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Home > Capital Markets Viewpoints > Bringing Trust Back to Wall Street

Capital Markets Viewpoints

Bringing Trust Back to Wall Street

by Bill Hambrecht

Introduction

Bill Hambrecht believes that Obama should steer clear of knee-jerk regulatory responses and instead restore transparency, fairness, and trust into the capital markets through solutions including forcing all derivatives trading onto regulated exchanges. Hambrecht, 73, has been in the securities business since 1958. He co-founded the San Francisco-based investment bank Hambrecht & Quist in 1968. Noted for its focus on the technology sector, H&Q was one of the pioneers of Silicon Valley’s venture capital industry. Hambrecht resigned from H&Q in December 1997 to form WR Hambrecht + Co., which has introduced a new “Dutch auction” technique that has increased the amount that companies can raise through flotations. Hambrecht is currently a director of Motorola, Inc., and on the advisery council to The J. David Gladstone Institutes. He is also in the wine business, owning several hundred acres of vineyards in Sonoma County and a winery in Healsburg, California. Hambrecht graduated from Princeton University in 1957. He was inducted to the American Academy of Arts and Sciences in October 2006.

Principles, Not Rules, Will Sort Out This Mess

Warren Buffett once famously described derivatives as “financial weapons of mass destruction” that were in danger of exploding at any time, taking with them the institutions that traded in them and perhaps also the entire economic system. Made in the 2002 Berkshire Hathaway annual report, it has proved a remarkably accurate prediction.

So what lay behind the great disruption of September and October 2008, when a number of leading banks nearly followed Lehman Brothers into oblivion and the world came perilously close to systemic financial meltdown—and what can be done to ensure it doesn’t happen again?

The view that finance was most likely to flourish in a regulatory vacuum, held by the administration of George W. Bush throughout its period in office, certainly played a major part. In the absence of regulation, questionable practices came to be seen as the norm.

In a regulatory vacuum, the investment banks were able to shift their emphasis away from being agency-based, service-oriented businesses towards being proprietary traders, and in the process they were able to leverage up their balance sheets to a previously unimaginable extent.

When Profit Is King

In pursuit of ever-greater profits and higher compensation for their executives, most investment banks transformed themselves into highly leveraged hedge funds. Meanwhile, the commercial banks, whose focus had traditionally been on direct lending, transformed themselves into packagers and sellers of loans, and started to encroach on the investment banks’ territory.

The banks found they were able to give themselves unprecedented amounts of leverage through the use and abuse of customer deposits. While the commercial banks relied on their “time and demand” deposits, the investment banks used deposits in brokerage accounts and the huge cash balances created through short sales.

As the two groups of banks converged, they found that the most interesting opportunities lay in quant-based, leveraged trading in unregulated markets, with a particular focus on lightly regulated debt instruments that traded from dealer to dealer.

Highly complex debt instruments based on the exploding market of prime and nonprime mortgage loans soon became their vehicles of choice, and banks bought and sold packages of these loans even though they were so complex they were barely understood, even by the ratings agencies that were supposed to assess their creditworthiness.

Because no independent or transparent pricing information was available, the issuers and underwriters of these opaque instruments had a huge amount of latitude when it came to establishing their value. It didn’t take long for the link between prices and fundamentals to get broken.

As the underwriters of the mortgage-related instruments were paid according to the volume of deals they completed, they had a vested interest in marking valuations as high as possible as well as in continuing to find buyers for these securities. When new buyers became thin on the ground, the investment banks became significant buyers themselves, leaving their balance sheets bloated with illiquid securities.

Essentially, it was the absence of any continuous or transparent market in these securities that made all this possible. And it was only when the US housing price bubble burst that holders of this paper were forced to come clean and admit there were was a huge gulf between their model valuations and real market values.

Ultimately, this is what lay behind the breakdown in trust which provoked the crisis of September and October 2008, something that few involved in the world of finance would like to see repeated any time soon, and which is now taking such a heavy toll on the wider global economy.

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Further reading

Books:

  • Christensen, Clayton M. The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail. Watertown, MA: Harvard Business School Press, 1997.
  • Christensen, Clayton M., Curtis W. Johnson, and Michael B. Horn. Disrupting Class: How Disruptive Innovation Will Change the Way the World Learns. New York: McGraw-Hill, 2008.
  • Ellis, Charles D. The Partnership: The Making of Goldman Sachs. London: Penguin Press, 2008.
  • Grossman, Jerome H., and Jason Hwang. The Innovator’s Prescription: A Disruptive Solution for Health Care. New York: McGraw-Hill, 2008.
  • Schroeder, Alice. The Snowball: Warren Buffett and the Business of Life. London: Bloomsbury, 2008.
  • Surowiecki, James. The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies and Nations. London: Little Brown, 2004.

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