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Investment chief talks about credit, housing, oil prices

Editor’s note: As head of investment management for Richmond-based Mechanics Bank, which maintains three offices in Marin and Napa counties, Brian Pretti oversees a portfolio of $1.7 billion. Mr. Pretti answered questions from the NORTH BAY BUSINESS JOURNAL about the state of the economy.



NBBJ: The emergency sale of investment house Bear Stearns and other recent events have caused high volatility in the markets. How long can we expect that volatility to continue, and what signs can we look for to tell us that markets are stabilizing?



Mr. Pretti: The emergency sale of Bear Stearns points directly at the most meaningful issue confronting the financial markets and economy at the moment  –  the U.S. credit cycle.  What the troubled financial markets are now facing can be traced back to credit-cycle problems that began last summer, as subprime loan defaults began.  From there, credit-cycle leverage started to implode, and the issues have only grown in severity. They have clearly moved well beyond subprime issues, and volatility will subside only when the credit markets begin to stabilize.

When defaults and write-offs/write-downs run their course – and we’re not there yet – stability will begin to reemerge.

 The central issue at Bear was one of leverage and cross default avoidance.  As of last quarter, Bear Stearns held $13 trillion in derivative vehicles and was very highly leveraged.  Had they gone under, the derivative contract failures would have reverberated across the financial system.  In today’s world, the financial system is linked together in a series of financial promises from one institution to another, to another, and so on.  If any important link in the chain fails, it has the ability to sever further links in the daisy chain.  If Bear had been allowed to blow up, there was a very good chance other financial entities would have also gone under. One problem is that in bankruptcy, Bear's assets would have had to be written down to market value.  Since many other financial institutions based the value of their assets on those held by Bear – derivatives – or they held similar or identical assets, they, too, would have had to write down assets, with an ensuing cycle of enormous pain throughout the system.

 What is really problematic overall right now is lack of confidence. The vast majority of financial firms have built their business models around the expectation of continuous access to liquidity – money – whenever and wherever it’s needed.  That assumption is failing, and in the last few weeks we’ve seen the almost overnight blowup of the Carlyle Group and Thornburg mortgage, a publicly traded mortgage REIT.  The problem in each case was that access to liquidity – borrowed funds – was no longer available as their lenders scrambled to shore up their own liquidity.  That same lack of liquidity put Bear Stearns in a vise last week, and until lenders regain some confidence, it will continue to put enormous pressure on the markets.



NBBJ: The value of the dollar has reached historical lows. How does this trend affect the U.S. economy?



Mr. Pretti: The falling dollar’s influence on the U.S. economy is most plainly seen and felt via our trade deficit. All else being equal, as the dollar becomes worth less compared to other currencies, foreign goods become more expensive to U.S.-based purchasers.  And since the U.S. is highly dependent on imports, the falling dollar ultimately becomes a source of inflation to the broader U.S. economy: higher prices – in dollar terms – for foreign goods, necessarily including oil.  

But in the current cycle, there is another very important dimension to this. Globally, commodities are priced in dollars. The most striking example is crude oil.  So as the dollar falls, foreign producers of commodities such as oil actually realize a decrease in prices for their products.  Just to keep their revenues even against a declining dollar, commodity producers have had to raise their prices. That is in large part responsible for the commodity price inflation we are now seeing.  

But there is an added element, a big increase in demand for commodities by emerging nations.  This double whammy of a declining dollar and increased foreign demand for commodities has acted to significantly boost prices, creating significant inflationary pressures in the domestic U.S. economy.  The bottom line? Higher costs for businesses and consumers.



NBBJ: How do you see the housing market affecting consumer spending and the overall economy?



Mr. Pretti: The recent housing up-cycle has been quite unique not only in terms of physical housing and housing prices, per se, but in terms of the character of mortgage credit availability.  Mortgage credit – and mortgage equity withdrawal – has been the major influence on recent consumer spending and a key underpinning of the broader economy.  Bear in mind, 70 percent of U.S. GDP is driven by what is called “personal consumption expenditures” –  otherwise known as consumer spending. During 2006, homeowners in the U.S. extracted close to $800 billion in home equity via home equity lines of credit, cash-out refinancing and outright sales of property.  Certainly, a good portion of the extraction found its way into consumer spending.  

