Frequently insightful but often misleading.

Henderson, David R.

Other People's Money: The Real Business of Finance

By John Kay

336 pp.; Public Affairs; 2015

[ILLUSTRATION OMITTED]

I can't give a AAA rating to John Kay's new book on finance; it's closer to a BBB+. Other People's Money is full of insights and, unfortunately, is sometimes misleading in important ways. His big-picture arguments are basically correct: that the financial sectors in the United States and the United Kingdom are overly complex and out of control; that this helped cause the 2007-2008 financial crisis; and that much of the dysfunction can be traced to regulation. Unfortunately, he misunderstands key events in U.S. economic history. And some of his proposed reforms are too vague to be useful; they sound more like wishes than reforms.

Regulation's role / Kay, who writes a weekly column for the Financial Times, has himself been a player in the financial markets. In the 1990s he was on the board of directors of the Halifax Building Society, which lent money to developers to build housing. That position gave him a perch from which to observe financial industry changes that concerned him.

One of his most important insights is that much of the complexity of financial instruments is due to government regulation. He lays out, for example, how the Basel Accords--which most of the world's major wealthy countries pledged to follow--led to some mischievous but totally predictable "regulatory arbitrage." Kay writes, "The basic rule on capital requirements is that a bank must have equity capital--the money that can be lost before a business is forced into insolvency--equal to 8 percent of its assets." Forget for a minute that, as Kay points out, 8 percent seems awfully low; the situation gets worse, and the reason has to do with the risk-weighting of assets. Mortgages carried a risk weighting of 50 percent, meaning that the capital requirement on such mortgages was 4 percent (8 percent x 50 percent) of the mortgage principle. But--this is my example, not Kay's--mortgage-backed securities (MBS) carried a risk weighting as low as 20 percent.

Can you see where this is going? Kay does, but an example would have been helpful. Here is mine: Imagine that a bank has 10 high-quality mortgages on its books for $100,000 each, for a total of $1 million. On those mortgages, it must hold capital of $40,000. The bank manager would like to relax that constraint, so what does he do? He packages the mortgages into an MBS, which requires that the bank hold only $16,000 (8 percent x 20 percent x $1 million) in capital on that security. The risk hasn't changed, but the capital requirement has fallen by 60 percent.

Kay notes another problem caused by the Basel rules: the crudeness of the risk weighting. Those weightings, he notes, "encouraged banks to accept riskier--and higher-yielding--loans within each risk category." One great example: "The risk weighting attached to a 60 per cent loan-to-value mortgage for a local physician was the same as that for the no-deposit loans to NINJAs ([borrowers with] no income, no job, no assets) that were marketed in US cities."

Kay points out that regulation led to regulatory arbitrage and new financial instruments to facilitate that arbitrage, and then the problems with those financial instruments led to more regulation. Although he doesn't quote Ludwig von Mises on this issue (he does quote Mises's and Friedrich Hayek's insights on central planning elsewhere), he could have. It was Mises who noted that government interventions often lead to problems that then cause government not to repeal the first interventions but to add more.

Comfort of bailouts / But why did bankers and other financial firms act so irresponsibly in the years leading up to the 2007-2008 financial crisis? The reason is moral hazard--the willingness of an actor to take greater risk if he knows someone else will bear part of the cost.

When the giant investment firm Long Term Capital Management (LTCM) faced a financial crisis in 1998, the federal government twisted a lot of bankers' arms to bail it out. I wish that Kay had pointed out that LTCM didn't need a government-organized bailout. What many observers forget is something that should be trumpeted from the rooftops: prior to the feds stepping in, Goldman Sachs, AIG, and Berkshire Hathaway had made LTCM a low-ball offer that it rejected. Had the company been confident that no government-organized bailout was forthcoming, it likely would have accepted the offer. The LTCM bailout was one of the key precedents that led most managers of large financial firms to assume that if they ever faced a crisis, they too would be bailed out. And they were right. Of course the problem, as Kay points out, is that this near-certainty of bailout makes a future financial crisis more likely because investment firms have less incentive to refrain from overly risky behavior.

Kay adopts a tailgating metaphor used by Raghuram Rajan when he was chief economist at the International Monetary Fund. (I reviewed Rajan's 2010 book on the financial crisis, Fault Lines, in the Winter 2010-2011 issue of Regulation.) Rajan pointed out that drivers who tailgate on high-speed freeways find that the strategy works fine most of the time. But in the few instances when it doesn't work, the consequences can be catastrophic. Kay applies this metaphor to government. He writes:

   Governments too have become tailgaters,
   taking risks in support of the
   financial system that will probably pay
   off, but which may entail immense costs
   if they do not. Some governments will
   announce that the measures they took
   in 2008 had no cost, or even yielded a
   profit. Such claims have already been
   made for the US government's TARP
   programme. But guarantees are not free.

