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Sunday, November 23, 2008

Wall Street's Ethical / Competitive DNA

If the recent past is any prologue, the news over the coming months will be remarkably easy to predict. A new economic statistic will be released, the world markets will drop another five percent, and executives of yet another uncompetitive, debt-laden behemoth selling expensive credit-dependent products will suddenly fly to Washington (private jet, of course -- no point in mingling with the commoners in commercial steerage until you HAVE to…) hat in hand to explain why more taxpayer dollars should backstop their business.

As GM, Ford and Chrysler executives prepared to participate in the ritual two weeks ago, I wrote a commentary (#1) that examined the economic mismatch between the size of the "Three" and current market demand and contrasted their ability to make material changes in their business and products with the needs of the current situation. It wasn't (and still isn't) a pretty picture.

Now, on November 23, 2008 it appears to be Citibank's turn at the rite of failure. However, the sheer number of bank and brokerage failures experienced in the past year warrants a broader review. Focusing on any one institution -- even one as big as Citibank -- seems guaranteed to miss the root issue. A recent article (#2) published at www.portfolio.com by writer Michael Lewis entitled The End prompted me to read his older book Liar's Poker published in 1989. His recent piece was a follow-up to the book in which he attempted to analyze what, if anything was learned by the financial industry since he wrote the book. The answer is NOTHING. Going back to read his book makes it pretty clear what the root issue is.

Liar's Poker as a Standalone Work

The book was originally published in 1989 as a memoir of sorts of his experience working for three years for Solomon Brothers. It wasn't a tale of a failure and the disillusionment stemming from it. Quite the opposite. Lewis was quite successful financially in his three years at the firm. That is precisely why he left. He realized the wealth financial firms were producing for their traders and executives had nothing to do with the value they were providing to customers (and in MANY cases came directly at the expense of their customers) and therefore were unsustainable. A few points about the book itself are worth mentioning before tying it back to the larger point here.

Liar's Poker is very well written and contains several chapters which do a tremendous job explaining the mechanics of the derivative securities that have melted down the world's financial systems. The technical content of the book is so well done and apropos for the current situation twenty years later that other than a few date references and the name Solomon Brothers itself, the book reads like it was written in 2008. Reading it will give anyone watching the current market a disturbing sense of déjà vu.

The book is uniquely valuable because of two aspects of Lewis' experience in working for Solomon Brothers. First, because of his art history undergraduate background, he wasn't exactly expecting or even wanting a career in high stakes finance. As a result, when a chance meeting with the wife of a Solomon executive at a dinner with the Queen of England (you'll have to read the book for the full story…) turns into a position at the firm, Lewis immediately enters the dragon's lair with the perspective of an unlikely outsider -- he didn't even have an MBA. Probably because of his sense of the improbability of landing the job in the first place, he continued doing free-lance writing for other publications which probably kept him in the habit of noting details of his experience at Solomon in real time. As a result, the book is far more vivid than it would be if it had been written entirely in retrospective after quitting the firm.

His perspective in working at Solomon was also unique because as a trainee, he was pulled into the corporate headquarters like all of the other new-hires of the class of 1985 for six months of seminars on corporate practices, etc. before beginning real work. However, he was assigned to the London office, so he was in the unique position of learning virtually all of the key players in the firm's growing mortgage bond trading operation while getting to watch them from a distance -- with an outsider's perspective.

Back to the Future

If Liar's Poker was going to be republished now, Lewis might just as well use Back to the Future as the title. Reading the book now is like traveling back in time to the point where many of our current problems first began. However, the unique nature of Lewis' circumstances for landing his gig at Solomon Brothers in the first place and his insider-yet-outsider perspective while working there are why the book is particularly useful to read now. The book became a bestseller in 1989 and even now, the promotional "blurbs" for the book often cite how funny or entertaining the book is to read. My take on the tone might be colored by 20 years of hindsight reading it now but the book doesn't read like Lewis was aiming at "funny" or "entertaining."

Two elements of the book can be recounted here to explain the strange mis-read of the book's original audience. The first involves the story at the beginning of the book that explains the Liar's Poker game Lewis chose to set the tone for the book. Liar's Poker is a numbers game that was popular with traders at the time (and who knows, maybe still now) which uses digits of the serial numbers of US currency as "cards" in the hand being played. Everyone playing takes out a dollar bill and stakes a position or "hand" based upon the quantities of digits in the serial number of their bill. In Liar's Poker, hands are ranked by either the same number of higher digits (three 5s beats three 4s) or more of a lower digit (four 4s beats three 5s). The game circles around all of the players until all of the players challenge the same player's "bid" then everyone shows their hands.

The game of Liar's Poker was the perfect metaphor for Lewis' experience because as Lewis writes, part of the game depends upon a basic understanding of the math behind the probabilities behind the possible combinations of digits appearing in the serial numbers (somewhat akin to card counting in blackjack). Of course, that's the part of the game anyone can master after playing enough times. The rest of the game relies on each player's ability to bluff, each player's ability to read the bluffs of the other players, and each player's willingness to take risk.

