I have often cited Bill Gross, who manages the world’s largest Bond Portfolio, as an economic sage. He sends out a monthly investment letter and his September missive is pretty troubling. As we have discussed for months, the world financial system is in the process of a global “delevering”. I compare it to that point when a couple sits down with the monthly credit card bills and decides you can no longer carry tens of thousands of dollars of credit card debt at 16% interest. To pay it down you usually have to sell something–a stock, a bond, that boat you never use or maybe that second home you were going to retire to. That’s delevering. This process is going on all over the world and as the chart above shows the composite prices of stocks, bonds and real estate are falling at the fastest rate since The Great Depression.
This rarely observed systematic debt liquidation is what confronts the U.S. and perhaps even the global financial system at the current time. Unchecked, it can turn a campfire into a forest fire, a mild asset bear market into a destructive financial tsunami. Central bankers, of course, adopting the cloak and demeanor of firefighters or perhaps lifeguards, have been hard at work over the past 12 months to contain the damage. And the private market, in its attempt to anticipate a bear market bottom and snap up “bargains,” has been constructive as well. Over $400 billion in bank- and finance-related capital has been raised during the past year, a decent amount of it, by the way, having been bought by yours truly and my associates at PIMCO. Too bad for us and for everyone else who bought too soon. There are few of these deals now priced at par or above, which is bondspeak for “they are all underwater.” We, as well as our SWF and central bank counterparts, are reluctant to make additional commitments.
What Gross is saying is that he and many other managers of large capital pools were suckered into thinking this was an ordinary Recession. So they rushed in to prop up Lehman Brothers or Citibank with new capital. But the market keeps dropping and so they are underwater and loath to commit anymore funds. That’s why the attempt to refinance Freddie and Fannie in the last three weeks failed. So on a macro level, when the assets you need to sell in order to pay down the debt keep falling in value because there are no buyers–you are in a trap–“a financial tsunami”. Gross says there is only one solution.
If we are to prevent a continuing asset and debt liquidation of near historic proportions, we will require policies that open up the balance sheet of the U.S. Treasury – not only to Freddie and Fannie but to Mom and Pop on Main Street U.S.A., via subsidized home loans issued by the FHA and other government institutions.
To watch the Republican Convention last night, you would have no clue that there is a financial tidal wave 1000 miles off shore heading right for both Wall Street and Main Street. McCain’s only hope is that it doesn’t break on shore before Nov. 4th.