What’s Wrong with Wall Street?
Lehman Brothers is no more.
AIG has become a ward of the state. There are no longer any big independent Wall Street investment banks. The market has crashed. Madoff stole a record $50 billion. Etc. If the historical events of 2008 have taught us anything, they have taught us that Wall Street is broken. The natural questions are: what went wrong, and how do we fix it?
The most common response to the first question is simply greed. However, I don’t believe greed is the problem. For those who now expect me to echo the sentiment of Gordon Gekko (Michael Douglas’ character from the movie “Wall Street”) and say that greed is good, I hate to disappoint. Greed is not good in my opinion. The problem with simply saying the cause of this crisis was that people on Wall Street were greedy is that in order for that to be true, either there must have been a time when people on Wall Street were not greedy, or there has actually never been a time when Wall Street has worked. I seriously doubt there is anyone who would argue the former, and while there are probably some extremists who would argue the latter, the evidence against this argument is overwhelming.
I have thought long and hard on this issue, and greed, while certainly a factor, just didn’t seem to fully explain this crisis. Something was missing. The words of an old mentor kept coming back to me. In large complex organizations, the vast majority of problems are caused by structural issues, not human fallibility. Wall Street is structurally broken, and it is going to take more than a spiritual revival to fix it.
To understand why Wall Street is broken, you must first understand why Wall Street exists in the first place. What is Wall Street’s purpose? Wall Street exists to bring together people with business ideas with people who have capital to invest. This is the essence of capitalism: Investors decide what companies will be provided the capital they need based on the merits of their business plans, not on some central plan devised by government leaders or on political connections. Capital is free to flow to the best business ideas. These companies use that capital to build plants, to create products that people actually want to buy, and to create jobs and prosperity.
For all of its history, Wall Street and the investment banking firms that had come to represent it have financed American industry. The railroads, steel, oil, automobiles, computers, and the Internet were all financed by Wall Street – real industries made up of real companies that produced real products and real jobs. The business managers would come to Wall Street with their ideas and plans, and the investment banks would underwrite loans in the form of bonds, or ownership stakes in the form of stock. The investment banks would take those stocks and bonds and distribute them to investors through their brokerage offices around the country. These investment banks made money by charging fees to the companies they helped and by charging commissions on all the stocks and bonds they sold to investors around the country.
Then something happened starting in the 1980s. Technology along with advent of the discount broker started putting pressure on all those commissions. It became more and more difficult for the big Wall Street firms to charge those high commissions on simple stock and bond transactions. At the same time the work of Harry Markowitz, the founder of modern portfolio theory, was becoming more accepted, and the concept of risk management was becoming popular in the investing world. Everything you know about diversification, risk and return all came from the work of Markowitz.
This desire for diversification, along with the introduction of the 401(k) plan, helped launch the mutual fund industry.
Here is where it is important to understand how “investment education” for the masses gets disseminated. For Wall Street to push a concept, it must be generally correct (they would not be so foolish as to push out and out lies), but it also must be profitable to Wall Street. Mutual funds were very profitable. All of a sudden the average client who might invest in ten to twenty stocks and bonds could be sold a mutual fund instead. The fund invested in hundreds of stocks and bonds. And guess what, the mutual funds buy and sell stocks and bonds the same way anyone else buys and sells stocks and bonds – through Wall Street brokerages. Sure, they pay lower institutional commission rates, but they make up for that in volume and also tend to trade far more often than the average investor.
But that is just the revenue that happens behind the scenes. On top of all that, the Wall Street brokerages still got commissions from selling the funds themselves, and they got a piece of the ongoing management fees. As brokers started shifting away from selling individual stocks and bonds towards selling funds, they had to come up with new ways of explaining their purpose, i.e. “adding value.” After all, picking funds didn’t seem nearly as hard as identifying a lucrative stock, especially early on when there were not as many funds out there. So they became “advisers.” That is when Wall Street really embraced Mr. Markowitz and his theory. Owning one mutual fund is not enough; one must own several funds that invest in different types of investments.
Review of Economy
The Economy is bad. and we are afraid that it will get worse before it gets better. The market meltdown that occurred at the end of September and the beginning of October removed any resiliency that the economy had shown previously. Consumers simply stopped spending. Economic activity nearly came to a standstill as consumers and businesses alike were frozen by the combination of the continued housing crisis, the credit crisis, and the meltdown on Wall Street. GDP growth for the 3rd quarter 2008 was negative 0.5%, and it is estimated to be down 4.3% in the 4th quarter.
Unemployment has risen to 7.2% and continues to get worse as there are few new jobs being created. We believe that unemployment will peak around 8.3%, as the economy will most likely continue its decline through the first half of 2009.
However a recovery will happen. Most economists expect positive growth to return in the 3rd or 4th quarter. The real question is what will the recovery look like and how long will it take before the employment picture improves?
Review of Market
The S&P ended down 21.94% for the quarter, but this really does not tell the story. Almost all of that damage was done by October 10, when the market first bottomed. We then went into a trading range where the market would rise and then fall to re-test that bottom. We did that three times before finally bottoming on November 20. From November 20 to year end the S&P 500 was up 20.48%. This is a silver lining in what was the worst year in the market since 1937. The market recovery is underway.The Lehman Brothers US Aggregate Bond index was up 4.57% as the credit crisis has begun to ease, and the Fed continued to lower interest rates, taking the Fed Funds target rate to nearly zero.
International markets did slightly better with the MSCI EAFE down 19.90%. Emerging markets remained distressed declining 27.56%.
