We don’t need Wall Street anymore. It’s killing us to let
Wall Street keep going the way it is. Our governments won’t help
us—Wall Street dominates them. But there is a way around Wall
Street. Direct routes are open for individuals and businesses to
bypass Wall Street.
Wall Street is not going to change. Government is not going to regulate Wall Street in the public interest. To escape the harm of Wall Street we need to ignore it.
For 50 years, I worked as a securities lawyer and certified public accountant. From my front row seat, I’ve come to believe that the only way to get out of our economic mess—and to prevent it happening again—is to bypass Wall Street and take the direct route to raising and investing money. The information and opinions I’ve put together are on this website. These are the major themes developed:
• Wall Street does very little to raise money for businesses. It has become a casino, placing bets for its own account and taking fees on bets for institutional funds and the very wealthy.
• Wall Street is not open to investing money for the middle class, except through its managed funds, and it is closed to raising money for all but the biggest businesses.
• Wall Street is doing great harm to our economy and our way of life, while its traffic cops run a protection racket for Wall Street abuses.
• Direct routes are open for money to flow between individuals and businesses, bypassing Wall Street.
• There are steps government could take to help us bypass Wall Street.
This website will give you
facts and arguments for bypassing Wall Street. It's a "living book"
and I’ll update it as events unfold. You can email me
with your suggestions for additions or revisions. (firstname.lastname@example.org)
The website’s references to sources are in brackets, right in the text, rather than as footnotes. You can easily skip over them. Or you can read them and click on the website references. I’ve included a few personal experiences for flavor. They’re in parenthesis. You are free to refer to or quote anything on the site, with attribution.
Most of us hear and see “Wall Street” nearly every day. On television news, a report will begin “On Wall Street today . . ..” The business print media is dominated by The Wall Street Journal. For most of us, “Wall Street” is shorthand for a mysterious complex that comes between the people who provide money for investment and the people who use that money. It even takes on its own personality, as in “Wall Street reacted by . . ..”
Wall Street, the place, was named after the wall
built to keep invaders out of
The so-called Buttonwood Agreement was a single sentence: “We the Subscribers, Brokers for the Purchase and Sale of Public Stock, do herby solemnly promise and pledge ourselves to each other, that we will not buy or sell from this day for any person whatsoever any kind of Public Stock, at a less rate than one-quarter per cent Commission on the Specie value of, and that we will give a preference to each other in our Negotiations.” [Marshall E. Blume, Jeremy J. Siegel and Dan Rottenberg, Revolution on Wall Street, W. W. Norton & Company, 1993, page 23] These last few words established the monopoly that is today enforced by the federal government, the monopoly rule that only brokers accepted as members can trade in stocks and they can only trade among themselves. At first, non-member brokers met outside, on “the curb,” to trade in unlisted shares. In 1908, they formed the American Stock Exchange, also a members-only market. [Charles R. Geisst, Wall Street: A History, Oxford University Press, 1997, pages 10-21. By 2012, The AMEX had less than 1% of U.S. stock trading, was owned by NYSE Euronext and renamed NYSE MKT. Matt Jarzemsky and Jacob Bunge, "Closing Bell Rings for Exchange's Name," The Wall Street Journal, May 11, 2012, page C1] Only broker-members could buy or sell through the exchanges. Fixed commissions, rather than price competition, were the rule at the very start.
In the 1930s, when government regulation came to
Wall Street, Congress defined "exchange" to include “a group of
persons . . . which provides . . . a market place or facilities for
bringing together purchasers and sellers of securities.” [Securities
Exchange Act of 1934, section 3(a)(1),
definition reflected the history of trading in securities before
modern tools of information technology, back when "economy of time
and labor, as well as a theoretically perfect market, could be best
secured by an organization under one roof of as many dealers in a
commodity as could be found." [William C. Van Antwerp, The
Stock Exchange from Within, Doubleday, Page & Company,
1913, page 6.] There had been over a hundred stock exchanges in
1900, when the media for communications and delivery were still
costly and unreliable. Today, there are effectively only two
stock exchanges dealing with individual orders, the New York Stock
Exchange and NASDAQ. The third largest exchange, BATS Global
Markets, has gained a 10% share of the
After the Securities Exchange Act of 1934, the
monopoly expanded from exchange members to all brokers and dealers
who registered with the Securities and Exchange Commission.
Anyone trespassing on the turf of registered broker-dealers could be
prosecuted by the
Wall Street was all about stocks and bonds until
the 1970s, when
Today, Wall Street has come to stand for high
finance, the movement of monetary symbols among governments,
corporations and the wealthy. The people who work on Wall
Street are practitioners of arcane games that use money as a marker.
These are “zero sum” games, where one player’s winnings are another’s
losses. Only a very few of those games actually involve the
transfer of money from investors for use in operating businesses.
As Eugene Robinson put it: “Wall Street's theoretical role is
to allocate capital most efficiently to the companies that can make
the best use of it. Wall Street's actual role is more like that of a
giant casino where the gamblers are rewarded for taking outrageous,
unconscionable risks with other people's money. If the bets pay off,
the gamblers win. If the long-shot bets turn out to have been
foolish, we're the ones who lose.” [Eugene Robinson, “The Wall
Street Casino, Back in Business,” The Washington Post,
In its earlier days, Wall Street served as a bridge from wealthy individuals to entrepreneurs who had plans that needed capital. Financial intermediaries were useful in finding and matching money with entrepreneurial talent. On the supply side were families with far more money than they’d need for immediate financial security. They wanted to put that money to work for them, to pay for their chosen lifestyle and build more wealth. The risk of losing some of their capital was acceptable, if the projected returns looked to be worth the risk. Sometimes they had financial advisers they paid to investigate and analyze this risk/return ratio.
Demand for the use of other people's money first came from governments, looking for ways to acquire territory or wage wars. Later it also came from private companies that built and operated ships, canals and railroads. This flow of capital through Wall Street, between very rich individuals and business managers, is the picture of capitalism as it existed in the time of Karl Marx and other critics. The middle class, the bourgeoisie, had modest capital needs for their businesses, farms and professions. They could get by with savings, bank borrowings and direct financial arrangements with family and acquaintances.
By the time the middle class began to have some money it could save, entrepreneurs were launching new businesses, based on technological advances and expanded markets. Wall Street could have expanded its services to deal directly with the money supply from this broader level of families with disposable income. It could have been the channel from a growing middle class to emerging business ventures. The model for this evolution on Wall Street was right around the corner in retail banking.
Commercial banks once accepted deposits only from those wealthy enough to maintain very substantial balances. They lent money only to governments and large businesses. But most banks adapted to a society in which there were more than the very rich and the poor and they evolved into providing services to nearly everyone. The people who dealt with securities did not. They chose to ignore both the supply of money from new middle class families and the demand for money from the developers of new business ventures. What happened instead was that Wall Street continued to do business with people who had the largest amounts of money to invest or to use.
Because Wall Street chose not to gather money directly from the middle class, another layer of financial intermediaries was created, to control the flow of capital and gather fees as it went through the channels. Mutual funds sprung up to bundle the money from middle class families and invest it in ways picked by the fund managers. This created Wall Street’s “buy side,” the professional money managers who accumulate money from individuals and use it to buy investment products from the “sell side” of Wall Street. [Marshall E. Blume and Irwin Friend, The Changing Role of the Individual Investor, A Twentieth Century Fund Report, John Wiley & Sons, 1978]
The great majority of those working on Wall Street are sell side financial intermediaries, acting as agents for their clients and customers. Brokers and investment bankers dominate the sell side. They have combined selling new issues of securities with running a market for reselling securities, where they trade for themselves as well as for their customers. Members of the buy side include money managers for mutual funds, pension funds, endowments and the other funds. The big-name securities firms have departments on both sides of the Street.
Running between the two sides of the Street are all of the lawyers, accountants, rating agencies and other support services. It is this entire network that is called into play when we refer to what happens on Wall Street.
Some financial intermediaries are simply matchmakers, acting as a go-between for people who have money to put to work and people who want to use money in their business. They provide an introduction service and some advice on the mechanics. Others are strictly brokers, limiting themselves to being agents for buyers and sellers of existing financial products. The major financial intermediaries, like investment banks and commercial banks, are also agents of change in the characteristics of the money that passes through them. They serve purposes similar to electrical transformers which alter the voltage between the generator and the user. Financial intermediaries theoretically transform the denomination, the maturity and the risk. We say “theoretically” because Wall Street has found ways to abandon its transformation role, to pass on those risks to the providers or users of money.
Denomination transformation usually means taking in money in small amounts and lending or investing it in much larger amounts.
Maturity transformation is generally accepting money that can be returned on demand or other short-term period and using that money to make long-term loans and investments.
Risk transformation is a little more complex. The concept is that the risk of not getting a return of the money is placed on the intermediary. The person providing the money to the intermediary is protected from borrower defaults, changes in interest rates or other market conditions. Risk transformation is also provided to those receiving money from financial intermediaries. They, of course, bear all the risks of how they use the money and whether they will generate the cash flow to meet payment terms. But they have been protected from changes in interest rates and fluctuations in the money markets. Think of the individual with a savings account at a bank. So long as the bank itself is operating, the money they’ve deposited can be withdrawn at any time. The interest rate will stay the same and they don’t need to worry about whether the money will be there when they want it. Meanwhile, the bank will be making loans on very different terms, taking on the risks from interest rate and maturity differences, as well as the risk that a borrower will fail to repay.
In recent years, financial intermediaries have
largely abandoned their roles in risk transformation, first with the
risk of interest rate changes and then with the risk of default.
The shift of interest rate risk began after Paul Volcker was
appointed Chairman of the Federal Reserve Board in 1979 and undertook
to cleanse the economy of stagflation. Financial
intermediaries’ cost of money, measured by one-month certificates of
deposit, went from less than 6% in 1977 to 16% in 1981. Banks
raised their prime rate in that period from 7% to 19% and rates on
new 30-year mortgages rose from 9% to 17%.
[Federal Reserve Statistical Release H.15, Selected Interest Rates,
www.federalreserve.gov/releases/h15/data.htm] The jolt was
especially strong for intermediaries, like savings banks, who took in
short-term deposits and held 30-year fixed-rate loans. Before
1977, savings banks managers were said to have been following the
“Rule of Three:” take money in at three percent, lend it out at three
percentage points higher and be on the golf course by three in the
afternoon. (I remember long, desperate discussions with our law
firm clients over what they could do when that three percent positive
spread in rates had become a twelve percent negative spread.
Should they refuse to accept deposits at the much higher rate?
Should they sell their fixed-rate mortgages and take a huge loss now?
Should they aggressively seek new money and invest it in short-term
The principal response was introduction of the adjustable rate mortgage. The new instrument shifted most of the risk of interest rate fluctuations onto the borrowers. It took some time to develop industry standards for the new loan structures and fixed-rate loans have remained as an alternative. There were people who questioned whether it was right for savings banks to abandon their role as absorbing the risk of interest rate changes, arguing that they were in the money borrowing and lending business and should find ways to deal with the risk, rather than pushing it on to their customers. (I was at a conference in the early 80s about the new mortgage instruments. In the audience was Martin Mayer, author of many books on finance and a guest scholar at the Brookings Institute. He asked the panel, as I recall, “If this industry is not about risk transformation, what is it about?” The panel went back to discussing the characteristics of ARMs.)
Having abandoned much of the interest rate risk,
savings bank managers were ready when Wall Street proposed to relieve
them of their role in transforming the risk of default, together with
transforming maturity. Wall Street’s proposal was to bundle a
group of mortgage loans and sell them as mortgage securities.
The disastrous consequences of Wall Street’s handling of mortgage
securities are a separate subject in the chapter on “The Harm That
Wall Street Causes.” What it did to banks was to strip them of
a major economic function, transforming risk and maturity, and turn
them into brokers. In a Wall Street Journal article,
Eleanor Laise said, “In the process, risks previously borne by big
banks . . . have been placed squarely on the shoulders of consumers.”
[“Some Consumers Say Wall Street Failed Them,”
Like commercial banks, Wall Street’s investment bankers have also abandoned their role of transforming risk. Their principal reason for being was to provide assurance that a proposed underwritten sale of bonds or stocks would actually happen. As described in chapter two, the term “underwriter” came about when businesses wanted to go forward with their plans for the new money they were raising, without waiting for the public offering to close. It could be weeks or even months between the agreement to sell an amount of securities and the closing, when investors delivered the money. Investment banking firms gathered their own capital base, so they could stand behind their promise that the money would be there.
As power shifted from the businesses issuing securities to the investment bankers who sold them, the time became shorter between signing the underwriting agreement and delivering the money at closing. For the last fifty years, the “firm commitment” underwriting agreement has been signed only a few hours before the sales to investors was confirmed. While all the preparation and selling efforts are taking place, only a “letter of intent” documents the rights and duties of the business and the underwriter. This letter of intent very clearly does not commit the underwriters to go through with the offering and purchase any shares. The only binding part is that the issuer will pay the underwriter’s expenses if the sale is not completed. Even when the underwriting agreement is signed, there is a “market out” clause, letting the investment bankers cancel the transaction if any of the named events has happened. That list of events has grown over the years. As a result, investment bankers have abandoned virtually the entire risk that created securities underwritings to begin with. Wall Street has shifted back to the issuer all of the risk that the offering will not be sold and the money collected. The so-called “underwriters” are now just like a consignment store—if the shares sell, the company gets its money and the investment bankers get their commission. If the shares don’t sell, the issuer is out the time and cost. Except for the rituals, the “firm commitment” underwriting has become the same as the “best efforts” selling role, where a licensed securities broker agrees to use its best efforts to sell the entire offering but makes no guarantee. Calling it a "firm commitment" just opens an easier path with regulators and exchanges, who will waive requirements if it is a “firm commitment” underwriting.
Wall Street has become a closed system, in which the flow of capital is from professional money managers to the officers of large corporations, which are owned by the money managers. The sell side and buy side intermediaries collect the money and pass it on, subtracting a small percentage for their service. It’s like a conveyor belt of money, with Wall Street taking a little bit out of each dollar that goes by. But that capital flow, once what Wall Street was all about, has become a small part of Wall Street’s business. The rest of it is running a casino for betting on the price movement of Wall Street-manufactured contracts, still called “securities.” Unlike other licensed gambling casinos, the house gets to place bets alongside the customers.
Of course, it gets extremely complex, intricate, sophisticated. That’s part of the mystique. Only Wall Street insiders can begin to understand what goes on there. The rest of us appear to have no alternative but to trust that they know what they’re doing with our money and our world economy. Our purpose here, in describing Wall Street, the harm it causes and the ineffectiveness of the regulators, is to put a context around the suggestion that we bypass Wall Street in raising capital and investing in businesses and governments.
Wall Street’s biggest business, the one that most affects us all, is the buying and selling of contracts that go up and down in their market price. At the most basic, these contracts are shares of common stock or bonds, representing ownership or debt of huge corporations. Once upon a time, these shares were sold by the corporations for the purpose of raising capital to grow the business. The buyers hoped the corporation would someday pay out a portion of its earnings in dividends, providing them with a much higher return than they would have gotten from leaving their money in bank deposits. They also expected that their shares would increase in value as the corporation grew and prospered, allowing them to one day sell the shares at a price far more than they had paid.
The prudent investor would also consider buying bonds. These are contracts to repay the amount invested on specific dates and to pay a rate of interest on the bond amount. If the corporation doesn’t perform so well, the investor owning a bond is more likely to get back the money paid than the investor owning shares of common stock. The other major difference between bonds and stocks is that interest on bonds is a contractual obligation, while dividends on common stock are paid only if the corporation’s board votes to do so. An investor taking the long view will study the risks and the returns for a corporation’s stock or bonds and make a decision about what fits the investor’s personal objectives and tolerances.
Now imagine you are looking not at what meets the needs of investors or of businesses, but only at what is in the best interests of Wall Street. If investors are buying stocks and bonds to hold for several years, there is very little in it for the intermediaries. The sell side of Wall Street gets a commission or trading profit only when there is a transaction. On the buy side, growth of the assets under management is based upon the manager’s performance, compared to its peers in the business. This measurement is on a quarter-to-quarter basis, so there is frequent buying and selling. In striving to outperform their rivals, most fund managers get tips from brokers, on expected short-term price movements. They pay for these tips by directing their trades to the brokers who deliver nonpublic information that lets them get the jump on their competitor managers. Holding on for the long term is not the way either the sell or buy side does business.
Nearly all the buying and selling of securities
on Wall Street involves either stocks and bonds issued by
corporations or derivative securities issued by intermediaries.
That means that Wall Street makes most of its money from the buying
and selling of “previously-owned” securities, not anything that
actually moves money from investors to operating businesses.
It was the fixed commission rates that brought out the political power of Wall Street’s buy side. Money managers for big pension funds, mutual funds and other institutions lobbied Congress to end the monopoly pricing. In fact, the lure of institutional business had caused many brokers to find ways to rebate part of the commissions they received. This raised difficult enforcement issues and softened the sell side resistance to abolishing fixed rates. Congress finally opened commission rate competition on “Mayday” 1975.
Chris Welles published a book in 1975, just as
Both sides of Wall Street watched as the big winnings began to go to the intermediaries who put their own money into the game. Trading for the firm’s own account became more profitable than acting as a broker or money manager for clients.
Long after most large businesses were operated as corporations, Wall Street firms proudly remained partnerships. Staying in the partnership form was a statement to all who dealt with Wall Street: “You can trust us, because each partner’s wealth and reputation stand behind our every transaction.” If a corporation officer makes a huge mistake, or commits fraud, that officer and the corporation may be made to pay. But all other officers and durectirs are insulated from any loss, except the value of the shares they may own in their employer. In sharp contrast, the mistakes or felonies of a partner can put every other partner’s assets and freedom on the line.
Wall Street’s sell side had seen their clients
start or finance new businesses and then take them public for massive
capital gains. They saw how they could continue to run their
own businesses and get even greater compensation, if they were armed with vast pools
of money to expand and acquire. Wall Street brokers and
investment bankers changed their attitude about operating as
partnerships. Going public as corporations became more
important than retaining the partnership image and privacy.
Their partners’ profits could simply be replaced by corporate
bonuses, skimming off all but the leftovers for shareowners.
That put the officers/former partners at war with their shareowners.
[Susanne Craig, “Goldman Holders Miffed at Bonuses,” The Wall
We all paid a price for Wall Street going
public. One price was the loss of investment advisors, and
their replacement with casino managers and sellers of manufactured
securities. “The decision of the brokerage houses to sell their
clientele products rather than services grows out of the shift from
the partnership to the corporate form, and the demand from the firms’
own stockholders for a greater degree of stability in earnings than
the delivery of personal services can promise.” [Martin Mayer,
Stealing the Market: How the Giant Brokerage Firms, with Help from
Wall Street’s buy side began with insurance companies and endowment funds for universities, hospitals and other charitable organizations. During World War II, corporations started pension funds, as a way to attract and hold employees during a time of government wage controls. Since there was a 93 percent tax on “excess profits,” the deduction for pension plan contributions made them a cheap way to get extra compensation to employees. The pension contributions were not taxable to the employees, so the effect was that taxpayers as a whole were subsidizing the transfer of money from employers to their employees. These were “defined benefit” programs, so that large pools of managed money were built to fund a promised level of retirement payments. Buy side money managers became a new professional group.
Mutual funds, which had been minor players since 1924, became huge and active investors in the 1970s. Their marketing concept was that the small investor could get diversification and professional management. Individual Retirement Accounts and other tax programs had been created to take the place of the diminishing corporate pension funds. Suddenly, individuals were responsible for their own investment decisions and most of them turned their money over to mutual funds.
Wall Street’s buy side became the professional money managers for all these institutions. Their share of trading on the New York Stock Exchange went from only 20 percent in 1950 to 75 percent by 1975. [Marshall E. Blume, Jeremy J. Siegel and Dan Rottenberg, Revolution on Wall Street, W. W. Norton & Company, 1993, page 105] By the 1990s, money managers were earning extraordinary compensation from the trading profits they maneuvered for the funds they ran. They had gone from salaried professionals to commissioned performers. But real wealth came not from management fees, even based upon percentage compensation. Money managers left their employers and started their own mutual funds and, later, hedge funds, where they could have ownership of the business and get large incentive payments taxed as capital gains.
Whether cause or coincidence, the 30 years after Wall Street went corporate and entrepreneurial have seen it come to dominate our economy and set unimaginable heights of personal compensation. “From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.” [Simon Johnson, “The Quiet Coup,” The Atlantic, May 2009, www.theatlantic.com/doc/200905/imf-advice. See, also, Benjamin Friedman, "Is our financial system serving us well?", Daedalus: Journal of the American Academy of Arts and Sciences, Fall 2010, page 9, http://www.mitpressjournals.org/doi/pdf/10.1162/DAED_e_00037]
The last 30 years have also seen the nearly complete deregulation of Wall Street, the dismantling of protections put into place by the New Deal. For a very detailed account of the “12 Deregulatory Steps to Financial Meltdown,” you may read the March 2009 report, by Essential Information and the Consumer Education Foundation. [Robert Weissman and James Donahue, Sold Out: How Wall Street and Washington Betrayed America, Essential Information*Consumer Education Foundation, www.wallstreetwatch.org, March 2009, www.wallstreetwatch.org/reports/sold_out.pdf]
When money passes from individuals through Wall Street’s buy side and sell side, it undergoes a transmogrification, a drastic change in uses and purposes. Individuals have no ability to direct how their money will ultimately be used. It is Wall Street values that determine where money will go and on what terms. This closed financing system limits practices and restrains innovation. Capital has to go through rigid structures, dominated by a few people who know each other and think alike. They gather capital from diverse sources and funnel it through their own structures, reflecting their values and their limited frames of reference.
Most of us still have the image of Wall Street as an impartial channel for money passing from individuals to growing businesses. We need to have our images catch up with today’s reality. “Where is Wall Street and Who Works There” is very different today.
The Wall Street intermediaries who have owned the public offerings business are the investment bankers. They are generally a department of securities broker-dealer firms, the “members only” club through which all public securities transactions must pass. For over seventy years, their oligopoly has had the protection and regulation of the federal Securities and Exchange Commission. In late 2008, the remaining members of the club became parts of bank holding companies, to have additional funding and regulation by the Federal Reserve Banks and its Board of Governors.
(I’ve had 50 years experience as a securities
lawyer and certified public accountant. The part I know most
about, the role that really interests me, is how businesses raise
money by selling their securities to large numbers of individual
investors. Unfortunately, these public offerings of newly
issued securities to individuals have turned out to be a very minor
part of Wall Street’s total business. Raising capital for
business is heavily overshadowed by trading in previously-owned
securities and in the derivative securities that don’t raise money
for anyone. New issues are now sold predominantly to money
managers for investment funds. Today’s initial public offerings
are usually well over $100 million each. Rather than being the
young businesses that would be the future economy, they often are
divisions of giant corporations being spun off or being resold after
purchase by a private equity company. [Lynn Cowan,
“Private-Equity Exits Are Seen Dominating 2010 IPOs,” The Wall
Wall Street still sells new issues of securities in public offerings. It’s a very profitable business, because it is the last holdout for the fixed commission, the flat percentage fee that is the same rate no matter how large the transaction. There is no price competition among the investment banking departments of the major securities broker-dealers, including the commercial banks who are back after repeal of the Banking Act of 1933. Nor have there been any successful inroads by other financial intermediaries.
Because they have an oligopoly, the investment bankers have no incentive to improve the way they do business. A public offering underwriting operates as if the last technological advance ever made was the telephone. You’d think that the Internet would force a change in how public offerings are conducted. But the investment banker oligarchy has resisted attempts to crack its hold.
In the mid-90s, The Charles Schwab Corporation started Epoch Partners, an online investment bank that would cater to individual investors. Schwab shared ownership of the startup with two competing online brokerage firms, TD Waterhouse and Ameritrade. They gave up in 2001 and sold the firm to Goldman, Sachs Group. According to David S. Pottruck, then Schwab’s co-chief executive, "It was just not going to happen for us to reinvent the investment banking business. There's much too strong an in-place structure to that industry." To sell Epoch Partners, Schwab and TD Waterhouse gave Goldman Sachs access to their more than 10 million customers for selling underwritten offerings.
E*Trade Group had started E*Offering to do
online offerings of new issues. They sold it in 2000 to WIT
Soundview (later called Soundview Technology Group) which itself was
acquired in 2004 by The Charles Schwab Corporation and now just
provides services to securities broker-dealers. [From article
by Patrick McGeehan, “New-Era Banks Slip Into the Past,” The
Other new online investment banks also faded away. According to The New York Times reporter, Patrick McGeehan, “Despite the criticism that has been heaped on the major investment banks for how they handled initial offerings in the late 1990's, the old rules still apply and the old rulers still apply them. . . . In 1999 and 2000, six online firms managed 196 stock offerings that raised almost $30 billion, according to Thomson Financial Securities Data. So far this year [through June 2001], three of them, including Epoch, have participated in seven offerings that raised slightly more than $1 billion.”
The one remaining investment bank with an online emphasis is W. R. Hambrecht & Company. Bill Hambrecht had built the very successful technology stock firm, Hambrecht and Quist, from 1968 until it was sold in 1999 to J.P. Morgan Chase. Bill then founded W. R. Hambrecht & Co., where he introduced using the Dutch auction for new securities offerings. It operates very much like a conventional underwriting, with two differences. Like a conventional underwriting, Hambrecht, as managing underwriter, sets a price range for the expected offering a few weeks before it is to be sold. Conventional underwriters subjectively arrive at the final price by talking with their largest institutional money manager prospects, at “road show” or one-to-one conversations, effectively gathering informal, oral bids for shares. Hambrecht lets any brokerage customer place an emailed bid for shares at any price within the range. The final price is the one at which enough bids can be accepted to complete the offering. Everyone who bid at the final price or a higher number receives shares, at the final price.
The other difference is that Hambrecht includes
individual “retail” investors in the bidding process. Customers
of the brokerage firm are emailed announcements of the offering and
can access the preliminary prospectus before submitting a bid.
Bill Hambrecht’s reputation, network of acquaintances and persistence
have kept the underwriting business going, including taking the lead
for Google’s IPO. Unlike some of the failed online
investment bank ventures, Bill Hambrecht has never counted on being
included in underwriting syndicates managed by the major investment
banks. His firm has been the managing underwriter for
offerings, not making the mistake of thinking "that if you had
distribution, the underwriters would cut you into the business.
It's a wonderfully profitable business for the big firms. They're the
last guys that want to change it." [Patrick McGeehan, “New-Era
Banks Slip Into the Past,” The New York Times,
Hedge funds became major players in Wall Street’s buy side, largely because they could do things that others could not. They are structured like mutual funds, gathering money from many persons under one manager. But they use that money in all the ways that mutual funds are forbidden to do. They get away with it by weaving their structures to fit specific exemptions from the Investment Company Act of 1939. By 2010, there were 23,603 distinct hedge funds reporting performance data. These funds had total assets of $1.41 trillion in 2009, down from the 2007 peak of over $2 million. [Sizing the 2010 Hedge Fund Universe, http://www.pertrac.com/assets/Uploads/PerTrac-2010-Hedge-Fund-Database-Study-April-2011.pdf and PerTrac 2009 Hedge Fund Database Study, http://www.pertrac.com/PER0020/WEB/localdata/WEB/DATA/WEBSECTIONS]MATTACHMENT/PER0020_1368//PerTrac%202009%20Hedge%20Fund%20Database%20Study.pdf]
One of the two Investment Company Act exemptions used is for funds that have no more than 100 investors. [Section 3(c)(1), http://taft.law.uc.edu/CCL/InvCoAct/sec3.html] The other exempts a fund held by no more than 500 “qualified purchasers.” [Section 3(c)(7), http://taft.law.uc.edu/CCL/InvCoAct/sec3.html] They include an individual who owns at least $5 million in investments and institutions with at least $25 million in investments.
Part of the New Deal legislation, the Investment
Company Act was aimed at the investment trusts which flopped so
dramatically in the 1929 Crash. The law required that
investment companies register with the
Hedge funds are completely free of these restrictions, as well as all the other limitations of the Act. They pay their managers big percentages of the profits (which have been taxed at 15% capital gains rates). Most hedge funds borrow as much as they possibly can. And they invest in absolutely any financial instrument that is presented to them, if it meets their risk/reward analysis. [For a description of the beginnings of hedge funds, see Scott Patterson, The Quants, Crown Business, 2010, pages 33-35]
Their name, “hedge funds,” is a bit misleading. The investing technique of hedging is a way to offset or neutralize the risk on one investment by also purchasing another, related investment. It may mean buying shares in a technology company while also signing up for a put option on an index of technology stocks. If the individual shares go down because of a tech selloff, the put option will have increased in price. This is a strategy that an individual, or a pension fund manager might use. But hedge funds are into increasing risk, not reducing it. They are more likely to find ways to increase the amount of their bet on an outcome that results from their unique insight, or access to nonpublic information. However, they may use hedging to neutralize all the risks in an investment, except the one that they have figured out will work for them.
Hedge fund managers play every game that can be found on Wall Street. Some are technical games, like arbitrage, where simultaneous purchases and sales of securities are made in different markets when there is a miniscule price difference. Some are fundamental analysis, like predicting that a particular company is about to have an event that will cause a sudden move in the price of its securities. These predictions often get some help from spreading rumors and enlisting allies. Then there is the ancient game of trading on insider information.
The first hedge fund is said to have been
started by Alfred Winslow Jones in 1949. [Sebastian Mallaby,
Senior Fellow for International Economics at the Council on Foreign
Relations and author of More Money Than God: Hedge Funds and the
Making of a New Elite, Penguin Press, 2010, in "Learning to Love
Hedge Funds," The Wall Street Journal, June 12-13, 2010, page
W1] They quickly grew in number to over 10,000 separate funds.
Several hedge fund managers received over a billion dollars in annual
fees, from sharing in the results of their funds. The standard
compensation agreement for managers is 2% of the amount in the fund
and 20% of the profits. In 2007, that brought $3.7 billion in
pay to John Paulson, the highest-earning hedge fund manager. In
second place was George Soros, one of the very first and most
successful, who earned $2.9 billion for the year. Average pay
for the top 25 fund managers was $892 million in 2007. To make
the bottom of the list, it took compensation of $210 million. [Institutional
Investor Alpha Magazine, as reported by Bloomberg,
For more description of hedge funds, see Gregory Zuckerman, “Shakeout
Roils Hedge-Fund World," The Wall Street Journal,
It has not only been the hedge fund managers who have scored great wealth from hedge fund operations. Banks and brokers provide capital and support services to hedge funds. Called Prime Brokerage, it includes executing and clearing trades, bookkeeping, preparing reports, keeping custody of securities and cash, borrowing securities for short sales and providing research. These are just add-ons to the two basic services. One of these is lending huge amounts of money for hedge funds to take their positions. The other is recruiting new investors for the hedge funds.
As the relationship between hedge fund managers
and their prime brokers expands, the “research” and financing take on
new meaning. Banks and brokers make their own moves in the
markets, although they are far more restricted in what they can do.
Once there is an inner circle closeness, the prime broker can pass
information and lend money to the hedge fund, so that it can make a
transaction that the prime broker couldn’t lawfully do itself.
Ways are found for the hedge fund to pay the prime broker, sharing
some of the gain from the transaction. “Reportedly, the prime
broker banks get up to 20 percent to 30 percent of their total bank
revenues from hedge funds . . ..” [Charles R. Morris, The
Trillion Dollar Meltdown, PublicAffairs, 2008, page 111]
In 2010, hedge funds “shelled out a total of about $3.7
billion in brokerage commissions to banks for equity trades,
according to research firm Greenwich Associates.”
Benefits they got from the brokers included “special access to senior
deal makers and corporate executives at dinners and other
gatherings.” [David Enrich and Dana Cimilluca,
“Banks Woo Funds With Private Peeks,” The Wall Street Journal,
In the aftermath of the 2008 Panic and its aftermath, hedge funds
may have peaked in attracting money from institutions and wealthy
In the aftermath of the 2008 Panic and its aftermath, hedge funds may have peaked in attracting money from institutions and wealthy individuals.“’We used to rely on the public making dumb investing decisions,’ one well-known
Before the 1970s, the role of securities rating agencies was about as important as the job of sewing labels onto clothing. They existed to judge the risk that bond issuers would default on their duty to pay interest on time or return the principal when due. Certain institutional investors were limited to purchasing only the highest rated bonds from corporations or governments.
When Wall Street began marketing new securities, especially those packaging mortgages, it was especially important to get an “investment grade” rating from Standard & Poor’s or Moody’s, the two principal rating agencies. These new securities were far more complex than the simple promise to pay by a corporate or government borrower. Few money managers would be willing to do all the work necessary to understand and evaluate the quality of a few thousand loans, or the legal niceties of a 150-page bond indenture.
Rating agencies were persuaded to begin rating mortgage-backed bonds, which were like a corporate bond, with a pool of loans as collateral for extra assurance that the bond was good. Once comfortable with these, rating agencies were willing to rate interests in the pools of loans themselves, known as pass-through certificates. Finally, ratings could be had for collateralized mortgage obligations and their many variations. Rating agencies are paid by the issuers of the securities they rate. This, by itself, is not necessarily a compromising arrangement. Audit firms are paid by the businesses they audit, even though lenders and investors rely upon their audit opinions. For rating agencies, it is the relationship with the handful of investment bankers and their lawyers that may have led to a breakdown in their analytical independence.
Most debt securities could never get favorable results from a rating agency without some form of third-party credit. Sometimes, a parent company could guarantee its subsidiary’s performance. More often, the backing was purchased from an insurance company. The rating agency would rely on the insurance company’s own financial condition, which needed to support a top rating. As insurance companies kept up with the boom in asset-backed securities, their exposure to risk grew phenomenally. For some reason, the rating agencies didn’t seem to let this affect their decisions.
Counterparties to credit default swaps
Insurance companies could never handle all the debt structures that Wall Street was inventing. The answer was to leave out the word “insurance” and let others into the role of promising to cover any defaults by borrowers. Brokers began arranging for a “counterparty” to take over the investor’s risk, calling it a “credit default swap.” According to Charles Morris, the amount of credit default swap contracts went from $1 trillion in 2001 to $45 trillion in 2007. Banks were the counterparties on $18 trillion and hedge funds were in for $15 trillion. [Charles R. Morris, The Trillion Dollar Meltdown, Public Affairs, 2008, page 125] Somehow, people tended to ignore the possibility that several big borrowers could default or, even more significantly, that a counterparty would have gotten in way over its ability to make good on its promises.
In the 1950s and 60s, venture capital firms were run by wealthy individuals who put together pools of capital from people like themselves. They were averaging higher returns than investing in traded securities and someone got the idea of gathering really big money from university endowments and other institutional money managers who were into “total return” investing. As a result, venture capitalists have become money managers for institutional investors, feeding their investments into the sell side for public offerings or acquisitions. Less than 2% of the money in venture capital funds comes from the managers, who take fees equal to 2% of the total fund amount plus 20% of profits when an investment is cashed out. Plenty of information is available about venture capitalists and their investments, from the National Venture Capital Association and PricewaterhouseCoopers. [www.nvca.org and https://www.pwcmoneytree.com/MTPublic/ns/nav.jsp?page=notice&iden=B]
The results of going after big money were first
a big increase in venture capital investing, to 1.1% of U.S. Gross
Domestic Product in 2000, followed by a continuing decline. The
need to produce short-term returns for institutional investors has
meant investing in later stage companies and exiting the investment
much sooner. Since 1997, investors have actually lost money in
venture capital funds, after paying the managers’ fees. [Carl
Schramm, president of the Kauffman Foundation, and Harold Bradley,
its chief investment officer, “How Venture Capital Lost Its Way,”
One summary of Wall Street: "In a
Once upon a time, investment bankers were useful.
Back before there were investment bankers, anyone who needed money for developing a business would go directly to family and friends. Larger projects could mean taking a proposal to the local wealthy family. Perhaps an acquaintance would arrange a referral or introduction, but the presentation and negotiations were directly between the person who had the money to invest and the one seeking to be the steward of that money.
As projects grew larger throughout
Financial intermediaries exist to match the needs of people who want income from their money with the needs of those who want to use that money. Some financial intermediaries, like banks, gather money from depositors and furnish money to individuals and businesses. As the money flows into and out of these institutions, it is transformed in amount, in the rate of interest paid and in the risk of loss. Those of us who deposit our money in a bank have no control over where it goes, no knowledge of how it is used.
These depository institutions work well, but only within a narrow range of risk and reward. Depositors are mostly interested in safety and convenience. We’re willing to settle for low interest rates on savings and perhaps no interest on our checking account. Borrowers understand that banks want their money back, usually within a year or so, and they also want ways they can recover their money if the borrower doesn’t pay on time.
Just having bank deposits and bank loans is not enough. Many of us are willing to take more risk than a bank deposit, in the hopes of getting a higher return. On the other side, there are businesses with a need for capital that can be used for longer times, and at a higher risk of loss, than banks would tolerate. That’s where securities come into play. These securities are agreements between the providers of money and the stewards who will be using that money. Until recently, when options, futures and other “derivative securities” became popular, securities meant either part ownership in a business (“shares” or “stocks”) or a promise to repay the money with interest (“bonds”).
Investment bankers are financial intermediaries who arrange for securities to be issued and purchased. They’re also hired by companies who are trying to buy or sell businesses, in mergers or acquisitions. This business is usually countercyclical to new securities issues and brings in fees while waiting for the next bull market. Most investment bankers are part of a commercial bank holding company or a securities broker-dealer which includes groups of brokers, buying and selling securities as agents. These firms also include departments acting as dealers, trading in securities for the banks’ own speculation.
Late in the 18th century, investment banking
partnerships began using their pooled capital to buy an entire issue
and then resell it to wealthy individuals. This was attractive
to the issuer because it had to deal with only one buyer in one
transaction, before getting on with using the money for the
business. To purchase larger issues, these partnerships “often
cooperated in putting together secret lists or embryonic syndicates
for sharing the risks . . ..” [Competition in the
Investment Banking Industry, Samuel L. Hayes,
Even with these early intermediaries, the people who were waiting to use the money still had the risk that it might not get completed, or that it could be delayed. The need remained for someone to take over the risk that the funding might not happen, or might come too late. Borrowing a term from the insurance industry, there was an opportunity to “underwrite” this risk. As competition heated up among financial intermediaries, some of them began agreeing to deliver the money, less their commission, at a specific date. They came to be called “underwriters,” and took over the risk that something might go wrong before the investors had all paid for the securities they ordered.
Before a securities issue (called “flotation”
Of course, underwriting a risk provides comfort only to the extent that the underwriter has the resources to make good on the risk. To achieve this credibility, the underwriting firms became groups of owners and lenders, so that they had access to substantial cash or liquid assets. Some of them were private banks, which took in deposits from the very wealthy. Others were merchant banks, offshoots of trading businesses. They gradually came to be known as investment bankers. For most offerings, several investment banks joined together to underwrite the securities.
At first, these new investment bankers
“purchased newly issued securities as a group at a fixed price, then
sold them individually at times, places and prices of their
choosing.” [Paul G. Mahoney, The Political Economy of the
Securities Act of 1933, University of Virginia School of Law,
Law & Economics Working Paper No. 00-11, May 2000, page 5,
cooperative structure took away competition among investment bankers
in negotiating with the business or government that was raising
capital. But they were still competing in lining up
prospective investors. So, their next step was to eliminate
that competition through the “syndicate system,” where the syndicate
members agreed they would all sell at the same price and time.
It was up to the syndicate manager to complete negotiations and keep
everyone else in line. The reason for using this oligopolistic
hierarchy: “The profits to be made from such flotations were
so immense and the mutual benefit of maintaining discipline among
syndicate participants in the flow of capital was so clear that the
competitive pyramid was an indisputable fact by the 1820s. The
early division of firms between the apex and the body of the pyramid
was thus a natural outgrowth of competitive dynamics as they then
existed.” [Competition in the Investment Banking Industry,
Samuel L. Hayes,
After the American Revolution, the new
Growth spurts for investment banking in the
The American Revolutionary War had been paid for largely by printing money. That was a financing method of last resort and led to hyperinflation. [“Inflation and the American Revolution” by H.A. Scott Trask, Ludwig von Mises Institute, http://mises.org/story/1273.] Currency printed by the Continental Congress was worth one-thousandth of its face amount by war’s end, leading to the phrase, “not worth a Continental.” The Continental Army also used “impression,” the confiscation of supplies rather than paying for them. Bitter resentment lingered long after the war.
To pay for the War of 1812, the U.S. Treasury tried to get the public to buy $16 million in bonds. The federal government had trouble finding buyers and nearly $10 million ended up being sold to what would later be called an “underwriting syndicate,” made up of the very wealthy John Jacob Astor and Stephen Girard and the former head of a British mercantile banker. The government got only 40% of the bonds’ face amount, an immense discount. This discount between the purchase price from the issuer and sales price to the investor is still called the “underwriting spread.” The syndicate financed the transaction with short-term borrowings and resold the bonds to their wealthy business acquaintances, at more than twice what they had paid. [Wall Street: A History, by Charles R. Geisst, Oxford University Press, 1997, pages 18-19].
By the 1830s, private banks were formed in the
Financing the Mexican War (1846-48) helped bring in British
private banks, which set up American affiliates. They accepted
deposits only from very wealthy British and Europeans, using the
funds to buy new bond issues for resale. The timing of their
fundraising from the rich coincided with a flight of capital from
The new business of investment banking got its
big push from the Civil War.
In marketing the war bonds, Cooke introduced
what we today call “dual motive” marketing of securities. In
addition to safety, return and convenience, he also appealed to the
patriotism of those who wanted to win the war and preserve the
Cooke introduced a form of “underwriting commitment” between his underwriting syndicate and the issuer. Unlike today, the syndicate did not commit to purchase and resell the entire offering. Rather, the issuer had a period of direct marketing and the syndicate agreed to buy what was left. The syndicate was underwriting the risk that the direct marketing effort would fail to sell the entire offering. If that happened, then the members of the syndicate would purchase the unsold portion and try to resell it. Today, this would be called a “standby commitment.” It is now used only in so-called “rights offerings,” where existing shareowners have the right to purchase a new issue of shares, usually at a discount to the market price. Underwriters agree to buy any shares not taken by the shareowners. The Cooke program, of a direct marketing by the issuer with a standby commitment, hasn’t been in serious use since 1900. All underwritten offerings must now be sold exclusively through the underwriters, and their full commission paid. (My first client in an underwritten initial public offering had commitments from its officers, directors and their families to buy a substantial portion of the offering. I tried to negotiate an exclusion of these shares from the underwriting and was told that it was never, never done. The client was asked to turn over the names to the managing underwriter, so they could get credit for commissions on those sales--and also try to add them as customers for other products.) Cooke also adopted the European practice of repurchasing bonds in the aftermarket, to maintain the price level while new bonds were still being sold, a practice later to be called “stabilization” and protected by the Securities Act of 1933.
In addition to Cooke’s sales to the
After the Civil War, Jay Cooke tried to apply his war bond marketing system to bond issues for the Northern Pacific Railroad. It didn’t work. Cooke made at least three mistakes that are now classic “don’ts” of corporate finance. One was that he advanced short-term funds to the railroad, which insisted on building rails faster than the bonds could be sold. This put Cooke into a different relationship with the client, one of creditor rather than service provider. That affects judgment, like lawyers representing themselves. Another error was to count on participation by other bankers (in his case the Rothschilds) without receiving a clear commitment. (A client of mine once assured a prospective investor that a bank had made “a moral commitment” for a substantial loan. The investor responded that “a bank is incapable of making a moral commitment.” He went on to explain that my client may have had a moral commitment from a bank officer, but the officer may be transferred or easily overridden by a senior officer or committee.)
Cooke’s third mistake was to misjudge his
market, the small investors. Railroad bonds did not appeal to
patriotism. Instead of a “dual motive,” the investor was left
with a straightforward financial risk/reward analysis. That is
a daunting challenge for a part-time investor. There was no
real comparison to be made between
The advances Cooke had made to the railroad
caused depositors in his private bank to withdraw funds. Cooke
went out of business in 1873, setting off a major panic on Wall
Street. That “brought a speedy end to the first great effort of
investment bankers to develop a large, permanent class of small
investors.” The firms that survived sold “new
issues abroad and to a select American clientele of large,
individual and institutional buyers.” [Samuel L. Hayes,
Before the 1890s, most businesses were still conducted as family partnerships. So long as the entrepreneur/founder remained in charge, expansion capital came from retained earnings and bank borrowings. When the business ownership passed on to the second and third generation family members, they were the ones who turned to investment bankers to raise capital and convert some of their holdings to cash. Railroads, their lawyers and lobbyists had developed the law of corporations to become the favored form for larger businesses. With incorporation, outside investment, beyond family and friends, became popular. Investment banking expanded from government securities through railroads to businesses in all industries. By 1910, there were underwriting syndicates of more than a hundred banking and brokerage firms. Steady relationships were developed between investment banks and the regular issuers of securities, as well as with the money managers at commercial banks and insurance companieswho were the principal investors.
Ever larger transactions were to come from
combining several competing businesses and selling securities in the
consolidated corporation. In 1901, J.P. Morgan put together the
United States Steel Corporation,
Along with the increased volume of securities
offerings, “fewer and fewer corporations chose to sell their own
securities, as had been common a generation earlier, when an
issuer’s reputation often was greater than that of the banking
house.” [Samuel L. Hayes,
Even with all this vast expansion to serve the
demand for capital, the supply side for investment was still limited
to institutions and wealthy individuals. “Before World War I,
only the very wealthy invested in securities. Most of them
lived in other countries. Investment banks had the
relationships with those investors. They were the gatekeepers
to raising capital within a few months.” [Raghuram G. Rajan &
Luigi Zingales, Saving Capitalism from the Capitalists,
Unleashing the Power of Financial Markets to Create Wealth and
We have an image of investment banking in 1913, from Harper’s Weekly articles written by Louis Brandeis, a successful corporate lawyer who also took on many public causes before his 1916 appointment to the U.S. Supreme Court. “The original function of the investment banker was that of a dealer in bonds, stocks and notes; buying mainly at wholesale from corporations, municipalities, states and governments which need money, and selling to those seeking investments. The banker performs, in this respect, the function of a merchant; and the function is a very useful one.” [Louis D. Brandeis, Other People’s Money: And How the Bankers Use It, National Home Library Foundation, 1933, page 5] That original function was about to become subordinate to other, more profitable activities, as another war was to change Wall Street.
To pay for World War I, the U.S. Treasury issued the Liberty Bonds of 1917-18 and the Victory Bonds of 1919. All of the bond issues sold out and a total of $21.5 billion in bond sales were made in just over two years. According to the Annual Reports of the Treasury Secretary, the first Liberty Bond issue was purchased by four million individuals and the second by nine million. By the fourth issue, there were over 21 million individuals purchasing. By comparison, the Treasury Reports estimated that only about 350,000 individuals purchased bonds in the years before the war began. [Paul G. Mahoney, The Political Economy of the Securities Act of 1933, University of Virginia School of Law, Law & Economics Working Paper No. 00-11, May 2000, http://papers.ssrn.com/paper.taf?abstract_id=224729, page 8, citing the Annual Report of the Secretary of the Treasury for 1917, H.R. Doc. No. 613, 65th Cong., 2d Sess., at 6 (1918) and the Annual Report of the Secretary of the Treasury for 1918, H.R. Doc. No. 1451, 65th Cong., 3d Sess., at 18 (1919).]
The Treasury Department made some direct sales, using marketing methods that Jay Cooke had developed for the Civil War. These direct offerings included small denomination saving stamps and bonds purchased on the installment plan. However, the great majority of the bonds were sold through commercial banks, investment bankers and securities brokers, all working without commission. These intermediaries had a longer-term self interest. As Investment Bankers Association then-president Warren S. Hayden said, about expanding the market for securities, “the government will have done in a year or two what our private enterprise as it was before the war could not have done in decades.” [quoted in Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970 edition, page 228.] Selling the huge volume of war bonds required marketing to the middle class, people who had never invested in securities. These first-time investors needed to be taught to trust parting with their money in return for nothing more than a piece of paper.
