Insiders Churning on Wall Street’s Fast Lane

The extraordinary aspect of Wall Street’s Dennis Levine insider trading case is not that a man managed to squirrel away $12 million by trading adroitly in confidential client information. Nor that anyone making a million dollars a year could be so greedy that he would steal money at all. The extraordinary fact is that a 33-year-old, who was not the head of a giant corporation, or a heart-transplant surgeon, or the inventor of anything useful, could make a million dollars a year in the first place.

Levine was a young mergers and acquisition specialist with the Wall Street firm Drexel, Burnham, Lambert. He pleaded guilty earlier this month to buying and selling stock on the basis of confidential information he had received in the course of his employment. When a company is a takeover target its stock price almost always rises. “Insiders,” that is, company directors, or lawyers and investment bankers involved in the deal--or anyone else who has received information not available to the investing public--are prohibited by federal law from dealing in the stock until the news of the takeover has been properly announced. Levine faces the possibility of a substantial prison term as well as the loss of his career.

His case has titillated as much interest in Wall Street salaries and bonuses as in the facts of his offense. The Wall Street Journal profiled five young men, all in their late 20s and early 30s, who earn between a half-million and a million dollars a year in the frenetic business of buying and selling companies or trying to guess which stock is going to go up tomorrow and which down. One of them, with the appropriately WASPish name of Hamilton James, advised the Journal’s readers that “$1 million sounds like a lot of money, but it’s really not. . . . The fact is, it’s easy to make $1 million and not accumulate a lot.”

Top salaries on Wall Street have always been high, but it is only with the extreme economic fluctuations of the last 10 years that astronomical incomes have become commonplace, especially for young people only a few years out of business school. The question is, are they worth it? The answer depends on the answer to a broader question: Does the financial community generate the economic product to justify its enormous rewards? The answer is sometimes yes, more often no.

Information exchange is one of Wall Street’s basic products. That is one of the reasons why “insider trading” violations are so difficult to pin down. Trading information is what Wall Street is for .

The arcane new currency and interest rate swaps illustrate how Wall Street adds economic value by smoothing information channels. Consider why swaps first became a product. In the recent past, solid Japanese companies, for instance, would have difficulty selling long-term, fixed-interest bonds in the United States because their names were not well known to the institutions--usually insurance companies and pension funds--who buy such things. But they could raise floating-rate loans from U.S. international banks that know about foreign companies.

A bright--and probably young--investment banker realized one day that many U.S. companies carried fixed-rate debt on their balance sheets that they would love to convert to floating rate interest--because they thought rates would fall and save them money. But the fixed rates they were paying were lower than the Japanese companies could find on their own. Eureka! The currency and interest swap market was born.

The swap was possible because of misinformation in the marketplace. The Japanese companies warranted lower interest rates than American investors were willing to give them. The swap bridged the information gap and got the Japanese companies rates closer to what they deserved. The costs of borrowing were reduced for all parties, and the investment banker earned the handsome fee he was undoubtedly paid.

It is instructive to note that the fees and profits earned by doing swaps have steadily narrowed, until some investment banks wonder whether they’re worth the trouble. What has happened is that the foreign names have become familiar. Information channels now function efficiently and the Japanese company is more likely to raise the money on its own.

The investment bankers who took U.S. companies into the Eurobond markets over the past decade performed a similar task of broadening information channels. In the 20th Century, American companies had rarely borrowed overseas--although they often did in the 18th and 19th Centuries. By allowing Americans to borrow worldwide, investment bankers helped internationalize the capital markets, tie the industrial economies much closer together and, as an incidental benefit, make it much easier for the United States to run big budget deficits, because other countries can supply the excess credit required.

The booming mergers and acquisition market itself is a typical product of inefficient information systems. For 10 years after the stock market doldrums in the early 1970s, U.S. company shares were grossly undervalued, so undervalued that oil companies, for example, were typically valued at a price lower than oil held in reserve. When corporate raiders like T. Boone Pickens began snapping up companies at bargain-basement prices, they and the investment bankers who engineered their deals dramatized how low stock prices were and fueled the stock market runup that has yet to peak.

The problem is that genuinely innovative transactions are few and far between. Once someone invents a new transaction, all the other firms jump on the bandwagon, chasing the high fees that can be earned. The economic justification for the latest round of mergers and acquisitions is increasingly difficult to perceive; one suspects that deals are done only for the excitement and the fees. Levine, himself, despite his million-dollar income, was not a deal technician, but was described by his co-workers as a salesman. His job was to convince clients that they needed to merge or acquire somebody to create business for his firm.

Long ago, John Maynard Keynes remarked, “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlwind of speculation.” Wall Street existed, he said, “to direct investment toward its most profitable channels . . . but the best brains of Wall Street have in fact been directed toward a different object.”

Wall Street has a vested interest in churning deals. Sharp moves up or down in bond or stock prices, a frantic wave of buying and selling companies--often the same company several times over--all generate action, and action generates fees and million-dollar bonuses for youthful fast-talkers like Levine.

Over the long haul, the problem is self-correcting. Mergers and acquisitions are harder to do these days, because the real bargains have long since been snapped up and the markets have corrected--or overcorrected--for the previous undervaluing. Similarly, the big institutions with funds to invest have long noticed that the portfolios managed by professional managers typically perform less well than if the money had simply been invested in a random portfolio. And they are now insisting that their managers do just that--the new “index funds” are essentially random portfolios--while paying much smaller fees for the service.

The burst of financial activity over the last few years has obscured deep-seated problems at many Wall Street brokerage firms and investment houses. The services they provide, by and large, are not worth the high fees they charge. As the economy settles down into something approaching stability, as it appears to be doing, the huge fee opportunities from simple churning should begin to dry up; investors and corporate clients will insist on value for their money. If that turns out to be true, the next new hot product on Wall Street may be dealerships for used Maseratis and Porsches.