Friday, February 19, 2021

Are Shareholders Indifferent to Data Breaches?

Comment by Riazul Islam and Ingo Walter

In the governments’ harried efforts to deal with the social and economic consequences of Covid-19 close to $5 trillion is likely to be paid-out in history’s largest unemployment compensation program combined with “stimulus” payments to provide income relief and create a fiscal boost to accelerate a recovery. The payouts have put a premium on speed to accelerate pandemic relief and create a meaningful fiscal boost. But crisis, confusion and haste are the mortal enemies of accuracy, transparency and accountability, and open the door to stealing other people’s money.

Even before the Covid-19 crisis, identity fraud drained an estimated $16.9 billion from victims’ accounts last year. Now the financial locusts have found a new opportunity to feast -150 million recipients of stimulus funds and over 30 million laid-off or furloughed workers filing state unemployment claims. Why the predatory bonanza? Better hacking, plus cursory payment-security protocols in the crisis deluge. 

The air supply for systemic financial fraud is identity data stolen in dozens of cyber-attacks on financial and nonfinancial firms, and traded on the “dark web.” In all, billions of accounts have been compromised worldwide. They can be overlapped to reveal just about all the access information needed to steal identities and intercept payments - especially in a crisis setting like this one. The dark pool of data is buffered by thousands of fraudulent website domains, robo-calls and emails to fill in the blanks, extracted especially from the elderly, the poor and the unemployed who can be bamboozled into disclosing personal information in order to access promised benefits. The phishing is good, and the catch far exceeds random spam. 

What can be done about this plague? The kind of severe punishment expected in cases of massive systemic crime has been disappointing. Locusts are legion, they are resistant, and they move around. Once stolen, following the money is usually a fool’s errand. 

But how about cutting off the air supply – getting much more serious about combatting cyber-attacks whose data yield populates the dark web. There have been plenty of cases in recent years, sometimes stealing data on corporate and banking clients in the hundreds of millions. Law enforcement, regulatory bodies and the hacked firms themselves have ramped-up their cyber-security, but at a pace and intensity that seems to lag the frequency and severity of the attacks. Some prominent targets seem to consider successful cyber-attacks a cost of doing business, and pass the damage on to customers or shareholders in higher prices and lower returns. Anyway, cyber risks can be insured, and the premiums built into operating expenses.
Even taking into account the need for business confidentiality, corporate attention to cyber-security events often seems weak. Maybe that’s because boards and managements pay attention only to the firm-level costs of the damage and ignore the social costs, as the stolen information hits the dark web to victimize countless others – call it “pollution not worth the cost of cleanup.”

Logically, shareholders should care about the impact of data breaches. Investors should expect to see a reduction in the valuation of company suffering an announced  data breach as consumer and business customers jump to competitors, ramp-up operating costs, suffer potential fines and penalties levied by government agencies, and possibly endure class action lawsuits down the road.

Surprisingly, this doesn’t seem to be the case the case. A new study analyzing the shareholder impact of data breaches across 92 large data breaches at publicly-traded companies from 2015 to 2020 finds that these generally result in little or no impact on stock prices. Only companies whose core businesses have both financial and personally identifiable information compromised - such as Equifax, Capital One, ADP, and First American Financial - suffer substantial stock-price reductions. Most other companies escape a strong, negative impact of announced data breaches on their stock prices.

The study suggests that shareholders do not believe there’s is a material impact on the valuation of a company that suffers a publicly disclosed data breach. This absence of discernible market impact suggests investors do not believe there’s a material change in the company’s future cash flows. Perhaps this is due to cybersecurity insurance cover, but companies are certain to incur adverse revenue and cost impacts. The data show that they are not reflected in stock valuations possibly because they are thought to be immaterial or that investors have “learned” to ignore them from past incidents.

