Two veterans of the investment industry, Joe McNay and Doug Kass, provided a somber assessment of the financial markets, identifying sparingly few areas for opportunity over the next several years.

Kass and McNay had hardly any kind words to say about the political and financial leadership responsible for creating the current crisis.

Kass refers to Bush, Paulson, and Bernanke as the “three stooges of 21st century capitalism,” claiming they were “asleep at the wheel” during the period leading up to the credit crisis.  He believes their policies, which facilitated excess leverage and poor lending standards, were “timid and unimaginative” and led to “challenges our economy and markets have never before seen.”  Kass characterizes these policies as “Ponzi finance,” although he credits the Federal Reserve for its aggressive and appropriate action since the crisis unfolded last August.

“The actions taken by the Fed [interest rate cuts and the Bear Stearns rescue] speak to the depth of the crisis,” says Kass.  “Derivatives have poisoned the system.  Leverage of 30-to-1 is like playing Russian roulette with five of the six chambers loaded.  When you include off-the-balance-sheet items like credit default swaps, it is like having all six chambers loaded and pulling the trigger.”

Kass reminded the audience that at the time of the Bear Stearns bailout, 1 month T-bill rates had dropped to 12 basis points and 3 month rates to 56 basis points – lower than comparable Japanese rates for the first time since July of 1993. 

“With nanoscale interest rates, the twin diseases of greed and leverage compounded a situation where the financial system refused to look at itself in the mirror,” says Kass.

McNay says “we are in a set of conditions that are potentially catastrophic.”  Emphasizing this point, Kass cites Merrill Lynch, which ended 2007 with $37 billion in equity but has subsequently written off 73% ($25 billion) of that amount.  Citibank ended 2007 with $118 billion in equity, and has written off $38 billion.  “These are remarkable figures and beyond belief,” says Kass, adding “Merrill will never again be Mother Merrill.”

Kass and McNay agree the Bear Stearns’ bailout was the right decision, and Kass stated the markets came “as close to collapse as anyone dares to imagine.”  He says the time to deal with moral hazard was much earlier, but that would have required “a degree of foresight and forthrightness” beyond the capabilities of the collective leadership at that time.

“Quantitative models have led to investments in companies that the investors know nothing about,” says Kass, adding that this “did untold damage to the ability to distinguish value from lack of value.”

McNay traces the roots of the credit crisis to 1991, and cites a slow and gradual growth in leverage over a 15 year period, exemplified by home loans that were made with increasingly smaller down payments and homeowner equity.  “This led to open ended greed on the part of all players.”  McNay agrees with Kass and believes that nobody saw a problem coming.  “It was irresponsibility on the part of investment banks consumed with greed,” he says.

Display article as PDF for printing.

Would you like to send this article to a friend?