THE SHORT, HAPPY LIFE OF A HIGHLY LEVERAGED MARKET
Some fifteen-odd years ago, fresh off a Bachelor’s in Finance, followed by a quick stint through the Eurodollar and S&P pits in Chicago, and on the verge of a new and fascinating career as a retail stockbroker and ersatz, suspender-clad, Master of the Universe in the Tom Wolfe image, I found myself pondering our nation’s financial affairs, engulfed by my extraordinary grasp of macro-economics and how my soon-to-be customers would reap spectacular rewards on the back of my superior intellect. In my interior, glass walled office, between incessant directives from the squawk box, constant advice from the elder brokers to dance everybody into mutual funds so as to earn the monthly trailer, and the ever present real need to put somebody into something so as to put some commission money in my pocket that week, I came to the simplistic conclusion that we, as a country, had but three choices for righting our hopelessly listing fiscal super-tanker; Inflate, Deflate or Default. I knew that, before the new millennium would dawn, our proverbial ship would surely hit the sand and we, the uber-consumers that we were, would pay a severe price for our decades upon decades of debt-driven prosperity and insatiable decadence. I reckoned that the world would demand fiscal responsibility from our leaders and that, if the international investors didn’t see it soon, they would lose their appetite for our sovereign debt. I theorized that our elected officials, when times worsened enough, would harken the call of their voters at the expense of the elitist Swiss banker and, subsequently, Treasury would be forced to loosen the purse strings in an effort to bolster the consumer at the very moment in time when they needed to put him on a diet. The ramifications of all this would be a weakening currency, higher interest rates and runaway inflation. This course would take us to a day in which Treasury would announce that, for the first time in US history, a scheduled coupon payment on a T-Note would be skipped as they were unable to issue adequate T-Bills to finance said interest due. A Default. At this time, of course, the gig would be up. In short, I suspected we would follow the model, to quote Oliver Stone (which is always dangerous,) of “…some piss-poor South American country…!” In the ignorance of my youth I anticipated this coming of events with a sense of excitement that almost approached joy.
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As it turned out, to my surprise, the naïve intellectual framework from which I was working proved about as valid as the pricing formulae employed by the scholars at LTCM. There are always factors for which we do not account. Far from being the end of an empire, the 1990’s became the real glory days of the American capitalist experiment. With the Latin American investment fad coming to an end, the collapse of the British Pound, the ever-deepening Japanese stagnation and the burgeoning technological revolution which fueled the go-go run in the NASDAQ and the equity markets in general, the United States became the only game in town and those foreign investors, of whom I feared would grow skeptical, had to take a number to get in line to finance our growing affluence. With this massive inflow of capital, and with the Greenback becoming the commodity of choice for central bank reserves, we embarked upon the Elysian Greenspan years, bolstered by the long term decline in interest rates, that was rooted in the early eighties, and blossomed and bore fruit in the mid to late nineties.
And bear fruit we did. Recall back to those halcyon days of day trading and irrational exuberance: The roaring QQQ’s, Juniper Networks, Dell, HP, and, most importantly, anything dot.com. Fifty year olds who once burned draft cards were now reading the Journal and counting the chickens of their 401K’s, only gladly investing the CD money inherited from their depression era parents into anything that did anything on the internet. We were making millionaires galore, there seemed no end to the upside of the stock market and the wealth it was creating, and it was going to last forever. But then something happened, as it always does, and the air began to exude from the bubble; slowly at first but then with greater and greater force.
In this instance the pin that caused the prick was one Joel Klein and the U.S. Department of Justice under the waning years of the Clinton Administration. It seems that Microsoft, the tech company of all tech companies, was simply making too much money. It could not be fair that this behemoth use its grandiose power to crush its competition beneath its enormous feet before said upstarts could even get out of the gate, and in doing so maintain its almost monopolistic stranglehold on PC users from Nome to New Zealand. Little did the DOJ know, although it was as plain as day, that attacking the mothership could very well mean bringing the whole system down with her. Yet, attack they did. In short order the scales began to fall from the eyes of many investors and the risks associated with many of these companies that, actually, had no business model at all, came to be realized. The NASDAQ Composite Index hit an all time high of 5132.52 on March 10, 2000 and by the end of that same year had fallen to 2470.52, a decline of over 51% (this index stands at about 2058 as this is written, some 60% below the high set over eight years ago!)
