Thursday, February 2, 2012

Mitt Romney and the Greenspan Put

The 1980's economic backdrop was perfect for LBO's.
A high but declining interest rate allowed financial operators the maximum advantage when exploiting the differential tax treatment of debt and equity. Throw in the cash-flow multiple contraction from the discounting formulae and there you go.

So the market responded.
From Macroeconomic Resilience:
Private Equity and the Greenspan Put
Mitt Romney’s campaign for the Republican nomination for the US Presidential election has triggered a debate as to the role of private equity (PE) in the economy. The critical of the private equity industry tend to focus on their perceived tendency to layoff employees and increase leverage. Regarding layoffs, there is very little evidence that PE firms are worse than the rest of the corporate sector. However, this does not imply that their role is entirely positive. But it does imply that the excesses of PE mirror the excesses of the larger economy during the neoliberal era. This is obvious when the role of leverage is examined. As Mike Konczal notes, “something did change during the 1980s, and LBO was part of this overall shift.” The road that started with LBOs in the 1980s ended with the rash of dividend recapitalisations between 2003–2007, a phenomenon that has even resurfaced post the crisis.

It is easy to find proximate causes for this dynamic and commentators on both sides of the political spectrum attribute much of the above to the neo-liberal revolution – the doctrine of shareholder value maximisation, high-powered managerial incentives, a drive towards increased efficiency etc. The acceleration of this process in the last decade usually gets explained away as the inevitable consequence of a financial bubble with irrationally exuberant banks making unwise loans to fuel the leverage binge. But these narratives miss the obvious elephant in the room – the role of monetary policy and in particular the dominant monetary policy doctrine underpinning the ‘Great Moderation’ which focused on shoring up financial asset prices as the primary channel of monetary stimulus, otherwise known as the ‘Greenspan Put’. All the above proximate causes were the direct and inevitable result of economic actors seeking to align themselves to the central banks’ focus on asset price stabilisation.
As I elaborated upon in an earlier post:
creating any source of stability in a capitalist economy incentivises economic agents to realign themselves to exploit that source of security and thereby reduce risk. Similar to how banks’ adaptation to the intervention strategies preferred by central banks by taking on more “macro” risks, macro-stabilisation incentivises real economy firms to shed idiosyncratic micro-risks and take on financial risks instead. Suppressing nominal volatility encourages economic agents to shed real risks and take on nominal risks. In the presence of the Greenspan/Bernanke put, a strategy focused on “macro” asset price risks and leverage outcompetes strategies focused on “risky” innovation. Just as banks that exploit the guarantees offered by central banks outcompete those that don’t, real economy firms that realign themselves to become more bank-like outcompete those that choose not to…….When central bankers are focused on preventing significant pullbacks in equity prices (the Greenspan/Bernanke put), then real-economy firms are incentivised to take on more systematic risk and reduce their idiosyncratic risk exposure.
The focus on cost reduction and layoffs is also a result of this increased market-sensitivity combined with the macro-stabilisation commitment encourages low-risk process innovation and discourages uncertain and exploratory product innovation. The excesses of some forms of private equity are often instances in which they apply the maximum possible leverage to extract the rents available via the Greenspan Put. Dividend recaps are one such instance.
James Kwak summarises the case of Simmons Bedding Company:
In 2003, for example, THL bought Simmons (the mattress company) for $327 million in cash and $745 million in debt. In 2004, Simmons (now run by THL) issued more debt and paid a $137 million dividend to THL; in 2007, it issued yet more debt and paid a $238 million dividend to THL. Simmons filed for bankruptcy in 2009.
The obvious question here is why banks and financial institutions would lend so much money and allow firms to lever up so dramatically. Kwak lays the blame on the financial bubble, principal-agent problems, bankers bonus structures etc....MORE