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Wall Street's amazing, hard-to-defend, profits

historicwallstreetprofits.jpg

The important thing to remember about Wall Street's profits isn't how big they are. It's how big they are in in comparison to revenues. Annie Lowrey runs through the numbers:

Last week, J.P. Morgan announced that it made a first-quarter profit of $3.3 billion on revenue of $28.2 billion, meaning for every dollar of business the bank did, it kept 12 cents as profit. This morning, Goldman Sachs — the Wall Street giant charged by the Securities and Exchange Commission with defrauding customers with mortgage-backed financial products last week — released its first-quarter earnings statement as well. It made $3.46 billion in profit from $12.78 billion of revenue — meaning for every dollar of business it did, it kept 27 cents.[...]

Consider another high-profit company in a competitive industry — say, Exxon Mobil. Last year, it made about $19 billion in profit on $300 billion in turnover, giving it a margin of six percent. WalMart? It is in the low-margin grocery and retail business, and managed a profit margin of around 3.5 percent. In the first quarter, Goldman’s margin was just two percentage points below Google’s — and consider how dominant Google is in its industry.

In short, the profits point to a lack of competition. That is one thing the Dodd bill — via derivatives regulation — attempts to fix. Right now, Wall Street firms do not bid for big derivatives contracts — they simply quote a price and work over-the-counter. For that reason, derivatives are wildly profitable for the companies. The Dodd bill will force derivatives pricing to become public to the market, driving down margins as companies compete.

As Ryan Avent noted the other day, it's very difficult to get a straight, convincing answer about the good all this is doing for the rest of the country. "If financial sector growth is so good for the real economy," he wrote, "it ought to be easier for its defenders to demonstrate this empirically. ...The costs of a large financial sector are extremely apparent while even the most ardent backers of financial innovation have a difficult time explaining how economic performance would have been harmed by restrictions on financial activity."

By comparison, you may not like pharmaceutical companies, but no one is confused about the potential upside of their profits. Lifesaving drugs are a good thing. Wall Street, however, tends to fall back on the word "liquidity" in these discussions. And it's true: During the boom times, we had a ton of liquidity. But it was fake liquidity. The $500,000 loans we gave underemployed folks to buy big homes did not represent real liquidity. The illusion of easy money is not the same as easy money, as we've now learned.

A neat comparison here would be Canada: We know that Canada has a more staid banking sector than the United States. We know that they're not as engaged in the "innovation" that Wall Street busies itself with. We also know that Canada's banks survived the financial crisis without too much trouble. So here's the question: Does Canada's economy -- which certainly doesn't seem like a credit-starved hellhole -- suffer from a terrible absence of liquidity? Is there any measurable effect at all? And if not, remind me again of the benefits of financial innovation and the sector's sky-high profit margins?

Graph credit: Simon Johnson and James Kwak.

By Ezra Klein  |  April 20, 2010; 11:06 AM ET
Categories:  Financial Regulation  
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Comments

SOmeone forgot to close an italic tag...

Posted by: wiredog | April 20, 2010 11:14 AM | Report abuse

This is the same system that was used to great personal profit by China's Imperial eunuchs, and by the courtiers of Louis XIV.

It is a classic rentier economy.

The economic role currently being played by Wall Street is not the efficient allocation of capital. They are focused simply on directing as much capital as possible to the place where they can control it. They don't want to keep it--they just want it to go THROUGH them. Because that's where they take their percentage.

Revenue flowed into the Emperor's treasury from local lords, and then flowed back out to them. It flowed into the treasury of Louis XVI, and then into the provinces. But as it flowed in and as it flowed out, these guys got their cut. And the bigger the money coming in was, the bigger a percentage of it they could take with no one the wiser.

The king was thrilled--more money coming in! More ways for him to build shiny things and reward his allies! The more his allies needed him to send money back, because they were sending more money to him!

The same thing is happening in our system. Everything from lower capital gains taxes to 401(k)s to deficit spending to middle class wage stagnation means more and more money ends up on Wall Street. Wall Streeters can skim off a bigger and bigger percentage as a transaction cost, and they can still generate high returns because new money is always coming in.

Posted by: theorajones1 | April 20, 2010 11:26 AM | Report abuse

Time for the financial transactions tax on day and computer trading, targeting speculative day trading and computer arbitrage trading. retirement accounts up to 3 million exempt. We need to try to wring out some of the profits from market speculation and get back to value investing.

