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Posted at 11:20 AM ET, 01/10/2011

Who is the financial sector ripping off?

By Ezra Klein

Over the last couple of weeks, I've been e-mailing smart economists and finance types with the same question: Is finance a rip-off? And if it isn't, what explains the sector's incredibly high-profit margins? After all, in a normal market, high profits are usually a sign of some inefficiency or competitive barrier -- otherwise, competition from other firms would've driven the profits down to near nothingness. But that's not been true in finance, suggesting that someone is getting ripped off. Matt Yglesias made a longer version of this argument here. I've suggested that the high levels of product complexity are serving the same market-distorting function as intellectual property protections here. But I wanted to ask the players themselves.

All of the replies I got were interesting, but they were all some form of the word "maybe." The problem, most said, was that the argument finance is a rip-off doesn't totally match the evidence, but nor does the argument that finance isn't a rip-off. Finance, after all, is an extremely competitive industry. There are lots of big banks, and smaller players, and many of the customers are legitimately sophisticated. In that world, the high profits don't make sense, but it's also not obvious who's being ripped off, or how they're being ripped off.

Which suggested another possible explanation: that the profits are simply misleading. Consider what we see in this graph of financial-sector profits:

financeprofits.jpeg

The profits you see between 2002 and 2007 are just extraordinary. But they were also illusory. The financial system, by underpricing risk, was ripping itself off. The enormous profits were part and parcel of a bubble that, absent massive government intervention, would've wiped out most of the banks and, given the level of devastation, substantially shrunk the global financial system.

But there was a massive government intervention. Profits are returning to their pre-crisis highs. At least, they look like they are. But what's really happening is that the Federal Reserve, in an effort to recapitalize and stabilize the financial system, has been handing the banks incredibly cheap money that they can then invest in extremely safe, but slightly higher yielding, products like treasury securities. It's called a carry trade, and it's been an effective way to nurse the banks back to health, but it won't be around forever. And it suggests that, like the 2002-2007 profits, the current round of profits is partly an illusion, too.

That doesn't mean the financial sector's profits don't signal a rip-off. It's just that the people who got ripped off were taxpayers, who had to bear the costs of the first bubble, and the people getting ripped off now are various central banks, which are purposefully handing giant bags of cheap money to the big banks. The question then is what profits will look like in five years or so, after the Federal Reserve has pulled most of its support. If they're still incredibly high, then this explanation won't look very good. But if they fall substantially, it'll suggest that the high profits weren't so much about the finance industry as they were about the bubble and its aftermath.

By Ezra Klein  | January 10, 2011; 11:20 AM ET
Categories:  Financial Crisis  
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Comments

There is a historical aspect worth considering, why banking is no longer boring to paraphrase Krugman. In Reich's book Supercapitalism, Reich discusses how over time, entities emerged that were able to aggregate consumer power (investors) into these new things called mutual funds. From here, they could acquire larger blocks of companies, and essentially hold them over a barrel for higher returns under the threat that they had the capacity to pull their money and tank the stock (his discussion is much more complex). As a society we benefit from this in our role as investors, but how do the companies meet investor demands? It stands to reason that at the same time, globalization began to increase at an increased rate; companies began to source product to attain higher margins. Wage growth slowed (I do not know about compensation). So in our roles as workers, the picture is murkier.

The point is that, as investors, we want higher returns, and financials have to cater to this demand. I don't think my last graf explains the 2000s, but the causal forces underpinning the trend seemingly lead to good outcomes for us as investors, but potentially bad outcomes in our roles as taxpayers, workers, possibly consumers.

Posted by: rcd2 | January 10, 2011 11:44 AM | Report abuse

There are lots of blatant, obvious ripoffs creating huge profits for the financial sector. What about providing mortgages to millions of people at terms that could not be supported, resulting in the collapse of the real estate market? Anyone with commonsense could see that was happening. Now they're trying to foreclose on properties without following the letter of the law, and so far nobody is being held accountable. Or how about getting money from the treasury at very low rates and then lending it back to people with credit cards at 19-25%? The list goes on and on.

