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The Rules, Part VII

I wrote the following on April 8th, 2010:


In a long bull market, leverage builds up in hidden ways within corporations, and does not get revealed in any significant way until the bear phase comes.

If I were to change that sentence, I would change the word “corporations” to “organizations.”  Why?  Everyone attributes greed to the corporate sector, but the same is true in different ways of governments and nonprofits.

Year to year, organizations measure progress.  Corporations look at profits.  Politicians look at whether they are still in office or not the success of programs passed.  Those that run non-profits look at how they have done on their missions, amid scarce resources.

But, when things are good for a long time, institutional laziness sets in.  I remember being out at some party at a golf course in Philadephia in 1996, when our best salesman uttered the inanity, “Let the stock market pay your employees.”  Really, he was a decent fellow, and brighter than most who sold for us, but his statement reeked of the bubble logic that assumes that stock markets are magic.  They always go up.  Corporations and individuals come to rely on the stock market going up, because it always beats bonds and cash over long enough periods of time.  That is true, but less so than most think, and the time periods have to be longer than most can tolerate.

Back to topic.  Non-profits are slaves to the stock market.  Giving goes up considerably when there is appreciated stock to give.  People donate more from wages when they are secure in their homes, and they think their retirements will go well, (fools that they are).

Governments are also slaves to rising asset values.  When housing prices fall, sales drop, and transfer taxes plummet.  But real estate taxes fall as well.  My property taxes dropped by 30% — I can hardly believe it, even though I thought they overshot 3 years ago.

Governments also get used to the boom, and begin forecasting increases in wage taxes, capital gains, real estate, and all other taxes.  They rely on the increase, and borrow beyond that.  But more insidiously, since they run on cash accounting they begin to fudge accruals to make the cash accounting look good.

Tough negotiations with the public employees union?  Offer less of a wage increase, and a generous increase to the pension benefit. That will reduce the present cash costs, leaving others to deal with the costs shifted into the future.

Cash costs of paying your debts too high?  Wall Street has many derivatives that can lower your cash cost today, at a price of probably or certainly raising your cash costs in the future.  Ask Jefferson County, Alabama; they will tell you.  Greece and Italy did much the same to enter the Eurozone, amid winks from those that presently disapprove.

“Can’t we raise the spending rate on our endowment?” naive nonprofit board members ask.  Tell them to look at the 10-year Treasury yield — that is a reasonable proxy for sustainable distributions.  Most nonprofit board members don’t know up from down economically; they tend to favor the present over the future.

Corporations are the same, but they do it differently.  They run on accrual accounting, so they tend to tweak accounting to make net income look good, relative to cash flow.   Also, they buy back stock, which increases leverage.  Even raising the dividend increases leverage, because it is like junior debt, corporations know their stock prices will fall if it isn’t paid or increased.

Buffett says something to the effect of, “Until the tide goes out, you don’t know who is swimming naked in the harbor.”  Bear markets reveal optimistic assumptions and accounting chicanery.  This is true for any organization, because we all rely on the same economy.  Yes, the wealthy support some organizations more than others, but many governments rely on taxes from the wealthy more than they realize.

This even applies to individuals.  Who paid attention to the increases in debts, especially junior debts like home equity lending during the boom?  My last firm did, and I wrote about it at RealMoney, but it felt lonely at the time.  Silent seconds, low LTV lending, mortgage insurance, and other means of getting people into housing that they couldn’t afford looked like like the pinnacle of success for US housing policy.  Now, with all of the wounds the banking system has taken, and all of the foreclosures, past, present and future, many are beginning to think differently, but you can’t see that in government policy.  Many people are not capable of bearing the fixed commitments associated with home ownership, and there is no way that government policy can materially change that.  But the government continues to encourage high home ownership and asset prices, merely delaying the inevitable reconciliation of bad debts and lower housing prices.

It’s the nature of a boom.  Free money brings out the worst in us, leading many to borrow more to get even more prosperity that seems to never end.  When the bust comes, it ends, with interest compounded.  The positive dynamic becomes a negative one, until sufficient debt is compromised, cancelled, or paid off.  There’s no way around it, but our government will fight on hopelessly.  They always do.


Most government officials and central bankers are bright people, but they serve a flawed theory.  They think that debt is neutral; it doesn’t matter how much of it exists in an economy, and that it doesn’t matter how you finance assets, because there are no costs to bankruptcy, people have perfect knowledge, etc.

Economists often make theories, and describe rough elements of the world to be irrelevant to a first approximation.  They ignore history and particularly depressions, naively assuming that they know the economy better today than their relatively foolish forebears did.  They would do far better to work in financial businesses so they can see the real limits that exist in financial relationships.

You can’t borrow as much as you want; lenders, even more than equity investors, are not risk neutral.  Booms and busts are normal, even with Keynesian intervention; the intervention may make things better in the short run, and lead to a liquidity trap in the long run.  So we endure today as a result of poorly run monetary policy, and lousy bank regulation.

rt r

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