Yet More Corruption in Banks

15 December 2014 | By ken in Society | No Comments Yet

The Broken Firewall

Several years ago, in my therapy, practice I saw a financial analyst with a major bank who agonized about the appearance of wrong-doing should he talk to a salesman about a pending stock offering. The problem was, some of the people in sales had information that could be useful to him.

But the rule was strict. There was a firewall between analysis and sales — for good reason. The part of the bank that sold financial products to its customers had a duty to be rigorous and fair to them about the value of those products, while the part of the bank that generated new offerings was committed to promoting the companies they underwrote. If the bank did not keep those two parts separate, there would be an unmistakable conflict of interest, and my analyst would run the risk of being called to task by the compliance department.

Turns out that he worried in vain. As Gretchen Morgenson pointed out in The New York Times yesterday in reporting on a fine levied on 10 firms for violations of this very principle.

“The rules are not a great mystery here,” Brad Bennett, chief of enforcement at the Financial Industry Regulatory Authority, said in an interview last week. “You cannot use the analyst to solicit investment banking business.” The reason for that is the same as it always was, notes Morgeson, adding that this “takes us back to the financial scandal of the early 2000s involving corrupt Wall Street research.
Remember that mess? Firms whose analysts were supposed to be impartial instead used their bullish stock recommendations to attract investment-banking business. The losers in the situation were investors who didn’t know that the analysts were biased and who heeded their calls to buy the shares.”

In the new case, according to Morgenson, analysts went all out to assist their banks to get the deal, one offering in an email to “crawl on broken glass” naked to get the deal. “Right now, my whole life is about posturing for the Toys R Us IPO,” he wrote in a subsequent message according to The Times.

Since crawling on broken glass is not illegal, this probably reflected the analyst’s youthful enthusiasm and desperation. More importantly, the client who put pressure on the banks making the public offering was hardly free of blame. According to The Times, “It required any firm wishing to underwrite its initial public offering to submit an investment banking pitch and company valuation that included deep involvement and support from the firm’s retailing analyst. The retailer went so far as to tell Merrill Lynch that its analyst’s view could influence what underwriting role it might receive in the deal.”

One of the company’s officials said, “Such pitches were intended to protect [the client], “from being ‘burned’ by an analyst’s decision to adopt a negative view” of the retailer after winning the investment banking business. But that’s just the point. To be true to his clients, the analyst has to be free to arrive at a “negative view.”

I’m not a lawyer, so I am not sure what rules or regulations the client’s action violated – whether they were co-conspirators or accessories – but it is hard to imagine that they were guiltless.

The stench is the sign of a corrupt system, and picking off individuals to prosecute will hardly fix that.

Bankers More Likely to Lie

09 December 2014 | By ken in Society | No Comments Yet

What Would it Take to Change?

When bankers are reminded they are bankers, a new study has found, they are more likely to lie.

A team of economists at the University of Zurich has found evidence that banking culture encourages dishonest behavior. According to a study reported in Nature, bankers lied more than those in other professions when reporting the results of a coin toss.

The researchers, noting recent scandals in the banking industry regarding manipulated interest rates, rogue traders and fraud, wanted to find out “whether the business culture actually renders bank employees more dishonest, or whether more-dishonest people simply choose to work in the banking industry.”

In devising the test, the researchers reminded the bankers of their professional identities before tossing the coins, a technique that is called “priming.”

So one would have to wonder – and worry – if their identities as bankers had that effect on a coin toss, what about when real money was involved? A tendency to be morally soft when faced with hypotheticals can become far more serious when the temptation of a deal involving millions or an important career opportunity is at stake.

Can anything be done about this? Alain Cohn, who is now with the University of Chicago, suggested banks should take a page from medicine and require their own version of the Hippocratic oath. “It is very important to let employees know exactly what desired and undesired behaviors are . . . . Then we could use a professional oath to activate these norms.”

Not so simple, I think. The power of the Hippocratic oath derives in part from its venerable age and universal acceptance. When a doctor takes the oath he or she knows that over the years hundreds of thousands of doctors have taken it before, and they stand as witnesses to it importance. Moreover, he or she knows that the oath is part of what it means to be a doctor. Before they start their training, they grasp their obligation to subscribe to it.

