Someone Else's Money

Will Page:  Welcome to Bubble Trouble, conversations between the economist and author Will Page, that's me, and the independent analyst, Richard Kramer, that lay out some inconvenient truths about how financial markets really work. Today, the good and bad of someone else's money. More in a moment.

 Welcome along to Bubble Trouble. Last week's trouble forms this week's bubble. And in this week, the fifth week of Bubble Trouble, we're gonna wrap up on our foundational building blocks to help you spot next week's trouble.

 Let's recap on the story so far. In the first episode, we discussed Sycophants and Stenographers. You know those folks. The ones that are paid to praise as opposed to appraise. In the second week, we discussed the trends that are often presented by companies that are going public. Trends that appear too smooth to be true. And we uncovered why nothing can be that smooth in the first place. In the third week, we looked at the concept of the total addressable market and how these are often conflated with themes and dreams which rarely become reality. In the fourth episode we discussed the attention, the scarcity of attention, the fact there's only 24 hours in a day despite that when you add up all the hours you claim to spend in media, you end up with a figure far bigger than that.

 And in this fifth and final episode of the foundational building blocks of Bubble Trouble, we're gonna discuss the most important subject of them all: money. More importantly, someone else's money.

 Let's get to the basics. Where does money even come from? Well, I don't think that in today's economics, the way it's taught, the way it's applied, people actually know the answer. Very few economists hear of the words fractional reserve lending, where a bank can own one dollar yet lend out 10. Or even the actual process of auctioning money from the central into the money markets. This is often glazed over in today's curriculum. So we are in an interesting situation where the majority of the economists pouring out of the universities around the world today don't know where money has come from. They're just taking it for granted.

 Not only that, but I think there's a behavioral aspect to money that we're missing here in terms of who thinks they get what share of it. Who gets what share of the spoils of cash, Richard?

Richard Kramer:  I think the sheer notion of money has become mesmerizing, uh, much like the stock market. Because everyone thinks they can make money from being smart and, indeed, smarter than the next person. And if you go back to all of the behavioral economics and the work of Daniel Kahneman and Amos Tversky, it showed us that most people consistently overestimate their smarts in many areas. And I'd say the market in making money is a classic example of a place where people overestimate their own abilities. And it has that mesmeric power because you always think it's easier to make money than maybe it ends up being.

Will Page:  And of course, if you're taking the title of this week's podcast, Someone Else's Money, you're taking on a debt. And I wanna now move into understanding debt as a force for good and a force for bad. Or as a film that we're gonna be talking about later, Barbarians at the Gate, famously said, "Debt can be an asset."

 So when I try to understand debt, I often think of debt in terms of, if you're an individual, or if you're a firm. If, if you owe money as an individual, you pay interest on that debt. And that interest is a cost. And that interest can be a crippling cost. When you own debt as a firm, you will also pay interest on that debt, but that interest can also have a benefit in that you set it off against your taxes, something that you would never expect as an individual. So debt clearly is different depending on who you are.

 Richard, how do we understand when you've got a problem with debt?

Richard Kramer:  Well, there's an old phrase. If you owe someone a million dollars, you have a problem. But if you owe someone $100 million or a billion dollars, they have a problem. They can't simply come by and, and garnish your assets, whatever you've got in your sitting room, kick you out of your house and, and grab everything they can see to pay off those, you know, what are fairly reasonable debts. But the, frankly, very well intentioned aims of allowing people to deduct certain categories of interest from their tax bill, for example, the mortgage on their house, has been spun into a giant industry of private equity and a big part of the investment banking world, which allows people to rack up debts to ensure that they never bleed out money to the government in the form of taxes. Or that they always make sure that they're owing someone else while they're taking their own share.

Will Page:  Let's move from your perfect example there of if you owe hundreds of thousands to the bank or you a owe a hundred million, that could literally be a hundred thousand in interest payments or a hundred thousand in a stock of debt. There's a difference between the two. And I, I wanna spend a minute distinguishing between the stock of debt that you owe and interest payments that recur from that stock of debt.

 If I look at the stock of debt that the British government currently [inaudible] , which is greater than the value of the economy pretty much, around about a third of that is quantitive easing. And that means we owe it to ourselves. Is there an argument there for a debt jubilee where you just cancel out the debt that you owe to yourself and therefore the stock of the debt falls down to more sort of manageable size?

