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Where and When Did Wall Street Go Wrong?

Posted by Larry Doyle on June 23, 2011 8:32 AM |

You do not need to read Sense on Cents to know that Wall Street and America have problems. That said, the future of both the financial services industry and our nation are inextricably linked.

The innovative ideas which our nation must generate to drive future growth and employment require capital. Wall Street has that capital. In my opinion, Wall Street needs to seriously refine the use of its capital for its own benefit and that of our nation.

Can Wall Street adapt? Does Wall Street understand the errors of its ways? When might some real leaders on Wall Street call out for the industry to clean up its act? These questions can only be properly addressed in the future if there is an acknowledgment and understanding of where and when did Wall Street go wrong in the past. Let’s navigate.

I love capitalism, the markets, and the Wall Street game within the context of free and fair markets. The competition, relationships, market instincts, the pace, many truly great people . . . Wall Street embodies all of these characteristics like no other industry I know. What happened then?

In my opinion, the financial services industry redirected its focus from the “service” element to the “financial” component at a rapid rate starting in the mid-1990s.

Many within the industry would make the case that the growth in derivatives, new products, and electronic trading were simple outgrowths of innovation. I disagree. I strongly believe Wall Street ‘went wrong’ due to the fact that it did not and has not implemented real quality control in its product and systems development over the last fifteen years.

I broached this topic recently with a young Wall Street executive. I shared with him that I viewed these lack of quality controls as a failure of senior management on Wall Street and the regulators charged with protecting investors.

In my strong opinion, many senior managers had little idea as to the escalating levels of risk embedded in products and systems. Selling risk at increasingly expensive levels became more and more part of the Wall Street mentality and was central to the Wall Street casino’s zero sum game.

Having discussed this topic just last evening, how uncanny that the Financial Times’ John Gapper addresses it this morning in writing, The Price of Wall Street’s Black Box:

It is no coincidence that the Wall Street banks have lobbied with such energy against efforts to force trading of more derivatives on to exchanges and through clearing houses. They do not want the black box of fixed income and derivatives trading, which has provided so much of their profits for so long, to be exposed to plain view.

The failure of US prosecutors to secure criminal convictions against any senior bankers or hedge fund managers apart from Raj Rajaratnam is a let-down. They have been defeated by the difficulty of proving fraudulent intent in the deceptions that flourished as banks struggled with mortgage losses.

Yet JPMorgan’s battle with the Securities and Exchange Commission, in which it paid $153m to settle civil fraud charges, carries an important lesson. The behaviour revealed in the JPMorgan and Goldman cases is a product of the conflicts of interest embedded in how integrated Wall Street banks work. As they say in Silicon Valley, it’s not a bug – it’s a feature.

That feature is inherent in most of what banks do, but the opacity and complexity of credit derivatives – especially mortgage-related securities such as collateralised debt obligations – let deception, overpricing and ultimately fraud flourish. From this black box came the bulk of revenues and bonuses.

The questions beg: who developed the black boxes? who maintains them? who writes the code? who is structuring the transactions that embed and disguise the risks? where are the “quality controls”?

I can assure you that many salespeople on Wall Street charged with moving the risk embedded in these transactions have only a limited understanding of what they are truly selling. Additionally, I also believe that many, perhaps most, investors (both individuals and institutions) neither understand nor are properly equipped to assess the risks as well. As John Gapper writes:

For investors, it was akin to being informed by a mechanic at the local garage that your vehicle needs expensive new parts and servicing. The garage has an incentive to charge you as much as possible and the information asymmetry between professional and customer makes it easy to pad the bill.

Do you trust your mechanic? Do you blindly bring your vehicle to any shop?

The decline in trading volume across so many market segments is a statement by so many institutional and individual investors that Wall Street management (Jamie Dimon, Lloyd Blankfein, James Gorman, Brian Moynihan, Tom Montag, Brady Dougan, Robert Wolf, Vikram Pandit et al) had better start to focus and bring real transparency and integrity as to what is going on in the black box, or dare I say, “under the hood”.

Until we see meaningful progress and developments on this front — and we have seen little real progress so far — (Sense on Cents does monitor this regularly!!) . . . navigate accordingly.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. The opinions expressed are my own. I am a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.

  • L. George Rieger

    Larry skewers Wall Street for being “artful dodgers” of admitting to their culpability in the leverage mess. Larry says that “it ain’t over.” As usual, Larry hits the bullseye.

  • coe

    I think you have nailed part of the case, LD..Wall St may well possess intellectual capital (let’s concede there are many “smart” folks that do spend their time on computers and in modeling cash flows, volatility, and other arcanely monetizeable concepts), but as a participant and a long-time observer, I would make the argument that the groundrules and ethics and reward systems related to applying that “capital” to the client proposition took a serious turn for the worse in the past 10-15yrs..btw, that begs the question to what extent the better good was served by product innovation and pushing the edge of the envelope..M.I.T. trained quants might be able to split the atom, and forecast infinitesimal wormholes in the capital markets universe to exploit, but do they really have a feel for the soul of a company or of an originator or investor class – it’s problems, it’s folklore, it’s needs? Challenge!! And I happen to agree with you that neither the management teams, nor the clients, for that matter, could possibly fathom the details of the risks embedded in many of these innovations..isn’t it a great blessing to have well-trained regulators and insightful legislators and a fair and informed media on the case providing a counterbalance to the forces of capital markets “progress”…hmmm! The scary truth is that there are critical linkages between the Wall St maneuvers in the dark and the economic future and strength of our country – and both the symptoms and the supervisory process have gone wrong..if I had to pin down the when, it might have been triggered when partnerships went public, and ethics fled the scene to be replaced by outsized compensation packages crafted at the expense of clients, shareholders, and even colleagues..and to spin an old Stephen Wright line, “..I’m pretty sure it was some guy named Eddie” that was indeed, Patient Zero! Keep punchin’, LD, keep punchin’






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