Summary:
Economist special briefing looking at Wall Street near-collapse and future changes in financial system; financial services industry racing ahead when economy slowed down; causes and consequences; incentives and regulation (19/03/2008)
Facts and Figures
- American financial services industry
- share of total corporate profits
- 1980: 10% ; 2007: 40%
- share of stockmarket value
- 1980: 6%; 2007: 19%
- accounts for 15% of America's gross value added
- accounts for 5% of private-sector jobs
- value of outstanding credit default swaps: $45tr (2008)
- financial sector debt vs. non-financial debt
- 1980: 1:10; 2008: 1:2
- Leverage of banks
- Goldman Sachs: $1.1tr assets on $40bn equity
- Merrill Lynch: $1tr assets on $30bn equity
Notes:
- American financial services industry from early 1980s to 2007
- share of total corporate profits from 10% to 40%
- share of stockmarket value from 6% to 19%
- account for only 15% of America's gross value added
- account for only 5% of private-sector jobs
- 1982 to 2000, unparalleled bull market for shares and bonds
- something changed in 2001, after bursting of dotcom bubble
- America's GDP growth since then been weaker than in any cycle since 1950s
- growth in consumer spending, total investments and export been correspondingly feeble
- but financial services industry did not slow down; raced ahead of real economy ("as ground beneath it fell away")
- industry been able to boost income and profits by using debt, securitisation and proprietary trading
- investors (hungry for yield) went along
- industry has further combined computing power and leverage to create burst of innovation
- value of outstanding credit default swaps at $45tr
- financial sector debt vs. non-financial debt
- 1980: 1:10; 2008: 1:2
- investment banks trading heavily on own debt accounts
- Goldman Sachs: $40bn equity as foundation for $1.1tr assets
- Merrill Lynch: $30bn equity for $1tr assets
- "In rising markets, gearing like that creates stellar returns on equity. When markets are in peril, a small fall in asset values can wipe shareholders out."
- Banks' course made possible by cheap money, in turn facilitated by low consumer-price inflation
- central banks have conspired with banks' urge to earn fees and use leverage
- previously, credit controls or gold standard restricted creation of credit
- as result of liquidity and "financial firms' thirst for yield," boom in American subprime mortgates
- tendency for financial services to go over cliff is accentuated by financial assets' habit of growing during booms
- by lodging their extra assets as collateral, intermediaries can put them to work and borrow more
- since 1970s, debts have grown faster than assets during booms
- banks using borrowed money to buy more of the securities they lodged as collateral; raises prices of the those securities; enables banks to raise more debt and buy more securities
- "pro-cyclical leverage" feeding on itself
- banks get punished by shareholders if they sit out next round
- "bank trapped in a dance it cannot quit; but sooner or later music stops"
- mechanisms that create abundant credit will eventually also destroy it
- "most things attract buyers when price falls, but not necessarily securities"
- financial intermediaries need to limit their leverage in falling market; sell assets; lowers price of securities; puts further strain on balance sheets leading to further sales; continues until those without leverage will buy
- cycles not necessarily result of poor monitoring or huge incentives; human nature; competing with star trader next door
- but pay and lack of regulation probably made this crisis worse; proper incentives needed
- prediction that in future senior executives will face prospect of some of their bonuses being contingent on bank's performance over several years
- but is already the case: many senior bankers paid in shares they cannot immediately sell
- e.g. Bear Stearns' employees owned third of company; already looking to longer term
- more regulation?
- regulation does not just offer protection, but also clever ways to make money by getting around it
- capital reserve requirements set up incentive to create structures free of capital burden (e.g. 364 days credit, "not permanent")
- hundreds of billions of dollars in SIVs and conduits to get round the rules
- reformed capital adequacy rules needed, monitor this shadow banking rigorously
- gaming on boundary between AAA and other bonds, passing off poor credit as AAA, making a lot of money, for a while
- financial industry likely to stagnate or shrink in next few years
- partly because last phase of its growth was founded on unsustainable leverage
- partly because value of underlying equities and bonds unlikely to grow as in 1980s and 1990s
- foolish regulation may make it worse
