Profit From Paranoia

Alan Greenspan, one of the key perpetrators of the housing and debt bubble, said a truly amazing thing in his Congressional testimony.

He said, "those of us who have looked to the self-interest of lending institutions to protect shareholders' equity (myself especially) are in a state of shocked disbelief." He also argued that the housing-market collapse happened "because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria."

Now, Greenspan is surely at least a bit brighter than your typical light bulb, but he seems to be three foot-candles behind in his understanding of the biggest financial crisis of our time.

To him, the models were just broken -- but that totally misses the bigger picture. This crisis isn't simply the failure of a model. It's proof of the biggest flaw in capitalism: All the participants can act completely rationally, and still set up such huge instabilities in the system that they threaten the global economy.

Just like Spock
Despite all the hand-wringing to the contrary, almost all the perpetrators of this crisis were actually acting logically.

Take the people who bought houses that they couldn't afford. If you don't have a lot of assets to lose, and someone's willing to give you a low-interest, nothing-down loan to buy a house during a bull market, it makes a lot of sense to take it. In fact, it makes sense to take as much as they'll give you. If prices rise, you make a killing. If the market falls, you walk away. Heads, you win. Tails, the bank loses.

Stupid loans made perfect sense for executives at lending institutions, both personally and professionally. Personally, you reap the benefits of the loans in the form of bonuses -- which are based on the short-term performance of the company. Professionally, if you conservatively avoid making the liar loans, you'll lose the company money and likely lose your job to boot.

It was even rational for Moody's (NYSE: MCO  ) to use less-conservative models when rating securitizations -- because they make money rating deals. Why would they discourage securitizers and risk cutting off the flow of cash?

The only stakeholder for whom stupid lending didn't make sense was ... the shareholder. Why? Because, in the end, we bore the risk for all of that stupid lending. Even among the survivors, the carnage has been extreme. Citigroup's (NYSE: C  ) plunged from above $50 to below $14. Fifth Third Bancorp (Nasdaq: FITB  ) has fallen from $40 to $11.50. And AIG (NYSE: AIG  ) managed to burn both shareholders and taxpayers with its plunge from $70 to $2.

Shareholders are supposed to be represented by the board of directors, who are supposed to force management to strategize for the long term. Since management usually nominates members of the board, however, a director will usually side with management when there's a conflict with shareholders. In other words, it's logical for directors to act like weenies.

Watch your own back
Everyone might have been acting rationally, given the small slice of the world they were working within, but it added up to a pretty substantial meltdown. All this rationality has two implications.

First, rationality won't save us -- precisely because everyone is working within only a tiny piece of the whole puzzle. That's where regulators are supposed to step in, allowing people and institutions to do the 920,321 things that won't destroy our economic system, but stopping them from doing the 97 things that can. But try telling that to Mr. Greenspan.

Second, we as shareholders are dependent on management acting with prudence and integrity -- and not just taking the easier and more rational path of making risky bets to achieve short-term profit goals. And that means being paranoid about the management of the companies you're investing in.

Consider these three ways to deal with these challenges.

Find management that thinks like owners
If executive pay is ridiculous, it gives you a clear indication that management isn't running the business for you. The birthday party that Tyco's (NYSE: TYC  ) former CEO Kozlowski threw using company money is the most over-the-top example, but it seems like new examples of executive greed surface every week.

Of course, one way to find management that thinks like owners is to find management that is owners. If insiders own significant equity, they're likely to fight hard to preserve it.

Look carefully at debt and leverage
It's no coincidence that the investment banks had insane leverage, and that they're among the hardest hit in this crisis. For instance, before recent funding, Morgan Stanley (NYSE: MS  ) and Goldman Sachs (NYSE: GS  ) had debt-to-equity ratios of 30 and 22, respectively. At those levels, a mere 5% loss is enough to wipe out shareholder equity.

Even without losses, debt can sink a company if it is unable to roll over or pay back the debt when it matures. That's a crucial issue right now, since the debt markets are running scared. But in every market, it's smart to steer clear of companies with significant debt for their industries.

Focus on businesses that you can buy with a margin of safety
If you buy far enough below fair value, then even if something goes wrong, you're still likely to make money. Even businesses with great management can run into problems, so always protect your downside with a substantial margin of safety.

The Foolish bottom line
It might seem counter-intuitive in this volatile market, but the market crash means there are many stocks selling with wide margins of safety -- and some of them have the kind of management you want in your corner. But it pays to be paranoid.

