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.
In the excerpt below from his new book, Exile on Wall Street: One Analyst's Fight to Save the Big Banks from Themselves, Mayo gives an inside view of the fights, scolding, and threatening that resulted from his "sell" ratings on banks.
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.
Analysts are supposed to be a check on the financial system—people who can wade through a company's financials and tell investors what's really going on. There are about 5,000 so-called sell-side analysts, about 5% of whom track the financial sector, serving as watchdogs over U.S. companies with combined market value of more than $15 trillion.
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.
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.
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. 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.
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.
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.
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.
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."
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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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.
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.
"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.
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."
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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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.
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.
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.
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.
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.
A spokesman for Deutsche Bank says, "We fully support our analysts' ability to publish independent research for the benefit of our clients."
***
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.
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.
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.
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.
Buy the book and read more.
—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).
