Fear of Finance II

I wound up being quite unhappy with my "fear of finance" piece, because it completely ducked one of the most important questions: why the extraordinarily outsized pay packets of the high financiers? Why doesn't competition--which sorta works elsewhere in the economy--cause us to see greatly reduced earnings? We understand, we think, why celebrities get paid so much--a combination of increasing returns in distribution, being the genuinely best in the world, and being well-known for your well-known-ness. But why financiers?

What is it that blocks effective entry and competition, exactly?

Comments

[Matt]

It is basically the central banks failing to enroll all citizens in banking that is at fault.

Financiers are highly corelated with government and therefore the fed. These guys operate on far right side, they time their activities with conservative bubble making and the go-along fed.

As one moves right on the X axis, correlation ratios among the elements increase. Basically, it is who you know.

A few things need to be corrected. First, the central banks of North America need to define the standard, protected, accurate account framework that gets all citizens in the banking system. Then the central banks need to standardize on bond security and rating systems for each North American region. The NASB or the Feds need to define the demographically correct retirement bond system in each region, and observe all federal rules for retirement in each region.

[curmudgeonly troll]

It's instructive that even after the Google auction IPO, the banks can still charge 6% for taking a company public. And a hot startup would still rather Goldman take them public (after giving a pre-IPO gift to a first-tier VC), to get their company validated and distributed at a high price.

Some products are sold, not bought. People demand someone tell them with authority what is going to happen, even when it cannot be known. Hence the demand for CNBC (and in certain instances pundits and professors)

So long as men worship the Caesars and Napoleons, Caesars and Napoleons will duly arise and make them miserable (and poor).

(And of course attempts to impose a different outcome through government simply lead to choosing the Caesars and Napoleons from a different caste and methods even less scrutable to the average Joe. Behind every form of government lurks an oligarchy)

[The New York City Math Teacher]

Why not collusion and mutual patronage? Could one not imagine that the owner-controller-managers of corporations are now using that control as patrones would control latifundia, and not as honest fiduciaries nor as a co-stakeholders with other interested parties in corporate governance?

What possible work is worth 500 million dollars a year, unless the wage is contracted corruptly?

[Kate G]

Brad, i didn't read the original piece so I'm just going on your post here, forgive me if this isn't the issue you are addressing. I would look at it very differently. Of course, to me, the "market" doesn't set any kind of real rate of return for labor really except in certain unusual circumstances. Most labor is kind of hostage to the social settings in which it is negotiated--you can't move elsewhere and quit a lousy job, the supply of other interchangeable parts/workers is huge, etc... etc...etc...

But jobs in the stratosphere aren't exactly like that. And the people giving out th ejobs--the people with money to invest looking for a money manager, the people with compaines tha tneed to be run, etc... are actually in a pretty difficult and, in its own way, ignorant position. They don't rely on objective information about money management or management skills but rely, as most people do, on proxies like "how famou sis this guy?" and "have other people truste d him with their money?"
And th enumber of people who fit that bill, that social bill, may be quite small.

Kagte G.

[Matt]

In your envelope calculations of the 1/3s, you have no way of knowing if that guess is even anywhere close to the proper distribution, and so your math that you let legitimate your intuitive assumption that all those wildly overpaid M&A execs are actually creating value for the world is completely baseless.

I think that social and economic corruption being the dominant forces behind the extreme over-compensation of finance types is vastly more likely the cause you're looking for than any positive economic force or even any damaging to the majority of society but logical non-sociological outcome of legitimate supply and demand.

[Matt]

In your envelope calculations of the 1/3s, you have no way of knowing if that guess is even anywhere close to the proper distribution, and so your math that you let legitimate your intuitive assumption that all those wildly overpaid M&A execs are actually creating value for the world is completely baseless.

I think that social and economic corruption being the dominant forces behind the extreme over-compensation of finance types is vastly more likely the cause you're looking for than any positive economic force or even any damaging to the majority of society but logical non-sociological outcome of legitimate supply and demand.

