THE SATURDAY ESSAY
NOVEMBER 8, 2011
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.
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By MIKE MAYO
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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."
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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.
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***
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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.
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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.
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"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. John Kuczala
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."
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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.)
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***
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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.
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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.
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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.
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.
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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.
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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.
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A spokesman for Deutsche Bank says, "We fully support our analysts' ability
to publish independent research for the benefit of our clients."
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***
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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.
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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.
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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.
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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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—Mr. Mayo is managing director at Credit Agricole Securities.
Adapted from "Exile on Wall Street: One Analyst's Fight to Save the Big Banks
From Themselves" (Wiley).
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