Keeping your balance on Dover Beach

 

“I sit in one of the dives

 On Fifty-second Street

 Uncertain and afraid

 As the clever hopes expire

 Of a low dishonest decade:

 Waves of anger and fear

 Circulate over the bright and darkened lands of the earth..”

 

- WH Auden, ‘September 1, 1939’.

 

There may be a few stubborn holdouts who believe in the primacy of economic analysis, but the investment community is otherwise coming round to the reasonable conclusion that successful investing particularly during turning points in the evolution of markets is as much psychological as fundamental. This would reinforce the essential truth behind Keynes’ infamous comparison of investment to judging a beauty contest:

 

“It is not a case of choosing those [faces] which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.” (‘General Theory of Employment, Interest and Money,’ 1936.)

 

There is, of course, another way of gaming the markets, and one with a better likelihood of ultimate success. And that is to make proprietary investments which, whether they work out or not, can be sold at a profit by leveraging one’s brand - to investors in thrall to that brand. Investment products, after all, tend to be aggressively sold rather than passionately bought. Such is the logic behind the full service investment bank. In its senior incarnation, FullServiceInvestmentBank nurtures a relationship with a promising startup. FullServiceInvestmentBank then takes PromisingStartup public (earning mysteriously sticky IPO fees of roughly 6.5%), and simultaneously creates cannon fodder for its private client division. FullServiceInvestmentBank then issues research on PromisingPublicCompany in return for brokerage commissions. After a suitable period it then romances  PromisingPublicCompany with proposals for potential corporate acquisitions that primarily appeal to executive vanity. Assuming its client rises to the bait, FullServiceInvestment Bank earns more fees for consultancy advice. At some point PromisingPublicCompany becomes AilingPublicCompany, and FullServiceInvestmentBank charges more fees for further strategic advice that may or may not be self-serving or conflicted – this is about revenues and expressly not client service. In the most perfect incarnation, which is admittedly rare and presumably illegal, FullServiceInvestmentBank mysteriously manages to play both sides of this game against its supposed client, PublicCompany, by acting as both bodyguard and matchmaker. In any event, a merger or breakup is on the cards, dangling the prospect of yet more fees. Lather, rinse, repeat.

 

The ways of Wall Street invariably seem impenetrable to outsiders. This may indeed be because they defy conventional commercial logic. Most listed businesses are presumed to be run for the benefit of shareholders, employees and “stakeholders” (whatever that means), in that order. But as Bloomberg’s Michael Lewis writes (“What does Goldman know that we don’t ?”), conventional commercial logic and Wall Street make uneasy bedfellows. How else to explain, for example, the payment for failure pocketed by outgoing Merrill Lynch CEO and amateur golfer Stan O’Neal ($161.5 million) versus Merrill’s latest $16.7 billion writedown ? Commercial language can’t really cope with this mismatch between reality and the money-porn fantasy that passes as executive compensation. Fiction can at least attempt to – we can legitimately say that this is ‘Alice through the Looking Glass’ stuff. As Michael Lewis and the Wall Street Journal’s Kate Kelly point out, just one Wall Street firm – Goldman Sachs – has managed to neatly sidestep the subprime car crash that piled into all of its rivals. But as Ms. Kelly’s recent article suggests, only because senior management at Goldman overruled its own traders on the sly and took short positions in subprime junk even as trading employees were busy loading up the truck like everybody else. Because management’s short positions were larger than the loss-making long-biased holdings of subordinate staff, the firm managed to survive the carnage. But does this not sound like a chaotic modus vivendi for a trading firm – the white-collar version of an arm-wrestling match ? And as Michael Lewis asks, “why do you need the traders ? And what happens when the guys at the top of the firm are wrong ?”

 

Brokerage stock investors would respond by reference to the cyclicality discount imposed on investment bank valuations. Trading earnings are not consistent. But even at today’s battered down valuations, it is debateable whether investors have truly priced in the disappearance of so many different revenue streams for what may be some time to come, and the likely permanent closure of some of the more exotic or opaque structuring areas. Those investors who bought what they presumed to be AAA rated debt offering a riskless premium to Treasuries and saw it default in a matter of months will surely take a more sceptical view of Wall Street’s plat du jour in future – if they have the luxury of retaining their jobs at all.

