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Daniel Nestlerode: Turmoil on Wall Street

by on August 05, 2012 6:59 AM

Here we go again. Knight Capital (KCG), one of the major market makers on Wall Street, experienced what they are calling a computer glitch that led to massive trading errors and in the end (so far at least) losses for the firm in excess of $400 million in just a couple of hours. Its stock price declined from a high of $10.40 on July 31 to less than $3 Thursday afternoon.

To be clear I am not recommending this stock for investment. I believe they have management and control issues that nearly caused Knight’s demise in just one day. The Securities and Exchange Commission (SEC) has launched yet another investigation into this matter.

It would seem that they (the SEC) are running from fire to fire trying to stay ahead of the problems in the investment markets. May witnessed Facebook’s initial public offering fiasco. You’ll also remember the flash crash on May 6, 2010. And before that there was the collapse of Lehman Brothers in the financial crunch of 2007-2009 leading to bailouts of banks, investment firms and at least one insurance firm. Who is minding the shop?

So we bounce from crisis to crisis in the financial markets, seemingly no better off for having passed the Dodd Frank bill two years ago. In all fairness the entire bill has not been implemented as the government is still writing the rules and deciding how they will apply to the various financial entities.

Still, after two years you would think a well-crafted piece of legislation would by now be part of the practices in the financial community. Yet this is not the case. The new law adds a great deal of complexity to the financial system. In my opinion, if you are attempting to protect the overall financial system, adding complexity is the wrong thing to do. Complex things fail frequently. Ask Knight Capital about this issue of complexity.

In a breath of fresh air, Sandy Weill, arguably the father of the repeal of Glass Steagall (the law that separated commercial banking from investment banking), called for a return to something like Glass Steagall, separating the investment banks from the commercial or lending banks.

His notion is that we could do away with the Dodd Frank law and replace it (all 2,700 pages) with a two or three page law that would be easy and clear for all the participants in the markets. While many banking executives are aghast as this notion, the former president of the Kansas City Federal Reserve and FDIC director, Thomas Hoening believes that Weill is on the right course. So do I.

In the old days on Wall Street, all investment firms, mine included, were either partnerships or closely held corporations. Executives making the big decisions understood that their personal wealth was on the line every day.

Over the years, many of these closely held corporations or partnerships transitioned to publicly held corporations with many outside shareholders. Management became insulated from their bad decisions by keeping their personal wealth separate from the firms they were managing. Goldman Sachs was the last major firm to transition from a partnership to a publicly held and traded corporation. Since this transition has taken place, we have seen a number of major Wall Street firms fail, while in some cases management escaped with golden parachutes or at least with their personal wealth intact.

Somehow this just all seems so wrong. Call me old fashioned, I believe investment bankers and owners of brokerage firms should be married to the outcomes of the way they manage their firms. We would have a lot fewer Jon Corzines taking big bets on European debt with his firm’s (the defunct MF Global) operating capital.

What I come away with for myself and for investors in general is that it is as important who you deal with as the companies you invest your money in.

Despite regulation and oversight from a number of government entities and other organizations, investment firms keep failing and continue to make massive management blunders that put their shareholders and customers at risk.

It is no wonder that Main Street folks are continuing to turn away from Wall Street as too risky and poorly managed to warrant their business. The last time they did this was in the seventies, before things changed. But that is another story.

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Dan Nestlerode is the Director of Research and Portfolio Management at Nestlerode & Loy Investment Advisors in State College. A graduate of Penn State University, Nestlerode has been an investment advisor since 1965. He can be reached at danielj@nestlerode.com.
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