With the NASDAQ, the engine of our economy, in dire straits, we muddled about for some months in late 2000 and early 2001, and then the second shoe, the terrorists attacks of September 11th. In the aftermath of this event, and given the financial circumstances prior to this date, it seemed obvious that we were entering a low return environment insofar as equities were concerned. In a flight to quality capital poured into short term Treasuries once again, bolstering the dollar and keeping a cap on interest rates. Unfortunately, low yields are often indicative of expected returns, and in this case the axiom held. Over the following months, and years, the Bush Doctrine came to be our mainline position on foreign policy, with disastrous market effects, most notably the decline in the dollar. As a debtor nation that runs an enormous balance of trade deficit, it is imperative that we constantly attract new capital in an effort to refinance the old. All of the dollars sent to China, India and other cheap labor markets must, in the end, be repatriated if our system is going to remain afloat. Since we, along with the rest of the developed world, engage in a system of fiat money, with our currency backed by nothing more than “Full Faith and Credit,” then it is incumbent upon us to maintain at least a minimum level of that “Faith” in the eyes of the investing world, specifically central banks and foreign sovereign wealth funds with hoards of dollars gained as a result of commercial trade. Should these players ever lose confidence in our economy, then the seeds of disaster, long planted, are watered and fertilized. The Bush Doctrine has been sufficient to cast doubt in the eyes of the world; and with this doubt, there is the slightest suggestion in global circles about the emperor and his clothes.
On Main Street, however, even as the financial system grew ever more risk tolerant, things were seemingly okay. The day traders found other jobs and the stock jocks and their ilk moved their attention from exchange traded equities to a market with much less transparency, much less regulation, much more leverage and, accordingly, much more juice: single family homes. For a while it was nothing more that refinancing that put a little jingle back into everyone’s pockets. And, at first, refinancing seemed prudent enough. After all, why pay 8.5% on a thirty year fixed when you could refinance at 6.5% for the same terms? Of course, the action didn’t stop there. As it happened, it became apparent that home values were on the rise and, when refinancing, homeowners were quick to discover that they had much more equity in their homes than they ever realized. For all the stock tips and inside deals and high-tech funds they had owned, it turned out that the best investment they ever made was in buying that house ten years ago when the family outgrew the apartment. The brave new world was upon us and, again, it looked as though it would go on forever. Not only were you able to refinance your home and lower your monthly payment, you were actually able to take out equity and use the cash for such important things as going on nice vacations and buying a new SUV. We had been told for years that the stock market was the best place to accumulate wealth and protect from inflation, but that mantra was all wrong, our houses were the best place to build wealth and we could use them like an ATM whenever we needed a little extra cash. Single family residences were sure to go up forever as more and more people could afford to buy instead of rent, and mortgages became easier and easier to obtain. It wasn’t long until “flipping” became a common term to be heard from the coffee shop to the golf course. Why limit yourself to the value of your own home when you could, with little to no equity, buy a rundown house, add a few cosmetic touches, and sell it quickly to a first time buyer who was itching for his part of the American Dream?
And as this great shift from equities to houses was taking place all across the land, denizens of propeller heads on Wall Street were busy calculating the best ways to dip their fingers into their share of the pie. The low yield environment along with the collapse in stock prices had taken its toll on the investment banks and greatly reduced the revenue from some of their most lucrative businesses in the form of retail commissions and M&A fees. Something, to be sure, had to be done. Bear, Stearns was among the first to recognize that the future very well could lie in the hands of the up and coming wave of hedge fund managers leaving the fund companies and starting their own shops. Acting as a prime brokerage, this firm and all the others could generate huge fees with every new fund as they charged for everything from fund raising to clearing to lending to market making and distribution. Not only did these banks facilitate the exploding industry, they encouraged its rapid growth. The fund managers were, largely, hacks, of course. For every seasoned veteran who jumped into the hedge fund world their were dozens of kids whose experience was limited to long-only mutual fund investing and who scarcely, if at all, even remembered the crash of 1987. But the money was so good. Whereas at a traditional fund company managers are paid a salary, though often handsome, at a hedge fund the sky is the limit. Managers are usually allocated 2% of assets as a management fee to cover expenses and then, the real gravy, they are paid from 15% to 40% of any net gains each year as a performance bonus. Giving due credit to an anonymous commentator, hedge funds are often nothing more than a compensation scheme disguised as an asset class. And further, and most importantly, they aren’t even hedge funds anymore. There is little to no hedging involved. These long only managers have left the mutual fund companies and moved into private funds that allow them more leeway, more leverage and more compensation, but they maintain their long only strategy. The majority of funds are providing beta when they should be providing alpha. Alpha is a hard thing to come by.
