Tim Price: Investing through the looking glass | book extract and offer
The financial services industry is unique, writes Tim Price – no other industry in the world compensates its employees so generously while delivering such modest tangible value to its customers or society at large.
Despite the best creative efforts of tens of thousands of extremely well-paid financiers, the former US Federal Reserve chairman Paul Volcker famously suggested that the most important financial innovation of the past 20 years was the ATM machine.
Ever since the markets blew up in 2008, many investment practitioners have been engaged in something akin to a whodunit. Just how did we get into this mess? I suggest an answer – everybody did it. We all played a part. As Lord Overstone remarked, no warning can save people determined to grow suddenly rich.
In the run-up to the global financial crisis, accident-prone bankers were only doing what they always do – gambling, badly, it transpired, with other people’s money. There was no shortage of irrational behaviour by property speculators, or homeowners, as they are sometimes called. But the rot in the system runs deep.
After the collapse of Lehman Brothers in September 2008, most banks did not fail – because the central bankers of the world did not allow them to. The financial markets are now in thrall to these unelected monetary technocrats. The extraordinary monetary policies that central bankers are now pursuing are destabilising financial markets and suppressing their natural price signals. These policies are legitimised by advocates of neo-Keynesian economics, a subset of a science that is in fact no true science at all.
The financial system is suffused with delusional behaviour. Academics pretend markets are rational. Fund managers pretend they have some kind of investment ‘edge’. Financial journalists pretend to make sense of it all for the layperson.
The only true wisdom is in knowing we know nothing, or a vanishingly small amount, about how unstable the financial system has now become, and why – in large part due to the activities of the very people notionally charged with saving it.
Our story begins at just past 7am on Saturday morning, September 13, 2008. Jamie Dimon, the chief executive officer of JP Morgan, the US’s largest bank, has gone into his home library and dialled into a conference call with his management team.
Here is what he told them: “You are about to experience the most unbelievable week in America ever, and we have to prepare for the absolutely worst case. Here’s the drill. We need to prepare right now for Lehman Brothers filing [for Chapter 11 bankruptcy protection]. And for Merrill Lynch filing. And for AIG filing. And for Morgan Stanley filing. And potentially for Goldman Sachs filing.”
There was a collective gasp on the phone. What happened next would make financial history and send trillions of dollars on their way to money heaven. Lehman Brothers would indeed file for Chapter 11, shortly after midnight on Sunday September 14, 2008.
Watching in disbelief
But as the US authorities watched in disbelief as the global financial system started to implode on itself, they decided the rest of Wall Street would not be allowed to follow in Lehman’s footsteps. So Merrill Lynch, ‘the thundering herd’, was swept into the welcoming arms of Bank of America.The global insurance giant AIG was rescued.
Morgan Stanley was bailed out, with the help of $107bn (£85bn) in loans from the Fed. Goldman Sachs, like the other remaining investment banks, was permitted to convert to a bank holding company, and borrow directly from the Fed – a privilege denied to Lehman Brothers in its hour of need.
The financial system was saved – for the time being, at least – but at extraordinary cost. Five years after the failure of Lehman Brothers, the Dallas Federal Reserve estimated the full cost of the financial crisis was as much as $14 trillion – very nearly a full year of US gross domestic product.
The financial crisis wasn’t triggered by the failure of Lehman Brothers or by a shock reversal in the fortunes of any one individual firm. Lehman Brothers was merely a symptom. So, for that matter, was the decline in value of so-called ‘sub-prime’ mortgages associated, in popular opinion, with Wall Street’s near-terminal collapse. Sub-prime mortgages were merely the first part of a gigantic edifice of debt to fall.
The failure of Lehman Brothers threatened to derail the debt train. With highly interlinked financial markets frozen by fears over bank and counterparty risk, there was the very real threat of a global Depression. A credit-driven economy requires trust between financial institutions. If that trust evaporates, trade stalls and the economy contracts.
And a gigantic debt mountain absolutely requires constant economic expansion, so that all those debts can be serviced. Which is why the US government went ‘all in’ in order to shore up Wall Street in 2008 – and why the UK government went ‘all in’ in order to secure the future of the high street financial giants Royal Bank of Scotland and Lloyds Bank at roughly the same time.
The history of the last four decades is a history of ever-larger financial crises and bail-outs. 1987 brought us a mini-crash, but a mini-crash deemed sufficiently terrifying for then Fed chairman Alan Greenspan to slash interest rates – the Federal Reserve’s time-honoured response to any slide in market confidence.
1998 brought us the collapse of the ironically named hedge fund Long Term Capital Management, a dry run for the Lehman failure. Once again, interest rates would be slashed by way of response – and Wall Street’s heads would be banged together by the Fed to facilitate a rescue of the fund.
The early 2000s brought us the dotcom bust. Right on cue, the Fed responded to the resulting recession by slashing interest rates. Those dramatically lower interest rates triggered a speculative property boom. The collapse of that property boom was met with … markedly lower interest rates.
But we now seem to have reached the end-game. US interest rates, and indeed rates throughout the western economies, cannot realistically go much lower. (Admittedly, at the time of writing, some 30% of all sovereign bond yields, along with several eurozone countries’ bank deposit rates, had turned negative. Like the White Queen in ‘Alice through the Looking-Glass’, we must now all believe as many as six impossible things before breakfast.)
Meanwhile the mountain of debt – borrowings by governments, corporations and households – has just kept on getting bigger. McKinsey estimate that since 2007, far from deleveraging, the world’s major economies have added $57 trillion to their combined debt loads – raising their debt to GDP ratios by some 17 percentage points in the process.
It was Herbert Stein who coined the appropriate adage for our current debt predicament: “If something cannot go on forever, it will stop.”
The global bond market is currently worth well over $70 trillion. The chances are you and your clients have some meaningful exposure to that $70-plus trillion of debt. Now ask yourself a question. After an explicit policy of suppressing bond yields, and now that global interest rates are down to their lowest levels for 5,000 years, do we think bonds are outrageously expensive, or merely hilariously mispriced?
Given the size of the world’s bond markets dwarfs that of the world’s stockmarkets, what do we think happens to stock prices if and when $70 trillion-worth of bond investors decide to head for the exits at once ?
Courtesy of central bank monetary misbehaviour and eight years and counting of quantitative easing, we are in the process of finding out. We all work within a global monetary system; we are all essentially trapped in the same room. But not everyone will leave this room alive.
The world has experienced a 40-year-plus period of unrestrained credit expansion. Notwithstanding the vast increase in the supply of debt, the price of that debt has risen too. (It is as if the economics laws of supply and demand had been rescinded.) Much of that period has also been accompanied by a rise in stockmarkets. As inflation has drifted lower, stocks and stock prices have welcomed it.
Many time-honoured principles of finance, investment and economics no longer make any sense. That assumes they ever did. This is a world in which it is easy to become unsettled, unfamiliar with the new financial rules, distrustful of the future, and increasingly wary of our monetary authorities.
A new financial era requires a new type of mind-set. To protect our investments and help them grow, we will all need to think a little differently. To prosper, we should understand, first, how we got here and, second, how we will all need to challenge a number of assumptions about the way the financial world really works.
Tim Price is the manager of the VT Price Value Portfolio and the author of Investing Through the Looking Glass: a rational guide to irrational financial markets (£19.99 – Harriman House). This is a modified extract from the book.
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