INTERESTING LETTER FROM WALL STREET
Many of us read the farewell letter from the hedge fund manager Andrew Lahde, who mocks the counterparts to his trades and closes with a rant on the legalization of marijuana. I’m sure his letter has found a new audience now that bankers and money managers are getting called into hearings on the Hill.
Recently I received a note from an old school friend who went on to establish overseas operations for a bulge bracket investment bank in several emerging markets. He sent a note out to friends and colleagues that serves as a defense of the financial sector, and a reminder that capitalism practiced properly should be a heartless and profitable endeavor. I have reprinted it here with his permission, and avoided attribution to comply with his employment terms. It makes for better reading than Lahde’s tirade.
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For those brokers, bankers, and investors confused and depressed by the current financial imbroglio, I recommend returning to that American favorite of yesteryear, Frank Capra’s “It’s a Wonderful Life”. There is an important lesson in this movie which is as relevant today as it was in 1946. The lesson is not about money, or prudence, or social values. The lesson is about the public’s perception of our industry.
George Bailey is pathetic and incompetent. There, I said it, and you know that it is true. He gives up his dream of traveling the world and spends his life running his father’s dumpy savings and loan company. These are the simplest and least sound financial institutions ever invented; they borrow short and lend long with no diversification, and tend to go bankrupt whenever the yield curve inverts or local asset markets are depressed. They are extremely prone to bank runs because even the smallest whiff of insolvency will send every depositor rushing to get their money out while they can (which is why most large institutions moved AWAY from deposits as a funding source, because they are UNSTABLE). He allows a known alcoholic to carry around huge sums of cash, and is then shocked that the money is lost. We are supposed to be impressed that he keeps this forlorn institution together through strength of personality, a trait we usually associate with frauds like Madoff. His other virtue is that he has not become rich, presumably because his economically unviable company is unable to make much money. His complete incompetence leads to America’s first (though sadly, not the last) S&L bailout, where the good townspeople lend him money at below market rates to avoid his insolvency (which in the days before FDIC would have meant their loss, not his).
On the other side of town, Mr. Potter runs a tidy little bank. He has recurring fee businesses and multiple sources of funding which help him manage through the cycle. We can assume he has economies of scale. And importantly, he doesn’t seem to hire alcoholics to trundle his money around town in between swigs of cheap gin. He gives loans based on an analysis of the risk of default, and the quality of the collateral. And he is quick, we are sure, to seize that collateral in the event of default. For this, we are told, he is evil, pure pure evil.
The key scene of the movie shows Bedford Falls without George’s savings and loan company. Here we find the central message, the message that we must pay particular attention to here. This one small change in the world, we are told, has dramatic effects. In a world where people can only borrow money if they can afford to pay it back, in a world run, in other words, on the basic principles of finance and capitalism, the small town has changed from a thriving community to a den of vice. Compassion has turned to avarice, community has turned to greed, and the relative gap between rich and poor has widened. The American dream of prosperity for all has become subverted into a world where the rich get richer and the poor are exploited.
It is all quite fantastic, when you spell it out, that Capra could pull this off. Why on earth should we celebrate the life of Mr. Bailey, and rue the life of Mr. Potter? Why would we think that having banks run on sensible economic values would undermine the moral fabric of our society? Coming out of The Depression, most people believed that Capitalism had failed, and could not provide wealth for the masses. This lead to the rise of Communism abroad, and The New Deal at home. Actually, popular perception from this time is contained in the word “Capitalism” itself; though it has become a synonym for an economy based on free markets, it was coined by Marx to mean an economy run by those who provide capital (Potter!) as opposed to those who provide labor (Bailey’s customers!). Even in Red, White and Blue America, heart strings area much more easily pulled by images of the great proletariat than hard working bankers. It would take another 40 years for Hollywood to produce a movie with a the message “Greed is good”, celebrating (still reluctantly and only ironically) the Great American Financier.
So here we are in 2009, still being told that the world’s problems are due to having too many Potters and not enough Baileys. We are being told that we, in finance, have been over paid, over greedy, and irresponsible. We are being told that our work was a sham, we added no value, and made money by risking other people’s money. It gets said so many times, and the problems are so vast, we start believing it.
