Bonds Are Not Forever E-Book

Simon A. Lack

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch
• Veröffentlichungsjahr: 2013

Seitenzahl: 382

Beschreibung

An up-close look at the fixed income market and what lies ahead Interweaving compelling, and often amusing, anecdotes from author Simon Lack's distinguished thirty-year career as a professional investor with hard economic data, this engaging book skillfully reveals why Bonds Are Not Forever. Along the way, it provides investors with a coherent framework for understanding the future of the fixed income markets and, more importantly, answering the question, "Where should I invest tomorrow?" Bonds Are Not Forever chronicles the steady decline in interest rates from their peak in the 1980s and the concurrent drop in inflation during that period. Lack explains how those two factors spurred a dramatic growth in borrowing among both governments and individuals. Along the way, Lack describes how a financial industry meant to provide capital needed to drive productivity and economic growth became disconnected from Main Street and explores the grave economic, social, and political consequences of that disconnect. * Provides practical solutions for avoiding the risk of falling bond markets and guaranteed negative real returns on savings * Explains how the bursting of the real estate bubble in 2007-2008 led to massive borrowing by governments as they attempted to offset a sharp fall in economic activity * Details how the trends of exploding debt and a financial sector that has grown much bigger than it needs to be have dramatically changed the game for savers Offering a uniquely intimate, yet analytically thorough look at the coming fixed income crisis, Bonds Are Not Forever is must reading for investment professionals, as well as retail investors and their advisors.

Leseprobe

Contents

Preface

Acknowledgments

Chapter 1: From High School to Wall Street—The Bull Market Begins

As Bad as It Gets

Trading in Gilts

The Old Class Structure

A Nineteenth-Century Market

Finance Starts to Grow

Is Finance Good?

Investing after the Bubble

Chapter 2: A Brief History of Debt

Interest Rates in Ancient Times

Medieval Credit

The Beginnings of Modern-Day Finance

Borrowing Reaches the Mass Market

Student Debt

Big Borrowers in History

What We Owe Now

Chapter 3: Derivatives Growth

Welcome to New York

Early Derivatives Growth

Swaps Take Off

Size Isn’t Everything

Derivatives Reach Omaha

Norwegian Wood

Chapter 4: Bond Market Inefficiencies for Retail

Stocks Are Fairer than Bonds

Why Change Is Slow

Structured Notes

The Internet Threatens the Swaps Oligopoly

Municipal Bonds

Chapter 5: Trading Derivatives

Computers and Swaps

Should Banks Innovate?

Growth in Innovation

Volcker’s Problem

Bring Me Clients with a Problem

Derivatives Missteps

Trading by the Book

An Options Book Blows Up

Chapter 6: Politics

Why Should We Worry?

Who Says There Is a Problem?

Look to the Future

Looking Ahead

Monetization—A Thought Experiment

Imperial Overstretch

More Debt Means More Banking

Chapter 7: Managing Risk 1990–1998

Traders and Risk

Why Traders Are Bad at Budgeting

The Growth of Global Trading

Managing Obscure Basic Risks

What’s the Social Purpose?

Wall Street Fuels the Debt Growth

Chapter 8: Inflation

Germany’s Defining Economic Experience

Inflation Today

The Fed’s Huge Mistake

You Can’t Spend Quality Improvements

What Critics Say

Measuring What They Can, Not What Counts

Chapter 9: Bonds Are Not Forever

Wall Street Built It

Make Your Own Bond

High Dividend, Low Beta

Hedged Dividend Capture

Master Limited Partnerships (MLPs)

Deep Value Equities

Debt Is Bad

Bonds Are Not Forever

References

Glossary

About the Author

Index

Cover Design: Wiley

Cover Image: © iStockphoto.com / alexdans

Copyright © 2013 by Simon A. Lack. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923 [phone], fax [phone], or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, [phone], fax [phone], or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at [phone], outside the United States at [phone] or fax [phone].

Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com.

Library of Congress Cataloging-in-Publication Data:

Lack, Simon, 1962-

Bonds are not forever : the crisis facing fixed income investors / Simon A. Lack.

pages cm

Includes bibliographical references and index.

ISBN 978-1-118-65953-3 (cloth); ISBN 978-1-118-65970-0 (ebk);

ISBN 978-1-118-65960-1 (ebk)

1. Bonds. 2. Fixed-income securities. 3. Investments. 4. Capital market. I. Title.

HG4651.L33 2013

332.63′23—dc23

2013019671

To my grandparents, Roy and Kathleen Rogers

PREFACE

Three big themes have linked together to dominate bond markets over the past 30 years. Since inflation peaked in the early 1980s, we’ve experienced a secular decline in interest rates, an increasing financial services sector, and sharply growing indebtedness. By sheer coincidence, my career began at approximately the same time that these three trends emerged, although my identification of them is most definitely one of hindsight rather than foresight.

