Over the coming weeks, I’ll unpack what I’ll call my “Top 5 Things An Investor Should Know”. Hope you find it insightful and interesting…
This week starts with #1:
Unregulated capitalism is a bad thing.
Don’t get me wrong, I’m a capitalist. I believe in profit taking. I also lean much more to the free market economy side than to Keynesian economics (see this for more on free markets vs. Keynesianism). But, unregulated and unchecked capitalism has resulted in the “Wall Street Gone Wild” situation that we’ve experienced over the past decade - from dot com bubbles, to exorbitant profits, to a global meltdown, to exorbitant profits at the expense of the taxpayer (bailouts), to exorbitant profits, to exorbitant profits, to exorbitant profits.
While I don’t want to get too much into politics, it’s important to understand how politics and regulation affect the markets…I’ll try to keep this simple.
Let’s begin in the 90s when the Clinton administration thought it would be a nice idea that more people in America owned homes. I believe the exact words were: "Every American deserves to live the American dream". Well, most everyone that could afford to own homes already did in the booming economy. But what about those that couldn’t own homes (because they couldn’t afford them)? Well, the administration put pressure on the financial institutions and Fannie Mae and Freddy Mac to relax lending standards to those that didn’t and couldn’t own homes. Enter subprime mortgages and ARMs (Adjustable Rate Mortgages) - instruments considered “creative financing”. People (that normally would be turned down for a home loan) could now get loans and realize their American dream of home ownership. Hurray for the American dream, right? It sounded good…
Fast forward to 1999. An important piece of legislation known as the “Glass Steagall Act” was repealed. For understanding, Glass Steagall was put in place after the events of the Great Depression occurred. It in essence built a wall between any crisis Wall Street might have and “Main Street” not allowing a spillover effect – and was in effect for 65 years. Add in the “Commodities Futures Modernization Act of 2000” that kept financial derivatives from regulatory oversight and required no money down of the issuer in reserves to back up the derivatives, and we had massive deregulation and now the seeds for economic destruction. Financial institutions (Goldman Sachs, Lehman Brothers, Bear Stearns, e.g.) and insurance companies (AIG anyone?) got bigger and bigger.
At the same time, these financial institutions were piling more and more into creative financing and financial engineering. For example, consider mortgage backed securities (MBS): taking mortgages, bundling them together, and selling them in packages or slices. The problem, as we’ve discovered, was that many of those MBS packages had subprime mortgages in them…some even comprised of most all subprime mortgages!
Now what happened in 2007? You have people with a home loan that couldn’t normally afford it, a recessing economy, and a dash of job loss. That resulted in loan defaults. People couldn’t afford to make their home payments anymore. What happened to those mortgage backed securities that were grounded in the assumption that people would make their home payments? All the big institutions issuing those seemingly good investments (which were actually junk) and getting them rated as good (I’ll have more to say about ratings agencies in another post) began having cash problems because they couldn’t cover the defaults (because they weren’t required to have money in reserve).
Wall Street took risky bets, peddled junk, and got caught. Now, a true hardcore free market and capitalistic approach would have been to let the companies fail and send a clear message to any institution wanting to gamble with other people’s money. Economist Allan Meltzer puts it like this:
“Capitalism without failure is like religion without sin – it just doesn’t work.”
And how about a proverb:
“He who oppresses the poor to increase his wealth and he who gives gifts to the rich – both come to poverty” (Proverbs 22:16).
Apparently this isn’t the case in America any more. Instead, these institutions were labeled “too big to fail” and received a bailout - billed to the American taxpayer (thank you George W.). After all, the Washington elites had buddies on Wall Street that needed to maintain their quality of life, right? It might strike some as strange that such reforms benefitting these companies also happened with former Goldman Sachs elites at the helm of some key administrative positions (e.g., Robert Rubin, Secretary of the Treasury under Clinton and 26 year veteran of GS; Henry Paulson, Secretary of the Treasury under George W. and former CEO of GS). You might also find the article in this link interesting, if not upsetting at the least. Evidence of more crony capitalism? But I digress…
So in hindsight was making the American dream available to all worth it? Was deregulation worth it? It’s a nice political tactic, but in hindsight it cost us a lot. There is a reason that some people get turned down for mortgages – they can’t afford them. No matter how creative institutions got in their financing, the bottom line is that those mortgages should never have been handed out because the recipients couldn’t afford it. Financial institutions knew this, but the government prodded them along. They acquiesced like good boys and girls, then saw the deregulation gap open up and took the car for a joy ride while their proverbial government parents were asleep.
Consider this: the Dow Jones Industrial Average (commonly referred to as “the Dow”) first crossed the 10,000 level in 1999 and it finally crossed back over 10,000 this last month (as of this writing, the Dow is around 10,750). After including dividend income on stocks, the Dow has returned approximately 15% since 2000 – that’s about 1.5% per year. Investors could've done better holding bank certificates of deposit. Five-year Certificate of Deposits (CDs) were yielding 7% in 2000 and 4% in 2005 -- which would've returned 5.5% per year over the same period (and a total return of 71%). CDs are certainly not giving off those returns anymore. But most of us “sheep” owned investments in the stock market and between 2000 and 2010 Wall Street lost 20% of our retirement playing the stock market.
