Economic Insights from a Lord of Finance
Source: David Galland, Casey Research (11/4/11)
"The only way to resolve the sort of problems we're facing is through growth, and if you don't get growth, then the policy makers will continue to debase the currency."
Whether you call them fat cats, greedy bankers, soulless manipulators or unindicted co-conspirators, the one sure thing, in the minds of most, is that they wield the power behind all thrones and that it is their whispered agreements, invariably made in darkened rooms full of cigar smoke, that decide the economic fates of us all.
Over the years, I have met quite a few of these "Lords of Finance" and found them to possess the same wide range of traits, positive and negative, shared by all humans: fear, insecurities, self-delusion, high hopes, good intentions, social aspirations, good habits and bad.
And, of course, the greed that the Lords of Finance are said to possess in extra doses. Like Gordon Gekko, I have no problem with greed, as long as the pursuit of that which gives you pleasure does no harm to others.
There is one trait, however, that, in my experience, is almost always present in a Lord of Financeand that is an acute intelligence. When it comes to matters of finance, even the average Lord of Finance has a keenly honed mind that has been trained to precision to understand the complex pieces of investment markets.
Which brings me to my interview. We'll call him LOF, because the only way he would agree to be interviewed was if it was anonymous. A former colleague of a friend of mine, his career on Wall Street has stretched over 40 years and includes 10 years as the chief financial officer for one of the world's most powerful investment banks. Leaving that position to strike out on his own, he and a group of colleagues went into money management, overseeing billions of dollars. Now, slowing down in the latter years of his career, he and his colleagues manage "only" tens of millions.
My goal for the interview was two-fold. First, it is to help calibrate our own views on the outlook for the economy with an individual who is not just hyper-intelligent but who has spent a lifetime immersed in the money game at the very highest levels. Casey Research sees the ongoing crisis getting far worse before it gets better. But what about a Lord of Finance?
Secondly, I wanted to gain some insights into the rarified world inhabited by the Lords of Finance. Is their dismal reputation warranted, or are they just people whose education and professional instincts have taken them to the top of highly rewarding and highly influential careers?
Let's find out.
DAVID: People have a lot of perceptions about the "Lords of Finance," if you willthe big banks, the operations in New York, the political connections and so forth. As you worked in the executive suite of one of the largest and most influential of these institutions for a long time, I want to get your take on those perceptions and also see how well our views on the current economic situation sync up, or not.
LOF: This is totally anonymous, right?
DAVID: Yes, completely anonymous.
LOF: Okay, great.
DAVID: So as a background, the first question, how long have you worked in the financial industry, what did you work in, and what sort of capacities?
LOF: Right. Well, I guess it started in the mid-'60s, so I've been in the business now for 45 years. It is hard to believe, and the first 25 or so, really the first 30, I guess, were with a major investment bank that will go unnamed, rising to the position of chief financial officer.
Since retiring, I was involved with a firm managing billions of dollars. So, in answer to your question, most of my career has been with a big bank, but I have also run my own money management business. I am also a CPA, having started with a big CPA firm back in the early '60s.
DAVID: Right. So 40-plus years in the business.
DAVID: In all that time, have you ever experienced anything in the markets and the economy similar to what's going on today?
LOF: No. In my experience, this is unique. And I remain concerned about the potential for another serious crisis. And for the first time, I'm concerned as to whether or not the American economy really has the kind of robust characteristics that we have enjoyed for most of my life and most of our careers, which is something quite new to me.
DAVID: So you aren't buying the story that we're out of the worst of this and that it's happy days from here?
LOF: No, I certainly don't buy that story.
DAVID: How would you describe the current state of the big financial houses? Does the fact that they're still laying off thousands of people suggest these firms are hunkering down for a protracted period of slow growth?
LOF: Yes, I'm sure that's what they're doing. I think they're also in an environment that is extremely uncertain, looked at from their point of view. You have a public that is still angry with them, for good reason, for their culpability in what happened in 2008 and 2009 and continues to happen.
