Reviewed February 2021
FINANCIAL SUPERSTRUCTURES AND MARKET RETURNS
Abstract: This article examines several aspects of the global financial system that significantly influence investment returns but cannot be quantified. These include U.S. Federal Reserve policy, global central bank policy, lobbyists and legislators, corporate "financial engineering", changes in SEC regulations, and financial media narratives among others.
Numerous institutions and businesses operate within or are associated with the financial and banking industries. Their interests and actions affect market returns and risks. A general descriptive word for them doesn't exist. I've chosen to use the term "financial superstructure". We think it is vital for all investors placing money in publically traded securities to have at least some understanding of these structures, the interests of participants within them, and their effect upon market risks and returns. These are the most powerful inhabitants of the global financial system.
Our analysis covers ten categories of financial superstructure: the Federal Reserve and central banks, shadow banking, economics and economic statistics, lobbyists and legislation, corporate financial engineering, high frequency trading, regulatory agencies, institutional financial services, the financial media and retail financial services. Each entity is presented in terms of its popularly promoted mainstream narrative compared to its deeper structure and operations.
These entities were chosen because directly or indirectly they influence financial markets and prices. The World Bank, the International Monetary Fund, the Organization for Economic Cooperation and Development, the Financial Industry Regulatory Authority, financial analysts, corporate accountants, auditors, bond rating agencies, and dark pools could also have been included since they too have a significant influence on financial markets. However, to keep this article to a reasonable length ten entities were selected which were considered to have the greatest influence. These are presented sequentially in their roughly estimated declining order of influence on financial market risks and returns.
Financial superstructures are infrequently mentioned in the academic literature on risk and return, probably because they can't be quantified. Antii Ilmanen, a portfolio manager and U.Chicago Ph.D. offers an exhaustive comprehensive analysis of research on investment markets in his book, "Expected Returns" (2011). Ilmanen reviews academic research and writing and covers historical data on equities, fixed income, real estate, currency markets, sources of premiums on stocks, bonds, currencies, commodities, and other asset classes, credit risk, tail risks, illiquidity premiums and virtually anything to do with investment risk and return. He, however, offers no references to financial superstructures.
We cannot put precise numbers on the extent to which these superstructures influence investment risks and returns. The structures themselves and their influence are always changing and evolving. For example, derivatives trade over the counter and in private deals with a small percentage, about 15%, tracked by regulators. They almost always involve very high leverage and despite industry claims to the contrary place many trillions at risk. As of 2019 over $200 trillion of these are held by the major US investment banks. In 1985 derivatives were a small and virtually insignificant part of the US or global financial system. Credit default swaps, CDS's, one form of derivative which prices off of fixed income and equity risk, were virtually nonexistent in the 1990's yet became a major contributor to the 2008 financial crisis. CDS derivative chains based on debt and promises between financial firms collapsed and counterparties couldn't pay. As of 2019 little of substance has changed and it could happen again. Financial superstructures have an impact, sometimes large, on market risks and returns yet when they will do so and how much they will affect them cannot be known in advance.
THE FEDERAL RESERVE, THE BANK OF INTERNATIONAL SETTLEMENTS,
AND THE BANKING SYSTEM
MAINSTREAM NARRATIVE: The Federal Reserve, the "Fed" for short, is the US central bank. It oversees US banking systems, makes sure there is adequate liquidity in the banking system, and ensures bank stability, stepping in if necessary during a financial crisis. The Fed also has a dual mandate to maximize employment and stabilize prices. Other than occasional glitches the Fed functions well and helps guide the American economy and banking. Rating agencies like Standard and Poor's and Moody's insure that bank capital is of high quality. Banks are responsible corporate citizens and make many contributions to national wellbeing.
DEEP STRUCTURE: Central banks certainly provide useful functions but it is by no means clear that they serve the needs of most of the citizens within their countries. They have very close relationships with the investment banking community and make decisions which beneficially influence their business. The NY Fed and Treasury Department meet frequently with the CEO's of JPM, Goldman and other mega-banks for advice and guidance. The US Federal Reserve is not part of the US government and is entirely owned by private banks. Not surprisingly, it's theories and actions serve the interests of bankers and the investment industry. Its supposed mandates are maximum employment, stable prices and moderate long term interest rates. The chairman and vice chairman and seven members of the Board of Governors are appointed by the President and subject to approval by the Senate.
Retail "corner" commercial banks, of course, provide many essential services that citizens need, cashing checks and offering conservative savings accounts and CD's. However, the largest U.S. banks today are mixes of commercial banks, brokerages and investment banks merged in complex corporate structures. The investment divisions of the firms engage in a wide variety of risky and speculative activities including buying or selling derivative products, guaranteeing debt in CDS's, levered high frequency computer trading, underwriting, and executing mergers and acquisitions. In the 2008 financial crisis the investment banks essentially took over the US Treasury when Hank Paulson, a CEO of Goldman Sachs, became Treasury Secretary. He then declared the large banks "too big to fail" and bailed them out with taxpayer dollars. Goldman and other major banks often give top employees substantial bonuses if they are moving from the investment firm into a government position. Wall Street always looks after itself.
Enormous wealth is available to those who reach the top of the banking and investment banking industry. Jamie Dimon, CEO of JP Morgan, and Llloyd Blankfein, CEO of Goldman, are both billionaires. Generating company profits and high incomes is the primary goal for those associated with the investment banking industry though that is not loudly announced in public. According to Lloyd Blankfein, "Goldman Sachs is doing God's work."
