Best of the Week
Most Popular
1. Market Decline Will Lead To Pension Collapse, USD Devaluation, And NWO - Raymond_Matison
2.Uber’s Nightmare Has Just Started - Stephen_McBride
3.Stock Market Crash Black Swan Event Set Up Sept 12th? - Brad_Gudgeon
4.GDow Stock Market Trend Forecast Update - Nadeem_Walayat
5.Gold Significant Correction Has Started - Clive_Maund
6.British Pound GBP vs Brexit Chaos Timeline - Nadeem_Walayat
7.Cameco Crash, Uranium Sector Won’t Catch a break - Richard_Mills
8.Recession 2020 Forecast : The New Risks & New Profits Of A Grand Experiment - Dan_Amerman
9.Gold When Global Insanity Prevails - Michael Ballanger
10.UK General Election Forecast 2019 - Betting Market Odds - Nadeem_Walayat
Last 7 days
Why Record-High Stock Prices Mean You Should Buy More - 20th Nov 19
This Invisible Company Powers Almost the Entire Finance Industry - 20th Nov 19
Zig-Zagging Gold Is Not Necessarily Bearish Gold - 20th Nov 19
Legal Status of Cannabis Seeds in the UK - 20th Nov 19
The Next Gold Rush Could Be About To Happen Here - 20th Nov 19
China's Grand Plan to Take Over the World - 19th Nov 19
Interest Rates Heading Zero or Negative to Prop Up Debt Bubble - 19th Nov 19
Plethora of Potential Financial Crisis Triggers - 19th Nov 19
Trade News Still Relevant? - 19th Nov 19
Comments on Catena Media Q3 Report 2019 - 19th Nov 19
Venezuela’s Hyperinflation Drags On For A Near Record—36 Months - 18th Nov 19
Intellectual Property as the New Guild System - 18th Nov 19
Gold Mining Stocks Q3’ 2019 Fundamentals - 18th Nov 19
The Best Way To Play The Coming Gold Boom - 18th Nov 19
What ECB’s Tiering Means for Gold - 17th Nov 19
DOJ Asked to Examine New Systemic Risk in Gold & Silver Markets - 17th Nov 19
Dow Jones Stock Market Cycle Update and are we there yet? - 17th Nov 19
When the Crude Oil Price Collapses Below $40 What Happens? PART III - 17th Nov 19
If History Repeats, Gold is Headed to $8,000 - 17th Nov 19
All You Need To Know About Cryptocurrency - 17th Nov 19
What happens To The Global Economy If Oil Collapses Below $40 – Part II - 15th Nov 19
America’s Exceptionalism’s Non-intervention Slide to Conquest, Empire - and Socialism - 15th Nov 19
Five Gold Charts to Contemplate as We Prepare for the New Year - 15th Nov 19
Best Gaming CPU Nov 2019 - Budget, Mid and High End PC System Processors - 15th Nov 19
Lend Money Without A Credit Check — Is That Possible? - 15th Nov 19
Gold and Silver Capitulation Time - 14th Nov 19
The Case for a Silver Price Rally - 14th Nov 19
What Happens To The Global Economy If the Oil Price Collapses Below $40 - 14th Nov 19
7 days of Free FX + Crypto Forecasts -- Join in - 14th Nov 19
How to Use Price Cycles and Profit as a Swing Trader – SPX, Bonds, Gold, Nat Gas - 13th Nov 19
Morrisons Throwing Thousands of Bonus More Points at Big Spend Shoppers - JACKPOT! - 13th Nov 19
What to Do NOW in Case of a Future Banking System Breakdown - 13th Nov 19
Why China is likely to remain the ‘world’s factory’ for some time to come - 13th Nov 19
Gold Price Breaks Down, Waving Good-bye to the 2019 Rally - 12th Nov 19
Fed Can't See the Bubbles Through the Lather - 12th Nov 19
Double 11 Record Sales Signal Strength of Chinese Consumption - 12th Nov 19
Welcome to the Zombie-land Of Oil, Gold and Stocks Investing – Part II - 12th Nov 19
Gold Retest Coming - 12th Nov 19
New Evidence Futures Markets Are Built for Manipulation - 12th Nov 19
Next 5 Year Future Proof Gaming PC Build Spec November 2019 - Ryzen 9 3900x, RTX 2080Ti... - 12th Nov 19

Market Oracle FREE Newsletter

$4 Billion Golden Oppoerunity

How Long Will the Bidding Up of Asset Prices on Leverage Go On

Stock-Markets / Market Manipulation Jul 11, 2012 - 12:54 PM GMT

By: Fred_Sheehan

Stock-Markets

Best Financial Markets Analysis ArticleThe Tisch family's shipping venture (A Buyer's Market) jogged the memory. The August 26, 1985, issue of Grant's Interest Rate Observer, in which Jim Tisch discussed buying ships for less than 10% of the new construction price, included a mix of leveraged developments that appeared doomed. Some were. Some go on and on.


