Public Interest and Financial Regulation
Risk cannot be separated from investment performance or economic growth. It is neither something undesirable nor desirable; rather, it exists in all financial transactions, both mathematically and psychologically. In short, risk is permanent.
In the first article of this series on financial crises, I provided an overview of the problem: concerns about regulatory policy effectiveness vis-à-vis financial security, and about public interest in general.
In this article, I continue by defining financial risk and public interest, and how failures in regulatory policy affect financial security. Financial risk is often thought of as something negative; something to be avoided, and something that most people hope does not materialize. When making important decisions about their own money, individual investors often disregard risk in lieu of profits, only to adjust their investment strategy after they have suffered a major financial loss. Likewise, many policymakers adjust regulatory policy only after a major financial crisis has occurred. While the former hopes that risk does not materialize, and the latter addresses it after it does, both tend to behave as if it is not a component of the investment process. However, risk cannot be separated from investment performance or economic growth. It is neither something undesirable nor desirable; rather, it exists in all financial transactions, both mathematically and psychologically. In short, risk is permanent.
Thus, the concern in the investment decision-making process is not to disregard risk; rather, it is to understand the limitations, restraints, opportunities, and threats that it presents to financial consumers.
Likewise, the goal of regulatory policy as it pertains to the investment industry is not to eliminate risk because doing so would also result in the elimination of potential investment returns. Rather, it is to implement policies that will prevent systemic crisis (defined as a situation when all or most of the assets in a national bank system are wiped out, often resulting in runs on banks, spillover effects and damage to the public interest). Financial risk is also linked to investment advice and compensation. The Financial Industry Regulatory Authority (FINRA) requires that investment advisers provide advice that is suitable to the clients’ risk tolerance. A proportional relationship exists between risk and compensation. Thus, when investors assume more risk, not only does the probability of them losing money increase, but the potential compensation for investment advisers also increases. Financial risk (as it pertains to investment advice) can be categorized into two different categories: appropriate, or inappropriate. It is appropriate when investors assume more risk based on the advice of their investment adviser, and the level of risk they assume is consistent with their risk tolerance. It is inappropriate when an investment adviser pushes investment products on financial consumers, or recommends an investment strategy, that is inconsistent with said investors risk tolerance. Both FINRA and the Securities Exchange Commission (SEC) have identified specific types of inappropriate behavior (such as churning; unauthorized trading; failure to supervise; negligence; omission of facts; breach of fiduciary duty; unsuitability; and misrepresentation) that are associated with high risk, all of which pose a serious threat to financial security. For instance, in 2012, SEC charged Jefferies, LLC (a Boston-based investment firm) with failing to supervise its mortgage-backed securities desk during the Global Financial Crisis of 2008.[1] According to the SEC filing, Jefferies employees were lying to customers about pricing, which mislead them (the clients) about the actual amount of money that the firm was earning. [2] A lack of supervision on the part of Jefferies about its mortgage-backed securities desk resulted in misstatements about the associated risk.[3]
In 2003, SEC charged Invesco Funds Group, Inc. (a mutual fund company) with fraud and breach of fiduciary duty for allowing marketing timing.[4] According to SEC, Invesco Funds Group fraudulently accepted investments by dozens of market timers for the purpose of enhancing management fees, and in so doing, breached their fiduciary duties to their shareholders.[5] Jefferies and Invesco exemplify the tens of thousands of cases and law suits brought against investment advisory firms and their employees by the government. A democratic government is charged with many tasks, including the implementation of policies that benefit the public interest. Reducing risk and protecting financial consumers against unsuitable advice stands as one of these tasks.
