Now it’s Lehman’s turn.
Ten years ago, the New York Federal Reserve Bank called upon Lehman Bros. and a handful of other major players on Wall Street to rescue a high-flying hedge fund. The firms grumped and whined…but they came up with the money, $3.7 billion. The rescue was a success. LTCM’s positions were unwound slowly; there was no panic; Wall Street soon went back to doing what it is supposed to do – separating customers from their money.
Long Term Capital Management was run by a couple of Nobel Prize winning economists who believed they could use past financial patterns to model the future – just as if price movements were the same as the weather. If a hurricane had hit Houston twice in the last century, they figured the odds that another hurricane would hit the city at 1 in 50. Likewise, if the price of Lehman stock traded between, say, $10 and $30 during its 158-year history, they figured – grosso modo – that it would stay between $10 and $30.
LTCM went bust when the future turned out to be different from the past. Anyone with his eyes open at the time could have told the Nobel laureates why: weather patterns were independent of human decisions; market patterns are not.
One of the big revelations of the ’90s – or was it the ’80s? – was that stocks were traditionally, historically under-priced. Compared to bonds, said a popular financial author, stocks were a better deal. Stock buyers earned a premium over bonds for the risk they undertook, he said. But if you held stocks “for the long run,” the risk disappeared. Buying stocks seemed like a no-brainer.
Thus did the lumpen investoriat begin pumping money into stocks…cautiously in the beginning of the ’90s…and recklessly at the end of the decade. And by the year 2000, the stock market no longer reflected the “random” movement of prices as predicted by the previous hundred years of stock market history; instead, it reflected the recent and remarkable belief that stocks always went up…and that if an investor held long enough the risk disappeared.
From the peak of 2000 ’til today, stock market investors have earned nothing for their trouble. In nominal terms, stocks are about where they were 10 years ago. Adjusted for inflation, they are down 25%-80%, depending on how you measure it.
Wall Street made a fortune selling stocks to naive investors. When the stock marked topped out, the financial industry might have gone back to sleep. Instead, it got a double dose of caffeine. The Greenspan Fed cut rates in 2001-2002 while the Bush administration boosted spending and cut taxes. All of a sudden, every hand on Wall Street turned to pumping out credit – derivatives, SIVs, CDOs, MBS. They didn’t really have to invent any new theories, they merely recycled the same numbskull ideas that sank LTCM – basically, that you could eliminate risk by modeling historic price movements. If Lehman Bros., for example, had never failed in more than a century and a half – the odds that it would fail this year were so close to zero as to be not worth discussing.
“Lehman lurching closer to liquidation,” says the front page of today’s International Herald Tribune.
Now, it’s Lehman that is failing. And no consortium of Wall Street banks is willing, or able, to bail it out. Lehman has some $80 billion of dubious credits. These were the products of its own – and many other – whiz kid financial engineers. Lehman hired some of the best talent on Wall Street. It has some of the world’s top financial mathematicians on its payroll. It could compute the risk of loss down to 3…4…heck…as many decimal places as you like. But it could do so only as LTCM did – based on past history.
As we explained, once investors came to consider stocks as a riskless way to get rich, they bid up prices to the point where they were all risk…and no reward. And when their models told them that they could make money by lending money to people who couldn’t pay it back, practically every loan they made took them closer to bankruptcy.
*** The financial industry gained more than any other from the big credit expansion. It makes sense that it should be the industry that suffers most when credit goes the other way.
In that regard, history is a good indicator of what to expect. You can guess about the very broad patterns of the future, based on what you know about the past…and of your fellow man. We know, for example, that investors tend to go from one extreme to another. At once, they are afraid of credit…and then they feel as though credit were their best friend in the world. And they go from feeling very optimistic about the future…to feeling very pessimistic. These feelings have market consequences. When they are upbeat and sans soucis they are willing to lend at very low rates of interest, for example. Why not? They’re sure they’ll get their money back. And when they are feeling lucky, they’ll invest in wild-eyed schemes and half-baked projects too. Everything is going their way; so why not?
But then, the mood changes. The schemes fail. Money is lost. And gradually people come to believe that the future holds more bad days than good ones. Yields rise – as they ask for higher rates of interest before lending money. Not only are they afraid that they may not get their money back, they’re also afraid that the money they get back may not be worth as much as the money they lent out. At the peak of the yields cycle in ’82, for example, investors wanted 14% interest before they’d lend money even to the U.S. government!
When they get gloomy, they want higher cash dividends from their stocks too. Gone are the days when they believed they could just buy stocks and get rich. They come to believe that if a stock is not paying its way – with dividends each year – out it goes. During the Great Depression, for example, stock market investors sold stocks down to such a low level that they paid an average dividend of more than 10%.
We’re still a long way from there. The yield on the 10-year T-note is above 3.7% – but still about 200 basis points below the level of consumer price inflation. Which is to say, real yields on Treasury paper are negative. Still, they’re better than dividend yields, which average only about 2.5%. Investors still believe that their stocks will go up, so they’re willing to accept dividend yields of less than half the current CPI.
But we’re headed in the right direction. Lehman is going bust. AIG is struggling…hopping for a $40 bailout from the government. Houses in California are down 30%…and still sinking.
Alan Greenspan, who bears more responsibility for the present state of financial affairs than anyone, says this may be a “once in a century,” event. This time he could be right…
Markets and Money