Sunday, 22 July 2018

​The age of leverage wanes

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WE HAVE SPENT most of our time since the end of the Fed’s QE programme obsessing about when the tightening cycle will begin and what influence that will have on life, the universe and everything. The Fed chose not to raise rates last week, but the real issue is not whether rates went up by a quarter point, or when that will now happen. It’s about leverage.

Just as there was an age of steam, there was an age of leverage. There was a great time to be in Derby making locomotives or in Glasgow building ships. There were also great times to be in Birmingham making steel, or in Manchester spinning cotton, or in Stoke-on-Trent making bone china or in Coventry assembling cars. All these industries boomed and then faded, and so it is with banking. There was a great time to be in London creating credit and that time is clearly drawing to a close.

Let’s face it, banking is inherently boring. It’s about lending money and praying that it will come back with the interest paid. Well, at least it was boring until the growth of derivatives which enabled off-balance sheet leverage. Aided by a period of falling rates – we’re talking the post 1973 super-cycle which is now coming to an end – if enough leverage was applied, the profit would eventually present itself on a plate. A bad year here and there could be forgotten and treated as proof that the profitable years were due to nothing less than the traders’ amazing skills.

BUT LIKE THE age of steam, the age of leverage will have had a finite lifespan during which those who were in the right place at the right time will have done very well and those who are hell-bent on chasing past glories will lose their shirts.

I suspect that in the fullness of time the entire financial crisis will be put down to the growth of derivatives and to the regulatory idiocy of having permitted the risks involved to be held as an off-balance sheet contingent liability. Sticking a Ferrari V12 engine in a Fiat 500 does not turn the latter into a supercar, while the risk of something blowing up is increased hugely.

FOLLOWING THE CRASH of 1929, the 1931 Macmillan Committee report concluded that “the function of a central bank is to regulate the volume and the price of credit”. Had this simple wisdom been taken seriously and not left forgotten – it was buried in paragraph 303 of the report – we might never have had a 2007/2008.

If there is one thing our central banks did not do, that was to regulate – yes, you’ve got it – the price and the volume of credit. On the contrary, by permitting risk to be built up off-balance sheet it firmly encouraged the development of ever more complex forms of not only first but second and third derivatives of simple credit and rate risk.

Although not yet fully under control, there are very clear signs that the free-wheeling derivatives markets are headed for the scrapheap and with them the earnings that made banking the place to be for the best part of 2-1/2 decades.

The high-earning environment provided more job opportunities than there were people of adequate talent to fill them. The system ended up filled with some highly average people who critically thought that they were worth what they were being paid. Hubris abounded.

So if the tail has wagged the dog for 25 years, what happens when that tail is finally amputated? I suspect Fido will repair to his bed in the corner and go back to sleep.

Sticking a Ferrari V12 engine in a Fiat 500 does not turn the latter into a supercar, while the risk of something blowing up is increased hugely

THE CLOSER WE’VE got to the bottom of the rate cycle and the further away from the erstwhile one-way bet, the more some of those hedge fund wizards seem to struggle to make returns commensurate to the fees they like to charge. All of a sudden, many of them are looking utterly pedestrian and devoid of the magic touch which made some of them fabulously rich. I have often enough visited the subject of how their greatest skill was to convince the willingly gullible that leveraged beta was really alpha, and all I can add to that is “well played”.

The masters of the art, however, are the high frequency traders who add absolutely nothing to anything. Their arbitrage is so irrelevant to the conduct of the business of banking and investing that it should be stood up against a wall and shot. I can’t blame the practitioners, for they are doing nothing illegal. I don’t know how exactly it will happen but I would not be very surprised if HFT is regulated out of existence within the next few years.

In the same way in which the telecom sector, treated like the highest of high tech industries 10 years ago, was found out and reclassified in investors’ minds as a highly competitive, high-cost, low return utility-type business, banking is well on its way to becoming the same.

As the best graduates desert the queues to join investment banks and head for the sexy tech openings, our industry will quieten down and become the boring backwater it was when I joined up and when it was the repository for those who couldn’t get a proper job. What did I say about very average but overpaid people who simply got lucky by being in the right place at the right time?

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