Hedge fund returns: Just as Adam Smith predicted
Felix Salmon points us to a report about hedge fund returns and tells us that they're now getting about the same returns as the general market. With this nice illustration:
Excecllent, Adam Smith is proved right again. For recall what he said about capital seeking returns.
There's a natural rate (or if you prefer, a general rate) of return to capital. Yet sometimes people find a new way of doing things. Might be a new technology, might be a new method of organization, a new strategy, new goods, but something different which offers a higher return upon capital. Those people that follow that new path make excess profits: no, not profits we consider excessive, just profits above that normal or general rate.
Other capitalists, being greedy and lustful for profits, filthy lucre, thus enter this trade that offers excess profits. More capital trying to exploit this opportunity brings down the return to that normal or general level for each unit of capital seeking to do the exploiting which is what we're seeing above. The super-profits of hedge funds in US equities seem to be gone.
We could just leave it there: but we shouldn't, for it's one of the things that drives society forwards. We want places where excess profits can be made to be exploited: profits are only another way of saying value added and the accumulated value added is the wealth of us all, by definition, that's what economic wealth is. It is the hunger for excess profits that leads capitalists to explore the crooks and crannies of technology to find those places where they might make them. And thus it's that hunger which drives forward technology itself to the benefit of us all.
And, as Old Adam told us all those years ago, those excess profits will get competed away and the hunt will be on for the next opportunity.
Bank reform: getting the policy right
Create new, 'safe' banks if you want to – but not at the cost of lots more regulation and dismembering Britain's hugely important financial services sector. That's the message of a new report and briefing paper being published by the Adam Smith Institute today.
The Independent Commission on Banking (ICB) – set up by George Osborne – was told to work out ways to make the banks more secure and avert future banking crises. Their first suggestion was to split up the banks into 'safe' high-street and 'risky' investment operations. Then load them with higher reserve requirements, so they have to keep a bigger cushion of 'safe' assets.
Both prescriptions are wrong. It wasn't the 'risky' investment banks that caused the UK's problems. It was the retail banks and building societies that got into trouble, mostly by lending too much on mortgages during the housing boom, or buying US investments that they did not understand. When the boom subsided, their customers couldn't repay their mortgages and the US investments turned out to be highly toxic. Regulators daydreamed while this was all happening, and the Bank of England – having fuelled the boom – squeezed hard just when the banks needed more cash to tide them through this rough patch. The retail banks just ran out of money.
So breaking up the banks isn't going to make any difference. And raising their capital requirements higher than anything being contemplated by Brussels or Basel will just put them at a huge disadvantage against world competition. It also means they will have less cash lying around to lend to small firms – the drivers of employment and growth in the UK. Small firms will find it harder to get loans, and will pay more for them.
Investment-bank customers are savvy enough to look out for themselves, but ordinary families and businesses want banks that are safe. So, instead of trying to dismember existing banks, why don't we simply allow people to create new ones? We suggest a new form of banking licence that allows people to create Trust Banks to do just that. They could operate as they pleased, but the Bank of England would have to be sure that they were sound, and could survive the failure of any parent or sibling company. And Trust Bank customers would be the only ones who would get a government guarantee that they would not lose their deposits. It's a market solution to a problem caused by over-complex regulation, badly enforced.
The Big Bang: 25 years on
It's 25 years since the Big Bang deregulation of financial services in the City of London.
I remember the City before the Big Bang. It seemed more like a gentlemen's club rather than a place of business. It was dominated by sleepy upper-crust partnerships, most of them the same names that had been in the Square Mile for centuries. They couldn't take on the opportunities offered by the world's growing globalisation, even if they had wanted too. No wonder the City had been overtaken by New York. It was a closed shop with its own bizarre and old-fashioned customs, underpinned by regulation and law.
Nor could this cobwebby old-boy City have handled the privatisation revolution that Margaret Thatcher had in mind. Before the sale of BT in 1984, just a few thousand people owned shares. Today, nearly ten million people have some stake in British business – thanks to Big Bang.
True, lots of American financial firms pounced to buy up their sleepy London counterparts. But that brought in new capital and new ideas. London grew and overhauled New York to become the world's top financial centre once again.
People also say the Big Bang produced a 'loadsamoney' culture and huge salaries in the financial sector. Wrong. The deregulation certainly opened up new markets, and brought in more capital that allowed firms to grasp those new opportunities. And computerisation, which came in at the same time, made that new business hugely more efficient. The rise in wages and profits simply reflected that new productivity.
Other people blame the Big Bang deregulation of the City for the over-borrowing and over-spending that led to the current financial crisis. But it seems a bit much to blame that on something that happened 25 years ago. More recent mistakes – huge over-spending and over-borrowing by governments, easy money and expansionary policies – are a much better explanation. And we have only governments, not the bankers, to blame for that.
