WHEN AS a young journalist I first started writing about business, my total lack of experience was saved by two pieces of advice that I have blessed ever since. Robert Heller, my first editor, dispatched me on an initial assignment for Management Today with the words: ‘Don’t believe anything until you see it with your own eyes.’
And a shrewd City PR punctured any remaining gullibility by pointing out that whatever people like him said for public consumption, there was little in business that hadn’t been seen before. Wait long enough and the cycle will come around: what goes up almost always ends by coming down. As well as sparing me acute personal embarrassment (well, mostly), these common-sense lessons have a wider application to business generally – as events of the past few weeks demonstrate. If companies had paid more attention to such hoary basics and less to the blandishments of City and Wall Street slickers, the world economy wouldn’t be in the mire it is wading through now.
The visibility test ought to be a basic one for any investor or manager, particularly when bubbles are in the air. In the internet boom of the late Nineties, the inflated valuation of web start-ups was the direct result of investors taking the business model – how they would make any money – on trust. Not trusting their own eyesight, they allowed the internet emperors to convince them that virtual clothes were the same as real ones.
That seems inconceivable now: yet the hedge fund and private equity-fuelled binge just ending was similarly based on an optical illusion. As Warren Buffett, the undisputed Olympic champion of investors, points out, extracting more from the economy than its constituent companies create in value is a logical, physical and financial impossibility.
Yet that’s what the purveyors of today’s modish financial instruments wanted us to believe, and they found many willing buyers who have come to count the cost. The frictional costs charged by financial intermediaries are now a burden of 20 per cent on corporate income, Buffett says – income that otherwise would come straight through to investors and pension funds. One more time: if you can’t see it, you can’t weigh it and you can’t trace an owner, it probably doesn’t exist.
Northern Rock is a good example of what happens when a company succumbs to this kind of voodoo economics, precisely because it is a company that wanted to be, and by its own lights was, ‘good’. Firmly identified with its northeast roots, it is devoted to its community and full of philanthropic and cultural good works. It gained much respect during the miners’ strike of 1984-85 by declining to repossess the houses of strikers unable to pay their mortgages.
Alas (another useful lesson), social responsibility doth not on its own sustainable corporations make. Dazzled by the promise of outsize returns from the thin-air economy, Northern Rock turned itself from a boring old bank lender, requiring a deep knowledge of creditworthiness and asset values, to a trendy retailer of securitised loans and mortgages to hedge funds and CDOs (collateralised debt obligations), requiring a deep knowledge of opaque and arcane financial markets. It wasn’t borrowers that tripped Northern Rock, whether sub-prime or not: it was its own unbounded faith in what it couldn’t see.
Of course, everything is made worse by the failure to remember lesson No 2. Previous cycles have amply demonstrated that borrowing short to lend long can look smart in the short term, but can also turn you into a penniless idiot in the long. Similarly with debt in general. An ‘efficient’ balance sheet in the short term does not necessarily equip a company for success in the long term and, indeed, it may make success more difficult if it squeezes out the resources to innovate and grow. We shall certainly see this point underlined in the near future as one or more debt-heavy private equity chickens comes crashing home to roost.
Of course it’s easy to be wise after the event. But that is exactly what the two precepts are designed to avoid – particularly in financial services, whose products, although companies appear to have forgotten it, were meant to provide security rather than heart attacks. Whatever happened to banking prudence? The queues besieging Northern Rock branches in the first UK bank run for a century and a half tell a visible story of devastating loss of trust: an unfortunately deserved result for an industry that has steadfastly ignored the truism – and its own statutory advice – that what goes up can equally well come down.
It’s no excuse either that when gravity finally reasserts itself, as it always does, the pieces don’t always land in the original location. We ought to know by now that history is cleverer than that. Here’s a third piece of advice for the next time the financial cycle turns around. In Mark Twain’s words: ‘History doesn’t repeat itself, but it does rhyme.’
The Observer, 30 September 2007