EfficientMarkets.com: Wall Street, 1997; Wall Street, 1998
December 10, 1997
Mr. Warren E. Buffett
1440 Kiewit Plaza
Omaha, NE 68131
Dear Mr. Buffett:
Wall Street is rife with toll collection, zero-sum gaming, and organized crime.[1] This is expensive for investors, issuers, and taxpayers and corrosive of the values of productive work, fairness, and honesty for all of America. The technology now exists to make much of the securities business fairer and more efficient.[2] The market and political conditions are right also. But technology and good timing are not enough—leadership is required. I think you could, if you wanted to, successfully lead the effort. I would like to help.
Wall Street performs several necessary functions: raising capital, making secondary markets, and providing financial advice. But it does them so inefficiently and corruptly that calling it useful is akin to calling lung cancer useful because it helps people quit smoking and lose weight. Whether collecting “underwriting” fees for allocating oversubscribed securities to favored customers, testing the boundaries of tax law or GAAP, or systematically front-running customer orders, the modern securities firm has mastered the art of getting something for nothing.[3]
But Wall Street has long been the best place to make an easy buck (I hope that I am preaching to the converted on this and many other points). What is different today? The numbers, both per person and in aggregate, are bigger than ever. Never before has so much been paid to so many for so little.[4] And the damaging effect on the rest of the country has increased as entry to the house of easy money has become fairer.[5] Twenty or thirty years ago only the very few with the “right” background could aspire to work at Morgan Stanley. Indeed, how many even knew that such jobs existed or what they paid? Today anyone who reads Business Week or the Wall Street Journal has a rough idea of the numbers, and anyone who can get into a good business school has a chance at a job. The result is that Wall Street compensation has a stronger effect on the allocation of labor and perceptions of fairness than ever before. Wall Street’s pay scale makes most other jobs seem like volunteer work. Consequently, people from many productive occupations (engineers are particularly well represented) are abandoning their careers and attending business school in the hopes of landing jobs in the securities business. And those who decide that the securities business is not for them (or that they would be unable to make the switch) compare their pay to Wall Street’s and conclude that our economy does not distribute its bounty fairly.[6] Both factors must ultimately hurt our nation.
The time is right for change. First, these are the highs and a bloated and smug adversary is an easier mark.[7] Between rising markets, increasing transaction volumes, and multiplying new “products” (especially derivatives on anything and everything—popular with dealers because they capture extraordinary bid-offer spreads in several markets simultaneously and with customers because they circumvent their accounting or regulatory strictures), the last several years have been spectacular for Wall Street. Yet securities firms make the most precisely when they do the least: new-issue volumes go up as the effort required to sell them goes down. Creating an alternative to the current underwriting system will be easier while securities are still flying off the shelf.
Second, and not coincidentally, there is growing uneasiness about economic inequality in our country. But even liberals accept the premise that widening pay differentials are largely the result of widening skill differentials. Under this theory, even extremely high salaries are simply the rewards of a ruthless meritocracy, which can be reduced only after-the-fact (by taxation). Anyone who has worked on a trading floor should find this laughable, for the securities business is far closer to a bloodless version of the Gambino family’s operations than to the University of Chicago’s perfect markets. Making Wall Street more efficient and honest will quickly compress the right tail of America’s income distribution.[8]
Third, the Internet can do very cheaply and fairly what Wall Street does very expensively and unfairly. There was a time when an army of salespeople with telephones was the best way to disseminate market information (including securities prices) and distribute securities. But various real-time services long ago took over the newscaster function (although the Street preserves its price-information cartel in new markets as long as possible), leaving salespeople with three roles that should not exist: whispering to customers others’ supposedly confidential transactions, allocating new issues based on relationships rather than price (at the issuers’ expense), and selectively gouging customers as circumstances allow. Fortunately, electronic markets cannot perform any of these tasks.
But who will challenge the present system? Ensuring that markets are at least honest, and preferably efficient as well, is a clear responsibility of government, which it has equally clearly abdicated. Municipal yield burning[9] has yet to land anyone in jail; front-running in the bond market has never even been investigated; and the courts, lacking guidance from Congress, cannot agree on a definition of insider trading. But what can one expect when a Democratic President with populist airs selects the head of Goldman Sachs (as one of the premier municipal-bond underwriters, surely one of the premier yield burners) as his top economic advisor? And even if every existing cheat or criminal on Wall Street were weeded out, the system would still generate excessive toll-collection fees and zero-sum gaming profits. Furthermore, inherent conflicts of interest (underwriter vs. distributor, underwriter and distributor vs. securities analyst, market maker vs. speculator, and merger adviser vs. arbitrageur) guarantee that unethical and illegal activities would quickly resume. Attacking the existing system without creating a new one would yield only a partial and temporary cure.
