“Speaking For Myself . . .”
In an earlier post, I expressed my feeling that the story of wealth inequality playing out across America was merely the tip of the iceberg. It is, in fact, little more than a soundbite. In various and subtle ways, the structural weaknesses and injustices (negative externalities) generated by free financial markets impose costs many of which remain off balance sheets but are, nonetheless, imposed on all either through market prices or through taxes. Simply leveling the playing field through measures like the financial transaction tax and Tobin tax, which I think are vital, does nothing to address other underlying problems which unregulated finance has inflicted upon us all. Today’s absentee landlords are known as shareholders, and include a huge proportion of working Americans, who know very little of where their money is being invested and nothing at all about who is managing their money or how they are managing it.
Fortunately for me, we have yet another example of Wall Street mismanagement: 150,000 is the number of investors, some of whom will have to wait for years before they see their money, directly affected by the MF Global collapse. I know these people, or people very much like them, and in the larger sense, almost all of us are these people. If you have a 401k or an IRA. If you have or are thinking of investing in financial markets, you are one of these people. You are those who largely accept the tenets of capitalism (I do, but with caveats): that if you work hard enough, you get a little lucky, and you get to reap the rewards of your efforts. If you are one of those who believes in the integrity and good faith of those you entrust to handle your money, do your accounting, and those who run the firms you invest in, you are one of those people. I believe markets are the most efficient means to determine value/price, though not always-witness the housing bubble. There is a very good case for wondering if this has been warped as well – take a good, cold hard look at securities markets today and ask yourself the degree to which greater fool theory determines value, because really, who is a value investor anymore? What else does technical analysis actually describe? Underlying value? Please. We treat the hard-work-yields-success paradigm as if it were a cause-and-effect dynamic, but the truth is, more than a little luck is needed. And to those who wish to throw the maxim that people make their own luck (through diligence and intelligence) at me, I’d have to say that luck plays a far greater part than you might think. One can fail through lack of effort at a crucial point or the flaw intellect has failed to detect, but neither hard work nor smarts will guarantee success either, because strength has limit, knowledge is not perfect and the state of the marketplace itself is dynamic. The markets at all levels, like life, really are a gamble.
We assume that the managers act with integrity (but we don’t know), and that the regulators are on the case making sure that forms are followed (which is hardly ever true).
So I admire the small business entrepreneurs, whether they make it or not. They makes the attempt knowing that they don’t know everything they need to know, and hope that flexibility, determination and thought will suffice to make up the shortfall; and they hope that the vagaries of pure chance and hazard pass them by.
About a year ago, a customer came up to me with a few books on how to start your own business. Her teen-aged daughter stood next to her. Dressed as a professional, she looked bright enough, and I took a deep breath then asked her if she was thinking of starting her own business. She said she was. I glanced over at her daughter, then looked her straight in the eye and told her that if she decided to go ahead with this, she should have the backing of her family beforehand, because she wasn’t going to be available for them for several years, and that was the case if all went well. She smiled and thanked me.
I saw her again a few weeks ago. I didn’t recognize her, but she knew me. She told me I was right. She said that her business was doing great and she had even been offered a publishing deal in the event she wanted to write a book. (If not a secondary profit generator, it is at least fabulous marketing opportunity.) She told me that she thought that she could control the business, rather than the reverse, but that plainly, business demands had trumped all other concerns.
Running a business is more absorbing, more demanding, than having a family. I know. I’ve been through the startup adventure five times.
For the record, about 66% of all startups fail within 36 months. Yet another reason to admire their grit, and the truth is that their hard work is rewarded with failure rather than success by a whopping margin.
Can You Tell Me Of One Corporate Merger Which Ever Worked Out Really Well?
