Bypass Wall Street

The Direct Route to Raising Capital and Investing 

Table of Contents
(Start wherever you wish, by clicking on a heading)


Where is Wall Street and Who Works There
Why We Once Needed Investment Bankers and Don’t Anymore
The Harm That Wall Street Causes
Direct Routes Open Now for Bypassing Wall Street

The Traffic Cops on Wall Street
What Government Could Do
Proposals for Change



    We don’t need Wall Street anymore. It’s killing us to let Wall Street keep going the way it is. Our governments won’t help us—Wall Street dominates them. But there is a way around Wall Street. Direct routes are open for individuals and businesses to bypass Wall Street.

   Wall Street is not going to change. Government is not going to regulate Wall Street in the public interest. To escape the harm of Wall Street we need to ignore it.

    For 50 years, I worked as a securities lawyer and certified public accountant. From my front row seat, I’ve come to believe that the only way to get out of our economic mess—and to prevent it happening again—is to bypass Wall Street and take the direct route to raising and investing money. The information and opinions I’ve put together are on this website. These are the major themes developed:

•  Wall Street does very little to raise money for businesses. It has become a casino, placing bets for its own account and taking fees on bets for institutional funds and the very wealthy.

•  Wall Street is not open to investing money for the middle class, except through its managed funds, and it is closed to raising money for all but the biggest businesses.

•  Wall Street is doing great harm to our economy and our way of life, while its traffic cops run a protection racket for Wall Street abuses.

•  Direct routes are open for money to flow between individuals and businesses, bypassing Wall Street.

•  There are steps government could take to help us bypass Wall Street.

This website will give you facts and arguments for bypassing Wall Street. It's a "living book" and I’ll update it as events unfold. You can email me with your suggestions for additions or revisions. (

    The website’s references to sources are in brackets, right in the text, rather than as footnotes. You can easily skip over them. Or you can read them and click on the website references. I’ve included a few personal experiences for flavor. They’re in parenthesis. You are free to refer to or quote anything on the site, with attribution.

Table of Contents

Where is Wall Street and Who Works There?


Most of us hear and see “Wall Street” nearly every day.  On television news, a report will begin “On Wall Street today . . ..”  The business print media is dominated by The Wall Street Journal.   For most of us, “Wall Street” is shorthand for a mysterious complex that comes between the people who provide money for investment and the people who use that money.  It even takes on its own personality, as in “Wall Street reacted by . . ..”

Wall Street, the place, was named after the wall built to keep invaders out of New York City’s lower Manhattan.  Wall Street, the people, were brokers and speculators in stocks and bonds who first met in coffee shops along Wall Street to trade in securities.  They had no formal organization or rules and the auctions for stocks were open to anyone.  That changed when one of them created an economic panic from speculating on insider information and ended up in debtors’ prison.  The New York legislature outlawed “public stock auctions.”  The way to get around the new law prohibiting public stock auctions was to make them a private affair, no longer open to the “public.”  After the one stockbroker went to prison, the remaining 24 gathered under a buttonwood tree in 1792, to start the New York Stock Exchange.  Its members met at Tontine’s Coffee House to call out the price they were willing to pay for a security (the bid) and the price they would take to sell (the offer). 

Wall Street’s Monopoly

The so-called Buttonwood Agreement was a single sentence:  “We the Subscribers, Brokers for the Purchase and Sale of Public Stock, do herby solemnly promise and pledge ourselves to each other, that we will not buy or sell from this day for any person whatsoever any kind of Public Stock, at a less rate than one-quarter per cent Commission on the Specie value of, and that we will give a preference to each other in our Negotiations.”  [Marshall E. Blume, Jeremy J. Siegel and Dan Rottenberg, Revolution on Wall Street, W. W. Norton & Company, 1993, page 23]  These last few words established the monopoly that is today enforced by the federal government, the monopoly rule that only brokers accepted as members can trade in stocks and they can only trade among themselves.  At first, non-member brokers met outside, on “the curb,” to trade in unlisted shares.  In 1908, they formed the American Stock Exchange, also a members-only market.  [Charles R. Geisst, Wall Street: A History, Oxford University Press, 1997, pages 10-21.  By 2012, The AMEX had less than 1% of U.S. stock trading, was owned by NYSE Euronext and renamed NYSE MKT.  Matt Jarzemsky and Jacob Bunge, "Closing Bell Rings for Exchange's Name," The Wall Street Journal, May 11, 2012, page C1] Only broker-members could buy or sell through the exchanges.  Fixed commissions, rather than price competition, were the rule at the very start.

In the 1930s, when government regulation came to Wall Street, Congress defined "exchange" to include “a group of persons . . . which provides . . . a market place or facilities for bringing together purchasers and sellers of securities.”  [Securities Exchange Act of 1934, section 3(a)(1),]  This definition reflected the history of trading in securities before modern tools of information technology, back when "economy of time and labor, as well as a theoretically perfect market, could be best secured by an organization under one roof of as many dealers in a commodity as could be found."  [William C. Van Antwerp, The Stock Exchange from Within, Doubleday, Page & Company, 1913, page 6.]  There had been over a hundred stock exchanges in 1900, when the media for communications and delivery were still costly and unreliable.  Today, there are effectively only two stock exchanges dealing with individual orders, the New York Stock Exchange and NASDAQ.  The third largest exchange, BATS Global Markets, has gained a 10% share of the U.S. stock market in the last four years, “catering to the needs of the broker-dealer and trading community.”  [ On March 23, 2012, BATS Global Markets Inc.(the name uses the initials for “Better Alternative Trading System”) began trading its own initial public offering of $100 million, at $16 per share, with the first trade for 1.2 million shares at $15.25.  “Within nine-tenths of a second from that opening, the stock had fallen to about 28 cents . . .. Within 1.5 seconds, the price bottomed at $0.0002.”   BATS suspended trading due to “a software bug.”   The same morning of the offering, one of its Wall Street underwriters issued a report that the offering had “generated significant demand.”  [Tom Lauricella, Scott Patterson and David Benoit, “Trading Firm IPO Fizzles in Seconds: Apple Shares Also Affected as Glitch Mars Debut of BATS Global Markets,” The Wall Street Journal, March 24-25, 2012, page A1, A2]

After the Securities Exchange Act of 1934, the monopoly expanded from exchange members to all brokers and dealers who registered with the Securities and Exchange Commission.  Anyone trespassing on the turf of registered broker-dealers could be prosecuted by the SEC and state securities administrators.  For a humorous depiction of how the broker monopoly operated back then, see, Fred Schwed, Jr., Where are the Customers' Yachts?  A Good Hard Look at Wall Street, Simon & Schuster, 1940, 1955 and George Goodman, under the pseudonym "Adam Smith," The Money Game: How it is played in Wall Street, what money really is, what we think it is and how it makes us behave, Random House, 1967]

Wall Street Expands Beyond Stocks and Beyond New York

Wall Street was all about stocks and bonds until the 1970s, when Chicago became part of Wall Street.  Chicago brokers had developed markets for trading futures contracts on agricultural commodities and they were looking for other products to trade.  In 1972, a Chicago Mercantile Exchange broker began trading futures contracts on foreign currency exchange rates.  Financial futures quickly became the major business for the Chicago markets.  [Scott Patterson, The Quants, Crown Business, 2010, page 39] This led the way to the invention of more “derivatives”--the securities that derive their price from what is happening with another security.

Today, Wall Street has come to stand for high finance, the movement of monetary symbols among governments, corporations and the wealthy.  The people who work on Wall Street are practitioners of arcane games that use money as a marker. These are “zero sum” games, where one player’s winnings are another’s losses.  Only a very few of those games actually involve the transfer of money from investors for use in operating businesses.  As Eugene Robinson put it:  “Wall Street's theoretical role is to allocate capital most efficiently to the companies that can make the best use of it. Wall Street's actual role is more like that of a giant casino where the gamblers are rewarded for taking outrageous, unconscionable risks with other people's money. If the bets pay off, the gamblers win. If the long-shot bets turn out to have been foolish, we're the ones who lose.”  [Eugene Robinson, “The Wall Street Casino, Back in Business,” The Washington Post, September 15, 2009,]

Wall Street Ignores the Middle Class

In its earlier days, Wall Street served as a bridge from wealthy individuals to entrepreneurs who had plans that needed capital.  Financial intermediaries were useful in finding and matching money with entrepreneurial talent.  On the supply side were families with far more money than they’d need for immediate financial security.  They wanted to put that money to work for them, to pay for their chosen lifestyle and build more wealth.  The risk of losing some of their capital was acceptable, if the projected returns looked to be worth the risk.  Sometimes they had financial advisers they paid to investigate and analyze this risk/return ratio. 

Demand for the use of other people's money first came from governments, looking for ways to acquire territory or wage wars.  Later it also came from private companies that built and operated ships, canals and railroads.  This flow of capital through Wall Street, between very rich individuals and business managers, is the picture of capitalism as it existed in the time of Karl Marx and other critics.  The middle class, the bourgeoisie, had modest capital needs for their businesses, farms and professions.  They could get by with savings, bank borrowings and direct financial arrangements with family and acquaintances.

By the time the middle class began to have some money it could save, entrepreneurs were launching new businesses, based on technological advances and expanded markets.  Wall Street could have expanded its services to deal directly with the money supply from this broader level of families with disposable income.  It could have been the channel from a growing middle class to emerging business ventures.  The model for this evolution on Wall Street was right around the corner in retail banking. 


Commercial banks once accepted deposits only from those wealthy enough to maintain very substantial balances.  They lent money only to governments and large businesses.  But most banks adapted to a society in which there were more than the very rich and the poor and they evolved into providing services to nearly everyone.  The people who dealt with securities did not.  They chose to ignore both the supply of money from new middle class families and the demand for money from the developers of new business ventures.  What happened instead was that Wall Street continued to do business with people who had the largest amounts of money to invest or to use. 

Buy Side Money Managers Join Wall Street

Because Wall Street chose not to gather money directly from the middle class, another layer of financial intermediaries was created, to control the flow of capital and gather fees as it went through the channels.  Mutual funds sprung up to bundle the money from middle class families and invest it in ways picked by the fund managers.  This created Wall Street’s “buy side,” the professional money managers who accumulate money from individuals and use it to buy investment products from the “sell side” of Wall Street.  [Marshall E. Blume and Irwin Friend, The Changing Role of the Individual Investor, A Twentieth Century Fund Report, John Wiley & Sons, 1978]

The great majority of those working on Wall Street are sell side financial intermediaries, acting as agents for their clients and customers.  Brokers and investment bankers dominate the sell side.  They have combined selling new issues of securities with running a market for reselling securities, where they trade for themselves as well as for their customers.  Members of the buy side include money managers for mutual funds, pension funds, endowments and the other funds.  The big-name securities firms have departments on both sides of the Street.  

Running between the two sides of the Street are all of the lawyers, accountants, rating agencies and other support services.  It is this entire network that is called into play when we refer to what happens on Wall Street.

Wall Street Transfers Risk onto its Customers

Some financial intermediaries are simply matchmakers, acting as a go-between for people who have money to put to work and people who want to use money in their business.  They provide an introduction service and some advice on the mechanics.  Others are strictly brokers, limiting themselves to being agents for buyers and sellers of existing financial products.  The major financial intermediaries, like investment banks and commercial banks, are also agents of change in the characteristics of the money that passes through them.  They serve purposes similar to electrical transformers which alter the voltage between the generator and the user.  Financial intermediaries theoretically transform the denomination, the maturity and the risk.  We say “theoretically” because Wall Street has found ways to abandon its transformation role, to pass on those risks to the providers or users of money.

Denomination transformation usually means taking in money in small amounts and lending or investing it in much larger amounts. 

Maturity transformation is generally accepting money that can be returned on demand or other short-term period and using that money to make long-term loans and investments. 

Risk transformation is a little more complex.  The concept is that the risk of not getting a return of the money is placed on the intermediary.  The person providing the money to the intermediary is protected from borrower defaults, changes in interest rates or other market conditions.  Risk transformation is also provided to those receiving money from financial intermediaries.  They, of course, bear all the risks of how they use the money and whether they will generate the cash flow to meet payment terms.  But they have been protected from changes in interest rates and fluctuations in the money markets.  Think of the individual with a savings account at a bank.  So long as the bank itself is operating, the money they’ve deposited can be withdrawn at any time.  The interest rate will stay the same and they don’t need to worry about whether the money will be there when they want it.  Meanwhile, the bank will be making loans on very different terms, taking on the risks from interest rate and maturity differences, as well as the risk that a borrower will fail to repay.

In recent years, financial intermediaries have largely abandoned their roles in risk transformation, first with the risk of interest rate changes and then with the risk of default.  The shift of interest rate risk began after Paul Volcker was appointed Chairman of the Federal Reserve Board in 1979 and undertook to cleanse the economy of stagflation.  Financial intermediaries’ cost of money, measured by one-month certificates of deposit, went from less than 6% in 1977 to 16% in 1981.  Banks raised their prime rate in that period from 7% to 19% and rates on new 30-year mortgages rose from 9% to 17%.       [Federal Reserve Statistical Release H.15, Selected Interest Rates,]  The jolt was especially strong for intermediaries, like savings banks, who took in short-term deposits and held 30-year fixed-rate loans.  Before 1977, savings banks managers were said to have been following the “Rule of Three:” take money in at three percent, lend it out at three percentage points higher and be on the golf course by three in the afternoon.  (I remember long, desperate discussions with our law firm clients over what they could do when that three percent positive spread in rates had become a twelve percent negative spread.  Should they refuse to accept deposits at the much higher rate?  Should they sell their fixed-rate mortgages and take a huge loss now?  Should they aggressively seek new money and invest it in short-term U.S. treasury securities at a positive spread, to offset some of the losses on their loan portfolio?  Were there any hedging techniques that would help?  In the future, how could they shift the interest rate risk back onto the depositors or forward onto the borrowers?)

The principal response was introduction of the adjustable rate mortgage.  The new instrument shifted most of the risk of interest rate fluctuations onto the borrowers.  It took some time to develop industry standards for the new loan structures and fixed-rate loans have remained as an alternative.  There were people who questioned whether it was right for savings banks to abandon their role as absorbing the risk of interest rate changes, arguing that they were in the money borrowing and lending business and should find ways to deal with the risk, rather than pushing it on to their customers.  (I was at a conference in the early 80s about the new mortgage instruments.  In the audience was Martin Mayer, author of many books on finance and a guest scholar at the Brookings Institute.  He asked the panel, as I recall, “If this industry is not about risk transformation, what is it about?”  The panel went back to discussing the characteristics of ARMs.)

Having abandoned much of the interest rate risk, savings bank managers were ready when Wall Street proposed to relieve them of their role in transforming the risk of default, together with transforming maturity.  Wall Street’s proposal was to bundle a group of mortgage loans and sell them as mortgage securities.  The disastrous consequences of Wall Street’s handling of mortgage securities are a separate subject in the chapter on “The Harm That Wall Street Causes.”  What it did to banks was to strip them of a major economic function, transforming risk and maturity, and turn them into brokers.  In a Wall Street Journal article, Eleanor Laise said, “In the process, risks previously borne by big banks . . . have been placed squarely on the shoulders of consumers.”  [“Some Consumers Say Wall Street Failed Them,” November 21, 2008, page B1.  The article quotes from Jacob Hacker, author of The Great Risk Shift, Oxford University Press, 2006.]

Like commercial banks, Wall Street’s investment bankers have also abandoned their role of transforming risk.  Their principal reason for being was to provide assurance that a proposed underwritten sale of bonds or stocks would actually happen.   As described in chapter two, the term “underwriter” came about when businesses wanted to go forward with their plans for the new money they were raising, without waiting for the public offering to close.  It could be weeks or even months between the agreement to sell an amount of securities and the closing, when investors delivered the money.  Investment banking firms gathered their own capital base, so they could stand behind their promise that the money would be there.

As power shifted from the businesses issuing securities to the investment bankers who sold them, the time became shorter between signing the underwriting agreement and delivering the money at closing.  For the last fifty years, the “firm commitment” underwriting agreement has been signed only a few hours before the sales to investors was confirmed.  While all the preparation and selling efforts are taking place, only a “letter of intent” documents the rights and duties of the business and the underwriter.  This letter of intent very clearly does not commit the underwriters to go through with the offering and purchase any shares.  The only binding part is that the issuer will pay the underwriter’s expenses if the sale is not completed.  Even when the underwriting agreement is signed, there is a “market out” clause, letting the investment bankers cancel the transaction if any of the named events has happened.  That list of events has grown over the years.  As a result, investment bankers have abandoned virtually the entire risk that created securities underwritings to begin with.  Wall Street has shifted back to the issuer all of the risk that the offering will not be sold and the money collected.  The so-called “underwriters” are now just like a consignment store—if the shares sell, the company gets its money and the investment bankers get their commission.  If the shares don’t sell, the issuer is out the time and cost.  Except for the rituals, the “firm commitment” underwriting has become the same as the “best efforts” selling role, where a licensed securities broker agrees to use its best efforts to sell the entire offering but makes no guarantee.  Calling it a "firm commitment" just opens an easier path with regulators and exchanges, who will waive requirements if it is a “firm commitment” underwriting.

Wall Street Becomes a Casino

Wall Street has become a closed system, in which the flow of capital is from professional money managers to the officers of large corporations, which are owned by the money managers.  The sell side and buy side intermediaries collect the money and pass it on, subtracting a small percentage for their service.  It’s like a conveyor belt of money, with Wall Street taking a little bit out of each dollar that goes by.  But that capital flow, once what Wall Street was all about, has become a small part of Wall Street’s business.  The rest of it is running a casino for betting on the price movement of Wall Street-manufactured contracts, still called “securities.”  Unlike other licensed gambling casinos, the house gets to place bets alongside the customers.

Of course, it gets extremely complex, intricate, sophisticated.  That’s part of the mystique.  Only Wall Street insiders can begin to understand what goes on there.  The rest of us appear to have no alternative but to trust that they know what they’re doing with our money and our world economy.  Our purpose here, in describing Wall Street, the harm it causes and the ineffectiveness of the regulators, is to put a context around the suggestion that we bypass Wall Street in raising capital and investing in businesses and governments.

Wall Street’s biggest business, the one that most affects us all, is the buying and selling of contracts that go up and down in their market price.  At the most basic, these contracts are shares of common stock or bonds, representing   ownership or debt of huge corporations.  Once upon a time, these shares were sold by the corporations for the purpose of raising capital to grow the business.  The buyers hoped the corporation would someday pay out a portion of its earnings in dividends, providing them with a much higher return than they would have gotten from leaving their money in bank deposits.  They also expected that their shares would increase in value as the corporation grew and prospered, allowing them to one day sell the shares at a price far more than they had paid.

The prudent investor would also consider buying bonds. These are contracts to repay the amount invested on specific dates and to pay a rate of interest on the bond amount.  If the corporation doesn’t perform so well, the investor owning a bond is more likely to get back the money paid than the investor owning shares of common stock.  The other major difference between bonds and stocks is that interest on bonds is a contractual obligation, while dividends on common stock are paid only if the corporation’s board votes to do so.  An investor taking the long view will study the risks and the returns for a corporation’s stock or bonds and make a decision about what fits the investor’s personal objectives and tolerances.

Now imagine you are looking not at what meets the needs of investors or of businesses, but only at what is in the best interests of Wall Street.  If investors are buying stocks and bonds to hold for several years, there is very little in it for the intermediaries.  The sell side of Wall Street gets a commission or trading profit only when there is a transaction.  On the buy side, growth of the assets under management is based upon the manager’s performance, compared to its peers in the business.  This measurement is on a quarter-to-quarter basis, so there is frequent buying and selling.  In striving to outperform their rivals, most fund managers get tips from brokers, on expected short-term price movements.  They pay for these tips by directing their trades to the brokers who deliver nonpublic information that lets them get the jump on their competitor managers.  Holding on for the long term is not the way either the sell or buy side does business.

Nearly all the buying and selling of securities on Wall Street involves either stocks and bonds issued by corporations or derivative securities issued by intermediaries.  That means that Wall Street makes most of its money from the buying and selling of “previously-owned” securities, not anything that actually moves money from investors to operating businesses.  Before May 1, 1975, the principal way that Wall Street got paid was through commissions on trades made for customers.  Most of the active securities at that time were listed on the New York Stock Exchange.  Since the “Big Board” began in 1792, commission rates had been fixed—any broker caught discounting a commission would be expelled from the Exchange.  There was no price competition allowed.

It was the fixed commission rates that brought out the political power of Wall Street’s buy side.  Money managers for big pension funds, mutual funds and other institutions lobbied Congress to end the monopoly pricing.  In fact, the lure of institutional business had caused many brokers to find ways to rebate part of the commissions they received.  This raised difficult enforcement issues and softened the sell side resistance to abolishing fixed rates.  Congress finally opened commission rate competition on “Mayday” 1975.

Chris Welles published a book in 1975, just as the SEC finally ended fixed commission rates.  [Chris Welles, The Last Days of the Club: The Passing of the Old Wall Street Monopoly and the Rise of New Institutions and Men Who Will Soon Dominate Financial Power in America, E. P. Dutton & Co., Inc., 1975.  Chris Welles died at 72 in 2010.]  He predicted that the sell side, brokers, would fade away, that “the era of the great Wall Street Club will come to a close.”  [page xi]  In its place, Welles predicted that the money managers for institutions “will soon dominate financial power in this country.  The members of this new Club may well massively abuse their power in ways that will make the transgressions of the old Club seem like minor stock fraud.”  [Ibid.]  What Welles did not foresee was that the old Club members would move over to occupy the new Club as well.  Nor could he have known that trading for themselves, and inventing new games with derivatives, would become more important to the old Club than brokering trades for commissions.

Both sides of Wall Street watched as the big winnings began to go to the intermediaries who put their own money into the game.  Trading for the firm’s own account became more profitable than acting as a broker or money manager for clients. 

Wall Street Partnerships Become Corporations

Long after most large businesses were operated as corporations, Wall Street firms proudly remained partnerships.  Staying in the partnership form was a statement to all who dealt with Wall Street:  “You can trust us, because each partner’s wealth and reputation stand behind our every transaction.”  If a corporation officer makes a huge mistake, or commits fraud, that officer and the corporation may be made to pay.  But all other officers and durectirs are insulated from any loss, except the value of the shares they may own in their employer.  In sharp contrast, the mistakes or felonies of a partner can put every other partner’s assets and freedom on the line.

Wall Street’s sell side had seen their clients start or finance new businesses and then take them public for massive capital gains.  They saw how they could continue to run their own businesses and get even greater compensation, if they were armed with vast pools of money to expand and acquire.  Wall Street brokers and investment bankers changed their attitude about operating as partnerships.  Going public as corporations became more important than retaining the partnership image and privacy.  Their partners’ profits could simply be replaced by corporate bonuses, skimming off all but the leftovers for shareowners.  That put the officers/former partners at war with their shareowners.  [Susanne Craig, “Goldman Holders Miffed at Bonuses,” The Wall Street Journal, November 20, 2009, page C1] 

We all paid a price for Wall Street going public.  One price was the loss of investment advisors, and their replacement with casino managers and sellers of manufactured securities. “The decision of the brokerage houses to sell their clientele products rather than services grows out of the shift from the partnership to the corporate form, and the demand from the firms’ own stockholders for a greater degree of stability in earnings than the delivery of personal services can promise.”  [Martin Mayer, Stealing the Market: How the Giant Brokerage Firms, with Help from the SEC, Stole the Stock Market from Investors, BasicBooks, 1992, page 12.]   Another huge price for Wall Street's incorporation was the Great Recession of 2008, which can, at least in part, be attributed to this change, since "the public ownership structure of major firms meant that all the borrowing and bets were done with other people's money. Wall Street's old privately owned investment partnerships would never have wagered their net worth on so much risky junk."  Matt Miller, "Rescuing Capitalism from Wall Street," Washington Post, April 8, 2010, []  Michael Lewis graphically describes the harmful effects of Wall Street partnerships becoming corporations in The Big Short: Inside the Doomsday Machine. [W.W. Norton & Company, 2010, pages 257-259]

Buy Side Money Managers Become Entrepreneurs

Wall Street’s buy side began with insurance companies and endowment funds for universities, hospitals and other charitable organizations.  During World War II, corporations started pension funds, as a way to attract and hold employees during a time of government wage controls.  Since there was a 93 percent tax on “excess profits,” the deduction for pension plan contributions made them a cheap way to get extra compensation to employees.  The pension contributions were not taxable to the employees, so the effect was that taxpayers as a whole were subsidizing the transfer of money from employers to their employees.  These were “defined benefit” programs, so that large pools of managed money were built to fund a promised level of retirement payments.  Buy side money managers became a new professional group.

Mutual funds, which had been minor players since 1924, became huge and active investors in the 1970s.  Their marketing concept was that the small investor could get diversification and professional management.  Individual Retirement Accounts and other tax programs had been created to take the place of the diminishing corporate pension funds.  Suddenly, individuals were responsible for their own investment decisions and most of them turned their money over to mutual funds. 

Wall Street’s buy side became the professional money managers for all these institutions.  Their share of trading on the New York Stock Exchange went from only 20 percent in 1950 to 75 percent by 1975.  [Marshall E. Blume, Jeremy J. Siegel and Dan Rottenberg, Revolution on Wall Street, W. W. Norton & Company, 1993, page 105]  By the 1990s, money managers were earning extraordinary compensation from the trading profits they maneuvered for the funds they ran.  They had gone from salaried professionals to commissioned performers.  But real wealth came not from management fees, even based upon percentage compensation.  Money managers left their employers and started their own mutual funds and, later, hedge funds, where they could have ownership of the business and get large incentive payments taxed as capital gains. 

Wall Street Dominates the Economy and Government

Whether cause or coincidence, the 30 years after Wall Street went corporate and entrepreneurial have seen it come to dominate our economy and set unimaginable heights of personal compensation.  “From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.”  [Simon Johnson, “The Quiet Coup,” The Atlantic, May 2009,  See, also, Benjamin Friedman, "Is our financial system serving us well?", Daedalus: Journal of the American Academy of Arts and Sciences, Fall 2010, page 9,]

The last 30 years have also seen the nearly complete deregulation of Wall Street, the dismantling of protections put into place by the New Deal.  For a very detailed account of the “12 Deregulatory Steps to Financial Meltdown,” you may read the March 2009 report, by Essential Information and the Consumer Education Foundation.  [Robert Weissman and James Donahue, Sold Out: How Wall Street and Washington Betrayed America, Essential Information*Consumer Education Foundation,, March 2009,

When money passes from individuals through Wall Street’s buy side and sell side, it undergoes a transmogrification, a drastic change in uses and purposes.  Individuals have no ability to direct how their money will ultimately be used.  It is Wall Street values that determine where money will go and on what terms.  This closed financing system limits practices and restrains innovation.  Capital has to go through rigid structures, dominated by a few people who know each other and think alike.  They gather capital from diverse sources and funnel it through their own structures, reflecting their values and their limited frames of reference. 

Most of us still have the image of Wall Street as an impartial channel for money passing from individuals to growing businesses.  We need to have our images catch up with today’s reality.  “Where is Wall Street and Who Works There” is very different today.

Wall Street Keeps Its Monopoly on Public Offerings

The Wall Street intermediaries who have owned the public offerings business are the investment bankers.  They are generally a department of securities broker-dealer firms, the “members only” club through which all public securities transactions must pass.  For over seventy years, their oligopoly has had the protection and regulation of the federal Securities and Exchange Commission.  In late 2008, the remaining members of the club became parts of bank holding companies, to have additional funding and regulation by the Federal Reserve Banks and its Board of Governors.  

(I’ve had 50 years experience as a securities lawyer and certified public accountant.  The part I know most about, the role that really interests me, is how businesses raise money by selling their securities to large numbers of individual investors.   Unfortunately, these public offerings of newly issued securities to individuals have turned out to be a very minor part of Wall Street’s total business.  Raising capital for business is heavily overshadowed by trading in previously-owned securities and in the derivative securities that don’t raise money for anyone.  New issues are now sold predominantly to money managers for investment funds.  Today’s initial public offerings are usually well over $100 million each.  Rather than being the young businesses that would be the future economy, they often are divisions of giant corporations being spun off or being resold after purchase by a private equity company.  [Lynn Cowan, “Private-Equity Exits Are Seen Dominating 2010 IPOs,” The Wall Street Journal, January 11, 2010, page C3] ) 

Wall Street still sells new issues of securities in public offerings.  It’s a very profitable business, because it is the last holdout for the fixed commission, the flat percentage fee that is the same rate no matter how large the transaction.  There is no price competition among the investment banking departments of the major securities broker-dealers, including the commercial banks who are back after repeal of the Banking Act of 1933.  Nor have there been any successful inroads by other financial intermediaries.

Because they have an oligopoly, the investment bankers have no incentive to improve the way they do business.  A public offering underwriting operates as if the last technological advance ever made was the telephone.  You’d think that the Internet would force a change in how public offerings are conducted.  But the investment banker oligarchy has resisted attempts to crack its hold.

In the mid-90s, The Charles Schwab Corporation started Epoch Partners, an online investment bank that would cater to individual investors.  Schwab shared ownership of the startup with two competing online brokerage firms, TD Waterhouse and Ameritrade.  They gave up in 2001 and sold the firm to Goldman, Sachs Group.  According to David S. Pottruck, then Schwab’s co-chief executive, "It was just not going to happen for us to reinvent the investment banking business. There's much too strong an in-place structure to that industry."  To sell Epoch Partners, Schwab and TD Waterhouse gave Goldman Sachs access to their more than 10 million customers for selling underwritten offerings. 

E*Trade Group had started E*Offering to do online offerings of new issues.  They sold it in 2000 to WIT Soundview (later called Soundview Technology Group) which itself was acquired in 2004 by The Charles Schwab Corporation and now just provides services to securities broker-dealers.  [From article by Patrick McGeehan, “New-Era Banks Slip Into the Past,” The New York Times, June 22, 2001.  Data from

Other new online investment banks also faded away.  According to The New York Times reporter, Patrick McGeehan, “Despite the criticism that has been heaped on the major investment banks for how they handled initial offerings in the late 1990's, the old rules still apply and the old rulers still apply them. . . . In 1999 and 2000, six online firms managed 196 stock offerings that raised almost $30 billion, according to Thomson Financial Securities Data. So far this year [through June 2001], three of them, including Epoch, have participated in seven offerings that raised slightly more than $1 billion.”

The one remaining investment bank with an online emphasis is W. R. Hambrecht & Company.  Bill Hambrecht had built the very successful technology stock firm, Hambrecht and Quist, from 1968 until it was sold in 1999 to J.P. Morgan Chase.  Bill then founded W. R. Hambrecht & Co., where he introduced using the Dutch auction for new securities offerings.  It operates very much like a conventional underwriting, with two differences.  Like a conventional underwriting, Hambrecht, as managing underwriter, sets a price range for the expected offering a few weeks before it is to be sold.  Conventional underwriters subjectively arrive at the final price by talking with their largest institutional money manager prospects, at “road show” or one-to-one conversations, effectively gathering informal, oral bids for shares.  Hambrecht lets any brokerage customer place an emailed bid for shares at any price within the range.  The final price is the one at which enough bids can be accepted to complete the offering.  Everyone who bid at the final price or a higher number receives shares, at the final price.

The other difference is that Hambrecht includes individual “retail” investors in the bidding process.  Customers of the brokerage firm are emailed announcements of the offering and can access the preliminary prospectus before submitting a bid.  Bill Hambrecht’s reputation, network of acquaintances and persistence have kept the underwriting business going, including taking the lead for Google’s IPO.  Unlike some of the failed online investment bank ventures, Bill Hambrecht has never counted on being included in underwriting syndicates managed by the major investment banks.  His firm has been the managing underwriter for offerings, not making the mistake of thinking "that if you had distribution, the underwriters would cut you into the business.  It's a wonderfully profitable business for the big firms. They're the last guys that want to change it."  [Patrick McGeehan, “New-Era Banks Slip Into the Past,” The New York Times, June 22, 2001]

Hedge Funds

Hedge funds became major players in Wall Street’s buy side, largely because they could do things that others could not.  They are structured like mutual funds, gathering money from many persons under one manager.  But they use that money in all the ways that mutual funds are forbidden to do.  They get away with it by weaving their structures to fit specific exemptions from the Investment Company Act of 1939.  By 2010, there were 23,603 distinct hedge funds reporting performance data.  These funds had total assets of $1.41 trillion in 2009, down from the 2007 peak of over $2 million.  [Sizing the 2010 Hedge Fund Universe, and PerTrac 2009 Hedge Fund Database Study,]MATTACHMENT/PER0020_1368//PerTrac%202009%20Hedge%20Fund%20Database%20Study.pdf]

One of the two Investment Company Act exemptions used is for funds that have no more than 100 investors.  [Section 3(c)(1),]   The other exempts a fund held by no more than 500 “qualified purchasers.” [Section 3(c)(7),] They include an individual who owns at least $5 million in investments and institutions with at least $25 million in investments.   

Part of the New Deal legislation, the Investment Company Act was aimed at the investment trusts which flopped so dramatically in the 1929 Crash.  The law required that investment companies register with the SEC and provide prospectuses to all prospective investors.  There are several restrictions on the kinds of investments that can be made, to minimize the risk of loss from speculation.  The investments also must have an active market, so they can be sold quickly to pay investors who want their money back.  Two critical restrictions from the Act led to creating the hedge fund industry.  One is that a mutual fund manager may only be paid a flat percentage of the amount in the fund--no sharing in the profits or other performance fee is allowed.  The other is that the fund can’t borrow any money.  Most professional investors, even the heavily regulated banks, invest many times more than the amount they have received from investors.  They “leverage” that base by borrowing.  The interest due on the borrowings is supposed to be less than what they can earn by investing the extra cash.

Hedge funds are completely free of these restrictions, as well as all the other limitations of the Act.  They pay their managers big percentages of the profits (which have been taxed at 15% capital gains rates).  Most hedge funds borrow as much as they possibly can.  And they invest in absolutely any financial instrument that is presented to them, if it meets their risk/reward analysis.  [For a description of the beginnings of hedge funds, see Scott Patterson, The Quants, Crown Business, 2010, pages 33-35]

Their name, “hedge funds,” is a bit misleading.  The investing technique of hedging is a way to offset or neutralize the risk on one investment by also purchasing another, related investment.  It may mean buying shares in a technology company while also signing up for a put option on an index of technology stocks.  If the individual shares go down because of a tech selloff, the put option will have increased in price.  This is a strategy that an individual, or a pension fund manager might use. But hedge funds are into increasing risk, not reducing it.  They are more likely to find ways to increase the amount of their bet on an outcome that results from their unique insight, or access to nonpublic information.   However, they may use hedging to neutralize all the risks in an investment, except the one that they have figured out will work for them. 

Hedge fund managers play every game that can be found on Wall Street.  Some are technical games, like arbitrage, where simultaneous purchases and sales of securities are made in different markets when there is a miniscule price difference.  Some are fundamental analysis, like predicting that a particular company is about to have an event that will cause a sudden move in the price of its securities.  These predictions often get some help from spreading rumors and enlisting allies.  Then there is the ancient game of trading on insider information.

The first hedge fund is said to have been started by Alfred Winslow Jones in 1949.  [Sebastian Mallaby, Senior Fellow for International Economics at the Council on Foreign Relations and author of More Money Than God: Hedge Funds and the Making of a New Elite, Penguin Press, 2010, in "Learning to Love Hedge Funds," The Wall Street Journal, June 12-13, 2010, page W1]  They quickly grew in number to over 10,000 separate funds.  Several hedge fund managers received over a billion dollars in annual fees, from sharing in the results of their funds.  The standard compensation agreement for managers is 2% of the amount in the fund and 20% of the profits.  In 2007, that brought $3.7 billion in pay to John Paulson, the highest-earning hedge fund manager.  In second place was George Soros, one of the very first and most successful, who earned $2.9 billion for the year.  Average pay for the top 25 fund managers was $892 million in 2007.  To make the bottom of the list, it took compensation of $210 million.  [Institutional Investor Alpha Magazine, as reported by Bloomberg,; For more description of hedge funds, see Gregory Zuckerman, “Shakeout Roils Hedge-Fund World," The Wall Street Journal, June 17, 2008,].

It has not only been the hedge fund managers who have scored great wealth from hedge fund operations.   Banks and brokers provide capital and support services to hedge funds.  Called Prime Brokerage, it includes executing and clearing trades, bookkeeping, preparing reports, keeping custody of securities and cash, borrowing securities for short sales and providing research.  These are just add-ons to the two basic services.  One of these is lending huge amounts of money for hedge funds to take their positions.  The other is recruiting new investors for the hedge funds.   

As the relationship between hedge fund managers and their prime brokers expands, the “research” and financing take on new meaning.  Banks and brokers make their own moves in the markets, although they are far more restricted in what they can do.  Once there is an inner circle closeness, the prime broker can pass information and lend money to the hedge fund, so that it can make a transaction that the prime broker couldn’t lawfully do itself.  Ways are found for the hedge fund to pay the prime broker, sharing some of the gain from the transaction.  “Reportedly, the prime broker banks get up to 20 percent to 30 percent of their total bank revenues from hedge funds . . ..”  [Charles R. Morris, The Trillion Dollar Meltdown, PublicAffairs, 2008, page 111]   In 2010, hedge funds “shelled out a total of about $3.7 billion in brokerage commissions to banks for equity trades, according to research firm Greenwich Associates.”  Benefits they got from the brokers included “special access to senior deal makers and corporate executives at dinners and other gatherings.”  [David Enrich and Dana Cimilluca, “Banks Woo Funds With Private Peeks,” The Wall Street Journal, May 16, 2011, page A1, A14] 

In the aftermath of the 2008 Panic and its aftermath, hedge funds may have peaked in attracting money from institutions and wealthy individuals.  “’We used to rely on the public making dumb investing decisions,’ one well-known Manhattan hedge-fund manager told me. ‘but with the advent of the public leaving the market, it’s just hedge funds trading against hedge funds. At the end of the day, it’s a zero-sum game.’ Based on these numbers—too many funds with fewer dollars chasing too few trades—many have predicted a hedge-fund shakeout, and it seems to have started. Over 1,000 funds have closed in the past year and a half.”  [Gabriel Sherman, “The End of Wall Street As They Knew It: After surprisingly successful financial reform, public vilification, and politics that have turned against them, the Masters of the Universe are masters no longer,” New York, February 5, 2012,]

Rating agencies

Before the 1970s, the role of securities rating agencies was about as important as the job of sewing labels onto clothing.  They existed to judge the risk that bond issuers would default on their duty to pay interest on time or return the principal when due.  Certain institutional investors were limited to purchasing only the highest rated bonds from corporations or governments.

When Wall Street began marketing new securities, especially those packaging mortgages, it was especially important to get an “investment grade” rating from Standard & Poor’s or Moody’s, the two principal rating agencies.  These new securities were far more complex than the simple promise to pay by a corporate or government borrower.  Few money managers would be willing to do all the work necessary to understand and evaluate the quality of a few thousand loans, or the legal niceties of a 150-page bond indenture.

Rating agencies were persuaded to begin rating mortgage-backed bonds, which were like a corporate bond, with a pool of loans as collateral for extra assurance that the bond was good.  Once comfortable with these, rating agencies were willing to rate interests in the pools of loans themselves, known as pass-through certificates.  Finally, ratings could be had for collateralized mortgage obligations and their many variations.  Rating agencies are paid by the issuers of the securities they rate.  This, by itself, is not necessarily a compromising arrangement.  Audit firms are paid by the businesses they audit, even though lenders and investors rely upon their audit opinions.  For rating agencies, it is the relationship with the handful of investment bankers and their lawyers that may have led to a breakdown in their analytical independence.

Insurance companies

Most debt securities could never get favorable results from a rating agency without some form of third-party credit.  Sometimes, a parent company could guarantee its subsidiary’s performance.  More often, the backing was purchased from an insurance company.  The rating agency would rely on the insurance company’s own financial condition, which needed to support a top rating.  As insurance companies kept up with the boom in asset-backed securities, their exposure to risk grew phenomenally.  For some reason, the rating agencies didn’t seem to let this affect their decisions. 

Counterparties to credit default swaps

Insurance companies could never handle all the debt structures that Wall Street was inventing.  The answer was to leave out the word “insurance” and let others into the role of promising to cover any defaults by borrowers.  Brokers began arranging for a “counterparty” to take over the investor’s risk, calling it a “credit default swap.”  According to Charles Morris, the amount of credit default swap contracts went from $1 trillion in 2001 to $45 trillion in 2007.  Banks were the counterparties on $18 trillion and hedge funds were in for $15 trillion.  [Charles R. Morris, The Trillion Dollar Meltdown, Public Affairs, 2008, page 125]  Somehow, people tended to ignore the possibility that several big borrowers could default or, even more significantly, that a counterparty would have gotten in way over its ability to make good on its promises.

Venture Capital Becomes Another Wall Street Money Manager

In the 1950s and 60s, venture capital firms were run by wealthy individuals who put together pools of capital from people like themselves.  They were averaging higher returns than investing in traded securities and someone got the idea of gathering really big money from university endowments and other institutional money managers who were into “total return” investing.  As a result, venture capitalists have become money managers for institutional investors, feeding their investments into the sell side for public offerings or acquisitions.  Less than 2% of the money in venture capital funds comes from the managers, who take fees equal to 2% of the total fund amount plus 20% of profits when an investment is cashed out.  Plenty of information is available about venture capitalists and their investments, from the National Venture Capital Association and PricewaterhouseCoopers.  [ and

The results of going after big money were first a big increase in venture capital investing, to 1.1% of U.S. Gross Domestic Product in 2000, followed by a continuing decline.  The need to produce short-term returns for institutional investors has meant investing in later stage companies and exiting the investment much sooner.  Since 1997, investors have actually lost money in venture capital funds, after paying the managers’ fees.  [Carl Schramm, president of the Kauffman Foundation, and Harold Bradley, its chief investment officer, “How Venture Capital Lost Its Way,” Business Week, November 30, 2009, page 080.  See John Jannarone, "Venture Capital Could Shrivel Away," The Wall Street Journal, July 19, 2010, page C8]  Some new firms are going back to the original model.  [Spencer E. Ante, “’Super Angels’ Shake up Venture Capital,” Business Week, May 21, 2009, and Spencer E. Ante, “ Nurtured by Super-Angel VCs,” Business Week, September 15, 2009,]   

One summary of Wall Street:  "In a soundbite, the U.S. financial system performs dismally at its advertised task, that of efficiently directing society's savings towards their optimal investment pursuits.  The system is stupefyingly expensive, gives terrible signals for the allocation of capital, and has surprisingly little to do with real investment."  [Doug Henwood, Wall Street: How It Works and for Whom, Verso, 1997, page 3.  The book is now available free online, at]



Table of Contents

Why We Once Needed Investment Bankers and Don’t Anymore

Once upon a time, investment bankers were useful.

Back before there were investment bankers, anyone who needed money for developing a business would go directly to family and friends.  Larger projects could mean taking a proposal to the local wealthy family.  Perhaps an acquaintance would arrange a referral or introduction, but the presentation and negotiations were directly between the person who had the money to invest and the one seeking to be the steward of that money.  

Direct investing was too limited before electronic communication

As projects grew larger throughout Europe, businesses raised money through direct relationships with “wealthy private individuals and influential politicians.”    [Samuel L. Hayes, III, A. Michael Spence, David Van Praag Marks, Competition in the Investment Banking Industry, Harvard University Press, 1983, page 6.]  As the amounts needed increased, the job of raising money took precious time away from developing the business, and often the money wasn’t raised in time to do any good.  The means of communication were limited to writings delivered on foot or horseback and to personal meetings.  Gathering information about prospective investors meant innumerable approaches to someone who might know someone.  As a result, a market grew for the services of an intermediary to find prospective investors and arrange the terms. 

Financial intermediaries exist to match the needs of people who want income from their money with the needs of those who want to use that money.  Some financial intermediaries, like banks, gather money from depositors and furnish money to individuals and businesses.  As the money flows into and out of these institutions, it is transformed in amount, in the rate of interest paid and in the risk of loss.  Those of us who deposit our money in a bank have no control over where it goes, no knowledge of how it is used.

These depository institutions work well, but only within a narrow range of risk and reward.  Depositors are mostly interested in safety and convenience.  We’re willing to settle for low interest rates on savings and perhaps no interest on our checking account. Borrowers understand that banks want their money back, usually within a year or so, and they also want ways they can recover their money if the borrower doesn’t pay on time.   

Just having bank deposits and bank loans is not enough.  Many of us are willing to take more risk than a bank deposit, in the hopes of getting a higher return.  On the other side, there are businesses with a need for capital that can be used for longer times, and at a higher risk of loss, than banks would tolerate.  That’s where securities come into play.  These securities are agreements between the providers of money and the stewards who will be using that money.  Until recently, when options, futures and other “derivative securities” became popular, securities meant either part ownership in a business (“shares” or “stocks”) or a promise to repay the money with interest (“bonds”).     

The Role of Investment Bankers—in Their Beginning Years

Investment bankers are financial intermediaries who arrange for securities to be issued and purchased.  They’re also hired by companies who are trying to buy or sell businesses, in mergers or acquisitions.  This business is usually countercyclical to new securities issues and brings in fees while waiting for the next bull market.  Most investment bankers are part of a commercial bank holding company or a securities broker-dealer which includes groups of brokers, buying and selling securities as agents. These firms also include departments acting as dealers, trading in securities for the banks’ own speculation.  

 This chapter is a brief description of the need that introduced investment banking and how investment bankers have kept hold of their role as intermediaries in the movement of money between those who have it to invest and the businesses and governments who want to use the money.  In idealistic theory, the investment banker's “job is to serve the users and suppliers of capital by providing the facilities through which savings are channeled into long-term investment.” [Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970 and 1979, page ix of the 1970 edition.  This chapter is drawn from three sources, principally from Professor Carosso’s book, 1970 edition, from Charles R. Geisst, Wall Street: A History, Oxford University Press, 1997, and from Samuel L. Hayes, III, A. Michael Spence and David Van Praag Marks, Competition in the Investment Banking Industry, Harvard University Press, 1983.  Professor Carosso’s book resulted from an offer to Harvard from Kidder, Peabody & Co. to pay for a scholarly history of that major investment banker.  Professor Carosso expanded it to include American investment banking generally.  Kidder, Peabody was started in 1865.  After it was acquired by General Electric in 1986, the firm was embroiled in insider trading scandals, depicted in James B. Stewart’s book, Den of Thieves, and the movie, Wall Street.  After a trading fraud was uncovered in 1994, GE sold Kidder Peabody’s assets and the firm ceased to exist.  Professor Carosso died in 1993.  Charles Geisst is the author of several books about Wall Street, including 100 Years of Wall Street, McGraw Hill, 2000, Monopolies in America, Oxford University Press, 2000, The Last Partnerships: Inside the Great Wall Street Money Dynasties, McGraw Hill, 2001 and Wheels of Fortune: the History of Speculation from Scandal to Respectability, John Wiley & Sons, Inc., 2002.  Competition in the Investment Banking Industry grew out of a study requested by the Antitrust Division of the Justice Department, when it was considering the competitive implications of a proposed merger of securities firms.  One of the three authors, Samuel L. Hayes, III, is professor of investment banking at Harvard Business School and the most-quoted authority on U.S. investment banking.]

America’s structure for investment banking was drawn from what had been going on in England and Northern Europe.  In the 1700s, most investments were sold directly by the issuer to wealthy individuals.  That meant that managers of the enterprise had to develop the relationships with investors and negotiate the terms with each one.  This took a great deal of time away from developing the business, while they risked being left with less capital than they needed to raise.  As projects became larger, there was a great need to have someone else raise money, for a percentage commission.  The first intermediaries were called loan arrangers, and they would find both sides of a transaction and shepherd it through to funding.  That certainly speeded up the process and saved time for the entrepreneur, but it still left the uncertainty of how much money would be gathered and when it would be available for use. 

Late in the 18th century, investment banking partnerships began using their pooled capital to buy an entire issue and then resell it to wealthy individuals.  This was attractive to the issuer because it had to deal with only one buyer in one transaction, before getting on with using the money for the business.  To purchase larger issues, these partnerships “often cooperated in putting together secret lists or embryonic syndicates for sharing the risks . . ..”  [Competition in the Investment Banking Industry, Samuel L. Hayes, III, A. Michael Spence and David Van Praag Marks, Harvard University Press, 1983, page 7]   

Even with these early intermediaries, the people who were waiting to use the money still had the risk that it might not get completed, or that it could be delayed.  The need remained for someone to take over the risk that the funding might not happen, or might come too late.  Borrowing a term from the insurance industry, there was an opportunity to “underwrite” this risk.  As competition heated up among financial intermediaries, some of them began agreeing to deliver the money, less their commission, at a specific date.  They came to be called “underwriters,” and took over the risk that something might go wrong before the investors had all paid for the securities they ordered. 

Before a securities issue (called “flotation” in Europe) came to market, underwriters gathered lists of other intermediaries and investors who expressed interest, negotiated the terms with the issuer and committed to pay at closing.  That basic structure is what investment bankers still do today.  However, we’ll see how the risk of a failed financing has been shifted almost entirely back onto the issuers, so the term “underwriter” is a today just a vestige of the original insurance concept. 

Of course, underwriting a risk provides comfort only to the extent that the underwriter has the resources to make good on the risk.  To achieve this credibility, the underwriting firms became groups of owners and lenders, so that they had access to substantial cash or liquid assets.  Some of them were private banks, which took in deposits from the very wealthy.  Others were merchant banks, offshoots of trading businesses.  They gradually came to be known as investment bankers.  For most offerings, several investment banks joined together to underwrite the securities. 

At first, these new investment bankers “purchased newly issued securities as a group at a fixed price, then sold them individually at times, places and prices of their choosing.”  [Paul G. Mahoney, The Political Economy of the Securities Act of 1933, University of Virginia School of Law, Law & Economics Working Paper No. 00-11, May 2000, page 5,] This cooperative structure took away competition among investment bankers in negotiating with the business or government that was raising capital.  But they were still competing in lining up prospective investors.  So, their next step was to eliminate that competition through the “syndicate system,” where the syndicate members agreed they would all sell at the same price and time.  It was up to the syndicate manager to complete negotiations and keep everyone else in line.  The reason for using this oligopolistic hierarchy:  “The profits to be made from such flotations were so immense and the mutual benefit of maintaining discipline among syndicate participants in the flow of capital was so clear that the competitive pyramid was an indisputable fact by the 1820s.  The early division of firms between the apex and the body of the pyramid was thus a natural outgrowth of competitive dynamics as they then existed.”  [Competition in the Investment Banking Industry, Samuel L. Hayes, III, A. Michael Spence and David Van Praag Marks, Harvard University Press, 1983, pages 8-9]

After the American Revolution, the new United States of America relied on the European investment bankers to finance its acquisitions and wars.  To pay France for the Louisiana Purchase in 1803, the United States hired Baring Bros., the dominant merchant bank in England.  The fact that the money raised would help Napoleon pay for France’s war against the English did not interfere with the underwriting.  As one member of the Baring family and bank put it, “Every regulation is a restriction, and as such contrary to that freedom which I have held to be the first principle of the well-being of commerce.”  [Stephen Fay, The Collapse of Barings, W.W. Norton, 1996,

Growth spurts for investment banking in the United States have come from financing wars. Before the War of 1812, long-term financing in America was a sideline of merchants, to facilitate their main business, along with a few loan contractors.  Alex. Brown & Sons, which started as a linen merchant, is claimed to have conducted the first initial public offering in the United States, of Baltimore Water Company in 1808.  [  Alex. Brown is now part of Deutsche Bank.]   

The American Revolutionary War had been paid for largely by printing money.  That was a financing method of last resort and led to hyperinflation. [“Inflation and the American Revolution” by H.A. Scott Trask, Ludwig von Mises Institute,]   Currency printed by the Continental Congress was worth one-thousandth of its face amount by war’s end, leading to the phrase, “not worth a Continental.”  The Continental Army also used “impression,” the confiscation of supplies rather than paying for them.  Bitter resentment lingered long after the war.

To pay for the War of 1812, the U.S. Treasury tried to get the public to buy $16 million in bonds.  The federal government had trouble finding buyers and nearly $10 million ended up being sold to what would later be called an “underwriting syndicate,” made up of the very wealthy John Jacob Astor and Stephen Girard and the former head of a British mercantile banker.  The government got only 40% of the bonds’ face amount, an immense discount.  This discount between the purchase price from the issuer and sales price to the investor is still called the “underwriting spread.”  The syndicate financed the transaction with short-term borrowings and resold the bonds to their wealthy business acquaintances, at more than twice what they had paid.  [Wall Street: A History, by Charles R. Geisst, Oxford University Press, 1997, pages 18-19]. 

By the 1830s, private banks were formed in the United States to help finance roads, canals and then railways.  The bankers diversified into buying and reselling these new issues of securities.  The market also attracted European investment bankers who set up American firms. [Wall Street: A History, by Charles R. Geisst, Oxford University Press, 1997, page 37-42]  Banks which took deposits from the public also got into the business of buying securities from issuers and reselling them.  That brought one of the problems that would later cause the legal separation of commercial and investment banking—banks making short-term loans to businesses as a way to get the commissions on buying and reselling their long-term securities.  Investment banking as a stand-alone business in America may have begun with Nathaniel Prime, who left stock brokerage in 1826 to form Prime, Ward & King.  He “would approach a firm and offer to take an entire new issue of stock or bonds, and then distribute it to clients, many of whom were overseas.”  [Robert Sobel, Inside Wall Street, W.W. Norton, 1977, page 197]  

Financing the Mexican War (1846-48) helped bring in British private banks, which set up American affiliates.  They accepted deposits only from very wealthy British and Europeans, using the funds to buy new bond issues for resale.  The timing of their fundraising from the rich coincided with a flight of capital from Europe.  The concept of property was being challenged by European intellectuals, creating the first “red scare” of communism.  Marx and Engels had published The Communist Manifesto in 1848.  According to its opening words:  “A spectre is haunting Europe — the spectre of communism.”  [Karl Marx and Frederick Engels, Manifesto of the Communist Party, 1848,] That spectre helped make wealthy Europeans ready to invest in the United States.  [Wall Street: A History, by Charles R. Geisst, Oxford University Press, 1997, page 45]

The new business of investment banking got its big push from the Civil War.  Lincoln’s treasury secretary, Salmon P. Chase, failed at selling bonds to the commercial banks and failed again trying to sell bonds to wealthy individuals and businesses.  He brought in Jay Cooke, who had a new private banking house.  Cooke had learned about the securities business when he was a young reporter for the New York Herald. His Wall Street-hating editor had him exposing securities manipulations.  Cooke chose to sell the government’s war bonds to the general public, making sales in amounts as small as $50.  The bonds paid good interest and could be purchased by people of modest means.  Cooke had a sales force of 2,500, in every Union state and territory, and used newspaper advertising, posters and handbills.  There were night sales offices, called “Working Men’s Savings Banks.”  In one year, 1864, Cooke sold $360 million in bonds.  [Robert Sobel, Inside Wall Street, W.W. Norton, 1977, page 199]  He "transformed government bond sales into a mass-market enterprise.  By the end of the war, Cooke had enticed one out of every four Northern households to buy war bonds . . .."  [Allen C. Guelzo, Abraham Lincoln: Redeemer President, William B. Eerdmans Publishing Co., 1999, page 380]

In marketing the war bonds, Cooke introduced what we today call “dual motive” marketing of securities.  In addition to safety, return and convenience, he also appealed to the patriotism of those who wanted to win the war and preserve the Union.  One of his newspaper ads read:  “But independent of any motives of patriotism, there are considerations of self-interest which may be considered in reference to this Loan.  It is a six per cent loan free from any taxation.”  [Quoted in Charles R. Geisst, Wall Street: A History, Oxford University Press, 1997, page 52, from Henrietta M. Larson, Jay Cooke: Private Banker, Harvard University Press, 1936, page 69.]  For a brief period, a century and a half ago, there was a model for the middle class to invest in securities. 

  Cooke introduced a form of “underwriting commitment” between his underwriting syndicate and the issuer.  Unlike today, the syndicate did not commit to purchase and resell the entire offering.  Rather, the issuer had a period of direct marketing and the syndicate agreed to buy what was left.  The syndicate was underwriting the risk that the direct marketing effort would fail to sell the entire offering.  If that happened, then the members of the syndicate would purchase the unsold portion and try to resell it.  Today, this would be called a “standby commitment.” It is now used only in so-called “rights offerings,” where existing shareowners have the right to purchase a new issue of shares, usually at a discount to the market price.  Underwriters agree to buy any shares not taken by the shareowners.  The Cooke program, of a direct marketing by the issuer with a standby commitment, hasn’t been in serious use since 1900.  All underwritten offerings must now be sold exclusively through the underwriters, and their full commission paid.  (My first client in an underwritten initial public offering had commitments from its officers, directors and their families to buy a substantial portion of the offering.  I tried to negotiate an exclusion of these shares from the underwriting and was told that it was never, never done.  The client was asked to turn over the names to the managing underwriter, so they could get credit for commissions on those sales--and also try to add them as customers for other products.)  Cooke also adopted the European practice of repurchasing bonds in the aftermarket, to maintain the price level while new bonds were still being sold, a practice later to be called “stabilization” and protected by the Securities Act of 1933.

 While the words “underwriting” and “underwriters” are still being used, they no longer have the original meaning of underwriting a risk, like insurance companies do.  Today, the underwriting agreement is only signed when all of the shares have been spoken for by investors and all regulatory steps have been cleared.  There is a period of just a few hours during which the underwriting syndicate owns the securities, before payment is received from investors, the underwriting commission is collected and the balance is turned over to the issuing business.  Even for those few hours, there is a “market out” provision in the underwriting agreement for a list of calamities that could occur and allow the underwriters to call off the closing.

In addition to Cooke’s sales to the United States middle class, the Civil War caused German immigrant merchants to start businesses to gather money from Europe’s wealthy families looking for safe havens from communism.  Some of these became major investment banking firms, such as Goldman Sachs and the late Lehman Brothers.  The War also caused New Englanders to start “Yankee houses,” such as J. Pierpont Morgan & Co., which has today become both J. P. Morgan Chase and Morgan Stanley.

After the Civil War, Jay Cooke tried to apply his war bond marketing system to bond issues for the Northern Pacific Railroad.  It didn’t work.  Cooke made at least three mistakes that are now classic “don’ts” of corporate finance.  One was that he advanced short-term funds to the railroad, which insisted on building rails faster than the bonds could be sold.  This put Cooke into a different relationship with the client, one of creditor rather than service provider.  That affects judgment, like lawyers representing themselves.  Another error was to count on participation by other bankers (in his case the Rothschilds) without receiving a clear commitment.  (A client of mine once assured a prospective investor that a bank had made “a moral commitment” for a substantial loan.  The investor responded that “a bank is incapable of making a moral commitment.”  He went on to explain that my client may have had a moral commitment from a bank officer, but the officer may be transferred or easily overridden by a senior officer or committee.)

Cooke’s third mistake was to misjudge his market, the small investors.  Railroad bonds did not appeal to patriotism.  Instead of a “dual motive,” the investor was left with a straightforward financial risk/reward analysis.  That is a daunting challenge for a part-time investor.  There was no real comparison to be made between U.S. government bonds and any private sector investment opportunity.  With War Bonds, the only real risks were that the war would be lost, or that it would generate hyperinflation and make the money worth less when it was repaid.  By contrast, railroad bonds meant assessing the feasibility of the new routes to be built, the competition and the management.  (We advised on a direct public offering for a railroad, but used a dual motive marketing.  Rather than bonds, it offered shareownership to residents of its service area, to its riders, railroad buffs and other communities that wanted to support the railroad as well as try for a gain on the value of their shares.)

The advances Cooke had made to the railroad caused depositors in his private bank to withdraw funds.  Cooke went out of business in 1873, setting off a major panic on Wall Street. That “brought a speedy end to the first great effort of investment bankers to develop a large, permanent class of small investors.”  The firms that survived sold “new issues abroad and to a select American clientele of large, individual and institutional buyers.”  [Samuel L. Hayes, III, A. Michael Spence and David Van Praag Marks, Competition in the Investment Banking Industry, Harvard University Press, 1983, page 26]

Before the 1890s, most businesses were still conducted as family partnerships.  So long as the entrepreneur/founder remained in charge, expansion capital came from retained earnings and bank borrowings.  When the business ownership passed on to the second and third generation family members, they were the ones who turned to investment bankers to raise capital and convert some of their holdings to cash.  Railroads, their lawyers and lobbyists had developed the law of corporations to become the favored form for larger businesses.  With incorporation, outside investment, beyond family and friends, became popular.  Investment banking expanded from government securities through railroads to businesses in all industries.  By 1910, there were underwriting syndicates of more than a hundred banking and brokerage firms. Steady relationships were developed between investment banks and the regular issuers of securities, as well as with the money managers at commercial banks and insurance companieswho were the principal investors. 

Ever larger transactions were to come from combining several competing businesses and selling securities in the consolidated corporation.  In 1901, J.P. Morgan put together the United States Steel Corporation, America’s first billion dollar business.  After the new corporation issued securities to the owners of the companies it acquired, Morgan managed an underwriting syndicate of about 300 firms as members.    

Along with the increased volume of securities offerings, “fewer and fewer corporations chose to sell their own securities, as had been common a generation earlier, when an issuer’s reputation often was greater than that of the banking house.”  [Samuel L. Hayes, III, A. Michael Spence and David Van Praag Marks, Harvard University Press, Competition in the Investment Banking Industry, 1983, pages 53-54]  Prestige became the principal competitive tool among investment bankers.  Their status was reflected in the newspaper advertisements for completed offerings, the so-called “tombstone announcements” with their pyramid listings from the managing underwriter at the top through several status tiers to the large base at the bottom.

Even with all this vast expansion to serve the demand for capital, the supply side for investment was still limited to institutions and wealthy individuals.  “Before World War I, only the very wealthy invested in securities.  Most of them lived in other countries.  Investment banks had the relationships with those investors.  They were the gatekeepers to raising capital within a few months.”  [Raghuram G. Rajan & Luigi Zingales, Saving Capitalism from the Capitalists, Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity, Crown Business, 2003, page 220.]

We have an image of investment banking in 1913, from Harper’s Weekly articles written by Louis Brandeis, a successful corporate lawyer who also took on many public causes before his 1916 appointment to the U.S. Supreme Court.  “The original function of the investment banker was that of a dealer in bonds, stocks and notes; buying mainly at wholesale from corporations, municipalities, states and governments which need money, and selling to those seeking investments.  The banker performs, in this respect, the function of a merchant; and the function is a very useful one.”  [Louis D. Brandeis, Other People’s Money: And How the Bankers Use It, National Home Library Foundation, 1933, page 5]  That original function was about to become subordinate to other, more profitable activities, as another war was to change Wall Street.

The Middle Class Enters the Investment Market

To pay for World War I, the U.S. Treasury issued the Liberty Bonds of 1917-18 and the Victory Bonds of 1919.  All of the bond issues sold out and a total of $21.5 billion in bond sales were made in just over two years.  According to the Annual Reports of the Treasury Secretary, the first Liberty Bond issue was purchased by four million individuals and the second by nine million.  By the fourth issue, there were over 21 million individuals purchasing.  By comparison, the Treasury Reports estimated that only about 350,000 individuals purchased bonds in the years before the war began.  [Paul G. Mahoney, The Political Economy of the Securities Act of 1933, University of Virginia School of Law, Law & Economics Working Paper No. 00-11, May 2000,, page 8, citing the Annual Report of the Secretary of the Treasury for 1917, H.R. Doc. No. 613, 65th Cong., 2d Sess., at 6 (1918) and the Annual Report of the Secretary of the Treasury for 1918, H.R. Doc. No. 1451, 65th Cong., 3d Sess., at 18 (1919).]

The Treasury Department made some direct sales, using marketing methods that Jay Cooke had developed for the Civil War.  These direct offerings included small denomination saving stamps and bonds purchased on the installment plan.  However, the great majority of the bonds were sold through commercial banks, investment bankers and securities brokers, all working without commission.  These intermediaries had a longer-term self interest. As Investment Bankers Association then-president Warren S. Hayden said, about expanding the market for securities, “the government will have done in a year or two what our private enterprise as it was before the war could not have done in decades.” [quoted in Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970 edition, page 228.]  Selling the huge volume of war bonds required marketing to the middle class, people who had never invested in securities. These first-time investors needed to be taught to trust parting with their money in return for nothing more than a piece of paper. 

The commercial banks were particularly imaginative and aggressive in selling Liberty Bonds and Victory Bonds to the nonwealthy.  Banks opened branches convenient to working people, kept evening hours and advertised. National City Bank of New York, the largest American bank of the time and now called Citibank, even had “a network of salesmen who went door-to-door.”  [Raghuram G. Rajan & Luigi Zingales, Saving Capitalism from the Capitalists, Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity, Crown Business, 2003, page 220-21]  “Bonds were sold on the installment plan with interest charges offset by interest on the bonds, creating a virtually cost-free way for small investors to buy.”  [Lawrence E. Mitchell, The Speculation Economy, Berrett-Koehler Publishers, Inc., 2007, page 253]  Employers were encouraged to buy bonds and resell them to their employees, deducting installments from their paychecks.

“These developments changed the distribution process for new issues. Bankers perceived that more money could be obtained from the millions of middle class wage earners than from a few wealthy families. Moreover, the Liberty Loan drives produced a generation of salesmen who were experienced at contacting hundreds or thousands of retail customers rapidly.  After the war, these salesmen created a nation-wide network of securities dealers who specialized in selling securities to individual investors.   These securities dealers employed 6,000 stock and bond salesmen in 1910, increasing to 11,000 in 1920 and 22,000 by 1930.” [Paul G. Mahoney, The Political Economy of the Securities Act of 1933, University of Virginia School of Law, Law & Economics Working Paper No. 00-11, May 2000,, page 12, citing the U.S. Dept. of Commerce, Bureau of the Census, Historical Statistics of the United States, Colonial Times to 1970, Part 2, p. 1104 (Washington, DC, US Government Printing Office, 1975).]

The new retail dealers purchased new issues for resale and also held inventories of securities traded in the secondary markets, to meet the growing demand of middle class households for investments.  As attention turned to “the masses” for distributing securities, new securities brokers were formed and became members of selling groups.  Retail dealers became the base of the securities distribution pyramid, with the managing underwriter at the peak.  They were not included in the underwriting syndicates, where membership was only for traditional investment bankers.  After selecting members of the underwriting syndicate, the managing underwriter would pick firms to become part of a “selling group.”  These dealers would be allotted a portion of the syndicate’s commitment, at a markup from what the syndicate paid the issuer but still at a discount from the price charged to the investor.  They had to sell at the same price and time set by the syndicate manager, or “bookrunner.” 

The managing underwriter’s authority to include brokerage firms in the selling group continues to be a powerful tool for enforcing anticompetitive practices.  For instance, syndicate managers would keep out brokers which had participated in a “best efforts underwriting.”  Those are offerings in which a broker agrees with the issuer to use its best efforts to sell the securities and to get paid only for what it sells.  Investment bankers will only do “all or nothing,” “firm commitment” underwritings and they discourage anyone breaking ranks with any other arrangement.   J.P. Morgan & Co. and other established investment banking firms continued as wholesalers only, creating syndicates and selling groups of up to 1,200 firms.

The war bond success with smaller investors was the carrot for investment bankers to expand their market for selling new securities issues.  The stick was the new federal income tax.  Investment banker Paul Warburg was quoted in The Magazine of Wall Street that taxes had “decreased the importance of the one-time class of professional capitalists as the exclusive field to cultivate for the purpose of placing investment securities.  The savings of the masses will become an element of growing importance in the regard, if private enterprise is to successfully finance the future of our country.”  [“Paul M. Warburg Says:  ‘Immigrants Are Potential Capitalists’,” June 26, 1920, page 226, quoted in Vincent P. Carosso,  Investment Banking in America: A History, Harvard University Press, 1970 edition, page 251.]  As the War Bonds matured, Wall Street sold corporate bonds to the new investor class. By the 1920s, more businesses had begun using shares, as well as bonds to raise capital, and more individuals were becoming investors.  Commercial banks, the institutions that took in deposits from the public and made loans to individuals and businesses, had been a big part of the War Bond campaigns.  After the war, they used the teams they had built to sell corporate bonds and then ownership shares to individuals.  Commercial banks had branch offices and consumer credit relationships, so they could serve the bank’s business loan customers who needed to sell securities for long-term growth capital.  The bank’s deposit customers became their market for bonds and stocks.

Commercial banks began acting like investment bankers, forming affiliates to underwrite securities issues.  Their market share got larger each year until, just before the Great Depression, commercial banks and their securities affiliates were the underwriters for nearly 37% of new issues.  By 1930, they were the selling firms for over 60 percent of the underwritten stocks and bonds.  “Their role in distribution made commercial banks by far the most important element in the investment banking business.  They relied heavily on salesmen and advertising, and the affiliates appealed directly to the parent’s deposit customers, with whose accounts and habits they were familiar.”  [Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970 edition, page 279.]

Cutting Out Commercial Bank Competition—and the Middle Class

Investment bankers maintained their position as intermediary for raising money from wealthy individuals, institutional money managers and securities brokers.  Commercial banks were becoming the channel for money from the middle class.  We’ll never know what would have happened if the commercial banks had been able to continue their competition with investment bankers for supplying capital to businesses and government.  Instead, two related intervening events put investment bankers back into their monopoly control over the issuance and sale of new securities.

One event was the steep decline of the financial markets as we went into the Great Depression.  Long-term capital, for which bonds and shares are issued, is the fuel for growth.  There just wasn’t much growth during the 1930s and very little demand for the services of investment bankers in their role as securities underwriters.  On the supply side, those who could have afforded to invest were not encouraged to do so in the Depression environment. 

The opening for investment bankers to get rid of their competition came with the public anger over money it lost on stocks and bonds purchased in the Roaring 20s.  Commercial banks had been full participants in the speculation and manipulation that was exposed after the 1929 stock market crash.  Stories of their bad practices were used to help Congress enact the Banking Act of 1933, prohibiting commercial banks from being investment bankers or selling securities.  More about how investment bankers carried off this maneuver is in the chapter “The Traffic Cops on Wall Street.”

The new law, known as Glass-Steagall after its authors, protected the investment bankers’ monopoly for another half century.  It also created the Federal Deposit Insurance Corporation, to guarantee bank depositors that they could get their money back if the bank failed.  The law also put ceilings on the interest rates banks could pay depositors, protecting them from price competition.  Banks with securities marketing affiliates had a choice:  Give up the securities business or operate without government-insured deposits.

After their success in lobbying Congress to get commercial banks off their turf, investment bankers kept the capital channels restricted to their “preferred lists” of institutional money managers, securities brokers and wealthy customers.  There were good reasons for the less wealthy to avoid investing in the 1930s, but one of them was that no one was trying to sell them securities.  Investment bankers returned to what they had been doing before World War I opened up the middle class market—moving money from the wealthy to big business.

