Author: Eric Uhlfelder

24 March 2009, Financial Advisor

While he believes the economy will not revisit the depths of the Great Depression, Dr. Henry Kaufman fears for the financial system.

The economic crisis didn’t surprise Dr. Henry Kaufman; he just thought it would’ve come much sooner.

One of the country’s leading economists and financial consultants, Kaufman recalls speaking at a Federal Reserve Bank sponsored conference in Jackson Hole, Wyoming in 1984, warning folks about the growing sophistication and opacity of our financial system, which he felt demanded new supervision and regulations. But he didn’t find many people were listening.

Having grown up in the shadow of World War II in Germany during the Depression, Kaufman, now 81, reminds us that his generation has always carried with it a greater fear of risk than he sees in current business and public leaders. This is evident whether looking at quantitative managers who believed they had derived fool-proof methods for sidestepping economic meltdowns or financial regulators who embraced the oxymoronic concept of laissez-faire oversight.

Most worrisome to Kaufman was the creation of mammoth financial conglomerates with huge balance sheets and thin capital bases, who have magnified the debt problem through their seamless distribution of credit. And this has blurred the measure of solvency.

“Liquidity has come to mean your capacity to borrow,” he says, “and that has led to an extraordinary change in business and household finance.” The subsequent explosion of securitizations, credit derivatives, and soaring leverage has created far less transparent, more vulnerable, and less stable institutions.

Where these trends should have stoked fears, Kaufman believes that our ability over the past half century from preventing crises to morphing into depressions has given us an unrealistic sense of confidence in deregulation and the relentless upward bias of markets.

He points to a series of economic failures in the1990s: Southeast Asia’s currency collapse, Russia’s debt default, and economic turmoil across Latin America. “These crises were definable in geographic and financial terms,” says Kaufman. Though involving hundreds of billions of dollars, they were relatively transparent and quantifiable tremors. As a result, companies, governments, and investors were not crippled by these events as the world’s major economies took only glancing hits.

Something Different

But today’s crisis is systemic, embedded in the world’s major financial centers of NY, London, Paris, and Frankfurt. And its potential dimensions are very hard to measure because financial dysfunction has metastasized globally through the explosion of debt, derivatives and securitized obligations. “We can’t accurately measure the scale of the problem,” says Kaufman, “because underlying valuations are so uncertain, creating markets that are increasingly opaque.”

Still, some observers find comfort in the lessons learned from the Great Depression. But Kaufman warns that we shouldn’t place too much solace in that experience. “Things were a lot less complex in the 1930s,” says Kaufman. “Sure there were monetary and fiscal policy mistakes that made matters worse back then, and we aren’t repeating the same missteps today. But remember at the time there were no financial derivatives, the dimensions of lending and investing were much more transparent, and domestic economies were more definable.”

Dr. Kaufman is currently reading The Lords of Finance, Liaquat Ahamed’s history of central bankers from London, Paris, Berlin, and Washington, in the aftermath of World War I, which had left the western world in economic turmoil. Ahamed argues that the bankers’ well-intentioned missteps, including the introduction of the gold standard, arguably contributed to the Great Depression by inadvertently restricting policy response to collapsing economies.

“While I don’t think it’s a guide to how things will eventually play out today” says Kaufman, “the book reveals the limits of our leaders’ capacity to combat systemic problems, cataloguing the various mistakes that were made, which arguably paved the way for an even more devastating global war.”

So how much can we learn from history?

“Today, we’ve got a student of the Depression chairing the Fed,” observes Kaufman, “but despite his solid credentials, Bernanke failed to recognize the excesses of the financial market–the enormous growth of debt, the enormous growth of financial derivatives, the deterioration in the quality of credit in the housing market–until it was very late.”

These excesses were being fueled by 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,” says Kaufman.


A fan of opera and an avid art collector with a passion for modern American paintings [see images below], especially Marsden Hartley, Kaufman believes one’s understanding of art improves when focused—a sentiment he applies to President Obama’s rangy domestic strategy. “I would’ve preferred if the administration concentrated on economic stimulation and put off its other programs to a later time,” says Kaufman. But overall, he thinks Obama is pursing the only feasible choice there is.

