I am throwing a line of thinking out in the hope of getting reader input. I put a post up a couple of days ago on looting and am still puzzling the question.
I believe that deregulation led to looting, in the Akeloff/Romer sense, that people at Wall Street firms were overpaid relative to the true, properly risk reserved earnings of the business.
The problem is that the mechanism is more complicated than the sort that they and later Bill Black discussed, that of CEO level pilfering (well, save maybe in the case of the Fuld and Gregory at Lehman, although they were badly self-deluded as opposed to criminal in intent. I personally think they were criminal in action, that the accounting was fraudulent, but they somehow rationalized it).
What I believe happened is this (very crude story line, but I am highly confident, to use that old Drexel chestnut, that his pans out):
1. Wall Street firms got big, both as banks started invading their turf (and banks big to begin with). This meant greater spans of control. In the old days, anyone who was running a meaningful profit center was a partner, and there were few enough partners that the management committees could keep on top of them. But as firms got bigger, you had important profit sources that did not have an expert at a higher level running them. They might have some general knowledge of a business, but not specific knowledge.
2. Trading became more important as a profit center relative to other activities due to (gradual) erosion of profits in other areas thanks to deregulation.
3. Rising popularity of hedge funds gave top traders (proprietary traders) a ready exit, plus set a new high pay bar
4. Other boats in trading land rose pay-wise due to 3. Other big producers could always exit to another firm, if not set up own firm.
5. Even if non-prop traders who are “producers” in theory can be replaced, in practice having top guy disappear, taking key people with him, is a bad position to be in. You do lose momentum, you even risk control failures on the desk. If the book is big and active, they do have management hostage. Particularly in new, specialized areas, it would take time to poach someone from another house to fill the gap. (A big issue here is I am not sure how to define who might be able to hold the firm hostage. The head of any major trading desk might fit the bill; not sure who else ought to be included).
As a result of 1-5, middle level (meaning MD but not executive level) employees were effectively able to extort management. Think of what would happen in a nuclear reactor if the staff who knew how to run it could go on strike. So collectively they were able to get themselves overpaid, often in the form of getting to run bigger risks than they should have (ie, the payout norms may on the surface not have change, in terms of ratio of pay relative to apparent production/profitability, but if you are running much bigger risks, you’ve increased your personal top line to the detriment of the enterprise).
And the top level guys had reason not to question it because:
1. Fighting it would risk having the firm appear less profitable, talent would exit
2. Firms were now public, incentives and pay badly skewed towards short term incentives.
3. Competition in many markets based on league tables, meaning market share
I have spoken to some experts who believe this fact pattern to be true, but as of 2-3 years ago could not prove it.
I believe that this probably cannot be established in a rock-solid fashion without having access to internal data (and policies), but I wonder whether readers can point to any anecdotes or case examples (in the public domain, say in Institutional Investor, The Deal, other industry publications) supporting the logic chain above.
Thanks!
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But why did the regulators turn a blind-eye to the fact that zero-down loans were being made to people who never should have qualified.
How hard would it have been for regulators to demand that, regardless of whatever teaser rates were being offered, people had to qualify at the 30-year mortgage rates, they had to provide proof of income, and they had to provide at least a 5% down payment.
(i) The production process in investment banking is to a significantly higher degree embedded in the people, and about interacting with other people in an ad-hoc manner.
Elsewhere a production process focused on machines or procedures means that it is much easier to replace any single individual. In investment banking knowledge of particular clients and being socialized into a role in a team is a lot more important.
When we wanted to feel good about ourselves we'd use the analogy of infantry and special forces. Infantry has (or so it seemed to us) a lot of hierarchy designed for command and control, while special forces are (so it seemed to us) a lot more focused on processing and reacting to immediately available information in the presence of the enemy.
Another frequent analogy we'd use were lawyers and accountants. Accounting and audit work is so proceduralized that picking up one accountant and replacing him with another is easily done. Same, though perhaps to a lesser degree, is true of lawyers, their work is to a large degree about creating written output – take one lawyer off a project and replace him with a new one – sure it will take them a day or two to get up to speed, but if they know the industry and the particular area of law after that day or two they're almost as good as the previous lawyer.
Now take an investment banker. Say he is managing an M&A transaction which is at negotiations stage. Even if he has made some meeting notes typically they're only useful to him. He has also accumulated a lot of "soft" knowledge about the personalities, power dynamics, and various group and individual objectives on the other side of the negotiating table. So let me ask: can you afford to replace him?
An M&A banker in a middle of a transaction and a trading banker in a middle of a trade are deemed irreplaceable.
(ii) Investment banking is to a larger degree than other industries focused on handling confidential client information — how does a manager explain to a client who is contemplating M&A, or has disclosed his trading position — that a team member who knows this information has left for a competitor, or even worse a competitor in the client's industry?
If an investment banker is only partially disloyal he will try to take the business to his new employer, if he is really disloyal he will use the information against his former clients.
And in case you start thinking about legality and ethics, which can of course be dealt with in a manner that protects the investment banker both from a legal and reputational standpoint, it seems that new employers and clients very much appreciate this disloyalty as it brings valuable, dare I say, inside information. In fact if you don't bring inside information to your new team and your new clients you are deemed to be suspect (as in what was this guy doing over there if he doesn't know anything useful).
This is a very important point. Investment bankers could not engage in what by the standards of other industries is unethical if there wasn't a demand for it from the client side. Sure they know, it sucks, but it may give them a temporary advantage that makes them look good to their bosses or investors. The people that are most afraid of an investment banker jumping ship or setting up his own are his superiors.
(iii) Investment banking despite appearance to the contrary is about relationships with a (relatively) small group of (usually) high level people.
An employee that leaves and attempts to take relationships can cause a lot of damage to the business (lost revenue), to the perception of your team (how the hell did you allow this to happen, and why did you not know about it earlier) both by the clients and inside your organization, and to your position versus your clients.
If such an employee leaves you need to make an effort to protect relationships with clients he has been exposed to. It is a very time intensive activity — as what he knows, to whom he has been exposed, what is the strength of his relationship vs. your relationships, and what he might do is in the heads of a number of people, rather than in a data base, a personnel or a production process file.
