It's not terrorists that have threatened the economy so much as the failings in the financial systemby Edward Chancellor / November 20, 2001 / Leave a comment
Minutes before noon, on Thursday, 16th September 1920, an explosion took place on the corner of Wall Street and Broad Street, in front of the offices of JP Morgan & Co.
The blast killed 40 people and injured several hundred more. At the New York Stock Exchange, the windows were blown in, forcing brokers to gather in the middle of the floor. No one claimed responsibility for the attack, although a note was found in a letter-box several blocks away, warning of “sure death to all of you” and signed “American Anarchists.” The Great Red Scare had come to Wall Street. The financiers signalled their defiance: “Back to work tomorrow. The Reds will be defeated.”
The stock market was unperturbed and the Dow Jones Industrial Average closed a point up on the day of the attack, at 88.63. However, the economy was suffering from the post-war slump and over the next 12 months shares lost half their value. No one was ever prosecuted for the “outrage,” as it became known, although many suspicious-looking foreigners were arrested in the months and years that followed. As time passed people’s fears waned, and soon the great bull market arrived. On the ninth anniversary of the bombing, the Dow Jones stood at 372, up more than four times in the decade.
The loss of human life caused by the attack on the World Trade Centre was nearly 200 times greater than the 1920 attack. The direct damage to property was initially estimated at more than $20 billion, against a mere $3m worth back in 1920 (roughly $100m at today’s prices). The stock market was unable to shrug off the attack this time; when the market re-opened on Monday, 18th September, after the longest closure since 1933, the Dow Jones Industrial Average dropped by 7 per cent. By the end of the week, the market had fallen 14.3 per cent and an estimated $1.38 trillion had been wiped off share values.
Yet from an economic viewpoint, the greatest difference between the two tragedies lies not in the extent of the damage but in the timing. The first attack occurred before the roaring twenties were underway. Its importance diminished as the second greatest bull market of the 20th century got under way. The second attack, by contrast, follows the end of the greatest bull market in history. Speculative manias are an inevitable feature of the market system. A confluence of prosperity and technological innovation has produced bubbles on numerous previous occasions. However, a lowering of standards in the financial world is also a common feature of bubbles, and this is evident now, as it was in the 1920s.
By the spring of 1932, the Dow Jones index was down nearly 90 per cent from its peak. By that date, it was leading financiers-not anarchist subversives-who were on trial. The corruption of Wall Street during the 1920s was laid bare by the investigations of the senate committee on banking and currency, which became known as the Pecora hearings, after their leading counsel, the Sicilian-born lawyer Ferdinand Pecora. In his 1939 book, Wall Street Under Oath, Pecora exposed with relish the activities of the leading Wall Street firms. JP Morgan, for instance, had a practice of distributing securities at below market prices to persons on its “preferred lists,” including the former president Calvin Coolidge. National City Bank, forerunner of today’s Citigroup, also attracted Pecora’s attentions. Under the leadership of Charles Mitchell, the firm had become notorious for purchasing dud securities for its own account and later selling them on at a profit to the customers of the retail bank. Besides taking a bonus of around a fifth of National City’s operating profits, Mitchell and his colleagues also speculated for their own account. For instance, Mitchell bought stock in Boeing in October 1928 shortly before the bank started distributing the stock to the public at a far higher price. Pecora castigated the incentive systems of Wall Street firms, and accused the banks of fixing prices in the market with so-called “wash sales,” of participating in stock pools which ramped individual stocks before passing them on to the public, and of many other sins.
In the investment classic, Security Analysis (1934), Benjamin Graham and David Dodd observed the lowered standards of the investment banking houses during the 1920s. Graham and Dodd also lamented the decline in the quality of investment research: “In the last three decades,” they wrote, “the prestige of security analysis on Wall Street has experienced both a brilliant rise and an ignominious fall… the ‘new era’ starting in 1927, involved the abandonment of the analytical approach… facts and figures were manipulated to support the delusions of the period.”
