Understanding the Financial Crisis: extremist predictions for 2009

On Saturday, I had the good fortune to attend a Stanford University alumni event in London (the only European date in a four-year, 20-city world tour by President John Hennessy and distinguished faculty, called Leading Matters). It is not only a way for Stanford to reconnect with alumni, but also a great opportunity for alumni and their guests to hear about multidisciplinary research from faculty members on topics ranging from personalized DNA-based medicine to ecosystems sustainability and energy policy.

The most successful session by far, though, was one where academia and practice came together: Business School Dean Bob Joss (whom I am a great fan of – see a short article here) started off a discussion with alumni Jerker Johansson, CEO of UBS Investment Bank, and Bill Browder, founder and CEO of Hermitage Capital Management.

browder-bill-hermitage-capitalNow, I’m going to focus on what Bill Browder said. It is very much of a Black Swan scenario – yes,  blacker than it’s been so far. Not that I’m giving you such a big scoop: first, because Browder has already gone on the record as fundamentally bearish (see here);  second, because in a couple of weeks’ time you will be able to listen to the whole session on iTunes (the meritorious organizers of the event are making recordings and notes public – see for example the Los Angeles sessions from last January here); third, because he’s probably going to give much the same speech at the  London campus of the University of Chicago next week. It was Browder’s talk that generated the most heated debate at the cocktail reception and dinner that followed, and I did take some notes, so I thought I’d share them with you.

Browder made four – admittedly extremist, but in his view quite solid – predictions for how the crisis will play out in the rest of 2009.

  1. Commercial banks will start “gating” their deposits (i.e., introducing restrictions on how much a depositor is allowed to redeem), probably in the European Union.
    Rationale: the entire banking system still has a precariusly low level of capitalization, and government guarantees are no longer credible – a country like Ireland, with €7bn in offical reserves, cannot possibly make good on €400bn of guaranteed deposits. If 10% of depositors decide to pull their money out, Ireland needs to come up with €40bn in cash, and by the time the ECB has scheduled a meeting to see if they can help out the Irish, the whole Irish banking system is insolvent. That’s why the last resorts for banks – or for governments, really – will be to tell you that you cannot take out more than, say, a thousand euros per week. Can’t happen? It’s already happened – in Russia, Argentina, Latvia, Ukraine. Sooner or later, it is happening somewhere in the EU.
  2. The price of long-term US government bonds will crash.
    Rationale: 10-yr and 30-yr Treasury yields are unrealistically low. The US is facing the biggest budget deficit in its history: even if you argue that the US is not just like any other borrower (which Browder doesn’t believe, by the way), bond prices cannot defy gravity indefinitely. Who will buy enough bonds to finance a $2 trillion deficit? Nobody. Even if buyers can be found for bonds covering half of it, for the other half the Fed’s going to have to print money. And you don’t want to be caught holding bonds with a single-digit nominal return when the Fed prints enough money to generate double-digit inflation. (By the way, an interesting side effect may be that other countries can’t issue bonds at all, because issuing by the US Treasury is crowding out everybody else).
  3. There will be a number of sovereign defaults, including in the EU.
    Rationale: follows from the above. Current risk premiums already imply a probability of defaulting within the next 5 years between 10 and 20% for the usual suspects: Ireland, Greece, Poland, Italy. The probability that at least one of them defaults, even if we don’t know which one, is pretty high. Again, it’s happened before (Russia, Argentina, etc.)
  4. The price of gold will go up.
    Rationale: it’s the only thing that governments cannot print.

The best question from a rather traumatized audience was: “What has to happen for you to be wrong?”

Browder replied that, for his argument to be wrong, asset prices have to stop falling. If we’ve bottomed out today, then the predictions above are wrong. However, note that, no matter how much they commit in relief programs and stimulus packages, governments have never been able to stop asset prices from falling.

Recommendations for the retail investor? Put 90% in Treasuries with extremely short maturities (2 weeks to a month) or, if you have access to it, buy commercial paper by the likes of Microsoft, Johnson & Johnson, and Philip Morris. Put the other 10% in gold. And sit tight.

