karl-henrik pettersson

karlhenrikpettersson.se

Filosofiska tankar om företagande och ekonomi

Vilket samhälle vill vi ha? Hur mycket marknad? Hur mycket politik? Varför dessa ekonomiska orättvisor?

U.S. political crisis (2): A new financial crises with its epicenter on Wall Street? Probably

A few weeks ago, on April 1st, my book, Dagbok från USA, came out in Sweden. It will also, sometime coming summer, be published in English (as an e-book for Kindle and for other readers with the title: “Diary from the United States – Notes on a society in crisis). As an appetizer for English speaking readers, I will the coming week publish three essays, excerpts from the book (chapter 4). The first essay you can read here.

This is the second essay. It concerns the ability to create stability in the economy, stability in income and jobs. In the coming decades, there is hardly a more important responsibility for U.S. politicians (other than possibly national security and defense issues). Stability in income and jobs may be threatened. It appears that the financial sector in the United States, and particularly the TBTF banks, only a few years after the subprime crisis, has again entered a speculative phase. There is a risk that we may have another financial crisis with its epicenter in the U.S.

Essay 2: Is it God-given that the financial sector growth follows GDP?

It’s hard not to think of a bubble when, as in this chart, click for bigger picture  (Source: Jones, 2008), one can see how the U.S. financial sector’s profits in the last decade are completely disconnected from GDP, and from profits in the rest of the economy (“Non-Financial Profits”). The chart was made by Jim Reid, an economist at Deutsche Bank, probably around 2008. What he saw in the graph was an abnormality. It shouldn’t look like this, and he coined the phrase “a trillion dollar mean reversion”. By this he meant that while the financial sector’s profits in the long term reasonably should track GDP growth – sometimes above GDP growth and sometimes below – sooner or later there should be a correction, a return to “normality”. And the correction, as he calculated it, was at the time on the order of a trillion dollar.

A correction did come with the financial crisis of 2008-2009. The financial sector’s profits plummeted, and when they reached their lowest point in the fourth quarter of 2008, the profit curve was below the GDP curve. The correction Jim Reid thought was  inevitable had been achieved – but only for a moment. From the lowest point in late 2008, financial profits began to bounce back. Banks and other financial institutions’ profits again developed after a completely different pattern that didn’t correspond with how the profits in the economy in general developed. It seemed as if the old order with the financial sector in a unique position, the one that applied before the financial crisis, was back. Could it be that the financial sector itself had become a bubble? Could it be that the subprime crisis for a short time led us to believe that the financial sector returned to normal in the sense that it would continue to develop in line with the broader economy? In this paper, I examine the question: Is the financial sector a bubble? By “bubble” I then mean unsustainable increases in the financial sector’s volume and profits. Could it be that the subprime crisis was just a temporary setback, certainly dramatic, in an upward trend for the financial sector that began long ago, in the late 1990s, and continues today at this writing (May 2011)? The financial sector is defined as companies whose main task is to work with financial instruments and the trading of financial instruments: banks, investment banks, hedge funds, mutual funds, brokers, etc. I discuss the conditions in the United States. This means that the financial sector more specifically is defined in the way the Federal Reserve and other U.S. authorities are doing. The time horizon is the period after 1990 with emphasis on conditions between 2000 and 2010.

Why has the U.S. financial sector profits exploded?

There are at least five profound explanations, none of them necessarily more important than the other, of why the financial sector profits have exploded over the last 10-15 years, why the curve of “Financial Profits” in Jim Reid’s chart looks the way it does.

