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24th August 2009

Top gearing

“Remember, that credit is money.”

- Benjamin Franklin.

About 15 years ago, an older relative who enjoyed considerable status and influence within her
local community expressed some surprise about how her bank account operated. She had always
assumed that the banknotes that she deposited within her account would literally be kept in some
kind of vault for safe keeping and left untouched. She fully expected to see the very same notes
whenever she made a withdrawal. The idea that her money would be reused and lent on by the
bank – and that the bank notes that returned would not likely be “hers” – came as something of a
revelation to her. (Quite how bank depositors manage to earn interest was evidently not
something that she unduly worried about. But given that current savers now earn essentially
nothing, perhaps her lack of concern on the topic is more widely shared.)

Banks and banking are certainly poorly understood. Given the severity of the crisis, we can say
with some confidence that banking is poorly understood even by bankers. The widespread
unfamiliarity with the workings of the banking system may even be a good thing, for a while. For as
Henry Ford once said,

“It is well enough that people or the nation do not understand our banking and monetary system
for if they did, I believe that there would be a revolution before morning.”

Someone else who believes that the prospect of a revolt against the bankers is entirely
conceivable is Michael Lewis, author of „Liar‟s Poker‟ (the definitive account of investment banker
atavism – in this case, at Salomon Brothers in the mid-1980s) and former bond salesman, who
knows something of the nature of the Wall Street beast. You can read the transcript of this
podcast here. Among the pertinent highlights: in 1970, roughly 5% of male Harvard graduates went
into finance. By 1990 the figure had risen to 15%; by 2007, 20% of the men and 10% of the women
planned to head to Wall Street. Lewis suggests that half of the remainder also applied and just
didn‟t get jobs:

“..a radical misallocation of human talent. You can say it‟s faith in the free markets, but it‟s caused
by the huge growth of a culture of financial manipulation.. With the sub-prime mortgage racket
generating lots of fees, the people within each big Wall Street firm who create that business
acquire enormous power. So when the business gets decreasingly sane [gorgeous phrase], when
the loans get shakier and shakier, and the leverage gets bigger and bigger, they‟re the ones who say
we‟ve got to keep doing this. Even though people not directly implicated in the business might
have said, “No, it‟s time to stop.”.. For thirty years the people who have had the most money to
throw around were engaged in financial manipulation. Now they have outsized influence over the
way the company [and country] is run.. I think it‟s politically risky. There’s a real chance that
there’s going to be an uprising about this, and they‟re going to have trouble controlling the
process.” (Emphasis mine.)

Future generations will rightly wonder how taxpayers stood by while their present and future
earnings were essentially redirected into the pockets of bankers who messed up, not trivially, but
in a way that threatened the integrity and working of the entire financial system. Chief executives
at banks have defended the ludicrous continuation of the bonus culture on the basis that talent
needs to be rewarded at free market rates. This is, of course, absurd. If there were any talent out
there in banking to create social value as opposed to leaching off the taxpayer and shareholder, it
would be leaving the banks and setting up new entrepreneurial ventures to provide capital to
those individuals and businesses most worthy of receiving it. As it is, banks are being stuffed with
money from the government purse and sitting on it – or, as Luke Johnson suggested a couple of
weeks ago, putting it to work perpetuating the misallocation of capital to the property sector.

The ongoing unavailability of bank finance, despite governments cramming capital down the throat
of the banking sector goose, can be seen in the figures for corporate bond issuance, which on a
global basis broke through the $1 trillion mark this year with four months still to go. This reflects
the credit drought for the corporate sector and the difficulty companies face in securing bank
loans. It also points to the income drought facing investors, who are otherwise caught between
the rock of artificially low government bond yields and the hard place of quasi-zero deposit rates
from those same pesky banks. Ironically, on exactly the same day that the corporate bond issuance
figures were released, Standard & Poor‟s announced that the number of companies defaulting on
their debts had risen to record levels this year – even as returns for the most speculative
corporate bonds had soared since January.

