The End of an Era

Has the Financial Industry's Heyday Come and Gone? APRIL 28, 2008 For the past three decades, finance has claimed a growing share of the U.S. stock market, profits and the overall economy. But the role of finance -- the businesses of borrowing, lending, investing and all the middlemen in between -- may be ebbing, a shift that would redefine the U.S. economy. "The role of finance in the economy is going to come down significantly in the coming years," says Carlos Asilis, chief investment officer at Glovista Investments, a New Jersey money manager. "From a societal standpoint, we got carried away with finance." The trend already has hurt companies beyond banks and Wall Street firms. General Electric Co.'s first-quarter profits at its financial-services businesses were 21% lower than a year earlier. Retailer Target Corp., which got 13% of its before-tax profit last year from credit cards, last month wrote off $55.5 million in credit-card loans, 8.1% of its total portfolio at an annualized rate. Cast Your Vote Question of the Day: What's your forecast for the U.S. financial industry over the next two years? "I think you're seeing a clear inflection point," says Tom Gallagher, an ISI Group analyst. "Whether it's financials as a share of the stock market or financials as a share of GDP, we've peaked." Finance was lifted by deregulation, globalization and technological innovation. Combined, these forces allowed capital to flow far more freely around the globe, brought flexibility to the economy and made finance lucrative. Domestic financial-sector profits accounted for 13% of pretax profits in 1980, the Federal Reserve says. Last year, they accounted for 27%. In 1980, GE garnered 92% of its profit from manufacturing. In the first quarter, profit from GE's financial businesses, which extend credit from personal loans to factory purchases, represented 56% of profit. As finance rose, financial workers took a bigger chunk of total U.S. pay. And as technology allowed financial firms to do more with fewer people, individual paychecks got fatter. Finance was a major factor in the widening gap between the very rich and the middle class. In 1980, finance workers made about 10% more than comparable workers in other fields, estimates New York University economist Thomas Philippon. By 2005, that premium was 50%. That money diverted some of the brightest minds from other pursuits. "We're seeing significantly more of our students going into the financial sector," says Vincent Poor, dean of Princeton's engineering school. "Traditionally, engineering students had not followed that path." The creation of securities backed by mortgages and other loans and other innovations made it easier for financial firms to spread risk, and thus they became more willing to lend to households to fuel spending. Household debt including mortgages and credit cards went from 13% of household assets in 1980 to 19% last year. During that period, personal savings rates fell to nearly zero. In the 2000s, finance went into overdrive, creating an alphabet soup of derivatives that, it turned out, didn't have the risk-reducing properties they were supposed to have. Mr. Philippon compares some to "sheep with fifth legs -- something you would see in a zoo and wonder what Nature was thinking." For finance workers, this shift could resemble the 1980s, when manufacturing lost its pole position in the U.S. labor market and thousands found that skills they had honed over the years were less marketable. The Bureau of Labor Statistics already counts 60,000 fewer people working in finance than a year ago. Merrill Lynch & Co. is cutting 4,000 jobs, and Lehman Brothers Holdings Inc. is cutting 1,425. Many of Bear Stearns Cos.' 14,000 employees are expected to lose their jobs when J.P. Morgan Chase & Co. swallows the firm. Mr. Philippon argues that the surge of financial activity that began in 2002 created an employment bubble that is now busting. His model suggests total employment in finance and insurance has to fall to 6.3 million to get back to historical norms, and that means losing an additional 700,000 jobs in the sector. Finance has seen job cuts before and bounced back. After the 1987 stock-market crash, E.F. Hutton & Co. was taken over by Shearson Lehman Brothers, then a division of American Express Co., and shed 5,000 jobs. Among them was Jeffrey Applegate's job as a strategist. He spent the subsequent year doing carpentry and thinking he might make a career of it if financial jobs didn't come back. He got hired by Shearson Lehman, which evolved into the present-day Lehman Brothers. Now chief investment officer for Citigroup Inc.'s Citi Global Wealth Management, Mr. Applegate thinks the damage to the financial sector this time will be more lasting than 1987. (Citigroup has announced 6,000 job cuts since the credit crisis began.) But he doubts finance's role in the economy will ebb much. Globalization's demand for free-flowing capital will continue. And the process of turning loans into securities is too powerful a tool for risk management and credit creation to abandon. "Is securitization going to go away? I doubt it," he says. "Is it going to be more transparent? Are ratings going to be more robust? Is there going to be more regulation? Yeah." Global governments are moving to require financial firms -- both commercial banks and investment firms like Bear Stearns -- to hold bigger capital cushions against the credit they extend so they are better able to withstand financial tornadoes. And that lower leverage, inevitably, means lower profits for finance. But even before new regulations bite, investors are wary of the securities that ultimately are tied to mortgages and other loans made to consumers. And that could pinch American consumers long dependent on credit to spend, sometimes beyond their means. Harley-Davidson Inc. last year earned about 15% of its operating income through its financial services division, which offers financing to its motorcycle customers; that's up from 5% a decade ago. In the first quarter, Harley had a hard time selling the loans it originated; its financial-services profits fell by 41%, as a result. With its customers feeling the economic downturn and less able to borrow to buy bikes, the company, which shipped 330,619 Harley-Davidson motorcycles last year, plans to ship between 23,000 and 27,000 