A Finance Sector Too Big for Its Britches

Last year, Berkshire Hathaway (NYSE: BRK-B  ) Vice Chairman Charlie Munger said, "We would be better off if we downsized the whole financial sector by about 80%." That may have been an exaggeration, but not by much.

We often hear that one of America's great strengths is the depth of its financial markets. That's true to a point, but there are limits. A new study by the International Monetary Fund shows that rich countries hit a point "at which financial depth no longer contributes to increasing the efficiency of investment."

That point, they showed (link opens PDF file) this week, tends to hit when a country's private sector debt totals 80%-100% of gross domestic product. The United States hit that threshold two decades ago, and now chugs along at about double the level:

Source: World Bank.

What happens when credit levels spike above 100% of GDP? The IMF paper shows that rising private-sector credit helps fuel growth when it's at a fairly low level of GDP -- say, when private-sector credit rises from 20% of GDP to 30% of GDP. But after the 100% threshold, the boost to growth vanishes. And worse, countries past the threshold tend to face more frequent, deeper, and longer financial crises (this should sound familiar).

Then there's the impact a large financial sector has on misallocating talent. Fifty years ago, 4% of Harvard's undergraduate 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 other types of productive work could these brilliant minds be doing instead? Munger himself worried: "A big percentage of Cal-Tech grads are going into finance. I regard this as a regretfully bad outcome. They'll make a lot of money by clobbering customers who aren't as smart as them."

But there's something more important here to think about, and that's who has caused the big boom in private-sector credit. A predictable villain to blame is the Federal Reserve, which controls the money supply and pumps credit into the economy. But the Fed doesn't make private-sector loans. It doesn't take out mortgages, run up a credit card, or engage in leveraged buyouts. That's all done by the will of private borrowers. Even when loans are cheap and artificially attractive, the decision to go into debt is entirely up to the consumer or the business. I don't think you can even lay blame on the big banks like Bank of America (NYSE: BAC  ) or Citigroup (NYSE: C  ) . A banker offers you a loan? Say no. He points out that it's a low interest rate? Say no. See how easy that was?

The credit boom of the last two decades is mostly indicative of people's yearning to live a life they can't afford. It's keeping up with the Joneses, or the fake-it-till-you-make-it effect. There are all kinds of explanations for it. Some say income inequality caused the material aspirations of common folks to be inflated by the legitimately rich, and the only way they could afford it was through debt. Others say an increasing level of short-termism in business caused managers to boost near-term profits with leverage at the expense of long-term sustainability.

The reason doesn't really matter. We've gone into a lot of debt. We've done it voluntarily. It's now backfiring, and the effects will probably linger for years to come. "There is no faster way to feel rich than to spend lots of money on really nice things," Motley Fool's Bill Mann wrote four years ago. "But the way to be rich is to spend money you have, and to not spend money you don't have. It's really that simple." Timeless advice.

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Fool contributor Morgan Housel owns shares of Berkshire Hathaway and preferred shares of Bank of America. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Berkshire Hathaway, Bank of America, and Citigroup. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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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 July 13, 2012, at 6:21 PM, xetn wrote:

    Ending the Fed and FDIC would result in a downsizing of the banks. The reason: they would have no protection for their risk-taking and would be facing real bankruptcy for their bad results.

    The big risk at that point would be government bailouts. But without a Fed, where would they get the money? China?

  • Report this Comment On July 16, 2012, at 12:41 PM, jwiest wrote:

    Nice chart. Thank you Reagan... :(

  • Report this Comment On July 16, 2012, at 1:06 PM, Brent2223 wrote:

    And the bigger the industry gets, the less people understand. If I see one more life insurance commercial that tells me to buy some so I can 'leave a little for the kids' I'm going to puke. But screw life insurance altogether, I'm just going to get a reverse mortgage and get me some income for life. Wait a sec, you mean going into debt for 150% of the market value of my house isn't just free money? What's a lien?

    You don't need to be a Cal Tech grad to pull one over on most people these days, you just need a pulse.

    How is a free market system with private too big to fail corporations a fair wealth distribution system? Capitalism, we don't need no stinkin communist government to keep the people down cause they're more than happy to do it to themselves....

