One of the great illusions of late 20th century finance was that banks were profitable. On paper – investment, commercial and mortgage banks appeared extremely profitable. The percentage of total S&P 500 profits that was attributable to financial companies rose steadily from 1980 to 2000, and by 2007 reached 40%, depending on how you measured it. This meant that two out of every five dollars of profit generated by America’s 500 largest companies came from the financial function. This, by the way, understated things, since it left out the quasi-banks like General Electric and GMAC.
The illusion comes from the fact that this paper profit was not the result of selling products that allowed businesses and consumers to be more productive and more profitable in their own right. What was really happening was that financial firms were extracting equity that had been built up over nearly a century by businesses and consumers. The financial business had become a predatory business, scavenging the land for pockets of wealth to convert into cash that would be funneled in part to the banks as fees.
It’s not clear that even at the highest levels the bankers understood what they were doing, since businessmen in the heat of competitive battle do not have the time to muse over the broader social implications of what they do. This is a job for government policy wonks and business professors, most of whom spent their time enabling and cheerleading for the banks. Moreover, some of what the industry did helped their customers, such as automated bill paying, even though this was a smaller proportion of bank profits.
Since the large banks and financial companies in the U.S. have blown up ”“ in part because the equity available for mining and extraction has dried up ”“ we the taxpayers are being asked to save their hides. As taxpayers, we represent the last available, and largest pool of equity ”“ the good faith and credit of the United States as represented by the government’s taxing power. At this very moment, the financial oligarchs are at it again, looking for ways to convert stored-up wealth into cash for themselves. Don’t you think you should know who they are and what game is going on here?
The traditional form of equity mining is found in the mutual fund industry, which pays itself by extracting as much as three-quarters of a percent from your investment portfolio every year as their fee. If you put $100,000 into a mutual fund, after twenty years the fund managers will have removed $15,000 of your equity in fees. To justify this, the first thing mutual fund managers do is set the bar for their performance as low as possible. They don’t ask that you judge their performance on how much investment gains they produce for you each year; they judge themselves on how well they have performed in relation to the market’s performance. If the market declines 5% during the year, but they have put you in investments that only lost 4%, they trumpet themselves as a rousing success. Even if they do more poorly than the market, they still take their 0.75% out of your account.
You won’t notice the 0.75% so much if the market is rising, and it is very important for the mutual fund industry to have this happen. But should the market hit a rough patch, the industry is ready for you. There isn’t a mutual fund manager in the world who isn’t armed with a chart showing you the long term performance of the stock market, appreciating at an 8% rate per annum over time. This 100 year chart glosses over the rough patches that can last a decade or two, and woe to you if you are retired during this time and need money from your investment account. The industry trains its salesmen to believe that 8% p.a. returns are in the long run ordained by the heavens and therefore guaranteed to all investors, but because it is in the long run, the mutual fund industry emphasizes that you, the investor, need to invest for the long haul. They don’t want your money moving in and out of the account; they want it sitting passively with them year after year, earning 0.75% guaranteed for them. That’s the difference between you and the mutual fund industry. The 8% p.a. they imply is a guaranteed return on your money really isn’t, but the 0.75% p.a. fee guaranteed to the fund, really is.
The hedge fund industry is the mutual fund industry on steroids. Hedge funds get a much larger annual fee, usually 2% p.a., and they typically restrict participation only to wealthy individuals, so the fee is much more lucrative. To attract these individuals, hedge funds promise outsized market performance. In this sense, they are very different from mutual funds, in that they ask their investors to judge them on the positive returns they make year after year, even in down markets. Because they ”œguarantee” positive returns, they also take 20% off the investment profit each year, leaving 80% for the investor.
The markets that the hedge fund industry invests in are the exact same markets that the mutual fund industry invests in, so how do hedge funds guarantee a profit? For one, they don’t always buy stocks ”“ they sometimes go short the market, selling stocks in advance of a down move and making a profit as the stock declines. Mutual funds don’t do this. Second ”“ and much more important ”“ hedge funds employ leverage. They take your $100,000 and borrow $3,000,000, and then invest all of it. This is highly risky stuff when you only have $100,000 in real equity, which could be wiped out in just a 3% down move in the market. It becomes essential for the hedge funds to ensure they make a profit. Part of this is done in an honest-to-God way, by timing the market. Some hedge funds own stocks when the market is going up, and they go short as the market is going down. This is very difficult to do, so only a small minority of hedge funds are actually good at trading with their wits.
