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Bypassing Wall Street
Where is Wall Street and Who Works There?
Most of us hear and see “Wall Street” nearly every day. On television news, a report will begin “On Wall Street today . . ..” The business print media is dominated by The Wall Street Journal. For most of us, “Wall Street” is shorthand for a mysterious complex that comes between the people who provide money for investment and the people who use that money. It even takes on its own personality, as in “Wall Street reacted by . . ..”
Wall Street, the place, was named after the wall built to keep invaders out of New York City’s lower Manhattan. Wall Street, the people, were brokers and speculators in stocks and bonds, who first met in coffee shops along Wall Street to trade in securities. They had no formal organization or rules and the auctions for stocks were open to anyone. That changed when one of them created an economic panic from speculating on insider information and ended up in debtors’ prison. The New York legislature outlawed “public stock auctions.” The way to get around the new law prohibiting public stock auctions was to make them a private affair, no longer open to the “public.” After the one stockbroker went to prison, the remaining 24 gathered under a buttonwood tree in 1792, to start the New York Stock Exchange. Its members met at Tontine’s Coffee House to call out the price they were willing to pay for a security (the bid) and the price they would take to sell (the offer).
Wall Street’s Monopoly
The so-called Buttonwood Agreement was a single sentence: “We the Subscribers, Brokers for the Purchase and Sale of Public Stock, do herby solemnly promise and pledge ourselves to each other, that we will not buy or sell from this day for any person whatsoever any kind of Public Stock, at a less rate than one-quarter per cent Commission on the Specie value of, and that we will give a preference to each other in our Negotiations.” [Marshall E. Blume, Jeremy J. Siegel and Dan Rottenberg, Revolution on Wall Street, W. W. Norton & Company, 1993, page 23] These last few words established the monopoly that is today enforced by the federal government, the monopoly rule that only brokers accepted as members can trade in stocks and they can only trade among themselves. Non-member brokers met outside, on “the curb,” to trade in unlisted shares. They later formed the American Stock Exchange, which is also a members-only market. [Charles R. Geisst, Wall Street: A History, Oxford University Press, 1997, pages 10-21.] Only broker-members could buy or sell through the exchanges. Fixed commissions, rather than price competition, were the rule at the very start.
In the 1930s, when government regulation came to Wall Street, Congress defined "exchange" to include “a group of persons . . . which provides . . . a market place or facilities for bringing together purchasers and sellers of securities.” [Securities Exchange Act of 1934, section 3(a)(1), http://taft.law.uc.edu/CCL/34Act/index.html] This definition reflected the history of trading in securities before modern tools of information technology, back when "economy of time and labor, as well as a theoretically perfect market, could be best secured by an organization under one roof of as many dealers in a commodity as could be found." [William C. Van Antwerp, The Stock Exchange from Within, Doubleday, Page & Company, 1913, page 6.] There had been over a hundred stock exchanges in 1900, when the media for communications and delivery were still costly and unreliable. Today, there are effectively only two stock exchanges dealing with individual orders, the New York Stock Exchange and NASDAQ.
After the Securities Exchange Act of 1934, the monopoly expanded from exchange members to all brokers and dealers who registered with the Securities and Exchange Commission. Anyone trespassing on the turf of registered broker-dealers could be prosecuted by the SEC and state securities administrators. For a humorous depiction of how the broker monopoly operated back then, see, Fred Schwed, Jr., Where are the Customers' Yachts? A Good Hard Look at Wall Street, Simon & Schuster, 1940, 1955 and George Goodman, under the pseudonym "Adam Smith," The Money Game: How it is played in Wall Street, what money really is, what we think it is and how it makes us behave, Random House, 1967]
Wall Street Expands Beyond Stocks and Beyond New York
Wall Street was all about stocks and bonds until the 1970s, when Chicago became part of Wall Street. Chicago brokers had developed markets for trading futures contracts on agricultural products and they were looking for other products. In 1972, a Chicago Mercantile Exchange broker began trading futures contracts on foreign currency exchange rates. Financial futures quickly became the major business for the Chicago markets. [Scott Patterson, The Quants, Crown Business, 2010, page 39] They led the way to the invention of more “derivatives,” the securities that derive their price from what is happening with another security.
Today, Wall Street has come to stand for high finance, the movement of monetary symbols among governments, corporations and the wealthy. The people who work on Wall Street are practitioners of arcane games that use money as a marker. These are “zero sum” games, where one player’s winnings are another’s losses. Only a very few of those games actually involve the transfer of money from investors for use in operating businesses. As Eugene Robinson put it: “Wall Street's theoretical role is to allocate capital most efficiently to the companies that can make the best use of it. Wall Street's actual role is more like that of a giant casino where the gamblers are rewarded for taking outrageous, unconscionable risks with other people's money. If the bets pay off, the gamblers win. If the long-shot bets turn out to have been foolish, we're the ones who lose. . . . The main event is making Wall Street serve the economy again, rather than the other way around. Putting more security cameras around the casino isn't nearly enough.” [Eugene Robinson, “The Wall Street Casino, Back in Business,” The Washington Post, September 15, 2009, www.washingtonpost.com/wp-dyn/content/article/2009/09/14/AR2009091402709.html?hpid=opinionsbox1]
Wall Street Ignores the Middle Class
In Wall Street’s earlier days, it served as a bridge from wealthy individuals to entrepreneurs who had plans that needed capital. Financial intermediaries were useful in finding and matching family money with entrepreneurial talent. On the supply side were families with far more money than they’d need for immediate financial security. They wanted to put that money to work for them, to pay for their chosen lifestyle and build more wealth. Taking on the chance of losing some of their capital was acceptable, if the projected returns looked to be worth the risk. Sometimes, they had financial advisers they paid to investigate and analyze this risk/return ratio.
