naked capitalism

There is a very peculiar article by Steven Davidoff up at the New York Times: “As Wall St. Firms Grow, Their Reputations Are Dying.” It asks a good question: why does reputation now matter for so little in the big end of the banking game? As we noted on the blog yesterday, a documentary team was struggling to find anyone who would go on camera and say positive things about Goldman, yet widespread public ire does not seem to have hurt its business an iota.

Some of Davidoff’s observation are useful, but his article goes wide of the mark on much of its analysis of why Wall Street has become an open cesspool of looting and chicanery (as opposed to keeping the true nature of the predatory aspects of the business under wraps as much as possible).

The bottom line on this article might be: don’t look to lawyers to do industry analysis.

Davidoff blames the changes on size and technology. That’s inaccurate. Very large companies can still compete based on service quality: think airlines with outstanding service like Emirates or Singapore Air. And as we will discuss shortly, technology was not at the top of the casual chain in the sea changes that took place in the capital markets businesses.

The biggest culprit far and away was the end of private partnerships. The NYSE rule requiring that members be partnerships was revoked in 1970, but the first firms to go public were low life retail brokers known as “wire houses”; the white shoe investment banks stayed private. The first nail in the Wall Street reputational coffin was the explosive growth of the bond trading business, fueled by newly volatile interest rates in the stagflationary 1970s. Traditional investment banks (the sort that did M&A and lead managed underwritings) didn’t need much capital, but bond traders did. And trading has very strong network effects (which means disproportionate returns to scale) and high barriers to entry (you needed to be a major player in Treasuries, major corporate issues, and interest rate swaps in all major time zones, which implied not just tech but other infrastructure: offices, salesmen, communications).

The rapidly escalating infrastructure costs (bond inventories, scale needed to be in all important markets) produced a winner-take-nearly-all market. Bond king Salomon, which had gone public via a merger with Phibro, earned more than the rest of the industry combined. Its shell shocked competitors went public, either by merging into bigger public companies or by offering their own shares. Goldman was the lone holdout, taking instead an offer of capital from Sumitomo Bank.

Partnerships are conservative for two reasons. One is widely discussed: they have unlimited liability. A partner can lose everything. That tends to focus the mind and leads partnerships to be very careful and deliberate as to who they admit into their inner circle and how they monitor non-partner risk-takers. But second is that partnership capital is illiquid. The most likely exit is to extract equity gradually via sale to younger members of the firm. But they aren’t rich; in most cases, they earn their way in via their share of firm profits. Thus the partners are forced to take a very long term view of the value of their franchise. They don’t merely have to get to retirement; they have to do what they can to make sure that the next generation of partnership will be good enough stewards to be able to cash them out.

The end of private partnerships was far and away the most important change. It allowed for the culture to shift to a vastly more short term orientation and also encouraged the firms to use more leverage, which over time shifted the balance of power towards traders (since partnership equity is scarce and costly, pure fee businesses like M&A are prized).

The bond boom and globalization of the US firms set off the first wave of changes. Behavior devolved further with the rise of over the counter derivatives in the 1990s. OTC derivatives benefit from big balance sheets (bank were better positioned to do this business than the investment banks) and are also the perfect venue for chicanery, since only very savvy customers can understand how the trades are priced (the inability to price compare or decompose risks turns customers into sheep to be shorn).

Notice in Frank Partnoy’s FIASCO how he depicts Morgan Stanley’s derivatives operation as savagely predatory. This was a radical change from Morgan’s partnership days, or indeed that of any normal business. Can you think of any enterprise where salesmen are encouraged to “rip customers faces off” or blow them up?

As these businesses made more money, and hardly any bad actors died (Bankers Trust, whose staff was caught on tape discussing with relish the many ways they screwed over customers, did not survive), the traders, who are by nature predatory, began to become more powerfully within their firms, and their mindset began to dominate the firms’ cultures.

But these were hardly the only forces at work. Enforcement in the securities business, ex insider trading cases, was a joke. By contrast, the SEC was feared in the 1970s and early 1980s. Corporate America had started playing investment banks off against one another in the 1980s, going from working closely with one or two firms to using “beauty contests”. Putting Wall Street on a transactional footing gave the investment banks less reason to worry about reputation and more cause to focus on raw placement muscle. And in the 1990s, as big companies became more and more short-term oriented and CEO pay skyrocketed, it provided useful cover for the deterioration in Wall Street behavior.

Davidoff misses a key driver in this section:

In the absence of reputation, the government and regulators act as substitutes to ensure appropriate conduct. The government becomes the enforcer through civil and criminal actions for law-breaking. So what you get is more law to cover for lost reputation.

This is simplistic. Prior to the rise of the less regulated bond markets (the SEC figured bond buyers were big boys and focused more on equities) and largely unregulated derivatives markets, most of what was the securities market took place in the heavily regulated equities markets. My recollection is that over 70% of Wall Street profits circa 1970 was from equity brokerage. Even if you care about reputation, you get credit for it less in an unregulated market than a regulated market. It’s harder for customers to know who the bad guys are when no one is policing. As the example of Bernie Madoff attests, a good bedside manner and hanging out with the right people is too easily mistaken for honor.

Ryan Chittum contends that a recent New York Magazine article by John Gapper shows that financiers secretly want to reined in:

… the quotes he gets from anonymous Wall Street executives…look something like cries for help. Sort of an “Deep down I hate what I do, please tie my hands. ‘Cause if you don’t, then I gotta do what I gotta do.”

I wish that were true, but the evidence suggests otherwise. If financial services incumbents are really suffering from guilty consciences, they could always go into other lines of work. I think they’d simply like to be better thought of but make pretty much the same money as they do now. And the primacy of the money making means there’s no reason to expect a new spirit of self-dicsipline, and every reason to believe they’ll fight outside constraint, just as they do now.