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"We are clearly not having as much fun taking off leverage as we had putting it on, or at least the vast majority are not. This week in Outside the Box we look at some very thought-provoking insights from my good friend Paul McCulley, who helps us think about how we got here and what will be the end point. From the letter:
"But what ailed Lehman was but a manifestation of what ailed, and ails the global financial intermediary system: the presumption that grossly levered positions in illiquid assets can always be funded, because those doing the funding will always assume the borrower is a going concern."
You need to read this when you have the time to think. The quotes from Keynes are important.
Paul is a managing director, generalist portfolio manager, and member of the investment committee in the Newport Beach office of PIMCO. In addition, he heads PIMCO's short-term bond desk. And is an avid fisherman
John Mauldin, Editor
Outside the Box"
So, let's read it.
This seems clear to me.
"What I do know is that the global financial system was fundamentally broken long before Lehman's watery death.
Thus, I believe the powerful, systemic policy responses that have unfolded in the post-Lehman world were destined to come about. Lehman was but the unfortunate tipping point."
It seems to me that this downturn needn't have been so messy.
"But what ailed Lehman was but a manifestation of what ailed, and ails the global financial intermediary system: the presumption that grossly levered positions in illiquid assets can always be funded, because those doing the funding will always assume the borrower is a going concern."This has been proven correct, more or less, if you include the government doing the funding. It's actually attempting to save others from Lehman's fate.
"But, I submit, it was the loss of understanding of first principles that lies at the heart of the on-going paradox of deleveraging, which is the proximate cause of the on-going downward spiral of asset and debt deflation."
Here, I agree completely.
"But regardless of the origins of banking, its founding premise has always been the same: In normal times, the public's collective, ex ante demand for access to at-par, immediately-available bank money is always greater than the sum of the public's individual, ex post demand for access to such liquidity."Thus, the genius of banking, if you want to call it that, is simple: a bank can take more risk on the asset side of its balance sheet than the liability side can notionally support, because a goodly portion of the liability side, notably deposits, is de facto of perpetual maturity, although it is notionally of finite maturity, as short as one day in the case of demand deposits. "
The bank can lend out more than it has, because not everyone wants their money at the same time. I think that's it.
"It's the same alchemy that permits mutual funds to commit to next-day redemption at tonight's NAV, even though all reasonable people know that a mutual fund – with the possible exception of a money market fund – could not possibly liquidate all assets on the wire tomorrow at tonight's NAV marks."
I think that this is the same thing. Not everyone is going to redeem money from a mutual fund at the same time.
"Systemically, it's the illusion of liquidity, as so elegantly described by John Maynard Keynes:
"For the fact that each individual investor flatters himself that his commitment is ‘liquid' (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual. This is the dilemma."
First of all, it's not an illusion if it works in reality. To render liquid investments illiquid would be a problem, especially if you can't get at it when you want to invest in something. I don't see it as a dilemma, since it's been practically solved.
"So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and knows very little about them), except by organizing markets wherein these assets can be easily realized for money."
That's a good argument for money, and for liquidity. Yes.
"Yes, liquidity for all at last night's marks is an illusion. But for banks, unlike mutual funds, it's not so much an illusion after all, for two simple reasons: banks have access to deposit insurance underwritten by fiscal authorities and to a discount window underwritten by the monetary authority (and one step removed, the fiscal authority)."
If everyone shows up at once, banks can:
1) Borrow money from the government
2) Part of the money will be given back by the government
"Thus, banks are unique institutions, providing a "public good:"
- Liquidity on demand at par for their depositors, because of the safety net underwritten by the sovereign, yet
- The ability to invest in longer-dated, more risky, not-always-at-par loans and securities, because the existence and credibility of the public safety net systemically renders the public's ex post demand for liquidity at par below the public's ex ante demand."
"Yes, banking with a sovereign safety net against deposit runs is a really cool business. Indeed, the difference between the public's ex post and ex ante demand for at-par liquidity could be called the banking system's "float," similar to that of a Buffet-style insurance company. "
It's a good thing for banks that the government is backing them.
"But since it's a really cool business and since the sovereign providing the liquidity safety net is a de facto equity partner in the business, the sovereign quite rationally wants a say in how the business is run – the degree of leverage, corporate governance, risk management controls, etc. Kinda like I do when I pay the insurance premium on my 19-year old son's car. Jonnie doesn't like it, and neither do bankers. Or would-be bankers."