Our Government Bypasses Wall Street to Pay for World War II

In World War II, the U.S. government spent over $300 billion, more than it had spent in all of its pre-war existence.  The federal budget went from $9 billion in 1939 to $98 billion in 1945.  Some of the cost was met by increased taxes, but most of it was financed by selling bonds.  A total of $185.7 billion in bonds were sold to more than 85 million Americans, about half the total population.  Most of the bonds paid interest at less than the going rate for government and corporate bonds.  Marketing vehicles included the Payroll Savings Plan, where employers deducted bond purchase amounts from every paycheck, and savings stamps, at ten cents each, sold for children to buy and paste in booklets to be turned in for bonds.  Selling bonds to people at all income levels also soaked up money that might otherwise have been spent on the limited consumer goods that were available during the war, which could have caused inflation. 

World War II bonds were a great and successful direct public offering.  Unlike all of our other wars since the American Revolution, investment bankers were not chosen to underwrite the bonds.  The U.S. Treasury set up a War Finance Division which used all available media to bring Americans into regular bond purchases.  Advertising space and time were donated by newspapers, magazines and radio stations.  Movie stars and other public figures appeared at bond rallies and held radio telethons. Irving Berlin wrote the theme song, “Any Bonds Today,” performed by the Andrews Sisters.  Auctions for bond purchase pledges were held for items like Betty Grable’s stockings and Man-o-War’s horseshoes.  Some businesses created and placed their own ads to promote war bond purchases.

The actual selling to individuals was done by volunteers.  They were trained to go door-to-door and to staff kiosks.  Without receiving any commissions or other pay, the volunteers made telephone calls to arrange times to meet at a home, place of business or sales kiosk. Communities were given quotas and put in contests for selling the most bonds.  One can only imagine what could have been done with the tools of the Internet.

Even with this immense and successful marketing, banks and other institutions and businesses bought three times the dollar amount of war bonds that were sold to individuals.  These purchases were for the firms’ own investment and not for resale.  Investment bankers and other financial intermediaries were not a significant factor in financing World War II.  The biggest financial transaction in history had bypassed investment bankers.  Perhaps the chilly relationship between Wall Street and the Roosevelt administration had something to do with it.  Maybe it was simply the realization that direct marketing from the government to the public would be better and cheaper.

When the last War Bond had been sold, there was no recorded sign of financial intermediaries using the direct offering program to market other securities.  New securities issues were still dominated by the same investment bankers and they stayed with their underwriting syndicates, selling to other broker/dealers, institutional money managers and wealthy individuals.  But now, investment bankers and securities broker-dealers had the market all to themselves.  Commercial banks had been frozen out by Glass-Steagall, the Banking Act of 1933.  The New Deal securities laws entrenched registered securities broker-dealers as the monopoly for selling securities.  It had become unlawful to even attempt to act as a financial intermediary for securities, without first being registered with the SEC as a broker-dealer.  [Securities Exchange Act of 1934, Section 15,]

Wall Street—But Not Investment Bankers--Court the Middle Class

After the World War II, many retail brokerage firms did seriously try selling to the middle class.  They focused on trading previously-owned securities on the exchanges and in the over-the-counter markets.  They also sold to retail customers from their allotments of securities in underwritten public offerings.  “Having a stockbroker became as necessary as having a minister or a psychiatrist in the new American middle-class society . . ..”  [Charles R. Geisst, Wall Street: A History, Oxford University Press, 1997, page 274] The bull market that developed after President Eisenhower’s 1952 election continued for more than fifteen years.  Thousands of retail brokers were hired.  Commission rates on trades were fixed by the New York Stock Exchange, so there was no price competition among brokers in the trading of existing securities. 

Even with this growth in the Wall Street sell side, “investment banking in the 1960’s was as highly concentrated as it had been sixty years earlier.  In some respects it was even more so.  No matter how measured—firm size, capital employed, underwritings, syndicate managements—a relatively few large houses, mostly located in New York City, conducted most of the nation’s new issues business.”  [Vincent P. Carosso, Investment Banking in America: A History Harvard University Press, 1970 edition, page 505]  Nearly all sales of new issues of securities continued to be sold to the same people and in the same way.  Institutional money managers were invited by the managing underwriter to “road show” presentations and private meetings.  Brokers working for firms in the underwriting syndicate or selling group telephoned their customer list and made “cold calls” to prospects. 

While investment bankers today still deal only with institutional money managers and wealthy individuals, other broker-dealer firms on Wall Street are marketing to the middle class--mostly selling mutual fund shares to investors and running a casino for traders in derivatives, commodities, currencies and other zero-game gambling.  Managing underwriters will bring retail brokerage firms into a few of their underwriting syndicates and selling groups, but there is no real marketing effort to retail customers.  None of the successful techniques used by the U.S. Treasury in selling World War II bonds was introduced into the underwriting pattern.  In fact, the federal securities laws were presented as an absolute barrier to the advertising and soliciting that would reach those who are not finance professionals.  This excuse isn’t really true but it provides a quick and easy answer to why there is no effort to reach a mass market.

The real reason that investment bankers don’t sell shares directly to the middle class is because they don’t have to.  They can make their full commission without spending the extra time and money to reach the mass market.  Underwritten offerings are the last holdout of the fixed commission, and the commission is technically paid by the issuer, not the investor.  That means that the underwriter gets the same amount per share, whether the sale is for 100 shares or 10,000 shares.  Obviously, the underwriter is going to focus on the prospects who can buy 10,000.  These prospects for big sales are their counterparts on Wall Street’s buy side—the money managers for funds.  Underwriters can place an entire issue with a few “road show” breakfasts, luncheons and dinners, along with some telephone calls.  [Some underwritten offerings have an abbreviated electronic “retail road show” available on the Internet.]

The commission on nearly all Initial Public Offerings of common stock, among all the Wall Street investment bankers, has been maintained at seven percent.  Competition among them is all about who knows whom, which image and promises are the most persuasive and other nonprice subjective issues.  There just is no price competition on any but a few IPOs.   (I once described this phenomenon to a friend who had a perfect score on the Law School Aptitude Examination, graduated from Harvard Law School and had then chosen to surf and play his guitar.  When I told him that I didn’t believe that investment bankers even spoke out loud about how they stifled competition to keep their fixed commissions, he responded, “They don’t need to.  It’s in their mother’s milk.”)

Mutual Funds Come Between Investment Bankers and the Middle Class

After World War II, as money began to accumulate within the middle class, including their retirement accounts, another layer of financial intermediary became integral to the process—the mutual fund manager.  This allowed Wall Street to get three sets of fees from a public offering of securities:  Investment bankers get their full commission from the issuer, mutual fund managers get their fee based on the size of their fund and brokers are paid for selling mutual fund shares.  The sell side was vastly expanded by the success of mutual funds.  They have become the mechanism for gathering money from the middle class.  Mutual fund managers are the marketing arm for Wall Street to attract money from the retail market.  They have also become the buy side for the new securities issues underwritten by investment bankers.  Investment bankers don’t deal directly with the middle class.  That is left to mutual funds, as another financial intermediary earning commissions on moving the public’s money.

Mutual funds are a creature of the Investment Company Act of 1940, which was one of the last New Deal laws to tackle Wall Street abuses—the investment trusts that had been sold to unsophisticated small investors in the 1920s.  These trusts had often been riddled with conflicts of interest and many were near total losses after the Crash of 1929.  The Investment Company Act placed serious reporting and regulatory requirements on funds that sold shares to the public and invested in securities.  The new investment pools created to comply with the new law were marketed as “mutual funds.”  Today, there are over 10,000 mutual funds, more than the number of companies with shares traded on U.S. stock exchanges and active over-the-counter markets.

By the early 1960s, over half of all new shares sold to the public were those issued by mutual funds.  This is likely why the SEC stopped including mutual fund shares in its reports of new security offerings.  [Investment Banking in America: A History by Vincent P. Carosso, Harvard University Press (1970 edition), page 498].  A whole new layer of intermediary was placed between those investing smaller amounts and the businesses with public shareownership.  The arguments for inserting another intermediary taking another percentage of the investors’ money are usually “professional management” and “portfolio diversity.”  While analyzing the value of mutual funds as the way for individuals to invest is outside the subject of this book, the recorded averages are unfavorable.  Statistics summarized by Motley Fool show: “The average actively managed stock mutual fund returns approximately 2% less per year to its shareholders than the stock market returns in general.”  [] On diversification, the conclusion from analysts is that it can be achieved within a modest personal portfolio.  [] But the marketing of mutual funds, hoovering up money from the middle class, allows investment bankers to continue selling new issues only to those who buy in very large amounts.  This makes it possible for Wall Street investment bankers  to insist on using the expensive, inefficient marketing methods developed a century ago. 

In all of the process of marketing new securities, mutual funds are about the only place where the mass marketing War Bond lessons are used today.  The mutual fund industry has lobbied a series of minor modifications to the SEC rules about advertising, allowing funds to advertise in ways forbidden to operating businesses.  They have become omnipresent in magazines and newspapers, on television and radio and now on the Internet.  They have adopted all of the tools of direct marketing.  Now, many of them are “no load” funds, selling their shares directly through advertising, without paying a broker or using a sales representative.

The result is that the flow of capital from nonwealthy individuals to businesses passes through at least two sets of intermediaries, each taking a percentage fee.  The underwriting investment banker sells its clients’ shares to the mutual fund manager, who either sells its mutual fund shares directly to the individual or pays a commissioned broker to sell its shares.  Why couldn’t the issuer bypass all two or three of these intermediaries and market directly to the individual?  The chapter called “Direct Routes Open Now for Bypassing Wall Street,” shows how this is beginning to happen and what can be done to move it along.

An argument can be made in favor of keeping the investment banking business separate from selling securities to retail customers.  There could be some value in having a group of specialists who served only the businesses and governments issuing securities. Like the English system of barristers and solicitors, the investment banker would serve the interests of the client and the capital markets, without being influenced by the business of dealing with investors.  Retail brokers and buy side money managers would take care of the demand side, while investment bankers focused on supply side needs and concerns.  However, Wall Street investment bankers are most loyal to their own firm, including its trading department.  Next, their interests lie with favoring money managers with large pools of money to invest.  That’s where their repeat business is, not with the client issuing its securities.

Financial Derivatives Become the Investment Banker’s Stock in Trade

Whatever validity the argument for investment-banking-only firms might have had, it went away with the changes on Wall Street after the bull market of 1953 to the late 1960s.  Stocks and bonds began to have competition from other financial instruments.  Out of the commodity futures markets came securities used to hedge stock and bond investments.  This was the beginning of “financial derivatives,” so called because they are derived from the risk and price movement in other securities.  On the buy side of Wall Street, derivatives became accepted and popular because the purchaser could get the effects of price changes by using only a fraction of the money it would have taken to buy the underlying stock or bond.  On the sell side, these new derivative securities were relatively free of competitive pressure on commissions and fees.

Bigger changes came with the end of fixed  pricing on stock trading commissions. Monopoly pricing of commissions had been set by the New York Stock Exchange since it began in 1792, resulting in huge profits during the bull market of the 1950s and 1960s.  Fixed commissions meant that every brokerage customer paid from the same fee schedule to buy or sell stocks or bonds.  There was no price competition and no break for large orders over small ones.  Customers retained their brokers based on personal relationships, reputation for good results or other nonprice factors. 

As mutual funds came into increasing popularity in the 1960s, their professional money managers joined with managers of pension funds and others to pressure for discounts on their huge transactions.  They had much more market power than individual investors and some brokers began finding ways to circumvent the Stock Exchange rates.  In 1971, the NASDAQ Trading Market began automated, over-the-counter trading to compete with the Stock Exchanges.  Recognizing the inevitable crumbling of fixed rates, the SEC required a phasing in of negotiated commissions.

When fixed commissions went away, brokerage firms began finding other ways to make profits.  They looked to transactions that weren’t easy to compare, that could not be shopped around for the lowest price. This led to bonds issued by foreign companies (the Eurobond market) and by American companies that didn’t carry investment grade ratings (the junk bond, or high-yield market).  It also led to the creation and selling of new securities that were simply markers for the movement in stocks, bonds and other financial measures (the derivatives market).  As former retail securities brokers began to diversify into creating transactions and securities, they were moving in on the underwriting business.  Unlike commercial banks, they had no legal impediments to becoming investment bankers.  That’s because they were registered as securities brokers and dealers.  They could buy and sell securities for themselves, as dealers, and also for customers’ accounts, in their capacity as brokers.  Their interests as dealers, buying and selling securities for their own account, often conflicted with their interests as brokers for customers and as investment bankers for businesses issuing new securities to raise money.

  Investment Bankers Become Corporations, Trading for Their Own Accounts

A major goal of Roosevelt’s New Deal had been to separate the functions of broker and dealer.  The securities laws define a “broker” as someone “in the business of effecting transactions in securities for the account of others,” while a “dealer” is “in the business of buying and selling securities for his own account.”  [Securities Exchange Act of 1934, sections 3(4) and 3(5),]  The drafters of that New Deal legislation wanted to force Wall Street firms to choose whether they would be a broker or a dealer.  A lobbying blitz by the Investment Bankers Association kept that restriction out.  This dealer status allows investment bankers to keep the firm commitment underwriting structure, where they technically purchase and resell a new issue of securities.  They receive money from the investors and transfer it to the issuing business, less their “underwriting discount.”

The lobbying victory against separating brokers and dealers not only allowed brokers to  underwrite new issues and to trade for themselves.  It also allowed investment bankers to diversify into being a broker, an agent for the resales of securities.  By the 1970s, most investment bankers had acquired or developed brokerage businesses, to participate in the trading of securities, including the new derivatives.  At the same time, most Wall Street retail brokers had pirated employees from investment banks and gone into competition for underwritings.

Investment bankers built profitable departments as securities dealers, trading in securities with their own money for the firm’s own profit.  However, being a dealer requires lots of available money.  To have that money on hand, the Wall Street partnerships began incorporating and having public offerings of their own stock.  [For an illustration of the argument that incorporation was a major contributor to Wall Street’s crash, read “The End,” by Michael Lewis, in a brief sequel to his book Liar’s Poker, in, November 11, 2008,]  Those that had been primarily investment bankers, distributing new issues of stocks and bonds, became major traders in securities for their own account with their new public capital.  Partners gave up their direct ownership of the profits, but more than replaced it by bonuses taken from the new proprietary trading gains.

Buying and selling with their own money became the dominant business for the most profitable investment banks, like Goldman Sachs:  “Before the financial crisis, everyone on Wall Street used to joke that Goldman wasn't so much an investment firm as a giant, risk-laden hedge fund. It seems that old label still applies.”  [Matthew Goldstein, “Goldman: The Same as it Ever Was,” Business Week, April 21, 2009,]  "By 2007, some of these banks were essentially public hedge funds, taking massive, highly levered bets on the housing market."  [Robert J. Rhee, Associate Professor of Law, George Washington University, "The Decline of Investment Banking: Preliminary Thoughts on the Evolution of the Industry 1996-2008," Journal of Business and Technology Law, Volume 5, number 1, page 97, University of Maryland School of Law,]

As investment bankers began to have public shareowners, they became subject to the need for steadily increasing earnings.  Underwriting new securities issues is a boom and bust business.  But the business cycle for mergers and acquisitions is generally the mirror of the public offering cycle.  When new stock offerings slack off, it is usually because market valuations, such as price/earnings ratios, are at the low end of their trading range.  By contrast, companies with depressed stock prices are hunted by acquirers.  Investment bankers often call on senior executives of companies, with ideas for what businesses they might acquire or how they might be acquired by a "white knight" to defend themselves against a hostile takeover.

A major diversification for investment bankers was to expand their advisory fee business for mergers and acquisitions.  Like public offerings, M&A advisory agreements usually called for fees to be paid at closing, based upon a percentage of the transaction size.  If the client was a target company, the fee might be for successfully fighting off an acquisition, or for getting a better price than the original offer.  M&A work was an ideal complement to public offerings.  The same types of personalities and skill sets are involved.  The decision makers at the prospective clients are the same people. 

Investment bankers diversified their businesses even further away from underwriting new issues of securities, beyond brokerage, proprietary trading and M&A advisory work.  Some started or bought real estate investment operations.  Others acquired money management firms, placing the firm on both the sell side and the buy side of transactions.  They went after the international markets, usually starting with opening offices in London.  Investment banks even poached on the business of the big commercial banks, in the syndication of large loans to business and government.  Loans that are too large for one bank to make are divided up among many lenders, with a fee going to the bank that put the syndicate together.  Not only did investment bankers begin competing in this role, but they included pension funds and other large pools of managed money as syndicate members.  Whatever creativity there may have been in the investment banks, it went into alternative profit sources, rather that improving the flow of capital from individuals to businesses.  The underwriting business of Wall Street investment bankers was left to remain largely the same as it has been for the last century.

With all this new business and diversification, Wall Street firms became victims of the very monster they had created.  The shift from long-term investing to frequent trading had made for much more frequent buying and selling, which earned more brokerage commissions and more opportunities for profitable trades for their own account.  However, the securities intermediaries were now public companies themselves.  They had to respond to the same pressure for quarter-to-quarter profit increases.  For example, Merrill Lynch, which had grown huge from being the broker for the middle class, was reported in 2001 to have changed its strategy “to focus the firm’s brokerage business on attracting wealth investors with at least $1 million in assets.  The move away from small investors is part of a broader plan to boost profits at the big securities firm.”  Its then president, Stanley O’Neal, announced plans “to expand in areas where the firm can achieve high profit margins, such as equity derivatives.”  [The Wall Street Journal, November 2, 2001, page A1] Running a casino for high rollers was to be more profitable than moving capital from individuals to businesses.  Merrill Lynch went on to gigantic losses in 2008, firing Mr. O’Neal and being acquired by Bank of America.  In 2012, Merrill Lynch raised its minimum account size from $100,000 to $250,000.  [Andrew Osterland, “Merrill Lynch raises the bar for its brokers,” Investment News, January 6, 2012,]

As investment bankers diversified, others were on the move as well.  This expansion of roles became a two-way street.  Large corporations began bringing some of the capital-raising functions in house.  The SEC adopted its Rule 415, which allowed businesses to register a proposed offering and then wait until the market was at its most favorable to actually sell the offering.  This took away the dependence upon one investment banker and allowed the company to shop around for someone to bring them the best terms.  Traditional relationships were weakened.

Wall Street Commercial Banks Become Investment Bankers Again

Commercial banks didn’t just stand by and watch investment banks encroach on their turf. While the Banking Act of 1933, Glass-Steagall, still kept them from direct competition, a big opportunity was handed to them as the investment bankers developed the new derivatives market.  Many of these derivatives, like interest rate swaps, were not “securities” and commercial banks could muscle into the market.  “Swap trading began a revolution that would pave the way for commercial banks’ intrusion back into investment banking after decades of separation.”  [Wall Street: A History, by Charles R. Geisst, Oxford University Press, 1997, page 347]

That revolution won a big battle when the Federal Reserve Bank effectively overruled Congress in 1990 by giving JP Morgan, first, and then other money center banks, limited permission to underwrite securities.  The Fed first interpreted the Banking Act of 1933 as allowing no more than ten percent of a bank’s revenue to come from the securities business.  As the Federal Reserve permitted more encroachments, increasing the ten percent limit on investment banking revenue to 25 percent, a full-scale and successful lobbying effort was launched for repeal of the wall between commercial banking and investment banks.  JP Morgan prepared a study called “Glass-Steagall: Overdue for Repeal,” which argued against the investment bank oligarchy, pointing out that well over 90 percent of U.S. debt and equity underwritings were managed by only 15 investment bankers.

The distinction between investment banks and commercial banks went away almost completely in response to the credit crisis in late 2008.  Independent investment banks were acquired by commercial banks, were liquidated or they were allowed to become parts of bank holding companies.  How will that change the underwriting process?

Investment Bankers No Longer “Underwrite” Securities Offerings

In the Funk & Wagnalls 1911 Dictionary, “underwrite” is defined, in finance, as “to engage to buy all the stock in (a new enterprise or company) which is not subscribed for by the public.”  That fits with the insurance concept of “underwrite.”  It represents a transfer of risk from the business raising capital to the financial intermediary.  The theory was that investment bankers were the experts in the market for securities, so they could best judge the risk and adapt to it.  They also had the opportunity to diversify their risks, among several companies and over different market timing.

“For a fee or premium, the underwriter agreed to take up whatever portion of the issue was not purchased by the public within a specified time. And just as insurance companies frequently reinsure large underwritings with other companies in order to distribute the risk, so the initial underwriter often protected himself by agreements with sub-underwriters, to which the issuer was not a party. The typical underwriting syndicate was not limited to investment bankers or so-called issuing houses. It included or even consisted entirely of insurance companies or investment trusts or other institutions, or even large individual investors who thus obtained large blocks of securities at less than the issue price.  . . This method of distribution is called in the United States ‘strict’ or ‘old fashioned’ or ‘standby’ underwriting. It is seldom, if ever, used here except in connection with offerings to existing stockholders by means of warrants or rights”  [Louis Loss, Joel Seligman, Troy Paredes, Securities Regulation,, Aspen Publishers, 2009, Chapter 2.A.1]

 A “firm commitment underwriting” is what investment bankers have called their practice for the last 80 years or so.  In fact, it is neither an underwriting nor a firm commitment. The risk of an offering selling remains with the company seeking money.  Until all of the steps have been completed and all of the shares have been spoken for, the company has only a “letter of intent” to rely upon.  It specifically states that it is not a commitment to complete an offering.

Why We Still Have Investment Bankers Today

We no longer need investment bankers to raise capital for business.  Their market first existed because of the painfully slow communications media that existed until the electronic age.  They gathered information about prospective investors and handled the steps in a marketing process: letting prospects know that the securities are going to become available, gathering indications of interest, negotiating a price and closing the transaction.   Today all of this can be done by a few people at computer terminals.

Of course, this possibility has been true for over a decade.  Michael Lewis described it in a 1999 article:  “There are some obvious barriers to the Internet taking over the market for initial public offerings: SEC regulations, investor habit, the desire of some corporate CEO's to have someone around to blame when things go wrong. But it is a short and logical step from selling stocks over the Internet to raising money for a private company over the Internet, and then to raising ALL money over the Internet.  Which is to say that it's only a matter of time before computers -- instead of Wall Street bankers -- stand between borrowers and lenders.”  [“How Capitalism Will Eat the Capitalists,” Bloomberg News, April 22, 1999]

It’s been over a decade since that observation by Michael Lewis and we still have the same process for new issues as it was a century ago.  What has happened to maintain the underwriting system?  One explanation is that an artificial need for the system has been created as the real need faded away.  Investment bankers have kept up the myth that they are the only ones who can sell securities offerings.  They’ve had a lot of help from the government in perpetuating that myth.  The legal obstacles are so intimidating that it is easy to believe that only the professionals can surmount them.  SEC rules and practices are extremely restrictive for any written communication (including electronic).  But for oral communications it has been anything goes, except being caught in outright fraud.  Of course, underwritten securities are sold by oral communications, either by telephone or in meetings.  The only written material is the prospectus, which is delivered after the purchase order has been taken.

Meanwhile, the regulatory hurdles for direct securities offerings remain in place or have become higher.  When the investment bankers lobbied Congress to exempt their underwritings from state securities laws, they limited it to securities approved for listing on the major stock exchanges, including Nasdaq.  Those listings are available only to proposed “firm commitment” underwritings.  Since no one can do firm commitment underwritings except SEC-registered broker-dealers with sufficient capital, businesses still believe they need Wall Street investment bankers to raise money from the public.

The barriers to raising capital without Wall Street can easily come down.  Our communications technology and direct marketing ability can replace the monopolistic maze maintained by Wall Street.  Is there any real need at all for investment bankers?  (Once I was talking with a partner in one of the oldest Wall Street investment banking firms.  We were discussing changes in the way money could be moved and whether investment bankers were necessary.  He said that there would always be investment bankers, because CEOs needed someone they could talk to about matters that they couldn’t discuss with anyone else, especially their board of directors, subjects like “this business has about peaked and is headed for a big decline; how do I take care of myself?”)

Who is going to tell entrepreneurs that they don’t need investment bankers?  Surely not the securities lawyers, who depend heavily on clients referred by investment bankers.  Not the accountants, who hope to be recommended as auditors by a prospective client’s investment bankers.  And not the management of companies who have recently completed underwritten offerings.  They will have been indoctrinated with the lore of investment bankers as the only path to riches.  Even Nobel laureate Paul Krugman described investment banks in his 2009 book as “repositories of specialized information that could help direct funds to their most profitable uses.”  [Paul Krugman, The Return of Depression Economics and the Crisis of 2008, W.W. Norton & Company, 2009, page 83]  The phrase sounds like an academicians version of Gordon Gekko’s line about insider tips, from the movie Wall Street::  “If you’re not inside, you’re outside.” 

What about the investor side of raising capital?  Don’t we need Wall Street investment bankers to gather information about a company going public and make judgments for us?  Well, first there is the conflict of interest.  If a public offering doesn’t get sold, the investment banker doesn’t get paid.  Beyond that, we are no longer in the days before the Internet.  We now have all the raw data and advice at our fingertips.  As the legendary investment professional Peter Lynch said over 20 years ago, “I can’t imagine anything that’s useful to know that the amateur investor can’t find out.  All the pertinent facts are just waiting to be picked up.  It didn’t used to be that way, but it is now.”  [Peter Lynch, with John Rothchild, One Up on Wall Street, Penguin Books, 1989, page 182]

Couldn’t Wall Street be reformed to serve the interests of capital formation for America’s businesses, governments and individual investors?  Roger Martin, Dean of the Rotman School of Management at the University of Toronto, wrote:  “In response to the question: What does Wall Street have to change to produce better leaders, a different culture and a more long-term focus? Forget about it. Don't even waste time thinking about it. The purpose of Wall Street firms is to trade value for their own benefit, not to build value for the economy either short-term or long-term. While at one point in its history, a non-trivial part of Wall Street's activity involved financing the growth of American companies, that is now a minor piece of its business. Wall Street is primarily engaged in encouraging individuals and companies to trade value between one another and tolling the parties for the service, and trading against the outside economy for its own account. . . . Wall Street has only one prerogative and that is to maintain the illusion that it adds value so that it can charge spectacular sums for its services. . . .  And increasingly, Wall Street has recognized that the above businesses earn chump-change in comparison to the consistently super-normal returns of their best business of all: proprietary trading, in which Wall Street makes supernormal returns trading for its own account. Given that Wall Street can't demonstrate that it provides valuable trading insight for outside clients, it begs the question: how can it earn super-normal returns trading on its own account? The answer is not a very reassuring one: proprietary trading based on proprietary information. And the very best proprietary information is information that comes closest to being illegal. This is not a zero-sum game. Wall Street wins and everybody else loses. . . . So I think it is foolish to think about Wall Street producing leaders that help build the economy. That isn't in the DNA. Wall Street exists, first and foremost, to benefit Wall Street and that isn't going to change anytime soon.”   [The Washington Post, September 16, 2009,]

Even if we could do without Wall Street, why not just leave it alone and let it continue to have its monopoly?  The reason we need to bypass Wall Street is that it is causing great harm to our country.  The harm is even far greater today than when Franklin Delano Roosevelt said, “Practices of the unscrupulous moneychangers stand indicted in the court of public opinion, rejected by the hearts and minds of men.”  [Franklin D. Roosevelt, Public Papers and Addresses, vol. 2, New York:: Russel & Russel, 1933, page 12]

The Harm that Wall Street Causes

We don’t need Wall Street anymore.  We have all the tools to bypass the financial intermediaries and take charge of raising and investing money.  Today’s technology allows the suppliers and users of capital to communicate directly with each other.  Later sections of Bypassing Wall Street describe how those direct relationships are happening now and how they can be developed as an alternative to the Wall Street intermediaries. 

It isn’t only that we have the ability to bypass Wall Street, so that we should do it just because we can.  We urgently need to free ourselves of the grip that Wall Street has over finance.  The harm that Wall Street causes is intolerable.  This chapter takes us into some of the most egregious penalties inflicted on us all by Wall Street.  As Nobel laureate economist Joseph Stiglitz said in addressing his peers, the purpose of a financial system is "to manage risk and allocate capital at low transaction costs." What has Wall Street actually done? "They misallocated capital. They created risk. And they did it at enormous transaction costs." []

Wall Street Causes Our Economy to Crash

A few days after the Crash of 2008 began, Robert Samuelson wrote, “Greed and fear, which routinely govern financial markets, have seeded this global crisis. Just when it will end isn't clear. What is clear is that its origins lie in the ways that Wall Street -- the giant investment houses, brokerage firms, hedge funds and ‘private equity’ firms -- has changed since 1980.”  [Robert J. Samuelson, “Wall Street’s Unraveling,” Washington Post, Wednesday, September 17, 2008; Page A19]  Eric Hovde added at the same time, “Looking for someone to blame for the shambles in U.S. financial markets? As someone who owns both an investment bank and commercial banks, and also runs a hedge fund, I have sat front and center and watched as this mess unfolded. And in my view, there's no need to look beyond Wall Street -- and the halls of power in Washington. The former has created the nightmare by chasing obscene profits, and the latter have allowed it to spread by not practicing the oversight that is the federal government's responsibility.”  [Eric D. Hovde, “Calling Out the Culprits Who Caused the Crisis,” Washington Post, Sunday, September 21, 2008; Page B01.  See]

There have been two massive government reports and several books detailing the harm Wall Street caused in creating the Great Recession.  [See the 553-page Financial Crisis Inquiry Report, January 2011, at and Senate Committee on Homeland Security and Governmental Affairs, Press Release, April 13, 2011,  Books published about the 2008 Wall Street debacle include:  John Cassidy, How Markets Fail; William D. Cohan, House of Cards; William D. Cohan, Money and Power: How Goldman Sachs Came to Rule the World; Charles Ellis, The Partnership; Greg Farrell, Crash of the Titans; Gary Gorton, Slapped by the Invisible Hand; Alan C. Greenberg, The Rise and Fall of Bear Stearns; Simon Johnson and James Kwak, 13 Bankers; Kate Kelly, Street Fighters; Paul Krugman, The Return of Depression Economics and the Crises of 2008; John Lanchester, I.O.U.: Why Everyone Owes Everyone and No One Can Pay, 2010; Michael Lewis, The Big Short; Roger Lowenstein, The End of Wall Street; Susanne McGee, Chasing Goldman Sachs; Bethany McLean and Joe Nocera, All The Devils Are Here; Gretchen Morgenson and Joshua Rosner, Reckless Endangerment: How Outsized Ambition, Greed and Corruption Led to Economic Armageddon; Charles R. Morris, The Trillion Dollar Meltdown; Scott Patterson, The Quants; Henry M. Paulson, On the Brink; Yves Smith, ECONned; Robert J. Shiller, The Subprime Solution; Andrew Ross Sorkin, Too Big to Fail and the HBO movie of the same name; Joseph E. Stiglitz, Freefall; Matt Taibbi, Griftopia; Gillian Tett, Fool's Gold;  Vicky Ward, The Devil's Casino; Gregory Zuckerman, The Greatest Trade Ever]

Of course, many factors contributed to the Panic of 2008, as well as the earlier panics that were triggered by Wall Street abuses.  Some causation can be laid to crowd psychology and mass mania.  [Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds, Richard Bentley, 1841, Farrar, Straus and Giroux, 1932]  Classical economists since John Stuart Mill have applied this theory to economic bubbles, or manias, and the panics and crashes which followed   The theory is defined in a model developed by Hyman Minsky.  It describes the cyclical flows of optimism and pessimism among investors and lenders.  But the cycles, beginning with the mania, and followed by the panic and later crash, “start with a ‘displacement,’ some exogenous shock to the macroeconomic system.”  The result is that “the anticipated profit opportunities would improve in at least one important sector of the economy.”  People “would borrow to take advantage of the increase in the anticipated profits.”  [Charles P. Kindleberger and Robert Z. Aliber, Manias, Panics, and Crashes: A History of Financial Crises, fifth edition, John Wiley & Sons, Inc., 2005.  See, also, Carmen M. Reinhart and Kenneth Rogoff, This Time is Different: Eight Centuries of Financial Folly, Princeton University Press, 2009 and J. Bradford DeLong, "Notes on Bubbles,"] 

The Minsky model, with its "exogenous shock," certainly described what happened in the Panic of 2008.  Wall Street created the Minsky “displacement” that came from the anticipated profit opportunities in real estate ownership and financing.  The changes in the way real estate was financed, created by mortgage securities and credit default swaps, were a primary cause of the liquidity and credit crunch.  [Markus K. Brunnermeier, "Deciphering the Liquidity and Credit Crunch 2007-08," Journal of Economic Perspectives, Winter 2009, pages 77-100]  In September 2008, when the mania suddenly stopped, we went into a panic and had the resulting crash.  Wall Street was the instigator and the driving force behind that displacement.  “By increasing leverage — that is, by making risky investments with borrowed money — banks could increase their short-term profits. And these short-term profits, in turn, were reflected in immense personal bonuses. If the concentration of risk in the banking sector increased the danger of a systemwide financial crisis, well, that wasn’t the bankers’ problem.   [Paul Krugman, “Bubbles and the Banks,” The New York Times, January 7, 2010, Krugman, Next up: Financial system reform&st=cse]   Canada, by contrast, maintained regulatory controls over banks’ borrowings and risky investments.  It largely prevented a breakdown of its financial system.  [Paul Krugman, “Good and Boring,” The New York Times, January 31, 2010,]

This wasn’t the first time Wall Street ruined our economy.  Looking back, you see a repeated pattern of financial manipulation that created bubbles.  When the bubbles burst, innocent people lost their savings, their jobs and their homes.  Since 1792, Wall Street has perpetrated the “Panics” that burst price and credit bubbles and led to recessions and depressions.  In that first Panic, it was a Wall Street broker’s stock market insider trading that created the bubble.  Discovery of the fraud burst the bubble, causing an economic decline.  The government, in that first year of our Constitution, also set a pattern of token punishment and toothless reform.  We were promised something different this time.  “My job is to help the country take the long view — to make sure that not only are we getting out of this immediate fix, but we’re not repeating the same cycle of bubble and bust over and over again . . ..”  [President Barack Obama, in an interview with columnists on Air Force One, reported by Bob Herbert, The New York Times, February 16, 2009,]

While the first American panic was caused by Wall Street insider trading, later panics came from more complex manipulation by Wall Street, such as selling newly created securities that made promises that couldn’t be met.  The first players in those games would do spectacularly well, creating an urgent demand for more—the Minsky model “displacement.”  Then some event would trigger discovery, followed by a collapse which brought down the entire economy.  England has had the same consequences from games played by the City, its equivalent of Wall Street.  This description of Britain’s South Sea Bubble of 1825 could as well apply to what happened with mortgage securities and derivatives nearly two centuries later:  “The hope of boundless wealth for the morrow made them heedless and extravagant for to-day. . . . Resolutions were passed to the effect that the calamity was mainly owing to the vile arts of stock-jobbers . . ..  Popular imitativeness will always, in a trading nation, seize hold of such successes, and drag a community too anxious for profits into an abyss from which extrication is difficult.  ”  [Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds, 1841, reprinted by Farrar, Straus and Giroux, with a foreword by Bernard M. Baruch, 1932, pages 71, 73 and 88]

One of the most damaging of Wall Street’s abuses came with the Panic of 1873, when Wall Street “had crafted complex financial instruments that promised a fixed return, though few understood the underlying object that was guaranteed to investors in case of default.  (Answer: nothing).”   When the bubble burst, “the stock market crashed in September, closing hundreds of banks over the next three years. The panic continued for more than four years in the United States and for nearly six years in Europe.”  [Scott Reynolds Nelson, professor of history at the College of William and Mary, “The Real Great Depression,” The Chronicle of Higher Education, October 17, 2008,]

Wall Street created another source of Panics in the 1890s, when investment bankers found a new line of business—mergers and acquisitions.  In addition to the harm caused by eliminating competitors and creating industry monopolies, the takeover battles could lead to bubbles and their bursts.  One war between investment banks, for control of the Northern Pacific Railroad, led directly to the Panic of 1901.  Two Wall Street groups launched and reacted to raids, by placing orders for huge purchases of the railroad’s shares.  As the stock price soared, short sellers sold heavily, betting that they would cover their short sales after the price dropped back down.  Instead, Northern Pacific shares kept going up.  As the short sellers were forced to sell other stocks to raise cash for covering their shorts, the rest of the market sank.  Ron Chernow described the result as “the biggest market crash in a century,” with this New York Herald  headline for May 9, 1901: "GIANTS OF WALL STREET, IN FIERCE BATTLE FOR MASTERY, PRECIPITATE CRASH THAT BRINGS RUIN TO HORDE OF PYGMIES." [Ron Chernow, The House of Morgan, Simon & Schuster, 1990, pages 92, 93]  According to Chris Farrell:  The takeover struggle for the northwestern rail is a convoluted tale of market manipulations, ruthless maneuvers, corners and shorts, soaring and plunging prices. . . . However, like so many struggles on Wall Street to this day, it was really a fight for power and dominance, of outsized ego and overheated rivalry.”  [Chris Farrell, “Wall Street: Is It Good to Apologize for Greed?”, Business Week, November 22, 2009,]

After each Panic, Wall Street has had its defenders.  Following the Panic of 1907 came a book titled The Stock Exchange from Within, by a self-described “busy stockbroker.”  [William C. Van Antwerp, The Stock Exchange from Within, Doubleday, Page & Co., 1913, preface.  The book was reprinted by Kessinger Publishing, LLC, 2006 and is available online at Van Antwerp was also a collector of rare books and an alternate delegate to the 1936 Republican National Convention.]  He first tells us who really caused the Panic:  “We, as a people, have brought the disaster upon ourselves by reason of our indiscretions.  We have lost our heads and entangled ourselves in a mesh of follies.”  Then Mr. Van Antwerp goes on to explain that an individual will “not admit such reproaches, even in our communings with self. . . . He says Wall Street did it.  His fathers said the same thing, and his children will follow suit.” [pages 186-187]   

Besides, Mr. Van Antwerp wrote, panics are not really so bad.  In fact, the recessions that follow do some necessary good chores: “Moreover, panics are rarely such unmitigated calamities as they are pictured by those who experience them.  At least they serve to place automatic checks upon extravagance and inflation, restoring prices to proper levels and chastening the spirit of over-optimism.” [page 185 in the 1913 edition]  A couple months after the Crash of 1929, which led to the Great Depression, Mr. Van Antwerp gave a speech to San Francisco’s Commonwealth Club: “In 1929, we merely suffered a case of nerves following a debauch. It is not to be expected that sound and conservative industry will be shaken this time.”  He placed the blame for the Crash of 1929 squarely on the middle class:  “This present panic had its roots back in 1917, when our masses found that they could invest money in bits of paper called Liberty Bonds. From investing to speculating was an easy step.”  [  The role of "finance capital" in economic cycles is described by William Greider in One World, Ready or Not, Simon & Schuster, 1997, pages 227-258.]

In each of the Panics, there has been a particular player who took the game to its ultimate escalation, often getting out before the resulting collapse.  Matt Taibbi laid out a chronicle of how just one Wall Street firm, Goldman Sachs, had caused five boom and bust cycles, beginning with the Crash of 1929.  Taibbi claims that the firm’s investment trust, Goldman Sachs Trading Corporation, was a manipulation that collapsed and led to the Great Depression.  Others were the tech bubble of the late 1990s, the oil price up and down, the housing price inflation/collapse and the federal bank bailout.   He predicted the next would be the cap-and-trade game. [Matt Taibbi, “The Great American Bubble Machine: From Tech Stocks to high gas prices, Goldman Sachs has engineered every major market manipulation since the Great Depression--and they’re about to do it again,” Rolling Stone, July 9-23, 2009, page 52,]  One harm from the boom and bust cycles is the increase in frauds.  "Swindling increases in economic booms because greed appears to grow more rapidly than wealth . . . Swindling also increases in times of financial distress . . . to avoid a financial disaster."  [Charles Kindleberger and Robert Z. Aliber, Manias, Panics, and Crashes: A History of Financial Crises, John Wiley & Sons, Inc., Fifth Edition, 2005, page 189]  Neuroscience has suggested why Wall Street traders make the ups and downs of the financial markets so extreme:  When traders are winning at their bets, as the market is quickly moving past rational heights, their testosterone levels keep elevating until they reach irrational exuberance and make foolish decisions.  Then, when the markets are rushing to new bottoms, their levels of cortisol increase, making them afraid to take even rational risks. [John Coates, "The Biology of Bubble and Crash," The New York Times, Sunday Review, June 10, 2012, page 5 and Drake Bennett, "When Animal Spirits Attack," Bloomberg Businessweek, June 4-10, 2012, page 4]

Gretchen Morgenson and Joshua Rosner, in their book about Wall Street and mortgage securities, said:  "Their greed and self-interest . . . helped propel world financial markets to the brink of collapse.  The voraciousness of these firms would also push the nation's economy into its most serious recession in more than seventy-five years."  [Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon, Times Books/Henry Holt and Company, 2011, page 274.  See interview of Gretchen Morgenson by Bill Moyers,]

These Wall Street-caused panics bring their greatest harm to small businesses and their employees, America’s middle class.  During the Great Recession started by Wall Street’s 2008 collapse, "Wall Street banks cut back small business lending by 9 percent, more than double their 4 percent cutback in overall lending."  [Elizabeth Warren, interviewed by John Tozzi, Bloomberg Businessweek, June 28-July 4, 2010, page 46].  Job losses consistently were far greater for businesses with fewer than 50 employees than for larger employers.  [For instance, see the ADP National Employment Report for September 2009,

A more subtle but disruptive harm from Wall Street's monopoly over the movement of money for investment is its tendency to concentrate vast sums into a small segment of the economy.  In 2011, for instance, Wall Street postponed doing  IPOs and, instead, raised huge amounts of money from money managers for "private placements" of securities for Facebook, Twitter and other social media businesses.  Those ventures spent much of the money hiring technical staff.  The result was a shortage of these trained individuals and an increase in their compensation beyond the ability of smaller competitors to pay.  [Pui-Wing Tam and Stu Woo, "Talent War Crunches Start-Ups," The Wall Street Journal, February 28, 2011, page B1]  The disruption is international.  As Wall Street has globalized its business, it moves billions into a developing country and then suddenly takes it out.  The resulting panics and recessions are left behind, to be worked out--or not--by the local government, the International Monetary Fund and World Bank, or by revolution.

At the macroeconomic level, letting Wall Street control raising money for business and investing has allowed the money monopoly to tamper with the balance between consumption and investment.  The theory is that businesses choose to expand plant and equipment based upon their expectation of sales of the additional products and services they could provide.  The easy access to money on very favorable terms will not, by itself, persuade prudent managers to issue more shares or bonds when they can't see making a profit on the new investment.  A 1935 Brookings Institution study concluded that "the growth of new capital is adjusted to the rate of expansion of consumptive demand rather than to the volume of savings available for investment.  Between 1923 and 1929, for example, the volume of securities floated for purposes of constructing plant and equipment remained practically unchanging in amount from year to year, despite the fact that the volume of money available for investment purposes was increasing rapidly. . . . The excess savings which entered the investment market served to inflate the prices of securities and to produce financial instability.”  [Harold G. Moulton, The Formation of Capital, The Brookings Institution, 1935, pages 158, 159]  

Wall Street Sacrifices Everything for Short-Term Profits

The original purpose of a trading market was to assure investors that they would be able to resell securities they purchased.  The businesses and governments that issued the securities needed money they could use for the long term.  Their securities would either be bonds, to be repaid after several years, or shares of ownership, without any repayment date.  Investors wanted the ability to cash out the securities they bought, at any time and for any reason.  Availability of this liquidity encourages people to invest, even if they may need to get their cash back on short notice, or if they want to cash out with a profit and turn their money over to something else.  Other investors will be interested in buying these previously issued securities, if the price is right and the process is simple and trustworthy.  A trading market provides the mechanics to match sellers and buyers.

However, in a classic “tail wagging the dog,” raising capital from new securities issues has become an almost insignificant part of Wall Street.  The focus changed from selling new securities to raise money for businesses; it shifted into earning commissions from getting customers to buy and sell existing securities.  Then, the central focus moved again, and became trading for Wall Street’s own profits, rather than for its customers.  The bonds and shares, and all the derivative securities based on them, became markers for trading. Once short-term trading gains were the objective, rapid turnover became the strategy.  Take the profit and get on to the next trade.  At the extreme, “naked access” computer program trading can buy and sell a position in less than a second.

Wall Street’s trading mentality has infected management of the businesses which have publicly traded securities.  Wall Street firms take huge positions in a company’s shares or bonds or, more likely, options or other derivatives.  These trades are based upon what a trader for the firm expects about the company’s next quarter’s results, or about a possible merger or other event.  The trader may act on a tip about what a customer or another trader expects for the company.  Businesses whose managements deliver on these short-term expectations are rewarded by more buying than selling, translating into price increases for their securities and greater management compensation. 

Wall Street’s buy side, the money managers, are focused only on their own quarter-to-quarter performance.  They demand inordinate amounts of time from chief executives and chief financial officers in their attempts to learn something that will give them a few hours jump on the next quarter’s results, so they can trade in or out.  As more and more corporate ownership is concentrated in institutions, Wall Street money managers "can directly demand that the existing management of the companies whose shares they hold plunder them for the instant returns expected by an extractive financial system."  [David C. Korten, When Corporations Rule the World, Berrett-Koehler Publishers and Kumarian Press, 1995, page 244]

Wall Street’s analysts came to have more influence over the decisions of CEOs than their own boards of directors.  On both the buy side and sell side of Wall Street, analysts are employed to rate the investment quality of a company’s securities.  The rating labels fluctuate but they are basically “buy,” “hold” or “sell.”  An academic study of Fortune 500 companies from 1996 to 2000 showed that, when analysts reduced the rating, it became 50% more likely that the company’s board of directors would dismiss its president within six months.  Where even one analyst stopped rating a company, the chance of the board firing the president within a year went up by nearly 40%.  According to the study’s author:  “Our findings suggest that boards are not focused enough on fundamentals and too focused on Wall Street.”  [Professor Margarethe Wiersema, The Paul Merage School of Business, University of California, Irvine, “CEO Dismissal: The Role of Investment Analysts as an External Control Mechanism.” Proceedings of the sixty-eight Annual Meeting of the Academy of Management, 2008. (with Y. Zhang)]

Managers can get huge rewards for playing to Wall Street’s short term trading.  They can divulge “whisper” earnings predictions for a quarter, then bring in the reported earnings on target.  The analysts who were favored with the selective expectations will have been able to make a profit by trading between the whisper and the formal releases.  When traders become confident that they will be able to consistently make money on a company’s securities, they will favor it with a higher trading price range than other companies in the same industry.  This in turn justifies increased salary and bonuses for the managers.  When those managers get their compensation in the form of options to buy their company’s shares, they can vastly multiply their income.  It is in the managers’ interest to receive options pegged to a temporary dip in the share price, then exercise the options and sell the shares at a peak price.  Managers and traders together have the power to manipulate those trading prices.  [For a description of this effect upon management of General Electric, see Jeff Madrick, Age of Greed: The Triumph of Finance and the Decline of America, 1970 to the Present, Alfred A. Knopf, 2011, pages 192,193]

The Aspen Institute issued a statement in September 2009, on the harm done by short-term investment objectives, signed by some of America’s most prominent names in business and finance.  Among the harms the signers said “have eroded faith in corporations continuing to be the foundation of the American free enterprise system” was that short-term traders “have little reason to care about long-term corporate performance . . .,” with the result that “managers and boards pursue strategies simply to satisfy those short-term investors.”  [“Overcoming Short-termism: A Call for a More Responsible Approach to Investment and Business Management,” a statement issued by the Aspen Institute Business & Society Program’s Corporate Values Strategy Group and signed by 28 additional leaders representing business, investment, government, academia, and labor, and society program/overcome_short_state0909.pdf

The harm from short-term investment objectives perverts entire business segments.  For instance, this from a book publisher’s website:  “It used to be that publishing houses would invest much of their profits from bestsellers into promoting new and talented authors. It used to be that the large publishing houses would also use these profits to provide an assortment of valuable titles that might not all sell at a profit, but that would be of great benefit to the public. . . . We now see CEOs and stockholders insist on a formula production line that says, ‘This title was on the bestseller list for 32 weeks, therefore we want to make the next book that we publish as similar as possible to the last one.’ They want to repeat the former book’s sales performance. Their philosophy: ‘Don’t reinvent the wheel; duplicate it!’ Due to that mentality, we now have only 40 authors or so that dominate more than 80 percent of the book market!” 

Fixation on short-term takes away jobs and harms our domestic economy. Consider robotics, the use of computers and machines to perform tasks done by humans.  There are about nine million robots being used today.  [International Federation of Robotics,,]  Experience has been that robotics generally creates more jobs than it displaces--in the long run.  [Erik Brynjolfsson and Andrew McAfee, Race Against the Machine:  How the Digital Revolution is Accelerating Information, Driving Productivity, and Irreversibly Transforming Employment and the Economy, Digital Frontier Press, 2011, and David J. Lynch, "Did That Robot Take My Job?," Bloomberg Businessweek, January 9, 15, 2012, page 15]  Despite the long-term growth available from automation, the use of robots is inhibited because managers of publicly-traded companies will forego the large current expense of buying and installing robots.  Instead, they will move the work to a country which currently has low-cost human labor.  That can improve the next quarter's earnings per share, increasing their company's stock price and the value of their stock options.  But outsourcing jobs and importing products takes U.S. jobs away permanently.  The Economic Policy Institute "calculates that the growth in the U.S. trade deficit in 2010 created 1.4 million jobs overseas in 2010 and that many of those jobs were outsourced by American companies.  'But for the growth in the U.S. trade deficit, we would have created about 2.5 million jobs last year, enough to drive down the unemployment rate well below 9%.'”  [Robert E. Scott, Senior International Economist and Director of International Programs, Economic Policy Institute,]  In the economic recovery after 2008, managers of privately-held companies have been investing in automation, with a boost from a temporary tax deduction.  [] The result is that costs of production in the United States are beginning to match manufacturing in China.  [Timothy Aeppel, "Man vs. Machine, a Jobless Recovery," The Wall Street Journal, January 17, 2012, page B1]  Businesses that aren't managed to please Wall Street can automate, eventually outperforming their publicly-traded competitors, while creating U.S. jobs.   Short-termism means that there is no publicized movement to deal with the inevitability that jobs won't provide enough income for all of us in the future.  We should be looking at what will happen when machines, software and other technology keep replacing human labor.  As the return on invested money increases, and return on labor decreases, how do those of us who can't get a job pay the bills?  The next wave of technology will drastically accelerate an issue we aren't yet recognizing.  Chrystia Freeland, Editor of Thompson Reuters Digital, writes:  "A new wave of the technology revolution is cresting and, like its predecessors, will again change the way we work and live."  []   The answer suggested is more training for using technology.  But who is going to pay for that?  Not taxpayers supporting public education.  Not tuition payments paid by more                







   student loans.  And not businesses paying only for short-term results.  The result is higher compensation to the skilled, low pay for the unskilled and a declining middle class.  [David Autor, MIT Department of Economics and National Bureau of Economic Research, The Polarization of Job Opportunities in the U.S. Labor Market: Implications for Employment and Earnings, The Center for American Progress and The Hamilton Project, April 2010,]                                                                                                Jim Collins co-authored the very popular 1994 book, Built to Last: Successful Habits of Visionary Companies. [Co-authored with Jerry I. Porras, HarperBusiness, 1994]   Just six years later, his article, “Built to Flip,” started with this report from one of his former students about dealing with Wall Street’s venture capitalists:  "I developed our business model on the idea of creating an enduring, great company -- just as you taught us to do at Stanford -- and the VCs looked at me as if I were crazy. Then one of them pointed his finger at me and said, 'We're not interested in enduring, great companies. Come back with an idea that you can do quickly and that you can take public or get acquired within 12 to 18 months.'”  Collins and Porras see a rise in social instability as a result of the Built to Flip short-termism:  “Not only is there an increasing sense that the social fabric is fraying, as the nation's wealth engine operates for a favored few; there is also a gnawing concern that those who are reaping more and more of today's newly created wealth are doing less and less to ‘earn’ it.”  [Fast Company, February 2000, issue 32 page 131]

Wall Street Starves Entrepreneurs

The course of our nation is set by how our money is allocated.  If we had a direct relationship between the individuals who invest money and the business managers who use their money, our dollars would be like votes cast for our beliefs and our desires for the future.  Instead, our investment choices are limited to the products Wall Street is selling.  Most of those products are nothing more than bets on some short-term future event.  We are sold shares that were issued forty years ago.  They have nothing to do anymore with supplying capital.  We’re just buying from someone else who is selling.  We’re betting that the trading price will go up and the sellers are betting it won’t.  None of our money will actually get to the business that once issued the shares.  It’s likely that it isn’t even shareownership that we’re buying.  We may be sold options, futures, swaps or other derivatives, which are even more remote from any business use of capital.

Wall Street makes commissions by selling and buying previously owned securities and the derivatives that are based upon those securities.  Much more important to Wall Street are the huge trading profits made from using computer programs and inside information to trade for itself in securities.  This recycling of gambling symbols, where one side of a trade wins and the other side loses, has become the “capital market.”  Being drawn into that win/lose game keeps us from even considering the opportunities of investing in new business activity.  All the money is going to sellers, traders and commissioned intermediaries.  Unlike when new securities are issued by operating businesses, none of that trading money goes to finance business growth, or to pay employees and suppliers.  With the “investors” having become traders, there is little money for early stage companies.

Yet it is young businesses that are most important to our economy.   A November 2009 study by The Kauffman Foundation, from U.S. Census Bureau data, showed that two-thirds of the net new jobs created in 2007 came from businesses less than five years old. "This study sends an important message to policymakers that young firms need extra support in the early years of formation so they can grow into viable job creators. Sometimes a single barrier, such as limited access to credit for business growth, can mean the difference between survival and failure. We must create an environment that aids firm formation and growth if we are going to turn employment around."  [Robert Litan, vice president of Research and Policy at the Kauffman Foundation,]  The work most often cited for the correlation between young businesses and job creation has been that of David L. Birch in “Who Creates Jobs.” [The Public Interest, Number 65, Fall 1981,  page 3,]   He described small companies with rapid revenue growth as “Gazelles.” However, the Gazelle theory was largely contradicted by a 2008 study called “High-Impact Firms: Gazelles Revisited.” It analyzed businesses with significant revenue growth and expanding employment, ones which “account for almost all of the private sector employment and revenue growth in the economy.”  The study found that these firms average 25 years old, with less than three percent under four years.  Only half of the companies have fewer than 500 employees. “Job creation is almost evenly split” between the two size categories.  U.S. Small Business Administration, Small Business Research Summary, number 328, June 2008, page 1 and page 44, ]

It is precisely the young businesses that need to raise money by selling shareownership—money that is permanent, that never has to be paid back and has no interest payments.  But once young businesses have exhausted their founders’ resources, and what they can raise from family and friends, they need to sell shares to the public.  Wall Street investment bankers have a legal monopoly on being the intermediary between business and investors.  By ignoring young businesses, Wall Street is starving entrepreneurs.  As a result, they are preventing jobs from being created.  Their reasoning is simple: they make more money, in the short term, by focusing on trading, especially in products other than shareownership.  Their interest in new issues of shares and bonds is limited to very large public offerings. 

Consider just one example of the great harm from Wall Street's choice to all but ignore small business:  Solar energy.  Scores of entrepreneurial businesses became the photovoltaic industry in the 1970s.  (I subscribed to a newsletter published by Robert Carbone, who left his job as a Bank of America securities analyst to focus exclusively on these new businesses and technology.)  By the 1980s the capital-starved companies had either been acquired by major oil companies or given up.  Three decades later, solar energy is dominated by huge installations that feed into the existing electric grid operated by major power companies.  "Only 6 to 7 percent of solar panels are manufactured to produce electricity that does not feed into the grid. . . . A $300 million solar project is much easier to finance and monitor than 10 million home-scale solar systems . . .."  [Elisabeth Rosenthal, "African Huts Far From the Grid Glow With Renewable Power," The New York Times, December 25, 2010,

Small businesses need to sell shares to raise money for growth.  But Wall Street has all but abandoned serving as an intermediary for new stock issues for young businesses, turning instead to quick turnover products.  The New York Stock Exchange, where Wall Street began, is still an indicator of what Wall Street considers important.  Under the Big Board’s new name and scope, NYSE-Euronext, only 16% of its 2009 third quarter revenue came from listing securities.  The rest:  30% derivatives trading, 22% cash trading, 16% market data, 8% software and technology services and 8% other. [

Even the Exchange president, Duncan Niederauer, acknowledges that small companies are “the economic engine to this country, certainly after every recession.  That’s where most of the new job creation comes from.”  [Mary Anastasia O’Grady, “Is the Stock Exchange Obsolete?” The Wall Street Journal, October 31, 2009, page A17]  Those are the words from the Exchange, while these are the facts:  “A combination of mergers, fewer U.S. IPOs . . . has driven down the number of U.S. stock listings by a startling 43% since the peak in 1997 . . ..  Today, only about 15% of start-up companies backed by venture-capital firms eventually go public compared with more than 90% in the early 1980s, according to the National Venture Capital Association.”  Quoting Professor Jay Ritter, “The prolonged drought in IPOs raises concerns about whether an important engine of growth in the U.S. economy has come to and end.”  [Aaron Lucchetti, “U.S. Falls Behind in Stock Listings,” The Wall Street Journal, May 26, 2011, page A1, A14]

Many of the challenges facing the United States today can be met in ways that would generate earnings for workers and investors.  Rising to those opportunities has historically been the role of entrepreneurs, the founders of new businesses aimed at market solutions to current human needs and desires.  Wall Street and government propaganda would have us believe that the free market actually operates to decide which entrepreneurs gather money to develop their businesses.  The reality is that Wall Street has a government-enforced monopoly on the flow of money from individuals into securities—and it has more profitable games to play with our money.  Great harm comes from Wall Street’s lack of interest in providing that capital to new business founders, with  entrepreneurship in the United States in a long decline.  [Barry C. Lynn, Cornered: The New Monopoly Capitalism and The Economics of Destruction, John Wiley & Sons, Inc., 2010, pages 130-131]

How are we ever to provide new businesses with the money they need to develop opportunities, if Wall Street is the only road and it’s closed to the traffic of money that could be coming from individuals and going to entrepreneurs?  As George Gilder put it, "the crucial source of creativity and initiative in any economic system is the individual investor."  [Wealth and Poverty, Basic Books, page 39]  The capital needs of small business are just not going to be met by the intermediary structure.  On the buy side, where money managers are choosing investments, the economies of scale are weighted toward securities based on big business.  It takes as much time to evaluate a small business as it does a large one—actually more, because the information is more difficult to find.  Time spent investigating small business is even harder to justify, because it results in a small investment. For the buy side money manager, it takes more investments in small business to put all of a fund’s money to work in a diversified portfolio than it does with big business investments.

A further deterrent to Wall Street money getting to small business is that buy side managers consider small business investments to have a higher liquidity risk.  That is, there is more of a chance of not being able to sell without forcing the price lower.  Big business has securities listed on an SEC-registered stock exchange, where trades can be made by going through an SEC-registered securities broker-dealer, who is a member of that exchange.  Small businesses either have no trading market at all, or they are bought and sold in the interdealer, “over-the-counter” market.  It would be a crime for anyone but an exchange or broker-dealer to be in the business of providing a market for buying and selling securities.  Often, there is only one broker-dealer making a market in a small company’s shares.  That’s what one securities regulator called “an invitation to manipulation.”  It’s hard to fault buy side money managers for avoiding securities not on an exchange, ones which are traded by a broker-dealers, since they have a long and deep history of manipulation and nondisclosure.  In May 2011, the SEC granted NASDAQ permission to start a BX Venture Market, and it is supposed to begin in 2012, but past experience with the American and Pacific Stock Exchanges suggests it may do little to provide money for young businesses.  [] 

Even if Wall Street’s buy side were open to investing in small business, it could only happen if the sell side were willing to originate and sell new issues of small business securities.  That is not happening.  The big investment banking firms, with the help of the SEC and Congress, continue to squeeze out competition.  They are still the principal path to an underwritten initial public offering.   But they allocate their IPO time and attention to whatever will generate the most fees—either in the initial public offering or in the trading and other activities that will follow it.  Today, Wall Street investment bankers are mostly wrapped up in creating and selling derivative securities, which don’t raise capital for anyone. 

The rare new issues of stock or bonds actually do channel money from investors to businesses.  Not so for trading in previously-issued securities, especially not so for derivatives, like options, futures, swaps, structured investment vehicles and other devices.  They are all “zero sum games” where one person’s wins are offset by another’s loss.  And, like other forms of legalized gambling, the only one consistently taking money out is the one operating the game, or the one with some private information or tool.  A consistent winner at securities trading can be like the poker player who knows what cards are held by other players, or the blackjack player who can count the cards played and know what remains in the deck.

When investment bankers actually do underwrite a public offering of newly issued securities, it is probably not going to be for a young, growing business.  More likely, it will be something created by the same investment banker or one of its affiliates.  It might be a company purchased by a private equity fund and then going public again, so the fund can get back what it paid and a profit.  Or it could be a “special purpose acquisition fund,” which is a newly-formed shell corporation that raises money in an IPO and then uses it to pay the owners of an existing business it buys.  These are ways of recycling money from one group of investors to another.  Nothing is put into the stream of creation or expansion.

In the few times that an investment banker does act as an IPO underwriter for a young business, raising money for growth, it is usually for a venture capital fund client.  By the time of the IPO, the VCs will have set the business exclusively on the path to maximize return to investors over a two to ten-year term.  The VCs objective will be either to maximize the share trading price while insiders sell out or to have the whole business acquired.   

Wall Street’s short-term obsession effectively determines the industries that will be supported.  The companies selected for an IPO are the ones that can turn a quick profit for Wall Street’s sell side and earn future income for its buy side.  Why is social networking the darling of Wall Street underwriters, rather than nanotechnology, photovoltaics, battery technology or new pharmaceutical companies?  One explanation is that social networking is a current fad and, more important, a new entrant can have software and a market presence within a few months.  The other industries may have far greater long-term prospects, but that’s their disqualifier—they are long-term, not now.  Another factor in selecting an IPO candidate is how much it will generate in future investment banking, brokerage and proprietary trading income.  Will it make acquisitions, to generate transaction fees?  Will it have very active trading, earning brokerage fees?  Will its share price fluctuate widely, providing trading profits to those who have pre-public information about the business? 

Back in 1961, and again in 1969, more than a thousand entrepreneurial businesses were marketed in initial public offerings.  After one of the periodic collapses in the new issues market, there were fewer than fifty IPOs in any of the years from 1974 until 1980.  Those were the years when Wall Street was going through upheaval from the end of fixed commissions on trading.  After that, the number of IPOs averaged about 530 a year in the 1990s. [Drew Field, Direct Public Offerings, Sourcebooks, 1997, page 1] However, from 2001 through 2008, the average was only 134 a year. [David Weild and Edward Kim, "Why are IPOs in the ICU?" Grant Thornton, undated, available at]

Not only are there far fewer underwritten initial public offerings these days, but those that do get through must be for companies much larger than the typical entrepreneurial business. Through 1998, about 75% of the IPOS were for less than $50 million each, while the last ten years have had fewer than 25% that size.  For IPOs of under $25 million each, the number averaged nearly 300 from 1992 through 1997, when they began a sharp decline.  Initial public offerings of that size have been fewer than 25 a year from 2000 through 2008.   [David Weild and Edward Kim, Why are IPOs in the ICU?, Grant Thornton, undated, available at Thinking/IPO white paper/Why are IPOs in the ICU_11_19.pdf]  “To stage a successful IPO today,” according to the managing director of tech banking at J.P. Morgan Securities, “companies need close to $100 million in annual revenue and a potential stock-market value of at least $250 million—and preferably much more.  [Rebecca Buckman, “Tougher Venture:  IPO Obstacles Hinder Start-Ups,” The Wall Street Journal, January 25, 2006]  

Just as businesses have to be larger to do an IPO, size requirements have been introduced for the purchasers at first time public offerings, excluding all but the wealthiest individuals with brokerage accounts. At broker-dealers with middle class customers, IPOs are still reserved for larger investors.  Fidelity Investments, for example, had a rule that clients must have $500,000 with the firm or place 36 trades in a 12-month period to qualify to buy traditional IPOs. [Eleanor Laise, “More IPO Entryways for Small Investors,” The Wall Street Journal, April 8-9, 2006, page B4]

After 2008, Wall Street's sell side and its buy side have often skipped the IPO and kept the financing within their coterie of investment banks and fund managers.  They arrange huge "private placements," which are then traded by "transaction specialists" like SecondMarket, SharesPost or Felix Investments.  [Liz Rappaport and Jean Eaglesham, "Private-Share Trades Probed," The Wall Street Journal, February 23, 2011, page C1]  SharesPost paid the SEC $80,000 to settle its charge for not having registered as a broker-dealer.  This was part of a "crackdown" on trading in pre-IPO shares.  []  The SEC has said the actions have "nothing to do with the agency's concerns about the legislation" to exempt small business public offerings, even though SEC Chairwoman Schapiro sent an objection letter to Congress the same week.  [Randall Smith and Jean Eaglesham, "SEC Cracks Down on Pre-IPO Trading," The Wall Street Journal, March 15, 2012, page 1A, 2A,]  Wall Street has objected that these pre-IPO transactions are necessary.  "Without these intermediaries to ensure liquidity, fewer employees and investors would be willing to work for and finance these high-growth companies, and that would not be a good thing for entrepreneurship in America."  Scott Shane, "SEC Should Back Off Markets for Start-Ups' Shares," Bloomberg Businessweek, March 18, 2011,]  In other words, let Wall Street buy up shares issued to employees and angel investors.  That postpones the IPO, when anyone at all, even the middle class, could buy shares in the aftermarket.  Keeping investments among investment bankers and money managers means the IPO will happen at a time when the insiders feel the big increases in value have all taken place.  

The decline in IPOs, along with the disappearance of publicly traded companies through acquisitions, has sharply reduced the number of companies listed for trading on exchanges.  From 1991 to 2008, the number of New York Stock Exchange listings remained at just under 2,000.   But adjusting for growth in Gross Domestic Product, this represents a 40% decline.  During the same period, listings on NASDAQ, the home of  smaller companies, declined from over 4,000 to under 3,000.  With the GDP adjustment, this was a 56% drop.  [David Weild and Edward Kim, “A Wake-up Call for America,” Grant Thornton, November 2009, companies and capital markets/gt_wakeup_call_.pdf]

It’s hard to call initial public offerings a path for small business.  It is also hard to call them “public offerings.”  In fact, most IPOs are sold to money managers for hedge funds, pension funds and other institutions, who are clients or prospective clients of the IPO underwriting firm.  The underwriter, in setting the offering price, has a conflict between serving the interests of the company selling shares and the money managers who buy them.  The conflict gets resolved in favor of the money managers.  During the 1980s and 90s, in "99.46 percent of the cases, the share price at the end of the first day of trading was significantly higher than the IPO price, and those fortunate enough to be able to buy at the share price would make a significant capital gain. . . . The investment bankers appeared to set the price for the IPOs so as to maximize the price pop on the first day of trading . . .."   [Charles Kindleberger and Robert Z. Aliber, Manias, Panics, and Crashes: A History of Financial Crises, John Wiley & Sons, Inc., Fifth Edition, 2005, page 160.] The nonwealthy individual investor will probably be able to buy an IPO only in the few hours or days after the offering, when the money managers and wealthy broker clients “flip” their allotment from the underwriters, for a quick trading profit.  Even these second and third round individuals only get to buy shares if they are active investors with brokerage accounts.

Yet it is the “public” that most believes in small business.  According to Gallup’s survey of public confidence in U.S. institutions, small business gets the second highest ranking, between the military and the police, with 67% of the public having a “great deal” or “quite a lot” of confidence in small business.  In last place, at 16%, was big business, just below Congress, at 17%. []  Wall Street's starving eantrepreneurs is taking its toll. "Small business has long made up just over half the economy.  In the past decade its share has fallen below 50 percent for the first time, and the decline has been accelerating."  [John Tozzi, "A Shrinking Contribution," Bloomberg Businessweek, February 20-26, 2012]

One big impediment for initial public offerings of smaller businesses is that Wall Street firms employ fewer stock analysts these days.  The huge losses and closures of Wall Street brokerage firms in 2008 eliminated half of the senior analysts.  [Aaron Pressman, “In Search of Stock Research,” Business Week, January 19, 2009]  Publicly traded companies thrive on analysts’ attention because their reports trigger buying and selling, creating robust marketplaces for their shares.  That makes coverage by analysts crucial for start-ups considering stock offerings, since it is the Wall Street buy side money managers who speculate on short-term price movements.  They insist on the prospect of an active trading market, spurred on by securities analysts.

The harm from Wall Street abandoning small business IPOs isn’t just that the public has confidence in small business and yet is largely closed out from investing in it.  The harm is also greater than the loss of businesses that create the greatest number of jobs.  The most dangerous harm may come from the role of small business as the best defense against the excesses of big business.  If a big business, by itself or acting in concert with its big competitors, is making unconscionable profits, some entrepreneur will want to seize the opportunity to enter the field.  By starving entrepreneurs, Wall Street takes away our best defense from being abused by big business.  It impedes the process of “creative destruction” that Joseph Schumpeter said “is the essential fact about capitalism.”  [Joseph A. Schumpeter, Capitalism, Socialism and Democracy, Harper, 1975, originally published in 1942, pp. 82]

Wall Street Has Caused a Disconnect Between People and Our Economy

Wall Street has refused to market new securities issues to the middle class.  Instead, investment bankers have chosen to earn their fixed commissions on “public offerings” by selling them to Wall Street’s buy side money managers.  New issues of securities are selected, packaged and sold to attract professional investors looking for short-term profits.   These buyers may “flip” the securities within minutes, to be resold to other speculators who didn’t make it into the favored first-buyer list.  Those second-level buyers will mostly resell again whenever they can show a quick gain.  Not many of the early owners will have any interest in the long-term direction of the issuing business.  In the boom IPO market that ended in 2000, Wall Street did bring in middle class individuals, usually in the second or third round after the investment bankers’ friends had flipped the initial offering.  When the bust came, it was these individuals who were left holding the bag, many of them vowing never to try shareownership again. 

Middle class individual investors are left with buying securities in the trading markets or, more likely, owning shares in mutual funds, while wealthy individuals may invest in hedge funds that are let in on initial public offerings.  Either way, any relationship between the middle class individual investor and the underlying business is remote.  There is certainly no direct communication between individuals and business managers.  Investing is focused on what the stock price may do in the near future, rather than on the business behind the securities. 

