On October 9, 2007, the S&P 500 reached an all-time closing high of 1,565. Led by home prices, which began to fall from their inflated 2006 peak, it drifted downward, then accelerated to a low of 676 on March 9, 2009, a decline of 57 percent. A million dollars’ worth of the index at the high fell to $430,000 at the low. Single-family homes declined 30 percent. One bright spot was bonds. Borrowing declined and interest rates fell, pushing US government and higher-quality corporates up strongly. Despite an offset from this rise in bond prices, the net worth of US households, which peaked in June 2007 at $65.9 trillion, fell to $48.5 trillion during the first quarter of 2009, a loss of 26 percent. It was the worst blow to national wealth since the Great Depression eighty years earlier.
The lessons learned then by our grandparents were forgotten after two generations. The stock market collapse that triggered that calamity was the climax to a speculative bubble. As stock prices rose in the 1920s, “investors” (mostly gamblers) came to believe that they would continue ever upward. A leading economist of the day encouragingly declared that stocks had permanently reached a new high plateau. But the key to the disaster that followed was easy money and leverage. Investors could buy stocks on as little as 10 percent margin, meaning that they could put up only 10 percent of the purchase price and borrow the other 90 percent. It sounds eerily familiar because it is. The 2008 collapse in housing prices had the same cause: unlimited unsound loans to create highly leveraged borrowers.
Here’s how it worked in the stock market in 1929. If shares trading for $100 each were purchased for $10 down and a $90 loan per share and subsequently went to, say, $110, the happy investor then had $20 per share of equity, equal to $110 minus the $90 he originally borrowed from his broker. He doubled his money on a mere 10 percent rise in the stock. He can now borrow 90 percent against this $10-per-share profit to buy an additional $90 worth of stock, bringing the total value of his stock to twice what he originally bought. If the investor repeats this each time his stock goes up another 10 percent, both his equity and his loan will double again at each step. After five such increases of 10 percent over the previous price, the stock will trade at $161 per share, a 61 percent gain. Meanwhile our pyramiding investor will have doubled his equity five times, to thirty-two times the starting amount. Ten thousand dollars becomes $320,000. After ten steps up of 10 percent, during which the investor’s stake undergoes ten doublings, the stock will be at $259 and from the original purchase of $10,000 worth of stocks using only $1,000, the investor now has $10,240,000 of the same security. His equity is 10 percent of this. He’s a millionaire. Such is the hypnotically enticing power of leverage.
But what happens if the stock price then drops 10 percent? Our giddy investor loses his entire equity and his broker issues a margin call: Pay off the loan—which is now more than $9 million—or be sold out. As stock prices rose in 1929, investors leveraged themselves in this way to buy more, driving prices higher. The positive feedback loop led to an average total return on large-company stocks of 193 percent from the end of 1925 to the end of August 1929. A purchase of $100 on no borrowing grew to $293, and our 10 percent down investor who pyramided might have doubled his money more than ten times, gaining more than a thousand times his original investment. However, as prices eased in September and October 1929, the equity of the most highly leveraged investors vanished. When they were unable to meet margin calls, their brokers sold their stock. These sales drove prices down, wiping out investors who hadn’t been quite as leveraged, triggering a new round of margin calls and sales, driving prices down further. As the equity bubble burst, the greatest stock market decline in history began. Large-company stocks eventually dropped by 89 percent, to one-ninth of their earlier peak prices.
As waves of leveraged investors were ruined, bank and brokerage firms, saddled with bad debts, were wiped out, in turn ruining other institutions to whom they owed money. As the contagion spread, economic activity declined sharply, US unemployment reached 25 percent, and a worldwide depression ensued. It was only in January 1945—after more than fifteen years and most of World War II—that, on a month-end basis, large-company stocks finished above their August 1929 all-time high. Again, an investment in corporate bonds more than doubled on average over this period and long-term US government bonds almost did so, showing that diversification into asset classes other than equities, though possibly sacrificing long-term return, can preserve wealth in bad times.
