Hitting the limits

Disclosure: The author has intentionally, and continues to, hold only assets that are either liquid or utilitarian. He does not own stocks or property and considers the mobility required to use his education to be of greater importance than financial investment.

I've had a lot of time to reflect on property management and economics over the past week, and the exercise has not been uplifting. It has produced, however, an interesting narrative that you readers might enjoy.

In my youth, I spent a great deal of time with bankers. As a result, the old small bank "rules of thumb" for income/loan ratios, price/earning ratios and some of the mechanics of commercial finance were drilled into me from the beginning. My reaction to events of the last twenty years is heavily influenced by that experience. The most interesting story, I think, has been the transition of commercial banking into investment banking.

The commercial bank model assumed that a borrower would provide a stream of revenue. The banker's job was to find new customers, arrange lines of credit, and then help those customers continue paying by arranging new credit terms or special deals with other bank customers. For instance, a bank with a large construction business as a client would be more likely to lend to a hardware store, since their original customer could use the goods in the new customer's warehouse if something went wrong. Thus, banks tended to be tied to a given industry, and rose and fell with one sector of the economy. Today, this is still done, but it's called "private equity." (there's a great story about a firm buying a fashion magazine and using it to promote "thin belts" as the new fashion item, boosting sales from another company of theirs)

The Investing Banking model assumes that any stream of revenue should be sold to investors. In the short run, this is enormously more profitable because instead giving out a bunch of capital and waiting for loan payments to trickle in, the banker "originates" the loan and sells it to an external investor as a Structured Investment Vehicle (SIV) or Collateralized Debt Obligation (CDO). Thus, issuing loans doesn't affect the capital base of the bank, unless they do something like insure the value of the security, but that's an off-balance sheet transaction and so doesn't count. As a result, the amount of credit available, and thus money creation, is limited only by the amount investors can buy.

This approach also move innovation up the value chain. Instead of employing tens of thousands of commercial bankers to find relatively simple innovations (the builder helping out the struggling hardware store), now the world needs thousands of very smart "quants" to find statical arbitrage. Since banks don't need to keep industry experts on staff, and they have more money to lend, interest rates go down. If something goes wrong, instead of an "offer you can't refuse" to receive help from another bank customer, it's much easier to get an extra bridge loan. As long as there's someone to buy that next security, life is good.

But what happens when the market for iffy debt saturates? Well, either everyone goes bankrupt together or we go find another sucker. With TARP, the US government promised to be the Sucker of Last Resort, and now the EU's large Eurozone economies have promised to do the same thing for sovereign debt. Is this "find another buyer" model sustainable? I'm starting to doubt it.

Equity markets, social security and Chinese purchases of US Treasury bonds all represent wealth transfer mechanisms that count on relatively young people giving money to their elders. Middle managers at the Chinese central bank and treasury are typically fans of Currency Wars, a book that makes very a clear case that the Politburo's export-subsidizing policies are effectively a huge tax on them. The loudest advocates against any changes to Social Security in the US come from people who also demand no new government revenues, and so the SSA will turn to statical tricks to keep payments reasonable. Stagnating real wages and rising unemployment, especially among people under 30, chokes off the flow of money into 401ks, and so depletes the order books on the NYSE and other exchanges.

I'm thinking that this is actually very good news, net. Moving innovation away from the "real" economy and into finance has encouraged manufacturing and physical R&D to leave the United States. If the most profitable move for a pension fund is to build a wind farm or factory instead of buying the bad mortgages, that has to be good for the country as a whole. The next few years will be rough, but I think we'll emerge with a better world for it.