The Financial Sector Earnings Illusion
I have often written that contemporary “money” and Credit are merely debit and credit journal entries in a massive global electronic ledger. Also deviating from history, financial claims (“money” and Credit) are today detached from actual economic wealth creating capacity. There is no restraint in issuance, as would be the focal point of a system backed by precious metals, nor is lending to finance business investment the commanding Monetary Process for the creation and use of financial claims. Moreover, leading monetary authorities brazenly disregard traditional mores of monetary discipline and prudence. This is why I stick with “Global Wildcat Finance” as an apt description of the current environment characterized by runaway monetary expansion.
There are myriad problems with ungrounded finance. Foremost, there is no mechanism to rein in the over-issuance of financial sector liabilities (including bank & money market deposits, agency and corporate debt, MBS, ABS, “repos” and “structured” instruments). And as we have witnessed repeatedly, inevitable bouts of financial and economic tumult – the consequence of previous excess – are routinely, if temporarily, alleviated with only greater Credit inflation.
The combination of unfettered finance and “activist” monetary management has been a recipe for momentous over-issuance (monetary inflation) and resulting myriad Bubbles. Authorities have no prescription for remedying the situation outside of stop-gap measures that foster only greater monetary inflations – providing further boon for destabilizing lending and speculating excess. I have previously written about comparable fiascos, including John Law’s Mississippi Bubble, the French assignat inflation, and the “Roaring 20s.”
The U.S. financial sector and global central banks are the fountainhead for today’s great inflation. It is worth again noting that Citigroup’s $1.3 Trillion balance sheet expanded at a 24% annualized rate during the second quarter. This is roughly in line with the ongoing growth rate for the combined $3.3 Trillion global central bank balance sheet. There is nothing comparable in history to such a massive and comprehensive global monetary inflation.
For years now, the U.S. financial sector has thoroughly delighted in its unrestrained capacity to issue liabilities and expand holdings. And with an ultra-accommodative Fed manipulating interest-rates downward, the more aggressive the financial sector expansion (Credit inflation) the greater reported accounting profits. Indeed, no industry has anything comparable to the financial sector’s control over its own expansion and reported earnings (also explaining why so many companies have wanted into the finance business). And for years now, investors and speculators have relished in this sector’s heady and consistent earnings growth. This has especially been the case since the technology bust, with enthusiasm for the financial sector a major contributing factor in the vigorousness of the recent “reflation.”
These days, I would imagine that there are some perplexed holders of bank and brokerage stocks. On the surface, things appear to be proceeding swimmingly: interest rates remain low, asset growth strong, the economy reasonably robust, and Credit losses meager. Financial sector expansion has been unrelenting and earnings growth generally stellar, yet many key stocks trade poorly. The question worth pondering this evening is whether this is normal “ebb and flow,” or is there something more significant at work. I will argue the latter.
It is worth recalling how, during the late-nineties, a torrent of liquidity pushed the technology sector into self-destructing excess. Technology was the hot sector in an environment of profligate finance. Massive speculative flows, gross over-spending, endemic over/mal-investment, and general manic upheaval fostered a spectacular industry profits boom and bust. Those caught extrapolating the “terminal phase” earnings climax were rather viciously blindsided.
Finance has since supplanted technology as the hot sector, in a decisive progression of Bubble Dynamics. Massive over-expansion will prove similarly destructive for industry profits, along with being catastrophic for the soundness of the financial system, economy and our currency. There has certainly been over-expansion and heightened competitive pressures, fostering risky and excessive lending. But I will attempt to delve beyond traditional facets of Credit excess.
The financial sector’s predicament is that its massive expansion has nurtured untenable systemic financial and economic Bubbles. This problem is truly endemic, and there is no effective way to slow or manage the process. And while these Bubbles are sustained for now through continued financial sector expansion (Credit inflation), the consequences of gross excess at this stage of the cycle are indeed perilous – and the problem is truly both domestic and global.
Examining the billions of quarterly accounting earnings reported these days by the likes of the JPMorgans, Citigroups, Bank of Americas, and Goldman Sachs of the world, I would posit that they provide today only an Illusion of True Profitabilty. Yes, financial institutions can aggressively lend to consumers and increase leveraged speculations in largely consumer loan-backed securities, but the value of these assets will be negatively impacted at any point where additional loans and speculations are not forthcoming. We have witnessed, in Minskian terms, The Ultimate Systemic ‘Ponzi Finance.’ Meanwhile, the consensus believes that the financial sector is the primary beneficiary of a New Financial Profits Paradigm.
The reality of the situation is that this earnings Bubble Illusion is maintained only by unending Credit inflation and finanical excess. And with asset markets and the economy so distorted, what will prove stunning losses are forestalled only by unrelenting lending and speculative excess.
There are two integral aspects of future financial sector losses today held at bay by expansion. First, there are Credit losses. Current Mortgage Finance Bubble excess encourages many insolvent borrowers to postpone the day of reckoning through the extraction of inflated home equity. Millions of other borrowers are unknowingly risking future insolvency by over-borrowing to purchase (or extract equity from) over-priced properties. It is a central tenet of Credit Bubble analysis that prospective Credit losses expand exponentially during the late-stage of excess, and this dynamic has become much less analytically nebulous over the past year. When the mortgage finance Bubble inevitably falters, losses will quickly mushroom and astound.
