THE CREATORS AND CORRUPTORS

OF AMERICAN FINANCE

E D WA R D M O R R I S

The Scottish philosopher Thomas Carlyle famously asserted that “the his-tory of the world is but the biography of great men.” Most historians take exception to that simple approach to understanding the world’s develop-ments, but with respect to modern American finance, Carlyle’s “great men” theory rings true. Had the men profiled in the preceding chapters—the reformers, the democratizers, the academics, the financial engineers, and the empire builders—not come on the scene, the new, multi-trillion-dollar asset classes devoted to venture capital, derivatives, hedge funds, junk bonds, index funds, and asset-backed securities may never have emerged. Nor, perhaps, the trillion-dollar financial institutions. Collectively, these fourteen men played a major role in transforming finance from an impor-tant but subsidiary sector of the U.S. economy to its main driver.

The numbers back up finance’s new dominance. Consider corporate profits. In the early 1980s, financial businesses accounted for between 5 and 10 percent of the profits earned by U.S. corporations. Banks and investment firms were relatively small, and their roles were largely limited to facili-tating transactions as agents and intermediaries—underwriters, brokers, deposit takers, short-term lenders, and money managers. But starting in the last two decades of the twentieth century, financial institutions experi-enced a prolonged growth spurt fueled by two concurrent developments: the explosion of new financial products and services and the deregulatory

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initiatives that allowed them to more easily access new capital, diversify their businesses, and act not just as intermediaries but as principals—proprietary traders, arbitrageurs, bridge capital providers, securitizers, pri-vate equity investors, and hedge fund operators. As a result, the finance industry’s share of U.S. corporate profits ballooned to around 30 percent. Today, no other industry—not energy, not technology, not health care, and certainly not manufacturing—comes anywhere close to the percentage of profits claimed by finance.

The finance sector’s growing domination of U.S. corporate profits is reflected in the overall economy. For most of the twentieth century, finance accounted for a little over 2 percent of U.S. gross domestic profit. By 1990 its GDP share had increased to 6 percent and in recent years it has been more than 8 percent. The Dow Jones Company has recognized this trend in its selection of the thirty companies it believes best repre-sent the U.S. economy. For almost one hundred years, the Dow Jones Industrial Average included not a single financial services company; J. P. Morgan was the first to be included, in 1991. Today—with BankAmerica, American Express Company, and Travelers Companies joining JPMorgan Chase—there are four.

Has Financialization Been Good for Us?

There is an awkward new word to describe the finance sector’s increasingly powerful role in the economy: “financialization.” This book’s fourteen men are in many ways responsible for this—and an important closing question is whether financialization has, on balance, been a good thing. There are several reasons to think it has been—and at least as many suggesting it has not.

In the plus column, stock ownership has almost always been a posi-tive experience for sensible, well-advised, and long-term-oriented inves-tors. The quality of their lives and their retirements has been enhanced by direct ownership in a capitalist economy. Several of the men profiled deserve credit for promoting a healthy expansion of individual invest-ing in the stock market, including Ferdinand Pecora, who led the hear-ings that resulted in investor-protecting regulation; Charles Merrill, who built a business based on responsible and informed investing; and John Bogle, who gave investors a cost-effective approach to investing through index funds.

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And despite his personal peccadilloes, it is hard to be anything but laudatory about Georges Doriot. The professionally managed venture capi-tal industry that he created has done more than just promote economic growth—in today’s technological world, it has proven indispensable in developing the innovations necessary for global competitiveness. The peo-ple who run venture capital firms—and today there are hundreds of firms larger than Doriot’s American Research and Development Company—are quick to point out that their business has little in common with that of Wall Street. But in fact, they have largely usurped the role the Wall Street underwriter once played in allocating equity capital. The general partners of venture funds have become the new gatekeepers of finance. Some of the decisions about which new industries and which individual companies will get capital are still made in New York and the other money centers of the country, but nowadays those decisions are more often made in Califor-nia’s Silicon Valley. Unlike Pierpont Morgan, who often had the last word regarding which railroads and industrial companies received funding, today’s Wall Street investment bankers usually line up to bid for the initial public offerings of already successful venture-funded businesses. And also unlike Pierpont Morgan, whose guiding principle was to avoid risk, venture capitalists understand and even embrace it. As Doriot himself experienced, a successful venture capital portfolio will contain many losers but hopefully a few big winners as well. This has transformed risk from a four-letter word to a fact of financial life—and the American economy has benefited hand-somely from a long list of venture-funded “fliers” that includes names such as Google, Apple, Oracle, Amazon, Genentech, Facebook, and Starbucks.

Among the other pluses for financialization are liquidity and efficiency. With so much trading in the financial markets—and with the securitization of so many assets—institutional and individual investors alike can usually buy and sell financial assets without fear of disrupting market prices; mak-ing large trades without affecting price is the hallmark of a liquid mar-ket. Heavy trading volume also keeps the markets efficient. With enough informed participants on both the buy side and sell side of securities trades, investors can be reasonably confident that the price of a stock, a bond, or even a derivative is reflective of its intrinsic value. Paradoxically, Benja-min Graham, who so methodically described how to ascertain intrinsic value, may have been his own worst enemy. By educating a large audience through his books and lectures on the topic, he made the markets more efficient—and the prospect of finding investments selling above or below their true value all the more difficult.

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Yet financialization has brought about many problems. One, utterly basic, is that finance is a cost. Commissions, fees, and the like are necessary costs, and the existence of an effective system of financial intermediation is required for any developed economy. That said, above a certain point—around 2 percent of GDP perhaps—any excess payments to the financial sector become a drag on the economy. When money managers and traders garner a growing share of the nation’s wealth by skimming profits off the top—whether as hedge fund partners, high-frequency traders on the stock exchanges, or securitizers who transform the origination of a simple home mortgage into several commission-generating transactions—little is added to the economy or the public weal.

