The Consumer Financial Protection Bureau was Built to Look Out For You

After the financial crisis, one of the complaints was that often ordinary consumers were not savvy enough to know what they were buying in terms financial products. Economic theory assumes that both parties in an economic transaction have full and complete knowledge, but in terms of getting a credit card, or getting a mortgage, what happens in reality is an gross information asymmetry in terms of the financial institution having much more knowledge of what they are offering than what the consumer knows. This is, in part, what we can point to as a cause of the financial crisis. The adjustable rate arms resetting on people who didn’t know that the rate would pop like it did, doubling the monthly payments and driving that loan into default – but the originator didn’t care if they weren’t holding that loan on their books anymore.

So, it was situations like this that led the Harvard Law Professor, now Senator and presidential candidate to say, “There ought to be a law”. Her proposal for a regulator facing consumer to institution transactions helped lower that informational asymmetry. One of these initiatives is in implementing the Credit Card Accountability, Responsibility and Disclosure Act Of 2009. This law was put into place to eliminate abusive lending practices and let consumers know the cost of fees and penalties. Specific parts of the legislation include information about how long it will take to pay off a balance at a minimum payment rate, limiting marketing towards college students, and helps limit interest rate hikes.

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Personally, I try to limit holding a balance on credit cards, but this might have helped me when I was younger. I first signed up for a card so I could get a basketball hoop on my dorm. I spend and didn’t always pay off the balance, and I missed deadlines, so my interest rate was almost 30% annualized on a balance that was near the limit. I had to keep paying more than the limit to keep the interest rate from adding to the principal, which would take me over the limit and incur more fees.

There are critics that say that the CARD act didn’t go far enough in limiting deceptive practices, but if they couldn’t get the full wish list passed in 2009, there’s no chance of getting more robust consumer facing regulations passed in today’s regulatory environment. Just one example of how large financial institutions exercise their power over consumers. Just a couple of weeks ago, I received an email about changes to my user agreement with Chase, in that by continuing to use my Chase Card, I implicitly accept. In this agreement, buried deep, was a notice that one of the terms changings was an acceptance to join in mandatory arbitration if I had any disagreement. The banks write into your contract the right to sue them being removed. And the only way to opt out of this part of the agreement is to write a letter to the bank by a certain time. I want to do it, but even though I think of myself as a savvy consumer and I don’t like those terms, I most likely will not remember to sit down and write a letter to the bank and then mail it in. (And I worry about them not receiving it. Do I need to send it certified mail?). So even though we have an institution newly in place, the banks and other financial institutions are doing their best to circumvent the regulations and the regulators. This, of course, is being aided and abetted by the people in charge at a higher level, where the ideology is that government can only do bad things, and corporations are always acting in the best interest of society by maximizing shareholder value. 

A Diseased Heart Still Pumps Blood: Securities Markets in the Economy

Over the past week, I have been thinking about the role of the securities markets in an economy. Overall, I am of two minds when I think of the securities market. The predominate one, the animalistic firing in my amygdala is that we should be fearful of the securities markets. You see, for someone of my age and upbringing, for the most part my entire life was one where the economy was mostly working. I was born in 1981, so I don’t remember the downturn associated with the inflation and the Volcker shock. I vaguely remember the recession of the early 90s that helped put Clinton in and secured the third way liberalism of Clinton and Blair. There was 9/11 and the tech bubble bursting with Enron and WorldCom and Tyco being exposed as cheats, but Bush came in, and gave everyone tax cuts and the economy recovered.

The economy worked in such a way that I didn’t have to think about it or even be curious about how well it worked. It worked so well that I had the confidence with all my intellectual gifts that I would be safe in majoring in English with a creative writing component without really worrying about what kind of job would be available on the back end.

What I didn’t know, as I was in college and then in grad school was that there was something going on in the securities markets. The stock market was growing, and housing prices were going up. If you have American cable 15 year ago, you couldn’t avoid televisions shows about house flippers extolling the get rich quick properties of property. Incidentally, this retrospective thought triggered “Mihelic’s First Rule of Finance” in that if a television commercial exists for a product, you are the one getting scammed. Gold, Reverse Mortgages, Quicken Loans? All there to take your money at a rate above what a savvy investor would be able to do if they weren’t relying on television commercials. What was going on that housing prices were not just rising. They were being pulled up by the creation of demand for loans. The loans were sliced up into securities and sold onto other investors, and maybe this process was done again and again. You also had companies like AIG Financial Products writing credit swaps on the loan derivatives that they did not have the capital to back up. So, this demand drove banks and other originators to lower their credit standards so that they were offering loans to people with poor credit and no jobs and no way to pay the loans. They sold loans that were negative amortization loans, meaning that the monthly payment did not cover how much was added to the loan in interest so that the amount outstanding on the loan grew every month even if people were staying current. They sold these loans at high rates and with teaser rates that were going to reset, and they sold these loans to people who could have qualified for better rates but got a horrible deal because they were in traditionally underserved communities. While this was going on there was lax underwriting and undocumented transfers on the chain of title of loans and property. And none of it mattered as long as house prices were appreciating.

