Wall Street Fights Darwin? Main St. Loses.

February 20, 2015

Science reveals the functional dynamics of the world around us. Both biological and business. For the codes governing the cosmos also control the means by which companies are run.
Newtonian physics. Mendelian genetics. Chaos theory. Darwinian evolution. The more these disciplines teach us, the more clearly we see the world around us.
Darwin's theory of natural selection is applicable to people and corporations. Consider Neanderthal man. He learned to stand upright. Created and utilized tools. Hunted and survived in often inhospitable environs. Likewise, corporations the world over have evolved into global profit machines. Exploiting competitive advantages like predatory cats on the Serengeti planes.
Natural selection describes the process of favorable traits becoming more prevalent within successive generations of a population. This occurs when individuals of varying genotypes differ in their fitness and make disproportionate contributions to the gene pool. This concept, evolutionary fitness, is one of the most critical in biology. And outside of the rain forest, or the vast African planes, perhaps no place better captures the Darwinian spirit than does Wall Street.
At the turn of the 20th century, Wall Street began selling wares to Main Street. Firms like Merrill Lynch and JP Morgan sold stocks and bonds to families in Connecticut, Kentucky and Kansas.
The 1920s brought the advent of the mutual fund. Wall Street's brokers spent the rest of the century selling stocks, bonds and funds as if their lives depended on it. Eventually, the Street added insurance, annuities and separately managed accounts to its arsenal. But the sales pitch never changed.

These products were created to draw investors into the markets. Promising a modicum of professional management, diversification, and the opportunity to share in the American dream. All the while, they insured that Wall Street's fee income was residual. Annuitized. Even if the benefits to Main Street were anything but.
The 1929 crash brought investors nationwide to their knees. As did seemingly every market crash thereafter. The most recent being the credit crisis of 2008.
Fossil evidence indicates that the key to Homo habilis's successful evolution has been a progressive increase in brain size. Much like the key to Wall Street's evolution has been the progressive increase in its profitability. And while this has, in many cases, benefited society, it certainly has not always been the case.
Over time, Wall Street's salesman sold more financial products to more investors resulting in ever more profits. Of course, the Street's stewards saw the potential offered by the model, and its continuing evolution. So the brokerage firms grew. They went from having had a small cadre of well-informed agents who knew their clients, investments and markets, to having armies of semi-informed salesmen. Today's four largest brokerages, in fact, employ well over 60,000 of these salesmen. And these armies of brokers continue to largely employ the same model used a century ago. Only, many of these brokers, arriving from other, non-related industries, don't know the markets, companies and risks as well as they once did.
According to Darwin, there are two main processes that define the outcomes of evolutionary biology---microevolution and macroevolution. Focusing on the former, macroevolution looks at evolutionary forces on a grand scale. The kind of scale that leads to the creation of a new species. For comparative purposes, let's consider the Wall Street bank known as Morgan Stanley (MS), for whom, considering that they acquired Smith Barney, I once worked.
MS traces its roots back to J.P. Morgan. Following the 1933 passage of the Glass-Steagall Act, it became illegal for a corporation to have an investment banking and a commercial banking business under the same roof. J.P. Morgan chose to remain in commercial banking. Leaving former employees Henry Morgan and Harold Stanley to form Morgan Stanley. In its first year, the firm captured 24 percent of all the public securities offerings in the U.S. And soon became the quintessential American investment bank.
In 1997, MS merged with the brokerage firm Dean Witter, becoming Morgan Stanley Dean Witter and Co. Eventually dropping "Dean Witter" in 2001.
The company forged a dominant position in the investment banking world. Served as lead underwriter for Netscape, Compaq, Apple, Cisco, Facebook and Priceline, among many others.
Then came the credit crisis. MS, like many Wall Street firms, realized the harrowing plight of a mismanaged balance sheet. Was caught in a short squeeze in which one of its trading units lost $300 million in a single day. Teetering on the brink of insolvency, Treasury Secretary Hank Paulson offered MS to JPMorgan Chase at no cost. Jamie Dimon, JPMorgan's CEO, refused the offer.
Eventually, MS's mismanagement and financial errors cost the firm over 80 percent of its market value. Accordingly, the Fed forced MS to transition into a traditional bank holding company. And borrowed over $107 billion from the Fed and American taxpayers. Following by a huge capital infusion from China Investment Corporation.
