Distrust Toppled Investment Banking Industry

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The widespread economic and market panic has trickled down through the economy in such a way that even our housekeeper is affected by it. Like many, she is gripped by fear and a lack of understanding.

To help her understand what's transpired in an easy-to-understand way, I had to explain why highly competent investors (handicapped by their own knowledge) failed to protect themselves and their clients. The cause was simple: Widespread, pervasive DISTRUST.

As a business anthropologist in the investment community (partner with Kairos Capital Advisors) I am always watching people, particularly those networks of people that make up businesses and the market. To understand more about what happened in the market, I first explained how people act with trust or distrust.

Have you ever had someone lie to you? Maybe not even lie, but a stretching of the truth? Have you noticed how the lack of trust spreads? They may have stretched the truth about their competence in one area, but knowing they exaggerated about one thing leads you to distrust them on unrelated issues. More obvious is when someone steals; say a housekeeper (not my housekeeper) pocketed a couple of dollars she found while doing laundry. You now begin to suspect that she has been stealing from you all along and this two-dollar incident leads you to believe she may have stolen hundreds of dollars. Perhaps you misplaced your earrings but you are now sure that the housekeeper must have stolen them.

It takes a long time to build trust. Unfortunately it can be destroyed in an instant. Now what if your housekeeper were to deny the incident, claim she never took the two dollars and you must have misplaced it? Distrust grows and there is no hope of rebuilding it.

The first step to rebuilding trust is to accept responsibility and offer to take action over time to rebuild what's been eviscerated. If you choose to salvage the relationship, you will give the person a chance to earn your trust back, though it takes time and repeated, observable actions to win what was lost back.

Distrust is an insidious mood; it can spread beyond the person who broke it in the first place. Perhaps you never hired a housekeeper before. This was your first experience. Would you not consider that perhaps ALL housekeepers steal and therefore you won’t hire another? At the very least you may step back, reassess, perhaps talk with your neighbors to be sure this is not a widespread practice by housekeepers in general before you hire another.

Let’s now take it one step further. Your housekeeper hasn’t actually stolen two dollars. You did indeed misplace it. However, you have been bombarded by friends’ tales of household help stealing from them left and right. You could possibly begin to wonder whether or not your housekeeper, like those of your friends, may be stealing and you just haven’t caught her yet.

With this background of distrust you begin to watch your housekeeper with new eyes. Now the two dollars disappear and you think “aha”, she is just like the others and jump to the conclusion that she is a thief even though she is not. This distrust may not be limited to your housekeeper. Now you begin to watch the gardener, the contractor and the pool man, anyone who could have the access and opportunity to steal from you. Distrust is dangerous because like a metastasized cancer, it spreads everywhere quickly. It destroys relationships, sometimes unnecessarily.

It is this spread of distrust, much of it caused by rumors that experienced investors knew to be false, which caused many to short or sell stocks. Throughout the history of the stock market, rumors always arise, though an experienced investor knows that false rumors usually are revealed to be false and normalcy is promptly restored. In fact these rumors (or rather invalid assessments) created buying opportunities for investors who understood that all would be righted in a short time; the drop in stock value temporary.

But before I could show Marcia, our housekeeper, how distrust toppled the investment banking industry, I needed to first show how businesses built trust and value. I started out explaining in an uncomplicated way how the market generally works.

As our readers already know (but wasn’t as clear to my Brazilian housekeeper), public companies usually report earnings each quarter and set new targets for the next quarter at the same time. People buy or sell stocks in these businesses based on whether or not they trust that these companies will reach the targets, and whether or not those targets will improve the valuation enough to warrant a higher stock price. Companies that achieve their targets over time build more trust. It takes many quarters and years to build a company’s reputation.

Now there are many “speed bumps” that can hinder a company’s race to their quarterly goal. These “speed bumps” can also make it more likely that some will reach their goal while others may not.

Importantly, there are external factors that could hinder a company’s growth. Rising gas prices would affect the firms, such as airlines and transportation companies, whose operating costs would rise. Trade regulations would affect those companies who rely on open markets to access customers in other parts of the world. Tax increases could make the cost of doing business increase and reduce profitability. Healthcare requirements could increase the cost of doing business and again affect profitability.

Many of these “speed bumps” are the result of policy changes, but sometimes they materialize due to internal mistakes. A failed product, such as an unsafe or unreliable air bag in a car, could lead to a recall jeopardizing future sales. Management could change, which would call into question the competence of the new team's ability to achieve a target.

Suffice it to say, investors are always assessing events of the internal and external variety in hopes of assessing their impact on company operations, not to mention what it will mean for the firm's future share price. These “speed bumps” and a company’s failure to achieve a target generally result in a lack of confidence. But a lack of confidence is different than distrust. It is generally contained to a specific set of circumstance, and doesn’t affect other domains. The path toward rebuilding confidence is usually clear.

What's happened in these uncertain markets of late has been the result of a growing lack of trust. This is not a “crisis of confidence”, but something much more powerful. Distrust is the story here, and it's been a paucity of trust so great that it obliterated the century long business of investment banking. How did this come about?

Before elaborating it's useful to remind reader that policy emanating from Washington drives individual behavior. It makes some assets more valuable than others.

