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False hopes

Finance | William Jensen | 23 Jan 2009

William Jensen says we have lived through a period of abnormally high returns.

It is difficult not to feel profound disappointment with the leaders of those financial institutions which underpin our economies and global commerce. At the top of that roll-call of let-down are the bankers who built a celestial city from a little bit of real things and a great deal of nothing that continues to crumble and suck the rest of the world into its vortex. Even the most generous of spirits will struggle to excuse the majority in that industry of the charge of cynical self-interest.

Second in line come the credit rating agen-cies, a good many investment advisers and droves of investment managers, especially alternative managers, all of whom became so enchanted with financial engineering and risk modelling that their grasp of financial reality deserted them. This again is a gener-ous reading that allows for a high degree of delusion and does not seek to cite naked self-interest as the primary cause of our collective undoing. Whatever excuses you may invoke, credit rating, multi asset class diversification and non-directional investment strategies have each failed to protect investors. 

Regulators, too, have let the side down and revealed themselves to be largely oblivious to the specific and systemic risks we believed they were paid to detect and miti-gate. One argument has it that they were not paid enough to attract the brightest people to rival the ingenuity of the investment banks, the OTC derivatives markets, the structured products that turned sows' ears into silk purses and the host of other inventions of clever minds that have contributed to our current misery. If that is indeed an argument that regulators or politicians would wish to field in defence of regulation, then it surely begs the question of how costly it needs to be to work or, alternatively, why bother if we cannot afford it.

Finally we have our central bankers and our politicians who often seem to have been sleep-walking into catastrophe. For too long, it seems that these national leaders failed to recognise the connection between the interlinked global financial industry with all its components and the rest of the economy that depends on a fully-functioning banking and credit system. It takes a power cut to make one realise how dependent we have become on electricity, yet a cursory look at how we cook, heat, communicate and travel would make the connection obvious. Do treasuries and ministries of trade really not understand the flow of commerce and its dependence on such elementary facilities as trade credit? It has taken a financial black-out to lay bare the underlying relationships, but the damage is already done for many businesses.

Confidence has taken a bad hit for all these reasons and now we are in the grip of some-thing between a recession and a depression. Each agent in the roll-call of disappointment is learning on the job and our best hope is that they succeed in halting the decline at the point of recession and avoid descent into the abyss of depression.

There has been a destruction of ‘paper money' on a massive scale. I describe it as that rather than ‘wealth' because I believe much of it didn't exist in the first instance. Leverage - copious credit at low cost - was used extensively to amplify returns from businesses and assets that were only capable of generating pedestrian returns by comparison with those that leverage could achieve. The mistake, I believe, was that the evidence over the long run of financial history is that the so-called pedestrian returns are what the real economy can deliver, and the recent era of supranormal returns was a fool's paradise, detached from history. To illustrate, first take the long-term historic real return on equities calculated by Barclays and  published annually in the Equity Gilt Study. In the UK in 2008, the annualised real rate of return on equities (with gross dividends reinvested) from 1925 to 2007 was 6.1 per cent; the equivalent statistic for US equities was 7.1 per cent.

I don't intend you to draw any more from this than that we have lived through a period of abnormal investment expectations.

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Who's Who: William Jensen