As for investors, capitalists who “make their money work for them,” it’s largely the same – luck plays a far greater role than we publicly admit. Trusting your money to financial services companies, especially operating in loosely or completely unregulated markets, is much more of a gamble than is generally realized. While you may look around and see others who have cashed in (during the housing boom, especially in California we are told, this became cocktail party chat – how well somebody there had done in real estate.) and you think, “why not me?” If you are especially sensitive (and savvy), you might sense that the forces of the free market at that particular moment were favorable enough you had a good chance for success, but you’re also aware that you must watch very carefully for these ill-defined and incompletely comprehended market forces to change course very quickly.
But at the outset, you don’t really know. So while gazing at the specter of “success” you really have to pull yourself back down to earth and examine the risk. Or risks. Some of these are what sunk MF Global.
So what are we talking about when we say “risk?” Well, Erik Banks, Morton Glantz and Paul Siegel define five types of risk1 all of which MF Global investors agreed to undertake, whether they knew it or not:
- Credit risk – an event that causes the debtor to slow, interrupt or stop paying on the note. Certainly for investors, this was known and accepted.
- Market risk – losses sometimes occur due to nothing but changes in the market. Some derivatives are more exposed to market driven forces than others. If your instrument depends on credit spreads, interest rates, foreign exchange rates or the yield curve, you’ve accepted risks that are truely unknowable in advance, and absolutely beyond your control. You better be looking for one hell of an ROI up front. Especially these days.
- Liquidity risk – little else matters if your investment is in an instrument nobody will ever buy and you can’t convert your gains or pare your loses. Essentially, this is exactly what happened when Goldman Sachs pulled the plug on the housing bubble and the entire market for CDO’s collapsed. Even those composed of fairly reliable corporate bonds became illiquid after this macro economic event, and investors like the City of Narvik who held these were stuck with their them, relying on much smaller, slower revenue flows and quickly had to cut municipal services as a result.
- Legal risk – this arises from lack of following the legal and regulatory up to and including a Bernie Madoff (or Bankers Trust) type fraud. The foreclosure scandals we see unfolding on about a weekly basis these days are largely failures of this type – a failure to maintain an adequate paper trail, which lenders like BoA and their stable of loan servicers seem to be making up for through fraud. MF Global may also be guilty of some regulatory breaches, such as using client’s funds for proprietary bets, though the verdict isn’t in on this at present.
- Operational risk – Lost paperwork, a break down in interior reporting, management and control systems, etc. In the foreclosure mess, this is a huge source of risk, loss and injustice. The example of MF Global applies here (in the best case scenario), in being unable to account for millions of dollars – it seemingly lost track of investors’ money, and those investors may never see that money ever again. Or at least any more than two thirds of it.
Such problems, especially operational problems which I will focus on here, are far more widespread than you might realize, but if you’ve ever been the victim of a lost payment, had trouble getting confirmation that your ESOP shares are recorded (a three year fight my mother had to wage after my father passed), or received corporate statements and ballots even though you never bought into the ESOP (having never bought into an ESOP plan at one employer, I got both of them for years – even after I’d changed jobs) or continued receiving these even after disposing of your block of shares (again, my mother kept receiving these for four years after cashing out), you’ve discovered an operational flaw, and they are hardly ever isolated instances.
MF Global, which seemed to misplace some $600 million of its customers’ money (since reported to be resting over at JPMorgan/Chase) may be a victim of an operational risk they unwittingly undertook. That the managers couldn’t readily account for this money during a due diligence indicates (best case scenario, remember) insufficient in house systems set up to keep track of in house funds. At the very least.
Such problems are endemic throughout our economy. By themselves, most of them are fairly minor, but taken together the picture alters dramatcally. The foreclosure mess we’re witnessing today, we are witnessing today illustrates an enormous systemic fault throughout our banking system for example. The ESOP instances I mention above are all indicators of other such serious weaknesses in the retirement savings systems managed (or mis-managed) by some major Wall Street broker/traders. Apart from market swings, how safe are your retirement savings if your investment broker can’t readily find your records?
Mega finance is only as strong as its weakest control mechanism.
Don’t Mess With the Law of Diminishing Returns. Ever.