As the great depression arrived, along with the collapse of corporate America, Wall Street firms stood accused of having encouraged the huge accumulation of business debt during the 1920s. In particular, they had been instrumental in the construction of vast industrial holding companies with complex pyramid structures of subsidiaries, layered with debt. As long as share prices were rising, the holding company structure was leveraged for profits. Unfortunately, the leverage also worked in reverse. For instance, the van Sweringen brothers had taken a loan of half a million dollars and with the assistance of JP Morgan put together a railroad empire, the Alleghany Corporation, based on a pyramid structure of holding companies and debt. By 1932, Alleghany’s shares were trading at less than 1 per cent of their 1929 peak, and the van Sweringen brothers were insolvent. Many other holding companies and their promoters were in a similar position.
Given these practices-the profiteering by financiers, the distribution of favours to friends, the flogging of poor securities to the public, the decline in the quality of investment research and the encouragement of unstable corporate structures-it is not surprising that Wall Street was the butt of public anger in the early 1930s. In particular, the banking firms were seen as suffering from a fundamental conflict of interest-the desire to benefit themselves and represent their corporate clients while at the same time serving investors. Commenting on the problems of Wall Street in the late 1920s, Justice Harlan Fiske Stone asserted, “that when the history of the financial era which has just drawn to a close comes to be written, most of its mistakes will be ascribed to the failure to observe the fiduciary principle, the precept as old as Holy Writ, that ‘a man cannot serve two masters.'”
Perceptions such as these informed the raft of New Deal legislation governing the securities market: the Glass-Steagall Act, which separated commercial and investment banking, and the Truth-in-Securities Act, both of 1933; and the Securities Exchange Act of 1934, which established the Securities and Exchange Commission (SEC) and tightened the rules against market manipulation; and the Public Utilities Company Holding Act of 1935, which legislated against the holding company structure for utilities.
The events of 11th September have brought to a temporary halt the critical examination of Wall Street practices of recent years-practices that bear a striking resemblance to those of the 1920s. After the dust has settled, this process must continue, since the failings of the financial system are potentially more dangerous to the economy than the destruction caused by terrorists.
Wall Street research played an important role in stimulating the market euphoria of recent years. During the 1990s, analysts who covered individual companies became increasingly involved in the investment-banking activities of their employers. This was a long-term consequence of the deregulation of brokerage commissions that occurred in the US in 1975 and in Britain with the Big Bang of 1986, which deprived research departments of much of their revenues. Analysts’ compensation became more tied to the investment-banking fees they generated. They served as “rainmakers” (initiating new business), they advised and marketed new share issues (for which they were paid big bonuses); and they assisted their corporate finance colleagues with mergers and acquisitions.
As consequences of these developments, brokerage research notes frequently became little more than corporate PR for investment bank clients. The modus operandi was revealed in a 1992 memorandum from Morgan Stanley to its staff: “our objective is to adopt a policy, fully understood by the entire firm, including the research department, that we do not make negative or controversial comments about a client as a matter of sound business practice.” More recently, JP Morgan Chase instructed its analysts to send reports to its investment bankers and corporate clients for vetting prior to publication. Another bank, Credit Suisse First Boston, went even further by merging its research and investment banking departments into a single operational unit. CSFB’s technology analysts were required to report to the head of technology banking, Frank Quattrone (this practice has recently been discontinued).
Analysts who didn’t toe the line found themselves out of a job. For instance, three banking analysts-Charles Peabody of Kidder Peabody, Michael Mayo of CSFB, and Sean Ryan of Bear Stearns-were all “let go” by their employers after issuing negative reports. On the other hand, analysts who served the investment bank’s purpose were well rewarded. Jack Grubman, the telecoms specialist at Salomon Smith Barney, is reported to have earned $25m in 1998.
