The Times They Are A-Changin'

A new paradigm

Fees instead of performance

No partnership means no personal responsibility
Until 1971, New York Stock Exchange firms had to be partnerships. If a partnership firm went bankrupt the partners were personally responsible, the creditors could seize their personal wealth. In the 1980s, things began to change. Now Wall Street is hooked on other people's money. Short time profit and direct reward became the norm; instead of big profit or big loss was, you got big profit or no loss. Top management only risk what they own in company stock and can't sell, there might be time restrictions forcing them to keep some stock for some years.

First banks, then much of the financial sector
Behind all this mortgage trading is the borrower; in the end he is the one who has to pay those trading in mortgages. Not long ago the banks were living on the interest from the house buyer. Now securitization is more the rule than the exception; bundling mortgages together into compound securities and selling them. Now the house buyer is supposed to finance not only the bank but to provide for all those dealing in securitized mortgages. If the interest from the borrower is not enough, the dealers can extract extra fees for extra handling, often unwarranted and even illegal. They can even provoke foreclosures and making people lose their homes.

Fees instead of performance
Originally, when funds were smaller, the typical 2% annual fee was meant to cover overheads, with the performance fees (typically 20% of the increase in value) being the icing on the cake. Now the funds are much bigger; with managing just one $5 billion fund, the annual fee is $100 million which means the banks are doing very well without having to care about performance. There is a lot over for the top dogs and this without including those other fees a bank is prone to charge. This is far from the principle that management fees "should cover normal operating costs for the firm and its principals and should not be excessive"; now investors - pension funds, endowments and foundations - are suffering.
With monkeys often surpassing professional stock brokers, maybe mortgage brokers were not doing much better. Not having to care much about performance must have been a relief to the banks.

Foreclosure instead of modification

Modification is good for you and the bank
Before securitization, banks used to keep the mortgage; should a borrower get in trouble, it was unthinkable not to modify the loan if the borrower had income enough. It was not charity, it was business; with a 70% loss on foreclosure, a 30 - 50% loss on modification was a clear win - win, for both the bank and the borrower.

Foreclosure instead of modification
With banks depending on fees instead of performance, foreclosures have increased while loan modifications and short sales have decreased. Even if a modification or a short sale gives more money, that money goes to the bank's investors. Fees associated with foreclosure go to the bank; with performance a secondary consideration, foreclosure is the bank's preferred choice.
There are cases where the banks prefer modification to foreclosure. JPMorgan Chase did modify some loans, very piously declaring they had done a cost-benefit analysis finding that foreclosure "is a costly and punitive way of trying to collect your money". The catch? Chase was servicing $1.5 trillion in mortgages; of these, Chase owned $350 billion. The modifications were restricted to those $350 billion of mortgages that Chase owned, the investors were left out.

Do investor managers care?
Investor funds are getting ripped off but do their managers care? They are showing a remarkable indifference to bank abuse, reacting little or not at all although they have every reason to complain. In a way, fund managers are in the same position as the banks; they depend mainly on fees and not on performance. That's the beauty of the system: if you are defrauded by your bank, you can go to another bank (hoping it is more honest). If the fund manager understands what's going on, he's just happy to be part of the deal; he has no incentive to move. The real victims, pensioners and others, probably do not understand what's going on and if they do they can't do much. It's the banks pushing their lemons on to the investor funds and these letting their customers pay.

From rewarding performance to rewarding failure

Once there was Ford
Are wealthy people necessary? Maybe they are. Pro-finance writer Thomas Sowell thinks so; to make his point, he gives some examples. His selection is interesting: Ford (cars), Carnegie (steel) and Rockefeller (oil). All in industry, in manufacturing or raw materials. And, what I find highly significant, the examples are from the end of the 19th century and from the begin of the 20th. Maybe they were no saints. Still they made important contributions to the development of the US and indirectly to the world.
It is still possible to get rich by being productive. Directly like Bill Gates. Indirectly, through investing, like Warren Buffet. Treating all super rich the same, whether they are looting or productive, might be counterproductive. It can alienate people who want to get rich without looting. If I may misquote former Secretary of State Henry Kissinger, we might have a case of ninety percent of the bankers giving the other ten percent a bad reputation.

Big finance taking over industry
In the days of Ford, Carnegie and Rockefeller, the banks served industry; now industry is there to serve the banks. Industry still can make people rich but the emphasis has shifted; big finance is taking over more and more of the wealth. From 1950 to 2006, their share of GDP increased almost threefold, from 2.8% to 8.3%. 20 years ago, the banks held 26% of industry assets; now their share has more than doubled to 61%.

The state taking over innovation
Before big finance took over, productive industry was behind much of development and innovations. Banking was important, backing Carnegie, Ford, Rockefeller and their enterprises. With big finance taking over the economy, the government has to take over more of the technical development. Important Apple technology, like GPS and touch-screen, comes from government founded research. At MIT, it is the US Army that is funding advanced research they hope will make chips that are a million times faster than they are today.

From rewarding performance to rewarding failure
It's been a giant leap, maybe not for mankind but at least for big finance and for most of those depending on it. From rewarding performance and punishing failure, big finance has pushed through a policy to their own advantage and to the detriment of the others; from rewarding performance they have gone to rewarding failure.

© Anders Floderus