11 April 2009

Devil's Advocate

As our economic woes deepen, everyone is eager to place blame at the feet of whatever nemesis his or her ideology deems fit. On the right, this entire downturn was precipitated by undisciplined and untrustworthy individuals getting sub-prime mortgages to buy homes outrageously out of their price range and then defaulting on said mortgages…triggering an avalanche that eventually lead us into the current credit crunch. Furthermore, many will claim that lenders were forced to do this because of federal “fair housing/lending” and “anti-redlining” regulations.

On the left, there is an agreement that sub-prime mortgages are at the heart of this mess, but blame is placed on the unscrupulous brokers who apparently tricked unsuspecting (and admittedly unsophisticated) homebuyers into taking risky loans just to make a quick commission, and on the “financial geniuses” who devised the now toxic “collateralized debt obligations” as well as other exotic derivatives. From this view, the whole of the rest of the cascade of events that has brought us to this point is entirely the fault of greedy (and by virtue of this unraveling—incompetent) executives, brokers, and associated “money-men.”

My view
I say there is enough blame to go around; we ALL contributed to this mess! Collectively and individually, as corporations, and governments—almost as a rule—we overextended ourselves in respect to debt; and from the most unsophisticated wage earner to the brightest minds working in the most prestigious investment firms, we all assumed that asset values, growth, and incomes would only go up. This crisis is finally the slap in the face that we all needed: we cannot borrow our way into prosperity! As the offspring of depression-era, immigrant parents, financial discipline and thriftiness was ground into me from an early age, so I have been aware of—and avoided at all costs—the trap of living beyond ones means. Never the less, I will not even hold myself blameless; I truly believe that all of us in the materialistic west have some culpability in this mess.

No doubt, new government regulations addressing the problems that got us into this mess will be soon be put into effect; unfortunately, as backward-looking legislation, they will generally not address those issue that will eventually precipitate the next economic crisis. In fact, it is almost impossible to predict the future in this respect. The only thing we can hope for is that the laws our governments are creating will make the financial world a little more transparent; the bright light of transparency in the murky world of finance is the only reform that, in the long term, really ever works.

What I find disturbing though, is this “eat the rich” sentiment that lumps all executives and everyone in the financial industry together as greedy, incompetent, and useless. There is a disconcerting air of bolshevism in a lot of the rhetoric I’ve been hearing lately. Yes, a lot of the financial middlemen will rightly lose their jobs, and I admit that I feel a certain schadenfreude in seeing the business school colleagues who went into the finance specialty losing their lucrative positions. However it is naive to think that these functions are unnecessary and that “workers can control the means of production,” as the communist experiment of the last century disproved. We will always have executives and financiers who—by virtue of their extraordinary skills and intelligence—will demand and receive compensation commensurate with their abilities, just as highly skilled entertainers and athletes do without question.

The worst possible outcome would be the introduction of salary caps; they would most certainly be circumvented, further muddying the waters of the business and financial worlds—the opposite of what we want: transparency! Likewise, a ban on derivatives (which given the simplest definition—a bet on an underlying security—sounds like a good idea,) but would contribute more opaqueness, as these instruments would be reinvented in other forms. These exotic vehicles actually have a legitimate use: they hedge and balance other business transactions.

I am generally not in favour of “rescue packages” for private businesses, even large ones like General Motors that will effect dozens or hundreds of partners, thousands of employees, and maybe hundreds of thousands of others not directly employed by the company. I just have an aversion to anything that creates a distortion in the marketplace, be it subsidies, regulations, or taxes that affect one company or industry more severely than another (or, more perversely, prevents a business from entering a certain field/industry or—in the current situation—prevents it from failing/dissolving.)

That being said, I do understand why large financial institutions cannot be allowed to fail, as the resulting banking and credit crisis the would cause the entire economy grind to a screeching halt. Therefore the questions are: “how are bailout funds to be used” and “who decides how the money is used.” Specifically, whom do you trust more to “save” these firms: corporate executives—the rascals that caused (or at least contributed) the failure, or the rascals in Washington (or where ever your lawmakers/bureaucrats reside.) Quite frankly, I’m not sure of the answer myself.

Where does the money go?
On the most basic level, the problem with these troubled institutions is that their balance sheets were out of whack: their assets no longer equaled their liabilities, and therefore the government infused this money—fixing the problem. Now the question is: what happened to this bailout money? There aren’t little cubbyholes in the company’s treasury for general funds, bonus funds, electricity expenses, etc. it just become part of the company’s assets and is used in the same way that all the rest of its assets are used—fulfilling the company’s obligations to its stakeholders: investors, partners, employees, vendors, and yes—executives.

