Originally published August 24th, 2007
Why the Azimuth blog? Our primary reasons were to get organized (observations and ideas), create an audit trail of our thinking and decision making – right or wrong, and chronicle the ebb and flow of financial markets from fear to greed and back. We also wanted to create a resource for a select group of like-minded people we respect and hope will contribute to this interchange of ideas. And lastly, we wanted to give our clients a window into the investment process.
As you are surely aware from even a cursory glimpse of this blog, there are several recurring themes. In a business where portfolio managers with fully-invested mandates are stuffed into confining style boxes, the performance game is played out in months and quarters, conformity is rewarded, and sound economics and historical perspective are considered career liabilities, we take a different tack: big picture generalists and contrarians, with a strong sense that history and economics actually matter.
As I write this, we are in the midst of perhaps the greatest credit mania the world has seen. How did we get into this mess? Who is responsible? How will it play out?
Manias, by their nature, are collective detachments from reality. Traditional norms of behavior are abandoned, standards eroded, egos inflated, and dissent muzzled. We like this definition found on dictionary.com: “a form of mental illness in which the sufferer is over-active, over-excited, and unreasonably happy.” The boom phase is where sins are committed; bust exposes those sins and forces a return to sanity and health.
We believe the current mania in credit has at its core four related frauds:
- Artificially cheap and abundant credit. The root problem is the central bank’s license to essentially print money out of thin air and the banking system’s ability to pyramid credit a multiple of times on top of this. Not only is this scam inherently inflationary (sometimes of the asset variety), but leads to what the Austrian economists call “malinvestment.” This newly created money and credit found its way into the “New Economy” during the late 1990s. As that bubble burst, another much greater wave of new money ignited first a housing bubble (which hit a wall in 2005), followed by a professional speculator bubble.
- Drive to expand homeownership. For the past two decades, inviting more people to live “the American dream” has been a matter of public policy. Government-sponsored enterprises, such as Fannie Mae and Freddie Mac, ramped up their activities to the point where several years ago these businesses owned or insured roughly half of the residential mortgage market in this country. Banks, through “community lending” initiatives, have also been coerced into providing cheaper credit to lower income borrowers. What has taken place is a quasi-socialization of the mortgage market.
- Lack of true market pricing in the securitized loan market. In the structured finance arena, the over-reliance on “mark to model” pricing short-circuited a re-pricing of credit that should have taken place as the housing bubble started unwinding in the second half of 2005. The securitization assembly line was kept humming and the credit spigot left open much longer than it should have. Essentially, problems were swept under the rug and the day of reckoning put off.
- Belief in ability of authorities to regulate economic activity.There is a pervasive feeling that markets are incapable of regulating their own activity and that government bureaucrats are necessary, if not perfect. However, reality has fallen short of theory. E.g., the original whistleblowers of Enron were capital-risking, profit-seeking short sellers like Jim Chanos and critically thinking journalists like Fortune’s Bethany McLean. The SEC not only missed the problems at Enron due in part to negligence (last review of their financials was in 1997, four years prior to the blowup), but also Tyco International in which they did an extensive investigation during the early 2000s, then rendered a clean bill of health right before the stock collapsed. The government sanctioned rating agencies (especially Moody’s, S&P) also have a long history of being pervious gatekeepers.
If there is one overriding theme to this blog, it is our appreciation for the free market and disdain for government intervention into peaceful, voluntary, and – by definition – mutually beneficial activity. The interventionists, throughout history, have been motivated primarily by two groups: passionate ideologues and scoundrels looking to use the gun of the state to their unfair advantage. As guest author of this blog, Phil Duffy (also my dad), likes to say, “the greatest enemy of capitalism is the capitalist.” What he is really referring to is the “political capitalist.” (In a wonderful book on the subject, The Myth of the Robber Barons, Burton Folsom distinguishes between true “market entrepreneurs” and “political entrepreneurs” during the early days of mercantilism (or cronyism) from the mid- to late-1800s.) The most influential and harmful political capitalists today reside within the financial establishment. Unlike you and me, they expect to live in a world of asymmetric risk in which they are bailed out when making poor bets.
Unfortunately, when the easy money fueled tech/telecom/dot-com boom of the late ’90s met its maker, very few fingers were pointed at the true causes. Capitalism got the blame and the financial enablers, finaglers, and gatekeepers largely got off the hook. In fact, the regulatory apparatus was expanded with the passage of Sarbanes-Oxley, for example. At the time, we felt there was plenty of unfinished business and that we were setting ourselves up for greater problems down the road. Little did we know…
We will profess a certain fascination with the whole sordid affair. This is one grand Greek tragedy with a colorful cast of characters, including Alan Greenspan, Ben Bernanke, Jim Cramer, Larry Kudlow, Franklin Raines, Hank Paulson, Angelo Mozilo, and Ken Fisher. As this play moves from spectacle to farce to disaster, our hope – and belief, is that we will learn from this and be better off. Ultimately, we are all human and susceptible to human failings. The road to true recovery begins not just by rounding up the culprits, but laying blame where it really counts: by looking in the mirror.