Makers and Takers

Key idea 1

Similar to the Great Depression, our recent Great Recession was initiated by a faulty financial system.

Americans who grew up during the Great Depression in the 1930s likely had some déjà vu when it came to the 2008 financial crisis. Both financial crises have debt, credit, and economic bubbles as major contributing factors. Similar to 2008, growing debt and consumer credit led to the Great Depression.

Debt is a financial product, just like using credit cards. The financial sector expands in proportion to the amount of debt issued. The financial sector had not achieved its current scale at any previous period in history while the author was writing Makers and Takers, having attained it right before the Great Depression.

In the United States today, as in the 1920s, credit is widely available. About 75% of major household items were accessed by Americans using credit back then. Credit was used as a shield against the extreme income inequality that resulted from falling worker wages and stock market investors’ explosive profits prior to both the Great Depression and our own Great Recession.

Ultimately, there was a steadily expanding economic bubble in the years preceding the 1929 financial crash. The bankers weren’t held responsible after the fall—sound familiar?

Following a decline in copper prices, banks like the National City Bank of New York began to sell stocks in copper mines, convincing their uninformed clients that doing so would be wise. This led to the formation of the 1920s bubble. This led to the formation of the bubble that finally caused the 1929 stock market crash. Charles Mitchell, the chairman of National City, was publicly humiliated during Senate hearings, but he quickly went back to Wall Street. He never even served a day in prison.

The bankers accountable for our financial crisis are no different. Former Lehman Brothers CEO Richard Fuld is still employed in the financial industry at Matrix Advisors and Legend Securities.

Given how similar the two financial crises were, you may be wondering if history has taught us anything at all. We’ll look at how the US economy brought us back to the 1930s in 2008 in the next major idea.

Key idea 2

In the years following the Great Depression, financial regulations were once again relaxed to fulfill the increasing demand for credit.

The Glass-Steagall Act went into effect following the Black Tuesday, October 29, 1929, stock market crash. To shield the public from the risky trading practices of American banks, new legislation has been implemented that separates their commercial and investment activities.

The distinctions between commercial and investment banking continued to be hazy in spite of these rules. Before long, bankers were taking advantage of this once more.

The negotiable certificate of deposit, or CD for short, was a new product that Walter Wriston of the National City Bank of New York introduced in the late 1940s to further blur the lines between commercial and investment banking.

Higher interest rate savings accounts were offered by CDs. They were designed to make it more difficult for tax authorities to monitor wealthy people’s finances by keeping them out of their personal bank accounts. Bank accounts have always been handled by commercial banks, but Wriston started selling the CDs so that other people could trade them for a profit.

Credit cards arrived in 1967, dealing another blow to the Glass-Steagall Act (and a victory for traders like Wriston). They were created in response to consumer resentment over rising inflation eroding their purchasing power. The laws governing credit and interest rates were loosened in part thanks to credit cards.

Politicians were involved as well as bankers in the leadership of the combined commercial and investment banking sector.

Americans started to expect greater wealth after World War II. President Carter completely deregulated interest rates in 1980 in response to mounting calls for more lenient credit regulations, which had impeded economic growth due to rising inflation. This gave banks the freedom to charge whatever interest rates they pleased in order to attract capital as they developed intricate financial products, such as derivatives and variable-rate mortgages, that were nearly impossible to control.

Key idea 3

Organizations prioritize immediate profits rather than concentrating on sustained long-term growth or providing solutions for their customers.

The water in a pool gets tainted if someone urinates in it. The same is true of the economic system; developments in finance have an impact on the waters surrounding the whole economy. When profit-maximizing financial models were introduced, this is what transpired.

In the financial sector, the emphasis on boosting shareholder value has prompted companies to put short-term profits ahead of long-term business value, which has reduced expenses and jeopardized the quality of their output. For example, a switch failure forced General Motors to recall hundreds of thousands of vehicles in 2013.

The switch’s engineers were aware of the malfunction and changed the design, but they did not rename the new component. How come? because they were afraid to disclose the flaw in their rigid, budget-conscious organization to those higher up the ladder. General Motors’ error cost the public dearly: the switch resulted in 124 fatalities and numerous injuries.