The commercial banks were particularly
imaginative and aggressive in selling Liberty Bonds and Victory
Bonds to the nonwealthy. Banks opened branches convenient to
working people, kept evening hours and advertised. National City
“These developments changed the distribution process for new issues. Bankers perceived that more money could be obtained from the millions of middle class wage earners than from a few wealthy families. Moreover, the Liberty Loan drives produced a generation of salesmen who were experienced at contacting hundreds or thousands of retail customers rapidly. After the war, these salesmen created a nation-wide network of securities dealers who specialized in selling securities to individual investors. These securities dealers employed 6,000 stock and bond salesmen in 1910, increasing to 11,000 in 1920 and 22,000 by 1930.” [Paul G. Mahoney, The Political Economy of the Securities Act of 1933, University of Virginia School of Law, Law & Economics Working Paper No. 00-11, May 2000, http://papers.ssrn.com/paper.taf?abstract_id=224729, page 12, citing the U.S. Dept. of Commerce, Bureau of the Census, Historical Statistics of the United States, Colonial Times to 1970, Part 2, p. 1104 (Washington, DC, US Government Printing Office, 1975).]
The new retail dealers purchased new issues for resale and also held inventories of securities traded in the secondary markets, to meet the growing demand of middle class households for investments. As attention turned to “the masses” for distributing securities, new securities brokers were formed and became members of selling groups. Retail dealers became the base of the securities distribution pyramid, with the managing underwriter at the peak. They were not included in the underwriting syndicates, where membership was only for traditional investment bankers. After selecting members of the underwriting syndicate, the managing underwriter would pick firms to become part of a “selling group.” These dealers would be allotted a portion of the syndicate’s commitment, at a markup from what the syndicate paid the issuer but still at a discount from the price charged to the investor. They had to sell at the same price and time set by the syndicate manager, or “bookrunner.”
The managing underwriter’s authority to include brokerage firms in the selling group continues to be a powerful tool for enforcing anticompetitive practices. For instance, syndicate managers would keep out brokers which had participated in a “best efforts underwriting.” Those are offerings in which a broker agrees with the issuer to use its best efforts to sell the securities and to get paid only for what it sells. Investment bankers will only do “all or nothing,” “firm commitment” underwritings and they discourage anyone breaking ranks with any other arrangement. J.P. Morgan & Co. and other established investment banking firms continued as wholesalers only, creating syndicates and selling groups of up to 1,200 firms.
The war bond success with smaller investors was
the carrot for investment bankers to expand their market for selling
new securities issues. The stick was the new federal income
tax. Investment banker Paul Warburg was quoted in The Magazine
of Wall Street that taxes had “decreased the importance of the
one-time class of professional capitalists as the exclusive field to
cultivate for the purpose of placing investment securities.
The savings of the masses will become an element of growing
importance in the regard, if private enterprise is to successfully
finance the future of our country.” [“Paul M. Warburg Says:
‘Immigrants Are Potential Capitalists’,”
Commercial banks began acting like investment bankers, forming affiliates to underwrite securities issues. Their market share got larger each year until, just before the Great Depression, commercial banks and their securities affiliates were the underwriters for nearly 37% of new issues. By 1930, they were the selling firms for over 60 percent of the underwritten stocks and bonds. “Their role in distribution made commercial banks by far the most important element in the investment banking business. They relied heavily on salesmen and advertising, and the affiliates appealed directly to the parent’s deposit customers, with whose accounts and habits they were familiar.” [Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970 edition, page 279.]
Investment bankers maintained their position as intermediary for raising money from wealthy individuals, institutional money managers and securities brokers. Commercial banks were becoming the channel for money from the middle class. We’ll never know what would have happened if the commercial banks had been able to continue their competition with investment bankers for supplying capital to businesses and government. Instead, two related intervening events put investment bankers back into their monopoly control over the issuance and sale of new securities.
One event was the steep decline of the financial markets as we went into the Great Depression. Long-term capital, for which bonds and shares are issued, is the fuel for growth. There just wasn’t much growth during the 1930s and very little demand for the services of investment bankers in their role as securities underwriters. On the supply side, those who could have afforded to invest were not encouraged to do so in the Depression environment.
The opening for investment bankers to get rid of their competition came with the public anger over money it lost on stocks and bonds purchased in the Roaring 20s. Commercial banks had been full participants in the speculation and manipulation that was exposed after the 1929 stock market crash. Stories of their bad practices were used to help Congress enact the Banking Act of 1933, prohibiting commercial banks from being investment bankers or selling securities. More about how investment bankers carried off this maneuver is in the chapter “The Traffic Cops on Wall Street.”
The new law, known as Glass-Steagall after its authors, protected the investment bankers’ monopoly for another half century. It also created the Federal Deposit Insurance Corporation, to guarantee bank depositors that they could get their money back if the bank failed. The law also put ceilings on the interest rates banks could pay depositors, protecting them from price competition. Banks with securities marketing affiliates had a choice: Give up the securities business or operate without government-insured deposits.
After their success in lobbying Congress to get commercial banks off their turf, investment bankers kept the capital channels restricted to their “preferred lists” of institutional money managers, securities brokers and wealthy customers. There were good reasons for the less wealthy to avoid investing in the 1930s, but one of them was that no one was trying to sell them securities. Investment bankers returned to what they had been doing before World War I opened up the middle class market—moving money from the wealthy to big business.
In World War II, the
World War II bonds were a great and successful direct public offering. Unlike all of our other wars since the American Revolution, investment bankers were not chosen to underwrite the bonds. The U.S. Treasury set up a War Finance Division which used all available media to bring Americans into regular bond purchases. Advertising space and time were donated by newspapers, magazines and radio stations. Movie stars and other public figures appeared at bond rallies and held radio telethons. Irving Berlin wrote the theme song, “Any Bonds Today,” performed by the Andrews Sisters. Auctions for bond purchase pledges were held for items like Betty Grable’s stockings and Man-o-War’s horseshoes. Some businesses created and placed their own ads to promote war bond purchases.
The actual selling to individuals was done by volunteers. They were trained to go door-to-door and to staff kiosks. Without receiving any commissions or other pay, the volunteers made telephone calls to arrange times to meet at a home, place of business or sales kiosk. Communities were given quotas and put in contests for selling the most bonds. One can only imagine what could have been done with the tools of the Internet.
Even with this immense and successful
marketing, banks and other institutions and businesses bought three
times the dollar amount of war bonds that were sold to individuals.
These purchases were for the firms’ own investment and not for
resale. Investment bankers and other financial intermediaries
were not a significant factor in financing World War II. The
biggest financial transaction in history had bypassed investment
bankers. Perhaps the chilly relationship between Wall Street
When the last War Bond had been sold, there was
no recorded sign of financial intermediaries using the direct
offering program to market other securities. New securities
issues were still dominated by the same investment bankers and they
stayed with their underwriting syndicates, selling to other
broker/dealers, institutional money managers and wealthy
individuals. But now, investment bankers and securities
broker-dealers had the market all to themselves. Commercial
banks had been frozen out by Glass-Steagall, the Banking Act of
1933. The New Deal securities laws entrenched registered
securities broker-dealers as the monopoly for selling securities.
It had become unlawful to even attempt to act as a financial
intermediary for securities, without first being registered with the
After the World War II, many retail brokerage firms did seriously try selling to the middle class. They focused on trading previously-owned securities on the exchanges and in the over-the-counter markets. They also sold to retail customers from their allotments of securities in underwritten public offerings. “Having a stockbroker became as necessary as having a minister or a psychiatrist in the new American middle-class society . . ..” [Charles R. Geisst, Wall Street: A History, Oxford University Press, 1997, page 274] The bull market that developed after President Eisenhower’s 1952 election continued for more than fifteen years. Thousands of retail brokers were hired. Commission rates on trades were fixed by the New York Stock Exchange, so there was no price competition among brokers in the trading of existing securities.
Even with this growth in the Wall Street sell side, “investment banking in the 1960’s was as highly concentrated as it had been sixty years earlier. In some respects it was even more so. No matter how measured—firm size, capital employed, underwritings, syndicate managements—a relatively few large houses, mostly located in New York City, conducted most of the nation’s new issues business.” [Vincent P. Carosso, Investment Banking in America: A History Harvard University Press, 1970 edition, page 505] Nearly all sales of new issues of securities continued to be sold to the same people and in the same way. Institutional money managers were invited by the managing underwriter to “road show” presentations and private meetings. Brokers working for firms in the underwriting syndicate or selling group telephoned their customer list and made “cold calls” to prospects.
While investment bankers today still deal only with institutional money managers and wealthy individuals, other broker-dealer firms on Wall Street are marketing to the middle class--mostly selling mutual fund shares to investors and running a casino for traders in derivatives, commodities, currencies and other zero-game gambling. Managing underwriters will bring retail brokerage firms into a few of their underwriting syndicates and selling groups, but there is no real marketing effort to retail customers. None of the successful techniques used by the U.S. Treasury in selling World War II bonds was introduced into the underwriting pattern. In fact, the federal securities laws were presented as an absolute barrier to the advertising and soliciting that would reach those who are not finance professionals. This excuse isn’t really true but it provides a quick and easy answer to why there is no effort to reach a mass market.
The real reason that investment bankers don’t sell shares directly to the middle class is because they don’t have to. They can make their full commission without spending the extra time and money to reach the mass market. Underwritten offerings are the last holdout of the fixed commission, and the commission is technically paid by the issuer, not the investor. That means that the underwriter gets the same amount per share, whether the sale is for 100 shares or 10,000 shares. Obviously, the underwriter is going to focus on the prospects who can buy 10,000. These prospects for big sales are their counterparts on Wall Street’s buy side—the money managers for funds. Underwriters can place an entire issue with a few “road show” breakfasts, luncheons and dinners, along with some telephone calls. [Some underwritten offerings have an abbreviated electronic “retail road show” available on the Internet. http://www.retailroadshow.com/index.asp]
The commission on nearly all Initial Public
Offerings of common stock, among all the Wall Street investment
bankers, has been maintained at seven percent. Competition
among them is all about who knows whom, which image and promises are
the most persuasive and other nonprice subjective issues.
There just is no price competition on any but a few IPOs. (I once described
this phenomenon to a friend who had a perfect score on the Law
School Aptitude Examination, graduated from
After World War II, as money began to accumulate within the middle class, including their retirement accounts, another layer of financial intermediary became integral to the process—the mutual fund manager. This allowed Wall Street to get three sets of fees from a public offering of securities: Investment bankers get their full commission from the issuer, mutual fund managers get their fee based on the size of their fund and brokers are paid for selling mutual fund shares. The sell side was vastly expanded by the success of mutual funds. They have become the mechanism for gathering money from the middle class. Mutual fund managers are the marketing arm for Wall Street to attract money from the retail market. They have also become the buy side for the new securities issues underwritten by investment bankers. Investment bankers don’t deal directly with the middle class. That is left to mutual funds, as another financial intermediary earning commissions on moving the public’s money.
Mutual funds are a creature of the Investment
Company Act of 1940, which was one of the last New Deal laws to
tackle Wall Street abuses—the investment trusts that had been sold
to unsophisticated small investors in the 1920s. These trusts
had often been riddled with conflicts of interest and many were near
total losses after the Crash of 1929. The Investment Company Act
placed serious reporting and regulatory requirements on funds that
sold shares to the public and invested in securities. The new
investment pools created to comply with the new law were marketed as
“mutual funds.” Today, there are over 10,000 mutual funds,
more than the number of companies with shares traded on
By the early 1960s, over half of all new shares
sold to the public were those issued by mutual funds. This is
likely why the
In all of the process of marketing new
securities, mutual funds are about the only place where the mass
marketing War Bond lessons are used today. The mutual fund
industry has lobbied a series of minor modifications to the
The result is that the flow of capital from nonwealthy individuals to businesses passes through at least two sets of intermediaries, each taking a percentage fee. The underwriting investment banker sells its clients’ shares to the mutual fund manager, who either sells its mutual fund shares directly to the individual or pays a commissioned broker to sell its shares. Why couldn’t the issuer bypass all two or three of these intermediaries and market directly to the individual? The chapter called “Direct Routes Open Now for Bypassing Wall Street,” shows how this is beginning to happen and what can be done to move it along.
An argument can be made in favor of keeping the investment banking business separate from selling securities to retail customers. There could be some value in having a group of specialists who served only the businesses and governments issuing securities. Like the English system of barristers and solicitors, the investment banker would serve the interests of the client and the capital markets, without being influenced by the business of dealing with investors. Retail brokers and buy side money managers would take care of the demand side, while investment bankers focused on supply side needs and concerns. However, Wall Street investment bankers are most loyal to their own firm, including its trading department. Next, their interests lie with favoring money managers with large pools of money to invest. That’s where their repeat business is, not with the client issuing its securities.
Whatever validity the argument for investment-banking-only firms might have had, it went away with the changes on Wall Street after the bull market of 1953 to the late 1960s. Stocks and bonds began to have competition from other financial instruments. Out of the commodity futures markets came securities used to hedge stock and bond investments. This was the beginning of “financial derivatives,” so called because they are derived from the risk and price movement in other securities. On the buy side of Wall Street, derivatives became accepted and popular because the purchaser could get the effects of price changes by using only a fraction of the money it would have taken to buy the underlying stock or bond. On the sell side, these new derivative securities were relatively free of competitive pressure on commissions and fees.
Bigger changes came with the end of fixed pricing on stock trading commissions. Monopoly pricing of commissions had been set by the New York Stock Exchange since it began in 1792, resulting in huge profits during the bull market of the 1950s and 1960s. Fixed commissions meant that every brokerage customer paid from the same fee schedule to buy or sell stocks or bonds. There was no price competition and no break for large orders over small ones. Customers retained their brokers based on personal relationships, reputation for good results or other nonprice factors.
As mutual funds came into increasing popularity
in the 1960s, their professional money managers joined with managers
of pension funds and others to pressure for discounts on their huge
transactions. They had much more market power than individual
investors and some brokers began finding ways to circumvent the
Stock Exchange rates. In 1971, the NASDAQ Trading Market began
automated, over-the-counter trading to compete with the Stock
Exchanges. Recognizing the inevitable crumbling of fixed
When fixed commissions went away, brokerage firms began finding other ways to make profits. They looked to transactions that weren’t easy to compare, that could not be shopped around for the lowest price. This led to bonds issued by foreign companies (the Eurobond market) and by American companies that didn’t carry investment grade ratings (the junk bond, or high-yield market). It also led to the creation and selling of new securities that were simply markers for the movement in stocks, bonds and other financial measures (the derivatives market). As former retail securities brokers began to diversify into creating transactions and securities, they were moving in on the underwriting business. Unlike commercial banks, they had no legal impediments to becoming investment bankers. That’s because they were registered as securities brokers and dealers. They could buy and sell securities for themselves, as dealers, and also for customers’ accounts, in their capacity as brokers. Their interests as dealers, buying and selling securities for their own account, often conflicted with their interests as brokers for customers and as investment bankers for businesses issuing new securities to raise money.
A major goal of
The lobbying victory against separating brokers and dealers not only allowed brokers to underwrite new issues and to trade for themselves. It also allowed investment bankers to diversify into being a broker, an agent for the resales of securities. By the 1970s, most investment bankers had acquired or developed brokerage businesses, to participate in the trading of securities, including the new derivatives. At the same time, most Wall Street retail brokers had pirated employees from investment banks and gone into competition for underwritings.
Investment bankers built profitable departments
as securities dealers, trading in securities with their own money
for the firm’s own profit. However, being a dealer requires
lots of available money. To have that money on hand, the Wall
Street partnerships began incorporating and having public offerings
of their own stock. [For an illustration of the argument that
incorporation was a major contributor to Wall Street’s crash, read
“The End,” by Michael Lewis, in a brief sequel to his book Liar’s
Poker, in Portfolio.com,
Buying and selling with their own money became
the dominant business for the most profitable investment banks, like
Goldman Sachs: “Before the financial crisis, everyone on Wall
Street used to joke that Goldman wasn't so much an investment firm
as a giant, risk-laden hedge fund. It seems that old label still
applies.” [Matthew Goldstein, “Goldman: The Same as it Ever
Was,” Business Week,
As investment bankers began to have public shareowners, they became subject to the need for steadily increasing earnings. Underwriting new securities issues is a boom and bust business. But the business cycle for mergers and acquisitions is generally the mirror of the public offering cycle. When new stock offerings slack off, it is usually because market valuations, such as price/earnings ratios, are at the low end of their trading range. By contrast, companies with depressed stock prices are hunted by acquirers. Investment bankers often call on senior executives of companies, with ideas for what businesses they might acquire or how they might be acquired by a "white knight" to defend themselves against a hostile takeover.
A major diversification for investment bankers was to expand their advisory fee business for mergers and acquisitions. Like public offerings, M&A advisory agreements usually called for fees to be paid at closing, based upon a percentage of the transaction size. If the client was a target company, the fee might be for successfully fighting off an acquisition, or for getting a better price than the original offer. M&A work was an ideal complement to public offerings. The same types of personalities and skill sets are involved. The decision makers at the prospective clients are the same people.
Investment bankers diversified their businesses
even further away from underwriting new issues of securities, beyond
brokerage, proprietary trading and M&A advisory work. Some
started or bought real estate investment operations. Others
acquired money management firms, placing the firm on both the sell
side and the buy side of transactions. They went after the
international markets, usually starting with opening offices in
With all this new business and diversification,
Wall Street firms became victims of the very monster they had
created. The shift from long-term investing to frequent
trading had made for much more frequent buying and selling, which
earned more brokerage commissions and more opportunities for
profitable trades for their own account. However, the
securities intermediaries were now public companies themselves.
They had to respond to the same pressure for quarter-to-quarter
profit increases. For example, Merrill Lynch, which had grown
huge from being the broker for the middle class, was reported in
2001 to have changed its strategy “to focus the firm’s brokerage
business on attracting wealth investors with at least $1 million in
assets. The move away from small investors is part of a
broader plan to boost profits at the big securities firm.” Its
president, Stanley O’Neal, announced plans “to expand in areas where the firm
can achieve high profit margins, such as equity derivatives.”
[The Wall Street Journal,
As investment bankers diversified, others were
on the move as well. This expansion of roles became a two-way
street. Large corporations began bringing some of the
capital-raising functions in house. The
Commercial banks didn’t just stand by and watch investment banks encroach on their turf. While the Banking Act of 1933, Glass-Steagall, still kept them from direct competition, a big opportunity was handed to them as the investment bankers developed the new derivatives market. Many of these derivatives, like interest rate swaps, were not “securities” and commercial banks could muscle into the market. “Swap trading began a revolution that would pave the way for commercial banks’ intrusion back into investment banking after decades of separation.” [Wall Street: A History, by Charles R. Geisst, Oxford University Press, 1997, page 347]
That revolution won a big battle when the Federal Reserve Bank effectively overruled Congress in 1990 by giving JP Morgan, first, and then other money center banks, limited permission to underwrite securities. The Fed first interpreted the Banking Act of 1933 as allowing no more than ten percent of a bank’s revenue to come from the securities business. As the Federal Reserve permitted more encroachments, increasing the ten percent limit on investment banking revenue to 25 percent, a full-scale and successful lobbying effort was launched for repeal of the wall between commercial banking and investment banks. JP Morgan prepared a study called “Glass-Steagall: Overdue for Repeal,” which argued against the investment bank oligarchy, pointing out that well over 90 percent of U.S. debt and equity underwritings were managed by only 15 investment bankers.
The distinction between investment banks and commercial banks went away almost completely in response to the credit crisis in late 2008. Independent investment banks were acquired by commercial banks, were liquidated or they were allowed to become parts of bank holding companies. How will that change the underwriting process?
In the Funk & Wagnalls 1911 Dictionary, “underwrite” is defined, in finance, as “to engage to buy all the stock in (a new enterprise or company) which is not subscribed for by the public.” That fits with the insurance concept of “underwrite.” It represents a transfer of risk from the business raising capital to the financial intermediary. The theory was that investment bankers were the experts in the market for securities, so they could best judge the risk and adapt to it. They also had the opportunity to diversify their risks, among several companies and over different market timing.
“For a fee or premium, the underwriter agreed
to take up whatever portion of the issue was not purchased by the
public within a specified time. And just as insurance companies
frequently reinsure large underwritings with other companies in
order to distribute the risk, so the initial underwriter often
protected himself by agreements with sub-underwriters, to which the
issuer was not a party. The typical underwriting syndicate was not
limited to investment bankers or so-called issuing houses. It
included or even consisted entirely of insurance companies or
investment trusts or other institutions, or even large individual
investors who thus obtained large blocks of securities at less than
the issue price. . . This method of distribution is called in
A “firm commitment underwriting” is what investment bankers have called their practice for the last 80 years or so. In fact, it is neither an underwriting nor a firm commitment. The risk of an offering selling remains with the company seeking money. Until all of the steps have been completed and all of the shares have been spoken for, the company has only a “letter of intent” to rely upon. It specifically states that it is not a commitment to complete an offering.
We no longer need investment bankers to raise capital for business. Their market first existed because of the painfully slow communications media that existed until the electronic age. They gathered information about prospective investors and handled the steps in a marketing process: letting prospects know that the securities are going to become available, gathering indications of interest, negotiating a price and closing the transaction. Today all of this can be done by a few people at computer terminals.
Of course, this possibility has been true for
over a decade. Michael Lewis described it in a 1999 article:
“There are some obvious barriers to the Internet taking over the
market for initial public offerings:
It’s been over a decade since that observation
by Michael Lewis and we still have the same process for new issues
as it was a century ago. What has happened to maintain the
underwriting system? One explanation is that an artificial
need for the system has been created as the real need faded away.
Investment bankers have kept up the myth that they are the only ones
who can sell securities offerings. They’ve had a lot of help
from the government in perpetuating that myth. The legal
obstacles are so intimidating that it is easy to believe that only
the professionals can surmount them.
Meanwhile, the regulatory hurdles for direct
securities offerings remain in place or have become higher. When
the investment bankers lobbied Congress to exempt their
underwritings from state securities laws, they limited it to
securities approved for listing on the major stock exchanges,
including Nasdaq. Those listings are available only to
proposed “firm commitment” underwritings. Since no one can do
firm commitment underwritings except
The barriers to raising capital without Wall Street can easily come down. Our communications technology and direct marketing ability can replace the monopolistic maze maintained by Wall Street. Is there any real need at all for investment bankers? (Once I was talking with a partner in one of the oldest Wall Street investment banking firms. We were discussing changes in the way money could be moved and whether investment bankers were necessary. He said that there would always be investment bankers, because CEOs needed someone they could talk to about matters that they couldn’t discuss with anyone else, especially their board of directors, subjects like “this business has about peaked and is headed for a big decline; how do I take care of myself?”)
Who is going to tell entrepreneurs that they don’t need investment bankers? Surely not the securities lawyers, who depend heavily on clients referred by investment bankers. Not the accountants, who hope to be recommended as auditors by a prospective client’s investment bankers. And not the management of companies who have recently completed underwritten offerings. They will have been indoctrinated with the lore of investment bankers as the only path to riches. Even Nobel laureate Paul Krugman described investment banks in his 2009 book as “repositories of specialized information that could help direct funds to their most profitable uses.” [Paul Krugman, The Return of Depression Economics and the Crisis of 2008, W.W. Norton & Company, 2009, page 83] The phrase sounds like an academicians version of Gordon Gekko’s line about insider tips, from the movie Wall Street:: “If you’re not inside, you’re outside.”
What about the investor side of raising capital? Don’t we need Wall Street investment bankers to gather information about a company going public and make judgments for us? Well, first there is the conflict of interest. If a public offering doesn’t get sold, the investment banker doesn’t get paid. Beyond that, we are no longer in the days before the Internet. We now have all the raw data and advice at our fingertips. As the legendary investment professional Peter Lynch said over 20 years ago, “I can’t imagine anything that’s useful to know that the amateur investor can’t find out. All the pertinent facts are just waiting to be picked up. It didn’t used to be that way, but it is now.” [Peter Lynch, with John Rothchild, One Up on Wall Street, Penguin Books, 1989, page 182]
Couldn’t Wall Street be reformed to serve the interests of
capital formation for
Even if we could do without Wall Street, why
not just leave it alone and let it continue to have its monopoly?
The reason we need to bypass Wall Street is that it is causing great
harm to our country. The harm is even far greater today than
when Franklin Delano Roosevelt said, “Practices of the unscrupulous
moneychangers stand indicted in the court of public opinion,
rejected by the hearts and minds of men.” [Franklin D.
Roosevelt, Public Papers and Addresses,
We don’t need Wall Street anymore. We have all the tools to bypass the financial intermediaries and take charge of raising and investing money. Today’s technology allows the suppliers and users of capital to communicate directly with each other. Later sections of Bypassing Wall Street describe how those direct relationships are happening now and how they can be developed as an alternative to the Wall Street intermediaries.
It isn’t only that we have the ability to bypass Wall Street, so that we should do it just because we can. We urgently need to free ourselves of the grip that Wall Street has over finance. The harm that Wall Street causes is intolerable. This chapter takes us into some of the most egregious penalties inflicted on us all by Wall Street. As Nobel laureate economist Joseph Stiglitz said in addressing his peers, the purpose of a financial system is "to manage risk and allocate capital at low transaction costs." What has Wall Street actually done? "They misallocated capital. They created risk. And they did it at enormous transaction costs." [http://economistonline.blogspot.com/2010/01/report-from-aea-meeting-part-i.html]
A few days after the Crash of 2008 began,
Robert Samuelson wrote, “Greed and fear, which routinely govern
financial markets, have seeded this global crisis. Just when it
will end isn't clear. What is clear is that its origins lie in
the ways that Wall Street -- the giant investment houses,
brokerage firms, hedge funds and ‘private equity’ firms -- has
changed since 1980.” [Robert J. Samuelson, “Wall
Street’s Unraveling,” Washington Post,
There have been two massive government
reports and several books detailing the harm Wall Street caused
in creating the Great Recession. [See the
553-page Financial Crisis Inquiry Report, January 2011, at
and Senate Committee on Homeland Security and Governmental
Affairs, Press Release,
Of course, many factors contributed to the Panic of 2008, as well as the earlier panics that were triggered by Wall Street abuses. Some causation can be laid to crowd psychology and mass mania. [Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds, Richard Bentley, 1841, Farrar, Straus and Giroux, 1932] Classical economists since John Stuart Mill have applied this theory to economic bubbles, or manias, and the panics and crashes which followed The theory is defined in a model developed by Hyman Minsky. It describes the cyclical flows of optimism and pessimism among investors and lenders. But the cycles, beginning with the mania, and followed by the panic and later crash, “start with a ‘displacement,’ some exogenous shock to the macroeconomic system.” The result is that “the anticipated profit opportunities would improve in at least one important sector of the economy.” People “would borrow to take advantage of the increase in the anticipated profits.” [Charles P. Kindleberger and Robert Z. Aliber, Manias, Panics, and Crashes: A History of Financial Crises, fifth edition, John Wiley & Sons, Inc., 2005. See, also, Carmen M. Reinhart and Kenneth Rogoff, This Time is Different: Eight Centuries of Financial Folly, Princeton University Press, 2009 and J. Bradford DeLong, "Notes on Bubbles," http://issuu.com/delong/docs/delong---notes-on-bubbles---april-21--2009-]
The Minsky model, with its "exogenous shock," certainly
described what happened in the Panic of 2008. Wall Street
created the Minsky “displacement” that came from the anticipated
profit opportunities in real estate ownership and financing.
The changes in the way real estate was financed, created by
mortgage securities and credit default swaps, were a primary
cause of the liquidity and credit crunch. [Markus K.
Brunnermeier, "Deciphering the Liquidity and Credit Crunch
2007-08," Journal of Economic Perspectives, Winter
2009, pages 77-100] In September 2008, when
the mania suddenly stopped, we went into a panic and had the
resulting crash. Wall Street was the instigator and the
driving force behind that displacement. “By increasing
leverage — that is, by making risky investments with borrowed
money — banks could increase their short-term profits. And these
short-term profits, in turn, were reflected in immense personal
bonuses. If the concentration of risk in the banking sector
increased the danger of a systemwide financial crisis, well, that
wasn’t the bankers’ problem. [Paul Krugman,
“Bubbles and the Banks,” The New York Times,
This wasn’t the first time Wall Street
ruined our economy. Looking back, you see a repeated
pattern of financial manipulation that created bubbles.
When the bubbles burst, innocent people lost their savings, their
jobs and their homes. Since 1792, Wall Street has
perpetrated the “Panics” that burst price and credit bubbles and
led to recessions and depressions. In that first Panic, it
was a Wall Street broker’s stock market insider trading that
created the bubble. Discovery of the fraud burst the
bubble, causing an economic decline. The government, in that
first year of our Constitution, also set a pattern of token
punishment and toothless reform. We were promised something
different this time. “My job is to help the country take
the long view — to make sure that not only are we getting out of
this immediate fix, but we’re not repeating the same cycle of
bubble and bust over and over again . . ..”
[President Barack Obama, in an interview with columnists on Air
Force One, reported by Bob Herbert, The New York Times,
While the first American panic was caused by
Wall Street insider trading, later panics came from more
complex manipulation by Wall Street, such as selling newly
created securities that made promises that couldn’t be met.
The first players in those games would do spectacularly well,
creating an urgent demand for more—the Minsky model
“displacement.” Then some event would trigger discovery,
followed by a collapse which brought down the entire economy.
One of the most damaging of Wall Street’s
abuses came with the Panic of 1873, when Wall Street “had crafted
complex financial instruments that promised a fixed return,
though few understood the underlying object that was guaranteed
to investors in case of default. (Answer: nothing).”
When the bubble burst, “the stock market crashed in September,
closing hundreds of banks over the next three years. The panic
continued for more than four years in the
Wall Street created another source of Panics in the 1890s,
when investment bankers found a new line of business—mergers and
acquisitions. In addition to the harm caused by eliminating
competitors and creating industry monopolies, the takeover
battles could lead to bubbles and their bursts. One war
between investment banks, for control of the Northern Pacific
Railroad, led directly to the Panic of 1901.
After each Panic, Wall Street has had its defenders. Following the Panic of 1907 came a book titled The Stock Exchange from Within, by a self-described “busy stockbroker.” [William C. Van Antwerp, The Stock Exchange from Within, Doubleday, Page & Co., 1913, preface. The book was reprinted by Kessinger Publishing, LLC, 2006 and is available online at www.archive.org/stream/stockexchangefro00vana/stockexchangefro00vana_djvu.txt. Mr. Van Antwerp was also a collector of rare books and an alternate delegate to the 1936 Republican National Convention.] He first tells us who really caused the Panic: “We, as a people, have brought the disaster upon ourselves by reason of our indiscretions. We have lost our heads and entangled ourselves in a mesh of follies.” Then Mr. Van Antwerp goes on to explain that an individual will “not admit such reproaches, even in our communings with self. . . . He says Wall Street did it. His fathers said the same thing, and his children will follow suit.” [pages 186-187]
Besides, Mr. Van Antwerp wrote, panics are
not really so bad. In fact, the recessions that follow do
some necessary good chores: “Moreover, panics are rarely such
unmitigated calamities as they are pictured by those who
experience them. At least they serve to place automatic
checks upon extravagance and inflation, restoring prices to
proper levels and chastening the spirit of over-optimism.”
[page 185 in the 1913 edition] A couple months after
the Crash of 1929, which led to the Great Depression, Mr. Van
Antwerp gave a speech to
In each of the Panics, there has been a particular player who took the game to its ultimate escalation, often getting out before the resulting collapse. Matt Taibbi laid out a chronicle of how just one Wall Street firm, Goldman Sachs, had caused five boom and bust cycles, beginning with the Crash of 1929. Taibbi claims that the firm’s investment trust, Goldman Sachs Trading Corporation, was a manipulation that collapsed and led to the Great Depression. Others were the tech bubble of the late 1990s, the oil price up and down, the housing price inflation/collapse and the federal bank bailout. He predicted the next would be the cap-and-trade game. [Matt Taibbi, “The Great American Bubble Machine: From Tech Stocks to high gas prices, Goldman Sachs has engineered every major market manipulation since the Great Depression--and they’re about to do it again,” Rolling Stone, July 9-23, 2009, page 52, http://www.rollingstone.com/politics/news/the-great-american-bubble-machine-20100405] One harm from the boom and bust cycles is the increase in frauds. "Swindling increases in economic booms because greed appears to grow more rapidly than wealth . . . Swindling also increases in times of financial distress . . . to avoid a financial disaster." [Charles Kindleberger and Robert Z. Aliber, Manias, Panics, and Crashes: A History of Financial Crises, John Wiley & Sons, Inc., Fifth Edition, 2005, page 189] Neuroscience has suggested why Wall Street traders make the ups and downs of the financial markets so extreme: When traders are winning at their bets, as the market is quickly moving past rational heights, their testosterone levels keep elevating until they reach irrational exuberance and make foolish decisions. Then, when the markets are rushing to new bottoms, their levels of cortisol increase, making them afraid to take even rational risks. [John Coates, "The Biology of Bubble and Crash," The New York Times, Sunday Review, June 10, 2012, page 5 and Drake Bennett, "When Animal Spirits Attack," Bloomberg Businessweek, June 4-10, 2012, page 4]
Gretchen Morgenson and Joshua Rosner, in their book about Wall Street and mortgage securities, said: "Their greed and self-interest . . . helped propel world financial markets to the brink of collapse. The voraciousness of these firms would also push the nation's economy into its most serious recession in more than seventy-five years." [Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon, Times Books/Henry Holt and Company, 2011, page 274. See interview of Gretchen Morgenson by Bill Moyers, http://billmoyers.com/segment/gretchen-morgenson-on-industry-influence/]
These Wall Street-caused panics bring their greatest harm to
small businesses and their employees,
A more subtle but disruptive harm from Wall Street's monopoly
over the movement of money for investment is its tendency to
concentrate vast sums into a small segment of the economy.
In 2011, for instance, Wall Street postponed doing IPOs
and, instead, raised huge amounts of money from money managers
for "private placements" of securities for Facebook, Twitter and
other social media businesses. Those ventures spent much of
the money hiring technical staff. The result was a shortage
of these trained individuals and an increase in their
compensation beyond the ability of smaller competitors to pay.
[Pui-Wing Tam and Stu Woo, "Talent War Crunches Start-Ups,"
The Wall Street Journal,
At the macroeconomic level, letting Wall Street control raising money for business and investing has allowed the money monopoly to tamper with the balance between consumption and investment. The theory is that businesses choose to expand plant and equipment based upon their expectation of sales of the additional products and services they could provide. The easy access to money on very favorable terms will not, by itself, persuade prudent managers to issue more shares or bonds when they can't see making a profit on the new investment. A 1935 Brookings Institution study concluded that "the growth of new capital is adjusted to the rate of expansion of consumptive demand rather than to the volume of savings available for investment. Between 1923 and 1929, for example, the volume of securities floated for purposes of constructing plant and equipment remained practically unchanging in amount from year to year, despite the fact that the volume of money available for investment purposes was increasing rapidly. . . . The excess savings which entered the investment market served to inflate the prices of securities and to produce financial instability.” [Harold G. Moulton, The Formation of Capital, The Brookings Institution, 1935, pages 158, 159]
The original purpose of a trading market was to assure investors that they would be able to resell securities they purchased. The businesses and governments that issued the securities needed money they could use for the long term. Their securities would either be bonds, to be repaid after several years, or shares of ownership, without any repayment date. Investors wanted the ability to cash out the securities they bought, at any time and for any reason. Availability of this liquidity encourages people to invest, even if they may need to get their cash back on short notice, or if they want to cash out with a profit and turn their money over to something else. Other investors will be interested in buying these previously issued securities, if the price is right and the process is simple and trustworthy. A trading market provides the mechanics to match sellers and buyers.
However, in a classic “tail wagging the dog,” raising capital from new securities issues has become an almost insignificant part of Wall Street. The focus changed from selling new securities to raise money for businesses; it shifted into earning commissions from getting customers to buy and sell existing securities. Then, the central focus moved again, and became trading for Wall Street’s own profits, rather than for its customers. The bonds and shares, and all the derivative securities based on them, became markers for trading. Once short-term trading gains were the objective, rapid turnover became the strategy. Take the profit and get on to the next trade. At the extreme, “naked access” computer program trading can buy and sell a position in less than a second.
Wall Street’s trading mentality has infected management of the businesses which have publicly traded securities. Wall Street firms take huge positions in a company’s shares or bonds or, more likely, options or other derivatives. These trades are based upon what a trader for the firm expects about the company’s next quarter’s results, or about a possible merger or other event. The trader may act on a tip about what a customer or another trader expects for the company. Businesses whose managements deliver on these short-term expectations are rewarded by more buying than selling, translating into price increases for their securities and greater management compensation.
Wall Street’s buy side, the money managers, are focused only on their own quarter-to-quarter performance. They demand inordinate amounts of time from chief executives and chief financial officers in their attempts to learn something that will give them a few hours jump on the next quarter’s results, so they can trade in or out. As more and more corporate ownership is concentrated in institutions, Wall Street money managers "can directly demand that the existing management of the companies whose shares they hold plunder them for the instant returns expected by an extractive financial system." [David C. Korten, When Corporations Rule the World, Berrett-Koehler Publishers and Kumarian Press, 1995, page 244]
Wall Street’s analysts came to have more
influence over the decisions of CEOs than their own boards of
directors. On both the buy side and sell side of Wall
Street, analysts are employed to rate the investment quality of a
company’s securities. The rating labels fluctuate but they
are basically “buy,” “hold” or “sell.” An academic study of
Fortune 500 companies from 1996 to 2000 showed that, when
analysts reduced the rating, it became 50% more likely that the
company’s board of directors would dismiss its president within
six months. Where even one analyst stopped rating a
company, the chance of the board firing the president within a
year went up by nearly 40%. According to the study’s
author: “Our findings suggest that boards are not focused
enough on fundamentals and too focused on Wall Street.”
[Professor Margarethe Wiersema, The
Managers can get huge rewards for playing to Wall Street’s short term trading. They can divulge “whisper” earnings predictions for a quarter, then bring in the reported earnings on target. The analysts who were favored with the selective expectations will have been able to make a profit by trading between the whisper and the formal releases. When traders become confident that they will be able to consistently make money on a company’s securities, they will favor it with a higher trading price range than other companies in the same industry. This in turn justifies increased salary and bonuses for the managers. When those managers get their compensation in the form of options to buy their company’s shares, they can vastly multiply their income. It is in the managers’ interest to receive options pegged to a temporary dip in the share price, then exercise the options and sell the shares at a peak price. Managers and traders together have the power to manipulate those trading prices. [For a description of this effect upon management of General Electric, see Jeff Madrick, Age of Greed: The Triumph of Finance and the Decline of America, 1970 to the Present, Alfred A. Knopf, 2011, pages 192,193]
The Aspen Institute issued a statement in
September 2009, on the harm done by short-term investment
objectives, signed by some of
The harm from short-term investment objectives perverts entire business segments. For instance, this from a book publisher’s website: “It used to be that publishing houses would invest much of their profits from bestsellers into promoting new and talented authors. It used to be that the large publishing houses would also use these profits to provide an assortment of valuable titles that might not all sell at a profit, but that would be of great benefit to the public. . . . We now see CEOs and stockholders insist on a formula production line that says, ‘This title was on the bestseller list for 32 weeks, therefore we want to make the next book that we publish as similar as possible to the last one.’ They want to repeat the former book’s sales performance. Their philosophy: ‘Don’t reinvent the wheel; duplicate it!’ Due to that mentality, we now have only 40 authors or so that dominate more than 80 percent of the book market!”
Fixation on short-term takes away jobs and
harms our domestic economy. Consider robotics, the use of
computers and machines to perform tasks done by humans.
There are about nine million robots being used today.
[International Federation of Robotics,
Experience has been that robotics generally creates more jobs
than it displaces--in the long run. [Erik Brynjolfsson and
Andrew McAfee, Race Against the Machine: How the
Digital Revolution is Accelerating Information, Driving
Productivity, and Irreversibly Transforming Employment and the
Economy, Digital Frontier Press, 2011,
http://raceagainstthemachine.com/ and David J. Lynch, "Did
That Robot Take My Job?," Bloomberg Businessweek,
January 9, 15, 2012, page 15] Despite the long-term growth
available from automation, the use of robots is inhibited because managers
of publicly-traded companies will forego
the large current expense of buying and installing robots.
Instead, they will move the work to a country which currently has
low-cost human labor. That can improve the next quarter's
earnings per share, increasing their company's stock price and
the value of their stock options. But
outsourcing jobs and importing products takes
student loans. And not businesses paying only for short-term results. The result is higher compensation to the skilled, low pay for the unskilled and a declining middle class. [David Autor, MIT Department of Economics and National Bureau of Economic Research, The Polarization of Job Opportunities in the U.S. Labor Market: Implications for Employment and Earnings, The Center for American Progress and The Hamilton Project, April 2010, http://economics.mit.edu/files/5554] Jim Collins co-authored the very popular 1994 book, Built to Last: Successful Habits of Visionary Companies. [Co-authored with Jerry I. Porras, HarperBusiness, 1994] Just six years later, his article, “Built to Flip,” started with this report from one of his former students about dealing with Wall Street’s venture capitalists: "I developed our business model on the idea of creating an enduring, great company -- just as you taught us to do at Stanford -- and the VCs looked at me as if I were crazy. Then one of them pointed his finger at me and said, 'We're not interested in enduring, great companies. Come back with an idea that you can do quickly and that you can take public or get acquired within 12 to 18 months.'” Collins and Porras see a rise in social instability as a result of the Built to Flip short-termism: “Not only is there an increasing sense that the social fabric is fraying, as the nation's wealth engine operates for a favored few; there is also a gnawing concern that those who are reaping more and more of today's newly created wealth are doing less and less to ‘earn’ it.” [Fast Company, February 2000, issue 32 page 131 www.fastcompany.com/magazine/32/builttoflip.html]
The course of our nation is set by how our money is allocated. If we had a direct relationship between the individuals who invest money and the business managers who use their money, our dollars would be like votes cast for our beliefs and our desires for the future. Instead, our investment choices are limited to the products Wall Street is selling. Most of those products are nothing more than bets on some short-term future event. We are sold shares that were issued forty years ago. They have nothing to do anymore with supplying capital. We’re just buying from someone else who is selling. We’re betting that the trading price will go up and the sellers are betting it won’t. None of our money will actually get to the business that once issued the shares. It’s likely that it isn’t even shareownership that we’re buying. We may be sold options, futures, swaps or other derivatives, which are even more remote from any business use of capital.
Wall Street makes commissions by selling and buying previously owned securities and the derivatives that are based upon those securities. Much more important to Wall Street are the huge trading profits made from using computer programs and inside information to trade for itself in securities. This recycling of gambling symbols, where one side of a trade wins and the other side loses, has become the “capital market.” Being drawn into that win/lose game keeps us from even considering the opportunities of investing in new business activity. All the money is going to sellers, traders and commissioned intermediaries. Unlike when new securities are issued by operating businesses, none of that trading money goes to finance business growth, or to pay employees and suppliers. With the “investors” having become traders, there is little money for early stage companies.
Yet it is young businesses that are most important to our economy. A November 2009 study by The Kauffman Foundation, from U.S. Census Bureau data, showed that two-thirds of the net new jobs created in 2007 came from businesses less than five years old. "This study sends an important message to policymakers that young firms need extra support in the early years of formation so they can grow into viable job creators. Sometimes a single barrier, such as limited access to credit for business growth, can mean the difference between survival and failure. We must create an environment that aids firm formation and growth if we are going to turn employment around." [Robert Litan, vice president of Research and Policy at the Kauffman Foundation, http://www.kauffman.org/newsroom/kauffman-foundation-analysis-emphasizes-importance-of-young-businesses-to-job-creation-in-the-united-states.aspx] The work most often cited for the correlation between young businesses and job creation has been that of David L. Birch in “Who Creates Jobs.” [The Public Interest, Number 65, Fall 1981, page 3, www.nationalaffairs.com/public_interest/detail/who-creates-jobs] He described small companies with rapid revenue growth as “Gazelles.” However, the Gazelle theory was largely contradicted by a 2008 study called “High-Impact Firms: Gazelles Revisited.” It analyzed businesses with significant revenue growth and expanding employment, ones which “account for almost all of the private sector employment and revenue growth in the economy.” The study found that these firms average 25 years old, with less than three percent under four years. Only half of the companies have fewer than 500 employees. “Job creation is almost evenly split” between the two size categories. U.S. Small Business Administration, Small Business Research Summary, number 328, June 2008, page 1 and page 44, www.sba.gov/advo/research/rs328tot.pdf ]
It is precisely the young businesses that need to raise money by selling shareownership—money that is permanent, that never has to be paid back and has no interest payments. But once young businesses have exhausted their founders’ resources, and what they can raise from family and friends, they need to sell shares to the public. Wall Street investment bankers have a legal monopoly on being the intermediary between business and investors. By ignoring young businesses, Wall Street is starving entrepreneurs. As a result, they are preventing jobs from being created. Their reasoning is simple: they make more money, in the short term, by focusing on trading, especially in products other than shareownership. Their interest in new issues of shares and bonds is limited to very large public offerings.
Consider just one example of the great harm
from Wall Street's choice to all but ignore small business:
Solar energy. Scores of entrepreneurial businesses became
the photovoltaic industry in the 1970s. (I subscribed to a
newsletter published by Robert Carbone, who left his job as a
Bank of America securities analyst to focus exclusively on these
new businesses and technology.) By the 1980s the
capital-starved companies had either been acquired by major oil
companies or given up. Three decades later, solar energy is
dominated by huge installations that feed into the existing
electric grid operated by major power companies. "Only 6 to
7 percent of solar panels are manufactured to produce electricity
that does not feed into the grid. . . . A $300 million solar
project is much easier to finance and monitor than 10 million
home-scale solar systems . . .." [Elisabeth Rosenthal,
"African Huts Far From the Grid Glow With Renewable Power,"
New York Times,
Small businesses need to sell shares to raise money for growth. But Wall Street has all but abandoned serving as an intermediary for new stock issues for young businesses, turning instead to quick turnover products. The New York Stock Exchange, where Wall Street began, is still an indicator of what Wall Street considers important. Under the Big Board’s new name and scope, NYSE-Euronext, only 16% of its 2009 third quarter revenue came from listing securities. The rest: 30% derivatives trading, 22% cash trading, 16% market data, 8% software and technology services and 8% other. [www.nyse.com/press/1256810868304.html]
Even the Exchange president, Duncan
Niederauer, acknowledges that small companies are “the economic
engine to this country, certainly after every recession.
That’s where most of the new job creation comes from.”
[Mary Anastasia O’Grady, “Is the Stock Exchange Obsolete?”
The Wall Street Journal,
Many of the challenges facing the
How are we ever to provide new businesses with the money they need to develop opportunities, if Wall Street is the only road and it’s closed to the traffic of money that could be coming from individuals and going to entrepreneurs? As George Gilder put it, "the crucial source of creativity and initiative in any economic system is the individual investor." [Wealth and Poverty, Basic Books, page 39] The capital needs of small business are just not going to be met by the intermediary structure. On the buy side, where money managers are choosing investments, the economies of scale are weighted toward securities based on big business. It takes as much time to evaluate a small business as it does a large one—actually more, because the information is more difficult to find. Time spent investigating small business is even harder to justify, because it results in a small investment. For the buy side money manager, it takes more investments in small business to put all of a fund’s money to work in a diversified portfolio than it does with big business investments.
A further deterrent to Wall Street money
getting to small business is that buy side managers consider
small business investments to have a higher liquidity risk.
That is, there is more of a chance of not being able to sell
without forcing the price lower. Big business has securities listed on an
Even if Wall Street’s buy side were open to
investing in small business, it could only happen if the sell
side were willing to originate and sell new issues of small
business securities. That is not happening. The big
investment banking firms, with the help of the
The rare new issues of stock or bonds actually do channel money from investors to businesses. Not so for trading in previously-issued securities, especially not so for derivatives, like options, futures, swaps, structured investment vehicles and other devices. They are all “zero sum games” where one person’s wins are offset by another’s loss. And, like other forms of legalized gambling, the only one consistently taking money out is the one operating the game, or the one with some private information or tool. A consistent winner at securities trading can be like the poker player who knows what cards are held by other players, or the blackjack player who can count the cards played and know what remains in the deck.
When investment bankers actually do underwrite a public offering of newly issued securities, it is probably not going to be for a young, growing business. More likely, it will be something created by the same investment banker or one of its affiliates. It might be a company purchased by a private equity fund and then going public again, so the fund can get back what it paid and a profit. Or it could be a “special purpose acquisition fund,” which is a newly-formed shell corporation that raises money in an IPO and then uses it to pay the owners of an existing business it buys. These are ways of recycling money from one group of investors to another. Nothing is put into the stream of creation or expansion.