fewer in 2008. Write to Justin Lahart at justin.lahart@wsj.com For the past three decades, finance has claimed a growing share of the U.S. stock market, profits and the overall economy. But the role of finance -- the businesses of borrowing, lending, investing and all the middlemen in between -- may be ebbing, a shift that would redefine the U.S. economy. "The role of finance in the economy is going to come down significantly in the coming years," says Carlos Asilis, chief investment officer at Glovista Investments, a New Jersey money manager. "From a societal standpoint, we got carried away with finance." The trend already has hurt companies beyond banks and Wall Street firms. General Electric Co.'s first-quarter profits at its financial-services businesses were 21% lower than a year earlier. Retailer Target Corp., which got 13% of its before-tax profit last year from credit cards, last month wrote off $55.5 million in credit-card loans, 8.1% of its total portfolio at an annualized rate. Cast Your Vote Question of the Day: What's your forecast for the U.S. financial industry over the next two years? "I think you're seeing a clear inflection point," says Tom Gallagher, an ISI Group analyst. "Whether it's financials as a share of the stock market or financials as a share of GDP, we've peaked." Finance was lifted by deregulation, globalization and technological innovation. Combined, these forces allowed capital to flow far more freely around the globe, brought flexibility to the economy and made finance lucrative. Domestic financial-sector profits accounted for 13% of pretax profits in 1980, the Federal Reserve says. Last year, they accounted for 27%. In 1980, GE garnered 92% of its profit from manufacturing. In the first quarter, profit from GE's financial businesses, which extend credit from personal loans to factory purchases, represented 56% of profit. As finance rose, financial workers took a bigger chunk of total U.S. pay. And as technology allowed financial firms to do more with fewer people, individual paychecks got fatter. Finance was a major factor in the widening gap between the very rich and the middle class. In 1980, finance workers made about 10% more than comparable workers in other fields, estimates New York University economist Thomas Philippon. By 2005, that premium was 50%. That money diverted some of the brightest minds from other pursuits. "We're seeing significantly more of our students going into the financial sector," says Vincent Poor, dean of Princeton's engineering school. "Traditionally, engineering students had not followed that path." The creation of securities backed by mortgages and other loans and other innovations made it easier for financial firms to spread risk, and thus they became more willing to lend to households to fuel spending. Household debt including mortgages and credit cards went from 13% of household assets in 1980 to 19% last year. During that period, personal savings rates fell to nearly zero. In the 2000s, finance went into overdrive, creating an alphabet soup of derivatives that, it turned out, didn't have the risk-reducing properties they were supposed to have. Mr. Philippon compares some to "sheep with fifth legs -- something you would see in a zoo and wonder what Nature was thinking." For finance workers, this shift could resemble the 1980s, when manufacturing lost its pole position in the U.S. labor market and thousands found that skills they had honed over the years were less marketable. The Bureau of Labor Statistics already counts 60,000 fewer people working in finance than a year ago. Merrill Lynch & Co. is cutting 4,000 jobs, and Lehman Brothers Holdings Inc. is cutting 1,425. Many of Bear Stearns Cos.' 14,000 employees are expected to lose their jobs when J.P. Morgan Chase & Co. swallows the firm. Mr. Philippon argues that the surge of financial activity that began in 2002 created an employment bubble that is now busting. His model suggests total employment in finance and insurance has to fall to 6.3 million to get back to historical norms, and that means losing an additional 700,000 jobs in the sector. Finance has seen job cuts before and bounced back. After the 1987 stock-market crash, E.F. Hutton & Co. was taken over by Shearson Lehman Brothers, then a division of American Express Co., and shed 5,000 jobs. Among them was Jeffrey Applegate's job as a strategist. He spent the subsequent year doing carpentry and thinking he might make a career of it if financial jobs didn't come back. He got hired by Shearson Lehman, which evolved into the present-day Lehman Brothers. Now chief investment officer for Citigroup Inc.'s Citi Global Wealth Management, Mr. Applegate thinks the damage to the financial sector this time will be more lasting than 1987. (Citigroup has announced 6,000 job cuts since the credit crisis began.) But he doubts finance's role in the economy will ebb much. Globalization's demand for free-flowing capital will continue. And the process of turning loans into securities is too powerful a tool for risk management and credit creation to abandon. "Is securitization going to go away? I doubt it," he says. "Is it going to be more transparent? Are ratings going to be more robust? Is there going to be more regulation? Yeah." Global governments are moving to require financial firms -- both commercial banks and investment firms like Bear Stearns -- to hold bigger capital cushions against the credit they extend so they are better able to withstand financial tornadoes. And that lower leverage, inevitably, means lower profits for finance. But even before new regulations bite, investors are wary of the securities that ultimately are tied to mortgages and other loans made to consumers. And that could pinch American consumers long dependent on credit to spend, sometimes beyond their means. Harley-Davidson Inc. last year earned about 15% of its operating income through its financial services division, which offers financing to its motorcycle customers; that's up from 5% a decade ago. In the first quarter, Harley had a hard time selling the loans it originated; its financial-services profits fell by 41%, as a result. With its customers feeling the economic downturn and less able to borrow to buy bikes, the company, which shipped 330,619 Harley-Davidson motorcycles last year, plans to ship between 23,000 and 27,000 fewer in 2008.