Michael Lewis recently wrote on Portfolio.com:
“To this day, the willingness of a Wall Street investment bank to pay me hundreds of thousands of dollars to dispense investment advice to grownups remains a mystery to me. I was 24 years old, with no experience of, or particular interest in, guessing which stocks and bonds would rise and which would fall. The essential function of Wall Street is to allocate capital—to decide who should get it and who should not. Believe me when I tell you that I hadn’t the first clue.”
This passage leads me to think that perhaps Mr. Lewis is a secret disciple of Trotsky. The Soviet Union had teams of well educated and well meaning comrades studying every known piece of data to determine the price of everything in their economy. We all know how well that worked. Markets bring together buyers and sellers to judge demand and supply and arrive at a price. That can be done by standing together in a sweat filled room, meeting under a tree in down town Manhattan, or communicating zeros and ones representing order information across vast networks. In every case, there is slippage and friction, and the middle man takes his cut. Salomon Brothers was making gobs of money as an intermediator in a market it had helped invent. Why wouldn’t they pay their employees? Perhaps the phone company should not be paid for transmitting order information from clients that it can not understand? Or perhaps he is arguing that Salomon’s “share” of the profits was larger than it should be, or his relative income compared to others was too high. In that case, he can also explain why real estate brokers make more money than architects, good car salespeople make more money than engineers, and bookies make a lot more money than school teachers. That isn’t an economic argument, that is a topic for old men to discuss over bridge while lamenting that the world has gone to hell and in their day kids respected their elders.
No, the problem is not that people on Wall Street are “too greedy”; the problem is that the economy runs in cycles, always has, and always will. The government can try countering the cycles by monetary means or fiscal means, but no one has ever seriously suggested that regulation has anything at all to do with it. The people who founded the SEC with the intention of creating less information dissymmetry, greater market transparency, and protecting small investors from scams would be very surprised to hear that they are now also responsible for stopping investors from putting money into mutual funds when prices are high, or buying a house that they can not afford!
The real cause of the current downturn was excessive leverage across millions of assets by hundreds of millions of people, and to blame the guy who sat in the middle of that flow is hollow rhetoric. The real problem was caused by very complex interaction between many entrenched interests and no one person or institution is to blame. If we want to start waving fingers around, we could start with the Fed (who was convinced that asset inflation was different than price inflation), Congress (who mandated banks lend to sub-prime borrowers, and then mandated the GSE’s to buy those loans), the GSE’s (who only had their privileged and abused position because of Congress), and the rating agencies (an oligopoly which exists only because of regulation). We can lament that too many businesses and too many individuals were too optimistic about their ability to produce income and service debt, and that modern society forgot the value of thrift. We can point to many lost opportunities to re-regulate or deregulate that might have made the problem a little more bearable. But there is no silver bullet, no smoking gun, no fork in the road that led to a happy ending. It never ends well, it always ends badly. And then it always starts again. That’s why it’s called a cycle.
Humans fundamentally abhor financial gain, and the bigger the gain the more they abhor it. If you want to understand why, you can read Steven Pinker’s “The Blank Slate” which talks about human’s genetic predisposition towards perceived fairness and the biological basis of righteous indignation. Or you can go back and watch “It’s a Wonderful Life” again, and laugh like hell that anyone would be happy about that way that movie ends! No matter the facts, everyone wants to blame the broker or the banker.
So the next time you read an article telling you that the world has turned into Pottersville, that the reason people in far off lands are starving is because a few hedge fund managers had caviar and champagne for dinner last night, that the reason the poor can no longer afford a home is because Wall Street invented something called a CDO, think back to that movie and remember how predictable is public reaction. Then go back to work, comfortable that you provide a valuable service helping capital flow from those who have it to those who need it.
We are not a sham industry. Hedge funds are not all Madoff. Investment banks are not all AIG Derivatives. No matter what Michael Lewis says, we have provided the world a service, and mostly we have made money the old fashioned way – by earning it.