7 Ways the Recession Will Ultimately Improve America

These things gotta happen every five years or so, ten years. Helps to get rid of the bad blood. –Clemenza, The Godfather

The recession is undoubtedly a very difficult time for America and the rest of the world. However, during this rough period, its important to realize that things will get better. Here are 7 areas and ideas that will emerge stronger when the economic crisis subsides:

1. Risk will be decentralized and distributed among more, smaller entities. If you were a shareholder of a major investment bank or brokerage, you made phenomenal profits from the late 1990s to around 2007 because all of the “big 5″ – Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley took sizeable proprietary risk on their own books and won as the market was rising and “normal”. However, in the last 18 months, all of those profits and much more have been wiped out because of these same proprietary positions. The problem all along was that few of the proprietary trades were actually generating alpha — that is, excess returns when the investments were adjusted for risk. Instead, they were largely just bets that were 99.9% likely to win, but had a 0.1% (or less) chance of wiping out far more than what they had risked. In the last 2 years, that tiny chance happened, and it took down all the risk takers and decimated models that hadn’t taken into account “tail events”.

   One of the biggest issues was the fact that these 5 brokerages, and others, had grown into financial supermarkets. They traded every product in existence, and the risk between the products was poorly analyzed and managed. Shareholders who bought Merrill Lynch because they thought the private client retail brokerage business was good ended up seeing their money lost to the black hole of CDO writedowns. While there is a definite element of caveat emptor to anyone buying a public company, it is becoming increasingly apparent that nobody fully understands the complex interactions between complex products held by a huge bank. Going forward, investors will be far more careful to separate the risks that they’d like to take. If they want to own a financial trading company because they think there are good returns to be made in facilitating the crossing of trades between hedge funds, they will buy a company that takes very little risk of their own and instead makes money by acting as a broker for low-risk crossing of securities. If they want exposure to a certain market segment or manager, they will invest in ETFs, mutual funds or hedge funds with more structure and oversight to risk taking than the large banks are likely to have. By allocating funds among smaller, more focused entities, investors will be better able to manage and understand the risks in their own portfolios.

2. The financial system will be forced to get rid of large, “too big to fail” behemoths. The other critical concern to the “financial supermarket” model is the impact of the failure of one of these massive firms across the financial system. With leverage, we have seen that one bad area of a company can take down the entire firm. Before derivative contracts were widely used to link risks across the economic system, failure of a firm simply meant that customers needed to find a new brokerage. However, now that hundreds of trillions (conservative estimates put the derivative market notional outstanding at over $280 trillion) of outstanding derivatives contracts link banks together, theoretically a few bad bets by one desk of one bank can then take down that entire bank, which can then fail on derivatives contracts to other banks. The system is far too intertwined in its current incarnation, and needs to be revised.

   The revision will come in part from nationalization and in part from “hiring away” the best members of desks at big trading firms that are subject to the TARP. Since a smaller shop can set up a trading division and not have to worry about restricting incentive compensation, there is huge opportunity for a profitable trading desk to simply leave the large banks and begin trading at smaller places. Before, boutique firms were restrictive because they didn’t have enough capital needed for flow traders to work most effectively; but with capital restrictions affecting desks at even the biggest firms, this is becoming less of an issue. There is definitely still very good money to be made in financial services, so many businesses will remain attractive. The difference will be how they are structured and focused, and that will be the distinguishing factor between the firms of the 2000s and the firms going forward.

3. The reduced allure of Wall Street will encourage the smartest students to start companies or develop new technologies. While I don’t think all the money is gone from finance, I think at least the easy money will vanish for a while. The money remaining for the time being is in hedge funds, and they predominantly hire established traders. For the next few years, it will be difficult to get a great job at either a bank or a fund, so the temptation for engineering students to go into finance will be lessened. Whether this translates into more students opting for engineering careers or simply shifting to another field remains to be seen, but more engineering candidates means more innovation for the country. For more on this, see my earlier post titled Trade Idea: Sell Wall Street, Buy Science
4. Companies that used to be able to survive in a good economy by clinging to old business models will be forced to modernize or perish, and new companies will have a chance to replace the old ones. Traditional newspapers are a prime example. The business model of “deliver newpapers to homes and newstands and make money on advertising and subscriptions” has been showing signs of weakness for over 10 years — since the widespread adoption of the internet. Young people have never grown accustomed to reading their news from a newspaper, and now overwhelmingly get their news almost entirely from the internet.  Since the distribution model no longer works, does this mean that traditional news sources like the New York Times cannot make money and should simply shut their doors? Clearly there is still tremendous value in traditional reporting and the news it produces. However, blogs are stepping in as alternative, often first-hand news accounts that can complement, and in some cases, replace other news outlets. For an example of this, look no further than The Drudge Report, which got its popularity as the first site to break the Monica Lewinsky story years ago. Since then, blogs and other alternative news sources have only gotten more important.

