In late 2011, I was amazed by the valuations financial services stocks were being awarded. Having blown up (for all practical purposes) the financial system beginning in the summer of 2007, it was only natural that financial stocks should be sold off, because, well, some were insolvent. But as time wore on and the market began to recover, by four years on, I wondered why financial stocks were still trading for, in some cases, half of their tangible book/value or even less in some cases.
The response I typically received was: “What is their book/value? How can you figure that out?” Good point. So now the stocks have offered generous returns to investors over the last year, and I wonder, “What now?” So, I called up my old friend Nathan Greenwald, with whom I had toiled at Individual Investor magazine (alas, now defunct) some 17 years ago, to look into the matter. Nathan is a former portfolio manager, analyst and trader with lots of professional experience. (For more on Nathan, turn to his bio in our contributors section on page 10. He is also going to begin to blog on our website, WealthManagement.com.) In his article on page 41, he notes that executives at financial institutions have been recognizing that wealth management, retail wealth management, is perhaps a sector they ought to be in.
Over the last couple of years, I have been trying to divine what the heck happened to cause such a financial catastrophe. Readers of my blog, VonAldo.com, know my free market leanings, and that basically I believe that the financial system of the United States was in essence nationalized in 1913 with the creation of the Federal Reserve. Basically, government screws up the pricing mechanisms of the private economy. So the buildup of the 2007 crisis was a long time coming through various social-engineering policies of the federal government. But there were other causes too. Fair-value accounting was one major factor, first tried by FDR back in the 1930s but later abandoned. For more on this, see John A. Allison’s The Financial Crisis and the Free Market Cure (McGraw-Hill).
Another factor was the “value at risk” (VaR) model, which allowed financial companies to lever up by underestimating risk. There is no room to discuss details on this page, but basically VaR allowed traders to show, by backtesting, that various underlying securities in any given portfolio had a great chance to succeed with only a small percentage chance of losing money, and therefore, not much risk. For more on this, see Pablo Triana’s The Number that Killed Us: A Story of Modern Banking, Flawed Mathematics, and a Big Financial Crisis (Wiley). The book has been criticized as “anti-mathematical,” but I was taken aback by this comment in the intro of the book: “[Nassim] Taleb [the author of The Black Swan] quickly realized that it is useless to try to measure that which does not lend itself to be measured.” (Here he was referring to market risk and to the arbitrary backtesting of a historical period of a trader’s choosing to predict how securities in a portfolio would correlate and behave in ginning up a VaR calculation.) Triana continues (and this is what scares me): “Market activity is simply too untamable, too wild, too undecipherable. In an environment where everything is possible and where the next unprecedented crash may be around the corner, it is hopeless to try to infer much from the historical record.” Wow. What does one tell one’s client after handing him an asset allocation model? You probably don’t want to hang that quotation up on your office wall. But I came upon that vexing issue back in the day when I quipped (during the Asian contagion, perhaps), “The unprecedented happens all the time.”
I’d be interested in financial advisors’ thoughts on this.
David A. Geracioti
Editor-In-Chief