THIS week’s print edition has a leader condemning the failure of governments (and investors) to learn the right lessons from the Black Monday stock market crash 25 years ago:
The biggest mistake was to do with monetary policy. Central banks around the world responded quickly to the crash, some cutting interest rates, others pumping money into the system…Calming a fraught financial system made sense at the time, but it introduced the idea of the “Greenspan put”, the notion that central banks would always intervene to support the markets when they fell sharply. This was compounded by Mr Greenspan taking the opposite position when it came to asset bubbles: that even when prices were sky-high, it was not the job of central banks to outguess markets by trying to bring them back to earth…For investors, markets became a one-way bet: central banks would intervene when markets were falling, but not when they were rising. The “great moderation” was a long period of steady growth and low inflation—and a huge build-up of debt.
Subsequent research showed that the collapse in the equity risk premium in the 1990s could be explained by the perception that the Federal Reserve was unwilling to ever let investors take their lumps. Ironically, Mr Greenspan’s successor at the U.S. central bank, Ben Bernanke, has been even more aggressive at doing whatever it takes to goose risky asset prices, although one could argue that the circumstances he faces now are different than those faced by Mr Greenspan between 1987 and 2006. The most sophisticated financial players are well aware of the generous safety net provided by the Federal Reserve and, according to two stories from yesterday’s papers, they are eagerly returning to the unsafe and destructive practices of the go-go years.
Yesterday’s Wall Street Journal contains a detailed article on the return of one of the private equity industry’s most unsavory behaviours:
Private-equity firms are adding debt to the companies they own in order to fund payouts to themselves, a controversial practice now reaching a record pace…In these deals, known as “dividend recapitalizations,” private-equity-owned companies raise cash by issuing debt. The proceeds are distributed in the form of dividends to buyout groups. The resurgence has been helped by investors’ appetite for high-yielding debt at a time of historically low interest rates. Debt issued to fund private-equity dividends has topped $54 billion this year, after a flurry of deals earlier this month, according to Standard & Poor’s Capital IQ LCD data service. That is already higher than the record $40.5 billion reached in all of 2010, when credit markets reopened after the crisis. For private-equity investors, the deals produce payouts amid a slow market for initial public offerings and acquisitions.
[…]Some of these deals involve a risky type of debt known as “payment in kind toggle”—or PIK-toggle—bonds that give companies the choice to defer interest payments to investors. Instead, they could opt to add more debt to the balance sheet. The default rate for companies that sold PIK-toggle bonds was 13% from 2006 to 2010, twice the default rate for comparably rated companies that didn’t use the bonds, according to a study by Moody’s Investors Service. Six companies have sold PIK-toggle bonds to pay private-equity dividends in September and October, double the number sold in the previous 14 months. “The market is simply letting its guard down at the expense of getting some incremental yield,” said Sandy Rufenacht, chief investment officer of $1.3 billion high-yield asset manager Three Peaks Capital. He said he is selling bonds he owns in companies that issue new PIK-toggle bonds. Despite concerns, the PIK-toggle deals are generally finding a welcome reception among investors, because the securities can yield more than standard junk bonds, which traded at record-low rates in September.
The buyout barons are surely onto something. After all, the Fed has promised that interest rates will not rise for many years. That is plenty of time to extract enough cash to make the deals profitable, even if the debts prove crushing in the long run.
Meanwhile, the Financial Times reports that Morgan Stanley, the investment bank, is taking advantage of the “Bernanke Put” to improve its Basel III capital ratio:
Morgan Stanley’s change reduced its average VaR in the third quarter to $63m instead of the $82m it would have been under the company’s old model. That means under the new model the bank expects to lose no more than $63m in a single trading day, within a certain probability, rather than $82m under the old model. “It all goes to point out, again and again and again, how malleable and manipulable and flaky VaR can be,” said Pablo Triana, professor at ESADE Business School. “Just change weights on data and, voila, you are perceived as less risky and you can be more leveraged.” Ruth Porat, Morgan Stanley’s chief financial officer, said that the bank had changed the VaR model to be more heavily weighted to one-year historical data. The model was previously geared towards four-year data. “We’ve been running this model and the prior model in parallel since 2011, which gives us a high level of comfort from the model,” Ms Porat told analysts Thursday. “It’s been approved by regulators.”
Morgan Stanley used to model risk by looking at trading data from the past four years. They switched to using data from only the past 12 months. This is significant. Morgan Stanley and its regulators, which shamefully allowed the change, appear to believe that the events of 2007-2009 are not statistically significant. In other words, the markets will never again be allowed to experience losses like those felt during the crisis, so no profit-maximizing bank should incorporate that experience into its risk management. It should not be hard to see why this idiocy is precisely what makes devastating crises so much more likely in real life than in the models.
Clearly, we have learned nothing. Unlike the Bourbons, we also seem to be forgetting everything.
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