[GeorgeNYC]

Conspiracy theories aside, there is something that troubles me about the fundamental concepts surrounding "investment" markets versus "commodity" type markets. I think it is fair to say that a "market" particularly if it is open and fair, etc. should reach an "equilibrium" where a price is set and supply and demand satisfied. The price is always set at the margin.

pHowever, I think that the idea of "market capitalization" is somewhat deceiving. Conceptually, I am not clear that the equilibrium achieved by such markets is necessarily the same as the equilibrium achieved by "commodities" markets. I guess what concerns me is that this equilibrium may not necessarily reflect the "value" of the market. i.e. the market capitalization achieved by multiplying the last sale price by the number of shares may not equal the "value" of the company if it were sold as a complete enterprise. Maybe this is where the "finance" guys can make their money.

However, if this is true, then that would mean that the "market" is not accurately providing the right price signals. I guess that is my point. If the stock markets really provided accurate "valuation" signals then why would anyone ever buy anything at a premium?

I understand the idea as well that there might be "synergies" through mergers but then would not those same "synergies" also allow for firms to invest in complimentary activities off their own capitsl accounts rather than through acquisitions?

Although I hate to say it, it seems at least intuitively true that the "financiers" make their money by spotting market inefficiencies or externalities that do not properly transmit price signals of value.

Flipping that around for a second, what that means is that if I am Mr. Average Joe investor and bought a stock at $100 that price should reflect the value of the company. But if someone offers me $120 in a private equity deal that, of course, makes me happy. But if that PE firm then turns around and sells two years later for $200 one has to ask why the management could not "on my dime" have done the same thing. Although the PE guys "found" $60. My question is why did the "market" not find it? Does it have t do with the competition for good management? Does it have to do with incentives? Maybe it just has to do with the PE guys knowing how to get that pig to stand still for a proper application of lipstick?

I guess the point is that there is something else going on aside from a true "market" searching for equilibrium. (That thought is heretical of course). Obviously in a "commodity" market, the only drivers are supply and demand. There is no possibility that someone will buy my "underpriced" oil and sell it for a profit. The market is what the market is.

I do not buy the "risk" idea either. That these guys are just being rewarded for taking on "risk." There is usually no "down" side. It is not like they loose their personal fortunes if something goes wrong (unless they had it invested). Most of this stuff happens with OPM. True THOSE investors are risking their money but not the whiz kids doing the deals.

Rambling a bit more. I guess what struck me was your talk about the "value" of all of these assets out there. There is a lot of "paper" valuations out there. The true "value" of the asset should be the present value of the stream of income to be produced by that asset. But as one could expect, opinion will greatly differ on that! But also, that is a different question of "value" than a commodity "purchase." The lump of coal is bought because I need to warm my house. A very simple calculation. "Investment" is something different. I do not "need" to invest. But if I have money laying around there is reason to "invest" if I think that I will get a "return." Otherwise it is just spending money.

[sd]

George NYC wrote:

"I understand the idea as well that there might be "synergies" through mergers but then would not those same "synergies" also allow for firms to invest in complimentary activities off their own capitsl accounts rather than through acquisitions?"

No.

Take the example of a $5B (revenues) soap company buying a $2B soap company. One of the synergies is the scale that comes from combining legal departments. Say a $5B soap company requires 50 lawyers. A $2B soap company requires 30 lawyers. A $7B soap copmapny requires 60 lawyers. (Made up numbers, but realistic). So by combining the two companies, 20 lawyers can be fired. If each lawyer costs $200K per year in pay, benefits and support costs, then the combined entity saves $4M.

Do the same math with the finance, HR, IT, R&D and marketing departments and the total synergies could be worth $20M a year. If soap companies trade at 7X EBITDA, then overhead synergies alone would allow the $5B soap company to pay $140M over the market price for the $2B soap company and still come out ahead. In this case that's a 10% acquisition premium (assuming operating margins in the soap business of about 10%).

