Let's Get It Right

Back in the summer,1 I warned that the financial markets were headed for serious problems. But even my worst fears pale in comparison to what actually happened: nothing less than a near-death experience for western finance. The markets survived the collapse of Bear Stearns & Co., Inc., in February of 2008. But, the aftershock created a series of tsunamis that overwhelmed the world markets; institutional

Back in the summer,1 I warned that the financial markets were headed for serious problems. But even my worst fears pale in comparison to what actually happened: nothing less than a near-death experience for western finance.

The markets survived the collapse of Bear Stearns & Co., Inc., in February of 2008. But, the aftershock created a series of tsunamis that overwhelmed the world markets; institutional failure after institutional failure flooded the system. In September 2008 alone, we saw the markets struggling to absorb the government conservatorship of Fannie Mae and Freddie Mac; the largest bank failure in U.S. history, Washington Mutual; the assisted takeover of an even larger failed institution, Wachovia Bank; the $600 billion bankruptcy of Lehman Brothers Holdings Inc.; the government bailout of insurance giant American International Group, Inc. (AIG); and the unveiling of the highly controversial and profoundly flawed $700 billion federal bailout plan of the U.S. financial system (which did not become law until October of 2008).

We're starting 2009 under the leadership of a new administration and facing a new set of economic challenges: a bailout of the American automobile industry; the most serious recession in 25 years; continued reluctance on the part of financial institutions to lend; and few signs that the all-important housing market is beginning to recover from its depression.

We can get this nation back on track. Individual investors can make money in a limited number of asset classes — but they should concentrate on preserving capital until the storm passes.

What Happened

First, we need to be honest about what happened. Without question, the bankruptcy of Lehman Brothers was the tipping point that almost sent the global financial system into an uncontrollable tailspin. The markets had several months to prepare for the probability that Lehman Brothers would be unable to survive as the smallest of the independent investment banks. The firm's large and increasingly illiquid and troubled real estate portfolio was an insurmountable problem. But one of the most powerful emotions driving human behavior — and financial markets — is denial. Many important market players, including Lehman Brothers' own management, convinced themselves that the government would never allow such an important firm to experience free-fall bankruptcy. Unfortunately, they were woefully wrong.

For the officials that allowed Lehman to collapse, the firm's demise turned into a lesson in unintended consequences. Lehman's fall claimed victims as diverse as:

  • the Reserve Primary Fund, a large money market fund that lost so much money on its Lehman holdings that it set off a panic in the entire multi-trillion dollar money market industry;
  • the arcane and opaque $55 trillion credit default swap (CDS) market, in which tens of billions of insurance contracts on Lehman's credit or to which Lehman was a counterparty had to be settled; and
  • hedge funds that lost access to more than $60 billion of assets held in custody at Lehman Brothers' Prime Broker unit in London.

Without question, regulators would not have allowed the firm to fail had they foreseen the ripple effect.

Indeed, Lehman's collapse shattered the psychological underpinnings of the global financial markets. Martin Wolf of the Financial Times describes the financial system as “a pyramid of promises — often promises of long or even indefinite duration.”2 Wolf also points out that, “[a]s the financial system grows more complex, it piles promises upon promises.”3

When Lehman Brothers collapsed, the pyramid of promises came tumbling down. Credit, which is a promise to repay a fixed amount of money, is the form that many of these promises take. In recent years, credit became the dominant form that financial promises assumed. In the wake of Lehman's bankruptcy, investors and institutions lost confidence in the ability of their counterparties to keep their promises. They no longer believed that borrowers would repay their loans.

The government was forced to step in and guarantee these promises to restore that confidence and give financial actors the impetus to begin making promises again. One could argue that propping up Lehman would have been a far less expensive way to support the financial system than allowing it to collapse.4 Once the systemic damage done by the Lehman bankruptcy began to be tallied, nothing less than the type of broad guarantees brought by the passage of $700 billion Troubled Asset Relief Program (TARP) was needed to prevent a domino-like collapse of more financial institutions and a complete collapse of the system.

Everybody, including those that created it, now realizes that the initial form of the Bush Administration's bailout plan was severely flawed. Purchasing $700 billion of toxic mortgages, as originally intended, would do little to restore the credit markets to health. The biggest problem: many of these securities are still carried on the books of financial institutions at far above their current market value. So, to buy the mortgages, the government would be faced with the choice of either paying fair market value for the assets, thereby triggering further losses at these institutions — or overpaying for the mortgages and thereby cheating the American taxpayer.

