Sunlight is said to be the best of disinfectants; electric light the most efficient policeman. – Louis D. Brandeis. Other People’s Money and How the Bankers Use It (1914)
The problem with Other People’s Money (OPM) is investors are not as careful spending it as they are with their own. They take greater risks than warranted. They don’t scrutinize as closely as they should. They don’t check to see if they are being blinded by undue optimism. They don’t build sufficient protections or stop-loss triggers into investments.
How do we as a society institutionalize an investment culture that encourages private risk-taking but not recklessness? We’re not just interested in fraud. We seek to correct an attitude that often considers other people’s money as less important than our own.
How do we prudently invest grandma’s retirement money?
Academics often incorrectly believe it’s enough to make sure everyone has skin-in-the-game. But creditors, investors and investees are susceptible to herd instincts. They become blind to risk. Blind to their own self interest.
There are potentially four players in every OPM transaction: the owners of the money (creditors), the investors, the investees, and in the case of bailouts the government (i.e., the taxpayer). Each potentially engages in activities that undermine a prudent investment culture, for example:
- Owners of money (creditors) succumb to panic buying. Bernie Madoff recounts how family and friends begged him to take their money for his Ponzi scheme even though he tried to warn them off.
- Investors ignore risks, assume too much risk or carelessly discount risks. Investment bankers recount how in the 2008 crisis they continued their plunge into mortgage-backed securities merely not to fall behind their peers in sales or salary.
- Investees understate risks or their own creditworthiness (e.g., liar loans). These are typically homeowners or businesses.
- Governments foster carelessness by providing too many examples of bailouts for poor investment or business decisions (i.e., too big to fail)
We must set up institutional structures with explicit recognition of these and other self-destructive behaviors. We must place at our disposal a panoply of techniques. This is not one-size-fits-all.
Not Quite a Ponzi
People put a gun into the hands of criminals and then act surprised when the criminals turn around and rob them. You give a pile of money to investment bankers which they use to lure in more money. When the pile gets big enough they take it all.
Investment bankers pay out good returns to early investors. People get addicted to the gains. They get complacent.
In the background, deep within the investment financial books, trouble is brewing. Management sees it but the investor only sees regular returns. Risks in the underlying investments are quietly growing in line with the steady gains seen by investors.
A few shaky investments are kept alive using a rolling debt scheme. More bets are placed on high risk investments with early returns. The portfolio of blue chip investments is sold off to maintain the façade of steady growth.
Illiquidity is building in our portfolio and lo! along comes an economic crisis. Everyone takes a bath. Only our investors take more of a bath without fully realizing it. We had plenty of bad investments on the books and the crisis gave us the chance to quietly unload them. We love crises.
Now we can start the next round of luring money into our new and improved mutual fund, pension fund, investment fund, etc.
The smart money on Wall Street is quite adept at this methodical theft of American wealth. Especially from the middle class who mindlessly hand over their savings in response to slick promotional materials.
You lost money on Wall Street? Pour into the streets in protest. Changed the world didn’t you?
To fix ‘the system’ you need to fix all the players: creditors, investors, investees and governments.
It costs money to properly institutionalize risk management protections (i.e., reduced investment returns) but I look upon them as barriers to entry for global banking center wannabes. If I were the Saudis I would put these protections at the heart of a new global banking center backed up by Sharia Law: infractions result in loss of limbs. Real skin (and bones) in the game.
Build these protections into trading markets to keep the U.S. and U.K. at the center of global capital formation and investments. Today we enjoy a scale of capital formation where we can implement these at a very low cost to individual financial institutions.
All players lose when an investment goes sour. The classic example is the requirement for homeowners to put 20% down on a home purchase. We don’t want homeowners walking away from mortgages when times get tough. It sends a signal that the borrowers have some financial wherewithal. Similarly we don’t let mortgage originators walking away from their loans: they must self-finance a meaningful portion of every mortgage they write.
If shares in an investment are to be sold to the public through exchanges, mutual funds, investment fund, investment houses, etc. they must retain ownership in a meaningful portion of those shares. Public sales must be subjected to more than today’s token oversight required for an exchange listing. Owners of sales channels must also participate in losses.
Mandate periodic, forced liquidation of entire investment portfolios to shake out systemic risks. Twice year an investment house must sell off their entire portfolio and settle with investors. A few days later investors can return. Obviously we stagger this practice across investment houses. Obviously we fix the tax code to avoid negative tax implications.
This is an auditing technique that assumes a worst case scenario just happened. An army of examiners descend on a firm or an industrial sector to find out what happened. We carefully define the collapse scenario and don’t rest until we uncover its causes (counterfactually). We use these findings to proactively strengthen protections for current and future investments, and to work with firms found to be on shaky grounds.
We set up sting operations to catch people likely to perpetrate scams involving highly leveraged, high-risk investments using Other People’s Money. This includes covertly placing law enforcement officials into positions of authority within financial institutions to combat control fraud.
Short Sales Markets
We mandate short sales markets get established for new financial innovations flooding Wall Street (e.g., mortgage-backed securities, credit default swaps). Investors must be able to bet against the success of an innovation, as financed by the innovators.
How do you fairly share a cake between two kids? Let the first kid cut and the second gets first choice. All investment bundles must be packaged separately from those who buy and sell them.
