Michael Lewis, Wall Street, and Trust

Outsourcer?Right after Michael Lewis’s 60-Minutes appearance to promote his new book Flash Boys I wrote a blogpost about it.

The next day I received a phone call from a retail stock broker. His tone was somewhere between kindly uncle and exasperated old-timer, but his message was clear:

“That Lewis guy’s obviously got an axe to grind,” said the caller. “He lost big-time in the market and he’s trying to get even with people. And that Katsuyama guy he writes about, he’s just a spoiled baby, trying to make an even bigger buck than he was lucky to get paid in the first place. The whole thing is just a bunch of hype designed to sell books, and you’re getting suckered into it.”

If you know anything about the book (and if you don’t, here’s a good start), you know that’s a crock. In any case, my caller exhibited three traits:

  1. He’s convinced the world is of the dog-eat-dog variety,
  2. He’s convinced that everyone else believes the same thing,
  3. The default strategy therefore is do unto others before they do unto you.

My caller does not believe in people with different value systems. Let’s call such people “unicorns” Canadians.  (Did I mention Katsuyama is Canadian?)

Now, I suggest the odds of making my caller more trusting and  trustworthy through more regulations are roughly zero. The odds of making him trustworthy  through incentives, can be only slightly better (and I can’t even imagine the incentives).

The only way he’s ever likely to behave in a trusting and trustworthy manner is if he gets beat in a level playing field market by those who are capable of trusting and being trusted.

The Showdown on CNBC

The next day, Lewis and the book’s hero Brad Katsuyama appeared in a very confrontational spot on CNBC  with Bill O’Brien, President of BATS. BATS is an exchange that the book accused of being at the heart of misleading investors and supporting high frequency trading in a legal form of “front-running.”

O’Brien wasted no time throwing the first punch, leading off with:

O’Brien: Shame on you, Michael and Brad, shame on you both for falsely accusing literally thousands of people and possibly scaring millions of investors in an effort to promote a business model. It’s a very, very old tactic to try to build a business on the planks of fear, mistrust and accusation; this is certainly taking that to a new level. It reflects either an unwillingness – a continued lack of understanding about how this market operates or just unwillingness to acknowledge it, because you’re trying to launch a new business and you want to get volume for your platform…

Katsuyama: If you’re going to launch these accusations, let me ask – what market data do you use to price trades?

O’Brien:  We use direct feeds.

Katsuyama: No, you don’t. [You use SIP feeds]

O’Brien: Yes, we do [use direct feeds]

The very next day, the Wall Street Journal reported:

BATS Global Markets Inc., under pressure from the New York Attorney General’s office, corrected statements made by a senior executive during a televised interview this week about how its exchanges work…the exchange operator said two of its exchanges, EDGA and EGX, use a slower feed, known as the Securities Information Processor, to price trades.

This is what is known, in my circles as – technical term – being caught in a flat-out lie.

In any case, Mr. O’Brien exhibited the same three traits as my retail-level caller:

  1. He’s convinced the world is of the dog-eat-dog variety,
  2. He’s convinced that everyone else believes the same thing,
  3. The default strategy therefore is do unto others before they do unto you. Which of course is just what he tried to do.

O’Brien does not believe in people who believe in honesty or fair dealing; in other words, he does not believe in unicorns or Canadians – even when staring one in the face (did I mention that Katsuyama is Canadian?).

The odds of making O’Brien and his ilk more trustworthy through better regulations are roughly zero. The odds of making him trustworthy  through incentives, only slightly better (and I still can’t even imagine the incentives).

The only way he’s likely to behave in a trusting and trustworthy manner is if he gets beat in a level playing field market by those who are capable of trusting and being trusted.

And that is precisely what Brad Katsuyama is setting out to do in the development of a new exchange, IEX. Not a regulatory answer; not a new incentives answer; an answer based on the hope that enough customers in the market will actually choose to do business with an exchange that is unconflicted, that is transparent about its data, that offers only easy-to-understand offers, and that enforces a level playing field.

Will it work?  Stay tuned. There are some interesting positive signs, including even from (hold your breath) Goldman Sachs.

Trust on Wall Street

Having focused solely on trust in business for over 15 years now, several things are apparent to me.

1. The Mother Theresa Paradox is Real. The less trust exists in an industry, the less interested are the industry players in reforming it. It is the already-trust-conscious industries (and companies) who are convinced of trust’s value, and who are interested in improving it. This despite the fact that trust is an overwhelmingly powerful competitive advantage for anyone who can see it. Katsuyama’s new exchange will be a great test of that proposition.

By anybody’s measure (e.g. Edelman’s Trust Barometer), financial services are at the bottom of the trust list. Low hanging fruit, for anyone willing to think their way out of the low-trust box.

2. You Can’t Get Trust with Cheese.  The rats-and-cheese model of behavioral change through incentives doesn’t work with trust, because incentives are personal and trust is relational. Unless you can make incentives team-based and long term, they fail. Even then, they can and will be gamed by very smart rats. See next item.

3. Regulation Is a Vicious Circle. Wall Street pays much more than regulators, and many regulators go to work in the industry they regulate. Regulators have small budgets. But even if that were untrue, you can’t regulate morality. In fact, the more you make “ethics” the target of regulatory efforts, the less it becomes about morality and the more it becomes just compliance.

4. The Needed Values are Clear. They’ve been obvious for some time. They are:

  1. a focus on the client first for the sake of the client
  2. a belief in collaboration
  3. a focus on relationships, not transactions
  4. a default to transparency

These are key to trust. They are clearly in short supply on Wall Street.

So, how to increase ethics on Wall Street? Two answers:

One is, cheer on Brad Katsuyama’s noble capitalist market experiment in honesty, transparency and customer focus.

The other? Instead of Occupy Wall Street, how about – Outsource Wall Street! To Canada!

Within months, I suspect, we’d see lower transaction costs, less risk of flash crashes, higher liquidity, higher legitimate volume, and a reduction in the total size of the industry with no loss of value added.

All it takes is the willingness to operate based on values other than dog-eat-dog.


Trust Hero: Brad Katsuyama, on CBS 60 Minutes

Illustration: Truth and LieMichael Lewis’s new book Flash Boys goes on sale at Amazon this morning, March 31. The headline, as he put it in Sunday’s exquisitely timed CBS 60 Minutes – “The stock market is rigged.”  And it’s rigged in favor of high-frequency traders.

