The “Professional Investor” Excuse

On Tap takes on the often-used fiction that investment banks have done nothing wrong because they were simply dealing with professional investors who knew what they were getting into. He uses the always reliable device of taking aim at something on the Wall Street Journal op-ed page (a column by Holman Jenkins, in this case)–not only do people actually believe these things, but they get column-inches in one of America’s best newspapers.

To Jenkins, OT responds:

“Generally speaking and contrary to popular belief, caveat emptor is not a well-established legal principal . . . Professionals in other fields have many avenues of recourse when they are sold a defective product—just because you’re an expert doesn’t mean you’ve disclaimed all warranties.”

OT also takes on the argument that banks are always betting against their clients, and the clients should know that.

By James Kwak

48 responses to “The “Professional Investor” Excuse

  1. He meant “legal principle“.

    Well.

    It is true that most of what Goldman does when “betting against its clients” is merely hedging their risk. My point of attack would not be to dispute that, but rather to ask, what value does such market-making provide to the real economy?

    The usual answer is “liquidity”, but as a certain economist observed long ago, liquidity is massively overrated. It is certainly valued by speculators, but it is not at all clear that it does more good than harm to the real economy.

    My problem with Goldman Sachs is that almost everything they do is totally non-productive and does not facilitate production, but nevertheless receives a king’s ransom in compensation.

    That, and the fact that they get to profit from their “too big to fail” status (low cost of capital) plus access to the Fed’s printing press (aka. “emergency liquidity facilities”).

    All those smart people ought to be doing something useful with their lives. Or be in jail; I keep vacillating.

  2. for me, it’s clear that you need to hold the “professional investors” responsible also because if you don’t, they’re bound to repeat their mistakes. Fund managers who didn’t do their work and burned their client funds by being on the wrong side of a trade with GS (isn’t that redundant ?!?!?!?!) need to be removed from their positions. it’s THEIR JOB to do the work to value these instruments – they didn’t do it.

    as far as “just because you’re an expert doesn’t mean you’ve disclaimed all warranties” – it’s a total straw man. there ARE NO WARRANTIES on these financial products. if people are mad (justifiably) because the ratings agencies completely failed in their jobs too and butchered their risk analysis, then hold THEM accountable too! but to continue to just vilify the GS’s of the world vastly misses the point, and guarantees that we’ll repeat the same mistakes.

    For me a better analogy is a doctor who buys cheap surgical tools from China that end up contaminating his clients’ bodies when he uses these tools in surgery. You can blame the chinese manufacturer, but you also have to hold the doctor responsible – he’s supposed to have the expertise to know better. That’s his job.

  3. Street and City salesmen (they are almost all male) routinely ply their customers with alcohol, drugs, prostitutes, expensive meals and tickets, luxurious transportation and accommodation, jobs for friends and family, and so on. They are far cleaner in the US than in Europe, where almost anything goes. And whatever nasty stuff that happens here just isn’t expensed. So most securities are bought be institutional investors who have flipped against their fiduciaries. The game is rigged. This is what is known as “relationship building.” I don’t know why no one ever points this out. Perhaps because so few bloggers/posters have ever worked at a large broker/dealer?

  4. Steve Randy Waldman also had a very nice post a while back about how liquidity is overrated:

    http://www.interfluidity.com/posts/1209978923.shtml

  5. More fodder for us. Caveat emptor applies to everything, all of the time, especially to investments. We all know, and have known for years that the Wall Street “games” are and will be alive and well, and made them an order of magnitude worse in the great era of deregulation, which legitimized the games far more than ever before, or at least to the extent that they were in the great Roaring Twenties lead in the the Great Depression. No, this is not the Great Depression, but rather a perminent version entitle the Great Recession, and will continue until and unless we have the courage to rein in the profligate fiscal immorality rampant in the Wall Street-Washington connection.

  6. I think Bernard J. Reis and John T. Flynn have a relevant perspective on this issue.

    “There are certain basic things that the investor must realize today. In the first place, he must recognize the weakness of his individual position… [T]he growth of investors from the comparative few of a generation ago to the millions of the present day has made it a practical impossibility for the individual investor to know what is occurring in the affairs of the corporation in which he has an interest. He has been forced to relegate his rights to a controlling class whose interests are often not identical to his own. Even the bondholder who has superior rights finds in many cases that these rights have been taken away from him by some clause buried in a complicated indenture… The second fact that the investor must face is that the banker whom tradition has considered the guardian of the investors’ interests is first and foremost a dealer in securities; and no matter how prominent the name, the investor must not forget that the banker, like every other merchant, is primarily interested in his own greatest profit.”