Like Father, Like Son

Republican red faces as regulators close bank By Andrew Ward in Washington and Joanna Chung in New York Published: September 8 2008 03:11 Last updated: September 8 2008 03:11 A bank with ties to the family of John McCain was shut down by federal regulators on Friday, marking the 11th US bank failure this year and threatening to cause ripples across the presidential election campaign. Andrew McCain, son of the Republican presidential nominee, was a director of Nevada-based Silver State Bank until resigning in July for “personal reasons”. He was a member of Silver State’s audit committee, which has responsibility for overseeing the bank’s financial accounts. Silver State was heavily exposed to construction and land development loans that have come under pressure as the housing market slumps. Much of the bank’s business was concentrated in Las Vegas and other western cities that have suffered some of the sharpest falls in land prices after years of rapid growth and heavy speculation. [Me: Anyone else remember Charles Keating and Lincoln Savings and Loan?} Silver State had about $2bn of assets and $1.7bn in deposits at the end of June and reported a second-quarter net loss of $72.3m. Its failure is expected to cost the Federal Deposit Insurance Corporation, which insures bank deposits up to $100,000, about $450m-$550m. There is no evidence that Mr McCain did anything wrong nor that his departure was connected to the bank’s financial troubles. But the episode is a potential embarrassment to his father at a time when bank failures are adding to a broader sense of gloom and economic insecurity among US voters. It could revive memories of John McCain’s role in the “Keating Five” scandal during the 1980s savings and loans crisis, when he was reprimanded by a Senate watchdog for lobbying on behalf of a campaign donor whose mortgage lending institution was under investigation by regulators. [Me: Apparently, at least one British journalist does.] The younger McCain joined the board of Silver State in February after it acquired Arizona-based Choice Bank, for whom he had served as a director since 2006. He is an adopted son from his father’s first marriage but also has close ties to the senator’s second wife, Cindy, in his role as chief financial officer of Hensley & Co, the Arizona-based beer distribution company controlled by Mrs McCain. The 11 bank failures in the US this year compare with three in all of 2007 and none in the preceding two years. More are expected. The number of so-called “problem” banks grew from 90 institutions at the end of the first quarter to 117 at the end of June, the highest level since 2003, according to the FDIC. It is drawing up plans to raise additional capital to shore up its insurance fund that has been depleted by this year’s bank rescues. The fund currently holds about $45bn.