Posted by: AuthorEditor | January 10, 2011 11:50 AM | Report abuse

There are lots of blatant, obvious ripoffs creating huge profits for the financial sector. What about providing mortgages to millions of people at terms that could not be supported, resulting in the collapse of the real estate market? Anyone with commonsense could see that was happening. Now they're trying to foreclose on properties without following the letter of the law, and so far nobody is being held accountable. Or how about getting money from the treasury at very low rates and then lending it back to people with credit cards at 19-25%? The list goes on and on.

Posted by: AuthorEditor | January 10, 2011 11:51 AM | Report abuse

Corporations, including banks, are legally bound to find every possible way to maximize profits, including gaming the tax loophole system, to the detriment of the public welfare. This is not the case in other countries, where the laws require corporations to consider the public welfare.

Posted by: harold3 | January 10, 2011 11:53 AM | Report abuse

Why do you think the financial sector is "very competitive"?

Think about the number of large I-banks, and how often a new member is added to their ranks. Think about how many members were lost in the recent bust (Lehman, Bear, and Merrill consolidating with Bank of America -- which had an independent I-banking practice).

At least on the issuance side (issuing stocks and bonds), there are a small number of very large players, and that small number has been significantly reduced in the last few years.

But this is kind of beside the point. We know that, as a sector, financial profits have increased dramatically. We also know, that, as a sector, finance does a minimal amount of value creation. The financial sector moves money around. In fact, the financial crisis of 2007-2008 was caused, in large part, when it turned out that the "value creation" in securitization turned out to be largely illusory.

By definition, therefore, the vast majority of profits in the financial industry represent money taken from the other, productive sectors of the economy. That can't be a healthy thing.

Posted by: rnarnarna | January 10, 2011 12:14 PM | Report abuse

Two things: 1) Ending pensions results in a huge transfer of wealth to Wall Street as 401k plans become the norm. 2) Stagnant wages lead to debt-financed purchasing which fuels financial sector growth and profits. The housing bubble was just the next big event in this chain. Is there any evidence that this general picture is flawed?

Posted by: willows1 | January 10, 2011 12:18 PM | Report abuse

"Or how about getting money from the treasury at very low rates and then lending it back to people with credit cards at 19-25%"

Credit cards aren't necessarily rip offs by the banks. Banks also get ripped off by their customers who end up defaulting on their unsecured loans. This is why interest has to be so high.

Charge off rates right now are ~10%.

Let's assume that there are 30 people that have $1,000 on their card on average, but always pay their balances, and the credit card company earns no interest on the $30,000 typically outstanding. They all receive 0% loans.

Now, let's assume you have 60 people that pay 20% interest on balances of $7,500 on average. That's $90,000, on balances of $450,000.

Now you have 10 people who default on $10,000 balances, and pay their 20% interest for on average half the year ($1,000 each, or $10,000 total). However, these balances are all sold to collection agencies for $500 each, meaning the bank recognizes $95,000 in credit losses.

So I have $90,000 + $10,000 + $5,000 - $100,000 = $5,000. That's on balances of $30,000 + $450,000 + $100,000 = $580,000. So we have in this case a 0.86% net interest margin after credit costs ($5,000 / $580,000).

Yes, there are things like late fees and interchange fees and such, but then there are also servicing costs and rewards to be paid on those accounts as well.

Posted by: justin84 | January 10, 2011 12:36 PM | Report abuse

If runaway financial sector profits are the result of a bubble, then, according to your graph, the bubble would have had to start inflating around 1990. That's when financial sector profits begin to climb much faster than non-financial profits. Does that time frame make sense?

