Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

October 2008

Thrift, living within one’s means, avoiding debt—there is much to be said for traditional financial values after all. A little more faith in such virtues and less “creativity” on the part of bankers might have prevented much of the present misery in the financial sector, and spared taxpayers the ultimate cost of a vastly expanded national debt. To be sure, Wall Street probably would have been a less exciting and profitable place, but a few more old-line investment firms might still be in existence and one of the most massive government interventions into the private economy in our history could well have been avoided. But wistful thinking on what might have been will not get us out of the current difficulties, although it could and should offer insights into how to shape future policies that can prevent a recurrence of the crisis that now poses a serious threat to the international economy.

The root causes of the greatest financial catastrophe in decades are complex and not entirely of recent vintage. They include economic incentives so deeply ensconced in the American economic and political psyches that they would be hard to dislodge, even if the political will could be mustered to do so. Changing them would require making difficult choices over such issues as taxation policy and the compensation schemes of large corporations. While the government’s plans to use huge amounts of borrowed funds to recapitalize the banking system may get us through a very nasty period, failure to address these underlying issues will eventually engender the same financial and business behaviors that have brought us to the present circumstances. People respond to incentive structures as they find them, and people do not change very much.

The notion of an “ownership society” entails one such bundle of incentives. The “American Dream” of owning a home—an idea heavily promoted by politicians and the homebuilding industry—is deeply embedded in the public psyche; however, tax policies favoring mortgage debt for home purchases have also been a powerful draw. First introduced in 1913, their popularity took off in the 1950s. The system seemed to work well for many years. Nevertheless, as with many good and well-intentioned ideas, when people began to buy homes for “the tax deduction” or for investment and retirement without regard for the price to be paid for the property, things had been carried a bit too far. The tax incentives predictably caused a huge misallocation of capital to the real estate sector, literally changing the landscape of the country. They also encouraged profligacy: More and larger homes were built than necessary, underlain by a mountain of debt subsidized by the taxpayers. Driven by this artificial demand, home prices eventually became too high to be affordable, even with the tax subsidy, and the current mortgage crisis was born. As for the attractiveness of property as an investment, contrary to popular belief, home ownership has been a mediocre commitment over time, especially in recent years when property prices were widely and wildly uneconomic.

One of the most elusive and challenging sources of perverse incentives in our economy relates to the “agency problem.” First described in the early 1930s, the issue involves the inherent conflict of interests between the owners of corporations (shareholders)—generally a disparate and unorganized group—and the managerial class that runs the corporations. Managers’ interests are quite well-defined and organized, and their actual control of businesses gives them ample incentive and ability to pursue their interests largely unimpeded. The result has been the creation of compensation structures and the development of a business culture that, as we have all witnessed in recent years, not only has come to reward incompetence, but, in the pursuit of short-term gains, has encouraged an unacceptable level of risk-taking with other people’s money, at little or no risk to the executives themselves. One executive neatly summarized the attitude last year: “As long as the music plays, you have to dance.” Such a brazen disregard for risk should normally raise eyebrows; instead it was viewed as reflecting business reality. Soon afterwards this particular executive lost his position—and walked away with tens of millions of dollars in compensation, leaving his successor (and the taxpayers) to clean up the mess he left behind.

The agency problem has been with us for a long time, but it has never been adequately resolved. Despite corporate blather about “aligning the interests of management with those of the shareholders,” managements’ idea of a solution has been to introduce ever more egregious compensation policies involving stock options and other equity-related awards (“entrepreneurial rewards for bureaucratic outcomes,” as the Financial Times aptly described the practice), not to mention the perennially popular one-way bonus programs. Typically these compensation schemes are based on short-term accomplishments, while ignoring the consequences of actions that may be damaging in the long run. Wall Street, for example, is now paying the price for having used too much borrowed money in past years, but as long as the good times lasted, high “leverage” produced big profits and bonuses. Until the beneficiaries of these systems come to fear the wrath of the gods, and the loss of their own wealth, we can expect the excesses and problems to return again and probably entail ever more public involvement and expense.