Demand for the use of other people's money first came from governments that wanted to acquire territory or wage wars. Later it also came from private companies that built ships, canals and railroads. This flow of capital through Wall Street, between very rich individuals and business managers, is the picture of capitalism as it existed in the time of Karl Marx and other critics. The middle class, the bourgeoisie, had modest capital needs for their businesses, farms and professions. They could get by with savings, bank borrowings and direct financial arrangements with family and acquaintances.
By the time the middle class began to have some money it could save, entrepreneurs were launching new businesses, based on technological advances and expanded markets. Wall Street could have expanded its services to deal directly with the money supply from this broader level of families with disposable income. It could have been the channel from a growing middle class to emerging business ventures.
The model for this evolution on Wall Street was right around the corner in retail banking. Commercial banks once accepted deposits only from those wealthy enough to maintain very substantial balances. They lent money only to governments and large businesses. But most banks adapted to a society in which there were more than the very rich and the poor and they evolved into providing services to nearly everyone. The people who dealt with securities did not. They chose to ignore the supply of money from new middle class families and the demand from the developers of new business ventures. What happened instead was that Wall Street continued to do business with people who had the largest amounts of money to invest or to use.
Buy Side Money Managers Join Wall Street
Because Wall Street chose not to gather money directly from the middle class, another layer of financial intermediaries was created, to control the flow of capital and gather fees as it went through the channels. Mutual funds were created to bundle the money from middle class families and invest it in ways picked by the fund managers. This created Wall Street’s “buy side,” the professional money managers who accumulate money from individuals and use it to buy investment products from the “sell side” of Wall Street. [Marshall E. Blume and Irwin Friend, The Changing Role of the Individual Investor, A Twentieth Century Fund Report, John Wiley & Sons, 1978]
The great majority of those working on Wall Street are sell side financial intermediaries, acting as agents for their clients and customers. Brokers and investment bankers dominate the sell side. They have combined selling new issues of securities with running a market for investors to resell securities, where they trade for themselves as well as for their customers. Members of the buy side include money managers for mutual funds, pension funds, endowments and the other funds. The big name securities firms have departments on both sides of the Street.
Running between the two sides of the Street are all of the lawyers, accountants, rating agencies and other support services. It is this entire network that is called into play when we refer to what happens on Wall Street.
Wall Street Transfers Risk onto its Customers
Some financial intermediaries are simply matchmakers, acting as a go-between for people who have money to put to work and people who want to use money in their business. They provide an introduction service and some advice on the mechanics. Others are strictly brokers, limiting themselves to being agents for buyers and sellers of existing financial products. The major financial intermediaries, like investment banks and commercial banks, are also agents of change in the characteristics of the money that passes through them. They serve purposes similar to electrical transformers which alter the voltage between the generator and the user. Financial intermediaries theoretically transform the denomination, the maturity and the risk. We say “theoretically” because Wall Street has found ways to abandon its transformation role, to pass on those risks to the providers or users of money.
Denomination transformation usually means taking in money in small amounts and lending or investing it in much larger amounts.
Maturity transformation is generally accepting money that can be returned on demand or other short-term period and making long-term loans and investments.
Risk transformation is a little more complex. The concept is that the risk of not getting a return of the money is placed on the intermediary. The person providing the money to the intermediary is protected from borrower defaults, changes in interest rates or other market conditions. Risk transformation is also provided to those who receive money from financial intermediaries. They, of course, bear all the risks of how they use the money and whether they will generate the cash flow to meet payment terms. But they have been protected from changes in interest rates and fluctuations in the money markets. Think of the individual with a savings account at a bank. So long as the bank itself is operating, the money they’ve deposited can be withdrawn at any time. The interest rate will stay the same and they don’t need to worry about whether the money will be there when they want it. Meanwhile, the bank will be making loans on very different terms, taking on the risks from interest rate and maturity differences, as well as the risk that a borrower will fail to repay.