Some changes are already in the works, driven by the profit motive. Stock exchanges are being dragged into trading sixteenths by third-market brokers. Electronic trading systems are beginning to reduce costs and provide anonymity in foreign exchange and equity markets. The Internet’s potential to replace trading floors is obvious to all. But the best candidates for implementing the transformation are hamstrung by their current revenue streams: securities firms want to milk the existing system as long as possible (and their astronomical cost structures do not allow for lower revenues); information distributors (Telerate, for example) do not want to antagonize their biggest customers (securities firms) by attacking their bread and butter businesses, market making and underwriting. Furthermore, no one in the securities business has any economic incentive to escort the helpless from the field or pursue reforms that would reduce government subsidies. The invisible hand will not solve all the problems.[10]
What is needed is a new securities firm, the first dedicated to making financial markets honest and efficient for all participants through (1) new ways of distributing primary securities and trading secondary securities, (2) education of market participants, and (3) reforms to reduce (a) government subsidies to the securities industry, (b) tax and accounting incentives for economically inefficient activities, and (c) government-created volatility.
The firm would not position securities, instead using the Internet (or a private version until the public one is fast enough) to bring together buyers and sellers (including issuers in the primary market). A small group of (unaffiliated) skillful market makers would be able to profitably provide liquidity by working bids and offers in the system. However, most existing market makers, no longer able to trade at off-market prices with the uninformed and deprived by the system’s anonymity of their current front-running and coattailing opportunities, would seek other careers.[11] This system would provide better execution for customers and reduce the market noise caused by front-running.
Nor would the firm research or recommend specific securities or predict market levels.[12] Instead, a small group of market veterans (recruiting worthy traitors to their class will be tricky but not impossible) would show customers (including governments) how to most efficiently achieve their issuance and investing goals in each market: both how to avoid being taken under the current system and how to use the new system as it becomes viable. An important part of this consulting would be determining if the customer should even be playing the game, for many participants are ill-prepared to beat the markets and merely pay a lot of tolls while doing worse (sometimes far worse) than a passive (indexed) portfolio. Why should anyone care if the incompetent or reckless ply the markets? Because as Robert Citron and the savings-and-loan bandits and fools before him demonstrated, it is rarely their money they are frittering away. Furthermore, big mistakes add to market volatility, which helps Wall Street at the expense of the real economy.
Finally, a team of accountants, economists, and market professionals would study how to best reform the rules of the game, both for the securities business and corporate governance. Proposals to the appropriate authorities (governmental as well as the FASB and other private regulators) would be accompanied with education of the public to ensure adoption. A few of the many issues that need attention:
What attributes are needed to lead this firm? Credibility comes first. The difficulty is that four different groups must believe in the new firm: corporate executives, government officials, market participants, and the public (first as a necessary source of political pressure for reform, later as customers of the eventual retail operation). This is equivalent to finding a comedian who can draw laughs in both Disney World and Las Vegas. Teaching skills come next, for much of the battle is in demystifying what people do on Wall Street (even the liberal New York Times describes successful deal makers and traders with terms such as financial engineer, whiz-kid, or rocket scientist, when parasite or thief would often be more accurate). The leader must have the independence of thought and action to base the new firm on principles rather than interests, for many different oxen will be gored. The final requirement is a motive: the belief that today’s financial markets are inefficient, corrupt, and harmful to America, coupled with the desire to set them right.
My selection process was not scientific, but I am pleased with the result. I started with a short list of familiar names (the job will be difficult enough for someone with name recognition); did some research … and concluded that you would have credibility with all four groups and would be an excellent teacher. While I hesitate to judge a man I have not met, you are reputed to be an independent thinker. And your wealth certainly allows for independent action. Lastly, unless I have grossly misinterpreted your comments on the securities business, you have long held the necessary belief (indeed I must apologize for taking so many words to restate your proposition that you won’t find much traffic on the high road on Wall Street). The purpose of this letter is to find out whether you want to act on that belief.
