Geoff Gannon July 22, 2008

On Liquid Courage

There are two recent pieces on morality and credit worth reading. One is written by David Brooks; the other by Jim Grant.

Brook’s piece is good; Grant’s is better. Brooks takes the matter as far as he can. He sees the importance of the everyday examples that constitute a culture; but fails to see the overwhelming importance of incentives – incentives that have been both perverse and pervasive throughout the third millennium.

(The borrower) and the lenders were not only shaped by deteriorating norms, they helped degrade them. Despite all the subterranean social influences, there still is that final stage of decision-making when individual choice matters. Each time an avid lender struck a deal with an avid borrower, it reinforced a new definition of acceptable behavior for neighbors, family and friends. In a community, behavior sets off ripples. Every decision is a public contribution or a destructive act.


Unfortunately, he goes on to write:

Meanwhile, social institutions are trying to re-right the norms. The government is sending some messages. The Treasury and the Fed are trying to stabilize the system while still ensuring that those who made mistakes feel the pain.

Brooks is out of his depths here.

Ultimately, the pain will come in the form of inflation. It has to. Either the Fed will realize it has assumed weaknesses that are mostly illusory – or the Fed will cure those weaknesses the only way it can. Either the Fed’s balance sheet will turn out to be solid, or the Fed will have to counterfeit that solidity.

Unlike Brooks, Grant resorts to numbers:

In June 2007, Treasury securities constituted 92% of the Fed’s earning assets. Nowadays, they amount to just 54%. In their place are, among other things, loans to the nation’s banks and brokerage firms, the very institutions whose share prices have been in a tail spin. Such lending has risen from no part of the Fed’s assets on the eve of the crisis to 22% today. Once upon a time, economists taught that a currency draws its strength from the balance sheet of the central bank that issues it. I expect that this doctrine, which went out with the gold standard, will have its day again.

John Bethel of Controlled Greed recalls a past phrase from Grant – “the democratization of credit and the socialization of risk”. There is no clearer example of this phenomenon than the weakening of a public balance sheet to strengthen private balance sheets.

The first part of that phrase is as important as the second. When do you hear someone told they shouldn’t buy that house or take out that student loan? Is anyone ever told they can’t afford to own a house, or attend a four-year school?

No. These are the new unalienable rights. Unfortunately, they still have to be paid for out of pocket. No amount of money is too much to spend on your education or your abode…

But if that’s true, what difference does the price make? If you’re going to buy the best – the absolute best you can (because you’re worth it) – then what difference does the price make?


All that matters is whether you can afford it – and since you’ll be borrowing the money, whether or not you can afford it will depend (almost) entirely upon whether or not a lender thinks you can afford it – and whether or not a lender thinks you can afford it will depend (almost) entirely on how cheap he can get the money and how valuable he thinks your asset is – and since your house is a marketable asset all that really matters to your lender is how much he thinks other people are willing to pay for your house – and all that really matters to those other people is how much their lender thinks they can borrow at the current rate – and so far this millennium, that rate has been low, low, low.

And no one’s trying to take the addict to rehab.

In the third millennium, coming clean about your oil addiction is suddenly in vogue; but, cutting off a credit-whore remains a thankless job.

We talk a lot about loans and very little about balance sheets – especially personal balance sheets. An individual has one great earning asset: her labor. It’s a terrific asset. It can support a lot of debt. But, we mustn’t forget it can only support a finite amount of debt.

The housing bubble inflated by overburdening a more tangible asset. The ugliest truth of the mortgage mess – the truth everyone prefers to sidestep – is the bottom line: you can’t saddle an asset with more debt than it can bear. If a leveraged buyout can bankrupt a corporate cash cow (and it can) – why should we be surprised to find that loading a house up with debt can crush it?

Because it had never happened before – or, if it had – we hadn’t measured it.

As is our custom, we didn’t let logic get in the way of the data.

Thankfully, we’ve now been proven empirically wrong, so this shouldn’t happen again.

We’ll come up with something new next time.

Brooks is right about one thing. In the end, it does come down to personal responsibility – and no where was there less personal responsibility than inside the housing bubble.

No distinction was made between price and value. Everyone trusted the market (and, of course, everyone was the market).

A house was worth what it could be sold for; a loan was worth what it could be sold for.

It was one big Keynesian beauty contest.

You didn’t have to appraise a liquid asset; everyone else did it for you.

No one needed to know what anything was worth.

And now no one does.

Greed has been unfairly singled out as our nation’s greatest vice. Greed may be a sin, but it isn’t deadly.

Being greedy, lazy, and stupid all at once – now that can kill you.

We drank a little too deeply of this newfangled liquidity. We did some things we aren’t too proud of. And slowly, slowly, we’re beginning to remember just what those things were.

In his 2002 letter to shareholders, Warren Buffett wrote that despite several years of falling prices, he wasn’t finding many stocks to buy; evidence, he said, of just how crazy “The Great Bubble” valuations had been. He went on to make a prediction:

Unfortunately, the hangover may prove to be proportional to the binge”.

Now that our liquid courage has left us, that kind of thinking is all you hear.

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