INVESTMENT

Modern Forms of Capitalism, Part 2: Financial Capitalism


The developed economy began to cool about 50 years ago. Official information says it clearly. Over the past two decades, most economies in North America and Europe have stagnated.

Actual inflation-adjusted GDP compound annual growth rate (CAGR) in the United States From an average of 4.2% and 4.5% in the 1950s and 1960s, it has been approximately 3.2% throughout 1970, 1980 and 1990, respectively, before falling to 1.8% from 2000 to 2020. On the basis of GDP, the picture is even worse: the average CAGR pigeon ranged from 3.2% in the 1960s to 1% from 2000 to 2020.

Eight years ago, former U.S. Treasury Secretary Larry Summers described the perceived growth in the years leading up to the Global Financial Crisis (GFC) as an illusion and dusted off a phrase first coined during the Great Depression, saying the country had probably entered a period. “Secular stagnation.”

Several factors can contribute to this misery: an older population saves more and spends less; In the face of growing inequality, the rich also save their wealth instead of investing it productively; And automation puts pressure on wages, making usage even more frustrating.

But the reasons for this lazy growth are not of concern to us here. Importantly, partly in response to this recession, capitalism had to evolve.

Variant 3: Financial capitalism – an uncontrolled model

Although there is no perfect moment to mark the beginning of financing, August 15, 1971 works for a better book when global finance moves from centralized to an Uber-intermediate model.

That day, President Richard Nixon announced that the United States would free the dollar from gold, thus weakening the Bretton Woods system. The move encouraged innovation. Synthetic derivatives were created: the Chicago Mercantile Exchange introduced futures contracts written in financial instruments the following year, and the Chicago Board of Trade introduced the first interest rate futures contract three years later. Arbitrage, options trading and various other activities have grown rapidly.

As of 2011, the market value of over-the-counter (OTC) and exchange-traded derivatives was about $ 800 trillion. A decade later, it’s probably much bigger.

In addition to the conventional, if named externally, alternatives, swaps, forwards and futures, slow growth helps to start the securitization boom.

Mortgage-backed securities (MBS) were introduced in 1970 by Guinea May, a U.S. government-backed mortgage guarantor. Soon after, investment bank Salomon Brothers created the first privately issued MBS. Securitization then entered the corporate bond market in the form of parallel debt obligations (CDOs), created by specialist firm Drexel Burnham Lambert in the 1980s.

Financial Analyst Journal Current Issue Tile

Mass credit creation

A market for corporate bonds emerged in the late 19th and early 20th centuries and collapsed for decades as a side show of the main event: the equity market. That changed in the 1980s. High-yielding bonds became all the rage during the junk bond era as debt took center stage.

The securitization of commodified loan products has benefited consumers, corporations and the government. Once everyone had easy access and could trade credit with little things, if there were any obstacles, debt consolidation became a normal part of life.

Thanks to debt, corporations can manage stagnant U.S. economies, introduce new growth strategies and push products to customers who can’t always afford them.

With the widespread commercialization of debt, debt has outperformed equity as a major source of capital savings. Debt became a new product. Soon, it began to adopt the product that dominated the world economy for almost a century: oil. Between the two global supply pressures of the 1970s, petroleum lost its luster.

The new custodian of people’s money

As world markets are no longer governed by Bretton Woods policy, governments have not been able to coordinate strong leadership in the global economy. Many have launched ambitious economic democratization programs. Markets were expected to be self-regulating.

Since reganomics in the 1980s, licensing-fairism has become a common economic principle. Subsequent U.S. administrations have more or less acknowledged their inability to manage the increasingly complex, global and debt-ridden economy. Uncontrolled printing of money after GFC and during the COVID-19 epidemic has further strengthened that belief.

Other western markets have adopted deregulation as the default mechanism, which has helped boost growth. Although shareholder capitalism copes well with changes in the model – partly due to intense, debt-financed M&A activity compensating for economic stagnation – financial markets eventually take over.

The main operators of financial capital are banks, insurers, hedge funds, private capital firms, bond investors, traders and retirement plan managers, among many others. These administrators of other people’s money, not capitalists or corporate executives, are the most influential economic actors.

They provide orders for managing, lending, and investing in a relaxed set of contractual and regulatory guidelines. They amass wealth on the basis of ownership and generate income from transactions, enriching countless fees from interactions with borrowers, consumers, investors and depositors.

Under this model, the classical, industrial capitalism was not as functional as wealth-based transactions. Increasingly, the value of such transactions is increasing through the use of credit.