In the few times that an investment banker
does act as an IPO underwriter for a young business, raising
money for growth, it is usually for a venture capital fund
client. By the time of the IPO, the VCs will have set the
business exclusively on the path to maximize return to investors
over a two to ten-year term. The VCs objective will be
either to maximize the share trading price while insiders sell
out or to have the whole business acquired.
Wall Street’s short-term obsession effectively determines the industries that will be supported. The companies selected for an IPO are the ones that can turn a quick profit for Wall Street’s sell side and earn future income for its buy side. Why is social networking the darling of Wall Street underwriters, rather than nanotechnology, photovoltaics, battery technology or new pharmaceutical companies? One explanation is that social networking is a current fad and, more important, a new entrant can have software and a market presence within a few months. The other industries may have far greater long-term prospects, but that’s their disqualifier—they are long-term, not now. Another factor in selecting an IPO candidate is how much it will generate in future investment banking, brokerage and proprietary trading income. Will it make acquisitions, to generate transaction fees? Will it have very active trading, earning brokerage fees? Will its share price fluctuate widely, providing trading profits to those who have pre-public information about the business?
Back in 1961, and again in 1969, more than a thousand entrepreneurial businesses were marketed in initial public offerings. After one of the periodic collapses in the new issues market, there were fewer than fifty IPOs in any of the years from 1974 until 1980. Those were the years when Wall Street was going through upheaval from the end of fixed commissions on trading. After that, the number of IPOs averaged about 530 a year in the 1990s. [Drew Field, Direct Public Offerings, Sourcebooks, 1997, page 1] However, from 2001 through 2008, the average was only 134 a year. [David Weild and Edward Kim, "Why are IPOs in the ICU?" Grant Thornton, undated, available at http://www.grantthornton.com/staticfiles/GTCom/files/GT%20Thinking/IPO%20white%20paper/Why%20are%20IPOs%20in%20the%20ICU_11_19.pdf]
Not only are there far fewer underwritten
initial public offerings these days, but those that do get
through must be for companies much larger than the typical
entrepreneurial business. Through 1998, about 75% of the IPOS
were for less than $50 million each, while the last ten years
have had fewer than 25% that size. For IPOs of under $25
million each, the number averaged nearly 300 from 1992 through
1997, when they began a sharp decline. Initial public
offerings of that size have been fewer than 25 a year from 2000
through 2008. [David Weild and Edward Kim, Why
are IPOs in the ICU?, Grant
Just as businesses have to be larger to do
an IPO, size requirements have been introduced for the purchasers
at first time public offerings, excluding all but the wealthiest
individuals with brokerage accounts. At broker-dealers with
middle class customers, IPOs are still reserved for larger
investors. Fidelity Investments, for example, had a rule
that clients must have $500,000 with the firm or place 36 trades
in a 12-month period to qualify to buy traditional IPOs.
[Eleanor Laise, “More IPO Entryways for Small Investors,” The
Wall Street Journal,
After 2008, Wall Street's sell side
and its buy side have often skipped the IPO and kept the
financing within their coterie of investment banks and fund
managers. They arrange huge "private placements," which are
then traded by "transaction specialists" like SecondMarket,
SharesPost or Felix Investments. [Liz Rappaport and Jean
Eaglesham, "Private-Share Trades Probed," The Wall Street
The decline in IPOs, along with the
disappearance of publicly traded companies through acquisitions,
has sharply reduced the number of companies listed for trading on
exchanges. From 1991 to 2008, the number of New York Stock
Exchange listings remained at just under 2,000. But
adjusting for growth in Gross Domestic Product, this represents a
40% decline. During the same period, listings on NASDAQ,
the home of smaller companies, declined from over 4,000 to
under 3,000. With the
It’s hard to call initial public offerings a path for small business. It is also hard to call them “public offerings.” In fact, most IPOs are sold to money managers for hedge funds, pension funds and other institutions, who are clients or prospective clients of the IPO underwriting firm. The underwriter, in setting the offering price, has a conflict between serving the interests of the company selling shares and the money managers who buy them. The conflict gets resolved in favor of the money managers. During the 1980s and 90s, in "99.46 percent of the cases, the share price at the end of the first day of trading was significantly higher than the IPO price, and those fortunate enough to be able to buy at the share price would make a significant capital gain. . . . The investment bankers appeared to set the price for the IPOs so as to maximize the price pop on the first day of trading . . .." [Charles Kindleberger and Robert Z. Aliber, Manias, Panics, and Crashes: A History of Financial Crises, John Wiley & Sons, Inc., Fifth Edition, 2005, page 160.] The nonwealthy individual investor will probably be able to buy an IPO only in the few hours or days after the offering, when the money managers and wealthy broker clients “flip” their allotment from the underwriters, for a quick trading profit. Even these second and third round individuals only get to buy shares if they are active investors with brokerage accounts.
Yet it is the “public” that most believes in
small business. According to
One big impediment for initial public
offerings of smaller businesses is that Wall Street firms employ
fewer stock analysts these days. The huge losses and
closures of Wall Street brokerage firms in 2008 eliminated half
of the senior analysts. [Aaron Pressman, “In Search
of Stock Research,” Business Week,
The harm from Wall Street abandoning small business IPOs isn’t just that the public has confidence in small business and yet is largely closed out from investing in it. The harm is also greater than the loss of businesses that create the greatest number of jobs. The most dangerous harm may come from the role of small business as the best defense against the excesses of big business. If a big business, by itself or acting in concert with its big competitors, is making unconscionable profits, some entrepreneur will want to seize the opportunity to enter the field. By starving entrepreneurs, Wall Street takes away our best defense from being abused by big business. It impedes the process of “creative destruction” that Joseph Schumpeter said “is the essential fact about capitalism.” [Joseph A. Schumpeter, Capitalism, Socialism and Democracy, Harper, 1975, originally published in 1942, pp. 82]
Wall Street has refused to market new securities issues to the middle class. Instead, investment bankers have chosen to earn their fixed commissions on “public offerings” by selling them to Wall Street’s buy side money managers. New issues of securities are selected, packaged and sold to attract professional investors looking for short-term profits. These buyers may “flip” the securities within minutes, to be resold to other speculators who didn’t make it into the favored first-buyer list. Those second-level buyers will mostly resell again whenever they can show a quick gain. Not many of the early owners will have any interest in the long-term direction of the issuing business. In the boom IPO market that ended in 2000, Wall Street did bring in middle class individuals, usually in the second or third round after the investment bankers’ friends had flipped the initial offering. When the bust came, it was these individuals who were left holding the bag, many of them vowing never to try shareownership again.
Middle class individual investors are left with buying securities in the trading markets or, more likely, owning shares in mutual funds, while wealthy individuals may invest in hedge funds that are let in on initial public offerings. Either way, any relationship between the middle class individual investor and the underlying business is remote. There is certainly no direct communication between individuals and business managers. Investing is focused on what the stock price may do in the near future, rather than on the business behind the securities.
As late as the 1970s, academics and policy
makers seemed unconcerned about individuals being replaced by
institutions as the owners of American business. The
Twentieth Century Fund, a nonpartisan foundation since 1919,
published a study about the change, from individuals owning most
of the corporate shares in
Wall Street’s recycling of gambling symbols
keeps us from even considering the opportunities for investing in
new business activity. If we could stand back and think
about the future of American business, we could have a very
different approach to investing. Many of the challenges
Our economy is as important to each one of
us as our government. It is our economy that makes it
possible for us to get paid money for our work. It allows
us to buy the things and services we need and want. When
our economy gets out of whack, with a recession or inflation, we
experience discomfort, fear and even misery. For nearly all
of us, however, we have a feeling of powerlessness over the
course of our economy. This lack of participation leads to
alienation from our nation. “The ultimate (root) causes of
disharmony between state security and human welfare result from
failures of the social contracts that bind countries and
populations together in cooperative activity.”
[Maurice D. Van Arsdol, Jr., Stephen Lam, Brian Ettkin and Glenn
Guarin, Crossing National Borders: Human Migration Issues in
With our government, most of us feel we have at least some say
in what it does and who makes decisions that affect our lives.
However imperfect the process, we have a sense of democratic
participation in a republican, representative structure.
Politicians can be voted out of office. We citizens can
sometimes cause laws to be repealed and new ones enacted.
In contrast, our economy gives us no such sense of participation. We’ve
let it come under the control of Wall Street, with limited
restraint by a government that is itself largely responsive to
Wall Street. Elizabeth Warren described it this way:
"For three decades, the once-solid, once-secure middle class has
been pulled at, hacked at, and chipped at until its very
foundations have started to tremble. Families have done their
best to adjust — sending both mom and dad into the workplace,
cutting back flexible spending on food, clothing and appliances,
and spending down their savings. When they learn that they have
been tricked . . . they start to wonder who wrote the rules that
allow that to happen. Distrust spreads everywhere — to industry,
to politics, to the institutions that were supposed to make us a
The concept of a free market economy is that we are casting our votes with the ways we acquire and spend our money. We can offer our services where we decide we’ll be most useful, fairly paid and well treated. In a free market, we can put the money we save into channels that will support worthwhile activities and pay a fair return. As a result, our collective decision making could influence businesses to grow or to wither, to the general benefit of us all. In practice, however, Wall Street has created a disconnect between us and our economy. There is no direct relationship between our economic decisions and what influences business decisions. This disconnect, coupled with the government/Wall Street axis of power, leads to what Tamara Draut calls "Young Adults' Political Retreat" [Tamara Draut, Strapped: Why America's 20- and 30-Somethings Can't Get Ahead, Doubleday, 2006, pages 177-206. See, also, "Young, Underemployed and Optimistic," Pew Research Center, February 9, 2012]
Wall Street’s political power means that government decisions about our economy are made to help Wall Street. [See explanation on "Crony Capitalism," Moyers & Company, billmoyers.com/video, Air Date: January 20, 2012] Those decisions ignore the rest of us and often harm us. For instance, consider the very low level of interest rates. Wall Street is largely in the business of using other people’s money to leverage much larger bets than it could make using only its own money. The lower the cost of renting other people’s money, the greater the return there can be from risking that money. The Federal Reserve, which is actually owned by banks, is largely able to set interest rates. Keeping those rates low favors Wall Street banks, which are in the business of borrowing and employing money. The people who are hurt by keeping rates low include middle class retirees, who receive interest income from deposits and bonds. The government has accommodated Wall Street, to the detriment of individuals trying to live off income from their savings. In the name of saving the economy, the Federal Reserve and the U.S. Treasury have forced interest rates down in recent years and provided Wall Street with taxpayer funds, so that the cost of money to the money industry has been around two percent.
Everyone in politics and the media seem to
look at interest rates from the perspective of the people who
borrow money. From that vantage point, the government gets
kudos for keeping the cost of borrowed money low. But what
about the providers of that money? When the government
manipulates interest rates down, that means that bank
certificates of deposit and money market funds pay a much lower
rate. Retirees who depend on CDs and other fixed income
securities have seen their incomes cut by half or more. In
an article titled “Taxing Grandma to Subsidize Goldman Sachs,”
Peter Morici wrote: “Having fed the campaign machines of
both political parties and lavished speaking fees on future White
House economic advisors, these financial wizards have managed to
purchase preferred treatment in our capital.” [Peter
If Wall Street blunders in playing the casino with borrowed money, the government bails it out and gives it a grubstake to get back in the game. Despite the public and media outrage after the 2008 bubble burst and outflow of trillions in taxpayer dollars, the government has done virtually nothing to prevent a replay of the tragedy. As individuals, we have been disconnected from our economy. All the power and influence is with Wall Street and the government it has purchased.
Before the first World War, fewer than
100,000 Americans owned securities listed on the New York Stock
Exchange. After the War, individual investors were courted
by Wall Street, because so many of them had purchased Victory
Bonds. Nearly all of these war bond investors had purchased
a security for the first time and a big change in attitude and
behavior occurred when individuals became willing to exchange
their money for a piece of paper. After that, Wall Street just
had to sell another piece of paper to the bond buyers and the
observers they influenced. “By the late 1920s, there were over 3
million shareholders, with half of them buying and selling shares
through brokerage accounts, while six hundred thousand were doing
so on margin—borrowing money to purchase shares, and using the
stock to collateralize the loan.” [Robert Sobel,
That all but ended with the Crash of 1929 and the Depression. Half the brokerage firms were gone by 1932. Of the survivors, only half of those were still in business by 1937. Commercial banks had been the major marketers of securities to individuals and they were forced out of the securities business by the Banking Act of 1933. Those that remained on Wall Street had little interest in doing business with individuals, except for the very wealthy or the professional traders.
In 1940, the New York Stock Exchange
commissioned a public opinion poll by Elmo Roper. It showed
that the public had an “image of the stock broker as a polished
crook, and the N.Y.S.E as a nest of thieves.”
["What Does the Public Know about the Stock Exchange? Roper
Survey Reveals Extent of Misconceptions and Misinformation about
the Services of the Exchange," Exchange Magazine, (January
1940)] While it was still business as usual for
others on Wall Street, Charles Merrill saw this public perception
as an opportunity. He had started a brokerage partnership,
Merrill Lynch & Co. in 1914 and sold out just before the 1929
Crash. He came back in 1940, merging three firms into
Merrill Lynch, Pierce, Fenner & Beane. Most of the old
offices were replaced with cheerful, efficient spaces for brokers
to meet with clients. [Edwin J. Perkins, “Market
Research at Merrill Lynch & Co., 1940-1945; New Directions for
According to Martin Mayer, Merrill started
the new business "because he felt the need to make a political
statement. His was the brokerage firm that would serve the
ordinary customer." [Martin Mayer, The Money
Bazaars: Understanding the Banking Revolution Around Us,
E.P. Dutton, Inc., 1984, page 35] Merrill began a major
educational advertising effort to explain how investments worked.
The brokers were called “account executives” and they were
trained not to give investment advice. Instead, they were
to recommend securities approved by the firm’s research
department, with separate lists for aggressive, conservative and
moderate investors. Free research reports were sent to
clients and prospects. The biggest innovation that Merrill
made was in how the brokers were paid. They got a salary
and bonuses—no commissions. “Let others take care of the
very wealthy and the gamblers, Merrill seemed to be saying; our
firm will cater to the middle class.” [Robert Sobel,
Other brokerage firms copied the Merrill
approach. The New York Stock Exchange, under President
Keith Funston, advertised “Own Your Share of America,” “People’s
Capitalism” and “A regular dividend check is the best answer to
communism.” [Robert Sobel,
However, there’s an old Wall Street saying, “Don’t confuse brains with a bull market.” When the market turned in 1969, the momentum vanished. Bringing in the middle class was suddenly out of favor on Wall Street, losing out to wooing institutional money managers and trading for the brokerage firm’s own account. Wall Street’s buy side, trading in thousands of shares at a time, had been paying the same cost per share as the individual buying a hundred shares. Of course, Wall Street sell side brokers wanted only to do business with the customers who made them far more money for the same amount of work.
Interest in the middle class returned after
fixed commissions were abolished in 1975. Wall Street’s buy side
had won a major victory over the sell side when Congress took
away the fixed rates for buying and selling stocks.
Now the money managers could negotiate openly with brokers,
forcing them to compete on the basis of what they charged for
executing an order to buy or sell. Many of the old Wall
Street firms were very slow to adapt to the new rules of the
game. They just weren’t willing or able to reduce costs,
streamline operations and change their compensation structure.
Merrill Lynch moved far away from its founder’s concept.
Its strategy was “to focus the firm’s brokerage business on
attracting wealthy investors with at least $1 million in assets.
The move away from small investors is part of a broader plan to
boost profits at the big securities firm.” [The Wall
As a result, a new breed of securities firm sprung up, the discount broker. The most successful of the discount brokers has been Charles Schwab & Co., which was started right after the end of fixed commissions in 1975. At the beginning, the business was aimed at providing execution of individuals’ orders for buying and selling stocks and a few other securities. Schwab has expanded in many ways over the years, such as owning a bank and a securities trading firm, making mortgage loans and providing support for independent investment advisers. It has made a few skirmishes into distributing new issues of securities but has never really tried to become an investment banker.
(I met with Charles Schwab in the late 1970s, about a joint venture in marketing “negotiable certificates of deposit,” which savings banks had been allowed to issue. The certificates worked like bonds and would have a trading market. We suggested that the banks offer the CDs directly to Schwab’s customers and that Schwab would handle the market for resales. Other priorities got in the way, but we did learn about Charles Schwab’s personal view of his place in the financial markets.)
Except for the discount brokers, Wall Street’s sell side has
continued to downplay any relationship with
Ralph de la Torre, CEO of Caritas Christi
Health Care, lamented in late 2008: “Health care has been
holding its breath. We live and die on the tax-free bond
market, and right now we’re dying. Projects are being
postponed. All the commodities that health care buys and
the companies and people it touches—from imaging to pharma to
physicians—are about to dive off the cliff. The bond
markets are closed tight. Until they reopen, we’re going to
have a big problem. I think there’s going to be a pretty
substantial consolidation in health care. As many as 20% of
hospitals could close. There’s going to be no capital
spending for at least the next year or two.” [“The
Recession: What Top CEOs are Thinking,” Business Week,
Health care, along with the infrastructure and other public needs, have been starved for funding because local government decision makers are locked into an archaic system of selling bonds through Wall Street underwriters. The 2009 economic stimulus plan had the federal government selling bonds to the Chinese, then sending the money to states for funding infrastructure projects. The common sense way would be for the state and local agencies to market bonds directly to the communities most affected by the infrastructure. Infrastructure projects could be set up for payment by their users, like toll bridges with fast passes. Then the agencies could market revenue bonds to people who benefited from the project, without raising taxes.
Instead of these common-sense ways of raising money for local services, the government and nonprofit officials follow the century-old ritual of going to Wall Street, where bonds are sold in $5,000 minimum amounts, mostly to mutual funds, banks and insurance companies. The Wall Street underwriter often places a small offering entirely with one money manager, collecting the customary percentage fee for a “public” offering. Even if an individual investor learned about an offering and was willing to buy the $5,000 minimum, there remains the problem of whether the bond could be resold before its maturity. Broker-dealers who acted as underwriters might or might not be willing to repurchase the bonds. If they did repurchase, they would set the price low enough to assure a big profit from reselling the bond. There would be no reported source of pricing information or history of trades in the bonds, no way to find out how much a bond is worth in today’s market.
Most government procurement programs, like buildings and equipment, require competitive bidding. Not so with procuring money. Sales of about 85 percent of local government bonds have prices, interest rates and selling commissions which are negotiated with one selected investment banker. That's "because local politicians don't want to alienate investment bankers who donate to charities and political campaigns. . . . 'Firms get chosen to be negotiated underwriters as payback.'" [Darrell Preston and John McCormick, "Chicago Pays for Selling Bonds Without Bids," Bloomberg Businessweek, May 17-23, 2010, pages 46, 47, quoting J.B. Kurish, associate dean, Emory University, Goizueta Business School] Even when competitive bidding is required, bond issues of under $1 million usually receive only one bid. [Comment by Robert C. Pozen in The Deregulation of the Banking and Securities Industries, Lawrence G. Goldberg and Lawrence J. White, editors, Lexington Books, 1979, page 337]
One indication of how profitable it is for
investment banks to underwrite local government bonds is the
continuing story of “pay to play” scandals. The temptation
for bribery comes because government officials choose the
underwriter. The decision factors are rather subjective,
such as, which underwriting firm has the better relationships
with Wall Street’s buy side. [John Tepper Marlin,
“Muni Bonds Pay-to-Play,” The Huffington Post,
“Three federal agencies and a loose consortium of state
attorneys general have for several years been gathering evidence
of what appears to be collusion among the banks and other
companies that have helped state and local governments take
approximately $400 billion worth of municipal notes and bonds to
market each year. E-mail messages, taped phone
conversations and other court documents suggest that companies
did not engage in open competition for this lucrative business,
but secretly divided it among themselves, imposing layers of
excess cost on local governments, violating the federal rules for
tax-exempt bonds and making questionable payments and campaign
contributions to local officials who could steer them business.”
[Mary Williams Walsh, “Nationwide Inquiry on Bids for
Municipal Bonds,” The New York Times,
What has the government done about "pay-to-play?" The
The American Recovery and Reinvestment Act of 2009, the “stimulus” law, included a gift to Wall Street dressed up as a way to finance local governments. It authorized “Build America Bonds,” which pay interest rates comparable to corporate bonds, rather than the much lower rates typical for government debt. The federal government pays 35% of the interest cost. These Build America Bonds were to replace conventional local government bonds, which are exempt from an individual’s federal and state income tax. The problem with conventional bonds for Wall Street is that it doesn’t want to market to individuals, who look for the tax break. The easy sell for a Wall Street investment banker is to institutional money managers. However, most institutions are themselves exempt from federal and state income taxes, so they have no interest in conventional local government obligations paying only two-thirds of the rate on corporate bonds. With Build America Bonds, the investment bankers can get corporate bond rates for an entire issue of bonds, allocating them to a few of their favorite customers. The interest cost to the local government is about the same, because the federal government subsidizes a third of the amount paid to investors.
Average underwriting fees on Build America Bonds are 8.2%,
compared to about 5% on conventional local government bonds, and
less than 1% on most corporate bonds. Neither issuer nor
investor really cares that the investment bankers are taking much
more than their usual cut. The program is designed for Wall
Street investment bankers to make “surprisingly high” fees.
[Edward Prescott, Nobel prize economist at the Federal Reserve
Bank of Minneapolis and Arizona State University professor,
quoted by Ianthe Jeanne Dugan, “Build America Pays Off on Wall
Street,” The Wall Street Journal,
How does Wall Street hold onto its control over the use of securities? Why hasn’t its government-protected monopoly been penetrated? We know they’re greedy, overpaid, that they cause harm—but we haven’t tried to get along without them. They seem to have the keys to the vault. Only they understand what they’re doing. “Wall Street is a very seductive place, imbued with an air of power. Its executives truly believe that they control the levers that make the world go round.” [Simon Johnson, “The Quiet Coup,” The Atlantic, May 2009, www.theatlantic.com/doc/200905/imf-advice. Professor Johnson is a former International Monetary Fund chief economist and now an MIT professor. His blog is http://baselinescenario.com]
Part of Wall Street’s mystique is the myth that investing is too complex for us to do ourselves, so we need the wizards of Wall Street to do it for us. Not so, says Peter Lynch, one of the most successful buy side professionals. He managed Fidelity’s Magellan Fund from 1977 to 1990, as it grew from $18 million to $14 billion. In his book, One Up on Wall Street, he said, “Twenty years in this business convinces me that any normal person using the customary three percent of the brain can pick stocks just as well, if not better, than the average Wall Street expert.” [Peter Lynch, with John Rothchild, One Up on Wall Street, Penguin Books, 1989, page 13] Instead, he says, “People seem more comfortable investing in something about which they are entirely ignorant. There seems to be an unwritten rule on Wall Street: If you don’t understand it, then put your life savings into it.” [page 24] Wall Street’s sell side analysts promote buying stocks but rarely suggest selling them. “Just 5.1% of analyst ratings are “sells,” according to data compiled by Bloomberg.” [http://www.investmentnews.com/article/20110520/FREE/110529994/-1/INDaily01&dailycount=4&issuedate=20110520]
On the buy side, the performance record is
well-documented. Whatever the reasons, most money managers
who make investment decisions consistently turn in poorer results
than the comparable indices of all securities in the same
category. Once an investor decides to invest in a
particular kind of security, like shares in large corporations,
history shows that better results would come from buying a little
interest in all of them than to have a professional pick
individual companies. A 2009 study by Standard & Poor’s
showed that most managed mutual funds failed to do as well as
their comparable S&P indices. For the
five years 2003-2008, the index for the largest 500 companies had
better returns than 72% of funds investing in shares of large
businesses. For smaller companies, where stock picking is
often said to require extra skill, more than 85% of the fund
managers did worse than the small capitalization index. For
emerging market funds, results were below the index for 90% of
the managed funds over the five-year period. Even 80% of
the bond funds were behind bond benchmarks, not counting junk
[Sam Mamudi, “Managed
Funds Take Beating from Indexes,”
The Wall Street Journal,
(From our experience in advising direct public offerings, we found that nine out of ten investors in direct offerings had never before owned securities in an individual company. Nor had they ever been a customer of a securities broker-dealer. Nevertheless, they went through a risk/reward analysis as rigorous as most reports from Wall Street’s sell side or buy side. In fact, their investigations were often much broader. They went beyond the financial data for the company and its industry and into the personality of management, the characteristics of customers and their feel for the life cycle of the company’s products.)
The myth of complexity has worked as a
marketing strategy for Wall Street’s investment bankers and
brokers. Until Madison Avenue was hired to remake Wall
Street’s image, the sell side registered representatives were
commonly called stockbrokers. The names have been changed,
to financial consultants, financial advisors, wealth management
advisers and the like. This more obscure naming has
coincided with the increased complexity of the products they
sell. The new titles and new instruments say to us, “You
need me because you couldn’t possibly understand.” That
statement is at least half true: most of us do not
understand the products that are being sold to us. For
instance, to pick just one of these products, the “portable
alpha” was sold to middle class individuals shortly before the
2008 Panic. The “alpha” stands for the sophisticated
judgment that brings above-market returns on investment.
The concept was to use part of the money invested to buy futures
and swaps contracts on the market, getting the benefit of how an
index fund operates, without having to put up the full amount
those funds require. The rest of the investment went into
hedge funds, which are supposed to beat the market. (I may
not have described this correctly. That illustrates the
problem of complexity.) The portable alpha strategy caused
huge losses to middle class investors when the stock market
dropped in 2008. [Randall Smith, ‘Alpha’ Bets Turn
Sour, The Wall Street Journal,
Complexity makes it easier for Wall Street to get away with price-fixing conspiracies, like one uncovered by a whistleblower trader at Bank of America. "It involves a vast bid-rigging and kickback conspiracy, implicating every major Wall Street bank and an assortment of brokers, dealers, and con artists. The perps allegedly manipulated the bidding for short-term investments [of] the proceeds from the sale of municipal bonds--an arcane but lucrative practice that violated the Sherman Antitrust Act and cheated bond issuers out of billions of dollars." [Thomas Brom, "When Thieves Fall Out," California Lawyer, July 2010, page 10] To Bank of America's credit, it had outside lawyers confirm the whistleblower's account and then turned itself in to the Justice Department under the Antitrust Criminal Penalty Enhancement and Reform Act. That law provides leniency for the first conspirator to admit an antitrust violation. The dozens of others involved included JP Morgan Chase, Morgan Stanley, Citigroup, Wells Fargo and Goldman Sachs. Evidence included more that 600,000 audiotapes of derivatives traders.
The history of mortgage securities shows the path from an understandable security into instruments that are too complex for analysis, and thus just right for deception. The first mortgage security, the Mortgage-Backed Bond, was a promise by a bank to pay fixed interest amounts and return the principal at the bond’s maturity date. In addition to the bank’s credit supporting the obligation, the bank deposited a pool of its mortgages with a trustee. The amount of the mortgages totaled 150% of the amount of the bonds and the bank was required to replenish the pool to maintain that level. An investor could rely on the solvency of the bank and also know that, if the bank failed, there was plenty of cushion in the mortgages held by a trustee.
Wall Street saw real limits to its own profitability with Mortgage-Backed Bonds. First, the only revenue was the one commission investment bankers took when the bonds were sold, with nothing else for the thirty years the investor might hold the bonds. Second, using $150 of mortgages for each $100 of bonds “wasted” the extra 50% by making them unavailable for packaging into more securities. So, the next mortgage security was the Pass-Through Certificate. Investors were sold a fractional share of a pool of mortgages. They received interest and return of principal as the homeowners made their monthly payments. The Pass-through Certificate allowed 100% of the mortgages to be packaged and sold. If the buyers reinvested the money passed through from mortgage payments, more commissions were generated.
The deterioration in quality that led to the 2008 debacle in mortgage securities began with this change from Mortgage-Backed Bonds to Pass-Through Certificates. The bank that originally made the loans was no longer responsible for anything other than collecting mortgage payments and passing them through to investors. Even that responsibility was often transferred to another servicing agent, so the originating banks were off the hook for loan quality as soon as the loans were bundled and sold as Pass-Through Certificates. The risk had been entirely transferred from the people who made the loan decisions and onto people like those who had put their money into retirement funds, managed by Wall Street’s buy side.
Wall Street learned that buy side money
managers would purchase Pass-Through Certificates, even though
they were more complicated and their repayment timing was
uncertain. Pass-Throughs were still relatively simple and
the buy side felt they could make investment decisions without
having to rely completely on the sell side. This changed when
Wall Street quickly moved on to the Collateralized Mortgage
Obligation, with its segments, called “tranches,” based upon
relative risk. CMOs were packaged by computer programs,
sorted by characteristics that predicted likelihood of default.
One tranche would get a triple-A rating for conservative
investors and, several tranches later, the “toxic waste” would be
sold to the most gullible. Wall Street looked at their huge
profits from CMOs and decided that they could package credit card
balances, auto loans, music royalties and other payment streams
into Collateralized Debt Obligations, or “CDOs.” In
describing this history, Charles Morris commented: “The
complexity of the instruments spiraled into absurdity.”
Wall Street “gleefully spewed out phantasmagorical 125-tranche
instruments that no one could possibly understand.”
[Charles R. Morris, The Trillion Dollar Meltdown,
PublicAffairs, 2008, page 41] Since the destruction of 2008,
there has been an effort to start over, with “covered bonds,”
marketed as having come from a European model. These are
like mortgage-backed bonds, except that the collateral pool of
mortgage loans is retained by the lender, rather than placed with
a trustee. [Richard Barley, “Covered Bonds Set to
Roar?” The Wall Street Journal,
(We tried a very different approach, with the Mortgage Trust Certificate. Our client was a very large savings bank with a few billion dollars of home mortgages it had originated. With a firm of mathematician consultants, we would analyze a portion of a pension fund’s payment obligations over the next 30 years and then select a pool of mortgages that would generally provide cash flow to match the projected payouts. The lending bank was obligated to have the mortgage pool maintain the cash flow stream, supplying additional mortgages when necessary. No securities broker-dealer was involved. There was to be a direct and ongoing relationship between the bank and the pension fund. We explained the mechanics to rating agencies and to third-party insurance companies who would guarantee the bank’s obligation. The concept was easily understood by everyone involved. Unfortunately, other priorities got in the way and the project was never finished. In retrospect, it seems like a quixotic venture.)
(Earlier, before mortgage securities became a huge market, I worked with a client on a computer-based market for selling mortgages directly. Sponsored by Fannie Mae, Freddie Mac and other government-sponsored entities, it was called AMMINET, for Automated Mortgage Market Information Network. It was modeled basically on the original NASDAQ, the automated quotation market for stocks. Lenders would make packages of mortgages available for pension funds and others to buy, leaving Wall Street out of the flow. My client was to design and operate the computer program. The effort never made it to market. Its basic, simple approach was the exact opposite of the complexity that furthers the Wall Street mystique. Instead, mortgage lenders were forced into supplying mortgages for off-the-shelf products designed by Wall Street for maximizing its own take from transactions.)
An awful lot of the bad stuff that occurred
in our financial system has happened because a proposed
transaction was never explained in plain, simple language.
Financial innovators were able to create new products and
markets without anyone thinking through their broader financial
consequences — and without regulators knowing very much about
them at all. It doesn’t matter how transparent financial markets
are if no one can understand what’s inside them. [Michael
Lewis and David Einhorn, “How to Repair a Broken Financial
World,” The New York Times,
Borrowing from academic papers on quantifying risk, and hiring
the academicians themselves, Wall Street has presented investment
schemes and invented securities that used theoretical
diversifications and hedging structures to create the appearance
of no risk, or very limited risk. For instance, an article
by David X. Li, then working at JPMorgan Chase, appeared in
The Journal of Fixed Income in 2000.
It bore the
academic title, "On Default Correlation: A Copula
Function Approach." (In statistics, a copula is used to couple
the behavior of two or more variables.) Wall Street used
the approach to build a way around the difficult task of
analyzing the risk of each mortgage or other asset placed in a
For an even riskier game, Wall Street creates options, swaps
and other derivatives from these new securities, to both
stimulate and serve the mania for greater risk-return ratios. The
giant of these new made-up securities was the Credit Default
Swap, which is a bet that a particular borrower or package of
debt securities would or would not fail to pay. Like most
options, it could be used by the owner of the security to hedge
its credit risk. For most players, however, it was a way to
bet on the economic future of a debt instrument. “The CDS [credit
default swap] and
Securities derived from mortgages are only
one part of the complexity devastation wreaked by Wall
Street. [For a description of "how close the financial system had
come to a catastrophic seizure" in October 1987, see Scott
Patterson, The Quants, Crown Business, 2010, pages 47-53.]
The tax exempt bond market, used to finance state and local
governments, has been badly damaged by Wall Street’s practice of
inventing and selling complex financial contracts. This
market once moved rather predictably with changes in interest
rates. Then, in 2008, municipal bond funds lost an average
9.4% and some of them were down over 30%. One cause was
Wall Street’s marketing of “tender option bonds” or “inverse
floating rate obligations.” These instruments split the
income from a municipal bond into a short-term fixed rate and a
long-term variable rate. [Jason Zweig, “Muni-Bond
Bargains: Devil’s in Details,” The Wall Street Journal,
Hospitals were sold interest rate swaps and
auction-rate securities, incurring huge losses. [Ianthe
Jeanne Dugan, "Hospitals Claim Wall Street Wounds," The Wall
Wall Street is still using the disaster it created to extract
more money from local governments and university endowments.
Before the Panic of 2008, Wall Street sold them instruments that
would swap their fixed-rate long-term debt for a variable-rate
obligation. With names like "constant maturity swaps,
swaptions and snowballs, they lowered the amount of interest
borrowers had to pay, for a brief period.” [Randall Dodd,
"Municipal Bombs," Finance and Development, International
Monetary Fund, June 2010,
When the variable rates went up, Wall Street offered to terminate
the swap agreement--for a fee. "In all, borrowers have made
more than $4 billion of termination payments . . .. In
addition to getting termination payments, Wall Street is finding
another way to profit--underwriting bonds that borrowers are
selling to raise money for the termination fees and to refinance
their variable rate debt." Michael McDonald, "The Wall
Street Product That Soaks Taxpayers," Bloomberg Businessweek,
Out of the complexity of using securities comes a mystique surrounding the investment bankers who appear to know how it all works. Wall Street maintains its monopoly of the money flow by perpetuating the illusion that it knows all the whos and whats and how-tos and that no outsider will ever know them. To have some sort of common language with investors, Wall Street grabs onto shorthand concepts that can seem to make some sense. One of the most common is the earnings multiple, the concept that a company’s shares trade at a multiple of its earnings, divided by the number of shares it has issued. The multiple is explained as depending upon the industry, the company’s growth rate and future prospects. A big problem with this is the pressure it puts upon each quarter’s earnings per share. It has lead to a lot of “creative accounting,” which Andrew Tobias describes in The Funny Money Game. [Andrew Tobias, The Funny Money Game, Playboy Press, 1971, pages 134 to 152]
Robert J. Ringer self-published his 1973
book, Winning through Intimidation and sold 1.7 million
copies in the next four years. [www.trivia-library.com/b/self-help-advice-est-by-winning-through-intimidation.htm.
A later edition was published by Fawcett in 1984.] His
advice was geared to his own business experience as a broker for
apartment buildings. The techniques he suggested are pretty
gross, compared to the sophistication of the investment banker.
But the underlying premise is the same: Success in business
comes from creating illusions, not from the quality of the
product or service offered. The intimidation game on Wall
Street does include high-end variations of the tricks Ringer
suggests. There are the limousines, breakfasts in the
private dining rooms, hard-to-get tickets to events,
introductions to famous people, being included among those who
wear clothes and watches seen in slick
A story is told that James Carville, while
working for President Clinton, would be in White House meetings
with Robert Rubin and others, discussing the national economy.
Every issue seemed to be resolved when Rubin or someone else from
Wall Street would say how the bond market would react. Carville
would remark: “If there is reincarnation, I want to come
back as the bond market. Nobody gets more respect.”
[In another version, Carville said that, reincarnated at the bond
market, "You can intimidate everybody." Simon Johnson and
James Kwak, 13 Bankers: The Wall Street Takeover and the Next
Financial Meltdown, Pantheon Books, 2010, page 98, citing
Louis Uchitelle, "The Bondholders Are Winning: Why America
Won't Boom," The New York Times,
The academic support for encouraging
complexity may have begun changing. Some writers seem to be
moving back to accepting that some
risks cannot be quantified, predicted or even imagined.
[See Nassim Nicholas Taleb, The Black Swan: The Impact
of the Highly Improbable, Random House, 2007]
There are even academicians suggesting that commercial banks
should no longer provide money for buying complex derivatives.
[Amar Bhidé, Glaubinger professor at
Wall Street has gathered for itself a great monopoly of government-enforced power in finance. Through exercise of that power, it has fostered the concentration of American business into a few huge corporations in each industry. In perhaps its most pernicious effect, Wall Street has forced a concentration of business ownership in wealthy individuals and institutions. As Wall Street’s buy side has grown, it has led to limiting the majority ownership of business within professional money managers for huge funds and other institutions.
Concentration of power in finance.
As a former Federal Reserve System Governor put it :“We cannot have a durable, competitive, dynamic banking system that facilitates economic growth if policy protects the franchises of oligopolies atop the financial sector.” [Kevin M. Warsh, as quoted by Gretchen Morgenson, “Telliing Strength From Weakness,” The New York Times, Sunday Business, April 29, 2012, page 5]
Perhaps the most obvious and disturbing
side effect of that concentration of power in Wall Street is that 100 financial
institutions own over half of all corporate shares, “constituting
majority control of corporate
Wall Street personalities are extremely
competitive, in the “mine is bigger than yours” syndrome.
Size seems to be more important than profitability, innovation or
a reputation for integrity, good relationships or other standard.
As a result, many of the players on Wall Street have become “too
big to fail.” The
One effect of "too big to fail" is that
everyone now believes that credit of the
Government has not only abandoned
enforcement of antitrust laws against Wall Street.
It has facilitated the concentration of power in Wall
Street. Examine the market for U.S. Treasury
obligations, from 30-day Treasury bills to 30-year Treasury
bonds. The Federal Reserve Banks handle the initial
distribution of these securities through a few investment and
commercial banks, the so-called “primary dealers” chosen by the
Federal Reserve Bank of
There were 40 of these “primary dealers”
twenty years ago and only 18 by 2010, of which 7 were
Henry Kaufman was the most-quoted securities analyst/economist of the 1980s, when he worked for Salomon Brothers, now part of Citigroup. His dour outlook led to the nickname, “Dr. Doom.” In a December 2008 opinion editorial, Kaufman noted how the ownership of debt securities had become concentrated in just 15 financial conglomerates. “These were the very firms that played a central role in creating an unprecedented amount of debt by securitization and complex new credit instruments. They also pushed for legal structures that made many aspects of the financial markets opaque.”
Kaufman’s gloomy prediction: “In the years
ahead, the influence of these financial conglomerates will be
overwhelming—and they will limit any moves toward greater
economic democracy. These conglomerates are and will
continue to be infused with conflicts of interest because of
their multiple roles in securities underwriting, in lending and
investing, in the making of secondary markets, and in the
management of other people’s money. . . . Through their
global reach, these firms will transmit financial contagion even
more quickly than it spread in the current credit crisis.
When the current crisis abates, the pricing power of these huge
financial conglomerates will grow significantly, at the expense
of borrowers and investors.” [The Wall Street
Journal, December 6-7. 2008, page A11. Kaufman is the
author of On Money and Markets: A Wall Street Memoir,
McGraw-Hill, 2001.] The future that Kaufman
forecasts in this Wall Street Journal article is not far
from this 1937 report to the Communist Party: “A very
important contributing factor to the decline of the stock market,
and the uneven recession in various branches of industry is this:
that big capital, the reactionary monopolists, may be considered
as being on a sort of political strike. . . . It is not excluded
that in expectation of this Congress [the special session of
Congress called by Roosevelt] and what it may do, the monopolists
seek to produce or hasten the aggravation of economic conditions,
in order to terrorize Congress and keep it from adopting
progressive political measures.” [Alex
Bittelman, “Economic Trends Today, Monopoly Sabotage,
and Tasks of Our Party – A Report to the Political Bureau of the
Communist Party on the Present Economic Situation,”
Daily Worker, October 28,
1937, as quoted by Dave Cowles, “Strike of Capital,” The New
International: A Monthly Organ of International Marxism,
Volume IV, No. 4, April 1938, page 107,
Kevin Phillips warns that the
Congress and the Federal Reserve Board are assisting the concentration of financial institutions in Wall Street. For instance, Congress used the 2012 "Jumpstart Our Small Business Startups Act" to include a section called “Private Company Flexibility and Growth,” It changed the number of shareowners, from 500 to 2,000, that banks and other corporations may have without complying with most SEC requirements. That will promote mergers within the 6,643 community banks, which typically have 100 or so local shareowners. At the same time, the Federal Reserve pushed local banks into consolidation by ordering "even the smallest lenders to comply with comprehensive international capital requirements known as Basel III." [Robin Sidel, "Small Banks for Sale: 2012 Has Been Big Year," The Wall Street Journal, June 18, 2012, page C1]
Concentration of power in big business
Nearly every business needs a source of permanent money, in addition to the temporary funding that meets seasonal or occasional needs. Small businesses usually raise their permanent money from savings, personal borrowings, family and friends. They get their temporary funding through bank borrowings, with or without government support. There is no real place for Wall Street in small business financing, with the exception of the fast-track, venture capital-supported “the next Apple,” or Google or other latest hot IPO.
Wall Street makes its real money on big business. Much of it comes from taking a percentage as money changes hands in transactions. As a percentage, the take is about the same on large transactions as on small ones. So, the incentive is always toward doing large securities offerings, large mergers and acquisitions. Big businesses have huge underwritten issues of securities. They generate merger and acquisition fees while gobbling up competitors and expanding into related arenas. It is big business that provides the raw material for stock options, credit default swaps and other derivatives. Big business also creates the opportunities to trade on information that gets leaked to favored Wall Streeters before it is public. Since virtually all money for investment has to flow through the Wall Street monopoly, it is made available to big business only--just the opposite from what is needed. "Rather than reinvest in the industries that once made us great, we must move beyond the industrial tasks of the past, toward the great new enterprises of the future." [John Naisbitt, Megatrends: Ten New Directions Transforming Our Lives, Warner Books, 1982, page 58]
One harmful result is that small business is
largely ignored by Wall Street. Investment banking had its
beginnings as a service to entrepreneurs—finding sources for
growth capital and sheparding a transaction through to closing.
The objective was to provide money to build a business.
That changed in the 1890s in
Louis Brandeis, who went on to a lengthy term as United States Supreme Court Justice, wrote a series of magazine articles which were published in 1914 as the book, Other People’s Money: And How the Bankers Use It. [Louis D. Brandeis, Other People’s Money: And How the Bankers Use It, Frederick A. Stokes Company, 1914, republished by National Home Library Foundation, 1933, Kessinger Publishing’s Rare Reprints] Brandeis describes how the great American industries, like railroads, steel, machinery, automobiles and telephone were all initially financed by individuals and the government. It was only after 30 to 80 years of business development that investment bankers added them as clients. He goes through each of the major industries of the time, detailing how the hundreds of competitors were initially financed without any Wall Street participation and then how, decades later, Wall Street engineered their consolidation into a single industry-dominant corporation. This is a brief summary of his chapter, “Where the Banker is Superfluous,” with page references to the republished book:
Railroads. Before the 1890s, Wall Street investment bankers’ major clients were the railroads. But the bankers were definitely not there to help the pioneers of railroad transportation. “The necessary capital to build these little roads was gathered together, partly through state, county or municipal aid; partly from business men or landholders who sought to advance their special interests; partly from investors; and partly from well-to-do public-spirited men, who wished to promote the welfare of their particular communities. About seventy-five years after the first of these railroads was built, J. P. Morgan & Co. became fiscal agent for all of them by creating the New Haven-Boston & Maine monopoly.” [page 93]
Steamships. Robert Fulton, the
inventor, built the first steamship with financing from a friend
who was a judge. Funding for the first steamship to cross
Telegraph. The telegraph was
invented by Samuel F. B. Morse, with the financial support of his
partner, Alfred Vail. When it came to paying for the first
telegraph line, Congress appropriated $30,000 for an installation
Farm Equipment. When Cyrus
McCormick invented the mechanical reaper, an ex-Mayor of
Steel. Andrew Carnegie was already wealthy by 1868, when he introduced the Bessemer process, which propelled the American steel industry to world leadership. It wasn’t until thirty years later that Wall Street, particularly J. P. Morgan & Co., began the consolidation of the steel industry. By 1901, all parts of the business had been combined and United States Steel was capitalized at $1.4 billion. Brandeis describes the formation of United States Steel, “combining 228 companies in all, located in 127 cities and towns, scattered over 18 states. Before the combinations were effected, nearly every one of these companies was owned largely by those who managed it, and had been financed, to a large extent, in the place, or in the state, in which it was located. When the Steel Trust was formed all these concerns came under one management. Thereafter, the financing of each of these 228 corporations (and some which were later acquired) had to be done through or with the consent of J. P. Morgan & Co. That was the greatest step in financial concentration ever taken.” [page 104. Italics in the original.]
Telephone. Over 90 percent of
the money spent by Alexander Graham Bell to build the first 5,000
telephones came from Thomas Sanders, who had a business cutting
soles for shoe manufacturers. From 1874 through 1878,
Sanders borrowed and invested $110,000, although the shoe
business he owned was only valued at about $35,000. Sanders
was motivated by a debt of gratitude, because
The point is not just that investment bankers failed to provide growth capital for new industries. What Brandeis shows is that investment bankers raised money to buy up and consolidate entire industries into single dominant companies. They created monopolies where there had been lively competition.
Wall Street’s focus on big deals is especially destructive when combined with its trader mentality. In most businesses, the lure of a short-term profit opportunity can be overcome by the vision of greater long-term prospects. Not so with Wall Street. We’d like to think of financiers as nurturing small businesses into large businesses, investing early for modest returns so they would grow into loyal mature businesses and profitable clients. Instead, one of Wall Street’s first accomplishments was to create big businesses out of small businesses. This was like a farmer selling the seed corn, getting a little more money this year but giving up the source of future crops.
The companies of
Laws were changed to facilitate this
consolidation into big businesses.
The bonanza for Wall Street was far greater than the huge fees received from transactions and new stock issues. A trading market for millions of corporate shares was created. In 1890, there were less than ten manufacturing companies with shares traded on the stock exchanges, with total market capitalization of $33 million. By 1903, with the consolidations into new giant corporations, that became over $7 billion. [John Micklethwait and Adrian Wooldridge, The Company: A Short History of a Revolutionary Idea, The Modern Library, 2003, page 69]
Concentration of power in wealthy individuals
Wall Street investment bankers have functioned as gatekeepers, keeping ownership of the instruments of production in the hands of the wealthy and their servants.
Wall Street has made no secret of its focus
on wealthy individuals. Making the rich richer is seen as
the fastest way to those multimillion dollar bonuses. So
long as Wall Street remains the channel for investing
discretionary money, then its business model will continue to
cause wealth to concentrate. The strategy has paid off for
Wall Street, as the income and proportion of wealth held by the
richest continues to increase. Even during the
market crash of 2008 and the recession that followed, the
wealthiest one percent increased their share of
To gather funds from rich individuals and institutions, Wall
Street added complex, fast-moving games to stocks and bonds.
It was the year 1973 when options were permitted to trade on an
exchange and when Black and Scholes published their formulae for
pricing options. Not so coincidentally, 1973 was also when
the average income per taxpayer, adjusted for inflation, was at
its high of $33,000. By 2005, it had gone down by nearly $4,000.
[Bob Herbert, “Reviving the Dream,” The New York Times,
Americans seem to be unaware of our extreme
concentration of wealth. A random sample drawn from a
national panel of over a million Americans showed that "All
demographic groups – even those not usually associated with
wealth redistribution such as Republicans and the wealthy –
desired a more equal distribution of wealth than the status quo.
. . . First, respondents dramatically underestimated the current
level of wealth inequality. Second, respondents constructed ideal
wealth distributions that were far more equitable than even their
erroneously low estimates of the actual distribution."