Tool of the shorts, but who cares?

I don't know if it's middle age brain setting in or what, but I'm having a hard time keeping track of the casualties of the mortgage bubble. Fortunately, there's the Mortgage Lender Implode-O-Meter to help casual observers of mortgage debacle keep score. While there, be sure to check out Option ARMageddon.

Isn't it ironic (don't you think?)

So much for the great moderation!

I'm tardy in posting this, but this David Leonhardt column should be required reading.

So, how bad could this get?

Until a few months ago, it was accepted wisdom that the American economy functioned far more smoothly than in the past. Economic expansions lasted longer, and recessions were both shorter and milder. Inflation had been tamed. The spreading of financial risk, across institutions and around the world, had reduced the odds of a crisis.

Back in 2004, Ben Bernanke, then a Federal Reserve governor, borrowed a phrase from an academic research paper to give these happy developments a name: “the great moderation.”

These days, though, the great moderation isn’t looking quite so great — or so moderate.

The great moderation now seems to have depended — in part — on a huge speculative bubble, first in stocks and then real estate, that hid the economy’s rough edges. Everyone from first-time home buyers to Wall Street chief executives made bets they did not fully understand, and then spent money as if those bets couldn’t go bad. For the past 16 years, American consumers have increased their overall spending every single quarter, which is almost twice as long as any previous streak.

A financial system gone very, very wrong

They say more money has been lost chasing yield than has been lost at the point of a gun. Paul Krugman, the curmudgeon economist / New York Times columnist, reminds us why in his latest missive:

In other words, the United States was not, in fact, uniquely well-suited to make use of the world’s surplus funds. It was, instead, a place where large sums could be and were invested very badly. Directly or indirectly, capital flowing into America from global investors ended up financing a housing-and-credit bubble that has now burst, with painful consequences.

The good news is that Krugman does not foresee America experiencing an economic recession as severe as Argentina circa 1950 (but only because our debt to foreigners is US Dollar- denominated.) Oh, and he uses the word “sophistry” in describing structured financial assets. Love it!

How We Got Ourselves into This Mess

I thought it was just the capital markets mourning the death of my father. In today’s Wall Street Journal, Mr. Greenspan argues there was more to the story:

On Aug. 9, 2007, and the days immediately following, financial markets in much of the world seized up. Virtually overnight the seemingly insatiable desire for financial risk came to an abrupt halt as the price of risk unexpectedly surged. Interest rates on a wide range of asset classes, especially interbank lending, asset-backed commercial paper and junk bonds, rose sharply relative to riskless U.S. Treasury securities. Over the past five years, risk had become increasingly underpriced as market euphoria, fostered by an unprecedented global growth rate, gained cumulative traction.

The crisis was thus an accident waiting to happen. If it had not been triggered by the mispricing of securitized subprime mortgages, it would have been produced by eruptions in some other market. As I have noted elsewhere, history has not dealt kindly with protracted periods of low risk premiums.

The root of the current crisis, as I see it, lies back in the aftermath of the Cold War, when the economic ruin of the Soviet Bloc was exposed with the fall of the Berlin Wall. Following these world-shaking events, market capitalism quietly, but rapidly, displaced much of the discredited central planning that was so prevalent in the Third World.*

It appears retirement has turned the master of opaque into the master of the obvious:

The current credit crisis will come to an end when the overhang of inventories of newly built homes is largely liquidated, and home price deflation comes to an end. That will stabilize the now-uncertain value of the home equity that acts as a buffer for all home mortgages, but most importantly for those held as collateral for residential mortgage-backed securities. Very large losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted adjustment, the U.S. economy, and the world economy more generally, will be able to get back to business.

* He does admit, later in the editorial, that free money following the dot-com crash may have had something to do with this mess.

