Fintech – News and Analysis

After discontinuing blogging at techandfinance.com I took some of my favorite material and I am not posting it here on a WordPress blog…so you may notice that some of it is — not dated — let me say is has a certain slightly historical flavour. But reading it again makes me think I should go back to some of these sources and see what they have been up to since. My most recent work is at my Forbes blog, http://blogs.forbes.com/tomgroenfeldt and I continue to write for Banking Technology in London, which is online at http://www.bankingtech.com. Always happy to get feedback from readers.

Tom

If you want to understand the current banking crisis, start with Philip Augar whose latest book about investment banking, Chasing Alpha, covers the crash and its causes. 

Augar has a doctorate in history, although his recent books don’t mention it. As I recall from The Death of Gentlemanly Capitalism, he sort of stumbled into banking, and then thrived. He led NatWest’s global equity business and eventually became treasurer of Schroders. So he brings professional research and writing skills along with an insider’s view of the City and Wall Street to his books. 

In Chasing Alpha, he depicts an England and America that had gone money mad. UK household debts soared, Americans piled into houses they couldn’t afford using subprime mortgages with cursory or no credit  checks, and New York investment banks acted like giant Hoovers, sucking money out of unsupervised mortgage brokerage operations and bundling it into mortgage-backed securities that they stashed off their balance sheets in Special Investment Vehicles (SIVs) which they “insured” through credit default swaps, all approved by the credit ratings agencies. The net result was to make Bernie Madoff look like an underachiever.  

The historical facts make up a critical take on banking, as he recalls city scandals such as Guinness, Blue Arrow, BCCI, Maxell and Polly Peck.  Asset managers, meanwhile, seriously underperformed the FTSE. It is a highly unoriginal sin in investment banking to confuse good luck with talent, but the run of exceptionally benign market forces from 1997 to 2007, a good talent pool, and support from New Labour made the City a highly profitable place to work and led bankers to think they fully deserved their stratospheric pay. 

In 1996, Gordon Brown pushed back against Tony Blair’s idea to promote a stakeholder economy, as promoted by The Guardian’s Will Hutton. Blair told an audience in Singapore: “It is surely time to assess how we shift the emphasis in corporate ethos from the company being a mere vehicle for the capital market to be traded, bought and sold as a commodity, towards a vision of the company as a community or partnership in which each employee has a stake.” Brown poured cold water on the notion and New Labour went with the shareholder view, the view which GE’s ex CEO Jack Welch recently derided in a statement to the FT: “On the face of it, shareholder value is the dumbest idea in the world,” he declared to a stunned world.” 

Something of a missed opportunity there, perhaps one to revisit in determined next moves in governing the economy.  

This wide-ranging account includes a reasoned discussion of private equity and concludes that it plays a relatively small, and relatively benign role in the economy. Here I think he is too kind. Businessweek did a piece on the way private equity firms strangled a regional US chain, Mervyns by stripping its assets, sucking out $400 million in cash, renting back the real estate at high rents, and putting 30,000 people out of work, many with no severance and unpaid vacation time. (Admittedly this is partly the result of horribly inadequate labour laws in the US)

He cites Gordon Brown’s Mansion House speech in June 2007, just before becoming Prime Minister, and its by now well known praise for The City. (London has enjoyed one it its most successful years ever, for which I congratulate all of you here on your leadership skills and entrepreneurship” was just part of it). The larger point he makes, one also made by BBC reporter Robert Peston in “Who Runs Britain”, is that New Labour bowed before The City – or at least it did once Brown persuaded Blair that the Stakeholder route would not work. 

At the same Mansion House event, Bank of England Governor Mervyn King noted that excessive leverage is the common theme of past financial crises. “Are we really so much cleverer than the financiers of the past?” he asked.

Augar notes the leverage used by investment banks

Goldman Sachs 24:1

Morgan Stanley 25:1

Lehman 32:1

Bear Stearns 33:1

This is the sort of leverage more commonly associated with hedge funds than banks.

Great while the market was going up, but when the market turned, it moved fast. In October 2007 Stan O’Neal left Merrill, Chuck Prince at Citi followed in November, and in January Jimmy Cayne was gone from Bear Stearns. Over the same period England was creating and expanding rescue packages for its banks.

The failure was system-wide, Augar concludes.  Could the CEO of HBOS have announced that everyone else was wrong and he was scaling back? As at least one senior executive has told journalists, if he had cut back on the leverage he would have been replaced.