First, deregulation. During the past twenty years there has been significant deregulation in the financial markets in the U.S., as in all OECD countries. Admittedly, when talking about interest rates and credit volume controls (which, incidentally, never had the same significance in the U.S. as in Europe), deregulation of financial markets began much earlier, at the end of the 1970s. It was also a deregulation that allowed for modern money and capital markets. But this occurred before deregulation had a real impact in the sense that banks and other institutions could make big money given more freedom. However, during the 1990s, we got a number of important new deregulatory measures in the U.S., which opened up more profitable markets. The Glass-Steagall Act, which expired in 1999, is probably the most important. It meant that now U.S. banks, just as in Europe, could conduct both conventional banking and investment banking in the same firm. This has accelerated development in some areas, such as proprietary trading. It’s in turn part of the background to the explosion of profits. More generally, one need not doubt that deregulation has contributed to earnings growth in the U.S. financial sector over the past 15-20 years. Expressed differently, financial institutions have step by step through deregulation acquired new markets to operate in, and they have done so successfully in the sense that, all else being equal, the profits have risen.

Second, there has been plenty of cheap money and cheap capital available in the economy, and occasionally there have been very good times. Especially in the last decade, from 2002 until 2007, monetary policy in the U.S. has been very lax. The Federal Reserve, with Alan Greenspan as chairman, held short-term rates low, at the level of 1%, for long periods. And America’s large financial imbalances, especially the current account deficit, meant that there was plenty of money in the system. After 2003 and up to the crisis, there was a boom. Times were good, and the mood in the stock and housing markets was excited, sometimes euphoric. Credit expansion was very strong. All are factors that have contributed to the financial sector’s earnings explosion.

Third, the housing bubble. The extreme price increases for single-family housing in the United States after 2000, and the increasingly hectic mortgage carousel, favored banks’ profits. In practice, this meant very strong volume increases in mortgages, which rose in a few years, from 2000 to 2008, from 15% of GDP to 25%. In absolute figures, the mortgage loan portfolio in the U.S. increased from $1,500 billion in 2000 to $3,500 billion in 2008. This is an almost incomprehensibly large increase – compare Sweden’s GDP in 2009 of about $400 billion. In parallel, the financial sector developed other, primarily commission-based methods to make money on the housing bubble. Housing loans were often made for the short term, which meant they had to be renegotiated now and then. Every such transaction incurred new charges for the borrowers.

Fourth, securitization. In simple terms, securitization means that if a bank has a large portfolio of a particular type of credit on its balance sheet, let’s say home loans, it can sell off the portfolio as a package to another company, which in turn converts the portfolio into new securities. Individual loans in the portfolio that the bank sold – where differences in size, maturity and interest rates from one loan to another, of course, are large – reconstituted in this way into securities with more precise contours, precise duration, exact interest rate, and, above all, a rating. It means that these securities become tradable. It opens up a huge market where those with money to invest, such as pension fund or hedge fund companies, can find high-yielding and, or so everybody thought, safe securities to invest in. And this was done on a massive scale. When the securitization in the United States was most extensive in the final months of 2006 and first half of 2007, about $100 billion per quarter was brought into the market in new securities. Not only mortgages for housing and commercial properties but also portfolios of credit card loans, car loans and many other types of credit, were securitized. With the crisis, not surprisingly, the interest in securitization turned radically downward. During the first half of 2008, there was only $5 billion per quarter in the form of new securitized assets. The subprime crisis had struck.

It’s no coincidence that the period when the securitization in the United States grew and became significant for the financial sector, from the early 1990s until 2007, coincides with the period when the financial sector’s relative earnings exploded. Securitization developed into a formidable profit machine for financial firms, not the least for the major U.S. banks. Fifth, proprietary trading. Banks’ freedom to conduct business against their own balance sheets used to be highly regulated in virtually all OECD countries. In view of the principal-agent problems that might arise, legislators typically were critical of, and therefore limited, a bank taking risks on its own account through non-hedged investing in securities such as stocks or bonds, or currencies. There simply is, regulators argued, a potential conflict of interest between the bank’s customers and the bank itself. There has been an important exception to this basic rule. American investment banks did not have these restrictions. They have been able to speculate in securities by taking the risk on their own account. Little by little, an increasing proportion of the large U.S. investment banks’ profits came from proprietary trading. When the boundaries between banks and investment banks disappeared with the end of the Glass-Steagall Act in 1999, there were in practice even greater opportunities for proprietary trading and even greater opportunities for more institutions to make money that way.

