Why Wall Street Can't Handle the Truth
Longtime bank analyst Mike Mayo tells the inside story of why it's so hard to yell 'sell' in a crowded room—and lays out how Wall Street needs to change to avoid the next financial collapse.
By MIKE MAYO
Over the past 12 years, longtime banking analyst
Mike Mayo has issued numerous calls to sell bank stocks, a rarity in a
system where nearly all stocks are rated buy or hold. His negative
ratings have frequently gotten him in trouble with banks, clients and
his own bosses, who didn't want to alienate those companies. In this
excerpt from his new book, "Exile on Wall Street," Mr. Mayo gives an
inside view of the fights, the scolding and the threatening phone calls
he received as a result of yelling "sell"—and offers a proposal to fix
the banking sector.
Taking a negative position doesn't win you many friends in the
banking sector. I've worked as a bank analyst for the past 20 years,
where my job is to study publicly traded financial firms and decide
which ones would make the best investments. This research goes out to
institutional investors: mutual fund companies, university endowments,
public-employee retirement funds, hedge funds, and other organizations
with large amounts of money. But for about the past decade, especially
the past five years or so, most big banks haven't been good investments.
In fact, they've been terrible investments, down 50%, 60%, 70% or more.
Analysts are supposed to be a check on the
financial system—people who can wade through a company's financials and
tell investors what's really going on. There are about 5,000 so-called
sell-side analysts, about 5% of whom track the financial sector, serving
as watchdogs over U.S. companies with combined market value of more
than $15 trillion.
Unfortunately, some are little more
than cheerleaders—afraid of rocking the boat at their firms, afraid of
alienating the companies they cover and drawing the wrath of their
superiors. The proportion of sell ratings on Wall Street remains under
5%, even today, despite the fact that any first-year MBA student can
tell you that 95% of the stocks cannot be winners.
Over the years, I have pointed out certain problems in the banking
sector—things like excessive risk, outsized compensation for bankers,
more aggressive lending—and as a result been yelled at, conspicuously
ignored, threatened with legal action and mocked by banking executives,
all with the intent of persuading me to soften my stance.
Looking inside the world of
finance—with its pressures to conform and stay quiet—may offer some
insight into why so many others have fudged. And it may offer some
answers as to how crisis after crisis has hit the economy over the past
decade, taking the markets by surprise, despite what should have been
plentiful warning signs.
***
It started in 1999, when I was managing director (the
equivalent of partner) at Credit Suisse First Boston. At the time, what
gave me the biggest concern was a sense that stocks within the banking
sector were likely to turn downward.
Five years after the interstate banking law of 1994, which allowed
banks to operate across state lines, the easy gains from consolidation
were over. When banks couldn't maintain their growth momentum through
mergers and cost cuts, they took the next logical step—they made more
consumer loans. Logic dictated that this meant the quality of those
loans would probably decrease, and, in turn, create a greater risk that
some of them would result in losses. At the same time, executive pay was
soaring, aided by stock options, which can encourage executives to take
on greater risk.
For my 1,000-page report on the entire banking industry, with
detailed reports of 47 banks, I wasn't just going to go negative on a
few main stocks but the entire sector. This was completely the opposite
of what most analysts were saying, not just about banks but about all
sectors.
In decades past, the ratio of buy
ratings to sell ratings had not been this lopsided, and in theory it
should be roughly 50-50. That seems right, doesn't it? Some stocks go
up, some go down, because of the overall market direction or competitive
threats or issues specific to each company. In the late 1990s, though,
the ratio was 100 buys or more for every sell.
Merrill Lynch had buy
ratings on 940 stocks and sell ratings on just 7. Salomon Smith Barney:
856 buy ratings, 4 sells. Morgan Stanley Dean Witter: 670 buys and
exactly 0 sells.
Analysts almost never said to sell specific companies, because that
would alienate those firms, which then might move business for bond
offerings, equity deals, acquisitions, buybacks or other activity away
from the analyst's brokerage firm. Say the word "sell" enough times, and
you win a long, awkward elevator ride out of the building with your
soon-to-be-former boss. And here I was, ready to go negative on the
entire banking sector.
