Greed, Overconfidence and Capital Cycles

Oct 11, 2023
Mark LaMonica is the head of individual research at Morningstar Australia

I recently went on leave and read two books exploring financial meltdowns that have me thinking about capital cycles and the impact they have on us as investors. I wrote about the lessons we can learn in Why high growth may lead to poor outcomes.

Historical patterns repeat themselves. And lessons from history show us the genesis of financial disasters lay in visions of limitless growth.

Here is what you can learn from these books.

All the devils are here by Bethany McLean and Joseph Nocera

Lewis Ranieri was a young trader on Wall Street who joined the mortgage trading desk at Salomon Brothers. We are told all it takes is one good idea. Lewis Ranieri had an idea. Banks lent money to people who bought houses. They paid the banks back over a long period of time and the bank made money as the interest rates on the mortgages were higher than what the bank paid depositors. The only requirement was to restrict lending to people that could pay back the mortgages. This kept credit losses low.

The issue banks faced was that the money was tied up for long-periods of time. A mortgage could be 30 years. A bank makes money from lending and the less money the bank has the less it can lend out. It didn’t help that the pool of people that could be lent money was constrained by borrowers who were credit worthy.

Lewis’s idea was to take the loans that a bank issued and pool them together to form a security. That security could then be sold to investors. He called the process securitisation. Securitisation allowed a bank to sell mortgages for cash. Cash that could be used for further lending. Investment banks such as Salomon liked securitisation because they could take a fee for creating the securities. Investors got access to unique and safe assets with higher interest rates than other low credit risk assets.

There were a lot of impediments to securitisation. Namely legal. And it took a long time to get laws changed. Congress and the American people would have to be convinced that securitisation was good for more than investment bankers. The driver for many of the legal changes came from the bipartisation notion that increasing homeownership was a worthy goal. This was the unifying message. If securitisation helped to expand the number of people who could borrow money for a house it was a worthy way for private corporations to further a public goal.

As securitisation expanded it became more profitable for Wall Street banks. Investors wanted to buy the mortgage-backed securities because the interest rate on the packaged loans was higher than what they earned from other high-quality bonds like US treasuries. And they were thought to be safe. The loans were backed by the value of the house. And house prices in small areas of the US may go down from time to time but they never all went down together. And the beauty of securitisation was that a diversified bond with loans from homeowners all over the country could be created.

The issue that the Wall Street banks ran into was that there was supply shortage. People just didn’t buy houses that often and there was a limited pool of credit worthy buyers. Plus every bank and large government sponsored entities like Fannie Mae were all trying to do the same thing.

A set of circumstances developed in the early 2000s that helped with supply. Thanks to the dot-com meltdown, the recession that followed and the terrorist attacks on 9/11 the Federal Reserve lowered interest rates significantly. And they stayed low. All of a sudden there were lots of homeowners that wanted to refinance. There was a further tail wind. Housing prices were going up so homeowners could refinance their mortgage and take extra cash out. The loans got bigger.

There was also a shift in lending standards. Wall Street had come up with ways to mitigate credit risk by creating all sorts of different types of securitised bonds. The details aren’t important. What is important is that new financial instruments were created to keep the supply of bonds high as Wall Street worked further afield to find new buyers. Foreign banks were easy targets.

The party was raging on Wall Street and main street. Nobody cared that while the original justification for securitisation was to increase homeownership the vast majority of loans were for refinancing. That was a minor detail when everyone was making so much money. Credit rating firms earned fees issuing ratings. Banks and mortgage brokers earned commissions sourcing loans. Homeowners took on more debt and bought TVs, cars and vacations. All of this to supply the insatiable securitisation machine.

Nobody wanted the party to stop. The banks and mortgage brokers encouraged and abetted fraud from homeowners. The credit rating agencies lowered standards. Wall Street banks warehoused large inventories of loans prior to securitisation and kept some of the worst loans on their balance sheets. Investors cheered financial profits and the growth coming from the consumer debt binge.

The fraud and poor decisions extended the party. But it couldn’t stop the eventual end. It all came crashing down.

Den of thieves by James Stewart

A young Micheal Milken read a book called Corporate Bond Quality and Investor Experience in university. The book is by an academic named W. Braddock Hickman and is an exploration of corporate bond data between 1900 and 1943. One wonders if reading or writing the book was a more mind-numbing endeavour.

