Thursday, February 2, 2012

Capitalism: The Big Bank Theory

    How do you define capitalism?  In today’s world that question seems to be harder and harder to answer accurately.  While there has never been a consensus on the exact definition of capitalism, I have recently found that the privilege of living in a capitalistic society has been replaced by another definition of what that entails.  That new definition seems to include words such as greed and corruption.
    Capitalism only works in a free and open society where there is a balanced competitive scale.  The Civil War was fought because that scale was not balanced.  The northern states could not compete with the southern states in the marketplace.  The southern states had a clear and unfair competitive advantage because they employed slave labor.  Capitalism, as much as anything else, led to President Lincoln’s quest to end the disgusting institution of slavery, and restore the balance of economics.  Today, we could say the same unfair competitive advantages take place in other parts of the world where cheap labor and lack of worker’s rights are found in countries that are now our largest competitors.  This ladies and gentlemen is outsourcing and the main reason why the U.S. economy has been steadily declining.
    So here we are in 2012 in the midst of another presidential campaign.  A campaign where nightly news programs throw grenades in the form of insults with the far left accusing someone from the far right of being a greedy capitalist, and where someone from the far right accuses someone from the far left of being a socialist.  No one person, or political party, owns the definition of capitalism.  The benefits of capitalism are enjoyed by both political parties.  The fund raising dollars that all candidates depend upon come from a capitalistic society.  The most sizeable contribution dollars to both political parties come from the profits of corporate America. 
    So where does the anger and the confusion with capitalism stem from?  My belief is the banking/mortgage crisis which began in 2008.  2011 saw the rise of a powerful movement in the U.S. led by “Occupy Wall Street”.  While I agree with the movement’s anger, I also feel that they have misplaced their anger towards capitalism as a whole.  They seem to have trouble defining their anger and that comes from a lack of knowledge of the topic they are protesting.
    That brings us back to the question of “How do you define capitalism?”  I am a capitalist, and I believe in everything that a free and open market place has provided and will continue to provide.  I believe capitalism is a living system and that if you are willing to work hard and willing to assume some amount of risk, then it may pay off in a big way.  “May” being the keyword.  There are no guarantees in an openly competitive marketplace and that is the beauty of capitalism.  The free market determines the worth of your efforts.  My belief in capitalism is why I can clearly define my anger with the big banks, and tell you today that nothing they did to create the mortgage crisis resembled capitalism.
    The practices of the major banks during the real estate boom (which eventually led to the mortgage crisis and the plummet in the U.S. economy) spat in the face of capitalism.  As I previously stated, I believe the capitalist way of doing things is to reap the rewards or suffer the losses of the risk you are willing to assume.  The banks found a way to reap all of the rewards of the mortgages they were writing while pushing the risk they were taking on, by lending to riskier borrowers, on to others.  That is not capitalism, and the product that was created to pull this off was the Mortgage Backed Security (MBS).  The MBS allowed the banks to pool all of their high risk mortgages into bond offerings.  The MBS was then sold to the marketplace, and the capital gained from the offering was supposed to offset the risk of potential defaults on any of the riskier mortgages. 
    The MBS was an easy sale because ratings agencies like the Standard & Poor’s slapped a juicy AAA rating on the MBS offerings.  They never considered how risky the mortgages were that were packaged inside of the MBS.  The AAA rating altered capitalism because investors did not truly know the risk they were assuming when buying a MBS.  That is why when we are discussing the Standard & Poor’s decision on the credit rating of the United States that it does not mean much to me.  That agency time and time again has turned its back on doing the right thing.  Why would I care what they have to say about anything?  If they had not rated a pile of garbage ‘AAA’, then the Mortgage Backed Security would not have been easily sold and that would have forced the banks to stop writing high risk mortgages, or suffer the consequences themselves.
    Being born into a society that practices capitalism is a privilege.  So the next time you or someone you know wants to use the banking crisis as an indictment against capitalism, please remember that was not capitalism.  If you are looking to point a finger then start with the regulators and policy makers.  They approved the use of Mortgage Backed Securities while ignoring the obvious slap in the face to capitalism that defined the securities creation.

Jon R. Orcutt, founder of Allocation For Life, is an asset allocation strategist and author of “Master the Markets with Mutual Funds: A Common Sense Guide To Investing Success"