Finance: Cleaning Up After the 'Perfect Storm'Eric K. Clemons
This is the first of two parts.
In an interview more than two decades ago, the chairman of the New York Stock Exchange, Richard Phalen, noted that the financial community "makes money in the dark." It is the job of regulators and investors, said Phalen, to "drag us back into the light." At roughly the same time, Saul Hansell wrote an illuminating story on derivatives traders for Institutional Investor. The gist of the story: "You tell me how you pay them, and I'll tell you what they really do when you are not looking."
I've never forgotten either of these, the "profitability of darkness" and the "law of the wallet," as forces in the evolution of the financial services industry. Indeed, these two conditions—the decrease in transparency and lack of oversight in the financial industry, and the law of the wallet gone wild—do much to explain our current financial crisis.
But there are other conditions—changes in the structure of the financial services industry and in our attitude toward financial services more generally—that also contributed to the "perfect storm" now battering Wall Street and Main Street. These four are the most crucial:
1. Transparency came to be seen as an evil, not a good. Yes, Sarbanes-Oxley no doubt created enough administrative burdens to reduce the attractiveness of serving on the board of public companies or of launching IPOs in the U.S. But it also contributed to the evolution of an entire industry based on the premise that you could get wealthy fast by investing in companies that were not obligated to observe the legal niceties of reporting to investors. Complete and accurate financial disclosure is the investor's last line of defense.
2. Regulation was replaced with ideology, on both sides of the party divide. This was especially true in the case of the belief that home ownership was not only desirable, but almost a right, to be encouraged through regulatory policy. This was followed closely by the belief that markets automatically police themselves. Former Federal Reserve Chairman Alan Greenspan's partial mea culpa of October 2008, now seems absurd; how could he—how could anyone—have thought that the market would correct immediately for abuses that were not visible? At the same time that the American economy became increasingly dependent on nonbank lenders and the "shadow banking system," regulation of nonbank financial institutions lessened or in some instances almost ceased to exist. Derivative instruments, such as securitized mortgages and securitized credit-card debt, greatly increase the efficiency of our capital markets. But when innovation and a significant portion of the markets' activities are not regulated, we now know this can create systemic risks that are unacceptable.
3. Financial and nonfinancial institutions grew more dependent on one another. In our newly interconnected financial services industry, the connections among banks, shadow banks, and nonbanks are difficult to observe and poorly understood, but when part of the structure begins to fail, for any reason, the ripples turn into cascades of collapse.
4. The financial freeze-up reinforced itself. As lenders deal with their own capital problems, they tighten credit to legitimate institutions downstream, reducing their ability to lend in turn. Much of this has been automatic, like the power grid failing when one station overloads and the others around automatically react inappropriately: A bank stops lending because it has to mark its portfolio to a market that has collapsed, which causes another bank to reduce credit-card limits, which automatically reclassifies the credit rating of some customers, which increases their interest payments and reduces their purchases, which causes yet another retailer to fail, which then has its own ripple effects.
No, this did not affect everybody on Wall Street. Not all financial services firms went for the too-easy money, and not all forgot their mission. Not all hedge funds were overleveraged. Not all private equity firms were asset strippers, and not all abused their ability to recapitalize their now privately-held companies to enrich themselves rather than rebuild; many were turnaround specialists for distressed businesses or served as incubators for innovative startups. Not all Wall Street employees received seven-digit salaries and eight-digit bonuses, and some that did actually earned them.
The damage from the financial industry's excesses has been staggering—and we are all partly to blame.
Creating Nothing of Value
Of course none of this would have happened without a change in social norms. We have become "quick hit junkies," actually believing in the idea that money can be earned in investment banking without creating something of value first. While merely symptomatic, the changing role of Wall Street and Wall Street compensation is significant. We have moved from contingent performance bonuses to automatic bonuses, and now to mandatory retention bonuses, even for personnel whom firms do not wish to retain.
Once, top earners at an arbitrage desk or a bond trading desk, traders who had made enormous profits for the house, whether or not they created any value for the economy, earned performance bonuses. How did we go from discretionary performance bonuses to mandatory bonuses for precisely those individuals who destroyed the house (at least in the case of AIG) and required the federal government to provide hundreds of billions in bailout funds to keep the house from taking down the array of companies networked to them?
Big financial firms forgot their mission. Investment banks and insurance companies became hedge funds. Regulators allowed key institutions to take on risks and leverage unprecedented in recent times. The compensation for house traders is unprecedented, as it no longer is connected in any way with the principal role of finance.
In Memory of Morgan
It's worth noting the experience of a financial titan of another era, John Pierpont Morgan, who helped further the industrialization of the U.S. by facilitating the financing and consolidation of many industries. He amassed personal wealth, of course, but not nearly that of the entrepreneurs he empowered; indeed, John D. Rockefeller noted at the end of Morgan's life that Morgan was not a wealthy man. Today the Street and its euphemistically mislabeled "producers" amass fortunes even while squeezing out investors, bankrupting their houses, and derailing the economy.
Is it any wonder that most of the students in the graduate business courses I teach disdain the lower compensation and slower career paths of companies that make actual products or provide actual services? In the years immediately before the current financial disruption, they would grudgingly have accepted positions in traditional investment banks if they were not offered private equity or hedge fund positions. Yes, if necessary, they would even more grudgingly have accepted offers from the top consulting firms. Some of them might have even signed on with traditional industrial companies. But their dream jobs have long been in hedge funds and private equity.
Remember, this is an industry where in order to make The New York Times' list of top earners, you needed annual compensation of $100 million or more, and where those in the big time had annual compensation of $1 billion. This is compensation for people who may never actually have facilitated the production of anything.
Perhaps the greatest underlying problem is that we as a society have accepted this nonsense. Wall Street traders got rich on what we now know were illusory paper profits and illusory increases in market value. Society got a little richer on these same paper profits, and none of us looked too hard at their source. We came to accept the idea of successful Wall Street traders as "producers" for the house. Almost by definition, they are of course not producers, but speculators.
The best of them, the rocket scientists, are simply gamblers with a reliable system, one that lets them beat the rest of us and take money out of the markets without facilitating investment. The worst, of course, are cheats like Bernard Madoff, who, likewise, take money out of the markets—not as speculators, but as thieves.
Next: Fixing what's broken in the financial system.