An Object Lesson in Investing

By Ian Williams, AlterNet

November 13, 2003

Every year, ordinary Americans put billions, indeed trillions of dollars into Wall Street. Even if we do not directly own a single share, our pension funds and our insurance companies pour our money into the financial markets that are, as we are often told, the secret of our success as the world's largest economy.



Adam Smith, the father of modern economics much-quoted by conservatives, once said, "People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices." It's a description that fits today's Wall Street to a tee.



They may not be the evil capitalists favored by those Soviet cartoons of yore, sitting in smoke-filled rooms in their top hats. They may not be scheming to take over the world, as some in the anti-globalization movement would have you believe. But the current workings of the finance industry are, in sum, a giant conspiracy to loot ordinary investors for the benefit of its members and their friends.



The sources for my paranoia on this point are not loony Leninists, but the financial sections of major newspapers. The Wall Street Journal and the Financial Times look increasingly like a cross between the National Inquirer and a criminal court docket, with Captains of Finance pictured daily doing a perp walk across their pages.



While adding the throwaway caveat that there are many sincere and honest people in the finance sector, we should note that in order to stay honest, they almost have to buck the system. To prove my point, let's trace the progress of your hard-earned dollars through the financial food chain.



Let's say an unwitting investor goes to a broker, who then recommends a mutual fund. Hitherto regarded as unassailable, the mutual fund's virtue is now under question thanks to the investigation launched by New York's attorney general Eliot Spitzer. To begin with, your broker may be receiving kickbacks from the fund managers for steering you in the "right" direction. So your money is going to the fund that gives the broker the best returns rather than you.



To add insult to the proverbial injury, not all investors are made equal in the eyes of a mutual fund. They often offer special deals to major investors, who are allowed to trade after the markets have officially closed for the day. It's a bit like allowing people to bet on a horse race after the winners have gone past the finishing post.



The funds are also tied to the brokers' interests in other ways. The "sell-side" of brokerage firms is made up not just of stock sales teams, but also of analysts. These so-called independent researchers recommend which companies to buy – always an overwhelming majority of those on offer – and which to sell, a number that is all too frighteningly small.



There is usually a strong correlation between "buy" recommendations and whether or not the brokerage house has a stake in the contract for new stock issues – or hopes to acquire one in the future. While analysts are supposed to be protected by a "Chinese Wall" from such temptations, bonuses and commissions often make up a large part of their remuneration. I have spoken to several who confess to netting 0,000 for making one phone call.



Many mutual funds took a beating in the last two years because they followed the sell-side analysts' recommendations and pumped their money into the bubble stocks that were being touted by the brokers and bankers. It is the average investor, however, who paid for their abysmal performance. The mutuals either took a percentage of your money up-front, or charged you a management fee for losing your money.



Here are your choices then. Invest in a mutual fund or invest in the companies recommended by your broker – and in either case end up as a victim of the same bad advice.



However you invest your hard-earned money, it is likely to go through the New York Stock Exchange. Unlike the NASDQ, the NYSE has a network of so-called "specialists," who act as middlemen between buyers and sellers. It now turns out that these firms were skimming off the top themselves. Instead of matching the seller with a potential buyer, the specialists bought the stock themselves and resold it to the seller at a slight profit. But don't worry, the Exchange regulates itself, which is why the directors handpicked by former Chairman Richard Grasso paid him a whopping 0 million for putting them on the regulatory board.



After passing through this chain of sticky hands, at last your money arrives at its destination, ready to do its job, i.e. finance the American economy. And does it? Well, yes, but only up to a point.



If you invested in an Initial Public Offering at the height of the dot.com boom, for example, a large chunk of your money (around 20 percent) went in charges and fees to bankers, lawyers and the finance houses that pulled together the deal. Of course, you'd have to wait your turn for that privilege. A bulk of IPO stocks were sold not to the public, but to friends, management, potential clients, and the executives of the company, who got their stock allocations at the beginning, along with the big institutional investors.



