The Big Bank Theory

Forbes published its annual list of the richest Americans last week. If you're like me, this is fun reading. I like seeing who's doing well and how they made it.

Something from the list caught my attention this year: The sheer number of those who made their fortunes from finance.

Fully one-fifth of those on this year's Forbes list come from the financial industry, including hedge fund managers, private equity tycoons, and bankers. One-fifth. For perspective, I dug up the 1985 edition of the Forbes Richest Americans list. Back then, four people, or less than 1%, of America's richest hailed from the finance world.

This meteoric rise in financial-sector wealth isn't restricted to billionaires and financial entrepreneurs. Since the mid-1980s, there's been a surge in average compensation for finance employees that outstrips every other industry (More on why here):

Source: Bureau of Economic Analysis, author's calculations.

In 1959, the average finance employee made 7% more than the average worker from other industries. By 2006, finance workers out-earned their non-finance peers by 57%.

And for what?
This rise would be well and good if the average finance worker added more value to society than everyone else. And Wall Street has convinced some of us that they indeed do. Comedian Jon Stewart once sarcastically called this the Big Bank Theory.

But think about it. Does the financial industry really add anything to society? Some parts, yes. Basic banking. Brokerage services. Financial advisors. Some investment banking. These are all vital elements of the economy. They help businesses grow and people achieve goals.

But nearly every financier from the Forbes list traffics in a different business entirely. They aren't helpers or advisors. They rarely even finance other people's creations. They simply trade the financing of other people's creations back and forth -- they're paper pushers. Traders. Hedge fund managers. Private equity executives. They don't create anything. They have no patents. They build no factories. Most employ very few people. They're several steps removed from anything relevant -- and yet they out-earn nearly every other industry. Insanity is too kind a word. It's just sad.  

A good example of this comes from an old New York Times article describing the life of Avis Rent-a-Car, a company whose ownership has bounced between several dozen financiers over the years:

Modern capitalism has two parts: there's business, and there's finance. Business is renting you a car at the airport. Finance is something else. More and more of the news labeled "business" these days is actually about finance, and much of it is mystifying. Even if you can understand -- just barely -- how it works, you still wonder what the point is and why people who do it need to get paid so much. And you strongly suspect that the swirl of financial activity around Avis for the past six decades has had little or nothing to do with the business of renting cars.

The article then ridicules The Wall Street Journal, which takes a modern finance view of Avis' future:

The Journal warned, "If a buyout or acquisition deal doesn't materialize for Avis, stock and bond investors will have to focus on the fundamentals of its car-rental business." Goodness! Anything but that!

Getting what you pay for
To some degree, there's nothing wrong with this kind of speculative finance. It's capitalism. It's always been around -- just more so today.

The danger is in the incentives. It's now far more lucrative to finance stuff than it is to make stuff, and it's even more lucrative to trade the financing of the stuff.

The result is entirely predictable: Brainpower floods into high finance like gnats to a bright light. Fifty years ago, 4% of Harvard's graduating class went into finance. Today it's about a quarter. At Princeton's School of Engineering, financial engineering is the most popular undergraduate major. What is financial engineering, you ask? It involves derivatives, leverage, Ferraris, bankruptcies, and invariably a bailout. Nothing you'd be proud of.

Two decades ago, Michael Lewis' phenomenal book Liar's Poker laid out Wall Street's utter swamp of a culture. Lewis once wrote that the goal of his book was to convince college students that abandoning their childhood dreams to make a fortune on Wall Street is a terrible idea. Instead, he writes, "Six months after Liar's Poker was published, I was knee-deep in letters from students ... who wanted to know if I had any other secrets to share about Wall Street. They'd read my book as a how-to manual." Morals do funny things when you wave a seven-figure bonus in someone's face.

Berkshire Hathaway's (NYSE: BRK-A  ) (NYSE: BRK-B  ) Charlie Munger (himself a financier) put it a little more eloquently: "Ever more of the nation's ethical young brainpower is attracted into lucrative money management and its attendant modern frictions, as distinguished from work providing much more value to others."

