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July 16, 2024 - 10:00am
The economist Hyman Minsky’s name can once more be heard in ominous whispers around Wall Street. Private equity firms have recently been undertaking such funny financial manoeuvres that those who invest in the funds have had to put a stop to it. With private equity markets depressed, fund managers have been taking on so-called net asset value (NAV) loans to pay their investors’ dividends. Far from being happy to get their money, investors realised that the funds they had invested in were borrowing from Peter to pay Paul, and told them to cut it out.
In his stellar 1992 paper “The Financial Instability Hypothesis”, Minsky argued that there were three types of borrowing which corporate entities engaged in. He called these: hedge, speculative, and Ponzi. Hedge financing involves loans which are taken on, typically for business operations, and can then be paid back using a company’s cash flows. Speculative financing describes loans usually taken on to invest in the company, which can then ideally be paid off by the future cash flows generated by the new investment. Meanwhile, Ponzi financing refers to loans taken out by desperate companies which use them to simply pay interest on previous loans.
Minsky argued that when Ponzi financing units became predominant in an economy — or in part of the economy — this indicated that a financial crisis was brewing. The clue is in the name: a Ponzi scheme is upheld only through finding more and more people to pay up in the promise of money that is itself a result of convincing more and more people to pay up. It is hard not to see in private equity’s use of NAV loans to pay off dividends a classic Ponzi-financing regime.
Private equity’s entire model is based on Minsky’s concept of speculative financing. Fund managers buy up companies and then load them up with debt. This debt is typically used to drastically increase investment in the companies — and in doing so grow them and produce returns for investors. This carries risks. If too many of the investments go bad, the fund might go bankrupt and investors might pull out. There is more than a little speculation that the NAV loans signal that much of the sector has already gone bad and is engaged in increasingly funny tricks to try to cover it up.
If these were simply private investors, the damage would be limited. A few rich people losing money on their speculative investments is nothing to get upset about. But it is by no means clear this is the case. Private equity has become an asset class, meaning that those working in asset management — the more conservative side of the investment industry that typically manages pension funds and other low-risk investments — have started to allocate capital into this space. This has become notorious in Australia with the rise of the so-called “Supers”, and Britain’s new Labour government is reportedly interested in exploring this as an option.
There are also questions surrounding the links between private equity investing and the property markets. After the 2008 crisis, the central banks and regulators said: “Never again”, and imposed strict regulations on bank lending. When we look at mortgage-lending data, we see that banks are not providing the credit for the current rise in house prices — leading to suggestions that it might be the so-called “shadow-banking” sector of private equity and hedge funds which is driving the market.
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SubscribeWe could really do with some examples here. Specifically, which funds are doing this and what were the failing investments that are driving the demand for new financing?
We do know that certain types of investment have gone badly wrong in recent years, for example the sorts of investment driven by government policy, such as green technology, eg, battery storage, electric cars and wind farms. What all these have in common is that government regulation encouraged the flow of capital into these schemes but was not capable of eradicating the risks, which duly turned up in the form of the pandemic and the Ukraine and Gaza wars. Now the appetite for wind energy investment, which was only ever feasible in a world of negative interest rates, has pretty much vanished, and existing wind energy installations are propped up wholly upon government interference in energy markets: there is no longer any pretence that they are actually competitive in terms of the combined requirement of being both on-demand and affordable.
We had a banking crisis in 2009 that was blamed on the banks themselves but later was revealed to be the consequence of state interference. We had a miniature pensions industry crisis in 2022 that was blamed at the time on the Truss/Kwarteng government but which is now revealed as the Bank of England failing to adjust competently for the effects of government policy upon pension funds in prior years by different governments.
It’s only a guess on my part, but if we are about to enter a third financial crisis, I am willing to bet once the shouting is over, we’ll be able to identify, once again, the fingerprints of the dead hand of the state all over it.
Excuse me?
The banking crisis was very much the consequence of banks doing stupid things. They were, if you recall, offering huge home loans to people with no income or assets with low up-front fees and then vast balloon payments that the borrowers were never going to be able to afford. They were then bundling up those loans into “synthetic assets” which they were using some very iffy maths to present as AAA assets with virtually no risk and then offloading them toute suite to any pension fund dopey enough to buy them. Governments did not force them to do any of these things.