The story under a page one headline: "Mortgages: A Federal Risk" suggested "it might be helpful to know the extent of the Treasury's exposure to mortgage values (and thus to the great postwar bull market in houses, which seems to be getting tired). Helpful, or not, the numbers are staggering." In 1984, the federal government guaranteed $386.7 billion of loans in 1984. The biggest component by far is mortgages. "The heart of the mortgage numbers [were] real estate loans that the federal government itself was on the hook for...." [For comparison: the coarse measurement for the size of the national economy - the GDP - rose from $4.2 trillion in 1985 to $15.1 trillion in 2011. - FJS]

According to usgovernmentrevenue.com, the federal government spent $851 billion in 1984. During this final year of the first term of the Reagan Administration, the government received $666 billion in revenues, thus spending $185 billion beyond its receipts. It was in the same year the government added $386 billion in (mostly) real estate guarantees. There may be a mismatch of calendar and fiscal years here, but Moody's and S&P still had cause to downgrade the U.S. government's AAA-rating. How long could this go on?

In the same issue, a recent circular from Kohlberg Kravis Roberts & Co. was discussed. The founding partners had participated in 13 buyouts between 1965 and 1976 that produced an estimated 63% annual return. KKR was formed in 1976, after which (to the time of this circular, announcing its fifth equity investment buyout fund) the annual rate-of-return had been 46.8%.

KKR goes on, with some successes and some failures. RJR Nabisco and TXU were among the firm's ill-chosen ventures. Even if investors should have looked elsewhere after 1985, the principals have prospered. Henry Kravis continues to accumulate assets (that is, his personal fortune) by not veering much from the same leveraged strategy described to potential investors in the 1985 memorandum. Of the targeted companies: "There should be a low debt-to-equity ratio, thereby permitting significant additional leverage in the new capital structure."

One consequence of this strategy has been the leveraging of corporate balance sheets across industries, no matter the inclinations of corporate management. A company that preferred to manage its balance sheet conservatively (mostly equity with little debt) stood as much chance of escape as a slow-moving target in a schoolyard, dodge-ball game. If it did not wise up (a little equity and mostly debt), KKR and its brethren would be sure to notice.

Companies in cyclical and capital-intensive industries that had traditionally eschewed debt were now showered with investment banking offers (along with the investment banks' well-compensated, Nobel-winning academics) to layer their balance sheets with faddish debt offerings. The result is an international corporate structure that is not poised to weather a decline in asset values. It is often claimed that U.S. corporations are "cash rich." This is highly misleading, as any reporter would discover with ten minutes of investigation, yet the claim is good for averting the S&P 500 and for deflecting closer inspection of companies that are buying back their own shares. The latter is another officially sanctioned though little mentioned contrivance to skew asset prices upwards.

Fannie Mae was the topic of another article. The credit-worthiness of Fannie was compared to its relatively unknown sister, Sallie Mae. (The latter won by a landslide.) As for Fannie, its chairman's second quarter letter to shareholders was discussed. Quoting part of what was quoted: "charge offs...for loan losses increased from $19.4 million to $27.6 million in the second quarter. During the second quarter, charge-offs exceeded the rate at which we provided for losses. The primary cause of this significant increase is the growing number of properties that Fannie Mae is acquiring through foreclosure. The problem is concentrated in depressed housing markets like Houston and Southern Florida, though is not limited to these."

-David O. Maxwell CEO, FNMA - second quarter [1985, believe it or not - FJS] report to shareholders.

Grant's commented: "To the investing world, the stocks and bonds of Fannie Mae might just as well be candy. Never mind the company's enormous leverage, its chronic losses or...its mounting credit problems."

Well, then, why was Fannie so attractive? The editor of Grant's had an answer: "Almost nobody could believe that 'they' (the Treasury, the Fed, the Department of Housing and Urban Development) would ever allow the Federal National Mortgage Association to go the way...." The way it in fact did go - twenty-three years later.

