Friday, September 26, 2008

Credit Addicts and Their Enablers

Posted by Jeff Lipshaw

There's an old joke (I guess it's a joke) about a person searching for a lost wallet at night under a street light.  "But you lost it over there," says a bystander, pointing down the street.  "Yes, but there's no light there," responds the searcher. 

I'm not sure I can improve on Christine Hurt's analysis of the situation:  this crisis is not about evil, or class warfare, or fraud.  It's about bubbles.  Bubbles are about systemic misapprehension of risk.  Bubbles are about the perception that something in the market always goes up, or at least, everybody else thinks it's going up, and if we are going to compete with them, we better do what they're doing.  When the bubble burst, and it's really hard to understand how it all happened, and worse, when we still don't understand the impact of the bursting, it is certainly a lot easier to resort to tried and true bromides and political stereotypes (the bright spot under the street lamp) than to accept the more likely truth:  we are all either addicts or enablers and co-dependents to the addicts.

Imagine a family.  Dad, Mom, and the kids.  Dad and Mom own a house.  They believe the value of the house is the one true immutable in the world - it will always go up.  Dad and Mom go out and borrow against the equity in their house to supplement the family's life style.  And what a binge it is!  Vacations to Hawaii.  Private schools.  Each kid gets a car.  But the family now has a lot more fixed debt, and it has to be paid back sometime.  The kids don't think about it, and Mom and Dad aren't worried; they know the value of the house will support it, and they seem to be alright making the payments.

But now there's a small glitch.  Dad loses his job.  Or the interest rate cranks up a notch.  Now Dad and Mom are having a hard time making the payments.  The drastic way out would be to sell the house, tap the equity and pay off the lifestyle loan, but it turns out the value of the house has gone down.  Uh oh.  Somehow the piper has to be paid.  Who's going to pay it?  Dad, Mom and the kids.  Dad and Mom say to the kids:  sorry but we have to move to a small apartment, sell the cars, take you out of private school, and put you in public school, because we just aren't worth what we used to be.  The kids say:  "how can that happen?  Life was good.  Mom and Dad, you were greedy scum (if not fraudulent creeps)."  Mom says to Dad:  "I told you something wasn't right!"  Dad says to Mom:  "you never should have bought those clothes."  Mom said to Dad:  "what made you think we could afford a golf club membership?"  And the kids blame both of them, even though their lives in the short-term were probably better as a result of the binge.

Now take my story and write it large.  We can see the analog of the kids' position in my following paraphrase of a bitter post over at the Wall Street Journal's website on the bail-out term sheet.  An angry taxpayer notes that you contributed to the binge if, in the last eight years, (1) you worked in a position that allowed you to influence or alter the way people purchase real estate; (2) you purchased a house without a down payment or an understanding of your debt obligation; (3) you purchased a home with an interest only, Alt-A, sub prime, piggyback or other type of nonstandard mortgage to shoehorn your way into a house you could never afford without the benefit of financial magic; (4) you participated in cash out refinancing to pay for your kids education, improve your house, take a vacation or anything else that will not bring you a probable return for your spending borrowed money; (5) you worked within the real estate industry or any other business being financed by unduly cheap money. 

This rant (not unwarranted, by the way) gets at the addicts but I'm not sure it identifies the enablers.  In my analogy, the kids got to share, albeit indirectly, of the pleasures of the binge.  Put another way, the creation of wealth in the financial markets is no longer "us" and "them."  I don't have at my fingertips the amount of the NYSE and NASDAQ capitalization that is owned by institutions, but it's huge.  When I say institutions, I mean mutual funds (Fidelity, T. Rowe Price, Vanguard), insurance companies, union pension funds, state employee pension funds (like CalPERS), university endowments, private foundations, 401(k) plans, 403(b)(7) plans.  These institutions work for us, rich people and not so rich people, by making investment choices, which in turn are a matter of assessing risk.  If CalPERS took no risk with the pension funds held for all the California public employees, and bought nothing but T-bills, it would have a flock of exceedingly upset retirees.  The question is how much did CalPERS and the institutions like it (a) benefit from the bubble, and (b) enable the bubble by buying up the leveraged debt securities or the equity securities of the companies investing in the leveraged debt?  Empiricists, do me a favor.  Please track how much of the stock of AIG, Fannie Mae, Freddie Mac, and Sallie Mae was held over the last seven years by pension funds, and in particular, union pension funds.**  (Note to file:  CalPERS was one of the big investors in Enron.  And full disclosure:  as I recall my investment advisor bought Enron for me at about $80, but, as I recall, had the good sense to sell at $22.)  This isn't to blame them:  it's to say maybe we have met the enemy and they are us. 

My point here is that a lot of people who are professionals in the quantification and monetization of risk got it wrong.  They managed to get it wrong all at the same time because there is a "herd" aspect to this:  if you don't show the short term returns others are getting, capital (for who owns the capital, see above, because it's all of us) will flee to other managers.  I suspect the bell curve of venality is about what it is for any other group in society - most of them were probably about as evil as Mom and Dad.  (This is the subject for another time:  are corporate boards any more venal than synagogue boards, or non-profit boards, or law faculties, or the Congress?  Put another way, what if your battles happen not to be for money, but instead the currency is power, or influence, or fame, or position, or re-election?  But I digress.)

So now we're having a big family council, trying to decide who bears the brunt of this seven-year long family binge.  Like the above-quoted ranter, the kids say "we benefited from this, but we didn't cause it, why should we have to pay for the excess?  Dad should have to quit the golf club, and Mom should have to get rid of her car."  One of the kids wants to cap Dad's allowance.  One of them has asked the FBI to look into whether there was fraud.  Mom and Dad say:  "look, kids, we're really sorry we messed up, but we are still the best thing you've got to get this right."