The 2008 financial crisis was borne out of these three trends, and its aftermath has many consequences. American economic history is full of successes, although not every economic development has been good. Many financiers have made fortunes through a bigger banking sector and more widespread indebtedness, yet the inflation-adjusted lot of the typical family has barely improved. An understandable public policy response to the financial excesses is developing around the belief that, in finance, big is bad and greater oversight is in the public interest. This swinging of the pendulum back in a more populist direction likely heralds change in other trends as well. The sharp increase in government debt as a result means the weight of financial obligations will be a prominent feature on the investment landscape for the foreseeable future. When there is an absolute abundance of public sector debt to be financed at all levels of government, the prudent investor should probably use commensurately more reticence in committing to securities with fixed returns.

This book seeks to connect the three big themes of falling inflation, a growing finance sector, and huge government debt into a coherent framework for assessing future returns on fixed income. Woven into this analysis are personal anecdotes from someone who was part of the growth of Wall Street simply because that was the intersection of opportunity and personal aptitude. Bonds have been a great investment for a very long time, but Bonds Are Not Forever.

This book includes a website, which can be found at www.bondsarenotforever.com. This website includes a description of the book, links to press coverage and events featuring the book, and links to the SL Advisors, LLC website for more information about the investment strategies mentioned here.

ACKNOWLEDGMENTS

A book is a collaborative process, and this project would not have been possible without help from many people. My business partner and friend, Henry Hoffman, provided numerous recommendations for improvement and applied intellectual rigor to assertions that might otherwise have been simply opinions. Many of the conclusions drawn herein are the result of countless hours of spirited debate with Henry about investment strategies, economics, and the shortcomings of the U.S. political process. Several friends reviewed individual chapters and offered many improvements. Chapter 2, “A Brief History of Debt,” benefitted from Roger Taylor’s thoughtful input, backed by his long career in bond research. Pat Britt, with whom I worked in the early 1980s, provided insightful feedback on Chapter 3, “Derivatives Growth.” Jon Bramnick, New Jersey state assemblyman and Assembly Republican Leader, helpfully reviewed my analysis in Chapter 6, “Politics.” Jim Glassman, senior economist at JPMorgan Chase and a former colleague, provided many suggestions and corrections for Chapter 8, “Inflation.” My friend of 30 years Larry Hirshik also offered improvements and confirmed my recollection of events we shared many years ago. Fred DaVeiga cleverly suggested the title, revealing yet another of his many talents, and my sister-in-law, Katherine Oldfield, inspired the front cover design. My mother, Jeannie Lucas, did research and initial editing and acted as cheerleader throughout. Last, but by no means least, my beautiful wife, Karen, and our three wonderful children, Jackie, Daniel, and Alexandra, provided the encouragement to pursue this endeavor and the space in which to conclude it. I am indebted to them and to all the people listed here, without whom this book would not have been written.

CHAPTER 1

FROM HIGH SCHOOL TO WALL STREET—THE BULL MARKET BEGINS

Inflation Memories

It was February 1972, and at nine years old I found playing with my toy soldiers in the flickering candlelight an exciting change from the steady illumination of incandescent bulbs. My British platoon skillfully maneuvered behind the German lines, taking advantage of the shadows to surprise and quickly overwhelm the enemy. In those days the Germans were always the competition, whether on the battlefield or the English football pitch. The change in routine caused by the loss of electricity thrilled me as a young boy, but was not so exciting for my grandparents because it was a scheduled loss of power whose timing had been announced in the daily newspaper. February in Britain is dark at the best of times. After a long winter night, a person awakes to a dull, gray sky. By the time I began my career working in London’s financial markets, the British winter, while not nearly as cold as that of New York, felt rather like two months living at the bottom of a damp, dark pit, with only an occasional glimpse of daylight through a window. However, an English evening in July, when the days are long but never humid, can be the best place in the world.

Britain in the early 1970s was at the mercy of the trade unions, and a coal miners’ strike was preventing fuel from reaching the power stations around the country. The proud people of a nation that still recalled the empire on which “the sun never set” found itself powerless at home, reduced to eighteenth-century means of illumination. Arguably, Britain was continuing its steady relative decline from the late nineteenth century, at which time the United States began to surpass Britain by measures such as iron and energy production, and industrial output (Kennedy, 1987). The steady rise in importance of other powers accelerated following World War II, when victory was achieved only at an enormous financial and material cost; confirmation of Britain’s reduced status came during the 1956 Suez Crisis when U.S. pressure forced an embarrassing climb down on a once dominant power. Yet diminished global influence didn’t need to translate into self-destructive actions at home. Nonetheless, in 1972, while the trade unions and the government argued over pay, a country once described as “built on coal” was unable to use enough of it to light its homes. There were many low points for Britain and its economy in the 1970s when I was growing up, including a bailout by the International Monetary Fund (IMF) in 1974.