How businesses make goods is also determined by the interests of their shareholders. One of the core tenets of the free market is that businesses must provide the goods and services that consumers want, and this goes against that idea. These days, businesses in a variety of industries hardly ever seem to be interested in developing a new product to meet a customer’s need. Their short-term goal of increasing shareholder value is still their main priority.

Think about how a Morgan Stanley report from 2010 urged the pharmaceutical sector to generate value by buying out businesses and paying shareholders rather than conducting research. This was an obvious indication of Wall Street’s influence over business strategy in the sectors that support our daily needs and occasionally even our lives.

Key idea 4

While shareholders may not finance the development of innovative products by major corporations, they do enjoy the resulting advantages.

Consider requesting a dollar from a friend. They consent, but only if you promise to reimburse them with two dollars afterwards. Not so great, huh? This is, after all, essentially how shareholders and companies currently interact.

Large, profitable corporations mainly benefit their shareholders. Corporate raiders were the moniker given to shareholders in the 1980s who made concerted efforts to change company policy in order to boost their profits. They earn millions of dollars today and are referred to as shareholder activists.

Shareholder activists purchase shares of well-known companies and then try to influence the board to increase the value of those shares. Think about the partnership between Apple and activist shareholder Carl Icahn. The business returned $112 billion (yes, one billion!) to the investor and business tycoon as well as the other shareholders between 2012 and 2015. That’s $112 billion that can’t be used to create cutting-edge technology that will increase Apple’s long-term worth.

The wealthiest 10% of Americans own 91% of all US stocks, so Apple is not the only company in this game. Payments to shareholders typically enrich the wealthy even more, with pension funds and common people who own stock receiving the smallest portion of payouts.

Companies should probably compensate their shareholders for the money they put into the business so it can make its products. Activist shareholders, however, seldom ever cover the initial costs of R&D.

Typically, innovation is funded by governments. A large portion of the technology needed for smartphones, such as touchscreens, GPS, voice activation, and even the internet itself, was created as part of government initiatives and institutions like the military, which made it possible for large corporations to later commercialize the technology into successful products.

Many people are wondering how we got to this point as rich people continue to benefit from shareholder payouts for products they had no involvement in developing. In the upcoming chapter, let us examine this further.

Key idea 5

Banks are not the sole participants in the contemporary financial landscape, and they extend their activities beyond the realm of finance.

Large brands have been more active in lending and investing in the last few decades; these are traditionally the domains of banks and financial institutions. Determining a company’s true core business is becoming increasingly challenging.

Most big businesses nowadays have a lending department. Lending units were first set up to provide credit to clients who wished to buy one of their products, but as time went on, they started to turn a profit. Financial departments became more adventurous and started taking bigger chances after every victory.

For example, prior to the financial crisis, General Electric (GE) was actively acquiring and divesting companies in order to boost the value of its shares. Notably, GE also held a sizable interest in mortgages, which is where the problems started. Following the collapse of the real estate markets, the government was compelled to provide GE with a massive $139 million bailout.

Businesses are starting to act more like banks, and banks are challenging businesses on pricing. Teams at Coca-Cola became aware of unusual activity in the aluminum market in 2011. Prices were rising, but so was demand. It emerged that Goldman Sachs had acquired aluminum storage facilities in order to deftly take advantage of a legal loophole.

Rotating the same stock between plants increased prices just as much even though it’s illegal to store stock and raise prices after a certain point. As a bank, Goldman was taking positions in the commodities market based on the price of aluminum, but as a company, it actively worked to drive up prices.

Key idea 6

Banks profit at the expense of regular people through plans to rent out rental properties at high rates and poorly managed retirement accounts.

Imagine being evicted from your home and then being required to pay exorbitant rent to someone else. In summary, this is the course of events that preceded and followed the global financial crisis of 2008. The housing crisis started to benefit the financial sector at the expense of the common person as banks began to buy up and rent out homes.

