospectus for the billion-dollar “IPO” of Shanda Games in September 2009. [www.sec.gov/Archives/edgar/data/1470157/000095012309046352/h03368b4e424b4.htm and comment by Henry Blodgett, “Goldman Hoses Clients in Busted Shanda Games IPO,” Clusterstock, www.businessinsider.com/henry-blodget-goldman-hoses-clients-in-busted-shanda-games-ipo-2009-9] This is a far cry from the idealistic image: “Because of their role in financing new ideas, financial markets keep alive the process of ‘creative destruction’—whereby old ideas and organizations are constantly challenged and replaced by new, better ones. Without vibrant, innovative financial markets, economies would invariably ossify and decline.” [Raghuram G. Rajan & Luigi Zingales, Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity, Crown Business, Crown Publishing Group, a division of Random House, Inc., New York, 2003]
What has actually happened is that more public companies disappear than the ones that are created by IPOs.
In 2000, over 9,000 publicly-traded companies filed proxy statements with the SEC, compared to only about 4,100 by 2010. Since 1996, the 4,299 publicly traded stocks added through IPOs has been far less that the 7,725 that went away. [Jason Zweig, "The Demise of the IPO--and Some Ideas on How to Revive It," The Wall Street Journal, June 26-27, 2010, page B7, citing Wharton Research Data Services]
Mature corporations rarely raise capital by selling shares. Take General Electric, for example. The last time GE issued new shares was in 1995, when it sold $594 million. Meanwhile, GE has repurchased shares, at market prices, for a cumulative total of $37 billion at the end of 2007. In turn, some of this repurchased stock was sold, to its own managers when they exercised their management stock options. The managers generally resell the new shares for cash in the market. GE’s balance sheet shows the gain it made on buying and selling its own shares as the major part of the over $26 billion in its “Other Capital” account. The net result of GE’s issuing new stock, then repurchasing it, and then using the repurchased shares to cover management’s stock options, is that GE has taken nearly 100 times as much money out of the public market from buying shares as it ever raised from selling shares. Meanwhile, it has been paying out about half of each year’s earnings in dividends. By keeping the rest of its earnings, it has increased its retained earnings to over $117 billion! That has allowed GE to borrow cash, to a total of over $195 billion at the end of 2007. Some 58% of GE’s shares are owned by institutions. [Information gathered from GE annual reports, filed with the SEC and available at CIK#: 0000040545.]
GE’s experience with buying back its shares is the norm for mature American corporations. Nearly every large corporation has a program in place for repurchasing its own shares in the market, through brokers. During 1997 through 2008, 438 of the Standard & Poor’ 500 companies spent a total $2.4 trillion in buying back their own shares of common stock. A perspective on the amount these corporations paid out to sellers of their shares can be seen through the buyback-to-profit ratio: how the amount spent to repurchase shares compares to the companies’ profits. That ratio was 0.9 to 1 in 2007. That means the S&P 500 paid out 90% of their earnings to buy back their own shareownership. In 2008, when profits were down, the ratio became 2.8 to one—they spent nearly three times their earnings to repurchase shares.
The most profitable company of all, ExxonMobil, paid out 173% of its first quarter 2009 earnings to repurchase its stock. From 2000 through 2008, the big technology companies, Cisco, Hewlett-Packard, IBM, Intel and Microsoft, spent more on stock buybacks than on research and development. Big Pharma (Amgen, Johnson & Johnson, Merck and Pfizer), while justifying high drug prices by the need to pay for researching new drugs, had huge stock repurchase programs. Amgen’s buyback-to-profit ratio was 1.16 to 1 during the 2000-2008 years. [William Lazonick, professor at the University of Massachusetts, Business Week, August 24&31, 2009, page 096]
Why do American corporations spend so much buying back their own shares? They will say things like “Our shares represent the best value for a return on investment” or “We can best serve our shareowners by supporting the market for their shares.” The real reason is often that managers are exercising stock options they have been granted as compensation. They spend their employer’s money to keep the price up while they exercise their personal options and resell the shares into the market.
The myth that Wall Street investment bankers raise money to grow business is just that—a myth. What they really do is move money and securities around among the players, taking sizeable chunks for themselves, like a giant shell game. As Steven Pearlstein commented, “the best approach to Wall Street might be to simply ignore it and turn our attention to those parts of the economy that can create real economic value and broadly shared prosperity.” [Steven Pearlstein, “Blaming Wall Street on bonuses is hypocritical,” Washington Post, January 15, 2010] The next section, “Direct Investing Routes Open Now,” describes the progress already made in bypassing Wall Street.