Here, Darwin's theory of natural selection would have dictated that MS die an ignominious death. Yet, as homo sapiens--especially those in the public sector--are apt to do, the government stepped in, resuscitated the flat lining firm, adrenalized it with enough cash to feed a third-world nation, and let the patient rest and recover.
Recover the firm did. Though not to its original form. While shareholders and the firms' clients lost billions throughout the firm's credit crisis misfortunes, the denizens of Wall Street presiding over the Frankenstenian creation that emerged post-crisis were unscathed. Left to their own devices, they acquired Smith Barney and more than doubled the firm's client-facing army of salesmen. Which brings us to today.
For some years and by Wall Street's standards, the firm wallowed in mediocrity. But last year, MS went from laggard to leader among the big banks. MS shares jumped 25 percent, largely on the shoulders of its growing wealth management unit which now generates 40 to 50 percent of revenues. In fact, earnings jumped 87 percent in Q3 alone. As importantly for shareholders, MS's return on equity hit 9.4 percent, up from 6.1 percent the prior year. ROE measures a firm's efficiency at generating profits from shareholder's investments. Shareholders would be pleased. Yet, from whence did said profits come? Main Street's nest eggs, of course. The very group of bystanders forced to bail these ne'er-do-wells out some seven years hence.
Darwin's theory posits the assumption that the strongest of genetic traits are inherited, one to the next, thereby passing on the fittest qualities to subsequent generations. Of course, Darwin hardly knew Wall Street. Nor its miscreant, biologically ill-conceived cadre of member firms. For as MS goes, so goes for for any of its peers.
But, let's stay with MS, shall we?
Today, MS boasts one of the largest collections of financial salesman the world over. And most of its problems are behind it. True, five months ago, the firm paid $95 million to Mississippi's Public Pension Fund for having mislead investors in mortgage-backed securities. A piddling, really. Guess some habits never die.
Yet, analysts see earnings reaching up to $3.50 a share in 2016. Many foresee a doubling of the dividend, as well. Prospectively rising from 40 cents to 75 cents. Further, share buybacks could double.
Critical to that growth has been an expanding investor deposit base. Enabling the firm to glean significantly more in fees. Not to mention the higher net interest income gotten by permitting investors to leverage up and borrow against their portfolios.
"In short," said MS CEO James Gorman, "we do not think that this firm is close to
reaching its full potential."
That potential, I infer, would be well beyond that of the firm JPMorgan chose not to acquire for FREE six years ago. That has, following a government bailout, retooled itself into the greatest purveyor of Wall Street's financial products the world has ever seen. That requires, one might assume, vastly more inflows of Main Street's money so that it can fulfill Mr. Gorman's dream of reaching its full potential. The most profitable firm it can be. With the highest profit margins it can achieve. So maximizing earnings per share potential four times a year. Each and every year. All predicated upon the fees charged to the very Main Street investors who recently bailed it out.
Given the aforementioned details, consider a speech given yesterday by President Obama in which he called for investment advisors dealing with Main Street's nest eggs to meet a higher standard, known as a "fiduciary standard." This in contrast to the "suitability standard" to which the major brokerage firms, like Morgan Stanley, have long adhered.
So, what's the difference?
Some clients work with investment "advisors"--like those at our firm--who are held to a fiduciary standard. Some clients work with investment "brokers" from the likes of Morgan Stanley, Merrill Lynch, UBS, Well Fargo Advisors, et al., which are held to the suitability standard. Clients often believe that the investment advice received from both sides as similar. Because many of the "broker's" cards read "advisors." Or bear fancy titles. How many vice presidents need one firm have?
Yet, there is a key difference.  The distinction pertains to the standard to which the advisor is held, and thus the means by which he approaches client relationships.
Now, I have worked on both sides of the fence. At Smith Barney/Morgan Stanley (suitability), and presently for Hyde Park Wealth Management (fiduciary). So making me an apt surveyor of the industry landscape.
According to the Securities and Exchange Commission (SEC), investment advisors provide an array of services pertaining to the client's overall financial planning. This may include investment, financial, estate and asset protection planning. These advisors may charge fees for service, manage individual portfolios, or allocate to and manage third-party investments when in the client's best interests.
The SEC recognizes that broker-dealers (BDs) like Morgan Stanley, Merrill Lynch and UBS serve many of the same functions as investment advisors. But the SEC does make a distinction between the two. By considering BDs to be financial intermediaries who help to connect investors to individual investments. And playing the critical role of enhancing market liquidity and efficiency by linking capital with a variety of investment products.
