macroresilience

resilience, not stability

Private Equity and the Greenspan Put

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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. TED counters that lenders do in fact typically make informed decisions and also correctly points out that the rest of corporate America is not immune to such leveraged mishaps either. Both explanations ignore the fact that this sort of severely tail-risk heavy loan is exactly the payoff which maximises the banks‘ and their employees’ own moral hazard rent extraction. In an earlier post, I identified that many hedge fund strategies are an indirect beneficiary of moral hazard rents – the same argument also applies to some private equity strategies.

But as I have noted on many occasions, the moral hazard problem from tail-risk hungry TBTF financial institutions is simply the tip of the iceberg. It was not only the banks with access to cheap leverage that were heavily invested in “safe” assets, but also asset managers, money market mutual funds and even ordinary investors. The Greenspan/Bernanke Put incentivises a large proportion of real and financial actors in the economy into taking on more and more tail risk with the expectation that the Fed will avoid any outcomes where these risks will be realised.

Too many commentators fail to recognise that so much of what has made the neo-liberal era a thinly disguised corporate welfare state can be traced to the impact of a supposedly “neutral” macroeconomic policy instrument that in reality has grossly regressive consequences. To expect corporate America to not take advantage of the free lunch offered to it by the Fed is akin to dangling a piece of meat in front of a tiger and expecting it not to bite your hand off.

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Written by Ashwin Parameswaran

February 1st, 2012 at 5:56 pm

12 Responses to 'Private Equity and the Greenspan Put'

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  1. Are you saying that the Fed skewed the risk/reward ratio and allowed some agents to take on more risk than they otherwise would have considered?

    LM

    2 Feb 12 at 5:38 pm

  2. [...] Why should we be surprised when private equity takes advantage of low interest rates.  (Macroeconomic Resilience) [...]

  3. So why is the whole screaming about the threatened capitalism? This is not capitalism. The corporations are in charge via the politicians, combined with aggressive militarism toward the inferior nondemocratic “others” – fascism. And party troubadours /Fukuyama for example/ exalts the forever lasting liberal democracy /what a hypocrisy, we have stupid oligarchy/. It is all lies and crap..

    noname

    2 Feb 12 at 7:40 pm

  4. [...] – Telegraph S. Korea, Japan want exemption from Iran oil sanctions – Tehran Times Private Equity and the Greenspan Put – Macroeconomic Resilience Just Fill the Darn Potholes, We’ll Do the Rest – Baum, [...]

  5. LM – Exactly. They may not have taken on this risk knowingly but the system evolved in a manner that more risk was taken – those who took less risk were fired and replaced by those who took more risk and thrived in the “Great Moderation” etc.

    noname – what we have is crony capitalism.

    Ashwin

    3 Feb 12 at 7:32 am

  6. Ashwin, you tell that to the million who lost their life in Iraq.. “Sorry, we have crony capitalism, the monkeys who bombed you are not sick brainless warmongers, no, no they are just corrupted. It has nothing to do with petrol, arm sales and the only right political order – democracy.” You wait until some harsher version of “Patriotic” Act, SOPA, PIPA, etc. come in place.. all in the name of freedom.

    noname

    3 Feb 12 at 9:00 am

  7. And dear, you better get your head out of the place you currently keep it before the “capitalism” become too crony for you to handle it.. http://turcopolier.typepad.com/sic_semper_tyrannis/2012/02/mr-president-tell-bibi-no-publicly.html

    noname

    3 Feb 12 at 9:14 am

  8. Don’t get me wrong, I am not trying to insult you in any way. Even if my words touch some painful meme, it is your mental construct that gives you pain. USA is empire, an empire in decline. I find very frustrating your focus over economic/utilitarian domain. An empire functions by projecting pseudo-democratic “face” in front of the domestic “public” and exercising ruthless colonial operations “abroad”. An empire in decline means the situation is no longer sustainable. There are few possible scenarios: 1) Rapid technological advancement, combined with swift change of part of the ruling elites /call it reform/ 2) meta-stable downward trend /status quo/ 3) collapse /the “elites” forcefully complete the prevailing trend towards fascism/. Scenario one is by my view the most desirable. The technological change will not be supported by the pseudo-republican wankers and their masters from the corporations. Like it or not most of these “elites” are mentally infantile and completely incapable for the task, nevertheless they concentrate the economic and political power. By technological advancement I don’t mean stupid ways to milk the kids like facebook, but entirely new class of technology, something unaccessible by the majority of present “elites”. As for scenario two, it is meta-stable in short run, especially with the bunch of warmongering monkeys who are pushing US towards another war. Scenario three does not allow any predictions about time to be made. It will reveal very fast, unexpected, and US will becomes militarized despotism that will last probably few years, millions will die /mostly abroad/, the current elites will be completely eradicated and US will get nice, pleasant socialism /from contemporary point of view/. So the whole concert about the democracy and blah, blah.. future dominance as the only possible way to develop is well.. stupid people who are attached to the present elites and believe by running the usual propaganda their cognitive dissonance will magically disappear. There is no way to repair the “crony capitalism” as you call it via political process. The “democracy” /even being pseudo/ will not allow it. The politicians are installed there not by the masses /this is why I call it oligarchy/ but by the capital via the high level operatives in the corporations.

    noname

    3 Feb 12 at 12:30 pm

  9. And sorry for my awful english, replace ‘means’ with ‘mean’. But I am sure you get the overall picture. You are smart guy, I have no doubt about it.

    noname

    3 Feb 12 at 1:03 pm

  10. noname,

    1) You used “means” and “mean” correctly in your long post, no need to replace one with the other. :)

    2) Are you just upset that Ashwin is referring to the current system as any kind of capitalism at all? When you say, “you tell that …”, it sounds like you think he is endorsing the current regime, but he clearly is not. “Crony capitalism” is not a positive description. :P

    Eric

    3 Feb 12 at 10:55 pm

  11. noname

    11 Feb 12 at 10:32 am

  12. [...] of corporate America’s efficiency-seeking impulse. I’ve made a similar point in a previous post that the the excesses of private equity mirror the excesses of the economy during the neoliberal [...]

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