June 27th, 2009

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Cataclysm Averted, Expectations Diminished

Saturday, June 27th, 2009

By *JONATHAN R. LAING* Pimco’s prescient seer, Paul McCulley, predicts a low-return world.

*THERE WAS LITTLE IN ECONOMIST PAUL MCCULLEY’S* background to suggest he would be among the few Wall Street savants to see the credit crisis coming in all its fury.

After all, he lacked the fancy academic economics pedigree of many of his peers. He earned a B.A. from Iowa’s Grinnell College (1979), followed by an M.B.A. from Columbia two years later. He began his investment career as an obscure Fed-watcher for now-defunct E.F. Hutton after a couple of years in private industry. This was followed by a three-year stint as an economist at California’s Columbia Savings & Loan. The job ended badly in 1990, when the S&L, long a favorite junk-bond dumping ground of Michael Milken and Drexel Burnham, blew up after high-yield paper collapsed. Then it was on to a brief sojourn at giant fixed-income manager Pimco, seven years as fixed-income strategist at UBS Warburg, followed in 1999 by a triumphant return to Pimco. [image: [pimco]] Thomas Michael Alleman for *Barron’s* McCulley says that the “new normal economy” holds the bleak prospect of tepid, 1% to 2% GDP growth, as deleveraging and unemployment grind on.

But all those years laboring in the vineyards have emphatically paid off. McCulley has worked his way up to a position of eminence at Pimco. With founder Bill Gross and CEO Mohamed El-Erian, he’s part of a triumvirate that oversees the investment strategy of the company’s nearly $800 billion of mostly fixed-income assets. McCulley’s reputation has only been burnished in recent years by several monster calls.

Back in 2007, he saw early the potential for a full-fledged meltdown in the U.S. and global credit markets from the insensate layering-on of debt earlier in the decade. He warned that the weirdness that had occurred in the subprime-mortgage securities market was a symptom of an overall pathology that eventually would spread to a host of other asset classes and, ultimately, economies around the world.

At the Jackson Hole Federal Reserve conference in August 2007, he even coined a term that has since come into common parlance as the transmission device fated to undermine the credit system — the shadow banking system. As McCulley saw it, over the past decade or so, a host of unregulated non-bank financial entities had arisen, among them pedal-to-the-metal investment banks and high-octane hedge funds using entities like conduits, collateralized debt obligations and structured investment vehicles.

*THE PERILS OF SHADOW BANKING* went beyond the dodgy subprime paper and other low-quality assets these entities trafficked in. These operations also lacked sufficient capital buffers to absorb losses, the result of absurd over-leveraging. They also were destined to blow sky-high if any run began by their lenders because they lacked the liquidity sources of regular banks, namely access to insured deposits and the Federal Reserve’s discount window. According to McCulley, the moment of truth for the shadow banks came in the fall of 2007, when they suddenly weren’t able to finance themselves by rolling over their asset-backed commercial paper.

That set off what McCulley terms the greatest margin call in the past 100 years, climaxing in the weeks following the collapse of Lehman Brothers in September 2008. In a frenzy to cover debts and raise cash, financial institutions engaged in round after round of asset sales, at first dumping anything that was liquid before moving deeper into their portfolios. The panic became the ultimate vicious cycle, in which selling drove asset prices ever lower, only to beget further selling. Says McCulley: “It was the ultimate Keynsian paradox of thrift, in that the prudent actions of individual institutions to sell and get liquid collectively proved ruinous to the financial markets and general economy.”

The second great call came when McCulley, as a Keynsian adept, sensed that only massive fiscal and monetary stimulus by the federal government could keep the U.S. credit system from collapsing into a deflationary dwarf star. He was an early cheerleader for extreme monetary measures, including the Fed’s buying even corporate-bond index funds and stock funds if necessary to halt the asset meltdown.

In retrospect, he thinks that the passage last fall of the $700 billion Troubled Asset Relief Program, or TARP, might have saved the day. For not only did financial institutions get badly needed infusions of new capital, but TARP money was also used to support several imaginative programs levered with Federal Reserve loans to buy up troubled assets.

“TARP was an essential addition to the triple malted shakes the government is now lavishing on the banking system — deposit-insurance increases, FDIC guarantees on some bank debt and large secured lending facilities to increase bank liquidity,” McCulley explains. “It’s heartening to see in recent months how big banks and other financial institutions have been able to raise new money in the private debt and equity markets. We needed the sovereign to spend more and substitute its balance sheet for that of the broken private sector, and it has worked. Armageddon has been avoided.”

