Wednesday, February 15, 2012

TRUST in the Marketplace

So much of our financial system relies on Trust.
What happens when trust is eroded in the marketplace?

What is amazing to me is how much of our financial system is based on trust - when you think about it.  In the U.S., we still rely on magnetically-encoded Credit Cards, which you present at a store, swipe, and they just presume you are who you say you are.  In Canada and in Europe, they switched to "smart cards" a long time ago, which rely on a PIN to confirm a transaction.

And our credit card system has a lot more fraud as a result.  No one checks to see if you are who you say you are.  I write "SEE ID" in the signature block of my card, and few clerks every look at it or even check.  It is all based on trust.

The first time I used eBay, I was amazed by how the entire thing is based on trust. I paid someone for an item, and they mailed it to me.  What was to prevent them from just taking my money?  The feedback system is one answer, of course.  But for the most part, it is just raw trust involved.  And if that trust evaporates?  Well, so will eBay.  There is no point in sending people money and getting nothing in return, right?

In some specialized markets, trust is a very important element.  I recall seeing a documentary about the diamond business.  Buyers and sellers meet in the diamond district in New York, and if the buyer likes the stones, he takes them with him - he just pockets them.  No contract, nothing in writing, just a handshake and he walks out with a half-million in stones.

Or consider those commodity traders in the "pit" shouting buy and sell orders to each other.  You place an order and you are honor-bound later on to fulfill it.  Nothing in writing, in many cases.  No signatures or guarantees.  Just a shouted 'buy' or 'sell' order in a frantic, busy marketplace.

Now of course, this isn't to say there are not consequences when trust in the marketplace is violated.  "Trust, and Verify" as Ronald Reagan once said.

If you steal a credit card and then try to use it - as a friend of mine's daughter once discovered - it is a Felony, and you can expect to spend weekends in jail at least - and have a permanent scar on your employment record.  "Convicted Felon" is not a trivial matter.

And if a diamond broker reneged on an agreement to pay for the diamonds he just pocketed, he would find his livelihood gone, his brokerage house broke, and perhaps sued in court.  As a result, it rarely happens - if ever.  The fact that the dealers are all part of a tightly-knit community, and all of the same religion, adds to the bonding and trust factor - which facilitates trade.

Similarly, in the commodities business, if you say, "Did I say 'buy'?  Because I meant 'sell!'" then you would find yourself in a lot of trouble, and moreover, no one would want to trade with you.

Markets where there is a lot of trust are robust markets.  Trading can go on and is facilitated by the knowledge that you can trust the parties involved to live up to their agreements.  Markets with little or no trust tend to stagnate and fail.  As trust dries up, people are less likely to consume or buy - as they are not convinced they can trust the players in the marketplace to fulfill their end of the obligation.

Think about how many transactions you partake in every day, and how trust is involved in all of them - big and small.  You buy or sell a house, and you sign a lot of papers and you trust the closing attorney will pay off the old mortgage with the proceeds of the new one.  If not?  Well, everyone is in a lot of trouble.  And this happened in Northern Virginia, to one ambitious Attorney who felt he could use client closing funds to "float" his business losses.  When the wreckage was cleared, millions of dollars of money were found missing, and many homeowners, who did not buy title insurance, found themselves in a bit of a pickle.

Title insurance is an enforcement mechanism in such a transaction - as is the eventual criminal and civil prosecution of the attorney involved.  When a fiasco like that happens, prosecuting attorneys want to make sure an example is made of the person doing the bad deeds - so that others are not tempted to do the same.

And throughout history, some of the harshest punishments have been meted out to people who violated the trust of the marketplace.  As I have noted before, in the past, counterfeiting was a capital crime - punishable by death, sometimes horrible deaths, such as drawing and quartering.  When you mess with the idea of money you are potentially ruining the entire market, and indeed can bring down a government.  Even shaving coins (taking material off the edges and collecting it) was deemed a very serious crime, sometimes punishable by death.   The idea was, to discourage those who would violate the trust of the marketplace.

Today, we are more lenient, of course.  And for many white-collar criminals, not only are the punishments very light (a few weeks in Country-Club jail) but oftentimes non-existent.  In many cases, violating the trust of the marketplace is not only unpunished - it is perfectly legal.

In our 401(k)-era, a huge number of middle-class people are forced to be unwitting participants in the financial markets.  We are expected to manage our own retirement by saving money and investing it wisely.   Our panicky nature has already lead to wild swings in the marketplace as it is.  But compounding this are the various entities in the marketplace that have set out to pluck these merry travelers as they traverse through the forest.