To prevent a repeat of 1929, the Securities Exchange Act of 1934 empowered the board of governors of the Federal Reserve System to prescribe the part of the purchase price the investor has to put up to purchase a listed security. He may borrow any or all of the remainder. Since 1934 this has varied between 40 percent and 100 percent. A 100 percent margin means all purchases must be fully paid for with cash. In 2009, initial margin was 50 percent. Stock exchanges specify the minimum amount of margin that must be maintained as prices fluctuate, the so-called maintenance margin. For instance, at the maintenance margin rate of 30 percent, when the net worth of an investor’s account is less than 30 percent of the value of the stocks he owns, his broker calls for cash to pay off enough of the loan to bring the investor’s equity back to the 30 percent level. Otherwise, the broker will sell off stock until this is accomplished.
The collapse of the banking system was fueled in part by depositors, who, seeing some banks fail, rushed to withdraw their money from the others while there was still time. To dispel such panics in the future, the Banking Act of 1933 (the second Glass-Steagall Act), separated commercial and investment banking in an effort to limit the impact of speculation. It also established the Federal Deposit Insurance Corporation (FDIC), which covered losses up to a certain limit. (In 2015 the amount insured was $250,000 per account.) This safety net was severely tested in the 1980s, when the savings and loan collapse cost the Federal Deposit Insurance Corporation—that is, US taxpayers—$250 billion, about $1,000 for every man, woman, and child in the country.
Beginning in the 1980s, government, including presidents, Congress, and the Federal Reserve, gave us three decades of reduced regulation of the financial industry. Leverage, easy money, and “financial engineering” then brought a series of asset bubbles and threats to the stability of the financial system itself.
The first worldwide shock was the crash of October 1987, when the US market fell 23 percent in a single day. The cause was a massive feedback event driven by the recently invented quant product of portfolio insurance, leveraged through the new financial futures markets. Fortunately, equities and the economy recovered quickly. Unfortunately, little was learned about the perils of excess leverage.
A second warning came in 1998 with the collapse of the hedge fund Long-Term Capital Management (LTCM). Run by a high-rolling trader and two winners of the Nobel Prize in Economics, this so-called dream team of the best traders and academic financial theorists in the world was on the verge of losing the fund’s entire $4 billion of net worth. In the deregulatory environment of the time, they were leveraged between thirty and one hundred times. Profits of less than 1 percent annualized were magnified with borrowed money into yearly returns of 40 percent or so. As long as the world of asset prices was normal, all was well, but just as in 1929 when investors on 10 percent margin were wiped out by a small reversal in prices, so LTCM, with its margin ranging from 1 to 3 percent, was ruined by a sea change in markets.
As Nassim Taleb points out eloquently in his book The Black Swan, apparent excess returns like those for LTCM in normal times may be illusory as they may be more than offset by infrequent large losses from extreme events. Such “black swans” can be bad for some and good for others. Ironically, having passed in 1994 on the chance to invest in LTCM and temporarily get rich, I made money in 1998 by exploiting the distorted market prices left in the wake of their collapse. LTCM’s loss was our gain in Ridgeline Partners.
LTCM’s collapse threatened to put $100 billion or so of bad assets on the books of other institutions. This would bankrupt some banks, brokerage houses, or hedge funds, in turn spreading around more bad assets and bankrupting more institutions. If allowed to happen, this domino effect might have led to a worldwide financial collapse, but a Federal Reserve–inspired consortium intervened, took over LTCM, supplied more funding, and conducted an orderly liquidation.
Nothing appears to have been learned from this. Spearheaded by Congress, the banking industry got what it wanted. The first Glass-Steagall Act, enacted in the Great Depression to separate commercial and investment banking, was repealed in 1999. This allowed big institutions to take on more risk with less regulation through the trading of massive amounts of unregulated derivative securities. When Commodity Futures Trading Commission chairperson (1996–99) Brooksley Born wanted to regulate the derivatives that would later be a major cause of disaster, the PBS program Frontline detailed how she was blocked in 1998 by the triumvirate of Federal Reserve chairman Alan Greenspan, US Treasury Secretary Robert Rubin, and Deputy US Treasury Secretary Lawrence Summers, all of whom would later advise government on the 2008–09 bailout. Nassim Taleb asked why, after a driver crashes his school bus, killing and injuring his passengers, he should be put in charge of another bus and asked to set up new safety rules.
