Morningstar Magazine - April/May 2018 - 16

Dispatches

The Bacle begins when prices are low, and
there is not much going on, until a good
idea shows up. The good idea will spread and
create profit and excitement, and eventually
generate the whole cycle.
Rule 2: Every bad idea starts as the good idea.

There is no need to fear a bad idea. An idea
that is bad to begin with cannot go anywhere. Your
company compliance manual does not need
to have a rule forbidding you to drop a cinder block
on your foot. Only good ideas have staying
power. For example, when you go to a party, but
feel intimidated by a large number of people
you don't know, a glass of champagne is a fine
way to help you relax, strike up conversations with
the other guests, and even make some witty
remarks. The first glass is a good idea. The second
glass makes you even wittier, a trifle ribald
perhaps, but your new friends certainly enjoy your
stories. You get on the dance floor and discover
you can still do some fancy steps, and wondrously,
you are now irresistible. The second glass
was a pretty good idea, too. Is a third glass of
champagne still a good idea? Nope. You
are entering the last stage of your Bacle, and
it is time to switch to club soda or the Debacle may
be a calamity.
Rule 3: Bacles have three parts.

Just as our cocktail party had three levels
of intoxication, Bacles have three parts,
too. My brilliant friend Paul McCulley described
three phases of investment in a Bacle.
He in turn pinched the idea from the economist
Hyman Minsky.1
Minsky had three Bacle investment levels
of interesting intoxication:
3 Hedged assets
3 Speculative assets
3 Ponzi assets

What do these three levels refer to?
The 2008 Debacle is classic. It was all about the
home mortgage business, so we will pick examples

from mortgages. A hedged asset is safe and
old fashioned. You lend a buyer money to
buy a house subject to a 20% down payment and
verified adequate income on the buyer's
part. You can make a decent return on the spread
between your bank's cost of funds (say 3%)
and the mortgage (say 6%). You have a secure
investment because you have a trustworthy
borrower who has equity in a house that is worth
more than the mortgage.
After a few years, mortgage defaults have
been so low that your boss tells you that
the portfolio is too conservative. Profit margins
are fine, but we are losing market share.
We can grow faster if we relax standards and
finance speculative assets. A speculative mortgage
has a down payment of only 10%, and the
house carrying costs relative to buyer's income
is dangerously high, but a higher interestrate spread will cover the increased risk. Besides,
house prices have been rising, so if you
have to foreclose, there is no way you will have
to take a loss on the resale.
In the real world in 2006, the mortgage industry
went into phase three, Ponzi assets, in
which underwriting standards virtually vanished.
The reasons you wanted to write these mortgages
were only two:
3 House prices would keep rising rapidly because
they always do.
3 We are going to sell the mortgage to someone else,
so it won't be our problem.

Obviously, this was close to the peak, and
Debacle loomed.
One of Minsky's insights into the process
was to explain why phase one, hedged assets,
wasn't permanent. He showed that the
cause of instability was stability. The stable profits
made during phase one convince market
participants that risks are very low, so taking on
more risk means more profits-and for
the next few years that is absolutely correct.
The first phase of stable prosperity seduces us into

level two, big profits, and then level three,
euphoria, which is unstable.
Rule 4: The Debacle is caused by the Bacle.

How about now? The U.S. stock market
has quadrupled from its 2009 low. Can I make this
look like a three-phase Bacle? Of course.
1 The world didn't end during the financial crisis.

Stocks are really cheap, so you can buy a
portfolio with a good dividend yield. These are
hedged assets.
2 ZIRP. With interest rates at zero, any valuation
model shows that stocks are cheap, and
growth stocks are the cheapest. FAANG! Stocks are
speculative assets.
3 Euphoria. No down months in 2017, VIX at record
low levels. Bitcoin! Even though interest rates are
back to normal, and valuations are no longer
cheap, no one cares, momentum rules. Ponzi time.
Technical Appendix

The word pair Bacle-Debacle will not withstand
serious scholarly analysis, but so what?
The "x:de-x" construction is growing in popularity.
We all board airplanes, but a few weeks
ago, I heard a United announcer say, "Arriving
Flight 6517 will 'deboard' at Gate 2."
Workers will come and "dewater" your flooded
basement. Your software can be loaded on
your computer by hitting the install button and
then removed by hitting uninstall. Inflation
alternates with deflation, tour with detour, offense
with defense, fenestration with defenestration.
There are a few loose ends: There is no condition
of "mentia," or a kid who is "linquent." The words
scent and descent both exist but don't make
a meaningful pair.
One of my friends who had a difficult marriage
said, "Oh, you mean I am heading from 'vorce'
to divorce." K
Ralph Wanger, CFA, ran Columbia Acorn Funds from 1970
to 2003.

1 Minsky (1919-96) was an economics professor at the University of California, Berkeley; Washington University in St. Louis; and Bard College.

Morningstar April/May 2018

Table of Contents for the Digital Edition of Morningstar Magazine - April/May 2018