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Pour O pour the Pirate Sherry, Fill O fill the Pirate glass.

And to make us more than merry, let the Pirate bumper pass.

                             - W.S. Gilbert, “The Pirates of Penzance”


The opening scene of Gilbert and Sullivan’s delightful masterpiece “The Pirates of Penzance” depicts a grand carouse where the Pirate King constantly re-fills the drinking glasses of his companions, as they celebrate their young companion Fredrick’s graduation from apprentice pirate to journeyman pirate.  Having attained his majority, Fredrick is now free to pillage and plunder on his own.

The eponymous Pirates are lovable rogues who, we learn in the denouement, are “all noblemen who have gone wrong”.  Upon receiving full pardon for their jolly indiscretions, they are married to a troop of fresh-faced maidens and settle down, presumably to enjoy their estates, their incomes, and the manifold entitlements that accrue when one is a landed Englishman.

Not so the USA.  Self-sufficient pioneers who tamed the Wild West, we built a democracy of free and equal citizens who brought forth the most dynamic capitalist society the world has ever seen.

Rather than ask where we went wrong, perhaps we should be asking which model is more sustainable.

Calvin Trillin penned a delightful, and thoroughly on-target piece for the New York Times Opinion page (13 October, “Wall Street Smarts”) tracing the havoc wrought by the inverting of the relationship of class standing to income. 

For generations, Wall Street was populated by two types.  The first were ne’er-do-well sons of privilege – those who could not get into medical or law school, who often excelled at drinking and socializing, and not much else.  These tender souls needed to be put where they could earn a respectable living, and not harm themselves or others.  They often were sent to Wall Street where they bought and sold securities under the tutelage of their uncles, fathers and more academically successful brothers – those who had become judges, doctors, lawyers and professors.

The other type – the ones who built vast fortunes – often came from poverty.  Many never finished high school.  Not a few of them were penniless immigrants or their sons.  There really were men who started out in the mailrooms and rose to become titans of Wall Street. 

In 1900 the Tuck School of Business, at Dartmouth College, offered a masters of Science degree in Commerce – technically the first Graduate Business degree.  Soon thereafter, in 1908, Harvard established its Graduate School of Business Administration.  The MBA was born, and the witless sons of privilege began to acquire a patina of academic respectability.  Being “noblemen who had gone wrong” was now formally sanctioned by the most august institutions of higher learning.

For generations, young people were taught theories of profit-maximizing mechanisms, ways to increase cash flows, and encouraged to figure out ways to beat high-school dropout millionaires at the game of trading stocks and bonds.  Finally, there were enough MBAs on the trading desks of the major Wall Street firms, that their technologies took over, and their approach to trading became self fulfilling.  What William Gibson, in his iconic masterpiece Neuromancer, calls “a consensual hallucination.”  When enough folks believe a narrative, it tends to come true.

As wealth grew, as represented by pieces of paper with an increasing number of zeroes at the end, little attention was paid to the fact that true innovation was on the decline.  America, which grew to greatness through innovation, was focusing more and more innovation on the financial sector.  We often hear that finance is the lubricant of commerce.  With the excess focus on Wall Street, it was as though no one was manufacturing cars or trucks any more, but you could get an oil change and lube job on every street corner.

At first, Wall Street firms sought an edge by finding brilliant graduate students in top university physics labs.  They lured the brightest away from careers in rocket science (literally) and put them to work crunching algorithms to run trading systems.

Within a short time, those same skills were transferred out of the physics labs.  Instead, the same level of number-crunching was now being taught in the business schools, with direct application to trading securities.  Is it any wonder NASA is constantly battling funding cuts?  Why walk on the surface of Mars?  We are already marching roughshod over the financial capitals of the world.

As incomes and innovation stagnated, Americans fell into another consensual hallucination.  We believed we were richer than previous generations by virtue of rising stock prices and rising home prices.  The Paradigm had shifted yet again.  Why save cash like our Depression-era parents, when our real wealth continued to mount in the value of our homes and our 401Ks?  The drawdown on assets became the new way to cash in on the American Dream.

