Slump Inevitable : Wall Street’s Big Spenders Defy History

The man fit Hans Kessler’s profile of the typical Ferrari buyer. He was under 40, employed as “an investment banker or money dealer of some sort” and anxious about only one thing as he wrote out a check: How soon could he take delivery of his $170,000 Ferrari?

“Doctors and lawyers buy Porsches, things that really have a utilitarian value,” Kessler remarked later. “This is more of a toy. You can barely fit a briefcase into a Ferrari. This is a car to be seen in.”

As a salesman in Manhattan’s sole Ferrari dealership, Kessler is an experienced observer of the money culture of Wall Street. When he first began selling the cars in the late 1960s, his typical customers would be over 40, “heads of corporations and real enthusiasts.”

$40,000 Over List Price

No more. Today, 80% of his customers are employed in the financial district. Many of them are in their 20s and 30s. If his typical buyer even knows how many cylinders power the Ferrari Testarossa (the answer is 12), “it’s a rarity. Half of them can’t handle a standard-shift car. They’ll pay $40,000 over list price just to get the car immediately, which in our business means in four months.”

The extravagant spending habits of Wall Street’s youthful rich during the five boom years of the current bull market have become a byword among those who work in the upscale service industries of Manhattan.

“I’ve gone from Hong Kong to Tokyo to Europe, and I’ve never seen people act like this,” said Elaine Lewis, a leading Manhattan interior designer who numbers the city’s top developers, as well as young financial district grandees, among her clients.

$10,000 Is Like 10 Cents

“They want an exercise room with the best equipment; that’s a couple of hundred thousand dollars,” she said. “Just installing some of their sound systems costs 30 or 40 thousand, before you count the price of the equipment itself. They want the TVs that flip down from the wall or up from the floor. You tell them something will cost $10,000, it’s like you told them 10 cents.”

Sales of high-priced cooperative apartments along 5th and Park avenues, where financial professionals account for more than 20% of the market, according to one respected survey, have been quickening. Prices are rising faster now than they were at the start of the bull market in 1982, and the average net worth of buyers rose to $1.9 million this year from $1.1 million just a year ago.

Today, Wall Street’s money culture is on display as never before. The wealth and size of top firms in the securities industry have grown faster over the last five years than at any time since the Great Depression. The 10 largest Wall Street firms of 1982 had total capital of $4.7 billion. On the current roster, the 10 largest firms had a total of nearly $19 billion as of Jan. 1, 1987. Meanwhile, the Wall Street work force has grown by almost 40%, to 144,800 this year from 108,000 five years ago.

The pay of some professionals under the age of 40 reaches $500,000 a year or more. Insider-trading charges against young investment bankers whose licit earnings alone were $500,000 to $1 million a year contribute to Wall Street’s aura as a place of otherworldly pay and garish spending.

Today, five years into the second-longest bull market of this century, there are some in the financial markets who wonder whether such flaunting of wealth falls into the category of whistling past the graveyard. For history ridicules any expectation that the good times in the securities markets will continue indefinitely.

Industrial Average Drops

Concern about the bull market’s longevity has intensified recently. After a strong rally for most of the summer, the Dow Jones industrial average has swooned. Since Aug. 25, the index has fallen 161 points.

“A very, very bad example has been set by life style,” Peter Cohen, chairman and chief executive of the Shearson Lehman Bros. brokerage house, said recently. “Our young people’s whole time-horizon has been shortened up considerably.”

Cohen, 41, said that when he began his Wall Street career in 1969 at the firm of Reynolds Securities (now absorbed into Dean Witter Reynolds), “there was a notion that the firm’s owners were very wealthy--but there was no manifestation that I could see. This generation now sits around and flaunts its success in front of young people, who say they don’t want to wait for it.”

Wall Street Problems

Wall Street investment firms face two related problems as the bull market enters its maturity. One is how to protect themselves from the cycle of dwindling business and slumping revenues that is bound sooner or later to follow the euphoria of the 1980s.

Firms are trying to diversify their products and services in an effort to develop a counter-cyclical business base. They are giving their brokers more incentive to sell clients long-term investment packages, rather than simply stocks or bonds, in the hope that clients will not simply withdraw their funds when the securities markets slump.

“We’re in four main businesses: asset management, trading, investment banking and retail brokerage,” said Donald B. Marron, chairman and chief executive of Paine Webber Group. “Each has its own cycles and character, but it remains to see how (the mix) works.”

The second problem, once a business slump forces pay scales down, is how to motivate young recruits who have been attracted by today’s displays of wealth in the financial district.

