The law of unintended consequences is right up there with the diktat of sod and gravity as among the ineluctable forces of the universe. The credit crunch and attendant economic crisis have wrought chaos. Some of this has been completely predictable. Did anyone really believe that house prices could only ever rise, credit was a limitless free good or that CDO-squared was an important financial innovation?
However, some of the collateral damage has been inflicted in surprising places.
1. De-equitization Do you remember when the fashion for share buybacks and private equity buyouts had commentators burbling on about de-equitization? For a fleeting moment the phenomenon was real. In 2006, US companies raised $41 billion through initial public offerings, less than half the $97 billion of public-to-privates. UK companies raised $19 billion, but $27 billion of equity capital left the market.
So far this year, equity capital raisings have hit $136 billion in Europe and $100 billion in the US. There will be more to come. The peak year for European equity capital-raisings following the last recession was 1993. That was after the economy bottomed and growth had resumed. That year almost 10% of market capitalization was added. This amounts to about $528 billion currently. With buyouts dead and M&A at a quarter of pre-credit crunch levels, equity capital markets and government bond desks are the places to be for bankers.
2. Defined benefit pension schemes and balanced budgets Pensions based on final salaries have been under pressure for some time. At the end of 1997, 96% of UK pension provision was in the form of defined benefit schemes. By the end of 2007, this had fallen to 66%. The demise of final-salary pensions has since been accelerated by the economic crisis and the sobering fact that the FTSE 100 is at the same level today as it was in February 1997. It is hardly surprising that 96% of UK companies say that defined benefit schemes are no longer affordable.
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The winners in this new order, sadly, are regulators, lawyers and private detectives. A more paranoid world will not be a happier one |
The state is not in a position to help retirees. The IMF wrote in a recent report: “Net present value calculations illustrate the differential impact of the [current] crisis vis-à-vis ageing: in particular, for advanced countries, the fiscal burden of the crisis is about 11% of the ageing-related costs” (ie, pensions and healthcare). The financial crisis has caused fiscal deficits to blow out to levels seen only in times of war. The next battleground will be demographics and it is going to be 10 times more expensive. This sounds terrible but could be good news for markets. The average defined contribution balance in the US at retirement is a pathetic $40,000. Assuming the option of dying young is unattractive, the only way to solve the problem of governments and corporations stepping back from paying for retirement will be for individuals to put much more money to work.
3. The efficient market hypothesis When CFAs give up on efficient markets it is time to wave the white flag. The notion that prices accurately reflect all available information should really have been dealt a fatal blow in October 1987. But in the interim all those wannabe CFAs needed something to fill their coursework and this elegant theory and its offspring (CAPM, Modigliani-Miller, Black-Scholes, etc) fitted the bill.
It also had the wonderful side-effect of making finance incomprehensible to outsiders. Like lawyers and doctors before them, financiers not only had their qualifications, industry associations, ginger groups and conferences. Most important of all, they had their own language. The intention might have been to educate but the result was to obfuscate. It took the Catholic Church 359 years to admit that it was wrong and Galileo was right. The TMT and credit bubbles have finally shaken financial professionals out of their complacent belief in efficient markets.
4. Belief In the current environment, pet theories about how markets have changed are two a penny. That caveat duly registered, my sincerest belief of all is that the most important thing that has changed is belief. Belief that a triple-A rating means something. Belief that when a hedge fund manager’s performance compounds at 10% annualized it is achieved through skill not larceny. Belief that “my word is my bond” has any value. RIP. The winners in this new order, sadly, are regulators, lawyers and private detectives. A more paranoid world will not be a happier one.
In a famous Beyond the fringe sketch from 1962, Jonathan Miller enquires of Peter Cook. “Goodbye sir, or is it au revoir?” Cook made it clear that it was indeed goodbye. The four familiar parts of the financial markets described above are gone. However, the credit crunch has also temporarily exiled products and services that will make a comeback. For them it really is a case of au revoir. They will be explored in my next column.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own