These results are profoundly discouraging to those who believe in market discipline and rely on it for economic efficiency. It seems to fail here, and sets the stage for substantial damage to society going forward. But control rights in the vast majority of traded shares are vested in institutional fund managers. Maybe they don’t much care either, and prefer to wait and see the direct and indirect fallout before doing any portfolio rebalancing. And maybe there’s little room even for that, given the shift to index funds and ETFs, where portfolio weights are on autopilot. It looks like progress on data breaches and invasions of privacy will have to look beyond the invisible hand of market discipline.

Thursday, February 18, 2021

Obituary - Roy C. Smith

Roy C. Smith

My friend, colleague, and co-author of this blog passed away on November 15, 2019 in Naples, FL. Roy was born in Norfolk, VA in 1938. He lived most of his professional life in Montclair, NJ and spent summers in Chatham, MA and winters in Naples, FL.

Roy was a bigger-than-life individual in virtually every way, his career bridging multiple professions. After graduating from the U.S. Naval Academy, he served as an officer in the Atlantic Fleet on the USS Decatur, taking part in the Cuban Quarantine Operation in 1962. He was a graduate of the Harvard Business School (M.B.A. 1966). He served as a long-time investment banker and General Partner at Goldman, Sachs & Co., specializing in international investment banking and corporate finance. At Goldman, Roy established and directed the firm’s business in Japan and the Far East, headed business development activities in Europe and the Middle East, and served as President of Goldman Sachs International Corp. while running the firm’s London office in the early 1980s.

In 1988 he retired from Goldman as a Limited Partner joined what was then known as the Graduate School of Business of New York University. Before long he became the Kenneth Langone Professor of Finance and Entrepreneurship and Professor of International Business. He taught at NYU Stern for 30 years. 

Roy was a dedicated practitioner-scholar – an internationally published author of six books and co-author (with me) of another eight, plus nearly 100 articles on global banking and financial markets, entrepreneurship, corporate governance and business ethics. He became one of the media’s favorite “go-to” people for incisive commentary on financial events of the day.

Roy was a founding member of NYU’s Center for U.S. - Japan Business and Economic Studies, now the Center for Global Economy and Business. Outside NYU Stern, he was a popular lecturer and visiting professor of finance at several universities and institutes in Europe, including INSEAD in Fontainebleau, IESE in Barcelona, Luigi Bocconi University in Milan, NYU Abu Dhabi and, for shorter stints, at Kiel University, Swiss Banking School in Zurich and IMD in Lausanne.

Roy will be missed. His contributions to this blog covered a wide range of subjects, and he was happy to call a spade a spade. He greatly enjoyed some of the controversy he inevitably generated. His productivity in terms of blog contributions spiked during his winter months in Naples where he had a ready audience of accomplished senior residents who, he said, harbored much wisdom - to test his ideas. 

Roy cannot be duplicated as a contributor to this blog. But his spirit will live on as we continue with new contributors, to be announced. Stay tuned….

Ingo Walter

Monday, August 12, 2019

China’s Existential Dilemma

By Roy C. Smith

The US-China trade dispute should have been resolved a year ago, enabling both countries to get on with their growth agendas and avoid a lot of unnecessary market disruption and investment uncertainty.

Early negotiating sessions suggested that China would yield to some US demands and increase agricultural purchases to avoid any new tariffs. But Mr. Trump apparently wanted more and negotiations slid off into the political arena where both Trump and Xi Jinping risk losing face for crumbling before an adversary, which made things worse.  Now both sides are in territory in which blows may have to be struck and the time until an agreement is achieved has been delayed further. Even if the blows are more symbolic than forceful, their effect will be on slowing the growth rates in both countries and several others.

China’s official growth rate was 6.2% in the second quarter of 2019, the lowest in 27 years, and is predicted to slow further even without the trade dispute. According to local economists, China’s true growth rate is probably well less than 6% and many indicators show the turmoil over tariffs and the slowing of long-term foreign direct investment will bring it down further.