Set it up so creditors in high-risk investments routinely lose. Government loan guarantees and bailouts must contain a lottery provision: they will automatically not be honored or invoked in a random 25% of cases. Creditors beware.
You can’t participate in public financial markets (in any capacity) without a license. You lose it should you get caught in an OPM collapse.
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The listed techniques are illustrative. There are many more. The examples under each technique are illustrative.
My intention was to give a flavor for the variety of techniques available and not their inner workings. Not all are practical for all investment decisions. Consider them as rubrics for further study and consideration.
A 2006 $5.4 billion highly leveraged buyout of a large middle-income housing project ₪ in lower Manhattan was made with the intention of converting 11,232 rent-stabilized apartments to market rate. The tenants association went to court and successfully blocked the conversion. Rent-stabilized checks could not cover the buyers’ debts so the orchestrators of the investment scheme simply walked away (Tishman Speyer Properties and BlackRock Realty) leaving investors to bear the losses.
CalPERS [the California Public Employees’ Retirement System] lost $500 million. A Florida pension fund lost $250 million. The government of Singapore lost over $600 million. It all just went poof.
Tishman Speyer & BlackRock acted as real estate brokers (the investees). Pension funds and governments were the investors. They invested pensioner and taxpayer monies (the creditors). Pension funds had skin in the game. They took a serious bath and passed this loss onto the creditors, who had no recourse to recover their losses.
Skin-in-the-game for the real estate agents would probably not have averted this botched deal, though it may have unclouded the blind optimism and reduced the scope of the disaster.
Yes the real estate companies should have been required to pony up a meaningful stake analogous to any homeowner receiving a home mortgage.
You can be assured some really good narratives were spun and some really good political allies were recruited before this deal was consummated. A counterfactual investigation would have assumed a win for the tenants association and would have recommended the need for stop-gap and/or sell-back provisions in the purchase agreement. The report of this independent investigation would be made available to all bidders. Without good legal reasons for overturning an association win, or discounting the price in the event of a win, this deal should not have happened.
Short Sales Markets
The property was purchased at auction. A short sales market funded by the winning bidder would have driven down bid prices for all participants. A ‘pessimists’ market would have put a price on the risk of a tenants association win in the courts. The higher the bid on the property the greater the potential losses for the buyer the higher the profits for the short sellers. Loss potential could double for the new property owners. This would have greatly tempered enthusiasm for the deal among all bidders.
Tishman Speyer Properties and BlackRock Realty and pension fund management should no longer be allowed to trade in public monies. This threat of excommunication would have pushed them to be much more creative in monetizing the risk inherent in the deal. For example they could have leveraged their considerable political clout to insist on inclusion of a purchaser rebate provision in the event of a tenant association win in the courts.
Q. What happened to Go Straight to Jail?
That referred to elimination of regulations attempting to assign blame for business failures ex post facto at a very legalistic level. Trying to control behaviors at a detailed level almost always fails. We look for ways to structure markets so players are not tempted to engage in reckless behaviors that land them in jail. Up-front scrutiny and structuring of investment deals is quite consistent.
Q. Yet more government intervention?
Yes. The 11,323 tenants of this property have been in turmoil now for almost a decade. Perhaps millions of pensioners lost significant value in their retirement accounts. There isn’t a clearer case of the need for government oversight and intervention.
We currently have $16 trillion in public debt (on a GDP of $16 trillion) so there is no wiggle room for financial panics, for letting private markets work it out so-to-speak. The Feds have a keen interest in maintaining calm in the markets so as to allow the economy to grow its way out of this government debt fiasco. And this can only happen with deep intervention.
If you owe your banker $1,000 then you are at his mercy. If the Feds owe $16 trillion then we’re all at their mercy.
Q. Your recommendations in the in-depth example would have made the deal less attractive?
Less deceptively attractive. If the deal were intrinsically attractive the protections would not have changed a thing. The Short Sales Market for example makes an intrinsically attractive investment even more profitable, since property buyers would also pocket all short seller investments.
Q. Your recommendation for a Short Sales Market seems unfair to the seller of the property?
If there are two private parties to a transaction then Short Sales Markets are not appropriate. In the above in-depth example investors were playing with Other People’s Money (pension and government monies) and the technique is fully justified.
As a society we need to get much more serious about how we invest Other People’s Money. Capitalism has outgrown its primitive days on the street corner and yet we see reforms that only nip around the edges. New financial innovations crop up regularly and we shoehorn them into ancient trading and regulatory schemas.
Today we have day traders scanning stock charts for head-and-shoulders, triple tops, rising wedges, etc. New technologies are leveraged to rattle investors so as to profit on their greed and panic. Mutual funds bilk investors and then reopen under new names.
What the hell!
Is this any way to run the world’s premier capital markets?
I provide a starter set of new tools for risk management. We use them as the basis of a complete transformation of capital formation and investing. We can stop the methodical theft of American wealth by clever financiers.
We must build a modern financial trading infrastructure and investment culture that systematically checks investor and investee recklessness. This blog entry is intended to start the conversation. The days of NYSE, NASDAQ, TSE and LSE are numbered.
Stop the silliness of 99% protest movements. We have met the enemy and he is us.