FSO editorials

Risky Businesses?

Part 1

by Richard A. Eckert, CFA| August 26, 2009

There has been much handwringing over the risky behavior that landed the U.S. economy—and, indeed, the entire global economy—in the morass in which it currently finds itself. However, we feel that this is a misconception; risky business that, in fact, the genesis of today’s ongoing financial and economic crises lay not in excessive risk-taking, but in the absence of risk-taking. Or the efforts to avoid risk while still harboring the expectation of above-average returns. From that perspective, the current crises can be viewed as merely the mechanism by which the fundamental principles of microeconomics—not to mention the global capital markets—reassert themselves and restore some equilibrium to the relationship of risk and reward. There were way too many individuals, especially in the bloated financial services and real estate industries, enjoying outsized rewards while taking on little to no risk—or little to no perceived risk.

“Nothing ventured, nothing lost…

This appeared to be the mantra of American business over much of the last 30 years (see Exhibit I). Paradoxically, this represented a period characterized by deregulation, lower taxes, declining interest rates, the end of the Cold War, and, partially as a result, smaller government..

Exhibit I

Normally these trends would have been supportive of higher levels of business investment and lower return thresholds. But, as late as 1993, private fixed investment amounted to the same 12-13% of GDP it had since 1965. Declines in the role of government spending in the economy were absorbed entirely by the American consumer. From 1980 to 1993, government spending fell from 36% of real GDP to 33% while consumer spending rose from 64% to 67%. Businesses did not ramp up their spending significantly until the mid to late 1990s, which coincided with not only the Internet/technology boom, but also the necessity of preparing for Y2K. From 1993 to 2000, this component of GDP climbed from 12.6% to 17.6%, largely displacing government spending, which fell from 32.9% of the total to 27.6% over those seven years. Consumer spending also kept expanding as a percentage of total GDP, increasing from 66.9% to 67.8% over the same time frame.

But, withY2K behind it and the fallout from the bursting of the “tech bubble” in front of it, business spending as a fraction of GDP, peaked in 2000. In fact, business spending seemed to level off even in real dollars (see Exhibit II). Although spending in that sector increased by roughly 10% to $2.2 trillion in 2005, solely on the strength of residential construction, which was $195 billion, or 34%, higher in 2005 than in 2000, total fixed private investment fell back to $2.0 trillion in 2008 amidst the collapse in housing starts.

Exhibit II

So, notwithstanding the most propitious business environment in decades, American businesses stepped up neither their investments nor their contribution to real GDP. Indeed, if one factors out Y2K spending in the late 1990s and the increases in residential construction in the early 2000s, total fixed private investment has probably stayed at 12-13% of real GDP. We can buy the arguments that, in a service-oriented economy, businesses are not nearly as capital intensive and that the cost of capital goods has declined in both real and nominal terms. But given the sweeping and powerful incentives—which included an end to the progressive tax system and interest rates that hadn’t been seen since Eisenhower administration—the rate of business formation should have eclipsed the decline in the cost of capital goods and capital intensity and existing businesses should have been more aggressive in the use of leverage. After all, the hurdle rates on new projects had to have dropped precipitously.

However, despite the inducements alluded to above and the popular myths about American entrepreneurship and Yankee ingenuity and enterprise, more and more Americans are electing to become or remain employees (Exhibits III & IV)….

Exhibit III

Exhibit IV

…and most nonfinancial businesses appear to regard debt as they do the plague (and why wouldn’t they, when equity investors seem willing to buy a stake in them at prices that imply little or no expectation of return). See Exhibit V.

Exhibit V

…and everything to gain”

So what did the U.S. government and its citizens and taxpayers get in return for their investments (e.g., foregone tax receipts, the ultimate—current—costs of relaxed supervision, a larger share of the tax burden, lower savings rates, and higher debt service requirements)? What about advances in personal computers? The “information superhighway”? Telecom? They were not advances at all, but merely the commercialization of technologies that had been developed during the Cold War and space programs. We have microprocessors, for instance, because NASA could not load Frank Borman, Jim Lovell, and Bill Anders as well as an IBM mainframe into the same Apollo capsule and expect it to achieve the velocity required to break clear of the Earth’s gravitational field.