These "regular Americans" were shown three pie charts of wealth
distribution, without disclosing that they represented the
Is concentration of wealth harmful? Is anyone really hurt when the rich get richer? One answer is that accumulating wealth in the few leads to depressions, which definitely harm most of us. The theory is that rich people put far more of their discretionary cash into investment than consumption. As a larger proportion of society’s wealth is concentrated at the upper end, investment in productive capacity gets ahead of our ability to consume the resulting output. By itself, that could adjust in time without creating a severe slowdown in the economy. If, however, as the theory goes on, banks and investors take on more risk to find places to invest, an economic slowdown can lead to a sudden aversion to risk and “flight to quality.” Investors try to sell their riskier assets and put money into short-term U.S. Treasuries or other safe and liquid vehicles. Financial intermediaries become unable to meet their obligations, stop making new commitments and call in everything due from their customers. Businesses lose their credit lines and can’t meet payrolls or pay creditors.
According to the Joint Economic Committee of
Congress: “Peaks in income inequality preceded both the Great
Depression and the Great Recession, suggesting that high levels
of income inequality may destabilize the economy as a whole.”
The Committee reported that “the share of total income accrued
by the wealthiest 10 percent of households jumped from 34.6
percent in 1980 to 48.2 percent in 2008,” while the top 1 percent
“rose from 10.0 percent to 21.0 percent, making the United States
as one of the most unequal countries in the world. . . .
In short, the evolution of income inequality in the
The claimed correlation between increased
concentration of wealth and economic downturns goes back at least
to a paper by Mentor Bouniatian, published just before the Great
Batra claimed that a recession is caused by a decline in demand for goods and services, and will end when demand increases again, whether by the passage of time or by stimulation from government spending. A depression occurs “when a recession is accompanied by a collapse of the financial system . . ..” [Ravi Batra, The Great Depression of 1990, Liberty Press, Venus Books, 1985, page 134] So, the next question Batra asks: “What causes a financial panic?” We can revise his answer to reflect experience of the last 20 years. As the rich get richer and the middle class gets poorer, there is less borrowing done by the rich, while the middle class borrows more. Part of the middle class borrowing is to make up for declining real income from their jobs. Another part is to emulate what they see the rich doing with their money, the “social comparison theory of happiness.” [See Jerry Suls and Ladd Wheeler, The Handbook of Social Comparison, Springer, 2000 and the film, "The Economics of Happiness," by Helena Norberg-Hodge, Steven Gorelick & John Page] Wall Street reacts by serving up ever more risky games to play, because acceptance of risk increases with wealth. [Arrow-Pratt Measure of Relative Risk-Aversion, part C of The Theory of Risk Aversion, http://cepa.newschool.edu/het/essays/uncert/aversion.htm#pratt]
peak concentrations of wealth in recent
Is it just a theory that increasing concentration of wealth leads to an economic depression? Perhaps the studies of what happened in 2008 will shed some light on its validity. In the meantime, we can each imagine what might have happened if Wall Street had not been so single-minded about selling speculative games to the rich and instead had extended credit to the middle class. What if they had promoted broad ownership of business and government debt securities, if Wall Street had helped each of us select shares and bonds of companies we thought would bring us a good return, and if the money managers did not have their vast pools of money to play with derivatives, arbitrage trading and the other games?
Concentration of financial power and wealth leaves the middle class out of society’s increasing wealth and makes us all victims of the periodic collapse of Wall Street. By separating the ownership of business from the workers, the benefits of greater productivity have mostly gone to the owners, leaving the workers behind. Since 1973, “the typical family’s income has grown at about one-third the rate of productivity. . . . Had the median household income continued to grow with productivity, it would now be in the $60,000 range instead of the $40,000 range.” [Jared Bernstein, All Together Now: Common Sense for a Fair Economy, Berrett-Koehler Publishers, Inc., 2006, page 57] Hardest hit are minority families, where the disparity in wealth is far greater than it is in income. While Blacks earn 62 cents for every dollar of white income, Blacks have only 10 cents for every dollar of net worth whites have. While Latinos earn 68 cents for every dollar of white income, Latinos have only 12 cents for every dollar of net worth whites have. [“State of the Dream 2010: Jobless and Foreclosed in Communities of Color,” United for a Fair Economy, http://faireconomy.org/files/SoD_2010_Drained_Report.pdf]
A recent book has confirmed one of the
greatest harms caused by having the rich get richer while the
rest stay about the same or get poorer. Richard
Wilkinson and Kate Pickett studied comparisons among the richer
nations, as well as comparisons of states within the
The subject of wealth and income inequality suggests the uncomfortable thought of taking from the rich and giving to the poor. Of course, it doesn’t have to work that way. Simply alleviating extreme poverty, while leaving the rich alone, substantially narrows inequality. But Wall Street’s emphasis on building wealth for the wealthy does nothing to relieve poverty. About the only positive effect could be that a few who have become very rich on Wall Street will contribute their time and money to charities that help the poor. Mostly, however, people who do that have come from successes outside Wall Street. Wall Street's control over the mechanics of international finance, moving "hot money" from one developing nation to another, can be blamed for causing greater inequality and the resulting violence and revolts. [See Amy Chua, World on Fire: How Exporting Free Market Democracy Breeds Ethnic Hatred and Global Instability, Doubleday, 2003, page 9]
Wall Street's focus on selling investments to the already wealthy has left the middle class to be lured by the persuasive powers of borrowing and spending. This means that earnings from work continue to be the only source of significant income for nearly all of us. We have very little chance of ever having a financial return on money we've kept from spending. Government-promoted lotteries, with their dismal odds, are the only hope we have of breaking free of relying on our ability to find and perform a job. [Jeremy Rifkin, The End of Work, G. P. Putnam & Sons, 1995]
The problems created by wealth and income
inequality can arguably be offset by increased mobility—making it
possible for people to gain wealth. [Jonathan D.
Fisher and David S. Johnson, “Consumption Mobility in the United
States: Evidence from Two Panel Data Sets,” Topics in Economic
Analysis & Policy, Volume 6, Issue 1, Article 16, The
Berkeley Electronic Press, page 27,
Mobility upward into the middle class can begin to alleviate
poverty. Professor C.K. Prahalad, author of The Fortune
at the Bottom of the Pyramid, [Wharton 2004] has
said: “to ‘make poverty history,’ leaders in private, public and
civil-society organizations need to embrace entrepreneurship and
innovation as antidotes to poverty.’” [C.K. Prahalad,
“Aid is Not the Answer,” The Wall Street Journal,
Concentration of power in institutions
After the Roaring 20s, millions of Americans owned shares directly in American business. By 1931, AT&T had 642,000 shareowners, the Pennsylvania Railroad and United States Steel each had 241,000. An AT&T advertisement showed a grandmotherly woman with her hands in a mixing bowl, with the caption "She's a Partner in a Great American Business." Ad copy called AT&T "a democracy in business--owned by the people it serves.. . . More than half of them have held their share for five years or longer. . . . More than 225,000 own five shares or less. Over fifty per cent are women. No one owns as much as one per cent . . .." [Included in Roland Marchand, "AT&T: The Vision of a Loved Monopoly," adapted from his book, Creating the Corporate Soul, University of California Press, 1998 and included in Jack Beatty, Colossus: How the Corporation Changed America, Broadway Books, 2001, page 200] (A friend told me that his father, a lifetime AT&T employee, was encouraged to call upon shareowner families as he traveled the country.)
When the Securities Act of 1933 was adopted, institutions owned less than ten percent of the shares listed on the New York Stock Exchange. [Louis Lowenstein, What’s Wrong With Wall Street: Short-term Gain and the Absentee Shareholder, Addison-Wesley Publishing Company, Inc., 1988, page 58] The relative ownership by individuals and by institutions has dramatically reversed since then. By 2007, institutional ownership was over 76%. [Institutions are defined as “pension funds, investment companies, insurance companies, banks and foundations.” http://www.conference-board.org/utilities/pressdetail.cfm?press_id=3466]
A huge gift to Wall Street has been government encouragement of employer-sponsored retirement plans, through tax deductions for employer contributions, combined with the investment standards and government insurance of ERISA, the Employee Retirement Income Security Act of 1974. The employer connection to accumulating assets for retirement is an anachronism, an accident of history. During World War II, the government set controls on wages, but benefits were not counted. Employers could compete to attract and keep the scarce employee candidates by offering a pension, as well as health benefits. Our national habit of employer-paid pensions and health care was just an unintended consequence of wartime wage and price controls. Perhaps other avenues for wealth accumulation have never been tried, because the combination of social security and corporate pensions was expected to take care of our retirement needs.
Most employers, except the government, have already stopped providing “defined benefit” pension plans. These were the programs that promised to pay retirees a percentage of what they had been earning. Instead, businesses switched to “defined contribution” plans, which paid a percentage of an employee’s current earnings into a fund. The retirement benefits were then measured by what the employer had paid in for the employee, together with proportionate investment earnings. The change has taken the open-ended liability away from the employer, but it still ties the employee's asset-building to a particular job. From company-wide plans, many employers have gone to sponsoring individual retirement programs, the IRAs and 401ks. These severely limit the individual’s choice of investments, often to a few selected mutual funds or the employer’s own shares. The conditions imposed by employer plans mean that Wall Street buy side firms are paid fees to make investments. They do this mostly by investing in mutual funds, which get a fee for investing in securities. The mutual fund managers buy the securities through Wall Street sell side firms, which almost never invest in small businesses, or even in new issues of securities. Three sets of intermediary fees are skimmed off, as the money goes from employer and employee contributions into Wall Street’s churning of previously-owned securities and derivatives.
This institutional concentration of
investment money has been mirrored by a constant decline in
ownership of public companies by individuals. We often are
told that some large percentage of Americans are stockholders.
What is seldom mentioned is that this includes shares of mutual
funds owned by individuals or, more likely, their retirement
accounts. It is the money manager for the fund that is
making investment decisions and actually owning and voting the
shares in an operating company. This institutional
ownership puts at least one financial intermediary between the
individual and management of a company. One effect is the
disconnect between managers and the ultimate economic owner.
Very few individuals know what companies are owned by their
funds. They certainly don’t have any voice for shareowner
voting. Wall Street has also been effective in selling
foreign institutions, like sovereign wealth funds and ruling
family funds, in ownership in American businesses. After
OPEC was formed in 1973, David Rockefeller, Chairman of Chase
Manhattan Bank, said "We plan to serve as one of the bridges
Institutions have minimum size requirements
for the companies in which they invest. Almost none of them
ever puts the fund’s money into small businesses. Even
initial public offerings are generally for $50 million or more,
so the company has to be quite large before it ever goes public.
It will have had many millions of dollars invested by
institutional venture capital funds, or it will be a spinoff of a
large business from an even larger conglomerate. All of
this tends to direct capital into the largest corporations, while
starving our younger, entrepreneurial businesses. In the
final paragraph of his1914 book, Louis Brandeis quotes President
Woodrow Wilson: “No country can afford to have its
prosperity originated by a small controlling class. The
Whatever faults we may find with the
investment bankers of a century or so ago, they did channel money
The reason why so little money goes from individuals into young businesses is that (1) Wall Street has a government-enforced monopoly on selling new issues of securities, (2) Wall Street’s monopoly pricing is a fixed percentage of the money raised, whether in large or small amounts and (3) Wall Street’s short-term mentality won’t wait to grow small clients into large ones. Entrepreneurs have to go through venture capital firms or investment bankers to grow beyond the start-up phase. At the supply end, individuals must turn money over to broker-dealers or fund managers to invest. As a result, nearly all of the savings by individuals will be used to trade in "previously-owned" securities and their derivatives, with a trickle going into new issues made by large businesses. "The potential of our economy to underwrite a society of broad prosperity is being sacrificed to financial speculation. . . . The real economy of enterprises and workers is hostage to a casino of financial speculation. . . . Every category of gatekeeper who had a fiduciary relationship with small shareholders was corrupted." [Robert Kuttner, The Squandering of America: How the Failure of Our Politics Undermines Our Prosperity, Alfred A. Knopf, 2007, pages 4,5, 74.]
Wall Street Promotes Speculative Trading Instead of Long-Term Investing
Most of Wall Street’s revenue has come from two sources, one from acting as a broker in executing trades in existing securities and the other from being a dealer, buying and selling securities for its own account. Federal securities laws, and the laws in every state, give broker-dealers a monopoly over both of these businesses. Anyone trying to cut in on the business, without first getting a broker-dealer license, can be sent to prison.
Since competition isn’t a challenge to monopolists, Wall Street broker-dealers concentrate on increasing the volume of transactions on which they take a broker’s commission or a dealer’s markup. “Churning” is the basic tool. Keep pushing sales of securities and recycling the proceeds back into the market. Just one example of how this is carried out is the concept of “Rotation,” meaning how industries come and go in favor, such as from “growth” stocks to “value” stocks and then from one industry segment to another. This generates commissions for the brokerage side of Wall Street, as investors sell one group and buy another. Even greater income comes from trading on inside information as to which sector will be coming into favor and which will be leaving, as well as from underwriting commissions doing IPOs in the hot new industry.
For businesses seeking growth capital, the rotation game can mean being closed out of the IPO market for years and then having a few months in the “window of opportunity,” when investment bankers come calling. As an industry rotates into favor, investment bankers start with underwriting the most attractive businesses and work their way down to the riskier ones. They usually overdo the quality downgrade, until there are failures and frauds, poisoning the whole pool for years. Meanwhile, they have moved on to a new fad.
(In my years of doing securities law work,
my clients went through several of these cycles. One of
them led to pioneering a Direct Public Offering. We were
hired in 1973 to help a savings and loan with an IPO. It
signed a “letter of intent” with Wall Street underwriter G.H.
Walker. (As in George Herbert Walker
Bush, whose family founded and owned the investment banking
firm.) But the IPO market for our client’s industry dried
up in late 1973. By 1976, when there was some renewed
activity, G.H. Walker had merged with William Staats, which was
then acquired by White Weld, soon to be taken over by Merrill
Lynch. Our client was too small to interest the giant.
We met with all the investment banking departments of securities
firms that might have the interest and ability to do the IPO.
None wanted to take it on. Our client needed investor
capital to support its growth and a Direct Public Offering was
born out of this necessity. It marketed shares directly to
its customers and other communities, in a public offering
registered with the
Wall Street Has Turned to Derivatives and Other Nonproductive Games.
What caused the 2008 financial catastrophe?
Perhaps we can blame it on the rock and roll. Savings and
investments were not very complicated, right up to the late
1960s, the Summer of Love and
It was as if the unrest of the 1970s hit
Wall Street. In 1972, money market mutual funds were
created, to pay higher interest rates than the banks. The
next year, the
In this alternate reality, stocks and bonds were not enough. There is a limit to the volume of trading that can be generated by churning existing securities that were originally issued by businesses to raise money for operations. Fewer than 7,000 stocks are listed on the two significant U.S. Exchanges. Adding in the stocks traded over-the-counter reported on Nasdaq’s Bulletin Board brings the total publicly traded issues to just over 10,000. Only a few of the 5,000 or so securities with Pink Sheet data are being traded with any regularity. But even if we included all of them, there would be 15,000 stocks available for turning over.
To build more activity, with commissions and trading profits, Wall Street needed more products, more markers in the casino games. An early step was to impose another layer of financial intermediaries between the individuals who provide money and the businesses that use the money. What Wall Street had to do was create other securities, using stocks and bonds as the basic building blocks. Mutual funds, which issued their own shares and used the money raised to buy securities, have provided new securities and greatly enhanced trading volume. There are over 16,000 mutual funds reported by the Investment Company Institute, including closed-end funds, exchange traded funds and unit investment trusts. [www.icifactbook.org/fb_sec1.html#number] That means there are more mutual funds than the 15,000 operating company stocks. Then there are the hedge funds, which grew from 3,000 in 1998 to more than 9,000 by 2007, according to the Government Accounting Office. [www.gao.gov/new.items/d08200.pdf] A private consulting firm reported the number of hedge funds in 2007 at 23,603, including funds that invested in other hedge funds. [Sizing The 2010 Hedge Fund Universe: A PerTrac Study, http://www.pertrac.com/assets/Uploads/PerTrac-2010-Hedge-Fund-Database-Study-April-2011.pdf, page 5] Together, there are some 40,000 mutual funds and hedge funds. Why would there be nearly three times as many funds as there are operating businesses with traded securities?
In addition to all the mutual funds and
hedge funds, Wall Street started inventing new instruments,
derivative securities which moved faster and farther than shares
or bonds. A
derivative security is one derived from another security.
Like avatars in a virtual reality game, derivative securities are
just made-up icons measured by the performance of a real
security. Derivatives are not new, nor is their involvement
in financial disasters: it was tulip derivatives that were behind
the Dutch crash of 1637. [John Lanchester, “Cityphilia,”
London Review of Books,
News about derivatives would never have made it into the general media, except for their devastating effect upon our personal economics. The derivatives games have drastically influenced whether we can keep our jobs and afford to stay in our homes. In 2008, derivatives based on home mortgage loans were even the subject of “instant history” books, like The Big Short: Inside the Doomsday Machine, [Michael Lewis, W. W. Norton & Company, 2010]; Freefall [Joseph E. Stiglitz, W.W. Norton & Company, Inc., 2010] and Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis. [Paul Muolo and Mathew Padilla, Wiley, 2009]
Since the 1970s, Wall Street has diversified away from raising capital for business and into inventing derivatives and trading for their own accounts. They could have kept to their primary mission and improved the markets and instruments for companies to use for raising money for growth. They could have designed instruments that would fit the new pools of capital, such as retirement accounts for individuals. They could have developed marketing tools that would persuade individuals to buy corporate shares instead of more expensive cars and larger homes.
Instead of improving their own business of trading stocks and bonds, Wall Street executives chose to move into other products. The greatest harm to us all has come from Wall Street’s runaway use of computer technology to create derivatives. To the extent anyone tries to justify the financial futures, options, swaps and the like, they argue that these derivatives help to “manage risk.” For instance, someone with a fluctuating-rate debt instrument can swap it for a fixed-rate payment schedule, to protect against the risk of interest rates going higher. On the other side, a speculator who wants to bet on lower rates can deliver a fixed-rate debt and take back the one that fluctuates. To protect against the risk of default, a bond owner can purchase another derivative, a credit default swap, from a counterparty that believes it has priced the risk profitably. A stock investor can hedge against falling value by purchasing put options on the same stock or industry segment. However, those beneficial uses just scratch the surface on the games that are played in this casino.
Speculators in stock price movements no longer have to buy and sell a company’s shares. Options are the right to buy or sell a stock within a fixed period of time, at a fixed price. They were first introduced as options on an index, like the S&P 500. Now, they are available for many individual companies, so the trader can bet on price movement without actually purchasing the shares. “Some 379 million options traded last year, a surge from 1.7 million in 2010, according to TABB Group, a research and advisory firm.” The propulsion to ever-shorter trading got an extra boost in mid-2010, when exchanges began offering options on individual stocks, with one-week expirations instead of the customary one-month. [Chris Dieterich, “Traders’ New Cry: See You in a Week: ‘Short-Term’ Options Bet on a Stock’s Action in a Handful of Days Instead of Month; a Volatility Play,” The Wall Street Journal, January 12, 2012. The TABB Group executive Summary is available at http://www.tabbgroup.com/PublicationDetail.aspx?PublicationID=1033; the full report costs $3,000]
Another set of derivatives came from the futures market, which had long traded in bets on what the price would be for wheat, pork bellies and other agricultural products. The buyer of a futures contract is agreeing to deliver the real thing at a specific future date and a set price. The buyer is betting that the price for immediate delivery (the cash or “spot” price) will be lower on the contract delivery date. It is almost unheard of that anyone actually delivers the underlying commodity on the agreed delivery date. What really happens is that the contract either expires as worthless, because the spot price is higher at the delivery date, or the person on the other side of the futures contract pays the difference between the lower spot price and the contract price. It is a zero sum game, in that all the profits are equal to all the losses, not counting the commissions and fees charged for participating in the market.
Futures markets were intended to serve two types of participants. One is the speculator, who bets on the future price, just like gambling on the results of sporting events or elections. The other is someone in the business of actually using the commodity to be delivered. For these "commercial traders," the futures market provides a hedge against price fluctuations that could cause big losses to the business. Oil refineries buy crude oil for future delivery and sell their products at prices which include that cost. When they purchase oil, they can also sell an oil futures contract at the same price, for the same amount and same delivery date. That way, any price changes will cancel out. It takes the risk away from the refinery and places it on the speculator.
Of course, the futures market has become much more complicated than the simple hedge. The real activity is among the speculators, those who are betting that the price of a commodity will go up and those betting it will go down. If there are more bettors on higher prices (the bulls) than on lower prices (the bears), the futures contracts will continue to have higher settlement date prices. This will go on until the bulls start dropping out and the bears increase. Sometimes the rational analysis of speculators is replaced by a mania, a belief that the market price will only go up, never down. Observers will call this “the greater fool theory of valuation.” Even if buyers don’t believe in the fundamentals for the price, they are convinced that someone will come along who is willing to pay an even higher price. This is the “bubble” that, when it bursts, can cause calamity.
The futures markets were once spread all
Oil derivatives have taken on a role in
financial speculation that has almost nothing to do with the
supply and demand for that commodity. It is now part of an
arbitrage game, playing off the stock market. Since
oil futures first started trading in 1983, their correlation with
stock prices has been only about a tenth of one percent.
Since 2008, it has been at 34% and reached 70% in 2010. “Crude
oil is now influenced more by the stock market than by its own
inventory levels or demand patterns.” What happened?
Wall Street has overtaken the trading in oil futures, moving in
and out on programmed trades. “Oil and stocks are joined up
by actual money flows, as more fund managers start to trade in
both markets. Many of them are so-called ‘algorithmic
traders,’ who trade based on technical signals instead of
fundamentals.” [Carolyn Cui, “Oil Gets a New Dance Partner:
Stocks,” The Wall Street Journal,
Wall Street speculation in the futures
markets for food has been blamed for increased hunger in poor
countries. “From about
late 2006, a lot of financial firms—banks and hedge funds and
others—realized that there was really no more profit to be made
in the US housing market, and they were looking for new avenues
of investment. Commodities became one of the big ones—food,
minerals, gold, oil. And so you had more and more of this
financial activity entering these activities, and you find that
the price then starts rising. . . . It sounds incredible, but
world rice prices increased by 320 percent between January 2007
and June 2008. So in just 18 months you have tripling of world
rice prices. World wheat prices go up by 240 percent, maize
prices by 218 percent. Crazy increases in these trade prices of
these commodities. . . . This bubble burst in June 2008 . . .
because that was when banks had to move their profits back to the
Derivative securities, fashioned from subprime home loans, have been especially harmful to communities of racial minorities, according to sociologists at Princeton University. Segregated, low-income areas had formerly been "red-lined" as undesirable by traditional lenders, who held and serviced the loans they originated. When making home loans became separated from continuing to own the loans, it created "geographic concentrations of underserved, unsophisticated consumers that unscrupulous mortgage brokers could easily target and efficiently exploit. . . . In the end, subprime lending not only saddled borrowers with onerous terms and unforeseen risks, but it also reinforced existing patterns of racial segregation and deepened the black-white wealth gap." [Jacob S. Rugh and Douglas S. Massey, "Racial Segregation and the American Foreclosure Crisis," American Sociological Review, Volume 75, number 5, October 2010, pages 629-651, at page 632]
The speculation in oil and food futures has
led to a new kind of derivative for other commodities. In
December 2009, the Securities and Exchange Commission approved
new exchange traded funds for trading in platinum and palladium.
Unlike most futures trading, these ETFs actually buy and store
the physical commodity. That has the effect of taking
supply out of the market, raising the price of the futures.
Higher prices also have the effect of “hurting consumers such as
car makers, liquid-crystal-display glass makers and
medical-device makers.” [Matt Whittaker and Carolyn
Cui, “ETFs Drive Up Platinum, Palladium,” The Wall Street
Then came another derivatives game, options on financial instruments. Options are the right to sell (a put option) or to buy (a call option) a security at a particular date and price. Unlike a futures contract, an option does not commit the holder to do anything other than pay a price for the option. That price is usually a small percentage of what it would cost to buy the underlying, “real” security. You get to play the game of guessing whether a security’s price will go up or down, without having actually to buy or sell the security or even agree to buy or sell it in the future. Options allow you to get the short-term price increase or decrease on a security, while paying only a fraction of the cost of buying the security itself. If you guess right, you can collect the same profit you would have gotten from buying the security on which the option was based, minus only the cost of the option. If you miss the mark, you only lose what you paid for the option.
Some option contracts use indices tied to a group of companies’ shares, like the S&P 500. Participants may use them as legitimate hedging tools, by simultaneously buying an individual company stock and selling an index option. Before long, the stock option concept went from broad market indices to options on stocks in specific industries or company size category or specific countries. Then, stock options were created that are the right to buy or sell a single company’s shares by a certain date at a set price. The option buyer is betting whether the price will move up or down. The option is “settled” without anyone actually buying or selling shares, with the result that trading in options can be done with far less capital. But it still means that capital is being tied up in a zero-sum game among its players, capital that could have been used to actually buy new shares from a business that would use the funds to develop a product or service.
(My brief foray into playing the derivatives game was with futures call options on 30-year Treasury bonds. My options gave me the right to buy a futures contract which, in turn, would give me the right to buy the bonds. Having both an option and a futures contract had the effect of increasing leverage and multiplying the amount of potential gain. I was betting that the price of the bonds at the delivery date on the futures contract would be higher than the price payable on the futures contract. If the price was below the futures price commitment, I’d be out the cost of the option. The odds looked to me much better than a lottery. Just as other gamblers tell themselves about sports betting, I could fantasize that I had some knowledge and ability in analyzing what the results would be, that it wasn’t really gambling, that it was a game of skill, perhaps even a career. I did OK, but I know that eventually I would have given back all my gains. Friends insisted that I get out and stay out.)
As the 1970s progressed, derivatives, especially options, gained respectability from government and academia. But the trade in derivatives was hampered by one big thing: no one could work out how to price many of them. The interacting factors of time, risk, interest rates and price volatility were so complex that they defeated mathematicians until Fischer Black and Myron Scholes published a paper in 1973. Within the year, traders were using equations and vocabulary straight out of Black-Scholes (as it is now universally known) and the worldwide derivatives business took off like a rocket.
In 1973, the year that the
Black and Scholes, the academics who created the formula for pricing options, were co-founders of Long Term Capital Management, a hedge fund manager that successfully used the Black-Scholes Formula from 1993 to 1998. But their formula didn’t anticipate what would happen to the financial markets when Russia defaulted on its debt. In a prelude to the 2008 collapse of Wall Street, the Federal Reserve Bank of New York jawboned a bailout by Wall Street banks, which had lent LTCM nearly all the money used in its maneuvers. After the bailout, the banks went back to business as usual.
With support from the
The summer before the Crash of
Futures and options instruments multiplied, with hedges, straddles and portfolio management strategies adding complexities. As Wall Street looked for more marker securities upon which to build more derivatives, real estate loans became the new game in town. First were mortgage-backed bonds, which were debt obligations secured by a pledged collateral pool of mortgages that had a value equal to 150% of the bond amount. If the bond issuer failed to pay, the bondholders could sell the mortgages. Then, in 1977, came the first private Pass-through Certificates. They were fractional interests in a pool of mortgages that collected payments of interest and principal and passed them through to the owners. Both of these instruments were modeled on what was already being done by the government sponsored entities, Fannie Mae, Freddie Mac and Ginnie Mae.
Seeing the success of Pass-Through Certificates, Wall Street grabbed onto the mathematical formulae of the “rocket scientists” it had hired to come up with Collateralized Mortgage Obligations, or “CMOs.” These securities divided a pool of loans into tranches, based upon the risk involved in each. The lower risk tranches got triple A ratings from the rating agencies, while the high risk, “toxic” tranches carried high interest yields and paid large commissions to the brokers who sold them. The appetite for CMOs led to using car loans, music royalties and any other installment payments for Collaterized Debt Obligations, or “CDOs.”
(I stopped doing legal work on mortgage
securities in 1985, after completing my first and only
Collateralized Mortgage Obligation. Unlike the Mortgage
Backed Bonds and Pass-through Certificates I’d done, the
As derivatives like futures, options, CMOs
and CDOS expanded, the process moved on to inventing derivatives
on these derivatives. The most publicly known are the
Credit Default Swaps, a form of betting on whether payments on
contracts will be made on time. They’re a little like
sports betting, such as whether a quarterback will complete the
next pass. These Credit Default Swaps grew to unimaginable
amounts. “For example, the bets on who might default,
called credit default swaps, grew unregulated to now comprise
$683 trillion of contracts (Bank for International Settlements
December 2008) – while real global production measures only the
$62 trillion of global
One of the most difficult derivatives to
understand is also the one that has caused some of the greatest
losses: The “synthetic collateralized debt obligations” or
synthetic CDOs. They are a group of bets on whether a
company will default on its bonds. The bets are sold as
“insurance” and “credit default swaps.” The groups include
a hundred or more companies and the buyers are the banks, hedge
funds and others who purchase bonds. They cover their risk
of default by paying a premium to the owner of the synthetic
Instead of channeling money from individuals to growing
businesses, Wall Street has invented thousands of securities that
are nothing more than bets on future events. Increasingly
gigantic amounts of money have been sent to Wall Street to play
these zero sum, nonproductive games. In late 2009, the
global derivatives market had reached $600 trillion, equal to ten
times the gross domestic product of all the countries in the
world. Of that, $204
trillion was held by
Of course, many participants in these games of greed and fear
are not residents of Wall Street. People buy and sell
derivatives of their own free will, however ignorant or careless
they may have been. “I'm not saying that average Americans
were as culpable as Wall Street in creating this financial and
economic crisis; our sins were venial, whereas theirs were
mortal. Madoff's alleged fraud was at least
straightforward. Much worse was the creation of exotic
‘derivative’ investment products -- whose true value turned out
to be impossible to ascertain -- that were bought and sold with
enormous leverage. As long as real estate values kept rising, it
didn't matter what these chimerical investments were worth. What
mattered to Wall Street was the ability to collect enormous fees
from real people, in real dollars, for trading unicorns and
dragons.” [Eugene Robinson, “The Year of Madoff,”
A practice similar to the derivatives
markets was made a crime a century ago by
The 1987 market crash was not the only clear
warning of what was to come in the derivatives market. Wall
Street continued right after that to sell packages of interest
rate swaps and other derivatives related to the debt market.
When interest rates rose in 1993, many bond prices dropped by ten
percent. Holders of derivatives experienced a much greater
loss in value. The treasurer of
One of the early warnings about derivatives
came from Warren Buffett, in his 2002 annual report to Berkshire
Hathaway shareowners: “The derivatives genie is now well
out of the bottle, and these instruments will almost certainly
multiply in variety and number until some event makes their
toxicity clear. . .. In our view, however, derivatives are
financial weapons of mass destruction, carrying dangers that,
while now latent, are potentially lethal.” [www.berkshirehathaway.com/letters/letters.html]
“Felix G. Rohatyn, the investment banker who saved New York from
financial catastrophe in the 1970s, described derivatives as
potential ‘hydrogen bombs.’” [Peter S. Goodman, “The
Reckoning: Taking a Hard Look at the Greenspan Legacy,” The
New York Times,
When the Panic of 2008 hit, and some Wall
Street players were bailed out, it still didn’t fix the crisis.
“This is because the credit crisis reflects something more
fundamental than a serious problem of mortgage defaults. Global
investors, now on the sidelines, have declared a buyers' strike
against the sophisticated paper assets of securitization that
financial institutions use to measure and offload risk.”
[David Smick, “Commentary: Why there's a crisis -- and how to
stop it, CNNPolitics.com,
What happened to the credit markets in
October 2008 was that banks became afraid to lend money to other
banks, a practice that is a major source of bank funding.
Bankers didn’t know which of their correspondent banks had loaded
up on derivatives, and how many of those derivatives may have
become unsaleable. “The reason banks became reluctant to
lend money to each other was linked to risks arising from new
types of financial instrument. Recent years have seen huge
amounts of ingenuity applied to the devising of new types of
investment vehicle. Most of these are forms of derivative,
in which a product derives its value from something else.”
[John Lanchester, “Cityphilia,” London Review of Books,
Government reform proposals have focused on
this unsaleability of derivatives, the fact that so many of them
are traded privately, without continuous, public bid and asked
quotations. The suggestion has been that a repeat of the 2008
collapse could be avoided by having “transparency” from exchange
trading of derivatives. One prediction is that greater
transparency will be required for some, but not all derivatives.
“This half-measure will allow new Petri dishes of systemic risk
to fester in darkness as Wall Street returns to the ‘financial
innovation’ laboratory.” [Paul M. Barrett, “The
Crisis Commission’s Missing Witness,” Bloomberg BusinessWeek,
The harm to United States citizens can be
clearly seen and measured for at least one part of the
derivatives mess. American International Group, Inc., the
world’s largest insurance company, had a financial products unit
which sold “insurance” against losses that could happen to owners
of derivatives. One of the simpler products was a credit
default swap, which charged a premium for insurance against a
loss caused by a pool of mortgages going bad. It turned out
to be a very bad bet by
Credit default swaps and interest rate swaps insured by
Rather than deter the use of credit default
Why did the Federal Reserve bail out those
investment bank customers of
The same “increase your turf” motive may
explain why foreign banks got so many billions from the Federal
The near miss from bankruptcy definitely did
not scare Wall Street into staying away from derivatives.
Beginning with the first quarter of 2009,
Wall Street also went headlong after the
Panic into selling “structured” securities to individual
investors, in amounts as small as $1,000. These are
derivatives for the little people. One of their advantages
Wall Street is that they are each a “proprietary product” to the
bank or broker selling it. To get a sense of the amount and
complexity of what is being sold, consumers are sent to
www.structuredretailproducts.com for a trial subscription to
its service. [Jessica Silver-Greenberg, Theo Francis
and Ben Levisohn, “Old Banks, New Tricks,” Business Week,
Wall Street’s “Prime Brokerage” Games with Hedge Funds
The first hedge fund is said to have begun in 1949, with the strategy of buying undervalued stocks and then hedging the market risk by selling overvalued stocks. [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, page 120] Today, over 23,000 hedge funds are vehicles for any kind of trading strategies with whatever instruments are thought to produce big winnings. Nearly all of them rely on borrowing as much money as they can, to leverage the amount committed by institutional money managers and wealthy individuals.
Private-equity funds are financed in the
same way as hedge funds. They buy businesses, often
publicly traded ones in distress or underperforming in their
industry. The private equity funds drain any available cash
out in dividends and fees and then do an “initial” public
offering of what’s left, or sell it to another business.
[David Henry and Emily Thornton, “Buy It, Strip It, Then Flip It:
The quick IPO at Hertz makes buyout firms look more like
fast-buck artists than turnaround pros,” Investor beware,
Wall Street’s easy credit to hedge funds and
private equity firms fits precisely within the Minsky model for
what causes an economy to crash and go into recession, as it did
in October 2008. [Charles P. Kindleberger and Robert
Z. Aliber, Manias, Panics, and Crashes: A History of Financial
Crises, fifth edition, John Wiley & Sons, Inc., 2005, page
25.] Just over a year after that panic, Wall Street
was drumming up new prime brokerage business, “boosting their
lending to hedge funds and private-equity funds to levels unseen
since before the financial crisis, raising their risk levels and
adding fuel to the buying power of key players across the stock,
debt and buyout markets.” That fits the easy credit/high
risk scenario that keeps creating economic crises. [Gregory
Zuckerman and Jenny Strasburg, “Banks’ Loans to Funds Are Back at
Levels Before Crisis,” The Wall Street Journal,
Program trading, naked access, flash trading, quote stuffing, etc.
Computers have helped drastically accelerate
the movement to ever faster trading. The Crash of
New ways to bet on price movements are
constantly being invented. Computer communications
technology has led to “high-frequency trading,” where
computerized models trade in and out in milliseconds.
Participants have moved their operations to be physically near
the computers where trades are executed because, even at the
speed of light, there can be a competitive advantage to placing a
computer close to the equipment used by an exchange.
Imagine a poker table where the first to play a card can win.
This “high frequency trading” operates entirely through
computer-programmed trading strategies--so-called "algorithmic
trading." No human has to
make any decision. Some programs read everything that goes
across the Internet, finding and analyzing words related to a
company and then place buy or sell orders. [Graham Bowley, "Wall
St. Computers Read the News, and Trade on it," The New York
How much of the buying and selling on U.S.
Exchanges is done by high frequency traders? By 2009, over
half of all trades on U.S. exchanges were these high frequency
trades. “High-frequency trading now accounts for 60 percent
of total U.S. equity volume, and is spreading overseas and into
other markets.” [Jonathan Spicer and Herbert Lash,
“Who’s Afraid of High-Frequency Trading?” Reuters,
We have all become more aware of
high-frequency trading after the
High frequency trading has moved beyond stocks to futures and other derivatives, where it has reached 40% of the trades. Both markets are plagued by orders placed and cancelled to manipulate prices. "An estilmated 80 to 90 orders are put into futures markets for every trade that actually happens, according to Mr. Gensler [Chairman of the Commodities Futures Trading Commission], and experts say obout 90% of all orders on stock exchanges are canceled." [Scott Patterson, "CFTC Targets Rapid Trades," The Wall Street Journal, March 16, 2012, page C1, C2.
The rules of the exchanges are that only member broker-dealer firms may trade. However, to get the speed they want, hedge funds and other trading firms “rent” their brokers’ computer codes. Only brokers who are members of the exchange are allowed to place orders, but some brokers get paid for letting trading customers use their access codes to communicate with the exchange computers. This “sponsored access” occurs when the customer routes orders through the brokers’ computers, where they can be checked for any rule violations. A few brokers’ let customers skip the brokers’ computer system entirely and tie directly into the exchange network, using the brokers’ “market participant ID” computer access codes to interface with the exchange computers. That’s known as “naked access” and it allows a hedge fund or other trader to buy and sell a security in less than a second. [http://aitegroup.com/reports/200912141.php?PHPSESSID=57b191c4e3eb35bfe05c2ff11067be93] No one could be in and out of owning a security in a split second, based upon some change in information about the underlying business. This is speculative trading, based upon computer-programmed instructions that have nothing whatsoever to do with any real world information.
There are several advantages to naked
access, over sponsored access. First of all, it is some
milliseconds faster, giving participating customers a competitive
advantage. [“A firm that uses naked access can
execute a trade in 250 to 350 microseconds, compared with 550 to
750 microseconds for trades that travel through a broker’s
computer system by sponsored access . . ..” [Scott
Back at that imagined poker table, what if a
player could get a quick glance at the hands held by the others?
That is the advantage of “flash trading” in the securities
markets. It is a quick view on the computer of orders
placed but not yet executed. “The order is ‘flashed’ to a
select group of participants who can act on the order before it
is routed to other exchanges to be filled.” [Jacob Bunge
and Joan E. Solsman, “Direct Edge Rides Citi to Record Trading
Share,” The Wall Street Journal,
Wall Street traders are not satisfied with
being able to peek at prices for pending trades before placing
their own buy or sell orders. Looking at the cards held by
other players is not enough--they are looking to reshuffle the
cards. They are finding ways to go beyond flash trading, to
ferret responses and
cause price changes through "sniping" or "sniffing," by placing orders that they cancel before
they are executed. One technique, called "quote stuffing,"
places a mass of orders, all within a fraction of a second,
followed directly by canceling them all. For instance,
Nanex, LLC, a data provider, looked at a day in which an average
38 orders were placed every second to buy or sell one company's
stock. But in one second, there were 10,704 orders, followed by
5,483 the next second. All but 14 of those orders were
cancelled within the next second. This may cause other
buyers and sellers to place orders as they conclude the market
price is moving. The first round of orders is a feint,
intended to deceive other high frequency traders, enticing them
to place orders before they see the cancellations. This
allows the quote stuffer to purchase and sell at the two
different prices--the price in the "real" market and the price of
the trade made in reaction to the quote stuffing. [Tom
Lauricella and Jenny Strasburg, ""
High frequency trading's wild potential for
disruption is described in the Flash Crash series of events,
revealed in the
A very simple game Wall Street plays is to
borrow taxpayer money and then lend that money back to the
federal government. In a free market, that game wouldn’t be
possible. But this is a government-rigged market, available
only to “banks,” which now includes investment banks. The
Federal Reserve System, which is owned by the banks but has the
power of government, has made it possible for its member banks to
“earn a huge spread by borrowing virtually unlimited amounts for
nothing and lending that same money back to the Treasury. . . .
Rather than giving capital to businesses with real products and
services, Wall Street plays a government-backed shell game,
enriching bankers’ pockets at everyone else’s expense.”
[Ann Lee, adjunct professor at New York University, former
investment banker and hedge fund partner, “The Banking System is
Still Broken,” The Wall Street Journal,
The cost of this game to the rest of us is
many times greater than what is taken from our pockets to pay
Wall Street the interest spread between the money borrowed and
the return from its purchase of government debt.
Artificially low interest rates on Treasury securities forces
lower rates to be paid on nongovernment debt as well. That means
that bank certificates of deposit and money market funds pay
interest at rates
much lower than historic norms. Retirees who depend on CDs
and other fixed income securities have seen their incomes cut by
half or more. The media greets low interest rates as a
gift, which they are for banks and others who can borrow, but
that gift is bought with a painful loss of income to people
relying on interest income for their living expenses. As
economists Peter Morici has said, “Having fed the campaign
machines of both political parties and lavished speaking fees on
future White House economic advisors, these financial wizards
have managed to purchase preferred treatment in our capital.”
[Peter Morici, University of Maryland Professor and former
Chief Economist for the U.S. International Trade Commission,
“Taxing Grandma to Subsidize Goldman Sachs,” Business Week,
A new type of financial intermediary spread in the mania of the 1920s—the investment trusts. They started out as a fixed group of securities placed in a trust, with shares in the trust sold to investors who wanted income with the stability of a diversified portfolio. Then their managers began selling securities from the portfolio and buying new ones, to increase income, pay management fees and compete with other trusts for investors. Investment banks and commercial banks used their name recognition and reputations to start their own investment trusts, which often purchased securities from their bank sponsors.
The use of investment trusts was a way to attract capital from middle class individuals, without letting them actually own securities of individual companies. Instead, they were sold nonvoting shares in a trust. The trust managers invested their pooled funds in new issues, often distributed by their affiliated investment bank or commercial bank. The management fees and the underwriting commissions were both taken out of the pool of investors’ money. Many of these investment trusts came undone in the Crash of 1929. Goldman Sachs Trading Corporation sold its shares in early 1929 at $104 a share. The price by May 1932 was $1.75. [John Kenneth Galbraith, The Affluent Society and Other Writings, 1952-1967, The Library of America, 2010, pages 234-238, http://www.loa.org/images/pdf/Galbraith_Goldman_Sachs.pdf, from The Great Crash, 1929, Houghton Mifflin Harcourt Publishing, 1997]
After the Investment Company Act of 1940, the investment trusts came back to life as mutual funds, operating within that law’s restrictions, which were supposed to prevent the abuses of the 1920s. But greed and the lust for power took over the buy side of Wall Street as surely as it did the sell side. There was the same “My compensation is bigger than yours” and “My fund is larger than yours.” To play the buy side greed and power game, money managers went from investors in businesses to gamblers at the casino. “They all reject the need or feasibility of making company-by-company judgments about price and value, industry structure, managerial competence, or many of the other factors that would affect the selection of one stock over another as a long-term holding. These are the performance game, index fund, portfolio insurance, and other so-called modern strategies. Mostly they inflict on investors heavy costs, and invariably they distract managers from their fiduciary and social responsibilities.” [Louis Lowenstein, What’s Wrong with Wall Street: Short-Term Gain and the Absentee Shareholder, Addison-Wesley Publishing Company, Inc., 1998, page 1]
Institutional investing is all about each quarter’s rate of return. Fund managers are like corporate CEOs. They get multimillion dollar paychecks based on the “peer analyses” made by selected compensation consultants, who are paid big fees. The consultants compare a fund’s size and rate of return with that of similar institutions. “These typically young portfolio managers, who could expect to peak in their early forties, were generally compensated on the basis of their quarterly performance. This gave them powerful incentives to manage their institution’s portfolios to achieve the highest quarterly prices possible.” [Lawrence E. Mitchell, The Speculation Economy, Berrett-Koehler Publishers, Inc., 2007, page 277]
Institutional money management was dramatically changed after passage of the Employee Retirement Income Security Act of 1974, called “ERISA.” The new law was interpreted as directing money managers to look beyond traditional stocks and bonds for entrusting pension fund investments. The leader in this “total return investing” was the Yale University endowment, which consistently and significantly had higher returns through the 1980s than other university and charitable funds. Wall Street’s sell side jumped to provide derivatives and other instruments for this total return investing. Opportunities for investment spread to commodities, derivatives and other products sold by securities broker/dealers. In addition, real estate investment managers, venture capital firms, hedge funds, private equity funds and other intermediaries presented their proposals to money managers. In the Panic of 2008, most of these total return funds lost a quarter of their value.
Jack Bogle, founder of the Vanguard mutual funds, has written that, “The principal instigating factor” for mutual funds going wrong “has been a basic shift in orientation from a profession of stewardship to a business of salesmanship.” [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, page xxii] He points out that, over the period from 1985 through 2004, “fund costs consumed more than 40 percent of the return provided by the stock market itself. . . . Looked at from yet another perspective, the investor put up 100 percent of the capital and assumed 100 percent of the risk, but collected only 57 percent of the profit. The mutual management and distribution system put up zero percent of the capital and assumed zero percent of the risk, but collected 43 percent of the return.” [page 163]
In describing how the mutual fund industry changed, Bogle traced the history of the first one, Massachusetts Investors Trust. Started in 1924, it had a mutual legal structure, that is, the fund shareowners elected a board of trustees which actually managed the fund’s business. In 1969, it converted to having a separate management company. Before that happened, the fund’s expense ratio—the amount of its expenses as a percentage of the amount invested in the fund, was 0.19 percent. By 2003, the expense ratio had gone up to 1.22 percent.
There are basically two types of mutual funds. One is the index fund, where the fund manager simply purchases securities to match the S&P 500 stock index or some other well-known index. The other is the actively managed fund, where the fund manager makes decisions about which securities to buy and sell, within some general category, like “growth” or “large capitalization.” The two important differences between these fund types are definitely counterintuitive: (1) actively managed funds charge much higher management fees and (2) index funds consistently have higher returns for the plan beneficiaries. If actively managed funds cost more and return less, why do they have 90% of the $1.5 trillion in 401(k) plans?
Mutual fund money managers market their funds to the corporate sponsors of employee retirement plans. They find ways to convince employers’ plan administrators to offer the funds they manage as the limited options for investment by employees. One of the most convincing marketing techniques is known as “revenue sharing,” which is simply a rebate to the plan administrators from the management fees collected by the fund managers. Those management fees are paid by the employees. In return, fund managers siphon off a portion of what the employees pay and turn it over to the employers’ administrators. Employees pay twice, once in the lower investment results that mutual funds experience and again in higher management fees.
