Men at Arms Scene

I know a lot of proverbs about money. My favorite is probably the Russian proverb that states, loosely translated, that “When money speaks, the truth remains silent”, which I’ve always liked. But perhaps the best observation about money that I’ve ever heard comes from a book by the English humorist Terry Pratchett. In Men at Arms, a hilarious book, one of his characters,  the sergeant Vimes, stumbles upon a tremendous truth:

“The reason that the rich were so rich, Vimes reasoned, was because they managed to spend less money.

Take boots, for example. He earned thirty-eight dollars a month plus allowances. A really good pair of leather boots cost fifty dollars. But an affordable pair of boots, which were sort of OK for a season or two and then leaked like hell when the cardboard gave out, cost about ten dollars. Those were the kind of boots Vimes always bought, and wore until the soles were so thin that he could tell where he was in Ankh-Morpork on a foggy night by the feel of the cobbles.

But the thing was that good boots lasted for years and years. A man who could afford fifty dollars had a pair of boots that’d still be keeping his feet dry in ten years’ time, while the poor man who could only afford cheap boots would have spent a hundred dollars on boots in the same time and would still have wet feet.

This matters, because it turns out that a huge number of manipulations aim at parting a man with his money, and they all tend to obey the core idea that Pratchett articulates above – it’s easier to manipulate the poor than the rich.

Let’s start at the bottom of the economic stairs, for example, with payday lenders. Those are the shops that you often see advertised on late-night television, which promise to lend you small sums to tide you over until payday. Most of their customers are working-class, relatively poor folks who are having trouble making ends meet and turn to high-interest payday loans for help. Since these folks tend to be poor borrowers, payday loaners tend to charge high interest – expect to pay around $15 for a 14-day, $100 loan. As many of them argue, that’s only like $1.10 a day or so!

Pay Day Loan - Root of all Manipulation - Money ManipulationDon’t they look happy??

But scratch the surface, and the manipulations will soon appear. For one thing, that $1.10 a day translates into a 400% or so  interest rate, which makes your credit cards look positively cheap. So how do payday lenders get around usury laws that forbid this type of interest rates? Well, some of it is done via fees – a lender will charge the maximum usury rate, for example, and then add a “processing fee” of $9.95 per $50 tranche, for example. Those fees will effectively keep the rate above the 400% mark. Others form partnerships with banks in states that do not have usury laws, and that allows them to charge any rate they want, even in states that do have usury laws. And since the idea of payday loans was originally to allow the working poor to access credit for a one-time emergency, many states passed laws that forbid payday lenders of lending to the same person for more than 45 days, for example. Payday lenders then promptly devised long-term loans (more than 140 days), which were essentially rolling 44-day loans – no single loan was longer than 44 days, so the regulations didn’t apply to them, but the lender was effectively borrowing for as long as half a year or more. Of course, if you miss a payment, you get added fees, but many of them will allow you to take another loan to cover those fees. Generous, no?

Ok, so you would never go to a payday lender (although I really encourage you to do so – $15 is not too much to pay to see some very interesting manipulation at work). But you may be surprised by where these types of loan creep up, under different names. Watch television around this time, for example, and you’ll see a dozen ads for tax preparation services like H&R Block, most of which will tout their tax refund service – if you are owed money by the IRS, these kind folks will lend you money based on what the IRS owes you, so that you don’t have to wait for the IRS to process your refund.

Refund Anticipation Loan - Money ManipulationAgain, note the happy.

Why wouldn’t you do that? Well, these types of loans are essentially pay day loans, complete with high interests, high fees, and relatively low risk for the lender. And many people who would never dream of getting a payday loan happily accept a tax refund loan, which can be just as expensive and just as manipulative – especially when the loan (which is rarely referred to as a loan, by the way – the preferred term is “immediate refund”) is ‘free’ (true, since the loan doesn’t carry interest – you just get less than what the IRS owes you, with the difference effectively being the interest), easy, and you don’t have to wait “months” for the IRS bureaucracy (most refunds are actually processed within 3-4 weeks). It’s so easy to sell these loans, in fact, that H&R Block was forced to settle suits in 2003 in NY and in 2006 in California for predatory lending, precisely because of the way it aggressively marketed refunds to low-income taxpayers).

Let’s go up the financial stairs a little. You don’t take payday loans, you don’t fall for the refund loans – you’ve even managed to save some money, and you’ve wisely invested it in mutual funds. Oops! Until that last part, you were doing so well!