Fortunately, Treasury Secretary Henry Merritt “Hank” Paulson, Jr., quickly changed tactics and used the broad authority provided in TARP to invest $250 billion directly in the nation's financial institutions, including $125 billion in nine of the largest and most systemically important firms.

These investments will be a far more efficient use of American taxpayers' money — but only if the government can compel these firms to re-circulate the funds back into the economy through new loans. Each dollar should create about $10 of new economic activity through something economists call the “money multiplier effect” — making about $2.5 trillion available.5

Unfortunately, as of early December 2008, the recipients of these funds had not yet begun to loosen their purse strings and make loans to consumers and businesses. Instead, the TARP money was being used to burnish battered balance sheets. Banks still did not believe that borrowers were in a position to keep promises and repay loans.

How To Fix It

There is a way out of the economic morass into which years of speculation and profligate government spending have driven the United States. But economic renewal and redirection will require a government commitment of funds and ideas into productive activities and away from policies that reward the types of speculative economic activity that brought the most powerful economy in the world to its knees. The remaining TARP money could go a long way to solving the United States' problems, if used wisely. The American people need not be taxed into oblivion, and the U.S. dollar need not be permanently debauched. We can get this nation back on the right economic track.

There will be two broad components to America's economic recovery: an economic recovery program and sane regulatory reform.

  • The Economic Recovery Program: The $700 billion bailout package that President-elect Obama will inherit from the Bush administration gives broad authority for the new administration to place its stamp on economic policy, and to do so very quickly. Barack Obama's actions out of the starting gate will provide an early read on his economic philosophy and governance approach.

    I strongly recommend he take these five steps:

    1. Housing — The economy will not improve until the national housing markets stabilize. For that to happen, the deterioration in housing prices must end. The Obama administration's first order of business should be a housing stimulus plan designed to keep people in their homes and lighten their mortgage burdens. There are already too many vacant homes in this country; adding more will only increase the economic burden on the financial institutions that own them, the families that lose them, and the communities that surround them. Mortgages should be modified by extending their maturities, lowering their interest rates and reducing their principal amounts where the amount of the loan exceeds the value of the home by a specified amount. The government (or the financial institution holding the mortgage) then should become a de facto partner in owning the property and share in any profits ultimately earned when the house is sold.

    2. Government Stimulus Plan — There will undoubtedly be a government stimulus plan passed in the early days of the new administration. Any plan should be at least $750 billion in size. This plan should be focused on building projects that are environmentally responsible and add to the productive capacity of the U.S. economy. This is no time for earmarks and “bridges to nowhere.” Lobbyists should be banned from the process and merit should be the only criteria for funding projects. Much of America's transportation and energy infrastructure need repair. For example, the country's electricity grid needs significant rebuilding. Furthermore, the United States needs to build something on the order of 50 or 60 nuclear power plants to reduce its dependence on fossil fuels. Instead of listening to excuses about how long it takes to build these plants and how expensive it is to complete them, let's get it done. If the French can power 75 percent of their homes with nuclear energy, what's our excuse?

    3. Energy — Energy remains one of the most significant long-term challenges facing the United States. The recent drop in oil prices does nothing to change that. When President George W. Bush took office, oil was $18 per barrel. In early December, it dropped below $50 per barrel purely as a result of the crippled economy. The fact that it is only 250 percent rather than 800 percent more expensive than it was when the last president took office doesn't mean we don't have a problem. Reducing our dependence on fossil fuels is an economic and environmental priority. There are two highly unpopular steps that President-elect Obama should take as soon as he takes office that would make clear “change” has arrived. Both actions would have a significant impact on lowering gasoline usage. First, he should propose that Congress raise gasoline taxes by $1.50 per gallon to discourage unnecessary gasoline usage. Second, he should reinstitute the 55 mph speed limit on all federally financed highways. These will be hugely controversial moves that will demonstrate that our new president is willing to place principle above politics. Like Pavlov's dogs, until Americans equate gasoline usage with pain, they will not be broken of a habit that threatens their economic and environmental future.

