EfficientMarkets.com: Wall Street, 1997; Wall Street, 1998
November 12, 1998
Mr. Warren E. Buffett
1440 Kiewit Plaza
Omaha, NE 68131
Dear Mr. Buffett:
Thank you for your kind reply to my screed. Because of the mind-numbing nature of my job (some argue that alone justifies the pay, but assembly-line workers might disagree), I can get my thoughts on paper only when on vacation. Hence my delay in writing back. Although the highs for the securities business have unfortunately passed, other timing factors are more favorable than when I first wrote:
But timing is a moot point if I failed to convince you that there is an alternative to the current system and that you could create it (… Wall Street is corrupt—something you knew before I was born). I will try again, starting with a look at some of your probes of the system.
During your stint as Salomon’s chairman, you addressed two problems common to all securities firms: irrational compensation and unethical conduct. My perception is that you had some success in correlating compensation to the firm’s results, but ultimately encountered the same problem any unilateral strike against excessive pay would have faced in a time of exploding compensation and new firms entering the business: many employees could get a better deal away.[2] And though I can not fault you for looking after your investment, any effective reform of Wall Street must focus on reducing revenues rather than on redistributing them.
You also attempted to improve Salomon’s ethical climate. I must disagree with your assessments of both how bad things were and how they could be improved.[3] Paul Mozer was exceptional for his recklessness, not for his ethics: even those traders who brazenly gouge and front-run customers know better than to fool with the Treasury. A history of illegal and unethical behavior at Salomon ending in 1991 would devote no more than a page to the bidding scandal, if the criterion was harm to investors, issuers, and taxpayers (indeed, at least in the short run, Mozer’s inflated bids saved the Treasury a basis point or so and only hurt market pros who were caught short). This is not to excuse violating government rules or to minimize the longer-term cost of threatening the credibility of Treasury auctions, but just to lend some perspective on what goes punished and unpunished on Wall Street. To pick one subject worthy of a full chapter, how much did Salomon’s mortgage-backed desk take out of the S&Ls on their way down? This is hard for an outsider to estimate, but it was at least an eight-figure and probably a nine-figure sum. (Then of course, some of the same gang made millions more buying the S&Ls’ assets back from the Resolution Trust Corp. on the cheap.) Yes, only a few may have committed and covered up the bidding violations, but “misconduct and misjudgments were limited to those few” does not describe Salomon or any other securities firm.
Your local-paper test is a good standard for ethical behavior.[4] And I am sure that your presence did temporarily change the way business was done. But a trading floor’s conflicts of interest mean that appeals to virtue compete directly with appeals to mammon. Unless you have recruited exclusively at monasteries, virtue loses. For the shareholders’ sake, this is just as well because “good profits” generally are “inconsistent with good behavior” for dealers in competitive securities markets. To test this notion, sit an alert compliance officer armed with a listen-only headset next to Salomon’s ten-year (the favorite maturity for corporate hedging and therefore the best seat for front-running) Treasury trader for a week. I predict his revenues are halved. I have heard a lot about “first-class business … in a first-class way” during my time at Morgan …
I think my [perspective] on the securities business lies somewhere in the middle of Wall Street’s ethical spectrum. Morgan is not [a small, honest retail brokerage firm], but neither is it Drexel or even Smith Barney—I saw how Morgan priced some municipal defeasances and I think I know how Smith Barney priced its.[5] Yes, there are many honest retail brokers who help individuals make sensible long-term investments. But institutional business has several unique problems. First, large transactions can generate enormous per-ticket profits through front-running (an order for a hundred shares cannot be front-run, an order for a million shares can be) and gouging (while the percentage markups are far worse on the retail side, the per-ticket tolls in institutional transactions dwarf those in retail).[6] Second, institutions require more complicated services than individuals: Ford needs to structure and distribute its securities and hedge its foreign-exchange exposure. These services may be difficult for the outsider to evaluate or price. You wrote in Berkshire’s 1996 annual that “we more than got our money’s worth” from Salomon Brothers. Yes, if you are the largest shareholder of a securities firm and know a thing or two about the markets, that firm will treat you fairly (even so, Internet distribution will make a 1.5% underwriting fee look excessive).[7] All but the reckless on Wall Street know to take only what they can get away with—an amount that varies from customer to customer and transaction to transaction. This brings us to the third distinguishing characteristic of institutional business: transactions usually involve somebody else’s money (as you frequently point out, this is not true for Berkshire) and therefore lack the self-correcting mechanism of an aware injured party which ultimately catches many dishonest retail brokers.[8] This last point cannot be overemphasized: it is the primary moral argument for change.
