Government Debt vs. Tough Love
Introspection is forcing many managers and investors to privately reconsider the basic premises of their long-term investment strategies. With the popular US stock indexes at or near all time highs, why don’t they feel better? The relative investment performance of many high-quality value-focused managers is lackluster. The companies they own are doing well, and for the most part they are sitting on lots of cash earned overseas from faster growing markets than their own home market.
One of the sectors which is doing very well for many portfolios is financial services securities. In terms of market value, this sector is the second largest in the S&P 500. Furthermore, in most other markets, the financials are the largest high-quality names. Our own private financial services fund is having a good year, producing returns at least twice as large as a “normal” year would produce. And that may be a symptom of the deeper problem.
The “Two Drunks” Structure
When two people who have had too much to drink are marching down the street supporting each other, there is a symbiotic support system at work. In most countries, governments are thought to be the guarantors of at least the banks’ depositors, if not the majority of their creditors. In most societies, the largest owners of government debts (those that are not a government entity like social security) are the banks. The drunks are into one another’s pockets in a major way.
The Reason and the Costs Of Financial Dependence
We all know the historic reasons for these relationships. In the past, each side was feared to be in danger of failing. Under these circumstances heads, some of them innocent, would roll. There would be disruption of “normal” activities and many things would grind to a halt — that is, until replacements came into being with new leadership and fresh capital. Order would be restored with the absence of some wonderfully historic nameplates such as Bear Stearns, Lehman, Washington Mutual, Countrywide, and Merrill Lynch — as well as, at least initially, more assorted spending and investing. In a parallel example, think about some function or people who were let go and not replaced. In all likelihood they were not earning their cost of capital and in the past were a drag on all who were.
No Bailouts Plus “Tough Love”
In a somewhat simplistic view, the bottom line of corporate, bank, and government failures is that they run out of money. This was probably a result of the fact that they did not earn enough to pay their debts (including to their own people), and because their clients and citizens did not value their services highly enough to meet their obligations. As an independent investment advisor and private citizen, no one is holding a safety net beneath me if I don’t meet my obligations. I recognize that I am not likely to get some form of bailout. With the specter of tough love, I have to manage my affairs to pay off my legal and (more importantly for me) my familial and charitable obligations.
What Would the World Look Like Under Tough Love?
Governments would rely on their taxing authority to meet much more limited needs. Some of present expenditures would be taken over by the private sector; this would include the postal system, Medicare, Social Security, Patent Office, Library of Congress, mortgage companies, student and farm loans, many government facilities, and more. At the same time, the private marketplace would determine what would be the minimum level of capital required for a bank to be considered sound and safe. This probably would mean that banks would keep very little of their capital in medium to long-term bonds.
Do I Expect This To Actually Happen?
No, but I think there is some chance that we will haltingly move in this direction.
If There Is Any Chance, How Should This Be Played?
In a conceptual sense, we are already seeing replacements for traditional banks. You can’t tell this from midtown Manhattan or in many wealthy suburban communities, but the number of bank branches is dropping. The financial agents for college-age kids are credit cards, student loans, and the “Bank of Mom” or other relatives. In some respects Google, Alibaba, Amazon and undoubtedly others including financial services web-based brokers, large family offices, gatherers and distributors such as BlackRock, Blackstone, KKR, and T. Rowe Price (which is held by my private financial services fund) will play roles that banks have played in the past. Not all of these stocks will be successful, but some exposure in portfolios will be warranted.
Who is providing financial services for your children and how will this impact your plans in the future?
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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