That will put pressure on China to address political dissatisfaction throughout the country that has already begun to develop over future job growth, opportunity for upward mobility, and the adequacy of pensions and health care services for an aging population.  For years China watchers have said that a minimum growth rate had to be achieved for the people to continue to allow the Chinese Communist Party to rule without elections. That assumed rate used to be around 8%. Xi Jinping knew this when he came to office, and he acted quickly to consolidate his personal power, and then to distract attention from growth to pride in China’s long history, rising global influence and power, as seen in its South China Sea activity and in expensive demonstration projects like the “Road and Belt” initiative. But the decline in growth has led to bankruptcies, increased layoffs, unemployment and public protests and demonstrations. So far, these protests have not been very disruptive, but In January 2019, Xi warned fellow party members of the rising dangers of public dissent.

Dissent has now broken out in Hongkong, where for ten consecutive weeks, more than 2 million protesters have taken to the streets and violence erupted on several occasions. The resistance is to increased grasp by China of local political power. Hongkong is much more than a returned autonomous colonial territory – it is a vital business center for the country (affecting  about 25% of China’s GDP) and key to the financial markets of Southeast Asia. Bottling up Hongkong with political and maybe military strife could be disastrous to the Chinese economy, and could include a capital flight (which may already have begun) that China would be unable to prevent without draconian measures, which could precipitate a financial crisis such as occurred in Japan 1989 and ended that country’s ambitions to being an economic superpower.

Financial crises are like avalanches, you never know in advance where they are coming from or when.  A large part of China’s securities and bank credit market activity is presently provided by non-Chinese investors that can change their minds in a flash. China is now sitting on a record level of debt (300% debt to GDP), about 60% of which is not federal, but of more unsteady corporate and municipal entities.  Declining economic conditions have caused defaults to rise, credit ratings to fall and access to credit to be constrained.  Avalanches in credit instruments begin under circumstances like theses, then accelerate and broaden to include all securities, pushing  market values well below their true value, and, because of mark-to-market accounting, requiring massive loss taking (and bailouts) within the financial system. This happened in New York in 2008, in the Euro-era in 2010. +In both cases, the velocity of market movements greatly exceeded governments ability to halt them.

China can survive a financial crash, though at great cost to the economy. But economic distress can open the doors to political risk that protests such as are occurring now in Hongkong could spread to nearby Guangzhou, Shenzhen and even to Shanghai, autonomous industrial cities in the South, distant from Beijing, where millions of migrant workers with few economic rights would be subject to a sudden increase in layoffs and economic difficulty unassisted by social safety nets.  

This could be an existential moment for Mr. Xi and his Communist Party colleagues in Beijing. It could get out of hand and require violent repression to settle, which  like Tiananmen Square in 1989, was deemed the only way to save party rule.

These circumstances give Mr. Trump the advantages in negotiating with China that he has claimed from the beginning (“We can win a trade war...”).  He may be prepared to face a Chinese existential crisis, though it would not be in the US’ interest to have one. Mr. Xi , on the other hand, may believe that Mr. Trump cannot sustain a trade war with China through an election year, and China can wait him out. Maybe, but Trump is unpredictable, changeable and seemingly very confident in his political base to support him in the election.  This could end up in a very dangerous game of "chicken." with disproportionate consequences. China would be well advised to find a way to settle the trade issues soon, even at some loss of face, to slow the growth decline but, more important, to preserve political stability. This should be obvious, but all politics are domestic in the end, making some obvious things hard to do.

Americans need to remember that the US struggled for more than 20 years to manage trade disputes with Japan, a country we wanted as an ally but many Americans believed exploited US benevolence. Then we spent another 20 years dealing with China’s rise as the next Japan. But China is not a democracy, and though it has said it has opened its markets to link with the capitalist system, it has joined the capitalist system only in part, while preserving Deng Xiaoping’s notions of “socialism with Chinese characteristics,” or capitalism with exceptions.

The Chinese characteristics, however, are seen by Mr. Trump, and many others, to include many anti-competitive measures prohibited by the World Trade Organization, such as providing large subsidies to state-owned enterprises that make up a large portion of the Chinese economy. Trump sees these as exploitative, Xi sees them as essential to keep large, unprofitable state companies from collapsing.

