Investment Industry needs independent players!

The most recent print issue of Money noted that the big Canadian banks managed to earn $31.7 billion in 2012, just a few years after there was grave concern that they’d even remain solvent.

“There is no question that Canadian banks play a vital role; locally, provincially, nationally and inter-nationally. Without the banks, our economy could simply not function efficiently or effectively. But are the banks getting too big and going too far to gain market share and profits at the expense of their own customers?” (Quote from Spring 2013 issue of Money Magazine.)

In November of last year I published a piece entitled Banks own the investment industry! A good thing? In many respects allowing the banks to provide everything from our mortgage to investment services is incredibly convenient. But at what price? It has become near impossible for many smaller investment dealers to stay in business. Fraser Mackenzie is a recent victim of an industry that requires scale in order to compete:

At their shareholder meeting on April 29th, 2013 it was decided: “Our assessment of the current business climate has led the owners to conclude that deploying our capital in the continuance of our regulated investment dealer businesses can no longer generate an acceptable rate of return. Institutional interest in early stage mining and oil & gas companies, sectors to which we have been heavily committed, has dried up: as has the associated trading in the equities of early stage resource companies. Furthermore, the regulatory cost burden is increasing at a time that industry-wide revenues are declining. On balance, it makes sense for our shareholders to re-deploy their capital.”

Indeed, well over half of the total value of trading done on the TSX in a typical month is conducted by the banks.

My guess is their actual market share of all trading is far above half if we were to also include trading platforms not part of the Toronto Stock Exchange. The banks keep growing, and the regulatory burden also grows more onerous. In my estimation, the larger financial companies relish regulation as an additional barrier to entry. Regulatory oversight is a minor inconvenience to the big banks, whereas for less diversified specialty businesses (mutual fund companies, standalone investment dealers, investment managers) the added expense can be devastating.

Obviously there are huge benefits to scale – but do consumers really benefit or are these economies of scale all kept as bank profits? MER’s for their proprietary mutual funds might appear very reasonable, but it’s impossible to determine whether or not the plethora of fees I pay for other services are subsidizing these seemingly lower expense ratios. Transparency is near impossible. Although many banks did collapse as a result of the the financial crisis, the massive rebound in the profitability of those surviving banks (even though they lost ridiculous amounts of capital doing stupid things with asset backed securities, derivatives trading etc.) suggests that those everyday fees paid by consumers and businesses must exceed the marginal cost of providing these services by quantum leaps and bounds.

Another concern I have – besides the demise of competition in the financial services industry – has to do with motivation. It’s true that every business is designed to make money, but in days of yore a mutual fund company, investment manager or stock broker had to have happy customers in order to succeed. If they didn’t help the client make money, the client would go somewhere else. I believe that as each independent firm disappears, so does choice. Making a great deal of money from you no longer requires you to be served well. What are you going do? Go to another bank?

The prime directive (to borrow an expression from Star Trek) of the financial services behemoths is profits. The financial advisor’s role is to enhance corporate profitability. Financial advisors today are increasingly handcuffed not just by regulatory compliance, but also ‘corporate’ compliance. Wouldn’t an investment specialist whose only mandate is to do well for his client be more properly motivated (and less conflicted professionally)? Would your investment objectives be better served by an independent advisor who is rewarded only because you the client are earning profits (and not because you are earning his employer more revenues)?

It isn’t necessarily true that an independent advisor is any better than one employed at a bank. I personally know of hundreds of outstanding advisors working at banks and insurance companies. But it must also be true that a satisfied, properly motivated, objective and focussed financial professional will do a better job whether he/she is at an independent or a bank.

We can’t begrudge the banks their success but left to their own devices, they’d all have merged into one by now. In December of 1998 then Canadian Finance Minister Paul Martin rejected the proposed mergers of the Royal Bank with the Bank of Montreal and CIBC with the Toronto-Dominion Bank. We know from our U.S. history that government and regulatory authorities are frequently frustrated by the political muscle (lobbyists, lawyers) of the large financial firms. Ultimately having one gigantic Canadian bank – providing all our financial services, investment needs, insurance requirements – might (or might not) be a worthy corporate ambition, but it’s hard to imagine such a monopoly being good for the likes of us. After all, just consider the progress that has been made in telecommunications since Bell Canada (or AT&T) was forced to reckon with serious competition.

The banks need independent players. Not only should banks discourage the obliteration (by bullying or by absorption) of non-bank competition, they should use their political muscle to keep the regulators from picking on Independent players. Government agencies cannot help themselves – if they are impotent against the strong they naturally attack the weak – even though when all the weak are dead the regulators would have no jobs. You don’t need a police force when there’s nobody you can effectively police.

Independent players create minimum standards of service and ethics, and fuel industry innovation. In every instance, the independent is a bank customer too. Mutual fund and investment managers pay fees to banks, buy investment banking offerings, custodial services and commercial paper and also trade through bank facilities. Independent dealers provide services and financing to corporations deemed too small to matter by larger financial companies; that is, until these businesses grow into large profitable banking customers. Put another way, why not adopt the Costco model where smaller independents can shop for stuff to sell to their own customers, and higher end specialty shops and department stores can all remain standing, rather than the take-no-prisoners approach of Walmart?

