In March 2009 I wrote an article offering my thoughts on what caused the market crashes in 2008 and the Great Recession. Here we are almost seven years later, and almost nothing has changed. Take a look at what I said and you'll see why.
U.S. financial institutions were for many years the product of the best and the worst aspects of our economic system. They were rightfully the envy of the world and ambassadors of capitalism around the globe. When functioning at their best, these institutions were responsible for unmatched real wealth creation for their clients, their shareholders and their employees. Unfortunately, the worst of our current system was also on display in the manner in which these institutions managed their own businesses as off balance sheet liabilities, excess borrowing, and taking extremely large and risky positions became all too common. Then came the rise of irresponsible executive pay in the form of outsized bonuses with no regard to performance and the explosion of irresponsible issuance of company stock and stock options.
This has all led to where we are today. The very existence of many of our major financial institutions is in question and the radical restructuring of our economy is becoming a real possibility. Citicorp was once considered the vanguard of U.S. capitalism. Bank of America was the entrepreneurial success story of the western expansion and conservative banking. General Electric Credit was the AAA rated underwriter of the world's biggest companies. All of these and many others are now only shadows of what they once were because of the self-interested "heads I win, tails you lose" approach they all followed.
The captains of Wall Street were allowed to put themselves in a position to make huge personal gains with essentially no personal risk. They were able to pass the risk to others - namely the shareholders of enterprises whose interests they were supposed to advance. Our free enterprise system only functions well when risk is rewarded and failure is penalized. Over the last few decades, there has been an increasing disconnect between the interests of shareholders and employees in large financial enterprises. How did this happen? As public corporations became larger and larger, the employees of the financial firms stopped representing their shareholders and found more and more ways to profit themselves. All too often this was done at the expense of the very shareholders they were supposed to protect. These "masters of the universe" first convinced themselves and then somehow others that they were entitled to huge compensation when they were successful in taking huge risks with other people's money. If risky bets paid off, there was gargantuan compensation for the employees. If those risks did not pay off, the losses would belong to the shareholders. Amazingly, large compensation continued to be paid to the employees even when the bets failed. This was often justified by the "fear" that these employees would move to competing firms.
If people truly risked their own capital, then those who made profits in one year but suffered losses later would have the prior years' gains offset by losses. This has not been the case for Wall Street's employees where bonuses in one year never have to be recouped. In fact, bonuses remained at high levels even in years of under performance. What was the penalty for poor performance? If losses ever became too large so that bonuses were curtailed, then the employees would simply move to similar firms and start again at continued high compensation.
This result of "heads I win, tails you lose" is not a failure of unregulated capitalism. It is a failure of the representatives of the shareholders to exercise their fiduciary duty. No one with his or her own money at stake would have taken "bet the company" risks the way that Wall Street did. However, it is quite reasonable for those with limited personal financial exposure to take large risks on which they have much to gain on their lucky bets when others take the financial hit for the bets that do not pay off.
Who with their own money would: a) leverage their own investments 25 to 1, so that a 4% decline in asset value would result in bankruptcy? b) pay an outside manager $50,000,000 for gambling with their money? c) pay large bonuses in a year in which there were large losses? d) reward those who put short term profits ahead of long term survivability of their firms?
Similarly, who would have made a sub-prime mortgage with their own money? Would any prudent investor risk his or her own capital to make a loan to someone who (a) clearly had no ability to repay the principal of the loan, (b) could not even pay the interest under the loan once the initial ("teaser") rates were adjusted (and maybe could not even pay at the teaser rate), (c) had no equity in the property so that even if the property actually maintained its value, the lender would lose about ten percent of his investment in the event of foreclosure, or (d) had either no credit history or horrible credit history? Who, representing his or her own interest, would make decisions by assuming that prices could never fall? Who would believe that a pool of unsafe mortgages becomes safe only because there are a lot of them in the pool? (The current default rate of sub-prime mortgages is over 43%!)
If our system is to function efficiently, then we must get rid of "heads I win, tails you lose." Our system will continue to fail us until we restore the relationship between risk and return to the individuals who actually make the investments (bets?). The western capitalist system has worked quite well over the past two hundred years. It has created unimaginable wealth for the masses as well as the wealthy. However, the directors of large public corporations must start exercising their fiduciary duty. Great wealth should be reserved only for those who (1) successfully take risks with their own money, (2) successfully innovate and develop new products, services and enterprises, and (3) truly increase the wealth of society. We need to stop paying huge sums to those who merely manipulate our system, gamble with other people's money, pretend they know more than the rest of us, put us all at risk of systemic failure, and continue, unapologetically, when their very actions lead the entire financial system to near cataclysm.
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Leland Faust is a financial expert, author, speaker and triathlete. He is the founder of CSI Capital Management and served as Chief Investment Officer for 33 years, managing over 1.5 billion. He is one of only two investment advisors to be included in the list of 100 most powerful people in sports by the Sporting News. He was selected by Barron's as one of the top independent investment advisors in the country. His first book is scheduled to be released in the fall of 2016 and he is available for speaking opportunities. Follow Leland on twitter @LelandFaust.