Credit to Goldman Sachs, which was, I think the first major bank to notice that even a very modest decline in the underlying value of property would render the entire asset class essentially worthless. But even they didn’t stop selling that stuff to their own clients until long after they themselves were out.
NB if you want to know which funds, were using the NAV loans described, then the link (to the FT) will tell you – it isn’t paywalled.
No, I will not excuse you, I’m afraid. How could you possibly not ask yourself WHY banks were lending money to people who they knew were poor credit risks? The answer to the question is simple: the US government, from the Clinton era onwards, were mandating credit availability to such people as part of social policy. The banks only agreed to this arrangement on the basis that the government guaranteed any losses arising from the policy, and so this is where Fannie May and Freddie Mac, the NGOs dealing with home loan guarantees, come in. They were the vehicles that underwrote subprime loan asset classes, and they were of course ultimately underpinned by the US taxpayer.
Banks do not lend money to people they think might not repay it, and the only way you can make them do this is to underwrite the banks’ risk. The taxpayer in 2009 was paying the costs of incompetent government policy, not private sector recklessness.
John. Take a breath.
Federal backing for mortgage debt in order to reduce costs goes back to the founding of Fannie Mae and Freddie Mac in the 30s and it didn’t cause a disaster for 70 years because the banks had to hold those loans on their books. Banks didn’t want the loans blowing up even if they were backed by the government – any more than I want my comprehensively insured car stolen.
The 2007 financial crisis wasn’t caused by Fannie Mae and Freddie Mac. It was caused by the process of securitisation. Now, instead of holding the loans on their books, the lenders could originate them by lending to just about anyone who would sign on a line and then securitise even the trashiest of loans into AAA-rated assets before selling them – and all the risk associated with them – to someone else.
It was the ability to turn junk loans into investment grade securities, that caused the bubble. And that was a failure of the rating agencies (not an arm of the Government).
Any sensible government that had been looking at this, would have stopped it immediately, because, even if it hadn’t gone bang, it was still driving up the price of a commodity necessary to life (i.e. housing) and thereby transferring wealth upwards (from poor communties in the Sun Belt, to the shareholders of banks) for no good reason. The increased housing costs faced by households having to take out mortgages at 5, 6 or even 8 times their income vastly outweighed the benefit of the reduced interest rates facilitated by the loan guarantees.
Once again you miss the point: the reason there was no problem for 70 years was that for those 70 years, the government wasn’t interfering in the commercial banking sector by making banks lend to poor credit risks. I have made this quite clear already.
You mention securitisation, by which you mean the use of collateralised debt obligations (CDOs) to package primary debt contracts into tradeable commodities on derivatives markets – yes, this happened, but once again you’re missing the point that this activity had been made into a near-risk-free gamble because of the aforementioned government guarantee on what were in reality high risk loans. Had those CDOs been created on the same loans with no government underwriting, they would have traded as junk assets, and consequently no bubble could have developed on the basis of them.
I see that you’re hammering away at this in response to everyone else here as well: the reason you’re outnumbered in this instance is that everyone else here understands this issue better than you do yourself.
No, the Government bought loans on terms that were asserted, through the achemy of securitisation to be risk free by banks.
The banks made this claim because it had done some sums (incorrectly as it turned out) and then sent those sums to be analysed by ratings agencies (paid by the banks) who failed to find the flaw in the sums.
Once that pathway had been established, the banks then presented this “risk free” mechanism as a public good – an expansion of the guarantees long offered by Fannie and Freddie and lobbied to do more of it.
The more straw was woven into gold in this way, the more money got made and the sketchier the loans inside the securities got.
You can argue that it was error rather than evil but, ask yourself this.
Even before the risks of CDOs were understood, imagine that a third sector outfit working in one of the communities where these loans were being doled out like smarties had published some big flashy report saying that this policy was driving up house prices and indebtedness among poor working people and that the loan guarantees were having perverse effects, what would the banking sector have done?
Would they have said, “fair enough, we’ll go do something else?” or would they have argued that the report was nonsense and that they should have been permitted to carry on doing this stuff? Hint, they made money on it.
