Wall Streeters: Book Review

October 14, 2019

Wall Streeters: The Creators and Corruptors of American Finance (2017), Edward Morris. Covers 14 men with influence on 20th century banking. (Not the list I would use, but some interesting insight). The book gives only a partial understanding of modern banking and leaves big holes. The only obvious crook is Michael Milken and he is treated more as an innovator than criminal. But these 14 are important and this is a useful read on banking as a supplement. Morris talked about Carlyle's "great man theory," but demonstrated both mixed results and many other factors in financial history.  

 

1. J.P. Morgan. Morgan is basically the first super banker (mainly in the 19th century), responsible for building monopolies in railroads and then in industry. Thus, banking would dominate both transportation and industry. Investor money came mainly from Europe and initially Morgan's role was to protect investor interests. Morgan served some of the role of a central bank in the Panics of 1893 and 1907. Morgan believed in self-regulated capitalism. The Pujo Committee investigated Morgan and the other money trust banks, demonstrating the need for reform. 

2. Paul Warburg was a German banker later affiliated with Kuhn Loeb. He believed in the need for a US central bank (which provides liquidity and emergency lending in a panic), similar to the ones he was familiar with in Europe (England, France and Germany), but with unique American characteristics. Thus, district feds, a chairman appointed by the president, etc. The Aldrich-Vreeland Act of 1908 established the National Monetary Commission to study central banking practices. A problem with US banks was the National Banking Act during the Civil War where money (banknotes) were backed by government bonds (creating an "inelastic" currency, with the money supply unintentionally fixed). The other problem was creating a lender of last resort (a central banking function). Participants at Jekyll Island produced what became the (Republican) Aldrich Plan. Woodrow Wilson became president after opposing the plan (but all the candidates did). 

3. Carter Glass, a Democratic Congressman became the champion for a central bank and he was given credit for what became the Federal Reserve (which looked like the Warburg-inspired Aldrich Plan). Note that he earlier referred to eastern bankers as "money devils." Arsene Pujo held congressional committee meetings on the concentration of financial power, the Money Trust. Morgan and the rest dominated industry after industry, including board seats. Problems were an inelastic currency and poor reserve system. (Consider especially the seasonality of agriculture, plus business cycles.) A central bank was needed but politically had to be called something else--the Federal Reserve, passed in 1913 as the Owen-Glass Bank and Currency Act. William Jennings Bryan was the major opposition; a major reason was his opposition to Federal Reserve notes as the currency. Glass became Treasury Secretary in 1919, serving less than a year to fill a vacant senate seat. During the Great Depression is initially did exactly the wrong thing by restricting the availability of money. The Humphrey-Hawkins Act of 1978 gave the Fed the mission to promote full employment in addition to fight inflation.   

4. Ferdinand Pecora. The stock market crashed in 1929, then the economy continued down, starting the Great Depression. Hoover thought it was the speculators, but the real villain was the Federal Reserve which contracted the money supply basically to prop up the price of gold. Congress investigated the causes of the crash and got nowhere, until Pecora, a lawyer and former prosecutor, was brought in to wrap things up for the Senate Banking and Currency Committee. Instead, he discovered much of the illicit activity of Wall Street, including stock pools to rig stock prices. Charles ("Sunshine Time Charlie") Mitchell, president of National City Bank, was indicted for tax evasion based on his testimony; also he made $3.5 million for 1927-9, while creating sham transactions to generate tax losses. The bank also sold South American bonds, basically of  bad bank loans, which defaulted (the bank focused on growth, rather than quality). Chase created Chase Securities to sponsor stock pools. Chase Bank president Albert Wiggin was fired for insider trading, including short selling bank stock, borrowing from Chase to cover his shorts. None of Morgan's partners paid income taxes in 1931 or 1932; the "preferred list" for new issues was discovered (several politicians were on the list, including Coolidge). The Glass-Steagall Act was passed which created the FDIC for deposit insurance and separated commercial and investment banks. The Securities Acts required regulation of exchanges and the issuance of audited, GAAP-based financial statements (including "anti-Wiggin rules").

5. Charles ("Good Time Charlie") Merrill established a retail market for stocks. First key was the sale of Liberty Bonds to support World War I, establishing a customer-friendly market. This lead to a free-for-all 1920's market for bilking the public by Mitchell and others. Merrill was for establishing good relations with the public and encouraged customers to get out before the 1929 crash. Combining with Edmund Lynch he created knowledgeable account executives as professionals. He provided initial capital for Safeway, and other grocers and retailers, who were shunned by other firms. He later merged with EA Pierce and others to create the largest retail brokerage concentrating on small investors. He favored the regulations of the New Deal for transparency and truthfullness. Don Regan became CEO in 1971 and ML became a corporation and expanded its role beyond retail to "financial supermarket." It had problems by the 1980s, such as the lawsuit by Orange County because of derivatives. Stan O'Neal became CEO and ML took on even greater risks included mortgage-backed securities (toxic assets). As a failing firm in 2008, it was acquired by Bank of America.

6. John Bogle founded Vanguard under Wellington Fund and created the first index funds beginning with S&P 500, the idea of concentrating on an average return ("Bogle's Folly"). It was a tough sell, but these eventually became an important part of mutual funds.

