You Wrote ‘Bailout Nation’ During the Financial Crisis, What Is Your View Five Years Later?
So we had a situation during the crisis where there was a window for the government, the Treasury Department and the Federal Reserve to really affect some discipline on Wall Street. If you read Roger Lowenstein’s book ‘When Genius Failed The rise and Fall of Long-Term Capital Management,’ which blew up famously in 1998, there were 28 key partners who had to be exposed to their liability, to long-term capital management (LTCM).
And the Fed could have very easily said: ‘Hey this is on you guys, you made loans to a highly leveraged hedge fund, what did you think was going to happen? You lent money to them at a hundred to one, what are you thinking?’ Instead the Fed, concerned about destruction, misses the opportunity to teach a lesson about moral hazard. When LTCM was rescued there was a general thought: Hey these guys are on the job if we screw up they got our backs.
So when 2004, ’05, ’06, ’07 started coming along, everybody was pretty comfortable in terms of taking on more risk using more leverage. Look at Bear Stearns and Lehman Brothers. They were 40 and 50 to 1 [debt compared to capital] you look at AIG it was a trillion to one or more.
That’s why it cost the government $88 billion to bail them out and I have to tell you I am surprised that all of the net assets of AIG ended up being sufficient to pay it back. There’s a footnote on that: They get this $25 billion dollar tax credit so there’s a little razzle-dazzle; it’s not quite 100 percent paid back but hey it’s much closer than I ever expected it to be. So I give the architects of that bailout for this being a viable valid approach to rescue.
What Could Have Been Done Better?
Let’s use Bank of America as an example. Bank of America gets nationalized, which really means Uncle Sam provides debtor in possession financing. This is really what happens normally with small companies. Someone who takes them out of bankruptcy give some operating money to keep functioning.
The equity gets down to zero—senior management out the door. There is certainly a layer beneath, which can get promoted without a problem. Bondholders, effectively they are highest in the line of who owns what’s left as the lenders. So they take what comes out of that minus Uncle Sam’s share of providing debtor in possession financing.
And you slowly feed all the pieces to the public. So you clean up the balance sheet and take all that debt. By the way there is no such thing as toxic assets. Well at 100 cents on the dollar they are toxic. But at 15 or 20 cents on the dollar there is plenty of upside there. So you take those assets and auction them off and you take what you get—maybe 15, 20, 25 percent. You take Merrill Lynch, which now has no bad debt on its books and you spin it off as a stand-alone.
You take Countrywide, which no longer has any bad mortgages and you spin it off as a stand-alone. And you do that with Bank of America and you do that with all the other divisions. It takes about a year it’s painful. The shares are worth zero.
Had we gone through what I recommended in the book I think it would have been more painful, it would have been tearing the Band-Aid off. But here we are five, six years later, we’d be much healthier. We’d have a much healthier financial system; our housing market would be much better. What would have happened in that process: We would have written all these bad mortgages down.
You know a lot of the reasoning behind the Fed doing what the Fed is doing was to help prop up the holdings of the banks. They are still stuck with mortgages. Fewer bad mortgages that we had two or three years ago but if you want to know why we had QE for all this time it’s to allow the real estate market to rise enough that the banks can work their way out of these mortgages.
Had we gone through that normal bankruptcy reorganization process, all those mortgages, all those houses that were bought for $400,000 and $500,000 and $600,000 with no money down, with no income check, all that junk; houses that are now worth $250,000 would get sold to somebody else for 50 cents on the dollar.
They go to the people who live there and say: Hey you took at $600,000 mortgage the house is worth $250,000, we’ll renegotiate, start paying your mortgage, new mortgage at $225,000. So the mortgages will get sold as part of that toxic pile for 15, 20 cents on the dollar and they go out at 30 or 40 cents on the dollar.
And everybody is happy. The people who are living in houses can afford them. They are spending money like normal people going through this deleveraging process. There are lots and lots of benefits to following the law and going through regular reorg. We didn’t want to do it because it’s way too painful short term and it’s way too scary. And you have a Treasury secretary who was former head of Goldman Sachs [Hank Paulson] when this began and the next guy was former president of the New York Fed [Timothy Geithner]. It’s funny you have bankers in those roles.