Ironically enough, in an era in which technology pervaded the U.S. public’s consciousness, influencing everything from the popular lexicon to investment decisions, enrollment of U.S. born citizens in science and engineering, particularly at the graduate level, declined precipitously from a peak of roughly 430,000 in 1993¹ through the end of the decade. Although those numbers purportedly turned around in 1999 with enrollment reaching an all-time high of 455,400 in 2002² , a Google™ inquiry of recent U.S. college and university publications found that many schools still bemoan the drop in enrollment in scientific and engineering disciplines. Some university officials openly ponder the ongoing viability of those programs at their schools. And, according to a source at a large contractor to the U.S. military, the Pentagon considers declining enrollments of native-born American citizens in science and engineering programs a strategic vulnerability.

So it appears that Americans aren’t even taking any risks in their personal lives and decision-making. The risks involved in entering a science and engineering program include, among others, the inability to master the complex concepts, the fear of failure, the stigma of dropping out or switching to a less rigorous discipline, and the difficulty in readily identifying job opportunities and career paths (even in academia, the resources allocated to these programs are being curtailed and the number of tenured positions, fellowships, and other scholarships trimmed). The latter is especially discouraging for those committing to an even longer portion of their young lives to obtaining a master’s or doctorate degree.

Or the answer to declining enrollments in scientific endeavor could lie on the reward side of the equation. Why spend many years at school applying oneself to the mastery of difficult subject matter when one could earn more money than a PhD in one’s discipline right away by selling real estate, brokering loans, underwriting or otherwise processing loans, appraising properties, brokering securities, raising capital, trading, finding merger partners, managing assets, etc? And, as an intermediary—with very little or none of one’s own principal at stake—the only risk is reputational. But, in a world awash in liquidity and high in asset turnover, there was always lots of capital looking for a home. No transaction, it seems, no matter how toxic, was capable of sullying the reputation of the person arranging it. And, frankly, it was a lot easier and a lot more fun—not to mention a lot more lucrative—for example, finding the “dumb money” willing to invest in one’s corporate finance client, a young company hoping to go public, than to design an aerospace component that no was more than 2.5 cubic feet in size, could run at a couple thousand RPM at temperatures up to 1,500 degrees and would average 10,000 flight hours between failures.

As illustrated in Exhibit VI, employment in the finance, insurance, and real estate sectors grew significantly faster than the private U.S. workforce as a whole from 1960 through 1987, ramping up as they did from 5.3% of the total to 7.5%. Although employment in those industries, as a percentage of total private sector employment in the U.S. declined slightly and leveled off at approximately 7.0%, a decomposition of these trends reveals that the apparent stagnation of employment growth in the finance, insurance and real estate sectors resided entirely in traditional credit intermediaries (e.g., banks, thrifts, credit unions) and the insurance industry.

Exhibit VI

Exhibit VII provides graphical detail on these trends. Traditional credit intermediaries accounted for roughly the same portion of the private U.S. workforce in 2007, 4.3%, as they did in 1997, 4.4% (1977 is the first year for which subsector detail is available). Employment in capital markets-related businesses (i.e., broker/dealers, investment managers), as a percentage of total private sector employment, doubled from 0.4% to 0.8% in that timeframe. Real estate sector employment, which had already risen from 1.2% in 1960 to 1.5% in 1977, kept climbing and represented 1.9% of all private industry workers by 2007. Concomitantly, employment in the “Information-communications-technology-producing industries actually fell, as a fraction of the total private workforce in the U.S., from 3.7% in 1987 (the first year for which this series is available) to 3.3% in 2007. We do observe that this percentage rose temporarily in the late 1990s—reaching 4.1% in 2000—most likely the result of hiring to apply Y2K fixes.

Exhibit VII

So it seems that the answer to the question posed at the outset of this section is “too many commercial bankers and too many investment bankers being paid too much money to bring too many bad loans and too many bad ideas to market!”

Resources:

¹ National Science Foundation, Data Brief, July 2008.

² Ibid

Contact Information

Richard A. Eckert, CFA (415) 674-4996 | San Francisco, CA | Email