The rest need help. A lot of hedge funds are bullies; they have such huge amounts to invest, that the mere act of investing distorts market liquidity and forces prices to go in the direction they want (see George Soros on how to do this). Many hedge funds are momentum investors who jump on a bandwagon and ride the market for all its worth, distorting the market in the process. This is how oil was pushed up to $143/bbl and just as quickly collapsed ”“ hedge funds rushed in to push it up, and scrambled to exit at the same time. Then there are the hedge funds which skirt the edge of the law, or sometimes break the law, by seeking insider information on potential mergers or acquisitions. The easiest and cleanest way to do this is to align your hedge fund with the mergers and acquisitions department of a big bank. This way you can use your leverage to bet on the company being acquired, and more often than not, create the pressure necessary to force the acquired company to sell to their predator.
Established originally by Michael Milken in the 1980s as the leveraged buyout business, private equity is the practice of borrowing huge amounts of money to take over a company, liquidate its common equity so that it is entirely privately owned by the investors, and then ”œslim down and shape up” the company so that it can be brought back to the stock market in a public stock offering, at great profit to the private owners. Suppose you don’t have the money to buying something as gargantuan as a company? Easy. You borrow it from the banks, using as your collateral the very assets of the company you seek to acquire. The audacity of taking over a company you don’t own by borrowing against its assets is one of the great travesties of modern finance, but government has never seen fit to outlaw this practice.
There is a second travesty at work here. In case you are wondering why the management of a company puts up with the predatory tactics of the private equity industry, in many such buyouts the management of the company is operating secretly in cahoots with the private equity buyer. The management gets a side agreement to continue to run the company after it is taken over, and to get millions of dollars in guaranteed payouts for agreeing to do this. The losers in this game are the employees, since often 15% or more of the staff can be fired to help trim down the company for ultimate resale to the market. One other thing that is quick to go is the employee pension plan. To the extent it has any positive value, it is looted by the private equity investors. One of the earliest practitioners of private equity was Jack Welch, who was known as Neutron Jack for his practice of buying companies and leaving only the buildings standing.
Private equity reached absurd amounts of equity extraction this decade. It used to be that the private equity investors would ”œslim down” the company first and then three or five years later bring it public again by issuing common stock and getting themselves out with a huge profit. By the middle of this decade, greed couldn’t wait. In the typical deal, the private equity investors would buy a company with its own assets as collateral, then borrow billions of dollars more from banks which were promised part of the equity in the deal, and therefore part of the future, enormous profits. With this borrowed money, the investors would immediately declare a dividend for themselves. One such investor took out $500 million dollars in a dividend for himself. If you remember seeing lists a few years ago of the men in the hedge fund and private equity business who made billions for themselves, this is how it was done ”“ equity mining. No hard work; no actual profit; just gaming the system, loading up the victim with debt, and taking money out as their personal profit.
Home Equity Lines of Credit
If this private equity mining sounds familiar, it should. The exact same process went on in the home mortgage business. Our buccaneers of finance found equity to extract not just in corporate America, but among consumers and the wealth they had built up in their homes through many patient decades of paying off their mortgages. In the 1990s, banks created the tool to mine this equity ”“ the home equity line of credit, which effectively turned homes into commodities and cash machines. When the Federal Reserve lowered interest rates on these lines of credit to 1% in 2001, the doors were now wide open for the great looting of the American dream. Consumers were already in a mood to borrow against their homes, because their wages had been stagnant for nearly 20 years, especially if they worked in an industry that was subject to the rapacious destruction of the private equity investors. A great marketing campaign began to convince consumers to lower their monthly payments, and in this campaign, the word debt was rarely mentioned. Consumers were given the impression they somehow had cash locked up in their house that could now be liberated; they were rarely told the truth ”“ that this was equity being exchanged for debt. The banking and mortgage industry, in the meantime, extracted trillions of dollars in points and fees – the amounts are so staggering that you can see in the national housing statistics how home equity has collapsed while mortgage debt has soared.
The Pom-Pom Squad
You can’t go about raping and looting the wealth of this country without important help in keeping the public oblivious. This is the role of the propaganda arms of the financial industry ”“ the Wall Street Journal, the business pages of the newspapers, the television cheerleaders on CNBC, the professors at business schools, and the think tanks that glorify buccaneer capitalism. The public has to be told over and over that equity mining is a social good which cleanses out the deadwood in corporations, rewards the visionaries amongst us, and in the long run provides jobs (it helps if the government alters the official unemployment statistics to ignore the people who are underemployed). The financial buccaneers themselves are to be glorified publicly with plenty of airtime and deferential interviews. Naysayers ”“ such as people who see bubbles in the financial markets ”“ are to be kept out of the public eye and ridiculed should they somehow escape the screening process.
