It might seem churlish, and perhaps even a little cruel to tell institutional investors involved in fire-fighting the current market flames, that the seeds for the proliferation of this crisis, and ultimately for ensuring it never happens again, lie partly in their hands. But it’s true. Worryingly, long-term investors have been willing to sacrifice fundamental economics at the altar of excessive speculation. The mesmerising pace of collapse of some of the world’s biggest financial names has prompted some to point out that Warren Buffet’s 2002 assault on derivatives as ‘weapons of mass destruction’ looks terrifyingly prescient, but in reality it was just good financial sense that few wanted to hear. Buffet’s analogy is all the more apt if you consider that the impact of weapons of mass destruction has been more deadly in terms of what wasn’t found: there were none located in Iraq. The world’s most successful ‘long-term’ investor, warned that what you don’t find with some derivatives contracts are financial market staples like collateral, guarantees, correct valuations, or realistic earnings forecasts. Those observations made six years ago have been spot on regarding the market for mortgage-backed securities based on sub-prime lending and mixed toxically into the broader market. What Buffet said youcould find is complexity, greed and “mark-to-myth” securities values: “The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen).” Yet many institutional investors either bought or watched important counter-parties buy into certain derivatives products like there was no tomorrow. Few questioned the prevailing orthodoxy. John Maynard Keynes, the UK economist, famously said: “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation.” The analogy sums up what many outside of financial markets, and increasing numbers within, now believe: that large parts of the market have become a dangerous froth, puffed up on precarious, fiendishly complex lending and trading practices. Financial markets should not be the tail that wags the dog. Too much of the valid institutional pursuit of strong returns has focused on short-term gain and not long-term growth. The latter demands robust questions about the structure of financial markets and their place within broader economies and society as a whole. It also requires that long-term investors act collectively, along with regulators, to assess the viability of market
instruments, notably if they are exposed to them through their investments as they inevitably are in today’s markets. Any institutional investor looking at the performance of the MSCI World index, down 22.7% in the last year, which has pulled down 3-year figures to 0.19% and ten-year returns to 2.12%, will acknowledge that protecting the longevity and health of markets is their real interest – and that of their beneficiaries. Instead, many have been in thrall to complex securities products that often seemed to defy economic rationale: debt as equity, risk as opportunity, liquidity as being omnipresent, leverage as benign, down as up. Something is deeply flawed in the psyche of markets when a mortgage crisis in the US based on poor lending can turn into a deadly version of liquidity musical chairs – to adapt the now infamous quote of ‘former’ Citigroup chief, Chuck Prince: “As long as the music is playing, you’ve got to get up and dance.” Today, the frequency of the musical ‘outs’ is weekly and increasing numbers of the world’s market players are left without a chair. Banks stuffed with impossible to price over-the-counter sub-prime mortgage debt, no buyers, and a balance sheet short on real assets are left stranded as the market dumps or shorts the stock and ratings downgrades finish the job. We’ve reached a new nadir, however, when markets can drive down the share price of HBOS, one of the UK’s biggest retail banks (i.e. supposedly asset rich), within 24 hours to half its value, pushing it into emergency merger discussions. Questions are again being asked about whether short-sellers really provide market liquidity or spook the market en masse? In addition, few know what the further economic fallout will be if more insurance companies, exposed to sub-primeand credit insurance underwriting contracts in their various forms, pace AIG, go bust. The speed of this financial game of death is breathtaking and unpredictable. Some commentators claim we are witnessing a so-called ‘black swan’ once-in-a-lifetime crisis. That is clutching at metaphor. What do you call a group of black swans – a ‘dark pool’ or a ‘depression’ perhaps? In the last 15 years we’ve had a series of market ‘black swan’ calamities: LTCM, Russian debt, Enron and the dot.com bubble. The credit crunch is merely the latest, most dangerous and least controllable. The danger of metaphors – including those of Buffet and Keynes, of course – is that they offer little nuance. The real question is how did we arrive here and what can be done to prevent it happening again? Indeed, we don’t yet have a clue where or when it will end. One thing is sure, this is no ordinary financial blow-up; not when so much taxpayer money in the US, UK and Europe is shoring up bank balance sheets and taking significant risk on the respective collateral. Optimists point to the relatively benign conditions in the ‘real’ economy at present. But high oil prices and deflating property markets have presaged almost every recession this century. That’s before we debate ‘moral hazard’ or the economic equity of bailing out banks rather other industry sectors: topics that can win and lose elections. It’s not exaggerating to say that banks have become too big, too complex and too risky for our well-being if central banks and regulators have to tailor policy to prop them up to stave off economic collapse. Policy makers are likely to step in quickly to try and re-establish themselves at the wheel; expect updated versions of the Glass-Steagall Act in order to shore up consumer confidence in markets.
Donald MacDonald, chairman of the United Nations Principles for Responsible Investment (UNPRI), recently alluded to the potential remedy when he said that increasing support for the PRI showed investors had taken a long hard look at the credit crunch, and some of the practices that caused it, and decided they could benefit from more comprehensive analysis of investment risk incorporating environmental, social and governance issues into decision-making and ownership practices. I agree, but would caution against oversimplifying an ESG solution. What is required is a fundamental rethink from institutional investors about what investment practices they support, if they are to be, as I, and many others believe they should, long-term, patient capital stewards with the health of the wider economy embedded in their DNA. Foresight needs to be as important as hindsight.That means, amongst other things, challenging the culture of executives and bankers making short-termgains at shareholder expense. A starting place would be to read and question the recent International Institute of Finance Report, put together by the world’s biggest investment banks in response to the credit-crunch, which agreed that compensation should be aligned with shareholder interests and “long-term” profitability.
It also means having a stronger voice in current debates such as that between the Committee of European Securities Regulators and the European Commission about proposed changes to improve the investment ratings industry, which was found sorely compromised over sub-prime. Furthermore, it means differentiating between good and bad investments; between useful exchange traded interest rate derivatives and highly risky over the counter products, or perhaps even between economically viable private equity and hedge fund investments? That, after all, is what being long-term, responsible investors is about.