Shorting the Economic Recovery

PERHAPS ONE OF THE greatest failings in the run-up to the financial meltdown was a lack of perspective -- an inability by many market participants to see the big picture. Not so with Kevin Duffy and Bill Laggner, principals of the Dallas-based hedge fund Bearing Asset Management. With the help of their proprietary credit-bubble index, developed in 2004, the managers sounded early warnings on housing and credit excesses, and capitalized handsomely on their forecasts by shorting Fannie Mae, Freddie Mac, money-center banks and brokers, builders, mortgage insurers and the like.

Students of the Austrian school of economics, which espouses a free-market philosophy that ascribes business-cycle booms and busts to government meddling with interest rates, the pair is solidly in the contrarian camp, believing that the worst for the markets may be yet to come.

The two established Bearing in June 2002 after running their own money and, before that, a stint by Duffy at Lighthouse Capital Management and by Laggner at Fidelity. Bearing now has about $60 million under management, and they have returned on average an impressive 18.28% annually since setting up shop. They hold refreshingly against-the-grain views on what's ahead.

Barron’s: You’ve said that perhaps the most redeeming feature of capitalism is failure. Please explain.

Duffy:Any healthy system needs a way to correct error and remove waste. Nature has extinction, the economy has loss, bankruptcy, liquidation. Interfering in this process lengthens feedback loops. Error and waste are allowed to accumulate, and you ultimately get a massive collapse.

Capitalism is primarily attacked by two groups: utopians who wish to impose a more “compassionate” system, and political capitalists who want to enjoy the fruits of success without bearing the pain of failure. They use the coercion of the state to gain privileges, at the expense of everyone else.

As a country we’ve become less tolerant of economic failure. The result has been a series of interventions, such as meddling in the credit markets, promoting homeownership and creating a variety of safety nets for investors. Each crisis leads to an even greater crisis. The solution is always greater doses of intervention. So the system becomes increasingly unstable. The interventionists never see the bust coming, then blame it on “capitalism.”

What would you have done differently as the credit bubble was bursting and the Fed and the Treasury were declaring that the world would come to an end without an $800 billion bailout package ?

Duffy: Allow those who essentially bet wrongly to fail, instead of bailing out people with friends in high places.

What about the argument that a financial panic would have ensued and crushed the little guy ?

Duffy: The little guy actually has been crushed. Nobody is asking where this money is coming from. And the money has to essentially flow into the political economy at the expense of the real economy. The little guy is always going to be the last one in the soup line. So he will get a bone tossed to him, like cash for clunkers. But if you are Goldman Sachs or if you have got essentially the red bat-phone to Washington, D.C., you are first in line.

Laggner: AIG made sure its creditors received 100 cents on the dollar. Essentially you have the socialization of risk, but the survivors are still highly leveraged. There is still a multi-trillion dollar shadow banking system that FASB [the Financial Accounting Standards Board] wants to address next year. The central planners have already spent $3.15 trillion on various bailouts, credit backstops, guarantees, etc., and given approximately $17.5 trillion of government commitments, etc., while allowing many of these institutions to remain in place, with the same people running them.

What else could have been done ?

Laggner: We could have isolated the money centers and put them in temporary receivership. Then, we could have created — with a mere $100 billion — a thousand community banks. If you believe in fractional reserve lending [in which banks lend multiples of their deposits], something we don’t support, they could have created a trillion dollars in new credit that would have flowed to small and medium-sized businesses. Those are the parts of the economy that are choking. Because there has been no reform, it looks like we are going to be spending more money. We are going down this very treacherous path, where debt continues to skyrocket. Private-sector debt is being offset by the public sector. Meanwhile, the cost of funds for small and medium-sized businesses has gone up, while the cost of borrowing for the survivors is little to nothing, and they are speculating with that money, as opposed to letting it flow through into the real economy.

What kind of financial reform would you like to see ?

Laggner: We don’t believe in a central bank. The idea that banks can speculate with essentially free money from the [Federal Reserve], which ultimately is the taxpayer, and that when they lose money the Fed bails them out and then passes that invoice to the taxpayer — that whole model is broken and needs to go away.

How would you refashion the system ?

Duffy: To get to the heart of the problem, we need to address fractional-reserve banking, which is causing the instability. We have essentially socialized deposit insurance and prevented the bank run, which used to impose discipline on this unstable system. At least it had some check on those who were acting most recklessly. Until we address the root of the problem, we are going to have a series of crises, greater responses and intervention, and more bubbles — and the system will keep perpetuating itself.

Where are we in the deleveraging process ?

Laggner: We had a massive real-estate bubble and credit growth, thanks to off-balance-sheet banking that went to four or five times gross domestic product in the latter part of this decade — and of course it burst. Because of huge government commitments, we now have rolled the credit bubble into a sovereign-debt bubble.

The question is, how is the government going to service all this debt? As the real economy contracts and as the political economy expands, this coordinated global debasement strategy ultimately fails.

How do you play that ?

Duffy: The immediate risk is the economy. We’ve had a nine-month rally. We think it’s a false rally. Some sentiment levels have returned to the extremes of optimism of 2007. We are essentially doing a long-short strategy — long physical gold, short the Standard & Poor’s 500. At the 1980 peak, the ratio of the gold price to the S&P was about six times; at the low in 2000, it got down to 0.2; today it is at about one. We can go to two, three, four times.