Posted by: jeanlucj | January 10, 2011 12:39 PM | Report abuse

Corporations, including banks, are legally bound to find every possible way to maximize profits, including gaming the tax loophole system, to the detriment of the public welfare. This is not the case in other countries, where the laws require corporations to consider the public welfare.

Posted by: harold3 | January 10, 2011 12:49 PM | Report abuse

If you look at the Federal Funds rate history, there are three lengthy periods where the rate was systematically reduced: 1989-93 (7pts); 2001-05 (5pts); 2008- (5pts). These correspond quite well with the periods of the most dramatic increase in financial sector profits. The turbulent profits in the mid-late 90s correspond with a 5-year period in which the funds rate was increased 3pts (and Greenspan's "irrational exuberance" remarks in late 1996).

Posted by: ajc3 | January 10, 2011 12:55 PM | Report abuse

Where you wrote "ripping itself off" I would have written "ripping the future off." The bubble was new debt immediately monetized for obscene wealth.

Posted by: SamPenrose | January 10, 2011 1:01 PM | Report abuse

what SamPenrose said. Plenty of people got out the back door (or the front door) with mucho money in pocket, in the form of fees and other up front changes for things that later came home to roost or blow up.

Posted by: bdballard | January 10, 2011 1:05 PM | Report abuse

I would submit that the answers are:

(1) All of us, through fees supported by price fixing/collusion type behaviors.

(2) All of us, through socialization of private losses

(3) All of us, through use of customer assets to shield internal assets from losses.

Posted by: eggnogfool | January 10, 2011 1:06 PM | Report abuse

Back in the day (1980s and '90s), I worked for Wall Street firms and I always wondered why we were so much better compensated than those in other industries. The answer, of course, was always that Wall Street firms made so much money. And I remember thinking, why don't other firms enter the market and drive prices down? I still don't know the answers to these questions, but I can assure you it's not a recent phenomenon.

Posted by: mtracy84 | January 10, 2011 2:26 PM | Report abuse

I find Steve Pearlstein's analysis of the non-competitiveness of the Wall Street firms to be persuasive.

"This story, first reported by Bloomberg News and confirmed by several government and Wall Street sources, goes a long way in explaining why so many people on Wall Street get paid so much more than everyone else. A handful of established firms control access to global financial markets and use this power to extract monopoly-like profits and funnel them to their executives and employees.
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The reason for the lack of price competition is pretty simple: The banks know that if they start offering big discounts, all their rivals will be forced to do the same. In the end none of them would gain a competitive advantage, but all of them would wind up with less money. The only winner from a price war would be their customers.

This kind of cozy competition only works in markets where it is virtually impossible for upstart firms to gain a foothold by offering a lower price.

Size is part of it: An investment bank has to be big enough and have strong enough relationships with thousands of institutional investors and money managers to be able to market large stock and bond offerings in a matter of days.

Given the huge sums of money that are raised through these offerings, it may seem silly for a company to try to save a few million dollars in fees by eschewing the established players, who invariably claim they are so much wiser and more experienced that they will be able to get an extra 50 cents for each share of stock or shave the interest rate on a bond by an eighth of a percentage point. There's no way to prove they are right, but there's no way to disprove it either -- and surely nobody's ever been fired for going with Goldman Sachs.

So what we have is a suspicious consistency in IPO fees: 6 to 7 percent for deals of less than $200 million, 4 to 5 percent for moderate priced deals and 3 to 4 percent for those over $1 billion. Most of the fees go to the lead underwriters, with the rest scattered among the losers of each beauty contest. The fee pot is divided in three: Twenty percent is an underwriting fee for the banks' guarantee that they will buy the entire issue even if nobody else will. That was once an important consideration, but in today's markets, the investment banks ensure that no IPO goes forward unless the entire offering is pre-sold. As a result, the underwriting fee is now a pure windfall. "

http://www.washingtonpost.com/wp-dyn/content/article/2010/08/19/AR2010081906574.html

Given the barriers to entry, the best solution is more robust anti-trust enforcement.

