Why Has Finance Provided Such Good Paying Jobs
There has been much gnashing of teeth as last year’s “bail out babies” (technically bankrupt companies and banks) are busy dishing out big bonuses again. In fact, the bonuses are comparable to those paid before the crash of 2007. Congress has been inundated by outraged citizens demanding that this stop and the “wage czar” has ordered a number of major banks to limit cash compensation for the top executives of those that well-liked the government’s largess’.
There are larger questions, though, that underlay the definition of profits and the utility provided to our economy by these financial institutions. How is it that one year they are flat on their backs needing tax payer money to survive and the next year they are rolling in profits and ladling out bonuses to their employees? They argue that finance is a very competitive business and that huge profit, retention and acquisition bonuses are needed or there will be a brain drain from one bank/hedge fund, to another.
OK, that’s how the financial industry explains things. Let’s look at this from another angle and instead ask the question, where did these profits come from and how are they helping our economy grow? Floyd Norris (To Rein in Pay, Rein in Wall St, New York Times, B1, October 30, 2009) begins by saying that Wall street is not the economic engine they would want us to believe but instead relies on techniques and strategies that have little to do with enhancing the economy but have a lot to do with creating profits for their minions. The Buttonwood column (The Economist, October 10, 2009) describes things this way: “At the heart of the current crisis is a fundamental confusion about the nature of wealth….Wealth consists of the goods and products we wish to occupy or of things (factories, machinery, an educated workforce) that give us the ability to accomplish more such goods and services. Financial assets arise from the desire to postpone consumption so that money can be saved, either for precautionary reasons or to invest so that more goods and services can be consumed in the future…financial assets are not wealth but a claim on real wealth (the stuff we actually consume-MP).”
First, a little history. It turns out that our government tracks profits generated by various sectors of the economy and for the six decades from 1929 to 1988, the financial industry generated about 1.2% of the gross domestic product’s (GDP) profits. In fact, during those 60 years, the profits have never been greater than 1.7% of GDP. In the 1990’s things began to change with financial industry profits shooting up, reaching a high of 3.3 percent of GDP in 2005. Did this more than doubling of profits mean that the financial industry was a major factor in the growth of our economy? Did it reflect an allocation of credit (a primary function of the financial industry) that helped build new industries, foster growth amongst small businesses, and in general make the allocation of credit more efficient?
According to Floyd Norris, there is small evidence of this. Rather, there has been easy money, low interest rates and asset bubbles which mediate a misallocation of credit similar to what happened in the 1980’s with the S/L debacle and the emasculation of that industry (remember the Resolution Trust Corporation? ) as well as excessive bank lending to South American countries, companies and individuals requiring intervention by the Federal Reserve and a helping hand by the U.S. government to rebuild devastated balance sheets. Sound familiar?
Buttonwood, using the analogy of the stock market, adds a further explanation. “The fundamental reason why equity prices rise over time…is that they are linked to the goods and services being produced by companies. As the economy grows so do the revenues of such firms (with the potential for increases in fraction prices-MP)…It is the link between speculation and asset prices that explains (the current crisis). The ability to borrow money (from the financial industry) to buy assets fueled the rise in asset prices. And the wealth effect of higher prices persuaded those in English-speaking countries to borrow money to sustain consumption.” In other words, easy money was chasing the same basket of assets (housing, equities, etc.) thus bidding up prices. The higher prices of things (their value) then allowed people to borrow more money continuing a spiral of upward debt and consumption. This, by the way, is the exact opposite of what is taking plot in China where savings and thus investment in capital goods and infrastructure far outweighs the purchasing of consumables.
“The U.S. and most other G-7 economies have been significantly and artificially influenced by asset heed appreciation for decades. Stock and home prices went up – then consumers liquefied and spent the capital gains either by borrowing against them or selling outright. Growth, in other words, was influenced on the upside by leverage, securitization, and the belief that wealth creation was a function of asset appreciation as opposed to the production of goods and services…. What has happened is that our “paper asset” economy has driven not only stock prices, but all asset prices higher than the economic growth required to account for them. Granted, one must be careful of beginning and ending data points in any theoretical “proof.” Such is the fallacy of Jeremy Siegel’s Stocks for the Long Run approach which begins at very low PEs and ends most long-term time periods with much higher ones, justifying a 6.5% “Siegel constant” real rate of return for U.S. equities over the past 75 years or so (Bill Gross, Investment Outlook, November 2009)”.
