Wall Street: A Beginner’s Guide for Liberal Arts Majors: Why Should I Care?

November 14, 2016

Image Courtesy of Motor Trend

Welcome to Part 2 of the “Wall Street: A Beginner’s Guide for Liberal Arts Majors Series.” I want to start off by saying that this series is in no way limited to those people who studied the “liberal arts.” We don’t like to profile that way here at Loose Cannon and would like all majors to feel equally included. In Part two of the series we are going to look at Wall Street from an average citizen’s perspective. To be clear, an average citizen in this context does not mean a slightly overweight male in khaki cargo shorts begrudgingly driving a Chrysler Pacifica but rather a member of the United States who does not plan on owning a business or becoming a financier. Let’s dive in.

Me after my first retirement savings meeting. Image courtesy of goliath.com

Most people’s first encounter with Wall Street comes in the form of a 401(k) from your first job. Bob from HR takes you through the introductory spiel of benefits and perks of the company, (I too am hoping that package includes Columbus Day off) mentions something about said company matching a certain percentage of 401(k) contributions, and directs you to a vague Fidelity website that asks you to select an investment vehicle where if you make the right decision at just the right time, the stars align, and there is not a full moon out that night you will have an above average chance at one day maybe being able to retire. Maybe. Let’s now look a bit closer in exactly how this process works.

A 401(k) is nothing more than one version of a retirement savings plan, and is named in reference to the part of the tax code that governs them. The 401(k) was introduced in the 1980’s as a supplement for pensions and is now one of the leading retirement vehicles for the working American.

The basic structure of the 401(k) or many of the retirement savings accounts is to take the amount of money you want to contribute, tax free from your paycheck, and spread that out into a mutual fund managed by a money manager. Let’s unpack this further.

A mutual fund is an investment vehicle made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. The advantage of a mutual fund, theoretically, is to minimize risk by pooling your money with a host of others and diversifying the investments you make. Let’s bring back our good buddy George at Instoogle Force which has just issued a bunch of new stocks to the market by way of an equity financing round known as the IPO. A mutual fund may have stock investments in Instoogle Force’s stock along with a plethora of other companies, say for example Chrysler. The beauty of a mutual fund is that the money you invest is not dependent on the performance of one stock. If Instoogle Force’s stock price is dropping due to underperformance of George’s original predictions, than Chrysler’s rising stock price (due to that hot new Pacifica model no doubt) can help offset any losses you would have to your 401(k) investments.

Mutual funds are rated based on their net asset value (NAV) score which is a representation of the mutual fund performance based on all of the stocks and bonds that any one fund owns. Money managers which make the decisions to buy or sell securities with the help of a team of researchers try to increase their NAV score by accruing higher returns than certain indexes provided by the likes of Standard and Poor’s rating agencies.

To give one example of how the investor makes money in a mutual fund would be to again consider Instoogle Force’s stock in the portfolio. The fund manager and team may believe from research and data analysis that Instoogle Force’s current stock price is lower than what the company’s stock may one day be worth. By purchasing large amounts of Instoogle Force stock early, the mutual fund can benefit from selling the stock later on when the market price for Instoogle Force may have jumped substantially. These gains are then passed on to investors in the fund, and your 401(k) balance will now increase by whatever percentage you are owed by the mutual fund. Additionally, if the fund decides not to sell Instoogle Force’s stock it may collect the dividends that Instoogle Force pays to each of its shareholders.

Apart from 401(k)’s and mutual funds, another way that Wall Street can effect the “average citizen” comes in the form of small town commercial banking which materializes in the form of bank loans and checking accounts. Commercial banks are distinctly different from investment banks as the former is mainly involved in savings or checking accounts, mortgage loans, and small business loans, where the latter is involved in ushering companies into the public markets, crafting deals for company mergers, as well as acting as a broker for clients wishing to buy or sell on the open market. It seems that all people interact with a local commercial branch in some form or another, except perhaps the brave men and women from here.