Execution of damage control also requires a lot of strategizing even if at times it might just result in a 5 second off the cuff remark (so and so is no longer with us) designed to trivialize a damaging situation. More likely it is a telephone call where you try to make it sound normal and regular (as in: this type of stuff happens all the time and there is nothing to worry about). With the more senior people you usually need to meet the client face to face to account for the situation; more often than not, these meetings become pitches to keep the client's business — the clients very well realize what is going on and will enjoy using the new found leverage for all it is worth.
Not sure why my comment did not post, but here it is again. Shorter:
See:
* Confessions of a former Investment Banker
* Confessions of a Former Derivatives Trader
* Pump & Dump Helium Bookkeeping:
At the core of all these accounting problems is a non-transparent form of corporate bookkeeping called "pro forma." As opposed to the more transparent and rigid practice called GAAP (Generally Accepted Accounting Practices), pro forma bookkeeping allows for all kinds of manipulations like hiding debt as income, double booking revenues and sneaking drug money onto the bottom line. What has yet to be fully explored by any of the major media is which other major corporations use pro forma bookkeeping. The reason is that all of the major media companies use it too. Also on the pro forma system are GE (NBC), AOL/Time Warner (CNN), Microsoft (MS-NBC), Viacom (CBS), Disney (ABC), IBM, Intel, Cisco Systems, Sun Micro, Tribune (the Chicago Tribune and the L.A. Times), the Washington Post (Newsweek) and the New York Times.
Financial Tsunami Revolution: Enronesque Helium Bookkeeping, Ponzi Scheme Derivatives and Pump & Dump Chickens Come Home to Roost
We created a system where 'Enlightened Self Interest' was at the root of every choice that was made.
This was the essence of the compensation agreements of the past decade.
What did you expect?
Bruce Krasting
So Yves, your question is multi-part, and for that reason hard to address with a straightforward answer. It is clear that most of the risks which have destroyed major financial firms presently were taken at MD/operational levels rather than directly by the most senior management. Senior management in fact has an incentive to keep their firms alive and profitable—they get to stay managers—and so the mortal risks/looting do not seem obviously directed from the very top of these firms as in the case of Enron, WorldCom, et. al. Therefore the question _appears_ to become, how did operational traders/directors get the latitude to kill their firms? With the corollary question, did operational traders/directors exploit their latitude to deal for personal enrichment heedless of consequences, i.e. 'pillaging' (to put a term to it)?
Not to dispute the thoughtful observations of PD (which make sense to me) pointing to a somewhat different question, I would answer this conundrum with four words: Nick Leeson, Jerome Kurviel.
1) Senior management doesn't care how the sausage is made, they care about the sizzle and poundage of the endproduct. That is a cultural issue in the financial industry, but in corporate business generally (though I say that as an outsider to the process). To think otherwise, one would never get to be senior management in the first place. The person at the far end of the table who says, "Let's go over the risks again on that" doesn't get the promotion; the person who says, "I beat my number by a mile, and if you'll back me more I'll beat it by two miles" gets the promotion. I'm not saying that firms don't do risk evaluation, but their heart isn't in it, and the less so the higher individuals rise. The goal is to avoid anything _blowing up_ on their watch, that's all, and creative accounting is the cure-all for that condition. Those who make their numbers are favorite sons unless it is evident that they do so via outright and blatant criminality which will catch up with their firms in a hurry. To anything else, top management is going to look the other way so long as they get a credible explanation for where the dough is coming from. [Cont.]
2) Those who make money get more marbles to play with. Nick and Jeri started off small. Little deals in out of the way places. Boiler rooms of their respective outfits really. They weren't supposed to be doing what they did, but the found a way to wire the one-armed bandit and hit three cherries. Boom: money. Boom-boom: big money. Management didn't make an overt decision in either case to bet the firm's capital, and all the capital the firm could leverage, on either of these dudes. Rather, the 'talent' built a 'track record of success,' encouraging management to let them have more and more marbles to play with, a bit at a time, then a fistful, then by the barrelful. It was 'working.' Of course, because management was studiously looking the other way, and didn't really understand in either case _HOW_ that money was being made, top management really had no idea how far in the firm as a whole was. It would seem absurd, but it's a function of doing things in a semi-clandestine fashion where the final results are all anyone cares about. It's rather like those burnt by Madoff who understood he was running some kind of scheme but stayed in because the payoff was good: they didn't have a way of knowing that their captial was gone because it was a 'won't ask, don't tell' proposition.
3) Accounting fraud is endemic in these circumstances; indeed, it's employment is essential for them to occur. I'm in complete agreement with Andrea above regarding the functional fradulence of pro forma accounting. But let's leave that for a moment and return to Nick and Jeri. Both of them circumvented internal controls. Both of them falsified trading records. Without doing so, they could not have operated their deals at all, period. But at first, no one got hurt, right? Their deals were spot on, and finished in the money big time (or at least did so most of the time). All they did was bend the rules, then, right? It's only fraud if you _lose money_, right? That's the conception within the institutional culture, as I see it. If you make money (without blatantly looting your clients or counterparties, at most shops), you're a devil-may-care captain of finance, and the best boy of top management. And if you lose money you're a loser, an ex-employee, and a defendant, while top management stays top management and just turns to their next best boy.
Bending the rules only counts if you break the bank. Of course, that is incentive, nay necessity, for those actually dealing to slurve those numbers around by all means necessary and possible. Corporate accounting at the top of the pile is . . . I can't even come up with a good word off the top of my noggin. Bizarro, maybe. But it bears no resemblance to any statement of credible truth. Independent Accountant has had much gnashing of the teeth on this, but it's become a problem for our society which is screamingly out of control. Really nothing of substance was done after dot.theft and all the rest, and that simply greenlighted off the books slumglummery. [Cont.]
None of these things quite adds up to a conspiracy to loot, to me, in the sense of Bernie Ebbers for example. (Or at least not quite so blatantly.) Oh, there were conspiracies. Selling bad crap knowingly as AAA to uninformed butsiders is fraud, and many operations traders are ethically guilty of that, though whether the paper and oral trail of their actions can be established for each and everyone is questionable. Government will lose interest long before incarcerating even a plurality of those culpable in this way.
