Wall Street Meltdown: A Different Perspective

Most people reading this blog already know that what has happened last week and over the weekend with the bankruptcy of Bear Stearns and Lehman, bailouts of AIG, Freddie and Fannie, the sale of Merrill Lynch, and the capitulation of Goldman and Morgan Stanley as independent investment banks is the stuff of financial history legend.  Students and academicians will be studying these events for the next hundred years, much in the way the Great Depression of the 1930's in the U.S. and other financial crises in other countries are still studied all over the world, looking for reasons and insights and more importantly how to NOT let them happen again.

The Wall Street Journal published an op-ed piece this morning by L. Gordon Crovitz that displayed a startlingly insightful, and yet simplistic, view into this that sliced right to the heart of the issue.  And it sliced into the patient's heart from an angle that previously had not been used.

All of the stories that I've seen have reiterated the same general story of "lack of federal regulations led to unfettered corporate greed".  There are offshoots to this story around "overly complex financial instruments" and "too big to fail" and other topics.

To me (and obviously to L. Gordon Crovitz), these are all secondary issues.  The primary issue is that the global free market failed to properly account, over time, for the balance sheet risk in the stock and bond prices of the entities that held these mortgage-backed derivatives.  It is BS that their risk was too complex for anyone to understand.  If smart people could create these instruments then other smart people could decode them and understand their risks.  Maybe not overnight after massive, inter-locking positions have been built up, but they certainly could have been understood over time as the positions were being built up over a multi-year period.

If the risk of these entities had been properly understood as the riskiness of their balance sheets increased over time, the free market would have driven their stock and bond prices appropriately lower over time, SMOOTHLY.  The management of these companies would have reacted appropriately to their lowered market values, and would have reduced the riskiness of their balance sheets (again, slowly and smoothly over time) in order to bring their market values back up.

But this did not happen?  Why not?

As Mr. Crovitz posits, it's because the Eliot Spitzer led charge against the Wall Street research analyst industry in 2000 removed a fundamental governor to the system.  It is the job of the Wall Street research analyst to do "investigative reporting" into the health of public companies.  In late 2000, several regulations were enacted that made it much harder, and much less attractive, for research analysts to perform high-quality investigative reporting on the public companies that they follow.  This post is not to get into how, why or what these regulations were, but suffice it to say that while they may have been well-intended, we now see that they may have led to horrible unintended consequences.

In 2008 there are less than half the number of research analysts that were on Wall Street in 2000.  The need for high-quality investigative reporting into public companies did not diminish, and the people that could do that job the best took jobs with hedge funds, but I'm sure that it slowed the number of smart, young people wanting to become research analysts to a trickle.

I'm also quite sure that many of the ex-research analysts turned hedge fund manager were pounding the table internally at their hedge funds (for months and probably years) screaming about how the stock and bond prices of these entities did not properly reflect the riskiness of their balance sheets, and pushing the fund to take huge short positions.  Kudos to them because those that did take short positions collectively made their investors billions in profits in a few short weeks.

But those insights were concentrated into a small number of equity long/short hedge funds that focused on the financial services sector.  Those insights were not widely dispersed to the general market; in fact the hedge funds are motivated to keep their proprietary information closely guarded and no matter how "right" they think they are they do not want to take too large a position because it could move the market and eliminate their ability to profit from the information disparity.

If high quality public company research had been done at the Wall Street investment banks, in effect creating more "table pounders" and keeping them at a (investment banking) platform that allowed, and encouraged, them to scream at all market participants in a very public way, the free market system may have functioned as it was designed, i.e. smoothly moving prices up and down and compelling management teams to take actions that properly align risk potential with return potential.

This gets to the title of Mr. Crovitz's op-ed piece: Information Haves and Have Nots.  That is absolutely the right title for this concept.  By chopping down the Wall Street research analyst function (causing it to be re-planted at the closed-information hedge funds), it created a smaller number and more concentrated set of "haves" containing information on the appropriate prices for the entities that held exposure to mortgage-backed derivative risk.  The vast majority of market participants became information "have nots".

We will now pay the price for that information disparity for years and possibly decades.

Moral of this story: Be aware of the unintended side effects of even the best-intended regulations.

Comments

[Doug Newkirk, BFKN]

I've been mulling over Crovitz's argument. While it is certainly no surprise that a WSJ commentator would blame a government prosecutor and not any industry participants for the current crisis, and I'm no fan of Spitzer, I'm not sure I agree. Spitzer simply divorced analysis from deal-making, as too many banks (and issuers) had let the sell-side research become a way to win the investment banking business (and another way to support the stock in the after-market) and thus, the sell-side research had become corrupted (Spitzer would argue). (Even as to that point, I've had some reservations, since I saw sell-side analysts at my investment banking clients kill several IPOs, even after the process had started.)

