Portfolio manager’s Letter June 2009
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.
Henry Kaufman Wrote a piece for the Financial Times in April, in which he blamed the FED’s failure to act to restrain the banks and Wall Street’s increasing use of leverage on Greenspan’s supposed susceptibility to “Libertarian dogma”. Clearly Dr. Doom has a different definition of Libertarianism than I do. While it may be true that Greenspan liked to consider himself a Libertarian, I am not sure this was an entirely accurate conclusion on his part.
While Greenspan generally supported deregulation, when it came to interfering with the market place he loved to jump in with both feet. This was because he liked to come out looking like a hero. Using the FED to pump up the tech bubble or the credit bubble has nothing to do with libertarianism, but is a peculiar form of liberal economic policy that loves to interfere with free market functioning. This is a policy that encouraged our financial institutions and the investing public to believe that recessions were out of style and unnecessary. It was a policy that was much beloved on Wall Street, and inside the beltway.
Greenspan wrote in “The time of Turbulence” that he was continually under heavy pressure from congress to push for easy money, in his book he points out that not once in the eighteen years that he was chairmen did he get a call from a congressman suggesting that the FED raise interest rates, while requests for lower rates were constant and non-ending.
The argument can be made that the belief that the government will always bail us out that was a fundamental cause of our great credit bubble. Greenspan and the FED intervened in 1987 shortly after he took office, and it felt so good then that he was never able to stop. He gave us the soft landing in 1994, bailed out the banks in 1998 when they lent obscene amounts of money to Long Term Capital Management (LTCM), pumped up the Tech bubble in 1999, and then the real estate bubble with free money in 2002 – 2005.
He presented the “Greenspan Put” to Wall Street, the big commercial banks, and their smaller hedge fund cohorts as a huge financial amphetamine that encouraged them to remain blissfully ignorant risks that were building. Thus was created the mother of all economic moral hazards. If you do something really stupid, it read, the FED will be there to climb on its white horse and ride to the rescue.
In the “Time of Turbulence” Greenspan brags that the proudest moment of his 18 year tenure was the soft landing he engineered in 1994, because it lead to the longest period in our history without a recession. With this claim he inadvertently relinquishes any claim to being a Libertarian. Intervention is intervention even if the hope is to relieve or avoid the pain caused by a market correction.
Looking back now we have to wonder what would have happened if there had been a hard landing in 1994. What would have been the impact on LTCM and the Tech bubble? Were we not just trading a small present problem for a much bigger one in the future? The unintended consequence of this kind of intervention is what we call a moral hazard.
The LTCM crisis could have been a wonderful educational experience, but the New York FED feared damage to the financial system and intervened. All of the main principals instrumental in our current crisis were present for the 1998 adventure (with the exception of the deceased LTCM of course). Merrill Lynch was there, only with Kamansky in charge, Goldman Sachs was present (represented by Corsine and John Thain).
The Wall Street gang was all there, Lehman Bros, Chase, JP Morgan, UBS, Barclays, Morgan Stanley, etc, and of course Bear Sterns with James Caine (who was the only one who refused to participate in the LTCM bail-out). The one big difference this time is that the cast has been expanded to include many more large banks and financial institutions from all over the World.
Even though the scale of the present crisis is much larger, the similarities are striking (except for the fact that the institutions do not have LTCM around to blame). Yes, Long Term Capital Management was guilty of egregious over-leveraging, but they could not have done this without the help of the people passing out the credit. All the big commercial and investments banks were competing to get John Meriwether’s business. Wall Street was shoveling money to LTCM in 1998 in a mad rush to pump up their bottom lines.
Many of the biggest losers in the current crisis were big lenders to Long Term Capital Management and they could have established internal controls that would have prevented the recurrence of stupid lending, but they chose not to. Again gain a better understanding of the term “moral hazard” by the study of the Long Term Capital Management bailout. The subsequent ability of the banks to recover all the money they loaned to LTCM and contributed to the bailout did nothing to encourage them to institute safeguards to prevent sloppy lending.
Indeed, why should they have done so? The loans pump up the banks earnings and the employees bonuses, and where is the risk if when stupidity gets the best of you, the FED will be there to bail you out.
So again we have to ask the question what if LTCM instead of going to the FED had been placed in Bankruptcy and lenders forced to accept pennies on the dollar. This would have caused problems for the banks, and maybe a failure or two, but might they not have paid more attention to the risk in the future? Was not the end result of this intervention the replacement of a big problem 1998 in for a much larger one in 2008?
In 1998 the stock market was well into what had become an 8 year bull market. When Long Term Capital Management threatened to end this run, Greenspan reduced the Discount Rate three times in rapid succession. The stock market which had been tanking turned around took off as tech stocks ascended to orbit in 1999.
Although the “Greenspan Put” was a big factor in turning Wall Street blind to risk, it was certainly not the only factor. Nor was the Federal Reserve the only instrument of the federal government that fed the mortgage crisis. The Tax deduction for mortgage interest certainly encouraged the public to increase their debt. To this the Clinton Administration added a huge tax exemption for the tax on capital gains.
Congress did their bit by continuing to pressure on Fanny and Freddy to encourage home ownership for subprime borrowers, and by always pressuring the FED to lower interest rates. The causes of our current credit crisis are many and varied but it is not going to help our understanding by trying to place all the blame on Wall Street and greedy, over paid CEO’s.
Hyman Minisky identified the central irony free market economics. He said “Stability is Unstable” The longer banks go without experiencing problems in their loan portfolio the more they will be tempted lower their loan standards. Implicit in this irony is the totally unacceptable (but inescapable) conclusion that government intervention such as we saw from Greenspan’s FED that is initially successful, probably will eventually make the problem worse. This may also lead us to conclude that the ultimate cause of the lean years is the fat years, and to accept market cycles as inevitable.
None the above should be read as a screed against regulation, but an objective view of history leads to the conclusion that there are limits to its benefits. Regulation that increases available information about market participants for example 10Ks, 10Qs, 13fs, etc., helps to create more efficient markets.
But when any Federal agency tries to sell a program that claims to solve basic problems of human behavior such as Mr. Market Bi-polar disease; or to overcome the inclination of long periods of strong economic performance to nurture the growth of fraud and other human foolishness; we can rest assured that the end result will not only be a waste of time, but that it will eventually lead to an increase in general pain and suffering.