In The USA: the Next Revolution

[tequila]

What is the contribution of the financial sector?

High pre-crisis returns in the financial sector proved temporary. The return on tangible equity in UK banking fell from levels of 25%+ in 2006 to - 29% in 2008. Many financial institutions around the world found themselves calling on the authorities, in enormous size, to help manage their solvency and liquidity risk. That fall from grace, and the resulting ballooning of risk, sits uneasily with a pre-crisis story of a shift in the technological frontier of banks’ risk management.

In fact, high pre-crisis returns to banking had a much more mundane explanation. They reflected simply increased risk-taking across the sector. This was not an outward shift in the portfolio possibility set of finance. Instead, it was a traverse up the high-wire of risk and return. This hire-wire act involved, on the asset side, rapid credit expansion, often through the development of poorly understood financial instruments. On the liability side, this ballooning balance sheet was financed using risky leverage, often at short maturities ...

If risk-making were a value-adding activity, Russian roulette players would contribute disproportionately to global welfare. And if government subsidies were the route to improved well-being, today’s growth problems could be solved at a stroke. Typically, this is not the way societies keep score. But it was those very misconceptions which caused the measured contribution of the financial sector to be over-estimated ahead of the crisis.

The proper role of the financial sector is to assess risk and allocate capital to productive purpose.

The most profitable sectors of finance, as Haldane notes, do not involve this function at all - they are principally forms of gambling, with the exception that the players enjoy a substantial government subsidy (if not a full governmental backstop) and play with other people's money.

I'm not sure why such people are afforded either respect or power, but we award them outsize amounts of both. Such an unstable arrangement does not appear to be sustainable IMO.

[Presley Cannady]

The proper role of the financial sector is to assess risk and allocate capital to productive purpose.

Which is precisely what it does. What seems to be lost on some is the notion that risk assessment and determining productive opportunities is not an exercise in self-evident pontificating.

I'm not sure why such people are afforded either respect or power, but we award them outsize amounts of both.

Because we've produced the $1.6 quadrillion line of credit that sustains low unemployment and multi-trillion dollar GDPs.

Such an unstable arrangement does not appear to be sustainable IMO.

Only if we peg the definition of "sustainability" to either zero volatility or some arbitrary degree of it.

[tequila]

Which is precisely what it does. What seems to be lost on some is the notion that risk assessment and determining productive opportunities is not an exercise in self-evident pontificating.

Please advise me how the inflation and subsequent destruction of the RMBS derivatives market was a precise assessment of risk and an outstanding allocation of capital to productive purpose.

Because we've produced the $1.6 quadrillion line of credit that sustains low unemployment and multi-trillion dollar GDPs.

Really? How did you produce that? And why did you get so bad at producing it since 2008?

As for massive credit lines, I think Ben Bernanke has a lot more to do with that than you.

Only if we peg the definition of "sustainability" to either zero volatility or some arbitrary degree of it.

Do you think that the events of 2008 or 2011 constitute a sustainable environment?

Apropos:

Rash to Some, Stock Buybacks are on the Rise

When Pfizer cut its research budget this year and laid off 1,100 employees, it was not because the company needed to save money.

In fact, the drug maker had so much cash left over, it decided to buy back an additional $5 billion worth of stock on top of the $4 billion already earmarked for repurchases in 2011 and beyond.

The moves, announced on the same day, might seem at odds with each other, but they represent an increasingly common pattern among American corporations, which are sitting on record amounts of cash but insist that growth opportunities are hard to find.

The result is that at a time when the nation is looking for ways to battle unemployment, big companies are creating fewer jobs, and critics say they are neglecting to lay the foundation for future growth by expanding into new businesses or building new plants.

What is more, share buybacks have not fulfilled their stated purpose of rewarding investors over the last decade, experts say. “It’s a symptom of a deeper problem, which is a lack of investment in the long term,” said William W. George, a Harvard Business School professor and former chief executive of Medtronic, a medical technology company. “If we’re not investing in research, innovation and entrepreneurship, we’re going to be a slow-growth country for a decade ...”

The principle behind buybacks is simple. With fewer shares in circulation, earnings per share can rise smartly even if the company’s underlying growth is lackluster. In many cases, like that of the medical device maker Zimmer Holdings, executives are able to meet goals for profit growth and earn bigger bonuses despite poor stock performance.

