Invest Like the Best with Patrick O'Shaughnessy
· Patrick O'Shaughnessy
[00:00:00] S0: This is a unique conversation. It's my second with Alan Waxman, the founder and leader of Sixth Street, one of the largest private capital investment firms in the world. Him and I have been going back and forth about the history of financial guidelines and incentives, and how those systems, through time, shape the system that we live in today and shape outcomes in financial markets. We thought it would be a neat opportunity to walk through, in great detail, what he calls System 1, 2, and 3, going back all the way to 1933 and the initial regulation Glass-Steagall, which kicked off System 1. We then go through System 2 from 2000 to 2008 and the Global Financial Crisis, and then go into great detail for the system that we're living in today. The reason all this history is interesting to me is that ultimately it's about the incentives and the ways that investors and investing firms make money. We have this great conversation about what Alan calls the factory model of investing, defined by the industrialization of both raising money and deploying money, sort of the opposite of the old-school artisanal investment model that's focused entirely on earning outstanding investment returns. His historical perspective and lens on what's driving outcomes, I think is useful information and history for all of us as we try to navigate one of the most dynamic periods of creative destruction in capital markets history. Please enjoy my second conversation with Alan Waxman. Please enjoy my second conversation with Alan Waxman. We're facing one of the most interesting capital market setups of all time, alongside one of the most interesting world environments, geopolitics, technology. And you and I have talked a lot about the shaping forces that will determine how things play out from here. One of those things that I want to start with – we'll talk about AI, we'll talk about geopolitics, some other big things that might be shaping the world. But there's one that is probably under-discussed, that you are in a very unique position to teach us about, which is what you call the guardrails and the incentives of the financial system itself. The reason we're doing this today is so much discussion of private credit, direct lending, things happening in private markets, that's getting a lot of attention in the news. You can see it in stock prices of certain companies.
· Patrick O'Shaughnessy
And I think the whole world is grappling with this, trying to figure out what the hell is going on and what to expect. And you are a deep historian of this topic. And so I thought it would be a really cool opportunity just to have you teach us all about this important factor in what's going to happen in the future. So what is your general frame for the financial system and how it impacts the world?
· Alan Waxman
[00:00:00] S1: There's a lot going on in the news. What I'd say is what you're reading in the news today are the symptoms, but not really the root cause. And as an investor, when we try to figure out what's happening in the current moment, which is – we're definitely in a moment right now. We do two things. First of all, we think about it from the standpoint of, how did this get here? What's the history of it? How did we get here, to really figure out the current moment and also determine where we're going? So I think we'll talk a little bit about the history of how we got here. And then the second thing, and you hit this, is looking at everything through systems. And we think about systems. We think about the incentive system, guardrails, and market structure. First of all, I'm not an economic historian. What I'm going to do is tell the story of history as it relates to the current moment. I think you've got to go back to pre-1929 crash. And when you think about the American financial system, it was basically like the Wild Wild West. It was pretty unregulated. And there were many causes of the 1929 crash. There was poor monetary policy, agricultural recession, margin lending. But one of the main parts that caused it is you had this idea of commercial banks. So think about commercial banks. So individuals go put their money into a bank as deposits. Commercial banks basically were in the same house as principal risk-taking activities, so the investment banks. So these were all part of the same thing. As you can imagine, when that happens, there's a massive conflict of interest. So really, the story starts for the current moment, starts in 1933. So this is after the 1929 crash. This is after 9,000 banks fail. Think about that. 9,000 banks fail. 1933, Glass-Steagall, probably one of the most important regulations that took place, and also the establishment of the FDIC, which ensured deposits for individuals at banks up to a certain limit. And Glass-Steagall basically said, these commercial banks, which were deposit-taking institutions from individuals, just got really burned in the 1929 crash, basically become separated from the investment banks, who at the time – think about principal risk-taking. So think about in today's parlance, private capital, investment banks. Those got separated. And that's kind of the first system.
· Alan Waxman, Patrick O'Shaughnessy
When I think about the first system that explains where we got to the current moment, let's just call it System 1, it's from 1933 to 1999. And when you look at post-World War II with the separation of commercial banks and investment banks, you basically have, after post-World War II, 50 years, a pretty stable system other than the S&L crisis in the 1980s, which was a big event. It was a pretty good system. But the system wasn't optimized for economic growth. Because you only had a pretty conservative – with a lot of guardrails – commercial bank providing finance. [00:00:00] S0: Yeah, it's just low risk appetite. [00:00:00] S1: So it's a low risk appetite. And again, because one, the fixed income market hadn't developed, which is part of the story here. But also, because investment banks, they were more in the moving business than the storage business. They were pricing securities to basically sell to other people. They weren't pricing it to hold for their own balance sheet. Now, that changed as we get into the 80s. But again, broadly speaking, for this first system from 1933 to 1999, it was working, it just wasn't optimized. [00:00:00] S0: The lesson from this is with really good guardrails, you can get long stability.
· Patrick O'Shaughnessy, Alan Waxman
[00:00:00] S0: The lesson from this is with really good guardrails, you can get long stability. [00:00:00] S1: You can get long stability. But again, you also have to think about job creation and economic growth. And I think if there's one criticism of the system, which is why the Glass-Steagall Act got repealed in 1999,and I can talk about why it got repealed, what sort of steps led up to that, is that it wasn't optimized. And as you go to a more globalized world and you're competing with, say, European banks, you become less and less competitive. So in a non-globalized world, it was probably OK. But as we got to a more globalized world, it wasn't really optimized to maximize economic growth for the country. [00:00:00] S0: OK, so we get to the mid-late 90s. What happens? In addition to new competitive pressures, walk us through that transition into what becomes System 2.
· Patrick O'Shaughnessy, Alan Waxman
[00:00:00] S0: OK, so we get to the mid-late 90s. What happens? In addition to new competitive pressures, walk us through that transition into what becomes System 2. [00:00:00] S1: So at the time, again, we've got separation of investment banks and commercial banks. All of a sudden, European banks who weren't part of the same Glass-Steagall regulation, they started to unite with each other. So commercial banks and investment banks in Europe started to come together, which started to put the American commercial banks at a big disadvantage. And not only were they coming together, but they were also taking on more leverage than what was allowed with the guardrails of American commercial banks. So as a result of that, as you can imagine, all the commercial banks – and many market participants were saying, "Hey, we can't really compete against some of these European guys." In 1998, Deutsche Bank bought Bankers Trust, and that was definitely a moment. Citibank announced that it was merging with Travelers, which at the time when they announced the merger, it actually wasn't allowed under Glass-Steagall, under the current regulation. So that's what sort of led up to it. So I think it's a couple of things – globalization. Now, all of a sudden, you're competing against Europeans who have – think about it, they can provide services and balance sheet and capital. You're at a pretty big disadvantage. So the System 1 started to get less competitive as we moved into a globalized world. And that led to 1999 when Glass-Steagall was repealed.