And at least for now, that's largely disappearing.  With the contraction of mortgage credit availability to U.S. households  –  mortgage credit that in the prior cycle often found its way into consumption  –  less credit availability will mean less spending.

There is also an emotional element that cannot be ignored. Because the single-largest U.S. household asset is residential real estate, as house prices were escalating, homeowners simply felt wealthier.  This feeling of emotional and financial well being – perceived wealth – translated into spending.  This has been termed the “wealth effect.”  

Now that home prices are declining and homeowners are watching their net worth shrink, it’s having a depressing influence on the homeowner psyche – and acting to depress consumer spending as well.



NBBJ: Could a possible recession cause consumers to save more and spend less? Would that have any benefits for the economy?



Mr. Pretti: For many years now, the U.S. savings rate has been sitting near generation lows.  I’m convinced that since 1980, Americans have learned to “save” via asset inflation - common stock values and real estate price appreciation instead of the old-fashioned method of banking a percentage of their income regularly, which very few Americans do anymore.  

What people are ignoring, however, is that the major demographic force of baby boomers helped cause this asset inflation in the first place.  Contributing to IRAs, 401(k)s, profit-sharing plans, pensions, etc. has been a big force behind stock price appreciation while this flow was a one-way street.

Residential real estate prices have been driven in part by this same demographic force – the largest age-group in history creating new households and demanding more housing.

But as the boomers push into retirement years, this asset inflation tailwind will subside as IRAs, 401(k)s, etc. are gradually liquidated.  In fact, that tailwind will become a bit of a headwind as ongoing liquidation takes place to fund retirement living expenses.

Perhaps the fact that the equity market and residential real estate prices are now leveling off or falling in value may spark a bit of a renewed interest in traditional savings.  The lack of asset inflation may wake folks up to the fact that pure savings is important, too.

But if we enter recession, this potential resurgence in savings may be forestalled for a time as households draw down savings for living expenses.  Interestingly, we are seeing very large pre-59 1/2 401(k) and IRA withdrawals right now.  That illustrates financial stress at the household level.

So at least for now, I’d have to say that a recession will not spark a renewed interest in savings but rather deplete existing savings levels a bit.  More likely, how residential real estate and common stock prices perform in the future may drive a renewed interest or need on the part of households to save.



NBBJ: What impact will the credit crisis have on businesses during the next year?



Mr. Pretti: I’ve long argued that what the U.S. has been living through since the last recession is not a normal business cycle.  Instead, I would call it a credit cycle – mostly related to mortgage credit.

Having said this, the credit contraction of the moment will fall most meaningfully on smaller businesses that depend on banks for debt. As banks tighten the credit reins due to losses and rising loan loss reserves, it’s their customers – small business – that will be hit with either higher costs of credit or tighter credit terms.

Additionally – and this is quite important – businesses will be hit by the credit crunch because household access to credit will be restricted due to falling home prices, less mortgage credit availability and higher mortgage costs.

Because households have been borrowing against their homes, they will do far less discretionary spending than occurred in the earlier part of this decade during mortgage financing excesses.

That may be the most important credit market issue for business ahead – consumer/mortgage credit availability and its impact on consumption.



NBBJ: How is the rising cost of oil affecting your investment decisions?



Mr. Pretti: Rising oil prices are an implicit tax on businesses and consumers. Given that hydrocarbon usage literally pervades our lives, rising oil prices are by definition inflationary.  We are already seeing this.

As of January, the year-over-year increase in the headline CPI level is the largest number we’ve seen in years, due specifically to rising energy and food costs.  The January PPI (Producer Price Index) number was the highest year-over-year increase seen since 1981.

For corporations, rising energy prices pinch profit margins. For consumers, higher energy costs simply crowd out alternative forms of consumption – consumer spending in general.

As this applies to investment decisions, we need to look for companies who can offset or completely pass through rising energy prices to their customers.  These companies that can essentially pass through inflationary pressures will do better relative to those companies that cannot.

Clearly, in a rising oil price environment, companies involved in the energy industry do well  –  crude oil, natural gas, oil services, drillers and producers, etc. I have predicted that oil would rise to $100 a barrel for five years now, and initially, people scoffed. They're not scoffing now.



NBBJ: International demand is also causing spikes in other commodities, such as concrete and steel. Who will be hurt by this trend? Who benefits?