Complaints about high frequency trading are not new. What is new, to nearly all of us, is the story of an unlikely trust hero that Lewis profiles, and the amazing response to HFT that he is developing.

Brad Katsuyama, a Canadian employee of Royal Bank of Canada, ran the New York trading desk for RBC. He noticed that the trading action was as if someone was constantly front-running him, causing him higher prices to fill orders, and thus higher costs to his customers. He soon found the problem was endemic in the industry.

He teamed up with an Irish fiber networks expert. The two of them and their team figured out how it all worked. Firms like Spread Networks had figured out how to lay enough fiber cable to allow just milliseconds of advantage – enough to notice an order from someone like RBC, then quickly get in front of that order at other exchanges, and buy-then-sell the same stock before the victim’s trade, running on slower networks, could get filled.

It is, as Lewis says, “legalized front-running.” And it was clearly worth billions.

Trust Motives

Now comes the trust part. Katsuyama and his team figured out how to beat the front-runners by spreading their orders to all arrive at the same time at different exchanges.  But he wasn’t done yet. He wanted to change the rigged market. Why? “Because it just didn’t feel right. Customers of pension funds and retirement funds are getting bait-and-switched every day.”

Katsuyama quit his million-plus job and set out to found a new exchange. What motivated him – the chance to earn multiple millions more, in good capitalist fashion? No. In his words, “It felt like a sense of obligation; we’ve found a problem affecting millions of people, blindly losing money they don’t even know they’re entitled to.”

They founded IEX, a competitive exchange; using 60 kilometers of cable to disadvantage the HFTs, they beat them at their own game. The exchange is off to a good start, though with lots of powerful enemies.

Selling Trust 

Katsuyama himself is a bit giddy. “To think that trust itself is actually a differentiator in a services business – it’s kind of a crazy idea.”

Of course, it is anything but crazy. As Michael Lewis says, “When someone walks in the door who is actually trustworthy, he has enormous power. And this is about trying to restore trust to the financial markets.”

Exactly. As anyone who’s been reading this blog for years knows, trust sells. Trust scales. Trust creates value. Trust is an enormous competitive advantage.

If you can drag untrustworthy practices out into the sunlight, customers overwhelmingly prefer trustworthy practices. Key investors like David Einhorn agree; Einhorn figures IEX is a winner.

More power to Katsuyama and to IEX. It’s good to have someone you can trust on Wall Street. I would not bet against him.

Six Reasons We Don’t Trust Wall Street

In 2013, finance is the least trusted industry globally.

It hasn’t always been this way. Within the industry, it’s tempting to think that trust can be regained by reputation management. Reputation is seen largely as a function  of communications or PR departments in 50% of companies in one survey.

But it goes deeper than that – deeper even than enlightened views of reputation management. There are serious structural issues that have driven down trust in the sector, and it’s hard to see how trust can be restored without directly addressing some of them.

But let’s let you be the judge of that. Here are Six Reasons we’ve lost trust in Wall Street.

1. “Wall Street” Ain’t What It Used to Be.  In 1950, a discussion of “Wall Street” unambiguously meant the NYSE, the Big Board, and brokerage firms like E.F. Hutton. Today, Wikipedia says:

The term has become a metonym for the financial markets of the United States as a whole, the American financial sector (even if financial firms are not physically located there), or signifying New York-based financial interests.

That means “Wall Street” came to include commercial banking (think Chase and Bank of America), mutual funds, hedge funds, investment and trading operations like Goldman Sachs, private equity, and insurance companies like AIG.  I think it’s fair to say the “new” financial businesses have had more than their share of the negative press that financial services has gotten over the years.

Many years ago, the president of GM could say – in good conscience – “What’s good for General Motors is good for America.”  Can you picture Lloyd Blankfein saying, “What’s good for Goldman Sachs is good for America” with a straight face?

2. Finance Has Shifted to Zero-sum Uses. In traditional banking, borrowers create increased value with the money they borrow from lenders and put to good economic use. By contrast, in pure trading, no value is created. It is a zero-sum proposition. And the proportion of the financial sector represented by essentially pure trading has increased dramatically.

At the same time, Paul Volcker says the financial services’ share of “value-add “in the US economy grew from 2% to 6.5%.  That’s not “value added” in the economic sense – it’s just an increase in price over cost. And, Volcker added, it was due not to innovation, but to increased compensation. As he famously put it, “The biggest innovation in the industry over the past 20 years was the ATM machine.”

Wall Street has increasingly focused on the “point spread,” not the fundamentals. In the NFL, they don’t let players bet on point spreads. But on Wall Street, that’s the name of the game.

The industry’s counter to such data is that they have increased liquidity, thereby lowering risk and volatility.  Yet volatility in the stock market has steadily increased for decades, while the industry has gotten less efficient. And “black swans” have become part of our lexicon – we have massively underestimated risk.  The value of the added liquidity is far outweighed by the risks it has entailed.

3. Finance Is a Larger Part of the Economy. In 1950, the US financial sector accounted for 2.8% of GDP. By 2011, that number had grown to 8.4%.  In 2011, the financial industry generated 29% of all US profits.  That proportion had never exceeded 20% in all of the 20th Century.  From 1980 to 2010, the profit per employee in the financial sector of the US economy grew by over a thousand percent – far more than all the rest.

And as finance became less efficient, more profitable, and more zero-sum oriented, it also came to dominate business more. In 1937, 1 percent of the graduates of Harvard Business School went into finance. In 2008, that number hit 45%.

4. The Shift to the Short Term. 
As of 2011, 60% of the daily turnover in US stock markets was accounted for by high-frequency trading something that didn’t exist a decade before.  In 1960, the average holding period for stocks on the NYSE was 8 years. By 2010, it was down to 3-4 months.

In 1950, the marginal tax rate was 85%, putting a brake on short-term trading, since capital gains taxation of 25% kicked in only after 6 months.

A short-term mentality has always plagued the US in comparison to Europe and especially Asia. The shorter the timeframe, the more focused we become on transactions, and the less value we place on relationships. And that kills trust.

5. The Transactionalization of Finance.  J.P. Morgan once said, “A man I do not trust could not get money from me on all the bonds in Christendom.”  For several years now, we’ve had the IBGYBG problem on Wall Street: “I’ll be gone, you’ll be gone – do the deal, who cares.”