A couple of years ago, a friend of mine applied for a job as a technology analyst at a leading investment bank and was inadvertently faxed the headhunter’s meeting notes with its client. These notes stated that the type of person the bank was looking for, “should have no pretence as to how the analysis business works.” It continued: “corporate finance is a critical part of the Group and the bank does not want analysts who are prissy about their independence… Analysts’ salaries are paid 50 per cent by corporate finance.” The analysts they were looking for “need to be strong on marketing” and finding corporate opportunities. Above all, they “need a reason to work hard (eg expensive tastes, big mortgage, schools, etc). They must need the money!”
As analysts became more and more the puppets of the investment bankers, they lost interest in alerting the public to the downside of any investment. Over the course of the 1990s, the number of sell recommendations issued by the investment banks’ research departments dwindled. According to First Call, a division of the financial information company Thomson Financial, the ratio of buy to sell recommendations went from six to one in the early 1990s to around 100 to one in 2000-the year in which the major US share index, the S&P 500, declined more than 10 per cent and the high-tech Nasdaq Composite was down nearly 60 per cent from its high. In February of this year, Fortune magazine reported that the research departments at the ten largest investment banks had 57 “sell” recommendations to over 7,000 “buy” recommendations outstanding.
In April 1999, Arthur Levitt, the now retired chairman of the SEC, expressed a concern “that investors are being influenced too much by analysts whose evaluations read like they graduated from the Lake Woebegon school of securities analysis-the one that boasts that all securities are above average.”
Despite the increasing number of equity analysts-some 4,000 in London alone-their forecasts have become steadily worse over the past few years. The analysts collectively failed to anticipate the slowdown in the US economy towards the end of last year and continued to maintain absurdly optimistic hopes for a profits recovery as the economy drifted into recession. As a result, anyone following analysts’ recommendations is likely to have suffered losses far greater than the market’s own decline. A recent academic paper reveals that analysts’ “strong buy” recommendations last year produced losses of 48.7 per cent adjusted for the market’s own movement; while the shares of companies that analysts recommending selling actually beat the market by 31.2 per cent. In other words, if an investor had acted contrary to the analysts’ advice, his portfolio would have outperformed the market by nearly 80 per cent.
The decline in the quality of published brokerage research has hurt private investors more than professionals. Analysts speak to fund managers directly and commonly give private briefings, which run contrary to their published advice. One analyst reportedly rang an institutional client to inform them of a new buy recommendation from his firm, “it is spelt S-E-L-L” announced the analyst. A recent SEC study discovered cases of analysts selling stocks for their own account while publicly advising others to buy. In one case, an analyst with a buy recommendation on a company had actually sold its stock short with the intention of buying it back at a lower price.
New Deal legislation made illegal the involvement of investment banks in stock market pools. However, during the recent bull market the Wall Street firms have performed similar tricks with their venture capital portfolios. The game worked like this: the analyst would identify a young technology company as a potential client; the investment bank (and in some cases, its employees) would take an equity stake in the firm. After a brief period the bank would arrange to take the company public, with the in-house analyst doing a “road show” to market the shares. Following the initial public offering (IPO), the analyst would then put on his other hat, publishing purportedly objective research on the company’s attractiveness to outside investors; and the bank would generally dispose of its shares following the expiry of the six-month “lock-up” period after the flotation.
During 1999, investment banks put money into more than 300 start-up companies. Leading firms, such as Lehman Brothers, earned up to a fifth of their profits from so-called “private equity” investments. In the six months ending in March 2000, Goldman Sachs floated nine companies in which it had an equity stake. The profits from such investments could be vast. When Chase Manhattan and several employees started disposing of its stake in internet software company, Infospace, in early 2000, they were sitting on a paper profit of some 7,000 per cent.
According to an SEC investigation, over a quarter of analysts who owned, or whose employer owned, shares in a company issued buy recommendations within a week of the lock-up’s expiry; what is known as a “booster shot.” The same investigation found that about one third of analysts had invested personally in the companies they covered prior to flotation.
