Wednesday, July 5, 2017

Leverage is not a sign of risk seeking.

Building on this post about JW Mason's paper from the other day, I want to discuss debt and business cycles a little more.


It's strange to me how much space debt takes up in our discourse about business cycles.  These don't look like cyclical measures to me.

I think we get closer to something cyclical if we look at equity values.
Something is wrong with the legend.  This is corporate nonfinancial equities / GDP ... Source

Even this is a little hit and miss, but at least we do tend to see some cyclical behavior here.  And this makes more sense.  When you seek risk in your savings, do you invest in fixed income or do you invest in equities?  And, part of what is happening here is that, on an Enterprise Value basis, firms tend to deleverage during expansions, mostly because the value of equities is rising.  Now, if you were a firm, and equity prices were high, and you wanted to raise capital, would you issue more high priced stock or would you issue more debt?  Why would you leverage up in this context?  You might respond that if interest rates are low, then bonds are basically fetching high prices too.  But, at the end of economic expansions, interest rates tend to be high.  They are low now, but that is because savers are risk averse now.  (There is also an upward drift in equity/GDP because equities increasingly reflect the value of foreign operations.)

How weird is it that in 2006, after a few years of middling stock market returns, when there was a massive influx of savings into AAA securities, we associated that with risk seeking behavior?  Why do we do that?

There is a recent example that might illuminate this issue.  Recently, many people noted that Tesla had a larger market capitalization than Ford. I was pretty amazed by that, so I looked up their financials.

Ford has a market cap of $46 billion plus $143 billion in debt. Tesla has a market cap of $58 billion and $7 billion in debt.  In other words, Ford is 3 times the size of Tesla ($189 billion vs. $65 billion), but claims on their assets are mostly in the form of debt instead of equity.

Now, do you suppose risk-seeking investors choose to invest in Ford over Tesla because they like how the high level of leverage gives them higher returns even though that leverage is dangerous?

Do you think a risk-seeking, over-optimistic market would have more Fords or more Teslas?  And, thus, do you think a risk-seeking, over-optimistic market would have more debt or less debt?  Would it have more equity or less equity?

Investors in Ford are mostly seeking a safe, certain cash flow.  They see some big giant buildings with expensive equipment and they figure that, even if Ford doesn't make a profit for its shareholders, its likely to earn back most of that investment, in any case.

If investors in Tesla are the risk-takers, then why don't they demand that Tesla sell a bunch of bonds to leverage their investment?  Because that's not what motivates leverage!  What motivates leverage is savers looking for certainty.  And, given the choice between loaning cash to Ford or Tesla, they have a clear preference for Ford.

Think of the madness we engage in when we see a potential approaching economic contraction, and we see rising debt levels, and we react by deciding that sentiment needs to be tamped down.  And, lo and behold, if we do it boldly enough, like we did in 2007 and 2008, lending actually does decline when we tear up the financial system.  And we pat ourselves on the back.  "See.  All that risk-seeking debt led to an inevitable collapse, and now those borrowers are finally deleveraging in the way smart people like us knew they needed to."  And, library shelves fill up with articles about the mystery of why interest rates remain so low after the crisis.

Then, debt wants to grow again, because we are afraid to let the economy grow, so nobody wants to own the residual stake (equity).  And, when debt does grow, we fret that it looks like those risk-taking investors still haven't learned their lesson, and we need to have another contraction to get all that excess borrowing out of the system.

Debt in the housing bubble

Now, think about how this played out in the housing bubble.  I have written before about the CDOs, CDOs-squared, synthetic CDOs, etc.  These are all seen as part of excess borrowing and leverage.  But, the problem was that they couldn't find any borrowers to take the mortgages.  That is the only reason those products developed.  If they could have found mortgage borrowers, they would have just packaged them into new basic RMBSs.  The mortgages would have been sliced and diced into new AAA-securities.  But, since they didn't have any new mortgages, they had to slice and dice the B-rated tranches from the existing mortgage pools to create new AAA-securities.

There are two contradictory claims about the period.  One is that spreads were low because the investors were too sanguine about the potential for falling home prices.  The other is that the portfolio managers who were investing in the AAA-rated securities from those CDOs and the exotic CDO products thought they were getting a free lunch, because they had higher yields, but they had a AAA rating.  So, they bought them, not understanding that they were riskier.

