A Manifesto for a Boring Financial System

Today, I sit and think about the role of financial markets in the economy. What do the stock markets and the bond markets and banks even do? How do they operate, and what kinds of risks do they pose? How do we stop these risks? Of course, I won’t stand up and leave the computer nor will you finish reading this essay with full knowledge of these complicated issues. If we as a discipline had finished up an completed our understanding of the role of these institutions and how to control them we would still have the market at Irving Fisher’s ill-timed comment right before the 1929 stock crash that “Stock prices have reached what looks like a permanently high plateau,” cementing his place in history as an anti-prophet. Of course, he did other things but if he is remembered to the laymen, it is for that utterance. But perhaps you can say that he was early, and the pride in his voice was there only because the discipline was young, and the practitioners thought they had all the answers. Alas, there were other names, more recognizable to today’s readers making similar claims that would not be born out in history. In another instance, we have the great historian of the Great Depression and later Fed Chair Ben Bernanke, in remarks on Milton Friedman’s birthday give the older economist a valediction: “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again” (“Birthday”). In my education, I have circled back to this moment mentally many times and let it play through my hands and fall to the ground like sand. It amazes me and is a perfect bookend to Fisher’s remark. The over-enthusiasm of the earlier quote is the other side of the hubris of the latter quote. “Look,” the sages say, “there is no need to worry because we have all this figured out”. Of course, these remarks are only telling in retrospect. If the stocks had stayed at the high plateau, only economists would know Fisher’s name. If there wasn’t a housing crash caused in part by keeping those low and steady rates the Fed kept through the 2000s, Greenspan would still be the “Maestro” and we would continue to say that in awe instead without that hint of sarcasm I use when I say Maestro, and he wouldn’t have to have been hauled in front of Congress to explain that there was “a flaw in the model that I perceived is a critical functioning structure that defines how the world works, so to speak” (Naylor). There was a flaw, some sort of weakness that could pass along instability from institution to institution and bring down the whole financial system and the larger economy down, even after pouring trillions of dollars of cash and promises to back up the banks and investment banks leading to a slow recovery and giving political space to all sorts of unsavory characters. For me, there’s a direct line from the crash of 2008 to the rise of Donald Trump, and that’s not a good thing.

I want to pull back for a second from the financial crisis and think about what we mean when we say, “the economy”. At a macro-level, we can talk about contributions to the GDP, C + G + I + (X-M) and ask what is going on with each of those pieces. The talking heads can say that we have an economy in America that is about 70% driven by consumption. But the GDP is driven by final goods, and there’s so much that is not accounted in the GDP (and all the bad things that are counted in there) that looking from a top-down macro-level doesn’t capture what the economy really is, or if it captures it, it abstracts too much for the guy on the street to have a good sense of what is going on. I say this because what the economy really is is people making economic decision under uncertainty. Do you quit your job, and if you, will it be easy to find a new job? Do you move, looking for better opportunity? Should you start saving your money, thinking that there may be a downturn? There are organizations that try to quantify these questions. Both the Conference board and the University of Michigan survey Americans about how they feel about the economy and how they think the economy will act soon, asking questions like in the below figure from the ninth page of the Michigan survey.

fig 1

Of course there are all sorts of problems with survey data in that it captures what people think and not how they actually act, but we’re looking for leading indicators here, and the leading indicator at the current moment shows that for both of them, the sentiment is high. The American consumer in aggregate is on fire.  You and I don’t make these decisions in the aggregate though. We make these decisions on our own. I refinanced my mortgage last year, thinking that the rate would keep going up, and despite all my Fed tracking, the President and the economy put enough pressure on the rate-setting committee that they decided to not keep raising the rates. Now the market is saying that there will at least be a pause in the raising of the rates and that there might be a whole percentage point lowering of the federal funds rate. That means my mortgage is locked in at a higher rate that I would be able get if I refinanced now, and I still could if I wanted to pay more fees and reset my amortization table. I might move in a year, so I think I won’t approach that decision for now, and thinking historically, it is at 4.5%, which is low. What the economy is is people, operating under uncertainty, making these economic decisions. They play these roles as consumers, as workers, and as members of government.