Can you say “moral hazard?”

In the Christmas movie It’s a Wonderful Life, local employees of a local bank lend mortgage funds to local borrowers, with the bank then holding the mortgage itself. By 2007, the lending was done by non-local employees of non-local mortgage companies who then resold the mortgage to non-local banks, who then securitized and sold to global investors. A relationship business had become thoroughly transactionalized.  This drives down trust.

6. The Attack on Regulation. The LIBOR rate-rigging scandal shocked everyone last year. But rate-rigging turned out to be not a bug, but a feature.  The chairman of the CFTC said LIBOR rates “are basically more akin to fiction than fact.” The truth is more like the Wizard of Oz saying, “Pay no attention to that man behind the curtain.”

It’s a market that turned out to be mythical – can you say “Bernie Madoff?”

The Glass-Steagall Act was repealed in the late 90s, arguably giving free reign to bankers to misbehave. The industry has fought consumer legislation governing things like credit card costs, not to mention the mix of Dodd-Frank rules.

It’s hard to trust an industry which visibly and without much embarrassment argues for more and more, after the rather remarkable feast of the last two decades.

The solutions to trust issues that I hear about most coming from the financial services industry tend to be reputation management and personal trustworthiness. I do believe that both these tools – especially personal trustworthiness – could be applied to great effect in certain financial sectors – notably financial planning, wealth management, traditional investment banking, and commercial lending.

But that’s not where the money is, nor where the biggest problems lie. And it’s going to take a whole lot more than the usual approach to reputation management to deal with them.

Until the sector can address those six areas of structural disconnect, the issues of trustworthiness will continue to dog the industry.

The Tyranny of Low Cost Strategies and the Gospel of Walmart

High Frequency Trading is in the news again. HFT is highly computerized stock trading, which secures faster execution for bigger computers located physically closer to the stock exchange. It now amounts to over half the daily flow on the stock exchanges.  Critics argue it amounts to legalized front-running, is unethical, and should be illegal.

The issue was raised starkly in a July 24 2009 CNBC interview  wherein a critic of HFT (Joe Saluzzi) accuses a proponent (Irene Aldridge) of defending unethical behavior. Aldridge’s reply:

“How dare you accuse us being unethical! We are the ones cutting margins, you are the ones being unethical.”

Ms. Aldridge’s response captures perfectly the moral flip-flop that business has achieved in the past few decades. Never mind whether HFT amounts to front-running, involves collusive behavior by the exchanges, or is unfair to retail investors, says Ms. Aldridge – the moral high ground, the Ethical Trump Card, is Low Cost. In the name of lower prices, even fractions of pennies, all is justified.

The Gospel of Walmart

Let’s leave Wall Street for Main Street. We all know the Walmart story – low prices all the time. But as a Fast Company article wrote, back in 2007:

The giant retailer’s low prices often come with a high cost. Wal-Mart’s relentless pressure can crush the companies it does business with and force them to send jobs overseas. Are we shopping our way straight to the unemployment line?

If revenue were GDP, Walmart would be the world’s 25th largest economy. That is pretty big market power.

Walmart’s benefits are clear: lower prices, all the time, for millions of consumers. But along with those costs come trade-offs. The reduction of brand power. The exporting of jobs. The reduction of pay and benefits for workers in the name of lower costs to consumers.

More insidiously, what we get in the Walmart deal is lowest-common-denominator consuming. We get buyers who aren’t presented with quality alternatives, can’t recognize them if they are presented, and are trained to view low price as the primary Pavlovian trigger for purchasing.

That’s how we get tramplings at 5AM holiday store openings; that’s how the US produces twice the garbage per capita of Sweden; and I suspect (though can’t prove it) it helps us move toward becoming a nation of hoarders.

Is it all worth it?

The Tyranny of Low-Cost Strategies: Linking Wall Street and Main Street

What links high frequency trading to Walmart?  There is a common ancestor in the family tree of business thinking.

In the 1970s, thinking about business strategy took an abrupt turn – from CUS to COM.  That is, from being about the company’s relationship to its customers, to being about the company’s relationship to its competitors. (If you’re interested, the leading thinkers were Bruce Henderson, Michael Porter, and the Boston Consulting Group).

By 1980, the conversion was complete: anytime anyone said “strategy,” you knew it meant “competitive strategy.”

One of the most powerful points Porter made in his classic Competitive Strategy was that there were two successful generic strategies, and the first of them was Low Cost Producer. He who got the lowest cost got the greatest volume, which led to higher market share and higher profits, which led to lower costs, and so on. It was a road toward legal monopoly, insofar as laws permitted.

Porter’s rules were learned very well: by Jack Welch at GE, by Walmart, by the mortgage business, by Wall Street traders, and by every exec ed program in every business school in the world. It became – and I do not use the word lightly – gospel truth that the highest business good was to lower costs.

The root purpose of lower costs was to gain sustainable competitive advantage for the company. But the collateral benefit, the offshoot which could be spun for great PR, was that the consumer benefited as well. Allegedly.

This insight took only a little bit of tweaking (let’s revise Adam Smith and Milton Friedman, season with a dose of Ayn Rand and a dash of Alan Greenspan, and voila!) to come up with an ideology that said not only is low cost a successful business strategy, it is also the Key to Capitalism, which in a capitalist society is also the source of ethics. Allegedly.

This is how we get to Ms. Aldridge’s high dudgeon at being accused of unethical behavior (“Moi?!”) In this all-too-common alternative view of the world,  profit underlies ethics, business success is the root of morality, and low cost is the Ur-explanation that requires no further referent point for ethical discussion.

“We are the ones cutting margins – you are the ones being unethical.” In that statement, the transformation is complete: low cost is the new moral high ground.

Be careful what you wish for.


The Ugly Truth Behind Goldman Director’s Resignation

A few hours ago, the New York Times published a blistering Op Ed by Greg Smith, a Goldman Sachs director, titled Why I Am Leaving Goldman Sachs. It is getting remarkable coverage in the twittersphere, blogosphere and conventional press.

And no wonder! It is a scathing indictment by a privileged insider of one of the great Wall Street firms. It’s Matt Taibbi’s Vampire Squid story all over again – but this time from the Inner Circle.

