This book is, in a sense, a tour of Wall Street. Most tours of Wall Street begin at the intersection of Wall and Broad streets, and this tour is no exception.
There it is, beyond the illegal barricades that keep taxpayers and terrorists alike from a public street and public sidewalk, right beyond the courteous gents with helmets and machine guns where tourists used to line up for the now invitation-only visitors’ gallery. Our tour begins at that symbol of all that is holy and bizarre and wretched about American capitalism. It is where Wall Street wraps itself, sometimes literally, in the American flag. It is such a patriotic location that it is easy to get confused and think that George Washington took his oath of office on the trading floor and not at Federal Hall across the street.
The New York Stock Exchange is emblematic of many things, some of them very interesting, some very dull, and some ironic. In the latter category, what could surpass that day in April 2005 when fifteen traders were arrested by the feds for alleged felonies in this building on the same day the same U.S. Attorney’s office was rounding up some Islamic loonies for allegedly plotting to blow it up? One can almost imagine the defense that might be offered: “We were just trying to fight willful violations of the 1933 Securities Act and associated stock exchange regulations, O cursed infidel!”
The NYSE represents all the obnoxious aspects of Wall Street, but let’s be clear on something at the start: The actual activity that takes place in this building, the buying and selling of stocks, is of no consequence to you whatsoever. I mean “no consequence” and “whatsoever” in every sense of those words. You shouldn’t care how stocks are traded if you buy stocks. In fact, you shouldn’t buy stocks. Period.
Let’s take those concepts one at a time:
Make-money-on-Wall-Street books are right up there with weight-loss plans and find-your-mate-in-ninety-days books as instructions for voyagers into cloud-cuckoo land. The markets are so rude and chaotic, so absurdly and consistently surprising, that some traders occasionally dredge up chaos theory, used to predict such arbitrary phenomena as the weather and the movement of raindrops, and try to apply it to the ups and downs of the market. Professional investors are notorious for failing to beat the market, and amateurs are worse. Not that it matters, of course. People never tire of wanting to get rich or thin, or sexy without being rich or thin. Much of Wall Street is built on catering to that fantasy (the rich part, that is).
You can reasonably expect to do as well as the market. As you’ll be seeing in the chapters on money managers, index funds and ETFs (Exchange-traded funds—stocks that replicate the indexes) are your only sane choices in U.S. equities. Sure, doing your own research and picking stocks is more fun than just putting your money in an index fund, but it has been proven to be an expensive pastime.
Wall Street firms don’t want you to know this, but the general rule is that so-called small investors stink as investors and stink as stock pickers. The studies that have been conducted on occasion—and there aren’t many of them; this is one area of research the Street is not interested in funding—all pretty much say the same thing. Probably the most dramatic is a landmark study of 66,000 households, conducted in 2000, which found that between 1991 and 1996, households earned an average return of 16.4 percent, underperforming the market by 1.5 percentage points. The more people traded, the worse they did, with active traders showing an average return of 11.4 percent.
If you think that ordinary folks have dramatically improved as investors since the early 1990s, look at the more recent study by the consulting firm of Watson Wyatt Worldwide. The firm found that self-managed 401(k) plans achieved an annual return of 6.86 percent between 1990 and 2002, while professionally managed plans realized 7.42 percent. The kind of underperformance described by Watson Wyatt can drain a $100,000 portfolio of $88,000 over a thirty-year period, if you are chump enough to think you can consistently pick stocks that can beat the stock indexes.
Evidently amateur stock investors tended to keep a lot of cash and fixed-income stuff in their 401(k) plans, which was fine in horrible years such as 2002 but lousy in years like 1995. In that year, the S&P 500 rose 37.6 percent, while amateur investors’ 401(k) plans lagged a full 20 percentage points behind. Pension funds did only slightly better, 19.5 percent. All that “do-it-yourself investing” stuff that you’ve been hearing preached by everyone from Peter Lynch to the aptly named Motley Fool Web site to the financial press—including the contrite author of this book, who cowrote an article for BW in 1993 called “You Can Do It”—just doesn’t pan out.
In the same year as my forgettable BW article, the S&P 500 had a total return of 10 percent. Amateur investors who did their own research and picked their own stocks and asset allocations realized a 7.9 percent rate of return, according to the Watson Wyatt study, while active managers did only a hair better.