So why can't the $5B soap company simply invest capital to grow organically by $2B in revenues? One of two reasons:

1) Consumers are brand-loyal in soap, meaning that it would take years to organically grow to $7B in revenues. Because a dollar today is worth more than a dollar tomorrow, its still a better option to do the M&A deal.
2) Consumers are not brand loyal in soap, meaning that any increase in the production capacity in the industry will result in a price war that will erode profit margins.

[christofay]

Yes, there is going to be hell to pay as the Greenspan/Bush econ plan unwinds.

If inconsistency is a good, then there is hope for this blog yet. Two blog subjects before this we find "The question left hanging is why an economic policy team that looked very good at the time to Bruce (and that looked good at the time to me) turned out to do so badly--and why the foreign-policy team turned out to do much, much worse." the subject here is fear of finance, the worm is our elite posing as financiers.

[Observer]

Because the IPO M&A "market" is really a pseudo-market instead of a being real one.

The buyers are the high value accounts in the broker firms. They are trying to make higher than market returns in their portfolios. The excess fees the financiers make is the "bribe" paid by those high value clients to said financiers in order to participate in the initial subscription.

Were an outside competitor firm to start up and attempt to work outside that system and went directly to the public, you would have exactly one response: the established firms would simply buy the upstart and change it's policies.

Were an inside competitor firm to attempt to break with the system, their high value clients would simply migrate to the other firms that give them the insider subscriptions and higher returns. Their fees base would dwindle and the renegade firm would then be forced to start to go directly to the unwashed masses but without high value clients. Then the renegade firm would eventually be bought out at a discount by the remaining other firms.

However, if a renegade firm really wanted to do business with those lower value clients in the first place, the firm could simply start up a business unit to do that without breaking the buddy system at the top and losing their high value clients.

[Neil B.]

Well, at least for CEOs: Their pay isn't really part of a true "market." In a true market, you have to buy something valuable to you out of your own "scarce" financial resources. If you spend a lot on a shoddy pair of shoes, *you* not only have a crummy pair of shoes to wear, but less money to spend on other things.

But, business operatives often have pay picked for them by committees which *use other people's money* - IOW, the board members have no less of their own spending money if they pay the CEO 100M than if they pay him/her 10M, because company funds are used. As for why the shareholders, "the owners" can't stop it, well - the voters supposedly own this government, and look how much so many of us hate it. It isn't direct democracy, and powers set up a lesser of evils choice that is hard to scrutinize. That isn't all there is to it, but will get you thinking about it.

tyrannogenius

[Doctor Jay]

One of the things that promotes high CEO pay is the fact that CEO's are hired because they are good negotiators. And they get paid well because they are good negotiators.

Can you imagine hiring someone as a CEO because he offers to work for less than the other guy?

Of course, there is no open loop feedback, no objective measures. So even if a CEO does badly, he can say, "Well, it would have been much worse without me." Because you can't do a controlled experiment.

In the same way, IPO firm is going to talk to you about how they are going to get you 20 to 30 percent more, so the 6 percent fee seems small. Yeah, you might pay a smaller fee from an auction, but is that really selling?

Google changed nothing because Google is nothing like any other company. It was already number one at what it does when it went IPO. The founders still hold a majority stake, and have extended their middle finger at Wall Street quite clearly and repeatedly. Not everyone feels secure enough to do something like that.

[TJM]

why the extraordinarily outsized pay packets of the high financiers? Why doesn't competition--which sorta works elsewhere in the economy--cause us to see greatly reduced earnings?
What makes you think the price for M&A advice isn't at equilibrium? The cut for the advisors (both sides) and the attorneys (both sides) is a negotiated fee structure that results from competition. The value basis for the deals, though, can vary to include total value ( the entire right side of the balance sheet) or just the equity value. Large $ deals yield large $ fees. That's part of the market.

[James Killus]

The fees paid to M&A brokers are sacrifices to the Gods of Finance. If the sacrifice is not sufficient to propitiate the Gods, then your deal will fail.

Alternately: this is a nice little deal you have here. We wouldn't want something to "happen to it," would we?