Until very recently, buying mutual funds was marketed as the intelligent thing to do for average Americans. You may own some right now, either in your IRA or 401k, or even outside those as an investment vehicle. Just under half of us in the US do.

Mutual Funds are Manipulation!Okay, the happy thing is getting creepy now.

So what’s so manipulative about that, you ask? Well, mutual funds are probably some of the most manipulative financial products available – anywhere.  Remember that when you give your money to a mutual fund manager, he aggregates it with many, many other contributions and goes out to buy stocks that he likes. The idea is that since he is smart, he will pick better stocks than you would, and get you higher returns. Isn’t that nice of him? But consider this:

– Almost all mutual funds underperform the market as a whole. If you simply invested in the S&P or Dow Jones index (basically a basket of stocks that exactly mirror the index), you would have made 2-3% a year more than in mutual funds, and paid a lot lower fees. This is not a small difference, by the way. Over time, fees and this under-performance can mean that literally half the proceeds of the investments go to the fund – not the investor. When you buy a mutual fund, you’re essentially giving up half your proceeds – before tax! – to the mutual fund.

–  More relevantly, mutual fund managers have become very savvy at manipulating relatively un-informed investors. For example, because fund managers have to report quarterly what stocks they own, prior to the end of the quarter managers like to basically buy a number of good stocks so that the portfolio looks better. Crucially, mutual fund managers have to report which stocks they own, not how long they’ve owned them, which allows them to “window-dress” the portfolio just before reporting time. You can actually see this trend on the market when there is an orgy of buying of good quality stocks just before reporting time.

– Until it got a lot of regulatory scrutiny, portfolio managers used to “pump” [warning: PDF] stocks. What is stock pumping? Just before the performance of the mutual fund was measured, the manager would lodge a lot of buy orders for the stocks he owned – sending their price skywards, and inflating his performance. Once the reporting was done, the stocks crashed back down, but by then he had bought himself another quarter of great performance – and more investors.

– Mutual funds quickly recognized that advertising would only take them that far. To get  a lot of people to invest in their fund, what was needed was a distribution network. Thus was born the commission system – if you are a bank manager, or a broker, and you get your clients to invest in a mutual fund, they will often pay you up to 5% of the total investment as a commission to thank you for being a client. They don’t call it commissions (that would be too clear), they call it the load, and it is reported, albeit in small characters, in the fund’s prospectus.

As more people learned to beware of loaded funds, fund managers created amusing twists – back-load structures, for example, which truthfully advertise no front-end commissions (they just pay the commissions when the investor wants to withdraw his money), and invented a number of other structures to basically hide the commissions.

So, if you’re investing in mutual funds, you too are most likely being manipulated- you are earning less than you could, after all, and paying far more in commissions and fees than you probably understand.

Let’s say that you’re not an average investor. You are a wealthy, very wealthy entrepreneur, or even a fund manager for a pension fund. You laugh at the poor schmucks that are manipulated into buying mutual funds.

One day, Goldman Sachs, one of the smartest firms in the world, comes around and offers you a CDO, a financial product that lumps together thousands of mortgages and offers great returns. Great returns, and low risk, because what were the odds that thousands of mortgages would default at one?

Used Car Salesman - Money  ManipulationSo, wanna buy one? Or 12,000,000 of them?

What Goldman Sachs didn’t tell you, of course, is that most of the mortgages were chosen by Paulson & Co, a hedge fund, that then turned around and worked with Goldman to essentially bet that the mortgages would default. In other words, Paulson & Co. sold mortgages to investors through Goldman and then structured a bet that would pay them big money if when those mortgages failed. You have to admire the manipulation gumption shown by both, here, you really do. Of course, the CDO collapsed and Goldman Sachs was eventually sued, but not before you – and other very savvy investors – lost billions.

This is the reality of the boot analogy I started with, writ large. Individuals typically spend a lot more time and effort earning money than managing it. This is what makes all of these manipulations possible – remember that manipulation is all about shifting behaviors by a small amount. But when it comes to money, small shifts matter: most of Wall Street is built on the money from the fees, the interests, the commissions paid by workers and investors, not by any value-creation engine.  And, in that context, manipulation pays: payday lenders manipulate the working poor. The mutual fund industry preys on the average working family. And the Goldman Sachs of the world manipulate the wealthy and  savvy investors. The core of Pratchett’s argument holds, though – it is relatively easier to manipulate the poor rather than the rich, and that is why there are so many more payday lenders than Goldman Sachs.