That brings me to Dick Grasso. He got rich—$140 million rich—the Wall Street way. He didn’t get rich by picking stocks, as that is for suckers and Dick Grasso was no sucker. He didn’t do anything particularly intelligent or clever. He didn’t invent a new “financial product” that anyone can remember, and neither was he particularly innovative.
You may find it disagreeable that he made so much money, and you may find it distressing that he did so. You may have bought this book because you wanted further support for your feelings in the matter. Well, I am sorry to disappoint you. Dick Grasso was fairly paid, and I can prove it.
Grasso and his colleagues, predecessors, and successors * earned their paychecks by keeping alive, and thriving, an institution that by all rights should have been dead and interred in a marble crypt a long time ago.
To say that the New York Stock Exchange is alive is something of an overstatement. It is actually undead, the Dracula of Corporate America, which makes its living by clinging, leechlike, to a securities industry that is sick and tired of it, but has no practical alternative because all the trading—the “liquidity”—is there. Every spouse in a bad marriage can understand the situation. Can’t live with it, can’t live without it.
Mind you, there is a significant difference between being undead, as is the NYSE, and being half-dead or comatose or even obsolete. A hideous thing you’ve probably forgotten still exists, the American Stock Exchange, periodically arises from a stupor to stagger around a few blocks away from the NYSE (across the street from a cemetery, which figures). Nobody ever pays it very much attention anymore. In May 2005 its president resigned for some reason, and that barely made the papers, buried way back. Even in its best days the Amex was known as “the Curb,” and it is hard for an institution named after the gutter to fall very far.
Originally the Amex was owned by its members, just like the NYSE. As it stumbled from blunder to blunder it was acquired with much fanfare by the NASD. It continued to stumble and trip and stagger, so it was sold back to its members, but it didn’t matter anymore because the Amex was in a kind of semicomatose state. Any other business in America would have long since declared bankruptcy—actual bankruptcy, as opposed to the moral bankruptcy that has long afflicted this very creepy, much-investigated, poorly managed, and horrifically regulated little stock exchange.
At last look the Amex listed options and some microcap stocks, and had a lovely building that would probably be more valuable to the New York City economy if it were subjected to the kind of “adaptive reuse” that turned the old police headquarters on Centre Street into condominiums. Real estate agents put the value of the building at about $70 million, which means it could easily be worth more than the actual Amex business, even if you throw in the barbershop on the first floor. As James J. Angel, a finance prof at Georgetown University, told Business Week, “Amex as an institution lost its reason for being long ago. The real question is whether it should start liquidating the assets and put them to better use.” Which makes sense, except when you realize that this is not just any old business. This is a stock exchange, so the “free market” applies only when it is not inconvenient.
In contrast to the Amex—well, there really is no comparison. The very words New York Stock Exchange make you want to sit up straight and brush the crumbs off your lap. It oozes class and reputation. It has a brand identification that Dracula himself would find difficult to beat, even after that lousy Broadway show. The Grasso mess didn’t change its public image all that much. And if you think about how he served the NYSE—well, you really have to marvel at what a great job he did.
What made Grasso so valuable to the exchange was not that he managed the NYSE so well but that he managed to maintain the regulatory and political environment, whose ethos is more Stalinist than Calvinist, that protects the NYSE’s franchise from encroachment. In a strictly free-market environment, the NYSE would have become a slightly larger version of the Amex years ago, openly ridiculed as it wheezed along. Grasso ensured that the free market impinged on the NYSE only as much as the NYSE wanted to be impinged on. His pride and joy was a “trade-through rule” that required big institutions to direct their stock trades to the NYSE whether they liked it or not.
Basically, Grasso was paid a lot of money to ensure that the NYSE did a lousy job, and to ensure that the big firms traded there whether they liked it or not.
Think that’s easy? Try it some time. Work in your basement every night to come up with a worse mousetrap. Not a better mousetrap, but a mousetrap that lets the mice wriggle away and is inferior to cheaper mousetraps you can pick up at Wal-Mart. Then try selling that mousetrap on street corners and see if you can achieve market dominance without anyone believing it does a better job.
If you can pull that off, you have replicated the business model of the New York Stock Exchange.
