The Cause of Bubbles = Financial Engineering vs Investing

The only way to address executive compensation and the inevitable boom and bust cycles that will happen in perpetuity in this country is to finally recognize the difference between financial engineering and investing.  For some reason no one in any of our regulatory agencies seems to want to admit or deal with the differences.  Too much pressure from Wall Street ?

In any event, the following is  a post from a year ago. I thought it was worth republishing.

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  entrepreneurs and businesspeople will be used as intended, 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.

24 thoughts on “The Cause of Bubbles = Financial Engineering vs Investing

  1. you can email me at wes_21@hotmail.com

    Comment by jwjpipes -

  2. hey mark not sure if you read comments….if you do im reaching out in desperation. I am a huge mavs fan and live in san antonio…im here because my sister recently attempted to commit suicide and is in the hospital and my friends 29 year old brother just died of cancer. going through a rough time. looking for anything to make us smile. i know it sounds corny but i was wodnering if you could help us out with some tickets to the game tuesday….i know this is really lame but we are both broke and looking for something to take our mind off the pain we are living in…..thanks a lot

    Comment by jwjpipes -

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  5. Great post Mark – I agree 100%. one question for you – how would you treat LBO’s – taking a public company private by borrowing against its assets/cash flow, usually by insiders? It seems to me to be a conflict of interest – if you’re the CEO leading the buyout, then why can’t you raise the share price to where it should be? And not buy out the co. at a low price, run it for a few years, and then go public again or sell to another company? it seems like the shareholders are already paying you good bux to do that. mike c

    Comment by mojomikey -

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  7. “Its not wrong to run with bull markets and leverage to the hilt.” Yet, “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.”

    1) Aren’t you contradicting yourself? LT investors are very unlikely to leverage to the hilt, because they would have to make interest payments. Institutional investors may be able to afford this, but not individuals.

    2) FINANCIAL ENGINEERS CREATED FINANCIAL MARKETS!!! Bond rating companies were more at fault for what happened in 2008 than any financial engineer (not that they are the only cause).

    Comment by phillipm09 -

  8. Pingback: Financial Engineering vs. Stupidity « Marc It Up

  9. Lazy analysis – correlation does not equal causality. Drop the ball squarely on our govt not doing its job. One small example: The SEC has been empowered to regulate the rating agencies like S&P and Moodys. They *sold* bond ratings and rated bonds that were junk as equivalent in risk to a US govt bond. In SEC speak, the rating agencies are “nationally recognized statistical rating organizations” and are empowered to do so by the SEC. Rating a pool of second mortgages of sub-prime borrowers where the collateral was vacation homes as AAA is LUDICROUS. Had the rating agencies not rated this CRAP as AAA, then the organizations that bought them for the most part would not have bought them. The rating agencies were a giant enabler and the SEC did not ACTIVELY regulate these organizations.

    The credit crisis was not the result of financial speculation, it was the result of a lack of doing the oversight that the govt was supposed to do. The Madoff ponzi scheme same thing. Our taxes are supposed to go to oversight, not to “CYA” activity by regulators, but that is the end result.

    Comment by bikenfly -

  10. I’ve got some ideas on the current housing market and would like to discuss them with you, Mark Cuban.

    I believe the economy, culture and society are in a unique transition from the 20th century.

    The fun is making a difference.

    Comment by tangiblesolutions23 -

  11. Mark, you’re trying to out-think the room.

    The issue is really quite simple: bad . . . no, make that downright stupid . . . credit analysis. That’s the cause of the melt-down. No more, no less. When bankers en masse lend money to borrowers who have zero chance of being able to re-pay, there is only one possible scenario; crisis. The presence or absence of all the other stuff, the financial engineering, the leverage, etc. is just ornamentation establishes the details of what this particular crisis looks like. Had we had no financial engineering, etc., the crisis would have had a different appearance, but we’d have still had a crisis.

    To prevent such crises from recurring, we’d need to find a way to banish stupidity, something humanity has been struggling with since some cave man stuck his hand into a flame in an attempt to take it with him.

    Comment by mhg6mhg -

  12. the only flaw in this scenario is that ipo’s are not available to the public. They are only available to large money managers, the wealthy and company insiders. The last of these rairly sell within the 5 year period. The bubble is created purely out of greed. Handcuffing such maney managers that are using other peoples money to profit personally would go a long way to ending the NEXT bubble!

