All your have is your name and reputation

The Globe and Mail had an article entitled Does your investment adviser put you first? The article amounted to an endorsement of the CFA Charter:

The best advisers in this country already work to a fiduciary standard, but they’re not easy to spot in a financial industry where generating revenue from clients is the main objective. One approach is to look for advisers who have earned the Chartered Financial Analyst (CFA) designation.

CFAs are the paratroops of the investment advice industry. They’re trained to a higher standard and more is expected of them. Each year, they’re required to sign off on a code of conduct that includes a clause saying CFAs “have a duty of loyalty to their clients and must act with reasonable care and exercise prudent judgment. Members and Candidates must act for the benefit of their clients and place their clients’ interests before their employer’s or their own interests.”

I received my CFA designation in 1989. I haven't retained much of the study material from the exams, but the one thing I do remember very vividly is the CFA Code of Ethics. I have come to recognized that in this business, all you have is your name and your reputation. If either of those are tarnished, they are tarnished forever.
 
Consider the case of David Sokol. I have not commented about the Sokol affair because I don't have very much to add. My personal opinion is that what he did was likely not illegal, but unethical. Regardless of the legal consequences and any fallout from any investigation that may ensue, the reputation of all those involved have been damaged by this affair.
 
 
Real-time ethical dilemmas
Frequently, ethics training doesn't go far enough. While it is important to impart an understanding of the ethical standards to students and trainees, most organizations don't want to take the sensitive next step of involving people in discussions of ethical dilemmas. Consider, for example, this Guardian story of Wachovia being accused of laundering $378.4 billion for the Mexican drug gangs.
 
There is no doubt that such a volume of funds flowing through the bank was a lucrative business, but it seemed that the business didn't pass the smell test [emphasis added]:

When he looked at Wachovia, the first thing Woods noticed was a deficiency in KYC [Know Your Client] information. And among his first reports to his superiors at the bank's headquarters in Charlotte, North Carolina, were observations on a shortfall in KYC at Wachovia's operation in London, which he set about correcting, while at the same time implementing what was known as an enhanced transaction monitoring programme, gathering more information on clients whose money came through the bank's offices in the City, in sterling or euros. By August 2006, Woods had identified a number of suspicious transactions relating to casas de cambio customers in Mexico.

Primarily, these involved deposits of traveller's cheques in euros. They had sequential numbers and deposited larger amounts of money than any innocent travelling person would need, with inadequate or no KYC information on them and what seemed to a trained eye to be dubious signatures. "It was basic work," he says. "They didn't answer the obvious questions: 'Is the transaction real, or does it look synthetic? Does the traveller's cheque meet the protocols? Is it all there, and if not, why not?'"

Also consider these obvious red flags:

Over two days, 10 wire transfers by four individuals "went though Wachovia for deposit into an aircraft broker's account. All of the transfers were in round numbers. None of the individuals of business that wired money had any connection to the aircraft or the entity that allegedly owned the aircraft. The investigation has further revealed that the identities of the individuals who sent the money were false and that the business was a shell entity. That plane was subsequently seized with approximately 2,000kg of cocaine on board."

Many of the sequentially numbered traveller's cheques, of the kind dealt with by Woods, contained "unusual markings" or "lacked any legible signature". Also, "many of the CDCs that used Wachovia's bulk cash service sent significantly more cash to Wachovia than what Wachovia had expected. More specifically, many of the CDCs exceeded their monthly activity by at least 50%."

When training people in ethics, they need to be confronted with ethical dilemmas. On one hand, you have the potential for a very large volume of business. On the other hand, the transactions have a distinct unpleasant odor to it. What do you do?

I reiterate my belief that at the end of the day, all you have are your name and reputation.

What's wrong with personal integrity?

I got an unusual amount of hate mail after my post Would you bet on pro wrestling? In that post, I wrote that the Goldman Sachs affair had demonstrated that Wall Street had lost its way is in the process of destroying its own franchise of trust.

While I did receive some praise, I found that I was also confronted with Libertarians brandishing their Road to Serfdom like so many Red Guards during the Chinese Cultural Revolution holding Chairman Mao’s little red book. They seemed to be reacting instinctively and believed that my answer called for more regulation. They hadn’t even spent time to read the post and their objections didn’t even address my proposals:

• Bring back the partnership investment bank. Such a structure makes the risk and return symmetric for investment bankers. If bankers want to do something stupid and foolish, then let them. However, I have found in the past that having virtually all of your net worth tied in a firm makes you think a lot more about risk control and how you make money.
• Require all derivative contracts to be listed on a centralized exchange. Greater transparency would create more transparency and allow market participants to better price risk. While the likes of AIG could repeat its adventure in derivatives, but greater transparency could allow the market to restrain AIG’s actions through the risk pricing mechanism.

These proposals allow the market to work. Does this sound like heavy handed regulation?


In praise of good government
Unlike the Libertarians, I appreciate the role of good government and I don't regard government as evil. Good government is invisible and we don’t appreciate it until something goes wrong, much like how husbands may not appreciate their wives making them dinner every night...until there is no dinner.

Government establishes a structure for the system to work. Government is the mechanism that created a system of weights and measures. It assures us that when we buy a pound of meat or a gallon of gasoline, that we get something that is indeed a pound or is a gallon.

Government is a traffic cop. It compels drivers to stop at red lights and go on green lights so that there is no chaos on the roads. Similarly, it directs traffic in the skies through a system of air traffic control when we fly.

We should be grateful for these invisible functions, which we never think of and take granted. These functions of government make our everyday lives easier.


Political backlash is building
Already, I see the political backlash building. Respected figures, who are hardly on the fringe, are speaking out. Todd Harrison, founder of Minyanville, believes that Goldman Sachs is the poster child for class warfare. Also read Kurt Brouwer’s account of the conflicts on Wall Street and why he left Merrill Lynch. Barry Ritholz at the Big Picture is proposing a commercial in support of financial reform bill.

