March 2009, Financial Times

How long have you been worried about our financial system?

In 1984, at a forum at Jackson Hole, Wyoming, sponsored by the Federal Reserve Bank of St Louis, I spoke about my growing concern about the changing character of the country’s financial structure and its growing vulnerabilities. Even back then, it was evident that the system was evolving into a more sophisticated, more opaque network of operations that demanded new supervision and regulations. But my warnings were received with silent indifference.

What most concerns you today?

We have permitted the creation of mammoth financial conglomerates with huge balance sheets and thin capital bases that have magnified the debt problem because they helped to facilitate the seamless distribution of credit. This has blurred the meaning of liquidity, which had traditionally been measured as the cash and equivalents an institution carried on the asset side of its balance sheet.

Now, over the past ten years, liquidity has come to mean your capacity to borrow. That’s an extraordinary change across businesses and households. Without this exposure, the downgrading of credit of many corporations would not have taken place to the degree it has. But this has been facilitated by the creation of new credit instruments and quick access to credit, which many institutions have marketed. This shift has created more vulnerable and less stable institutions.

With huge financial conglomerates controlling a large proportion of financial assets in the US and abroad, this begs the issue [which should’ve been addressed long ago]: how are we going to supervise and regulate these institutions. A partial response has been de facto nationalization of a good portion of our financial institutions. But we’re still quite far from resolving this matter, which will be an extraordinary political battle.

What specific issue stands out?

Marking to market. Of all the current issues plaguing our system today, “marking to market” is the centerpiece of the crisis. Because we lack a clear, widely accepted means of marking to market during this crisis, we can no longer value many instruments and institutions, and this has resulted in extremely volatile stock prices.

Is there anything we can do about this problem?

We need to create some sort of supervisory oversight that would establish acceptable standards for marking to market.

What has surprised you most about the crisis?

How long it took to hit. A number of problems were building up in the financial markets over a considerable period of time. But perhaps because we appeared to have been able to manage past crises, we came to believe that somehow we’d be able to overcome any mess, including excessive corporate leverage and soaring consumer indebtedness, without suffering too much dislocation. This blinded us to the severity of the problems we were facing.

The financial component of the crisis is the largest we’ve faced since the Depression. However, our economy remains in much better shape than it was in the 1930s, and I surmise it will not sink to that level because of the wide array of safety nets in place and aggressive government action that’s addressing the distress head on.

How far do you think we are from the bottom of the crisis?

We probably won’t see a bottom for another year. That said, the problems in the financial markets are still far from over.

What has made this crisis different from earlier ones?

Past crisis, such as what we saw in Southeast Asia, Russia, and South America in the late 1990s were far more definable in geographic and financial terms. This made them relatively transparent. While the liabilities were significant, they were quantifiable. As a result, companies, governments, and investors could effectively respond to these crises. Moreover, the fundamentals of the world’s major economies were not at risk.

But today’s crisis is unique compared to all others we’ve seen since World War II because it is domiciled in the world’s major financial centers–NY, London, Paris, Frankfurt. And the potential dimensions of the problem have been very hard to measure because the disease has globally metastasized through the explosion of derivatives and securitized obligations, which has in turn propelled the levels of debt.

We can’t accurately measure the scale of the problem because underlying valuations are so uncertain as a result of an inability to meaningfully mark to market. This producing markets that are increasingly opaque.

So you see a large part of the crisis directly related to the proliferation of securitization?

Certainly with less securitization we would have had less credit, and the dimensions of the problem would’ve been more visible. Securitization is supposed to be based on adequate knowledge of the underlying securities. But the system in fact has become more obscure because securitization has led to the proliferation of complex credit instruments.

As of last year, the notional value of credit derivatives reached nearly $60 trillion. These products were virtually unknown in the 1980s and most of the 1990s. Now we are dealing with numbers that are huge, diffused, and difficult to access because most derivatives are traded over the counter-not exchange traded. As a result, the true dimensions of the problems and on-going risk are virtually impossible to discern.

Were there any other factors regulators missed, which if they had addressed, might’ve contained the crisis?

Over the last decade, the industry and regulators had put a great deal of faith in the quantification of risk. One would have thought that the implosion of Long-Term Capital Management in 1998 would have highlighted the limitations of risk quantification and it’s potential contagion.

But despite the evident shortcomings, the industry continued to embrace quant theory, and regulators were basically saying: “since you understand your risk models better than we do, we’ll just check your procedures to see they make sense.” Regulators, instead, should’ve been challenging the conceptual soundness and limitations of quantitative analysis.

To me, the most obvious flaw of such risk modeling was that it basically went back just several years. Many quants felt this limited time analysis provided a reasonable range of likely risks, when in fact, it didn’t. Too often “quant” thinking was based on the presumption that ‘whatever has prevailed will continue to prevail.’