You are comically incorrect, John, and George is precisely right. The Great Financial Crisis was a result of deregulation, an act of legislative vandalism capped when Clinton signed the bipartisan Financial Services Modernization Act or GLBA in 1999. It allowed banks, insurance companies and investment houses to merge and thus repealed the Glass-Steagall Act which had been in place since 1932
You are correct. And it was, if I recall, a bunch of policies introduced by one Bill Clinton that were significant enablers of the 2008 financial crisis. Clinton repealed Glass-Steagall which separated commercial from investment banking, signed the Commodity Futures Modernization Act, which exempted credit-default swaps from regulation. Then In 1995 Clinton loosened housing rules by rewriting the Community Reinvestment Act, which put added pressure on banks to lend in low-income neighborhoods. And voila, the perfect cocktail for banking excess was created.
I get bored of people railing against ‘evil banksters’ and decrying the entire FS sector as a bunch of fat cats gloatingly smoking cigars whilst hurling another orphan on to the fire to keep themselves warm. It’s tiresome, ignorant and dull.
Businesses (of whatever hue) follow the rules. The rules are made by governments, governments are comprised of politicians. That is where the buck stops. If you don’t like tax avoidance, then change the rules. If you don’t like lead in petrol then change the rules. If you don’t like reckless lending to those who can’t afford to pay it back then don’t allow it in the first place. The reality is that western governments the world over were happy to collect the taxes from corporate profits, consumer spending, property and economic growth during the boom-boom cheap debt years of 2000-2009, and had no interest in trying to understand the systemic risk their loose fiscal policies had created (let alone do anything about it) until of course it was too late. And whatever myriad failings politicians may have they always manage to retain the core skill of pointing the finger of blame at someone else.
I guess you missed the bit about predatory lending and outright fraudulence in loan applications in the run-up to the Great Financial Crisis by, wait for it, NOT the applicants themselves (many of whom were in any event incapable of cooking up such a scheme) but agents of the gigantic mortgage originators (viz. Countrywide Financial, Ameriquest, New Century et al). These originators sold off these loans to the banks which in turn packaged them into the infamous CDOs and synthetic CDOs.
You can find out more in the work of William K. Black (professor at UMKC), the simplest introduction to which is a 9 part series of interviews which begins here: https://www.youtube.com/watch?v=jFH5-5D5_Lc
I think he’s referring to the American institutions of Freddie Mac and Fannie Mae being directed by federal government to allow more and more mortgages to be approved for low income households to turn them into property owners in order to ‘reduce inequality’.
I know what he’s referring to. I’m saying it’s a stupid perspective.
The banks were doing this at the scale they were, not because they were told to but because they were making money doing it. They were also lobbying governments to allow them to do more of this sub-prime stuff – not only in the mortgage market but also in the form of credit cards and payday lending. They weren’t doing it out of charity, they were doing it because they saw a way to sell a product and then offload the risk. they had captured the rating agencies and they were lobbying the Government to buy more of the dross they were creating.
And they were off-loading it to anyone they could, pension funds, Fannie and Freddie and, despite all of that, all the banks were still holding so many securities when the bomb finally exploded that almost all of the investment banks in America (and the UK) would have gone bankrupt but for Government intervention.
I’m not saying that the Government covered itself in glory – it didn’t. I’m saying that blame lies with crooks not with their victims nor the cops – however corrupt or bumbling they might be.
But banks make money by loaning it. That’s their business model. When the government promises them they won’t lose money in these particular transactions, you and I are on the hook. That’s the fault of government, not the banks.
No it isn’t. When a company sells a product, be it a securitised loan or a car, the primary responsibility for ensuring that the product isn’t an effing time bomb, lies with the vendor – the bank.
If VW sold a car that caught fire on the regular, the owners of those cars would sue VW, not the FIA or EuroNCAP.
That is what I recall during speeches given by Clinton. It all made perfect sense since the taxpayer was on the hook for it when the balloon popped. I had friends in the banking industry at the time who were shaking their heads while giving loans to people without any verification of income. They were told to do it.