   Without a doubt, some newspapers will go out of business because they are unable to transition their business model to effectively make money on the internet. Other papers, on the other hand, will successfully make the transition and become even more successful because of it. The internet is an amazing thing, and if you’re the best news source on the web, you can make far more money than if you’re the best source in New York City. The increased competition and a greatly leveled playing field will cause the best businesses to naturally rise to the top while the worse performers are filtered out.

5. Internet ad-based revenue models will begin to give way, leading to new models based on hard revenue. Since the beginning of the internet, much of it has been free, supported by only ads, because there was no effective way of collecting tiny payments from visitors in return for content. The processing costs to charge someone, say, $0.01 or even $0.001 for reading an article on a blog was prohibitively expensive, so advertisements became the only source of revenue that a site could rely on. As advertisers reduce the rates they are willing to pay for “clickthroughs”, the advertising model begins to deteriorate, and content providers must begin to seriously look at alternatives.

   On the surface, the end of the completely “free” internet seems like a bad thing, since we have come to expect everything online to be free. However, done effectively, micropayments have the potential to be a game-changing development. Imagine if you could, at the beginning of each month, buy $10 worth of micropayment “credits” that you could use to pay for sites in increments from $0.001 to $0.20. Popular sites could charge a penny or less, and make plenty of money to hire the best staff and provide the best material. Using the newspaper example from above, a premier news provider like the New York Times could charge a tiny amount per user and still make enough money to be a viable company. Sites that were able to thrive on advertising alone could remain free, of course, but the ability to charge small token amounts for content would likely create entirely new and interesting sites and business models that are currently unavailable for the price of free.

6. Companies will look deeper into their operations for ways to reduce costs, which will give an opportunity for new technology products and players to break into the corporate landscape. During the last few months at my previous employer, the company made a concerted effort to identify and cut wasteful spending in areas that were overlooked during earlier bull market times. As we move deeper into a tough economy, more and more companies will scrutinize their existing operations for areas where they can save money and optimize procedures. This process will create an opening for new players in the corporate game that can enter with the promise of lowering costs and simplifying maintenance.

   When times are good, companies are more willing to stick with their current setups that may be old, outdated and expensive, simply because they lack the impetus to really delve deep and cut costs. One very extreme example of this is Microsoft Office. Nearly every corporate employee has Word, Powerpoint, Excel and Outlook on their desktop. However, for almost all of them, these programs are overkill — for their basic word processing or presentation needs, there are several software packages costing little or nothing that could easily suffice for all but the most advanced users. Take, for instance, OpenOffice or Google Docs — both allow you to create Word-format documents and easily share them among co-workers. In a pinch, a company could switch to one of these alternatives and save hundreds per user per year in licensing fees. Perhaps an exaggerated example, since Microsoft Office is ubiquitious on the enterprise scene, but I am confident that any office has dozens of examples of software and other licensed services where they could find alternatives that retain 95% of the capabilities for 20% or less of the price. Companies don’t look for these types of opportunities in good markets, since the profits of the business far overshadow the expensive support costs, but in times where every dollar counts, this is a great area for new businesses to step in and gain a foothold in the corporate market.

7. With less “free money” going around, people will have to genuinely innovate if they want to “get rich”. People can be roughly categorized into two camps — those who create value and those who maintain value. Those who create value — like Bill Gates, Steve Jobs and Warren Buffett — ultimately provide the jobs and incomes from the next tier who maintain that value. Bill Gates started Microsoft and made billions of dollars doing it — but the billions that he took home was only a small fraction of the value that he created, since thousands or hundreds of thousands of other people made money either directly or indirectly as a result of Microsoft. When the economy is great, those that maintain value can make a very good living for themselves as a result of being onboard a profitable company or having a position in a lucrative niche. In a poor economy, however, the ability to make outsized personal wealth by being a maintainer of value is less certain. Poor economies force people to be more creative if they wish to carve out wealth of their own.

   The creators of value undoubtedly have a more difficult time in a recession as well, but they are more in control of their situation and can more easily adapt than those that have “safe” jobs maintaining value that has already been created. Furthermore, since a steady paycheck is less certain than ever, the opportunity cost of leaving a job and starting up a business is much lower than its been in the last 5-10 years. Therefore, the ambitious people that want to “strike it rich” will be more likely to take risks at creating value, since the path of maintaining value is now less certain and more difficult than ever. Funding and startup capital remains a difficulty, but even that is not insurmountable, and the rewards in the end have the potential to be great. By starting something in a time where estabilished companies are being challenged, a lean newcomer has a rare opportunity to truly shake things up.