    False Security: The Betrayal of the American Investor
    Bernard J. Reis and John T. Flynn
    Equinox Cooperative Press, NY (1937)

  7. Just give me William K. Black when I want an opinion on the financial industry!!!

    “How the Servant Became a Predator: Finance’s Five Fatal Flaws”

    ~ http://www.huffingtonpost.com/william-k-black/how-the-servant-became-a_b_318010.html

  8. I agree with Kid Dynamite on this one. If you buy a black box of an investment, you do not know the components, but you also know that you do not know the components. It’s your job to appreciate that fact.

  9. It’s all BS. everyone criticizes bankers. Institutional investors are in fact sophisticated and have received prospectuses that clearly stated the quality of assets they were buying. The problem is that institutional investors don’t read prospectuses and don’t measure their absolute performance but their relative performance vis a vis other institutional investors. As long as they’re as bad as the guy next door, it’s ok. perverse incentives everywhere. just manage your own money, don’t trust any “experts”

  10. The problem with major A-holes like WSJ editorial scribblers and guys like “Lawyernomics of Cumtempt” is, they live in a world where no one was victimized by CDS, CDOs. They don’t live in school districts that can’t provide educational resources to kids because they were duped by investment “professionals”. They only read things like WSJ and GQ magazine and National Review. They’re fine and their friends are fine, and IF there is a problem that doesn’t affect them, they don’t care to know about it.

    Our country is slowly becoming like “merry old England” and class distinction is becoming a huge problem now. And the recent order of the Murder of Democracy by Justice Roberts and 4 of his colleagues isn’t going to help any. Again, I hope all of them enjoy every moment of it because they will burn in Hell eventually.

  11. Thanks to everyone for your replies so far. Just to clarify I’m not saying the institutional investors are necessarily completely without any blame (or that they shouldn’t be held at all responsible). My point is that just because those people are professionals, it shouldn’t not absolve investment banks from any liability.

  12. We already know clearly how you feel on this Dynamite. “Let them eat cake”.

    Still trying to get blog hits off James’ and Simon’s drainage pipe?????

  13. Ted K wrote:

    “…and IF there is a problem that doesn’t affect them, they don’t care to know about it….I hope all of them enjoy every moment of it because they will burn in Hell eventually.”

    “I live in the Managerial Age, in a world of “Admin.” The greatest evil is not now done in those sordid “dens of crime” that Dickens loved to paint. It is not done even in concentration camps and labour camps. In those we see its final result. But it is conceived and ordered (moved, seconded, carried, and minuted) in clean, carpeted, warmed and well-lighted offices, by quiet men with white collars and cut fingernails and smooth-shaven cheeks who do not need to raise their voices.

    Hence, naturally enough, my symbol for Hell is something like the bureaucracy of a police state or the office of a thoroughly nasty business concern.”

    C. S. Lewis (1898 – 1963)

  14. Nevermind, “Slow Dynamite” is just here for marketing purposes. Most of us could guess that. Even “Slow Dynamite” has a hard time defending bankers now, so he goes with “Oh ya, well those guys are jerks too” form of argument.

  15. The quote attributed to Niels Bohr comes to mind: “An expert is a man who has made all the mistakes which can be made, in a narrow field.”

    Problem is that while in most fields of knowledge making a mistake just means that you take longer getting somewhere, in high finance everyone except the expert has to pay (and pay and pay…).

  16. Good quote from Niels Bohr. On Tap, I have watched IBs sell to stuffee banks and investors for decades. Why did they acquire such a name, because it was well kown they were reliable- gullible even. This applies to syndicated loans, eurobonds and cov lite bonds etc. Prospectuses were written like doorstops – contained such a mass of material that they wer usually unreadable or cleverly buried much of the important stuff in a cloud of legalese and excess trivial information. There is a real need to get clarity here too, so that people whether professional or not actually get information to make a properly infomed decision. I do not excuse professionals – many were just chasing yield at any cost but many too were taken for a ride. I think there was far more cynical exploitation than this explanation seeks to address

  17. way to add value to the discussion, Ted. You may notice that since i have no ads on my blog, i don’t need to get blog hits off anyone’s drainage pipe.