The evidence for this achievement, this worse mousetrap, can be found in several million pages of studies and research (about half of which—the ones paid for by the NYSE—describe the NYSE as terrific, and the other half—the ones paid for by its competitors—describe it as lousy).
First some definitions are in order.
The floor of the exchange is not just a colorful backdrop for broadcasts by the cable news channels, or a place for the after-hours parties that Grasso used to keep the press in tow (until he became a piñata, at which time the towline was cut). No, its primary function is to be a market—a place where stocks are sold just as your grocer sells meat or canned goods. Instead of men in blood-splattered white smocks, you have traders in blood-splattered…no, make that clean, well-tailored blue jackets and hand-tied bow ties.
There are two types of brokers on the floor of the exchange—floor brokers and specialists. The specialists are sort of like the men behind the counter who take your order for hamburger or prime rib. They specialize in trading certain stocks—hence the title “specialist.” Unlike the man who sells you meat, and who is pretty well free to gouge whomever he wants, specialists have a legal obligation to see to it that the prices are accurate and fair—a “fair and orderly market,” as it says in the regulations.
Since you are not permitted to go onto the floor of the stock exchange to place your order, the exchange has a bunch of fellows called floor brokers, who are the only ones allowed to take your order to the specialist.
I have oversimplified things here, but that is the gist of the situation. Now, not all stocks trade on the NYSE by a long shot. Thousands of stocks trade elsewhere—a few hundred on the half-dead Amex, thousands on the Nasdaq Stock Market, and then a few thousand more on the Pink Sheets, wherein are listed the microcap runts of the litter. Nasdaq is a computer network. No specialists, no floor brokers, no trading floor. Most stock markets nowadays, from Tokyo to London, are like that—all electronic.
In other words, as in the old wisecrack, NYSE floor traders can be replaced by a computer—literally. What they do requires very bright people, much as it would take a very bright person in the seventeenth century to perform calculations that a utility in your Palm Pilot can perform in a nanosecond.
The NYSE maintains that its trading floor does a better job of trading stocks than would a computer network of stock dealers. In a way, the NYSE has to say that. That’s because the people who own the exchange are its members, also known as seat holders, and those are the same people you see down on the floor on CNBC, walking around purposefully and throwing bits of paper on the floor. The ones who don’t own their seats lease them from retirees in Florida who used to do that walking-around and paper-throwing when they were younger.
The NYSE floor also serves a valuable public relations function. You can’t interview the push buttons of a self-service elevator, but my friends in the cable news channels can interview the few remaining elevator operators when they do a story about elevators, and they can interview their counterparts, the floor brokers and specialists at the New York Stock Exchange, whenever they want a sound bite on the markets. In fact, Nasdaq, which really is a computer network, was so jealous of all those interviews and photo ops that it established a “market site” on Times Square to give the cable-news talking heads a place to talk.
The NYSE and its defenders (such as every New York City elected official going back to Peter Stuyvesant) say that having people throwing papers around on a trading floor contributes measurably to the smooth flow of the markets generally, thereby justifying the existence of the specialist system and the existence of the exchange and the existence of the big building at Wall and Broad with the columns in front, and all salaries and benefits and pensions paid therein. The stock exchange, and the specialists themselves, of course, tend to portray specialists as the firefighters of finance, rushing into unrewarding trades when others are fleeing in the opposite direction. They are there for you—to “put you [brokerages] and your customers first,” as the Specialist Association put it in a handout circulated in the industry a few years ago.
The job of all those specialists on the exchange floor—their legal obligation, in fact—would seem to be extraordinarily high-minded to the point of masochism, if done properly. They have a duty to buy and sell stocks against the flow of the market, such as buying when the market is crashing, when other traders are cashing out and cutting their losses, putting their capital at risk just for the sake of seeing a smile curl on the lips of people they have never met.
The NYSE’s various factotums insist that this is not a fatuous pipe dream but an actual, glorious reality. They point to several million pages of studies and reports, while the NYSE’s opponents point to several million pages of studies and reports.
However, there’s one number that really tells the story.
Everything the specialists do is counted and measured pretty minutely, including the extent to which they buy when stocks are going down and sell when stocks are going up. The term for that is the stabilization rate. This is a big, fat, important number. NYSE rules require that specialists go against the grain 75 percent of the time. If they don’t do a good job stabilizing prices, specialists can get their stocks yanked away from them.
