Sebastian Mallaby
Senior Fellow, Council on Foreign Relations
Asked about the EU crisis:
Missed his first point.
2) Greek debt forgiveness may come.? 3) EFSF assist Italy and Spain with rollover.? 4) Markets judging governments.? Slow motion run. 5) move toward political and maybe fiscal union.
All liquidity and buying time.? Emerging markets in the G20 look at the EU, and are surprised at the lack of coherence.? Zoellick doesn’t want to see the US get there.
What can Germany do?
Germany’s policies individually are reasonable, but not in aggregate. 2,3) Could provide even more in aggregate to the EFSF or IMF SDRs –> Germany: other Europeans should become more like Germany.
US underestimates Germany’s commitment to the Eurozone.? Merkel building commitment among the German electorate (?!)
What political/fiscal reforms could take place?? Uncertain.
Germany: Markets should not dominate the State (DM: Hegel?), unlike US & UK.
What else can be done?
Italy might be fixable, with a little bit of time.? Spain also.
Isn’t this just a question that reserve assets now appear to be risk assets?
Get countries to recognize the externalities inherent in their policy choices.? Get the emerging markets to move toward flexible exchange rates and independent central banks.
US Dollar will remain the main reserve currency, but may go multipolar to many reserve currencies.
Gold will judge the policies of Central Bankers.? At least Central Banks should look over their shoulder at it.
Q&A
Corruption? Why not exclude those nations the Eurozone that can’t stand the rigor?
US less transparent than the World Bank.
Question comes down to cross-subsidy of the less rigorous.
Why do you do what you do?? Do you do it for money?? Many do.? Do you do it because you love it? Some get to do that.? Do you do it because you think you have the truth, and want to make it known?? Few do that.
Mike Mayo seems to be one who works for the latter two reasons, and that made him unusual on Wall Street.? As an analyst of bank stocks on Wall Street, Mike Mayo was not always right, but he was right more often than not.? He had a strong desire to tell what he saw to be the truth, which did not win him friends amid general overleverage in the banking sector (the banks lent too much).
Wall Street does not exist to make the buyers of the securities rich, rather, Wall Street exists to help companies get financing; the large profits of Wall Street come from the creation of stocks, bonds, and other securities to institutions and individuals.
There may be a question, though: if Wall Street does not exist to enrich the buyers of securities, then why do they employ analysts who try to point out value to potential buyers?? Even today, it is because Wall Street wants to make money off of the underwriting of future securities.? After all there is no money to be made in the secondary trading of ordinary securities anymore.
That is why the opinions of analysts still remain roughly 65% bullish, 30% neutral, and 5% bearish.? Their posture reflects the way Wall Street positions itself for those they make money from: securities issuers, not securities buyers.
And similar to rating agencies, it has to be that way, because only the securities issuer has a concentrated interest in the issuance of a security, and for bonds, the rating.
So what happens when a rare smart truth-teller, Mike Mayo, comes along, and does not care about the revenue generation potential of his opinions?? He gets a good reputation from institutional investors, but often loses his job inside investment banks, because he was not profitable for them.? Some clever investment bankers would use a negative opinion from Mike Mayo to sell products to fix the problems of the bank in question, but that was rare.
Book Structure
This book is part autobiography, and part a financial economics text.? We learn about those who raised Mike Mayo, and those who influenced him in his career development.? We also learn about the economics of Wall Street, as I have described above.? But behind all of it is the nagging question, “Why do you do what you do?”? In an area rife with ethical conflicts, where money goes more rapidly to those who will be cheerleaders and promoters rather than truth-tellers, asking the questions that disturb the soul are uncommon, but affected the author.
In short, the book tells of his life, and how he came to be a bank analyst.? It goes through his successes, and some of his failures.? It spends too much time on his correct analyses of Citi (Citigroup).? It shows him learning how to be professional, and take the emotion out of issuing opinions, and reactions to opinions.