  • Report this Comment On July 16, 2012, at 1:10 PM, BuffMagnum wrote:

    "Nice chart. Thank you Reagan... :("

    Its private sector debt dude, you're blaming Reagan for that? What about the 20+ years that he wasn't president?

  • Report this Comment On July 16, 2012, at 1:20 PM, slpmn wrote:

    xetn - I need a better explanation of why the banks would downsize if you took away Federal regulatory oversight. The regulators don't provide protection from risk taking. The protection exists because the banks are so big their failure threatens the national economy. The executives running these things do not have any incentive to minimize risk-taking because that's where their marginal profits are generated. Removing the regulators will not change that.

    There is no political will to break up the big banks because anti-government ideologues will not unite with anti-big business liberals long enough to pass the legislation needed to do it. All of the free-marketers running around trashing government 24/7 need to acknowlege that sometimes, maybe once in a generation, government actually has to take action in the best interest of the markets. Having an oligopoly of too-big-too-fail banks threatening the economy is the anithesis of the free market, capitalist ideal.

  • Report this Comment On July 16, 2012, at 1:59 PM, mdk0611 wrote:

    About charts and debt:

    1. Notice that the 2 points during that chart's history where debt rose the fastest were during the Dot Com bubble and the Housing Bubble. The finance sector might be too big for it's britches, but it also needs some grownups to slice through irrational exuberence during the good times to maintain the quality of their balance sheets. That goes for those who would purchase securitized pools as well.

    2. Reducing private debt through the means of increasing public debt might kick the problem down the road a bit, but it doesn't solve it. If Morgan were to show a graph of public debt in 10 years where it exceeds 100% of GDP we've solved nothing.

  • Report this Comment On July 16, 2012, at 2:03 PM, TMFMorgan wrote:

    <<Reducing private debt through the means of increasing public debt might kick the problem down the road a bit, but it doesn't solve it.>>

    Total debt, public and private combined, as a share of GDP has been falling for four years.

    http://research.stlouisfed.org/fred2/graph/fredgraph.png?&am...

  • Report this Comment On July 16, 2012, at 2:28 PM, Seanickson wrote:

    I think the way to be rich is to not spend money that you have

  • Report this Comment On July 16, 2012, at 2:32 PM, TrojanFan wrote:

    @BuffMagnum

    Let me start by saying that I am a registered Republican and a fan of Regan generally, but an honest assessment of where we find ourselves today demands a willingness to take a critical view at some of his policies and decisions and the ramifications of them.

    It actually is fair to lay some of this blame at Regan's doorstep because his policies openned the floodgates. There is little room for disputing that fact. He set the precedents which so many others after him have followed and expanded upon to extraordinarily dangerous levels, but the point of divergence clearly began under his leadership and was exponentially exacerbated by those who later emulated his methods and I can point to reams and reams of examples of that. Aggregate government debt to GDP exploded under his administration as his stated strategy was to spend the Soviets into the ground in pursuit of launching a great arms race of nuclear proliferation in the hope of bankrupting the USSR and bringing an end to communism. He suceeded in the former, but his long-term success with the latter is certainly open for debate given the global rising tide of socialism that's happening right now on the back of the catastrophic and simultaneous global failure of capitalism that was the subprime debacle owing much of its scope and intensity to the global redistribution of that risk which was presided over by an incredibly bloated financial services industry of which I am an increasingly cynical and somewhat disenchanted member.

    There were an array of decisions that he made while at the helm that contributed to this, but in my view none had a greater or more lasting and market distorting impact than his selection of Alan Greenspan to chair the Federal Reserve following Volker's period of Herculean inflation fighting. Ironcially, it was actually Volker's inflation fighting credentials that gave Greenspan the scope and room to operate and stimulate the economy through policy initiatives under his FED and he certainly didn't let any of that ammunition go to waste. Shortly thereafter the nation's love affair with Greenspan and the embedded Greenspan put began and a whole raft of asset price inflation bubbles began one after the other. That laid the groundwork for the smoke and mirrors economy and politics that we are all living under today.

    Easy money is easy until the bill comes due and then it's not so easy any more. We all have to adjust to that new reality going forward.

  • Report this Comment On July 16, 2012, at 2:37 PM, TMFGortok wrote:

    Something your article misses Morgan is that the government likes to insert its 'influence' into sectors of the economy through laws. For example, the CRA requires that banks give loans to people in neighborhoods that they might otherwise not (known as 'redlining'.), and this is just one of example of one law where the government tells businesses what they can and cannot do. If your choice is to give out a risky loan (that you can write off) or not to be able to conduct business because you have a CRA inquiry, which one would you take?

