Sunday, September 21, 2008 0 comments ++[ CLICK TO COMMENT ]++

The End of the Financial Sector As We Know It

This is pretty much the end of the financial boom of the last 30 years. A boom that started in the early 80's has finally run its course. GaveKal termed it the financial revolution and I agree it has been one. There have been immense benefits--easier access to credit; ability for public to own financial instruments; ability of businesses to off-load financial risk; more efficient hedging of financial risk; and so on--but all this will slow down in the future. It should be pointed out that the change that I'm referring to will occur not just in mortgage finance but in the full financial sphere.

Perhaps the best indication of the end is word that Goldman Sachs--the strongest investment bank in the world--and Morgan Stanely--another American giant in investment banking--are set to become bank holding companies. Although this does not mean that they will become a conventional bank, it does mean that the increased regulatory oversight will end their freedom. I anticipate two things from this. One, their leverage will be much lower in the future (hence shareholder profits will be lower.) Two, they won't be, depending on how you look at it, as nimble or reckless as investment banks had been over the last few decades.

If the strongest investment bank, Goldman Sachs, is facing threats--none of it fundamental and all from market perception of future--then it's the end of the current way of doing business.

Another harbinger of the end of the financial revolution is the beating G.E. shares have been taking of late. Whenever a megacap like G.E. drops 20% in one week (it recovered by the end of the week) it clearly means the market is re-thinking its future. A lot of people think of G.E. as an industrial giant but it has been coasting off financial profits for more than a decade. The New York Times alludes to this:

Yet General Electric is as much a bank as a blue-chip industrial company. Half of its profits come from its giant finance arm, GE Capital, whose global portfolio spans aircraft leasing, commercial real estate lending, credit cards and home mortgages.

Indeed, G.E. is the largest nonbank finance company in the United States, with assets of $696 billion and $545 billion in debt. If it were a bank, GE Capital would be the nation’s fifth-largest.

G.E. has very little exposure to subprime residential mortgages yet the market has been re-pricing its shares over the last year (the economic slowdown is also impacting the company but it alone can't explain the huge decline in share price.) The reason, I believe, is based on the view that future profits from financial operations won't be anywhere near what they were in the past.

G.E. relying heavily on financial profits is not a rare case in American industry. In fact, companies like GM and Ford derived a huge chunk of their profits (almost all the profits in some years) from their auto finance, mortgage finance, and credit card operations. There was a running joke a few years ago that these companies were finance companies and not car manufacturers. This is less so now since GM has sold off most of its finance divisions and others have pursued similar path. Nevertheless, it is an indication of how influential the financial sector has been on industry in general.

The important point being missed by some people is the realization that one of the main reasons for the decline in financial stocks is due to the market re-pricing their long-term future. Goldman Sachs, G.E., and others are not dropping because of losses on mortgages (both seem to have steered clear of the questionable residential mortgages and only seem to have limited exposure to commercial mortgages.) I see the financial sector shrinking relative to the rest of the economy. The implication for investors is that returns will likely be nowhere near they were in the past. Financial sector, particularly investment-related, has also been lucrative for employees but this is likely to be less so in the future.

(Do note that I'm talking about America here. The opposite is likely to be case in the developing world. There is still huge growth potential in those countries. For example, credit cards, public stock/bond ownership, retail financing, insurance, and so forth are still in their infancy in most of the populous Asia, Africa, Eastern Europe, and Latin America.)


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