In recent years, financial intermediaries have largely abandoned their roles in risk transformation, first with the risk of interest rate changes and then with the risk of default. The interest rate shift of risk began after Paul Volcker was appointed Chairman of the Federal Reserve Board in 1979 and undertook to cleanse the economy of stagflation. Financial intermediaries’ cost of money, measured by one-month certificates of deposit, went from less than 6% in 1977 to 16% in 1981. Banks raised their prime rate in that period from 7% to 19% and rates on new 30-year mortgages rose from 9% to 17%. [Federal Reserve Statistical Release H.15, Selected Interest Rates, www.federalreserve.gov/releases/h15/data.htm] The jolt was especially strong for intermediaries, like savings banks, who took in short-term deposits and held 30-year fixed-rate loans. Savings banks managers were said to have been following the “Rule of Three:” take money in at three percent, lend it out at three percentage points higher and be on the golf course by three in the afternoon. (I remember long, desperate discussions with our law firm clients over what they could do when that three percent positive spread in rates had become a twelve percent negative spread. Should they refuse to accept deposits at the much higher rate? Should they sell their fixed-rate mortgages and take a huge loss now? Should they aggressively seek new money and invest it in short-term U.S. treasury securities at a positive spread, to offset some of the losses on their loan portfolio? Were there any hedging techniques that would help? In the future, how could they shift the interest rate risk back onto the depositors or forward onto the borrowers?)
The principal result was introduction of the adjustable rate mortgage. The new instrument shifted most of the risk of interest rate fluctuations onto the borrowers. It took some time to develop industry standards for the new loan structures and fixed-rate loans have remained as an alternative. There were people who questioned whether it was right for savings banks to abandon their role as absorbing the risk of interest rate changes, arguing that they were in the money borrowing and lending business and should find ways to deal with the risk, rather than pushing it on to their customers. (I was at a conference in the early 80s about the new mortgage instruments. In the audience was Martin Mayer, author of many books on finance and a guest scholar at the Brookings Institute. He asked the panel, as I recall, “If this industry is not about risk transformation, what is it about?” The panel went back to discussing the characteristics of ARMs.)
Having abandoned much of the interest rate risk, savings bank managers were ready when Wall Street proposed to relieve them of their role in transforming the risk of default, together with transforming maturity. Wall Street’s proposal was to bundle a group of mortgage loans and sell them as mortgage securities. The disastrous consequences of Wall Street’s handling of mortgage securities are a separate subject in the chapter on “The Harm That Wall Street Causes.” What it did to banks was to strip them of a major economic function, transforming risk and maturity, and turn them into brokers. In a Wall Street Journal article, Eleanor Laise said, “In the process, risks previously borne by big banks . . . have been placed squarely on the shoulders of consumers.” [“Some Consumers Say Wall Street Failed Them,” November 21, 2008, page B1. The article quotes from Jacob Hacker, author of The Great Risk Shift, Oxford University Press, 2006.]
Like commercial banks, Wall Street’s investment bankers have also abandoned their role of transforming risk. Their principal reason for being was to provide assurance that a proposed underwritten sale of its bonds or stocks would actually happen. As described in chapter two, the term “underwriter” came about when businesses wanted to go forward with their plans for the new money they were raising, without waiting for the public offering to close. It could be weeks or even months between the agreement to sell an amount of securities and the closing, when investors delivered the money. Investment banking firms gathered their own capital base, so they could stand behind their promise that the money would be there.
As power shifted from the businesses issuing securities to the investment bankers who sold them, the time became shorter between signing the underwriting agreement and delivering the money at closing. For the last fifty years, the “firm commitment” underwriting agreement has been signed only a few hours before the sales to investors was confirmed. While all the preparation and selling efforts take place, there is only a “letter of intent.” It very clearly does not commit the underwriters to go through with the offering and purchase any shares. The only binding part is that the issuer will pay the underwriter’s expenses if it is not completed. Even when the underwriting agreement is signed, there is a “market out” clause, letting the investment bankers cancel the transaction if any of the named events has happened. That list of events has grown over the years. As a result, investment bankers have abandoned virtually the entire risk that created securities underwritings to begin with. Wall Street has shifted the risk back to the issuer. The so-called “underwriters” are now just like a consignment store—if the shares sell, the company gets its money and the investment bankers get their commission. If the shares don’t sell, the issuer is out the time and cost. Except for the rituals, the “firm commitment” underwriting has become the same as the “best efforts” selling role, where a licensed securities broker agrees to use its best efforts to sell the entire offering but makes no guarantee. Calling it a firm commitment opens an easier path with regulators and exchanges, who will waive requirements if it is a “firm commitment” underwriting.
Wall Street Becomes a Casino
Wall Street has become a closed system. The flow of capital is from professional money managers to the officers of large corporations owned by the money managers. The sell side and buy side intermediaries collect the money and pass it on, subtracting a small percentage for their service. It’s like a conveyor belt of money, with Wall Street taking a little bit out of each dollar that goes by. But that capital flow, once what Wall Street was all about, has become a small part of Wall Street’s business. The rest of it is running a casino for betting on the price movement of manufactured contracts, still called “securities.”
