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It was not lack of regulation, but lack of ethics, that killed The Street

Wall Street - Ethics and Regulation Ian Fraser

The former Salomon Brothers bond trader who lifted the lid on sharp practice in Wall Street with Liar’s Poker in 1989 has returned to his former stamping ground.

In his new book, The Big Short: Inside the Doomsday Machine, Michael Lewis focuses not on bulge-bracket banks but on a small band of wacky outsiders, including one described as “a loner with a glass eye, a medical degree and Asperger’s syndrome.”

These near-cranks include tiny hedge fund players and short-sellers from the fringes of society who, in the mid-Noughties, had the nouse to recognise that mortgage-backed securities (MBSs) and collaterized debt obligations (CDOs) were an accident waiting to happen. Rather than accumulating such products, they chose to short-sell them, and they never lost their nerve even as more establishment firms continued to amass such products.

I won’t go further into this extraordinary group of individuals—Lewis does that far better than I ever could in the book. Suffice to say that Reuters blogger Felix Salmon recently described The Big Short as “probably the single best piece of financial journalism ever written.”

In a long interview with Bloomberg, Lewis has explained how he feels Wall Street has changed since the 1960s and 1970s. He traced the roots of the cultural shift to the late 1970s and 1980s. That was when the old “partnership model”—whereby Wall Street (and also City of London) firms were small, specialized, had a long-term perspective, and focused on serving their clients’ needs—was abandoned.

As Wall Street firms changed their ownership structures, their ethos changed. The “long-term greed” advocated by former Goldman Sachs boss Gus Levy, and individuals whose first loyalty was to their institutions, fell by the wayside to be replaced by an uglier, more rapacious, selfish, and short-termist culture. In the interview Lewis said:

“No partnership would have ever allowed itself to own billions of dollars of AAA-rated CDOs backed by subprime. It just wouldn’t have happened. They would have scrutinized it in a different way.”

Lewis argued that another change on Wall Street was that it became “intellectualized and over-complicated” with the arrival of things like the Black–Scholes options pricing model. He believes this made it temptingly easier for Wall Street-ers to pull the wool over the eyes of less-knowledgeable clients and perhaps more dangerously over the eyes of their own bosses. Their erstwhile legitimate business of allocating capital efficiently lost attraction as it became less profitable, so investment bankers branched out into areas such as proprietary trading and the launch of ever more “innovative” products in their relentless pursuit of higher profits. He said:

“The minute you’re starting to think, ‘The way I make money is exploiting the idiocy of my customers,’ is the minute you start creating securities that are designed to explode, that you could be on the other side of.”

Lewis concluded by saying that Wall Street occupies an essentially parasitic relationship with the rest of the society. “It’s totally out of control. It’s not making America a great place; it’s making America a worse place right now.” He added that finance needs to occupy a healthier, more productive relationship with the rest of society.

Further reading for Wall Street and capital markets

Tags: asset price bubbles , financial crisis , hedge funds , Michael Lewis , short selling , subprime , The Big Short , US , Wall Street
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