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Monday, September 15, 2008

Wall Street's one way bets

For the past 20 years, the practice of senior Wall Street executives, with board and shareholder acquiescence - if not complicity, has been to construct high risk one way bets for their own benefit.

When they win, they profit enormously: gigantic bonuses and option grants are scattered promiscuously while the shareholders do OK - but not much more. When these bets really blow up in their faces, and the executives are fired, they depart with fat severance packages. The current euphemism is "Golden Parachute", but the reality is that they are being greatly rewarded, at shareholder expense, for failure.

The Chapter 11 (Reorganization) Bankruptcy filing by Lehman Brothers which will likely become Chapter 7 (Liquidation), statements by the regulator of Fannie Mae and Freddie Mac, and the abrupt takeover of Merrill Lynch by Bank of America may, with luck, signal the end of some of these one way bets. The best of the ugly news is a statement by the Federal Housing Finance Agency stating that severance payments will not be made to Daniel Mudd (CEO of Fannie Mae) and Richard Syron (Chairman and CEO of Freddie Mac) despite such provisions in their contracts.

I suspect that the top Executives, and many second echelon ones as well, at Merrill Lynch will find the culture and attitude to risk taking at Bank of America, which is to acquire them, to be radically different from that to which they are accustomed. Given the impending demise of Lehman Brothers, and the expected loss of jobs there, pay scales will be less generous. The supply of investment bankers will likely exceed demand for a few years to come.

It is time for shareholders to restrain the excesses of management. Actively managed mutual funds are notorious for the speed at which they churn (I use the word deliberately) their portfolios: they are speculators not owners. With the rise of Mutual and Exchange Traded Funds that mirror the market's indices, we can hope to find a new generation of money managers who are willing to be owners rather than gamblers.

Money managers should take a lesson from Berkshire Hathaway and its CEO Warren Buffet. Aside from its 100% ownership of a large stable of companies, Berkshire Hathaway is a major player in the stock markets. Acting like an owner, not a speculator, is Berkshire Hathaway's investment philosophy and it is rare to find management, at companies where it is a significant shareholder, with hands too obviously in the cookie jar .

Shareholders of the world unite. (Apologies to Karl Marx!)

Many will blame the current financial crisis on the sub-prime mortgage mess. The reality is that the financial sector, over a twenty year period and with the complicity of former Federal Reserve Chairman Alan Greenspan (Bubblespan?), has constructed a gigantic pyramid scheme, built on sand, which is now collapsing on us.

Shareholders, and the Boards of Directors that are supposed to represent us, acquiesced in this horror show. While management deserves the greatest punishment, we too will suffer but we must accept our share of the blame.

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