The peasants are gathering with their pitchforks. Wall Street needs to clean up its act. Any political backlash has the potential to get out of control and the social consequences won't be pretty.

Readers will recall that I concluded my previous post with the comment that:

In finance and in life, all you have in the end is your name and your reputation.

In all of the objections that I've heard, there is one thing that I don't understand. What’s wrong with valuing personal integrity?

Would you bet on pro wrestling?

I have been a longtime advocate of thinking about your assumptions before taking action or coming to a conclusion about a situation. The Goldman Sachs affair makes me take issue with the dogmatic defenders of Ayn Rand and her ideas about efficient and self-adjusting free markets. What bothers me is that the Goldman Sachs defense boils down to "buyer beware, the investors are all big boys" and "as long as it's not illegal it's ok."

I have not always been a fan of the Obama White House, but I agreed with President Obama when he admonished the bankers last week (full text here):

I believe in the power of the free market. I believe in a strong financial sector that helps people to raise capital and get loans and invest their savings. But a free market was never meant to be a free license to take whatever you can get, however you can get it.

While I agree with Obama that there is a problem, I believe that the Volcker approach favored by the White House is overly heavy handed. A better approach is this.


Examine your assumptions
Let me make this clear. I do believe in free markets and I do believe in the ability of free markets to efficiently allocate resources, but those principles only hold under certain conditions and assumptions.

Those of us who remember the basics of microeconomics know about the elegance of supply and demand curves. Underlying the elegance of these mathematical models (and that’s all they are) are assumptions about the symmetry of information and the rationality of human behavior.

Math majors all know about proof by counterexample. You can disprove an axiom if you can show a counterexample that violates it. So here are some proofs by counterexample.

Consider how the Dederot effect spur people to spend beyond their means. Also consider this example of how Costco breaks long cherished microeconomic assumptions about human rationality. Closer to home, read this account of the manipulation of the silver market. Behavioral economics show that people aren’t necessarily rational at all, but biological and chemical:

Despite what we’ve been led to believe, the market isn’t rational or efficient at all—it’s all about feelings. The major plot points of the crisis largely turned on emotion: Dick Fuld was too egotistical to sell Lehman Brothers when he had the chance, so his pride drove it into the ground; Bear Stearns hedge-fund managers lost huge sums of money on subprime mortgages despite the fact that they suspected the worst (“I’m fearful of these markets,” Ralph Cioffi e-mailed a colleague back in 2007); Merrill Lynch was the “fat kid,” as the investor Steve Eisman has put it, so desperate to be like Goldman Sachs that it barreled into every dumb investment imaginable and had to be bailed out by Bank of America. Almost every single bank chief doubled down on mortgage junk at exactly the wrong moment. Emotions led otherwise intelligent men—because, let’s face it, all of them were men—to make terrible decisions.

According to a new breed of researchers from the field of behavioral finance, Wall Street’s volatility is really driven by our body chemistry. It’s the chemicals pulsing through traders’ veins that propel them to place insane bets and enable bank executives to make risky decisions—and those same chemicals tend to have the same effect on everyone, turning them into a herd of overheated animals. And because the vast majority of these traders and finance executives are men, the most important chemical in question is testosterone.

How the Street lost its way
Goldman Sachs and others on Wall Street used to believe in getting rich slowly. You serve your clients well and you will be well rewarded in the end.

Somewhere along the way, the Street lost its way and sacrificed client relationships in its search for short-term profits. Tom Brakke at Research Puzzle wrote about how this attitude affected his relationship with his brokers when he was on the Buy Side [emphasis mine]:

To be clear, no one ever tied me down and made me buy anything, but I developed a general wariness of the Street and its practices. Even though my firm generated tons of trading business and those on the sell side were adept at acting like intermediaries, their actions were often those of adversaries.

The firms (the majors especially) often knew facts I didn’t know or figured the odds better than I did. That’s not surprising, since they were full of talented, well-paid hard chargers who were placed perfectly at the center of the flow of ideas and money. I expected that to be the case. What I was slower to understand was that even as a big client they weren’t going to tell me the whole truth if it meant extra profit for them.

The credo at Wall Street firms went from “serving our clients well” to “hey they are big boys” and “if it’s legal it’s ok”. Tom Brakke continued [emphasis mine]:

The practice of skirting the edges of regulations, client relations, and possible conflicts of interest, so much a part of the Wall Street model of yore, needs rethinking, even at the cost of near-term profits. It simply hasn’t worked, other than to allow for outsized payoffs for the edge-pushers (until the inevitable retrenchment due to enforcement action or market failure). It’s not long-term greedy, it’s long-term stupid.

In the pursuit of short-term profits, Wall Street has destroyed its own franchise of integrity and client service. Todd Harrison put it best when he reflected that [emphasis mine]:

Ruby Peck was my grandfather and the bond we shared is difficult to describe. He was my guiding light, my inspiration, my role model and my best friend.

He taught me how to be a man and what a man should be…We used to take walks and hold hands as he passed his pearls of wisdom to me:

“What goes around, comes around.,,
And, above all else, “All we have is our name and our word.”

And it’s coming around. Wall Street may have irreparably damaged its own franchise and the resulting loss of confidence could bring the whole edifice tumbling down. While the Ayn Rand followers may rail about government regulation and the destruction of the finance industry that is essential to America, they missed the boat when they kept silent while Wall Street dismantled its own reputation.

Let me put it another way. You may bet on professional boxing because you enjoy the sport and believe that the matches are fair and not fixed, but would you bet on professional wrestling?

In finance and in life, all you have in the end is your name and your reputation.