Defining Public Interest
But, what is public interest? Public interest is central to policy debates, economic theory, the tenets of democracy, and the very nature of a democratic society. Although academia lacks a specific definition as to what constitutes the public interest, any such explanation would likely emphasize the well-being or general welfare for all members of society. According to U.S. PIRG (the Boston-based, non-profit, special-interest organization that focuses on public interest research and advocacy), tax reform, public transportation, healthcare, consumer protection, higher education, and financial security are among the primary issues that are important to the public.[6] Collectively, these (and other) issues provide a base from which I define what is commonly referred to as public interest. Indeed, public interest is a broad topic that includes many issues, all of which are fundamental to the well-being of individuals and the society in which they live. This study concentrates on only one of these issues, financial security, by exploring the interaction between regulatory policy, public interest, educational requirements for investment professionals, and the risks facing financial consumers that invest large percentages of their personal savings in the financial markets.
More specifically, as it pertains to public interest, the term financial security refers to the risks associated with financial products such as stocks, bonds, or derivatives, and real estate products such as Mortgage Backed Securities (MBS) and/or mortgages (particularly subprime mortgages that are offered to individuals that are deemed a high credit risk, such as low-income minorities and African-Americans), and the manner in which these products are presented to the public by the financial and banking industries. This is not meant to suggest that there are inherent problems associated with investment products. While some products, such as stocks or derivatives, bear a higher level of risk as compared to other types of products, such as Treasury bonds or certificates of deposit (CD), the risk to consumers does not necessarily lie in the product itself; but rather, in whether the product is suitable for their risk tolerance. If the level of risk associated with investment products is inconsistent with risk tolerance, then financial security is also at risk.
When risk is widespread, or systemic, it often results in financial crisis. Some might argue that because the value of the stock and real estate markets are determined by the economic laws of capitalism, financial consumers will eventually incur losses. While this argument, in principle, may be consistent with the tenets of capitalism, it is inconsistent with the tenets of public interest when consumers suffer large financial losses when the financial or banking industries intentionally (1) omit pertinent facts about investment or mortgage products; (2) fail to accurately disclose the levels of risk involved with such products; and/or (3) fail to provide advice that is deemed suitable by regulatory standards. Such behavior negatively affects public interest because it creates an economic environment that typically bodes poorly for the public sector, yet profitable for the private sector.
Thus, as it pertains to financial security, public interest can be defined as the right of all democratic citizens to live and work in a society whose economy is characterized by economic transparency, effective financial regulation, and judicial enforcement.
To elaborate, economic transparency refers to an open policy adopted by the private sector that makes known to the public sector all material facts and conditions associated with a product, such as price, availability or the risks associated with purchasing it. By effective financial regulation, I refer to a regulatory system that (1) creates and implements policies that protect individuals against the type of unscrupulous (and illegal) behavior by the private sector that conceals the level of risk to the financial consumer; and (2) supports an economy that allows corporations to earn a profit, provided that they do so in an honest and ethical manner. Judicial enforcement, as it pertains to public interest, refers to a legislative system that can effect punishment against any organization or individual that is found guilty of violating federal regulatory policy. If these conditions (economic transparency, financial regulation, and judicial enforcement) exist, citizens of such a society can freely pursue their own self-interests, particularly when doing so leads to gainful employment, the purchase or refinancing of a primary residence, wealth creation, and a financially secure retirement. Moreover, if the above-mentioned conditions are met, organizations that operate in such an environment can build and grow a business that is profitable, contributes to the economy, and supports the community through the production and distribution of useful products and services.