Alternately, substitute "broker" for "lawyer":

"In every big transaction, there is a magic moment during which a man has surrendered a treasure, and during which the man who is due to receive it has not yet done so. An alert lawyer will make that moment his own, possessing the treasure for a magic microsecond, taking a little of it, passing it on. If the man who is to receive the treasure is unused to wealth, has an inferiority complex and shapeless feelings of guilt, as most people do, the lawyer can often take as much as half the bundle, and still receive the recipient's blubbering thanks." --Kurt Vonnegut, God Bless You, Mr. Rosewater (1965)

[wml]

If it's market failure, then the implication is that because fees are so high, there are deals that should happen but don't because of the high fees.

So something to check: are there large numbers of firms that should merge/etc. that aren't?

[Richard]

I think the answer as to why market forces don't bring down fees is that there are no market forces to bring down fees. The participants on both sides of the deal, the company officers and the financiers have a mutual interest in siphoning off as much shareholder equity for themselves as they can get away with. Rather than compete with each other, they find it to their advantage to cooperate against their real competitor for gains, the shareholder. The shareholders have little leverage and therefore the market forces do exactly as you expect, reduce shareholder gains and maximize the gains for the officers and financiers.

[Lee A. Arnold]

"What is it that blocks effective entry and competition, exactly?"

Is it the small number of customers? What is the actual number of entities (institutions, rich people) who are active in this market?

Are they going to bid their buddies down to a butler's salary? Will they feel comfortable in a business deal with someone who doesn't think about wealth the way they do?

[br]

Perhaps you can explain to this non-economist how the global stock market can earn inflation-adjusted returns of 6% indefinitely.

My problem is this: For the stock market to go up faster than GDP, either corporate earnings have to go up faster than GDP or P/E ratios have to go up. If corporate earnings going up faster than GDP is the explanation, the 6% return doesn't represent real creation of value, but merely capitalizes a transfer of income from workers and consumers to investors. (Indeed, if shares of national income are constant, the earnings of the shares held by the average investor in publicly traded companies should grow more slowly than GDP because public investors own companies that go out of business but don't own new companies that enter the market.)

P/E ratios, it seems to me, can't go up indefinitely. For one thing, they ought not exceed the (inverse) risk-free interest rate. It's logically possible that interest rates could decline indefinitely (that's what Marx thought, after all), but that doesn't seem compatible with a world in which owners of capital are gaining at the expense of other sectors. At the least, it ought to be acknowledged that the analysis you're presenting here assumes an unending increase in average P/E ratio, since that's not an assumption that most people would think is being made.

All this is important, because if the assumed increase in stock prices is reduced to a number a little below the economic growth rate, say 1% or 2%, all the growth and more goes to the finance sector and individual investors (outside perhaps of index funds) get zero or negative returns.

I'm sure there's lots of literature on this topic, but since we're not all economists here, some explanation would be helpful.

[save_the_rustbelt]

Those who preach loudly the virtues of the free market make really certain they do not have to face the market.

Today most of them were having lunch together in the Hamptons planning their future collusions.

[save_the_rustbelt]

Those who preach loudly the virtues of the free market make really certain they do not have to face the market.

Today most of them were having lunch together in the Hamptons planning their future collusions.

[roublen]

Can you please, please write something smart on growth in the money supply? Because I a) don't know if money supply growth in the post-1996 era has been unusually high in historical terms b) I'm not sure what to think of money supply growth, even if it has been unusually high.

But this would be my guess: the large amounts of money being made is related to the fact that they can influence the amount the money being created, and that they've been creating a lot of it.

[roublen]

also, what Matt said. Even though I didn't understand all of it;)

[James Killus]

br, you have forgotten another possibility, that more and more of the GDP is represented in the stock market.

Consider, at one time, most real estate was not securitized. Then, in the 1970s, the REIT (real estate investment trust) was invented and this securitized a lot of real estate that had not been previously represented as stock. The same thing happens when any private company goes public; a chunk of wealth not previously corporatized become stock.

