Bob Rodriguez — Are We Crossing The Rubicon?

Kurt Brouwer April 3rd, 2008

One of the finest mutual fund managers we know thinks the Federal Reserve just crossed the Rubicon, that is it passed the point of no return. Now, the Fed will be forced into a much more intrusive regulatory role.

Bob Rodriguez runs FPA Capital and FPA New Income (see Robert Rodriguez — Mutual Fund Switch Hitter ). Bob has a superb long-term record with each fund. He also presciently wrote about problems with subprime loans a couple of years ago.

Now, Bob rakes the Federal Reserve over the coals in a stern statement of concern regarding the recent takeover of Bear Stearns and the proposed Federal plan to aid beleaguered homeowners.

It’s a pretty long letter and I recommend you read the whole thing, but I will excerpt a few important paragraphs [emphasis added]:

Crossing the Rubicon (First Pacific Advisors, March 30, 2008, Robert L. Rodriguez)

These past two weeks have been extraordinary in that the Federal Reserve has had to take actions that have not been used since the Great Depression and a few that heretofore have never been used. There have been several crises in the capital markets that lead us to comment on what they appear to mean. During the last year, we have conveyed a growing concern, through several prior commentaries, as to the dangers and implications of an absence of fear toward various types of increasing risks in our financial system. We believe the culmination of these risks forced the Federal Reserve to take the recent extraordinary actions of creating two new lending facilities for primary dealers and facilitating a merger of Bear Stearns with JPMorganChase to prevent a liquidity and solvency crisis from potentially toppling the U.S. capital markets. The partners of First Pacific Advisors, LLC (FPA) discussed these events on March 21 and came to several conclusions about what the long-term implications of these actions might be and we will share them with you in this commentary. Fortunately, over the last two years, our preparations for potential financial market disruptions have meant that FPA and most of our product areas have essentially avoided the calamitous effects of this credit crisis.

We have been in disagreement with the Federal Reserve’s policy actions since this credit crisis began. In FPA New Income’s September 2007 shareholder letter, we argued that future Fed policy actions, the lowering of the Federal Funds rate, may prove rather ineffective in dealing with the unfolding credit crisis.

The Fed proceeded under the assumption that this was a liquidity crisis, whereby lowering the Fed Funds rate would resolve the credit problems and return stability to the capital markets. However, with each lowering of the Fed Funds rate, there appeared to be very few positive responses from the U.S. capital markets. Even with a record 125 basis point cut in the Fed Funds rate between January 22 and January 30, liquidity and stability in the financial markets did not return by any appreciable degree.

As the Fed Funds rate declined, a growing flight to quality, as reflected by the rush into Treasury securities and away from any security that might have credit risk, began to take hold. Despite the decline in Treasury interest rates, these declines did not spread to other areas of the capital markets, as exemplified by the 30-year Agency mortgage-backed securities market, where yields rose while Treasury yields declined. At one point, FNMA and Freddie Mac yield spreads increased to over 300 basis points above the Treasury curve versus a more normal 150 basis point spread. Our capital markets were shutting down since participants did not trust the counter parties with whom they were trading.

...In our opinion, a new financial system is in the process of being created. This is the beginning of a new era.

I believe the subprime lending mess came about due to actions taken by the government and reactions by private Wall Street firms. For example, various legislations and regulations (for example, the Community Reinvestment Act of 1996) pushed lenders to make loans to borrowers with marginal or even poor credit. As it was, that kind of made sense, but what came next did not.

Brilliant minds on Wall Street, using a process called securitization, bought and bundled thousands of subprime loans. These bundles would be sold as mortgage-backed securities. Once new vehicles such as hedge funds, structured investment vehicles and other highly-leveraged entities began buying these mortgage-backed securities, the stage was set — for trouble.

Rodriguez blames, among others, the Federal Reserve under Chairman Alan Greenspan for not seeing this problem and taking steps to slow it down.

...With the limited resources we have at FPA compared to the Federal Reserve, how could we see this mortgage risk developing and the Fed not? We have to conclude that the Fed was aware of the growing risks in the mortgage and derivatives markets; however, it was unwilling at that time to take appropriate risk-reduction measures.

…Ever since the government bailout of Chrysler in 1979-80, this country has been on a course of raising the safety net so that the market’s discipline, in a capitalistic economic system, has been truncated. We have witnessed a growing level of decisions that are based upon expediency rather than sound long-term decision making. Each time these expedient decisions are made, the level of risk within the U.S. economy has been increased. The market’s discipline is not allowed to work for fear of the potential economic fallout.

In light of the above comments, the partners of FPA came to a unanimous conclusion that the recent Federal Reserve actions and the potential new Congressional policies under consideration are likely to lead to a significantly higher level of long-term inflation in the U.S. We are more than disappointed in the substandard decision making that has taken place within the Federal Reserve and other governmental entities these last several years. The misguided monetary policies of the former Chairman of the Federal Reserve, Alan Greenspan, created an era of ‘too big to fail’ that has led to two major asset bubbles. With each successive bubble, the policy actions available to the Federal Reserve to reduce financial system risk have been systematically reduced. The extraordinary actions taken by the Bernanke Federal Reserve reflect acts of desperation rather than long-term policy solutions. The rapidly changing events within the capital markets are forcing the Fed to adopt policies that have the potential of long-term negative consequences. These recent events, and their fundamental changes to the U.S. financial system, are forcing the leaders of FPA’s product areas to reassess their present portfolio allocations. In essence, we believe we have ‘Crossed the Rubicon’ into a new financial era.

This last sentence intrigues me. What steps will he take? C’mon Bob, inquiring minds want to know. Fortunately, I am an investor in his funds, so I’ll see over time what steps he takes, but a hint or two would have been nice.

For a contrary view on this situation see Bill Gross — Stop Falling Home Prices Now.

Hat Tip: Steve Janachowski

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