Posted by: jnc4p | January 10, 2011 2:38 PM | Report abuse

Yes, their fees can be quite high. One example is the bond market which carries exhorbitant fees that accrue to the banks and intermediaries that handle the transactions. If the bond market were to become more transparent and organized like the stock market, the excessive fees would vanish.

Posted by: wswest | January 10, 2011 3:14 PM | Report abuse

Ezra,

The economists you probably know best are macroeconomists, and they're not intellectually equipped to answer the question you posed. Talk to a microeconomist like a professor of finance economics if you want an answer.

First of all, let's get terms right. There are profits, then there are rates of return on capital. It's the latter that counts for investors. That's why Google makes so much more money for its owners than the oil companies. Oil companies have a lot of capital on the balance sheet. Software companies don't.

Second, you have to go beyond one dimension. It's not just rate of return, but risk that matters for pricing an asset. What were Goldman Sachs', Morgan Stanley's, and Lehman Brothers' rates of return in 2008? Not so good, hugh? So volatility is a very important component.

Ask anyone who held an S&P 500 portfolio in 2008 that had financial sector weightings near 40% if they agree with the premise of your post regarding financial sector profitability. I think you'll get an earful from them.

Posted by: ElGipper | January 10, 2011 3:23 PM | Report abuse

Is there any way around finance to run capitalist society? No. Finance is very important part, without it there no way to match people who have capital and people who need capital, and also there is no way to define asset price if there no trading, which essentially keeps evaluating asset prices based on every information available out there

Posted by: amritpalsidhu | January 10, 2011 3:27 PM | Report abuse

The people who got really ripped off are those who weren't in the game, the innocent bystanders of the middle class who don't have access to cheap credit — if the can get any credit at all — or are seeing their existing credit squeezed by smaller limits and higher rates.

Posted by: tomcammarata | January 10, 2011 7:01 PM | Report abuse

That graph of profits doesn't prove your point. You would need a graph of profits whose integral was zero over some interval. That the losses match the profits. But if you add up the profits over those years they clearly "banked" a lot of money. The curve is positive over the entire interval. Moreover, the financial aid from taxpayers or the federal reserve was not and is not nearly as large as those profits.

Posted by: zosima | January 10, 2011 7:36 PM | Report abuse

The big upward swing in profit for the financial sector began about the time that the 401k law went into effect. Coincidence? (Not rhetorical; I'm asking.)

Posted by: theodoraroosevelt | January 10, 2011 8:41 PM | Report abuse

I always wonder about the real profits on mortgages. If we pay 30 years' worth of interest up front, and then sell the house after 5 or 10 years, doesn't that make the effective interest rate we paid astronomical? And doesn't that happen more often than not?

Posted by: RachelM2 | January 10, 2011 9:38 PM | Report abuse

RachelM2--> You don't pay 30 years of interest up front.

It's obvious that it's ripping off the future taxpayer who implicitly backs the risk through continued taxpayer purchase of risky mortgages.

Posted by: staticvars | January 10, 2011 10:20 PM | Report abuse

"I always wonder about the real profits on mortgages. If we pay 30 years' worth of interest up front, and then sell the house after 5 or 10 years, doesn't that make the effective interest rate we paid astronomical? And doesn't that happen more often than not?"

You definitely don't pay 30 years of interst up front. The interest on a $200,000 30 year mortgage at 5% is $186,511.57.

The monthly payment is fixed at $1,073.64.

On the first month, the bank takes the principal ($200,000), multiplies by 5%/12 (0.4167%), to arrive at an interest payment of $833.33. The extra $240.31 which you pay is applied towards principal.

The next month, you have $199,759.69. The bank applies the same interest rate, and charges you $832.33 in interest. The extra $241.31 is applied to principal. And so forth.

Posted by: justin84 | January 11, 2011 10:05 AM | Report abuse

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