The WM Interview
Robert L. Rodriguez was early to recognize problems in the credit markets, having gone to a "plain vanilla" stance years before the financial tsunami hit. Referring to himself as a "car nut"--he races cars and peppers his speech with racecar analogies--he notes that the current economic situation and stim packages are akin to having a left foot on the brake and right foot on the gas, a car racing technique.
Rodriguez, CEO of First Pacific Advisors, LLC, in Los Angeles, says he sees no real recovery until the "second half of 2010--at the earliest," but cautions that the current situation "could take five to 10 years" to resolve, and says that the boomer generation may have to adjust to a lower standard of living. "People will have to retrench," by reducing consumption and increasing savings. He adds that "the longer we try to push things off, not deal with the problems the longer the system will take to recover."
Rodriguez and his team at FPA were early and vocal about the current crisis, and their research papers and speeches calling attention to their findings reside on their Web site, fpafunds.com. Rodriguez rails about some of the key things he believes still are missing with regard to the breakdown of underwriting and banking: "The basic concept of full disclosure, marking-to-market, are a couple of the basic elements that have to be done." Now that Treasury Secretary Tim Geithner's stress test of the banks is getting underway, Rodriguez argues that, "it has to be public and the various banks that are taking capital have to open their kimono. Oh, by the way, the first one that has to open their kimono? The Federal Reserve."
After 25 years at First Pacific, Rodriguez is ready for a break; in early March, he announced that he would take a one-year sabbatical starting in January 2010. FPA partner Steven Romick will become a managing partner along with J. Richard Atwood, who is also COO and CFO. Partners Thomas Atteberry, Dennis Bryan and Rikard Ekstrand will take over Rodriguez's portfolio management duties.
Bob Rodriguez sat down in mid-February with Wealth Manager Editor in Chief Kate McBride in New York.
Since we talked [more than a year ago] a lot has happened--you had talked about going to "plain vanilla" bond holdings and about the pretty horrifying conference calls that some of the rating agencies had held...a lot of what you had foreseen back then has come to pass. What are you looking at going forward--how horrendous is this?
It's very bad. I still do not have confidence in The Fed or Treasury or the Federal government--it's not what they say it's what they do. One of the latest actions was done at the end of the year [when] they put $5 billion into GMAC at 8% and had GMAC lend money out so people could buy cars from GM at a 0% to 2.9% rate so your marginal return-on-capital is less than the marginal cost of capital--that's not positive. And they lowered the credit score from 720 to 621--which is one point above subprime. What is what got GMAC into trouble in the beginning? Aggressive lending at giveaway rates--so I didn't see anything change there.
In my opinion, from the beginning The Fed and Treasury have been on the wrong road. They've always felt they were addressing a liquidity crisis when I argued it was a capital crisis--a far different thing. This was laid out in my speech in June 2007 "Absence of Fear," when I argued what would happen with Basil Accords when the structured finance model would break and the re-intermediation of banks would lead to a contraction in credit availability. In April and June, Bernanke said that [with] subprime--there would be no contagion, and so did Paulson. So when they had problems in subprime and Alt-A...these were canaries in the financial coal mine; and as opposed to thinking that there was a problem in the financial coal mine, they thought they just had sick canaries and they went out and got some more canaries.
I always wondered why this always seemed familiar to me...I did research on the banking crisis of 1907 about 30 years ago and so I got another [book] on it and said, "Of course, of course, ofcourse," [motioning as if paging through]. It was a new model that was developing in 1907, a new bank called a trust--they acted a bank they looked like a bank, they squawked like one--they even had vaults--but they didn't have the capital reserves as the national banks nor did they have the same amount of cash as a percentage. Why? Because if they held less capital and less cash they could earn a higher return! How is that any different than the non-bank banks of today?
Right--it's leverage in different clothing?