Richard Kramer:  Part of the problem with canceling out debts generally, is that someone's holding them. So if you imagine yourself as the holder of that debt, if you were holding a third of the UK government debt on your own personal account, and the government came along to you and said, "We'd like to cancel this debt. We're not going to pay it back." You'd be pretty upset. And it, it strikes to the heart of the notion of debt that you indeed do take out that loan, you borrow that money, with the intention of handing it back at some point.

 And indeed, in the form of government debt, it's a call option, if you will, or a call on future tax receipts. And that's something that is very difficult to wiggle out of without undermining, whether it's the pension funds, the state pensions funds, or others, that are expecting that money to come back to them so that they can disburse it down the road to people who need it.

Will Page:  You're dancing in between public sector debt and private sector debt here, which is interesting. Does this raise the issue of the moral hazard?

Richard Kramer:  Well, the moral hazard is everywhere. And, look, borrowing and leverage, it was first seen as a bad thing, a thing to be avoided. People would have parties in America when they would burn their mortgage certificates. They would be thrilled when they had escaped these strictures or the monthly requirement of servicing debt. And clearly, when interest rates were high, that was an even bigger issue for people to escape from.

 Then it became something to be manipulated to get the greatest outsize return. And the notion was that if you had a stable recurring cash flow, you could borrow against that and take money out today against the future cash flows you'd expect to see tomorrow or, or a long time in the future. And that moral hazard built up that there was more and more debt added to the piles. And, as we talked about when we spoke about smoothing earlier, that is certainly justified in many cases by questionable metrics.

 So at some point in the last 10 to 20 years, borrowers became comfortable telling the lender that they would have future cash flows when they were built on adjusted EBITDA or other metrics which excluded certain one-off costs. And, if you owed money every month on your mortgage but you had a burst pipe and that took all your cash for the month to repair it, you can't just go to the bank and say, "Well, I'm not gonna pay you this month because I'd like to adjust that cost out of my mortgage payments."

Will Page:  [laughs]

Richard Kramer:  But that is certainly what happens all the time in the financial markets. And it's, to some degree, an extension of the kind of magical thinking we spoke about in previous episodes, that you don't really need to be responsible for those debts if you can push them out far enough into the future or you can dangle the promise that they will be repaid at some point down the road.

Will Page:  Also the discussion of moral hazard reminds me of, perhaps, one of the best jokes I ever told in my failed career as a stand up comedian which is, "A financial journalist asked an investment banker around the time of the credit crisis, 'What do you have to say about the moral hazard?' And the investment banker says, 'I understand what the second word means, but you'd have to explain to me the definition of the first. Morals.'"

 Let's turn now to interest rates. You've mentioned this before. We're now living in a period where, literally, for the past decade, interest rates have been set below the rate of inflation. Which, when I was at university, was taught to you as something that you'd never see. Like a real outlier in economic history. It's now the norm, from the exception to the norm, that interest rates are below the rate of inflation. That raises questions about why that is happening that we might want to touch on. But also, take me through what happens when interest rates are not just super low, but lower for longer. Like how does that change the, the mindset, the psychology of how we treat debt?

Richard Kramer:  There is no doubt that having the persistent low interest rates that we've had now for close on a decade or more has distorted the notion of money. It's left an impression that cash is trash. That-

Will Page:  [laughs]

Richard Kramer:  ... you can leave it in the bank but you're not gonna get a return on it. And, indeed, inflation means that it will dwindle in value as opposed to appreciate. So the old idea that keeping your money under the mattress or in the bank, it was better to keep it in the bank because you get paid a nominal amount to keep it, is now actually a negative given all the fees that you probably have noticed your bank piles onto you for just holding your money there.

 While this unusual period has played out in the markets, it's meant that the calculation of the weighted average cost of capital, what you need to generate as a return to have a positive outcome versus the costs of borrowing and the equity risk premium that you'd have on top of borrowing, because equity is always carrying some levels of risk, has gone down and down to where it's seen as almost, uh, ridiculously low. And that's why we get bubbles. When people don't have a consistent store of value within money, and they're looking around, whether it was for tulips in Holland in the 17th century. Or, more recently, people putting their money in other asset classes they think will have a more durable value as a store of money than the money itself.

 And, you know, that can be real estate or it can be fine wine or art or any other-

Will Page:  NFTs.

Richard Kramer:  ... asset class. NFTs. If you can understand them and you don't mind the fact that they have lost a substantial amount of value recently. People don't appreciate the lack of volatility in money until they start to mess around with some of these other assets classes [laughing] and realize how volatile they can be. And certainly if your bank balance was gonna fluctuate as frequently as bitcoin, you might be less well pleased when you went around every month to pay your mortgage.