7. Georges Doriot. Founded INSEAD, Europe's premier business school. Earlier he co-founded ARDC, a venture capital fund in Boston (basically to provide development money for research from MIT and Harvard), which invested in Digital Equipment. Later venture capital funds settled in what became Silicon Valley.

8. Benjamin Graham became known for value investment, mainly as a teacher of Warren Buffet. The idea in the early 20th century of putting stock in an investment portfolio (rather than mere speculation) was new. He claimed that his financial analysis produced an intrinsic value measure which could be compared to stock price; partly, it assumed irrational pricing by other investors. He wrote Security Analysis  with Dodd and a friendlier book called Intelligent Investor. 

9. Myron Scholes, co-creator of the Black/Scholes model to value option derivatives. With this and expansions by Robert Merton and others, derivatives could be priced and became a powerful risk avoidance (or risk taking) tool. Risk is measured by the variability of its price over time and standard deviation of its returns. Scholes may be more famous for his connection to Long-Term Capital Management, a hedge fund using sophisticated and massive bets on mispriced spread on correlated items, like going long on Russian bonds and short on US treasuries (assuming quick "convergence"); risk exposure in theory was limited based on value-at-risk (an estimated maximum loss). Their bets got bigger as profits got smaller, in part because other firms were making similar trades. In the end their bets proved wrong and LTCM went bankrupt and still needed a bailout from the investment banks. 

10. Alfred Winslow Jones created the first hedge fund in 1949. He combined a leveraged position in a stock while simultaneously selling short another stock; generally this was buying stocks with strong upside potential ("undervalued") with that was likelier to go down ("overvalued"). This was based on technical investing, using stock movements. A journalist wrote in 1966 that a $100,000 investment would now be worth $4.9 million before tax). The fund did not do as well with the stagflation of the 1970's.  

11. Michael Milken was the one true crook. He popularized junk bonds as an investment alternative that provided a greater return (in a portfolio, risk adjusted) than investment-grade bonds. His analysis was based on fallen-angels (previously investment grade bonds), but he created an IPO market for junk bonds, used especially for hostile takeovers and  other forms of leveraged buyouts. He created a market including a secondary trading market, solving the liquidity problem of junk bonds. Milken used a multitude of illegal acts to assist his efforts and make more money (like insider trading using Boesky and Levine). A large number of these bonds defaulted.

12. Lewis Ranieri was the mortgage security champ at Salomon Brothers. Bond trading was a Salomon specialty, including being a primry dealer of World War I's Liberty bonds. Ranieri got assigned to mortgages, something of a backwater (where government, corporate and municipal bonds were the primary focus). With Paul Volcker as Federal Reserve chairman, interest rates went to double digits, distressing savings and loans. S&Ls were allowed to sell their mortgages (at huge losses), but spread the losses over the lives of the mortgages (up to 30 years). Ranieri bought huge amounts and resold them at a profit (often to S&Ls). He repackaged them as mortgage-backed securities (MBSs) , but these were a hard sell given that debtors could pay off their (high interest) mortgages early, but they did pay higher interest rates. The big answer was the use of tranches (slices), creating separate bonds by maturity, repayments (early to late), interest versus principal, various measures of risk, and so on. This could satisfy short-term investors like banks and casualty insurance companies or long-term investors like pension funds. Various factors (greed, pass the trash, government overreach) led to the subprime meltdown. Salomon crashed because of cheating on Treasury purchases.

13. William Donaldson  was co-founder of Donaldson, Lufkin, & Jenrette (DLJ) in 1959, the first investment bank (and member of the New York Stock Exchange--they received commissions) to go public, in 1970--giving them more capital than partner-competitors. Their initial focus was to provide high-quality analysis for institutional investors, especially small companies. May Day 1975, the SEC outlawed fixed commissions on stocks, leading to discount brokers. Investment banks, most of which went public used their new capital to increase risky transactions: securities trading, risk arbitrage, private equity, venture capital, and hedging. DLJ was sold to Credit Suisse in 1996. Donaldson went into government service, eventually heading the SEC.

14. Sanford Weill created the financial supermarket (and biggest bank) that became Citigroup, which sounded great but was an unmanageable conglomerate. (Merrill Lynch did much the same and was acquired by Bank of America before failing.) Citi started as National City under Sunshine Charlie Mitchell. Weill started early as a back office guy and made this a state-of-the-art operation. He then went after firms that were failing because of lousy back offices. This became CBWL-Hayden Stone which went public in 1971. Within a decade the firm was Shearson Loeb Rhodes, the Shearson/American Express. Additional acquisitions were Commercial Credit, Primerica and Drexel Bernham, all with big cost cutting measures. Travelers was another big one and the company became Travelers Group. All it lacked was a commercial bank (more or less outlawed by Glass-Steagall). Citicorp was merged (the largest in American history at the time), while Washington lobbying allowed it and passed the Financial Services Modernization Act in 1999. Weill apparently was obsessed with quarterly earnings (think manipulation), with little thought of a long-term vision. Weill was forced out in 2003. The firm performed poorly and involved with several illegal acts. Various subsidiaries were sold or spun off, and the firm was bailed out during the sub-prime meltdown. 

 

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