It takes us through three phases of his opinions: mixed, bullish (1994-1998), and bearish (1998+).? He was willing to be bearish and lose credibility in the short run.? Of course, what do we call someone who is wrong in the short run?? We call them wrong, though those who are patient may still benefit.
After that, the book offers his opinions on what is wrong with finance, which he summarizes as ABC: fix the Accounting, put insolvent banks into Bankruptcy, and reduce the Clout of banks. All salutary suggestions I think.
Quibbles
Though he spent time on some of his failures, he should have spent more time there.? That said, I am impressed by his determination.
Saving the big banks from themselves still seems to be an afterthought rather than a goal, despite all of his efforts.
Who would benefit from this book: Most investors would benefit from this book.? It will make you skeptical of investment banks; it will teach you how Wall Street thinks.? Beyond that, you might enjoy the story of someone who tweaked the nose of Wall Street, and survived (for now).? If you want to, you can buy it here: Exile on Wall Street: One Analyst’s Fight to Save the Big Banks from Themselves.
Full disclosure: The publisher asked if I wanted the book.? I said ?yes? and he sent it to me.
If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)
Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.
This is the first book that I have reviewed twice.? I reviewed the third edition of the book previously, but I am reviewing the sixth edition now.
Kindleberger places the manias, panics, and crashes on a common grid, to see their similarities,? In it he draws on a number of common factors:
Loose monetary policy
People chase the performance of the speculative asset
Speculators make fixed commitments buying the speculative asset
The speculative asset?s price gets bid up to the point where it costs money to hold the positions
A shock hits the system, a default occurs, or monetary policy starts contracting
The system unwinds, and the price of the speculative asset falls leading to
Insolvencies with those that borrowed to finance the assets
A lender of last resort appears to end the cycle
The advantage over the third edition is that you get to hear about the Asian crisis LTCM, the tech bubble, Madoff, and the present crisis (banking & housing, soon to be sovereigns).
The main point for readers is to beware when monetary policy is easy, banking regulation is lax, and many seem to favor buying the asset du jour, often with leverage.? What is self-reinforcing on the way up will be self-reinforcing on the way down, but with greater speed and ferocity, as bad debts have to be liquidated.
Quibbles
Hindsight is 20-20.? If the US Government had rescued Lehman, something else might have proven to be “too big to rescue,” that the government might allow to fail, but miss the connectedness of the institution.? I do think the US Government should have been a DIP lender to troubled firms, but not a buyer of equity.
Who would benefit from this book: Most investors would benefit from this book.? It will make you more skeptical of assets that seems to be doing unnaturally well; it will also make you more skeptical about catching falling knives in the market.? If you want to, you can buy it here: Manias, Panics and Crashes: A History of Financial Crises.
Full disclosure: The publisher asked if I wanted the book.? I said ?yes? and he sent it to me.
If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)
Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.
I want to toss out a half-baked idea for others to play with, criticize, and adjust.
But first, a fully baked idea: the Euro was doomed to fail.? Any core Euro after kicking out the miscreants is also doomed to fail.? You can’t have monetary union long-term without political/fiscal union.? The roadblocks to economic union are cultural issues that express themselves politically.? The upshot is that either you politically merge nations that are similar (and intermarry), or your nation should have its own currency, so that needed macroeconomic adjustments can occur.? A single currency for disparate nations is a decidedly bad idea, and the Euro-sceptics so roundly derided in 1998 have been proven right within 14 years.
So, now for my half-baked idea — it is time to undo the Eurozone in entire, but we will keep the Euro, or rather, Euros.? This would have to be done quickly or it would not work well.? When those in the Eurozone wake up one morning, they find that they do not have Euros any longer, but Greeks have Greek Euros, Germans have German Euros, etc., and they do not trade at parity.
Most of this would take place through bank deposits and savings, which would instantly shift.? Currency is far smaller and would be stamped (for paper bills) or struck (for coinage) by governments that have an interest in having more currency in circulation, but until the stamping or striking, a euro is a euro, and can be used anywhere.? In the short run, that would mean that some currency would leak to core Eurozone countries and away from the periphery.