I’m going to let everyone else revel in the spectacle of moral outrage, and focus on one statement Mr. Smith makes:

If clients don’t trust you they will eventually stop doing business with you. It doesn’t matter how smart you are.

This is true: but occasionally clients will need a little help from their friends.

Trust or Money?

The public dialogue about trust in business is polarized. One side says, “Trustworthy behavior ultimately pays off.” The other side says, “Get real, only suckers believe that.”

I’m a believer in free markets. I also believe free markets are relatively rare. Here’s how trust plays out in them.

Personal Trust

The market for trust at the most basic level – interpersonal relationships – is very free. If you behave in an untrustworthy manner, you will lose the trust of others, quickly and surely. If you betray a co-worker or a boss, you’ll get your come-uppance quickly. Ditto for one-on-one retail businesses.

It is also at that level – the deeply personal – that trust is strongest. The difficulty always comes in scaling trust.

Scaling Trust

The easiest form of social trust is tribal, clan-based. Think of the Mafia, think Chinese family culture, think sports fans. The way to operate a really successful clan is through culture. Read Francis Fukuyama on national cultures of trust.

Now read Epicurean Dealmaker on Goldman Sachs’ culture, The Fish Stinks from the Head, written three years ago. This movie has been playing for some time now.

When corporations achieve great internal trust through strong culture, they can accomplish great things. They can also accomplish terrible things.

The market for trust at the corporate level is far, far from a free market. The power of tribal trust alone is enough to crush dissenting individuals. Whistle-blowers rarely fare well; and the stronger the culture, the worse they are treated.

We hear too often the debate about whether trust is profitable or not. In the long run, across enough organizations, the answer is yes.  (See Trust Across America for some data to this effect).

The question is: is there a linkage in the shorter term, in fewer interactions? If Greg Smith is right that customers eventually leave untrustworthy companies – how come it takes them so long?

The Wheels of Justice Grind Exceeding Slow

There is no iron-clad “law” of social justice that says high trust will yield high returns, or that good will be returned for good, etc. Despite the best efforts of trust proponents and new-order-capitalism theorists, the trustworthy behavior of one individual or one company is not guaranteed to be rewarded in this lifetime, this market, this quarter.

Worse yet, downright villainous bad behavior can be rewarded very, very handsomely.  Greg Smith quit Goldman today after 12 years; but those 12 years have been astronomically profitable for Goldman. Markets these days are far from free and trust doesn’t pay off quickly.

So let’s not be naïve about the inherent power of trust to vanquish all evil.

The challenge for all of us is to get above tribal trust and climb to a higher level of societal trust.

Can the GOP stop its circular firing squad? Can the US Congress ever serve its broader constituency? Can organizations like Goldman re-learn how to transfer internal trust to external clients? Can salespeople learn to trust, and entrust, their customers? Can the Chamber of Commerce stop fighting regulators?

Goldman can’t be relied on to fix itself. It has failed to do so. The question is not how evil they are or how many more public resignations it will take. It is how long will society wait for corrections to happen?

The Invisible Hand is not all-seeing when it comes to trust. In fact, it can be downright blind. Occasionally, clients need a little help.

What is To Be Done?

You can find your own battle in this framing of the war. Ask yourself: whom do you trust? Who’s your clan? Who do you throw in with?

Then ask yourself: whom am I fighting? Who is the enemy? Who don’t I trust? And challenge yourself to take it to another level.

Don’t be a voyeur watching the Goldman saga turned into TMZ gossip television.  Use it. Do something about it. Up the stakes.

Trust one-on-one is easy. Even tribes and corporate culture aren’t all that hard. The challenge is to remember that we no longer live in a tribal world.

The Ugly Truth in the Goldman story is that it’s not self-correcting. This is not a Greek tragedy with the gods pulling the strings. It’s not even a Hollywood comedy, with script-writers pulling us to a natural resolution.

Social trust is a choice, not an inevitable law of nature. And this is not a dress rehearsal.

Trust & Investment Banking: Interview with The Epicurean Dealmaker

The Epicurean Dealmaker is the nom de plume of an investment banker who has written a blog by that name since January 2007.

TED (as I’ll refer to him henceforth) recently achieved a measure of fame, or at least notoriety, by being interviewed and quoted in a New Yorker article calmly but deeply critical of the financial industry, titled What Good is Wall Street?

As he puts it:

I facilitate, justify, and advise parties to M&A transactions, when I am not advising against them. I have been doing this for almost two decades, mostly at a couple of big banks everyone has heard of and lately at an independent advisory boutique. I am one of the bad guys, if you like.

Or, as he suggests in a more recent post, referring to the changes in the investment banking business, “I am one of the good guys, if you please.”

The title of his blog refers to the apparent contradiction between the view of the philosopher Epicurus– that an imperturbable emotional calm is the highest good–and the view of his profession, which is about rather the opposite.

It’s not surprising that TED was chosen for that New Yorker interview—as his choice of name suggests, he has a talent for seeing contradictions in the world; or maybe he just likes playing at being schizophrenic. In any case, he has a unique perspective on the financial sector, and it’s a treat to interview him for Trust Quotes.

CHG: First of all, TED thanks very much for speaking with us here today. I have thoroughly enjoyed reading your blog for several years now. In addition to the rare combination of philosophy and Wall Street, I have always found your comments to be grounded in common sense.

Let’s start with some context. When you joined the field of “investment banking” 20 years ago, what did that term mean?

TED: Thanks, Charlie. I have enjoyed reading your informative and insightful blog on trust issues ever since I got involved online, too. And I promise that I will release your dog back to you unharmed as soon as I am convinced you have presented my views in the most favorable light possible.

As far as “investment banking” goes, when I started over two decades ago, the term described those individuals and firms which acted as middlemen in the global financial markets for capital and control. Our job was to bridge the gap between the providers of capital—investors, both individual and institutional—and the users of capital, which consist of for-profit businesses, state, local, and federal governments and other entities. In addition, investment bankers helped corporations buy and sell control of each other and subsidiary businesses, which is known as mergers and acquisitions, or M&A.

CHG: You and I both believe that investment banking in that sense plays some very socially useful roles. Could you elaborate?

