It’s Not That I Don’t Believe You
Finance gets a bad rap. The common media tact is to pepper public thought with notions of greed and malpractice, notions which are often founded on hard facts. The felt reality is every decade there is some derivative product linked crisis and every few years some white collar Ponzi scheme or blowup. These recurring events plague our financial system with mistrust of all wealthy financiers -- and trust, you can imagine, is a central component of any lending, transaction, or investment. At a level, we wish to have honest faith in what we invest in and who we invest with.
So, vexingly, the societal issues of finance are salient and lead to palpable mistrust while the benefits are hidden. The picture painted is often of two dimensional vice -- the industry is (1) exclusively money oriented and (2) the people in it are greedy. The true texture, however, is the industry has a third dimension, it (3) provides immense value to civilization. But how? The largest wall street banks have pulled down over a trillion dollars in profit in the last decade. One must ask: doing what, exactly?
Massive amounts of money are being made yet something about it all seems so slimy, extractive, mysterious. What do these people do that makes them so worthy of their yachts and mansions? If we could expel this bad-feeling mystique maybe we could recover some of the lost trust. And if so much profit is hitting bottom lines, we can only hope the core of finance is not actually rotten. It is with this context I intend to persuade of three thoughts. First, finance does real good. Second, ethical financial practice can exist and is a design problem. Third, the way to make and maintain an ethical financial system is to have upstanding designers keen on making and maintaining it.
Before going further, let me clarify my meaning of finance -- I define finance as one of two activities: either the transfer of value from one party to another in the present (i.e. a transaction, trading) or the creation of transferable perceived future value (i.e. an investment, investing). The concepts become muddled since one can trade investments from one to another however for our purposes the transfer of investments is distinct from their creation. The transfer is subject to market forces; the creation is a design problem. And we are primarily concerned with the latter. In the creation of investment, we find the origin of value.
To keep this grounded, illuminative, and scoped, I’m going to stick with municipal finance. One, it’s patriotic since the whole of municipal financing is how local, tangible governments fund themselves and two, even in the commonplace industry of municipal debt we find both fantastic and awful outcomes.
On the fantastic side, think of a hospital and the value, the real and true value, it provides to the community it serves. Imagine some mid-sized town in the heartland of our country which has never had a level two trauma center before, now builds one. This town will, on a forward looking basis, have citizens see loved ones saved from the clutches of death, friends cured of dire illnesses, and previously unavailable medications now easily accessed. The happiness, the well being, and the ease of human life in town will rise. It is hard to put a price on that.
But not impossible. See, this infirmary -- let’s say it cost $50M upfront to build -- was almost certainly not paid for with the cash the town had on hand. Most likely, this project would have been funded off the back of a tax-exempt hospital revenue bond issued by the state or town. Here’s how that happens: the local government sees all the good a hospital would do, estimates the costs, and then approaches investors with a proposal: you lend us the money to build this hospital and we’ll pay the money back (with interest) using the operating revenues of the hospital itself. Investors take into account the current interest rate environment, the solvency of the town, the implied solvency of the proposed hospital, and then the pricing action of the bond’s interest rate takes over. Investors and the town come to an agreement, say, $50M lent at 5% a year annualized to be paid back over ten years. Then, after the bonds are sold to investors, the municipality now has the funding to build the hospital it wants. This short story is but one example of how an investment comes into being. There is a vision, that vision is funded, and then it is reified. At its core, finance allows this process of making visions real and does so by creating investments. So, this is point one -- this almost magical ability, generalized, is finance’s core value add to our world.
Finance is not all healthy citizens and well funded hospitals though. Most famously, Orange County in 1994 had the largest municipal default in U.S. history. This default was not caused by local economic strife -- the economy was strong and vibrant. It was not caused by budget problems -- the town’s finances were more than adequate. No, the default was caused by the Treasurer-Tax Collector’s investment strategy for the county's asset pool. These investments were held, more or less, as collateral against the town’s debt obligations and these (highly levered) investments were decreasing in value. The investments declined so much that the financial institutions who offered Orange County their leverage, terminated their agreements, forcing liquidation and losses. The problem arose that, due to the decreased value of the recently liquidated positions, Orange County could no longer cover their debt obligations. So, they defaulted.
