The Investor’s Corner

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Finan­cial Self-Defense Dur­ing a Delever­ag­ing Cycle

By Paul Valle­jo

It is always use­ful to read out­side-of-the-box thinkers. It is a well known max­im in the invest­ing world that “you can­not make mon­ey off of what every­one knows,” as mar­ket prices have already react­ed to what every­one knows.  This makes the field of per­son­al finance some­thing par­tic­u­lar­ly dan­ger­ous to be over­ly reliant on wide­ly held “expert” advice.

In oth­er expert fields, you can gen­er­al­ly rely on experts  to be cor­rect. If your arm is painful and swollen, and nine out of ten doc­tors x‑ray it and say it is bro­ken, it is prob­a­bly bro­ken. How­ev­er, when expert mon­ey man­agers all agree on the great prospects for an asset, the price of that asset has like­ly changed to make the expect­ed out­come unlike­ly. In the last decade and a half, the US  has seen  two  pop­u­lar invest­ment vehi­cles become dis­as­ters for peo­ple’s sav­ings. Most recent­ly was real estate, which every­one (includ­ing Fed Chair­men)  knew nev­er goes down:

Also amus­ing are the edi­tor reviews on amazon.com from the book:

“An invalu­able book … Today’s real estate mar­kets are boom­ing and Lereah makes a con­vinc­ing case for why the real estate expan­sion will con­tin­ue into the next decade. This book should prove to be a tru­ly prac­ti­cal guide for any house­hold look­ing to cre­ate wealth in real estate.” —DEWEY DAANE, FORMER GOVERNOR OF THE FEDERAL RESERVE BOARD OF GOVERNORS

“An impor­tant book, whether you agree with the author (as I do) that hous­ing will remain an excel­lent invest­ment or are con­vinced that home prices are poised for a plunge, David Lereah lays out a com­pelling vision of hous­ing as a con­tin­u­ing pos­i­tive investment—and how you can prof­it from real estate if you already own the home you live in, are look­ing to move from rental hous­ing to an own­er-occu­pied home, or want to use real estate as an invest­ment.” —DAVID BERSON, CHIEF ECONOMIST, FANNIE MAE 

Pri­or to  the real estate bub­ble in the US, every­one was “invest­ing for the long term” in equi­ties dur­ing the dot com boom. If you we fol­low­ing the mar­kets dur­ing that time, you must remem­ber how skep­ti­cism was very out of fash­ion. Among the book pub­lished in 1999 were Dow 36,000, 40,000 and even  100,000, all of which sell now for a US pen­ny at Ama­zon.

So, as you are read­ing this blog, even if you haven’t decid­ed whether you accept endoge­nous mon­ey or debt defla­tions, you are doing some­thing more use­ful than read­ing the Wall Street  Jour­nal. Out­side-the-box  infor­ma­tion is valu­able — it is not priced into the mar­kets. Where you can destroy your­self is when put bor­rowed mon­ey into a pop­u­lar eco­nom­ic or invest­ing idea that turns out to be wrong (like the “New par­a­digm” inter­net stocks in 1999 (RIP by 2003), buy­ing hous­ing in the US dur­ing the bub­ble (RIP by 2009) , believ­ing in the cap­i­tal asset pric­ing mod­el or the Black Sholes option pric­ing mod­el (RIP with the LTCM fail­ure in 1998),  or bas­ing your invest­ments on fal­la­cious pre­dic­tions of neo­clas­si­cal eco­nom­ics (RIP TBD)). An obscure idea that turn out to be cor­rect is high­ly action­able.

So, with all that said, how does one pro­tect one­self dur­ing a delever­ag­ing? What might we expect? Well, the first thing you do is stay out of debt. The delever­ag­ing process puts down­ward pres­sure on prices, and post-bub­ble asset prices can fall fur­ther than any­one expects (note Japan’s asset prices dur­ing the delever­ag­ing cycle since 1990- see chart). Lever­age in this envi­ron­ment can turn a loss into a wipe­out.

