Profit and loss vs. crime and punishment in the world of high finance
There are two kinds of scandal on Wall Street: making money and losing money. Senator Carl Levin (D., Mich.) cited “record profits from 2004 to 2007” in explaining his investigation of Moody’s and Standard and Poor’s, and then in May cited losses at JPMorgan in calling for a swift regulatory response. President Barack Obama cites “record profits” for energy companies as constituting a case for federal action, and then cites losses at banks as justification for federal investigations. Perhaps there is a sweet spot in there somewhere, say a flat, reliable 10 percent return year after year — like Bernie Madoff’s.
The scandal of profit is easy enough to understand, if one can but appreciate the fact that Washington and Wall Street are complementary antechambers of Hell — specifically, the fourth circle of Dante’s inferno, in which the avaricious and the profligate, being a matched pair, spend eternity punishing one another:
As does the wave there upon Charybdis,
That breaks itself on that which it encounters,
So here the souls must dance their roundelay.
Here saw I people, more than elsewhere, many,
On one side and the other, with terrible howls,
Rolling weights forward by force of their chests.
They clashed together, and then at that point
Each one turned backward, rolling retrograde,
Crying, “Why do you hoard?” and, “Why do you squander?”
Thus they returned along the lurid circle
On either hand unto the opposite point,
Shouting their shameful curses evermore.
Avarice and envy are deadly sins, always a good starting point in the analysis of the relationship between high finance and low politics. Profit will always scandalize politicians, because scandal provides a pretext for seizing other people’s wealth, which is what politics in a modern democracy is all about.
The scandal of loss is a more modern phenomenon, probably with its origin in the stock-market crash of 1929. Like subsequent bubbles, the run-up in stock prices in the 1920s is an example of an unalterable universal law: The hotter the market, the dumber the new entrant. This holds true of both professional investors and amateurs. Investors in the 1920s were borrowing more money than they could afford to lose in order to invest in a market that they believed, against every known economic fact in human experience, could only move in one direction: up. They were analogous to the turn-of-the-century idiots buying $500,000 houses on $80,000 incomes with nothing down and negligible or negative net worths, who were only marginally more foolish than the fools who were lending them the money. We saw the same thing in the early 1990s with both institutional and individual investors who bet basically every farthing they had to their names on derivatives they did not understand in the slightest, or a few years later with the ones who dumped their kids’ college funds into such can’t-lose propositions as CDNow and Pets.Com, a firm that went from the NASDAQ to the outer darkness in 268 days, which is more or less what happens when you have a multi-million-dollar advertising budget and no profits. More than a few of the investors who survived the dot-com crash went big into real estate in the subsequent years, convinced, once again, that they had found a sure thing, which they had: a sure loser. In every bull run, there are a million “my brother-in-law made 20 percent last year” investment strategies.
The sob stories are the worst part of it. In 2010, Businessweek very sympathetically related the tale of one Leona Miller, a retired beautician in San Diego who sank twenty grand into a derivatives position, which the magazine describes thus: “Miller had bought a structured note — a bond combined with a derivative. In her case, it was a reverse-convertible note with a knock-in put option tied to Merck stock. The option meant the security could offer a relatively high interest rate. It also added risk, as Miller learned too late. A decline in the drugmaker’s shares, to below 32 from 40 when Miller bought the notes, triggered the put option. That allowed the note’s issuer, the Oslo-based export-credit agency Eksportfinans, to pay Miller off with Merck shares, then trading at 26.” Other than not quite understanding the meaning of “derivative,” “structured note,” “reverse-convertible,” “knock-in,” “put,” or “option,” she was unimpeachable in the due-diligence department. Why would she direct her investment manager to put what was presumably a good-sized chunk of her life’s savings into such an exotic product? “I just wanted him to make some money for me, like anybody else,” she said. “I still don’t understand too much about it.” Also, Merck manufactured one of the prescription drugs Ms. Miller took, so there’s that.
There is an explanation, it turns out, and that explanation is stupidity compounded by greed. That reverse-convertible, knock-in-put, Merck-stock-derivative monstrosity came with an interest rate of 9 percent, which is a heck of a lot better than Treasuries or CDs have been doing lately. It also came with the possibility of a meltdown. We have been here before: In the 1980s, a fair number of individual investors and professionals who should have known better took a hit on junk bonds, and the papers were full of their tales of woe, and a few years later the same thing happened with derivatives. And then a decade later 10 million liars committed bank fraud in order to get loans to buy houses they could not afford, and these dishonest, greedy little graspers are held up as a collective subject of public sympathy. But they were not the victims of unscrupulous mortgage lenders — they were their co-conspirators. A great many of Mr. Madoff’s “investors” were sophisticated financial players who ought to have taken one look at the flat, 45-degree line describing his annual returns and known that something was amiss — but there were above-market returns to be had. These clowns, too, should be regarded as possible criminal associates rather than as victims.
