Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes a bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill done.
— John Maynard Keynes
It’s not hard to notice that we are in the midst of Mr. Market swallowing a bigger dose of reality than he normally likes to take. One of my buddies who is quite cold blooded about investing cut her equity positions in a major way a few weeks back. What is perhaps more telling is that she had set up buy orders (she likes buying during dips) but has cancelled them. She also casually remarked that the Great Depression bear market was 20 years, but a more reasonable worst case scenario was the 1970s bear market, and that lasted 10 years.
She is comfortable she can see her way through that….but how many others can?
Now this may not be the start of a lasting deflating of a very big bubble. Plenty of very sound value oriented investment managers have been in a world of hurt for years expecting reversion to sensible valuations. And recall that Japan, which had an absolutely ginormous joint real estate and stock market bubble, didn’t have a dramatic unwind like our 1987 or 2008 crashes, but a fizzling over years.
But rather than trying to call a turn, since the market upset conditions do not come out of credit markets (which made it possible to foresee that the derivatives/subprime crisis of 2007-2008 could come to a very bad end), it might be more useful to ponder how we got into creating a hyper-speculative economy in the first place. Yes, I know some Howard James Kunstler/David Stockman/Caitlin Johnstone fire and brimstone might be more fun, in a world that has nor just normalized but even celebrated patent stupidity like NFTs and SPACs but maybe I’ll work myself up to that later.
Now of course one can blame neoliberalism. As Simon Johnson pointed out in his classic article The Quiet Coup, at the start of the 1980s, average banker pay was on a par with economy-wide compensation. But by the eve of the crisis, bankers earned a 80% premium to the average in the rest of the US.
The US has indeed become over-financialized, with societally-unproductive secondary market trading a big drain of collective resources. Yet it’s perfectly rational at the individual and firm level: you are twice as likely to become a billionaire in asset management as in tech.
The mess we are in has many causes, but let me single out a few, with emphasis one ones that may not have gotten the attention they warrant:
Credit markets explosion in the 1980s kicking off Wall Street brain drain. Remember Liar’s Poker? High and volatile interest rates turned bonds from a safe and sleepy backwater to one where investing was suddenly risky. Investors had to worry about interest rate risk as well as credit risk. Wall Street started hiring quants, both mathematicians and physicists, to do modeling.
Alan Greenspan’s misrule. Paul Volcker may have hated unions, but he wasn’t too keen about bankers either. Some of his major misdeeds:
Learning the wrong lesson from the 1987 crash and establishing the Greenspan put. Greenspan got all sorts of kudos for rescuing the stock market. What is not so widely recognized is he had the Fed prop up the Treasury market and even had the Fed call the Bank of Japan to have Japanese banks buy more Treasuries (I was in Japan during the 1987 crash and heard this first-hand from Sumitomo Bank staffer). Japan being a military protectorate of the US apparently meant it could be pushed around in other ways.
So Greenspan, the supposed ultimate libertarian, got into the business of bailing out markets. Even worse, he became obsessed with equities markets, when that was never the Fed’s job (I had suspected this in the 1990s, it was confirmed in a 2000 Wall Street Journal article).
He did it again during the S&L crisis by engineering a super-steep yield curve which enabled banks to earn unusually high profits from good old fashioned borrow short-lend long strategies (in fairness, this was a defensible rescue; the banks were chastened by their weakened state and it took them a while to earn their way out of their hole).
Greenspan actually noticed the markets were getting frothy in 1996 and made his famous “irrational exuberance” remark, which took over 140 points off the Dow. So Greenspan retreated.
So because Greenspan lost his nerve in 1996, we got a more spectacular dot com bubble than we might otherwise have had. And Greenspan was unnerved by its collapse. Mind you, there wasn’t enough leverage for the bust to blow back to the credit system. While there was damage in the real economy, it was contained.
But Greenspan overreacted, as if the loss of so much “easy come, easy go” wealth represented a serious blow to the economy (in fact, all that happened was a pretty mild recession). Greenspan dropped interest rates, not for the usual one quarter, but an unprecedented nine quarters, and with policy rates at negative real return levels.
Depriving investors of safe real yields produced the dysfunction of “reaching for return” strategies, particularly hedge funds and private equity funds. Without belaboring the point, to the extent that these strategies actually might be able to generate outsized alpha, the more money you threw at them, the less likely that outcome. By the time we started blogging, in 2006, it had been well established that hedge fund no longer generated alpha and you could generate “alternative beta” at much lower cost than typical hedge fund fees.
Promoting unsupervised derivatives casinos. I gasped out loud in 1996 or 1997 when I read that Greenspan washed his hands of having the Fed monitor derivatives risks of the large banks it supervised. He said he’d let a thousand flowers bloom, that they could all experiment with risk metrics and supervision and surely the best approach would prevail.
Somehow the Fed-orchestrated bailout of LTCM in 1998, which threatened to become systemic, did nothing to discredit this faith, despite it having had derivatives experts uber alles Myron Scholes and Bob Merton at the helm.
And of course, the successful war against Brooksley Born’s efforts to regulate credit default swaps came out of this line of thinking. We explained long-form in ECONNED ho the 2007-2008 crisis was a derivatives crisis, triggered largely by a particular subprime CDO strategy that created a no-lose wager for traders, but put tons of leveraged subprime risk on systemically important, undercapitalized players.
