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WALMART SELLS FOOD. They sell car tires. Board games too. You can stop at any Walmart in the world and buy the same plethora of consumer goods. One roof, dozens of product areas, thousands of individual items.
This “cross-vertical” strategy has many perks to consumers like us. But it’s not without flaws. From brand dilution to in-store clutter, down to a lack of item expertise when you ask questions of employees – there are issues with “selling everything to everyone.”
The financial world is no different.
Many national household names in financial services are “one name, many businesses.” Retail banking, wealth management, investment research, custodial services, market making, investment banking, private market access. The list goes on.
There is value in these institutions for consumers like us. Just as there is value to buying my snow tires and my peanut butter in the same Walmart store.
But there’s a core tension we must be aware of when financial services are a one-stop shop. The same connective tissue that creates value for customers also introduces deep conflicts of interest.
Ready to Launch
Let’s examine SpaceX’s recent initial public offering.
Morgan Stanley served as a joint investment bank (with Goldman Sachs) and sole stabilization agent for the IPO. Morgan Stanley managed early trading, retail distribution, and – yes – earned massive underwriting fees (to the tune of ~$100M).
As a consequence of Morgan Stanley’s involvement, clients of Morgan Stanley and their subsidiary, eTrade, received special access to the IPO. For example, long-time Tesla shareholders who held TSLA in a Morgan Stanley or E*TRADE account for at least 10 years qualified for a supplemental allocation of SpaceX on top of standard offerings. Nice perk!
In other scenarios, such cross-pollination might lead to lower-cost loans. It can lead to access to unique private investments. You can ask a question of your big bank and get a world-class expert to provide their niche answer.
There’s an upside here.
Stuck on the Launch pad?
But the same fuel that can propel you into the atmosphere can also blow up in your face. Deeper connections and internal conflicts are the same exact mechanism, just pointed in opposite directions.
Let’s step back to the late 1990s, when WorldCom was a darling of Wall Street. But much of WorldCom’s meteoric rise was a result of perverse incentives at a large bank.
Telecom analyst Jack Grubman of Salomon Smith Barney (owned by Citigroup) issued glowing ratings on WorldCom and other telecom stocks throughout the 90s. Those ratings flowed down to Salomon brokers on Main Street, who pushed WorldCom stock on everyday investors like you and me.
SSB/Citigroup also acted as WorldCom’s investment banker, earning huge fees as WorldCom acquired more and more small telecom firms.
The same bank also provided wealth management services to WorldCom’s CEO, Bernie Ebbers, frequently showering him with discounted shares of new IPOs.
Give WorldCom a great review. Sell its stock to Main Street, pushing the price higher. Lend WorldCom more money to acquire smaller companies. Earn huge fees. Give the CEO backdoor access. Give them more great reviews. Sell more stock to Main Street…etc.
The word you’re looking for is: perverse.
The rest is history. WorldCom collapsed amid $11 billion in accounting fraud. Grubman resigned, was banned from the securities industry, and paid fines. Ebbers was dragged in front of Congress and separately sentenced to 25 years in prison. Many individual investors were left holding the bag.
The episode became a symbol of Wall Street’s research/banking conflicts.
Model Rockets, Too
But the same conflicts happen on a smaller scale, too. Enter the “Smith” family. This is a true story.
The Smiths have about $2.5M invested with a wealth management advisor at Bank A. I won’t call out Bank A, but you know them. Their CEO is a borderline household name. You own them in any/all USA index fund.
The Smiths’ taxable account has about $200,000 in fixed-income assets (yielding around 4% interest). Also, the Smiths bought a small vacation home last year, splitting costs with family members. Their share was about $200,000.
“How,” the Smiths asked their advisor, “should we best pay for our share of the home? Where should we pull the $200,000 from?”
Their Bank A advisor suggested they use a pledged asset line of credit. They are using their investments as collateral to borrow the $200,000 at an 8% interest rate.
They still own the $200,000 in fixed income that earns 4%, while also borrowing $200,000 at 8%. They have locked in a negative arbitrage of $8000 per year. Bank A is still collecting their AUM fee on the $200,000 of invested assets – another $2000 per year.
Did the Smiths receive advice in their best interest?
Did their advisor/banker benefit from the path he steered them down?
Did Bank A’s diverse services work in the Smiths’ favor?
I doubt the Smiths’ banker / advisor is a bad actor. But his incentives are conflicted. As the late, great Charlie Munger would remind us: Show me the incentives, I’ll show you the outcome.
It’s Double-Edged
The same size and clout that provides early access to the SpaceX IPO also leads to WorldCom’s fraud and the bad advice given to the Smiths.
The mega-financial firms are a double-edged sword. You don’t get the good without risking the bad. Caveat emptor.
Jesse Cramer writes “The Best Interest” blog and creates the podcast, “Personal Finance for Long Term Investors.” After a decade as an aerospace engineer, Jesse switched careers and now helps families plan their retirements at an independent fiduciary firm. Jesse, his wife, and two daughters live outside Rochester, NY. His previous article was Happy Conclusion.
