President Trump has promised financial de-regulation, and has hired the former Chief Operating Officer of Goldman Sachs, Gary Cohn, to design it. Given Goldman’s sorry record over the last decade, that should worry us. It should worry us even more when we consider that there is no sign of a change in Fed policies, so that the “funny money†that caused the 2008 financial crash and subsequent malfeasances is till in full effect. Without reforming the Fed, de-regulating banks will be largely counterproductive.
Ultra-low interest rates have two economic effects on the banking system. First, they encourage investment of all kinds, in fixed assets and leveraged equity bets. At the same time, the returns on these bets steadily decline, as the investing market moves beyond bets that are economically sensible and productive and enters bets that are highly speculative or just offer very low returns.
You can see the effect of this in the drastic decline in the returns on hedge fund investments. As of the end of 2016, the Hedge Fund Research Institute Weighted Composite Index, representing the universe of hedge funds, had returned an average of only 2.4% per annum over the preceding three years, compared to a return of 6.6% per annum on the Standard and Poor’s 500 Index.
The major college endowments, investors in hedge funds, have thus drastically underperformed the markets, returning minus 1.5% in the year to June 2016. According to Marketwatch, a simple Bogle Model, consisting of 40% U.S. stocks, 40% bonds and 20% international stocks, would have handily outperformed the largest college endowments over the past year, with modest outperformance in the past three, five and ten years.
In light of this, it is not surprising that the Harvard endowment is firing half its staff. Indeed, one can only wonder why it is bothering to retain the other half. Leave the fund to be run by the janitor on a Bogle Model and it will finally outdistance Yale and Princeton in its investment performance, thus demonstrating once and for all the superior intellect of Harvard’s investment managers – or at least, of its janitor.
A banking system whose loan portfolio consists largely of gigantic leveraged financings of foolish bets is in bad trouble. What’s more, that trouble will not appear in the day-to-day running of the bank, because of the “mark-to-market†accounting employed by the banking system today. While markets are strong, the loans secured against bad assets will appear solid and will be valued at close to par. As soon as markets begin to weaken, the loans will appear in trouble, and their market price will decline, thus in today’s crazy accounting world causing a “death spiral†that will send banks into default. It happened in 2008, even though much of the dodgy housing paper then outstanding proved to have considerable value; it will happen again as soon as markets begin to falter.