*PIMCO HAS PLAYED THE GALVANIC* credit events of the past year with aplomb, if the performance of the Bill Gross-managed Pimco Total Return bond fund is a gauge. The fund, with a towering nearly $150 billion of assets, posted a 4.8% return last year, beating nearly 90% of its peers. This year, it’s again on a tear, up 4.85% and topping its benchmark index by over four percentage points, according to Morningstar.

McCulley’s calls have clearly played a role in this performance. Pimco mostly avoided the minefields of subprime-mortgage securities and the soon-to-be doomed debt securities of the shadow banking system. The asset manager played things conservatively, investing high up in the capital structures of quality issuers. Then, betting on McCulley’s conviction that government’s intervention in the credit crisis would be both massive and successful, Pimco has made a substantial profit on Fannie Mae and Freddie Mac debt and mortgage-backed securities; those have rallied sharply as the government has bought the paper to bring down mortgage rates.

Pimco has also profited handsomely from the rebound in the corporate debt market in recent months, particularly in guaranteed and non-guaranteed financial-sector debt.

Despite the financial system’s current healing, McCulley thinks it will take some time before there’s an economic recovery of any vigor. What Pimco calls the “new normal economy” holds the bleak prospect of tepid growth in gross domestic product of 1% to 2% for some time, as deleveraging grinds on and unemployment rates stay high. Notes McCulley: “The main economic headwind, of course, will be slack consumer spending. Households have suffered tremendous wealth destruction, and folks will be saving out of their paychecks rather than spending like before.”

Though he shares the obligatory concerns of any bond maven about the large U.S. budget deficits that loom over the next five years or so, he scoffs at the notion that the U.S. is headed for hyperinflation. “Serious inflation is of no concern now, with all the excess labor and industrial capacity that exists and the speed with which wage cuts are occurring in this cycle,” he asserts.

McCulley thinks that the high-grade corporate bond market still looks good, since the yield spreads between corporates and government securities remain elevated in historical terms. He also likes the so-called Build America Bonds, taxable municipal bonds on which the government subsidizes 35% of the interest. “These combine the safety of municipal bonds with more elevated yields,” he says. In any case, he sees no hike in the fed-funds rate until 2011.

*MUCH OF MCCULLEY’S ANALYSIS* revolves around the work of a neo-Keynsian economist named Hyman Minsky, who died in 1996. McCulley readily concedes that many traditional economists regarded Minsky as something of a kook because of his skepticism about the pieties of the efficient-market theory and self-adjusting equilibrium economics. Rather, Minsky believed, mankind often acts in irrational ways and thus imparts to markets endemic booms followed by nerve-shattering busts. [image: [what he sees]]

To McCulley, Minsky’s richest insights revolved around his observations of human behavior during debt cycles. “Debt leverage, of course, is what drives speculation during an upswing and then causes the collapse of asset prices and sometimes of the general economy on the downward swing in what I like to call the Minsky journey,” McCulley explains.

Minsky posited three stages during the upswing of a credit cycle: the “hedge unit,” when credit is extended only to companies or individuals with the cash flow and resources to pay off the loans; the “speculative unit,” which pushes lender and borrower into a more risky pas de deux; and finally the “Ponzi unit,” when merrily rising asset prices, spurred by heavy speculative buying, cause both lenders and borrowers to cast caution to the winds. Both are relying on the continued collateral values to bail out the loans.

Steeped in Minsky theory, McCulley watched with some horror in the middle of the decade as the bubbles swelled in home- mortgage finance and housing prices. Early on, the traditional, self-amortizing 30-year loan gave way to interest-only mortgages with balloon payments at maturity equal to the original principal to accommodate “speculative buyers.”

Inevitably, the home mortgage evolved into the Ponzi stage, with the negative-amortization loan. Here borrowers weren’t even required to make full interest payments on their loan. The difference would merely be tacked on to the outstanding principal and at maturity grow to as much 130% of the original balance. Obviously, both parties assumed that home prices would rise forever.

According to McCulley, the Fed was slow to react to the credit crisis because of the central bank’s conviction that it had conquered extreme volatility in inflation, economic cycles and employment through sophisticated monetary policy over the preceding two decades. Fed Chairman Ben Bernanke took to calling the phenomenon “The Great Moderation.” The rating agencies also played a major role in the bubble by giving inflated credit ratings to the complex securitizations that contained the bulk of the junky mortgage and other paper.

Whatever regulatory reforms and capital requirements the Obama administration is able to spearhead in the weeks ahead, McCulley is skeptical that capitalist economies like the U.S.’s will be immune to future financial smash-ups. Human nature and financial innovation almost ensure that systemic risk will again bedevil Free World economies once memories of the current crisis fade, as they surely will. The only unknown is what form it will take next time around.