"Revenue sharing" is also the euphemism used for the rebates from mutual funds to the brokers who sell them. “Big brokerage firms are finding it difficult to raise fees on their clients who buy mutual funds. So some brokers are turning to a different source for higher fees: the muthal-fund companies themselves. . . . the payments, known as ‘revenue sharing,’ have long been part of brokerages business and are considered perfectly legal.” One major brokerage firm, under a regulatory order for greater disclosure, reported revenue sharing was nearly a third of its 2011 profit. [Ian Salisbury, “Brokers Raise Fees, but Not For Investors: Why You Should Care,” The Wall Street Journal, April 3, 2012, page C9
Some fund managers use Wall Street sell side
firms and other “placement agents” to deal with plan
administrators. [Steven Rattner, hedge fund manager
and “car czar” in the Obama administration, was one of the early
placement agents. In 1989, Rattner got his firm,
Lazard Freres, to be placement agent for Providence Equity
Partners, a private equity firm. Lazard was paid a one
percent commission on the money it helped bring in. In
addition, Lazard got a third of the incentive fees the fund
earned on that money. “Heard on the Street,” The Wall
Buy side fund managers are tempted into unethical and illegal ways to increase their quarterly performance, as compared with their peers. For instance, the comparisons among funds are made as of the end of each quarter, so it is not unusual for managers to sell and buy on the quarter’s last business day. Stepping over the line, some ask themselves if there are ways they could have higher prices shown for their end-of-quarter holdings. One way is to place large orders, just before the market closes, for shares they already own. That sudden increase in demand moves the share price up. The next step past the line is to get the sell side broker to cooperate in putting in orders at prices higher than the market. These practices, known as “marking the close” or “portfolio pumping,” have been illegal for many years but still happen. [http://knowledge.wharton.upenn.edu/article.cfm?articleid=122 or http://knowledge.wharton.upenn.edu/articlepdf/122.pdf?CFID=10862081&CFTOKEN=46722360&jsessionid=a83039153a4af7e9ee6c18282b695611cd54]
The drive for quick profits has created moral hazards for the managers of mutual funds. According to Bogle, “Fund managers have moved away from being prudent guardians of their shareholders’ resources and toward being imprudent promoters of their own wares. They have learned to pander to the public taste by capitalizing on each new market fad, promoting existing funds and forming new funds, and then magnifying the problem by heavily advertising the returns earned by their ‘hottest’ funds, usually highly speculative funds that have delivered eye-catching past returns.” [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, page 164]
Mutual fund management fees run nearly $100
billion a year. In setting fees, fund managers have largely
been left alone by their regulators, the
Fund management companies chase flashy short-term returns, so their marketing can showcase a fund’s percentage return and peer group comparison. This has brought a stepped-up pace of buying and selling a fund’s portfolio. Back in the “twenty years from 1945 to 1965, the annual turnover of equity funds averaged a steady 17 percent, suggesting that the average fund held its average stock for about six years. But turnover then rose steadily, and the average fund portfolio now turns over at an average rate of 110 percent annually,” an average holding period of 11 months. [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, page 184]
Mutual fund managers even found a way to participate in stock manipulation and Ponzi schemes. There was a fad for a while called “momentum investing.” The theory was that once the price of a stock was moving in a direction, it would keep moving that way. The fund managers would buy a stock, then keep buying it as other managers did the same. They would appear on televised investor shows and talk up the stocks. The positive effect on their funds’ returns would bring in more money from investors, so they could buy more of the chosen stocks. [James J. Cramer, Confessions of a Street Addict, Simon & Schuster, 2002, pages 295-96] Of course, the resulting bubble had to burst. Like a game of hot potato, the last one to buy into the inflated stock took the big loss.
This driving for short-term profits, to
justify huge compensation, was protected by ERISA, which ordered
money managers to act like other money managers, instead of
common law standard, that they act like prudent individuals who managed their own money.
Copying each other led money managers into investing in derivatives and other
alternatives to stocks and bonds. It all caught up with the
buy side in the Panic of 2008. The consequences fell upon the
beneficiaries of funds with professional money managers,
including colleges and charities, as well as retirees who have
placed their life’s savings in mutual funds or who are counting
on their employer’s pension fund. The California Public
Employees’ Retirement System, the largest public pension fund,
lost 23.4% of its value in the fiscal year ended
Wall Street money managers buy and sell shares for trading profits, not to be long-term shareowners of a business. Buy side focus on short-term trading games has meant that they don’t act as shareowners who care about the prospects for the business. They only care about what will happen to the market price for the shares in the next minutes, hours or days. When they get proxy material for a shareowners’ meeting, they nearly always vote the shares they hold just as the company’s management suggests. One of the two exceptions is the union or public employees pension fund that has a cause to promote. The other is the hedge fund or private equity firm that is trying to maneuver a sale or change in management for the company.
This pervasive go-along-with-management practice is motivated by the money managers’ fear of losing business from the corporations who pay them to manage their pension funds. When an unwanted proposal is coming to a shareowner vote, the threatened CEOs have been known to ask their counterpart CEOs in other companies to put pressure on their pension fund managers to vote against the proposal. If they don’t go along with the CEOs, their firm’s reputation as a trouble-maker may keep them from winning new clients, or cause them to be cut off from the flow of telephone information from a company that feels threatened. “There is almost no dissent from the Wall Street Rule, which says that a shareholder who is not pleased with a company is better off selling the shares than trying to change or influence its direction.” [Louis Lowenstein, What’s Wrong With Wall Street: Short-term Gain and the Absentee Shareholder, Addison-Wesley Publishing Company, Inc., 1988, page 91] They follow the Wall Street Rule: “Vote with your feet.” Sell the shares if you don’t like what management is doing.
The escalation of CEO pay has been one consequence from this go-along practice on Wall Street’s buy side. The amounts taken home by corporate executives have made frequent news stories. Since reporters look for the other side, these stories usually have quotations from corporate defenders that the compensation is necessary to attract talent that will increase value for shareowners. Academic studies show that this claimed justification is not supported by the facts. “It turns out that the bigger the CEO’s slice, the lower the company’s future profitability and market valuation.” One study of the 10% of companies with the highest CEO pay found that: “Each dollar that goes into the CEO’s pocket takes $100 out of shareholders’ pockets.” [Jason Zweig, “Does golden Pay for the CEOs Sink Stocks?” The Wall Street Journal, December 26-27, 2009, page B1]
Of all the economic and political systems that we’ve tried, businesses are still the best structure for meeting most human needs and wants. Governments, charities and cooperatives have their place and we’ve learned that privatizing their services can definitely be taken too far. But most of us still believe that private enterprise, including the profit motive, still delivers the best results for most products and services.
Owner-operated businesses and family businesses have proven their sufficiency for smaller, local purposes. For larger businesses, with many owners who don’t work there, the corporate form has many advantages. Those absentee owners never have to worry about losing more than the money they paid for their shares. When they are ready to convert their ownership shares back into cash, there will probably be a ready market for them. That said, how did we get from having businesses serve our needs and wants, to gambling in the markets for stocks and derivatives? What can we do to restore the useful function of the corporation?
As the tech bubble was building in the 1990s, someone said that Silicon Valley changed for the worse when it switched from making products to making stocks. But the financialization of corporate business started long before. Professor Lawrence Mitchell describes the history in his book The Speculation Economy: How Finance Triumphed Over Industry, which deals only with the years 1897 through 1919. At the beginning of that period, American businesses “typically were owned by entrepreneur industrialists, their families and often a few business associates.” The change he describes “might never have come into being if financiers and promoters had not discovered that they could be used to create and sell massive amounts of stock for their own gain. The result was a form of capitalism in which a speculative stock market dominated the policies of American business.” [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2008, page ix]
"The financial crisis has provided us all
with a crash course on how much of our economy is based not on
the creation of real value, but on speculation. Over the last
year, we have learned that the speculative economy — the one that
trades in exotic derivatives like credit default swaps and makes
short-term, bubble-inducing bets on assets like real estate and
tech stocks — is vast and highly rewarded. We have learned that
the speculative economy undermines and consumes the productive
economy. And we have learned that money made by speculation is
often treated much more favorably by tax systems than money
earned through real work." [Stacy Mitchell, “A New Deal for
Local Economies,” Lecture at the Bristol Schumacher Conference at
The basic concept of investing is that people who want to earn a return on their money are matched with businesses which need money to grow. By its nature, “investing” is for the long term, money that is put to use for several years, or indefinitely. Lending money for seasonal working capital needs is the business of banks and other short-term lenders. Long-term investing is appropriate for individuals and institutions seeking to build their financial assets for the future.
The line between short-term lending and long-term investing is roughly the border between the commercial banking and securities industries. While the two businesses have very similar products, their business models are sharply different. Banks purchase money for a period of time. In exchange for deposits in a checking account they provide safekeeping, checking, online banking and related services. They may agree to pay a rate of interest on certificates or bonds or interbank loans, which come due on specific dates. Then the bank lends the money at a higher rate, to cover its operating expenses, reserves for loan losses and profit.
Investment in common stock is a very different proposition. Initially, the “joint stock companies” were organized around a particular venture. For instance, when a ship sailed from England to Asia, it needed enough money to last for a couple years. There would be no income until the ship came back, if it did. Anyone putting their money up for use would want something more than a promise to pay it back with interest. The solution was to allocate them a share of the hoped-for profits from the voyage. Investors put their money up before their ship sailed and waited for the day their ship would come in, their money returned and profits distributed. In 1602, The Dutch East India Company was chartered for a 21-year period, spreading investors’ money and risks over many voyages. By 1611, the Dutch had the first stock exchange, followed by the first market crash, triggered by the tulip mania in 1636. [John Micklethwait and Adrian Wooldridge, The Company: A Short History of a Revolutionary Idea, The Modern Library, 2003, page 20] Gradually the concept was expanded to finance canals, railroads and manufacturing businesses.
Einstein reportedly said that compound interest is “the greatest mathematical discovery of all time.” To help its success, he invented the Rule of 72, a shortcut to calculating how long it takes money to double at a particular rate of interest. [www.ruleof72.net/rule-of-72-einstein.asp] The corporation is certainly another great invention. It has made it possible for businesses to gather money from people who don’t have to pay constant attention to how it is being used. Authors John Micklethwait and Adrian Wooldridge of the Economist described “the three big ideas behind the modern company: that it could be an ‘artificial person,’ with the same ability to do business as a real person; that it could issue tradable shares to any number of investors; and that those investors could have limited liability (so they could lose only the money they had committed to the firm).” [John Micklethwait and Adrian Wooldridge, The Company: A Short History of a Revolutionary Idea, The Modern Library, 2003, page xvii] We would add a fourth big idea: a trading market that allowed shareowners to quickly get cash for their shares, while the corporation kept their initial investment forever.
As people made investments in ongoing businesses, not just voyages and projects, their share of the profits was distributed to them annually or quarterly. The payments were called dividends and were very different from interest on loans or bonds. The business had no obligation to pay dividends. No matter how profitable it was, it was entirely up to the board of directors whether and how much might be paid to shareowners. On the other hand, as the business grew, dividends would usually increase and, after several years, the annual dividends could be more than the amount the shareowner originally paid for the shares. The concept of sharing in profits worked well for investors, who were willing to exercise their risk/reward judgment in return for a higher expected return than they would get from a fixed-income security--one that paid interest and eventually returned the purchase price. Shares worked well for managers of the business, because they weren’t obligated to pay current interest and never had to pay back the money invested.
However, there were two groups who were less than happy with shares being sold on the basis of expected dividend payments. One was the CEO and top management who would rather retain all money in the business. They had big ambitions for growth, which would bring them greater compensation, prestige and power. The others who weren’t entirely happy with shareowners expecting dividends were the financial intermediaries who made commissions by selling shares in the trading market. If investors were buying shares to collect dividends over the long term, then Wall Street could only look forward to a one-time commission, at the time the shares were initially issued and sold by the business.
The answer for Wall Street and CEOs was to change the expectations of shareowners, from the dividends they would receive to the increase they could see in the market price for their shares. That way, the profit and resultant cash are kept in the corporation, available to fund the CEO’s ambitions for expansion and acquisitions. These retained earnings can also be used to cover the effects of any mistakes of judgment that the CEO makes. The financial intermediary could induce the investor to take profits (or losses) by selling the shares and using the money to buy different shares, generating commission income on both trades. Wall Street got Congress to change the laws, to tax gains on the sale of shares at a much lower rate than dividends. Dividends and gains are currently both taxed at the same low rate, but the proportion of corporate earnings paid in dividends is at the lowest level since 1936, at 29%, compared to an average of 53% for the entire period after 1936. [Jason Zweig, “What Will It Take for Companies to Unlock Cash Hoards?” The Wall Street Journal, May 28-29, page B1]
Wall Street began a vast new business when “price appreciation followed as a substitute for dividends.” [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2007, page 196] As investors changed their objectives from dividend income to profit on a sale of shares, Wall Street’s commission income took off. Unlike investors seeking dividends, traders like to take out loans to buy even more shares for short-term profits. Wall Street borrows the money from banks and lends it out again to its brokerage customers, through margin accounts. There is some profit in the spread between the interest rate it pays the bank and the rate it charges customers. More profitable is the ability to increase the customer’s volume of business by 50%, from money borrowed in the margin account. Most profitable of all is when Wall Street can steer its customers into using proceeds from stock sales to buy a different financial product, one that generates even more revenue for Wall Street.
The justification for trading is that it makes for a liquid market, one in which all investors can buy or sell at fair prices in a short time. But is all that volume of trading really necessary? Professor Lowenstein points out that the real estate market has less than a twentieth of the stock market’s annual turnover “and yet that is enough to support all the new homes and offices that are needed.” [Louis Lowenstein, What’s Wrong With Wall Street: Short-term Gain and the Absentee Shareholder, Addison-Wesley Publishing Company, Inc., 1988, page 27]
There has been a clear long-term trend away
from dividends and toward more frequent trading.
“Historically, dividends have accounted for almost one-half of
the market’s return—about 5 percent of the stock market’s 10.5
percent long-term annual return—with the remainder accounted for
almost entirely by earnings growth averaging about 5 percent
annually. Yet the dividend yield on
“The shift from investment to speculation, from a time when most Americans saw corporate securities as a way to get a steady return while protecting their principal to a time when Americans saw the stock market as a place to trade on the fluctuations of an increasingly volatile market, took place over the second and third decades of the twentieth century.” [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2007, page 206] By the first decade of the twenty-first century, this shift from investment to speculation had led to the extremes of high frequency trading, options and complex derivatives.
The game of buying and selling stocks got an
extra boost when Wall Street began earning huge fees by promoting
and defending hostile takeovers. “The modern exaggeration
of the domination of finance over industry started during the
takeover decade of the 1980s, when the hostile takeover became an
extreme way to satisfy stockholders’ demands for short-term
profit maximization by buying then out at a substantial premium
over market. Stockholders began to invest in the hope of
finding the next big takeover target.” [
The use of stocks and their derivatives to speculate on price changes has brought all the attention to short-term results. For corporate officers, the only goal is to keep the stock price up and on a steady rise. Their stock option profits and their very jobs depend upon being able to predict each quarter’s earnings as better than the last, and have those earnings come in as predicted. This “rent-a-stock” culture has destroyed industries, especially those with a dynamic that doesn’t fit the quarter-to-quarter game. Newspapers, for instance, have needed some restructuring to fit the unfolding of media technology. That would mean going through a period of losses and reinvestment. But as soon as management stepped off the quarter-to-quarter treadmill, the stock price would collapse and many newspapers became victims of hostile takeovers.
Wall Street has changed the objectives of
business, from serving human needs to generating short-term
profits. What can we do to restore business objectives?
Government is not the answer. We have watched Japan, after
World War II, when its Ministry of Finance influenced the
allocation of capital for long-term objectives, before its
banking system failed. We are now watching
The romantic fantasy of Wall Street is dramatized by the initial public stock offering, where a young business has done so well that it is now ready to share ownership with the investing public. Most entrepreneurs have a dream that they will one day take their company public, that money will flow into their business from thousands of people who will want to be a part of their enterprise. They can envision going public as the ultimate recognition of their success. Beyond self esteem, they know that a public offering can be the best way to raise capital for growing their business. The money is permanent capital, it never has to be paid back. No interest payments are ever required, any dividends are entirely up to management. With share ownership spread among many holders, no one really has any power to interfere with management’s business judgment.
In the fantasy, the relationship with an investment banker and Wall Street firm is seen like that of the relationship of a great novelist with an editor and publishing firm.
Wall Street doesn’t share the entrepreneur’s vision of the IPO process. For the securities firms that handle the underwriting, and sales in the aftermarket, an initial public offering is a one-time opportunity to earn large commission income in many related transactions. The IPO underwriter is able to do favors for others who will reciprocate when it’s their turn. The decision whether to take on a particular IPO will involve questions like, “Is this being presented to us by a venture capitalist or private equity firm that will generate more business for us?” “Can we hold or attract clients by helping them flip the shares we allocate to them, so they make lots of money in a few hours?” “Is this a company that will quickly acquire many other businesses, paying us advisory fees along the way?”
A particularly pernicious consequence of the IPO game is Wall Street’s need for ever-larger transactions. Investment bankers get paid a percentage, generally fixed at 7% for an initial public offering. That motivates the investment bank to have as large an offering as they can sell. The minimum amounts they are willing to do have grown to $50 million for an IPO with major firms. What if a business fits the rest of the picture for a successful offering, but really only needs $20 million? That company’s first subject in discussions with a Wall Street underwriter will likely be how the business plan can be changed to show a need for the higher amount. The investment banker may suggest an acquisition of another business. They may want the company to skip a beta test phase and go right on to full rollout of production and marketing. Perhaps they’ll suggest buying and furnishing a new facility, rather than staying in rented quarters. The huge supply of money on Wall Street’s buy side, with hedge funds and other managed pools, has created the ability to sell ever-larger IPOs. The result is that Wall Street selects IPO candidates based on the size of the offering, and the resulting fees. Say’s law is in full force when it comes to money available for buying IPOs--supply creates its own demand. [www.econlib.org/library/Enc/bios/Say.html]
The need to have a large IPO has a dangerous effect upon earlier stage financing, the private rounds necessary to grow to IPO readiness. For most of the last 30 years, venture capital firms have themselves raised very large amounts of money, from endowments and other institutional funds. Because they are part of Wall Street, they finance most of the businesses that later do IPOs with major investment bankers. In order for the venture capitalists to have a business ready for a $50 million public offering, they need to apply lots of venture funding and hurry up the process toward their exit plan. They even hire consultants, called “VC accelerators,” to get their clients IPO-ready as quickly as possible. The venture firms want to maximize their annual rate of return. If they are going to make 300% on their investment, they want to reach that “liquidity event” as quickly as possible. Moving an IPO from three years out to only two means getting a 150% return per year, instead of 100%.
The Wall Street monopoly over underwriting
IPOs has held firm against repeated efforts by off-Wall Street
broker-dealers and others to bring businesses together with
investors. The really serious competition has recently come
from securities firms and exchanges outside the United States.
A study prepared for the London Stock Exchange compared the US
underwriting fee of 7% to the range in six European countries of
2.5% to 4%. [www.londonstockexchange.com/companies-and-advisors/main-market/documents/brochures/cost-of-capital-aninternational-comparison.pdf]
The London Stock Exchange has marketed itself as a home to IPOs,
From the early days of investment banking, the commission method of getting paid created conflicts, with resulting harm to investors. Back in 1898, the U.S. Industrial Commission was appointed by the President to investigate concentration of economic power for a report to Congress. An economist testified to the Commission that: “These banking syndicates want a profit and the larger the stock issues the larger the commissions.” The Commission’s Report concluded: “Heavy capitalization is, without question, injurious to the interests of investors and the public at large; but to promoters and bankers it opens opportunities for great gains.” [Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970, page 76]
Fitting into the minimum size for an IPO can
be just the wrong move. Getting too much money too soon has
been the death of many promising ventures. Harvard Business
Clayton M. Christensen
has said: “93% of all innovations that ultimately become
successful started off in the wrong direction; the probability
that you’ll get it right the first time out of the gate is very
low. So, if you give people a lot of money, it gives them
the privilege of pursuing the wrong strategy for a very long
time. . . . The breakthrough innovations come when the tension is
greatest and the resources are most limited.” [The Innovator’s Dilemma,
Collins Business, 2003, quoted by Martha
Mangelsdorf, “How Hard Times Can Drive Innovation,” The Wall
(One of our clients had started a business
with a little savings and built it through retained earnings.
He decided to do a direct public offering through the
There are at least eight major profit opportunities for the underwriting firm that lands an initial public offering of shares: Fees from the client, for the initial underwriting• fees from quick resales, “flipping” shares when the aftermarket price jumps; fees in reselling the flipped shares for a third and fourth time; fees on business gained in return for allocating IPO shares to flippers; fees in selling shares for insiders, after the initial six-month lock-up; fees for investing money received by the company and its selling shareowners; • fees for arranging later private placements of the public shares (“PIPES”) and fees for advising on mergers and acquisitions with the now-public client.
The initial underwriting fees are pretty well fixed, at seven percent of the amount sold. That’s three and a half million dollars on the recent minimum offering size of $50 million. There are a few smaller broker-dealers left who may handle an offering as small as $10 million, but they charge ten percent, plus options, reimbursements and other items that bring the fee up to the maximum fifteen percent permitted under securities industry rules. [FINRA Rule 5110, http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=13339&element_id=6831&highlight=underwriting+compensation#r13339 One law professor suggests that the regulatory limit be abolished, “This would enable underwriters to charge more for smaller IPOs, making these deals profitable again and hopefully reversing their recent steep decline.” [William K. Sjorstrom, Jr. “The Untold Story of Underwriting Compensation Regulation,” University of California at Davis Law Review, volume 44, no. 2, http://lawreview.law.ucdavis.edu/issues/44-2_Sjostrom.pdf, page 625, 650]
When Wall Street underwriters compete for
IPO business, there is no cost comparison, since the underwriting
fees are fixed. Getting the highest price in the initial
offering is certainly talked about a lot when prospective
underwriters make their pitches. So is the ability to get
the offering cleared with the
Conflicts of interest arise when a business is issuing new securities, because Wall Street is an intermediary, serving both sides of the transaction. The investment banker is likely to come down on the side of the buyer in any conflict between the interests of the client issuing securities and the money manager buying them. Investment bankers are part of a large broker-dealer business that depends every day on its relationships with the money managers on the buy side. These Wall Street counterparts are far more important to the investment banker’s profits than the transitory relationship they will probably have with the IPO client. Getting the highest IPO offering price for the issuer clearly conflicts with getting a bargain price for the money managers.
(This conflict between issuer and money manager creates what I called the “Pricing Dance.” It begins with the very first handshake between the investment banker and the issuer’s management and continues right through to the final pricing, after orders will have been taken, based upon an estimated price range. The structure of the dance is to convey that the investment banker will work for the client to get the highest price possible, but that it will have to be one which “the institutions” will accept. I was in a meeting once when a founder of the investment bank came in from the golf course to give what I called the “level of greed” speech. It was about his inside knowledge of the minds of money managers, their most intimate and even unconscious motivations. To get them to say “yes” to my client’s offering, the price had to appeal to the money managers’ own level of greed. They had to see how, through reselling the shares at a large profit, or showcasing its increased market value in their report of quarter-end holdings, they would look so good that their bonus would increase many thousands of dollars.)
Once the IPO is complete, the “flipping” part of the game begins. Favored persons who were allocated shares in the offering often sell them within minutes or hours. Persons allowed to purchase the once-flipped shares likely resell them quickly as the aftermarket continues to “pop.” The profit opportunities from flipping are based upon the share price increasing significantly in the trading market that begins immediately after the final offering price has been set.
When investment bankers are selling themselves as underwriters for an offering, they stress their superior ability to create demand for the shares, well beyond what it takes to sell the offering. Managers and directors generally must commit to have their shares in “lock-up” for six months or so after the initial offering. Then they can begin selling them. Second in priority only to getting the offering done is boosting the aftermarket price so that these insiders can sell a chunk of their shares. Investment bankers used their securities analysts to convince the client of the firm’s ability to keep the price up long enough to let insiders cash out at maximum profits. This practice led to some racy extremes covered extensively by the media after the tech stock bubble burst in 2001. Perhaps the rawest example is the affidavit filed by the New York Attorney General’s office when it got an order against Merrill Lynch [www.oag.state.ny.us/media_center/2002/apr/MerrillL.pdf] and forced an agreement to change the analyst’s role. [www.oag.state.ny.us/bureaus/investor_protection/pdfs/merrill_agreement.pdf]
Building demand for new shares is, of course, a legitimate and necessary part of the underwriter’s job in a successful offering. But somewhere along the way, the definition of “successful offering” got changed. In the investment banker’s pitch to get the business, a successful offering was talked about as one that got completed on time, at a price that was fair to the issuer and the investors. What came to replace that definition of a successful offering was having a huge increase from the offering price to the trading price in the minutes, hours and days after the initial offering was completed.
CEOs would even brag about the size of the
“pop” in price after their company did its IPO. They
wouldn’t even pay lip service to the logical conclusion that the
business they managed had gotten only a fraction of the amount
that buyers were actually willing to pay. To get this price
jump, underwriters began by selling many more shares than were
actually being offered. When that practice started, it was
to accommodate buyers who would renege on their order for shares.
It worked like overbooking by the airlines to offset no-shows.
Then it became a tactic to build fever in the aftermarket, one
that was used long before the boom in tech stocks. In the
early 90s, Starbucks and The Cheesecake Factory had buy orders
for 50 times the shares available in the IPO.
[Gretchen Morgenson with Steven Ramos, “Danger Zone,” Forbes,
Securities analysts were not the only ones employed to create demand for new shares. Investment bankers worked with their firm’s sales brokers to find reciprocity deals: “I’ll scratch your back if you’ll scratch mine.” For instance, money managers could buy 10,000 shares in the IPO if they agreed not to sell them for a month or so and to buy another 10,000 a week later, at the going price in the trading market. Investment bankers would even work with the firm’s stock lending department, which collects a fee for lending shares it holds for customers. The borrowers use the shares to place “covered short sales,” bets that the share price will decline. The investment bankers would get the firm to refuse to lend shares in a recently underwritten IPO, to keep the negative pressure out of the market.
Local government officials have been ideal marks for Wall Street scams. They make decisions involving large sums of money and they aren’t very experienced in the world of finance. Even better, they often make decisions by board or committee, so that responsibility is diffused and no one person is responsible.
The Orange County, California bankruptcy in
1994 came about when Wall Street sold bonds to the County
Treasurer, a person with no education or training in securities.
Then it sold him reverse repurchase agreements, called “repos,”
which were effectively loans secured by the bonds. This
borrowed money went to pay for more bonds, which were used for
new repos. The big flaw was that the bonds wouldn’t pay off
for an average of over two years, while the repos were due within
six months. When the Federal Reserve started raising
interest rates, bond prices began declining. But Wall
Street kept selling repos to the Treasurer. When a repo
came due, Wall Street would sell them a replacement. The
securities firms eventually panicked and stopped selling the
replacements. Orange County could not pay the maturing
repos. Wall Street foreclosed on the bonds it held as
collateral and the County declared bankruptcy. [Mark
Baldassare, When Government Fails: The Orange County
San Mateo County, California, lost $37
million in complex bonds issued by Lehman Brothers, which could
be sold for only about a fifth of what they had cost before
Lehman’s 2008 failure. A report to San Mateo County by
Beacon Economics put the cost of the loss at $148 million and
1,648 lost jobs. [John Carreyrou, “Lehman’s Ghost
Haunts California, The Wall Street Journal,
Local governments are still being made the victims of Wall
Street schemes. The problem assumed a much larger scale
when derivatives were introduced in the late 1990s.
Interest rate swaps, credit default swaps, “swaptions” and other
exotic instruments were being bought and sold. Before the
2008 Panic, Wall Street convinced local government officials to
buy complex derivatives that were
supposed to offset borrowing costs or to increase investment
returns. Intricate tax structures allowed the governments
to get cash for part of their fixed assets. Many of these
investment contracts called for “breakup fees” or other penalties
to be paid the Wall Street firms for technical defaults, such as
a downgrade in credit ratings. As a result, local
governments have had to lay off workers and charge higher fees to
residents. “Many of the transactions shared a striking
similarity: provisions that protected the banks from big losses
and left the customers on the hook for huge payouts. Now,
as many of those deals sour, Wall Street is ramping up its
efforts to collect from Main Street.” [Theo Francis,
Ben Levisohn, Christopher Palmeri and Jessica Silver-Greenberg,
“Wall Street vs. America,” Business Week,
Wall Street searches for pools of money and devises ways to get at it, to gather commissions, fees and trading profits. One of those pools was “thrift institutions,” which includes savings banks, savings and loan associations and building and loan associations. Working with Congress and the regulators, Wall Street took billions from the thrift industry, leaving it much smaller and poorer.
You may remember Bailey Brothers’ Building and Loan, from the 1946 movie, “It’s a Wonderful Life.” The bad banker, Mr. Potter, manipulates a run to get rid of Bailey Brothers’ as a competitor. As the locals crowd in to withdraw their savings, Jimmy Stewart makes his impassioned speech about how their deposits are used to help their neighbors own homes. He effectively explains the Achilles heel of the thrift industry—it borrows short (deposits can be withdrawn at almost any time) and lends long (home loans are paid in monthly installments over many years).
Two of the New Deal’s objectives in The Banking Act of 1933 were to encourage savings by individuals and to cause local banks to lend money in their communities. They had been gathering funds locally and then sending the money to Wall Street banks, which paid them interest. The new laws provided government insurance for individual deposits and intensive regulation over how banks used their money. They also established federal savings and loan associations, to gather deposits and make home loans in their communities. These newly chartered institutions were all in the “mutual” form, meaning that they were owned by their depositors and borrowers, without any shares of stock.
To prevent Wall Street from siphoning off local savings, Congress prohibited the payment of interest on checking accounts and gave the Federal Reserve authority to set rates on savings accounts, with its Regulation Q. The rate set was generally around three percent and worked rather well until 1979, when the Fed allowed market interest rates to rise, in order to stop inflation. Interest levels reached nearly 20 percent. Money market funds were created, which drained funds from the regulated institutions by paying higher rates. It was the beginning of a new takeover by Wall Street of the locally-gathered savings and the home loans held by the savings and loan associations. [B“A Nation in Debt: How we killed thrift, enthroned loan sharks and undermined American prosperity,” www.the-american-interest.com/ai2/article.cfm?Id=458&MId=20]
Another government assist to Wall Street in
devouring thrifts came from the Federal Reserve. In 1978, it
began making exceptions to Regulation Q interest rate limits for
special types of accounts. Under orders from Congress, it
eliminated interest rate ceilings entirely by 1986.
[R. Alton Gilbert, of the Federal Reserve Bank of
In addition to the Fed making thrifts gather deposits at market rates, Congress passed new laws allowing them to go after higher returns on risks far beyond making home loans. This put Wall Street in a position to lure the money held by S&Ls in retail deposits. [Depository Institutions Deregulation and Monetary Control Act of 1980, Pub. L. No. 96-221; 94 Stat. 132, codified as 12 U.S.C. 226; Garn–St. Germain Depository Institutions Act of 1982, Pub. L. No. 97-320; 96 Stat. 1469, codified to 12 U.S.C. 226] Like the officials at the crippled local governments, thrift institution executives controlled lots of money and had very little knowledge of any investments except home loans. They became marks for derivatives and scores of other investment schemes.
One of the ways the federal government reversed the New Deal structures was to allow mutual savings and loan associations to convert into stockholder-owned corporations. The justification given was that they needed a level of risk capital investment to carry them through difficult economic times, such as the sudden spurt in interest rates. What actually happened was that some 5,000 local institutions were put “into play” for Wall Street. As mutual associations, responsible only to their local depositors and borrowers, the management philosophy was often described as “We don’t need to make big profits—just stay in the black and serve our community.” While stil In the mutual form, S&L managers had no incentive to sign on to Wall Street’s programs of taking more risk for higher profits. They didn’t own shares in the association, there were no stock options, no performance-based big bonuses.
All that changed when the mutual savings and loans converted to stockholder-owned corporations. Wall Street investment bankers appealed directly to the association managers with pitches such as “you’ve created a great business here; now you deserve to build up your own assets, for the sake of your family.” When an association was converted, the sales price for its shares could be appraised at substantially less than what it would trade for after the IPO. Loans could be arranged for the managers to buy lots of shares in the offering and there would be an executive stock option plan. As maximizing profits became the new goal, Wall Street could sell the managers all sorts of new investment products, just as an accommodating Congress had permitted in the new laws.
The raid on savings and loans followed the Wall Street pattern of reaping profits from: (1) underwriting fees in the IPO, (2) commissions on the resale of the new shares, as their favored customers flipped them for big, quick gains, (3) commissions and trading profits from putting the offering proceeds into investment products and (4) merger and acquisition fees from talking managers into acquiring ownership of competitors, or being acquired at big personal gain. The effect on the associations? Over 1,000 failed and were closed by regulators—only half survived. Taxpayers had to pay for a $153 billion bailout. [Timothy Curry and Lynn Shibut, “The Cost of the Savings and Loan Crisis: Truth and Consequences,” FDIC Banking Review, http://www.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.pdf, pages 26 and 31]
Wall Street went on to cripple another financial intermediary
that serves the middle class--credit unions.
cooperative, . . . democratically controlled credit unions
provide their members with a safe place to save and borrow at
reasonable rates. Members pool their funds to make loans to one
another." [National Credit Union Administration,
question 1] All federally-insured credit unions are members
of the National Credit Union Administration, which has announced
its intention to sue the Big Four investment banks, unless they
return more than $50 billion that credit unions invested in
mortgage securities. Claimed misrepresentations in selling
the bonds led to failures of credit unions and losses that must
be absorbed by the surviving ones. [Liz Rappaport,
"Banks Hit for Credit Union Ills," The Wall Street Journal,
Since the New Deal, the major competition for Wall Street has come from the federal government. In the Great Depression, Congress created programs to provide money for purchasing homes, growing businesses, operating farms, developing infrastructure. These programs either provided money directly from taxpayer dollars or guaranteed loans funded by banks or other private lenders. Still today, the website www.govloans.gov offers a cafeteria of direct and guaranteed loans.
Government guarantees are a way to use the credit of the United States to encourage investors to make loans that would otherwise seem too risky. The Federal Housing Administration, the Veterans Administration and the Small Business Administration and other agencies have guaranteed or insured loans made to their standards. They’re able to be self-supporting from the fees charged borrowers for putting the government’s credit behind the loans. Without the government’s role, lenders would either decline the loan or charge interest and fees that borrowers couldn’t afford.
Enter the government-sponsored entity, or
Largest of the GSEs is the Federal National Mortgage Association, or Fannie Mae. It was created in 1938, to purchase mortgages insured by the Federal Housing Administration. The money to buy those mortgages came from Fannie Mae bonds, carrying the credit of the United States. There was little business for Wall Street in this structure. Government bonds are sold with tiny commissions to any intermediaries.
That began to change in 1954, when lobbyists got Congress to reorganize Fannie Mae, making it partially owned by shareowners. The policy reason given was that its ability to sell government bonds gave it the unfair competitive advantage of raising cheaper money than other lenders. In 1968, Fannie Mae became entirely investor owned. Five of its 18 directors were to be appointed by the President but the other 12 elected by shareowners. At the same time, Congress created an almost identical private corporation, the Federal Home Loan Mortgage Association, or Freddie Mac. Both of them were allowed to buy conventional mortgages, as well as those FHA-insured or VA-guaranteed.
Through all of this restructuring, Fannie
Mae and Freddie Mac kept the image that the government would bail
them out if necessary. As it turns out, the image was
correct. Fannie Mae was placed in a conservatorship on
In the forty years that they lasted as GSEs, Fannie Mae and Freddie Mac were a feast for Wall Street. Nearly all of the mortgages purchased by the two were securitized and sold by Wall Street firms. The great bulk of the mortgages were “conventional,” rather than VA or FHA, so they could include the high-risk loans that brought down the home loan business and, with it, the economy.
The same process has come to student loans
for post-high school education.
Great amounts of money and professional time is expended in lawsuits by shareholders against corporations, their officers and directors. Shareholder litigation law firms need four characteristics for one of these class actions to be started and survive. One is a big, sudden drop in the price of the shares in the trading market. This will create a large loss, so the percentage-based contingent legal fees will make the case profitable.
The second element needed for a shareholder class action is a group of shareholders which includes institutional money managers and stock speculators. These are people who must explain to the source of their money that they either made a mistake when they bought into the company or that they were cheated. They are very likely to join any class action that is based on someone else having done them wrong.
Third must be some deep pockets among the defendants that can pay a settlement or a judgment. The corporation itself may not have enough left to be an attractive source of money. This is where insurance comes in. Nearly every publicly-traded corporation buys directors and officers liability insurance. Anyone asked to join a board of directors, or be recruited to senior management, will insist upon it. The irony is that this very expensive product just makes it more likely that the director or officer will be sued. It also means that there will probably be a big fight over whether the claim is covered by the insurance. [“Directors and Officers liability insurance: Paying a premium now for the right to sue your insurance carrier later,” The Curmudgeon’s Guide to Practicing Law, by Mark Herrmann, Section of Litigation, American Bar Association, 2006]
The fourth requirement for shareholder litigation is the easiest: Something that the corporation, its officers and directors did, or didn’t do, that would create liability. Hindsight being what it is, there is always something.
Wall Street creates the price volatility and short-term speculation that promotes shareholder litigation. The “herd instinct” is emphasized by having professional traders, advised by securities analysts, taking large positions and expecting a short-term profit. These traders are playing with other peoples’ money and need a scapegoat when they lose. The resulting lawsuits waste resources and harm the underlying business. The best protection from stockholder class action litigation is a large group of long-term investors, each having invested a relatively minor amount of their own money.
The term “moral hazards” pops up in a lot of current commentary. I think it means temptation. The temptation becomes greater as the payoff amount goes up and the risk from getting caught goes down. For Wall Street, the moral hazard is greatest when success means keeping big winnings, while losses may be passed off to someone else.
Any time money is being exchanged, there is temptation, a moral hazard, a conflict between what’s right and what’s self-serving. Every business, and most nonprofit entities, are receiving money for what they sell or do, and paying money for materials and services they use. It is just more so with Wall Street, because it is in the money business. It is constantly moving money from one person to another. Working on Wall Street is like being stationed on a conveyor belt, where money is the commodity and the objective is to get a piece of it as it flows by. The moral hazards for Wall Street are intensified by the sheer amounts of money involved in transactions, the size of the rewards that get handed out at the top and the way compensation is figured. Not a lot can be done about the large amounts of money that get transferred in a Wall Street transaction. But it puts more emphasis on the way people get paid.
The amounts paid to Wall Street, just in fees alone, are huge. In the five years before 2005, “revenues of investment bankers and brokers came to an estimated $1.3 trillion; direct mutual fund costs came to about $250 billion; annuity commissions to some $40 billion; hedge fund fees to about $60 billion; fees paid to personal financial advisers maybe another $20 billion. Even without including, say, banking and insurance services, total financial intermediation costs came to nearly $2 trillion, an average of $400 billion per year, all directly deducted by the croupiers from the returns that the financial markets generated before passing the remainder along to investors.” [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, page 231]
The amounts of money involved can overcome
such other values as loyalty. According to James Cramer,
“There are no loyalties on Wall Street. When you smell
blood in the water, you become a shark.” In describing how his
fellow hedge fund managers responded to troubles at Long Term
Capital Management: “Put simply, when you know that one of
your number is in trouble, you don’t lend him a hand, you try to
figure out what he owns and you start shorting those stocks to
drive them down. . . . You could feel the whole Street
collectively buying long-term
A prominent Wall Street adage is that “securities are not bought—they are sold.” The decision about which securities to sell has often been made on the basis of “what’s in it for me.” The questions asked by the broker, and the firm’s analyst, are ones like: “What will earn me the largest commission? What will help me get a bigger bonus? How can I earn favors from management?” According to a pair of former investment bankers: "Greed, Fear, and Abandon. Those are the three steps.. . .Greed and the pursuit of money is the banker's ultimate aphrodisiac. . . . If this doesn't work, move to the second stage of the process--fear. . . . Finally, if this doesn't work the banker will abandon in an unusually rapid fashion." [John Rolfe and Peter Troob, Monkey Business: Swinging Through the Wall Street Jungle, Warner Books, 2000, page 261. (Italics in the original). One former stockbroker, Donald E. Kendrick, warned of the moral hazards in The Average Investor's Rage, Vantage Press, Inc., 1990] The role of Wall Street in the mortgage securities debacle has been described this way: "If mortgage originators . . . were the equivalent of drug pushers hanging around a schoolyard and the ratings agencies were the narcotics cops looking the other way, brokerage firms providing capital to the anything-goes lenders were the overseers of the cartel." [Gretchen Morgenson and Joshua Rosner, Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon, Times Books/Henry Holt and Company, 2011, page 263]
The moral hazard on Wall Street has been exacerbated by the role of government in preventing a collapse of schemes that could “bring down the entire financial system,” as the phrase was used after the Panic of 2008. For a while, the silent assurance of a bailout by the Federal Reserve Banks was known as the “Greenspan put,” meaning that a disastrous loss position could ultimately be put to the Fed for transferring a loss onto others, including the taxpayers.
There have been pioneers on Wall Street who have set out to do business in ways that reduced the moral hazards. When Charles Merrill started Merrill Lynch in 1940, he told the world that its broker representatives would receive a salary, rather than a percentage of commissions on the trades they generated and the firm would not participate in underwriting new issues of securities. That all changed long ago. Before it was acquired by Bank of America in 2008, Merrill Lynch was a broker, dealer, underwriter, traded for its own account and did business the same way as all the other giant Wall Street sell side firms.
(My own observation is that most harm comes
from incompetence, masked by arrogance, rather than from criminal
conspiracies. Near the end of the Great Depression, a
popular book was published, called Where Are the Customers’
Yachts? [Fred Schwed, Jr., Where Are the Customers’
Yachts? Or a Good Hard Look at Wall Street. Simon & Schuster,
1940, second printing 1955.] The title was from an
old story about a tourist’s question, when the guide pointed out
the bankers’ and brokers’ yachts in the
Venture Capitalists Mimicked Wall Street and Its Moral Hazards
Myth has it that venture capital got its big boost when the capital gains tax rate was cut significantly in 1978. In fact, it was changed when VC managers used their historical performance records to get huge chunks of money from institutional money managers. [Charles R. Morris, The Trillion dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash, Public Affairs, 2008] With their percentage fees, VC managers became full-blown financial intermediaries. Income from their percentage compensation became their prime motivation. Since the percentage was generally set the same among VC firms, regardless of their performance, the way to make more money for the VC managers was to bring in new investors, preferably ones with deep pockets. Along came the Employee Retirement Income Security Act, or ERISA, and related rules, which changed the standard for investments by pension and other funds. Fund managers tapped into these institutions and the investment levels jumped to $2.5 to $5 billion a year in the early 1980s, with 300 new funds formed from 1981 to 1984 [Robert J. Kunze, Nothing Ventured: The Perils and Payoffs of the Great American Venture Capital Game, HarperBusiness, 1990 p.11]. Venture capital went from partnerships of investors to a financial intermediary business.
Venture capitalists need to have an “exit plan” before they ever commit to investing. How are they going to recover the cash they put in, plus or minus their gain or loss? Their preferred route is an underwritten initial public offering and they work closely with investment bankers, referring business back and forth to each other. The other “liquidity event” for VCs is to have the portfolio company acquired, for cash or marketable securities. But the IPO usually provides a higher valuation. It also lets the VC choose whether to sell in the IPO or pick times in the aftermarket. An IPO could allow the venture investor to cash out at least a portion of their ownership. Even better, the public offering would be followed by a trading market in the shares. The brokerage firms who acted as underwriters would become market makers and issue analyst reports to build ongoing interest in buying into the company. Between 1980 and 1984, these broker-dealers earned over $1.5 billion from commissions as IPO underwriters and aftermarket traders. [Robert J. Kunze, Nothing Ventured: The Perils and Payoffs of the Great American Venture Capital Game, HarperBusiness, 1990, p.14]
Venture capitalists measure their success in
the price they get on cashing out an investment. They also
look at how long it takes from investment to return. The VC
to IPO path travels well in “hot new issues” markets, when
underwriters are hungry for venture-backed companies they can
sell to the institutional money managers. At those times,
the VCs hire “VC accelerators,” consultants who show a company
how it can be dressed up for the quickest possible disposal.
When the new issues markets turns cold, VCs must either continue
to hold their investment in a private company or have it
acquired. In the hot market of 1999, the average
venture-backed company had its IPO just over four years after the
business began. By 2008, it was taking nearly nine years.
[Rebecca Buckman, “As High-Tech IPOs Dwindle, Start-Ups
Look to Private Money for More Backing,” The Wall Street
(I was asked to speak to a meeting of venture capitalists My subject was what a great tool direct public offerings would be for them, how raising money from the company’s communities would increase the value of the VCs investment. While speaking, I could sense that unmistakable glassy-eyed stare of the person who is deciding what to have for lunch, replaying the last game of golf or taking a fantasy trip. However badly I may have been presenting the subject, it was just not within their frame of reference.)
Venture capitalists were presented with a set of moral hazards when they morphed from groups of individuals pooling investments into funds with managers, who were paid a percentage management fee. As financial intermediaries, their eye was on maximizing their compensation, both the percentage of the fund amount and the percentage of profits. This first percentage tempted VC managers to keep the total in the fund as high as possible, often through decisions harmful to the investors. One way to inflate the fund amount, and the percentage compensation, was to value companies in the investment portfolio at higher than realistic amounts. Until there is an IPO or sale of an investment, the value is a matter of judgment. Comparisons are made to similar companies that are already publicly traded, or were recently purchased for a disclosed price. Estimates of future income and cash flow from the business are discounted to reflect a present value, considering the likely risks of achievement. The process can be influenced by choices and judgments, even if outsiders are hired to make a valuation.
To increase their take from profits, VC managers can also be influenced to drive particularly harsh terms on the young companies seeking capital to develop their business. Entrepreneurs are vulnerable when they are obsessed with their dream. Some of the nicknames for these provisions tell the story of the fear and greed behind them, such as “full-ratchet” clauses that increase the VC’s ownership percentage as the business stumbles, or the “drag-along rights” that force the business founders to join in a sale of the business dictated by the VC managers.
A moral hazard comes with investment in a company that is looking like a loser. The manager can keep a higher base for percentage pay by having the fund invest more money into the poor-performing company. This keeps it in the portfolio when to write it off would mean a cut in the manager’s profit sharing. A subtler variation of avoiding a writedown in compensation base occurs when another VC offers to invest in the needy company, but at a lower price than the first investor. If the new funding were accepted, it would set a reduced value for the initial investment. Under the adage, “a problem postponed is a problem solved,” the manager could cause the investment offer to be refused. This could keep the original investment cost as the valuation for management’s fee, while starving the client business from needed money.
VC investments that are winners present another set of moral hazards, especially when an underwritten initial public offering is the expected “liquidity event,” when their investment will be transformed into cash and marketable stock. The VC manager has a big personal return from a successful IPO, typically 20 to 30 percent of the net gain. In addition, the proceeds to the VC from a public offering are often left in the fund to reinvest. The IPO success can be the result of having the right managing underwriter. To attract the chosen broker-dealer firm to underwrite the offering, VCs began offering them so-called “mezzanine round” investments in the IPO candidates. By buying in at a pre-IPO price, the broker-dealer could turn a quick profit.
Wall Street Practices Create Moral Hazards for Corporate Managers
The fact that the smaller company that was acquired is lost to the economy is of no significance to Wall Street. The money to be made right now comes from doing business with large corporations. Nourishing young enterprises toward maturity, teaching their management about “high finance,” is time-consuming and the percentage fees on their early transactions are not big-bonus-making material. Better to lure the entrepreneurs into selling out, with appeals to their greed and promises about how their new owner will help them fulfill their dreams.
The greatest threat to monopoly businesses is the adequately financed new entrant with the creativity and agility to exploit gaps and weaknesses. The harm to us all from monopolies is described in Barry Lynn’s new book. [Barry C. Lynn, Cornered: The New Monopoly Capitalism and the Economics of Destruction, Wiley, 2010] Wall Street controls nearly all of the money available and allocates it to the existing monopolies. This leaves little opportunity for new ideas and energy to improve products and services, to make capitalism work. To quote from two icons of economics: "This process of creative destruction is the essential fact of capitalism." [Joseph Schumpeter, Capitalism, Socialism and Democracy, Harper & Brothers, 1942, page 83] "We need decentralization because only thus can we insure that the knowledge of particular circumstances of time and place will be properly used." [Friedrich Hayek, "The Use of Knowledge in Society," http://www.econlib.org/library/Essays/hykKnw1.html, page H.17]
It's ironic that the very minds that can
get rich and powerful on Wall Street are the minds that could
finally alleviate poverty. Paul Polak is a psychiatrist and
entrepreneur who has spent the second part of his life helping
the world’s poorest farmers increase their income. He came
to that work because: “I became convinced that the
most significant positive impact I could have on world health was
to work on finding ways to end poverty.” [Paul Polak,
Out of Poverty: What Works When traditional Approaches
Fail, Berrett-Koehler Publishers, Inc., 2008, page 5.]
“I have no doubt that the most important low-cost, high-leverage
solution to the complex issue of poverty is helping poor people
increase their income.” [page 55]
Muhammed Yunus, the founder of Grameen Bank and the microfinance
movement, was an economics professor when he experimented with
lending very small amounts to his Bangladesh neighbors for
acquiring tools and methods to increase their incomes. If a
physician and a professor could make such contributions to
alleviating poverty, imagine what experienced Wall Streeters
could accomplish. By contrast, a Wall Street
firm is said to have a “remarkable ability to convince
some of the world’s smartest young people that touting stocks,
sniffing out arbitrage opportunities, and shaking down corporate
clients amount to a noble calling.” [Ian McGugan,
“The Goldman Doctrine,” a review of William D. Cohan’s book,
Money and Power: How Goldman Sachs Came to Rule the World,
Doubleday, 2011, Bloomberg Businessweek,
A study by three economists was based upon
the proposition that “the ablest people” choose occupations with
the highest “returns to being a superstar.” Where will
individuals choose to work if they are particularly good at
applying mathematics or physics to solve extremely complex
issues? The professors say they’ll go where the few who
really excel are paid the greatest compensation. In
academic language, their analysis “suggests that private
incentives governing the allocation of talent across occupations
might not coincide with social incentives. Some professions
are socially more useful than others, even if they are not as
well compensated.” [Kevin M. Murphy, Robert W.
