When did banking change (or has it)?
I'm presently a high school student (so please excuse any ignorance I show in this post) and I took an economic history class at a local community college.
In this class, we studied up to WW1, with a heavy focus on finance during the GIlded Age. We studied bankers such as JP Morgan who were financiers of massive projects, such as steel mills and railroads.
So when did the transition happen from this sort of financing to the modern finance which seems to be largely arbitrary? (By arbitrary, I'm referring to things like high frequency traders, which don't seem to add any actual value to financial markets)
Not sure what you mean by "largely arbitrary."
Modern investment bankers help finance entire companies, making them better able to undertake such projects. "Steel mills" and "railroads" are still financed by places like JP Morgan in their Industrials Investment Banking groups, where they raise debt/equity for railroad and steel companies.
Thank you JPM PR department.
By arbitrary, I'm referring to things like high frequency traders, which don't seem to add any actual value to financial markets.
I apologize if I made it sound like I was referring to modern banking as a whole.
Investment bankers help companies issue equity or debt. When an investor initially buys this equity or debt, he pays the company a lot of money which helps the company grow and generate more projects (ie. Railroads and steel mills).
This debt or equity is, usually, then traded in an exchange such as the DOW or the NASDAQ.
Part of the reason that people are willing to give Facebook a billion dollars for their stock is that they will be able to trade it in the future on a stock exchange for a profit. If secondary markets didn't exist, then investors would be a lot less likely to give money to companies in exchange for debt or equity because they wouldn't be able to resell it easily.
It can be argued that high frequency traders contribute to the process by helping to make prices in markets more rational. To be honest, I don't think that high frequency traders do much to contribute to the economy.
That said, most areas of finance do contribute pretty tangibly to the economy.
This is a very astute observation for someone in high school. You are exactly right, modern finance has become largely arbitrary and does not function in support of the real economy anymore. Wall Street today is essentially a leach on the economy and no longer exists to serve its customers, but rather its own interests.
The simple answer to why this has happened is the absence of a free market. In a truly free market, businesses can only expand and be successful when they are providing value to its customers. Those that fail to do so will fail and go bankrupt. So when see that the largest banks clearly do not care about customer interests, but rather just about their trading profits, it's important to identify what is prohibiting the free market from working.
The answer is government. First, the Federal Reserve (Do some research on it) exists to protect the interests of the banking institutions that own it. The Fed is a private banking cartel that enacts inflationary monetary policy to benefit the largest international banks. When Wall Street was collapsing in 08, the Fed was secretly (Since exposed by Ron Paul) lending trillions of money all around the world to banks in order to keep them afloat. Without these loans, many banks would have failed as a result of their bad decisions. Secondly, congress has intervened in the free market to perpetuate the failed system we have. The TARP baiouts were designed to prop up financial institutions that the market clearly wanted to purge, but congress is owned by Wall Street so the decision was an easy one. Also, regulators such as the SEC and NY Fed provide Regulatory Capture (Look it up) to the large banks which essentially allows them monopoly power over the market.
Peole that think the answer to our problems is more government and more regulation are delusional because it was big goverment that got us in this mess in the first place. They fail to realize that there are greater regulations in a free market, not less. If a company does not effectively serve its customers, it has to go bankrupt. Government intervenening only makes things worse.
So true. I'm surprised how many people in this country don't know that the Fed is a private bank that collects taxes unconstitutionally via the IRS to pay the interest on debt it lends to our government. Most people are stupid and actually think the "Federal" Reserve is a federal agency. It's a private bank.
Spot on. Since you seem to put TARP in a negative light, I would like to say that I do think TARP was 100% a necessary evil in that situation. Without it, things would've gotten really bad. However, I did not agree with the follow up from TARP our gov't took by not slowly liquidating/divesting the firms responsible. Essentially, a very gradual bankruptcy should have taken place, but instead, Congress whored itself out per usual and said "well if you just pay us 500 MM, will call it even, eh?" Most of liberal Congress should have been ousted as well with the banks b/c of the pure ignorance of their over-regulation and corruption.
What happened to consequences and accountability in our country? smh
JS said it very well. The market's (Wall Street) sole purpose is to efficiently allocate capital to enterprise; this function is largely broken. Financial "innovation" created on unstable and unnecessary framework on top of this foundation and everything has been corrupted because of it.