That's really it. The tragedy of the Big Bank Theory isn't what current financiers are doing. It's what the next generation of our best and brightest won't be doing -- engineering buildings, discovering new medicines, designing computers. Useful things. Things where making the cover of Forbes earns you the respect, not the astonishment, of others.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel owns shares of Berkshire Hathaway. Berkshire Hathaway is a Motley Fool Inside Value selection and a Motley Fool Stock Advisor recommendation. The Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (20) | Recommend This Article (25)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 15, 2011, at 12:49 PM, davidxiestudio wrote:

    If you like to invest Warren Buffett style, take a look at this analyst's blog: www.staranalystonline.com

    These are the stocks that Warren Buffett would be very interested to get in if he is aware of them.

  • Report this Comment On March 15, 2011, at 1:25 PM, TheWizeNut wrote:

    I wonder what the rate of philanthropy among the finance sector-rich is compared to other sectors. here are some finance philanthropists. The rich redistribute willingly often:

    http://www.facesofphilanthropy.com/section/business-philanth...

  • Report this Comment On March 15, 2011, at 5:01 PM, ajtrombone wrote:

    Sure, a lot of people are going into finance now because it is currently very lucrative. No one is saying that this will be the case is a few decades. I personally tend doubt that it will be because an increase in the number of people in finace will cause the average real salary to go down. Simple supply and demand economics.

  • Report this Comment On March 15, 2011, at 6:33 PM, midnightmoney wrote:

    If someone is after money, then by all means they ought to go where it is found. If it bothers a person that those who don't deserve the money are raking it in and he or she is not, then there are four choices: 1/ join them (how much happier do you think you would be?), 2a/ seek to have them taxed back to earth or 2b/ seek to have earnings legally regulated by a non-irs body and distributed in a more socially useful way. 3/ fight for what is right; fight to change human consciousness, or lack thereof, so thoroughly as to excise the monkey out of our nature and the dirt out of dirtballs, 4/forget about it and live your life for purposes beyond becoming rich. I personally favour #2, admire greatly those who do #3 (and therefore appreciate your article), but will most likely personally continue doing #4.

  • Report this Comment On March 15, 2011, at 6:44 PM, xetn wrote:

    And having the Fed stand behind every mistake you make (moral hazard) makes it a "heads you win; tails you win" situation. (This is mostly for the megabanks; all members of the Fed).

    But now we are faced with a Fed crisis in the making to wit:

    http://mises.org/daily/5110/Three-Flawed-Fed-Exit-Options

  • Report this Comment On March 16, 2011, at 2:28 AM, dcflipflop wrote:

    Morgan, excellent article as usual. As a real engineer who works hard to design products that add value to our society, I find the use of the term "engineer" applied to these goons highly offensive.

    It's also highly troublesome that more of our youth are pursuing careers in an industry that, as you pointed out, doesn't really add value to society. Someone can spend four years of their life getting a degree that teaches them what? How best to take other people's money? And they call that a Bachelor of Science? Utterly ridiculous. This does not bode well for the future of the US. Especially since China and India seem to understand the value of real engineering.

  • Report this Comment On March 16, 2011, at 11:59 AM, vaidybala wrote:

    A little diversion from Big-Bang Theory:

    India and China are ancient civilizations with vast riches. India's has wealth been plunderedd by Islam for 1000 years and by the British for another 250 years. So, we cannot label India as shrewd or value engineered. In 5o years from 1950, it is difficult to do valuation, if at all. IT sector growth and foreign investments today give the illusion that India is growing. That is only a nanostory in a billion people nation!

  • Report this Comment On March 16, 2011, at 12:05 PM, vaidybala wrote:

    It is thought provoking article to note from 1% to more than 25% finance as as global Tycoons. This trend sure is seen now in modern youth who prefer finance to engineering because they say the pay difference is striking, why sweat the stuff. Leave engineering to less fortunate who do not understand the finance side of life, go to the riches not the trenches! Who to blame in this trend?

  • Report this Comment On March 16, 2011, at 12:11 PM, ChiefNoseeum wrote:

    Could part of the reason so much of US manufacturing has gone offshore is that the financial industry has bought it on credit and borrowed against it to finance their outsized compensation? Then, they cast the lemon aside after it would not give one more drop of juice.

  • Report this Comment On March 16, 2011, at 12:36 PM, TMFTypeoh wrote:

    So, whats the solution?

    As long as the incentive is there, more and more will seek finance.