I want to move now from looking at “the economy” now versus what it looked like right up until the crash. I have written elsewhere that I didn’t ever pay much attention to the economy at large until the financial crisis. I was cognizant of my role as a worker, but so much of what was happening in the real economy did not seem to have any sort of effect on the real economy, where I lived day to day. I made choices as if the baseline was nothing to worry about. When I was in undergrad, I figured it would be fine to major in English. I was aware of the boom and the bust in the dot-com era, but that didn’t touch me. Reflecting on this made me try to think about how the financial economy leaks into the real economy. There are polls of consumer confidence, and they do try to quantify these sentiments into one nice little number, but how are these sentiments created? To really think about this, I need to separate the person I am now from the person I was over a decade ago. What sorts of information does one person have if they are not keyed into to the financial news, and how do they interpret how the economy is and what the path will be? Talking informally to people this week, there are a couple of big indicators, and one of those is inflation. The price of gas is a big one. Though most of us go shopping in person or online, there is only one real price that you drive by every day, and that’s the gas price. If it goes up, there are stories on the evening news about how the new gas prices will hurt consumers, since it is a big enough part of their expenses, and one that can move with some volatility. In the lead up the crisis in 2008, the gas prices almost doubled. I remember gas at over $4.50 a gallon. This mattered because I was driving a 1998 Dodge Ram Pickup. That thing had a huge thirsty engine that only got about 12 miles to the gallon. To fill up the tank took thirty or more gallons, so a single fill-up cost almost a hundred and fifty dollars. I did not have that kind of extra money lying around, so I tried to get rid of the truck. When I tried to sell it, I found that people were not interested in paying much for the truck, so I donated it to get it off my hands because otherwise I would be fined for keeping it parked in city streets. In the run up to the crisis, as someone not really paying attention to the economy, the other number that would have been available would been the level of the stock market, but even that was not in my consciousness. Looking up the level of the DJIA in 2007-8, I was surprised to see that there was noted weakness in the spring, which would have been around the time of the insolvency of Bear Stearns and its being sold to Chase (“Historical Dow”). The Dow then recovered a bit and try as I might I cannot recall any concern that summer. I had been out of work. Teaching at a Catholic School in academic year 2007-08, I was not invited to renew my contract and a bit listless about what to do. I had liked teaching, but I needed to step away for a minute to reconsider my life path. It was in the summer of 2008 that I thought it would be a good idea to go into sales. I did some research and one of the easier industries to break through in would be automobile sales. So, I reached out to different dealerships and started doing research on some of the newest models that were going to be hitting the lots in the fall. I also remember seeing an article that the car sales were having their worst summer in a long time. Persisting, and not letting that bother me, I was hired on at a Chevrolet dealership. 

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And then that fall, the leakage of the financial economy into the real economy became a tsunami.

There come times when you cannot take the economy’s working for granted because it makes itself know to you no matter how you try to ignore it. Though NBER would later date the start of the recession to late 2007, I was still looking at car sales as a good way to make some money quickly, even though sales had turned down some. In the middle of September, there was no ignoring the fact that something had snapped. We were required to be on site at the dealership for fifty hours a week, and those were the longest days, spending ten or twelve hours doing nothing, or going through the motions of some training game the managers had dreamed up, or calling everyone in our database to see how open they might be to coming down and looking at the new models. It was not an auspicious time to be making a career change, and the low traffic in the dealership meant that it was dog-eat-dog between the salespeople for the few people who did walk into the dealership.

But we had been able to take the economy for granted. When Bernanke apologized to Friedman for the Fed’s role in the Great Depression, it was with the acknowledgement that at that point, the economic problem had been solved. The last recession was small and concentrated in the stock market. One reason that it did not leak into the real economy was because of the spread of stock ownership, where the top 10% own over 80% of financial assets (“Duetsche” 42). What was different about the crash six years later was that it was tied into people’s housing, so there was a feedback effect from people not making enough to cover their payments to this meaning that the risk level were understated and the price of assets backed by the housing is overstated, so they fall in tandem with a horrible negative feedback effect.

What is interesting is that it really should never have happened. Regulations were put into place after the crash of 1929 and then during the New Deal to make sure that banking was boring. The problem with this approach is that corporations accumulate political power that is strongly correlated with their financial power. That, plus people forget the original justifications for the regulations on the book and it becomes fine to breach walls that were put into place to prevent the next crash – oddly enough the very stability of the system, the fact that it was working, is used as a justification to erode the protections. Stability, as the rediscovered economist Hyman Minsky would put it, creates its own instability.  One important thing to note is that the financial power of these institutions was huge. By one measure, in the run up to the crisis, over 40% of corporate profits were created by banks and other financial institutions. After dropping, they were back over 30% in a couple years (“Wall Street”). All of this is of course notable because in many economists’ models up to the crash, banking and financial institutions were not part of the model. Buyers of sellers of goods met each other in the market with no intermediary. 