The pro-rata shares of the ECB would be handed back to the national central banks, and the ECB dissolved.? The national central banks would then be capable of pursuing the interests of their own nations.? What a thought!
But what about existing long term contracts to pay Euros?? If to a nation in the Eurozone, it can be paid in either of the new Euros, that of the payor or the receiver.? If to a nation outside the Eurozone, they get the Euro of that particular nation.? What was a credit loss or gain becomes a currency loss or gain.
Many of the Eurozone nations would have to support their banks during such a crisis for solvency reasons, but their national central banks would once again have the freedom to do this.
Yes, this would be painful, and it would be a mess.? But it would be a “Big Bang” that sets the nations of the Eurozone free from their artificial shackles, and allows the nations in the Eurozone to liquefy, inflate, and reconcile all of the debts built up.? It would also send losses to nations that lent to the Euro-fringe.? After this is done, all of Europe would be in better shape economically, and Europe would be more, not less united, because they don’t have to argue over monetary policy.
Thoughts?? I welcome them. :)? I know I have omitted a lot; I also know this is impractical given the nature of EU/EZ treaties, but I toss it out to stimulate discussion.
Update: thanks to Steve Hamlin for pointing out my typo in paragraph 2 — see his comment below.
Bubbles are easy to spot.? Wait, don’t most people say that bubbles are impossible to spot?
I’ll say that again: bubbles are easy to spot.? Why?? People have the wrong theory on bubbles.? They listen to those that don’t understand the efficient markets hypothesis, and think, “Prices are always fair predictors of the future.? I don’t have to think about the future as a result.” (It would be better to say that current prices are the short-term neutral line against which bets are placed.)
Don’t listen to academics on bubbles.? There have been booms and busts as far back as we can see.? If markets tend toward equilibrium, that is very well hidden — please require economists to take courses in history.? I mean this; I am not joking.? Neoclassical economics is not? a science; it is a religion, and with much less historical evidence to support it than Christianity has to support the historicity of the resurrection.
Spotting bubbles gets easier when you don’t simply look at rising prices.? It is better to look at what is driving the rising prices.? How are players financing the purchase of assets is more important to view than even price trends.
It is hard to get a bubble without having an increase in debt-finance.? Financing with debt is cheaper, and riskier than financing with equity.? Financing long-term assets with short-term debt is even cheaper and riskier than financing with debt that matches the term of the asset.? Most bubbles end with some sort of financing time-mismatch, where the inability to renew short-term indebtedness in order to hold the asset leads to a panic, which leads some to say, “This is a liquidity crisis, not a solvency crisis.”? When you hear that leaden phrase, ordinarily, it is a solvency crisis, with long-dated assets of uncertain worth, and near-term liabilities requiring cash.
This is why the simplest way of looking for bubbles is to look for where debt is increasing most rapidily, and where the terms and conditions of lending have deteriorated.
But where do we have these issues today?? Let me offer a few areas:
We have a chain of financing arrangements in the Eurozone where many banks might have a hard time surviving the failure of Greece, Italy, Portugal, and perhaps some other nations as well.? Failure of those banks might lead to bailouts by national governments and/or a significant recession.? Anytime financial firms as a group would have a hard time with the failure of a company, industry, government, etc., that is a sign of a lending bubble.
There is a major imbalance in the world.? China trades goods to the US in exchange for promises to pay later.? Creditor-debtor relationships are meant to be temporary, not permanent as far as governments are concerned.? There may never be a panic here, but so long as the US retains control of its own currency, it is safe to say that they will never get paid back in equivalent purchasing power terms as when they exported the goods.
China itself, though opaque, has a great deal of lending going on internally through its banks, pseudo-banks, and municipalities, a decent amount of which seems to be for dubious purpose at the behest of party members.? The government of China has always been able in the past to socialize those credit losses.? The question is whether covering those losses could be so large that the government follows an inflationary policy to eliminate the debts amid public discomfort.
