04.30.10
Posted in Blog at 11:48 am by Andrew Clearfield
The following exchange on the website LinkedIn was stimulated by a question posed by the sales manager for an Indian securities firm, “What are the three most essential skills of an equity sales person?” The question was posted on April 28, 2010, at the time of the acrimonious Congressional hearings on Goldman, Sachs’ alleged misbehavior in marketing a CDO that was deliberately designed, at the request of a Goldman client, as a shorting vehicle, without telling purchasers of the security that this was the case. Goldman’s defense was that this was industry practice, and not illegal. Perhaps not, but as a portfolio manager for many years, I found this defense alarming, and therefore felt it incumbent to put unwillingness to do this to one’s clients as my top criterion for a good salesman.
After reading the testimony of all those Goldman people, I think I’ll put Honesty at the top of the list. Two, Ability to Listen to What the Client is Saying. Three, Independent Analytical Intelligence. To expand upon these:
(1) I don’t want to have to worry about being nailed by my brokers. They can make mistakes, they don’t have to be perfect forecasters, but I don’t want them to shaft me (even by just withholding a key bit of information) in order to help out their own trading operation, or their own corporate finance group.
(2) Brokers who give you the same spiel whether you are looking for something totally different, are in a hurry, or obviously have your mind on something else, are useless. If they think the story is good, they should come back with it when they have your attention. If you don’t like it, and tell them why, they should note for future reference that this is something you don’t buy, period.
(3) I can read the research myself. The broker should be able to analyze it, and he should also be able to tell you how good he thinks it is, and not just parrot back the house line.
Anything else I would consider extraordinary, and not to be demanded, although I will pay more when I find it. For example, having a strategic thinker is a real asset. But you can’t expect this from most salesmen. Exceptional service—as opposed to merely very good service—is a plus, but I don’t kid myself into thinking I’m the only client the salesman has, even if I’m one of the biggest.
This prompted another member of this LinkedIn group to question my analysis:
Question for you Andrew regarding your above Gman comment about honesty. In the case of CDS (which as we know is a zero sum game). Is it common that in the various covenants of a “brokered” CDS contract, there is an exposure of the party on the other side of the trade? I think not? OK, if it’s between XYC and ABC they obviously know, but as Gman is acting as a “broker”, or market maker between two traders, the broker typically doesn’t reveal to each side the other trader’s identity. From what I know, that’s the case..but I may be wrong? Let us know if that’s been your experience.
Sir,
That depends upon whether I am talking to an institutional salesman or to the trading desk. I don’t necessarily have a client relationship with another organization’s trading desk; I know they are a counterparty, pursuing only their own interest. If I am talking to a broker, however, who claims to be a middleman, and especially to its institutional salesman, who claims to be my representative at that broker’s firm, I expect him not to deliberately try to screw me. Otherwise, what is he for? I can trade directly with a market-maker on the screen or over the telephone, and would have no expectations that this was anything other than an arm’s length transaction.
The broker/salesman tries to develop a personal relationship with the portfolio managers who are potential buyers and sellers of securities. He offers them advice on what he is seeing and hearing from his colleagues and from the marketplace. The PM, even if he works for the most savvy hedge fund in the world (and that is not the sort of buyer we are talking about in the Goldman case), is not in the same middle-of-the-marketplace situation, must necessarily talk to other PMs as competitors, and cannot have access to the same information, which is why he depends upon brokers for some assistance and advice. If his broker fails to tell him that he is knowingly marketing a security that he and his colleagues expect will fall sharply in price, the customer has every reason to feel betrayed. This is doubly true, when, as here, we are talking about equity sales, where there are so many more variables hidden behind the security.
Traders may be in the game only to maximize the results from their own book, but the reason they are nowadays under the umbrella of investment banks is because it gives them access to more order flow, on more advantageous terms, because the bankers can gain marketing muscle, and because the broker can offer better execution. But the quid pro quo is that the traders shouldn’t try to happily screw anyone who comes near them with the same abandon they could when they worked for specialized firms that offered no other service than bids and offers. Just as their corporate finance people should recognize they are under an obligation not to offer clients deceptive advice so that they are left exposed to a hit on their treasury, a bankruptcy, or a hostile bid.