Always harboring potential risks, such incentives built into our economy became toxic when easy money, unusually low interest rates, and a long period of prosperity led to a decline in financial morals; fear of risk receded and people saw only dollar signs. Regulatory failures played a role as well—controls introduced as a result of previous crises were permitted to lapse, and there reigned a general faith in the self-controlling mechanisms of free markets. However, when responsible parties do not pay the price for failure, market forces cannot be expected to do the job that free market theorists would prefer. One-way incentives distort free markets as much as “ill-advised” regulation. Again, people do not change very much. The “invisible hand” sometimes needs a helping hand.

Unless one believes that the “cleansing action” of a potentially severe economic contraction would be an attractive alternative way of eliminating the excesses that have clogged our financial system, the government’s efforts to end the financial freeze-up are necessary. As shockingly expensive as it looks, the loss of output, wealth and employment from a bad recession would be more costly still. However, the effort needs to include policies aimed at some of the underlying issues discussed above. At the very least the public should be made aware that the incentives built into the system will continue to produce negative consequences calling for diligent oversight.

When There’s Nothing To Do, Do Nothing

Only central bankers and economists can claim an inability to identify asset bubbles such as the ones we have experienced in stocks and real estate over the last decade. Those of us with actual responsibility for handling people’s money and protecting their well-being do not have that luxury. On the contrary, we have a duty to examine market conditions and make judgments regarding the attractiveness of assets. In a year when the stock market averages are down nearly 25% so far, and the very foundations of the financial system have been shaken, the obligations that duty imposes have been made abundantly clear.

Equally important is to act in a manner consistent with the conclusions of one’s analysis. During the past several years we have repeatedly maintained that certain financial practices were irresponsible, unsustainable, and would end badly. Risk was being mispriced. In fact, much of what the financial industry is now suffering through can be thought of as the long-anticipated repricing of risk. With respect to real estate, a sector whose unprecedented price declines are at the heart of the current turmoil, in our Commentary of January, 2005 we cautioned readers “to stay short, stay out of debt, and don’t buy property.” We felt real estate in the mid 2000s was in a speculative bubble akin to the stock market of the late 1990s and represented a real risk to capital. At the same time we found the stock and bond markets to be uninteresting risks and preferred the stability of large cash holdings, in spite of the relatively low returns from short-term instruments.

With hindsight it is clear that the appropriate policy to have adopted with respect to stocks, bonds, and property during the last few years was, as we stated at the time, to do nothing; analysis revealed few alternatives offering attractive risk/return profiles. Such a course of action is, unfortunately, not acceptable to most investors. Institutions are bound by short-term performance pressures; others can’t stand sitting on their hands for long. The choice to exercise restraint is a difficult one. Of necessity it comes early on, when excitement and lust for profits are at a zenith, and may look wrong for a long time. Yet risk is highest at such times and so the logical investment response is to protect capital and let cash accumulate. This is (or should be) a natural response to the ebb and flow of investment values. “None of the above” is a legitimate choice in investment in the absence of reasonably-priced alternatives. Cash will provide firepower when more favorable conditions return. However, as short-term results will suffer, such investment thinking conflicts with those ever-present incentive systems we described above, and requires a long-term perspective that is sorely lacking in most money management operations. Nevertheless, we believe clients benefit from a risk-averse approach; they can sleep soundly in volatile markets and possibly achieve better results in the long-run.

We entered the current difficult period with substantial amounts of cash, not, we hasten to add, because we foresaw a market fall, but because risk was mispriced and we felt it was wise to avoid involvement in a situation fraught with danger. With recent market declines risk is becoming better balanced and, importantly, future returns are rising. If the declines continue, we may finally be able to put those cash balances to more productive use.

 

Dennis Butler, MBA, CFA