Modern Investing

by David Schneider

  Goldman Sachs is a good example of how Wall Street institutions changed and transformed themselves from the late 70s to today. In his revelations Why I Left Goldman Sachs published in October 2012, former Goldman Sachs senior trader Greg Smith describes vividly how the firm’s former culture of serving the clients first turned into a culture of dog-eat-dog and bonus fetishization. Smith concludes that this cultural change is irreversible unless it is stopped from the outside. He came to the only sensible conclusion– leave the firm.48

  If you ever ask an investment banker about a possible conflict of interest between their own trading and trading for clients, they would vehemently deny any. They would say that barriers, so-called “Chinese Walls” are in place, with trading floors separated, sometimes at different locations. Supposedly, this keeps the flow of information between the trading activities of their clients and their own trading activity strictly compartmentalized. They will also refer to ever-increasing internal compliance and risk management departments whose sole purpose it is to enforce law and order.

  Obviously, this is nonsense. For starters, the senior figures within the institution have their fingers in both pies, and we are expected to believe that they never talk about business to each other. You need to understand that investment banks are a treasure chest of information. All market players have to deal with them like all gamblers have to deal with casino staff. Individual, professionals, central banks and even governments have to deal with them. Wall Street institutions are at the very top of the information food chain. Not letting the pool of information go to waste, they have been busy converting their trading floors, built to serve their clients, into profit centers that have contributed billions of net profits and created a bonus system the likes of which has never been seen before in the history of the world.

  Today, prop desks resemble modern hedge funds. They operate several hedge fund strategies at the same time on different teams and for different product categories. They have very similar financial incentives with very similar risk profiles in place, and they do what they were designed to do– make money in any market conditions with the edge they enjoy. In plain English, this means to make money on the backs of weaker players. If it means treating their own clients less favorably to violate their fiduciary responsibilities and to challenge the law, so be it.

  According to Greg Smith, his former top boss and Goldman CEO, Lloyd Blankfein, openly admitting to this pragmatic culture in front of a Senate subcommittee hearing. Smith is quoted as saying, “...in a sales and trading business, there is no fiduciary responsibility; that we are not obliged to do what is in the client’s best interest; that we were not advising the client; that we are just there to facilitate trades between big boys (i.e., large institutional investors).”49 If this revelation doesn’t frighten you when dealing with Wall Street, I don't know what would.

  But there is another part of the culture surrounding Wall Street’s prop desks that is equally concerning—the world of prop desks and their intricate network and relationships with leading hedge funds. In this web of close Wall Street relationships, not only prop traders or hedge fund managers are part of it, but also a few select money managers from the largest asset management companies. But, it’s the hedge fund world prop traders naturally lean towards and bond with. As a matter of fact, prop desks are the breeding grounds of new recruits for the hedge funds of the world. The very best prop managers don’t go even that far, but establish their own hedge fund firms, sponsored by their banks, in which they worked for many years. Indeed, they maintain exquisite relationships with the prop desks they left behind.

  Wall Street Mafia

  It is a fact that there is a small community on Wall Street that knows each other personally and builds strong professional bonds. There is nothing wrong with that; nor is it illegal or immoral. But, it becomes a serious problem when a small group of people abuses their favorable positions and relationships to gain an edge over all others. With a sense of entitlement and open ruthlessness, they present themselves as invincible, which can only be considered reckless and extremely dangerous for everybody else. Machiavelli would no doubt be proud that so powerful a group seems to have taken his lessons to heart. For the rest of us, though, surely the implications are terrifying.

  Some economist and industry experts trace the emergence of this openly aggressive culture and cut-throat ideology back to Enron and its notorious energy trading and deal-making teams before they went bankrupt in 2001. One trader was recorded singing, "Burn, baby, burn. That's a beautiful thing." Apparently, he couldn't contain his excitement when he made millions on the back of Californians without electricity in the summer of 2000, when a massive forest fire disrupted power supplies to California. In this chaos, Enron was able to raise electricity prices citing “demand and supply issues.” It entered the history books as “the Western power crisis.”

