Overlooked in the financial crisis is the role of intermediaries. The average American gives little thought to intermediaries. But ever-increasing intermediation is intruding into and contaminating our financial decision making. On a very basic level financial intermediation is defined as:
[T]the “matching” of lenders with savings to borrowers who need money by an agent or third party, such as a bank…
If this matching is successful, the lender obtains a positive rate of return, the borrower receives a return for risk taking and entrepreneurship and the banker receives a marginal return for making the successful match…. If the borrower’s speculative play with the depositor’s funds does not pay off, the depositor can lose the savings borrowed by the borrower and the bank can face significant losses on its loan portfolio.
Banks present as the most basic of financial intermediaries, and depositors do rarely examine how a bank makes money or the risks involved. The FDIC guarantees further stifles the thought process with its increasingly suspect guarantee for deposits under $250k. See As of August 14,2009, FDIC is Bankrupt.
Cult of the Expert
Wall Street has been very clever at promoting the cult of the expert. Standard advice: is that individuals should not pick their own products and should instead rely on our expertise. Intermediation took off with a vengeance: from the mutual fund craze of the 1950s and 1960s, to Index funds, to exchange traded funds, to vulture funds, hedge funds, private equity pools to more exotic investments such as mortgage backed securities. What Wall Street fails to mention is that the various intermediaries charge a hefty fee for their services. Hedge funds pushed the envelope introducing the infamous “2 and 20” where the firms made 2 per cent for managing the investor’s funds and 20% of the profit. In this scenario, where is the shared risk?
Current Financial Crisis Exposes the Wizard of Odds
The well burnished image of the expert financial intermediary has now collapsed. Unless an intermediary invested in gold and T-bills, portfolios suffered significant losses last year. All markets synchronized to the downside. The mantra of diversification across a broad range of asset classes, i.e.: bonds, emerging markets, large capitalization, small growth and real estate, turned out perfectly wrong. Robert Prechter referred to it as “all one market.” The bear market revealed that the past 25 years of financial wisdom was false. Nevertheless, win or lose, just like Vegas casinos, intermediaries still received their cut.
Intermediaries in Other Financial Areas
The cult of the professional intermediary has spread to other areas, for example, the insurance industry. These companies collect premiums and lend the funds at a higher rate, earning profits on the spread. Pension funds are another venue: employees defer their wages, and pool their investments under the auspices of a pension fund manager. This professional is charged with investing to out-earn the stock indices in order to provide the employee a pension after retirement. Even the great Warren Buffet is an elaborately disguised intermediary. While Berkshire Hathaway sounds like a real company, it is essentially a private equity and investment manager buying whole companies and derivatives. Despite the nomenclature, insurance companies, pension funds and even Berkshire Hathaway suffered major losses in the current crisis.
A Commentary on Society
As a culture we have glorified the “expert,” and financial intermediaries have prospered as a direct result. Our educational system encourages greater and great specialization and accreditation. But specialized information and knowledge does not equal good judgment. See Too Much Information and Too Little Wisdom. The financial crisis unmasked the cult of the expert. With a low interest rate environment, investors can ill afford the fee structure of the intermediaries that cut sharply into yield. Why pay 50 basis points or more for investment advice when a portfolio may earn one percent of less? An educated investor who takes on more personal responsibility may be the wave of the future. Perhaps personally supervised choices would not have been as devastating as of those of the “expert” intermediaries.
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Tags: Berkshire Hathaway. Robert Prechter, hedge funds, intermediation, mutual funds, private equity, Warren Buffet