Next, know the dif­fer­ence between invest­ing and spec­u­lat­ing. Peo­ple liked to say that they were “invest­ing” in stocks in the 1990’s or in hous­ing in the 2000’s, but this was a mis­use of the word. Peo­ple buy­ing dur­ing these bub­bles were bank­ing on asset price ris­es, with no ratio­nal basis for believ­ing the dis­count­ed cash flows of the com­pa­ny could jus­ti­fy the cur­rent price. If you have bought an asset with­out regard to dis­count­ed cash flows and need the price of the asset to rise in order to make mon­ey, you are not invest­ing; you are spec­u­lat­ing. Spec­u­lat­ing dur­ing a delever­ag­ing is unusu­al­ly per­ilous, both because asset prices gen­er­al­ly fall and it is a macro cli­mate that unfa­mil­iar and coun­ter­in­tu­itive  to most.

Also, be pre­pared for con­tin­ued unusu­al volatil­i­ty in com­modi­ties. Volatil­i­ty is nor­mal in com­modi­ties, but  this delever­ag­ing envi­ron­ment includes a com­bi­na­tion of fac­tors that make any fore­cast­ing par­tic­u­lar­ly hard. This includes defla­tion­ary pres­sure due to debt defla­tion, peak oilin con­ven­tion­al oil, new hydro­car­bon sup­plies in uncon­ven­tion­al sources (shale gas and oil, tar sands and sub­salt wells), agri­cul­tur­al dis­rup­tion due to cli­mate change, and jumps in some com­mod­i­ty prices as peo­ple scram­ble for real assets dur­ing bouts of Quan­ti­ta­tive Eas­ing (even though some of this pur­chas­ing is due to mis­guid­ed spec­u­la­tion that QE will lead to immi­nent infla­tion). These are of course in addi­tion to the ever-present geopo­lit­i­cal con­cerns. Reg­u­la­to­ry changes or price-sta­bi­liza­tion regimes more like­ly to be tried in an unset­tled envi­ron­ment.

Don’t invest based on an incor­rect par­a­digm. Dur­ing the past few years, many smart peo­ple oper­at­ing from the wrong par­a­digm have harmed them­selves and their clients by pre­dict­ing high infla­tion and ris­ing bond yields based on a mis­un­der­stand­ing  of mon­e­tary eco­nom­ics. After the bust of ’08, hedge fund titans, Bill Gross and a num­ber of Aus­tri­an-lean­ing mon­ey man­agers made incor­rect calls on inter­est rates and infla­tion because they don’t under­stand the dynam­ics of delever­ag­ing cycles.

One com­mon­ly made mis­take was see­ing the swift rise of base mon­ey and pre­dict­ing an immi­nent infla­tion. John Paul­son, who famous­ly made over 15 bil­lion USD short­ing sub­prime mort­gages in 2007, has sub­se­quent­ly dis­ap­point­ed investors, deliv­er­ing a 50% loss in 2011 alone.  How did such a thing hap­pen? By believ­ing that quan­ti­ta­tive eas­ing would pro­duce dou­ble dig­it infla­tion, he loaded up on finan­cials, com­modi­ties and oth­er assets that would do well in gal­lop­ing infla­tion. Ray Dalio of Bridge­wa­ter asso­ciates under­stands delever­ag­ing cycles, made no such mis­take, and has become the top hedge fund for client returns.

The mis­take on infla­tion comes from the con­ven­tion­al belief in a mon­ey mul­ti­pli­er mod­el, which is fun­da­men­tal­ly incor­rect (see Rov­ing Cav­a­liers of Cred­it). Quan­ti­ta­tive eas­ing does add to base mon­ey, but reserves that are not lent out do not add to mon­ey in cir­cu­la­tion. Bank reserves and cash, while both base mon­ey, have qual­i­ta­tive­ly dif­fer­ent effects on demand and infla­tion. How do we know if the increase in base mon­ey trans­lates to new bank lend­ing?  The Reserve Bank of St Louis  tracks the M1 mon­ey mul­ti­pli­er (the ratio of M1 to M0) and it shows that base mon­ey cre­at­ed in the Fed­er­al Reserve’s QE and twist pro­grams are not being mul­ti­plied by lend­ing in the bank­ing sys­tem. In a delever­ag­ing envi­ron­ment, accel­er­at­ing infla­tion is the wrong bet to make.

