It is a somewhat subtle, but recurring, theme on Going Private that losses are not crimes. Even deeper, perhaps, that losses have utility. They are, in fact, useful. As sure as talking heads are to focus on large executive payouts after decades of outperformance, while somehow managing to ignore the decades of outperformance, there is no surer way to narrow the mind of the pundit and trim thinking of the "financial journalist" than to show losses. Narrative fallacy is never so quick to emerge as after a reminder that markets can, in fact, travel in two directions. This, unfortunately, is the way of things. I am often inclined to attribute these effects to a badly spoiled population for which the belief that risk and return are not related is so ingrained, that evidence to the contrary is taken almost as a personal affront. It might even be difficult to enumerate the number of times I have touched on this subject.
At the risk of exhibiting indicators of multiple personality disorder, this passage probably bears repeating:
Financial bets gone wrong are not a crime. In fact, they are essential. Financial innovation has been a great boon to the American economy, but innovation entails risk, and risk means the potential for failure. The key point is that, when financial players step out too far on the risk curve in order to earn larger rewards, they are then allowed to suffer the requisite market penalties for reckless driving.
A post over on Naked Capitalism suggests that part of the most recent directional diversity issue the market has been having is the fact that there are no partnerships left among big investment banks on The Street. Or, more accurately, that investment banks are publicly held. Quoting Bloomberg, the entry notes:
Less than a decade after Wall Street's last major partnership went public, stockholders are paying the price for bankrolling the industry's expanding risk appetite.
Four of the five biggest U.S. securities firms lost about $83 billion of market value last year, almost 90 percent of their net income since 1999, data compiled by Bloomberg show. That cut the annual average return for Morgan Stanley, Merrill Lynch & Co., Lehman Brothers Holdings Inc. and Bear Stearns Cos. during those nine years to 9.7 percent from 16.8 percent.
Does it strike anyone else as somewhat tortured to compare market value losses to net income figures?
private partnerships that once dominated Wall Street guarded their
capital, used less leverage and limited their risk to trading blocks of
stock for clients and shares of companies in mergers, said Roy Smith, a
finance professor at New York University's Stern School of Business and
a former partner at Goldman Sachs Group Inc. Since raising money from
the public, many of the biggest firms have abandoned that caution.
"If you're betting with other peoples' money, you're more willing to take risk than if it's your own,'' said Anson Beard, 71, who retired from Morgan Stanley in 1994 after 17 years at the New York-based company, where he ran the equities division and helped with the initial public offering in 1986. "You think differently if you're paid in cash and not in ownership. It's heads you win, tails you don't lose.''
Apparently, Bloomberg has to introduce the "moral hazard" family of principal-agent problems to its readers gently, and via aged Morgan Stanley retirees.
Gelb's ultimate failure, despite his determination, proves out Stein's point about political correctness, that board members chosen for how their bios will look in an annual report are unlikely to have the expertise to enable them to provide effective oversight of an investment bank.
I'll take the argument one step further. Investment banks should not be public companies. We will put aside the most important reason, namely, that investment banks were far more prudent when they were putting partnership capital, rather than other people's money, at risk, and the costs of having investment banks play with other peoples' money are turning out to be awfully high. They can and are creating messes whose costs extend well beyond their shareholders and employees.
Investment banks are composed of multiple businesses with demanding requirements for managing them. Historically, the businesses have been overseen by people who grew up in them and knew them intimately.
It isn't acceptable in a modern public company to have a board composed largely of insiders, but that's what you need to have effective oversight of securities businesses, although that also puts the foxes in charge of the henhouse (the whole point of having external directors is to act as a check on insiders). And the few recent high profile retirees, or say heads of institutional investors that might some relevant knowledge would often be perceived to be cronies rather than independent.
The argument here is, near as I can piece together, that the moral hazard problem, created by public ownership of investment banks, is responsible for these losses. We never would have had this problems if we hadn't let them go public. ("If Woody had gone straight to the police, none of this ever would have happened.") Banks never had losses like this back when they were partnerships.
This argument, of course, exhibits a rather severe set of logical flaws. First of all, it ignores the fact that different market participants have different sensitivities to variance. Second, it ignores the role of diversification. Third, it seems to make the misstep of ignoring the connection between risk and return. Fourth, it cites Ben Stein. It is this last that most concerns me.
Perhaps it would be useful to point something out at this point:
Public ownership of financial institutions does not cause larger losses. Public ownership of financial institutions enables larger losses. This is a subtle but absolutely critical distinction.
Let's explore the argument a bit. Taking the matter to the other extreme, we have Switzerland. Switzerland provides us with an interesting datapoint by having a rather significant number of banks with unlimited partners at the helm. By "unlimited partner," I mean an individual who has unlimited liability with respect to the obligations of the bank. Regular Going Private readers will, at this point, be recognized by the wry grin on their faces.
It always amused me that the words "private bank" and "private banker" meant something quite different in the United States than in Switzerland, where the Swiss Private Bankers Association is composed of:
...entrepreneurs in the privately-owned banking sector who conduct their business using their own assets, assuming unlimited liability with their entire fortune and exercising their independent powers of decision.
Very distinct from the United States definition of Private Bankers which, of course, is:
...sales and marketing types in the medium to high end retail banking sector who conduct their business by talking others out of their assets and assuming no liability for mistakes made with other people's entire fortune while exercising their independent powers of decision to try to corner the market on Russian Pinot Noir.
The most successful (or perhaps "enduring") private banks in Switzerland are those connected to old families with well understood (and respected) fortunes backing the bank. Confidence in the institution is inspired both by the potential for ruinous loss to the general partner as well as knowledge that the vast resources of the general partner will be available to bank customers should any evil befall the institution. Of course, it is not difficult to see how this might inspire conservative habits among general partners. It would be interesting to compare the return on assets for the Lombard Odier's of the world with the rest of the banking world.
The disadvantages should be obvious. The size of the organization is, by definition, limited by the size and scope of the personal fortunes of the general partners. The extent of this prudence might mean that financial "adventure," so to speak, is limited to the business the partners can personally understand. Since few of these institutions have any more than five unlimited partners, the ceiling is pretty low.
Seeking risk in such an environment is a difficult thing. With your entire wealth on the line it is highly unlikely you will be able to tolerate a lot of variance with respect to your investments. (Just watch Deal or No Deal once or twice to get an idea of the practical effect). Diversification, obviously, prevents this sort of "risk of ruin" issue from creeping in.
It shouldn't strike the typically insightful readership of Going Private as at all doubtful that the separation of ownership and control and the specialization that this makes possible is a "good thing"(tm). Obviously, this means that financial endeavors are not limited in scope by the universe of knowledge contained in the heads of those with sufficient capital to finance their own adventures. In short, being brilliant but poor no longer prevents your unbridled intelligence from contributing to the collective progress of human endeavors.
It should also present no surprise that any sort of innovation (which has somehow become an evil word in finance) is also a "good thing"(tm). It also requires the assumption of risk.
Somehow it escapes me why diversifying via a public offering is de facto a bad thing for an institution tasked with evolving products to create liquidity, price risk and diversify. Or why it is not clear that, unless someone was so silly as to pour their entire life's savings into Bear stock, it is probably a good thing that we have larger, liquidity providing banks funded by well diversified, public shareholders.