Then you've got a regulatory bill, this Dodd-Frank bill, which has really yet to evolve because so many regulations have yet to be written by the various agencies. So the banks really don't know what the landscape is going to look like going forward, and that makes it very difficult to plan, especially when it's clear that the appetite is for more stringent regulations and not less.
Another aspect is that the environment in which they were able to make so much money by using tremendous leverage has certainly changed. It is highly questionable whether they can do that sort of business again, given that the balance sheets of these big banks are so opaque and so difficult to manage. So much so that I question whether any outside regulator can decipher and understand the risks that these banks have been taking. Actually, I question whether the banks themselves understand the risks that they're taking. I think there are so many interactions that I have to wonder whether anybody really understands the kinds of risks that are out there. All of which adds up to a very challenging environment for these banks to operate in.
DAVID: Speaking of uncertainty, Dodd-Frank contains something like 400 new rules the banks are going to have to comply with, most of which have yet to be implemented. That would support your contention that it's going to be very hard to plan in that kind of environment. Especially because some of the new legislation strikes right at the heart of key lines of their businesseslines that have gone away and are unlikely to return anytime soon. So that's got to really add some pressure.
But actions speak louder than words. Knowing everything you know about the big financial houses, would you invest in one today?
LOF: I would not. The way I look at the world as an investor today is very different than the way I looked at it in 2007. With hindsight, I now know that I was taking much too much risk in 2007, and part of that risk was in financial companies. I have significantly reduced that risk to a very, very small fraction of my own investment portfolio.
I think that it's a fool's game to invest in those banks, because there is so much uncertainty out there, in terms of the new rules and regulations, and also there is far too much risk embedded in these companies.
DAVID: Are you referring to derivatives?
LOF: Derivatives are certainly part of it, but it comes down to the exposure these companies have to other financial institutions. The interrelationships are immense, and the credit of each of these institutions is uncertain and hard to evaluate.
Let's put it this way, they're not doing business with the Procter & Gambles of the world, businesses you can do a fairly straightforward evaluation on. I no longer understand the complex interrelationships of the institutions. If I ever did, I no longer do. And I don't like to invest in things I don't understand, certainly not in size, so I'm uncomfortable with these institutions as an investor. For that matter, I would be uncomfortable as a regulator, and I would be uncomfortable as a customer.
DAVID: To many people, the "fat cat" bankers on Wall Street are viewed as the very epitome of unchecked greed, avarice, even evil. As you were part of that world for a long time, how would you respondis the poor image warranted? Do you think the culture in the big institutions has changed over the years since you retired?
LOF: Most of the people I worked with on Wall Street were good peoplewell meaning, ambitious, but with a very strong moral compass. I suspect that is still true today.
I do think that the culture has changed. . .in one important respect. For many, many yearsincluding when I worked thereWall Street was dominated by large partnerships. The partners had every nickel they hadboth in the firm and outside the firmat risk, even their homes and cars. I was stopped frequently by partners who worried incessantly about too much risk threatening their financial well-being.
We weren't permitted to take much of our capital out of the firm, and withdrawals were tightly monitored. Why? To reinforce the feeling that all we had was at stake and to encourage modest risk taking as opposed to "betting the ranch".
That all changed once firms went public and partners were able to have large stakes outside the firm and achieve "limited liability". It became "other people's money". A huge difference, I think, and one that contributed to a much greater willingness to do things that wouldn't have been done in an earlier era.
A second factor was the elimination of Glass-Steagall, which had previously kept activities within bounds. Once that was eliminated, banks and brokerages were able to greatly expand their risk takingwithout the capital necessary for such risk taking. And, in many cases, beyond the managerial expertise of any firm as well as the expertise of the regulators, because their activities became too complicated for mere mortals to understand.