And I'm not sure that operational dealers held senior management 'hostage' in quite the way you envisage. That may well have occurred in the way that PD maps out. But looking at how these folks have talked, I think many if not most of the dealers who killed the financial industry are just higher quantitative multiples of Leeson and Kurviel: they figured they had a way to beat the system by cutting a corner, and it just shot their wads for them that management would look the other way while shoving them all those marbles to play with. When their markets turned, they were so levered up they were dead in that moment. 1 July 07: dead. They never thought it would happen, or maybe that they would have time to build down whatever positions they had and get out. But that's delusion. Supported by the fact that creative accounting had to that point allowed them to skate over any thin ice previously, so why not now again?
And indeed, that is what we see now on the Guvmint Put in the Great Bank Stealout: Creative accounting, market manipulation, and 'confidence' are the tools employed to skate over the bad patch. . . . Nothing has changed except the titles of the criminals. *sigh*
Word verification thinks only a 'proel' could write this. Perhaps so . . . .
A former Lehman colleague tried for years to interest the SEC in accounting fraud taking place at the behest of the 'highest' levels of management there, which full knowledge of Lehman's corporate outside counsel. Dreadful. Don't fool yourself, the Executive Committee there was not even smart enough to consider plausible deniability. They would just call the lawyers and ask how it could get done. Mary Schapiro was a very good friend of both Lehman's GC and partners at its outside firm, and guess what? No one is asking any questions about how the sausage got made, even now. The Obama administration seems more interested in moving past the bad stuff, rather than resolving the underlying issues…why else would Summers be so senior in the Administration, and Rubin still involved? Very disappointing.
Can't really disagree with this. To add a thought.
Who really had control in the investment banks? It was the people making the apparently very large profits. They are more than aware of the uncertainty of the future – either the firm's or their own. And as such maximised the next period's revenues.
JMD, yes, most top line executives engaged in providing political and legal cover to their underlings knew very well what it was that the underlings were up to. However, though clueless about the nuts and bolts of business, they are not in general stupid.
Blatant disregard for norms and rules is their way of maintaining an elevated position in the ecosystem of investment banking. They usually can't get you the deals and they certainly can't execute the deals. But they can get compliance/legal/superiors off your back, as well as, make sure you get no flack from outsiders such as regulators, competitors, media, etc. It need not be outright corruption in the sense that if they’ve just dined with a regulator, prosecutor, senior manager, head of legal, etc. they are likely to know how aggressive a given official thinks he needs to be, they can put "our" view to them and can help you stay clear of them. Yes, there are many grey areas. Change the dinner with official scenario from the previous sentence as follows: instead of passively ascertaining the disposition of the official they now "clear" a certain action/approach with them.
Their title to a cut of profits even bigger then that of "producers" is that they can provide the political and legal cover that allows deals to safely happen. Being blatant about it is their way of signaling their superior position within the hierarchy: you got us the deal, you executed it, but it wouldn't happen without me, my connections, and my influence.
If they weren’t useful to the producers in navigating the political and influencing the legal obstacles they’d be thrown off by the organization.
Yves,
It is difficult to get a man to confront, when his paycheck demands that he live in denial.
So, for those people whose paychecks are not comfortable with a full impartial enquiry into the looting… no problem… I invest every spare penny I have, eitehr locally, or in gold. As the Gold Coin Exchange ad says: GOLD IS NOT IN NEED OF ANY BAILOUT, THANK YOU!
So, Yves if you looking for some who have done serious forensic enquiries into your looting issue; here are a few more:
“The use of national security law to create exceptions to the SEC law requiring books, records and transparency means that the basic conditions of markets are now gone. The black budget can now be the official budget for both government and private banks and corporations.
“Organized crime is now officially legal and combined with the stock and capital markets — all enforced by force and rigged profits. This is the economic infrastructure for fascism.”
The End of Financial Markets?
It's pretty much a steady story. Gold and silver prices – despite their wild volatility — are on a long term trend up, the Dollar and the Dow are on a long term trend down. Real things count, Ponzi schemes don't.
Large corporations and banks have had an amazing run. The Fed and the Treasury have stood ready to print money and securities to pump up the economy and profits with government contracts, credit supports and all sorts of financial shenanigans. Indeed, these days it seems like the entire federal credit mechanism exists to serve the pump-and-dump of capital markets and to take responsibility for the failures, liabilities and ongoing droppings of corporate and banking dinosaurs.
After 9/11, the government, heretofore uncomfortable about their refusal to produce audited financial statements as required by law, adopted the attitude that it was just going to ignore the laws requiring books and records and a lawful basis for expenditures. This would make it easier to pump out more and more government largesse to large corporations, banks and defense contractors.
The coup de grâce in creating black budgets for corporations and therefore the unified black budget GNP — the required financial infrastructure for fascism — came last week with the scoop by BusinessWeek that President Bush had delegated to the National Intelligence Director the power to excuse private companies from reporting requirements.
What this means is that private investors can take our tax dollars and our investment dollars to create and subsidize companies that have no fundamental economic or social purpose other than the cash flows they rig through governments and the control they exercise in the name of government and provide no financial transparency to their investors.
They have no obligation to provide the books and records that are the basis of accountability and the basic building block of liquid financial markets.
FTW ECONOMIC ALERT #4: THE ABYSS AWAITS, by Michael C. Ruppert, From the Wilderness
There there is the investigations of Patrick Byrne Ph.D, reported at Deep Capture, which includes:
The Setting
1.The Players (hedge funds)
2.The Pawns (journalists)
3.The Regulators
The Crime
4.The Crime: Naked Short Selling
5.The Corporate Democracy Hoax
6.Ruined Firms & Looted Pensions
7.Systemic Risk
The Cover-up
8.The Deep Capture Campaign
9.The Hijacking of Social Media
And don't worry.. there will be those who will be wanting to convince you… that this systemic failure of trust, and lies and deceipt and the crash of wall street was all because of random black swans… not cause of intentional looting and theft and deception and lies and cults of financial secrecy and fraud.. No, none of that.. those things don't occur on Wall STreet, where only gentlemen of integrity and honour work….
Yeah right….
PD and Richard Kline describe it well. It's not about how the sausage is made. It's about the sizzle.
At the executive level, it's a particular personality.
They creatively violate any rule and limit or end careers in order to keep the sizzle going. When one of them gets caught in some trouble, the other psychopaths 'sympathize' to the point they don't look crazy. But really, the thinking is more like, "The girl who got caught just isn't as good at their job."
And then the exec in trouble, do their best to wriggle their way out of consequences at all costs claiming others who judge them "don't understand."
And then they hire their own.