Image courtesy of Good Film Guide

In any case, when you stroll up to your local bank teller and deposit $3.05 into your account (it’s been a tough year here at Loose Cannon) that $3.05 is both an asset and a liability to the bank. It is an asset in one sense because accounting standards consider cash to be an asset and also because this website says so. It is a liability because the bank pays you interest for letting them use your money.

You might be wondering where your money goes after the bank teller has taken it from your hands to its resting spot in the counter drawer, and that is a great question. One of the first ways the bank uses your money is to loan the funds you have given them out to other parties. These generally come in the form of mortgages or small business loans. To put this into perspective the bank is paying you a nominal interest rate (somewhere in the ballpark of 0.06%) and lending out your money to new home buyers or small businesses with much higher interest rates (which depending on the product can be anywhere from around 3% to capping out around 30% or for a few very unlucky consumers 70%).

Now remembering what we originally defined as Wall Street, the commercial banking retail stores in your hometown are probably not considered high finance. So how does Wall Street get into the mix?

Wall Street interacts with the “main street” commercial banks often through the buying and selling of mortgage loans through the secondary mortgage market. (To clear up some confusion here, certain investment banks ie. JP Morgan Chase, or Citibank may have commercial banking arms, but the two divisions are distinctly separate.)

The secondary mortgage market, like all markets is a meeting place of buyers and sellers. In this particular market the sellers are the home loan originators. These are the folks who you would meet with to negotiate the terms of your mortgage loan. They will crunch the numbers, and based on your credit rating, income, and a few other factors determine what type of mortgage you can qualify for.

Once they have packaged your loan and the deal is set, the originators then sell the mortgages to aggregators in the secondary market. The aggregators have ties to Wall Street and create products like mortgage-backed securities. (sound familiar?). The two most well known aggregators in the game are Fannie Mae and Freddie Mac, which were created by the US government to help keep the flow of mortgages moving so more citizens can purchase homes from commercial banks.

The aggregators will then make deals with Wall Street brokerage houses by way of the mortgage backed securities trading desk. These trading desks then package the mortgages into financial products like collateralized debt obligations (CDOs), asset backed securities (ABS), and collateralized mortgage obligation (CMOs).

Image courtesy of narrativefirst.com

**Note. Although CDOs seemed to disappear for a while after the financial crisis of 2008, there now seems to be evidence that they are back to stay.

The final step in an ironic twist of fate, is for investors such as hedge funds, pension funds, mutual funds, banks, and the like to purchase these CDOs, ABSs, or CMOs to add to their portfolios in a never ending game to beat the market and provide returns for their clients.

So for those home owners with a 401(k) that are playing along at home, that technically means that the mutual fund in which your 401(k) is placed could have purchased a mortgage backed security that was created in part from the very mortgage that you took out to buy your new home. (..)

All of this seems like a long walk for a short drink of water. Why even involve Wall Street in this in the first place if the commercial banks can just provide the loans and make money off of the interest? The answer here comes down to the commercial banks ability to regulate its flow of cash. If Bank X has $500,000 in deposits from local townspeople, and 6 local citizens each need $100,000 mortgage to build a new home, that sixth person is out of luck. This is especially true when you consider the fact that the bank must keep reserves in accordance to the reserve ratio standards dictated by the Federal Reserve for its checking and savings account clients to remove their money. So the long and short of it is that the banks are able to move more loans for more people if they are able to sell these loans off to secondary markets on Wall Street.

So that just about wraps up Part 2 of the “Wall Street: A Beginner’s Guide for Liberal Arts Majors Series,” although perhaps it should be more appropriately named, “Wall Street: A Beginner’s Guide for Liberal Arts Majors or perhaps STEM majors, or Philosophy majors, or maybe even English majors who only minored in Economics Series.” I hope you have been able to learn at least a bit about how Wall Street functions in everyone’s lives. If you are hungry for more keep your eyes peeled for future additions with the more proper title of “Wall Street: A Beginner’s Guide for Liberal Arts Majors, or perhaps STEM majors, or Philosophy majors, or maybe even English majors who only minored in Economics Series.”

One clap, two clap, three clap, forty?

By clapping more or less, you can signal to us which stories really stand out.