You Called the Top Before the Last Crisis, What’s Your View on the Markets Now?
So the key question in my mind is: Are we in a new secular bull market? And when we talk about secular markets, these are the long periods of time—10, 15, 20 years where a dominant economic theme drives everything.
The key question is despite all the other things we’re talking about: Is 2013, or maybe we go back to the beginning which is 2009, is this a new secular bull market that could last 10 or 15 or 20 years? There are increasing signs that yes, this might be.
There is an ongoing bid for equities, there is a demand for risk assets and the people who have been erroneously calling for a market collapse for 5 years just refuse to acknowledge it.
I don’t believe the cash on the sidelines argument. If I have stock and I sell it to you well the cash goes from your sideline to mine. It doesn’t make a difference but there’s a ton of wealth, whether we’re talking about endowments or sovereign wealth funds or pension funds or just regular IRAs and 401ks.
There is lots of money that needs to be deployed and that creates a huge bid and it’s hard to find alternatives. Bonds pay very, very little, real estate has its benefits, commodities had a huge run; they seem to be broken.
Here we are in November 2014; gold is still 30-something percent off its highs. That was a fantastic bull market from ’01 to ’11 that bull market is now broken, that trend is broken and it’s hard to see. So we’re about $1,200 on gold.
If someone says gun to the head: Is it going to go up to $1,600 or down to $800? I would take a bet and say it’s going to go down to $800 first not to $1600. When a market like that breaks it takes a long time to recover. Remember we had the peak in gold in the early ’80s. You didn’t get past that for 20 something years later so it could be another 20–25 years if historical patterns hold.
What About Equity Valuations?
Stocks are not as appealing today as they were five years ago, they’re fairly fully priced; they’re fully valued. You have a lot of what’s been driving stocks was cheap money and share buy backs and increased dividends so they’re a little ahead of themselves.
Normally we have the economy doing this: Following a credit crisis it’s a much more gradual recovery and eventually it’ll start to normalize. We’re probably a couple of years from that—maybe even a recession away from that. But we’re seeing improved GDP; we’re seeing improved job creation we’re starting to see the very earliest signs of wage pressure, meaning everybody’s income is going to go up.
When that happens, you get a virtuous cycle and I don’t want to say trickle down because that’s really a terrible phrase, but we’ll start to see the benefits of the economic expansion go beyond just the top 10 percent or so of society. You know we’ve created 10 million jobs or so over the past six years it’s not as robust as it should be but it’s moving in that direction.
What If the Fed Starts to Raise Rates?
When we see the Fed start to raise rates it typically means that the gains we see in the market slow down a bit. When you start from a low level and low inflation and you’re raising rates people assume that’s a negative for stocks. It’s not. It’s where you start at a fairly high set of rates and there’s inflation.
When the Fed raises rates from there it’s terrible for stocks. But when you’re starting at zero, if you can’t grow your profits with the Fed taking rates to 2 percent, which is not a restrictive fed funds rate. They’re going to have to do it perfectly, they’re going to have to do it gradually and we don’t know if they’re going to hit the landing perfectly but so far between deflation and inflation they seem to be managing to work the middle where you don’t have deflation.
People have been screaming about here comes inflation for six years—it hasn’t shown up. And now when we look at all of the excess supply coming on in terms of oil that’s a key driver of inflation and energy prices. We are now close to $60 oil. And if you look at the chart of U.S. oil production, it’s practically doubled in the past five years. We are not that far away from being energy self-sufficient in this country and as soon as it happens we start to care a whole lot less about the mayhem in the Middle East.
Barry L. Ritholtz is the founder and chief investment officer of Ritholtz Wealth Management. A frequent and respected commentator on the financial markets, Ritholtz is the author of “Bailout Nation,” a critically acclaimed book about the banking rescue during the financial crisis and its consequences.
The interview has been edited for brevity and clarity.