Floyd Norris takes us one step back and asks why the financial sector has been so salubrious at increasing its share of national profits irrespective of whether it has actually contributed to the underlying economy. His answers descend into five categories, some of which you may be personally familiar with:
- Higher charges. In case you haven’t noticed, credit card fees are sky high. Forget about the teaser rates, the real ones that people pay are in the range of 15-20% or higher and that is on top of the fees charged to the merchant for accepting your card in the first place. Then, of course, there is also the fee you pay for the privilege of using the card. You may also have noticed the fees attached to your checking account, ATM machine, bounced checks (they alone brought in over $30 billion dollars in fees to the banks last year) and other retail uses. Distinct, those with substantial balances may get their fees waived, but for the vast majority of people the fees stick. There are other fees, however, that dwarf these and they are amazing to behold. Hedge funds come to mind and though you may not be directly invested in them, there is a good chance the good folks investing your IRA or retirement funds (CALPRS is an example) are. The “best and brightest” on wall street recognized that a few good years and some trusting customers could form the basis for their own hedge fund, the result being that thousands were created during the boom years. What really attracted these managers was the unique pay they received for taking risks with other people’s money. First, they charged on average one percent of the funds under management. What that meant was that if the fund averaged ten percent in profits, they were keeping one tenth of that amount as a management fee. Bear on, though, that’s not all. If the fund made a profit, not only did the managers get the one percent management fee, they also kept 20% of the profits. That was in the good years. If it was a bad year and the fund lost money, the one percent management fee was still collected but only the investor sustained the losses. The manager lost nothing. In fact, the manager didn’t even have to give aid previous year’s bonuses even though they may have been earned as a result of taking excessive risk which showed up in later years.
- “Too spacious to fail” is an apt phrase to describe the excessive concentration of financial wealth in a few businesses. In 1990, the ten largest financial institutions controlled about ten percent of financial assets in the United States. Considering the size of our economy and the money represented, that is an amazing concentration of wealth. However, according to Henry Kaufman and Niall Ferguson (The Road to Financial Reformation: Warnings, Consequences, Reforms: 2009) that was dwarfed by the concentration of wealth in 2008 for in that year the ten largest financial institutions controlled sixty percent of the financial assets in this country (J.P. Morgan Chase & CO., Bank of America Corp and Wells Fargo & Co. control a combined 33% of U. S. deposits as of June 30, 2009-WSJ, October 30, 2009). With this level of concentration, you create conditions leading to collusion and oligopolistic pricing. Why else would bid-and-ask spreads be increasing or fees for underwriting securities rise?
- Derivatives have been one of the main bogey men in this latest financial crisis; their lack of transparency means that it is hard to decide the level of risk being taken and that, in turn, makes it hard to price the derivative accurately. As Warren Buffet so ably stated, “If I can’t understand it, I won’t invest in it.” He also called derivatives financial time bombs! Another way to characterize this situation was what Richard Bookstaber, a former hedge fund manager and author of A Demon of Our Own Design (2007), called informational asymmetries between financial institutions and their clients. If you have ever purchased a bond and received a book (prospectus) accompanying it describing the risks and rewards inherent in the investment, you know what I mean. The prospectus contains page after page of fine print but who has the time or inclination to read such a tome when all you want to do is invest your money in something safe. So you rely on your financial advisor and the rating agencies’ grade for the bond. It is in that fine print, though, where critical information can be found that might scare you away from the investment. The financial institutions count on your not taking the time to inspect those pearls of information and rather to trust them and their guidance. The same thing also exists in the complex contracts written with the express aim of inserting “gotcha clauses,” the better to advantage the lending institution to the disadvantage of the borrower. Good luck opinion all the legal language, let alone using it to price the investment. Another opportunity for financial institution’s revenue enhancers.
- Fancy footwork with the IRS. Many of the financial innovations in recent years have been geared to tax avoidance rather than productive creation of real goods and services. The ideology of minimizing taxes while maximizing government services has led us not only to the meltdown in state and federal coffers but also to the place where we are open to the speedy tax hustle with a fancy title. Whether it is a tax avoiding off shore bank account, skirting the apt edge with questionable tax write-offs, or a myriad of other devices dreamed up by financial institutions, you are taking the risk while they are reaping the rewards in big fees and other enhancers.
- Other people’s money is an apt phrase to describe the high level of risk taken on by financial institutions in recent years. Why put their capital at risk, they reasoned, when they can gamble with other’s money? If you have ever borrowed against your stock portfolio on margin, you know that the limitation is fifty cents for every dollar of stock equity you bear. If it’s U.S. treasuries in your portfolio, it can be as high as ninety cents for every dollar. With hedge funds, banks and other financial institutions, though, these rules don’t apply. How about borrowing twenty to thirty times the value of your capital? That is leverage and when the friendly times are rolling, the profits pile up. Imagine that you make 5% on a particular investment. That is not much but if you could borrow thirty times your capital then the profit is no longer 5% but rather 5% multiplied by thirty for a profit of 150%. Complex analysis of the relationship between various assets, “black box” formulas and extremely fast execution of trades are supposed to insure that things don’t go wrong, but if they do, that leverage works in reverse. Now, instead of only losing a portion of your invested capital, you are losing thirty times that much. That’s what happened to Long Term Capital when they almost went broke in 1998. The leverage they used exceeded 75 times capital and by the last week of their existence they were losing $300,000,000 a day!