The brief era of government surpluses, where revenues exceeded expenses, ended. More tax cuts reduced revenue in 2001. Expenses increased with wars, the military budget, and the cost of entitlements. Deregulation continued. Americans spent more than they earned, consumed more than they produced, and borrowed abroad to pay for it. The administration and Congress, pushed by a powerful real estate lobby, promoted an expansion of homeownership to millions who couldn’t afford it. When my niece, who worked in the mortgage industry, declined to approve unsound loans, management sent them to another underwriter for approval. Homes, which allegedly always appreciate, were bought with little or no money down and low introductory teaser interest rates to lower the initial payments. Liar loans, where the buyer supplies false financial information, were easy to get and became common.
The mortgage industry sold the loans to Wall Street, where they were securitized, which means that they were packaged into pools to back a variety of bonds. These were then rated by agencies such as S&P, Moody’s, and Fitch, which—in a blatant conflict of interest—were paid by their customers, the same ones whose securities they were supposedly rating objectively. High ratings made the securities easier to sell, but when home prices began to decline from their inflated peak in 2006, many of these securities, including those that these agencies gave the very highest rating of AAA, turned out to have little value.
As prices for residential real estate in 2006 climbed to heights never before seen, many owners turned their houses into piggy banks. Having borrowed almost 100 percent of market value in many cases, they were underwater as soon as prices declined slightly. They then owed more than their houses were worth.
The vast expansion of credit that fueled the housing bubble was based largely on securities invented by a newly arrived army of financial engineers, or quants. Combining their training in mathematics and the hard sciences with notions like the efficient market hypothesis and its relative, the belief that investors are rational, they built new products using models that supposedly mirrored reality, but didn’t.
These products cost the US economy several trillion dollars in forever-lost gross national product and societal waste, and caused comparable damage worldwide. It’s worth taking time to understand them.
I encountered the first of these, called CMOs, or collateralized mortgage obligations, when they were developed in the mid-1980s. It helps first to analyze the individual home mortgages that were pooled as collateral for the CMOs.
Suppose that your best friend, wanting to buy a home for $400,000, asks you to lend him 80 percent of the purchase price, or $320,000, with the other $80,000 provided by his savings. In return he agrees to repay the loan over thirty years and to pay you interest at the going rate of 6 percent annually. This is called a fixed-rate loan, because the interest will remain at 6 percent no matter how the market fluctuates. If this were an interest-only loan then your friend would pay you 6 percent of $320,000, or $19,200 a year, and would finally repay the entire principal in one balloon payment of $320,000 at the end of thirty years.
Instead you elect a level-payment scheme in which your friend pays a fixed amount at the end of each month. This payment is a little larger than the monthly interest-only payment of $1,600 ($19,200 ÷ 12) and, as computed from standard real estate formulas, turns out to be $1,918.59. The extra amount reduces the principal slightly after each payment, which in turn cuts the amount of interest charged on the next payment. Thus, as time passes, an increasing part of each payment goes toward reducing the principal. The principal declines slowly at first, but near the end of the thirty years, the loan has been mostly paid off and the interest due is small, so the payments then mainly reduce principal. Your security for the loan is your friend’s house. Your contract specifies that in the event your friend defaults on the loan, you can sell the house and use the proceeds to pay yourself part of, or hopefully all of, what he owes. But you have no further recourse.
If housing prices have never gone down by much, at least not for a long time, what’s your risk? Well, this question is about average prices, not those of individual houses. Your friend’s neighborhood could turn into a slum. Or he might have bought the house in New Orleans shortly before Hurricane Katrina. In any case there are risks that threaten you with the loss of some or all of the money you have lent.
Life and casualty insurance companies deal with risks like this all the time. What they do is sell many insurance policies, any one of which may cost the insurance company more than it is paid in premiums—but their degree of risk, spread over the entire pool, is expected (on the basis of past experience) to leave the insurance company with a profit after it pays casualty losses and expenses.