Do you see the S&P 500 retesting its lows of this year ?

Duffy: It’s difficult to know. It depends on how much money gets printed. In real terms, can we get cut in half from here? We think so. S&P earnings are distorted because of accounting changes for banks and brokers; if banks were marked to market, S&P earnings next year could fall to $45 a share. Bullish sentiment is rivaling the 2007 top, and volatility has fallen dramatically. We like the VXX, an exchange-traded note that’s based on S&P 500 short-term volatility as measured by the VIX index. It’s down 67% this year, and fits into the whole idea that complacency is very high.

Indeed. Are there any sectors of the market that you do find attractive ?

Duffy: We are long consumer staples, discount retailers and pharmaceuticals. One way to participate is through the Gabelli Healthcare & Wellness Trust [ticker: GRX]. It holds roughly half health care and half global consumer brands in high-quality names like Danone [DA], Nestlé [NSRGY] and CVS Caremark [CVS]. It trades at a 20% discount to net asset value, though it has a fairly high expense ratio of 2.16%. If you look at Big Pharma, during the tech-stock and growth bubble of 2000, these companies traded as growth stocks, with an enterprise value to annual research and development spending of about 50 times. Today they’re trading at 10 to 15 times. We like fallen growth stocks that are cheap, like Wal-Mart Stores [WMT]. The stock has gone nowhere in the last decade, but gross profits have grown 2.7 times.

What are your other themes ?

Laggner: We are heavily short Japanese and U.S. government long-term bonds. Greece’s deficit to GDP is approaching 15%. If you look at the proposed debt-ceiling increase in the U.S. [the Senate voted Thursday on a near-term increase to $12.4 trillion from $12.1 trillion] and at the current administration’s planned spending, we are probably going to be at roughly 13% deficit to GDP this fiscal year, so basically we are Greece, where 10-year-bond yields rose 160, 170 basis points. [A basis point is a hundredth of a percentage point.] U.S. bonds are down about 20% this year, so we see a process in which creditors just shy away from funding our long-term obligations, and long-term rates keep creeping higher.

The Fed has controlled the long end by monetizing Treasuries and mortgage-backed securities. If they see the long end getting away and decide to come back into the market and buy, that will result in a much lower dollar and higher gold prices. Gold is reflecting not just inflation but instability around the world related to these business models that have been adopted by governments.

Yet the EU said it won’t bail out Greece.

Laggner: Maybe we’re at a turning point, where the bailouts have been so extreme that both our central bank and the ECB say we just can’t continue to do this, otherwise we are going to have currencies evaporate overnight. But we haven’t seen much of anything in the way of just cutting government spending, either here or in Europe.

What about the big banks? When do we see the denouement ?

Laggner: There is some deleveraging in the consumer space, but little or none in the professional-speculator space, the bank money-center space. Credit Suisse is apparently allowing its hedge-fund clients to return nearly to the leverage levels at the peak, in ‘07. Assuming financial-accounting regulators reinstate off-balance-sheet rules on securitizations early next year, Barclays estimates it will bring roughly $500 billion in off-balance-sheet assets back onto bank balance sheets in 2010. That is going to force the banks to raise capital. A lot of structured finance is carried on the books of banks at close to par.

The FDIC [Federal Deposit Insurance Corp.] took over Corus Bank and Guaranty Bank and liquidated their books, and that debt is going for anywhere from 33 to 37 cents on the dollar. Until the regulators force banks to realize these losses, it’s like the entire financial sphere is in suspended animation. A large chunk of CMBS [commercial-mortgage-backed securities] aren’t being serviced. The same with residential mortgages, whether in the loan-modification-market program or not: Banks are able to carry a lot of these loans as performing loans, even though they are not performing. Japan tried the same thing, and it just lengthened the process. And we are going down that Japanese road.

That can’t be good for the banks.

Duffy: We’re essentially short the political economy, and the most politically connected firm is Goldman Sachs [GS]. It has two sides: a highly secretive and profitable trading operation, and a more pedestrian public business. Our suspicion is that their secret sauce is access to friends in high places, and that the model breaks when it either flies too close to the sun or a public backlash opens them up to scrutiny. Trading and principal investments account for 67% of net revenue this year, the highest level ever. Goldman, aggressively plying the risk trade, is vulnerable to the next leg down.

Speaking of a backlash, we now have Goldman managers toting guns to protect themselves from populist rage. At what point will society demand some sort of change from the government ?

Laggner: A client sent me an e-mail the other day in which the tea-party demonstrators are getting a higher approval rating than the Democrats or Republicans. There is a backlash building, and that’s a very good thing. But it’s a process. As the arrogance level of central bankers or the money-center banks continues to grow, 2010 and the mid-term elections will be very exciting.

Duffy: Last year, 70% of the people were opposed to the bailout. And so far, through these massive interventions, government has been able to stabilize the financial system. But you have this divergence between the real economy and the political economy. People are still hurting. Consumer confidence has not rebounded like investor confidence has. If we are right, and we are heading for the next leg down, that’s when I think all bets are off. If the political economy and some of those who got bailed out are back asking for another bailout, that’s when the backlash really starts to heat up.

For bear markets to end, they have to teach lessons. But the people who didn’t see this bus coming 2[frac12] years ago — they’re back in droves, and they’re bullish. We haven’t changed behavior, and this bear market will not end until we do.

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