Portfolio manager’s Letter June 2009
It is fashionable 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. Still, 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, and the creation of a moral hazard. 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, Kaufman has a different definition of Libertarianism than I do. While it may be true that Greenspan liked to consider himself a Libertarian, He was never reluctant to use the power of the FED to manipulate the nation’s economy and encourage the introduction of a moral hazard.
While Greenspan generally supported deregulation, when it came to interfering with the market place he loved to jump in with both feet and create a moral hazard. This was because he liked to go out looking like a hero. Using the FED to pump up the tech bubble or the credit bubble has nothing to do with Libertarianism. Still, it 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 Greenspan 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. Congress was also good at creating a moral hazard.
The argument can be made that the belief that the government will always bail us out that was a fundamental cause of our 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 created the moral hazard that led to 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 moral hazard. If you do something foolish, it reads, the FED will be there to climb on its white horse and ride to the rescue.
Creating a moral hazard – 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 leads to the longest period in our history without a recession. With this claim, he inadvertently relinquishes any claim to being a Libertarian. Intervention is an 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 present small 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 an excellent educational experience, instead it created a moral hazard. The New York FED feared damage to the financial system and intervened. All of the primary principals instrumental in our current crisis were present for the 1998 adventure (except for the deceased LTCM, of course). Merrill Lynch was there, only with Kamansky in charge, Goldman Sachs was present (represented by Corzine 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 bailout). 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. All became victims of the moral hazard.
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 significant commercial and investment 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 irresponsible 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. Thus creating a moral hazard that helped inflate the 2007 bubble.
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 of 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, and avoided the moral hazard? 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 eight-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 moral hazard and a significant factor in turning Wall Street blind to risk, it was certainly not the only factor. Nor was the Federal Reserve the single instrument of the federal government that fed the moral hazard that helped to create 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 homeownership 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, overpaid CEO’s.
Hyman Minsky identified the central irony of 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 to lower their loan standards. Implicit in this irony is 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 of 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 fundamental 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 result will not only be a waste of time but that it will eventually lead to an increase in general pain and suffering.