Economists did not have these financial institutions in their models because financial institutions should be boring. They handle vast sums of money, and even if the just cream off a percent or two they do not think that you will miss those funds, but you do. There is no justification for the huge glass towers in midtown Manhattan other than the fact that we have allowed these institutions through their power to take these rents. They went from boring to being a huge amount of the corporate profits, by acting as middlemen in transactions that in theory at least would happen anyways. You can go to a textbook and see what a financial system that is boring should look like. The financial system should meet the needs of the real economy, and not be the driver of it. What are the needs? Companies need money. They might have a new product to launch or are investing their model in a new market, but they do not have the immediate liquidity. Companies do not like uncertainty. They may want to hedge their positions. Investors have money, and they may want a guaranteed return. Alternatively, they may feel like they can expose themselves to some risk to get a greater return. Financial products exist to make this all happen. 
If a company needs liquidity, there are two ways they can go about it. They can issue stocks which are usually a claim on the fractional percentage of the company’s profits, as well as a vote in the way the company is run. This basic model has been subverted some in recent years as some companies have issued shares with different claims on the profit or different levels of voting rights. The company gives up some rights to future cash flows with each share it offers, diluting the value overall of all the other shares. This share offering is beneficial for investors since in return for their cash up front, they have a claim on all future dividends, buybacks, and one-time cash disbursements that the company gives out to its shareholders as long as the company is in business and the shareholder owns the stocks.  The other way to get needed money is to offer bonds. Bonds are fixed term investments with a set return at the time of issuance. The buyer of these securities is guaranteed the nominal return of the bond’s coupon as well as the initial investment at the end of the maturity period of the bond (Ball 58). Both instruments trade on secondary markets, where based on changing interest rates and perceptions on the level of future cash flows, the price of these will be different from the initial price on offering. 

Consumers also might need money, no or in the future, so they can invest their current funds in one of these securities. Or they can go to a bank. A bank is an institution that accepts deposits and makes loans (Ball 222). In the United States, there are a lot of different kinds of banks, but if they are in the business of maturity transformation, we can talk about them in general. These institutions must have their own money to lend out. Investors in banks provide the initial capital, which is the backstop for all that they do. They then can take deposits and lend money. They can also borrow money from other institutions or the Federal Reserve to allow themselves the ability to make more loans. Banks make their money through fees and through the difference in the interest rates in which they lend and the interest rates at which they borrow. If the loans are good and the spread is wide enough, then there should be no problem keeping this system going. 

The final boring thing the financial system should be able to do is to eliminate risk. That’s not entirely possible, so perhaps it should be framed as the lowering of risk. Different financial products are available to buy and sell for both institutional and commercial customers that give the customer the right to buy or sell securities at a certain price. There are also financial institutions that package shares into mutual funds so that customers can be diversified and track an index without having to buy in and out of different securities. 

The problem is that it all stopped being boring, and that was by design of the actors in the financial system. They did what they could to increase risk and increase returns and ignored the simple fact that if you make derivatives out of mortgage backed securities, you would be in trouble if there was a lot of correlation in the change in housing prices nationally. Institutions ignored the lesson that if you borrowed too much money, then you diluted your capital base. Lehman Brothers by 2007 was leveraged over 30:1, meaning that they were only backed by 3% of their own capital (“Lehman”). That means that you as an institution can make money if the market is going up. You can make it hand over fist. It also means that if the market drops only three percent, your entire institution is not just illiquid, but insolvent. 

How do you make the financial system more boring then? The easy answer is grab a magic wand and decree that banks need higher capital levels, exotic derivatives are no longer legal, greater underwriting needs to be done on all loans. You wave that wand and you cap remuneration at banks and financial institutions to some percentage of the median. You wave that wand and outlaw the business model of private equity firms, who buy companies and load them with debt, and spin off their assets. Create the ideal classical world, one where Laurence Ball says is a place where “crashed are hard to explain” (71). You send people to jail for fraud. 

You wave that want and make these regulations global because what capital is good at is seeking the best place to make money for the short term. If you raise the cost of doing business in one jurisdiction, the capitalists will find the next best place to do business.

