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AP Photo/Richard Drew
A classic of the “sad trader” genre.
FRET NOT

The finance sector is awash in pain, which could well be gain for the US economy

By Matt Phillips

All of the sudden, the smart money doesn’t seem so smart.

Look around. The crowd of highly compensated, beautifully besuited insiders who dominate the large, influential banks, hedge funds, and private equity firms seem to have lost that spring in their step.

And for good reason. They’re having an incredibly difficult time making the kind of money they were once accustomed to. And their clients, customers, and shareholders have noticed.

On Wall Street, Goldman Sachs—long viewed as one of the world’s savviest financial operators—has watched its return on equity (a measurement of the firm’s ability to make money using capital from shareholders) tumble to 6.4% in the first quarter of 2016. Before the financial crisis, it hovered above 30%. Morgan Stanley, JPMorgan Chase, Bank of America, and Citigroup have appeared similarly powerless to stop the relentless decline in this key gauge of profitability.

It’s not only bankers who are befuddled. Hedge fund executives, too, have had an atrocious run.

As an asset class, hedge funds lost 0.4% during the first quarter, according to research firm Eurekahedge. That might not sound like the end of the world. But it’s an especially poor showing when you consider that investors who simply bought index funds tracking plain-vanilla benchmarks for stocks, such as the S&P 500, or bonds, such as the Barclays Aggregate US index, fared far better. The S&P 500 and the Barclays Aggregate returned 1.4% and 3%, respectively, for the first three months of the year.

Investors are now doing the logical thing, yanking billions of their dollars out of the high-priced investment vehicles. Why pay nosebleed fees for subpar performance?

“There is no doubt that we are in the first innings of a washout in hedge funds and certain strategies,” hedge fund manager Dan Loeb wrote in a recent client letter cited by Bloomberg.

Results in the world of private equity haven’t been much better. Titans such as Carlyle Group, KKR, and Blackstone all have reported disappointing results as market fluctuations hit the value of their investments, and as bets on the oil and gas sector were hurt by the ongoing tumult in energy.

So what’s going on here? Can we write off the poor performance across various parts of the financial topography as a coincidence? Perhaps.

There’s also policy. Central banks around the world have pushed interest rates to zero—and in some cases below zero—in a desperate effort to prop up growth. That’s changed the fundamental calculus for a range of financial players.

“I think that the catalyst is probably the low-return environment,” said Adair Turner, the former regulator who led the UK’s Financial Services Authority for four years in the immediate aftermath of the financial crisis of 2008. “The fact that safe returns are now so low concentrates people’s minds on something we could have concentrated on before.”

For instance, Turner says, with asset managers generating lower returns, the fees associated with managing those assets become more important. Witness the burgeoning shift among global investors toward low-cost investment products such as index funds designed to track the performance of overall markets. If it persists, that trend would likely put pressure on asset management fees, which were a large driver of the growth in the finance sector in the run-up to the financial crisis.

Also, new regulations are now forcing banks to operate using less leverage. (After all, it was only by making big, risky bets—generally made using other people’s money—that banks were able to generate returns-on-equity of 30% in the first place. And we know how that ended.)

Far too much finance

The difficulties of financiers also may be chalked up to another simple fact: We still have far too much finance and not nearly enough legitimate business for the sector to do.

Financial entities feast on debt. Think of the years before the crisis, when the financial sector swelled. Banks fattened on bevy of origination fees tied a surge of mortgages, home equity loans, auto loans, and credit cards issued to US households.

The banks then turned around and packaged up those those loans, and loans made by nonbank shadow lenders, into securities. Then they collected another juicy set of fees by selling them off to other investors, via their nifty—and highly profitable—bond trading divisions, which traded fixed-income products and tailored any derivative product that people might take a fancy to, for the right price.

Those were good times. But they were a long time ago. US private sector debt has essentially flatlined as households and corporations have tempered their demand for credit.

Meanwhile, the other large component of the surge of US finance—asset management fees—also has shown signs of a retrenching. Hedge fund management fees are off their 2007 peak of $69 billion, according to these Harvard Business School economists—and should be set to decline further if the outflow of assets continues through the year.

This will be an important area to watch to see if the financial sector is truly starting to contract, says Harvard Business School professor Robin Greenwood, one of the economists who co-authored an authoritative paper on the size of the financial sector.

“The value added of the financial sector is driven by, essentially, fees,” Greenwood says. And outsized fees and wages associated with finance, in turn, could be one of the reasons why overly large financial sectors seem to have a deleterious effect on economic growth. Some theorize that when nosebleed pay packages are the norm in the financial world, it starts to siphon off talented workers who otherwise would have contributed to real economic productivity somewhere else.

In other words, the pain currently being felt in the US financial sector could well be gain for the US economy. And who knows: If the real US economy actually starts putting together some solid economic growth built on fundamentals like innovation, productivity, and efficiency, that could begin to stoke demand by companies and households for credit.

Against a backdrop like that, perhaps even the smart money could figure out a way to profit.