    4. Energy and the American Automobile Industry — In October 2008, Congress approved, and President Bush signed, a $25 billion loan package for Detroit. Unfortunately, this loan package did not provide for U.S. taxpayers to receive any equity ownership in these failing businesses. This omission will become moot as the government steps in with a more comprehensive restructuring of the industry in early 2009. More importantly, though, the automobile industry can be the centerpiece of a new energy policy. At the heart of America's unhealthy dependence on fossil fuels is the American automobile. The $25 billion loan guarantee already approved by the government is designed to provide financing to allow the Big Three to revamp their plants to manufacture more fuel-efficient vehicles. This technology has been available for years, as evidenced by Toyota's success with the Prius and other hybrid vehicles (which, from a technology standpoint, U.S. manufacturers were perfectly capable of producing). Unfortunately, powerful business and Congressional interests have blocked moves to increase fuel efficiency standards. Obama could make an early mark as a leader by standing up to these interests and demanding that the United States stop destroying its environment and economy by clinging to the discredited business models of the Big Three automakers and lead the world into a future in which automobiles are the center of an ethos of responsible energy usage and environmental practices.

    5. Taxation — Unfortunately, there is little sign that President-elect Obama has the inclination to effect the kind of radical tax reform that this country needs. If he wants to effectively change tax policy at the margins rather than simply curry favor with traditional Democratic constituencies, Obama needs to utilize a scalpel rather than a cudgel.

    There are certain applications of the capital gains provisions of the tax code that are clearly inappropriate, such as permitting private equity managers to treat their carried interests as capital gains. A private equity general partner's profits are no more the fruit of their labor than a teacher's or a policeman's salary is the fruit of his or hers, and should be taxed at ordinary income rates.

    TARP fortunately limited the ability of hedge fund managers to defer taxes on their income for up to 10 years, effectively creating a zero percent tax rate in present value terms on billions of dollars of profits (this is no longer a problem for most hedge fund managers, because they're now in the business of losing years of profits, not making them).

    But entrepreneurial activity should not be penalized by high tax rates, and Obama should be careful to limit increases in capital gains and dividends so that there remains a significant gap between these rates and ordinary income rates. Such a gap is necessary to encourage certain types of economic activity that stimulate overall economic growth. Fortunately, his ill-advised plans to raise taxes on dividends and capital gains will likely be delayed due to the financial crisis.

  • The Regulatory Recovery Program: Calls for increased financial regulation are rampant in the wake of every financial crisis. But the problem is hardly a lack of regulation — printing the U.S. Code already kills far too many trees every year. Rather, what's missing is the right kind of regulation and the appropriate enforcement of the laws already on the books.

The rules against naked short-selling demonstrate this point. Naked short-selling was outlawed years ago. But the Securities and Exchange Commission stood by and permitted the rule to be widely violated. Only when the market collapsed did the SEC heed calls to enforce this rule. This kind of regulatory laxness breeds disrespect for the law and those who are charged with its enforcement.

Another regulatory lapse was the ability of the largest financial institutions in the world to establish off-balance-sheet entities designed to conceal assets from regulators and investors. These entities, known as structured investment vehicles, were leveraged as much as 100-to-one and flourished at the same time that the government was prosecuting Enron Corp. and its former executives for establishing exactly the same kind of off-balance-sheet entities that led to that company's demise. While politicians and prosecutors were screaming about the outrageous conduct of Enron's former leaders, they were tolerating the same kind of behavior by some of America's most highly respected corporations! This makes a mockery of the entire system.

Of course, the most egregious regulatory failure occurred in the credit derivatives market. Hiding in plain sight, the CDS market grew to more than $60 trillion in size while regulators, Wall Street firms and politicians stuck their heads in the sand.

CDSs are a type of insurance contract in which one party pays another to protect it from the risk of default on a particular debt instrument. If that debt instrument (a bond, a bank loan, a mortgage or a more complex structured security) defaults, the insurer compensates the insured for his loss. The insurer (which could be a bank, an investment bank or a hedge fund) is required to post collateral to support its payment obligation. But in the heady credit environment that led up to the credit crisis, this collateral deposit was often very small — too small.

Market participants aware of the rapid growth of the CDS market devoted their efforts to keeping it out of the hands of regulators based on specious arguments that CDSs involved off-setting trades that involved no “net” risk to the financial system. Apparently, it never occurred to anybody that the volume of CDSs vastly exceeded the size of the underlying credit risks they were supposed to be insuring, rendering the justification for a hands-off regulatory approach completely bogus.

Moreover, everybody ignored the real risk involved in a market of such gargantuan size, which is the insufficient number of creditworthy financial counterparties capable of absorbing the insurance exposures being written. CDS exposure lay behind the collapses of Bear Stearns, AIG, Lehman Brothers and the near (and future?) failures or forced mergers of many other large firms. As we enter 2009, the market has “shrunk” to somewhere in the vicinity of $50 trillion and remains a black hole staring the global economic system in the face.

