The role that I play, and which I have built my business around, is trying to help people in the markets understand what is happening in the world of policy and politics, because people in the markets need to be able to discount future outcomes. They are incredibly good at dealing with the risks of the portfolio that you can quantify, and incredibly bad at dealing with those you can’t quantify.
On the other side, I’ve spent a lot of time with policy makers because in general they are pretty clueless about how markets work, as we’re witnessing from current events. They need to understand why the markets are going in a particular direction, what the thought process is. I am literally like an interpreter/translator between these two camps. I don’t know if you guys remember Star Trek, but I feel a bit like I live between the Federation and the Klingons: they inhabit the same universe, but one likes order and the other likes chaos, and they can’t communicate together very well.
Today this is very important to understand, because the relative balance of power between policy and markets has dramatically shifted in favour of the policy, or more aptly, state side. The power of the state to re-define the game cannot be underestimated. I think what we are on the verge of now is markets beginning to recognise that what we’re going through is not just about losses that have already been incurred, but that the rules of the game are changing in such a way that of the activities we have been undertaking in the financial market, many will no longer be permitted going forward. Instead a whole new environment will be created by a new rule set, and this new rule set is highly likely to be what markets will perceive to be ‘unfortunate’ in the same way as Sarbanes-Oxley.
I was personally the White House negotiator for Sarbanes Oxley, and fought it tooth and nail, for which I was labelled a friend of the corporate criminals at the time. This is the atmosphere today as well. I can tell you that there is almost no-one brave enough to go up in front of a Congressional committee and fight on behalf of free and open markets. No one is brave enough to do this. The voice of the markets has been really diminished, and the voice of the state really enhanced.
The political response
It is not well understood in the markets just how powerful the political response to all this is going to be. I’m going to give you a US-centric view to begin with. If I am a member of Congress, here’s how I see it. I’m a Democrat now, as the Democrats are in the majority. My core constituents would be urban areas in America. That’s what Obama has come to power on. The people who received sub-prime loans were primarily African-Americans and Hispanics in urban areas. It’s the core constituency that has been most deeply affected. The political response is formidable. Throughout history, Wall Street has had no friends in Washington. They are the bad guys.
When I was going into government, I went in to visit one Congressional committee. When you are put up for those jobs, you are sometimes being put up for something that requires public confirmation as well. They said my biggest problem, from their point of view, was not that I’d lived overseas for 25 years, which was still not good (it tells you a lot), but it was because I’d been an investment banker. This was in 2001, not today.
Let’s understand historically what happens when a boom turns to a bust, and the public has incurred extraordinary losses. This event we’re going through brings the word ‘extraordinary’ to a whole new level. Typically Washington goes after Wall Street. We saw this with Rudolf Giuliani going after Michael Milken, shutting down DLJ and the whole high yield market at that time. Fast forward to the next big boom/bust, the period when I was in government, that’s Enron and Tyco, Elliot Spitzer goes after Enron, Ken Lay, and shuts down risk-taking amongst corporates for a period of time at least. Today we have Andrew Cuomo, the New York state prosecutor. If you had to name one Democrat of that generation, other than Obama, most likely to end up as president of the United States, I would say that is him. For Cuomo it is easy to add the pieces up. What launched Guliani and Spitzer to the governorship of New York, which by the way could be a launch pad from which he could then run for the presidency? It was those convictions. For Cuomo it is like throwing the ball, and wanting to hit this thing out of the ball park. The markets have not registered how serious this development is.
On the day that the Treasury announced the TARP program, they made three announcements. The first one was $25 billion to General Motors. If we’re going to give money to Wall Street, we’re certainly going to give it to Main Street first. The second announcement was the unleashing of the FBI on the 22 largest financial institutions in the country. This announcement went straight over the head of the market. This is profound, because the FBI have the widest powers of legal discovery. If they come in, and they go through your stuff, and they find you’ve got a girlfriend, whatever, that’s how they can negotiate with you to reveal stuff they can use in the prosecution. Thirdly, they announced the TARP program – that was the THIRD announcement in that particular press conference.