TED: Yes. Well, for one thing, global and even domestic capital markets are huge and extremely diversified. Even in the narrowest of segments, like, for example, technology-oriented equity markets, the numbers of potential providers of capital and the potential users of capital are huge and ever changing. It is surprisingly hard for the people who need money to find the people who have money. And, once they have found each other, their interests, prejudices, and perspectives are so different that they have difficulty talking to each other.

This situation is tailor-made for a middleman, who understands the perspectives and needs of each side, to make a connection. A similar process takes place in M&A. An added wrinkle is that raising capital or doing M&A tends to be a very rare occurrence for most people who do it, so they usually need both a guide and an advocate to help them through the process. I believe this serves a useful socioeconomic function.

CHG: We’ll dig more deeply into this later, but what has the term “investment banking” come to mean these days?

TED: Well. Over the last decade or so, large, global, integrated investment banks have really turned into hedge funds in disguise. Either explicitly, in the form of acknowledged proprietary trading or in-house private equity funds, or implicitly, in the form of large security origination, warehousing, and distribution factories, large investment banks have shifted dramatically from a pure middleman or agency model to a proprietary one.

Most of the revenues and profits investment banks earned during the years leading up to the financial crisis came from trading or investing for their own accounts. This is a role and business which is in fundamental conflict with the role of middleman. For one thing, you act as a competitor to many of your usual clients. For another, it is a far riskier business model than traditional intermediary investment banking.

Part of this transformation resulted from the gradual convergence of commercial and retail banking—lending money to corporations and individuals, in its simplest form—and investment banking into what have become known as universal banks. (Universal banking is only a recent development in the United States, having been the norm almost everywhere else, notably Europe, since inception.)

The other part was the tremendous explosion in the amount and velocity (turnover) of funds available for investment around the globe, which led to increased investment and trading, which in turn offered increased opportunities for trading intermediaries like investment banks to take advantage of.

CHG: I have to ask, how was it that you, given your interests and personality, got involved in Wall Street in the first place?

TED: After graduating from college, I did a number of things completely unrelated to finance. It took me a while, but I eventually figured out that what I enjoyed most about all my different jobs was the learning curve. When a job became routine, I had to leave. Essentially, I discovered that I have the attention span of a gnat. This was quite a revelation for me. Eventually, via friends and by just soaking up the atmosphere of New York City in the 1980s, I discovered investment banking, which is never the same job twice. It’s been a marriage made in heaven ever since.

CHG: So let’s raise the big question: what has happened to Wall Street, and IB in particular, in the last two decades?

TED: Well, as I said above, the industry strayed from its historical roots in pursuit of ever-larger profits, and this led it to taking on ever-greater proprietary risks. In retrospect, it now seems my peers did not have a good handle on either 1) the risks embedded in their own institutions’ activities or 2) the risks embedded in the highly integrated global financial network in which investment banks played a pivotal role.

CHG: Jamie Dimon says the problem lies not with size—after all, Europe and Canada have higher concentration than we do–but with unregulated financial flows. Others, like Sy Sternberg, are quite clear that the problems arose from repeal of Glass-Steagall. What’s your view—what went wrong?

TED: At the end of the day, it’s pretty simple: banks just got too big. Too big to manage effectively, too big to understand the complex waterfall of risks embedded in their business activities, and too big and interconnected for governmental authorities to allow to fail when they did in fact blow up.

Look, the challenge is this: traditional investment banks, and traditional proprietary investment firms (like, e.g., hedge funds), are designed to take relatively high risks. That’s how they make money. The problem arises when their failure or potential failure propagates through the global financial system like an out-of-control virus—through interconnection, domino effects, sheer size, or whatever—and threatens catastrophic failure of the entire system.

That is what governmental authorities perceived as a serious possibility when Lehman Brothers blew up, and AIG, Merrill Lynch, and other major financial institutions were teetering on the brink of failure.

Note that the failures I am talking about were failures or potential failures of the wholesale financial system, not the retail system of deposit taking and consumer loans (although, of course, the entire mortgage industry was deeply implicated). Nevertheless, governmental officials in this country were seriously worried that cascading failures could have paralyzed the global financial system to the extent that automated teller machines would not have been able to dispense cash on Monday morning.

I have no reason to believe they were exaggerating.

CHG: Let’s start honing in on trust. The concept of a client, client relationships, client service, is hardly new to Wall Street, whether we’re talking about commercial banks, investment banks, or even traders. But has it changed? Does ‘client relationship’ mean something at McKinsey that it doesn’t mean at Goldman Sachs?

TED: Wall Street really has two different definitions of the word ‘client’. The one that operates in my business of advising on mergers and acquisitions and raising capital means someone to whom I have special obligations of care, duty, and best effort. My job is to help them accomplish something, usually a deal.

Whereas on the sales and trading side of the business, ‘client’ really means counter-party: someone to whom you have no obligation other than to satisfy the terms of a particular trade. The situation gets a little blurry, of course, because there are sales and trading counter-parties for whom investment banks act as true middlemen—known as market making—and these tend to be stable, recurring relationships which do involve trust.

But the more an investment bank acts for its own interests—like a hedge fund—the less it cares about any obligation to its counter-party other than the terms of the trade itself.

CHG: It seems to me, from afar, that major banks have become a mixture of two kinds of very different businesses, and for some reason they have become blurred in the minds of those banks. I see traditional client-centric businesses like what you signed on to do; and I see, for lack of a better term, casino-like businesses. I do not mean that term to be purely judgmental; casinos are legal, they play a social role of sorts, and we have ample examples of how they can be run fairly with solid regulation, e.g. the Nevada Gaming Commission. But they are, clearly, very different businesses.

Are they not so clearly different? Or have the bankers lost their discriminatory ability to discern the differences?

TED: No, we can tell the difference. But you must understand that the casino bosses, as you call them, have taken over Wall Street. They have been in control for many years–because they made tons more money than my colleagues and me in the advisory and underwriting departments. And the Golden Rule on Wall Street is that he who makes the gold, makes the rules.

CHG: Let’s go over full-strength to trust now. First, broadly speaking: what is the role of trust in a financial system?

TED: Well, at base it is absolutely essential. The word “credit” derives from the Latin verb credere, “to believe.” Again, to use a simple but powerful example, think of a savings account at your local bank. If you and everyone else who had savings at that bank tried to withdraw all your funds at the same time, the bank would not be able to disburse them. There simply isn’t enough money in the vault: it has been lent out many times over to businesses and individuals. And yet (normally) no one worries about this, because that is just how banks operate.