Determining When Public Interest Has Been Damaged
Having a working definition of financial public interest is one matter; determining when it has been damaged is another. In other public interest issues, such as public health, public transportation, or the environment, researchers and scientists can measure how the actions of the private sector affects the public sector. For instance, if a company dumps chemicals into the water, and consequently, thousands of people become chronically ill; or if a tanker accidentally spills millions of gallons of oil into the ocean, and subsequently, millions of animals die, the damage to public interest can be measured by instance and prevalence rates of illness or death.[7] However, determining the impact on public interest that results from financial losses is challenging, partly because over the past several decades, public interest research has waned, and methods used to measure public interest have not kept pace with those in medical or environmental sciences.[8] Bozeman argues the need for a paradigm shift in public interest research and analysis, citing a “shortcoming of ideas and theories pertaining to public interest.” Bozeman notes that current public interest theories lack precision and rarely include analytical tools.[9] This suggests a need by social scientists to develop methods that can determine when public interest has been affected by systemic crisis. The development of such methods would be useful to policymakers that implement regulatory policies designed to prevent another financial crises from occurring again. On the other hand, the notion of developing analytical tools that could identify when public interest has been damaged, as Bozeman suggests, might not provide the type of data needed to help reduce risk for financial consumers. As previously mentioned, public interest is damaged when (1) the private sector has not demonstrated economy transparency in its dealings with the public vis-à-vis the products it offers; (2) when financial regulation has failed to either create or implement policies that protect financial consumers; or (3) when the judicial system fails to punish those whose violate federal regulator policy. It is unlikely that an analytical tool could accurately assess when the private sector is not being transparent; or when existing regulatory policies are ineffective; or when the judicial system has failed to impose adequate punishment on those who violate regulator policy. At the very least, such a tool would need to (a) monitor all financial organizations in real-time for truthfulness of statements made to the public and identify when those statements are inaccurate; (b) determine when regulatory policy is ineffective; and (c) determine if the judicial system has effectively punished violators of federal policy. In short, such a tool is improbable, and policymakers that strive to improve financial security would benefit more by relying on theories and models developed by researchers and academia.
About Financial Crisis
By definition, a financial crisis is an interruption to financial markets that is commonly associated with falling asset prices (usually equities) and insolvency among debtors and intermediaries that spreads through the financial system, disrupting the markets capacity to allocate capital.[10] It is often associated with panic, as financial consumers desperately attempt to withdraw their money after realizing that their bank may fail. During a financial crisis, investors sell assets and withdraw money from their banks or financial institutions as a means of preventing further losses or access to funds. Financial crises typically occur after the economy has exhibited high levels of risk. When risk runs high, financial consumers often misinterpret the market data by looking at the potential return on investment rather than the risks they face. FINRA asserts that risk tolerance is an extremely important component of the investment process, one that determines investment product suitability, or appropriateness.[11] Investors that assume too much risk often panic during a financial crisis because they realize that the volatility of their investments exceeds their risk tolerance level. Consumers that invest during market peaks (the highest point between the end of an economic expansion and the start of a contraction in a business cycle) are exposed to the greatest level of risk because they invest when prices are at their highest.
To exemplify the relationship between risk and financial crisis, consider the events that preceded the Global Financial Crisis of 2008, or the Great Recession. Between 2001 and 2006, millions of financial consumers invested in real estate. This period represents unprecedented growth in the housing markets, which was followed by a two-year recession characterized by a 115% increase in seasonally adjusted unemployment, a 45% drop in housing prices (on average), and a 13.21% decrease in household net worth.[12] Accordingly, a large percentage of investors who purchased homes between 2001 and 2006 subsequently experienced significant losses in household net worth after the housing market crashed. In turn, global financial markets dropped suddenly as investors worldwide panicked and sold securities in all asset classes. Figure 1 displays the reaction to the housing market crash in the Dow Jones Industrial Average (DJIA). The vertical lines represent intraday volatility.
Figure 1. Effect of the subprime mortgage crisis on the DJIA
Between September 1, 2008 and March 1, 2009, DJIA dropped 34.9%. Intraday fluctuations show that the DJIA traded as high as 11,790 on September 1, 2008, and as low as 6,470 on March 9, 2009 (a range of 45.12% within approximately 6 months). Data source: Global Advisers historical quotes database.
By contrast, the S&P Volatility Index (VIX), traded from a low of 22.40 on January 2, 2008 to a high of 52.76 on March 1, 2009, with intraday prices ranging between 15.82 and 44.25, (see figure 2).