Will Page:  I wanna dig back in on that term you gave me there, cash is trash. I, I like that. And I mentioned that interest rates being below the rate of inflation was considered the exception when I studied economics, now it's the norm for everybody who has witnessed money in the past 10 years. But interest rates are still positive in this country. They're still positive in America. But we are seeing, in countries like Sweden, negative interest rates. Can I just ask you to- do you see that being the new norm, where banks are literally penalizing you for holding the cash is trash in their deposits?

Richard Kramer:  It's become the norm now. But no one believes that's sustainable. Why would one lend money to a government, i.e. buy government debt, if you know that you're going to lose money on it by making that trade? And if you're looking for one reason why we've experienced these bubbles a- a- a- across the market right now, it's because people are in a desperate search for other asset classes that may be a durable store of value other than cash. Because leaving it in the bank means it's going to bleed away slowly and I'm not getting anything for it. I'm not getting the interest that I would've expected.

 If you read someone like Thomas Piketty, he will argue it's the worst of all cases when it's in the bank because it's not circulating in the system. So all that money trapped in the bank is not sloshing around, being invested by somebody, generating returns for that person and circulating to other people in the economy.

Will Page:  And potentially driving up even more bubbles, unnecessary bubbles, which lead on to even more trouble.

 Before we go to the break, I know that in the second part of this podcast we're gonna discuss a movie and a book that's now over three decades old, Barbarians at the Gate. Hilarious movie. One of the best economic lectures I could recommend anyone. You'll laugh all the way through it as well as learning so much. It's an asset which hasn't depreciated over time, which is ironic given its subject matter. Just tee us up in terms of this term Barbarians at the Gate, the private equity demons, desperate to extract debt and create value by loading and saddling companies up with debt. Why i- if that book is 30 years old, why is there so many more barbarians at the gate today?

Richard Kramer:  Well, it's a very simple sort of progression from Barbarians at the Gate, which was the buy out firm of, of KKR going after RJR Nabisco, if I recall. It's the notion that you can borrow many times in excess of the future cash flows of a company with the notion that you're going to apply some magic, in many cases slashing the company's costs, reducing its future value in some cases, and increase those cash flows such that you'll be able to service the debt and, always in the market, find the greater fool that you're going to sell it on to.

Will Page:  [laughs]

Richard Kramer:  Because none of these leverage buy out cases work. None of these asset ownership cases work on the premise that the owner is really going to be a long term owner.

Will Page:  Well as one colleague of mine once said to me, "Everybody needs a sucker." And in part two, we'll be making sure you're not that sucker as we go through some smoke signals and undercurrents to avoid in the future. For Richard Kramer, I'm Will Page, and you're with Bubble Trouble. Back with you in a moment.

 Back with part two of the fifth episode of Bubble Trouble. And we mentioned just before the break there a book and a movie that's now 30 plus years old called Barbarians at the Gate. And I, I posed to you, Richard, the question of why this book was a warning sign or a smoke signal, as we like to discuss in this podcast, for so many of us 30 plus years ago. Why are there so many more barbarians at the gate today?

Richard Kramer:  For every seller there needs to be a buyer. And this is where incentives come in. And we talked extensively in the Themes and Dreams episode of the podcast, about how you always wanna dangle the amazing prospect of growth in front of someone when you're trying to convince them to participate in an investment. Now, for a large portion of the markets, they never intend to be owners. They're just renters. And that can go from the high frequency trading funds that own a [crosstalk] stock for a fraction of a second to the momentum traders who see a stock rising and they wanna own it for a day. Or all the market neutral funds which are trying to pair off stocks in similar sectors and say, "This one is going to do better than the next one for just this day or this week or this month."

Will Page:  Nothing to do with funding a successful business, right?

Richard Kramer:  No. And indeed, a lot of the people who are trying to fund successful businesses in the venture capitalist world will say, "We're going to back 40 or 100 businesses. We have no idea which one will become the next Facebook. We're just hoping one of them will. And frankly, we're planning for 50 or 60% of them to completely go bust. So we're planning to lose the majority of our money on a large portion of our bets. But we think out of these hundred diamonds, one will turn out to be a true diamond and not just cubic zirconium."