Looking back at those times from a distance of 40 years and 3,500 miles in America, the 1970s were the most turbulent economic times since the Depression in the 1930s. Britain had its own set of home-made wounds in the form of militant trade unions, a manufacturing base that was losing out to its European competitors (especially the Germans), and a welfare state whose safety net was so generous it often made paid employment more costly than indolence.

Although Britain had its own partly self-inflicted problems, rising inflation in the 1970s and early 1980s wasn’t limited to the United Kingdom. President Ford even resorted to handing out pins labeled Whip Inflation Now (WIN), perhaps revealing the paucity of more robust ideas within his administration. For much of the developed world it was the greatest inflation in living memory. Today, it is recounted through bland numbers on a statistical release from the U.K. government. In 1972, when the miners were forcing Britain to her knees, inflation the United Kingdom was 7.6 percent (see Figure 1.1). Two years later, fueled in part by generous pay settlements won by the coal miners and other unions, it was 19.2 percent. A year later, in1975, U.K. inflation reached 24.9 percent, a level at which money loses half its value in just over three years. In one month (May 1975), prices jumped 4.2 percent, an annualized inflation rate of 63.8 percent!

FIGURE 1.1 U.K. Inflation 1948–2012

Source: U.K. Government, Office for National Statistics.

This is an abstract notion for most Westerners today. We read about inflation in Latin America, about hyperinflation in countries such as Zimbabwe, but few of us below the age of 60 have had to manage a household budget and make personal financial decisions under such circumstances. That includes me, but memories of my mother and grandparents worrying about “the cost of living,” about weekly price increases and the ongoing failure of income to keep up with expenses remain a part of my otherwise quite happy childhood.

Running commentary at the dinner table about how the price of sugar, washing powder, petrol, or school uniforms had gone up since the last time we gathered were a staple part of the conversation. Of course, nobody knew when it would end, or really even what was causing it (although the reasons seem clear enough to today’s economic historians). People blamed the trade unions for selfishly negotiating pay increases not backed by improved productivity, the government for conceding to their demands, and the Organization of Petroleum Exporting Countries (OPEC) for sharply hiking the price of oil. All of these were to blame. What was worse was that at the time nobody knew if double-digit inflation or worse was a permanent part of the economy.

AS BAD AS IT GETS

Hard economic times were not limited to Britain, though. The 1970s were tumultuous in America as well. While American trade unions were not nearly as powerful as their U.K. counterparts, photos of gas-guzzling cars lined up waiting to refill their tanks became an iconic image of that time. Shortages of basic goods, often accompanied by inflation, were a global phenomenon. The lax monetary policies followed by central banks and governments combined with some features unique to each country. In Britain, a steady loss of competitiveness, on top of an overly generous welfare state, was ultimately reversed by Maggie Thatcher when she came to power in 1979. In the United States, blame for the economic turbulence of the 1970s typically traces back to the 1960s, with the costs of financing the Vietnam War coincident with an expansion in welfare under Lyndon Johnson’s “Great Society.” The subsequent loss of confidence in the U.S. dollar led to the breakdown of the Bretton Woods Accord when President Nixon suspended its free convertibility into gold in 1971. This ushered in the current era of “fiat money,” in which a currency’s value is only as good as the market’s confidence in its government’s policies.

The 1970s and early 1980s saw two major oil price hikes, economic upheaval, and ultimately strong leaders in Margaret Thatcher and Ronald Reagan, determined to lead their respective countries along a better path to smaller government, sound money, and improved living standards. Britain and America share a great deal in terms of history and values. At that time, both countries were in need of decisive leadership to promote economic growth supported by competitiveness and sound money. Both found it.

In 1980, U.K. monthly inflation was 15 percent (in just one month, April 1980, prices rose 3.4 percent), and shortly thereafter the greatest bull market in history began in bonds. It followed the longest global bear market in history, one that began in 1946 after World War II and lasted 35 years. To illustrate, if a constant maturity 2.5 percent 30-year bond had been available throughout this period, its price would have declined from 101 to 17, a drop of 83 percent (Homer and Sylla, 2005). More than an entire generation of bond investors had lived through a relentless destruction of the purchasing power of their savings. In the years leading up to 1981 investors had been demanding ever higher yields on their fixed income investments to provide protection against the rapid erosion of purchasing power. High borrowing costs were stifling any industry that required borrowed money to operate, which is to say virtually the entire economy. As financial markets began to sense that inflation and interest rates were peaking, they bid up the prices of bonds aggressively. The long road to low and stable inflation had begun, and with it a bull market in equities as well (propelled by falling borrowing costs, which were helping so many companies).