Yes and when regulators required banks to run their regulatory capital calculations on these ‘assets’ that they had on their books the calculations were all for the most part wrong because all of the metrics for PoL, PoLGD, PoTL had all been derived from historic pools of home loans made back in the day when banks were imposing rigorous credit risk lending processes. Another thing regulators (and a lot of banks) failed to clock.
That’s correct.
But that is basically the same flawed thinking that the banks themselves were using to argue that their CDOs were safe investments. Piles and piles of compex calculations but all of them ultimately based on the flawed assumption that the US housing market would never, could never, fall in value for any length of time at the aggregate (National) level.
Now, that was true(ish) when they started the process. But then they used that historic assumption as justification to change the circumstances of the market. The false security offered by that historic assumption lead banks pile vast amounts of hot money into rubbish property in ways they never would have before. That influx of money was the factor that caused a hitherto unrecedented spike in value leading to precisely the sort of crash that the initial assumptions had said would not happen (because the assumption itself had changed the conditions).
So, sure, the regulators were using outdated metrics. But so were the banks.
The epicentre of sub-prime was the USA, and the driving force was Fanny Mae and Freddy Mac. These were and are government sponsored enterprises. Their charters were amended by the government to give them “an affirmative obligation to facilitate the financing of affordable housing for low- and moderate-income families”.
Mae and Mac buy home loans in the secondary mortgage market, creating a liquid market for home loans of all types of quality. Mae and Mac were the market makers for ever more sub-prime mortgage backed securities as per their charters. It was Mae and Mac that went bust first, it was Mae and Mac that got the largest bailout, and it was Mae and Mac that were government sponsored enterprises acting on government charters that made the market for sub-prime possible.
Fannie and Freddie were the marks. They were not the originators of the con.
Blaming F&F for the financial crisis is like blaming little old ladies for on-line fraud.
Wrong. Fanny Mae and Freddy Mac operated without any of the sort of problem you claim from their founding in 1938 (you might learn something from WHY they were founded, but that’s a separate issue) up until Clinton wrecked the regulatory environment which had made them so successful when he signed the bipartisan Financial Services Modernization Act or GLBA in 1999. It allowed banks, insurance companies and investment houses to merge and thus repealed the Glass-Steagall Act which had been in place since 1932.
Goldman Sachs noticed the problem after about 100 other investors and hedge funds did.
Hence my qualifier “major bank”. My point was that, even after they realised that this was an unexploded bomb, they continued to act in bad faith by selling and facilitating the product to others.
Presumably if the author named specific firms as the examples you’d like, they’d sue him.
The firms are named in the FT piece to which he links
Of course you will — because you are an ideologue who has already concluded that all financial crises arise from state intervention.
Too bad you have chosen a mental map utterly divorced from empirical reality.
It is a shame Minsky used the term speculative investment to describe investing in a company in the hope of creating something new and more valuable in the future. In ordinary English though, simply buying something and hoping it goes up in value is also called speculation. I think we can all appreciate the difference yet both types of investment are categorised as speculative investment. Without an agreed term for these two very different types of speculative investments, we end up grouping a type of speculative investment that is self-sustaining with one that on the scale of an economy looks more like a Ponzi scheme.
So, we have a type of speculative investment that involves loans used to buy a company, then said loans are loaded onto the company, with no actual new investment in any part of the business operations nor is there a meaningful plan to break up the company to release value. This special category of speculative investment is often driven by ego (person X simply wanting to own company Y) or anti-competition (buying a potential competitor) but since QE2 an ever increasing number are driven by the hope that in a rising stock market a company’s value will go up without actually doing anything. Is this in fact a carefully disguised a Ponzi scheme bankrolled by governments and central banks?
Our two decades of real economy slow growth and near stagnation in a financialised world of ever greater speculative investment would appear to be a quandary. Yet if we separate out speculative investment actively intending to yield value from passive speculative investment intended to capture value from a rising asset market, we see a very large proportion of recent speculative investment has been of the passive type. Thames Water in the UK is a classic example: loaded up with debt by multiple owners cashing in and selling it on, meanwhile the real investment in the business and its structure is entirely regulated and unchanged by any of the series of speculative investments made. Ultimately, the victim company is bloated by debt to pay off the previous owners. Rinse and repeat. Except until debt markets tighten and no new debt can be raised for new buyers to buy (sell) it again. And that’s where Thames Water is, and we are today. Was this a Ponzi scheme disguised as speculative investment?