AAA and near-AAA government debt has been the most rapidly growing class of debt of late.? Maybe AAA governments that are unwilling to cut spending or raise taxes are a bubble all their own.? Remember, when you are AAA, the rating agencies let you make tons of financial promises — think of MBIA, Ambac, FGIC, AIG, etc.? Only when its is dreadfully obvious do the rating agencies cut a AAA rating, but once they do, it is often followed by many more cuts as the leverage collapses.
Now, my view here is both qualitative and quantitative.? To find bubbles there are indicators to watch, such as:
Low credit spreads and equity volatility
Low TED spreads
High explicit/implicit leverage at the banks
High levels of short term lending/borrowing (asset/liability term mismatches)
Credit complexity and interconnectedness
Poor Credit Underwriting
Carry trades are common (many seek free money through seemingly riskless abritrages)
Accommodative monetary/credit policy
All manner of things showing that caution has been thrown to the winds and lending is done on an expedited/casual basis is a sign that a bubble may be present.? Kick the tires, look around, analyze the psychology to see if you can find a self-reinforcing cycle of debt? that is forcing the prices of a group of assets above where they would normally be priced without such favorable terms.
Not that this analysis is perfect, but it follows the broad outlines of Kindleberger and Chancellor.? Speculative manias are normal to capitalism; don’t be surprised that they show up.? Rather, be of sane mind, and learn to avoid participating in manias, long before they become panics or crashes.
The insurance industry is badly regulated, but it is much better regulated than the banking industry.? Consumers have better protections under state regulation.? The states are closer to consumers, and further away from insurers.
In order to change policy in a given state, an insurer would have to develop leverage over legislators, and that is tough, unless you are an in-state insurer.? But at the federal level, there is only one target, and a lot of resources can be deployed, because the payoff will be big.
Beyond that, state regulators are not so smart, and that is a good thing.? That means they will resist sophisticated schemes for solvency and consumer protection on which a sophisticated national regulator would sign off.
It is a lot easier to beat one gorilla than 50 monkeys.? Regulatory capture is a lot harder at the state level, so my recommendation would be to hand banking regulation over to the states.? After that, we can reduce the Fed down to the FOMC and NY Fed, and break their stranglehold on macroeconomics given all that they fund in academia.? End the regional Feds; they don’t do much anyway.
The idea is to get the government out of the lending business, because they aren’t very good at it.
If we would be more radical, end interstate banking.? This is a simple solution to the too big to fail problem.? If JP Morgan becomes 50 banks tomorrow, guess what?? None of those 50 banks would be big enough to cause a systemic crisis.? Same for Citi and Bank of America.? Too big to fail would be solved instantly.
My main point is this: if you don’t want banking regulation corrupted by the banks, then decentralize regulation, making it much harder for banks to aim at a single target.
Disproportionately, value managers are buyers of financial stocks.? This is a result of index construction, because financials trade at relatively low multiples of book value.? Financial stocks led the rally from 1987-2007, and for the most part, it was a good era for value investors.? Value investors tend not to focus on macro concerns; they just want to pick good stocks.
But what the value managers did not appreciate was that a lot of the outperformance of financials stemmed from the willingness of the Fed to engage in a reckless monetary policy that never allowed recessions to clear away the bad debt, and thus the debt/GDP ratio kept on building.? Along with that, poor bank regulation, led by the Fed, drove a decline in underwriting standards.
Well, no surprise that value managers did badly 2007 to the present.? And they will still do badly as debts are deflated, to the extent that they own banks.? There will come a time to own banks, but I think we have to go through one or two more macro-shocks before overall debt levels are reconciled.
I own no banks or REITs.? I own a number of insurers, all of which are conservatively managed.
The world yearns for debt relief.? There are many debts that will not be repaid at face value.? Better to recognize those realities now, and seek a compromise.? What’s that, you say?? Banks that lent the money won’t survive at the current market quote for the debts?? Best to take the bank into conservation NOW, and strike deals with their creditors.? Mark-to-market accounting should be the friend of regulators, letting them act to conserve institutions that have financed illiquid assets with liquid liabilities.