 

It seems astonishing that only a few years after Worldcom, Enron, Blodget et al., through the mechanism of fundamentally flawed repackaged debt Wall Street has managed not only to poison its own wells, but those across the global investment community. Raghuram Rajan’s recent commentary in the Financial Times on Wall Street’s equally flawed executive pay model has rightly triggered much debate among investors. After the dotcom research fiasco (where $10bn was paid in settlement, mysteriously without any acknowledgment of blame) and now subprime, with the apparent connivance of the ratings agencies, expecting Wall Street and the City to show moral leadership is like expecting brothel-keepers to advocate chastity. But for the individual, the lure of investment banking remuneration is hard to resist, as Tony Blair has shown.

 

The recent well-funded departures of key Wall Street executives after overseeing billions of dollars of losses plainly reveal the lack of correlation between executive compensation and the delivery of shareholder value. Executives in “real world” businesses – manufacturing (what’s left of it), retailing, real industries - despite more mundane compensation levels, are plainly held more accountable for their actions. There is a tone of hopelessness about this debate, but there need not be. Just as investors need not throng to buy the products or advice of invariably self-interested banks, so shareholders can vote with their wallets and elect to sell their stock in those same banks. On recent evidence, a growing constituency (admittedly not including sovereign wealth funds) appears to have worked this one out for themselves.

 

On the basis that January does turn out to be a leading indicator for the balance of the year, there is currently just one sub-index (pharmaceuticals and biotechnology) from the FTSE All-Share showing a positive return of any kind, which obviously does not bode well for the future. Interestingly, retailers are currently underperforming the banks. But in ‘reversal of fortune’ terms, the retailers are playing catch-up. So much bad news is now priced in for the financial sector that it feels exquisitely difficult not to start to nibble at current valuations, in the full knowledge that the sector isn’t out of the woods yet (rather, investors into the bank sector are having to pick their way across a minefield through a dense fog). Citi has shown us that bank dividends can get chopped, but if dividends are maintained, the likes of 8.2% (RBS) and 6.8% (Barclays) certainly stack up well against Gilt yields. With price / earnings ratios hovering around 5 or 6 times, according to Bloomberg analytics, a fair degree of apocalypse is already priced in. This is not the case for US investment banks: the S&P 500 Investment Banking and Brokerage Index, by contrast, trades on a price/earnings ratio of 10 (so not cheap enough yet by a long chalk) and a dividend yield of a puny 1.9%.

 

But to return to the macro picture. No amount of graphs, tables or share price charts can capture the essence of the current investment environment as well as some apposite ‘verbal pictures’ can. Matthew Arnold’s ‘Dover Beach’ (admittedly ripped at least one cultural milieu and two centuries out of context) does a surprisingly good job at painting the Zeitgeist of investment markets afflicted by a dysfunctional banking, currency and credit system in January 2008. Earlier in pre-subprime 2007 all is well:

 

“The sea is calm tonight.

 The tide is full, the moon lies fair

 Upon the straits..”

 

And then Wall Street exerts its inexorable malign gravitational pull:

 

“for the world..

 Hath really neither joy, nor love, nor light,

 Nor certitude, nor peace, nor help for pain;

 And we are here as on a darkling plain

 Swept with confused alarms of struggle and flight,

 Where ignorant armies clash by night.”

 

Readers are welcome to propose alternative language that better addresses a climate of loss of faith in establishment hierarchies, general mistrust, and the fear of an ever-darkening future. If nothing else, it would seem to make a lot of sense to view the equity market through an aspirational prism of maintaining capital values, rather through one of inevitable capital gain, because bear markets wear numerous disguises. Not least, favour “return of capital” over “return on capital”. Or to voice it in a way that even Wall Street might find uncomfortable: please give me my money back. For a sign of things that might be to come in financial sector remuneration, see last Thursday’s Wall Street Journal lead article: “(US) financiers’ pay spurs financial crisis”. As feared, but perhaps inevitably, the politicians are now rooting for dead bodies. Stan O’Neal, ‘Chuck’ Prince of Citigroup (just $29.5 million in departing compensation), and Angelo Mozilo of Countrywide Financial have all been asked to testify before the House Committee on Oversight and Government Reform. Each has been asked by Committee chairman Henry Waxman,

 

“You should plan to address how (your pay package) aligns with the interests of.. shareholders and whether this level of compensation is justified in light of your company’s recent performance and its role in the national mortgage crisis.”

