Ted Forstmann: the credit crisis will get worse
In the Wall Street Journal today, Ted Forstmann, of LBO giant Forstmann and Little fame, has warned that the credit crisis is far from over. Forstmann, who presciently called the bubble in High Yield ad LBO financing twenty years ago, is a voice of great repute, because of his familiarity with high leverage debt financing and its benefits and perils.
His perspective paints a very dire picture of a financial system so highly leveraged that it is on the verge of a collapse akin to the Great Depression.
“We are in a credit crisis the likes of which I’ve never seen in my lifetime,” Mr. Forstmann warns. He adds: “The credit problems in this country are considerably worse than people have said or know. I didn’t even know subprime mortgages existed and I was worried about the credit crisis.”
His comments give credence to the belief that the Fed’s easy money policy is at the heart of the credit problems we are now experiencing. Money was so cheap and plentiful that financiers did not have sufficient opportunities to invest it appropriately and sought ever more risk at ever lower return.
Mr. Forstmann’s argument about the present crisis starts with the money supply. After Sept. 11, 2001, the Federal Reserve pumped so much money into the financial system that it distorted the incentives and the decision making of everyone in finance. He illustrates this with what he calls his “little children’s story”: Once upon a time, when credit conditions and the costs of borrowing money were normal, the bank opened at 9:00 a.m. and closed at 5:00 p.m. For eight hours a day, bankers made loans and took deposits, and then they went home.
But after 9/11, the Fed opened the spigot. Short-term interest rates went to zero in real terms and then into negative territory. When real interest rates are negative, borrowing money is effectively free – the debt loses value faster than the interest adds up. This led to a series of distortions in the financial sector that are only now coming to light. The children’s story continues: “Now they [the banks] have all this excess money. And they open at nine, and from nine to noon or so, they’re doing all the same kind of basically legitimate things with it that they did before.”
So far, so good. “But at noon, they have tons of money left. They have all this supply, and the, what I would call ‘legitimate’ demand – it’s probably not a good word – but where risk and reward are still in balance, has been satisfied. But they’re still open until five. And around 3:30 in the afternoon they get to such things as subprime mortgages, OK? And what you guys haven’t seen yet is what happened between noon and 3:30.”
Straightforward economics tells us that when you print too much money, it loses value and prices go up. That’s been happening too. But Mr. Forstmann is most concerned with a different, more subtle effect of the oversupply of money. When it becomes too plentiful, bankers and other financial intermediaries end up taking on more and more risk for less return.
The incentive to be conservative under normal credit conditions is driven in part by what economists call opportunity cost – if you put money to use in one place, it leaves you with less money to invest or lend in another place. So you pick your spots carefully. But if you’ve got too much money, and that money is declining in value faster than you can earn interest on it, your incentives change. “Something that’s free isn’t worth much,” as Mr. Forstmann puts it. So the normal rules of caution get attenuated.
“They could not find enough appropriate uses for the money,” Mr. Forstmann says. “That’s why my little bank story for the kids is a fun way to put it. The money just kept coming and coming and coming and coming. What are you going to do with it? IBM only needs so much. The guy who can really pay his mortgage only needs so much.” So you start thinking about new ways to lend the money, which inevitably means riskier ways.
“I don’t know when money was ever this inexpensive in the history of this country. But not in modern times, that’s for sure.”
Combine this with loan syndication and securitization, and the result is a nasty brew. Securitization and syndication allow the banks to take the loans off their books and replenish their capital. They then use this capital to make new loans, which they securitize or syndicate and sell to the hedge funds, which buy them with the money they borrowed from the banks. For a time, everyone makes money.
But, it’s a game of musical chairs where everyone is dancing and making money and suddenly all the chairs are pulled out at once. In my view, this ending was always a foregone conclusion. As the debt bubble got bigger and bigger, I hoped the monetary authorities and regulators would come to their senses. They did not. They only added fuel to the fire by providing free money.
However, Forstmann doesn’t blame Alan Greenspan. He says this:
“In order to fix what’s going on in the United States there’s going to have to be a certain amount of pain. The market’s going to have to clear somehow. . . and it’s hard for me to believe that it gets fixed without” upheaval in the financial system, the economy and the country as a whole. “Things are going to fail. Enterprises are going to fail. The economy is going to slow,” he warns.
To be clear, although Mr. Forstmann talks about “fear and greed” getting out of whack, his is not a condemnation of “greedy speculators” or a “culture of greed” or any of the lamentations so popular among the populists in Washington. It is a diagnosis of the ways in which the financial sector responded to a government policy of printing money that was free, or nearly so. “The creation of much too much money caused all of this excess,” he says. In other words, his is not an argument for draconian regulation, but for sound money.
Nor does he blame Alan Greenspan, even though he argues that this all started with the dot-com bubble and 9/11. “Greenspan,” he allows, “had really tough decisions to make, so I don’t think it’s a black-and-white kind of thing at all.” It was, and is, rather, “a case of first impression.” Mr. Greenspan, he says, admits that he was “totally sure” that what he was doing was right. But he had “no idea what the consequences [were] going to be.”
According to Mr. Forstmann, we are now living with those consequences. And the correction has only begun.
Consequences, indeed. Let’s hope for a short, sharp shock so we can move on with our lives. What we should fear is politicians mucking about and central banks offering free money. That’s what got us into this predicament.
The Credit Crisis Is Going to Get Worse, The Wall Street Journal, 5 Jul 2008