Both home sales and rent prices in the US skyrocketed after the 2008 financial crisis. This trend may indicate that people are starting to rebuild their lives and are once again purchasing real estate.

Regretfully, this is not at all the case. Rather, investment groups have bought a large number of inexpensive properties to rent to low-income families. This is a lucrative business; the investment firm Blackstone Group generates $1.9 billion in revenue from its 46,000 homes.

The reason so many families are unable to purchase a home of their own is because the same investment groups that initially made the affordable ones have since taken them all and are renting them out. Thus, even though sales have increased, since 2004 the proportion of Americans who own a home has decreased.

The inaccessibility of housing is not limited to US citizens alone. Investment activities have also eaten into retirement. A retirement household’s average annual income to live on is approximately $104,000. This simply isn’t enough for couples between the ages of 55 and 64 to live a respectable life for the next 20, 30, or 40 years.

This is the outcome of retirement plan management done with a lack of vision. Fund managers receive rewards for short-term performance, just like companies do. Fund managers focus on the possibility of larger wins by taking on riskier bets rather than concentrating their strategy on long-term, sustainable growth. But these risks also result in significant losses and lower overall profit.

Key idea 7

Relatives between politicians and banks weakened attempts to restructure the financial sector after 2008.

We look to guardians and teachers to take care of our children while we are at work, and we also expect the government to oversee the financial system. It is, after all, their obligation. Why then is it so ill-managed?

Following the 2008 collapse of Lehman Brothers, policymakers appeared committed to overhauling the financial industry. After eight years, very few reforms have been approved. The 2014 federal spending bill included a few new lines of legislation.

The purported goal of this bill’s drafting was to compel banks to abandon their riskiest offerings, such as derivatives and swaps, which let them wager on the performance of stock market outcomes. The lines that were added to the legislation directly undermined this goal.

Furthermore, political action committees (PACs) funded legislators who supported the amended bill 2.6 times more than those who opposed it. The banks that control 90% of the swaps market, J.P. Morgan, Bank of America, Goldman Sachs, and Citigroup, couldn’t allow the bill hurt their bottom line.

That finance and governance have such a strong relationship may not be surprising. After their terms are up, government officials in charge of overseeing finance usually take positions in the industry. The modest wages government officials receive from the public service are far less alluring than the high salaries offered by banks. Thirteen of the thirty-five Treasury secretaries since 1900 have held bank jobs. Seventeen of them left their positions at the Treasury to work in banking.

What steps can we take then to improve the financial system? The author’s main suggestions will be examined in the upcoming chapter.

Key idea 8

We may be able to improve the financial system by lowering debt and promoting financial transparency.

The primary goal of finance, prior to the relaxation of financial sector regulations, was to promote economic and commercial expansion. In a time when banks have become companies and vice versa, how can we obtain financing to support regular business once more?

In order to reduce risk-taking, the first step is to simplify banking and financial regulations. A total of $81.7 trillion worth of financial transactions are made every day. It is impossible to supervise the financial system now that it is so large and complex. Even the boards of banks like Citigroup find it difficult to oversee their operations due to their own complexity.

Additionally opaque is regulation law. The 2010 Dodd-Frank Act aims to separate commercial from investment banking in an effort to lower the risk of bank failure, much like the 1933 Glass-Steagall Act did.

The 1933 Act was only 37 pages long, but the new Act is 2,319 pages long and has a plethora of new loopholes that can be used to conflate commercial and investment banking once more.

In order to stabilize the economy, we also need to limit debt by pushing people to save and making banks put up to 20–30 percent of their own capital as collateral for investments. Political bravery is required for this because credit and debt enable governments to conceal economic stagnation. It’s become evident since the 2008 financial crisis that a sound economy can only take so much debt.

Final Overview

The main idea conveyed in this book:

Uncontrolled and hazardous financial practices were responsible for both the economic downturn in the 1930s, known as the Great Depression, and the 2008 financial crisis. As the lines blur between commercial and investment banking, between commercial and political interests, and between companies and banks, affluent shareholders benefit, while ordinary citizens find it challenging to secure financing for their homes.