Proposals for adequate regulation and enforcement in the financial markets often run into objections from advocates of free-market capitalism. Like any discussion that involves “isms,” a lot of confusion and hard feelings can be generated by a failure to examine the assumptions and preconceptions that cluster around the central conception. We need a definition. For the sake of clarity, I will first detour into a discussion of what this form of capitalism is not, describing its antithesis – jungle-ethics financialism.
Financialism is an economic system where the primary activity consists of creating and manipulating financial instruments. Financial instruments – loans, mortgages, stocks, bonds, etc. - are in their original form firmly linked to economic reality: the mortgage finances home ownership; the stock certificate represents ownership of a company that owns physical assets, the bond secures debt incurred to build a factory.
However, when financialism sets in, financial instruments become progressively further removed from their role in supporting commerce in the real world and develop a life of their own, a weird shadow dimension, a hall of mirrors, a distorted alternate reality that intersects and reacts with the real economy in unpredictable and destructive ways. George Soros described this phenomenon as “reflexivity." Derivatives have a lot to do with it. Leverage and the abuse of easy credit are contributing causes. The shadow banking system is a symptom.
Jungle-ethics – does not require definition, but needs to be distinguished from the free-market concept necessary to the proper functioning of the capitalist paradigm. A system which exalts the most capable financial predator as its highest member will suffer periodic booms and busts – the prey, honest people who work and save and try to invest, become too few and too weak to sustain the predators above them on the feeding chain.
Capitalism – politically I am a Democrat, but discussions of Jack Kemp's legacy have included his mantra: work, save, invest. That is an excellent short-form description of capitalism as we understand it: the fruits of thrift and industry are accumulated and invested in the creation of additional means of production, thereby generating wealth. Free market capitalism relies on the laws of supply and demand to allocate capital to its most productive uses.
The onset of Financialism - Some early manifestations are less objectionable: an example would be the practice of borrowing money in order to repurchase shares. This has the effect of increasing EPS, but does not create any new value: it is simply financial engineering by management that does not have the creativity to develop new products, compete aggressively, or expand into adjacent businesses. The market finds this infinitely preferable to other uses of cash flow such as capex or R&D.
But the terminal stages involve increasing complexity and ultimately circumvent the laws of supply and demand. Consider the phenomenon of synthetic bonds or CDOs, where instead of getting genuine collateral such as mortgages or loans, the buyer becomes a seller of CDS protection. The rationale is that the swap payments mimic the cash flow of the referenced bonds, but at a lower cost because it is not necessary to do the tedious work and actually locate and purchase genuine bonds. In point of fact it is a counterfeit security, increasing the apparent supply of whatever type of credit buyers are most eager to purchase, or sellers to unload on the unwary.
Futures, originally conceived as a hedging mechanism and a source of stability in the market, become problematic when the transactions become entirely divorced from any intention of receiving or delivering the underlying commodity: instead, they are means of speculation. Legitimate market participants, whose business activities involve buying, selling or processing the commodity, are exposed to risk of loss due to market manipulation, rather than being protected from fluctuations caused by the operation of the laws of supply and demand.
Late Stage Financialism - In the final degenerate phase, the elect in the inner circle of darkness of the financial oligopoly report huge earnings by virtue of buying CDS protection on each other and then pumping up the premiums while conniving to create liquidity or solvency crises. Simple folk such as Bill Gross, who noted, with impeccable logic, that this is a zero sum game and that the system would be destabilized when the loser got voted off the island, were disregarded.
Warren Buffett noted that both sides of a trade can claim a profit and that it can take years for the loser to admit defeat. That was after he famously described derivatives as financial weapons of mass destruction. Of course Warren lost his credibility when he himself sold derivative protection, some sort of long term bet on the S&P 500. There has been much speculation about why he did that: my best guess is that he was old enough to know better but too young to resist. Such is the lure, the insidious power of Financialism, even that model capitalist, our beloved hero Buffett has been ensnared in the web of evil.