In praise of mark to market accounting
There's a useful idea out there: things are worth what they're worth. No, not what you paid for them, not what you think they might be worth in the future, but what someone will pay you for whatever it is. There's a further useful idea: that the accounts of an organisation should reflect this idea. What is owned by a corporation, a bank, should be listed in the books as being worth what someone will pay for them.
Two little stories about how such mark to market accounting could help solve our current financial woes. There are worried that if Greece defaults then Royal Bank of Scotland will be back for another bite at our wallets and we really don't want that again.
Our peripheral sovereign exposures outside of Greece, which we have already written down to 50 percent, are circa 1 billion pounds ($1.5 billion), which are modest relative to core tier one capital of circa 50 billion pounds.
Well, no, apparently not. For RBS has marked to market: Greek bonds are worth only 50% of face value, so RBS has them in the books at 50% of face value. They've already taken the loss in fact.
However, compare that with Felix Salmon talking about adjusting the principal on US mortgages:
Maybe the thing for the US government to do, then, is not to force Frannie to accept principal reductions outright — but rather just to force Frannie to mark their current underwater mortgages to some semblance of sanity, rather than doing their see-no-evil act and insisting on holding them at par. If Frannie has to take writedowns anyway, then maybe they’ll do so in a homeowner-friendly way.
One way of dealing with the housing problems over there is simply to say, well, yup, those houses just ain't worth what we all thought. So, instead of you having a $400,000 mortgage, we'll say it's now a $250,000 mortgage. Which is of course absurd....except that it's not. For the losses have already happened.
These mortgages were all bundled up into MBS and CDOs recall? Sliced and diced and sold off as bonds. And the people who bought those bonds have made huge losses: so the losses have already been recognised. As Felix points out, when people buy these bonds in the secondary market (ie, at market value) then they can see that there's a profit to be made by making exactly these principal reductions on the underlying mortgages. Instead of a $400k mortgage which is going to default, leaving them with a $250,000 house, why not just cut the mortgage to $250,000 and have no default?
The loss is already baked into the price at which they bought the bond so why not? Which leads us to the problem at Fannie Mae and Freddie Mac. They refuse to mark their mortgages and bonds to market. Meaning that they refuse to make these mortgage adjustments. But we all know full well that the losses have already occurred: that's why they're bust, recall? If they had to mark to market then the mortgage adjustments could be done and the problem would be over earlier.
Remember: we all know the losses have occurred, all we're actually suggesting is that everyone should recognise them. Just as with bankruptcy itself, when losses have occurred it is best to own up to and deal with them quickly. Which is what mark to market insists that everyone does with the benefits we see above.
RBS has already taken the losses of a Greek default: so we don't have to worry about a Greek default (at least, not about RBS). But not marking to market at Frannie means that the US mortgage and housing problems are likely to drag on for years. After all, all that is really being suggested is that accounts and accounting standards should reflect reality: which is what they're supposed to be doing, isn't it?
More QE
So, the Bank of England has announced another £75bn on quantitative easing. Bad news.
More quantitative easing means more kicking the can down the road. It means preventing markets from adjusting, and it means perpetuating the misallocated capital, excessive risk-taking, and over-leveraged balance sheets that got us into this mess in the first place. To put it simply, printing money does nothing to solve our current problems. If anything, it makes them worse.
There will be no return to sustainable economic growth until the authorities realize that we can’t defy economic gravity forever. Recessions are about adjustment and recalculation, and as long as policy is designed to prevent the liquidation of bad investments, the paying down of debt, and the reallocation of scarce economic resources, recovery will remain elusive.
Here are the economic policies we need: an effective bank resolution regime, a stable monetary environment, and a thoroughgoing commitment to removing tax and regulatory barriers to investment and entrepreneurship. Right now, we aren't getting any of them.
Another disaster waiting to happen
This morning’s City AM contained some admirably sound thinking on the European Commission’s proposal for a Europe-wide Financial Transaction Tax, which would involve imposing a minimum tax of 0.1 percent on bond trades and 0.01 percent on derivative trades.
First, Allister Heath in his daily editor’s letter:
There is of course no way that such sums [£40bn–£300bn] would ever be raised. Transactions would simply cease to happen. Tens of thousands of jobs would be lost overnight and the City of London would be destroyed. The tax would raise a couple of billion at most, while increasing volatility by forcing traders to concentrate on larger, less frequent trades.
Those deluded souls who believe they have discovered a new way of solving the world’s problems by taxing financial transactions will have achieved nothing other than crippling the economy. Why can’t the coalition simply come out and say this?
And then Neil Bentley in the paper’s excellent new comment section, The Forum:
A transactions tax would be easily circumvented by firms simply moving their trades out of the EU. This would, of course, hit the UK hardest because London is by far the largest financial market in the EU. Transactions would be pushed out to competitor jurisdictions, like New York, Singapore and Hong Kong, damaging the UK’s long-term competitiveness as a leading centre for financial services companies.
