Streetwise

Lauren Rudd

Sunday, October 28, 2012

The Scariest of Ghosts and Goblins

While a variety of scary ghosts and goblins will soon be knocking on your door asking for treats, none will be scarier than Wall Street.  As both an economist and Wall Street analyst, I am increasingly concerned over the continued decimation of investor confidence brought about by an unadulterated fear of the financial markets.

That fear was undoubtedly the deciding factor in the resultant decision by investors to exit equity mutual funds. According to a recent report by the Investment Company Institute, investors withdrew funds for the 12th consecutive week ended October 10. The net outflow, while still $2.3 billion, was certainly less than the withdrawal that occurred during the previous week when $10.6 billion, the largest departure of funds from stock mutual funds since August 10, 2011, was withdrawn.

Additionally, withdrawals from stock funds have exceeded deposits each and every week since July 18 and for all but two weeks in the period dating back to mid-February, despite the S&P 500 index being up 12 percent year-to-date. Furthermore, it is not just domestic stock funds that are being punished. The ICI noted that $295 million was withdrawn during the latest week from foreign stock funds and that withdrawals have exceeded deposits in those funds for the past 12 consecutive weeks.

If the data surprises you, it shouldn’t, especially when you consider the ongoing decline in economic prosperity. According to the Census Bureau, the median household income fell to $50,054 in 2011, down 1.5 percent from a year earlier. At the same time, income inequality widened, as the highest income echelon experienced a jump, while those in the middle saw incomes shrink. Yet, the national poverty rate did ease a little to 15.0 percent of the population in 2011, down slightly from 15.1 percent the year before.

So how is Wall Street reacting to the angst of investors? Difficult to tell since Wall Street has its attention riveted on trying to prevent the full implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, predicting direst of consequences if the section dealing with the Volcker rule is broadly implemented. If seems everyone has their own particular perdition to deal with.

What is amusing is the failure on the part of the Street to acknowledge that nothing in Dodd-Frank in general, or the Volcker rule in particular, specifically outlaws proprietary trading, which is trading for an institution's own account. The idea behind the Volcker rule is simply to ensure that such trading is not carried out under the auspices of an implicit guarantee of being made whole by the taxpaying public.

Because proprietary trading often encompasses complex financial instruments under increasingly risky circumstances, it's only prudent to warrant that taxpayers are not on the hook for rampant misbehavior, thereby preventing a repeat of what happened subsequent to the crash of 2008. Back then garden-variety commercial banks, such as Bank of America and Citigroup, appeared to have an implicit blank check from the government. Others, such as AIG, had their tentacles were so deeply wrapped around the financial system that the government felt that their collapse, even if it was from their own stupidity, couldn't be allowed to happen.

Without restraints such an assurance would again be assumed in those instances where deposits are guaranteed by the federal government or the bank is so systemically important that a bailout by the government would be necessary if a bank’s bets go south.

Wall Street forgets that the most difficult moment of the 2008 financial meltdown, the failure of Lehman Brothers, caused a crisis of confidence precisely because everyone on Wall Street had assumed it would eventually be bailed out — just like Bear Stearns had been. Expectations matter.