Did these types of products end up blowing up over everyone's heads? Yes, but that wasn't until everyone started to try to rig the system through predatory lending, gaming the ratings, etc. because of moral hazard.
The vast majority of financial derivatives in existence have the ability to create real value for companies. Generally, they help companies manage their financial risks. A US company being paid in Euros in three months can use currency futures to lock in the number of dollars it will receive, and not be subject to currency risk.
That being said, trading, prop trading, and hedge funds, have become huge parts of the financial sector. I think the main value they provide to the economy is that they keep markets liquid, so that company that needs to buy currency futures doesn't need to pay a huge spread to do it.
Is this value-add significant enough to justify the size of these sectors? Probably not. A lot of these traders and quant-types used to be computer scientists and engineers before entering finance. They would probably add more value to the economy as computer programmers at Google, but they make more money at a hedge fund.
I think some level of government regulation should play a role in fixing this disconnect
(As you might have guessed I'm obviously not a trader)
Check this out OP: http://www.kc.frb.org/publicat/sympos/2005/pdf/rajan2005.pdf
^ Interesting read. Also check this out:
http://www.youtube.com/embed/4Xx_5PuLIzc
This perfectly addresses OPs question:
http://www.youtube.com/embed/ed2FWNWwE3I
The question is, who the fuck is building steel mills these days?
I think prop shops, HFTs, and any speculator in general gets a bad name when the large majority of the masses don't realize how essential they are to having an efficient market. First, as one poster above said: they provide price discovery in a market that is mostly invested in by schmucks who think its a good idea to invest in apple the day before the "New iPad" is released (as if it is not already priced into the stock). Next they make the markets more liquid so that when you go to sell your asset that is tanking there is always some greater fool who will take the bet that prices will go back up. Lastly, they are a lot of times the reason that F500 companies can hedge their risk exposures. If there wasn't some speculator that was willing to say that oil prices will fall or the USD will gain on the Euro than the companies would be stuck playing the markets.
Also, I wouldn't trust anyone who says ABS are a bad thing, they clearly do not know what they are talking about. Those financial instruments are an absolute piece of financial engineering genius and there are plenty of articles that go in-depth about there usefulness so I won't explain further. The issue people have with them is not the mechanics of how ABS work but the fact that we had legislation telling lenders that they have to provide a loan so that every American can own a house. Lenders, banks especially, of course will listen and make the loan (with their hands tied) and then sell if off to be securitized. Can you blame them? I wouldn't want that NINJA loan on my books either. Eventually these NINJA loans oversaturate the market of MBS and the second we see a decline in housing prices (inability to refinance) all hell breaks loose.
It also doesn't help when you have completely incompetent ratings agencies who mislead investors into how risky the securitized products actually were. Of course you're going to be upset when you purchase an asset rated AAA and it defaults faster than your C-rated bond. However, if you would have bought an ABS rated BB and it defaulted there would be less room for dismay.
I don't blame you for holding this view because it's been repeated a million times. However, if you look into it, it's actually not true. If you look at the numbers, the Community Reinvestment Act had very little to do with the crisis. It's not like lenders were begrudgingly making these NINJA loans. They were making a ton of money on securitizing these mortgages and they didn't care about the credit quality because they were getting paid immediately through the capital markets.
They didn't need a law to incentivize them to make the loans. Lenders were not holding loans on their books, regardless of the credit quality, period. The reason is that, when you lend money and hold the loan on your books, that is tying up capital. If you immediately flip the mortgage into an MBS, you make money which you can then use to make even more loans, to immediately flip, to get money to make more loans. It is pretty obvious that that type of incentive structure made people pretend that risks of default were lower than they actually were. If you aren't holding that mortgage for 30 years, what do you care?
If you want to talk about where the government failed, it isn't in an act of regulation but an act of deregulation. CDS were completely unregulated in the USA. The Commodities Futures Trading Act specifically excluded swaps from regulation. Even though they are essentially insurance policies, AIG and others did not have to have minimum capital reserve requirements when they were writing CDS. That's like getting on TradeMonster and writing $1M of puts without the site forcing you to have sufficient collateral if things go wrong. Then when things blew up, they didn't have sufficient reserves and they had to cry out for Uncle Sam.
HUD and Fannie/Freddie played a huge role in the crisis I don't see how you can downplay that. People that argue that deregulation was the main cause of the crisis leave out the reason these banks are so large in the first place, and that's the government. If the government didn't insure everyone's bank accounts, depositors would actually care what their bank did with their money. Instead, Ctitbank is just as safe in the minds of the public even though its 10x more leveraged and risky than your local community bank.
The government's implicit bailout guarantee to TBTF banks which became an explicit guarantee in 08 is another way in which the government distorts the basic principles on which a free market operates. Capitalism is a system of profit and loss, with losses being arguably more important as they clear the market of bad debt, malinvestment, and poorly managed companies. What we have know is a system of private profits and socialized losses, and somehow we think we solved our problems.
I sort of argee with you on CDS regulation though. The shadow derivatives market is out of control (What is it something like $700 trillion outstanding, and yet everyone is "hedged") and as long as we perpetuate this ponzi system of socialized capitalism where no one cares about risk, they should be regulated to some degree.
re JeffSkilling
Great comment, i'm just curious on this theory:
If the banks had been allowed to fail (ie free market) wouldn't the economy be in much worse condition today and push recovery from the recession back another 10 years because lending would have come to a halt, $ wouldn't flow, and things would spiral worse and worse? Or is this just a conspiracy created by the banks/fed?
A good example of how this could work in in Bill Ackman's (the Grey hair younger guy) comments in the following clip (minute 3 or so and later in the clip).
http://www.youtube.com/embed/AWs4W9J_JDQ?rel=0
Yeah it's a good question, but the idea that if we didn't bailout Goldman and their friends that the entire financial system would have collapsed and that we'd be back in the dark ages is ludicrous. Wall Street certainly wanted you to think that and they succeeded in creating a panic atmosphere in the country that the sky would fall if they were not bailed out (
). The reality is yes, things would have gotten much worse initially if we had let these bad banks fail (All the TBTF banks would have been gone), but that's a good thing. You have to purge the bad investments and failed companies, clear the market, and start rebuilding from a solid foundation. The boom was the problem, the bust and correction is the solution. Just because rehab is painful or medicine tastes bad doesn't mean you don't take it. Yes, unemployment would have gone much higher and GDP would have further contracted, but we'd be growing now and on track for a real recovery as opposed to the perpetual stagnation we have now. If you want an example, check out the depression of 1920 where GDP contracted 20%, the government didn't intervene, and we recovered in a year. They don't teach you that one because it does not further the Keynesian/Big government cause. This time, we saw what Japan did and instead of learning from their mistakes, we copied they playbook. The reality is from this point on, we will not grow. We addressed literally none of the structural problems in our economy and made it much worse by going further into debt and printing trillions of dollars.
Everyone admits that we had 5-6 years of phony bubble growth from the housing bubble, but they somehow think if we just bail out a few banks and paper over the problem we won't have to atone for those past excesses. It's delusional. The reality is you can either take the short term pain, or face apocalyptic pain later.
Does anyone actually think we wouldn't have a functioning banking system without a few Wall Street banks that make most of their profits from prop trading and front running? There is still plenty of capital in this country and new banks would have been started over night. Also, existing retail and commercial banks that were not facing bankruptcy would have been more than willing to swoop in and pick up the market share left from the bankruptcies.
Capitalism works, but capitalism without bankruptcy is like Christianity without hell. Capitalism is a profit and loss system, and the losses are just as important as the profits. When the government intervenes and distorts the signals of the market, it makes things much worse. Now all we have a system of private profits and socialized losses. It's clear our politicians are not principled enough to be honest with the American people about the weakness of our economy, so from here on out we are just going to keep printing and borrowing until the music stops. And when the music does stop, good luck.
I do agree that HFT's have contributed to tightened spreads, but at a cost of increased systemic fragility. Just look at volume charts dating back from the 90s - lots and lots of quote stuffing. Although I don't have any data to back my argument, I do think that these HFT's tend to provide liquidity only at 'normal' times - they tend to sap liquidity right out of the system at 'crisis' times - precisely when liquidity is needed the most.