  As eye-opening as Enron’s case might be, there was a much more important event in financial history more than ten years earlier that provided the blueprints for Enron’s trading, deal-making and accounting shenanigans. Meet Ivan Boesky and Michael Milken—the forefathers of modern investing and Wall Street.

  In the midst of hairspray and the Gordon Gekkos of the 1980s, a new Reaganite ideology rose to prominence. There was no better expression of the philosophy of people like Boesky and Milken than Gekko’s rant in Wall Street with the “greed is good” sermon celebrating a new age. This was based on the speech that Ivan Boesky gave to students at the UC Berkeley School of Business May 1986 commencement ceremony (Milken’s alma mater).

  Boesky was a hedge fund manager who traded the same trading strategy Rubin had about ten years earlier: Merger Arbitrage. But where Rubin used probabilistic mathematical models and yellow legal pads to assess the likelihood of a deal completing successfully in order to have an edge, Ivan Boesky was not as patient and mathematically inclined as Rubin. What he wanted, and based his model on, was insider information. One iconic moment that would change Boesky’s life forever was his Waterloo moment with Cities Service, a huge oil company. It also exemplifies the concept of “moronic leverage,” as he used sizeable amounts of his own and his wife’s family fortunes.

  In May 1982, T. Boone Pickens, the famous oil billionaire and former corporate raider, launched a hostile tender offer for Cities Service. The price of Cities Service shot up from around $30 to almost $60. Immediately after the hostile bid, a “white knight” emerged to rescue Cities Service from the grasp of Pickens. The white knight was Gulf Oil, which made a friendly bid at $63 a share.50 At that moment, Boesky’s trading desk got busy. He committed all his firm’s capital and, on top of it, borrowed 900% more liquidity of that from banks and brokers, totaling $70 million. He made an all-out bet on the Cities Service deal. He and his entire team were convinced it was a sure bet. According to a person involved, it was a bet “I’d put my grandmother in.”51 Their confidence was derived from a very similar takeover battle that preceded the Cities Service deal. In that deal, a bidding contest erupted between the corporate raider and the white night, generating a very handsome profit for Boesky with a very similar leveraged bet.

  Unfortunately, markets don’t do what you want them to do, and Boesky experienced his very own lesson of the “rear-view mirror” fallacy. On August 6th, rumors were flying that Gulf got cold feet and that the company was considering withdrawing its bid. What Boesky went through emotionally can only be imagined. If the rumors were true, then share price of Cities Service would probably plummet back to $30. At that level, Boesky’s firm would have been wiped out completely. When the rumors were confirmed, the stock plunged, as expected, to $50 and then to $45 within hours. He was rescued from certain bankruptcy, thanks to a last minute miracle deal with another hedge fund manager and his close friend. And even though this deal might have saved him, his estimated loss was still $24 million, about 30% of the firm’s assets. At that point, Boesky swore never to lose money again. He understood that he needed to eliminate a
ll risk for his future bets if he wanted to remain to play the big money game on Wall Street. He needed to be at the very top of the information food chain, so he made a phone call only a week after his monumental experience. That would be one call in a series of many calls that would lead to a treasure chest of insider information about pending or failing takeover deals. When he dialed his number and someone picked up, he heard the familiar and friendly voice of a Wall Street banker.

  The phone was not taken by Michael Milken or even one of this bankers. It was different Wall Street player—one of many. Both Boesky and Milken would build a unique relationship, which would make them the juggernauts of their generation. Milken represented a new breed of predator investment bankers with a “take no prisoners” philosophy. He single-handedly transformed his firm Drexel Burnham Lambert from a second-tier institution to a challenger of Morgan Stanley and Goldman Sachs for Wall Street supremacy. Ironically, Milken always disliked working on Wall Street with its old white-shoe culture and exclusive gentlemen's clubs. As soon as he got so powerful that top management couldn't deny any of his personal requests, Milken moved to Beverly Hills, California with a loyal group of ragtag bankers and traders. There, he would establish his own command center and trading floor without any operational oversight or internal controls from New York headquarters. This decision alone would seal the fate of Drexel Burnham Lambert Inc.