The legal investigations side of this is extremely powerful. Now you have a president who in his most recent speech had a tone that was very much – “we will not allow people to get away with this.” The atmosphere is almost what I would describe as the typical witch hunt that must occur after you have had losses on a scale like this. The financial community still doesn’t get this, and isn’t managing it properly. As a result it will spin out of control, and what we’ll end up with is more than just a few people going to jail. By the way, my clients, like hedge funds, and investment banks, can say “we didn’t break the law.” Is this relevant? They got Al Capone on mail fraud, because they couldn’t get him on anything else. Did you once mis-date a cheque and put it in the post? You’re done.
It is a very fragile environment for the financial services industry, but without their – in my view – sufficient recognition of it.
In addition, I think we’re going to get out of this something that will make Sarbanes Oxley look like small time. We’re going to have tremendous rewriting of the rules of the game. The person to watch on this is Paul Volcker, who is heading the new commission which President Obama has put in place. Volcker as a personality is very interesting. The market perception of him is they love him, because he killed inflation. Thus, he is a market friendly guy. Paul asked me to be his research assistant when I was 22. It didn’t happen, but I got to know him. This is not a person who is friendly to financial markets. His view is that financial markets need to be constrained and controlled – this moment in history indicates his point of view.
At the core of it he wants to go back to the Glass Steagall Act. That’s where the bulk of the Obama team want to go. Take Citigroup as an example. It used to be Citibank, but it was allowed to become Citigroup through the passage of Gramm-Leach-Bliley which overturned Glass Steagall and permits investment banking and commercial banking to occur under the same roof. The view now is that it was a total waste of time. Effectively it was worse than that: it was dangerous to the whole economy to allow Citibank to become Citigroup. We’ve got to unwind it. I’m not saying we’re going to go all the way back to the Glass-Steagall Act, but I think we’re going to go awfully close. And noone is going to say this may not be a good idea. I think the risk is we’ll overshoot. That’s what always happens in public policy: the pendulum swings way too far.
This element of politics is now absolutely at the heart of what’s coming. I think one of the reasons the financial markets can’t settle down – there are many reasons – but at least one of them is the future of investment banking. We don’t know. If they’re not going to allow institutions to operate with leverage beyond x%, then you’re not going to have investment banks as we knew them. And that, by the way, is what the Federal Reserve is pushing for: as a balance sheet, on and off, your leverage can never be more than ‘x’ times. You can’t get to a point of 80x leverage or 100x leverage, as we saw with some of these institutions. The regulators will simply not permit it.
It is hard to settle down when you don’t know what the rules of the game are. I think that’s the key thing to watch. That, unfortunately takes a lot of time. Right now the mood in Washington is one of fire-fighting, putting out today’s fires rather than re-writing the fire code, but the re-writing of the fire code has to come out of this somewhere, and in the next 18-24 months that’s what we’ll see.
The quest for a cure
Let me step a little back to take you into the broader implications of this financial crisis, and why we have to spend a little time talking about geopolitics as well. One of the problems with this financial crisis is mis-perception of cause, and therefore mis-diagnosis of the cure. I think the media has created a view that this all started with American sub-prime mortgages, and that it is like a disease that has spread around the world. I was recently in Dubai, in November and December. In November they said: “This will not touch us; we’re immune.” In December they said: “We’re dead. We’re not a sovereign, we’re a sieve.” It’s amazing how, once it hits you, how fast you change your view.