At the
company's morning meeting between analysts and the sales staff, I gave a
short presentation on the report. "In no uncertain terms," I said,
"sell bank stocks. I'm downgrading the group. Sell Bank One, sell Chase
Manhattan…." The message went out over the "hoot," or microphone, to
more than 50 salespeople around the world. They would relay my thoughts
to more than 300 money managers at some of the largest institutional
investment firms in the business.
Afterward, I went back to my desk. Safe so far, I thought, and picked
up the phone to call some of the biggest banks that had been
downgraded, to give them a heads-up, along with some of the firm's
institutional-investing clients. Not long after that, I was summoned
back to the hoot for a special presentation to the sales force,
something that had never happened before. They wanted me to clarify my
thinking. Why not just leave the ratings at hold?
I laid out my case again: declining
loan quality, excess executive compensation and headwinds for the
industry after five years of major growth driven by mergers.
The counterattack started almost
immediately. One portfolio manager said, "What's he trying to prove?
Don't you know you only put a sell on a dog?" Another yelled, "I can't
believe Mayo's doing this. He must be self-destructing!" One trader at a
firm that owned a portfolio full of bank shares—which immediately began
falling—printed out my photo and stuck it to her bulletin board with
the word "WANTED" scribbled over it. I'd poked a stick into a hornets'
nest.
That morning, I got a call from a client who runs a major endowment.
"Check out the TV," he said. On CNBC, the commentators had picked up on
the news and were now mocking me. Joe Kernen joked: "Who's Mike Mayo,
and do we know whether he was turned down for a car loan?" I even got an
ominous, anonymous voice mail from someone with a strong drawl
cautioning, "Be careful with what you say."
Of course, the banks that I had downgraded were even more furious,
and they let me know it. Routine meetings with management are a standard
part of my work, yet when I requested these meetings after my call,
several banks said no. Worse, a couple of big institutions in the
Midwest and Southeast threatened to cut all ties with Credit Suisse—no
more investment banking deals, no more fees.
Within a few months, the market began
to experience problems. The Standard & Poor's bank index peaked in
July 1999 and fell more than 20% by the end of the year. Regional banks,
in particular, had their worst performance compared to the overall
market in half a century.
***
I was still negative on the sector in 2001, when I moved
over to Prudential, and I initiated my coverage with nine sell ratings.
This was a tough stance to take at the time because bank stocks were on
the rise. Soon enough, I would run into more of the usual problems.
After one meeting in New Jersey, one of the more senior portfolio
managers offered to "advise" me about my views on the banking industry.
The old-timer pulled me into a semidarkened room, just the two of us.
"I've been doing this a while," he said, "and you've gotta know when
to change your view. You can't be so negative." He probably meant it as
kindly advice from someone who had been around the block, but it came
across more like a disciplinarian father scolding his son. His argument
seemed to be that as long as the stock prices were going up, the banks'
management and operating strategies didn't matter.
Other
companies limited my access to senior executives. An analyst without
access to executives—and the one-on-one insights that investors often
pay for—can be perceived to be at a disadvantage compared to his or her
peers. Goldman Sachs was fairly up front about it, a rarity in the
industry. I had recently initiated coverage on the firm, so I had few
established relationships I could leverage. When I told one point of
contact at the company that I'd like to have more meetings with
management, he told me that the firm wasn't singling me out—they treated
everyone that way. When I pushed a little harder for a meeting, I
received a message that we needed to "have a conversation."
Feeling like a student being reprimanded by a teacher, I was told
that the most efficient use of management's time was for the executives
to generate money for the firm instead of talking to the 20 or so
analysts covering the company. An analyst like me would simply have to
be patient. While I could live with this—to a degree—the gatekeeper
added one more point: A consideration in granting analysts meetings with
management of Goldman Sachs was the analyst's standing, influence and
knowledge. "In other words," the gatekeeper added, "we evaluate you." (A
spokesman for Goldman Sachs declined to comment for this article.)
***
As the financial crisis started rumbling in 2007, I was
working at Deutsche Bank and went on CNBC in November to air my
concerns. I said the total cost of the crisis could approach $400
billion, a number that was much higher than anyone else's estimate to
that point—though one that still turned out to be too low.
