"A Paean to the Small Wall Street Firm"

Sydney M. Williams

Thought of the Day

“A Paean to the Small Wall Street Firm”

May 31, 2011

This piece is primarily commercial, so be forewarned. It did not start out that way, but as I was thinking of our industry and how it has evolved that became the result. You see, our firm had no need to be bailed out in the fall of 2008.

At lunch last Thursday I listened to Bill Cohan discuss his new book, Money and Power, subtitled “How Goldman Sachs Came to Rule the World.” What struck me was how different Wall Street is today than it was when I joined Merrill Lynch Training Class 105 in September, 1967. The story Mr. Cohan told was not a revelation. After all, I spent a dozen years at Salomon Brothers in the 1980s and very early 1990s. I have known prop traders and watched their desks. I have benefited from their successes. I witnessed what “portfolio insurance” did for markets in 1987. Like most of you, I nervously watched the near collapse of our financial system from the Lehman bankruptcy on September 15, 2008 to the decision to save Citigroup on November 24th. Again, giving insurance a bad name, the role played by Collateralized Debt Securities (CDSs) was one of the main accelerants of the crisis. (The principal cause, in my opinion, was too much leverage, not only within banks, but with consumers as well. Local, state and federal governments are still overleveraged.) I have read dozens of books on the reasons for the crisis, and I have written even more notes and thoughts on my perception of those days and what precipitated them. Nevertheless, Money and Power is a book worth reading.

When I entered the business, it was a customer-driven business. Whether one was dealing with corporations, institutions or individuals, satisfying the needs of the client came first. Most of us felt lucky that we had found the industry. It was dynamic; the clients were intelligent, successful and interesting. Every conceivable piece of news had some impact, so it paid to be alert and informed. It was interesting, lively and, not least important, financially rewarding.

In 1967 when I first joined Merrill Lynch, all firms were partnerships. That meant that every partner was jointly and severally liable. The knowledge that one’s home could be sold to satisfy creditors served as a governor on the type of risk one was willing to assume. Wall Street firms began going public in the late 1960s, with Donaldson, Lufkin, Jenrette and Merrill Lynch being the first. The trend accelerated in the 1980s and 1990s. Goldman was the last large partnership, finally succumbing in May 1999. And with the disappearance of partnerships went fiscal discipline. Risk was transferred to shareholders, while returns remained with the partners. In 2008, risk was assumed by taxpayers, while returns remained the province of the partners.

I have spent my entire career in the customer business. But a significant portion of Wall Streeters have straddled both the agency and principal sides of the business. During the 1980s, the proprietary desks at large firms, like Salomon, Goldman and Morgan Stanley were generating enormous profits, effectively competing against many of their clients. They were able to do so, in part because interest rates were declining and because they were able to take speedy advantage of momentary inefficiencies that periodically develop in markets. High Frequency Traders, both within publically traded investment banks like Goldman and private hedge funds like Renaissance Capital, have now largely reduced those spread opportunities for all but the most nimble. Glass-Steagall, which in 1933 caused banks to separate their investment banking operations from their commercial banking businesses was rescinded in 1999 when – you guessed it – another Goldman managing partner, Robert Rubin, was Secretary of the Treasury. That decision effectively allowed investment banks to use customer deposits to fund their own trades – to take a liability that was motivated by safety and use it to fund an asset whose return was predicated on risk.

In contrast, our firm is all about the customer. We have no other business. At the age of twenty-seven, Andy Monness started the firm in the summer of 1964. Its purpose was to provide research and trading to institutional and high net worth clients. Everything is the customer. Neil Crespi, fresh out of college, joined Andy in 1976. It has been a combination of his selling skills and his business acumen that have guided the firm for the last three and a half decades. In 1980 Herb Hardt joined the firm as head of research after putting in eight years with Fidelity. He has two degrees from Harvard and had earned U.S. Army captain’s bars while serving in Vietnam. On our desk we have young people fresh out of college; we have others with ten or more years of experience, and older ones with many years of experience on both sides of the Street who provide unique insights into markets and individual stocks. In our research department we have everything from a Yale medical doctor to a former member of the Israeli Army. And, in Neil’s son Robbie, we have, in my opinion, the single best salesman I have known – and I have known a lot of them.

It constantly amazes me that so many institutional clients feel compelled to deal with firms whose profits are driven by lines of business that are not client centric and, in fact, are often in direct competition with the interests of their clients. Perhaps this is prejudice speaking, but these investors are better served by firms such as ours where the motivation and the incentives are known, the insights and recommendations have no hidden agenda and where the ability and discretion of traders is their raison d’être.

In the days before it became politically incorrect, Goldman Sachs viewed themselves as a gigantic hedge fund. Now they speak of their role as “doing God’s work,” as Goldman’s Mr. Lloyd Blankfein once stated. But they were hedge funds and largely still are. Unfortunately they give legitimate hedge funds a bad name. Real hedge funds serve multiple useful purposes. Markets are more efficient because of them. They provide an opportunity for wealthy investors who are willing to assume more risk for the prospect of higher returns. They identify and highlight corrupt managements, dishonest accounting practices and over-priced securities. They tend to attract very bright and highly skilled men and women. But private hedge funds are not using depositors’ money to make those bets, nor are they using shareholders money. They are investing theirs and their limited partners’ money. With the notable exception of Long Term Capital in 1998, when they fail government (the taxpayer) does not step in to bail them out.

In the late 1960s, a few years after Andy started the firm, John Whitehead, then co-head of Goldman Sachs, issued twelve principles for employee behavior. At the top of the list was: “Our clients’ interests always come first.” We have never felt the need to issue a similar set of principles. After so many years it has become ingrained in our DNA. In betting against their clients, Goldman partners have been richly rewarded. In today’s culture, the ends justify the means. However, it is indeed unfortunate to the investing public and to taxpayers generally that Goldman no longer adheres to Mr. Whitehead’s first principle.