As late as the 1970s, academics and policy makers seemed unconcerned about individuals being replaced by institutions as the owners of American business.  The Twentieth Century Fund, a nonpartisan foundation since 1919, published a study about the change, from individuals owning most of the corporate shares in America, to today’s dominant ownership by institutional money managers.  After chronicling the shift, the study concluded that, “on the basis of available information, economic, equity, and social-policy considerations do not provide sufficient justification for encouraging the shift of individuals’ assets into stock and institutional assets out of stock.”  [Marshall E. Blume and Irwin Friend, The Changing Role of the Individual Investor: A Twentieth Century Fund Report, John Wiley & Sons, 1978, page 199]  As an aside, the study found:  “However, if it is desired to stimulate investment by small new firms for reasons other than those analyzed in our study, encouraging stock purchases by individuals, who have traditionally been most active in this market, might prove effective.”  [page 197]  Peter F. Drucker put in more succinctly:  "The capital market decisions are effectively shifting from the 'entrepreneurs' to the 'trustees,' from the people who are supposed to invest in the future to the people who have to follow the 'prudent man rule,' which means, in effect, investing in past performance.  But this is happening at a time when the need for new businesses is particularly urgent, whether they are based on new technology or engaged in converting social and economic needs into business opportunities."  [The Unseen Revolution: How Pension Fund Socialism Came to America, Harper & Row, 1976, page 71]  As individuals began abandoning investment in individual companies, Wall Street's buy side used pension fund money "to subsidize an equity market that might otherwise have long since collapsed," according to Jeremy Rifkin and Randy Barber of the Peoples Business Commission.  [The North Will Rise Again: Pensions, Politics and Power in the 1980s, Beacon Press, 1978, page 92]  It also had the effect of giving Wall Street ownership control over management of major businesses.

Wall Street’s recycling of gambling symbols keeps us from even considering the opportunities for investing in new business activity.  If we could stand back and think about the future of American business, we could have a very different approach to investing.  Many of the challenges facing the United States today can be met in ways that would generate earnings for workers and dividends or capital gains for investors.  If individuals were choosing where to place their capital based on these long-term views, we’d have a very different, and democratic flow of capital into business.  Otherwise, we’ll have to follow Japan and other countries into having the government allocate capital to selected technologies and innovations.  Even government/private cooperation, like the space program, still leaves an elite group deciding how our money will be directed.  [Richard J. Elkus, Jr., Winner Take All: How Competitiveness Shapes the Fate of Nations, Basic Books, 2008; Daron Acemoglu and James Robinson, Why Nations Fail, Crown, 2012 and Michael McFaul and Kathryn Stoner-Weiss, "The Myth of the Authoritarian Model," Foreign Affairs, January/February 2008,]  “The current financial system is choking off funds for innovation. . . . Excessive resources are allocated to proprietary trading, to lending to overleveraged consumers, to regulatory arbitrage, and to low-value-added financial engineering. Financing the development of innovation takes a backseat. . . . Unfortunately, most financial firms lack the expertise to invest in business ventures on a sufficient scale, now that a generation of financial professionals has been trained to focus elsewhere. Unless something changes, the gap in funds for business innovation will keep widening.”  [Edmund S. Phelps and Leo M. Tilman, “Wanted: A First National Bank of Innovation,” Harvard Business Review, January-February, 2010,]

Our economy is as important to each one of us as our government.  It is our economy that makes it possible for us to get paid money for our work.  It allows us to buy the things and services we need and want.  When our economy gets out of whack, with a recession or inflation, we experience discomfort, fear and even misery.  For nearly all of us, however, we have a feeling of powerlessness over the course of our economy.  This lack of participation leads to alienation from our nation.  “The ultimate (root) causes of disharmony between state security and human welfare result from failures of the social contracts that bind countries and populations together in cooperative activity.”  [Maurice D. Van Arsdol, Jr., Stephen Lam, Brian Ettkin and Glenn Guarin, Crossing National Borders: Human Migration Issues in Northeast Asia, United Nations University Press, 2005, page 11]

With our government, most of us feel we have at least some say in what it does and who makes decisions that affect our lives.  However imperfect the process, we have a sense of democratic participation in a republican, representative structure.  Politicians can be voted out of office.  We citizens can sometimes cause laws to be repealed and new ones enacted.  In contrast, our economy gives us no such sense of participation.  We’ve let it come under the control of Wall Street, with limited restraint by a government that is itself largely responsive to Wall Street.  Elizabeth Warren described it this way:  "For three decades, the once-solid, once-secure middle class has been pulled at, hacked at, and chipped at until its very foundations have started to tremble. Families have done their best to adjust — sending both mom and dad into the workplace, cutting back flexible spending on food, clothing and appliances, and spending down their savings. When they learn that they have been tricked . . . they start to wonder who wrote the rules that allow that to happen. Distrust spreads everywhere — to industry, to politics, to the institutions that were supposed to make us a stronger country.[Lynn Parramore interview, July 13, 2010,

The concept of a free market economy is that we are casting our votes with the ways we acquire and spend our money.  We can offer our services where we decide we’ll be most useful, fairly paid and well treated.  In a free market, we can put the money we save into channels that will support worthwhile activities and pay a fair return.  As a result, our collective decision making could influence businesses to grow or to wither, to the general benefit of us all.  In practice, however, Wall Street has created a disconnect between us and our economy.  There is no direct relationship between our economic decisions and what influences business decisions.  This disconnect, coupled with the government/Wall Street axis of power, leads to what Tamara Draut calls "Young Adults' Political Retreat" [Tamara Draut, Strapped: Why America's 20- and 30-Somethings Can't Get Ahead, Doubleday, 2006, pages 177-206.  See, also, "Young, Underemployed and Optimistic," Pew Research Center, February 9, 2012] 

Wall Street’s political power means that government decisions about our economy are made to help Wall Street.  [See explanation on "Crony Capitalism," Moyers & Company,, Air Date: January 20, 2012]  Those decisions ignore the rest of us and often harm us.  For instance, consider the very low level of interest rates.  Wall Street is largely in the business of using other people’s money to leverage much larger bets than it could make using only its own money.  The lower the cost of renting other people’s money, the greater the return there can be from risking that money.  The Federal Reserve, which is actually owned by banks, is largely able to set interest rates.  Keeping those rates low favors Wall Street banks, which are in the business of borrowing and employing money.  The people who are hurt by keeping rates low include middle class retirees, who receive interest income from deposits and bonds.  The government has accommodated Wall Street, to the detriment of individuals trying to live off income from their savings.  In the name of saving the economy, the Federal Reserve and the U.S. Treasury have forced interest rates down in recent years and provided Wall Street with taxpayer funds, so that the cost of money to the money industry has been around two percent. 

Everyone in politics and the media seem to look at interest rates from the perspective of the people who borrow money.  From that vantage point, the government gets kudos for keeping the cost of borrowed money low.  But what about the providers of that money?  When the government manipulates interest rates down, that means that bank certificates of deposit and money market funds pay a much lower rate.  Retirees who depend on CDs and other fixed income securities have seen their incomes cut by half or more.  In an article titled “Taxing Grandma to Subsidize Goldman Sachs,” Peter Morici wrote:  “Having fed the campaign machines of both political parties and lavished speaking fees on future White House economic advisors, these financial wizards have managed to purchase preferred treatment in our capital.”  [Peter Morici, University of Maryland professor and former Chief Economist for the U.S. International Trade Commission, “Taxing Grandma to Subsidize Goldman Sachs,” Business Week, April 14, 2009,]

If Wall Street blunders in playing the casino with borrowed money, the government bails it out and gives it a grubstake to get back in the game.  Despite the public and media outrage after the 2008 bubble burst and outflow of trillions in taxpayer dollars, the government has done virtually nothing to prevent a replay of the tragedy.  As individuals, we have been disconnected from our economy.  All the power and influence is with Wall Street and the government it has purchased.

Wall Street Excludes the Middle Class from Share Ownership

The United States has set the pattern for developing a middle class.  “In its earliest decades, the makeup of the United States was similar to that of many European nations:  a small, wealthy class of aristocrats and merchants, and the rest of society, whether farmers or landless workers, all scraping to get by.  . . . It was government policy in the early years of our history that turned a land of largely poor people into the middle-class nation of today.  Despite the lingering image of strong-willed, hard-working, self-made men, America’s comfortable middle class was made possible by concerted government policies.”  [J. Larry Brown, Robert Kuttner and Thomas M. Shapiro, Building a Real “Ownership Society”, The Century Foundation Press, 2005, page 7]  In the last thirty years, however, the trend has reversed.  As Wall Street star Felix Rohatyn said, there has been "a huge transfer of wealth from lower-skilled, middle-class American workers to the owners of capital assets and to a new technological aristocracy."  ["Requiem for a Democrat," a speech at Wake Forest University, March 17, 1995, quoted in Richard Sennett, The Corrosion of Character: The Personal Consequences of Work in the New Capitalism, W.W. Norton & Company, 1998, page 89]

Before the first World War, fewer than 100,000 Americans owned securities listed on the New York Stock Exchange.  After the War, individual investors were courted by Wall Street, because so many of them had purchased Victory Bonds.  Nearly all of these war bond investors had purchased a security for the first time and a big change in attitude and behavior occurred when individuals became willing to exchange their money for a piece of paper.  After that, Wall Street just had to sell another piece of paper to the bond buyers and the observers they influenced.  “By the late 1920s, there were over 3 million shareholders, with half of them buying and selling shares through brokerage accounts, while six hundred thousand were doing so on margin—borrowing money to purchase shares, and using the stock to collateralize the loan.”  [Robert Sobel, Inside Wall Street, W.W. Norton, 1977, page 101]

That all but ended with the Crash of 1929 and the Depression.  Half the brokerage firms were gone by 1932.  Of the survivors, only half of those were still in business by 1937.  Commercial banks had been the major marketers of securities to individuals and they were forced out of the securities business by the Banking Act of 1933.  Those that remained on Wall Street had little interest in doing business with individuals, except for the very wealthy or the professional traders.

In 1940, the New York Stock Exchange commissioned a public opinion poll by Elmo Roper.  It showed that the public had an “image of the stock broker as a polished crook, and the N.Y.S.E as a nest of thieves.”   ["What Does the Public Know about the Stock Exchange? Roper Survey Reveals Extent of Misconceptions and Misinformation about the Services of the Exchange," Exchange Magazine, (January 1940)]  While it was still business as usual for others on Wall Street, Charles Merrill saw this public perception as an opportunity.  He had started a brokerage partnership, Merrill Lynch & Co. in 1914 and sold out just before the 1929 Crash.  He came back in 1940, merging three firms into Merrill Lynch, Pierce, Fenner & Beane.  Most of the old offices were replaced with cheerful, efficient spaces for brokers to meet with clients.  [Edwin J. Perkins, “Market Research at Merrill Lynch & Co., 1940-1945; New Directions for Stockbrokers,” University of Southern California,] "

According to Martin Mayer, Merrill started the new business "because he felt the need to make a political statement.  His was the brokerage firm that would serve the ordinary customer."  [Martin Mayer, The Money Bazaars: Understanding the Banking Revolution Around Us, E.P. Dutton, Inc., 1984, page 35]  Merrill began a major educational advertising effort to explain how investments worked.  The brokers were called “account executives” and they were trained not to give investment advice.  Instead, they were to recommend securities approved by the firm’s research department, with separate lists for aggressive, conservative and moderate investors.  Free research reports were sent to clients and prospects.  The biggest innovation that Merrill made was in how the brokers were paid.  They got a salary and bonuses—no commissions.  “Let others take care of the very wealthy and the gamblers, Merrill seemed to be saying; our firm will cater to the middle class.”  [Robert Sobel, Inside Wall Street, W.W. Norton, 1977, page 104]

Other brokerage firms copied the Merrill approach.  The New York Stock Exchange, under President Keith Funston, advertised “Own Your Share of America,” “People’s Capitalism” and “A regular dividend check is the best answer to communism.”  [Robert Sobel, Inside Wall Street, W.W. Norton, 1977, page 107]  The results?  Trading volume went from 655 million shares in 1950 to over 3 billion in 1968.  Within 20 years, the number of shareowners increased from fewer than 6.5 million to more than 33 million, the number of brokers jumped from 11,400 to 53,000.

However, there’s an old Wall Street saying, “Don’t confuse brains with a bull market.”  When the market turned in 1969, the momentum vanished.  Bringing in the middle class was suddenly out of favor on Wall Street, losing out to wooing institutional money managers and trading for the brokerage firm’s own account.  Wall Street’s buy side, trading in thousands of shares at a time, had been paying the same cost per share as the individual buying a hundred shares.  Of course, Wall Street sell side brokers wanted only to do business with the customers who made them far more money for the same amount of work.

Interest in the middle class returned after fixed commissions were abolished in 1975. Wall Street’s buy side had won a major victory over the sell side when Congress took away the fixed rates for buying and selling stocks.   Now the money managers could negotiate openly with brokers, forcing them to compete on the basis of what they charged for executing an order to buy or sell.  Many of the old Wall Street firms were very slow to adapt to the new rules of the game.  They just weren’t willing or able to reduce costs, streamline operations and change their compensation structure.  Merrill Lynch moved far away from its founder’s concept.  Its strategy was “to focus the firm’s brokerage business on attracting wealthy investors with at least $1 million in assets.  The move away from small investors is part of a broader plan to boost profits at the big securities firm.” [The Wall Street Journal, November 2, 2001, page A1]

As a result, a new breed of securities firm sprung up, the discount broker.  The most successful of the discount brokers has been Charles Schwab & Co., which was started right after the end of fixed commissions in 1975.  At the beginning, the business was aimed at providing execution of individuals’ orders for buying and selling stocks and a few other securities.  Schwab has expanded in many ways over the years, such as owning a bank and a securities trading firm, making mortgage loans and providing support for independent investment advisers.  It has made a few skirmishes into distributing new issues of securities but has never really tried to become an investment banker.

(I met with Charles Schwab in the late 1970s, about a joint venture in marketing “negotiable certificates of deposit,” which savings banks had been allowed to issue.  The certificates worked like bonds and would have a trading market.  We suggested that the banks offer the CDs directly to Schwab’s customers and that Schwab would handle the market for resales.  Other priorities got in the way, but we did learn about Charles Schwab’s personal view of his place in the financial markets.)

Except for the discount brokers, Wall Street’s sell side has continued to downplay any relationship with America’s middle class.  Registered representatives are discouraged from providing services to individuals with less than, for instance, a million dollars to invest in securities.  Wall Street underwriters exclude retail brokers from recent initial public offerings, like General Motors and Tesla Motors, while Goldman Sachs creates a "special purpose vehicle" for their customers who can invest at least $2 million in a "private" offering of Facebook shares.  [Roben Farzad, "Initial Private Offering," Bloomberg Businessweek, January 6, 2011,; Anupreeta Das and Amir Efrati, "Cash Keeps Facebook's Status Private, The Wall Street Journal, January 4, 2011, page B1; Jean Eaglesham and Aaron Lucchetti, "Facebook Deal Spurs Inquiry, The Wall Street Journal, January 5, 2011, page A1.  Goldman Sachs further limited the sale to foreign investors, saying that "the level of media attention might not be consistent with the proper completion of a U.S. private placement under U.S. law.”]The middle class is shunted off by suggestions that they buy mutual funds, which pay significant commissions to the brokers and require very little of the broker’s or firm’s time in picking stocks and deciding when to sell and how to reinvest.  For middle class customers who want to own securities that were once actually issued by a business, Wall Street’s sell side will charge a flat fee, of up to three percent, for maintaining an account managed according to the firm’s investment formula.  Meanwhile, registered representatives who fail to achieve a minimum amount of revenue from their accounts are fired.  Wall Street tolerates the middle class so long as it pays for itself in the very short term and doesn’t interfere with its other businesses.

Wall Street Rations Money for Local Governments and Nonprofits

Ralph de la Torre, CEO of Caritas Christi Health Care, lamented in late 2008:  “Health care has been holding its breath.  We live and die on the tax-free bond market, and right now we’re dying.  Projects are being postponed.  All the commodities that health care buys and the companies and people it touches—from imaging to pharma to physicians—are about to dive off the cliff.  The bond markets are closed tight.  Until they reopen, we’re going to have a big problem.  I think there’s going to be a pretty substantial consolidation in health care.  As many as 20% of hospitals could close.  There’s going to be no capital spending for at least the next year or two.” [“The Recession:  What Top CEOs are Thinking,” Business Week, December 15, 2008, page 064]

Health care, along with the infrastructure and other public needs, have been starved for funding because local government decision makers are locked into an archaic system of selling bonds through Wall Street underwriters.  The 2009 economic stimulus plan had the federal government selling bonds to the Chinese, then sending the money to states for funding infrastructure projects.  The common sense way would be for the state and local agencies to market bonds directly to the communities most affected by the infrastructure.  Infrastructure projects could be set up for payment by their users, like toll bridges with fast passes.  Then the agencies could market revenue bonds to people who benefited from the project, without raising taxes.  

Instead of these common-sense ways of raising money for local services, the government and nonprofit officials follow the century-old ritual of going to Wall Street, where bonds are sold in $5,000 minimum amounts, mostly to mutual funds, banks and insurance companies.  The Wall Street underwriter often places a small offering entirely with one money manager, collecting the customary percentage fee for a “public” offering. Even if an individual investor learned about an offering and was willing to buy the $5,000 minimum, there remains the problem of whether the bond could be resold before its maturity.  Broker-dealers who acted as underwriters might or might not be willing to repurchase the bonds.  If they did repurchase, they would set the price low enough to assure a big profit from reselling the bond.  There would be no reported source of pricing information or history of trades in the bonds, no way to find out how much a bond is worth in today’s market.

Most government procurement programs, like buildings and equipment, require competitive bidding.  Not so with procuring money.  Sales of about 85 percent of local government bonds have prices, interest rates and selling commissions which are negotiated with one selected investment banker.  That's "because local politicians don't want to alienate investment bankers who donate to charities and political campaigns. . . . 'Firms get chosen to be negotiated underwriters as payback.'" [Darrell Preston and John McCormick, "Chicago Pays for Selling Bonds Without Bids," Bloomberg Businessweek, May 17-23, 2010, pages 46, 47, quoting J.B. Kurish, associate dean, Emory University, Goizueta Business School]  Even when competitive bidding is required, bond issues of under $1 million usually receive only one bid.  [Comment by Robert C. Pozen in The Deregulation of the Banking and Securities Industries, Lawrence G. Goldberg and Lawrence J. White, editors, Lexington Books, 1979, page 337]

One indication of how profitable it is for investment banks to underwrite local government bonds is the continuing story of “pay to play” scandals.  The temptation for bribery comes because government officials choose the underwriter.  The decision factors are rather subjective, such as, which underwriting firm has the better relationships with Wall Street’s buy side.  [John Tepper Marlin, “Muni Bonds Pay-to-Play,” The Huffington Post, January 12, 2009,; Rajesh Misra, Pay to Play in the Municipal Bond Industry, []

“Three federal agencies and a loose consortium of state attorneys general have for several years been gathering evidence of what appears to be collusion among the banks and other companies that have helped state and local governments take approximately $400 billion worth of municipal notes and bonds to market each year.  E-mail messages, taped phone conversations and other court documents suggest that companies did not engage in open competition for this lucrative business, but secretly divided it among themselves, imposing layers of excess cost on local governments, violating the federal rules for tax-exempt bonds and making questionable payments and campaign contributions to local officials who could steer them business.” [Mary Williams Walsh, “Nationwide Inquiry on Bids for Municipal Bonds,” The New York Times, January 8, 2009]  The recently retired manager of tax-exempt bond field operations for the Internal Revenue Service, Charles Anderson, said that “Pay-to-play in the municipal bond market is epidemic.”  He estimated the cost at $4 billion a year.

What has the government done about "pay-to-play?"  The SEC used the occasion to protect Wall Street's monopoly, by saying it is OK for a fund's investment adviser to hire a placement agent, but only if the agent itself is an SEC-registered broker-dealer or investment adviser.  [Release No. IA-3043; File No. S7-18-09,]   The Internal Revenue Service has a potent tool for dealing with the “pay-to-play” problem.  The IRS can revoke the government agency’s tax-exempt status.  Unfortunately, that punishes the investor who purchased the bonds and the government agency that issued them.  It doesn’t touch the broker-dealer or the officials who selected it as underwriter.  The effect of the IRS sanction is to make the interest paid suddenly taxable, retroactive to their first payment.  This possibility then becomes a further source of uncertainty and fear for the individual investor.

The American Recovery and Reinvestment Act of 2009, the “stimulus” law, included a gift to Wall Street dressed up as a way to finance local governments.  It authorized “Build America Bonds,” which pay interest rates comparable to corporate bonds, rather than the much lower rates typical for government debt.  The federal government pays 35% of the interest cost.  These Build America Bonds were to replace conventional local government bonds, which  are exempt from an individual’s federal and state income tax.  The problem with conventional  bonds for Wall Street is that it doesn’t want to market to individuals, who look for the tax break.  The easy sell for a Wall Street investment banker is to institutional money managers.  However, most institutions are themselves exempt from federal and state income taxes, so they have no interest in conventional local government obligations paying only two-thirds of the rate on corporate bonds.  With Build America Bonds, the investment bankers can get corporate bond rates for an entire issue of bonds, allocating them to a few of their favorite customers.  The interest cost to the local government is about the same, because the federal government subsidizes a third of the amount paid to investors. 

Average underwriting fees on Build America Bonds are 8.2%, compared to about 5% on conventional local government bonds, and less than 1% on most corporate bonds.  Neither issuer nor investor really cares that the investment bankers are taking much more than their usual cut. The program is designed for Wall Street investment bankers to make “surprisingly high” fees.  [Edward Prescott, Nobel prize economist at the Federal Reserve Bank of Minneapolis and Arizona State University professor, quoted by Ianthe Jeanne Dugan, “Build America Pays Off on Wall Street,” The Wall Street Journal, March 10, 2010, page C1]  The program was to last only through 2010 but is being talked up for becoming permanent.

Wall Street Uses Complexity to Maintain an Impenetrable Mystique

How does Wall Street hold onto its control over the use of securities?  Why hasn’t its government-protected monopoly been penetrated?  We know they’re greedy, overpaid, that they cause harm—but we haven’t tried to get along without them.  They seem to have the keys to the vault.  Only they understand what they’re doing.  “Wall Street is a very seductive place, imbued with an air of power. Its executives truly believe that they control the levers that make the world go round.”  [Simon Johnson, “The Quiet Coup,” The Atlantic, May 2009, Professor Johnson is a former International Monetary Fund chief economist and now an MIT professor.  His blog is]

Part of Wall Street’s mystique is the myth that investing is too complex for us to do ourselves, so we need the wizards of Wall Street to do it for us.  Not so, says Peter Lynch, one of the most successful buy side professionals.  He managed Fidelity’s Magellan Fund from 1977 to 1990, as it grew from $18 million to $14 billion.  In his book, One Up on Wall Street, he said, “Twenty years in this business convinces me that any normal person using the customary three percent of the brain can pick stocks just as well, if not better, than the average Wall Street expert.” [Peter Lynch, with John Rothchild, One Up on Wall Street, Penguin Books, 1989, page 13]  Instead, he says, “People seem more comfortable investing in something about which they are entirely ignorant.  There seems to be an unwritten rule on Wall Street: If you don’t understand it, then put your life savings into it.” [page 24]  Wall Street’s sell side analysts promote buying stocks but rarely suggest selling them.  “Just 5.1% of analyst ratings are “sells,” according to data compiled by Bloomberg.”  [

On the buy side, the performance record is well-documented.  Whatever the reasons, most money managers who make investment decisions consistently turn in poorer results than the comparable indices of all securities in the same category.  Once an investor decides to invest in a particular kind of security, like shares in large corporations, history shows that better results would come from buying a little interest in all of them than to have a professional pick individual companies.  A 2009 study by Standard & Poor’s showed that most managed mutual funds failed to do as well as their comparable S&P indices.   For the five years 2003-2008, the index for the largest 500 companies had better returns than 72% of funds investing in shares of large businesses.  For smaller companies, where stock picking is often said to require extra skill, more than 85% of the fund managers did worse than the small capitalization index.  For emerging market funds, results were below the index for 90% of the managed funds over the five-year period.  Even 80% of the bond funds were behind bond benchmarks, not counting junk bond funds.  [Sam Mamudi, “Managed Funds Take Beating from Indexes,” The Wall Street Journal, April 22, 2009, page C13]

(From our experience in advising direct public offerings, we found that nine out of ten investors in direct offerings had never before owned securities in an individual company.  Nor had they ever been a customer of a securities broker-dealer.  Nevertheless, they went through a risk/reward analysis as rigorous as most reports from Wall Street’s sell side or buy side.  In fact, their investigations were often much broader.  They went beyond the financial data for the company and its industry and into the personality of management, the characteristics of customers and their feel for the life cycle of the company’s products.)

The myth of complexity has worked as a marketing strategy for Wall Street’s investment bankers and brokers.  Until Madison Avenue was hired to remake Wall Street’s image, the sell side registered representatives were commonly called stockbrokers.  The names have been changed, to financial consultants, financial advisors, wealth management advisers and the like.  This more obscure naming has coincided with the increased complexity of the products they sell.  The new titles and new instruments say to us, “You need me because you couldn’t possibly understand.”  That statement is at least half true:  most of us do not understand the products that are being sold to us.  For instance, to pick just one of these products, the “portable alpha” was sold to middle class individuals shortly before the 2008 Panic.  The “alpha” stands for the sophisticated judgment that brings above-market returns on investment.  The concept was to use part of the money invested to buy futures and swaps contracts on the market, getting the benefit of how an index fund operates, without having to put up the full amount those funds require.  The rest of the investment went into hedge funds, which are supposed to beat the market.  (I may not have described this correctly.  That illustrates the problem of complexity.)  The portable alpha strategy caused huge losses to middle class investors when the stock market dropped in 2008.  [Randall Smith, ‘Alpha’ Bets Turn Sour, The Wall Street Journal, December 1, 2008, page C1.]  Back at it again in 2009, Wall Street’s new products included “long-short” funds and “replicators,” marketed as providing the winning strategies of hedge funds in packages for the middle class.

Complexity makes it easier for Wall Street to get away with price-fixing conspiracies, like one uncovered by a whistleblower trader at Bank of America.  "It involves a vast bid-rigging and kickback conspiracy, implicating every major Wall Street bank and an assortment of brokers, dealers, and con artists.  The perps allegedly manipulated the bidding for short-term investments [of] the proceeds from the sale of municipal bonds--an arcane but lucrative practice that violated the Sherman Antitrust Act and cheated bond issuers out of billions of dollars."  [Thomas Brom, "When Thieves Fall Out," California Lawyer, July 2010, page 10]  To Bank of America's credit, it had outside lawyers confirm the whistleblower's account and then turned itself in to the Justice Department under the Antitrust Criminal Penalty Enhancement and Reform Act.  That law provides leniency for the first conspirator to admit an antitrust violation.  The dozens of others involved included JP Morgan Chase, Morgan Stanley, Citigroup, Wells Fargo and Goldman Sachs.  Evidence included more that 600,000 audiotapes of derivatives traders.

Wall Street Uses Complexity to Hide Risk

The history of mortgage securities shows the path from an understandable security into instruments that are too complex for analysis, and thus just right for deception.  The first mortgage security, the Mortgage-Backed Bond, was a promise by a bank to pay fixed interest amounts and return the principal at the bond’s maturity date.  In addition to the bank’s credit supporting the obligation, the bank deposited a pool of its mortgages with a trustee.  The amount of the mortgages totaled 150% of the amount of the bonds and the bank was required to replenish the pool to maintain that level.  An investor could rely on the solvency of the bank and also know that, if the bank failed, there was plenty of cushion in the mortgages held by a trustee.

Wall Street saw real limits to its own profitability with Mortgage-Backed Bonds.  First, the only revenue was the one commission investment bankers took when the bonds were sold, with nothing else for the thirty years the investor might hold the bonds.  Second, using $150 of mortgages for each $100 of bonds “wasted” the extra 50% by making them unavailable for packaging into more securities.  So, the next mortgage security was the Pass-Through Certificate.  Investors were sold a fractional share of a pool of mortgages.  They received interest and return of principal as the homeowners made their monthly payments.  The Pass-through Certificate allowed 100% of the mortgages to be packaged and sold.  If the buyers reinvested the money passed through from mortgage payments, more commissions were generated. 

The deterioration in quality that led to the 2008 debacle in mortgage securities began with this change from Mortgage-Backed Bonds to Pass-Through Certificates.  The bank that originally made the loans was no longer responsible for anything other than collecting mortgage payments and passing them through to investors.  Even that responsibility was often transferred to another servicing agent, so the originating banks were off the hook for loan quality as soon as the loans were bundled and sold as Pass-Through Certificates.  The risk had been entirely transferred from the people who made the loan decisions and onto people like those who had put their money into retirement funds, managed by Wall Street’s buy side.

Wall Street learned that buy side money managers would purchase Pass-Through Certificates, even though they were more complicated and their repayment timing was uncertain.  Pass-Throughs were still relatively simple and the buy side felt they could make investment decisions without having to rely completely on the sell side.  This changed when Wall Street quickly moved on to the Collateralized Mortgage Obligation, with its segments, called “tranches,” based upon relative risk.  CMOs were packaged by computer programs, sorted by characteristics that predicted likelihood of default.  One tranche would get a triple-A rating for conservative investors and, several tranches later, the “toxic waste” would be sold to the most gullible.  Wall Street looked at their huge profits from CMOs and decided that they could package credit card balances, auto loans, music royalties and other payment streams into Collateralized Debt Obligations, or “CDOs.”  In describing this history, Charles Morris commented:  “The complexity of the instruments spiraled into absurdity.”  Wall Street “gleefully spewed out phantasmagorical 125-tranche instruments that no one could possibly understand.”  [Charles R. Morris, The Trillion Dollar Meltdown, PublicAffairs, 2008, page 41] Since the destruction of 2008, there has been an effort to start over, with “covered bonds,” marketed as having come from a European model.  These are like mortgage-backed bonds, except that the collateral pool of mortgage loans is retained by the lender, rather than placed with a trustee.  [Richard Barley, “Covered Bonds Set to Roar?” The Wall Street Journal, January 8, 2010,] 

(We tried a very different approach, with the Mortgage Trust Certificate.  Our client was a very large savings bank with a few billion dollars of home mortgages it had originated.  With a firm of mathematician consultants, we would analyze a portion of a pension fund’s payment obligations over the next 30 years and then select a pool of mortgages that would generally provide cash flow to match the projected payouts.  The lending bank was obligated to have the mortgage pool maintain the cash flow stream, supplying additional mortgages when necessary.  No securities broker-dealer was involved.  There was to be a direct and ongoing relationship between the bank and the pension fund.  We explained the mechanics to rating agencies and to third-party insurance companies who would guarantee the bank’s obligation.  The concept was easily understood by everyone involved.  Unfortunately, other priorities got in the way and the project was never finished.  In retrospect, it seems like a quixotic venture.)

(Earlier, before mortgage securities became a huge market, I worked with a client on a computer-based market for selling mortgages directly.  Sponsored by Fannie Mae, Freddie Mac and other government-sponsored entities, it was called AMMINET, for Automated Mortgage Market Information Network.  It was modeled basically on the original NASDAQ, the automated quotation market for stocks.  Lenders would make packages of mortgages available for pension funds and others to buy, leaving Wall Street out of the flow.  My client was to design and operate the computer program.  The effort never made it to market.  Its basic, simple approach was the exact opposite of the complexity that furthers the Wall Street mystique.  Instead, mortgage lenders were forced into supplying mortgages for off-the-shelf products designed by Wall Street for maximizing its own take from transactions.)            

An awful lot of the bad stuff that occurred in our financial system has happened because a proposed transaction was never explained in plain, simple language.  Financial innovators were able to create new products and markets without anyone thinking through their broader financial consequences — and without regulators knowing very much about them at all.  It doesn’t matter how transparent financial markets are if no one can understand what’s inside them.  [Michael Lewis and David Einhorn, “How to Repair a Broken Financial World,” The New York Times, January 3, 2009]  An early warning about complexity came from a most unlikely source.  On November 17, 1970, the President of the New York Stock Exchange, Robert W. Haack, delivered an address to the Economic Club.  It included lines like:  “Bluntly stated, the securities industry, more than any other industry in America, engages in mazes of blatant gimmickry.”  [As quoted in Chris Welles, The Last Days of the Club: The Passing of the Old Wall Street Monopoly and the Rise of New Institutions and Men Who Will Soon Dominate Financial Power in America, E.P. Dutton & Co., Inc., 1975, page 18] 

Borrowing from academic papers on quantifying risk, and hiring the academicians themselves, Wall Street has presented investment schemes and invented securities that used theoretical diversifications and hedging structures to create the appearance of no risk, or very limited risk.  For instance, an article by David X. Li, then working at JPMorgan Chase, appeared in The Journal of Fixed Income in 2000.  It bore the academic title, "On Default Correlation: A Copula Function Approach." (In statistics, a copula is used to couple the behavior of two or more variables.)  Wall Street used the approach to build a way around the difficult task of analyzing the risk of each mortgage or other asset placed in a CMO pool.  They could use Li’s correlation number. Rating agencies also began using the shortcut analysis, rather than the arduous task of understanding and quantifying the variables.

For an even riskier game, Wall Street creates options, swaps and other derivatives from these new securities, to both stimulate and serve the mania for greater risk-return ratios. The giant of these new made-up securities was the Credit Default Swap, which is a bet that a particular borrower or package of debt securities would or would not fail to pay.  Like most options, it could be used by the owner of the security to hedge its credit risk.  For most players, however, it was a way to bet on the economic future of a debt instrument. “The CDS [credit default swap] and CDO [collateralized debt obligation] markets grew together, feeding on each other. At the end of 2001, there was $920 billion in credit default swaps outstanding. By the end of 2007, that number had skyrocketed to more than $62 trillion. The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by 2006.”  [Felix Salmon, “Recipe for Disaster: The Formula That Killed Wall Street,” Wired, February 23, 2009,]

Securities derived from mortgages are only one part of the complexity devastation wreaked by Wall Street. [For a description of "how close the financial system had come to a catastrophic seizure" in October 1987, see Scott Patterson, The Quants, Crown Business, 2010, pages 47-53.] The tax exempt bond market, used to finance state and local governments, has been badly damaged by Wall Street’s practice of inventing and selling complex financial contracts.  This market once moved rather predictably with changes in interest rates.  Then, in 2008, municipal bond funds lost an average 9.4% and some of them were down over 30%.  One cause was Wall Street’s marketing of “tender option bonds” or “inverse floating rate obligations.”  These instruments split the income from a municipal bond into a short-term fixed rate and a long-term variable rate.  [Jason Zweig, “Muni-Bond Bargains: Devil’s in Details,” The Wall Street Journal, January 31, 2009, page B1]  Wall Street uses credit default swaps to bet against the very local government bonds it underwrites.  At the same time that Wall Street is selling the bonds to one group of its customers, it also sells another set of customers on bets that the price of those bonds will go down.  [Ianthe Jeanne Dugan, "Scrutiny for Bets on Municipal Debt," The Wall Street Journal, May 14, 2010, page C1]

Hospitals were sold interest rate swaps and auction-rate securities, incurring huge losses.  [Ianthe Jeanne Dugan, "Hospitals Claim Wall Street Wounds," The Wall Street Journal, July 8, 2010, page C1]

Wall Street is still using the disaster it created to extract more money from local governments and university endowments.  Before the Panic of 2008, Wall Street sold them instruments that would swap their fixed-rate long-term debt for a variable-rate obligation.  With names like "constant maturity swaps, swaptions and snowballs, they lowered the amount of interest borrowers had to pay, for a brief period.” [Randall Dodd, "Municipal Bombs," Finance and Development, International Monetary Fund, June 2010,] When the variable rates went up, Wall Street offered to terminate the swap agreement--for a fee.  "In all, borrowers have made more than $4 billion of termination payments . . ..  In addition to getting termination payments, Wall Street is finding another way to profit--underwriting bonds that borrowers are selling to raise money for the termination fees and to refinance their variable rate debt."  Michael McDonald, "The Wall Street Product That Soaks Taxpayers," Bloomberg Businessweek, November 15-21, 2010, page 53, 54]  Nonprofit organizations were hit by the same Wall Street tactic, which could include buying a letter of credit from the Wall Street bank "assuring that the bonds were a safe investment.” But the letter of credit would expire without renewal.  [Justin Scheck, "Money Woes Threaten Museum," The Wall Street Journal, November 19, 2010, page A8]            

Out of the complexity of using securities comes a mystique surrounding the investment bankers who appear to know how it all works.   Wall Street maintains its monopoly of the money flow by perpetuating the illusion that it knows all the whos and whats and how-tos and that no outsider will ever know them.  To have some sort of common language with investors, Wall Street grabs onto shorthand concepts that can seem to make some sense.  One of the most common is the earnings multiple, the concept that a company’s shares trade at a multiple of its earnings, divided by the number of shares it has issued.  The multiple is explained as depending upon the industry, the company’s growth rate and future prospects.  A big problem with this is the pressure it puts upon each quarter’s earnings per share.  It has lead to a lot of “creative accounting,” which Andrew Tobias describes in The Funny Money Game[Andrew Tobias, The Funny Money Game, Playboy Press, 1971, pages 134 to 152]

Robert J. Ringer self-published his 1973 book, Winning through Intimidation and sold 1.7 million copies in the next four years.  [  A later edition was published by Fawcett in 1984.]  His advice was geared to his own business experience as a broker for apartment buildings.  The techniques he suggested are pretty gross, compared to the sophistication of the investment banker.  But the underlying premise is the same:  Success in business comes from creating illusions, not from the quality of the product or service offered.  The intimidation game on Wall Street does include high-end variations of the tricks Ringer suggests.  There are the limousines, breakfasts in the private dining rooms, hard-to-get tickets to events, introductions to famous people, being included among those who wear clothes and watches seen in slick New York magazines.  But more effective is the aura created, that these Wall Street people are the ones who understand how high finance really works, that it is not something the rest of us could ever learn, that it’s a combination of breeding and immersion.

A story is told that James Carville, while working for President Clinton, would be in White House meetings with Robert Rubin and others, discussing the national economy.  Every issue seemed to be resolved when Rubin or someone else from Wall Street would say how the bond market would react. Carville would remark:  “If there is reincarnation, I want to come back as the bond market.  Nobody gets more respect.”  [In another version, Carville said that, reincarnated at the bond market, "You can intimidate everybody."  Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, Pantheon Books, 2010, page 98, citing Louis Uchitelle, "The Bondholders Are Winning:  Why America Won't Boom," The New York Times, June 12, 1994,]  The message seems to work:  "We work on Wall Street and understand it.  You don’t, so you can’t."

  Nothing so demonstrates the power of the Wall Street mystique as the bailouts of 2008.  Within a week of the request by the Treasury Secretary, himself a former CEO of an investment bank, Congress gave him authority to spend $700 billion of taxpayers’ money buying toxic mortgage securities that investment banks had manufactured but couldn’t sell.  Over the same period, politicians and the media were startlingly unconcerned when the Federal Reserve Board bought or guaranteed over a trillion dollars of securities from investment banks and commercial banks which had caused the credit market crisis.  All of this was done without any real conditions on how our money was to be used, how the banks would behave in the future and who should bear responsibility for all the pain caused people all over the world.

The academic support for encouraging complexity may have begun changing.  Some writers seem to be moving back to accepting that some risks cannot be quantified, predicted or even imagined.  [See Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable, Random House, 2007]  There are even academicians suggesting that commercial banks should no longer provide money for buying complex derivatives.  [Amar Bhidé, Glaubinger professor at Columbia Business School, “In Praise of More Primitive Finance,”] World political opinion may also be shifting from holding Wall Street in awe.  French President Nicolas Sarkozy gave the keynote address at the 2010 World Economic forum in Davos, in which he said:  “There is indecent behavior that will no longer be tolerated by public opinion in any country of the world.  That those who create jobs and wealth may earn a lot of money is not shocking.  But that those who contribute to destroying jobs and wealth also earn a lot of money is morally indefensible.”  [Marcus Walker and Emma Moody, “At Davos, Bankers Are On The Run,” The Wall Street Journal, January 30-31, 2010, pages A-1, A-11]

Wall Street has Concentrated Power in the Few

Wall Street has gathered for itself a great monopoly of government-enforced power in finance.  Through exercise of that power, it has fostered the concentration of American business into a few huge corporations in each industry.  In perhaps its most pernicious effect, Wall Street has forced a concentration of business ownership in wealthy individuals and institutions.  As Wall Street’s buy side has grown, it has led to limiting the majority ownership of business within professional money managers for huge funds and other institutions. 

Concentration of power in finance.

As a former Federal Reserve System Governor put it :“We cannot have a durable, competitive, dynamic banking system that facilitates economic growth if policy protects the franchises of oligopolies atop the financial sector.”  [Kevin M. Warsh, as quoted by Gretchen Morgenson, “Telliing Strength From Weakness,” The New York Times, Sunday Business, April 29, 2012, page 5]

 Perhaps the most obvious and disturbing side effect of that concentration of power in Wall Street is that 100 financial institutions own over half of all corporate shares, “constituting majority control of corporate America.”  Institutional investors of all types own about two-thirds of all U.S. stocks.  [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, page 69, 74]

Wall Street personalities are extremely competitive, in the “mine is bigger than yours” syndrome.  Size seems to be more important than profitability, innovation or a reputation for integrity, good relationships or other standard.  As a result, many of the players on Wall Street have become “too big to fail.”  The United States and Britain have considered a “too big to fail tax,” to pay for the increased regulatory scrutiny they require.  The big ones would be held to higher capital ratios and other standards intended to keep them out of financial trouble.  Despite a lot of talk about forcing these financial conglomerates to split into smaller pieces, there seems to be little chance of that happening.

One effect of "too big to fail" is that everyone now believes that credit of the United States government stands behind the huge institutions, while smaller ones must stand on their own.  As a result, the big ones can borrow money at a lower cost and take bigger risks for extra profit.  [Dean Baker and Travis McArthur, "The Value of the 'Too Big to Fail' Big Bank Subsidy," Issue Brief, Center for Economic and Policy Research, September 2009, and Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, Pantheon Books, 2010, pages 204-205]  It turns out that the Dodd-Frank Act will effectively provide government insurance for all creditors of the largest Wall Street firms, leaving the rest of the financial services industry at a competitive disadvantage.  William Wheeler, from MetLife, Inc., testifying before a Congressional committee, said that having the Financial Stability Oversight Council designate his company as a Systemically Important Financial Institution “would be the federal government’s signal that we are indeed ‘too big to fail,’ and that if we got into financial trouble, federal funds would be used to rescue the firm.  The implicit backing of the federal government could strengthen perceptions of our creditworthiness and may give us a significantly cheaper cost of funds than our peers.”  [Peter J. Wallison, “Dodd-Frank’s Too-Big-to-Fail Dystopia,” The Wall Street Journal, May 24, 2012, page A15]

Government has not only abandoned enforcement of antitrust laws against Wall Street.  It has facilitated the concentration of power in Wall Street.  Examine the market for U.S. Treasury obligations, from 30-day Treasury bills to 30-year Treasury bonds.  The Federal Reserve Banks handle the initial distribution of these securities through a few investment and commercial banks, the so-called “primary dealers” chosen by the Federal Reserve Bank of New York.  Before each auction of Treasury securities, government officials meet with the primary dealers for advice on how to price them.  Then the dealers purchase securities at the auction, as agents or for their own account.  These primary dealers were the private contractors chosen in 2008 by the Federal Reserve and the Treasury to lend government money to purchasers in the Term Asset-Backed Securities Loan Facility.  The TALF bailout financed purchases of securities from the banks and others caught when the markets froze.  The primary dealers, as you might guess, went to the hedge funds with this minimal down payment, low interest rate deal.

There were 40 of these “primary dealers” twenty years ago and only 18 by 2010, of which 7 were U.S. banks or broker-dealers and 11 were foreign banks or broker-dealers.  The Federal Reserve Bank of New York recently tripled the minimum net capital  required for primary dealers from $50 million to $150 million.  “The message is clear:  the New York Fed does not want a bunch of new start-up dealers knocking at their door.”  [Chris Bury of primary dealer Jefferies & Co., quoted by Min Zeng, “Cost to Primary Dealers Goes Up,” The Wall Street Journal, January 12, 2010, page C8]  (During 1984 and 1985, I purchased call options on Treasury futures.  For a modest option price, I could gamble on a short-term rise in the price of 30-year bonds.  My theory was that the primary dealers would manipulate the market down as they advised the government on the next auction’s price.  I figured the price would go up right after the dealers had purchased at the auction.  The dealers could then sell to their customers at the higher price and pocket the difference.  Coincidence or not, using the theory worked well for a few auctions.  Then friends, knowing I didn’t have a gambler’s temperament, insisted that I stop.  I’m glad to be out of it and know I would have ultimately lost everything, but I got a real taste of the mania that comes from playing rigged games.)  

Henry Kaufman was the most-quoted securities analyst/economist of the 1980s, when he worked for Salomon Brothers, now part of Citigroup.  His dour outlook led to the nickname, “Dr. Doom.”  In a December 2008 opinion editorial, Kaufman noted how the ownership of debt securities had become concentrated in just 15 financial conglomerates.  “These were the very firms that played a central role in creating an unprecedented amount of debt by securitization and complex new credit instruments.  They also pushed for legal structures that made many aspects of the financial markets opaque.” 

Kaufman’s gloomy prediction: “In the years ahead, the influence of these financial conglomerates will be overwhelming—and they will limit any moves toward greater economic democracy.  These conglomerates are and will continue to be infused with conflicts of interest because of their multiple roles in securities underwriting, in lending and investing, in the making of secondary markets, and in the management of other people’s money.  . . . Through their global reach, these firms will transmit financial contagion even more quickly than it spread in the current credit crisis.  When the current crisis abates, the pricing power of these huge financial conglomerates will grow significantly, at the expense of borrowers and investors.”  [The Wall Street Journal, December 6-7. 2008, page A11.  Kaufman is the author of On Money and Markets:  A Wall Street Memoir, McGraw-Hill, 2001.]  The future that Kaufman forecasts in this Wall Street Journal article is not far from this 1937 report to the Communist Party:  “A very important contributing factor to the decline of the stock market, and the uneven recession in various branches of industry is this: that big capital, the reactionary monopolists, may be considered as being on a sort of political strike. . . . It is not excluded that in expectation of this Congress [the special session of Congress called by Roosevelt] and what it may do, the monopolists seek to produce or hasten the aggravation of economic conditions, in order to terrorize Congress and keep it from adopting progressive political measures.”  [Alex Bittelman, Economic Trends Today, Monopoly Sabotage, and Tasks of Our Party – A Report to the Political Bureau of the Communist Party on the Present Economic Situation,” Daily Worker, October 28, 1937, as quoted by Dave Cowles, “Strike of Capital,” The New International: A Monthly Organ of International Marxism, Volume IV, No. 4, April 1938, page 107,] Kevin Phillips warns that the United States is headed for decline when it "lets itself luxuriate in finance at the expense of harvesting, manufacturing, or transporting things."  [Kevin Phillips, Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism, Viking, 2008, page 20]

Congress and the Federal Reserve Board are assisting the concentration of financial institutions in Wall Street.  For instance,  Congress used the 2012 "Jumpstart Our Small Business Startups Act" to include a section called “Private Company Flexibility and Growth,”  It changed the number of shareowners, from 500 to 2,000, that banks and other corporations may have without complying with most SEC requirements.  That will promote mergers within the 6,643 community banks, which typically have 100 or so local shareowners.  At the same time, the Federal Reserve pushed local banks into consolidation by ordering "even the smallest lenders to comply with comprehensive international capital requirements known as Basel III."  [Robin Sidel, "Small Banks for Sale: 2012 Has Been Big Year," The Wall Street Journal, June 18, 2012, page C1]

Concentration of power in big business

Nearly every business needs a source of permanent money, in addition to the temporary funding that meets seasonal or occasional needs.  Small businesses usually raise their permanent money from savings, personal borrowings, family and friends.  They get their temporary funding through bank borrowings, with or without government support.  There is no real place for Wall Street in small business financing, with the exception of the fast-track, venture capital-supported “the next Apple,” or Google or other latest hot IPO.

Wall Street makes its real money on big business.  Much of it comes from taking a percentage as money changes hands in transactions.  As a percentage, the take is about the same on large transactions as on small ones.  So, the incentive is always toward doing large securities offerings, large mergers and acquisitions.  Big businesses have huge underwritten issues of securities.  They generate merger and acquisition fees while gobbling up competitors and expanding into related arenas.  It is big business that provides the raw material for stock options, credit default swaps and other derivatives.  Big business also creates the opportunities to trade on information that gets leaked to favored Wall Streeters before it is public.  Since virtually all money for investment has to flow through the Wall Street monopoly, it is made available to big business only--just the opposite from what is needed.  "Rather than reinvest in the industries that once made us great, we must move beyond the industrial tasks of the past, toward the great new enterprises of the future."  [John Naisbitt, Megatrends: Ten New Directions Transforming Our Lives, Warner Books, 1982, page 58]

One harmful result is that small business is largely ignored by Wall Street.  Investment banking had its beginnings as a service to entrepreneurs—finding sources for growth capital and sheparding a transaction through to closing.  The objective was to provide money to build a business.  That changed in the 1890s in America, when investment bankers developed a way to do much larger financings, by consolidating small businesses into a few giant businesses.  They began collecting large percentage fees advising on mergers and acquisitions.  Key to this new business was raising money to pay off the sellers, as their companies disappeared into the consolidated structure.  

Louis Brandeis, who went on to a lengthy term as United States Supreme Court Justice, wrote a series of magazine articles which were published in 1914 as the book, Other People’s Money: And How the Bankers Use It [Louis D. Brandeis, Other People’s Money: And How the Bankers Use It, Frederick A. Stokes Company, 1914, republished by National Home Library Foundation, 1933, Kessinger Publishing’s Rare Reprints]  Brandeis describes how the great American industries, like railroads, steel, machinery, automobiles and telephone were all initially financed by individuals and the government.  It was only after 30 to 80 years of business development that investment bankers added them as clients.  He goes through each of the major industries of the time, detailing how the hundreds of competitors were initially financed without any Wall Street participation and then how, decades later, Wall Street engineered their consolidation into a single industry-dominant corporation.  This is a brief summary of his chapter, “Where the Banker is Superfluous,” with page references to the republished book:

Railroads.  Before the 1890s, Wall Street investment bankers’ major clients were the railroads.  But the bankers were definitely not there to help the pioneers of railroad transportation.  “The necessary capital to build these little roads was gathered together, partly through state, county or municipal aid; partly from business men or landholders who sought to advance their special interests; partly from investors; and partly from well-to-do public-spirited men, who wished to promote the welfare of their particular communities.  About seventy-five years after the first of these railroads was built, J. P. Morgan & Co. became fiscal agent for all of them by creating the New Haven-Boston & Maine monopoly.”  [page 93]

Steamships.  Robert Fulton, the inventor, built the first steamship with financing from a friend who was a judge.  Funding for the first steamship to cross the Atlantic came from an 1833 direct offering to the three Cunard brothers and over 200 other shareowners.  “In 1902, many years after individual enterprises had developed practically all the great ocean lines, J. P. Morgan & Co. . . . organized the Shipping Trust.”  [page 93]

Telegraph.  The telegraph was invented by Samuel F. B. Morse, with the financial support of his partner, Alfred Vail.  When it came to paying for the first telegraph line, Congress appropriated $30,000 for an installation from Washington, D.C. to Baltimore.  The telegraph business, as Western Union, operated without investment bankers until it was purchased in 1909 by American Telephone & Telegraph Company.  That purchase was financed through J.P. Morgan & Co. [page 94] 

Farm Equipment.  When Cyrus McCormick invented the mechanical reaper, an ex-Mayor of Chicago put up $25,000 to build the first factory there in 1847.  McCormick bought back the investment for $50,000 and the business was entirely owned by his family when he died in 1884.  In 1902, “J. P. Morgan & Co. performed the service of combining the five great harvester companies, and received a commission of $3,000,000.”  [page 94]

Steel.   Andrew Carnegie was already wealthy by 1868, when he introduced the Bessemer process, which propelled the American steel industry to world leadership.  It wasn’t until thirty years later that Wall Street, particularly J. P. Morgan & Co., began the consolidation of the steel industry.  By 1901, all parts of the business had been combined and United States Steel was capitalized at $1.4 billion.  Brandeis describes the formation of United States Steel, “combining 228 companies in all, located in 127 cities and towns, scattered over 18 states.  Before the combinations were effected, nearly every one of these companies was owned largely by those who managed it, and had been financed, to a large extent, in the place, or in the state, in which it was located.  When the Steel Trust was formed all these concerns came under one management.  Thereafter, the financing of each of these 228 corporations (and some which were later acquired) had to be done through or with the consent of J. P. Morgan & Co.  That was the greatest step in financial concentration ever taken.”  [page 104.  Italics in the original.] 

Telephone.  Over 90 percent of the money spent by Alexander Graham Bell to build the first 5,000 telephones came from Thomas Sanders, who had a business cutting soles for shoe manufacturers.  From 1874 through 1878, Sanders borrowed and invested $110,000, although the shoe business he owned was only valued at about $35,000.  Sanders was motivated by a debt of gratitude, because Bell had “removed the blight of dumbness from Sanders’ little son.”  [page 96]  When Western Union Telegraph Company began to sell telephone service in 1878, it was individual investors who came up with the money to keep alive the Bell Telephone Company.  [page 96, quoting from H. N. Casson, “History of the Telephone.”]  It was twenty years later that J. P. Morgan gained control of the business and formed the American Telephone & Telegraph Company.  Between 1906 and 1912, Morgan and Wall Street syndicates marketed about $300 million in bonds, using the money raised to buy other telephone companies, including control of Western Union.  Brandeis commented that this consolidation was, “in large part, responsible for the movement to have the government take over the telephone business.”  [page 99]

The point is not just that investment bankers failed to provide growth capital for new industries.  What Brandeis shows is that investment bankers raised money to buy up and consolidate entire industries into single dominant companies.  They created monopolies where there had been lively competition.   

Wall Street’s focus on big deals is especially destructive when combined with its trader mentality.  In most businesses, the lure of a short-term profit opportunity can be overcome by the vision of greater long-term prospects.  Not so with Wall Street.  We’d like to think of financiers as nurturing small businesses into large businesses, investing early for modest returns so they would grow into loyal mature businesses and profitable clients.  Instead, one of Wall Street’s first accomplishments was to create big businesses out of small businesses.  This was like a farmer selling the seed corn, getting a little more money this year but giving up the source of future crops.

The companies of America’s industrial revolution were generally small and funded without any financial intermediaries.  “The businesses of the industrializing nineteenth century were, more often than not, organized as partnerships or closely held corporations.”  [Lawrence E. Mitchell, The Speculation Economy, Berrett-Koehler Publishers, Inc., 2007, page 9]  There was little room for investment bankers to earn fees or trade in securities.  Wall Street’s solution was to gather up scores of small businesses and consolidate them.  “The giant modern corporation was created for a new purpose, to sell stock, stock that would make its promoters and financiers rich.  It took only seven years.  In the space of that explosive period, from 1897 to 1903, the giant modern American corporation was created by the fusion of tens, and sometimes hundreds, of existing business.”  [Lawrence E. Mitchell, The Speculation Economy, Berrett-Koehler Publishers, Inc., 2007, page 9]   It was in this climate that President Rutherford B. Hayes, said that “This is a government of the people, by the people and for the people no longer.  It is a government of corporations, by corporations and for corporations.” [John Micklethwait and Adrian Wooldridge, The Company: A Short History of a Revolutionary Idea, The Modern Library, 2003, page xiv]

Laws were changed to facilitate this consolidation into big businesses.  New Jersey seized upon gathering significant revenues by attracting the franchise fees and taxes from businesses choosing to incorporate under its charter provisions.  Because Americans were distrustful of corporations, the early state laws had limited them to specific business activities and a set period of years for their existence.  New Jersey loosened that, allowing corporations to engage in “any lawful business,” including buying shares in other corporations, paying for them with its own newly-issued stock.  Corporations were granted perpetual life.

The bonanza for Wall Street was far greater than the huge fees received from transactions and new stock issues.  A trading market for millions of corporate shares was created.  In 1890, there were less than ten manufacturing companies with shares traded on the stock exchanges, with total market capitalization of $33 million.  By 1903, with the consolidations into new giant corporations, that became over $7 billion.  [John Micklethwait and Adrian Wooldridge, The Company: A Short History of a Revolutionary Idea, The Modern Library, 2003, page 69]

Concentration of power in wealthy individuals

Wall Street investment bankers have functioned as gatekeepers, keeping ownership of the instruments of production in the hands of the wealthy and their servants. 

Wall Street has made no secret of its focus on wealthy individuals.  Making the rich richer is seen as the fastest way to those multimillion dollar bonuses.  So long as Wall Street remains the channel for investing discretionary money, then its business model will continue to cause wealth to concentrate.  The strategy has paid off for Wall Street, as the income and proportion of wealth held by the richest continues to increase.    Even during the market crash of 2008 and the recession that followed, the wealthiest one percent increased their share of U.S. wealth from 34.6% to 35.6%.  The share of the wealthiest ten percent increased from 73% to 75%.  [Robert Frank, "The Wealth Report,"]The Spectrem Group issues annual reports on the “affluent market,” which tallies U.S. household net worth, not including primary residences.  They reported 1,061,000 households over $5 million in 2010, up from 230,000 in 1997 and just below the 1,160,000 peak of 2007.  At $1 million, it was 8.4 million households in 2010, versus 5.3 million in 1997 and 9.2 million in 2007.  The startling numbers were for households with a net worth of over $25 million, which went from 12,500 in 2007 to 105,000 in 2010. [  For continuing information, see  For information on the disparity of wealth distribution, see the work of Emmanuel Saez,, particularly “Striking It Richer: The Evolution of Top Incomes in the United States,”‐UStopincomes‐2008.pdf, as well as and]

To gather funds from rich individuals and institutions, Wall Street added complex, fast-moving games to stocks and bonds.  It was the year 1973 when options were permitted to trade on an exchange and when Black and Scholes published their formulae for pricing options.  Not so coincidentally, 1973 was also when the average income per taxpayer, adjusted for inflation, was at its high of $33,000. By 2005, it had gone down by nearly $4,000.  [Bob Herbert, “Reviving the Dream,” The New York Times, March 9, 2009,]  The concentration of  power in wealthy individuals has continued through the Great Recession, according to The Boston Consulting Group’s report on distribution of the world’s wealth for 2009: “Less than 1 percent of all households were millionaires, but they owned about 38 percent of the world’s wealth, up from 36 percent in 2008.  Households with more than $5 million in wealth represented 0.1 percent of households but owned about 21 percent, or $23 trillion, of the world’s wealth, up from 19 percent in 2008.”  [Press Release, June 10, 2010,]  From a 2011 Economic Policy Institute Briefing Paper, "The wealthiest 1% of U.S. households had net worth that was 225 times greater than the median or typical household’s net worth in 2009. This is the highest ratio on record."  In 1962, the ratio was 125 to 1.  As to ownership of corporate shares, "Even at the 2007 economic peak, half of all U.S. households owned no stocks at all—either directly or indirectly through mutual or retirement funds."  [Sylvia A. Allegretto, "The State of Working America's Wealth 2011:  Through volatility and turmoil, the gap widens," Economic Policy Institute, March 23, 2011, page 2 and Figure C on page 7,  See Professors Jacob S. Hacker and Paul Pierson, Winner-Take-All Politics: How Washington Made the Rich Richer--And Turned Its Back on the Middle Class, Simon & Schuster, 2011.  Watch "Winner Take All Politics," Moyers & Company,, air date: January 13, 2012]

Americans seem to be unaware of our extreme concentration of wealth.  A random sample drawn from a national panel of over a million Americans showed that "All demographic groups – even those not usually associated with wealth redistribution such as Republicans and the wealthy – desired a more equal distribution of wealth than the status quo. . . . First, respondents dramatically underestimated the current level of wealth inequality. Second, respondents constructed ideal wealth distributions that were far more equitable than even their erroneously low estimates of the actual distribution."   These "regular Americans" were shown three pie charts of wealth distribution, without disclosing that they represented the United States, Sweden and an equal distribution.   While 92% preferred the Sweden distribution over the American one, a slight majority chose Sweden over the equal distribution.  When asked to construct their ideal distribution, they had the top quintile owning 32%, compared to their belief that ownership was 59% and to the actual 84% of wealth held by the richest 20%.  [Dan Ariely and Michael I. Norton, Building a Better America--One Wealth Quintile at a Time, 2010,, pages 2, 6]  It wasn't always this way.  At the time of the American Revolution, America had the greatest equality of income for any country for which data is available.  Peter H. Lindert, Jeffrey G. Williamson, American Incomes before and after the Revolution, Working Paper No. 17211, National Bureau of Economic Research, July 2011,

Is concentration of wealth harmful?  Is anyone really hurt when the rich get richer?  One answer is that accumulating wealth in the few leads to depressions, which definitely harm most of us.  The theory is that rich people put far more of their discretionary cash into investment than consumption.  As a larger proportion of society’s wealth is concentrated at the upper end, investment in productive capacity gets ahead of our ability to consume the resulting output.  By itself, that could adjust in time without creating a severe slowdown in the economy.  If, however, as the theory goes on, banks and investors take on more risk to find places to invest, an economic slowdown can lead to a sudden aversion to risk and “flight to quality.”  Investors try to sell their riskier assets and put money into short-term U.S. Treasuries or other safe and liquid vehicles.  Financial intermediaries become unable to meet their obligations, stop making new commitments and call in everything due from their customers.  Businesses lose their credit lines and can’t meet payrolls or pay creditors.

According to the Joint Economic Committee of Congress: “Peaks in income inequality preceded both the Great Depression and the Great Recession, suggesting that high levels of income inequality may destabilize the economy as a whole.”  The Committee reported that “the share of total income accrued by the wealthiest 10 percent of households jumped from 34.6 percent in 1980 to 48.2 percent in 2008,” while the top 1 percent “rose from 10.0 percent to 21.0 percent, making the United States as one of the most unequal countries in the world. . . . In short, the evolution of income inequality in the United States is largely driven by the trends at the very top of the income distribution, as very wealthy households have continued to accrue an ever greater share of the nation’s total income." [Report by the U.S. Congress Joint Economic Committee, “Income Inequality and the Great Recession,” September 2010, pages 1, 2]

The claimed correlation between increased concentration of wealth and economic downturns goes back at least to a paper by Mentor Bouniatian, published just before the Great Depression.  [Mentor Bouniatian, The Theory of Economic Cycles Based on the Tendency Toward Excessive Capitalization, The MIT Press, 1928.]  Another explanation comes from the technical analysis of economic cycles by Professor Ravi Batra, who missed the timing with his book, The Great Depression of 1990.  If he had only waited 20 years to predict “that the rising concentration of wealth would create a shaky banking system and a speculative fever in the U.S. stock market, which would then crash, leading to a major U.S. depression, and then, with a domino effect, culminate in a global depression.”  [Ravi Batra, The Great Depression of 1990, Liberty Press, Venus Books, 1985, page 6.  For an update on Professor Batra, see] Professor Batra charted the percentage share of wealth held by the richest one percent of U.S. adults. [page 133]  It peaked in 1929 at 36% and had dropped to 21% by 1949.  It was up to 34% in 1983, the last year in Batra’s chart.  [page 133]  Since then, the share owned by the richest one percent went to 35% in 1998, [ Edward N. Wolff,  Poverty and Income Distribution,  Wiley-Blackwell, 2nd edition, 2009, page 151] and back to 34% in 2004. [

Batra claimed that a recession is caused by a decline in demand for goods and services, and will end when demand increases again, whether by the passage of time or by stimulation from government spending.  A depression occurs “when a recession is accompanied by a collapse of the financial system . . ..”  [Ravi Batra, The Great Depression of 1990, Liberty Press, Venus Books, 1985, page 134]  So, the next question Batra asks:  “What causes a financial panic?”  We can revise his answer to reflect experience of the last 20 years. As the rich get richer and the middle class gets poorer, there is less borrowing done by the rich, while the middle class borrows more.  Part of the middle class borrowing is to make up for declining real income from their jobs.  Another part is to emulate what they see the rich doing with their money, the “social comparison theory of happiness.”   [See Jerry Suls and Ladd Wheeler, The Handbook of Social Comparison, Springer, 2000 and the film, "The Economics of Happiness," by Helena Norberg-Hodge, Steven Gorelick & John Page]  Wall Street reacts by serving up ever more risky games to play, because acceptance of risk increases with wealth.  [Arrow-Pratt Measure of Relative Risk-Aversion, part C of The Theory of Risk Aversion,

The peak concentrations of wealth in recent U.S. history were in 1929 and 2008, when the richest one percent of its residents received nearly 24% of its income. Both years were followed by market crashes, unemployment and severe economic distress.  According to Robert Reich:  “This is no mere coincidence. When most of the gains from economic growth go to a small sliver of Americans at the top, the rest don't have enough purchasing power to buy what the economy is capable of producing. . . . Under these circumstances the only way the middle class can boost its purchasing power is to borrow, as it did with gusto. . . . When the debt bubble finally burst, vast numbers of people couldn't pay their bills, and banks couldn't collect. [Robert Reich, “Unjust Spoils,” The Nation, June 30, 2010,]

Is it just a theory that increasing concentration of wealth leads to an economic depression?  Perhaps the studies of what happened in 2008 will shed some light on its validity.  In the meantime, we can each imagine what might have happened if Wall Street had not been so single-minded about selling speculative games to the rich and instead had extended credit to the middle class.  What if they had promoted broad ownership of business and government debt securities, if Wall Street had helped each of us select shares and bonds of companies we thought would bring us a good return, and if the money managers did not have their vast pools of money to play with derivatives, arbitrage trading and the other games?

Concentration of financial power and wealth leaves the middle class out of society’s increasing wealth and makes us all victims of the periodic collapse of Wall Street.  By separating the ownership of business from the workers, the benefits of greater productivity have mostly gone to the owners, leaving the workers behind.  Since 1973, “the typical family’s income has grown at about one-third the rate of productivity. . . .  Had the median household income continued to grow with productivity, it would now be in the $60,000 range instead of the $40,000 range.”  [Jared Bernstein, All Together Now:  Common Sense for a Fair Economy, Berrett-Koehler Publishers, Inc., 2006, page 57]  Hardest hit are minority families, where the disparity in wealth is far greater than it is in income.  While Blacks earn 62 cents for every dollar of white income, Blacks have only 10 cents for every dollar of net worth whites have.  While Latinos earn 68 cents for every dollar of white income, Latinos have only 12 cents for every dollar of net worth whites have.  [“State of the Dream 2010: Jobless and Foreclosed in Communities of Color,” United for a Fair Economy,

A recent book has confirmed one of the greatest harms caused by having the rich get richer while the rest stay about the same or get poorer.   Richard Wilkinson and Kate Pickett studied comparisons among the richer nations, as well as comparisons of states within the USA. Their book shows consistent correlation between inequality of wealth and such measures as life expectancy, ability to improve economic condition, educational achievement, prison population, teenage pregnancies and murders.   The nations and states that have better life qualities all have less income and wealth inequality than their peer nations or states.   The nation with the lowest life quality scores, and greatest inequality is the United States.  [Richard Wilkinson and Kate Pickett, The Spirit Level: Why More Equal Societies Almost Always Do Better, Penguin, March 2009 (UK), Bloomsbury Press, December 2009 (USA).  See and Richard Wilkinson, The Impact of Inequality: How to Make Sick Societies Healthier, New Press, 2006 and Unhealthy Societies: The Afflictions of Inequality, Routledge, 1996]  Michael Harrington has argued that we must "be concerned not simply with the static inequity of the maldistribution of wealth, but with the dynamic power of elite decision making that goes with it."  [The Next Left: The History of a Future, Henry Holt and Company, 1986, page 69]  Chrystia Freeland has written about studies showing that income inequality causes increased spending by those who can't really afford it.  [Chrystia Freeland, "Trickle-down consumption,", referring to Robert H. Frank  and Seth Levine, Expenditure Cascades, American Economic Association Annual Meeting paper, 2007 and to the February 2012 draft by Marianne Bertrand and Adair Morse, Trickle-Down Consumption.

The subject of wealth and income inequality suggests the uncomfortable thought of taking from the rich and giving to the poor.  Of course, it doesn’t have to work that way.  Simply alleviating extreme poverty, while leaving the rich alone, substantially narrows inequality.  But Wall Street’s emphasis on building wealth for the wealthy does nothing to relieve poverty.  About the only positive effect could be that a few who have become very rich on Wall Street will contribute their time and money to charities that help the poor.  Mostly, however, people who do that have come from successes outside Wall Street.  Wall Street's control over the mechanics of international finance, moving "hot money" from one developing nation to another, can be blamed for causing greater inequality and the resulting violence and revolts.   [See Amy Chua, World on Fire: How Exporting Free Market Democracy Breeds Ethnic Hatred and Global Instability, Doubleday, 2003, page 9]

Wall Street's focus on selling investments to the already wealthy has left the middle class to be lured by the persuasive powers of borrowing and spending. This means that earnings from work continue to be the only source of significant income for nearly all of us.  We have very little chance of ever having a financial return on money we've kept from spending.  Government-promoted lotteries, with their dismal odds, are the only hope we have of breaking free of relying on our ability to find and perform a job.  [Jeremy Rifkin, The End of Work, G. P. Putnam & Sons, 1995]

The problems created by wealth and income inequality can arguably be offset by increased mobility—making it possible for people to gain wealth.  [Jonathan D. Fisher and David S. Johnson, “Consumption Mobility in the United States: Evidence from Two Panel Data Sets,” Topics in Economic Analysis & Policy, Volume 6, Issue 1, Article 16, The Berkeley Electronic Press, page 27,] Mobility upward into the middle class can begin to alleviate poverty.  Professor C.K. Prahalad, author of The Fortune at the Bottom of the Pyramid, [Wharton 2004] has said: “to ‘make poverty history,’ leaders in private, public and civil-society organizations need to embrace entrepreneurship and innovation as antidotes to poverty.’”  [C.K. Prahalad, “Aid is Not the Answer,” The Wall Street Journal, August 31, 2005, page A8.  See, also, Gene Sperling, The Pro-Growth Progressive: An Economic Strategy for Shared Prosperity, Simon & Schuster, 2005]  That will not happen under Wall Street’s monopoly over the movement of money for investment.

Concentration of power in institutions

After the Roaring 20s, millions of Americans owned shares directly in American business.  By 1931, AT&T had 642,000 shareowners, the Pennsylvania Railroad and United States Steel each had 241,000.  An AT&T advertisement showed a grandmotherly woman with her hands in a mixing bowl, with the caption "She's a Partner in a Great American Business."  Ad copy called AT&T "a democracy in business--owned by the people it serves.. . . More than half of them have held their share for five years or longer. . . . More than 225,000 own five shares or less.  Over fifty per cent are women.  No one owns as much as one per cent . . .."  [Included in Roland Marchand, "AT&T: The Vision of a Loved Monopoly," adapted from his book, Creating the Corporate Soul, University of California Press, 1998 and included in Jack Beatty, Colossus: How the Corporation Changed America, Broadway Books, 2001, page 200] (A friend told me that his father, a lifetime AT&T employee, was encouraged to call upon shareowner families as he traveled the country.) 

