THE BEAR'S
LAIR The
waning of finance By Martin
Hutchinson
Wall Street's 2011 results were
disappointing and the howls of banker anguish over
shrunken bonuses have reverberated through the
better Manhattan restaurants, bars and clubs. The
rise in financial services' share of the economy,
seemingly so inexorable, has at least paused. Is
this merely a blip, or is it the beginning of a
reversal, in which financial services returns to
its historically modest position in our economic
life, and other forms of wealth creation take its
place?
The increasing share of financial
services in gross domestic product (GDP) has
apparently been inexorable since World War II.
Taking the "finance and insurance" sector of the
national accounts as a benchmark, its share of GDP
rose from 2.4% of GDP in 1947 (the first year
available) to a local peak of 4.3% of GDP in 1972.
Then it was flat for a few years, surged during the
1980s to 6.0% of GDP in
1987 and surged again in the 1990s to a peak of
8.2% in 2001.
That later peak was not
surpassed during the housing finance boom of the
mid-2000s, surprisingly, but was finally topped in
2010, in which the sector represented 8.5% of GDP.
Thus the surge in financial services activity is
consistent and long-term, nearly quadrupling as a
share of GDP over the last 63 years.
At
first sight, that makes it appear as though
financial services' growth is an inexorable
feature of a modern economy. However, if you go
back further, recognizing that GDP figures before
1947 are not very accurate (the concept was only
invented in 1934) you will see a further surge in
financial services, from a low of about 1.5% of
GDP in 1880 to a peak around 6% of GDP in 1929 -
followed by a catastrophic drop during the
Depression and World War II.
The 1930s
decline in financial services income is not
surprising. Stock brokerage and investment
management, which had been becoming major
businesses by 1929, were decimated by the
downturn. The Glass-Steagall Act, separating
commercial from investment banking, may have been
useful safety legislation, but it resulted in the
de-capitalization of brokerage and underwriting
businesses, leading to a dearth in public debt and
stock issues in the late 1930s such as had not
been seen since before the Civil War.
Home
mortgage lending, conducted in the 1920s without
government guarantees but on unsound principles of
10-year maturities and inadequate amortization,
was equally decimated by the decline in house
prices. Deposit banking was badly damaged by the
disappearance of one third of US banks in 1932-33.
Only insurance remained a stable and
reliable financial services product, and seems
likely to have maintained its share of GDP, more
or less. However, the decline in other financial
services was not just a product of poor markets
(thought it was to an extent a cause of them) but
represented a reorientation of the US economy away
from finance - egged on by populist politicians
who found it easier to blame the Great Depression
on finance rather than on their own errors.
It has to be said therefore that President
Barack Obama has so far failed where F D Roosevelt
succeeded, in that finance has not yet declined as
a share of US GDP. That may however be about to
change. (Incidentally, the massive Wall Street
contributions to Obama's 2008 campaign surely
represent in its purest form the adage, supposedly
coined by Lenin, that capitalists will sell you
the rope with which to hang them!)
Once
the current period of artificially low interest
rates ends, its stimulus to asset prices and
leverage will also end. At that point, many of the
products and services that have pushed up
finance's salience will become unprofitable.
One such product that has already declined
from its peak is securitization. In its initial
incarnation, securitization seemed a useful way to
remove excess home mortgage assets from bank
balance sheets and transfer them to investors who
would welcome this new low-risk asset class. The
business was greatly facilitated by the
availability of quasi-government guarantees from
Fannie Mae and Freddie Mac. However, after the
subprime debacle it became clear that
securitization could be used by unscrupulous
operators to originate mortgage loans that should
never have been made.
Today, much of the
demand for securitized products comes from
mortgage real estate investment trusts, or REITs,
leveraged up to the eyeballs and gambling on the
spread between short-term and long-term rates.
Once that spread disappears, there will be a
gigantic glut of this paper on the market as the
mortgage REIT losses wipe out their capital bases.
The home mortgage market will be disrupted, and
will operate only at considerably higher interest
rates in relation to Treasuries.
Finance's
intermediation profits will be correspondingly
diminished, or be wiped out altogether. Fannie Mae
and Freddie Mac will report losses so large that
they may prompt even a spineless Congress to put
those useless behemoths out of business.
The derivatives sector is largely
responsible for the financial services growth of
the past three decades. One of the changes that
have boosted derivatives' salience has been the
practice by industrial companies to treat their
finance departments as profit centers, thereby
encouraging speculative game playing by finance
staff claiming to "hedge" exposures.
