Inept “Dentists” of Wall Street

Some time ago, a long-time Wall Street executive frequently likened his job to that of a dentist. “I keep tapping, poking, and asking questions to see if something breaks,” he would say. “This is how I spend my days when managing risks of complex trades, esoteric holdings, and entire businesses.” It sure sounded like a fun job, especially since it enabled its fortunate holder to own a private plane and multiple homes. Years of success and seniority also gave him the air of confidence of a battle-tested military commander.

There was, however, a slight problem. This executive acquired the craft of financial dentistry in the 1960s and 70s, and has learned little since. He was completely uneducated about modern risk management and the realities of  today’s capital markets. His street-smart “poking” and “tinkering” was wholly inadequate to an understanding of the risks of complex financial instruments, securitize-and-sell businesses, or departments that made markets in derivatives.

What was at the heart of the changes that our executive has failed to understand?  The forces that, in the words of President Obama, have resulted in U.S. suffering from a “massive hangover from years of risk-taking.” Joseph Stiglitz, a Nobel economist echoed the sentiment: “What you don’t know is the source of Wall Street’s profits.” These sources were often misunderstood by financial dentists either. Lack of risk-based transparency is an important part of the premise behind Financial Darwinism. As secular forces commoditized basic financial businesses and began to erode their earnings and margins, financial institutions responded to these pressures with ever-greater risk and leverage. The entire process was obscured by the traditional measures of accounting earnings, outdated financial disclosures, and credit ratings not grounded in risk management.

State Street, Merrill Lynch

Recent developments involving State Street and Merrill Lynch provide the latest supporting evidence in this regard.  Net income of State Street, the world’s largest institutional money manager, fell 71 percent in the fourth quarter of 2008 because of investment portfolio losses; $450 million that was needed to prop up its mutual funds; unrealized losses on assets held in conduits, and so on. Judging by the precipitous drop in its stock price, none of its underlying risk exposures were understood by the markets.

The same happened with Merrill Lynch, whose risks were wholly misunderstood by the Bank of America – even after performing its merger-related due-diligence. BoA now expects losses for the next several quarters, and the Merrill acquisition will be dilutive to earnings for the next two years. 

Without Transparency, the Wrong Lens Prevails

Unfortunately, the need for risk-based transparency is still not being acknowledged by market commentators and analysts. They continue endless discussions using the measures of what they can see, without acknowledging the critical information that is missing. For instance, they debate at length various measures of capital ratios, Tier 1 vs. Tier 2, hybrid preferred stocks vs. common, and so forth, blaming misclassification of capital for the current troubles. “The definition of capital for the banking world has been confused over the last 20 years as the government regulatory bodies have counted various long-term funding sources as capital,” wrote Paul Miller, a bank analyst at Friedman, Billings, Ramsey & Co., in a Dec. 3, 2008, research report. What is misunderstood is that the discussion on capital without the knowledge of the risks taken on by financial institutions is meaningless.

Uphill Battle

The challenges to changing the faulty system are substantial. “The financial system will kick back against transparency,” warns Stiglitz. “Those working in markets see information as power and money, so they depend on a lack of transparency for success.” Moreover, “The complexity of the legislation works in the industry’s favor,” says Paul Mahoney, a regulation scholar at the University of Virginia.