  Milken was a genius banker: extremely hard-working, resourceful and obsessed with his work. He developed a new investment banking structure that was designed to generate cash non-stop and in amounts never before seen on Wall Street. His method was based on the two pillars of fee income and, more importantly, lucrative bets for his separate accounts. Just like Enron’s Andrew Fastow had his secret accounts to book his private equity dealings hidden away from top management, Milken had his secret internal bonus account where he only booked his most profitable trades to benefit himself, his West Coast gang and his loyal followers. He developed the blueprints of modern investment banking, with prop trading desks, at the heart of the money-making machine and an elaborate network of tipsters, proxies, and henchmen. They were all generously compensated because he made offers no one could refuse. Money talks on Wall Street.

  What he was capable of with this new structure could be seen at the height of his investment banking empire, when he controlled entire markets. This included the market for lucrative takeover deals financed through his innovate bond department, his crown jewel. He was regularly hired as an advisor for both sides of a takeover deal, literally negotiating with himself. He made millions in fees– advising clients, and issuing bonds that would finance all of those deals– while simultaneously trading for his account. Unfortunately, he would never see the day where his structure would unfold its full potential, where millions would be replaced by billions and entire sovereign states would give in to the power and influence of investment banks and a few hedge funds.

  A notoriously impatient man, he felt he needed to speed things up. He needed someone to do the dirty work for him. Ivan Boesky fit the bill.

  Milken benefitted from his relationship with Boesky through generous trading commissions, access to reliable capital sources, and the traffic Boesky’s trading generated in the market. As a very public figure, Boesky even appeared on the cover of Time Magazine. Hence, Boesky had a lot of followers and piggyback investors. Most importantly, Milken was able to camouflage his trading and trade positions through Boesky’s role as a secret proxy. It was a relationship made in heaven, mutually beneficial with all of the preferential treatment, kickbacks, and insider information. Unfortunately, it all came tumbling down. Milken and Boesky wound up in jail because they were ratted out by Boesky who wore wires at several of his last encounters with Milken.

  In April 1990, Milken pleaded guilty to six counts of security and tax violations. Three of them involved dealings with Ivan Boesky.52 In the aftermath, his investment bank Drexel Burnham Lambert imploded and, by 1990, disappeared. Millions of investors lost money on a scale that was never seen before. Many of the deals that he helped source and finance buckled under the burden of very high-interest payments and a loss of confidence. As a result, it caused a wave of corporate bankruptcies and industrial consolidation, including in the US banking sector. From these ashes, giant financial institutions, e.g. Citigroup and JPMorgan Chase, emerged; they would dominate world finance for the following decades.

  Milken was the real king of Wall Street at his time leaving behind the blueprints of Modern Investing and Wall Street as we know it today. As Milken demonstrated and had envisioned, the new institutions would be powered by prop desks that would dwarf anything he had ever had. With trading desks, traditional funds and hedge funds all interlinked and using state of the art technology and the best software available, a small group of astute player(s) would profit from the flow of information around the globe amassing enormous fortunes and political power in the process. Milken would not be part of this new financial order. Out of the game, and in prison, he finally tended to his charity that he had founded but had neglected during his busy career – “The Milken Family Foundation.”

  Why the Kamikaze?