Of course, it gets extremely complex, intricate, sophisticated. That is part of the mystique. Only Wall Street insiders can begin to understand what goes on there. The rest of us appear to have no alternative but to trust that they know what they’re doing with our money and our world economy. Our purpose in describing Wall Street, the harm it causes and the ineffectiveness of the regulators, is to put a context around the suggestion that we bypass Wall Street in raising capital and investing in businesses and governments.
Wall Street’s biggest business, the one that most affects us all, is the buying and selling of contracts that go up and down in their market price. At the most basic, these contracts are shares of common stock or bonds. Most shares of common stock represent ownership in huge corporations. Once upon a time, these shares were sold by the corporations for the purpose of raising capital to grow the business. The buyers hoped the corporation would someday pay out a portion of its earnings in dividends, providing them with a much higher return than they would have gotten from leaving their money in bank deposits. They also expected that their shares would increase in value as the corporation grew and prospered, allowing them to one day sell the shares at a price far more than they had paid.
The prudent investor would also consider buying bonds. These are contracts to repay the amount invested on specific dates and to pay a rate of interest on the bond amount. If the corporation doesn’t perform so well, the investor owning a bond is more likely to get back the money paid than the investor owning shares of common stock. The other major difference between bonds and stocks is that interest on bonds is a contractual obligation, while dividends on common stock are paid only if the corporation’s board votes to do so. An investor taking the long view will study the risks and the returns for a corporation’s stock or bonds and make a decision about what fits the investor’s personal objectives and tolerances.
Now imagine you are looking not at what meets the needs of investors or of businesses, but only at what is in the best interests of Wall Street. If investors are buying stocks and bonds to hold for several years, there is very little in it for the intermediaries. The sell side of Wall Street gets a commission or trading profit only when there is a transaction. On the buy side, growth of the assets under management is based upon the manager’s performance, compared to its peers in the business. Measurement is on a quarter-to-quarter basis, so there is frequent buying and selling. Most fund managers get their tips from brokers, on expected short-term price movements. They pay for these tips by directing their trades to the brokers who deliver nonpublic information that lets them get the jump on their competitor managers. Holding on for the long term is not the way either the sell or buy side does business.
Nearly all the buying and selling of securities on Wall Street involves either stocks and bonds issued by corporations or derivative securities issued by intermediaries. That means that Wall Street makes most of its money from the buying and selling of “previously-owned” securities, not anything that actually moves money from investors to operating businesses. Before May 1, 1975, the principal way that Wall Street got paid was through commissions on trades made for customers. Most of the active securities at that time were listed on the New York Stock Exchange. Since the “Big Board” began in 1792, commission rates had been fixed—any broker caught discounting a commission would be expelled from the Exchange. There was no price competition allowed.
It was the fixed commission rates that brought out the political power of Wall Street’s buy side. Money managers for big pension funds, mutual funds and other institutions lobbied Congress to end the monopoly pricing. In fact, the lure of institutional business had caused many brokers to find ways to rebate part of the commissions they received. This raised difficult enforcement issues and softened the sell side resistance to abolishing fixed rates. Congress finally opened commission rate competition on “Mayday” 1975.
Chris Welles published a book in 1975, just as the SEC finally ended fixed commission rates. [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. Chris Welles died at 72 in 2010.] He predicted that the sell side, brokers, would fade away, that “the era of the great Wall Street Club will come to a close.” [page xi] In its place, Welles predicted that the money managers for institutions “will soon dominate financial power in this country. The members of this new Club may well massively abuse their power in ways that will make the transgressions of the old Club seem like minor stock fraud.” [Ibid.] What Welles did not foresee was that the old Club members would move over to occupy the new Club as well. Nor could he have known that trading for themselves, and inventing new games with derivatives, would become more important to the old Club than brokering trades for commissions.
Both sides of Wall Street watched as the big winnings began to go to the intermediaries who put their own money into the game. Trading for the firm’s own account became more profitable than acting as a broker or money manager for clients.
Wall Street Partnerships Become Corporations
Long after most large businesses were operated as corporations, Wall Street firms proudly remained partnerships. Staying in the partnership form was a statement to all who dealt with Wall Street: “You can trust us, because each partner’s wealth and reputation stand behind our every transaction.” If a corporation officer makes a huge mistake, or commits fraud, that officer and the corporation can be made to pay. But all other officers are insulated from any loss, except the value of the shares they may own in their employer. In sharp contrast, the mistakes or felonies of a partner can put every other partner’s assets and freedom on the line.