Figure 2. Market volatility: January 2008 - November 2009 (Data source: Chicago Board of Options Exchange)
These wild swings in the financial markets exemplify the extreme levels of volatility that investors face when markets fail. I argue that the cause of this volatility (and subsequent market failure) is not the result of investment product failure (as some argue). Instead, the extreme volatility exhibited by the financial markets during this period was the result of substandard information and advice provided to financial consumers by the investment industry; and by the private sector (which used deceptive marketing and advertising methods designed to persuade consumers to purchase products that exceeded their risk tolerance). I further argue that this extreme level of volatility demonstrates a gross lack of moral judgment by investment professionals that are motivated by high compensation yet show little regard for the financial security of their clients. This volatility is also a good example of why many consumers make rash decisions about their investment capital, both on the uptrend and on the downtrend. For example, when markets rise quickly, it sends a message to investors that if they do not invest immediately, they will miss out on potential profiles. Conversely, when markets drop quickly, consumers have little time to make prudent decisions about their investment capital. As I discuss later, this manic-to-panic cycle (1) indicates that many investment advisers lack the human capital required to provide prudent advice to financial consumers; and (2) can be explained (to a degree) by social and behavioral psychology theories.
The connection between risk and financial crisis is made apparent by analyzing the housing market crash of 2008. The relationship between home values and the securities industry is more ambiguous. If a person loses his or her home, how does it relate to the value of securities that are traded publicly on the NYSE or other global exchanges? Moreover, how does this relate to my central argument, which asserts that regulators should establish minimum educational requirements for investment professionals in order to improve financial security? To clarify, mortgage-backed securities (MBS) are essentially asset-backed securities that are secured by a pool of mortgages. Between 2001 and 2006, millions of consumers purchased subprime mortgages that were backed by low-quality, mortgage-backed securities. During this period, investment banks bundled both prime and subprime mortgages into MBS (whereas before 2001, they were isolated from each other), thus creating the appearance that the probable rate of return on MBS was superior to other products. Many investors believed that MBS could not fail because they were backed by mortgages (which have historically exhibited lower-than-average risk). However, a major selling feature of these mortgages was the low entry point. Subprime mortgages have low interest rate requirements for the first year (which made them initially affordable for many financial consumers with weak credit scores and low income), but extremely high payments thereafter. In essence, monthly payment on a $500,000 subprime mortgage loan increased nearly 80% after the first year. This dramatic increase in monthly obligation left most subprime mortgage holders unable to make regular payments. Consequently, as millions of homeowners defaulted on their mortgages, MBS values dropped precariously because the assets backing them (mortgages) defaulted.
To suggest that the subprime mortgage crisis, and subsequent global financial crisis, was caused (at least in part) by unethical practices may be understating the importance that moral judgment holds in the investment advisory process.
Whenever a financial professional sells a financial product to a consumer, his or her advice must be based on what is in the client’s best interest (suitability). Regarding subprime mortgages, investment professionals were (and still are) compensated in two ways: (1) through fees paid directly by the borrower, including the loan origination fee and credit fee; and (2) through a yield spread premium (YSP) by the lender.[13] YSP is a bonus that a lender pays to the investment professional for placing (or steering) a borrower into a higher cost loan than that which the borrower qualifies.[14] Put differently, on a $500,000 subprime mortgage, YSP@2% = $10,000. Estimates show that in 2005, 1.5 million consumers purchased $2.6 billion more than necessary due to YSP.[15] This indicates that in 2005, investment professionals that sold subprime mortgages earned an additional $52 million in compensation by convincing financial consumers to purchase a low-quality loan that was neither suitable for their risk tolerance, nor consistent with their credit scores. As millions of home owners defaulted on their loans (which began in September 2009), volatility increased dramatically, financial markets dropped precariously, and many financial consumers lost both their homes and their life savings in a very short period of time. The previously mentioned behavior points to a serious lack of ethical behavior and moral judgment on the part of the brokers that sold subprime mortgages between 2001 and 2005. As previously mentioned, moral judgment is positively correlated to years spent in college. As with other fields within financial services, minimum educational requirements to sell mortgages are a high school diploma, while licensing requirements are similar to those for investment advisers.