DAVID: The news broke recently that the government is preparing to launch a new wave of lawsuits against the big banks over their mortgage lending practices. Do you get a sense that the honeymoon is over between the government and the big banks?
The average guy on the street looks at the big banks and the rotating door between the banks and government and thinks, "Well, these guys are all in the same bed." Is that an accurate assessment of the way things have been, and if so, do you think that cozy relationship is now changing?
LOF: Well, it's been pretty stunning how, on a number of fronts, the banks have gotten away with as much as they've gotten away with. That does suggest that there is this unholy alliance between the people that write the rules and the people that benefit or suffer from those rules, aside from the average person on the street, that is.
You're right, that's the perception, and I think it's accurate given that nobody has gone to jail. Considering what's happened, it's amazing that that's the case and suggests that corruption in the political process played a role in what happened. But that may be changing.
The elections of 2010 and perhaps the election of 2012 are putting a lot of people in office that are not beholden to the big financial institutions in the same way as was the case in 2008. That said, that's not necessarily good. I mean it's good in a sense, but at the same time, when you have the attitude out there that it's the government against the banks, that's not healthy for the economy either. It's too early to say how all that will play out, you know, on a bottom-line basis.
DAVID: Based on your observations, do you think the banks were deceitful in how they marketed overrated mortgage-backed securities, or were they just blindly opportunistic in going along with the flow?
LOF: Have they been deceitful? I don't really have an opinion on that, but I will say that the big problem in 2008 and 2009 was in the excessive overleveraging of these institutions and the amount of risk that they took on. The fact that they weren't as candid as you would like them to be in terms of what they said about what they created and what they soldI think that's pretty much always been out there, but most of the people on the other side of these trades were pretty sophisticated people.
So I guess you can say that it was a caveat emptor kind of situation. In my view, it was the scale of what they were doing, the immense leverage that was embedded in the system, that was more of a problem than whether they were deceitful or not.
DAVID: Has the leverage been markedly reduced at this point?
LOF: You know, I haven't studied it, so I can't tell you that I know. I believe it has been reduced, but by how much, I really couldn't say. Whether it's been reduced enough and whether there's enough capital in the system to cover the risk, who can say?
One of the things that's sort of interesting to me is that Warren Buffett invested five billion dollars in Goldman Sachs back in 2008, and that gave a lot of confidence to others that somebody like Buffett would put five billion dollars in even though the capital was pretty expensive. And then, within a couple of years, they pay it back, which makes me question why they would have taken Buffett's money in the first place.
I mean, it's nice capital, and yes, it costs a little bit more, and maybe the reputational aspect of having Buffett as one of your investors was important at the time, and so you take the capital and then pay it back, but that doesn't make a lot of sense to me. Then, recently, Buffett goes to Bank of America and offers them five billion dollars and they take it, but at the same time they're saying they don't need the capital, so it's confusing.
Do they or don't they need the capital? I'm not sure they know. I'm not sure anybody knows what kind of capital needs they have. Again, it gets back to my point as to how much they really understand their own businesses anymore, and the risks that are there and the amount of capital that they need.
If the companies themselves don't understand it, how do you expect those people that are overseeing them to understand it? Bottom line, I question whether there's enough capital in the system for the risk that is being taken, even today.
DAVID: Which begs the question that if another big bank runs into serious trouble, and Bank of America seems like a good candidate, do you think there's an appetite in Washington to arrange another bailout? Of course, the consequences of not bailing them out are pretty significant.
LOF: I don't think there is an appetite for more bailouts. You can see that by looking at what's happening in Europe.
The question of what to do with banks and what to do with the problems they could create for the economy if you let them go is being grappled with worldwide. I think the only hope the policy makers have is that these problems will be solved through growth, as that is the only rational solution.
Which means the real question is whether or not that growth will occur in a reasonable time period. Frankly, it is hard to see where that growth is going to come from. It is certainly hard to see that in Europe, and it is hard to see that here in the US as well.