In 2008, the largest U.S. banks and investment firms began failing and Wall Street went to the Fed. The Fed provided trillions in secret short-term loans and generous securities purchasing programs and other forms of financial assistance. Following the financial crisis the Fed fought for years in court to avoid providing details of the money it funneled to Wall Street banks during the crisis. When the Fed finally lost the legal battle, the Government Accountability Office (GAO) tallied up the secret super low interest rate loans that were made with no public or Congressional disclosure. The final tally came to $16.1 trillion dollars. This is not money that anyone earned or that was paid in taxes; it is money conjured in the Fed's computers. Why the Fed should be bailing out private profit making investment banks when they get into trouble is unclear.
Had the Fed not rescued the banks from the results of their highly speculative and often profitable activities before the 2008 crisis it is very likely the banks would have failed and been dismantled. Instead, they now control more of the banking market then in 2008 thanks to the Fed and taxpayers. Prior to the removal of Glass-Steagull in 1999 taxpayers had not been responsible for speculative losses in investment banks since 1933. As of early 2017 the four largest U.S. banks, JP Morgan, Citi, Bank of America and Wells Fargo owned or had sold over $200 trillion in derivatives in notional value, substantially more than in 2008. And, about 85% of these derivatives trade privately between parties so the collateral and embedded risk are not transparent. Chains of derivatives often link together banks and counterparties which can fail if only one bank in the chain fails.
The banking industry's misbehavior is visible virtually every day in the financial press. Any mega-bank could be chosen, Wells Fargo, Goldman Sachs or others, but Citi provides a good example of mega-bank culture at the top. From 2008 through May, 2015 the Citigroup "rap sheet" of significant crimes it committed, by no means all of them, includes twelve very large fines for foreclosure fraud, selling toxic mortgage loans, rigging the Yen Libor rate in financial derivatives and rigging foreign currency markets. Worse still, whistleblowers within Barclay's and other major banks have been barred from the premises and terminated because they reported violations to their superiors or legislators.
Not encouraging is that there is a revolving door between Wall Street and influential Washington positions and between Wall Street and regulatory agencies that are supposed to oversee Wall Street. In September 2016 Wells Fargo was fined $175 million dollars by various agencies for creating phony accounts and cross selling and billing for unnecessary services. Fifty-three hundred employees were fired for their activities while the head of the group responsible for the fraud quietly left the bank with a $125 million dollar bonus, reduced a little by a $19 million clawback in unvested equity awards, free but promised stock grants that she wasn't eligible to receive yet. In November 2016 the Financial Times reported that Wells continues cross selling despite the scandal over sham accounts.
Mega-banks have fought all attempts to increase proposed capital requirements, improve asset quality, separate commercial and investment banking as it was under Glass-Steagall from 1933 to 1999, regulate derivatives in a transparent market or curtail high frequency trading. Glass-Steagall was put in place to stop Wall Street from doing what caused the 1929 stock market crash but was removed by President Bill Clinton in 1999 after intensive lobbying for over six decades by the financial industry. Dodd-Frank in 2010 was supposed to prevent irresponsible behaviors by investment banks yet has done little. The so-called Volcker rule separating commercial deposit taking banks from risky investment banks was never implemented though in weakened form it is still on the books as of 2017. The taxpayer is still on the hook should derivative problems in major banks develop as they did in 2008.
At the center of the global central banking system is the Bank of International Settlements (BIS), sometimes referred to as the central bankers' bank. It was created by the chairman of the Bank of England and the German Reichsbank in 1930. Its original mission was to oversee German reparations payments for WWI. It never did so. During World War II the BIS accepted looted Nazi gold, conducted foreign exchange deals for the Reichsbank, and was used by the Allies and Axis as a secret contact point for executing international financial deals. After that it should have ended but managed to reinvent itself as the center of global central banking. The BIS states that two of its key missions are to "serve central banks in their pursuit of monetary and financial stability…" along with "arranging short term credit to central banks when needed".
The BIS and its assets are legally beyond the reach of any government or jurisdiction. Swiss authorities have no jurisdiction over the BIS premises in Geneva, Switzerland. The banks buildings are "inviolable" and all attendees are assured of the highest levels of confidentiality. The BIS strictly guards the banker's secrecy. The minutes, agenda and actual attendance are not released in any form. No official minutes are taken. The BIS has the right to communicate in code and any of its correspondence is covered by the same protections as embassies meaning they cannot be opened. BIS employees are exempt from any taxes and all officials are immune under Swiss law for life for all acts carried out in their duties. BIS headquarters are stunning architecturally, high tech and with in-house medical facilities and a bomb shelter. The BIS strictly guards the banker's secrecy. Its meetings attract little notice from the financial press and most investors know no nothing about it despite its dominant influence on central banks. It also makes substantial tax-free profits.
Every two months the Economic Consultative Committee (ECC) within the BIS, a small and very select group of the heads of the most powerful central banks in developed countries, meets in Geneva. This meeting includes the head of the US Federal Reserve and the central bank heads of the European Central Bank, the Bank of England, Germany, China and other large developed countries. They enjoy superb food and wine and discuss central banking interests in private though central bankers not on the committee can observe but not participate. It is the most influential and exclusive of the BIS's numerous gatherings.
The ECC makes recommendations on the global financial system and presumably discusses interest rates, money supply, payments systems, financial markets, economic policy and other topics of interest to central bankers. We do not know for sure what is discussed since no notes are allowed and no recordings made. The perspectives from these secret meetings presumably influence central banking policy and consequentially affect financial markets and investment returns. What is discussed would certainly reflect current theory and research in mainstream academic economics. However, as noted below, economics is not a science and economic theory changes continuously over time. The effects of central banking theories and actions on financial markets are not at all quantifiable but are unquestionably very substantial.