The details and relationships of savings to credit and investment in the global financial system are far more complex than your local bank’s accounts, but the idea is the same. Trust is absolutely essential to the proper functioning of any modern financial system.

CHG: Let me guess that, given how much more interdependent the world has become, there must be some areas of the financial sector where trust has actually increased. Is that true?

But I suppose the opposite is even more true, that there are many areas where trust has decreased. What areas stand out?

TED: I’m not sure trust has increased anywhere, to be honest. But then again, I’m not sure trust is actually a measure that makes sense in the financial system on a systemic basis. I am suspicious of global financial measures that cannot be quantified. How can you quantify trust?

In some sense, you could say trust is measured by credit ratings, credit spreads, and even the prices of financial assets like stocks and bonds themselves. But then again, prices are also the outcome of a balance of supply and demand. And there remains an enormous amount of money that needs to be put to work in financial assets.

I think it is safer to simply say that investors have always had to hold their noses when they invest. It’s just a matter of degree. Certainly, there is no doubt that trust of the financial system and its participants has plummeted among governments, regulators, and ordinary citizens.

CHG: What can we not trust now that we used to be able to trust? Is it particular markets? Or techniques? Or institutions? Where do you find trust is in particular short supply?

TED: Again, I’m not sure the basic challenge of trust in investment banking has changed at all. If you interact with an investment bank, your obligation as a potential customer is to understand what role the investment bank intends to play in your interaction. Is it acting as an agent, with all the attendant obligations of duty and trust, or as a principal, whose only obligations are to its own best interest?

Then, if it is the former, you must decide whether you trust the bank as agent, based upon all the criteria that you describe so eloquently in your own writing here. There is nothing particularly special or different about this kind of trust in investment banking. It is as it has always been. Perhaps only the scale has changed.

If it is the latter, then you as a customer are simply buying something from the investment bank, just like any other purchase. You want to make sure that the product is not defective, that it functions as advertised, and that it is not fraudulent in any way. These are measures of quality, or compliance, with norms and regulations, but they do not rise to the level of trust you normally speak of here, which is a deeper and more comprehensive set of criteria.

CHG: How does trust erode—what are the drivers of erosion? And what can we do to reverse the erosion? In particular, what are the proper roles of a few key institutions—regulators, legislators and educational institutions, to pick three.

TED: I will skip over this one, Charlie, if that’s okay. It doesn’t fit well with my primary conception of trust. I think of trust as a personal, one-on-one relationship, rather than a structural or institutional one. As an investment banker, I view it as my job to build trust with my clients, not anyone else’s.

CHG: Interesting. I’m very prone to that view too, that trust is primarily personal at root. But there are plenty out there who focus on ‘institutional trust,’ and will speak about audits, regulation and reliability statistics. Does that stuff leave you cold?

TED: Yes, it really does. For one thing, you can’t legislate morality. For another, the finance industry is so dynamic and volatile by its very nature that I sincerely doubt any externally imposed and monitored measures or regulation will be able to stay on top of the situation. Lastly, the proper role of regulation—which I believe in wholeheartedly, by the way—is not to impose or enforce someone’s ideas of trust or trustworthy behavior, but rather to prevent fraud, crime, and abuse. This is a much lower bar than establishing and maintaining trust.

CHG: Let’s deal with one sideways issue, the question of anonymity. Some commenters on this blog have been critical of anonymous bloggers. I think anonymity can play some interesting roles, and in some ways can be critical. You’re an anonymous blogger; your view on the subject?

TED: Anonymity can indeed foster all sorts of bad, irresponsible behavior, and I am not in favor of it in general. But blogging (or even commenting on another blog) under a pseudonym, as I do, is very different. Anonymity means no identity; pseudonymity means a false or assumed identity.

For one thing, operating under a pseudonym allows one to build up a corpus of opinion that can be judged in toto. Third parties can develop an opinion of your credibility and the value of your opinions for the very reason that you present a consistent identity, that you do in fact have a name. That this name is false, and a mask, is more a matter of convenience and perhaps professional necessity than it is of deception.

If people judge my words and opinions interesting, provocative, and worthy, it does not really matter whether they know me as TED or Joe Smith. One can always worry that a pseudonymous commenter or blogger has an ulterior agenda, but I suspect that is both hard to conceal over a long period of time (I have been blogging for over four years) and, frankly, beside the point. I challenge you to find anyone commenting in public who does not have at least one unstated agenda. And yet we should be able to judge and evaluate each other’s contributions nonetheless.

I claim to be an investment banker with over 20 years experience in the business. I claim many other things besides. Neither you nor anyone else really knows this to be true or not, and yet I hope my words and opinions themselves have earned me a measure of trust in this respect that a resume or a photograph would not add to. Perhaps I am naïve, but I believe that, given enough time, trust can be built upon words alone. My entire career testifies to that belief.

CHG: I think you’re a testament to the truth of that proposition. Thank you very much for spending time with us today!


The Epicurean Dealmaker on Trust and Investment Banking is number 19 in the Trust Quotes: Interviews with Experts in Trust series.

Recent interviews include:

Robert Eccles on Integrated Reporting (Trust Quotes #18)

Jordan and Barbara Kimmel on Trust Across America (Trust Quotes #17)

Sy Sternberg on Trust in the Life Insurance Business (Trust Quotes #16)

Read the complete Trust Quotes series.

The Best Movie You Haven’t Heard Of: Inside Job

Here are the ratings (% who liked) from Flixster for some of the movies playing this weekend:

90%            The Social Network

88%            Inside Job

81%            Unstoppable           

78%            MegaMind

78%            Jackass 3-D

77%            Red           

75%            Skyline

65%            Due Date

65%            Morning Glory

64%            The Next Three Days           

54%            Saw 3D

You know The Social Network. But how about the #2 movie, Inside Job? Ever hear of it?

96% of the critics liked it. Rotten Tomatoes rated it 96%.  It’s narrated by Matt Damon. Feeling out of the loop yet? Why haven’t you heard of this movie?

More on obscurity later, but here’s the official synopsis:

‘Inside Job’ is the first film to provide a comprehensive analysis of the global financial crisis of 2008, which at a cost over $20 trillion, caused… ‘Inside Job’ is the first film to provide a comprehensive analysis of the global financial crisis of 2008, which at a cost over $20 trillion, caused millions of people to lose their jobs and homes in the worst recession since the Great Depression, and nearly resulted in a global financial collapse.

