Let the Financial Scapegoat Go

by: Vincent Fernando, CFA

How did the current financial crisis, basically due to falling home prices and a type of dangerous mortgage derivative, create the widespread notion that the entire financial system is broken, too large, has overpaid employees, etc.?

Somehow this notion has become taken for granted, and all of finance is now being attacked as if every piece of the industry is the same, is culpable, and the entire system is flawed. Anyone adopting such a stance significantly misunderstands what happened.

I'll throw out some perpetrator examples. The Baseline Scenario.

Ordinarily, if an industry innovates, a few people make a lot of money, and then most of the benefits flow to that industry’s customers. Let’s take one of the greatest examples of recent history: Microsoft (NASDAQ:MSFT) and Intel (NASDAQ:INTC) together probably created a handful of billionaires and a few thousand multi-millionaires out of their employees;

That’s the way innovation is supposed to work. You invent something great, you make a lot of money, then your competitors copy you, prices go down, and the long-term benefits go to the customers. And you and your competitors all get more efficient, meaning that you can do the same amount of stuff at a lower cost than before. If you want to make another killing, you have to invent something new, or at least invent a better way of doing something you already do.

Felix Salmon at Reuters:

Even so, one would hope and expect that between sell-side productivity gains and a rise in the sophistication of the buy side, any increase in America’s financing needs would be met without any rise in the percentage of the economy taken up by the financial sector. That it wasn’t is an indication, on its face, that the financial sector in aggregate signally failed to improve at doing its job over the post-war decades — a failure which was then underlined by the excesses of the current decade and the subsequent global economic meltdown.

On this view, the seven-, eight-, and nine-figure salaries pulled down by Wall Street folks aren’t a sign of how efficient they are at doing their jobs, but are rather a sign of how inefficient their companies are.

The financial sector failed at doing its job over the post-war decades? That's a pretty broad statement. The Baseline Scenario article above argues that financial innovations do not create benefits for their customers in the same way that other innovations do. It's another absurdly broad statement. There are tons of financial innovations that are great ideas. And some that are bad. Clearly the system in place for originating mortgages and then packaging them into derivatives with mislabeled risk was one of the bad. But to attack all of finance, and all of financial innovation, just because we had a crisis (a free economy is expected to have crises now and then by the way), is to completely ignore the vast breadth and depth of the financial industry.

Finance hasn't improved at its job? Its innovations aren't useful to its customers?

Remember that thought next time you travel abroad and withdraw foreign currency from a foreign bank you never heard of, while using your hometown bank ATM card. Then think about how companies today use derivatives so that they can focus on doing their core business rather than being a commodity trader at the same time. Or think about how both companies and people can reduce or remove risk from portions of their lives through insurance. Or how with investment banking and many methods of funding, a good company or even a good start-up idea has easier access to capital than in the past.

Broad-based assaults on finance are not productive, they take focus away from analyzing what actually happened. For example, high salaries for investment banking wasn't the problem. Most of the i-bankers had absolutely nothing to do with the problems.

Actually, anyone whom you ever heard at a dinner table say that housing "never went down" is far more related to the problems that led to the current crisis. People globally taking part in a frenzied real estate boom were far more related to the problem. And of course a group of people in finance. But not the entire industry, not the entire system.

To broadly attack the financial system is to completely misunderstand what happened, and counterproductive in terms of preventing a future crisis as well. Let's instead spend more time digging into things such as government policies to promote home ownershig... let's cut the financial scape goat loose.