“The reason that the rich were so rich, Vimes reasoned, was because they managed to spend less money.

Take boots, for example. He earned thirty-eight dollars a month plus allowances. A really good pair of leather boots cost fifty dollars. But an affordable pair of boots, which were sort of OK for a season or two and then leaked like hell when the cardboard gave out, cost about ten dollars. Those were the kind of boots Vimes always bought, and wore until the soles were so thin that he could tell where he was in Ankh-Morpork on a foggy night by the feel of the cobbles.

But the thing was that good boots lasted for years and years. A man who could afford fifty dollars had a pair of boots that’d still be keeping his feet dry in ten years’ time, while the poor man who could only afford cheap boots would have spent a hundred dollars on boots in the same time and would still have wet feet.”

I know a lot of proverbs about money. My favorite is probably the Russian proverb that states, loosely translated, that “When money speaks, the truth remains silent”, which I’ve always liked. But perhaps the best observation about money that I’ve ever heard comes from a book by the English humorist Terry Pratchett. In Men at Arms, a hilarious book, one of his characters, the sergeant Vimes, stumbles upon a tremendous truth:

This matters, because it turns out that a huge number of manipulations aim at parting a man with his money, and they all tend to obey the core idea that Pratchett articulates above – it’s easier to manipulate the poor than the rich.

Let’s start at the bottom of the economic stairs, for example, with payday lenders. Those are the shops that you often see advertised on late-night television, which promise to lend you small sums to tide you over until payday. Most of their customers are working-class, relatively poor folks who are having trouble making ends meet and turn to high-interest payday loans for help. Since these folks tend to be poor borrowers, payday loaners tend to charge high interest – expect to pay around $15 for a 14-day, $100 loan. As many of them argue, that’s only like $1.10 a day or so!

Don’t they look happy??

But scratch the surface, and the manipulations will soon appear. For one thing, that $1.10 a day translates into a 400% or so interest rate, which makes your credit cards look positively cheap. So how do payday lenders get around usury laws that forbid this type of interest rates? Well, some of it is done via fees – a lender will charge the maximum usury rate, for example, and then add a “processing fee” of $9.95 per $50 tranche, for example. Those fees will effectively keep the rate above the 400% mark. Others form partnerships with banks in states that do not have usury laws, and that allows them to charge any rate they want, even in states that do have usury laws. And since the idea of payday loans was originally to allow the working poor to access credit for a one-time emergency, many states passed laws that forbid payday lenders of lending to the same person for more than 45 days, for example. Payday lenders then promptly devised long-term loans (more than 140 days), which were essentially rolling 44-day loans – no single loan was longer than 44 days, so the regulations didn’t apply to them, but the lender was effectively borrowing for as long as half a year or more. Of course, if you miss a payment, you get added fees, but many of them will allow you to take another loan to cover those fees. Generous, no?

Ok, so you would never go to a payday lender (although I really encourage you to do so – $15 is not too much to pay to see some very interesting manipulation at work). But you may be surprised by where these types of loan creep up, under different names. Watch television around this time, for example, and you’ll see a dozen ads for tax preparation services like H&R Block, most of which will tout their tax refund service – if you are owed money by the IRS, these kind folks will lend you money based on what the IRS owes you, so that you don’t have to wait for the IRS to process your refund.

Again, note the happy.

Why wouldn’t you do that? Well, these types of loans are essentially pay day loans, complete with high interests, high fees, and relatively low risk for the lender. And many people who would never dream of getting a payday loan happily accept a tax refund loan, which can be just as expensive and just as manipulative – especially when the loan (which is rarely referred to as a loan, by the way – the preferred term is “immediate refund”) is ‘free’ (true, since the loan doesn’t carry interest – you just get less than what the IRS owes you, with the difference effectively being the interest), easy, and you don’t have to wait “months” for the IRS bureaucracy (most refunds are actually processed within 3-4 weeks). It’s so easy to sell these loans, in fact, that H&R Block was forced to settle suits in 2003 in NY and in 2006 in California for predatory lending, precisely because of the way it aggressively marketed refunds to low-income taxpayers).

Let’s go up the financial stairs a little. You don’t take payday loans, you don’t fall for the refund loans – you’ve even managed to save some money, and you’ve wisely invested it in mutual funds. Oops! Until that last part, you were doing so well!