  18. Hate to play devil’s advocate here, but I think it needs mentioning. Whenever you buy/sell *anything* to a client, you are inherently taking the opposite view. One can argue that in a flow business, you are generally only making bid offer spread and are otherwise providing quotes in line with your beliefs, but in semi-liquid to illiquid markets, markets can dictate prices fairly far off from your personal opinions on the valuation. So, technically, yes– you are potentially selling something you know is not worth what you’re selling it for, but so what? I don’t see how this is at all specific to CDOs. Does this mean that you should never buy/sell anything close to prevailing market prices when you think it’s worth something else?

  19. Dynamite,
    It’s an interesting theory that:
    no ads currently=no incentives for blog hits or
    no ads currently=no hidden agenda/motives

    Let’s check with our fine panel of judges and see where that rates on the believability scale. Anyone is free to comment on a 1 to 10 scale. 1 is unbelievable, 5 is maybe, 10 is very believable.

    Oh, by the way I didn’t notice. I haven’t been to your site since you spread manure here in Baselinescenario after your visit with Treasury officials where you promised not to quote officials by name.

  20. ted, any intelligent reader knows that i certainly have no incentive to engage in a discussion with a comment thread troll like yourself, but i do it anyway, because there’s an objective – education.

    I will continue to post insightful, non-hateful comments, and you can continue to troll and ignore the issue. That’s probably why i get unique opportunities like a sit down with senior treasury officials, while you sit here spewing invective and raging against the machine.

  21. Dynamite,
    And please, oh “great educator” please share with us, ONE SINGLE THING, one single piece of revelation you got out of that meeting, other than some nice cookies??? Should we be green with envy that you got to meet Geithner??? Is he your new hero now?

  22. Sam K you are right of course that there is a bid/offer spread and that can sometimes be very wide in illiqud markets, I think the point here is rather more the dictation of prices and product information that is deliberately opaque as well as introducing complexity to obfuscate, rather than toclarify or offer explanation. Once this happens – as it did on a truly industrial scale, it is clear that there is gross assymetry of information and exploitation. How else do you explain the marketing of product on one side and the intentional shorting on the other by players like GS. Something is broken in the system when so-called market professionals cannot fathom risk and others set out to ensure it remains that way. Or am I just being cynical?

  23. i wrote two lengthy posts about that meeting, ted. they are free to read. i won’t link them here, lest you accuse me of trying to promote my blog.

    since we’ve reached the limits of nesting replies, i will concede to you – you win – you are the best commenter at completely ignoring the issue at hand and resorting to personal attacks and subject changes. congrats.

  24. There are plenty of reasons I might buy a CDO tranche even if I think the price is going to decline, e.g. a relative value play. If anything, I think there was a rather widespread market mispricing of risk. More importantly, these products are not created in a vacuum– they are created in an environment where there is a demand for them. I guess you could argue that their creation facilitated client speculation, but are you really willing to go so far as to say that it is a bank’s responsibility to try to curb that?

    I’m not saying you’re necessarily wrong; I just think that the media abuses the terminology and people don’t consider the myriad situations in which the particular buy/sell actions in question occur without there being any malice.

  25. I was hoping you could name ONE piece of valuable information you had learned from your unique sit down with Treasury officials. Not ONE thing??? Even you promised not to quote them and they still didn’t tell you ONE thing new???

    Ok, since you want to cede the argument I will accept that.

  26. hate to reply to myself, but realized I hadn’t read the full post linked. origination is indeed different than making bid/offer spread, but I think my point about liquidity and my point below about demand still hold.

  27. Bond girl, in what other industry can you sell defective tools and not get slammed with a recall when the tool you created blows up in your customer’s hands?

    How does it help the economy to have a financial sector that insures its instruments so that they are guaranteed profit, even if the tool they sell destroys the buyer?

    For those who provide health care, food, automobiles, toasters, they have to operate in accordance with protections designed to protect consumers from dangerous manufacturing errors.

    Why should finance be able to sell these black boxes with the caveat: “buyer beware”? At the end of the supply chain in finance are millions of people saving for retirement, college, etc. And they got slammed – and some even were destroyed – by the dangerously flawed instruments sold by investment bankers to institutional investors.

