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. The first book is All the devils are here by Bethany McLean and Joseph Nocera which explores the 2008 Global Financial crisis. The second is Den of thieves by James Stewart. More on both later.

Many investors focus on the business cycle. And this makes sense. When we buy a share we take an ownership stake in a company. Some companies are cyclical and their prospects will vary based on how the economy is doing. Some companies are non-cyclical and the economy will have little impact on their prospects. Where we are in the business cycle will impact how the overall market does and how sectors and individual companies perform.

Economic growth is important as is the growth in certain sectors in the economy. But growth is not the only thing that matters. As investors we need to be mindful that growth alone does not a good investment make.

Capital always chases growth

Capitalism is designed to foster competition. That competition becomes more intense as the level of growth increases. And competition is not something we relish as investors. We want to own companies that can fend off competitors and keep more of the spoils for shareholders. That is why we look for companies with a sustainable competitive advantage or moat. Too often we lose sight of that investment principal in our pavlovian response to growth.

Capital chases growth. A company in a high growth sector will be able to borrow with abandon. Venture capitalists, private equity and public market investors will battle to throw increasingly large piles of money at new and existing companies in a high growth sector. This infusion of capital creates more competition and often leads to poor outcomes for investors.

At first everyone is happy as revenue growth is off the charts. Companies expand to meet untapped demand. Faster revenue growth leads to even more capital. Companies soak up capital like a sponge and they will do anything to keep growing faster. They will lower prices, increase marketing and hire more people to further the production of goods and services.

It isn’t long until we read about the amazing employee perks in these high growth industries. Meals, facilities and offsites grow increasingly more lavish. The costs don’t matter because there is always more money available to fund anything and everything. Profitability doesn’t matter because that is tomorrow’s problem. The name of the game is revenue growth.

It is inevitable that challenges will arise. Running a business is hard in any environment. Running a business in an environment with increasing competition with unlimited resources is even harder. At some point it is inevitable that supply will outstrip demand.

In a rational environment supply would be lowered. But the pressure to keep the party going is intense. Some companies will do dumb shortsighted things that hurt them over the long-term. Some will commit fraud. Whatever it takes. There are just too many cheerleaders between employees, investors and the media that don’t want the party to end.

Eventually things fall apart. Valuations collapse as investors finally catch on that the limitless future hawked by ‘visionaries’ might not be realistic. Some companies will fail. Some will be sold at fire sale prices in a desperate bid at consolidation. Eventually a more rational competitive environment develops but only after investors have lost lots of money.

Smart investors understand that the seeds of growth may be demand based but eventually they sprout into an abundance of supply.

Competitions always have winners and losers

I’m a fan of history. Anyone who studies history must be careful when reading secondary sources. They are written after the fact by authors who have the benefit of hindsight. They are a commentary on historical events.

Those events can take on a sense of inevitability as the author crafts a narrative with the knowledge of how things ended up. Yet the participants who shaped and witnessed that history didn’t know how things would end. As Warren Buffett famously said, the rearview mirror is always clearer than the windshield.

The question for us as investors is how can discern these situations prior to their inevitable end. One way is to be a student of history. As unique as we perceive the present there is very little that is new. Studying history increases the chances that we will recognise patters.

Den of thieves

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

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.

All the devils are here

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.

What lessons are there for investors

The overarching lesson is simple. Be mindful of runaway growth. Be alarmed when the foundation of that growth is a simple and widely recognised truth which gets combined with a unifying vision that the growth contributes positively to society.

Growth will always be characterised as an appropriate reaction to demand. Capital will chase those prospects for growth. Valuations will rise. Supply will surge beyond demand. Poor business practices and fraud will follow when insiders understand the imbalance and are desperate to keep the party going.

We have passed through a period of low interest rates and plentiful capital. There is little doubt we will uncover similar stories as the world adjusts to the new normal. Where are the issues and what are the foundational truths and unifying visions that are justifying an unrealistic view of the future? I’m not 100% sure.

It could be in private assets which apparently offer higher returns and less volatility than the same assets trading publicly. These assets still haven’t been marked to market despite the fastest increase in interest rates in history and teetering public markets.

It could be in zombie companies operating in industries with supposed exponential growth that is always just around the corner. They took a page from Milken’s junk bond approach and just kept rolling over their debt in a low interest rate and permissive environment.

It could be in the opaque world of private credit where underwriting standards are apparently superior without the bothersome meddling of regulators. Perhaps it is commercial real estate, Chinese residential real estate or heavily indebted consumers and governments. It could be crypto or NFTs which are already teetering as fraud gets uncovered.

A good place for drawing up your own list is to pick a thematic ETF that has been issued in the last few years. Decarbonisation? AI? A good story may not mean a good investment opportunity. Are all of them overhyped narratives waiting to collapse? Of course not. But some undoubtably are.

These stories will seem obvious in retrospect but they will all follow patterns we’ve seen time and time again. I for one am happy to stay ensconced in the world of profitable and boring companies who regularly go through the monotonous activity of paying dividends. these are the companies that will benefit from new breakthroughs without the ruinous competition. 

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