The same idea is behind collateralized mortgage obligations. Assemble hundreds or thousands of mortgages. Four thousand mortgages at $250,000 each creates a $1 billion pool! Collect the interest and principal payments from each of these mortgages and use them to pay people to whom you have sold shares of the pool. This stream of monthly payments is much like those from a bond, and shares of the CMO pools were priced like bonds.
However, to price them accurately we need to know how much we are going to lose on defaults. When I studied this for Princeton Newport, I learned that the practice in the financial industry was to assume that default rates would follow normal historical experience. There was no attempt to quantify and adjust for infrequent large-scale bad events like the Great Depression, and the massive increase in defaults that could occur. The models failed to incorporate Black Swan risk into the pricing.
Another problem was forecasting the rate at which homeowners might pay off their mortgages early, perhaps to refinance their existing home. A thirty-year mortgage held for the full period is much like a long-term bond. Paid off in five to ten years, it is more like an intermediate bond, and if it is retired in two or three years, the payments resemble those from a very short-term bond. Since interest rates vary, depending on the length of time until a bond is redeemed (this variation in rates is known as the term structure of interest rates), the correct price to pay for the CMO depends on how rapidly the mortgages in the pool are paid off as well as on their default rate. As I noticed back in the 1980s, the prepayment rate on fixed-rate mortgages is highly unpredictable. When the Federal Reserve’s actions cause long-term rates to drop, new mortgages are cheaper than existing ones. Homeowners then pay off their mortgages early and refinance to lower their monthly payments. On the other hand, if rates rise, homeowners hang on to their fixed-rate existing loans, causing prepayment rates to plunge.
With pricing based on bad models, Wall Street used CMOs to pour credit into the housing market. Mortgage-lending companies refinanced new home mortgages, then sold them to banks and Wall Street firms, getting new cash to fund additional mortgages. The banks and Wall Street firms pooled these mortgages to back CMOs, which they sold to “investors,” getting their cash back to recycle into the purchase of yet more mortgages to back new CMOs.
Everybody got rich. The mortgage origination companies collected fees from the homeowner borrowers. The banks and brokers bought the mortgages, issued CMOs, and sold them at a profit. They also had a steady income from servicing the CMOs, collecting the payments from the mortgage pools, deducting a fee, and distributing the rest to the CMO holders. How could so many fees be collected and yet leave anything that could be sold for a profit to the buyers of the CMO shares? This was done via financial magic. The CMOs were divided into tranches (French for “slices”), creating a hierarchy of CMO classes, with the most preferred being paid first and the least preferred getting what was left, if anything. The rating agencies, paid by the CMO issuers to estimate the quality of the tranches, erred substantially in the direction of optimism. Since higher-rated securities sell for more than those of lower ratings, the CMOs sold for more than they would have otherwise. The magic was that the sum of the parts (tranches) were sold for more than the cost of the whole. Politicians prospered, too, as the real estate and securities industries contributed enthusiastically to their reelection campaigns. Everyone was winning and the party was on.
The academic community made its contributions. As Nobel Prize winner Paul Krugman pointed out, macroeconomists assured us that, due to their greater understanding, catastrophic failures could no longer occur. Scott Patterson details in his book The Quants how all of this was facilitated by quants who, with calculations based on academic financial theory, assured everyone that their model prices were accurate and the risks small.
Hundreds of billions of dollars’ worth of CMOs were sold to investors worldwide. The idea was so good that it was expanded to CDOs—collateralized debt obligations—where other kinds of debt like loans on autos or credit cards were used instead of home mortgages. Risky as these proved to be, an even more dangerous security, the credit default swap, or CDS, appeared on the scene, to the unconcern of sleeping regulators. A CDS is essentially an insurance policy that a lender can purchase to protect himself against a default by the borrower. Typically the insurance is bought for a certain number of years for a fixed annual payment. For instance, on the $320,000 loan to your home-buying friend, you might be worried about a default in the next five years so, if it were available, you might purchase insurance for the period at, say, $1,600 per year, or 0.5 percent of the initial loan amount.
