Certainly, markets that efficiently allocate capital are an important element of modern capitalism. But as Kevin Phillips notes in his book Bad Money, when finance overtakes manufacturing and trade as the dominant sector of a nation’s economy that is generally a leading indicator of economic decline. And in our country in the last decade the financial industry has become essentially a casino. In 2004, major investment banks were allowed to leverage up to 30x or even 40x (which means that a decline in asset values of 3 or 4% can wipe out a firm’s entire capital). And with the repeal in 1999 of the Depression-era Glass-Steagall separation of commercial banking (which enjoys federal deposit guarantees but is also subject to heavy regulation) and investment banking (where bankers are much more free to gamble with their money), gambling on the casino side can bring down the whole business or even the entire industry, requiring a taxpayer rescue.
Hedge funds are almost entirely unregulated. (Indeed, that is pretty much what distinguishes a “hedge fund” – its relative lack of regulation and transparency. It really has nothing to do with “hedging” per se. The term “hedge fund” really just defines a compensation structure not an asset class.) Their number has gone from around 600 in 1990 to almost 10,000 at their peak in recent years. Much of the selling pressure on markets now is hedge funds unwinding their bets. In theory, all this gambling increases the liquidity of markets and reduces inefficiencies and instability. In practice, it has increased instability and drained hundreds of billions of dollars out of the economy with no net gain for society as a whole. The financial industry has become, in effect, a massive tax on the overall economy. And that was even before it all imploded and required trillions of dollars of taxpayer money to prevent it from bringing down the “real” economy.
The incentive structure creates a strong bias for investment banks and fund managers to take inordinate risks. For example, Richard Fuld, the former CEO of Lehman Brothers, received $480 million between 2000 and 2008 for behavior that resulted in the demise of the 158 year old firm. Lehman Brothers goes under and helps spark a global financial crisis, but Fuld keeps his $480 million. Even in retrospect, from his own personal standpoint, Fuld engaged in perfectly rational risk-management behavior. (Last week, the Wall Street Journal had an interesting piece on the pay discrepancies between Japanese securities firms and the American firms they are taking over. For example, Nomura took over the Asian and European operations of Lehman. For the year ended March 31, the top 13 Nomura executives took home a total of $13 million. Quite a contrast with Fuld’s pay.)
Market stability is a public good and therefore the public has a strong interest in its maintenance. The collective behavior of individual market participants will not produce the optimal (or even minimum necessary) level of market stability. That is why regulation is required. It is heartening to see that Obama’s incoming Treasury Secretary understands this:
“[The] ‘public good’ dimension of financial stability means that while the whole economy benefits from a more stable financial system, each individual institution would prefer that others incur the costs associated with its provision. As a result, firms may collectively underinsure against the risk of failure.” Timothy Geithner
Sept. 15, 2006
The latest issue of Portfolio magazine has a great piece (“The End”) by Michael Lewis (author of Liars Poker, The New New Thing, Moneyball, etc.), presumably an excerpt from his new book, Panic (everything Lewis writes is great). Here is a bit of it (but go ahead and read the whole piece):
When I sat down to write my account of the experience [working for Salomon Brothers – now part of Citigroup – in the ‘80’s] in 1989—Liar’s Poker, it was called—it was in the spirit of a young man who thought he was getting out while the getting was good. I was merely scribbling down a message on my way out and stuffing it into a bottle for those who would pass through these parts in the far distant future. Unless some insider got all of this down on paper, I figured, no future human would believe that it happened. I thought I was writing a period piece about the 1980s in America. Not for a moment did I suspect that the financial 1980s would last two full decades longer or that the difference in degree between Wall Street and ordinary life would swell into a difference in kind. I expected readers of the future to be outraged that back in 1986, the C.E.O. of Salomon Brothers, John Gutfreund, was paid $3.1 million; I expected them to gape in horror when I reported that one of our traders, Howie Rubin, had moved to Merrill Lynch, where he lost $250 million; I assumed they’d be shocked to learn that a Wall Street C.E.O. had only the vaguest idea of the risks his traders were running. What I didn’t expect was that any future reader would look on my experience and say, “How quaint.”
… John Gutfreund did violence to the Wall Street social order—and got himself dubbed the King of Wall Street—when he turned Salomon Brothers from a private partnership into Wall Street’s first public corporation. He ignored the outrage of Salomon’s retired partners. (“I was disgusted by his materialism,” William Salomon, the son of the firm’s founder, who had made Gutfreund C.E.O. only after he’d promised never to sell the firm, had told me.) He lifted a giant middle finger at the moral disapproval of his fellow Wall Street C.E.O.’s. And he seized the day. He and the other partners not only made a quick killing; they transferred the ultimate financial risk from themselves to their shareholders. It didn’t, in the end, make a great deal of sense for the shareholders. (A share of Salomon Brothers purchased when I arrived on the trading floor, in 1986, at a then market price of $42, would beBy comparison, the Somali pirates are pikers.
worth 2.26 shares of Citigroup today—market value: $27. [Note: $16.50 today])
But it made fantastic sense for the investment bankers. From that moment, though, the Wall Street firm became a black box. The shareholders who financed the risks had no real understanding of what the risk takers were doing, and as the risk-taking grew ever more complex, their understanding diminished. The moment Salomon Brothers demonstrated the potential gains to be had by the investment bank as public corporation, the psychological foundations of Wall Street shifted from trust to blind faith. No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit. No partnership, for that matter, would have hired me or anyone remotely like me. …