A less tangible but perhaps more worrisome trend for the long run is the migration of talent to Wall Street. Compensation in the financial services sector greatly exceeds that in other industries for workers with similar skill levels. Rather than taking jobs in industry or education, many graduate stu-dents with degrees in math, engineering, and science seek more lucrative careers designing trading algorithms and structuring new financial prod-ucts. With the same motivation, a high percentage of the best and brightest college graduates choose Wall Street over more traditional occupations and professions. Even though the 2008 financial crisis significantly moderated this trend, finance still ranks very high among the favored career choices for Ivy League graduates.

In terms of the well-being of society, these career choices often lead to an overall loss to the economy, since a distressing amount of what goes on in Wall Street, especially in the trading rooms and hedge funds, is an institutionalized zero-sum game. Any gains one investor realizes are losses for another. No overall economic value is created by the traders. And since an extraordinary amount of leverage is often used to finance their trad-ing, they are prone to create catastrophic losses, such as those produced by Myron Scholes and the other general partners of Long-Term Capital Management. Those losses, if large enough, destabilize the markets and the economy—and, as we know too well, trigger taxpayer-funded rescues.

Another major problem with financialization is its effect on the politi-cal process. Watchdog groups such as the Center for Responsive Politics report that the financial services lobby donates far more money to political campaigns than any other sector, including health care, energy, or defense interests.1 In the early twentieth century a young Carter Glass only reluc-tantly took a position on the House Banking and Currency Committee. Today, landing a spot on the successor House Committee on Financial

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Services is a coveted and lucrative appointment. The money from lobbyists hired by the banks flows generously to finance committee members as soon as they are appointed—which may explain why the House committee now has sixty-one members. In a remarkably candid assessment of the power of the financial lobby in Washington, D.C., the longtime Illinois senator, Richard Durbin, remarked simply, “They own the place.”

If one assumes a connection between political donations and legislative favoritism, the continuation—and rapid growth—of obviously dangerous practices and policies in the financial markets becomes less puzzling. Carter Glass and Ferdinand Pecora decried the stock market of their day, saying it resembled little more than a gambling casino run only for the financial benefit of its operators. But in fact, no financial institution has more closely resembled a casino than today’s hedge funds, whose general partners con-stitute both the “house” and the players. Yet hedge funds, despite their well-proven economic dangers and lack of social utility, continue to operate with a most-favored status in Washington. They are, for instance, allowed to pay lower than normal taxes, because the U.S. tax code lets them classify much of their income as capital gain.

Most perplexing of all has been the continued existence of banks that are “too big to fail.” After the hundreds of billions of dollars used to bail out the eight mega-banks following the 2008 debacle, most of the same banks have only grown larger, and the banking industry more concentrated—and more politically influential. In the banks’ defense, their continued growth has made it possible for them to repay the rescue money that was provided to forestall their financial collapse; yet the repayments are hardly sufficient recompense for the widespread and long-lasting economic hardship suf-fered in the aftermath of the crisis.

There is no shortage of good ideas on how to shrink the size of today’s too big to fail banks, but the political will is lacking. Some have suggested that the government impose progressively higher tax rates based on bank size to fund a kind of insurance policy that would protect taxpayers in the event they are once again called upon to provide a financial rescue. Or, to prevent future jolts to the economy from a collapse, increasing the percentage of capital a bank has to maintain as it grows larger. Or, with a practical mind-set that equates too big to fail with too big to exist, simply busting them up into their component parts. When that latter approach was argued in the 1930s in connection with the proposed Glass-Steagall Act that separated investment banking from commercial banking, J. P. Morgan Jr. warned about the dire consequences to the economy if the bill passed.

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The chiefs of today’s big banks echo these warnings when such suggestions come up. Yet the Glass-Steagall Act passed in 1933 despite the protests of the bankers, and several years later, Pecora pointed out correctly that “no disas-ter befell”—not until much later, that is, when Sandy Weill and others on Wall Street successfully pushed financial deregulation through Congress, including a repeal of the Glass-Steagall Act.

Yet there is cause for optimism. Many of the characters we met in earlier chapters, including Bill Donaldson, John Bogle, John Reid, and even Sandy Weill, are now advocating a smaller American financial establishment with a greater emphasis on traditional client-based brokerage and investment banking businesses. At the same time, the financial reform measures of the 2010 Dodd-Frank Act, passed in the aftermath of the 2008 crisis, appear to be gaining traction.

And Morgan Stanley, the investment banking incarnation of the House of Morgan that has figured prominently throughout this book, has recently made strategic moves that bode well for a more sensibly run Wall Street. The firm was the first traditional investment banker to pass through the $1 trillion in assets level—and it dedicated too large a chunk of those assets to ill-advised proprietary trading ventures. But since its bailout, Morgan Stan-ley has scaled back. It shed its hedge fund business and greatly deempha-sized the trading that caused it such trouble. It has bolstered its traditional strength in investment banking. And by purchasing the Smith Barney operations from Citigroup, it is now, measured by number of brokers, the largest factor in the relatively stable retail sector of the investment busi-ness. Most encouraging, Morgan Stanley’s chief executive, James Gorman, has pledged to cease casino-like activities and to engage only in businesses that are client-focused and in which risk is controllable. “We should not be a firm that is betting our shareholders’ capital for our own benefit,” he says. “We should be working with our shareholders’ capital for our clients’ benefit.”2

That sounds like something Pierpont Morgan himself might have said.