We the public and individual investors sit forlornly outside while the great ones meet in solemn conclave to devise a way to keep the dark religion inviolate: a new structure, pyramidal in shape, with an immense eye at the apex: within is a larger hall of mirrors, shrouded in a deeper haze of smoke, more obfuscation, more obscurity, presided over by a mysterious wizard of systemic risk, who will emerge from behind the curtain to show us what used to be a fruited plain but is now an arid expanse of desert, relieved here and there by the odd green shoot wilting under the hot sun of reality, with a purple mountain majesty shimmering in the distance, unreachable and remote.
Financialism - that's what created the problems we have in the US economy today. If you can coin a better umbrella term to describe it, let me know. It is not capitalism.
Wild-west ethics is an alternative version – in this variant, the financial hero is a gunslinger, like Wild Bill Hickock.
Hickock was something of a card sharp: he loved it when somebody cheated at a game of poker because he would catch them, spring to his feet, pull out his six gun, and confiscate all the money on the table as compensation for the crime committed. He was judge, jury and executioner, a plaintiff who always won his case.
A wary fellow, Hickock glided down the street, lvigilant, knowing that at any moment some would-be gunslinger hero could bushwhack him and claim the title of fastest gun in the West. One day, playing poker in a mining camp saloon, he departed from his usual practice of sitting with his back to the wall. A cross-eyed coward by the name of McCall crept up behind him and shot him through the back of the head. Hickock died, holding aces and eights, the dead man's hand.
McCall was tried twice: the first trial, hastily conducted in the mining camp where his crime was committed, was a circus, with a jury that had been generously bribed with gold dust, and he was found innocent. A second trial in a different venue resulted in a conviction: he was hanged by the neck until dead.
But our sophisticated modern economy cannot be compared to a mining camp, the reader protests. Perhaps it can. In the mining camp, nothing of value is produced, it is all brought in from outside. Sounds sort of vaguely familiar, I can't quite place it, it will come back to me. There is gold all over, in the streams, in the hills, under the mountains: a horde of gold diggers descend on the area, stake claims, and fight over territory. They bring the gold into camp, where it is taken from them and redistributed, so much to the gin mill, so much to the saloon, so much to the gambling hall, so much to the dance hall, so much to the bordello, a little bit to the general store, on credit.
In the end it makes its way to a back room in the largest and fanciest saloon in the camp, where the high rollers and heavy hitters play a game of Texas hold'em and the winner takes all. Maybe there is no direct parallel, or maybe there is some sort of resemblance to what goes on here in the US of A. Is there any possible resemblance between Hank Paulson's handling of AIG and Wild Bill's tactics at the poker table? Certainly AIG was bluffing if not outright cheating. Paulson was armed with a bazooka, not a six gun.
How many of our financial gunslingers are holding aces and eights? There is no way to know, they all hold their cards very close to the vest. But the rules of the game are, there are no rules and they just changed anyway, drill the other guy from behind and grab what's on the table. And it is very hard to tell the lawmen from the crooks and the card sharks and the river boat gamblers, they all play the same game, it makes perfect sense to them. And the cowardly McCall is never brought to justice.
The Consequences - Jungle-ethics or wild-west financialism results in a situation were capital that should be used to create additional means of production is diverted into gaming the system: when it becomes the spoils of a rigged card game played by cheats and scoundrels: when financial instruments become divorced from economic reality; when excessive leverage creates precarious and unstable structures; when financial predators feed off the fruits of thrift and industry, destroying value.
Necessity of Regulation – ideally, regulation protects free-market capitalism from its antithesis, described above. As such, it is absolutely necessary to the proper functioning of the system. Appropriate regulation is prudential in nature, preventing market participants from endangering or gaming the system. It does not interfere with the operation of the laws of supply and demand: to the contrary, it prevents unethical market participants from manipulating supply and demand in ways that harm others.
A Failure of Regulation – the current financial crisis was caused by a massive failure of the entire regulatory system. Rather than assigning blame to individuals, political parties, or financial institutions, this discussion moves on to the central issue, the need for an informed, politically active group of individual investors to force Congress to 1) enact appropriate corrective legislation and 2) regulate the regulators. Ultimately, we as citizens and investors have stood by while speculators and manipulators ran amok. Our duly elected congressional servants, lacking explicit instruction from us, participated in the process. Perhaps we attempted to participate ourselves, small time predators in a treacherous jungle. Now we must insist on change.
