Without discipline negative behavior reoccurs

By DAVID MOON, Moon Capital Management, LLC
March 20, 2011

Some parents occasionally run into disagreements about punishment and consequences for their kids. One parent might be very rigid about the importance of consistency and the need for unacceptable behavior to result in negative outcomes. Sometimes the other parent, with completely loving intent, might be a bit less strict, unintentionally encouraging repeated negative behavior.

Not that I have any personal experience with this.

It’s an easy and obvious lesson that should have been applied on Wall Street and in Washington. Less than three years ago our financial system came within some degree of collapse. Our commercial paper system experienced an effective shut down.

Why? Because of risky loans that fell apart – then were, for the most part, bailed out by the US taxpayer.

The people who originated the loans, packaged the loans, resold the loans and borrowed the money mostly escaped negative repercussions for their actions.

Guess what’s back? Stupid loans. And they are back with a vengeance.

“Covenant-lite” loans don’t require the lender to provide safeguards to the borrower about things such as ongoing asset quality or cash flow. In the first two-and-a-half months of this year more covenant-lite loans have been originated than in any full year on record except 2007.

The total amount of these loans originated in 2011 already exceeds the second largest entire year on record, 2006, and is on track to far surpass 2007’s record.

Another worrisome trend in the credit market is the ballooning volume of loans and high yield bonds used to finance dividend deals in private-equity controlled companies. These are situations where an investment entity buys a company, then uses the assets of the acquired company as collateral to borrow money and pay themselves a huge one-time dividend, effectively taking much or all of their equity out of the deal.

It wasn’t just subprime mortgage lending that placed the US into a previously precarious pecuniary position. It was stupid lending just like this.

How can presumably smart people wade back out into such dangerous waters so quickly after being run back to shore by the sharks?

As you would expect, it’s about the money.

Lenders want to make these loans because they are struggling to make decent money in conventional ways. Creditworthy companies that easily exceed typical loan covenant requirements don’t need loans. Banks can’t make any money investing in securities because the Federal Reserve is buying Treasury securities and has driven interest rates to near nothing.

So, like most investors, lenders are resorting to riskier practices.

Why not? AIG made plenty of stupid investments and has yet to default on a single loan – all thanks to the taxpayer. Nor has an AIG lender, bondholder or counterparty (think Goldman Sachs) lost money either. Fannie Mae and Freddie Mac funded stupid loans. Congress and Tim Geithner have promised them a practically limitless bailout piggy bank.

And politicians continue to try and rescue the individuals who borrowed more money than they could afford, too.

Why shouldn’t all investors resort back to their old, dangerous practices? That’s what children do when they don’t have consequences for their misbehavior.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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