Should we find solace in the knowledge garnered from the Depression as a means of avoiding a repeat?

Not as much as people would like to think. Remember, things were a lot less complex in the 1930s. Sure there were monetary and fiscal policy mistakes that made matters worse back then, and we aren’t repeating the same missteps today. But at the time there were no financial derivatives, and the dimensions of lending and investing were much more transparent. While there was global trade, domestic economies were more definable.

I’m also concerned that the generation that experienced the Depression first hand is no longer running companies or in government. The younger generation that’s in charge has a limited sense of how bad things can get. This is evident in so much of the decision-making that has occurred over the last 10 years.

Yes, Fed chairman Bernanke certainly understands the depression. But he failed to recognize the excesses of the financial market until it was very late. If you’re a student of the 1930s, the enormous growth of debt, the enormous growth of financial derivatives, the deterioration in the quality of credit in the housing market should’ve rung a bell.

Moreover, because we’ve dealt with a series of post-war recessions that didn’t collapse into depression, we’ve developed a confidence that we know how to handle bubbles and excesses. This contributed to a sharp change in public policy over the past 20 years that promoted deregulation based on the belief that that markets know best and that they can respond to risks of an increasing credit bubble. Clearly they can’t.

Do you basically agree with Obama’s economic policies?

Perhaps I would’ve looked for more immediate economic stimulation and put off other programs to a later time. But overall, I don’t think we have a choice but to respond the way Obama is doing.

Ultimately, reviving the economy comes down to a single matter: removing toxic debt from the financial system. The way we’re going about it now, it’s going to be a slow process. I understand there can’t be any quick fixes. The cost of the toxic debt will have to be socialized. But the product of doing so will be a new financial structure that will more efficiently distribute of credit.

What would you suggest that’s not being done?

I would move to designate large financial conglomerates as public utilities [like water and electric utilities] with limits on return on equity. They would become highly constrained, with rules that would curb the various conflicts of interests we see today. For example, financial institutions that take in deposits should not be allowed to co-own hedge funds. And any depository institution that underwrites stock or bond issues should not be allowed to have equity or debt stakes in these issues. Ultimately, I would like to spinoff pieces of these conglomerates to reduce concentration of risk.

Are you worried about where current public policy could take us?

The US government lending is currently soaring while private sector lending is stable or falling. This may be OK for several years; otherwise, we would have a depression on our hands. But by the government becoming the economy’s key borrower and lender, the ultimate question is when will it step away from this role? At some point the private sector must reassert itself. Otherwise, we run the risk of moving toward a more European form of capitalism. In the long run, I don’t think that would be good for a striving economy. This is the underlying issue that few observers want to talk about.

Wouldn’t the Treasury market ultimately act as a break on that shift by pushing up the cost of extraordinary federal borrowing?

Not necessarily since there appears to be incessant demand for US government bonds.

Describe your current investment strategy?

We rely on various outside managers, including hedge funds, buy-out specialists, and venture capitalists, to execute our broad strategies. We realized going into last year that it was going to be a difficult time. Because there is risk of not being able to withdraw money from hedge funds during difficult markets, we started to liquidate a significant portion of our long-only positions throughout 2008 to avoid our capital getting locked up.

Also at the beginning of 2008, we started to short the S&P 500 index. Going into the second half of the year, we largely eliminated our exposure to commodities. At the same time, believing UK economy was significantly slowing and that its interest rates would likely come down, we went long British gilts. And throughout the year, we were building up cash. Collectively, these moves helped us to end 2008 slightly on the upside.

So far in 2009, we are continuing to draw down our equity position. At the same time, we’re selectively adding high quality municipal and short-dated high-quality corporate bonds.

What are the most compelling opportunities looking forward?

Despite the troubles afflicting municipal finance, we continue to believe in high-quality municipals bonds when supported by adequate credit research.

I also believe with the right manager, there are opportunities going long distressed debt. I would like to find a proven manager running a new pool of money that’s targeting this asset class. I believe legacy funds will continued to be hamstrung by accurately valuing securities already in their portfolios because of the challenges of marking to market. Moreover, with credit ratings still likely to fall and further devaluing distressed debt, it would be wiser to start establishing positions when we are closer to the bottom of this crisis, when valuations once again become more transparent, and when the impact of future events will more likely to push values up rather than down.

Therefore, considering the way the credit cycle is moving, I think we would stand a much better chance of being successful in a new fund than in investing in a legacy fund.

How do you expect distressed debt to perform if you expect intermediate and long-term sovereign yields to rise with economic recovery?

As the global economy begins to recover, we do expect distressed debt yields to start to come down even while sovereign yields rise because distressed spreads have been blown way out of the norm. So we should actually see a convergence between the two benchmarks.