 

A financial system wherein workers can only get paid upon completing transactions is inevitably geared to self-interest. Up-front commissions may be well-established, but the political winds are starting to blow – The Wall Street Journal, which reports the inquisitorial momentum with some sympathy, is hardly a bastion of socialist tendencies. Life in financial services is about to get a lot more interesting, irrespective of the direction of the markets.

Comments

[John Rogers]

I know next to nothing about the Casino Economy you describe but I am deeply interested in the real value of the planet we live on and the future of everything humans hold dear such as community and care for each other. I have spent the past 14 years as part of a worldwide movement which is pioneering what Bernard Lietaer (author of the visionary book The Future of Money) has described as 'complementary currencies', sometimes also known as local or 'community currencies'. We have learned a lot as we prepare to build liferafts for the millions of people who have no stake in the Casino but who are affected by the fallout from its addictions. Check out my website for many links on this topic. John Rogers, Germany

[Ellen]

Merrill's losses don't surprise me at all. As a former First VP , now retired, I laugh in disgust at the repeated major mistakes of "top notch" financial firms. First, in the 80's selling real estate limited partnerships which went on to collapse in the late 80's after tax reform. The brokers made a 6% commission selling them (not I). The accountants made a fortune trying to report the income/losses after they went bust. And the clients understood very little of what they ever received. One of the main edicts I first assumed as and advisor and learned later was correct; if you cannot fully understand the product and the trading desk cannot fully explain all details, then don't sell it to your clients. Of course I was minority in terms of my conservative approach to selling product to my clients. But in retrospect, I was right and did the right thing by my clients as opposed to the firm or myself. Furthermore, when CDO "tranches" became available for sale to the retail system, the word "tranche" should have sounded alarms. CDO's paid more to the broker than the more conservative,
unaltered products. Of course they pay more!!! Some one had to pocket the difference!! Since corporate governance is so weak in this industry and internal conflicts are inherent in the system, things will never be any different ...from LP's blow-ups and S&L crises , to analyst compromise, to front-running trades, to Enron , to sub-prime. It hasn't ended and there will be more. The question is ...what will be the next "new-new" cycle and how/when will we know? Remember the Glass-Steagall Act? The Banking Act of 1933. Bill Clinton repealed some aspects of it in Nov 1999. Fast forward eight years..and we have the "tranche-trash redemption".

[tim price]

"At a dinner in Washington in February 1998, Sandy Weill of Travelers invites Citicorp's John Reed to his hotel room at the Park Hyatt and proposes a merger. In March, Weill and Reed meet again, and at the end of two days of talks, Reed tells Weill, "Let's do it, partner!"

On April 6, 1998, Weill and Reed announce a $70 billion stock swap merging Travelers (which owned the investment house Salomon Smith Barney) and Citicorp (the parent of Citibank), to create Citigroup Inc., the world's largest financial services company, in what was the biggest corporate merger in history.

The transaction would have to work around regulations in the Glass-Steagall and Bank Holding Company acts governing the industry, which were implemented precisely to prevent this type of company: a combination of insurance underwriting, securities underwriting, and commecial banking. The merger effectively gives regulators and lawmakers three options: end these restrictions, scuttle the deal, or force the merged company to cut back on its consumer offerings by divesting any business that fails to comply with the law.

Weill meets with Alan Greenspan and other Federal Reserve officials before the announcement to sound them out on the merger, and later tells the Washington Post that Greenspan had indicated a "positive response." In their proposal, Weill and Reed are careful to structure the merger so that it conforms to the precedents set by the Fed in its interpretations of Glass-Steagall and the Bank Holding Company Act."

Bank which successfully grinds Glass-Steagall into irrelevance: Citigroup. Bank which writes down $18 bn in one quarter: Citigroup. Be careful what you wish for..