DAVID: On the topic of growth and trying to get money in the system, you're a financial guy, so maybe you can explain the tremendous amount of money sitting on deposit at the Fed earning almost no interest, but enough, apparently, to keep the banks from lending that money back into the economy.
Do you have any thoughts about why the Fed is paying interest rates on the deposits and why the banks are leaving that money on deposit? It's unprecedented as far as I'm aware. Any thoughts on that?
LOF: You're right, there is a tremendous amount of money that is not being employed in the economy, and it's all part of the same problem. And that problem is that the banks don't have any confidence, companies don't have any confidence, outside investors don't have any confidence. Everybody is frightened, and everybody is trying to protect themselves. That is not an environment that produces growth.
DAVID: So they are leaving the money on deposit at the Fed because they're not sure about their capital needs? What if the Fed were to go back to paying them nothing on their excess reserves, or actually start charging them to keep the money parked at the Fed? Wouldn't that help push that money back out into the economy?
LOF: All these potential decisions by the Fed have consequences that neither they nor anybody else can anticipate. What you're suggesting might work out, but I don't think anybody knows. I don't pretend in any way to have opinions as to what the Fed should or should not do. It's not something I study. It's not something I understand, particularly.
Instead, I try to approach these sort of things as a businessman or as an investor. And as a businessman and as an investor, I look around and see a lot of uncertainty, I see real potential for crisis. And when I see that, I just want to hunker down in some way, and that attitude influences every decision I make.
As I've mentioned before, since 2007 I've changed the way I think about things. As a result, for the last four years I've been working to position myself and my family in a way that I believe is more sensible. Becoming far more cautious could be the right thing to do or it could be wrong, but however you look at it, when you extrapolate that shift in attitude across millions of investors and business owners and even bankers who have been acting much the same way, it is not a positive for the economy. I guess that wasn't a specific answer to your question, but. . .
DAVID: No, it makes sense that this widespread reaction to uncertainty is a fundamental force in today's economy and investment markets. Any thoughts on interest rates? It seems odd that the U.S. government could have record levels of debt and continue to run record deficits and yet interest rates bump along at record lows. Does that make sense to you?
LOF: Actually, it has made sense to me. I have felt for some time that the people, including Bill Gross, who I think is great, who have been saying that interest rates and inflation are heading higher, although probably right in the long term, were not going to be right in the short term, and that the short term has a ways to go. Specifically, I have felt for some time that interest rates were headed lower, and I continue to believe that we could easily see 1.5% on the 10-year Treasury and somewhere in the 2s for the 30-year.
My rationale is that there are such tremendous headwinds preventing the economy from growing in any significant way, and it will probably be contracting, and those conditions are not going to produce rising interest rates. Quite the opposite. The headwinds are all the things that we've talked about, plus you've got this dramatic entitlement problem in our country and in Europe that is only going to grow more problematic.
If you go back in history and look at the ability of a democratically elected government to take things away from people who vote, the record is pretty clear. Predictably, if you've given people something significant, and then you try to take it away and they vote, the politicians will be voted out. So whether it's right or it's wrong, the populace in general will not stand for it, so therefore the politicians will avoid taking the hard measures that could actually help solve the problem.
Historically the only way to resolve the sort of problems we're facing is through growth, and if you don't get growth, then the policy makers will continue to debase the currency.
Ultimately that will happen, but in the period of time that I can foresee, which is the next three or four years, I don't see much of a chance that interest rates will go up. I think there is a very, very strong downward pressure on interest rates that will continue for a while.
DAVID: Obviously, the uncertainty will keep people looking for those safe harbors, and Treasuries are still considered safe harbors. The other thing that sort of strikes me as a factor now is the dismal shape of the Eurozone. I have to imagine that there is an awful lot of money currently in the Eurozone that would like to get out of there and is starting to move out. Of course, U.S. Treasuries are one of the few instruments that can actually handle any kind of real volume, so that will probably help keep rates down as well.
