In Part 2 of our talk with John Maudlin, he explains where all the money is, tells us what the word will be this summer, and plays one of the Fool's favorite parlor games, "Buy, Sell, or Hold?" Mauldin's latest book is The Millennium Wave: Prosper (& Profit!) in a Future of Accelerating Change.
Part 1 of the interview is here.
Rich Smith: From late 2005 into 2006, the news was still dominated by stories about Procter & Gamble (NYSE: PG ) buying Gillette, Arcelor Mittal (NYSE: MT ) consolidating the steel sector, and private equity buying everything else. You explained this by saying "The world is awash in cash looking for a home," and suggested, "Don't expect the wave of going-private deals to end anytime soon."
But what a difference a couple of years make. Nowadays, Blackstone's (NYSE: BX ) stock is falling. The Home Depot (NYSE: HD ) Supply deal got its price cut. Sallie Mae's buyout has fallen apart. What's happening here? Where did all the money go?
John Mauldin: The money is still there. The people who have it just don't trust the rating agencies anymore. They're afraid to buy the debt, and as a result, banks need to recapitalize. So what you are seeing today is sovereign wealth funds stepping in to fill the gap, buying stakes in Citigroup (NYSE: C ) , Morgan Stanley (NYSE: MS ) , and Merrill Lynch (NYSE: MER ) .
The sovereign wealth funds are not taking a five-year view. These funds have a very long-term view on their investments, and they are willing to take the risks that others might not take. But at the same time, you need to understand that they're getting deals that you and I will never get.
I wouldn't invest in banks right now, because I don't know what's inside. But these sovereign wealth funds can get convertible debt paying high interest rates and all sorts of deals that the rest of us cannot get. They'll get interest rates high enough that within a few years, their investment is paid back in full; so essentially, they're receiving free warrants on cheap stock in exchange for their loans. This tells you just how desperate Citi and the others are. They need to recapitalize now, and they will need more money in the future.
Smith: So what does this mean for private-equity buyouts?
Right now, people are repricing risk. Risk capital costs more, which prices more target companies out of the market. But if the market keeps falling, I think you'll pretty quickly see that the money is still there, if the price is right. Another 10% to 15% drop in prices would put a lot of companies in play. At that point, you will begin seeing some hostile takeovers.
So in my opinion, that will be the watchword this summer. Very large companies that still have access to capital will begin venturing back into the market and buying up the weaker firms. Companies that are beaten down are going to get bought out.
That '70s show
Smith: In your 2008 forecast edition of "Thoughts From the Frontline", you predicted: "a Fed rate below 3% by the end of the summer, if not before." You further predicted that it would not help, saying, "Rate cuts won't help the credit crisis, won't solve the problem of credit default swaps, and won't bring back the subprime market."
So increased money supply, plus economic doldrums -- are we talking stagflation?
Mauldin: The textbook definition of "stagflation" is a period of below-trend growth and higher-trend inflation. We seem to be there today. I wrote some years ago that the best case scenario to Greenspan's low rates and fight against deflation would be mild stagflation. And that looks to be the case.
I expect, though, that we'll see the inflation part of this problem go away over the next six to nine months. Remember, the biggest part of our recent inflation has been the rise in the price of oil. Oil costs so much now, though, that every $1 rise in the price is going to have less and less effect on the overall inflation picture. Plus, with two monster bubbles deflating, I don't see how inflation is going to be our big problem.
Is that a subprime mortgage in your pocket?
Smith: You also predicted, "Counterparty risk in the credit default swap market will be a huge story in 2008." Are you talking about the domino theory here?
Mauldin: Exactly. The question we have to ask is how deeply are the dominos stacked, and how connected. It's one thing to expose yourself to the risk of subprime loans. Counterparty risk is all about how you insure yourself against that risk, by getting someone else to cover your losses if the loans go sour.
The way it works is, I own a loan, and I want to insure against default. So I pay someone to underwrite the insurance on the loan. But the insurer doesn't have to put up any margin. In theory, it can write an unlimited amount of business. What happens if the insurer goes bankrupt? Suddenly, I'm at risk, too.
Smith: So do you think the government needs to regulate the activity?
Mauldin: More like enforce existing regulations; recognize a different fact pattern. The government needs to recognize that this is a case of de facto insurance -- a lender that enters into a credit default swap with, for example, a hedge fund is not de jure buying insurance, but the fact remains that credit default swaps are essentially insurance contracts.
How this differs from, say, a reinsurance contract is that there's no transparency here. We don't know which hedge funds or investment banks have entered into these arrangements, or with which counterparties.
Some of them may have written too much business and don't have their books balanced, or maybe they think the books are balanced, but their counterparty doesn't have the reserves to cover all the business it has written in the event of a default.
The solution I advocate is for the government to require that when a regulated bank enters into a credit default swap with a hedge fund, the bank provide proof to its regulators that the hedge fund possesses adequate reserves to cover eventual losses. If the hedge fund can't provide this, or the bank fails for whatever reason to provide the proof to its regulator, then the bank should not be allowed to count the credit default swap as part of its own reserves.
The end result of this is going to be that the banks will demand better disclosure from the hedge funds, and the hedge funds will in turn be forced to maintain adequate reserves -- without any need to regulate the hedge funds directly.
What's on your nightstand?
Smith: Last time we spoke, John, you told us to keep an eye out for Andy Kessler's book, The End of Medicine. I did, and it was worth the read. Any other books we should be aware of?
Mauldin: Definitely read Nassim Nicholas Taleb's The Black Swan. This is a very important book that every investor should read at least once.
Buy, sell, or hold?
Smith: Final question, and this one's compound. One of the longest-standing interview features at the Fool is a game we call: "Buy, sell, or hold." Rather than stock tickers, I give you a concept, and ask you to tell us whether you'd "buy" it (think it's got legs), "sell" (bunk), or "hold" (hard to say). And if you could briefly explain why, that would be great:
Mauldin: Sell. There's an oversupply.
Smith: Canadian tar sands.
Mauldin: Buy, because long-term, oil is going up.
Smith: Venezuelan heavy crude.
Mauldin: Neutral until Chavez gets thrown out. Then it's a screaming buy.
Smith: Russia, in general.
Mauldin: Buy. They have a lot of resources, they know where they're going, and they're on track to get there.
Mauldin: Sell. This country is not ready to elect as president someone who has two years of experience as a senator, and was a ward politician before that. He's not quite ready for prime time, but ask him to come back in four to eight years.