Shrinking Discipline and Its Consequences

What common characteristic, increasingly in short supply today, was shared among the Roman Legions, Goldman Sachs and the US Marine Corps? Aggressive Discipline.

Aggressive Discipline is based on an immutable moral system that establishes a bright line border on what is acceptable and what is not. Discipline is not just compliance with prohibitive laws and regulations, but a feeling as to what is right to do. The aggressive application of discipline is often found in the heat of battle/competition in the gray areas not covered by established precedents, laws or regulation. From time to time the three generally victorious champions mentioned above, make or made mistakes, but usually corrected them by internal actions. The heart of discipline is accepting not only the rules of the game, but also the principles behind the rules.

The most basic of financial dealing principles is that all trades will be honored on time and completely. In other words buy only what we can afford out of our present resources. These resources include our cash and our borrowing capacity. The disciplined approach to borrowing is not what we can borrow, which is determined by others, but what we can repay from our own activities. We have been attempting to escape discipline throughout our society. Financial leverage and deficit spending are really the same act, but one is in the private sector and the other in the public sector. I find it ironic that our cure for the excessive borrowing by individual “home owners” and finance “houses” is being shifted initially to the public sector by deficit spending, or if you prefer the term used inside the “Beltway,” stimulus. This illogical pattern unfolds as some individuals and corporations borrow money that cannot be repaid in time, resulting in the government paying these debts by the creation of more debt. While this may be straight line thinking for some, for me it is just passing the problem along temporarily.

What makes this behavior worse is that the diagram is not a flat circle but a rising cone of adding interest cost to the debt assumed. Eventually as citizens, whether income and estate tax payers or not, we will have to repay the society’s debt nominally in full. When the government resorts to inflation it is electing for the cruelest form of taxation, because inflation impacts all who use dollars. The greatest impact is on the poor, who just have expenses and little in the way of assets. All of these consequences trace back to the decision to purchase goods and services above our reasonable ability to repay the borrowed funds. We were attempting to escape the discipline of our current resources. What we were doing, in most cases, was perfectly legal, just not smart enough to accept the discipline of avoiding trouble.

Another example of our declining use of discipline is shrinking disclosure. Politicians and some banks are attempting to hide the current valuation of assets and liabilities because they are difficult to measure. This is the whole “mark-to-market” controversy. Any comparison to the Mad-Hatter’s Tea Party is purely coincidental. What is being missed is the real function of financial commerce, in particular banks. What do banks really do? They accept our cash, which we freely give to them believing that they will return it to us on demand. In order for a bank to earn enough for it to operate, it makes loans to others and makes investments. If on any given day all of the bank’s depositors (or even a significant portion) wanted their money back, we would quickly be dealing with an insolvent institution that owed more to its depositors than it had cash on hand. Sounds like potential trouble. However, on any given day each of us has less available cash than the total of all of our debts. Banks take protection by portraying themselves as conservative institutions with lots of reserves of their own, backed by some government money (FDIC).

There are many users of bank financial statements, including (1) depositors who are looking for safety, (2) borrowers in some cases looking for the individual bank’s capacity to make a single loan, (3) government agencies seeing whether the bank is in compliance with various national and international capital requirements, and (4) during this difficult time, a Bank’s Credit Management team, determining how much more they can lend, and to what type of borrower.

A significant number of bank loans and some investments have become more difficult than usual to measure as fixed income markets are no longer functioning in their traditional ways. There is a growing amount of loans and investments that are labeled “Level 3” on the books of banks, insurance companies, brokerage firms, and various types of funds. The government is concerned that the bank community is reluctant to make loans of any type, as banks’ lending capacity is being limited by the written-down value of previous loans, and investments are now significantly below cost. In this case, financial discipline is playing its proper role of limiting the actions of a prudent lender. Because this limitation is inconvenient for the government, our leaders are advocating that certain assets which are difficult to measure, be carried at cost (which has nothing to do with value). Furthermore, the contemplated new accounting rules may prevent a reasonable assessment of value to be included in the financial statement footnotes. Some carefully determined “normalization” of prices might be useful, but we should be suspicious.

A difference in accounting treatments can lead to very different investment decisions. A number of years ago I was hired as a consultant to review the performance of an SEC registered closed end fund. The numbers shown in the SEC report included write downs of various Chinese private investments. The performance was so bad relative to other SEC registered funds, locally managed funds and various securities indexes, that the directors wanted to fire the manager. The local external portfolio manager could not understand what the complaint was about. He managed a clone of the SEC fund and not only was there no complaints, but the cloned fund was regarded as a winner in the local community. When I examined the two portfolios of identical names, I noted the prices were different for a number of holdings of private companies. The local fund carried prices at cost and would only change the price upon sale. The SEC registered fund used our accounting rules as applied by a sophisticated US auditor, who changed the price of the private companies whenever there was information as to the price of a private sale or the public announcement of some trouble with a private company. The directors used my report to force a number of changes in the investment adviser and the subsequent removal of the portfolio manager. The bottom line is the fund that hired me is still in business today and both the clone fund and the investment adviser have disappeared.

The lesson is that the most realistic numbers help in making the correct decision. From my old performance analysis days comes the slogan “bad data leads to bad decisions.” In the end the admission of an error in thinking is the best way to prevent future mistakes in judgments.

How to apply this recognition to an investment world of shrinking discipline and purposely less disclosure? The impetus is to diversify. Diversify types of investments in terms of both types of investments and within different types of investments. Also diversify your sources of information and agents to be used. During these difficult periods, simpler companies with managements that have a lot at stake in the company’s reputation and capital structure make sense and have more appeal than my old stomping ground of financial conglomerates, multi-industry/multi-product and other diversified corporations. Not that these are bad investments, but they suffer in comparison with the simpler organizations at today’s prices, discipline and disclosure levels.