How much will this cost? The firm’s three prongs (execution, consulting, and reform) would have different financials. Research and education aimed at market reforms would generate only expenses, perhaps five to twenty million dollars per year. Consulting could be run at a small profit, with staffing declining over time as the firm’s message was disseminated. Unlike the other two branches, execution would require a significant fixed investment, in the range of twenty-five (using an existing pipeline) to two hundred (developing a proprietary pipeline) million dollars.[14] The financial return on this investment should be somewhere between poor and surprisingly good. Weighing against profitability, the firm would have to better the lowest existing execution charges in every market it entered.[15] But in its favor, the firm would be a monopolist: the only securities firm aimed at helping institutional (and eventually individual) customers use the financial markets as prudently as possible. And it would use low-cost means to compete with very high-cost firms. Consider too the value of the brand name—perhaps “Warren Buffett’s Efficient Market” (irony intended): I do not think you would have to buy much advertising. Furthermore, once up and running in the United States, expanding internationally should be easy and profitable.[16]
This is hardly the sort of prospectus to make you reach for your checkbook, but I do not think that spurious precision in estimating these figures would be helpful here. This is not a tough call: Wall Street’s revenues are a multiple of what they should be, not just fractionally too high.[17] And besides, I am not writing you because I want to help make you richer (nor do I seek to help make you less rich), but rather to propose an efficient way to achieve some important social goals. Although much good could be achieved with just the reform and consulting activities, I think the advantage of being able to directly implement market reforms justifies the risk of the execution prong. It also, if successful, would cover the expense of reform activities.
How long will this take? It should take under a year to get set up and another year to execute a few carefully chosen primary issuances. Distribution business should then snowball, for what corporate treasurer will want to explain to his CEO why he is still donating several million dollars to their traditional underwriting syndicate after it has been proven superfluous?[18] Liquidity in the firm’s secondary-markets system should follow the same pattern: once a few large investors and speculators begin to place their buy and sell orders there, existing dealers will have to trade with it, leaving behind the existing high-cost human brokers and creating a liquid, low-cost, and anonymous system that most customers will eventually choose to trade with instead of dealers. Achieving necessary regulatory changes will take longer, but I am confident that within five years the securities business would be fundamentally and irrevocably transformed. Assisting prosecutors with criminal cases and defrauded clients with civil cases against existing securities firms would speed up the process, but not alter the final result, and therefore would be optional depending on your taste for redressing past wrongs as well as preventing future ones.[19]
I have nothing against people making money. I have spent much of my life trying to do just that, especially in the job I have held for twelve years now, trading Treasuries for J.P. Morgan.[20] What I object to is people being paid huge sums for just showing up, figuring out how to pick the pocket of every taxpayer simultaneously, or outright thievery. I do not consider myself naive yet I am still frequently amazed at what Wall Street gets away with. I have discussed mainly the institutional sales and trading side of the business (particularly fixed income) because that is what I know, and the solutions are fairly obvious.[21] And while presumption unfortunately must lie at the heart of this letter (I thought it unlikely that you would contact me to ask for a hand in the remaking of our financial markets), it is not my preferred attitude, and I therefore defer to you on how to make deal making more rational, by changes to both corporate governance and securities firms’ regulation. I do think that demystifying sales and trading will make corporations more willing to question irrational business combinations and the fees that drive them (the fees for sensible business combinations are just as outrageous), for when someone points out that the emperor has no clothes, others are quick to agree.[22]
The firm will not relegate all of Wall Street to the minimum wage. In efficient and honest markets there will still be analysts, traders, and investors (I do hope that the current role of “salesperson” disappears, replaced by advisers whose compensation depends on the performance of their recommendations rather than the dealing spreads of their transactions) who get very rich, but they will have to be right to do it.[23] This is hard to do and therefore only a very small group will receive extraordinary rewards. Everyone else will have to accept a more ordinary wage for the fewer remaining jobs or find something to do in the real economy. The talented (of whom there are many) will find success (although almost always lower compensation) contributing to the production of goods and services. The rest will force down the wages of bartenders and real estate brokers.
There are bigger problems in the world than Wall Street’s excesses. I have read that you plan to contribute most of your fortune to fighting the most fundamental one, overpopulation. What I am suggesting is by comparison a very nice stocking stuffer. In addition to the desirability of its goals, the project has a certain symmetry that may appeal to you: you would use the knowledge and credibility you have accumulated along with your wealth in America’s markets to cleanse them more efficiently and thoroughly than anyone else could …
Sincerely,
__________
1. I am not referring to the recent allegations of mob penny-stock manipulation at fly-by-night shops, but instead to what goes on at respected firms every day.