Leverage in different clothing. I'm going to the J. P. Morgan Library, and next to his accommodation is where they did the strategy containing the banking crisis of 1907. They got the major banks together, they got a clearing agreement between all of the national banks, and they shared their financial statements. The trusts were not part of that system. They had no backup clearing so when they started to have problems they had no-one to go to. The non-banks of today--when the asset-backed securities market imploded, they did not have deposits so it imploded on them as well. The similarities are so high. So how did they contain the crisis of 1907? They got all the financial statements and ledgers in a room and went around saying "Who's solvent, who's insolvent?" Morgan had one of his lieutenants go over to one of the trusts; [Morgan wanted] to know whether they're solvent or insolvent. [The lieutenant] came back and said "I believe they're solvent," whereupon J. P. Morgan said, "We will draw a line of the sand there." That was at Trust Company of America. The one that caused the mess was the Knickerbocker Trust.
So you have this element of something that has been lacking throughout this entire process, called transparency. In March 1933 when the bank holiday came, they reopened the banks in three phases: the first banks were the most secure and they had the implicit guarantee of deposits--they hadn't passed the deposits guarantee yet but FDR said "These banks you can trust, we'll stand behind them." During '33, I believe it was, approximately 4,000 banks were shut. How many banks have we seen close so far?
Speaking of transparency, we had a little thing called Bear Stearns; and after the Bear Stearns debacle, on March 31, I published a piece, "Crossing the Rubicon," [which] said we have crossed over into a new financial system, a new era. Little did I know that within six months how dramatic that change would be. I believe that was probably one of the very first that identified the new financial system. What we didn't know: what the rules of the game were, what the size of the playing field [was], or even what the playing field looked like. The Federal Reserve took on the Bear Stearns assets. Have they ever disclosed what those assets are?
Not that I've seen.
Have they ever disclosed what the evaluation methodology is, of those assets? No. So we have no transparency with The Fed, we have no idea of what they're doing other than they have broad categories at The Fed and how they've ballooned their assets--it's another black box. The capital at The Fed hasn't increased so their leverage has gone sky-high. That doesn't give me a lot of comfort.
Yes, the credit markets have opened to a degree. A lot of people look at the TED spread, what's going on in commercial paper, but much of what our markets are, are a function of the guarantees or implied guarantees of the Federal government right now--they're not a true market.
Because you can't trust your trading partner?
If the Federal government took away all their guarantees, how would the financial markets work?
You couldn't trade with anybody.
You couldn't trade with anybody, so that tells me it's an artificial market--still.
Do I trust the mortgage market? Absolutely not--they're changing the rules of the game and then they're also manipulating the prices upwards and the yields down. Not going to play in that category.
When you say "prices upwards" do you mean prices of the actual paper upwards, not home prices?
They've said "We're going to get mortgage rates down to 4%. So, how do you get them down to 4%? You buy the underlying assets to where you get the yield down to 4%. If you take away that [support] what would happen to the prices of those securities? The prices would probably fall and the yields would do what? Go up. So it's a manipulated market. They're trying to manipulate rates lower so that more people can afford the homes they're in and that gets me back to: People believe that if we solve the housing problem all this pain will go away. The mess that we're in is not just housing. We've had a pandemic breakdown in underwriting standards.
We still have another major shoe to fall, in the commercial multi-family area. The hit in that area could be upwards in the neighborhood of maybe $400 to $500 billion. There's about $3.4 trillion in commercial mult- out there, of which about $760 billion is CMBS. Between the end of '04 and the third quarter of '08 $1.1 trillion of that stuff was created.
Created in the same way as the regular residential mortgage-backed stuff was created--so, sliced and diced?
I'm talking about questionable underwriting standards. At one time I saw cap rates on commercial properties down to 3%. [Now cap rates are] more like 8% or 9%. You're talking about rents coming down, so you do a combination of rent decline with cap rates increasing and you're talking about probably 40% declines in the values pf commercial properties--and that still hasn't hit. You think about financial services industry; the real big layoffs didn't start hitting until the second half of '08 and really the fourth quarter of '08. And these problems will permeate the community bank area...so we have a long ways to go still. So I'm still very cautions, still very, focused on capital preservation.