This is mandatory reading for those who did not see it.
From the WSJ:
In disclosing plans to buy a quarter-trillion dollars of bank stock in the name of the American taxpayer, Treasury Secretary Hank Paulson harped on confidence. “Today, there is a lack of confidence in our financial system, a lack of confidence that must be conquered,” he said on Tuesday.
What Mr. Paulson did not get around to mentioning was the excess of confidence that preceded the shortfall. Under the spell of soaring house prices (and before that, of stock prices), Americans trusted the things they ought to have doubted. But markets are cyclical, and there is always a new day. In compensating fashion, people will eventually doubt the things they ought to have trusted. Investment opportunity follows disillusionment. It’s complacency that precedes bear markets.
If the confidence deficit seems so high, it’s because the preceding confidence surplus was full to overflowing. People suspended critical judgment. They accepted at face value the pretensions of central bankers and the competence of investment bankers. Not one professional investor in 50, probably, doubted that wads of subprime mortgages could be refashioned into bonds that were just as creditworthy as U.S. Treasurys.
Federal Reserve Chairman Ben S. Bernanke and his predecessor, Alan Greenspan, were fine ones for believing impossible things. They propounded them, too. Never mind asset bubbles, they said. Not only can’t you predict them, but you can’t even recognize them after they’ve swollen to grotesque maturity. Better just to tidy up after they burst. Now Mr. Bernanke is likening our present troubles to those of the 1930s. The comparison is more confidence-sapping than he seems to realize. From peak to trough, 1929 to 1933, the gross domestic product was almost sawed in half, before adjusting for changes in the purchasing power of the dollar. No such mitigating fact helps to explain today’s set-to. It’s a crisis of competence of our financiers, of bankers and central bankers alike.
To the self-satisfied elders of the Fed, the past 25 years were a sweet validation of the art of central banking and of the efficacy of paper money. “The Great Moderation,” some of them called this interlude of low inflation and subdued economic activity — neither too boomy on the up side nor too recessionary on the down side. For these manifold blessings, the officials thanked, in good part, themselves, i.e., “the credibility of monetary policy,” as the president of the Federal Reserve Bank of San Francisco, Janet Yellen, put it earlier this year.
But it wasn’t the vigilance of monetary policy that facilitated the construction of the tree house of leverage that is falling down on our heads today. On the contrary: Artificially low interest rates, imposed by the Federal Reserve itself, were one cause of the trouble. America’s privileged place in the monetary world was — oddly enough — another. No gold standard checked the emission of new dollar bills during the quarter-century on which the central bankers so pride themselves. And partly because there was no external check on monetary expansion, debt grew much faster than the income with which to service it. Since 1983, debt has expanded by 8.9% a year, GDP by 5.9%. The disparity in growth rates may not look like much, but it generated a powerful result over time. Over the 25 years, total debt — private and public, financial and non-financial — has risen by $45.1 trillion, GDP by only $10.9 trillion. You can almost infer the size of the gulf by the lopsided prosperity of the purveyors of debt. In 1983, banks, brokerage houses and other financial businesses contributed 15.8% to domestic corporate profits. It’s double that today.
RelatedAttaching a face to an issue, as the presidential candidates did in the latest debate, has a history of success and plenty of backfires. Read Forbears of ‘Joe the Plumber.’
The modern financial economy requires a certain minimum leap of faith. The paper dollar is an example. There is nothing behind it except the government’s good intentions, yet we hoard it as if it were gold. However, we collectively outdid ourselves in credulousness in the runup to the financial crisis. People believed the Fed’s good press, as, evidently, the Fed did itself. Then there was the ever-flattering dollar. Warts and all, the American scrip is the world’s top monetary brand. It is this country’s leading export — and the agent of not a little of today’s financial dislocations. It is the dollar — the world’s reserve currency — that has allowed this country to consume much more than it produces and to put the deficit on a mammoth annual running tab, about $700 billion in even this year of a much improved trade picture.
Over the past few months, the dollar has found favor as a safe haven. But it was a drug on the market for years before. Asian central banks would buy up greenbacks by the boxcarful. Few profit-seeking entities seemed to want them. The central banks did not obtain their dollars for free, of course. They bought them from local exporters, paying with the local currencies that the bankers themselves printed. Since the close of 2002, developing-country central banks have absorbed more than $2 trillion in this fashion. This is debt that, under a gold-based monetary system, the United States could probably not have incurred. Living so grandly beyond our means, we would have raised the suspicions of our creditors, who would not unreasonably have begun to exchange their paper dollars for the gold that stood behind them. The loss of gold would have cut short our high living.
Our foreign creditors accepted dollars in payment for their goods and services — and then obligingly invested the same dollars in America’s own securities. It’s as if the money never left the 50 states. If Americans seemed an unusually complacent lot before the roof fell in, it was no wonder. Owning the reserve currency franchise, any other people would have been just as fat and just as happy.
So, brimful of confidence, we ran down our savings and ran up our debts. Among the myriad varieties of 21st-century debts we incurred were mortgage contraptions so complex as to baffle even the people who invented them. Yet professional investors snapped them up at interest rates only a few tenths of a percentage point higher than Treasury-bill yields. It bolstered the investors’ confidence that the structures — residential mortgage-backed securities and variations on the same — were appraised triple-A.