If all Goldie and its peers can offer today are bids and offers, they should (a) fire all those expensive salesmen and bankers, (b) stop hawking research, and (c) stop pretending they are an investment bank, or anything other than a used car lot for securities. It is the development of amicable business relationships under the guise of offering advice that creates a moral obligation towards your client. Whatever Darwinian universe the traders want to inhabit is their own business, but it should not be allowed to infect the whole firm.
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04.21.10
Posted in Blog at 1:23 pm by Andrew Clearfield
In most conservative circles, the current push by the Democrats to pass more financial services regulation has been received with skepticism fading over into outright hostility at yet-another power grab by Washington. The piece in the National Review’s online Corner column to which I was responding here was no exception. I was becoming concerned that too many believers in free markets were convincing themselves that just because there was a lot of dirty bathwater, there was no baby in it.
Editor:
As Frank Luntz was recently quoted in The Corner:
By the way, it’s time to hold Wall Street equally accountable, but there are better ways than creating yet another Washington bureaucracy. It requires better enforcement, not new laws.
This has been the mantra of almost all those who oppose the latest regulatory bill in the Senate. In principle, they are right. The problem is, that existing laws don’t cover many of the problems that were exposed in the 2007 – 08 financial crisis.
Far be it for me to recommend that the bloated bureaucracy in Washington be made still bigger, or the federal government be allowed to become even more intrusive than it already is, but we have a problem that contains the seeds of the next financial catastrophe, and it is no good pretending that it isn’t there simply because its existence inconveniently contradicts the principles of free-market capitalism or libertarianism: under the present laws, the big banks have license to run amok.
Without constraints on their size, we now live in a world where five or seven so-called “investment banks” (most are really ‘universal’ banks) completely dominate the capital markets. All are “too big to fail.” Given that there exists no authority to demand otherwise, there is no reason why mergers could not reduce their number still further. If there is a bid, institutional shareholders must accept a higher offer for their shares; even if they wanted to reject a deal as being economically inadvisable, they have no choice. Thirty years ago there were over a hundred significant players in the financial markets, fifteen years ago, there were still several dozen. With so many players, the opportunity for systemic risk was greatly reduced. Today, mistakes by just a couple of the survivors could bring down the system. The process of consolidation has gone too far.
Conflicts of interest are now hard-wired into the system. When I began my career as an institutional portfolio manager (for TIAA-CREF, let me add, not some small player), there was a great deal of worthwhile research available, and thus a proper range of opinions, from bullish to bearish, on any stock, new tactic, or market trend. In some countries (e.g., the U.K. and France) the brokers who talked to investors were not allowed to have any position in a security, either long or short. Since (aside from encouraging activity of course), their only interest was in keeping their investor clients satisfied, their opinions could be trusted not to be deliberately deceptive. Similarly, investment bankers (the real ones, those engaged in corporate finance) had as their only interest making sure that their corporate clients got the best price at the best time for their securities issues. They were not allowed to sell securities directly to the investing public, not even to the most sophisticated institutions. Market makers were not allowed to deal directly either with investors or with issuers. Other traders—those who worked for their own account—were by definition investors, and as competitors to the traditional long-only funds, insurers, and private individuals, occupied no privileged position within the system.
In the United States, where the only legal barrier was between deposit-taking banks and all others, the division of function tended to be maintained by tradition, by client concerns about conflict of interest, and by the requirement that stock exchange members, at least, had to be unlimited partnerships. We had wire houses and institutional brokers, investment banks specialized in corporate finance only, and there were research boutiques as well. There were separate firms that specialized in risk arbitrage. Critics—mostly the commercial banks which wanted to use their market capitalization to buy their way into the sexier business of the capital markets—complained of its inefficiency. Everyone, naturally, wanted to game the system to his own advantage, and there were fads. But by virtue of its fragmentation, the system worked as a free market, with sufficient numbers of participants to insure that the invisible hand could have an effect before total disaster set in. There was euphoria at times, of course, and there were some nasty bear markets, but for fifty-four years, from the end of the Great Crash of 1929 – 32, to the ‘portfolio insurance’ crash of 1987, despite World War II, several sterling crises, the collapse of the ‘nifty Fifty,’ Silver Monday, Franklin National, and Continental Illinois, etc. etc., there were no full-blown financial panics: the survival of the system never was in doubt.