The millennial market mania was also characterised by a flood of new issues, mostly in the technology sector. This was a hugely profitable business for the investment banks, which in the US receive fees of around 7 per cent on IPOs-in Europe, the fees average less than half this figure, leading some commentators to suggest that investment banks are operating a cartel in the US. In 1999, 214 internet companies were floated in the US, raising around $17 billion and generating underwriting fees for the banks of roughly $1 billion.
The banks resorted to a number of stratagems to keep the market for IPOs “hot.” First, the banks would set the issue price for new shares at below the level dictated by market demand. Secondly, they frequently restricted the supply of shares available. For instance, when the handheld computer firm, Palm was floated in March 2000, fewer than 4 per cent of its shares were made available to investors. The manipulation of supply and demand could have a profound impact on the first-day trading in a stock. Palm’s shares issued at $30, opened for trading at $165 (the same shares were recently selling for $3.50). The ramping of shares on the first day of flotation became a regular feature of the millennial market. According to finance professor, Jay Ritter, in 1999 more than 100 new issues doubled on their first day. The average first-day rise for new issues was around 70 per cent. Had the investment banks priced the shares at a level nearer to the first-day closing price, they would have raised an extra $36 billion for companies, which came to the market. While this “money left on the table” did not benefit the newly-floated companies-many of which soon ran out of money following the collapse of the bubble-it brought real profits to those investors who had received shares prior to flotation.
A number of US authorities, including the New York Attorney’s Office, are now investigating the charge that certain investors were required to support new issues in the secondary market by purchasing shares at a pre-determined price. In particular, the activities of Credit Suisse First Boston have come under the spotlight. In the late 1990s, CSFB made an aggressive push in technology banking. Following the hiring of star investment banker, Frank Quattrone, in 1998, the bank shot to the top of league tables for technology-related IPOs. Towards the end of last year, allegations emerged that CSFB wanted kickbacks from investors in return for allocations of new issues, including the payment of extra commissions, which is not against the law, and supporting new issues in the aftermarket, which is. Although Quattrone has not been named in the investigations, three CSFB employees-one of whom reported to him-have been sacked.
During the recent bull market, as in the roaring twenties, there was a marked decline in the quality of new issues. Hungry for the 7 per cent commission fee received for underwriting new issues, bankers were prepared to take to market companies that had no profits, unproven business plans and insufficient funding to see them through to profitability. The financing of such companies is normally left to experienced venture capitalists, with the stock market serving as an exit for their mature investments. Former dotcom executives now relate how they were swamped by eager investment bankers, ready to offer their services for an IPO, at a time when their companies had scarcely started operations. Recent figures from Thomson Financial reveal that of the 547 IPOs issued in the US in 1999, around a quarter were trading below $1 or no longer existed. This is an abysmal record, although not as bad as the 99 per cent failure rate of new companies floated on the unregulated London market during the South Sea bubble of 1720. One is drawn to conclude that, in both periods, most of the companies were floated simply to take advantage of short-term market euphoria.
Small investors have suffered the greatest losses. They ended up owning around 70 per cent of all internet shares, yet they received little or no allocation of shares at the point of issue. They were forced to buy the shares in the secondary market from those insiders who had received an allocation at the time of the IPO. Individual investors also hold a disproportionately large stake of companies quoted on the Nasdaq stock exchange, which has fallen by some 75 per cent from its peak. Pecora’s description of the 1920s stock exchange as a “glorified casino where the odds were heavily weighted against eager outsiders” is equally applicable to the millennial market.
