Easy Money - Moral Hazard
Common sense tells us that tight money is bad for profits. The cost of money is an expense, and if money is hard to get, it limits the amount of capital available for expansion. Easy monetary policy promotes full employment and low interest rates, but, life is a paradox where all blessings are mixed. Easy money is like a drug that feels good for a while, but eventually leads to all kinds of bad behavior, and eventually to a crash and burn.
Below is a list of links to our feeble attempts describe a few examples of the bad behavior that were the intended or more often the unintended result of the moral hazard of easy money. This is not behavior that is unique to current times, but has been with us as long as there have been markets. One lesson is that without easy credit there would be no bubbles. It is an important lesson because the thing about bubbles is that sooner or later they always pop. Important though this lesson is it does not appear to be one that can be learned without pain it is like the lesson you learn by trying to carry a cat home by its tail. Nor is the memory of this lesson one that lasts very long, and it certainly does not pass from one generation to the next
Leaning Things the Hard Way IV - Moral Hazard
It is popular to blame deregulation for our economic collapse. Clearly what deregulation there was came at the worst possible time, and probably helped to make things worse, but deregulation did not cause our bubbles to form. For the bubbles we will have to give a lot of credit to our Federal Reserve, and particularly to Alan Greenspan. It may turn out that our problem was not too little Governmental intrusion it the market place, but too much."
Moral Hazard
I Just finished rereading "When Genius Failed" Roger Lowenstein’s excellent book about the fall of Long Term Capital Management. I thought it would be interesting to compare this earlier blow up with the current pyrotechnics in the bond market; and the fall of Bear Sterns. Indeed the parallels are surprising, surprising that is, if you assume, like I do, that large financial institutions should be able to learn from their mistakes.
The Credit Bubble
It has been said that the main force pushing the speculation in housing today are the loose lending standards. One reason for these loose standards has to do with mortgage securitization. A number of private companies (not Fanny or Freddy) have now entered the mortgage securitization business and the loan officer can now sell any kind mortgage that he can dream up. The securitization of these loans means the people writing the mortgage bear none of the risk generated by the loan. He gets to keep his fees and transfers most of the risk to the investors buying the bonds. Whether the buyers of these bonds (hedge funds, foreign investors, etc.) understand the risks they are accepting is an open question.
Unintended Consequences
Expansionary monetary policy promotes growth, prosperity, and full employment, but as always there are unintended consequences and when the medicine is applied to an economy too liberally for too long, money becomes so easy that the games begin. Huge sums are available to managements whose main imperative is self enrichment. Equity bubbles expand, companies like Enron appear, flourish, and spread their lust for fast, conspicuous wealth as if it where a communicable disease.
Hedged Fund
The one unbroken rule on Wall Street is that easy equity and cheap leverage inevitably attract those species most dangerous to investment capital: mediocre talent with no comprehension of the limits of their talent, and intelligent people who are ethically challenged. Money has been pouring into hedge funds that use various strategies to speculate in convertible and junk debt. These strategies include the liberal use of derivatives and lots of leverage. For example "Grant's" estimates that hedge funds with $60-80 billion in equity from investors have invested $200 billion in various hedged convertible securities.
Other People's Money
More about the evils of cheap capital and why tight money is good for investors. "There is no better way to make managers understand how valuable capital is, than to charge them for it," ...Warren Buffett The flip side of the problems created by cheap money, is the benefit that comes from tight money. It teaches respect for capital. The managers of Berkshire’s various wholly owned businesses can get all the money that they want, but they have to pay. On the other hand if CEO returns money from earnings to the parent, Berkshire pays them a nice return (2 to 3 percent above the respective interest charged).
Build it and they will come
Every major correction in the stock market has been preceded by a period of cheap money. Why easy money is bad for the stock market, and why corporate CEO's think that if they are smart enough to get their hands on large piles of cash they must be smart enough to spend it.
The Federal Reserve Board and Monetary Policy
This is also a story about central banks. Central banks occasionally become enamored with easy money and every time the eventual result is disaster. Think about the United States in 1920's and 1970's, and about Japan in the 1980's. Periods of easy money have been very bad for the nation's economy. Not only does easy money breed inflation, it seems to encourage accounting games and Ponzi schemes. There can be no better example of this phenomenon than the tech bubble and the real estate bubble. We were not great fans of Alan Greenspan and his goldilocks economy. Below are links to our Client Letters where we had something to say about FED policy.
On Learning Things The Hard Way
The miracle of Capitalism is that it works at all. Its main virtue, we have been told, is that it is better than the alternatives. To the extent that it does work it is because of its ability to adapt and change, whereas competing ideologies are so dependent on dogma that they become fossilized shortly after conception. Important as this ability to chance is, it does not come easy. Capitalism is no pushover; it is more like a very stubborn mule, so for progress to continue the occasional application of a very large 2x4 is necessary.