SHADOW BANKING
MAINSTREAM NARRATIVE: The shadow banking system consists of financial entities and investment firms operating largely outside the formal central banking system. It consists of repurchase agreements, structured investment vehicles, complex derivatives, money markets, hedge funds, credit default swaps, asset backed commercial paper in mortgages and loans, and securities lending. According to the financial industry, derivatives allow easier access to credit and reduce risk in the financial system and the shadow banking system contributes to overall economic stability and growth.
DEEP STRUCTURE: In a June 2008 speech US Treasury Secretary Geithner, then president and CEO of the New York Federal Reserve Bank and a close friend of Wall Street, placed blame for the freezing of credit markets on a "run on the entities in the shadow banking system by their counterparties." Rather than reducing risk the global shadow banking system hides it and increases risk. It led directly to the 2008 financial crisis. It can be, however, very profitable for financial firms and banks. Numerous parties participate in the global shadow banking system including the largest investment banks, insurance companies, hedge funds, large speculators and others. Supranational organizations composed of multiple countries also participate and include entities like the European Investment Bank, the EU, the International Bank for Reconstruction and Development, the World Bank and the Asian Infrastructure Investment Bank. In 2016 supranational entities issued a record $256 billion of new debt according to the Financial Times (8-10-17).
Most derivatives are promises of varying complexity for repayment of the money invested if some event occurs at some defined time in the future. The majority of derivatives peg off of interest rates and bonds. Some are so complex that computer models must be used to construct them and few understand the risks embedded in the securities. Different from this is a money market, a straightforward form of short term debt though borrowers in the money market can and did get into financial trouble in 2008.
Credit default swaps are a form of insurance and often used by speculators or investors to guarantee bonds they hold or are traded for profit. Problems arise because the firms selling CDS's speculate in them and aren't required to have much if any capital set aside to cover claims. These claims can easily destabilize a corporation, as was the case with America's largest insurance company in 2008, AIG. AIG was bailed out for $165 billion, courtesy of the US taxpayer. Counterparties are sometimes linked together in collateral chains and if one fails it has a domino effect on others. Since the proliferation of derivatives is a relatively new development in financial markets we do not know how much embedded risk they contribute to the financial system nor how or when problems may surface during extreme market or financial events. Derivatives are supposed to be tracked by regulators but an estimated 85% of them are not.
ECONOMISTS AND ECONOMIC STATISTICS
MAINSTREAM NARRATIVE: Economics is an established field with knowledge based upon theory, economic data and statistical analysis. Economists help us understand economies and have developed many tools to manage modern economies better, help make them more stable and stimulate economic growth. Economic research influences public policy, banking, investing and financial markets in beneficial ways.
DEEP STRUCTURE: Economics is a branch of philosophy with many differing theories, models and opinions as to what data matters. It is a social science. New or modified theories appear from time to time and economic thinking has changed dramatically over the last century and continues to change. Unfortunately, extensive academic research has found that economic predictions are no better than chance guessing, that economists usually miss major turning points in the economy, and that major market events like manias, panics and crashes cannot be predicted.
Central banks, including the U.S. Federal Reserve, are run by economists and wield great power based on their theories. These theories today advocate the manipulation of interest rates, expansion of the money supply, repos, currency swaps, securities purchasing and other central bank strategies which support financial markets. After the 2008 crisis the Fed engaged in quantitative easing and other programs to support banks and investment firms which would otherwise have failed in true free market capitalism.
The methodology underlying the construction of economic statistics by US government statistical agencies has been continuously modified over the last three decades. Economic data from two decades ago or five decades ago is not comparable with much economic data today. The formulas for computing various economic indicators have changed substantially. And, past modifications in statistical analysis have almost always made the US economy look a little better. This is akin to flying an airplane with faulty gauges showing everything is fine.
Changes in government statistical methodology have included the removal of home prices from the consumer price index (CPI) in 1984. The imputed value of rent homeowners say they think they could get on their home, were they to stop living in it, replaced home prices in the CPI. Today this has resulted in about $1.4 trillion of hypothetical rent income added to the GDP annually and it removed the rapid inflation of home prices relative to rent prior to 2010. The Boskin-Greenspan Commission in 1996 resulted in a reduction in annual inflation reports by about 1% based on the disputable idea that the CPI overstates inflation. Hedonic and substitution adjustments to the CPI, introduced gradually over many years, significantly reduce the reported inflation rate. CPI is part of the GDP calculation and thus lower inflation makes the economy look stronger and reduces the rate of government transfer payments to retirees dependent upon Social Security, various forms of welfare, and government salaries. Since government produced economic statistics became popular after World War II their manipulation for political purposes has become commonplace throughout the world.
As of 2016, central banks globally are enamored with Keynesian economic theories. These theories emphasize stimulating demand in economies through low or negative interest rates, rapid increases in the fiat money supply, and securities purchasing programs. The idea is that easy money boosts consumption and securities prices which then augment production and economic growth. The central concept here is that consumption precedes production. This is faulty in that almost all historical evidence indicates that production, not consumption, is required to produce economic growth. There is also considerable historical evidence that that low interest rates and easy money produce a variety of economic ills over the long term including high levels of inflation, slow economic growth, and bubbles and crashes. Easy money theories, however, are very profitable for Wall Street and low interest rates allow the US government to borrow more cheaply and run up the federal debt more rapidly. As of 2019, US government debt, business debt and consumer debt are at high levels and rapidly climbing.
