Heads I win, tails you lose

You are in a public elevator, mildly displeased by the black doodles on the stainless-steel control panel. You are willfully ignoring that faint stench. You just don’t want to think about its source.

But at least that darn thing is moving in the right direction. Suddenly, there is a screeching sound. “Is it supposed to sound like that that? Whatever.”

A few moments later, there is that sound again. Your heart rate increases, warmth rushes to your face, you’re breathing faster.
Maybe you can get out on the next floor and take the stairs? It’s not that far anymore anyway. You are looking for the right button, but can’t quite figure out, which is the right one. The doodles are all over it!

“Out! Just OUT!” You are hammering on the controls. “Why doesn’t it STOP!”. The sound gets louder and louder. Your heart pounds against your chest. The screeching gets increasingly high pitched and louder, louder still. Until there is a snap.
You could feel it better in your stomach than you could hear it.

All you can hear now are your own panicked screams as the elevator begins to race towards the bottom of the shaft.

That’s how the financial crisis of 2008/09 felt for the people who experienced it.
They were in it for the ride. They didn’t know who built the financial system, who maintained it, how to operate it properly or how to get out of it safely.
A lot of people lost all they had worked for. A lot of people despaired, self-medicated, overdosed and died. A deep financial crisis produces a lot of victims, most of them are unsuspecting victims. Some people … let’s say they could do better.

Welcome to the seventh installment on justice. I already warned you, that I have no expertise in financial matters what so ever, but that it won’t stop me from offering an opinion on it. So here we go!

Who’s to blame? Just give me a name!

Although the facts are largely uncontested: a bank went insolvent, which triggered a cascade of other failures in the financial and commercial world, as well as a whole lot of credit defaults and foreclosures, which was only stopped after governments around the world bailed out banks, there are a lot of diverse and competing stories about the “real” reasons for the financial crisis.

Greedy banksters that ripped off the population, corrupt politicians that got their pockets filled by selling out the population, stupid governmental regulations that made banks loan out to people with bad credit scores, inefficient regulations, too much regulation, insurances worked well and insurances failed miserably.

There’s at least one movie for each brand of economics on the same screen. There are plausible stories to tell about individual actors that, when extend to the whole situation, make perfect sense.

Unfortunately, there are multiple, conflicting stories. They can’t all expose the one real reason we are looking for.

I don’t think there is a single reason or a single group of actors to blame for. I’d like to remind people of “Adam’s Iron Law of Bad Behavior”:

One of the most consistent rules of life is that bad behavior happens almost 100 percent of the time whenever you have this combination of variables: 1)There is money to be made from the bad behavior
2) The odds of detection are low
3)Lots of people are involved When you have that setup, it is reasonable to assume crime is rampant. Unfortunately, I just described much of the financial world. [ADAMS, p.122-123]

So my personal bias when looking at it is: the system’s wrong!

Most people in it did just what they were incentivized to do. Financial advisors peddled products with huge profit margins to a widening audience, advertisers bundled assets of different risks levels and pushed them to customers, who did not understand them, but were eager to buy them, because their neighbor Bob got rich by doing so. At least he says so. I am pretty sure most of the financial actors did due diligence on their own product, but I would be amazed to learn that most of them had studied or priced in “system-wide disruptions” or the effects of their own products on the risk structure of the market as a whole.
I ‘m also pretty sure it didn’t help that the managers of these financial institutions were protected by “limited liability”. Limited liability is a concept, where the “institution” is made accountable and only the assets of the institution can be used to reimburse claimants. So if a hedge fund has paid a hundred million dollars as bonus to a manager and goes bankrupt soon after that, the manager can keep it.
I think limited liability is a valuable concept to spur innovation by limiting the exposure to risks for entrepreneurs. But scaled up do the dimensions of modern banks, I think it just induces imprudent risk-taking, according to The Iron Law.

I share the urge to find “the responsible people” and “bring them to justice!”. I just don’t know, if that wouldn’t entail huge segments of the populations as well, that loaned money to buy houses they couldn’t afford, but wanted.

The financial sector

Let’s look at the financial market from a system’s perspective.

The financial sector is providing a public service. It moves money from people, who have it, but don’t know what to do with it, to people who have plan, but no money. This is in deed a huge service! It’s one of the main drivers of human progress. At least in my mind.

But there are also huge information asymmetries. A banker knows on average a lot more about the risk structure of their products than a customer. This differential in information equals a large profit. Even more so, if the bank can burrow money itself to take up the most advantageous positions from a risk-reward perspective. If a bank, that sells insurance on financial instruments, is darn sure it’s smarter than the average Joe on the market – which is probably true – why not participate in it as well? It’s free money! Well, almost. But the risk is minimal! Bankers are human after all. I think they are subject to the same well-known cognitive bias regarding probabilities as all of us are.

