The 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."
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