Death of a Golden Goose

Where do Wall Street's mega-profits come from? With free lunches still a myth, it stands to reason those truckloads of dollars have to come from somewhere and someone. With the market wobbly and regulatory reform in the headlines, the question is more important than ever. Especially the question of who the chumps may be.

In this era of bank bailout bonanzas, we know that taxpayers rank high among the chumps. They saved the banking system, and bankers took home the beef--and the lobster, shrimp cocktail, caviar, champagne, and cognac. As middle class taxpayers struggle to keep up with the costs of subsidizing Wall Street, the banks' lobbying blitzkrieg rampages through the halls of Congress in a fairly successful effort to prevent meaningful regulatory reform. For the mostly wealthy people running the financial system, it is apparently better to receive than give.

Customers are a prominent source of Wall Street's profits. The big banks' lobbying scrum in Congress to combat transparency in the derivatives markets aims to protect outsized markups and markdowns that customers can't see. If they can't see these expenses, they can't negotiate very well. Even though customers in the derivatives markets are institutions, they for the most part trade with investor money, like pension contributions, 401(k) contributions, and so on. Markups, markdowns and other transaction costs they incur ultimately come out of investor pockets in the form of lower returns. If derivatives customers are business corporations, then those costs come out of the pockets of shareholders or the customers of the business corporations (in the form of higher prices). As we noted, there still ain't no such thing as a free lunch.

Even in relatively transparent securities markets, such as the mutual fund market, the investor is sold the Brooklyn Bridge. Counterintuitively, mutual fund fees tend to rise the larger funds become. This is true for both stock funds and bond funds. Things were supposed work the other way around. We were told that larger funds would use economies of scale to reduce fees and pass more gains onto investors. However, the mutual fund industry also seems to believe that receiving is better than giving. There are a few exceptions, often in the cases of index funds. But most money managers appear to have captured the benefits of economies of scale for themselves.

The outsized profits of big banks in recent recession years and the increase in mutual fund fees even as funds get larger imply that the relatively high level of concentration in the securities industry is another reason for bankers' big pay days. Businesses love monopolies and oligopolies, and fight governmental efforts to curtail concentration. Some of the biggest lobbying fights in the financial reform arena have been aimed at suppressing measures that would require the big banks to split up, and lose some of their market power. On the other hand, a measure that would protect big banks, concentrating regulatory power in the Fed (which sees size as a regulatory advantage, and which has a long history of brushing aside the interests of retail customers) has pretty much become a certainty. If you don't like Microsoft, you won't like the big banks (and the Fed) because oligopoly in the financial services industry appears to be in our future.

Even do-it-yourself individual investors who frugally stick to index funds and the lowest cost online brokers pay part of the price. They add liquidity to the market and make it easier for the big firms to trade and sell stock and ETF offerings. But what returns do these investors get? The Dow Jones Industrial Average is trading at 1999 levels, if you look at its numerical value. Factor inflation into the picture and the time machine takes you back to 1997, when Monica wasn't a name associated with Presidential scandal. A passbook savings account would have been more profitable.

When an industry imitates the Sheriff of Nottingham, counting 12 for itself and 1 for the poor (which by this count would be just about everyone else), it can only expect ire, taxation and regulation. But potentially far worse would be the loss of customers. The recent bull market was notable for the absence of individual investors. Indeed, one of the quirks of the recent downturn is that it wasn't preceded by a rush of Mom and Pop investors jumping in at the top. Mom and Pop, now the tired, drawn Ma and Pa of Grant Wood's American Gothic, have smartened up about playing on a freeway filled with tractor-trailers driven by overpaid bankers. They're sticking to the farm and to simple investments. Something complex and unpredictable like stocks (and there's no arguing after the Flash Crash that the stock market has become more mysterious and unpredictable over the years, not less so) is left for gamblers and naive dreamers.

Individual investors have been the golden goose for the stock market. Through mutual fund investments and direct stock purchases, they are a major source of savings, the true capital of Wall Street. Without managed money to play with, the big firms could hardly make a fraction of the profits they enjoy. Individual investors are less well informed, and thus easier marks. Many of them hold investments for long periods of time, providing stability while Wall Streeters trade in and out in frantic and often unsuccessful efforts to beat the S&P 500. Without these vasts herds of retail sheep to shear, the big firms would only have each other to snipe at. That would be tough going and far less profitable.

Of course, enormous amounts of capital are invested in stocks because of financial plans already in place. Much (but certainly not all) 401(k) money will stream into stocks. But Wall Street ultimately needs big growth for its big pay days. And the growth goose may not fly again for a generation or more.