When the Securities Act of 1933 was adopted, institutions owned less than ten percent of the shares listed on the New York Stock Exchange.  [Louis Lowenstein, What’s Wrong With Wall Street: Short-term Gain and the Absentee Shareholder, Addison-Wesley Publishing Company, Inc., 1988, page 58]  The relative ownership by individuals and by institutions has dramatically reversed since then.  By 2007, institutional ownership was over 76%. [Institutions are defined as  “pension funds, investment companies, insurance companies, banks and foundations.”

A huge gift to Wall Street has been government encouragement of employer-sponsored retirement plans, through tax deductions for employer contributions, combined with the investment standards and government insurance of ERISA, the Employee Retirement Income Security Act of 1974.   The employer connection to accumulating assets for retirement is an anachronism, an accident of history.  During World War II, the government set controls on wages, but benefits were not counted.  Employers could compete to attract and keep the scarce employee candidates by offering a pension, as well as health benefits.  Our national habit of employer-paid pensions and health care was just an unintended consequence of wartime wage and price controls.  Perhaps other avenues for wealth accumulation have never been tried, because the combination of social security and corporate pensions was expected to take care of our retirement needs.

Most employers, except the government, have already stopped providing “defined benefit” pension plans.  These were the programs that promised to pay retirees a percentage of what they had been earning.  Instead, businesses switched to “defined contribution” plans, which paid a percentage of an employee’s current earnings into a fund.  The retirement benefits were then measured by what the employer had paid in for the employee, together with proportionate investment earnings.  The change has taken the open-ended liability away from the employer, but it still ties the employee's asset-building to a particular job.  From company-wide plans, many employers have gone to sponsoring individual retirement programs, the IRAs and 401ks.  These severely limit the individual’s choice of investments, often to a few selected mutual funds or the employer’s own shares.  The conditions imposed by employer plans mean that Wall Street buy side firms are paid fees to make investments.  They do this mostly by investing in mutual funds, which get a fee for investing in securities.  The mutual fund managers buy the securities through Wall Street sell side firms, which almost never invest in small businesses, or even in new issues of securities.  Three sets of intermediary fees are skimmed off, as the money goes from employer and employee contributions into Wall Street’s churning of previously-owned securities and derivatives.

This institutional concentration of investment money has been mirrored by a constant decline in ownership of public companies by individuals.  We often are told that some large percentage of Americans are stockholders.  What is seldom mentioned is that this includes shares of mutual funds owned by individuals or, more likely, their retirement accounts.  It is the money manager for the fund that is making investment decisions and actually owning and voting the shares in an operating company.  This institutional ownership puts at least one financial intermediary between the individual and management of a company.  One effect is the disconnect between managers and the ultimate economic owner.  Very few individuals know what companies are owned by their funds.  They certainly don’t have any voice for shareowner voting.  Wall Street has also been effective in selling foreign institutions, like sovereign wealth funds and ruling family funds, in ownership in American businesses.  After OPEC was formed in 1973, David Rockefeller, Chairman of Chase Manhattan Bank, said "We plan to serve as one of the bridges between the Middle East and the industrial world."  [Quoted by Kenneth C. Crowe, America for Sale, Doubleday & Company, Inc., 1978, page 50]

Institutions have minimum size requirements for the companies in which they invest.  Almost none of them ever puts the fund’s money into small businesses.  Even initial public offerings are generally for $50 million or more, so the company has to be quite large before it ever goes public.  It will have had many millions of dollars invested by institutional venture capital funds, or it will be a spinoff of a large business from an even larger conglomerate.  All of this tends to direct capital into the largest corporations, while starving our younger, entrepreneurial businesses.  In the final paragraph of his1914 book, Louis Brandeis quotes President Woodrow Wilson:  “No country can afford to have its prosperity originated by a small controlling class.  The treasury of America does not lie in the brains of the small body of men now in control of the great enterprises. . . . Every country is renewed out of the ranks of the unknown, not out of the ranks of the already famous and powerful in control.”  [Louis D. Brandeis, Other People’s Money: And How the Bankers Use It, Frederick A. Stokes Company, 1914, republished by National Home Library Foundation, 1933, Kessinger Publishing’s Rare Reprints, page 152] 

Wall Street Has Made Capitalism a Casino Game

Whatever faults we may find with the investment bankers of a century or so ago, they did channel money from Europe into American railroads, factories and other industries that employed people and built infrastructure.  For the last thirty years, Wall Street has chosen to direct money into speculative stock trading, derivatives, takeover plays and other betting games that serve no productive use.  [See Harold Meyerson, “Wall Street’s Just Desserts,” Washington Post, September 18, 2008, page A21]  As Nobel-prize winning economist Paul Krugman wrote:  "For the fact is that much of the financial industry has become a racket — a game in which a handful of people are lavishly paid to mislead and exploit consumers and investors."  [Paul Krugman, "Looters in Loafers," The New York Times, April 18, 2010,]  For a table showing "The Evolution of Critical Derivatives, 1972-2005, see Kevin Phillips, Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism, Viking, 2008, page 35.

The reason why so little money goes from individuals into young businesses is that (1) Wall Street has a government-enforced monopoly on selling new issues of securities, (2) Wall Street’s monopoly pricing is a fixed percentage of the money raised, whether in large or small amounts and (3) Wall Street’s short-term mentality won’t wait to grow small clients into large ones.  Entrepreneurs have to go through venture capital firms or investment bankers to grow beyond the start-up phase.  At the supply end, individuals must turn money over to broker-dealers or fund managers to invest.  As a result, nearly all of the savings by individuals will be used to trade in "previously-owned" securities and their derivatives, with a trickle going into new issues made by large businesses.  "The potential of our economy to underwrite a society of broad prosperity is being sacrificed to financial speculation. . . . The real economy of enterprises and workers is hostage to a casino of financial speculation. . . . Every category of gatekeeper who had a fiduciary relationship with small shareholders was corrupted."  [Robert Kuttner, The Squandering of America: How the Failure of Our Politics Undermines Our Prosperity, Alfred A. Knopf, 2007, pages 4,5, 74.]

One Wall Street brokerage firm has even crossed over from betting on securities prices to betting on sports.  Cantor Fitzgerald, a major Wall Street bond broker, started Cantor Gaming in March 2009.  [] It operates  trading rooms in six Nevada casinos, where a player has four computer screens of data.  Branches at other Las Vegas casinos use mobile devices.  The gamblers place bets on individual plays in different sports.  The Cantor Gaming CEO says "We've created a giant price-making technology company and we've applied it to sports betting." He claims 15 percent of Nevada's sports gambling market, which the state Gaming Control Board says totaled $1.4 billion in the first seven months of 2010. [Peter Coy, with Beth Jinks, "Bringing Wall Street Technology to Las Vegas," Bloomberg BusinessWeek, September 30, 2010, page 41,; [Rolfe Winkler, “Gambling IPO Faces Long Odds,” The Wall Street Journal, January 9, 2012, page C8]

 Wall Street Promotes Speculative Trading Instead of Long-Term Investing

Most of Wall Street’s revenue has come from two sources, one from acting as a broker in executing trades in existing securities and the other from being a dealer, buying and selling securities for its own account.  Federal securities laws, and the laws in every state, give broker-dealers a monopoly over both of these businesses.  Anyone trying to cut in on the business, without first getting a broker-dealer license, can be sent to prison. 

Since competition isn’t a challenge to monopolists, Wall Street broker-dealers concentrate on increasing the volume of transactions on which they take a broker’s commission or a dealer’s markup.  “Churning” is the basic tool.  Keep pushing sales of securities and recycling the proceeds back into the market.  Just one example of how this is carried out is the concept of “Rotation,” meaning how industries come and go in favor, such as from “growth” stocks to “value” stocks and then from one industry segment to another.  This generates commissions for the brokerage side of Wall Street, as investors sell one group and buy another.  Even greater income comes from trading on inside information as to which sector will be coming into favor and which will be leaving, as well as from underwriting commissions doing IPOs in the hot new industry. 

For businesses seeking growth capital, the rotation game can mean being closed out of the IPO market for years and then having a few months in the “window of opportunity,” when investment bankers come calling.  As an industry rotates into favor, investment bankers start with underwriting the most attractive businesses and work their way down to the riskier ones.  They usually overdo the quality downgrade, until there are failures and frauds, poisoning the whole pool for years.  Meanwhile, they have moved on to a new fad.

(In my years of doing securities law work, my clients went through several of these cycles.  One of them led to pioneering a Direct Public Offering.  We were hired in 1973 to help a savings and loan with an IPO.  It signed a “letter of intent” with Wall Street underwriter G.H. Walker.  (As in George Herbert Walker Bush, whose family founded and owned the investment banking firm.)  But the IPO market for our client’s industry dried up in late 1973.  By 1976, when there was some renewed activity, G.H. Walker had merged with William Staats, which was then acquired by White Weld, soon to be taken over by Merrill Lynch.  Our client was too small to interest the giant.  We met with all the investment banking departments of securities firms that might have the interest and ability to do the IPO.  None wanted to take it on.  Our client needed investor capital to support its growth and a Direct Public Offering was born out of this necessity.  It marketed shares directly to its customers and other communities, in a public offering registered with the SEC and state securities regulators.)

Wall Street Has Turned to Derivatives and Other Nonproductive Games

What caused the 2008 financial catastrophe?  Perhaps we can blame it on the rock and roll.  Savings and investments were not very complicated, right up to the late 1960s, the Summer of Love and Woodstock.  Banks took deposits and paid interest at rates fixed by law.  Governments and businesses sold bonds, which paid interest and had a date for paying back the amount invested.  Businesses sold shares of ownership which never came due but could be resold in a trading market.  Securities brokers handled the trading market, for which they were paid fixed commission rates.

It was as if the unrest of the 1970s hit Wall Street.  In 1972, money market mutual funds were created, to pay higher interest rates than the banks.  The next year, the SEC allowed stock options to be traded on the Chicago Board of Trade.  There was suddenly a whole different perspective on financial instruments.  Our minds were expanded from the “buy and hold,” and “put money into growing, profitable businesses” concepts.  We were swept away with finding a fast-moving game and playing it to the hilt.

In this alternate reality, stocks and bonds were not enough.  There is a limit to the volume of trading that can be generated by churning existing securities that were originally issued by businesses to raise money for operations.  Fewer than 7,000 stocks are listed on the two significant U.S. Exchanges.  Adding in the stocks traded over-the-counter reported on Nasdaq’s Bulletin Board brings the total publicly traded issues to just over 10,000.  Only a few of the 5,000 or so securities with Pink Sheet data are being traded with any regularity.  But even if we included all of them, there would be 15,000 stocks available for turning over. 

To build more activity, with commissions and trading profits, Wall Street needed more products, more markers in the casino games.  An early step was to impose another layer of financial intermediaries between the individuals who provide money and the businesses that use the money.  What Wall Street had to do was create other securities, using stocks and bonds as the basic building blocks.  Mutual funds, which issued their own shares and used the money raised to buy securities, have provided new securities and greatly enhanced trading volume.  There are over 16,000 mutual funds reported by the Investment Company Institute, including closed-end funds, exchange traded funds and unit investment trusts.  []  That means there are more mutual funds than the 15,000 operating company stocks. Then there are the hedge funds, which grew from 3,000 in 1998 to more than 9,000 by 2007, according to the Government Accounting Office.  []   A private consulting firm reported the number of hedge funds in 2007 at 23,603, including funds that invested in other hedge funds.  [Sizing The 2010 Hedge Fund Universe: A PerTrac Study,, page 5]  Together, there are some 40,000 mutual funds and hedge funds.  Why would there be nearly three times as many funds as there are operating businesses with traded securities?       

In addition to all the mutual funds and hedge funds, Wall Street started inventing new instruments, derivative securities which moved faster and farther than shares or bonds.  A derivative security is one derived from another security.  Like avatars in a virtual reality game, derivative securities are just made-up icons measured by the performance of a real security.  Derivatives are not new, nor is their involvement in financial disasters: it was tulip derivatives that were behind the Dutch crash of 1637. [John Lanchester, “Cityphilia,” London Review of Books, January 3, 2008,]  In the last decades, stocks, bonds and other “real” securities have largely become just markers for options and other derivatives. 

News about derivatives would never have made it into the general media, except for their devastating effect upon our personal economics.  The derivatives games have drastically influenced whether we can keep our jobs and afford to stay in our homes.  In 2008, derivatives based on home mortgage loans were even the subject of “instant history” books, like The Big Short: Inside the Doomsday Machine, [Michael Lewis, W. W. Norton & Company, 2010]; Freefall [Joseph E. Stiglitz, W.W. Norton & Company, Inc., 2010] and Chain of Blame:  How Wall Street Caused the Mortgage and Credit Crisis[Paul Muolo and Mathew Padilla, Wiley, 2009]  

Since the 1970s, Wall Street has diversified away from raising capital for business and into inventing derivatives and trading for their own accounts.  They could have kept to their primary mission and improved the markets and instruments for companies to use for raising money for growth.  They could have designed instruments that would fit the new pools of capital, such as retirement accounts for individuals.  They could have developed marketing tools that would persuade individuals to buy corporate shares instead of more expensive cars and larger homes.

Instead of improving their own business of trading stocks and bonds, Wall Street executives chose to move into other products.  The greatest harm to us all has come from Wall Street’s runaway use of computer technology to create derivatives.  To the extent anyone tries to justify the financial futures, options, swaps and the like, they argue that these derivatives help to “manage risk.”  For instance, someone with a fluctuating-rate debt instrument can swap it for a fixed-rate payment schedule, to protect against the risk of interest rates going higher.  On the other side, a speculator who wants to bet on lower rates can deliver a fixed-rate debt and take back the one that fluctuates.  To protect against the risk of default, a bond owner can purchase another derivative, a credit default swap, from a counterparty that believes it has priced the risk profitably.  A stock investor can hedge against falling value by purchasing put options on the same stock or industry segment.  However, those beneficial uses just scratch the surface on the games that are played in this casino.

Speculators in stock price movements no longer have to buy and sell a company’s shares.  Options are the right to buy or sell a stock within a fixed period of time, at a fixed price.  They were first introduced as options on an index, like the S&P 500.  Now, they are available for many individual companies, so the trader can bet on price movement without actually purchasing the shares.  “Some 379 million options traded last year, a surge from 1.7 million in 2010, according to TABB Group, a research and advisory firm.”  The propulsion to ever-shorter trading got an extra boost in mid-2010, when exchanges began offering options on individual stocks, with one-week expirations instead of the customary one-month. [Chris Dieterich, “Traders’ New Cry: See You in a Week: ‘Short-Term’ Options Bet on a Stock’s Action in a Handful of Days Instead of Month; a Volatility Play,” The Wall Street Journal, January 12, 2012.  The TABB Group executive Summary is available at; the full report costs $3,000]

Another set of derivatives came from the futures market, which had long traded in bets on what the price would be for wheat, pork bellies and other agricultural products.  The buyer of a futures contract is agreeing to deliver the real thing at a specific future date and a set price.  The buyer is betting that the price for immediate delivery (the cash or “spot” price) will be lower on the contract delivery date.  It is almost unheard of that anyone actually delivers the underlying commodity on the agreed delivery date.  What really happens is that the contract either expires as worthless, because the spot price is higher at the delivery date, or the person on the other side of the futures contract pays the difference between the lower spot price and the contract price.  It is a zero sum game, in that all the profits are equal to all the losses, not counting the commissions and fees charged for participating in the market.

Futures markets were intended to serve two types of participants.  One is the speculator, who bets on the future price, just like gambling on the results of sporting events or elections.  The other is someone in the business of actually using the commodity to be delivered.  For these "commercial traders," the futures market provides a hedge against price fluctuations that could cause big losses to the business.  Oil refineries buy crude oil for future delivery and sell their products at prices which include that cost.  When they purchase oil, they can also sell an oil futures contract at the same price, for the same amount and same delivery date.  That way, any price changes will cancel out.  It takes the risk away from the refinery and places it on the speculator.

Of course, the futures market has become much more complicated than the simple hedge. The real activity is among the speculators, those who are betting that the price of a commodity will go up and those betting it will go down.  If there are more bettors on higher prices (the bulls) than on lower prices (the bears), the futures contracts will continue to have higher settlement date prices.  This will go on until the bulls start dropping out and the bears increase.  Sometimes the rational analysis of speculators is replaced by a mania, a belief that the market price will only go up, never down.  Observers will call this “the greater fool theory of valuation.”  Even if buyers don’t believe in the fundamentals for the price, they are convinced that someone will come along who is willing to pay an even higher price.  This is the “bubble” that, when it bursts, can cause calamity.

The futures markets were once spread all over the United States, with Chicago having the major ones.   The principal players were not really part of Wall Street.  As the futures markets expanded, it attracted Wall Street traders and brokers in their unquenchable thirst for new securities games to play.  In 1994, the New York Mercantile Exchange and the New York-based Commodity Exchange merged and became the largest center for trading futures on physical commodities.  Congress has passed laws purporting to regulate futures markets, but they have really been the results of lobbying by contestants in a turf war between Chicago commodities brokers and Wall Street, and between their respective regulators, the Commodities Futures Trading Commission and the Securities and Exchange Commission.  A most recent and painful example of Wall Street’s domination of a futures market has been the one for oil.  The futures market in oil was created in 1981, when the executive branch removed price and allocation controls and allowed the New York Mercantile Exchange to begin a trading market in gasoline futures.  [Barry C. Lynn, Cornered: The New Monopoly Capitalism and The Economics of Destruction, John Wiley & Sons, Inc., 2010, pages 189-190]  Congress separated speculators from “commercial traders," but left the so-called “swaps exemption.”  Wall Street firms could purchase some physical assets, as if they were in the oil business, putting them in the commercial trader category.  Then they could sell swaps to hedge funds, pension funds and other pure speculators.  Bills introduced into Congress to eliminate the swaps exemption seem to have died in committee. 

Oil derivatives have taken on a role in financial speculation that has almost nothing to do with the supply and demand for that commodity.  It is now part of an arbitrage game, playing off the stock market.   Since oil futures first started trading in 1983, their correlation with stock prices has been only about a tenth of one percent.  Since 2008, it has been at 34% and reached 70% in 2010.  “Crude oil is now influenced more by the stock market than by its own inventory levels or demand patterns.”  What happened?  Wall Street has overtaken the trading in oil futures, moving in and out on programmed trades.  “Oil and stocks are joined up by actual money flows, as more fund managers start to trade in both markets.  Many of them are so-called ‘algorithmic traders,’ who trade based on technical signals instead of fundamentals.” [Carolyn Cui, “Oil Gets a New Dance Partner: Stocks,” The Wall Street Journal, August 16, 2010, page C1]  "Historically, financial speculators accounted for about 30 percent of oil trading in commodity markets, while producers and end users made up about 70 percent."  In February 2012,  "Speculators who'll never take delivery of oil made up 64 percent of the market."  [Kevin G. Hall, "Once again, speculators behind sharply rising oil and gax prices," McClatchy Newspapers,]

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Wall Street speculation in the futures markets for food has been blamed for increased hunger in poor countries.  “From about late 2006, a lot of financial firms—banks and hedge funds and others—realized that there was really no more profit to be made in the US housing market, and they were looking for new avenues of investment. Commodities became one of the big ones—food, minerals, gold, oil. And so you had more and more of this financial activity entering these activities, and you find that the price then starts rising.  . . . It sounds incredible, but world rice prices increased by 320 percent between January 2007 and June 2008. So in just 18 months you have tripling of world rice prices. World wheat prices go up by 240 percent, maize prices by 218 percent. Crazy increases in these trade prices of these commodities. . . . This bubble burst in June 2008 . . . because that was when banks had to move their profits back to the US to cover their losses in the subprime market. From about March/April 2009 the prices have started rising again, and more and more of these investors, index investors, as they're called, have now started entering and buying OTC contracts in the forward market. And this is because there is really no reason for them not to do that, because they're getting very cheap interest, they've got a huge moral hazard because they know they'll get bailed out if there's a crisis, and this is a very profitable avenue of investment at the moment."  [Jayati Ghosh, Professor of Economics at Jawaharlal Nehru University, in an interview with Paul Jay,]

Derivative securities, fashioned from subprime home loans, have been especially harmful to communities of racial minorities, according to sociologists at Princeton University.  Segregated, low-income areas had formerly been "red-lined" as undesirable by traditional lenders, who held and serviced the loans they originated.  When making home loans became separated from continuing to own the loans, it created "geographic concentrations of underserved, unsophisticated consumers that unscrupulous mortgage brokers could easily target and efficiently exploit. . . . In the end, subprime lending not only saddled borrowers with onerous terms and unforeseen risks, but it also reinforced existing patterns of racial segregation and deepened the black-white wealth gap." [Jacob S. Rugh and Douglas S. Massey, "Racial Segregation and the American Foreclosure Crisis," American Sociological Review, Volume 75, number 5, October 2010, pages 629-651, at page 632]   

The speculation in oil and food futures has led to a new kind of derivative for other commodities.  In December 2009, the Securities and Exchange Commission approved new exchange traded funds for trading in platinum and palladium.  Unlike most futures trading, these ETFs actually buy and store the physical commodity.  That has the effect of taking supply out of the market, raising the price of the futures.  Higher prices also have the effect of “hurting consumers such as car makers, liquid-crystal-display glass makers and medical-device makers.”  [Matt Whittaker and Carolyn Cui, “ETFs Drive Up Platinum, Palladium,” The Wall Street Journal, January 20, 2010, page C9]  "The holdings create a certain amount of overhang, raising concerns about how sharp any correction, whether driven by profit-taking or hedge-fund asset reallocation, would be."  [Matt Whittaker, "Palladium Shines in the Glow of Metal-Backed ETFs," The Wall Street Journal, April 16, 2010, page C9]  Users of metals have accused Wall Street of storing huge amounts of metals in warehouses, to restrict the supply and drive up the prices.  [Tatyana Shumsky and Andrea Hotter, “Wall Street Eyed in Metal Squeeze: Some Say Warehousing Inflates Prices,” The Wall Street Journal, June 17, 2011, page C1]

 The same concept and structure used for commodity futures were applied to the future price for foreign currencies, then to U.S. Treasury bonds.  These “financial futures” are commitments to deliver or to buy a security or currency at a date a few days or months out, at a stated price.  Financial futures came to include the single stock futures contract.  They are another way of betting on the future price of a company’s shares, modeled on the futures contracts used for commodities like wheat, pork bellies and oil.  When single stock futures contracts were first used, both the SEC and the Commodities Futures Trading Commission claimed jurisdiction over regulating them.  To settle the dispute, Congress in 1982 banned the instrument from trading anywhere.  When it passed the Commodity Futures Modernization Act of 2000 (tacked on to the “Consolidated Appropriations Act”), it gave the agencies shared jurisdiction.  But it also used the 262-page law to create exemptions and exclusions from trading limitations and rules for “eligible contract participants.”  These players include individuals or businesses (such as hedge funds) with $10 million in assets and employee benefit plans with $5 million in assets. [see summaries of the Act by Daniel P. Cunningham and Katherine J. Page of Cravath, Swaine and Moore for the International Swaps and Derivatives Association,, by Glen S. Arden of Jones Day,  and by Dean Kloner, an associate with Stroock & Stroock & Lavan,]   This wholesale market is the focus for Wall Street investment banking firms on both the buy and sell side.  The Act directed a study of the use of swap agreements for the retail trade.

Then came another derivatives game, options on financial instruments.  Options are the right to sell (a put option) or to buy (a call option) a security at a particular date and price.  Unlike a futures contract, an option does not commit the holder to do anything other than pay a price for the option.  That price is usually a small percentage of what it would cost to buy the underlying, “real” security.  You get to play the game of guessing whether a security’s price will go up or down, without having actually to buy or sell the security or even agree to buy or sell it in the future.  Options allow you to get the short-term price increase or decrease on a security, while paying only a fraction of the cost of buying the security itself.  If you guess right, you can collect the same profit you would have gotten from buying the security on which the option was based, minus only the cost of the option.  If you miss the mark, you only lose what you paid for the option.

Some option contracts use indices tied to a group of companies’ shares, like the S&P 500.  Participants may use them as legitimate hedging tools, by simultaneously buying an individual company stock and selling an index option.  Before long, the stock option concept went from broad market indices to options on stocks in specific industries or company size category or specific countries.  Then, stock options were created that are the right to buy or sell a single company’s shares by a certain date at a set price.  The option buyer is betting whether the price will move up or down.  The option is “settled” without anyone actually buying or selling shares, with the result that trading in options can be done with far less capital.  But it still means that capital is being tied up in a zero-sum game among its players, capital that could have been used to actually buy new shares from a business that would use the funds to develop a product or service. 

(My brief foray into playing the derivatives game was with futures call options on 30-year Treasury bonds.  My options gave me the right to buy a futures contract which, in turn, would give me the right to buy the bonds.  Having both an option and a futures contract had the effect of increasing leverage and multiplying the amount of potential gain.  I was betting that the price of the bonds at the delivery date on the futures contract would be higher than the price payable on the futures contract.  If the price was below the futures price commitment, I’d be out the cost of the option.  The odds looked to me much better than a lottery.  Just as other gamblers tell themselves about sports betting, I could fantasize that I had some knowledge and ability in analyzing what the results would be, that it wasn’t really gambling, that it was a game of skill, perhaps even a career.  I did OK, but I know that eventually I would have given back all my gains.  Friends insisted that I get out and stay out.)

As the 1970s progressed, derivatives, especially options, gained respectability from government and academia.  But the trade in derivatives was hampered by one big thing: no one could work out how to price many of them.  The interacting factors of time, risk, interest rates and price volatility were so complex that they defeated mathematicians until Fischer Black and Myron Scholes published a paper in 1973.  Within the year, traders were using equations and vocabulary straight out of Black-Scholes (as it is now universally known) and the worldwide derivatives business took off like a rocket.

In 1973, the year that the SEC approved options trading on the Chicago Board of Trade, it also allowed operation of the new Chicago Board Options Exchange.  After Black’s death in 1995, Scholes and Robert Merton were awarded the Nobel Prize in Economics for this work.  In the news release announcing the award, the Royal Swedish Academy of Sciences said:  “A new method to determine the value of derivatives stands out among the foremost contributions to economic sciences over the last 25 years.”  []

Black and Scholes, the academics who created the formula for pricing options, were co-founders of Long Term Capital Management, a hedge fund manager that successfully used the Black-Scholes Formula from 1993 to 1998.  But their formula didn’t anticipate what would happen to the financial markets when Russia defaulted on its debt.  In a prelude to the 2008 collapse of Wall Street, the Federal Reserve Bank of New York jawboned a bailout by Wall Street banks, which had lent LTCM nearly all the money used in its maneuvers.  After the bailout, the banks went back to business as usual.

With support from the SEC and Nobel prizewinning economists, derivatives trading came to dwarf the stock market.  There were futures and options on individual stocks and groups of stocks, which led to the simultaneous buying and selling of derivatives for the same underlying securities, using different markets.  This brought index arbitrage and program trading.  One securities firm marketed its use of the Black-Scholes formula as “portfolio insurance.”  A major step had been taken toward the financial collapse of 2008.  [Michael Greenberger, Law Professor at the University of Maryland, “The Role of Derivatives in the Financial Crisis,” Testimony before the Financial Crisis Inquiry Commission, June 30, 2010,]

The summer before the Crash of October 19, 1987, when the Dow Jones Industrials dropped 22.5% in one day, institutional money managers had put over $100 million into these arbitrage strategies.  [Marshall E. Blume, Jeremy J. Siegel, Dan Rottenberg, Revolution on Wall Street: The Rise and Decline of the New York Stock Exchange, W.W. Norton & Company, 1993, page 159]  The flaw in the Black-Scholes equation was the assumption that index futures could always be sold in a down market.  It didn’t provide for a panic market, when there were no buyers.  That was the end of “portfolio insurance” but only to be replaced by more bets labeled “insurance.”

Futures and options instruments multiplied, with hedges, straddles and portfolio management strategies adding complexities.  As Wall Street looked for more marker securities upon which to build more derivatives, real estate loans became the new game in town.  First were mortgage-backed bonds, which were debt obligations secured by a pledged collateral pool of mortgages that had a value equal to 150% of the bond amount.  If the bond issuer failed to pay, the bondholders could sell the mortgages.  Then, in 1977, came the first private Pass-through Certificates.  They were fractional interests in a pool of mortgages that collected payments of interest and principal and passed them through to the owners.  Both of these instruments were modeled on what was already being done by the government sponsored entities, Fannie Mae, Freddie Mac and Ginnie Mae.

Seeing the success of Pass-Through Certificates, Wall Street grabbed onto the mathematical formulae of the “rocket scientists” it had hired to come up with Collateralized Mortgage Obligations, or “CMOs.”  These securities divided a pool of loans into tranches, based upon the risk involved in each.  The lower risk tranches got triple A ratings from the rating agencies, while the high risk, “toxic” tranches carried high interest yields and paid large commissions to the brokers who sold them.  The appetite for CMOs led to using car loans, music royalties and any other installment payments for Collaterized Debt Obligations, or “CDOs.”

(I stopped doing legal work on mortgage securities in 1985, after completing my first and only Collateralized Mortgage Obligation.  Unlike the Mortgage Backed Bonds and Pass-through Certificates I’d done, the CMO was dizzyingly complex.  Most important, I listened to the investment bankers laugh about how they marketed the “toxic waste” tranches and the kind of fund managers who could be sold on them.  That same year, I got my one and only call from a head hunter.  The client was Drexel, Burnham, Lambert, the formerly sleepy Philadelphia broker brought to riches by Michael Milken and his junk bond operation.  They were looking for someone to build a parallel business in mortgage securities.  I’ve been so glad ever since to have declined any interest in pursuing it.) 

As derivatives like futures, options, CMOs and CDOS expanded, the process moved on to inventing derivatives on these derivatives.  The most publicly known are the Credit Default Swaps, a form of betting on whether payments on contracts will be made on time.  They’re a little like sports betting, such as whether a quarterback will complete the next pass.  These Credit Default Swaps grew to unimaginable amounts.  “For example, the bets on who might default, called credit default swaps, grew unregulated to now comprise $683 trillion of contracts (Bank for International Settlements December 2008) – while real global production measures only the $62 trillion of global GDP (IMF October 2008).”  [Hazel Henderson, “The New Financiers,” Ethical Markets, 2009,]

One of the most difficult derivatives to understand is also the one that has caused some of the greatest losses:  The “synthetic collateralized debt obligations” or synthetic CDOs.  They are a group of bets on whether a company will default on its bonds.  The bets are sold as “insurance” and “credit default swaps.”  The groups include a hundred or more companies and the buyers are the banks, hedge funds and others who purchase bonds.  They cover their risk of default by paying a premium to the owner of the synthetic CDO.  The risk for each company in the pool will have been evaluated and the premium set to reflect the perceived risk of default.  Like real insurance, the seller of the bets is protected by having issued sythetic CDOs on a diverse pool of companies.  However, if total losses from defaults come to more than around 5% of the total debt, investors in the synthetic CDOs could lose the entire amount they paid.  Soon after the first synthetic CDOs, "half of CDOs issues were synthetic, but the funds never reached the real housing economy; they were contracts to pay based on future movements in the prices of existing mortgage bonds.  There were no new mortgages, but there was added debt, and a lot of profit for the banks."  [Jeff Madrick, Age Of Greed: The Triumph of Finance and the Decline of America, 1970 to the Present, Alfred A. Knopf, 2011, page 381.  The sad history of one synthetic CDO is chronicled by Mark Whitehouse and Serena Ng in “Insurance Deals Spread Pain of U.S. Defaults World-Wide,” The Wall Street Journal, December 23, 2008, page A1.]

Instead of channeling money from individuals to growing businesses, Wall Street has invented thousands of securities that are nothing more than bets on future events.  Increasingly gigantic amounts of money have been sent to Wall Street to play these zero sum, nonproductive games.  In late 2009, the global derivatives market had reached $600 trillion, equal to ten times the gross domestic product of all the countries in the world.   Of that, $204 trillion was held by U.S. banks, with almost all of it, $197 trillion, owned by the four largest Wall Street banks. []  That’s “up from $106 trillion in 2002 and a relative pittance just two decades ago. Theoretically intended to limit risk and ward off financial problems, the contracts instead have stoked uncertainty and actually spread risk amid doubts about how companies value them.” [Peter S. Goodman, “The Reckoning: Taking a Hard Look at the Greenspan Legacy,” The New York Times, October 9, 2008,]  That half a quadrillion dollars in the derivatives market is lost to investing in shareownership or bonds of businesses that could make our lives healthier, safer and more satisfying.  “Today we’re awash in capital and literally running out of nature.”  [Peter Barnes, Capitalism 3.0, Berrett-Koehler, 2006, page xiii]

Of course, many participants in these games of greed and fear are not residents of Wall Street.  People buy and sell derivatives of their own free will, however ignorant or careless they may have been.  “I'm not saying that average Americans were as culpable as Wall Street in creating this financial and economic crisis; our sins were venial, whereas theirs were mortal.  Madoff's alleged fraud was at least straightforward. Much worse was the creation of exotic ‘derivative’ investment products -- whose true value turned out to be impossible to ascertain -- that were bought and sold with enormous leverage. As long as real estate values kept rising, it didn't matter what these chimerical investments were worth. What mattered to Wall Street was the ability to collect enormous fees from real people, in real dollars, for trading unicorns and dragons.” [Eugene Robinson, “The Year of Madoff,” Washington Post, December 30, 2008, page A15.  Bernard Madoff, a former chairman of the NASDAQ Stock Exchange, confessed to a massive Ponzi scheme fraud in 2009 and began serving a 150-year prison term.]  Trading on today's derivatives clearing houses are controlled by nine persons from huge Wall Street firms.  Called the “derivatives dealers club,” they resist broadening participation, such as electronic trading of derivatives .  [Louise Story, "A Secretive Banking Elite Rules Trading in Derivatives," The New York Times, December 11, 2010,]

A practice similar to the derivatives markets was made a crime a century ago by New York’s Bucket Shop Law, which was followed by laws in other states.  Before these laws, securities brokers and others accepted wagers that a company’s shares would go up or down in price. [Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970, page 127, note 62]  The Financial Services Modernization Act of 1999 [also known as the Gramm-Leach-Bliley Act, Pub.L. 106-102] preempted these state bucket shop and gambling laws to the extent they might be applied to hybrid instruments, swap agreements and transactions among eligible contract participants.  The “Modernization Act” went even further to create an unregulated market for Wall Street’s derivative securities.  It set up a legal monopoly for a betting parlor on securities.  Only registered broker-dealers could participate.

The 1987 market crash was not the only clear warning of what was to come in the derivatives market.  Wall Street continued right after that to sell packages of interest rate swaps and other derivatives related to the debt market.  When interest rates rose in 1993, many bond prices dropped by ten percent.  Holders of derivatives experienced a much greater loss in value.  The treasurer of Orange County, California had invested nearly $8 billion of the County’s money and funds of 180 other municipalities in bond-based derivatives.  The turn in interest rates caused a $1.5 billion loss, bankrupting the County.  In 2001, Enron became the largest bankruptcy in history after exposure of its games with derivatives and accounting.  Enron had invented a series of derivatives, including contracts on future weather.  It would trade the products it created at monopolistic profits.  But then the investment bankers would copy Enron’s successful derivatives and competition would take away their profitability.

One of the early warnings about derivatives came from Warren Buffett, in his 2002 annual report to Berkshire Hathaway shareowners:  “The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. . ..  In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”  []  “Felix G. Rohatyn, the investment banker who saved New York from financial catastrophe in the 1970s, described derivatives as potential ‘hydrogen bombs.’”  [Peter S. Goodman, “The Reckoning: Taking a Hard Look at the Greenspan Legacy,” The New York Times, October 9, 2008,]

When the Panic of 2008 hit, and some Wall Street players were bailed out, it still didn’t fix the crisis.  “This is because the credit crisis reflects something more fundamental than a serious problem of mortgage defaults. Global investors, now on the sidelines, have declared a buyers' strike against the sophisticated paper assets of securitization that financial institutions use to measure and offload risk.”  [David Smick, “Commentary: Why there's a crisis -- and how to stop it,, October 10, 2008,  David Smick is author of The World Is Curved: Hidden Dangers to the Global Economy, Penguin Portfolio, 2008. He is chief executive of Johnson Smick International, a financial market advisory firm based in Washington, D.C., which publishes The International Economy magazine.]

What happened to the credit markets in October 2008 was that banks became afraid to lend money to other banks, a practice that is a major source of bank funding.  Bankers didn’t know which of their correspondent banks had loaded up on derivatives, and how many of those derivatives may have become unsaleable.  “The reason banks became reluctant to lend money to each other was linked to risks arising from new types of financial instrument.  Recent years have seen huge amounts of ingenuity applied to the devising of new types of investment vehicle.  Most of these are forms of derivative, in which a product derives its value from something else.”  [John Lanchester, “Cityphilia,” London Review of Books, January 3, 2008,, not paged] 

Government reform proposals have focused on this unsaleability of derivatives, the fact that so many of them are traded privately, without continuous, public bid and asked quotations.  The suggestion has been that a repeat of the 2008 collapse could be avoided by having “transparency” from exchange trading of derivatives.  One prediction is that greater transparency will be required for some, but not all derivatives.  “This half-measure will allow new Petri dishes of systemic risk to fester in darkness as Wall Street returns to the ‘financial innovation’ laboratory.”  [Paul M. Barrett, “The Crisis Commission’s Missing Witness,” Bloomberg BusinessWeek, January 25, 2010, page 18]

The harm to United States citizens can be clearly seen and measured for at least one part of the derivatives mess.  American International Group, Inc., the world’s largest insurance company, had a financial products unit which sold “insurance” against losses that could happen to owners of derivatives.  One of the simpler products was a credit default swap, which charged a premium for insurance against a loss caused by a pool of mortgages going bad.  It turned out to be a very bad bet by AIG.  When AIG begged for its fourth rescue from the Fed, it said, in its February 26, 2009 draft presentation:  “What happens to AIG has the potential to trigger a cascading set of further failures which cannot be stopped except by extraordinary means. . . . Insurance is the oxygen of the free enterprise system. Without the promise of protection against life’s adversities, the fundamentals of capitalism are undermined.”  []

Credit default swaps and interest rate swaps insured by AIG totaled $440 billion, with less than $40 billion pledged as collateral, at a time when the total market value of all AIG equity was about $200 billion.  [Gretchen Mortenson, “AIG, Where Taxpayers’ Dollars Go to Die,” The New York Times, March 9, 2009,] Yet, Wall Street kept on buying and pushing insurance as protection for its customers.  They either didn’t care whether AIG could cover the loss or they believed that widespread losses would never occur. Those on Wall Street who actually thought about AIG’s role in the derivatives game may also have believed that AIG would never be allowed to fail, that the government would bail it out.  They were rewarded for taking this moral hazard.  [John Carney, “Don't Forget: AIG's Customers Were Running A Scam Too,” The Business Insider,]

When AIG didn’t have enough reserves to pay its customers, the Federal Reserve Banks provided what had come to be $173 billion by early 2009. Why would the Fed do that?  Insurance companies are not even regulated by the federal government; heavy duty lobbying has kept them governed solely by each state’s insurance commission.  It would be understandable if AIG’s swap customers were United States commercial banks, members of the Federal Reserve System.  But it turns out they were U.S. investment banks, like Goldman Sachs, Morgan Stanley and Merrill Lynch, and foreign banks, like Deutsch Bank, Royal Bank of Scotland and HSBC Holdings.  [Serena Ng and Carrick Mollenkamp, “Goldman, Deutsch Bank and Others Got AIG Aid,” The New York Times, March 7-8, 2009, page B1.  Editorial, “The Gift That Keeps on Giving,” The New York Times, March 16, 2009,]  

Rather than deter the use of credit default swaps, the AIG disaster seems to have prompted greater use of these derivatives.  In the first half of 2009, some 70% of the credit lines extended to borrowers in good standing had interest rates tied to the price of the borrowers’ credit default swaps.  If the swaps became more expensive, the interest rate on the loan would go up.  Wall Street’s explanation is that increasing the borrower’s interest cost somehow protects the lender from default.  Given that the credit default swap market is used for speculation, an unfounded rumor could send the swap price spiraling up, triggering an increase in the interest rate, causing the borrower to have real financial problems and then, as a result, the bank would have a loss on the loan.

Why did the Federal Reserve bail out those investment bank customers of AIG, for which it had no regulatory responsibility?  One explanation is a rule of bureaucracies:  Always increase your turf, your sphere of influence, the scope of your power.  A clue for that motive is in what happened to the three investment banks disclosed as receiving bailout money funneled through AIG.  As a part of the bailout, Merrill Lynch became part of Bank of America, while Goldman Sachs and Morgan Stanley signed up as bank holding companies.  That put all three of them directly under the Federal Reserve’s authority.  They took bailout funds directly from the Fed and got billions more of Fed-created money passed through AIG.

The same “increase your turf” motive may explain why foreign banks got so many billions from the Federal Reserve via AIG.  The financial crisis that hit in 2008 has been worldwide.  Europe and other countries with banking systems have been pushing for an international authority over all financial institutions.  That could put an international government structure over the Federal Reserve—unless the Fed could grab that job for itself.

The near miss from bankruptcy definitely did not scare Wall Street into staying away from derivatives. Beginning with the first quarter of 2009, SEC-reporting businesses were required to disclose their exposure to derivatives in their financial statements.  A study of that quarter’s reports showed that some 80% of the derivative assets and liabilities were on the books of five firms, all of them on Wall Street:  Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Bank of America.  That five held 96% of the credit default swaps.  [, as reported in “Executive Summary,” Business Week, August 10, 2009]  “The economy hasn’t yet recovered from the implosion of risky investments that led to the worst recession in decades—and already some of the world’s biggest banks are peddling a new generation of dicey products to corporations, consumers, and investors.”  [Jessica Silver-Greenberg, Theo Francis and Ben Levisohn, “Old Banks, New Tricks,” Business Week, August 17, 2009, page 020]

Wall Street also went headlong after the Panic into selling “structured” securities to individual investors, in amounts as small as $1,000.  These are derivatives for the little people.  One of their advantages for Wall Street is that they are each a “proprietary product” to the bank or broker selling it. To get a sense of the amount and complexity of what is being sold, consumers are sent to for a trial subscription to its service.  [Jessica Silver-Greenberg, Theo Francis and Ben Levisohn, “Old Banks, New Tricks,” Business Week, August 17, 2009, page 020]  One report tells of an 84-year-old retired beautician whose broker sold her a "reverse-convertible note with a knock-in put option tied to Merck stock," for which the brokerage firms get a fee seven times greater than an investment-grade bond.  [Zeke Faux, "Individual Investors Duped by Derivatives," Bloomberg BusinessWeek, October 4-10, 2010, page 43, referring to Satyajit Das, Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives, FT Press; Revised edition, 2010]

Wall Street’s “Prime Brokerage” Games with Hedge Funds

 Hedge funds have become the preferred structure for gambling in derivatives and other nonproductive games.  Wall Street banks have made serving these funds, often managed by their former employees, their highest priority, calling it “prime brokerage.”  Wall Street investment banks and commercial banks lend the hedge funds most of the money they use to trade in securities.  The banks execute the trades, for commission income, and they pass information back and forth on profitable trading opportunities.

The first hedge fund is said to have begun in 1949, with the strategy of buying undervalued stocks and then hedging the market risk by selling overvalued stocks.  [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, page 120]  Today, over 23,000 hedge funds are vehicles for any kind of trading strategies with whatever instruments are thought to produce big winnings.  Nearly all of them rely on borrowing as much money as they can, to leverage the amount committed by institutional money managers and wealthy individuals.

Private-equity funds are financed in the same way as hedge funds.  They buy businesses, often publicly traded ones in distress or underperforming in their industry.  The private equity funds drain any available cash out in dividends and fees and then do an “initial” public offering of what’s left, or sell it to another business.  [David Henry and Emily Thornton, “Buy It, Strip It, Then Flip It: The quick IPO at Hertz makes buyout firms look more like fast-buck artists than turnaround pros,”  Investor beware, Business Week, August 7, 2006, page 28]  Of course, the fund managers use maximum leverage—employing borrowed money for 80% or more of the purchase price.  Meanwhile, operating businesses, providing products and services, and employing workers, are denied loans and refused IPOs.  Wall Street bankers “say lending to hedge funds and private-equity firms can be more lucrative and potentially safer than lending to businesses and consumers.”  [Gregory Zuckerman and Jenny Strasburg, “Banks’ Loans to Funds Are Back at Levels Before Crisis,” The Wall Street Journal, January 9-10, 2010, page C-1]

Wall Street’s easy credit to hedge funds and private equity firms fits precisely within the Minsky model for what causes an economy to crash and go into recession, as it did in October 2008.  [Charles P. Kindleberger and Robert Z. Aliber, Manias, Panics, and Crashes: A History of Financial Crises, fifth edition, John Wiley & Sons, Inc., 2005, page 25.]  Just over a year after that panic, Wall Street was drumming up new prime brokerage business, “boosting their lending to hedge funds and private-equity funds to levels unseen since before the financial crisis, raising their risk levels and adding fuel to the buying power of key players across the stock, debt and buyout markets.”  That fits the easy credit/high risk scenario that keeps creating economic crises. [Gregory Zuckerman and Jenny Strasburg, “Banks’ Loans to Funds Are Back at Levels Before Crisis,” The Wall Street Journal, January 9-10, 2010, page C-1]

Program trading, naked access, flash trading, quote stuffing, etc.

 We have generally considered the difference between investing and trading to be a factor of the time between purchase and sale.  Roughly, a holding period of more than a year is considered investing.  Less than a year is called trading or speculating.  From Wall Street’s point of view, investing generates only an occasional commission or gain, while trading brings a stream of commissions or profits.  When Wall Street firms use their own money to buy and sell, they go for rapid turnover. 

Computers have helped drastically accelerate the movement to ever faster trading.  The Crash of October 19, 1987, when the Standard and Poor’s 500 stock index fell 23 percent in one day, has been blamed on “program trading,” the computer-based trading for arbitrage among stock prices, options and financial futures.  The head of the commission appointed to study the cause of the “market break” said:  “If we have learned anything from the events of last October, it’s that the nation’s financial marketplaces are inextricably linked.  What historically have been considered separate marketplaces for stocks, stock-index futures and options do in fact function as one market.”  [Nicholas Brady, later Secretary of the Treasury, New York Times, February 4, 1988]  The only remedy taken after the 1987 panic was to have the exchanges stop trading automatically when prices fell beyond a set trigger.  The separate marketplaces were left uncoordinated and largely unregulated.  As a result, the “quants” continued to invent their computer algorithms and history repeated itself in October 2008.  [For a description of the takeover of Wall Street trading, and the price we’ve all paid, see Scott Patterson, The Quants:  How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It, Crown Business, 2010]

New ways to bet on price movements are constantly being invented.  Computer communications technology has led to “high-frequency trading,” where computerized models trade in and out in milliseconds.  Participants have moved their operations to be physically near the computers where trades are executed because, even at the speed of light, there can be a competitive advantage to placing a computer close to the equipment used by an exchange.  Imagine a poker table where the first to play a card can win.  This “high frequency trading” operates entirely through computer-programmed trading strategies--so-called "algorithmic trading."  No human has to make any decision.  Some programs read everything that goes across the Internet, finding and analyzing words related to a company and then place buy or sell orders. [Graham Bowley, "Wall St. Computers Read the News, and Trade on it," The New York Times, December 21, 2010,]  The trade may not even be in reaction to whatever is happening with the company that issued the securities, the economy or any other events.  A program can be all about trading techniques.  A fictional algorithm is explained by Robert Harris in the novel, The Fear Index.  [Alfred A. Knopf 2012]  The stock exchanges registered with the SEC have petitioned to trade stocks in tenths of a penny, instead of a penny.  They say they need the change in order for them to compete with the Alternate Trading Systems and Dark Pools, which are not subject to SEC registration.  [Jacob Bunge, “Exchanges Want to Take Stock Quotes Below a Cent, The Wall Street Journal, January 26, 2010, page C1]

How much of the buying and selling on U.S. Exchanges is done by high frequency traders?  By 2009, over half of all trades on U.S. exchanges were these high frequency trades.  “High-frequency trading now accounts for 60 percent of total U.S. equity volume, and is spreading overseas and into other markets.”  [Jonathan Spicer and Herbert Lash, “Who’s Afraid of High-Frequency Trading?” Reuters, December 2, 2009,] Exchanges are competing to get derivatives trading business and high frequency trading is already over 60% of futures trading on the Chicago Mercantile Exchange.  Congress gave high frequency trading a boost in the Dodd-Frank "Wall Street Reform" Act, which requires swaps to be traded on exchanges, instead of in private transactions.  "High-frequency trading's share is likely to grow amid a number of market-structure changes to be implemented over the next few years as part of the Dodd-Frank financial overhaul."  [Scott Patterson, "CFTC Plans to Examine High-Frequency Trading," The Wall Street Journal, January 31,2012.  Scott Patterson's reporting became a book, Dark Pools: High-Speed Traders, A.I. Bandits, and the Threat to the Global Financial System," Crown Business, 2012]

We have all become more aware of high-frequency trading after the May 6, 2010 “Flash Crash,” when the Dow Jones Industrial average dropped nearly a thousand points during trading. In describing that day, Scott Patterson wrote:  "High-frequency firms have in recent years become central to how the market operates, growing to account for about two-thirds of daily market volume, according to industry estimates. . .  When the market hits certain levels as it falls, these firms’ computers are programmed to sell automatically as protection against further losses. . . .  As the losses accelerated, there were little or no ‘buy’ orders left in many stocks and other assets, causing a plunge that saw some securities spiral to near zero.”  [Scott Patterson, “Did Shutdowns Make Plunge Worse?” The Wall Street Journal, May 7, 2010, C1, C3.  For a fictional description of a flash crash, see Robert Harris, The Fear Index, Alfred A. Knopf 2012] 

High frequency trading has moved beyond stocks to futures and other derivatives, where it has reached 40% of the trades.  Both markets are plagued by orders placed and cancelled to manipulate prices.  "An estilmated 80 to 90 orders are put into futures markets for every trade that actually happens, according to Mr. Gensler [Chairman of the Commodities Futures Trading Commission], and experts say obout 90% of all orders on stock exchanges are canceled."  [Scott Patterson, "CFTC Targets Rapid Trades," The Wall Street Journal, March 16, 2012, page C1, C2.

The rules of the exchanges are that only member broker-dealer firms may trade.  However, to get the speed they want, hedge funds and other trading firms “rent” their brokers’ computer codes.  Only brokers who are members of the exchange are allowed to place orders, but some brokers get paid for letting trading customers use their access codes to communicate with the exchange computers.  This “sponsored access” occurs when the customer routes orders through the brokers’ computers, where they can be checked for any rule violations.  A few brokers’ let customers skip the brokers’ computer system entirely and tie directly into the exchange network, using the brokers’ “market participant ID” computer access codes to interface with the exchange computers. That’s known as “naked access” and it allows a hedge fund or other trader to buy and sell a security in less than a second.  [] No one could be in and out of owning a security in a split second, based upon some change in information about the underlying business.  This is speculative trading, based upon computer-programmed instructions that have nothing whatsoever to do with any real world information. 

There are several advantages to naked access, over sponsored access.  First of all, it is some milliseconds faster, giving participating customers a competitive advantage.  [“A firm that uses naked access can execute a trade in 250 to 350 microseconds, compared with 550 to 750 microseconds for trades that travel through a broker’s computer system by sponsored access . . ..”  [Scott Patterson, “SEC Aims to Ban ‘Naked Access’, The Wall Street Journal, January 14, 2010, page C1, referring to a report by Sang Lee, managing partner of the Aite Group, “Land of Sponsored Access: Where the Naked Need Not Apply,” December 14, 2009,]  But naked access also provides anonymity, so that the exchanges and securities regulators don’t know who is making the trades, since the only traceable identity is the broker-dealer who has rented out its access codes.  Estimates are that over half of all trading volume in stocks is being done through naked access.  [Scott Patterson, “Regulators Target ‘Naked’ Access: Concerns Over Risk Management of Anonymous, High-Speed Trades,” The Wall Street Journal, October 13, 2009, page C1]  In November 2010, the SEC adopted a rule ostensibly to bar naked access.  What the rule actually does is require the licensed  broker-dealer to follow "risk management controls" which are "reasonably designed to manage the financial, regulatory, and other risks, such as legal and operational risks, related to market access." []  Some could view the SEC's action as business as usual, with more records generated.

Back at that imagined poker table, what if a player could get a quick glance at the hands held by the others?  That is the advantage of “flash trading” in the securities markets.  It is a quick view on the computer of orders placed but not yet executed.  “The order is ‘flashed’ to a select group of participants who can act on the order before it is routed to other exchanges to be filled.” [Jacob Bunge and Joan E. Solsman, “Direct Edge Rides Citi to Record Trading Share,” The Wall Street Journal, September 4, 2009, page C5]  The traders use the flash for "gaming," which is a form of front-running, when "a high-speed firm's computers detect a large buy order for a stock, for instance, the firm will instantly start snapping up the stock, expecting to quickly sell it back at a higher price as the investor keeps buying."  [Scott Patterson, "Fast Traders Face Off With Big Investors Over 'Gaming'," The Wall Street Journal, June 30, 2010, pages B1, B3]  The principal flash trader is Direct Edge, which is owned by a foreign securities exchange and three Wall Street firms, including Goldman Sachs.  Its CEO is a Goldman Sachs alumnus.  Together with a similar trading system, BATS Exchange Inc., Direct Edge had taken over 22.6% of matched trading in July 2009, compared to 6.3% two years earlier.  BATS dropped the practice in September 2009 and has since become an SEC-registered exchange.  Senator Charles Schumer has called flash trading “a two-tiered system where a privileged group of insiders receives preferential treatment.”  [Randall Smith, “The Flash-Trading Thorn in NYSE’s Side,” The Wall Street Journal, August 31, 2009, page C1]  The SEC is still gathering comments on how it might tinker with rules about flash trading.  ["Elimination of Flash Order Exception from Rule 602 of Regulation NMS," Release No. 34-62445; File No. S7-21-09

Wall Street traders are not satisfied with being able to peek at prices for pending trades before placing their own buy or sell orders.  Looking at the cards held by other players is not enough--they are looking to reshuffle the cards. They are finding ways to go beyond flash trading, to ferret responses and cause price changes through "sniping" or "sniffing," by placing orders that they cancel before they are executed.    One technique, called "quote stuffing," places a mass of orders, all within a fraction of a second, followed directly by canceling them all.  For instance, Nanex, LLC, a data provider, looked at a day in which an average 38 orders were placed every second to buy or sell one company's stock. But in one second, there were 10,704 orders, followed by 5,483 the next second.  All but 14 of those orders were cancelled within the next second.  This may cause other buyers and sellers to place orders as they conclude the market price is moving.  The first round of orders is a feint, intended to deceive other high frequency traders, enticing them to place orders before they see the cancellations.  This allows the quote stuffer to purchase and sell at the two different prices--the price in the "real" market and the price of the trade made in reaction to the quote stuffing.  [Tom Lauricella and Jenny Strasburg, ""SEC Probes Cancelled Trades: Regulators Looking Into Role 'Quote Stuffing' May Have Played in Flash Crash," The Wall Street Journal, September 2, 2010, page A1, A12]  Another gambit is placing large numbers of trades, each in tiny amounts, like a tenth of a cent.  These "sub-penny" orders, placed at prices much lower or higher than the real market, are intended to dupe the algorithms of other traders about a stock's price direction or volume of trades. 

High frequency trading's wild potential for disruption is described in the Flash Crash series of events, revealed in the September 30, 2010 report by the SEC and the CFTC, "Findings Regarding the Market Events of May 6, 2010,"  []  From its Executive Summary:  "May 6 started as an unusually turbulent day for the markets. . . . At 2:32 p.m., against this backdrop of unusually high volatility and thinning liquidity, . . . a mutual fund complex initiated an automatic execution algorithm . . ." to sell $4.6 billion of "E-Mini contracts . . .  as a hedge to an existing equity position."  The buyers included high-frequency traders, who quickly placed orders to resell, and "cross-market arbitrageurs, who transferred this sell pressure to the equities markets by . . . simultaneously selling . . . individual equities in the S&P 500 Index."  The high frequency traders "began to quickly buy and then resell contracts to each other--generating a 'hot potato' volume effect as the same positions were rapidly passed back and forth.”  CBS' 60 Minutes devoted a segment of its October 10, 2010 broadcast to high frequency trading.  [transcript at, video at]

Wall Street Recycles Taxpayers’ Money and Reduces Retirees’ Income

A very simple game Wall Street plays is to borrow taxpayer money and then lend that money back to the federal government.  In a free market, that game wouldn’t be possible.  But this is a government-rigged market, available only to “banks,” which now includes investment banks.  The Federal Reserve System, which is owned by the banks but has the power of government, has made it possible for its member banks to “earn a huge spread by borrowing virtually unlimited amounts for nothing and lending that same money back to the Treasury. . . . Rather than giving capital to businesses with real products and services, Wall Street plays a government-backed shell game, enriching bankers’ pockets at everyone else’s expense.”  [Ann Lee, adjunct professor at New York University, former investment banker and hedge fund partner, “The Banking System is Still Broken,” The Wall Street Journal, October 16, 2009, page A17]

The cost of this game to the rest of us is many times greater than what is taken from our pockets to pay Wall Street the interest spread between the money borrowed and the return from its purchase of government debt.  Artificially low interest rates on Treasury securities forces lower rates to be paid on nongovernment debt as well. That means that bank certificates of deposit and money market funds pay interest at rates much lower than historic norms.  Retirees who depend on CDs and other fixed income securities have seen their incomes cut by half or more.  The media greets low interest rates as a gift, which they are for banks and others who can borrow, but that gift is bought with a painful loss of income to people relying on interest income for their living expenses.  As economists Peter Morici has said, “Having fed the campaign machines of both political parties and lavished speaking fees on future White House economic advisors, these financial wizards have managed to purchase preferred treatment in our capital.”  [Peter Morici, University of Maryland Professor and former Chief Economist for the U.S. International Trade Commission, “Taxing Grandma to Subsidize Goldman Sachs,” Business Week, April 14, 2009,]

Mutual Fund Managers Have Adopted Wall Street Morals and Practices

A new type of financial intermediary spread in the mania of the 1920s—the investment trusts.  They started out as a fixed group of securities placed in a trust, with shares in the trust sold to investors who wanted income with the stability of a diversified portfolio.  Then their managers began selling securities from the portfolio and buying new ones, to increase income, pay management fees and compete with other trusts for investors.  Investment banks and commercial banks used their name recognition and reputations to start their own investment trusts, which often purchased securities from their bank sponsors. 

The use of investment trusts was a way to attract capital from middle class individuals, without letting them actually own securities of individual companies.  Instead, they were sold nonvoting shares in a trust.  The trust managers invested their pooled funds in new issues, often distributed by their affiliated investment bank or commercial bank.  The management fees and the underwriting commissions were both taken out of the pool of investors’ money.  Many of these investment trusts came undone in the Crash of 1929.  Goldman Sachs Trading Corporation sold its shares in early 1929 at $104 a share.  The price by May 1932 was $1.75.  [John Kenneth Galbraith, The Affluent Society and Other Writings, 1952-1967, The Library of America, 2010, pages 234-238,, from The Great Crash, 1929, Houghton Mifflin Harcourt Publishing, 1997]

After the Investment Company Act of 1940, the investment trusts came back to life as mutual funds, operating within that law’s restrictions, which were supposed to prevent the abuses of the 1920s.  But greed and the lust for power took over the buy side of Wall Street as surely as it did the sell side.  There was the same “My compensation is bigger than yours” and “My fund is larger than yours.”  To play the buy side greed and power game, money managers went from investors in businesses to gamblers at the casino.  “They all reject the need or feasibility of making company-by-company judgments about price and value, industry structure, managerial competence, or many of the other factors that would affect the selection of one stock over another as a long-term holding.  These are the performance game, index fund, portfolio insurance, and other so-called modern strategies.  Mostly they inflict on investors heavy costs, and invariably they distract managers from their fiduciary and social responsibilities.”  [Louis Lowenstein, What’s Wrong with Wall Street: Short-Term Gain and the Absentee Shareholder, Addison-Wesley Publishing Company, Inc., 1998, page 1]

Institutional investing is all about each quarter’s rate of return.  Fund managers are like corporate CEOs.  They get multimillion dollar paychecks based on the “peer analyses” made by selected compensation consultants, who are paid big fees.  The consultants compare a fund’s size and rate of return with that of similar institutions.  “These typically young portfolio managers, who could expect to peak in their early forties, were generally compensated on the basis of their quarterly performance.  This gave them powerful incentives to manage their institution’s portfolios to achieve the highest quarterly prices possible.”  [Lawrence E. Mitchell, The Speculation Economy, Berrett-Koehler Publishers, Inc., 2007, page 277]

Institutional money management was dramatically changed after passage of the Employee Retirement Income Security Act of 1974, called “ERISA.”  The new law was interpreted as directing money managers to look beyond traditional stocks and bonds for entrusting pension fund investments.  The leader in this “total return investing” was the Yale University endowment, which consistently and significantly had higher returns through the 1980s than other university and charitable funds.  Wall Street’s sell side jumped to provide derivatives and other instruments for this total return investing.  Opportunities for investment spread to commodities, derivatives and other products sold by securities broker/dealers.  In addition, real estate investment managers, venture capital firms, hedge funds, private equity funds and other intermediaries presented their proposals to money managers.  In the Panic of 2008, most of these total return funds lost a quarter of their value.

Jack Bogle, founder of the Vanguard mutual funds, has written that, “The principal instigating factor” for mutual funds going wrong “has been a basic shift in orientation from a profession of stewardship to a business of salesmanship.”  [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, page xxii]  He points out that, over the period from 1985 through 2004, “fund costs consumed more than 40 percent of the return provided by the stock market itself. . . . Looked at from yet another perspective, the investor put up 100 percent of the capital and assumed 100 percent of the risk, but collected only 57 percent of the profit.  The mutual management and distribution system put up zero percent of the capital and assumed zero percent of the risk, but collected 43 percent of the return.”  [page 163]

In describing how the mutual fund industry changed, Bogle traced the history of the first one, Massachusetts Investors Trust.  Started in 1924, it had a mutual legal structure, that is, the fund shareowners elected a board of trustees which actually managed the fund’s business.  In 1969, it converted to having a separate management company.  Before that happened, the fund’s expense ratio—the amount of its expenses as a percentage of the amount invested in the fund, was 0.19 percent.  By 2003, the expense ratio had gone up to 1.22 percent. 

There are basically two types of mutual funds.  One is the index fund, where the fund manager simply purchases securities to match the S&P 500 stock index or some other well-known index.  The other is the actively managed fund, where the fund manager makes decisions about which securities to buy and sell, within some general category, like “growth” or “large capitalization.”  The two important differences between these fund types are definitely counterintuitive:  (1) actively managed funds charge much higher management fees and (2) index funds consistently have higher returns for the plan beneficiaries.  If actively managed funds cost more and return less, why do they have 90% of the $1.5 trillion in 401(k) plans?

Mutual fund money managers market their funds to the corporate sponsors of employee retirement plans.   They find ways to convince employers’ plan administrators to offer the funds they manage as the limited options for investment by employees.  One of the most convincing marketing techniques is known as “revenue sharing,” which is simply a rebate to the plan administrators from the management fees collected by the fund managers.  Those management fees are paid by the employees.  In return, fund managers siphon off a portion of what the employees pay and turn it over to the employers’ administrators.  Employees pay twice, once in the lower investment results that mutual funds experience and again in higher management fees.

"Revenue sharing" is also the euphemism used for the rebates from mutual funds to the brokers who sell them.  “Big brokerage firms are finding it difficult to raise fees on their clients who buy mutual funds.  So some brokers are turning to a different source for higher fees: the muthal-fund companies themselves. . . . the payments, known as ‘revenue sharing,’ have long been part of brokerages business and are considered perfectly legal.”  One major brokerage firm, under a regulatory order for greater disclosure, reported revenue sharing was nearly a third of its 2011 profit.  [Ian Salisbury, “Brokers Raise Fees, but Not For Investors: Why You Should Care,” The Wall Street Journal, April 3, 2012, page C9 

Some fund managers use Wall Street sell side firms and other “placement agents” to deal with plan administrators.  [Steven Rattner, hedge fund manager and “car czar” in the Obama administration, was one of the early placement agents.  In 1989, Rattner got his firm,  Lazard Freres, to be placement agent for Providence Equity Partners, a private equity firm.  Lazard was paid a one percent commission on the money it helped bring in.  In addition, Lazard got a third of the incentive fees the fund earned on that money.  “Heard on the Street,” The Wall Street Journal, April 23, 2009, page C12]   These placement agents have relationships with money managers, get their attention and then endorse their client’s proposition.  This presents an opportunity for the intermediary to get paid by both sides.  Sure enough, scandals have been uncovered.  One indictment alleged that the former chief political advisor to the New York State Comptroller had shared fees from hedge funds and private equity firms for investments made by the state’s retirement fund.  [ INDICTMENT.pdf and] Calpers, the California Public Employees Retirement System, disclosed that it had paid over $125 million to placement agents, three of whom were retired members of the Calpers board.  [Jim Christie and Megan Davies, “Firms paid $125 million in fees for Calpers business,” Reuters, January 14, 2010,]

Buy side fund managers are tempted into unethical and illegal ways to increase their quarterly performance, as compared with their peers.  For instance, the comparisons among funds are made as of the end of each quarter, so it is not unusual for managers to sell and buy on the quarter’s last business day.  Stepping over the line, some ask themselves if there are ways they could have higher prices shown for their end-of-quarter holdings.  One way is to place large orders, just before the market closes, for shares they already own.  That sudden increase in demand moves the share price up.  The next step past the line is to get the sell side broker to cooperate in putting in orders at prices higher than the market.  These practices, known as “marking the close” or “portfolio pumping,” have been illegal for many years but still happen.  [ or]

The drive for quick profits has created moral hazards for the managers of mutual funds.  According to Bogle, “Fund managers have moved away from being prudent guardians of their shareholders’ resources and toward being imprudent promoters of their own wares.  They have learned to pander to the public taste by capitalizing on each new market fad, promoting existing funds and forming new funds, and then magnifying the problem by heavily advertising the returns earned by their ‘hottest’ funds, usually highly speculative funds that have delivered eye-catching past returns.”  [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, page 164]

Mutual fund management fees run nearly $100 billion a year.  In setting fees, fund managers have largely been left alone by their regulators, the SEC and state securities agencies.  The changes that have been forced upon them have come mostly from private litigation, which is usually decided in Wall Street’s favor.  Mutual fund shareowners lost a 2010 case before the United States Supreme Court, in which they claimed that fund managers were charging fees at twice the rate that the managers charge pensions funds and others who are independent and can negotiate their fees.  The Court ruled that the fee charged had to be “so disproportionately large it bears no reasonable relationship to the services rendered and could not have been the product of arm’s length bargaining.” [Jones v. Harris Associates L. P.,, Jess Bravin and Jane J. Kin, “Fees Case Strikes at Heart of Mutual Funds,” The Wall Street Journal, October 30, 2009, page C3]

Fund management companies chase flashy short-term returns, so their marketing can showcase a fund’s percentage return and peer group comparison.  This has brought a stepped-up pace of buying and selling a fund’s portfolio.  Back in the “twenty years from 1945 to 1965, the annual turnover of equity funds averaged a steady 17 percent, suggesting that the average fund held its average stock for about six years.  But turnover then rose steadily, and the average fund portfolio now turns over at an average rate of 110 percent annually,” an average holding period of 11 months.  [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, page 184]         

Mutual fund managers even found a way to participate in stock manipulation and Ponzi schemes.  There was a fad for a while called “momentum investing.”  The theory was that once the price of a stock was moving in a direction, it would keep moving that way.  The fund managers would buy a stock, then keep buying it as other managers did the same.  They would appear on televised investor shows and talk up the stocks.  The positive effect on their funds’ returns would bring in more money from investors, so they could buy more of the chosen stocks.  [James J. Cramer, Confessions of a Street Addict, Simon & Schuster, 2002, pages 295-96] Of course, the resulting bubble had to burst.  Like a game of hot potato, the last one to buy into the inflated stock took the big loss.

This driving for short-term profits, to justify huge compensation, was protected by ERISA, which ordered money managers to act like other money managers, instead of common law standard, that they act like prudent individuals who managed their own money.  Copying each other led money managers into investing in derivatives and other alternatives to stocks and bonds.  It all caught up with the buy side in the Panic of 2008. The consequences fell upon the beneficiaries of funds with professional money managers, including colleges and charities, as well as retirees who have placed their life’s savings in mutual funds or who are counting on their employer’s pension fund.  The California Public Employees’ Retirement System, the largest public pension fund, lost 23.4% of its value in the fiscal year ended June 30, 2009.  In the same period, the California State Teachers’ Retirement System was down 25%.  Real estate and private equity investments were the big losers in their investment portfolios, while fixed-income investments performed best.  The pain from managers using public retirement money for big risks/big compensation gambles has also flowed directly to the state and local governments and their taxpayers.  They will have to pay contribution increases of up to 4% of their payroll.  [Craig Karmin, “Calpers Has Worst Year, Off 23.4%, The Wall Street Journal, July 22, 2009, page C3]

Wall Street Money Managers Don’t Restrain Corporate Greed

Wall Street money managers buy and sell shares for trading profits, not to be long-term shareowners of a business.   Buy side focus on short-term trading games has meant that they don’t act as shareowners who care about the prospects for the business.  They only care about what will happen to the market price for the shares in the next minutes, hours or days.  When they get proxy material for a shareowners’ meeting, they nearly always vote the shares they hold just as the company’s management suggests.  One of the two exceptions is the union or public employees pension fund that has a cause to promote.  The other is the hedge fund or private equity firm that is trying to maneuver a sale or change in management for the company. 

This pervasive go-along-with-management practice is motivated by the money managers’ fear of losing business from the corporations who pay them to manage their pension funds.  When an unwanted proposal is coming to a shareowner vote, the threatened CEOs have been known to ask their counterpart CEOs in other companies to put pressure on their pension fund managers to vote against the proposal.  If they don’t go along with the CEOs, their firm’s reputation as a trouble-maker may keep them from winning new clients, or cause them to be cut off from the flow of telephone information from a company that feels threatened.  “There is almost no dissent from the Wall Street Rule, which says that a shareholder who is not pleased with a company is better off selling the shares than trying to change or influence its direction.” [Louis Lowenstein, What’s Wrong With Wall Street: Short-term Gain and the Absentee Shareholder, Addison-Wesley Publishing Company, Inc., 1988, page 91]  They follow the Wall Street Rule:  “Vote with your feet.”  Sell the shares if you don’t like what management is doing.

The escalation of CEO pay has been one consequence from this go-along practice on Wall Street’s buy side.  The amounts taken home by corporate executives have made frequent news stories.  Since reporters look for the other side, these stories usually have quotations from corporate defenders that the compensation is necessary to attract talent that will increase value for shareowners.  Academic studies show that this claimed justification is not supported by the facts.  “It turns out that the bigger the CEO’s slice, the lower the company’s future profitability and market valuation.”  One study of the 10% of companies with the highest CEO pay found that:  “Each dollar that goes into the CEO’s pocket takes $100 out of shareholders’ pockets.”  [Jason Zweig, “Does golden Pay for the CEOs Sink Stocks?” The Wall Street Journal, December 26-27, 2009, page B1]

The SEC has done its part to discourage money managers from exercising the rights of corporate democracy.  If shareowners try to communicate with ten or more other shareowners about an upcoming vote, they become subject to the SEC’s proxy rules, a costly and very public process.