TRADING IN GILTS

By coincidence, my career in financial markets began in London within a few weeks of that peak in interest rates and inflation. I had grown up during the most extended financial turmoil in living memory, with double-digit interest rates and savings that rapidly lost their real (i.e., inflation-adjusted) value. I began my career in finance within a month or two of the very worst of high interest rates and rampant inflation. It was the threshold of the gradual return to sound money, and it would be complemented by an inexorable rise in the value of all financial assets. At the same time, finance and financial markets were set to gain enormously in importance through greater employment and would contribute a substantially larger share of overall economic output. Liberalization of markets would lead to a dizzying array of financial instruments to be traded. This occurrence combined with the relentless fall in trading costs would support the steady increase in financial engineering and debt creation that culminated in the crash of 2008. None of this was even remotely plausible to someone recently out of high school and beginning his career in “The City.” Yet, in hindsight, my entry into the workplace was blessed with fortunate timing.

The U.K. market for government bonds, or “gilts” as they are known in Britain, has as long a history as any in the world. Consolidated annuities (known as “consols” for short) are perpetual securities that were created in 1756 by consolidating a series of already issued perpetual annuities. They have no maturity date (although theoretically the U.K. government may redeem them). Their history is detailed in a 2005 book soporifically named A History of Interest Rates by Sidney Homer and Richard Sylla. It’s probably not flying off the shelves at Amazon. Nevertheless, for those interested in such things it is a comprehensive record of the cost of borrowing that goes back to biblical times in measuring the price of credit.

Bond markets are not nearly as exciting as stocks. Bonds issued by governments don’t involve colorful CEOs, corporate takeovers, or profits warnings. Bonds are boring; in fact, bonds are meant to be boring. Investors don’t buy them for excitement—for thrills they buy stocks or go to the racetrack. Because bonds move far less than stocks and are rarely prone to the extremes of greed and fear so prevalent in equity markets, the people who traffic in them tend to be more staid as well.

Equity traders have been known to accuse their colleagues in bonds of being communists. On days when the government releases weak economic data, government bond prices often rise (because their yields fall), and traders in most markets generally do better when prices are rising. Economic misery, which tends to restrain inflation, causes bond traders to leap for joy while equity markets and consumer sentiment both tumble. There’s an essential difference in outlook between the two markets. Equity traders are happiest when they are optimistic on the economic outlook because higher corporate profits tend to fuel rising stock prices. By contrast, bond traders are often cheerful when everybody is miserable. Rising unemployment, slowing retail sales, and falling house prices are all associated with falling interest rates and a bull market for bonds. Try watching the professionals on TV from any big bond firm (Pimco, for example) sincerely lament another weak economic report while their investments are most likely rising in price. Professed and genuine concern for the newly unemployed competes with the quiet satisfaction of a more highly valued bond portfolio.

The U.K. gilt market (so named after the “gilt-edged” credit quality of the bonds traded there) of 1980 operated in a way that was scarcely different from the 1880s. The market consisted of brokers, who charged a commission and traded with the public as brokers do, and jobbers who were market makers and did not deal with the public at all. The market was structured with two large jobbers named Wedd Durlacher and Akroyd and Smithers, in effect surrounded by a far larger number of brokers. Brokers were allowed to trade only with jobbers and investors, not with one another. The jobbers could not trade with anybody except the brokers or (occasionally) with other jobbers. The jobbers held a monopoly on market making, but in return had given up the ability to face investors. The brokers had the exclusive right to deal with the general public, and in exchange were allowed to act only as agents (i.e., they couldn’t take positions themselves).

Business took place on the large floor of the London Stock Exchange. Jobbers stood at their “pitch,” or assigned post, while brokers moved around the floor in search of the best deal for their client. A broker would ask a jobber to quote a price that was, in the best tradition of London markets, always “two-way” (i.e., bid and offer). Years later, when I was trading U.S. government bonds in New York, I always felt that the U.S. custom, whereby the client had to disclose whether they were buying or selling before obtaining a quote from the dealer, was providing a needless advantage at the expense of the client. A U.S. government bond dealer will show only one side of a two-way market—the client will ask for “a bid on 25,” for example, or request that the trader “offer 50.” Showing a two-way market keeps the dealer honest, in that if his bid/ask spread is wide, that’s an indication that his profit margin is possibly too high and may signal the client to go elsewhere. Other markets, such as foreign exchange, always required that the market maker quote a two-way price. The trader could try to guess whether the client was buying or selling, but if he shaded the price the wrong way, he ran the risk of the client’s trading on the other side (i.e., buying when the dealer thought he was a seller) and perhaps profiting off the dealer’s attempt to “read” him.

