Changes in Wall Street Firms that Led to the Credit Crisis

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Today's Guest Blogger: Dennis Mack, New York Investing meetup member, graduate of Harvard Law '69 and Fulbright scholar.


It is my belief that one of the major factors that has led to the current Wall Street collapse is the loss of internal self-regulation by the financial institutions once they became public companies. When I started practicing law on Wall Street, brokerage firms and investment banks were partnerships. The senior partners (often depicted in movies as miserly, backward thinking and overly demanding) were reluctant to take excessive risks because it was their personal capital that was at stake and the capital of their business partners and, perhaps, family members. When the brokerage firms and the investment banks sold shares to the public, we as a society lost the connection between risk-takers and risk-absorbers. The traders and bankers took on risks, but it was other people's money (the public shareholders) that actually suffered the losses. The traders and bankers were richly rewarded for short term results, but there was always a one-in-ten chance that their bets would result in a wipe-out - not of the traders and bankers but of their shareholders. The traders and bankers could just move to new firms.

In the old days, traders and bankers did not move to new firms. They became part of the firm and would not dream of leaving it. They married into the firm - literally sometimes by marrying the daughter of a partner. That may seem stifling but it also meant that the partners and those traders and bankers knew that their success was tied to the success of the firm. Now, there is a great disconnect. Traders and bankers can make their reputation at a financial institution and demand more or they will walk. Compensation committees award the higher bonuses because it does not come out of their own pockets. When there is a problem (uncovered by management) or an insufficiently generous bonus, the trader/banker could move on to another institution or even set up his own shop and practice his craft. His track record at the old shop would draw in money at 2% and 20%. In an up market with cheap borrowed money from China, they were able to magnify small returns into large returns and demand their big bite. No matter that leverage is a two edged sword that would eventually decimate the client's portfolio while still giving the manager his 2%.

In 1969, when I was assigned the task of organizing my first hedge fund in Panama/Bermuda, I was flabbergasted by the fee structure. I peppered the client with questions about whether people would actually pay such a fee when there was no clawback in later years after the fund would decline. They explained to me that a hedge fund was designed to create positive returns in both up and down markets and therefore the risk I perceived was negligible. They also said that if an investment manager had to give credit for past losses, he would have no incentive to service the fund after the loss and might even leave the management company to get a new start elsewhere. Besides, they argued, it would be unfair for new money coming into the fund to get a free ride up - not having to pay a 20% fee on the gains that they would enjoy.

The extraordinary rise in executive compensation in other corporations is a whole other story, but there are at least two connections. First, there was the rise of finance in business schools. This sent the best students into finance or consulting. It also meant that corporations were valued less on the products that they could turn out for a profit than the profits that could be augmented by adroit maneuvering among the tax, accounting and financial rules. People who could massage the results for the best appearance rose through the ranks. To retain them, you had to pay them like financial managers. Second, in pre-WWII America, individuals and family trusts owned corporations. Insurance companies invested in bonds and mortgages. Mutual funds were tiny. Pension plans were not funded. Individuals and family trusts bought and held. Trading on the stock exchanges was very, very low. There were concentrations of individual money that controlled corporations. Investors with large shareholdings voted their shares as if it were meaningful. They had a long term commitment to the company. Today, most shares are held by financial institutions. Many of them are traders and not investors. Some vote to support their trading strategy - not for the welfare of the company and its shareholders. Some are even able to rent the votes of real shareholders in order to produce a result that will allow them to profit personally. There is a disconnect between shares and corporate decision making.

We learned in law school that shareholders own the corporation and elect the directors to run it on their behalf. Today, management presents to the atomistic community of shareholders a slate of their golf buddies to direct the company pretty much at the behest of the management. Management takes the risks and are paid large bonuses whether they succeed or not while an ever-changing body of shareholders pass their holdings from chump to chump until the music stops in Chapter 11 or 7.

How do we change that? Do we want to require brokerage companies and investment banking houses to return to private partnerships when they have to compete with foreign behemoths? Do we want to impose upon financial institutions fiduciary duties in voting? Should only the very wealthy invest in stock and be incentivized to hold on to it for the long term (e.g., 5 years or longer)? We must start talking about some very fundamental changes, but we must see it within the competition of a global marketplace for financial and management expertise. I wonder whether US regulation alone can resolve our problems.

NEXT: New York Investing meetup members in the Videosphere

Daryl Montgomery
Organizer,New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.