The stock market bubble also fostered a boom in mergers and acquisitions, especially in the high technology field, which many bankers exploited to their benefit. In 1999, three leading investment banks-Morgan Stanley, Goldman Sachs and Merrill Lynch-each advised on deals worth more than $1 trillion. In the same year, US investment banks pulled in more than $3.2 billion in fees from mergers. During the late 1990s, the telecoms companies and their suppliers expanded rapidly through acquisition. Cisco, a company that makes hardware for the internet and was for a short period the most valuable company in the world, completed more than 70 acquisitions since 1993. The British mobile phone company, Orange, changed ownership so frequently that fees generated for the advisers far exceeded the company’s historic revenues. The hyperactive deal-maker, Juan Villalonga, former head of Spanish telephone giant, Telef?3nica, was advised by seven separate investment banks as he tried to fashion a multinational, telephone, mobile phone, internet and media conglomerate. The former state-owned Italian telephone company, Telecom Italia, was virtually run by bankers from Lehman Brothers, after the firm was taken over by Olivetti in 1999. After Britain’s Vodafone paid nearly $181 billion for Mannesmann, a German engineering and mobile phone company, in 1999, investment bank and legal fees were estimated at close to $900m in cash.
The record for mergers resulting from the recent boom is as bad as for IPOs. Several leading European telephone companies, including Deutsche Telekom and France Telecom, are currently straining under the burden of debt acquired to finance their takeovers. Vodafone has lost around two-thirds of its value since swallowing Mannesmann. Marconi, the British telecoms equipment supplier which emerged from the venerable blue-chip, GEC, is close to bankruptcy following a couple of ill-advised acquisitions in the US: although Marconi spent more than $6.5 billion in cash on these deals, its current market value is less than $1 billion. JDS Uniphase, a Canadian manufacturer of optical networking equipment, has recently declared losses of nearly $56 billion, following the write-off of goodwill from its over-priced acquisitions. By August of this year, the aggregate value of write-offs by US technology companies, largely related to takeovers, exceeded the aggregate profits of all the companies quoted on the Nasdaq stock exchange over the past five years. Analysts forecast that total write-offs for acquisitions could reach $1 trillion by the end of the year.
Of course, the directors of acquisitive companies must take most of the blame for their errors. However, their advisers willed them on. It is often said that investment banking has become transaction-driven business rather than one based on long-term corporate relationships. Because bankers are paid according to the size of the deals, contingent on their success, they have a strong incentive to urge companies on to greater and greater deals. Naturally, the analysts at the investment bank research departments generally welcomed the mega-deals of the period. Indeed, there is anecdotal evidence that some analysts even put pressure on companies to engage in unwanted transactions. Mark Getty, the head of Getty Images, a digital picture library, claims that analysts warned him that unless he made acquisitions and generated fees for their investment banks, they would drop research coverage of his company. Getty’s claim that investment banks fuelled the boom in technology, media and telecommunications is supported by the fact that in 1999 nearly half of US investment banking fee income came from this sector.
The damage wreaked by the technology bubble has not affected investors alone. According to Tim Congdon of Lombard Street Research, “the high tech bubble of 1999 and early 2000 was a disaster for American capitalism. The mishandling of the investment process in the new technologies will cause productivity growth to be slower than it would otherwise have been.” In June, the House Banking Subcommittee on Capital Markets initiated hearings into conflicts of interests facing investment bank analysts. One witness to the hearings, US fund manager David Tice, asserted that in recent years Wall Street had fostered a culture of corporate irresponsibility: “by refusing to evaluate objectively internet and telecoms companies during the high tech frenzy, analysts fuelled (rather than checked) the bubble.”
The future prospects for growth are also damaged by the burden of debt accumulated during the bubble. In the US, telecoms companies alone took on more than $600 billion of debt during the bubble. The immediate consequence has been record levels of debt defaults and mass redundancies in the telecoms sector. This year, more than a quarter of a million employees of telephone companies and their suppliers have been laid off. Following the events of 11th September, the situation has further deteriorated.