This is no idle threat – when an FTT was implemented in Sweden in the 1980s, share prices fell quickly and substantially, and half of all Swedish equity trading moved to London. The volume of bond trades fell by 85 per cent and futures trades by 98 per cent. As a result, the Swedish government eliminated the tax, trading volumes resumed, and Sweden is now one of the most vociferous opponents of the tax.
And remember:
The UK’s financial services industry accounts for around 10 per cent of total economic output, 11 per cent of the UK’s total income tax, and 15 per cent of corporation tax. Additional tax is also collected from more than 1m people who work in the industry through employer national insurance.
So – what we’ve got here is a plan for a tax that would cause severe damage to the most significant sector of our economy, which would not raise much money, and which would fail to reduce volatility. Sounds like a great idea, right?
Andrew Lilico on bank bailouts
Read the full article at Telegraph.co.uk
It’s RBS, Stupid
Reams of paper have been used to design a safety mechanism for the UK banking sector.
Given that the near collapse of the UK banking system took place in 2008, there is a strong feeling that the Independent Commission on Banking’s (ICB) 363-page Final Report deals with yesterday’s problems.
Two further general observations are warranted about the Report.
First, as Eamonn and other ASI bloggers have noted, it accorded disappointingly little priority to promoting competition. Regrettably but perhaps understandably, given the size of the existing banks with which any newcomer would be competing.
Secondly, many would argue that the central problem is not the banks themselves but some of those running those banks that needed massive subsidies simply to survive.
After all, HSBC is still powering ahead. Admittedly, its enviable status is mainly due to heavy Asian exposure. And, if memory serves, Lloyds did pretty well under the prudent management of the late Sir Brian Pitman.
Not surprisingly, the Government reacted to the ICB’s Final Report by aiming for the long grass. Conveniently, it homed in on 2019, the year when Basle III – with its much higher capital requirements - kicks in.
In the intervening eight years, the Treasury will focus on Royal Bank of Scotland (RBS), the owner of the NatWest and of up-market Coutts. Its unprecedented collapse featured prominently in Alistair Darling’s fascinating memoirs.
RBS received an astonishing £45.5 billion investment from the Government.
Its shares now trade at just above 20p, compared with the Government’s average c50p entry price – the taxpayers’ paper loss is now approaching £30 billion. Selling down this 83% stake now seems years away.
The 41% publicly-owned Lloyds did derive some benefit: the ICB reined back on its interim proposals for further divestments beyond the 632 branches earmarked for disposal under Project Verde.
More worryingly, given the impending Eurozone crisis, further taxpayer support for the banking sector cannot be ruled out.
Criticisms of Vickers
A new Adam Smith Institute briefing paper, out today, argues that:
- The Vickers report is a botched opportunity. It will not solve the errors of the past.
- The Independent Commision on Banking's (ICB) proposals will pile new levels of regulation when the problem was that former regulations were either poorly conceived, imperfectly enforced or went unheeded.
- The ICB proposals run the risk of institutionalising moral hazard by entrenching the expectation of bailouts.
- The ICB proposals also fail to get to grips with the systemic risk inherent in the deficiencies in international capital regulation.
- Ring-fencing should not have been be the ICB's priority. Instead the report should have concentrated on competition, transparency, and resolution regimes.
- Ring-fencing fails to address the problems in the banking system. In fact, the systemic risk in 2007 and 2008 stemmed from banks which would have complied with most of the report's ring-fencing criteria.
- Ring-fencing bank operations won't achieve the separation of risk the ICB claims. Difficulties in a non ring-fenced subsidiary would depress the stock price of the parent company and thus the scope to recapitalise the tier-one capital of the ring-fenced bank.
- The ICB's presentation of the history of why the banks failed is self-serving. It does not take into account the role policymakers had in encouraging regional banks to take on aggressive funding policies. It also includes irrelevant examples such as Lehman Brothers. Vickers’ narrative ought to be robustly challenged (see p4 of the report).
- The UK banking system is oligopolistic. The implicit protection mandated by ring-fencing would be a further force against competition. The retail banking monopoly would be best addressed with a firm “no bailout” policy and, where necessary, anti-cartel regulation.
- We also need to introduce a culture of transparency on top of the macro-prudential reporting proposed by Vickers – with principles-based disclosure and regulation replacing the former regime of compliance by process-oriented box ticking.
- The report should have gone further in designing a resolution regime for the orderly winding-up of failed banks
Miles Saltiel, the author of the report and a fellow of the Adam Smith Institute, said:
“The Independent Commission on Banking’s final report has its priorities all wrong. Vickers’ central proposal – ring-fencing – addresses a problem the UK banks did not have during the crisis, and largely fails to deal with the real problems now and then. A stronger focus on competition and transparency would make many of the proposed reforms unnecessary.”
Tom Clougherty, executive director of the Adam Smith Institute, added:
“Vickers should have focused on getting rid of the government guarantees that encourage reckless behaviour, while also coming up with a credible plan for winding up failed banks. Only a clear “no bailout” policy will encourage more responsible banking and increase competition in the sector.”