Monday, October 10, 2011

Is Wall Street Mostly Worthless?

I’ve been mulling this over for a while, unsure of what I thought, but with recent events around the country calling into question the salaries and privileges of the country’s very top earners (i.e., those largely in finance) I thought I’d try to get the issue straightened out. It also seems appropriate because the profits from the financial sector (as a percentage of the US as a whole) have grown tremendously the last few decades (see the figure on pp. 2 of this study). To preface this, I want to note that I love finance and investing. I love the idea of taking part in the funding of businesses with my capital, and sharing in the wealth and prosperity of the US in general. Don’t think I’m looking at this as a WTO-bashing liberal, or as someone who is wont to bemoan the deals Peruvian farmers are getting when selling their wares into the US. Essentially, I’m a capitalist, a free-trader, and a liberal in the economic sense.

Now, in terms of finance as it stands today in the United States, I thought we’d take a look at what the industry does as opposed to what it is “supposed” to be doing. When I refer to finance here, I’m talking about the large investment houses (i.e., Morgan Stanley, Goldman Sachs, and its cohort). These firms have been making money hand-over-fist as the economy has struggled (note the above chart, from Kevin Drum), so the exercise seems worthwhile. First, it seems that the number one role of finance would be to help funding businesses in need of capital. Oddly, when analyzing the numbers this isn’t what seems to be happening. For example, in the first 9 months of 2010 at Morgan Stanley, this type of activity accounted for less than 15% of the firms revenue (at Goldman Sachs, it was 13%). So, how exactly are these companies making so much money if they’re not mostly funding businesses? It appears that it’s due to trading, as in the first 3 quarters of 2010 it accounted for 63% of Goldman Sachs’ revenue stream.

For those unfamiliar with investing, this requires a brief explanation. When the public (and these firms) buy and sell stocks, the companies’ whose stocks are being traded receive no direct benefit. If I’m selling Apple’s shares (to some other individual) after they’ve gone up, I’m getting richer, but unless Apple is selling new shares, it doesn’t directly benefit. Every time Goldman’s or Morgan Stanley buys or sells stocks for a client, they take a cut. The big investment firms actually contribute to the growth of business when they advise on initial public offerings (i.e., when a company's stock is first issued), but, oddly, that hasn’t been happening much. During the 3rd quarter of 2010, just 33 US companies went public, and combined they raised just 5 billion dollars (peanuts in this industry). The Wall Street firms are still able to make big money buy increasing the amount of buying and selling of already-existing stock (and bonds, commodities, etc.). Jack Bogle, in his book (pp. 56), shows us how effective they’ve been at this:

[In] 1951, the annual rate of turnover of all stocks was 25%. It would remain in that low range for the better part of two decades, then gradually rise to above 100 percent in 1998, approaching the 143 percent turnover rate of the late 1920s. Yet by [2008], stock turnover had shot up another two times over.

In other words, all of the stock outstanding in the US, on average, changes hands at least twice per year. This is insane. When this happens, the particular company (whose stock is changing hands) doesn’t benefit, nor, on average, does the individual trading the stock (cause one does better in investing the less one trades). Those benefitting are the large Wall Street investment banks. The take a cut of each transaction, essentially acting as a parasite, extracting rents and adding little value. Sure, the individual ultimately makes the call since it's their portfolio, but the big investment bank is supposed to be acting in the clients best interest (i.e., as a fiduciary). The next time you’re on the phone with your broker, ask why they have you trading so often when it actually produces little benefit.

The second (but perhaps most) pernicious feature of Wall Street as it currently stands is what Tyler Cowen calls its ability to going short on volatility. What he refers to is the way Wall Street is able to make small bets every day that the economy won’t explode. This is a very profitable strategy (as seen in the chart above), and seldom leads to problems. Occasionally, though, the economy does explode (as we saw in 2008-2009). While this would usually lead to problems for a firm betting on the fact that it won’t ever happen, it didn’t in this case. Why? Well because the government stepped in and made the big banks whole. Rather than the investment banks having to suffer the consequences of a risky strategy, the simply book the profits, while the tax payer provides a buffer on the downside (i.e., heads we win, tails you lose). In his article, Cowen uses Wall Street’s ability to game the system as an explanation for the soaring levels of wealth disparity between those at the top compared to the middle class. Do read the whole thing.

Just to provide some idea of the wealth disparity he’s referring to, this New Yorker piece states that

By 2006, wages in the financial sector were about sixty per cent higher than wages elsewhere. And in the richest segment of the financial industry—on Wall Street, that is—compensation has gone up even more dramatically. Last year, while many people were facing pay freezes or worse, the average pay of employees at Goldman Sachs, Morgan Stanley, and JPMorgan Chase’s investment bank jumped twenty-seven percent, to more than three hundred and forty thousand dollars. This figure includes modestly paid workers at reception desks and in mail rooms, and it thus understates what senior bankers earn. At Goldman, it has been reported, nearly a thousand employees received bonuses of at least a million dollars in 2009.

The same article goes on to cite two economists who studied the issue of the disparity of income from those in finance to those in other sectors of the economy. After considering more complicated theories, “Philippon and Reshef determined that up to half of the pay premium was due to something much simpler: people in the financial sector are overpaid. “In most industries, when people are paid too much their firms go bankrupt, and they are no longer paid too much,” he told me. “The exception is when people are paid too much and their firms don’t go broke. That is the finance industry.”” If this weren’t bad enough, another side effect is the fact that it’s luring a lot of our universities' best and brightest from more productive fields. See here.

The saddest thing is the fact that many of these exorbitant salaries are being paid by the fees on our investments, thus inhibiting our comfortable retirement. Ever considered the expense ratio on the mutual funds in your 401(k) or IRA? In finance, as John Bogle states, you get what you don’t pay for. In other words, the fees we are charged to invest for retirement don’t add value (also see here), but just add to the investment firm’s bottom line. Luckily, as Bogle also notes, the “the stock market is a giant distraction from the business of investing.” The fact that Wall Street is a mess shouldn’t deter you from investing. If you want to get serious about retirement, great, but make sure to invest at Vanguard, which is a non-profit enterprise. To send you on your way into the cruel (but worthwhile) investment world, I refer you to William Bernstein’s book (pp 128):

“The prudent investor treats almost the entirety of the financial landscape as an urban combat zone. This means any stock broker or full-service brokerage firm, any newsletter, any advisor who purchases individual securities, any hedge fund. Most mutual fund companies spew more toxic waste into the investment environment than a third-world refinery. Most financial advisors cannot invest their way out of a paper bag. Who can you trust? Almost no one.” [italics are his]

Not only do these guys blow up the economy and make a killing, but they partly do so by sucking money out of the accounts we rely on for retirement. Perhaps people around the country are right to be upset.

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