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Why allow the financial industry to help itself to your money?

This blog provides you with objective information that could solidify a lifelong commitment on our part to low cost investing. Low cost investing is how you keep more of your own investments for your family, instead of naively giving your money to the financial industry.

In case you did not notice, the financial services industry has not done the world any favors lately. The financial industry has probably not done you any favors, either. This industry will take as much as it can and then try to take more. Only you can protect your own wallet from an industry that overall has a highly negative value-added with respect to individuals.

A dog eat dog securities world with trusting sheep in an unfair fight

Global securities markets have a dog-eat-dog ethos with winners and losers. Highly competitive and ruthless securities markets are necessary for efficient price setting and capital allocation. I applaud when full-time financial professionals engage in competition among themselves with knowledge, resources, and skill.

However, when similar strategies are applied to individuals who lack knowledge, education, and resources, then this is an unfair fight. When the inadequacies, ignorance, biases, and misconceptions of individuals are exploited systematically, this is deplorable. When financial industry marketing and promotions imply that there is a partnership or advisory role, but actions taken indicate that this is not the case, then this is moral bankruptcy. When the financial industry is so strong that it distorts fairness in governmental regulation, then many deplorable behaviors are not criminal, only because laws and enforcement are too weak.

I believe that enlightened individuals should never naively expect fairness, when they deal with most of the financial services industry. Despite the financial industry’s recent self-induced credit crisis, self-immolation, and taxpayer bailout, there is no reason to believe that financial services industry will ever change. The game is just too profitable for the financial services industry to expect it ever to change.

The mass of American financial consumers are trusting, docile sheep regarding their personal financial affairs. The amount they are willing to waste on overpriced financial services is astonishing. Far too many US consumers pay far too much and get woefully little value in return from the financial services industry. The industry repeatedly scrapes the consumer excess off the table and stuffs it into its salaries, bonuses, and corporate earnings reports. The only salvation for some individuals is that eventually they will wake up and decide to stop paying tribute to this industry.

The credit crunch and Great Recession are just the latest in a recurring series of financial crises

After several years, the economic and political dust of the recent global credit crisis and subsequent “Great Recession” has only just begun to settle. Comprehensive, durable, and effective solutions to the conditions that lead the world down into this economic mire have yet to be put into place. Some regulatory measures are being put into place, but at best, they are partial measures that do not fundamentally address “too big to fail.” In fact, the failures of financial firms during the recent crisis have caused this industry to become even more concentrated, and it firms are even bigger than before.

The credit crisis and Great Recession was caused by a financial system whose actors and companies consistently chose self-interest. Some individual industry participants may not have understood the danger their actions posed to the economy and society. However, anecdotal evidence has emerged that many understood the dangers but just did not care.

Astute, high-ranking financial industry personnel knew the risks and could have made different choices, but they chose personal compensation over everything else. Senior executives milked their firms for cash salary and cash bonuses, which is the compensation norm in the securities and investment banking world. If their firms died, they would still do just fine. While some Wall Street senior executives lost their jobs, US taxpayers and TARP money kept other Wall Street firms from bankruptcy and allowed thousands of financial executives to keep their jobs.

Academics sometimes call what happened, an “agency” problem. In theory, shareholders of a firm choose a Board of Directors to act in their best interests, and in turn, the Board hires a CEO to manage the firm. The Board also influences the hiring and compensation of other very senior executives. The Board, the CEO and the senior management team are “agents” of the shareholders. The Board and company executives are supposed to act as responsible and prudent agents of the shareholders. However, an agency problem arises when the interests of management agents diverges from the interests of shareholders.

Compensation was at the crux of this agency problem. Historically, most Wall Street firms had evolved from partnerships where earnings were distributed annually in cash. Even as they incorporated, went public, and acquired masses of individual shareholders, huge cash bonuses persisted. Through huge debt ratios, Wall Street and other financial firms borrowed to leverage their bets and their bonuses.

These agents were in it for themselves and took extraordinary risks that they themselves would not have to repay. Lehman Brothers went bankrupt and its shareholders held useless paper. While the general world economy went to hell in the resulting credit crunch and shareholders in other industries across the world saw their asset values decline dramatically, many irresponsible Wall Street agents kept their jobs because of taxpayer largesse. The games continue.

While blame can be spread to regulators, as well, at its core this crisis demonstrated that the securities industry executives were simply irresponsible about excessive risks taken by their firms. This October 23, 2008 New York Times article entitled “Greenspan Concedes Error on Regulation,” provides some key insights about this crisis:


Greenspan’s surprising comments about his own culpability as a regulator are noteworthy. Apparently, he had somewhat magical expectations about the responsible behavior of those who ran these financial firms:

“But on Thursday, almost three years after stepping down as chairman of the Federal Reserve, a humbled Mr. Greenspan admitted that he had put too much faith in the self-correcting power of free markets and had failed to anticipate the self-destructive power of wanton mortgage lending.

“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief,” he told the House Committee on Oversight and Government Reform.”

Prior to the crisis, regulators loosened regulatory controls significantly allowing the securities industry to invent new derivatives craps table, while the Federal Reserve flooded the economy for years with cheap money. Alan Greenspan was a highly influential part of the US regulatory apparatus that decided that things would be fine, if foxes were permitted to guard the hen house.

After the dust settled, Alan Greenspan then expressed shock that industry executives behaved recklessly and took the money. Remember who else was shocked? In the 1942 movie, Casablanca, Rick (Humphrey Bogart) said: “How can you close me up? On what grounds?” Captain Renault (Claude Rains) responds: “I’m shocked, shocked to find that gambling is going on in here!” as Captain Renault is handed money by a croupier.