THE U.S. POLITICAL SYSTEM AND LOBBYISTS
MAINSTREAM NARRATIVE: Political systems developed to create order and stability and bring about better societies for their citizens, securing civilization and civil order through the rule of law. In the U.S. we live in a republican democracy where citizens have a significant influence over legislators and the legislation they write. Our political system generally reflects the will of the people and offers a choice of policies. Politicians generally have the best interests of the country at heart. Lobbyists help politicians understand key issues better and help legislators pass smart legislation that benefits citizens.
DEEP STRUCTURE: The U.S. political system as of 2019 cannot be said to be functioning well. Polls consistently show that only 15% or so of the general public approve of the job Congress has been doing and 70% or so of the public believe the country is headed in the wrong direction. In order to buy influence Wall Street, major corporations, and wealthy individuals provide funding to politicians of both parties through lobbyists, Political Action Committees, and other means. They are largely successful in doing so.
Politicians must continuously raise money to remain in office and those at the top of the financial system are happy to provide it. A political career can often become a lucrative career for politicians with the average net worth of Representatives around $3 million and that of Senators around $6 million. With these net worth numbers it appears the majority of our elected representatives are likely in the top 1%. When elected representatives leave office about half become lobbyists and many secure employment and very high incomes from the same corporations they passed legislation to benefit.
Perhaps the most detailed analysis of the effect of lobbying on legislators and legislation is that of Robert Kaiser, "So Damn Much Money" (2009). Robert Kaiser has monitored American politics for The Washington Post for nearly 50 years. In his book he examines the history of lobbying and how money from special private interests prevents legislation which is beneficial for the country, how special interests became the principal funders of elections, and how behavior that was once considered corrupt or improper has become commonplace. Lobbyists known for their ability to influence policy decisions have higher status in Washington than simple favor seekers or pursuers of earmarks for special projects within legislation. Lobbyists have become indispensable to politicians and sometimes tell PACs, political action committees, which representatives to give their money to. And, many studies show that lobbying is money well spent, often returning high multiples of the cost.
From the broadest historical perspective, political systems continually evolve in unpredictable ways as do their laws. This evolution can have profound effects on a nation's economy and markets. For example, the conclusion of World War I and difficulties with burdonsome reparations payments from Germany to the Allies led to German hyperinflation in the 1920's. This in turn led to the rise of Hitler, democratically elected in 1933. This quickly became a Nazi's military dictatorship, and led to World War II. World War II again destroyed the German economy. As a consequence, in the first half of last century the German equity markets gave no return for a 50 year period. Only Japan can claim the same distinction. Yet, World Wars are completely unpredictable. In 1900 it was widely believed that the destructive wars of the past millennia, almost constant, had come to an end. The failure of Germany and Japan to deliver positive equity market returns for the next 50 years would have been totally unpredictable in the year 1900 or for that matter even in 1940 before the outcome of the war was clear.
Gerald Cassidy, examined in one chapter in Robert Kaiser's book, is described as a modern day Jay Gatsby who built one of Washington's largest and most profitable lobbying firms and accumulated a personal fortune of more than $100 million. Ironically, Cassidy said he would support public financing of elections, noting that it will never happen. He also noted that moneyed interests often set a legislative agenda that flouts the public interest. "Everyone on Capitol Hill knows giving money leads to political access." Leon Panetta, former congressman, chief of staff for Bill Clinton, and head of the C.I.A. and Secretary of Defense, observed, "The lobbyists are in the driver's seat".
In one example Cassidy mentions the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, a legislative project driven by the banking and credit card industries. The Center for Responsive Politics in Washington, an independent group that studies politics and money, calculated that banks and credit card companies gave about $40 million to elected representatives to promote the new law. The act made it more difficult for consumers to evade paying their debt by declaring bankruptcy. The final version of the law forced debtors to repay their credit card debt even before they paid alimony or child support. The legislation essentially turns bankrupted people into paupers. Consumer groups and academic experts argued the act would create unfair burdens for families forced into bankruptcy but corporate promoters and their lobbyists obtained the legislation that benefited them anyway. Constant lobbying by financial firms affects Wall Street regulation and, in turn, investment risks and the economy.
CORPORATE FINANCIAL ENGINEERING
MAINSTREAM NARRATIVE: Corporations are legal entities which structure businesses. Laws govern them and larger corporations often sell stock in public offerings. The money from these public offerings provides capital to invest in growth and investors may buy shares to profit from that growth. Competent and highly paid people run these corporations and their main objective is to enhance shareholder value, a concept that evolved out of 1980's management theory. Management compensation rises with an increase in shareholder value since management receives large grants of stocks and options in the companies they oversee. This incentivizes management to grow companies. Overall, publically funded and traded corporations are the economic backbone of America and help companies innovate and grow and help the US economy grow.
DEEP STRUCTURE: As of late 2016 enhancing shareholder value has come to mean driving up share prices and increasing dividend distributions to shareholders through financial engineering and debt. The correlation of stock buybacks and equity price increases from 2013 through end 2016 had been close to 1.0 and that has continued into 2019 as quarter after quarter new buyback records are hit. Corporations in 2015 spent more than their net income on buybacks and dividends. Yet if corporations are to grow then capital expenditures, research and hiring are essential for driving that growth. These categories of corporate expenditures are declining. Essentially, shareholder enhancement as it is practiced in 2016 is a form of equity extraction. It drives up share prices and rewards large shareholders with wealth. Coincidentally, these large shareholders are top management, directors and financial institutions. Net corporate debt has risen $5 trillion or so since 2019, it is at record levels as of early 2019, and is rising fast.