  28. But we can trush experts to handle so many of our other affairs (water treatment, trash disposal, electricity provision, car repair), and usually these things work out fine, with the help of regulatory agencies, protective laws, etc. Why can’t we make finance experts work in a system that makes them worthy of trust too?

  29. Rickk from Canada

    “If old truths are to retain their hold they must be restated in the language and concepts of successive generations.”

    F.A. Hayek: The Constitution of Liberty

    http://www.lancs.ac.uk/staff/ecagrs/Hayek%20quotes.htm

  30. The difference between a $15 toaster and a $1bn CDO is that the toaster is sold with an explicit warranty which spells out the selling-party’s obligations and recourse for the buying parties under a number of situations.

    Generally speaking, the CDO is sold absent such warranties, hence the selling party, by nature of the contract and nature of the transaction (lack of fiduciary responsibility to the selling party, etc) aren’t, and more often than not, be liable if a financial product sold under such terms doesn’t make the buyer oodles of money.

    Some of these securities (and ones far-simpler even) were sold with something resembling the warranty on a toaster, often in the form of a put feature whereby under certain circumstances, the seller would be forced to buy-back the security, usually at a pre-determined price, often above “market” or even at par.

    The article linked-to in this post is unreal in that it fails to acknowledge this fundamental reality. While I understand the limitations of the “they should have known better” argument, it holds true more often than it doesn’t. Sure, there were some transactions that didn’t (and hopefully will be proven) pass legal muster, but from what I know these will be the vast minority of deals.

    Just because something is complex (often by design) does not mean it is illegal. Investors got greedy and wanted risk-free returns. They outsourced diligence and now they (should) have to pay for their laziness.

  31. OT is correct. And while we are at it, that disclaimer on the back of the ticket to your favorite professional sporting event is also a crock of baloney that doesn’t hold up in court. Just because someone says they don’t want to be held responsible doesn’t mean that they aren’t legally responsible.

  32. Again, I’m not necessarily trying to free investors of any responsibility, I’m merely saying calling them “experts” should not absolve the investment banks of any liability.

    Also, I understand there are indeed actual warranties on toasters, for instance (But they need not be explicit, as you suggest. Default contract rules include some implied warranties.) My question is WHY the system works a different way in finance, though. We wouldn’t allow behavior like this in any other industry, but we allow it here.

  33. Thanks for the reply. You raise an interesting question, no doubt, and in response, I’d like to draw an analogue to the medical industry.

    Pharmaceutical reps (many of whom have little-to-no medical background) queue-up at Dr.s office all over the country every day trying to sell them the latest pill or therapy. Dr’s can buy (prescribe) these treatments to patients, but they are under far greater scrutiny in so doing than when the Pharma reps hawk the treatments to the Dr’s. Why? At least partially, its because the Dr should have the knowledge, training, experience, and judgment to decide the merits of the specific product. However, there is (virtually) no way in hell the average patient, lacking those attributes of the Dr, could be expected to have an ice-cube’s chance in hell of making that determination.

    Similarly, qualified investors (the definition of which I think needs work, to say the least, but that’s beyond the scope of this post) and institutional accounts can buy products/services that Joe & Jane Investor cannot, for the same/similar reasons.

    While there’s clearly a wide range of expertise and resources across the qualified and institutional investor space, the underlying fact I think carries more weight than the alternative: don’t buy something you don’t understand. If you do, especially if that decision was informed by outsourced “diligence experts” like the brain trust @ S&P/Moody’s/Fitch, frankly, I have no sympathy for any unexpected/adverse consequences you may run-into down the road.

    I will say, again, that in some case I have no doubt there was clearly illegal conduct on the part of firms involved in structuring/marketing/selling/rating securities. However, if I had to guess, I’d venture this was the case in only a small % of deals, but if you or anyone else has compelling evidence to the contrary (beyond non-sequitur and conjecture), I’m open to re-evaluating my position.