    The only solution i can see if for the gov't to limit wall street pay, which we know the lobbiests for the big banks will fight.....hard.

    Even then, those who want the money bad enough will move to other countries that will pay them for their "talents".

    Its a tough situation. What's your thoughts Morgan? You usually have great solutions to problems like this.

  • Report this Comment On March 16, 2011, at 12:44 PM, NovaB wrote:

    In other words, the entire financial industry is a ponzi scheme.

    One bubble bursts and the next one starts inflating.

    These guys are making fortunes simply by buying paper napkins from buddy A and selling it to buddy B.

    I have a very bad feeling we all know how this movie ends. The question is when.

  • Report this Comment On March 16, 2011, at 1:00 PM, ETFsRule wrote:

    This reminds me of what they said about Hosni Mubarek. He made his fortune (estimated at up to $80 billion) by skimming a little money off the top from every business transaction in his country. After a few decades it really adds up.

  • Report this Comment On March 16, 2011, at 5:17 PM, DJDynamicNC wrote:

    It's a pretty logical end result for unrestricted capitalism. Those with money will accumulate more money, and more ways of using that money to leverage even more money, and on and on.

    In fact, that's specifically the goal of capitalism.

    It's kind of an awful mess.

  • Report this Comment On March 16, 2011, at 6:48 PM, midnightmoney wrote:

    DJDynamic,

    I'd counter in a nutshell that capitalism is the system that is maintained by any and all means necessary in some countries by those with power and who deem it the proper economic and social mode of existence. As an ism, it has no goals; those are the provenance of humans. The goals of those who ruled the communist ussr were exactly the same as those who rule under capitalism--to accumulate wealth and hold onto power.

    I definitely agree that it's an awful mess.

  • Report this Comment On March 16, 2011, at 7:19 PM, marxengels wrote:

    MidnightMoney

    Now you have named the game. True even before Machiavelli laid it out in The Prince.

    The question is how do you get a fairer system, or how much accumulation at the very top triggers a revolution?

  • Report this Comment On March 16, 2011, at 7:59 PM, midnightmoney wrote:

    marxengels,

    I don't believe revolution will occur as a result of accumulation of wealth at the top because humans will protect themselves as individuals and members of family first and foremost and at absolutely all costs, including those of the noblest aspirations of revolution. Revolution on economic grounds as Marx predicted would be bloody and cataclysmic and require humans to sacrifice themselves in ways that are not wired into our genes. Further, I believe it is actually love that prevents revolution, which would pry the individual away from his or her nearest and which s/he will not--indeed cannot--allow to happen even if it would align his interests with that of the human community as a whole to a far greater extent. What say you?

  • Report this Comment On March 17, 2011, at 8:10 PM, midnightmoney wrote:

    marxengels,

    I was looking forward to a response from you. Hope you're well this evening.

  • Report this Comment On March 18, 2011, at 11:30 PM, ershler wrote:

    midnightmoney,

    Just because the rulers of the USSR did something doesn't make it a communist action. I think everyone would agree communism would work great as long as everyone did what they were supposed to but obviously most people are going to look out for themselves first.

    None of this will matter when the Chinese own everything:)

    Also, most of their (China's) leaders are trained engineers.

  • Report this Comment On March 19, 2011, at 1:02 PM, midnightmoney wrote:

    ershler,

    and just because capitalists do things that all humans do by nature does not make them capitalists, it makes them human.

    my point was that the rulers of communist ussr behaved the same as the rulers of capitalist countries insofar as they hoarded wealth and power. We label one system communist and another capitalist yet there are striking similarities when it comes to the behaviour of the ruling class. At the end of the day, both capital and commune are roots with ism attached to them, and both fail to describe what life is like in either.

  • Report this Comment On March 19, 2011, at 5:57 PM, Computergeeksta wrote:

    I love many of your articles. They always contain simple little bits of truths. I'm sure everyone reading this is probably looking to enrich their financial life. I am currenty in the science and research industry, but in the process of transitioning to the darkened industry of financial services. The very industry that adds value to society is always a victim to mass layoffs so that corporate executives can reap huge bonus. Unfortunately, there's no incentive to work hard and let the fruits of your labor go to upper management. Hopefully this doesn't drive most away of our talented workforce overseas to China or other nations.

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