Last week, Fortune ran an article called “Crisis Counsel” that began, “Will the sub-prime lending meltdown and credit crunch send us into a financial free fall? We asked the sharpest minds in business to share their reactions to the downturn, and their insights on the road ahead.”
I think you’ll find remarkable similarities between their comments and others you’ve read on this site. The following are highlights from the article.
Warren Buffett, Chairman and CEO, Berkshire Hathaway:
Because many institutions are highly leveraged, the difference between “model” and “market” could deliver a huge whack to shareholders’ equity. Indeed, for a few institutions, the difference in valuations is the difference between what purports to be robust health and insolvency. For these institutions, pinning down market values would not be difficult: They should simply sell 5% of all the large positions they hold. That kind of sale would establish a true value, though one still higher, no doubt, than would be realized for 100% of an oversized and illiquid holding.
In one way, I’m sympathetic to the institutional reluctance to face the music. I’d give a lot to mark my weight to “model” rather than to “market.”
Wilbur Ross, Chairman and CEO, W.L. Ross & Co:
Liquidity is not about physical cash; it is mainly a psychological state. Subprime problems have consumed only trivial amounts of global cash but already have burst bubbles by shocking lenders. Clever financial engineering effectively had convinced lenders to ignore risk, and not just in subprime. A major hedge fund participated in a loan to one of our companies, but sent no one to a due diligence meeting. So I called the senior partner to thank him and tell him about the non-attendance. He responded, “I know. For a $10 million commitment, it wasn’t worth going to a meeting.”
The present $200 billion of delinquencies will grow to $400 billion or $500 billion next year because $570 billion more low, teaser-rate mortgages will reset to market and consume more than 50% of the borrowers’ income. Therefore most of the loans will be foreclosed or restructured. Probably 1.5 million to two million families will lose their homes. Meanwhile, few lenders will put mortgages on the foreclosed houses, so the prices will plummet. Despite these tragedies, total losses will probably be less than 1% of household wealth and only 2% to 3% of one year’s GDP, so this is not Armageddon. However, even prime jumbo mortgages will be more expensive and more difficult to obtain.
John Mack, Chairman and CEO, Morgan Stanley:
I was around in 1987, and that crisis was more disruptive and much more alarming than this is. So was the 1998 foreign-debt crisis. It’s not all bad news now. There’s still liquidity in the markets. There’s plenty of investor money in China, Russia, the Middle East, as well as the U.S. The rest of the world has developed to the point that, if the U.S. goes into a recession, I don’t think we’ll have a global recession. I don’t think a recession is going to happen, but it’s what our central banks have to worry about.
Bill Miller, Chairman and chief investment officer, Legg Mason Capital Management:
These sorts of things are what’s known to the academics as “endogenous to the system”–that is to say, they’re normal. They happen usually every three to five years. So we had a freezing up of the market for corporate credit in the summer of ’02. We had an equity bubble just before that. In ’98 we had Long-Term Capital. In ’94 we had a mortgage collapse like we’re having right now. In 1990 we had an S&L; collapse. In ’87 we had a stock market collapse. These things flow through the system, and they’re part of the system. I saw one quant quoted over the weekend saying, “Stuff that’s not supposed to happen once in 10,000 years happened three days in a row in August.” Well, I would think that you would learn in Quant 101 that the market is not what’s known as normally distributed. I’m not sure where he was when all these things happened every three or five years. I think these quant models are structurally flawed and tend to exacerbate this stuff.
But these events represent opportunities. When markets get locked up like this, it’s virtually always the case that you’ll have opportunities if you have liquidity. Instead of worrying how bad it’s going to get, I think people should be thinking about where the opportunities might be.
The NYSE financial index is probably the best barometer of what’s to come. The financials tend to be a very good indicator of where the market’s going. They tend to lead the market because they’re the lubrication for the economy. So I think the financial index will tell you if this thing is over, and so far it’s telling you it’s not over. It’s still falling. But just as financials lead on the downside, they will lead on the upside.
Jim Rogers, Founder of the Rogers Raw Materials Index:
Historically, when an industry goes through a retrenchment like this, you have two or three big companies going bankrupt and most of the companies in the industry losing money for a year or two or three. Well, we haven’t gotten anywhere near that in the homebuilding business, so I think that bottom is a long way off. As far as the credit bubble, we have another several months, if not more, of mortgages that are going to reset and people who are going to find themselves with even higher monthly payments. There are many, many more losses to come, most of which we won’t know about for weeks or months.
Normally you have markets go down 10% or so every couple of years. We haven’t had a 10% correction in the stock market in nearly five years. I don’t know if this is the beginning of it, but we’ve got a lot of corrections coming. It wouldn’t surprise me to see a little bounce–say if a central bank cuts rates. But that will just lead to the markets falling further late this year or next year. It would be better for the market, it would be better for investors, and it would be better for the world if we went ahead and cleaned out the system. If they do cut rates in the U.S., it would be pure madness. Because the market’s down 7% or 8% from an all-time high? My gosh, what’s that going to say about the dollar? What’s that going to say to foreign creditors? What’s that going to say about inflation? The Federal Reserve was not founded to bail out Bear Stearns or a few hedge funds. It was founded to keep a stable currency and maintain its value.
I have been and continue to be short the investment banks and the commercial banks. If they bounce up, I’ll probably short more. I’m certainly not buying anything. The market’s only down 8%. I don’t consider that a buying opportunity. The things that I’m short, some people probably think are buying opportunities, but I don’t. I’ve been short the banks for close to a year, and for a while it was not fun. But I added to my positions, and now it’s a lot of fun.
Jeremy Grantham, Chairman, GMO:
There is a lot of pain still to be had in the equity markets, particularly aimed at the risky end of the spectrum. We think the fair value on the market is about a third lower in the U.S and EAFE from today and about a quarter less in emerging markets.
Most of that is not because P/E’s are high. The great weakness in equities is that profit margins are off the scale globally. They’re off the scale for the same reason that the risk premium got so low–that we’ve had wonderful global conditions, wonderful global growth, wonderful global liquidity, wonderfully low inflation. That will do it every time, without fail. So the profit margins went steadily up under a constant series of pleasant surprises: Global growth was always a little better than expected, consumption in the U.S. was always a little stronger th
an expected.Pleasant surprises are the key to profit margins. If you can put together three years of constant pleasant surprises, you will have fabulous profit margins. It isn’t to do with productivity, it isn’t to do with China or India. It’s to do with pleasant surprises. And of course, the longer the pleasant surprises, the higher the hurdle. The hurdle is now desperately high. It is virtually impossible to pleasantly surprise the world now. And profit margins will of course drift or drop down to normal and below. That’s the pressure on the markets. That is what causes the market value to be a third less than it is today.
And people don’t get that. People always look at P/E and take great comfort. Often it’s perfectly fine to do that. But today it’s horribly misleading because the main pain is in profit margins.
In five years, I expect that at least one major bank (broadly defined) will have failed and that up to half the hedge funds and a substantial percentage of the private equity firms in existence today will have simply ceased to exist.