‘Riches of Croesus’

“Those who really want to be in investment banking, and are attracted to it for professional joy, may not do as well financially as they did three years ago, or they may do better,” George Ball, chairman and chief executive of Prudential-Bache Securities, said. “But a fair number of people coming in will expect the riches of Croesus, and they will be disillusioned.”

Senior executives regard the public’s fascination with Wall Street extravagance as something of a virus that constantly must be eradicated from their recruits’ bloodstreams.

“Everyone coming in is conditioned by this public notion of the glamour of the business,” Marron said. “By definition, that’s going to create excess. That’s very dangerous.”

Of course, as in everything on Wall Street, the mythology of profligacy somewhat overstates the reality. For many in well-paying financial district jobs, New York itself provides the initial dose of disillusionment. Six-figure wages can rapidly disappear into the voracious financial drain of a modest family life style in Manhattan, where the sale price per room of what would be a middle-class apartment in most cities has risen to more than $100,000 today from $11,000 in 1975.

On West End Avenue, a district of apartment buildings on Manhattan’s Upper West Side popular among the city’s young professional class, the average two-bedroom cooperative apartment or condominium now costs between $355,000 and $405,000, up 10% from a year ago, according to figures compiled by the Corcoran Group, a realty concern. (The only time since 1975 in which prices dropped was 1981-82, the short slump just preceding the start of the bull market.)

“Most of the people on Wall Street making $250,000 or so don’t have much net worth beyond their apartment,” said Sheldon I. Goldfarb, a Manhattan securities lawyer who has acted as the court-appointed receiver of assets for three convicted insider-traders.

Yet the public impression of Wall Street life styles is set by those few who channel their exceptional wealth into a few categories of consumption. “Fancy cars and vacation homes” are the two that Goldfarb says characterize the more extreme spenders.

Even more modest securities professionals say they regarded the bull market’s fifth anniversary this August not as a warning that all good things must come to an end but as an invitation to live beyond their current means on the expectation that they will continue to earn more.

“Most of the guys are living a higher life style by taking bigger mortgages,” said Richard Cooperberg, 27, an equities and options trader for Gruntal & Co. “Who really knows what’s overboard today? This market is a tease.”

Boom-and-Bust Cycle

The spending styles of Wall Street superstars are mirrored, if less flashily, by those of the firms themselves. More than other industries, the securities business is locked in a perpetual boom-and-bust cycle. The overhead expenses of investment firms customarily peak just as the business cycle turns down. Firms expand office space, incur millions of dollars in fixed costs in telecommunications and hire wildly as the boom ages; when it ends, Wall Street is stuck with so much embedded expense that many firms slip rapidly into red ink.

Employees become the victims of this cycle because payroll is virtually the only expense that firms can cut rapidly. Professional employees--brokers, investment bankers, traders--can be particularly hard hit because they are paid disproportionately more than clerical and secretarial workers, their expectations are loftier and their jobs become redundant faster than those of the so-called “back-office” workers.

So far, the bull market leg of the business cycle has run to form. Not only have the stock and bond markets surged, but the development of integrated worldwide capital markets has produced in such staid old businesses as currency trading and investment banking an exponential surge in importance and profitability. The expansion frenzy has contributed to securities firms’ eagerness to pay $250,000 and more to a skilled trader or investment banker in his 20s or 30s.

Professional compensation is by far the biggest expense of securities firms, and it has been soaring unchecked for at least three years. In the 12 months that ended March 31, the industry’s total payroll was $20.3 billion, up from $16.1 billion the previous year and $12.2 billion the year before that.

Payrolls Outpace Revenues

In that time, the payrolls, which include money paid to investment bankers, traders and brokers as well as wages for the army of clerks, computer operators and others who make the business hum, have risen faster than total revenues. Compensation expenses came to 39.1% of revenues in the year ended in March, compared to 37.7% the previous year and 37.2% in the year that ended March 31, 1985.

The rise in payroll costs contributed to a shrinkage in industrywide profit margins to 10.8% last year from 12.1% the year before.

“If revenues come down sharply, you’ve got to whack your costs,” said Perrin Long, an experienced industry analyst for Lipper Analytical Services. “You can’t whack your leases (which are subject to contractual agreements), so you whack your people.”

One lesson of Wall Street’s 1973-74 downturn, the last truly comprehensive slump in the securities markets (the Dow Jones industrial average fell from 1,051 in January, 1973, to 577 two years later), is that no degree of self-confidence can protect the investment business from the market cycle. Hundreds of small and mid-size firms went out of business. By mid-1974, there were 7,000 fewer brokers employed than there had been in 1971.