While Chasing Alpha has the value and shortcomings of a book produced as the crisis moved along (Augar notes that Sir Fred Goodwin left RBS with no leaving package; apparently his pension hadn’t hit the papers at the time of publication) my favorite of his books is The Greed Merchants, which came out in 2005. 

Here he notes the incredible growth in profitability in the securities industry from 1973 to 2000, four times the growth of corporate profits.

It became accepted practice for employees to take half the revenues of firms which had gone public. 

Augar is the only analyst I have read who offers an industry wide view on the reason – he says the securities business is a cartel with a few players who maintain oligopolistic pricing (IPOs fees in the US have stayed at 7 percent persistently) and the high payouts are a way to mask the huge profitability of the firms. (They are almost immune to business-changing lawsuits because all the firms with the depth to handle such a lawsuit work for the Wall Street firms). 

The financiers are among the leading political donors, and the political leaders on both sides of the Atlantic feared to annoy the bankers.

“Washington and Westminster had so much riding on Wall Street and the City that they could not and cannot afford to upset them.”

Investment banks concentrate power and knowledge through an integrated model of trading, sales, research and corporate banking. Augar says the largest banks know more about the world’s economy than any other organizations, because they are plugged into the markets for equities, bonds and commodities and talk constantly with leaders of the largest corporations – just 200 CEOs are regular users of investment banking services and the total number of clients globally, if you include occasional users, is no more than 1,000, he says.

Perhaps most damning is Augar’s conclusion that the US-UK investment banking model is actually bad for the economy. The banks enabled the waves of corporate corruption, such as Enron and Worldcom, in two decades they took more than $150 billion out of capital markets through abnormally high compensation, an amount that could certainly help plug the pension deficits in the two countries, and they have promoted mergers which made sense only in accounting rules while destroying value.

His conclusions? The integrated model has to be broken up – that’s the only way to alleviate the inherent conflict of interest between advising clients and making a proprietary profit on trading. Second, advising clients and then profiting from the mergers and acquisitions leads to conflicts for both banks and CEOs.

CEOs of companies are no match for fast-talking bankers, he says, and the bankers were able to dangle life-changing rewards in front of them in return for deals that actually destroyed value.

Advice should come from fee-charging advisory firms which do not handle deals. Deposit taking institutions should be separated from securities trading, and lending banks should keep the risk on their balance sheets, although he doesn’t specify whether this means keeping the entire loan. Investment banks would become providers of liquidity as pure trading houses.

This might lead to less liquidity and an increase in the cost of capital, although that isn’t certain, he adds, but such as system would be transparent and free of conflict of interest.

“Tinkering with the rules did not work in 2003 and it is doubtful it will make a lasting difference in 2009. Unfortunately, more tinkering is exactly what is being discussed at the time of writing.”

His first book on the City, “The End of Gentlemanly  Capitalism,”  showed the way clubby and somewhat outdated City firms were taken over by Americans, Swiss and German banks. The Americans in particular brought highly professional management, meritocracy in hiring and promoting, the ability to cross-subsidise London from New York, plus, of course, and the ungodly habit of working through lunch. (It too is an excellent book and easy to read).

All three books are valuable for understanding how we got to this point and where we can go from here. Augar has appeared more recently in the Financial Times where he had a recent article saying “It is time to put finance back in its box.” 

“Unless governments in America and Britain really open themselves up to new ideas, emerging economies in Asia and mainland Europe, places where alternative economic and corporate governance models do exist, will seize the initiative and redefine the global agenda.”

He told Joe Nocera of the New York Times that

…he believes that the regulatory environment helped bring about the “Americanization” of the City of London, and that it was ultimately ruinous. All the big American investment banks raced to London — which they saw as a place to do business not just in Britain but all over the Continent. After the abolition of Glass-Steagall, the commercial banks came roaring in as well. 

“Gordon Brown instituted a lot of pro-City policies,” Mr. Augar said. “He cut the capital gains tax. He combined about nine different regulators into the F.S.A.” — the Financial Services Authority — “which adopted something it called ‘proportional regulation.’ ” Mr. Brown himself had a more apt phrase: “light touch regulation,” he called it. In other words, he consciously aligned regulation in Britain with the free-market, deregulatory approach being promoted by Mr. Greenspan and Mr. Rubin.

Nocera, after a quick tour of London talking to finance experts, concludes that Britain faces a bigger problem than the US because financial services has been such a large part of the national economy.

“The country is drowning in debt. Mr. Brown’s Labor government is running large deficits in an effort to stimulate the economy.

