Global Financial Crisis Survey
Robert L. Rodriguez, CFA is Managing Partner and Chief Executive Officer of First Pacific Advisors, LLC. Rodriguez has been credited by many with predicting the crisis in advance. See 8 who saw the crisis coming from Fortune (8/6/2008), They called it right from Kiplingers (12/22/2008), The Doomsayers Who Got It Right from The Wall Street Journal (1/2/2009), as well as Roger Lowenstein's The End of Wall Street, which credits Rodriguez's fund with the top return of any diversified mutual fund over the 25 years ending September 2009 (annualized return of 14.77% versus S&P 500 10.36%). FPA took extraordinary actions prior to the crisis in debt (by upping credit quality and eliminating credit risk) and in equities (by eliminating areas like financial services), as well as by asking it's clients for increased latitude to raise liquidity in the portfolios. FPA placed Fannie and Freddie debentures on its investment restricted list in January 2006, and by the spring of 2007 culled its commercial paper approved list so approximately 80% of it's formerly approved names were restricted.
1. Which FCIC View best represents the causes of the Financial Crisis?
Wallison Dissent. In June 2005 my associates, Julian Mann and Tom Atteberry brought to my attention the fact that credit performance of our pools of Alt-A securities began to materially erode barely nine months since issuance, despite having an average FICO score of 718. I said that by the time we found out why this was occurring, it would be too late. We sold all the pools by September 2005 and then proceeded to determine whether this decline in underwriting performance was even wider spread. In our September 2005 FPA New Income shareholder letter we stated, "We are concerned that these trends [referring to Alt-A] may be a very early sign of the emergence of credit quality deterioration in general." For nearly 20 years, we had invested in Alt-A securities without any credit issues. In our March 2007 shareholder letter, we devoted a Special Commentary section to discussing Alt-A and sub-prime credit issues and referenced a February 2007 First American Title mortgage study documenting the deterioration in various types of mortgage loans for a decade and in particular, since 2003. We also disagreed with the view of Federal Reserve Chairman Bernanke that the fall-out from the sub-prime markets was largely contained. I guess the Fed Chairman was unaware of these trends or this study. There is little question in my mind that the degradation in underwriting standards was one, if not the key issue, that led to the credit crisis. This trend would not have developed unless government policy was a significant driver in housing. The Fed's low interest rate policy acted as a booster rocket to this developing crisis.
2. Which narrative presented by Douglas Elliott and Martin Baily of the Brookings Institute in Telling the Narrative of the Financial Crisis: Not Just a Housing Bubble best represents the causes of the Financial Crisis?
It was the fault of the government. I have never liked the explanation that everyone was at fault. This is a convenient explanation that allows all who were involved to escape appropriate critical judgment. You can't fire everyone. It was the government's drive to increase home ownership, along with low interest rates, that created the environment for Wall Street to take this trend to a new level and investors, particularly regulated institutions, who clamored for securitized assets that allowed them to acquire AAA securities but with substantially wider yield spreads. This trend was driven by Basel 1's risk weight capital requirements. I highlighted this issue in my speech, Absence of Fear. I would argue that faulty regulatory capital design helped this crisis develop. I have again warned about Basel regulatory deficiency in my speech, Caution: Danger Ahead, as a contributing factor to the European sovereign debt crisis. Inadequate capital penalties encouraged European banks to aggressively buy risky sovereign debt for its yield advantage. This is reminiscent of what unfolded in securitized debt, CDOs etc., prior to the last financial crisis and helped to increase the size and scope of that crisis.
3. I believe the Global Financial Crisis is ongoing and I project it will end in the year2013 or beyond. I believe that we have been in an interlude period between 2010 and 2012. If the deterioration in the US fiscal status does not reverse, we will experience a crisis of equal or greater magnitude than what we've seen already. Excesses (like Fannie & Freddie) have not been addressed and are morphing into excesses at the sovereign level.
4. What were the primary causes of the Global Financial Crisis?The proximate cause was the Federal Reserve's unwise and unsound policy, along with regulatory roles which allowed credit to blossom. Wall Street ran with it and the private side took that flexibility in excess and supercharged it (yet the fed did not recognize it). Before the crisis, Bernanke believed there would be no contagion and subprime was a small area. In a 2007 speech, Absence of Fear, I argued that subprime credit was the canary in the credit coal mine and we had a major problem. Soon thereafter the Fed was taking extraordinary actions.
5. What still should change as a result of the crisis?One of the issues that has not been addressed is "Too Big Too Fail", which is why Europe is a mess. Their banking system is far more concentrated than the US and thus is more aligned or attached with their central government. The money from the ECB is being funneled into the banks and the banks are buying the sovereign debt (it's a shell game). It is the process by which the ECB has created three year loans through the LTRO at 1 % cost that allows banks to borrow, with pledged securities, and then buy sovereign debt. I refer to this process again in my Caution: Danger Ahead speech. In particular, I reference Italy. The Italian government guaranteed Italian bank loans and with this guarantee, the banks pledged these assets for additional ECB loans that provided the necessary liquidity to buy more Italian government debt, thus, my shell game reference. It is amazing to me that this game is allowed to continue. In the short-run it can but in the long term, reality will prevail. In a similar way, I believe institutions in this country knew that something was unsound, but they kept playing the credit game until the music stopped-----financial crisis. At FPA I did not allow this game to continue. Here in the United States we are seeing further concentration in the banking system. Now beyond TBTF, the financial excesses are unfolding at the federal level. I would argue that the monetary policy of Chairman Bernanke is creating that same type of environment of cancers in the system and we will not know what the negative effects are until later (just like we didn't know about the bad credit underwriting in the last cycle). Bernanke's interest rate policy is forcing various financial institutions and investors to take risks that they otherwise would not. I believe this policy is incredibly dangerous and unwise and I believe the Chairman should be replaced.
Compiled by Gary Karz, CFA
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