The United States is a system of laws. Those laws need to be sensible — and they need to be enforced in a fair and apolitical way.

Here are seven regulatory changes that should be immediately adopted that would prevent a replay of the credit crisis of 2008:

  1. Require executive compensation to be based on multiple years of performance, and to include clawback provisions to prevent executives from retaining compensation based on corporate earnings in early years that are lost in later years.

  2. Limit financial institution leverage to no more than 10-to-one. Allowing these firms to leverage themselves as much as 30-to-one or more was a recipe for disaster.

  3. Hedge fund leverage should be limited to no more than two-to-one for equities (the current margin limit) and three-to-one for debt investments. If an investment needs more leverage than that, it's a lousy investment. We also should restrict the ability of individual investors and hedge funds to use borrowed money to invest in certain products that contain their own internal leverage, such as leveraged exchange traded funds (ETFs). These ETFs-on-steroids are responsible for the dramatic final hour moves in the Standard & Poor's 500 and Dow Jones Industrial Average that have rocked market confidence during the last half of 2008.

  4. Immediately outlaw all off-balance sheet entities. They serve no purpose other than to conceal information from investors and regulators.

  5. Private equity firms should be required to register as investment advisors under the Investment Advisers Act of 1940, as amended. This would subject them to the same valuation and disclosure rules as other investment managers and eliminate the gross abuses of valuation techniques and publication of phony performance data that they continue to promulgate on public pension funds. Right now, private equity funds are operating in a regulatory black hole.

  6. Require all hedge funds to register as investment advisors under the Investment Advisers Act of 1940, as amended.

  7. Reinstitute the downtick rule for short-selling.

How To Invest

All eyes will be on Obama as he takes office in the worst economic downturn in memory. The outlook for 2009 can only be described as bleak. Deflation will be a far more significant threat than inflation for the foreseeable future as the massive deleveraging of the global economy causes asset values of all types to decline. The U.S. economy is unlikely to experience real positive gross domestic product growth until late 2009 at the earliest, and growth into 2010 will likely be well below trend.

  • Interest Rates: It's safe to say that interest rates will flirt with zero in the United States throughout 2009. The Federal Reserve's decision to target the federal funds rate between 0 percent and 0.25 percent is a clear sign the Fed is pulling out all of the stops to stimulate the economy.

    Additional moves will involve the central bank directly purchasing securities to infuse liquidity into the financial system and to further lower the cost of borrowing for strapped consumers and homeowners.

    Central banks abroad also will lower rates, although they are lagging behind in this race to the bottom. The Bank of England made unprecedented interest rate cuts in November and December. Meanwhile, the inflation-obsessed European Central Bank, (which, in a monumental policy blunder, was as recently as July 2008 still rasing rates), joined in with rare 50 and 75 basis point reductions. Japan lowered its rates by 20 basis points, from 0.50 percent to 0.30 percent, which in other circumstances might seem merely symbolic, but is a sign of how desperate central banks are to be seen to be working in concert to battle the global forces of deflation now stalking the planet.

    While interest rates will stay low throughout 2009, this is simply a sign of how desperate the economic situation has become. Low rates indicate that traditional monetary policy tools aren't working. The next steps will be the types of actions that only the most pessimistic among us have ever envisioned. For example, the government could become a direct lender. Let's hope we don't have to go that far.

  • Currencies: The U.S. dollar rallied strongly against the Euro and the British pound as the financial markets ran off the tracks in the second half of 2008. These three currencies should be viewed as a single currency block going forward, and they should be expected to experience weakness against Asian currencies. I continue to like the Swiss franc despite the need for Switzerland to invest billions of dollars to bail out UBS.

    The long-term outlook for the dollar/Euro/pound is poor because of all the money being printed to buoy their economies. But all currency values are relative, and the U.S. dollar should do well against the Euro and the British pound in 2009 for two reasons: (1) Interest rates in Europe and the United Kingdom have farther to fall than in the United States and the dollar/Euro and dollar/pound interest rate differential should shrink significantly; and (2) the European and U.K. economies are likely to suffer from an even more dramatic slowdown than the U.S. economy, in part due to the weakening of their currencies.

    Over the long term, investors should be moving some of their assets out of the dollar, which is clearly in long-term decline especially against its Asian counterparts.

  • Stocks: Investors looking for a rapid recovery in stock prices are likely to be disappointed. Due to recessionary conditions, corporate earnings will be weak for most of the year. Wall Street analysts will continue to lag behind the curve in reducing their earnings estimates, which is why they are analysts — investors should discount anything they say. In early 2008, I predicted that the Dow would drop to 9000 (a 30 percent decline) and that the S&P 500 and Nasdaq would drop by similar percentages.