Size matters. Simon Johnson once cited research that found after banks grow to about $30 billion, they’ve maxed out the possible efficiencies available to the business model. I cannot vouch for the figure, but I believe the premise that anything more than this, and the work needed to maintain the systems to keep the business running begins to outweigh the profitability of any new business brought in (not only through sales, but through M/A activity as well, don’t forget). The reason I have no trouble believing this is because I’ve seen this dynamic in action myself several times. Two of the membrane switch businesses I help build seemed to max out profitability at around $6 million in gross annual sales. More business than that and quite quickly, the processes which took you to that point become unwieldy. More work, staffing, resources and investment are needed to maintain these systems, and fulfilling orders started to become more and more difficult. Another membrane switch company I was part of eventually went under largely because of this and this was a highly successful, well respected industry leader. The largest order ever placed for custom membrane switches came to us, and we weren’t even looking for it. We were that good, and known for being so, that they were willing to accept just about any reasonable proposal fitting their parameters. The company, predictably, went through another, huge, round of growth and though people there were diligent, experienced and driven, the inefficiencies overcame the business model. In two years, the company was in serious trouble, and it ceased operations entirely about two years after that.
Thank you Professor Johnson. At least I know that my observations are now supported by independent findings.
The point of all this being, the larger and more successful the company you’re looking to invest or do business with, the possibility of operational risk events becomes more and more certain. BoA’s CEO Brian Moynihan cannot possibly control the events at every branch and facility, nor can he possibly absorb the data needed to even grasp what’s really going on in them. Much less the integrity and practices of out-sourced loan servicers.
The implications of operational inefficiencies arising through size are several:
For one, the small government advocates of the right have a valid point. For instance, it is estimated that as much as $60 billion annually is lost through Medicare fraud. A huge problem. My counter argument is that the private sector is no better, and in an unregulated environment, is certainly going to be a good deal worse (one company alone just lost track of $600 million and by any measure, that ain’t chump change), for government can be held accountable while the private sector hardly ever is.
The extra costs all of us are paying to maintain enormous entities like TBTF banks and highly diverse mega-corporation like GE is unknown, but I would suspect something in the range of hundreds of billions of dollars, just within the industry itself, which does not count the public sector costs. Taken together, 7-8% of GDP might be a conservative estimate of the cost of private sector inefficienies. (I wish there was reliable data on this, and if anyone knows of a study or report from academia, Treasury, the CBO, or the GAO, feel free to point me in the right direction.)
All of which is why my #Occupy demand is to break up the big banks. A return to Glass-Steagall may not be enough, for I’d like to see a cleaner break. Commercial (FDIC insured) banking, investment banking, insurance and the various in-house hedge funds and broker/traders must be separated. This should be a national economic priority, as certainly we as taxpayers have every right to limit the risks (both in size and in kind) we agree to undertake in insuring commercial bank depositors, as we’re the ones footing the bill. Furthermore, restrictions on the size of these institutions, much like what was proposed by Brown-Kaufman Amendment (no banking institution of any kind be allowed to grow larger than x% of US GDP) must be brought back to the table and passed. Investment banks should be required to report every transaction booked in unregulated havens like the Cayman Islands, where ICE is supposedly located, and booking laws should be passed (if a transaction is executed in New York, then it is booked in New York and not in an unregulated tax haven like the Cayman Islands).
It makes policy sense. It makes political sense. As stakeholders in our own banking system, we have every right to make some demands for our own protection, because, again, as “owners” of the entity insuring American deposit accounts, we should absolutely demand it. And it should make business sense as well.
Informed consent, or no consent at all.
Post script: One other kind of risk goes unmentioned by the three authors of the Credit derivatives book I cited above, is a risk that doesn’t show up on the balance sheet. It was really reputational risk that sunk MF Global in the end. It finally lost the trust of the marketplace. All of Wall Street is on trial and this is so richly deserved.
1Banks, Erik; Glantz, Morton; Siegel, Paul, Credit Derivatives, McGraw-Hill, New York, 2007.