Over the past twenty years, in conjunction with the age of the hedge fund, Wall Street has increasingly fallen in love with the quant. Quantitative analysis, financial engineering, riskmetrics, VAR and etc. and etc. all regress back to the theory that mathematical models can be applied to financial instruments in such a way as to accurately quantify risk and assess return under varying market conditions. This “black box” method of calculating value and risk played right into the hands of the banks and their new hedge fund customers as these participants are in constant search of an edge. Derivatives, which are nothing more than instruments that “derive” their value from other instruments, became the backbone of the globe’s financial system over the past decade and a half and, increasingly, these instruments became more complex and more intertwined. Rather than reduce systemic risk, as the models often suggested, these instruments, and their inter-correlations, have increased risk substantially. The hedge funds became easy customers willing to buy whatever Goldman and Morgan Stanley and Lehman and Bear, Stearns, and myriad others, were selling from day to day. There was huge appetite for high-yield product and there was, potentially, a huge supply of mortgage paper waiting in the wings for some bank to package. And the packaging came quickly and the packaging came creatively. Mortgages, which had historically been held to maturity by banks and other lenders, had for many years been securitized and sold into the secondary market as interest bearing securities. Following this process to its logical end, before long these banks could tailor a product to sell to a specific fund or they could sell pools of generic product to lots of funds. The fund manager could buy principal only paper, interest only paper and other derivatives which sliced the original mortgage up in more ways than a ginsu knife. The broker would not only place the paper with the fund but would finance it, price it and sell the fund manager insurance to protect him against certain aspects of the risk if need be. It was great, the fees were huge, and the supply was endless. Everybody was making money. And, given the success of these mortgage derivatives and the strength in the underlying housing market, the demand for product grew greater and greater until the highest yielding securities, the so called subprime paper, worked its way into white-shoe portfolios as a legitimate asset class.
The banks became so addicted to the fees from these derivative transactions that they began to focus more and more of their firm’s assets towards this area. After all, there was no money to be made the old fashioned way. This was a means by which to earn a return on equity that was far and away in excess of what would be earned investing in Treasury securities or exchange traded equities; they were reaching for yield (in the vernacular, one who acts in this way is known as a “yield whore.”) The lack of transparency in this market meant that there were huge markups to be made in writing these exotic options. In their quests for increased yield these players were, as is always the case, assuming increased risks. These are smart people, for the most part, and they were aware that there was risk involved. The problem is that they fell in love with their risk models and they grossly miscalculated the counterparty risk involved with these instruments. In the end, there was no real hedge; if you insure against disaster, but the disaster wipes out the insurance company, you are still left holding the bag.
To this point, what we have experienced is a greed driven perfect storm. And when I say greed, my primary focus is the politician’s greed for re-election. Our elected officials, in their infinite wisdom, maintain a desire for every American to have a nice car, plenty of food on their table and to own their own home, as this makes for all the more peaceful constituents. Towards this end they see no moral hazard in subsidizing their objectives and have, in fact, done just that for many, many years and on both sides of the aisle. We can write off mortgage interest, we can avoid capital gains tax when we buy another home, we have (or had) GSE’s that add liquidity to the mortgage market, we allow tax credits for new home purchases, and etc. We have subsidized, and continue to subsidize, this market. When a market is subsidized, excesses inevitably accrue. This instance is no different. It is hard to lay much blame at the feet of the investment bankers and traders. They are, after all, private market participants whose only objective should be to maximize their personal gain. Did they, in retrospect, assume risks that were inordinate to their returns? Absolutely. However, one might ask why they were willing to take such risks? And the answer would probably fall right back to our government, only this time, not to an elected official, but to the sage former Chairman of the Federal Reserve, Alan Greenspan himself. The philosophy, put forward by Greenspan and Co. and known as the “Greenspan Put,” that there are certain institutions within our system that are too large to fail and that, if such institutions suffer significant losses and become subject to potential insolvency, will be aided by the government either through a liquidity infusion or an orderly sale, has probably played the most significant role in leading us to the decisions we now face. It only makes sense that, when the trapeze artist knows that a net is below him, he attempts stunts he would otherwise avoid.
And so, years later, I come back to my original thesis: Inflate, Deflate or Default. The current Treasury bailout package may, or may not, provide enough liquidity and backstop to stem the torrent; I have my doubts. The crash of commodity markets in July set off a series of margin calls that added enormous stress to an already cash strapped, teetering market. The four banks that we have left will survive in new form but with many old problems. It is not likely that we will see them in eager pursuit of new loan business. Morgan Stanley and Goldman Sachs, given their conversion to commercial banks, will operate from here forward at significantly lower leverage ratios than what they are accustomed to. We are, like it or not, deleveraging. By its very definition, deleveraging shall lead to less economic activity. This deleveraging should result in commodity deflation, and overall deflation to some extent or another, with the wildcard being the propensity of Uncle Sam to print his way out of this mess. Deflation, though it may be painful, is the far superior choice to the other two.
If I have learned anything over the past twenty years it is that I do not know what is going to happen to a specific market, nobody else does either, and, importantly, I don’t feel a need to know. I can say, with all confidence, that things have changed and what once worked well may not work at all now. Opportunities will arise and we must be prepared when they do. We must identify and respect risk. Politicians will continue to tinker and cause trouble to markets and we are, undoubtedly, headed for more regulation.
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