It's no longer a question of whether the subprime lending market is heading for hurt -- that city is already burning. New Century (OTC: NEWC.PK) is already in bankruptcy, and competitors like Fremont General
But the nagging question remains: What does this mean for the broader credit markets and the economy as a whole? Can we believe the oft-quoted party line that the subprime mess has been contained and is not contaminating other areas? Or has the fuse just been lit on some economic dynamite hiding under our markets?
To get some perspective on one side of this issue, I had a chance to talk with Kevin Duffy, a principal at Bearing Asset Management. Bearing is a Houston-based firm that runs The Bearing Fund, a macro-focused hedge fund that grounds itself in market history and the Austrian economics school of thought.
Matt Koppenheffer: First of all, thanks for taking the time to share your thoughts with the Foolish community. To start, can you give us a brief overview of the investing philosophy at Bearing?
Kevin Duffy: We consider ourselves generalists and take a top-down, big-picture approach. We believe that you need a firm intellectual foundation in order to effectively interpret not only current events but also history. Our grounding in Austrian economics gives us a lens to be able to see through the spin out there.
KD: The basic idea behind the Austrian school is that, to a large extent, the government should not get involved with manipulating the economy. It's a very free-market, laissez-faire type of approach. An example would probably help illustrate it.
Back in the late 1980s, Japan's Nikkei index more than tripled in the course of five years. The prevailing feeling was that by the turn of the century all of us in the U.S. would be pushing brooms for the Japanese -- their economy was portrayed as an absolute juggernaut.
The collaboration between business and government was a major area of focus for the media during this time and was cited as the driving force behind Japan's success. Of course, with the government's help, what was really behind a good deal of the growth was unsustainable credit creation. Worse still was the fact that the government stepped in and tried to bail everyone out as soon as things started to turn sour. The outcome was a lost decade in Japan.
MK: You have said elsewhere that you see a big credit bubble not only in the U.S., but globally. Can you tell us about how you are tracking the credit bubble?
KD: Over the past 12-plus years, we have seen an incredible boom in the industries involved with credit. Since there is no single index that tracks this part of the market the way that the Nasdaq tracked the tech boom, we have created our own Credit Bubble Index which aggregates banks, brokers, credit card and credit insurance companies, government-sponsored entities (or GSEs -- for example, Fannie Mae
Overall, the index is up 10 times the level it was at the end of 1994. Some components of the index have had spectacular run-ups. For example, the builders were up 9.7 times between the beginning of 2000 and the middle of 2005, while subprime was up 7.2 times. For sake of comparison, the Nasdaq was up 10.9 times in the five-year period before it crashed, and the Nikkei was up just 3.4 times in the five years before it crashed. More recently, strength in banks and brokerages has masked weakness in the index for well over a year, despite the stock market setting new highs.
MK: It sounds like we could be headed for some tough times if this starts to unravel. How do you see this unfolding? Is there any easy way out?
KD: The bubble has been created by two forces. First, you have the central bank baiting the hook by driving interest rates through the floor and making credit irresistible. Then you have the bankers and borrowers taking the bait, creating the cheap money that fuels the bubble. This is the psychological aspect of it -- as long as everyone continues to believe the hype, the populace can send any given asset class to the moon. This aspect of it can build on itself, but as asset prices rise, it takes greater doses of credit just to keep the game going. At some point the jig is up, typically when bankers are scraping the bottom of the barrel for borrowers and asset prices make no economic sense.
Unfortunately, there really isn't an easy way out as we see it. Once the sins have been committed, you have to pay the piper eventually. The best solution is for the government to step back and just let it run its course and work off the excesses. If the government steps in and tries to cushion the fall, or eliminate it altogether, it'll only prolong and worsen the situation.
MK: You mentioned the brokerage stocks as an area that's potentially ripe for correction. Though they pulled back a bit in February, they're still largely unscathed. What do you see ahead for this group?
KD: The rationalizations for this bubble are much different when compared to the Internet bubble. Back then, valuations didn't matter. This time, most of the speculation is in so-called value stocks that have had their earnings inflated by cheap credit, especially the financials.
The brokerages, in particular, have been bailed out continually by the government and seem to be playing the credit bubble aggressively. Goldman Sachs
We think that there's a big correction ahead for the brokerages. We're currently short Goldman in particular -- it's one of our favorite shorts.
MK: So it sounds like you see a correction ahead for the market in general, and an even bigger correction for some of the most affected areas. Are there any areas right now where you see opportunity for investing long-term?
KD: We're having a very difficult time right now finding anything worth getting excited about. We were able to get in on the poultry producers a while back when the bird flu hysteria got everybody crazy. Right now, though, we don't see many good long ideas.
Normally, in a bubble, there are pockets of opportunity because investors sell the furniture just to buy more of the bubble stocks. This time, everything is getting bid up. Right now we like cash, gold, and portfolio insurance such as put options and volatility futures.
MK: This seems like a pretty bleak scenario!
KD: [laughs] I don't look at it as bleak. It's the boom that's the destructive part, when everyone is getting carried away. The bust is the healthy, cleansing part -- I think you can definitely take a glass-half-full perspective on it.
There's a lot going on right now that's really positive. Just as our grandparents lived through the transportation revolution, we're currently living through the computing revolution. When you expand the division of labor, good things happen, and the long-term trend is toward greater division of labor throughout the global economy.
Positive change comes from good ideas percolating up, and the bad ideas failing. Right now, central bankers are treated like rock stars, but we'd be much better off if they were discredited and the economy broke its addiction to cheap credit. Never underestimate human resiliency.
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