Madoff – Madoff Case Demonstrates Wall Street’s Transformation

In a much simpler time you went to your broker to buy or sell a stock. And that broker had access to top-notch research on companies and markets, research that was once respected. Each brokerage house would pay handsomely to the best and the brightest since their business often depended on being right. That system has changed in just the past fifteen years.

Flash back to the early 1980′s, when smart, insightful people ran investment houses. They saw an opportunity to cash in on an as yet untapped market – small investors. Computer technology was evolving fast enough to begin to allow an expansion of the use of mutual funds; computer trading and account calculations are a necessary function of mutual fund management. Once capabilities reached critical mass the gateway to the stock market was open for the little guy.

In typical Wall Street fashion, what started out as a good idea was perverted into a business model. The innovation that made mutual funds a viable option for large numbers of small investors changed to a way of doing business. As competition for client funds grew fierce, funds began to pay increasingly higher commissions to brokers. In the 1990′s those commissions became high enough (and complex enough to be hidden from the investors) for brokers to transition themselves from stock traders to mutual fund sellers, or asset gatherers.

Operating under those parameters Wall Street began to value those who could gather assets more than those who could make money for their clients. To brokerage firms, it does not matter if you lose money for clients, or even if you lose clients, as long as the commissions keep coming in from new ones. Instead of being a fountain of financial knowledge, brokerage firms became collections of used-car salesmen.

This entire banking crisis was built on that fact. Wall Street had become so good at selling that they even sold themselves on garbage.

Credit derivatives were another good idea, bastardized and sold en masse. A security that had well-defined risk/return characteristics and built-in credit protections is very useful to insurance companies and pension funds, institutions with specific needs. But, like annuities, once the salesmen realized they could make a fortune selling these complex securities they began to manufacture them as fast as they could, regardless of their initial purpose or intent.

The profit potential was so big for mortgage derivatives that Wall Street just created another class of borrowers, called subprime, when the pool of credit-worthy borrowers ran dry. There was no thought or consideration of the potential ramifications, only sales targets to meet. Since credit derivatives were so complex most of the investors buying them had little idea of their downside – the complexity made selling easier.

But the best sales job of all was perpetrated on the brokerage firms themselves. The biggest source of income for investment houses in 2006 and 2007 was principal transactions – brokerage firms were using their own money to buy credit derivatives and other complex assets. And because the sales job was so good, they bought so much of their own garbage that the entire system has nearly collapsed.

Which brings us to Bernie Madoff and individual investors. He was clearly good at selling, and not so good at investing. As a microcosm of Wall Street, he stands as a warning to investors. Before investing in hedge funds or products with unclear or complex strategies, remember that the business model for brokers has changed.

There are alternatives. There are still investment advisors who do things the old-fashioned way and doing your homework is still the best safeguard. It may not be flashy and sexy, and get the attention of your neighbors and co-workers, but if you can find a good advisor it will be more than worth it in the long run. Even the best sales jobs fall apart at some point.

Jeffrey P. Snider is President and Portfolio Manager for Atlantic Capital Management. For more economic and market analysis sample our research at http://www.client-centered.net.