Are you currently in distressed debt?

Only indirectly through diversified money managers do we have small exposure in distressed debt. Nothing is currently in a distressed debt manager.

Do you still rely on credit agency ratings for identifying municipal and corporate bond investments?

Only as a starting point. We still believe that a AAA-rated bond stands a far better chance of performing than a BBB-rated bond. But it helps to do one’s own due diligence
combined with common sense before investing in any particular issue.

Is buyout strategy still a part of your overall investment strategy?

We have a modest amount of money in buyout firms. Those managers are not yet fully invested. And frankly, I don’t know what the ultimate return on that money might be. It’s too hard to tell. They have a portfolio of companies which eventually have to be sold. That won’t occur so quickly, dependent on when the economic recovery really takes hold, which is not likely to be any time soon. I think it’s very difficult for buyout firms today to place an investment they have into the open market.

We will most likely have to wait for clear evidence of economic recovery before we see increased credit and liquidity necessary to promote private equity and buyout activity. And for that, it will take at least a year or two.

Do you expect the US dollar to retain its current strength?

I believe the dollar will remain stable for the foreseeable future because there isn’t a currency substitute. The yen doesn’t have the depth, and its geared to an insular home market. The euro is being hit by economic and political problems that’s preventing member governments from collectively addressing the crisis.

Extensive East European borrowing in euros will likely have a significant backlash on the western European economies and the euro, especially if local currency devaluation leads to significant defaults. This begs the question: who’s going to bailout Eastern Europe, not to mention the troubled economies of Italy and Spain.

Finally, Russia casts a pall over the continent via its control of energy. So there is really no reserve currency substitute for the dollar.

Any thoughts about gold?

I wish had clear thoughts about gold one way or another. But I don’t.

Is it too early to consider investing in any financial institutions?

For me it is because I don’t have a clear idea how to evaluate them at this time.

Are you concerned about Treasury market bubble?

Not over the next year or two. As long as private sector credit demands are very modest or contracting, and monetary policy continues to be accommodating, the American government will have no problem issuing massive amounts of new bonds. The US government is also benefiting from global economic contraction which in turn is reinforcing the US dollar’s status as the world’s reserve currency. The US is still an extremely stable society. Therefore it poses no problem with the dollars coming back into the US securities market and therefore the US government market. It’s not certain how long these conditions will last. But they certainly are solidly in place right now.

That said, however, the issue for the US government bond market will be when private sector credit demands lift again. There is no indication of that happening again in this calendar year. Short-term Treasury bill yields are virtually none existent and 30-year Treasury yields are below 3.7 percent. We have a positively sloped yield curve that leaves sufficient room to accommodate market response with causing a dramatic breakdown in Treasury prices. Accordingly, I think it’s premature to say that we have a Treasury bubble and it’s about to burst.

The US government bond market will also be helped by the Federal Reserve’s willingness to buy longer-dated governments to help stabilize markets. The key to the mortgage market is 10-year governments. The US government has not yet bought longer-dated governments. So that change will further relieve pressure on yields. The market may test support levels. But if government intervention in fact occurs as promised, that should put a lid on yields and ensure that we won’t be seeing a bubble that bursts.

Looking out a year or two, when credit demands from the private market, cities and states, and individuals reassert themselves and come into the market, while issuing demands for the US government will still be large, that will be a key test for the bond market. When that occurs, we will likely see intermediate and longer-term government bond yields will go up while short rates remain anchored by monetary policy.

The Bank of England has started buying Gilts, which has reduced Gilt yields by at least 50 basis points over the last week or two since this move started.

But this will likely occur only when the economy is the process of recovering. This will create some market tensions between public and private capital demands. This would suggest there will be return to the equity market.

We will see intermediate and longer term yields rise faster than short rates because the Federal Reserved will not rush to raise short-term rates to ensure adequate economic recovery. The Fed will require significant indication that the economy is on a strong footing before it will push up rates.

Investors will not need to get in front of this likely scenario because there will be plenty of indication [and time] before the underlying conditions assert themselves.

Prospects in Private Equity

The market for private equity is illiquid, and since the crisis began, it’s become more difficult to raise new money. And the current performance is virtually impossible to measure because of the challenge of determining value is so difficult. These are investments in businesses where there is no open credit market generally. And therefore it’s up to the general manager (who manages the private equity) along with someone like the accountant who looks over his shoulder. Determining the market value is based on being able to sell a business on the open market, which is very challenging right now. All of this goes back to the issue of being able to meaningfully mark an asset value’s to market.

We will see a fundamental change in the nature of private equity going forward. Where in the past there was access to extensive credit, we will now see much greater percentage of equity into deals. This means that we will likely be seeing a lower rate of return in private equity deals because in the past higher leverage typically translated into higher rates of returns. Ultimately, this may mean that there will be less money flowing into private equity.

