Saturday, February 14, 2009

You say depression, I say long recession... oh let's take the whole year off

(What I wonder will mark the bottom? Perhaps a 2010 Barron's Roundtable with Faber, Hickey, Fleck, King, Grant, Taleb and Roubini where Abby Cohen only gets to cater. I'd frame that one! I will say this, their interview candidates are getting better.- AM)
February 14, 2009

Robert Albertson doesn't see a quick end to the financial crisis, and believes it could drag on another two or three years.

The seeds of this crisis -- most notably, too much liquidity, in his view -- were sown earlier in the decade. Albertson sounded several warnings: "We conclude that denial is growing," he wrote in a November 2006 note. "The markets are hearing what they want."

The 62-year-old chief strategist for Sandler O'Neill & Partners has had a long career on Wall Street, including an extended stint as director of bank research at Goldman Sachs (1987 to 1999). Albertson joined Sandler O'Neill, an investment bank focusing on the financial sector, in 2002. Barron's caught up with him last week in his midtown office.

In 2006, you wrote that the consensus economic view was way too optimistic. What concerned you?

Albertson: There were three key trends that had been growing over the years. The first was that there was a complete reversal of global monetary flows. We had never had the emerging markets running the show on liquidity, and it became huge.

Do you mean in terms of emerging-market governments buying Treasuries and basically funding a lot of borrowing in the U.S?

That is right, essentially. So it dawned on me that the Fed[eral Reserve] no longer really had control. But more importantly, the money flows were distorting interest rates to the low side -- ridiculously so. Then, starting in 2003, the Fed compounded the problems by driving rates even lower.

What were the other themes that alarmed you?

The assumptions on home prices in the United States and elsewhere were clearly decoupling from any kind of reality. And third -- and I didn't notice this until about 2004 -- the consumer in America didn't go through a recession in 2000; we had a half-recession, if you will. So [consumers] continued to spend.

I looked at those three themes together, and I thought there was too much liquidity in the system, and that it was going to come back to haunt us.

Talking about subprime mortgages seems almost quaint these days, considering all of the other things that have happened in this financial crisis.(Tell that to Barron's editor!- AM)

Everyone was noticing how much subprime delinquencies were going up, and by 2006 it was evident that [they were] unraveling. But then I looked at prime-mortgage delinquencies, and found out they were deteriorating at exactly the same time and pace. So this said to me it wasn't a subprime problem.

When I looked beyond just mortgages, I began to see the same unraveling in all consumer credits in 2006. So the conclusion had to be that we were going through a credit-loss cycle to end all credit-loss cycles.

What is your biggest surprise about how this crisis has unfolded?

Instead of recognizing the damage in a controlled fashion and trying to deal with it, everything has gone to the other extreme. In other words, stress tests back in 2005 or 2006 were useless; they were silly and assumed things were going to continue to go to the moon.

Now you hear about nothing but toxic assets and their worthlessness and the impending disaster, and I have to believe the reality is probably somewhere in between.

What is your sense of how far along we are in trying to work this out?

You have to look at this from the economic side, and then from the financial-sector side. On the economic side, all consumer debt is at 130% of income. Go back to 2000, and it was at 100%; 10 years earlier it was at 80% or 90%. It has to come down. So the first step is that we have to deleverage, probably by 10 to 20 percentage points, to repair the consumer's balance sheet.

Also, the savings rate used to be 10% to 12% of income, but it went to zero, and it is back up to 3%. It probably has to go back to somewhere near 10%. So, let us just say we got a 25% correction in consumer income, which is about $10.5 trillion.

That is a $2.5 trillion headwind of income that has to go toward debt reduction and savings, as opposed to spending. But no government-stimulus program is going to offset that effectively. To me, it is a two- or three-year process.

Where do you think we are in terms of stabilizing the economy?

We are certainly in a recession, and it is probably a depression, if you define it as a long recession. We may have some false starts, but it is going to take two or three years to come out of this. In terms of the financial system, we have to recognize the damage to the balance sheets -- and there are various estimates. I have done a very granular-level look at bank loans, just in the banking system by category, and when I tally it up, it is close to $1 trillion of embedded losses.

The banking system earns money, so it can pay down some of that on its own. The banking system got $200 billion in the original TARP [Troubled Asset Relief Program], excluding the big investment banks, and that is helpful. But we probably then have another $200 billion to $300 billion of additional capital just to fill the remaining hole there. That is going to take a couple of years, if we want to get it from the private sector, as we should. Getting it from the government is wrong.

How effectively has the government responded to this crisis?

I'm seeing very odd interpretations from the government, in particular about what we need. The government isn't thinking about deleveraging. The government is talking about jump-starting consumer credit. I hear the word jump-start all the time. It is such a bad word. Jump-start consumer credit for what? So we can be more indebted?

So what has to be done?

We need to reduce the debt. If you jump-start credit, you are just going to prolong the problem and deepen it. What we need now is the patience to de-lever. We don't need the stimulus package. We need a savings package (Pay the man Shirley. - AM), but that couldn't be further from the goals at the moment. The mistake is that the government believes credit drives the economy, instead of the economy driving credit. They have got that backward, and this is a very dangerous time to be misfiring.

