It seems to me I haven’t read anything at all about the real issue with the financial industry. Yesterday, a Fox Financial Industry analyst went on about the new taxes that the Obama Administration was intending to impose upon the financial services industry and how they were shortsightedly killing the engine responsible for financing and bringing innovative new companies to market. Oh really? We haven’t had any meaningful investment in innovative new public company formation in nearly ten years. A realistic look at our history is in order.
The growth engine for the US Economy for nearly twenty five years has been innovative new company formation, most of it in information technology and biotech companies. It will be that way for the foreseeable future until rising standards of living cause labor costs to come more into line across the globe. Fortunately, the US has had the world’s premier innovation infrastructure and an economic engine to go along with it for most of the last sixty years. That economic engine broke down with the 1999-2000 “dot-com” implosion. How did that happen? Economic support for technological innovation is a three tier system in this country, one that has worked remarkably smoothly since the early fifties. Basic technological advances come from government and corporate sponsored research conducted by the nation’s premier research universities, from business funded industrial research laboratories, and out of direct government conducted research at places like the NIH (National Institutes of Health). The seed level support necessary to commercialize these advances comes mostly from private financing which is far and away the most important funding source for new technological innovations. Enterprises that demonstrate promise get late stage investment leading to an Initial Public Offerings from Investment Banking firms. It is this late stage private Investment Banking support that has dried up completely since the “dot-com” crash in 2000.
Beginning in the seventies, a two tier investment banking model evolved. First tier Investment Banks filled the need for a mature investment banking presence that could work with the growing venture capital marketplace and provide an “exit model” for well run start-up companies that were ready for the public market. These first tier investment banks survived by providing a steady stream of new companies that both survived and thrived in the market-place after going public. The top tier Investment Banks (e.g. firms like Morgan Stanley and Goldman Sachs) periodically recommended new companies for investment to wealthy individual and institutional investors when the risk profile for new company formation was deemed attractive in comparison to other investments. In the world of start-up companies, this was known as “opening the IPO (Initial Public Offering) window”.
Throughout the eighties, advances in computer technology and developments in creative financial engineering radically changed financial services. Beginning with the Options Market in the late seventies, concepts such as “portfolio insurance” (the cause of the 1987 crash) and junk bonds became popular. Next came derivatives and “off-book” corporate financing, the source of the Enron debacle. Eventually this led to the housing crisis and the current recession, the causes of which are well documented. The last thirty years have possibly been more transformative in the financial services industry than any other. The result has been a radical transformation of investment banking. The most innovative and creative financial products (and some would say the most dangerous) were created outside the traditional financial services industry. Eventually, they became almost the exclusive products of Hedge Funds like Long Term Capital Markets (LTCM), famous for its legendary melt-down. Hedge funds have became so profitable that traditional investment banks have had no choice but to begin to act more like them. Into this mix came the “dot-com” era. The newly empowered “profit above all else” mentality of investment banking, coupled with the irrational appeal of the Internet created a toxic mix. Ironically once the traditional Investment Banks realized how strong the demand was for new internet ventures, they acquired the first tier investment banks and began creating IPO’s for the same unproven companies their new subsidiaries had once worked so hard to screen from the public market. After the crash, like many investments that have gone bad, no one wanted to touch an unproven IPO.
The result; during the last ten years we have had a one third reduction in the growth of wages and new job opportunities when compared with the nineties. This is the so-called “jobless” recovery from the 2000-2003 recession. We are currently facing a similar prospect following this recession. Compare some of the numbers. During the period 1980 through 2000, the number of new jobs created in information technology and biotech almost exactly matched the total number of new jobs created in the entire economy. Throughout that same period, the total amount of venture capital available in the United States averaged about $30B per year. Compare that with the hundreds of billions expended each year in risk-based investments conducted by investment banks and hedge funds. Consider further for a moment what the US economy has gained (or lost!!) as a result of that investment. Finally, look at what has happened to the country’s competitive position. Near the end of the semi-conductor era, analysts wrote off the ability of the US to compete in chip manufacturing; conventional wisdom said that business would go to Asia with lower labor costs. Silicon Valley Venture Capitalists knew better and continued to fund start up ventures in the areas of programmable logic chips and semi-conductor equipment manufacturing. Essentially they recognized and funded the segments of industry reflecting the United States’ lead in intellectual property. These businesses now contribute 20% of the revenue in the chip industry. When the dot-com crash occurred, all domestic investment in internet technology ceased. The sudden retreat opened the door for an entire generation of Chinese and to a lesser extent Indian entrepreneurs. To ensure the continuation of this trend, China, along with most of our other major competitors use state run or “sovereign” investment funds to channel investments into areas deemed important for the growth of the local economy.
This is not a pitch for government picking winners and losers. It is a pitch for appropriate government intervention in the financial markets to level the playing field for financing and bringing innovative new companies to market. I am not sufficiently knowledgeable to know whether the new financial regulations will do the trick, but I suspect they will not. Rumor has it that John Mack, the CEO of Morgan Stanley, has been a proponent of restoring the old two tier investment banking model. That would be a good start. It might also be a good idea to look at the Capital Gains Tax and create a penalty in the form of higher Capital Gains Taxes on financial industry profits created solely through high risk investments in market speculation or derivatives. We could also lower Capital Gains Taxes on profits from new business investment. Or do both. In short, if we’re going to fix the system, let’s do it in a way that helps us continue to lead the world in innovation.
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