Private equity investments are in transition. For one reason, credit ratings of corporations will be going down. Second, the amount of private equity required in deals will be raised. Third, lenders [banking institutions and others] will be more conservative lenders than before. All of these factors will recasting the business of private equity and we have yet to realize the impact of all of these events.

We have not made any new investments in private equity. And currently it’s a small percentage of what we have. Only a compelling idea would get us to move money into private equity this year. I’m much more interested in new managers moving into distressed debt.

Your thoughts on the current rally?

No one should believe that we are going back to the heady days of the last decade. We are in a period where we are going to lower our expectations. One reason: the financial markets no longer have the firing power to create credit by the magnitude it was created the last time around.

But I have no idea if we have reached a bottom. Some stocks like Citi probably have since it’s fallen 98% from its peak. And the market could still go lower.

Where would you park cash?

Parking cash means having the cash readily available in liquid form…the places should be US government obligations, highly-rated short-dated corporate obligations, short-dated obligations of Fannie Mae and Freddie Mac, which are now governmentally guaranteed.

Money market funds seem to be OK now.

Looking forward, do you have any thoughts for investors?

Expect more corporate downgrades going forward, which will eat into bond prices. So for debt investors, make sure of the credit worthiness of corporate obligations. You may get a bit more meaningful help on this front from credit rating agencies going forward; they are under stress and should be more prudent than in the past, likely to move with greater alacrity when conditions demand a change in credit rating.

I would still be very cautious with equities going forward. But for those insisting on trying to value hunt, restrict your view to only companies with strong balance sheets, leading market share, and which stand a high probability of seeing their earnings soar when the economy does eventually recover.

Any thoughts on improving regulation of private equity and hedge funds?

I think there should be greater disclosure to a supervisory authority about a fund’s exposure, especially by industry and sector. Levels of borrowing don’t need to be restricted, but they do need to be made clear. And as I’ve said earlier, we certainly must improve the standards and disclosure of marking to market. This greater detail will help better assess the true value of investments and funds. These changes won’t be easily realizable. But if we don’t achieve them, we’ll just continue to expose ourselves to the same old risks.

Should short selling ever be restricted?

I have no view on this matter.

Do we need to improve corporate transparency?

I would want all risks identified on the balance sheet. When you create off-balance sheets activities, for example, like derivatives and credit default swaps, they have to be recognized as part of a credit creation process. And I would demand more detailed presentation of contingent liabilities.

Finally, the lack of confidence in the system is palpable. Any thoughts?

I agree. This is among our greatest problems. I’m concerned about the lack of a new voice to provide confidence and leadership going forward. In the 1930s, the new voice then was that of John Maynard Keynes. Then starting in the 1960s, Milton Friedman stepped up. But today, the philosophies of the most qualified financial experts have been discredited by their failure to have recognized the dangers of the storm that has now engulfed the global economy. And there are others whose vested interests have compromised their standing.

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PERSONAL

Dr. Kaufman is currently reading The Lords of Finance, a history of central bankers from London, Paris, Berlin, and Washington, in the 1920s, whose well-intentioned missteps arguably contributed to the Great Depression and war. “While I don’t think it’s a guide to how things will eventually play out today” says Kaufman, “it reveals the limits of our leaders’ capacity to combat systemic problems, cataloguing the various mistakes that were made, which arguably helped lead us into a global war.”

Dr. Kaufman thinks “that unless you are a professional, you improve your understanding of what art is all about when you focus.” In this case, he and his wife’s focus is on American 20th Century Art. He cites his love for Marsden Hartley, an early American modernist painter who died in 1943. He’s also a fan of Arthur Dove and Milton Avery.

Kaufman is also a fan of the opera, though he admits, he has trouble with Wagner’s Ring Cycle.

London is among his favorite destinations: it’s a comfortable, walkable city, loaded with museums and theatre, with many friends.

Kaufman has three sons–one works with him, another is in Atlanta in real estate development business; and the third lives in upstate NY….and has 4 grandchildren.

KAUFMAN & COMPANY

Through his firm, Henry Kaufman & Company, he manages family money via asset allocation, relying on subadvisors to execute strategy. Kaufman is an advisor to domestic and international institutions, addressing economic and financial issues. He doesn’t provide specific investment advice.

In addition, he advises a host of non-profit institutions, including universities and museums, and he has regular public speak engagements.

Before he retired from Wall Street in the latter part of the 1990s, he was managing $1.5 billion in fixed income.

He’s the author of “On Money and Markets: A Wall Street Memoir,” 2001, and is presently finishing his latest book, entitled “The Paths of Financial Reckoning.”