“If that, too, sounds like the response of the Obama administration to the financial crisis, it is indeed quite similar. Here’s the big difference. New York is a big city in a big country, and our national banks, as big as they are, are much smaller as a percentage of gross domestic product. London is a big city in a small country, and during the bubble, its banks became truly immense, outsize really, given the size of the country they operated in.”

But Britain can’t regulate alone, he adds.

“…although no one will say this out loud, Britain can’t regulate unilaterally anymore — it is simply too dependent on American institutions. Its regulatory response will be to mimic whatever the Obama administration decides to do. 

Nocera also caught up with Martin Wolf the Financial Times who told him “If regulation is transformed in London it is because of what the U.S. does,.The U.S. will say, ‘You are to follow us.’ We now have no regulatory autonomy.”

Are political leaders in the US, UK or Europe up to the challenge? I doubt it.

“That’s everybody’s challenge: come up with a clearly beneficial example of financial innovation without mention A.T.M.s, and no one can do it. If there are arbitrage opportunities and you’re able to spot them a few seconds before anybody else, you can make a lot of money, but there’s no actual social gain from doing that.”

Good profile, and amazing to see how late he was to become interested in politics – he was mostly interested in problem-solving in economics and worked in Reagan’s Council of Economic  Advisers. He is pretty critical of some people in politics. Don Regan, Reagan’s Secretary of Treasury “was not that bright.” And he can’t stand Robert Reich or Lester Thurow (known among economists as Less than Thorough) for glib assertions and inadequate thought.

The profile shows the distance between economics and finance, and corporate governance, for that matter and he was critical of Obama, his last choice among the Democratic candidates, for all his sentimental feel-good stuff.

And he is a science fiction fan.

“If you read other genres of fiction you can learn about the way people are and the way society is, but you don’t get very much thinking about why things are the way they are, or what might make them different. What would happen if.”

Economics, he learned at Yale, was a way of making sense of the world.

If you read Krugman, whether you love him or hate him, you should find this interesting.

Also see the author’s live chat with Krugman.

From the interview:

“Government isn’t nearly as bad—or the private sector nearly as good—as it’s often portrayed. I know I lot of very good, very hard-working government employees; and while I don’t work for a large corporation, I do read Dilbert.”

You have to admit, they completely avoided the problems the US ran into, and they are offering some advice through the pages of the FT.

Chrystia Freeland , the paper’s managing editor who is Canadian, weighed in with  “What Toronto Can Teach  New York and London at the end of January.

She amusingly weighs the arguments that Canadians are too nice or too dull. I recall a discussion about an equities matching pool being set up in Toronto and I asked whether they were concerned about firms’ gaming the system, only to be assured that would not be permitted.  As if the mere fact it was impolite was enough, but if not, they were ready to ban the gaming institutions. Refreshing, in part because it was not exactly the prescription you would expect to work in New York.

“In my conversations with Canadian bankers, one of the things that struck me was how often they referred to mothers. Nixon mentioned his mother and her good opinion when explaining why he gave back his bonus in 2008; [TD CEO Ted]Clark uses the mother-in-law test, as in ‘Would you sell it to your mother-in-law?’ to help TD employees figure out if they should be hawking a product to their customers. In an era when Wall Street investment banks issue notes warning their clients they may be short-selling the investments they are marketing, this sounds like a charmingly Canadian attitude. But it is easier to be nice if you don’t need to be nasty just to make a buck. ”

I seem to remember reading a quote from the head of TD, presumably Clark, who asked someone in the bank to explain a complex instrument. He couldn’t follow and said he wanted the bank to get out of any instrument that couldn’t be readily explained. Ah, if only Citi and a few others had followed such a path.

Clark and several other Canadian banking chief appeared more recently in the FT suggesting some basic reforms, and citing three basic problems.

“…first, excessive leverage in the banks and investment dealers. Second, a lack of common standards for the quality and level of capital. And third, weakness in risk and liquidity management.” While Freeland said Canadian banks securitized some mortgages, Clark said holding them is key to stability. Perhaps some mid point can be found where banks must hold some of their mortgages, combined with standardized details fed into a database and a way around relying on the ratings agencies — since fixed rates mortgages can be a useful investment for pension funds and insurance companies.

Clark’s big point is important and often overlooked.

“Policymakers have a unique opportunity to refocus banking on economic growth and job creation. For this to happen, policies must address the root causes of the financial crisis.”