The London Stock Exchange in 1980 was only a few years away from “Big Bang,” the 1986 deregulation of the overall market that would radically alter almost everything about how “The City,” as London’s financial center is called, operated. Back then, the entire place followed rigid work practices, from commissions, which were uniform across all firms, to career paths and how clients transacted their business. Finance had long provided jobs for those who were quick-witted and confident. London’s financial market place is physically not far from the East End of London, with its rowhouses of tenements barely changed from World War II. Multiple paths existed for the aspiring financier: education at a private school (perversely called a “public” school in the United Kingdom) followed by a university degree, then entry to a blue-blooded stockbroker in the gilt market. This was dubbed by some the “champagne and polo crowd,” evoking the cultural background of those whose leisure regularly includes the enjoyment of both.

THE OLD CLASS STRUCTURE

Another path was from comprehensive (i.e., not elite) school, and probably not university, to a job in the equity markets or the money markets, where one’s peers would be the “gin and tonic and squash crowd,” denoting less cultured and cheaper relaxation. The open outcry, rough and tumble of a large physical market was a comfortable place for someone who might just as easily be competing to sell fruit and vegetables fewer than 10 miles away for vastly different compensation. London has become a much more culturally diverse place, with little patience for the staid old ways, and that’s no doubt a good thing. Still, the London Stock Exchange in 1980 in many ways mirrored the class system of the country. Britons could instantly place someone in their appropriate class as soon as words were spoken, and, while business could be transacted across class lines, social life was rarely so flexible.

Forest School in Snaresbrook is close to London’s East End. The surrounding forests from which it draws its name quickly give way to gritty working-class neighborhoods as you head toward the center of the city. Before reaching the gleaming towers of London’s financial district, it’s necessary to pass through run-down areas such as Leyton, Hackney, and Bethnal Green, none of which could be confused with the leafy suburbs of the stockbroker belt. Historically, immigrants to the United Kingdom have often settled in the East End, from the Huguenots fleeing religious persecution in France in the seventeenth century to the South Asians today. Forest was and remains a public school with neighbors who can only dream of affording the tuition to send their children there, and yet the presence of so many minority students highlights the economic mobility that immigrants achieve. In many ways, my alma mater, Forest School, was typical—all boys, classes that ran six days a week, with a heavy emphasis on competition across all endeavors, both academic and sporting. When I was there in the 1970s, there were many boys that didn’t look “English,” to use the terminology of that time, because they weren’t white. Today’s coeducational student body is no less diverse, and yet more “English” because the country is itself more diverse.

The closely packed houses of London’s East End have usually been home to workers struggling to move up a rung or two, and also home to a fair amount of crime. A student from Forest School, easily recognizable in his uniform, would head warily in that direction to a place where looking at someone the wrong way, or indeed looking at them at all, was to invite trouble. So this public school’s catchment area for students included parts of London that wouldn’t normally send their children to one. Nonetheless, the experience was typical of most public schools. Boys were assigned to “houses,” which were the basis for intense internal competition in everything from sports to drama. In fact, competition was ever present, whether it was in class rankings for subjects or an English football game with a neighboring school. Anything that mattered was subject to comparison with your peers.

“Monitors” (selected students in their senior year) were the first layer of sometimes arbitrary discipline, empowered to administer corporal punishment if they judged it appropriate. It was its own somewhat insular and challenging world, with far less parental involvement than is the case in most schools today. School was a tight community, where problems were invariably resolved with little outside influence. You had to figure things out within the confines of the physical boundaries and the social ones. Therefore, I found the seven years I spent there hugely impactful, as those years often are.

The school’s song, in Latin, was sung on key days during the year, and portraits of headmasters past adorned the walls of the dining hall where grace was said (in Latin) before boys could eat their (usually barely edible) lunch. The hierarchy and the traditions were all part of the education, in addition to the academic experience. Although fewer than 10 percent of the population shared this type of schooling, they represented a far bigger percentage of the U.K. workforce in law, medicine, senior levels of the government, and, of course, finance.

On top of this unusual mixing of social classes, I took the less conventional route out of school and went straight to work in The City, passing up university out of the poorly informed, youthful confidence that my formal education was already sufficient. I soon found myself with the champagne and polo crowd in U.K. government bonds, known as the gilt market, in spite of the absence of a university degree on my resume. I was a “blue button,” so named after the blue badge with my employer’s name on it that placed me precisely at the bottom of the ladder. In many ways, the gilt market was like starting school again, with my firm taking the place of my schoolhouse and my blue button status ensuring that the yellow badges (members) and silver badges (partners) barely even acknowledged my existence, just as senior-year students in school barely tolerate the existence of those merely a few years younger.