The view is that “this has nothing to do with us. This is some American phenomena that is reaching into our lives, and if only we could stop it.” A truer diagnosis is that we had an incredibly low cost-of-capital environment worldwide. Anyone could raise capital at any time, for any purpose, at virtually no cost. And that was from China, where they had record amounts of foreign direct investment – anyone who opened a factory (and they did) – to the US, where you could fund a mortgage. The cost of capital went up. When the cost of capital goes up, it literally acts like a knife, it splits through every balance sheet in the world economy. When I say that, I don’t just mean financial balance sheets, I mean personal balance sheets, sovereign balance sheets, every kind of balance sheet that exists. It splits apart the winners from the losers. The winners are all those balance sheets which remain viable, despite the higher cost of capital, and the losers are the balance sheets that are rendered no longer viable because of the higher cost of capital.
The thing that differentiates the two typically is just plain old-fashioned, very boring, cash flow. Things that generate genuine cash flow survive this; things that don’t, and depend on leverage for returns, get damaged if not mortally wounded by these kinds of events. The process of splitting apart is underway. That’s how the markets moved from first a recognition that maybe it’s a bank that’s in trouble to maybe it’s the banking system. Maybe it’s the non-banking system as well. Maybe it’s not only corporates, but sovereigns. That’s why the market is now building in massive risk premium for sovereign defaults, and I do think we’re going to see some sovereign defaults. I think we’re going to see Western European sovereign defaults, which have occurred throughout history, but are still going to come as a big surprise and shock.
The problem for markets is that they’re not recognising that this is the phenomena which is driving us forward, but like focusing on the risks you can quantify. The most important risks right now are the risks you can’t quantify. To be clear, we spend a lot of time focusing on the deleveraging of financial balance sheets, and what will impact on the global economy via that, but what we really need to focus on is the deleveraging of personal hopes and expectations, and what is the impact on the world economy of that. It’s literally a human behavioural problem now, and this manifests itself in a lot of different ways.
Let me give you a few examples, because this is where it hits geopolitics.
China’s critical role
In the spring I’m taking some of the board members of the Fed to China, because they’ve never been. Not having been to China, they don’t really get the whole China story. Whatwe have happening is the regulators in the US trying to come up with a plan to fix the financial system, but they’re not taking into account that as long as the Chinese economy is not floating, it off-sets everything else. You can’t fix this in Washington. It’s a global phenomena.
In China we’ve had a massive destruction of excess capacity, a huge increase in unemployment, massively understated by the official numbers to the point that Hu Jintao gave a speech in December – which hardly anybody noticed because they’d all gone for Christmas – where he said “we are prepared for the first time [since Tiananmen Square] to use the army in case of domestic civil unrest.” I can’t tell you how serious a development for the world economy it is if the Chinese are going to use truncheons to maintain peace in the population as opposed to economic policy.
The official expectation in the market is that the current 9% growth rate in China falls to 6%. When you spend any time with the Chinese leadership, they say: “Six? We are already at zero, and we’re worrying we’re going to have a contraction.” This is on a scale that China has never experienced in its modern history. In the West, particularly in the US, we get booms and busts. People understand. In China this is the first personal experience of assuming you’re going to be a millionaire: you’re going to have a car, you’re going to have an apartment, but now you’re going to be confronted by the fact that you’re going to have nothing, and you have lost everything you’ve made. It is a huge personal adjustment that has to occur.
This personal adjustment is occurring worldwide. We’ve seen it in the West in Iceland. They thought they had a very well-funded pension, and suddenly it’s literally zero, it’s worth zero. And protests, as they throw out the Icelandic government. We’ve now had three governments in Europe chucked out as a result of these affairs, and I would say this is just the start. Belgium, Latvia just a few days ago, there will be much more of this. The problem is, throwing out the government and bringing in a new one doesn’t actually fix this, and that’s why people hit the streets. We’re seeing this already in Ireland and here in the UK. Unfortunately it is still very early days, because the unemployment rate hasn’t even gone up yet, and it will get higher as the corporates and the sovereigns get nearer to that default environment.