Well, what is it?  Were spreads too low or were spreads higher on those securities than they were on normal AAA-securities?  It can't be both.  This is typical of stories about the time.  It's like the facts don't matter.  If portfolio managers really were systematically fooled, then they would have bid those spreads down.  But, they didn't.  How do I know that?  Well, I really only know that because the people that tell this story always claim it, even though it undermines the story.

But, this isn't even really my main point.  My main point is that actually spreads weren't low.  They were high.  There was all this money chasing AAA-rated securities.  But, they couldn't find mortgage borrowers to take the money.  Normally, if this was the case, how would that problem get solved?  The problem would get solved by lowering the spreads until more borrowers were willing to take the mortgages!

Notice how outrageous it is that, among all the stories of stupid investors who didn't know their risks and unqualified borrowers who were duped into borrowing at predatory rates, it seems that nobody has noticed that the overriding problem of the time was that the market for mortgages wasn't settling at a market clearing yield.  Somehow, the spreads demanded by the investors couldn't go low enough to entice new mortgage borrowers, so that they needed to create the securities with other bonds.

This is because the market was already in disequilibrium.  The reason exotic CDOs were spreading was because lenders were too nervous about home equity to lower their spreads and borrowers were too nervous about it to take on new mortgages.  This was because, already, expectations of future home values were negative enough that expectations of negative equity drove a wedge between lender and borrower too large for a price to settle where all the supply of credit could be utilized.

In the midst of this dislocation, prices held fairly steady through 2006 and the first half of 2007.  How?  In 2005, about 2% of homeowning households were selling and leaving Closed Access cities, on net.  Prices were rising even with that selling pressure.  When mortgage markets started breaking down in 2006, which is when exotic CDOs really took off, that migration stopped.  Buying pressure dropped significantly, but at the same time, so did selling pressure.  Households stopped selling and moving away.  And, of course, housing starts were dropping sharply, which also took pressure off of collapsing demand.

PS. John Cochrane finds a particularly explicit example of this type of thinking regarding debt.


  1. Fascinating post. Ben Bernanke was probably correct when he said there was a global glut of capital...

    Even if you disagree you may wish to review Richard Koo's balance sheet recession ideas re Japan and Adair Turner on British housing.

    I do wonder about a financial and monetary system that largely creates new money by lending on zoned property.



    Jerome Powell discusses housing finance reform

  3. You know, here is an observation that is neither here nor there, but interesting.

    Everyone speaks in sheer horror of government "bail-outs" of financial institutions, including Jerome Powell in regards to Fannie and Freddie.

    Then this from Powell:

    "The two GSEs remain in government conservatorship, with associated contingent liabilities to US taxpayers.6 Fannie and Freddie have remitted just over $270 billion of profits to the Treasury, more than paying back the government's initial investment."

    Looks like U.S. taxpayers are up about $100 billion on their bail-out of Fannie and Freddie. And still gaining.

    Then Powell says 2008-style calamities happen perhaps once or twice a century.

    So…what is so bad about a government financial-sector bailout during a horrific crisis---and a bailout in which taxpayers make profits? A bail-out that re-liquifies lending ability? This is bad?

    My recollection is the government made money on all its financial-sector bailouts. If private-sector shareholders in the bailed-out institutions lost all their money, I see no problem with this.

    Powell concludes with this:

    "Housing finance reform will protect taxpayers from another bailout…."

    I want to be protected from making $100 billion in profits in a few years?

    I am sure you have reservations about other aspects of Powell's presentation.

    Another note; Powell say Fannie and Freddie own $5 trillion in mortgages. I gather Fannie and Freddie are regarded as "owned" by the federal government (and federal taxpayers) at this point.

    Does this mean U.S. taxpayers now own $5 trillion in mortgages? That strikes me as a handsome asset. This never seems to be a talking point.

    Perhaps I would prefer selling the whole package off for $5 trillion in concert with tax holidays a couple of years.

    1. Yeah. Thanks for the link. There is a lot to comment on. I might do a post on it. On your point it is especially strange that before he admits the government profited, he uses the old "privatized gains socialized losses" line. But clearly what happened was the opposite of that, as he points out. This topic is so strange. People can put contrary facts right in front of their own face and just gallop along with the narrative. Because the narrative is so ingrained that people are immune to contrary information.