by Carl Hegelman
A long time ago I was involved in an attempt to finance the buyout of a card club in LA. It was quite a profitable business, doing about $100 million a year in revenues, on which it cleared close to $30 million after cash expenses. They made their money by charging people to sit at a table and play poker, taking a little piece of each hand. That way they could get away with not being a gambling establishment, which would have been illegal in Los Angeles, because they weren’t actually a participant in the game; they were just a venue where people happened to sit down and play a game of skill against one another for money. The people who pitted their wits against one another won or lost, and the owners of the club took their cut and lived the high life.
It’s a long story with enough characters and plots to keep Damon Runyon busy for a good while, but that’s not really the point and it can wait for another time. The point is, our economy is becoming a card club and we really should try to figure out what to do about it.
There are good things and bad things about gambling (or, as Wall Street prefers to call it, “gaming”). On the one hand, people should be allowed to do whatever they want with their money, including blowing it at a card club. Also, it generates jobs: ask all those mini-skirted cocktail waitresses in Las Vegas. On the other hand, is this really a valuable contribution to our economy and society? In aggregate, the players come out losers: only the house makes money; for the rest it’s a negative-sum game. Some people get hurt — viz., the compulsive gamblers who fritter away their paychecks, especially the ones who borrow from the “juice guys” and end up in dumpsters; a very few people, maybe, win.
Still, the majority of reasonable, level-headed people would probably conclude that gambling is a mostly-harmless leisure activity, like bowling or going to a movie. The people who do it aren’t being forced at gun-point. And they pretty much know they’re going to lose a bit of money. That’s the price they pay for the fun of hanging around in a casino hoping they might be one of the lucky ones who hits the jackpot. If a few people get hurt, well, that’s an additional price, just like crash victims are an additional price for allowing people to drive cars or fly in planes, alcoholics are an additional price for allowing people to drink, etc etc. And, after all, how bad can it get? People only have so much discretionary cash to give to casinos. In the US, apparently, we gamble away about $90 billion a year, or about $385 per person for everybody over 18, mostly in casinos (including the Indian kind) and state lotteries.
The thing is, though, these numbers really understate the true size of the casino industry: If a casino is a venue where the punters, in aggregate, always lose and the house always wins, then there’s a much bigger “gaming industry” going around under an assumed name. To wit, the so-called Financial Services industry. The dynamics of the world’s financial markets are very much the same as those of the casino: the more people gamble, the more they lose and the more the house makes. The secret is to keep passing the ice cube from hand to hand and collect the drips. This kind of gambling, because it’s so much bigger, is doing us all a lot of damage. It is not a mostly-harmless leisure-time activity, and it’s one of the things that is ruining our economy.
A lot of people don’t seem to realize the negative-sum nature of, for instance, the stock market. They have the idea that the stock market somehow feeds money to businesses that need it, and that said businesses then hire people and buy machines to produce stuff that we need. This is not true, though it is an impression bankers are in no hurry to correct. The stock market is a place where people who have already invested their money in these businesses can then sell their shares to other people.
It’s obvious, when you think about it. If you buy 1,000 shares of Intel at $20, Intel doesn’t see any of that $20,000. The person who sells you the 1,000 shares is who gets the money. Right? Less, of course, the tiny commission that the brokers get from the seller and the buyer for filling the orders. Oh, and there’s another little charge — the so-called bid-ask spread, which is another small kind of hidden piece the markets take (e.g., you pay $20.00 plus commission; the seller gets $19.99 less commission).
Of course, companies do raise money when they sell new shares, which then get traded on stock exchanges. But let’s put this in perspective. The amount of money raised in the US by companies going public with Initial Public Offerings (IPOs) runs around $40 billion to $45 billion per year. The amount raised in “secondary offerings” by companies already listed on US stock exchanges averages $50 billion to $60 billion. So let’s say around $100 billion a year of new money comes into the US stock exchanges every year. (The banks, by the way, typically take about 7% to sell an IPO; and by some estimates the total cost to the company is more like 15%, because the banks usually under-price the deal to make it easier to sell and collect their commission.)
Now, contrast this number-$100 billion a year-with the amount of stock that people bet on every trading day. On the New York Stock Exchange and the NASDAQ, the amount of stock traded every trading day is around $125 billion. That’s around $32 trillion every year, or $320 for every new dollar actually invested in companies. (And that doesn’t count the increasing amount traded on the “dark pool” private exchanges). None of this money goes to any productive enterprise, it’s just a round-the-clock poker game. The house cut on this volume is much smaller than for an IPO, but it’s not pocket change.
The stock market is just one of the games, don’t forget. There’s a lot of other tables in the global casino. The bond and bank-loan markets are actually a lot better (for the bankers) in some ways, because bond and loan volume is in the trillions of dollars every year and, better still, bonds and loans come due after a relatively short time and most often you need to do new bonds and loans to pay off the old ones. Drip drip. Generally, too, the spreads (the amount taken by the middleman) are higher than for stocks in the trading markets after the deal is done. Then there’s the foreign-exchange market, where $4 trillion changes hands every trading day: that’s the entire US economy in less than four days, the entire world economy every two weeks or so. In all these markets, of course, there are also “derivatives”, which are securities whose price depends on the prices of the stocks, bonds, loans, mortgages, commodities, and currencies in the primary markets: a whole new area for one poker player (or his computer) to face off against another one. Drip drip drip.
It doesn’t help, by the way, that the poker players here (i.e. mutual funds, insurance companies, pension funds, endowment funds, etc) are mostly playing with other people’s money. Letting other people play your poker for you is not a good place to start, as Warren Buffett has explained with his usual clarity and dry wit. Because the “money managers” who bet your money on the markets every day don’t do it for free. They get quite a lot of the drips off the ice cube, too. (And it’s a big ice-cube: institutional investors in the OECD countries manage probably in excess of $40 trillion). This symbiosis of banks with an interest in high volume and “investors” playing with other people’s money is not a formula for wealth creation, at least for the rest of us.
This is not to give the idea that these markets have no useful purpose. In fact, they’re crucial to our system. If we didn’t have big, liquid markets where we could sell our stocks and bonds if we needed to raise cash, we’d be back in the 17th century and nobody would invest in anything. And if we didn’t get “price signals” from these markets showing where the money is best invested, we’d probably invest in all the wrong things (I mean, more often than we actually do, which is quite often-witness the dot-com and other bubbles).
But it’s come to the point where the tail is wagging the dog; in fact, not just wagging the dog but flinging the poor beast about like a rag doll, with potentially disastrous consequences for him. In 1965 the average daily trading volume on the New York Stock Exchange was 6.2 million shares. That’s about 30 second’s worth of trading on the NYSE and NASDAQ today. And it wasn’t like the economy was hurting as a result: the economy was pretty good. In the 1960, the average holding period for US stocks was about eight years; today, it’s more like seven months. The poker players are in a veritable frenzy.
Moving the money around more often doesn’t really benefit anybody except the banks. Why are we doing this? And what can we do to stop it? It’s a complicated subject, and nobody really has the answer yet. Maybe the only consolation is that eventually the banks will own the ice cube and we can all have fun watching them die of cognitive dissonance.
Carl Hegelman (a pen name) is a corporate bond analyst and a connoisseur of leisure.