HUMMONEY - Golden Eggs and Such (Perspective)

- by Greg Lewin

I want to begin with some wisdom extracted from a recent essay written by Jeremy Grantham.

“In 1965, 3% of the US GDP that was made up of financial services was clearly sufficient to the task, the proof being that the decade was a strong candidate for the greatest economic decade of the 20^th century. We should be suspicious, therefore, of the benefits derived from the extra 4.5% of the pie that went to pay for financial services by 2007, as the financial services share of GDP expanded to a remarkable 7.5%.  This, in turn, should eventually reduce the growth rate of the non-financial sector, which it indeed did: from 3.5% a year before 1965, this growth rate slowed to 2.4% between 1980 and 2007, even before the crisis.”

Simply stated as the financial industry grew the rest of the economy shrunk. If you follow the growth of leverage throughout this period you realize financial innovation is simply an attractive moniker for piling on the debt. In my opinion, the age of financial innovation simply correlated with the age of financial compensation. I believe this is why the financial regulation bill recently passed in Washington is so misguided: over 2000 pages of policy when the only subject of any consequence is that of the permissible use of financial leverage by all financial institutions. Financial leverage compounds the magnitude of every risk taken and importantly compounds the potential reward. 

Unfortunately, the risk/reward equation does not grow proportionally, because along with leverage comes additional costs and limited timeframes. When you borrow you must repay on a given schedule.  But the greed gene always seems to dominate and although the prior equation suggests that leverage should be employed only in financial assets exposed to less risk, the financial industry seems to be willing to apportion leverage across all asset classes in the hope that diversification will lend some measure of protection on the path to increasing compensation.  While that has not turned out so well, regulation of financial leverage is still largely absent from financial re-regulation. 

This may be a consequence of the old relationship between those who have money, in this case Wall Street, and those who need money, politicians, and no one wants to mess with that incredible goose.

Until financial leverage is carefully regulated, financial risk will always supersede business risk. And it is business risk where jobs are created as opposed to financial risk where compensation is created. 

---The views expressed here are of the author, HUMMoney contributor Greg Lewin; currently a General Partner at TLF Capital, an investment management firm. During the past 26 years he has been a senior money manager or partner in Wall Street firms including Neuberger Berman, Charter Oak Partners and Sailfish Capital.