Demand for financial engineers rises and falls with asset inflation. So there is nothing odd about these professionals now enjoying a good market for their services. But why is Big Tech such a large recruiter?
The art (not science) of financial engineering – camouflaging a rise in leverage which boosts present and future earnings for the purpose of sustaining a bull equity run – is most sought after when irrationality in capital markets is at its strongest. That occurs in a monetary inflation featuring virulent asset inflation as its most obvious symptom. Hunger for yield or irrational exuberance means that sober rational cynicism which would help investors spot the engineers’ camouflage is abnormally weak.
Even so, one might have imagined that the Big Tech companies, given the fantastic nature of their profits (excluding Amazon which many analysts would not put in the Big Tech category), had a seductive enough narrative to spin without employing financial engineers. But with present equity values of the FAANMGs (Facebook, Apple, Amazon, Netflix, Microsoft, Google) reaching to the sky, it seems that engineers are needed to sustain the belief in persistent exponential earnings growth. And the financial engineers may also be helpful in dealing with those huge cash piles built by present monopoly power which could invite the scrutiny of regulators, anti-trust authorities and tax-hungry governments.
The force against which financial engineers fight is the rational perception that earnings due to a rise in leverage should not add to equity value. That is what we learn in Finance 101 under the lecture title of “The Modigliani-Miller Theorem.” According to this, if shareholders could have effected on their own personal account whatever leverage change the company makes, then they would not pay a price for any boost to reported earnings deriving from this.
Specifically, in those stages of asset inflation when interest rates are very low or even negative, companies can bolster their earnings per share and earnings return on book equity capital, as measured by the accountants, by adding to debt outstanding and retiring equity. But the rational shareholder would not pay any extra for that reported boost. He could have achieved the same result by adding to the leverage of his personal portfolio or reducing the amount of safe bonds – meaning less negative leverage.
Yet we know that in practice during asset inflations, rapid earnings per share growth bolstered by the financial engineers seems to work wonders. Indeed the implicit profits stemming from leverage (not disclosed) are multiplied by the same high price-earnings multiple to justify inflated equity value. Moreover, when the price of equity is climbing, leverage ratios calculated at market value (of equity and debt) may actually be falling despite the engineers.
In performing their skills inside Big Tech the financial engineers are not dealing with leverage in its usual...