    This is just one clause in one law, Given enough time, I could find a thousand clauses in thousands of laws where the government inserts its judgement into the supposedly free market.

  • Report this Comment On July 16, 2012, at 2:40 PM, grusilag wrote:

    "There is no faster way to feel rich than to spend lots of money on really nice things," Motley Fool's Bill Mann wrote four years ago. "But the way to be rich is to spend money you have, and to not spend money you don't have. It's really that simple."

    Why is it the consumer's burden not to spend money that they don't have, but not the banker's burden not to lend money that they don't have?

    The above is not a facetious question. I think if you understand that there are NO limits to the amount of debt that can be created in a system (because you are not limited to loaning money that you have) then it is a foregone conclusion that folks will borrow more than they can. Remember if you couldn't lend more than you have (on aggregate) then you can't borrow more than you can pay back (on aggregate). But if one side is able to lend more, much more, than it has, then the other side must borrow more, much more to pay back those loans.

    The above also goes toward showing why this quote: "Even when loans are cheap and artificially attractive, the decision to go into debt is entirely up to the consumer or the business. I don't think you can even lay blame on the big banks like Bank of America (NYSE: BAC ) or Citigroup (NYSE: C ) . A banker offers you a loan? Say no. He points out that it's a low interest rate? Say no. See how easy that was?" is not accurate. When newly created money is lent on interest the only way to pay back that money plus interest is to borrow more. Borrowing becomes a necessity in such a system.

    At bottom we have to at least understand that debt is how our money is created - all of it. Without debt there would be no money.

  • Report this Comment On July 16, 2012, at 2:49 PM, TMFMorgan wrote:

    Gortok,

    I'm not in favor of CRA, and this doesn't go against your point, but it's worth noting that the vast majority of subprime loans made during the bubble were by organizations not subject to CRA, and in hindsight CRA loans have had a much lower default rate than comparable private loans. And again, no borrower was forced into a CRA loan. They applied for them and went into debt voluntarily.

  • Report this Comment On July 16, 2012, at 3:08 PM, aggiewes wrote:

    I agree with you Morgan, we are in this mess because people took out loans they could not afford. You are in charge of yourself if you take on to much debt then you are responsible for it. It is as simple as that.

  • Report this Comment On July 16, 2012, at 3:10 PM, TrojanFan wrote:

    @TMFGortok

    I have to take exception with this. This is one of the most often cited and abused examples that proponents of deregulation use to impune the government for its interference in the free market.

    I work with people who would literally go out and break borrowers knee caps with baseball bats to collect if the law of the land didn't make such behavior illegal and prosecuteable.

    To blame the CRA for banks' decision to lend $500K+ to migrant farm workers who had never in their life made more then $25K in a year and had no hope of ever paying it back under even the rosiest of assumptions absent winning the lottery is intellectually disengenuous and a laughable proposition. Banks made those loans not because they were coerced, but because they wanted to. They did it because they new they could earn a fee for doing it, bundle it in a mess of similar loans and securitize it and then jam it down on some foolish pension or insurance account who was a lot less smart and clever than the banker who was packaging it and puking it out on them.

    That debacle happened not because of the CRA, but because the industry was completely misincentivized and unsupervised. When have you heard of a financially crippling enforcement of the CRA. Sure the law is on the books, but I don't think it's ever going to bring Citibank or BofA's business to a grinding halt even in the face of rampant non-compliance. Let's call a spade a spade for once. Given the sheer size and political influence of those institutions can you think of a single regulator who actually has the stones to shut them down even if they deserved it?

    It all comes down to incentives at the end of the day. The banks were incentivized to generate volume over quality because they held onto little if any of the risk of the product they generated and this remains the case. If you put a clawback provision into a loan officer's orgination that places a lien on his home if one of his borrowers defaults then you are going to see a surge in loan quality and a decline in default the likes of which you never thought was possible.

    If you write incentive structures in such a way that people get hit with a baseball bat if they screw up, then guess what? You see a lot less mistakes.

