Ben Stein is up to his old tricks. Here he gave the impression of being done for the year, having penned an article of a classic end of year type, “what I should do better next year.” But he snuck another piece in this week, “Tattered Standard of Duty on Wall Street.”
The article claims there were once halcyon days on Wall Street “for a good long time after World War II” when, “The investor’s interests always had to be superior to those of the investment bank, financial adviser or broker.” Felix Salmon has already waxed eloquent on the big error in the piece. Stein, a lawyer, seems unable to understand when financial firms have a fiduciary duty and when they don’t. And when they have a brokerage relationship, they do not have a duty of care (they do have to represent the merchandise accurately, however).
Ben, let me explain something to you. If I sell you something – whether it’s a car or a house or a stock or a ham sandwich – I have no fiduciary responsibility to you. Caveat emptor, and all that. If I am investing your money on your behalf, then I have a fiduciary duty. Sometimes, investment banks (the “sell side”) also own asset-management companies (the “buy side”). But if you’re looking for fiduciaries, you’re not going to find them on the sell side, only on the buy side.
Actually, while I’m at it, let me explain something else. If an investment bank underwrites a sale of securities, then the bank’s client in that transaction is the issuer, not the investors. In an IPO, for instance, the issuer often pays the underwriter 7% of the proceeds. The investors, meanwhile, make their own decisions as to whether they think the stock is a good buy at the IPO price. If you want to get a good idea of who a bank is working for, just look to see who’s paying them.
While I do want to get to the point of my wee addition, which is why Stein can get away with this drivel, let me briefly deal with my pet peeve with his work, which is it is only tangentially connected with fact. I’m going to mention just a couple of errors. Yes, they will no doubt seem minor, but the piece is RIFE with them.
First, in the quote from the piece above, he talks about investment banks in the post WWII timeframe as if they had investors. The investment banking industry did not become integrated until the late 1970s-early 1980s in the aftermath of the elimination of fixed equity brokerage commissions in 1974. The demise of fixed commissions worked to the advantage of firms like Salomon Brothers and Goldman, which had strong institutional distribution and trading operations (Salomon in debt, Goldman in equities).
The leading investment banks in the late 1960s and early 1970s were Morgan Stanley, Kuhn Loeb, First Boston, and Dillon Read. Of these, Morgan was dominant. And of them, only First Boston had any meaningful distribution. Morgan Stanley had no sales and trading, just the investment banking (corporate financing, M&A, and related services to large corporation) and a syndicate operation. In the 1960s, Merrill Lynch was a “wire house” (a retail equity sales firm) and Goldman was an institutional equity firm with a large commercial paper operation and a small corporate financing unit (in those days, it was called the “buying department”).
In other words, “investment banking” meant something very different in those days than it does now. And the conflicts Stein wails about weren’t possible in firms that weren’t integrated. But in those supposed glory days, the firms also charged proportionally much greater fees and had a cozy oligopoly. You can afford to be genteel when you are making easy money.
Stein segues into an attack on Goldman for its role in the “subprime mortgage mess” and thereafter refers to “C.M.O.s” Collateralized mortgage obligations are indeed a mortgage security. The way Stein uses the term C.M.O. in the piece, he clearly means to refer to all of Goldmans’ mortgage securities sales activities (Stein is upset that Goldman was short the mortgage market at the same time it was peddling mortgage-related paper.
But mortgage debt is more than just C.M.Os. it also includes simple pass throughs and collateralized debt obligations, and arguably collateralized loan obligations (although CLOs generally consist mainly of LBO debt, they can have whole loans, such as commercial and residential real estate loans) and mortgage securities included in the assets.
He repeatedly discredits himself, yet his previous, off beam piece about Goldman sparked an investigation by Senator Dodd. What is going on here?
In his latest article, Stein is tapping into the inchoate unhappiness of Americans about the service we receive generally. Airlines stink, doctors can afford only to spend a little time with patients and yet consumers have to fight our insurance companies to honor their agreements, most gas stations are self service and grocery stores are implementing self scanning. All these changes are made in the name of efficiency, but in most cases (the airlines are the prime example) the companies don’t appear to be making out like bandits.
And then we have Wall Street. They actually seem to have benefited from the broad sweep of economic and competitive changes over the last decade, grotesquely so. And the latest example of how they have done well while it seems harder for many other sectors of the economy, the specter of ever-escalating paydays at the same time when millions may be losing their homes means there must be something immoral, perhaps even illegal, afoot. And Goldman, having done the best by a wide margin, is the prime suspect.