(Uh oh…)

The book starts out with a story of how one day, during one of his management-by-walking-around walks through the bond trading floor, Solomon Brothers Chairman John Gutfreund suddenly challenged John Meriwether, one of the firm's top bond traders, to a single round of Liar's Poker. In front of the entire floor of traders. For one million dollars.

Lewis' narrative reads like the screenplay to For A Few Dollars More where Manco attempts to intimidate Mortimer into leaving town by shooting his hat off his head then incrementally further down the street as Mortimer chases it. Only in the Solomon scene, Meriwether manages to avoid the game by counter betting his chairmen TEN million dollars. The chairman calmly eyes his lead bond trader for a period, demures and walks away, normal trading resumes, and Lewis dives into the rest of his tale.

That episode makes a critical point for the book and for current readers trying to make sense of events on Wall Street today. What types of people have a mentalities that seek out such risks involving such huge stakes and games of brinksmanship? The types that work on Wall Street, it turns out. The types that are supposed to be managing OUR money. The types working in an environment that has concentrated so much wealth in their hands that sums of money constituting a fortune to the rest of us are mere pittances to be waged in pointless games.

After that introduction, Lewis goes back to explain the unlikely chain of events that led him to get hired at Solomon then spends a few chapters describing the training program at Solomon and the manner in which trainees vied for permanent positions in the various divisions of the firm. The first surprise Lewis describes is the behavior of the new hires in the training program. Wall Street started booming in the 1982 timeframe and stories of new hires quickly making large amounts of money in the bond trading operations of firms supporting junk bonds and the leveraged buyouts they made possible started intensifying competition for Wall Street jobs. One would think recent MBAs graduates selected to work at one of the big dogs on Wall Street would arrive grateful, eager to learn and more eager to make a good impression with their new employer.

One would be wrong.

The stories Lewis conveys of his "class of 1985" -- all 127 of them -- read more like the behavior of a class of 8th graders on a day with a substitute teacher. The training classes were structured to have key executives from the ranks up to the board of the firm come in and pontificate on various aspects of the firm, its strategies and unique codes of conduct for working deals, etc. The new hires were supposed to sit attentively and ask pertinent questions of the honored guests. Instead, the class immediately stratified into "suck-ups" who sat at the front of the class, frat boys who sat in the back tormenting the weak in the herd and a group of floaters in the middle who simply tried to make heads or tails of the jungle around them. Here's how Lewis described it (page 41):

That the back row was more like a postgame shower than a repository for the future leadership of Wall Street's most profitable investment bank troubled and puzzled the more thoughtful executives who appeared before the training class. As much time and effort had gone into recruiting the back row as the front, and the class, in theory, should have been uniformly attentive and well behaved, like an army. The curious feature of the breakdown in discipline was that it was random, uncorrelated with anything outside itself and, therefore, uncontrollable. Although most of the graduates from Harvard Business School sat in the front, a few sat in the back. And right beside them were graduates from Yale, Stanford and Penn. The back had its share of expensively educated people. It had at least its fair share of brains. So why were these people behaving like this?

And why Solomon let it happen, I still don’t understand. The firm's management created the training program, filled it to the brim, then walked away. In the ensuing anarchy the bad drove out the good, the big drove out the small, and the brawn drove out the brains. There was a single trait common to the denizens of the back row, though I doubt it ever occurred to anyone: They sensed they needed to shed whatever refinements of personality and intellect they brought with them to Solomon Brothers. This wasn't a conscious act, more of a reflex. They were the victims of the myth, particularly strong at Solomon Brothers, that a trader is a savage and a great trader a great savage.

Fast Forward to the Present

Lewis actually wound up speaking to later classes of new hires before he left in 1988. The classes got bigger each year and the trainee behavior he described became worse each year as the bond trading bubble attracted more and more graduates with winner-take-all attitudes and a false sense of entitlement from having survived graduate school and "winning" a coveted spot on Wall Street.

Now consider those words were written in 1989 to describe the process used to select and indoctrinate MBAs hired between 1985 and 1988. Over twenty years ago. I'm sure the process and types of players Lewis described at Solomon were not unique to that firm. The class of 1985 is now present in middle or senior management across Wall Street and many in Lewis' class in particular quickly rose to unique positions of power throughout the bond and mortgage backed securities business due to the unique role Solomon played in growing those markets.

Now fast-forward to the present and consider the situation people like the "class of 1985" have produced in the financial markets and the larger economy. Everything Lewis described in his book -- the arrogance, the outsized compensation, the indiscriminate risk-taking, the double dealing of traders for their own interest and against the fiduciary interests of their customers -- has been institutionalized throughout nearly every large financial firm in the industry. By sheer demographics, firms like Citi are managed almost entirely by executives who grew up in the swing-for-the-fences heyday of Wall Street and profited from the game and have no ethical or strategic DNA that would aid them in operating effectively in any other competitive climate.

This is the ethical and competitive DNA of the people now begging the US Treasury and the Federal Reserve for bailout money. The correct answer seems pretty obvious.


Hell no.


#1) http://watchingtheherd.blogspot.com/2008/11/automotive-hail-mary.html

#2) http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom