The Cause of Bubbles =Investment vs Financial Engineering

Let me get this straight.  In 2008, funds trying to squeeze out another basis point or two thought they were being conservative  buying insurance on heavily leveraged portfolios of sub prime loans and other debt. Once those loans started to default, it  created a cascading deleveraging event which lead to major financial institutions failing and the “smartest” minds on Wall Street being forced to dump everything to raise cash, which in turn lead to a crisis of confidence and deleveraging that created the worst week in the history of the stock markets. Did I get this right ?

In 1987, funds, trying to squeeze out another basis point or two thought they were being conservative, buying insurance on leveraged stock portfolios. Once the stock prices on those portfolios started to drop, their insurance programs pushed them to dump everything AND sell stock index futures to raise cash, which in turn lead to a crisis of confidence and deleveraging that created the worst single day melt down in the history of the stock markets.  Did I get this right ?

Think it wont happen again ? Of course it will.  Whatever money the Fed makes available to stimulate the economy will be used, as intended,  by entrepreneurs and businesspeople to create and grow businesses.

Unfortunately, it  will also be used by financial engineers to try to find a way to make HUGE profits from  highly leveraged,risk laden financial packaging. Why wouldnt they ?

If you can borrow  cheap money  , invest  in some asset that can be marked to an increasing market, borrow  against the gain and buy something else and do it as many times as possible,  wouldnt you ? Its exactly how homeowners In a bull market drove up real estate prices with a few making huge money.

If you could do the same thing, but instead of with houses, with stocks or asset backed securities, and instead of with thousands, do it with billions so you could profits in the 10s of millions or more, wouldnt you ?

Hell yes you would. You certaintly arent going to tell yourself that you could be creating the next big bubble that could rival 1929, or for future generations, would rival 2008, so dont do it. You would go for the money.

Which is the genesis of our problem in the US.  Its not wrong to run with bull markets and leverage to the hilt. That can be a very good thing. But we have to make the upside based on investments, rather than financial engineering. Which is exactly why we have to change our tax code. We want to encourage investment, not financial engineering.

The financial  markets  were originally defined as markets that created capital for businesses to start and grow.

Today, that is rarely the case. Sure companies do come to the markets for cash for growth and that should be encouraged.  But those examples are a tiny percentage of the market.  When a stock turns over its float multiple times in a day, those are not investors buying and selling the stock. Those are traders or financial engineers.

The ONLY WAY WE ARE GOING TO END THIS BOOM AND BUST CYCLE IS IF WE DIFFERENTIATE BETWEEN INVESTORS AND EVERYONE ELSE.

Investors should be rewarded for actually owning companies and gaining returns on their investments. Financial engineers should have to pay a premium for the risk they introduce to the entire financial system. It was not investors that brought on the last 2 crashes. It was the financial engineers.

The beautiful thing about this country is that we like to work hard, and we like to take chances. Unfortunately, over the last 15 years, the incentives have been to take chances as a financial engineer rather than as an entrepreneur. We give far more money to people who play games with financial instruments than we give to people who come up with ideas for the next big thing.  That needs to change if we want to remain a leader in this world.

Here is what I would do to change things

I would change to zero the taxes on any gains from the sale of stock or bonds purchased during an IPO and held for 5 or more  years. All dividends/interest paid by that stock/bond would be tax free. If you sell it prior to the 5 years, you are taxed at your personal regular income tax rate.

In addition, I would not allow the stock to be borrowed against in any way. If it was, it would be considered an effective sale. Which means you couldnt borrow on it tax free until you have held it 5 years.  Bottom line, if you hold the stock/bond , like a real investor would, you are rewarded for it.

For purchases  post IPO, in the open market,  the same rules apply, except I would tax a personal income rates the dividends/interest  for the first 5 years of ownership.

For all other transactions, whether they are options, derivatives, stocks, bonds, whatever, all gains and losses would be taxed at personal income rates.

If you are a great financial engineer and make tons of money at what you are doing, more power to you.If you are good at what you do, you pay more to Uncle Sam, but you still make a boatload of money.

I would keep taxes on private transactions, just where they are. Private transactions are less liquid and harder to value, which in turn makes them harder to borrow against. Which reduces leverage in the system and encourages investment. Its hard to financial engineers a private company. I would tax gains and losses in private companies at capital gains levels, but I would extend to  3 years the marker to not be considered a short term investment. I would keep the active vs passive rules.

Next there is the issue of leveraging. No one ever complains when cheap cost of funds creates leverage and drives a market up.  And no one ever will. So we have to set strict leverage limits. We set margin/leverage limits on day traders as the tech bubble burst. The only difference between the day traders of the tech bubble and the Investment Banks and AIGs of the world that cratered in this bubble is that the big guys started with more chips at the table. And they picked their own credit lines and there was no pit boss to watch over them. I would limit to 2x the leverage available on any asset that is insured by the government or is offered by any organization that is elgible for government insurance  or tax incentives of any kind.

Of course, I would still levy a fee of anywhere from 1c to 10c on every transaction of stocks or bonds which would go into a general fund, that I will call the “Oh Shit We Missed It Fund”. It will be there to fund the inevitable situation where someone figures out how to work around whatever regulations and tax code that is created.

As an entrepreneur, I can tell you that this would not change how I ever started or invested in any business. As someone who trades stocks, It would impact my investment decisions. I would only trade out of necessity. I would be willing to take lower yields on my investments, making it cheaper for companies to raise funding.

I also recognize that it would mean that the chances of the Dow ever hitting 14k in 2008 dollars is about as likely as my catching my elbow on the rim playing basketball. I dont think thats a bad thing.

46 thoughts on “The Cause of Bubbles =Investment vs Financial Engineering

  1. the CLO’s and CDO’s that were structured and created this mess are offshore, and many are not even paying taxes!!

    Comment by pire ilaçlama -

  2. Great post. The issues surrounding the current crisis are complex,
    and powerful leadership is needed. Don’t expect any quick fixes.

    Comment by Justin MacArthur -

  3. Hi people,

    I am new to this forum blogmaverick.com and hope that anybody can
    give me an advice on the forex market – I am looking for an introduction
    for noobs. I have already a little knowledge about shares. (Hope this is the adequate category.)

    Help is so much appreciated. Most important question: can a noob make money on the forex market?

    Thanks,
    Jim

    Comment by jimbomel -

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  5. You are EXTREMELY naive. This is a planned event by the new world order to create One World Government under Socialism. Machivelian politic’s at work. Government creates a major problem, then comes in as the great savior. Getting total control in the process. One needs look no further than the take over of AIG (worlds largest insurance company)where the PRIVATELY OWNED federa; reserve gained 80% control as part of the deal. DUH! Pay attention and follow the money or lack thereof. Also keep in mind the US dollar is FAKE money, and has nothing to back it other than the tax’s Americans pay.
    Blessings to all and welcome to Global Depression.
    Tom

    Comment by Tom -

  6. Mark, brilliant observation re: investment vs. financial engineering. I’ve had this same feeling for some time now and made this exact arguement (although with no solution) in coversation with a friend earlier this year. This is the first time I’ve ever seen someone else articulate this same observation. Why is there such limited discussion on this topic? Please help keep this conversation going as I feel like our leaders are missing the “bigger picture” lessons re: the direction of our economy and the role of Wall Street.

    Comment by David -

  7. Although the crisis has not yet directly effected any company directly
    in my country as of now – it is creating havoc in the stock market
    with hedge funds and FIIs pulling out of the market. Hopefully, it is
    shortlived.
    Anyway, thanks for such an insightful post. It was a pleasure reading
    it.

    Comment by drjupitor -

  8. Pingback: HRM Today - Blog Archive » 25 Ideas for Employees and Employers in the Financial Crisis

  9. Pingback: Oliver's Stuff » Think it wont happen again ? Of course it will. Whatever money the Fed...

  10. Mark,

    i dont disagree that the tax code should be changed, but i disagree with the idea that IPO’s should get some special treatment. most individual investors cant find quality fundamental information on a company going public until they are already being traded. so essentially, youre proposing that individual investors should A) hand all their money over to the people that leveraged themselves 40:1, or “invest” based on an idea, and not a sound company.

    as for the cause of bubbles, it often involves leverage, and to that end we can agree. but this goes beyond financial engineering and to the heart of human nature. people speculated in housing, and have done so since people have been building homes. they did it with dot-com stocks, they did it with the “nifty fifty” in the 1950’s/60’s, they did it with railroad stocks in the 1800’s. hell, they even did it with tulips.

    we can make the system better, and i do appreciate the ideas floated around by you and others, but this has just as much to do with the fact that humans have done this since as long as financial history has been written.

    Comment by Ryan -

  11. Bubbles behave like avalanches – once they reach a critical size,
    they are hard to stop and will destroy almost everything on
    their way down, until they hit the bottom and you may start improving
    the prevention system, e.g. flatten the slope, building barriers or
    blowing the snow clouds on time away.
    Snow equals money, in this case the Fed brought a snow shower
    in 2002 and 2003 with their freaking low prime rates.
    The big fault was, that most of the money clustered in a few stocks
    and only the speculators had the key for those storage rooms. It was
    like gambling money for them.

    It`s time now to change the financial system in many dimensions. Your
    ideas are very inspiring and hopefully will find their implementation
    in the “new” market. But i fear, the solutions will be primarily
    one-dimensional, easing the pain of the current crisis, and not
    approaching its causes.

    Comment by Marc -

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  13. Hedge funds, panicky traders and margin calls are causing a huge sell off.

    I would love to hear some ideas on some solid companies that have been battered by the panic, but run a good business?

    Comment by EG -

  14. Mark, good post. I agree, tax laws should favor long-term investors
    far more than traders and financial engineers. As someone who
    came to this country almost 30 years ago, I do believe the US
    economy will recover and even thrive in the near future. The fact
    that rogue companies are punished quickly and violently in our
    markets is a testament to the strength of our system. In Europe
    and Asia such companies could survive for years. The feedback
    mechanism in our market is not perfect, but it is better than
    anything else out there.

    Regards,
    Jacob

    Comment by Biju Jacob -

  15. the CLO’s and CDO’s that were structured and created this mess are offshore, and many are not even paying taxes!!

    Comment by Ben -

  16. Great post, Mark. You are spot on with this analysis. This is a good example where the problem is BETTER regulation (ie, good tax policy), rather than MORE regulation. If only the voting public cared enough to get rules such as this implemented. People are too short-sighted andself-interested when the pork comes pooring home, though.

    Comment by John Sloan -

  17. “The beautiful thing about this country is that we like to work hard, and we like to take chances. Unfortunately, over the last 15 years, the incentives have been to take chances as a financial engineer rather than as an entrepreneur. We give far more money to people who play games with financial instruments than we give to people who come up with ideas for the next big thing. That needs to change if we want to remain a leader in this world.”

    maybe the best thing youve written yet
    j

    Comment by staypuftman -

  18. Mark,

    Admittedly I’m a little on the lite side when it comes to finances and financial markets, so I’m reading all I can and listening. That said, I don’t have the money to go long or to even stat back into saving a lot (since the divorce). But, I am doing something smart, getting me ready for that rainy day and the opportunity to “go long”. I’m paying down all my debt. I’m saving a little, and freeing up money that I have so I can start investing for my future. And I’m looking at CDs for the time being. Thanks for the advice. Go Mavs! (Go Cowboys!)

    from Maryland

    Comment by simply scott -

  19. I think you nailed it on CNBC last night. You should post a schedule on when you are appearing on TV or give a recap on your blog. Twitter might be too much but I don’t think people would mind too much if you dropped a note once in a while.

    What confuses me is why do you have more understanding of the financial market than the hosts and most of the guests? Do they not have access to the same or more info that you have? If anything they get their data first, so you would think that they would keep abreast of the current situation.

    I think it can be wrapped up like this: Information by itself is worthless. Everyone has access to it and cannot be of much value to the individual investor. Only when information is dissected, analyzed, and applied to your situation, can it truly become intelligence.

    Comment by TomH -

  20. Higher taxes and more fees are not incentives, they are demotivators. We do not need demotivators in the market. That harkens back to the 1970s when people with investment dollars were reluctant to invest funds in innovation because of the LACK of risk/reward. They were assured of having a certain majority of their funds taken in taxes and fees: demotivation.

    We need another idea entirely. Forget taxing, fees, and new laws. By the way, I am not Libertarian, I just know that taxes, fees, and restrictive laws do not work. They never have. Growth comes from investment and innovation (and some luck). We have to think motivation.

    Comment by Curtis -

  21. I came across this post as a “random hot post” in WordPress’s control panel – you certainly seem to have some good ideas. I have to admit that I’m no expert on modern economics, but it doesn’t take a genius to see that the way the stock market works these days is fundamentally wrong, and actually contrary to the interests of both businesses and consumers. I wrote about it here:

    http://www.sachikospace.com/english/2008/10/financial-crisis-raises-fundamental-questions/

    I think we really need to get back to basics, and make some fundamental changes. I really think business executives need to have more personal liability, so public companies are run by the same sound rules of business that private companies are – we need to put the consumer ahead of traders.

    Comment by Sachiko -

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  23. The first thing I’ve read that’s made since all this crap started. Hope somebody’s listening..

    Comment by MouthyGirl -

  24. In my view, it’s not that simple. I don’t think we can say:
    Investors (Good) vs. Financial Engineers (Bad)

    You are right about your premise but wrong in the solution.

    The same people who are financial engineers will use legal tactics
    to redefine themselves as “investors”. Why wouldn’t they?

    The solution to me is to realize the greed is hear to stay and set up
    regulations as best as possible to minimize risk. Financial
    engineering is fine as long as it doesn’t create a 45+ trillion
    house of cards.

    Mortgage swaps should have been regulated in the same way as
    insurance. We should treat financial engineers as
    “insurance companies”. That’s my 2c.

    Thanks very much for the article!

    Comment by Larry Freeman -

  25. Mark
    They are talking your idea on public ownership ofthe “trash debt”
    What time are you on CNBC?

    Comment by dan -

  26. the days of MIT mathematicians running to Wall Street for financial engineering jobs has to end if this nonsense has any chance of ending.

    Comment by stone -

  27. Mark, I thought you were a libertarian. We need fewer regulations,
    not more. What causes bubbles is government manipulations in the
    markets coupled with low interest rates set by the federal reserve.

    Comment by Jay -

  28. .10c a share?? that’s $100 on a 1000 sh purchase! I guess the
    markets should be the playground of the wealthy. There would be
    much less liquidity and it would encourage companies to do reverse
    splits. All bad especially for small investors. What we need are
    regulated exchanges for the CDS, mortgages that allowed these
    investment banks, banks , and GSEs to get 40-1 leverage. A clearing
    house in regulated markets insure that it’s participants have the
    neccessary capital (don’t over leverage) to invest. 40-1 leverage
    wipes out equity when a position goes against you by 2.5%. I’m
    not allowed to do that, why should they? Why should I be penalized
    in the market when I didn’t cause the problems?

    Comment by Rich -

  29. Adams’ post reminds me of a quote that I am rather fond of:

    “The first 3 rules of an entrepreneur are never, never, never run out of cash. The fourth rule: Take money when you don’t need it. It won’t be there when you do.” – Cary Bullock

    Comment by Lance -

  30. So you’re saying the root cause of the housing bubble was the Taxpayer Relief Act of 1997? That’s a great insight.

    I’m on board with you general idea of incentivizing investment v market gaming. But I wonder if there’s a simpler solution.

    Comment by Scott Stewart -

  31. Hi Mark, good post. I really hope something does change with how the markets work.

    Alsl enjoyed your post about the dividend yielding stocks. I’m glad there
    is an outlet foe good information instead of always hearing the company line.

    Comment by Rajiv -

  32. Winners and losers of this financial meltdown.
    http://gianpaolograzioli.blogspot.com/2008/10/winners-and-losers-of-financial-market.html

    Comment by gianpaolo -

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  34. You are right on target with this one Mark! Too bad the “elite” making
    the rules don’t have a business mindset and are controlled by the
    negative side of greed. The new business in this country is to find
    loopholes inside our economy to make money instead of staying ahead
    of the world with global ideas.

    Comment by OleBoy -

  35. Sorry for a couple of dropped letters above. Where is the comment spell check when you need it? LOL

    Comment by Adam Bryson -

  36. What i like most about reading your blog is that it opens my mind to concepts and terms that we don’t hear anywhere else. I totally get the term financial engineers – that’s what they are. Yet you don’t hear the talking heads using that term and I think they should. I’m sick of hearing about how opanies need to be able to borrow to make payroll. That’s not what it is all about. The reality is that if a company can’t make payroll then they are not a viable business model and no bank will ln them money anyway. The banks lend money to the companies that don’t “need” it. That’s the problem that mainstreet is facing and they don’t have the stock market to help either. Rebates and tax credit don’t help either – you have to have the cash to pend upfront and wait to get it back. That doesn’t elp main street. Find a way to get main street ealthy and the reqards will trickle up – not down. That”s my two cents anyway.