“Most firms saw their profits disappear almost completely,” Long said.

Bonuses Vanished

Not unexpectedly, employee bonuses vanished. In mid-December, 1973, a Drexel Burnham & Co. employee confided to the Wall Street Journal that his bosses had responded to inquiries about that year’s bonus pool by telling him “I was lucky the door was still open and that I had a job.”

Some firms maintained profits in those days by raising their commission rates to customers, which were then regulated by the New York Stock Exchange. The NYSE prohibited brokerage firms from charging below a given rate for trades of various sizes, a rule designed to keep firms from battling one another, like so many airlines, in profit-destroying price wars.

Today’s industry leaders argue that changes in the business will work to protect profits from a slump. “Today’s market is global and not national, and most cycles are national ones,” Paine Webber’s Marron said, arguing that the global flow of capital will continue to enrich investment firms regardless of localized downturns.

But other changes may make the big firms less resilient. On May 1, 1975, securities commissions were deregulated, and cost-conscious clients have been pressuring brokerage firms to lower them. Few brokerage houses today would have the courage to defray losses by trying to raise rates.

Furthermore, with as much as 50% of some investment banks’ revenues derived from merger and acquisition fees, the industry is vulnerable to a slowdown in mergers caused by tax-law changes and rising stock prices (which make mergers more costly).

The recognition that some young stars and many middle-level professionals are overpaid has been gradually seeping into the board rooms of Wall Street. “There’s very definitely a middle range of people whose compensation will be brought sharply back into focus,” said Charles Amerkanian, president of the Wall Street headhunting firm of National Recruiting Advisors.

However, securities executives say lofty salaries for young stars can still be justified today by the millions of dollars in fees, commissions and trading profits they generate every year. But some wonder how much of the young peoples’ success is due to the extraordinary buoyancy of the securities markets of the 1980s--and thus how much will evaporate when the markets top out.

Although some individual securities markets have experienced sharp pullbacks in price from time to time in the ‘80s, “probably at least half our professionals have never seen a bear market,” Paine Webber’s Marron said. “They hear people talking about it, but it’s hard to imagine. That’s at the heart of some of the excess.”

The street’s experience during one recent localized slump is scarcely comforting. In April, an unexpected sharp collapse in the mortgage- and municipal-bond markets produced hundreds of millions of dollars in losses at many leading firms, including a $100-million loss at the accomplished trading house of Salomon Bros.

The worst loss--$377 million--was apparently suffered at Merrill Lynch & Co., much of whose mortgage-security trading was entrusted to Howard Rubin, a 35-year-old whiz kid hired away from Salomon in 1985 with $1 million a year in salary and bonus. The $300-billion market in his trading specialty had not even existed when Rubin joined Wall Street, much less gone through a complete bull-and-bear cycle.

In his trading, Rubin had been riding the mortgage market’s nearly unchecked rise--260% in 1986 alone. By this April, unbeknown to his superiors, he had accumulated a huge inventory in one exotic variety of the bonds, apparently confident that the market’s customary vigor would support his investment. But the April slump opened a sinkhole from which Rubin could not extricate himself and the firm.

For all that, there are no signs that the big securities firms are planning to steal a march on the bear market by trimming staff and expenses now. Although several have said they are cutting their rate of staff growth this year, in most cases that means only a modest deceleration.

At First Boston, for example, executives say staff growth will be cut back this year to 20% from last year’s 32%. (With 4,240 employees as of last Jan. 1, that means an additional 850 recruits this year.)

Other firms say they will similarly temper their growth. “We have the feeling that we have the critical mass (of personnel) in place right now,” said Jeffrey B. Lane, president of Shearson Lehman Bros. “We’re not bidding as aggressively as before.”

So far, only Salomon Bros., which added 2,300 employees last year (an industry-leading increase of 40%), has said it will freeze hiring for the remainder of 1987.

Securities executives say they are loath to restrict hiring now because no one can predict when the bull market will run out its string.

“The street is not prepared for the end of the bull market,” Ball said. “That’s not a criticism, because whether the decline is three hours, three months or three years away is the great unknown. If you had perfect vision and saw a six-month decline from 3,000 on the Dow industrials to 2,000, you could hedge by buying options and laying off limited amounts of people. Since you don’t, the cost of a hedge is enormous. You just don’t know if a bear stance will be worth anything.”

Says William Wyman, a principal of the securities industry consulting firm of Oliver-Wyman Inc.: “The firms have a dilemma, because as long as the bull market lasts it makes sense to hire people. If the bull market lasts two more years, a firm that cuts back now could fall behind competitively.”