When you or I start a job, we generally negotiate or just accept a certain hourly wage or weekly to monthly salary plus a possibility of a bonus and benefits. At a certain level, these wages/salary become trivial compared to the prospect and promise of bonuses, stock options, golden parachutes, etc. Corporations must make these lucrative offers in order to hire & retain the best and brightest in the field, just as professional sports team have to offer star players multi-million dollar contracts. To those who are outraged at bonuses paid to executives at failing companies such as AIG, I ask: “where do you make the cutoff?” Imagine that you cut all bonuses and stock options for a CEO who earns a salary of $1 per year (actually very common), what is he to do? Furthermore, with this reputation, how do you expect to hire a new CEO in the future? Remember, in 1994, Ben & Jerry’s Ice Cream initially insisted that they would only pay their CEO seven times what the lowest paid employee made; despite their progressive credentials, they soon had to abandon this promise in order to find an individual of the caliber needed to guide what had become a large corporation.

Regardless of what new regulations are enacted, we are seeing the end of the secretive back-room dealing-making that has characterized so much of the financial industry. Even if governments do nothing, the market will demand more transparency and lower costs (spreads) for financial transactions. The result will be higher returns for investors and less cost to borrowers, which of course means lower earnings for the businesses and individual that broker these transactions…and, of course, less of those high-paying financial-sector jobs.

More specifically, we will see a convergence of returns. We all know that riskier investments demand higher returns. This relationship is not punitive—it is not just to punish the reckless—it is to cover the inevitable losses that riskier investments entail. In the long-term everybody gets about the same return plus a premium proportionate with the volatility the investor must endure. What everyone has looked for was that elusive, safe investment with a higher than normal return. While there have always been a few of these, I predict that these “secret” investment will all but disappear, to the point at which we can finally say with certainty that the outliers on the risk to return graph are definitely scams (as should have been obvious with Madoff.)

The one bright spot for governments investing (and it is not just the US Federal government that is doing this) in private industry is that they are buying in at a low point; In a few years they will almost certainly have realized a substantial profit—at which time they should divest of these private concerns. It is a mistake to think that these bailouts are a gift from government to private industry; remember that Chrysler was bailed out in 1979, and by 1983 had totally repaid it 1.5 billion dollar loan to the government.

I find that, as individuals, this hand-wringing and finger-pointing is entirely useless; what does it help you or me to assign blame to this or that group, person, or ideology? In a time of turmoil such as now, it is prudent for a bright, young person to look around and ask, “where is this going, and where should I place myself to benefit from the inevitable changes ahead?” I really think now is the time to position oneself for the new business, regulatory, and financial climate that is coming upon us, and I am convinced that it will be characterized by more transparency—and therefore be more information-oriented, and consequently utilizing more information and communication technologies.

We have seen part of this technological revolution in finance on the personal investment front; we no longer call our broker to place a trade (from which he would take a percent or two in commission.) Instead we log on to our discount brokerage website and enter trades ourselves for a fixed $12-$15! Furthermore, on the NASDAQ stock exchange, there isn’t even a trading floor; it all takes place inside of computers. Yes, there are still brokers and market makers, but we’re definitely seeing the disintermediation of actual human beings transacting financial business. Likewise, we see that the computers of Experian, Equifax, and TransUnion (in communications with the computers of nearly all consumer credit providers) automatically determine an objective credit score for nearly every adult in America. Even loan origination (well, shopping at least) is being automated by sites such as LendingTree.com.

The ratings of corporate entities however, have long been suspect. With this crisis, we have confirmation that the stars and letter grades assigned to bonds, equities, and derivatives by the likes of Moody and MorningStar are worthless. So the obvious need is an objective system like that of the FICO (300-850) credit scores assigned individuals. I assume that someone like Dun & Bradstreet is ideally positioned to fill this need. Obviously you can’t as readily assign a single number to represent the fiscal health of a complex organization with all its divisions, subsidiaries, assets, investments, and liabilities, but together with governmental and market pressure for more transparency, I am convinced we will see the creation of one or more objective, independently audited corporate/financial rating service.

With the availability of all this data, the next obvious step is an electronic marketplace where businesses and investors can transact short and long-term lending directly without the packaging and interference of financier or their hefty commissions.

So, dear reader, if you agree with my predictions, how do you think an IT nerd with an MBA like me should position himself to catch this next wave? More specifically, where is this financial information revolution going to start—geographically and with what companies/groups? (Obviously I’m not talking about the existing and useless “financial news” industry that just speculates and rehashes earnings reports, annual reports & 10-Qs, nor the endless speculation of pundits.) I’m serious about this; I would appreciate any advice.
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