    This is the problem with the Too Big to Fail paradigm. There are a lot of institutions out there that deserve cease their existence if they had to face the full wrath of the market test, but they are allowed to continue to survive at our considerable collective expense.

    Keeping these institutions alive and the financial interests of their stakeholders protected means this economy is going to be running at stall speed for the better part of a decade or possibly even an entire generation just like Japan.

  • Report this Comment On July 16, 2012, at 3:57 PM, slpmn wrote:

    I work with bankers daily, and they complain about regulatory burden daily. One thing they don't complain about is CRA because it does not, in fact, force them to make bad loans. I'm not saying they like it, they don't. Like many regulations, it requires them to do a bunch of tracking and reporting, which is a costly burden.

    What the rise in private sector debt correlates with is the rise of securitization and derivatives. Securitization disconnected the borrower from the lender and derivatives made it easier to make new kinds of securities at the same time it made them orders of magnitude more difficult to analyze by investors.

    Were those two products of financial innovation never invented, the mortgage bubble never would have occured because banks don't lend to people who can't afford it if they have to keep the loan.

  • Report this Comment On July 16, 2012, at 4:25 PM, TMFGortok wrote:

    @TMFMorgan @TrojanFan You're under the mistaken impression that I said that the CRA was the cause of the subprime crisis. I did not. What I did say is that there are laws that the government uses to forces businesses to make mortgages they otherwise wouldn't. (If they would make those mortgages voluntarily, then there wouldn't be a 'need' for a law, would there?)

    The mortgage crisis was caused by malinvestment brought upon by the Federal Reserve flooding the market with cheap credit by artificially lowering interest rates. It was further exacerbated in part by the idea of the implicit guarantees by the government of Freddie and Fannie (Government Sponsored Enterprises).

    I didn't say the CRA had much to do with the crisis -- only that there are a lot of laws the government uses to force private behavior down a path it deems necessary, and that those paths don't always end up in good places.

  • Report this Comment On July 16, 2012, at 4:30 PM, TMFMorgan wrote:

    <<You're under the mistaken impression that I said that the CRA was the cause of the subprime crisis.>>

    I clearly wrote: "I'm not in favor of CRA, and this doesn't go against your point, but it's worth noting ..."

  • Report this Comment On July 16, 2012, at 4:37 PM, TMFMorgan wrote:

    <<The mortgage crisis was caused by malinvestment brought upon by the Federal Reserve flooding the market with cheap credit>>

    That was an incentive. People and banks made the loans. No one forced them to.

    I didn't buy a house in 2006. Was I lucky, or did I make a choice to avoid the bubble? And if the Fed caused the housing bubble, why did some banks (Wells Fargo) fare so much better than others (Countrywide, WaMu)? Was it because they were lucky, or because they made a willful decision to not make dumb loans?

    I'm not rooting for the Fed -- they made terrible choices and played a role -- but your constant attempt to place all the blame on one organization because it lines up with your ideological kicks just doesn't make sense to me.

  • Report this Comment On July 16, 2012, at 4:59 PM, slpmn wrote:

    <<The credit boom of the last two decades is mostly indicative of people's yearning to live a life they can't afford.>>

    When have people not yearned to live a life they can't afford?

    <<Others say an increasing level of short-termism in business caused managers to boost near-term profits with leverage at the expense of long-term sustainability.>>

    Leverage wasn't the root of the problem, it merely exasperated it when things turned sour. Capital is a cushion, and that cushion was paper thin by 2007-2008.

    Greed, malincentives, whatever, have all been around forever. They become problems when tools are created that allow the greedy to make bets so large they destabilize the entire economy, and when the regulators/regulations established as a check on them have been gutted by the prevailing anti-regulatory economic school of thought over the previous 20-30 years.

  • Report this Comment On July 21, 2012, at 1:03 PM, fishmeluck wrote:

    @slpmn:

    Just to expand on one of your points..."when tools are created that allow the greedy to make bets so large they destabilize the entire economy..."

    I wonder, if a historical list were made of countries/banking systems, of cases where your point was fulfilled and where it was not, and the number of the former were divided by the number of the latter, how close would the ratio be to infinity.

    Yet, people continue to propose more regulation as the solution, while the proof is abundant that existing regulations are totally ineffective, regulations have never been effective, and the only solution is to reform the monetary system to take the possibility of excessive credit formation out of the system by design.

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