How Our Financial Markets Really Work

-Millions of investors buy into the technology bubble on the bad advice of analysts, then lose most of their savings.
-Employees spend their adult lives working for a corporation, only to watch their pension plans crumble in size and significance.
-Mutual funds let outside investors steal from their customers for a share of the loot.
-Hedge funds collect massive fees for months or years, then shut down overnight leaving investors with their capital in tatters.
-Borrowers are encouraged to take on more debt, then get squeezed into bankruptcy by rising rates.
-Loyal employees face layoffs when private equity firms take over a company and extract every penny and ounce of worth that they can find.

These and related stories occur everyday and are part of a severely corrupted financial system that is destroying the wealth of most Americans and the strength of the US economy. The mainstream media and industry experts are always quick to express outrage when incidents like these occur, acting as though the perpetrators are isolated cases and the crimes are not likely to be repeated. But observe the industry long enough and you'll find that corrupt acts occur regularly and throughout the financial system.

This entry describes many of the corrupting features of the American financial system and attempts to give a framework for understanding why corruption is so widespread and damaging. Understanding the systemic flaws is a first step toward protecting oneself and bringing about systemic change.

The Primary Function of the Markets
In the fairy tale world of capitalistic, free-market economies, the financial markets provide for the efficient allocation of capital. In the real world of corruptialistic, rigged-market economies, the financial markets provide for the efficient transfer of wealth from the working and investing masses to people in positions of power. There is enough productive capacity in the American financial system to sustain the popular myths in media, government and corporate circles, but corruption in the system is extreme and greatly undermines the economic security of the nation.

A Culture of Greed
A misplaced faith in the efficiency of the capital markets allows many to believe that their own corrupt actions are acceptable or even beneficial in a capitalistic economy. The myth states that a multitude of individual players, all acting in their own best interests drives a system toward accurate pricing and efficient use of capital. The reality is that good people are often corrupted by positions of power and learn to rationalize fraud, theft and waste in ways that pad their own pockets at the expense of others.

A culture of greed within financial institutions and in the executive offices of major corporations, creates an environment where bottom line results are what matters most, and how those results are achieved is secondary. While most high powered executives, brokers and traders don't see themselves as being corrupt or doing direct damage to the economy, the actions they take to further their careers and the interests of their employers are often very destructive.

Conflicts of Interest
When investment banks made most of their profits by underwriting stock and bond offerings, their analysts often faced pressure to pitch these securities to unsuspecting investors and money managers faced pressure to fill up client accounts with the same securities. This conflict of interest was widely abused during the technology bubble and exposed after it burst. Now investment banks make most of their profits by financing, investing in, and trading with hedge funds. Pressures within these banks now push analysts and money managers to support the new profit engines with conflicted advice and unscrupulous actions.

Short-Term Gain vs. Long-term Risk
A dominant feature of the American corrupitalistic system in recent years has been the shameless pursuit of short term objectives at the expense of long term success. Risk vs. reward is a standard equation in most business decisions, and taking on greater amounts of risk will typically offer higher rewards over the short term. Our financial system is structured so that managers are most often compensated based on short term performance measures and this encourages them to take on high levels of risk with investor capital.

On a national level the pursuit of short term rewards has led the country to bury itself hopelessly under a mountain of debt and impossible promises. On a corporate level it has resulted in the decreasing competitiveness of American industry. Politicians seek reelection and executives seek to boost their annual bonuses, but neither group has the long term interests of their constituents at heart.

Creative Accounting
Accounting rules allow a large amount of assumption and estimation when it comes to determining a company's bottom line. Creative accounting is a term to describe the way executives bend and twist the numbers to arrive at the results that meet their personal objectives. It takes place in industry as well as government with the result that nobody can really trust the quarterly and annual results presented in press releases. Worldcom went bankrupt after it was exposed for overstating profits by roughly $2 billion. The federal deficit numbers touted by the President are hundreds of billions of dollars less than the true deficit each year. Auditors are generally hired by the executives being audited, so the conflict of interests prevents truly independent accounting.

Corporate Governance
Shareholders of publicly traded companies generally do not have a valid say in how the companies are run. Executives choose their own slate of directors to watch over them and shareholders don't have any real choice in the voting. Shareholder proposals are regularly blocked from inclusion on voting proxies with the approval of the Securities and Exchange Commission. Indeed, the SEC's stated objective is to protect "shareholder confidence" rather then to actually protect shareholders. That way the people in positions of power are free to go on taking advantage of clueless investors.

