From Whence We Came Part I

"Those Who cannot Remember the Past are Condemned to Fulfill It."
- George Santayana

My doctor has recently informed me that my blood pressure has escalated. Having had a front row seat to the unbelievable policy-making that has emerged from our nation's leaders in response to our economic crisis, it is no wonder.

Before launching a whole series of invectives in a future blog concerning the unjust and incompetent decisions emanating from what was once, and should have remained swamp, aka Washington D.C., a little review of past history is in order. There was once a quaint and innocent time in American economic history when: people used to be required to put at least a 20% down payment before buying a house; bankers used to be dour individuals, reticent to lend money to those but the most credit-worthy; and investment advisers used to caution people about the steep losses that might befall those investing/speculating in potentially risky assets (i.e. stocks and real estate). It was a more sober time perhaps. People were worried more about the prospect of capital losses than capital gains. While less fun than the carefree modern era of finance, it was also more stable. Most people relied upon setting aside part of their incomes on a regular basis in the event that rainy days should come to pass. Great fortunes were not gained as frequently, but neither were vast fortunes lost.

But starting in the 80's, change began to occur. Not, from my perspective, all for the worse mind you. Far from it. Paul Volker proved himself to be perhaps the most courageous and talented central banker in American history. By raising interest rates in a time of economic crisis and inflation, he arguably caused the most severe recession since the depression. But in so doing, he also broke the back of what had been rampant inflation since the days of LBJ's The Great Society programs. Moreover, the economic power of unions began to wane significantly, thereby unshackling to a large degree human capital, and leading to greater employment. Absolute and marginal tax rates were lowered, providing greater incentives for both individuals and corporations to work hard.

But with the good, usually comes the bad. As corporations prospered, particularly in the financial sphere, so did their influence grow in DC. This, coupled with more conservative politicians, led to legislation pushing all forms of deregulation concerning financial institutions. As the good times of the 80's continued into the 90's, something quite pernicious began to develop. Fewer and fewer controls and oversight were in place to regulate financial institutions.

Increasingly egregious conflicts of interest arose for financial services companies as they tried to serve the interests of their clients and their shareholders. Similar conflicts confronted individual brokers and financial advisers, as they were compensated through commissions only received by selling certain financial products. And the more they sold, the higher their incomes.

All of this came to a head as we approached the turn of the millennium. Stock prices, and particularly those in the tech sector, had achieved returns that exceeded anything seen in modern US financial history. They were so fantastic that anyone with a cursory understanding of investing history should have been aware of the fact that it was unsustainable. There has never been a major asset class which has appreciated ad infinitum without facing serious price declines along the way.

Had the financial institutions safeguarding the vast majority of American savings and investment funds been properly serving the interests of their clients, two types of warnings would have been issued. First, the institutions themselves would have disseminated "sell" recommendations on hundreds of tech companies, and the sector as a whole, based upon the gross overvaluation of the sector. Ahhhh, but Wall Street was reaping billions and billions of dollars in fees creating IPOs and providing other services to the very tech companies it was making buy and sell recommendations about for its retail investment clients. Often it was the very same individuals at investment banks that first launched an IPO for a company and then issued the bank's "analysis" of the company from an investment perspective. Virtually without exception, every tech company was a great "buy" for the investing public. Far be it for Wall Street to have the courage to bite the hand that was feeding it by declaring that the vast majority of these companies being rushed to market: had no track record of success; operated in wholly speculative market sectors; were largely run by tech wonderkids who had little, if any, management experience; and were massively overvalued by any objective finance metric.

Second individual brokers and financial advisers would have been calling each of their clients warning them of the dangers of an precipitous fall in US stocks. Remarkably, from the anecdotal evidence I gleaned at the time form talking to friends and colleagues, the opposite occurred. Brokers and advisers were mostly encouraging their clients to "follow the returns." Even though the gravy train had long left the station, and was about to be utterly derailed, the average retail investor was still being sold on the story of vast profits to be made by investing in companies engaging in tech endeavors that few brokers/advisers took the time or effort to understand. As these financial service professionals usually generated more revenues for themselves by having their clients purchase stocks or equity-based mutual funds, it appears that greed and neglience trumped prudence.

This takes us to the precipice of the new century in our story, as well as the role (or lack thereof) played by the Fed and the agencies tasked with overseeing financial companies. But that will have to wait for the next installment.