Historic investment opportunities
The picture that I’m painting for you I know is very, very gloomy. However, the flip-side of it is that I do think these events are creating truly historic investment opportunities. The world is now divided into two camps, as far as I can tell, on two levels. All the fiduciaries I know only see the utter darkness of deflation because they own assets, and there’s no buyer for them. The real money I talk to – pension funds, sovereign wealth funds, family offices, individuals – they only see that inflation will come out of current events. The other way of cutting it is that the vast majority of people think this is the end of capitalism as we know it, and a small group thinks that the opportunity to become a billionaire in our lifetime has never been closer. I’m in the second camp, for sure. Once you have prices falling to this degree, not just of assets, but of people, office space, skill sets that are suddenly available that weren’t available before, human nature is such that people will create new things out of this. It actually comes down to your view of human nature, which again is something you can’t quantify. Either you believe that people will just give up, they’ll just go on the dole, or you believe that they will take the market signals and build something new. That’s a big choice anybody has to make today, and it defines all your actions, both in your personal life and your corporate portfolio.
I already see a huge amount of entrepreneurial risk-taking occurring in the world economy. These deals are definitely happening, but there’s no press coverage, and there isn’t going to be for three or four years, because that’s the way it works. All those kinds of deals you only hear about when they go to an IPO, which is four to five years from now. The first IPOs will start in three years’ time, then we’ll have a wave, and then everyone will get optimistic again. The social unrest side of the equation will not only get press coverage, but it will be massively exaggerated.
Inflation versus deflation lies at the heart of most of the financial institutions’ decision making process. For us personally it matters a lot which way it’s going to go, and we’re on a knife’s edge. For the first time in history you have globally coordinated efforts to create inflation. Every single government in the world is desperately trying to conjure up inflation, and they’re doing it through an expansion of monetary and fiscal assets on a scale that each country has never before seen. Am I going to bet against this? No, I believe it will work, it will definitely work. It has to work, not only because we know from history that if you add that many new assets you get inflation – it is an inevitable outcome. It is also the natural way to deal with debt.
There are many ways you can deal with debt, and this raises the world ‘default’ again. One way you can default is to wake up in the morning and say “I’m never paying you back.” That’s a Latin American-style default. Another style of default is when governments effectively default on their own citizens by saying: “We know we told you you could retire at 55, but now it’s 92,” or “we said we’d pick up your rubbish every day, or twice a week, but now it’s every three months.” These are ways you default on commitments, and I think what is going to happen is that governments are making promises they won’t be able to keep, and they will start defaulting on their citizens, and eventually reach a point where the citizens protest, chuck out the government, and the new government will find it much easier to renege on the promises of the previous government, plus they will have to make a choice, and ask themselves: “Should we default on the citizens, who can throw us out, or should we default on the foreigners, who can’t?”
That’s when the bond markets start to come into play. That’s why the markets are starting to anticipate that this will occur. The sovereign default side of that story is important, because how do you default as a nation? You could say: “I’m never paying you back.” Rough, hard to recover from. Or you could say: “We’re going to reschedule.” I think we’ll see some of that. Or you could say: “Let’s inflate.” In which case you never need to use the word ‘default’, and all the debt disappears through that channel. The problem then is you have to deal with the consequences, and I’m a little concerned we’ve all been hit by this terrible train wreck called Deflation, but then you get hit by a truck called Inflation. I’ve been reading a lot of books about what happened in the 1930s, and that is exactly what occurred. First public confidence is undermined by the deflation, but it is the inflation that sets the stage for something much more serious in a society. To lose all your savings and your confidence that there is any point to having savings. That’s further down the road. The decisions you make today with portfolios will probably come to fruition in a two or three year period, and that’s exactly the time frame inflation occurs on.
This is also creating a huge divide in the policy community, which leadsto further uncertainty, creates more volatility, creates a tougher environment for the investors.