Up until the 1990's corporations and the financial media reported earnings using Generally Accepted Accounting Principles (GAAP). Gradually, corporations and the financial media began to report non-GAAP earnings. GAAP earnings are largely honest earnings which include the cost of share buybacks and options grants and other accounting gimmicks which are omitted from non-GAAP earnings reports. The gap between non-GAAP earnings and GAAP earnings rose to record levels in 2015 with non-GAAP earnings 27% higher than GAAP earnings. GAAP earnings are typically hidden in footnotes. All these maneuvers make corporate financial health look far better than it is, detach stock prices from underlying fundamentals, and keep investors eager to invest.
HIGH FREQUENCY TRADING COMPUTERS
MAINSTREAM NARRATIVE: High Frequency Trading, HFT, involves the use of supercomputers which purchase prices directly from exchanges. HFT data arrives in nanoseconds and HFT computers often place "flash" trades which only last for milliseconds. Algorithms, basically complex if-then statements in long chains, are run as data or news comes off of exchanges on laser beams faster than fiber optic cables can carry the data or computers are co-located just feet from the exchange's computer price data. The majority of trading today on the New York and Nasdaq exchanges today is done by HFT computers. HFT provides liquidity for markets and help markets operate more efficiently in setting prices.
DEEP STRUCTURE: HFT has nothing to do with investing based on company fundamentals or macroeconomic conditions or any information investors are likely to obtain from the mainstream financial media or their computer screen data. Up until 2005 HFT didn't exist. In 2002 the major exchanges began to sell data to investment firms, delivering it tiny fractions of a second before the general investor saw prices on their screens. HFT is a form of ultra hi-speed computer trading and front running. Machines place the trades with no human involvement.
Ph.D.'s rewrite the computer trading programs daily. HFT trading systems are very expensive to set up and run so ordinary investors cannot participate on their own. One common HFT tactic involves "spoofing", placing bogus orders to create the illusion of substantial supply or demand, thus moving prices. Computers then cancel the orders before they can be executed allowing the spoofer to exploit the manipulation for their own gain. HFT profits result entirely from getting pricing data nanoseconds faster than other investors. Essentially, this is a form of market rigging in microseconds.
There is extensive evidence that HFT is harmful to securities markets and that the rationale backing it is faulty. When prices are dropping HFT computers instantly remove bids and liquidity disappears completely, sometimes leading to flash crashes in prices. When prices are rising HFT fuels gains artificially by buying the momentum until it dissipates and bids disappear. Exchange traded funds, ETF's, are heavily traded by HFT and have had some spectacular price collapses, "flash crashes", as have individual stocks. This is discussed elsewhere on our website in "DFA vs. Vanguard vs. ETF'S". HFT increases market risk and price moves can be extreme with large price declines and reversals in short periods of time. Major firms like Goldman utilize HFT extensively in proprietary trading even though many in the financial industry have called for a ban on HFT. It is highly profitable.
REGULATORY AGENCIES
MAINSTREAM NARRATIVE: Regulatory agencies like the Securities and Exchange Commission, the Financial Industry Regulatory Authority and the Commodity Futures Trading Commission oversee financial markets to protect investors, establish rules for markets, and ensure markets operate with integrity. They identify and prosecute those participants in the industry engaged in exploitative or illegal practices. The Federal Reserve sets rules to insure banks are solvent and can handle financial stress. Regulators insure that markets work well, minimize systemic risk, and are fair to investors.
DEEP STRUCTURE: Regulatory authorities are substantially controlled by those they are supposed to regulate, prosecutions are rare, suspensions for flagrant securities violations often allow bad actors back in the markets quickly, and penalties are typically well below the profits made from violations and companies can afford them. Management level executives even purchase insurance with corporate funds to protect themselves from personal lawsuits and fines are paid from company cash flow. Personal consequences for violating rules are typically small and very rare. Fines are considered the cost of doing business. Legal settlements are almost always phrased as "X corporation agreed to pay the regulator Y dollars, neither admitting nor denying allegations."
Wall Street incessantly lobbies Congress to reduce funding for regulatory agencies and dilute or remove regulations that might reduce profits. It employs armies of attorneys who are specialists in securities law and negotiating with regulators. It also is a big contributor to political campaigns. The usual sales pitch is that regulation is oppressive and harms free markets, investors and the economy.
During President Clinton's second term, the president removed safeguards for the US economy and banking system put in place by Glass-Steagull in 1933 and also signed into law the Commodities Futures Modernization Act. Glass-Steagull separated commercial banks and investment banks from 1933 to 1999. These changes minimized regulation in derivatives markets that led to the 2008 crisis and taxpayer funded bailouts of investment banks.
A revolving door exists between investment firms, regulators and Washington. During 2008 Congress was persuaded that large profit seeking US investment banks were "too big to fail" by Hank Paulson, former C.E.O. of Goldman Sachs and the current Secretary of the Treasury. Mr. Paulson saved about $150 million in personal taxes due to his brief time in Washington due to an exemption on capital gains for the Treasury Secretary as he sold his Goldman stock. Prior to 2008 few if any enterprises were considered too big to fail and the concept is certainly not compatible with the ideas of free markets, succeeding or failing, and a competitive capitalism where companies can fail.
One of the highly prized slots in any administration is Chair of the Securities and Exchange Commission. President Trump nominated Jay Clayton, a law partner whose firm had represented Goldman Sachs since the later 1800's with Clayton himself serving as Goldman's outside legal counsel. He was confirmed. Clayton's wife, Gretchen, had worked at Goldman for the prior 17 years, rising to Vice President as a wealth manager. Wall Street enjoys a strong influence in Washington and is actively engaged in political fund raising, lobbying and regulation at many levels.
