What did we see in the U.S. mortgage market as home prices rose and interest rates
declined? First, low teaser rates. Then higher loan-to-value ratios. Then 100%
financing. Then low-amortization loans. Then no-amortization loans. Then loans
requiring no documentation of employment or credit history. These things made it
possible for more buyers to stretch for more expensive homes, but at the same time they
made mortgages riskier for lenders. And these developments took place when home
prices were at sky-high and interest rates were at multi-generation lows. In the end,
buyers took out the biggest mortgage possible given their incomes and prevailing interest
rates. Such mortgages would land them in the houses of their dreams . . . and leave them
there for as long as conditions didn’t deteriorate, which they invariably do.
When credit markets are tight and providers of capital are reticent, money can be hard to come by. Companies’ demand for financing can exceed the supply, putting negotiating power in the hands of the lenders. Thus lenders can insist on – and obtain – strict covenants, and bonds issued in such an environment are likely to be relatively safe. But when usually disciplined bond buyers have to compete against others who aren’t acting in a disciplined fashion, their ability to insist on covenant protection goes out the window. In economics, Gresham’s Law says “bad money drives out good.” That’s why, when paper money joined gold as legal tender, gold was put in the strongbox rather than spent, and only paper money circulated. The same thing happens in the investing world: bad investors drive out good. When undisciplined investors are out there with lots of money to get rid of, there’s less scope for disciplined investors to insist on strong covenants. That’s why the level of covenant protection is a good barometer of the market climate.
Eventually, one would think, many of the forestalled defaults will demonstrate their inevitability, with the companies falling from more highly leveraged heights. And certainly the capital markets’ willingness to finance less-than-deserving companies will lead ultimately to a higher level of corporate distress. Thus, everything else being equal, the bigger the boom – the greater the excesses of the capital markets in the upward direction – the greater the bust. Timing and extent are never predictable, but the occurrence of cycles is the closest thing I know to inevitable. And usually, the air goes out of the balloon a lot faster than it goes in.
It’s folly to think we know in advance just what it is that will cause the market pendulum to stop swinging in one direction and start in the other, but it’s even greater folly to think that nothing of that nature will happen. That’s my twist on one of my favorite quotes, from behaviorist Amos Tversky: It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly whats going on..
It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so. Over the last few years, some people went around saying, “We don’t know what bad thing will happen, but something will,” and others said, “We’re confident that nothing bad will happen.” Now, as is often the case, unassuming caution seems to be winning out over cocksure optimism.
When credit markets are tight and providers of capital are reticent, money can be hard to come by. Companies’ demand for financing can exceed the supply, putting negotiating power in the hands of the lenders. Thus lenders can insist on – and obtain – strict covenants, and bonds issued in such an environment are likely to be relatively safe. But when usually disciplined bond buyers have to compete against others who aren’t acting in a disciplined fashion, their ability to insist on covenant protection goes out the window. In economics, Gresham’s Law says “bad money drives out good.” That’s why, when paper money joined gold as legal tender, gold was put in the strongbox rather than spent, and only paper money circulated. The same thing happens in the investing world: bad investors drive out good. When undisciplined investors are out there with lots of money to get rid of, there’s less scope for disciplined investors to insist on strong covenants. That’s why the level of covenant protection is a good barometer of the market climate.
Eventually, one would think, many of the forestalled defaults will demonstrate their inevitability, with the companies falling from more highly leveraged heights. And certainly the capital markets’ willingness to finance less-than-deserving companies will lead ultimately to a higher level of corporate distress. Thus, everything else being equal, the bigger the boom – the greater the excesses of the capital markets in the upward direction – the greater the bust. Timing and extent are never predictable, but the occurrence of cycles is the closest thing I know to inevitable. And usually, the air goes out of the balloon a lot faster than it goes in.
It’s folly to think we know in advance just what it is that will cause the market pendulum to stop swinging in one direction and start in the other, but it’s even greater folly to think that nothing of that nature will happen. That’s my twist on one of my favorite quotes, from behaviorist Amos Tversky: It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly whats going on..
It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so. Over the last few years, some people went around saying, “We don’t know what bad thing will happen, but something will,” and others said, “We’re confident that nothing bad will happen.” Now, as is often the case, unassuming caution seems to be winning out over cocksure optimism.
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