Conclusion: 2010 and After

“It is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion.... Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

John Maynard Keynes in The General Theory

The condition is easily diagnosed. Over the last half century, the rise of the investment industry has created overwhelming incentives for investors to follow one another into risks they often do not understand. As a result, world markets are hopelessly synchronized. This obstructs rational pricing and, in a capitalist world that relies on markets to set prices, endangers our prosperity. Finding a cure, however, is more difficult.

The financial disaster of 2007–2009 has not cured any of the underlying factors that led markets to become intertwined and over-inflated. They may still not be addressed even if, as is possible, the world navigates the next few years without a second recession or a major new collapse in stocks, real estate, or other assets. If the twin planks of the recovery—China’s resurgence and the ability of big U.S. banks to “muddle through” with government help—stay in place, then the prospects for a recovery are good. But the stakes are higher now. Markets turned in 2009 because the United States put its credit rating on the line by borrowing furiously while extending guarantees to many private companies and securities that were in trouble. By setting the price of money, the U.S. Treasury market drives all others, and if bond investors decide that mountainous U.S. debt will lead to inflation or to default by Uncle Sam, yields will rise. The crisis of confidence in the debt of countries like Portugal and Greece shows what could happen. And in such circumstances, the U.S. Treasury will not be able to help because it will not be able to borrow more. Thus, the next asset price crash could be profoundly worse than the last one—and this makes the need to cure the underlying conditions that lead to crashes all the more urgent.

Some fixes are easy. The absurdly complicated instruments that created the subprime bubble, like synthetic collateralized debt obligations, should of course go. But the roots of the problem lie deeper. The institutionalization of investment cannot be reversed. Most of the financial innovations that created the synchronized bubble, like index funds, or even securitized mortgages, are in any case good ideas, so finding fixes will involve hard choices.

Making this harder, solutions must deal with human nature, our tendencies to suffer swings of emotion, to move in herds, and to expect that others will rescue us from the consequences of our actions. Over the last half century, the investing industry has unwittingly intensified those tendencies. Changing this requires a cultural shift; investors must have an incentive to treat others’ money as if it were their own. The following is an outline of how markets can be made more fearful, and maybe more efficient.

Moral Hazard

Previous financial crises reined in moral hazard—the encouragement to take risks that comes when investors believe they will not have to suffer losses—by inflicting grievous losses on key investors. The latest crisis was very different—it showed that the United States and other governments would spend trillions of dollars to sustain the biggest financial groups. Hence the belief that risk takers will be rescued is stronger than ever. Air must be taken out of markets that at the time of writing, in early 2010, are currently betting that the government dare not let them fail. It is still too soon to do it. But at some point, either by raising rates or by allowing a big bank to go down, government must make clear it will not be there to bail out the reckless.

A safe place to start would be the megabanks like Bank of America, which are even bigger as a result of shotgun mergers arranged during the crisis. They cannot be allowed to fail. Either these biggest banks must be regulated so tightly that they simply are not allowed to gamble, or they must be made smaller. Governments can allow the market some say if they do this by raising reserve requirements, which in practice would force banks to sell off assets. This need not involve imposing a breakup. But the growing political debate over how to regulate banks and make them smaller is not just a response to populist anger; some such move is necessary if moral hazard is ever to be addressed.

The Decline of Banks and the Rise of Markets

The rise of money markets created a new class of bank-like institutions that do not need to buy deposit insurance. This shadow banking system, including money market funds, must now be regulated as if they were banks. Reforms to solidify the repo market, which denied banks their short-term funding when it seized up, are vital. And regulators need to overhaul the rules that inadvertently spurred banks to pile into mortgage-backed securities and outsource to rating agencies like Standard & Poor’s their central function as lenders—figuring out who can pay back a loan and who cannot.

What remains of the banking industry has lost its old roles and, like unemployed teenage boys, they have shown a terrible knack for getting into trouble when they are left to their own devices. Once money markets are subject to the same regulation as banks, their advantages may evaporate, enabling banks to regain their old businesses of lending. If not, the economy can possibly do without banks in their traditional form. Hedge funds drove many trends to destruction by 2007, but the much-feared disorderly collapse of a big hedge fund did not occur. Instead, it was the inherent instability of banks that brought the roof down. And so for banks, the status quo is not an option.

Other People’s Money

Reforms to the banking system must also address the conflicts between principals and agents that arise whenever those who take on a risk are able to sell that risk to other parties. In securitization, where some principal-agent split is inevitable, loan originators must be required to hold a significant proportion of their loan portfolio or in other words to “eat their own cooking.”

Investment banks that are now public might return to the partnership model. Then the money on the line would be that of the partners themselves, not shareholders. Again this might not require government intervention. Existing investment banks, who probably dislike all the attention on the bonuses they pay, could go private. Or hedge funds, which are structured as partnerships and increasingly already carry out investment banking functions, could evolve further. The trickiest principal-agent split, however, affects investment managers.