THE INSTITUTIONAL FINANCIAL SERVICES INDUSTRY
NARRATIVE: The institutional side of the financial industry caters to pension funds, endowments, foundations, corporations, hedge fund managers, private equity and high net worth private investors. Institutional investors are offered all manner of services and investments ranging from underwriting securities and lending to customized derivatives for risk management. The ostensible purpose of these services and investments is to manage risks, raise capital, and grow assets. Investment banking is essential to capitalism and free markets and a key source of corporate and national wealth and growth.
DEEP STRUCTURE: Information provided to institutional investors is similar to that provided to retail investors but is generally more varied and sophisticated. Offerings are often complex and difficult to understand. Institutional investors are often given access to investments not typically available to smaller investors, investments like derivatives, hedge funds, and private equity. As is the case with retail brokerages, potential returns are emphasized and costs and risks are downplayed.
Asset management fees are generally quite high with hedge funds and private equity collecting a 2% management fee and 20% of the profits. Investment bankers often take 5% of a stock issuance. Some top managers and deal makers can become billionaires. Although institutional brokerage activities benefit businesses and the economy by providing capital for operations and expansion most of the services provided do not directly generate new goods or services. Wall Street works primarily with digital and paper assets, not directly with physical things, and makes its living from moving money around in one way or another or in recurring fees.
Investors should always remember that Wall Street is a profit seeking engine whose primary purpose is to generate revenues for itself. Financial markets were not created to help investors make money but to enrich those who create securities and cater to the gambling instinct that is common to humans. A 1930's stockbroker Fred Schwed captured the self-interest of the industry in the title of his very funny 1940's book, "Where are the Customers Yachts?" The biggest winners in the investment industry are those in the industry. Corruption and scandals are frequent and consistent throughout financial history.
The institutional side of Wall Street and the investment banking industry is constantly involved in legal misbehavior and regularly pays large legal fees to defend itself and large fines to regulators, usually not admitting or denying guilt. It is widely believed the firms consider the fines paid a cost of doing business. In December 2016 the Commodity Futures Trading Commission (CFTC) ordered Goldman Sachs to pay a fine of $120 million for its rigging of the US dollar Isdafix interest rate that benefitted its interest rate derivatives in the $300 trillion market for interest-rate swaps. The CFTC also fined Citigroup $250 million and Barclays $115 million for manipulating Isdafix interest rate swaps.
Of course, those who work on Wall Street are pleased when investors are pleased but getting paid well is what comes first. Values such as advancing capitalism, discovering prices, or facilitating a prosperous and stable national economy are secondary if considered at all. Wall Street's excesses have led to serious economic problems for the U.S. and its citizens on many occasions, the most recent being in 2008. The comments below regarding retail brokerage services also apply to institutional services though information and services provided at the institutional level are far more sophisticated and most firms trade their own proprietary accounts in addition to client accounts.
THE FINANCIAL MEDIA
MAINSTREAM NARRATIVE: The financial press and media present countless financial and banking experts, portfolio managers, pundits, predictions and investment recommendations. Investors are offered advice on how to adapt their investments to the ever changing news flow, the best mutual funds or advisors and new investments, data on the economy, tips on taxes, financial planning and just about anything related to money and investments.
DEEP STRUCTURE: Financial media can be a source of information and learning for investors. However, experience, knowledge and skill is necessary to determine the quality of the information and whether Wall Street or investor interests come first. One main function of the financial media is to whet investor's appetites and stimulate interest in financial products and services. The media's aim is similar to that of the financial industry, generating revenues, but its revenues come from selling investment related advertising, not investment services.
Major financial information providers like the Wall Street Journal, CNBC, and CBS Marketwatch tend to select stories and data which reflect an optimistic viewpoint on the markets and often omit or spin data which would present the market and economy in a negative light. Information presented is typically ahistorical and simplified rather than detailed and presenting the genesis of opportunities and problems and their complexity. There always seems to be a hot idea or new data that requires action by investors. Accuracy and depth is not the financial media's aim though appearing to be objective and helpful for investors is.
For example, on October 28th, 2016 the Bureau of Economic Analysis announced its "advance" Q3 2016 GDP growth estimate of 2.9% versus an expectation of 2.5% and much above the prior two quarters in 2016. CNBC, the Wall Street Journal and other mainstream financial media headlined "Best economic growth in two years" and "Data dispel fears of economic slowdown". Virtually all government statistical agency data is announced in the financial press with an optimistic tilt.
Under the surface the Q3 2016 GDP number was far less robust than the headlines, in fact weak. First, this is an "advance" estimate and refers to an annualized estimate formed by taking the Q3 estimate and multiplying it by four. The same thing was done again in Q119. Advance estimates are almost always revised substantially downwards. Inventories, already high, added 0.61% to Q316 GDP, not good since these aren't sales, and exports added 1.17%. Oddly, soybean exports were responsible for about one-third of the growth in Q3 2016 GDP. This is an extreme statistical outlier and makes little sense given soybeans are usually 1% or so of total US exports. Personal consumption expenditures, the consumer, typically accounts for about 70% of GDP. That slid from Q216 to Q316. Capital expenditures by business declined for the fourth consecutive quarter, something never seen outside of a recession and important for future growth. Removing inventory builds and exports of soybeans, Q3 2016 GDP growth was a little over 1% as it had been in the prior two quarters. Financial media kept spirits high with a happy headline of growth.