The backlash against the investment banks has been gathering pace. Nearly 300 fraud suits against them had been lodged with the US courts by the middle of September. These relate to alleged manipulation of the secondary market in new issues; misrepresentations by investment bank analysts and self-dealing by banks which promoted their own venture capital investments. Most of these cases will fail, since accusations of fraud are difficult to prove.
The flaws in the financial system that were exposed in the 1930s led to the New Deal legislation. The recent bubble has revealed similar flaws. Policymakers might consider a number of reforms. First, the problem of conflicting interests between the investment research and corporate finance departments of the banks must be resolved. To date, only palliatives have been offered-for instance, the ending of direct links between analysts’ pay and individual investment bank deals and forbidding analysts from investing in the companies they cover. This is not enough. Research departments should be forced to become operationally and financially independent of the investment banks. In other words, the cross-subsidy from investment banking to research should end. This reform is comparable to the SEC’s desire that accountancy firms separate their audit and consultancy operations (the US regulator perceived a danger that the quality of auditing was declining as it became a loss-leader for accountancy firms eager to provide other, more profitable, services). While the ending of the investment bank subsidy would most likely reduce the quantity of research available and investors would have to pay more for research in future, its quality should rise. It would also level the playing field between the providers of investment research, since the supply of virtually free research by the investment banks makes life difficult for independent research firms.
Secondly, the market for new issues needs to be examined. A balance is necessary between encouraging a spirit of risk-taking and protecting investors, especially private ones. The current system performs neither of these functions well: immature companies were floated on the stock market and then left to sink, while investors took massive losses. The failure of companies and the losses of investors has led to increasing risk aversion, which then throttles enterprise. The rules for listing on the stock market should be tightened. It may be too much to expect that all companies be profitable before flotation, but such cases could be scrutinised by a special committee of the stock exchange, and limited to cases where the capital requirements of the business are too great to be met by venture capitalists alone. Promoters might also be restricted from selling stock until their firms had reached profitability, instead of the futile six-month lock-up which currently applies. This might focus their minds on achieving profitability rather than running up the stock price and bailing out before the company fails. Furthermore, investment banks should be forbidden from underwriting shares of companies in which they have a venture capital investment.
The problem of “hot issues” also requires attention. The profits to be gained from manipulating new issues to produce a “pop” on the first day are an irresistible temptation. The investment bankers who asked for kickbacks in return for IPO allocations and demanded that new issues be supported in the secondary market were doing nothing new. Such trickery has flourished in unregulated markets in all places and in all times. It might be checked by moving from a fixed-price system for underwriting new issues to an auction method, where the price of a new issue is set by the free interaction of supply and demand (this system is already operated by WR Hambrecht, a small US investment bank). By removing their powers of patronage in the distribution of new issues, investment banks would have less incentive to manipulate the market. In addition, the allocation of new issues should be made more transparent.
Finally, there remains the question of how to reform the business of mergers and acquisitions so that such activity improves the allocation of resources, rather than simply making bankers rich. A pile of academic evidence suggests that too much merger activity takes place. In most cases, the shareholders of the acquiring company are the long-term losers. This has certainly been the case in recent years. Nevertheless, fee-hungry bankers continue to entice chief executives into value-destroying deals. So long as their compensation is contingent on completion of deals and related to the size, rather than benefits, bankers will have an incentive to encourage their clients to overpay. One solution might be for investment banking to switch to a fee system based on the number of hours worked-like lawyers or accountants. Alternatively, the investment banks’ fees might be related to the long-term performance of companies they advise: if a deal proved to be value-destructive, then at least the banks would also suffer.
Participants in financial markets are too ingenuous to remain shackled permanently by regulation. And in euphoric times, investors often ignore the protection that is there. The reforms I have suggested are not intended to inhibit the activities of the investment banks, but rather to improve their efficiency. The capitalist system functions well because the incentives are normally clear. Once the interest of the investment banks is better aligned with that of their clients, be they investors or corporations, the system should work even better in future. n