Will Page:  [laughs] Okay. So let's turn to some smoke signals here. I wanna do some arithmetic here and just recap on how I was taught that private equity worked. And there's a great example of putting debt into action. Which is you have a house which is a hundred. And you wanna acquire that house for that hundred. And the way that you acquire it is to take on 99 debt and one equity. And as long as the rental income of owning the house covers the cost of financing the debt, you can sell that house for 101 and double your money. Correct?

Richard Kramer:  It's not quite that simple because, as you will know, as a good economist, there are loads of transaction costs. So why don't you factor in what the current stamp duty is for buying and selling a house in the UK. What is that, Will?

Will Page:  Uh, around about three, four percent of the transaction fee?

Richard Kramer:  No. It's, uh, right now it's 10 or 12 for non-doms.

Will Page:  Okay. So I haven't bought a house in a long time.

Richard Kramer:  Right. So, uh, you know, there are also going to be all sorts of one-off, upfront costs that the bank is going to take for managing that transaction for you. And you have to find a willing buyer.

Will Page:  Agreed. But if you do sell the house for 101 or 102, you can effectively double your money. But is there a way in that simple arithmetic example that debt itself can become an asset? You talked about how you can rip out costs earlier. Can we run that example with the sort of carpet bagging model?

Richard Kramer:  Yeah. So what I think you'd see time and again in the markets is you buy the house. Let's say 50/50 equity/debt. And you say to 10 other potential house sellers, "Guess what? I own half of this wonderful property that's worth a million dollars. I'm gonna borrow against that to buy your property. And maybe I borrow against that single asset multiple times. Maybe I borrow against that single asset once and then turn the new asset that I just bought into another form of equity that I can borrow against." And that's how you build Ponzi schemes or build mountains of debt. And that's why when an empire of any real estate tycoon starts to unravel, or as we're seeing right now in the UK with Greensill Capital and Gupta Enterprises, when you pull on that one thread that says what's the underlying value of the asset, you realize that there was a mountain of debt built on top of it, all pledged from a small core of assets.

Will Page:  And that leads to contagion, right? That's when you have the domino theory. If Greensill goes, who's next to go? And then things can tumble down very, very quickly.

 All right. Let's to move to our, our, our three kind of hand holding moments for our, our listeners here, our smoke signals and our under currents that we always like to deal with in the second half of the show. It sounds to me like the first smoke signal, taking a leaf out of the book of Barbarians at the Gate, is just to be wary of loading companies up with debt for a short term gain.

Richard Kramer:  Yeah. Look. For me, the first big smoke signal is the combination of leverage or debt with uncertain cash flows. Hey, if you're an electric utility, you roughly know how many customers you have in a given area and how much their likely electrical use is, or water use, or gas use or what have you. But a lot of companies are loaded up with debt but have not very certain cash flows, or their cash flows depend on some speculative event in the future.

 And the risky thing is that just like equity investors are prone to bubbles, debt investors are always looking for higher and higher yields. And they're looking for riskier and riskier investments because you can command a higher premium to invest in risky assets. And the nature of debt should mean that you'll be able to pay back regularly, but you get paid more if that regular payment is not so certain.

Will Page:  Our second smoke signal, um, I know we wanna go into this in a future episode, but I gotta throw this weird acronym at you. SPACs. Richard, when we see the hyper [inaudible] SPACs just now, it just feels like the script for Bubble Trouble's being written in the Financial Times at the moment. Give me the high level overview of why SPACs matter in the context of a podcast called Someone Else's Money. Take it away.

Richard Kramer:  Well, SPACs are special-purpose acquisition companies. And typically, they would've been formed up when an investor or a group of investors was looking to acquire an asset. Now, in this speculative world where there's way too much money sloshing around and, as we know from the interest rates from governments, money is effectively free, well, lots of people have decided, why don't I raise a fund? And the best definition I've heard of SPACs is give me money for an idea I haven't had yet.

Will Page:  Or as I like to call that, a premature baby without a business plan.

Richard Kramer:  Yes. And I might have that idea. And guess what? Based on my track record as an entertained, as a business person or as a financier, if you give me your money, I hope to make some for me and maybe also for you.

Will Page:  So we have that queue that we talked about about who re- reaps rewards of debt. You know, where are you in the pecking order of getting your money back?

Richard Kramer:  Absolutely. And the, the second point about SPACs is, typically, you don't give someone your money and say, "Yeah, go ahead and invest it at some point in the future." SPACs typically have two years to do this. The clock is ticking. And that's a really bad incentive. When you really have to spend your money quickly, you tend to make bad decisions, especially when there's a limited number of targets out there to spend your money on and you know you have to do it in a limited period of time.

