Wednesday, March 07, 2012

Wall Street DOES have an interest in your future!

I was reading Harry Newton's blog post today where he says "Wall Street is a product machine. It creates what it can sell you. It has NO interest in the future of what it sold you" and while I superficially agree with that, after a little thought I realized that something was missing from Harry's formulation, something very important. I realized that "It has NO interest in the future of what it sold you" is not an accurate assessment of Wall Street's mentality at all. The rest of this post is a near replica of an email that I sent to Harry.
 
There is plenty of evidence in the financial media since the financial crisis that Wall Street all too frequently DOES have a very deep and passionate interest in your future and the future of what it sold you – namely, to profit handsomely from your downside. So, for example, they will sell you stocks, and then short them, profiting from your loss. Or sell you "dogs" of bonds and then buy them back at a steep discount when you want to dump them. Or, one of the big GS scandals where they sold customers mortgage securities that they intended to short or bet against or had hedge fund clients intending to do so. The list goes on. They have a very intense "interest" in how things go for the future of what they sell you. Maybe the particular salesman/broker doesn't because he just wants his commissions, but I can assure you that there are plenty of others at the firm who do have an interest.
 
The real point is that the primary interest of Wall Street is collecting fees, commissions, and other payments based on the flow of transactions. You say cash is king, but on Wall Street transaction flow is king.
 
The secondary point is that as long as transaction flow is maintained, Wall Street is more than happy to profit from any downside you the customer experience.
 
The "prop trade" desks on Wall Street have two functions: 1) to "support" the flow of transactions – that is what they were doing with ARS, until they stopped, and 2) to bet against the customer and profit from the downside.
 
The real point of ARS was to provide a steady flow of Muni underwriting transaction flow, unlike the situation we saw later with the mortgage market.
 
Wall Street firms have something called "inventory" which is a combination of the stocks and bonds that they are selling as a result of underwriting "support" and "cheap" stocks and bonds they speculate on when you dump them in bear markets or due to other fear-based emotion (you can be sure that they were big buyers of BP while the oil spill was in progress.) They buy the stuff cheap, and then sell it back to you (or your neighbor or friend) at a nice profit on balmy days when the sun comes out again. In any case, this "inventory" is a very clear interest in the future of what they sell you, either to continue selling it to you in a rising market or to buy it up cheap in a down market. Note: There is currently a lot of Wall Street interest in buying up "distressed" mortgage securities, proving that Wall Street does have an "interest" in anything and everything that they sell you.
 
Wall Street caters to a lot of different types of interests, ranging from hard-core value investors to hot-tip casino speculators and twitchy day traders. Just like Vegas, they have a very deep and passionate interest not just in taking as much of your money as possible, but just as much interest in having you return again, again, and again – as you yourself do! So, it is rather misleading to say that they have "NO" interest in the future of what they sell. It's much more complex that that. Half of the time they have a "NEGATIVE" interest (selling you crappy offerings like ARS or overpriced IPOs or other so-called "products"), but just as importantly they, like Vegas, offer a implied promise that if you are willing to gamble and take on enough risk, that sometimes you can "beat the house", at least for a short period or maybe only for a single transaction. And, most importantly to us "true" investors, if you are willing to do your homework and be much more dispassionately calm and prudent in how you choose risk and extremely patient in your outlook, you can identify bargains and opportunities that slip by under the radar of Wall Street since they have so many bigger (and more gullible) fish to go after.
 
On the muni front, the sad thing is that all too often Wall Street sells local governments exactly what they ask for, a little lower cost (which government officials and bureaucrats are FORCED to ask and beg for due to the intense pressure to keep expenses and hence local taxes down), even if in exchange for confusing fine print that can have serious downside. If the local governments weren't so desperate to save "just a few shekels" to hold taxpayer activists at bay, Wall Street wouldn't have such a slam-dunk, shooting fish in the barrel market for complicated munis, the likes of which brought you and your friends the "innovation" of ARS.
 
I wouldn't for one moment let Wall Street off the hook for any of the many egregious practices that they do engage in, but accuracy in how we characterize their FULL activities is still important. I think you just got a little sloppy with this point. A decent correction is in order.
 
The guidance for investors should not be "Wall Street has NO interest", but for us to ask the question "What are the particular interests of Wall Street in this specific offering and how do they mesh or conflict with my own interests?"
 
I learned the hard way to stay away from convertible debentures – they seem appealing, but Wall Street's interest besides the upfront fees is that they collect commissions from the hedge funds that immediately turn around and short the stock on the expectation that any company feeling desperate for a convertible debenture is "headed down." Or maybe more to the point, the stock is likely to be a rollercoaster leading to repeated shorting and covering that just fills the pipeline with a commission revenue stream. And once the stock goes down, the debenture goes down and then they can buy them back at a steep discount and earn a huge yield on them. My personal example involved... yes, you guessed it – Goldman Sachs. That's another example of how Wall Street does have an "interest" in the future of what they sell you.
 
There are no "perfect" investments; it is all a matter of identifying, managing, and balancing potential upsides with potential downsides, and, as importantly, understanding that both upsides and downsides will evolve over time in unpredictable ways.
 

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