Regulations ever and always favoring more liquidity and lower transaction cost. Here the SEC is guilty along with banking regulators. More liquidity is not virtuous. First, it deprives financial institutions of low risk transaction revenues. It is always better to keep financial institutions safe and stupid. Second, the lack of cheap safe income leads to financial firms becoming more dependent on trading. Who is the best source of trading profits? Customers! What’s the easiest way to profit from them? By cheating, like front running, less than full disclosures. Third, it makes it cheap for everyone to speculate. Policy makers should be promoting buy and hold investing, not trading.
Going to ZIRP. The Bernanke Fed panicked in the runup to the crisis. It dropped interest rates dramatically at key junctures, leading to the observation that “75 is the new 25” meaning the Fed was lowering interest rates by 75 basis points at a clip when 25 would have been seen as aggressive.
I knew it was a big mistake when the Fed dropped its policy rate below 1%, that it was painting itself in a corner. The lower interest rates are, the bigger the drop in bond prices or loan valuations on any given increase. A half a point interest rate increase whacks bond prices more severely at 0.50% than it does at 4%.
The failure to hold anyone at executive or board levels accountable for the 2007-2008 risk management disaster, let alone fraud. Regulators should have forced widespread blood-letting and early retirements. The failure to do so signaled that bad conduct would go unpunished and helped institutionalize the sort of elite impunity that has corrupted what passes for American leadership.
The successful cover-up of the second bailout, the “get of of jail almost free” for the widespread failure to conform to rigid mortgage securitization requirements, resulting in “securitization fail” and foreclosure fraud. We covered this at length in real time, and a team of activists, coordinated on Matt Stoller’s listserv, almost succeeded in getting some justice for wronged homeowners, via a group of dissident attorneys general led by Eric Schneiderman. But Obama flipped Schneiderman, the other attorneys general took a powder, and the banks got away with fake settlements (the hard cash portion was small; they were getting credits for things they would have done anyhow and in some cases, for conduct that was harmful to investors). Critically, there were no meaningful reforms to servicing practices, which set the stage for student loan servicing misconduct.
Bernanke and Yellen perpetuating the Greenspan put. We are told that by 2014, the Fed had come to realize that its super low interest rate experiment had been a bust. It did not stimulate the economy save for encouraging leveraged speculation. But Bernanke was too cowed by Mr. Market to beat a retreat. The taper tantrum of 2014 rattled the Fed, which thereafter engaged in only the most timid of rate increases now and again.
Readers no doubt have other critical decisions and actions that they deem played a big role in how we got where we are. But perhaps the fundamental failure was the lack of willingness to take action that would crimp financial services industry profits. As we wrote in ECONNED:
It is easy to be overwhelmed by the vast panorama of financial instruments and strategies that have grown up (and blown up), in recent years. But the complexity of these transactions and securities is all part of a relentless trend: toward greater and greater leverage, and greater opacity.
The dirty secret of the credit crisis is that the relentless pursuit of “innovation” meant there was virtually no equity, no cushion for losses anywhere behind the massive creation of risky debt. Arcane, illiquid securities were rated superduper AAA and, with their true risks misunderstood and masked, required only minuscule reserves. Their illiquidity and complexity also meant their accounting value could be finessed. The same instruments, their intricacies overlooked, would soon become raw material for more leverage as they became accepted as collateral for further borrowing, whether via commercial paper or repos.
But even then, the bankers still needed real assets, real borrowers. Investment bankers screamed at mortgage lenders to find them more product, and still, it was not enough.
But credit default swaps solved this problem. Once a CDS on low-grade subprime was sufficiently liquid, synthetic borrowers could stand in the place of subprime borrowers, paying when the borrowers paid and winning a reward when real borrowers could pay no longer. The buyers of CDS were synthetic borrowers that made synthetic CDOs possible. With CDS, supply was no longer bound by earthly constraints on the number of subprime borrowers, but could ascend skyward, as long as there were short sellers willing to be synthetic borrowers and insurers who, tempted by fees, would volunteer to be synthetic lenders, standing atop their own edifice of risks, oblivious to its precariousness.
Institution after institution was bled dry. Yet economists and central bankers applauded the wondrous innovations, seeing increased liquidity and more efficient loan intermedation, ignoring the unhealthy condition of the industry.
The firms that had been silently drained of capital and tied together in shadowy counterparty links teetered, fell, and looked certain to perish. There was one last capital reserve to tap, U.S. taxpayers, to revive the financial system and make the innovators whole. Widespread anger turned into sullen resignation as the public realized its opposition to the looting was futile.
The authorities now claim they will find ways to solve the problems of opacity, leverage, and moral hazard.
But opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the innovations. No one at the major capital markets firms was celebrated for creating markets to connect borrowers and savers transparently and with low risk. After all, efficient markets produce minimal profits. They were instead rewarded for making sure no one, the regulators, the press, the community at large, could see and understand what they were doing.
Magnetar and its imitators made unbelievable profits by finding a nexus of spectacular leverage, eager demand, and camouflaged risks. Whether you like the results or not, their novel use of an arcane instrument was exceptionally clever. If the world had been spared their cunning, the insanity of 2006–2007 would have been less extreme and the unwinding milder. But the hedge funds were not the only ones who fed this strategy; the other institutions who carried out the same correlation trade strategy and European bank staff padding their pockets with negative basis trades are just as culpable.
Viewing the underlying problem as one of bubbles misses the true dynamic. When borrowed funds pump up asset values, the unwind damages financial intermediaries, and that has far more serious repercussions than the loss of paper wealth alone. Leverage offers a strategic point at which regulators can intervene. Regulators can tackle debt levels surgically by barring certain types of instruments and practices. But this effort can take place only if authorities do not cede control of the financial system to the inmates. Unfortunately, to a large degree, that has already happened.