Brent Sheather: Woolley's thinking right on the money

Most people know that things aren't right in the financial world at present.

Heck - things are so bad New Zealand's position is starting to look good relative to most other Western countries, with the exception of Australia.

The markets seem to be lurching from crisis to crisis, confidence is fragile and some of the world's biggest financial institutions have been caught ripping off their clients using complex products with embedded fees which no one understands.

What's more, in some cases it appears the only rationale for building the complex product was to take advantage of the unsuspecting counter-party.

One of my clients a few years back, aged in his late 70s, was sold 100-year General Motors bonds by a leading US stockbroker who just happened to be underwriting the issue.

Fiduciary responsibility is out the window, not only for retail investors but for institutional as well, with gullible city councils and banks in Europe being caught on the wrong side of derivative trades.

Despite ripping off customers and making obscene profits, the banking systems in the US and Europe are being bailed out by taxpayers. This is partly because around half of the obscene profits were paid in bonuses to the nit-wits who managed the banks into bankruptcy. Yet there is no talk of them giving the money back.

Today the idea that shares should be bought and sold merely to reflect future dividends is old-hat. According to some reports 70 per cent of the trading on the NYSE is high-frequency trading by hedge funds trying to exploit tiny mis-pricings where information advantages are measured in nano-seconds.

The stock exchanges encourage this sort of behaviour because turnover means dollars for them. The downside is high volatility, as demonstrated by the meltdown of a couple of weeks ago, when several blue chip US stocks lost 99 per cent of their value in minutes, only to subsequently return to their previous levels.

Another side-effect of high profits in the banking system is that all the best graduates seem to aspire to work as stock brokers and investment bankers instead of doing something that actually creates a tangible benefit to society like engineers and scientists.

The role of the finance sector is merely to direct money from those who have it to those who need it and, as such, the process should be almost frictionless. But as Tim Finn of Split Enz once sang, "there's a fraction too much friction".

Government responses thus far have been more regulation. But the twin worries are that the clever bankers will somehow get around the rules, and legislation can have unintended consequences. As regards the latter, James Grant, writing in "Grant's Interest Rate Observer", recounts the story how following the Titanic disaster, passenger ships in the US were forced to carry a greatly expanded number of lifeboats.

The legislators argued that there should be "boats for all" in the wake of the Titanic. "Boats for all" were duly delivered, despite warnings from some in the industry.

Things went well until in severe winter weather the S.S. Eastland became top-heavy with ice because of the lifeboats it was carrying and capsized in the Chicago River with substantial loss of lives on July 24, 1915. Chalk that one up to the rule of unintended consequences.

However, regulation alone won't do it. Unfortunately, the more one finds out about the finance industry the more worried one becomes that the system is broken. The commission-driven finance company debenture and Feltex disasters are just small-scale local symptoms of the disease. Something needs to be done, but what?

Banning commissions, as they intend to do in the UK and Australia, would be one small step for New Zealand, but globally the finance industry seems to choose the game to be played and then plays it in such a way that the clients always lose.

Change is needed and in the UK one man has given it a lot of thought. He is Dr Paul Woolley, who presented his thoughts on these matters at the London School of Economics in May, and has kindly sent me his lecture notes.

First some Woolley background. He founded, then ran, the London office of Grantham Mayo Van Otterloo for 20 years. He was a partner in GMO with legendary manager Jeremy Grantham.

He is a former academic, banker, IMF economist and fund manager. After GMO he founded, with a donation of £4 million, the Paul Woolley Centres for the study of Capital Market Dysfunctionality at the London School of Economics and the University of Toulouse.

He has been to New Zealand a number of times, walking all the major tramping tracks in the past 10 years or so. Woolley believes the financial markets need fixing and the objectives of the Paul Woolley Centres are to define the problems and propose solutions.

As he sees it, the situation is as follows: "Economic theory and received wisdom have brainwashed everyone into believing that capital markets are efficient, that prices are always right, capital markets are self-stabilising and competition keeps banks and financial firms from earning abnormal profits. The reality is very different.

"The finance industry is performing its utilitarian task of channelling savings into real investment badly and at punitive cost. And as soon as profits disappear, bail-outs are needed."

The punitive cost comment might well resonate with local clients of private bankers and financial planners. This column noted two weeks ago that a sensibly diversified investment portfolio put together today could be expected to produce a free cash flow yield (that is, cash income) of 5.2 per cent a year.

Some 3 per cent of this goes, under the standard financial planning model common to most in the industry, in annual fees to the financial adviser, fund manager, platform provider, custodian and candlestick maker, etc.

Woolley, in his lecture notes, contends that most financial functions are or should be low-risk, utility-like roles and as such should not attract high charges.

Yet banking and finance is the world's single largest industry and bank profits have got bigger and bigger in the past 40 years, rising from 10 per cent of private sector earnings in the 1960s to 40 per cent in 2007.

These figures are after bonuses. Woolley asks why there have been no academic papers inquiring as to why the finance sector has grown into such a monster.

The simple answer is that finance theory says financial markets are efficient; that is, banks are as big as they are because they reflect the future profits they will achieve.

"The theory holds that financial markets are self-stabilising - speculators will make money by finding mis-priced stocks and driving them back to fair value." They haven't, therefore there is no problem!

We have been down this road many times before: Alan Greenspan famously refused to let the air out of the tech bubble in the late 1990s on the grounds that financial theory said bubbles could not exist.

But this efficient-markets theory has one simplification too many - it ignores the fact that investors hire others to invest in the stock market for them.

Mum, Dad and the institutions act as principals and the fund managers are their agents. It's this delegation of responsibility that causes most of the problems.

That is enough for one Saturday. In a fortnight we will take a closer look at what Woolley sees as being wrong with the world of finance and the steps he thinks the major investment funds should take to put things right.

* Brent Sheather is an Auckland stock broker/financial adviser and his adviser/disclosure statement is available on request and free of charge.