But it did matter when the house prices stopped appreciating. Everything blew up, and to mix my metaphors, Chuck Prince of Citi famously justified all of it by saying that “As long as the music is playing you have to get up and dance,” but then the music stopped and we saw who was wearing no clothes. None of this would have mattered if, like the tech bubble, it was just a handful of people on Wall Street and Sand Hill Road that lost money, but because they were pulling from the real economy, when the music stopped people lost their homes, people lost their jobs, and the government felt that the best way, the only way to intervene was to recapitalize the banks and financial institutions that created the mess in the first place. It is no surprise that this led to populists reactions on the right and the left from the Occupy Movement to Tea Party candidates in congress and the political rise of Bernie Sanders and Donald Trump. Something was fundamentally broken in a way that was not evident for the whole of the Great Moderation. And I know this because I was affected by the wave that washed over the economy. I was unemployed for two years and sent out thousands of job applications and ended up with only a handful of interviews as I read everything I could to try to figure out what happened. So that means that the lizard brain part of me thinks of the securities market what I want to do is burn the whole thing down.

However, there is a more analytical part of me. Once the signal from the amygdala clears, then the frontal lobe gets its say. Securities markets, like all institutions, exist because at their founding they filled a niche that needed to be filled. I think of the origin story of Wall Street, how dealers met at in the shade of the buttonwood tree on Wall Street to clear transactions. It was easier to have one central place to meet instead of having young boys just running through the city all day. New York was not even a city as we think of what a city is now. The tallest building was a church and most of uptown was still farmland, yet there needed to a central place to trade shares in businesses.

Securities markets do have two key roles in the economy. The first is that they provide liquidity and working capital. A business can offer shares for sale or bonds and then they get an infusion of cash. This cash can be invested in productive activities in the real economy instead of the business waiting for investable cash through business activities. The business does give up some right to future cash flow in terms of what the bond’s coupon is, or what the expected dividends are, but this offering is like a bank in that liquidity is key because sometimes you have a good business but it is cash limited. The other important role is in both the primary market when a business sells on securities and in the secondary market when securities owners buy and sell existing shares or bonds, is that the market is a continual process in finding prices for existing businesses, and in the aggregate it becomes a way for everyone to know what the right price is for these securities. The price discovery mechanism makes it easy to invest in public, security offering companies, distributing ownership to anyone who can buy a share and potentially democratizing the economy.

The problem is that at some point from a nascent institution coming into being to fill a niche, as it grows and evolves to meet the needs of the environment it is in, it can move from being a useful part of the economy to being a drag on the economy itself. In addition to this, path dependency means that something like the securities market insinuates itself in parts of the economy where it is a net harm but where it is impossible to create policy that just rolls back the clock to whatever imaginary point where it crossed the line. So, as much as I still want to blow up the whole thing, I realize that there are problems with ripping out the institution root and branch because it does have a productive purpose to play as long as we have capitalistic social relations. Ultimately, the securities market in the economy is like a diseased heart in an individual. It may kill the person one day, but up until then it still pumps blood.

Ultimately, can the market be beat?

And if someone can beat the market, how do you find the people you entrust your money to. I think it is John Bogle, the founder of Vanguard, who liked to talk about a coin flipping competition. If you have thousands of people who are all flipping coins, statistically, you will find people who have amazing streaks. If someone flipped a coin that landed heads thirty times straight, we might then assume that that person has a great aptitude for flipping coins. But we know that in coin flipping, this is a completely random chance of happening, and will happen if there are enough instances of flipping. 

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But when it comes to stock picking, we move from the idea that the stock was picked at random and instead had a group of skilled analysts behind it. Then we start to build a narrative and say that we can look at the history of some “Firm X” and then judge if their return less fees beats a benchmark consistently. If so, maybe we can say they have their skills and I should trust them with my money. The thing is, there is always that disclaimer that past performance is not indicative of future success, so even if they are good stock pickers (coin flippers) their run might end. If the market is truly random, it will end.