...

In addition, executives, who are often large shareholders, stand to benefit from even a small, short-term jump in stock prices.

Earlier this month, Pfizer increased its estimate for stock repurchases this year to between $7 billion and $9 billion — essentially spending in one year nearly all of the money it set aside in February for multiyear buybacks. There has been a steady drumbeat of other companies laying off workers even as they have disclosed plans to buy back more stock. On June 23, Campbell Soup said it would buy back $1 billion in stock; five days later it announced plans to eliminate 770 jobs. Hewlett-Packard announced a $10 billion stock repurchase in July, and jettisoned 500 jobs in September after it discontinued its TouchPad and smartphone product lines ...

Powered by huge stock buybacks — the company bought $500 million worth of its own shares last year, more than twice what it spent on research and development — Zimmer posted earnings growth of 10 percent a share, even though operating income and revenue grew by less than 5 percent in 2010.

That helped its senior management, including the chief executive, David C. Dvorak, collect millions in cash and stock incentive payments by meeting earnings-per-share goals. For example, 50 percent of Mr. Dvorak’s $1.03 million cash bonus was tied to achieving per-share earnings of $4.28 in 2010. The company earned $4.33, but without the share repurchases the company would have made $4 to $4.10 a share ...

[Dayuhan]

The result is that at a time when the nation is looking for ways to battle unemployment, big companies are creating fewer jobs, and critics say they are neglecting to lay the foundation for future growth by expanding into new businesses or building new plants.

Companies hire workers, build plants, and expand into new business because they see increasing demand for their products. Why would a company build a plant and hire workers to produce goods if there's no market for the goods to be produced?

[bourbon]

Companies hire workers, build plants, and expand into new business because they see increasing demand for their products. Why would a company build a plant and hire workers to produce goods if there's no market for the goods to be produced?

Has living in Asia completely sapped you of creativity?

[Fuchs]

Companies hire workers, build plants, and expand into new business because they see increasing demand for their products. Why would a company build a plant and hire workers to produce goods if there's no market for the goods to be produced?

This happens quite often, actually. Companies develop new markets when their executives believe in a product.

I've experienced how almost ten companies struggled to survive in a market that was barely large enough for two of them, but they welcomed every opportunity to get even more entrepreneurs into their market.

The reason was that they focused entirely on developing the market. Every new 'competitor' was one more who marketed for the product category.



On a related note, I've done feasibility studies for small-scale industrial plants that had no chance of ever creating a profit without three shifts.
The entrepreneur was our client and wanted a reasonable study, so we told him he's got no chance and delivered our study. The study included a break-even scenario labelled "best case".
He took the best case scenario, talked to his bank (which wasn't able to read the text due to language barrier) and got the credit. He invested and got lucky with unusually high market prices (for a while).

[tequila]

Companies hire workers, build plants, and expand into new business because they see increasing demand for their products. Why would a company build a plant and hire workers to produce goods if there's no market for the goods to be produced?

From the article:

Over the last decade, in fact, companies that spent the most on repurchases had a total shareholder return of 37 percent versus 127 percent for companies that spent the least, according to research by Gregory V. Milano, chief executive of Fortuna Advisors, which consults with companies on how to raise their share price over the long term.

In the cases of Pfizer and Zimmer, analysts say the rush to buy back shares crimped development of new products, a prime reason that both companies are experiencing slow revenue growth.

Despite the looming expiration of the patent for its best-selling drug, Lipitor, Pfizer spent more than $20 billion repurchasing shares from 2005 to 2010.

“In that era, it wasn’t the best use of cash,” said Catherine Arnold, an analyst with Credit Suisse. “They should have been doing more to fix the company.”

Matthew Dodds, an analyst with Citigroup, said, “Zimmer has shown little appetite for acquisitions or diversification, yet they don’t sport a pipeline that can drive investor interest."

Nevertheless, Zimmer is on track to repurchase $1 billion worth of its shares this year, double last year’s pace, and it actually borrowed money last quarter to achieve its goal.

[Dayuhan]

From the article:

Are you prepared to base a conclusion purely on second hand accounts, or are you actually familiar enough with the inner workings of the company to decide what the best uses of its cash are? Surely you realize that analysts may have all kinds of agendas of their own, and that there's likely more than one side to that story... or are you willing to accept the story at face value because it supports your preconceived opinions about corporate governance?