I came up with this figure by
combining losses not only from banks but from everywhere else in the
financial system, as well, including mortgages and related securities.
The project had been difficult and tedious, and members of my team had
stayed at the office until midnight each night for weeks to dig up data.
The $400 billion number was an imperfect estimate, even with all that
work, but at least I could be more vocal about my stance and help
investors pull their money while the stock market—and the shares of most
Wall Street banks—had yet to reflect these issues.
I also said that the banking industry
had to come clean about the extent of its exposure to problem mortgages
and other assets. After eight years of warning about an impending storm,
I was now shouting from the mountaintop, saying that it was time to
take cover.
Some of the attention my calls generated was not so positive, even
within my own firm. My supervisors at Deutsche Bank told me that I
should avoid making those kinds of strong, negative comments about the
banking sector in the press.
Not long after that, I was summoned to
a meeting on an upper floor of the building with a senior manager at
Deutsche Bank. He said that the firm did not like to be seen as publicly
negative on the U.S. banking sector at a time when it held certain
short positions.
In the end, Deutsche Bank made $1.5 billion on one of its proprietary
trades during the crisis by betting against mortgage-backed securities.
The firm ended up losing about $4.5 billion overall, far less than most
big banks, in part because of its aggressive short positions on the
U.S. housing market.
But all I understood at the time was
that I was in a cone of silence. The bank wouldn't interfere with my
analysis of the sector or my research reports, but there was now a gag
rule when it came to any more media spots. I could no longer talk to the
broader financial community or to investors at large, only to
institutional investors who were clients, and as a result, banks could
more easily downplay their problems.
A spokesman for Deutsche Bank says, "We fully support our analysts'
ability to publish independent research for the benefit of our clients."
***
To fix the banking sector, should we rely more on
government regulation and oversight or let the market figure it out?
Tougher rules or more capitalism? Right now, we have the worst of both
worlds. We have a purportedly capitalistic system with a lot of rules
that are not strictly enforced, and when things go wrong, the government
steps in to protect banks from the market consequences of their own
worst decisions. To me, that's not capitalism.
It's easy to understand the appeal of certain regulation. If we'd had
the right oversight in place, we would have limited the degree of the
financial crisis, which included bailouts measured in hundreds of
billions of dollars and millions of people losing their homes due to
foreclosures. But we also would have sacrificed innovations in credit
and a vibrant financial sector.
Moreover, the real problem with
regulation is that it often doesn't work very well, in part because it's
always considering problems in the rearview mirror. The financial
system today is almost dizzyingly complex and moving at light speed, and
new rules tend to address fairly precise things, like banning specific
types of securities or deals.
The more effective solution would come from letting market forces
work. That doesn't mean no rules at all—a banking system like the Wild
West, with blood on the floor and consumers being routinely swindled. We
need a cultural, perhaps generational, change that compels companies to
better apply accounting rules based on economic substance versus
surface presentation.
Even in 2011, some banks were woefully deficient in detailing the
amount of their securities and loans that are vulnerable to the ravages
of the European financial crisis. The solution is to increase
transparency and let outsiders see what's really going on.
What we need is a better version of
capitalism. That version starts with accounting: Let banks operate with a
lot of latitude, but make sure outsiders can see the numbers (the real
numbers). It also includes bankruptcy: Let those who stand to gain from
the risks they take—lenders, borrowers and bank executives—also remain
accountable for mistakes. As for regulation, the U.S. may want to look
to London for ideas. In the last decade, the U.K. equivalent of the
Securities Exchange Commission (called the Financial Services Authority)
fired much of its staff and hired back higher-caliber talent, at higher
salaries. This reduced the motivation for regulators to jump to more
lucrative private sector jobs and improved the understanding between
banks and regulators.
A better version of capitalism also
means a reduction in the clout of big banks. All of the third-party
entities that oversee them need sufficient latitude to serve as a true
check and balance. My peer group, the army of 5,000 sell-side Wall
Street analysts, can help lead the way to provide scrutiny over the
markets. Doing this involves a culture change to ensure that analysts
can act with sufficient intellectual curiosity and independence to
critically analyze public companies that control so much of our economy.
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