In some ways, the “too big to fail” argument for smaller banks addresses this issue. Financial industry profits have risen to a huge chunk of total corporate profits in both the US and UK. Some historians have pointed out that an overly financial economy often leads the way to a crash, citing the Netherlands and a few others I don’t recall.

It’s probably hopeless optimism to think Parliament or Congress will address these issues intelligently, but in Washington the Obama administration seems ready to take at least a few useful steps toward reform.

See also Julie Dickson, superintendent of financial institutions in Canada, who looks to market forces, appropriately tied to bank liquidity, to provide effective self-regulation.

“…embedded contingent capital. This is a security that converts to common equity when a bank is in serious trouble, instantly increasing the core capital of the bank without the use of taxpayer dollars. The principle is similar to “CoCos”, the convertible bonds already issued by some banks. But it would apply to all subordinated securities and would be at least equivalent in value to the common equity. This would create a notional systemic risk fund within the bank itself – a form of self-insurance pre-funded by private investors to protect the solvency of the bank.

“As an example, consider a bank that issues $40bn of subordinated debt with these embedded conversion features. If the bank took excessive risks to the point where its viability was in doubt and its regulator was ready to take control, the $40bn of subordinated debt would convert to common equity, in a manner that heavily diluted the existing shareholders. While other, temporary measures might also have to be taken to help stabilise the bank in the short run, such capital conversion would significantly replenish the bank’s equity base. ”

In other words, tie investors tightly to the bank’s potential for failure. As Samuel Johnson said, “When a man knows he is to be hanged…it concentrates his mind wonderfully.”

The Experience Economy is nothing new — Microsoft was deploying the concept in its financial services marketing a few years ago and in 1999 B. Joseph Pine and James Gilmore published  “The Experience Economy: Work Is Theater & Every Business a Stage.” Commentators on Amazon compared it to other books such as Experiential Marketing and The Entertainment Economy. 

Such sociological slowpokes.

Back in 1965, Alvin Toffler, best know for “Future Shock,” wrote a book called “The Culture Consumers: Art and Affluence in America,” which noted that the booming American economy was capable of satisfying most consumers’ needs and had produced what he called the Comfort Class. People across the country were turning to visual arts and performance arts, as producers, consumers and sponsors. He noted that colleges and universities across the country were both bringing in top performers and putting on some of the world’s most challenging plays and musical productions with student groups, sometimes including highly respected professionals from outside the area as part of the production.

Unlike some critics of American culture, or its reputed lack of culture, Toffler traveled the country, visited university campuses, talked to professional and amateur performers and to impresarios competing with local university booking offices for both talent and audiences.

He also looked at what psychologists have to say about art, its role through the ages (lightly touched upon, but a useful reminder that art has only rarely been the sole province of the professional.) In other words, his reporting isn’t politically correct, New York City parochial or infused with psych babble. This is quality journalism at its best — inquisitive, imaginative in its effort and fact-based in its delivery.

“Art, not merely because it sometimes transmits the value of a past age, but because it has been a part of human society since the beginning, is an anodyne for rootlessness.”

Thomas Friedman Imagines What Leaked Chinese Diplomatic Cables Would Contain

The New York Times columnist is scathing about American politics in his imagining what the Chinese would be saying. He compares the fast train from Washington to New York — three hours — to the same distance traveled in China, 90 minutes. And unlike the US experience, in China mobilel phone calls wouldn’t drop 12 times during the trip. The Chinese note that cell phone quality is better in Zambia than in the U.S. 

One of his key points, put into the words of a Chinese cable, is that most Americans don’t realize how far behind they have fallen because so few of them travel outside the country. 

I have wondered how many Tea Party advocates have been outside the U.S.  They might seethe quality of life is high across Europe, that people have just as much personal freedom as Americans and more meaningful political freedom because politics is not so heavily dominated by money.

Republicans who label Obama a socialist display a weird time warp. Just what does socialism mean today — Sweden? This name calling is inane. 

“There is a willful self-destructiveness in the air here as if America has all the time and money in the world for petty politics,” writes Friedman. He speculates on how the Chinese would analyze this:

“They travel abroad so rarely that they don’t see how far they are falling behind. Which is why we at the embassy find it funny that Americans are now fighting over how “exceptional” they are. Once again, we are not making this up. On the front page of The Washington Post on Monday there was an article noting that Republicans Sarah Palin and Mike Huckabee are denouncing Obama for denying “American exceptionalism.” The Americans have replaced working to be exceptional with talking about how exceptional they still are. They don’t seem to understand that you can’t declare yourself “exceptional,” only others can bestow that adjective upon you.”

