Looking back, we might be able to understand how we got there. Only then, we can truly answer the question of whether the financial crisis and the ensuing economic crash was a Black Swan. This is an important issue that we need to consider. We must determine whether the volatility was truly random. If we conclude that the volatility was not random, the next step is to figure out what caused the volatility and whether we could have anticipated it.

Needless to say, we do not believe that the financial markets and economic volatility was random. In fact, we believe that it was forecastable. In line with one of the conditions of the Black Swan, we will use hindsight to attempt to understand the market volatility and uncertainty surrounding the crisis. In our defense, we believe that we can say something even stronger. We wrote about the negative impact of the delevering of the United States and world economy. Unfortunately, we anticipated a swifter and more adequate policy response. The point here being that some of what happened leading to the crisis was a forecastable event [3].

A final possibility to consider is that the policy changes, in addition to affecting the risk returns of the economy, they also resulted in some changes and innovations that proved to be quite beneficial in the long run, even though some short run excess may have been created. To illustrate the impact of the policies on the incentive structure, let’s focus on the retention rates reported in Table 32.1. They represent the amount an investor would keep after paying the top rates applicable.

Looking back, one can argue that the election of Ronald Reagan marked an inflection point. Some may say that hindsight is 20/20, but in our defense, we can say that much of what we are now writing, we did anticipate and forecast at the time [5]. We also did forecast other things that did not come to pass, but we do believe that our calls were roughly consistent with what has transpired over the last three decades. So, we do not quite believe that it is all hindsight. Rather than review all of the policies, let’s focus on the economic policy adopted by Reagan. In 1979, corporate debt yielded $30 worth of after-tax income; capital gains resulted in a net of $38.90, while dividends netted only $16.20 (Table 32.1). Clearly in 1979, capital gains were the preferred vehicle, as it resulted in the highest after-tax return. Capital gains had a $22.70 advantage over dividends. Think of it this way, if one could convert dividends into capital gains, the investor could receive an additional $22.70. In other words, corporations had a strong incentive to deliver returns in the form of capital gains. No wonder capital gain-intensive vehicles like small-caps outperformed during the 1970s.

The Reagan tax rate reduction also altered the relative attractiveness of the return delivery mechanisms available to corporations. The tax rate reduction increased the after-tax returns of corporate debt, dividends, and capital gains (Table 32.1, column 2, and rows 4–6). The first Reagan rate cut increased the after-tax return of interest dividend income by 67%. The second Reagan tax rate cut had an equally impressive increase in the after-tax return of these two vehicles. It should not surprise people that the market valuation attracted capital and resulted in a market increase that was a multiple of the increase in after-tax return.

The Reagan tax rate had other effects on the economy and the markets. It significantly altered the relative attractiveness of the different vehicles. Corporate debt became top dog. By 1982, debt had a $23 and $6.8 advantage over dividends and capital gains, respectively. The debt advantage over dividends and capital gains grew to $24.5 by the time the second Reagan tax rate cut had taken effect. Viewed this way, it is easy to see why corporations and investors had a strong incentive to convert corporate profits into interest or corporate debt payments. Two basic strategies emerged: one was to capture accumulated capital gains of companies that were carrying their assets at historical costs. The other was to reduce the tax liability of profitable corporations by altering their structure and the way they delivered returns to investors. The basic idea of the second strategy is to load up the company with debt, such that the interest payments erase the corporate profits. Doing so effectively eliminates the corporate tax payments and the income is taxed only once at the individual level.

A financier named Michael Milken understood that many corporations were carrying assets at historical costs and that the market value of these assets was significantly higher. He also understood that many profitable corporations were delivering their returns in the form of dividend payments to their investors. Debt was the vehicle that allowed for the reduction of the tax payments associated with capital gains and/or dividends. The structure used by Milken required some equity, some bank financing and the bulk of the financing in the form of his high yield instruments. Milken, then a successful bond salesman for the firm Drexel Burnham Lambert, accurately gauged the markets appetite for leverage buyouts (LBOs) and popularized the perfect LBO financing instrument: junk bonds. As investors would buy junk bonds, which promised high returns based on future company cash flows, the LBO itself would be financed and everyone concerned would come out a winner. Indeed, for several years the process worked splendidly. LBOs went through and rather than being just high risk, junk bonds delivered high returns, and at favorable tax rates to boot.

As the LBO/junk-bond marriages went off without a hitch, junk bonds were set on a high pedestal by the financial media. Not only were they high yield, but also their default rates were not much greater than higher-quality, lower-risk bonds. Junk, for a time, wasn’t so shabby, in particular because LBO operations, rather than paying dividends, were converting existing cash flows into debt. In other words, early on there was real money behind these transactions, and the over-focus on debt was sustainable. Soon enough, however, the merit of the LBO mattered much less than the financing instrument.