Why shouldn't they have a say? They're on the hook if things go sideways. By the way, the "sovereign" is the taxpayers.
"Thus, both bankers and would-be bankers have, from time immemorial, sought to get the benefits of the sovereign's liquidity safety net without shouldering the associated regulator nuisance. And I'm sure that 19-year old sons and daughters, too, have been doing the same for just as long."
I thought you said that it started with the Medici's. Anyway, yes, the bankers are trying to get away with as much as they can. It's called TARP. Leave the amusing lines to me old boy. It works better that way.
"Over the last three decades or so, the growth of "banking" outside formal, sovereign-regulated banking, has exploded, in something that I dubbed the Shadow Banking System. Loosely defined, a Shadow Bank is a levered-up financial intermediary whose liabilities are broadly perceived as of similar money-goodness and liquidity as conventional bank deposits. These liabilities could be shares of money market mutual funds; or the commercial paper of Finance Companies, Conduits and Structured Investment Vehicles; or the repo borrowings of stand-alone Investment Banks and Hedge Funds; or the senior tranches of Collateralized Debt Obligations; or a host of other similar funding instruments. "
Shadow Banks are:
1) Businesses that have very low capital but seem like banks
They might have:
1) Money Market Mutual Funds
2) Commercial Paper of Finance Companies and SIVs
3) Repo loans of Banks and Hedge Funds
4) Senior Tranches of CDOs ( The first to collect and safest )
5) Other crap
"The bottom line is simple: Shadow Banks use funding instruments that are not just as good as old-fashioned sovereign-protected deposits. But it was a great gig so long as the public bought the notion that such funding instruments were "just as good" as bank deposits – more leverage, less regulation and more asset freedom were a path to (much) higher returns on equity in Shadow Banks than conventional banks."
Well. That's what I've been saying. Riskier investments were being sold as less risky.
"And why did the public buy such instruments as though they were "just as good" as bank deposits? There are a host of reasons, not the least of which was lust for yield."
"Lust For Yield". That's a title for a novel. They wanted to make more money.
But most fundamentally, Keynes again gives us the systemic answer (his italics, not mine):
This sounds like Taleb. It does help explain why people trusted the Credit Ratings Agencies."In practice we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention – though it does not, of course, work out quite so simply – lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely.
"And so, Keynes provides the essential – and existential – answer as to why the Shadow Banking System became so large, the unraveling of which lies at the root of the current global financial system crisis. It was a belief in a convention, undergirded by the length of time it held: Shadow Bank liabilities were viewed as "just as good" as conventional bank deposits not because they are, but because they had been. And the power of this conventional thinking was aided and abetted by both the sovereign and the sovereign-blessed rating agencies. "
Okay. Fair enough. People got complacent.
"Until, of course, convention was turned on its head, starting with a run on the ABCP market in August 2007, the near death of Bear Stearns in March 2008, the de facto nationalization of Fannie and Freddie in July, and the actual death of Lehman Brothers in September 2008. Maybe, just maybe, there was and is something special about a real bank, as opposed to a Shadow Bank!
And indeed that is unambiguously the case, as evidenced by the on-going partial re-intermediation of the Shadow Banking System back into the sovereign-supported conventional banking system, as well as the mad scramble by remaining Shadow Banks to convert themselves into conventional banks, so as to eat at the same sovereign-subsidized capital and liquidity cafeteria as their former stodgy brethren.
The new conventional wisdom: levered capitalism is good, and made even better with a bit of socialism to protect the downside."
That's the lesson, if you mean guaranteed by the government. I just believe that everybody knew that going into this. By the way, some of these problem banks are real banks.
"I'm quite sure that last sentence is not going to sit well with some of you. It's not supposed to sit well. It doesn't sit well with me, I must acknowledge, nay confess. Like most of us, I've always had a separation in my mind between strictly capitalist activities and strictly public activities. Not that the demarcation is always clean. But it's a useful way of thinking."It's fine with me.