These issues are difficult but not unresolvable. To resolve them, both sides will have to swallow stuff they don’t want -- but  can be renegotiated in the future. That's what politicians in capitalist countries do,  Failing to do so will bring back some Cold War intransigence that we would be better off to avoid.

Wednesday, July 24, 2019

Why Americans Don’t Trust Economics Anymore.

By Roy C. Smith

For as long as we can remember, Republicans and Democrats have been divided by their economic policies. Republicans have been the party of low taxes, fiscal discipline, and champions of the private sector as the country’s growth engine.  Democrats have been supporters of Keynesian economic theory that says when things slow down, its OK to promote growth by government spending programs and subsidies that require substantial additional borrowing, even if that leads to unbalanced budgets, increased inflation and a weaker dollar.

These may be the party’s basic economic platforms, but in reality, they are ignored. That’s because politics and other things invariably get in the way. As Dick Cheney once said “principle is okay up to a certain point, but principle doesn't do any good if you lose.”  So, when Mr. Trump wins an election, the Republicans have a tax cut, even though the economy had already returned to a low unemployment growth mode and could only be inflated by further stimulation, which would raise inflation and interest rates, and threaten future growth. If Republicans weren’t worried about this, why should Democrats? Everybody likes a tax cut.

Anyway, all the bad things didn’t happen, at least not right away. Though the US was running a big fiscal deficit (4% of GDP), and total government debt held by the public reached 78% of GDP in 2018 (a post-war record), with prospects following the 2017 tax cut of the ratio exceeding 100% within ten years, no one seemed to care very much. The debt, after all, was repayable in dollars and we could always print more of them, like Japan has done for years (its debt to GDP ratio is 236%). This is a key argument of the Modern Monetary Theory now being promoted by some Democratic presidential candidates as an explanation for how their platform of new social programs will be paid for.

Nor were markets very bothered by the debt. The low prices of consumer goods resulting from the US trade deficit with China and other countries, kept inflation down and generated sizeable financial flows into the US that funded new capital investments and boosted bond prices that kept long-term interest rates relatively low. Stock prices rose too, to new records during the first two Trump years (despite two high-volatility setbacks). Because US international trade has risen to represent 27% of its total GDP, trade affected the economy significantly by slowing the rate at which the direct effects of deficit spending might otherwise have occurred.

So, when Congressional negotiators announced agreement yesterday on a budget bill that would increase the deficit by $32 billion over ten years, the markets only shrugged.

Should they be more concerned?

Well, maybe not. The markets are about expected outcomes over time, and these are indeed determined by underlying theory, but also by other stuff, especially politics and markets forces. When Ronald Reagan’s deficit financed tax bill passed in 1981, economic growth shot up to average 4.3% from 1982-1990, and unemployment fell from 11% to 5.6%. Debt to GDP, which was only 32% in 1980 left room for leverage so the ratio rose to 54% in 1990, helping to kill the boom. When George H.W. Bush, Reagan’s successor, ran for reelection in 1992, the economy was in recession and the deficit had ballooned from 2.7% to 4.7% of GDP, and growth slowed from 1990-1992 to 1.7%. When Bush, ignored Dick Cheney’s other great economic pronouncement (“Reagan proved deficits don’t matter”) and went back on his promise of “no new taxes,” many in his party deserted him for Ross Perot and he lost the election to Bill Clinton, whose economic policy was to reduce the deficit ratio further (to 33%) so bond market rates could go down even more (“everyone wants a lower cost mortgage”) and the economy improved to average 4.5% growth from 1997 to 2000 and the deficit turned to surplus, the first one in 28 years,.

But, when the deficit chickens fly away, it is just a matter of time before they come home to roost.  We end up paying for the benefits of the deficits at a later time, in one way or another – in a financial crisis, a recession, inflation, high unemployment, or a meaningful change in voter perceptions about economics.

