What’s wrong with Wall Street and how to fix it?

12 May, 2008 | by

 

Yesterday I read a very well written Fortune magazine article titled “what’s wrong with Wall Street and how to Fix It”. I’m sure by now you’ve read countless press releases on the sub prime debacle which don’t always provide a concise view of the situation we now found ourselves in. Rarely do you find articulation of such a complex topic, in written format, that provides just the right blend of depth to go with simplicity, to ensure it resonates with a broad audience. I believe this article fits that mold and wanted to summarize some of its key points and chime in with some personal commentary of my own.

The author, Shawn Tully, encapsulates Wall Street’s issues into three distinct categories. The first is their unyielding appetite for risky trading as opposed to more traditional and reliable fee based business that commercial banks tend to gravitate towards. The second is the dangerous levels of leverage these firms work with. Furthermore, these firms quite frankly work with outdated risk management systems which do not provide any meaningful safeguards against the prevention of a collapse of any sort. The third and probably the most publicly known issue is that of the disproportionate amount of profits that go to executives or traders on the upswing of a bull-market versus the shareholders holding the bag (now a little emptier) in the downswing of a bear-market.

In other words:
- Wall Street prefers high risk trading which can lead to mammoth returns.
- Wall Street leans towards utilizing leverage which can also lead to mammoth returns.
- Wall Street has a business model which overwhelmingly favors the traders and not the shareholders, which can also lead to mammoth returns.

Are you sensing a trend yet? Rather then regurgitate some of the authors points that expand on those three categories, I’d like to move on to some of his recommendations to fix this precarious situation.

Broken Business Model?
The first recommendation was that of Wall Street Bankers returning to more of a fee-based business in order to stabilize their business model. The author goes on to say returning to such a business model will still prove to be highly profitable if the street could put itself on a diet. I think this is poetic sentiment to think firms would return to a more stable (aka – less profitable) way of doing things. Yes…I’m sure they’ll head in that direction for a little while but if history has taught us anything, it’s that greed tends to trump rational sense over and over again.

Ethics:
The next point was one I fully agreed with and only hope it’s addressed sooner then later. Wall Street firms have a tendency to use privileged client information in order to trade for their own accounts and reap the benefits of someone else’s research. That’s like offering to hand in a friend’s homework and then surreptitiously copying the answers and pawning them off as your own when it’s time to submit your homework. Amazing…Back when I was in school, students generally stayed away from such an ill advised activity given the steep penalty issued if one was to be caught. Expulsion! It just boggles my mind that it’s not only accepted on Wall Street but it’s actually rewarded. Handsomely I might add. I tend to agree with the authors view that technology will eventually sort this issue out but to have let it go on for this long indicates to me that people were turning a blind eye to these egregious acts seeing that there were enough profits to go all around. What a novel idea…Greed trumping ethics in order to turn a profit. And the trend continues…

Leverage Ratios:
I can’t speak knowledgably on the leverage ratios that would be prudent for the Street or even how they should be managed, but the data clearly indicates better controls need to be instituted to prevent or minimize market instabilities.

Compensation Structure:
The compensation structure is probably my biggest pet peeve as it’s obviously out of control. Let’s think about it logically…You have a trader that invests other people’s money, and because of that fact, feels no hesitation in betting big with the prospect of a large bonus payout. Hedge funds for instance take 20% off the top of profits. But on the flip side, if they have a bad year, the shareholder is left holding the bag and there are absolutely no ramifications for the actions of that same irresponsible trader. Sound fair to you? Let’s put it this way…If your job offered you sterling incentives based on you delivering massive returns (or high performance of any kind for the sake of this example) no matter what it took to deliver those results and on top of it you could theoretically retire in a single year from bonuses alone. Wouldn’t you up the ante and take on that risk, especially if it wasn’t your money to begin with? I sure would.

Regulation:
I think the authors view on this point is rather naïve to think traders would ever bank their bonuses forward or impose some sort of self regulation. That would be great but let’s be honest, what are the chances of that happening without new overarching governance to the entire industry? None what so ever! But the author goes on to make a brilliant point which I’ll quote, “If investment banks can borrow from the Fed, they should be subject to the same rules as commercials banks.” He’s on the money with that argument seeing that the Fed recently bailed out Bear Sterns as they teetered on the brink of extinction. The irony is almost palpable, isn’t it?

The Bear Sterns bailout will all but guarantee that new legislation to come into play over the coming years and hopefully recalibrate expectations for traders and shareholders alike. It’s only a shame it took a major catastrophe like this to spark such a change, but that’s the world we live it, right? I mean, look airport security…Was it ever on anyone’s radar before 9/11?

Greed:
The recent credit crisis and Wall Street’s ability to exacerbate the situation further solidifies my perspective on one certainty when it comes to business – any business. Without proper regulation and active monitoring to govern an incentive laden business model, greed will always find a way to rear its ugly head. I’m sure these traders didn’t set out to cause the trouble we’re in today. They were cowboys riding the housing boom without truly understanding its implications, all in the name of reaping the immediate rewards. Ok, not cowboys, maybe drug dealers would be a more suitable analogy. Don’t bail on me yet…hear me out. At first they probably used their leverage just a little bit to test the waters, took some profit (got the taste), then took a little more leverage (now hooked), then before you know it they faced a full blown addiction (leveraged to the hilt), no longer knowing which side was up.

Closing:
I know history has a tendency to repeat itself but hopefully the powers that be now see the writing on the wall. Success in this instance would not be defined by simply fixing the current mess that the economy is in, which is clearly a monumental challenge all unto itself. That challenge is merely a precursor to what is truly needed. Success to me would be consistently mandating the due diligence necessary in order to prevent such an event from happening in the first place. Impossible you say? Maybe. But isn’t that something worth striving for?

If these events have taught us anything it is that our economy albeit robust and resilient can be fragile at times and is invariably entwined with the global community at large. In order to stay atop the global food chain, it is imperative that we do so organically and more importantly, ethically, as to not only practice what we preach as a nation but to restore what is drastically needed and what will most assuredly bring our economic system back to the forefront…Integrity.

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