Rick Ruleís Thoughts on the Recession (Part II)
Source: Stealth Investor††(3/4/08)
Rick Rule of Global Resource Investments, in a conversation with John Pugsley of Stealth Investor, gives his thoughts on the current recession. In Part I, Natural Resources In Jeopardy?, he weighed in on the potential for a continuation of the bull market in commodities. Rick's success is legendary in the mining, energy, and exploration business. There is simply no one who is more knowledgeable, in Pugsley's opinion.
SI: Rick, the specter haunting every natural-resource investor today is the degree to which demand for hard commodities will be affected by the current economic slowdown. Whatís your perspective on the chances of the current recession getting worse?
RR: There is little disagreement that weíre in a recession. What are the probabilities of it going much deeper? We will probably not know the answer to that question until 18 months from now. By then, the extent of the damage will be more clear.
SI: The Fed is pouring money into the banks. Will it help?
RR: The Fed is acting like the problem is a lack of liquidity. Just the opposite is true: Thereís too much liquidity. The problem that weíre having now is a credit problem, not a liquidity problem. Too many loans were made to people who couldnít pay them back, and there doesnít seem to be a willingness to let this bad debt work its way through the system. Everybody enjoyed the party. Now everybody would like to cure the hangover with more vodka.
SI: There seems to be a hope that the problem will be confined to sub-prime mortgages.
RR: I define sub-prime as the business of lending money to anyone with a low probability of being able to pay it back. Itís not a particularly intelligent lending activity. The problem surfaced when sub-prime mortgages began to default, but weíre starting to see the sub-prime problem spread to the so-called alt-A mortgages, i.e., people who maybe could pay it back, but decide not to. Somebody who bought a $700,000 house with no down payment, in say San Bernardino, California, now finds the $700,000 house is a $600,000 house. The person says, well, either I can pay off a loan on a house where Iím $100,000 under water, or I can give the key back to the bank. Many people are choosing to give the key back and walk away. If the foreclosures in sub-prime and alt-A portfolios result in a rising number of lending institutions selling those foreclosed properties, housing prices will be driven further down.
SI: It seems to be happening. For the first time since the Great Depression, U.S. housing prices actually fell in 2007.
RR: It could get worse. Youíll see more and more people whose equity has gone negative, and who could pay, decide not to pay. How deep will the recession get? As I said, I suspect that we are at least 18 months away from knowing the answer to that.
SI: Of course, housing isnít the only area where consumers got into debt beyond their ability to pay.
RR: Absolutely. Youíre now starting to see lots of arrearages in credit-card portfolios. People seemed to believe that if they had credit available on their credit card, it was the same as having money. There are millions of consumers in the United States with thousands in outstanding credit card debt at interest rates between 18 and 22%, and these people are having increasing problems paying it back. If the recession deepens, the jobless rate will increase, and itís likely that more and more people who are making payments on a house they couldnít afford and a car they couldnít afford, will be unable to make payments on the widescreen TV, iPods, and vacations they bought with their credit cards.
SI: I read a couple of days ago that the average credit card balance for U.S. households is close to $10,000.
RR: And defaults are rising. Remember that the house payment is secured by their house. If they donít pay it, they have some chance of being homeless. If they donít make their car payment, they have a chance of somebody taking their car. But if they donít pay their credit card, somebody takes their credit card away. No credit limit left? Who cares? Let Ďem cancel the card. So I suspect that youíre going to see increasing amounts of credit-card debt default, and of course these credit-card obligations were in many cases securitized in the same way mortgages were securitized. By that I mean, not at all, because the person originating the loan planned to pass the paper on.
SI: And didnít care about the quality of the creditor when they loaned the money.
RR: Correct. You strip the fee and you sell the paper, and you may very well sell it to a leveraged pool. The owners of the pool borrowed $90 million to buy $100 million in credit-card debt, the idea being that they paid 7% on the money that they borrowed, and wound up earning 16 or 17% on the credit card portfolioÖuntil defaults begin. The problem isnít just a credit-card debt default. The underlying debt, the $90 million that the conduit borrowed to finance the purchase of the credit card debt, now defaults.
