THE BEAR'S LAIR Financial services rust belts
By Martin Hutchinson
Those who have visited Michigan recently or the Mahoning Valley of Ohio in the
1980s can recognize the symptoms of a rust belt. A hitherto prosperous
industry, paying high wages to its employees, has been overtaken by market
changes and is forced into harsh downsizing or even bankruptcy. As a result,
the lives of many inhabitants degenerate into alcoholism, home foreclosures and
welfare.
This time around, the decaying industry is finance, and the rust belt cities
are London and New York.
The parallels with the US automobile industry are closer than they look. In the
early years of the auto industry, it included both large
companies and small specialty manufacturers, the latter being remembered now as
producers of "vintage" cars of very high quality. Then the Great Depression
wiped out most of the specialty producers, which could not compete with the
mass producers' costs. For the next several decades, the business was dominated
by a heavily capitalized oligopoly with extremely highly paid employees, quite
high profitability but deteriorating product quality. Finally, it became clear
that the oligopoly was uncompetitive and the industry began to shed workers and
close plants.
In finance, the early specialty producers were the London merchant banks; for
Duisenberg, Packard and Stutz you can substitute Hambros, Warburgs and Hill
Samuel. They, too, had superb product quality and are remembered with great
fondness by their former customers. They were driven out of the business by
heavily capitalized competitors, in this case running behemoth high-risk
trading desks rather than mass-production assembly-line factories. The
employees of the well-capitalized behemoths were even better paid than the
unionionized, UAW car workforce in the 1950s. Then gradually product quality
began to deteriorate, and bad practices such as "liar loan" securitized
mortgages, accounting "mark-ups" of assets that had not been sold and
self-deluding risk management crept in.
The main difference between the two cases is that the collapse of the finance
sector has taken the form of a sudden Gotterdammerung rather than the
steady but inexorable decline characteristic of the US automobile industry. The
bottom line is the same: Detroit needs to downsize radically, but so does Wall
Street.
As I have written previously, in and after the 1980s the central activity of
the financial sector became not service but rent-seeking. Finance doubled its
share of gross domestic product (GDP) in the 30 years to 2006, but very little
of the addition represented products and services that provided true value to
the economy as a whole.
Securitization was mostly a complex and expensive means of getting assets off
banks' balance sheets. Derivatives helped manage risks, but only a tiny
percentage of the multi-trillion dollar outstandings in the derivatives markets
represented risk amelioration; the rest was just trading noise or outright
speculation. Hedge funds and private equity funds were mostly a means of
multiplying excessively the fees charged for investment management; they almost
drove out of business the true venture capital funds, which had a genuine
economic value.
Principal trading, the most exciting activity of all in the glory years for
greedy investment bank partners, was simply a means of using large amounts of
outside shareholders' capital to trade on insider information about the
market's deal flow. All of these activities were legal; none of them added
value to anybody but their immediate practitioners, while they represented
additional costs and lower returns for everybody else. In other words, they
fulfilled the dictionary definition of rent seeking.
Given the aggression, greed and high intelligence of the average investment
banker, rent seeking can never be eliminated completely. Nevertheless, the
conditions that made it flourish have already changed, and good policy will
ensure that they do not recur in the future. In particular:
Financial complexity is mostly an additional source of risk, and provides
little or no added value to the economy as a whole. A Bernard Madoff-style
Ponzi scheme could grow to the monstrous size it did only in an environment in
which even institutional investors were ignorant and incurious about the way in
which their investment returns were derived.
More than a decade of easy money after 1995 increased asset prices, thereby
providing returns to those who bought assets on a leveraged basis, while making
leverage itself very easy to obtain.
The move from thinly capitalized "Duisenberg" investment/merchant banks,
providing advice to companies and arranging their financing, to behemoth
"General Motors" financial conglomerates that took principal positions in the
securities of companies they advised produced an immense interconnecting web of
conflicts of interest and insider trading opportunities.
Risk management methodologies, which achieved acceptance so great that under
the Basel II regulations "sophisticated" banks were allowed to select their
own, were fundamentally flawed. They rested on an academic theory of efficient
markets that in practice is easily disprovable and represents a very poor
approximation to reality. The prolonged period of easy money and bullish
markets appeared to validate them; we now know better.
Remuneration practices in the industry became far more generous than their
historical norms, more also than that necessary to attract staff of the right
intellectual caliber and other qualities. This was a product of the almost
uninterrupted bull market in bonds and stocks from 1982 to 2007, a large part
of the returns from which was scooped off by financial sector employees who
added far less value than they extracted.
