Scam Science: Old School Wall Street

mod (Andy) note: "Blast from the past - Best of Eddie" - This one is originally from September 2010 . If there's an old post from Eddie you'd like to see up again shoot me a message.

I have a feeling this week-long series is going to be both fun and difficult to write. It's going to be fun because the subject of financial scams has always been an area of fascination for me. It's going to be difficult because it's going to require you, the reader, to go back to a point in time that will be difficult to imagine - and it's my job to take you there.

The scams I'm going to cover this week are based on practices I personally witnessed from 1992-1995. They were widespread, and just about every firm on the Street (every firm I knew of, anyway) took part in them. Some were merely shady, others outright fraud. I neither admit nor deny my personal participation in any of them. This series will cover the mechanics behind each of them.

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Try to imagine a time before the Internet. I know it's hard, but it really wasn't that long ago. Let's say you wanted to know where IBM was trading, or you wanted to see AT&T's latest 10-q. Where would you go? For most people, they'd pick up their morning paper and scan the stock listings for IBM's previous day open, high, low, and close. It they wanted AT&T's 10-q, they'd have to be a registered shareholder and wait for it to come in the mail (yeah, the snail mail).

Things were a little easier if you were in the business. For pricing data, you probably had access to a Quotron (the early predecessor of a Bloomberg terminal) which would give you static pricing data that refreshed when you smacked the space bar. It would also give you Dow Jones headline news, but only the headlines. If you wanted the full story, you had to call your research department. Likewise for things such as 10-k's and 10-q's.

Stockbrokers were like gods back then. Imagine Bud Fox in the original Wall Street, and you've got a very close approximation to the reality of the early 1990's. Brokers controlled the flow of information. If you wanted to know something - anything - about a company you had to call your broker. Mutual funds and hedge funds both existed then, but neither were popular with investors yet. This was also a time before firms hired professional money managers.

The stockbroker did it all back then: research, analysis, portfolio management, investment banking and private equity raises, and he was ultimately responsible for client profits and losses. But the early 90's were the last days of disco for the stockbroker, and the one-two punch of the Internet giving everything away for free and the firms growing tired of rogue brokers and thus replacing them with "professional" money managers (what a crock) brought their reign to an ignominious close.

I started in 1992, a year when the average stockbroker made $118,500. Today the average stockbroker makes $38,500 and might as well be working the phones at Pizza Hut because all he's doing is taking orders. What a joke. I had one guy in my office (a USC grad, if that matters) who routinely made over $100,000 gross a month when he was 24 years old. He was nowhere near the sharpest knife in the drawer, either, and I can say that because he and I were close friends.

The stranglehold on information and several other factors built the foundation of numerous scams run by every firm on the Street at one time or another. Some of the other factors were:

• Stock prices were fractional instead of decimal - Regulators didn't require stocks to be quoted in decimal format until April 9, 2001. Stocks trading in fractions allowed for much larger bid-ask spreads and enabled firms to charge clients phantom commissions (known as "chop") that the client never realized he was paying.
• IPO's and secondary offerings could be managed to virtually guarantee double digit returns - By overselling indications of interest and lining up aftermarket buy volume, deals could be managed to consistent double digit returns, enabling firms to get rid of their junk by granting access to profitable offerings.
• Limiting the sales of principal deals enabled firms to artificially elevate stock prices and limit short selling - Strict enforcement of "no selling" policies ensured that there was no stock available for short sellers to borrow and that any long sell orders could be matched with buys prior to their execution. This allowed firms to "box" their principal deals and maintain quoted pricing as much as twice as high as the actual market for the stock.

In this series I'm going to cover the actual nuts and bolts of the prevalent scams of the time. I'll explain the mechanics of chop, what it means to "cross" and "box" stocks, how a "net-net" deal works, and the most common predatory trading techniques. I'm sure your initial response will be, "That could never happen today.", and for the most part you'd be right. The Internet and the free flow of information forced firms to clean up their acts.

But I'm also certain that some version of these scams is alive and well and in practice today. A leopard doesn't change its spots. I still crack up when I hear about the perceived prestige there is in being "invited" to participate in an IPO.

Hopefully, the posts will be entertaining (more entertaining than this one, anyway) and, if you have any questions about the specific scams, I'll be happy to answer them in the comments section. Enjoy Labor Day (if you happen to have the time off) and let's have a great week!