Grit and Emotions of Finance

Finance, insurance included, clearly has moved several notches up in terms of its contribution to GDP, as a sector most developed economies have seen a high single digit contribution in terms of the pie size (U.S. is at 7.5%) in the economy, which was quite unbelievable two decades back. The deck includes banking, insurance and reinsurance, stock, commodity and derivatives trading and the hedge funds of course. 

The surplus of the economy, from individuals to corporate which adds up to the capital stock must be put to good use and that is where Finance steps in. Creating the surplus on the other hand need the blessings of finance where credit and leverage are strong facilitators. The exchanges of all kinds provide the risk hedging and bring buyers, sellers and the intermediaries to insure themselves from the volatility in prices. 

But think of it that when productivity peaks it becomes that much more difficult to create a positive delta. When profits are high, making a positive profitability change becomes difficult. 

Marginal product of capital must diminish eventually, but not quite. This is where the job becomes increasingly difficult and if there are no positive delta above the risk free return, the stock of capital will have some tough opponents, inflation and cost push will destroy enormous value that the economies can ill afford. For assets that depreciate fast this problem is compounded. Investment banking has quite a few challenges in this regard. 

But Finance must step in to change this. It is dedicated to this eternal search for yields that are not apparent or visible. There is always this small possibility that many miss to see where a change is waiting to happen and Finance steps in to find the right buyer. Here there is some ruthless grit involved, almost passionless execution. There are no waiting times for under-performance. 

Finance works to find buyers and sellers who have a gainful transaction. If an asset has to be recycled, from a stage of limited utility to a stage of exalted opportunity, there is always a buyer waiting to make a transaction who is willing to take risk. 

This job is one of recycling that Finance helps to perform, but it also underwrites risk in the process. 

If you think all these transactions see the light of day you would be wrong, a varying percentage of these transactions do not succeed to return value to the holder of equity and in turn the debt holders. Some risks are therefore waiting to be written off with a touch of sacrifice. 

When too much risk is being underwritten you may have to go to the lender of last resort who can bail the economy out but then the entire economy must pay for it through an intense sacrifice. 

I have seen finance operating in the boom years that culminated in 2005, when the world’s growth engine was lubricated by finance, some sectors got over lubricated like housing. I was a close follower of housing starts in U.S. and the enormous built-up was waiting for a cascade event. But the price rise in housing never seemed to stop thus always attracting new buyers who could encash part of their home equity. 

This is where the emotions of Finance played its part and somewhat got swayed by the lack of reason, believing that systemic pool risk had no single loser so the music could go on. To the dangers of a tidal wave there seemed to be more believing to get into one large ship instead of many, the bundling and packaging of risk went into one single large pool. 

But the tail risks where too much to ignore and it took just a few margin calls to stop the surge, the credit markets fell off the cliff. This is where regulation stepped in and too much or too little is where the jury is still out. 

I was at the Center of all this being part of a global acquisition process and saw how this recycling worked, existing stock holders of a company that had no chance of survival got an extra ordinary return on their invested capital while the new acquirer had to wait for several years to turn the corner. 

Between a surplus that had no immediate channel of investment and a reeling deficit that needed large injection of funds, Finance stepped in to intermediate a transaction. 

Underwriting of risk is a shared judgment and eventually not every path can be clearly crafted. 

In any case Finance is always there to step in, recycling it to a buyer who could find value if the going deviated from the expectations. 

But the world of finance still revolves around creating and managing expectations, if they do too much, where emotions get the better of reason, we have corrections in the offing, which comes at a great cost. The Main Street is intertwined with Finance but the coexistence depends on the quality of dreams on both sides; the stretch must be backed in deeds that are sealed with trust and promise.