The slow-moving, but powerful give-and-take between economic theory, politics and markets one day requires a price for today’s neglect of the deficits. Most likely it will be in the form of lower GDP growth, which the Federal Reserve is now forecasting to fall to 1.9% for 2020 from its cyclical peak of 3.1% (in 1Q 2019, but it  dropped to 2.1% in Q2), back towards the average US GDP growth since 2000 of 2.0%. And, Trumpian uncertainties, well known to the markets today, could make things worse.

It may not, however, because other things such as a brilliant trade deal, that could change the game. But if it does, the system will adjust over time. Even at 20% interest rates, US debt was refinanced in financial markets after the Volcker Shock in 1979. Political sympathies for unchecked deficits may change and markets will discount future stock prices for lower growth or other concerns. Market power is now enormous, with more than $300 trillion in market capitalization of all tradeable stocks and bonds in world markets. And, other factors, unknown to us now, may also affect long-term outcomes.  But even then, fear of deficits, won’t last for long, and deficits will come back in style.  



Wednesday, July 3, 2019

She's the One

By Roy C. Smith

Yesterday, the European Parliament nominated Christine Lagarde, 63, Managing Director of the International Monetary Fund (IMF) to replace Mario Draghi as President of the European Central Bank (ECB) at the expiration of his 8-year term. Lagarde is a former French Minister of Finance under Nicholas Sarkozy, who took over at the IMF also in 2011, after the global financial crisis of 2008-2009 had spread to threaten European financial markets and economic stability.

The financial crisis had profound effects in Europe. It was only through the painstaking efforts of Germany and France, the IMF and the ECB over about 2 years that the subsequent “European sovereign debt” crisis of 2010 could be resolved. The resolution involved the Euro-Area (countries using the euro) establishing voluntarily a $1 trillion fund to make direct loans to the troubled countries (on the condition of strict reforms to be approved and enforced by the IMF), and later, for the ECB to break historical precedent by (1) extending large loans to euro area banks to restore financial stability (“the ECB will do whatever it takes…”) and (2) to support euro-area government bonds in secondary markets, in a form of “quantitative easing” to encourage recovery. Between these two efforts, the ECB’s contribution, which involved employing several trillions of euros in market interventions to provide liquidity, was by far the more important in ending the crisis.

But the sovereign debt crisis clearly revealed some major flaws in the euro system. It was not a typical federal system that could impose fiscal policy and enforce standards on the members, nor did important members of the system want it to be so if that would mean extending a mutual guarantee of member country debts. Indeed, the German constitution prohibited participation in such guarantees and a seminal case was brought to the German Constitutional Court to decide what, if anything, Germany could do to assist other countries in the debt crisis. (It could participate in case-by-case relief but only if these were approved by the Bundestag.)

However, much was learned in the slow process of discovery of what was possible. There was much give-and-take, and many ideas were proposed by the European Commission (the EU’s executive authority) that were not taken up, including jointly-backed Eurobonds, a Banking Union with common deposit insurance for euro-area banks, a European Monetary Fund to act like the IMF for euro members, and a financial transaction tax to help pay for such reforms. On the other hand, a step was approved in 2011 to require members to limit their budget deficits and debt-to-GDP ratios, and the temporary European financial stability fund that assisted Greece, Ireland, Portugal and Cyprus, was renamed the European Stability Mechanism and made permanent. 

Most important, however, was the agreement of the euro-area countries to authorize new and substantial interventionist and regulatory powers for the European Central Bank, which gave credibility to the euro-area’s willingness to do what was necessary to end future crises. This important shift in the role of the ECB came about with the appointment of the former Bank of Italy head, Mario Draghi, 71, an activist former head of the G20’s Financial Stability Board, to replace Jean Claude Trichet, a traditionalist former head of the Banque de France. Draghi knew that the considerable resources of the ECB would be necessary to regain the confidence of financial markets in the euro system, but he had carefully to gain the support of the various European heads of state (and the US Treasury and Federal Reserve) to do so.

The Sovereign Debt Crisis, however, made it clear that the EU was a two-tiered economic system, with some members (the euro-area) operating according to one set of rules (which became much more restrictive during the crisis), and the non-euro members working under different rules that were mainly related to trade and the four freedoms of the Single Market Act. Several of these latter countries, especially some from Eastern Europe that were able to enjoy growth rates higher than those of the euro-area as a result, were not eager to see more powers accrue to EU institutions.