SI: The proverbial house of cards. So, residential mortgages and credit-card debt are part of the debt problem. But those arenít the only overly leveraged areas.
RR: Thatís right. The third place that I think weíre going to have problems is in the commercial lending sector. Nobody talks very much about leveraged buy-outs, but theyíve been financed with a whole bunch of sub-prime paper. To illustrate, say that somebody did a leveraged buy-out on a sheetrock (wallboard), manufacturer, and they bought the company for a billion dollars. For this billion-dollar purchase, they put $50 million dollars down and borrowed $950 million. At the time they bought it, the housing industry was going great guns and the company was making $110 million a year. What a deal.
All of the sudden, housing starts begin to decline, people are ordering a lot less sheetrock, and this company that was generating $110 million dollars a year of free cash, is now generating only $20 million a year. Or even worse, itís now losing $10 million. It is very, very difficult to service $950 million worth of debt with no cash flow. And I suspect that there are quite a lot of those loans out there.
The root of the credit crisis is two-fold. First, the government established a moral hazard by bailing out stupid borrowers and stupid lenders over the last 15 years. Second, the sophistication by which that debt is packaged and re-sold has meant that the ownership of this debt is extraordinarily diffused. If youíre a mortgage broker, you originate the loan, you sell the loan to an aggregator, the aggregator pools it with $100 million worth of loans, slices it into A, B, and C packets, sells off the B and C slices, pockets his fees, and keeps the A slice. What Iím saying is, we donít even know where all of this debt is. The people who own the B or the C slices may be an already-broke pension fund, a mutual fund, or a bank. The short-term obligations may even wind up in money-market funds. Who owns this sub-prime debt? Collectively, we all hold it.
SI: Whatís your guess on how this will unfold?
RR: I suspect, if past is prologue, the reaction of politicians to a recession will be very, very different from how they deal with inflation. The politicianís punishment for inflation is having to pander to the publicís demand for subsidies, price controls, and so on. As I said, after a party like weíve had, there are a lot of people that reach for the vodka, rather than sobering up by going for a run.
On the other hand, the politicianís risk from a recession, where people lose their houses and lose their jobs, can be quite severe. The politician could get booted out of office.
SI: Politicians arenít blamed for inflation; theyíre blamed for a recession.
RR: Correct. So, as I said, this isnít a liquidity crisis, itís a credit contraction, and it will continue for some period of time. How long? Itís impossible to know.
SI: You travel a lot internationally and pay a lot of attention to international markets. What do you see abroad?
RR: They came to the party, too. The suggestion that the excesses were confined to the United States is ridiculous. There were lots and lots of foreign banks that were very large participants in leveraged buy-out lending, in the US home mortgage business, in commercial paper, and in collateralized debt lending.
Nor did all of the stupid loans originate in the U.S. domestic economy. An example would be the current availability of credit to Argentina. The woman who was just elected president of Argentina basically was elected as thanks to her husband, the previous president, who told the international creditors to go to hell. In other words, Argentina's voters rewarded a politician for stiffing the world on its sovereign debt.
The idea that people are lining up to lend money to a country that is a proven deadbeat, suggests to me that the same type of easy money idiocy that fueled the sub-prime boom in the United States exists on a global basis. If ever there was a sub-prime borrower in the world since the end of World War II, it would be Argentina. Argentina pays a spread over U.S. treasures of less than 200 basis points. I would suggest that the probability of an Argentinean default in the next ten years is somewhere around 100%. I couldnít venture to say what a U.S. default probability is, but surely itís less than 100%.
SI: Argentina stiffs its creditors by defaulting on its bonds. The U.S. doesnít need to. Since dollars are held all over the world, the U.S. simply prints more of them.
RR: So internationally, weíre vulnerable. The world banking system is all tied together; the debt is spread around the world. And itís not just the debt, itís all the other things that go along with the American presence in the world. And all this has good and bad implications for the natural resource business.
SI: And particularly for the commodities such as gold and oil. But thatís enough for today. Letís get into the link between the dollar and gold next week.
RR: Good enough.
SI: Rick, thanks for taking the time to share your insights and expertise.