Until very recently, buying mutual funds was marketed as the intelligent thing to do for average Americans. You may own some right now, either in your IRA or 401k, or even outside those as an investment vehicle. Just under half of us in the US do.

Okay, the happy thing is getting creepy now.

So what’s so manipulative about that, you ask? Well, mutual funds are probably some of the most manipulative financial products available – anywhere. Remember that when you give your money to a mutual fund manager, he aggregates it with many, many other contributions and goes out to buy stocks that he likes. The idea is that since he is smart, he will pick better stocks than you would, and get you higher returns. Isn’t that nice of him? But consider this:

– Almost all mutual funds underperform the market as a whole. If you simply invested in the S&P or Dow Jones index (basically a basket of stocks that exactly mirror the index), you would have made 2-3% a year more than in mutual funds, and paid a lot lower fees. This is not a small difference, by the way. Over time, fees and this under-performance can mean that literally half the proceeds of the investments go to the fund – not the investor. When you buy a mutual fund, you’re essentially giving up half your proceeds – before tax! – to the mutual fund.

More relevantly, mutual fund managers have become very savvy at manipulating relatively un-informed investors. For example, because fund managers have to report quarterly what stocks they own, prior to the end of the quarter managers like to basically buy a number of good stocks so that the portfolio looks better. Crucially, mutual fund managers have to report which stocks they own, not how long they’ve owned them, which allows them to “window-dress” the portfolio just before reporting time. You can actually see this trend on the market when there is an orgy of buying of good quality stocks just before reporting time.

– Until it got a lot of regulatory scrutiny, portfolio managers used to “pump” [warning: PDF] stocks. What is stock pumping? Just before the performance of the mutual fund was measured, the manager would lodge a lot of buy orders for the stocks he owned – sending their price skywards, and inflating his performance. Once the reporting was done, the stocks crashed back down, but by then he had bought himself another quarter of great performance – and more investors.

– Mutual funds quickly recognized that advertising would only take them that far. To get a lot of people to invest in their fund, what was needed was a distribution network. Thus was born the commission system – if you are a bank manager, or a broker, and you get your clients to invest in a mutual fund, they will often pay you up to 5% of the total investment as a commission to thank you for being a client. They don’t call it commissions (that would be too clear), they call it the load, and it is reported, albeit in small characters, in the fund’s prospectus.

As more people learned to beware of loaded funds, fund managers created amusing twists – back-load structures, for example, which truthfully advertise no front-end commissions (they just pay the commissions when the investor wants to withdraw his money), and invented a number of other structures to basically hide the commissions.

So, if you’re investing in mutual funds, you too are most likely being manipulated- you are earning less than you could, after all, and paying far more in commissions and fees than you probably understand.

Let’s say that you’re not an average investor. You are a wealthy, very wealthy entrepreneur, or even a fund manager for a pension fund. You laugh at the poor schmucks that are manipulated into buying mutual funds.

One day, Goldman Sachs, one of the smartest firms in the world, comes around and offers you a CDO, a financial product that lumps together thousands of mortgages and offers great returns. Great returns, and low risk, because what were the odds that thousands of mortgages would default at one?

So, wanna buy one? Or 12,000,000 of them?

What Goldman Sachs didn’t tell you, of course, is that most of the mortgages were chosen by Paulson & Co, a hedge fund, that then turned around and worked with Goldman to essentially bet that the mortgages would default. In other words, Paulson & Co. sold mortgages to investors through Goldman and then structured a bet that would pay them big money if when those mortgages failed. You have to admire the manipulation gumption shown by both, here, you really do. Of course, the CDO collapsed and Goldman Sachs was eventually sued, but not before you – and other very savvy investors – lost billions.

This is the reality of the boot analogy I started with, writ large. Individuals typically spend a lot more time and effort earning money than managing it. This is what makes all of these manipulations possible – remember that manipulation is all about shifting behaviors by a small amount. But when it comes to money, small shifts matter: most of Wall Street is built on the money from the fees, the interests, the commissions paid by workers and investors, not by any value-creation engine. And, in that context, manipulation pays: payday lenders manipulate the working poor. The mutual fund industry preys on the average working family. And the Goldman Sachs of the world manipulate the wealthy and savvy investors. The core of Pratchett’s argument holds, though – it is relatively easier to manipulate the poor rather than the rich, and that is why there are so many more payday lenders than Goldman Sachs.