Ain’t so. Humans have never found a way to live without risk. And our current economic system cannot provide a better than purely miserable return on your money without undertaking some risk. That’s not for want of trying, of course. And these days it seems that financial people, investors, and governments take on huge risks and blow off the possible consequences as if they were living on a permanent cloud. What has happened to sanity?
From my memory of things, as a long-time reader of business magazines and the Wall Street Journal, we started going off track back in the 1980s. Then the smartest, most persuasive of the financial people invented the “high-yield” or “non-investment-grade” or “speculative-grade” bond. This was a way—and still is, to some extent—for the largest, most solid of U.S. corporations to raise more money than would normally be possible in the financial markets.
Credit rating agencies like Standard & Poor’s, Moody’s, and Fitch Ratings exist to study the conditions under which corporations and governments raise money by selling bonds.1 Based on the stability and strength of the entity borrowing the money, the size of its other obligations, and its history of honoring its debts, the agencies assign a rating to the bond. The scale goes from the highest, AAA, down through AA to A, then through the Bs and Cs, with pluses and minuses, just like a school grade. A rating of D indicates a debt that’s already not being repaid as promised.
These rating systems don’t try to eliminate risk, simply categorize it. If you want minimal risk, buy AAA-rated bonds like U.S. Treasuries. You won’t make much in interest, but your money is secure. The high-yield bonds, in contrast, were and still are offered under conditions and promises to pay that make them about the last thing on the borrower’s mind. If things go badly with the corporation and it has to line up its creditors in the order by which they’ll get paid, the high-yield investor is standing at the end of the line and likely can whistle for his money. The attraction of these bonds, for the buyer, is that they pay really well. With a greater risk that the bond might become just a piece of paper, the buyer expects to earn a whole lot more for taking and holding it. You expect to be paid well to hold a hot potato, too.
The magic trick that financiers in the 1980s pulled off was convincing buyers that, because of the high yield and despite the low rating, these were great deals. After all, the companies floating these bonds were all solid earners, among America’s biggest corporations, and nothing really was going to go wrong. Hey, you can trust these guys! Even though these bonds soon picked up the name “junk,” people forgot about that and snapped them up. It looked like a way to make big money without real risk.
Suddenly corporations had a lot of cash from selling junk promises to pay. Some used it wisely, but many went on buying binges, snapping up smaller companies and undertaking expansions that—in previous times and with less money in play—might not have looked so attractive. But the concepts of “debt” and “obligation” are so Puritan. The smart financial people called it “leverage”—making a little bit of your money and a lot of other people’s do the work of a long stick.2
The trouble with an environment like this is that Gresham’s law, that bad money drives out good, still operates. People who are playing fast and loose with their promises tend—over the short run—to do better than, have an advantage against, and out-compete the dullards who play it safe and won’t jump into the pool. Companies like Enron and WorldCom puffed up and suddenly became as big as, or bigger than, old established companies like Chevron, AT&T, or GM, Ford, and Chrysler. Until the bubbles burst, that is, and they disappeared.
In the mid-1990s, the smart financial people invented another couple of concepts to address risk and keep the party going: the hedge and the derivative. These are simple concepts that became incredibly complex and mysterious.
A hedge is just what it sounds like—hedging your bet. If you undertake a risky gamble on a stock going up or down, then make a simultaneous bet against that happening, or a bet on some other, inversely probable occurrence. This is like betting both red and black on the roulette wheel, or betting on both fighters in a boxing match. The bets are never exactly equal, because that would be pointless. The idea is to recoup some of your loss if the situation goes south. Very smart people work up statistical relationships and use a stunning amount of math to gauge the risks and rewards between the original investment and the hedge. A company called Long Term Capital Management was founded in 1994 to employ these strategies so that money would grow fast and without risk. The tower of complications it constructed collapsed and the company closed in 2000.
A derivative is just a form of bet. Two financial parties agree to pay each other certain sums of money based on the movement of some reference variable like a stock market index, the future value of gold or some other commodity, or any complexly dynamic phenomenon. The derivative is not an investment in the market or the gold or any underlying value; the parties are simply using it as a condition of the bet. This is not very different from betting on the order in which cards will come out of a deck.
Not surprisingly, derivatives are often used as hedges for actual investments in the market for stocks or commodities or real estate.
As noted elsewhere,3 I am not a mathematician, or statistician, or any kind of trained scientist, but I am plagued with a great deal of caution and common sense. I don’t like to jump into a pool until I know how deep it is. I don’t like to undertake an obligation unless I have a clear view to how I’m going to fulfill it. And my guts tell me you can’t avoid all risk over the long term. You can hedge a bet now and then. You can dodge the consequences of risky behavior once or twice. You can build a house of cards up to two or three levels. But sooner or later you have to come back to a ground state with respect to risk. You have to equilibrate4 and return to a condition of balance.
While the economy may not be a zero-sum game,5 every person and organization operating within it ultimately leads a zero-sum existence. You are born into this world with nothing of your own, and you will leave it the same way.6 Electrons absorb energy and rise from one shell level to the next, then release that energy and drop back. A person’s getting and spending ultimately equal out. A company’s stock and debts ultimately equal its assets and profits. Risks and rewards ultimately balance out. And nobody cheats the hangman.
Every speculative fever—from the tulip mania of the 1630s and the stock market boom of the 1920s, to the tech boom of the 1990s and the housing bubble of the 2000s—goes through predictable phases. From being a new thing that only the rich, the smart, and the daring will invest in, the prized commodity—whether bulbs or stocks or houses—becomes something that everyone is willing to borrow to acquire, because there’s really no risk, because the demand is infinite and the price will never go down.7 Sooner or later, however, risk catches up, everyone steps in a hole, and the market collapses.
It always has, and it always will. But it is our nature to believe that this time, just this once, things will be different and we can cheat the hangman. … Isn’t hope a beautiful thing?
1. A bond is nothing more than a portable form of loan. It represents a corporation’s or government’s obligation to pay back the money it borrowed. A bond differs from a simple loan in that anyone holding the bond can sell it anytime in an open market to someone else, who will eventually receive from the borrower the principal money plus interest. Depending on how people feel about the bond and its issuer at the time of sale, the price may be a bit more or less than the principal-plus-interest to be paid back. This difference establishes a “yield” for the bond.
2. Among the probably unwise uses was the “leveraged buyout.” The managers of a company would decide they didn’t like being custodians, having shareholders, and obliging themselves to meet the shareholders’ and stock analysts’ quarterly expectations. So the managers floated a lot of unusual debt, bought up shares of the company’s own stock, and ended up owning the company—plus a mountain of owed money that hung over these companies, swinging back and forth and descending over time like Poe’s pendulum.
3. See my blog Fun with Numbers from September 19, 2010.
4. To borrow a word from the sciences.
5. See The Economy as an Ecology from November 14, 2011.
6. Yes, of course, sometimes Mummy and Daddy are rich and can set you up with a lot of advantages, but you yourself are born as naked as any pauper’s child. And yes, you may leave behind a great fortune for the benefit of your heirs, but you die as penniless as any husk on the burning ghats.
7. It didn’t help that, in the latest bubbles, the U.S. Federal Reserve, which manages the country’s money supply and sets the basic rate at which money can be borrowed, has kept that rate low for reasons other than providing easy money for everyone to get drunk on. They thought low interest rates would keep inflation from taking off; instead other things took off. Managing risk is like packing a partially inflated weather balloon into a suitcase: if you push it in here, it pops out somewhere else.