More proprietary trading – together with intensive product development, in which lots of new financial products, like credit default swaps (CDS) and other derivatives, arrived on the market and became key instruments – is an important reason why the financial sector’s profits since the mid-1990s have risen faster than GDP, and faster than the profits in non-financial firms. One could more generally say that the U.S. financial sector during this period successfully developed new ways to make money. An increasingly large proprietary trading business is thus one example. That traditional banking became more and more commission-based is another. It became more common to make such lending arrangements that the number of transactions, and thus the opportunity to charge fees, would increase. In his book Freefall, Joseph Stiglitz argues that banks’ increased focus on making money, has meant that they moved away from their social mission to help households and businesses to easily, and at the lowest possible cost, borrow the money they need. The balance, says Stiglitz, seems to swing more and more over to the banks’ self-interest to make as much money as possible. The banks’ social mission has taken a back seat. We need not doubt that these five factors weigh heavily when it comes to explaining why the U.S. financial sector’s profits increased faster than GDP since the mid-1990s. The question is whether it also has meant increased risk-taking.

Have financial firms increased their risk-taking?

The risk-return relationship, i.e., high yield implies increased risk, is well known and well documented both in finance theory and empirically. If in any part of the economy, it’s in the financial sector that the risk-return relationship should be particularly strong. In other words, it’s a reasonable hypothesis that the relative profit explosion that occurred in the financial sector, especially during the first half of the last decade, can largely be explained by increased risk-taking.

The symptoms of increased risks are many. First, the financial sector debt has increased rapidly. As a rule of thumb, rapid debt growth is almost always an indication of increased risk, and the development of the U.S. financial sector debt has been dramatic. This FRED chart, click for bigger picture  (from the Federal Reserve Bank of St. Louis) shows that clearly. Since 1990, borrowing by the U.S. financial sector has increased from 40% of GDP to just under 100% of GDP today. And even more interesting is that this expansion is much more rapid than in any of the other three sectors in the U.S. economy: non-financial enterprises, households, and the public sector. The indebtedness of non-financial companies followed household debt up to about year 2000. Thereafter, one cannot find anything equivalent to the mortgage bubble’s impact on household debt, which increased dramatically. Non-financial enterprises’ debts have largely been following GDP during the last decade. Furthermore, the liabilities of the public sector have remained fairly constant as a share of GDP up to the financial crisis. Of course, the big federal stimulus programs changed that, but the fact remains that during the period we are discussing here, from 1990 until today, it seems that the U.S. financial sector’s debt growth has been in a class by itself.

This development is thought provoking. Stated in other terms, it means that the financial sector has, to a large extent, “taken on a life of its own”. The debts in the financial sector have increased significantly because of internal deals that required credits, deals between different financial institutions. Polemically, one can say that the rapid increase in financial sector debt in the new millennium is essentially explained by either the subprime mortgage bubble, or by “change-money-with-each-other” activities. Both definitely have the character of speculation.

The high relative growth of debt is the most important sign that the financial sector has assumed increased risk, but there are also other signs. New financial products, particularly derivatives of various kinds, and all the tools and instruments used in the securitization process, have created the conditions for greater risk-taking. It’s reasonable to argue that the net effect has meant increased risk, and it’s also likely that the corporate culture of banks and other financial institutions has become more risk inclined, not least as proprietary trading activities have widened. The degree of speculation also correlates positively with the general mood in the economy. When times are good, and they were for much of the last decade in the U.S., banks are willing to take on more risk. My conclusion is that increased risk-taking significantly contributed to the financial sector’s relative earnings explosion. A bubble was built, but whether the bubble burst once and for all with the subprime crisis, is another matter. I will return to that question. A short digression. Could it not also be argued that large banks lending to states, which turned into a nightmare last year, especially for the large European banks, with sovereign debt crises in the PIIGS countries, is another sign of financial sector speculation? I would say no. Under the so-called Basel rules government bonds have been regarded as safe investments. They do not require any additional capital. It’s not the banks that decided that bonds issued by, say, the Greek state are without risk (which is the implicit assumption behind zero capital requirements for sovereign bonds). It was a political decision based on what regulators and other bureaucrats proposed. For this reason I would argue that sovereign bonds on banks’ balance sheets should not be considered as speculative investments.