The Spoils of Private Equity

Ever wonder how the Gordon Gecko’s of the current decade are faring? Director Robert Greenwald’s new film, “The War on Greed, Starring the Homes of Henry Kravis,” provides of glimpse of just how well the sultans of leverage have done this decade. New York Times reporter Andrew Ross Sorkin describes the vignette as a “tongue-in-cheek story — think ‘Lifestyles of the Rich and Famous’ meets ‘Roger & Me’ — detailing Mr. Kravis’s homes and lifestyle, juxtaposed against the homes and incomes of working families.

How bad is the housing market?

More grim news about the U.S. housing market today.

• Home prices slumped 4.5% in the third quarter from a year earlier, matching the second quarter’s record decline. And if that doesn’t make you want to deleverage the real estate exposure in your portfolio, consider this: The S&P/Case-Shiller National Home Price Index also fell 1.7 in the third quarter alone, marking the largest quarterly decline in the index's 21-year history.

• That certainly doesn’t sound good, but the news that made me want to run for the hills came from a report released today by the U.S. Conference of Mayors and the Council for the New American City. The study, prepared by forecasting firm Global Insight Inc., predicts that the value of U.S. homes will fall by $1.2 trillion, and that "at least" 1.4 million homeowners will lose their properties to foreclosure in 2008.

Meanwhile, back in Greenspanland things look pretty rosy. According to press reports, former Federal Reserve Chairman Alan Greenspan said that he had "no particular regrets" and that the faltering U.S. housing market is not a result of his policies.

"The housing bubble is a not a reflection of what we did, as it is a global phenomenon," Mr. Greenspan told an audience in Oslo last week.

Right, free money had nothing to do with this asset bubble. Do I look as credulus as Larry King? Earlier this month, Joseph Stiglitz, a Nobel Prize-winning economist, said Nov. 16 that there is a 50% probability that the U.S. will tumble into a recession after the ``mess'' left by Mr. Greenspan. Defending his record in a statement the same day, Mr. Greenspan said that the criticisms were "inaccurate or incomplete." On the housing front, Mr. Greenspan said that investors are realizing that the drop in U.S. house prices has yet to abate after the ``shocker'' of the subprime mortgage market slump. ``Markets are becoming aware of the fact that the decline in house prices is not stopping,'' said Mr. Greenspan. ``The sub-prime was a shocker because no one expected it. It was the weakest link in the international financial sector.''

Bear Stearns 'Tokin' CEO

Those of you who are fortunate enough not to know what a CDO, CDO squared, or CDO cubed is may have missed the hilarious Wall Street Journal front page story that inventoried the transgressions of Bear Stearns beleaguered and beloved CEO, Jimmy Cayne. Weekday afternoons playing golf instead of managing risk. Ditching crisis management meetings for bridge tournaments. YAWN. Sounds like usual senior executive self-indulgence. But wait, what's this? In addition to being an avid golfer and bridge player, he was an avid dope smoker? (Thew NewsCorp influence on the Journal is already shining through.) For more on this developing story, check out this irreverent satirical editorial allegedly penned by Stephen Schwarzman (CEO of Blackstone, the private equity giant).

We'll Shop Our Way Out of This Mess!

This cannot be susainable:

Sept. 25 (Bloomberg) -- Consumer confidence fell more than forecast in September to the lowest level in almost two years, as declining home values, a deteriorating labor market and tougher borrowing standards took a toll on Americans' spirits. The Conference Board's index of confidence dropped to 99.8 from a revised 105.6 in August and workers were less optimistic about job prospects, the New York-based group said today. The report raises concern that the prolonged housing recession and tougher credit standards will put a brake on consumer spending, which accounts for more than two-thirds of the economy.

A run on the bank in England

The Wall Street Journal describes a literal run on the bank today in England:

"Early Friday, Northern Rock customers queued outside at least one branch to withdraw their savings after the mortgage lender was forced to tap the Bank of England for emergency funds. Some savers had been concerned weeks ago about the possible fallout from the subprime lending crisis on the U.K. lender. In Kingston, England, a line began to form more than an hour before the Castle Street branch opened as concerns about the institution's liquidity unnerved savers. A staff meeting appeared to be taking place before doors were unlocked. Around 9:00 local time, the line outside contained about 30 people, but swelled to more than 70 within half an hour. Almost all were over 50 years old and retired. All planned to withdraw their cash."