Vishny, Andrei Schleifer, “The Allocation of Talent: Implications
for Growth,” The Quarterly Journal of Economics,
This academic conclusion was applied to jobs
on Wall Street in a feature article by Lisa Bannon. “The
earnings of an engineer and someone in finance with the same
level of postgraduate degree were roughly the same in 1980, but
by 2005, the finance professional earned 30% to 40% more, on
average . . ..” [Lisa Bannon, “Beyond the Bubble: As Riches
Fade, So Does Finance’s Allure,” The Wall Street Journal,
Professor Louis Lowenstein noted that over half of the 1986 graduates of the Columbia School of Business took jobs at investment banks and commercial banks. Over 85 percent of the Columbia Law School graduates were hired by the big city law firms who do financial transactions and litigation. “We seem to forget that corporate finance is, or at least ought to be, a relatively minor pursuit, one whose principal purpose is simply to see that those who design, produce and distribute goods and services have sufficient capital.” [Louis Lowenstein, What’s Wrong With Wall Street: Short-term Gain and the Absentee Shareholder, Addison-Wesley Publishing Company, Inc., 1988, page 86] The Great Recession may have reversed that, at least for a while. Of Harvard’s 2008 graduates, 41% took jobs in investment banking, private equity firms or hedge funds. That dropped to 28% in 2009. The lowest ever was in 1937, when only one percent went to Wall Street. [http://bx.businessweek.com/harvard-business-school/view?url=http%3A%2F%2Fwww.hbs.edu%2Frecruiting%2Fmba%2Fresources%2Fcareer.html]
(My first job out of law school was with one of the Big Four accounting firms, where I ended up in the tax department. I spent the next few decades trying to avoid tax work. But I met scores of very intelligent, capable people who spent their entire work lives dealing with tax issues. Clients were willing to pay them large hourly rates in the hope of saving even more in payments to their governments. It has always seemed sad that these talented, productive professionals were figuring out ways to avoid paying taxes, rather than working on issues that would be more useful. Later, when Wall Street began inventing and selling derivatives, I saw an even greater diversion of talented people.)
There is a much greater, but more indirect waste of human talent that comes from leaving Wall Street in control of distributing securities. Its monopoly focus on financial intermediaries and wealthy speculators has kept the middle class from direct ownership of business. This means that corporate profits are taken mostly by managers—CEOs and their lieutenants, as well as the money managers at mutual funds, pension funds and other intermediaries. One result is that businesses are run to generate income for these managers and short-term profit-takers, not for long-term shareowners. Net income after payments to management is spent to make the business larger, to justify even greater compensation. Corporate executives, intermediaries and speculators all make money buying and selling the shares. Not much of the earnings of the business are paid out in dividends.
Because we don’t participate in the Wall
Street insiders’ games, the rest of us are left with our income
tied to our work, even if we have put savings into long-term
investments. Our ability to pay our living expenses is
dependent upon businesses having jobs available for us to do.
But those corporate executives and financial intermediaries are
doing everything they can to eliminate jobs. The result is
not only unemployment because of the loss of jobs paying a middle
class income. It also means underemployment as we take
low-paying work, doing tasks that can’t yet be profitably
outsourced to developing nations or automated. One
out of four jobs in the
All of us lose the contributions that could have been made by the potential inventors, entrepreneurs and other talented roles for people who are instead just making do with unchallenging work.
Wall Street has callously announced that we are all governed by only two emotions: fear and greed. All marketing of securities is a manipulation of one or the other, or both. Throw in a bit of mob psychology and we have the manias and panics that make for market volatility, the mass buying and selling that generates commissions and insider trading profits. Michael Lewis will show you Wall Street morality in shocking dark humor. [Michael Lewis, Liar's Poker: Rising Through the Wreckage on Wall Street, W. W. Norton & Company, 1989, The Money Culture, Penquin 1992 or The Big Short: Inside the Doomsday Machine, W.W Norton & Company, 2010.]
During Alan Greenspan’s long tenure as Chairman of the Federal Reserve Board, he coined two phrases that told us what Wall Street was doing to our national psyche. The first came as the bubble in technology stocks was early in its run-up, when he attributed it to “irrational exuberance.” As the bubble inflated more and more, he called it “infectious greed.” Whatever else we may think of Greenspan, he captured the pathology in these four words. A much longer and older description is in the 1841 book, Extraordinary Popular Delusions and the Madness of Crowds. Describing John Law’s Mississippi Scheme of 1719: “He did not calculate upon the avaricious frenzy of a whole nation; he did not see that confidence, like mistrust, could be increased almost ad infinitum, and that hope was as extravagant as fear.” [Charles Mackay, Memoirs of Extraordinary Popular Delusions, Richard Bentley, 1841, reprinted by Farrar, Straus and Giroux, 1932, page 1]
There’s more to greed than just making and keeping wealth. The strongest motive can be the “chump factor.” Paul Krugman has said that we find “it hard to resist getting caught up in the momentum, to take a long view when everyone else is getting rich.” [Paul Krugman, The Return of Depression Economics and the Crisis of 2008, W.W. Norton & Company, 2009, page 61] If we don’t get in there, it will pass us by. We’ll look like a wimp, a chump to ourselves and others. “To a substantial extent, we no longer admired those who were merely hard workers. To be truly revered, one had to be a smart investor as well.” [Robert J. Shiller, The Subprime Crises: How Today’s Global Financial Crisis Happened, and What to do about it, Princeton University Press, 2008, page 57.]
(We watched this infect some of the entrepreneurs who came to us for direct public offering advice. Consciously or not, they were aware of all the get-rich-overnight stories about underwritten IPOs. At first, our talk with them would be about the mission of their business, how they were meeting a human need, how their products and services were benefiting customers. They were doing well by their employees and other communities. Somewhere along the way, questions would turn to the expected trading market for the securities to be sold. Then it would be about the percentage of the business to be sold for the amount of money to be raised. At that point, we’d often see the glazed-eye clue that their thoughts were no longer on what we were saying. They were doing the arithmetic about how rich they would be and how that wealth would compare with others they knew.)
Fear and greed govern the way Wall Street sells to its customers. They’re also the only motivational tools Wall Street uses to hire and retain employees. Much of the criticism after the 2008 crash was directed to the huge bonuses paid to people who successfully took great risks. The government tried to limit the bonuses, calling them part of a “heads I win, tails I don’t lose” compensation scheme. The employees taking the risks would get great personal gain if they bet right, but they wouldn’t lose their jobs, or have pay cuts, if they bet wrong. By restricting the bonus amounts, the government figured it could cut down on the risks that were causing banks to fail and be bailed out with taxpayer money.
Perhaps a greater harm was the perpetuation
of a value that infects us all. Other businesses follow
Wall Street, since that’s where the fabulous riches are made.
The fact is, however, that studies show that financial incentives
don’t work. In fact, they are often counterproductive.
Barry Schwartz, a Swarthmore College psychology professor,
mentioned three of the studies in an essay, “The Dark Side of
Incentives.” [Business Week,
The current epitome of the Wall Street
psyche is Goldman Sachs. The Sunday Times of London
printed an interview by its reporter, John Arlidge, in which the
CEO of Goldman Sachs, Lloyd Blankfein, candidly described that
mindset. [John Arlidge, “I'm doing 'God's work'. Meet
Mr. Goldman Sachs: The Sunday Times gains unprecedented access to
the world's most powerful, and most secretive, investment bank,”
The Times of London,
1. "We help companies to grow by helping them to raise capital. Companies that grow create wealth. This, in turn, allows people to have jobs that create more growth and more wealth. It’s a virtuous cycle." To drive home his point, he makes a remarkably bold claim. "We have a social purpose." The facts, of course, are that very little of what Wall Street does has anything to do with raising capital for business.
2. Of the $20 billion to be paid by Goldman in 2009 salaries and bonuses, equivalent to $700,000 for each employee but heavily skewed toward those at the top: “If you examine our practices on compensation, you will see a complete correlation throughout our history of having remuneration match performance over the long term. Others made no money and still paid large bonuses. Some are not around any more. I wonder why."
3. On any government interference with Wall Street: “’I’ve got news for you,’ he shoots back, eyes narrowing. ‘If the financial system goes down, our business is going down and, trust me, yours and everyone else’s is going down, too.’"
4. In response to angry name-calling: “He is, he says, just a banker ‘doing God’s work.’
"In 2007, the Goldman Sachs boss Lloyd Blankfein earned $68m, a record for any Wall Street CEO. A good investment banking partner at Goldman will make $3.5m a year, a good trading partner $7-10m a year, and a management committee member $15-25m.” For even more colorful language describing Wall Street’s attitude toward its business and customers, you can read the affidavit filed by the New York Attorney General’s office in its action against Wall Street’s use of securities analysts. [AFFIDAVIT IN SUPPORT OF APPLICATION FOR AN ORDER PURSUANT TO GENERAL BUSINESS LAW SECTION 354 and accompanying news release, www.oag.state.ny.us/press/2002/apr/MerrillL.pdf]The New York Times published an Op-Ed by Greg Smith, on the day he resigned as a Goldman Sachs executive director and head of the firm’s United States equity derivatives business in Europe, the Middle East and Africa. His concluding sentence: "People who care only about making money will not sustain this firm — or the trust of its clients — for very much longer." [Greg Smith, "Why I Am Leaving Goldman Sachs," http://www.nytimes.com/2012/03/14/opinion/why-i-am-leaving-goldman-sachs.html?pagewanted=1&_r=1&ref=todayspaper]
Wall Street has become the career choice for young people caught up in the winner-take-all value system. It has had the same draw for college students that drug dealers have for high school dropouts—a seemingly quick way to have all the flashy symbols of big money. Remember the 1990s bumper sticker, “The one who dies with the most toys wins?” Many CEOs, financial types and professionals say things like, “For me, money is just the way of keeping score.” One observation is clear, “if you think money is the answer, there will never be enough.” Wall Street’s single-minded pursuit of scoring money infects us all. No matter whether the love of pursuing money was already there before the Wall Street career, or was developed on the job, it is the primary value, governing every decision and action. However, study after study has shown that money does not bring happiness. Once above the basic poverty level, there is no correlation. [The World Database of Happiness, directed by Professor Ruut Veenhoven of Erasmus University, Rotterdam, correlation by nation between happiness and wealth, http://worlddatabaseofhappiness.eur.nl/statnat/statnat_fp.htm. Also, see www.happyplanetindex.org/public-data/files/happy-planet-index-2-0.pdf] Yet, Wall Street perpetuates the myth that getting money—lots of it and quickly—is what life is all about. That harms us all. Some of our most capable people are ignoring community, service, family and other values, while they chase making more money than anyone else.
Our government and other governments around the world have sacrificed billions of dollars and immense political capital to save investment bankers. Few of us even asked why this effort was necessary. If we did ask, the answer was something like, “the credit markets are frozen and money won’t be there for Main Street businesses to pay their employees and suppliers.” This justified taking money from present and future taxpayers and giving it to the investment banks. Few of us asked, “Why not make alternative financing available directly to those businesses?”
It turns out that investment bankers no longer do much to provide money to grow and sustain businesses. Nearly everything they do is based on reshuffling ownership of securities or using derivatives to place bets on the future price of securities. Only a tiny fraction of their activities is actually raising money from investors for growing businesses. Money they raise in IPOs, initial public offerings, is mostly just part of the recycling of ownership by Wall Street’s buy side. Many of the “initial” offerings are of mature businesses that “private equity” funds have purchased from their public shareowners, sold off divisions and drained of all cash. Investment bankers dump the remains back onto the public, calling it an IPO. The sales that are really “initial” are generally businesses that have been built by institutional venture capitalists, with the IPO being the exit plan for cashing out their investment.
When Wall Street does do an “Initial Public Offering,” it usually has nothing to do with early stage businesses and nothing to do with financing new products or industries. Just look at the prospectus for the billion-dollar “IPO” of Shanda Games in September 2009. [www.sec.gov/Archives/edgar/data/1470157/000095012309046352/h03368b4e424b4.htm and comment by Henry Blodgett, “Goldman Hoses Clients in Busted Shanda Games IPO,” Clusterstock, www.businessinsider.com/henry-blodget-goldman-hoses-clients-in-busted-shanda-games-ipo-2009-9] The Shanda story is a far cry from the idealistic image, expressed like this: “Because of their role in financing new ideas, financial markets keep alive the process of ‘creative destruction’—whereby old ideas and organizations are constantly challenged and replaced by new, better ones. Without vibrant, innovative financial markets, economies would invariably ossify and decline.” [Raghuram G. Rajan & Luigi Zingales, Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity, Crown Business, Crown Publishing Group, a division of Random House, Inc., New York, 2003]
What has actually happened is that more
public companies disappear than the ones that are created by
IPOs. In 2000, over 9,000 publicly-traded
companies filed proxy statements with the
Mature corporations rarely raise capital by
selling shares. Take General Electric, for example.
The last time GE issued new shares was in 1995, when it sold $594
million. Meanwhile, GE has repurchased shares, at market
prices, for a cumulative total of $37 billion at the end
of 2007. In turn, some of this repurchased stock was sold,
to its own managers when they exercised their management stock
options. The managers generally resell the new shares for
cash in the market. GE’s balance sheet shows the gain it
made on buying and selling its own shares as the major part of
the over $26 billion in its “Other Capital” account. The
net result of GE’s initial issuance of shares, then repurchasing
them, and then using the repurchased shares to cover management’s
stock options, is that GE has taken nearly 100 times as much
money out of the public market from buying shares as it ever
raised from selling shares. Meanwhile, it has been paying
out about half of each year’s earnings in dividends. By
keeping the rest of its earnings, it has increased its retained
earnings to over $117 billion! That has allowed GE to
borrow cash, to a total of over $195 billion at the end of 2007.
Some 58% of GE’s shares are owned by institutions.
[Information gathered from GE annual reports, filed with the
GE’s experience with buying back its shares is the norm for mature American corporations. Nearly every large corporation has a program in place for repurchasing its own shares in the market, through brokers. During 1997 through 2008, 438 of the Standard & Poor’ 500 companies spent a total $2.4 trillion in buying back their own shares of common stock. A perspective on the amount these corporations paid out to sellers of their shares can be seen through the buyback-to-profit ratio: how the amount spent to repurchase shares compares to the companies’ profits. That ratio was 0.9 to 1 in 2007. That means the S&P 500 paid out 90% of their earnings to buy back their own shareownership. In 2008, when profits were down, the ratio became 2.8 to one—they spent nearly three times their earnings to repurchase shares.
The most profitable company of all,
ExxonMobil, paid out 173% of its first quarter 2009 earnings to
repurchase its stock. From 2000 through 2008, the big
technology companies, Cisco, Hewlett-Packard,
Why do American corporations spend so much buying back their own shares? They will say things like “Our shares represent the best value for a return on investment” or “We can best serve our shareowners by supporting the market for their shares.” The real reason is often that managers are exercising stock options they have been granted as compensation. They spend their employer’s money to keep the price up while they exercise their personal options and resell the shares into the market.
The myth that Wall Street investment bankers
raise money to grow business is just that—a myth. What they
really do is move money and securities around among the players,
taking sizeable chunks for themselves, like a giant shell game.
As Steven Pearlstein commented, “the best approach to Wall Street
might be to simply ignore it and turn our attention to those
parts of the economy that can create real economic value and
broadly shared prosperity.” [Steven Pearlstein, “
Bypassing Wall Street is already happening. It is part of the trend toward disintermediation in finance and business. [Paul Hawken includes a chapter on "Disintermediation" in The Next Economy, Holt, Rinehart and Winston, 1983, pages 117-132] Direct investing routes are operating right now. Most of them are serving individual investors, providing a way for them to go directly to the organization that will be using their money. A few institutional investors are bypassing Wall Street. "We are in the middle of a strategy to invest all of our assets in a way that is 'as direct as possible'. You can think of it as 'off-the-grid' investing." [Don Shaffer, “Canceled IPO, What’s Next For Global Stock Markets?” RSF Social Finance, March 26, 2012, http://rsfsocialfinance.org/2012/03/canceled-ipo/]
We hear so much about how the
TreasuryDirect’s current website describes its direct investing this way: “In your TreasuryDirect account, you can purchase and hold Bills, Notes, Bonds, Treasury Inflation-Protected Securities (TIPS), and savings bonds and it's available to you 24 hours a day, 7 days a week. Your TreasuryDirect account is protected by a password of your choosing. The system allows you to conduct most of your transactions online, -- you can purchase, reinvest, sell securities, and perform account maintenance from your home or work computer. You can also view all your account information, including pending transactions. TreasuryDirect offers you all of these features with no maintenance fees, no matter how much you have invested.” [www.treasurydirect.gov/indiv/myaccount/myaccount_treasurydirect.htm]
The 2008 version of this page had said: “TreasuryDirect is our web-based system that allows you to purchase the full range of Treasury consumer securities in one convenient online account. TreasuryDirect is our primary retail system for selling our securities. This system allows us to establish direct relationships with you as an investor, enabling you to do business with us electronically using the Internet and conduct transactions without personal assistance from us. I. . . . Our long-term goal is to consolidate all retail sales of Treasury securities in TreasuryDirect. With this consolidation, we'll realize savings in administrative costs and be able to enhance our customer service.”
What TreasuryDirect doesn’t say flat out is that you’ll never need Wall Street to buy and sell U.S. Treasury securities. By using this direct route, you will always get the best pricing, the greatest transparency and the lowest transaction costs. You can even participate in Treasury auctions, right alongside the Wall Street institutions.
The U.S. Treasury has also given direct access to China, so it no longer has to buy "through Wall Street banks, which can often drive up the price of Treasuries at an auction if they know how much large clients are willing to pay. Such a practice that is not specifically illegal, though most traders would deem it unethical." [Emily Flitter, "Exclusive: U.S. Lets China Bypass Wall Street for Treasury Orders," Reuters, May 21, 2012] This doesn't save any fees, but it means that Wall Street doesn't learn about China's intentions before the transaction is completed.
The commercial paper
securities market is a way for large corporations to borrow
money for up to nine months, at a lower cost than borrowing from
a bank. Wall Street acts as a dealer for some commercial
paper, but many corporations have employees who sell their paper
directly to fund managers and other corporations with excess
cash to invest. Bypassing Wall Street saves the issuer
about a half of one percent on each transaction, equal to $5,000
per $10 million. Commercial paper doesn't have to be
registered with the
Wall Street managed to hijack and grossly abuse the commercial paper SEC exemption by packaging and selling "asset-backed commercial paper." They transferred long-term mortgage securities into "bankruptcy-remote" shell companies, which then issued short-term commercial paper. Investors were mostly money-market mutual fund managers, going after the higher yield, trying to outperform their competition. In the panic after Lehman Brothers failed, the Federal Reserve came to the rescue of Wall Street's buy side with purchases, guarantees and loans for holdings of commercial paper. The basic commercial paper market survives, with about a trillion dollars outstanding, most of it issued by financial institutions. [Tobias Adrian, Karin Kimbrough, Dina Marchioni, "The Federal Reserve's Commercial Paper Funding Facility," Federal Reserve Bank of New York Economic Policy Review, http://www.newyorkfed.org/research/epr/forthcoming/1006adri.pdf] Back in 2001, nonfinancial issuers had $250 billion dollars in commercial paper outstanding. That has shrunk to about $150 billion. [Federal Reserve Release, www.federalreserve.gov/releases/cp/]
Corporations can finance longer term purposes by issuing bonds. These are placed through Wall Street's sell side and sold mostly to buy side money managers. Any trading in bonds or mortgage securities has also gone through Wall Street brokers. Now, a sell side firm, BlackRock Inc., operates its own trading desk for its clients' bond trades of up to $2 million eac. It recently announced Aladdin Trading Network, a trading platform for its biggest clients "that would let the world's largest money manager and its peer bypass Wall Street and trade bonds directly with one another . . . at a fraction of the price charged by Wall Street." [Kirsten Grind and Serena Ng, "BlackRock's Street Shortcut," The Wall Street Journal, April 12, 2012, page C1]
At the other end of the spectrum from the world’s largest money raisers are the would-be entrepreneurs who need money for a start-up business. Most of them first use up all their savings, credit cards and garage sale proceeds. Then they turn to family and friends, who make up 92% of all “informal investing,” where the money does not go through a bank, broker or other financial intermediary, according to the Global Entrepreneurship Monitor. [www.gemconsortium.org/default.aspx]
Information about informal investing is understandably
difficult to gather. Every three years, the Federal
Reserve Board surveys
A problem with informal investing, particularly friends and family, is simply that it is informal. Any written documentation is often absent or incomplete. Enforcement of the terms can get very complicated and unpleasant. Asheesh Advani responded to this problem in 2001 with CircleLending, his “specialty loan administration company,” and with his 2006 book. [Asheesh Advani, Investors in Your Backyard: How to Raise Business Capital From the People You Know, Nolo Press, 2006] CircleLending was acquired in 2007 by Virgin Money USA, owner of Virgin Airlines and other businesses. In its first six years, CircleLending had set up $200 million in loan volume while maintaining a default rate of less than 5% on private loans and less than 1% on private mortgages. VirginMoney’s website had a timeline for its business development, showing the volume of what it calls “social lending” at a $1.8 billion annual rate in 2009. The business was closed in December 2010. [http://www.americanbanker.com/bulletins/-1029613-1.html Another site offering a similar service is www.lendingkarma.com.]
Local communities have often offered
securities directly to their residents, to finance a local
project or business. Some small towns have turned to
direct community offerings to replace local businesses that were
lost from “big box store” competition or declining population.
[Sharon Earhart, “Making Merc work: When Powell, Wyo., lost its
main retail clothing store, residents rolled up their sleeves
and opened their own,” and companion analysis by
Shellie Nelson, “Western
towns sell it their way,” Headwaters News,
An early biofuel venture, ethanol, required
plants to process corn and they cost from $50 million to $125
million each. Scores of the plants were funded by farming
communities through direct community offerings. “Wall
Street has little to do with this decidedly grass-roots
investment boom.” [Scott Kilman, “In
Football and soccer teams have been
particularly successful with direct community offerings.
Woody Tasch was chairman of Investors' Circle, whose individual and foundation members invest in early stage businesses that are seen as serving social and environmental purposes. He uses the term “slow money” to describe investing in local food businesses. [Woody Tasch, Inquiries into the Nature of Slow Money: Investing as if Food, Farms, and Fertility Mattered, Chelsea Green, 2008, www.slowmoneyalliance.org] Local ownership of farms and food processors has been studied as the Community Food Enterprise. [www.communityfoodenterprise.org/introduction/types-of-cfe-models] The E. F. Schumacher Society operates the Self-Help Association for a Regional Economy, which provides documentation for "Use in Establishing a Community-Based Small Business Loan Collateralization Program." The way it works is that people in the local community open certificates of deposit with a neighboring bank. The CDs are then pledged to secure a loan to a local business, at a rate four points over the CD interest. [http://www.smallisbeautiful.org/share/1_intro.htm]
The legal form of cooperative corporation
is not necessary for a business to be community owned and
financed. Grameen Bank, the Nobel Prize-winning pioneer in
microlending, is 94% owned by its thousands of borrowers, with
the rest owned by the Government of Bangladesh and two banks.
For 2006, they received dividends equal to their entire
The largest shareowner in Divine Chocolate, based in
You might think that local governments are a natural for marketing bonds directly to their neighbors, the people who will benefit from the public facility that is to be financed by the bonds. Those governments even have the huge advantage of paying interest that is exempt from federal and state income tax.
For over a century, there has been a
trickle of direct local government bond offerings.
Legislatures have even ordered state departments to market bonds
to average citizens, but the programs always fizzled out, or
never even got started. Instead, local governments
continue to do business with Wall Street, paying large
commissions for bonds sold in $5,000 minimum purchases and
usually placed with insurance companies and mutual funds.
One reason the system hasn’t changed is because investment
bankers make campaign contributions to elected officials and pay
fees to people with political access. Rules against this
“pay-to-play” haven’t been seriously enforced and, according to
During the 1980s, several governments
experimented with direct marketing of bonds. Many of them
were offered in minimum purchases of much less than the
traditional $5,000. That earned them the sobriquet
“minibonds.” When direct bond offerings actually happened,
they have generally been highly successful. For instance:
The Salt River Project, a Phoenix, Arizona electric utility,
sold $267 million in bonds to 21,000 residents, at a $200
minimum purchase and a $10,000 maximum. Purchasers could
cash in a bond at any time, paying a 3% redemption fee.
A prospective investor in the
So far, introduction of the Internet has
done little to loosen Wall Street’s grasp on selling local
government bonds. Muniauction.com, operated by the
Grant Street Group, has daily auctions of bonds. [www.grantstreet.com/auctions].
Initially, sales on the Internet were only to bond dealers, but
they seem now to include institutional investors and
corporations. Individuals still have to go through a
broker. “More companies are getting ready to issue small
portions of their debt needs online. Only a few, though,
have been willing to step forward because many don’t want to
anger dealers.” [Toddi Gutner, The E-Bond Revolution,”
In his 1914 book, Louis Brandeis described direct public bond offerings made in 1913 by five American cities, in what he referred to as “over-the-counter” sales. Testimonials by local officials describe the success from marketing bonds directly to local residents. [Louis D. Brandeis, Other People’s Money: And How the Bankers Use It, Frederick A. Stokes Company, 1914, republished by National Home Library Foundation, 1933, Kessinger Publishing’s Rare Reprints, page 81] If the success of direct public offerings of local government bonds was discovered as early as 1913, why have they been used only sporadically in all the years since? One answer is the human reluctance to accept responsibility if there is no promise of significant personal reward. There is not much in it for a public official to go against “the way we’ve always done it” and risk failure.
[For information about direct public
offerings of municipal bonds, see: Municipal Minibonds:
Small Denomination Direct Issuances by State and Local
Governments, by Lawrence Pierce, Percy R. Aguila, Jr. and
John E. Petersen, Government Finance Research Center of the
Government Finance Officers Association (February 1989); “The ‘Mini’ Trend in Municipal Finance:
Minibonds,” Comment by Christina L. Jadach, Harvard Journal
on Legislation, Vol 19:393 (1982); “Mini-Municipals: A Quiet Revolution in
Tax-Exempt Finance is Afoot, Barron’s,
There is a space between making a donation
to a cause, on the one side, and making a loan or buying shares
on the other side. Some charities and political campaigns
have moved a bit into that space, by offering ways for donors to
participate in the organization’s activities. The appeal
is to a motivation beyond that reached by auctions, souvenirs,
name recognition and other perquisites. It is directed to
a desire to be a part owner, economically and in governance.
Some businesses are finding ways to be in that same fundraising
space, to offer a sense of ownership, without running afoul of
the securities laws. Several approaches, called
“Crowdfunding,” are described in:
http://twitter.com/crowdfunding. Jeff Howe, in his book,
“Crowdfunding isn’t new. It’s been the backbone of
the American political system since politicians started kissing
babies.” [Jeff Howe, Crowdsourcing: Why
the Power of the Crowd Is Driving the Future of Business,
2009, page 253] A detailed paper on crowdfunding was
presented by Professor C. Steven Bradford "Crowdfunding
and the Federal Securities Laws," October 7, 2011.
A detailed paper on crowdfunding was presented by Professor C. Steven Bradford "Crowdfunding and the Federal Securities Laws," October 7, 2011. [http://www.sec.gov/info/smallbus/acsec/bradford_crowdfunding.pdf
“donate” through crowdfunding usually receive a product of
minimal value in return. As one site puts it:
“To contribute, just browse and select a business
and click the blue “Back This Venture” button. You can then
choose the level of funding you’d like to give and select your
sites have proliferated, some have gone beyond "only token
compensation such as coupons or free samples," including "a 2%
cut of the store's revenue over four years." [Emily
Maltby, "Tapping the Crowd for Funds," The Wall Street
“Many entrepreneurs have found that they don’t need to borrow
funds or sell equity in their companies – if they have a solid
fan base, there are many ways to tap into that resource for
funds. Strategies in this category include pre-selling,
customer financing, crowdfunding, memberships, donations, and
sponsorships. The great thing about this strategy is that
securities law does not apply.” Examples: “Awaken Café –
pre-sold “café-creator” cards that allowed them to fund the
build-out of the café and entitled buyers to purchase products
once the café was open – raised over $14,000! Little
According to the Fan-Funded Forum website, there are numerous offerings being made to sports, music and art fans. However, many of them seem to have intermediaries who operate and charge like brokers. [www.fanfundedforum.com/category/fan-funding-sites/, www.music4point5.com/blog/why-fan-funding-is-the-way-to-go/] (We had an intriguing call in the early 1990s, asking us to meet with a lawyer for members of the Grateful Dead. It ultimately didn’t go anywhere and then Jerry Garcia died in 1995. The band was a great “what if” exercise for a virtual DPO. It had a data base of 150,000 deadheads for its magazine/catalog, most of whom were the “true believers” that form the base for successful direct offerings. Shares could be sold at concerts. The prospectus could have a Garcia-designed cover and the perquisites to be offered shareowners would be a marketer’s dream.)
Crowdfunding and fanfunding websites have been raising “donations.”
reportedly has about 500 start-up businesses using its site and
charges $1,100 each. Donations have averaged
$1,300 and amounts raised about $30,000.
IndieGoGo charges six percent of the amounts raised through its
site, which it says totaled over $1 million for 24,000 projects
in the last three years. [Angus Loten,
“Crowd-Fund Sites Eye Boom,” The Wall Street Journal,
In July 2010, the
Congress has gone around the
“Crowdfunding” is Title III of the “Jumpstart Our Business Startups Act,” signed into law April 5, 2012. The elegantly short bill introduced as HR 2190 became very complex when it was joined with several other bills to become HR 3606. The major change was a victory for Wall Street and its traffic cops, the SEC and state securities administrators. The "exemption" was reduced from the proposed $10 million to $1 million in securities offered to the public and a business will have to hire an intermediary. Direct public offerings would not qualify for the exemption from pre-approved filings with the SEC and the states. That is a major step backward from SEC Rule 504, which allowed $1 miiion direct public offerings. The business would either have to use a securities broker-dealer or a “funding portal.” A definition of funding portal is added at section 3(a)(80) of the Securities Act of 1933 and an new section 4A is added to include the requirements for funding portals, including their registration with the SEC and with a self-regulatory organization governed by the SEC. You can expect more details and more requirements in SEC regulations.
Social websites are all about direct communication among people with shared interests. Around 2007, several of them sprang up for people to lend each other money, without going through any intermediary. As they started out, these "P2P" sites allowed borrowers to post the amount, term and purpose of the loan they wanted. Lenders could then bid the amount they wished to lend and the rate of return they were looking for. The site manager’s role was limited to operating the site, assigning ratings based on a borrower’s credit history and administering the loans.
Most of the early P2P sites had researched and complied with
state lending laws. However, they did not deal with
federal and state laws for selling securities. That all
came to a head in 2009, with regulatory challenges. Some
sites closed permanently, while others were reopened after
settlement agreements with the
Prosper Marketplace was imported from England and became the
early leader for P2P sites in the
By 2011, small business loans have increased to about 10% of
the lending on the two major peer-to-peer sites.
[Angus Loten, “Peer-to-Peer Loans Grow: Fed Up With
Banks, Entrepreneurs Turn to Internet Sites,” The Wall Street
Venture capital in the 1950s meant investment partnerships of wealthy individuals who sought out early stage businesses to support with their money and experienced judgment. Then it morphed into professional money managers for huge institutional funds, taking percentage fees for betting on the companies that would soon do a Wall Street initial public offering, or quickly sell out to a big business.
The lost spirit of financing entrepreneurs
may have been reborn with “angel investors.” These are
usually local groups of individuals who meet to receive
proposals and sometimes jointly make investments in young
businesses. A recent count came up with 340 groups of
angel investors. [Angel Capital Education Foundation,
10,000 and 15,000 angels belong to angel groups in the United
investments were made at an $18 billion annual rate during 2011,
of which nearly 40% were for seed and start-up ventures. The
average investment was just under $340,000 and 90% were
made within a half day's travel time of the investors' homes.
[Center for Venture Research,
Some angel investors have become fairly
large and diversified and are called “super angels.”
[Spencer E. Ante, “Super Angels Shake Up Venture Capital,
As angel investors become "super angels,"
or "micro venture capitalists," it may be inevitable that they evolve along the same path as
venture capitalists did in the last century. After
successfully investing their own money, often in conjunction
with other angels, they have begun raising funds from
institutions and wealthy individuals, aggregating $8.5 million
to $73.5 million each. What elevates super angels into an
unofficial upper class generally is the magnetic effect their
participation in a deal has on other investors—a main reason
entrepreneurs like to do business with them. And, for
super angels, investing has evolved into something more than a
hobby. These players are now raising funds with outside
money, investing full time and competing with venture
capitalists.” [Pui-Wing Tam and Spencer E. Ante, “’Super
Angels’ Fly In to Aid Start-Ups,” The Wall Street Journal,
Angel investors can share experiences through the Angel
Investors Association, which has a list of members at
Shafrir has described the peer-to-peer relationship between
angel investors who built their own companies and the start-up
entrepreneurs they finance and mentor. [Doree Shafrir, “Pennies
from Heaven,” Newsweek,
Scott Shane, citing the Census Bureau’s Survey of Business
Owners, reports that only 2.7 percent of startup companies got
financing from any outside source; only 2.8 percent of those
seeking funds from angel investors actually received financing,
compared to less than a 0.2 percent success rate from venture
capitalists. [Scott Shane, author of Fool’s Gold: The
Truth Behind Angel Investing in
In the underwritten public offering arena, Wall Street has done “blank check” or “blind pool” offerings, where an experienced management team forms a corporation without any operating business or even a plan for a business. Investment bankers sell shares to investors who trust that the managers will find a business to buy and operate profitably.
What if the management team is just out of
school, without ever having run a business? Stanford
Professor Irv Grousbeck helped conceive of the “search fund” and
advises many of the entrepreneurs. This definition of
search funds is on the website for the Center
for Entrepreneurial Studies, Stanford Graduate School of
Business: “Conceived in 1984, the search fund is an
investment vehicle in which investors financially support an
entrepreneur's efforts to locate, acquire, manage and grow a
privately held company. MBA and law school graduates are using
this approach more and more frequently to become entrepreneurs,
often shortly after graduation, despite a relative lack of
operating experience.” [www.gsb.stanford.edu/ces/resources/search_funds.html]
This site has extensive written and video materials on search
funds, including reports on its studies of search fund
performance. The Center “has identified and tracked over
130 search funds raised since 1984, many of which have purchased
companies successfully in the
Results have been mixed for investors in
the 141search funds reported to have been started by mid-2010:
"Nearly one-third of search funds launched to date have lost all
their investors' money. . . . And just 38% of all search funds
have posted a positive return, down from 48% two years ago."
[Kyle Stock, "Risky 'Search Funds' Draw Entrepreneurs," The
Wall Street Journal,
Money for most new businesses comes from their founders’ savings and personal borrowings. A second round may come from “friends and family.” These beginning businesses can only survive by keeping costs as low as possible, including what they pay for advice and services. To meet this need, there are “incubators,” which provide operating space, office support services and some level of management consulting. Many of them also introduce their tenants to venture capital or angel investors.
The first incubator began in
The National Business Incubation Association is now 25 years
old and has nearly 2,000 members, about 1200 of whom operate
business incubators. [www.nbia.org/about_nbia]
The Association says that the survival rate after five years is
87 percent for incubator clients, compared to 44 percent for
businesses that don't use incubators. About 80 percent of
incubators begun in the past few years deal with businesses in
one or two sectors. [Lauren Hatch, "Betting on
Incubators to Create Jobs," Bloomberg Businessweek,
The federal government has shown signs of supporting
incubators. The Business Incubator Promotion Act was
introduced in the 2008-2009 and 2009-2010 sessions of Congress
but hasn’t made it out of committee. [http://www.govtrack.us/congress/bill.xpd?bill=s111-1662]
It would authorize the Commerce Department’s Economic
Development Administration to make grants to incubators for
operations and support services, in addition to construction and
renovation projects. Another bill would spend $250 million
to fund business incubators targeting high-growth industries.
[Lauren Hatch, “Betting on Incubators to Create Jobs,”
In Community Supported Agriculture,
customers pay in advance for a share in the season’s harvest.
The farmer uses this money to grow food, instead of borrowing
money from a bank and repaying it when customers buy at harvest
time. The United States Department of Agriculture
describes it as “a community of individuals who pledge support
to a farm operation so that the farmland becomes, either legally
or spiritually, the community's farm, with the growers and
consumers providing mutual support and sharing the risks and
benefits of food production.” [
Community Supported Agriculture is not only a
way to market shareownership in food being grown for the table.
It has been used for other agricultural products. Former
television news producer Susan Gibbs has a flock of sheep and
goats producing for her Internet wool and yarn business.
She offered a 1% share in the spring shearing, delivered as yarn
or as wool for spinning. Word of the offering was spread
by bloggers. [www.fiberfarm.com/about
and article by Robert Tomsho, “Shepard’s Tale” The Wall
Just as a business can raise money from its
customers, it may also have its suppliers become shareowners.
Fabindia sells hand-woven clothing and furnishings through its
nearly 100 stores in
One of the oldest direct securities
marketing methods is the rights offering, where a business
offers new securities to the people who already own its shares
or debt. The term “rights offering” comes from the days
In a rights offering, shareowners can
purchase new shares in proportion to the number they already
own. They usually have up to 20 days to decide after
receiving the offer. There can be a timing advantage
because rights offerings do not need the prior shareowner
approval that would be required for companies listed on a stock
exchange. The requirement for
A rights offering can be handled entirely
by the company. If an investment banker has a role in a
rights offering, it is a limited one. They may provide a
“standby commitment,” or “backstop,” to purchase any leftover
shares at the offering price. They may also act as a
“dealer manager,” following up with shareowners to sell them on
exercising their rights. The commissions are far less than
an underwritten offering. As you might expect, investment
bankers have generally frowned upon rights offerings. But one
major corporate law firm proclaimed, in 2008, “the negative
perception often associated with rights offerings is
dissipating. The time is right for the rights offering to be
viewed as a viable capital raising technique for
An early opportunity to bypass Wall Street came with dividend reinvestment programs. The first DRIPs were public utility corporations with large numbers of individual investors living in their service area. They saw it as a way to recapture money they paid out in dividends. For the investors, it was a way to increase their investment in companies they liked, without having to take money out of their spending budget. It was also an exercise in “dollar cost averaging,” since they were buying in steady amounts, while the share price might be going up and down. Most of the companies don’t charge for purchases and some even give a small price discount.
The next step for DRIPs was to allow shareowners to invest more than the amount of their dividends, by adding their own money to the dividend amount. Some businesses have even gone to letting someone buy their first shares directly, without ever having to go through a broker. That led to direct stock purchase plans. These DSPPs can include corporations that don’t even pay dividends but allow anyone to buy their shares directly.
DRIPs and DSPPs are sometimes referred to as “no-load stocks,” because there is no commission paid by the buyer or the company issuing the shares. They are very different from no-load mutual funds, although both are sold directly to the investor, without a financial intermediary collecting a fee. The mutual fund is itself an intermediary, collecting money from people who buy its shares and then reinvesting that money in a portfolio of shares, bonds or other investments, while charging a percentage management fee. DSPPs allow direct purchases of shares in an operating business. Jeff Fischer of The Motley Fool describes the mechanics of DRIP programs at www.fool.com/dripport/howtoinvestdrips.htm. Michael Robertson provides that service for DSPPs, at his Get Rich Slowly website. [www.getrichslowly.org/blog/2009/04/07/direct-stock-purchase-plans-a-better-way-to-invest/]
Loyal3 is a transfer agent offering a DSPP that it calls Customer Stock Ownership Plan. or CSOP, a term first used by Louis O. Kelso in the 1950s. [Wendy Willbanks Wiesner, “Twist a Concept and Trademark It,” Investor Uprising, The Individual Investor Intelligence Network, www.investoruprising.com/author.asp?section_id=1418&doc_id=230753&] If a company wants to raise money through selling its shares, it would still have to go to Wall Street. “Both the IPO CSOP and Follow-On CSOP are offered alongside a traditional underwritten public offering.” [Loyal3.com/the_csop. The process is described at http://www.youtube.com/watch?v=XttOks53gKY] Since the 1990s, another stock transfer agent, Transfer Online, has been offering a trading board for buying and selling existing shares. [http://www.transferonline.com/trading/demo_company]
In June 2011, the Nasdaq Stock
Exchange announced that it would be offering a program for
individuals to buy shares in participating companies, through a
partnership with Loyal3. According to John Jacobs, Chief
Marketing Officer and Executive Vice President of The NASDAQ
There are “folio services” firms for those who want to build a diversified portfolio with modest regular purchases. They will purchase shares for individuals in a fixed amount each week or month. The investor sets the amount and chooses the companies. The service provider records ownership of fractional shares, to make the amount come out even.
This automatic investing through a folio service is a useful way to employ “dollar cost averaging” and to provide the disciplined investing of set amounts at regular intervals. However, the service doesn’t strip away the financial intermediary and create a direct relationship between the investor and the business. The purchases are made in the trading market, rather in new issues that raise money for growing the business. The company’s shares are only a marker for gambling on price movements and dividend yields.
When they started, the services were buying
shares directly from the company. While the folio services
company was sort of a financial intermediary, the investor
didn’t have to open a brokerage account. Then, one of the
folio services companies, Sharebuilder, which started as
NetStock Direct in 1996, was acquired in 2007 by
Part of what a financial intermediary is
supposed to do is to identify prospective investors and tell
them about an offering of securities. Nearly everyone who
does that must be part of the broker-dealer monopoly. If
they don’t pass the tests and meet the qualifications for
registration as a broker-dealer, the
A lot of ingenuity has gone into finding ways to assist businesses in raising money from public offerings, without being forced into becoming a broker-dealer. Some of the attempts have been to escape supervision of nefarious practices. But others have been motivated by a desire to provide an honest and open marketplace where entrepreneurs may display their proposals and investors can look them over—sort of a Craig’s List, where the offering business pays a fee to tell its story and the investor then deals directly with the business.
Since the early days of the Internet, there have been websites offering to find money for businesses. Most sites that come up from a search turn out to be commissioned intermediaries. Some of them offer to prepare business plans and others say they will provide all the services to locate, present, persuade and close a funding. Some are registered broker-dealers, while others claim to do things that may or may not require that license. One site that is close to simply posting is GoBig Network, which calls itself “an online network of funding sources. . . . You can either advertise to investors, with what we call a funding request posting or you can browse through our member pages and subscribe so that you can directly contact the members most relevant to you. Both of these paid services, the request and subscription, are available at either a monthly recurring, or one-time annual fee.” [http://www.gobignetwork.com/pages/about-us] A key to avoiding regulatory interference is that only accredited investors may participate as prospective investors.
Another posting site is RaiseCapital.com,
which says “RaiseCapital.com is a website that introduces
entrepreneurs and investors. Some fund raising efforts may
(Disclosure: From 1976 to 2008, we advised businesses in doing DPOs and I authored two books on the subject, Take Your Company Public The Entrepreneur’s Guide to Alternative Capital Sources, Simon & Schuster, 1991 and Direct Public Offerings: The New Method for Taking Your Company Public, Sourcebooks, 1997.)
The Internet is a magnificent tool for direct
public offerings. Our client, Annie’s Homegrown, succeeded
with the first Internet direct public offering in August 1995.
With later offerings, we were able to have prospective investors
receive a share offering, read the prospectus, order shares and
pay for them by credit card or online check—all in one sitting
at their computer. The power of raising small amounts of
money through the Internet, from a very large number of
individuals, has been dramatically demonstrated by recent
political campaigns. Professor William K. Sjostrom, Jr.,
Adjunct Professor of Law at William Mitchell College of Law,
published a paper on “Going Public Through an Internet Direct
Public Offering: A Sensible Alternative for Small Companies?”
Federal and state securities regulation can be challenging for direct public offerings. The structure and the mindset of the regulators is geared toward offerings through broker-dealers. However, with some perserverance, DPOs have been successfully cleared and completed in all states.
The ability to have a trading market may be used for choosing Wall Street rather than a DPO. In fact, broker-dealers have been happy to provide a trading market for DPOs. For smaller offerings, there are order matching services operated by the company or its stock transfer agent. Community banks showed the way in DPOs, because banking regulations often required that they have many shareowners in their service area.before they could get their charter. In February, 2012, SecondMarket announced a customized secondary market for community bank shares. [https://www.secondmarket.com/discover/news/secondmarket-launches-pilot-program-for-private-community-banks. See Felix Salmon, "A private stock market for small banks," Reuters, http://blogs.reuters.com/felix-salmon/2012/02/16/a-private-stock-market-for-small-banks/#commentform and Karen Weise, "SecondMarket's Unlikely Second Act," Bloomberg Businessweek, March 12-18, 2012, page 49]
Why aren’t there more DPOs? Some say the answer is tied to the personality of CEOs: that, like self-publishing for an author, they’re afraid people will think their business couldn’t attract an underwriter. Cynics claim that the CEO needs someone to blame when an offering fails. Others suggest that gullible CEOs actually believe the investment banker’s letter of intent is a firm commitment to underwrite the offering. Executives could be put off by the need for direct offerings to comply with state filing requirements. These filings are time-consuming and may result in blocking a direct public offering to residents of a state. By contrast, Congress exempted underwritten offerings from state laws, since they could be accepted for exchange listing. [Securities Act of 1933, section 18(b)(1), www.law.uc.edu/CCL/33Act/sec18.html] The regulatory thicket is especially intimidating because nearly every experienced securities lawyer is with a large law firm, where they "only do underwritten offerings." (We've had securities lawyers in those firms tell us that they won't risk offending their broker-dealer clients, or that they have reciprocal business referral understandings, where underwriters send them business and the lawyers refer prospective IPO clients to the underwriters.) It's a similar picture when looking for an audit. The big accounting firms are wedded to Wall Street and the smaller ones don't have the securities public offering qualifications.
Those entrepreneurs who get through the lawyer/accountant barriers find that resistance from the market is not a real limitation to marketing their securities. Because over 90% of the DPO investors don't have an account with a securities broker-dealer, they are free of the "that's not the way it's done" syndrome. Of course, the major limit on marketing DPOs is the individuals’ lack of money for investing. As Jeff Gates puts it: “Expecting a broad base of wage earners to buy their way into significant ownership (i.e., from their already stretched paychecks) is what I call 'Marie Antoinette Capitalism'—only instead of urging 'Let them eat cake,' the modern refrain is 'Let them buy shares.'" [Jeff Gates, The Ownership Solution: Toward a Shared Capitalism for the Twenty-First Century, Addison-Wesley1998, page 23]
Louis Brandeis asked the same question about why there weren’t more direct offerings, back in 1913. One of his Harpers Weekly articles was called “Where the Banker is Superfluous.” As to why issuers nearly always use investment bankers, Brandeis said: “It is not because the banker is always needed. It is because the banker controls the only avenue through which the investor in bonds and stocks can ordinarily be reached.” [Louis D. Brandeis, Other People’s Money: And How the Bankers Use It, Frederick A. Stokes Company, 1914, republished by National Home Library Foundation, 1933, Kessinger Publishing’s Rare Reprints, page 74]
(I find some comfort in the history of other new ways of doing things, like the fax machine. The first patent on facsimile transmission was issued in 1843 and the first commercial use began in 1922. I remember watching a facsimile machine work in a U.S. Army show in the late 1940s. My first one was a Xerox telecopier in 1976, which I kept in a closet because it smelled so bad. Then they were suddenly ubiquitous from the 1980s until scanning caught on.)
One of our clients asked us to explain, for its board of directors and other backers, why a direct public offering would be good for the business and for society in general. This is an edited version of our response:
Why a DPO is good for your business:
1. A direct public offering is consistent with your values. Creating a community, based upon shared beliefs, is a logical extension of your values. The “small group of thoughtful, committed individuals,” from your Margaret Mead quotation, becomes even more capable of making change when it is joined in ownership of a national business.
2. Shareowners are better customers and goodwill ambassadors. Businesses that have marketed shareownership directly to their customers find that shareowner customers purchase two to three times the average for other active customers.