  34. Holman is an idealogue who won’t be happy until we return to Gilted Age capitalism. The comment that every commercial transaction involves a seller betting against a customer is far of the mark. Sellers of commercial and financial products don’t usually bet against the customer. If they sell a proprietary product they presumably profit from the value added e.g. sell a MBS the bank created and the bank profits (handsomely) from the mark up, just as an auto dealer realizes the profit between what he paid for the good and what he sold it for. The dealer isn’t in business to warehouse inventory, he’s in business to sell it. He cannot afford to hold the inventory in any event. Similarly with respect to MBS they package, Goldman and Citi cannot afford to inventory all the products they create, so they sell them if it can (we are still paying for the fact that Citi and other institutions warehoused what they couldn’t sell, often off the books). Goldman’s practice of selling their own products short after a sale to a customer does indeed involve betting against the customer, which should be classified as an abusive sales practice and banned. It reflects that the seller did not believe what it represented to the buyer at time of sale, and we all know these MBSs did not sell themselves (witness the warehousing and concealment of the fact that the market was not as large as one would be led to believe from just looking at volume created and purportedly sold.) This is classic manipulative conduct. Holman thinks its great. Holman might not survive long if “sophisticated investors” were armed, and neither would Goldman.

    Nothing above is meant to relieve any buyer of the obligation of due diligence. It is merely to point out that there is a difference between aggressive capitalism and fraud. Holman doesn’t get it.

  35. Not letting me rely to your post below, so I’ll reply here.

    The analogy to the medical industry is interesting, but before the Pharma reps can even sell the products, they need to be approved by the FDA, right? I don’t think any of the regulatory agencies (or the rating agencies, if you want to argue the government outsources this role through its regulations) scrutinize financial products nearly that closely. Although, admittedly, I’m not sure how you could “test” the products ex-ante.

    As for the fraud, I’ll be interested to see the results of the litigation that will go on. I recall the monolines were finding somewhat high percentages of problems (misrepresentation, fraud, etc.) with underlying mortgages in the CDOs they backed (again, they shouldn’t necessarily be free from guilt, considering they should have examined these securities more closely the first time around). As for the rating agency and mortgage origination stuff, it seems as though there was some pretty solid reporting efforts exposing some of the problems in those areas early in the crisis, but it’s kind of fallen by the wayside.

  36. The pharma reps may need to be licensed but the level of “expertise” is akin to brokers/”financial advisors” having to pass the Series 7 (i.e. a complete joke).

    I’m in 100% agreement that our current crisis is largely a failure of 1. well-crafted regulation, 2. stringent, intelligent enforcement.

    I’d guess (again key word, admittedly) that in the vast majority of cases, banks (and other parties) played by the rules; its not their fault they were weak from the start and rendered even-more useless by the epic failure to enforce even the most basic issues. I am really curious, like REALLY REALLY curious why the rating agencies haven’t been the subject of much more scrutiny, since they were, in-effect, the enabling force for many of these products to be structured, marketed, and sold. I’m not abstaining the banks and other financial firms from responsiblity, not hardly, but I think its pretty interesting that semi-within the rules (or so it would appear is the official interpretation), ibanks were allowed to go back/forth to the rating agencies, tweaking this or that clause or threshold, until they got the rating they needed to sell the product.

    If, however, there was sincere fraud (I’m not talking about he-said/she-said sort of stuff), then I hope its punished so-as to deter similar behavior in the future, although there isn’t much historical precedent to expect such outcomes, unfortunately.

  37. “The analogy to the medical industry is interesting, but before the Pharma reps can even sell the products, they need to be approved by the FDA, right?”

    Poorly written sentence by me. By “they” I meant the products needed to be approved — not the Pharma reps.

    And, yes, the rating agencies definitely deserve more scrutiny (and along with that, many of the regulations that embed them into the system).

  38. Ah my bad as well, the 2nd reading makes much more sense!

    While I hope (and am pretty certain) FDA certification is much more stringent than FINRA/SEC/S&P/whatever, we’d be silly to pretend that the system isn’t gamed (or at least attempted to be). Remember Fen-phen? http://en.wikipedia.org/wiki/Fen-phen

    I think the point, across both industries, is that those doing the regulating often lack the incentives and occasionally the resources to effectively do their jobs.