 Unfortunately, the petty politics don’t appear to be slowing down anytime soon.

President Obama said something about trying to duplicate the Sputnik concern and improve education in his State of the Union address. Andrew Hacker, co-author of “Higher Education? How Colleges are Wasting our Money and Failing Our Kids — and What We Can do About it.” Picks apart some numbers in the New York Review of New York Review of Books.

 Invest in further education? We may live in a knowledge economy, but much of the knowledge has been outsourced. “Asian engineers now build entire industrial systems…” Education in science, technology, engineering and mathematics (STEM) may be oversupplied. About 4.8 million people hold STEM jobs while nearly 16 million have STEM degrees.

“To say, as ‘Help Wanted’ does, that we are not producing enough college graduates to satisfy future demands seems doubtful at best. Even in prosperous times, not all graduate obtain jobs typically associated with a degree,” he writes. And he quotes Paul Parton of Educational Testing service that  we should not assume “that if someone who has been to college is employed at a job, that job requires someone who has been to college.”  Often employers require a college degree even if it is not needed; it is one way to reduce the pile of resumes.  It is also a way to puff up appearance.

“Hospitals want to be able to say that their nurses have bachelors of science degrees.”

Lucy Kellaway, the irrepressible Financial Times management columnist, passed along a recent newspaper account of an English banker with degrees from Oxford and Harvard and 20 years at JP Morgan who was recently hired and worked at a high level for a month before anyone ran a background check.

He turned out to be a conman who had been in prison and is being treated for depression.

“You simply need to pick the right wardrobe and learn the right language,” she concluded.

 Be Bold Wisconsin wants more four-year degrees, yet it isn’t at all clear this is going to help students or the economy, although it will keep colleges and universities busy. “Help Wanted” suggests the country needs 8.2 new college graduates; Hacker said that would cost about $550 billion, plus living costs. 

 it is a matter of economic disgrace that the US ranks 24th out of 35 OECD countries in math skills. In fact, says Hacker, relatively few jobs require math skills much beyond basic arithmetic, at say, oh about an 8th grade level.

In fact, the US Bureau of Labor Statistics suggests if you want a career with a future, although not necessarily a lucrative one, you should hone your food service skills, practice being pleasant (receptionists, customer service reps) read Kerouac (long-haul truckers) take care of people, but not at an RN level — aides and orderlies and LPNs are in the top 10 growth careers, get into construction or landscaping or become a security guard. 

 And presumably if you want to do well, find a company that looks at your skills, not just your credentials.

Richard Holway, a UK IT analyst and a founder of  TechMarketView, recalls the pre-Facebook days in his latest newsletter.

“At the weekend a few old technologists like me got together and discussed the ‘good old days’ of the 1960s. How each day several hours were spent in the pub at lunch time – from the CEO to the lowliest programmer  like me at the time – and then again on the way home. We discussed how all the great ideas were both born and communicated from the pub. How all the most interesting news was disseminated, successes celebrated and sorrows on failures drowned over a pint.”

Silicon Valley firms used to be known for their Friday afternoon pizza and beer parties and even now are much more likely to have a pool table in the office than non-IT companies. Have we lost something here?

David Brooks, writing in The New York Times, makes a similar point as he described Rahm Emanuel campaigning for mayor of Chicago.

“Many of us are drawn to the big power politics of Washington, but city politics is better than national politics because the problems are more tangible and the communication is more face to face.

This is a point Edward Glaeser fleshes out in his terrific new book, “Triumph of the City.” Glaeser points out that far from withering in the age of instant global information flows, cities have only become more important.

That’s because humans communicate best when they are physically brought together. Two University of Michigan researchers brought groups of people together face to face and asked them to play a difficult cooperation game. Then they organized other groups and had them communicate electronically. The face-to-face groups thrived. The electronic groups fractured and struggled.

Cities magnify people’s strengths, Glaeser argues, because ideas spread more easily in dense environments. If you want to compete in a global marketplace it really helps to be near a downtown. Companies that are near the geographic center of their industry are more productive. Year by year, workers in cities see their wages grow faster than workers outside of cities because their skills grow faster. Inventors disproportionately cite ideas from others who live physically close to them.

For years, cities like Detroit built fancy towers and development projects in the hopes that this would revive the downtown core. But cities thrive because they host quality conversations, not because they have new buildings and convention centers.”