Investment advisors are bound to a fiduciary standard that requires them to place a client's interests above their own. It includes a duty of loyalty and care, and means that an advisor must always act in the best interests of clients.
Broker-dealers, on the other hand, must fulfill a suitability obligation. Defined as making recommendations that are "consistent with the best interests of the customer." BDs are regulated by FINRA (a self-regulatory agency, so allowing the wolves to watch themselves), which requires brokers to make suitable recommendations without having to place their interests below that of the client. The suitability standard determines that the BD must reasonably believe that all recommendations are suitable for client's financial needs, objectives and circumstances.
Another critical distinction? An advisor's fiduciary duty requires abject loyalty to the client. Whereas a broker's duty is to the broker-dealer for which he works, not necessarily the client he serves. An essential difference.
This difference alone enables the Wall Street brokerages to hire and train glorified salesmen who spend the lion share of their time selling. The firm. Products. Services. Seminars. Whatever. Most of my colleagues at the brokerage firm worked with hundreds of clients. Using the firm's turn-key investment management products. They had to, because their margins were so thin that client acquisition was the name of the game.  Their was at least one broker in the office who claimed over one thousand clients. Though I'm certain they were all well served.
The BD's suitability standard can lead to conflicts between a broker-dealer and the client. The most obvious having to do with fees. Investment advisors would be strictly prohibited from buying a mutual fund or other investment if it would pay a higher fee or commission. Under the suitability requirement, however, this isn't the case. So long as the investment is deemed "suitable" for the client. This can incentivize brokers to sell their products ahead of more effective solutions that may cost less.
Further, the broker-dealer model has other motivations well beyond those of serving clients.
In 2011, Fortune magazine described the combination of a brokerage and an investment bank as an "engine to distribute product brought to market by the investment bank" through the brokers selling "suitable" investments to clients.
Finally, the biggest conflict of all, which directly underscores the idea that a broker's duty is to his firm, not necessarily to clients. The big publicly traded broker-dealers have been able to leverage this distinction in order to best serve their primary constituents, their shareholders. Morgan Stanley, Merrill Lynch, UBS and Well Fargo must report financial results quarterly. So, if the standard to which their advisors adhere states that their duty is to the firms for which they work, and the firm's primary focus rests on its quarterly earnings, where do clients' best interests fall in that equation?
Well, having observed from the inside throughout two bear markets, 2001 and 2008, I can assure you that clients' interests were not the top priority. So explaining why the firm's management eschewed the utilization of trailing sell stops, holding cash positions, or plying any other tactics aside from keeping clients fully invested while assuring them that everything would be fine. Even as the crises worsened.
So, back to Morgan Stanley. Whose evolution has been selectively Darwinian, as suited the firm. Market dropping precipitously? "Stay the course, Mr. Client. We'll be fine in a few years!" Yet when the firm teetered on the brink, it wasn't about staying the course. Nor, as natural selection would dictate, paying for its mistakes. Suddenly the firm was taking bailouts from the Chinese, the Fed and the U.S. taxpayer.
Whereas natural selection strengthens future generations by codifying within their DNA an aversion to repeating the mistakes of the past, what did Morgan Stanley and its peers learn? Zilch. Because they were bailed out. Remember, like Bear Sterns and Lehman Brothers, Merrill Lynch was all-but dead until the U.S. Treasury forced a shot-gun wedding with Bank of America.
In Darwin's 1871 masterwork, The Descent of Man, he posited the then-controversial idea that man and ape descended from common ancestry. The proposition that humans descended from such a primitive form shocked the public. Yet, his audience eventually found hope in the idea that man, having come from such simple beginnings, could ascend to such levels. Alluding to the idea that our best days were yet to come.
The evolution of the Wall Street brokerage firm has been, to the detriment of clients, the inverse of natural selection. More Darwin Award than Darwinian. For in this case, the defective organism was not permitted the opportunity to evolve. But was resuscitated, dusted off, and set on its way. Like a teenager who runs afoul of the law. Only to be bailed out and returned to the scene of the crime.
Were I an anthropologist, I might postulate that the weakest, most defective traits have been preserved and rewarded. Unless I happened to be a shareholder. In which case I'd probably keep my mouth shut. Let the historical record speak for itself.

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