Where do we need compromises?
In Europe, Germany, France and the Netherlands need to realize they will not get full payment from Portugal, Ireland, Italy, Greece and Spain.
China and OPEC need to realize they will never get full payments from the US.
Japanese citizens need to grasp that their government will never make good on all of its obligations.
US citizens need to understand that Medicare is out of control and must be reduced, somehow.
US citizens need to get that promised benefits to municipal pension plans are too high.
Many mortgages are deeply under water, in the US and abroad.
Many loans made by Chinese banks to Party projects are not money good.
If the creditors will realize that the odds of getting par are close to nil, then a real negotiation can begin where the true value of the asset can be recognized.
Our world can be productive again, once we wipe clean all of the bad debts.? One thing that I admire about credit default swaps, when a credit event occurs, the process is clean and rapid, and relatively little cash changes hands.? Would that it could be the same for clearing debts in our more complex world.
In one sense, this is just recognizing reality before one is forced to do so, which is an admirable discipline.? The alternative is extend and pretend.? Loan more money, because for some reason unknown, it will recover.
That is no relief; it only increases the burden.? There needs to be reductions in principal, rather than rates.? Banks that don’t agree with this need to be handed over to the FDIC.
Don’t get me wrong, this is complex, but banks need incentives to shore up their balance sheets, so that they can lend once their position is solid.
As I have said from the beginning, if you want to solve this crisis, one must reconcile all of the bad debts.? Lenders need to take their hits.? Governments should liquidate bad banks, but make creditors as whole as possible.
I’m not an expert on game theory, but the rule of thumb I have run across is to win in games with more than two parties, you must assemble a coalition that has more than 51% of the aggregate power within the game.
Practical rule number two is that the one on the winning side that arranges/controls the communications/relationships tends to walk off with a larger proportion of the stakes won in the game.
I learned this early as a young actuary working on my pricing models, and noted that those that really made out well in insurance were the successful agents.? They brought two parties, insured and insurer together, who most of the time would not have found each other.? Then, they did policyholder service for the company and the customer controlling the flow of information in the process.? There were times when I thought it would be useful for the company to talk more directly to the insured, but marketing sometimes objected, and so we didn’t.? The agents owned all the loyalty in the transactions.
As an older actuary, I saw this writ large when I was running an annuity division.? Using regression, I did what I think was one of the industry’s most advanced studies of deferred annuity withdrawal.? The Society of Actuaries produced a similar (but broader) study roughly one year behind me.? One of the main results of the study was that withdrawal rates spike when the surrender charge ends.? The reason is because most agents try to roll the business to a new product so that they can earn another commission.? (Trivia note: I learned that those policyholders that did not roll along with the agent were very sticky business.)
Multiparty transactions exist because there is something complex going on, and the multiple parties each serve a need, providing a service, or eliminating a risk.? Let’s move to the concept of buying a house.? Here is my informal list of all of the parties:
Buyer
Seller
Realtor for the Seller — helps convince the buyer to buy.
Realtor for the Buyer, or, sub-agent for the seller — helps the buyer find a good property to buy.
Title insurer — assures that there are no mistakes in the transfer of title.
Mortgage insurer — insures mortgage lender against default when there is little equity for the buyer.
Property & Casualty insurer — protects the lender and buyer against losses from property damage, or injury to people on the property.
Mortgage lender (first lien) — provides most of the money for the purchase
Mortgage lender (second lien and beyond) — provides some money for the purchase, but in foreclosure gets paid after the first lien lender.
Appraiser — gives an estimate of the value of the property so that the first lien lender does not lend too much.
Home Inspector — finds defects in the property so that the buyer can adjust his price down.
Taxation authorities — collect taxes, so that services that make the community livable are provided.
Community Association — enforces neighborhood standards, so that property values are enhanced.
There are more, but I can’t think of them…
Note: I did the “smiley-face” version of the roles parties play in the process.? I could have done the cynical version, but didn’t.? Also note that not all of the parties are needed on a given transaction.? The complexity erupts because the buyer needs to borrow to complete the transaction, and the lender wants protection.