Wall Street Changed the Objectives of Business

Of all the economic and political systems that we’ve tried, businesses are still the best structure for meeting most human needs and wants.  Governments, charities and cooperatives have their place and we’ve learned that privatizing their services can definitely be taken too far.  But most of us still believe that private enterprise, including the profit motive, still delivers the best results for most products and services.

Owner-operated businesses and family businesses have proven their sufficiency for smaller, local purposes.  For larger businesses, with many owners who don’t work there, the corporate form has many advantages.  Those absentee owners never have to worry about losing more than the money they paid for their shares.  When they are ready to convert their ownership shares back into cash, there will probably be a ready market for them.  That said, how did we get from having businesses serve our needs and wants, to gambling in the markets for stocks and derivatives?  What can we do to restore the useful function of the corporation?

As the tech bubble was building in the 1990s, someone said that Silicon Valley changed for the worse when it switched from making products to making stocks.  But the financialization of corporate business started long before.  Professor Lawrence Mitchell describes the history in his book The Speculation Economy: How Finance Triumphed Over Industry, which deals only with the years 1897 through 1919.  At the beginning of that period, American businesses “typically were owned by entrepreneur industrialists, their families and often a few business associates.”  The change he describes “might never have come into being if financiers and promoters had not discovered that they could be used to create and sell massive amounts of stock for their own gain.  The result was a form of capitalism in which a speculative stock market dominated the policies of American business.” [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2008, page ix] 

"The financial crisis has provided us all with a crash course on how much of our economy is based not on the creation of real value, but on speculation. Over the last year, we have learned that the speculative economy — the one that trades in exotic derivatives like credit default swaps and makes short-term, bubble-inducing bets on assets like real estate and tech stocks — is vast and highly rewarded. We have learned that the speculative economy undermines and consumes the productive economy. And we have learned that money made by speculation is often treated much more favorably by tax systems than money earned through real work."  [Stacy Mitchell, “A New Deal for Local Economies,” Lecture at the Bristol Schumacher Conference at Bristol, England, October 17, 2009,  reprinted at “Making Money Work: How Can We Reconnect Capital with Community? Our investments tend to fund consolidation and speculation. But new models are emerging that allow us to finance the economy we really want,” April 23, 2010, and excerpted in]

The basic concept of investing is that people who want to earn a return on their money are matched with businesses which need money to grow.  By its nature, “investing” is for the long term, money that is put to use for several years, or indefinitely.  Lending money for seasonal working capital needs is the business of banks and other short-term lenders.  Long-term investing is appropriate for individuals and institutions seeking to build their financial assets for the future.

The line between short-term lending and long-term investing is roughly the border between the commercial banking and securities industries.  While the two businesses have very similar products, their business models are sharply different.  Banks purchase money for a period of time.  In exchange for deposits in a checking account they provide safekeeping, checking, online banking and related services.  They may agree to pay a rate of interest on certificates or bonds or interbank loans, which come due on specific dates.  Then the bank lends the money at a higher rate, to cover its operating expenses, reserves for loan losses and profit.

Investment in common stock is a very different proposition.  Initially, the “joint stock companies” were organized around a particular venture.  For instance, when a ship sailed from England to Asia, it needed enough money to last for a couple years.  There would be no income until the ship came back, if it did.  Anyone putting their money up for use would want something more than a promise to pay it back with interest.  The solution was to allocate them a share of the hoped-for profits from the voyage.  Investors put their money up before their ship sailed and waited for the day their ship would come in, their money returned and profits distributed.  In 1602, The Dutch East India Company was chartered for a 21-year period, spreading investors’ money and risks over many voyages.  By 1611, the Dutch had the first stock exchange, followed by the first market crash, triggered by the tulip mania in 1636.  [John Micklethwait and Adrian Wooldridge, The Company: A Short History of a Revolutionary Idea, The Modern Library, 2003, page 20]  Gradually the concept was expanded to finance canals, railroads and manufacturing businesses.

Einstein reportedly said that compound interest is “the greatest mathematical discovery of all time.”  To help its success, he invented the Rule of 72, a shortcut to calculating how long it takes money to double at a particular rate of interest.  []   The corporation is certainly another great invention.  It has made it possible for businesses to gather money from people who don’t have to pay constant attention to how it is being used.  Authors John Micklethwait and Adrian Wooldridge of the Economist described “the three big ideas behind the modern company: that it could be an ‘artificial person,’ with the same ability to do business as a real person; that it could issue tradable shares to any number of investors; and that those investors could have limited liability (so they could lose only the money they had committed to the firm).”  [John Micklethwait and Adrian Wooldridge, The Company: A Short History of a Revolutionary Idea, The Modern Library, 2003, page xvii]  We would add a fourth big idea:  a trading market that allowed shareowners to quickly get cash for their shares, while the corporation kept their initial investment forever.

As people made investments in ongoing businesses, not just voyages and projects, their share of the profits was distributed to them annually or quarterly.  The payments were called dividends and were very different from interest on loans or bonds.  The business had no obligation to pay dividends.  No matter how profitable it was, it was entirely up to the board of directors whether and how much might be paid to shareowners.  On the other hand, as the business grew, dividends would usually increase and, after several years, the annual dividends could be more than the amount the shareowner originally paid for the shares.  The concept of sharing in profits worked well for investors, who were willing to exercise their risk/reward judgment in return for a higher expected return than they would get from a fixed-income security--one that paid interest and eventually returned the purchase price.  Shares worked well for managers of the business, because they weren’t obligated to pay current interest and never had to pay back the money invested.

However, there were two groups who were less than happy with shares being sold on the basis of expected dividend payments.  One was the CEO and top management who would rather retain all money in the business.  They had big ambitions for growth, which would bring them greater compensation, prestige and power.  The others who weren’t entirely happy with shareowners expecting dividends were the financial intermediaries who made commissions by selling shares in the trading market.  If investors were buying shares to collect dividends over the long term, then Wall Street could only look forward to a one-time commission, at the time the shares were initially issued and sold by the business. 

The answer for Wall Street and CEOs was to change the expectations of shareowners, from the dividends they would receive to the increase they could see in the market price for their shares.  That way, the profit and resultant cash are kept in the corporation, available to fund the CEO’s ambitions for expansion and acquisitions.  These retained earnings can also be used to cover the effects of any mistakes of judgment that the CEO makes.  The financial intermediary could induce the investor to take profits (or losses) by selling the shares and using the money to buy different shares, generating commission income on both trades.  Wall Street got Congress to change the laws, to tax gains on the sale of shares at a much lower rate than dividends.  Dividends and gains are currently both taxed at the same low rate, but the proportion of corporate earnings paid in dividends is at the lowest level since 1936, at 29%, compared to an average of 53% for the entire period after 1936.  [Jason Zweig, “What Will It Take for Companies to Unlock Cash Hoards?” The Wall Street Journal, May 28-29, page B1]

Wall Street began a vast new business when “price appreciation followed as a substitute for dividends.” [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2007, page 196]  As investors changed their objectives from dividend income to profit on a sale of shares, Wall Street’s commission income took off.  Unlike investors seeking dividends, traders like to take out loans to buy even more shares for short-term profits.  Wall Street borrows the money from banks and lends it out again to its brokerage customers, through margin accounts.  There is some profit in the spread between the interest rate it pays the bank and the rate it charges customers.  More profitable is the ability to increase the customer’s volume of business by 50%, from money borrowed in the margin account.  Most profitable of all is when Wall Street can steer its customers into using proceeds from stock sales to buy a different financial product, one that generates even more revenue for Wall Street. 

The justification for trading is that it makes for a liquid market, one in which all investors can buy or sell at fair prices in a short time.  But is all that volume of trading really necessary?  Professor Lowenstein points out that the real estate market has less than a twentieth of the stock market’s annual turnover “and yet that is enough to support all the new homes and offices that are needed.”  [Louis Lowenstein, What’s Wrong With Wall Street: Short-term Gain and the Absentee Shareholder, Addison-Wesley Publishing Company, Inc., 1988, page 27]

There has been a clear long-term trend away from dividends and toward more frequent trading.  “Historically, dividends have accounted for almost one-half of the market’s return—about 5 percent of the stock market’s 10.5 percent long-term annual return—with the remainder accounted for almost entirely by earnings growth averaging about 5 percent annually.  Yet the dividend yield on U.S. stocks dropped to 1 percent in early 2000 . . ..  Turnover in stocks that pay no dividends now runs at an average rate of 175 percent per year; turnover in stocks that pay dividends runs about 85 percent per year . . ..”  [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, pages 122-123]

“The shift from investment to speculation, from a time when most Americans saw corporate securities as a way to get a steady return while protecting their principal to a time when Americans saw the stock market as a place to trade on the fluctuations of an increasingly volatile market, took place over the second and third decades of the twentieth century.” [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2007, page 206] By the first decade of the twenty-first century, this shift from investment to speculation had led to the extremes of high frequency trading, options and complex derivatives. 

The game of buying and selling stocks got an extra boost when Wall Street began earning huge fees by promoting and defending hostile takeovers.  “The modern exaggeration of the domination of finance over industry started during the takeover decade of the 1980s, when the hostile takeover became an extreme way to satisfy stockholders’ demands for short-term profit maximization by buying then out at a substantial premium over market.  Stockholders began to invest in the hope of finding the next big takeover target.”  [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2007, 276]

The use of stocks and their derivatives to speculate on price changes has brought all the attention to short-term results.  For corporate officers, the only goal is to keep the stock price up and on a steady rise.  Their stock option profits and their very jobs depend upon being able to predict each quarter’s earnings as better than the last, and have those earnings come in as predicted.  This “rent-a-stock” culture has destroyed industries, especially those with a dynamic that doesn’t fit the quarter-to-quarter game.  Newspapers, for instance, have needed some restructuring to fit the unfolding of media technology.  That would mean going through a period of losses and reinvestment.  But as soon as management stepped off the quarter-to-quarter treadmill, the stock price would collapse and many newspapers became victims of hostile takeovers.

Wall Street has changed the objectives of business, from serving human needs to generating short-term profits.  What can we do to restore business objectives?  Government is not the answer.  We have watched Japan, after World War II, when its Ministry of Finance influenced the allocation of capital for long-term objectives, before its banking system failed.  We are now watching China, as its one-party government decides which businesses will be launched and supported.  Overwhelmingly, we Americans reject government control.  But, so long as we let Wall Street have its monopoly on the investment process, it will be Wall Street bankers and brokers who set objectives for business.  Our objectives as individual investors will only reach business managers if we deal with them directly.

The IPO is Not About Financing Business, It’s About the Game

The romantic fantasy of Wall Street is dramatized by the initial public stock offering, where a young business has done so well that it is now ready to share ownership with the investing public.  Most entrepreneurs have a dream that they will one day take their company public, that money will flow into their business from thousands of people who will want to be a part of their enterprise.  They can envision going public as the ultimate recognition of their success.  Beyond self esteem, they know that a public offering can be the best way to raise capital for growing their business.  The money is permanent capital, it never has to be paid back.  No interest payments are ever required, any dividends are entirely up to management.  With share ownership spread among many holders, no one really has any power to interfere with management’s business judgment. 

In the fantasy, the relationship with an investment banker and Wall Street firm is seen like that of the relationship of a great novelist with an editor and publishing firm. 

Wall Street doesn’t share the entrepreneur’s vision of the IPO process.  For the securities firms that handle the underwriting, and sales in the aftermarket, an initial public offering is a one-time opportunity to earn large commission income in many related transactions.  The IPO underwriter is able to do favors for others who will reciprocate when it’s their turn.  The decision whether to take on a particular IPO will involve questions like, “Is this being presented to us by a venture capitalist or private equity firm that will generate more business for us?” “Can we hold or attract clients by helping them flip the shares we allocate to them, so they make lots of money in a few hours?”  “Is this a company that will quickly acquire many other businesses, paying us advisory fees along the way?”

A particularly pernicious consequence of the IPO game is Wall Street’s need for ever-larger transactions.  Investment bankers get paid a percentage, generally fixed at 7% for an initial public offering.  That motivates the investment bank to have as large an offering as they can sell.  The minimum amounts they are willing to do have grown to $50 million for an IPO with major firms.  What if a business fits the rest of the picture for a successful offering, but really only needs $20 million?  That company’s first subject in discussions with a Wall Street underwriter will likely be how the business plan can be changed to show a need for the higher amount.  The investment banker may suggest an acquisition of another business.  They may want the company to skip a beta test phase and go right on to full rollout of production and marketing.  Perhaps they’ll suggest buying and furnishing a new facility, rather than staying in rented quarters.  The huge supply of money on Wall Street’s buy side, with hedge funds and other managed pools, has created the ability to sell ever-larger IPOs.  The result is that Wall Street selects IPO candidates based on the size of the offering, and the resulting fees.  Say’s law is in full force when it comes to money available for buying IPOs--supply creates its own demand.  [

The need to have a large IPO has a dangerous effect upon earlier stage financing, the private rounds necessary to grow to IPO readiness.  For most of the last 30 years, venture capital firms have themselves raised very large amounts of money, from endowments and other institutional funds.  Because they are part of Wall Street, they finance most of the businesses that later do IPOs with major investment bankers.  In order for the venture capitalists to have a business ready for a $50 million public offering, they need to apply lots of venture funding and hurry up the process toward their exit plan.  They even hire consultants, called “VC accelerators,” to get their clients IPO-ready as quickly as possible.  The venture firms want to maximize their annual rate of return.  If they are going to make 300% on their investment, they want to reach that “liquidity event” as quickly as possible.  Moving an IPO from three years out to only two means getting a 150% return per year, instead of 100%.

The Wall Street monopoly over underwriting IPOs has held firm against repeated efforts by off-Wall Street broker-dealers and others to bring businesses together with investors.  The really serious competition has recently come from securities firms and exchanges outside the United States.  A study prepared for the London Stock Exchange compared the US underwriting fee of 7% to the range in six European countries of 2.5% to 4%.  [] The London Stock Exchange has marketed itself as a home to IPOs, especially its AIM market for younger companies.  “Since its launch in 1995, over 3,000 companies from across the globe have chosen to join AIM. Powering the companies of tomorrow, AIM continues to help smaller and growing companies raise the capital they need for expansion.”  []

From the early days of investment banking, the commission method of getting paid created conflicts, with resulting harm to investors.  Back in 1898, the U.S. Industrial Commission was appointed by the President to investigate concentration of economic power for a report to Congress.  An economist testified to the Commission that:  “These banking syndicates want a profit and the larger the stock issues the larger the commissions.”  The Commission’s Report concluded:  “Heavy capitalization is, without question, injurious to the interests of investors and the public at large; but to promoters and bankers it opens opportunities for great gains.”  [Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970, page 76]

Fitting into the minimum size for an IPO can be just the wrong move.  Getting too much money too soon has been the death of many promising ventures.  Harvard Business School professor Clayton M. Christensen has said: “93% of all innovations that ultimately become successful started off in the wrong direction; the probability that you’ll get it right the first time out of the gate is very low.  So, if you give people a lot of money, it gives them the privilege of pursuing the wrong strategy for a very long time. . . . The breakthrough innovations come when the tension is greatest and the resources are most limited.”  [The Innovator’s Dilemma, Collins Business, 2003, quoted by Martha Mangelsdorf, “How Hard Times Can Drive Innovation,” The Wall Street Journal, December 15, 2008, page R2] 

Marketing guru Guy Kawasaki gave more reasons why it can be deadly for a business to get too much money.  For instance, a business that has lots of money will keep tinkering with a business plan that is basically flawed, while the lean business will have to admit it is wrong and change plans.  Another example:  Big money can use promotion to attract customers, rather than developing a product or service that gets customers who will repeat their purchases and excitedly tell others about it.  According to Kawasaki:  “When companies have too much money, they hire professionals who charge twice as much for half the results and leave the companies with little in-house expertise.”  [“Let the Hard Times Roll! Why too much capital can kill you,” The Journal of Private Equity, Summer 1999]  Or, as Orson Welles said, "The enemy of art is the absence of limitations."


(One of our clients had started a business with a little savings and built it through retained earnings.  He decided to do a direct public offering through the SEC exemption for issuances of no more than $1 million a year.  Venture capitalists had approached him,  wanting to invest much more.  But, he said, “I can’t grow this business faster than 25% a year and be profitable.  If I had a big investment from a VC, with pressure to grow at 100% plus, it would ruin the business.”)

There are at least eight major profit opportunities for the underwriting firm that lands an initial public offering of shares:  Fees from the client, for the initial underwriting• fees from quick resales, “flipping” shares when the aftermarket price jumps; fees in reselling the flipped shares for a third and fourth time; fees on business gained in return for allocating IPO shares to flippers; fees in selling shares for insiders, after the initial six-month lock-up; fees for investing money received by the company and its selling shareowners; fees for arranging later private placements of the public shares (“PIPES”) and fees for advising on mergers and acquisitions with the now-public client.

The initial underwriting fees are pretty well fixed, at seven percent of the amount sold.  That’s three and a half million dollars on the recent minimum offering size of $50 million.  There are a few smaller broker-dealers left who may handle an offering as small as $10 million, but they charge ten percent, plus options, reimbursements and other items that bring the fee up to the maximum fifteen percent permitted under securities industry rules.  [FINRA Rule 5110, One law professor suggests that the regulatory limit be abolished, “This would enable underwriters to charge more for smaller IPOs, making these deals profitable again and hopefully reversing their recent steep decline.”  [William K. Sjorstrom, Jr. “The Untold Story of Underwriting Compensation Regulation,” University of California at Davis Law Review, volume 44, no. 2,, page 625, 650]  

When Wall Street underwriters compete for IPO business, there is no cost comparison, since the underwriting fees are fixed.  Getting the highest price in the initial offering is certainly talked about a lot when prospective underwriters make their pitches.  So is the ability to get the offering cleared with the SEC and sold to Wall Street’s buy side.  Investment bankers rely heavily on the two motivations they acknowledge and manipulate: fear and greed.  They will talk about their special ability in making it through the “window of opportunity,” before the market for the shares goes away.  There has also been non-price competition, such as reciprocal business promised by the underwriter to the prospective IPO client.  [Randall Smith, “Pay to Play? Companies Put a New Squeeze on Their Investment Banks,” The Wall Street Journal, August 26, 2003, page A1]

Conflicts of interest arise when a business is issuing new securities, because Wall Street is an intermediary, serving both sides of the transaction.  The investment banker is likely to come down on the side of the buyer in any conflict between the interests of the client issuing securities and the money manager buying them.  Investment bankers are part of a large broker-dealer business that depends every day on its relationships with the money managers on the buy side.  These Wall Street counterparts are far more important to the investment banker’s profits than the transitory relationship they will probably have with the IPO client.  Getting the highest IPO offering price for the issuer clearly conflicts with getting a bargain price for the money managers. 

(This conflict between issuer and money manager creates what I called the “Pricing Dance.”  It begins with the very first handshake between the investment banker and the issuer’s management and continues right through to the final pricing, after orders will have been taken, based upon an estimated price range.  The structure of the dance is to convey that the investment banker will work for the client to get the highest price possible, but that it will have to be one which “the institutions” will accept.  I was in a meeting once when a founder of the investment bank came in from the golf course to give what I called the “level of greed” speech.  It was about his inside knowledge of the minds of money managers, their most intimate and even unconscious motivations.  To get them to say “yes” to my client’s offering, the price had to appeal to the money managers’ own level of greed.  They had to see how, through reselling the shares at a large profit, or showcasing its increased market value in their report of quarter-end holdings, they would look so good that their bonus would increase many thousands of dollars.)

Once the IPO is complete, the “flipping” part of the game begins.  Favored persons who were allocated shares in the offering often sell them within minutes or hours.  Persons allowed to purchase the once-flipped shares likely resell them quickly as the aftermarket continues to “pop.”  The profit opportunities from flipping are based upon the share price increasing significantly in the trading market that begins immediately after the final offering price has been set. 

When investment bankers are selling themselves as underwriters for an offering, they stress their superior ability to create demand for the shares, well beyond what it takes to sell the offering.  Managers and directors generally must commit to have their shares in “lock-up” for six months or so after the initial offering.  Then they can begin selling them.  Second in priority only to getting the offering done is boosting the aftermarket price so that these insiders can sell a chunk of their shares.  Investment bankers used their securities analysts to convince the client of the firm’s ability to keep the price up long enough to let insiders cash out at maximum profits.  This practice led to some racy extremes covered extensively by the media after the tech stock bubble burst in 2001.  Perhaps the rawest example is the affidavit filed by the New York Attorney General’s office when it got an order against Merrill Lynch [] and forced an agreement to change the analyst’s role.  []

 Building demand for new shares is, of course, a legitimate and necessary part of the underwriter’s job in a successful offering.  But somewhere along the way, the definition of “successful offering” got changed.  In the investment banker’s pitch to get the business, a successful offering was talked about as one that got completed on time, at a price that was fair to the issuer and the investors.  What came to replace that definition of a successful offering was having a huge increase from the offering price to the trading price in the minutes, hours and days after the initial offering was completed. 

CEOs would even brag about the size of the “pop” in price after their company did its IPO.  They wouldn’t even pay lip service to the logical conclusion that the business they managed had gotten only a fraction of the amount that buyers were actually willing to pay.  To get this price jump, underwriters began by selling many more shares than were actually being offered.  When that practice started, it was to accommodate buyers who would renege on their order for shares.  It worked like overbooking by the airlines to offset no-shows.  Then it became a tactic to build fever in the aftermarket, one that was used long before the boom in tech stocks.  In the early 90s, Starbucks and The Cheesecake Factory had buy orders for 50 times the shares available in the IPO.  [Gretchen Morgenson with Steven Ramos, “Danger Zone,” Forbes, January 18, 1993] The practice cooled down after the Tech Bubble Crash of 2001 and all the legal actions and fines that followed.  However, by 2011, the “pop” game and layers of favored early buyers were back in full force.  The first day after Linkedin’s IPO, when there were 8 million shares available for trading, some 30 million shares were actually bought and sold.  The entire issue was turned over nearly four times and the price doubled from what the company got in the IPO.  [Martin Peers, “Overheard,” The Wall Street Journal, May 21-22, 2011, page B18]  Then the game shifted to the single-stock options market, where speculators bought puts, betting that the elevated price would go back down.  [Chris Dieterich, “LinkedIn Traders Salivate,” The Wall Street Journal, May 27, 2011, page C7]

Securities analysts were not the only ones employed to create demand for new shares.  Investment bankers worked with their firm’s sales brokers to find reciprocity deals: “I’ll scratch your back if you’ll scratch mine.”  For instance, money managers could buy 10,000 shares in the IPO if they agreed not to sell them for a month or so and to buy another 10,000 a week later, at the going price in the trading market.  Investment bankers would even work with the firm’s stock lending department, which collects a fee for lending shares it holds for customers.  The borrowers use the shares to place “covered short sales,” bets that the share price will decline.  The investment bankers would get the firm to refuse to lend shares in a recently underwritten IPO, to keep the negative pressure out of the market. 

Wall Street Crippled Local Governments

Local government officials have been ideal marks for Wall Street scams.  They make decisions involving large sums of money and they aren’t very experienced in the world of finance.  Even better, they often make decisions by board or committee, so that responsibility is diffused and no one person is responsible. 

The Orange County, California bankruptcy in 1994 came about when Wall Street sold bonds to the County Treasurer, a person with no education or training in securities.  Then it sold him reverse repurchase agreements, called “repos,” which were effectively loans secured by the bonds.  This borrowed money went to pay for more bonds, which were used for new repos.  The big flaw was that the bonds wouldn’t pay off for an average of over two years, while the repos were due within six months.  When the Federal Reserve started raising interest rates, bond prices began declining.  But Wall Street kept selling repos to the Treasurer.  When a repo came due, Wall Street would sell them a replacement.  The securities firms eventually panicked and stopped selling the replacements.  Orange County could not pay the maturing repos.  Wall Street foreclosed on the bonds it held as collateral and the County declared bankruptcy.  [Mark Baldassare, When Government Fails: The Orange County Bankruptcy, University of California Press, 1998, pages 90-91, 102] 

San Mateo County, California, lost $37 million in complex bonds issued by Lehman Brothers, which could be sold for only about a fifth of what they had cost before Lehman’s 2008 failure.  A report to San Mateo County by Beacon Economics put the cost of the loss at $148 million and 1,648 lost jobs.  [John Carreyrou, “Lehman’s Ghost Haunts California, The Wall Street Journal, February 24, 2010, page A1, A14]

Local governments are still being made the victims of Wall Street schemes.  The problem assumed a much larger scale when derivatives were introduced in the late 1990s.  Interest rate swaps, credit default swaps, “swaptions” and other exotic instruments were being bought and sold.  Before the 2008 Panic, Wall Street convinced local government officials to buy complex derivatives that were supposed to offset borrowing costs or to increase investment returns.  Intricate tax structures allowed the governments to get cash for part of their fixed assets.  Many of these investment contracts called for “breakup fees” or other penalties to be paid the Wall Street firms for technical defaults, such as a downgrade in credit ratings.   As a result, local governments have had to lay off workers and charge higher fees to residents.  “Many of the transactions shared a striking similarity: provisions that protected the banks from big losses and left the customers on the hook for huge payouts.  Now, as many of those deals sour, Wall Street is ramping up its efforts to collect from Main Street.”  [Theo Francis, Ben Levisohn, Christopher Palmeri and Jessica Silver-Greenberg, “Wall Street vs. America,” Business Week, November 30, 2009, page 034, 036]  “Well, if you think it’s costly to refinance a home mortgage, try refinancing a derivatives-laced muni.  The price, in the form of a termination fee, can be enormous.  New York State, for one, has paid $243 million in recent years to extricate itself from swaps-related debt.  That money went straight from taxpayers’ pockets to Wall Street.”  [Gretchen Morgenson, “How Banks Could Return the Favor,” The New York Times, June 10, 2012, page 4]

Wall Street Cleaned Out Savings and Loan Associations

Wall Street searches for pools of money and devises ways to get at it, to gather commissions, fees and trading profits.  One of those pools was “thrift institutions,” which includes savings banks, savings and loan associations and building and loan associations.  Working with Congress and the regulators, Wall Street took billions from the thrift industry, leaving it much smaller and poorer.

You may remember Bailey Brothers’ Building and Loan, from the 1946 movie, “It’s a Wonderful Life.”  The bad banker, Mr. Potter, manipulates a run to get rid of Bailey Brothers’ as a competitor.  As the locals crowd in to withdraw their savings, Jimmy Stewart makes his impassioned speech about how their deposits are used to help their neighbors own homes.  He effectively explains the Achilles heel of the thrift industry—it borrows short (deposits can be withdrawn at almost any time) and lends long (home loans are paid in monthly installments over many years).

Two of the New Deal’s objectives in The Banking Act of 1933 were to encourage savings by individuals and to cause local banks to lend money in their communities.  They had been gathering funds locally and then sending the money to Wall Street banks, which paid them interest.  The new laws provided government insurance for individual deposits and intensive regulation over how banks used their money.  They also established federal savings and loan associations, to gather deposits and make home loans in their communities.  These newly chartered institutions were all in the “mutual” form, meaning that they were owned by their depositors and borrowers, without any shares of stock. 

To prevent Wall Street from siphoning off local savings, Congress prohibited the payment of interest on checking accounts and gave the Federal Reserve authority to set rates on savings accounts, with its Regulation Q.  The rate set was generally around three percent and worked rather well until 1979, when the Fed allowed market interest rates to rise, in order to stop inflation.  Interest levels reached nearly 20 percent.  Money market funds were created, which drained funds from the regulated institutions by paying higher rates.  It was the beginning of a new takeover by Wall Street of the locally-gathered savings and the home loans held by the savings and loan associations.  [B“A Nation in Debt:  How we killed thrift, enthroned loan sharks and undermined American prosperity,”]

Another government assist to Wall Street in devouring thrifts came from the Federal Reserve. In 1978, it began making exceptions to Regulation Q interest rate limits for special types of accounts.  Under orders from Congress, it eliminated interest rate ceilings entirely by 1986.  [R. Alton Gilbert, of the Federal Reserve Bank of St. Louis, “Requiem for Regulation Q:  What it Did and Why it Passed Away,”, page 31]

In addition to the Fed making thrifts gather deposits at market rates, Congress passed new laws allowing them to go after higher returns on risks far beyond making home loans. This put Wall Street in a position to lure the money held by S&Ls in retail deposits.  [Depository Institutions Deregulation and Monetary Control Act of 1980, Pub. L. No. 96-221; 94 Stat. 132, codified as 12 U.S.C. 226; Garn–St. Germain Depository Institutions Act of 1982, Pub. L. No. 97-320; 96 Stat. 1469, codified to 12 U.S.C. 226] Like the officials at the crippled local governments, thrift institution executives controlled lots of money and had very little knowledge of any investments except home loans.  They became marks for derivatives and scores of other investment schemes. 

One of the ways the federal government reversed the New Deal structures was to allow mutual savings and loan associations to convert into stockholder-owned corporations.   The justification given was that they needed a level of risk capital investment to carry them through difficult economic times, such as the sudden spurt in interest rates.  What actually happened was that some 5,000 local institutions were put “into play” for Wall Street.  As mutual associations, responsible only to their local depositors and borrowers, the management philosophy was often described as “We don’t need to make big profits—just stay in the black and serve our community.” While stil In the mutual form, S&L managers had no incentive to sign on to Wall Street’s programs of taking more risk for higher profits.  They didn’t own shares in the association, there were no stock options, no performance-based big bonuses.

All that changed when the mutual savings and loans converted to stockholder-owned corporations.  Wall Street investment bankers appealed directly to the association managers with pitches such as “you’ve created a great business here; now you deserve to build up your own assets, for the sake of your family.”  When an association was converted, the sales price for its shares could be appraised at substantially less than what it would trade for after the IPO.  Loans could be arranged for the managers to buy lots of shares in the offering and there would be an executive stock option plan.  As maximizing profits became the new goal, Wall Street could sell the managers all sorts of new investment products, just as an accommodating Congress had permitted in the new laws.

The raid on savings and loans followed the Wall Street pattern of reaping profits from:  (1) underwriting fees in the IPO, (2) commissions on the resale of the new shares, as their favored customers flipped them for big, quick gains, (3) commissions and trading profits from putting the offering proceeds into investment products and (4) merger and acquisition fees from talking managers into acquiring ownership of competitors, or being acquired at big personal gain.  The effect on the associations?  Over 1,000 failed and were closed by regulators—only half survived.  Taxpayers had to pay for a $153 billion bailout.  [Timothy Curry and Lynn Shibut, “The Cost of the Savings and Loan Crisis: Truth and Consequences,” FDIC Banking Review,, pages 26 and 31]

Wall Street went on to cripple another financial intermediary that serves the middle class--credit unions.  These "nonprofit, cooperative, . . . democratically controlled credit unions provide their members with a safe place to save and borrow at reasonable rates. Members pool their funds to make loans to one another."  [National Credit Union Administration,, question 1]  All federally-insured credit unions are members of the National Credit Union Administration, which has announced its intention to sue the Big Four investment banks, unless they return more than $50 billion that credit unions invested in mortgage securities.  Claimed misrepresentations in selling the bonds led to failures of credit unions and losses that must be absorbed by the surviving ones.  [Liz Rappaport, "Banks Hit for Credit Union Ills," The Wall Street Journal, March 23, 2011, page A1; Liz Rappaport and Ruth Simon, “Feds Sue Bankers Over Fall In Bonds, The Wall Street Journal, June 21, 2011, page A1] 

Wall Street Trashed Government Sponsored Entities

Since the New Deal, the major competition for Wall Street has come from the federal government.  In the Great Depression, Congress created programs to provide money for purchasing homes, growing businesses, operating farms, developing infrastructure.  These programs either provided money directly from taxpayer dollars or guaranteed loans funded by banks or other private lenders.  Still today, the website offers a cafeteria of direct and guaranteed loans. 

Government guarantees are a way to use the credit of the United States to encourage investors to make loans that would otherwise seem too risky.  The Federal Housing Administration, the Veterans Administration and the Small Business Administration and other agencies have guaranteed or insured loans made to their standards.  They’re able to be self-supporting from the fees charged borrowers for putting the government’s credit behind the loans.  Without the government’s role, lenders would either decline the loan or charge interest and fees that borrowers couldn’t afford.

Enter the government-sponsored entity, or GSE.  These legal creations may be owned by shareholders but are viewed by investors as government-backed.  Often, that backing is implied because it is not in the law creating the entity.  Sometimes it is no more than a feeling that “they would never let it fail.”  Agencies that guarantee or insure loans are still, after all, part of the U. S. Government, responsible to the political process.  A program that breaks even, with no profit or loss, is a great success to the government if it is meeting the need for which it was established.  But there is not much of a place in those programs for Wall Street.  Securities that carry the full faith and credit of the United States virtually sell themselves.  The profit margin to financial intermediaries is narrow and the competition is intense.

  Largest of the GSEs is the Federal National Mortgage Association, or Fannie Mae.  It was created in 1938, to purchase mortgages insured by the Federal Housing Administration.  The money to buy those mortgages came from Fannie Mae bonds, carrying the credit of the United States.  There was little business for Wall Street in this structure.  Government bonds are sold with tiny commissions to any intermediaries.

That began to change in 1954, when lobbyists got Congress to reorganize Fannie Mae, making it partially owned by shareowners.  The policy reason given was that its ability to sell government bonds gave it the unfair competitive advantage of raising cheaper money than other lenders.  In 1968, Fannie Mae became entirely investor owned.  Five of its 18 directors were to be appointed by the President but the other 12 elected by shareowners.  At the same time, Congress created an almost identical private corporation, the Federal Home Loan Mortgage Association, or Freddie Mac.  Both of them were allowed to buy conventional mortgages, as well as those FHA-insured or VA-guaranteed.   

Through all of this restructuring, Fannie Mae and Freddie Mac kept the image that the government would bail them out if necessary.  As it turns out, the image was correct.  Fannie Mae was placed in a conservatorship on September 8, 2008 and the U.S. Treasury agreed to provide up to $100 billion in funding, whenever Fannie Mae’s liabilities rose to  exceed its assets.  The Treasury received preferred stock and the right to buy 79.9% of Fannie Mae’s common stock, “for a nominal price”.  [Fannie Mae’s Form 10Q for the quarterly period ended September 30. 2008,, pages 2-4]  Freddie Mac got a similar bailout.

In the forty years that they lasted as GSEs, Fannie Mae and Freddie Mac were a feast for Wall Street.  Nearly all of the mortgages purchased by the two were securitized and sold by Wall Street firms.  The great bulk of the mortgages were “conventional,” rather than VA or FHA, so they could include the high-risk loans that brought down the home loan business and, with it, the economy.

The same process has come to student loans for post-high school education.  SLM Corporation, commonly known as Sallie Mae, is the parent company of a number of college savings, education lending, debt collection, and other subsidiaries. “Sallie Mae was originally created in 1972 as a GSE. The company began privatizing its operations in 1997, a process it completed at the end of 2004 when the company terminated its ties to the federal government. [ for Sallie Mae, and other private student loan originators, was presented by the Federal Direct Student Loan Program enacted in 1993.  However, funding for loans made directly by the Department of Education was cut from over $7 billion in 2006 to a half billion in 2008, until the private student loan market dried up.  After the Crash of 2008, Congress raised the limits and government student loans increased by $3.1 billion, picking up most of the $3.4 billion drop in private loans.  Bribery of college loan officers and other scandals in the student loan business contributed to the 2008 withering of buyer interest for securities backed by student loans.  By late 2008, “Hedge funds, endowments, and others are currently sitting on $62 billion in education-related securities, deeply troubled debt trading as low as 20 cents on the dollar.” [“These Lenders May Not be Missed,” Business Week, December 22, 2008, page 040.]

 Wall Street Promotes Wasteful Class Action Litigation

 Great amounts of money and professional time is expended in lawsuits by shareholders against corporations, their officers and directors.  Shareholder litigation law firms need four characteristics for one of these class actions to be started and survive.  One is a big, sudden drop in the price of the shares in the trading market.  This will create a large loss, so the percentage-based contingent legal fees will make the case profitable. 

 The second element needed for a shareholder class action is a group of shareholders which includes institutional money managers and stock speculators.  These are people who must explain to the source of their money that they either made a mistake when they bought into the company or that they were cheated.  They are very likely to join any class action that is based on someone else having done them wrong.

 Third must be some deep pockets among the defendants that can pay a settlement or a judgment.  The corporation itself may not have enough left to be an attractive source of money.  This is where insurance comes in.  Nearly every publicly-traded corporation buys directors and officers liability insurance.  Anyone asked to join a board of directors, or be recruited to senior management, will insist upon it.  The irony is that this very expensive product just makes it more likely that the director or officer will be sued.  It also means that there will probably be a big fight over whether the claim is covered by the insurance.  [“Directors and Officers liability insurance:  Paying a premium now for the right to sue your insurance carrier later,” The Curmudgeon’s Guide to Practicing Law, by Mark Herrmann, Section of Litigation, American Bar Association, 2006] 

 The fourth requirement for shareholder litigation is the easiest:  Something that the corporation, its officers and directors did, or didn’t do, that would create liability.   Hindsight being what it is, there is always something.

 Wall Street creates the price volatility and short-term speculation that promotes shareholder litigation.  The “herd instinct” is emphasized by having professional traders, advised by securities analysts, taking large positions and expecting a short-term profit.  These traders are playing with other peoples’ money and need a scapegoat when they lose.  The resulting lawsuits waste resources and harm the underlying business. The best protection from stockholder class action litigation is a large group of long-term investors, each having invested a relatively minor amount of their own money.

The Way Wall Street Works Creates Moral Hazards That Infect Us All   

The term “moral hazards” pops up in a lot of current commentary.  I think it means temptation.  The temptation becomes greater as the payoff amount goes up and the risk from getting caught goes down.  For Wall Street, the moral hazard is greatest when success means keeping big winnings, while losses may be passed off to someone else.

Any time money is being exchanged, there is temptation, a moral hazard, a conflict between what’s right and what’s self-serving.  Every business, and most nonprofit entities, are receiving money for what they sell or do, and paying money for materials and services they use.  It is just more so with Wall Street, because it is in the money business.  It is constantly moving money from one person to another.  Working on Wall Street is like being stationed on a conveyor belt, where money is the commodity and the objective is to get a piece of it as it flows by.  The moral hazards for Wall Street are intensified by the sheer amounts of money involved in transactions, the size of the rewards that get handed out at the top and the way compensation is figured.  Not a lot can be done about the large amounts of money that get transferred in a Wall Street transaction.  But it puts more emphasis on the way people get paid.

The amounts paid to Wall Street, just in fees alone, are huge.  In the five years before 2005, “revenues of investment bankers and brokers came to an estimated $1.3 trillion; direct mutual fund costs came to about $250 billion; annuity commissions to some $40 billion; hedge fund fees to about $60 billion; fees paid to personal financial advisers maybe another $20 billion.  Even without including, say, banking and insurance services, total financial intermediation costs came to nearly $2 trillion, an average of $400 billion per year, all directly deducted by the croupiers from the returns that the financial markets generated before passing the remainder along to investors.”  [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, page 231]

The amounts of money involved can overcome such other values as loyalty.  According to James Cramer, “There are no loyalties on Wall Street.  When you smell blood in the water, you become a shark.” In describing how his fellow hedge fund managers responded to troubles at Long Term Capital Management:  “Put simply, when you know that one of your number is in trouble, you don’t lend him a hand, you try to figure out what he owns and you start shorting those stocks to drive them down. . . . You could feel the whole Street collectively buying long-term U.S. bonds to squeeze Long-Term Capital into buying back those bonds at the highest possible price.” [James J. Cramer, Confessions of a Street Addict, Simon & Schuster, 2002, page 182]

A prominent Wall Street adage is that “securities are not bought—they are sold.”  The decision about which securities to sell has often been made on the basis of “what’s in it for me.” The questions asked by the broker, and the firm’s analyst, are ones like:  “What will earn me the largest commission?  What will help me get a bigger bonus?  How can I earn favors from management?”  According to a pair of former investment bankers: "Greed, Fear, and Abandon.  Those are the three steps.. . .Greed and the pursuit of money is the banker's ultimate aphrodisiac.  . . . If this doesn't work, move to the second stage of the process--fear. . . . Finally, if this doesn't work the banker will abandon in an unusually rapid fashion."  [John Rolfe and Peter Troob, Monkey Business: Swinging Through the Wall Street Jungle, Warner Books, 2000, page 261.  (Italics in the original).  One former stockbroker, Donald E. Kendrick, warned of the moral hazards in The Average Investor's Rage, Vantage Press, Inc., 1990]  The role of Wall Street in the mortgage securities debacle has been described this way:  "If mortgage originators . . . were the equivalent of drug pushers hanging around a schoolyard and the ratings agencies were the narcotics cops looking the other way, brokerage firms providing capital to the anything-goes lenders were the overseers of the cartel."  [Gretchen Morgenson and Joshua Rosner, Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon, Times Books/Henry Holt and Company, 2011, page 263]  

The moral hazard on Wall Street has been exacerbated by the role of government in preventing a collapse of schemes that could “bring down the entire financial system,” as the phrase was used after the Panic of 2008.  For a while, the silent assurance of a bailout by the Federal Reserve Banks was known as the “Greenspan put,” meaning that a disastrous loss position could ultimately be put to the Fed for transferring a loss onto others, including the taxpayers. 

There have been pioneers on Wall Street who have set out to do business in ways that reduced the moral hazards.  When Charles Merrill started Merrill Lynch in 1940, he told the world that its broker representatives would receive a salary, rather than a percentage of commissions on the trades they generated and the firm would not participate in underwriting new issues of securities.  That all changed long ago.  Before it was acquired by Bank of America in 2008, Merrill Lynch was a broker, dealer, underwriter, traded for its own account and did business the same way as all the other giant Wall Street sell side firms. 

(My own observation is that most harm comes from incompetence, masked by arrogance, rather than from criminal conspiracies.  Near the end of the Great Depression, a popular book was published, called Where Are the Customers’ Yachts? [Fred Schwed, Jr., Where Are the Customers’ Yachts? Or a Good Hard Look at Wall Street. Simon & Schuster, 1940, second printing 1955.]  The title was from an old story about a tourist’s question, when the guide pointed out the bankers’ and brokers’ yachts in the New York harbor.  The author, who had been a Wall Street trader since 1927, observed: “The crookedness of Wall Street is in my opinion an overrated phenomenon.” “They involve vastly greater sums, and they make more interesting reading.  Best of all, they suggest to the public an excuse for the public’s own folly.”  “The burnt customer certainly prefers to believe that he has been robbed rather than that he has been a fool on the advice of fools.” [page 196 in the 1955 printing])

Venture Capitalists Mimicked Wall Street and Its Moral Hazards

 When entrepreneurs need more money than they can raise from family and friends, they naturally turn to wealthy individuals.  Beginning in the 1950s, groups of wealthy individuals would pool their money and have one of them select and manage investments in early stage businesses.  During the 1960s and 1970s, these venture capital funds made total investments of no more than $300 million a year.  [Robert J. Kunze, Nothing Ventured:  The Perils and Payoffs of the Great American Venture Capital Game, HarperBusiness, 1990, p.6]  As VCs grew, they began having full-time managers, who were paid annual fees of about two percent of the amount in their fund, as well as success fees equal to 20 percent of the gains from disposition of an investment.  No longer were the managers co-investors, handling administrative duties so that they and their friends could make money on their pooled investments.  They became MBA-schooled managers.

Myth has it that venture capital got its big boost when the capital gains tax rate was cut significantly in 1978.  In fact, it was changed when VC managers used their historical performance records to get huge chunks of money from institutional money managers.   [Charles R. Morris, The Trillion dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash, Public Affairs, 2008]  With their percentage fees, VC managers became full-blown financial intermediaries.  Income from their percentage compensation became their prime motivation.  Since the percentage was generally set the same among VC firms, regardless of their performance, the way to make more money for the VC managers was to bring in new investors, preferably ones with deep pockets.  Along came the Employee Retirement Income Security Act, or ERISA, and related rules, which changed the standard for investments by pension and other funds.  Fund managers tapped into these institutions and the investment levels jumped to $2.5 to $5 billion a year in the early 1980s, with 300 new funds formed from 1981 to 1984 [Robert J. Kunze, Nothing Ventured:  The Perils and Payoffs of the Great American Venture Capital Game, HarperBusiness, 1990 p.11].  Venture capital went from partnerships of investors to a financial intermediary business.

Venture capitalists need to have an “exit plan” before they ever commit to investing.  How are they going to recover the cash they put in, plus or minus their gain or loss?  Their preferred route is an underwritten initial public offering and they work closely with investment bankers, referring business back and forth to each other.  The other “liquidity event” for VCs is to have the portfolio company acquired, for cash or marketable securities.  But the IPO usually provides a higher valuation.  It also lets the VC choose whether to sell in the IPO or pick times in the aftermarket.  An IPO could allow the venture investor to cash out at least a portion of their ownership.  Even better, the public offering would be followed by a trading market in the shares.  The brokerage firms who acted as underwriters would become market makers and issue analyst reports to build ongoing interest in buying into the company.  Between 1980 and 1984, these broker-dealers earned over $1.5 billion from commissions as IPO underwriters and aftermarket traders.  [Robert J. Kunze, Nothing Ventured:  The Perils and Payoffs of the Great American Venture Capital Game, HarperBusiness, 1990, p.14]

Venture capitalists measure their success in the price they get on cashing out an investment.  They also look at how long it takes from investment to return.  The VC to IPO path travels well in “hot new issues” markets, when underwriters are hungry for venture-backed companies they can sell to the institutional money managers.  At those times, the VCs hire “VC accelerators,” consultants who show a company how it can be dressed up for the quickest possible disposal.  When the new issues markets turns cold, VCs must either continue to hold their investment in a private company or have it acquired.  In the hot market of 1999, the average venture-backed company had its IPO just over four years after the business began.  By 2008, it was taking nearly nine years. [Rebecca Buckman, “As High-Tech IPOs Dwindle, Start-Ups Look to Private Money for More Backing,” The Wall Street Journal, July 1, 2008,  page C3.]  Even after the 2008 “capital markets crisis,” there is no sign of VCs trying to find an alternate route to the investment dollars of nonwealthy individuals.  Instead, they are raising the needed growth capital from investment bankers who specialize in private placements with institutional investors. 

(I was asked to speak to a meeting of venture capitalists  My subject was what a great tool direct public offerings would be for them, how raising money from the company’s communities would increase the value of the VCs investment.  While speaking, I could sense that unmistakable glassy-eyed stare of the person who is deciding what to have for lunch, replaying the last game of golf or taking a fantasy trip.  However badly I may have been presenting the subject, it was just not within their frame of reference.)

Venture capitalists were presented with a set of moral hazards when they morphed from groups of individuals pooling investments into funds with managers, who were paid a percentage management fee.  As financial intermediaries, their eye was on maximizing their compensation, both the percentage of the fund amount and the percentage of profits.  This first percentage tempted VC managers to keep the total in the fund as high as possible, often through decisions harmful to the investors.  One way to inflate the fund amount, and the percentage compensation, was to value companies in the investment portfolio at higher than realistic amounts.  Until there is an IPO or sale of an investment, the value is a matter of judgment.  Comparisons are made to similar companies that are already publicly traded, or were recently purchased for a disclosed price.  Estimates of future income and cash flow from the business are discounted to reflect a present value, considering the likely risks of achievement.  The process can be influenced by choices and judgments, even if outsiders are hired to make a valuation.

To increase their take from profits, VC managers can also be influenced to drive particularly harsh terms on the young companies seeking capital to develop their business.  Entrepreneurs are vulnerable when they are obsessed with their dream.  Some of the nicknames for these provisions tell the story of the fear and greed behind them, such as “full-ratchet” clauses that increase the VC’s ownership percentage as the business stumbles, or the “drag-along rights” that force the business founders to join in a sale of the business dictated by the VC managers.

A moral hazard comes with investment in a company that is looking like a loser.  The manager can keep a higher base for percentage pay by having the fund invest more money into the poor-performing company.  This keeps it in the portfolio when to write it off would mean a cut in the manager’s profit sharing.  A subtler variation of avoiding a writedown in compensation base occurs when another VC offers to invest in the needy company, but at a lower price than the first investor.   If the new funding were accepted, it would set a reduced value for the initial investment.  Under the adage, “a problem postponed is a problem solved,” the manager could cause the investment offer to be refused.  This could keep the original investment cost as the valuation for management’s fee, while starving the client business from needed money.   

VC investments that are winners present another set of moral hazards, especially when an underwritten initial public offering is the expected “liquidity event,” when their investment will be transformed into cash and marketable stock. The VC manager has a big personal return from a successful IPO, typically 20 to 30 percent of the net gain.  In addition, the proceeds to the VC from a public offering are often left in the fund to reinvest.  The IPO success can be the result of having the right managing underwriter.  To attract the chosen broker-dealer firm to underwrite the offering, VCs began offering them so-called “mezzanine round” investments in the IPO candidates.  By buying in at a pre-IPO price, the broker-dealer could turn a quick profit.

Wall Street Practices Create Moral Hazards for Corporate Managers

 Wall Street’s emphasis on speculative trading, rather than long-term gains and dividends, puts CEOs and CFOs under great pressure to tell Wall Street what the current quarter’s earnings are expected to be, so that trades can be made before the public finds out.  Especially when these executives have stock options tied to the current market price, they look for any way to pass on good news.  “When our financial markets are driven by speculative trading, there is overwhelming pressure to cook the books in order to sustain artificial prices in the stock market . . .. If the money manager focuses almost exclusively on the price of the stock rather than on the intrinsic value of the corporation, we should not be surprised when the corporate manager, in an attempt to ‘game’ the system, focuses on the stock price, too.”  [John C. Bogle, The Battle for the Soul of Capitalism, Yale University Press, 2005, page 93]

Even those of us far away from Wall Street are infected by the response it makes to moral hazards.  We come to believe that “everybody does it,” and even that we’re chumps and losers if we don’t get on the bandwagon.  “Most Americans believe that investment fraud like the recently revealed Ponzi scheme run by Bernard Madoff happens regularly on Wall Street, according to a recent survey.  In a CNN/Opinion Research poll, 74% of those surveyed said they think Madoff's behavior is common among financial advisors and institutions.”   [David Goldman, “Americans think Madoff's behavior is common – poll,” December 23, 2008,]   In a chapter called "The Case for Eliminating Wall Street," David Korten has written:  "Even more damaging in some ways than the economic costs are the spiritual and psychological costs of a Wall Street culture that celebrates greed, favors the emotionally and morally challenged with outsized compensation packages, and denies the human capacity for cooperation and sharing."  [David C. Korten, Agenda for a New Economy: From Phantom Wealth to Real Wealth, Berrett-Koehler Publishers, 2009, page 45] 


    Wall Street Promotes Monopolies


        Wall Street makes money when small companies are acquired by big corporations.  The merger & acquisition investment bankers get a percentage of the acquisition price for bringing the buyout candidate to the prospective acquirer and pushing to get the deal done.  Then the underwriting or private placement investment bankers get a percentage of the money they raise for the acquirer, to finance the acquisition.  This ties the investment bankers closer to management of the large corporation, to help it grow even larger through more acquisitions and financings. 


The fact that the smaller company that was acquired is lost to the economy is of no significance to Wall Street.  The money to be made right now comes from doing business with large corporations.  Nourishing young enterprises toward maturity, teaching their management about “high finance,” is time-consuming and the percentage fees on their early transactions are not big-bonus-making material.  Better to lure the entrepreneurs into selling out, with appeals to their greed and promises about how their new owner will help them fulfill their dreams. 

The greatest threat to monopoly businesses is the adequately financed new entrant with the creativity and agility to exploit gaps and weaknesses. The harm to us all from monopolies is described in Barry Lynn’s new book.  [Barry C. Lynn, Cornered: The New Monopoly Capitalism and the Economics of Destruction, Wiley, 2010]  Wall Street controls nearly all of the money available and allocates it to the existing monopolies.  This leaves little opportunity for new ideas and energy to improve products and services, to make capitalism work.  To quote from two icons of economics:  "This process of creative destruction is the essential fact of capitalism."  [Joseph Schumpeter, Capitalism, Socialism and Democracy, Harper & Brothers, 1942, page 83]   "We need decentralization because only thus can we insure that the knowledge of particular circumstances of time and place will be properly used."  [Friedrich Hayek, "The Use of Knowledge in Society,", page H.17]

(Entrepreneurs we advised on direct public offerings were enthusiastic about the independence they would have after their first sale of securities.  Some of them went on to a series of direct public offerings, raising money for rapid growth.  Nevertheless, many of our most successful direct offering clients were acquired by large corporations.  After years of struggling with a young business, the chance to become independently wealthy—right now—can be hard to pass up, especially when that is the definition of success.  As Wall Street becomes less important as a source of funding, I hope the culture of quick money, and the status it provides, will subside.)


Wall Street Entices Some of Our Best Minds Away from More Useful Work


It's ironic that the very minds that can get rich and powerful on Wall Street are the minds that could finally alleviate poverty.  Paul Polak is a psychiatrist and entrepreneur who has spent the second part of his life helping the world’s poorest farmers increase their income.  He came to that work because:  “I became convinced that the most significant positive impact I could have on world health was to work on finding ways to end poverty.”  [Paul Polak, Out of Poverty:  What Works When traditional Approaches Fail, Berrett-Koehler Publishers, Inc., 2008, page 5.]  “I have no doubt that the most important low-cost, high-leverage solution to the complex issue of poverty is helping poor people increase their income.”  [page 55]  Muhammed Yunus, the founder of Grameen Bank and the microfinance movement, was an economics professor when he experimented with lending very small amounts to his Bangladesh neighbors for acquiring tools and methods to increase their incomes.  If a physician and a professor could make such contributions to alleviating poverty, imagine what experienced Wall Streeters could accomplish.  By contrast, a Wall Street firm is said to have a “remarkable ability to convince some of the world’s smartest young people that touting stocks, sniffing out arbitrage opportunities, and shaking down corporate clients amount to a noble calling.”  [Ian McGugan, “The Goldman Doctrine,” a review of William D. Cohan’s book, Money and Power: How Goldman Sachs Came to Rule the World, Doubleday, 2011, Bloomberg Businessweek, April 11-17, 2011, pages 86, 87]

A study by three economists was based upon the proposition that “the ablest people” choose occupations with the highest “returns to being a superstar.”  Where will individuals choose to work if they are particularly good at applying mathematics or physics to solve extremely complex issues?  The professors say they’ll go where the few who really excel are paid the greatest compensation.  In academic language, their analysis “suggests that private incentives governing the allocation of talent across occupations might not coincide with social incentives.  Some professions are socially more useful than others, even if they are not as well compensated.”  [Kevin M. Murphy, Robert W. Vishny, Andrei Schleifer, “The Allocation of Talent: Implications for Growth,” The Quarterly Journal of Economics, Harvard University, May 1991, pages 503, 529.

This academic conclusion was applied to jobs on Wall Street in a feature article by Lisa Bannon.  “The earnings of an engineer and someone in finance with the same level of postgraduate degree were roughly the same in 1980, but by 2005, the finance professional earned 30% to 40% more, on average . . ..” [Lisa Bannon, “Beyond the Bubble: As Riches Fade, So Does Finance’s Allure,” The Wall Street Journal, September 18, 2009, page 1, 20, citing Thomas Philippon, New York University finance professor,]  Of course, Wall Street superstars earned many times more.  The culture of Wall Street appeals to and enforces the “Winner-Take-All Society.”  [Robert H. Frank, The Winner-Take-All Society: Why the Few at the Top Get So Much More Than the Rest of Us, Penguin, 1996, pages 7-8, hardcover, The Free Press, 1995, subtitled: How more and more Americans compete for even fewer and bigger prizes, encouraging inequality and an impoverished cultural life]

Professor Louis Lowenstein noted that over half of the 1986 graduates of the Columbia School of Business took jobs at investment banks and commercial banks.  Over 85 percent of the Columbia Law School graduates were hired by the big city law firms who do financial transactions and litigation.  “We seem to forget that corporate finance is, or at least ought to be, a relatively minor pursuit, one whose principal purpose is simply to see that those who design, produce and distribute goods and services have sufficient capital.” [Louis Lowenstein, What’s Wrong With Wall Street: Short-term Gain and the Absentee Shareholder, Addison-Wesley Publishing Company, Inc., 1988, page 86]  The Great Recession may have reversed that, at least for a while.  Of Harvard’s 2008 graduates, 41% took jobs in investment banking, private equity firms or hedge funds.  That dropped to 28% in 2009.  The lowest ever was in 1937, when only one percent went to Wall Street.  []

(My first job out of law school was with one of the Big Four accounting firms, where I ended up in the tax department.  I spent the next few decades trying to avoid tax work.  But I met scores of very intelligent, capable people who spent their entire work lives dealing with tax issues.  Clients were willing to pay them large hourly rates in the hope of saving even more in payments to their governments.  It has always seemed sad that these talented, productive professionals were figuring out ways to avoid paying taxes, rather than working on issues that would be more useful.  Later, when Wall Street began inventing and selling derivatives, I saw an even greater diversion of talented people.)

There is a much greater, but more indirect waste of human talent that comes from leaving Wall Street in control of distributing securities.  Its monopoly focus on financial intermediaries and wealthy speculators has kept the middle class from direct ownership of business.  This means that corporate profits are taken mostly by managers—CEOs and their lieutenants, as well as the money managers at mutual funds, pension funds and other intermediaries.  One result is that businesses are run to generate income for these managers and short-term profit-takers, not for long-term shareowners.  Net income after payments to management is spent to make the business larger, to justify even greater compensation.  Corporate executives, intermediaries and speculators all make money buying and selling the shares.  Not much of the earnings of the business are paid out in dividends.

Because we don’t participate in the Wall Street insiders’ games, the rest of us are left with our income tied to our work, even if we have put savings into long-term investments.  Our ability to pay our living expenses is dependent upon businesses having jobs available for us to do.  But those corporate executives and financial intermediaries are doing everything they can to eliminate jobs.  The result is not only unemployment because of the loss of jobs paying a middle class income.  It also means underemployment as we take low-paying work, doing tasks that can’t yet be profitably outsourced to developing nations or automated.   One out of four jobs in the United States pays less than two-thirds of the median wage, the highest of the 19 richest nations.  [John Schmitt, “Low-Wage Lessons,” Center for Economic and Policy Research, January 2012,, citing the Organization for Economic Cooperation and Development]   

  All of us lose the contributions that could have been made by the potential inventors, entrepreneurs and other talented roles for people who are instead just making do with unchallenging work.  

Wall Street’s Morality Harms Our National Psyche

Wall Street has callously announced that we are all governed by only two emotions:  fear and greed.   All marketing of securities is a manipulation of one or the other, or both. Throw in a bit of mob psychology and we have the manias and panics that make for market volatility, the mass buying and selling that generates commissions and insider trading profits.  Michael Lewis will show you Wall Street morality in shocking dark humor.  [Michael Lewis, Liar's Poker: Rising Through the Wreckage on Wall Street, W. W. Norton & Company, 1989, The Money Culture, Penquin 1992 or The Big Short: Inside the Doomsday Machine, W.W Norton & Company, 2010.]

During Alan Greenspan’s long tenure as Chairman of the Federal Reserve Board, he coined two phrases that told us what Wall Street was doing to our national psyche.  The first came as the bubble in technology stocks was early in its run-up, when he attributed it to “irrational exuberance.”  As the bubble inflated more and more, he called it “infectious greed.”  Whatever else we may think of Greenspan, he captured the pathology in these four words.  A much longer and older description is in the 1841 book, Extraordinary Popular Delusions and the Madness of Crowds.  Describing John Law’s Mississippi Scheme of 1719: “He did not calculate upon the avaricious frenzy of a whole nation; he did not see that confidence, like mistrust, could be increased almost ad infinitum, and that hope was as extravagant as fear.”   [Charles Mackay, Memoirs of Extraordinary Popular Delusions, Richard Bentley, 1841, reprinted by Farrar, Straus and Giroux, 1932, page 1]

There’s more to greed than just making and keeping wealth.  The strongest motive can be the “chump factor.”  Paul Krugman has said that we find “it hard to resist getting caught up in the momentum, to take a long view when everyone else is getting rich.”  [Paul Krugman, The Return of Depression Economics and the Crisis of 2008, W.W. Norton & Company, 2009, page 61]   If we don’t get in there, it will pass us by.  We’ll look like a wimp, a chump to ourselves and others.  “To a substantial extent, we no longer admired those who were merely hard workers.  To be truly revered, one had to be a smart investor as well.”  [Robert J. Shiller, The Subprime Crises:  How Today’s Global Financial Crisis Happened, and What to do about it, Princeton University Press, 2008, page 57.] 

(We watched this infect some of the entrepreneurs who came to us for direct public offering advice.  Consciously or not, they were aware of all the get-rich-overnight stories about underwritten IPOs.  At first, our talk with them would be about the mission of their business, how they were meeting a human need, how their products and services were benefiting customers.  They were doing well by their employees and other communities.  Somewhere along the way, questions would turn to the expected trading market for the securities to be sold.  Then it would be about the percentage of the business to be sold for the amount of money to be raised.  At that point, we’d often see the glazed-eye clue that their thoughts were no longer on what we were saying.  They were doing the arithmetic about how rich they would be and how that wealth would compare with others they knew.)

Fear and greed govern the way Wall Street sells to its customers.  They’re also the only motivational tools Wall Street uses to hire and retain employees.  Much of the criticism after the 2008 crash was directed to the huge bonuses paid to people who successfully took great risks.  The government tried to limit the bonuses, calling them part of a “heads I win, tails I don’t lose” compensation scheme.  The employees taking the risks would get great personal gain if they bet right, but they wouldn’t lose their jobs, or have pay cuts, if they bet wrong.  By restricting the bonus amounts, the government figured it could cut down on the risks that were causing banks to fail and be bailed out with taxpayer money.

Perhaps a greater harm was the perpetuation of a value that infects us all.  Other businesses follow Wall Street, since that’s where the fabulous riches are made.  The fact is, however, that studies show that financial incentives don’t work.  In fact, they are often counterproductive.  Barry Schwartz, a Swarthmore College psychology professor, mentioned three of the studies in an essay, “The Dark Side of Incentives.”  [Business Week, November 23, 2009, page 84]  One study was of people living around a proposed toxic waste dump.  Offering them a significant cash amount to accept the dump converselly cut in half their willingness to have the dump in their community.  Another was a day care center that began fining parents when they were late to retrieve their children, only to have lateness increase.  In the third study, people walking by strangers unloading a sofa were less likely to help if they were offered payment.  The professor’s conclusion:  “Despite our abiding faith in incentives as a way to influence behavior in a positive way, they consistently do the reverse.”  [Business Week, November 23, 2009, page 84.  Professor Schwartz mentions the sources for each study.]

The current epitome of the Wall Street psyche is Goldman Sachs.  The Sunday Times of London printed an interview by its reporter, John Arlidge, in which the CEO of Goldman Sachs, Lloyd Blankfein, candidly described that mindset.  [John Arlidge, “I'm doing 'God's work'. Meet Mr. Goldman Sachs: The Sunday Times gains unprecedented access to the world's most powerful, and most secretive, investment bank,” The Times of London, November 8, 2009,]  Some of the article’s quoted excerpts:

1.  "We help companies to grow by helping them to raise capital. Companies that grow create wealth. This, in turn, allows people to have jobs that create more growth and more wealth. It’s a virtuous cycle." To drive home his point, he makes a remarkably bold claim. "We have a social purpose."  The facts, of course, are that very little of what Wall Street does has anything to do with raising capital for business. 

2.  Of the $20 billion to be paid by Goldman in 2009 salaries and bonuses, equivalent to $700,000 for each employee but heavily skewed toward those at the top:  “If you examine our practices on compensation, you will see a complete correlation throughout our history of having remuneration match performance over the long term. Others made no money and still paid large bonuses. Some are not around any more. I wonder why."

3.  On any government interference with Wall Street:  “’I’ve got news for you,’ he shoots back, eyes narrowing. ‘If the financial system goes down, our business is going down and, trust me, yours and everyone else’s is going down, too.’"

4.  In response to angry name-calling:  “He is, he says, just a banker ‘doing God’s work.’ 

"In 2007, the Goldman Sachs boss Lloyd Blankfein earned $68m, a record for any Wall Street CEO. A good investment banking partner at Goldman will make $3.5m a year, a good trading partner $7-10m a year, and a management committee member $15-25m.”  For even more colorful language describing Wall Street’s attitude toward its business and customers, you can read the affidavit filed by the New York Attorney General’s office in its action against Wall Street’s use of securities analysts.   [AFFIDAVIT IN SUPPORT OF APPLICATION FOR AN ORDER PURSUANT TO GENERAL BUSINESS LAW SECTION 354 and accompanying news release,]The New York Times published an Op-Ed by Greg Smith, on the day he resigned as a Goldman Sachs executive director and head of the firm’s United States equity derivatives business in Europe, the Middle East and Africa.  His concluding sentence:  "People who care only about making money will not sustain this firm — or the trust of its clients — for very much longer."  [Greg Smith, "Why I Am Leaving Goldman Sachs,"]

Wall Street has become the career choice for young people caught up in the winner-take-all value system.  It has had the same draw for college students that drug dealers have for high school dropouts—a seemingly quick way to have all the flashy symbols of big money.  Remember the 1990s bumper sticker, “The one who dies with the most toys wins?”  Many CEOs, financial types and professionals say things like, “For me, money is just the way of keeping score.”  One observation is clear, “if you think money is the answer, there will never be enough.”  Wall Street’s single-minded pursuit of scoring money infects us all.  No matter whether the love of pursuing money was already there before the Wall Street career, or was developed on the job, it is the primary value, governing every decision and action.  However, study after study has shown that money does not bring happiness.  Once above the basic poverty level, there is no correlation.  [The World Database of Happiness, directed by Professor Ruut Veenhoven of Erasmus University, Rotterdam, correlation by nation between happiness and wealth,, see]  Yet, Wall Street perpetuates the myth that getting money—lots of it and quickly—is what life is all about.  That harms us all.  Some of our most capable people are ignoring community, service, family and other values, while they chase making more money than anyone else.

The Wall Street Capital Formation Myth

Our government and other governments around the world have sacrificed billions of dollars and immense political capital to save investment bankers.  Few of us even asked why this effort was necessary.  If we did ask, the answer was something like, “the credit markets are frozen and money won’t be there for Main Street businesses to pay their employees and suppliers.”  This justified taking money from present and future taxpayers and giving it to the investment banks.  Few of us asked, “Why not make alternative financing available directly to those businesses?” 

It turns out that investment bankers no longer do much to provide money to grow and sustain businesses.   Nearly everything they do is based on reshuffling ownership of securities or using derivatives to place bets on the future price of securities.  Only a tiny fraction of their activities is actually raising money from investors for growing businesses.  Money they raise in IPOs, initial public offerings, is mostly just part of the recycling of ownership by Wall Street’s buy side.  Many of the “initial” offerings are of mature businesses that “private equity” funds have purchased from their public shareowners, sold off divisions and drained of all cash.  Investment bankers dump the remains back onto the public, calling it an IPO.  The sales that are really “initial” are generally businesses that have been built by institutional venture capitalists, with the IPO being the exit plan for cashing out their investment.

When Wall Street does do an “Initial Public Offering,” it usually has nothing to do with early stage businesses and nothing to do with financing new products or industries.  Just look at the prospectus for the billion-dollar “IPO” of Shanda Games in September 2009. [ and comment by Henry Blodgett, “Goldman Hoses Clients in Busted Shanda Games IPO,” Clusterstock,]  The Shanda story is a far cry from the idealistic image, expressed like this:  “Because of their role in financing new ideas, financial markets keep alive the process of ‘creative destruction’—whereby old ideas and organizations are constantly challenged and replaced by new, better ones.  Without vibrant, innovative financial markets, economies would invariably ossify and decline.”  [Raghuram G. Rajan & Luigi Zingales, Saving Capitalism from the Capitalists:  Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity, Crown Business, Crown Publishing Group, a division of Random House, Inc., New York, 2003]

What has actually happened is that more public companies disappear than the ones that are created by IPOs.  In 2000, over 9,000 publicly-traded companies filed proxy statements with the SEC, compared to only about 4,100 by 2010.  Since 1996, the 4,299 publicly traded stocks added through IPOs have been far less that the 7,725 that went away.  [Jason Zweig, "The Demise of the IPO--and Some Ideas on How to Revive It," The Wall Street Journal, June 26-27, 2010, page B7, citing Wharton Research Data Services] 

Mature corporations rarely raise capital by selling shares.  Take General Electric, for example.  The last time GE issued new shares was in 1995, when it sold $594 million.  Meanwhile, GE has repurchased shares, at market prices, for a cumulative total of $37 billion at the end of 2007.  In turn, some of this repurchased stock was sold, to its own managers when they exercised their management stock options.  The managers generally resell the new shares for cash in the market.  GE’s balance sheet shows the gain it made on buying and selling its own shares as the major part of the over $26 billion in its “Other Capital” account.  The net result of GE’s initial issuance of shares, then repurchasing them, and then using the repurchased shares to cover management’s stock options, is that GE has taken nearly 100 times as much money out of the public market from buying shares as it ever raised from selling shares.  Meanwhile, it has been paying out about half of each year’s earnings in dividends.  By keeping the rest of its earnings, it has increased its retained earnings to over $117 billion!  That has allowed GE to borrow cash, to a total of over $195 billion at the end of 2007.   Some 58% of GE’s shares are owned by institutions.  [Information gathered from GE annual reports, filed with the SEC and available at CIK#: 0000040545.] 

GE’s experience with buying back its shares is the norm for mature American corporations.  Nearly every large corporation has a program in place for repurchasing its own shares in the market, through brokers.  During 1997 through 2008, 438 of the Standard & Poor’ 500 companies spent a total $2.4 trillion in buying back their own shares of common stock.  A perspective on the amount these corporations paid out to sellers of their shares can be seen through the buyback-to-profit ratio: how the amount spent to repurchase shares compares to the companies’ profits.  That ratio was 0.9 to 1 in 2007.  That means the S&P 500 paid out 90% of their earnings to buy back their own shareownership.  In 2008, when profits were down, the ratio became 2.8 to one—they spent nearly three times their earnings to repurchase shares.

The most profitable company of all, ExxonMobil, paid out 173% of its first quarter 2009 earnings to repurchase its stock.  From 2000 through 2008, the big technology companies, Cisco, Hewlett-Packard, IBM, Intel and Microsoft, spent more on stock buybacks than on research and development.  Big Pharma (Amgen, Johnson & Johnson, Merck and Pfizer), while justifying high drug prices by the need to pay for researching new drugs, had huge stock repurchase programs.  Amgen’s buyback-to-profit ratio was 1.16 to 1 during the 2000-2008 years.  [William Lazonick, professor at the University of Massachusetts, Business Week, August 24&31, 2009, page 96]

Why do American corporations spend so much buying back their own shares?  They will say things like “Our shares represent the best value for a return on investment” or “We can best serve our shareowners by supporting the market for their shares.”  The real reason is often that managers are exercising stock options they have been granted as compensation.  They spend their employer’s money to keep the price up while they exercise their personal options and resell the shares into the market.