The only bright spot in Browder’s argument was: the Euro is not going to fall apart. Stress on the Euro is coming from the likes of Ireland and Portugal, not from the healthier countries. The people with the biggest problem have the biggest incentive to stay in the Euro, because doing otherwise would be disastrous for them (as far as Italy goes, I’ve believed for months that without it we’d all be in the streets, banging pots and pans, Argentinian-style). Conceivably, France and Germany could decide they’d be better off getting out of the Euro and leaving the rest of the Euro countries to fend for themselves: yet their political commitment to the Euro is too big. It took 40-50 years to make the Euro, it won’t get unmade in the short run.

And on that happy note, my dear readers, let me remind you that the next Leading Matters is scheduled in San Francisco on May 9 and, given the proximity to the University, promises to be packed with interesting speakers, although it won’t be featuring Bill Browder, I believe. Still, if you have any friends who’ve been to Stanford, get yourself invited and you’ll have a great time fulfilling your intellectual curiosity. And wishing you were back in school, maybe!

3 thoughts on “Understanding the Financial Crisis: extremist predictions for 2009

  1. A few considerations on Browder’s points:

    #1: On deposit gating: the situation in Ireland is rather nuanced. First, foreign bank penetration there is quite high (if I’m not wrong, at least 2 out of the top 5 Irish banks are foreign-controlled). They can easily tap into funds from their international operations, in case they need to. Second, most of the foreign money on Irish accounts comes from the UK. Odd as it seems, when Irish banks started sinking in October 08, inflows from UK actually increased. That was because the Irish government removed size limits on deposit insurance (while UK insurance is still capped to £50k). Finally, a large chunk of UK money in Ireland is Euro-denominated: as long as the pound remains at record low vis-a-vis the Euro, much of the UK money tied up in Ireland won’t be repatriated. Bottomline: with the UK banking system and the pound in dire straits, an Irish bank run is unlikely.

    #2: On US bonds: There’s no doubt that US long term yields are set for a persistent increase – at least in the long run. In 2009 however, US yields may go down even further, as the Fed competes with investors in buying US bonds, in its effort to flood the US economy with freshly minted dollars. The Fed did right that last Wednesday: by splurging $300bn on long dated bonds, they managed to lower the 10y yield by 50bps in few minutes. Also the crowding out argument is controversial: perhaps marginal issuers may suffer a US treasuries glut, but Euro quality issuers (Germany, France and, to a lesser extent, Italy) will offer a safe heaven to investors concerned about inflation in the US and further depreciation of the dollar – both likely scenarios, given Fed’s aggressiveness in countering the downturn.

    #3: On EU defaults: Germany, France won’t allow any EU country to default. It’s the Lehman argument: when the US Treasury let Lehman fail, investors and pundits alike praised US principled stance against moral hazard. But as the markets started wondering who the next Lehman would have been, investors went on full panic mode and credit dried up. In hindsight Lehman default made the downturn much nastier than it would have been otherwise. Now, imagine if Greece is allowed to default: then all the other members of the exclusive PIGS club (besides Greece: Portugal, Italy and Spain), won’t be able to fund themselves at a reasonable price. Ireland and perhaps Belgium will soon follow. As all EU members have relinquished their monetary policy to the ECB, they won’t be able to print money. With serial defaults spreading all over the EU, the monetary union will unravel taking the whole European banking system down with it. A more palatable alternative to this doomsday scenario would be the issuance of joint EU bonds (even if Germany is currently opposing it). The bonds will be guaranteed by the EU as a whole, and their proceeds will be channelled to the weakest countries, allowing them to fund their deficits at more attractive rates, in exchange of partial control on their finances by EU.

    As for investment recommendations: I don’t know if eBay issues commercial paper, but if that’s case I’d love to buy it. It’s difficult to imagine a more defensive name than that, when people shun high street shops to bargain their way out of a recession. I’m even tempted to buy eBay equity – confident that you and your colleagues down in Zurich are working hard to hit your targets.

  2. Thank you Paola for your summary. I have known Bill Browder since he started investing on Russian assets and I have always praised his independent mindset and outspoken attitude. In a world where the vast majority of economists and commentators are willing to pay a fortune to earn the privilege to sell themselves, people of Bill’s caliber are most in demand.

    Gian Piero Alpa

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s