But major forces in the U.S. began chipping away at this system. Stock exchange members were allowed to incorporate, then to issue shares to the public. The blue-ribbon investment banks merged with institutional brokers, then with the wire houses, to obtain “distribution,” i.e., to have a sales force to push their issues upon the investing public. Trading for the firm’s own account became accepted, then de rigueur, despite the fact that investors no longer knew whether they were being advised to take a good bet, or being sold a bill of goods by someone who knew more than they. In self-defense, American institutions began to build up their research staffs (which was very expensive), but they could never command the kind of resources that market intermediaries could. Issuers liked being able to call up ‘their’ banker, and tell it to silence any analyst who had unkind things to say about their share price, or their financial situation. Armed by their wealth and huge market caps, the American houses began to take over brokers in other parts of the world. Since then, we have had financial crises in 1987, in 1991, in 1997, in 2000, and most recently, in 2007 – 08.
The problem isn’t just that the principle of caveat emptor has been reaffirmed. Any participant in the financial system, as in any market, should always be careful to look after his own interests. It is that this is no longer enough. Financial intermediaries have been allowed to become so big, and so riven with conflicts of interest, that there is no longer a true free market in securities, and since everything is now securitized, the free market in financial services can no longer be self-correcting. The invisible hand only manifests itself when the situation has gotten so out of hand that catastrophe is already upon it. And of course, big government would then be there to bail out too-big-to-fail banking, but not market investors, who would have lost (a third? a half? three-fourths?) of their wealth.
Therefore, I’m afraid some sort of new regulation is required. Hand-wringing on behalf of the poor boys at Goldman Sachs doesn’t help either: they may or may not have broken the law, but there is no way I would continue to deal with any broker who had sold me such a deal, if I had any choice. Sadly, no one has such a choice today. The Dodd bill may have many lousy features, and one must be careful of anything from the people who gave us Fanny Mae and Freddie Mac, but just enforcing existing law is no longer enough. Somehow, the financial system must be brought back within the realm of free markets. Just relying upon the bid-and-offer mechanism of the stock market won’t do it under present conditions.
It should be incumbent upon conservatives to push for the right kind of regulation, even if this gives Washington some new powers. The worst financial power the Government has right now is their ability to get in bed with a handful of giant banks in a corporatist muddle of interests, as one set of barons might deal with another. Only by modifying the system can we reduce the risk of that.
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04.20.10
Posted in Blog at 5:31 pm by Andrew Clearfield
Toyota’s recent public relations disasters involving the recall of their Prius hybrid because of sticking accelerators, and then of one of their SUVs because it rolled over too easily, prompted a great deal of reflection in the business press wondering what had gone wrong with a one-time champion of quality control? Observers pinned much of the blame on an inbred corporate culture that could not admit to the rest of the world that the company was capable of making a mistake. Corporate governance professionals noted that the denial of responsibility had run right up to the boardroom. In response to a discussion which opened on the Society of Corporate Secretaries and Governance Professionals’ page, I was prompted to revisit observations I had originally made when I began to look at Japanese corporate governance nine years ago. At the time, the accepted wisdom was that it was useless to engage Japanese companies, because the Japanese culture would never allow criticism of any sort from outside a company. I was intrigued to discover that this wasn’t necessarily the case.
At the 2001 ICGN Conference in Tokyo, the CEOs of about eight leading Japanese companies addressed the conference. Toyota stood out as the only company adamantly opposed to any Western-style reforms of their corporate governance régime whatsoever. They were successful, they said, and they argued that therefore everyone else must be wrong. . .
This ignored the fundamental fact that corporate governance is a risk factor, folks, not a profit factor. It doesn’t do anyone much good to defend one’s governance practices by pointing to the track record. The point is to protect your company against what might go wrong in the future, both foreseeable risks, such as management succession issues and yes, product recalls, and the ‘Black Swans’ you can’t even envision. Toyota wasn’t doing that, couldn’t respond properly when such an issue arose, and a major marketing disaster was the result.
Japanese companies almost all have boards that are much, much too large, composed entirely or almost entirely of employees. No one is ever going to even question a management decision. That’s not a board; at best, it might be a council of elder statesmen within the company, which can be used to sound out opinions when the CEO is genuinely uncertain what to do. But as soon as a decision has been made, or a consensus has emerged, such a group would be useless, even in a culture less-consensus-driven and anti-confrontational than Japan’s.