2. Market efficiency, here and throughout this letter, means low transaction costs, not correctly priced securities.
3. Why do the employees (and not the shareholders) pocket most of this money, even though the system, not the brilliance or hard work of individuals, is its primary source? Although I am more interested in stanching these revenue flows than in redirecting them to shareholders—because Wall Street’s victims are mostly involuntary (e.g., issuers facing an underwriting cartel, taxpayers, and investors unable to elude front-runners), whereas its shareholders are mostly voluntary—I offer some possible explanations: (1) the employees were the shareholders not too long ago and still consider the firm’s capital their own; (2) the securities business, more than most, allows for crediting revenues to specific individuals; (3) the pie cutters are usually former top producers who want to believe that their successes were the product of talent and hard work, not of a racket, and that the same is therefore true for current producers; (4) people who spend their day getting the better of customers face-to-face and over-the-phone have no trouble designing compensation plans that shortchange faceless and voiceless shareholders; and (5) traders hold implicit call options on their individual results; many are also given explicit calls on their firm’s shares: with unlimited upside, fixed downside (dismissal, with another firm usually ready to offer the same skewed odds), and poor management, it is surprising there are not more trading disasters.
4. This money is fueling dizzying consumption. Just ask any German-car dealer (because the United States does not produce the absolute best in many consumer product categories, those with unlimited budgets tend to buy imported goods, thus reducing the trickle-down benefit for American manufacturing workers) or residential contractor (many of the houses going up in Greenwich could pass for small hotels) in the New York City area.
5. Nor is Wall Street money necessarily good even for its recipients. It frequently breeds arrogance (not surprising in a country that equates income with accomplishment), extravagance, and a lack of compassion for the less fortunate (also understandable—if making several hundred grand and up is so easy for us, why can’t those people make the twenty grand necessary to survive?). And can it be good for one’s character to work in a system where a “relationship” is defined as someone you can steal from? I admit this argument would be shouted down at Harry’s: you will not receive thank-you notes from Wall Street for pursuing this proposal.
6. A small group did not have to put up with feeling cheated. Corporate executives were unhappy to learn in the 1980s that the thirty-five-year-olds advising them (or selling or trading their securities) were making as much as they were. Fortunately, they control their own pay, so they gave themselves raises. Keeping up with Wall Street was not the only reason for the explosion in executive compensation, but it was a contributing factor.
7. I refer to Wall Street’s revenues, not its share prices, though the recent wave of acquisitions may have achieved the latter as well. It is hard to imagine the levels of market activity that will be required to justify these valuations (especially since the acquisition prices—never mind the customary employment contracts—eliminate the need to hustle for most senior employees).
8. The left tail is a far tougher problem.
9. See http://muninews.com for a good selection of articles on this topic. [Web site no longer available; read instead this Bloomberg article by Joe Mysak.]
10. It will, however, gradually erode traditional securities firms’ profits in sales and trading.
11. While a small percentage of individual salespeople and traders can keep their mouths shut about a significant trade, the layout of a trading floor—many people sitting close together who get paid a lot for distributing or trading off of information—ensures that nearly always someone with less discretion gets wind of the transaction.
12. These functions would be performed by advisory firms for explicit fees. I doubt investors will directly support as many stock analysts and market forecasters as they currently support indirectly.
13. That Freddie Mac was the largest player in this abuse of the tax system only confirms (1).
14. The former is probably the more sensible choice, as the technology is still evolving rapidly. The public Internet, already suitable for distributing prospectuses and other stable information, may soon be fast and reliable enough for trading.
15. Many markets currently have extremely low apparent execution charges because dealers reap front-running profits on most large transactions.
16. My sense is that most other countries’ markets are even less efficient and, on average, no more honest than ours. I am confident that we lead the world in zero-sum gaming.
17. As mentioned earlier, it is only overly generous compensation that keeps its profits in check. To see the true scale of Wall Street’s excess returns, pick a securities firm and recalculate net income after substituting a per-employee expense number from another industry (anything other than professional sports should make the point).
18. Surely his Wall Street sponsored trips to the Masters and the Super Bowl will not be sufficient reason.
19. That Rudolph Giuliani was considered a tough prosecutor of Wall Street crime is a sad comment on America’s different standards of justice for white-collar and street criminals. Knocking off a 7-11 in Texas will get you more hard time than Ivan Boesky ever served.
20. I am a graduate of the University of Chicago (BA in economics and MBA in finance). I too have profited from the system I decry.
21. My assumption is that the sum of inefficiency and corruption in other parts of the securities business is roughly equal to what I have observed, because the compensation is equally outlandish and I suspect market wizards are no more common in other markets than in fixed income.
22. This is not to suggest that corporations are entirely lambs being fleeced. Many CEOs are more interested in building empires and stuffing their wallets than in making their shareholders better off.
23. Those who are right should find their wealth increased by the amount of toll reduction.
EfficientMarkets.com: Wall Street, 1997; Wall Street, 1998
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