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:
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.