On the other hand, getting bankers to change would not be a simple matter. Businesses that want to change their cultures to make employees more engaged and assertive are finding just how hard that is.

The profession itself would have to rebalance its priorities, not just ask new members to be more honest. New bankers, clearly, will do what they see being done by old, established, successful bankers – and that is not just a matter of “talking the talk.” There would have to be reflection on the temptations to be dishonest, and serious penalties for violations. And it would be a good idea to start with self-policing, the kind of ethical boards that investigate consumer complaints, not just rely on government investigators to find the miscreants and prosecute.

Frankly, it is not a promising sign that this study was initiated by academics. Universities have a long and honored tradition of scholarship – going back almost as long as medicine’s link to Hippocrates. As a result, academics understand they are accountable for their work, but they may overestimate the ability of other professions to be ethical.

Establishing an oath is not a bad idea, but that would have to be just the first step in an arduous and prolonged process.

Investors Following the Crowd

01 December 2014 | By ken in Society | No Comments Yet

Wisdom and Folly

The wisdom of crowds doesn’t apply to picking stocks.

A new study published in the Journal of Portfolio Management shows that “hot stocks,” those that generate a lot of buzz and, as a result, move a lot, generally do not do well: “Measured by turnover, the more popular a stock, the less its return; the less popular a stock, the higher its return.”

They attribute the allure of hot stocks to publicity in the media and investor over confidence. If a large number of investors are influenced by those factors, then prices will go up temporarily, but that can also “reduce the potential for appreciation in the longer term.” “Disappointment often follows,” as the report on the study in The Wall Street Journal noted.

It has been well established that the safest and surest way to succeed in the stock market is to invest in a basket of securities that reflect an index, such as the Dow Jones. Unexciting, but well proven.

Most of us just don’t have enough information to succeed otherwise. Stocks often rise and fall on quarterly earnings reports, but as The Journal noted, to profit from those swings is “like picking up pennies in front of a steamroller being driven like a Ferrari.”

Even professionals are led astray, and find it difficult to outperform “Index Funds.” There are exceptions, of course, like Warren Buffet. But even brilliant managers of hedge funds are often tempted by insider knowledge to try staying ahead of the crowd. They end up being prosecuted and paying big fines – if not in jail.

The “wisdom of crowds,” as James Surowiecki put it in his book, only applies when individuals actually do not know what others are thinking, when they are exercising autonomous judgments and those judgments are aggregated. The classic example he uses is people independently estimating the number of marbles in a jar. Most estimates are wrong, but the average of estimates is astonishingly accurate.

It turns out that looking to your neighbor to see how many marbles he sees in the jar is a sure way to get it wrong. In the stock market as well, the pressure to fit into the crowd and conform takes over and will lead you astray.

The Journal summarized the figures: A few hot stocks, like shares Tesla Motors are made huge gains. “But 14 of the stocks on the list [of most active shares] are down this year . . . even though the stock market is rallying and the S&P 500 has closed at a record 47 times. Social-media company Twitter has fallen 38%, Internet radio provider Pandora Media is down 27%, and daily-deals site Groupon is down 36%.”

The bottom line: “An investor who split $10,000 equally among the 20 stocks at the start of the year would have had only $9,152 by Tuesday, including dividends . . . . The same $10,000 invested in the broad-market S&P 500 index would have grown to $11,391.”

Boring but safe.

The Super Rich

25 November 2014 | By ken in Society | 1 Comment

And the Rest of Us

Most of us may not have noticed, but the rising tide of income inequality is engulfing the super rich as well.

As The Times put it recently: “For decades, a rising tide lifted all yachts. Now, it is mainly lifting megayachts. Sales and orders of boats longer than 300 feet are at or near a record high, according to brokers and yacht builders.”

The same is happening to private planes: “Sales of the largest, most expensive private jets — including private jumbo jets — are soaring, with higher prices and long waiting lists. Smaller, cheaper jets, however, are piling up on the nation’s private-jet tarmacs with big discounts and few buyers.”

The underlying dynamic is the same, and it affects everyone, though obviously it affects us differently — depending where we are on the spectrum of wealth. The poor may have difficulty scraping together the money to buy a new car – or even repair the one they have — but the problems of the rich are different.

