Thursday, October 9, 2008

Momento Mori: on Wall Street’s Death by Negligence

What we have known as "Wall Street" is now stunningly no more.

Manhattan’s great investment banks are gone. The last two – Goldman Sachs and Morgan Stanley - are converting into banks, submitting to more intrusive government regulation in return for more secure sources of capital.

Communism couldn't kill this Wall Street; capitalism, however, did. Adam Smith won out over Karl Marx.

This "Wall Street" died at its own hands in a form of negligent suicide. It lived by the sword of extreme market capitalism and died by that same sword. It overdosed on toxic behaviors as did John Beluchi, Jimi Hendrix, Janis Joplin, and Jim Morrison.

The epitaph, I suppose, for "Wall Street’s" mighty rise and astonishing fall should be "Sic Transit Gloria Mundi" - "thus passeth worldly glory".

Street talk for what killed Wall Street’s investment bank titans is that it was “greed” that did them in. As in a Greek tragedy, excess and hubris worked through a cycle of boom and bust to humble even the best and the brightest. It’s an old story, really, new in its techniques of subprime mortgages, CDOs, and credit default swaps, but very old in its moral fundamentals.

But I don’t think it was greed precisely that was the cause of the losses and bankruptcies.

Greed - understood as seeking a profit, as pursuing one’s interest in business transactions – has not always been so terribly dysfunctional and hurtful to the common good. Indeed most of our modern life was devised, produced, distributed and sold by capitalist behaviors and motivations. There was a baby in Wall Street’s bathwater to be sure.

Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Sterns and their predecessors brought companies to life by raising capital for them. America’s growth and resulting economic well-being rested on robust capital markets. Without them there would have been no railroads, steel mills, General Motors, Ford, Boeing, Microsoft, or all the other Fortune 1,000 and smaller companies that ever sold stock or debt securities to finance their businesses.

So what went wrong? When did this “Wall Street” of once sound investment banking houses start walking on the wild side towards perdition?

The short answer is too much leverage – too much debt. Lehman Brothers, as an example, was leveraged 30 to 1 when it failed. When its chickens came home to roost in questions about how it was going to pay off its debt as the market turned sour, Lehman had insufficient capital of its own to be credibly self-reliant in down markets.

This answer raises a further question: why the need for so much leverage?

The answer to this question gets us closer to the culprit. Lehman wanted to buy securities and other tradable assets to resell them for a profit. It borrowed money to buy assets. It was not raising capital for other companies and taking a fee for the service. That was the traditional role for investment banks. No, Lehman had become a big trader on its own account as well. Lehman and the other investment banks were buying and selling any number of assets – short sales, currencies, options, puts and calls, stocks, bonds, many sorts of derivatives – to speculate on price movements.

When done well, such trading earned huge returns and permitted lavish bonuses and life styles on the part of its owners and employees.

The point to note is that trading is not real investing. It is playing in the space left open by other buyers and sellers. Trading is short term; it is not designed to hold rights to the income or the capital appreciation of companies over the long haul. The time frame for trading is “right now”.

Trading is not a special, distinct part of capitalism with its genius for engineering modern economic growth. Trading has been with us since the dawn of time. Markets predate capitalism by millennia. Capitalism is a recent evolution in human social practices, substantially starting in Holland and England only in the 1600’s.

In the ancient Chinese state of Qi before the time of Confucius, there was a famous Prime Minister, Quan Zi. His lord, Duke Huan, loved purple cloth but grew annoyed when the price for such beautiful cloth rose too high even for him. A shrewd judge of human nature, Quan Zi advised his Duke as follows: since the dye used to make the cloth purple left a smell, the next time someone approached the Duke wearing purple clothes, the Duke should hold his nose as if the smell was repugnant to him. The Duke did so and all the courtiers, suddenly fearful of offending the Duke by wearing purple, sold all their purple clothes. The price of purple cloth in the markets of Qi immediately dropped. Quan Zi bought up all the purple cloth for a song and gave it to his now very happy Lord.

Such trading in markets has a long history throughout human history. But capitalism seeks patient capital to invest over the long haul in companies that need the cash for working capital, wages, raw materials, plant, equipment, etc. For capitalism to succeed, the right kind of investment capital markets is very necessary. But it must be a market that attracts investment, not speculation. A market in speculation is a casino.

From the beginning of capitalism, old trading habits were brought over to finance and trade the new possibilities created by the new, emerging economic system. But trading habits loosed inside capitalism have been disruptive.

The first boom and bust irrational exuberance in capitalism was the tulip mania in Holland in the early 1600’s. That mania for buying tulip bulbs was not systematically different in its origins, dynamics or eventual losses from our current boom/bust cycle in buying certain financial products.

Trading and investing thrive on different and inconsistent incentives. Traders like to take a fee from every trade; investors look to dividends and the sale of appreciated ownership shares as a company becomes successful in its business for their returns.

Trading is akin to speculation: you pay money for a chance to win. You don’t always win so your winnings over time need to compensate for your losses and the risks associated with the gambles taken. Trading and speculation are inherently short term and limited in their consideration of consequences. Their spirit is at odds with the motivations and perseverance needed to grow a business.

Capital markets exist to accommodate traders and trading in financial instruments. Investment capital is raised by selling equity and debt contracts. We can’t, as far as I can tell, eliminate trading from capitalism. Providers of capital and companies need the liquidity which the ability to sell into a robust market of buyers permits; trading sets prices, which give vital information on values and trends, successes and failures.

But the goose that lays the golden eggs is not one that lives on trading alone. Firms need patient capital - investors, not speculators renting stock for a while in order to profit from market movements. Speculators can easily divert management’s attention away from long term strategies to short term manipulations of stock prices.

The most important role of financial intermediaries is to provide capital; therefore, short term trading in capital contracts should be subordinate to the mission of finding ways to raise money for companies so that they can create jobs, products and services – and, in consequence, the precious commodity of real economic growth.

From here on out, I suggest, that financial markets be so structured that trading beyond a certain band is burdened with responsibilities that will reduce the appeal of more and more speculative trading and so bring incentives in financial markets back to the provision of patient capital.

We need a trading regime that performs useful services without spinning out of control and throwing us into spasms of wasteful excess.

We might want to consider having different kinds of markets – one for trading and one for investing, or pricing arrangements that add to the purchase price of the trade as the risk associated with each new, incremental trade gets bigger and bigger. If risk were properly priced, the demand for financial instruments would contract as risk conditions change adversely given the growth of excessive supply. Too much supply financed with debt leads to a boom, which sets us up for the ensuing bust.

But, this strategy would require taking into account up front all the external consequences – both positive and negative - for consumers, society, workers, lenders, investors, suppliers, government – that will flow from the activities funded by the extension of credit.

1 comment:

Anonymous said...

[url= ]Acheter cialis online[/url] [url= ] viagra [/url] [url= ]Achat cialis online[/url] [url= ]Achat viagra [/url] [url= ]Acheter du cialis en ligne[/url] [url= ]Acheter viagra en ligne[/url]