Everyone wanted in on junk bonds, and regulators in their infinite wisdom allowed savings and loans (S&Ls) into the game. The S&Ls either held or issued high yield bonds. Unfortunately, as competition increased, standards were relaxed and the leverage factor increased. For many S&L borrowers the projects were close to 100% financed. Even worse, the loans were secured by the project themselves. So in many ways these investments became a one sided bet. If they worked, the project owner got a big payoff and realized huge capital gains. If the project failed, the owner walked away and the lending institution, the S&L, was left holding the bag. It is easy to see that with such an incentive structure, projects became increasingly riskier and the end game was easy to forecast. This is one clear example where government policies altered the risk characteristics of the overall economy. With the repeated applications, that is, loans, the outcome could not be in doubt. We all know how a game of Russian roulette ends. This was the case with the famous S&L debacle.

This is the first part of the story. But at this point, it is worthwhile to draw the parallel with the financial crisis. The story is the same, all one has to do is change the name of the players. The government increased the tax advantage of home ownership, which led to a surge in the real estate prices. But it did more than that. It also relaxed the qualification requirements for financing. The rising home prices and easier financing increased not only the demand for real estate and real estate financing, but it also increased the leverage factor. Much like the S&L crisis, the increase in financing and leverage was facilitated by new financing instruments. Securitizations became the financing mechanism that facilitated the leverage factor much like the junk bonds had done earlier. The rising prices also leads to an increase in the supply of real estate and eventually as the demand is satisfied, the prices will stop rising. But that is not all. If at that price there are excess returns and there are little or no restrictions to entry, new supply will continue coming online until the excess profits are eliminated and the prices and rates of returns converge to their long run average. This is a simple explanation that does not assume a Black Swan event.

Once the crisis hit, the government had to intervene and that gets us to the second part of the problem. It took over and closed many S&Ls, credit became tight, and the economy slowed down. To deal with troubled assets, the RTC was created. Over time the RTC disposed of these assets. However, in the meantime, the asset overhang had a significant negative impact on the real estate market for a few years. But the aftermath of the S&L crisis was nowhere near that of the effect of the financial crisis that led to the Great Recession. Taking the failure of the Lincoln Savings and Loans as the epicenter of the S&L crisis and the subsequent and unrelated events, such as the invasion of Iraq in 1991 and the George H.W. Bush tax rate increase, it is easy to see why these events would have a negative and adverse effect on the US economy. The S&L debacle, the credit crunch, and the tax increase culminated in a recession. Fortunately, the fundamental policy changes put in place by the Reagan administration remained in place even during the Clinton administration. While it is true that President Clinton raised personal income tax rates, at the same time, the United States inflation rate declined. More importantly, in 1994 the Republicans took over Congress and gridlock was the key word for the remainder of the Clinton administration. Clinton was unable or unwilling to reverse the Reagan policy mix. During the gridlock years, President Clinton lowered the capital gains tax rates and a different set of issues came to the forefront. The point here is that there was no Black Swan.

Additionally, government policies and regulations in the quest to increase home ownership—a goal of both Democratic and Republican administrations—pushed leverage to excessive levels. It is widely accepted that much of the current market malaise began with the housing market debacle. We also believe that the 1997 legislation that changed the tax treatment of owner occupied houses marked the beginning of the housing boom. Let’s look at a housing investment from a tax perspective. We know that the imputed income of an owner occupied house is not taxed. Similarly, the cost of carry, that is, the mortgage payment, is tax deductible to the homeowner. Finally, the homeowner gets to enjoy up to $500,000 worth of tax-free capital gains every 2 years. Assuming a normal down payment, a 4–1 leverage factor would not be uncommon. This means that a house that appreciated at the inflation rate would generate a return on equity well above those of the stock market’s historical returns. The 1997 legislation induced homeowners to increase the size of their homes and to turn them over more frequently. The increase in demand due to the favorable tax treatment may very well explain why home prices did not experience a decline during the 2000 recession. However, it does not explain the explosion that occurred after the new millennium. For that, we need at least two additional factors and more than that will make our case even stronger.

One of the needed factors was the Fed’s easy money policy that lowered interest rates for a considerable period. The so-called “Greenspan Put,” which reduced the cost of carry significantly and encouraged a carry trade, resulted in an increased leverage for the economy as a whole. Then there is the tax rate structure. Recall that in 2002 under President Bush the top income tax rates were reduced and the capital gains and dividends began to be taxed at the same rate (Table 32.1). The personal income tax rate reduction increased the after-tax return of the corporate debt interest payments to $63.9 from $59.2. More importantly, debt still retained an advantage over capital gains of $8.7 per $100 worth of pretax income. Hence, debt was the preferred financing vehicle during the Bush administration. But to complete the parallel, we need to identify the equivalent of high yield bonds of the 1980s. The securitization of mortgage-backed securities filled that void. The logic of the mortgage-backed financing early on was right on the money. But as with high yield bonds, eventually everyone wanted in. Fannie and Freddie wanted in and, in time, they would purchase them. We know what happened next: a replay of the S&L crisis except that this time the crisis was deeper and wider than the S&L crisis. Also, unlike the S&L crisis, the government did not step in to create an RTC-like vehicle to take over the failed real estate that mortgage-backed issuers were financing. This interpretation of the events leads to the conclusion that there was no Black Swan, just bad policy and some excesses. The RTC during the S&L crisis accomplished its mission and the economic expansion continued. The US economy had a couple of economic slowdowns in between before the financial crisis hit.