That, is the essence of capitalism.
"I am shocked, shocked to find out there is gambling going on in this establishment!"
"Your winnings, sir…"
"Oh, thank you.."
When a morally and intellectually bankrupt ideology such as free-market, libertarian, laissez-faire fundamentalism takes hold of a nation, a ruinous outcome is all but certain, regardless of the nuts and bolts of how this transpires.
There was a wonderful 7-part series in the NY Times dealing with Han van Meegeren, the Dutch painter and Nazi collaborator who foisted a number of fake Vermeers on the art market. His wheelings and dealings with the Nazi heirarchy took place over several years and reveal a much larger involvement on his part than just creating and selling forgeries. The author of the NY Times piece, Errol Morris, is like Yves in that he is also interested in the gritty details. He writes: "I’m interested in the nuts and bolts of these transactions – to make them come alive in some way."
http://morris.blogs.nytimes.com/category/bamboozling-ourselves/
But if we step back and take a larger view, we see that, even though the nuts and bolts of these frauds may vary, patterns and similarities always emerge in regimes consumed with a crusading zeal. One commonality is that an ideology is always extant that gives the marauding the imprimatur of being "legal." Morris details a series of transactions that German Nazis entered into with Dutch collaborators and then concludes: "Although these transactions were dignified with several contracts, they were for all intents and purposes looting and theft."
Hannah Arendt argued that intellectual corruption always precedes the corruption of the law and is the reason for the law becomes corrupted:
She (Arendt) observes that one is confronted with a kind of government quite different from those on which philosophers, from Aristotle through Montesquieu, have based their theories of politics. She writes that the totalitarian regime "defies all positive laws including those that it has established. But it does not operate without the guidance of law, nor is it arbitrary for it claims to obey strictly and unequivocally those laws of Nature or of History (seminal to its ideology) from which all positive laws have been supposed to spring." Then she adds: "it is the monstrous claim of totalitarian rule that far from being lawless it goes to the source of authority, from which all positive laws received their ultimate legitimation…" She claims that "totalitarian lawfulness executes the law of History or of Nature" without translating it into standards of right or wrong for individual behavior, and that in contrast with any constitutional regime it does not need a consensus juris.
~
http://findarticles.com/p/articles/mi_m2267/is_2_69/ai_90439540/pg_2/?tag=content;col1
Today, in the public dialogue we see the phenomenon Arendt describes unfold before our very eyes. Free-market fundamentalism still has its defenders. There's really little differece from Morris' description of what happened in Holland 60 year ago:
The interrogations in the aftermath of the war are surreal, almost comical. Everybody, of course, describes themselves as good guys, despite what they had done… Who knows what fabrications the Nazis constructed for themselves to allow them to see their actions as heroic rather than criminal?
There is way too much being discussed in the post and in the comments to address everything, at least in one response.
I will limit this response to PD's discussion of the differences between lawyers, accountants and investment bankers.
If lawyers and accountants are essentially fungible while investment bankers are not, could it be because of the ethical standard that govern lawyers and accountants and the fact that investment bankers have none? If investment bankers actually were required to maintain a minimum level of ethical conduct, even to the point of avoiding the appearance of impropriety, would individual bankers ever be irreplaceable?
The reason that the legal and accounting professions imposed ethical standards on their professionals was because of the importance of trust in those professions.
But trust is probably more important to the banks than any other institution. Without trust, banking does not work, and our money system collapses.
So, why shouldn't bankers be governed by ethical standards? Or are they already? That seems hard to believe in view of what has been said about the source and nature of bankers' leverage.
For example, the discussion of the investment banker who is managing M&A negotiations indicates that there is nothing to stop her from walking out the door with all her soft knowledge in her head. A lawyer in the middle of trial cannot do that because of the ethical rules that bind her. Even if a lawyer gets fired by her firm, she still must work with new consel to bring them up to speed, which includes sharing all the soft knowledge of the personalities, power dynamics, etc.
Re the role of competing for market share, this was the driving factor in Fannie's decision to buy more subprime loans. From a Bloomberg story in December 2008:
A June 27, 2005, internal presentation by Fannie shows the company at a “strategic crossroad” to either “stay the course” or “meet the market” by increasing risk and entering the subprime market. In staying the course, Fannie noted that it would continue to lose market share, and generate lower revenue and profits. In meeting the market, the document shows that Fannie identified the subprime market as a source of growth. “The choice was presented relatively starkly in order to identify what the key issues were,” Mudd said in response to a question from Representative John Tierney, 57, a Massachusetts Democrat.
Excessive risks were taken not to loot, but to validate the compensation executives were already being awarded. How could Mudd justify $14M in compensation if Fannie was losing market share?
Cite information and more here:
http://residentialpropertyanalytics.blogspot.com/2008/12/executive-compensation-and-market-share.html
Tao Jones,
I appreciate your thoughts on the importance of trust.
And I think, until we personally experience the violations of trust, personally, we — by and large — go about our lives, with a picture of a level of trust, that we imagine exists, that really (in my view) does not.
For example, I am involved in a legal matter in South Africa, and this matter has been going on since June 2002, with an Appeal in the High Court.
It involves a political criminal act — a bomb threat — after which I turned myself in, to plead to the necessity defence; in order to place certain information into the legal public record, in that certain political individuals were thereby legally and politically notified of this information, and could no longer, pretend they were unaware of it, via their favourite means of avoiding accountability; known as plausible deniability!
Anyway, in the past 7 years, there have been many briefs filed, and applications for legal counsel, and hiring and firing of legal counsel.
Would you believe me, if I told you, I have not been able to find one Lawyer in South Africa, who supported my defence, of 'tellign the truth, the whole truth, and nothign but the truth' about what I did, how, when and where! Every single one, has advised me that my defence should be to LIE, LIE AND LIE AGAIN!
I tell you, my views about lawyers and 'the law' and 'the judicial system of law'……… have been fundamentally changed…
So, I hope one day I meet a lawyer, who thinks 'telling the truth' is worth fighting for, and that judges and magistrates prefer hearing the truth, and justifications for acts, based upon honesty, even if criminal; than on lies and deceptions.
Anyway… thanks for rant… sorry not directly related to accountant and banker looting.. but maybe they pick their cues from the bastions of 'legal morality'.. and if the lawyers are the one's who have no respect for the law.. then what example are they setting?