3. Long-term shareowners provide stable relationships. Individuals who have purchased shareownership directly from the business will generally have a several-year horizon for their investment and will hold through ups and downs, if they are kept informed with regular information. This contrasts with institutional money managers and the securities analysts who serve them, who are generally focused on quarter-to-quarter performance.
4. Price volatility/litigation risk is reduced with community share ownership. Money managers and other analyst-influenced investors tend to transact in large blocks and move as a herd on short notice. The resulting large price changes can bring lawsuits. Long-term individual investors do not sell on isolated events, particularly if they are kept informed, and they act independently. They tend not to be interested in being part of a class suing their directors and management.
5. Direct share marketing more efficiently manages capital formation. Financing through intermediaries often requires catching “a window of opportunity” in the market, whether or not it fits with the uses a business has for new capital. Direct public offerings are far less subject to fads, so they can be coordinated with capital budgeting.
6. Your shareowner communities support management’s vision. Individuals who buy their shares directly from you have made their own decision to invest, not because of a broker’s recommendation. They are joining your founders as shareowners, not just buying a financial instrument as an impersonal investment. Hostile tender offers or proxy solicitations are not likely to attract them. They can be marshaled to assist the business in issues involving customers, government agencies or the media.
7. Individual shareowners require less management time. Individuals do not expect to tell management how to run the business. Nor do they seek selective disclosure of nonpublic information by quizzing management, unlike institutional money managers, who demand frequent CEO/CFO telephone interviews, in-person road shows and special reports. Executives of companies that have marketed shares directly to individuals have found they spend a fourth as much time on shareowner communications as their institutionally-owned peers.
8. You can use direct purchase plans to maintain market demand. People who invest through brokers generally view it as a single transaction rather than a continuous process. You can have a program for monthly share purchases through direct debits to the shareowner’s designated bank account.
9. Cost of capital will be lower with a DPO. Transaction costs in a DPO are generally half or less than an underwritten public offering. More significant, your offering price and number of shares offered are determined by the board of directors, rather than by a securities broker-dealer whose primary interest may be serving its buy-side customers with underpriced shares.
10. DPOs don’t create shareowner veto powers. Institutional investors, who dominate the underwritten offering market, have recently made demands on CEOs and directors about how they run the business. Private financings, such as venture capital or “angel” investors, include covenants in the investment documents to restrict management. When individuals buy in a direct public offering, they don’t expect to interfere in management.
Why a DPO is good for society in general:
1. Direct share ownership increases democracy in business. Much more of what affects our lives now emanates from business, rather than from government. Yet, most “publicly-owned” businesses are actually controlled by a small group of professional money managers, using funds gathered from the public through retirement plans, insurance, public charities and mutual funds.
2. DPOs cause a natural selection of businesses, so they reflect shared values. Institutional money managers base their investment decisions upon limited risk/reward analyses about expected short-term share price performance. We have seen that individuals invest in DPOs for dual motives: They do the same risk/reward study (generally for a much longer term). But they also involve their social and moral values in deciding whether they want to support this business. Over time, surviving businesses will reflect society’s shared values.
3. Individual shareownership provides better corporate direction. The objectives of the “investment community” of brokers and money managers are different from the objectives of customers, employees, neighbors and other members of a business-based community. Direct ownership helps people learn about business from the viewpoint of an owner, not just a consumer and employee. They add a much broader perspective for management.
4. Direct share ownership can free individuals from wage dependence. The path to financial independence can be a long, slow one with diversified managed investments, like retirement plans and mutual funds. In contrast, economic security frequently happens from the ownership of shares in one or two companies, through investment or employee stock options. DPOs can bring financial independence to early investors, so that they can contribute their time, experience and wisdom without needing a salary.
5. Direct shareownership provides a sense of power. There is a frustration that comes from evidence that business controls governments, universities, think tanks and other powerful institutions. Owning some shares, being able to vote for directors, participating in annual meetings—these can provide some sense that individuals can ultimately change the values and actions of business.
6. Direct shareownership relieves the sense of alienation. Most of us have an “us against them” attitude about business. It may be the workers against the bosses or the powerless many versus the powerful elite. Owning shares creates a sense of community, in the context of a business.
7. DPOs create new wealth, reversing the continuing concentration. Ownership of capital has evolved into smaller and smaller percentages of the population, especially in the last few years. Some broadening of ownership has come from employee stock options, which have made multimillionaires of a few thousand former wage earners. DPOs bring that opportunity to individuals who pick the right early stage company.
8. Businesses can survive that don’t fit the traditional mold. Access to capital is usually a test of conformity. Venture capitalists, bank loan officers, government small business program administrators, even “angel” investors tend to have conscious and unconscious standards that cause them to reject business concepts and entrepreneurs who are too different from the norm of their experiences. DPOs allow people with new ideas to find others like them and join together in ownership.
9. Owning shares directly allows people to vote with their capital. So many of us question whether our political votes mean much at all. Through DPOs we can use some discretionary capital to vote for a business concept, or a management team that may be effective in doing the right thing, as we believe that to be. Our investment may be small, but DPOs bring together like-minded people, so that together we can make a difference.
10. The ability to attract capital from individuals will be a competitive tool. DPOs of corporate shares are the lowest cost, permanent capital available. Businesses that can do DPOs to meet their objectives will succeed over those who must rely on traditional sources.
(We have thought that DPOs would catch on if a high-profile business used the concept, so I’ve tried to recruit some very public opportunities to demonstrate how a direct public offering could work. The companies have had communities of many thousand true believers. They have had great stories and colorful leaders. One was the Chrysler Corporation in 1979, the first time the federal government was asked to use taxpayer money to keep the carmaker out of bankruptcy. Lee Iacocca had just been hired to sell its cars and turn the business around. I wrote him and Chrysler board members, explaining how a direct public offering of shareownership to Chrysler’s “true believers” would raise the $1.5 billion that eventually came from taxpayer-guaranteed loans. I never heard back, but it’s been fun to imagine what Chrysler’s path might have been the last 30 years with more than a million active individual shareowners.
Another “might have been” is Google. Its 2004 IPO had been the subject of comments and competition for years before it happened. Would it be a traditional underwritten public offering? Who would be the managing underwriters? What innovations could Google force onto the process? The final outcome was a “modified Dutch auction.” Google set the minimum bid price and the total number of shares being offered. Anyone could bid to purchase a number of shares at a price per share. Bids were accepted, starting with the highest price bid and proceeding down, until the total number offered were included. All accepted bids were then at a price equal to the lowest accepted bid. The modification came in Google’s last minute decision to price the offering even lower than the formula result.
I sent Google a letter in 2001 with reasons why it should do a direct public offering. There was no reply and, given what Google has done as a public company, we can see why our arguments would not have been persuasive. Here are the points from the letter:
You don’t have to turn over control of your public offering. In a DPO:
• You control the timing. Individuals who already believe in Google will purchase all of the shares you wish to offer, whenever you choose to offer them. You don’t have to fit through a “window of opportunity” defined by money managers and investment bankers.
• You control the amount offered. Why sell $100 million in an initial offering, when your need for cash and for share liquidity could be met with a much smaller offering? Direct offerings can be made to match operating needs, avoiding the pressure to invest excess cash. Dilution can be reduced by a series of offerings, each priced to reflect increasing value.
• You control the pricing. Because you’re Google, all of the shares you offer will be purchased, almost regardless of the price. Your board can set the price in a direct public offering, based upon a pricing analysis that is free from the drama of the first-day “pop” and the need to present favored professionals with trading profits.
• You control with whom you share ownership. Direct public offerings are purchased by individuals who already have a relationship with the business. The average investment is about $1,000. Shareownership would reinforce the community you have created.
• You control who joins your management. You do not have to “put in place financial managers and processes that resonate with Wall Street,” in the words of the current Business Week article. With direct public offerings, your board can continue to use its own experience and wisdom.
• You control the offering process. Your direct offering can be designed, staffed and implemented under your direction. Communications with investors will be electronic, without the road shows, one-on-ones and unexpected diversion of management time and resources. You don’t have to compromise your way of doing business to go public. In a DPO:
• You are relieved from the pressure for quarterly performance and comparison with analyst-defined peer groups. People who use your services will invest because they have watched an excellent team prove itself in an extremely competitive environment. They have no short-term expectations.
• You will have a much more
stable aftermarket price. Volatility is very much
affected by having large blocs of shares held by professional
money managers who act alike. After a direct offering, you
will have thousands of individuals, holding small amounts each,
with long-term objectives and making their own independent
decisions. (On the myth that you need an underwriting to
have an exchange listing: “We
find, however, limited evidence that a listing on any of the
major global exchanges brings an advantage in valuation or
liquidity.” [David Cogman and Michael Poon, “Choosing where to
list your company: How much does choice of listing
location matter? Investors will follow good companies no matter
where they list, McKinsey Quarterly, February 2012] )
• You will have far less concern over shareholder litigation. Sudden share price drops create the profit in shareholder class actions. Market prices after direct offerings have moved gradually, even upon very negative news. Because you have managed your own offering, you will not be attacked for claimed abuses in the distribution of shares.
• You will be free from interference with management decisions. Individuals who have invested small amounts do not expect any participation beyond the annual shareowners’ meeting. You will not be threatened with analyst downgrades or major sales if you ignore recommended mergers, acquisitions, alliances or policy shifts into the latest trend.
• You will spend far less
time servicing shareowners. Direct purchases will
include an election to receive all communications from you by
posting on your website and email. Your
Facebook, the social networking site, created a lot of attention from speculation about how it would do its IPO. One reporter said Facebook "is consciously trying to out-Google Google" by signaling it may eliminate investment bankers in its inititial public offering. Facebook's CFO had reportedly met with buy-side fund managers about doing a $10 billion direct public offering, alfthough some say it was an attempt to negotiate an underwriting fee lower than Google's 2.8%. [Randall Smith, "Facebook Could Shun the Street," The Wall Street Journal, November 30, 2011, page C3, quoting Max Wolff, chief economist of GreenCrest Capital Management LLC] The Money & Investing editor of The Wall Street Journal has written that: "By virtue of its size, business model and popularity, Facebook is the rare company that doesn't need Wall Street to go public. It should press home the advantage and blaze a trail for others to follow." [Francesco Guerrera, "Facebook's $10 Billion Question," Current Account, The Wall Street Journal, December 13, 2011, page C1, C2] When Facebook filed with the SEC, however, it was for a conventional Wall Street underwriting, where the shares "will be divvied up among the best customers of" the six broker-dealers, who "will set the ilnitial trading price and rig it to jump up nicely on the first day of trading--handing their clients a sweet, guaranteed return. Only then will Joe Investor (a designation that includes most of Facebook's 845 million users) get a chance to buy a piece of the social network . . .." The result? "But even tech companies that claim they will resist outside pressure soon find that the demands of Wall Street are as inexorable as gravity. . . . Whether it likes it or not, Facebook will now be accountable to a lot of people who do not share its values." [Brad Stone, "Friends With Benefits," Bloomberg Businessweek, February 6-12, 2012, pages 10, 11, http://www.businessweek.com/magazine/facebook-wall-street-friends-with-benefits-02012012.html]
Microlending as an organized process began with Muhammed Yunus and his founding of the Grameen Bank. “Grameen” stands for “community” and the bank is still today more than 90% owned by its borrowers. The very small loans are usually to create entrepreneurs from the working poor. Information on a continuing basis about microfinance, with several stories a day, can be gathered from Micro Capital [www.microcapital.org. See also Elaine L. Edgcomb and Joyce A. Klein, Opening Opportunities, Building Ownership: Fulfilling the Promise of Microenterprise in the United States, Aspen Institute, 2005, http://fieldus.org/Publications/FulfillingthePromise.pdf and http://fieldus.org/index.html]
Microlending changed dramatically after The
Nobel Peace Prize was awarded in 2006 to Grameen Bank and
Muhammed Yunus. Suddenly, financial intermediaries saw the
opportunities in the high returns and low default rates of
microlending. It was the same story as with venture
capital investing in the 1980s. New for-profit funds were
created. Portfolios of microloans were sold as collateralized
loan obligations. Microlending grew at 50% a year
from 2006 into 2009. [Eric Bellman, “
As microlending caught on and seemingly
everyone jumped in, there have been abuses. Some of the
new lenders have ignored the community support side of the
Grameen model, charged much higher interest rates and enforced
payment in unlawful and physically dangerous ways. Some of
the borrowers have gotten loans from several microlenders,
taking on more debt than they can repay. [Ruth David, "In
a Microfinance Boom, Echoes of Subprime," Bloomberg
Where will Microfinance fit with the established financial intermediaries? A report from the leading consulting firm to big business “argues that the time is right for banks to step up their efforts to serve micro-, small and medium-sized enterprises (MSMEs) in emerging markets.” Following the practices recommended in the Report “could raise profits after tax from ~$50 to ~$130 million per annum.”[Mutsa Chironga, Jacob Dahl, Tony Goland, Gary Pinshaw and Marnus Sonnekus, Micro-, small and medium-sized enterprises in emerging markets: how banks can grasp a $350 billion opportunity, McKinsey & Company, April 2012, Executive Summary, pages 1, 2, http://www.mckinsey.com/clientservice/Financial_Services/Knowledge_Highlights/Recent_Reports/~/media/Reports/Financial_Services/MSME_Banking.ashx]
Bill and Melinda Gates Foundation gave $19.4 million to Mercy
Corps to create a “bank of banks” to work with the more than
50,000 microfinance institutions in Indonesia, to test
whether “linking diverse and small financial institutions
together is a commercially viable and effective way to make
savings, loans and other products more widely available to the
poorest people." [Bob Christen, Director of Financial Services
for the Poor at the Bill & Melinda Gates Foundation, at
to The Wall Street Journal, the Gates Foundation is
testing whether “commercial enterprises—banks and other
profit-seeking businesses—can best serve the broadest swath of
people by using tools such as capital markets to fund
expansion.” [Robert A. Guth, “Giving a
The nonprofit Accion International has established its Center for Financial Inclusion, "to advance the commercial model of microfinance while upholding the interests and needs of poor clients worldwide. . . .to connect the microfinance community with the major drivers of the global economy – e.g. capital markets and technology – and harness their capabilities to address the financial needs of poor people." http://centerforfinancialinclusionblog.wordpress.com/center-for-financial-inclusion/
While microlending is being pursued by financial intermediaries and charitable institutions, others are working to keep both the lending and the source of funds within the community. One way is to provide a method for community members to save. The Consultative Group to Assist the Poor has found that “savings accounts in financial institutions serving the poor outnumber microloan accounts seven to one.” [www.cgap.org/p/site/c/aboutus/] Executives of the Grameen Foundation have said: “Well-designed savings products help clients plan for the future, create new business products for MFIs (microfinance institutions), and mobilize additional capital for MFIs. For even the very poorest, for whom many credit products currently being offered by MFIs may not be appropriate, savings may be a useful tool to help them access financial services.” [Alex Counts, President and CEO of the Grameen Foundation and Patrick Meriweather, its Director of Business Development, New Frontiers in Micro Savings, March 2008, [www.grameenfoundation.org/pubdownload/dl.php?pubID=58]
Grameen Bank has shown how a microlender
can be free of dependence upon outside funding. Muhammad
Yunus responded to an interviewer’s question about the
difference between philanthropy and the Grameen Bank: “We
stopped taking any external money in 1995. . . . But earlier,
when donors wanted to give us money, we were always swayed and
took the money. If donors hadn’t given us the money, we
would have discovered earlier that we have the strength.
If it’s a business, it should be running as a business.” [Business
But Wall Street and big charities are still trying to adapt
microlending to the financial intermediary mode. Wall
Street is well on its way to ruining one of the greatest
programs for making capitalists from the world’s poorest.
[Ketaki Gokhale, “A Global Surge in Tiny Loans Spurs Credit
Bubble in a Slum,” The Wall Street Journal,
Which way will become the microfinance paradigm? One
participant suggests that
there will be three paths, "straight commercial funds that
obey the rules of the marketplace, social investment funds that
explicitly combine social and financial aims, and pure grants. .
. . Like any other donation or investment, a little research and
due diligence beforehand can bring assurance that funders and
those they entrust with their money share the same goals."
[Elisabeth Rhyne, Managing Director of ACCION's Center for
Financial Inclusion, "Funding the Risk Frontier in
Microfinance," The Huffington Post,
An important barrier to buying directly
from the issuer is the fear that the securities will not have a
ready market when there is a need or desire to sell.
Some new stock trading markets have been created for
smaller businesses. The Alternative Investment Market,
started by the London Stock Exchange in 1995, has listed over
3,000 "smaller and growing companies." [http://www.londonstockexchange.com/companies-and-advisors/aim/aim/aim.htm]
In 2009, Chinese regulators started ChiNext,
"tailor-made for the needs
of enterprises engaged in independent innovation and other
growing venture enterprises."
ChiNext operates within the Shenzhen Stock Exchange and had 141
listings in December 2010, while the Small and Medium Enterprise
Board had 518 listings. [http://www.szse.cn/main/en/]
Since at least the 1950s, many
individual securities brokers have maintained "matching
services" for trading in local banks and other businesses.
They keep a list of people who have expressed interest in
selling and those who say they'd like to buy shares. When
they have a match, the brokers arrange for the transfer and
payment. Their motive is usually to develop local customer
Since at least the 1950s, many individual securities brokers have maintained "matching services" for trading in local banks and other businesses. They keep a list of people who have expressed interest in selling and those who say they'd like to buy shares. When they have a match, the brokers arrange for the transfer and payment. Their motive is usually to develop local customer relationships.
In the last two or three years, some
registered securities broker-dealers have begun operating
matching services for much larger companies that have not yet had their
initial public offering. The services allow employees and
early investors to cash out, selling to people who want to buy
in before the IPO. The companies, and the
These matching service markets would get a boost from the
Private Company Flexibility and Growth Act (HR 2167), introduced
Brazilian marketing consultant Cecco Grecco
persuaded Bovespa, the Sao Paulo Stock Exchange to sponsor a
Social and Environmental Stock Exchange. (www.bovespasocial.com.br/institucional/home.aspx)
It is not really a trading market. Rather, it operates
more like the P2P social lending sites. Charitable
organizations submit their funding proposals to a team of
evaluators, who review plans, interview principals and make site
visits. The one in ten that passes this inspection is then
listed. Donors can choose to contribute toward the amount
posted. [“A Stock Exchange for Do-Gooders,” Mac Margolis,
(In watching the havoc caused by mortgage
securities and their derivatives, I often indulge in a couple of
“what ifs” from my own experience. One was the effort to
create the Automated Mortgage Market Information Network
(Amminet.) My client, Remote Computing Corporation, was
hired in the early 1970s to design and host a computer program
for trading in mortgages. The project was sponsored and
funded by the federal government agencies and
government-sponsored entities in housing finance. The
concept was that mortgage lenders would post information about
packages of loans they were willing to sell. Money
managers for funds could access the data on a computer terminal
and use the telephone to negotiate and arrange
to buy mortgages. This was about the same time as the
National Association of Securities Dealers Automated Quotation
(Nasdaq) System was started. It was initially just an
electronic way for a securities dealer to post the prices at
which they were willing to buy or sell a company’s shares.
Transactions would be negotiated by telephone. Today,
Nasdaq is a full electronic stock exchange. Amminet could
have developed the same way, as the Internet and other
technological advances made it possible, except there would have
been no broker in between the buyers and sellers. As I recall, the Amminet program met
resistance and ran aground. If it had been allowed to
operate, perhaps an active trading market would have preempted
all the mortgage securities games that Wall Street ran into a
huge catastrophe. This was all 15 years before the
Internet. Remote Computing Corporation’s business
model is now coming back as “cloud computing.” [Steve
(The other “what if” was the Mortgage Trust Certificate. My client was Coast Federal Savings and Loan Association, which was one of the largest S&Ls in the late ‘70s. Mortgage securities were in their infancy and Wall Street had not yet put together the Collateralized Mortgage Obligations that became tools of such mass abuse. Our objective was to build a direct relationship between mortgage lenders and pension fund managers. We would match the income and cash flow needs of pension funds with the return and payment projections of a pool of mortgages. In those days, the mortgages made by S&Ls were tightly regulated and losses were negligible. We got a mathematical consulting group to prepare the tools for matching mortgage pools to pension fund projections. We generated interest from fund managers but needed a triple-A rating from S&P or Moody’s to get immediate and widespread acceptance. The rating agencies were willing but we’d need a guarantee or credit default insurance from an AAA-rated corporation. We met with two of them. Maybe it would have worked eventually, but commitment waned at that stage and the opportunity went by.)
Whenever there is a “sale” of a “security,” the
The regulators and the courts have interpreted “sale” and “security” very, very broadly. That’s not just to enlarge their turf. The cases that present the question usually come from complaints by investors claiming fraud. The alleged perpetrators are claiming that they weren’t selling securities, so they can’t be forced to comply with securities regulation.
How can a legitimate business raise money from strangers without all the securities law hurdles? One of the most creative alternate routes is Kickstarter, started in April 2009. It is a website through which “project creators” offer products, services or “rewards” to “inspire people to support their project.” The site states flat out that it is not an “investment mechanism,” that project creators “keep 100% ownership and control.” [www.kickstarter.com/learn-more] The project creators set an amount of money which must be pledged by a fixed date. If the goal is met, the pledges are charged through Amazon to credit cards and the project creator receives the funds. If not, no one pays anything. Kickstarter takes a 5% fee if the project is funded. By mid-2010, over $1.5 million had been pledged among 5,000 projects on the Kickstarter site. [John Tozzi, "Eight Companies Kick-Started by Fans," Bloomberg Businessweek, June 28-July 4, 2010 page43]
Kickstarter’s suggestions to project
creators include: “The key to a successful
project is asking your networks, audience, friends and family
for help. Kickstarter is a tool that can turn your networks into
your patrons; it is not a source of funding on its own. Rewards are very
important. Offer something of real value for a fair price. And
more experiential rewards, things that loop backers into the
story, are incredibly powerful.”[http://blog.kickstarter.com/post/172227888/where-invites-come-from]
“Kickstarter has emerged as a legitimate option
for financing independent films, where a six-figure project is
on the low end. So far, the company has raised more than $21
million from nearly 240,000 backers for 2,443 films, according
to co-founder Yancey Strickler. He says six films have crossed
the $100,000 mark.” The financings have also
“created a fan base for the film.” [Ira Boudway, “Kickstarter:
Financing Small Movies Online,” Bloomberg Businessweek,
The simplicity of the Kickstarter program
is all the more admirable, given the complexity of the
securities laws, which protect the turf of the securities
broker-dealer monopoly. We have described “dual motive”
investing, where individuals are offered the satisfaction of
furthering their beliefs and values, while also getting a
possible financial return. Kickstarter caters to the first
motive only, expressly disclaiming any investment payback.
Individuals can help someone they like achieve a goal in which
they believe. There may also be the fantasy that, if the
project and creator are successful, they may be on the inside
track to participate as an investor. The possibility of
that motivation is certainly not enough to turn the Kickstarter
program into an investment, anymore than charity drives are when
they offer prestige and visibility to their donors. An
author of several books, in an article about self-publishing,
commented: “If I need to cover upfront costs,
I can always wage a modest campaign on the grassroots online
fund-raising phenomenon Kickstarter, which has worked for me
before.” [Neal Pollack, “Peddling Your
Prose,” The New York Times Book Review,
There will be more direct routes opening as Wall Street has become even less accessible by individuals and small businesses. “When the systems break down, it sometimes falls on the do-it-yourselfers to do what they need to do.” [Frank Silverstein, Producer of MSNBC’s “Your Business,” in an October 2008 email to me.] Some of the new routes will survive attacks from Wall Street and the traffic cops who protect Wall Street. As the head of one alternative to Wall Street predicted:
“It may take ten years, or fifty years, but
the signs are clear. A relative few committed investors are
driving the shift to an entirely new approach to working with
”If today's capital markets can be described as complex, opaque, and anonymous - based on short-term outcomes, we are beginning to see more and more financial transactions that are direct, transparent, and personal-based on long-term relationships.” [Don Shaffer, President & CEO of RSF Social Finance, “Notes From the Leading Edge of Social Finance,” GreenMoney Journal, Spring 2010, www.greenmoneyjournal.com/article.mpl?newsletterid=45&articleid=619]
Plenty of government departments have been set up to police Wall Street. The problem is that they operate like the old protection racket—“We’ll let you get away with doing wrong—and we’ll chase away your competitors—if you pay us off.” For elected officials, the payoff is campaign contributions and other favors. For government employees, it is the offer of high-paying jobs after they’ve put in their time in “public service.” David Stockman, former budget director for President Reagan, said in a January 20, 2012 interview with Bill Moyers: “We now have an entitled class of Wall Street financiers and of corporate CEOs who believe the government is there to do . . . whatever it takes in order to keep the game going and their stock price moving upward,” [http://billmoyers.com/segment/david-stockman-on-crony-capitalism. See, also, GMoyers & Company Show 103: How power and influence helped big banks rewrite the rules of our economy. from BillMoyers.com on Vimeo.
It’s not a new issue. President Andrew Jackson complained in 1833 that a banking corporation “had been actively engaged in attempting to influence the elections of the public officers by means of its money” and asked “whether the people of the United States are to govern through representatives chosen by their unbiased suffrages or whether the money and power of a great corporation are to be secretly exerted to influence their judgment and control their decisions.” [http://millercenter.org/scripps/archive/speeches/detail/3640] Currently, we have this from Arthur Levitt, founder of a Wall Street firm and former Chairman of the SEC: "I don't know of a single member of Congress who is willing to resist the seductions of money and campaign contributions and the kind of flattery that comes from those who have special interests.
President Woodrow Wilson described the problem: “We have been dreading all along the time when the combined power of high finance will be greater than the power of government. . . . If the government is to tell big business men how to run their business, then don’t you see that big business men have to get closer to the government than even they are now? Don’t you see that they must capture the government, in order not to be restrained too much by it? Must capture the government? They have already captured it. . . . Nevertheless, it is an intolerable thing that the government of the republic should have got so far out of the hands of the people; should have been captured by interests which are special and not general. In the train of this capture follow the troops of scandals, wrongs, indecencies with which our politics swarm." [Woodrow Wilson, The New Freedom: A Call for the Emancipation of the Generous Energies of a People, BiblioBazaar, 2007, pages 102, 23]
President Franklin Roosevelt put it most colorfully: "For out of this modern civilization economic royalists carved new dynasties. New kingdoms were built upon concentration of control over material things. Through new uses of corporations, banks and securities, new machinery of industry and agriculture, of labor and capital—all undreamed of by the fathers—the whole structure of modern life was impressed into this royal service. There was no place among this royalty for our many thousands of small business men and merchants who sought to make a worthy use of the American system of initiative and profit. They were no more free than the worker or the farmer." [http://www.presidency.ucsb.edu/ws/index.php?pid=15314]
George Stigler, a Nobel Prize Laureate in
economics, built a career on the study of this “capture theory” of
economic regulation. His central thesis is that “as a rule,
regulation is acquired by the industry and is designed and operated
primarily for its benefit.” [George Stigler, The Theory of
Economic Regulation, University of Chicago, The Rand
Corporation, 1971, p. 3. See, also, George J. Stigler, “The
Theory of Economic Regulation,” The Bell Journal of Economics and
Management Science, 1971,
At the level of the individual elected or appointed official:
"Nearly everyone in government has 'clients' to protect or advance,
sponsors who often helped put them there." [William Greider,
Who Will Tell the People: The Betrayal of American Democracy,
Simon & Schuster, 1992, page 66. On page 258, Greider
writes: "If one
asks, for instance, why the Democratic party never did anything
during the 1980s to confront the various abuses and instabilities
unfolding in the financial system, a power analysis of the party
establishment might provide the answer. . . . The nation's leading
banks and brokerages have assembled a formidable team of Democrats
to protect them from hostile legislation [listing the names]."]
The regulated industry "owns" its regulatory agency, while industry
members and lobbyists "own" the individual regulators and
Part of a protection racket, or capture theory,
is for everyone involved to deny what is really going on and to have
a consistent cover story. That cover story needs to say that
what’s happening is a legitimate activity, one that we all need;
that it’s true there have been some rogue participants but we’re
taking care of them. Simon Johnson and James Dwak call this
"cultural capital: the spread and ultimate victory of the idea that
a large, sophisticated financial sector is good for
Wall Street should be a place where ethics prevails. Its people are trusted with moving huge amounts of money in complex, secretive transactions. It would seem that the most honest and fair individuals and firms would also be the most successful. It doesn’t work that way. Whatever ethical standards may have become a person’s character seem to be shed by the time they are in a Wall Street career, like a snake wiggling out of its skin. What replaces those discarded ethics are rules. Instead of guidance from within, life becomes governed by external stop lights, flashing go, stop and proceed with caution. The question asked before taking action is not, “Is this right?” It has become, first, “What’s in it for me?” Then, “Is this permitted?” and, if not, “Will I get caught?”
From the beginning, securities regulation has
not been about safeguarding the public. Emphasis has always
been placed on protecting the financial intermediaries from
competition. “A statute of Edward I, in 1285, authorized the
Court of Aldermen to license brokers in the City of
Also just like today, the government in
In the same year we created the
When the government was unable to stop the
Panic of 1907, Treasury Secretary George Cortelyou traveled to
When J.P. Morgan died in 1913, Congress
replaced him by creating the Federal Reserve Board and its regional
banks. The Fed operates as a fourth branch of government,
owned by its members, which now include Wall Street investment
banks. Its powers are immense, affecting the economic lives of
everyone on the planet. The law has given Wall Street the
power of the
Wall Street justifies its existence as being necessary to transform customers’ available cash into loans and securities, which provide money to businesses and governments. Like any other intermediary, it needs to have a profitable spread between the cost of the money it acquires and the return on the money it provides. That spread is not always available in the open market. That’s where the Federal Reserve comes in. The Fed has a bottomless supply of money and it has the power to set whatever interest rate it wants. So all it has to do is to make that money available to its member banks, at a price that allows the banks to make a profit. They can even make a profit simply by lending the money back to the federal government, through purchasing Treasury securities.
This recycling of taxpayer money, with Wall
Street siphoning off its percentage, has immense consequences for
the rest of us. By keeping short-term interest rates
artificially low, and Fed borrowings plentiful, banks don’t need to
pay individuals higher rates to get their money in deposits.
That’s nice for the banks, but what about all the individuals who
rely on interest income from insured bank deposits for their rent
and groceries? "When they say the economy, they mean—the Fed
means its constituency: the banks. And the banks’ product is debt.
And that’s what they’re trying to produce." [Michael Hudson,
Amy Goodman and Juan Gonzalez, “Fed Creates Hundreds of Billions Out
of Thin Air: Have We Launched an Economic War on the of the
radio interview transcription at
Low interest rates also mean that insurance companies and pension
funds earn less from the reserves they keep in bonds, causing higher
insurance premiums for households and funding shortfalls for their
pensions. [Matthew Philips and Dakin Campbell, "The Hidden
Burden of Ultra-Low Interest Rates," Bloomberg Businessweek,
February 6-12, 2012, page 45] Wall Street's clients are big businesses and Federal Reserve
policy is implemented to make big businesses increase their bank
borrowings and bond issues, while minimizing their default rate.
It doesn't seem to matter if the Fed's actions ignore, or harm
individuals and small
business. [Scott Shane, "QE2 Will do Little to Help Small
Business," Bloomberg Businessweek,
The only member of the Fed’s Open Market
Committee who consistently dissents from keeping interest rates even
lower than inflation levels is Thomas Hoenig, president of the
Kansas City Federal Reserve Bank, who says: “I really don’t
think we should be guaranteeing Wall Street a margin by guaranteeing
them a zero or near zero interest rate environment. . . . [T]he
For a prospective investor, becoming a partner in a business is a major, potentially life-changing decision. Even a small investment as a partner has the effect of putting all of one’s eggs into a single basket. The new partner’s entire property and future income could be taken away if the partnership were to go under and creditors come after the partners personally. Then there is the issue of management. In a general partnership, the law giesall partners equal votes, no matter how active they are in management. There is no weighting for how large or small their investment may be. Finally, ownership interests in partnerships are hard to sell. Without some special agreement, anyone buying a partnership interest can’t become a partner without the consent of all the other partners. Because of the unlimited liability feature, no one in their right mind would become a partner in a business without a thorough investigation of the other partners.
To meet these weaknesses in partnership investing, the corporation evolved from the charters that had been granted by kings and queens “to pursue their dreams of imperial expansion.” It “brought together the three big ideas behind the modern company: that it could be an ‘artificial person,’ with the same ability to do business as a real person; that it could issue tradable shares to any number of investors; and that those investors could have limited liability (so they could lose only the money they had committed to the firm).” [John Micklethwait and Adrian Wooldridge, The Company: A Short History of a Revolutionary Idea, The Modern Library, 2003, pages xvi, xvii]
It was the use of corporations that made Wall Street possible. Well into the 1800s, most American businesses, even large ones, were conducted as partnerships. Raising money to finance partnerships was a very personal matter. Bringing in a new partner meant letting someone else become part of top management, since each partner must approve any serious business decision. It also meant that all the partners had their entire personal wealth open to being taken away by creditors of the partnership. One big mistake in judgment by a single partner could bankrupt every one of the partners.
Selling a partnership interest could be nearly impossible, since the buyer had to be accepted by the other partners and the new partner could be blindsided by personal liability for what the partnership may have done in the past. This meant there was little room for a Wall Street intermediary in selecting and approving a new partner. By contrast, corporate shareowners have no personal liability—they can only lose the amount they paid for their shares. Those shares are freely tradable and corporate managers don’t much care who owns shares in the corporation.
Wall Street makes most of its profit from trading in corporate securities. It collects commissions for finding buyers for newly issued shares and makes far more by operating a trading market for the shares. Even greater profits have come from manufacturing and trading in derivative instruments based upon corporate securities. Wall Street had a great interest in having corporations be the entity of choice for all business ventures.
The federal government has mostly stayed away from chartering corporations, leaving that prerogative to the states after James Madison, at the Constitutional Convention, tried to include chartering corporations in the powers of the federal government. At first, state governments had serious public policy standards for granting a business the right to operate as a corporation. In exchange for letting investors escape personal liability, and giving them free transferability of their investments, the states granted corporate charters only for specific business purposes. The initial charters would expire in a few years and would not be renewed if the conditions had been ignored.
Corporations are still created by state
governments today, except for a few special industries that need
federal charters. Competition among the states for
incorporation fee revenues led to what has been called
“chartermongering,” a “race to the bottom” in permissiveness for
corporate management. [Thom Hartman, Unequal Protection:
The Rise of Corporate Dominance and the Theft of Human Rights,
Berrett-Koehler Publishers, Inc. 2002, page 134] The first
corporate charters were limited to a specific purpose, for a term of
just a few years, and could be revoked if management stepped outside
the granted authority. By the early 1900s, some state
legislatures could still terminate corporations for failing to
comply with their responsibilities. After a few more years of
lobbying state legislatures, a corporation could engage in “any
lawful business” and for a perpetual term. [John Micklethwait
and Adrian Wooldridge, The Company: A Short History of a
Revolutionary Idea, The Modern Library, 2003, page 46]
While state governments were accommodating Wall
Street by removing restrictions on the use of corporations, the
United States Supreme Court kept defining corporate powers and
protections to be more and more like those of human citizens,
beginning with the Dartmouth College case in 1819 [www.law.cornell.edu/supct/html/historics/USSC_CR_0017_0518_ZS.html]
through to the Citizens United case in 2010. [www.scotuswiki.com/index.php?title=Citizens_United_v._Federal_Election_Commission#Decision]
One of the most useful in permitting corporate misbehavior is the
right of corporations to invoke the attorney-client privilege.
[Mark W. Everson, former I.R.S. Commissioner, “Lawyers and
Accountants Once Put Integrity First,” The New York Times,
These parallel government actions, by the state
legislatures and U.S. Supreme Court, gave Wall Street the feedstock
it needed to become
In the years just before and just after 1900, Wall Street built its basic meal ticket by consolidating thousands of businesses into a few large corporations. In addition to the fees generated by effecting the mergers and placing securities, trading commissions came as markets were created for millions of shares of common stock issued in the consolidated corporations. From the perspective of most Americans, the result was the disappearance of competitors in several industries. Their elected representatives responded to the voter uproar with an attack on monopolies, like the Steel Trust, the Sugar Trust and the Money Trust. The focus of alarm was on efforts to pass and enforce antitrust laws. Only later would attention turn to the role of Wall Street in arranging the monopolizations and issuing the securities to carry them out.
The tool that Wall Street used in creating the
giant corporations was the ability to grossly overpay for the
businesses being merged.
Many of the businesses incorporated in the boom years after the Civil War had become owned by the children and grandchildren of their founders. These later generations were often happy to exchange their shareownership for spending money and financial security. Since Wall Street brokers had exclusive access to the stock trading markets, they were paid for selling shares in the new holding companies exchanged for the inherited businesses. Buyers in the new holding companies weren’t concerned that they were paying for watered stock. They were counting on the gain from owning a monopoly business.
The practice of watering the stock is said to have been brought to Wall Street by Daniel Drew, who had been a cattle drover before he took up corporate finance. He would feed his cattle salt as he drove them to the market, not letting them drink until just before he arrived. They weighed in freshly bloated with water and sold for more than they would have otherwise been worth. He carried the same technique over to issuing stock in amounts well over the value of the business. Government and the media set up watered stock as the evil that came from the corporate consolidations, one “that proved, in the end, to be a red herring that diverted them from their main task in the long struggle to regulate competition and protect consumers from monopolies. . . . While reformers’ attention was diverted, overcapitalization during the merger wave created the modern stock market. . . . The problem of overcapitalization is a key to the triumph of finance over industry and to the shape that regulatory efforts to control giant corporations took.” [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2007, pages 59, 60]
The first big government investigation of investment banking came from the Industrial Commission, appointed by President McKinley and active from 1898 to 1902. It looked at the practice of combining several businesses into a new corporation and selling its securities to the public. The Commission found that the price to the public was far greater than the value of the assets, referring to it as “watered stock.” No action was taken. The government’s reaction to Wall Street’s drive to merge entire industries into one big corporation continued to focus on overcapitalization—the issuance of more shares in the new corporate giants than could be matched to the value of the businesses acquired. This was seen as leading to monopolies, as competitors were absorbed into the dominant corporations in each industry. Congress saw the culprit as the state incorporation laws that had been changed to permit overcapitalization and, as a result, the solution proposed was to preempt the state laws by requiring federal corporate chartering of every business operating beyond a single state. One federal incorporation bill was passed unanimously by the House of Representatives in 1903 but failed to get through the Senate.
No one at the time seemed to realize that Wall Street was building a new industry, one which would create, buy and sell securities. A century later, revenues in the securities industry would far surpass railroads and most manufacturing. At the time, however, the government saw only antitrust and overcapitalization issues. Today, we accept that the market price of a company’s shares will have little relationship to the value of the property it uses in the business. Unfortunately, we also still accept that Wall Street is the monopoly for raising and investing money.
The foundation for Wall Street’s new industry, the stock market, had been vastly expanded by the issuance of common stock by the giant corporations, as they soaked up thousands of competing businesses in major industries. The price of stocks doubled from 1904 to 1906. Then came the Panic of 1907, which many blamed on the Money Trust, “a loosely bound small group of banks and investment banks that controlled the money supply and the New York Stock Exchange.” [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2007, page 219]
President Theodore Roosevelt was the big
trustbuster of the early 1900s and there was much talk about “the
Money Trust.” However, when his administration was unable to
stop the Panic of 1907, he turned to J.P. Morgan, who used his
position as the Godfather of Wall Street to restore financial order.
When the Federal Reserve System was established in 1913, the
publicity said it “was designed to remove some of Wall Street’s
power.” [Robert Sobel, Inside Wall Street: Continuity and
Change in the Financial District, W. W. Norton & Company, 1977,
page 202] Nevertheless, the first president of the Federal
Reserve Bank of
In response to the Panic of 1907, the House Banking and Currency Committee established a subcommittee to investigate the concentration of money and credit. Called the “Money Trust Investigation,” it is also known as the Pujo Committee, after its chairman, Congressman Arsene P. Pujo. The Committee focused on the underwriting syndicate, why it seemed to always include the same investment bankers and why the managing underwriters never tried to take business from another firm’s client. A witness in charge of one of the top firms said that they prefer “to deal with our friends rather than people we do not know,” while another said “we make alliances for the occasion. We have no standing alliances.” [Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970, page 145] Nevertheless, the Committee’s majority found “an established and well-defined identity and community of interest between a few leaders of finance . . . which has resulted in great and rapidly growing concentration of the control of money and credit in the hands of these few men.” [Money Trust Investigation: Report, 129, 133-35, quoted in Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970, page 151] The Committee’s chief counsel, Samuel Untermyer, later wrote: “It is not healthful or desirable that a few banking houses should monopolize the prestige and profit of acting as intermediaries between those who need capital . . . and the investors who are able to supply it. The need should be supplied by a public market for securities.” [Samuel Untermyer, “Speculation on the Stock Exchanges and Public Regulation of the Exchanges,” The American Economic Review, V, supplement, March 1915, pages 224- 68, quoted in Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970, pages 153, 154].
No legislation came from the Money Trust Investigation. After the Committee’s report in 1913, Congress “struggled with ways to curb speculation, especially futures trading, margin buying, short selling and wash sales that by general consensus had turned the nation’s securities markets into gambling dens.” [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2007, page 227] After intense lobbying, Congress did nothing to deal with the problems in the Pujo Committee report. In 1919, bills began to be introduced in Congress to regulate the sale of new securities, including preparation and filing of offering materials with the federal government. All of these efforts were defeated and no serious attempt to restrain Wall Street was to be made until 1933.
The “Roaring 20s” lived up to their name for Wall Street. Liberty Bonds had been marketed with great success in World War I, opening up the middle class to exchanging money for paper investments. What Wall Street did was to divert the new investors away from putting their money into securities issued by governments or real businesses and into securities manufactured on Wall Street. Before the 1930s, the only federal law applying to investment banking was the postal fraud law, which had criminal penalties for swindlers using the mail. [For a description of this period on Wall Street, see John Brooks, Once in Golconda: A True Drama of Wall Street 1920-1928, E.P. Hutton, 1969]
There were more calls for regulation after World War I. The Capital Issues Committee had been reviewing all new issues of securities over $100,000, to protect the success of the Victory Loan program. It recommended that the Federal Trade Commission police the sale of securities. After the War, it unanimously called for supervision of new issues, fearing that the millions of Americans who had been introduced to investing in securities would be exploited. Congress introduced several bills in response to the Committee’s report, but none became law. A series of other bills for regulating securities issues were defeated in the 1920s.
Before the early 1900s, the states all had some regulation of the
securities issued by corporations chartered in their state, but they
had no authority over securities sold to their residents by
businesses incorporated elsewhere. By 1903, states had begun
requiring prospectuses to be filed for offerings made in their
states. In 1911,
Regulation brings trade associations and, in
1912, the Investment Bankers Association of America was created out
of the American Bankers Association. It proposed its own model
state blue sky law, but only
For more than 100 years, our political leaders
have pointed to the concentration of power in Wall Street and the
painful consequences. As early as the 1890s, a popular orator
would rail against “a government of Wall Street, by Wall Street and
for Wall Street.” [Mary Ellen Lease, quoted in Charles Derber,
Corporation Nation: How Corporations are Taking Over Our Lives
and What we Can Do About It,
Some of the strongest language indicting Wall
Street came in the opening paragraphs of Franklin D. Roosevelt’s
inaugural address on
The remedy, FDR said, was “strict supervision of all banking and credits and investments, so that there will be an end to speculation with other people’s money . . ..” [John T. Woolley and Gerhard Peters, The American Presidency Project. Santa Barbara, CA: University of California www.presidency.ucsb.edu/ws/index.php?pid=14473] Just two months later, Roosevelt signed into law the Securities Act of 1933, which had the Federal Trade Commission regulate the sale of new securities. In June came the Banking Act of 1933 (called the Glass-Steagall Act, after its authors), which prevented commercial banks from also underwriting securities. The next year brought the Securities Exchange Act of 1934, requiring registration of securities brokers, dealers and exchanges, as well as regulating their practices. It also established the Securities and Exchange Commission to administer all of the federal securities laws, taking over from the Federal Trade Commission.
The Crash of 1929 had been followed by a continuing decline in share prices for the next two and a half years. By 1932, common stock prices were only ten percent of their 1929 level. A near-disappearance of underwritten new issues reflected the lack of interest in buying corporate shares. Nearly half the Investment Bankers Association membership went out of business by 1933. The Crash also brought Congressional hearings and legislation, including the
• Securities Act of 1933, requiring registration and prospectus standards for new issues of securities,
• Banking Act of 1933, forbidding commercial banks from also being investment banks,
• Securities Exchange Act of 1934, regulating brokers and trading markets, and requiring public reporting by businesses with traded securities,
• Trust Indenture Act of 1939, requiring registration and investor protection tools for bonds,
• Investment Advisors Act of 1940, providing very light regulation of money managers and other persons selling investment advice, and
• Investment Company Act of 1940, regulating mutual funds.
The big victory for investment bankers came from the Banking Act, which forced deposit-taking banks to choose either the business of accepting deposits and making loans or the business of buying and selling securities. The Banking Act also created the Federal Deposit Insurance Corporation, which put the full faith and credit of the United States Government behind consumer-size bank accounts. That guarantee of deposits was hard for a bank to pass up in a time when bank failures had wiped out the life savings of so many. Nearly all of the banks chose to give up underwriting, brokering and dealing in securities, sometimes splitting themselves into two separate businesses.
By 1970, one of the firms that had chosen the securities business described itself this way: “Morgan Stanley is an organization which specializes in basic investment banking services—the raising of debt and equity capital in the domestic and international markets and such closely related activities as general financial advisory services, mergers and acquisitions, and brokerage services for institutions and corporations.” [Morgan Stanley 1970, a book published by the firm.] Wall Street investment bankers had been restored to their monopoly franchise, free of the competition from commercial banks that had plagued them during the 1920s.
Investment bankers and securities brokers won
another major legislative battle in 1938.
During the 1930s, the federal government itself got into competition with investment bankers. The Reconstruction Finance Corporation was started in 1932, under President Hoover, for making loans to businesses which served the national interest. Some of the New Dealers pushed for even greater government involvement in financing business. They blamed the renewed economic decline in 1937 on a “strike of capital” by Wall Street against government reforms. “Throughout the 1930s the RFC was the world’s largest corporation because of the vast amount of money it distributed to industries in need. When war broke out, it became the natural organization to coordinate the war effort through industry. . . . The great inroads made by the RFC in helping finance the war effort were making investment bankers nervous. They were feeling the heat created by the RFC, which was only responding to their own lack of enthusiasm in the first place.” [Charles R. Geisst, Wall Street: A History, Oxford University Press, 1997, page 265] Congress voted to abolish the RFC in 1953.
In financing the second World War, the role of the Treasury in earlier wars was taken over by the Federal Reserve Board, which acted as a managing underwriter. Each of the Federal Reserve Banks coordinated bond sales within its district. No commissions, fees or expenses were paid to the securities industry. The government also took steps to assure the supply of funds that individuals would invest in bonds. President Roosevelt asked consumers to restrain their borrowing and spending, while War bonds were heavily marketed as a contribution to the war effort. Very important was the way the Federal Reserve kept interest rates stable. War usually brings inflation and high interest rates, a real deterrent to bond investors. The Fed stood ready to buy or sell Treasury bills, the shortest term debt, at a three-eights of one percent yield. This kept long-term bonds at about 2.5 percent for the entire War.
President Truman, who held a bias against Wall Street, asked the Federal Reserve to continue its financing efforts through the Korean War, saying “my approach to all these financial questions was . . . to keep the financial capital of the United States in Washington. This is where it belongs—but to keep it there is not always an easy task.” [From Truman’s Memoirs, quoted in Charles R. Geisst, Wall Street: A History, Oxford University Press, 1997, page 269]
According to its website, “The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” [www.sec.gov/about/whatwedo.shtml] Experience shows that its actual mission is to protect Wall Street’s monopoly and to settle turf disputes among Wall Street insiders.
The real reason for setting up the
Bringing the “Money Trust” under FTC supervision had been included in proposed Congressional legislation since the 1920s, but the Investment Bankers Association had successfully lobbied against any of the bills becoming law. The Great Crash in 1929 made it likely that Congress would finally do something about regulating securities issues. Rather than trying to stop the momentum entirely, investment bankers directed their efforts toward getting laws that would work for their benefit.
The Securities Act of 1933, governing the sale
of newly issued securities, put enforcement in the hands of the FTC.
