Here is a great summary of the growing corruption in the financial industry by Charles Hugh Smith
We start with David P.’s excellent exploration of systemic fraud:
Your essay The Collapse of Our Corrupt, Predatory, Pathological Financial System Is Necessary and Positive was entirely correct about risk. But let me come at this from a different angle – namely fraud. Finance skims a percentage off the real economy. Some part of the skim is legitimate reward for capital allocation – a necessary part of a capitalist system and part of what makes it more efficient than a command economy. But some part of the skim is fraud.
Where are we now? Let’s look at the sources of skim:
First there are the more legitimate skim sources – interest payments, management fees, IPO fees, M&A fees, trade commissions.
Then there are the less legitimate bank sources: penalty credit card interest rates, late fees, usage fees, over-the-limit fees, late payment fees, bounced check fees, low balance fees. And the capital markets sources – front-running, insider trading, account churning, manipulation of the news cycle, the captive analyst “ratings game”, trading against your own client’s order book, forex trades which are marked at the day high or low irrespective of when the trade took place, market manipulations at options expiration, stuffing your managed client accounts full of dubious IPOs and new issues that your organization is earning fees from originating.
Bucket shops and ponzi schemes take it even a step further – no actual financial activity takes place. Its simply robbery.
And now we add the new stuff: credit default swaps without margin, fraudulent loan origination, sliced & diced mortgages, mark to myth accounting, foreclosure halts to avoid realizing losses, extend & pretend, quote stuffing, HFT trading activity that boils down to denial of service attacks on exchange computers causing delays in pricing information, highly complex derivatives sold to unsuspecting but optimistic public servants, too big to fail status providing cheap backup in the event of trouble, and increased organizational size that facilitate cartel-like control over government and regulators.
But if that’s not enough, there is the structure itself: they aren’t doing this with saved capital, but rather with freshly printed and/or borrowed capital. Its all done with 12:1 leverage at a minimum. So only 8.3% of the gambling (optimistically anyway) is actual capital – saved surplus. And if Basel II says it’s risk-free, well there’s no need for reserves at all. It is just manufactured money, which effectively mean each bet is diluting the actual savings of real people. And if the bet goes bad, the Fed will ride to the rescue with low-cost money. But usually the bet goes well, because ordinarily the number of sources of fraud today is so HUGE, its practically impossible not to succeed.
Unless of course they get too greedy. Or the debt levels rise so high that large numbers of borrowers default. And guess where we are.
The financial system is supposed to allocate capital and take a modest skim as reward for helping society to be efficient. When they are doing this, they provide a net benefit to society because it’s a win-win proposition. They are making society more efficient, and they thus earn their percentage.
However, and this is the key point: fraud provides no net benefit to society. Fraud extraction is a zero sum game. For every dollar extracted through fraud, someone in the productive society ends up losing – savings, salary, whatever. This is why fraud is bad.
(I say that leverage is zero sum because constructing money from thin air for a leveraged investment causes inflation and thus steals from savers.)
Currently, it is my opinion that the vast majority of today’s highly profitable financial activity is fraud. They have gone way, way beyond their mandate of capital allocators. Because most of its activities are based on fraud, the finance industry is acting as a parasite, sucking the life blood from the rest of society. Its bad enough we have peak everything, a world population of 7 billion people, and globalization to deal with – but we also have to face these challenges while a leech is weakening us with every step we take!
As a result, when this bloated, fraud-based financial system dies, we’ll have a awesome, positive chance to rip off the parasite and replace it with something more beneficial. Simply re-executing glass-steagall will do for a start. Bring back 9-3 boring banking, where banks retain the mortgage and live with the risk, and capital markets once again do their job of capital allocation — but without the fraud so rampant today.
Same conclusion, different angle. Intrinsically, I believe that capitalism does actually allocate capital more efficiently than competitive systems. And yet, how the current system works is so wrong. And I figured out it was fraud. Fraud was the bad guy. Remove fraud, and things get a lot better.
But after re-reading your essay, fraud wasn’t the whole answer either. Fraud might be the leech, but leverage is the system killer.