Those are the kinds of stocks we look for at our Motley Fool Inside Value investment service -- and right now we're recommending two companies that fit that profile. You can find out what they are -- and get our other recommendations for new money now -- by taking a 30-day free trial. Click here to get started -- there's no obligation to subscribe.

Fool contributor Richard Gibbons thinks he's a Vulcan, but is really more like a paranoid Ferengi. He does not own any of the stocks discussed in this article. Moody's is a Motley Fool Inside Value and a Stock Advisor recommendation. Tyco is an Inside Value pick. The Fool's disclosure policy is more wrinkled than Alan Greenspan.


Read/Post Comments (10) | Recommend This Article (29)

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  • Report this Comment On November 04, 2008, at 1:07 PM, Leedsichthys wrote:

    "Alan Greenspan, one of the key perpetrators of the housing and debt bubble..."

    How long are we going to continue this tired refrain? I've seen and heard countless people laying significant blame on Greenspan, as if he forced people to make bad decisions by maintaining low rates. But what, exactly, do you think he should have done?

    After 9/11/2001, the Fed began actively cutting interest rates by pumping dollars into the banking system. The prime rate fell from 6.5% on 9/11 to 4.75% in December 2001. During this time, the tell-tale sign of an overheating economy - rising inflation - was conspicuously absent. So the Fed, which is primarily responsible for managing inflation, lowered rates, and the prime rate eventually fell to 4% in June 2003.

    Since inflation was not a factor, why not lower rates? The argument is that cheap money allowed those who couldn't afford to borrow at higher rates to borrow, and caused banks to lend recklessly.

    It might surprise those of this opinion to know that in the 30 years prior to 1965, the prime rate was never higher than 5%, and that in the post-war period until August 1958, it was never as high as 4%. This was a period of unsurpassed prosperity in America, and the cheap money enabled millions of families to purchase houses. If low interest rates were the cause of the recent bubble and meltdown, why was there not similar calamity in the late 1940s to 1951, when the prime rate was under 3%?

    Fact is, cheap money does not cause undue risk-taking. Stop blaming the housing bubble on cheap money.

    A much better argument to use against the Fed entails failing to properly regulate those companies for which it had some oversight responsibility. However, when considering the nature of the cascading failures in the financials, wherein the failure of less than 10% of residential mortgages has caused massive losses across the financial spectrum, the SEC deserves at least as much blame due to its failure to regulate the credit default swaps market.

    In the end, there's enough blame to go around, and nobody with a finger in this pie comes out clean.

  • Report this Comment On November 04, 2008, at 6:36 PM, knoconnor wrote:

    Thank you Richard for a rare intelligent commentary on the reasons for the economic mess we are in.

  • Report this Comment On November 04, 2008, at 7:37 PM, espositocj wrote:

    Richard missed the basic issue of the oversight lacking, especially by auditors who are supposed to sample transactions for proof of economic soundness. The SEC should have forced better auditing and it along with the accounting standards board should have put rules on the amount of risk in credit default swaps and the other leveraged derivatives and any off balance sheet financials that weaken the firm. Apparently nobody paid attention to the Enron situation as a historical parallel that could happen in the finance industry. As Richard pointed out the benefits to the major parties in the meltdown side stepped the accountability issue, that doesn't mean that nobody was there to put a halt to the problem arising from the greed of those parties.

  • Report this Comment On November 05, 2008, at 2:08 AM, rbgibbons wrote:

    Leedsichthys, I'd agree with you that there is blame to go around. However, Greenspan deserves a large chunk of it for several reasons. The first is the regulation issue. If Greenspan wanted regulation, he could made it happen. He was still respected then.

    Second, he ignored bubbles, saying things like you can't identify a bubble until after it's popped, and that there was no such thing as a national housing bubble. That cheerleading helped perpetuate the problems.

    Third, he ignored the inflation that existed because it didn't fit his models. There was clearly asset inflation going on at the time and distortions in the CPI calculations were impacting the reported inflation. The liquidity he was providing was going into assets, inflating their prices. He should have been able to see that, and compensate.

    I think, however, that he may have been too scared to act conservatively and pop the bubble, because the resulting recession could have been blamed on him and ruined his legacy. Turns out that his legacy was ruined anyway.

    Richard

  • Report this Comment On November 05, 2008, at 9:38 AM, brad4now wrote:

    CHRISTIAN GREED. Worldly GREED.

