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Model demolition

1 November 2011 By Edward Hadas

It may just be an unhappy coincidence. Still, there was a common theme to three pieces of bad news from different parts of the financial world on Tuesday. Monuments of financial folly are falling apart and the debris is hazardous.

Start with Greece. The decision to hold a referendum on the latest bailout plan makes a disorderly sovereign default more likely. How did the country get into this mess? Domestic and euro zone politicians bear much of the blame, but if lenders had not been so willingly blind, the country would not have been able to borrow mountains of debt, and Greek citizens would not have become accustomed to an unaffordable lifestyle. For two decades, though, the accepted financial wisdom was that the euro zone made that a safe bet. Just like U.S. mortgages before them.

As for investment banking, Credit Suisse is taking the axe to risk weighted assets in the fixed income business, while losses at Nomura may mean it has to reconsider the future of its European business. Most investment banks expanded because their managers shared the boom-time belief that financial intermediaries could earn high returns with low risk by trading at the expense of clients. Clients still seem pretty complacent, but now that regulators are imposing more reasonable capital requirements, the approach seems to be unravelling.

Capitalism’s third big hit in one day brought private equity into the equation. The sector’s principal competitive advantage has always been the tax deductibility of debt. That is effectively a subsidy from taxpayers to risk-taking investors. These investors are still taking – and underestimating – risks. One of them, illiquidity, just hit the owners of ISS, a Danish services provider. The company has done well in the six years of private equity ownership, but an IPO was pulled earlier in 2011, and a takeover offer was withdrawn this week.

The crisis of finance is now well into its fourth year, with no end in sight, and the risks to real economy are increasing by the day. Financial exuberance, like other sorts of addictive behaviour, is fun while it lasts. But it eventually brings far more pain than joy.

 

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