Kaufman believes reviving the economy ultimately comes down to a single matter: removing toxic debt from the financial system. It will be a slow process, with the public eventually bearing the cost of defibrillating banks’ balance sheets.

But in doing so, Kaufman would like to go further than the Treasury Secretary Geithner’s recently announced plan, designating large financial conglomerates as public utilities–like water and electric utilities–with limits on return on equity. Such a metamorphosis would substantially reduce banks’ various conflicts of interests.

For example, Kaufman would want to prevent financial institutions who take in deposits from co-owning hedge funds. And he thinks any depository institution that underwrites stock or bond issues should not be allowed to have equity or debt stakes in these issues. “Ultimately,” Kaufman concludes, “I would like to spinoff pieces of these conglomerates to reduce the concentration of risk.”

Defensive Investing

Kaufman realized that at the start of 2008 it would be a very difficult year. So he took a variety of defensive steps.

First he began liquidating his long-only funds to avoid potentially seeing capital tied up. He subsequently sold off his commodity exposure, and started to short the S&P 500 index. Sensing the British economy was primed for a massive slowdown and interest rate cut, Kaufman began building up a long British gilt position. All throughout the year, he was squirreling away cash. And these moves collectively helped him end 2008 in the black.

So far in 2009, Kaufman is continuing to draw down his equity position. At the same time, despite troubles afflicting municipal and corporate finance, he’s selectively adding high quality municpals and short-dated, highly rated corporate bonds.

Because spreads on distressed debt have blown out to extraordinarily levels, Kaufman is most enthusiastic about establishing a substantial position in a new fund that’s targeting this asset class. “Legacy portfolios will continue to be hamstrung,” Kaufman believes, “by continued difficulties valuing securities already in their portfolios.”

Moreover, with credit ratings still likely to fall further resulting in additional devaluation, he thinks it would be wiser to start establishing a distressed debt position a bit further down the line when markets may be closer to bottoming. Sometime this year, he surmises valuations may be more transparent and the impact of future events may more likely push values higher rather than lower.

US Debt and the Dollar

Asked whether he is concerned about a Treasury market bubble bursting and colliding into his debt positions, he says that’s not likely over the next year or two. So long as private sector credit demands remain constrained and monetary policy continues to be accommodating, he thinks the American government will have no problem issuing massive amounts of new bonds.

In fact he thinks talk about a Treasury bubble, much less one that’s about to crack, is premature. “We have a positively sloped yield curve that leaves sufficient room to accommodate market response without causing Treasury prices to breakdown,” he says. And the Federal Reserve’s new commitment to buying longer-dated governments should further stabilize prices.

However, in the next year or two, when he expects private market credit demands to pick up, Kaufman anticipates intermediate and longer-term government bond yields will likely rise. While inflation fears could fuel this shift in the yield curve, Kaufman believes improving economic conditions will inform this shift in interest rates.

If this scenario does play out, it doesn’t ostensibly sound like it would benefit distressed debt. But Kaufman sees current distressed spreads so wide that they would likely contract once the economy begins to expand again.

While record federal spending could drive the dollar lower, Kaufman expects the greenback to remain stable during this year and next because there isn’t a reserve currency substitute. “The yen doesn’t have the depth, and its geared to an insular home market,” says Kaufman. Meanwhile, he sees the euro being hit by economic and political problems exacerbated by the inability of member governments from collectively addressing the crisis.

He’s also worried about huge levels of debt held by European emerging economies denominated in stronger western currencies. Devaluation of Central and Eastern European currencies will likely further exaggerate default rates. To Kaufman, “this begs the question: who’s going to bailout Eastern Europe, not to mention the troubled economies of Italy and Spain?”

Given the global stresses, gold would seem a solid bet. Not to Kaufman. “I wish had clear thoughts about the metal one way or another,” he says, “but I don’t.”

How about bidding on drastically beaten down financials? “Not for me,” he exclaims, “because I don’t have a clear idea how to evaluate them at this time.”

While stocks have bounced off their 13-year lows, Kaufman is by no means certain that the worst is over for equities. But for those thinking about reloading on stocks, Kaufman advises extreme caution and to keep things simple. “Restrict your sights to only companies with strong balance sheets, leading market share, and those that stand a high probability of enjoying sharp earnings growth when the economy does eventually recover.”




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