Signs have multiplied recently that all is not well in the overworked, overpaid world of Wall Street. The Chairman of Morgan Stanley has been forced out, quarterly earnings are coming in generally down, and both JP Morgan Chase and Citigroup have been zapped with $2 billion legal settlements for misguided corporate finance work. Are these apparently independent signals random noise or the clucking of chickens coming home to roost?
The financial services industry has had an immensely good quarter of a century, growing hugely as a percentage of United States output, or indeed of the world’s output, but this has been concentrated in relatively few areas. Of the businesses that were considered part of the financial services world in 1980, corporate lending has shrunk as a percentage of the whole, arbitraged away by the capital markets, while insurance has had a fairly grim 25 years, as trial lawyers and decreasing risk aversion in the population have combined to shrink the size and profitability of this business (few today use life assurance as a form of saving, for example.)
On the other side, a number of mundane financial services businesses have shown explosive growth, and new businesses have become major profit earners:
Consumer revolving credit outstanding (mostly credit card balances) grew from $53 billion in April 1980 to $796 billion in April 2005 or from 2.1 percent to 6.8 percent of the previous year’s Gross Domestic Product. Margins in this business improved sharply over the period, as market interest rates dropped while credit card interest rates tended to rise and fees soared.
Home mortgage loan applications increased over the period from 1.3 million to 41.6 million, thus multiplying about 20-fold per head of the U.S. population. Savings and loan associations, the traditional originators of home mortgages, effectively disappeared, but were replaced by a huge home mortgage secondary market. This may have made home mortgages cheaper; more important to the industry it revolutionized the volume of fees that could be charged at all stages in the process.
New York Stock Exchange trading volume has increased from 53 million shares per day in January 1980 to 1,451 million shares per day in the first quarter of 2005, or from 21 to 124 shares daily volume per million dollars of nominal GDP – i.e. volume is up six-fold in terms of the size of the economy. Since the NYSE’s share of total U.S. trading volume has declined from roughly 70% to 40%, the overall increase in share trading has been correspondingly higher.
The derivatives business hardly existed in 1980. The first interest rate swap was done in 1981; at December 2003 there were $111 trillion principal amount of these outstanding — thus roughly $5 trillion of fixed and floating rate interest payments are made (or netted) on these contracts each year. The currency swap did exist in 1980, but its outstanding volume was maybe one thousandth of 2003’s $6.4 trillion principal amount. The options market was an obscure corner of the industry in 1980, in 2003 $28.9 trillion principal amount of these contracts was outstanding (and if you think all those were properly hedged and accounted for, I’ve got a bridge to sell you!) Then there’s the latest wrinkle, credit default swaps, of which $8.4 trillion were outstanding in December 2004, more than double the figure of a year earlier.
Whereas the financial services industry in 1980 was dominated by commercial bankers, and was still run, even at an operating level, by executives over 50, today the trading and position taking desks are by far the greatest revenue and profit generators, while commercial banking and conventional corporate finance have shrunk relatively in importance. Consequently, only the most senior people in the industry, whose role is largely limited to management rather than deal-making are over 40, and the general expectation is that participants will make “drop dead money” by about 35. This cultural change is very important indeed; if the Wall Street money machine ever stops churning out gigabucks, and its denizens are forced to work for a living over a full career like normal people, we can expect their thwarted angst to produce a series of financial scandals and disasters that make Enron look like a tea party.
The big question must therefore be: is there an end to this gravy train, or is a bloated financial services sector a permanent feature of the U.S. and world economy? If the latter’s true, it’s probably not a good thing. While Gross Domestic product per capita is theoretically maximized by operation of the free market, which in this case is producing wealth for millions of financial service sector employees, a great deal of that wealth appears on close inspection to be extracted from the pocketbooks of the sector’s customers, without any great obvious benefit to the latter.
If credit card debt soars, consumption is increased for a time, but eventually more and more of the consumer’s disposable income is absorbed by interest payments and so he either files for bankruptcy or struggles with his mountain of debt, accepting a lower living standard while doing so.
If home mortgage debt soars, there is some benefit in enabling consumers to achieve liquidity by refinancing their homes, but in the long run this liquidity simply raises house prices in relation to income, enriching builders temporarily and owners of undeveloped land within even the most distant reach of cities, but lowering living standards in the long run as everyone struggles to service a larger mortgage or accepts inferior housing.
If share trading volume soars there is some benefit to large institutional investors, who achieve better liquidity on their large holdings, but little to the individual investor, whose spread on a typical 100 or 1000 share order of corporate stock may well be wider than in 1980 (it almost certainly will be wider if the share is relatively illiquid and traded electronically.)
Derivatives are essentially a zero sum game. They provide the ability to hedge an exposure, but for every gain on a derivatives position there is an equal and opposite loss somewhere else, and much of the volume and profit in the market is made from scalping less sophisticated investors, or organizing complex multi-market derivatives products, the cost of which can safely be hidden in the footnotes to the financial statements of a large company. “Extraordinary items” – those losses that do not flow through the income statement but are deducted directly from the corporation’s capital account – have soared as a percentage of net income for the Standard and Poors 500 companies in the last 20 years; much of this increase can be traced to hurried and well hidden recognition of unexpected derivatives losses.
In summary, large parts of the financial services business are parasitic, in the sense that they extract wealth from the system without providing equivalent value. While participants in the financial services business are enriched by this activity, it impoverishes by an equivalent or greater amount the rest of the community. A certain amount of downsizing in this business is thus likely to be a net benefit to the U.S. economy as a whole.
To assess the likelihood of such downsizing, imagine a world in which the obvious imbalances in the current U.S. economy have been corrected, as some day they must inevitably be.
The savings rate has increased, so consumption has been depressed and credit card balances are being drawn down (although there has been a concomitant increase in bankruptcy filings.)
House prices have ceased to soar, and long term interest rates have increased. Accordingly, there is very little mortgage refinancing, and the volume of new home mortgages has dropped sharply. Defaults on “interest only” and “adjustable rate” mortgages have soared.
The stock market has fallen back, and equities have fallen out of favor, while the huge funds flows from overseas into the U.S. economy have diminished. Accordingly, trading volumes are well down. Also, a lot of deals that looked good when the market was rising and IPO or private equity money was easy to come by have turned sour. The trial lawyers are swooping in for the kill.
A prolonged period of inverted yield curve, where short term rates are higher than long term rates, has both reduced the profitability of bond trading and converted into loss many of the derivatives-driven profits that have sustained Wall Street since the Fed eased short term rates in 2001. Huge unexpected losses have been reported in interest rate swap portfolios, options portfolios and above all in credit swap portfolios, a product as yet untested by downturn. Consequently derivatives volumes are down, as is the enthusiasm of major corporations for complex derivatives-driven hedges that may increase profits in the short term but produce unexpected losses thereafter.
In such an environment, the profitability of Wall Street would be decimated, and its youth-oriented get-rich-quick culture damaged, probably beyond repair. The share of financial services in overall output, which has grown so greatly in the last quarter century, would be sharply diminished.
— Which would on balance be very good news indeed for the rest of us!
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.