If rent seeking is to a large extent eliminated, it is likely that the
financial services sector will approximately halve in size, returning to around
its 1970s share of GDP. Its usage of capital will decline only modestly, since
the excessive leverage built up in the last decade will need to be corrected.
Conversely, the sector's human resource usage needs to decline by much more
than half - after all, we have a multitude of tools today that allow the
relatively simple functions of traditional finance to be performed much more
efficiently, and with less human input. In addition, with modern
telecommunications technology, many of the routine tasks of finance (including
almost all the non-mechanizable parts of the back office, but also much
research and document preparation) can be performed by well-educated but
lower-paid employees in India or elsewhere. Thus, while the sector's overall
value-added will halve, the portion of value-added attributable to capital will
significantly increase; that attributable to labor will decline.
For the financial practitioners of New York and London, the future is thus
bleak. Rewards will be greatly reduced, as the market operates ferociously both
on the income side and the employee costs side of their employers. Headcount
will also be greatly reduced, as functions are eliminated, work is outsourced
to the Third World and the weaker entities go bankrupt or are merged into
competitors. The decline in practitioners' incomes might be as much as 80%,
even after a modest market recovery, though the number of practitioners should
reduce by only 50% to 60%.
That also promises a weak future for the local beneficiaries from financial
services incomes in New York or London. Such losers would include local housing
markets and those of the smarter resorts, together with the army of real-estate
agents, decorators, construction companies and lawyers that have benefited so
egregiously during the bubble. It would also include local restaurants,
clothing retailers, jewelers and other high-end products and services.
The tourism business will find far fewer takers for the kind of "short break"
luxury sybaritic packages in which it has recently specialized. Thus the
short-term knock-on effect on the overall economy of poorer bankers will be
severe, even though the long-term economic benefits of eliminating the
dead-weight costs of the bloated banking community will be even greater.
The two centers most adversely affected by these changes will be London and New
York. Asian financial centers will continue to benefit from the faster regional
rates of overall economic growth, while as in the 1980s, the problems of Dubai
will spread far beyond finance.
In New York, the "rust belt" effect will be severe but not overwhelming - it
will be 1970s Cleveland rather than 1980s Youngstown. Many of the skyscrapers
of the financial district and the luxury residential areas will become ghost
buildings, as their predecessor buildings did in the 1930s, but they are
unlikely to descend to the chain-round-the facility
guarded-by-a-Rottweiler-and-a-tattooed-thug state symptomatic of the worst
industrial blight.
However, the resemblance to 1970s Cleveland (which defaulted in 1978) will
probably be increased by a municipal bankruptcy. Mayor Michael Bloomberg has
pursued the policy of former New York mayor (1965-73) John Lindsay. He has
increased municipal spending by 52% over six years while prices rose 20%, and
has relied on hefty increases in property taxes to fund the increase. Those
funding sources have disappeared, but we are still only at the stage of
cosmetic cuts and financing gimmicks.
As the downturn continues, New York's fiscal state will become rapidly worse,
and default is inevitable in a year or two. Bloomberg has altered the rules to
allow himself to run for mayor again this November; he would be mad to do so,
since the fiscal deterioration would make his third term a very unpleasant
experience.
London will be the Youngstown of this downturn, an excellent market for
Rottweilers, wire mesh and tattooed thugs. The city's Docklands area in
particular will revert to its 1970s squalor, albeit with some very expensive
buildings scattered around. Few of the financial institutions that have
prospered so lavishly in the London of the past couple of decades are British
owned, and those that are were excessively involved in the British mortgage
market - an even bigger disaster than the US market because home values were
even more outrageous at the peak.
Given that the financial sector will be downsizing anyway, will top management
in Frankfurt, New York or Tokyo want to keep its stable of expensive London
whiz-kids in order to continue participating in a market that was never central
to their overall strategy and is now unprofitable? I doubt it.
Even the Russian mafia may leave, though probably to Cyprus rather than Moscow.
Whereas New York's downturn may produce municipal bankruptcy, London's downturn
has a fair chance of producing national bankruptcy. Going forward, British
youth will have to find a new way to make a living - single-malt Scotch and
tourism cannot support a nation of 60 million people.
Inhabitants of London and New York have spent the last couple of decades
sneering at their provincial cousins, particularly those involved in the grubby
world of manufacturing. Now the Rust Belt has reached them also.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-09 David W Tice & Associates.)
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