I think this misses the point that for the last 30 years we have had a paper economy of increasing size, that increasingly existed for itself, and that when it interacted with the real economy it generally trashed it. Institutions were embedded in this system. Generations of employees, managers, and CEOs grew up in this culture. It was all self-reinforcing.
Mid level management probably always knows more about the nuts and bolts of how things are done than senior executives do. So does middle management always hold senior management hostage. No, it is a silly argument, made even sillier by the fact that if middle management actually did know what was going on they would have been telling senior management to put on the brakes. Nor do I think that it was middle managers who were responsible for pushing the government into deregulation of financial markets.
And even if CEOs weren't experts say in the fine points of derivatives and the mortgage markets, they probably could all read, because we have seen this all before. We, and they, saw the effects of bad loan making and fraud in the S&L crisis. We, and they, knew about the problems of derivatives in a market downturn after LTCM. We, and they, learned about the dangers of fantastical paper vehicles and the compensation tied to them from Enron. Indeed in this regard, Enron is key. It wasn't just about some rogue traders. It was about a rogue corporate culture that was rotten whether you looked at it from the top down or from the bottom up. Not everyone who worked at Enron was a crook, but many were, and practically everyone who worked outside of their core pipeline business must have known this at some level. If you are in a math heavy industry and people are telling you 2 + 2 = 50, it really isn't that hard.
Yves, "Information markets" by Wilhelm and Downing does a decent job of using data to link deregulation and more aggressive investment bank practices.
PD,
With all due respect, I believe you are missing my point, This discussion is not about the investment banking side of the business, but the trading side. I ran an M&A department and understand that side of the business. The traditional investment banking side (save development of complex new products like CDOs, which often reports jointly to the banking and trading sides) has limited potential for looting because the profits are pretty much what you see. Underwritings and M&A all show their income in the current accounting period. and very very rarely have long tailed liabilities. The one exception is lending to fund M&A deals, and that is a classic late in cycle behavior that always ends in tears.
As an aside, M&A types are not as indispensible as you suggest. The very top guys with brand names can walk with their book, but most decent sized deals are done with pretty good sized groups at the IB working on them. If a deal was small enough to have been staffed as you said, so that one person had unique knowledge, trust me, losing it would not be seen as meaningful.
So what I am trying to get a better handle on is the knowledge at the desk/product level versus the senior level on the trading side, to what degree could the executive committee be insufficiently knowledgeable and effectively held hostage. Michael Lewis saw it happening at Salomon in the 1980s. I have to believe it s widespread now, but I lack a good way to get to the bottom of this. Any ideas here would be appreciated.
Hugh,
I have to differ with you here also. Wall Street has a remarkable lack of institutional memory. Most of the key leaders at big firms are in their early 40s, and the bulk of the producing employees are in their thirties. They have not seen a bad bear market. In fact, the one they saw (the Asian crisis) would reinforce their view that they are scary when in progress but heal quickly>
You also do not understand how Wall Street works, I suggest you Google or search on Bloomberg to find some remarks that john Whitehead, former co-chairman of Goldman, made to Lloyd Blankfein a couple of years ago criticizing him about pay levels. Whitehead made it clear that the reason that pay had gotten out of line was the very issue I allude to here, fear of losing staff below the executive level to competitors, particularly hedge funds.
You are also mistaken re your assumption that middle management would put on the brakes.It is absolutely not in their interest. The more everyone appears to be making, the more they get paid. In fact, a saying has sprung up in the last cycle, "IBG, YBG", "I'll Be Gone, You'll Be Gone." In other words, don't worry about the problem that is about to blow, by the time it does, we will have moved on or made so much money it does not matter.
I could go on longer form, but I suggest you read up on trading and how many of these products were sold.
Finally, the analogy between other industries and financial services is incorrect. Yes, in most industries the grunts have more technical expertise than the senior. But that knowledge is not indispensible, scarce, and time-consuming to grow internally (if you can even do that).
PD,
With all due respect, I believe you are missing my point, This discussion is not about the investment banking side of the business, but the trading side. I ran an M&A department and understand that side of the business. The traditional investment banking side (save development of complex new products like CDOs, which often reports jointly to the banking and trading sides) has limited potential for looting because the profits are pretty much what you see. Underwritings and M&A all show their income in the current accounting period. and very very rarely have long tailed liabilities. The one exception is lending to fund M&A deals, and that is a classic late in cycle behavior that always ends in tears.
As an aside, M&A types are not as indispensible as you suggest. The very top guys with brand names can walk with their book, but most decent sized deals are done with pretty good sized groups at the IB working on them. If a deal was small enough to have been staffed as you said, so that one person had unique knowledge, trust me, losing it would not be seen as meaningful.
So what I am trying to get a better handle on is the knowledge at the desk/product level versus the senior level on the trading side, to what degree could the executive committee be insufficiently knowledgeable and effectively held hostage. Michael Lewis saw it happening at Salomon in the 1980s. I have to believe it s widespread now, but I lack a good way to get to the bottom of this. Any ideas here would be appreciated.
Hugh,
I have to differ with you here also. Wall Street has a remarkable lack of institutional memory. Most of the key leaders at big firms are in their early 40s, and the bulk of the producing employees are in their thirties. They have not seen a bad bear market. In fact, the one they saw (the Asian crisis) would reinforce their view that they are scary when in progress but heal quickly>
You also do not understand how Wall Street works, I suggest you Google or search on Bloomberg to find some remarks that john Whitehead, former co-chairman of Goldman, made to Lloyd Blankfein a couple of years ago criticizing him about pay levels. Whitehead made it clear that the reason that pay had gotten out of line was the very issue I allude to here, fear of losing staff below the executive level to competitors, particularly hedge funds.
You are also mistaken re your assumption that middle management would put on the brakes.It is absolutely not in their interest. The more everyone appears to be making, the more they get paid. In fact, a saying has sprung up in the last cycle, "IBG, YBG", "I'll Be Gone, You'll Be Gone." In other words, don't worry about the problem that is about to blow, by the time it does, we will have moved on or made so much money it does not matter.
I could go on longer form, but I suggest you read up on trading and how many of these products were sold.
