Why do financial professionals make so much money? Engineers and physicists are also very smart but don't make comparable salaries. Teachers and professors--unlike most in finance--all have graduate degrees yet earn a small fraction of what financial professionals make. Nor are financiers particularly liked or admired (as opposed to doctors, who have high salaries and are generally respected). In fact, in literature and the Bible, moneylenders are often depicted as unsavory and rapacious.
For better or worse (mostly better), our free market economy relies on profit-making to guide economic decisions. The system does not distinguish between profits in manufacturing and profits in services or finance. And if there's money to be made in finance, then smart people are going to go out and make it. Hence the question becomes: What does the financial sector do that is so important to the economy that it generates so much income and so much assistance even when it is has been doing badly?
Most people don't understand finance because they see the world through the eyes of a borrower. They don't have lots of extra cash to invest but do require the occasional loan to buy a house or car or perhaps to send a son or daughter to college.
The lender's view of debt is very different. The person with money is trying to decide how to safely get the highest return possible. The lender has various options and weighs the potential rewards and risks. There is no urgency because these are the lender's surplus funds that can easily find a safe haven.
In return for a fee the financier plays the role of pooling the money from those who have it and distributing it to those who need it. Since they are at the center of the flow of money to consumers, governments and businesses, financiers control the lifeblood of the economy.
In today's world the financier's role has grown enormously, and this is the basis of financial wealth and its centrality to our economy. From 1945 through 1980, the Glass-Steagall law divided financial functions into separate institutions: Savings and loan banks (S&Ls) were restricted to providing home mortgages; commercial banks could not operate across state lines and served local businesses; New York banks served large businesses; insurance companies invested cautiously; a few firms served high-income clients; and investment banks served large companies on mergers, acquisitions and bond and stock issuance.
Today S&Ls play a very small role in the larger economy, the largest commercial and investment banks have become bank holding companies, and competition has become global. Big investors include hedge, private equity, money market, pension and sovereign wealth funds, as well as university endowments, insurance companies and companies with excess cash.
In this environment financial institutions have offered a number of highly priced services that companies and investors find worth the cost. This is a very competitive market and clients pay for what they perceive to be higher returns, less risk and reduced capital costs. While the financial sales pitch is intense, the purchasers are very experienced investors.
Finance is an unusual industry because it mainly uses other people's money and deals in long-term assets that have no certain value today. The incentives are skewed to take great risks, and the euphoria of a rising market often clouds the judgment of virtually everyone involved. As a consequence, the allure of great wealth has led to many scams, manias and subsequent panics.
The recent housing crash is an example of what high-powered finance can do right and what can go wrong.
On one hand, the process of securitization seemed to transfer risk to those who were willing to hold it and to provide loans to those who needed it. Structured finance, by prioritizing cash flows, seemed to create bonds that, under reasonable assumptions, had a very low probability of default. The system ostensibly became even safer when some investors used credit default swaps as insurance against default.
When interest rates were low from 2002 through 2004, a wave of refinancing and an expansion of subprime lending led to a rising share of homeownership, especially among low-income people.
When interest rates rose in 2005, this market dried up. Faced with losing a lucrative cash cow, financial firms instructed mortgage lenders to change the qualifying rules (permitting borrowers to have lower credit scores, giving high loan-to-value of-home loans, requiring no documentation of income and assets, and permitting a higher ratio of debt payments to income). At the same time, these less financially capable borrowers were given ARMs with teaser rates. Of course, all this added lending further fueled the largest short-term increase in home prices ever.
As we know, the process entered one of its manic phases as few people recognized the changed circ*mstances. First, many mortgages were given to people who had little chance of paying them off--and no chance of paying them off once housing prices stopped climbing at 10% per year. Second, many investors maximized yield by using lots of debt (leverage), which made losses pile up very fast when the market turned. Third, many instruments were bought by investors who relied on the coveted AAA-rating from the credit-rating agencies. Fourth and finally, there were so many interlocking contracts that it was impossible to disentangle them when the system was stressed.
When confronted by arguments about the fragility of the system, many financial analysts, government regulators and investors brashly dismissed the negativists out of hand.
Some people weren't so easily fooled. For example, Robert Shiller and Nouriel Roubini (who writes a column for Forbes) wrote many pieces about the crazy spike in housing prices. Jamie Dimon at JPMorgan decided in 2006 to cut his firm's exposure to subprime bonds and to do more hedging; a little later
Others saw the dangers but underestimated the downside risk. They looked at their balance sheets and thought that they could weather any storm. They were comforted that the previous "crises" of the last 30 years were fairly easily contained--e.g., the S&L crisis, the 1987 and 2001stock market crashes, and the collapse of Long Term Capital Management.
Today, the costs of financial excess seem very high. But what's the alternative--a Soviet-style planning board? Without a realistic alternative the financial industry had to be saved in 2008 and 2009, no matter what the cost. We'll never know what the future would have been if we had let more financial firms go bankrupt. But most economists think it would have cost more both in material and human resources and we might now have an unemployment rate of 15% to 20% (as opposed to the 9.7% rate of last month).
Going forward, three things stand out.
First, it is wrong to say that financiers are "up to their old ways paving the way for a next big financial crisis." The current crisis was caused by the mistakes made by many players who have learned some lessons and aren't going to behave the same way soon. In particular, it will be very hard to find buyers for bonds that aren't clearly rock-solid.
Second, although another "big one" is not likely to happen soon, history shows that we should expect periodic mini-crises every five years. For this reason, we need to create a regulatory framework that will ensure that the next crisis results in manageable losses.
Third, there is no easy way to contain high financial pay. The best we can do is tie bonuses to long-term performance and postpone their payment. However, if high pay is still a public concern, the easiest solution is to increase the marginal tax rates of high earners--perhaps to 45% for earnings over $1 million (including cashed-in stock options as deferred earnings) and 55% for earnings over $5 or $10 million. There is no reason to single out financiers, and these tax rates should apply to all high earners.
Stephen J. Rose is a research professor at Georgetown University's Center on Education and the Workforce and the author of Rebound: Why America Will Emerge Stronger from the Financial Crisis (forthcoming April 2010).
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