The myth that Wall Street investment bankers raise money to grow business is just that—a myth.  What they really do is move money and securities around among the players, taking sizeable chunks for themselves, like a giant shell game.  As Steven Pearlstein commented, “the best approach to Wall Street might be to simply ignore it and turn our attention to those parts of the economy that can create real economic value and broadly shared prosperity.”  [Steven Pearlstein, “Blaming Wall Street on Bonuses is Hypocritical,” Washington Post, January 15, 2010] The next section, “Direct Investing Routes Open Now,” describes the progress already made in bypassing Wall Street.

Direct Investing Routes Open Now


Bypassing Wall Street is already happening.  It is part of the trend toward disintermediation in finance and business.  [Paul Hawken includes a chapter on "Disintermediation" in The Next Economy, Holt, Rinehart and Winston, 1983, pages 117-132]  Direct investing routes are operating right now.  Most of them are serving individual investors, providing a way for them to go directly to the organization that will be using their money.  A few institutional investors are bypassing Wall Street.  "We are in the middle of a strategy to invest all of our assets in a way that is 'as direct as possible'.  You can think of it as 'off-the-grid' investing."  [Don Shaffer, “Canceled IPO, What’s Next For Global Stock Markets?” RSF Social Finance, March 26, 2012,]

  Here are some of the direct investing routes open now:.


We hear so much about how the United States is being financed by selling its debt to other countries, especially China.  But can you guess who purchased 86% of the new Treasury securities sold in the first quarter of 2009?  Individuals in the United States.  [Andrew Batson, “Households Start to Rival the Chinese in Treasury Market,” The Wall Street Journal, August 17, 2009, page C6]  The United States Treasury is the largest money raiser in the world.  To encourage individuals to invest in Treasury securities, it operates TreasuryDirect, an online service for buying, holding and selling treasury securities.  There is no charge at all for buying securities online directly from the federal government.  The only requirements for opening an account and buying securities are a Social Security number, a U.S. address of record, bank account and routing numbers, an email address and use of a computer with a web browser.  The minimum purchase was dropped in 2008 from $1,000 to $100.  Compare this with the minimum $5,000 that Wall Street requires for purchasing local government bonds.

TreasuryDirect’s current website describes its direct investing this way:  “In your TreasuryDirect account, you can purchase and hold Bills, Notes, Bonds, Treasury Inflation-Protected Securities (TIPS), and savings bonds and it's available to you 24 hours a day, 7 days a week.  Your TreasuryDirect account is protected by a password of your choosing. The system allows you to conduct most of your transactions online, -- you can purchase, reinvest, sell securities, and perform account maintenance from your home or work computer. You can also view all your account information, including pending transactions. TreasuryDirect offers you all of these features with no maintenance fees, no matter how much you have invested.”  []

The 2008 version of this page had said:  “TreasuryDirect is our web-based system that allows you to purchase the full range of Treasury consumer securities in one convenient online account. TreasuryDirect is our primary retail system for selling our securities. This system allows us to establish direct relationships with you as an investor, enabling you to do business with us electronically using the Internet and conduct transactions without personal assistance from us.  I. . . .  Our long-term goal is to consolidate all retail sales of Treasury securities in TreasuryDirect. With this consolidation, we'll realize savings in administrative costs and be able to enhance our customer service.”

What TreasuryDirect doesn’t say flat out is that you’ll never need Wall Street to buy and sell U.S. Treasury securities.  By using this direct route, you will always get the best pricing, the greatest transparency and the lowest transaction costs.  You can even participate in Treasury auctions, right alongside the Wall Street institutions.

The U.S. Treasury has also given direct access to China, so it no longer has to buy "through Wall Street banks, which can often drive up the price of Treasuries at an auction if they know how much large clients are willing to pay. Such a practice that is not specifically illegal, though most traders would deem it unethical."  [Emily Flitter, "Exclusive: U.S. Lets China Bypass Wall Street for Treasury Orders," Reuters, May 21, 2012] This doesn't save any fees, but it means that Wall Street doesn't learn about China's intentions before the transaction is completed. 

Commercial Paper

The commercial paper securities market is a way for large corporations to borrow money for up to nine months, at a lower cost than borrowing from a bank.  Wall Street acts as a dealer for some commercial paper, but many corporations have employees who sell their paper directly to fund managers and other corporations with excess cash to invest.  Bypassing Wall Street saves the issuer about a half of one percent on each transaction, equal to $5,000 per $10 million.  Commercial paper doesn't have to be registered with the SEC if the money raised is for working capital purposes, that is, to be "used for current transactions."  [Securities Act of 1933, section 3(a)(3),]  The economic policy behind the commercial paper exemption was that the financial strength and reputation of the issuers were sufficient protection for the very sophisticated investors who participated in the market. 

Wall Street managed to hijack and grossly abuse the commercial paper SEC exemption by packaging and selling "asset-backed commercial paper." They transferred long-term mortgage securities into "bankruptcy-remote" shell companies, which then issued short-term commercial paper.  Investors were mostly money-market mutual fund managers, going after the higher yield, trying to outperform their competition.  In the panic after Lehman Brothers failed, the Federal Reserve came to the rescue of Wall Street's buy side with purchases, guarantees and loans for holdings of commercial paper. The basic commercial paper market survives, with about a trillion dollars outstanding, most of it issued by financial institutions.  [Tobias Adrian, Karin Kimbrough, Dina Marchioni, "The Federal Reserve's Commercial Paper Funding Facility," Federal Reserve Bank of New York Economic Policy Review,] Back in 2001, nonfinancial issuers had $250 billion dollars in commercial paper outstanding.  That has shrunk to about $150 billion.  [Federal Reserve Release,]  

Corporations can finance longer term purposes by issuing bonds.  These are placed through Wall Street's sell side and sold mostly to buy side money managers.  Any trading in bonds or mortgage securities has also gone through Wall Street brokers.  Now, a sell side firm, BlackRock Inc., operates its own trading desk for its clients' bond trades of up to $2 million eac.  It recently announced Aladdin Trading Network, a trading platform for its biggest clients "that would let the world's largest money manager and its peer bypass Wall Street and trade bonds directly with one another . . . at a fraction of the price charged by Wall Street."  [Kirsten Grind and Serena Ng, "BlackRock's Street Shortcut," The Wall Street Journal, April 12, 2012, page C1]   

Family and Friends

At the other end of the spectrum from the world’s largest money raisers are the would-be entrepreneurs who need money for a start-up business.  Most of them first use up all their savings, credit cards and garage sale proceeds.  Then they turn to family and friends, who make up 92% of all “informal investing,” where the money does not go through a bank, broker or other financial intermediary, according to the Global Entrepreneurship Monitor.  [

Information about informal investing is understandably difficult to gather.  Every three years, the Federal Reserve Board surveys U.S. households to estimate the percentage of households owning part of a private business in which no household member is active in the management. In 2007, approximately 1.6% of U.S. households were passive owners in a private business.  For 2009, the Global Entrepreneurship Monitor survey showed that 4% of U.S. residents ages 18 to 64 had made an informal investment in someone else's business in the past three years. The average amount invested per business was $7,200 a year.   [] A 2004 study limited to accredited investors—generally, individuals with either a million dollars in assets or annual incomes of $200,000—reported that 10.5% had made an informal investment during the previous three years.  [Paul D. Reynolds and Richard T. Curtin, New Firm Creation in the U.S.: A PSED I Overview, Springer, 2009]

A problem with informal investing, particularly friends and family, is simply that it is informal.  Any written documentation is often absent or incomplete.  Enforcement of the terms can get very complicated and unpleasant.  Asheesh Advani responded to this problem in 2001 with CircleLending, his “specialty loan administration company,” and with his 2006 book.  [Asheesh Advani, Investors in Your Backyard:  How to Raise Business Capital From the People You Know, Nolo Press, 2006]  CircleLending was acquired in 2007 by Virgin Money USA, owner of Virgin Airlines and other businesses. In its first six years, CircleLending had set up $200 million in loan volume while maintaining a default rate of less than 5% on private loans and less than 1% on private mortgages. VirginMoney’s website had a timeline for its business development, showing the volume of what it calls “social lending” at a $1.8 billion annual rate in 2009. The business was closed in December 2010.  [  Another site offering a similar service is]

  Direct Community Offerings

Local communities have often offered securities directly to their residents, to finance a local project or business.  Some small towns have turned to direct community offerings to replace local businesses that were lost from “big box store” competition or declining population.  [Sharon Earhart, “Making Merc work: When Powell, Wyo., lost its main retail clothing store, residents rolled up their sleeves and opened their own,” and companion analysis by Shellie Nelson,Western towns sell it their way,” Headwaters News, March 2, 2005]

Plentywood, Malta and Glendive, Montana, along with Powell and Worland, Wyoming and Ely, Nevada, all lost anchor stores in their downtowns.  All the towns are in counties with fewer than 10,000 residents. “When the Stage department store in Plentywood, Montana closed its doors, community leaders created a limited liability corporation and sold shares for $10,000 apiece to raise the $200,000 it took to open the doors of the Little Muddy Dry Goods.”  Inspired by the success of the Plentywood store, Malta leaders sold shares for its community-owned store for $500 a share.  Community leaders in Powell formed a corporation and also sold stock for $500 a share, with a 20 share maximum purchase. The towns of Worland and Ely followed, selling shares and opening stores.  “The stores are all making money, but their presence in the communities is serving a much more crucial role. They are drawing other businesses to the area and serving as a destination for area shoppers.”  [  Also, and “Community-Owned Stores: New Anchors for Older Main Streets,”  See Stacy Mitchell, “Some Communities Don't Depend on Chain Department Stores--They Own Their Own,” 2004.  Stacy Mitchell is senior researcher with the Institute for Local Self-Reliance and a newsletter publisher. []  More recently:  “When the local general store went out of business, the residents of Port Townsend, a small Washington city northeast of Olympic National Park, . . . turned to a process called a direct public offering . . ..” [Matthew Kish, “Local investors get creative with new financing tools,” Portland Business Journal, May 4, 2012]

An early biofuel venture, ethanol, required plants to process corn and they cost from $50 million to $125 million each.  Scores of the plants were funded by farming communities through direct community offerings.  “Wall Street has little to do with this decidedly grass-roots investment boom.” [Scott Kilman, “In Midwest Investment Boom, corn-to-Fuel Plants Multiply,” The Wall Street Journal, March 9, 2005, page A1]

Football and soccer teams have been particularly successful with direct community offerings.  In the United States, the Green Bay Packers completed four offerings, from 1923 through 1998.  The last offering raised more than $24 million from over 100,000 shareowners.  []Another direct public offering began in December 2011, for $62.5 million.  [Cicely K. Dyson, "Green Bay's Hottest Stock," The Wall Street Journal, December 7, 2011, page B1]  In England, some 1,500 soccer fans recently pledged $70.50 each to buy a team, using a web site called  [Max Colchester, “One Team Gets 26,000 Owners—All With a Vote on Who Plays: Fifth-Tier English Soccer Side Set to Become First Pro Team Run by an Online Community” The Wall Street Journal, January 2, 2008,]  

Woody Tasch was chairman of Investors' Circle, whose individual and foundation members invest in early stage businesses that are seen as serving social and environmental purposes.  He uses the term “slow money” to describe investing in local food businesses.  [Woody Tasch, Inquiries into the Nature of Slow Money: Investing as if Food, Farms, and Fertility Mattered, Chelsea Green, 2008,]  Local ownership of farms and food processors has been studied as the Community Food Enterprise.  []  The E. F. Schumacher Society operates the Self-Help Association for a Regional Economy, which provides documentation for "Use in Establishing a Community-Based Small Business Loan Collateralization Program."  The way it works is that people in the local community open certificates of deposit with a neighboring bank.  The CDs are then pledged to secure a loan to a local business, at a rate four points over the CD interest. [] 

 Amy Cortese persuasively gives us reasons for community ownership of businesses in her book.  [Amy Cortese, Locavesting:  The Revolution in Local Investing and How to Profit From It, John Wiley & Sons, 2011]  Gar Alperovitz describes organizations and actions being taken in his article, “The New-Economy Movement.” [The Nation, June 13, 2011,]  There are efforts being made to establish local stock exchanges to trade companies whose shares are owned by members of the communities they serve.  One in organization is the Lancaster Sustainable Enterprise Exchange.  [  See article by Joel Millman, “Tiny Exchanges for ‘Loca-vestors,’” The Wall Street Journal, June 2, 2011, page C1]

 Perhaps the most established form of direct community offering is the co-op or mutual form of business organization.  “U.S. cooperatives serve some 120 million members, or 4 in 10 Americans. Worldwide, some 750,000 cooperatives serve 730 million members,” according to the National Cooperative Business Association.  []  Mondragon Corporation, begun in Spain in 1956, is an international model for multiple cooperatives, owned by communities of customers, employees and neighbors.  []  Direct community offerings of co-op ownership can even work well for financial intermediaries.  For instance, borrowers from mutual savings banks become voting owners, as do the owners of life insurance policies issued by mutual insurance companies.  these co-op financial companies have a much lower cost of entering the business than their capital stock competitors.  [Andrew Tobias, The Invisible Bankers, Washington Square Press, 1982, page 296]

The legal form of cooperative corporation is not necessary for a business to be community owned and financed.  Grameen Bank, the Nobel Prize-winning pioneer in microlending, is 94% owned by its thousands of borrowers, with the rest owned by the Government of Bangladesh and two banks.  For 2006, they received dividends equal to their entire investment.  []  The largest shareowner in Divine Chocolate, based in Washington, D.C., is a cooperative of 45,000 Ghanaian cocoa farmers.  According to Mark Magers, the company’s CEO, “Guilt is not a good business model.  . . . We're not a charity, we're a for-profit business differentiated because we're owned by cocoa farmers and fair trade certified.”  [Karen E. Klein, “Sharing Profits with 45,000 Farmers,” Bloomberg Businessweek, May 17, 2011,]

Direct Local Government Bond Offerings

You might think that local governments are a natural for marketing bonds directly to their neighbors, the people who will benefit from the public facility that is to be financed by the bonds.  Those governments even have the huge advantage of paying interest that is exempt from federal and state income tax. 

For over a century, there has been a trickle of direct local government bond offerings.  Legislatures have even ordered state departments to market bonds to average citizens, but the programs always fizzled out, or never even got started.  Instead, local governments continue to do business with Wall Street, paying large commissions for bonds sold in $5,000 minimum purchases and usually placed with insurance companies and mutual funds.  One reason the system hasn’t changed is because investment bankers make campaign contributions to elected officials and pay fees to people with political access.  Rules against this “pay-to-play” haven’t been seriously enforced and, according to former SEC chairman Arthur Levitt, ”'Fraud in the municipal market and incompetence, which in some ways is worse than fraud, has never been greater.’” Even so, “Some 70% of the debt in the municipal market is held by individual investors.”  [Martin X. Braun, “Can the SEC Get Its Street Cred Back?,” Bloomberg BusinessWeek, April 12, 2010, page 28]

During the 1980s, several governments experimented with direct marketing of bonds.  Many of them were offered in minimum purchases of much less than the traditional $5,000.  That earned them the sobriquet “minibonds.”  When direct bond offerings actually happened, they have generally been highly successful.  For instance:  The Salt River Project, a Phoenix, Arizona electric utility, sold $267 million in bonds to 21,000 residents, at a $200 minimum purchase and a $10,000 maximum.  Purchasers could cash in a bond at any time, paying a 3% redemption fee.  East Brunswick, New Jersey sold its first mini-bond in 1978, raising $529,000 to build a public works garage.  They had a second, $500,000, offering the next year.  Massachusetts and Ocean County, New Jersey each had $1 million offerings in 1979.  Assistant State Treasurer James Hosker said, “We opened the line at 9 a.m. and shut it off at 11.  We could have sold $5 million that first day.”  [Thomas G. Dolan, “Mini-Municipals:  A Quiet Revolution in Tax-Exempt Finance, Barron’s, August 6, 1979, page 11]

Yet, when California was desperately searching for a way to sell its bonds in late 2008, it still clung to the usual intermediaries.  The state spent $250,000 on radio and print ads in San Francisco and Los Angeles.  It set up a special website for the bond sale, which told individuals:  “You must have an account with one of the brokerage firms participating in the bond or note sale. Bonds and notes cannot be purchased directly from the State. If you do not have an account at one of the participating firms, you may open one and purchase bonds or notes during the early order period.  Investors are encouraged to begin the New Account process well in advance of the sale. Depending on the brokerage, internal new account procedures may take some time to process. Each firm has its own requirements for opening an account. The State does not endorse any particular brokerage firm. Additionally, the State does not guarantee that any one of these firms will open an account for an investor.” [Kevin Yamamura, “Buy State Bonds, Schwarzenegger Urges,” The Sacramento Bee, October 10, 2008.  See [“Will Minibonds be a Megahit?  California eyes selling muni debt in $25 denominations; lower buy-in designed to attract more investors,” Bloomberg News, September 10, 2011,]

A prospective investor in the California bonds asked, "Why pay a broker?  There's no fee with U.S. savings bonds, and I can buy those online."  A spokesman for the California Treasurer responded that, unlike the federal government, the state can't legally sell notes or bonds directly, "so we have to have a middle man. That's standard procedure."  [Jon Ortiz, “California sells $5 billion in short-term bonds,” Sacramento Bee, October 17, 2008, page 10B]  Even if there really is such a legal prohibition, you might think that California’s financial crisis would prompt a change in any law or procedure that stood in the way of direct offerings. 

Massachusetts pitched an issue of $1,000 denomination bonds in May 2011.  Individuals could buy bonds for two days, before the rest would be sold to institutional investors.  The state’s Treasurer announced: “By purchasing these tax-free bonds you are helping to finance bridges, roads, and other important infrastructure projects which will help meet our current and future needs in cities and towns throughout Massachusetts.”   However, like California, the announcement made clear:  “Bonds cannot be purchased directly from the Commonwealth.”  [  The online instructions for purchase tell individuals that “You must have an account with one of the brokerage firms participating in the bond sale.”] 

So far, introduction of the Internet has done little to loosen Wall Street’s grasp on selling local government bonds., operated by the Grant Street Group, has daily auctions of bonds.  [].  Initially, sales on the Internet were only to bond dealers, but they seem now to include institutional investors and corporations.  Individuals still have to go through a broker.  “More companies are getting ready to issue small portions of their debt needs online.  Only a few, though, have been willing to step forward because many don’t want to anger dealers.”  [Toddi Gutner, The E-Bond Revolution,” Business Week, November 15, 1999]

In his 1914 book, Louis Brandeis described direct public bond offerings made in 1913 by five American cities, in what he referred to as “over-the-counter” sales.  Testimonials by local officials describe the success from marketing bonds directly to local residents. [Louis D. Brandeis, Other People’s Money: And How the Bankers Use It, Frederick A. Stokes Company, 1914, republished by National Home Library Foundation, 1933, Kessinger Publishing’s Rare Reprints, page 81]  If the success of direct public offerings of local government bonds was discovered as early as 1913, why have they been used only sporadically in all the years since?  One answer is the human reluctance to accept responsibility if there is no promise of significant personal reward.  There is not much in it for a public official to go against “the way we’ve always done it” and risk failure.

[For information about direct public offerings of municipal bonds, see:  Municipal Minibonds: Small Denomination Direct Issuances by State and Local Governments, by Lawrence Pierce, Percy R. Aguila, Jr. and John E. Petersen, Government Finance Research Center of the Government Finance Officers Association (February 1989); “The ‘Mini’ Trend in Municipal Finance: Minibonds,” Comment by Christina L. Jadach, Harvard Journal on Legislation, Vol 19:393 (1982); “Mini-Municipals: A Quiet Revolution in Tax-Exempt Finance is Afoot, Barron’s, August 6, 1979, page 11; “Boston’s Offering of Minibonds’ Proves Good Lure,” by Johnnie L. Roberts, The Wall Street Journal, September 13, 1984, page 37; About New York’s Municipal Assistance Corporation proposal:  “Issue of ‘MiniMacs’ Pleases Politicians, Riles Bond Lawyers,” by Daniel Hertzberg, The Wall Street Journal, June 8, 1977; “The Muni E-Bond Revolution,” by John E. Petersen, The Magazine of States and Localities, April 2000; “The Mini trend in Municipal Finance: Minibonds,” by Christine L. Jadach, 19 Harvard Journal on Legislation 409, Summer 1982; South Carolina’s program, and; Sales this month of ten-year bonds in Bergen County, New Jersey,; New York City bonds,; Denver Justice Center bonds,]


There is a space between making a donation to a cause, on the one side, and making a loan or buying shares on the other side.   Some charities and political campaigns have moved a bit into that space, by offering ways for donors to participate in the organization’s activities.  The appeal is to a motivation beyond that reached by auctions, souvenirs, name recognition and other perquisites.  It is directed to a desire to be a part owner, economically and in governance.  Some businesses are finding ways to be in that same fundraising space, to offer a sense of ownership, without running afoul of the securities laws.  Several approaches, called “Crowdfunding,” are described in:; Crowdfunding.pdf;  and  Jeff Howe, in his book, Crowdsourcing says:  “Crowdfunding isn’t new.  It’s been the backbone of the American political system since politicians started kissing babies.”   [Jeff Howe, Crowdsourcing: Why the Power of the Crowd Is Driving the Future of Business, Crown Business, 2009, page 253] A detailed paper on crowdfunding was presented by Professor C. Steven Bradford  "Crowdfunding and the Federal Securities Laws," October 7, 2011. [

People who “donate” through crowdfunding usually receive a product of minimal value in return.  As one site puts it:  To contribute, just browse and select a business and click the blue “Back This Venture” button. You can then choose the level of funding you’d like to give and select your reward.”  [ crowdfunding sites have proliferated, some have gone beyond "only token compensation such as coupons or free samples," including "a 2% cut of the store's revenue over four years."  [Emily Maltby, "Tapping the Crowd for Funds," The Wall Street Journal, December 9, 2010, page B5]  By January 2012, crowdfunding sites in operation included:,,, and  There were even several sites which listed crowdfunding sites.  [;]

“Many entrepreneurs have found that they don’t need to borrow funds or sell equity in their companies – if they have a solid fan base, there are many ways to tap into that resource for funds.  Strategies in this category include pre-selling, customer financing, crowdfunding, memberships, donations, and sponsorships.  The great thing about this strategy is that securities law does not apply.”  Examples: “Awaken Café – pre-sold “café-creator” cards that allowed them to fund the build-out of the café and entitled buyers to purchase products once the café was open – raised over $14,000!  Little City Gardens – told its story on a crowdfunding site and solicited donations in exchange for t-shirts, stickers, newsletter subscriptions, etc. – raised over $17,000!”  [Cutting Edge Capital,]Examples of projects are dramatized by Kenton Powell, “Crowdfunding: The New Venture Capital,” Bloomberg Businessweek, October 24-30, 2011.  Examples of projects are dramatized by Kenton Powell, “Crowdfunding: The New Venture Capital,” Bloomberg Businessweek, October 24-30, 2011.

According to the Fan-Funded Forum website, there are numerous offerings being made to sports, music and art fans.  However, many of them seem to have intermediaries who operate and charge like brokers.  [,]  (We had an intriguing call in the early 1990s, asking us to meet with a lawyer for members of the Grateful Dead.  It ultimately didn’t go anywhere and then Jerry Garcia died in 1995.  The band was a great “what if” exercise for a virtual DPO.  It had a data base of 150,000 deadheads for its magazine/catalog, most of whom were the “true believers” that form the base for successful direct offerings.  Shares could be sold at concerts.  The prospectus could have a Garcia-designed cover and the perquisites to be offered shareowners would be a marketer’s dream.)

Crowdfunding and fanfunding websites have been raising “donations.”  ProFounder [] reportedly has about 500 start-up businesses using its site and charges $1,100 each.  Donations have averaged $1,300 and amounts raised about $30,000.  IndieGoGo charges six percent of the amounts raised through its site, which it says totaled over $1 million for 24,000 projects in the last three years.  [Angus Loten, “Crowd-Fund Sites Eye Boom,” The Wall Street Journal, May 12, 2011, page B10]  Jessica Jackley, co-founder of microfinance fundraiser Kiva, started ProFounder and is already offering an investment structure.  ProFounder would show the entrepreneur how to comply with securities laws and calculate payments to investors of a share of each quarters’ revenues.  []  “The platform has coordinated 14 successful raises with over $350,000 raised. The total average individual raise is $26,000 and the average number of investors is 20. Currently 530 startups are in the process of raising funds using ProFounder.”  [Leena Rao, “Crowdsourced Fundraising Platform ProFounder Now Offers Equity-Based Equity Tools,” TechCrunch, May 3, 2011] 

In July 2010, the Sustainable Economies Law Center petitioned the Securities and Exchange Commission to adopt a “new exemption for securities offerings up to $100,000 with a limit of $100 per investor.  In April 2011, SEC Chairman Schapiro mentioned this petition in response to questions from Congressman Darrell E. Issa, including one about crowdfunding. The Chairman acknowledged that: “Interest in crowdfunding as a capital formation strategy that offers investors an ownership interest in a developing business and the promise of an opportunity for a return on invested capital is growing.” She also noted that:  “The petition has received almost 150 comment letters, all in favor of the creation of such an exemption, with some offering different thresholds for offering size and/or individual investment limits. The comment letters are available at”   However, referring to the Commission’s earlier Rule 504 exemption, for offerings of up to $1 million, the letter says, “In light of investor protection concerns about fraud in the market in connection with offerings conducted pursuant to this exemption, the exemption was significantly revised in 1999,” citing Release No. 33-7644, Revision of Rule 504 of Regulation D, the "Seed Capital" Exemption (February 25, 1999), [, page 22, 23.  See Wall Street Journal, April 9-10, 2011]  The revision the Chairman mentioned simply allowed Rule 504 shares to be freely traded only if they had been registered in one or more states.  SEC Release 33-7644, February 25, 1999,]   

 On September 8, 2012, the Obama administration spoke in favor of the SEC adopting a crowdfunding exemption, for offerings of up to $1 million, as well as raising the Regulation A “exemption” from $5 million to $50 million.  []  However, the SEC’s September 13, 2011 response was to refer the crowdfunding subject to its Advisory Committee on Small and Emerging Companies.  []  Two days later, Meredith B. Cross, Director of the SEC’s Division of Corporation Finance, in Congressional testimony, explained that, in the beginning of crowdfunding, individuals “were either simply donating funds or were offered a ‘perk,’ such as a copy of the related book.  As these capital raising strategies did not provide an opportunity for profit participation, initial crowdfunding efforts did not raise issues under the federal securities laws.”  Director Cross expressed her concern that an exemption from the securities laws for profit participation securities “would present an enticing opportunity for the unscrupulous to engage in fraudulent activities that could undermine investor confidence.”  [A footnote to her testimony acknowledged “that the antifraud provisions of the federal securities laws continue to apply” to unregistered offerings.  September 15, 2011, and News Brief by Cydney Posner,]

Congress has gone around the SEC to enact a crowdfunding exemption.  The same day as the SEC’s Cross testified, the Committee’s chairman, Patrick McHenry (R-NC) introduced HR 2930, the “Entrepreneur Access to Capital Act.”  [  A podcast of conversation with Congressman McHenry is available at]  As introduced, it would no longer require registration under the Securities Act, or registration under state laws, if a business sold no more than $10 million in securities in a year and if no one investor bought more than $10,000, or 10% of the investor’s annual income.  [An outline description of the bill by John Tozzi, "Don't Call It an IPO," is in Bloomberg Businessweek," November 21-27, 2011, page 66] The bill passed the House Financial Services Committee on October 26, 2011 and the full house on November 3, 2011, by a 407-17 vote.  []  The Senate Committee on Banking, Housing and Urban Affairs, which held.hearings on  HR 2190 and companion bills on December 1, 2011. []. Comments in favor of the bill are described by John Berlau, director of the Center for Investors and Entrepreneurs at the Competitive Enterprise Institute.  [“Making it Legal to Tweet For Investors,” The Wall Street Journal, November 4, 2011, A19]  Arguments against are included in an article by Sarah E. Needleman and Angus Loten, “When ‘Friending’ Becomes A Source of Start-Up Funds,” The Wall Street Journal, November 1, 2011, page B1.  For a proposed Politico ad supporting the bills, see and]  A series of  crowdfunding bills were introduced in the Senate.  [S 1791, S 1970 and S 2190 .  See

“Crowdfunding” is Title III of the “Jumpstart Our Business Startups Act,” signed into law April 5, 2012.  The elegantly short bill introduced as HR 2190 became very complex when it was joined with several other bills to become HR 3606.  The major change was a victory for Wall Street and its traffic cops, the SEC and state securities administrators.  The "exemption" was reduced from the proposed $10 million to $1 million in securities offered to the public and a business will have to hire an intermediary.  Direct public offerings would not qualify for the exemption from pre-approved filings with the SEC and the states.  That is a major step backward from SEC Rule 504, which allowed $1 miiion direct public offerings.  The business would either have to use a securities broker-dealer or a “funding portal.”  A definition of funding portal is added at section 3(a)(80) of the Securities Act of 1933 and an new section 4A is added to include the requirements for funding portals, including their registration with the SEC and with a self-regulatory organization governed by the SEC.  You can expect more details and more requirements in SEC regulations.   

A few weeks after the JOBS Act was passed, the SEC issued this warning:  “The Act requires the Commission to adopt rules to implement a new exemption that will allow crowdfunding. Until then, we are reminding issuers that any offers or sales of securities purporting to rely on the crowdfunding exemption would be unlawful under the federal securities laws.”  [Information Regarding the Use of the Crowdfunding Exemption in the JOBS Act,] Lobbyists are competing to be the trade association for the new funding portal segment of the financial sercives industry.  [Robert Schmidt, "Lobbyists Wanted: No Experience Required," Bloomberg Businessweek, May 29-June 3, 2012, page 31]


Peer-to-Peer Financing/Social Lending

Social websites are all about direct communication among people with shared interests.  Around 2007, several of them sprang up for people to lend each other money, without going through any intermediary.   As they started out, these "P2P" sites allowed borrowers to post the amount, term and purpose of the loan they wanted.  Lenders could then bid the amount they wished to lend and the rate of return they were looking for.  The site manager’s role was limited to operating the site, assigning ratings based on a borrower’s credit history and administering the loans. 

Most of the early P2P sites had researched and complied with state lending laws.  However, they did not deal with federal and state laws for selling securities.  That all came to a head in 2009, with regulatory challenges.  Some sites closed permanently, while others were reopened after settlement agreements with the SEC and the North American Securities Administrators Association.  The survivors were forced to go through contortions to comply.  Several of the sites have introduced financial intermediaries—mutual funds or broker-dealers—into the middle of the money flow, so that it is no longer a direct relationship among members of a community.  [For a description of what the sites were like just before 2009, see Direct Community Finance.htm.  A more recent commentary is by Joe Light, “Would You Lend Money to These People,” The Wall Street Journal, April 14-15, 2012, page B7, B10]

Prosper Marketplace was imported from England and became the early leader for P2P sites in the United States.  Since it was launched in 2006, it has made over $280 million in loans and has over a million members []  Lending Club has funded nearly $460 million in loans.]   When the regulatory battle came, Prosper spent $4 million dealing with it, even shutting down its operations for nine months.  Prosper's lobbyist got the House to put P2P lenders under the jurisdiction of the new consumer agency to be created by the 2010 Dodd-Frank reform bill, but the SEC blocked the provision in the Senate.  Prosper's CEO Chris Larsen claims the company now spends more than $1 million annually on legal fees and audits, and makes more public disclosures--about two a day--than almost any other company.  The filings include details on each potential borrower's credit score and why they need money.  [Robert Schmidt and Jesse Westbrook, "An Online Lender Takes On the SEC," Bloomberg Businessweek, June 14--20, 2010, page 25]

By 2011, small business loans have increased to about 10% of the lending on the two major peer-to-peer sites.  [Angus Loten, “Peer-to-Peer Loans Grow: Fed Up With Banks, Entrepreneurs Turn to Internet Sites,” The Wall Street Journal, June 16, 2011, page B10]  You can keep up with developments in P2P or Social Lending at,, and  Other P2P sites provide rental markets for automobiles, homes, tools and other privately-owned property.  [Barrett Sheridan, "Stranger, You Can Drive My Car," Bloomberg Businessweek, December 13-19, 2010, page 39,]The investors in P2P loans were initially individuals dealing with their own money and making their own analysis and decisions.  By 2012, mutual funds, hedge funds and wealth management firms had invested in the two major P2P sites.  Lending Club had 30 institutional investors with $170 million invested, reaching 40% of its total loans, while Prosper had $40 million from institutions, about 50% of its loans.  

Angel Investors

Venture capital in the 1950s meant investment partnerships of wealthy individuals who sought out early stage businesses to support with their money and experienced judgment.  Then it morphed into professional money managers for huge institutional funds, taking percentage fees for betting on the companies that would soon do a Wall Street initial public offering, or quickly sell out to a big business. 

The lost spirit of financing entrepreneurs may have been reborn with “angel investors.”  These are usually local groups of individuals who meet to receive proposals and sometimes jointly make investments in young businesses.  A recent count came up with 340 groups of angel investors.  [Angel Capital Education Foundation,]  Between 10,000 and 15,000 angels belong to angel groups in the United States.  []Angel investments were made at an $18 billion annual rate during 2011, of which nearly 40% were for seed and start-up ventures. The average investment was just under $340,000 and 90% were made within a half day's travel time of the investors' homes.  [Center for Venture Research, University of New Hampshire, Jeffrey Sohl, Director,]

Some angel investors have become fairly large and diversified and are called “super angels.”  [Spencer E. Ante, “Super Angels Shake Up Venture Capital, Business Week, May 21, 2009,; Udayan Gupta, “Super-Angels Steal a March on VC, Institutional Investor, March 4, 2011,] Intermediaries have stepped in, offering to arrange meetings with angel investors for fees from $125 up to $5,000, a process called Pay-to-Pitch.  [Scott Austin, "Start-Ups Get Free Chance to Pitch to Angel Investors," The Wall Street Journal, June 17, 2010, page B5 and Ty McMahan, reporter for Dow Jones VentureWire, “Free Pitches,” The Wall Street Journal, August 16, 2010, page R7]

As angel investors become "super angels," or "micro venture capitalists," it may be inevitable that they evolve along the same path as venture capitalists did in the last century.  After successfully investing their own money, often in conjunction with other angels, they have begun raising funds from institutions and wealthy individuals, aggregating $8.5 million to $73.5 million each.  What elevates super angels into an unofficial upper class generally is the magnetic effect their participation in a deal has on other investors—a main reason entrepreneurs like to do business with them.  And, for super angels, investing has evolved into something more than a hobby.  These players are now raising funds with outside money, investing full time and competing with venture capitalists.”  [Pui-Wing Tam and Spencer E. Ante, “’Super Angels’ Fly In to Aid Start-Ups,” The Wall Street Journal, August 16, 2010 and "Big Tech Investors Want a Piece of the Micro Pie," The Wall Street Journal, January 27, 2012, page C3]  Is it just a matter of a few years before angel investing will have transmogrified into just another financial intermediary, collecting fees as money flows through?  Many websites purport to link entrepreneurs with angel investors.  Some seem to be facades for commissioned money-matching services.  Others, like, describe information services for communities of entrepreneurs and investors.  Similar functions seem to be promoted by KeiretsuForum, [] CapLinked [] The [] and AngelSoft []

Angel investors can share experiences through the Angel Investors Association, which has a list of members at  Doree Shafrir has described the peer-to-peer relationship between angel investors who built their own companies and the start-up entrepreneurs they finance and mentor. [Doree Shafrir, “Pennies from Heaven,” Newsweek, November 29, 2010, page 38,]

Scott Shane, citing the Census Bureau’s Survey of Business Owners, reports that only 2.7 percent of startup companies got financing from any outside source; only 2.8 percent of those seeking funds from angel investors actually received financing, citing, compared to less than a 0.2 percent success rate from venture capitalists.  [Scott Shane, author of Fool’s Gold: The Truth Behind Angel Investing in America, Oxford University Press, 2008, in “Why Equity Financing Eludes Startups,” Bloomberg Businessweek, July 9, 2010,]      

Search Funds

In the underwritten public offering arena, Wall Street has done “blank check” or “blind pool” offerings, where an experienced management team forms a corporation without any operating business or even a plan for a business.  Investment bankers sell shares to investors who trust that the managers will find a business to buy and operate profitably. 

What if the management team is just out of school, without ever having run a business?  Stanford Professor Irv Grousbeck helped conceive of the “search fund” and advises many of the entrepreneurs.  This definition of search funds is on the website for the Center for Entrepreneurial Studies, Stanford Graduate School of Business: “Conceived in 1984, the search fund is an investment vehicle in which investors financially support an entrepreneur's efforts to locate, acquire, manage and grow a privately held company. MBA and law school graduates are using this approach more and more frequently to become entrepreneurs, often shortly after graduation, despite a relative lack of operating experience.” [] This site has extensive written and video materials on search funds, including reports on its studies of search fund performance. The Center “has identified and tracked over 130 search funds raised since 1984, many of which have purchased companies successfully in the United States or United Kingdom. A 2009 CES analysis of 79 qualifying search funds found investor returns to be an average 37% IRR [internal rate of return] and 13.5x multiple of investment.”  []  Advice on the Stanford site includes:  “Search funders should contact high net worth individuals, most of whom were known beforehand. The goal is to amass a group of 10-20 individuals who each contribute $15,000 to $20,000 to fund the search, raising a total of $150,000 to $400,000. These funds are used to pay the entrepreneurs (frugally) and to cover the expenses of the search, which is expected to consume 1 to 3 years. . . . Search funders have been known to have anywhere from 8 to 25 investors.”

 More information about search funds is available from the Center for Private Equity and Entrepreneurship, Tuck School of Business at Dartmouth College, [Elnor Rozenrot, Case Study #50034, updated October 18, 2005, under the supervision of Adjunct Associate Professor Fred Wainwright, can watch a Wharton School of the University of Pennsylvania panel discussion about search funds at;jsessionid=a83035824d7da987595b1111f35a321e7024?CFID=10862081&CFTOKEN=46722360&jsessionid=a83035824d7da987595b1111f35a321e7024] Financial intermediaries already have their noses under the tent in search funds.  One venture capital/private equity firm has a section on its website about search funds.  []

Results have been mixed for investors in the 141search funds reported to have been started by mid-2010:  "Nearly one-third of search funds launched to date have lost all their investors' money. . . . And just 38% of all search funds have posted a positive return, down from 48% two years ago."  [Kyle Stock, "Risky 'Search Funds' Draw Entrepreneurs," The Wall Street Journal, July 12, 2010, page C1]


Money for most new businesses comes from their founders’ savings and personal borrowings.  A second round may come from “friends and family.”  These beginning businesses can only survive by keeping costs as low as possible, including what they pay for advice and services.  To meet this need, there are “incubators,” which provide operating space, office support services and some level of management consulting.  Many of them also introduce their tenants to venture capital or angel investors.

The first incubator began in Batavia, New York in 1959.  An example of contemporary business incubation is Plug and Play, started in 2006.  It  “provides startups with everything they need to get up and running quickly: office space, data and telecommunications services, networking events, recruiting services, and most of all, contact with fellow startups and potential investors.” [Robert D. Hof, “Keeping the Faith in Silicon Valley,” Business Week, August 24&31, 2009, page 058,] Prospective investors come to the site for presentations by the tenants.  Any investment is negotiated directly between the entrepreneur and the investor. 

The National Business Incubation Association is now 25 years old and has nearly 2,000 members, about 1200 of whom operate business incubators.  []  The Association says that the survival rate after five years is 87 percent for incubator clients, compared to 44 percent for businesses that don't use incubators.  About 80 percent of incubators begun in the past few years deal with businesses in one or two sectors.    [Lauren Hatch, "Betting on Incubators to Create Jobs," Bloomberg Businessweek, August 16-29, 2010, page 20]

The federal government has shown signs of supporting incubators.  The Business Incubator Promotion Act was introduced in the 2008-2009 and 2009-2010 sessions of Congress but hasn’t made it out of committee.  []  It would authorize the Commerce Department’s Economic Development Administration to make grants to incubators for operations and support services, in addition to construction and renovation projects.  Another bill would spend $250 million to fund business incubators targeting high-growth industries.  [Lauren Hatch, “Betting on Incubators to Create Jobs,” Bloomberg Businessweek, August 16-29, 2010, page 20]

Community Supported Agriculture

In Community Supported Agriculture, customers pay in advance for a share in the season’s harvest.  The farmer uses this money to grow food, instead of borrowing money from a bank and repaying it when customers buy at harvest time.  The United States Department of Agriculture describes it as “a community of individuals who pledge support to a farm operation so that the farmland becomes, either legally or spiritually, the community's farm, with the growers and consumers providing mutual support and sharing the risks and benefits of food production.”  [Alternative Farming Systems Information Center,]

Community Supported Agriculture is not only a way to market shareownership in food being grown for the table.  It has been used for other agricultural products.  Former television news producer Susan Gibbs has a flock of sheep and goats producing for her Internet wool and yarn business.  She offered a 1% share in the spring shearing, delivered as yarn or as wool for spinning.  Word of the offering was spread by bloggers.  [ and article by Robert Tomsho, “Shepard’s Tale” The Wall Street Journal, April 19, 2008,

Suppliers as Shareowners 

Just as a business can raise money from its customers, it may also have its suppliers become shareowners.  Fabindia sells hand-woven clothing and furnishings through its nearly 100 stores in India.  Started in 1960 by an American, John Bissell, Fabindia had $65 million in sales by 2008.  Its products are purchased from over 20,000 weavers, organic farmers and other artisans.  Each of the suppliers is encouraged to buy shares in the company, at $2 each.  Collectively, about 15,000 of them own over 25% of the business, with Fabindia employees and private investors owning the rest.  The shares can be sold, to other shareowners, during two periods each year.  [Manjeet Kripalani, “Weaving a New Kind of Company,” Business Week, March 23 & 30, 2009, page 064]

  Rights Offerings

One of the oldest direct securities marketing methods is the rights offering, where a business offers new securities to the people who already own its shares or debt.  The term “rights offering” comes from the days when U.S. corporation laws and corporate charters required the company to offer any new shares to the present shareowners, before they could be sold to outsiders.  Some European companies still have these “preemptive rights.”  Their purpose is to allow owners to maintain their same percentage ownership and not be diluted by a new issue sold to others.

In a rights offering, shareowners can purchase new shares in proportion to the number they already own.  They usually have up to 20 days to decide after receiving the offer.  There can be a timing advantage because rights offerings do not need the prior shareowner approval that would be required for companies listed on a stock exchange.  The requirement for SEC registration is the same as any other public offering, although many state securities laws exempt rights offerings from filings.  Because the offering price is usually a bit below any public trading market quotation, shareowners can sell their rights for someone else to use.

A rights offering can be handled entirely by the company.  If an investment banker has a role in a rights offering, it is a limited one.  They may provide a “standby commitment,” or “backstop,” to purchase any leftover shares at the offering price.  They may also act as a “dealer manager,” following up with shareowners to sell them on exercising their rights.  The commissions are far less than an underwritten offering.  As you might expect, investment bankers have generally frowned upon rights offerings. But one major corporate law firm proclaimed, in 2008, “the negative perception often associated with rights offerings is dissipating. The time is right for the rights offering to be viewed as a viable capital raising technique for U.S. issuers.”  []

Between 1935 and 1955, rights offerings accounted for about half of the common stock issues that exceeded $1 million each. Yet, since 1980, only a small percentage of public issuers in the United States used them, with the exception of the financial services industry.  In the last half century, corporations have gotten larger, small publicly-held businesses have disappeared and ownership is dominated by institutions.  The rights offering has little appeal to Wall Street money managers and speculators who purchase shares for short-term price movement, not for long-term shareownership of a business.  [Professor B. Espen Eckbo, Tuck School of Business, Dartmouth College, Equity Issues And The Disappearing Rights Offer Phenomenon,” Journal of Applied Corporate Finance, Vol. 20, No. 4, 2008, Page 72,]


An early opportunity to bypass Wall Street came with dividend reinvestment programs.  The first DRIPs were public utility corporations with large numbers of individual investors living in their service area.  They saw it as a way to recapture money they paid out in dividends.  For the investors, it was a way to increase their investment in companies they liked, without having to take money out of their spending budget.  It was also an exercise in “dollar cost averaging,” since they were buying in steady amounts, while the share price might be going up and down.  Most of the companies don’t charge for purchases and some even give a small price discount. 

The next step for DRIPs was to allow shareowners to invest more than the amount of their dividends, by adding their own money to the dividend amount.  Some businesses have even gone to letting someone buy their first shares directly, without ever having to go through a broker.  That led to direct stock purchase plans.  These DSPPs can include corporations that don’t even pay dividends but allow anyone to buy their shares directly. 

DRIPs and DSPPs are sometimes referred to as “no-load stocks,” because there is no commission paid by the buyer or the company issuing the shares.  They are very different from no-load mutual funds, although both are sold directly to the investor, without a financial intermediary collecting a fee.  The mutual fund is itself an intermediary, collecting money from people who buy its shares and then reinvesting that money in a portfolio of shares, bonds or other investments, while charging a percentage management fee.  DSPPs allow direct purchases of shares in an operating business.  Jeff Fischer of The Motley Fool describes the mechanics of DRIP programs at  Michael Robertson provides that service for DSPPs, at his Get Rich Slowly website.  []

Loyal3 is a transfer agent offering a DSPP that it calls Customer Stock Ownership Plan. or CSOP, a term first used by Louis O. Kelso in the 1950s. [Wendy Willbanks Wiesner, “Twist a Concept and Trademark It,” Investor Uprising, The Individual Investor Intelligence Network,]  If a company wants to raise money through selling its shares, it would still have to go to Wall Street.  “Both the IPO CSOP and Follow-On CSOP are offered alongside a traditional underwritten public offering.”  [  The process is described at]  Since the 1990s, another stock transfer agent, Transfer Online, has been offering a trading board for buying and selling existing shares.  []

In June 2011, the Nasdaq Stock Exchange announced that it would be offering a program for individuals to buy shares in participating companies, through a partnership with Loyal3.  According to John Jacobs, Chief Marketing Officer and Executive Vice President of The NASDAQ OMX Group, Inc.  "We're excited to offer eligible companies the opportunity to create deeper loyalty between their brand and consumers, and look forward to introducing a segment of the market that may not be currently investing to an easy, affordable stock ownership program."  [Nasdaq Press Release, June 2, 2011\ACQPMZ201106020807PRIMZONEUSPRX___223514.htm “They say they can turn the noninvesting customers of well-known, consumer-oriented public companies into shareholders, giving the companies more loyalty in both areas.”  [Brendan Conway, “NASDAQ Hopes to ‘Friend’ Investors in New Stock Pitch, The Wall Street Journal, June 3, 2011]  Loyal 3 said Nasdaq would begin selling its own shares through the plan. [Noreen Seebacher, “Selling Stock Through Social Media,” Investor Uprising, The Individual Investor Intelligence Network,; Ms. Seebacher has also written about the origins of Loyal3 and its CEO, “Nasdaq Social Partner Was Called on the Carpet,” ]  By February 2012, Holman W. Jenkins, Jr. reported:   "Today a reluctant Nasdaq spokesman will only tell us: 'We don't have a relationship with [Loyal3] any longer.'  What happened apparently was resistance from some of the exchange's key constituents, big retail brokers, who see Loyal3 as a competitor."  [Holman W. Jendins, Jr., "A Stock Market for the Rest of Us?" The Wall Street Journal, February 22, 2012, page A13]

Folio Services 

There are “folio services” firms for those who want to build a diversified portfolio with modest regular purchases.  They will purchase shares for individuals in a fixed amount each week or month.  The investor sets the amount and chooses the companies.  The service provider records ownership of fractional shares, to make the amount come out even. 

This automatic investing through a folio service is a useful way to employ “dollar cost averaging” and to provide the disciplined investing of set amounts at regular intervals.  However, the service doesn’t strip away the financial intermediary and create a direct relationship between the investor and the business.  The purchases are made in the trading market, rather in new issues that raise money for growing the business.  The company’s shares are only a marker for gambling on price movements and dividend yields.

When they started, the services were buying shares directly from the company.  While the folio services company was sort of a financial intermediary, the investor didn’t have to open a brokerage account.  Then, one of the folio services companies, Sharebuilder, which started as NetStock Direct in 1996, was acquired in 2007 by ING, the huge bank/broker.  It dropped the direct purchase feature and now promotes purchases in its own mutual funds and electronically traded funds.  ING Direct charges for each purchase.

Posting Services

Part of what a financial intermediary is supposed to do is to identify prospective investors and tell them about an offering of securities.  Nearly everyone who does that must be part of the broker-dealer monopoly.  If they don’t pass the tests and meet the qualifications for registration as a broker-dealer, the SEC, the Financial Industry Regulatory Authority and the state securities regulators can close them down, impose fines and put them in jail.  Anyone with a broker-dealer license must comply with the rules for acting as a go-between in a company’s sale of shares to investors.

A lot of ingenuity has gone into finding ways to assist businesses in raising money from public offerings, without being forced into becoming a broker-dealer.  Some of the attempts have been to escape supervision of nefarious practices.  But others have been motivated by a desire to provide an honest and open marketplace where entrepreneurs may display their proposals and investors can look them over—sort of a Craig’s List, where the offering business pays a fee to tell its story and the investor then deals directly with the business.

Since the early days of the Internet, there have been websites offering to find money for businesses.  Most sites that come up from a search turn out to be commissioned intermediaries.  Some of them offer to prepare business plans and others say they will provide all the services to locate, present, persuade and close a funding.  Some are registered broker-dealers, while others claim to do things that may or may not require that license.  One site that is close to simply posting is GoBig Network, which calls itself “an online network of funding sources. . . . You can either advertise to investors, with what we call a funding request posting or you can browse through our member pages and subscribe so that you can directly contact the members most relevant to you. Both of these paid services, the request and subscription, are available at either a monthly recurring, or one-time annual fee.” []  A key to avoiding regulatory interference is that only accredited investors may participate as prospective investors.

Another posting site is, which says “ is a website that introduces entrepreneurs and investors. Some fund raising efforts may require SEC and/or other regulatory approval. These issues should be reviewed on a case-by-case basis. does not guarantee the regulatory compliance of any post.”  [] There is no charge to register as an investor or to post a request for funding, by text or video.  Revenue for the site apparently comes from its sponsors and advertisers.


(Disclosure: From 1976 to 2008, we advised businesses in doing DPOs and I authored two books on the subject, Take Your Company Public The Entrepreneur’s Guide to Alternative Capital Sources, Simon & Schuster, 1991 and Direct Public Offerings: The New Method for Taking Your Company Public, Sourcebooks, 1997.) 

 DPOs—short for direct public offerings—are not just IPOs, skipping the investment banker intermediary.  Direct public offerings bring investors from a very different group of individuals.  To test this, we did follow-up surveys of people who had expressed interest in DPOs, including those who had purchased and those who had not.  We found that fewer than 10% of the investors had accounts with a brokerage firm, or had ever owned shares in a corporation, except through mutual funds or retirement plans.  Yet they had actually read the prospectus and done the same risk/reward analysis that you’d expect from a professional analyst.  Those who purchased shares intended to own them for an indefinite number of years, so their decision was based on long-term factors like management quality, competition and growth potential.

The Internet is a magnificent tool for direct public offerings.  Our client, Annie’s Homegrown, succeeded with the first Internet direct public offering in August 1995.  With later offerings, we were able to have prospective investors receive a share offering, read the prospectus, order shares and pay for them by credit card or online check—all in one sitting at their computer.  The power of raising small amounts of money through the Internet, from a very large number of individuals, has been dramatically demonstrated by recent political campaigns.  Professor William K. Sjostrom, Jr., Adjunct Professor of Law at William Mitchell College of Law, published a paper on “Going Public Through an Internet Direct Public Offering: A Sensible Alternative for Small Companies?” [53 Florida Law Review 529, 2001, available at SSRN:]

Federal and state securities regulation can be challenging for direct public offerings.  The structure and the mindset of the regulators is geared toward offerings through broker-dealers.  However, with some perserverance, DPOs have been successfully cleared and completed in all states. 

The ability to have a trading market may be used for choosing Wall Street rather than a DPO.  In fact, broker-dealers have been happy to provide a trading market for DPOs.  For smaller offerings, there are order matching services operated by the company or its stock transfer agent.  Community banks showed the way in DPOs, because banking regulations often required that they have many shareowners in their service area.before they could get their charter.  In February, 2012, SecondMarket announced a customized secondary market for community bank shares.  [  See Felix Salmon, "A private stock market for small banks," Reuters and Karen Weise, "SecondMarket's Unlikely Second Act," Bloomberg Businessweek, March 12-18, 2012, page 49]  

Why aren’t there more DPOs?  Some say the answer is tied to the personality of CEOs: that, like self-publishing for an author, they’re afraid people will think their business couldn’t attract an underwriter.  Cynics claim that the CEO needs someone to blame when an offering fails.  Others suggest that gullible CEOs actually believe the investment banker’s letter of intent is a firm commitment to underwrite the offering.   Executives could be put off by the need for direct offerings to comply with state filing requirements.  These filings are time-consuming and may result in blocking a direct public offering to residents of a state. By contrast, Congress exempted underwritten offerings from state laws, since they could be accepted for exchange listing.  [Securities Act of 1933, section 18(b)(1),]  The regulatory thicket is especially intimidating because nearly every experienced securities lawyer is with a large law firm, where they "only do underwritten offerings."  (We've had securities lawyers in those firms tell us that they won't risk offending their broker-dealer clients, or that they have reciprocal business referral understandings, where underwriters send them business and the lawyers refer prospective IPO clients to the underwriters.)  It's a similar picture when looking for an audit.  The big accounting firms are wedded to Wall Street and the smaller ones don't have the securities public offering qualifications.

Those entrepreneurs who get through the lawyer/accountant barriers find that resistance from the market is not a real limitation to marketing their securities.  Because over 90% of the DPO investors don't have an account with a securities broker-dealer, they are free of the "that's not the way it's done" syndrome.  Of course, the major limit on marketing DPOs is the individuals’ lack of money for investing.  As Jeff Gates puts it:  “Expecting a broad base of wage earners to buy their way into significant ownership (i.e., from their already stretched paychecks) is what I call 'Marie Antoinette Capitalism'—only instead of urging 'Let them eat cake,' the modern refrain is 'Let them buy shares.'"  [Jeff Gates, The Ownership Solution: Toward a Shared Capitalism for the Twenty-First Century, Addison-Wesley1998, page 23]

Louis Brandeis asked the same question about why there weren’t more direct offerings, back in 1913.  One of his Harpers Weekly articles was called “Where the Banker is Superfluous.”  As to why issuers nearly always use investment bankers, Brandeis said:  “It is not because the banker is always needed.  It is because the banker controls the only avenue through which the investor in bonds and stocks can ordinarily be reached.”  [Louis D. Brandeis, Other People’s Money: And How the Bankers Use It, Frederick A. Stokes Company, 1914, republished by National Home Library Foundation, 1933, Kessinger Publishing’s Rare Reprints, page 74] 

(I find some comfort in the history of other new ways of doing things, like the fax machine.  The first patent on facsimile transmission was issued in 1843 and the first commercial use began in 1922.  I remember watching a facsimile machine work in a U.S. Army show in the late 1940s.  My first one was a Xerox telecopier in 1976, which I kept in a closet because it smelled so bad.  Then they were suddenly ubiquitous from the 1980s until scanning caught on.)

One of our clients asked us to explain, for its board of directors and other backers, why a direct public offering would be good for the business and for society in general.  This is an edited version of our response:

Why a DPO is good for your business:

1.  A direct public offering is consistent with your values.  Creating a community, based upon shared beliefs, is a logical extension of your values.  The “small group of thoughtful, committed individuals,” from your Margaret Mead quotation, becomes even more capable of making change when it is joined in ownership of a national business.

2. Shareowners are better customers and goodwill ambassadors.  Businesses that have marketed shareownership directly to their customers find that shareowner customers purchase two to three times the average for other active customers. 

3.  Long-term shareowners provide stable relationships.  Individuals who have purchased shareownership directly from the business will generally have a several-year horizon for their investment and will hold through ups and downs, if they are kept informed with regular information.  This contrasts with institutional money managers and the securities analysts who serve them, who are generally focused on quarter-to-quarter performance. 

4.  Price volatility/litigation risk is reduced with community share ownership.  Money managers and other analyst-influenced investors tend to transact in large blocks and move as a herd on short notice.  The resulting large price changes can bring lawsuits.  Long-term individual investors do not sell on isolated events, particularly if they are kept informed, and they act independently.  They tend not to be interested in being part of a class suing their directors and management.

5.  Direct share marketing more efficiently manages capital formation.  Financing through intermediaries often requires catching “a window of opportunity” in the market, whether or not it fits with the uses a business has for new capital.  Direct public offerings are far less subject to fads, so they can be coordinated with capital budgeting. 

6.  Your shareowner communities support management’s vision.  Individuals who buy their shares directly from you have made their own decision to invest, not because of a broker’s recommendation.  They are joining your founders as shareowners, not just buying a financial instrument as an impersonal investment.  Hostile tender offers or proxy solicitations are not likely to attract them.  They can be marshaled to assist the business in issues involving customers, government agencies or the media.

7.  Individual shareowners require less management time.  Individuals do not expect to tell management how to run the business.  Nor do they seek selective disclosure of nonpublic information by quizzing management, unlike institutional money managers, who demand frequent CEO/CFO telephone interviews, in-person road shows and special reports.  Executives of companies that have marketed shares directly to individuals have found they spend a fourth as much time on shareowner communications as their institutionally-owned peers.

8.  You can use direct purchase plans to maintain market demand.  People who invest through brokers generally view it as a single transaction rather than a continuous process.  You can have a program for monthly share purchases through direct debits to the shareowner’s designated bank account. 

9.  Cost of capital will be lower with a DPO.  Transaction costs in a DPO are generally half or less than an underwritten public offering.  More significant, your offering price and number of shares offered are determined by the board of directors, rather than by a securities broker-dealer whose primary interest may be serving its buy-side customers with underpriced shares.

10.  DPOs don’t create shareowner veto powers.  Institutional investors, who dominate the underwritten offering market, have recently made demands on CEOs and directors about how they run the business.  Private financings, such as venture capital or “angel” investors, include covenants in the investment documents to restrict management.  When individuals buy in a direct public offering, they don’t expect to interfere in management.         

Why a DPO is good for society in general:

1. Direct share ownership increases democracy in business.  Much more of what affects our lives now emanates from business, rather than from government.  Yet, most “publicly-owned” businesses are actually controlled by a small group of professional money managers, using funds gathered from the public through retirement plans, insurance, public charities and mutual funds.

2.  DPOs cause a natural selection of businesses, so they reflect shared values.  Institutional money managers base their investment decisions upon limited risk/reward analyses about expected short-term share price performance.  We have seen that individuals invest in DPOs for dual motives:  They do the same risk/reward study (generally for a much longer term).  But they also involve their social and moral values in deciding whether they want to support this business.   Over time, surviving businesses will reflect society’s shared values.

3.  Individual shareownership provides better corporate direction.  The objectives of the “investment community” of brokers and money managers are different from the objectives of customers, employees, neighbors and other members of a business-based community.  Direct ownership helps people learn about business from the viewpoint of an owner, not just a consumer and employee.  They add a much broader perspective for management.

4.  Direct share ownership can free individuals from wage dependence.  The path to financial independence can be a long, slow one with diversified managed investments, like retirement plans and mutual funds.  In contrast, economic security frequently happens from the ownership of shares in one or two companies, through investment or employee stock options.  DPOs can bring financial independence to early investors, so that they can contribute their time, experience and wisdom without needing a salary.

5.  Direct shareownership provides a sense of power.  There is a frustration that comes from evidence that business controls governments, universities, think tanks and other powerful institutions.  Owning some shares, being able to vote for directors, participating in annual meetings—these can provide some sense that individuals can ultimately change the values and actions of business.

6.  Direct shareownership relieves the sense of alienation.  Most of us have an “us against them” attitude about business.  It may be the workers against the bosses or the powerless many versus the powerful elite.  Owning shares creates a sense of community, in the context of a business.  

7.  DPOs create new wealth, reversing the continuing concentration.  Ownership of capital has evolved into smaller and smaller percentages of the population, especially in the last few years.  Some broadening of ownership has come from employee stock options, which have made multimillionaires of a few thousand former wage earners.  DPOs bring that opportunity to individuals who pick the right early stage company.

8.  Businesses can survive that don’t fit the traditional mold.  Access to capital is usually a test of conformity.  Venture capitalists, bank loan officers, government small business program administrators, even “angel” investors tend to have conscious and unconscious standards that cause them to reject business concepts and entrepreneurs who are too different from the norm of their experiences.  DPOs allow people with new ideas to find others like them and join together in ownership.

9.  Owning shares directly allows people to vote with their capital.  So many of us question whether our political votes mean much at all.  Through DPOs we can use some discretionary capital to vote for a business concept, or a management team that may be effective in doing the right thing, as we believe that to be.  Our investment may be small, but DPOs bring together like-minded people, so that together we can make a difference.

10.  The ability to attract capital from individuals will be a competitive tool.  DPOs of corporate shares are the lowest cost, permanent capital available.  Businesses that can do DPOs to meet their objectives will succeed over those who must rely on traditional sources. 

(We have thought that DPOs would catch on if a high-profile business used the concept, so I’ve tried to recruit some very public opportunities to demonstrate how a direct public offering could work.  The companies have had communities of many thousand true believers.  They have had great stories and colorful leaders.  One was the Chrysler Corporation in 1979, the first time the federal government was asked to use taxpayer money to keep the carmaker out of bankruptcy.  Lee Iacocca had just been hired to sell its cars and turn the business around.  I wrote him and Chrysler board members, explaining how a direct public offering of shareownership to Chrysler’s “true believers” would raise the $1.5 billion that eventually came from taxpayer-guaranteed loans.  I never heard back, but it’s been fun to imagine what Chrysler’s path might have been the last 30 years with more than a million active individual shareowners.

Another “might have been” is Google.  Its 2004 IPO had been the subject of comments and competition for years before it happened.  Would it be a traditional underwritten public offering?  Who would be the managing underwriters?  What innovations could Google force onto the process? The final outcome was a “modified Dutch auction.”  Google set the minimum bid price and the total number of shares being offered.  Anyone could bid to purchase a number of shares at a price per share. Bids were accepted, starting with the highest price bid and proceeding down, until the total number offered were included.  All accepted bids were then at a price equal to the lowest accepted bid.  The modification came in Google’s last minute decision to price the offering even lower than the formula result.

I sent Google a letter in 2001 with reasons why it should do a direct public offering.  There was no reply and, given what Google has done as a public company, we can see why our arguments would not have been persuasive.  Here are the points from the letter: 

You don’t have to turn over control of your public offering.  In a DPO:

 •  You control the timing.  Individuals who already believe in Google will purchase all of the shares you wish to offer, whenever you choose to offer them.  You don’t have to fit through a “window of opportunity” defined by money managers and investment bankers.

  •  You control the amount offered.  Why sell $100 million in an initial offering, when your need for cash and for share liquidity could be met with a much smaller offering?  Direct offerings can be made to match operating needs, avoiding the pressure to invest excess cash.  Dilution can be reduced by a series of offerings, each priced to reflect increasing value.

•  You control the pricing.  Because you’re Google, all of the shares you offer will be purchased, almost regardless of the price.  Your board can set the price in a direct public offering, based upon a pricing analysis that is free from the drama of the first-day “pop” and the need to present favored professionals with trading profits.

 •  You control with whom you share ownership.  Direct public offerings are purchased by individuals who already have a relationship with the business.  The average investment is about $1,000.  Shareownership would reinforce the community you have created.

 • You control who joins your management.  You do not have to “put in place financial managers and processes that resonate with Wall Street,” in the words of the current Business Week article.  With direct public offerings, your board can continue to use its own experience and wisdom.

 • You control the offering process.  Your direct offering can be designed, staffed and implemented under your direction.  Communications with investors will be electronic, without the road shows, one-on-ones and unexpected diversion of management time and resources.  You don’t have to compromise your way of doing business to go public.  In a DPO:

 • You are relieved from the pressure for quarterly performance and comparison with analyst-defined peer groups.  People who use your services will invest because they have watched an excellent team prove itself in an extremely competitive environment.  They have no short-term expectations.

 •  You will have a much more stable aftermarket price.  Volatility is very much affected by having large blocs of shares held by professional money managers who act alike.  After a direct offering, you will have thousands of individuals, holding small amounts each, with long-term objectives and making their own independent decisions.  (On the myth that you need an underwriting to have an exchange listing:  We find, however, limited evidence that a listing on any of the major global exchanges brings an advantage in valuation or liquidity.” [David Cogman and Michael Poon, “Choosing where to list your company:  How much does choice of listing location matter? Investors will follow good companies no matter where they list, McKinsey Quarterly, February 2012])

 •  You will have far less concern over shareholder litigation. Sudden share price drops create the profit in shareholder class actions.  Market prices after direct offerings have moved gradually, even upon very negative news.  Because you have managed your own offering, you will not be attacked for claimed abuses in the distribution of shares.

 •  You will be free from interference with management decisions.  Individuals who have invested small amounts do not expect any participation beyond the annual shareowners’ meeting.  You will not be threatened with analyst downgrades or major sales if you ignore recommended mergers, acquisitions, alliances or policy shifts into the latest trend.

•  You will spend far less time servicing shareowners.  Direct purchases will include an election to receive all communications from you by posting on your website and email.  Your SEC filings and news releases will be sufficient.  You will not have to hold telephone conferences or attend analyst/money manager meetings.

Facebook, the social networking site, created a lot of attention from speculation about how it would do its IPO. One reporter said Facebook "is consciously trying to out-Google Google" by signaling it may eliminate investment bankers in its inititial public offering. Facebook's CFO had reportedly met with buy-side fund managers about doing a $10 billion direct public offering, alfthough some say it was an attempt to negotiate an underwriting fee lower than Google's 2.8%.  [Randall Smith, "Facebook Could Shun the Street," The Wall Street Journal, November 30, 2011, page C3, quoting Max Wolff, chief economist of GreenCrest Capital Management LLC]  The Money & Investing editor of The Wall Street Journal has written that:  "By virtue of its size, business model and popularity, Facebook is the rare company that doesn't need Wall Street to go public.  It should press home the advantage and blaze a trail for others to follow."  [Francesco Guerrera, "Facebook's $10 Billion Question," Current Account, The Wall Street Journal, December 13, 2011, page C1, C2]   When Facebook filed with the SEC, however, it was for a conventional Wall Street underwriting, where the shares "will be divvied up among the best customers of" the six broker-dealers, who "will set the ilnitial trading price and rig it to jump up nicely on the first day of trading--handing their clients a sweet, guaranteed return.  Only then will Joe Investor (a designation that includes most of Facebook's 845 million users) get a chance to buy a piece of the social network . . .."  The result?  "But even tech companies that claim they will resist outside pressure soon find that the demands of Wall Street are as inexorable as gravity. . . . Whether it likes it or not, Facebook will now be accountable to a lot of people who do not share its values."  [Brad Stone, "Friends With Benefits,"   Bloomberg Businessweek, February 6-12, 2012, pages 10, 11,]          

(The DPO process is described at  Case studies of some of the DPOs we advised are at  


Microlending as an organized process began with Muhammed Yunus and his founding of the Grameen Bank.  “Grameen” stands for “community” and the bank is still today more than 90% owned by its borrowers.  The very small loans are usually to create entrepreneurs from the working poor.  Information on a continuing basis about microfinance, with several stories a day, can be gathered from Micro Capital [  See also Elaine L. Edgcomb and Joyce A. Klein, Opening Opportunities, Building Ownership: Fulfilling the Promise of Microenterprise in the United States, Aspen Institute, 2005, and]

Microlending changed dramatically after The Nobel Peace Prize was awarded in 2006 to Grameen Bank and Muhammed Yunus.  Suddenly, financial intermediaries saw the opportunities in the high returns and low default rates of microlending.  It was the same story as with venture capital investing in the 1980s.  New for-profit funds were created.  Portfolios of microloans were sold as collateralized loan obligations.   Microlending grew at 50% a year from 2006 into 2009.  [Eric Bellman, “India to Track Microloan Borrowers,” The Wall Street Journal, March 10, 2010, page A19]  One microlender, SKS Microfinance, backed by venture capital institutions, had a $250 million initial public offering and listed on the Bombay Stock Exchange and the National Stock Exchange of India.   Banco Compartamos, a microlender in Mexico, completed a $467 million IPO in 2007 and has been criticized for charging interest at an average 68% average rate.  [Bruce Einhorn, with Ruth David, “An IPO for India’s Top Lender to the Poor,” Bloomberg Businessweek, May 10—16, 2010, page 16]  In the United States, microlenders loaned $57 million in 2008, as their attention turned to financing going businesses that could no longer get bank loans.  [Karen E. Klein, "Microfinance Steps into the Funding Breach," Bloomberg Businessweek, June 28-July 4, 2010, page 48]

As microlending caught on and seemingly everyone jumped in, there have been abuses.  Some of the new lenders have ignored the community support side of the Grameen model, charged much higher interest rates and enforced payment in unlawful and physically dangerous ways.  Some of the borrowers have gotten loans from several microlenders, taking on more debt than they can repay.  [Ruth David, "In a Microfinance Boom, Echoes of Subprime," Bloomberg Businessweek, June 21-27, 2010, page 50]  Several organizations are working to maintain the principles, and the very low default rate, by subscribing to “Client Protection Principles,” like avoiding over-indebtedness, disclosing all the costs, not overcharging, avoiding abusive or coercive collection practices, having a mechanism for problem resolution and respecting the clients’ privacy.  [] One study concluded that microfinance "appears to have no discernible effect on education, health, or womens’ empowerment."  [Abhijit Banerjee, Esther Duáo, Rachel Glennerster, Cynthia Kinnan, "The miracle of microfinance? Evidence from a randomized evaluation," June 30, 2010,  But see analysis by David Bornstein, "Grameen Bank and the Public Good, The New York Times, March 24, 2011,]  A United Nations working paper describes the economic and self-esteem benefits of microfinance but argues that the poor also need government-run finance and education.  [Anis Chowbury, "Microfinance as a Poverty Reduction Tool--A Critical Assessment," DESA Working Paper No. 89,  See critique by Doug Henwood, Wall Street: How It Works and for Whom, Verso, 1997, pages 313-314]  

Where will Microfinance fit with the established financial intermediaries?  A report from the leading consulting firm to big business “argues that the time is right for banks to step up their efforts to serve micro-, small and medium-sized enterprises (MSMEs) in emerging markets.”   Following the practices recommended in the Report “could raise profits after tax from ~$50 to ~$130 million per annum.”[Mutsa Chironga, Jacob Dahl, Tony Goland, Gary Pinshaw and Marnus Sonnekus, Micro-, small and medium-sized enterprises in emerging markets: how banks can grasp a $350 billion opportunity, McKinsey & Company, April 2012, Executive Summary, pages 1, 2,]

The Bill and Melinda Gates Foundation gave $19.4 million to Mercy Corps to create a “bank of banks” to work with the more than 50,000 microfinance institutions in Indonesia, to test whether “linking diverse and small financial institutions together is a commercially viable and effective way to make savings, loans and other products more widely available to the poorest people." [Bob Christen, Director of Financial Services for the Poor at the Bill & Melinda Gates Foundation, at]  According to The Wall Street Journal, the Gates Foundation is testing whether “commercial enterprises—banks and other profit-seeking businesses—can best serve the broadest swath of people by using tools such as capital markets to fund expansion.”  [Robert A. Guth, “Giving a Lot for Saving a Little: Gates Foundation to Invest in Programs to Help Collect Deposits for the World’s Poor,” The Wall Street Journal, July 31, 2008,]

The nonprofit Accion International has established its Center for Financial Inclusion, "to advance the commercial model of microfinance while upholding the interests and needs of poor clients worldwide. . . .to connect the microfinance community with the major drivers of the global economy – e.g. capital markets and technology – and harness their capabilities to address the financial needs of poor people." 