In recent years, mutual insurance companies have gone public (because their managers wanted their jackpot), formerly non-profit hospitals have gone public. Individual professionals or partnerships have first incorporated, then joined larger firms as acquisitions.

Each of these transactions increases the net capital stock represented by the stock market, often without increasing the actual wealth of the country. There have been investment groups securitizing coins, fine art, and comic books, the very definition of sterile investments. All add to the market total.

Then, in "bubble economics" banking system liquidity is confined to assets by tilting the tax code (and labor laws) toward the investor class. So part of what happens is that even sterile investments increase in net worth.

Every Ponzi scheme eventually falters and fails, but if enough money is involved, it can go for a long time before die Rechnung.

[glory]

http://www.caijing.com.cn/newcn/English/Economist/2007-07-24/25264.shtml

"Economics has an efficient wage theory. Its name misrepresents its content. It says that a person should be paid above market if his position allows him to do a lot of damage. For example, if a pilot slackens, he could kill a lot of people. Hence, the market wants to overpay him to keep him focused. A similar person who drives a truck can do less damage and is less well paid. In financial industry, if a person makes one mistake, he could cause losses of hundreds of millions to his clients. Hence, his clients want to pay him above market just to encourage him not to make mistakes. This efficiency wage theory applies to CEO’s too. Most CEO’s I have come across are not very capable but are very well paid. They mostly ride the momentum and go with the flow. Because their bad decisions can destroy so much, the market wants to give them enormous incentives not to make mistakes. Still, so many of them destroy their companies anyway. Efficiency wage is really a bribe. But, bribes don’t always work.

"The close distance to money doesn’t fully explain the prosperity of the PE industry. I suspect that the star effect is equally important..."

[zak822]

The question in play is "Why doesn't competition--which sorta works elsewhere in the economy--cause us to see greatly reduced earnings?"

Because there is no real competition in this arena. You guys should stop pretending there is; the failure of the theory means the theory should be re-examined for validity.

[knzn]

At least in the hedge fund world, I’d suggest it’s a combination of risk aversion, imperfect information, and true superstardom – the last of these perhaps in a vanishingly small proportion, but part of the imperfect information problem is that we never really know whether anyone is a true superstar or just pretending to be.

Risk aversion is a factor that may be underappreciated. We don’t hear much about the unsuccessful financiers who end up making little or no money and going on to face dismal career prospects, but I believe they exist, or at least I believe that there is enough belief in their existence to deter people with good low-risk career prospects from taking high-risk finance jobs.

Imperfect information is perhaps the most important factor. Salesmanship is critical to success in the hedge fund business. For any good investment results, nobody knows whether those results were due to luck (and nobody knows what the true underlying correlation with other investments is, and so on). So the set of successful finance people includes only those who (1) had good investment results, (2) successfully sold those results, and (3) continued to have good investment results. That narrows down the field to the point where there isn’t much need to compete on price. Or to put it differently, the competition is in salesmanship rather than price.

You might ask why competition doesn’t lead to greatly reduced earnings among con men. But of course, you wouldn’t ask because the answer is obvious. It’s kind of similar with financiers. I’ll stop short of actually saying that financiers are a type of con men.

[Neil B.]

Hey br: That's exactly what's happening. The extra growth in standard of living etc. is being sucked up by the top tier, due to ascendancy of conservatives and lobbyists, the "financialization of the economy" etc.

[Prakash]

Lack of financial literacy.

Finance has become one of the most important sectors of the economy mediating between a lot of other sectors.

Lack of financial literacy is the primary reason we don't see a walmart of finance, with cheap IPOs to companies, cheap funds for everyone, etc. People still think that there are other people with extra-ordinary financial capability. Once they understand the issues and start asking the tough questions, then there might be a change here.

The other reason could be inadequate development of markets themselves. Maybe after the maturation of idea futures, propositions like - Are there people who can consistently beat markets - can be put to test, or atleast a probability could be obtained.