Posted by: srw3 | April 20, 2010 11:34 AM | Report abuse

Can someone explain to me the relationship between Blanche Lincoln's derivatives regulations and the Dodd bill? I know I've asked this before, so if it's been answered already and I've missed it, my apologies. People keep talking about the Dodd bill and its restrictions on derivatives, but I don't know if the Lincoln proposal, which evidently made Wall Street shudder, is already incorporated into it, if her proposal is already dead, if it's going to be considered as a separate bill, or what.

It's easy to understand why the financial sector has so much higher profits than other competitive industries: nobody has enough information to make informed decisions. With other products I can determine if I'm getting a good deal by investing because I can compare it to other similarly situated products. With the financial industry nobody knows if the investment they've got, with the 12% markup, is a good deal because nobody understands the investments in the first place. Everyone was trusting in the financial industry, and they turned out to not be worthy of that trust.

Posted by: MosBen | April 20, 2010 11:44 AM | Report abuse

I think the fundamental issue is that the financial sector is different from the rest of the economy, and we're not sure how to handle that reality. We are (rightly, I think) hesitant to make policies that rein in profit and innovation, but some degree of exception may be appropriate.

Posted by: jduptonma | April 20, 2010 11:46 AM | Report abuse

I think the answer is more benign. A lot of the assets these banks held were decimated a year ago and written down to market value but never sold. The short term assets matured and were paid; and the longer term assets are recovering in value as the financial markets recover.

The idea that there isn't enough competition on Wall Street is ludicrous. Any herfindahl analysis (like the DOJ or FTC use for antitrust analysis) would show a highly competitive and fragmented market.

Posted by: sold2u | April 20, 2010 11:49 AM | Report abuse

The fundamental issue here is that we (the taxpayers, and in particular the future taxpayers) lending the banks money for free, to enable them to meet bigger reserve requirements, and then they can buy interest yielding treasuries, so we end up paying them interest on the money they are borrowing from us. How could the banks not make massive profits?

A lot of these profits are also paper profits. We suspended the mark to market accounting rules, so many banks are still pretending that your house and assorted derivatives based on your mortgage are still worth the money they lent you to buy the house. Thus they continue to prevent actions that would allow the housing market to truly reset in value.

Proprietary trading desks are dangerous, and I hope they are brought out into the open. However, these should just make these work more effectively, from a price standpoint. It should cause more net profits, with perhaps a thinner margin.

Posted by: staticvars | April 20, 2010 11:58 AM | Report abuse

Conveniently, the starting date (and thus the index) starts in the aftermath of the 1929 stock market crash.

Posted by: sold2u | April 20, 2010 12:14 PM | Report abuse

The $500,000 loans we were handing to underemployed folks so they could by big homes was not real.

Grammar fail, Ezra. That's not like you.

Posted by: SqueakyRat1 | April 20, 2010 12:17 PM | Report abuse

@Ezra: remind me again of the benefits of financial innovation and the sector's sky-high profit margins?

For those that work on Wall St? Dude, ain't that the American dream? That we should all want to work on Wall St. where the profits are 27% instead of at Wal-Mart, where they are 3.5%?

Posted by: rjewett | April 20, 2010 12:24 PM | Report abuse

"In short, the profits point to a lack of competition. That is one thing the Dodd bill — via derivatives regulation — attempts to fix. Right now, Wall Street firms do not bid for big derivatives contracts — they simply quote a price and work over-the-counter. For that reason, derivatives are wildly profitable for the companies. The Dodd bill will force derivatives pricing to become public to the market, driving down margins as companies compete."

This isn't exactly right. Wall Street firms DO bid for contracts. There is competition between many firms. Say you were looking at a pricing run for homebuilders. You'd see a series of prices looking like this for KB Homes and Pulte*. If you wanted to get long KBH and short PHM, you could sell KBH protection at 282, and buy PHB protection at 348. In fact, you could even call Barclays and ask if he could get PHM done at 346 - sometimes it works.

JPM GS BAC BC RBS
KBH 282/292 278/288 279/294 280/290 280/290
PHM 335/350 337/352 333/353 338/348 341/351

In short, it's incorrect to say that there is no competition or bidding for derivatives. Not only are there many vendors, but you can actually call and haggle over the price - since when does Walmart let you do that? Sometimes you could even buy from one and sell to another at a profit. Is it as competitive as it could be? Well no. But more competition isn't going to drive down Wall Street profit margins to Walmart's levels. Making a market in credit default swaps is always going to be more lucrative than selling groceries because its difficult and risky. Also, there are high dollar amounts on notional contracts. Even a 1bp spread on a $50mm 5yr trade is worth ~$20,000, and lots of those quickly add up (of course right now, the spreads are much higher on most contracts).

