Thursday, October 23, 2014
7

The Wolves of Wall Street

LONDON – “What a commentary on the state of twentieth-century capitalism,” mused “motivational speaker” Jordan Belfort as he looked back on his life of fraud, sex, and drugs. As head of the brokerage firm Stratton Oakmont, he fleeced investors of hundreds of millions of dollars in the early 1990’s. I saw Martin Scorsese’s film The Wolf of Wall Street and was sufficiently intrigued to read Belfort’s memoir, on which the screenplay is based. I learned quite a lot.

For example, the scam known as “pump and dump,” which netted Belfort and his fellow Strattonites their ill-gotten gains, comes into much clearer view in the memoir than it does in the film. The technique works by buying up the stock of worthless companies through nominees, selling it on a rising market to genuine investors, and then unloading all of it.

It was not just small investors who were ruined; what stands out is the greed and gullibility of the rich who were sold the same rubbish by the “young and stupid” salesmen Belfort preferred to hire. Belfort was (is) obviously a super-slick snake-oil merchant, brilliant in his trade until drugs ruined his judgment.

Belfort, once again selling the elixir of success after a brief stint in prison, professes to feel shame for his behavior; but I suspect that deep down his contempt for those he swindled outweighs any sense of remorse. In a recent book, Capital in the Twenty-First Century, the economist Thomas Piketty highlights the phenomenon of “meritocratic extremism” – the culmination of a century-long passage from the old inequality, characterized by inherited wealth and discreet lifestyles, to the new inequality, with its outsize bonuses and conspicuous consumption. Stratton Oakmont was a conspicuous example of this trajectory.

Belfort has been described as a perverse Robin Hood, robbing the rich to give to himself and his pals. The rich were the old-money Protestant establishment whose members had lost their skills for protecting their wealth, which was therefore rightfully forfeited to street-savvy up-and-comers – mainly Jewish – amoral enough to help themselves to it. But Stratton Oakmont’s peculations were hardly an exception on Wall Street. As a good friend, who was an SEC regulator for 20 years, told me when I asked about the extent of fraud, “I found it to be pervasive. The system simply makes it too easy, and human nature colludes on both sides. Greed is the source of all cons.”

The Wolf of Wall Street was a predator, but so were all those reputable investment banks that shorted the products they were selling, and the retail banks that offered mortgages to unviable borrowers, which they could then repackage and sell as investment-grade securities. They were all wolves in sheep’s clothing.

A decent banking system has two functions: to look after depositors’ money and to bring together savers and investors in mutually profitable trades. Savings are deposited with banks because they are trusted not to steal them, and custody has a price. The deals that banks arrange between borrowers and lenders are the lifeblood of modern economies – and risky work for which bankers deserve to be well rewarded. But any money that bankers earn over and above the cost of compensating them for providing an essential service represents what former British regulator Adair Turner calls “social waste,” or what used to be described as “usury.”

It is not the extent of the financial system that should alarm us, but its concentration and connectivity. In the United Kingdom, an ever-increasing share of bank assets has been concentrated in the five largest banks. Standard economic theory tells us that excessive profits are the direct result of concentrated ownership.

Connectivity is the link between banks. These links can be locational, as in Wall Street or the City of London. But they became global through the development of derivatives, which were supposed to increase the stability of the banking system as a whole by spreading risk. Instead, they increase the system’s fragility by correlating risk over a much larger space.

As a paper by Andrew Haldane of the Bank of England and the zoologist Robert May points out, derivatives were like viruses. Financial engineers and traders shared the same assumptions about the risks they were taking. When these assumptions turned out to be false, the entire financial system was exposed to infection.

Concentration and connectivity reinforce each other. Two-thirds of the recent growth of banks’ balance sheets in the UK represents internal claims among banks rather than claims between banks and non-financial firms – a clear case of money breeding money.

Reformers want to cap bankers’ bonuses, create firewalls between banking departments, or (more radically) limit a single bank’s share of total banking assets. But the only durable solution is to simplify the financial system. As Haldane and May put it: “Excessive homogeneity within a financial system – all the banks doing the same thing – can minimize the risk for each individual bank, but maximize the possibility of the entire system collapsing.” As long as banks can make a profit from trading, they will continue to expand derivatives in excess of any legitimate hedging demands from non-banks, creating redundant products whose only function is to make profits for their inventors and sellers.

How to curtail derivatives is now by far the most important topic in banking reform, and the search for solutions should be guided by the recognition that economics is not a natural science. As May recounts: “The odds on a 100 year storm do not change because people think that such a storm has become more likely.”

In financial markets, the odds do depend on what people think. The less thinking they have to do, the better. Jordan Belfort was partly right: people who go into finance should not be too clever.