What should a financial system look like? Here’s a wish list:

1. It should be make business run smoothly and intermediate between actors.

2. It should be transparent about risks.

3. It should not be able to fail.

4. It should not need money from the government

5. It should be subject to limited regulation. Complexity is the enemy of transparency here.

Do we have anything that looks remotely like that in the financial world? The surprising answer is: yes. It’s called “equity financed mutual fund”.

Mututal Funds

A mutual fund accepts your money, gives you shares and invests in whatever asset they happen to specialize in. If the value of the assets goes up, so does the value of the fund’s shares and vice versa. But the interesting thing is: it doesn’t matter how bad the assets of the mutual fund fare; the fund itself can’t go bankrupt. None did in the in the 2008 crash. [KOTLIKOFF, p.93]
The value of your assets might go to zero. It’s bad for you, but not so bad for the mutual funds holding company and certainly not for the system itself.

Each of these mutual funds perform a function, we normally assume only banks fulfill: they bring money to investments. You can further differentiate them into “open-end” and “closed-end” funds.

Closed-end funds are closed to new investments after a due date. A good example for a closed-end fund would be a fund that buys and holds 30y mortgages. Let’s say they are in the initial phase for 6 months and raise enough money to buy 1000 of them somewhere in Georgia. The shareholders of the mutual fund would receive the pay-outs of the mortgages and be hit by defaults of the mortgages bundled in the fund. They can of course sell their shares on the secondary market. But the amount of underlying assets remains fixed after the initial phase. The same 1000 mortgages.

The open-end mutual fund buys liquid assets like stocks. A shareholder can redeem the share at any time. The mutual funds then sells the underlying assets on the market and transfers the money to the former shareholder. There is no special due date and the fund remains open for new investors.

The underlying asset could also be the most liquid of them all: cash. Why would you need a cash mutual fund? Well, because it’s a great substitute for checking accounts!
Today’s checking accounts are, as far as I know, a loan of the account holder to the bank. They are promises of the bank to pay you. But if all tried to hold the banks accountable to their promises we’d run into the problem of leverage; the banks just don’t have enough money to “cash out” all of these promises. If the bank goes belly up, so do the checking accounts.

If you have cash mutual funds, they “really” hold cash. So let’s say there were these cash mutual funds. How would buying groceries work? Just like normal! You pay with your card. In the background, the customers mutual fund holding company moves some of the customers shares (i.e. the price of your shopping) in a cash mutual fund to Walmart’s mutual fund holding company. It’s like you’d expect a bank to work anyway, right?

More complex instruments

But what about “financial innovations”? Well, I have absolutely nothing against innovation! So could this model of mutual funds be used for that? Sure.

All financial tools I know of can be expressed as bets.

Let’s say you are holding bonds of IBM. They will become due in 6 months. It will be a neat sum of money! But there is a nagging thought. “What, if they can’t make it? They have been around for so long, maybe this is the year they will go under? What, if Corona has gotten to them?”. You are yearning for peace of mind. You want insurance! But can you insure against something like that? Yes, you can! How? Easy! Let’s take a page from one of the most diligent financial institutions known to men: the racetrack!

Racetracks operate on a “pari mutuel” system. All bets of a particular type are put together in a pool, taxes and the “house-take” are deducted and the odds are calculated by sharing the pool among all winning bets.
If you want to hedge against your IBM bonds becoming worthless, you can think of it as two-horse race: You place your bet on “IBMtotallyDefaults” and somebody else picks “AbsolutelyNotBra”. IBM is (as far as I know) a solid company, so there will probably be a lot of people willing to bet on “AbsolutelyNotBra”. In the end, there might be 100 units bet on “IBMtotallyDefaults” and 10 people bet 100 units each on “AbsolutelyNotBra”. The house and the state together take their cut, 10 units in this example. If “IBMtotallyDefaults” wins, i.e. IBM defaults on their bonds, 1090 units belong to that bettor. “AbsolutelyNotBra” wins, the 10 bettors get 109 units each.
By engaging in such a bet, you can “buy” insurance for your IBM bonds.
A few of the infamous names of the 2008/09 crisis facilitated bets like that. Of course they did not call it “bets”, but “credit default swaps” or CDS.
But instead of operating as trustworthy as a racetrack, they took their proceeds and invested/bet it themselves. They got leveraged so much, that they could not pay out all the bets they made. I imagined that “be at least as trustworthy as a racetrack” is not too high a bar for a financial institution. Well, you always learn!