"As far as I know, the place where I buy my fishing tackle is a capitalist outfit. If we customers don't buy enough rods and reels, the owner will go broke; his operation is simply not systemically important enough to be bailed out by the taxpayers, including my neighbors who don't fish. In contrast, the local Department of Motor Vehicles, sometimes called the DMV, is unambiguously not a capitalist outfit, but a public outfit. It cannot go broke, as evidenced by our tolerance of its fluctuating service level, because it provides a public service that the private sector can't provide. To be sure, AAA can get you new plates for your car, but you can't renew your driver's license at the AAA; for that, you have got to go to the monopoly called the DMV.
Well actually, that's not entirely true, either. The DMV is actually an oligopoly, with offices in many surrounding neighborhoods. And rumor has it here that the service is a lot quicker at the San Clemente office than the Costa Mesa office, which serves Newport Beach. So the consumer does have the choice of driving to San Clemente, a form of time arbitrage versus going to the Costa Mesa office. However, rumor also has it that this rumored better service in San Clemente is so widespread that, as Yogi Berra might say, the San Clemente office has become so popular nobody goes there anymore.
But you get the point: there is private enterprise and there is public enterprise."
I got the point when you made the distinction.
"And then there is banking, a hybrid of the two. There is no way ‘round this, for good or bad, because fractional reserve banking depends upon the sovereign's safety net against liability runs, a safety net that the private sector definitionally can't universally supply. In this sense, the safety net is like national defense: we all need it, but since nobody individually has the incentive to pay for it, we collectively tax ourselves to pay for it."I hate hybrids.
"Yes, sometimes we collectively end up paying $800 for military toilet seats, as was the case about 25 years ago. But that doesn't change the proposition that public goods do exist, and a stable system of intermediation of private savings into private investment is indeed a public good. The maturity transformation power of a fractional reserve banking system provides an unambiguous benefit to society and as such, must be underwritten by society."
Some would argue with that, but I'm fine with it.
"I could regale you yet again about the power of the analytical thinking of Hyman Minsky, complete with his Forward Journey turning into his Moment, followed by his Reverse Journey. But I don't need to do that any more: we've collectively lived it and are now caught in the debt-deflationary pathologies of "the paradox of deleveraging." Not everybody in the private sector can delever at the same time without creating a depression. Accordingly, the sovereign must go the other way, levering up the public balance sheet. And Washington has finally started to do so with appropriate vigor and enthusiasm."
I actually like being regaled. Deleveraging by government leveraging. Okay. More like "reckless abandon" than "vigor and enthusiasm".
"It's not a pretty picture. In fact, it's repugnant, giving proof to the proposition that breaking the paradox of deleveraging does involve socializing the downside of previously profitable private sector activities. In a recent speech, I called it "creeping socialism" and was interrupted by an irate, older man in the back of the room bellowing, "It ain't creeping socialism, it's galloping socialism!" I really didn't have a soothing come back, noting that many things are what they are only in the eye of the beholder. But his point wasn't lost on me or anybody else in the room."
It's lost on me. That's been our system. Remember the S & L Crisis?
"And it is not lost on Washington, DC either, I can assure you. If the sovereign must backstop a private sector activity that produces a public good, then the sovereign will, at least in a democracy, rightfully demand both bottom-up and macro-prudential rules to harness the greed that lubricates the invisible hand of capitalism. Yes, the visible fist of government and the invisible hand are presently engaged in a massive arm wrestling contest in the provision of financial services. And the fist is winning."
Wait a second. An invisible hand is, what, hand wrestling, it can't be arm wrestling because there aren't any arms involved, a visible fist. Given that scenario, the visible fist is going to win each time they hand wrestle.
A"t least for now. Capitalism, and especially financial market capitalism, brought this outcome upon itself through greed and hubris. Capitalism is now re-grouping and learning how to play by new rules, which are still being written. And ultimately, I'm sure, capitalistic bankers will once again bend those rules in the pursuit of higher profitability. And that's okay, I think. In the end, we really don't want to turn our banking system into the DMV. At the same time, we also don't want our banking system to be nothing more than a betting parlor."
Greed and hubris. I agree. The banks will try and take advantage of the rules in the future. Yes. Don't say "betting parlor", that get's people upset with you. I should know.
"Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the 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."
Paul McCulley
I'm telling you and Keynes, Paul, that the casino analogy doesn't work with a lot of people. But I appreciate the support. Cheers.
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