Nowhere was the Pom-Pom Squad more efficiently employed than at CNBC, which is owned and managed by General Electric Corporation, which itself had ceased to be a manufacturing company, and had instead derived the bulk of its profits from its finance arm. To top it off, GE was run by the most worshipful business manager of all time ”“ Jack Welch; the same Neutron Jack who made a specialty of firing people, and who made a career of extracting equity from companies GE would buy and sell. Jack Welch was lauded as the most talented business manager in America, and he still is invited to companies and seminars to dispense his wisdom for a substantial fee. Every so often he gets questions these days about why GE’s profit collapsed shortly after he left the company. The real answer is that the equity mining business at GE Capital Markets ran its course, but the public answer ignores this. Instead, we are led to believe that the people left running GE after Jack Welch lack his genius. Fortunately for these mere mortals, they own CNBC and are able to limit the amount of criticism directed at them by the business media.
The Pom-Pom Squad has come under fire lately from some astute observers like Jon Stewart, but the cheerleaders are still in business and they are all around you. Notice that while these cheerleaders acknowledge that their team has fallen down on the job, they never question the ability of the coaches to bring home ultimate victory. Worse still, the people who were so skilled at equity mining remain on TV as guest commentators, and get to write op-eds for the Wall Street Journal. Nothing of substance has changed in the cheerleading business.
You do not need to be a banker to run a major bank these days; in fact very few CEOs of big banks are. Vikram Pandit ran a hedge fund before taking over at Citigroup for Chuck Prince, a former general counsel. He himself was anointed to the job by Sandy Weil, who spent his career buying financial companies with his sidekick Jamie Dimon, who now runs JPM Chase. It is possible that none of these men has ever made a bank loan in their life, and what they know about credit or other banking risks is what people reporting to them have told them.
Why don’t you need personal experience as a banker to run a bank? What these men all have in common is that they are serial acquirers of other banks. In this respect, they are like Jack Welch or private equity investors. The skill they are purveying is their ability to buy other banks, fire people, and dress themselves up as visionaries and heroes willing to make tough decisions. They bring to the job a narcissistic personality, because they believe themselves to be, and want to be seen, as indispensable to the bank’s future. In this age of CEO worship, they are expected to dominate their board of directors, be the ultimate public face of the bank, and reap outlandish personal rewards in the process.
It is to these men we owe the concept and the reality of ”œtoo big to fail.” In their rush to buy other banks, and their desire to be the biggest on the block, they created behemoths that touch almost all areas of the economy. At some point in the last decade, but certainly after 1999 when it was now legal to combine an investment with a commercial bank, all of the big players did just that. This alone produced financial companies so large that their failure would impact millions of Americans, but the real cost of failure showed up in something called systemic risk.
This is the risk that the failure of one bank will drag down one or more other banks to default as well, creating a cascade or daisy chain of financial destruction. In the early 1990s, there were probably 75 major banks in the world that dealt regularly with each other, so the daisy chain wasn’t as tightly wound. By 2000, thanks to the efforts of the serial acquirers running the banking industry, this number was reduced to 20 major banks. At this point it was too late. The collapse of a bank in Spain could easily drag down a bank in the U.S., Australia or elsewhere. Compounding the systemic risk is the fact that in all major industrial countries (possibly excepting Japan), housing bubbles have erupted in response to the commoditization of the housing stock, and very low interest rates. What the serial acquirers have done, other than being stewards over equity mining operations, is to make sure that if trouble should occur down the road, they have the regulators and the government there to bail them out. They have perfected the skill of holding an entire nation ransom for their own misjudgments.
The Barney Fife Fan Club
Barney Fife was the deputy sheriff of the town of Mayberry on the 1960s American television show. He was so hapless and inept he was not allowed to carry any bullets in his gun. He would have fit right at home at the Office of Thrift Supervision, or the Office of Federal Housing Enterprise Oversight, which had responsibility for regulating Fannie Mae and Freddie Mac. These understaffed and underskilled regulators operated like Barney Fife, without any bullets in their guns. They gave the illusion of protecting the country from fraud, poorly designed products, excessive risk-taking, and mismanagement.
Bigger and more respectable regulatory agencies had the bullets but their guns were confiscated. The SEC, responsible for overseeing the equity markets, was told by the Bush White House to fire dozens of regulators, and the man they put in charge of the SEC believed that regulation itself was evil in comparison to the beauties of self-regulation as practiced by the banks. At the Federal Reserve, Alan Greenspan was given the opportunity to exercise oversight powers, but declined on the same grounds: the markets knew far better how to police themselves than the government ever could. Neither agency contemplated the possibility that the markets, when left alone, might self-destruct rather than self-police.
