March 27, 2012
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This essay is excerpted from a recent version of The Credit Strategist (formerly the HCM Market Letter). To obtain the complete issue, you must subscribe directly to this publication; Please go here. The Credit Strategist is on Twitter - @credstrategist
“Watch your thoughts, for they become words. Watch your words, for they become actions. Watch your actions, for they become… habits. Watch your habits, for they become your character. And watch your character, for it becomes your destiny! What we think we become.”
Margaret Thatcher (from her father)
“Character is what we a person does when nobody is looking.”
There was a recent essay in Forbes by Jerry Bowyer entitled “Systemic Risk Is About Character” (February 27, 2011, p. 30) that made some valuable points about the responsibilities every participant in the financial system should be thinking about as he or she conducts his or her business. Financial risk,
Mr. Bowyer argues, is created by the values that drive human behavior, not by exogenous events. Human beings, companies, and societies as a whole are responsible for creating risk through their own conduct: “[r]isk is not event-driven; risk is character driven.”
The issue of character colors everything. It is at the center of the presidential election that is unfolding in front of our horrified eyes as candidates alternately bore and appall us by either repeating or changing their positions. Character is what is missing from the halls of Congress, where the Senate has failed to pass a budget in more than 1,000 days and legislation is held captive by special interests that barely even pretend anymore to place principle above their selfish interests.
On Wall Street, a lack of character allowed the business practices that led to the 2008 financial crisis to flourish without being questioned. And it is a lack of courage to speak the truth to power that leaves the system vulnerable to the risks still posed by leverage, derivatives, rehypothecation and other obviously dangerous practices. Finally, to address a topic receiving more attention that it deserves because it should have been fixed a long time ago, the debate over the carried interest tax speaks to a lack of character among our business and political leaders. Why is it only now that so many are unwilling to say to the Steven Schwarzmans of the world that their work is unworthy of a special tax break, that they insult our intelligence by marching up to Capitol Hill claiming they will stop taking risks if they have to pay the same tax rate as school teachers on the fruits of their labor when they have not been taking any meaningful risks at all?
As a long-time investor in leveraged companies, the character of management has long informed my decisions of where to direct capital. There is no margin of safety when you invest in a company managed by dishonest or reckless managers, or a management team that has a history of placing its own interests before those of its shareholders or creditors. The same is true of choosing an investment manager. Personal integrity is without question the most important quality required of an investment manager; if you invest with a man or woman of low character, you are placing your capital at great risk. The way an investment manager manages his own affairs and those of his firm and how he treats his employees and his family is the best indication of how he is going to handle your money. That is why it is important that people get to know – really know – their managers before they hire them. Character is more valuable than intelligence in choosing someone to shepherd your capital.
Too much complacency?
I rarely publish mid-month issues unless the financial markets are in the midst of crisis, and markets are decidedly not in crisis today. But like many diseases that silently attack the human bodily and only kill it years later, there are a number of forces eating away at the U.S. and global economy that threaten capital. The primary force is the incessant money creation that has become virtually the sole raison d’etre of central bankers around the world. To the extent these public servants are exercising the creative sides of their brains, they are doing so only to develop new ways of injecting liquidity into the global financial system.
The world’s four largest central banks – the Federal Reserve, European Central Bank (ECB), Bank of England and Bank of Japan - have stretched their balance sheets from $3.65 trillion at the time Lehman Brothers failed to over $9 trillion today (add in the central banks of China and Switzerland and the total rose from $7.23 trillion to $13.2 trillion over that period). By the time the current easing cycle is finished, it would be reasonable to expect total assets on the big four balance sheets to exceed $12 trillion without a commensurate increase in economic growth in the underlying economies. The total debt of Europe’s central banks (the ECB plus the national central banks) is now $5.7 trillion, with the ECB’s composite balance sheet doubling in size over the past six months. That is some serious monetary tumescence.
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