Gilts were the preserve of the “well-spoken” public schoolboys who had grown up in elite establishments steeped in practices many decades old. In a memorable holdover from much earlier times, the employees of one stockbroking firm called Mullins were all required to wear top hat and tails every day on the trading floor. Socially, they were the top of the pyramid, drawing their employees from only the most exclusive public schools. They were truly in the champagne and polo crowd.

A NINETEENTH-CENTURY MARKET

Mullins retained a special designation in that they were the only firm allowed to trade directly with the U.K. Treasury. In an archaic structure that epitomized the Old World style of business and fed many along the food chain, the U.K. government would issue its new gilts only to Mullins. Mullins would then turn around and sell these on to the jobbers, who would buy only what they knew they could sell back to the other stockbrokers, who would then sell them at very high commissions to the investing public. It was emblematic of the closed, anticompetitive methods of the time.

The brokers from Mullins followed a long tradition of dressing somewhat like the students from Eton, perhaps Britain’s most elite public school and from which, no doubt, many of them had graduated. Their nineteenth-century dress code persisted until the late twentieth century. When the Big Bang in 1986 transformed commissions, structure, and customs, this particular tradition went, too, as Mullins was absorbed by investment bank S. G. Warburg and the gilt market abandoned the physical trading floor in favor of doing business over the phone. I don’t think it’s missed, although it’s extraordinary to think that even within my 30+ year career they were part of the landscape.

In addition, just as moving from first year to sixth year in school can’t realistically be completed in fewer than five years, graduating to the next level as a stockbroker in the gilt market required as much as anything that you “do your time.” The rigidity of commissions and market practices required a similarly inflexible career path, in which talent or ambition would take second place to chronologically determined promotions. For me, my impatience with this way of business culminated with a discussion of my performance and my first pay raise. I entered the boardroom to meet with my boss, having put on my suit jacket, as was the custom for such a formal discussion. My diminutive annual salary of £2,750 was surely about to be rounded up to £3,000. To my dismay a mere £200 was added, confirming my lowly position at the base of the ladder in contrast to my own inestimable self-worth. Shortly afterward, I concluded that the gilt market’s time frame and mine were at odds, and I moved to the money markets, where my starting salary as a trainee broker was quickly agreed at £5,000.

So I left the rigid social confines of the London Stock Exchange, where your accent would assign you to the equity market (working class, gin and tonic and squash) or the gilt market (upper class, champagne and polo, although in my time there I experienced neither). Instead, I entered the money markets, where social classes mingled, the business environment was more freewheeling, and ability might just get you a step ahead.

FINANCE STARTS TO GROW

I was one individual making personal decisions that were dictated by the world I found but to whose shifting circumstances I did not give much thought. The United States and Britain were at the threshold of an advance in financial services that would substantially increase their impact on future economic growth. A 2012 paper by Robin Greenwood and David Scharfstein, both of Harvard Business School and the National Bureau of Economic Research (NBER), examines this shift in some detail (Greenwood and Scharfstein, 2012). The authors focus on a concept called gross domestic product (GDP) value added. Rather than measure the simple output (i.e., revenue) of an industry, they believe the more important measure is the value added. This makes sense since any business has inputs that it needs to generate its output. To use an example, a supermarket might take in $100,000 of revenue in a week and only spend $80,000 buying all the produce from various wholesalers. The $20,000 remaining goes to pay compensation to the workers in the supermarket and profit to the owners. It’s this $20,000 that is the GDP value added measure used by the authors, essentially salaries and bonuses to the workers in financial services and profits to the owners of the businesses. As such, it excludes all the other inputs or expenses, such as leased office space, information technology (IT), and others. These are someone else’s GDP value added. They are not directly created by the bankers, brokers, and asset managers in finance.

Greenwood and Scharfstein found that financial services’ share of U.S. GDP measured in this way grew from 4.9 percent in 1980 to 8.3 percent1 in 2006, where it peaked just prior to the mortgage crisis that began in 2007 (see Figure 1.2). In 1950, finance was only 2.8 percent of GDP, so although it had been growing as a proportion of GDP prior to 1980, the annual rate of growth doubled pre-1980 versus post-1980 (from 0.07 percent per annum to 0.13 percent per annum). Britain experienced a similar though less marked increase because its economy was already more biased toward finance than the United States at that time. Canada, Japan, and the Netherlands all saw an increase in finance within their economies, although it was by no means a worldwide phenomenon. In many European countries the opposite effect was observed, as other industries gained a bigger share of overall economic output. Germany, France, and Italy all saw modest falls in financial services’ share of GDP over this period, while in Norway and Sweden the share dropped by over a third.

FIGURE 1.2 U.S. Financial Services Percentage of GDP

Source: Bureau of Economic Analysis.