Will Page:  Especially if you find yourself in that limited period of time having to acquire growth. I mean, if you had to buy another company to grow, who on earth would sell to a SPAC? Just name your price. The, the seller is a price maker not the price taker in this situation. So it's gonna be very hard to acquire growth if you can't produce it organically within, like you say, a very short time period.

Richard Kramer:  Yeah. And what makes this even more toxic at the moment is this Hunger Game scenario where you have thousands of SPACs all desperate to make acquisitions. And that means the seller is running your favorite example from a previous episode, the Keynesian Beauty Parade. The seller is able to bring in the SPACs and say, "So which one of you is going to pay me the highest possible price even if I know you're gonna turn around and dilute your investors by 50% to do it?"

Will Page:  So we've got a bit of a toxic combination here, correct?

Richard Kramer:  Yeah. And the interesting thing is that it really perfectly fits the investment bank business model. Which is the cost of doing a deal is the same, whether they do a deal for a hundred million bucks or $10 billion.

Will Page:  It's a deal. The deal generates the value.

Richard Kramer:  The deal generates the value. And if you're taking a percentage of the value of the deal, your incentive is to make the deal as big as possible. The bigger the amount of money you raise, the bigger the paycheck is for the bank. And once they've gotten in the treadmill of raising these SPACs, they become, uh, a factory. And that's why you have literally thousands of these special-purpose acquisition companies, which have been formed up in the last six months or so. I- Imagine a pack of rabid, extremely hungry wild dogs let loose on a limited amount of supply of dog food or meat.

Will Page:  You talk about a rabid wild set of dogs there. That sets up an image in my head not of rabid wild dogs but of Harry Redknapp our soccer manager who had a, a model of the transfer market where he got paid every time one of his players was transferred. So anybody who played for this manager was moving around clubs every year, not to make clubs become successful but to generate transaction fees. And I'm sure no football agent right now is really that worried about how the clubs are doing. What they're really worried about is is there enough deal flow happening? Whether those deals do any good or not is irrelevant. They make money on the deal, correct?

Richard Kramer:  Absolutely. And that cuts right to the heart of something we talked about in previous episodes and even this episode, which is incentives. And the fact of tax deductibility of interest in the US tax code is really an original sin. It encourages leverage. It encourages borrowing. It encourages investment and that's a good thing. But it also encourages larger, more speculative investment when you're always looking for outsize returns relative to the next guy.

Will Page:  Okay. So we've got our two smoke signals, saddling companies up with debt for short term gain. Very little to do with making companies successful. Lots to do with extracting value from the debt. And our second smoke signal, being that business of the value is in getting deals done, not whether those deals are doing any good or not. Making money out of the transaction with debt, as opposed to making debt produce economic activity.

 What's the undercurrent here? The one thing that regardless of how clever we get at spotting bubbles and avoiding their troubles, what's the undercurrent that we're never gonna get, get away from? I mean, it sounds to me like the way the game is rigged is that debt is incentivized. Correct?

Richard Kramer:  Well, and I'll tell you another a- angle on this. And it goes back to your favorite phrase about moral hazard. If you're the chief executive of a company and you know the average tenure of a FTSE chief executive is three years, four years? If you load the company up with a ton of debt that comes due in five to 10 years, hey, it's not my problem. If Harry Redknapp gets brought in to fix a struggling club in the relegation zone, buys a bunch of players, and when they don't get relegated, sells them all the year after, the club doesn't complain and Harry Redknapp has made out like a bandit.

 But it's simply the question of who is left holding the bag with all that debt? Who's funding the short term profits? And will they really be covered in the end? Or is this something that's a parcel that's gonna be passed on to the next guy who comes in the door and takes a look at the real state of the balance sheet?

Will Page:  So there you have it. Someone Else's Money. Certainly not yours. And at some point, you're gonna have to pay that back.

 Next week, we're gonna go straight into real events, stuff that's hitting the headlines right now. And I think the first one has to be the issue of SPACs. We'll be dissecting that rather weird acronym into all of its details.

 I want to thank my colleague, Richard Kramer. And remember, this week's bubble is next week's trouble. I'm Will Page.

 If you're new to Bubble Trouble, we'd encourage you to follow the podcast wherever you listen. Bubble Trouble is produced by Eric Newsome and Jessie Baker at Magnificent Noise. You can learn more at BubbleTroublePodcast.com. See you next time.