A throng of confusions

My Main Street upbringing taught me that Wall Street - a term that covered not only stock brokers, traders, and the like, but also corporate executives - was a well-organised cabal. Those inside the system were wealthy, because they knew things. Those the outside, such as my schoolteacher parents, would never be initiated into Wall Street's mysteries.

After 30 years of observing the Street, and on occasion being among its members (briefly working at an investment-management firm; hobnobbing with future Wall Streeters while obtaining an MBA), I can safely say that my parents were wrong. Wall Street isn't a fraternity of the informed. It's a throng of confusions, groping its way along a dimly lit passage.

Paid to mismanage

I was reminded of the fact from a recent Matt Levine column, about a shale driller called PDC Energy (PDCE). The company has been criticised by a dissident shareholder for goading management to boost production by paying its CEO production bonuses. The firm's revenue has almost doubled since 2014, from higher oil and natural gas shipments, but PDC is bleeding red ink, as declining energy prices have rendered much of that output unprofitable.

As Levine points out, PDC's compensation plan would seem to contravene the currently popular idea, floated by several academic researchers, that today's institutional shareholders discourage corporate competition. Because the giant investment-management organisations own the entire stock market, runs the notion, they would like every firm to succeed. Their portfolios perform best if companies protect their profit margins, rather than attempt to expand their market shares.

Yet not only PDC, but also most of the industry, is structured to drill, baby, drill. Predominantly, shale-driller CEOs are paid to explore. Meanwhile, their largest shareholders are money-management companies that, in theory, seek the opposite behaviour from their investments. Per Levine, the four biggest owners of PDC, that collectively hold 36 per cent of its equity, are BlackRock, Vanguard, Dimensional Fund Advisors, and Fidelity.

Who's in charge?

"The practical explanation" for this discrepancy, writes Levine, "might be that CEO pay practices are mostly based on the preferences of CEOs, and passive institutional shareholders tend to sign up for whatever those preferences are." By this hypothesis, Wall Street's stock market strings are not pulled by the major institutional shareholders but instead by the managers that they (indirectly) hire.

That strikes me as largely correct, but I would further Levine's argument. The investment-management institutions are not the only ones on Wall Street that react rather than lead. On the contrary, all of Wall Street spends much time testing the winds. Chief executive compensation occurs because of what CEOs desire, fund boards seek, academics write, and consultants urge. As well as what shareholders demand. The cross-currents are severe.

The academic practice is to assume that prevailing industry practices are rational, because the market's scarcely visible hands make for the best of all possible results. Believing that requires a vivid imagination. Consider, for example, CEO compensation during the 1990s, when granting stock options was in fashion. Allegedly, attempting to score windfalls from these options prodded otherwise complacent CEOs into taking more risk. At the same time, though, when publicly traded companies announced major acquisitions, their stocks routinely fell rather than rose. The CEOs were paid to do more, but most institutional shareholders hoped that they would do less.

The two stories did not hang together. The true explanation for how corporate managements were treated, it seemed, was that each stock market participant saw a different part of the elephant. People viewed the role of CEOs--and therefore how companies should act--from their own perspectives. As a result, corporate managements received many commands, from many directions, which sometimes were contradictory.

The result is not so chaotic as to be fully unpredictable; there are broad trends in executive compensation, just as (to give an example) there are broad trends in popular music. But the instructions do not come from the top down. Behaviour alters over time slowly, gradually, and unevenly - in many cases, almost imperceptibly. When they do adjust their customs, participants often have difficulty articulating the reason for their change. It just seemed to them something they should do.

‘Schemes more likely accidents’

This discussion has concerned a single topic, executive pay, to illustrate the mechanisms. Its lesson, however, is general. What the public perceives as Wall Street schemes are more likely to be Wall Street accidents. Schemes typically require several parties to come together and reach an agreement. That, for the most part, is not how the Street operates.

For example, entering 2008, the credit-rating agencies didn't huddle with investment banks to create unreliable but highly rated housing bonds. That, ultimately, is what did indeed happen--but the problem arose from a core of ignorance, enhanced by greed, the fear of losing clients, and (as is often the case) the perception that if competitors were doing the same thing, it must be correct.

(Note: Morningstar did not issue credit ratings in 2008, but the company has since entered the field. Credit ratings accounted for 3.6 per cent of Morningstar's 2018 revenues.)

Similarly, the 2003 mutual fund timing scandal did not occur because fund-company executives had a plan. They did not. What they did have, to varying degrees, were customers who sought special treatment. The execs knew that these customers had accounts at other fund companies, which meant that their rivals were facing similar pressures, but after that it was guesswork. Each exec made his or her (mostly his, it being the mutual fund industry) own decisions. Some were noble, others were partially compromised, and a few were terrible.

No squids here

Make no mistake, this column does not argue for Wall Street's innocence. It argues instead for its incompetence. Whether Wall Street attracts employees of lower moral character than elsewhere can be debated, but what can't be questioned is that it has many people who commit wrongs. It certainly does. However, despite my parents' belief, and despite what one often encounters in both the popular press and political discussions, I see no evidence that Wall Street differs from other, less-profitable industries in how it goes about its business.

Memorably, Rolling Stone once called Goldman Sachs a "vampire squid" that has "engineered every market manipulation since the Great Depression." I place more faith in that magazine's music reviews.