You have long complained about merger fees, going so far as to abstain from voting for the Duracell acquisition. Unfortunately, without an alternative source for the necessary imprimatur, what is a board of directors to do? Now consider whether Morgan Stanley could even ask for ten million dollars for their blessing of a deal if their status as one of the handful of masters of the world’s investment flows was exposed as a sham—that they were at best toll-collectors and at worst thieves. How could they be considered credible judges of the worth of complex businesses after they were shown to routinely misprice simple bond offerings in order to maximize their profits?
So far, Wall Street 3, Buffett 0. We know what does not work: reallocating revenues from employees to shareholders, changing ethics through exhortation rather than a change in incentives, and bemoaning excessive fees without attacking the confidence game underpinning them … What does work? Berkshire short-circuited Wall Street’s fee machine for the California Earthquake Authority, saving it from $20 to $40 million dollars per year. Morgan Stanley wanted to price its services as if it were underwriting the risk of catastrophe, rather than just finding investors to assume it. That Ajit Jain considered it also a good deal for Berkshire is even better: there are profits to be had in disintermediating Wall Street.
I think the success of your “first business love” is also instructive. GEICO has done for many buyers of car insurance what the Internet will do for issuers and investors—remove the toll imposed by the commissioned salesperson. (Sales commissions are worse than mere tolls in other forms of insurance—see Prudential’s life-insurance sales practices—and on a trading floor: they are the spur to promoting high-margin products and churning.) Change a few words in your description of GEICO’s strategy and you have the concept for an electronic securities firm: “GEICO’s method of selling—direct marketing—gave it an enormous cost advantage over competitors that sold through agents, a form of distribution so ingrained in the business of these insurers that it was impossible for them to give it up.”[9] You may consider it a stretch, but I am also scoring this one for you, making it Wall Street 3, Buffett 2.
But enough of preliminaries. How do you replace a system that [has so many powerful and wealthy supporters]? Wall Street aside, there is plenty of inefficiency and corruption among the other three elements of the current system: corporate executives who donate their shareholders’ dollars to securities firms out of some combination of ignorance and a conscious desire for freebies; money managers (of whom there are far too many—do investors need eight thousand mutual funds to choose from?) who overtrade, rarely beating indexes, but frequently receiving kickbacks for oiling Wall Street’s machine; and regulators and elected officials who look to securities firms for job offers and campaign contributions, not indictments and reforms. But, though my first letter was unclear on this point, I am not suggesting goring all the oxen simultaneously. Instead, the project will focus on one element at a time, using the interests and emotions of the others against it. Wall Street, as the most parasitic element, is the proper first target on both moral and practical grounds. And among Wall Street’s businesses, underwriting is the best place to start: it generates eight billion dollars a year (not counting revenues from associated hedges or swaps, which, with front-running and gouging, can exceed the underwriting fees); it helps maintain the mystique necessary for fee collection in other businesses; and it is vulnerable to replacement by technology. Four ingredients are needed: corporations willing to issue securities over the new system, investors willing to buy them, technology to bring them together, and regulatory approval to allow it.
Previous attempts at disintermediation have failed because of Wall Street’s threat, whether explicit or implicit, to punish the securities of corporations that use the new system.[10] This would take two forms presumably—downgrading analyst recommendations and reducing, or eliminating, secondary market making. But surely you know a few CEOs (for it would be CEOs, not treasurers, who would initially make this decision) who understand that Wall Street analysts can only influence securities prices in the short run and would therefore be willing to suffer their wrath in exchange for significant savings,[11] particularly if an electronic secondary market, developed jointly with the new primary system, was available to foil any dealer boycott.[12] While some courage would be required of the first few pioneers, a baser motive might drive the corporate treasurers who would follow: resentment of the frequently arrogant and always better-paid investment bankers who currently handle their financings.