Ultimately, you want to do that because as long as we have capitalism around, we need to do our best that it works for people operating in the real economy. The more the real economy and the financial economy get separated from each other, the greater the risk of a great and debilitating crash that is exogeneous to the real economy. You end up with a situation where the options become framed as one of two choices, liquidation of the system or a propping up of the failed system so that it can recreate the conditions of the crash. Alas, none of us have that magic wand, but through national regulators and international agreements, capital requirements have increased such that the big banks are holding more dry powder, but it will not be enough. The seeds of the next crash are already being sown. The alarm is being raised by some economist or commentator, but they are being ignored because no one like to hear bad news and besides this time is different. But until we make and keep banking boring, each successive time will be different, but it sure will rhyme.

Works Cited

Ball, L. M. (2012). Money, banking, and financial markets. New York City, NY: Worth.
Bernanke, B. S. (2002, November 8). On Milton Friedman's Ninetieth Birthday. Retrieved June 30, 2019, from https://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021108/
Consumer Data. (n.d.). Retrieved from https://www.conference-board.org/data/consumerdata.cfm
Deutsche Bank's capital position. (n.d.). Retrieved from https://www.db.com/company/index.htm
Dow Jones Industrial Average Historical Prices, 2007-2019. (2019, April 17). Retrieved from https://knoema.com/jhxfibc/dow-jones-industrial-average-historical-prices-2007-2019
Naylor, B. (2008, October 24). Greenspan Admits Free Market Ideology Flawed. Retrieved from https://www.npr.org/templates/story/story.php?storyId=96070766
Stewart, H. (2010, September 19). Consumer Spending and the Economy. Retrieved from https://fivethirtyeight.blogs.nytimes.com/2010/09/19/consumer-spending-and-the-economy/
Surveys of Consumers. (n.d.). Retrieved from http://www.sca.isr.umich.edu/

Weissmann, J. (2013, May 11). How Wall Street Devoured Corporate America. Retrieved from https://www.theatlantic.com/business/archive/2013/03/how-wall-street-devoured-corporate-america/273732/

Untaming the Horse: Financial Regulation in America

Banks and financial institutions have been able "innovate" faster than the regulators. They have been able to capture regulators to their will. The history of these continued failures speak to the need for robust and proactive regulation. These are some of those stories. 

I.

There is a story in the days before the Federal Reserve about the panic of 1907. There was a run on a bank – the Knickerbocker trust. There was a worry that it would spread, as panics often did. Instead of letting the failure of one bank topple over the whole system, JP Morgan got a bunch of other bankers in the library of his personal headquarters at Madison Avenue. He wouldn’t let his peers, the lions of the turn of the century financial world, leave the building until they had pledged their own capital to the banks to stop the panic. Peace was restored.

There is another story in which there was another panic, this time with the stocks dropping and other banks failing, and Morgan’s son tried to do the same thing. The market kept dropping. More banks closed, Roosevelt was elected, and the depression lasted a decade until massive federal spending picked up with the beginning of US involvement in the second world war.

There is a third story, as the financial crisis came to a tipping point in the fall of 2008. Bernanke, Paulson, and Geithner gathered up the leading lights of the turn of the new century in a room. This room was at the headquarters of the New York Federal Reserve, an institution created in the shadow of the panic of 1907 and the fall of the Knickerbocker trust. This time, the leaders were government employees, working for the Federal Reserve or the Department of Treasury. They were being asked not to put up their own capital, but to accept capital from the government. Some bankers were reluctant, as accepting capital was a de facto admission that their banks were insolvent, or at the very least were having liquidity problems. No one wanted to admit that they were having problems or exposed to counterparties with their own issues. But ultimately, everyone did. They even changed the charter of a couple of the institutions so that they could formally accept money from the Federal Reserve because technically up to that point they weren’t even banks. So Goldman Sachs became a bank, that it could fall under the Fed’s preview and take the Fed’s money even though if you asked any at Goldman the crisis hadn’t touched them, they were not to blame, and their hands were clean, thank you very much. Even though it’s been a decade, it might be too soon to be bringing judgement on if this intervention worked or not. Will we be able to tell what’s next?

II.

Two statues sit outside of the headquarters of the Federal Trade Commission in Washington DC. In the gloriously neoclassical and overly didactic symbolism of the capitol, these statues show a man wresting a horse, both subjects with rippling stone muscles. It is called Man Controlling Trade and shows the mission of the FTC. But it can also be seen as a metaphor for all the regulators in Washington and New York. Capitalism is this wild horse, who can rampage but be put to product use. It is up to the functionaries to make sure that this raging horse is harnessed so that its capabilities are put to good use and it doesn’t rage about the countryside, putting people out of jobs and homes.