The mis­take Bill Gross and oth­ers made on inter­est rates seems to have come from the neo­clas­si­cal belief in the “loan­able funds mod­el.”  The loan­able funds mod­el shows how the inter­est rate is deter­mined by the amount of funds avail­able for lend­ing. The sup­pli­ers of funds save more when inter­est rates are high. The bor­row­ers bor­row less when inter­est rates are high. This sets up the clas­sic equi­lib­ri­um graph where “X” marks the spot of the equi­lib­ri­um inter­est rate.

Unfor­tu­nate­ly, this mod­el is a com­plete fic­tion and should­n’t be the basis for either invest­ment or pol­i­cy deci­sions. It is the nature of banks that they can extend cred­it with­out any­one hav­ing saved it. They are not lim­it­ed by the quan­ti­ty of what peo­ple actu­al­ly set aside after con­sump­tion. The reserves that banks lever­age can orig­i­nate as sav­ings deposits (sav­ings), or they can be trans­ac­tion­al demand deposits that peo­ple are using to pay their week­ly bills (con­sump­tion). If the bank­ing sys­tems is short of reserves, the cen­tral bank is com­mit­ted to cre­at­ing new reserves to main­tain their tar­get rate.

Of course today the bank­ing sys­tem is awash with reserves, but even under more “nor­mal” cir­cum­stances, it is unclear why any­one would think the mar­ket for loan­able funds mod­el is pre­dic­tive, when sav­ings rates and inter­est rates in the US have both come down in tan­dem since 1980.

Final­ly, for when the next delever­ag­ing crunch hits, be pre­pared to be asked to bail out the finan­cial sys­tem and be ready to say no!  Whether you are in Aus­tralia, whose prospects for a delever­ag­ing cycle  are well chron­i­cled on this blog, or in the still vul­ner­a­ble US,  or in Europe, finan­cial insti­tu­tions will be reach­ing for your pock­ets.

Man­u­fac­tur­ing con­sent

When high­ly lever­aged insti­tu­tions are on the brink of implod­ing, the first thing they will try to do is ask for some­one to bail them out. They know that no one in their right mind would be okay with absorb­ing the loss­es of pri­vate, prof­it dri­ven insti­tu­tions. So pub­lic pro­nounce­ments from both the finan­cial sec­tor and cap­tured or duped  gov­ern­ment offi­cials will make peo­ple feel that if a mas­sive bailout is not forth­com­ing, the finan­cial sys­tem will drag every­thing down with it.

One might think that it should be obvi­ous that elect­ed offi­cials would make sure that all the par­tic­i­pants in the prof­its of a risk tak­ing enti­ty would absorb the loss­es first, before the tax-pay­ers would be put at risk. But this has not been the case in prac­tice. When finan­cial insol­ven­cy has loomed, some­times stock hold­ers are wiped out (Fan­nie Mae) but often they have just been dilut­ed (AIG, Cit­i­group). That equi­ty own­ers  should get a dime if tax­pay­ers are put at risk is trou­bling enough but they at least absorbed large loss­es.

The biggest heist comes as finan­cial com­pa­ny bond-hold­ers  are made whole when the gov­ern­ment is scared or cor­rupt enough to step in and recap­i­tal­ize the com­pa­ny with­out tak­ing the com­pa­ny into receiver­ship.  Receiver­ship allows the wip­ing out of stock­hold­ers and bond­hold­ers if nec­es­sary, while main­tain­ing the func­tion­ing of the orga­ni­za­tion for depos­i­tors and coun­ter­par­ties. The very last par­ty that should take a loss is the pub­lic, who did not share in prof­its, bonus­es, or bond div­i­dends when the com­pa­ny was doing well. Unfor­tu­nate­ly, this is not at all what has hap­pened in prac­tice.