Now, going back to my earlier thoughts, in this case, the first-lien mortgage lender has things set up to his advantage.? Many of the parties to the sale of a house exist to protect his interests.? It is the dominant party in this sort of transaction.? This leads to two current problems:
Mortgage reinsurance captives owned by banks originating the loans.
P&C Insurance that is forcibly placed by the lender when the buyer does not make P&C insurance payments.
In addition, lenders that originate low down payment mortgages often force the mortgage insurers to cede low-risk parts of the business to reinsurance captives controlled by the lenders. This is a continuing problem, with many of the mortgage insurers refusing to go along with the most uneconomic reinsurance deals.
It got worse from there, with more mortgage insurers giving in, and lenders demanding a larger proportion of the profits.? Nominally they were reinsurance premiums, but for the most part they were closer to being commissions.? Why did the mortgage insurers go along with this?? Because the first-lien lenders were the dominant party in the transactions, controlling most of the other parties.? As a result, borrowers putting small amounts of money down ended up paying more for their mortgage insurance because of the pseudo-commission paid to the mortgage lender because of the captive reinsurer.? As I have sometimes said, “Reinsurance is the ultimate derivative; it can obscure almost any transaction.”
On force-placed insurance I have written as well, and it sounds a lot like this post.? The similarity is that the insurance is primarily designed to protect the mortgage lender, and the mortgage lender again collects a commission in the process because it is at the hub of communications.? The mortgage agreements give them discretionary power.
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My simple rule to average people when involved in complex transactions is this: be cynical.? No one is interested in your well-being, and most of the transactional terms are skewed against you.? To the extent that you can borrow less, and eliminate some of the parties that would be a part of the transaction, it is to your good that you do so.? The best situation is that you buy for cash, if you have it.
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Now, this same sort of analysis can be applied to securitizations, and other multiparty transactions.? Watch for who has control; it is a valuable option to have.? But that is an essay for another day.
Chinese Capitalism isn’t magic.? Some parts are a little sketchy.? There are several difficult to sustain aspects of Chinese economic/financial policy.
1) The banks are basically extensions of the Chinese government.
2) Loans that the banks make are often politically motivated, made to those connected within the party; many of those loans are not economic, and the loans don’t perform.
3) Asset management companies are formed to absorb the bad debts when they become a risk to the banks.? These are funded by the Ministry of Finance, which effectively shifts losses back to the government in an indirect way, often via the People’s Bank of China.
4) China has massive foreign currency reserves, but the ability to use them domestically is limited.
5) Since 2008, forcing the the banks to lend has accelerated.? In understanding the indebtedness of the Chinese nation, one must aggregate and net the debts of the banks and other financial entities sponsored by the government.? In the US, that would mean adding and netting the debts of the GSEs.
6) The financial markets of China are bank-centric.? The bond market does not play much of a role, except that the banks absorb many of the bonds, sometimes at negative interest spreads.
7) Chinese finance can be very complex, with difficult-to-understand flowcharts for cashflow and promises, some of which hide bad debts eventually absorbed by the PBOC.? They are another example of how structured finance can obscure economic results.
8 ) When companies went/go public in China, the rewards often disproportionately went/go to party leaders and friends/family thereof.
In short, what privatization has happened in China has benefited those connected to the Party, while the banking sector the economy is the slave of the Government, despite the offering of shares to the public.
I recommend this book highly, and think the authors did a good job in being realistic about China and its financial economy.? China has a weird economy.? They could subsidize and own businesses explicitly, but instead, the subsidies are hidden inside financing.
But wait, what is the endgame here?? If all of the banks are mere extensions of the government, once inflation gets large enough, the Chinese government will have to modify/abandon what they are doing.? China steals from its consumers (financial repression) to aid its producers, who in turn give money to the Party, with whom the producers are in league.
Full disclosure: I asked the publisher for the book and he sent it to me.
If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)
Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.