econscius

Mike Mayo’s Solutions For Wall Street Analyst Over-Optimism

In Analyst Ratings, Banking Bailouts, Finance, Mike Mayo, Regulation, Stock Analysts, Wall Street on November 7, 2011 at 1:57 am

Maverick banking securities analyst Mike Mayo has a timely new book out called “Exile on Wall Street: One Analyst’s Fight to Save the Big Banks From Themselves” (Wiley, 2011).  He relays his depressing stories about life as a banking industry bear amongst the Wall Street bulls.  The gist of his experiences is financial firms are in the business of selling stocks, creating a hugely strong incentive for stock analysts to be overly optimistic.   “Sell” truly is a bad word -which got Mr. Mayo in trouble at several points in his career- and he points to data showing 45% of analyst calls were “Buy” and just 3% “Sell”.  He also has some interesting ideas on a fix. Excerpt found at http://online.wsj.com/article/SB10001424052970203804204577016160354571908.html?mod=WSJ_hp_mostpop_read.

The excerpt does not mention something I understand to be the case: because “Sell” is a bad word, “Hold” is tantamount to sell.  Forty-two percent of calls were “Hold”, which when added to the “3%” rated as “sell”, gets close to the 50% Mr. Mayo points out would be a random proportion. I think it is solid advice for investors to be cognizant of the Wall Street bias to encourage people buy stocks.  After all, that is the business they are in. When you see something other than “Buy”, be it “Sell” or “Hold”, you may take it as meaning the analyst does not think you should be an owner of that stock. 

I also think people should really think twice about just making decisions about owning a stock based on an analyst’s “buy” or “sell” rating, anyway.  I prefer to look at actual financial statements and analyse them.  Analyst reports make for interesting reading above and beyond the “Buy”, “Sell” or “Hold” headline.  If you do not feel comfortable understanding a financial statement on your own, there is an argument you may be better off delegating stock-picking to investing experts, which can be accomplished at a low-cost through mutual funds.

I call out Mr. Mayo’s proposed solutions.  I especially agree with his points about regulation being backward-looking and stifling innovation as well as his point that failed financial firms must be allowed to go bankrupt.  Quoting [emphasis added]:

“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.”

Mr. Mayo, managing director at Credit Agricole Securities, continues:

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.”

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Charging bull picture from Wikipedia Commons.

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