There are many other pieces to this puzzle, but the geopolitics is very, very deep. Many countries will now begin to move in a direction that is less friendly to stability as a result of these events. I would say in Dubai they have had something called the bar and mosque ratio. Given that Dubai was the most westernised, progressive Muslim location, they made a deal: they could have the bars, the girls in bikinis on the beach, the open capitalist orientation, but the price was they had to build a new mosque in every neighbourhood. That was how the society found its balance. Now the bar side of that equation is going to decrease: the demand falls down, the willingness to fund it collapses, and the willingness to fund the mosque side of the ratio goes up: western capitalism doesn’t work; our approach is vindicated, etc. That shift in the society has huge implications for the region, as an example.
What this all means for hedge funds
Many of the hedge funds I deal with around the world are not suffering just because these are difficult markets to navigate, but they’re not understanding that all these events are changing the landscape to an extent that may not allow them to persist in their activities in the way they have in the past. However, I think we’re going to get a new crop of hedge funds that can navigate in this environment. I also think over time we’re going to see the yield curve steepen. This is a very specific point, but why, in the past, did we have hedge funds? Because the yields were so low, there was so much money chasing so few genuinely good deals, it compressed all the yields. When your returns are very narrow, you need leverage to pump up the result, which was what everybody was doing. In a market where you are going to get better rates of return which naturally exist, you don’t need those complex machines.
Let me put it this way: today you can make a plain vanilla loan to a US manufacturer whose sales are actually increasing in the current environment, because they make something where there’s a genuine demand for the product, and a genuine cash flow. You can have this loan three times collateralised, and an equity kicker, and it’s paying 25%. Why are you giving your money to a hedge fund when you’re getting 25% for a plain vanilla loan? That’s why a lot of the hedge funds are starting to set up funds that do nothing but lend. They’re becoming banks, because they see there’s a gap in the market. And there’s no regulation there.
There’s a huge morphing of the kinds of activities you’re involved in. Finally, what this means is decompression of the size of the financial sector, which we all know was going to occur, but people haven’t registered that as you take global GDP, the huge percentage of it that went into financial skills and resources and is now being compressed, all that skill and talent has to go somewhere. My view is that it is going into the real economy because there is no place else for it to go. When I say to hedge fund managers in New York this means they’re moving to Des Moines, they say “I’ll never move to Des Moines.” Well, actually, it’s not your choice. The people in Des Moines know how to own and operate a business, and generate genuine cash flow. They have to decide whether you have anything useful and then they’ll let you come. This is a massive shift in the balance of power between the real economy and the financial services sector. My personal view is that this is a huge opportunity as all this skill is going to infuse the real economy side of the equation. The real fortunes in history are always made on the real economy side, not in financial services.
The quality of what remains in financial services, let’s face it, will be much higher, because this is all about cleaning out the peoplewho really shouldn’t have been in this game to begin with. It’s a tough view, I realise, but the overall quality of the outcome is vastly enhanced by these events. Also, the deleveraging of personal balance sheets, messy as it is, is a recalibration in society towards something which is much more sustainable in the long run, which is a better thing from an investing point of view.
Dr Philippa Malmgrem is the President of the Canonbury Group, a financial services company based in London. She is also a member of the Global Fund Advisers Network, which raises funds for alternative investments.
Dr Malmgren served as an adviser on international economic issues to George W. Bush during his presidential campaign. She then joined the White House and served as Special Assistant to the President for Economic Policy on the National Economic Council. She was a member of the President’s Working Group on Financial Markets and the President’s Working Group on Corporate Governance. While in the White House, she was responsible for all financial market issues for the President and was in charge of liaison between the White House and all the financial regulators, including the Federal Reserve and the SEC. She was assigned to the White House Office of Homeland Defense Working Group on Terrorism Risks to the Economy.
Before joining the administration, she was President of Malmgren and Company in London. Dr Malmgren has also been Deputy Head of Global Investment Strategy at UBS Warburg in the UK. She was Chief Currency Strategist for Bankers Trust Company, and previously headed the global asset management business for Bankers Trust in Asia.