Of course, all this made Draghi very controversial.  Many in Europe (especially in Germany), believed he had usurped and applied powers never intended under the Maastricht Treaty. He used massive ECB resources to intervene in markets that some thought ought to have been left free, and had directed that new European controls and regulations be applied to large banks that had previously only had to contend with more lenient and forgiving national rules.

By 2012 it was clear that the EU had evolved into a “confederation” (a voluntary association of states for a common but limited purpose) and the euro-area into something more than that but still far less than a federalized fiscal union, i.e., a centrally administered tax and spending regime that absorbs most of the sovereign economic powers of its member countries. Most of the EU members are protective of their sovereign powers, and their voters are reluctant to give them up, so increasing the federal function of the EU is a tall order. But, as the Sovereign Debt Crisis revealed, tall orders can be less tall in extremis.

In a confederation there are no fiscal powers so economic management hangs on monetary powers delegated in this case to the ECB, making it the most important institution in the EU.

Christine Lagarde is the best possible choice to replace Draghi. She worked with Draghi for eight years on these and related problems and was one of the insiders in addressing the Sovereign debt crisis. She is known in Europe as a skillful politician (abilities needed in the job) who is respected by all of Europe’s heads of state and financial officials. She is the former head of the world’s largest international law firm, Chicago-based Baker McKenzie, speaks several languages and is a former member of the French national swimming team.

She has no experience in central banking but this is of no importance – the ECB has an outstanding professional staff of economists and bankers upon whom she can rely, just as she did at the IMF. What the EU wants is someone able to get the most out of its most important institution.  Europe’s future is very unclear, with populism, Brexit and member country discipline all creating new financial challenges for the EU. Lagarde is the one for the job.
So, addio e grazie Mario, and bienvenue, Christine, et bonne chance.

Tuesday, May 14, 2019

Will FinTech Companies Disintermediate the Banks?

By Roy C. Smith

Regulation following the Financial Crisis of 2008 has tied the global banking industry in knots, especially the European portion of it.  Increased capital requirements (relative to risk-adjusted assets), decreased leverage, requirements for liquidity, stress tests and fears of litigation for products or trades that go wrong -- along with serious damage to reputations -- have forced most large banks into subdued “regulated public utility” business models, from different from the opportunistic, trading oriented, integrated capital markets/commercial banking model that all adopted after the repeal of Glass-Steagall in 1999.

So, the financial services industry is now vulnerable to attacks from outside the industry, especially from those aiming to use modern technology in various ways to secure competitive advantage.

A new financial industry – Financial Technology (“FinTech”) – has already risen to challenge the old by offering new ways to use modern software and Internet technology on a (much cheaper) non-banking regulatory base to disintermediate traditional financial products (mortgages, personal loans and deposits, trading, asset management, and transaction processing). And they have been quite successful so far by reducing the cost of and access to financial products to tech-savvy retail users. Quicken Loans is now the country’s second largest mortgage provider; in 2017 five of the top ten mortgage providers were non-banks that accounted for $114 billion of mortgages. Lending Tree is the leader in the non-bank digital lending market place, providing $41 billion of personal and commercial loan originations in 2017, and a variety of “robo-advisers” accumulated $181 billion of advisory assets under management. In addition to these sectors, FinTech activity also is spreading to insurance, payment processing, and blockchain management. All of these sectors have been growing much faster than their banking industry peers, but because of the vast size of the global financial services industry, their cumulative market shares remain small. Risks associated with FinTech activities, so far, have been minimal - exposures are diversified over large numbers of relatively small separate accounts.

In February 2019, Forbes published its fourth top-fifty FinTech list. The top five firms on this list had combined (estimated) market value of $50 billion. Some have already gone public, others are “unicorns” (financed by private equity funds) waiting their turns.

