No Safety in Securities

Our use of the term “securities” to define investment vehicles should be outlawed.  The word “securities” is used interchangeably with financial instruments.  Part and parcel of this definition is the understanding of the implied value and safety supposedly inherent in the financial instrument, often including a sizeable amount of collateral to safeguard that security.  Without an underlying intrinsic value, securities are rendered way too risky and thus, dangerous. Today, the use of “securities”, as applied to financial mediums, is a total, unadulterated oxymoron.

Remember the slogan of Smith Barney from 1979 until 1986, uttered by the ever-authoritative voice of John Houseman?  “We make money the old-fashioned way.  We EARN it.”  Just as the term “securities” is synonymous with sound investments, so the word “earn” should have responsible, accountable and moral principles behind it.

A bit of history of our financial industry is in order.  Please note, my major reference is William D. Cohan’s book “House of Cards”.  Cohan worked on Wall Street for 17 years and used the demise of Bear Stearns (for whom he did not work) as the template for the near-collapse of Wall Street over the last two years.  I will follow this with a brief commentary on Warren Buffett, that scion of wise and sound investing, and his decision to throw in with the cads at Goldman Sachs.

Cohan’s contention that the first major step in the bastardization of Wall Street came with the firm of Donaldson Lufkin & Jenrette (DLJ) when they went public in 1970.  Previous to that, Wall Street firms were structured as partnerships.  The principals shared in the profits as well as the liabilities, to the full extent of their own personal net worth.  If times were good, their personal take was also good.  If times were bad, their entire financial being was on the line.  As a result of this personal involvement, the partners were attentive to the daily trades and underwritings of their firm.  Responsibility, accountability and transparency played a large part in their day-to-day operations.

With the advent of DLJ going public, the sharing of profits and losses shifted from the individual partners to the shareholders and creditors.  The “personal” touch was removed.  Thus, DLJ and those firms that subsequently followed suit by becoming publicly owned, never replaced the personal responsibility with corporate responsibility.  Easy come, easy go.  The compensation model was also altered to favor a payout of 50% to 60% of pre-tax revenues to their commission-generating employees.  With the absence of any personal ethical responsibility in generating revenues, these firms became mega-machines of selling and marketing.  The individual players cared more about creating revenues, which would eventually be paid out to them in the form of bonuses,  than they did about the quality of the investments  they offered, or did not, to their customers.  These investment bankers were peddling nothingness to their investors.  No value, no safety.  Doesn’t sound like “security” to me.

For example, take Michael Milken, the originator of junk bonds in the 1980’s.  His initial aim in designing the high yield bond was admirable: to supply those companies with less than stellar financials an investment strategy to increase their capital.  However, of course Wall Street had to become creative and the whole junk bond market was then orchestrated to benefit the underwriters by selling often worthless securities to the public.  These instruments were labeled as “high yield”, but the Wall Street firms had taken a reasonable method of supplying capital to smaller, cash-strapped companies and used it to go that one step further into selling bonds with virtually no collateral backing them up.  Not much “security” in that.

The junk bond model was a forerunner, an omen, of the recent debacle on Wall Street with subprime mortgage-backed securities.  Just as the Street took those high-yielding bonds to the Nth degree of risk, so they structured these mortgage “assets” in packages, even more riskier in this combined, pre-packaged form than an individual asset was, and sold them to unsuspecting investors.  Whereas the junk bond scandal almost brought down our debt market, the subprime mortgage disgrace just about brought the housing industry to its knees.

To add insult to injury, even the rating companies, such as Moody’s and Standard & Poor’s, have come under investigation for their purportedly abetting the investment houses’ facades in selling overly risky vehicles.  These rating companies are supposed to be independent of those entities that they scrutinize, so that the ratings will be honest and realistic.  The possibility that there is no longer any “security” in our rating companies is frightening.

The final nail in the coffin is that many of our leaders consider these mega-banking houses to be “too big to fail,” thus presenting a Catch 22 to instituting any regulations at all.  “Too big to fail” is not an acceptable excuse for allowing these mega-banks, with their thinly-veiled strategies of offering investments worth little value and security, to an unknowing public.  Avoiding corrective regulations simply because of the fear of a domino effect of “too big to fail” is as detrimental to our overall economic system as was the initial structuring and offering of the investments.  Please read the Op-Ed in the New York Times today by Thomas Hoenig and Robert Reich’s commentary on this same issue.

President Obama is right when he says that any financial regulatory reform must include restrictions on derivatives and the securitization of over-the-top risky investment vehicles.  Just yesterday, the go-ahead was issued for futures contracts to be traded on as-yet-unearned revenues of as-yet-unreleased cinematic films.  Once again, this sort of “betting the bank” on basically empty instruments is another ploy to further up the revenues of Wall Street firms that constantly need new, more “creative” ways of enhancing their revenue streams.  These movie futures are not any more “securities” than were junk bonds or subprime mortgages.  It is a furthering of that classic scam of the Emperor’s new clothes.

So what was Warren Buffett thinking when he took a $5 billion stake in Goldman Sachs in September of 2008?  I have always been of the mind that Buffett was an intelligent investor, basing his investments on solid financial figures, rosy outlooks, buying low and selling high.  Moreover, his basic integrity and honesty was demonstrable and admirable.  In terms of its financials alone, Goldman Sachs fit the bill  in 2008 of fulfilling Buffett’s investment requirements.  By July 2009, Berkshire’s stake in Goldman had increased by $2 billion.  As of the market’s close on Friday, that profit had fallen by half.

Now though, I wonder if Buffett knew about the fraud allegations (charged by the SEC yesterday) that Goldman carried out in 2007.  Buffett does his pre-purchase homework thoroughly, and I cannot imagine he did not do so in 2008 when he committed  that $5 billion of Berkshire’s funds to Goldman Sachs.  Does that mean that he knew about the subprime shenanigans of Goldman and chose to ignore them?  I cannot believe that either.  We will have to wait and see exactly what the repercussions, if any,  these SEC charges against Goldman might have on the value and moral integrity of Buffett and Berkshire Hathaway shares.  Probably, based on similar past situations, Berkshire will wind up either exercising their Goldman warrants or not.  Berkshire will come out of this smelling like a rose, having earned 10% a year, minimally, on their Goldman position.  Also, if Goldman Sachs was truly warned nine months ago about pending charges, why didn’t Buffett sell his interest in that investment house at that time?  The part of all of this that really troubles me is not the initial investment or outcome based on Berkshire’s due diligence and paper analysis of Goldman. Rather, I question Buffett’s level of moral knowledge and subsequent decision to take a stake in Goldman despite their dubious intentions of the past.  I was firm in my belief that Berkshire shares were truly “securities”; now I am not so sure.

Life goes on.  It’s always something.  Nevertheless, financial instruments should no longer be considered “securities” without tighter restrictions attached to them.  Plus, investment banking houses that market those securities should also be subject to more stringent restraints on accountability, transparency, risk and capital requirements.  There is nothing secure about “securities” that are merely a dumping ground for garbage, a petri dish for risk and a fallacious factory for generating ever-more revenues.

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