What is your advice to the government?

The first thing you need to realize is that all that capital flow from emerging markets, which is now plateauing and likely to decline, will put enormous pressure on our government's borrowing costs.

Presumably if emerging markets curtail their buying of Treasuries, the demand for those securities lessens, pushing up rates. Then what?

The U.S. government is thinking in terms of adding trillions to our debt that is going to cost 5%, 6%, 7% or 8% eventually -- not 2% or 3%.

If [officials] really understood that, I don't think they would be so ready to put the taxpayer at risk. Secondly, the consumer has gone through an artificially prolonged period of spending based on too much debt, house prices and home-equity lending, and that has to come out of the financial system.

But assume that consumers repair their balance sheets. Doesn't that make it harder for gross domestic product to recover?

There is no choice; that is where we are. We should have had this decline in consumer spending in 2000, along with the corporate sector decline that should have been the recession that reset the economy. We have a cyclical economy; that is normal. We had an 18-year expansion, which had never happened before.

What is the biggest danger of the stimulus plan?

That it will be a false start. It will be priming a pump that still has an empty well underneath. It will stop again even harder, and we will be further in debt and have further problems in the financial system from that debt.

What else concerns you?

Just as we ignored the absurdity of home prices before, we are now taking that absurd calculation to the negative in terms of bank balance sheets.

There are many securities in banks that are perfectly current and likely to pay over time that are now being marked down to 30 or 40 cents on the dollar -- because the accountants think they aren't going to work out. We aren't giving it a chance. So we are now absorbing problems that don't exist in the future. We are truncating them into the present, and we are making the hole that much deeper and the inability to fill that hole becomes that much more shocking and it scares the private investor away.

It looks like the stimulus package, whatever form it finally takes, will include some tax cuts along with a lot spending.

As I said, there is at least $2.5 trillion that has to come out of consumer spending in order to pay down debt and build savings. If you want to replace that $2.5 trillion with the government, they are only at around $800 billion. No. 2, going back to the economic stimulus of early 2008, we now recognize that the bulk of it wasn't spent; it was saved. So you can split this package any way you want. It isn't going to give the desired effect. It is going to give a false small blip, although it could give us a spike.

You noted recently that bank lending is a small fraction of consumer borrowing. Could you elaborate?

I'm fearful that the government doesn't understand how consumer credit is generated. If savings decline and deposit growth stalls, which it did, how did we have an expansion in the mortgage, auto, and student loans over the last five to seven years? We got it from Wall Street via the secondary market.

Wall Street went out and found investors willing to take a package of securities. When you go get a car and you do it on credit, you don't want to go to the bank. At the showroom someone helps you fill out the form for what is, in essence, a loan that is going to be funded by Wall Street, which then finds the investor. For all consumer debt, Wall Street has provided $3 out of $4 of the credit. That is what has collapsed, and that is what needs to be rebuilt.

What needs to be done to fix the secondary loan market?

No. 1, we have to have price discovery, so we all understand how toxic the toxic assets are. The second thing we need to do is literally rebuild what has been destroyed, somewhat unnecessarily, on Wall Street in terms of generating credit from investment pools and other liquidity pools – not from deposits. The final thing we need to do is to stock the banks with deposits, and we can't do that until people save.

Is it time to start nibbling at the financials?

The opportunity is coming, and it could come as early as later this year -- if it is clear the government understands the problem and does no more harm. This could be a massively great opportunity to invest, but it could also be a kiss of death, and you can't tell which one it is from the information we now have.

What is your advice to investors?

Keep your powder dry; focus on sectors outside the financials, and remember how we got here -- which was the enormous strength of the emerging markets getting the model right and building their own domestic infrastructures and their own domestic demand.

We make a big mistake when we think that we are still leading the world and that all those emerging markets rely on us and other industrialized countries for export demand. It is still critical. It is still important, but most of these countries, most notably Brazil and China, now have huge domestic markets, and no one has noticed that they are increasingly independent.

Your outlook is very cautious, but are there any sectors that look attractive to you?

My fear is that the recession is multiyear, and completely different from what we have seen before. It seems to me that the consumer is down for the count. The government can only go so far, and the corporate sector can revive eventually. If you want to focus on areas that are going to benefit from infrastructure improvement, that certainly makes sense. If you want to focus on agriculture, commodities and raw materials, and bet on the emerging-market demand driving those prices up, that makes sense as well.

Any parting thoughts?

Don't make the same mistake twice. Don't make an assumption that makes no sense. Everyone assumed home prices wouldn't go down, but don't assume they can't bottom and go up. No one would ever have guessed interest rates would have been this low. Don't assume that is a normal state; assume they are going back up again.Everyone recognizes that recessions only last 18 months -- but that is wrong, some last longer. We are in a test now for what could be something longer. Don't be in a rush to commit funds. Do it very gradually and wait for conviction, as opposed to the fear of missing the bottom.

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