Such is life when governments and their ostensibly independent central banks are allowed to muck
about with interest rates, thus distorting market values all the way through the capital market
chain. Quantitative easing manipulates government bond yields lower on the dubious premise of
stimulating the broader economy. Coordinated monetary policy drives down base rates toward
zero, and forces bank depositors into higher risk assets simply to keep their head above water.
Some of this micro meddling would be justified if the banks were passing on the liquidity so
generously supplied to them, but they are not. Those investors not lured by the siren-like returns
of speculative quality assets are left to ponder whether or when the tidal wave of easy money
sloshing round banks and asset markets will trigger real inflationary pressure. (That inflation is at
work in financial asset prices is hard to deny – an over-supply of money chasing ultimately finite
resources.)

Meanwhile, risk assets continue to surge higher. How durable the rally is remains, of course, to be
seen. But those chasing equity markets ever higher should consider the following question: how
can the world return to pre-2007 levels of economic growth when the supply of credit is being
hopelessly constrained ? And those brave investors buying bank stocks might wish to consider the
report „Small Lessons from a Big Crisis‟ by Andrew Haldane, Executive Director for Financial
Stability at the Bank of England, presented to the Federal Reserve Bank of Chicago Annual
Conference in May this year. Haldane suggests the following hypothetical trade. Imagine placing a
hedged bet in 1900: a £100 long investment on UK financial sector equities versus a £100 short
bet against general UK equities (i.e., a bet on UK banks outperforming the rest of the market).
How would that bet have performed ?
The chart below shows the results.

For the first 85 years, the bet looks like a rather unexciting trade. By 1985 it would have delivered
£500, the equivalent of 2% per annum. And then comes the period 1986 to 2006. By the end of
2006 (note: before the credit crisis gets truly into gear), our once unexciting bet would have
delivered £10,000, or the equivalent of over 16% per annum. As Haldane observes,

“There is no period in recent UK financial history which bears comparison.”

And then, of course, it all went horribly wrong. The cumulative fall in UK banking stocks up to the
low point (so far) in March is the largest in history at over 80%, “outstripping the fall following the
first oil price shock in 1973/4 and the stock market crash of 1929”. By the end of 2008, our
century-old gamble would have delivered a capital sum of £2,200, or the annualised equivalent of
less than 3% - reversion, in other words, back to the mean.

Just how did UK banks manage to generate such spectacular recent returns ? Haldane points
below to the obvious answer: leverage. “Movements in leverage have clearly been the dominant
driver. Since 2000, rising leverage fully accounts for movements in UK banks‟ return on equity –
both the rise to around 24% in 2007 and the subsequent fall into negative territory in 2008”.
Haldane also points out that those banks unable to deliver sufficiently high returns on assets to
meet their return on equity targets resorted instead to gearing up their balance sheets. The rest is
history (as, probably, are many of the banks, at least as far as mark-to-market accounting is
concerned).

Where does this leave us now ? 2009 has seen an extraordinary rally by more speculative assets,
leaving “value” behind in the dirt. As Rob Arnott suggested two weeks ago, the gulf between
“value” and “growth” stocks, for example, has only been more marked once in history – at the
height of the dotcom boom. The rally may persist – and the outperformance of junky assets over
high quality ones might persist alongside it. But the rally is taking valuations back toward those that
pertained when the world was rolling orgiastically in credit. The credit is gone. We will not see its
like again for years to come.

You do not have to understand the precise workings of banks to know that buying their equity
now – or for that matter the equity of speculative quality companies – represents unusual risk.
The world has changed and the financial world in particular now looks radically different from the
ill considered credit spree that dominated until western property markets and the associated
banks started to creak and then collapse in the summer of 2007. The seemingly benign market
environment is dangerously misleading. Those investors chasing the momentum of the most
speculative cyclical stocks – and debt of comparable quality – are incurring exceptional levels of
risk. Perhaps, like bankers shovelling other people‟s capital toward essentially unproductive uses,
they simply don‟t care.

The commentary will now be taking its summer break, and will return later in
September.

Tim Price
Director of Investment
PFP Wealth Management
24th August 2009.
Email: tim.price@pfpg.co.uk Weblog: http://thepriceofeverything.typepad.com

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