The authors don’t dwell much on the reasons behind these different outcomes. In looking at the data, it’s clear that those countries with a longer history and more dominant role in financial markets were the ones that witnessed the growth. During this time, there was a growing focus on the need to be global and to have scale in order to thrive. I worked during most of this period at one large American bank, which morphed from Manufacturers Hanover Trust to Chemical Bank to Chase Manhattan, before winding up as the behemoth that is JPMorgan today. Many smaller acquisitions took place along the way, and the constant strategic justification was the need to provide a global platform to our global clients.

Furthermore, banking is also heavily reliant on IT and the development of the Internet from the mid-1990s improved communications dramatically, allowing more trading functions to be managed in a smaller number of major financial centers. Language and common culture no doubt also played a role, and with spoken English as well as U.K. law already the common currency across many areas of banking, the British Empire and its former members had a big lead. The fact that the United States was the largest economy, market, and only superpower is probably a factor, too.

London already had a dominant position in this sector throughout Europe. These trends probably served to marginalize centers like Brussels, Paris, and Milan. New York never really had a close competitor within its time zone, although Chicago’s futures pits made it the home for exchange traded derivatives. It’s therefore likely that for these reasons and maybe others, the Anglo-Saxon countries allowed and encouraged bankers and asset managers to play a bigger role in their economies. It’s doubtful that the political leaders of the late 1970s and early 1980s sought this transformation, and the past 30 years have witnessed an evolution with many twists along the way, as the creative destruction that defines capitalism has created winners and losers. The way the French sneer at Anglo-Saxon hedge funds and their brand of capitalism may reflect different values that led France to inhibit similar growth in their domestic markets. Perhaps it also reflects disappointment that so many young French people choose to live and work in London, where the opportunities are often far greater.

The GDP data from which this analysis is drawn identifies two areas within financial services that are responsible for most of the growth—securities and credit intermediation. Insurance is the third big component of financial services, although its growth over this time was unremarkable and fairly steady going back as far as 1940.

The securities industry, which includes everything from trading and underwriting to asset management, increased its share of GDP value added from 0.4 percent in 1980 to 1.9 percent in 2006 before falling back modestly to 1.7 percent in 2007 (see Figure 1.3). This more than quadrupling of virtually all things related to investment securities in barely more than a single generation is probably unprecedented in history. The securities industry further breaks down into subcategories, of which asset management is by far the biggest, representing over half of all securities industry activity by 2007.

FIGURE 1.3 Securities Industry Percentage of GDP

Source: Bureau of Economic Analysis.

Credit intermediation, which includes traditional banking such as taking deposits and making loans, also saw substantial growth albeit from a higher base. This increased from 2.6 percent of GDP value added in 1980 to 3.6 percent in 2006 before dropping back in 2007 to 3.4 percent, although by 2011 it had increased modestly back to 3.6 percent (Bureau of Economic Analysis, 2013). Banking went from being six times as big as the securities industry in 1980 to only twice as big almost 30 years later, although it, too, represented a bigger share of the economy.

IS FINANCE GOOD?

So Wall Street and Banking (and sometimes the two are synonymous) had by 2006 reached over 8 percent of the entire U.S. economy. As we all discovered during the 2007-2008 Crisis, their actual impact was substantially greater than this, since their collapse led to the worst recession most of us have ever seen and the brink of financial catastrophe. These two industries affect the lives of so many more people than simply those employed within it. As well as employing more workers, finance has contributed to the increasing dispersion of incomes within most developed countries. Many finance jobs provide more than your average middle-class income that has stagnated for the past 10 years. Indeed, from 1980 to 2006, pay in finance rose cumulatively 70 percent more than in the rest of the economy (Philippon, 2008).

The growth in the securities industry and in credit intermediation were related phenomena. Much of the growth in credit intermediation was fueled by residential mortgages. The long bull market in bonds created regular incentives for homeowners to refinance their mortgages to take advantage of lower rates. At the same time, public policy became geared toward increased home ownership, while the tax deductibility of interest on home mortgages combined with the increased percentage of loans underwritten by the federal government, all contributed to the increased percentage of families living in their own homes.

Data from the U.S. Census Bureau shows that the home ownership percentage was remarkably stable from 1965 until the late 1990s, fluctuating between 63 percent and 66 percent. President Clinton made increasing home ownership one of his goals, stating to the National Association of Realtors in November 1994 with his typical eloquence that “most Americans should own their homes, for reasons that are economic and tangible, and reasons that are emotional and intangible, but go to the heart of what it means to harbor, to nourish, to expand the American Dream” (Morgensen, 2011). Clinton enlisted support from all the stakeholders including banks, securities firms, builders, and realtors, and his strategy was greatly facilitated by the corruptly led twin federal agencies FNMA and FHMC (Fannie Mae and Freddie Mac) (Morgensen, 2011).