Trillions of dollars’ worth of these credit default swaps were issued, and began trading like any other security. To buy or sell these contracts, you didn’t have to own the debt the CDS insured. That in itself wasn’t the problem, since the financial markets are simply one big casino, though one with economic benefits, and all investment positions are equivalent to bets. The problem was that the issuers of CDSs could issue them with no collateral other than their “full faith and credit,” meaning that if their bets lost they might not have the money to pay.
The margin (collateral set aside to assure payment) was generally small to zero. These unregulated items often were held by subsidiaries, so they wouldn’t appear explicitly in the financial statement of the parent company. A case in point was American International Group (AIG), a huge worldwide insurance company, which—when the crisis hit in 2008—was threatened with collapse. During the US government handout of hundreds of billions to save the financial system, AIG was the largest single recipient—a whopping $165 billion. They had issued trillions of dollars in CDSs through a subsidiary, backed mainly by their name. As the bonds they insured dropped in price, they had to post collateral to back the (now losing) CDSs they had sold. Eventually, they couldn’t pay, threatening to create hundreds of billions in losses for banks and investment houses worldwide. Not only did the US bailout of AIG help domestic companies such as Goldman Sachs, which held $10 billion of bad paper assets from AIG that was absorbed by the taxpayers, but the largesse was distributed worldwide to cover AIG’s defaults.
To see how crazy this was, imagine that Joe Sixpack offered to sell you a CDS on your $320,000 loan to your friend for $1,600 a year for five years. Joe is doing well, has a million-dollar house with no debt, and is therefore “good for the money.” Happy with $1,600 a year in extra income, Joe continues to sell CDSs on residential mortgages. Unregulated, he sells a thousand just like the one he sold you, and his income grows to $1.6 million a year. If these loans average $320,000 each, he is insuring a total of $320 million, all backed by his million-dollar house. You object, arguing that Joe couldn’t sell this many CDSs because once he’s sold a few of them people would realize there was a good chance he couldn’t pay off in a crisis. Ah, but what if Joe did this in a subsidiary and didn’t disclose the vast scale of his operations? Welcome to AIG.
Each CDS Joe Sixpack sells is a potential future liability. It should be carried as such on his books and will prove to be a good sale only if the premiums he receives, plus reinvestment income, are more than enough to cover the future claims against the credit default insurance he has sold. Just like the similar situation that arises for life insurance companies, Joe needs to set aside a reserve on his books to cover these future payouts, and he needs to increase those reserves as the likelihood of payouts increases. If instead Joe collects the income and doesn’t put aside a reserve, then he is running a Ponzi scheme like the one I described at XYZ Corporation in the 1970s, where they sold call options on precious metals far too cheaply, called the proceeds income, and did not set aside an appropriate amount for payouts they might have to make later to the option holders. How did AIG’s CDS operation differ from either Joe’s scheme or XYZ’s?
In 2004, five major investment banks persuaded the US Securities and Exchange Commission to increase their allowable leverage. Previously, they could borrow $11 for every $1 of net worth. This meant they only had $1 out of every $12, or 8.33 percent, as a cushion against disaster. Under its chairman Christopher Cox, the SEC allowed Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Stearns, and Lehman Brothers to expand their leverage to something like 33:1, rivaling the levels that doomed the ill-fated hedge fund Long-Term Capital Management just six years earlier. With, say, $33 in assets and $32 of liabilities for each $1 of net worth, a decline of a little over 3 percent in assets would wipe out their equity. Once this happened and a bank was known to be technically insolvent, creditors would demand payment while they could still get it, triggering a classic run on the bank, just as in the 1930s.
When the crisis hit four years later in 2008, the same length of time it took excess leverage to destroy LTCM, the run on the bank threatened to destroy all five of these geared-up Goliaths. Three of these five investment banks ceased to exist as independent entities; the other two, Morgan Stanley and Goldman Sachs, were saved by government intervention plus, for Goldman, a multibillion-dollar purchase of 10 percent preferred stock and warrants by Warren Buffett’s Berkshire Hathaway. Both returned to prosperity in 2009, with Goldman triumphant. Partners were on track to share near-record bonuses of between $20 billion and $30 billion. The elimination or marginalization of some rivals was not a bad thing. Appearing pixyish in his public appearances, when CEO Lloyd Blankfein was asked about the gigantic bonuses, he explained that the firm was “doing God’s work.” The argument is the standard academic one that more trading creates efficient capital markets, with better prices for buyers and sellers, for the benefit of all humankind. It came out later that part of God’s work was bankers knowingly selling mortgage-based junk securities while at the same time making massive bets that would pay off if their clients were ruined. When you compare the pay scale for God’s bankers with that for his clerics, you must conclude that the work of bankers is indeed divine.
