One of the downsides of being a triple-crisis blogger is that you are always on the lookout for crises. It’s not a role I particularly enjoy, but it is what it is. So as the markets wind down for the year and the illusion of calm falls over us like a blanket of denial (yes, keep positive folks), I thought I’d write a piece about what I see as, perhaps, the emerging story of 2011. Its one that comes from reading the New York Times and the Financial Times yesterday morning, while thinking about two pieces I have read this year: one by Andy Haldane back in July and one by John Cassidy in late November.
The story in both papers, in case you missed it, was about how for many Wall Street and City of London bankers, the traditional Christmas bonus dished out this year would, for some, contain lots of zeros, and not much else. Its not so much that profits are down (they are), so the story went, but because the perception of ‘the bonus culture’ as creating excessive risk taking has led to higher base salaries and escrow-type arrangements at many US banks, while in the UK and Europe many mid-tier bankers are about to be eliminated from the bonus pool altogether, with talented juniors and senior executives being protected.
The FT reports that fixed income and equities departments will see cuts on the order of 15 percent, with M and A departments losing up to 35 percent. Within banks losses will be shared according to performance, and here’s the rub: the banks are not performing nearly as well as they used to, which brings me to Cassidy’s piece.
Cassidy’s November New Yorker piece asks a simple question, “What Good is Wall Street?” That is, what’s the social utility of banking? If it significantly adds to capital formation, then the argument for compensation orders of magnitude beyond other sectors is somewhat justified. The problem is showing this since doing so rest upon a series of counterfactuals that are hard to prove. That is, absent a particular innovation, growth would have been lower, which is very tricky stuff. For example, the existence of a $400 billion swaps market doesn’t mean that its absence would result in lower GDP growth. It does however mean lots of fees for those who arrange the swaps.
Looking at the link between what banks do and capital formation, Cassidy notes that since the dot.com bust, US IPOs have all but ceased to be while investment banking has grown in size, which is odd. Meanwhile, for Morgan Stanley, the part of the firm that does link borrowers to savers and raise capital, traditional investment banking, constituted a mere 15 percent of 2009 revenues. For Citibank “about eighty cents of every dollar in revenues came from buying and selling securities, while just 14 cents on every dollar came from raising capital for companies.” As such, the claim that these institutions are doing “God’s work,” AKA capital formation, seems to skate on rather thin ice.
All of which makes the scale of financial compensation relative to other sectors stand out even more. After all, if they are not doing God’s work, one must wonder where the generation of such rents comes from. Cassidy notes that, controlling for education; compensation in finance is about 60 percent higher than it is elsewhere, on average, with top earners several orders of magnitude off that average. So does it tell us anything that the bonus system, the rewards machine, is being compacted and reduced at this time? There is a piece by Andrew Haldane that suggests so.
Haldane, executive director of Financial Stability at the Bank of England, authored a piece in the LSE report from July 2010 on the Future of Finance that sets out to measure the contribution of the financial sector to growth. Is it a productivity miracle or a statistical mirage? Haldane concludes that it’s a mirage, but what is of most interest is the argument in his paper about the real business model of investment banks. Rather than do the tedious and low earning job of capital formation, and as we see in the Citibank and Morgan figures from Cassidy this is actually a minority pursuit, Haldane argues that what banks have actually done is to create a unique business model with three core elements.
First of all, you give up on customers and develop counterparties. That is, you fatten your trading book, and to do that you need lots of different products to trade, hence the growth of complex and opaque securities. Second, you use said securities and the firm’s balance sheet to develop massive amounts of leverage so that even if the margins on each trade are thin, with enough volume you can earn a lot of cash. Finally, you ‘cover’ all this by writing deep out of the money options that give you a near risk free income stream: until it doesn’t.
This is how banks actually make their money, until 2007, which raises two problems going forward. First of all, the revenues generated by this model are contingent upon some raw material going into the system as an input that one can profit from as the asset increases in value. Over the past twenty years those raw materials were equities and then real estate and then (briefly) commodities. The latter markets are too small and fragmented to pump this system, hence the 2006-7 boom and bust, and the former two and now either held up by massive amounts of free liquidity (equities) or are underwater (real estate). As such, it’s not clear that these engines of profitability can be effectively restarted.
This is a worry since the bailouts, which I fully supported since letting national payments systems go bust is never a good idea, were based upon two complimentary definitions of what this was a crisis of. For the Americans this was a crisis of liquidity. That is, the engine was sound; it’s just run out of oil (credit crunch) and with enough liquidity it will spontaneously restart (limited stimulus etc.) For the British, the engine blew a cylinder and it had to be rebuilt (12.5 percent of GDP as bank recapitalization), and with enough oil (liquidity) it will restart. But what if the raw material, the gasoline in this analogy, is no longer available? Then the business model as a whole may be in terminal decline. In the UK, Haldane notes, intermediation activities went from 1.5 percent of GDP in 1978 to 15 percent by 2008, which “equates to annualized returns to banking of almost 15 percent.” Perhaps then the bonus slim-down is a leading indicator that such returns are no longer sustainable?
What may pop-up in 2011 and would make this situation more urgent is the mortgage foreclosure mess. By turning the Fed (and other central banks) into a bad bank for the worst crap on banks’ balance sheets, and by pumping the system with huge repo programs and unlimited liquidity, it was possible to save the payments system and allow the banks to pick up the deleveraged/fire-sale assets they dumped in the crisis for a song, hence the stock market rise. What also helped here were mortgage foreclosure forbearance programs, which while a normatively good thing, simply kept people in houses that were never going to realize their value, thus prolonging the agony. These policies also allowed the banks to pretend that these liabilities are not there. Next year they come back home to the balance sheets of banks that, as per above, have a business model under stress, and whose revenues are declining and whose costs will, because of foreclosures, start increasing. All of which will take place in an ‘austerity-struck’ economy that cannot generate the growth needed to clear the housing market and consequently, the banks’ balance sheets.
So let’s have sympathy for those poor souls doing without bonuses this year. After all, next year they may be even more of these unfortunates. And the year after, here may be no bonuses in the cupboard at all. Merry Christmas!