Lessons for Europe From the Global Financial Crisis
Are European investors getting sucker-punched by U.S. financial innovation?
January 9, 2009
One of the most profound statements of American pride can be viewed by travelers on the train route between New York and Washington.
Passing through Trenton, New Jersey’s state capital, approximately 70 miles outside of New York City, a bridge over the Delaware River displays a bold statement in even bolder neon letters.
In a clear sign of a bygone era, the message displayed in large capital letters along the arch of the Trenton Bridge proclaims categorically: “Trenton Makes, the World Takes.”
First installed in 1935, it referred to Trenton’s leading position in the manufacturing of goods such as steel, rubber, wire rope, linoleum and ceramics. The sign’s unequivocal message can only be properly understood as a throwback to an era when U.S. manufacturing dominated the world economy.
That part of modern economic history, of course, is well past. And yet that message still very much applies, as the current global financial crisis has made plain — albeit in a different sector of economic activity.
When it comes to financial products, especially presumably “cutting-edge” ones, it has typically been U.S. innovators (plus their London sub-arm) that ruled the roost. CMOs, CBOs, ABCP, TRSs — you name the esoteric product, many of them were shaped in the U.S. of A.
That sounds very much like a straightforward story of financial innovation. Clearly, premiums are to be earned by those — and in those markets — where the innovation occurs.
Since Americans are risk-takers and are in general bored by plain-vanilla stuff, it was only natural that it earned nice margins off these innovations.
But what about continental Europe? Financial markets there have been marred by overcapacity and a general aversion to financial innovation for some time. This was only made worse by a profound lack of innovative capabilities at home.
As a predictable result of all that, returns on capital in Europe’s home-made financial markets and products tended to be lackluster.
That would be disappointing, but not disastrous, if continental Europe’s financial managers at least had had a great deal of self-discipline. Unfortunately, that was not the case.
The best examples are the managers of Germany’s Landesbanks, state-owned institutions with large pools of assets on their balance sheets — and a sterling credit rating.
That made them a much-desired partner for the marketing and sales staffs of U.S. financial firms, who offload the credit risks they generate every day by dumping large pools of often-dubious assets onto those hapless European managers.
The sales pitch to these bankers was straightforward. If they wanted to achieve high rates of returns — as top managers of their institutions — they should buy these products. As advertised, nothing else available or produced in Europe itself offered yields that were even comparable.
As it turned out, it was a case of a perfect — but ill-fated — transatlantic complementarity. U.S. institutions were keen on removing from their balance sheets the credit risks they produce, and European institutions were keen to have risks on their balance sheets that looked safe, but offered high returns.
Truth be told, the U.S.-based issuing banks’ sales and marketing staffs were somewhat sadistic — because they knew full well that they were selling to parties that often should not be in the banking business in the first place.
After all, top bankers work where the salary is highest — in the investment banks. Second-rate bankers work for their leading national commercial banks, where the pressure of the markets is felt somewhat less.
That left the Landesbanks — and other state-owned institutions — as the employers of last resort for manager types who may have the dreams, but not the qualifications, of being a financial top gun.
In their own minds, these third-rate bankers were always at ease. First, if something went wrong, they could simply claim that everybody else in their sector was doing it, too. Beyond such references to herd mentality, they could also claim they were “cheated by the Americans,” who had sold them bad products.
And if the whole thing blew up, as it did, even that scenario is not so bad. They had gotten to pursue their dream: Act the role of a big financial boss, while playing with plenty of other peoples’ money.
That, however, is exactly where the problem lies: Europe is an aging continent with vast pools of money gathered by a retiree (or near-retiree) generation on the back of the economic boom of the second half of the 20th century.
Given widespread risk-averseness, a general inability to create innovative products and a desire for high returns, that old world of Europe is destined — and doomed — to take what “Trenton” (in the sense of the wider New York area) “makes.”
As a result of these significant shortcomings, a lot of the financial cancer represented by subprime loans ended up being held by European institutions and investors in their desperate and ill-advised desire to chase yield.
In hindsight, Europe would have been much better off if its financial markets had been consolidated to a point where the twin problems of over-banking and large pools of assets chasing yields had been addressed in the appropriate manner.
In essence, that would mean reshaping European business and finance in a more risk-oriented manner — so that investors could take on promising financial risks in Europe itself, for example, by betting on homespun entrepreneurial ideas that promise a significant payoff.
Of course, for this to happen in a real manner would involve a sea change in Europe’s corporate and social structure. And because that did not happen in time, European investors ended up as the hapless “takers” — adding lots of financial risks made in America onto their own balance sheets.
The sign on that bridge across the Delaware River is still true, albeit not in the world of manufacturing. What the New York area makes, the (old) world still takes.
Europe is destined to take what "Trenton" (in the sense of the wider New York area) "makes."
Much of the financial cancer represented by subprime loans ended up being held by European institutions and investors in their desperate and ill-advised desire to chase yield.
Count on European investors being the hapless "takers" — adding lots of financial risks made in America onto their own balance sheets.
In hindsight, Europe would have been much better off if the twin problems of over-banking and large pools of assets chasing yields had been addressed in the appropriate manner.
The U.S.-based issuing banks' sales and marketing staffs knew full well that they were selling to parties that often should not be in the banking business in the first place.