We put our money into mutual funds, and have no idea what it is doing.  Is there a load on this fund?  You ask a financial adviser point blank, and they smile at you and say, "of course not!" when in fact there is a 5% fee of which he gets a "taste".  But since verbal promises are not enforceable in a court of law (because they cannot be proven), he can get away with saying that - and saying that the funds he puts you in - that benefit HIM - are a smart investment for you.

Stock prices are manipulated on a regular basis - and we are all hyped to buy a stock by some guy on television, who has already bought at a lower price.   We buy, he sells.  The same is true for gold.  The guy telling us to BUY gold owns an interest in the gold company, or is a paid spokesperson for him.  This is trust?  This is even legal?

We are all told that the latest IPO will be a goldmine - as it everyone could invest in the same thing at the same time and everyone will make money.  That makes no sense, on its face.  Someone has to pay more, down the road, for this stuff.  Rather, these IPOs are just a chance for insiders to "cash out" and sell a tiny fraction of the company to the public.  But we buy, and then act shocked with the price of the stock skyrockets - and then crashes.  And it was all planned out in advance.

New cars are another example of lack of trust.  Even if you could find an "honest" new car dealer, pay a reasonable new-car price, the darn thing is worth 10-20% less the day you take it home.  And as a result, so many people get angry with their cars or the dealers and vow to switch brands next time, as if that would change anything at all.

But alas, finding an "honest" new car dealer is problematic.  Most of them  - particularly the smaller ones - pad the prices and play all sorts of games, to the point that you never know if you got a good deal or got snookered.  Usually, the latter.  And because of this, I stay out of new car dealerships.  There is no trust there whatsoever.  They are all basically scum - willing to tell you that your existing car requires $10,000 worth of work, if they can use that to leverage you into a new car.  That's called lying, in my book.

But more to the point, I think one problem with our current economy is the erosion of  trust in the marketplace.  We call for more and more "de-regulation" and claim that this will improve our economy.   But there reaches a point where you can de-regulate to the point where trust disappears and the economy stagnates.

If there were no consequences for violations of trust, trust disappears.   If the merchants in the diamond market could not be held accountable for their actions, they would no longer trade as readily - demanding, instead of a word and a handshake, cash-up-front.

And for many merhcants in our economy, this is how things work.  When I was working at a wholesale hydraulics distributor, we filled orders for hoses and fittings and then invoiced the customers on 30-days payment.  We trusted the customers to pay within that time period.  In the meantime, we had shipped them perhaps thousands of dollars of materials.

What happens if they don't pay?  Oftentimes, the damage to the wholesaler can be enough to bring them down.  Or, they demand cash-up-front, which inhibits business transactions, particularly when the customer is hoping to get paid in turn from his customer, for installing the parts we provide.  When everyone has to pay cash - when there is no trust - the market suffers.

In the last decade, we have seen how removing the trust limitations in the lending business ended up hurting us all.  When there are no consequences for making bad loans, people make bad loans - and keep doing so until the entire financial system melts down.  Yes, we trusted people to pay back those loans, but we also, in the past, used to verify that they were capable of paying those loans back, before we made them.  Making irresponsible loans was a violation of trust.

The new administration has implemented or proposed new restrictions and regulations into the marketplace.  Credit card providers have to be a little more transparent in their transactions and consumers are better protected from falling into credit card traps.  Some decry this as an unwarranted intrusion into the marketplace, which should be allowed to settle its differences economically.  But of course, this is blatant hypocrisy.  The same Credit Card companies who decry being denied the ability to "slam" your interest rate are the ones that petitioned Congress to make it harder for you to escape them in Bankruptcy.

Regulations, it seems, are fine and dandy when applied to individuals but not to corporations.  Although Mr. Romney says that both are the same thing!

Frankly, I don't trust credit card companies, which is why I have a small balance card with a low interest rate, no annual fee, and no cash-back gimmicks.  It is all too easy to end up in a lot of debt, trying to finagle a free flight or cash back.

And I guess that is why I try to seek out simple, direct deals in life, rather than to try to finagle some sort of complex deal that requires I master a byzantine set of rules and trust the other fellow not to change them in mid-stream (such as raising the number of miles to qualify for a free flight!).

Or why I seek a 30-year fixed mortgage over some adjustable-rate payment optional funny-money deal.  Simplest is best, in most cases. The few exceptions don't generate enough money to warrant altering that absolute rule.

And a funny thing, too.  Trustworthy people usually offer simple, direct deals without a lot of flim-flammery.  Untrustworthy people (and organizations) tend to load you up with complicated deals that can bite you on the butt.  And at that point, they can claim you didn't read the rules carefully enough!  Trustworthy people don't play that, in my opinion.