WASHINGTON, Sept. 23 (UPI) -- At some point, the question must arise: was the explosion in size of the financial services business in 1982-2000 real, or was it yet another figment of an overheated market's imagination?
After all, the bad news continues to roll in on banks and brokerages, with J.P. Morgan Chase last week announcing an extra $1 billion write-off on its telecom loan portfolio, and brokerage after brokerage firing their top analysts and being hauled before the U.S. Securities and Exchange Commission.
The Japanese experience here is instructive.
In 1990, seven of the 10 largest commercial banks were Japanese, as had been the first investment bank to report net income of $1 billion -- Nomura Securities, in 1987. Japanese banks were the most aggressive in international loan markets, because their capital base grew every year as the value of their "core" shareholdings soared.
Japanese institutions were the major competitors for Western talent, particularly from the fading and underpaying London merchant banks. They generally had to pay a premium to attract the best people, since the Japanese consensus management culture was difficult to integrate with the fast pace of a trading desk, or Western financial markets as a whole.
The current view is quite different. Japanese brokerage houses are now considered hopelessly backward, surviving by stuffing Mrs. Yamamoto with overpriced shares in companies controlled by their clients. Japanese banks, too, are supposed to be woefully undercapitalized, in danger of insolvency if the Nikkei share index continues to drop, because of their huge holdings of equities and continual write-down of real estate loans, most of which were based on the valuations of a decade or more ago.
Last week, the Bank of Japan took action. It committed to buy shares from Japanese banks at market prices, to the extent that this was needed for their liquidity or solvency. This step was condemned by Western commentators, who saw it as a "propping up the market" exercise similar to that undertaken by Malaysia and Hong Kong in recent years.
But the BoJ is buying equities only from the banking system. While this helps the market in a negative period, market support isn't the primary goal of the exercise. The BoJ's aim is to avert bank insolvency.
There is little "moral hazard" in the BoJ's action, since there is no chance that it will set off an orgy of irresponsible stock investment by the banks. It is now more than a decade since they made their excessive real estate loans and excessive "tokkin" investments in equities, and all of them have come close to bankruptcy and/or engaged in forced mergers since then.
Western commentators, positively Calvinist in their approach to the purity of the Japanese banking system -- which has already undergone 12 years of painful ritual purification -- show no such Calvinism when it comes to their own financial systems.
The general view appears to be that a couple of down quarters and the firing of a few superstar analysts should be quite enough to adjust the outlook of the U.S. financial services industry. After that, it can go back to the heroic growth of 1982-2000, in which it rivaled only information technology as an employer of overpaid yuppies.
Could this be wrong? The share of financial services in the U.S. and world economies has indeed grown over the past two decades, and both employment and remuneration in the sector have soared beyond the wildest dreams of '80s practitioners.
After all, all Salomon Brothers, a leading investment bank, was sold in 1981 for $545 million, about the same as Drexel's Michael Milken earned on his own as early as 1987. And, less than the then fairly obscure Jon Corzine (now a Democratic senator from New Jersey) earned from Goldman Sachs' $30 billion 1999 initial public offering. It is not clear, however, that the growth was sound or will be sustained.
Take equity research. In 1982, a good friend, discussing her future Wall Street career, sneered at the possibility of entering this field, on the grounds that even the top practitioners earned less than $250,000 (far more than she, I or anyone else she knew was earning at that time, of course!)
That seems about right; endless studies have shown that even the best research adds little to a share portfolio's return, so top salaries for this skilled but limited specialty should probably be in the mid-six figures. Of course, they're not.
Top analysts, such as Jack Grubman, formerly at Salomon Brothers, take home $10 million per annum or more in a bull market. However, nobody is paying them that for the quality of their research; instead their research is a sales tool for the more dubious offerings of the firm's new issue operation, spiced with the occasional nugget of insider information to make sure clients read it.
Needless to say, Grubman-style interactions between corporate finance and research have become illegal. Why, then, will anyone again pay a research analyst more than is merited by the value of the research itself, plus maybe a slight premium for the advertising benefit if they get recognized in the Institutional Investor All Star team? As I said, mid-six figures, tops.
Take principal trading, whereby banks and investment banks pay superstar traders to make money for the firm, using its overblown balance sheet and ability to leverage.
Numerous studies have shown that, with the possible exception of a very few exceptional individuals like Warren Buffett, it is impossible to outperform the market consistently.
But if management or the market will give you several billion dollars to play with, and the possibility to leverage several billion more, you can make a very nice living during a bull market by short-term trading, taking care that your position is always somewhat "long" so that when all the dust of trading clears, you will show a profit.
This profit can be increased if you can trade on insider information -- for example getting hold of company "whisper numbers" of earnings, which were so prevalent before October 2000's Regulation FD, which mandated full and equal disclosure for all investors.
The bear market that began in March 2000, and the increased regulatory scrutiny of insider trading, have spoiled this game for stocks, of course. But 2001 was a very good year for bond principal trading and insider information laws are much less carefully enforced outside the common stock arena.
Nevertheless, it is likely that in future, investors will cease paying twice net asset value for what is essentially an actively managed stock portfolio. This area will become less profitable, and financial sector capitalizations will decline.