Though there were individual personal and institutional casualties among the financial establishment, the politically connected wealthy raided the public purse for a trillion dollars to save entities that were “too big to fail.” Expensive sops were disbursed to mollify and reward special-interest groups. Those who turned in a vehicle to be scrapped, and then bought another car, were paid up to $4,500 in a program known as Cash for Clunkers. Spun as good for the environment, the only requirement was that the new purchase get gas mileage of one to four miles a gallon more, depending on the category of vehicle. The environmental benefits of this small gain in mileage were more than offset by the extra pollution produced in the manufacture of a whole new automobile. Car dealers, however, cheered as the boost from replacement-car sales cleared inventory from their packed lots.
As full-time and part-time unemployment rates continued to climb, unemployment insurance was repeatedly extended. This is good to the extent it is needed, but it would seem to be in the public interest to employ as many of those idle beneficiaries as possible in doing useful work. Programs like the Works Progress Administration (WPA) and the Civilian Conservation Corps (CCC), which I remember from my childhood, built roads, bridges, and public works during the 1930s, and the improvement in our infrastructure benefited us all for decades.
The real estate industry got its political handout. First-time homebuyers got an $8,000 fully refundable tax credit—“fully refundable” means you can apply for and get the $8,000 check even if you never paid a penny of tax in your life. The deceptive language is typical of politicians. Under this poorly monitored program a four-year-old bought a house. At least it was his first time.
In some cases, unrepentant mortgage lenders accepted the tax “refund” as the down payment, requiring no additional equity from the buyer. Congress further rewarded the real estate lobby by extending the program to those who hadn’t bought a house in the last three years. Inspired by Cash for Clunkers, why not pass a new program called Dollars for Demolition in which people who own run-down residences get paid a “fully refundable” tax credit of, say, $100,000 to tear down their house and build a new one? This would reenergize the construction industry—a key part of the American economy. There is no end to the possibilities.
Asset bubbles, where investor mania drives prices to extreme heights, are a recurring puzzle for investors. Can you profit? Can you avoid major losses? In my experience, it has been easy to spot a bubble after it is well under way, as prices and valuations far exceed historical norms and seem to have no economic sense. Examples include the savings and loan boom in the 1980s, the tech stock overvaluation in 1999–2000, and the great inflation in housing prices that peaked in 2006. Making a profit is trickier. Like a Ponzi scheme, it’s not easy to tell when it will end. If you bet against it too early you can be ruined in the short run even though you are right in the long run. As Keynes said, the market can remain irrational longer than you can remain solvent.
What about avoiding losses? Once you spot the bubble, you simply don’t invest in it. However, there is the problem of spillover damage or contagion. The collapse of housing prices from 2006 to 2010 didn’t just hurt speculators and those who bought too late. Derivatives spread the damage throughout the world. In March 2009, when the S&P 500 had fallen 57 percent from its peak, I could not tell whether to buy stocks or to sell what I had. Either decision might have been a disaster. If we continued into a major worldwide depression, buying more would be costly. In the other scenario, the one that occurred, this was the bottom, and stocks rebounded over 70 percent in less than a year. Warren Buffett, who had better information and insight than almost anyone, later told The Wall Street Journal’s Scott Patterson that at one point he was looking into the abyss and considering the possibility that everything could go down, even Berkshire Hathaway. It was only when the US government indicated it would do whatever was necessary to bail out the financial system that he realized we were saved.
How can we prevent future financial crises driven by the systemic and scarcely regulated use of extreme leverage? One obvious step is to limit leverage by requiring sufficient collateral to be posted by both counterparties when they trade. That’s what is done on regulated futures exchanges, where contracts are also standardized. This model has worked well for decades, is easy to regulate, mostly by the exchanges themselves, and has had few problems.