    Comment by Adam Bryson -

  37. Although there would be many details to work out with this policy, I agree that it is a step in the right direction. This is the kind of innovative thinking we need from our government. I’m pretty confident that a discussion of this solution has not even been discussed in Washington even though it directly attacks the real issue which as Mark states is the rewarding of financial engineering and not of investment. Mark, you always come through with some of the most innovative solutions to the toughest issues that we face. Hopefully, you use your influence to get a couple of congressmen to listen to you and at least think more critically and foreward about these issues that we face today. We all can write our congressmen (or email) about this post and get them to think about attacking the root of the problem.

    Comment by Doug -

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  39. These are the kinds of ideas that can actually solve our problems by
    getting at the root causes. Is anyone in Washington listening? The
    problem with most of the quick fixes Washington prefers is that they
    just postpone reckoning and make the problems worse in the long run.

    Comment by Steve -

  40. You make a lot more sense than the economics professor I had to listen to. I especially like the point about not allowing stocks to be borrowed against or it would be considered a sale. Excellent point.

    Jillian

    Comment by Jillian Sands -

  41. Amen Mark, I love the quote “The beautiful thing about this country is that we like to work hard, and we like to take chances.”

    You really know how to cut through all the BS and get to the heart of
    the matter.

    Comment by GO Zone Investments -

  42. Mark, I wish they’d enact your rules.

    We’ll engineer around them.

    We always do.

    Take away the rules and we’re back to 1908. But it would work this time.

    Comment by Apep -

  43. You might find this intersting:

    http://unqualified-reservations.blogspot.com/2008/09/maturity-transformation-considered.html

    If falls in line with your skepticism of leverage, but does it in a bit more systematic manner.

    Comment by n -

  44. A lot of the boom and bust cycle has to do with monetary policy. The Fed lowers interest rates and it creates these speculative bubble in whatever asset class happens to get hot: tech, homes, etc…

    The real solution would be to get rid of the Fed and go to a gold standard or at least make the Fed adhere to a more conservative and stable monetary policy like Milton Friedman advised in Capitalism and Freedom.

    This is the fundamental cause of these massive boom and busts.

    Comment by Greg Feirman -

  45. Mark,

    I’m loving your posts on finance/investments. Not that I don’t like basketball, I just like finance and business a hell of a lot more!

    Couple thoughts. On the IPO investor tax break, we’d have to make sure that we don’t create an artificial opportunity to take companies private and re-IPO down the road to game the system. Minor detail, but worth mentioning.

    How about the idea of allowing companies to change their dividend policy to include shareholders of record from a date range instead of a single date. As an example, if a shareholder owns a stock from 01/01/2008 – 12/31/08 they would receive an annual dividend of x%. If you bought on 01/01/08 and didn’t hold it for a year, too bad. The dividends go to the long term investors, and the speculators are stuck trying to make their money on the stock appreciation.

    You could probably boost yields to long term investors to something near 10% on solid companies. Most short term traders don’t consider dividends as a key investment criteria anyway, so they probably wouldn’t miss the dividend much. It may be tough to pull off (or even require two classes of stock), but you have to admit it would create a lot more buy and hold investors.

    Keep the ideas coming, it’s nice to see there are others out there thinking through the big picture and trying to prevent tomorrow’s crisis from happening.

    From MC>
    Great idea on the range of dates. LOVE IT !

    Comment by Shane Jones -

  46. Sounds reasonable to me. IMHO one of the most egregious abuses of the tax code was allowing profits by hedge fund managers to be taxed as cap gains instead of regular income. Unless it’s your money on the line there no way you should get the benefit of the lower tax rate. The fact the loop hole wasn’t closed tells you a lot about power and money in Washington DC.

    I can’t believe you haven’t been on CNBC lately; they could definitely use some new blood.

    Thanks for all of the insight.

    Comment by l.a.guy -

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