Finally, the analogy between other industries and financial services is incorrect. Yes, in most industries the grunts have more technical expertise than the senior. But that knowledge is not indispensible, scarce, and time-consuming to grow internally (if you can even do that).
de-regulation of banking allowed "main street bank liquidity" to be transferred into the hot money sector a.k.a Wall Street Banking
The idea that this industry can be regulated makes about as much sense as trying to domesticate a wolf. Main Street Banking needs to be completely severed from Wall Street Banking. They need to go back to what used to be referred to as 5/8/3 banking -take five lend at 8 and be on the golf course at 3.
If we do that we won't have to bother about "looting" since it will be one set of thieves robbing another set of thieves.
just a quick comment:
take some of the better known names in the investment banking world such as vikram pandit, anshu jain,lloyd blankfein, john mack etc all had extensive insight into the trading businesses
these people were not 'held ransom' by their top traders
figures such as hank paulson didn't need to have trading backgrounds to understand how the trading floors operated
i would tend to agree with the earlier comment relating to 'enlightened self-interest': remember, these were all publicly listed institutions with significant institutional shareholders who represented us.. the 401k-crowd.. it was our own 'undoing'
While Yves focus here is the trading side, please permit me to be more broad.
Yes its all about the "sizzle" – whether its M&A or trading.
I have two observations to offer:
1. In IB, as in politics and the corportate world, we no longer have the type of leaders we admire and stand up to do the right thing – in IB terms, long term profitability. In short, the executive management (and even mid level MD) *are* held hostage and IB, as the world in general, has turned into a celebrity-fest. That is in IB land, senior managemnt hold onto the coat tails of the latest "golden haired boy" (excuse me for being sexist, I am female). There is too much at stake not to. Firstly, one wants to desperately believe that what is promised will be delivered and secondly, not to rock the boat. The comment above that stated that the asker of the question about real imbedded risk in a transaction will not be promoted but rather seen as a wet blanket.
Its all about the "sizzle" is the root cause of Wall Street and Main Street woes. The "sizzle" is all important as everything is about short-termism. CEO's want to get out by the end of their 5+ year term and achieve this by sacrificing long and medium term gains for short term ones.
Why the short term? Because the banks are public and that is what shareholders focus on. Its pavlovs dog theory – basically all about expecations.
If this happened at IB's, can you imagine whats under the sheets im Main Street Banks? I can because I am in risk there. During 2003/04 during the run for revenue, the banks costs were cut to the core (at a time when funds should have been put aside for building foundations ie technology, training etc etc) to build up CEO's profile. CEO leaves, new CEO, in the current environment, cannot improve profitability by increasing revenue and there are few costs left to be cut.
In addition, during those years 2003-2007/8 the push for revenue was so strong that the "rain makers" ran the firm. Risk executives who rocked the boat and tried to be heard about some of the risks they identified were "beaten up" – in short a career limiting move. Even if you have your own ethics and continue to speak up, you soon get cut out of the loop. Only now can one say "I told you so". The other danger during this period was that the *risks were not appropriately priced* – if they were and proper capital allocation took place, we would not be standing here today.
Generally speaking, the world's ethical standards have deteriorated significantly since, say end 80's (co-inciding with deregulation???). The cult of celebrity is rife everywhere. People dont have the confidence or will to stand up for what they believe in (and the costs are high if you have a family to support and career to progress).
I worked for a firm once which I greatly admire and it was my favoured job. The firm had a motto "First class business in a first class way". And they did this. Customers had to pass a "smell test" and the trading side of the busiess was a success and they were innovators in products and (internal) risk-management models. Sadly this bank got taken over, its name is still the same but the culture is long gone.
Wall street, main street its all the same problem.
The cause = shorttermism and until this changes, human behaviour will be driven by the same drivers that got us here in the first place.
To look at human behaviour, and this applies to toddler training, pet training, and adult relationships: establish the edge of the envelope. When people know what the boundaries are and how far they can be pushed, that is how far they push. If boundaries (analogy for regulation in this context) are firm, then behaviour follows.
I think it is no coincidence that these problems evolved and then compounded following relaxing of regulation.
It is human nature and the understanding of this that needs to form the basis of regulation.
I know myself when dashing to meet someone how late I can be before their tolerance is pushed. With one person that may be 5 mins and another 20. Although I try to be punctual always, the slippage is a function of what I am "permitted" by the other party.
I have rambled and this post does not go to the heart of answering the question Yves desperately wants answered but its the other side of the coin.
There is no doubt this is happening on Main Street too – just wait for the loan losses to really start biting.
In respect of Yves comment about senior management not having the specialised knowldege – absolutley. But what the real problem is that people didnt have teh courage to ask "please explain that to me again in words of one syllable or less" for fear of being tossed aside for another who had the skill of the silver tongue and just said what others wanted to hear: "yes, yes, yes".
as an addendum to the 'enlightened self-interest' pointer.. here's some lateral thinking to really get the conversation going
so in 2004, JP Morgan buys 51% of Highbridge Capital – well-known hedge fund player
Highbridge Capital were amongst many things, major short-sellers in stocks & CDS protection buyers of names such as Bear Stearns, Lehman Brothers etc
thus – we the general public, who naturally own shares in JPM thru our 401k via index-tracker pension plans… whilst JPM happily owns an asset management arm that is actively short-selling (or betting on the default of) institutions such as Bear Stearns, Bank of America, Merrill Lynch etc etc (hey who knows, maybe even Highbridge was short JPM stock)
hey, but what do i care? i am just in it for the pension payout… which just got decimated/backdated depending on who's terminology you prefer
Yves, while your observations cannot be disputed by me and are on the money, I just dont think you are going to be able to get any "anecdotes or case examples (in the public domain, say in Institutional Investor, The Deal, other indusaccess to internal data (and policies), try publications) supporting the logic chain (items 1-3) above.
You will only be able to get individuals description of what happened. Even access to internal data (and policies) would not necessarily give rise to conclusions as the banks policies are already reviewed by the regulators (!?! yes, they didnt understand underlying transactions either). It is the extent to which these policies were manipulated or deals approved that were outside of the policy guidelines on a reular and frequent basis that gave rise to the sequence of events (undisputed by me) you outline.
All the players were complicit (but the problem is that they not know/understand what the underlying questionable trades were). I believe (but cannot evidence) that management knew teh traders were rorting the bonus system but allowed it to happen for the reasons you outline and in addition, because the market was growing and it would be made up for next quarter.