Greenspan on Inflation
In a world of paper currencies were a countries money supply is always a political issue, the politicians always want easy money. Greenspan notes that in his 17 years at the head of the FED he did not receive one phone call from a President or congressman requesting that he raise interest rates. Whereas there was constant pressure from politicians of all shapes and sizes to lower rates.
Stability is Unstable
Hyman Minsky an economist popular in the 1970s postulated, "stability is unstable" this economic paradox exists, Minsky explained because long periods of stability lure investors, bankers, and businessmen into taking on progressively more risk. While our economic system is good at correcting past mistakes it is even better at inventing new engines of instability.
Inflation Is
Since money is just another commodity, the more you increase the supply (the amount of currency circulation), the more you drive the price (value) down. This makes sense and how can you argue with the guy that wrote the book on monetary policy, and who won the Nobel Prize for his effort. Yet this rule of Dr. Friedman's now seems to have been suspended, if not repealed.
The Price of Easy Money
The problem is that prolonged comfort has conditioned financial institutions globally to price their financial contracts with inadequate risk premiums. If pain is the mother of wisdom, does not comfort make us stupid?
A Greenspan Put Floats Charlie's Ducks
The 'Greenspan Put' kept the rain falling, and the water kept rising. All the ducks thought they were getting smarter and smarter. The gap between what the ducks thought and reality became so wide that it fostered acts of superhuman stupidity. One example is all that is necessary to understand the enormity of this gap. Bernie Ebbers borrowed $400 million to buy stock in his company. That's 400 with six zero's...for an equity position that is probably worth about $45.00 in today's market. What the hell was running though his duck brain? Clearly the water in the pond was going to keep going up forever. Sadly I fear this duck will soon receive the world's largest margin call from a bankruptcy court.
Stupid FED Tricks
What if" questions for the FED. What if there had been a recession in 1994? What if there had been no drop interest rates in October 1998? "The whole idea that we can hire some politicians to turn a knob here and change a little policy there, and presto, no more human grief, is not just naive it is dangerous, but that is what we are dealing with here. The notion that economic cycles are bad because they cause pain, and that we can fix this by adjusting a few monetary levers, has always been a foolish notion.
Bubble Watching
Will the FED be able to avoid Bubble Number two? As far as the recovery is concerned fast is bad slow is good...I know that rapid and aggressive easing is politically popular and that a lot of the walking wounded from Wall Street are screaming "faster", "faster". Greenspan is famous for being the rescuer of economies, but I wonder if he has not become too fond of this role.
Identifying Problems
How Higher interest rates and a slowing economy effect tech stocks. And why a little pain is good for the economy...Today the market has many problems; Stock options are considered a free lunch, yet cheat shareholders out of hundreds of billions of dollars. Companies massage their earnings with accounting games. Many TV commentators think corporate earnings always increase. Enormous amounts of money are concentrated under the management of people whose primary concern is career risk.
Big Al and the Bubble Machine
(It is time to turn off the bubble machine.) A comment on Fed policy in the spring of 2000, and impact of its policy on the stock market and the nation's economy. Will a soft landing really work?
Back in 1994 Greenspan invented the idea of a soft landing, and now everybody assumes that recessions are politically incorrect. Now everyone assumes the worst that the future has to offer is an occasional soft landing. This a big part of the problem there are just too many people buying stock that a too young to have experienced a serious recession.
Buffett on Capital allocation
At one of the first Berkshire Hathaway annual meetings I attended, Warren Buffett described his system for allocating capital. The managers of Berkshire's various wholly-owned businesses could get all the money that they wanted, but they had to pay. I forget the actual numbers, but as I recall the rates varied from company to company depending upon the industry and typical capital requirements within their sector. Interest rates were generally a couple hundred basis points above market rates. On the other hand if the CEO returned money from earnings to the parent, Berkshire paid a very nice return (2 to 3 percent above the respective interest charged). It seemed a strange system to me then, but as I have thought about it over the years it has started to make sense.
Lessons for the investor - Boring Is Good
As a money manager, we like to invest in stocks that are not popular and try to avoid, like the plague, all areas were stocks have become popular and money is flowing freely. The best returns on capital investment come from investment at times or in places were money is hard to get.
With equity investments there is a direct relationship between popularity and risk. The more popular a stock or an industry sector has become, the higher the risk an investment in that area carries. Risk builds in any market as money pours into a particular vehicle. The more the money moves in a particular direction, the higher the risk. Risk is always a moving target, where as concepts such as Beta perceives it as static. In the 1950's it was accepted wisdom that bonds where a low-risk investment, but the 1970's proved this was not true.