The next year, in the Securities Exchange Act of 1934, investment
bankers got Congress to take that away and to set up the
Policing by the
With its hundreds of lobbyists, and direct connections to Congress, Wall Street was able to hijack the political objective of helping small business raise capital through the new “crowdfunding” phenomenon. The process started with a bill that would exempt offerings of under $10 million from SEC and state securities filings and clearances. That became just one part of the “Jumpstart Our Business Startups Act,” signed into law April 5, 2012. the exempt offering amount was cut to $1 million and a business is forced to hire a broker or "funding portal" registered with the SEC. The other parts of the JOBS Act are ironically titled “Reopening American Capital Markets to Emerging Growth Companies,” which removes several inconveniences for Wall Street and its clients who only have revenues of less than a billion dollars; “Access to Capital for Job Creators,” which allows Wall Street to advertise its offerings to accredited investors; “Small Company Capital Formation,” which raises the size of offerings, from $5 million to $50 million, that can be done with the less restrictive SEC Regulation A, while exempting the offerings if they are to be listed on an exchange or sold to “qualified purchasers:" and “Private Company Flexibility and Growth,” which raises the number of shareowners that a company could have before it had to register and file reports with the SEC and become subject to Sarbanes Oxley restrictions.
The SEC continually says it doesn’t have the money to enforce laws against Wall Street defrauding investors. But money is no limit when it comes to keeping the casino tables working for Wall Street players. The high frequency traders are suspected of manipulating the market through the volume and speed of their trades. They are viewed like card counters at blackjack tables and are serious enemies of "the house," which operates the game. To trace trading in real time, the SEC has proposed a “consolidated audit trail,” at an estimated cost of “about $4 billion upfront and $2.1 billion annually, far exceeding the agency’s 2011 budget of $1.2 billion.” Fees to cover the cost would be collected from exchanges, brokers and the Financial Industry Regulatory Authority. [Scott Patterson, “SEC Pushes Plan For Audit System,” The Wall Street Journal, September 21, 2011, page C1, C3]
For the last 21 years, the
In a particularly flagrant example of protectingits constituency, the SEC violated laws requiring preservation of records when it destroyed the records of investigations that did not result in prosecutions of securities firms. [William D. Cohan, “Destruction at the SEC,” Bloomberg Businessweek, September 5-11, page 8, Matt Taibbi, “Is the SEC Covering Up Wall Street Crimes?” Rolling Stone, August 17, 2011, http://www.rollingstone.com/politics/news/is-the-sec-covering-up-wall-street-crimes-20110817 and “Why Isn’t Wall Street in Jail?” Rolling Stone, February 16, 2011, http://www.rollingstone.com/politics/news/why-isnt-wall-street-in-jail-20110216. See Democracy Now! interview with Matt Taibbi at http://whosnews.net/news-videos/us-politics-news-videos/matt-taibbi-is-the-sec-covering-up-wall-street-crimes-democracy-now-interview]
Single-industry regulation can be a bonanza for
its members. Cozy relationships can be developed among
regulatory officials and corporate officers, lawyers and lobbyists.
The “revolving door” can open to encourage employees to move from
public to private jobs and from private to policy level government
positions. People working on both sides understand each other
and the unwritten rules. Congress is careful to preserve the
Just one example of the payoffs for Wall Street
from having the
The SEC's protection has extended to the big
businesses which are Wall Street's clients. Contrary to its statutory duty "to protect
(As lawyer for a meat trade association, I ran across a model for how Wall Street lobbied away the threat of FTC supervision. The “Meat Trust” had responded to an antitrust decree and an FTC proposal that part of its industry be taken over by the government. The Packers and Stockyards Act was passed in 1921, with the stated intent to prohibit unfair and deceptive practices, manipulating prices, creating a monopoly, etc. [Title 7 U.S.C. §§ 181-229b, www.law.cornell.edu/uscode/uscode15/usc_sec_15_00000045----000-.html] However, it placed exclusive enforcement with the Department of Agriculture, making it clear that “The Federal Trade Commission shall have no power or jurisdiction over any matter which by this chapter is made subject to the jurisdiction of the Secretary” of Agriculture, with limited exceptions. [Title 7 United States Code §227, www.law.cornell.edu/uscode/7/usc_sec_07_00000227----000-.html] The legislative history disclosed that the Act had been drafted and lobbied by lawyers for the “Big 5” meat businesses. The previous year, the FTC had forced the Big 5 into a consent decree, after an investigation ordered by President Wilson. The real purpose of the Packers and Stockyards Act was to take away antitrust enforcement from the FTC and lodge it with the far friendlier Department of Agriculture, where it is today. There has been minimal funding and no serious enforcement of the Packers and Stockyards Act since it was enacted.)
There are at least three big advantages to being regulated by an
agency that is supposed to oversee only one industry. One is
control over the funding process. If the agency is becoming
too difficult, industry lobbyists can persuade the administration
and Congress to “cut off their water” until they behave. This
recently occurred when the
Only a few federal financial industry regulators are
subject to Congressional appropriations. Most operate on fees
and other income they collect. Paul Kanjorski, Chair of
the Financial Institutions Subcommittee, had said that self-funding
is in line with a major goal of the legislation to change the
culture and climate of the
However, Senator Richard Shelby said that keeping the
The second advantage to being regulated by a single-industry
agency is how people in the regulated industry can gain access to
regulatory officials, without competition from other industries
knocking on their door. Industry members can stay well within
codes of ethics and still develop close relationships at all levels
of the agency.
Related to access is the third advantage of single-industry regulation. That is the effective “revolving door” practice, where the regulated industry hires from the regulatory agency, and the agency hires from regulated firms, as well as from their lawyers and accountants. Apologists for the practice argue that the agency can recruit higher quality applicants because they know that a few years' experience will land them a lucrative position in the regulated industry, or the law, accounting and consulting firms that service the industry. They also say that regulation is more effective when staff in the industry and its service firms understand the workings of the regulatory agency.
Matt Taibbi commented on one flagrant revolving
door example, that of Walter Lukken, former acting head of the
Commodity Futures Trading Commission who later became head of the
Futures Industry Association, "the chief lobbying arm of futures
"As the chief regulator of the commodities markets, it was Lukken’s job to spot and combat speculative abuses and manipulations that might have led to artificial price hikes and other disruptions." Referring to testimony before Congress on the big jump in oil futures prices, Taibbi wrote: "By insisting that the spike was 'not a result of manipulative forces,' Lukken helped Wall Street in its efforts to avoid reforms that might have prevented such abuses, like the closing of a series of loopholes and exemptions that allowed a handful of major speculators to play a lopsided role in the setting of commodity prices. . . . But really it's the same old story: regulators keep falling down on the job, and keep getting rewarded for it by Wall Street, and nothing gets done about it." [Matt Taibbi, “Revolving Door: From Top Futures Regulator to Top Futures Lobbyist,” Rolling Stone, January 11, 2012, http://www.rollingstone.com/politics/blogs/taibblog/revolving-door-from-top-futures-regulator-to-top-futures-lobbyist-20120111#ixzz1jHvk2qst]
There may be individuals who can completely
separate their allegiance to the agency’s mission from their own
career goals. (I knew one law firm senior partner who told his
associates to always make a “soft” job offer when dealing with a
regulator on an important matter. Several of these offers
eventually resulted in the firm hiring the former regulators.
My own telephone conversations with
A very public example of how the
Part of protecting Wall Street’s monopoly is to
enforce its code of conduct for people allowed to be included in the
monopoly. In 1933, the National Industrial Recovery Act
permitted self-regulatory industry groups to adopt codes of fair
practice enforceable by the federal courts. As the only national
trade association for the securities industry, the Investment
Bankers Association prepared a “Code of Fair Competition for
Investment Bankers” that was approved by a presidential executive
order in March 1934. The Supreme Court declared the NIRA
unconstitutional in May 1935 but, with the assistance of the
When Joseph Kennedy’s son became President in
1960, a series of gross scandals at the American Stock Exchange
brought attention to the adequacy of
All three branches of the federal government ostensibly have a role in protecting individual investors from unfair practices in the securities industry. The history has been, however, that they actually protect Wall Street from disappointed investors. The game is to appear responsive to the complaints of voters, while really enabling Wall Street to continue cheating. [Watch "How Big Banks are Rewriting the Rules of Our Economy," Moyers & Company, billmoyers.com/video, Air Date: January 27, 2012]
One example of looking responsive but doing
nothing was revealed in the Lehman Brothers bankruptcy report by
Anton R. Valukas, for which his law firm billed over $38 million:
“In mid-March 2008, after the Bear Stearns near collapse, teams of
Government monitors from the Securities and Exchange Commission (‘
A recent case illustrates how all three
government branches contribute to keeping investors from recovering
losses caused by Wall Street fraud. For its part, Congress
made it unlawful to use any manipulative or deceptive device in the
purchase or sale of a security. But it added, “in
After Congress had adopted section 10(b) of the
Securities Exchange Act, granting Wall Street immunity from the
general fraud laws, it was up to the
That question came before the U.S. Supreme
Court in 2008, in a case that didn’t actually name a Wall Street
firm. [Stoneridge Investment Partners v. Scientific-Atlanta,
The real subject in Stoneridge, never mentioned by the Court, was Enron. Several institutional investors had sued Enron, which was bankrupt and couldn’t pay any judgment. They also sued Enron’s Wall Street bankers alleging that they were the ones who contrived financial transactions which falsified Enron’s financial statements. They bankers allegedly sold new Enron securities with falsified financial statements and recommended Enron’s stock through false analyst reports. After the trial court ruled that the plaintiffs could go to trial, some of the investment bankers settled, including Citicorp for $2 billion, J.P. Morgan Chase for $2.2 billion and CIBC for $2.4 billion. Other defendants appealed the decision. The investors had won the trial, but the federal circuit court reversed the decision and said that the Enron case could not include the investment bankers as defendants. Two other circuit courts, in other securities fraud cases, had decided the same issue, coming down on opposite sides. That created a conflict that only the Supreme Court could resolve. The high court chose to accept the Stoneridge Investment Partners case to review the issue, rather than the Enron cases. Stoneridge did not even involve investment bankers.
Stoneridge Investors had lost money on shares in Charter Communications, Inc., a cable TV operator. Charter had purchased cable set top boxes from Scientific-Atlanta, Inc. and Motorola, Inc. Charter arranged to overpay $20 for each set top box it purchased until the end of the year, with the understanding that respondents would return the overpayment by purchasing advertising from Charter, at inflated prices. The companies backdated documents to make it appear the transactions were unrelated. Stoneridge sued the vendors for having participated in the fraud.
The Supreme Court decided, on a five to three vote,
that the two set box vendors could not be liable to the investors.
Since the investors did not know of the vendors’ involvement in the
fraud, the court said they could not have relied upon the vendors
having been honest. The majority acknowledged that
general fraud law would have held the vendors liable. But it
ruled that Congress did not want that result in securities fraud
cases. The investors had also claimed that the vendors had
“aided and abetted” the fraud, which Congress had also made
unlawful. But the majority held that Congress intended “that
this class of defendants should be pursued by the
The big effect of the Stoneridge decision was on investment bankers, lawyers and consultants who were claimed to have invented fraudulent schemes and guided companies in carrying them out, like those in the Enron cases. The court’s majority acknowledged that it had been appropriate to consider “the practical consequences” of its decision. One of these practical consequences was the frivolous lawsuit argument, that “the potential for uncertainty and disruption in a lawsuit allows plaintiffs with weak claims to extort settlements from innocent companies.” Referring to the friend of the court brief by NASDAQ, the opinion added that holding responsible the undisclosed participants in a fraudulent scheme “may raise the cost of being a publicly traded company under our law and shift securities offerings away from domestic capital markets.” The judicial branch of our government decided it was better to let defrauded investors take their losses than to risk putting Wall Street at a competitive disadvantage to their counterparts in other countries.
The executive branch of government found it
politic to be on both sides of the case. The
The cleverest bit of politics in the Stoneridge
case was maneuvering it to come to the Supreme Court before the
Enron litigation or any other case where financial intermediaries
and their lawyers were active in creating the fraud. On the
legal issues, the Stoneridge case will likely excuse them all, just
as if they had been before the Court themselves. It must have
been easier to hold the justices together in the Stoneridge case,
where vendors had just been asked to “do me a little favor,” than in the
massive Enron financial manipulation scheme, where investment
bankers, lawyers and accountants were alleged to be deep into the
design and execution of the fraud. Former Senator Arlen Spector and
others tried unsuccessfully to modify the Stoneridge ruling in the
Dodd-Frank securities reform law.
It would have permitted aiding
and abetting prosecution for those who “advise on or assist in
structuring securities transactions and who have actual knowledge of
securities fraud.” [Bruce Carton, "Changes in
Securities Enforcement Thanks to Dodd-Frank," Securities Docket,
We have heard much about “derivatives” and
their role in the Panic of 2008 and the “Flash Crash” of
The federal government started regulating derivatives in 1921, with the Futures Trading Act and adopted the Commodity Exchange Act in 1936. Congress created the Commodities Futures Trading Commission in 1974, when most futures trades were bets on what the prices would be for agriculture commodities, like wheat, corn and pork bellies. The commodities futures market accommodated a symbiotic relationship between speculators, who wanted to bet on their ability to predict farm price movements, and the farmers and processors, who wanted to protect themselves by hedging against the risk of those price movements. The CFTC has promoted vastly expanded speculation in futures and options, far beyond farm products, into oil, securities, currencies and many other markers for placing bets.
The CFTC initially set limits on speculative trading but, in
1992, it carved out exemptions from these limits for derivatives
based on futures. Wall Street began coming up with
derivatives-on-derivatives and marketed them to hedge funds and
other speculators. To get around the limits on speculation,
Wall Street lobbied itself into being exempt. “‘When the CFTC
granted the 1991 hedging exemption to J. Aron (a division of Goldman
Sachs), it signaled a major shift that has since allowed investors
to accumulate enormous positions for purely speculative purposes,’"
said Rep. Bart Stupak (D-Mich.) Now, he added, “‘legitimate
businesses that hedge and take physical delivery of oil are being
trampled by the speculators who are in the market purely to make
profit.’" [David Cho, “A Few Speculators Dominate Vast Market for
Oil Trading,” Washington Post,
In 1999, the President's Working Group on Financial Markets
recommended that "derivatives should be exempted from federal
reported in Simon Johnson and James Kwak, 13 Bankers: The Wall
Street Takeover and the Next Financial Meltdown, Pantheon Books,
2010, page 136] The Commodities Futures Modernization Act of
2000 delivered many exemptions and exclusions from regulation for
derivatives and for classes of investors/speculators. It
opened an unregulated betting parlor for individuals and businesses
with assets of at least $10 million and employee benefit funds of at
least $5 million—the prime buy market for Wall Street investment
bankers. The exempt bets include “hybrid instruments” and
“swap transactions” sold to “eligible participants.” This
helped bring pensions funds and other institutions into the market,
mostly through “index” securities tied to a basket of futures
markets. Reflecting particularly clever Wall Street lobbying,
the exemptions were not only from regulation by the CFTC but also
Professor of Law Michael Greenberger left a Washington, D.C.law firm in 1997 to become Director of the Division of Trading and Markets at the Commodity Futures Trading Commission. In 2009, he described passage of the "Commodities Futures Modernization Act" this way: “On a December evening, December 15th, 2000, around 7:00, Phil Gramm . . . introduced a 262-page bill as a rider to the 11,000-page appropriation bill, which excluded from regulation the financial instruments that are probably most at the heart of the present meltdown. He not only excluded them from all federal regulation, but he excluded them from state regulation as well, which is important because these instruments could be viewed to be gambling instruments, where you’re betting on whether people will or will not pay off their loans.” http://www.democracynow.org/2009/9/2/american_casino_doc_investigates_roots_of]
The role of Congress as Wall Street’s traffic
cop was highly visible during the Summer of 2008, around the issue
of speculation in the market for securities derived from oil
futures. Several Congressional Committees held hearings,
including one May 20, before the Senate Committee on Homeland
Security & Governmental Affairs, called "Financial Speculation in
Commodity Markets: Are Institutional Investors and Hedge Funds
Contributing to Food and Energy Price Inflation?" The
relentless news coverage came from the relationship between trading
in these derivatives and prices at the gas pump. The lobbying
and public relations were a competition between the airlines [www.stopoilspeculationnow.com/Pages/aboutus.aspx] and Wall
Street firms. “A strong lobbying effort by Wall Street banks,
the trading industry and market operators may successfully head off
proposals for tougher federal controls on oil futures trading.”
[Ian Talley, “Oil-Futures Players Resist Controls,” The
Wall Street Journal,
One hedge fund manager testified that these institutional speculators keep rolling over their positions, they “never sell,” and that, “Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits.”[Committee on Homeland Security and Governmental Affairs, testimony of Michael W. Masters, managing member of Masters Capital Management, LLC, http://hsgac.senate.gov/public/index.cfm?Fuseaction=Hearings.Detail&HearingID=3fe95f08-0b7d-45d0-94ea-4c4346c353de]
This continuous buy demand creates an unreal
market. The money used for speculation could have gone to
productive uses, like financing new and expanding businesses, or
buying securities to fund infrastructure repair. The diversion
into futures securities is like individuals deciding to spend their
discretionary income on buying for their stamp collection, except
that the speculators are causing harm and bringing unnecessary risk
to us all. [A contrary view was presented by Hilary Till,
Research Associate of the EDHEC-Risk Institute, in
The Secretary of the Treasury and other
politicians continue to explain gas prices as a result of supply and
demand, especially supply, saying things like: “If only we
could drill for more oil, then we could supply the demand and the
price would stabilize.” The media similarly offers
explanations based upon the supply of physical oil output.
Reporters look at what happened in the oil futures market today and
then look to an event that interrupted the supply—sabotage in
Under pressure from members of Congress, the
Commodity Futures Trading Commission looked at records of oil
futures traders on the New York Mercantile Exchange, or NYMEX.
It found “that financial firms speculating for their clients or for
themselves account for about 81 percent of the oil contracts on
NYMEX, a far bigger share than had previously been stated by the
agency. . . . The biggest players on the commodity exchanges often
operate as ‘swap dealers’ who primarily invest on behalf of hedge
funds, wealthy individuals and pension funds, allowing these
investors to enjoy returns without having to buy an actual contract
for oil or other goods. . . To build up the vast holdings this
practice entails, some swap dealers have maneuvered behind the
scenes, exploiting their political influence and gaps in oversight
to gain exemptions from regulatory limits and permission to set up
new, unregulated markets. Many big traders are active not only on
NYMEX but also on private and overseas markets beyond the CFTC's
purview. . . . Using swap dealers as middlemen, investment funds
have poured into the commodity markets, raising their holdings to
$260 billion this year  from $13 billion in 2003. During that
same period, the price of crude oil rose unabated every year.
CFTC data show that at the end of July , just four swap
dealers held one-third of all NYMEX oil contracts that bet prices
would increase.” [David Cho, “A Few Speculators Dominate Vast
Market for Oil Trading,” Washington Post,
“Trading by swaps dealers—the big Wall Street banks involved in
energy trading—on behalf of financial investors and commodity
companies, along with noncommercial traders such as hedge funds,
accounts for an estimated 70% of trading in U.S. markets, up from
about 57% three years ago, according to the CFTC.” [Siobhan Hughes,
“Bill Targets Speculation Over Energy,” The Wall Street Journal,
Even in the midst of the post-2008 turmoil over
derivatives, when financial regulatory reform was often Topic A in
politics, the CFTC went on expanding the betting parlor offerings.
One Wall Street firm lobbied the CFTC to allow trading in the
expected box office receipts for movies. [Michael Cieply and
Joseph Plambeck, “
A major source of harm to us all comes from the
way the betting parlor for derivatives is linked with the trading
markets for “real” securities, the shares and bonds representing
ownership and debt of operating businesses. Wall Street’s big
players place bets in both the derivatives markets, regulated by the
CFTC, and the stock markets, regulated by the
Arbitrage games among the trading markets for
stocks and their derivatives have become especially difficult to
police as the number of markets have multiplied and become
individual profit centers. What were once a few nonprofit
exchange services, dominated by the New York Stock Exchange, have
now become many trading platforms, all operated by for-profit
publicly-traded companies. “Now the
Exchange traded funds, which are pools of stocks tied to
an index and traded on exchanges, have become favorite tools of high
frequency traders and other speculators, accounting for 35% to 40%
of all exchange trading. “Leveraged ETFs” use
derivatives to increase the gain or loss from buying and selling a
fund. [Scott Patterson, “ETF Role in Market Turmoil Examined,”
The Wall Street Journal,
Since Congress gave Wall Street the derivatives
betting parlor, its agencies have aided in building the complex
rules that make it possible for the cleverest gamesters to play the
odds with their computer programs and algorithms. Twelve days
State law enforcement officers have often been
a real nuisance to Wall Street. Every state, the
A big victory for investment bankers came with
the National Securities Improvement Act of 1996. Congress left
the securities industry free to sell shares throughout the
The “specified securities” exempted from state review are
basically all of the ones that are sold by Wall Street, leaving the
states to regulate securities sales made directly by small
businesses and the securities sold in ways that bypass Wall Street.
The exemptions from state regulation are called "covered securities"
and they include securities issued by companies listed on the
The Improvement Act also gave immunity from
state filings to mutual funds, and the brokers who sell them.
The definition of exempt “covered securities” was even extended to
private placements of securities. The
Left out of the escape from state regulation were all of the offerings in which Wall Street has no interest: securities listed on regional exchanges or the NASDAQ Small Cap market and securities sold under Securities Act Rules 504, which is limited to sales of $1 million in a year, [www.law.uc.edu/CCL/33ActRls/rule504.html] or Rule 505, for sales up to $5 million in a year. [www.law.uc.edu/CCL/33ActRls/rule505.html] Also left under state filing requirements were the Regulation A exemption for offerings of up to $5 million a year, which must also be reviewed by the SEC but are not subject to filing SEC reports and complying with the Sarbanes-Oxley Act.
The result of the National Securities Markets
Improvement Act was to give Wall Street investment bankers a free
pass to sell securities throughout the
Once in a great while, there has been an
occasional burst of concern for small business expressed by
politicians and regulators. Sometimes, useful action is taken.
The last pro-small business cycle was in the early 1980s and a major
result was the creation of a separate category for “small business
issuers.” They were corporations with annual revenues of not
more than $25 million, or corporations with their publicly-traded
shares valued at less than that amount. The
The federal-preemption-of-state-law ploy was
also used to protect Wall Street’s mortgage lending operations in
the U.S. Supreme Court case, Cuomo v. The Clearing House
Association, LLC, [www.law.cornell.edu/supct/html/08-453.ZS.html,
2009]. The Office of the Comptroller of the Currency and The
Clearing House Association, a trade group of national banks, each
filed a lawsuit to enjoin an investigation by
Congress followed the Supreme Court in the next protection
Wall Street from state regulation. After the House passed the
“Wall Street Reform and Consumer Protection Act of 2009,” the bill
went to the Senate, which passed its “Restoring American Financial
Stability Act of 2010.” The different title in the Senate,
leaving out any reference to Wall Street reform or to consumer
protection, reflects the differences in the bill itself. For
When Wall Street began to go after home loans as a vast source of securities business, it got Congress to take a series of steps to get the states out of its way. One of the earliest was included in the Depository Institutions Deregulation and Monetary Control Act of 1980. All of the states have long had usury laws, making it a crime to charge more than a certain rate of interest. Of course, these laws exempted banks and most other institutionalized lenders. But state usury laws would have crimped the style for securitizing home loans, especially those made by nonbank mortgage originators for Wall Street to package as mortgage securities. State usury laws only affected interest rates higher than those charged on home loans. So, if Wall Street had been willing to stay within the standards used by established mortgage lenders, it would not have been necessary to get rid of state usury law limits. But the profit was seen to be in subprime lending, where much higher interest rates could be charged to borrowers who couldn’t qualify for the usual channels. Congress obliged Wall Street’s lobbyists and preempted state usury laws. [Depository Institutions Deregulation and Monetary Control Act of 1980]
Congress also helped Wall Street develop its
mortgage securities business with the Alternative Mortgage
Transactions Parity Act of 1982. Before that Act, state and
federal laws and regulations had limited mortgage loans to those
with a fixed-rate and with interest and principal to be paid in
monthly installments over a period of up to 30 years. This new
“Parity Act” opened the door to loans with adjustable rates,
payments of interest only and creatures like the “option-
It’s hard to match the federal government’s campaign against state regulation with the conclusions of the U.S. Treasury’s recommendations on financial regulatory reform: “The financial crisis was triggered by a breakdown in credit underwriting standards in subprime and other residential mortgage markets. That breakdown was enabled by lax or nonexistent regulation of nonbank mortgage originators and brokers. But the breakdown also reflected a broad relaxation in market discipline on the credit quality of loans that originators intended to distribute to investors through securitizations rather than hold in their own loan portfolios.” [Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation, Department of the Treasury, 2009, page 44] Treasury’s recommendations are all about more agencies and powers for the federal government.
After all the Congressional investigations and New Deal laws, there was one last government attack on the investment banking cartel. This time, it was through the executive and judicial branches, although it began in Congress, with the Temporary National Economic Committee in 1938—which was defunded in 1941. Known as the “Monopoly Committee,” [Charles R. Geist, Wall Street: A History, Oxford University Press, 1997, page 258] it produced tens of thousands of pages of testimony and many monographs of its conclusions. The Committee found extreme concentration of underwritten securities issues in a few Wall Street investment bankers, close relationships between investment bankers and their biggest clients and very little effort to finance small business.
In 1944, while Franklin Roosevelt was still
president, the U.S. Department of Justice used the Committee’s work
to begin a major investigation of the way Wall Street conducted
underwritten public offerings of stocks and bonds. The result
Harry Truman had become president on
When the government began putting on evidence, there were three practices left to sustain the monopoly charge. One was that they didn’t poach on each others’ clients. If an investment banking firm had managed an underwriting for a particular business, the rest of the firms would not try to have that business pick them for the next offering. Second was that the positions in an underwriting syndicate for a particular issuer would remain the same for that company’s future issues. Those positions were reflected in the “tombstone” announcements of a completed offering, where the managing underwriter was at the top of the pyramid and the other firms participating were on descending lines. Third was the use of reciprocity in selecting members of an underwriting syndicate. If investment banker A was given a $10 million allotment in an underwriting managed by investment banker B, then banker A could be expected to include banker B for a similar amount in an underwriting it managed.
Most of us outside the securities industry
might consider these practices not to be worth such a massive legal
battle. But there was a fourth theory: price fixing.
That theory was based on the standardized Underwriting Agreement,
Agreement Among Underwriters and Selling Agreement, in the forms
that have been used since the 1920s. They require every firm
in the offering to sell at one offering price and to receive the
same commission. The managing underwriter is also authorized
to buy and sell securities in the aftermarket and to keep the
trading price from dropping below the offering price. The
The Department of Justice tried the case for
over two years, without calling a single witness, except the ones
used to introduce documents. Printed materials were over
100,000 pages and included materials from each of the government
investigations, beginning with the 1905 Armstrong Committee.
At Judge Medina’s urging, the government finally added two
witnesses. One was Robert R. Young, a former stock speculator
who had successfully sold short in 1929. [His biography, by
Joseph Borkin, is titled Robert R. Young, The Populist of Wall
Street, Harper and Row, 1969] When Young completed his
The other government witness was Harold L.
Stuart, whom a defense attorney referred to as the “dean of
investment bankers.” Judge Medina said that Stuart was someone
“upon whose testimony I could rely with confidence.” [Vincent
Carosso, Investment Banking in America, Harvard University
Press, page 491, note 126] However, the government’s
lawyers only questioned Stuart perfunctorily, in what
After the government put on its evidence, and before the defense had begun its part of the trial, Judge Medina dismissed all of the charges. He took the unusual step of dismissing “on the merits” and “with prejudice.” That meant that the government could not file a new complaint on the same allegations. The 200-page opinion can be read as a “once-and-for-all” defense of investment banking, intended to put an end to the long series of Congressional investigations and political hay made from attacks on Wall Street. The Justice Department, under President Eisenhower, chose not to appeal the decision. According to Vincent Carosso, the historian of investment banking, the trial “shattered the old myth of a Wall Street money monopoly.” However, Carosso also wrote that “investment banking in the 1960s was as highly concentrated as it had been sixty years earlier. In some respects it was even more so.” [Vincent Carosso, Investment Banking in America: A History, Harvard University Press, pages 495, 505]
When the Attorney General decided not to appeal
Why did the federal government start the
antitrust case? Why did it drop so many of the charges before
the trial began? Why did the government have to be forced to
put on witnesses? Why did it choose only two witnesses and why were
they ones which defeated the government’s case instead of making it?
When Judge Medina dismissed the complaint and said the government
could not file another one, why did the government not appeal?
These are political questions, not legal strategy. A political
theory advanced by Robert Sobel for why the case was started is
that, wanting to “revive the New Deal spirit after the war, the
Truman Administration had warmed over that issue which had served
F.D.R. so well in 1932-34.” [Robert Sobel, Inside Wall
Street: Continuity and Change in the Financial District, W. W.
Norton & Company, 1977, page 205] That may have been true when the
case was started in 1947, with Truman headed for his narrow
reelection victory the next year. But Eisenhower was elected
in 1952, two years before
While the government has looked the other way at Wall Street’s monopoly practices, a private action was brought on behalf of persons who purchased technology IPOs in the bubble years just before 2000. According to Justice Breyer’s opinion for the United States Supreme Court: “A group of buyers of newly issued securities have filed an antitrust lawsuit against underwriting firms that market and distribute those issues. The buyers claim that the underwriters unlawfully agreed with one another that they would not sell shares of a popular new issue to a buyer unless that buyer committed (1) to buy additional shares of that security later at escalating prices (a practice called ‘laddering’), (2) to pay unusually high commissions on subsequent security purchases from the underwriters, or (3) to purchase from the underwriters other less desirable securities (a practice called ‘tying’). The question before us is whether there is a ‘plain repugnancy’ between these antitrust claims and the federal securities law. [citations] We conclude that there is. Consequently we must interpret the securities laws as implicitly precluding the application of the antitrust laws to the conduct alleged in this case.” [Credit Suisse Securities v. Billing, , www.law.cornell.edu/supct/html/05-1157.ZO.html, 2007]
The technology bubble IPO was among the few cases brought by disappointed investors that made it through the courts after 1995. Private securities litigation had become a nuisance to Wall Street and its corporate clients, so they got Congress to make it far more difficult for plaintiffs to bring class actions. Abuses by some plaintiffs’ lawyers gave them plenty of talking points for their successful lobbying. The law that Wall Street received from Congress reads like a long series of hurdles and barriers that disappointed investors must navigate before a case can actually get to trial or settlement. [United States Code, Title 15, chapter 2B, section 78u-4, www.law.cornell.edu/uscode/uscode15/usc_sec_15_00000078---u004-.html]
Congress controls the Securities and Exchange
Commission through its annual budget. The lobbying pressure
from Wall Street has always been to keep the
The most prominent SROs are the securities
exchanges. They must be registered with the
The self-regulatory functions for the
securities industry have been outsourced to the Financial Industry
Regulatory Authority, created in July 2007 through the consolidation
of the National Association of Securities Dealers and the member
regulation, enforcement and arbitration functions of the New York
Stock Exchange. [www.finra.org/AboutFINRA/index.htm] FINRA oversees nearly
4,750 brokerage firms, about 167,000 branch offices and
approximately 633,000 registered securities representatives.
Its basic purpose is to protect Wall Street’s monopoly from
nonmember competition and from so-called rogue brokers who break the
rules and make the industry look bad. FINRA has
the bureaucratic itch to expand its turf. It
spent $300,000 in 2011’s first quarter on lobbying Congress and the
One self-regulatory program was the Consolidated Supervised
Entities Program, set up in 2004 and referred to as the CSE.
It was intended to address a big gap in financial regulation—the
large Wall Street investment banking corporations. Because
they don’t take in deposits, they were not under the Federal Reserve
Board, the FDIC, the Controller of the Currency or state bank
regulators. While their brokerage subsidiaries were subject to
FINRA rules, their major business, and biggest risks, were from the
buying and selling they did for their own profit, and the huge
borrowings they took on to leverage their trading. Under the
CSE, these unsupervised giants could voluntarily submit to
A few days after the failure of Lehman Brothers, leading to the
Chairman Cox went on to say: “As I have reported to the Congress multiple times in recent
months, the CSE program was fundamentally flawed from the beginning,
because investment banks could opt in or out of supervision
voluntarily. The fact that investment bank holding companies could
withdraw from this voluntary supervision at their discretion
diminished the perceived mandate of the CSE program, and weakened
its effectiveness. The Inspector General of the
Serious political reformers are aware that government agencies are not enough to protect us. They realize that laws are not always enforced. Sometimes the lack of detection and prosecution is because the agencies are starved through token funding by Congress. Or the agencies may end up being staffed by persons more sympathetic to the industry regulated than to the public. The “revolving door” may influence individuals who work for a regulator, while expecting to go to a job with a regulated business, or vice versa. Some regulatory agencies may just atrophy in bureaucratic red tape.
Foreseeing this frustration, lawmakers have often created “private rights of action,” inviting persons harmed to start their own court proceeding. An extra inducement may be the possible award of triple the amount of actual damages, reimbursement of legal expenses or the promise that lawyers can attract follow-on clients for more cases. In the federal securities laws, these private rights of action have led to a more or less permanent class of securities plaintiffs’ law firms. Wall Street has successfully lobbied Congress into erecting barriers to shareowner class actions, while some prominent class action lawyers have been punished for paying plaintiffs to bring lawsuits.
The private action remedy, if it is at all
effective, is likely to be a case of way too little, way too late.
For instance, a class-action lawsuit was brought against dozens of
investment banks and brokerage firms for the unlawful games used to
inflate trading prices for shares of recently-completed IPOs in the
late 1990s. Losses were claimed in the many billions. It
was ten years before the case was settled and the amount was a
relatively token $586 million. Of that, the six lead
plaintiffs’ law firms were expected to take a third and also put in
for reimbursement of $56 million for their expenses. [Nathan
Koppel, “Tech-Firm Holders Settle Suit Over IPOs,” The Wall
The federal securities laws enacted in the 1930s specifically include the right to bring private lawsuits to recover investment losses. [Securities Act of 1933, sections 11, 12 and 18, www.law.uc.edu/CCL/33Act/index.html; Securities Exchange Act of 1934, sections 18 and 20, www.law.uc.edu/CCL/34Act/index.html] The U.S. Supreme Court has said that the words of the law and regulations “implied” a private right to sue in cases based on section 10(b), which makes it unlawful to use any manipulative or deceptive device in the purchase or sale of a security. [Superintendent of Insurance of New York v. Bankers Life and Casualty Co., 404 U.S. 6, at 13, note 9, 1971] However, private enforcement of the federal securities laws has become a game played by class action securities litigators and insurance companies. Corporate directors and officers are routinely indemnified by the corporation from any liability to securities owners and the corporations also buy directors’ and officers’ liability insurance to cover what they might have to pay on the indemnities. The dollar limits of that insurance become the treasure chests for the litigators, who will get a big percentage in fees and their expenses.
By the 1990s, Wall Street got Congress to
override a presidential veto of the Private Securities Litigation
Reform Act of 1995. That law watered down the ability to bring
a class action on behalf of securities holders. [Securities
Act of 1933, section 27,
www.law.uc.edu/CCL/33Act/sec27.html; Securities Exchange Act of
1934, sections 21D and 21E,
www.law.uc.edu/CCL/34Act/sec21E.html. For a summary
description of the legislation, see the law firm memorandum by
Pillsbury Winthrop Shaw Pittman LLP at
http://library.findlaw.com/1999/Sep/1/129878.html] After the “Reform Act,” shareowner class
actions are more difficult and costly, but they are still a trick
game, in which the corporations and their insurers settle cases by
paying a few institutional investors and their lawyers, with the
money for the settlement and the large insurance premiums
coming out of the corporate net worth that belongs to all
shareowners. As U.S. District Court Judge Jed S. Rakoff said,
when rejecting the proposed settlement over Bank of America’s
claimed failure to disclose Merrill Lynch bonuses, “shareholders who
were the victims of the bank’s alleged misconduct [would] now pay
the penalty for that misconduct.” [Michael Orey, “Do Shareholder
Class Actions Make Sense?,” Business Week,
Securities class actions are either dismissed or settled; they rarely ever get through an actual trial. The settlement amount is usually right around the insurance policy limits and negotiations get more complex when the primary insurer is backed up by other policies. [Professors Tom Baker, University of Pennsylvania Law School, and Sean Griffith, Fordham Law School, “How The Merits Matter: Directors' And Officers' Insurance And Securities Settlements,” University of Pennsylvania Law Review, Volume 157, No. 3, Page 755, www.pennumbra.com/issues/pdfs/157-3/Baker.pdf] Insurance polices have a "dishonesty exclusion," which lets insurers escape payment if a court finds fraud or willful violation of the securities laws. Settlements before a court finding are made without admitting dishonesty, to collect on the insurance, "a huge incentive to settle even the most spurious claim." [Pamela A. MacLean, California Lawyer, July 2010, page 32, reviewing Circle of Greed: The Spectacular Rise and Fall of the Lawyer Who Brought Corporate America to its Knees, by Patrick Dillon and Carl M. Cannon, Broadway Books, 2010] Once there is a settlement agreement, another long process drains off fees and expenses before the people who once owned the security ever receive any leftovers.
The real cause of most of these drainoffs of corporate funds from securities litigation is the volatility of the securities markets. To make money from a lawsuit, there needs to be four elements: a legal duty; a breach of that duty; damages caused by that breach and, finally, a source of money to pay damages. In the class action securities litigation world, it all begins with the last of these, a calculation of damages—the difference in the market value of the securities just before the breach from the value after—and the insurance coverage available to pay the damages. If the price drop has been large enough, and the insurance policy limits are high enough, a securities litigator can always find the duty and breach which can be said to have caused the drop.
The effect of the private remedy today is that insurance premiums paid by corporations get distributed to lawyers for plaintiffs and defendants and all the accountants, expert witnesses and other participants in the process. The insurance companies increase premiums to make sure something is left over for them. The vision of “private attorneys general” enforcing the securities laws to protect investors is mostly a sham.
There are basic confidence schemes that have been used for centuries to trick money from marks. [www.impactlab.com/2009/10/03/top-ten-con-games/] Most of them rely upon the victim’s greed overcoming conscience and reason, as in W.C. Fields’ movie, “You Can’t Cheat an Honest Man” and the book of that title. [James Walsh, You Can’t Cheat an Honest Man: How Ponzi Schemes Work and Why They’re More Common than Ever, Silver Lake Publishing, 2010] Some con games can be worked without violating any criminal law. Others may be technically illegal but law enforcement officers don’t consider them worth the effort of arrest and prosecution, because they know that they won’t take any heat for letting it go by.
Most of Wall Street’s schemes involve some form of inside information. The Wall Street participant in a transaction knows something important that the other side hasn’t yet learned. As Gordon Gekko said in the movie, Wall Street, “If you’re not inside, you’re ‘outside.’” [This and other quotes from the film, like “greed is good,” can be read at www.imdb.com/title/tt0094291/quotes] One of the insider schemes that the securities laws protect—for Wall Street firms, but not for its employees—is “front-running.”
At front-running’s most primitive form —and against the rules—a brokerage employee receives a large order to buy a traded security and figures the order will cause the price to go up before it can be filled from sell orders. The employee then puts in a buy order for the employee’s personal account, followed by the price-changing customer’s buy order, and then followed by the employee’s sell order at the now higher market price. This gross practice is usually perpetrated by an employee, acting alone, trying to pick up some extra money that doesn’t get shared with the employer. As a result, the brokerage firm wants to catch this “rogue” and prevent the bad customer relations and publicity that could result. The even stronger, quirky motivation is that the employee is trying to make a personal profit that should really belong to the employer. The regulators have computer programs that can pick up trades that look like front-running, so they can help Wall Street clean its house, while getting credit for protecting the public.
The “quiet period” is another tool given Wall
Street under the Securities Act, ostensibly to prevent
“gun-jumping,” which is getting ahead of the general public.
The quiet period is the time between a company’s decision to have a
public offering of its securities and up to 40 days after the
offering is completed. [The quiet period is part of a complex
set of rules about disclosure, revised July 2005 in a 468 page
In reality, the quiet period’s “main purpose
seems to be to give fat-cat players an edge over ordinary investors.
How? In the runup to their IPOs, companies stage road shows, where
big investors get to hear and question company management and its
bankers. Meanwhile, because of regulations affecting the quiet
period, the company often refuses to talk to the press or address
any questions average investors might have. Information is
often given to pros at road shows that average investors don't have
a prayer of receiving. Says Jay R. Ritter, a finance
professor at the
The major threat to a monopoly is competition.
Since 1792, when brokers and dealers started the New York Stock
Exchange, the first rule of Wall Street has been that securities
trading is for members only. The biggest sin on Wall Street is
“trading away,” doing any business outside of club members and club
rules. That includes any moonlighting by an employee or any
alliance by a member firm with a nonmember business. When
enactment of the federal securities laws brought the requirement
that broker/dealers must be licensed by the
The Wall Street way to raise capital is the syndicate of investment banker allies who divide up the new securities for sale to their wealthy customers. Early in the 1900s, new broker firms began to encroach on the monopoly of major investment bankers, by using advertising and public relations to educate middle class newspaper and magazine readers about investing in securities. The Securities Act of 1933 put a stop to this competition. It prohibited written communications before an offering had effectively been completely sold. The major investment bankers, who could sell an entire issue with a few telephone calls, again had the field to themselves.
In the late 1930s, the Temporary National
Economic Committee investigated the concentration of economic power,
“including that created by ‘financial control over industry.’
In the investment banking field, it was clear that the costs
imposed by the Securities Act tended to discourage smaller issuers
from engaging in public offerings, which deprived less prestigious
underwriting houses of business. Under pressure from the
Wall Street also brings the government in to enforce rules upon its employees, preventing them from ever competing with their employers. Trading away is the number one crime on Wall Street. What “trading away” means is that an employee is doing some business on the side, cutting the employer out of the deal. We all know people, in the building trades, for instance, who do jobs on weekends or days off, getting paid directly by the customer. Employers generally look the other way, so long as the side jobs don’t interfere with how the employee performs at the regular job. It’s hard to believe that prosecutors and courts would step in to punish these moonlighters.
Not so on Wall Street. It has a government-protected monopoly on the securities business. Anyone who deals with customers about securities has to be under contract to a licensed broker-dealer. If a registered representative gets caught doing a piece of business that doesn’t go through the broker-dealer’s books, it can be the end of the representative’s license, the end of any ability to work in the securities industry. It can also mean fines and imprisonment.
A recent example shows how seriously the
government takes its job of protecting Wall Street against
competition from employees who receive money that could have gone to
their employer. One of Wall Street’s minor sources of revenue
comes from its practice of lending stock to persons who have sold
the stock short and are supposed to be in position to deliver the
sold shares. Of course, the shares are actually owned by the
brokerage firm’s customers, but that’s another issue. The
collects the fees charged for borrowing shares. Morgan
Stanley, now owned by Bank of America, found out that some of its
employees were directing stock lending business through finders, who
then split their fees with the employees. The Brooklyn U.S.
Attorney’s office prosecuted 19 employees. They were all
convicted and were sentenced to up to three years in prison. After
the convictions, Morgan Stanley issued a statement that the
employees had violated the firm’s policies. [Amir Efrati,
“Ex-Trader Pleads Guilty in Stock-Loan Case, The Wall Street
Many of the abuses revealed in the Crash of
1929 investigations involved securities firms operating a business
model with a built-in conflict of interest. They acted as
brokers executing trades for customers and they were also dealing in
securities for their own account. Sound familiar? That’s
because the major broker-dealers and banks are still doing business
the same way, often betting against the customer and causing big
problems. Congress and the
Some of the biggest conflicts of interest at
Wall Street firms come from their dual role of buying and selling
securities for customers while also buying and selling securities
for themselves. The
The draft Securities Exchange Act of 1934 required securities firms to choose between acting as an agent for others or buying and selling securities for their own account. That would have applied to underwriting new issues of securities, since investment bankers structurally purchase shares or bonds from their client, the securities issuer, and resell them to their customers. Underwriters would have been required to change their business model. They could either have acted as an agent for the issuer in selling the securities or they could have purchased and resold the new issue of securities. The same firm could not have done both.
The proposal to separate the functions of brokers and dealers started out as the Fletcher-Rayburn bill. Sam Rayburn, the long-time Speaker of the House of Representatives and mentor to Lyndon Johnson, said that opposition to his bill was “the most powerful lobby ever organized against any bill which ever came up in Congress.” [Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970, page 377.]
Instead of making it into law, the issue was
deferred for study to the newly formed
Wall Street investment banks have never been interested in selling new issues of securities to the middle class individual. Their underwriting commission rate is the same on small sales as it is on large ones, while the time involved to make a small sale can be about the same as for a large one. As long as an issue of securities can be sold to a few large investors, there is no incentive to develop business with anyone other than institutions and wealthy individuals. In practice, the small investor involves even more work, because of the need to develop a trust relationship and to educate the customer.
The only serious competition to Wall Street’s investment bankers came from commercial banks, which encroached on their turf after their learning curve in the successful Victory Bond programs of World War I. Commercial banks were the only group willing to sell to the small investor. They already had a trust relationship with their middle class depositors and they had learned successful marketing techniques from selling Victory Bonds. After the War, banks created affiliates to distribute securities issued by their loan customers, often selling them to their deposit customers. One of the ways they accommodated these retail customers was to sell securities on the installment plan, with 25 percent down and five percent per month. As the banks grew their underwriting business, they began to draw clients away from the investment banks.
After the 1929 crash, stories emerged about speculation, manipulation and fraud by the commercial banks and their securities affiliates. These stories became Congressional testimony, supporting the Banking Act of 1933, which made it unlawful for commercial banks to act as investment bankers or as securities broker/dealers. Glass-Steagall, named after the two sponsors of the Banking Act of 1933, has been the short-hand term for the law forcing commercial banks to get out of the securities business. In 1934, after the Banking Act had become law, a study was published in the Harvard Business Review, comparing offerings underwritten by the eight largest private investment banks with the eight largest affiliates of commercial banks. It concluded that: “One can now say that there has been no significant difference in the quality of the new security originations of these two groups.” [Terris Moore, “Security Affiliates Versus Private Investment Banker—A Study in Security Originations,” Harvard Business Review, July 1934, page 484.]
In the Glass-Steagall Act, the investment bankers got Congress to freeze out the commercial banks. Any bank which accepted deposits, with the new FDIC insurance, could not also underwrite securities or operate a brokerage business. This prohibition lasted until the 1980s, when investment bankers were out-lobbied and Congress let commercial banks back into the securities business. Then, after the Panic of 2008, the two remaining big investment banks chose to become bank holding companies, to come under the shelter of the Federal Reserve and its unlimited supply of cheap borrowing.
The public buildup to forcing commercial banks out of the
securities business began in 1932, with hearings before the Senate
Banking and Currency Committee, called the Pecora Committee, after
its Chief Counsel, who much later published his story of the
hearings. [Ferdinand Pecora, Wall Street under Oath : The
Story of Our Modern Money Changers, Simon and Schuster 1939, A.
M. Kelley, 1973] Pecora had been a New York District Attorney.
When Pecora became a New York Supreme Court Justice, Joseph P.
Kennedy, the first
The Glass-Steagall Act forced bank managers to
choose between selling securities and accepting FDIC-insured
deposits. While investment bankers continued to be unregulated
until 2008, commercial banking is heavily regulated, by the regional
Federal Reserve Banks, Comptroller of the Currency and state banking
supervision. Much of this regulation is intended to protect
the banks from the consequences of mistakes they may make in lending
and investing. Commercial banks are required to have a
protective layer of shareowners’ equity to absorb losses. By
contrast, investment banks have had no regulation of their
investments or their capital adequacy. They have been free to
borrow as much as they can to invest in whatever they choose.
As described by Justin Fox in Portfolio.com:
“Investment banks have a natural tendency to expand until they use
all of the balance sheet they're given. That's one of the reasons
After a long battle between commercial bankers and investment bankers, the Glass-Steagall Act was completely repealed. The fight to bring it back was a big part of the financial reform bill machinations in 2008. The commercial banks’ attack on Glass-Steagall was like the siege of a city in ancient time. There was the frontal attack in the 1960s, to break down the wall that Congress had built. The banks recruited a lobbying army, at first just to allow them to en