So Stein, in talking inaccurately about fiduciary duty (and much else) accesses a desire to turn the clock back to when customer relationships meant more, when a vendor would cut his customer some slack and might even be proactive to make sure he didn’t stray. But in those days customers were faithful and margins were fatter. Is America willing to give up Wal-Mart, price comparisons on the Internet, and their Wall Street analogues, dirt cheap commissions, lower M&A fees, and (at least in plain vanilla products) competitive fees on money management products? What Stein is asking for is a return to a relationship-oriented approach, but it’s a two-way street. Customers who shop for the finest prices, by definition, aren’t loyal.
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Why has Ben Stein not been EXPELLED?
Yves,
I agree with you that there is a growing backlash against Wall Street. However, I find your “two-way street” defense surprising and unpersuasive. If a manufacturer puts a cheap, but dangerous and latently defective product into the stream of commerce, we don’t excuse the manufacturer by saying that its customers on the whole, benefited and anyway they were “shopping for the finest prices.” There should have been effective financial regulation to protect customers from the harm we see developing now, but there was not. Therefore, it doesn’t shock me that people like Stein (and I assume plaintiffs lawyers) are dusting off the fiduciary duty claims.
Maybe Ben is feeling pangs of remorse for selling his `Yes, You Can Time the Market!’ baloney to America’s noise traders, but I doubt it. His audience thinks the markets should be a charity. He’s so cute when he climbs on stage to sing to them.
phillip,
A fiduciary duty applies when one party has discretion over the affairs of another. Money managers and trustees are fiduciaries because they control assets on behalf of other parties.
Stein is dead wrong in saying brokers have a fiduciary duty. They don’t. That’s what I am objecting too. What we have seen is due to a general decay in prevailing social values, a transactional rather than relationship orientation, and lax enforcement at the SEC, a decline in the standards practiced by many in sales roles. A stock broker (or other types of security salesmen) have a fiduciary duty only when the client has given them discretionary authority.
If you read this section from Palgraves Dictionary of Economics and Law, you will see that the relationship that Stein focused on, that of broker/institutional salesman and investor, doesn’t fit that pattern:
Features of Fiduciary Relationships. (1) Fiduciary relationships are service relationships, in which fiduciaries provide to entrustors services that public policy encourages. Bailees, escrow agents, agents, brokers, corporate directors and officers, partners, co-venturers, lawyers and trustees all render service to entrustors. Some fiduciaries, such as partners, may be both fiduciaries and entrustors of each other.
(2) To perform their services effectively, fiduciaries must be entrusted with power over the entrustors or their property (‘power’). … Arrangements in which entrustors are precluded from controlling their fiduciaries in the performance of their services, categorized in law as ‘trust’, vest far more power in the fiduciaries than arrangements, categorized in law as ‘agency’, in which entrustors control their fiduciaries in the performance of their services. The extent of vested power depends also on the freedom of entrustors to remove their fiduciaries and retrieve the entrusted property. … The magnitude of the powers entrusted to fiduciaries is also related to the cost of specifying the fiduciaries’ future actions. Thus the services of escrowees and bailees, which do not require broad discretion, can be spelled out easily in advance, while the services of investment managers and trustees, which require broader discretion, can be described only in general terms because the details depend on future unknown circumstances.
(3) The sole purpose of entrustment is to enable fiduciaries to serve their entrustors. Entrustment enables fiduciaries to use entrusted power for other purposes – for their own use or the use of third parties. Entrustors’ losses from abuse of entrusted powers can be higher than their benefits from the fiduciaries’ services. therefore, and entrustor will not hand over $100 to a fiduciary if the probably loss of the $100 from the fiduciary’s embezzlement, (e.g., a 50% chance) exceeds the expected gain from the relationship (e.g. $5).
(4) Entrustors’ costs of monitoring fiduciaries’ use of entrusted power are likely to exceed entrustors’ benefits from the relationship. For example, if the adviser’s interests conflict with those of the entrustors, the value of their advice, even their expert advice, is doubtful. Monitoring such conflicts of interest is costly. Similarly, the very utility of the relationship for clients would be undermined if the clients must watch over their discretionary investment managers to prevent abuse of power.
(5) Entrustors’ costs of monitoring the quality of fiduciary services are likely to be very high, because most fu services involve expertise that entrustors do not possess. These monitoring costs may exceed the benefits to entrustors from the relationship. … In addition, the quality of some services cannot be determined by their results: a defendant may lose his case even if his lawyer has performed brilliantly. The quality of some services cannot be easily established at the time of performance: it may take years to discover that a will is faulty.