  • Report this Comment On November 08, 2008, at 4:23 AM, gorengad wrote:

    Rbgibbons,

    I agree with Leedsichthys. It seems to me that Greenspan has become a scapegoat for people's frustration with the market break down.

    Financial engineers will always create new devices that are tricky to regulate (CDS, Enron type accounting, etc..) and the regulators will always be behind.

    Capitalism is a work in progress. I still believe that the US model of it will evolve and thrive.

  • Report this Comment On November 08, 2008, at 9:11 PM, borneofan wrote:

    The key proviso is that everyone acted rationally... but that the market data used by all these rational actors was provided by free money from Fannie and Freddie.

    Fundamentally, this is a failure of government. Greed has nothing to do with it (no more or less than at any other time in history).

    Congress created the CRA programs to shove home ownership at those neither qualified nor inclined as such. Congress created the Fed to regulate the currency. Congress created Fannie and Freddie.

    The blame lies totally with Congress. Others were complicit, but only Congress is culpable. Look no further.

  • Report this Comment On November 14, 2008, at 4:39 PM, TerryHogan wrote:

    I'm admittedly no economist, but what about the huge increase in the money supply under Greenspan? M3 basically tripled under his watch. That has more to do with the asset-inflation that occured than the low interest rates. Doesn't it?

  • Report this Comment On November 21, 2008, at 11:31 AM, VEttariPEPC wrote:

    Mr. Greenspan allowed the markets to run rampant, claiming that he thought that those in charge would look-out for the better good of the stockholders and those who had deposited money in the banks (which would be the rest of us).

    Now, Mr. Greenspan is Jewish. Didn't he know that Scripture clearly teaches that given half a chance, "the feet of all are swift to run towards evil"? We as a country have refused to accept this basic pronouncement by Divine Writ that humans need to be controlled (i.e., law) so that their "feet" are not permitted to run toward evil.

    And so, with Mr. Greenspan's good blessing, millions of people lied on their mortgage applications about their incomes so that they could buy a McMansion. And so, we see, greed, selfishness, and lies are at the heart of our mortgage crisis.

    The moral lesson to be learned?

    It is written in the Book of Proverbs that "God hates a lying tongue". If this is true, God is not particularly fond of the US right now. How could he be? The "social engineers" want to ban God from everything; and then they ask "where was God" when jets slam into our buildings.

    We cannot have it both ways. We cannot lie, cheat, and steal and then expect God's blessing. We cannot "serve God and worldly goods", as Jesus said. For, as he asserted, we would "either love the one and hate the other, or love the other, and hate the former". And this is exactly what is happening in the US. Our love of money and worldly possessions is causing our society to abolish all remnants of faith in the Judeo-Christian God. We now love money, and hate God.

    And so, Reverend Wright's pray that God should damn America seems to be coming true. We have all seen his "God Damn America" sermon. But, in a way, he is right. Not only did this country practice slavery, but it still has immense racial tension. Now, add to that history a new propensity on the part of the citizenry to lie on even mortgage applications. And, what do you get. The following:

    "No harm befalls the righteous, but the evil doers have their fill of trouble" (Proverbs 12:21)

    "The Lord detests lying lips, but he delights in men who are truthful." (Proverbs 12:22)

    "Misfortune pursues the sinner, but prosperity is the reward of the righteous." (Proverbs 13:21)

    "The integrity of the upright guides them, but the unfaithful are destroyed by their own duplicity" (Proverbs 11:3)

    The unfaithful are destroyed by their own duplicity? Oh, how true those words are. For, the whole world is wallowing in crisis because of the duplicity of people who lied on mortgage applications, because of the duplicity of mortgages brokers who encouraged people to lie on those applications, because of the duplicity of Rating Agencies who gave "liar loans" a Triple-A rating. Yes, "duplicity" is at the heart of the economic melt-down of the whole world. We, as a civilization, have been destroyed by our own duplicity, by our own lying.

  • Report this Comment On November 24, 2008, at 2:54 PM, newbear100 wrote:

    Oct 20 issue of Investors Business Daily has an excellent and detailed article on the genesis of this crisis dating back to the 1977 Community Reinvestment Act, the rise of ACORN and other blackmailers of banks and yes, our indifference to social engineering attempts by the congressional Democrats. Their quoted statements in this article prove that these people were not only inept, but peddled premeditated deceptions to keep both Fannie Mae and Freddie Mac as a hostage to their party. A required reading !!!

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