Of course, no Japanese director, no matter how independent, is going to get into a direct confrontation with the CEO, but the Japanese do have more subtle ways of indicating concern and even direct disagreement. Opposition can be expressed successfully, so long as it comes from respected counsellors, who understand and live within the Japanese culture. The problem is that rarely are directors with any real standing chosen from outside the company; in most cases, if there are token outside directors, they are both affiliated with the company, and chosen because they are not likely to make waves in the boardroom.
‘Twas not always thus. Before World War II, many companies had strong outside directors who represented major investors in the company. But MacArthur’s imposed destruction of the supposedly “fascist” concentration of capital and ownership after the war, and the fact that Japan was impoverished by her defeat, made the conquest of companies by managerialism very easy. The incredible expansion of the Japanese economy, and then of her neighbors, for forty years after the Occupation masked the problems that were accumulating, and allowed everyone to forget that there was nothing inherently ‘Japanese’ about their governance arrangements, that other approaches had once worked well in Japan.
Somehow, the Japanese have to be convinced that for their own good, they need to roll back some of this managerial power, and allow a little bit of old-fashioned financial capitalism back into their system. Perhaps experiences such as this will help that message get through to those who can effect such changes: the CEOs of the major institutional shareholders and the mandarins at METI and the Ministries of Law and Finance. But it won’t be easy, because the primary impetus is going to have to come from inside.
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04.01.10
Posted in Blog at 1:28 pm by Andrew Clearfield
An article in the Wall Street Journal on March 31, 2010 cited a senior regulator at the Bank of England on the very high social costs imposed by every banking bailout, and supported the notion that banks should not be allowed to grow “too big to fail,” because of the vast total cost of a banking crisis. One reader replied that our former Glass-Steagall Act had put American banks at a disadvantage with respect to their foreign counterparts, and stated that “the move to repeal Glass-Steagall began fifty years ago.” I can seldom resist the opportunity to reply to an historical misconception, and I wanted to clarify the record on U.S. banking deregulation.
The move to repeal Glass-Steagall began the day after it was passed. There are some who can’t stand any sort of regulation, and some who resent not being able to place the whole world under their own flag or logo. The fact that both U.S. commercial banks and U.S. investment banks remained very profitable despite these restrictions was irrelevant.
The big European banks were the envy of the U.S. money center banks in the 1970s because of their broader deposit base, and especially because some savers, e.g., the Germans, were so risk-averse they were happy to leave billions in low-interest bearing deposits just to avoid the terrifying market risk posed by—bonds, for example. The fact that U.S. savers were unwilling to live with such low returns was disregarded. The dreaded code-word of the day was ‘disintermediation’ [of the banking system] and we were supposed to avoid it by allowing state-wide and then interstate banking. If we’d had it sooner, it would have permitted our money-center banks to buy more market share in sovereign loans to Paraguay, for example.
After the survivors recovered from that one, and the geographical limitations upon our banks began to be erased, they turned their envy upon the universal banking franchise of the foreign banks. Calls for the abolition of Glass-Steagall became louder. Having the same freedom as the foreign banks would let them wheel and deal like the J.P. Morgans and National City Banks of the ‘twenties. Except that the foreign banks were mostly risk-averse, and avoided the kind of aggressive dealmaking that characterized our investment banks. They also maintained huge inner reserves that made their results less exciting, but made the banks safer. (Funny: I never heard an American banker lobby for that particular freedom!)
Still, our libertarian regulators broke down the Glass-Steagall barriers so that our banks, with bigger equity bases than the Europeans and Asians, could buy up the investment banking world, and even corrupt some of their foreign counterparts. With the results we’ve seen, which were pretty much those feared by the architects of Glass-Steagall. The commercial banks wanted the much higher return on assets of the investment banks, and the investment banks wanted to leverage up a larger capital base. The investment banks did not want to submit to the regulatory burden of the commercial banks, and the commercial banks did not want to suffer the extreme volatility of return of the investment banks. In the end, we got the leverage and the volatility—much more volatility than anyone had expected. Anyone want to break down any more regulatory barriers?
Through most of the history of this saga of burdensome regulation and artificial barriers, the American banks remained some of the most highly-rated and most profitable in the world, with higher returns on assets and larger market capitalizations than most of their foreign counterparts. One question still troubles me: What were they all whining about, and why should we have broken our system in order to accommodate them?
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