Regulators, not Greenspan, to blame

“The last 18 months were quite a ride,” he told advisors on Tuesday at a conference on alternative investments sponsored by Mindpath. “It got a lot worse than I ever thought it would get. I went into it expecting the market to be down 15%; we came down 30%.”

While he identifies leverage as the problem — “it’s always because of leverage,” he says — nevertheless, this time was really different. “Normally it’s on the corporate balance sheet. This time around, corporations had the least leverage I’ve seen in my life.”

Instead, the leverage was to be found on the balance sheets of the banks. “Securitization is a wonderful process, but something went horribly wrong,” Allen said, asking how, “you can put 100 bad loans in a security, but you don’t have 100 bad loans coming out of it?”

Apart from that, there was no room to cover risk. Typically, in the 1980s and 1990s, securitizations were 10% over-collateralized. Now, by contrast, securitizations have gone “from 10% over-collateralization to 10 times leverage.” Allen points out that the Canadian asset-backed commercial paper that failed in 2007 had 10 to 12 times leverage.

The source of the leverage — or at least the source of the assurance — was that the models financiers were using were based on falling volatility. Assets that were 30 times as risky received triple-A ratings. For that reason, Allen calls securitizations “rating agency arbitrage.” He points to one monoline insurer in the U.S. — a company that insured bonds against default — that issued debt at 16% to maintain its triple-A rating.

For him, the ratings agencies are very much at the centre of the debacle. But so too is the U.S. government. One reason was the attempt to increase home ownership, which had been a steady 64% over the past 50 years; it reached 69% in 2006, meaning “five million houses in the U.S. that people couldn’t afford.” Moreover, the two government-sponsored entities that supplied liquidity to mortgage lenders had an “insane” capital structure, with only 1.5% equity.

More telling about the current U.S. mess, Allen argues, “the irony of the banks is that the banks are the most heavily regulated entities in the economy. No one tells Telus how much leverage they can have on their balance sheets.”

As a result, “the only people that had watchdogs everywhere took the most risks.” In that sense, there’s little blame for Greenspan, though he may have kept rates too low for too long. Rather, it was “the feds’ complete lack of oversight over the SEC and the rating agencies” that were to blame.

As for the next few years, Allen says he’s not very optimistic. “We’re in a deflationary spiral today. It’s going to be followed by a period of rampant inflation.” This will trigger higher interest rates, leading to a new recession.

While the future environment is “going to be unlike anything we’ve ever seen,” Allen still thinks “there’s lots of money to be made,” particularly in high-yield debt. The market is discounting a default rate that’s twice as bad as what occurred in the 1930s, with 30% or 35% defaults. It’s currently 4%, and Allen thinks it’s more likely to be 12%.

On the other hand, “I don’t think we are going to see the market rally as default rates go from 4% to 12%,” he adds.

Allen is also big on gold, in the form of mining companies, to reduce exposure to a declining U.S. dollar. “Gold is a lay-up,” he says.

Oil and infrastructure, too, should fare well, given demand pressures.

Still, “over the next four to five years, equity risks are best taken in the credit markets,” he argues. In these kinds of environments, high-yield bonds have always led the S&P 500, with only 40% of the risk. Beyond that, “We’ve gone through 30 years of leveraging debt.” Now the pendulum has shifted: “deleveraging is good for debt and bad for equity.”

(02/11/09)