Yet Milken latched on to one conclusion. That a well-diversified portfolio of low-grade bonds offered a higher return than highly rated bonds. Even when the inevitable defaults were taken into account. This is the holy grail of investing. Finding mispriced assets. The low-grade – or junk bonds – were not priced appropriately given their risk.

The seeds of a revolution in finance were sown in that simple truth. And you always need a simple truth. A foundation for everything that will come. A north star for when people start thinking that what is happening doesn’t make any sense. This notion that a diversified portfolio of junk bonds was safe was the necessary ingredient for what happened next.

When Milken started his first job on Wall Street he manoeuvred his way into a position to take advantage of this truth. There was one problem. The supply of junk bonds was limited. The only junk bonds were so called fallen angels. This bit of finance jargon refers to companies that issued credit grade bonds that had subsequently hit hard times.

While Milken showed some early profits in his foray into junk bonds he wanted more. He had proved Hickman’s thesis in a limited way and created some nascent demand for junk bonds. What he didn’t have was enough supply. He needed newly issued junk bonds. Long story short is that he finally got more supply. He did this by joining with an emerging force on Wall Street. The corporate raiders who were starting the first leveraged buyouts (LBOs).These corporate raiders were taking companies private by loading them up with debt. They would restructure them and sell off the parts or the whole company for a profit. Think Gordon Gekko in Wall Street admonishing management that a new era in investing was upon us with his ‘greed is good’ line.

The only way to issue the amount of debt needed to take a company private was to issue junk bonds. The companies were in too much debt to receive a strong credit rating. And Milken and his firm Drexel Burnham Lambert were the biggest player in this space. Whole deals were done on the basis of Milken issuing a written statement called a highly confident letter. This letter said that Milken was confident he could find buyers for the junk bonds. Billion dollar takeovers were consummated on his word.

The merging of junk bonds and leveraged buyouts was important. There was a north star for investors in junk bonds. What was needed was a unifying vision for society to latch onto. And this was the notion that Milken and the corporate raiders - and by extension LBOs and junk bonds - were good for America.

The story was simple. The country had grown complacent and lazy during the 70s and Japan and West Germany were pulling ahead. LBOs would cut the fat and make America competitive again. This message conveniently had parallels with Reagon’s political message. This is why Gekko ended his ‘greed is good’ speech with the admonishment that greed will save ”that other malfunctioning corporation called the USA.”

Milken was the king of Wall Street. He moved his operation to LA to keep his meddlesome bosses in New York at bay and got himself a new toupee to fit his image. At one point he was earning $107k an hour – in the 1980s. The challenges Milken faced extended beyond his stubborn follicles. He needed to match supply and demand for junk bonds. Each seller he found would need a buyer. And to keep that demand up he needed to make sure that the principles first outlined in Hickman’s page turning bond tristes held true. Returns had to be strong.

Milken needed to keep the party going. There was a simple way to do this. The only way a junk bond issuer could default was if they ran out of money. If the original junk bonds were rolled over continuously into new junk bonds there would be no default. Milken just had to find new buyers. As time passed and the pile of junk bonds got bigger and bigger this became harder. Soon he had to start making fraudulent claims. They got bolder and bolder.

Eventually a young lawyer looking to make a name for himself as a precursor to a political career started sniffing around. Rudolph Guiliani began his Wall Street assault by prosecuting low level players. Eventually the trail led to Milken who was indicted on 98 counts of racketeering and fraud. He has the dubious distinction of being the first individual who wasn’t in organized crime to be indicted for organized crime. Trump is facing charges under the same statute.

Milken went to jail and Drexel Burnham Lambert imploded and filed for bankruptcy. Guiliani became mayor. And the corporate raiders and LBOs? They rebranded. The three-piece suits and in your face 80s style excess were traded in for Patagonia vests, khakis and a projected image of benevolent capitalism. The industry’s reincarnation was not complete without a name change. Private Equity fit the bill.

The investors that purchased the junk bonds suffered huge losses. Many of them happened to be banking entities called Savings and Loan Associations (“S&L”). Hundreds of S&Ls eventually collapsed. The US government spent billions bailing them out but couldn’t stave off a major recession.

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