As
innumerable investors can attest, the principal
effect of such hedging is to make financial
statements completely impenetrable, so that hedged
oil companies, for example declare huge profits
when prices fall, the reverse of their economic
reality. A little shareholder pressure and
reformed corporate governance should eliminate
much of this activity.
While it seems
likely that interest rate swaps, currency swaps
and their associated options will remain a modest
part of the financier's toolkit, the same cannot
be said of their eldritch cousin credit default
swaps (CDS).
The principles of the Life
Assurance Act of 1774, which forbade taking out
policies on unrelated lives and then arranging
accidents, must be applied to this market, so that
counterparties cannot take large naked short
positions on credit. The legal and payment
uncertainties surrounding these instruments in any
case make them almost pure gambling contracts.
There will doubtless be another financial
crash shortly, in which CDS are heavily
implicated; it is to be hoped that regulators
don't neglect this area after the next crash as
they did after the last one.
Fast trading,
whereby institutions position their machines at
the stock exchange in order to get earlier
information of trading flows, on the basis of
which they trade, is pure rent-seeking and a form
of insider trading. The various Tobin tax
proposals being mooted, while they may do other
damage, should at least cut off this illicit
source of financial services revenue.
Hedge funds and private equity funds have
been major beneficiaries of loose money,
attracting institutional capital by promising
superior investment returns unlinked to the
conventional equity market. It should already be
clear, and is becoming increasingly so to the
dumbest state pension fund and even to the Harvard
endowment, that both these claims are untrue.
In the long run, the returns of hedge
funds and private equity funds are not superior,
especially net of their excessive fees. Second,
those returns are highly correlated to the stock
market, since they depend crucially on the readily
available and excessively cheap money on which all
bubbles are built.
Finally, in Europe
especially, financial services companies have
sought to be universal dumpsters for government
debt. While the pre-2008 belief that government
debt was risk-free was nonsense, in general
financial services entities (unlike some
unleveraged global manufacturing companies) are
not better credit risks than the governments under
which they operate. Hence it makes no sense for
them to hold government debt, other than as part
of their underwriting function.
They have
been encouraged to do so by the spuriously steep
yield curves of recent years, which have
encouraged them to invest in long-term paper while
funding it in the short-term market. Like the
unfortunate First Pennsylvania Bank in 1980, some
of them will pay the ultimate price for this
folly, while others will merely suffer large
losses and be forced to sell off operations and
fire staff in order to survive.
However,
the principal factor cutting back financial
services' share of the economy is the tsunami of
regulation that has been and is being imposed on
the industry as a result of the 2008 crash. This
also happened in the 1930s: the Securities and
Exchange Commission and the Glass-Steagall Act
deflated financial services inordinately, doing
great economic damage thereby.
It is now
clear that the damage from Dodd-Frank's 848 pages
arises not from the Act itself, which was fairly
anodyne and missed many of the better legitimate
targets among the industry's bad practices, but
the regulations it encouraged, which contain a
large multiple of the complexities of the Act
itself. Much of the financial services industry
will be engaged in battling those regulators every
inch of the way, while other parts of its business
will be severely hampered by the rules they
produce.
There are thus three factors
cutting back financial services' share of the
economy. First, there is a natural reaction
against the excesses of recent decades, in which
some of their more egregious business practices
will no longer work and will be abandoned. Second,
an end to the current excessively loose monetary
policy will result in a dampening of speculation
and a reduction (much of it the hard way, through
bankruptcy) in systemic leverage. Finally, the
surge of regulation through Dodd-Frank and the
equivalent European Union regulations will itself
dampen activity in the sector, forbidding some
practices and making others uneconomic.
Just as deregulation from the 1970s
encouraged the growth of the financial services
sector so new regulations, imposed ineptly, will
cut it back as they did in the 1930s.
The
financial services sector may not fall back to the
2.4% of GDP it represented in 1947, but it could
easily fall back to the 4% or so of GDP it
represented in the 1970s, about half the current
size in terms of the overall economy.
The
moral is thus clear: don't put too much money in
bank stocks, and above all, don't waste the lives
of your intelligent offspring by encouraging them
to enter this currently overblown sector, prone to
parasitism in bull markets.
Martin
Hutchinson is the author of Great
Conservatives (Academica Press, 2005) - details
can be found on the website
www.greatconservatives.com - and co-author with
Professor Kevin Dowd of Alchemists of Loss
(Wiley, 2010). Both are now available on
Amazon.com, Great Conservatives only in a
Kindle edition, Alchemists of Loss in both
Kindle and print editions.
(Republished
with permission from PrudentBear.com.
Copyright 2005-12 David W Tice & Associates.)
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