LOF: Absolutely. I think that's absolutely true.
DAVID: You seem to be expecting short-term deflation, longer-term inflation, would that be a good way to describe it?
LOF: It's pretty hard to create a scenario where you don't have inflation in the long run, but what the long run is, is another question, and the long run could be quite a ways out.
Let me add that I am more positive about the future than I may otherwise sound. I think that the American economy, in particular, has resilience that is pretty impressive, and that ultimately we are going to get through this. But I think it's going to be a very, very long period of time before that happens; it could easily be five to ten years.
When we do come through it, I think the economy will have a vibrancy that people won't expect, but it's going to be a while, and at that point, I think we're going to have to deal with some serious inflationary pressures.
DAVID: Given the obligations and the entitlements and the current level of debt and no end in sight to the trillion-dollar-plus deficits, it seems to me that this is not going to end without some sort of default, either overt or covert in terms of inflation. If for no other reason than that these obligations can't be met. Would you agree with that?
LOF: Yes, I don't think they can be met. I think it's impossible. I think they have to be restructured in some way. You've got to restructure the whole entitlement system, and politically you can't do that right now.
I recently had a conversation with the economist at a major bank, and I asked him what he thought. I said, "What do you think the chances are of another crisis of the magnitude or greater that we had in 2008 and 2009, and if that crisis occurs, when would it occur?"
He said he thought that there was a real chance of that happening, and if it happened, it would probably happen sometime after the election in 2012 when the markets realize that even in a new administration, these problems will not be dealt with.
In his view, once the markets understood that, we are likely to see a very, very bad crisis. Then, just maybe, at that point will the political process make the necessary adjustments. But I think that even that's questionable.
DAVID: I just finished an article for John Mauldin's newsletter, in which I looked back at all the times the U.S. monetary system was in danger of failing and had to be fixed.
As it's been 40 years since the last major do-over of the monetary systemwhen Nixon closed the gold windowmost people think of the monetary system as being fixed in stone, and the notion of it stumbling doesn't even come up in the average conversation. But in reality, it has been restructured numerous times since the Civil War.
In our view, the current fiat system is not going to make it to the other end of this crisis intact, but will have to be remade in some way that anchors money to commodities, with gold at the core.
How do you and your friends in high finance view gold these days? Do they still view it as a barbarous relic, as they did a few years ago? Are they starting to buy it for their portfolios? Personally?
LOF: I think that more and more of what you might call respectable opinion puts gold in a different category than they would have five years ago. You hear an increasing number of serious commentators, people like Byron Wien, for example, talking about having a 5% position in gold, and you never would have heard that five years ago.
Back then, favorable opinions on gold would have been seen as far out. Today having a significant gold holding is more and more in tune with respectable opinion than it ever was. The mainstream guys are also thinking in terms of things like TIPS and in terms of holding other currencies.
In other words, they're investing in things that they never would have thought of doing before this crisis, but gold in particular. And not so much as a commodity but as a currency. That's been my view for some time, but now I am hearing that same view on a much broader basis.
DAVID: So I take it you have been buying gold personally?
LOF: I have.
DAVID: Starting when, more or less?
LOF: Well, I've had a gold position for 20 years in gold coins, and then in the last three years I've been adding to that through ETFs.
DAVID: What percentage of your portfolio, more or less, would you say is now in gold?
LOF: It's probably 3% or 4%, but it probably should be higher.
DAVID: Moving along, it's safe to assume you're pretty well off financially. What did you think of Buffett's call that the government should be taxing the rich more?
LOF: I have what you may find an interesting point of view on that. I do think that inequality is a bad thing, and it is something that causes political unrest. Being a dedicated Republican, as much as I dislike this administration, I would have to believe that if there were a Republican administration in place and we had this kind of an economy, you could easily see a lot more political unrest in the street than you do right now.