By the late 1990s the home ownership percentage had reached the top of its multidecade band of 66 percent (see Figure 1.4). By 2000 it was at 67 percent and in 2004 it reached 69 percent before moderating for a few years and then falling more sharply back to its long-term range as the housing bubble burst. Government policies were aided by increased securitization of mortgages, and the increased securitization also led to a bigger securities market with more assets to manage for the securities industry. In this way, the two fastest-growing areas in financial services were linked and to some degree fed off one another.

FIGURE 1.4 U.S. Home Ownership Percentages

Source: Current Population Survey/Housing Vacancy Survey, Series H-111 Reports, Bureau of the Census, Washington, DC 20233.

Some compelling questions are prompted by the developments of the past 30 years. Society may well challenge the wisdom of promoting home ownership beyond what was, in hindsight, a stable, equilibrium level. Owner-occupied homes are widely believed to promote stable communities with lower crime rates and higher incomes; however, the incentives to own your own home clearly resulted in many people buying homes they could not afford, with mortgages they should not have been given. While the policies that promoted this were no doubt well intentioned, the sad outcome of so many people losing their homes, and in many cases a hard-earned down payment, exposed the flawed nature of this approach.

Household debt also grew along with Wall Street. Outstanding consumer credit jumped in the 1950s, as the end of World War II brought soldiers home and ushered in the beginning of the Baby Boom and increased household formation. It then fluctuated between 10 and 13 percent of GDP during the 1960s and 1970s (see Figure 1.5). Nevertheless, from 1980 to 2003, consumer credit grew steadily from 12.6 percent of GDP to 18.6 percent. Although during recessions it shrank, the overall trend was clearly higher. There’s little doubt that securitization aided the process as banks packaged debt into bonds and moved it off their balance sheets to investors globally.

FIGURE 1.5 Consumer Credit as a Percentage of GDP

Source: Federal Reserve.

Government debt (federal, state, and local) also grew strongly from 1980. No doubt, the growth of finance helped this as well. As a percentage of GDP, government debt is close to the levels following World War II (see Figure 1.6). When combined with household debt, our total obligations are assuredly at a record.

FIGURE 1.6 U.S. Total Government Debt Percentage of GDP 1902–2012

Source:USGovernmentSpending.com.

Another important question is whether the growth in financial services has created widespread benefits for anybody beyond those directly employed in the industry. Greenwood and Scharfstein conclude that a bigger asset management industry has led to higher equity prices than would otherwise be the case through greater investor diversification. Their logic is that investors hold generally more diversified portfolios of equities, thanks to the greater use of financial advisers and mutual funds. In theory, this improved diversification should lower the return required for investors to hold equities (because portfolios are now less risky through being more diversified). A lower required return for equity investors translates directly into a lower cost of equity capital for public companies.

It’s a reasonable argument, albeit hard to prove empirically. Cheaper access to equity financing is most certainly good for the broader economy, since it makes it easier for companies to finance themselves and invest in new projects, with corresponding broad-based benefits throughout the economy. Yet they also note that asset management fees have stayed surprisingly high and that there seem to be few economies of scale that pass through to the investor in terms of lower fees. In some respects, they echo the findings in my 2011 book, The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True, in which I showed that hedge fund managers had kept all the profits made with their clients’ capital through exorbitant fees. This is an extreme case of the financial services industry retaining substantially all of the benefits of a potentially good thing (active asset management). It nonetheless begs the question of whether such behavior is simply rent seeking with little added societal value. Increasing dispersion of incomes and the stagnation of median household real wealth suggest that gains have been unevenly distributed. Politically, the median voter’s economic state is far more important than the average voter’s when the two are diverging, as is the case today. As average incomes are less reflective of the average person (due to “the 1 percent” doing so well and pulling up the average), a public policy response cannot be far behind.

INVESTING AFTER THE BUBBLE

Perhaps the most interesting question is the one facing investors. We are probably at an inflection point in two important ways. The collapse in the real estate bubble with its consequently deeply unpopular bank bailouts has focused attention on the securities industry, its pay practices, and what the appropriate relationship should be between banks and the society they are intended to serve. At its core, Wall Street is supposed to facilitate the channeling of savings into productive types of capital formation, which will foster economic growth and job creation as well as investor returns above inflation. To many people, Wall Street has increasingly lost sight of this goal; one simple example is the growth of computerized, high-frequency trading (HFT). Managers of HFT strategies even value physical proximity to the New York Stock Exchange so as to gain vital milliseconds in the transmission of their orders and therefore a more profitable outcome. It’s hard to come up with a more obvious case of a perfectly useless activity that is clearly part of a zero-sum game on whose other side lie conventional investors seeking a return on their capital.