Is it God-given that financial sector growth follows GDP?

No, it’s not “God-given” that financial sector growth follows GDP growth. But one could say it’s logical when looking at the financial sector’s three classical tasks:

  • To allocate credits
  • To handle savings and liquidity for households, corporations, and other legal entities
  • To be responsible for the payment system in the economy

The fact that the U.S. financial sector has broken the relationship with GDP suggests that it has taken on new tasks besides these three. These new tasks must in principle involve one of two areas: 1) they must successfully offer households or businesses, or both, valuable financial products that are not related to credit, savings, and payments. It’s difficult to see what it could be; possibly advanced problem solving coupled with sophisticated technology, such as risk management services for businesses. There might also be some new products based on trading. Or 2) it has to do with “inter-bank business”, where the financial sector in itself creates markets for different products. It has apparently been done, especially on the trading side. But since “inter-bank” is a market where professionals do business with each other, and a market where it’s difficult to find a temporary monopoly through product development, it should essentially be a zero-sum game in terms of profit. In any case, the risk-adjusted profits should in the long term be very limited. This is related to that the level of risk in such transactions, by definition, is high. Besides arbitrage, it’s all about speculation.

Parenthetically, what is meant by speculation? The concept is not crystal clear, but in the financial context, it means that someone makes a short-term investment in a security of some kind. “Short-termism” is the main characteristic of speculation. The investment is made because one believes it will be profitable. The opposite, to know anything with certainty, is of course not possible. A long-term investment grounded in fundamental analysis has a high probability of becoming a good deal, but the outcome is never certain. Speculation is thus tantamount to taking a high risk with a short-term investment. Speculators often increase risk intentionally, for example through leveraging via borrowing or through large volumes.

My conclusion is therefore that these “inter-bank” trades are mainly about speculation so defined. The financial sector’s large relative profits, which particularly in the last decade disconnected from the other corporate sectors of society, are thus a reflection of considerable risk taking. This would mean that the profit explosion is an anomaly. The level of profit will in one way or another be returned to normal. Put another way. Jim Reid was right when he talked about “a trillion dollar mean reversion”. It also means that it’s reasonable that the financial sector growth on the whole, and in the long term, is following growth in the real sector, roughly equivalent to GDP growth. If it does not, it may be a bubble that is being built up.

Is the financial sector a bubble?

Academic research knows almost everything about how financial bubbles arise and develop. The setting in the country in which a bubble might occur is almost always the same. The times are good. There’s an expansionary monetary policy, which means that there is plenty of money in the economy. Surprisingly often, the country also has financial imbalances, such as a large external debt that is growing (current account deficit). Businesses and households have easy access to credit. Interest rates are low. The bubble develops in two stages. The first stage is characterized by a general expansion of credit. For a particular asset class, such as family homes as in the subprime crisis, credit growth is exceptionally strong. Consequently the price of this asset rises very quickly. As the asset is often used as collateral for loans, it means that price increases will widen the supply of credit. And that space is taken. In other words, we get a self-reinforcing process and credit expands even faster. It’s so rapid that usually no bank or other creditor understands how quickly increasing risks are building up on their balance sheets.

Suddenly something happens that creates uncertainty. It can be almost anything, seemingly trivial or random, but the consequences are immediate. The prices of the asset suddenly turn downward. The most risk-prone lenders run into trouble. In the Swedish financial crisis of the 1990s (considered “one of the big five” global financial crises by Reinhart and Rogoff in their book This Time is Different), it was the finance companies that were first, they had taken the high risk credits that banks didn’t want to have on their balance sheets, and one by one, they went bankrupt in the autumn of 1990. Pretty soon the crisis hit the entire financial system. The bubble had burst.

