Tuesday, August 28, 2012

The last of the financials

Why has the financial sector grown so big in so short a period, that is, in less than 30 years? In fact, before the recent housing bubble bust, the financial sector was the employer of choice for most of the MBA graduates from the top business schools in the US.

Looking at the longest recorded stretch of the credit picture in the US (see chart from The Financial Times below), dating back to 1870 but with the debt components tracked only from 1929, it's evident that debts prior to the 1930s never amounted to twice the GDP. Even though we don't have the breakdown of the debt components prior to 1929, we can reasonably infer that they were stable throughout that period because total debt grew at a measured pace. And the financial sector borrowings, i.e., excluding the customer deposits placed with it, had always remained relatively small even during the Great Depression of the 1930s. So generally banks then financed themselves using equity.

As can be seen in the above chart, the main financing during the 1930s was raised directly by the non-financial corporations in the form of bonds. The corporations lent the money to brokers who relent it as 90% margin loans to their clients who ultimately speculated on the stock market. The failure of these loans however was only a secondary cause of the 1930s Great Depression — the primary cause of all economic depressions has always been excess capacity. Since then, the non-financial corporations have learned their lesson by keeping their debt leverage to reasonable levels.

During the Great Depression, as the non-financial corporations raised bonds directly, the banks, deprived of their traditional loan business to corporations, bought the corporations' bonds. They also wrote loans with only 10% margin requirements to buyers of stocks. About 40% of their loans went to financing stock speculation.  Not content with that, they also speculated directly in stocks. Their participation in this speculation and its financing eventually led to the failure of 10,800 banks. Because of their leverage, the banks are the first to fail — and they fail big — in any economic depression, that is, a condition characterised by a substantial collapse in money supply.

Up until the turn of the 20th century, the banks' leverage was much lower. Their capital ratio was never less than 20% (see chart at left from The Economist depicting the percentage of book equity to book assets, this approximating the capital ratio). However a high capital ratio means a bank has to use more of its own capital which is not as rewarding as using other people's money (OPM) — mainly customer deposits — because the cost of OPM is much lower. A low capital ratio therefore translates into more profits for the bank shareholders, provided the money supply keeps growing at a healthy pace.

But one thing obvious from the above chart is that the banks' capital ratio during the Great Depression was much higher that at any time since. Therefore insisting on the banks to increase their capital ratio wouldn't necessarily shield them from future crises though it may lower the risk of failure, albeit only marginally. However banks in the 1930s were not as big as they are now though there were many, about 25,000. With low capital requirements then, setting up a bank was easy.

There are two intriguing questions here. One is why the finance sector only becomes big now. The other is why the current depression unfolds over a prolonged period rather than like the quick bust of the Great Depression. Remember that the start of this depression can be traced to the collapse of the Japanese stock market towards the end of 1989. For the US, the Dotcom bust in 2001 is the  the starting point. For this post, we'll answer the first question. The second will follow in the next post.

The problem with being big is that once you've tasted bigness, you're loath to scale down since size has its own benefits. But in an economic depression, size doesn't guarantee safety. It just makes the fall that much more catastrophic. The government has to step in to rescue no matter what.

The case of Lehman Brothers is instructive. When Lehman failed exactly four years ago, it had $660 billion worth of assets at book value, making it the biggest corporate bankruptcy in history. Because banks cross-lent to one another extensively, the US Treasury's decision to let Lehman fall soon led to to the seizure of the money market. Market participants pulled back their lending, scared that the counter-parties might go belly up. Only a $9 trillion guarantee and overnight loans by the Fed restored market normalcy. This rescue was never made public; only the much smaller $700 billion TARP rescue fund was. Helped by Obama's four straight years of annual deficits exceeding $1 trillion each, the banks have managed to regain ground and the Fed its money.

We can be sure that the next time around, the Fed won't let another Lehman fall. But by letting the banks grow, the Fed is in thrall to the big banks. However with the depressed state of the economy even four years after the Lehman collapse, the politicians and the Fed have squandered whatever political capital they have left. So it's arguable whether the public can stomach another Lehman-type rescue by the Fed though it's in its interest that the Fed does so.

The debt picture doesn't tell how exactly has the financial sector grown because it looks only from the credit side. We need to see the obverse of debt, that is, the asset or debit side. The chart below from The Economist shows that the financial sector's assets started their relentless increase beginning in the mid 1980s. Now if you look at the debt chart above, you'd notice the similarity in the movements. Bear in mind that both charts reflect the amount as a percentage of GDP. So any movement above 100% means that the assets or debts increase at a faster pace than that of the GDP. The assets are however greater than the debts. This can be easily accounted for by equities which are the only financial assets that are not debts.

Technically, equities perform the same function as money except that they are safe money unlike debts which are toxic money, that is, in conditions of declining money supply. In the lead to a depression, the value of equities will fall but debts retain their value until the moment it becomes unsustainable and snaps. That's why the values of all financial assets and commodities can suddenly plunge.

To be sure, the banks began their growth after the 1973 oil crisis when the US started to suffer increasing trade deficits. The wealth generated by those deficits went to the oil producers who deposited them back with the US banks. But the 1970s were the days of high inflation, so the debt value as a percentage of GDP was contained.

However by 1981, the inflation was brought down by Paul Volcker's harsh interest rate regime. Unknown to many, more influential was the extra capacity brought on by the oil producers who by then had substantially increased both oil production and spare capacity. Essentially since then inflation has been much subdued because technology and globalisation have both been unleashing limitless capacity. Even when commodity prices have gone up, inflation has never reared its ugly head. But inflation did appear in short and sharp bursts particularly for those countries that suffered severe debt crises, such as Korea, the South-east Asians, Sweden and more recently Iceland. Their inflation came stealthily through currency devaluation which was a one-off event, after which price levels stabilised.

It is this low inflation environment that has accommodated the big increase in credit supply and on its heels, the burgeoning financial sector. In an inflationary environment, holding on to financial assets can be detrimental because they may lose value faster than real assets. In contrast, a low inflationary or, worse, deflationary environment favours creditors since their debts hold value even when prices are crashing everywhere. This tremendous debt increase has enabled all sorts of financial outfits — ABS pools, hedge funds, pension funds, and many others — to proliferate and some to grow big.

How will the financial sector evolve once the money supply settles to its natural level? The most vulnerable will be the big banks. When the Fed provided financial assistance during the 2008 financial crisis, it should have been made conditional upon the banks eventually splitting themselves, if for no other reason than facilitating the banks to be shuttered when money supply plummets. The investment banks are already planning to reduce their assets by $1 trillion and costs by $10 billion over the next two years. Whether such reductions are sufficient remain to be seen.

Even George Soros last year returned his investors all their money, foreseeing that there was no money to be made when money itself would disappear. But big funds such as the pension retirement funds are putting more of their assets into hedge funds hoping the hedge funds could outfox the market. The right thing to do should have been to close down the retirement funds and distribute the capital to the retirees, letting them manage their own money. These retirement funds are at risk of being wiped out in the coming money disappearing act.

When these giant financials are gone, there is very little likelihood that they will make a comeback in the Fifth Kondratieff Wave. The new investment of this final wave no longer favours the accumulation of large capital. In future big production facilities will be passe when 3D printing can produce items economically in units of one. Mineral commodities except gold and silver will best be left underground as nanomaterials with better material properties enter commercial use and renewable energy takes centre stage.

As this depression progresses, bid farewell to the financial giants; we'll never see the likes of them again.

No comments:

Post a Comment