The Future of Financial Services and the End of Trading-profits Businesses

Financial services, as a sector, has been clobbered.  Bankruptcy, forced takeover, government support -- no news here, the situation is dire.  Basically, if a firm is associated with subprime or CDS or, now, consumer credit, the news is horrible.  I'm not telling you anything you don't already know.

We're focused on abusive lending, incompetent credit risk management, irresponsible leveraging, a whole money-industrial complex that's come to a halt.  Michael Lewis just wrote a piece for Portfolio that epitomizes the current perception of the industry -- call it the "they're all crooks and dopes" perspective.  It's a great article so it will get a lot of play, deservedly.  It's a kind of sequel to Liar's Poker, Lewis's immortal, prophetic skewering of the Masters of the Universe.

Time for a little contrarian thinking here.  Financial services, the industry, is indispensable.  Current trends -- by which I mean the interlinked macro forces of technology, globalization, increased longevity, deregulation, and the collapse of centrally-planned economies -- are all good for financial services.  Maybe deregulation will slow down -- but nobody thinks we should go back to the 1970's or even the 1980's.  The essence of deregulation is freedom to set prices and nobody wants to put the government back in that business -- and no industry benefits more from freedom to set their own prices than financial services.  The consensus is that the credit boom and bust were stoked by bad regulations, not lack of regulations.  And, like General Franco on Saturday Night Live long ago, the centrally-planned economic model (Cuba, North Korea) is "still dead." 

Financial service profits come in two forms: fee for service, and trading profits.  Today's collapse is overwhelmingly attributable to reverses in the second one.  Lots of companies owned assets that, they suddenly learned, are worth a lot less than they paid.  There is feed-through to fee revenues, of course -- but customers still need to trade, they still need custody, they still need banking advice.  They have less money but it still needs managing, even if you change managers.  Those macro forces are driving that demand.

Of course there are risks.  Prostrate capital markets don't help the customers of the fee-paying businesses.  There is always the possibility that the G20 will decide, in their wisdom, that Seventies-style regulation wasn't so bad after all; or (the true nightmare scenario) that maybe protectionism deserves another try.  When you list those risks, though, you realize how far-fetched they are.  Far more likely will be mild reforms -- fix the rating agencies, improve swaps disclosure -- that will quickly become as boring and mainstream as Reg FD.  With any luck they will find a way to fix Sarbanes-Oxley to make it do what it should have done all along -- actually improve our ability as investors to understand what the companies we own are up to with our money.  Wouldn't that be nice?

Of course, the bloodletting may not be over yet, either.  If you accept the premise, though, that the problem is in businesses that trade assets, and not in businesses that collect fees, then you can start to think about which financial companies might be well positioned to survive the shakeout and turn the corner.