Again, if performance is measured quarterly and management reviewed/rewarded/pusnished by the stockholders on a quarterly basis, will not the employees behave to optimise (with what ever means possible) annual (in the case of bonus evalution) performance.
It is the skewed (ie short term) reward system on which IB is renummerated that drives this behaviour.
As to getting hard information, having worked in IB (butnot trading), it will be difficult as this is a "soft" area and I believe little "hard" data will emerge. That is the nature of complicity.
I think "off the record" converstions with some of your fellow trading-side bloggers may result in what you're looking for. A far eastern friend of your site may be a good starting point as well as some others close to home.
Also, traders behaviour that gave rise to your scenario is just that. They are not the risk assessors, it is those that approved the trades that are held more accountable. A trader would sell his grandmother for a profit but that trade still requires credit approval (even for traders with huge lines – they got approval for those lines).
ps even if you are a credit executive and decline a trade/line, the traders are so aggressive (I can match them and hold my ground) but they then go over your head and your bosses head straight to highest management and say words to the effect of "why are these turkeys declining our request. Every bank on Wall Street is rolling out a red carpet to/for abc123" and the rest, as they say, is history. I had one fortuitous example where I declined, boss supported me, were were about to get rolled when by the fortune of good timing (no matter what anyone says, timing is impossible to predict) the entity collapsed before we could engage in trades.
Bottom line of all my digressions, and Ive said it before – banking is like little boys playing soccer. Ball goes to one end, they all follow as opposed to playing a strategic game. As Yves equivalent says – sheep following each other over the cliff!
Yves: "You also do not understand how Wall Street works"
What does this even mean? As the bursting of the housing bubble and the financial meltdown have shown, Wall Street doesn't work. A systemic event has a meaning. It is far more than some thirty or forty something traders running amok. The crisis we are currently in has roots that go back decades. It began in housing but has gone on to many other financial sectors, somewhat like an onion with layer after layer being peeled back, and it did not affect a few companies here and there but nearly all financial concerns.
Turning the world's financial system into a casino took a lot of effort in many companies at many levels over many years. Certainly, IBG, YBG was part of the corporate culture, but who hired the people who had this view? Why was IBG, YBG allowed to dominate? To say that much of Wall Street has no "institutional memory" lacks explanatory power for the same reason. This is all part of the no one could have predicted school of ducking responsibility. In fact, many people, myself being one of these despite my woeful knowledge of Wall Street, did predict most of what has happened. The real questions are why a lack of institutional memory was fostered on Wall Street, why were so many hired who could securitize roadkill but knew nothing about how to make a responsible loan, why was there such a reliance on mathematicians who could do advanced statistics and calculus but failed miserably at simple arithmetic? What we are seeing has got to be the most eminently predictable set of disasters in our history. What does it say about the pathology of a financial system that almost no one in it saw all this coming, or worse saw it (IBG, YBG) and didn't care?
You are clearly asserting expert knowledge here but I have to wonder to what end. What is this knowledge that you have which would give me some fresh insight into this deeply criminal and moronic enterprise, known as Wall Street? Is there something beyond greed and herd instinct that you are alluding to?
The lack of coordinated regulation with an eye to the nation's future calls for an industrial policy, akin to what China (and Japan) have long had.
This argument comes across as a flimsy defense of senior management, that it was important for them to risk blowing up the bank, because the alternative was worse (the share price going down).
Banks probably overpaid staff during the boom years, as one does (what were actually peak profits were treated as average profits). Employees negotiate with senior management over division of spoils, often the currently profitable business areas have the upper hand. Balance sheets got very large over the last ten years.
How do you leap from these premises to looting? The nuclear reactor analogy assumes that all of the MDs on Wall Street were ganging up on senior management, otherwise when a MD jumps ship senior management just elevates a subordinate or brings in a MD from another firm. If the options are a massive conspiracy, or else ignorant and complacent senior managers, I'd opt for the latter.
My reading and experience brings me to the conclusion, that forces over may years (since WWII), that America was to big to fail. The America prior was internal in politics, granted corporations via the military had forays out side the boarders (Philippians, Cuba, etc).
After WWII America became the dominate force only rivaled by Russia, at this point America became external/strategically politically. In the ensuing cold war all means were attempted (Government/Military/Corporate), the Faithful vs the Godless was the strongest/broadest tool to be applied.
This attitude of victory at all costs has trickled down through society, transformed the old America to a new reality, to win at all costs and remain the dominate power on this planet. Just look at best practices in all corporation's over a 50 year window, the transformation from long term to MTM is mind boggling.
So does society's gradual decay from values that look for enhanced interactions to the greater good of its citizens rest on all of us. NO!!! The individuals and groups that are responsible for this decay are the most educated and elevated in society, hence their husbandry of this country is absolute and as such bear the responsibility.
Did Politicians, Executives and Management know what they were doing was for short term personal gain "YES" was it the rule of the day "YES" are they responsible as educated and experienced individuals "YES" do they cry as a child, when caught for the first time shoplifting candy from the corner shop "YES".
Skippy…the rose colored glasses must come off, G. Washington stole land promised to the Soldiers of the Independence, to line his pockets after the war was won. All leaders should have a degree in the humanity's, not just assembly line sheepskins, so they can run out and make a wad of dough.
Sanjay above cuts through the clutter. Looting to this level was enabled by this huge transfer or main street money to "the hot money sector a.k.a Wall Street Banking."
And massive failures are the only way to discourage private investors from further inflating the hot money sector. The corrupt Fed has stepped in at every turn to prevent any reckoning and correction.
This unimaginable theft from the real economy continues, with politicians on both sides fully complicit.