While microlending is being pursued by financial intermediaries and charitable institutions, others are working to keep both the lending and the source of funds within the community.  One way is to provide a method for community members to save.  The Consultative Group to Assist the Poor has found that “savings accounts in financial institutions serving the poor outnumber microloan accounts seven to one.”  []  Executives of the Grameen Foundation have said: “Well-designed savings products help clients plan for the future, create new business products for MFIs (microfinance institutions), and mobilize additional capital for MFIs. For even the very poorest, for whom many credit products currently being offered by MFIs may not be appropriate, savings may be a useful tool to help them access financial services.”  [Alex Counts, President and CEO of the Grameen Foundation and Patrick Meriweather, its Director of Business Development, New Frontiers in Micro Savings, March 2008,  []

Grameen Bank has shown how a microlender can be free of dependence upon outside funding.  Muhammad Yunus responded to an interviewer’s question about the difference between philanthropy and the Grameen Bank: “We stopped taking any external money in 1995. . . . But earlier, when donors wanted to give us money, we were always swayed and took the money.  If donors hadn’t given us the money, we would have discovered earlier that we have the strength.  If it’s a business, it should be running as a business.” [Business Week, November 27, 2006, p.82]  Mr. Yunus has expressed his opposition to the attempts to imprint microlending with the Wall Street business model.  "Microcredit should not be presented as a money-making opportunity.  It is an opportunity to make an impact on poor people's lives.  An IPO gives a wrong message."  [As quoted by Eric Bellman, "IPO Pits Profit vs. Altruism," The Wall Street Journal, July 9, 2010, Page C1, C3]  The Calvert Foundation, formed in 1985 by The Calvert Funds, issues "community investment notes" to about 7,000 individuals, in amounts as low as $20 and paying interest at a half percent to two percent, depending on the maturity date.   “The community investment notes are for people who want to make a difference but not give the money away,” according to Calvert spokeswoman Carrie McGarry.  [Jeff Benjamin, "Microfinance Investment Specialist Names New Boss," Investment News, January 7, 2011,]

But Wall Street and big charities are still trying to adapt microlending to the financial intermediary mode.  Wall Street is well on its way to ruining one of the greatest programs for making capitalists from the world’s poorest.   [Ketaki Gokhale, “A Global Surge in Tiny Loans Spurs Credit Bubble in a Slum,” The Wall Street Journal, August 13, 2009, page A1]  Using the statistics on returns on microfinance, Wall Street started over 100 funds, selling $30 billion in securities to individuals and institutions.  After taking out commissions and management fees, the remaining funds are used to buy stocks or bonds of small banks in the poorest countries.  [Rob Copeland, “For Global Investors, ‘Microfinance’ Funds Pay Off—So Far,” The Wall Street Journal, August 13, 2009, page A12]  By 2011, Muhammad Yunus would say, “I never imagined that one day microcredit would give rise to its own breed of loan sharks.”  In response to the claims that money for lending must come from the international credit markets, he pointed out that most of Grameen Bank’s 2,500 branches are self-reliant, without any outside funding.  “All borrowers have savings accounts at the bank, many with balances larger than their loans. And every year, the bank’s profits are returned to the borrowers — 97 percent of them poor women — in the form of dividends.”  [Muhammad Yunus, Sacrificing Microcredit for Megaprofits,” The New York Times, January 14, 2011,]  According to  David Korton, "The microcredit experience brings to light a larger principle: the institutional structure of a financial system determines where money flows and who benefits. In short, structure determines purpose." ["Microcredit: the Good, the Bad, and the Ugly," Yes Magazine, January 19, 2011,]

Which way will become the microfinance paradigm?  One participant suggests that there will be three paths, "straight commercial funds that obey the rules of the marketplace, social investment funds that explicitly combine social and financial aims, and pure grants. . . . Like any other donation or investment, a little research and due diligence beforehand can bring assurance that funders and those they entrust with their money share the same goals."  [Elisabeth Rhyne, Managing Director of ACCION's Center for Financial Inclusion, "Funding the Risk Frontier in Microfinance," The Huffington Post, September 11, 2010,]

Alternative Investment Markets 

An important barrier to buying directly from the issuer is the fear that the securities will not have a ready market when there is a need or desire to sell.  Some new stock trading markets have been created for smaller businesses.  The Alternative Investment Market, started by the London Stock Exchange in 1995, has listed over 3,000 "smaller and growing companies."  []  In 2009, Chinese regulators started ChiNext, "tailor-made for the needs of enterprises engaged in independent innovation and other growing venture enterprises. [] ChiNext operates within the Shenzhen Stock Exchange and had 141 listings in December 2010, while the Small and Medium Enterprise Board had 518 listings. []  In the U.S., a new BX Venture Market, to be operated by NASDAQ, received SEC permission to operate, on May 6, 2011. []  The American Stock Exchange and the Pacific Stock Exchange each operated small company exchanges for a few years in the 1970s and 1980s before they were discontinued.

 Since at least the 1950s, many individual securities brokers have maintained "matching services" for trading in local banks and other  businesses.  They keep a list of people who have expressed interest in selling and those who say they'd like to buy shares.  When they have a match, the brokers arrange for the transfer and payment.  Their motive is usually to develop local customer relationships.

In the last two or three years, some registered securities broker-dealers have begun operating matching services for much larger companies that have not yet had their initial public offering.  The services allow employees and early investors to cash out, selling to people who want to buy in before the IPO.  The companies, and the SEC, are watching to be sure the trading does not result in more than 500 shareowners, triggering the requirement to register and report publicly with the SEC.  [,   See the agenda for the May 11, 2011 conference on the “Private Company Stock Market,”]

These matching service markets would get a boost from the Private Company Flexibility and Growth Act (HR 2167), introduced June 14, 2011 by Arizona Congressman David Schweikert and reported out of committee October 26, 2011. [].  “Officially, the bill aims to increase from 500 to 1,000 the number of investors a company can have before it is required to publish its financial information. But in reality, it would simply delay companies from going public – thereby encouraging trading in secondary markets that are rife with questionable practices and shutting out the average investor.”  [Coldain, “’Facebook Rule’ Would Delay IPOs, Open Door to Secondary Market Excesses”, Jun 17, 2011,]

Brazilian marketing consultant Cecco Grecco persuaded Bovespa, the Sao Paulo Stock Exchange to sponsor a Social and Environmental Stock Exchange. (  It is not really a trading market.  Rather, it operates more like the P2P social lending sites.  Charitable organizations submit their funding proposals to a team of evaluators, who review plans, interview principals and make site visits.  The one in ten that passes this inspection is then listed.  Donors can choose to contribute toward the amount posted. [“A Stock Exchange for Do-Gooders,” Mac Margolis, Newsweek, June 9, 2008, page 56.] 

Dead Ends—Direct Routes That Were Blocked

(In watching the havoc caused by mortgage securities and their derivatives, I often indulge in a couple of “what ifs” from my own experience.  One was the effort to create the Automated Mortgage Market Information Network (Amminet.)  My client, Remote Computing Corporation, was hired in the early 1970s to design and host a computer program for trading in mortgages.  The project was sponsored and funded by the federal government agencies and government-sponsored entities in housing finance.  The concept was that mortgage lenders would post information about packages of loans they were willing to sell.  Money managers for funds could access the data on a computer terminal and use the telephone to negotiate and arrange to buy mortgages.  This was about the same time as the National Association of Securities Dealers Automated Quotation (Nasdaq) System was started.  It was initially just an electronic way for a securities dealer to post the prices at which they were willing to buy or sell a company’s shares.  Transactions would be negotiated by telephone.  Today, Nasdaq is a full electronic stock exchange.  Amminet could have developed the same way, as the Internet and other technological advances made it possible, except there would have been no broker in between the buyers and sellers.  As I recall, the Amminet program met resistance and ran aground.  If it had been allowed to operate, perhaps an active trading market would have preempted all the mortgage securities games that Wall Street ran into a huge catastrophe.  This was all 15 years before the Internet.  Remote Computing Corporation’s business model is now coming back as “cloud computing.”  [Steve Hamm, “IBM Reaches for the Clouds,” Business Week, April 6, 2009, page 034]

(The other “what if” was the Mortgage Trust Certificate.  My client was Coast Federal Savings and Loan Association, which was one of the largest S&Ls in the late ‘70s. Mortgage securities were in their infancy and Wall Street had not yet put together the Collateralized Mortgage Obligations that became tools of such mass abuse.  Our objective was to build a direct relationship between mortgage lenders and pension fund managers.  We would match the income and cash flow needs of pension funds with the return and payment projections of a pool of mortgages.  In those days, the mortgages made by S&Ls were tightly regulated and losses were negligible.  We got a mathematical consulting group to prepare the tools for matching mortgage pools to pension fund projections.  We generated interest from fund managers but needed a triple-A rating from S&P or Moody’s to get immediate and widespread acceptance.  The rating agencies were willing but we’d need a guarantee or credit default insurance from an AAA-rated corporation.  We met with two of them.  Maybe it would have worked eventually, but commitment waned at that stage and the opportunity went by.)   

Routes Around Securities Regulation

Whenever there is a “sale” of a “security,” the SEC and state securities regulators are involved.  You must either fit within an exemption in their laws or you must apply to register the securities and license anyone selling them.

The regulators and the courts have interpreted “sale” and “security” very, very broadly.  That’s not just to enlarge their turf.  The cases that present the question usually come from complaints by investors claiming fraud.  The alleged perpetrators are claiming that they weren’t selling securities, so they can’t be forced to comply with securities regulation.

How can a legitimate business raise money from strangers without all the securities law hurdles?   One of the most creative alternate routes is Kickstarter, started in April 2009.  It is a website through which “project creators” offer products, services or “rewards” to “inspire people to support their project.”  The site states flat out that it is not an “investment mechanism,” that project creators “keep 100% ownership and control.” []  The project creators set an amount of money which must be pledged by a fixed date.  If the goal is met, the pledges are charged through Amazon to credit cards and the project creator receives the funds.  If not, no one pays anything.  Kickstarter takes a 5% fee if the project is funded.  By mid-2010, over $1.5 million had been pledged among 5,000 projects on the Kickstarter site.  [John Tozzi, "Eight Companies Kick-Started by Fans," Bloomberg Businessweek, June 28-July 4, 2010 page43]

Kickstarter’s suggestions to project creators include: “The key to a successful project is asking your networks, audience, friends and family for help. Kickstarter is a tool that can turn your networks into your patrons; it is not a source of funding on its own.  Rewards are very important. Offer something of real value for a fair price. And more experiential rewards, things that loop backers into the story, are incredibly powerful.”[]  “Kickstarter has emerged as a legitimate option for financing independent films, where a six-figure project is on the low end. So far, the company has raised more than $21 million from nearly 240,000 backers for 2,443 films, according to co-founder Yancey Strickler. He says six films have crossed the $100,000 mark.”  The financings have also “created a fan base for the film.” [Ira Boudway, “Kickstarter: Financing Small Movies Online,” Bloomberg Businessweek, May 26, 2011,]

The simplicity of the Kickstarter program is all the more admirable, given the complexity of the securities laws, which protect the turf of the securities broker-dealer monopoly.  We have described “dual motive” investing, where individuals are offered the satisfaction of furthering their beliefs and values, while also getting a possible financial return.  Kickstarter caters to the first motive only, expressly disclaiming any investment payback.  Individuals can help someone they like achieve a goal in which they believe.  There may also be the fantasy that, if the project and creator are successful, they may be on the inside track to participate as an investor.  The possibility of that motivation is certainly not enough to turn the Kickstarter program into an investment, anymore than charity drives are when they offer prestige and visibility to their donors.  An author of several books, in an article about self-publishing, commented:  “If I need to cover upfront costs, I can always wage a modest campaign on the grassroots online fund-raising phenomenon Kickstarter, which has worked for me before.”  [Neal Pollack, “Peddling Your Prose,” The New York Times Book Review, May 22, 2011, page 31]

There will be more direct routes opening as Wall Street has become even less accessible by individuals and small businesses.  “When the systems break down, it sometimes falls on the do-it-yourselfers to do what they need to do.”  [Frank Silverstein, Producer of MSNBC’s “Your Business,” in an October 2008 email to me.]  Some of the new routes will survive attacks from Wall Street and the traffic cops who protect Wall Street.  As the head of one alternative to Wall Street predicted:

The era of Wall Street domination is over.”

“It may take ten years, or fifty years, but the signs are clear. A relative few committed investors are driving the shift to an entirely new approach to working with money.

”If today's capital markets can be described as complex, opaque, and anonymous - based on short-term outcomes, we are beginning to see more and more financial transactions that are direct, transparent, and personal-based on long-term relationships.”  [Don Shaffer, President & CEO of RSF Social Finance, “Notes From the Leading Edge of Social Finance,” GreenMoney Journal, Spring 2010,

The Traffic Cops on Wall Street


Plenty of government departments have been set up to police Wall Street.  The problem is that they operate like the old protection racket—“We’ll let you get away with doing wrong—and we’ll chase away your competitors—if you pay us off.”  For elected officials, the payoff is campaign contributions and other favors.  For government employees, it is the offer of high-paying jobs after they’ve put in their time in “public service.”  David Stockman, former budget director for President Reagan, said in a January 20, 2012 interview with Bill Moyers: “We now have an entitled class of Wall Street financiers and of corporate CEOs who believe the government is there to do . . . whatever it takes in order to keep the game going and their stock price moving upward,” [  See, also, GMoyers & Company Show 103: How power and influence helped big banks rewrite the rules of our economy. from on Vimeo.

It’s not a new issue.  President Andrew Jackson complained in 1833 that a banking corporation “had been actively engaged in attempting to influence the elections of the public officers by means of its money” and asked “whether the people of the United States are to govern through representatives chosen by their unbiased suffrages or whether the money and power of a great corporation are to be secretly exerted to influence their judgment and control their decisions.”  [] Currently, we have this from Arthur Levitt, founder of a Wall Street firm and former Chairman of the SEC:  "I don't know of a single member of Congress who is willing to resist the seductions of money and campaign contributions and the kind of flattery that comes from those who have special interests.

President Woodrow Wilson described the problem:  “We have been dreading all along the time when the combined power of high finance will be greater than the power of government. . . . If the government is to tell big business men how to run their business, then don’t you see that big business men have to get closer to the government than even they are now?  Don’t you see that they must capture the government, in order not to be restrained too much by it?  Must capture the government?  They have already captured it. . . .  Nevertheless, it is an intolerable thing that the government of the republic should have got so far out of the hands of the people; should have been captured by interests which are special and not general.  In the train of this capture follow the troops of scandals, wrongs, indecencies with which our politics swarm."  [Woodrow Wilson, The New Freedom: A Call for the Emancipation of the Generous Energies of a People, BiblioBazaar, 2007, pages 102, 23] 

President Franklin Roosevelt put it most colorfully:  "For out of this modern civilization economic royalists carved new dynasties. New kingdoms were built upon concentration of control over material things. Through new uses of corporations, banks and securities, new machinery of industry and agriculture, of labor and capital—all undreamed of by the fathers—the whole structure of modern life was impressed into this royal service.  There was no place among this royalty for our many thousands of small business men and merchants who sought to make a worthy use of the American system of initiative and profit. They were no more free than the worker or the farmer."  []  

George Stigler, a Nobel Prize Laureate in economics, built a career on the study of this “capture theory” of economic regulation.  His central thesis is that “as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit.” [George Stigler, The Theory of Economic Regulation,   University of Chicago, The Rand Corporation, 1971, p. 3.  See, also, George J. Stigler, “The Theory of Economic Regulation,” The Bell Journal of Economics and Management Science, 1971,]  At the level of the individual elected or appointed official:  "Nearly everyone in government has 'clients' to protect or advance, sponsors who often helped put them there."  [William Greider, Who Will Tell the People: The Betrayal of American Democracy, Simon & Schuster, 1992, page 66.  On page 258, Greider writes:  "If one asks, for instance, why the Democratic party never did anything during the 1980s to confront the various abuses and instabilities unfolding in the financial system, a power analysis of the party establishment might provide the answer. . . . The nation's leading banks and brokerages have assembled a formidable team of Democrats to protect them from hostile legislation [listing the names]."]  The regulated industry "owns" its regulatory agency, while industry members and lobbyists "own" the individual regulators and legislators.  However, “the Washington culture of influence peddling is not entirely, or even primarily, the fault of the corporations that hire the lobbyists and pay the bills. It’s a vast protection racket, practiced by politicians and political operatives of both parties.”  [[Michael Kinsley, “How Microsoft Learned the ABC’s of D.C.,” Politico,]

 In 635 pages, a bipartisan U.S. Senate Report on the 2008 financial collapse illustrates the capture theory and its harm.  It “catalogs conflicts of interest, heedless risk-taking and failures of federal oversight that helped push the country into the deepest recession since the Great Depression.”  Referring to one federal agency, the Office of Thrift Supervision, the release says, “When diligent oversight conflicted with OTS officials’ desire to protect their ‘constituent’ and the agency’s own turf, they ignored their oversight responsibilities.”  [Senate Committee on Homeland Security and Governmental Affairs, Press Release, April 13, 2011,, pages 1, 3]  One writer referred to this as “a textbook example of regulatory capture combined with financial Stockholm syndrome.”  [Les Leopold, “How Wall Street Thieves, Led by Goldman Sachs, Took Down the World Economy—Their Outsized Influence Must be Stopped,” Alternet, April 25, 2011,, page 1]  One example of the capture theory in operation is the way the SEC brings civil cases against Wall Street's most flagrant violators.  Rather than refer the cases for criminal prosecution, it issues a shield with a settlement in which the violator "neither admits nor denies" the charges, but pays a fine equal to a small percentage of the ill-gotten gains. Commenting upon Judge Rakoff's refusal to accept one of these settlements with Citigroup, John Cassidy says "What is at stake is the government’s overall failure to bring to book Wall Street for its conduct during the credit bubble. . . . And so far the Justice Department hasn’t brought criminal charges against anybody."  [John Cassidy, author of How Markets Fail, in "Rational Irrationality," his New Yorker blog,]

Part of a protection racket, or capture theory, is for everyone involved to deny what is really going on and to have a consistent cover story.  That cover story needs to say that what’s happening is a legitimate activity, one that we all need; that it’s true there have been some rogue participants but we’re taking care of them.  Simon Johnson and James Dwak call this "cultural capital: the spread and ultimate victory of the idea that a large, sophisticated financial sector is good for America."  [13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, Pantheon Books, 2010, page 90]  Matt Lauer, on the Today television show for April Fools’ Day, 2010, asked Treasury Secretary Timothy Geithner, former president of the Federal Reserve Bank of New York, about policing Wall Street.  Geithner acknowledged that the recent past “was a crazy way to run a financial system” but that Wall Street was needed for “taking the savings of Americans and using those savings to finance growing businesses.”  This is the myth of capital formation, the cover story for protecting Wall Street’s monopoly for trading in securities.  The truth is that only a very tiny percentage of Wall Street’s activities move money from individual savings into growing businesses.

Wall Street should be a place where ethics prevails.  Its people are trusted with moving huge amounts of money in complex, secretive transactions.  It would seem that the most honest and fair individuals and firms would also be the most successful.   It doesn’t work that way.  Whatever ethical standards may have become a person’s character seem to be shed by the time they are in a Wall Street career, like a snake wiggling out of its skin.  What replaces those discarded ethics are rules.  Instead of guidance from within, life becomes governed by external stop lights, flashing go, stop and proceed with caution.  The question asked before taking action is not, “Is this right?”  It has become, first, “What’s in it for me?” Then, “Is this permitted?” and, if not, “Will I get caught?” 

Government Enables and Enforces Wall Street’s Monopoly 

From the beginning, securities regulation has not been about safeguarding the public.  Emphasis has always been placed on protecting the financial intermediaries from competition.  “A statute of Edward I, in 1285, authorized the Court of Aldermen to license brokers in the City of London, and there are records of a number of prosecutions against unlicensed brokers before the year 1300.”  [Louis Loss, Joel Seligman, Troy Paredes, Securities Regulation, Aspen Publishers, supplemented annually, Volume 1 of an 11 volume set, “Background of the SEC Statutes.”]  The English government established and enforced standards for licensed brokers, just as the English and United States governments do today.  A 1697 English statute set penalties for unlicensed trading in securities.  It also established fixed commission rates and required every transaction to be recorded.  Our Securities and Exchange Commission is still in that role, except that most fixed commissions haven’t been enforced since 1975.

Also just like today, the government in England was called upon to do something about a financial crisis three centuries ago.  Shares of the South Sea Company, which had been granted a monopoly on trading with South America, had risen from £128 at the beginning of 1720 to over £1,000 in July of that year and were back down to £125 by December.  Directors of the Company had sold £5 million of its stock at the top.  The government response was called the Bubble Act of 1720 and, instead of punishing or preventing the insider trading and price manipulation, it was directed at preventing imitators of the South Sea Company’s business.  The only real sanction was that brokers trading in the imitator companies could lose their license and pay treble damages.  This mismatch between the wrong and the remedy foreshadowed how governments would deal with later collapses, including the 2008 credit crisis.

In the same year we created the United States of America, insider trading by a broker caused our first “panic” and the first government reaction.  Securities traders and their agents had been meeting in a Wall Street coffee house to conduct the “open outcry” auctions that still take place on trading floors.  After the panic, New York State passed a law prohibiting “public stock auctions.”  The Wall Street coffee house regulars took that law as an invitation to create a monopoly.  They gathered under a buttonwood tree on Wall Street and agreed to a members-only market, escaping the new law’s prohibition on “public” auctions.  In their one-sentence agreement, they fixed a minimum commission for all members and agreed to give each other “preference.”   Neither this monopoly nor the price-fixing was disturbed by the government for nearly 200 years.  In fact, Congress placed the police powers of the SEC behind enforcement of rules made by members of the stock exchanges and the brokers’ trade association.   

The United States government has a particular conflict when it comes to reining in Wall Street.  Throughout our country’s history, the federal government has often found that it absolutely needed Wall Street to raise money for its own purposes.  The War of 1812, the Mexican War and the Civil War were largely financed through the connections of investment bankers to wealthy Europeans and Americans.  In 1894, President Grover Cleveland failed at selling Treasury bonds in Europe.  He then went to the leading investment banker of the time, J.P. Morgan, who sold the bonds and later issues as well.

When the government was unable to stop the Panic of 1907, Treasury Secretary George Cortelyou traveled to New York to ask Morgan to lead a rescue of Wall Street brokers.  After Cortelyou got the Treasury to deposit $25 million in New York banks, and John D. Rockefeller committed another $10 million, Morgan pressured the banks to lend $25 million to “cash-strapped stockbrokers, who have been unable to borrow and are facing ruin.”  Morgan also bailed out New York City by finding buyers for $30 million of its bonds.  He even persuaded the city’s clergy to preach sermons calling for calmness and confidence. [Federal Reserve Bank of Boston, Panic of 1907,

 The government has protected Wall Street’s monopoly by requiring anyone in the business of selling securities to be licensed by Wall Street’s own trade association, first the Investment Bankers Association, then the National Association of Securities Dealers and now the Financial Industry Regulatory Authority.  Attempts by other segments of the financial industry to muscle in on investment bankers have been stopped by the government.  Back in 1900, life insurance companies posed a serious threat to the underwriting business of investment bankers.  With the large capital they built to pay insurance claims, they could buy and resell new issues of securities.  The New York legislature appointed the Armstrong Commission in 1905 and, acting on the committee’s recommendation, the New York legislature prohibited life insurance companies from underwriting securities.  By 1907, twenty states had banned the practice and a major source of competition was quashed.  Charles Evans Hughes, the committee’s chief counsel went on to become New York Governor, Republican candidate for President against Woodrow Wilson, Secretary of State, Chief Justice of the Supreme Court and founder of a Wall Street law firm.  A similar encroachment by commercial banks was eliminated by the Banking Act of 1933.  

The Federal Reserve Subsidizes Wall Street

When J.P. Morgan died in 1913, Congress replaced him by creating the Federal Reserve Board and its regional banks.  The Fed operates as a fourth branch of government, owned by its members, which now include Wall Street investment banks.  Its powers are immense, affecting the economic lives of everyone on the planet.  The law has given Wall Street the power of the U.S. government over the supply of dollars and the cost of money.  Its basic purpose is to do what J.P. Morgan did—save the Wall Street monopoly from itself.  [William Grieder, Secrets of the Temple: How the Federal Reserve Runs the Country, Simon & Schuster, 1989]

Wall Street justifies its existence as being necessary to transform customers’ available cash into loans and securities, which provide money to businesses and governments.  Like any other intermediary, it needs to have a profitable spread between the cost of the money it acquires and the return on the money it provides.  That spread is not always available in the open market.  That’s where the Federal Reserve comes in.  The Fed has a bottomless supply of money and it has the power to set whatever interest rate it wants.  So all it has to do is to make that money available to its member banks, at a price that allows the banks to make a profit.  They can even make a profit simply by lending the money back to the federal government, through purchasing Treasury securities. 

This recycling of taxpayer money, with Wall Street siphoning off its percentage, has immense consequences for the rest of us.  By keeping short-term interest rates artificially low, and Fed borrowings plentiful, banks don’t need to pay individuals higher rates to get their money in deposits.  That’s nice for the banks, but what about all the individuals who rely on interest income from insured bank deposits for their rent and groceries?  "When they say the economy, they mean—the Fed means its constituency: the banks. And the banks’ product is debt. And that’s what they’re trying to produce."  [Michael Hudson, Amy Goodman and Juan Gonzalez, “Fed Creates Hundreds of Billions Out of Thin Air:  Have We Launched an Economic War on the of the World?,”, radio interview transcription at]  Low interest rates also mean that insurance companies and pension funds earn less from the reserves they keep in bonds, causing higher insurance premiums for households and funding shortfalls for their pensions.  [Matthew Philips and Dakin Campbell, "The Hidden Burden of Ultra-Low Interest Rates," Bloomberg Businessweek, February 6-12, 2012, page 45]   Wall Street's clients are big businesses and Federal Reserve policy is implemented to make big businesses increase their bank borrowings and bond issues, while minimizing their default rate.  It doesn't seem to matter if the Fed's actions ignore, or harm individuals and small business.  [Scott Shane, "QE2 Will do Little to Help Small Business," Bloomberg Businessweek, November 30, 2010,

 The Fed’s single-minded service to big bank profits is even causing financial writers to complain.  “Ben Bernanke doesn't seem to understand that while he is allowing huge profits for banks and investment firms so they can recover massive losses from the financial meltdown, he is intentionally damaging what could be a much stronger recovery with the misery he's causing the average American consumer.”  [Ed Wallace, “Blame High Oil Prices on Speculators and Bernanke,” Bloomberg Businessweek, April 19, 2011,]

The only member of the Fed’s Open Market Committee who consistently dissents from keeping interest rates even lower than inflation levels is Thomas Hoenig, president of the Kansas City Federal Reserve Bank, who says:  “I really don’t think we should be guaranteeing Wall Street a margin by guaranteeing them a zero or near zero interest rate environment. . . . [T]he saver in America is in a sense subsidizing the borrower in America. . . . We need a more normal set of circumstances so we can have an extended recovery and a more stable economy in the long run.”  [Quoted in “The Weekend Interview” by Mary Anastasia O’Grady, The Wall Street Journal, May 15-16, 2010, page A13]

The States and the Supreme Court Fashion Corporations to Serve Wall Street

For a prospective investor, becoming a partner in a business is a major, potentially life-changing decision.  Even a small investment as a partner has the effect of putting all of one’s eggs into a single basket.  The new partner’s entire property and future income could be taken away if the partnership were to go under and creditors come after the partners personally.  Then there is the issue of management.  In a general partnership, the law giesall partners equal votes, no matter how active they are in management.  There is no weighting for how large or small their investment may be.  Finally, ownership interests in partnerships are hard to sell.  Without some special agreement, anyone buying a partnership interest can’t become a partner without the consent of all the other partners.  Because of the unlimited liability feature, no one in their right mind would become a partner in a business without a thorough investigation of the other partners.

To meet these weaknesses in partnership investing, the corporation evolved from the charters that had been granted by kings and queens “to pursue their dreams of imperial expansion.”  It “brought together the three big ideas behind the modern company: that it could be an ‘artificial person,’ with the same ability to do business as a real person; that it could issue tradable shares to any number of investors; and that those investors could have limited liability (so they could lose only the money they had committed to the firm).”  [John Micklethwait and Adrian Wooldridge, The Company: A Short History of a Revolutionary Idea, The Modern Library, 2003, pages xvi, xvii]

It was the use of corporations that made Wall Street possible.  Well into the 1800s, most American businesses, even large ones, were conducted as partnerships.  Raising money to finance partnerships was a very personal matter.  Bringing in a new partner meant letting someone else become part of top management, since each partner must approve any serious business decision.  It also meant that all the partners had their entire personal wealth open to being taken away by creditors of the partnership.  One big mistake in judgment by a single partner could bankrupt every one of the partners. 

Selling a partnership interest could be nearly impossible, since the buyer had to be accepted by the other partners and the new partner could be blindsided by personal liability for what the partnership may have done in the past.  This meant there was little room for a Wall Street intermediary in selecting and approving a new partner.  By contrast, corporate shareowners have no personal liability—they can only lose the amount they paid for their shares.  Those shares are freely tradable and corporate managers don’t much care who owns shares in the corporation. 

Wall Street makes most of its profit from trading in corporate securities. It collects commissions for finding buyers for newly issued shares and makes far more by operating a trading market for the shares.  Even greater profits have come from manufacturing and trading in derivative instruments based upon corporate securities.  Wall Street had a great interest in having corporations be the entity of choice for all business ventures. 

The federal government has mostly stayed away from chartering corporations, leaving that prerogative to the states after James Madison, at the Constitutional Convention, tried to include chartering corporations in the powers of the federal government.  At first, state governments had serious public policy standards for granting a business the right to operate as a corporation.  In exchange for letting investors escape personal liability, and giving them free transferability of their investments, the states granted corporate charters only for specific business purposes.  The initial charters would expire in a few years and would not be renewed if the conditions had been ignored.

Corporations are still created by state governments today, except for a few special industries that need federal charters.  Competition among the states for incorporation fee revenues led to what has been called “chartermongering,” a “race to the bottom” in permissiveness for corporate management.  [Thom Hartman, Unequal Protection: The Rise of Corporate Dominance and the Theft of Human Rights, Berrett-Koehler Publishers, Inc. 2002, page 134]  The first corporate charters were limited to a specific purpose, for a term of just a few years, and could be revoked if management stepped outside the granted authority.  By the early 1900s, some state legislatures could still terminate corporations for failing to comply with their responsibilities.  After a few more years of lobbying state legislatures, a corporation could engage in “any lawful business” and for a perpetual term.  [John Micklethwait and Adrian Wooldridge, The Company: A Short History of a Revolutionary Idea, The Modern Library, 2003, page 46]  Delaware has chartered more corporations by far than any other state and a fourth of its total tax revenues come from corporate licensing fees.  [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2008, page 30; Richard L. Grossman and Frank T. Adams, Citizenship and the charter of corporations, The Apex Press, Council on International and Public Affairs, 1993,; research by Jane Anne Morris, summarized by Thom Hartman, Unequal Protection: The Rise of Corporate Dominance and the Theft of Human Rights, Berrett-Koehler Publishers, Inc., 2002, pages 75-76]

While state governments were accommodating Wall Street by removing restrictions on the use of corporations, the United States Supreme Court kept defining corporate powers and protections to be more and more like those of human citizens, beginning with the Dartmouth College case in 1819 [] through to the Citizens United case in 2010. [] One of the most useful in permitting corporate misbehavior is the right of corporations to invoke the attorney-client privilege.  [Mark W. Everson, former I.R.S. Commissioner, “Lawyers and Accountants Once Put Integrity First,” The New York Times, June 19, 2011, page 8] Corporations still don’t have the rights to vote, hold office or bear arms.  However, in several ways, corporations have greater rights than those of individuals: they can live and accumulate property forever.  Their owners’ liability to outsiders is limited to the amount they have actually paid into the corporation for their shareownership—usually a tiny fraction of the earnings that have been retained in the corporation.  And they don't get executed or put in prison for crimes.

These parallel government actions, by the state legislatures and U.S. Supreme Court, gave Wall Street the feedstock it needed to become America’s largest industry.  The Supreme Court said a corporation had nearly all the rights and powers of a partnership or individual, plus a few more.  The states said a corporation could be in any lawful business and stay alive forever.  The courts and legislatures carefully protected shareholders from any responsibility beyond the money they used to buy their shares.  The government had handed Wall Street the essential tools for operating a stock market and expanding into speculating in derivative securities based upon corporate shares.

The “Watered Stock” Red Herring

In the years just before and just after 1900, Wall Street built its basic meal ticket by consolidating thousands of businesses into a few large corporations.  In addition to the fees generated by effecting the mergers and placing securities, trading commissions came as markets were created for millions of shares of common stock issued in the consolidated corporations.  From the perspective of most Americans, the result was the disappearance of competitors in several industries.  Their elected representatives responded to the voter uproar with an attack on monopolies, like the Steel Trust, the Sugar Trust and the Money Trust.  The focus of alarm was on efforts to pass and enforce antitrust laws.  Only later would attention turn to the role of Wall Street in arranging the monopolizations and issuing the securities to carry them out.

The tool that Wall Street used in creating the giant corporations was the ability to grossly overpay for the businesses being merged.  New Jersey had led the way in loosening standards for corporate charters, so that a corporation could issue shares to acquire other businesses.  The amount of new shares paid to the sellers could be set without any limits.  This led to what was called “overcapitalization,” or “watering the stock.”  It also created millions of shares for trading, usually on the New York Stock Exchange.  “Overcapitalization allowed promoters to issue enough shares to induce the industrialists to sell their plants into the giant combinations and to pay themselves huge fees.  It was also how they created the modern stock market.”  [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2007, page 58]   

Many of the businesses incorporated in the boom years after the Civil War had become owned by the children and grandchildren of their founders.  These later generations were often happy to exchange their shareownership for spending money and financial security.  Since Wall Street brokers had exclusive access to the stock trading markets, they were paid for selling shares in the new holding companies exchanged for the inherited businesses.  Buyers in the new holding companies weren’t concerned that they were paying for watered stock.  They were counting on the gain from owning a monopoly business. 

The practice of watering the stock is said to have been brought to Wall Street by Daniel Drew, who had been a cattle drover before he took up corporate finance.  He would feed his cattle salt as he drove them to the market, not letting them drink until just before he arrived.  They weighed in freshly bloated with water and sold for more than they would have otherwise been worth.  He carried the same technique over to issuing stock in amounts well over the value of the business.  Government and the media set up watered stock as the evil that came from the corporate consolidations, one “that proved, in the end, to be a red herring that diverted them from their main task in the long struggle to regulate competition and protect consumers from monopolies. . . . While reformers’ attention was diverted, overcapitalization during the merger wave created the modern stock market. . . . The problem of overcapitalization is a key to the triumph of finance over industry and to the shape that regulatory efforts to control giant corporations took.”  [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2007, pages 59, 60]

The first big government investigation of investment banking came from the Industrial Commission, appointed by President McKinley and active from 1898 to 1902.  It looked at the practice of combining several businesses into a new corporation and selling its securities to the public.  The Commission found that the price to the public was far greater than the value of the assets, referring to it as “watered stock.”  No action was taken.  The government’s reaction to Wall Street’s drive to merge entire industries into one big corporation continued to focus on overcapitalization—the issuance of more shares in the new corporate giants than could be matched to the value of the businesses acquired.  This was seen as leading to monopolies, as competitors were absorbed into the dominant corporations in each industry.  Congress saw the culprit as the state incorporation laws that had been changed to permit overcapitalization and, as a result, the solution proposed was to preempt the state laws by requiring federal corporate chartering of every business operating beyond a single state.  One federal incorporation bill was passed unanimously by the House of Representatives in 1903 but failed to get through the Senate.

No one at the time seemed to realize that Wall Street was building a new industry, one which would create, buy and sell securities.  A century later, revenues in the securities industry would far surpass railroads and most manufacturing.  At the time, however, the government saw only antitrust and overcapitalization issues.  Today, we accept that the market price of a company’s shares will have little relationship to the value of the property it uses in the business.  Unfortunately, we also still accept that Wall Street is the monopoly for raising and investing money.

The foundation for Wall Street’s new industry, the stock market, had been vastly expanded by the issuance of common stock by the giant corporations, as they soaked up thousands of competing businesses in major industries.  The price of stocks doubled from 1904 to 1906.  Then came the Panic of 1907, which many blamed on the Money Trust, “a loosely bound small group of banks and investment banks that controlled the money supply and the New York Stock Exchange.”  [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2007, page 219] 

Government Left Wall Street Unconstrained Until the New Deal

President Theodore Roosevelt was the big trustbuster of the early 1900s and there was much talk about “the Money Trust.”  However, when his administration was unable to stop the Panic of 1907, he turned to J.P. Morgan, who used his position as the Godfather of Wall Street to restore financial order.  When the Federal Reserve System was established in 1913, the publicity said it “was designed to remove some of Wall Street’s power.”  [Robert Sobel, Inside Wall Street: Continuity and Change in the Financial District, W. W. Norton & Company, 1977, page 202]  Nevertheless, the first president of the Federal Reserve Bank of New York was J.P. Morgan’s son-in-law.

In response to the Panic of 1907, the House Banking and Currency Committee established a subcommittee to investigate the concentration of money and credit.  Called the “Money Trust Investigation,” it is also known as the Pujo Committee, after its chairman, Congressman Arsene P. Pujo.  The Committee focused on the underwriting syndicate, why it seemed to always include the same investment bankers and why the managing underwriters never tried to take business from another firm’s client.  A witness in charge of one of the top firms said that they prefer “to deal with our friends rather than people we do not know,” while another said “we make alliances for the occasion.  We have no standing alliances.” [Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970, page 145]  Nevertheless, the Committee’s majority found “an established and well-defined identity and community of interest between a few leaders of finance . . . which has resulted in great and rapidly growing concentration of the control of money and credit in the hands of these few men.”  [Money Trust Investigation: Report, 129, 133-35, quoted in Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970, page 151]  The Committee’s chief counsel, Samuel Untermyer, later wrote:  “It is not healthful or desirable that a few banking houses should monopolize the prestige and profit of acting as intermediaries between those who need capital . . . and the investors who are able to supply it.  The need should be supplied by a public market for securities.”  [Samuel Untermyer, “Speculation on the Stock Exchanges and Public Regulation of the Exchanges,” The American Economic Review, V, supplement, March 1915, pages 224- 68, quoted in Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970, pages 153, 154].

No legislation came from the Money Trust Investigation.  After the Committee’s report in 1913, Congress “struggled with ways to curb speculation, especially futures trading, margin buying, short selling and wash sales that by general consensus had turned the nation’s securities markets into gambling dens.”  [Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed Over Industry, Berrett-Koehler Publishers, Inc., 2007, page 227]  After intense lobbying, Congress did nothing to deal with the problems in the Pujo Committee report.  In 1919, bills began to be introduced in Congress to regulate the sale of new securities, including preparation and filing of offering materials with the federal government.  All of these efforts were defeated and no serious attempt to restrain Wall Street was to be made until 1933.

 The Money Trust Investigation Report dropped its earlier recommendation to have the Interstate Commerce Commission regulate securities issues.  It did, however, recommend that commercial banks be prohibited from underwriting and selling securities.  (Congress waited another two decades to take this action.)  Reaction to the growth of banks had enough political clout to get the McFadden Act passed in 1927.  It prohibited banks from opening branches outside of their home state.  This early demonstration of Congressional involvement in investment banking practices set a pattern that continues through today:  Use public hearings to vent public outrage, issue a report that excoriates bad behavior, then do nothing or just pass laws that don’t do much except strengthen the investment banking monopoly.  If it is necessary to create a regulatory agency, keep its funding so low that it can’t accomplish much and becomes a tool of the regulated industry. 

The “Roaring 20s” lived up to their name for Wall Street.  Liberty Bonds had been marketed with great success in World War I, opening up the middle class to exchanging money for paper investments.  What Wall Street did was to divert the new investors away from putting their money into securities issued by governments or real businesses and into securities manufactured on Wall Street.  Before the 1930s, the only federal law applying to investment banking was the postal fraud law, which had criminal penalties for swindlers using the mail.  [For a description of this period on Wall Street, see John Brooks, Once in Golconda: A True Drama of Wall Street 1920-1928, E.P. Hutton, 1969]

There were more calls for regulation after World War I.  The Capital Issues Committee had been reviewing all new issues of securities over $100,000, to protect the success of the Victory Loan program.  It recommended that the Federal Trade Commission police the sale of securities.  After the War, it unanimously called for supervision of new issues, fearing that the millions of Americans who had been introduced to investing in securities would be exploited.  Congress introduced several bills in response to the Committee’s report, but none became law.  A series of other bills for regulating securities issues were defeated in the 1920s.

Before the early 1900s, the states all had some regulation of the securities issued by corporations chartered in their state, but they had no authority over securities sold to their residents by businesses incorporated elsewhere.  By 1903, states had begun requiring prospectuses to be filed for offerings made in their states.  In 1911, Kansas passed the first licensing system for persons selling securities and required registration of securities issues and a permit to be issued before sales could begin.  Its banking commissioner, J.N. Dolley, called for protection against promoters who "would sell building lots in the blue sky,” giving the “blue sky” nickname to state securities laws.  Most other states followed and the new laws were upheld by the U. S. Supreme Court in 1917. [Hall v. Geiger-Jones Co., 242 U.S. 539 (1917)].

Regulation brings trade associations and, in 1912, the Investment Bankers Association of America was created out of the American Bankers Association.  It proposed its own model state blue sky law, but only Maine adopted it.  The IBA was more successful in lobbying for the defeat of several bills introduced in Congress.  One would have applied the principles of the Pure Food and Drug Act to the securities business.  Another would have authorized the Justice Department to prosecute securities dealers for mail fraud.  Early drafts of the Securities Act of 1933 placed its administration with the Post Office Department.  The final law was to be under Federal Trade Commission jurisdiction but that was changed when the Securities and Exchange Commission  created the SEC in 1934.

The Great Depression, the New Deal and a Wall Street Strike of Capital

For more than 100 years, our political leaders have pointed to the concentration of power in Wall Street and the painful consequences.  As early as the 1890s, a popular orator would rail against “a government of Wall Street, by Wall Street and for Wall Street.”  [Mary Ellen Lease, quoted in Charles Derber, Corporation Nation: How Corporations are Taking Over Our Lives and What we Can Do About It, St. Martin’s Press, 1998]  One of the early critics of Wall Street was Louis Brandeis.  After he was appointed to the U.S. Supreme Court in 1916, he could not participate directly in the efforts to reform the securities business.  However, “he kept in touch with the New Dealers through an elaborate network of former students and disciples.  Through them, his ideas reached FDR and his advisers, who referred to him as ‘Isaiah.’”  [Charles R. Geisst, Wall Street: A History, Oxford University Press, 1997, page 232]

Some of the strongest language indicting Wall Street came in the opening paragraphs of Franklin D. Roosevelt’s inaugural address on March 4, 1933:  “Practices of the unscrupulous moneylenders stand indicted in the court of public opinion, rejected by the hearts and minds of men. . . . They know only the rules of a generation of self-seekers.  They have no vision, and when there is no vision the people perish.”

The remedy, FDR said, was “strict supervision of all banking and credits and investments, so that there will be an end to speculation with other people’s money . . ..”  [John T. Woolley and Gerhard Peters, The American Presidency Project. Santa Barbara, CA: University of California]  Just two months later, Roosevelt signed into law the Securities Act of 1933, which had the Federal Trade Commission regulate the sale of new securities.  In June came the Banking Act of 1933 (called the Glass-Steagall Act, after its authors), which prevented commercial banks from also underwriting securities.  The next year brought the Securities Exchange Act of 1934, requiring registration of securities brokers, dealers and exchanges, as well as regulating their practices.  It also established the Securities and Exchange Commission to administer all of the federal securities laws, taking over from the Federal Trade Commission.

The Crash of 1929 had been followed by a continuing decline in share prices for the next two and a half years.  By 1932, common stock prices were only ten percent of their 1929 level.  A near-disappearance of underwritten new issues reflected the lack of interest in buying corporate shares.  Nearly half the Investment Bankers Association membership went out of business by 1933.  The Crash also brought Congressional hearings and legislation, including the

•  Securities Act of 1933, requiring registration and prospectus standards for new issues of securities, 

•  Banking Act of 1933, forbidding commercial banks from also being investment banks,

•  Securities Exchange Act of 1934, regulating brokers and trading markets, and requiring public reporting by businesses with traded securities,

•  Trust Indenture Act of 1939, requiring registration and investor protection tools for bonds,

•  Investment Advisors Act of 1940, providing very light regulation of money managers and other persons selling investment advice, and

•  Investment Company Act of 1940, regulating mutual funds.

The big victory for investment bankers came from the Banking Act, which forced deposit-taking banks to choose either the business of accepting deposits and making loans or the business of buying and selling securities.  The Banking Act also created the Federal Deposit Insurance Corporation, which put the full faith and credit of the United States Government behind consumer-size bank accounts.  That guarantee of deposits was hard for a bank to pass up in a time when bank failures had wiped out the life savings of so many.  Nearly all of the banks chose to give up underwriting, brokering and dealing in securities, sometimes splitting themselves into two separate businesses.

 By 1970, one of the firms that had chosen the securities business described itself this way:  “Morgan Stanley is an organization which specializes in basic investment banking services—the raising of debt and equity capital in the domestic and international markets and such closely related activities as general financial advisory services, mergers and acquisitions, and brokerage services for institutions and corporations.” [Morgan Stanley 1970, a book published by the firm.]  Wall Street investment bankers had been restored to their monopoly franchise, free of the competition from commercial banks that had plagued them during the 1920s.

Investment bankers and securities brokers won another major legislative battle in 1938.  Roosevelt had gotten the National Recovery Act through Congress in 1933.  It called upon all industries to adopt codes of fair competition, which could then be enforced by the federal government.   The Investment Bankers Association, as the only national trade association in the securities industry, drew up a code, which was adopted by President Roosevelt in 1933.  When the NRA was declared unconstitutional in 1935, the code continued under the Investment Bankers Conference, Inc., with the blessing of the SEC.  Faced with the threat of direct government regulation, investment bankers supported the 1938 Maloney Act, with the result that the Investment Bankers Conference became the National Association of Securities Dealers, Inc. and no one could engage in business as a securities broker or dealer except through membership.  The NASD has since become the Financial Industry Regulatory Authority and the SEC delegated to FINRA its power to license and regulate brokers and dealers in securities.  What had started as a trade association of private investment banking businesses is now a “self regulatory organization,” with rules that can be enforced just like those of a federal government agency.  Members of FINRA’s Board of Governors are representatives of Wall Street firms and of the “public”—which includes several retired Wall Street executives. 

During the 1930s, the federal government itself got into competition with investment bankers.  The Reconstruction Finance Corporation was started in 1932, under President Hoover, for making loans to businesses which served the national interest.  Some of the New Dealers pushed for even greater government involvement in financing business.  They blamed the renewed economic decline in 1937 on a “strike of capital” by Wall Street against government reforms.  “Throughout the 1930s the RFC was the world’s largest corporation because of the vast amount of money it distributed to industries in need.  When war broke out, it became the natural organization to coordinate the war effort through industry. . . . The great inroads made by the RFC in helping finance the war effort were making investment bankers nervous.  They were feeling the heat created by the RFC, which was only responding to their own lack of enthusiasm in the first place.”  [Charles R. Geisst, Wall Street: A History, Oxford University Press, 1997, page 265]  Congress voted to abolish the RFC in 1953.

In financing the second World War, the role of the Treasury in earlier wars was taken over by the Federal Reserve Board, which acted as a managing underwriter.  Each of the Federal Reserve Banks coordinated bond sales within its district.  No commissions, fees or expenses were paid to the securities industry.  The government also took steps to assure the supply of funds that individuals would invest in bonds.  President Roosevelt asked consumers to restrain their borrowing and spending, while War bonds were heavily marketed as a contribution to the war effort.  Very important was the way the Federal Reserve kept interest rates stable. War usually brings inflation and high interest rates, a real deterrent to bond investors.  The Fed stood ready to buy or sell Treasury bills, the shortest term debt, at a three-eights of one percent yield.  This kept long-term bonds at about 2.5 percent for the entire War.   

President Truman, who held a bias against Wall Street, asked the Federal Reserve to continue its financing efforts through the Korean War, saying “my approach to all these financial questions was . . . to keep the financial capital of the United States in Washington.  This is where it belongs—but to keep it there is not always an easy task.”  [From Truman’s Memoirs, quoted in Charles R. Geisst, Wall Street: A History, Oxford University Press, 1997, page 269]

The SEC is Set Up to Police (Protect) Wall Street

According to its website, “The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”  []  Experience shows that its actual mission is to protect Wall Street’s monopoly and to settle turf disputes among Wall Street insiders. 

The real reason for setting up the SEC as a new agency to regulate the securities industry may have been to bring responsibility for law enforcement into the hands of people who would be more receptive to the needs of the industry being regulated.  The Federal Trade Commission is charged with enforcing antitrust and other unfair competition.  According to its website, “When the FTC was created in 1914, its purpose was to prevent unfair methods of competition in commerce as part of the battle to ‘bust the trusts.’ Over the years, Congress passed additional laws giving the agency greater authority to police anticompetitive practices.”  [

Bringing the “Money Trust” under FTC supervision had been included in proposed Congressional legislation since the 1920s, but the Investment Bankers Association had successfully lobbied against any of the bills becoming law.  The Great Crash in 1929 made it likely that Congress would finally do something about regulating securities issues.  Rather than trying to stop the momentum entirely, investment bankers directed their efforts toward getting laws that would work for their benefit. 

The Securities Act of 1933, governing the sale of newly issued securities, put enforcement in the hands of the FTC.  The next year, in the Securities Exchange Act of 1934, investment bankers got Congress to take that away and to set up the SEC as single industry police to monitor the securities business.  The result was that Wall Street was effectively exempted from hundreds of years of the common law against fraudulent practices.  The SEC became the exclusive federal agency to define securities fraud and police securities transactions.  Joseph P. Kennedy, a major contributor to Roosevelt’s presidential campaign, was appointed the first SEC Chairman and lasted a year.  He came to the job from many years of making millions in stock speculations and turned out to be a moderate regulator, soothing both Wall Street’s anger at government interference and the New Dealers desire to make Wall Street pay for its sins.  Kennedy did shape the SEC as the protector of established investment bankers by forcing “marginal brokers” to close.  [Charles R. Geist, Wall Street: A History, Oxford University Press, 1997, page 236]

Policing by the SEC has been a history of protecting Wall Street from outside competition.  When the SEC staff is pressured to follow up on investor complaints, the Wall Street firms pay multi-million dollar fines and move on, like parking tickets for a drug dealer.  It has been written about the SEC:  “Created to protect investors from financial predators, the commission has somehow evolved into a mechanism for protecting financial predators with political clout from investors.”  [Michael Lewis and David Einhorn, “The End of the Financial World as We Know It, The New York Times, January 3, 2009,]  When Congress made a show of protecting investors, after the 2008 market collapse, the "investor advocate" and "investor advisory" authorities were placed within the SEC, not as independent agencies.  [Dodd-Frank Wall Street Reform and Consumer Protection Act, sections 915 and 911,]

With its hundreds of lobbyists, and direct connections to Congress, Wall Street was able to hijack the political objective of helping small business raise capital through the new “crowdfunding” phenomenon.  The process started with a bill that would exempt offerings of under $10 million from SEC and state securities filings and clearances. That became just one part of the “Jumpstart Our Business Startups Act,” signed into law April 5, 2012.  the exempt offering amount was cut to $1 million and a business is forced to hire a broker or "funding portal" registered with the SEC. The other parts of the JOBS Act are ironically titled “Reopening American Capital Markets to Emerging Growth Companies,” which removes several inconveniences for Wall Street and its clients who only have revenues of less than a billion dollars; “Access to Capital for Job Creators,” which allows Wall Street to advertise its offerings to accredited investors; “Small Company Capital Formation,” which raises the size of offerings, from $5 million to $50 million, that can be done with the less restrictive SEC Regulation A,  while exempting the offerings if they are to be listed on an exchange or sold to “qualified purchasers:" and “Private Company Flexibility and Growth,” which raises the number of shareowners that a company could have before it had to register and file reports with the SEC and become subject to Sarbanes Oxley restrictions.   

    The SEC continually says it doesn’t have the money to enforce laws against Wall Street defrauding investors.  But money is no limit when it comes to keeping the casino tables working for Wall Street players.  The high frequency traders are suspected of manipulating the market through the volume and speed of their trades.  They are viewed like card counters at blackjack tables and are serious enemies of "the house," which operates the game.  To trace trading in real time, the SEC has proposed a “consolidated audit trail,” at an estimated cost of “about $4 billion upfront and $2.1 billion annually, far exceeding the agency’s 2011 budget of $1.2 billion.”  Fees to cover the cost would be collected from exchanges, brokers and the Financial Industry Regulatory Authority.  [Scott Patterson, “SEC Pushes Plan For Audit System,” The Wall Street Journal, September 21, 2011, page C1, C3]

For the last 21 years, the SEC has been able to make whistleblower awards for insider-trading cases, but it had paid out only $160,000 before a $1 million payout in 2010.  [Jesse Westbrook, "Whistleblowers Get a Raise," Bloomberg Businessweek, August 2-8, 2010, page 31.  See Dan Jamieson, “Want to Blow the Whistle?  Don’t Try Calling the SEC,” Investment News, May 26, 2011,]  The Dodd-Frank Act added Section 21F to the Securities Exchange Act of 1934, to force the SEC to pay whistleblower awards for tips on securities law violations, and to prohibit retaliation by their employers.  In May 2011, the SEC adopted a 305-page rule to implement the section.  [Release No. 34-64545,  SEC Chairman Mary Schapiro’s speech announcing the rule is at, video at

In a particularly flagrant example of protectingits constituency, the SEC violated laws requiring preservation of records when it destroyed the records of investigations that did not result in prosecutions of securities firms.  [William D. Cohan, “Destruction at the SEC,” Bloomberg Businessweek, September 5-11, page 8, Matt Taibbi, “Is the SEC Covering Up Wall Street Crimes?” Rolling Stone, August 17, 2011, and “Why Isn’t Wall Street in Jail?” Rolling Stone, February 16, 2011,  See Democracy Now! interview with Matt Taibbi at]    

Single-industry regulation can be a bonanza for its members.  Cozy relationships can be developed among regulatory officials and corporate officers, lawyers and lobbyists.  The “revolving door” can open to encourage employees to move from public to private jobs and from private to policy level government positions.  People working on both sides understand each other and the unwritten rules.  Congress is careful to preserve the SEC's exclusive jurisdiction over Wall Street, while also taking care to underfund the SEC, so it can't take its job too seriously.  This pattern carried over when Congress appointed and funded the Financial Crisis Inquiry Commission, which issued its report in January 2011.  [].  Lynn Turner, former SEC Chief Accountant, observed that Congress “never gave it enough money to do its job, not unlike how Congress has treated many of the regulators. It didn't hire the attorneys and accountants trained as investigators as Pecora [the New Deal commission] did. Some of its top staff were seconded from the Fed which as the report notes, was one of the biggest reasons for the crisis. Its top and initial head of staff left long before the project was done as did other staff frustrated by the superficial work of the Commission.”  []

 Just one example of the payoffs for Wall Street from having the SEC as its single-industry regulator:  The economist John Maynard Keynes proposed a tax on stock transactions, to deter investors from short-term trading.  The subject has been revisited many times since, particularly as computer-generated program trading has come to dominate stock exchange volume.  Wall Street is, of course, adamantly opposed to the idea and it has never gotten any support from the SEC:  “The explanation lies partly in the history of the Commission, which has been one of seeking accommodation with Wall Street, no confrontation, and partly in its staffing.” [Louis Lowenstein, What’s Wrong With Wall Street, Addison-Wesley Publishing Company, Inc., 1988, page 85]

The SEC's protection has extended to the big businesses which are Wall Street's clients.  Contrary to its statutory duty "to protect investors," the SEC has actually protected the incumbent CEOs and directors from investors.  Shareowners who want to propose candidates for the board of directors have had to pay all the costs to prepare their own proxy statements and to distribute them, solicit responses, receive votes, etc.  Shareowner groups have long asked the SEC to let their nominees be included in the company’s proxy statement, without getting any action.  Opposition had been consistent and powerful from CEO organizations like the U.S. Chamber of Commerce and the Business Roundtable.  In August 2010, forced by Congress in its financial reform law, the SEC finally let that happen—but only if the proposing shareowners hold at least 3% of all the shares.   [Kara Scannell, “Investors Set to Win New Rights on Proxies,” The Wall Street Journal, August 5, 2010, page B1]  The result is a loss for CEOs but also a loss for individual investors.  The winner is Wall Street's buy side, the private equity takeover firms and the hedge funds, who can buy 3% of a company and nominate their own directors.  As Harvard professor, corporate director and former CEO put it:  "These changes are likely to empower short-term money movers such as hedge funds at the expense of long-term owners--and pressure management to focus on the short term, which is the exact opposite of what's needed."  [Bill George, "Executive Pay: Rebuilding Trust in an Era of of Rage," Bloomberg Businessweek, September 13-19, 2010, page 56]  A former SEC commissioner claims that "unions and cause-driven, minority shareholders . . . would use it to advance their own labor, social and environmental agendas instead of the corporation's goal of maximizing long-term shareholder wealth."  [Paul Atkins, "The SEC's Sop to Unions," The Wall Street Journal, August 27, 2010, page A15]

  (As lawyer for a meat trade association, I ran across a model for how Wall Street lobbied away the threat of FTC supervision.  The “Meat Trust” had responded to an antitrust decree and an FTC proposal that part of its industry be taken over by the government.  The Packers and Stockyards Act was passed in 1921, with the stated intent to prohibit unfair and deceptive practices, manipulating prices, creating a monopoly, etc.   [Title 7 U.S.C. §§ 181-229b,]  However, it placed exclusive enforcement with the Department of Agriculture, making it clear that “The Federal Trade Commission shall have no power or jurisdiction over any matter which by this chapter is made subject to the jurisdiction of the Secretary” of Agriculture, with limited exceptions.  [Title 7 United States Code §227,]  The legislative history disclosed that the Act had been drafted and lobbied by lawyers for the “Big 5” meat businesses.  The previous year, the FTC had forced the Big 5 into a consent decree, after an investigation ordered by President Wilson.  The real purpose of the Packers and Stockyards Act was to take away antitrust enforcement from the FTC and lodge it with the far friendlier Department of Agriculture, where it is today. There has been minimal funding and no serious enforcement of the Packers and Stockyards Act since it was enacted.)

There are at least three big advantages to being regulated by an agency that is supposed to oversee only one industry.  One is control over the funding process.  If the agency is becoming too difficult, industry lobbyists can persuade the administration and Congress to “cut off their water” until they behave.  This recently occurred when the SEC Chairman was Arthur Levitt, who had been head of a securities firm and president of the American Stock Exchange.  When he took his job too literally, key senators proposed drastic cuts in the SEC budget.  The history of the SEC, beginning with its first Chairman, Joseph P. Kennedy, has been one of under funding.  For many years, the SEC has collected far more in fees and fines paid by the industry than it has received from Congress for its operations.  Yet, the SEC staff went from 1,700 in 1940 to 770 in 1954, “and all but a handful of them were clerks, typists, political appointees, rejects from other agencies, time servers, and ambitious young men who hoped to use their employment as a means whereby they could land more worthwhile positions in the financial district.”  [Robert Sobel, Inside Wall Street: Continuity and Change in the Financial District, W. W. Norton & Company, 1977, page 172]   

Only a few federal financial industry regulators are subject to Congressional appropriations.  Most operate on fees and other income they collect.   Paul Kanjorski, Chair of the Financial Institutions Subcommittee, had said that self-funding is in line with a major goal of the legislation to change the culture and climate of the SEC []
However, Senator Richard Shelby said that keeping the SEC subject to Congressional appropriations "ensures the SEC has the funding it needs while still ensuring it be accountable to Congress
."  [ committee reconciling house and senate versions took self-funding out of the Dodd-Frank Wall Street Reform and Consumer Protection Act. [ ]  Instead, section 991(e) allows the SEC to put not more than $50 million a year from its registration fees into a reserve fund, and accumulate the reserve to not more than $100 million.  The Commission can draw on this fund for its functions, but it has to give notice of the date, amount and purpose to Congress.  The message remains clear:  Wall Street lobbyists can still get Congress to punish the SEC by cutting its funding, if it takes enforcement too seriously. 

The second advantage to being regulated by a single-industry agency is how people in the regulated industry can gain access to regulatory officials, without competition from other industries knocking on their door.  Industry members can stay well within codes of ethics and still develop close relationships at all levels of the agency.  SEC Commissioners and senior staff members are invited to speak at industry gatherings.  They visit with top industry personalities at social gatherings, office visits and telephone conversations.  All of this can be explained by a need for the regulators to understand issues in the regulated industry.  Nevertheless, there is no comparable access on behalf of the people who are supposed to be protected from bad practices, who are the investors and issuers of securities. 

Related to access is the third advantage of single-industry regulation.  That is the effective “revolving door” practice, where the regulated industry hires from the regulatory agency, and the agency hires from regulated firms, as well as from their lawyers and accountants.  Apologists for the practice argue that the agency can recruit higher quality applicants because they know that a few years' experience will land them a lucrative position in the regulated industry, or the law, accounting and consulting firms that service the industry.  They also say that regulation is more effective when staff in the industry and its service firms understand the workings of the regulatory agency.

Matt Taibbi commented on one flagrant revolving door example, that of Walter Lukken,  former acting head of the Commodity Futures Trading Commission who later became head of the Futures Industry Association, "the chief lobbying arm of futures investors. As the chief regulator of the commodities markets, it was Lukken’s job to spot and combat speculative abuses and manipulations that might have led to artificial price hikes and other disruptions."  Referring to  testimony before Congress on the big jump in oil futures prices, Taibbi wrote: "By insisting that the spike was 'not a result of manipulative forces,' Lukken helped Wall Street in its efforts to avoid reforms that might have prevented such abuses, like the closing of a series of loopholes and exemptions that allowed a handful of major speculators to play a lopsided role in the setting of commodity prices. . . . But really it's the same old story: regulators keep falling down on the job, and keep getting rewarded for it by Wall Street, and nothing gets done about it."  [Matt Taibbi, “Revolving Door: From Top Futures Regulator to Top Futures Lobbyist,” Rolling Stone, January 11, 2012,]

There may be individuals who can completely separate their allegiance to the agency’s mission from their own career goals.  (I knew one law firm senior partner who told his associates to always make a “soft” job offer when dealing with a regulator on an important matter.  Several of these offers eventually resulted in the firm hiring the former regulators.  My own telephone conversations with SEC lawyers often got around to a question from them like, “How’s the job market in San Francisco?”)  “It’s not hard to see why the S.E.C. behaves as it does. If you work for the enforcement division of the S.E.C. you probably know in the back of your mind, and in the front too, that if you maintain good relations with Wall Street you might soon be paid huge sums of money to be employed by it.”  [Michael Lewis and David Einhorn, “The End of the Financial World as We Know It, The New York Times, January 3, 2009,] In a June 2010 letter from the Senate Finance Committee to the SEC, asking its Inspector General to review the revolving door, Senator Charles Grassley said:  “We need to ensure that SEC officials are more focused on regulation and enforcement than on getting their next job in the industry they are supposed to oversee.”  [Tom McGinty, “SEC ‘Revolving Door’ Under Review,” The Wall Street Journal, June 16, 2010, page C1]

A very public example of how the SEC protects Wall Street occurred in a court case, brought on behalf of persons who purchased technology IPOs in the bubble years just before 2000.  As described in the first paragraph of the U.S. Supreme Court’s opinion:  “The buyers claim that the underwriters unlawfully agreed with one another that they would not sell shares of a popular new issue to a buyer unless that buyer committed (1) to buy additional shares of that security later at escalating prices (a practice called ‘laddering’), (2) to pay unusually high commissions on subsequent security purchases from the underwriters, or (3) to purchase from the underwriters other less desirable securities (a practice called ‘tying’).” [Credit Suisse Securities v. Billing, 551 U.S. 264 (2007),]  The SEC came into the case on the side of Wall Street and against the investors, arguing that regulation of the securities industry was its exclusive turf and the courts should stay off it.  The U.S. District Court agreed with the SEC and ruled in favor of the defendant investment bankers, but that was reversed by the Second Circuit Court of Appeal.  [426 F.3d 130 (2005).  The Second Circuit Court, located in New York, is the most knowledgeable and experienced in matters of finance.]  The U.S. Supreme Court later reversed the Second Circuit, agreeing with the District Court that enforcing the antitrust laws would disrupt the capital markets and that the SEC had the expert authority to regulate the securities industry. 

Part of protecting Wall Street’s monopoly is to enforce its code of conduct for people allowed to be included in the monopoly.  In 1933, the National Industrial Recovery Act permitted self-regulatory industry groups to adopt codes of fair practice enforceable by the federal courts. As the only national trade association for the securities industry, the Investment Bankers Association prepared a “Code of Fair Competition for Investment Bankers” that was approved by a presidential executive order in March 1934. The Supreme Court declared the NIRA unconstitutional in May 1935 but, with the assistance of the SEC, the investment banking industry continued “voluntary compliance” with the Code.  The IBA reorganized itself into the National Association of Securities Dealers and became the SEC’s self-regulatory organization for securities broker-dealers.  The NASD’s “Rules of Fair Practice” included (and still include) a ban on discounting the price or commission on underwritten securities sales.   The Rules preserved Wall Street’s very strict limits for how new issues are sold, so that the big investment banks have the advantage over retail brokerage firms and their middle class customers.  Before the date sales become final, underwriters may solicit “indications of interest” only through oral communications. They can’t use any mass marketing such as newspaper, radio or television advertising. The result is that marketing is directed to institutions and wealthy investors.  The Rules turn out to protect Wall Street from competition.  "In fact, the largest financial firms have shown repeatedly an ability to take even the toughest of regulations and turn them into profit centers."  [Adam Davidson, "A World Without Wall Street," The New York Times Magazine, January 15, 2012, page 14] 

When Joseph Kennedy’s son became President in 1960, a series of gross scandals at the American Stock Exchange brought attention to the adequacy of SEC regulation.  The new president asked for a Special Study of the Securities Market, and the first part was finished in April 1963.  On November 19, 1963, the “salad oil scandal” hit the news as the largest securities fraud of its kind, involving borrowings on fictitious commodities.  It took down two brokerage firms and caused huge losses at 20 banks and several trading firms.  As Wall Street prepared for the SEC to seek the broader powers recommended by the Special Study, President Kennedy was assassinated and the moment for renewed enforcement was past.  Nothing much of any substance has happened since. A 2010 Minority Report of the House Committee on Oversight and Government Reform lists recent problems with the SEC and recommends several remedies.  Nothing is in the Report about how the SEC has been protecting Wall Street's monopoly, the revolving door in hiring nor the influence of Wall Street with Congress.  []

How All Three Government Branches Protect Wall Street From Investors

All three branches of the federal government ostensibly have a role in protecting individual investors from unfair practices in the securities industry.  The history has been, however, that they actually protect Wall Street from disappointed investors.  The game is to appear responsive to the complaints of voters, while really enabling Wall Street to continue cheating.  [Watch "How Big Banks are Rewriting the Rules of Our Economy," Moyers & Company,, Air Date: January 27, 2012]

One example of looking responsive but doing nothing was revealed in the Lehman Brothers bankruptcy report by Anton R. Valukas, for which his law firm billed over $38 million:  “In mid-March 2008, after the Bear Stearns near collapse, teams of Government monitors from the Securities and Exchange Commission (‘SEC’) and the Federal Reserve Bank of New York (‘FRBNY’) were dispatched to and took up residence at Lehman, to monitor Lehman’s financial condition with particular focus on liquidity.”  [, page 8]  According to a commentary on the report, witnesses said “that the government didn’t raise significant objections or direct Lehman to take corrective action.”  [Paul M. Barrett, “Cold Case: Lessons from the Lehman Autopsy,” Bloomberg BusinessWeek, April 5, 2010, page 22] Six months later, Lehman’s bankruptcy triggered the Panic of 2008 and the Great Recession.

A recent case illustrates how all three government branches contribute to keeping investors from recovering losses caused by Wall Street fraud.   For its part, Congress made it unlawful to use any manipulative or deceptive device in the purchase or sale of a security.  But it added, “in contravention of” SEC rules.  [Securities Exchange Act of 1934, section 10(b),]  In legislative doublespeak, that means that the general rules for going after fraud could no longer be used against securities fraud perpetrators, they were replaced by exclusinve use of SEC rules.

After Congress had adopted section 10(b) of the Securities Exchange Act, granting Wall Street immunity from the general fraud laws, it was up to the SEC to make and enforce the rules under 10(b).  The SEC’s Rule 10b-5(a) [] makes it unlawful “to employ any device, scheme, or artifice to defraud.”  This seems to cover all kinds of cheating.  But the SEC doesn’t do much to catch and prosecute perpetrators of securities fraud.  In fairness, it is a very small agency by federal government standards, demonstrating another Congressional ploy of holding down funding for agencies that could interfere with business-as-usual.

If the SEC won’t bring criminal or civil action, can the injured persons seek a remedy in court?  The United States Supreme Court had  held that "A private plaintiff may not maintain an aiding and abetting suit under §10(b). Pp. 5-28." [Central Bank of Denver v. First Interstate Bank of Detroit, 511 U.S. 164, 1994,  Synopsis] A big question for Wall Street was whether disappointed investors could sue investment bankers who participated in setting up the transactions that were found to violate section 10(b). 