In the US (Fan­nie Mae, AIG, Bear Stearns and oth­ers),  UK (North­ern Rock), Ire­land and recent­ly Spain (with bad assets being con­sol­i­dat­ed into Bankia), pub­lic mon­ey has been lost while finan­cial insti­tu­tion bond­hold­ers have been made whole. Michael Lewis, finan­cial dis­as­ter reporter and author of “The Big Short,” described in an arti­cle for Van­i­ty Fair how the gov­ern­ment of Ire­land put its peo­ple on the hook for rough­ly 50,000 Euros each for the debts of pri­vate bond­hold­ers:

“The Irish banks, like the big Amer­i­can banks, man­aged to per­suade a lot of peo­ple that they were so inter­twined with their econ­o­my that their fail­ure would bring down a lot of oth­er things, too. But they weren’t, at least not all of them. Anglo Irish Bank had only six branch­es in Ire­land, no A.T.M.’s, and no organ­ic rela­tion­ship with Irish busi­ness except the prop­er­ty devel­op­ers. It lent mon­ey to peo­ple to buy land and build: that’s prac­ti­cal­ly all it did. It did this main­ly with mon­ey it had bor­rowed from for­eign­ers. It was not, by nature, sys­temic. It became so only when its loss­es were made everyone’s

In any case, if the Irish want­ed to save their banks, why not guar­an­tee just the deposits? There’s a big dif­fer­ence between depos­i­tors and bond­hold­ers: depos­i­tors can flee. The imme­di­ate dan­ger to the banks was that savers who had put mon­ey into them would take their mon­ey out, and the banks would be with­out funds. The investors who owned the rough­ly 80 bil­lion euros of Irish bank bonds, on the oth­er hand, were stuck. They couldn’t take their mon­ey out of the bank. And their 80 bil­lion euros very near­ly exact­ly cov­ered the even­tu­al loss­es inside the Irish banks. These pri­vate bond­hold­ers didn’t have any right to be made whole by the Irish gov­ern­ment. The bond­hold­ers didn’t even expect to be made whole by the Irish gov­ern­ment. Not long ago I spoke with a for­mer senior Mer­rill Lynch bond trad­er who, on Sep­tem­ber 29, 2008, owned a pile of bonds in one of the Irish banks. He’d already tried to sell them back to the bank for 50 cents on the dollar—that is, he’d offered to take a huge loss, just to get out of them. On the morn­ing of Sep­tem­ber 30 he awak­ened to find his bonds worth 100 cents on the dol­lar. The Irish gov­ern­ment had guar­an­teed them! He couldn’t believe his luck. Across the finan­cial mar­kets this episode repeat­ed itself. Peo­ple who had made a pri­vate bet that went bad, and didn’t expect to be repaid in full, were hand­ed their mon­ey back—from the Irish tax­pay­er

In ret­ro­spect, now that the Irish bank loss­es are known to be world-his­tor­i­cal­ly huge, the deci­sion to cov­er them appears not mere­ly odd but sui­ci­dal. A hand­ful of Irish bankers incurred debts they could nev­er repay, of some­thing like 100 bil­lion euros. They may have had no idea what they were doing, but they did it all the same. Their debts were private—owed by them to investors around the world—and still the Irish peo­ple have under­tak­en to repay them as if they were oblig­a­tions of the state. For two years they have labored under this impos­si­ble bur­den with scarce­ly a peep of protest..”

Nation­al­iza­tion is not suf­fi­cient

So if and when finan­cial com­pa­nies shout “fire” in your coun­try, real­ize that wip­ing out the stock­hold­ers is not enough if a bailout is to take place. Every enti­ty that par­tic­i­pat­ed and prof­it­ed by risk- tak­ing must suf­fer loss­es before the pub­lic risks a dime. Tak­ing the insti­tu­tion into receiver­ship allows for bond­hold­ers to take loss­es as they stand in line with oth­er cred­i­tors. Employ­ee bonus­es stand in line as well. For exam­ple, when AIG was bailed out by the gov­ern­ment, but not tak­en into receiver­ship, mil­lions in bonus­es and oth­er employ­ee com­pen­sa­tionwere pro­tect­ed even as the tax­pay­er was pay­ing for the black hole left by those very employ­ees.  Giv­en the lack of regard for pub­lic funds dur­ing the bailouts of the last 5 years, it is quite like­ly that cap­tured law­mak­ers will not lead the charge in mak­ing sure involved par­ties take the first loss, so it becomes an essen­tial part of self-defense that the pub­lic demand account­abil­i­ty.