The Future of the Financial System 2: Leaner and Smaller

The Future of the Financial System 2: Leaner and Smaller
January 12, 2012

(This item originally appeared in on January 12, 2012.)

What is a “financial system?” It is a system that provides finance.

What is “finance”? It is providing the money to undertake a plan. To whom is “finance” provided to? Non-financial companies and households.

The capitalist system works something like this: one person has a good idea, but no money. Another person has lots of money, but no good ideas. They get together, and create something new. The financial system facilitates this process.

The “idea” might be a startup venture. Or, it might be expansion of an existing business, such as adding new restaurants to a restaurant chain. The “person with an idea” might be a penniless Silicon Valley dreamer, or it might be the CEO of a Fortune 500 company.

Ideally, from the standpoint of the person with the idea and the person with the money, this process would be done with as little cost and effort as possible. We also want the people with the best ideas to get the most money, and for poor ideas to remain unfunded.

The process by which this works is very simple. It hasn’t changed much in five hundred years. There are two basic forms of finance: debt and equity. There are also a few alternatives, such as preferred equity and convertible bonds. But, even today, almost everything is done with plain vanilla debt and equity – not much different than it was done in 15th century Florence.

The “financial system,” by itself, doesn’t create any useful goods or services. Its sole purpose is to facilitate the flow of capital between those who have it and those who deserve it. (To be fair, investment advice might be considered a useful service, albeit one that is often overpriced compared to the benefits.)

The financial business should be, inherently, rather simple. It is also something of a commodity business. Have you noticed that all banks are basically the same? Consider the difference between your experience as a customer of, say, Bank of America and People’s United Bank (a regional Connecticut bank). Now consider the difference between your experience as a customer of General Motors and Mercedes, or Apple and Microsoft.

Recently, we’ve been thinking about the difference between today’s financial system and what our ideal financial system might look like. Today’s financial system is grossly bloated and consumes enormous resources. It is not only parasitic, but in the process of its parasitism, it creates many negative situations for the non-financial economy.

A lot of “financial innovation” of the past few decades hasn’t really provided any improvement on the centuries-old system of debt and equity. Rather, the bankers discovered something interesting – the more complicated they made things, the more they could take advantage of their position as a middleman between capital providers and capital end users. This led, for example, to the asset-backed security, the mortgage-backed security, the collateralized debt obligation, and eventually to the “CDO-squared” and even the “constant proportion debt obligation,” a short-lived device that will serve as the high-water mark of financial stupidity.

The idea behind these confections was that you could take debt of middling credit quality and, by creating a hierarchy of loss, create a synthetic debt of high credit quality. However, in practice, it became a way of selling loans for more than they were worth, to suckers (“institutional investors”) who would rather listen to a rating agency’s paid-for opinion than do any actual research on what they had bought.

Actually, banks had provided a similar service for centuries. It was called bank debt, or a bank deposit. The bank would hold loans of middling quality, and issue debt of (theoretically) high quality. The difference with the ABS or CDO was that the bank was no longer liable for the loss. Eureka! Now, banks could make any sort of loan, because they weren’t subject to loss. They could stuff the end investor with the loss.

We ended up with a situation where the end investor (CDO purchaser) had little idea of what he had bought. The bank didn’t care, because it wasn’t liable. The basic function that channeled capital into the most deserving hands – the promise of profit and the fear of loss – was disabled. The result, naturally, was gross misallocation of capital.

As banks moved beyond their useful function – connecting people with ideas to people with capital – their activities become inherently destructive. People began to complain about banks’ effect on society, through aggressive credit card or educational lending for example. Any society, eventually, will aim to curb such destructive practices.

To continue their position of privilege, in which they received more and more resources while doing less and less for the economy, the banks had to buy out the cops. The political system became more corrupted. This also turned into a bonanza: not only were they able to keep doing what they were already doing, within the private sphere, but they could then channel resources from the public sphere into their pockets. In other words, they could steal from taxpayers. The quantities were enormous.

This takes the form of “bank bailouts.” It has been going on, primarily via the IMF, since the 1970s. Today, the developed countries are getting a taste of the plundering that the emerging markets have suffered for decades. Witness Ireland, for example, which had a manageable government debt/GDP ratio of 25% before the recent crisis. It is now around 115%. How did that happen? The government borrowed the money to pay off mostly foreign bankers on their losses on private-sector loans.

On top of that, we have a great many transactions which amount to buying from the government at very low prices, and selling to the government at very high prices. Examine the conditions under which the FDIC sold the bankrupt IndyMac Bank to IMB HoldCo LLC, for example.

An example of “selling at very high prices” could be the recent promotion of Fannie/Freddie refi mortgages with very, very easy conditions. Each refi involves the payment of an existing mortgage in full – a mortgage which may be owned by a private bank. Indeed, even the Federal Reserve’s promotion of very low long-term interest rates (“quantitative easing”) has, as an effect, the promotion of mortgage refinance, which again makes banks whole and saddles the Federal Government, via Fannie and Freddie, with all the default risk.

The latest Federal Housing Finance Agency estimate is that the U.S. government will assume losses from Fannie and Freddie for $124 billion through 2014. It will probably be larger than that.

A similar sort of trick is being pulled right now regarding Greece. Many complain that the various “bailouts” of Greece aren’t helping, because they only add more debt to a situation caused by too much debt. But those criticisms miss the point: the question is not whether Greece will default – it will – but rather who owns the debt when it defaults. The longer this can be delayed, the more Greek debt, owned by private banks, matures and is paid in full, while the new debt issuance is bought by governments. The German and French taxpayer is gradually being left holding the bag.

This is not a “financial system.” It is merely a mechanism of plunder. We will look into the issue a bit more in the future.