In any event, if you're a shareholder and you disapprove of the Company's use of cash, you've the option to sell your shares. If you're not, why would you care?

[tequila]

Are you prepared to base a conclusion purely on second hand accounts, or are you actually familiar enough with the inner workings of the company to decide what the best uses of its cash are? Surely you realize that analysts may have all kinds of agendas of their own, and that there's likely more than one side to that story... or are you willing to accept the story at face value because it supports your preconceived opinions about corporate governance?

In any event, if you're a shareholder and you disapprove of the Company's use of cash, you've the option to sell your shares. If you're not, why would you care?

Given the number of conclusions that are passed on around here based on less than secondhand accounts, then yes.

Obviously analysts may have their own agendas, but given the market performance of Zimmer and Pfizer they would appear to have a point, as Jamie Dimon's apology for similar behavior at JPMorgan would also appear to indicate. Can you give a solid explanation of why a firm would invest in share buybacks rather than long term research, especially given the short-term incentives for CEOs to indulge in the former rather than the latter?

As for why people besides shareholders should care - if you haven't noticed, this thread is about wealth inequality and responses to such in the U.S. A very large part of this in the U.S. is driven by CEO pay, which has become incredibly skewed in the past 25 years despite no corresponding growth in performance?

Once again, you take it for granted that the exercise of risk assessment is free of error. This is an insane proposition, for the same reasons in finance as it is on the battlefield.

Where are you getting that I expect risk assessment to be flawless?

I do expect, however, that if the gamblers are compensated at such high levels that risk assessment would be better performed than it was in 2008. However, I would settle for the gamblers to lose their government backstop and be broken down to the point where their poor risk assessment did not destroy the entire financial system. Then they can go about being imperfect and going bust or being profitable without hurting the real economy.

By making market for value delivered by services and goods and their expected performance in the future. There's value in ensuring that a bushel of wheat will trade at a certain price five months from now. This is what derivatives fundamentally secure.

Sure, that is what derivatives were meant to do, but if you believe that most derivatives trading is strictly hedging, then you must be one of those who believes that Vegas gambling exists because people really enjoy card games.

With $1 trillion in net assets, the Federal Reserve is one of the single largest actors in the financial markets, but that's three orders of magnitude smaller than notional value of the derivatives market.

More to the point, they are the backstop for much of the gambling that goes on, and the ultimate lender of last resort. They are the ones who will step in when the markets freeze. When they do not, as the ECB seems determined to show us, the whole game can come to an end.

I think trying to determine sustainability from two snapshots is insane.

You don't see that 2008 and 2011 are related? That the Latin American debt crises of the 1980s, the Asian financial crisis of 1997, the equity bubble collapse in 2000, the real estate bubble collapse in 2008, and the European fiscal crisis of 2011 form a pattern of repeated bubbles followed by increasingly severe collapses? That doesn't sound like instability to you?

Perhaps you are one of those who believes the 20th century was very stable - WWI and WWII were just eight years in 100, after all.

[Presley Cannady]

Please advise me how the inflation and subsequent destruction of the RMBS derivatives market was a precise assessment of risk and an outstanding allocation of capital to productive purpose.

Short answer, credit ratings were assigned with great precision in the initial securitization, but the models underlying resecuritization were flawed (leading to a reevaluation in 2008).

Once again, you take it for granted that the exercise of risk assessment is free of error. This is an insane proposition, for the same reasons in finance as it is on the battlefield.

Really? How did you produce that?

By making market for value delivered by services and goods and their expected performance in the future. There's value in ensuring that a bushel of wheat will trade at a certain price five months from now. This is what derivatives fundamentally secure.

And why did you get so bad at producing it since 2008?

Bad? What do you mean bad?

As for massive credit lines, I think Ben Bernanke has a lot more to do with that than you.

With $1 trillion in net assets, the Federal Reserve is one of the single largest actors in the financial markets, but that's three orders of magnitude smaller than notional value of the derivatives market.

Do you think that the events of 2008 or 2011 constitute a sustainable environment?

I think trying to determine sustainability from two snapshots is insane.