By Alice Schroeder a former managing director at Morgan Stanley
Nov. 13 (Bloomberg) — A group of university students I spoke to recently asked if it was possible to make a living on Wall Street without compromising your values. I had to tell them no.
Wall Street has many decent, honorable people, but they work in a system that fundamentally compromises people’s ethics. The high pay is like an anesthetic that numbs you from feeling how you are being corrupted. Not only that, many honest people who work there would agree with an even more extreme statement: It’s hard to make a living legally on Wall Street.
The goal of investing is to get an edge, whereas the securities laws presume all investors should have the same information at once. If ever there was a recipe for a system rife with abuse, this is it. The harder that money managers, traders and analysts must work to get information that gives them that edge, the more likely some are to cross a legal line.
This week, Manhattan federal court dealt with a case of insider trading when Michael Koulouroudis pleaded guilty to charges that he traded on secret tips from UBS AG investment banker Nicos Stephanou, who previously took a guilty plea. Joseph Contorinis, a former money manager for Jefferies Group Inc.’s Paragon Fund, was indicted by a federal grand jury last week for his role in the scheme.
People who are looking from the outside at the Galleon hedge fund insider-trading case may also be thinking, “How could they have been so stupid?” Admittedly, naming the ringmaster “Octopussy” wasn’t the brightest move, yet the reason insider traders create networks to exchange illegal information isn’t because they are dumb. It is because so few money managers outperform market averages over time.
Not Enough Alpha
There is only so much alpha — that excess return above a baseline average — to be had in an efficient market. The incentive to create some artificial alpha one way or another is very high. Those who bend the rules successfully post good numbers, which adds to pressure on other Wall Streeters to push the gray boundaries of legal information flow.
One had to wonder if that’s what happened when the volume of 3Com Corp. call options surged to the highest level since September 2007 before Hewlett Packard Co. said it would buy the computer-networking equipment maker for $2.7 billion this week.
Investors also form an “us against them” mentality of sleuthing by whatever means is necessary to counter the stonewalling and obfuscation of company executives. A lot of inappropriate blabbing on Wall Street takes place by people who are outraged at some atrocity that is being committed by a company whose stock is overvalued.
The tippees feel self-righteous about using the information, no matter how it was obtained. They see themselves as leveling a playing field skewed by lying company managers who are aided and abetted by cynical investment bankers and invertebrate analysts who (still) do bankers’ bidding out of concern for their careers.
Beyond that, big money managers feel entitled to even more information by virtue of clout: the first phone call from analysts; a heads-up that a salesperson thinks a downgrade on a stock may be coming; preference in a hot banking deal. This is simple economics. It goes without saying (because it can’t be publicly acknowledged) that the millions of dollars of business that an institutional client is doing with an investment bank means they will be treated much better than a small retail client who is paying a 1 percent wrap fee on a $50,000 account.
The better class of financial advisers tries to make up for this crooked system with creativity and pride in the way they serve their clients. They resist pressure from their employers to sell products only because they are profitable.
Over Legal Line
They have another, bigger problem, the same one faced by the large institutions. There is only so much alpha to be had in the market, and they are chasing it along with everybody else.
The aggregate number of people trying to carve fees out of investor returns simply overwhelms the potential gains for stockholders. It is this oversupply of overhead that creates so much pressure to cross the legal line.
Victims of their own success, the banks have severely aggravated this situation by going public, then taking on too many masters to “diversify” earnings: institutional money managers, retail investors, investment-banking clients, prime brokerage clients, “financial sponsors” (private-equity and buyout funds), their own asset-management arms, and proprietary traders. It is all but impossible for people at investment banks to serve all these clients — whose interests conflict — while doing their real job: to satisfy the quarterly earnings expectations of the banks’ investors.
Incentives to Cheat
Breaking up the banks into their constituent parts and forcing them to return to privately funded partnerships might reduce the apparatus that provides all parties with the incentives to cheat.
Even in the very unlikely case that this happened, it would still leave a shortage of alpha. As long as working on Wall Street is the most prestigious and financially rewarding job in the U.S., too many mouths will show up every morning to be fed.
Here, I sense a breath of change in the air. Kids who left college to import crafts made by women war refugees in Sudan are beginning to be envied by junior bankers who toil 80 hours a week creating spreadsheets. That’s a trend to be encouraged.
Aspiring young bankers and hedge-fund managers, be assured of this: The more of you who choose to import crafts from Sudan, the easier the rest of you will find it to make a living legally on Wall Street.
(Alice Schroeder, author of “The Snowball: Warren Buffett and the Business of Life” and a former managing director at Morgan Stanley, is a Bloomberg News columnist. The opinions expressed are her own.)
To contact the writer of this column: Alice Schroeder at firstname.lastname@example.org.
Commentary by Alice Schroeder
Last Updated: November 12, 2009 21:00 EST