Coats: In defense of vultures and bottom-feeders

Coats-Column-SigThey clean up the mess beside the road that has been left there to rot. It is not a pleasant sight, but who can really object to the service these birds perform? Actually, the vultures I want to defend are not the feathered ones but the even uglier, so called, “bottom-feeders,” who take advantage of asset fire sales.

I am trying to find words to explain the stupidity of the attack on people who swoop in to buy things when their prices are depressed that will not be insulting to the intelligence of non-economists.

I think that everyone understands that if the demand for something increases its price will go up (or not fall as far). A so-called fire sale is when someone, often a company facing bankruptcy, is forced to liquidate some or all of its assets in order to pay its bills. The forced sale often pushes the price of the asset below its true long-run value (to the extent anyone knows what that is). Bottom-feeders step in and buy when they think the price has fallen to or below that long-run value. If they are right, they will make money in the long run when the price of the asset recovers.

Are they doing a bad thing? If we somehow could keep them out of the market, what would happen to the price of the asset being sold under duress? It would fall further, of course! If you think that these vultures are exploiting distressed sellers, you are free to offer a higher price.

The attack on “payday lenders,” so called because borrowers use an upcoming paycheck as collateral, is a bit more subtle. Interest fees on these emergency loans are very high, as these risky borrowers don’t qualify for normal bank loans. According to the Washington Post, “Each loan comes with steep fees. The CFPB found that payday borrowers pay a median US$15 in fees for every US$100 they borrow, amounting to an annual percentage rate of 391 percent on a median loan of US$350.”

The new Consumer Financial Protection Bureau (CFPB) has just proposed “sweeping new rules” that will limit their use. As with restrictions on vulture investors (which fortunately have not been proposed by the administration), restricting access to payday loans would force such borrowers to seek out loans with still worse terms or suffer the consequences of no loan. If you think that payday lenders are exploiting their customers, you are free to lend to them at better terms.

However, restrictions on payday loans have a big brother, paternalistic purpose. The argument is that these emergency borrowers can’t be trusted to use the money responsibly. “The agency found that about 80 percent of payday loans are rolled over into a repeat loan, causing fees to pile up for borrowers. Roughly 45 percent of payday customers take out at least four loans in a row.”

It is appropriate to take away the freedom of choice from people judged mentally or emotionally incapable of exercising that judgment in their own best interest. The power to do this is potentially dangerous and should only be used sparingly and with careful judicial guidelines and oversight. Dangerously, our government has pushed this boundary far beyond what can be justified in a free society. Big Brother has grown fat.

A further step in the direction of ever more intrusive government is the new rules issued by the Obama administration that would require investment advisors to put the interests of their clients above their own. “Trade groups representing businesses, Wall Street firms and other financial professionals joined forces to file a legal challenge against a new rule from the Obama administration that would restrict the advice brokers and advisers can offer to retirement savers … The groups are attempting to block a rule announced by the Labor Department in April that created a higher standard for the investment advice offered to retirement savers.

The new regulations require brokers selling investments for retirement accounts to put their clients’ interest ahead of their own,” according to the Post.

Putting the interests of investors above those of their advisors is a perfectly good standard. It is what I, and most people, expect from their financial advisors. The questionable self-interest of the trade groups opposing it is obvious. It doesn’t follow that every good practice should be made a legal requirement enforced by the government, which is the direction we have been going in recent decades resulting in thousands and thousands of pages of regulations in almost every area of economic activity. Markets tend to adopt good practice on their own.

Investment advisors who give the best advice from their clients’ point of view (rather than investments that might pay the advisors the highest commissions) are certainly more desirable to investors. The marketing issue is how to know and insure that is the standard followed by a particular advisor. If such a standard is written into your contract with your investment advisor – something she would surely proudly advertise – you would have the legal basis to sue if that standard were violated.

Private markets don’t have the best solutions to all problems of product quality but they do have the best solutions in an ever-changing technical world for most of them when given the chance.

Warren Coats, a former director of the Cayman Islands Monetary Authority, and former senior monetary policy adviser to the Central Bank of Afghanistan, Iraq and Kenya for the International Monetary Fund, is on the Editorial Board of Cayman Financial Review.