Wall Street Scandals have their own orbit don’t they? 2008 saw Lehman Brothers and Bear Stearns collapse in a heap of their own failed (and, with the benefit of hindsight, incredibly reckless) bets on exotic mortgage-related derivatives. 2004 revealed Edward Jones failing to disclose tens of millions of dollars from bedfellow American Funds in undisclosed revenue sharing. In 2000, we had Merrill Lynch analyst Henry Blodget writing that certain investment opportunities were “garbage” and worse in his internal memos, and writing glowing recommendations to the investors to whom the company’s brokers were selling these IPOs and other investments.
An article on the Scientific American website explains the Wall Street scandal machine, saying that skewed (it calls them “assymetrical”) bonus systems is the root of the problem. The way brokerage firms compensate their traders, it is actually smart to be reckless on Wall Street.
To see how this works, consider a trader who is making daily, sometimes hourly bets on… it could be anything, and often is. At the end of the year, the trader is paid a bonus which is usually a percentage of the trader’s profit–many times between 10% and 15%. The trader takes enormous risks. If he guess right, and makes $10 million, he takes home a $1 million to $1.5 million bonus, on top of the $200,000 base. He does this for three years, and then, suddenly, his guess turns out to be wrong and he costs the company a lot of money.
The result? By taking huge risks, and costing the Wall Street firm far more than he generated in revenues, the trader takes home between $3 million and $4.5 million in bonus income. He may be fired, but the article says that traders who lost big are often hired by other firms. One could not be allowed to lose $1 billion, it says, unless one was really important.
The author cites a trader who bet his bank’s money, and received 15% of the profits. In 2005, he bought obscure and high-yielding corporate bonds, which generated profits of $40 million. The trader’s share: $6 million. In 2006, he made $80 million and took home $12 million. In 2007, the markets turned, and his trades lost the firm close to $300 million. The trader was let go, retired comfortably, and the shareholders footed the bill for the enormous losses.
Multiply that by thousands of traders moving money around for a company’s own accounts, and you have one of the most efficient scandal machines ever devised.
Perhaps the worst scandal of all not only still persists today, but also continues to thrive (you can thank the Wall Street lobby machine). The broker-dealer advisory model pushed on Main Street under the guise of the “Suitability Standard” is where financial advisors provide advice and assistance to customers in return for commissions, fees, and other payments as a result of selling their inventory. Irrefutable academic research in behavioral ethics has made it clear that this is flawed.
The Motley Fool has a well researched article “Can Your Edward Jones Financial Advisor Really Serve Your Best Interest? The components of their compensation structure is a telling eye opener: Commissions for fund loads; 12b-1 Fees; New Account Bonuses; Branch Bonus and Travel Awards Programs to name a few. Burton Malkiel, author of the investing classic A Random Walk Down Wall Street, told Bloomberg that “in no event should you ever buy a load fund. There’s no point in paying for something if you can get it for free.” This is a point that John Bogle, founder of Vanguard and a leading proponent of index funds, has made as well throughout his long career.
In 2011, Edward Jones had $4.6 billion in revenue and $1.7 billion of that came from commissions. When Dodd-Frank legislation was being crafted in 2010, Edward Jones circulated a document called “The Fiduciary Dilemna” warning that a fiduciary standard would lead to “unintended consequences” that would severely limit or prohibit the broker-dealer from providing the most appropriate investments to the client. Unfortunately, your legislators blinked and billions continued to be made on the backs of Main Street.
Do you still wonder where scandals come from?