Moral Hazard and Aggregate Wealth Portfolio
"His name was George F. Babbitt. He was 46 years old now, in April 1920, and he made nothing in particular, neither butter nor shoes nor poetry, but he was nimble in the calling of selling houses for more than people could afford to pay."
--"Babbitt" by Sinclair Lewis (1922)
The largest financial bailout in United States history, which some traders are starting to call the ‘Securitized Housing Investment Trust’ (hint: think acronym), is causing an existential crisis amongst those who hold to purest free market ideology. Senator Jim Bunning, Republican of Kentucky, echoed this sentiment when he said, “The free market for all intents and purposes is dead in America.” These ideologues doth protest too much, methinks.
Since the 1929 crash, the last time the nation faced an economic train-wreck of this magnitude, the U.S. Government has effectively been in the insurance business and it has generally served us well. The vast majority of laws and regulations are designed to mitigate risk. Drunk driving laws minimize the number of car wrecks, and the short uptick rule (until recently eliminated) prevented unfettered short-selling from forcing solvent companies into insolvency.
Government institutions enforce these policies. What is the purpose of the military but insurance against an attack from other nations? What is the key purpose of a central bank other than insurance against a run on banks?
In fact, the present-day capital market system, which has been responsible for raising living standards to the highest in world history, relies upon laws and regulations: the Securities Act of 1933, the Securities Exchange Act of 1934, the Commodity Exchange Act of 1936, and the Investment Advisers Act of 1940. Although not perfect (and definitely requiring an overhaul), these laws have served Wall Street and LaSalle Street very well over time.
The problem with fundamentalist free market ideology is that it is only theoretical, and ultimately not pragmatic. Truth is, without government establishing the premise of private property enforced through law and justice, contract markets would soon devolve and be quickly replaced by gangster capitalism akin to Putin’s Russia. There is a term for the unfettered combination of concentrated power, ideological adherence and capitalistic greed, it is called “fascism.”
There is another term “beta,” which defines the systematic return/risk of assets. This concept is related to Modern Portfolio Theory and underlies the oft-stated investment strategy of buy-and-hold. What is not well-understood, even by many sophisticated investors, is that this theory is flawed. The issue is benchmark portfolio construction. Accordingly, the definition of “true beta” or “true market portfolio” must be extended to encompass other economic factors.
What academics came to recognize was that approximately one-third of non-governmental tangible assets in the U.S. are owned by the corporate sector, and only one-third of these corporate assets are financed by equity. As a result, Jagannathan and Wang (1993) concluded that assumptions underlying the concept of beta must be altered in order to resolve anomalies in the model. In other words, “true beta” or the “true market portfolio” must include the “aggregate wealth portfolio of all agents in the economy.” This is a revolutionary view with both political and economic ramifications.
Business balance sheets do not in practice reflect public infrastructure assets which businesses are dependent on. For example, a trucking company’s greatest asset is not its fleet of trucks, but the U.S. Highway system. Likewise, public liabilities such as the cost of pollution are also not reflected on corporate balance sheets. This is beginning to change with the idea of integrating regulations into “cap-and-trade” contract markets involving emission allowances.
It is time for a new economic ideology to take hold which adheres to the middle way. Government and free enterprise are actually joint partners in promoting economic growth and well-being. Certainly, political will effects a constant tug-of-war between interests, but this is not unlike the struggle between a sales-trading desk which drive revenues for an investment bank, and internal compliance/risk managers who ensure balance between risk and reward.
The problem with the prevalent populist stream of conversation regarding free markets versus socialism is that such dialogue is anachronistic. Rather, the conversation needs to shift to good versus bad governance, and public policy which enhances the value of the aggregate wealth portfolio of all agents in the economy.
- Mack Frankfurter, Managing Director
--"Babbitt" by Sinclair Lewis (1922)
The largest financial bailout in United States history, which some traders are starting to call the ‘Securitized Housing Investment Trust’ (hint: think acronym), is causing an existential crisis amongst those who hold to purest free market ideology. Senator Jim Bunning, Republican of Kentucky, echoed this sentiment when he said, “The free market for all intents and purposes is dead in America.” These ideologues doth protest too much, methinks.
Since the 1929 crash, the last time the nation faced an economic train-wreck of this magnitude, the U.S. Government has effectively been in the insurance business and it has generally served us well. The vast majority of laws and regulations are designed to mitigate risk. Drunk driving laws minimize the number of car wrecks, and the short uptick rule (until recently eliminated) prevented unfettered short-selling from forcing solvent companies into insolvency.
Government institutions enforce these policies. What is the purpose of the military but insurance against an attack from other nations? What is the key purpose of a central bank other than insurance against a run on banks?
In fact, the present-day capital market system, which has been responsible for raising living standards to the highest in world history, relies upon laws and regulations: the Securities Act of 1933, the Securities Exchange Act of 1934, the Commodity Exchange Act of 1936, and the Investment Advisers Act of 1940. Although not perfect (and definitely requiring an overhaul), these laws have served Wall Street and LaSalle Street very well over time.
The problem with fundamentalist free market ideology is that it is only theoretical, and ultimately not pragmatic. Truth is, without government establishing the premise of private property enforced through law and justice, contract markets would soon devolve and be quickly replaced by gangster capitalism akin to Putin’s Russia. There is a term for the unfettered combination of concentrated power, ideological adherence and capitalistic greed, it is called “fascism.”
There is another term “beta,” which defines the systematic return/risk of assets. This concept is related to Modern Portfolio Theory and underlies the oft-stated investment strategy of buy-and-hold. What is not well-understood, even by many sophisticated investors, is that this theory is flawed. The issue is benchmark portfolio construction. Accordingly, the definition of “true beta” or “true market portfolio” must be extended to encompass other economic factors.
What academics came to recognize was that approximately one-third of non-governmental tangible assets in the U.S. are owned by the corporate sector, and only one-third of these corporate assets are financed by equity. As a result, Jagannathan and Wang (1993) concluded that assumptions underlying the concept of beta must be altered in order to resolve anomalies in the model. In other words, “true beta” or the “true market portfolio” must include the “aggregate wealth portfolio of all agents in the economy.” This is a revolutionary view with both political and economic ramifications.
Business balance sheets do not in practice reflect public infrastructure assets which businesses are dependent on. For example, a trucking company’s greatest asset is not its fleet of trucks, but the U.S. Highway system. Likewise, public liabilities such as the cost of pollution are also not reflected on corporate balance sheets. This is beginning to change with the idea of integrating regulations into “cap-and-trade” contract markets involving emission allowances.
It is time for a new economic ideology to take hold which adheres to the middle way. Government and free enterprise are actually joint partners in promoting economic growth and well-being. Certainly, political will effects a constant tug-of-war between interests, but this is not unlike the struggle between a sales-trading desk which drive revenues for an investment bank, and internal compliance/risk managers who ensure balance between risk and reward.
The problem with the prevalent populist stream of conversation regarding free markets versus socialism is that such dialogue is anachronistic. Rather, the conversation needs to shift to good versus bad governance, and public policy which enhances the value of the aggregate wealth portfolio of all agents in the economy.
- Mack Frankfurter, Managing Director
posted by Cervino Capital Management LLC at 10/02/2008
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