It seems clear to me that very little has yet been fixed. What happened before could happen again, but probably just not in exactly the same place within the financial system. Just as militaries strengthen themselves to fight the last war, the specific, recent abuses associated with mortgage securities will probably be attended to narrowly. However, the financial playing field will just shift and the damage could return in another venue, unless genuinely fundamental changes are made.

The credit crisis and Great Recession are severe echoes of the Savings and Loan Crisis

During the credit crisis/Great Recession, it was striking to me how little the media conversation looked into history. One only needs to walk back two decades to find similar gross financial industry shenanigans during the Savings and Loan Crisis of the 1980s and early 1990s. If you have forgotten this history, look at Wikipedia for a refresher:


Regarding the particular arena of financial industry abuse, the territory of these two crises separated by just two decades is very similar. The industry’s particular securities concoctions differ, but the arena of both crises was real estate lending.

In the S&L Crisis, 747 S&Ls died; taxpayers ate about $88 billion measured in 1995 dollars; and as a result, we endured a recession in the early 1990’s to boot. Yet, the S&L Crisis was just “prequel” to the recent credit crunch and Great Recession. If you are working or already are retired, you had better hope that we are not on a linear trend with these financial crises occurring every decade, or your retirement might not be as comfortable as you hope.

I say “every” decade, since you might also remember that little “dot com” securities market bubble and crash in between these two financial crises associated with real estate. The dot com financial event was another market bubble followed by another recession – this time with a subsequent and largely jobless recovery.

While the mania to buy in to the Internet was widespread, the dot com bubble would never have happened, if Wall Street and many actors in the financial industry had not voided historical standards for taking companies public through initial public offerings. In pursuit of its own bonuses and profits in the dot come bubble market value run up, the investment banking industry kicked historical IPO profit and cash flow standards out the window.

Despite the historic industry maxim that companies being taken public should demonstrate a very high likelihood of sustained positive cash flow and profitability, the Netscape IPO in 1995 demonstrated that sexy Internet IPOs could be floated regardless of the underlying financials. Responsibility does not rest entirely with Wall Street, since they could not have polluted IPO standards without having buyers who were willing to ignore the risks and place their money.

Until it crashed, Wall Street rode the dot com bubble up with wave after wave of repetitive “50 bags of dog food sold on the web” and other IPOs without viable financials. The securities industry’s brilliant analysts publicly touted the virtues of these wonderful new companies, while disparaging them in private.

The locations of these floating securities crap games differed. However, when the behavior of financial industry participants is viewed, there is little difference between the S&L crisis, the dot com crash, and the credit crunch/Great Recession. Perhaps, we all should take an interest in genuine reform so that more systematic financial industry abuses are not lined up like freight cars into the future.

Protect yourself and your family from the financial services industry

As individuals, we cannot prevent financial crises, but we can take effective protective steps. If you do not have a financial plan, then make one. If you do not have inadequate assets, earn more if possible and certainly spend less of what you do earn. Save more, invest according to the principles laid out in this blog, and build up your assets. Learn how to ride out financial storms without panicking or do not expose yourself to financial and investment risk that you cannot handle.

In addition, stop feeding the financial industry beast. This brings us back to the rationale for this book. While we all need an efficient financial industry for banking, investments, insurance, credit, etc. the financial services industry we have is grossly out of proportion to its real value to our society. The financial industry takes in too much revenue and it generates too much profit.

Collectively we are all the source of this revenue, and the fact that the industry’s profits are so high simply means that we are getting much less value than we are paying. While individual cannot control this beast, they can stop feeding it.

I do not claim that I had any special insight about what was coming before the most recent financial crisis, but the rapid run up in residential property values beforehand made me quite uneasy. Home pricing shifted considering whether one could afford the price of the home overall to whether one could qualify for the monthly mortgage payment as underwriting quality went into the toilet. When I noted that a majority of California home purchases were no longer financed by fixed rate, fixed term mortgages, as had historically been the case, this became even more worrisome. However, worry was useless, because individuals cannot stop these crises. They can only survive them.

In the summer of 2007, I published a five-part article on The Skilled Investor website, that is entitled: “The Biggest Personal Finance Story of the Past 30 Years.” This story details how the public market value of the financial services sector had grown into another financial bubble in and of itself. While shareholders of financial firms may have been pleased, the rest of us were just feeding this beast. This financial industry bubble deflated somewhat, during the credit crunch and Great Recession, but taxpayers bailed out the industry. Now, this financial services industry valuation bubble is inflating again.

These quotes are highlights from the conclusion this 2007 article series:

“For individual investors, the logic of adopting a very-low cost passive index investment strategy is very compelling, because investment costs and taxes are among the few very significant investment factors that they actually can control.

“Therefore, 1) if securities markets are relatively efficient, 2) if individual investors are confused and highly unlikely to beat the markets and 3) if professionals also have a tough time beating the markets, then what strategies could the financial services industry adopt to increase their profits?

“Well, if getting a higher return from the market is not easy, taking away the investment assets of naive individual investors through excessive costs and fees can be a far easier path to higher profits. Furthermore, if investors are charged fees as a percent of their assets rather than a percent of their returns, then the individual investor does not even need to have a positive market return for the industry to get paid!

“One way or another, huge amounts of personal money are being poured into the financial sector by individuals and much less than what they pour in comes back to them. The choice is yours as to whether you want to keep pouring in your money or whether you want to adopt a lower cost personal finance strategy.”

Since I published these articles, over four years have passed with a nasty financial crisis and recession thrown in. My opinion has not changed. Cut your investment costs to the bone.



Personal Financial Planning

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