And in 2007 there arose two policies that combined with mistrust to unravel the market. All of us remember the Enron and WorldCom scandals. Those were examples of earnings opacity that led to policy changes meant to rebuild confidence in firm balances sheets.

First the SEC made the management of those companies responsible for their actions. Secondly, regulators sought to enhance reporting rules in hopes of preventing the Enron/Worldcom mistakes from happening again.

Unfortunately, when politicians and regulators seek to fix yesterday's problems, they often overreact. In short, there were many regulations put into affect, and not all of them were good.

Notably, the Financial Accounting Standards Board (FASB) Statement No. 157 became effective after November 15, 2007. What is commonly referred to as mark-to-market accounting changed how assets on balance sheets were valued. This required that public companies adjust their asset values based on the market value, as opposed to the book value of assets. In the past, performing loans (an asset) would be valued at book value. If a compnay had a $300,000 mortgage, which had been in good standing for 10 years, it could be booked at its accrued value. FASB 157 required that its value be adjusted to reflect the current market value of the mortgage.

In a time of distrust, when investors were selling these mortgages at fire sale prices, FASB 157 required that banks reduce the value of similar assets, even if performing, to the amount they were sold at by the latest distressed seller. As more mortgages were sold at distressed prices, driving their value down with each desperate sale, banks had to repeatedly reduce the value of those assets on their balance sheets even if they planned to hold them for the life of the loan. Compounding the banks’ problems were requirements to maintain reserves to offset these assets. As their assets fell in value, their capital requirements rose. This is how Fannie Mae and Freddie Mac got into trouble.

The second policy change that was the nail in the coffin for the investment banks, banks in general and AIG was the SEC's alteration of short selling rules on the books since 1938. This allowed investors to sell securities they didn’t own even if the share price was falling. This made it much easier to "short" shares, thereby opening the market to short selling on a massive scale.

The above policies, fueled by massive distrust, led to an avalanche of falling valuations. It all happened so quickly that even the most experienced investors were caught in disbelief. In simple terms, here is how it happened. Many want to blame a few investors who allegedly conspired to topple the investment industry. Everyone looks to parcel out blame in an environment of distrust. It may turn out that a few violated the law with regard to short selling, but it's more realistic to assume that a lack of trust sparked a forest fire that couldn’t be contained.

And thanks to mark-to-market accounting, banks were forced to continuously write down their assets and raise more capital. After Paulson perhaps foolishly let Lehman fail, distrust rose and banks began to experience a run on their capital at the very time they needed to raise reserves. Congress didn’t contain the damage until the $700B bailout was passed, and the FDIC raised the government’s guarantee on deposits to $250,000. Meanwhile, people began to close their money market accounts and liquidate their portfolios. Unlike commercial banks, investment banks were less secure because they didn’t have the safety net of government guarantees.

Short sellers, again fueled by distrust, began shorting bank stocks. Rumors fomented the latter, the kind of rumors that experienced investors knew to be exaggerated and perhaps untrue. Many of them bet against the gossip since this approach worked in the past.

Unfortunately, it is much harder to regain trust than it is to destroy it, so there was no time to invalidate the rumors before people liquidated their accounts and shorted the banks.

To understand this, a non-banking scenario is perhaps useful. Suppose you had a group of friends. Everyone begins gossiping about one of your girlfriends. They say she is nearly bankrupt, her husband is about to lose her job, and they’ve been living beyond their means. Would you trust giving her a loan? You might give her a gift if you were able to, but it's unlikely she would rate a loan. Even if the rumor turns out to be untrue, it's unlikely that she'll merit a loan until it is soberly observed over time that the rumors are false and she remains solvent.

The above is how distrust works. This is what happened with the banking industry in general, but the investment banks more so because they lacked the government guarantees when it came to solvency.

Policymakers perhaps should have foreseen the consequences of the 2007 policy alterations, but there was little time. Alan Greenspan testified that he didn’t see it coming. Even Ace Greenberg, the wise investor who headed up Bear Stearns for as long as I’ve been alive, couldn’t see it and certainly couldn’t stop it. Personal phone calls by him to other investors couldn’t reverse the rumors. This man had more experience and integrity navigating markets than nearly anyone, but even he didn’t have the clout to set the rumors straight in time to save Bear Stearns.

The pervasive mood of distrust, and the policy changes that allowed people to act on it, destroyed trillions of dollars of wealth in just weeks. Experienced investors, ones that for years were able to make deals based on a handshake and their honorable reputations, were engulfed in the losses because all that they knew and had experienced to be true about rumors vs. integrity led them to bet against rumormongering that was terrifying the markets.

Now the investment banks no longer exist. After 100 years they are gone, possibly never to return. This business model failed. Even the giants like Goldman Sachs could not combat the widespread impact of eroding trust.

Sadly, it will take years to rebuild trust lost, and which led to the disappearance of some venerable institutions. But like all problems economic, this too shall pass, and when it does one can hope for the ushering in of new policies that enhance, rather than inhibit, the essential process whereby public companies develop trust with those possessing capital.

Natalia Redenbaugh is a partner at Kairos Capital Advisors.
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