Financialization of the Unquantifiable

IPOs of every conceivable type have been part of the mix, and a key part of the Wall Street fee structure. We saw the dotcom insanity, real-estate related security insanity, and to this day still see hundreds of public companies out there with no earnings, no clear prospects of earnings, perhaps not even a clearly useful product. David Miller, who covers the biotech space, has often complained about how easy it is for "the shorts" to manipulate the stocks of the speculative biotech companies he follows, increase their cost of capital, and in some cases force them out of business.

I think he's missing the point. The reason these stocks are so easily manipulated is that they should never be public in the first place. Prior to 1980, companies with that kind of profile never would have been public. Financialization gave the companies' founders and early investors an "easy out" regardless of whether the company's product succeeded. Deals were done, risks were moved to mostly uninformed shareholders, and Wall Street, VCs and company managements prospered. Money was cheap because financialization combined with Wall Street hype allowed these companies to build business plans based not on their ability to actually generate revenues, but on their ability to sell stock.

In an definancialized world, these companies would have had to justify themselves to smart investors with much higher hurdle rates and expectations, along with an extremely long investment horizon and the ability to diversify across numerous investments. Many of the marginal ones never would have gotten around to wasting investor money. The ones that did finally make it to the point of being public would have been those with real fundamentals, not the subjective metrics that guys like David put forward as being fundamental.

Wall Street Balance Sheets: A Final Monument

Companies with real fundamentals don't worry about manipulation. You can only be manipulated if there are no hard facts. Hard facts tend to wipe out people spreading rumors. Biotechs, like the dotcoms, are easily manipulated because real fundamentals are either nonexistent or opaque to the point where few can understand them. They don't deserve to be treated as financial assets because for all but the most sophisticated insiders, they're nothing more than lottery tickets. It's only the wave of financialization that has raised them along with all the other boats in the economy.

It's a somewhat fitting eplilogue to this two-and-a-half decade period of time that it should end with the implosion of the very institutions who benefitted most from this dying era. Bear Stearns, ultimately was sunk by the fact that it was so fiancialized, so opaque, so far from being able to show real value, that it simply lost the trust of everybody around it. Should Lehman or any of the others fail, it will be for the same reason. They violated Tony Montana's first rule: "Don't get high on your own supply." They filled their own balance sheets with the toxic junk that they -- of all people -- should have known could kill them.

In the end, the balance sheets of Bear, Countrywide, Lehman and untold others became the final monument to a world of financialization gone mad.

That world is over.

What's Old is New Again

So where does it take us? It takes us to someplace that some of us can't even conceive of going.

I was speaking with a friend of mine whose business is analyzing and rating the financial strength of banks. He's a genius at understanding these crazy derivative investments that represent a huge chunk of the assets on most of the banks' books. He knows how worthless most of their books are.

Yet when pressed, he still told me: "This country's economy can't survive without structured finance. Some of it will go away, but too much of the nation's business is tied up in it." Obviously he benefits greatly from rating institutions that are so complex that few can understand them. But I think that beyond his vested interest, he really does have a tough time considering that banks may have to go back to being simple banks. That companies may have to finance themselves with relatively simple and comprehensible mixes of equity and debt, even that mortgage borrowers may have to justify themselves not to a securitization firm, but to a firm whose bankers will have to live off the long term spread between their borrowing costs and lending revenues, just like they did 30 years ago.

The Great Unwind

That's why I believe this unwind will be harder and longer than a lot of people think. Because my friend is right. Every company, from GE down to little guys like CKE restaurants has become a junkie to finanacialization. They've become addicted to the quick fix of predictable profits that come from investing in difficult to value (and thus easily re-valued) securities and derivative deals. They've become dependent on having balance sheets so complex that they can mean anything the company wants them to mean, even after Enron and Sarbanes-Oxley (one of the most useless pieces of legislation ever passed).

The banks have become addicts to the predictablility of transaction revenue (everything from mortgage origination to account fees) but don't have to live with the long term consequences of the decisions to enter those transactions. The bankers take their bonuses at the end of the year, regardless of whether their deals blow up on January 2nd. It was easy money. It's gone.

We're going to have to go back to manufacturing good cars, not making our money from financing them. [edit, July 28, 2008: Chrysler's decision to exit the leasing business suggests that they're realizing this, though possibly too late for it to matter.] GE is going to have to figure out how to make business in appliances and other stuff that people want to buy, because people no longer trust your financial products. And they'll have to learn to live with the relative unpredictabilty of results that comes from having a "real world" business rather than one whose numbers can easily be adjusted to always meet predictions. Many of the companies that have come to depend on financing rather than creating will be unable to get out of their current bind. They'll die. It'll be painful, but good riddance.

My grandfather, whom I've written about before, came of age in the Depression. He never trusted banks, brokerages, and others in the financial world. He sought out safe investments with slightly higher returns than the banks in the neighborhood. He always kept his accounts below the FDIC and other insurer thresholds and owned a lot of government or other safe bonds. He learned not to trust the various risk-taking strategies that he saw destroy the finances of so many people around him early in his life.

The hardest part of all this is not going to be unwinding the debt, though that will be part of it. The great unwind will be the unwinding of our debt-laden lifestyles. We're going to have to unwind conspicuous consumption and live within our means. Living for "stuff," the lifstyle that George Carlin lampooned so hilariously, is going to have to be brushed aside. And it will be. Economics always tend to dictate fashion. The economics of the unwind will dictate frugality and economy rather than spending and bling. We'll go there.

We've had an 60 year run of increasing financialization and now de-financialization is upon us. Many of the people who are currently living through the aftermath will never trust incomprehensible financial tools and products again. Like my grandfather, we'll all know somebody who lost a home or a livlihood. Banks like the ones my friend analyzes will face a stark choice: return to a business model that includes comprehensible balance sheets or become uninvestible. CKE restaurants will have to learn that their business is burgers, not interest rate swaps. If they choose otherwise, the folks who've live through this mess will tell them "no thanks" when offered their shares.

As Kevin DePew notes often, we're going through a realignment of social preferences. Risk is getting cast aside. The financialization ad infinatum that has been fueled by our willingness to take risk is finished. Jim Cramer's latest New York article is right: The era of the big Wall Street payout is over. The models are discredited, the products they've created are unwanted and their jobs are unneeded.

In the end though, it'll be a good thing. Our best and brightest will actually have to focus their attention on creating things, not financing and re-financing them. And most people won't have a clue what an investment banker is.

-btc