Herding

The herd mentality of the current generation of investment managers is driven by the way they are paid and ranked. Rank them against their peers and an index, and pay them by how much money they manage, and experience shows that they will hug ever closer to key benchmarks like the S&P 500. So somehow we must change the way we pay fund managers.

For hedge funds, which are not closely regulated, it is up to investors to refuse to pay fees on the skewed basis that at present encourages them to gear up to “go for broke” each year. Paying fixed annual fees, while basing any performance fees on periods much longer than one year, would make more sense.

In mutual funds, it is far too easy for mediocrities to make money in an upward market. Their fees go up merely for taking in more funds. Closet indexing must be actively discouraged, possibly by requiring “active” funds to publish their “active share” (the amount their portfolio deviates from the index). Closet indexing might also be rendered less harmful if mainstream index funds moved toward fundamental indexing, weighting their portfolios according to fundamentals such as profits, rather than their market price. This forces them, and anyone mimicking them, to sell stocks as they become over-valued. Paying managers a fixed fee would no longer reward them merely for accumulating assets, and so funds would be less likely to grow too big. Rewards above a fixed fee should only be for genuinely excellent performance. This brings up the greatest problem; how to determine that performance? In professions, performance-related pay relies on benchmarks, but we now know that benchmarking portfolio managers against their peers, or against a market index, just encourages them to herd together.

The solution may lie in the growing effort to understand and measure investing skill. It rests in mental discipline and the ability to resist the temptations of greed, panic, and mental shortcuts. By looking at how fund managers perform day by day and trade by trade, psychologists are beginning to identify the truly talented, and separate them from those who fall into mental traps and whose performance might look perfectly acceptable for long periods. This effort should continue. Skillful investors can, after all, profit while keeping the market more efficient at the same time.

The greatest power rests with those who make big asset allocation decisions—primarily brokers and pension fund consultants. They should follow what is called a “barbell”—either their investments are passive, with minimal costs, or they are given to active managers on the basis of their skill, who are paid according to that skill. There is no room for anything in between.

Another needed reform would change the design of investment products so as to deliver everyone from temptation. Rather than give savers a range of choices, give them a well-tailored default option, covering a sensible distribution across the main asset classes, with both passive and active management. To maintain investors’ confidence, it may make sense to declare guaranteed gains along the way, much as the old Victorian model of paternalistic pensions did. Libertarians might dislike this, but the default option should not be compulsory. You can choose something else if you wish. The key is that the default should be a good one and not overloaded by fees.

The industry is already moving in this direction.¹ This should restore investors’ confidence, avert the risk that “irrational exuberance” might again drive markets, and limit the worries for all managers about their success in accumulating assets. Instead, and quite healthily, they would merely have to worry about performing skillfully enough to earn a bonus.

Safety in Numbers

The old theory of diversification prompted overconfidence and created the rush into “uncorrelated” assets that then became linked. Core assumptions, like stable correlations over time, random returns, and emphasis on allocation by asset classes, have failed and must go. We need a new theory. Academics are already on the case.

Paul Woolley of the London School of Economics believes efficient markets might be salvaged if we can find a way to model the distorting effects of institutions on incentives. Andrew Lo, of the Massachusetts Institute of Technology, suggests markets are complex adaptive systems that can be modeled using Darwinian biology—which implies we are living in an era when a meteor has just hit the earth and we await the successors to the dinosaurs. But any new model must not aspire to the same precision as the old; finance and economics are contingent on human decision making and not the laws of nature. Abandon the attempt to predict markets with precision, and we might avert a return to the overconfidence such models created in the past.

As for diversification, those who allocate assets must stop thinking in terms of asset classes and the historic correlations between them. The search for new “uncorrelated” asset classes helped lead to disaster. Instead, they must look at the risks those assets bear and leave a margin for error—meaning more in “conservative” assets, and less potential “upside,” than they would like. Again, thankfully, such ideas are already bubbling through the investment industry.

All of these ideas involve putting limits on the wealth that markets can create, which is akin to the trade-off the world made after the Depression. Many would now be happy to make that trade-off again, even though, with the capitalist world aging, the growth rate we can expect in the next few decades may well be significantly lower than in the second half of the twentieth century.

The cycle of greed and fear is hard-wired into human nature. But this list of changes might just end the cycle of synchronized bubbles, avert another even more disastrous crash within the next few years, and move back to the norm where we can go two generations without a new bubble. Further, markets should distribute capital much more efficiently. They might even shower capital on technologies and innovations that can improve our well being, rather than sending resources and talents to an artificially bloated financial services industry.

Markets have risen to take a far greater role in our lives. If they can be disentangled and unsynchronized, they will work better for everyone.