These good Samaritans then collectively pumped the stock until it reached dizzying heights, and then unloaded it to individual stock holders mesmerized by the tales of fools' gold available in IPO's – - i.e. you. You were left watching it reconnect with the laws of gravity, as it hit rock bottom with a leaden thump.



Herein lies the telltale evidence of Wall Street greed. If the IPO's were about raising money for the company, then those involved would clearly want to get the highest price for the stock the moment it went on the market. But if the entire process was intended instead as a scam to loot the public, using the company as bait, then it makes sense to charge the lowest price at the outset to a select group of people who can then make a huge profit when the stock price soars.



Unfortunately, even if the shares don't immediately sink like a stone, your money isn't particularly safe. The CEOs of this world get much of their atrociously over-inflated rewards not from salary, but from options to buy shares. Stock options are supposed to "incentivize" managements to work harder. (Why we expect so many Americans to be inspired to feats of productivity just by a minimum wage, while others should need untold millions to give their best, is another story.) While the motivational effects of options are at best suspect, they do provide an incentive to hype the price of the shares so that high-level management can clean up. Enron, Tyco, WorldCom, Global Crossing, Arthur Anderson, should all ring an alarm bell or two.



Corporate executives of such companies do not like paying dividends, because that goes to the ordinary shareholders. Instead they extol the virtues of "shareholder value," of increasing the stock price. Indeed, many of them tell their shareholders that rather than "waste" money paying out dividends – which until the recent Bush giveaway was taxable – they prefer to buy back stock for the company to raise the share price.



There are several holes in this argument. One is that most ordinary shareholders own shares through their pension plans, and do not pay tax on dividends. The second is the uncanny similarity between the number of shares "bought back" by the company and the number of options issued to high-ranking company executives. In other words, under the banner of shareholder value, shareholders and employees are being once again robbed. Think of all those Enron employees whose pensions were locked up in plummeting stock, even as the executives were dumping their shares.



The moral, of course, is that free markets be damned, if people can make off with your money, you can be damn sure that they will – unless someone stops them. We have the best regulators in the world, of course. The NYSE checks the listings; the SEC monitors the company filings; independent auditors keep tabs on the books; and a board elected by the shareholders scrutinizes the company strategy. All of these men and women, each dedicated to a single end: the welfare of the shareholders. Right?



Let's see. The National Association of Securities Dealers keeps most of its judgments against its member's secret, so you have no idea if the nice broker trying to sell you a parcel of Enron has a "record." The New York Stock Exchange is part of the problem and not the solution, as its new chairman John Reed has tacitly admitted. The Securities and Exchange Commission, on the admission of its previous chairman, was lobbied into not counting the cost of stock options to managements as part of doing business. Besides, even if the lobbyists allowed it to work harder, it is already far too overstretched to mind the coop.



Most of its judgments are arrived at through mutual consent. So if a corporate honcho steals millions of dollars, he will avoid prison time and indeed a criminal record as long as he repays a little bit of it. Indeed, he will probably be invited to the White House and made a member of the president's inner-circle of "friends" if he makes a big enough donation with his loot. On the other hand, try stealing a few knick-knacks from a Wal-Mart and see where that will get you!



With the financial regulators displaying such fine form, we're left with Elliot Spitzer and other state attorney generals, who may have political ambitions, but are doing a better job of fighting these large-scale forms of white-collar crime. Thanks to them, Wall Street may try and genuinely clean up its act – for the moment.



However, the Street is based on the lemming principle. Much of this self-flagellation only happened when the market tanked. That was when the ponzi schemes unraveled and the truth about the rosy corporate accounting dawned on investors.



The next time the market goes up, you can bet that they will all be at it again. The same institutions will join in on the feeding frenzy, persuading average Joes and Janes to put their savings in the hands of this great money-skimming machine.



Ian Williams is the Nation's UN correspondent. He writes frequently for AlterNet, Foreign Policy in Focus, and Salon on international affairs.