Rattner: credit quality deterioration ‘well underway’

The chairman and chief executive officer of Willett Advisors – which manages the personal and philanthropic investment assets of Michael Bloomberg – and former Counselor to the Secretary of the Treasury, shared his thoughts on the US economy at the PDI New York Forum in September.

Rattner on…how the global financial crisis came about

It was a combination of factors that include, in no particular order: poor regulatory oversight from the federal government in terms of really understanding what was going on in the financial system and in curbing things that we later knew to be excesses; and poor risk management on the part of a lot of banks and other financial institutions who were buying things that they either didn’t understand or overpaid for or got out in front of them.

I remember in the summer of 2007 I was helping Mayor Bloomberg buy back part of the interests in his company that Merrill Lynch owned at the time. I sat down and tried to read Merrill Lynch’s financials and I couldn’t understand any of it – it was so complicated, there was so much off-balance sheet stuff, there were so many what we used to call the SIVs and the conduits and all this stuff. I remember thinking ‘this is a very unusual way to run an institution’ and of course it didn’t really work out very well.

It all came together in this perfect storm where you had over-leveraged banks – Bear Stearns first and then Lehman Brothers – and then this cascading effect into Fannie and Freddie [Mac], into Citi and [Bank of America], AIG and so on. And then of course the financial effects spilled over into the real economy and that caused a recession.

…where we are today

Hank Paulson, Tim Geithner and Ben Bernanke have been doing a number of sessions [at the forum] in the last few days. [They] deserve a lot of credit for what they did. This could have been 1929, this could have been the Great Depression, it could have been a financial Armageddon, and we’re really very fortunate that those three guys and a lot of other people really did save us. There’s no doubt about that.

The second message they’ve been conveying, which I agree with, is we are actually in some ways better prepared for the next crisis and in some ways worse. Essentially the Fed[eral Reserve] and the federal government did what it could to put us back on a growth trajectory, so when you look at how fast the economy turned, how fast the stock market turned, it really is quite remarkable. We’ve now had a long period of sustained growth, low inflation, low interest rates. We are now in the longest post-war expansion in history, we’ve had 124 months, and right now things are going pretty well. The biggest concern I have is that growth has been somewhat slower than normal and productivity growth – very, very importantly – has also been slower than normal, and that does tend to cause slow GDP growth.

…when the next downturn might hit

There was a study done not too long ago by The Economist which found that over a 15-year period, of 220 instances in which a member’s economy contracted in the year-ahead, not once did the IMF forecast the downturn.

So before any of us say ‘we’re going to have a recession next year’, I think we have to be humble about it.

Economists like to say that recoveries don’t die of old age, but they kind of do. You get imbalances in the economy, something gets out of whack, you start to get inflationary pressures, or you get these poor credit quality instruments floating around. But it’s really, really hard to predict. As I sit here today, I will fall into the trap of saying I think we’re still in a recovery mode for as far as I can see, but for the next year or two it’s very hard to see what would derail the recovery. The stock market might be a slightly different issue. But we are growing rather quickly, we still have quite low inflation, we don’t see those kinds of imbalances, at least not from where we’re sitting, again with a big note of humility.

…on regulatory weapons to fight a downturn

In reaction to the so-called bailouts of the banks and financial rescues, which were unbelievably unpopular among the people and still are to this very day, as part of Dodd-Frank, Congress took away from the Fed and the Treasury a fair amount of their power to provide emergency lending assistance to failing institutions. And that is a very scary situation. Because while you can hate the bailouts, or believe as I might that there are some things that could have been done differently, that would have created less popular resistance to them, it was the ability of the Fed and the Treasury to move in that really saved us from Armageddon.

There’s a second thing in Dodd-Frank that I don’t like. They have set up a better mechanism – and this is a plus – for winding down failing large banks. The Federal Deposit Insurance Corporation has always been able to deal with failing little banks, but wasn’t in a position to deal with failing large banks; they’re just so complicated.

They gave to the FDIC the authority to make sure the subordinated lenders and the equity holders in those banks take haircuts, which didn’t happen last time because it just couldn’t be done structurally. While very good at saving little banks, the FDIC doesn’t know anything about saving big banks. And I really think that power – and that was a political decision – would have been better vested in the Fed.

…on what keeps him up at night

I do worry about the trade war; tariffs are a tax, taxes slow the economy, trade is good for an economy, I think that’s been well proven, and if we get into a trade war and the amount of trade drops off, that’s also bad for economic growth.

The second thing is this build-up of inflationary pressures that one can vaguely see. I think it is a potential worry and something we should really keep a close eye on. I think the recent moves in 10- and 20-year treasuries may be signalling something, we’ll see, but we should be watching those unemployment numbers and the wage numbers and the consumer price index numbers and the personal consumption expenditures numbers – very, very carefully.

The third thing I worry about is that, on paper, what’s happening in the Howard Marks world of ‘too much money chasing too few deals’, is visible. You can see that spreads between high yields and investment grade loans are not all the way back to where they were right before the global financial crisis, but they’re pretty darn close. And there are other measures, like the share of deals being done through covenant-lite structures, that also tell you things are scary. And you can also look at the debt ratios that are going into private equity deals – the Fed had a policy that they didn’t want more than 6 times debt to leverage in private equity deals, that has sort of been nudged up a little bit. There’s indicators in every direction that while most of the really crazy financing structures that existed at the time of the great financial crisis have been taken off the table, the more conventional, simple act of credit quality deteriorating in a bull market is obviously well underway and is a scary situation.