Institutions that are “too big to fail,” and have a significant risk of doing so, should be broken into pieces that are small enough to fail without jeopardizing the financial system. As Alan Greenspan finally admitted, “Too big to fail is too big.” This is a catchy sound bite but it misstates the real problem. It’s not the mere size of an institution that creates the danger. It is the size of the risk to the financial system from a failure. As Paul Krugman points out, Canada’s financial system was as concentrated in big institutions as was that of the United States yet Canada didn’t have massive mortgage defaults, collapsing financial institutions, and giant bailouts. The difference was that Canada had strict standards for mortgages and tighter limits on bank leverage and risk.
Our corporate executives speculate with their shareholders’ assets because they get big personal rewards when they win—and even if they lose, they are often bailed out with public funds by obedient politicians. We privatize profit and socialize risk.
The ability of corporate executives to capture an increasing share of public wealth is reflected in what CEOs earn. Compared with one of their average workers, CEOs in 1965 took home 24 times as much but “four decades later the ratio was 411 to 1.” Another indication of increasing economic inequality is the share of national income captured by the top one-hundredth of 1 percent of all earners. In 1929 they captured 10 percent of national income. This fell to about 5 percent during the Great Depression, gradually rising again beginning in the 1980s. In the last few years the share of national income claimed by these 12,500 households broke its 1929 record of 10 percent and continues to increase. These executives claim that their compensation inspires them to be the creative engines of capitalist society, benefiting all of us. The crisis of 2008 is one of our rewards.
Studies done both before and after the 2008–09 recession showed that the larger the percentage of corporate profit paid to the top five executives, the poorer the earnings and the stock performance of the company. These superstars tended to drain their companies rather than benefit them. The executives claim that “market forces” determine their salary. However, as Moshe Adler, in his article “Overthrowing the Overpaid,” points out, economists David Ricardo and Adam Smith, writing more than two hundred years ago, “concluded that what a person earns is determined not by what that person has produced but by that person’s bargaining power. Why? Because production is typically carried out by teams…and the contribution of each member cannot be separated from that of the rest.”
A wave of populist outrage has led to demands for laws to limit executive pay. A simpler and more effective solution is to empower the shareholders. They are the owners of the company and the ones looted by their officers and directors.
At present, most corporate boards run their firms like third-world fiefdoms. When shareholders vote to elect directors, generally nominated by the self-perpetuating board, they typically can vote yes or no. One yes vote can elect a director in the face of a million no votes. The company rules are deliberately designed to make it difficult or impossible for independent shareholders to nominate directors or place issues on the ballot. Instead, corporations—their legal existence already being permitted and regulated by the state—should be required to conduct democratic elections following the usual voting rules in our American democracy. Moreover, any block of shareholders that together holds some specified percentage of the shares should have the unrestricted right to nominate directors and to put issues on the ballot, including the replacement of board members and top executives.
Some companies disenfranchise shareholders by having two or more classes of shares with different degrees of voting power. Management may, for instance, own A shares with ten votes each and the public may own B shares with one vote each. How would you like to live in a country where any “insider” could cast ten votes and any “outsider” got only one? Abolish this and make it one share, one vote. Another problem arises because, currently, institutions that hold shares in custody for their owners can cast proxy votes for those shareholders who decline to vote. These proxies usually perpetuate current management and ratify its decisions. Change this so that the only votes that count are those cast directly by the shareholder; so-called proxy votes would not count.
These two measures—democratic elections and shareholder rights to put issues to a vote—would allow the owners of the company, namely, the shareholders, to exert control over the compensation of top executives, their so-called agents, and would, in my opinion, be far more effective and accurate than direct government regulation.
Our economy slowly recovered in the years following the 2008–09 crisis. However, little has been done to add safeguards to prevent a recurrence. As the philosopher George Santayana famously warned, “Those who cannot remember the past are condemned to repeat it.” Though the institutions of society have difficulty learning from history, individuals can do so. Next, I share some of what I’ve learned.