I think the problem is also that, at some point, such a large part of the economy is speculative that we cannot see the differences anymore between opportunities and complete scams. Nor do financial behemoths really care at some point. If liquidity is so high that investors hardly know what to do with it, you get companies that are primarily interested in generating hype and PR, not profit. Investors just care about maintaining or increasing their piece of the pie. Never mind the real economy, that’s not where the money is anymore. Invest where others invest before it is too late. You saw this with the fake blood testing company Theranos and some of the crypto scams. Experienced investors seemingly have no idea where they actually put their money, only the hype really matters. Or capitalism itself has simply morphed into something different in the digital age and we need completely new paradigms to understand it.
Absolutely.
PS: Lets imagine the stock value as a function f(x, y, z) dependent on economic value/potential x, hype y and another part z that might represent macroeconomic conditions (e.g. recession). Then for many stocks nowadays would hold f(x,y,z) = f(y,z) or even f(x,y,z) = f(y) such as GameStop, NVIDIA and many more. We arrive at total irrational market. Its amusing to know there are quants with PhDs developing quantitative models based on rational assumptions that are underperforming monkeys.
Surely the headline question is redundant. The whole international financial system is one huge Ponzi scheme, isn’t it?
Actually the whole of current Western Governments’ social contracts are ponzi schemes. If you imagine that your state pension is or will be paid out of historic NI contributions think again. I think the only European country that can genuinely afford it is Norway, courtesy of 40 years of north sea oil and gas, Norges and a population of about 4m.
If only the UK had access to North Sea oil and gas.
The fiscal position of the UK and Norway were and are completely different. Actually, M Thatcher’s government used North Sea oil proceeds to pay off large amounts of accumulated debt.
It’s never sensible to max out your credit card to have a flutter on the stock exchange (see Labour’s National Wealth Fund for more details).
Mostly right that Private Equity represents a systemic risk through a combination of excessive debt and poor governance; the latter issue is equal to the scale of the first issue.
Wrong in that the 2008 financial crisis was the fault of the banks. The fault in 2008 rests with Government and Central Bank policies that the banks exploited until but asset bubble burst.
And the the Sackler family are just hard-working pharmacists. The real fault lies with the US government for accepting their knowingly fraudulent claim that oxy-contin is a non addictive miracle drug and thereby creating the conditions in which the poor Sacklers would be forced, by the ineluctible logic of shareholder value, to jam as many pills into the American working class as humanly possible.
Ronnie and Reggie Kray were, likewise, upstanding homini economici, tragically doomed to undertake a ruthless programme of racketeering by the Government’s dismal failure to clear up corruption in the Metropolitan police.
You see where this leads don’t you?
The problem with claiming that business will and should do anything that makes it money, even in the face of poor and even perverse regulatory incentives is that it doesn’t make the case you want it to at all.
You seem to want to claim that, because Government is sometimes stupid, it should be abolished, allowing the free market to rip. But you’re actually making the case that the market will do anything it possibly can in order to make money, regardless of the consequences. That isn’t an argument for deregulation at all.
And it’s weird because, whilst I am going out on a bit of a limb here, I have the odd feeling that, in matters of law and order, you and John Riordan above would normally be quite keen on the concept of personal responsibility for your actions.
Yes but banks lobbied for decades to reduce regulation and capital requirements and to allow them to speculate with retail banking money in investment banking.
So banks wanted framework which led to the crisis.
For various reason governments went along with it.
But no one forced banks to pursue crazy schemes. They did it for profits but expected average citizen to bail them out.
Current situation is a result of total lack of punishment for banks reckless behaviour.
I mean prison sentences.
Why would you mend your ways if you got away with it last time?
There are gangsters and there are banksters.
Not that different from each other.
Not sure if I agree that the additional borrowing against the funds is a warning sign of potential collapse. I suspect that it is simply a bridge to a lower interest rate environment when portco monetization will be far easier.
