will see how at certain stages in the credit cycle within a country, equity prices tend to accelerate to the upside and form bubbles at precise moments. We will show that this is a repeatable phenomenon and, therefore, relevant as a powerful starting point in forming a new way of thinking about markets. And we will do this without any equations.
Conversely, the trends in credit will also tell us when to “get out of Dodge” as bubble conditions become unsustainable. There is a consistent and easy to measure marker for all countries in the past two decades that is a highly accurate indicator of a bubble about to pop. Without an understanding of the credit cycle, it is my strong belief that equity investors will consign themselves to a fool's errand of a guessing game.
The second part of this book is all about the new financial architecture. It is not just coming from Silicon Valley but also from London, Frankfurt, Tokyo, Beijing, and throughout Scandinavia. It is truly a global phenomenon in which countries are escaping from the grasp of a banking system that they all too often see as an old-boy's club of poorly managed, overpaid, and incompetent bankers who do not have their customers' interests at heart and are poor at managing risk.
Furthermore, astounding technological advances have been achieved in the past four years, allowing powerful applications to be implemented for the first time. Wide-reaching and powerful programs developed by PayPal, for instance, have migrated to companies like Palantir and are now being used for mass solutions for storage, security, research, applications, and computation. In short, capacity is expanding now at a 2× rate, as predicted by Moore's Law. It is actually happening at a rate that is dozens of times faster.
Companies like Alibaba, Palantir, Intuit, Mint, Indinero, and Tencent, among dozens of others, are at the forefront of new forms of funding, analysis, research, credit checking, trading, and lending that are causing banks deep anxiety. These same banks, however, are so big and have so many entrenched interests to protect that they seem institutionally paralyzed from acting. The resulting tug-of-war is a fascinating phenomenon; in short periods of time, new industries are developing that can offer efficient and inexpensive financial services in a timely, legal, and fair way. These same institutions are also gathering around them the younger people who are disenchanted by institutions they perceive as engaging in criminal activity.
This book asks the question that was posed to me in discussions with Fred Feldkamp while he reviewed the final draft of this book. Fred is probably one of the best financial lawyers I have met and author of Financial Stability: Fraud, Confidence, and the Wealth of Nations.1 Fred challenged me as follows: Does the new world of algorithmic “bots” of financial technology end the ability of banks to extract artificially high spreads forever? Will the world will be better for it? Does the discussion of the toxicity of high LDRs in Part One of this book reveal just how much we let governements and universal investment bankers dupe us into losing trillions of dollars by generating what was, in hindsight, a system that thrived on picking off investors and businessmen, seriatim, by pretending there was a magical myth to the business of banking? We need to ask ourselves this question and whether regulators will allow a new form of finance to thrive and bloom in the face of global universal bankers who are seeing their worlds being swept away – gone with the wind.
Lastly, too much of the intellectual framework of modern finance has been shown up as either insufficient or out of touch with the realities of a broken credit system. I tell my students to explain their ideas as if they are talking to their grandmothers. I do the same when I teach. This book is about credit for grandmothers. We keep it simple. It is a simple “how to invest in multiple asset classes using the credit cycle” and is a useful guide for those who are in the business of political risk analysis. And we can get a front row seat in this technological slugfest as new and exciting upstart companies compete head-to-head with monolithic financial institutions, a few of which may just collapse under their own weight.
Part One
How Bank Credit Drives Economics (Not the Other Way Around) and Why
Chapter 1
A Few Simple Concepts That Anyone Can Understand
After 25 years of writing equity and fixed income research for a wide assortment of investment banks (Swiss, American, Dutch, Chinese, and Japanese), I became baffled by the way in which the vast majority of professional institutional investors who were my clients displayed a blind spot when it came to trends in credit. This is because they were fed volumes of analysis from economists who were almost all trained in the modern economics of the dynamic stochastic general equilibrium model. This is especially true for any economist who has worked for a central bank and then jumped ship to work for a bank. They assiduously look at inflation, valuations, capital formation, consumption trends, interbank rates, and the like.
This model adapted macroeconomics to microeconomics and tried first and foremost to discover where prices allow markets to clear from the point of view of the firm in a near-perfect world of pure competition. It assumed that all agents are identical. It assumed that markets are rational. It assumed that everyone is acting in their best interest and that this interest is best for all. It assumed that people essentially borrow from themselves.
There was no room for banking in this model. There was no room for Fannie Mae (which happens to control 50 percent of the mortgages in the country). There was no room for rationality. And as Nobel laureate Joseph Stiglitz pointed out, “Finance is uninteresting if the person can only borrow from himself… There can't be information asymmetries (apart from acute schizophrenia).”2 In other words, people do not borrow from themselves. They borrow from banks.
Alas, we are not the same. We are not rational. People do not behave the same way as a firm. Governments always create inefficient oligopolies that they can manipulate and control (i.e., telecom companies, defense contractors, banks, energy companies, port authorities, etc.). These oligopolies create distortions in wages, credit, growth, and the allocation of capital. Central banks are a great example of a government-manipulated oligopoly. And we borrow from others, often way too much.
So, we see that the model did not take into consideration credit excesses, the blind greed of bankers, irrationality, and behemoth mortgage entities like Fannie Mae. It did not take into consideration the many senior executives in banks who had no interest in the common welfare and were merely creating leverage in order to create revenue that they could turn into profits. It did not take into consideration the vast swell of frenzied irrationality that has persistently shown up in financial bubbles throughout history.
No wonder I was baffled in dealing with many economists who seemed blind to the dangers I saw coming over the horizon. I was looking at the world from the point of view of the banks and the financial system. Economists were looking at the world through the lens of income, output, inflation, and rationality. It was clear in my mind that the underlying capacity of a country's banking system to create credit is the cause of all the other variables mentioned above. These other variables are a mere outcome of the ability of governments and central banks to create credit.
This blind spot exhibited by so many money managers – and the erroneous information they received from the community of economists – made me wonder if I was wrong. And then I started to discuss the issue with very smart MBA students who had economics degrees. As I mentioned earlier, these discussions with economics majors in my MBA classes reinforced my suspicion that credit as a means for causing a structural shift in demand was absent not only from the formulas taught to economics majors but also from the investment process of most global investment houses.3
Why is this? It may come as a great surprise to many that, according to a recent paper by the IMF, “most (economic) models currently used for macroeconomic policy analysis…either exclude money or model money demand as entirely endogenous, thus precluding any causal role for reserves and money.”4 How can something as fundamental as the way in which credit and money interact be left out of economic models? This is a question that Joseph Stiglitz