I’ve finished the book “Bailout” and will review it next week. I am in the midst of the book “The Crisis of Crowding,” and will likely review it next week. What I write this evening is a bit of an experiment, and preparatory to what I write on “The Crisis of Crowding.”
Here’s the issue: I spend more time on liability issues than most investors. How is an investment financed? For those that have access to RealMoney, these old articles of mine explain the issues very well:
In hindsight, I wish we could have had consistent titles for the articles. The broad idea is this: how much risk might the holder of the asset be taking on depending on how he finances the asset? The asset in question is a long duration asset, like a house or a factory. Consider the spectrum:
- I own the asset “free and clear.” I have other unencumbered assets to deal with uncertainties.
- I own the asset “free and clear.”
- I have a significant amount of equity invested in the asset, and the rest is borrowed on fixed terms.
- I have a normal amount of equity invested in the asset, and the rest is borrowed on fixed terms.
- I have a modest amount of equity invested in the asset, and the rest is borrowed on fixed terms. I had to pay a higher interest rate to do this.
- I have a modest amount of equity invested in the asset, and the rest is borrowed on floating rate terms.
- I have no equity invested in the asset, and the financing is borrowed on floating rate terms.
As you go down the spectrum, the odds of loss go up that the owner of the asset might ever lose control of the asset. As financing shifts toward the end of the spectrum, the odds of a bubble go up, as cheap financing allows marginal buyers to buy more of the asset in question.
Now this can be framed more generally: what are the likelihood of outcomes on the assets that I buy versus the fixed commitments needed to support my purchase, or the internals of the asset (i.e. too much internal debt). The rate needed to support the purchase could be the rate needed to support a happy retirement.
And there is the problem. When needs are fixed and outcomes are variable, it can be quite a trouble, particularly when asset prices have been rising because of increased buying power from debt arrangements. Almost all systems would be relatively stable without debt. Even the dot-com bubble had its slug of debt from internal trade financing, and the need to pay taxes s a result of the options received.
When a large number of people are relying on decent-sized short-term asset price gains in order to do well, that is a recipe for disaster. Note: at the same time, that don’t need to make money, and have financial flexibility, don’t care to invest, because asset prices are too high compared to the cash flows that they are likely to throw off. They invest in cash-like equivalents, carefully researched ideas that look weird, biding their time, looking dumb as the mania proceeds.
When those that are inflexible expect a lot, and those that are flexible expect nothing, that is the peak of the market. There is no one left to buy the speculative assets in question, and things will mean-revert.
Prices of the speculative assets start to fall, and things cascade in ways that few would expect, because as prices fallvarious liabilities are called into question. And, if the liabilities are called into question, so are those who funded the liabilities, because they are less certain of receiving the cash flows that they expected. This process continues until only those with modest or no borrowings is left standing, or the government intervenes to protect her chosen.
[Note: all liabilities are assets of someone else, and net in aggregate to zero. That is even true of the duration of liabilities; aggregate liability durations net to zero as well. Liabilities are an important sideshow in a world driven by assets.]
The bottom comes when those that are inflexible expect nothing or worse, and those that are flexible expect that will make decent money as they wait. This is a trite saying, but as a friend of mine once said, “The tritest sayings in life are true,” here is the saying, “Patience is a virtue.” In investing, good things flow over time to those who are willing to invest during crisis, and sit back during the latter parts of a boom. Bad things come to those that chase the market, investing when things are hot, and divesting when things are not.
Asset returns are not what the financial planners tell you. Asset returns are lumpy. They are feast and famine, with more feast than famine, but with enough famine scare a lot of people away. The good returns come when most are scared, and think the market is rigged. The bad returns come after a period of prosperity, and those that don’t understand the market start investing, because it seems to be free money. As I often say, the lure of seemingly free money brings out the worst in people. (Someone please send the memo to Ben Bernanke.)
Those who are patient in investing earn most of the rewards over the long haul. Others may clip gains at the edges, but real wealth stems from owning the best assets when few want to invest, and being patient when opportunities are few.
Now, if everyone knew this and acted like this, the market would get really dull, and would grow at the rate of book value, like private businesses do. But not everyone is patient and provident. Moral tendencies vary. In the long run, those that insist on returns in the short run don’t get them, while those those that wait for returns in the long run do.
I’m planning on writing a summary post on the crisis, to explain what drove the crisis, and what did not. The framework that I have given here will instruct that process.
By David Merkel, CFA of Aleph Blog