When unfounded confidence was still supporting excessive leverage, private equity promoters bought up whole companies. They borrowed most of the purchase price at negligible interest cost and with few of the legal safeguards customarily afforded to senior creditors. The confidence of the creditors was even more ill-founded than that of the promoters — and far less explicable, because there was so much less potential profit in it for the lenders than for the equity investors. When the music finally stopped, some investors were still in mid-deal. Cerberus Capital Management had not yet consummated its proposed purchase of United Rentals, for instance. Neither had General Electric Capital Corp. and Blackstone Group bought PHH, nor Kohlberg Kravis Roberts & Co. and Goldman Sachs Capital Partners acquired Harman. Next thing you knew, the transactions were being canceled.
The would-be acquirers prided themselves on the thoroughness of their due diligence and on the conservatism of their financial forecasts. Each announced an acquisition price that, supposedly, gave full value to the selling shareholders while still affording the prospect of a not-so-distant payday for the leveraged acquirer. But, without willing lenders or a rising stock market, the buyers withdrew.
The share prices of the target companies thereupon pulled back. One had expected it. But the former takeover candidates’ prices have plunged by 70% or more. Reddy Ice, the No. 1 manufacturer and distributor of packaged ice, is cheaper by 92% than it was on the day last summer when its falsely confident suitor, GSO Capital Partners, bid to take it private at 50 times earnings. Interestingly, no new buyer has appeared now that the shares are quoted at less than seven times earnings. Confidence in the judgment of our private equity titans is belatedly being marked to market.
Such is the way of markets — and of the fallible investors who operate in them. High prices boost our confidence, low prices sap it. We seek out bargains in Wal-Mart, but run away from them on the New York Stock Exchange. The proliferation of investment bargains brings us no joy. Share-price volatility is testing all-time highs. The debt markets are inconsolable. The triple-A rated mortgage bonds that once yielded only a small increment over the basic wholesale money-market interest rate today fetch 12% and up. And those are the securities that, as Grant’s Interest Rate Observer does the numbers, appear to be money-good — barring another 20% or 25% decline in house prices. Yet if the risk of true apocalypse in real estate is great enough to warrant these towering mortgage yields, there can be no easy explanation of the relatively low yields still attached to the unsecured debentures of some big American retailers. Lowe’s Cos., the giant home-improvement chain, would surely feel it if house prices dropped — again — through the floor. But an issue of unsecured Lowe’s debentures, the 5s of October 2015, are quoted at a price to yield just 5.8%.
In investment markets, confidence and coherence tend to restore themselves. The hardy souls who lead the way back derive their confidence not from the Treasury Secretary but from the pages of “Security Analysis,” by Benjamin Graham and David L. Dodd, the value investor’s bible.
But these are frightening times, and there is no very large constituency favoring the natural restorative processes of free markets. “A new form of capitalism is needed, based on values which put finance at the service of business and citizens, not vice versa.” Nicolas Sarkozy, the president of France, recently said that, but the sentiment is on the lips of heads of state the world over.
In the past two weeks, governments in Asia, Europe and the U.S. have effectively nationalized vast swaths of banking. Central banks have ramped up their money printing. In the past week alone, the Fed’s balance sheet swelled by $179 billion, to a grand total of $1.77 trillion. In announcing such radical measures, intervening governments never fail to invoke confidence. They say they must restore it.
Destroying confidence, however, is what governments do best. And the confidence they can restore is usually the kind that got us where we are today. Inflation and moral hazard led directly to the immense overvaluation of equities and residential real estate — and of the bloating of the leverage that sustained those prices. Yet, to cure what ails us, credit creation and the public guarantee of banking liabilities are the policies today most favored.
Perhaps the world has gone so far down the path of socialized finance that there’s no turning back. However, the doughty remnant of capitalists should be under no illusion about the risks and opportunities they confront. They can’t miss the risks. Mr. Paulson pledges that the government’s bank investments will be passive and apolitical, but the record of the Depression-era Reconstruction Finance Corp. suggests that the federal government is a shareholder that can throw its weight around. Besides, would Mr. Paulson’s apolitical intentions bind his successor?
For the false confidence that played so important a part in the creation of the late excesses, the government should decently bear its share of blame. It accepts none of it, however, at least none that Messrs. Paulson or Bernanke have admitted to. Not that a federal confession of sin would expunge the financial errors of the debt-financed upswing. But it would, at least, clear the intellectual air and help the country and its creditors find a way to do better next time. For a start, the Fed might foreswear the Greenspan-inspired conceit that it can put the economy back together again after a debt bomb explodes.
And the opportunities? For the first time in a long time, stocks, tradable bank loans and mortgages are becoming cheap. The bear market is truly a value restoration project. Wall Street will be going on sale — if the government will let it. For the entrepreneur, the silver lining in the federalization of finance is obvious. Start a bank or broker-dealer to compete with the institutions that will soon be smothered in Mr. Paulson’s quarter-trillion dollar embrace. There’s oxygen, still, in the free market.
James Grant, the editor of Grant’s Interest Rate Observer, is the author of the forthcoming “Mr. Market Miscalculates: The Bubble Years and Beyond.”
The book is great also. You can read my review of it and pre-order it here.