Another evidence that HFT's are not really contributing to 'efficient' markets is that ever since they began to be the majority player, retail investors became net sellers. Now there is a plethora of reasons behind this, but I think one major factor is their distrust in the markets - the belief that the markets are rigged because these HFT's have a massive advantage in terms of information flow. In particular, equity markets these days are pretty much devoid of retail investors - it has been reduced to a game among a small number of players equipped with supercomputers. Concentration of volume is obviously detrimental to the robustness of the system.
My take - HFT's have created an illusion of stability (tightened spreads, etc), but when shit hits the fan, the crash will be that much worse.
Exactly. All the liquidity arguments are bullshit. That's always the first defense offered. Sure there is increased liquidity when vol is relatively low and everyone is on an even keel. What happens when you ACTUALLY need that extra liquidity? When uncertainty and vol start to tick up?
The size on the bid/offer starts to magically thin out. Add to that all the mean reversion and momo algos out there. It goes like this: there's some selling in the morning the mean reversion algos start buying, then additional buy side selling, mean rev algo pukes, momo algo kicks in, liquidity starts to dry up, stops get hit - voila some friendly selling to take profits turns into a 7% down day. The next day the stock will then gap up and by 10:30 that 7% loss will be erased. Sure seems efficient to me. I see it all the time. The market microstructure is fucked up.
I'll leave out all the front running, flash orders and other BS out of it for now.
The idea that it would take a few days to do a structured bankruptcy of the major street firms and break them up with little to no disruption of the general operations is just a total farce. The situations were so complex it would have taken months if not years to analyze these holding companies for solvent assets. A structured chapter 7 or 11 will allow for operations to continue albeit very crippled and inefficiently. The problem was not the banks themselves. The only people who gave a shit about them were ex industry people in government. The problem was the average main street companies who were getting driven into the ground from lack of day to day financing abilities due to banks sucking up all of their own liquidity to fend off a melt down of their assets. I know from personal experience. Our bank came to us and trippled our LOC rates over night to drive us away from using it.
heister, i disagree. you can change the capital structure of a failing bank pretty quickly. wiping out the shareholders and making the bond holders take a haircut and convert part of their debt to equity. his automatically gives the banks an effect similar or larger (depending on the haircut) than handing over taxpayer money. I can't see how one can argue that the government know enough about the value of the bank's holdings to bail them out with TARP, etc.. but not enough to allow for a pre-packaged bankruptcy/restructuring of the holding companies. What analysis did they do for TARP? You don't need to go through their assets line by line when you're not liquidating the banks.
There would be definite disruption of the bank's general operations, but nothing that the corporate world couldn't handle. Once you restructure the bank's liabilities they are automatically well capitalised enough to avert catastrophe as they will be able to access the capital markets. The bondholder haircut just has to be big enough.
The difference is you wouldn't see the government reaching into your pocket to pay for this or growing the fed's balance sheet to inflate the prices of securities over the following years.
Anyway, what do I care... it's your money, not mine.
Unde aspernatur distinctio consequatur aperiam commodi. Ullam quidem asperiores sunt labore non facere eaque. Numquam beatae qui eum quam quisquam fugiat. Sunt facere eaque placeat corrupti tempora.
Enim numquam expedita rerum voluptas. Voluptatibus in eos provident delectus ut fugit ad quo. Asperiores accusantium eum amet sequi.
Voluptatem quibusdam similique magnam non tempore. Laudantium ullam maiores non a laudantium architecto quos nesciunt. Occaecati illo et voluptatibus architecto.
Ut magnam nisi ut et eos sed exercitationem. Eos voluptate totam facere et eligendi qui. Dolores quod illum est provident. Aut optio sunt et voluptate quos optio.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...
Eos nihil voluptatibus culpa quisquam tenetur laudantium ut eius. Inventore incidunt eveniet minima sint qui voluptatibus est sed. Dolorem placeat quo eveniet quis quo voluptatum. Adipisci possimus ut laudantium quia est non omnis. Corporis qui similique vero numquam voluptate enim aut. Quod nihil aut labore ratione. Consequatur accusantium dolorem vel non.