What happened with the market’s policing function can be seen at Moody’s and Standard & Poor’s, the private rating agencies that stamped Aaa ratings on thousands of mortgage securities which have since collapsed under the foreclosure crisis in the U.S. The rating agencies were bought off by the very industry they were rating. They were suborned not just by the fact that their customers paid them for the ratings, but because the agencies were tied in very carefully to the quantitative researchers who created the models necessary to generate the ratings. The entire financial industry put its faith in perhaps a hundred or so quantitative experts prone to group think, particularly to the belief that because housing values in the U.S. had never declined since the 1930s, it was okay to use this assumption when modeling the future.
One other thing happened to the regulators: they identified with the industry they were regulating much more than with the general public or other actors in the economy. The Fed in particular has come to believe that what is good for banking is good for the economy, and that banking plays such an indispensable role in the economy that damage to the industry must be avoided at all costs. This is regulatory capture in the extreme, and it explains why the regulators have turned over the keys to the kingdom to the very people who have brought about our problems.
The Last Frontier
We come to the final stage of this process, wherein the financial industry has infiltrated the federal government itself, capturing it completely for its own purposes, and latching on to the last great source of equity ”“ the ability to tax.
You’ve no doubt noticed that the biggest and baddest of the banks ”“ Goldman Sachs ”“ the firm all other banks aspire to be ”“ has managed to position itself as the revolving door for high level employees at the U.S. Treasury. In the 1990s it began with a former chairman Robert Rubin being appointed as Treasury Secretary. Once the financial crisis hit in 2007, the existing chairman of Goldman Sachs, Hank Paulson, was brought on as Treasury Secretary. He peppered all the top positions at the Treasury with executives from Goldman Sachs. He also invited the current chairman of Goldman Sachs, Lloyd Blankfein, to join the Treasury in private discussions to decide the fate of AIG, a firm that owed billions of dollars to Goldman Sachs. President Obama has gone alone with this practice, appointing one of Bob Rubin’s protÃ©gÃ©s at Goldman Sachs ”“ Timothy Geithner ”“ as Treasury Secretary. His number two at the Treasury is a former executive at Goldman Sachs.
Stuff like this doesn’t happen by accident. Goldman Sachs has long had a program to move its executives in an out of government positions. It’s good for business. Employees are also encouraged to donate generously to Congress, which receives (no surprise here) the greatest amount of its PAC money from the financial industry, an industry that was equally generous to John McCain and Barack Obama during the 2008 campaign. We even have an ex-CEO of Goldman Sachs, Jon Corzine, a former Senator and now governor of New Jersey.
What makes this easy to do is the complexity of modern banking, especially with the derivatives and quantitative products common among the largest firms. Goldman Sachs is not selling to the government its record of success in dealing with difficult economic problems, it is selling its expertise in complex products. This is why someone like Timothy Geithner, who has no particular record of success at his various government jobs, and who is uninspiring as a Treasury Secretary, can remain in his position. He speaks the language of Wall Street and the markets, whereas career civil servants in the federal government do not.
Once ensconced at the Treasury, Goldman Sachs executives have proven adept at creating numerous programs to funnel taxpayer money to Goldman Sachs to keep it afloat. Other banks get a share of the bounty as well, but somehow Goldman Sachs seems to be first in line when they need cash, mostly indirectly to its counterparties whose failure could drag down Goldman Sachs.
A lot of this is happening behind the scenes, but not all of it. We all know enough to see that the federal government has been captured by the Wall Street interests who are at the center of our economic crisis. This part has been done out in the open, with naturally no protest from the Congress or the media. It is made easier by the fact that the Treasury is still allowed by the global bond markets to borrow gargantuan sums, though how long this will last is anyone’s guess. All we know is that no one in government has ever proposed that your taxes be raised to pay for all these bailouts. That would be impossible; the taxpayer today couldn’t afford it (the TARP program alone of $750 billion would require a near-doubling of the annual income tax). Instead, the government borrows the money, trillions and trillions of dollars in new debt each year. We are on the national installment plan; you’ll pay for this later, as will your children and grandchildren.
When the financing tap is finally shut off by the bond markets, we’ll start making our first interest payments on this new debt. It will come in the form of much higher long term interest rates, a weaker U.S. dollar, an inability to import cheap Chinese goods, and declining living standards. All this will happen because the U.S. will have eaten its seed corn. Its businesses will have been shorn of their retained earnings. Consumers will have depleted the equity in their homes. The ability of the federal government to raise taxes and protect the good faith and credit of the U.S. will be shot.
The equity mining business will have done its work well, having exhausted all the financial resources it could find. The U.S. will be approaching peak oil and water shortages at the very moment it runs out of financial equity and taxing power. It will be an ugly situation, except for the equity miners. They’ll be sitting in their gated communities with the fruits of their labor of the past 25 years. More than likely, the vast American public will never understand what exactly happened.