Mr. Pretti: Sparked by the declining dollar, the commodity price fire has been fueled by rapidly increasing foreign demand for physical commodities.

Companies that are heavy users of commodities, airlines for example, either have to raise prices or watch their profits suffer.  But what we are seeing today goes beyond energy, metals and industrial products to include food.  

While global mining, energy exploration and agricultural (think nitrogen fertilizer) companies benefit from these trends, consumers and companies that cannot pass through their increased costs are hurt.  We are watching price inflation in its most pure form, and on a longer term that hurts everyone.

If wages were to grow at a level to offset inflationary pressures, that would be a big help to consumers and businesses – but that is not happening.  Wage growth is lagging behind inflationary pressures. What that means is less discretionary consumption, at least domestically, as more dollars are needed just to pay for higher food and energy costs.  Globalization and the monetary policies of the Fed – too much credit and money creation – are responsible for our current inflationary circumstances.



NBBJ: As of January, U.S. unemployment was still below 5 percent. What are your expectations for job growth – or loss – over the next year?



Mr. Pretti: Set against historical precedent, the current unemployment rate of about 5 percent is relatively mild. But what is different today is how much of labor in our service economy is self-employment – independent contractors, consultants, etc.  This affects how we count unemployment.

For example, many temp employees are hired on a contract basis.  Are real estate agents employees of firms or independent contractors?  What about appraisers, mortgage brokers, residential construction workers, etc.?  If these folks lose their jobs, are they being counted as unemployed?  In many cases, they are not.  So the unemployment stats today are somewhat misleading compared with prior economic cycles, given that so many people are self-employed and do not show up on the payrolls of reporting firms.

Having said this, the rate of change in payroll employment has been weakening for almost 18 months now.  As of January, the year-over-year rate of change in U.S. payroll growth stands at 0.7 percent – the lowest number since early 2004, and at that time the trend was up.

Personally I expect a contraction in payroll employment before the current cycle is over, and that means the unemployment rate is set to move higher. The magnitude of payroll deterioration will relate directly back to the character of the credit cycle and the future consumption patterns of U.S. households.



NBBJ: What impact will the presidential election have on the economy?



Mr. Pretti: Maybe I'm not being politically correct, but I do not expect the presidential election to have a dramatic or meaningful impact on the economy.

Most of the economic forces that impact the financial well being of households are already in place: the residential real estate cycle, global competition, commodity price pressures and the credit cycle.  None of these will be changed by one man or one woman.

Truth be told, the next president is facing a number of meaningful economic headwinds that will not be solved by the magic wave of a legislative wand.  By nature, these forces are cycles and need to play themselves out.  Attempting to manipulate or interrupt these natural economic cycles, as politicians and legislators are often wont to do, usually only helps prolong or deepen them.

Having said this, I should point out that the outcomes of some impending tax changes will be influenced by the next president.

For example, favorable dividend and capital-gains treatment legislation is set to sunset in 2010.  Likewise the estate tax reverts back toward prior decade character after 2011 – unless Congress and the president act to block these changes.

Additionally, dealing with the Iraqi situation may indeed induce a varied set of potential outcomes.  Can the U.S. economy save a lot of money by leaving Iraq?  And what will that mean to control of energy resources and geopolitical power in the area? These are tough issues.



NBBJ: Large banks and investment houses such as Bear Stearns have taken heavy losses in the subprime meltdown. How does that compare with the position of community banks?



Mr. Pretti: In the current cycle the large banks have had the most exposure to credit problems of the moment: subprime, Alt-A and prime mortgages, CDOs (collateralized debt obligations), SIVs (structured investment vehicles) and CDS (credit default swaps).

The small community banks simply did not deal with these new-era financial vehicles, now gone bad.  So in one sense, the current set of circumstances puts the smaller, well-managed community banks in a relatively favorable position compared to their larger brethren.  They are not taking the hit to their balance sheets – write-offs and write-downs – that the big boys are, brought on by very aggressive lending via financial vehicles that only became popular over the last decade.  

As a result, you can be assured that larger banks are tightening their credit requirements and possibly even terminating lines of credit to some customers – and it is in times like this that small and mid-sized business owners can be grateful for a strong relationship with a community bank that knows them and their business.