Wall Street’s sell side had seen their clients start or finance new businesses and then take them public for massive capital gains. They saw how they could continue to run their businesses and get even greater compensation, armed with great pools of money to expand and acquire. Wall Street brokers and investment bankers changed their attitude. Going public as corporations became more important than retaining the partnership image and privacy. Their partners’ profits could simply be replaced by corporate bonuses, skimming off all but the leftovers for shareowners. That put the officers/former partners at war with their shareowners. [Susanne Craig, “Goldman Holders Miffed at Bonuses,” The Wall Street Journal, November 20, 2009, page C1]
We all paid a price for Wall Street going public. One price was the loss of investment advisors, and their replacement with casino managers and sellers of manufactured securities. “The decision of the brokerage houses to sell their clientele products rather than services grows out of the shift from the partnership to the corporate form, and the demand from the firms’ own stockholders for a greater degree of stability in earnings than the delivery of personal services can promise.” [Martin Mayer, Stealing the Market: How the Giant Brokerage Firms, with Help from the SEC, Stole the Stock Market from Investors, BasicBooks, 1992, page 12.] Another huge price was the Great Recession of 2008, which can, at least in part, be attributed to this change, since "the public ownership structure of major firms meant that all the borrowing and bets were done with other people's money. Wall Street's old privately owned investment partnerships would never have wagered their net worth on so much risky junk." Matt Miller, "Rescuing Capitalism from Wall Street," Washington Post, April 8, 2010, [www.washingtonpost.com/wp-dyn/content/article/2010/04/07/AR2010040702494.html?hpid=opinionsbox1] Michael Lewis graphically describes the harmful effects of Wall Street partnerships becoming corporations in The Big Short: Inside the Doomsday Machine. [W.W.l Norton & Company, 2010, pages 257-259]
Buy Side Money Managers Become Entrepreneurs
Wall Street’s buy side began with insurance companies and endowment funds for universities, hospitals and other charitable organizations. During World War II, corporations started pension funds, as a way to attract and hold employees during a time of government wage controls. Since there was a 93 percent tax on “excess profits,” the deduction for pension plan contributions made them a cheap way to get extra compensation to employees. The pension contributions were not taxable to the employees, so the effect was that taxpayers as a whole were subsidizing the transfer of money from employers to their employees. These were “defined benefit” programs, so that large pools of managed money were built to fund a promised level of retirement payments. Buy side money managers became a new professional group.
Mutual funds, which had been minor players since 1924, became huge and active investors in the 1970s. Their marketing concept was that the small investor could get diversification and professional management. Individual Retirement Accounts and other tax programs had been created to take the place of the diminishing corporate pension funds. Suddenly, individuals were responsible for their own investment decisions and most of them turned their money over to mutual funds.
Wall Street’s buy side became the professional money managers for all these institutions. Their share of trading on the New York Stock Exchange went from only 20 percent in 1950 to 75 percent by 1975. [Marshall E. Blume, Jeremy J. Siegel and Dan Rottenberg, Revolution on Wall Street, W. W. Norton & Company, 1993, page 105] By the 1990s, money managers were earning extraordinary compensation from the trading profits they maneuvered for the funds they ran. They had gone from salaried professionals to commissioned performers. But real wealth came not from management fees, even based upon percentage compensation. Money managers left their employers and started their own mutual funds and, later, hedge funds, where they could have ownership of the business and get large incentive payments taxed as capital gains.
Wall Street Dominates the Economy and Government
Whether cause or coincidence, the 30 years after Wall Street went corporate and entrepreneurial have seen it come to dominate our economy and set unimaginable heights of personal compensation. “From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.” [Simon Johnson, “The Quiet Coup,” The Atlantic, May 2009, www.theatlantic.com/doc/200905/imf-advice. See, also, Benjamin Friedman, "Is our financial system serving us well?", Daedalus: Journal of the American Academy of Arts and Sciences, Fall 2010, page 9, http://www.mitpressjournals.org/doi/pdf/10.1162/DAED_e_00037]
That 30 years has also seen the nearly complete deregulation of Wall Street, the dismantling of the protections put into place by the New Deal. For a very detailed account of the “12 Deregulatory Steps to Financial Meltdown,” you may read the March 2009 report, by Essential Information and the Consumer Education Foundation. [Robert Weissman and James Donahue, Sold Out: How Wall Street and Washington Betrayed America, Essential Information*Consumer Education Foundation, www.wallstreetwatch.org, March 2009, www.wallstreetwatch.org/reports/sold_out.pdf]
When money passes from individuals through Wall Street’s buy side and sell side, it undergoes a transmogrification, a drastic change in uses and purposes. Individuals have no ability to direct how their money will ultimately be used. It is Wall Street values that determine where money will go and on what terms. This closed financing system limits practices and restrains innovation. Capital has to go through rigid structures, dominated by a few people who know each other and think alike. They gather capital from diverse sources and funnel it through their own structures, reflecting their values and their limited frames of reference.
Most of us still have the image of Wall Street as an impartial channel for money passing from individuals to growing businesses. We need to have our images catch up with today’s reality. “Where is Wall Street and Who Works There” is very different today.
Wall Street Keeps Its Monopoly on Public Offerings
The Wall Street intermediaries who have owned the public offerings business are the investment bankers. The scholarly history of investment banking says that the investment banker’s “job is to serve the users and suppliers of capital by providing the facilities through which savings are channeled into long-term investment.” [Vincent Carosso, Investment Banking in America: A History, Harvard University Press, 1970, page ix.] Investment bankers are part of securities broker-dealer firms, the “members only” club through which all public securities transactions must pass. For over fifty years, their oligopoly has had the protection and regulation of the federal Securities and Exchange Commission. In late 2008, the remaining members of the club became parts of bank holding companies, to have additional funding and regulation by the Federal Reserve Banks and its Board of Governors.