For many, this is painful to read. Not the comeuppance in 2008, but Fannie's pretense over the previous decades. There were short sellers who knew, without any doubt, that Fannie was insolvent in 1998, in 2000, in 2002. They kept shorting Fannie. Post-modern accounting conventions and congressionally muzzled regulators impoverished portfolios at the same time Jim Johnston, Franklin Raines, and Angelo Mozilo got rich.

Whether or not Maxwell, Johnston, Raines, Mozilo, or Henry Kravis understood it, they, and much of the so-called one percent, were on the winning side of the restructuring of the American economy. Woe betide the college graduate of 1980 who pursued a career at a manufacturer or oil producer. For decades, an incremental $1.40 of debt produced $1.00 of additional GDP. By 1985, it took $4.00 of additional debt to produce $1.00 of economic growth. This defied the natural boundaries of a functioning economy. Surely, the game was up.

The investor who understood nature, history, and fundamental analytics did not foresee how far an economy could push the limits when it could print its own currency, painlessly. The U.S. dollar has, subsequently, had its up and downs, but foreign central banks willingly (or, maybe not so willingly) have absorbed trillions of dollar emanations by releasing trillions of their own currencies. How long can this go on?

Reading the August 26, 1985, issue of Grant's (and forbearing a synopsis of Professor James C. Van Horne's July 1985 paper in The Journal of Finance about the financial "promoter [who] wishes to make a profit regardless of whether an idea has substance"), we are reviewing an important moment in history; 1984 to 1986 was a time when finance and business broke from the past.

For instance, banking was now a growth industry. The loan officer at a money-center bank was no longer so concerned that a borrower could extinguish a loan as long as the interest could be paid. Rolling over the loan at maturity was enough. Lending had become a volume business. As long as the loan book rose at a faster rate than defaults, profits and dividends could meet growth targets.

Fifteen years after the Bretton Woods gold standard ended, redemption of loans was no longer necessary, since the volume of dollar growth was no longer restricted by redemption into gold.

Fast money has made more money since. Capital-intensive, slow assets lost. They went the way of disco. Dollars were growing at a faster pace than aluminum. It's easier and more fun to hand out money than run a factory. The latter pays off too slowly for the portfolio manager judged by quarterly or annual performance. So, the rust belt moved to China.

The question before the house: Can the Powers Who Want It to Remain So support asset prices of largely under producing and redundant assets, around the world, with more, and necessarily much larger, emissions of currency for another 27 years? (The investment strategy, no matter the answer to that question, is to buy gold and silver. Central bankers can only imagine, as a response to weaker asset prices, the production of trillions upon trillions of dollars, euros, yen, pounds, and yuan.)

A clue might be gleaned from the answer to the following question, aimed at (though we know in advance he would claim immunity) European Central Bank President Mario Draghi: "We know that most European banks no longer deal with each other. We know, for instance, the lending market among European banks contracted by $637 billion in the fourth quarter of 2011. To settle overnight balances, commercial banks now use the European Central Bank as its counterparty. That is, commercial banks trust that the ECB will not go bust before tomorrow morning. Yet, the ECB seems intent on diluting the credit worthiness of its own balance sheet. The ECB gave 75% haircuts (discounts) to some of the loans that banks used as collateral in LTRO2. Since then, you have added categories of collateral that were previously verboten. What will happen on the day banks decide your balance sheet is in worse shape than the counterparties they already rejected?"

ECB President Draghi might offer a similar response to that proffered by the host of a conference put on by Data Resources Inc. on August 12, 1985:

QUESTION: "It seems to me that the U.S. has turned into a three-tier economy. We've got the farm sector - it is on its ass - and the manufacturing sector - it is on its ass - and the services sector which in reality is the financial services sector, which in a great measure is the business of distributing and trading around government debt. Where does all this lead?"

ANSWER: "Let's move on to the next topic."

As a gander, the spoil sport at the Data Resources soiree underperformed over the next twenty-seven years. Those who moved onto the next topic - that is, many who do not recognize, even today, the insubstantial nature of the world's economy - have made a mint. The latter defines 99% of what goes by the label of Wall Street, since those who did not go with the flow found a new job. Do investment advisers and consultants have another 27 years before their investment strategies come a cropper? It would be improvident to dismiss the possibility, but it seems more likely that in a flash of recognition, sooner rather than later, legions of experts will, along with Mario Draghi, ask: "Where did all the money go?"

By Frederick Sheehan

See his blog at www.aucontrarian.com

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, November 2009).

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules