The Forty Percent Problem

In 2007, approximately 40% of the earnings of the S&P 500 were attributable to the financial services sector. It is difficult at this point to estimate with any assurance the extent to which those financial services sector earnings were inflated by fraud, aggressive accounting practices, overleverage and a cyclical spike in levels of transactional activity, but all of those factors contributed. And it's difficult to say the extent to which appropriate regulatory reform and consumer protections initiatives will undermine the core earnings power of the predatory franchises on which so much hope for sector recovery in pinned.



If you remove that 40% of the earnings from the price earnings ratio of the S&P 500, and you look at the 40% decline in the price level of the S&P 500 since 2007, one nicely offsets the other. That is food for thought.



There are other factors at work, of course. Earnings in 2007 outside the financial services sector were at a cylical high, and can be expected to deteriorate sharply in a recession (just as recovery from recession-depressed levels to some idealized norm can be expected). No one really knows what the price/earnings ratio of a stock, much less of a market index 'should' be--though much ink has been spilled on the subject.



It's sufficient to say that the market has discounted the collapse of the financial services sector, though the sequence of events through which that occurs has yet to unfold. And the ramifications of that haven't yet been fully felt--nor, perhaps, fully discounted by Mr. Market.



My own guess is that unemployment will continue to rise, the magnitude of commercial real estate problems will be revealed with ghastly consequences for any number of traditional bank lenders, house prices will, in the aggregate, continue to decline until residential real estate has roughly half the value prevailing at the peak in 2006 or so, credit card delinquencies will rise, and so on. And an already crippled financial services sector will founder. Someone along the way, it will lose its place at the table.



It will be interesting to see what the new world looks like. I suspect that the transition issues and difficult adjustments of the formerly middle class, the elderly, upside down homeowners, the structurally unemployed, etc., will dominate the discussion, and strategies for restoring the global edge of the American financial services sector, if any, will have a distinctly archaic ring. My gut feeling is that the developed world is in for a prolonged period of painful adjustment, and deteriorating public sentiment will be fueled by reports of relatively progress in those parts of the developing world that have sufficiently large domestic demand that their economic growth in not dependent on the American consumer. I'm not predicting blood in the streets, or even bread riots. Just an opaque and heavy economically glum environment that sours the social mood, and contrasts with the innocent happiness of the furriner on holiday, using the cheap dollar to rub it in.

Not Quite Ready for Prime Time

Let's get real. There seems to be a great deal of dissatisfaction with and disappointment in the Obama Administration's approach to the reforming the financial services sector and and outlawing the current (admittedly toxic) executive compensation practices. I think the disappointed are confusing cognitive recognition of a problem and identification of potential solutions with the actual process of change.

So why isn't meaningful reform in the cards for the next year or two?

Team Obama did not exactly enter the 2008 presidential race focused on the economy or the financial services sector in particular. As I recall, the global hot button was the Middle East (a/k/a Islamic terrorism, the wars in Iraq and Afghanistan) and the domestic hot button was reforming the health care delivery arrangements. Not much bandwidth was devoted, until around Labor Day, to the general economy, much less Wall Street (except when it came to fundraising).

So, if the first reason expectations should be low at this point in time is simply that financial reform wasn't on the agenda, the second has to do with that second little fact--the fund raising business. The financial services sector has bought and paid for the government and its regulators for at least a generation. It is easy to get angry about this, but it is also pointless to do so. Big campaign contributions and the machinery of retained lobbyists buy access and mindspace, and influence policy and regulation. But there is a limit to their impact. The Marc Rich pardon notwithstanding, it is very difficult to actually buy an outcome. When the result is controversial and the groups opposing it have made their campaign contributions and hired their own lobbyists, the impact of it all is, if not neutralized, at least offset (and can lead to truly bizarre outcomes and terrible policies with unbelievable real world outcomes--viz., the attempted privatization of military services by the like of Blackwater).

Right now, sitting here today, the financial services sector retains its seat at the table and is still regarded as a participant in the process, a patient whose informed consent is required for the procedure. Soon, enough, unless there are magic reversals in the unemployment rate and the direction of commercial and residential real estate prices, the financial services sector will come to be regarded as a corpse to be harvested for useful organs and dissected for the enlightenment of future generations of medical students. Not yet.

Then there is the issue of executive compensation. Given the extent to which Summers, Emmanuel and Geithner's wife have all suckled at the Wall Street teat over the last decade, I think it is impossible for those guys to approach the issue without trepidation. What made Larry Summers worth over five million dollars to Wall Street or Rahm Emmanuel worth over fifteen million? Politicians are not notoriously introspective, but it would be hard not to question yourself under the circumstances, and that is disregarding entirely the public embarassment and political advantage to one's adversaries of the situation, and without even reaching the ethical implications of either betraying a constituency you have allowed to buy you or failing to act in the public interest while in public service.

There are three reasons not to have high expectations. They are all grounded in the realpolitik of expediency. In the short term they are insurmountable. In the intermediate to longer term, they fall away, depending on the course of future developments. But for the time being, expect experimenting with the cosmetics and some serious rearranging of the deck chairs. And don't get mad or excited about it. Just wait patiently.