America became a national example of the well-known phenomenon of third-generation failure, whereby family businesses grow under their founders, and the founders’ children, only to be destroyed when the third generation immediately start spending the firm’s capital on Porsches, new summer homes, and trips to Europe.

Rome wasn’t built in a day.  Lest we forget, it was destroyed overnight. 

This Friday morning we heard Ben Bernanke on the latest chapter in our regulatory saga.  The good news is that Chairman Bernanke was rather forthcoming about the current status of the debate.  The very, very bad news is that, like the Pirate King reveling in the adulation of his crew, he doesn’t look anywhere near ready to yank the punchbowl.

Former Fed Chairman Volcker appears to be the only member of the current economic team who Gets It – and the only one that no one is listening to.  We have dubbed him the Obama Administration’s Trophy Wife, brought out in public for appearance’s sake.  Meant to be seen, and not heard.

Financial professionals are notoriously light on their grasp of the history of their own industry.  Those who shape the industry itself are often the promulgators of the fallacy that This Time It Will Be Different.  With leadership like this, can we expect the investing public to have a clue?

Volcker, a man who very much lived through the financial and political turbulence of dealing with the near destruction of the US economy, keeps repeating over and over, like a quietly inebriated man during a noisy cocktail party, “Bring back Glass Steagall. Bring back Glass Steagall.”  The other partygoers look at him, deem him no danger to himself or others, and step around him as they head back to the punchbowl for a refill. 

Volcker is anything but inebriated.  He sees clearly just how badly all this is likely to end.  But he has been the Daniel in the lions’ den of politics and has no illusions about his own power to remove the liquor.

“Mr. Volcker scoffs at the reports that he is losing clout,” reports the New York Times (20 October, “Volcker Fails To Sell A Bank Strategy”).  Asked about being sidelined in the current debate, Volcker responded, “I did not have influence to start with.”

Chairman Bernanke’s latest timid stroke includes supporting “international efforts to develop capital standards that would be countercyclical.”  This means forcing banks to beef up their capital in good times, when they can afford it – i.e. taking away that famous punchbowl.  But the world watches what folks do, not what they say, and the Pirate King can only keep his minions happy largely through the liberal and frequent dispensing of grog.  You don’t see pirates exhorting one another to cut back on their own drinking “for the general good of the crew.” 

Chairman Bernanke also proposed a resolution authority, along the lines of the FDIC, and suggested that financial firms might be charged an assessment to pay for it.  Of all the nutty ideas that surface again and again in Washington like a nasty case of acid reflux, the idea of the government running financial firms strikes us as a spectacular exercise in nincompoopery.  But then, we didn’t go to Princeton.  

In case Mr. Bernanke has been vacationing in a parallel universe and is not aware of the developments, the one effective paradigm of government resolution programs, the FDIC, is now broke.  Chairman Bair has had to ask for an emergency drawdown from the Fed and has pressed insured banks to cough up a special assessment.  The community banks, understandably, are livid, even as the nation racks up our 100th bank failure of the year.  Eight thousand-plus community banks did not have the clout to get heavy dollops of TARP, but they did get the House Financial Services Committee to drop them from the consumer protection bill.

Justifications for the bill’s emasculation are summarized by Representative Brad Miller (D – North Carolina) who pointed out the cost and disruption to business that confront a small bank when a team of examiners come in.  Community banks and credit unions “were perhaps not without sin in the past couple of years,” said Miller, “but they were certainly not engaged in the worst abuses.”

No, they weren’t then.  So the Financial Services Committee is creating the perfect opportunity for them to engage in the very worst practices going forward.

The same way that credit card issuers found a haven in states with lax – or no – usury laws, you can just bet someone has already cooked up three different billion dollar ways to partner with small local banks to offer products that could not launch at the remaining 200 that will be subject to audits. 

With no Hank Paulson to watch his back, will Pirate King Bernanke have the intestinal fortitude to say “No more grog, Mateys!”?  Given how well that went over with Lehman, we think he would be keel-hauled, then run up the yardarm.

Welcome to the consensual hallucination that is our capitalist system.  It’s Business As Usual – on steroids.

Our advice to the rest of the world:  Stand down and prepare to be boarded.


