There is an ongoing debate on the current nature of the economic environment and what should the response be by government. Today's Outside the Box by Paul McCulley takes up one view, arguing that we need a federal response and stimulus package to protect the overall economy and save capitalism from itself. Tomorrow, I am going to send yet another view arguing that by doing so we are hurting the prudent investor and businesses that did not over-leverage and behaved responsibly. Both are important to understand. And as I will argue on Friday in my 2009 Forecast Issue, both are right. And that is one of the great economic paradoxes that we are faced with today. Navigating through this period is particularly challenging, but I think it is critical that you understand what Paul says today and what Bennet Sedacca will say tomorrow. Understanding what is going to happen, whether or not we agree with the philosophy behind it should be our goal, as it will make us better able to respond with our own portfolio and business decisions.
By the way, Paul McCulley, the Managing Director of Pimco, always features a "conversation" he has with his pet rabbit at the end of each year. Not only is it instructive, but it can also be downright funny. I think you will enjoy this letter a lot. And sorry about the Outside the Box coming later this week. We lost power for the day yesterday due to a mild ice storm here in Dallas.
This week we look at a short but excellent summary of the state of the current economic crisis. I always enjoy reading David Rosenberg, the North American economist of Merrill Lynch. He has a no-nonsense style that is refreshing from most mainstream economists. The reality is that things continue to deteriorate. Today's stock market action shows that we are not of the bear market woods just yet. Rosenberg gives us a few reasons why.
Do government bailouts in times of banking crises work? Philippa Dunne & Doug Henwood of The Liscio Report highlight a major study of 42 fairly recent banking crises around the world. Result? Some types of government intervention works and some don't. One characteristic that is needed though is speed. Dithering, a la Japan, is a recipe for disaster. This is a brief summary of the report (to which they provide a link) and their conclusions as to the basic outlines of what the US should do. Given that Europe is already in the throws of its own bank crisis, and the rest of the world could experience problems, this should be useful reading. They also provide graphs of banking crises and comparisons with developed countries and the resulting market experience.
One major point? This is like the old Fram oil filter commercial line "Pay me now or pay me later." As this study points out, the tax payers and citizens of the US (and the world) are going to pay for this crisis in one way or another. Either a major recession (with high and persistent unemployment), reduced incomes and tax collections or a collective efforts to stabilize the banking system. The costs of inaction are much higher. It is not a matter of cost or no cost. We are going to have to pay in one form or another.
We cannot avoid the costs given where we are today. The time to avoid cost was years ago reigning in Freddie and Fannie and proper oversight of the mortgage industry. We (Congress) missed that opportunity. (Sadly, we are going to re-elect the very leadership to both parties largely responsible for the neglect. There is plenty of blame to go around. No amount of partisan finger pointing by Speaker Pelosi shifts that blame.) However, we can choose the form of the cost will be paid in. Personally, I prefer collective efforts to 10% or more unemployment and the risk of an extended recession and its costs. I know this is not pure free market theory, and sticks in the craw of many of my readers, but when many of my neighbors and friends will be unemployed and businesses are suffering theory will not make a very good meal. Congress must act now. This report is a good reminder of what has worked in the past.
My thanks to Philippa and Doug for allowing me to send this as a Special Outside the Box. You can see their work and blog at http://www.theliscioreport.com.
The purpose of Outside the Box is to present views which cause us to think through our basic assumptions. This week our old friend Michael Lewitt of Hegemony Capital Management gives us a view as to why the bailout bill going down may not be as bad as I think it might. There is much we agree on, however. And part of our agreement is that a deeper recession is in our future. Let me be clear. Muddle Through is now at risk.
I have talked with my publisher, and for the next few weeks of The continuing Crisis, we are going to send more than one OTB per week, and I may also add some short commentary. These are extraordinary times, and I know a lot of you (as I can tell from phone and emails) are worried and are interested in analysis that is not biased with either a perma-bull or perma-bear stance. I will call it as I see it, as always, and forward you material from my best sources.
That being said, we will get through this, one way or another. Sanity and clarity will return, as it always does after times of crisis. I wish you the best in your situation.
What a momentous weekend. I was pounding the table about the need to move quickly on Fannie and Freddie in my last few letters, and especially this last letter. And then they did it. There are a lot of details that have yet to come out, and it is likely to be far more expensive the Savings and Loan crisis was for the US taxpayer, but it did get done. Hopefully, we can get some real regulation for part of our costs, as well as get rid of the implicit guarantees by US taxpayers so that something like this never happens again. The fact that it did was the fault of the regulatory environment and Congress. They fired the heads of Fannie and Freddie (with multi-million dollar parting gifts), but sadly, the truly responsible parties will be re-elected to perpetrate yet more frauds.
This week in Outside the Box we will look at two essays, one by Paul McCulley, Managing Director of PIMCO (www.pimco.com). The second is a quick shot by Michael Lewitt of Hegemony Capital Management on the Freddie and Fannie nationalization (www.hcmmarketletter.com). They both make points that there is a lot of work still to be done by the authorities. This crisis is not over...
And on that note, I agree with this paragraph from Greg Weldon:
"There is talk that yesterday's 'event' signals an end to the credit crisis ... nothing could be further from the truth. The take over of Fannie and Freddie implies that the credit contraction continues to INTENSIFY, as the government will likely NOT ... EXPAND ... the balance sheets of these two entities. More importantly, the take-over does NOTHING in terms of bank lending standards, which continue to tighten. Nor does it do anything for Ma and Pa Kettle, as it relates to their ability to continue to take on more debt, which continues to worsen in line with intensifying erosion in the housing market and the labor market as was WELL EVIDENCED by ALL the macro-data released last week ... and the horrific labor market report. Indeed, today's markets move might provide the best "FADE" opportunity of the year!!!"
And Now, on to the essays by Paul and Michael.
I have often commented about the problem of personal savings. We worry about the lack of savings here in the US, but many do not understand that if everyone started to save 5% of there income immediately that it would seriously impact consumer spending, pushing the US into a recession. It is a paradox, as Paul McCulley points out, that what may be good for the individual may not be good for the collective country.
And in this week's Outside the Box, good friend and this week's Maine fishing buddy Paul McCulley writes about another paradox called the Paradox of Deleveraging. This Paradox is at the heart of the credit crisis. Many of you will not like his conclusions, as it calls for the government to step into the breach created by the problem he describes. But as I often point out, the purpose of Outside the Box is to make us think about ideas which may not be in our usual sources of information. Paul is the Managing Director at PIMCO, the world's largest bond manager. (www.pimco.com for more information.)
The subprime problem, we were told, would not spread to other markets. It would be "contained." And it has, according to Jim Grant. He quipped last week that it has been contained on planet Earth. The risks coming from rising defaults in the US (now above 600,000 and rising from just 200,000 a few years ago) are clearly spreading to markets far beyond the subprime world.
This week's Outside the Box talks about the next two dominoes that could fall: junk bonds and counterparty risk in the various credit default swap markets. Ted Seides is the Director of Investments at Protégé Partners, LLC, a hybrid fund of funds that invests in and seeds small, specialized hedge funds. He writes this week's piece in Peter Bernstein's Economic and Portfolio Strategy, one of the most respected of market analysis letters. You can learn more about the letter at www.peterlbernsteininc.com.
This piece is a little longer than most letters, but it is one of the more important editions of Outside the Box this year. This is a must read. You absolutely need to understand the nature of the systemic risk we are facing, and Ted does a great job of explaining in very clear terms the nature of the risks that we have created din our modern markets. I have left the footnotes in, and they are at the end of the letter.