Rent-seekers' Nirvana

Goldman Sachs' income from trading and principal investment rose 90% in the third quarter of 2009, while allocated remuneration per employee soared 46% to $527,000 in the first nine months of 2009.

Good luck to them, but it shows once again that they, and to a lesser extent the rest of Wall Street, are currently playing a different game than the rest of us. The question is: How best to restore the operation of a competitive free market?

Investment banking has changed radically over the last 30 years, and it's not clear that either regulators or the market fully understand the modern sources of its income. Trading, a fairly peripheral activity 30 years ago, has come to dominate the investment banking income statement, with income arising for investment banks both through acting as an intermediary and through "proprietary trading" for their own accounts.

The immense and unstoppable proliferation of derivatives is the principal factor that has brought this about. After all, total outstanding derivatives contracts at the end of 2008 had a nominal principal amount of $514 trillion, more than ten times the size of the world economy. You don't need to skim very much off the top of a pot of cream that size to make your practitioners very rich indeed.

A decade ago, defenders of the derivatives revolution could reasonably claim that the economic value and risk of those contracts was a tiny fraction of the total outstanding. Today, when we have seen multiple examples of credit default swaps paying close to 100% on billions of dollars of obligations, that claim has become laughable. The fraction of risk involved in that $514 trillion isn't as tiny as all that.

The intellectually curious must wonder what purpose all this activity serves. Defenders of derivatives and trading in general mutter the magic words "hedging" and "liquidity" and expect their questioners to fall back abashed.

However, there aren't $514 trillion of exposures to hedge. Indeed, in a $50 trillion world economy, there aren't even $50 trillion of exposures to hedge. Hence at a very conservative estimate, 90% of all derivatives activity serves nobody beyond the dealer community.

The same applies to liquidity. The immense trading volumes daily in the foreign exchange or futures markets do indeed provide liquidity, indeed more liquidity than can possibly be necessary to run the system.

Proponents of trading will again say that it is necessary for a large financial institution to make a $1 billion block trade, but why? Surely in a well-run economy, institutions should invest on a long-term basis, not engage in random short-term speculation.

If a senior institutional investor breaks up with his girlfriend who is CEO of a company, why should the entire resources of Wall Street be deployed to allow him to dump his institution's $1 billion position with one keystroke, rather than making him do so gradually, over a period of time during which calmer and wiser thoughts may prevail?

Likewise, there can be no significant systemic value, if a company reports an unexpected loss, in allowing the billion-dollar shareholder with the fastest trigger-finger to dump his position on the market, or on other shareholders who may have less immediate access to information.

If the economic value of hedging and liquidity are modest compared to the galactic amounts of contracts outstanding, or even to the enormous sums earned by trading, then it follows that some pretty large percentage of trading revenues represents nothing more nor less than rent seeking, the extraction of value from the economy without providing any economically valuable service in return.

The explosion in derivatives and trading volume can then be seen as a gigantic smokescreen, which has enabled Wall Street to extract larger and larger rents from the remainder of the economy.

That is intuitively sensible. Investment bankers and traders are intelligent, capable people, but an average per-employee remuneration of $527,000 in nine months, or $703,000 per annum, for the entire staff of Goldman Sachs (including janitors and interns) suggests that some mysterious force is preventing those returns from being driven down to a level for which all but the most senior of Wall Street veterans would happily work.

It's not a question of the "social value" of trading, a dubious concept in the best of times. It's a question of what barriers to entry prevent every corporation in America from setting up a derivatives trading department in order to extract some of these extraordinary returns.

The same applies to "proprietary trading," by which modern investment banks deploy large amounts of capital to achieve very high returns. The Efficient Market Hypothesis postulates such excess returns to be impossible, since capital would rush to the nexuses where they existed, and drive returns down to an equilibrium level.

One need not be a believer in the EMH to agree with its conclusions in this respect. Warren Buffett, the greatest investor in America, has achieved returns only barely above 20% annually in his 50-year investment career.

It is unreasonable to suppose that ever greater amounts of capital could be deployed into achieving returns considerably greater than that, year after year, if some artificial barrier to competitor entry was not involved.

There are two barriers to entry that appear to prevent capital from arbitraging away investment banks' trading returns. The first is insider information, not generally the illegal kind about corporate activities but the entirely legal kind about money flows, equally valuable in a trading environment.

If you are one of a handful of major dealers in a particular type of derivative contract, or you have a computer set up at the New York Stock Exchange that sees the order flow before competitors, you have insider information that is not available to third parties, just as surely as if you knew the secrets of next quarter's earnings.

The second kind of barrier to entry is that of crony capitalism. In the private sector, this is the way business has always been done. A company's CEO is a close friend of one investment banker rather than another, so he gives him preference when there is a transaction to be done. The position becomes much more doubtful when the public sector is involved, as increasingly is the case in this less and less capitalist environment.

If the Treasury Secretary is an alumnus of Goldman Sachs, as was Hank Paulson last year, there must be some suspicion at least when bailouts are arranged so that Goldman receives a $13 billion payoff at public expense on credit default swaps issued by AIG, as well as receiving a payoff on credit default swaps issued on AIG, payable only on an AIG default. To put it bluntly: Such largesse had not been available to Lehman Brothers.

Similarly, large government-directed contracts that are awarded without full competitive bidding, or advisory work where the investment bank's government contacts are themselves leveraged, or investment opportunities not available to the general public, are all examples where crony capitalism must at least be suspected — even if it can never be proved.

With the immensely greater amounts of capital now available to the major Wall Street houses and the death of the "it's not cricket" gentlemanly prohibitions against naked rent seeking, it's not surprising that such profits have multiplied.

If much of Wall Street's extraordinary profitability is in fact rent, then eliminating it will make the rest of us richer and make the U.S. economy as a whole more efficient, as capital is allocated more optimally. The rent seeking problem appears to be quite concentrated at the center of financial services. The losses reported by Bank of America and many regional banks suggest that old-fashioned banking is at best only normally profitable.

Both traders and Wall Street in general perform vital economic functions. But that does not mean they should be allowed to multiply the rewards to themselves for doing so ad infinitum. The free market needs to be restored.

Editor's note: This feature has been adapted from an article that first appeared on “The Bear's Lair,” published on the website Prudentbear.com.