    I am now warning investors that stock prices could decline by another 50 percent from that level. Goldman Sachs Group Inc. recently sharply lowered its estimate of S&P earnings to $55 in 2008 and $53 in 2009.6 It is reasonable to expect that the earnings multiple during a serious recession might sink to the 6x to 8x range. At a 9x earnings multiple (and the multiple could go lower in the type of severe deflationary environment we are experiencing), the S&P 500 would trade at 475, which would be roughly a 50 percent drop from early December levels. That would bring the Dow down to the 5000 range. I am not saying that this will happen, only that it's a very real possibility based on a review of third quarter 2008 corporate earnings and macroeconomic data.

    At the very least, investors should understand that the stock market's drop is not over. Very few industries will be immune from economic weakness. Investors tend to underestimate the feedback loops that lead markets to overshoot on the downside — and that is the phenomenon about which investors need to be concerned.

  • Bonds and Bank Loans: Debt markets will be the focus of a great deal of attention during the next year as companies (struggling under the weight of debts assumed in the last stages of the debt bubble that popped in the summer of 2007) begin to run out of cash and default. Corporate bonds are trading at distressed levels, signaling that many companies will experience serious financial difficulties in the year ahead. Investment-grade bonds have been unduly punished by these fears and offer significant value in the hands of an experienced fundamental credit manager. At spreads over Treasury bonds of 500 to 600 basis points and unleveraged yields in the high single digits, investment grade corporate bonds are very attractive investments in the hands of a fundamental credit manager.

    High-yield bonds, despite their very low prices, remain extremely risky propositions due to the fact that most were sold in highly leveraged buyout transactions (LBOs) that ultimately will have to be restructured, leaving little or nothing for both the equity holders and the subordinated debt holders. Accordingly, high-yield bonds should be avoided.

    Certain sectors of the bank loan market offer significant value. Specifically, loans of large capitalization borrowers that are capable of amortizing their debt over a relatively short period of time (three to five years) through free cash flow are currently priced at sharp discounts to par and yield 12 percent to 14 percent on an un-leveraged basis. These types of bank loans represent the most attractive debt investment available in the markets today. In contrast, second lien loans and mezzanine loans are unattractive due to their subordinated status and poor prospects for repayment.

  • Gold: Every investor should own a percentage of his assets in gold. Gold remains the anti-dollar, the anti-derivative, the anti-LBO, the quintessential anti-speculative asset. Whatever gold is worth today, it's certain to be worth more 10 years from now in view of where our political and business leaders have taken this country.

What To Hope

In James Joyce's Ulysses, the character, Stephen Daedalus says, “History is a nightmare from which I am trying to awake.” That may well describe investors' feelings about 2008. The coming year may not be as bad, but only because so much has been lost already. The nightmare is not over. Damage inflicted on the economy by the subprime mortgage meltdown and related credit abuses will take years to heal. Investors should continue to play it safe in what will continue to be an extremely fragile economic environment.

And then, maybe, just maybe, investors will have learned from all these mistakes. Maybe they'll direct their funds into productive areas of the economy. And maybe, just maybe, in the future we will avoid the excesses that led to this crisis, which almost destroyed Western capitalism.


  1. Michael E. Lewitt, “It's Going To Get Worse,” Trusts & Estates, July 2008 at p. 26.
  2. Martin Wolf, “Fixing Global Finance,” The Johns Hopkins University Press, Baltimore, 2008, at p. 10.
  3. Ibid., at p. 12.
  4. Earlier this year, I made a similar argument that the government should not permit the failure of the troubled insurance giant American International Group. See “Wall Street's Next Big Problem,” The New York Times, Sept. 16, 2008.
  5. The “money multiplier” describes the increase in the amount of money in circulation generated by banks' ability to lend money out of their depositors' funds. When a bank makes a loan, that money enters the economy as a new deposit from which the borrower can withdraw cash to spend. Because banks are required to keep only a portion of their depositors' money on reserve (generally 10 percent, although arguably this should rise based on recent history), it should be able to lend out approximately $90 for each $10 of money that the government invests in them.
  6. David Kostin, “Goldman Sachs Global Investment Research, 2009 Outlook: Shifting from Macro to Micro,” December 2008.

Michael E. Lewitt is the president of Harch Capital Management, LLC in Boca Raton, Fla.