Nov 10

Schumpeter, Minsky and me: Long waves in British financial markets – Part 2

My analysis indicates that we are now in the downswing of the fifth long wave in British financial markets since the Industrial Revolution. The upswing ended with the international financial crisis of 2007–09, and one would expect that the downswing will endure for between 20 and 25 years and evolve in two phases, each lasting approximately a decade: a recessionary phase which is now coming to an end, when the bad debts built up to fund speculative investments during the final bubble of the upswing are progressively liquidated; followed by a recovery. The recovery is likely to be characterised by consolidation, defensive mergers and the emergence of innovations that will drive the next upswing. As Kondratieff observed, “during the long wave downswing, a large number of important discoveries and inventions are made, which however are usually applied on a large scale only at the beginning of the next long upswing.”

The inflection point of each of the five long waves was marked by a major financial crisis, which is now sometimes termed as a Minsky Moment, after Hyman Minsky (1919-1996). Minsky was a student of Schumpeter at Harvard University during the 1940s, and like Schumpeter and Keynes, he recognised that capitalist economies do not converge to a stable general equilibrium in the way set out in conventional textbooks, but rather progress in a cyclical fashion. He also recognised that credit-financed speculation drives economies far above their natural rates of growth towards the end of the long wave upswing, leading inevitably to a financial crisis. These crises are the economic equivalent of a heart attack, when the entire financial system seizes up and there are widespread banking failures.

Individual banking failures can occur at any time. What is different about Minsky Moments is that they go beyond the failure of one or two individual banks in isolation, to a wider systemic collapse which ripples from one institution to another causing severe credit contraction and choking off the normal flow of funds from savers to borrowers.

Such moments occur once in a generation, and mark the inflection point from upswing to downswing. They are clearly identifiable in each of the five long waves since Industrial Revolution:

1. The Industrial Revolution
Upswing: 1785–1814
Inflection point: 1814–15
Downswing: 1815–1844

2. The Railway Revolution
Upswing: 1844–1873
Inflection point: The Panic of 1873
Downswing: 1873–1896, aka the Long Depression

3. The Automobile Revolution
Upswing: 1896–1929
Inflection point: The Crash of 1929 followed by banking crises and collapse of the Gold Standard in 1929–1932
Downswing: 1929–1948: The Great Depression followed by the Second World War

4. The Aerospace Revolution
Upswing: 1948–1971
Inflection point: The Secondary Banking Crisis of 1972–1974
Downswing: 1972–1992: The collapse of the Bretton Woods system followed by Stagflation during the 1970s and Recovery during the 1980s

5. The Internet Revolution
Upswing: 1992–2007
Inflection point: The International Financial Crisis of 2007–2009
Downswing: 2007 –

After each inflection point, the British Government of the day responded by introducing reforms to restore confidence in the banking system.

Paradoxically, my observation is that the safest time historically to invest in bank securities is in the aftermath of a Minsky Moment. It is such a cathartic event that the last thing survivors are likely to do is to repeat the mistakes that brought down their competitors. Gone are the reckless lending practices of the upswing’s final bubble. Gradually, bad and doubtful debts within the banking system are written down. The capital base of surviving banks is rebuilt to more prudent levels, often at the behest of the regulatory authorities. The priority of Bank Directors is to ensure their own survival. Above all, they seek to avoid the scandals and imprudent lending practices that destroyed the reputations and careers of their predecessors.

At the same time, new banking institutions emerge. Today they are called Challenger Banks, which are building up their loan books and market share at the expense of long established incumbents – banks like Virgin, Metro, Aldermore, First Direct and OneSavings.

During the period that follows a Minsky Moment, yields on bank bonds are likely to be exceptionally high, coming down only gradually as a fragile confidence returns.

Thus, somewhat to my surprise, running the numbers through my spreadsheets, I find that, today, the highest yielding security yet to be included in the Experimental High Yield Portfolio are a class of perpetual subordinated bonds issued by OneSavings Bank. This is despite the fact that the bank has reported excellent financial results, with new loans and advances of £986 million in the first 9 months of 2015 increasing its total loan book by 25% to £4.9 billion, accompanied by strong margins, a sound capital base and upward re-ratings by most analysts tracking the stock.

So the Perpetual Subordinated Bonds issued by the bank become the ninth security to be added to the portfolio.

Issuer OneSavings Bank plc
EPIC 1SBA
Coupon 6.591%
Maturity Date Undated, but callable on March 7th 2016
Payment Dates Half yearly on March 7th and September 7th
Offer Price 95.7
Running Yield (at Offer Price) 6.9%
Yield if called (at Offer Price) 16.3%
Nominal Amount £1,000
Cost £968.95 (inclusive of £11.95 accrued interest) + £5.75 commission = £974.70

MJN
November 10th 2015

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