Let’s hope that the few surviving independent firms can be allowed to thrive, and if we’re lucky perhaps new players will arise to provide unique services to Canadian clients and homes for advisors who are inclined to specialize in managing and not just gathering assets.

Mal Spooner

 

 

 

 

 

Is it the 1950’s again? The financial war is over!

There is a plethora of articles and blogs out there desperately trying to find a period comparable to now, in order to get some understanding of what markets might have in store for us over the next several years.  After three decades in the investment business, the only thing I can say with certainty is that such comparisons just don’t work.

George Santayana (December 16, 1863 – September 26, 1952) the philosopher and man of letters, is often quoted: “Those who cannot learn from history are doomed to repeat it.

It’s true people will make the same mistakes over and again, but history never actually repeats itself.  Trying to forecast the future is absurd, and so it must be even more ridiculous to expect that the future will be similar to some time period long ago.  Nevertheless, it’s winter and all my friends are on vacation so I’ve nothing else to do.

Post-War Reconstruction: In my simple mind, we’ve just fought a global war against financial corruption.  The weapon of mass destruction?  The ‘derivative!’ These things managed to infiltrate the entire global banking system and almost brought it crumbling down.  Like most wars, it’s difficult to put a pin into when things flipped from a crisis to all out war, but let’s say the seeds were planted when the U.S. Senate tried to introduce a bill in 2005 to forbid Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) from holding mortgage-backed securities (pretend capital) in their portfolios. That first cannonball missed the mark when the bill failed to pass.  By 2007 the two government sponsored entities were responsible for 90% of all U.S. mortgages, and the fly in the ointment was the use of ‘derviatives’ instead of real capital to hedge their interest-rate risk.   Banks did the same thing but much more aggressively. What followed is a long story we’ve been living for years.

Paul Volcker once said, “I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth — one shred of evidence.”  Well, we’ve plenty of evidence now that financial innovation led only to the mass destruction of wealth.

When the foundation fell out from under us (value of the derviatives dropped) we went to war in earnest.  The list of casualties like Lehman Brothers Holdings Inc. (announced September 15, 2008 it was bankrupt) just kept getting longer.

I believe the war ended six years after that failed 2005 Senate bill – in the summer of 2011. You can disagree, but your opinion is as meaningless as this whole exercize. (Laughing out loud.)

Way back when World War II (1939 – 1945) ended, governments around the globe began to print money and spend to rebuild the wealth that had been destroyed.  Isn’t this precisely what we’ve been doing since our financial crisis decimated wealth on a global scale?

So maybe some of what happened in the 1950’s post-war period will happen again?

In 1949 there was a brief struggle with the threat of deflation (and again in 1954) but for most of the decade inflation remained steady between 0% to 3%. We too saw the threat of deflation briefly in 2009.  However since then inflation has been fairly steady:  1.5% (December to December) in 2010 and 3.2% in 2011 in the U.S.  Although T-bills are currently paying a negative real rate of return (yields are below the inflation rate) there will come a time soon when investors insist on earning something or they just won’t hold them.  Short term rates will climb as they did throughout the 1950’s.

Prediction #1:  T-Bills will begin to rise until their returns cover the rate of inflation (see chart).

What happened in the stock market back then?  Government spending to rebuild infrastructure and create jobs had a significant impact, because arguably the 1950’s was one of the best if not the best decade for making money in the stock market.  Unfortunately, we only have reliable data for the Dow Jones Industrial Average dating back that far (okay, there might be more data out there but I’m surely not going to go looking for it). 

At the end of 1949 the Dow was at 200.13 and by the end of 1959 it had climbed to 679.36.  Excluding dividends that equates to a (IRR) return of about 13% per year for a decade.  As always lots of volatility had to be endured in stocks, but in the long run the reward was not shabby!  On the other hand, in Treasury bonds you might have averaged a 2% return, but suffered an actual loss in 5 out of the 10 years.

Prediction #2: Global growth fueled by government initiatives will translate into healthy returns on average in stock markets for several years to come.

Are we doomed to repeat history?  Although the 1950’s turned out okay, a wild ride was to come during the following couple of decades.  Easy money and inflation would eventually get the better of us and although there were some very good years for investors in the stock market (and those invested in shorter term T-bills for sure), inflation mayhem was on its way.

All we can hope for is that today’s policy makers have studied their history.  If we allow inflation to get out of control, interest rates will skyrocket like they did through the 60’s and 70’s. Younger folks today will have to suffer rising interest rates (mortgages, car loans) of the sort that created havoc for decision-makers and choked economic growth to a standstill for us older generations back in the day.

It’s true that if we don’t learn from history, we can and will make the same mistakes over again.  But I also said history does not repeat itself.  Although we somehow managed to eventually wrestle the inflation bogieman under control before, this does not mean we will be so lucky next time around.  And it’s a wealthier more technologically advanced world we live in now….which means we’ve so much more to lose if we really screw things up.

Prediction #3:  If governments don’t slow down their spending, bond investors will really get burned.

My instincts tell me that 2013 will be a happy New Year.  And bear in mind that if none, any or all of these predictions come true it will be an unadulterated fluke.

 

 

 

 

Malvin Spooner.