Well, here’s what the NYSE’s own numbers say: In the sixties and seventies, the stabilization rate was 90 percent or better, sometimes as high as 95 percent. In the eighties it got worse. In the 1990s it got lousy. By the mid-1990s the stabilization rate was scraping by at 75 percent, and in 2004 it climbed a bit but was still 80 percent, a lot worse than it was three decades earlier.
What these numbers mean is that over time, NYSE has managed to pull off a steady, quantifiable degradation of its supposed market-soothing function.
These specialists aren’t dummies. Have you ever heard of anybody on Wall Street trading stocks not because they want to make a buck but because they want to serve a noble purpose? When pros engage in short-term trading, the aim is to go with the flow and buy when stocks are rising and sell when stocks are declining. Buying when stocks are declining (or selling when they climb) is known as fighting the tape, and it is a risky thing to do when your time frame is a few minutes. Unless, of course, you know that a short-term downtrend is about to reverse. Only two kinds of people in the world have access to such red-hot market information—psychics in carnival acts and people who work on the floor of the stock exchange. They know the trades that are coming in from all over the world.
Still, 80 percent is a big number. Nice of them, isn’t it? Well, maybe not so nice, and not so stupid. * It so happens that a fellow named Marios A. Panayides, now a professor at the University of Utah, carefully studied the way specialists buy and sell stocks, and over the past couple of years he has been publishing papers containing his findings. One of the findings of his studies—which I should point out was not financed by any of the NYSE’s competitors—received absolutely zero attention despite all the hubbub over the NYSE, even though it cuts to the heart of the NYSE’s role in the markets. It’s what he describes as a “forecasting factor influencing [specialist] transactions.”
Marios found that in 1990—the freshest data he could get—62 percent of specialist transactions that are stabilizing (buying when prices are going down and selling when prices are going up) “happen when the prices are about to change direction. The opposite holds for destabilizing transactions.” Assuming that number is about the same today, it would mean that when specialists stabilize the market, they do so because they know they’ll be able to make a buck. He found “strong evidence that the Specialist is in fact able to differentiate between when the market prices are moving in the same direction or changing trends.” And when they are buying with the market, they usually know the market is going to continue in the right direction.
Marios’s conclusion, after years of poring over NYSE data, is that the specialists don’t make money when they abide by the NYSE rules and do stuff such as provide price continuity—no sudden increases or decreases in share prices—and stabilization. They make money only when they can get away with not doing all that good stuff. Thus the specialists are being asked to act against the grain of the free-market system, which gives traders not just the right but the obligation to maximize their profits. It’s unnatural—an inherently dysfunctional system that is an open invitation to abuse.
In light of the interesting data Marios has collected, you can understand why scandals keep happening at the NYSE. It’s just as a muffler dealer on Jerome Avenue in the Bronx once explained to me many years ago, when one of his friends (my uncle) was initiating me into the mysteries of the auto-repair business. Overcharging customers was the only way to make a living in a very tough, competitive, low-margin business.
If Dick Grasso had been paid $140 million to defend a useful, rational institution, it would have been a squalid form of self-overpayment. Being paid that sum to defend and keep alive an obsolete, inherently irrational institution that hasn’t always treated its customers very nicely—that isn’t at all squalid. It is the quintessential American success story as adapted by the postmillennium Wall Street: the man with the malfunctioning, but more politically powerful, mousetrap.
It is also the work of a fundamentally honest man. Such work requires the kind of dedication that comes only from a true believer.
I came to a full appreciation of Dick Grasso’s honesty and dedication one lovely summer evening when we met for dinner. The date was June 30, 2003. I am sure that Grasso, as a product of the New York City public school system, was aware of the meaning of that day. For every New York City schoolkid in the fifties and sixties, June 30 was Graduation Day. It was the day kids received their report cards, still written in blue-black ink on acid-free white paper, describing their academic performance and behavior and containing comments such as “Gary is a lovely boy!” or “Gary needs to work harder to achieve his potential.” Grasso was about to graduate from the NYSE, and he surely must have known that his report card was being written every day, and that he was getting really lousy grades from people like me. For years he had been everywhere in the media, a little bald man with comical talent of an outer-borough variety that brought to mind Larry “Bud” Melman of the pre-CBS Late Night with David Letterman. Coverage that had once been all kissy and loving was now turning nasty and almost spiteful.
