Bill Gross: Brilliant as Usual

Bill Gross’s Investment Outlook for this September was a wonderful contribution to the general knowledge pool of the investment community.  The article, which can be found here, proved spot on in its belief that Treasury Secretary Paulson would be required to rescue the GSEs in an effort to avoid systematic financial failure.  In discussing the need for a significant and prolonged involvement by the Federal government in the financial markets, Bill Gross brought up a term that I had not heard. His statement that a, “rarely observed systematic debt liquidation” is currently confronting, “the U.S. and perhaps even the global financial system” was a startling turnaround for a man who not long ago was on CNBC warning the world about the specter of inflation.  Gross’s comments, which relate to his belief that the financial markets are rapidly delevering suggest that there is the potential for significant deflationary pressures going forward as asset prices collapse under their own leverage.   

Gross’s main argument is that asset prices will continue to collapse until additional capital comes into the market, this is in addition to the $400B that financial institutions have raised so far in the credit crunch. His statement that, “we will require policies that open up the balance sheet of the U.S. Treasury – not only to Freddie and Fannie but to Mom and Pop on Main Street U.S.A., via subsidized home loans issued by the FHA and other government institutions.” Implies the need for a coordinated effort on a national scale in order to prevent further mortgage losses at the nation’s traditional banking institutions that goes far beyond what has already been undertaken during the rescue of the GSEs.  Such a statement has hints of governmental actions similar to what was taken to prop up Japanese and Chinese banks during their struggle with troubled loans in previous decades.   Yet, Gross’s point that the private sector is tired of trying to call a bottom in financials only to see their investments deteriorate substantially is well founded.  If in fact, the private sector is no longer willing or able to undertake any further significant investments only two options remain.  Either we need to see massive markdowns that leave no doubt that there will be no further write downs or we need to see the government come in and buy everything up to prevent asset price erosion.  Both are very scary scenarios.  

The possibility of a “systematic debt liquidation” driven by the forced sale of falling assets that had been purchased with significant leverage is likely the most significant issue facing the market at this time.  If such a liquidation were to occur it would undoubtedly cause the, “financial tsunami” that Gross has predicted as distressed sales of financial securities would lead to a domino effect in the financial industry.  While remedies exist to ease the pain of such a failure, we can only hope that Bill Gross is far too pessimistic about the current state of the financial markets and the economy.

Below is Gross’s take on the anatomy of delevering:

What Happens During Delevering

1. Risk spreads, liquidity spreads, volatility, term premiums – they all go up.
2. Delevering slows/stops when assets have been liquidated and/or sufficient capital has been raised to produce an equilibrium.
3. The raising of sufficient capital now depends on the entrance of new balance sheets. Absent that, prices of almost all assets will go down.

For Further Review:

Bill Gross's Investment Outlook for September

My Thoughts on the GSE Bailout

Disclosure: None