This was unprecedented. The town could meet its financial obligations via its solid economy and decent budget but it was choosing not to. Moreover, before this debacle, not many municipal bond investors had looked into the investment strategies of the county investment managers. The (usually correct) assumption was the investment managers were conservatively focused on principal protection (as to always match their debt obligations) and liquidity provision (as to be able to pay back the debt on demand). In both ill intention (the town was choosing not to pay back its debt and was instead claiming bankruptcy) and in lack of stewardship (the management of the collateral assets was deliberately speculative, not deliberately cautious), Orange County (and its investors) had failed to provide an ethical financial system. This could have been avoided.
Lax rules are bad rules. In this case, the covenants in the bonds, the mandates of the county’s investment pool, or even the county or state legislative stance on what can and cannot be used as collateral could have kept this system out of harm's way. In spirit, an ethical regulation of “no speculation with money you can’t lose” would have saved Orange County its financing reputation and would have saved investors a sizable chunk of money. So, this is point two -- ethical regulations are a way to strap any negligent financial actors into good investment dealings.
Lastly, simply put, we could have people responsible for money who seek to steward and profit, not who seek just to profit. In this case, the bond buyers could have investigated the probity of the investor managing the collateral, or that manager could have not taken such risky positions with such not-to-be-risked capital. Either way, the introduction of a financial professional who took it upon themselves to act as a moral sentry could have, were they awake and questioning, lead to better outcomes in this system. Which is point three -- we need ethical people at the helm of not just some, but all financial investment creation as both safety designers and stewards.
On this third point, there is a call to action. If you are creating a financial product, over the counter or otherwise, ask about the incentives and the regulations: “Who and what can be taken advantage of here? And how can we make that abuse difficult if not plainly illegal?” When asked in earnest, these two questions will save you more financial heartache in the long run than any sly and shady dealings will hand you in the short run. Be especially cautious too, when the answer to “Cui bono?” is yourself. The actors we are most lenient with are the ones responsible for feeding our families which, most of the time, is us. Luckily, in finance, the question is seldom the age old “to steal bread or not” -- rather, it is whether to extract a few extra basis points out of some investment dealing and in exchange introduce some small likelihood of catastrophic client or societal risk. Remember, at its baseline a financial security is a contract listing rules. The rules are designed by people like us. We must design them well and be intrinsically motivated to do so.
Just like how if we want a superb wedding cake, we need both a skilled baker and also for that baker to want to make a great cake, the only way to create ethical investments is to have ethical people (1) be skilled financiers and (2) think about how to make financial products ethically. To be clear, I do believe the large swath of financial professionals are actually ethical, but the deliberate focus on ethical product creation is often missing. The question “How could this be abused?” is not being asked often enough nor answered thoroughly enough. So to those who think “No, not I”: I support your sentiment but ask you to consider that it is not enough to have good morals passively, we must apply them actively. And for us financial professionals, it is here, in ethical investment creation, where we apply our morals in our profession for the betterment of our society. We need strong leaders not just to make returns as money managers but to make those returns soundly, as stewards of capital.
So, I will part with this. I am often told, finance is a greedy, greedy industry that does no good. And my response is always some variant of:
“Look, it’s not that I don’t believe you -- finance has, many times, abused its extraordinary tools. However, with ethical regulation we can stop those bombs before they go off and dissuade those who may be tempted to build and plant them. And this forethought comes from moral leaders willing to apply disciplined rules to markets. And those leaders who are responsible for our industry, they exist in all of us who are in finance. So as I said, it’s not that I don’t believe you -- it’s just that the future of finance is not this hopeless thing. Us who care cannot and will not let it be.”