Enlisting investors would be far easier than issuers, because the system would not reveal the identity of buyers of new issues or participants in the secondary markets. Money managers could participate anonymously in the new system without worrying about being shut out of the current system’s underpriced IPOs or “confidential” trade information. Here too resentment would play a role, for what self-respecting money manager does not consider himself smarter and harder working than Wall Street salespeople, who are paid more to execute his decisions than he is to make them. I think most large traders and investors would quickly join such a system. But I do not expect you to take my word for it: ask Vanguard’s John Bogle,[13] the investment managers at Berkshire’s insurance companies, and Mark Byrne of West End Capital.[14] And ask yourself whether you would use a system that allowed you to get in (and occasionally out of) large positions without reading about it in tomorrow’s newspaper.
While you may be “a life-long sufferer from technophobia,” it did not take you long to appreciate the two key virtues of distributing information over the Internet: efficiency (zero marginal cost) and fairness (“to make this material information … simultaneously available to all interested parties”), in line with your belief that investment results should vary with the ability to process publicly available information, not the ability to obtain nonpublic information.[15] It is precisely these qualities that make it perfect for distributing securities (and eventually for live broadcasting of all communications between corporate insiders and securities analysts). There are many electronic systems now operating—with many more in development—in various corners of the markets. Securities dealers, who know an inefficient and corrupt trading system when they see one and are generally paid on their results, have made locals at some futures exchanges the first casualties of electronic trading (just as issuers’ and investors’ self-interest will eventually put dealers out of work). The locals are protesting on their way down (Parisian locals even tried a work stoppage to protest the Matif’s conversion to electronic trading), but so did commercial banks when corporations began issuing securities instead of taking out loans. Could such systems (or ideally, one integrated system) replace trading floors? Ask your friend in the software business (but be skeptical when he tells you which system would do it best) or David Shaw.[16]
Finally, the new system requires changes in the rules of the game. The SEC has just released for public comment a proposal for the biggest overhaul of securities regulations since 1933. Former commissioner Steven Wallman (now at the Brookings Institution) could tell you whether these changes will go far enough. And Bob Kerrey or Bill Bradley could, if they wanted to, help you exert pressure to ensure that they do.[17] Publicizing how the bond market actually works, in contrast to the SEC’s recent conclusion that it “is functioning effectively,” should generate enough heat on Chairman Arthur Levitt—who is not going back to the Street and would probably like to ensure his legacy as a useful public servant (he established, in honor of his father, a public-policy center at Hamilton College)—to enact the necessary reforms.[18]
Individually each element appears workable, but someone has to bring these forces together … I challenge you to name another person who commands the same respect in all of the relevant spheres. Consider the reaction to Berkshire’s announcement of its silver position: newspapers put the story—of interest only to jewelers, miners, and speculators—on the front page; commentators pontificated that the era of low inflation was coming to an end; the price of silver surged (if only briefly); and most importantly, even those caught short did not accuse you of any impropriety. To the contrary, the lawyer who was preparing to sue Phibro said that Berkshire “has a great track record, we’re not considering putting them in” (traders usually have less charitable thoughts towards those wielding the red-hot poker, whether legally or not). Instead he wanted to seek damages from anyone who might have piggy-backed your trade![19] If you were to announce the creation of a system to make primary issuance and secondary trading of securities more efficient, the story would be on the evening news and issuers and money managers would line up to enroll (and investors would call to ask if they could buy a piece of it).[20] Who would doubt that it would succeed? Happily, since a critical mass of participants is what makes a market work, it would.
But even if your leadership would guarantee the project’s success, there are still many reasons for you to beg off:
I am sure you would have no trouble adding to this list. Then why bother with this project? A hundred years from now you will be remembered for accumulating more money than any investor who came before (or after? barring the discovery of an investors’ creatine, I think your position is secure), while adhering to a code (expressed in epigrams that will still be often quoted) seemingly at odds with the pursuit of wealth, and then leaving the money that solved (let us hope) overpopulation. As most of us will be fortunate to be fondly remembered by our grandchildren, this is no small legacy, but it could be greater still. Or maybe you would like to end the careers of those who have front-run you in the past, to protect others if not to exact revenge. If neither your place in history (I do not know whether Mr. Munger spoke for you accurately when he said, “we didn’t want to be remembered by friends and family for nothing but pieces of paper”[22]) nor justice in the present are sufficient motivation, you might find the project at least as interesting as a good game of bridge.
You may have found my first letter entertaining; this one cannot help but be annoying. It is also probably a waste of time, as I have read that you do not often change your mind. I would not be bothering you again (this is my last shot) but for something you once wrote: “I do know that when I am sixty, I should be attempting to achieve different personal goals than those which had priority at twenty.”[23] While I do not know what you had in mind then, much less how that idea might have changed over the intervening thirty years, perhaps this project could fill the bill.