Anyway, exchange trading should reduce bid/ask spreads by reducing pricing opacity (between market makers themselves - they don't want to be 'picked off' by a hedge fund or another party crossing their trade instantly with another bank for a profit) and by improving liquidity.

*This might have changed since the CDS big bang.

Posted by: justin84 | April 20, 2010 12:36 PM | Report abuse

What about seeing some hard prison time for these Banksters, who have engineered the fall of America by design?

Watch our video of where we all stand:
Invisible Empire 1 of 16
http://www.youtube.com/watch?v=FKJuyti1YjU

Posted by: PaulRevere4 | April 20, 2010 1:12 PM | Report abuse

"The illusion of easy money is not the same as easy money, as we've now learned."

Or: Easy money is often neither easy nor money.

Posted by: slag | April 20, 2010 1:21 PM | Report abuse

It's not a lack of competition, but a lack of legitimacy. More competition isn't going to make herbal remedies or homeopathic balms any more effective that they currently are (or aren't). More competition isn't going to make financial innovation (that is, funny ways to shuffle paper and distribute ownership and re-bundle ownership so it's not clear who owns what or what the risk is or what actually has the initial value we are supposedly purchasing) any safer, or the products produced to obfuscate risk and maximize profits any more legitimate.

Breaking up speculative gambling nonsense from regular banks and insurance companies is a start. Capital requirements is another good step. Stiffer regulation regarding what can be sold to the general public, or what kind of loan-sharking credit card companies can do with Joe Q. Public, would be a good idea. It's shouldn't be legal to obligate the guy (or allow him to obligate himself) who works at the corner store to a loan that's going to triple or quadruple in monthly payments and supposedly generate 1000% return on principal over the life of the loan. Then sell those loans as securities, with the implicit promise that hundreds of thousands of folks are going to be able to continue to pay their mortgage when the monthly payment balloons to triple it's original size.

And so on.

This is not an issue of competition, and government micromanagement of every little gear is not the answer. There are simple straight forward things that can be done (that the banks and Wall Street don't like), such as outlawing certain types of loan shark practices, preventing investment banks from being in traditional banking and insurance (there was a reason they weren't in the first place--got ride of that limitation and, a decade later, look! Oh, that's why we said they couldn't do that . . . ).

More (artificial, government-created rather than market based) competition just leads to more (and better masked) financial innovation.

Posted by: Kevin_Willis | April 20, 2010 1:43 PM | Report abuse

"If financial sector growth is so good for the real economy," he wrote, "it ought to be easier for its defenders to demonstrate this empirically. ...The costs of a large financial sector are extremely apparent while even the most ardent backers of financial innovation have a difficult time explaining how economic performance would have been harmed by restrictions on financial activity."

Agreed, this is difficult to defend. That isn't because financial innovations don't provide benefits, but rather the benefits are diffuse and overtime, and the costs are sudden and concentrated.

Things like banks, joint stock companies, bonds commodity futures markets and financial futures markets etc. were all at one time new financial innovations. These things are all blamed at various times for financial panics and crashes which cause various hardship when they occur. At the same time, these innovations have without doubt been on net beneficial over the long run, and we are better off that banks weren't outlawed after the first bank run hundreds of years ago. The solution is not to prevent innovation, but as we figure out how markets work try to restruture the rules of the game to minimize the risk while keeping the benefits of the innovation.

All else being equal, Mortgage Backed Securities and Credit Default Swaps should reduce the price of credit by allowing risk to be transferred more efficiently to those who are best prepared to face it. Of course, these innovations created their own problems. Putting swaps on an exchange and requiring collateral for ones linked to credit, and putting some commonsense regulations into the mortgage market (things like higher downpayments or requiring firms which securitize mortgages to hold a piece of the equity tranche of their MBS, whatever works) should allow us to continue receiving most of the benefits of these products while hedging against their risks. Since new innovations can occur, we should help protect bank balance sheets by requiring contingent debt, as our regulations will inevitably grow old and stale once more.

Posted by: justin84 | April 20, 2010 1:45 PM | Report abuse

In my RSS feed this post, that denounces the large profits and profit margins of the financial sector, was followed by a Featured Advertiser post from Ezra Klein.

Posted by: bigless55 | April 20, 2010 1:49 PM | Report abuse

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