You see, Man Controlling Trade is at best an ideal. If our sculptors wanted to represent the actual relationship between the individual business and their regulators, it would not be a man wrestling with the stallion, but instead a person in constant pursuit of the stallion. One thing that capitalism is very good at is innovation. But innovation is not necessarily ultimately for the public good. It is innovative and it isn’t passive. It actively uses the levers under its control to avoid and subvert regulation. Often, there is not the separation between the man chasing the horse and the horse itself. They lose their antagonism and work together.

III.

More stories, more concrete. A woman was chairperson of the Commodity Futures Trading Commission. Her name is Brooksley E. Born. During the Clinton years she saw that derivatives could become a destructive force in the economy. So, she said that these instruments needed to be traded on exchanges. Their terms and their prices needed to be transparent so that the markets could work their magic. Pressure came from above from the banks and through other federal workers who should have been working for the benefit of American Citizens and for the functioning of the economy as a whole. Instead of being pro-market, they protected their specific friends in business. These are names you recognize: Alan Greenspan, and Treasury Secretaries Robert Rubin and Lawrence Summers. They ruined her career. And Brooksley Born was right, as we saw a decade later as these very instruments were key to bringing down the entire financial apparatus.

Alternately. Banks called Savings and Loans fight their regulators, to be allowed to offer higher interest rates on deposits because in part money market funds were offering higher interest rates as the 70s became the 80s. They took these deposits and started offering as many loans as possible. They needed to make the loans to get the money to pay their depositors. This works until there’s a local downturn. The oil market goes south in the 80s, so people can’t pay their loans so the S&L’s can’t pay their depositors. So many of these small banks go bankrupt that the federal insurance institution set up to ensure depositors didn’t lose too much money went bankrupt itself and had to be bailed out. This cost the federal government billions of dollars.

One more. Again, in the Clinton era. Citibank announces that it will buy Travelers group, which sells insurance and other financial products. The problem is that this merger is against the law. The Glass–Steagall Act was put in place after the last time the financial crisis brought all of society down. It explicitly kept separation between banks and investment banks so that banks would not speculate with depositor money. The idea was to keep banking boring and stuck at the 3-6-3 rule, where you borrow at 3%, lend at 6% and are out of the office by three o’clock. What was the reaction to this transaction? Did they disallow it, throw its architects in the stockade? Of course not. A compliant congress passed the Gramm-Leach-Bliley Act to make this combination legal after the fact. Then of course a decade later the economic system crashed again.

IV.

The story of regulation for the last century or so seems to be this cycle, where there is a crash and then rules and regulations are put into place, and then capital fights and evades the rules, setting up the next crash. They capture regulatory agencies and the hodgepodge of these agencies have trouble coordinating – banks and financial institutions are regulated by the Federal Reserve, the FTC, The Department of Justice, the SEC, The Department of Treasury, the old OTS, the OCC among others. Having this sort of spread of agencies means that there is the possibility of searching for the lightest touch, a form or regulatory arbitrage in setting your charter so the least active regulator is your regulator. This is also seen at the state level where so many banks are incorporated in Delaware or South Dakota because they have low taxes and low levels of expected consumer protection.   

What this leads to is what I was talking with about statue of the horse in that the regulator, if it is even interested in doing its job and not fully captured, is always working from behind. The political power of these big financial institutions cements themselves so that they become essential. To big to fail is not just a thing that happened, but the outcome of years of decisions concentrating that political and financial power.  The next crisis is already brewing, but even if someone is sounding the alarm right now, the regulators will be asleep at the wheel. Because the problem is the cycle of crash then regulate then remove the regulations has been accelerated under the Trump Administration so we might just be hard up against the next crash. What will cause it? 

Against Scale in Banking: The Problem with the WalMart Effect

One of the problems with the financial system leading up to the crisis was not just the interconnectedness of the system, but also the scale of the system. The lead to an inversion of the saying that if you owe a thousand dollars to the bank, you have a problem – but if you owe a million dollars to the bank, the bank has a problem. This turned to the banks owing each other billions of dollars, and being not just dominoes, but huge dominoes that needed to be propped up. One proposal to fix this was to broaden who could open banks, with companies like Walmart trying to open branches, but the problem would be a different one of scale, but on the customer-facing side. You get economies of scale, but at a cost.