Hasty Pudding

In the give-and-take after Chairman Bernanke’s frightfully tame speech on Friday, one questioner suggested that, with all the intellectual and oratorical power at their command, President Obama and Chairman Bernanke should make educational videos and send them out in a nationwide consumer education program.  Topic suggested include, What’s a credit card, How to buy a house, and a range of individual investment activities.  Risk and return was suggested too, and individual financial responsibility.  “Look carefully – if it looks too good to be true, it’s probably a risk, and not a return.”

Mr. Bernanke replied that this reminded him of “Kids who speed then have to sit and watch films about car crashes.”  Inexplicably, this got a laugh.

We can only conclude that, either we Don’t Get It, or Mr. Bernanke was sitting at the head of a room full of folks Don’t Get It for a living.

In Don’t Get It-related news, Chairman Bernanke has warned Congress against rushing to early implementation of proposed new rules to protect credit card consumers from usurious rates and fees, and hidden charges.  According to the Washington Times (22 October, “Bernanke: Speeding Up Credit Card Rules Could Hurt Consumers”) Chairman Bernanke warned that early implementation might benefit consumers, but would leapfrog the standard period for solicitation of comment from industry and consumers, “which could lead” said Chairman Bernanke, “to unintended consequences.”

We have already seen a rash of credit card interest rate hikes, significantly emanating from the banks that would be out of business but for the TARP monies, when they realized Congress might actually pass this into law.  It looks to us like the industry has already submitted its comment.

Through A Pool Darkly

Senator Charles Schumer sent a letter to SEC Chairman Schapiro last week, in which he recommended the Commission take certain actions to tighten regulation of Dark Pools.  His opening sentence states his concern that the different regulatory treatment of exchanges and Alternative Trading Systems (ATS) “is creating a two-tiered system that undermines the transparency of our national market system and exposes our capital markets to significant additional risks.”

Regulation ATS, issued in 1998, was designed to provide competition to the established exchanges.  It worked, and now is being accused of having worked too well.

We wish to offer a couple of observations on the current debate.  First, Reg ATS promotes a two-tier structure, by not requiring broker dealers to file for approval, or to actively surveil their own ATS.  Ms. Schapiro was not SEC Chair when this rule passed – she was President of NASD Regulation, the successor to Finra.  As such, she is uniquely positioned to know what policy objective was being targeted by this move. 

Finra, charged under Reg ATS with surveillance of these private trading networks, has consistently shown itself to be a slow-moving organization.  The combination of no pre-approval process, coupled with no internal surveillance, guaranteed that the resulting ATS entities would be the dark pools they quickly became. 

But whose interests are actually being served?  In their push for greater transparency, the SEC and Congress must realize that the millions of individual investors whose life savings and pensions are invested in mutual funds, or managed by professional fund managers are among the primary beneficiaries of Reg ATS.

The purpose of a Dark Pool is to provide liquidity without market impact.  Indeed, the extent to which order execution affects liquidity in the marketplace is one of the primary measures of the quality of executions across all markets.  If they accomplished nothing else, the dark pools provided a venue where large institutional orders could be executed without attracting a swarm of small speculators – legitimate and otherwise – who regularly descend on large blocks like fleas to a dog. 

Not mentioned in the discussion, though surely also a factor, was the structure of the NYSE market, where floor traders could sniff out the specialists’ working orders.  And then there was the well-known fact that a number of specialists were themselves perpetrating fraud by trading against their own customers.

The exchange model continues to rule our social philosophy of investments.  We continue to believe that absolute transparency is best.  But history would indicate otherwise.  The decimation of NASDAQ trading desks wrought by the SOES bandits has been all but forgotten – permit us to continue on the theme of Wall Street’s dangerously short memory – and by this time next year no one will remember what a Flash Order is.

You may recall that certain specialists were taking customer orders on the NYSE, then trading ahead of them on other exchanges.  They were able to make these look like legitimate customer orders because there was no cross-surveillance between exchanges.  Shades of the SEC not getting third-party confirmation about any of Bernie Madoff’s business – the NYSE and the other exchanges on which NYSE specialists traded did not have a regular mechanism in place for surveillance of cross-exchange trading.