Sincerely,
__________
1. While some have questioned John Meriwether’s judgment, no one has publicly questioned his honesty. The New York Times (October 2, 1998) tells us that his colleagues consider him “scrupulously honest.” But if this is anything more than honor among thieves, why did he need a former vice chairman of the Fed with no trading experience as a founding partner of a relative-value fund? I do not think he was running regressions. And is it a coincidence that Long-Term counted the Bank of Italy among its investors and made a killing on the change in tax treatment of Italian government bonds?
2. Long-Term’s collapse should finally resolve the debate over whether Salomon’s arb desk paid enough for its capital.
3. Salomon’s ad in the Wall Street Journal, October 29, 1991.
4. “Informed and critical” reporting about Wall Street would play an important role in any reform. As most journalists do not understand how securities firms actually make money, the project would benefit from conducting a few seminars for them.
5. As the previous paragraph should make clear, I am not arguing that Morgan is a benevolent organization, only that my view of the securities business is not unfairly negative. Certainly as Morgan has evolved into a securities firm, two things have steadily increased: unethical behavior and employee compensation.
6. If you had accumulated and liquidated Berkshire’s zero position through a Merrill Lynch retail broker in pieces of fifty thousand, you would not have much to show for a good call.
7. Along the same lines, could you have amassed Berkshire’s silver position as discretely as you did without owning a major metals dealer? The publicity surrounding your zero transactions suggests not.
Ownership without market knowledge is apparently not enough: in February Goldman Sachs charged its part-owner Sumitomo 1% in fees (and, if my reading of the broker screens was right, front-ran the offsetting purchase of ten-year Treasurys as well) to underprice its $1.8 billion in preferred securities by at least two points.
8. The NASD’s monthly list of disciplinary actions against firms and individuals is full of retail brokers who have stolen ten grand from their clients, but bereft of institutional salespeople and traders, who routinely take ten or a hundred times that in one transaction.
9. Berkshire’s 1995 annual.
10. Prior to getting regulatory approval to underwrite corporate debt, Morgan worked on such a system (CapitaLink). Its first scheduled issuer, American Home Products, got cold feet after Merrill Lynch’s chairman called to warn that if they used the system, Merrill would discontinue making markets in their securities. Soon thereafter, Morgan was admitted to the club, found the drinks cold and the chairs comfortable, and lost interest in rendering it obsolete.
11. A firm looking to execute a share buy-back might even welcome the negative reports.
12. Even with the current system, an effective boycott is hard to envision—dealers make markets because it is profitable, not because they are sentimental towards their underwriting clients. If the bulge bracket stuck together, one or more of the recent entrants to the dealer ranks would quickly break the boycott.
13. Here and elsewhere in this letter I am trying to suggest participants in the securities business who, judging from their public statements, should support this project. You remain the only person I have contacted so far.
14. From what I have seen, he leaves less on the table than many customers but would still benefit from an electronic exchange.
15. Berkshire’s 1997 annual.
16. … his computer-driven dealer operations appear to provide efficient transaction services for investors. He shares your opinion of securities firms: “There’s a lot of hocus-pocus practiced by people with fancy suits. Quite often they’re selling you financial products that are terrible deals or providing very mechanical services at inflated prices” (Wired, January 1997).
17. Mr. Bradley would have to first resign his seat on Morgan’s International Council.
18. SEC press release, September 9, 1998. Of course it would be better to first privately educate SEC officials with the same type of seminars I mentioned for journalists.
19. The Wall Street Journal, February 5, 1998.
20. Whether to point out that the new system would be more honest as well as more efficient is an open question. Confidence in the inevitability of its success might be greater if you said you were launching it solely to make money.
21. The Wall Street Journal, November 19, 1997. I see no reason to feel guilty about making money, even lots of it, honestly. However, I do share your view that it is wasteful for the wealthy to consume excessive amounts of the world’s resources. I also think it is wasteful to not use any large comparative advantage one might have to improve the world.
22. The [Roger] Lowenstein biography [Buffett: The Making of an American Capitalist], page 174.
23. Ibid., page 115.
EfficientMarkets.com: Wall Street, 1997; Wall Street, 1998
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