If Walmart opened a bank, it would be like the effect Walmart had on other small-town service providers. They would be able to use their scale to be able to undercut existing community banks. They could offer lower rates on loans and higher rates on savings, with the offer of branches in multiple places. Overall, this would be good for individual consumers in that they would save a marginal amount of money or be able to make a little bit more. That’s in theory. I’m not sure how much more already existing mega-banks use their scale to act as a financial supermarket. I am a Chase customer because I was a WaMu customer and everything got passed to Chase a decade ago and switching costs are just a high enough hurdle I haven’t bothered switching to a Credit Union like I know I should.

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I have checking, savings, and a credit card with Chase, and the rates really aren’t competitive. Even after the Fed has been raising rates for a while, the rate on the savings account is essentially at a zero rate, while for some reason the rate I would have to pay on borrowed money has increased in lockstep automatically with every rate raise. It will take a minute to follow the Fed down though. I also have a credit card and savings account with Discover. The benefit of Discover is that they don’t maintain branches, so there is less overhear. And I see that in their offerings, so though the savings account pays less than treasuries, it is close, and the ease of transactions justifies that spread. 

The problem with a Walmart bank would be if the competition with community banks led to the closure of community banks, because what Community banks do in a way that Walmart would have no incentive to do is invest in the community. Where I live, the First National Bank of Brookfield is helping the Library’s new capital project with a three-million-dollar unsecured loan with a good rate. None of the larger national banks would do this, but the Library Director and Board have a good relationship with the President of the bank, and they made a deal. What Walmart has been shown to do is destroy capacity in the towns that they open in, closing smaller shops and making them the only option for whatever service they offer. This is not to love too much on mom and pop stores. They often can be worse employers than Walmart since as small shops they aren’t subject to the same sort of labor laws that Walmart is subject to. However, most people would rather live in a vibrant community with many providers of goods and services than live in a town with a Walmart just outside of city limits with a Main Street fully of empty shops and boarded up windows.   

Only One Domino Needed to Fall: The Interconnectedness of the Financial System

One of the fun things about the financial crisis was getting to see how interconnected everything was. Bear Stearns had to be saved because it had so many counterparties, though it was a smaller investment bank. Lehman should have been saved under the same sort of criteria, but the Fed didn’t step in and let it go bankrupt. What that meant was that even though the collapse had been going in slow motion from the summer of 2007, with Bear going under in the spring, unless you were really paying attention the financial crisis didn’t really start until mid-September.

The interconnectedness is because debt doesn’t exist in a vacuum. You borrow money, yes, but you borrow it from someone. That means that the debt you owe is sitting on someone else’s books as an asset of theirs. As long as you are making payments on that debt, the people you owe money to are receiving a revenue stream and it is working as anticipated. The problem starts when the debtor cannot make those payments anymore. Not only is the borrowing institution in trouble, as well as their capital holders and depositors, but so is anyone that has lent money to that institution. Bad debt can be passed on so that the lender who stops receiving their payments on the assets they hold, in turn can be seen as risky in whatever debt they hold. The more linkages like this, the worry stops being about the individual institutions but the system as a whole.

This is why back in there was a vocal and passionate minority of people who just wanted to see everything crash, echoing Mellon’s supposed words to “liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. Purge the rottenness out of the system.” The problem is that everything would have failed, creating real human costs – and no politician facing reelection anytime soon wants to see real human costs for people in their districts. As amazing at it seems, this meant that the response was to reward institutions and the people who ran those institutions that had gambled with the stability of the system by recapitalizing those very institutions. In one of the most egregious instances, we can look at the insurance company, AIG. One small arm of AIG, their financial products division run by Joseph Cassano sold credit default swaps to everyone. All the people who bought these as insurance products against default, went on with their business thinking they were protected. Alas, Cassano and company were not holding enough capital to pay off these instruments. They were taking the revenue stream people were paying and letting it go to the bottom line, but not holding a buffer. Like so much in the run up to the crisis, it didn’t matter if you were lying to your counterparties or our auditors or your regulators, as long as you were making money. But then asset prices start to fall, and these linkages start to really matter. Institutions that thought they were insured were not insured, and AIG finds themselves being insolvent because of this one division. What’s the regulatory response? Do you shut down AIG, send Cassano to jail for fraud? No! You bail out the company, essentially nationalize it, and then you don’t bat an eye when they pay out six figure performance bonuses six months later. Of course, it was a bad choice, but at the time it was a version of the least bad choice. Then you step back and then make regulation to try to make sure that the next time will be different.

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.