THE RETAIL FINANCIAL SERVICES INDUSTRY
MAINSTREAM NARRATIVE: Glass-Steagull was passed by Congress in 1933 to prevent a repeat of the 1929 market crash and its economic repercussions. It clearly separated conservative commercial banks and risky investment banks. With its removal in 1999 the banking and financial industries today have largely merged into larger companies, often called financial services companies. Commercial banks serve retail customers. They offer bank accounts and savings and CD accounts and are guaranteed by the FDIC and also often offer various investments. The retail component of the financial services industry provides a wide variety of investments, advice and services through brokerages. Retail marketing materials and advertisements emphasize that they help investors invest wisely, manage finances, grow their net worth, and plan for or enjoy retirement.
DEEP STRUCTURE: The retail financial services industry serves many essential functions. Long term investments do need to be made and many intelligent people want some guidance in investing and retiring. Yet, the financial industry is a sales business and its primary driver is profit. Competition is fierce at every level because big players in the industry can become wealthy. Financial professionals want to sell investments.
Though helping clients with financial matters and investments is important the desire for income is the overriding motivation for participants in the industry. Career advancement and iincome growth comes from generating high commissions and/or fees. Costs to investors are often hidden or hard to determine and risks are underemphasized. Research indicating low cost passive and index portfolios outperform active portfolios long term is seldom mentioned and numbers are presented to investors which have questionable statistics as their underpinning. Their aim is to motivate investors to place their money in investments and positive narratives help sell investments.
It is relatively common for employees in financial services to run afoul of regulatory agencies and laws and fines, lawsuits and arbitrations are nearly continuous. Scandals erupt regularly. As of 2016 the broker/dealer industry is actively fighting the imposition of fiduciary requirements on its stockbrokers. A fiduciary requirement would mean that retail brokerages must operate in the interest of their customers. Registered Investment Advisory Firms with the S.E.C., mutual fund managers, and C.P.A.'s have a fiduciary requirement. It would certainly seem reasonable that anyone dispensing investment advice to the public and profiting from it should be a fiduciary.
Retail investors are frequently presented with analyst predictions and investment advice, much of which represents the self-interest of the firms. Analyst forecasts have been carefully analyzed by academics and they are almost always overly optimistic. Negative forecasts are hard to find. In one large study of market forecasts covering 18 years and 186 public forecasts, analysts forecast a real return of 9% per year and a standard deviation of 8%. Actual real world market returns were 4.5% and the standard deviation was 19%. It is the rare analyst who can consistently offer recommendations which outperform the market, most perform at the level of random chance and past errors are rarely noted. Active mutual funds often carry high embedded costs of 1.3% or more. Active managers and retail brokers promoting their funds generally avoid these topics.
THE 2008 FINANCIAL CRISIS AND FINANCIAL SUPERSTRUCTURES
Various patterns of returns can be observed as we look at Dimson et al's research on over a century of financial market data from 25 countries. It may be found in "Triumph of the Optimists" by Dimson et al. and the Credit Suisse annually updated "Annual Investment Returns Yearbook" online for free. Certain generalizations about financial market risk and return can be made, for example equities produce higher long term returns than bonds and value stocks produce higher long term returns than growth stocks. However, we are adrift in a world of constantly evolving economic theories, regulations, security types, and unexpected economic events and ever changing market prices and sentiment.
Future returns in financial markets are not predictable except over very long periods. Nothing is for certain about tomorrow's securities prices today. Historical data show that on rare occasions it has taken equity markets 20 years or more to produce breakeven returns. Declines of 50% or more in equity portfolios have occurred on several occasions. Let's take a look at the 2008 financial crisis and how various components of the financial superstructure played key roles in creating it.
In the second half of the 1990's an equity bubble emerged in US equities and particularly in internet and technology stocks. In 1996 Fed Chairman Alan Greenspan expressed concern about "irrational exuberance" but continued to rationalize that a "new era" had come and provided cheap money to Wall Street and the economy. In 1999 the Nasdaq 100 doubled, peaked in early 2000, then lost about 80% of its value by 2002. Along the way to the 2000 top, the retail and institutional investment industry, the financial media and the Federal Reserve generally acted as cheerleaders citing a glorious future ahead for the US economy. Investors responded by buying equities and doubting voices were seldom heard.
In order to stimulate the economy after the Nasdaq and other markets crashed in March 2000 Fed chairman Greenspan cut interest rates from 5% on short term money in early 2000 down to 1% in June 2003, stimulating the reemergence of a new bubble in real estate and equities. Then, from 2004 through 2006 Greenspan raised rates 17 times up to 5.25%. They stayed there until late 2007, then were dropped to 0.0% to 0.25% when the financial crisis hit in 2008. They remain in a low 2.25% to 2.5% range as of early 2019 although the financial media constantly reports a strong recovery has occurred. Prior to 2008 interest rates had never been at 0.0% to 0.25% in the US. Cheap money leads to high equity, fixed and real estate prices.
The shadow banking system expanded rapidly in the 2000's, developing a multi-trillion dollar CDS market to insure bonds and mortgages and a derivative market in the hundreds of trillions. Bond rating agencies gave packaged syndicated mortgage pools with poor quality debt AAA ratings. Proponents of this new era financing, including Fed Chairman Greenspan, claimed that innovative financial engineering reduced risk in financial assets. Wall Street, the financial media, most economists, the housing industry and Washington applauded these changes in the structure of the equity and debt markets and pointed to ever rising equity and housing prices as confirmation of their effectiveness.