The same system can be used for “options”. Options are bets on the performance of certain stocks. Let’s say Ford stocks sell for 100$ today and you think they will totally be worth 300$ in 2 months. You can do the same “two horse trick” and create a financial instrument from that. [KOTLIKOFF, p.97] claims that you can do it for all existing derivatives.
If all these financial instruments are run in this “all the money is on the table” fashion and the house doesn’t bet as well, this system can’t go bankrupt.

The Auction

That’s a pretty big if. So you need to ensure that actors behave responsibly. And that means we are talking about regulators. There was a quip during the financial crisis, that went like “There were 123 regulatory agencies. Do you think that the 124th would have prevented this?!” Well, maybe not in the current system. I certainly can’t judge on that!

But if we are talking about a regulatory agency in the the hypothetical “mutual fund” world, their job would be quite easy. The regulator would hire competing private companies to verify, appraise, rate and disclose all aspects of the financial securities held by mutual funds.
So we would know at any moment, what the mutual funds have in their books. And whether or not they are betting themselves. We would enter a world of “show-me”, not “trust-me” banking. [KOTLIKOFF2, p.120]

[KOTLIKOFF2, p.118-119] gives an example of how to get loan in that world.
You would go to a financial service station, formerly known as bank, now as mutual holding company. They’d help you to fill out the paper work and send it to the regulator for processing. Or you could do it electronically from home.
The regulator would send it to one or multiple of their subsidiary rating agencies. They’d verify employment status, current and past earnings, appraise the value of the house you are going to buy, etc.
You’d be free to add additional ratings from private rating agencies, that you purchased, but these would be marked as “purchased”.
The information is than disclosed by the regulator and put on an auction. Maybe after certain, sensitive information, like ethnicity have been removed.
This is not unusual: Mutual funds would buy and sell all of their securities at auctions. There are a whole lot of different types of auctions for different systems. The Vickrey auction might proof to be a good starting point for iterations on the model to be used.

This is good for the regulator that wants to know what the risks in the financial system are. But it is especially great for the burrowers. The information asymmetry, that typically works against the burrower, disappears. Instead of having her to shop around everywhere to find a good mortgage rate, she would get the highest price, which translates to the lowest interest rate for her application in the market place. The same is true for auto loans, credit card lines of credit, student loans etc. This combination of reliable disclosure by the regulator and the ability to leverage the whole market for getting loans, should make the access to credit easier and more reliable than it is now.

Derisking Wall Street

Laurence Kotlikoff created the “Limited Purpose Banking”-proposal, mostly aiming at curbing the risk-taking behavior of the financial sector:

“1) Applies to all financial companies protected by limited liability. This includes incorporated commercial banks, investment banks, insurance companies, hedge funds, and private equity funds.
2) All financial companies protected by limited liability must operate exclusively as mutual fund companies that market mutual funds.
3) Mutual funds are not allowed to borrow and, thus, never fail.
4) Mutual fund companies required to also issue cash mutual funds, which hold only cash.
5) Cash mutual funds are used for the payment system.
6) Cash mutual funds are backed to the buck.
7) Mutual fund companies are not permitted to back money market or other non-cash mutual funds to the buck and can lose value.
8) A single regulator – the Federal Financial Authority (FFA) — hires private companies that work only for it.
9) Companies working for FFA verify, appraise, rate, custody, and disclose, on the web and in real time, all securities held by mutual funds.
10) Mutual funds buy and sell FFA-processed and disclosed securities at auction. This ensures that issuers of securities, be they households or firms, receive the highest price for their paper (borrow at the lowest rate)” [The Purple Financial Plan]

This plan let’s you run a financial business as risky, as you like: but only with unlimited liability. If your company goes bankrupt, kiss your yacht good bye!
If that game it too hot for you, you can provide financial services as a mutual funds holding company. You can create what ever gamble you can come up with, but you can’t bet with your financial company’s money on it.
I like the structure of this proposal. It seems to but down-side risks to where they belong: to the people who are gambling for the upside. But derisking the financial institutions is only looking at one side of the problem.

Getting sense into Main Street

The other side, I think, entails the people who did the borrowing in 08/09. The housing bubble, promised huge profits and so people leveraged themselves way, way beyond any reasonable level.

Why would people get into irresponsible levels of debt? Well, because they can get it to get what they want and get away with it! The Iron Law is at it again.
“We therefore [need] changes to the incentives that encourage people into debt – because so long as those incentives exist, we can be sure that at some point the financial sector will find a way to entice the public into debt, leading to yet another financial crisis.” [KEEN, 9478-9480]
Can we do something to help the people that burrow, the general public, to behave more responsible as well? Steve Keen has two proposal for that. Each targets one of the main reasons people get into debt for: stocks and housing.