Regulatory reform - A consensus is growing in support of regulatory reform. It's a given: the questions now revolve around the process, who will chair the commission, who will gain or lose turf, how stringent will regulation be, will any segment of the financial industry escape close supervision?
Defining the Agenda – broadly speaking, what needs to be done is to end the era of jungle-ethics financialism. It is important that turf wars and power grabs be excluded from the agenda. If properly done, the findings of a Committee to Investigate the Disaster will result in recommendations such as, but not limited to, the following:
All existing classes of financial instruments and products need to be reviewed, to determine whether they serve any useful purpose in supporting the functions of the real economy. Does the instrument in question facilitate working, saving and investing? Is it directly related to the real economy? Does it create systemic risk? Can it be perverted into gambling or speculation, gaming the system?
Credit Default Swaps
Those supported by insurable interest
Interest Rate Swaps
Those that perform necessary hedging functions for individuals or institutions whose primary business operations expose them to interest rate fluctuations
Those that are speculative in nature
Legitimate hedging by enterprises exposed to loss due to price changes in the commodity involved
Speculative transactions aimed at cornering the market, such as occurred during 2008, destabilizing the cost of crude oil and gasoline, exacerbating the economic crisis
Synthetic bonds and CDOs, creating fictitious excess supply of bonds, replicating and multiplying losses, offering endless opportunities to finagle and arbitrage
Leveraged ETFs, fundamentally dishonest products that destabilize the markets and encourage gambling on market direction
Securities lending, AIG got themselves in trouble doing this
Transactions must be subject to continuous review, to ensure that they relate to the real economy, that they are not manipulative in nature.
Naked CDS, logically these are naked short sales of bonds, and can be used to drive bond prices down or yields up, creating an unwarranted suspicion that a company is in financial trouble or even creating an implosion by denying the company access to credit markets.
The transactions that need to be forbidden all have one thing in common: there is no underlying intention of receiving or delivering the goods – they are simply bets on the direction of the market. This was outlawed as long ago as 1907, by the bucket shop laws, but we have been unable to learn from the experience and wisdom of previous generations and yet once more gambling and speculation have created economic hardship.
Excessive leverage – the natural consequence of artificially low interest rates, speculators attempt to achieve large risk-free returns by leveraging “low risk” transactions. Results have been destructive and destabilizing.
All financial institutions must be subject to regulation
That would include Hedge Funds
It would include former investment banks, whether they owe money to the USG or not
It would include clearing houses such as DTCC, which contain the information necessary to monitor transactions for manipulation and systemic risk
There will be no regulatory arbitrage
The Self-Regulatory Fiction needs to be abandoned. For too long the SEC has deferred to the concept that the markets would police themselves through organizations such as FINRA. This has demonstrably not worked and we should give up the pretense and naïve hope that it ever will work. Why pretend that the fox is guarding the hen house?
The SEC needs to be forced to reinvent itself as a law enforcement agency rather than a p/r apparatus. The mission is not to make investors believe the game is fair by crucifying minor celebrities such as Mark Cuban or Martha Stewart for insider trading, meanwhile ignoring a raft of specific and credible allegations against naked short-sellers, or other prime offenders such as Bernie Madoff. The mission is to quell jungle ethics.
Other Regulators that have become irrelevant or toothless must be restored to functionality.
Implications for Investors – If you're happy with the way things are there is no need to do anything: just tap into the easy riches created by financialism, outwit all the predators out there, lay down your cards and rake in your winnings.
If you're not happy you need to tell your Congressional representatives about it, loudly and firmly. Tell them you are not going to be distracted by a sop in the form of retaliatory taxation against AIG bonuses. Tell them they owe us an amends for their gross negligence in passing CFMA, the legislation that brought us Enron and exempted CDS from regulation. Tell them to read the GAO report on the SEC. Tell them to do something about it. Make sure it happens.
Then you will be able to work, save and invest safely.