The perils of feeding a bloated industry
Last week, the U.S. Justice Department filed a civil suit against Countrywide and its acquirer, Bank of America, seeking to recover $1 billion in losses sustained by Fannie and Freddie, now taxpayer-owned, from 2007 to 2009. Preet Bharara, the U.S. attorney in Manhattan who brought the case, said Countrywide was accused of conduct “spectacularly brazen in scope.”
In case you’ve been away from Planet Earth these past five years, Countrywide was legendary for its toxic loans and aggressive sales tactics. And its close ties to Fannie Mae have long been detailed in public documents filed with the Securities and Exchange Commission. For example, Countrywide was Fannie Mae’s biggest supplier of mortgages, many of which were Countrywide’s famous “Fast and Easy” loans. As for subprime loans, in 2005 alone, Countrywide sold $12.5 billion worth of risky mortgages to Fannie Mae.
Still, if the Justice Department’s lawsuit keeps taxpayers focused on the high societal costs that financial institutions like Countrywide have inflicted, that is all to the good. This is especially true given the immensity of the financial services industry and the power it continues to wield.
It is worth remembering that the credit crisis and ensuing economic downturn followed a spectacular expansion in the financial business, compared with other industries. Assessing the nature of that growth and whether it has benefited society is the subject of powerful new research by David Scharfstein and Robin Greenwood, professors at Harvard Business School.
In their study, “The Growth of Modern Finance,” the professors delve into figures showing that the financial industry accounted for 7.9 percent of the nation’s gross domestic product in 2007, up from 2.8 percent in 1950 and 4.9 percent in 1980. Finance’s share of GDP grew faster since 1980, they found, than it did in the previous three decades.
Other academics have tracked this meteoric rise and questioned its benefits. But Scharfstein and Greenwood go further, identifying specific corners of finance that contributed most to the growth.
This lets them dig deeper into the broader impact of this trend — like who wins and who loses in the race.
One part of the industry that has contributed greatly to the rise, they found, is money management.
Fees generated by asset managers, like those for mutual funds, hedge funds and private equity concerns, account for 36 percent of the growth in the financial sector’s share of the economy, the study concluded.
Driving that increase is the puzzling fact that asset management fees overall, typically charged as a percentage of the money overseen, have not fallen substantially.
Much of the increase here, therefore, has to do with the rise in asset values, which generate higher fees for money managers even though the cost of providing their services does not increase. A soaring Dow Jones industrial average is very lucrative for these folks.
Yes, investors can cut expenses by buying low-cost mutual funds, like those mirroring stock indexes. But most active managers continue to levy the same percentage fee on assets that have risen in value significantly, generating big gains for themselves, the professors note.
Another factor has kept asset management fees aloft: the rise of alternative investments, like hedge funds and private equity funds. Their costs — around 2 percent a year, plus a percentage of profits — skew the average fees higher.
Professional money management has many societal benefits, Scharfstein is quick to note. It’s brought more liquidity to markets, financed more entrepreneurial ventures and cut costs of capital for many companies.
TRANSFER OF WEALTH
But the stubbornly high fees charged by these managers are a troubling transfer of wealth from savers to finance workers, Scharfstein added. Over time, these costs have huge impact on how well an investor will live in retirement. In other words, the few benefit at the expense of the many.
“Normally you would think that competition should drive down prices,” Scharfstein said in an interview. “But that doesn’t seem to be working except for index funds. Part of the answer must be a lack of sophistication on the part of individual investors. But many public pension funds and other large institutions, which are supposed to be sophisticated investors, pay high fees — in many cases for pretty lackluster performance.”
The second major contributor to the ever- growing finance sector is the cost of household credit, mostly those costs associated with mortgages. Household credit costs, the professors reckon, have accounted for almost 40 percent of the increase in finance’s share of GDP in recent years.
CREDIT BOOM
This is not surprising, given that household credit, mainly mortgages, ballooned from 48 percent of gross domestic product in 1980 to 99 percent in the credit boom, the study notes. This was largely a result of an expanded securitization market that enabled lenders to originate home loans and bundle them into securities for sale to Wall Street and then to investors.
But this process, while highly profitable to the sector, undermined financial stability, the professors argue.
Participants failed to understand the risks, amplifying the panic when the market turned sour. And making household credit more available let borrowers pile on dangerous amounts of leverage, introducing more volatility into the system.
These are the social costs of the vast increase in this type of credit: The financial system became more complex and borrowers were imperiled. Over the past five years, we have witnessed millions of foreclosures, trillions in investment losses and an economic downturn we are still struggling to overcome.
“It’s probably good to be in a place where households can get access to credit,” Scharfstein said, “but the question is, at what cost?”
Fact is, we are still tallying it.