Monday, July 13, 2009

When Foundations Crumble

Bill Siegel of The Receivables Exchange wrote in his Liquidity Weekly post last Friday about the troubles facing CIT Group, Inc. CIT provides financing to hundreds of thousands of small to medium sized businesses (the SME sector).

Articles in the Wall Street Journal on both Saturday (7/11/09) and today make it clear that the failure of CIT would cause a great deal of harm to the SME sector of the economy, which generates the majority of new US jobs. CIT was founded in 1908 and has been one of the foundations of US commercial finance for decades.

We’ve seen no shortage of crumbling foundations in the global financial and business community in the past year. When names like Lehman Brothers and Bear Stearns cease to be; when the viability of AIG and Citigroup are seriously questioned; when the US becomes majority owner of General Motors; the assumptions on which many of us based our concept of economic reality are called into question.

But even more fundamental than the value and viability of such major enterprises are the conceptual foundations on which our understanding of financial reality itself have been built.

WSJ articles in on 7/10/09 and 7/11/09 raise questions about two of those conceptual foundations.

On page 1 of the WSJ last Friday was an article entitled: “Failure of a Fail-Safe Strategy Sends Investors Scrambling”. The “fail-safe strategy” discussed in that piece is asset allocation. It has been a foundation principle of finance that spreading investments across asset classes whose risk and return patterns are different will reduce portfolio risk and increase risk-adjusted return.

It can be argued, I think, that much of the structure of the global investment business reflects this one, single, powerful and pervasive assumption.

But what if it’s wrong?

That’s the question raised by the WSJ piece. There is too much at stake in the answer to that question to expect true objectivity from industry participants. Some of those quoted in the piece take the position that asset allocation has clearly failed. Others argue that it worked but not as well as expected. Others looked to the possibility that the rules of the system change under conditions of extreme systemic stress.

The very fact that the question is being seriously debated, however, has significant long-term implications.

A second foundation principle in modern US finance derives largely from research popularized by Professor Jeremy Siegel of the Wharton School of Business at the University of Pennsylvania. In 1994 Siegel published a widely-used study of the characteristics of stock market returns called “Stocks for the Long Run”.

As the title of his book implies, Siegel argues that over long periods of time equities generate a “remarkably constant” average return and that “the risks of holding stocks decrease over time”. Siegel wasn’t the first to make the case for long-term stock ownership, of course. It had been around for some time. But his research popularized the less-accessible work of some important predecessors.

Interpreted and articulated by persuasive Wall Street marketing departments, Siegel’s work (and others) helped convince both institutional and individual investors to both increase their equity exposure and to hang tough during volatile market “episodes”.

Siegel’s research was influential, in part, because of the duration of the data he used in reaching his conclusions. The return series reached back to 1802! The credibility of conclusions reached when a series of that duration is tested obviously seems higher.

But the piece in Saturday’s WSJ called into question the data used by Siegel for the early period of his research. The author, Jason Zweig, concludes that: “The 1802-1870 stock indexes are rotten with methodological flaws. So we have only the periods since then…to base our long term investment decisions on.” So the data series that Zweig finds reliable is about 1/3 shorter than Siegel’s study accepts.

Now it is natural in a period such as this to call into question the reasons for the failures of our systems. And not all of the answers will ultimately prove correct.

But I think that there is one thing that we can say with a high level of probability: we’ve come so close to total financial melt-down and so much faith has been lost in some fundamental concepts on which our system has been based, that investors will be looking diligently for alternative approaches and alternative vehicles.

The thesis of Bill Siegel’s piece on Friday was that the troubles being faced by CIT might ultimately provide a boost to the business of The Receivables Exchange.

I suspect that he is correct.

But I also think that, more importantly than the impact of any single entity or event, the business of investing in accounts receivable and the vehicle provided by The Receivables Exchange are likely beneficiaries of the re-evaluation of larger, foundational concepts in the business of finance.

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