Friday, March 16, 2012

Assessing Wall Street's 'Moral Fiber'?

Tadas Viskanta of Abnormal Returns, one of my favorite blogs, posted a comment on why incentives matter when it comes to investing:

Business models matter. Incentives matter. This should all be the fodder for Econ 101, but it seems like we need to keep learning this lesson over and over again. This week the Greg Smith op-ed in the New York Times raised the issue of incentives on Wall Street once again the fore.

If it is not already clear, Wall Street was never on your side. One need only take a cursory glance at Josh Brown’s Backstage Wall Street to see up close how Wall Street works against your better interests. What really rankles many about Wall Street and Goldman Sachs ($GS) in particular was the illusion that was somehow not the case. The Epicurean Dealmaker writes:

Continuing to paint yourselves as client centric when you are the opposite rankles. It is rank hypocrisy. It is bad public relations, because sooner or later people figure out you have not been telling the truth. Certainly there is nobody among your counterparties in the trading world who is under any misapprehension as to whose interests you put first. And increasingly, there are fewer and fewer muppets left elsewhere who believe the old line. It may in fact have the highest currency and belief among your own junior employees, whom you entice to join you in God’s work.

There do seem to be some exceptions to what typically goes on in the financial world. Tom Davenport writing at HBR extolls the culture that has been built into Vanguard from its origins and how it contrasts with that of Goldman Sachs. He writes:

But it isn’t true that the entire finance and investment industry is guilty of the cultural lapse that Smith is describing. In fact, if Goldman’s senior management and board would like to study a culture that does put clients first, they should hop in a limo and go 110 miles southwest to Valley Forge, Pa.—the home of the Vanguard Group.

The fact is that incentives matter. How you get paid affects how you do your job. That is why it is so important to know how all the various parties you interact with in the financial world are compensated. Mike Shedlock at Mish’s GETA writes:

Therein lies the rub. Wall Street pimps and whores have no fiduciary responsibility to clients but they do have a vested interest to peddle compete garbage to anyone and everyone…

Interestingly, independent investment advisors such as myself do have a hard legal requirement of fiduciary responsibility.

However, Wall Street pimps and whores do not have a legal requirement for fiduciary responsibility. Instead they duck and hide under “suitability” clauses.

Even if you don’t use intermediaries to do your investing you are still likely at the mercy of hidden incentives. For instance, do you know how you online broker is compensated for order flow? Maybe they internalize some of their order flow. It can make a difference. Rock bottom commissions do come with some tradeoffs. Another example is “commission-free” ETF trading. Again there is some compensation arrangement there that is allowing you to trade for free. It is worth understanding what is taking place.

As we note in our forthcoming book you are alone are the only one looking out for your own financial interests. The challenge is that you cannot invest for the future without interacting in some significant ways with big swaths of the financial industry. Your incentive is to understand the players in your investing game and just how they get paid, because some one is always getting paid.

Incentives matter a lot in every organization, especially in a financial institution. I've long argued that when it comes to incentives for pension funds and other asset managers, it's all about the benchmarks stupid!

If the board of directors at large pension funds are dumb enough to pay huge bonuses based on benchmarks that do not reflect the risks pension fund managers take in public and private markets, then they should be held accountable.

I believe in paying for true performance, not smoke & mirrors. When I used to grill hedge fund managers for a living, I was ruthless when they tried to bullshit me or pass a quick one by me. If you make a mistake, own up to it!

When I am trading in these crazy markets, there is nobody holding my hand. If I make a mistake, have to swallow my losses and move on. I don't have a bullshit benchmark to beat and answer only to myself. If I fuck up, it hurts, and if I'm right, it feels great.

Getting back to Tadas' comment, Emily Holbrook of Risk Management Monitor asks, Can Wall Street Change?:

Most of the American public were horrified back in 2008 when they learned just how ruthless and unethical some Wall Street banks were when it came to their client’s money. Since the fall of Lehman, the mortgage-backed security crisis and the Great Recession, changes (namely Dodd-Frank) have taken place to ensure that what happened in the Fall of 2008 will never (hopefully) happen again. But is it really working?

According to Greg Smith, who recently resigned from Goldman Sachs, not much has changed.

Smith was employed for 12 years as a London-based executive director for Goldman, overseeing equity derivatives. He resigned today and promptly issued an Op-Ed piece that was published in the New York Times.

In it, he tells how he joined Goldman right out of college and was immediately enamored with the firm’s culture, which revolved around teamwork, integrity and always doing the right thing for the client. That was then.

Now, as he scathingly writes, the firm’s culture has been lost and the decline in the firm’s moral fiber could well bring down one of the world’s largest banks. What once was a place that did right by clients is now a place where profits are placed above people. According to Smith, there are three quick ways to become a leader at Goldman:

a) Execute on the firm’s “axes,” which is Goldman-speak for persuading your clients to invest in the stocks or other products that we are trying to get rid of because they are not seen as having a lot of potential profit. b) “Hunt Elephants.” In English: get your clients — some of whom are sophisticated, and some of whom aren’t — to trade whatever will bring the biggest profit to Goldman. Call me old-fashioned, but I don’t like selling my clients a product that is wrong for them. c) Find yourself sitting in a seat where your job is to trade any illiquid, opaque product with a three-letter acronym.

He goes on to tell how over the last 12 months he has heard five different managing directors refer to their own clients as “muppets,” how junior analysts are learning from these same people and how little senior management does not understand that if clients don’t trust you, they will eventually stop doing business with you. He concludes:

I hope this can be a wake-up call to the board of directors. Make the client the focal point of your business again. Without clients you will not make money. In fact, you will not exist. Weed out the morally bankrupt people, no matter how much money they make for the firm. And get the culture right again, so people want to work here for the right reasons. People who care only about making money will not sustain this firm — or the trust of its clients — for very much longer.

This can be said about any organization operating in any industry.

Though we must take this OpEd as exactly that (an opinion) there is fact sprinkled throughout Smith’s diatribe: Trust may be the single most important, intangible asset an organization can gain and without it, a company is nothing. If not immediately, then eventually.

To change Wall Street, you need to change incentives. I've already discussed Soros on alignment of interests. Nothing has changed since then. Soros knows about the nonsense going on at investment banks. All hedge funds and institutional funds know what is going on. It's not a Goldman problem, it's endemic on Wall Street.

Below, PBS Newshour's Judy Woodruff discusses recent criticism of Wall Street culture with Georgetown University's James Angel and the University of Maryland's Michael Greenberger (transcript available here). Also embedded Parts 1 & 2 from an older PBS report which appeared after the crisis discussing how Goldman makes money (excellent, must watch).


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