Now the exchanges are peeved that they have lost so much business to the ATS.  But the ATS frequently provider superior executions and, since institutional investors have access to the information they need in the ATS in which they participate, we are note sure what force the transparency argument holds.  Indeed, it may be an outmoded market model. 

The two-tier market is not only here to stay, it is nothing new.  There has never been a market in all human history that was not dominated by one group, to the disadvantage of others.  The exchanges acted as primary liquidity providers, but then they changed the game by going public.  The absolute transparency model strikes us as a public utility model and not consistent with running an exchange as a for-profit business.

Taking as an example the oft-considered issue of Best Execution, this is a concept that gets massaged regularly, within the general parameters of speed, execution at the inside market, and liquidity impact of the execution.  “Full transparency” casts the exchanges as content providers.  But consumers of content know that not all content is information.  A lot of it is trash, and not all investors want to wade through it all just to get to hit the “sell” button.

The public information function of the exchange model is being challenged by what is essentially a contract model.  If negotiated transactions are what big customers want, they will get them one way or another.  By failing to take this into account, both Congress and the Commission look set to miss a major opportunity.

Making Sure Pay Doesn’t Crime

We are attuned to ways in which the mainstream media try to steal the debate from under our noses.  Let’s see how you like this latest example.

The Wall Street Journal (23 October, “Fed Hits Banks With Sweeping Pay Limits”) observes that we are now seeing “unprecedented federal intervention in pay decisions traditionally left to boards and shareholders.”  If that remark didn’t stop you in your tracks, then you haven’t been paying attention.

“Boards and shareholders”?  You’ve got to be kidding.

Since when do shareholders get to weigh in on employee or executive compensation issues?  Even fund managers, the shareholders who might wield the clout to do so, almost never engage in serious wrangling over pay issues.  That is because the issue of executive compensation is so massively cocooned that unwinding the protective covering is in itself a monumental task and is ultimately likely to create liability for those who attempt it.  Unless you happen to be one of the floor workers who is aware that you are receiving 1/300th of what your CEO is taking home, executive pay in corporate America remains a non-event.

A giant industry has grown up of companies that advise investment managers how to vote their proxies.  In response to SEC pressure, proxy voting procedures now take up considerable portions of fund managers’ compliance manuals, and the parameters whereby proxy consultants advise on voting are likewise detailed in hundreds of pages of documentation.  Among fund managers, voting with management recommendations has long been the norm.  A close second is following the recommendation of a proxy consulting service.  We are now back in the Never-Never-Land of attorneys and consultants, where not to follow the dictates of a consultant’s brief is to take direct liability for the consequences of one’s actions.

Meanwhile, the notion of a group of us banding together with our few hundred shares of stock and forcing a change at the executive level is not merely laughable, it is considered un-American.  Witness the nuns who routinely stand up at shareholder meetings – empowered by their orders’ ownership of 100 shares of stock – and vociferously decry the immorality of corporate actions.  They are tolerated and ignored.

As to expecting responsible action from the boards of public companies, they too respond only to what their lawyers tell them will shield them from liability.  America is now besieged by a mega-industry of compensation consultants, and the mere fact of their existence has spawned an Icarus-like upward spiral in pay packages.  Would the Wall Street Journal have us believe shareholders have the power to change this?  If they did, then they have no one to blame, and the Pay Czar doesn’t have a job.

Speaking of Owning the Dialogue, we don’t care for much of what we see on Fox News.  It’s mostly so loud you can’t figure out what they’re talking about, and we find the verbiage ranges from barely literate, to outright repugnant.  We have also been critical of President Obama for his refusal to get down and dirty on important issues.  But one doesn’t have to be a Glen Beck-ite or a Dittohead to see that the White House doesn’t belong in this particular gutter. 

The job of a free press is to speak truth to power.  When we at Research Edge talk about Owning The Debate, we mean raising the critical insights that either no one else has thought of, or that no one dares raise.  The notion of any government Speaking Power To Truth is far more repugnant than the worst drivel from the pathetic media outlets that falsely advertise themselves as News.

Mr. President, you can own the debate, you can let the debate slip from your grasp, or you can ignore the debate.  But you can’t lock up the debate.

Moshe Silver

Chief Compliance Officer