“The wealth of the top 1 percent grew an average of 3.9 percent a year from 1986 to 2012, though the top one-hundredth of that 1 percent saw its wealth grow about twice as fast. The 16,000 families in that tiptop category — those with fortunes of at least $111 million — have seen their share of national wealth nearly double since 2002, to 11.2 percent.”

Thomas Piketty, the French economist, recently clarified how existing capital grows faster than wages, countering some assumptions that had entered mainstream thinking. And he pointed out that the structure of taxes could have a major impact on the growth of wealth. But it is still striking how little we appear to want to do about that, how we are content to let the gap widen and widen.

Could it be that so much of that extra money ends up in the pockets of lawmakers in the form of campaign contributions? Perhaps, as a result, legislators have little interest in tax reform?

But another interesting question is why do people want so much more money than they could ever spend?

After a point where basic needs have been satisfied, money begins to have a purely symbolic meaning, and competition and envy shape the desire for more. There are billionaires who scrutinize the Forbes list of wealthiest Americans, just as sixth graders scrutinize test scores to see who came out on top. And there is no end to how much money is needed to triumph over others. Even if you have more money than anyone else right now, who can guarantee that someone else will not come along soon to trump your achievement?

But there is another factor. The growing wealth disparity means that we are in the process of creating a new class system. The money being made now, as a result, becomes the foundation of new dynasties, a way of ensuring that one’s descendants will continue to be secure and powerful for generations to come.

So this is a relatively rare moment in history in which a new social order is being created. That raises the stakes. A few billion dollars can give your descendants a permanent place in that order. On the other hand, failing to succeed on that level means that your children and their children will have to make it on their own.

For some, that’s a real incentive.

Why Boards Pay CEOs More

17 November 2014 | By ken in Society | No Comments Yet

Presumably corporations would not want to overpay their CEOs, which is why they hire “compensation consultants.” The consultants study the publically available information on comparable CEO compensation so that they can benchmark their peers.

But a new study by three professors at Cambridge University found otherwise: “We consistently find evidence that supports the argument that compensation consultants are hired to justify higher C.E.O. pay to the board, shareholders, and other stakeholders.”

Why do they all bother – for which, no doubt, they charge handsomely? Either the boards that commission the research ignore the findings or the consultants consider it expedient to inflate their recommendations.

Sorkin notes the obvious: It’s a mistake to let a CEO hire his own compensation consultant. According to the study, though, when that happened it “led to a 13 percent increase in pay.” It doesn’t make sense, “but it happens more than you would imagine.”

But an even better question is why, when they have the information they commission, they ignore it?

“Let’s be honest,” wrote Andrew Ross Sorkin in The New York Times, reporting on the study, “compensation at the top level is rarely based on a true marketplace. Unless a rival company tries to poach a chief executive, it is hard to determine exactly what they should be paid.”

Trying to be honest and respectful of the data, it looks like Boards want to please their CEOs. Far from paying fair market value – and possibly disappointing the CEOs who have a somewhat exaggerated sense of their own value – they flatter and appease them. As a result, compensation has no logic, either in relation to a norm or in response to performance.

It is as if board members and CEOs are members of the same club – which in some respects they are. Board members, often the CEOs of other companies, know how they want to be treated. They travel in the same circles and they are attentive to the perks and rewards they others are getting. Indeed, many of them are competitive and envious of those perceived to be better off than themselves.

Sorkin reports a story Warren Buffett tells about the time he ran Salomon Brothers. “At Salomon, everyone was dissatisfied with their pay, and they got enormous amounts. They were disappointed because they looked at others, and it drove them crazy.”

We are forced to think, though, that more than envy is at stake. CEOs are the nucleus of a new elite class. They often move from job to job, expecting the same privileged treatment, the jets, the bonuses and stock options that entitle them to extraordinary lifestyles.

For most boards, Sorkin concludes, “the best chief executive makes the most money.” That is, by definition. The greater the compensation, the best the performance must be. And those with the most compensation increasingly run the country with the power they exert not only through their corporations but also with their personal fortunes.

They endow new museums, concert halls, and hospitals. They fund schools and university departments, buy newspapers and magazines, create new charities – and, of course, donate heavily to political campaigns to maintain their access to power. In helping each other, they are also helping to establish their class and cementing their social position for years to come.