Conflicts between what’s good for shareholders and what’s good for society are subject to debate. Even those with a high priority on social welfare don’t necessarily want all their pension dollars to be invested in a “socially responsible” fund.
So why do so many assume that the private sector is always better than the government alternative. It may be because they are relying on a selective memory of their favorite companies with the benign, reliable customer service department. Or maybe they are just not aware of the less attractive side of corporate capital. Maybe we don’t have a clear idea of the damage excesses of free enterprise because they are not as well publicized. The banking sub prime meltdown should serve as a curb on enthusiasm about the cleansing attributes of free enterprise, but only if you know how we got here.
Since the 1960s, some of the larger U.S. commercial banks started to take on the profile of growth stock companies. Traditionally, banks had been content to earn steady and modest profits by serving the needs of mostly corporate clients. The so-called money center banks and their large regional competitors increasingly want to have their shares traded like the stocks of glamor “growth companies”. Instead of steady and stable profits, growth companies are able to maintain high stock prices with respect to their earnings (high price–to-earning ratio) if they can deliver reliable growth in quarterly earnings over several years. They preferred to be valued more like Polaroid in the 1950s, IBM in the 60s and 70s, or CISCO and Microsoft in the 90s. They participate in the quarterly earnings season frenzy promoted by outlets like CNBC where stocks prices are rewarded and punished depending on how well they matched the market expectations of their earnings per share. To maintain their growth status, they must increase their earnings per share from one quarter to the next.
To accomplish this, banks must continually, either grow or find new higher margin (increasingly profitable) activities to replace the older maturing lower profit business lines or somehow enhance the profitability of a current line. For banks that meant supplementing commercial lending with services that were paid for with fees instead of interest rates. Commercial banks increasingly eyed the profit making skills of their investment banking brothers. Until the late 1970s, investment banks (also called securities firms) were not publicly traded. Investment banks did not have to concern themselves with quarterly stock market reactions to quarterly earnings as they managed their much riskier businesses and the accompanying fluctuations in profitability. The activities of commercial and investment banks were kept in separate types of institutions by the Glass-Steagall Act of 1933. After the late 1970s, securities firms with substantial trading operations steadily converted to publicly traded companies.
During the 1980s, commercial banks began to lobby for permission to cross the Glass-Steagall barriers to engage in higher margin businesses. Citicorp, JP Morgan and Bankers Trust were probably the most aggressive in penetrating the securities domain. Incidentally, many of the large securities firms became public or were acquired by publicly traded firms. In many cases those acquiring firms were foreign banks. Glass-Steagall was eventually largely repealed in 1999 with the enactment of the Gramm-Leach-Bliley Act (GLB), also known as the Financial Services Modernization Act of 1999.
How do companies increase profitability? One way is to produce a unique and useful product in a growing market. That’s hard to do in banking. One strategy is to make the product so complicated that the customer can’t realistically determine the true cost to duplicate it. The other source of profit is the ability to charge clients for their market risk. These are two of the reasons that trading “over-the-counter” derivatives (the type that is not traded on exchanges) can be so profitable.
The route to complexity is math. The appetite for extreme mathematical, data and computational complexity explains the presence of so many professionals trained in the mathematical and computational sciences at Wall Street firms. It represents an overwhelming technical mismatch when compared to investment management firms and pension funds or non-financial corporate clients.
But since this investment in technology is expensive, it must be utilized to advantage. So when a highly profitable window opens up, it gets exploited immediately until it is exhausted. When collateralized bond obligations linked up with sub prime loans, the game was on.
Growth Road to Ruin
Between 1980 and the early 1990s, the mortgage bond business was moderately profitable – due to high liquidity and low perceived risk of the underlying home mortgages - and was several positions down the banking glamour scale below emerging derivatives trading and high profile mergers and acquisitions. The low perceived risk came from the pervasiveness of mortgage insurance issued by Fannie and Freddie. Market participants, including foreign investors felt little concern for defaults because the insurance came from “government agencies”. Although Fannie stopped being a government agency when it was privatized in 1968 to help balance the federal budget, its bonds, along with those issued by Freddie Mac, established soon after to promote competition, were referred to as agency paper until recently. Wall Street took advantage of the perception of safety for mortgage bonds and started to issue bonds using cheaper collateral (sub prime and “alt-A” loans) uninsured by the “agencies”. The business grew dramatically in size and profitability so much that the GSEs started to worry about losing market share to this “shadow banking system”. They accelerated their acquisition of sub prime-based assets. This is around the same time (2004) that the GSEs are just recovering from an accounting scandal so they were concerned about keeping the stock price up. The GSEs, in order to remain market dominant, were eager to grow and needed sub prime to satisfy their appetite. That’s why they didn’t protest the HUD guidelines (see previous posting, The Tragedy of the [Growth] Common [Stock]).
The only ways that the big banks, Freddie and Fannie could achieve their profit objectives all lead them to excessive risk: increased leverage, increased use of substandard loans, and speculating in derivatives with under-capitalized trading partners.
A corporate strategy based on high growth in earnings is intrinsically not long-term sustainable. It should not expect to support the foundations of a stable, low risk market delivering low cost loans. It never belonged at the center of the residential mortgage business.
No comments:
Post a Comment