FinTech firms compete on the basis of accessibility, price, convenience and the ability to gather customer attention in fresh and innovative ways. Accounts can be opened and deposits made in no time. Loans can be obtained without guarantees or collateral after filing out an on-line form for an algorithm to process. Costs of trading and execution are competitive with on-line brokers. But, so far, these low-overhead entities are not subject to banking and securities regulation, nor are they entitled to Federal Deposit Insurance.

FinTechs do not have large balance sheets, and so must sell off the loan/deposit packages they generate, either to FNMA (for qualifying mortgages), or to banks, the institutional or securitization markets. This, however, exposes FinTech firms to wholesale rates set by the interbank markets (to which FinTechs do not have access unless they have a partnership with a bank). In other words, after a certain amount of grabbing of low-hanging fruit, the FinTechs don’t add much economic value to the markets they hope to serve, especially to larger customers. They do hope to operate on a small business friendly basis, and at a lower cost because of lower overhead and regulatory costs.

FinTech risks can involve faulty algorithms that don’t keep up with quickly shifting changes in the consumer credit market, liquidity squeezes when mark-to-market accounting requires write offs just when assets need to be sold and new investors are scarce. Further, large retail banks will fight back – Goldman Sachs and Citigroup have announced major digital banking initiatives.

FinTech investors will do well to remember the tech revolution of the 1970s when approximately 100 PC hardware manufactures competed to dominate this new industry. Investment banks clamored to underwrite new issues of securities issued by companies with no profits.  Only a handful of these companies have survived. The early days of the Internet provided a similar scene of B-to-B and B-to-C innovation that also left only a few firms on the field after the “tech wreck” of 2000-2002. Those that disappeared either went bankrupt went bankrupt when roll-over and working capital finance dried up suddenly (many did), or were successful in quickly selling their firms to larger competitors like Microsoft that used high-priced stock to acquire technology they didn’t have.  There have always been profits to be made in technology revolutions, but big losses too.

Tech revolutions often start with attacks on stogy industries that need restructuring and renewal, and can raise capital because their undertakings are the newest new thing. The various financial service industries are now in the cross-hairs. The established financial services firms, particularly the banks, are also trying to adjust their business models to utilize technology to lower costs and make things work better. Some banks will make successful business model transitions, but many won’t and will be broken up and restarted by new investors supporting FinTech applications. Some of these may be large non-financial, tech heavy corporations like Walmart, Amazon or Apple  

But in the end, all finance involves other people’s money and requires regulation. Non-banking entrepreneurial ventures are not the same once they are captured by the regulators. Competition too is different in markets willing to take risks for small gains. The list of large non-banking firms that failed in taking over investment banks and brokers in order to turn them around is very large and includes such companies as General Electric, Prudential Insurance, Sears Roebuck, and American Express.

Still, Fin Tech firms have been able to attract start-up capital readily, some from private equity firms that intend to provide funds for promising companies to grow as fast as they can without worrying about profits, then selling to another financial service company or going public, much like Tesla, Lyft and Uber have done. But when bubbles burst, profits are hard to find. Uber’s stock is down 18% since its IPO, Lyft’s is down 33%, and early FinTech darling, Lending Club, is down 86%.

FinTech is here to stay, but not all the FinTech companies are.  The financial services industry needs the know-how, the energy and the new product innovation that FinTech represents, but a lot of it will come from tech engineers hired by the banks, such as Goldman Sachs at which computer engineers now represent a quarter of the firm’s total headcount.

Monday, May 6, 2019

Bridging The Public Pension Fund - Infrastructure Gap

By Clive Lipshitz and Ingo Walter

During the State of the Union address, President Trump issued a renewed call for an infrastructure bill. Two days later, the House Committee on Transportation and Infrastructure held its first hearing of the new Congress to address the state of U.S. infrastructure. Confronting the nation’s infrastructure gap is one of the rare bipartisan issues in Washington today. It is a priority for the American public and for elected officials at the federal, state, and local level, all of which make it a likely legislative focus for both the 116th Congress and the Administration.

