Another Reason Why Americans Distrust Wall Street

A recent Wall Street Journal/NBC poll of 1,000 voters found that the majority think that the financial reform legislation wending its way through Congress isn't going far enough. And with today's news that New York Attorney General Andrew Cuomo is investigating big investment firms to find out if they duped ratings agencies about the quality of mortgage-backed securities (MBS), yet another aspect of what's wrong with Wall Street will be probed.

According to The New York Times, Cuomo is looking into whether eight Wall Street banks -- Goldman Sachs (GS), Morgan Stanley (MS), UBS, Citigroup (C), Credit Suisse, Deutsche Bank, Crédit Agricole and Merrill Lynch -- "provided misleading information" to ratings agencies -- Standard & Poor's, Fitch Ratings and Moody's Investors Service -- to get higher credit ratings on the MBS they created and sold.

The Cuomo investigation emphasizes an important element in creating and sustaining the MBS market: the flow of relatively poorly paid people from ratings agencies to far-higher-paid positions on Wall Street. For example, the Times points out that Goldman offered a huge pay boost to a former Fitch Ratings employee, Shin Yukawa, to join Goldman in 2005. Yukawa helped devise the infamous Abacus deal, which is now the subject of April's Securities and Exchange Commission fraud charge against Goldman. In the fall of 2007, Yukawa may have used his Fitch contacts to help get that deal done. While analysts flowed from the ratings agencies to Wall Street, fees flowed the other way.

Saying One Thing, but Believing Another

This latest investigation is one of the many good reasons why America distrusts Wall Street. After all, these are the firms that helped cause the dot-com bubble and then the subprime MBS, which led to the financial crisis.

During the dot-com bubble, this same kind of false advertising helped Wall Street sell stocks that turned out to be inappropriate for most investors. During that boom, at least some Wall Street analysts wrote positive research reports on companies that the they really believed weren't good investments.

A case in point is former Merrill Lynch analyst Henry Blodget who, according to the Securities and Exchange Commission, issued "research reports on one internet company (GoTo.com) that were materially misleading because they were contrary to privately expressed negative views." In April 2003, the SEC ordered him to pay a $4 million fine and banned him from the securities industry.

At the core of its distrust is the well-founded belief that Wall Street portrays financial markets as fair when in reality the playing field is truly tilted against average Americans. And at the core of that tilt is information asymmetry -- the notion that Wall Street has far more information about securities than the people to whom it's hawking them.

False Marketing

More specifically, in many cases Wall Street offers clients and shareholders a far more upbeat picture than is warranted. This false marketing extends to Enron and Lehman Brothers, which both used control over their own accounting to paint a deliberately misleading, positive impression of how they were doing. Enron hid its debt off its balance sheet, painting itself as growing fast even as its cash flow was negative. And Lehman Brothers used an internal accounting trick it called Repo 105 to hide $50 billion in debt.

Taking it to an extreme, Madoff Securities used fake account statements to make clients think that they were regularly getting double-digit annual returns, while in fact Madoff was stealing their money.

And there's flash trading, the practice that accounts for 70% of stock trading volume, in which a computer inspects orders a fraction of a second before they're executed on an exchange. In so doing, "flash traders" can, for example, see that a big sell order is about to hit the exchange and sell that stock short right before the order is executed. The flash traders then profit from the price drop that follows the execution of the sell order. That kind of trading made $20 billion in profits for Wall Street in 2008. Sound fair to you?

Profiting From Asymmetry

As long as Wall Street pays more money than other potential employers, it will be able to attract the sharpest people. And as long as those types keep flocking there, Wall Street will keep devising ways to profit from information asymmetry.

So you -- and millions of other Americans -- may not trust Wall Street, but Jimmy-crack-corn-and-it-don't-care.