The U.S. subprime crisis followed exactly the same pattern. Like all other bubbles in history. It’s one thing that financial bubbles historically have followed this pattern. But how can one say that the financial sector itself is a bubble? Financial bubbles normally are about, as I just said, a particular asset class (such as railroad bonds in the 1870s, shares after the First World War, family homes during the current crisis, etc.) whose prices run amok and leave reality, largely due to generous lending, that in turn makes speculation possible. The financial sector as a lender is the very condition for a bubble to emerge. How then can the financial sector itself be a bubble? Not surprisingly, the financial sector per se can be a bubble. All financial sector companies considered as a single portfolio are an asset class that should be studied if one wants to demonstrate that what occurred in the last decade is about a financial bubble. Two issues are relevant. Has the aggregate market value of banks and other financial institutions, that is, financial firms collectively, some time in the last decade risen quickly and a lot? And thereafter turned down as quickly and as much? The answers are yes and yes. The market value of the U.S. financial sector (defined as the Dow Financial Sector) grew almost 90% in just over four years, from March 2003 to June 2007 when the downturn began. It was significantly faster growth than for non-financial firms during the same period, and the decline was dramatic when it occurred. From top to bottom, the financial sector’s market value sank by 80% in a very short time.

The second relevant question is whether the financial sector’s borrowing during the period has increased significantly, more than the real sector borrowing. Again, the answer is yes as I have already noted. The U.S. financial sector borrowing increased between 1998 and 2008 by 51%. During the same period, real sector borrowing increased by 18%.

What is the conclusion? It’s difficult not to argue that the U.S. financial sector in the past decade was in a bubble, and that bubble burst in 2007, triggered by the subprime crisis. However, the really interesting question is whether the subprime crisis was just a notch in the curve showing the financial sector’s profits. We can say that it probably was just a notch because we observe that the sector continues its speculation, perhaps more carefully, and after the Dodd-Frank Act a little more reined in by the authorities, but with the same instruments, with basically the same organization and, in fact, with much the same top management people as before the subprime crisis, at least if we talk about the TBTF banks. This leads to the question of the politicians’ handling of the crisis.

The rescue of TBTF banks became a political half-measure The world’s politicians and central banks intervened in 2008 in the financial sector with a combination of risk capital contribution, increased liquidity, and radical reductions in short-term interest rates. Globally, it was the largest stimulus package ever. The dramatic fall in the financial sector’s market value stopped. The turning point came early in 2009. About the same time the real sector turned up. If measured by the stock market’s behavior, the major stock exchanges began their recovery in mid-March 2009.

Why did politicians intervene so forcefully? The simple answer is that they had no choice. There are systemic risks tied to the financial sector. The risk of a bankruptcy of a large bank is a threat to the entire economy. Consequences in the real sector of a bank failure can be extremely serious. On the other hand, if a large industrial enterprise, even the country’s largest company, goes bankrupt, the contagion effects will be comparatively limited. The financial sector is special in the sense that there is this systemic risk. Banks also provide “the oil in the economic machinery”. Without a well-functioning financial sector enabling households and businesses to get the loans they need and to make their payments, we will immediately see dire effects in the economy as a whole, which is exactly what happened in 2008. When the credit market in a very short time “dried up”, unemployment rose. For example, manufacturing companies that rely on credit to get their products sold, like the automotive industry, ran into trouble right away. Volvo’s sales of heavy trucks fell dramatically after 2008, to take a Swedish example. The crisis quickly spread to other sectors. Politicians felt it was necessary to intervene, and to do so forcefully. Today we can say with certainty that if the U.S. government and Federal Reserve had not gone ahead with these huge stimulus packages and relief efforts, reinforced by the actions of other governments and central banks, the global economy would have entered into a very deep recession, something similar to the Great Depression of the 1930s. As a result of this effort, the major U.S. banks were saved. They were simply TBTF – too big to fail.