That U.S. infrastructure needs improvement is not news. Any discussion about closing the $2 trillion 10-year investment gap quickly zeros-in on funding – revenue streams in the form of dedicated taxes or user fees – and financing solutions. While there are perfectly suitable public finance tools, a large pool of untapped available capital resides in the retirement funds of public sector workers. In a new, detailed study of the $4.3 trillion U.S. public pension system, we’ve investigated the infrastructure investments undertaken by the largest public pension systems in the country. Our findings suggest now might be the perfect time to match pension capital with infrastructure investment needs, creating winners on both ends of the financial chain.

Infrastructure assets have features that are appealing to pension investors. They are long-duration and offer some degree of inflation protection. They are not correlated with the other asset classes so they offer much-needed diversification. Best of all, they generate steady cash flows to meet the needs of current retirees. These are among the reasons pension funds have cited when establishing programs to invest in infrastructure, and our analysis bears out most of these benefits. Still, infrastructure investment programs in big American public pension funds are relatively recent and they remain small – averaging less than 1% of fund assets.

Implicit in public pensions’ investment objectives is to accumulate cash flow-generating assets and hold them for a long time. Yet when pension funds invest in infrastructure, they typically invest in private equity-type funds that often have first-rate expertise but seek capital gains, not current income. And the funds usually buy infrastructure assets from other private owners. These investments have generated strong returns in the form of capital gains, benefitting substantially from rising valuations. Infrastructure assets now trade at multiples well in excess of those in other investment classes such as real estate and private equity. But these investments don’t generate much in the way of the cash-flows pension funds need to support current retirees. Bottom line: Insufficient investment in infrastructure as an asset class, using the wrong investment vehicles, and for the wrong purpose. There are better solutions.

To explore ways in which pension capital might evolve into a financing solution for U.S. public infrastructure, we might look to models that have been successful in other countries.

In Australia, asset recycling is a financing tool that has been used successfully to “repurpose” infrastructure capital. Public sector agencies sell long-term concession rights on existing infrastructure to investors (including pension funds) and use the proceeds to finance development of new infrastructure. The public sector retains ownership of the legacy assets, receives cash proceeds to develop new infrastructure, and avoids burdening its public finances with more debt. Private investors get a stream of proven cash flows from existing infrastructure over a fixed period of time. The federal government often provides an incentive in the form of a top-up of the proceeds from the concession sale.

True, institutional investors like pension funds are wary of investing in ground-up development -- they are properly concerned about cost overruns, delays, and unpredictability of revenue streams. But pension systems are uniquely positioned as informed and influential players in regional and local economies. Just one example: The Quebec pension fund, CDPQ, developed and operates Montreal’s light-rail system and was able to assemble the financial and technical resources and muster the political support to pull it off.

Among the other ways to deal with infrastructure project risk is partnering pension capital with the knowhow of EPC (engineering, procurement, construction) firms, which have extensive experience in designing and delivering new projects. Dutch pension funds, for example, have invested alongside engineering firms in new road construction projects.

Of course, using pension capital on public works requires strong governance to avoid white elephants, waste, and bloated costs. The presence of private capital can provide necessary transparency and discipline. And there is an argument for investing pension capital locally. If done right, it can generate economic development, which in turn leads to more jobs and more tax revenues – ultimately favorable to sustainable pension finance. Additionally, when pension funds invest directly in infrastructure, they don’t introduce the political risk of transferring “crown jewels” to private investors.

Most important is to put in place mechanisms that will allow for an improved flow of investable U.S. infrastructure assets. When that becomes evident to pension fund administrators, they will become more comfortable expanding their allocations to this attractive asset class – perhaps to the 5-10% levels that are common in Canada. This will provide hundreds of billions of dollars in incremental financing which will go a long way to reducing our infrastructure gap.

Clive Lipshitz is managing partner of Tradewind Interstate Advisors. Ingo Walter is Professor Emeritus of Finance at NYU’s Stern School of Business. Their study “Bridging Public Pension Funds and Infrastructure Development" has been released in the spring and is available on SSRN.