THE BEAR'S LAIR
Towards a future Wall Street
By Martin Hutchinson
The financial services industry as we have known it since the early 1990s has
effectively collapsed. Its flaws of over-optimistic risk management, aggressive
rent extraction and excessive leverage have proved fatal, as was eventually
inevitable.
Since a modern economy cannot function without an adequate financial services
sector, it is not sufficient to push the remaining invalids off into
bankruptcy. Instead we must make some decisions as to how we want to replace
them. As the great multiple bubble of 1995-2008 appears finally to have
deflated, it may now be time to peer into the mist ahead.
In determining the shape of the new financial services industry, we need first
to anatomize the flaws that must be corrected. This
week, I shall concentrate on diagnosis, anatomizing the multiplicity of
diseases that Wall Street has contracted. Next week, I will focus on cure, or
at least alleviation of the resulting economic ills.
The central flaw in the Wall Street of 1995-2008 (the previous decade, from
about 1985, had been a period of transition from a functioning model to a
flawed one) was the move towards proprietary trading and the rent seeking with
which that was associated.
There is an inherent conflict of interest in major financial advisors or
arrangers of deals being themselves large participants in the market. Buying a
few shares in a successful new issue is a traditional practice, and probably
does little harm (it tilts the playing field, but traditionally only modestly.)
However, ramping up the firm's capital until it is as large as the country's
major banks, and then leveraging that capital 30 to 1 to invest in illiquid
speculations, is not just a recipe for disaster. It also inserts the advisor,
quintessentially an intermediary, into the market as principal, distorting its
advice and providing a gigantic source of "insider trading" since the advisor
has inside information, not necessarily on the issuer, but certainly on the
market.
Goldman Sachs' 2006 investment in the Industrial and Commercial Bank of China -
a transaction that has not blown up and attracted little criticism either then
or subsequently - is a classic example of issuing houses' conflicts of
interest.
Goldman Sachs acquired a US$2.6 billion equity position in ICBC in May 2006, at
a price of 1.2 times book value, at a time when it was obvious that ICBC would
shortly go public and very likely (absent a 2008-style financial crisis two
years early) that it would succeed in doing so at a price far in excess of that
Goldman had paid. In the event, Goldman achieved through the flotation an
almost risk-free profit of $4.8 billion, a 185% return in only six months. It
did so through ignoring a huge conflict of interest between its duties as
advisor to ICBC and arranger of its financing and its huge speculative
shareholding in the bank.
The only risk remaining was that Goldman had to hold its ICBC stock for three
years (presumably until May 2009.) This looked a slam-dunk, but now looks less
so; ICBC's stock is currently down to HK$3.35 against its issue price of
HK$3.15 and could fall further. Still, 185% is 185%, even over three years. As
an additional wrinkle in this deal, two thirds of the investment was taken not
by Goldman itself but by funds controlled by Goldman partners, thus providing a
further conflict of interest between the partners and the corporation.
The private partnership is by far the most appropriate vehicle for what is
essentially a team-based and reputation-based advisory business. Experience has
now shown that control of a public company, particularly a public company with
resources that are a multiple of their own wealth, provides temptations to Wall
Street bankers that those fallible souls are unable to resist.
In London, the disappearance of traditional merchant banks, whose capital had
been provided primarily by their top management, and their replacement by Wall
Street or by other investment banking operations controlled by financial
behemoths produced the same effect: the capital involved in the business became
"dumb money", which could be manipulated to enrich those who controlled its
disposition.
The extreme examples of dumb money in 1995-2008 were the hedge funds and
private equity funds that proliferated especially since 2000. It is notable
that private equity funds have since 2000 been very limited investors in
venture capital, the sector of long-term investment in small growth companies,
genuinely beneficial to the US economy, which became the fad of the late 1990s
and cratered spectacularly thereafter.
There is a limited role for both hedge funds (speculative pools of money
designed to achieve short-term profits without regard to the market) and
private equity funds (holders of control stakes in companies undergoing
financially painful restructuring), but both sectors deserve only a very modest
share of the investment capital pool and their managers perform no especially
valuable service and thus deserve only moderate remuneration.
Institutions that invested in such funds in 2002-06 paid greatly inflated
rewards to fund managers without significantly diversifying their portfolio
from the US stock and bond markets. Any such institutions that invested heavily
as fiduciaries deserve to be sued by their beneficiaries and doubtless some
will be. Meanwhile, the downturn has delivered heavy blows to both the hedge
fund and private equity sectors, blows that were mostly richly deserved.
One result of the bloating of investment bank balance sheets and the separation
of capital from staff was the increasing reliance on phony risk management
schemes. The "Value at Risk" (VAR) methodology was highly convenient to staff
seeking immediate bonuses; it completely ignored the "tail" risk of a financial
downturn such as the current one, thus enabling highly correlated risks to be
built up to an extent wholly inconsistent with preservation of the enterprise
as a long-term functioning entity.