Read more from "Piketty's Charge"

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  1. CommentedStephen Pain

    I think that remoteness and complexity are factors. We see this in warfare, where drone technology using game simulation, creates a sense of distance, and at the same time requires much skill. The drone pilot is therefore concentrating very much on making sure the drone flies on course and follows the target etc. In the case of the financial market, the paradigmatic shift from price to added value and the digitalization of transactions, the reduction of face2face encounters at all levels of the economy, the focus on profit rather than real production, all erode away that Galbraithan concern for people. People matter. I think that a fraud has been perpetuated on a grand macroeconomc level - the financial system itself is a fraud. It has defrauded millions, if not billions of their income, it has disfranchised so many, and it has had an unconscionable influence over spheres where it should not have been allowed in.

  2. CommentedJohn McDonald

    Accuse, accuse, accuse. If the author knows about pervasive fraud on Wall Street, even at reputable firms, then the Justice Dept must know as well. That makes the Obama administration criminal co-conspirators.

  3. CommentedEdward Ponderer

    Who guards the guardians? Only the ultimate thief, the ego. It must not be ignored, nor black box -- for it is that that has "one ring to rule them all."

    It must be won over directly through integral education, a thorough understanding of the inter-connectivity of globalization, that we WILL sink or swim, ultimately, together. It must buy into to mutual responsibility, and become the ultimate mutual guarantor.

    We have the educational and psychological tool sot self-help human ego to its own survival and true, lasting prosperity. Unlike Jordan Belfort, we will be able to sell the ultimate snake oil salesman on this program -- because it is the one that truly knows -- we are not selling snake oil.

  4. CommentedZsolt Hermann

    As we look around the world and see the total area of devastation, from economics and finances to the political system, education, culture, social net and recently even "international laws" and national sovereignty, we need to defocus a bit, trying to peek behind the scenes, the frames of the movie to see the real 'evil".
    It does not really matter which part of the crisis we pick up, all the problems are driven by our inherently self-centred and egoistic nature.
    This nature built the ruthless, competitive, exploitative human system we all live in, in total opposition with the natural environment around us.
    Given the chance and talent all of us could become the bankers, politicians, corporate business men exploiting anything they can for their own greed, personal legacies, fame, dominion. We are all born with the same nature.
    As long as we try changing banking systems, political parties, CEO's and so on, we will always miss the point.
    It is our human nature that needs changing, attuning, so we can adapt to the global, interconnected and interdependent human system we evolved into, also understanding that this human system is only a minuscule part of the vast, but closed and finite natural system.
    We need a revolutionary education system for children and adults alike to show us who we are, how we work and into what system we have to fit in.
    Today we do not have to grope in the dark any more we have everything in front of us in full resolution, great detail: our own 'evil" nature and the fully matured system we need to adapt to.
    We simply have to put the pieces together and start changing, tuning the only thing that is changeable: ourselves.

      CommentedEdward Ponderer

      Who guards the guardians? Only the ultimate thief, the ego. It must not be ignored, nor black box -- for it is that that has "one ring to rule them all."

      It must be won over directly through integral education, a thorough understanding of the inter-connectivity of globalization, that we WILL sink or swim, ultimately, together. It must buy into to mutual responsibility, and become the ultimate mutual guarantor.

      We have the educational and psychological tool sot self-help human ego to its own survival and true, lasting prosperity. Unlike Jordan Belfort, we will be able to sell the ultimate snake oil salesman on this program -- because it is the one that truly knows -- we are not selling snake oil.

  5. CommentedJon Cloke

    "It is not the extent of the financial system that should alarm us, but its concentration and connectivity" _ I couldn't agree more, and wrote a paper on exactly this for a recent conference in Helsinki, for anyone who's interested - the title is 'The Evolution of Ultracapital and Actor-Network Capitalism', it's open access and available at http://hdl.handle.net/10138/41990

  6. CommentedProcyon Mukherjee

    An excellent commentary this provides about snake oil salesmen and their "meritocratic extremism", however the peculations of these cohorts cannot simply be a matter of literary-scholastic cadence or an artistic treatment as in the film; we need to question the larger machinations at work. This industry wants to seek alpha or reach for an yield when marginal product of capital has long surpassed its prime, and that at a time when the future looks more uncertain in terms of the growth against the headwinds we are all aware of (debt, demographics, etc); the rising penchant for bubbly assets is a creation of modern era financialization which draws so much from simple rent while feeding the same asset to buyers and sellers infinite number of times.

    The greater thrills are to be found in valuations (some games are now reaching multi-billion dollar valuations, some ideas no matter how frothy their collective spirit be) where so much money is being channelized, no one seems to be worried with the return, which is simply a matter of opinion.

    Looks that buying and selling ideas or assets, instead of goods and services is the new paradigm, where money is mooted; no one needs to be employed or no new factories to be built in this state.

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