Instruments such as derivatives and junk bonds serve a useful purpose, but that purpose is not to dominate the retirement nest eggs of retired beauticians. Take the 1980s junk-bond roller coaster, for example. Despite all of the angst and wailing over Michael Milken, corporate raiders, and the alleged decade of greed, junk-bond investors did pretty well: From 1981 to 1991, junk bonds returned 14.1 percent, vs. 12.9 for the Dow. But it was a pretty crazy ride, and the only investors who were able to weather the storm had relatively large and sophisticated portfolios with a significant diversification of risk — i.e., they were the kinds of investors who had any business investing in junk bonds in the first place. Investors working from the “my brother-in-law” strategy, unable to deal with the volatility of the junk-bond market, got themselves wiped out. The same was true in the derivatives fiasco of the 1990s, when the local government of Orange County, Calif. (to take one famous example), got greedy and stupid and put way too much into exotic instruments it did not need and did not understand, simply to chase returns. (Orange County got bailed out by its banker; now we do it the other way around.)
There are two problems, probably insurmountable, associated with the scandal of loss. One is that politicians’ self-interest causes them to respond to losses in the wrong way; the second is that Washington is not very good at telling a bad investment from a crime.
Democratic institutions have strong incentives to flatter the feelings of the ignorant and greedy among us, who are a large voting constituency. For this reason, Congress and the regulatory agencies treat the inevitable parting of fools and their money as a deficiency in the marketplace. When Granny puts all of her money into baht-denominated commodity swaptions and then loses it, the fault cannot possibly be hers: Surely there is something wrong with the market, surely those marginally employed and penniless borrowers were tricked into thinking they could afford half-million-dollar suburban spreads, surely companies with no profits or assets would have been outstanding investments if only we’d had the right regulations, etc., and we have to figure out a way to give people their money back. But when JPMorgan makes a boneheaded sort-of-a-hedge-sort-of-not investment and takes a $5 billion (and counting) lump, obviously JPMorgan is at fault, and it’s a national scandal.
That populist impulse actually inhibits useful financial regulation. The Dodd-Frank financial-reform package unleashed a swarm of regulatory fleas to nibble at pinstriped ankles on behalf of dozens of popular interest groups, but for all of the micromanaging of bank-card fees, point-of-sale disclosures, and executive-compensation practices, it did not impose any regulations that would address the system-risk problems that were made apparent in 2008–09. Evidence of that fact is undeniable: The too-big-to-fail banks are bigger than ever, as Bloomberg reports: “Five banks — JPMorgan Chase & Co. (JPM), Bank of America Corp., Citigroup Inc., Wells Fargo & Co., and Goldman Sachs Group Inc. — held $8.5 trillion in assets at the end of 2011, equal to 56 percent of the U.S. economy, according to the Federal Reserve. Five years earlier, before the financial crisis, the largest banks’ assets amounted to 43 percent of U.S. output. The Big Five today are about twice as large as they were a decade ago relative to the economy, sparking concern that trouble at a major bank would rock the financial system and force the government to step in as it did during the 2008 crunch.” Our “too big to fail” reforms addressed everything but banks’ being too big to fail. One of the problems is that more robust systemic reforms, such as higher capital requirements and stronger leverage-ratio rules, are impossible to explain to voters between episodes of Cake Boss and do not have any broad natural constituency. But tell Americans that you’ll cap ATM withdrawal fees at $1 and you’ll have yourself a peach of a campaign issue. Never mind that that has nothing to do with our recent financial turmoil.
JPMorgan’s recent unexpected loss has commanded official Washington’s attention precisely because official Washington is cognizant of its own failure to enact the right kind of Wall Street reform, and one of its worst fears is that voters will catch on to that fact. The Obama administration in particular must be on tenterhooks: It would not take a 2008–09 repeat to reveal that the administration has done very little to curtail systemic risk; a good bear market probably would accomplish that and, given that the stock market has roughly doubled over the past three years and may be due for a correction, everybody’s a little jumpy.
If things go south in the markets, you can expect the Inquisition. The Obama administration and its Justice Department have managed to conduct not one serious investigation into the events of 2008–09, but a relatively small loss at JPMorgan suddenly is all over the federal radar. Financial disruptions rarely are the consequence of criminal wrongdoing, though they often are an occasion for it — Wall Street, like any street, has its share of criminals, and there is nothing like the impending loss of wealth and livelihood to bring out the criminal in us all. But the political class tends to conflate malinvestment and malfeasance. Michael Milken–era junk bonds often are blamed for the subsequent savings-and-loan meltdown, but in fact the thrifts already were in trouble, and junk bonds composed a tiny fraction (1 or 2 percent) of their holdings. There was criminal wrongdoing at Enron, but Enron was going to collapse with or without it: The criminality at Enron seems to have been more a response to the company’s collapse than a cause of it. It was bad decisions, not bad morals, that brought down Long-Term Capital Management.
Making normal business losses a scandal — or, worse, a crime — makes no sense. As any small-town loan officer will tell you (and tell you, and tell you), most new businesses fail. As anybody who is paying attention will tell you, nobody — nobody — beats the market in the long term. The problem on Wall Street (which is also the great thing about Wall Street) is that the collection of people futilely trying to beat the market is known as: the market. High finance consists of a great many very smart people with lots of money trying to outsmart one another; big wins and big losses are baked into the capitalist cake. (Somebody made a whole pot of money when JPMorgan lost that $5 billion, after all.) There are ways to make that work for us as a society, and there are ways to exploit it for political gain. Guess which one is keeping Washington busy.