But problems with the economy and housing markets began to develop in 2007 and reached crisis proportions by mid-2008. Housing and stock prices fell fast and in March 2009 the Federal Reserve stepped in and began to buy assets from major banks, taking distressed assets off of bank books and providing liquidity. Federal Reserve money is simply conjured out of thin air and is not the result of production or taxes. At the root of the 2008 financial and economic collapse was too much debt. The Fed attempted to fix the problem by stimulating the US economy with zero percent interest rates and still further very large increases in debt. The US Treasury also contributed by adding over $9 trillion of US debt from 2009 through 2015, more than had been borrowed in the prior 200 years.
By the end of 2015 US government debt had risen over $9 trillion since 2009, roughly doubling all US debt created since 1776, corporate debt had risen about $4 trillion dollars and consumer debt had risen by over $1.0 trillion dollars if student loans and auto debt are included. By Spring 2019 total US government debt alone had grown to approximately $22 trillion. The Fed's theory was that cheap money would stimulate the economy. It didn't. Over that seven year period from 2009 through 2015 US GDP only rose about 15% while stock prices rose 250% or more and home prices rose about 30%. Cheap money stimulates asset prices and Wall Street and the financial industry cheered this on. Bonuses on Wall Street were healthy.
As the above analysis illustrates, investment returns and investment prices are constantly influenced by the interests and actions of numerous financial superstructures and their interactions with each other. In mathematical terms, markets are complex non-linear adaptive systems. That's why they are unpredictable. A new market event is not disconnected from prior events or other simultaneous events and multiple components of the financial superstructure are unpredictably influencing each other. And, components of the financial superstructure are constantly changing and evolving within themselves. This then feeds back into still other components within complex banking and financial systems and each component is affected by and adapts to other components as they change. Complex adaptive systems oscillate between randomness and order and do not seek equilibrium, unlike a coin toss which has the same probability of heads or tails coming up each time it is tossed. A complex non-linear adaptive market pricing system can lead to asset class returns that drift far outside long-term historical norms, generate manias, panics and crashes, and the causes the general unpredictability of risk and return that confronts all investors.
CONCLUSION
Most models of investment strategy focus on the historical performance of asset classes, how to capture premiums for asset classes or segments within markets, valuation metrics based on financial statements, mathematical trading systems, and macroeconomic theory and data. The financial superstructures examined above obviously influence investment risks and returns. Yet, their substantial influence is infrequently if ever mentioned in the large library of investment research that academics and the financial industry have generated. Their influence can't be quantified in a statistical manner like modern portfolio theory or historical asset class returns and that may be why financial superstructures are minimally studied by academics. The assembly of quantifiable data is far more likely to result in academic publications, investment models, industry awards, and sales pitches for financial products.
Since financial superstructures have a significant impact on future financial market returns, volatility, and worst case declines it shouldn't be at all surprising that future investment returns, market volatility and huge market declines are so unpredictable. The financial superstructure is always changing and the effects of those changes often take many years to manifest themselves. Would anyone in 1990 have known that Glass-Stegall would be removed in 1999 or the Commodity Futures Modernization Act would be put in place in 2000? Would anyone have known in the early 1980's that the theory that Paul Volcker used to justify very high interest rates would later be replaced by Keynesian theory which puts demand stimulus and consumption before production and advocates cheap money policies and very low interest rates? Would anyone in 2000 have known that high frequency trading by computers would come to dominate exchanges after 2008 or that $15 trillion or roughly 45% of all global sovereign debt would carry negative interest rates in 2016? The concept of negative interest rates only emerged around 2005. It could be that the financial superstructures examined above are the major source of market unpredictability and variation in investment risks and returns. We have no way of knowing if this is so but we do know that markets are complex nonlinear adaptive systems.
Most of the motivations and actions of the individuals employed in the various components of the financial superstructure described above are fueled by self-interest. Professional participants in the financial superstructure see things through their own particular frameworks since they are human and they don't necessarily agree with each other at all. Unfortunately though, when financial superstructures malfunction they can cause major damage to economies and societies and even lead to political upheavals.
RELATED READING: The following books examine various aspects of financial superstructures. They offer writing and research by well-known journalists, academics, attorneys, and financial industry insiders.
Acemoglu, D. & Robinson, J. "Why Nations Fail"
Berenson, A. "The Number"
Black, W. "The Best Way to Rob a Bank is to Own One"
Das, S. "Traders, Guns, and Money
Fleckenstein, W. & Sheehan, F. "Greenspan's Bubbles"
Freeland, C. "Plutocrats"
Gillispie, J. & Zweig, D. "Money for Nothing"
Harwood, J. & Seib, G. "Pennsylvania Avenue"
Johnson, S. & Kwak, J. "13 Bankers"
Kaiser, R. "So Damn Much Money"
Keen, S. "Debunking Economics"
Kurtz, H. "The Fortune Tellers"
Leblanc, R. & Gillies, J. "Inside the Boardroom"
Lebor, A. "Tower of Basel"
Lessig, L. "Republic Lost: How Money Corrupts Congress"
Lewis, Michael. "Flash Boys"
Mann, T. & Ornstein, N. "It's Even Worse Than It Looks"
Morgenson, G. "Reckless Endangerment"
Navidi, S. "Superhubs: How the Financial Elite and Their Networks Rule our World"
O'Glove, T. "Quality of Earnings"
Partnoy, F. "Infectious Greed"
Phillips, K. "Wealth and Democracy"
Ritholtz, B. "Bailout Nation"
Schilit, H. "Financial Shenanigans"
Sherden, R. "The Fortune Sellers"
Soltes, E. "Why They Do It: Inside the Mind of the White-collar Criminal"
Stockman, D. "The Great Deformation"
Suskind, R. "Confidence Men"