Michael Butler is chairman and CEO of investment bank Cascadia Capital. He is writing a book titled Financing the Future and the Next Wave of 21st Century Innovation, and is serializing it at peHUB. What follows is an excerpt from the second chapter.
It’s not the end of the world, but the wrenching global market crisis that’s now unfolding will change the financial world as we know it.
This is the sixth major readjustment of the financial system over the past 21 years. In 1987, we saw the equity market crash and rebound; in the early 1990’s, the junk bond market collapsed and shrunk; at the same time, the real estate market unraveled and then eventually re-spooled; in 1998, the Asian currency crisis descended and then lifted; and, of course, the Internet economy fell back to earth in the first years of this decade before a parachute eventually opened.
What’s going on today, however, is very different and potentially more damaging than past financial system readjustments.
Simply put, certain sectors of the financial system – like real estate – have employed extreme amounts of leverage to generate returns; in reaction to this, the financial system is now going through a necessary but painful de-leveraging process.
I believe this de-leveraging process will be more punishing than those of the past because the current turmoil, still in its early stages, is already wreaking bottom-line havoc on a wide range of financial players – including commercial and investment banks, hedge funds and private equity firms.
Indeed, some of the biggest and best names in the capital markets – Merrill Lynch, Citigroup, Morgan Stanley and UBS, for example – have seen their reserves depleted. Unprecedented Federal government intervention was also recently required to salvage what was left of Bear Stearns. And Washington has now made a decision that allows troubled investment banks to directly access the Federal Reserve Bank.
So this market crisis is clearly systemic and far-reaching, and that’s what sets it apart from the previous and more contained financial system readjustments we’ve experienced over the past two decades.
Today’s pervasive problems stem from the trillions of dollars’ worth of global mortgage products that were developed, bought and sold between 2002 and 2007. Whether they were bundled, sliced or diced, these financial instruments carried a toxic risk virus based on aggressive and unrealistic assumptions that slowly but surely spread throughout the world as well as to other fixed income markets.
And now that the markets have been infected, the question is how – and when – do they get healthy again? Just as importantly, what do they look like when they get out of this sick-bed?
Unfortunately, there is no magic pill or antidote. Even with Federal bailouts, things will just have to run their course. As of this writing, the market is still searching for a bottom. And we’ll know we’re there when all fixed income instruments can be priced with full transparency. Until that time, we’re going to have to wait – and sweat – this one out.
That said, there are four key outcomes that I see emerging from this crisis. And each of these will help change the way capital markets operate and are accessed going forward.
• New Business Models – After a generation of consolidation and aggregation, Wall Street will begin to break up its vaunted financial supermarkets. They’re inefficient, hard to manage, and too bureaucratic to keep up with the real-time pace of 21st century global markets.
• New Risk Appetite – After a loose cycle that left the back-end of so many debt obligations uncovered, we’ll soon see a powerful new conservative backlash emerge on the Street. The global mortgage market will also come under intense scrutiny and oversight, which will change the way these financial instruments are injected into the system.
• New Human Capital Flows – After experiencing the dislocation of the current crisis, some of the most talented financial minds in the world will migrate from hulking supermarkets to more nimble boutiques. With a host of complex new global markets proliferating, deep, expert and specialized firms will hold sway and the day.
• New Search for Growth – After making money in the most recent cycle through leverage, hedge funds, private equity firms, investment banks and corporations realize that employing significant debt to generate outsized returns just won’t work anymore. To be blunt: that game is over. Looking forward, companies that generate top-line growth will attract the best and smartest debt and equity market capital because growth will trade at a premium. Some of the hot growth areas will include China and India, the clean technology and alternative energy sectors, and U.S. middle-market companies.
This crisis is obviously a work in progress, an unfinished story that has yet to fully play out. As a result, there is so much we don’t know; but we do know that there’s plenty of capital in our interconnected world, and there also appears to be a willingness this time to learn from our recent excesses and mistakes. Hopefully, that should be enough to keep the markets buoyant until the healing is complete.