However, if Crovitz believes that better research would have kept the Inv. banks, hedge funds, mutual funds and other proprietary traders from buying all this now-illiquid (and opaque and likely highly overvalued) junk, then he, as a free marketeer, has the burden of explaining the market failure. That is, why couldn't buy-side analysis solve Crovitz's problem? Even if Crovitz is correct that Spitzer's kicking research off the corp fin deal-making gravy train rendered sell-side analysis unprofitable (since the brokerage business could no longer support research (since the Feds had already got rid of fixed commissions (a pro-market reform)), nothing Spitzer did precluded any banks or other financial firms from hiring BUY-side analysts, as the article recognizes. Plenty of margin should have remained to pay for good research on the proprietary side of the business for all the institutional investors(since on the buy side, the stakes for good research are not a broker's pennies on the dollar of each trade, but the owner's $1.00 of each dollar on the asset purchased (or sold, or not purchased)). So, I'm not sure Elliot has to take the entire blame.

[Dan Malven]

Doug:

Dan here. Good to hear from you. I appreciate you using the "sell-side" and "buy-side" naming conventions. Those in the industry understand them, for those not in the industry, "sell-side" refers to the type of research analyst that acts as a consultant/advisor to clients who take the financial risk of buying/selling securities. "Buy-side" is a research analyst who works at an entity (like a hedge fund or mutual fund) that takes the financial risk by buying/selling the security themselves, i.e. sell-siders advise while buy-siders put their money where their mouth is.

The issue with buy-side analysis is that if you see a buy-side short opportunity, you are guarded as to who you disclose it to because if everyone knows it then the market reacts and it's no longer an opportunity. So the buy-side shorts want to covertly build positions and then hope for disaster, which is what happened. The ones smart enough to see it became the "information haves". It is the sell-side analysts job to trumpet it to the world (generally speaking) and avoid disaster, thus educating the "have nots" and creating better information parity. But because sell-side became so unprofitable, the quality sell-siders turned into buy-siders, which helped create the disaster.

One other point about the regulations that were enacted is that they not only made it harder to make money from sell-side analysis, they also made it harder to perform high-quality sell-side analysis by altering the way that a sell-side analyst could communicate with management teams.

I admit the argument is not flawless, particularly is it only holds if one believes that only a small number of research analysts (either buy-side or sell-side) would have been smart enough to decode the complexity of the situation. If it's a small number, then having those people on the buy-side would not have moved the market enough to correct the problem (by design, because they didn't want to move the market slowly, they wanted to build big short positions slowly over time and then have disaster strike).

[AnonymousSellSideAnalyst]

I think you give us way too much credit. In my opinion, the bigger issue is the lack of detailed financial disclosure that would allow analysts and investors to analyze these issues. I don't think financial disclosure currently is anywhere near adequate to allow proper insightful analysis--especially of complex issues such as these. I think that the vast vast majority of shorting is done based on rumor and innuendo, not on cold analytics.

Separately, I do agree that Spitzer eviscerated the sell-side, and has made the process of raising capital less efficient for companies and no more transparent or high-quality for investors. Even well-intentioned initiatives like the Fair Disclosure regulations in my opinion have resulted in less not more information being made available to investors. The playing field may be more level, but the level is lower than it was before.

Of course, the real issue with sell-side economics is deregulation of and competition on trading commissions, that in combination with the proscription against benefiting from investment banking activity means that you cannot afford to pay for sell-side analysts. I will tell you, however, that there still is no shortage of highly talented individuals wanting to join the sell-side. I am not sure it is the case that the best-and-the-brightest are avoiding the sell-side for hedge fund opportunities, and I do not think that has become worse since Spitzer.

For various compliance and other reasons I'd rather not attach my names to these comments on your blog.

[Dan Malven]

AnonymousSellSideAnalyst,

Thanks for your input. Always great to hear from people who are actually doing the job that is being discussed.

Again, for those not in the industry, he is talking about Regulation Fair Disclosure (or Reg FD). I refer to this in my post about how it is now much harder to perform high-quality sell-side analysis...it is because of Reg FD.

Very good quote on how FD may have leveled the playing field, but the field is now much lower than before. This meltdown is a very real result of that lowered playing field.

[Robb Hendrickson]

crovitz concludes by making the case for private research firms, such as gerson lehrman, (at least partially) filling the information void. do you buy that? if so, how many such firms do you see playing that role? also, if not too off-topic: what path do you envision the corpfin side of IB taking...boutiques? ...and, as an early-stage investor, how do you foresee this market disruption playing-out for entrepreneurs and VCs? ...how will it impact seed-stage financing? ...and do you see more opportunity or lack thereof as a result of recent events?