On the MainStage at the ’62 Center on Oct. 19, William Cohan gave a lecture titled “Money and Power: Why We Keep Getting Crushed by Wall Street.” Cohan works as a contributing editor at Fortune magazine and this year published a book similarly titled to his lecture, Money and Power: How Goldman Sachs Came to Rule the World. Though couched in the language of corporate organization and incentive structures, Cohen’s talk told a story of pirates and bandits and the booms and busts of their treasure hunting schemes.
“This was a man-made crisis,” Cohan said in opening, referring to the financial crash of 2008. He argued that there were specific reasons for why the crisis struck and how another could be averted. Because there were specific people to blame, Cohan had been expecting popular backlash against Wall Street for a long time. Occupy Wall Street has fulfilled that expectation in part, but Cohan said he does not think it will be enough.
“The first [protest] reminded me of a street fair,” Cohan said. “I’m disappointed in them. The protesters, they don’t understand [Wall Street].” He remarked that some people have called him condescending for this attitude. “I’ve offered to go down and explain how Wall Street really works,” Cohan added. For now, he settles for explaining the situation to audiences along his book tour.
Cohan dispelled the notion that the 2008 crisis was a once-in-a-century event, as many on Wall Street itself argue. He ran a brief history of commercial and investment banks since the middle of the 20th century, drawing attention in part to its impressive, long-held ability to wriggle away from responsibility but more importantly to its instability.
“Wall Street is a dangerous place,” Cohan said. He focused on Goldman Sachs as one prime example. In the ’40s and ’50s, Goldman Sachs, along with 16 other investment banks, could have been broken up in a massive antitrust suit, but the case was ultimately thrown out. In 1970, another spate of lawsuits in connection with the bankruptcy of Penn Central Railroad could have brought down the investment firm, but only some of the lawsuits were successful. In 1994, Cohan said that Goldman Sachs nearly went under due to a risky bet on bond interest rates.
Having established the pattern of risk-taking and losses on Wall Street, Cohan went on to explain why such a pattern emerged and became even more prevalent in the modern era.
First, he identified the shift from investment banks as private partnerships to public corporations. Following the Glass-Steagall Act of the 1930s, commercial banks and investment banks were separated. Investment banks received funding from the partners who owned them. Thus, the partners themselves were liable for every investment they made.
“As a partnership, these firms were prudent about risk,” Cohan said. In the 1970s, however, several of the investment banks transitioned to become corporations. Goldman Sachs was the last to do so in 1998. As a corporation, the risk for managers and employees of the investment banks diminished substantially because it was spread out among the shareholders instead. This created a problem of information asymmetry as individual shareholders had very little information or understanding of how the firms actually worked in comparison to the previous partnership structure in which partners had strong incentives to keep close tabs on each other.
Cohan identified compensation as the second big problem in how Wall Street firms are run. In the old structure, partners were paid with pre-tax profits. In the corporate structure, managers and employees are paid salaries supplemented by bonuses, which are allotted in relation to revenues generated, not profits. This system weakens the incentive for employees to make sure the firm as a whole is in the black, which would be in the interest of shareholders, who own the company. “[Investment banks] don’t exist for their shareholders. They exist for their managers and employers,” Cohan said.
The third factor Cohan identified in the crisis was Wall Street’s impressive ability to innovate with financial instruments in recent decades. “What used to be a business of art now became a business of science,” he said.
The problem, as Cohan sees it, is simple. “There’s too much money to be made [in these financial instruments,]” he said. As a result, benefits and risks become distorted, and bubbles result.
Towards the end of his lecture, Cohan addressed the role of government. “Public policy has a big role in this, but politicians for a long time have been bought and sold in Washington,” he said.
During the Q&A session following the lecture, an audience member asked what Cohan would focus on if he had the chance to write a platform for Occupy Wall Street. “It gets down to the incentive system. How do you create that sense of prudent risk-taking?” Cohan said. He proposed a return to partnership-style investment banking, applied to corporations. Cohan views this as a much needed change to the American system of public policy and finance.
Though Cohan hopes that a popular movement will create the necessary political pressure, his expectations are not high for Occupy Wall Street.