Now ask yourself what Buffett and people at that level of wealth are afraid of. . .I can tell you they are not afraid of muchif you have whatever he has, 50 billion dollars, you're pretty well set. The real fear people like that have is social unrest, and so maybe what he's doing is trying to appease the masses by virtue of saying he should be taxed more, even though that's not going to make any kind of a dent in his net worth.
So it's an appeasement thing, and I understand why he's doing it, but I don't think it works. I don't think it appeases anyone, and I don't think it does anything to redress the inequality problem that's out there. That's a very, very great fear that people with money have, of social unrest on the home front.
DAVID: Do you anticipate your taxes going up, a little or a lot?
LOF: I think you have to assume that over time they will go up a lot. Whether or not that happens in a short time frame or a long time frame, I think the political pressures ensure it. If 50% of the people don't pay any taxes and they're voters, then that has to be the direction we are heading. As much as I don't think that will be good for the economy, and I certainly don't think that it will be good for me, I think it's pretty hard to resist the reality.
DAVID: Other than gold, what else are you investing in these days? Are you heavy in cash?
LOF: Yes, I'm more heavy in cash than I ever was. I still have an allocation to municipal bonds where I keep the duration relatively low. I have an allocation to common stocks of companies providing consumer staples, the Procter & Gambles and the Kimberly Clarks and the Johnson & Johnsons of the world. Companies that are in better financial shape probably than the U.S. government and that pay dividends of 3% or so.
I have an allocation to hedge funds run by very smart people who can do things and think things out in ways that surpass my level of confidence in doing it myself.
I have an allocation to convertible bonds, convertible bonds of companies where you keep the duration short, and you believe that they'll still have a pulse a few years down the road, so you're going to at least get your interest on the bond if you're wrong and if the stocks don't perform.
As I mentioned, I've got an allocation in gold and in TIPS. And I also believe in having money in private equity. I do believe if you want to take risk, put some money with a manager who is putting his money to work side by side with yours, watching for opportune situations, taking advantage of the dislocations that exist, and doesn't have a liquidity issue where investors have the ability to pull their money out whenever they get nervous. I think that is a very sound place to have an allocation to.
DAVID: To give us some sense of how concerned you are about things at this point, what percentage of your portfolio is in cash?
LOF: About 10%.
DAVID: That's all, so you haven't completely run to cover?
LOF: I consider my municipal portfolio, which is pretty short term and is maybe another 15% or so, and my convertible portfolio and my portfolio of consumer staples as all being things that constitute my safety net. If you add all those together, it's probably close to 40% to 50% of my portfolio, So, yes, it's not all cash, but it's, you know, at least in the categories that I feel comfortable with.
DAVID: Wrapping up, looking over, let's say, the next five years, on a scale from 1-10 with 1 being everything is going to be okay and 10 being something closer to Doug Casey's view that "people will be grubbing for roots and berries," where would you put yourself?
LOF: The next five years: 1 is hunky dory and 10 is Doug?
LOF: I guess I'd be a 6. I mean, I think that we're not going to be fighting in the streets and having to use our gold and silver coins to eat, but I do think the economy is going to be extremely sluggishvery, very sluggish. I think we're going to have high unemployment and there's going to be more unrest, but I think we'll slog through it.
DAVID: As you contemplate the future, is there anything in particular that keeps you up at night?
LOF: I don't stay up at night and worry about the economy. I do think that for most people that have been fortunate enough to live to an older age, the biggest concern they'll face is about their children and grandchildren. The older folks will struggle through it because when you get into your sixties and seventies, you don't need that much, and you can adjust, and you can compensate one way or another.
But when you're young and you've got a family, it's much harder to adjust, and I think those are the people that I worry about, and that's what I think other people are going to be worrying about, too. They're going to have their kids moving back in with them and not having any kind of self-esteem, and they're going to be worried about their grandchildren. That's really where the issues are, not people losing sleep over their own ability to survive.
DAVID: A wise observation. On that note, thank you very much for agreeing to this interview.
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