We have spent the last 30 years preoccupied by financial things. Finance was once the handmaiden of productive enterprise. That is, Wall Street served productive enterprise, raising and allocating capital for worthy endeavors. Finance existed for helping railroads, utilities, builders and manufacturers to issue stocks and bonds. Further, finance helped maintain orderly exchanges where stocks and bonds could be traded.
Building a successful business is difficult. Once an entrepreneur raises capital, he must deploy it properly. He must hire employees, build factories, develop products, plan marketing strategies, manage production, packaging and shipping, and a myriad of other activities.
A recent concept, financialization is defined as:
…a term sometimes used in discussions of financial capitalism which developed over several decades leading up to the 2007-2010 financial crisis, and in which financial leverage tended to override capital (equity) and financial markets tended to dominate over the traditional industrial economy.
[It] describes an economic system or process that attempts to reduce all value that is exchanged (whether tangible, intangible, future or present promises, etc.) either into a financial instrument or a derivative of a financial instrument. Source Wikipedia.
Financializing the economy promised a short cut to making money. We are now paying for that false promise.
Living through Financial Engineering
I started my corporate career in 1977. I worked for a telecommunications and manufacturing conglomerate that served 27 million telephone customers, employed 250,000 people worldwide, manufactured products ranging from the humble incandescent light bulb to sophisticated microchips. Leaders in the company were operating executives. Executive compensation was moderate.
In the 1980’s and 1990’s the winds of financializing change swept through corporate America. The underlying producing businesses were viewed as stodgy and unimaginative. Paper mills, lighting plants, railroads and telecommunication companies were boring “cash cows.” “White shoe” business schools preached financial innovation, or to give it a more professional sounding name, financial engineering. The CFO function dominated. Executive compensation increased exponentially.
The number of engineering opportunities was boundless:
- Terminate pension plans and pocket the surplus assets
- Create leveraged employee stock ownership plans to make 401k contributions
- Take out gigantic company owned life insurance plans on large swaths of the workforce
- Issue huge amounts of debt and buy back the company’s equity
- Create voluntary employee benefit trusts to pre-fund retiree health benefits for unionized employees.
- Create leasing and realty divisions within the company for both internal and external needs
- Take the firm private through a management organized leveraged buyout
These are but a few of the financial techniques employed to inflate company earnings or turn a quick profit. Most of these strategies involved taking on large amounts of debt and exploiting loop holes in the tax code. None of this enhanced the productive capabilities of the underlying business. The “cow” was slowly starving and the bricks and mortar of the enterprise were crumbling.
Enron and WorldCom
The beginning of the new millennium saw two major American corporations, Enron and WorldCom, disintegrate. Accounting fraud was at the heart of these collapses. Enron created off shore entities to hide losses and posted yet unrealized revenue as profit. WorldCom underreported line costs by capitalizing items which should have been expenses. They also inflated revenues through bogus accounting. Not only did these entities hurt their shareholders, but also their competitors who had to compete again these fraudulent entities for scarce capital.
Sarbanes-Oxley was passed in 2004 to stop these accounting maneuvers and restore integrity. The subsequent collapse of Bear Stearns and Lehman tells us that Sarbanes-Oxley failed, and that financial transparency still does not exist.
The Evils of Financialization
Financialization of the economy has become an evil unto itself. Culprits in the 2008 financial crisis: sub-prime lending, mortgage-backed securities, collateralized debt obligations, off balance sheet structured investment vehicles, hedge funds, private equity, excessive leverage are all the progeny of the 1980’s schemes and strategies to enhance corporate financial performance.
I have two observations. First, many of these maneuvers are nothing more than alchemy applied to finance. Old saws such as “there is no free lunch” and “you can’t get something for nothing” remain true. Slapping a Nobel Prize or a prestigious business school imprimatur on a strategy does not change these universal truths.
Second, an early rule of investing I learned is: when one sector becomes more than 30% of the value of the S&P 500 index, sell that sector. This was true in the 1980’s when the oil sector passed that benchmark and in 2008 when the financial sector did the same. Too much of society’s resources and human capital are now tied up in one area of the economy. At least in the case of oil there was a real societal good.
The financial industry in 2008 and now has become a financial casino without the glitz or charm of the Mirage. In fact, it has become a mirage and that says a lot.
loading...
Related posts:
- The People v. Wall Street
- The Economy at Street Level
- The Barbell Economy
- Is the US Economy an Impaired Asset? Part II
- The Organic Economy
Tags: Bear Stearns, Enron, financial engineering, financialization, Lehman, WorldCom