(I’ve had 50 years experience as a securities lawyer and certified public accountant. The part I know most about, the role that really interests me, is how businesses raise money by selling their securities to large numbers of individual investors. Unfortunately, these public offerings of newly issued securities to individuals have turned out to be a very minor part of Wall Street’s total business. Raising capital for business is heavily overshadowed by trading in previously-owned securities and in the derivative securities that don’t raise money for anyone. New issues are now sold predominantly to money managers for investment funds. Today’s initial public offerings are usually well over $100 million each. Rather than being the young businesses that would be the future economy, they often are divisions of giant corporations being spun off or being resold after purchase by a private equity company. [Lynn Cowan, “Private-Equity Exits Are Seen Dominating 2010 IPOs,” The Wall Street Journal, January 11, 2010, page C3] )
Wall Street still sells new issues of securities in public offerings. It’s very profitable, because it is the last holdout for the fixed commission, the flat percentage fee that is the same rate no matter how large the transaction.. There is no price competition among the investment banking departments of the major securities broker-dealers, including the commercial banks who are back after repeal of the Banking Act of 1933. Nor have there been any successful inroads by other financial intermediaries.
Because they have an oligopoly, the investment bankers have no incentive to improve the way they do business. A public offering underwriting operates as if the last technological advance ever made was the telephone. You’d think that the Internet would force a change in how public offerings are conducted. But look at this following descriptions of attempts by Charles Schwab and E*Trade to circumvent Wall Street’s antiquated methods [From article by Patrick McGeehan, “New-Era Banks Slip Into the Past,” The New York Times, June 22, 2001]:
In the mid-90s, The Charles Schwab Corporation started Epoch Partners, an online investment bank that would cater to individual investors. Schwab shared ownership of the startup with two competing online brokerage firms, TD Waterhouse and Ameritrade. They gave up in 2001 and sold the firm to Goldman, Sachs Group. According to David S. Pottruck, then Schwab’s co-chief executive, "It was just not going to happen for us to reinvent the investment banking business. There's much too strong an in-place structure to that industry." To sell Epoch Partners, Schwab and TD Waterhouse gave Goldman Sachs access to their more than 10 million customers for selling underwritten offerings.
E*Trade Group had started E*Offering to do online offerings of new issues. They sold it in 2000 to WIT Soundview (later called Soundview Technology Group) which was acquired in 2004 by The Charles Schwab Corporation and now just provides services to securities broker-dealers. [www.sec.gov/Archives/edgar/data/316709/000109230604000031/schedule13d.txt]
Other new online investment banks also faded away. According to The New York Times reporter, Patrick McGeehan, “Despite the criticism that has been heaped on the major investment banks for how they handled initial offerings in the late 1990's, the old rules still apply and the old rulers still apply them. . . . In 1999 and 2000, six online firms managed 196 stock offerings that raised almost $30 billion, according to Thomson Financial Securities Data. So far this year [through June 2001], three of them, including Epoch, have participated in seven offerings that raised slightly more than $1 billion.”
The one remaining investment bank with an online emphasis is W. R. Hambrecht & Company. Bill Hambrecht had built the very successful technology stock firm, Hambrecht and Quist, from 1968 until was sold it in 1999 to J.P. Morgan Chase. Bill then founded W. R. Hambrecht & Co., where he introduced using the Dutch auction for new securities offerings. It operates very much like a conventional underwriting, with two differences.
Like a conventional underwriting, Hambrecht, as managing underwriter, sets a price range for the expected offering a few weeks before it is to be sold. Conventional underwriters subjectively arrive at the final price by talking with their largest institutional money manager prospects, at “road show” or one-to-one conversations, effectively gathering informal, oral bids for shares. Hambrecht lets any brokerage customer place an emailed bid for shares at any price within the range. The final price is the one at which enough bids can be accepted to complete the offering. Everyone who bid at the final price or a higher number receives shares, at the final price.
The other difference is that Hambrecht includes individual “retail” investors in the bidding process. Customers of the brokerage firm are emailed announcements of the offering and can access the preliminary prospectus before submitting a bid. Bill Hambrecht’s reputation, network of acquaintances and persistence have kept the underwriting business going, including taking the lead for Google’s IPO. Unlike some of the failed online investment bank ventures, Bill Hambrecht has never counted on being included in underwriting syndicates managed by the major investment banks. His firm has been the managing underwriter for offerings, not making the mistake of thinking "that if you had distribution, the underwriters would cut you into the business. It's a wonderfully profitable business for the big firms. They're the last guys that want to change it." [quoted in the article by Patrick McGeehan.]
