The Thinker

Where did all my money go?

Those of you who dared to read your brokerage statements probably have the same question that I did. Where the heck did all my money go? Some of my mutual funds are worth half what they were two years ago. Given the current dropping stock market, I am likely to see further losses in many of my funds.

If I had put my money into AIG stock then yes, I would expect to be able to get just pennies on the dollar. However, I own mutual funds. The whole point of owning mutual funds is to spread out the risk. Some stocks in the portfolio are bound to suffer but it should not matter because other funds will gain. It should all balance out somehow.

The short answer is that the financial industry came down with a bad case of the flu. Pretty much all of them are in the hospital and are being pumped with fluids from the U.S. Treasury and the Federal Reserve Board in the hopes that they will recover. Then they can resume that voodoo that Wall Street used to do so well: showing regular returns for investors.

This begs the question: how did they all come down with the flu and the same time? Here too we sort of know the answers. As best this non-economist can figure out there were two root causes. First, the Federal Reserve Board under Alan Greenspan had a low inflation policy, even at the cost of keeping credit artificially cheap for unusual lengths of time. This had the effect of encouraging borrowing and made it possible for many of us to live far beyond our means. This helped facilitate the second root cause: ever more complex financial securities tied to cheap credit provided to risky borrowers. They became popular because they required no government review. They had the effect of hiding the risk of investing in these securities while giving the cash-rich places to invest money that would otherwise go under a mattress or earn next to nothing in a bank account. They looked reasonably safe because they were packaged like a mutual fund and thus presumed less risky.

Like someone whose diet consists of nothing but nachos and cheese dip, there is eventually a day of reckoning. One day you find your bowels obstructed, your blood pressure high and your cholesterol levels are through the roof. The world now has all this and more. We gorged ourselves mindlessly on bad debt. Our coaches (Congress, President Bush and the Federal Reserve) encouraged us to consume even more nachos and cheese dip. Now we weigh five hundred pounds and can hardly move from side to side in our hospital bed. In fact, the orderlies are having a hard time moving us to change our bedpans.

It is technically possible for a five hundred pound man to get back to a slim one hundred fifty pounds with a diet lasting many years, but the odds are heavily against the patient. Once you are used to a diet of nachos and cheese dip, it is hard to eat salads. You might think though that those who are providing us the food might be at least providing us with healthy food. As best I can tell, when it comes to the financial industry, with some caveats, the answer is you are allowed to serve as much junk food as you want.

I looked up what it took to establish a bank in Virginia, the state where I live. You definitely need a lot of starting capital. You also need five directors who set the bank’s policy. In addition, you need to hire a CEO. Virginia does not specify criteria for such a manager, although it suggests:

a suitable background and adequate training, a strong, well documented record of accomplishment in banking at a comparable level, a capacity for leadership, familiarity with the current banking environment, analytical ability, and a realistic outlook.

State chartered banks in Virginia also are required to undergo a “supervisory examination” no less than every three years. However, the state does not actually audit the bank. In fact, it goes out of its way to calm potential fears of the bank owners:

Although in some instances fraud has been discovered during the course of a supervisory examination, detecting dishonesty is not a primary purpose of an examination. An examination is concerned with a bank’s financial condition, its compliance with the various laws and regulations and the soundness of its operating policies; it cannot be relied on to detect fraud and embezzlement.

Presumably, before a bank charter is approved, Virginia will at least give it a sniff test to see if it smells, but it is clear that in Virginia’s case bank supervision is mostly superficial. Moreover, there are no requirements that I can find that the bank’s managers must have actual banking education. (I was hoping for something more than “I know how to use Quickbooks”.)  On the federal level, most banks choose to be FDIC insured. Presumably, this brings some federal scrutiny, but clearly not enough to keep many of these institutions solvent. Even if the criteria are clear, enforcement can be problematical. Moreover, as the Washington Post reported recently, banks can and do “shop around” for friendlier bank regulators. It suggested that the federal Office of Thrift Supervision is one of the more lax federal banking regulators.

If my limited research is correct, banks can be managed and run by people who aren’t necessarily even qualified bankers. Even if they have experience in banking, it is not clear that they need a level of certification to be a banker. I would think the criteria for any banker would include being an accredited Certified Public Accountant. Presumably, a banker needs to know more than a CPA and should have a broad understanding of financial risk, credit worthiness, assets to debt ratios and the like. Maybe they do but apparently, most were asleep during the lectures in MBA School, as they gorged their balance sheets with dubious toxic assets, which were never accurately valued. Given that so many banks are teetering on the edge of insolvency, it is reasonable to think the problem exists both nationwide and worldwide.

Banking regulation may be scattershot but at least it exists. On Wall Street, apparently all sorts of new and creative financial instruments can be created with no government oversight. The Securities and Exchange Commission has many powers, but Congress limits its powers (and budget). Indeed, until recently we wanted to free Wall Street from the tedium of government oversight. By doing so, it was believed that they would be free to whip up the magic of the free market. I understand that if you do not manage a herd of cattle they tend to overgraze or could come down with ailments like Mad Cow Disease. The same appears to be true on Wall Street. All things being equal, Wall Street will look for ways to line their own pockets first and their shareholders’ second. This appears to be exactly what happened.

Where did all my money (and yours) go? Much of it went to buy stocks and funds at prices that were way too high because they were not accurately and independently valued. Much of it also went into the pockets of swindlers on Wall Street who used the money to buy estates in the Hamptons, private jets, and luxury yachts. The federal government largely looked the other way. We investors largely looked the other way too, assuming that we were “safe” if we spread our risk by doing things like investing in mutual funds. However, primarily it was those we entrusted with managing our money that deliberately looked the other way. They were anxious for a big bonus for making quick profits rather than to looking out for the long-term needs of investors. Take my financial adviser. He is a bright guy. He knows how to find a good bet on a mutual fund. Nevertheless, he like most of them was clueless about the size and scope of our current financial disaster. He should not have been.

Supposedly, animals know when an earthquake is coming and move to safer ground. Our financial industry needs to be like this. Our bankers are fiduciaries of a public trust: our money. They should all be certified to the highest standards, maintain current credentials and demonstrate their financial acumen by showing that their funds are invested prudently. They should take an oath to such effect, go to prison if they do otherwise as well as have their personal wealth returned to their customers in the event they fail.

Similar criteria are needed for fund managers. Before creating any fund, they need to demonstrate to the government that the fund accurately states the risk of ownership. Rating firms similarly need to be impartial; in fact, they should be nationalized. Our money is too important to leave its valuation entirely in the hands of the free market.

In short, these investments belong to those who own them. Fund managers are fiduciaries with a solemn obligation to act prudently in the best interest of the owners. Funds are not funny money; they represent real dollars and reasonable expectations of future income. Since they deserve a high level of scrutiny and oversight, these fund managers need sterling credentials, certifications and regular oversight too. As for new financial instruments, they should get an impartial government examination before they are allowed on the market.

These are the sorts of long-term steps we need to take to ensure we are never caught with our financial pants down again. Anything less means that we will see similar debacles like this again.

 

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