European Central Bank Steps in as Lender of Last Resort….Again

As reported by Financial Times:

The European Central Bank on Wednesday loaned commercial banks €75bn ($104bn) for three months, a sign that institutions in the money market remain wary of lending to each other for periods of more than a week.

The Frankfurt-based central bank said 140 banks had applied for €139bn in central bank deposits, agreeing to pay an average interest rate of 4.52 per cent as compared with current interbank prices of 4.75 per cent.

The size of the refinancing operation shows how worried commercial banks remain that the crisis in the US mortgage market could yet render fellow institutions in the money market unable to repay loans.

It chimes with remarks by US Treasury secretary Henry Paulson that, even as short-term lending normalises, the crisis of confidence in the credit markets could last longer than any recent financial crises.

Category 5 Stink Bomb of Bad Mortgages

Dear Readers, I thought you might enjoy this cheery news, as reported in the Financial Times:

“Washington Mutual, the largest US savings and loan company, said on Monday it was increasing its reserves for loan losses to as much as $2.2bn because of a “near-perfect storm” in the mortgage markets.”

So much for a super-cycle.

So much for real estate markets being "local"

The news on the housing market just keeps getting worse. According to the New York Times, the median price of American homes is expected to fall this year for the first time since federal housing agencies began keeping statistics in 1950.

Mortgage Lender Implode-O-Meter

This website is devoted to tracking the mortgage finance meltdown. Is this guy nothing more than a tool of the shorts? He might be, but it's still a good read with lots of good information.

The New Tycoons

This thought-provoking NY Times article exposes the 21st century robber barrons: “…[S]tarting in the late 1970s, as the constraints receded, new tycoons gradually emerged, and now their concentrated wealth has made the early years of the 21st century truly another Gilded Age. Only twice before over the last century has 5 percent of the national income gone to families in the upper one-one-hundredth of a percent of the income distribution — currently, the almost 15,000 families with incomes of $9.5 million or more a year, according to an analysis of tax returns by the economists Emmanuel Saez at the University of California, Berkeley and Thomas Piketty at the Paris School of Economics. Such concentration at the very top occurred in 1915 and 1916, as the Gilded Age was ending, and again briefly in the late 1920s, before the stock market crash. Now it is back…”

China + Private Equity

A few of my favorite things (NOT.) According to the Wall Street Journal, the Chinese government has decided to enter the private equity bubble, which it is largely responsible for creating. "The key thing to take away from the Chinese government's plan to take a $3 billion stake in private-equity firm Blackstone Group: If you're paying for the fuel, you might as well get some of the heat. China's huge trade surplus with the U.S. and other countries has given it plenty of cash -- and a problem figuring out what to do with it. Because China lets its currency, the yuan, fluctuate only in a narrow band against a basket of foreign currencies, it can't easily convert all the money it makes overseas into yuan; to do so would send the yuan higher. So China has been sticking its money into overseas assets... The 10-year Treasury note yields just 4.79%, less than the rate of 5.25% that the Federal Reserve has set on overnight bank loans. Mortgage-backed securities and agencies don't yield much more. A key factor behind those low yields has been that Chinese demand has kept prices propped up. (Prices and yields move in opposite directions.) Those low yields are part of what has driven demand for riskier investments such as junk bonds, emerging-market debt and, yes, private-equity firms. That's driven up prices and driven down yields on these securities, making it cheaper for private-equity firms to borrow and invest."

More on China

The news about tainted imported goods from China just keeps getting scarier and scarier.

SEIU on Private Equity

SEIU (Service Employees International Union) issued a cautionary and sobering report on private equity this week. "The private equity buyout industry, armed with more than a half-trillion dollars of capital, is today engineering financial deals that together are larger than the annual budgets of most of the world’s countries. This financial juggernaut is generating hefty returns to its investors, extraordinary riches for its executives, and newly relevant questions about the impact of its business practices on American workers, businesses, communities, and the nation. "