And here we are.

** UPDATE:  I did a little quick investigation of my own.  If you look at AIG's proxy statement, Fidelity's funds owned 5.7% of the company as of Feb. 14, 2008, making it the second largest shareholder after C.V. Starr, which is Hank Greenberg's firm.  Meaning that all of us who had 401(k) or 403(b)(7) or other retirement or investment accounts with Fidelity got the benefit, not so indirectly, of AIG's market value, spurred on in part by its participation in the credit markets.  Similarly, as of June 30, 2008, the California Public Employees Retirement System (one of the largest pension funds in the country, holding $54 billion in assets as of that date) held securities in the following companies valued at the time as shown:  JPMorganChase, $395 million; Bank of America, $355 million, AIG, $229 million; Goldman Sachs, $228 million; Morgan Stanley, $133 million; KB Homes, $6.7 million. 

You can say that "we the taxpayers" are bearing the brunt of the diminution in asset value, but to some extent (and I think to a large extent), we are merely shifting the burden from a left pocket to a right pocket.  That tells us two things:  (a) it's still very unclear whether a bail-out helps or hurts in the end, but the markets seem to think it helps, and (b) It's a fair request that money not stick too much to those involved (transaction costs and agency costs), but, at the end of the day, all of us want competent people at the helm of all of those companies whose returns fund our retirements.

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Comments

walt kelly would be proud of this classic pogo strip sans drawing. jeff could have at least posted a drawing of "hisself" poling a flatboat in the swamp. it is always more important to fix the problem than to fix the blame. unfortunately many (most?) of those inside the beltway prefer to fix the blame (on someone else). is this because they don't know how to fix the problem, or because they lack the political courage to do so?

Posted by: fred ours | Sep 26, 2008 6:51:40 AM

I prefer this take on matters courtesy of Kelly Candaele recently in the Los Angeles Times (http://www.latimes.com/news/opinion/la-oe-candaele22-2008sep22,0,1549912.story):

'As a trustee of the Los Angeles City Employees' Retirement System, every week I receive materials in the mail from money mangers imploring me to consider investing in their strategy for generating high returns for our $10-billion pension fund. One of the most fascinating -- and revealing -- set of marketing materials comes from a company that lists the following options for investing our fund's money: credit default swaps, merger arbitrage strategies, collateralized debt obligations, interest rate contracts. You get the picture. Or perhaps, like most Americans not involved in the arcane "science" of finance, you don't get the picture.

It's unfortunate that it takes a financial crisis for Americans to divert their attention from what kinds of glasses Alaska Gov. Sarah Palin wears to issues that really matter, but a reevaluation of priorities may be the only upside to a meltdown that the news media is now desperately trying to explain.

In the so-called old economy, investors looked at the health of a company, the skills of management, potential market opportunities and the quality of the products produced. If, for instance, Harley-Davidson motorcycles looked as if it were producing high-quality bikes, investing in new engineering and training skilled workers, then that company could be a solid investment. Your investment was a wager, of course -- like all stock investments -- but nonetheless based on some modicum of analysis and solid research. If Harley-Davidson sold more motorbikes, then profits were made, investment was plowed back into the company and more jobs were created. Americans understand that basic logic of capitalism.

But try explaining a credit default swap -- the financial instruments now collapsing -- to your neighbor. Here is how one popular website defines the strategy: "A credit default swap is a credit derivative contract between two counterparties, whereby the 'buyer' or 'fixed rate payer' pays periodic payments to the 'seller' or 'floating rate payer' in exchange for the right to a payoff if there is a default or 'credit event' in respect of a third party or 'reference entity.' " At what point in this elaborate series of maneuvers is the economy enhanced and American workers' standard of living increased?

It is easy to parody the language quoted above. And Karl Marx did so in his mid-19th century writings by referring to various paper transactions as "fictitious capital." In our "postmodern" economic system, money makes money through speculation without the arduous process of actually producing anything.

It is firmly established that hedge-fund strategies, arbitrage arrangements and other complex investments have made a great deal of money for money managers and institutional investors who have embraced them. And some of these approaches can help hedge against risk, an important component in any large portfolio.

But more economists, writers and thankfully the American people are beginning to ask what these largely unregulated and opaque financial operations mean for the economy as a whole. In his recently published book, "Bad Money," historian and political commentator Kevin Phillips points out that if you include mortgage lending and real estate operations, financial services has grown from 11% of our gross domestic product in 1950 to more than 20% today, dwarfing manufacturing. As more and more of our economy is given over to financial machinations, inequality grows and working people's faith in the direction of the economy declines.

And Nouriel Roubini, an economics professor at New York University who predicted the current crisis, points out that the financial meltdown is much more than simply the product of a few overzealous and incautious executives. "We have a subprime financial system," he told the New York Times Magazine, "not a subprime mortgage market." Capitalism has come off its leash.

[...]

Sophisticated and reasonable regulations will help our economy as a whole and provide more transparency for investors -- like pension funds -- that are looking for good investments that also strengthen our economy. We would all be better off if the most common economic questions were the fundamental ones: What does this company produce? What is its market? And how well is the company run?'


Posted by: Patrick S. O'Donnell | Sep 26, 2008 7:18:53 AM

If the link above does not work enter "Kelly Candaele" in their archives search engine and it will show up in one of the first few results as "Back-to-basics investing."

Posted by: Patrick S. O'Donnell | Sep 26, 2008 8:29:34 AM

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