Kirk's Book Reviews
Kirk's Book Reviews
|Posted on June 10, 2016 at 6:35 PM|
My rating: 4 of 5 stars
The 2008/09 global credit crunch has created a boom in books about High Finance. Making ‘money out of money’ fascinates and infuriates us and often reaches a peak of interest following the downturn of the business cycle. Indeed, those millionaires that got rich speculating on commodities and share prices once basked in the glory of being a stabilising influence on the world economy. Then came the 2007 sub-prime crisis, the Lehman Brothers collapse of 2008 and the 2009 recession. For one brief summer graduates in Engineering, Astro-Physics and Mathematics decided a career on Wall Street might not be their destiny.
Skip forward seven years and things are back to normal. The brightest and best seek their fortune in the City and hope to get rich speculating on various price movements in the market. What has gone wrong with the Financial Sector and what does it say about our society?
John Kay tries to answer these questions and is on a mission to challenge some of the assumptions we have about the role of Finance in the aftermath of the last economic meltdown. On the whole, his analysis is successful and enlightening.
The author’s first priority is to describe how Investment Banking has moved so far away from its original purpose of providing capital for infrastructure and industrial growth. Take Goldman Sachs where underwriting debt and new equity for companies represents less than 10 percent of the bank’s net revenue. In other words, 90 percent of Goldman’s earnings are from Fixed Income, Currencies & Commodities (FICC) trading. This begs the obvious question: how useful is this to society?
But perhaps Kay’s most poignant observation is that a lot of global businesses today need not list on the stock market to fund expansion. As he points out, Exxon Mobil invested $20 billion on infrastructure and exploration projects in 2013, all from its own resources. In the same year the company spent $16 billion buying back its own shares and paid out $20 billion in capital. In total, Exxon Mobil has spent around $100 billion in the last ten years repurchasing securities it previously issued.
So why do companies list on the stock market if they don’t need capital? According to Kay, the nature of today’s companies are so much different to the railways and breweries that used to pursue capital-raising projects in the early twentieth century. And the facts don’t lie: operating assets make up little of the capital-intensive activities of modern enterprises such as Apple (only 3 percent). Instead, reputation, human capital and brand prestige are just as important to tech companies as plant maintenance and making the most of productive capacity. In reality, they undertake IPOs to realise value for early investors.
‘Stock markets are not a way of putting money into companies, but a means of taking it out,’ insists Kay in the iconoclastic style that characterises his writing. To be fair, he has a point: forty members of Apple became overnight millionaires when the company listed in the late 1980s. Today’s giants are similar: Google and Facebook were generators of cash early on and don’t need to raise billions to build new plant and develop infrastructure like the industrial behemoths at the turn of the twentieth century. Facebook’s ambivalent 2012 IPO prospectus more or less admitted the Board had no specific plans for the money raised on the Nasdaq.
If Main Street has been lagging behind Wall Street, the former now have a tutor in Kay. More statistics and observations follow like a swarm of bees hoping to sting you out of your ignorance. Why did Apple raise $17 billion in a bond offering in 2013 to pay a dividend? Did they need the money? No, but repatriating the cash from foreign jurisdictions would have incurred unfavourable taxes in the US.
Next in the firing line is our obsession with emulating Silicon Valley. Why do the Anglo-Saxon nations not cast an eye at the German Mittelstand for inspiration? The Stock Market value of German companies is only 40% of national income; the figure is over 100% in the US and UK. Yet Kay sees the grubby influence of Canary Wharf and Wall Street on this last bastion of productive capitalism as a defining battle for the future of Finance. Global investment banks have been trying to develop Germany’s capital markets in debt and equity for the last 30 years and may one day corrupt the nation’s world class family enterprises at the centre of its economy. Though the alchemists have had little success so far, the European Commission seems to be on the side of Goldman Sachs rather than the industrious pioneers and producers of the German heartlands.
Thankfully, the Mittelstand have shown scant interest in listing on the stock exchange and are more than capable of funding expansion through their own internal resources. Successive generations of family ownership and professional management are the key to their success. The author’s admiration for this unique producer class is clear: ‘In Britain and the USA successful medium-size businesses grow by acquisition or are themselves acquired. But this ‘hollowing out’ of the middle of the size distribution of companies has not occurred in Germany.’ (P.171) Expect Kay to write the epitaph if the vultures get their way.
If the Mittelstand represent an ideal of capitalism, the growth of Limited Liability companies mark one of its aberrations. Here we get the usual excoriations against Sandy Weil’s Citigroup and predictions that Salomon Brothers and Lehman Brothers might still be around if they’d retained their Partnership structure with their own capital on the line. The cue to rally against the demutualisation of British Building Societies is not without merit, but the author’s main criticism is how too many CEOs now prioritise their share-price above all other concerns. Hey, it’s not their money, so why not take bigger risks for the potential of huge gains?
The rise of Mark-to-Market pricing since the late 1980s has also helped the modern PLC create the illusion of wealth. Once a supporter of this valuation, Kay now admits that marking assets at full value of what they are likely to earn before their maturity is an easy way of inflating earnings and generating bonuses for senior staff. Geoff Skilling’s success in getting the SEC to authorise Enron to trade gas contracts allowed him to take advantage of this accounting method and book the full P&L in the present rather than as a steady stream of income over a longer period. Bear Stearns, Lehman Brothers, HBOS and RBS succumbed to the same temptation.
One final argument in this book that will get attention is the author’s assessment the Financial Sector has too much regulation, not too little. This is the most contentious part of the whole study and the least articulate of Kay’s judgements. Numerous pages are devoted to lamenting the evils of ‘Regulatory Capture,’ but the reader may still wonder what this means, other than an ill-defined advantage today’s lobbyists have over regulators.
Fortunately, Kay’s analysis of ‘Regulatory Arbitrage’ is far more intelligible. What do the growth of London’s Eurodollar market of the 1960s and the Credit Default Swap of modern times have in common? Answer: They both evolved as a way of circumventing the law. The former, known as Regulation Q, is a good example of unintended consequences. Government intervention after the Great Depression put a limit on the level of interest US Banks could offer depositors; capital reserve requirements were also high. But money lent to American banks from European institutions escaped the provisions; therefore, the former could recycle funds via Britain to get round the rules. Result: US banks found a way to pay higher interest on deposits and London banks enjoyed renting out their services for a commission. Alas, the Eurodollar market emerged thanks to a regulatory loophole.
It’s easy to see why Other People’s Money made the Longlist for the 2016 Orwell Prize. The author is an Economist with a gift for explaining complex subjects and making Banking & Finance accessible to a wide audience. However, a tendency to pre-warn the reader certain topics will be covered in more depth in later chapters can be repetitive (and confusing) and Kay, like many others, does not offer a convincing definition of Derivatives. This is a shame because he should excel at describing a ‘Put’ option on a Forward Contract or articulating the intricacies of an Interest Rate Swap. (Topics that still baffle me.)
The ‘Financialisation’ of our society may be irreversible unless western civilisation lapses into war, but until then today’s Science Graduates may continue to deprive us of their productive skills to trade commodities instead. The end of ‘Casino Banking’ is nowhere in sight, but stopping Investment Banks using deposits from their Retail operations is the first of many changes that need to happen if we are to prevent another crash. Like John Plender, Sir Mervyn King and Alex Brummer, the author is keen to add his name to the list of prophets lamenting the inevitability of the next crisis.