    I’ve argued this point with Dr. Bookstaber (now @ the SEC), although I doubt he paid me much attention, sigh…

  39. Recall the Orange county Ca bankruptcy a while ago, sharp Merril Lynch salesmen sold the county treasure a bill of goods that eventually went belly up. What needs to happen is that the fiduciaries duty needs to be made more explicit, and the prudent investor rule tightened. Everyone needs to be paranoid about financial product sales, as they are out to get your money. Consider that CalPers who should be able to hire top experts took a bath on CDOs.
    Further all financial product salesmen should be required to have a fiduciary duty for all investors of any size re: customer suitability.
    Of course the other piece is not rating the funds advisors every quarter on performance forcing them to all run in a herd.

  40. The Orange County folks got in WAY over their heads and bought things they didn’t understand (and very likely had no business even considering in the first place).

    This is not the fault of the Merrill sales team; they have no fiduciary duty, nor should they.

    You speak about CalPERS and that its not their fault their team of dozens of investment professionals doesn’t know their head from their arse. The fact of the matter is that CalPERS HAS a well-stated and established fiduciary duty to the public employees/members of the plan. This is established in several documents, for instance,

    http://www.calpers.ca.gov/eip-docs/investments/policies/invo-policy-statement/total-fund-statement.pdf

    “The Policies also are intended to ensure that the Investment Committee is fulfilling its fiduciary responsibilities in the management of CalPERS investments.”

    Information asymmetry (within our legal framework) is not a crime, nor is a it the fault of the selling party that a client legally entitled to purchase/transact in/with a given product failed, epically, to conduct the requisite diligence and analysis (or to come to what turned out to be the right conclusions).

    Stop making excuses. If CalPERS (etc) had done exhaustive research (think along the lines of what Pershing Square did with AMBAC), and STILL got burned, perhaps that’d be a different story. Unfortunately, the majority of the time these buyers who complain about being burned are doing so because they were lazy, and wrong, a lethal combination. I guarantee you, 100% that if the housing bubble had continued for another year or two and many of these buyers had made $ you’d hear nary a complaint out of them.

  41. Typo? Kwok writes:

    … one of America’s best newspapers …

    but surely must have meant to write:

    … one of America’s better newspapers …

  42. Actually, what he should have said is “one of Rupert’s better newspapers but, unfortunately, one now on its way to becoming a jounalistic travesty.” Its neanderthal editorial bent is creaping into all political stories from photo selection, story selection and slant to headlines.

  43. James Gornick

    Rick K from Canada:

    If no one has commented on this video you provided from Youtube–than I must congratulate your ability of finding this “Gem”.

    It certainly is a great video for the younger generation as well as us older folks that responds to the rap style that was presented during the video.

    Again, great choice and addition to this discussion forum.

    Keep up the calls for real reforms as this has been my theme under Far-fetched articles and posts for the past years.

  44. Eric Lindauer

    Ha. I love random attacks on people’s motivations. How do you prove why you did something? You can’t! Beautiful.

    On an unrelated note, I suspect that Ted K only posts because it distracts him from his incessant thoughts about making sweet sweet love to goats. Prove me wrong Ted!

    PS. Ted, when you attack someone for trolling for traffic, don’t add a link to your own blog.

  45. I would take issue with applying the term professional to these investors. Quoting from the CFA website (http://www.cfainstitute.org/centre/codes/ethics/index.html):

    “The Code of Ethics and Standards of Professional Conduct are the ethical cornerstone of CFA Institute. They are essential to our mission to lead the global investment profession and critical to maintaining the public’s trust in the financial markets.”

    Maintaining public trust in the financial markets was never a part of their equation.

  46. The professional investor theory is yet another one way street that seem to only apply to certain buyers. Thus, when those buyers lose money on the asset that was purchased it was all their own fault for taking the risk.

    GS took the risk to buy CDSs from AIG on the belief that AIG would be able to pay on the CDSs. But when AIG was on the verge of failure, GS went to the FED and the taxpayer for a full bailout. Some how GS forgot that they were a professional investor of the CDSs and should bare the loss of the own risks.

    This is yet another example of the powerful pushing all liability for their actions onto someone else.

  47. Cut the crap, Dr. Kwack–
    If they broke the law, BHO his wonderful AG who should/could/MUST go after them. So take your bitch to the source of issue going forward. If it makes you feel better, complain about past behavior of banks and so forth, but going forward that just plain doesn’t matter. That leaves you will limited choices. Either BHO et al don’t want to go after their secret buddies, they are stupid, have different priorities,….D) All of the above.
    You are so far in the tank you can’t even see realities.