That question came before the U.S. Supreme Court in 2008, in a case that didn’t actually name a Wall Street firm.  [Stoneridge Investment Partners v. Scientific-Atlanta, 552 U.S. 148, 128 S.Ct. 761 (2008),,]  But its importance to them, as well as their customers, is shown by the “friends of the court” briefs, which are allowed when the decision in a case may become a rule affecting others not parties to the case.  Briefs on the side of investors included the American Association of Retired Persons, the Consumer Federation, the Council of Institutional Investors, many state and local pension funds, and a majority of the states and the North American Securities Administrators Association.  For the defendants, briefs included those for the American Bankers Association, the Securities Industry and Financial Markets Association, Merrill Lynch, the New York Stock Exchange and the NASDAQ. []  The briefs on behalf of the securities industry make it clear that the Stoneridge decision would settle the issue between investors and investment bankers. 

The real subject in Stoneridge, never mentioned by the Court, was Enron.  Several institutional investors had sued Enron, which was bankrupt and couldn’t pay any judgment.  They also sued Enron’s Wall Street bankers alleging that they were the ones who contrived financial transactions which falsified Enron’s financial statements.  They bankers allegedly sold new Enron securities with falsified financial statements and recommended Enron’s stock through false analyst reports.  After the trial court ruled that the plaintiffs could go to trial, some of the investment bankers settled, including Citicorp for $2 billion, J.P. Morgan Chase for $2.2 billion and CIBC for $2.4 billion.  Other defendants appealed the decision.  The investors had won the trial, but the federal circuit court reversed the decision and said that the Enron case could not include the investment bankers as defendants.  Two other circuit courts, in other securities fraud cases, had decided the same issue, coming down on opposite sides.  That created a conflict that only the Supreme Court could resolve.  The high court chose to accept the Stoneridge Investment Partners case to review the issue, rather than the Enron cases.  Stoneridge did not even involve investment bankers. 

Stoneridge Investors had lost money on shares in Charter Communications, Inc., a cable TV operator.  Charter had purchased cable set top boxes from Scientific-Atlanta, Inc. and Motorola, Inc.  Charter arranged to overpay $20 for each set top box it purchased until the end of the year, with the understanding that respondents would return the overpayment by purchasing advertising from Charter, at inflated prices.  The companies backdated documents to make it appear the transactions were unrelated.  Stoneridge sued the vendors for having participated in the fraud.

The Supreme Court decided, on a five to three vote, that the two set box vendors could not be liable to the investors.  Since the investors did not know of the vendors’ involvement in the fraud, the court said they could not have relied upon the vendors having been honest.  The majority acknowledged that general fraud law would have held the vendors liable.  But it ruled that Congress did not want that result in securities fraud cases.  The investors had also claimed that the vendors had “aided and abetted” the fraud, which Congress had also made unlawful.  But the majority held that Congress intended “that this class of defendants should be pursued by the SEC and not by private litigants.”  Since the SEC only pursues a small fraction of securities frauds, any aiders and abettors were off the hook.

The big effect of the Stoneridge decision was on investment bankers, lawyers and consultants who were claimed to have invented fraudulent schemes and guided companies in carrying them out, like those in the Enron cases.  The court’s majority acknowledged that it had been appropriate to consider “the practical consequences” of its decision.  One of these practical consequences was the frivolous lawsuit argument, that “the potential for uncertainty and disruption in a lawsuit allows plaintiffs with weak claims to extort settlements from innocent companies.”  Referring to the friend of the court brief by NASDAQ, the opinion added that holding responsible the undisclosed participants in a fraudulent scheme “may raise the cost of being a publicly traded company under our law and shift securities offerings away from domestic capital markets.”  The judicial branch of our government decided it was better to let defrauded investors take their losses than to risk putting Wall Street at a competitive disadvantage to their counterparts in other countries.

The executive branch of government found it politic to be on both sides of the case.  The SEC’s role in the Stoneridge lower court proceedings was on the side of the investors, reflecting the growing political weight of Wall Street’s “buy side,” the institutional money managers.  However, before the Supreme Court, the United States was represented by the Solicitor General, who is part of the Department of Justice.  The United States brief was filed in favor of the defendants and against the investor plaintiffs, reportedly on directions from the White House. [Thomas Brom, “Scheme Liability Lives!” California Lawyer, July, 2008, page 14.] 

The cleverest bit of politics in the Stoneridge case was maneuvering it to come to the Supreme Court before the Enron litigation or any other case where financial intermediaries and their lawyers were active in creating the fraud.  On the legal issues, the Stoneridge case will likely excuse them all, just as if they had been before the Court themselves.  It must have been easier to hold the justices together in the Stoneridge case, where vendors had just been asked to “do me a little favor,” than in the massive Enron financial manipulation scheme, where investment bankers, lawyers and accountants were alleged to be deep into the design and execution of the fraud. Former Senator Arlen Spector and others tried unsuccessfully to modify the Stoneridge ruling in the Dodd-Frank securities reform law.  It would have permitted aiding and abetting prosecution for those who “advise on or assist in structuring securities transactions and who have actual knowledge of securities fraud.”  [Bruce Carton, "Changes in Securities Enforcement Thanks to Dodd-Frank," Securities Docket, August 4, 2010,]

Congress Sets Up Another Casino for Derivatives Games

We have heard much about “derivatives” and their role in the Panic of 2008 and the “Flash Crash” of May 6, 2010.  These instruments are designed to bet on price changes in some physical commodity or security.  The derivatives markets are akin to off-track betting parlors for gambling on horse races.

The federal government started regulating derivatives in 1921, with the Futures Trading Act and adopted the Commodity Exchange Act in 1936.  Congress created the Commodities Futures Trading Commission in 1974, when most futures trades were bets on what the prices would be for agriculture commodities, like wheat, corn and pork bellies.  The commodities futures market accommodated a symbiotic relationship between speculators, who wanted to bet on their ability to predict farm price movements, and the farmers and processors, who wanted to protect themselves by hedging against the risk of those price movements.  The CFTC has promoted vastly expanded speculation in futures and options, far beyond farm products, into oil, securities, currencies and many other markers for placing bets. 

The CFTC initially set limits on speculative trading but, in 1992, it carved out exemptions from these limits for derivatives based on futures. Wall Street began coming up with derivatives-on-derivatives and marketed them to hedge funds and other speculators.  To get around the limits on speculation, Wall Street lobbied itself into being exempt.  “‘When the CFTC granted the 1991 hedging exemption to J. Aron (a division of Goldman Sachs), it signaled a major shift that has since allowed investors to accumulate enormous positions for purely speculative purposes,’" said Rep. Bart Stupak (D-Mich.) Now, he added, “‘legitimate businesses that hedge and take physical delivery of oil are being trampled by the speculators who are in the market purely to make profit.’"  [David Cho, “A Few Speculators Dominate Vast Market for Oil Trading,” Washington Post, August 21, 2008, page A01.]

In 1999, the President's Working Group on Financial Markets recommended that "derivatives should be exempted from federal regulation."  [, reported in Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, Pantheon Books, 2010, page 136]  The Commodities Futures Modernization Act of 2000 delivered many exemptions and exclusions from regulation for derivatives and for classes of investors/speculators.  It opened an unregulated betting parlor for individuals and businesses with assets of at least $10 million and employee benefit funds of at least $5 million—the prime buy market for Wall Street investment bankers.  The exempt bets include “hybrid instruments” and “swap transactions” sold to “eligible participants.”  This helped bring pensions funds and other institutions into the market, mostly through “index” securities tied to a basket of futures markets.  Reflecting particularly clever Wall Street lobbying, the exemptions were not only from regulation by the CFTC but also from SEC rules.  The law formally allowed investors to trade energy commodities on private electronic platforms outside the purview of regulators. Critics have called this piece of legislation the "Enron loophole," saying Enron played a role in crafting it. [see law firm summaries of the Act by Cravath, Swaine and Moore,, by Glen S. Arden of Jones Day,  and by Dean Kloner, an associate with Stroock & Stroock & Lavan,] 

Professor of Law Michael Greenberger left a Washington, firm in 1997 to become Director of the Division of Trading and Markets at the Commodity Futures Trading Commission.  In 2009, he described passage of the "Commodities Futures Modernization Act" this way:  “On a December evening, December 15th, 2000, around 7:00, Phil Gramm  . . . introduced a 262-page bill as a rider to the 11,000-page appropriation bill, which excluded from regulation the financial instruments that are probably most at the heart of the present meltdown.  He not only excluded them from all federal regulation, but he excluded them from state regulation as well, which is important because these instruments could be viewed to be gambling instruments, where you’re betting on whether people will or will not pay off their loans.”]

   The role of Congress as Wall Street’s traffic cop was highly visible during the Summer of 2008, around the issue of speculation in the market for securities derived from oil futures.  Several Congressional Committees held hearings, including one May 20, before the Senate Committee on Homeland Security & Governmental Affairs, called "Financial Speculation in Commodity Markets: Are Institutional Investors and Hedge Funds Contributing to Food and Energy Price Inflation?"  The relentless news coverage came from the relationship between trading in these derivatives and prices at the gas pump.  The lobbying and public relations were a competition between the airlines [] and Wall Street firms.  “A strong lobbying effort by Wall Street banks, the trading industry and market operators may successfully head off proposals for tougher federal controls on oil futures trading.”  [Ian Talley, “Oil-Futures Players Resist Controls,” The Wall Street Journal, July 11, 2008,] Committee Chairman, Senator Carl Levin, turned over information about oil futures price manipulation to the Department of Justice, which has been criticized for not prosecuting.  [Peter S. Goodman, "Behind Gas Price Increases, Obama's Failure to Crack Down on Speculators," Huffington Post, March 15, 2012,

One hedge fund manager testified that these institutional speculators keep rolling over their positions, they “never sell,” and that, “Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits.”[Committee on Homeland Security and Governmental Affairs, testimony of Michael W. Masters, managing member of Masters Capital Management, LLC,]

This continuous buy demand creates an unreal market.  The money used for speculation could have gone to productive uses, like financing new and expanding businesses, or buying securities to fund infrastructure repair.  The diversion into futures securities is like individuals deciding to spend their discretionary income on buying for their stamp collection, except that the speculators are causing harm and bringing unnecessary risk to us all.  [A contrary view was presented by Hilary Till, Research Associate of the EDHEC-Risk Institute, in Nice, France, in her paper, “Has There Been Excessive Speculation in the US Oil Futures Markets? What Can We (Carefully) Conclude from New CFTC Data?” She found that there “has been no evidence of excessive speculation in the US oil futures markets over the last three-and-a-half years, and notably during the oil price spikes in 2008.”]

The Secretary of the Treasury and other politicians continue to explain gas prices as a result of supply and demand, especially supply, saying things like:  “If only we could drill for more oil, then we could supply the demand and the price would stabilize.”  The media similarly offers explanations based upon the supply of physical oil output.  Reporters look at what happened in the oil futures market today and then look to an event that interrupted the supply—sabotage in Nigeria, refineries shut down for maintenance, etc.  A relatively few in the mainstream media, like Moira Herbst and David Cho, were willing to report on the Congressional testimony that a major cause was Wall Street’s new derivative products being sold to institutional money managers. 

Under pressure from members of Congress, the Commodity Futures Trading Commission looked at records of oil futures traders on the New York Mercantile Exchange, or NYMEX.  It found “that financial firms speculating for their clients or for themselves account for about 81 percent of the oil contracts on NYMEX, a far bigger share than had previously been stated by the agency. . . . The biggest players on the commodity exchanges often operate as ‘swap dealers’ who primarily invest on behalf of hedge funds, wealthy individuals and pension funds, allowing these investors to enjoy returns without having to buy an actual contract for oil or other goods. . . To build up the vast holdings this practice entails, some swap dealers have maneuvered behind the scenes, exploiting their political influence and gaps in oversight to gain exemptions from regulatory limits and permission to set up new, unregulated markets. Many big traders are active not only on NYMEX but also on private and overseas markets beyond the CFTC's purview. . . . Using swap dealers as middlemen, investment funds have poured into the commodity markets, raising their holdings to $260 billion this year [2008] from $13 billion in 2003. During that same period, the price of crude oil rose unabated every year.  CFTC data show that at the end of July [2008], just four swap dealers held one-third of all NYMEX oil contracts that bet prices would increase.”  [David Cho, “A Few Speculators Dominate Vast Market for Oil Trading,” Washington Post, August 21, 2008, page A01.  See, also, Ann Davis, “’Speculator’ in Oil Market is Key Player in Real Sector,” The Wall Street Journal, August 20, 2008, page C1 and Ann Davis, “Data Raise Questions on Role of Speculators,” The Wall Street Journal, August 15, 2008, page D1]

“Trading by swaps dealers—the big Wall Street banks involved in energy trading—on behalf of financial investors and commodity companies, along with noncommercial traders such as hedge funds, accounts for an estimated 70% of trading in U.S. markets, up from about 57% three years ago, according to the CFTC.” [Siobhan Hughes, “Bill Targets Speculation Over Energy,” The Wall Street Journal, June 27, 2008]  A hedge fund manager testified that:  “This so-called swaps loophole exempts investment banks like Goldman Sachs and Merrill Lynch from reporting requirements and limits on trading positions that are required of other investors. The loophole allows pension funds to enter into a swap agreement with an investment bank, which can then trade unlimited numbers of the contracts in futures markets. . . the top five users of swap agreements are investment banks, four of which dominate swap dealing in commodities and commodities futures: Bank of America, Citigroup, JPMorgan Chase, HSBC North America Holdings, and Wachovia.”  [Moira Herbst, “Are Pension Funds Fueling High Oil?  A Senate hearing weighs charges that speculation by big investors and sovereign wealth funds is behind the rise in commodities and energy prices,” Business Week, May 21, 2008,  Ms. Herbst reports that the California Public Employees Retirement System invested about $1.1 billion in commodities swaps contracts.  She also mentions that: “In only five years, from 2003 to 2008, investment in index funds tied to commodities has grown twentyfold, from $13 billion to $260 billion.”

Oil got the most attention, when gasoline jumped to $4 a gallon.  But the derivative products that Wall Street created apply to foods like wheat, corn, beef, and pork, as well as minerals, like palladium and platinum, used in manufacturing consumer products.  The result from speculation is a huge and constant increase in the demand for futures contracts by institutions with very deep pockets.  Like the market for oil futures, the resulting higher prices for food futures have led to increases in the price of the actual commodity to consumers.  In the United States, high food prices are uncomfortable.  But in many other nations, price increases have meant that millions go without.

Even in the midst of the post-2008 turmoil over derivatives, when financial regulatory reform was often Topic A in politics, the CFTC went on expanding the betting parlor offerings.  One Wall Street firm lobbied the CFTC to allow trading in the expected box office receipts for movies.  [Michael Cieply and Joseph Plambeck, “Hollywood Tries to Block Market for Movie Bets,” The New York Times, April 7, 2010,] The Commission unanimously approved the concept in April 2010.  []

A major source of harm to us all comes from the way the betting parlor for derivatives is linked with the trading markets for “real” securities, the shares and bonds representing ownership and debt of operating businesses.  Wall Street’s big players place bets in both the derivatives markets, regulated by the CFTC, and the stock markets, regulated by the SEC.  The arbitrage games are vastly multiplied by exploiting price differentials among the various markets for stocks and the derivatives instruments based on stocks.  Add to this complexity all the intricate software development that the “quants” have built for Wall Street.  It was that “program trading” or “portfolio insurance” that brought about the Crash on October 19, 1987.  The size of the problem in 2010 was more than 30 times what it had been then.  “In 1987, about 600 million shares were traded on Black Monday. On May 6, 19.5 billion shares were exchanged in 66 million trades.”  [Zachary A. Goldfarb, “SEC proposes rules to prevent another ‘flash crash’,” Washington Post, May 19, 2010,]  “The slide in futures caused stocks to fall, leading to even more selling of futures.  The link shows that in times of stress, these two key parts of the market—stocks and futures—can have a dangerous self-reinforcing effect that can turn a garden variety selloff into an explosive crash.”  [Scott Patterson, “How the ‘Flash Crash’ Echoed Black Monday,” The Wall Street Journal, May 19, 2010, page C1]

Arbitrage games among the trading markets for stocks and their derivatives have become especially difficult to police as the number of markets have multiplied and become individual profit centers.  What were once a few nonprofit exchange services, dominated by the New York Stock Exchange, have now become many trading platforms, all operated by for-profit publicly-traded companies.  “Now the U.S. stock market is actually a network of 50 different venues connected by an electronic system of published quotes and sale prices.”  Most of the trading is arbitrage, buying in one market for derivatives or real securities and selling in another.  Government oversight, such as it is, serves only to keep the players within the rules of the games, with no attention to the economic purpose of encouraging investment in productive businesses.  As a result, “the market is now dominated by quick-draw traders who have no intrinsic interest in the fate of companies or industries. Instead, these former mathematicians and computer scientists see securities as a cascade of abstract data.”  [Nina Mehta, Lynn Thomasson and Paul M. Barrett, with Jeff Kearns, Whitney Kisling, Peter Coy, “The Machines That Ate the Market,” Bloomberg Businessweek, May 20, 2010,]

Exchange traded funds, which are pools of stocks tied to an index and traded on exchanges, have become favorite tools of high frequency traders and other speculators, accounting for 35% to 40% of all exchange trading.  “Leveraged ETFs” use derivatives to increase the gain or loss from buying and selling a fund. [Scott Patterson, “ETF Role in Market Turmoil Examined,” The Wall Street Journal, September 7, 2011, page C1]  Then there are "leveraged inverse ETFs, which move twice or more as much in the opposite direction to the market.  Speculators hold ETFs for an average of 16 days, and leveraged inverse ETFs for an average of just three days.  [Robin Farzad, "Beware of ETFs on Steroids," Bloomberg Businessweek, December 12-18, 2011]

Since Congress gave Wall Street the derivatives betting parlor, its agencies have aided in building the complex rules that make it possible for the cleverest gamesters to play the odds with their computer programs and algorithms.  Twelve days after the May 6, 2010 Flash Crash, the SEC and the CFTC issued a joint preliminary report, which suggested six “working hypotheses and findings.”  One of those was the “possible linkage between the precipitous decline in the prices of stock index products . . ., on the one hand, and simultaneous and subsequent waves of selling in individual securities, on the other, and the extent to which activity in the one market may have led the others;” while another hypothesis was “disparate trading conventions among various exchanges . . ..”  []

The SEC’s preliminary report of the May 6, 2010 Flash Crash sounds like a sudden revelation of a fact that had been known for at least 16 years.  Congressman Edward J. Markey held hearings in 1994 before the subcommittee on telecommunications and finance.  At those hearings, Charles A. Bowsher, head of the Government Accounting Office, testified that:  “The sudden failure or abrupt withdrawal from trading of any of these large U.S. dealers could cause liquidity problems in the markets and could also pose risks to others, including federally insured banks and the financial system as a whole. . . . In some cases intervention has and could result in a financial bailout paid for or guaranteed by taxpayers.”  That 1994 testimony was the very script for what happened in the Flash Crash of 2010.  Congressman Markey’s bill for regulating derivatives failed to pass, after Alan Greenspan, then Chairman of the Federal Reserve Board, reassured the committee that: “Risks in financial markets, including derivatives markets, are being regulated by private parties. . . . There is nothing involved in federal regulation per se which makes it superior to market regulation.”  Greenspan did warn that: “The very efficiency that is involved here means that if a crisis were to occur, that that crisis is transmitted at a far faster pace and with some greater virulence.”  He went on to call that possibility “extremely remote,” adding that “risk is part of life.” [Peter S. Goodman, “The Reckoning: Taking a Hard Look at the Greenspan Legacy,” The New York Times, October 9, 2008,  Peter Goodman also tells the story of Brooksley Born’s effort to shed light on derivatives, beginning in 1997 when she was Chairman of the Commodities Futures Trading Commission and crossed swords with Alan Greenspan, Robert Rubin, Larry Summers and others.]

  Congress Cancels Out State Regulation of Wall Street

State law enforcement officers have often been a real nuisance to Wall Street.  Every state, the District of Columbia and each of the Territories has a set of laws, regulations and rules governing the sale of securities and the intermediaries who sell them.  These “Blue Sky Laws” were adopted nearly 100 years ago and each state has required some form of filing and clearance before securities could be offered to its residents.  The state regulators are closer to the people, with the consequence that their officials may see political hay in pursuing complaints about Wall Street abuses.  For a national business, like the big banks and brokers, it is a real hassle having to deal with 50 different sets of attorneys general, secretaries of state, securities commissions and other law enforcement agencies. Wall Street has found it far preferable to have only one government agency, a federal one that it can influence and shape with political contributions, lobbying and the revolving door of staff exchanges.  The answer for Wall Street was to lobby Congress to wipe out state laws, using the constitutional doctrine of federal preemption to eliminate state regulation of all the securities offerings that are Wall Street’s bread and butter. 

A big victory for investment bankers came with the National Securities Improvement Act of 1996.  Congress left the securities industry free to sell shares throughout the U.S. without meeting any state standards for disclosures or for the merits of the offering. According to the SEC, the law has “provisions that realign the regulatory partnership between federal and state securities regulators . . .  to preempt state blue sky registration and review of specified securities and offerings.”  []  

The “specified securities” exempted from state review are basically all of the ones that are sold by Wall Street, leaving the states to regulate securities sales made directly by small businesses and the securities sold in ways that bypass Wall Street.  The exemptions from state regulation are called "covered securities" and they include securities issued by companies listed on the New York, American and Nasdaq Stock Market exchanges.  The law’s drafters carefully meshed it with rules of the exchanges.  For instance, the definition of covered securities includes those “approved for listing” on an exchange.  That’s to cover initial public offerings, where the shares won’t be listed until after the IPO is completed.  Could a company get approved for listing if it planned to do a direct public offering, bypassing Wall Street by selling the shares itself?  No, that door is closed.  The exchange rules will approve shares for listing only if they are to be offered in a “firm commitment” underwritten offering, through a registered securities broker-dealer.  Could the company get a broker-dealer to do a firm commitment for part of the offering and let the company sell the rest directly?  No, that is against the uniform requirement that a firm commitment underwriting must include all the shares being offered.  That means that the exemption from state filings cannot be used in a direct public offering, or even a “best efforts” offering which uses securities brokers as agents.  By this Improvement Act gambit, the investment bankers not only got rid of obstacles to their own way of doing business; they strengthened a big competitive advantage over alternative ways of marketing securities.

The Improvement Act also gave immunity from state filings to mutual funds, and the brokers who sell them.  The definition of exempt “covered securities” was even extended to private placements of securities.  The SEC had exempted from its own registration requirements any sale made to “accredited investors” and “sophisticated purchasers,” without any limit on the dollar amount of securities sold.  []  This Rule 506 had become extremely popular with brokers who sold securities to institutional money managers and millionaires.  But state securities administrators were still requiring filings and reviews before they would clear the offering for sale to people living in their state.  Prospectuses were reviewed for the adequacy of disclosure.  Many states also passed upon the merits of the offering, requiring the investment proposition to be “fair, just and equitable.”  As a favor to Wall Street, Congress simply put Rule 506 offerings into the category of “covered securities,” untouchable by state regulation.  The most that the states can now do is call for a notice filing.  They are powerless to stop it or require modification before selling efforts begin.  They have to wait until a fraud has actually taken place and try to prove it in court.  Nevertheless, the fraud cases have contributed to the closing of at least 16 securities broker-dealers, with nearly 2,500 registered representatives.  [Investment News, June 2, 2011,]

Left out of the escape from state regulation were all of the offerings in which Wall Street has no interest:  securities listed on regional exchanges or the NASDAQ Small Cap market and securities sold under Securities Act Rules 504, which is limited to sales of $1 million in a year, [] or Rule 505, for sales up to $5 million in a year.  []  Also left under state filing requirements were the Regulation A exemption for offerings of up to $5 million a year, which must also be reviewed by the SEC but are not subject to filing SEC reports and complying with the Sarbanes-Oxley Act.

The result of the National Securities Markets Improvement Act was to give Wall Street investment bankers a free pass to sell securities throughout the United States without state surveillance.  At the same time, it left the burden of state regulation on the backs of small business, independent securities broker-dealers and the more than ninety percent of us who are not millionaires.  Any business raising money from middle class individuals needs to go through all the hurdles of state registration of the offering.  In addition, they must find a way to comply with state licensing requirements for anyone selling a security.

Once in a great while, there has been an occasional burst of concern for small business expressed by politicians and regulators.  Sometimes, useful action is taken.  The last pro-small business cycle was in the early 1980s and a major result was the creation of a separate category for “small business issuers.”  They were corporations with annual revenues of not more than $25 million, or corporations with their publicly-traded shares valued at less than that amount.  The SEC created a separate Integrated Disclosure System for Small Business Issuers, with substantially less burdensome requirements for SEC filings.  That was all taken away in 2007, with the SEC’s regulation, ironically entitled “Smaller Reporting Company Regulatory Relief and Simplification.”  [Release Nos. 33-8876; 34-56994; 39-2451; File No. S7-15-07,]  It made no difference that small businesses today are the majority of members in the U.S. Chamber of Commerce, the National Federation of Independent Business and the National Association of Manufacturers.  They lobbied for the $700 billion Wall Street bailout but "lose interest when the money is going to community banks and small businesses." [Frank Knapp Jr., president of the South Carolina Small Business Chamber of Commerce, quoted by Mark Drajem, Laura Keeley and David Henry in "NO Lobbying Help for the Little Guys," Bloomberg Businessweek, August 2-8, 2010, page 33]   

The federal-preemption-of-state-law ploy was also used to protect Wall Street’s mortgage lending operations in the U.S. Supreme Court case, Cuomo v. The Clearing House Association, LLC, [, 2009].  The Office of the Comptroller of the Currency and The Clearing House Association, a trade group of national banks, each filed a lawsuit to enjoin an investigation by New York’s Attorney General, on the grounds that the state was preempted by the National Bank Act and the Comptroller’s regulations.  The decision followed the Supreme Court’s 2007 decision in Watters v. Wachovia Bank, N.A., [], in which the Court held that a national bank’s mortgage business is not subject to state licensing, reporting, or supervisory visits, that “federal control shields national banking from unduly burdensome and duplicative state regulation.” 

Congress followed the Supreme Court in the next protection of Wall Street from state regulation.  After the House passed the “Wall Street Reform and Consumer Protection Act of 2009,” the bill went to the Senate, which passed its “Restoring American Financial Stability Act of 2010.”  The different title in the Senate, leaving out any reference to Wall Street reform or to consumer protection, reflects the differences in the bill itself.  For instance, several U.S. Senators proposed an amendment to the take away the ability of states to enforce their laws against multistate banks.  Instead, the states could enforce any standards that might be adopted by the Federal Reserve Board’s new agency.  As the amendment’s sponsor, Senator Tom Carper posted on his website, “The compromise we passed today would preserve our national banking system while also giving state attorneys general the authority to enforce new rules issued by the consumer protection bureau.  This was a hard-fought but fair compromise that will give businesses certainty and provide an extra set of cops on the beat to help make sure that consumers aren't handed a raw deal."  []  The contrary view:  “This is an overt attempt to take cops off the beat and allow banks to get away with outright abuses.”  [Zach Carter, “Tom Carper is Attacking Consumers and Defending Wall Street,” Campaign for America’s Future, May 12, 2010,  See Stacy Mitchell, “Five Reasons the Carper Amendment Must be Defeated,” The Huffington Post, May 27, 2010,

When Wall Street began to go after home loans as a vast source of securities business, it got Congress to take a series of steps to get the states out of its way.  One of the earliest  was included in the Depository Institutions Deregulation and Monetary Control Act of 1980.  All of the states have long had usury laws, making it a crime to charge more than a certain rate of interest.  Of course, these laws exempted banks and most other institutionalized lenders.  But state usury laws would have crimped the style for securitizing home loans, especially those made by nonbank mortgage originators for Wall Street to package as mortgage securities.  State usury laws only affected interest rates higher than those charged on home loans.  So, if Wall Street had been willing to stay within the standards used by established mortgage lenders, it would not have been necessary to get rid of state usury law limits.  But the profit was seen to be in subprime lending, where much higher interest rates could be charged to borrowers who couldn’t qualify for the usual channels.  Congress obliged Wall Street’s lobbyists and preempted state usury laws.  [Depository Institutions Deregulation and Monetary Control Act of 1980]

Congress also helped Wall Street develop its mortgage securities business with the Alternative Mortgage Transactions Parity Act of 1982.  Before that Act, state and federal laws and regulations had limited mortgage loans to those with a fixed-rate and with interest and principal to be paid in monthly installments over a period of up to 30 years.  This new “Parity Act” opened the door to loans with adjustable rates, payments of interest only and creatures like the “option-ARM,” where the loan amount can get larger.  [Jon Birger, “How Congress Helped Create the Subprime Mess,” Fortune Magazine, January 2008,] Getting rid of usury limits and fixed-rate loans was a bit like granting terrorists unrestricted access to all the instructions and ingredients for chemical, biological and nuclear weapons of mass destruction.  Along with the Secondary Mortgage Market Enhancement Act of 1984. Congress had opened the door to a series of “structured products,” like the synthetic collateralized debt obligations, about which the SEC’s enforcement chief, Robert Khuzami said:  “The product was new and complex, but the deception and conflicts are old and simple.”  [Gregory Zuckerman, Susanne Craig and Serena Ng, “U.S. Charges Goldman Sachs With Fraud,” The Wall Street Journal, April 17-18, 2010, page A4.  See Simon Johnson and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, Pantheon Books, 2010, pages 72-73 and Jeff Madrick, Age of Greed: The Triumph of Finance and the Decline of America, 1970 to the Present, Alfred A. Knopf, 2011, page 360]  By 2011, after having burned all the institutional money managers, Wall Street had begun selling these same structured products to senior citizens.  “Individual investors have lost at least $113 billion and counting from Wall Street’s most toxic retail investments, which go by myriad names such as reverse convertibles, equity-linked, buffered or enhanced notes. Actual losses could be ten times that, since most burned investors don’t confront their brokers or win back their money.”  [John F. Wasik, “How Safe Are Your Savings: How Complex Derivative Products Imperil Seniors’ Retirement Security,” Demos, May 17, 2011,]

It’s hard to match the federal government’s campaign against state regulation with the conclusions of the U.S. Treasury’s recommendations on financial regulatory reform:  “The financial crisis was triggered by a breakdown in credit underwriting standards in subprime and other residential mortgage markets. That breakdown was enabled by lax or nonexistent regulation of nonbank mortgage originators and brokers. But the breakdown also reflected a broad relaxation in market discipline on the credit quality of loans that originators intended to distribute to investors through securitizations rather than hold in their own loan portfolios.”  [Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation, Department of the Treasury, 2009, page 44] Treasury’s recommendations are all about more agencies and powers for the federal government. 

 The Courts and Prosecutors Choose to Let Wall Street Run Loose

After all the Congressional investigations and New Deal laws, there was one last government attack on the investment banking cartel.  This time, it was through the executive and judicial branches, although it began in Congress, with the Temporary National Economic Committee in 1938—which was defunded in 1941.  Known as the “Monopoly Committee,” [Charles R. Geist, Wall Street: A History, Oxford University Press, 1997, page 258] it produced tens of thousands of pages of testimony and many monographs of its conclusions.  The Committee found extreme concentration of underwritten securities issues in a few Wall Street investment bankers, close relationships between investment bankers and their biggest clients and very little effort to finance small business. 

In 1944, while Franklin Roosevelt was still president, the U.S. Department of Justice used the Committee’s work to begin a major investigation of the way Wall Street conducted underwritten public offerings of stocks and bonds.  The result was United States v. Morgan, et al., in which the 17 major investment bankers were charged with violating the Sherman Antitrust Act, enacted in 1890 to break up monopolies.  The complaint said the defendants were members of “a combination, conspiracy and agreement to restrain and monopolize the securities business of the United States.”  [United States v. Morgan, 118 F. Supp. 621, 628, 1953] 

Harry Truman had become president on Roosevelt’s death in April 1945 and the Justice Department filed criminal conspiracy charges in July that year.  This enabled the government to use grand jury subpoenas to gather evidence, although it chose not to proceed with a criminal case.  The civil action was filed in 1947 and assigned to U.S. District Court Judge Harold Medina, who had been appointed by Truman the same year.  [Charles R. Geist, Wall Street: A History, Oxford University Press, 1997, page 269]  The trial began in 1950 and it was 1953 before the government completed putting on its case.  A year into the trial, the government dropped its charges that the investment bankers refused to act as commissioned sales agents instead of underwriters, that they neglected to assist small companies in need of capital and that they concentrated on selling to large institutional investors instead of individuals.  (It is my personal experience, from 1960 through today, that each of these three charges is still true.  However, I can understand how difficult they would be to prove.  As a friend once said, when I described how these practices worked without any written or oral agreement or acknowledgement that it was happening, “They don’t have to talk about it.  It’s in their mother’s milk.”

When the government began putting on evidence, there were three practices left to sustain the monopoly charge.  One was that they didn’t poach on each others’ clients.  If an investment banking firm had managed an underwriting for a particular business, the rest of the firms would not try to have that business pick them for the next offering.  Second was that the positions in an underwriting syndicate for a particular issuer would remain the same for that company’s future issues.  Those positions were reflected in the “tombstone” announcements of a completed offering, where the managing underwriter was at the top of the pyramid and the other firms participating were on descending lines.  Third was the use of reciprocity in selecting members of an underwriting syndicate.  If investment banker A was given a $10 million allotment in an underwriting managed by investment banker B, then banker A could be expected to include banker B for a similar amount in an underwriting it managed.

Most of us outside the securities industry might consider these practices not to be worth such a massive legal battle.  But there was a fourth theory: price fixing.  That theory was based on the standardized Underwriting Agreement, Agreement Among Underwriters and Selling Agreement, in the forms that have been used since the 1920s.  They require every firm in the offering to sell at one offering price and to receive the same commission.  The managing underwriter is also authorized to buy and sell securities in the aftermarket and to keep the trading price from dropping below the offering price.  The SEC and the Department of Justice were on opposite sides of the price-fixing charge.  The Department of Justice claimed the agreements were clear violations of the Sherman Antitrust Act.  The SEC’s position was that the agreements were not unlawful.  Judge Medina decided that Congress and the SEC would never have permitted anything illegal.  “The real point is that all those who worked together on the formulation of this most significant and beneficial legislation went about their task of integrating into the statutory pattern the current modes of bringing out new security issues then in common use by investment bankers generally, with complete assurance that no violation of the Sherman Act was even remotely involved.”   [118 F. Supp.621, 697]

The Department of Justice tried the case for over two years, without calling a single witness, except the ones used to introduce documents.  Printed materials were over 100,000 pages and included materials from each of the government investigations, beginning with the 1905 Armstrong Committee.  At Judge Medina’s urging, the government finally added two witnesses.  One was Robert R. Young, a former stock speculator who had successfully sold short in 1929.  [His biography, by Joseph Borkin, is titled Robert R. Young, The Populist of Wall Street, Harper and Row, 1969]  When Young completed his testimony, Medina was so annoyed with his behavior that he refused to shake hands with him.  [Remark by Judge Medina to Vincent Carosso, September 2, 1966, in Carosso’s book, Investment Banking in America, page 491, note 123.]  Young committed suicide five years later.  [The Handbook of Texas Online,]

The other government witness was Harold L. Stuart, whom a defense attorney referred to as the “dean of investment bankers.”  Judge Medina said that Stuart was someone “upon whose testimony I could rely with confidence.” [Vincent Carosso, Investment Banking in America, Harvard University Press, page 491, note 126]  However, the government’s lawyers only questioned Stuart perfunctorily, in what Medina said was “a most tremendous waste of time.”  [New York Times March 8, 1952, quoted in Vincent Carosso, Investment Banking in America, Harvard University Press, page 492.]  On cross-examination, Stuart demolished the government’s case, denying each element of the charges of conspiracy.  

After the government put on its evidence, and before the defense had begun its part of the trial, Judge Medina dismissed all of the charges.  He took the unusual step of dismissing “on the merits” and “with prejudice.”  That meant that the government could not file a new complaint on the same allegations.  The 200-page opinion can be read as a “once-and-for-all” defense of investment banking, intended to put an end to the long series of Congressional investigations and political hay made from attacks on Wall Street.  The Justice Department, under President Eisenhower, chose not to appeal the decision. According to Vincent Carosso, the historian of investment banking, the trial “shattered the old myth of a Wall Street money monopoly.”  However, Carosso also wrote that “investment banking in the 1960s was as highly concentrated as it had been sixty years earlier.  In some respects it was even more so.” [Vincent Carosso, Investment Banking in America: A History, Harvard University Press, pages 495, 505]

When the Attorney General decided not to appeal United States v. Morgan, Wall Street was off the hook.  In the half century since, no branch of the federal government has tried to go after the investment banking oligopoly.  The subject has come up whenever a merger was proposed of major investment bankers.  In 1979, the Antitrust Division of the Justice Department asked the Harvard Business School to analyze the competitive effect of a proposed merger on the investment banking industry.  This led to the book, Competition in the Investment Banking Industry. Its authors concluded that there “was a tendency toward increased concentration in investment banking.” [[Samuel L. Hayes III, A. Michael Spence and David Van Praag Marks, Harvard University Press, 1983, page 78]  In an interview, the lead author, Samuel L. Hayes, III, said:  “We don’t see the prospect for an upheaval . . ..”  There are “substantial barriers to entry for intermediaries who would like to offer investment banking services.”  [Pensions and Investment Age, June 13, 1983, page 34.]  The message from academia to the Justice Department:  Hands Off Wall Street, Business as Usual.  [Charles Ferguson, interviewed about his documentary film, "Inside Job," described the "triangular relationship" of "People going between having positions in universities as economists and being in industry and being in government, and often being paid by industry while they are in academia and while they are writing papers and making speeches about what policy should be toward the industry they're being paid by."  Emily Wilson, "Inside Job: Film Brings Us Face to Face with the People Who Nearly Destroyed Our Economy," Independent Media Institute, 2010,]

Why did the federal government start the antitrust case?  Why did it drop so many of the charges before the trial began?  Why did the government have to be forced to put on witnesses?  Why did it choose only two witnesses and why were they ones which defeated the government’s case instead of making it?  When Judge Medina dismissed the complaint and said the government could not file another one, why did the government not appeal?  These are political questions, not legal strategy.  A political theory advanced by Robert Sobel for why the case was started is that, wanting to “revive the New Deal spirit after the war, the Truman Administration had warmed over that issue which had served F.D.R. so well in 1932-34.”  [Robert Sobel, Inside Wall Street: Continuity and Change in the Financial District, W. W. Norton & Company, 1977, page 205]  That may have been true when the case was started in 1947, with Truman headed for his narrow reelection victory the next year.  But Eisenhower was elected in 1952, two years before Medina’s decision came down.  What was the intention when the case was not appealed?  One argument is that the objective was what actually happened.  Wall Street came back to life and the government kept its hands off.  By 1961, there were more than a thousand initial public offerings in a year.  The underwriting syndicate and all the ritual of investment banking were back, without the slightest objection from government.  It was as if the great antitrust case had signaled:  “The coast is clear; you can all come out again to play.”  The permissiveness toward Wall Street's monopoly has been part of the general lack of enforcement of federal antimonopolly laws since 1970.  [Barry Lynn, Cornered: The New Monopoly Capitalism and the Economics of Destruction, John Wiley & Sons, Inc., 2010]

While the government has looked the other way at Wall Street’s monopoly practices, a private action was brought on behalf of persons who purchased technology IPOs in the bubble years just before 2000.  According to Justice Breyer’s opinion for the United States Supreme Court:  “A group of buyers of newly issued securities have filed an antitrust lawsuit against underwriting firms that market and distribute those issues. The buyers claim that the underwriters unlawfully agreed with one another that they would not sell shares of a popular new issue to a buyer unless that buyer committed (1) to buy additional shares of that security later at escalating prices (a practice called ‘laddering’), (2) to pay unusually high commissions on subsequent security purchases from the underwriters, or (3) to purchase from the underwriters other less desirable securities (a practice called ‘tying’).  The question before us is whether there is a ‘plain repugnancy’ between these antitrust claims and the federal securities law. [citations]  We conclude that there is. Consequently we must interpret the securities laws as implicitly precluding the application of the antitrust laws to the conduct alleged in this case.”  [Credit Suisse Securities v. Billing, ,, 2007] 

The SEC came into the case on the side of Wall Street and against the investors, arguing that regulation of the securities industry was its exclusive turf and the courts should stay off it.  The U.S. District Court agreed with the SEC and ruled in favor of the defendant investment bankers, but that was reversed by the Second District Court of Appeal.  That Court, located in New York, is the most knowledgeable and experienced in matters of finance.  The U.S. Supreme Court later reversed the Second Circuit, holding that enforcing the antitrust laws would disrupt the capital markets and that the SEC had the expert authority to regulate the securities markets. 

The technology bubble IPO was among the few cases brought by disappointed investors that made it through the courts after 1995.  Private securities litigation had become a nuisance to Wall Street and its corporate clients, so they got Congress to make it far more difficult for plaintiffs to bring class actions.  Abuses by some plaintiffs’ lawyers gave them plenty of talking points for their successful lobbying.  The law that Wall Street received from Congress reads like a long series of hurdles and barriers that disappointed investors must navigate before a case can actually get to trial or settlement.  [United States Code, Title 15, chapter 2B, section 78u-4,]

The “Regulatory Gap” Proved Self-Regulation Doesn’t Work

Congress controls the Securities and Exchange Commission through its annual budget.  The lobbying pressure from Wall Street has always been to keep the SEC on a tight leash—give it enough money to keep up the appearance of firm regulation but not enough to interfere with Wall Street’s profitability.  The SEC’s response has been to privatize many of its responsibilities, taking the cost off its books and leaving the SEC Commissioners and staff in an “oversight” role.  The SEC refers to these outsourcing contractors as “Self-Regulatory Organizations” or “SROs,” despite the obvious oxymoron in the term.  What the SEC seems to mean is that no government regulation is necessary because Wall Street will behave for its own long-term benefit; enlightened self-interest will eliminate the excesses that nearly led to eventual collapse of the whole system. 

The most prominent SROs are the securities exchanges.  They must be registered with the SEC, which reviews changes in their rules and oversees their enforcement.  From 1792, when the New York Stock Exchange was first chartered, all exchanges had been nonprofit membership organizations.  Each broker-dealer member had one vote to elect a board of directors, which hired the management.  The mission was clear.  It was to help the members trade securities listed on the exchange, in the most profitable manner that complied with the rules of the exchange.  That structure and psychology changed when the exchanges converted to for-profit corporations and had their own initial public offerings.  Shares are now owned by anyone willing to pay the price.  The mission is now different.  Like any other business with publicly-traded shares, management is supposed to make money for its shareowners.  What happens to self-regulation when ownership is in the hands of nonmembers and the exchange is supposed to make money for these nonmembers? What is the effect of competition among for-profit exchanges to attract and keep listings?  How will exchanges respond to the Alternative Trading Systems and Dark Pools that aren’t limited by SEC oversight? [Hans Christiansen and Alissa Koldertsova, Organization for Economic Co-operation and Development, “The Role of Stock Exchanges in Corporate Governance,” Financial Market Trends, Vol. 2009, No. 1, Pgs. 191-220, ]

The self-regulatory functions for the securities industry have been outsourced to the Financial Industry Regulatory Authority, created in July 2007 through the consolidation of the National Association of Securities Dealers and the member regulation, enforcement and arbitration functions of the New York Stock Exchange.   []  FINRA oversees nearly 4,750 brokerage firms, about 167,000 branch offices and approximately 633,000 registered securities representatives.  Its basic purpose is to protect Wall Street’s monopoly from nonmember competition and from so-called rogue brokers who break the rules and make the industry look bad.   FINRA has the bureaucratic itch to expand its turf.  It spent $300,000 in 2011’s first quarter on lobbying Congress and the SEC, mainly to get itself appointed as the self-regulator for investment advisers.  $50,000 of that lobbying money went to the law firm of former Ohio Republican Congressman Michael Oxley, co-author of the Sarbanes-Oxley law.  []

One self-regulatory program was the Consolidated Supervised Entities Program, set up in 2004 and referred to as the CSE.  It was intended to address a big gap in financial regulation—the large Wall Street investment banking corporations.  Because they don’t take in deposits, they were not under the Federal Reserve Board, the FDIC, the Controller of the Currency or state bank regulators.  While their brokerage subsidiaries were subject to FINRA rules, their major business, and biggest risks, were from the buying and selling they did for their own profit, and the huge borrowings they took on to leverage their trading.  Under the CSE, these unsupervised giants could voluntarily submit to regulation.  The SEC ended the program, after its Inspector General strongly criticized the Commission's CSE supervision of Bear Stearns, which collapsed in March 2008.  [  See critique of the program by the minority of the House Committee on Oversight and Government Reform, May 18, 2010, pages 8-11, [] As Scott Patterson describes it, "in a move that would come to haunt not just the agency but the entire economy, the SEC outsourced oversight of the nation's largest financial firms to the banks' quants."  [Scott Patterson, The Quants, Crown Business, 2010, page 201] 

A few days after the failure of Lehman Brothers, leading to the Panic of September 16, 2008, the SEC abandoned the CES program as a failure.  Here is what then SEC Chairman Christopher Cox said in an unusually candid news release:  "The last six months have made it abundantly clear that voluntary regulation does not work. When Congress passed the Gramm-Leach-Bliley Act, it created a significant regulatory gap by failing to give to the SEC or any agency the authority to regulate large investment bank holding companies, like Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns.  Because of the lack of explicit statutory authority for the Commission to require these investment bank holding companies to report their capital, maintain liquidity, or submit to leverage requirements, the Commission in 2004 created a voluntary program, the Consolidated Supervised Entities program, in an effort to fill this regulatory gap. 

Chairman Cox went on to say:  “As I have reported to the Congress multiple times in recent months, the CSE program was fundamentally flawed from the beginning, because investment banks could opt in or out of supervision voluntarily. The fact that investment bank holding companies could withdraw from this voluntary supervision at their discretion diminished the perceived mandate of the CSE program, and weakened its effectiveness.  The Inspector General of the SEC today released a report on the CSE program's supervision of Bear Stearns, and that report validates and echoes the concerns I have expressed to Congress. The report's major findings are ultimately derivative of the lack of specific legal authority for the SEC or any other agency to act as the regulator of these large investment bank holding companies.  As we learned from the CSE experience, it is critical that Congress ensure there are no similar major gaps in our regulatory framework. Unfortunately, as I reported to Congress this week, a massive hole remains: the approximately $60 trillion credit default swap (CDS) market, which is regulated by no agency of government. Neither the SEC nor any regulator has authority even to require minimum disclosure. I urge Congress to take swift action to address this."  []

Private Securities Cases Become Their Own Scam

Serious political reformers are aware that government agencies are not enough to protect us.  They realize that laws are not always enforced.  Sometimes the lack of detection and prosecution is because the agencies are starved through token funding by Congress.  Or the agencies may end up being staffed by persons more sympathetic to the industry regulated than to the public.  The “revolving door” may influence individuals who work for a regulator, while expecting to go to a job with a regulated business, or vice versa.  Some regulatory agencies may just atrophy in bureaucratic red tape.

Foreseeing this frustration, lawmakers have often created “private rights of action,” inviting persons harmed to start their own court proceeding.  An extra inducement may be the possible award of triple the amount of actual damages, reimbursement of legal expenses or the promise that lawyers can attract follow-on clients for more cases.  In the federal securities laws, these private rights of action have led to a more or less permanent class of securities plaintiffs’ law firms.  Wall Street has successfully lobbied Congress into erecting barriers to shareowner class actions, while some prominent class action lawyers have been punished for paying plaintiffs to bring lawsuits. 

The private action remedy, if it is at all effective, is likely to be a case of way too little, way too late.  For instance, a class-action lawsuit was brought against dozens of investment banks and brokerage firms for the unlawful games used to inflate trading prices for shares of recently-completed IPOs in the late 1990s.  Losses were claimed in the many billions.  It was ten years before the case was settled and the amount was a relatively token $586 million.  Of that, the six lead plaintiffs’ law firms were expected to take a third and also put in for reimbursement of $56 million for their expenses.  [Nathan Koppel, “Tech-Firm Holders Settle Suit Over IPOs,” The Wall Street Journal, April 7, 2009, page C3]  A federal appeals court had ruled that there wasn’t a clear chain of causation between the underwriters’ actions and the investors’ losses, so the case could not be conducted as a class action.  The proportionately minor settlement amount “was a big victory for investment bankers,” according to Professor Jay Ritter, the principal authority on IPO practices.  [Randall Smith and Chad Bray, “IPO-Abuses Lawsuit is Finally Settled,” The Wall Street Journal, October 7, 2009, page C1]

The federal securities laws enacted in the 1930s specifically include the right to bring private lawsuits to recover investment losses.  [Securities Act of 1933, sections 11, 12 and 18,; Securities Exchange Act of 1934, sections 18 and 20,]  The U.S. Supreme Court has said that the words of the law and regulations “implied” a private right to sue in cases based on section 10(b), which makes it unlawful to use any manipulative or deceptive device in the purchase or sale of a security.  [Superintendent of Insurance of New York v. Bankers Life and Casualty Co., 404 U.S. 6, at 13, note 9, 1971]  However, private enforcement of the federal securities laws has become a game played by class action securities litigators and insurance companies.  Corporate directors and officers are routinely indemnified by the corporation from any liability to securities owners and the corporations also buy directors’ and officers’ liability insurance to cover what they might have to pay on the indemnities.  The dollar limits of that insurance become the treasure chests for the litigators, who will get a big percentage in fees and their expenses.

By the 1990s, Wall Street got Congress to override a presidential veto of the Private Securities Litigation Reform Act of 1995.  That law watered down the ability to bring a class action on behalf of securities holders.  [Securities Act of 1933, section 27,; Securities Exchange Act of 1934, sections 21D and 21E, and  For a summary description of the legislation, see the law firm memorandum by Pillsbury Winthrop Shaw Pittman LLP at] After the “Reform Act,” shareowner class actions are more difficult and costly, but they are still a trick game, in which the corporations and their insurers settle cases by paying a few institutional investors and their lawyers, with the  money for the settlement and  the large insurance premiums coming out of the corporate net worth that belongs to all shareowners.  As U.S. District Court Judge Jed S. Rakoff said, when rejecting the proposed settlement over Bank of America’s claimed failure to disclose Merrill Lynch bonuses, “shareholders who were the victims of the bank’s alleged misconduct [would] now pay the penalty for that misconduct.” [Michael Orey, “Do Shareholder Class Actions Make Sense?,” Business Week, September 28, 2009, page 66] The officers and directors, who caused or permitted the claimed wrongdoing, pay nothing and come out blameless, because the settlement agreements typically declare that no one admits or denies any wrongdoing. 

Securities class actions are either dismissed or settled; they rarely ever get through an actual trial. The settlement amount is usually right around the insurance policy limits and  negotiations get more complex when the primary insurer is backed up by other policies. [Professors Tom Baker, University of Pennsylvania Law School, and Sean Griffith, Fordham Law School, “How The Merits Matter: Directors' And Officers' Insurance And Securities Settlements,” University of Pennsylvania Law Review, Volume 157, No. 3, Page 755,]   Insurance polices have a "dishonesty exclusion," which lets insurers escape payment if a court finds fraud or willful violation of the securities laws.  Settlements before a court finding are made without admitting dishonesty, to collect on the insurance, "a huge incentive to settle even the most spurious claim."  [Pamela A. MacLean, California Lawyer, July 2010, page 32, reviewing Circle of Greed: The Spectacular Rise and Fall of the Lawyer Who Brought Corporate America to its Knees, by Patrick Dillon and Carl M. Cannon, Broadway Books, 2010]  Once there is a settlement agreement, another long process drains off fees and expenses before the people who once owned the security ever receive any leftovers. 

The real cause of most of these drainoffs of corporate funds from securities litigation is the volatility of the securities markets.  To make money from a lawsuit, there needs to be four elements: a legal duty; a breach of that duty;  damages caused by that breach and, finally, a source of money to pay damages.  In the class action securities litigation world, it all begins with the last of these,  a calculation of damages—the difference in the market value of the securities just before the breach from the value after—and the insurance coverage available to pay the damages.   If the price drop has been large enough, and the insurance policy limits are high enough, a securities litigator can always find the duty and breach which can be said to have caused the drop.  

The effect of the private remedy today is that insurance premiums paid by corporations get distributed to lawyers for plaintiffs and defendants and all the accountants, expert witnesses and other participants in the process.  The insurance companies increase premiums to make sure something is left over for them.  The vision of “private attorneys general” enforcing the securities laws to protect investors is mostly a sham.

Securities Laws Protect Wall Street Schemes, Like “Front-Running”

There are basic confidence schemes that have been used for centuries to trick money from marks.  []  Most of them rely upon the victim’s greed overcoming conscience and reason, as in W.C. Fields’ movie, “You Can’t Cheat an Honest Man” and the book of that title.  [James Walsh, You Can’t Cheat an Honest Man:  How Ponzi Schemes Work and Why They’re More Common than Ever, Silver Lake Publishing, 2010]  Some con games can be worked without violating any criminal law.  Others may be technically illegal but law enforcement officers don’t consider them worth the effort of arrest and prosecution, because they know that they won’t take any heat for letting it go by.

Most of Wall Street’s schemes involve some form of inside information.  The Wall Street participant in a transaction knows something important that the other side hasn’t yet learned.  As Gordon Gekko said in the movie, Wall Street, “If you’re not inside, you’re ‘outside.’”  [This and other quotes from the film, like “greed is good,” can be read at]  One of the insider schemes that the securities laws protect—for Wall Street firms, but not for its employees—is “front-running.”

At front-running’s most primitive form —and against the rules—a brokerage employee receives a large order to buy a traded security and figures the order will cause the price to go up before it can be filled from sell orders. The employee then puts in a buy order for the employee’s personal account, followed by the price-changing customer’s buy order, and then followed by the employee’s sell order at the now higher market price.  This gross practice is usually perpetrated by an employee, acting alone, trying to pick up some extra money that doesn’t get shared with the employer.  As a result, the brokerage firm wants to catch this “rogue” and prevent the bad customer relations and publicity that could result.  The even stronger, quirky motivation is that the employee is trying to make a personal profit that should really belong to the employer.  The regulators have computer programs that can pick up trades that look like front-running, so they can help Wall Street clean its house, while getting credit for protecting the public.

While the SEC and FINRA are equipped and willing to help Wall Street catch rogue brokers, it’s a very different story when the front-running is a Wall Street firms’ own practice, like letting favored customers in on “hot IPOs.”  A century ago, J. P. Morgan liberally brought in preferred people to buy at private sales of the holding companies he formed, before they were sold at public offerings.  The Securities Act of 1933 protects a very similar practice.  It says that new issues of securities must be sold only by use of a prospectus, which must be first cleared with the SEC.  But it defines “prospectus” as a communication “written or by radio or television.”  [Securities Act of 1933, section 2(10),]  In the real world of Wall Street, securities are sold not by a written prospectus, but by oral communications, by telephone or in meetings.  The whole purpose of the IPO “road show” is to let invited customers hear the company’s officers and the underwriter’s analysts present information that is not written in the prospectus, allowing them to place orders for the offering, front-running the public.

The “quiet period” is another tool given Wall Street under the Securities Act, ostensibly to prevent “gun-jumping,” which is getting ahead of the general public.  The quiet period is the time between a company’s decision to have a public offering of its securities and up to 40 days after the offering is completed.  [The quiet period is part of a complex set of rules about disclosure, revised July 2005 in a 468 page document, SEC Release No. 33-8591,]  Because the company in an IPO has been privately owned, not much information will have been publicly available about it.  SEC lawyers warn that any news or comment that seems to promote the company can cause the SEC to postpone the offering for a “cooling off” period of up to many months.  

In reality, the quiet period’s “main purpose seems to be to give fat-cat players an edge over ordinary investors. How? In the runup to their IPOs, companies stage road shows, where big investors get to hear and question company management and its bankers. Meanwhile, because of regulations affecting the quiet period, the company often refuses to talk to the press or address any questions average investors might have.  Information is often given to pros at road shows that average investors don't have a prayer of receiving.  Says Jay R. Ritter, a finance professor at the University of Florida: ‘There's a sleight of hand. Companies can say certain things that they're not allowed to write down.’ For instance, they often discuss analysts' forecasts of their earnings with road-show audiences but don't publish them.”  [Marcia Vickers, “There's No ‘Quiet Period’ For Bigwigs: Before an IPO, institutions get road shows -- while small investors get shut out,” Business Week, August 2, 2004,]

The SEC staff has said it will permit Internet road shows.  However:  “These road shows will be accessible only to Qualified Institutional Buyers (‘QIBs’) . . ..  Upon qualifying the potential Investor as a QIB,  . . . the broker-dealer will issue to each such QIB a password to view and/or participate in the Webcast.”  []   QIB’s are institutions with at least $100 million in assets.  Even with the universal access to the Internet, the SEC just won’t let individuals have the same access to the company’s officers and presentations as the Wall Street money managers for institutions.

 Investment Bankers Use the New Deal Laws to Protect Their Monopoly 

The major threat to a monopoly is competition.  Since 1792, when brokers and dealers started the New York Stock Exchange, the first rule of Wall Street has been that securities trading is for members only.  The biggest sin on Wall Street is “trading away,” doing any business outside of club members and club rules.  That includes any moonlighting by an employee or any alliance by a member firm with a nonmember business.  When enactment of the federal securities laws brought the requirement that broker/dealers must be licensed by the SEC, the full force of the federal government was placed behind enforcement of the club rules.  Anyone caught trading away can be barred for a lifetime from ever being inside the securities business. The SEC gets lots of criticism for being lax in protecting investors, but it has been vigilant in protecting Wall Street from competition.

 The federal securities laws effectively incorporated Wall Street’s monopoly agreement into federal law.  The Securities Exchange Act of 1934 makes a criminal of anyone encroaching on Wall Street’s protected turf without being a registered broker-dealer.  [Section 15(a),]  Even activity on the edge of that turf will be blocked.  The Securities Act of 1933 makes it unlawful for any person to use any “communication which, though not purporting to offer a security for sale, describes such security . . . without fully disclosing” the receipt of pay for the communication.  [Section 17(b),] The SEC sued a New York public-relations firm and its owner for disseminating information about stocks on their website,, without disclosing that the featured companies had paid for the touts.  [Litigation Release No. 15950, October 27, 1998

The Wall Street way to raise capital is the syndicate of investment banker allies who divide up the new securities for sale to their wealthy customers.  Early in the 1900s, new broker firms began to encroach on the monopoly of major investment bankers, by using advertising and public relations to educate middle class newspaper and magazine readers about investing in securities.  The Securities Act of 1933 put a stop to this competition.  It prohibited written communications before an offering had effectively been completely sold.  The major investment bankers, who could sell an entire issue with a few telephone calls, again had the field to themselves.

 Even within the investment banker syndicates, the managing underwriters often had problems with some of their members secretly cutting prices or selling before the set time.  When competitors agree to restrict competition, it can be very difficult to keep them all in line.  Somebody will be trying to find away around the rules while somebody else may consider open rebellion.  It is not unusual for an industry to get the government to enforce its agreements not to compete.  Their assigned traffic cops become the protectors of the monopolists.  The Securities Act of 1933 put the federal government in the role of enforcing the rules for participants in Wall Street underwriting syndicates. 

 Until recent years, a single investment banking firm did not have enough customers of their own to sell an entire issue.  They rounded up other securities broker-dealers to sign an underwriting agreement, with each member of the syndicate agreeing to take a portion of the offering for resale.  Before the Securities Act, syndicate members had begun to seek an advantage over their rivals by violating syndicate agreements that set the price and timing for the sales.  Some of them were “jumping the gun” by selling securities to customers a few days or hours before the planned simultaneous release for sale.  They would plant pre-offering advertising, which tempted them to jump the gun when customers called about the offering.  Another practice among selling group members was to share their commission on an offering with their customers, by discounting a bit from the offering price.  The increased speed of distributions and the focus on retail selling during the 1920s made it difficult for managing underwriters to monitor and control the behavior of hundreds, or occasionally thousands, of securities dealers participating in the distribution of a new issue. By the late 1920s, investment bankers realized that the viability of the syndicate system was threatened.  The answer for Wall Street was to bring in the federal government to enforce its monopoly rules.  The Securities Act of 1933 made it a crime to sell before the managing underwriter chooses to have the SEC registration statement become final.  The Act also prohibited any publicity before that date.

In the late 1930s, the Temporary National Economic Committee investigated the concentration of economic power, “including that created by ‘financial control over industry.’  In the investment banking field, it was clear that the costs imposed by the Securities Act tended to discourage smaller issuers from engaging in public offerings, which deprived less prestigious underwriting houses of business. Under pressure from the SEC, however, the TNEC concluded that the fault lay with ‘the capital markets’ and not with the Securities Act.”  [Paul G. Mahoney, “The Political Economy of the Securities Act of 1933,” University of Virginia School of Law, Law and Economics Working Papers, Working Paper No. 00-11, May 2000, page 41,]  Wall Street has effectively used the SEC to protect its monopoly even from any judicial supervision.  Anyone running to the courts for enforcement of investor protection will be met with the argument that the courts need to leave securities regulation to the agency created by Congress for that purpose. 

While the SEC has kept the hands of the federal government off Wall Street’s monopoly, state governments can still be a threat in enforcing their laws against fraud.  Then New York Attorney General Eliot Spitzer forced Wall Street into a 2003 settlement of claimed abuses surrounding underwritten IPOs.  Part of the settlement called upon the SEC to enact enforcement rules.  Eight years later, the SEC had not yet come up with the rules.  [Randall Smith, “Rule Over The Abuse Of IPOs Is Delayed,” The Wall Street Journal, May 3, 2011, page C1]  Not only that, but the SEC proposed to the court that it take away some of the restrictions in the settlement order.  Even the SEC chairman at the time of the settlement commented in 2010 that:  “This seems like it’s going in the wrong direction,” while Spitzer said:  “That was the moment when Wall Street should have been reformed, and it seems no one did anything.”  [Susanne Craig, Kara Scannell and Randall Smith, “SEC Didn’t Expand Upon Stock-Abuse Settlement,” The Wall Street Journal, March 19, 2010, pages C1, C3]  

Wall Street also brings the government in to enforce rules upon its employees, preventing them from ever competing with their employers.  Trading away is the number one crime on Wall Street.  What “trading away” means is that an employee is doing some business on the side, cutting the employer out of the deal.  We all know people, in the building trades, for instance, who do jobs on weekends or days off, getting paid directly by the customer.  Employers generally look the other way, so long as the side jobs don’t interfere with how the employee performs at the regular job.  It’s hard to believe that prosecutors and courts would step in to punish these moonlighters.

Not so on Wall Street.  It has a government-protected monopoly on the securities business.  Anyone who deals with customers about securities has to be under contract to a licensed broker-dealer.   If a registered representative gets caught doing a piece of business that doesn’t go through the broker-dealer’s books, it can be the end of the representative’s license, the end of any ability to work in the securities industry.  It can also mean fines and imprisonment.

A recent example shows how seriously the government takes its job of protecting Wall Street against competition from employees who receive money that could have gone to their employer.  One of Wall Street’s minor sources of revenue comes from its practice of lending stock to persons who have sold the stock short and are supposed to be in position to deliver the sold shares.  Of course, the shares are actually owned by the brokerage firm’s customers, but that’s another issue.  The broker-deaer employer collects the fees charged for borrowing shares.  Morgan Stanley, now owned by Bank of America, found out that some of its employees were directing stock lending business through finders, who then split their fees with the employees.  The Brooklyn U.S. Attorney’s office prosecuted 19 employees.  They were all convicted and were sentenced to up to three years in prison. After the convictions, Morgan Stanley issued a statement that the employees had violated the firm’s policies.  [Amir Efrati, “Ex-Trader Pleads Guilty in Stock-Loan Case, The Wall Street Journal, April 16, 2010, page C5]

Wall Street is Allowed to Play Both Sides of the Game

Many of the abuses revealed in the Crash of 1929 investigations involved securities firms operating a business model with a built-in conflict of interest.  They acted as brokers executing trades for customers and they were also dealing in securities for their own account.  Sound familiar?  That’s because the major broker-dealers and banks are still doing business the same way, often betting against the customer and causing big problems.  Congress and the SEC have never mustered the will to enforce a separation of the broker and the dealer functions.

Some of the biggest conflicts of interest at Wall Street firms come from their dual role of buying and selling securities for customers while also buying and selling securities for themselves.  The SEC defines these very separate roles as “broker” and “dealer.” [Securities Exchange Act of 1934, sections 3(a)(4) and (5),]  Nevertheless, Wall Street firms are licensed as “broker-dealers,” so they are free to trade for themselves at the same time they are advising and placing orders for customers.  A major part of the New Deal legislative proposals was to force Wall Street firms to be either a broker or a dealer, but not allow them to be both.

The draft Securities Exchange Act of 1934 required securities firms to choose between acting as an agent for others or buying and selling securities for their own account.  That would have applied to underwriting new issues of securities, since investment bankers structurally purchase shares or bonds from their client, the securities issuer, and resell them to their customers. Underwriters would have been required to change their business model.  They could either have acted as an agent for the issuer in selling the securities or they could have purchased and resold the new issue of securities.  The same firm could not have done both.

The proposal to separate the functions of brokers and dealers started out as the Fletcher-Rayburn bill.  Sam Rayburn, the long-time Speaker of the House of Representatives and mentor to Lyndon Johnson, said that opposition to his bill was “the most powerful lobby ever organized against any bill which ever came up in Congress.”  [Vincent P. Carosso, Investment Banking in America: A History, Harvard University Press, 1970, page 377.] 

Instead of making it into law, the issue was deferred for study to the newly formed SEC.  The new Commission eventually concluded that “although the combination of the broker and dealer functions did involve serious problems of conflict of interest, there was no need to legislate a complete segregation of these functions inasmuch as we had been granted ample administrative power to deal with most of the known abuses.”  [Report on the Desirability and Advisability of the Complete Segregation of the Functions of Broker and Dealer, Government Printing Office, 1936, pages 109-110, quoted by Martin Mayer in Stealing the Market: How the Giant Brokerage Firms, with Help from the SEC, Stole the Stock Market from Investors, BasicBooks, 1992, page 41.]

Government Kicks Commercial Banks off Wall Street’s Turf, Temporarily 

Wall Street investment banks have never been interested in selling new issues of securities to the middle class individual. Their underwriting commission rate is the same on small sales as it is on large ones, while the time involved to make a small sale can be about the same as for a large one.  As long as an issue of securities can be sold to a few large investors, there is no incentive to develop business with anyone other than institutions and wealthy individuals.  In practice, the small investor involves even more work, because of the need to develop a trust relationship and to educate the customer.   

The only serious competition to Wall Street’s investment bankers came from commercial banks, which encroached on their turf after their learning curve in the successful Victory Bond programs of World War I.  Commercial banks were the only group willing to sell to the small investor.  They already had a trust relationship with their middle class depositors and they had learned successful marketing techniques from selling Victory Bonds.  After the War, banks created affiliates to distribute securities issued by their loan customers, often selling them to their deposit customers.  One of the ways they accommodated these retail customers was to sell securities on the installment plan, with 25 percent down and five percent per month.  As the banks grew their underwriting business, they began to draw clients away from the investment banks. 

After the 1929 crash, stories emerged about speculation, manipulation and fraud by the commercial banks and their securities affiliates.  These stories became Congressional testimony, supporting the Banking Act of 1933, which made it unlawful for commercial banks to act as investment bankers or as securities broker/dealers.  Glass-Steagall, named after the two sponsors of the Banking Act of 1933, has been the short-hand term for the law forcing commercial banks to get out of the securities business.  In 1934, after the Banking Act had become law, a study was published in the Harvard Business Review, comparing offerings underwritten by the eight largest private investment banks with the eight largest affiliates of commercial banks.  It concluded that:  “One can now say that there has been no significant difference in the quality of the new security originations of these two groups.” [Terris Moore, “Security Affiliates Versus Private Investment Banker—A Study in Security Originations,” Harvard Business Review, July 1934, page 484.] 

In the Glass-Steagall Act, the investment bankers got Congress to freeze out the commercial banks.  Any bank which accepted deposits, with the new FDIC insurance, could not also underwrite securities or operate a brokerage business.  This prohibition lasted until the 1980s, when investment bankers were out-lobbied and Congress let commercial banks back into the securities business.  Then, after the Panic of 2008, the two remaining big investment banks chose to become bank holding companies, to come under the shelter of the Federal Reserve and its unlimited supply of cheap borrowing. 

The public buildup to forcing commercial banks out of the securities business began in 1932, with hearings before the Senate Banking and Currency Committee, called the Pecora Committee, after its Chief Counsel, who much later published his story of the hearings.  [Ferdinand Pecora, Wall Street under Oath : The Story of Our Modern Money Changers, Simon and Schuster 1939, A. M. Kelley, 1973]  Pecora had been a New York District Attorney.  When Pecora became a New York Supreme Court Justice, Joseph P. Kennedy, the first SEC Chairman, sent him a congratulatory telegram.] The investment bankers won the battle before the Pecora Committee hearings by cooperating with legislative staff in supplying information and drafting proposed legislation.  [Mahoney, Paul G., "The Political Economy of the Securities Act of 1933," University of Virginia Law School, Legal Studies Working Paper No. 00-11, May 24, 2000, or DOI: 10.2139/ssrn.224729]

The Glass-Steagall Act forced bank managers to choose between selling securities and accepting FDIC-insured deposits.  While investment bankers continued to be unregulated until 2008, commercial banking is heavily regulated, by the regional Federal Reserve Banks, Comptroller of the Currency and state banking supervision.  Much of this regulation is intended to protect the banks from the consequences of mistakes they may make in lending and investing.  Commercial banks are required to have a protective layer of shareowners’ equity to absorb losses.  By contrast, investment banks have had no regulation of their investments or their capital adequacy.  They have been free to borrow as much as they can to invest in whatever they choose.  As described by Justin Fox in  “Investment banks have a natural tendency to expand until they use all of the balance sheet they're given. That's one of the reasons the SEC's 2004 decision to remove constraints on leverage was such a bad one -- they're constitutionally incapable of constraining themselves.”  [“Blame Citigroup’s woes on the Citi-Travelers Merger,”, December 2, 2008]   The limit on deposits and borrowings for commercial banks is around 8%, or 12 times shareowners’ equity.  Investment banks operated at much higher leverage levels.  In the Summer of 2008, the two major remaining investment banks had borrowings equal to 24 and 28 times their shareowners’ equity.  [Peter Eavis, “Life after Debt for Wall Street,” Heard on the Street, The Wall Street Journal, December 3, 2008, page C14.]

After a long battle between commercial bankers and investment bankers, the Glass-Steagall Act was completely repealed.  The fight to bring it back was a big part of the financial reform bill machinations in 2008.  The commercial banks’ attack on Glass-Steagall was like the siege of a city in ancient time.  There was the frontal attack in the 1960s, to break down the wall that Congress had built.  The banks recruited a lobbying army, at first just to allow them to en