Hedge Funds Hedge funds became major players in Wall Street’s buy side, largely because they could do things that others could not. They are structured like mutual funds, gathering money from many persons under one manager. But they use that money in all the ways that mutual funds are forbidden to do. They get away with it by weaving their structures to fit specific exemptions from the Investment Company Act of 1939. By 2009, there were 18,450 distinct hedge funds reporting performance data, a decline from the year before. These funds had total assets of $1.41 trillion, down from the 2007 peak of over $2 million. [PerTrac 2009 Hedge Fund Database Study, http://www.pertrac.com/PER0020/WEB/localdata/WEB/DATA/WEBSECTIONS]MATTACHMENT/PER0020_1368//PerTrac%202009%20Hedge%20Fund%20Database%20Study.pdf
Part of the New Deal legislation, the ICA was aimed at the investment trusts which flopped so dramatically in the 1929 Crash. The law required that investment companies register with the SEC and provide prospectuses to all prospective investors. There are several restrictions on the kinds of investments that can be made, to minimize the risk of loss from speculation. The investments also must have an active market, so they can be sold quickly to pay investors who want their money back. Two critical restrictions from the ICA are most behind the hedge fund industry. One is that a mutual fund manager may only be paid a flat percentage of the amount in the fund. There is no sharing in the profits or other performance fee allowed. The other is that the fund can’t borrow any money. Most professional investors, even the heavily regulated banks, invest many times more than the amount they have from investors. They “leverage” that base by borrowing. The interest due on the borrowings is supposed to be less than what they can earn by investing the extra cash.
Hedge funds are completely free of these restrictions, as well as all the other limitations of the ICA. They pay their managers big percentages of the profits (which have been taxed at 15% capital gains rates). Most hedge funds borrow as much as they possibly can. And they invest in absolutely any financial instrument that is presented to them, if it meets their risk/reward analysis. [For the beginnings of hedge funds, see Scott Patterson, The Quants, Crown Business, 2010, pages 33-35]
Their name, “hedge funds,” is a bit misleading. The investing technique of hedging is a way to offset or neutralize the risk on one investment by also purchasing another. It may mean buying shares in a technology company while also signing up for a put option on an index of technology stocks. If the individual shares go down because of a tech selloff, the put option will have increased in price. This is a strategy that an individual, or a pension fund manager might use. But hedge funds are into increasing risk, not reducing it. They are more likely to find ways to increase the amount of their bet on an outcome that results from their unique insight. However, they use hedging to neutralize all the risks in an investment, except the one that they have figured out will work for them.
One of the two ICA exemptions used is for funds that have no more than 100 investors. [Section 3(c)(1)] The other exempts a fund held by no more than 500 “qualified purchasers.” [Section 3(c)(7)] They include an individual who owns at least $5 million in investments and institutions with at least $25 million in investments.
Hedge fund managers play every game that can be found on Wall Street. Some are technical games, like arbitrage, where simultaneous purchases and sales of securities are made in different markets when there is a miniscule price difference. Some are fundamental analysis, like predicting that a particular company is about to have an event that will cause a sudden move in the price of its securities. These predictions often get some help from spreading rumors and enlisting allies. Then there is the ancient game of trading on insider information.
The first hedge fund is said to have been started by Alfred Winslow Jones in 1949. [Sebastian Mallaby, Senior Fellow for International Economics at the Council on Foreign Relations and author of More Money Than God: Hedge Funds and the Making of a New Elite, Penguin Press, 2010, in "Learning to Love Hedge Funds," The Wall Street Journal, June 12-13, 2010, page W1] They quickly grew in number to over 10,000 separate funds. Several hedge fund managers received over a billion dollars in annual fees, from sharing in the results of their funds. The standard compensation agreement for managers is 2% of the amount in the fund and 20% of the profits. In 2007, that brought $3.7 billion in pay to John Paulson, the highest-earning hedge fund manager. In second place was George Soros, one of the very first and most successful, who earned $2.9 billion for the year. Average pay for the top 25 fund managers was $892 million in 2007. To make the bottom of the list took compensation of $210 million. [Institutional Investor Alpha Magazine, as reported by Bloomberg, www.bloomberg.com/apps/news?pid=20601087&sid=a0OfuYxe7n7g&refer=home; For more description of hedge funds, see Gregory Zuckerman, “Shakeout Roils Hedge-Fund World," The Wall Street Journal, June 17, 2008, http://online.wsj.com/article/SB121364877315978651.html].
It has not only been the hedge fund managers who have scored great wealth from hedge fund operations. Banks and brokers provide capital and support services to hedge funds. Called Prime Brokerage, it includes executing and clearing trades, bookkeeping, preparing reports, keeping custody of securities and cash, borrowing securities for short sales and providing research. These are just add-ons to the two basic services. One is lending huge amounts of money for hedge funds to take their positions. The other is to recruit new investors for the hedge funds.