Unfortunately, the rescue of the TBTF banks was done in a way that exacerbated the situation, so the systemic risk increased. If anything, the TBTF banks became even more system-critical for the United States than before the crisis and even more politically powerful by virtue of their size and nearly limitless lobbying resources. I think it was a big political mistake by Washington when the possibility existed, not to restructure the TBTF banks and thus reduce systemic risk significantly. It would have been possible, and attempts were made. Many wanted to break up the TBTF banks into two parts – a traditionally regulated banking organization and a deregulated investment banking business, similar to what existed before 1999 and the repeal of the Glass-Steagall Act. This “breaking up”-model became known as the Volcker rule, after former Federal Reserve Chairman Paul Volcker, who suggested just such a division. It would have decreased systemic risk as well as the major banks’ political power. But these ideas came to naught. Arguably this is because it’s inconsistent with American values, certainly not in keeping with the small-government strategy, to replace private ownership with public ownership, much less to allow politicians to control the restructuring of an industry.

Because the TBTF problem is essentially unresolved, I think we can expect a new major financial crisis within a few years with its epicenter in the U.S..

We can expect a new financial crisis in a few years

We know that the U.S. financial sector’s profits today have returned to the same level as before the crisis. In fact, profits in absolute dollars were higher for the full year 2010 than they ever have been, higher than 2006, the best year before the crisis. We know also that the U.S. financial sector’s profits as a percentage of business sector’s total profits today is back to the same figure, around 35%, we had at its highest level a couple of years before the crash. It’s clear from this chart, click for bigger picture. (Source: Madigan, 2011)

That the financial sector’s profits have bounced back is the same as saying – provided the hypothesis that the financial sector is a bubble is proven correct – that it’s likely that something dramatic will happen again. Expressed another way, all the efforts to stabilize the financial system made by the world’s governments and central banks in 2008 and 2009 have been effective in the sense that the financial sector has begun to function again. Real sector companies can get their loans and make their payments. However, what is more disturbing is that the financial sector in the U.S. – to judge from its quarterly reports – has again begun to speculate on a broad scale and may very well be on track to once more lose its link to the GDP. Someone might say that the stock market does not reflect this trend. U.S. financial stocks have not improved in 2010 and 2011 despite soaring profits. I think one can assume that the market has understood exactly the thesis of this paper – large new risks are being built up in the financial sector that will turn into in a new bubble that bursts. Further, European politicians’ “kick-the-can” handling of the sovereign debt crisis and American politicians’ inability to convincingly take hold of America’s own national debt problems, contribute to the fact that bank stocks do not follow bank profits. As I write this, we are also moving into a low growth period, at worst a recession. But underlying that explanation, it seems, it’s at least my view, as if the stock market believes that once again considerable risks are being built up in the U.S. financial sector. For everyone who believes, and I am among them, that the financial sector is not there for its own sake, and should not be allowed to take such huge risks that the stability of the entire world’s economy is threatened on the day the bubble bursts next time, what we now see, is to say the least, frightening. Somewhere in the future, probably within a few years because the financial sector’s revival is going so fast, we will have a new deep financial crisis. And it will almost certainly be worse than the one we thought we had just rescued ourselves from.

Literature:

Acharya, V. V. & Richardson, M. (ed.), 2009, Restoring Financial Stability, John Wiley & Sons, Inc, Hoboken, New Jersey;

Johnson, S. & Kwak, J., 2010, 13 Bankers, The Wall Street Takeover and the Next Financial Meltdown, Pantheon Books, New York;

Jones, S., 2008, “A trillion dollar mean reversion”, ft.com/alphaville, Financial Times, blog, July 15, 2008;

Madigan, K., 2011,“Like The Phoenix, U.S. Finance Profits Soar”, Real Time Economics, WJS Blogs;

Rebonato, R., 2007, Plight of the Fortune Tellers, Why We Need to Manage Financial Risk Differently, Princeton University Press, Princeton;

Stiglitz, J. E., 2009, Freefall, W. W. Norton & Company, New York;

 

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2012-05-01

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