Kay properly points out a major problem with government regulation: economies of scale in managing regulation. Large firms can and do have whole departments of people whose jobs are to manage compliance with regulation. That is much harder for a smaller firm to do. The cost of compliance takes a much higher percentage of a small firm's revenue and, therefore, may wipe out small firms, including firms that might have started as small innovators and grown to revolutionize otherwise stagnant industries.

Some problems / As noted in my introduction, though, Kay often goes wrong, either by misleading or by being literally incorrect about important historical points. Consider his treatment of some so-called "robber barons." With regard to five of them--Henry Clay Frick, Jay Gould, J. P. Morgan, John D. Rockefeller, and Cornelius Vanderbilt--Kay writes, "Their immense personal wealth was as much the product of financial manipulation as of productive activity." That charge may be true of Gould, who appears to have been a charlatan, but it's not true of the other four, who made their money mainly through productive activity. As I point out in "The Robber Barons: Neither Robbers nor Barons" (Econlib, March 4, 2013), Rockefeller's revolutionizing of the petroleum industry was a boon to consumers, and Vanderbilt's price-cutting brought down a shipping monopoly.

Kay also misleads readers about two relatively recent financial-industry heavyweights, Michael Milken and Frank Quattrone. He points out correctly that Milken helped invent "junk bonds." But Kay's tone is one of disdain and he ends his short section on junk bonds with the sentence, "Milken went to prison." Most readers will probably conclude that Milken should have gone to prison. However, though he did break several laws, those breaches appear to have profited him very little and cost others very little. In 1991, federal judge Kimba Wood, who had earlier sentenced Milken to a stiff prison sentence, told his parole board that the total loss from his crimes was $318,000. In his 2011 book Three Felonies a Day, Harvey Silverglate, one of Milken's defense lawyers, wrote, "Milken's biggest problem was that some of his most ingenious but entirely lawful maneuvers were viewed, by those who initially did not understand them, as felonious precisely because they were novel--and often extremely profitable." Although Silverglate clearly was an interested party, that statement fits the facts that I have been able to ascertain over the years. Milken was unfortunate enough to have been targeted by a politically ambitious U.S. attorney named Rudy Giuliani, who wielded the Racketeer Influenced and Corrupt Organizations Act to intimidate Milken.

Similarly, Kay writes that Frank Quattrone of Credit Suisse "expected favors from friends and clients in return for allocations of hot stocks." But Kay gives no citation for this claim. I think there's a good reason for this: a lack of evidence. For what really happened in the Quattrone case, see my "Hurray for Frank Quattrone: Rotten Tomatoes for the Media" (TCS Daily, August 28,2006), and the even more extensive article, "The Case for Frank Quattrone," by Roger Donway (Atlas Society, July 1, 2004).

Although Kay does see government's hand in the financial crisis, he is critical of the idea that excesses in mortgage securitization "were the result of US government measures to widen home-ownership." It's true that they weren't the result, but surely laws like the Community Reinvestment Act of 1995 had some effect by legally encouraging lenders to sell mortgages to people who were bad credit risks. What is Kay's argument against this view? He gives only one: the U.S. "transition from renting to owner-occupation had more or less been accomplished by the 1960s." But that doesn't handle the argument. Even if the regulations caused no net increase in homeownership, they surely increased the number of people with mortgages who were unlikely to pay.

Another problem: in arguing (correctly) that the risks that financial market participants care about are different from the ones "Main Street" cares about, he goes too far, writing: "The pedestrians on Main Street fear accident, illness and mortality, and worry about provision for old age." Those risks, he writes are "mostly handled outside the financial system altogether" and are dealt with "by friends and family, and by government and its agencies." With this latter, he presumably is referring (in the United States) to Social Security and Medicare. But financial markets certainly do provide products for accident, illness, and mortality (insurance), as well as for old age (IRAs, 401(k)s, etc.)

And I can't let pass his comment about "well-educated young white men baying for money and praying for liquidity." Did he really need to mention the race, age, and gender of market participants? If they were old black women, would their actions be less deserving of criticism?

One big disappointment is Kay's list of six principles for reform. They are not so much principles as wishes, with little elaboration on how to fulfill them. Here's one such principle: "Require that anyone who handles other people's money, or who advises how their money should be handled, should demonstrate behaviour that meets standards of loyalty and prudence in client dealings and avoids conflict of interest." How is this to be done? He doesn't say.

Moreover, he seems to propose a world "where there are no futures contracts or stock market indexes." Yet futures contracts existed long before the institutions that Kay justly criticizes, and have helped farmers and other businesses offload their risks onto those who want to bear them. Stock market indexes are a very cheap way that many of us use to estimate our wealth. It's hard to see that they do damage.

Kay is at his best when he's criticizing government regulation, especially regulatory arbitrage. But he's at his worst when he makes outlandish claims with little or no attempt to back them up. Caveat emptor.

DAVID R. HENDERSON is a research fellow with the Hoover Institution and professor of economics in the Graduate School of Business and Public Policy at the Naval Postgraduate School in Monterey, Calif. He is the editor of The Concise Encyclopedia of Economics (Liberty Fund, 2008).