(6) The fiduciaries’ costs of reducing the entrustors’ monitoring costs may exceed the benefits to fiduciaries from the relationship. Fiduciaries can reduce entrustors’ monitoring costs by ‘bonding’, insurance and third-party guarantees, provided their costs do not exceed their benefits from the relationship. Because of these limits, their efforts may not e enough to fully cover the entrustors’ risk of loss.
(7) Alternative external controls that reduce entrustors’ risks, such as market controls, either do not exist or are too weak. Courts recognize new fiduciary relations when, in their opinion, the historical protections of entrustors have eroded. For example, physicians recently joined the family of fiduciaries as they became involved in conflict of interest situations – when physicians own pharmacies that supply their patients’ medicines, or when the interests of the physicians’ employers conflict with the patients’ optimal medical treatment.”
For every ABX short position put on by Goldman, somebody took the other side. Perhaps another house very much like Goldman that also issued RMBS, but took a bullish view. Or maybe a sophisticated speculator who liked the long side. Think of a commodity market, in which a producer is long product and can sell a future on a related product to hedge. This is what Goldman did. Others in the same market did nothing to hedge and got burned when prices fell. Others still were so bullish that they went long for more product than they produced and got killed. Some others weren’t producers but liked the long-side speculation. All were institutional players with deep resources and access to information. What happened with Goldman isn’t a morality play; it’s how markets work. As Yves says, there’s no fiduciary responsibility in any of this.
Stein knows this very well. He’s playing to his crowd. From my point of view, telling small investors as he does that they can reliably obtain excess returns with no additional risk, just by following moving averages, is immoral. I’ll grant Stein his claim that major WS players used to be somehow more ethical if he’ll grant my claim that a snake-oil salesman with a simplistic trading strategy is an ageless Wall St cartoon.
I made the mistake of reading this before the Stein article, since I had hoped for a synopsis so i didn’t actually have to see that smirking monkey face. Well, I read Stein’s piece. He’s utterly, utterly absurd. It calls to mind how during the February-March corrections Jim Cramer was blaming “the motivated sellers” saying that the “market failed us”,. Hey, Jimmy and Benny, here’s a newsflash: it’s a market because people are in it to make money, and selling is the only way to do that. Just because the water looks fine from the surface doesn’t mean that the sharks won’t tear your leg off. That’s not declining social values, that’s how a market, which is a zero-sum game–works–you need someone to sell so you can buy.
I would say that Stein seems offended that anyone would have a trading strategy that involved something besides buy-and-hold, because the possibility of something besides that might really dampen his simple-minded approach. If anything, Stein is the snake-oil salesman here, what with having been lawyer for Nixon; Stein’s genuineness is questionable at best. The fact that he gets away with the schtick in public just shows America’s enduring love of con men.
Lastly, and only tangentially, the conventional wisdom is that Goldman hedged against its subprime shenanigans, and therefore was not burnt by the recent subprime implosion the way the rest of the banks were. Yet Goldman has more Level 3 assets than any other bank, and we have yet to hear any number regarding how “hedged” they were. I think they’re playing a PR con game with this… at the same time, they’ve got Hank “Disinterested Party” Paulson sitting on the Treasury. Sorry about the tin-foil hat but this is getting ridiculous.
Hard at Work,
Sorry you are slaving away when most people get a break. And sorry that you troubled yourself to read Stein’s piece. I generally don’t summarize them (beyond high concept) because it’s too painful.
Agreed completely with your observations about Goldman and its Level 3 assets. One comment here (I think it was from Lune) speculated some time ago that Goldman would have some “we got caught by unexpected circumstances” story in the first quarter and would announce losses and writedowns after they had paid themselves handsome bonuses.
Having worked in the industry in the 1980s, believe it or not, most firms did care about propriety. John Whitehead, one of the co-heads of Goldman, has recently decried what investment bankers in general, and the top guys at Goldman in particular, pay themselves.
The proper mode of behavior was, as it was described internally at Goldman, “long term greedy.” It’s much cheaper and more efficient to serve existing customers than to keep hunting for new ones and/or compete for business with ones you may have served previously. So firms were more service oriented (as opposed to sales oriented) and would try to steer clear of behavior that could lead to ill will or recriminations later. For instance, I worked on one major, highly profitable investment banking client, a major chemical company. It was very keen, as in overeager, to buy a pharmaceutical company. They looked at a number of stupid deals and were prepared to do something, anything to get into that space. The firm discouraged them because they knew those deals would be such turkeys they would be blamed this happened three times when I worked with that account). Today (or even as of the 1990s), you’d never see a investment bank discourage a client ready to write big checks so many times, perhaps the first time to make the point they tried to do the right thing and then they’d happily take the money.
They eventually did a large deal, BTW.