I realize that the aim of this query is to pin down specific agents, organizational structures and mechanisms behind the effects of "looting", but I think it would be a fundamental mistake to ignore the systemic dimension and the broader macro-economic environment, in and from which such looting behavior arises. And the two economic issues that should be focused on are rents, not just as land rents, but also and even more as the aim of oligopolistic corporate organization via market dominance, and the tendency of the system to generate fictitious "capital" or assets "values" to boost an otherwise sagging rate-of-profit from real productive investment. (I would define rents as secured profits detached and displaced from underlying real costs of production, rather than, in neo-classical fashion, as profits in excess of those obtainable from perfectly competitive markets, since "perfectly competitive markets" is a sheer counter-factual not in evidence and such a rate of profit could not be readily derived; in fact, according to the idealized model, such markets would yield no profits, since profits would equal the cost of capital, rate of interest). Once one recognizes the over-riding aim of large corporate organization as the securement of rents and not necessarily the maximalization of profits from real, but risky productive capital investment, rather than face the uncertainties of high long-run fixed investment costs, it's much more tempting to manufacture "certainties" from manipulations of "risks". At any rate, it was clear from early on in this decade/cycle that a housing bubble was forming, and that it was connected with the burgeoning CA deficit and the off-shoring of production by MNCs, to boost profits/secure rents in a dis-inflationary environment through cost-cutting. IIRC when "Calculated Risk" first started up at the beginning of 2005, he wrote a lucid, quite reasonable post outlining the "virtuous circle" between the trade deficit and the housing bubble and how it would eventually revert into a vicious circle. It was something that no attentive, common-sense observer could have failed to notice. My view was that the bubble was being deliberately blown, both by Fed and Bushevik policy and by the Wall St. banks and amounted to a broadly intentional looting of the household sector by corporate finance, since housing was the mainstay of the net worth of the broad American middle class,- (the working class and the poor have long since ceased to be of any account in this country),- and that it would end,- but when?- in a stagflationary collapse that would permanently lower the stand-of-living of the broad mass of U.S. households. At that time, my purview was too U.S.-centric and I didn't fully appreciate the international dimensions of the coming crisis, nor the full extent of deflationary pressures that would ensue, but, on balance, I still think stagflation will be the overall outcome. I viewed sub-prime warehouse lenders as cut-outs for the Wall St. securitization apparatus, to preserve plausible deniability, but that the latter were fully aware of what they were doing and recognized that housing "values", (which are actually land rents, since housing bubbles tend to occur where there are land-use restrictions), would eventually collapse. But then the Wall St. banks actually began to buy up sub-prime platforms, culminating in Merrill Lynch's acquisition of First Franklin at top dollar in 2006, just before they started to go bankrupt en masse. So I guess they must have drunk their own Koolaid.
continued…
But my broad point is that "looting" can't really be restricted and pinned down to some specific institutional or organizational mechanism, but belonged, whatever the specific agent-and-incentives problems, to the systemic organization of the macro-economic environment and its dominant "players". Corporate investment ex housing has been poor to mediocre throughout this cycle, while (reported) corporate profits have been at near record highs as % of GDP, and employment and wages have been stagnant, as production has been shifted offshore into the "platforming" of globalized industrial supply chains. Add to that the cult of monetary policy as the sole legitimate and sufficient means of economic policy, (which operates, first of all, through manipulating the yield curve of the banking system, and secondly through effecting "interest rate sensitive" sectors, i.e. most of all, housing and construction), and the pumping out of cheap credit into a disinflationary environment, in which cost-cutting was the key to profitability and there was an apparent dearth of real productive investment opportunities, and the appeal of leveraging up to boost sagging profits and thereby inflate financial asset "values", by which the whole system begins to run of fictitious capital, becomes well-nigh inevitable. The really fun part is that broad swathes of the middle class became complicit in their own looting, and thus, in the manner of corrupt crime bosses who maintain their sway by making sure their underlings are implicated in their crimes, the middle class gets to share in the blame-(shifting).
For the rest, it's an old Marxist saw that there is no need to appeal to conspiracy theories, since the broad orchestrations of the system will achieve the same results far more effectively than one central and guiding intentionality. As for the tendency to moralizing amply evinced in comments on this thread and elsewhere, as if moral norms were simple and direct substitutes for functional arrangements, and as if moral redemption alone would restore the ideal-type of the system, Neo-Marxist thinkers have remarked, ever since observing the rise of the Nazis, that normative ideology has long since ceased to be crucial to the operations of the system and been replaced with sheer cynicism; indeed, cynicism itself has become the prevailing ideology.
i would add to the above simply that the moral aspect interlinks with the idea of personal responsibility and/or accountability
would we take actions which have negative implications if we were to be held accountable for the resultant outcomes? probably unlikely en masse
thus – why did we allow our 401k etc to 'finance' the institutions that were making these mistakes which were so apparent?
even worse – as most of us probably outsourced our investment portfolios to specialist fund managers – why would they buy the shares of large investment banks in spite of what was going on?
or more importantly – why would these fund managers be comfortable getting fee income by investing in toxic crap?
had we all been a bit more conscientious in our actions wrt our savings – perhaps much of this could have been avoided?
Thanks for the many helpful comments. I may have been unduly optimistic about finding other "tell all" accounts, having read Frank Partnoy's Fiasco (which is really damning).
Recovering Banker,
I don't see this as a defense of top management but a recap of their rationalizations. After all, they profited greatly from the "gee we have to be within hailing distance of hedge fund pay or we lose our good people" palaver. It helped justify their own lavish comp.
As for "looting" that occurs when corporate officials /employees take more out of the enterprise than its true profitability warrants. As discussed in related posts. acceleration of revenue from future periods allowed payment of bonuses that now appear unwarranted. That alone may explain the phenomenon.
Looting require lax accounting standards to allow for the reporting of profits that exceed true economic profit.
Hugh,
I apologize for getting cranky with you, but not for the substance of my remark. You made several assertions about how IBanks worked by incorrect analogy with how most companies work, and even took a stroopy tone about it, then admitted later to not knowing the Street.
First, senior management until not all that long ago DID know the business better than the middle ranks. Partners had narrow spans of control and managed operations they grew up in. No one would dream that a guy working in, say, corporate bond trading, risk arb, or M&A knew more than the partners in those businesses. The management committee was only a part time job, populated by the most powerful partners. That changed as firms went public and got bigger, a 1980s-1990s phenomenon.
And middle management has negative incentives to take issue with bad practices, particularly ones that make their unit look more profitable. More apparent profit means more pay. Arguing for conservatism in a business producing unit is almost without exception a career limiting move.
You could have voiced your difference of opinion as a "gee it seems to me" and that would have been appropriate given your limited knowledge. Instead, you asserted you were correct and took a dismissive tone when conditions and practices in the industry contradict your view. You then get stroopy again in your next set of comments.
Yves,
I have experienced one firm where the MDs (incorrectly) up-fronted a lot of profits, paid themselves cash bonuses (rank and file receiving mostly deferred comp), and then after the MDs left the firm there were huge writedowns. However this occurred around the time of the Enron collapse, not recently.