Other financial crises, such as the Great Depression (1929-1940), placed a similar burden on the financial consumer. For instance, between 1930 and 1933, consumers lost approximately $1,337 billion, and 9,096 commercial banks were suspended.[16] Figure 3 displays the relationship between consumer losses and systemic risk between 1930 -1933.
Figure 3. Consumer losses as a result of bank closings: 1921-1933
As indicated by this chart, consumer losses increased as the number of commercial bank suspensions increased, thus suggesting that public interest is also affected by bank failures and suspensions. Source: National Bureau of Economic Research
The above-mentioned data indicates that even after more than one-hundred years of government intervention and regulatory policy (which is designed to reduce risk henceforth), financial consumers continue to face levels of investment risk sufficient to cause significant (and sometimes total) loss of their principle investment. This fact exemplifies why policymakers need to consider alternative approaches to improving financial security. In the next article of this series, I explore government intervention and non-intervention, regulatory regimes, and discrimination-based policy failures as a means of exemplifying why policymakers need to consider alternative approaches to improving financial security.
[1] U.S. Securities and Exchange Commission. SEC Charges Jefferies LLC with Failing to Supervise Its Mortgage-Backed Securities Desk during Financial Crisis <https://www.sec.gov/News/PressRelease/Detail/PressRelease/ 1370541108233#.UzCFEfldV8E> (cited March 10, 2014).
[2] U.S. Securities and Exchange Commission. SEC Charges Invesco Funds Group, Inc. and CEO Raymond Cunningham with Fraud and Breach of Fiduciary Duty for Allowing Market Timing at Invesco Funds <https://www.sec.gov/ news/press/2003-167.htm> (cited March 10, 2014).
[3] U.S. Securities and Exchange Commission. <https://www.sec.gov/ news/press/2003-167.htm> (cited March 10, 2014).
[4] U.S. Securities and Exchange Commission. <https://www.sec.gov/ news/press/2003-167.htm> (cited March 10, 2014).
[5] U.S. Securities and Exchange Commission. <https://www.sec.gov/ news/press/2003-167.htm> (cited March 10, 2014).
[6] U.S. PIRG. Financial Security. <https://www.uspirg.org/issues/ financial-security> (cited July 12, 2011).
[7] M.H. Merson, R.E. Black, and A.J. Mills, International Public Health: Diseases, Programs, Systems, and Policies (Sudbury, MA: Jones and Bartlett, 2006).
[8] Barry Bozeman, Public Values and Public Interest: Counterbalancing Economic Individualism, (Washington, DC: Georgetown University Press, 2007).
[9] Bozeman, Public Values and Public Interest, 23.
[10] Barry Eichengreen and Richard Portes, “Anatomy of Financial Crises,” in From Threats to International Financial Stability, ed. Richard Portes and Alexander K. Swoboda (New York: Cambridge University Press, 1987), 10-58.
[11] Financial Industry Regulatory Authority <https://www.finra.org/AboutFINRA/P125239> (cited June 15, 2013).
[12] Federal Reserve. B. 100 Balance Sheet of Households and Nonprofit Organizations (1). <https://www.federalreserve.gov/releases/z1/current/z1r-5.pdf> (cited August 25, 2011).
[13] Center for Responsible Lending. <https://www.responsiblelending.org/mortgage-lending/tools-resources/fact-sheet-yield-spread.html> (cited March 8, 2014).
[14] Center for Responsible Lending. <https://www.responsiblelending.org/mortgage-lending/tools-resources/fact-sheet-yield-spread.html> (cited March 8, 2014).
[15] Center for Responsible Lending. <https://www.responsiblelending.org/mortgage-lending/tools-resources/fact-sheet-yield-spread.html> (cited March 8, 2014).
[16] Federal Deposit Insurance Corporation. <https://www.fdic.gov/bank/historical/s&l/> (cited June 15, 2012).