Let’s start with housing. Higher prices on houses, in theory, spur more building. But “debt past a certain level drives not house construction, but house price bubbles: as soon as house prices start to rise because banks offer more leverage to home buyers, a positive feedback loop develops between house prices and leverage, and we end up where Australia and Canada are now, and where America was before the Subprime Bubble burst: with house prices out of reach of ordinary wage earners, and leverage at ridiculous levels so that 95 percent or more of the purchase price represents debt rather than owner equity.” [KEEN, 9504-9507]
By being just a little bit reckless, you can outbid a more prudent bidder. And higher prices on houses increases the notional wealth of all home owners. But “a little bit more reckless” times millions equals systematic risks.
Everything is just great, until new borrowers can’t be enticed into the market anymore, because they can’t service the level of debt out of their earnings. The housing market is then swamped with people who need to get rid of their houses and the bubble bursts. The proposal, called Property Income Limited Leverage (PILL), tries to sever that positive feedback loop between house prices and leverage by demanding that

the debt that can be secured against a property is limited to at most 10 times the annual rental of that property. [KEEN,9486-9487]

This requirement could easily be implemented in Kotlikoff’s scheme. The regulator would simply not approve to auction off mortgages, that violate this principle. “It would still be possible – indeed necessary – to buy a property for more than ten times its annual rental. But then the excess of the price over the loan would be genuinely the savings of the buyer, and an increase in the price of a house would mean a fall in leverage, rather than an increase in leverage as now. There would be a negative feedback loop between house prices and leverage. That hopefully would stop house price bubbles developing in the first place, and take dwellings out of the realm of speculation back into the realm of housing, where they belong.” [KEEN, 9526-9530]

The second proposal of Keen targets speculative bubbles in stocks. The “Jubilee Share” proposal is quite simple:

“To redefine shares so that, if purchased from a company directly, they last for ever (as all shares do now), but once these shares are sold by the original owner, they last another fifty years before they expire” [KEEN, 9484-9486]

Keen postulates that “[99%] of all trading on the stock market involves speculators selling pre-existing shares to other speculators. Valuations are ostensibly based on the net present value of expected future dividend flows, but in reality based on the ‘Greater Fool’ principle, where rising debt funds the Greater Fool. Anticipated capital gain is the real basis of valuation, and the overwhelming source of that capital gain is not increased productivity, but increased leverage.” [KEEN, 9488-9491]
The bucket stops, when prices are so high that people begin to realize they have been the “greatest fool” and have to start selling at a loss. The “value” is gone, the debt created to buy the shares still exists. Keen anticipates that this reform would force valuations to be based on prospective earnings, not on capital gain and thinks this would make speculation less attractive and tilt the balance in favor of raising capital via primary share issuance.

If that is true and we are starting to think about the concept of Universal Basic Assets seriously, Keen’s proposal to introduces Jubilee Shares, might be a great starting point: “All existing shares could be grandfathered on one date, so that they were all ordinary shares; but as soon as they were sold, they’d become Jubilee shares with an expiry date of fifty years from the date of first sale.” [KEEN, 9501-9502]
If companies issued more primary shares after that, a state run mutual fund, buying broadly indexed shares of companies, even in the early stages of their life cycles, with collected taxes and distributing the earnings on a per capita basis, might be at at least one way to get to a UBA. If society, not necessarily politicians, decided to go there.

To summarize this post: I think the financial system is broken. The existing incentives are not aligned to profit society as a whole and have become a great risk to the market system. This is a two-sided problem: the people working in the financial sectors and the general population behave in accordance with their interests, which leads to large instabilities in the system. I think justice demands to defuse the ticking time bomb that the financial markets are by making recklessness risky and nudging citizens to behave financially prudently.

This looks like a major task for the stabilization branch!
It sounds really appealing to me to create financial markets that have a “just” distribution of risk. But I am also aware that all proposals to change huge parts of the economic world represent risks themselves. What would be small steps to get there? Is crypto-currency a first step to “cash” mutual funds? Are crowd-sourcing platforms an early implementation of the “auction” market for all types of credit and investment? What do you think about it?

Sources:

[ADAMS] ADAMS, Scott. Loserthink . Penguin Publishing Group. Kindle-Version.

[KEEN] KEEN, Professor Steve. Debunking Economics (Digital Edition – Revised, Expanded and Integrated): The Naked Emperor Dethroned?. Zed Books. Kindle-Version.

[KOTLIKOFF] KOTLIKOFF, Laurence. You’re Hired. A Trump Playbook for Fixing America’s Economy. Available at: https://kotlikoff.net/wp-content/uploads/2019/03/Youre-Hired-A-Trump-Playbook-For-Fixing-Americas-Economy-1.pdf. Accessed 2020-05-15.

[KOTLIKOFF2] KOTLIKOFF, Laurence J.; BURNS, Scott. The clash of generations: saving ourselves, our kids, and our economy. MIT press, 2012.