The real winners here in all of this? Wall Street. Over that same period, Wall Street pocketed hundreds of billions for themselves. Wall Street bonuses, even during the crisis, barely slowed or retracted. For example, the U.S. Treasury Department’s “pay czar” reported in July that 17 banks gave executive $1.6 billion while receiving billions in bailout money at the same time. Keep in mind, that’s only 17 of the 419 companies that took bailout money! When the crisis hit in 2008, these institutions off-loaded trillions of debt on taxpayers and received taxpayer money. Average Wall Street bonuses for 2009 were up 17 percent when compared with 2008. For those that didn’t fail (err, were left to fail like Lehman Brothers) they emerged even stronger and more wealthy. In May 2010, Goldman Sachs reported making money on in-house trading and investments every trading day in the year’s first quarter – even though only seven of nine of their “recommended” trades for investors like you and I paid off. In the second quarter, they only had ten days of in-house trading losses. They win, we lose. See how this works? The rest of the economy is in shambles, many people are out of work, and many unfortunate folks who took the bait and signed up for a subprime mortgage also have no home now. Wall Street wins, we lose.
But before we get too worked up bashing Wall Street, here’s the deal. Even though it peeves many on “Main Street” (me included), we have to understand that Wall Street played within the boundaries of what they were allowed to do. At first blush, it seems as though they are acting unethically (I wouldn’t disagree), but with an increasingly deregulated market, more opportunities are available and capitalism says that there will be profit takers. In the face of deregulation and relaxed lending standards (thank you Clinton and Bush administrations) within a capitalistic system, Wall Street moved in and did what it does best: take profits.
Thus the old adage is true and can be applied to deregulation: “give them an inch and they’ll take a mile.” This is why regulation is so important in a capitalistic system. Without some regulation and boundaries in place to keep the playing field relatively level, the hedonists in the market are further unleashed and eat everything in sight.
It's interesting to me reading your post that you identify government intervention/interference as a primary culprit in screwing the economy, and yet advocate more regulation as the remedy. Perhaps the problem lies in the fact that these people are profiting on those that produce something, rather than actually producing themselves. There is a system set up which rewards people that have capital to invest without considering from where the capital has come. Regulating people who produce nothing misses the point of a capitalist economy. Those who take advantage of the spontaneous market created by one who sees a need and fills itare not necessarily a part of the market themselves. Regulating this side market of real wealth may be necessary, but it gives me pause to think of any sort of interference with a genuine capitalist system
ReplyDeleteInteresting comments…spoken like a true free market advocate! For one; however, be careful in assuming that my position of “having” regulation is the same as being an advocate for “more” regulation. In my opinion, we had a decent amount of regulation leading up to the repeal of Glass Steagall and the enactment of CFMA - regulation that should have been left alone and kept in place. Was it perfect, of course not (it’s government legislation after all!). The government’s intervention and trying their hand at deregulation is what caused so many problems, however. The point is that capitalism requires the opportunity to play on a level playing field. The deregulation of the last decade has tilted the field away from the general public’s direction – the whole point of the post. Was it level before the deregulation of the past decade? Again, of course not – but it was better than what we had in the past decade. The thing that you and I should be concerned about, and I hope I made it painfully obvious in the post, is that the government is handling the regulations. You’re spot on in observing the paradox of government being a deregulator and a regulator…an uncomfortable observation for everyone reading hopefully. The accountability and ethical dealings in Washington then come into play – a "whole ‘nother can of worms."
ReplyDeleteAlso, your mentioning that “regulating those who produce nothing (I’m assuming you mean Wall Street) misses the point of a capitalist economy” is an interesting comment. I will retort; however, and ask the question: “so then those who produce nothing, yet ‘take advantage of the spontaneous market created’ and who make bad decisions and risky bets that don't pan out deserve a bailout and taxpayer money to stay afloat? Just because they “produce nothing” means they should be exempt from being responsible in their dealings or from being regulated?" I think that’s a far stretch. As your comments allude, capitalism is a system of reward and failure. Where’s the failure allotted to those institutions? I find the system to be unfair in that regard. There very well is “a system set up which rewards people that have capital to invest without considering from where the capital has come” and I’m all for it. But the risk inherent in investing is that you can lose none, some, or all of your investment…and you have to accept that fact, and that’s what is fair in a capitalistic system. However, the “big boys” in our current financial system have been allowed to no longer play by those rules. The playing field is not level, my friend…thus there has to be some semblance of regulation and boundaries in which financial institutions play. Without a level playing field, there is no longer capitalism – only the road to imperialism.
I don't mean to be so harsh in my comments about wall street. It is a maker that has sprung from the fact that people that produce will, no doubt, have those that take adventage of their production. This is to be expected if not qnticiatwf
ReplyDeleteby those that qctvely watch the market, whether spontaneous or not. I should also consider the forum on which I state my business. All this notwithstanding, it is my hope that the ideas expressed ring true. It is the capitalist economy, unhinsered by governmet interference which allows for the creation of wealth. Proffiting by it or from it is a secondary result. Again taking into account the nature of the forum, where people see an opportunity to bettr/futher themselves they will no doubt take i; and perhaps in this regulation, as you very eloquently put it, is no doubt neccessary. What gives me pause, makes me cringe, is the idea of "I know better", and I'll tell you so through regulation/intervention. This administration has made it painfully obvious where this line of honking takes us. So while regulation makes sense from the investor point of view, within that particular market, I always must take a moment, give pause and reflect, whenever more government interference is called for.
Brian
do apologize for any grammatical errors, it's difficult to post from an iPhone. But please know that I own up to any fault in logic.
ReplyDelete