An interesting heterodox economist strongly influenced by Minsky is Steve Keen. He predicted 2008 and claims that much of mainstream (neoclassical) economics is fundamentally nonsense. Mainstream economists are obsessed with public debt, while – as Minsky claims – economic crises are actually caused by private debt. Moreover, Keen claims that mainstream economists fail to understand how the accounting of money creation actually works or even completely deny that it matters.
If I understand correctly, Minsky doesn’t just separate between the three types of borrowing but also argues that one leads to the other without proper regulation. The 2008 GFC started with subprime mortgages but showed that speculative- and Ponzi borrowing was endemic. I would argue that they didn’t really solve much, they basically reinflated the bubble by buying a huge amount of bonds and securities (QE). Bailouts may have been inevitable but the extreme asset inflation caused by the excess liquidity and cheap credit should have been limited somehow. Or the real economy should have also been stimulated but it was’t. All that free money mostly just accumulated in assets, which also produced more inequality. This is most obvious in the housing market. Basically FIAT currencies have, more or less, already collapsed compared to assets.
If they keep maintaining this passive Ponzi economy and continue to do bailouts and QE, it doesn’t make sense anymore to operate in the real economy, i.e. work and save money. In that case one should do what the rent seeking oligarchs have been doing: borrow and buy assets. Enjoy the free central bank money.
“Basically FIAT currencies have, more or less, already collapsed compared to assets.”
Correct. And if you wish to understand by how much then replot the price of gold over the last 20 years on an index basis keeping gold fixed at a value of 100 and varying the respective fiat currencies relative to it. This will show you the extent of confidence (or lack of it) in the fiat currency. It is also the best way to understand how and why the gold price moves.
Again Santiago, I think that is true but it conceals a larger truth.
The point of exiting the gold standard and moving to a fiat currency is precisely to allow the creation of more money, with which to foster more economic activity. If the intention of moving to fiat currency is to make money less scarce – whilst the quantity of gold available remains more or less fixed then the value of gold relative to fiat currency will inveitably rise. Your observation is therefore not only true but true almost by definition.
In short:
Money is, among other things, a store of value and seen in that way, money linked to a scarce commodity will have more scarcity value than money we can create out of thin air.
But, as I say, that obscures a larger truth about the other things that money is and what it is for.
Money is also a medium of exchange and a way to spur economic activity. The more money we can loan (on sensible terms) the more economic activity we can undertake and (in theory at least) the better life gets – because the ultimate economic value is not gold but human flourishing.It would be insane to pass up on to opportunity to do valuable work because of a scarcity of a precious metal whose abundance has no direct correlation with human flourishing or the opportunities to achieve it.
That’s not to say that gold and other precious metals aren’t a useful corrective to the risks of a fiat money system (i.e. too much money getting loaned, and the value of money inflating away faster than the growth in productivity it faciliatates) but the point you are making is about an investment strategy – it has nothing to do with whether fiat money is a better or worse choice at the aggregate level of the economy of real goods and services.
An excellent analysis of how financial crises are rooted in private rather than public debt levels is Richard Vague’s “A Brief History of Doom: Two Hundred Years of Financial Crises”
https://www.pennpress.org/9780812251777/a-brief-history-of-doom/
Private Equity has become a cancer on the economy. It is destructive in the way it mines value for outsized short term gains at the cost of the future and societal well being.
That aside, I think we have an even bigger problem in finance and business.
That is that you can have growth forever, that it is possible for a company to beat last years earnings or last quarters earnings forever. The driver of course being to push stock values up forever.
But, we live in a finite world with a global population that is due to start declining but already getting grayer. With ever increasing amounts of automation we have fewer good paying jobs to support consumerism.
We may well be reaching a point where outsized returns from value extraction or climbing stock values are no longer possible and we may have to start looking at mature businesses as a source of dividend income with boring stock values.
Sure, there will always be the “next thing” or the “next company” that will send some stocks up huge multiples in short periods of time, but we may well be at a point where investors need to look at most companies as a steady stream of dividend payments going forward.
Sensible investors already know boring stocks with steady yields produce a better and more reliable return than speculative volatile stocks. Of course a few speculators are clever or lucky enough to ride the ramp stocks up and get off at the right time but for most investors boring is best.