After all, the London merchant banks showed for 200 years that it wasn't necessary to be heavily capitalized in order to make a success of true deal-creating investment banking.
Derivatives are another new business area since 1980. Here, the keys are risk management and liquidity.
As Enron demonstrated, you must always have access to enough liquidity to withstand sudden moves in your derivatives portfolio. Expect, therefore, the market for novel derivative contracts, such as those in energy, to move to the houses on Wall Street that have rock-solid credit ratings.
The dirty secret of derivatives risk management is that risk management models, when options are involved, are highly imperfect. The models purport to demonstrate to top management that a portfolio is adequately hedged, but they rest on a number of dubious assumptions, in particular that both options and the outright contract can be traded on a continuous basis as markets move.
October 1987 proved that this isn't the case. However, that is now 15 years ago, which on the trading desks of Wall Street is about two career lengths, so traders active today have little experience of what can happen when markets move rapidly and liquidity dries up.
Thus even houses with rock solid credit ratings are likely to find themselves caught in some very nasty shocks if and when the markets move rapidly (which so far, in the 2000-2002 downturn, they have not done.)
Like the other new businesses on Wall Street, this one too may look a lot less attractive to providers of capital after the event. Alarmingly, Fed Governor Mark Olson, at a meeting Wednesday, claimed that in his time at Ernst & Young, in the 90s, auditors of banks had ceased to look at individual transactions, but only at risk management systems.
Since such systems have been shown time and again not to work in extreme situations, one must seriously question the quality of Wall Street's financial disclosure throughout the period.
On the commercial banking side, two trends have increased both the volume of business done and its risk level.
One is simply the increased aggressiveness of lending officers, who receive huge bonuses when asset volume targets are met. This is extremely unsound in a commercial banking business.
I attended a presentation in the summer of 2000 at which James H. Lee, the executive vice president of JP Morgan Chase, bragged about the huge volume of telecom leveraged buyouts that the bank was doing. An able and extremely aggressive individual, he has doubtless contributed substantially to the problems that the bank is facing and will face in the future.
Much better for its shareholders if the bank had employed a dozy traditional banker, remunerated accordingly, in the job of corporate loan origination.
Second, securitization has enabled banks to take loan portfolios off their balance sheets, while in most cases leaving for shareholders no assets, a modest income stream, and a 'toxic waste' element containing much of the portfolio's risk.
This business, attractive to banks seeking earnings and greater loan volume, has been particularly intensive in staff, because securitization transactions, particularly those that in any way break new ground, are about the most paperwork-intensive in all of finance.
As the business grows more standardized, and transactions are increasingly repetitions of past deals, the PC memory banks can do much of the work of the securitizers, so workloads will ease.
In addition, it is probable that, when the consumer recession finally hits, a number of banks with large securitized credit card portfolios will have to 'fess up to the toxic waste that securitization has left on their balance sheets. Again, this is unlikely to contribute to the business's growth.
In the mortgage area, securitization, and the huge volumes of mortgage financings and refinancings in the past year, has led to a serious mismatch in the balance sheet of Fannie Mae, the mortgage financing institution, that is in any case hopelessly over-leveraged by conventional banking standards.
Like other financial institutions, Fannie Mae hedges itself using risk management models; like others, it is finding that such models don't work in extreme situations, such as during the rocketing home mortgage origination market of 2001-02.
It was announced on Monday that Fannie Mae's duration mismatch had reached a record level of minus 14 months (in other words, the maturity of its liabilities is 14 months longer than that of its assets), compared with the six months that was thought to be the maximum allowable under its risk management system.
This poses a serious risk if interest rates stay low, with the yield curve positive -- especially if the Fed cuts short-term interest rates again, for example. In that event, Fannie Mae's liabilities will carry a higher cost than its assets yield, and it will have an operating loss, which -- because of its excessive leverage -- could quickly wipe out its capital.
This problem, in Fannie Mae and mortgage originators generally, is said to be contributing to the unprecedented run-up in Treasury bond prices, as mortgage banks try to lengthen their portfolio duration by buying long-term bonds. Of course, this sharp rise in prices only worsens the problem.
Add to this problem the likelihood of escalating defaults on the enormous mortgage portfolio that Fannie Mae has securitized but guaranteed, and there is now potential for a serious crisis. Fannie Mae carries an implicit government guarantee; this could get very expensive for the U.S. taxpayer.
In summary, the new businesses in the financial services industry since 1980 are mostly unsound and have served mainly as conduits for obscuring institutions' true profitability and providing huge payouts for management and practitioners. Most such businesses have limited value to the economy, if any.
In this sense, the financial services business is like the telecoms business; there is real economic value there, whose value has grown somewhat in recent years, but capacity expanded beyond all possibility of profitable usage in the period to 2000 and must now decline.
In telecoms, the overcapacity became obvious fairly quickly: in financial services, it is only beginning to appear. As in Japan in the 1990s, U.S. banks can expect the next decade to be one of continual write-offs and crises, with no apparent end in sight.
In retrospect, the late 1990s will glow to dismal financiers of the next decade as a distant Valhalla, a glorious past lost forever through the sins of financial mankind.
By 2012, a recovered Japanese financial system will doubtless be giving Calvinist advice to the deadbeats in New York and forecasting continuing economic gloom if the financial services mess is not cleared up.
(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