Other People's Money
With Capitalism, money (capital) is the major source of power. People who own the companies decide how they are run. With Corrupitalism most of the owners of capital have entrusted it to money managers who use it to promote their own interests. Fund managers are compensated based on short term performance. There is little incentive to seek out management teams that run companies are pursuing sound, long-term goals. Meanwhile there is a strong incentive to invest in hot performers rather than sound values. Many companies run up debt by issuing corporate bonds and then using the money to repurchase stock. While this boosts the short term performance of a company's shares, it sets the stage for a complete collapse down the road. Pension fund, mutual fund and hedge fund managers together control most of the nation's wealth and their short-sighted vision becomes the nation's short-sighted vision.

Hedge Funds
Hedge funds can take the abuses of the mutual fund world to a much higher level. The standard hedge fund compensation scheme greatly rewards short-term performance with no penalty for long term failure, which encourages managers to take high levels of risk. Hedge funds are able to greatly magnify that risk by borrowing vast sums to increase the leverage of their investments. The tremendous quantity of money borrowed into existence by hedge funds has helped fuel inflationary pressures and has subjected the entire economy to great risks. When Long Term Capital Management got in trouble the Fed organized a bailout because it threatened to unwind over $100 Billion in loans and default on a good portion of them. That would have caused a substantial shock to the economy. Now the amount of money borrowed by hedge funds is in the trillions causing even greater economic distortions and posing far greater risks for the economy.

Wall Street
Executives of the big Wall Street institutions run the financial system to suit their own interests. They finance major political campaigns at early stages and determine who has a chance to be elected. They fund companies and industries in a manner that creates booms and busts within those industries, enriching executives while shareholders get fleeced. Wall Street firms typically let the masses of investors place their bets on whatever is the hot trend of the day, then they take the opposite side of those trades and influence the markets and news to make sure that the masses end up losing on those bets. Perhaps most importantly, Wall St. has a direct line to the Fed and every morning sends signals on interest rates that help ensure that their largest bets end up being the correct ones.

The Fed
The Federal Reserve System's goals are not to maintain full employment or contain inflation as stated in official literature. The Federal Reserve is a system of banks that promotes the narrow, short-term interests of bankers. It was established in 1913 and since then the economy has had a long period of inflation with economic booms and busts every few years. The government appoints many of the Fed's governors, but because Wall Street bankers have significant control over the political process, political appointments always serve the interests of Wall Street banks.

The Boom and Bust Cycle
Creating steady growth and preserving economic stability are not difficult objectives for policy makers to accomplish. However, we have had a destructive and endless cycle of economic booms and busts because they facilitate the transfer of wealth from the masses to the rich, powerful and well positioned.

In boom times, credit expands rapidly. Bankers create money out of thin air and loan it out to businesses, generating profits off of the interest income. Banking profits are highest when credit is strong and bankers are allowed to maximize their leverage and risk. The problem with this (from a bankers perspective) is that eventually just about everyone in the economy starts to benefit from the expanding credit and inflation and competition for scarce goods begin cutting into the benefits of being wealthy.

During economic busts, credit, jobs and cash are hard to come by. Businesses and individuals become insolvent and are forced to transfer their assets to their creditors. Well positioned wealthy individuals and bankers benefit by being able to acquire assets and goods when prices are depressed. They do not suffer from a bust because they have enough cash to weather the storm. When the next boom begins, they'll be ready to ride the next wave of asset appreciation.

Complexity and Waste
The American Financial system is complex and the prevailing myth is that this complexity provides security and strength. In truth the complexity is wasteful and provides cover for fraudulent activities. If investment options were simple, and markets were efficient, then investors wouldn't need or seek help from financial advisors, but fear of losses drives the masses of investors toward professional portfolio managers, who are likely to abuse their position in managing other people's money. The derivatives markets have been championed as a way of reducing risk, but in truth they've added far more systemic risk to the marketplace, by ensuring that all sectors will be hit at the same time in a downturn. These markets are complex by design, allowing firms to use creative accounting to book profits on opposing sides of trade to meet short-term profit objectives while increasing long-term risk.

Systemic Reform
To bring effective reform to the financial system we must address the corrupting factors I've described above. Conflicts of interest should be eliminated and transparency and simplicity restored. Failure to do so will lead to a further deterioration in America's economic competitiveness. Perhaps it will take an economic meltdown on the order of the great depression to get enough people behind a movement for change, but I believe change will eventually come as the word continues to spread. Until then, keep learning and spreading the message so that you can protect yourself from the financial system and prevent it from stealing the wealth of the people you care about most.