The Only Guy On The FOMC With Any Experience Actually Managing Risk Is Sounding The Alarm

Below is a compilation I put together using excerpts from Richard Fisher’s speeches this year (emphasis mine):

There is no greater gift to a financial market operator—or anyone, for that matter—than free and abundant money. It reduces the cost of taking risk. But it also burns a hole in the proverbial pocket. It enhances the appeal of things that might not otherwise look so comely. I have likened the effect to that of strapping on what students here at USC and campuses elsewhere call “beer goggles.” This phenomenon occurs when alcohol renders alluring what might otherwise appear less clever or attractive. And this is, indeed, what has happened to stocks and bonds and other financial investments as a result of the free-flowing liquidity we at the Fed have poured down the throat of the economy. Here are some of the developments that signal we have made for an intoxicating brew as we have continued pouring liquidity down the economy’s throat:

• Share buybacks financed by debt issuance that after tax treatment and inflation incur minimal, and in some cases negative, cost; this has a most pleasant effect on earnings per share apart from top-line revenue growth.
• Dividend payouts financed by cheap debt that bolster share prices.
• The “bull/bear spread” for equities now being higher than in October 2007.
• Stock market metrics such as price-to-sales ratios and market capitalization as a percentage of gross domestic product at eye-popping levels not seen since the dot-com boom of the late 1990s.
• The price-to-earnings (PE) ratio of stocks is among the highest decile of reported values since 1881. Bob Shiller’s inflation-adjusted PE ratio reached 26 this week as the Standard & Poor’s 500 hit yet another record high. For context, the measure hit 30 before Black Tuesday in 1929 and reached an all-time high of 44 before the dot-com implosion at the end of 1999….
• Margin debt that is pushing into all-time records.
• In the bond market, investment-grade yield spreads over “risk free” government bonds becoming abnormally tight.
• “Covenant lite” lending becoming robust – surpassing even the 2007 highs – and the spread between CCC credit and investment-grade credit or the risk-free rate historically narrow. I will note here that I am all for helping businesses get back on their feet so that they can expand employment and America’s prosperity: This is the root desire of the FOMC. But I worry when “junk” companies that should borrow at a premium reflecting their risk of failure are able to borrow (or have their shares priced) at rates that defy the odds of that risk. I may be too close to this given my background. I have been involved with the credit markets since 1975. I have never seen such ebullient credit markets. From 1989 through 1997, I was managing partner of a fund that bought distressed debt, used our positions to bring about changes in the companies we invested in, and made a handsome profit from the dividends, interest payments and stock price appreciation that flowed from the restructured companies. Today, I would have to hire Sherlock Holmes to find a single distressed company priced attractively enough to buy. The big banks are lending money on terms and at prices that any banker with a memory cell knows from experience usually end in tears.

The former funds manager in me sees these as yellow lights. The central banker in me is reminded of the mandate to safeguard financial stability. We must watch these developments carefully lest we become responsible for raising the ghost of irrational exuberance.