Through exhaustive research and extensive interviews with key financial insiders, politicians, journalists, and academics, the film traces the rise of a rogue industry which has corrupted politics, regulation, and academia. It was made on location in the United States, Iceland, England, France, Singapore, and China.

There has been no shortage of books and articles about the meltdown. But most of those have had a reporter’s flavor to them—here’s what happened, then here’s what happened next.  I felt that no one had really pulled it together with a narrative theme and the data to back it up. Until this weekend, that is.  

The theme is now clear. Bad things happened. They were not an accident. They were the results of bad people behaving badly. They knew what they were doing. They did them anyway. And to this day, they refuse to acknowledge responsibility.  The issues of trust that became so manifest were not just about systems and markets; they were inescapably about people as well.  It’s one thing not to trust a system; it’s yet another to not trust those who inhabit it.

Think of this movie as what Michael Moore would produce if he had a PhD in economics and a career as a Federal Prosecutor. It’s the project of Charles Ferguson, who in fact does have a PhD in political science from MIT (he has also consulted to the White House and the Department of Defense, was a Senior Fellow at Brookings, and a member of the Council on Foreign Relations).

You may know Ferguson as the director of No End in Sight, a powerful documentary about the Iraq war. He’s confident enough to interrupt an economist and say, ‘You can’t be serious about that. If you would have looked, you would have found things.’ Or to tell a former Bush administration under-secretary of the Treasury, “Forgive me, but that’s clearly not true.”

Here is a review by A.O. Scott, in the New York Times. calls it “a masterpiece of investigative nonfiction moviemaking — a scathing, outrageous, depressing, comical, horrifying report on what and who brought on the crisis.

Here’s Kenneth Turan’s review in the LA Times.

Go see for yourself; see the trailer here.  

The Role of Ideology in the Meltdown

There’s much to say about this documentary; I’ll limit my thoughts to just one—the role of ideas in the meltdown. 

In this day and age of neuro-explanations and insistence that only measurable behavior is relevant for management, the role of ideas gets pooh-poohed. Big mistake. 

I’ve written before about the power of strategic doctrine taught in business schools to negatively influence our general business thinking. But after seeing this documentary, I’m newly persuaded. Ideas have huge power: especially when those ideas happen to greatly serve the economic interests of patrons.  

In the pharmaceutical industry, it’s become well accepted that a researcher or writer who takes money from a drug company is at the very least subject to rules of disclosure. Failure to do so constitutes an immediate presumption of conflict of interest.

Yet somehow, we have never held our nation’s leading economists and business school faculty to the same standards. One of the most eye-opening aspects of Inside Job for me was to put this issue front and center. 

Some of Fergusons’ hardest-hitting interviews are with the elite heads of academic institutions: Frederic Mishkin, a former Fed governor, now at Columbia Business School; his boss Glenn Hubbard, chairman of the Council of Economic Advisers under George W. Bush; John Campbell, Harvard’s economics department chairman; and fellow Harvard economist Martin Feldstein

They come off, respectively, as incompetent, blustering, inarticulate, and smug. None of them seem to have noticed a disconnect between their laissez-faire ideas and the disasters engineered by those who quoted them; much less any sense of impropriety at the comfortable financial relationships they shared with those very firms. 

Somewhere there is a researcher at Harvard Medical School screaming at the injustice of his not being published in NEJM because of some disclosure requirements, while his academic counterparts in business and economics were happily and openly opining on the health of the Icelandic banking system and the liquidity of the US subprime mortgage market, all the while getting very well paid. (Note: b-school profs provide functional consulting services to companies all the time; I don’t see that as an issue. This is vastly different; more another time). 

Results of the Meltdown

Ferguson touches clearly, albeit briefly, on one enduring outcome of this decades-long debacle–the increased gap in the US between the haves and the have-nots. 

In 1976, the richest 1% of Americans had 9% of the income. Now they have 24%. From 1980 to 2005, 80% of the gain in income went to the top 1%Guess what industry disproportionately accounts for that gain?

But the most significant casualty, I think, is a great old American belief: the belief that you can make it here in the good old USA, land of opportunity, where anyone can be what they want. You don’t have to be limited by the circumstances of your birth, like in all those Old World countries.

Sorry: no longer true. By one study, it is harder for someone to get ahead now in the US than it is in Denmark, Australia, Norway, Finland, Canada, Sweden, Germany, Spain, and even France. Only Italy and the UK are more class-bound, and I’ve seen other studies where even the Brits are less class-bound than we are. That decline in opportunity is another result of greater income disparity. Again, one of the legacies of the financial industry. One trust expert states very clearly that a key driver of low trust is high income inequality.  And here’s a good explanation of just why that is true.

You may disagree with a lot of what I’ve said here. You may think this movie won’t change your mind; and since it’s extremely hard to change people’s minds, you may be right. But if so, may I suggest you owe it to yourself to see it—if only to write back and point out the flaws in the movie.

Whistle Blowers Redux

Many of you remember Sherron Watkins, who shall forever be known as the Whistle Blower of Enron. She was named Person of the Week by Time Magazine back in early 2002. 

But Sherron was no fly-by-night. I saw her speak, and she’s smart, thoughtful, and clearly of strong character. A not-uncommon set of characteristics for whistle-blowers, as it turns out. Read her empathetic comments about another whistle blower, Harry Markopolos, of Madoff fame.

But there’s another whistle blower in town, and he deserves a look-see as well. In this case, his name is Ilya Eric Kolchinsky, and the company he’s blowing the whistle on is his former employer, Moody’s Investors Service

When Kolchinsky used to work for Moody’s, he criticized some of their practices. Moody’s resisted to some extent, and to some extent changed practices based on his criticism. Or so it seems. You can read the NYTimes article Kolchinsky and Moody’s.

What’s unusual here is that Kolchinsky is filing suit against Moody’s not to ‘out’ Moody’s original actions, but to say that Moody’s effectively blacklisted him after the fact. You can look up his LinkedIn page and see that he had quite a good track record before his stint at Moody’s, but has been doing consulting work well off Wall Street since then.

You can read the text of Kolchinksy’s lawsuit yourself. Make up your own mind; don’t take my opinion of its validity, judge for yourself.  