This spurious risk management technique achieved such acceptance that the
bureaucrats writing the Basel II system of bank capital controls built it into
their regulations, allowing banks using VAR essentially to allocate their own
capital.
This particular moral hazard is the principal downside of government bailouts.
If Wall Street thinks the government will always help out in extremis,
they will inevitably design ziggurat-like risk management structures that pay
off nicely for several years, making everybody involved rich, and then collapse
in ruins on the heads of taxpayers.
The problems of rent-seeking and phony risk management were exacerbated by Wall
Street's compensation structures which were highly politicized, opaque and
focused entirely on the short term. Bankers learned that building the long-term
standing of the institution was of little value, and that businesses that took
more than a year to develop were only to likely to benefit one's successor
rather than oneself.
Conversely, short-term profit maximization schemes that had immense long-term
risks or even costs were of great value in producing the current year's bonus.
Without the warped compensation schemes, the phony risk management would not
have happened.
Another Wall Street problem was that everybody became overpaid. In order to
justify the inordinate rewards that Wall Street's rent-seeking produced at the
top or for the luckiest traders, everybody's compensation was swollen far
beyond what would have been needed to attract executives of the necessary
considerable but narrow talent.
Attempts were made to justify this by working everybody 90 hours a week, but
nobody ever asked the question: what if Wall Streeters worked 45 hours a week
for half the reward? Their compensation would still have been generous, and the
productivity and societal connectedness of Wall Street talent would have been
much greater.
One of the principal rent-seeking methods employed by Wall Street was the
derivatives business. This has been sold to outside users and the public as a
means for corporations, banks and others to hedge their risks of currency,
interest rate or credit, thereby reducing their overall risk profile to that of
the operating business in which they were engaged.
However it quickly became much more than this largely because of humanity's
eternal quest to get something for nothing and Wall Street's financial
engineers' endless ingenuity in obscuring costs. For example, retail investors
were offered "risk-free" products in which they appeared to get much of the
upside of equity investment while having return of principal guaranteed. In
reality, through the magic of derivatives, such products' principal function
over the long run was to divert investor wealth into broker's pockets through
gigantic hidden fees and costs.
While derivatives focused largely on interest rates and freely traded
currencies, and on liquid equities in a market whose fluctuations were limited,
they produced nothing but profits for Wall Street. The invention of credit
derivatives, however, may have brought the happy game to an end. Unlike
interest-rate or currency products, credit derivatives are very one-sided in
their payoff; if there is a default, some large fraction of 100% of its nominal
principal must be paid out, while the annual insurance premium is only a small
fraction of that.
Thus, if one of the endless chain of intermediaries goes bust in a credit
downturn, it is likely that sums totaling a substantial multiple of the
original credit being insured must be paid out. The outstanding amount of
credit derivatives reached US$62 trillion earlier this year, at a time when the
total volume of insurable credit was less than $20 trillion at the most
generous estimate.
The effect of Wall Street participation in the credit derivatives market can be
shown by the case of AIG, an insurance company with a Wall Street derivatives
operation attached, in which the Federal government has had to pump in more
than $150 billion without any coherent explanation of where the money is going
or what it might be achieving. At first sight, it appears that the inevitable
credit derivatives disaster may have been entirely concentrated in one house -
or is it simply that AIG is the first to have been identified and that other
equally large holes have been blown in the fabric of other large derivatives
dealers? Doubtless, we shall shortly find out.
The final Wall Street folly was the practice of banks originating loans and
on-selling them, without keeping any "skin in the game". I have to say that, as
a participant, I thought securitization to be a largely useful invention,
although it was always clear that its legal and other structuring costs could
easily exceed any economic benefits. However, the existence of Fannie Mae and
Freddie Mac, two entirely irresponsible institutions with the implicit backing
of the federal government, encouraged the development of a securitized home
mortgage market in which the originators neither knew nor cared what happened
to the loan after they originated it.
Wall Street needed the help of the nation's encyclopedia salesmen and used-car
dealers, acting as "mortgage brokers", to perpetrate the disaster in subprime
and other securitized mortgages. They didn't do it alone. Nevertheless, Wall
Streeters were the brains behind the scam and they profited very well from it -
at the cost of significantly increasing the cost of home mortgages beyond what
it had been in the old days of local lending institutions.
The above list of diseases is probably not exhaustive, but it is above all
long. It is in retrospect extraordinary that such a diseased structure did not
collapse much earlier. Maybe, without being fed the stimulative drug of
excessive money supply, it would have done so. In any case, contrary to the
gnashing and wailing from the media and the political class about the recent
unpleasant events (if you were on the bull side) the reality is that we are now
at last in a position where the Wall Street monster has ceased to suck
resources from the remainder of the economy.
Going forward we can hope that the financial services business will continue
operating on a respectably downsized and less-wealthy basis, adding value where
desirable without sucking resources from other worthy endeavors. Next week, I
will suggest what such a new structure for Wall Street might look like, and how
we might get there from here.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-08 David W Tice & Associates.)
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