Financial market history book jacket: a reflection of the past for investors

Debt as a source of wealth

In the 1930’s, when John Maynard Keynes’s ideas were gaining traction, excess savings were seen as a risk that could lead to a lack of demand, low investment and unemployment.

A natural tendency to save does not only affect consumers. In his book MoneyAs John Kenneth Galbraith observes, in the past, “wise governments have always tried to balance their budgets. Failure to do so has always been evidence of political incompetence. “

In the post-World War II era, when consumer credit became widespread, it expanded people’s personal spending, financing the “way of life” in the words of consumer society – nowadays, we would say “lifestyle.” Financial intermediaries sell credit solutions and stop that lifestyle.

Citizens are not expected to just eat. Depositors must become investors, sometimes trading in margins. The more – and more often – they consume and do business, the better Costs are a bigger source of fees for investment intermediaries than cash deposits. Du Zour says: Cash trash.

For business, depositing cash is not commendable. In a system largely immersed in debt, the initial cost is not a trigger profit or cash deposit reinvestment. Many corporations, especially those that are private equity-backed, often report losses credited to their accounts.

Age of leverage

Thanks to financial engineering, debt has jumped into the stock issue and retained earnings as the main process of resource mobilization. Another trend underscores this fact: Debt-fueled stock buybacks.

Public investors – activist hedge funds, in particular – put significant pressure on corporate executives to repurchase their balance sheets or pay special dividends. The old argument for buyback was that holding cash is unproductive. If management has nothing to spend on it, why not return it to stockholders who find ways to make the best use of it?

Replacing debt for equity is a classic strategy in PE firm’s toolkit, but publicly listed corporations have made it a common practice. It even includes cash-rich companies. Earlier this year, Apple Bank raised $ 14 billion in bonds despite having $ 200 billion in cash equivalent reserves. Most of that liquidity was abroad; Apple did not like to pay tax on remittances. In modern capitalism, unnecessary cash leaks, such as paying taxes, should be avoided.

Traditionally, the main function of issuing bonds has been to fund capital expenditures. But this relationship does not last. Corporate debt is used as a tool to repay shareholders, not to fund growth. Assets are deposited outside, not within corporate remittances.


Creation of value in private equity

A chart illustrating how value is created in private equity

The financial model of value creation

The world economy has undergone an innovative process since the 1970s.

  1. Financial markets are irrigated by two springs: credit and fees.
  2. Significant corporate assets are accumulated externally, through financial engineering, as the figure above shows, although a portion is also collected from operational improvements.
  3. The capital accumulated from the company is leaked through fees, dividend distribution, and income from the settlement.
  4. Many firms collect fees from assets under management (AUM) and also earn revenue by redistributing or redistributing assets.
  5. A significant proportion of market participants, including PE firms, short-term investors manage other people’s money. They need a much more dynamic model to raise capital.
  6. Narrow ownership deadlines redirect business strategy and operational management to a more reasonable approach to price increases. For that reason, this system is often called runaway capitalism or capitalism over steroids.
  7. The risk of default remains within the corporate remittance in the form of accumulated losses. These losses are not estimated by financial intermediaries.

This business model is a direct, if distorted, descendant of shareholder capitalism. Value is generated from transaction-based activity and routine operational improvement. Although the benefits are not initially credited to the shareholders. The process unreasonably enriches intermediaries who impose agency fees.

Tiles for the future of work in investment management: 2021 report

Overall, the accumulation of wealth in financial capitalism is characterized by three elements:

  • Uncontrolled liquidity, propagated by deregulation.
  • Universal Credit: Debt is cheaper than equity – thus, it expands all economic activity.
  • Frequent transactions optimize profitability by generating recurring capital gains and fixed fees.

Financial markets are driven by credit hogs whose success depends on a transaction method that supports rapid – even temporary – value creation. Yet the idea of ​​maximizing long-term shareholder returns has not completely disappeared. We will see in Part 3 that it survives in digital capitalism.

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All post author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed do not reflect the views of the CFA Institute or the author’s employer.

Image Credit: টি Getty Images / Tetra Images


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Tags: corporate bonds, derivatives, equities, financial engineering, financial history, fixed income, investment industry, investment products and asset classes, modern forms of capitalism, private equity, stocks

Sebastian Canderle

Sebastian Candarle is a private equity and venture capital advisor. He has worked as an investment executive for multiple fund managers. He is the author of several books Debt trap And The good, the bad and the ugly of private equity. Cinderley also lectured on alternative investments in business schools. He is a Fellow of the Institute of Chartered Accountants of England and Wales and holds an MBA from The Wharton School.



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