There is a second key - and likely more pressing - issue with respect to future financial sector losses. I would strongly argue that today’s huge “trading” gains are also Illusionary – and as well sustained only by massive unrelenting Credit inflation and speculative excess. As long as the “banks,” brokerages, hedge funds and others continue accumulating positions, imputed market values will create the mirage of profitability and liquidity. But only those fooled by the nature of Bubble dynamics would today extrapolate inflated trading gains. Here again, when the financial sector Bubble wanes and players seek less risk and more liquidity, unsound markets will falter. Previously reported accounting gains will be quickly transformed into problematic losses.
Yesterday’s WSJ “Heard on the Street” column by Gregory Zuckerman provided an interesting account of the boom – and apparent unwind - of hedge fund Andor Capital Management. After posting years of stellar returns and growing assets to more than $9 billion, today “Andor is Haunted by a Bad Bet.” Management made the reasonable but losing wager that technology stocks would not have a stellar 2003. Justifiable and excusable perhaps, but one bad year has nonetheless radically changed the dynamics of the firm. Once a magnet for investor flows and talent, the firm now faces an abrupt reversal of fortunes.
For hedge funds generally, when things are going well they go real well. And they’ve been going extraordinarily well for years now. As always, bull markets are a great begetter of genius and wealth. Strong fund performance attracts additional investors, and the attendant flows work to increase the size of positions. Pressing winning positions will help produce only bigger winners, better performance, and heftier (self-reinforcing) investor flows (as well as scores of copycat strategies). And with a service fee of between 1% and 2% and a big incentive fee (often 20% of realized and unrealized gains go to fund management), an expanding fund company will have resources to attract “the best and brightest.” Others, having enjoyed the fruits of bull market success at various firms, on trading desks or from trading their own (and family) accounts, will use impressive track records to set up their own shops, raise funds and build positions.
“Masters of the universe” – fledgling and otherwise - meet fervid investors and speculative dynamics take over. Much too much (free-wheeling) finance chases a limited quantity of sound investments, although this seemingly serious predicament is for some time mitigated by enterprising investment bankers fabricating myriad securities, instruments, and derivative contracts. As fast as lenders can lend (to consumers and the asset markets) and securitizers can securitize, leveraged speculators will speculate in these instruments to the perceived benefit of all mankind.
Andor’s problem is that one year of losses has decisively altered the nature of the game. Since they will no longer receive the coveted incentive fee until previous losses are recovered, their pool of talent is easily enticed away. At the same time, previously giddy investors are left disappointed and increasingly distressed. Not only are they fearful of the ensuing talent exodus, they have further reason to rush to the exit: In a mirror image of the bullish dynamics/“inflationary bias” comprised of self-reinforcing strong performance, heightened inflows, position building and higher prices -- the downside of speculative dynamics has poor performance inciting outflows, position liquidations, lower prices and greater disappointment. And to make matters worse, opportunists are quick to seek gains from Andor’s hardship in the dog-eat-dog world of speculative finance. One wrong bet in one area can jeopardize all bets.
I highlight the Andor predicament this evening as I view it as an instructive “microcosm” of the unfolding vulnerability inherent to both the “leveraged speculating community” and the U.S. financial sector more generally. Importantly, a major reversal in speculative dynamics does not require a major development. And as much as speculative dynamics nurtures a self-reinforcing upward bias over the life of the boom, weakness rather rapidly begets vulnerability and fragility on the downside. Indeed, from reading history I have always been fascinated by the innate susceptibility of seemingly robust financial booms. As analysts, we are today afforded an incredible menu of Bubbles to study and scrutinize.
I would today argue that only as long as financial sector assets and total speculative returns expand will there persist The Illusion of Soundness and Stability. The liquidity to sustain this massive financial scheme is derived from financial sector ballooning – the expansion of risky consumer loans, securities holdings, leveraged trading positions, and derivatives (with few new financial claims backed or financing economic investment). Along with global central bank balance sheet growth, these unrestrained expansions have been perceived as a boon and generally non-problematic. I doubt this will remain the case going forward. In fact, a strong argument can be made that both U.S. financial sector and global central bank expansions are increasingly destabilizing.
For one, there are the deleterious effects to real economies that I have highlighted on numerous occasions (including over-consumption and incessant trade deficits here at home, and inflation in Asia). Second, there is the unfolding dollar problem. It is my view that we are nearing the point where the massive liquidity creation necessary to sustain the U.S. financial and economic Bubbles risks overwhelming the foreign exchange markets. Third, the bloated “leveraged speculating community” is acutely vulnerable to disappointment.
The final “blow-off” inflows into leveraged speculation, along with the amazing proliferation of funds and strategies, have ensured unfulfilled expectations and disenchantment. And with global markets – equities, debt, currencies, and commodities – turning increasingly tumultuous, many funds will suffer a fate worse than Andor’s. With this in mind, I sense that the leveraged speculator Bubble is more vulnerable today than it has been in almost two years. And for the complacent that would argue that hedge funds have withstood hardship in the past, I would retort that the industry has mushroomed to unwieldy dimensions, while the Fed today basically has no room to collapse rates and once again foment easy speculator profits (bailouts).
And this gets us back to The Financial Sector Earnings Illusion. Going forward, only continued financial sector ballooning will hold trading losses and bad debt expenses at bay – only gross excess will prolong The Ultimate Systemic ‘Ponzi Finance.’ But is this possible if the leveraged speculator community turns cautious? And what about the The Dollar Paradox? The financial sector expansion necessary to sustain U.S. financial and economic Bubbles today provides a clear and present danger to global currency markets and financial stability. The game is changing, and I don’t expect the unfolding environment to be especially hospitable to Financial Dreamland.
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