  Having studied Wall Street’s money-making capabilities and some of the more dubious techniques to gain and enforce their edge, the question is: why the occasional gigantic losses? Why the suicidal missions of some financial institutions? Milken and Drexel Burnham would never reign over their financial empires. Milken got caught up in criminal charges, and Drexel collapsed under the weight of lawsuits and unfavorable market conditions that caused big bets to go bad. In 1995 the venerable old British merchant bank, Barings Bank went the way of the dodo when one employee named Nick Leeson caused massive losses through failed speculations and then tried to cover it up. LTCM blew itself up in 1998 and since the subprime crisis, everyone is aware of Wall Street’s incompetence and recklessness. Its history is littered with corpses of failed investment banks and giant hedge funds. To paraphrase Michael Moore: “I think historians when they look at this time, they’re going to wonder why “Wall Street” overplayed their hand like this. Why would they, when they had it so good? “53

  Trying to answer these questions, William D. Cohan, author of Money and Power, made the following comment: “Why we never seem to learn from the problems caused by our ongoing reckless behavior is mysterious and unexplainable.”54

  The culprits are not alone. Even those who try to uncover the crimes and excesses of a few privileged Wall Street players are not free of their misjudgments and personal weaknesses. Elliot Spitzer, too, had to face his demons. His career nosedived soon after concluding his investigation. According to The New York Times in 2008, “Spitzer had at least seven or eight liaisons with women from a high-end prostitution agency over six months.” Investigators now believe that Spitzer paid up to $80,000 for prostitutes over a period of several years while he was Attorney General, and later as Governor.55 Apparently, the FBI wiretapped him, alerted by suspicious money transfers under the anti-money laundering provisions of the Bank Secrecy Act and the Patriot Act. They didn’t catch an international terrorist ring or financial activities that supported global terrorism. Instead, they found Wall Street’s #1 enemy.

  The financial theory assumes that market participants act and react rationally in the face of economic news: honestly and as intended under the law. Unfortunately, that is just an assumption. People make mistakes and give in to greed and fear. In this regard, all players and market participants – on and off Wall Street – are the same. They all tend to have their very own cognitive biases. The only difference is that some are more in control than others, and those who can, either stay away altogether or make sure that chance is as little a factor in their financial success as possible. If it weren't for a very common issue known as “overbetting,” or in other words “overplaying one’s hand.” Wall Street would be living in a perfect world of ever increasing profits and bonus payouts.

  Let me explain, one of the
most common errors committed by gamblers is “overbetting.” It is connected to gambler’s ruin. A lot of gamblers don’t know how much is too much, and they don’t know when to stop. Overbetting is always bad and always has dire consequences – not only for the person who did the actual overbetting but anybody connected to that person. When we remind ourselves of the few failures mentioned in this book, we can trace them back to the phenomenon of overbetting by a small group of seemingly sophisticated players with or without a superior edge. It is a widely known fact that players who believe they have a clean edge over others tend to overbet regularly, especially when they bet with other people’s money. But in the real world, there is never a 100% sure thing.

  JP Morgan and Sea Mammals

  In February 2012, some hedge funds noticed unusual trading patterns in the market for credit default swaps (CDS). CDS work like an insurance contract that pays out premiums, but demands full payment when a particular event occurs. These highly complex derivatives structures were the same derivatives that took center stage in the subprime mortgage crisis in 2007.

  These hedge funds suspected a trader who had some deep pockets as someone who was capable of manipulating the pricing of the derivatives in question. It was later revealed that this trader was none other than Bruno Iksil, a key JPMorgan Trader nicknamed the London Whale, who was infamous for his oversized bets and willingness to take a risk and reap enormous fortunes. Apparently, he accumulated outsized credit default swaps of such a size that he moved the entire market for these products. As the London Whale, he felt invisible at times. But this time in, he clearly overplayed his hand. By the middle of 2012, other players, mostly rival banks and hedge funds, placed heavy opposing bets. Like a pack of vultures smelling blood, they collectively and simultaneously attacked the weakened target with full force. Their strategy was simple: taking the opposite side of the bet, hence squeezing Bruno Iksil out of his bet, at very unfavorable prices for him and JPMorgan. Unbelievably, this pack included another trading branch of JPMorgan that purchased the derivatives that Iksil was selling. It seems that one hand did not know what the other was doing. I suspect a more Machiavellian ideology was the reason for these inner trading conflicts on JPMorgan’s trading floors. Besides, bonus time was around the corner.