    Comment by dewald2001 -

  13. Whoops, forgot to add my solution: A separation of capital requirements for insurance companies and banks. As far as I know it, banks have a total capital requirement which encompasses all their divisions. This is made up from risk analysis from each of the divisions, then added up. I think legally we should separate the liabilities. So as an example, if you as a bank want to have an investment banking division, you cannot use capital from your other divisions to recap losses from that investment bank division. That way capital which is on hand to fund lines of credit cannot be used to recoup losses from I bank trading.

    Same thing with an insurance company. If you are responsible for insuring the homes of millions of people, and you want to also insure risky hedge fund transactions, legally you should not be able to use premiums from house insurance to pay claims on trading losses.

    Comment by loucons -

  14. Got to say I disagree. I don’t see any difference between financial engineers and investors. The line that struck me was, “Financial engineers should have to pay a premium for the risk they introduce to the entire financial system.”

    I don’t think these parties are introducing any [b]unexpected[/b] risk to the market. Simply trading stock time and time again is just an exchange of funds from I bank to I bank and will increase price volatility. But this is the nature of ANY market. And these investment banks are designed to take heavy losses from such volatility. However when insurance companies, traditional banks and pension plans decide to insert themselves in this situation, this is imprudent. These parties are necessary for stability: people need insurance in case of accidents and people need a place to reliably store their money and collect pension. People don’t go hungry when a hedge fund fails, people DO go hungry when a bank is unable to extend credit lines to brick and mortars.

    They should not have insured and made loans to such a percent of their total porfolio to risky hedge funds.

    The way to limit this risk is through education and transparency. Because what we had were huge insurance companies making poor judgments based on convoluted information. They insured loans for much more than they should have. That’s not the fault of financial engineers, that’s the fault of retards at AIG and retards at rating agencies. Those are the people who should lose money. Frankly I am perplexed at how rating agencies such as Moodys and Std. and Poors are still in business after this. But that is an aside because insurance companies and banks have a responsibility to perform risk analysis on their investments themselves.

    Premiums insurance co’s charged should have been much higher on these highly levered, high-risk financial instruments. Banks should have demanded higher interest on loans made. I’m not even mentioning the fact that insurance executives encouraged this behavior, and then we bail them out with taxpayer money.

    Insurance companies behaved like a bank making loans to everyone that walked in the door regardless, then didn’t have enough in the coffers when the bank run took place.

    Comment by loucons -

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  16. I meant to add that I agree whole-heartedly with the general ideas related to the excessive leveraging. That needs to be fixed.

    Comment by jmlamontagne -

  17. I’m a little disappointed here. I usually really like your perspective, and I think you lead off very nicely in the first part of this entry, but then you turn to gospel and start bashing all short-term investors with way too black-and-white of an approach considering the topic. It’s much grayer than you make it seem.

    First off your suggestion on IPO’s is ridiculous. Almost no retail investor has access to those offers, but it’s rather a goldmine for institutional investors or rich individuals that are engaged in the market.

    A lot of your propositions would debalance the system and favour a certain type of investment. Not good.

    Long-term investors were just as responsible for the crazy valuations in just about every bubble. If they thought the prices on their assets was too high, they should/would have sold and prices would have gone down.

    You vastly under-value the worth of having liquidity in a market. Short-term traders provide that, and, are playing a zero-sum game if the market as a whole doesn’t go up. Which is why a lot of them are now out of jobs.

    Don’t really feel like expanding more as I’ve already written on this.

    Comment by jmlamontagne -

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  19. I congratulate Mr. Cuban for a concise description of the structural instability inherent in our economy, and his recommendation for policy change. The term “financial engineer” is particularly appropriate, as it leads one to the conjecture that perhaps these periodic financial crises are less accidental than they seem. This line of thinking tends to be generally dismissed as conspiracy theory. But if you think about the implications of financial engineering and the regulatory environment necessary to promote it, you will begin to see that a lot of seemingly irrational policy decisions make a lot of sense, especially in the context of informational asymmetry and moral hazard. Not everyone loses in a financial crisis.

    Comment by thegeniusfiles -

  20. This is an outstanding article, it should be required reading by EVERY “investor”

    Comment by Bill -

  21. You might catch your elbow on the rim playing Slamball.

    Comment by growhappy -

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  23. I agree. But I think you’re being a little too lenient on the traders. I think it should be a graduated tax, that starts sloping steeply depending on the gain.

    Comment by soiquitmyjob -

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