I think that the financial research shows that there are factors that are often undervalued, and for times, investing in these factors – momentum, company size, P/E ratios, etc. – can have a return that is greater than the overall market. The problem is that these factors are not everywhere and always relevant. Sometimes they are in effect and you can make money above the market, and sometimes you can lose relative to an index. I’m skeptical that anyone can beat the market consistently, but I don’t think it is truly efficient (so if you see a hundred-dollar bill on the ground, it makes sense to pick it up). I’m not sure the discipline is convinced on if the EMH exists and if it does just how strong it is, to the point that Thaler and Fama won their Nobles in the same year when they were largely notable for having competing theories of how markets work. For me, I think it is somewhat efficient, but I personally don’t have the skills or time to spend on watching the day to day movements of financial markets, so I do have my retirement in broad-based index funds with low fees. 

The Government's Gold Pile

For some reason the gold in Fort Knox gets trapped in some mythical idea of a hoard.

The gold there is held under the US Mint, which is part of the treasury, an executive branch office. It seems that it was accumulated in the mints for coinage, but the gold at Fort Knox is there just to be stored. This goes back to when the dollar was backed by gold, and theoretically you could exchange a dollar for an equivalent amount of gold. There were increasing limits on this, from Roosevelt making it only so that sovereigns could trade in their dollars, to the point where there were no more trade-ins after Nixon decided to close the gold window. The US does hold gold elsewhere – but at the mint cities of New York and West Point, and there is a vault under the Federal Reserve office in New York City where countries keep their accounts. 

With the current free-floating currency, holding onto a hoard of gold most likely involves costs that are not necessary since the currency is not backed by gold. I can’t think of a good reason that we should hold it, but I can think of two reasons that probably inhibits the selling of the Knoxian gold. First, if the US government started unloading that much gold, it would be a sudden glut of supply in the gold market, so people who are involved in the gold market and have their own little hoards most likely would not like to see the price of gold driven down, as one thing that gives gold its value is its relatively rarity. The other reason that we most likely don’t sell off the hoard is that there is a very vocal minority who want to move back to the gold standard so that there is something backing the currency other than the full faith and credit of the US government. These people would be loud voices against any selling off the gold at Fort Knox.

AAA Dilemma: What if the Ratings Agencies Disappeared?

In general, there’s a conflict with the ratings agencies because they are a bit of a proxy regulator, given power through the federal government to rate bonds and other financial instruments, and so many other bodies can’t invest their money in a financial instrument unless it has a certain rating from certain ratings agencies. Moody’s, S&P, and to a lesser extent Fitch have a stranglehold on the system because they’re written into law and there are high barriers to entry to starting a new rating agency. Anyways, there is the conflict because they exist in a market, but the companies that they rate pay them. 

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So there is this question about how independent the ratings are, since if they don’t get the rating, they like from one agency, they can just walk down the street to another. And then there is the prestige issue, where the people packaging financial instruments have more power because they work at Goldman and make multiples of what someone at a ratings agency does. Overall, I think this relationship had a big effect in the run up to the financial crisis because the CDOs were being rated AAA for even their riskiest tranches because there was a fundamental lack of underwriting going on and the ratings agencies were not ready to push back against these banks to say that you’re selling people trash that will blow up. Of course being real close to the day to day activity, you really don’t have the perspective to say that this will be one of the things that makes the whole house of cards fall down, but at least you can say that the credit on these mortgages is too bad, and you’re not taking in account correlation risks, and there is a chance that house prices may go down. The riskiest 5% of these are not as good as treasuries.

Thinking if the ratings agencies went away for some reason, the first thought is to say good riddance. But the second thought is that there is a lack of information in the marketplace by not having these quasi-independent bodies, overall it would drive up costs in the market and make borrowing more expensive for everyone. What it would more likely would do is make a mirror of the equity market. The larger companies would get independent research done, so Disney and US Steel could issue bonds, but for smaller and less liquid offerings, that is where costs would go up the most – bifurcation the market so that the rich got richer. Hopefully the state would step in to offer truly independent ratings until that agency got captured.

The Market: A Positive Sum Game

When financial markets channel funds from savers to investors, who benefits?

The simple answer to that question is that everyone benefits when financial markets channel funds from savers to investors. The saver, who might have very few options about where to put her money – in the book the author jokes about putting it under the mattress – with a functioning financial system can achieve greater return on her money. The investor wins because they now have capital. Having an idea to make or do something novel to fill a niche in a marketplace is worthless unless you have capital to invest. With a healthy financial market, you can go and get funds to facilitate your new idea that helps you undercut the local taxi market or local hotel market. Your idea can come to fruition when previously you had top hope to be individually wealthy or have the right connections.

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 But there’s more! By facilitating that transaction, where the savers and the borrowers benefit, it is not isolated to those parties. Society benefits, as there is now the thing that was not existing in our alternate world without good financial markets. You have Uber instead of calling a cab and hoping that their credit card machine isn’t “broken”, and they are ok with driving you to your neighborhood at that time of night.

And then, for their efforts, the financial market makers get a nice little sliver of the action to reward them for their coordination efforts. Just a little though.