Here’s why you should care.

The Perils of Whistle Blowing

In my humble and non-legal opinion, he’s got a case. And if he does, here’s what follows:

First, it sucks to be a whistle-blower. And if you don’t believe Kolchinsky, go back and read Watkins and Markopolis. The Enrons, Madoffs and Moodys of the world don’t take kindly to criticism.

Second, if they do this to whistle blowers who tell the truth (proven in Watkins’ and Markopolis’ cases, yet to be proven in Kolchinksy’s), then how can you trust what they have to say? Can you say “opaque”?

Third, if it’s true at Moody’s that you get punished for telling the truth, then what does that tell you about the internal culture at Moody’s right now? How likely is it that others are going to be telling the truth—particularly about whatever it is they’re telling you is the truth? And how fixed are things that need fixing?

Kolchinsky and Moody’s will get their day in court, and of course it’s premature to speculate. But I will say this. The sounds of whistles being blown often, albeit not always, signify fire. And if you get to the point where a multi-year Managing Director is suing you—well, I wouldn’t lay big money that he’s cuckoo.

It’s more likely that Wall Street is very effective at chilling dissent. Here’s what the Times article went on to say:

Experts on whistle-blower suits expressed surprise that more such suits had not been filed.

“We didn’t see people coming from Wall Street, from the brokerages — it was stunning,” said David K. Colapinto, the legal director for the National Whistleblowers Center, a nonprofit organization in Washington that tracks whistle-blower cases. “What it signals is there just are not incentives for people to come forward, and there may have been big disincentives.”

 My guess is it took nerves and a lot of provocation for Mr. Kolchinsky to take the steps he did.

The Trust Buzz of 2010: The Summer of Trust?

There’s a lot of buzz about "trust" this year.

Just look at the headlines: BP, Goldman Sachs, Toyota, Tylenol . . . . But the question remains, is all this talk going any where? Have we figured out how to make business more trustworthy? (And while we’re all talking, is anybody listening?)

At this week, I explore what 2010’s trust buzz is all about:

2010: The Summer of Trust
Love was the buzzword in 1967, but that year’s legacy was justthe opposite. Trust is this summer’s "love." What will the legacy be this time?

Do you think the "summer of trust" will have any real effect? Do you believe that trust and trustworthiness will improve going forward or get worse?

Read 2010: The Summer of Trust  and let me know what you think–in the comments section this time.

(I’m listening!)

Bad for the Customer, Good for the Stock Price: Wait, What?

Bill Bachrach has a business somewhat like mine, though with a specific vertical industry focus: he teaches people to become trusted professionals in the field of financial planning. I’ve read much of his material over the years and have the highest regard for what he has written (not to mention what he’s done—like the Hawaii Ironman Triathlon).

The other day, Bill found just the right words to express a paradox. Just how is it that an industry, by burning its own customers, can raise its stock price? We’ll come back to that: first, here’s Bill, from his newsletter The Trusted Financial Advisor:

The headline reads: "Wall Street wins big as Dodd drops fiduciary provision." And the first line of that article is "Chalk it up as a win for the securities and insurance industries." How do the securities and insurance industries win when the client loses? It’s a fascinating way to view the world, but not surprising.

Here’s my translation: "the lower the standards the easier it is for us to manage our advisors, salespeople, and agents." It’s the usual product-oriented, fear-based thinking from our industry at-large and it proves, once again, that you have a competitive advantage as an individual Trusted Advisor who chooses to put the client first.

Can you believe what you just read; you have a competitive advantage by putting the client first? Yes, you do. Doesn’t everyone put the client first? Apparently not. Amazingly enough, our industry considers it a win when they don’t have to adopt the highest standard of care for their clients. Wow.

Point One: There Are a Few Bad People Out There

Now, you can argue that the industry is right in its argument that the absence of a fiduciary standard is actually in the best interest of the client, but I’m with Bachrach on this one. If you disagree, I’ve got a bridge for you.

Some people think trust is naïve, that the world is a nasty place, that no one is trustworthy, and that trusting is a foolishly suicidal act.

Trust is not naïve—there is no trust without risk, for example—but it needs to be said that those people are not all wrong, not by a long shot. There are industries more rife than others with untrustworthy behavior, and the business of money, at least in recent years, is one of them.

But there’s a bigger issue that Bachrach’s indignation suggests:

Point Two: Watch Out for Profit-Justified Ethics

There are a number of researchers out there—I won’t name names, but you could research them easily—who invest quite a bit of time and energy in proving that "good" business is also good business; that you can do well by doing good. Profitability is shown to be correlated with values like transparency, social responsibility, candor, and customer focus.

I’ve studied a lot of that work, and think it is generally and fundamentally true. Doing good really does result in doing well. But—not in all cases, and not necessarily in the short run.

As Bachrach points out, you’ve got an entire industry that apparently believes they can make more money by gouging their customers than by being straight with them. Are they wrong? Put it this way: I wouldn’t even bet your money against Wall Street on this one. They are most decidedly not stupid.

Why’s this an issue? Because many of these socially-minded thinkers—whom I happen to think are basically right, and whom I support—are playing with fire when they use profitability as a justification for “good” behavior. The more you say, “the good-doing companies are actually more profitable than the evil companies,” the more you conflate the two. And the more you open it up for some companies to infer the converse and the inverse:

“It’s making the most money, so it must be the good thing,” and

“It’s not making money, so it must not be the good thing.”

And what you’ve then done is to re-define ethics in terms of profitability.

Now, there is no harm in pointing out that good deeds are usually more profitable. And none of these analysts intend to argue in favor of the perverse results. But intentions have a way of getting misinterpreted by those who have ulterior motives; those who are, oh let’s just say, bad.

It’s similar to what L.J. Rittenhouse said in a recent Trust Quotes interview, the "result of trying to replace moral standards with legal standards" is a lowering of integrity. So it is here, when we don’t guard against the turning of the ethical tables.

Just to be clear: if something is ethical, it’s usually profitable. But if it isn’t profitable, that doesn’t mean it isn’t ethical. And just because it is profitable doesn’t mean it is ethical.

There will be the more-than-occasional situation where the right thing to do is simply not the profitable thing to do. That’s when you find out who’s ethical, and who’s simply hustling their own customers.