You might have gotten the general impression, if you followed the gleeful coverage of Grasso’s travails, that the press was pursuing an almost personal vendetta against the NYSE and its once-lovable bald leader. And you would be onto something. That’s because all those years it had only seemed as if the press had been the NYSE’s biggest fans. In fact, the press was utterly terrified of the NYSE. Such had been the state of affairs since at least the 1980s, when the exchange’s PR apparatus was known for being—well, maybe just a bit nasty toward members of the media. I’ll leave it at that.
Over time, attitudes mellowed on both sides. Personnel changed. Tempers cooled. Still, it is fair to say that well into the Grasso era, the NYSE was still roundly despised by a great many people whose employers bought ink by the barrel. Relations did not improve when the NYSE devoted a section of its Web site to press goof-ups. It was used as a bludgeon to bawl out such hotbeds of left-wing extremism as the Wall Street Journal and the New York Post. Such unauthorized use of the First Amendment was not to go unavenged.
When Grasso stumbled, the media pounced, and loved it, and kept on pouncing. I did my pounce when the pay scandal broke in mid-2003, and Business Week put me to the task of writing a profile of Grasso. I requested an interview, and the exchange responded in typical, heartwarming fashion by having its chief flack at the time call the editor in chief at the time, Steve Shepard.
Grasso insisted, through his flack, that Shepard or some other grown-up accompany me to the interview. That struck me as inept. If I were being interviewed by a potentially hostile publication, I would insist on limiting the number of questioners. It was also ill-advised from another standpoint. Did he really want to get my editor in chief personally invested in this story? His other requirement was even more peculiar. Grasso insisted that the interview be conducted in a restaurant, and over dinner. If the interview were to be on Grasso’s home turf, in mid-workday, he would be in control of the environment and could limit the length of any questioning. He could be trapped with me for hours. It was like having a first date in a hot-air balloon slowly drifting to the Azores. It made absolutely no sense for a man who was trying to avoid being, pardon the expression, screwed by the media.
Another shock came on the day of the interview, which took place at a mediocre but pricey establishment in an out-of-the-way part of midtown, me with an editor other than Shepard and Grasso with the flack. As a rule, no CEO under attack would ever consent to the recording of a leisurely, relaxed interview. The danger is that the interview could then be shoved down his throat, verbatim, in an article. However, Grasso had no objection to the interview being recorded.
The best explanation I can come up with is that Grasso did not feel that he had anything to hide, and wanted to tell the truth. Maybe he also wanted me to see him up close, near enough to see the polish glisten off his shaved head, hear his organs process his low-carbohydrate food, and become infected by his charm. If that was his objective, he succeeded. Up close, Grasso is charming and unflappable. I had just been interviewing members of his family, a former high school teacher, and old school chums to get insights that might make him writhe a little, but I did not have any luck that night. He was impervious, deadpan.
Grasso was perfectly straightforward. He had nothing that he perceived as requiring concealment. At one point he looked me straight in the eye and told me how he pretty much hand-picked his board of directors, much as you might put your wife or golfing buddy on the “board” of the Subchapter S corporation you set up to shelter income from stamp collecting. He said he had an annual “audience”—the papal terminology went over my head at the time—with the board’s nomination committee, and gave them a list of people whom he wanted on the board. They went ahead and picked the members from that list, and never went to the trouble of coming up with names on their own. He said that he believed that this method of picking the board was completely “independent,” and actually a better method than was generally used by companies to pick their boards of directors.
He also insisted that he had no influence on his pay, and that the only thing he ever said, after receiving his annual pay package, was “Thank you.” He also has been quoted as saying that he has responded “I’m blessed” when given his paychecks. Dick Grasso was indeed blessed, and so was the NYSE. Both had ample reason for gratitude and many people to thank, especially in Washington.
The NYSE is more than just an obsolete marketplace, party space, terrorist target, and generous paymaster. It is a regulator. When it comes to regulating, the NYSE is the trendsetter for the rest of Wall Street. It sets the standard that the Street has been striving to meet, if not exceed, for many years.