Borrowing short and lending long is an age traditional strategy, but as Peter Eavis reports in the Wall Street Journal (October 31, 2009 “Finance’s Short-Circuit Needs Fixing”), “It is the biggest mistake in Finance, and it played a huge role in causing the credit crunch.” Bob Citron, Orange County’s disgraced treasurer, knows this all too well. He was the “brilliant” treasurer that Wall Street fawned on until the strategy of borrowing money at short term rates and buying long term investments came crashing down. When short term rates increased unexpectedly, banks holding the county’s long term paper as collateral had the honest legal to sell at a loss and they did so, saddling the county with billions of dollars in losses and forcing it into bankruptcy. You can guess the rest; over a decade later, the county still has to deal with the consequences to its budget. Speedily forward to 2007/8 and the same scenario unfolds. Quick money is made by Wall Street as they convince others as well as themselves that they can predict changes in interest rates snappily enough to provide protection against what happened in Orange County. When debt markets dried up as they did in 2007/8, however, this strategy fell apart, and the banks/hedge funds/investment houses were forced to sell their assets at any price, that is if there were buyers (which in many instances there weren’t). The rest is history. Goodbye, Lehman Bros; goodbye Bear Stearns; hello bank bailouts. Those great Wall Street profits in the good years were paid out as bonuses. When the bad years hit, government stepped in to lend money to the financial community so they didn’t have to keep selling their assets at a loss. After all, if they were forced to do so, even more “too big to fail” institutions would have collapsed into bankruptcy. But have you noticed, after one year’s dip, bonuses are serve as substantial as ever…humm.
What should be done, then, with ample pay packages and bonuses that can exceed a hundred million dollars in one year? To meet the demands of angry voters, a pay czar was appointed whose job it was to rein in such excesses. It looks good in the headlines to say that the top earners in any financial institution that the government has bailed out cannot be paid more than $500,000 in cash per year, but it is only that; window dressing.
For long term solutions that have teeth and will help prevent another financial meltdown, regulatory reforms and proper enforcement need to be put in place.
1. If a bank wants to grow its deposit deplorable with government insurance, then those depositor monies need to be invested conservatively. When government restrictions on S/L’s were relaxed in the early 80’s the outcome was predictable: the demise of the industry itself. In 1998, the Glass-Steagle act was overturned and banks were let loose to invest in ways heretofore limited by the memory of the Roaring Twenties and the ensuing Great Depression. Our Recession of 2007- was the result.
2. Too-big-to-fail must be stopped. Not only has the concentration of wealth created monopoly/oligopoly pricing opportunities (a condition anathema to a free market economy) but, as has been written about extensively, these organizations have become dysfunctional in their size and complexity. They are honest too expansive to manage and the result is unavoidable risk to the organization, as well as to the economy in which it functions. We criticize the Chinese government-run industries as inefficient and a drag on their economy; unfortunately, our “to colossal to fail” financial institutions exhibit much of the same behavior with the resultant system-wide risk. The Obama administration, along with central bankers around the world, has proposed that “too big to fail” financial institutions be limited in the scope of their activities and compelled to shrink and separate between conservative lending/savings banks that provide the credit for the real economy, and the risk-taking “investment” banks that did such a fine job of bringing us to the edge of financial disaster. Alan Greenspan and Paul Volker have supported the administration’s proposals.
3. We can’t blame it all on government or huge business. Our culture of “more is better” leads us to overextend our finances in the pursuit of a bigger house, another car, and a fancier vacation objective to name a few of our temptations. To pay for all this, we set ourselves up for the promises of wealth reflected in the many financial institution advertisements. They have taken advantage of the psychology of lust for more (their ‘animal spirits’ phrase is a much used term) by demonstrating the magic of compounding returns in the equity market (just save x amount per month and in thirty years you will be a millionaire), tax-deferred schemes that don’t dwell on the their limitations or long term tax implications, the volatility of the markets that may not suit either the investor’s temperament or short term needs, and the promise that others can manage your money better than you can. Why pay off your house mortgage (a guaranteed return on your capital equal to the mortgage interest rate) when you can turn your wealth over to others in the hopes they will derive a higher return than that mortgage interest rate?
As earlier in this paper Buttonwood explained, there is the real economy of goods and services and there is the financial sector which represents a claim on the wealth of the real economy. When government relinquishes its role as arbiter between competing interests, its excellent area as legislator of rules and enforcement of them, then the system is put in great jeopardy, the results of which we are experiencing today.
A primary role of government is to protect us from invasion by foreign forces. A corollary to that, in today’s highly complex and interrelated financial world, is government’s role in protecting our free market economy from invasion, either foreign or domestic, from monopoly/oligopoly pricing and moral hazard (the perception by a company or industry that they are too big to fail so will always be bailed out by the government). Government mediates between diverse interests, the process of which is very messy and inefficient. Yet it is this mediation and the commensurate rules properly enforced that allows us to live in relative safety and to retain the fruits of our labor. To suggest, as some do, that government needs to get out of the way and let the market work by itself is to completely ignore past history and the all too human tendency to run wild when rules are relaxed.
Michael Pinto, Ph.D. November 2009
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Filed under Monopoly Bankruptcy by on Jan 4th, 2011. 
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