As the relationship between hedge fund managers and their prime brokers expands, the “research” and financing take on new meaning. Banks and brokers make their own moves in the markets, although they are far more restricted in what they can do. Once there is an inner circle closeness, the prime broker can pass information and lend money to the hedge fund, so that it can make a transaction that the prime broker couldn’t lawfully do itself. Ways are found for the hedge fund to pay the prime broker, sharing some of the gain from the transaction. “Reportedly, the prime broker banks get up to 20 percent to 30 percent of their total bank revenues from hedge funds . . ..” [Charles R. Morris, The Trillion Dollar Meltdown, PublicAffairs, 2008, page 111]
Rating agencies Before the 1970s, securities rating agencies were about as important as the people who sew labels onto clothing. They existed to judge the risk that bond issuers would default on their duty to pay interest on time or return the principal when due. Certain institutional investors were limited to purchasing only the highest rated bonds from corporations or governments.
When Wall Street began marketing new securities, especially those packaging mortgages, it was especially important to get an “investment grade” rating from Standard & Poor’s or Moody’s, the two principal rating agencies. These new securities were far more complex than the simple promise to pay by a corporate or government borrower. Few money managers would be willing to do all the work necessary to understand and evaluate the quality of a few thousand loans, or the legal niceties of a 150-page bond indenture.
Rating agencies were persuaded to begin rating mortgage-backed bonds, which were like a corporate bond, with a pool of loans as collateral for extra assurance that the bond was good. Once comfortable with these, rating agencies were willing to rate interests in the pools of loans themselves, known as pass-through certificates. Finally, ratings could be had for the collateralized mortgage obligations and many variations.
Rating agencies are paid by the issuers of the securities they rate. This, by itself, is not necessarily a compromising arrangement. Audit firms are paid by the businesses they audit, even though lenders and investors rely upon their audit opinions. For rating agencies, it is the relationship with the handful of investment bankers and their lawyers that may have led to a breakdown in their analytical independence.
Insurance companies Most debt securities could never get favorable results from a rating agency without some form of third-party credit. Sometimes, a parent company could guarantee its subsidiary’s performance. More often, the backing was purchased from an insurance company. The rating agency would rely on the insurance company’s own financial condition, which needed to support a top rating. As insurance companies kept up with the boom in asset-backed securities, their exposure to risk grew phenomenally. For some reason, the rating agencies didn’t let this affect their decisions.
Counterparties to credit default swaps Insurance companies could never handle all the debt structures that Wall Street was inventing. The answer was to leave out the word “insurance” and let others into the role of promising to cover any defaults by borrowers. Brokers began arranging for a “counterparty” to take over the investor’s risk, calling it a “credit default swap.” According to Charles Morris, the amount of credit default swap contracts went from $1 trillion in 2001 to $45 trillion in 2007. Banks were the counterparties on $18 trillion and hedge funds were for $15 trillion. [Charles R. Morris, The Trillion Dollar Meltdown, Public Affairs, 2008, page 125] Somehow, people tended to ignore the possibility that several big borrowers could default or, even more significantly, that a counterparty would have gotten in way over its ability to make good on its promises.
Venture Capital Becomes Another Wall Street Money Manager
In the 1950s and 1960s, venture capital firms were run by wealthy individuals who put together pools of capital from people like themselves. They were averaging higher returns than investing in traded securities and someone got the idea of gathering really big money from university endowments and other institutional money managers who were into “total return” investing. As a result, venture capitalists have become money managers for institutional investors, feeding their investments into the sell side for public offerings or acquisitions. Less than 2% of the money in venture capital funds comes from the managers, who take fees equal to 2% of the total fund amount plus 20% of profits when an investment is cashed out. Plenty of information is available about venture capitalists and their investments, from the National Venture Capital Association and PricewaterhouseCoopers. [www.nvca.org and https://www.pwcmoneytree.com/MTPublic/ns/nav.jsp?page=notice&iden=B]
The results of going after big money were first a big increase in venture capital investing, to 1.1% of U.S. Gross Domestic Product in 2000, followed by a continuing decline. The need to produce short-term returns for institutional investors has meant investing in later stage companies and exiting the investment much sooner. Since 1997, investors have actually lost money in venture capital funds, after paying the managers’ fees. [Carl Schramm, president of the Kauffman Foundation, and Harold Bradley, its chief investment officer, “How Venture Capital Lost Its Way,” Business Week, November 30, 2009, page 080. See John Jannarone, "Venture Capital Could Shrivel Away," The Wall Street Journal, July 19, 2010, page C8] Some new firms are going back to the original model. [Spencer E. Ante, “’Super Angels’ Shake up Venture Capital,” Business Week, May 21, 2009, www.businessweek.com/technology/content/sep2009/tc20090915_065038.htm?link_position=link27 and Spencer E. Ante, “Mint.com: Nurtured by Super-Angel VCs,” Business Week, September 15, 2009, www.businessweek.com/technology/content/sep2009/tc20090915_065038.htm?link_position=link27]
One summary of Wall Street: "In a soundbite, the U.S. financial system performs dismally at its advertised task, that of efficiently directing society's savings towards their optimal investment pursuits. The system is stupefyingly expensive, gives terrible signals for the allocation of capital, and has surprisingly little to do with real investment." [Doug Henwood, Wall Street: How It Works and for Whom, Verso, 1997, page 3]
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