Over the years I have stayed in touch with many of my former students who graduated from Marquette University. This information was received recently from one of those former students who attended a conference that consisted of some of our leading thought leaders from the private sector. This group included leading Chief Executive Officers (CEOs) and Chief Investment Officers (CIOs).
Note: This material is intended for informational purposes only and does not constitute investment advice. Also, as I did not attend the conference or independently confirm all of the information presented below I can only report this secondhand; however, I do believe that this contains some interesting and valuable insights into the views held by many of our top CEOs and CIOs.
Is The U.S. Losing Its Competitive Edge?
- Many of the CEOs and CIOs believe that the U.S. has been losing it competitiveness the past decade and they discussed the perceived causes and what might be done to address it.
- Cause # 1: Failing K-12 Education System:
- The CEOs acknowledged that they have been forced to establish remedial reading, writing and arithmetic programs for entry level employees as a large portion of their entry level work force lacks the basic skills necessary to perform the work at hand.
- Cause # 2: Reduction In Quantity & Quality of R&D Spending as a Percentage of GDP:
- The CEOs complained about the lack of productive R&D spending relative to GDP and how the U.S. is falling behind other countries in both the amount of R&D spent as a percentage of GDP and the productivity of that spending.
- Cause # 3: Business Environment That Is Not Conducive To Investing:
- The CEOs believe that the current administration not supportive of the business community, with many saying that it is the most anti-business administration they have ever experienced.
- The most significant complaints were related to: a) The Obama administration’s efforts to circumvent Congress by regulating business through the various regulatory agencies (i.e. EPA and NLRB); b) the high corporate tax rate; c) the uncertainty surrounding the ObamaCare.
- As a result of the aforementioned, many of the CEOs indicated that much of their expansion and hiring will likely take place outside of the U.S. over the next several years.
Will Basel III Reduce Global Credit Availability?
- The consensus among the CEOs and CIOs was in the affirmative.
- Higher capital requirements will likely result in lower lending capacity, lower bank profitability and lower P/E multiples for financial stocks subject to Basel III regulations.
- Most COEs and CIOs were concerned that Basel III was only is an asymmetrical solution, dealing only with one side of the balance sheet.
- In particular, they felt that in order for Basel III to be most effective, it Basel III needs be structured to increase capital ratios of global financial institutions (i.e. the right-hand side of the balance sheet) and place limits on the amount of risk (i.e. the left-hand side of the balance sheet) that banks can assume.
- They almost unanimously agreed that the reduction in credit availability will likely significantly lower global growth levels.
Will Dodd-Frank Reduce U.S. Credit Availability?
- The CEOs and CIOS felt that Dodd-Frank will likely result in a “barbell” banking system. They feel that it will apply to banks with assets of $10 billion or more and that banks with less than $10 billion of assets will not be subject to Dodd-Frank’s: higher capital requirements; restrictions on business activities; and less stringent regulatory supervision.
- As such, when Dodd-Frank was passed in July 2010, banks with approximately $10 billion of assets had a decision to make: Shrink their balance sheet below $10 billion to avoid being subject to Dodd-Frank or merge with a larger bank that is able to absorb the higher capital standards, limitations on business restrictions and the cost of new and more frequent regulation associated with Dodd-Frank?
- As a result of Dodd-Frank’s implementation, they felt that it was likely that the number of smaller U.S. banks will increase and the number of “too-big-to-fail” U.S. banks will increase, resulting in a “barbell” banking system (i.e. the mega banks get bigger and the smaller get more numerous) that increases the size of “too-big-to-fail” banks (in direct contravention to the primary objective of Dodd-Frank).
- Consequently, the average U.S. middle market borrower is likely to be too large for the growing number of smaller banks (and their lower lending capacity) and too small for the growing number of “too-big-to-fail” banks, further exacerbating the current credit dislocation.
Why Did Securitization Go So Wrong?
- Several academics in the group discussed the recent published research that describes the post-mortem of the securitization disaster.
- The conclusion was that the switch from mortgage banks’ “underwriting to hold” to “underwriting to sell” switch in the 2000’s was a root cause of the implosion of the securitization market as evidenced most spectacularly in the sub-prime market.
- For example, in the old days, a banker would make a loan to a customer who lived in that banker’s town. The banker knew the borrower and a borrower’s character was the primary determinant in extending the loan and things like credit score and loan-to-value ratios were supplemental decision variables.
- As the securitization market grew, it became impossible to create mortgage-backed securities based on “character loans. As a result, the purveyors of securitizations needed to find decision variables that were homogenous and easily ascertainable.
- The result was that the banks decided to underwrite loans to be securitized based only on credit scores and loan-to-value ratios.
- As the pool of borrowers who met the more stringent credit scores and loan-to-value ratios was depleted, underwriters of securitized products lowered their credit score standards and started “buying” appraisals to make sure that the loan-to-value conformed to the underwriting standards.
- Eventually, the bottom fell out when loan originators started lending borrowers’ money to pay down other debt in an effort to make their credit scores look better.
- By the time the market imploded, there were anywhere from 3-9 intermediaries between the actual borrower of the loan and the owner of the securitized loan.
- The academics concluded that securitization will come back but that it will never likely reach its pre-crisis levels, resulting in credit becoming more expensive, more scare and less flexible.
What is the Impact of the Middle East Spring?
- Participants in the conference believe that this is the most underreported story in the U.S. today. That felt that the political turmoil engulfing the Middle East could be a major game-changer for global business.
- Specifically, many of the CEOs with energy backgrounds noted that Iraq and Saudi Arabia, two of our three largest allies in the Middle East, are surrounded by countries in the midst of regime change and many of those countries are being “advised” by Iran.
- Egypt, previously our largest Arab ally, is not only likely to turn away from the U.S. but it has established diplomatic ties with Iran for the first time in 30 years and that the upcoming Egyptian presidential elections could produce huge surprises for Western economies.
- The bottom line was that the executives fear that the political events in Egypt, Syria and Libya could lead to outcomes that might result in a disruption of oil supply and that it is not out of the realm of possibilities that oil prices could go much higher.
What Will Happen To Greece and the Other PIIGS?
- Everyone in attendance agreed that Greece will have to restructure its debt and bondholders will be forced to take a “haircut” on their debt. The question was, how much of a “haircut”?
- Experts in the field suspect that at least 50% of Greek sovereign debt will need to be written off or converted to equity for Greece to emerge from its current “death-spiral”. According to the conference participants, Greece has nearly $300 billion of sovereign debt outstanding and $150 billion of it is owned by Western European banks.
- As such, if the Western European banks are forced to write their Greek debt down to market, it will result in a $75 billion loss, excluding any losses from their exposure to Ireland and Portugal. As a result, this is the major reasons for the hesitation on the part of the Europeans to force Greece to address its structural deficits head-on.
Has QE 2 Been Successful?
- The consensus of the participants at the conference was that it has not been successful. Why? Since QE2 was initiated in November 2010:
- Interest rates are at or near 0% yet U.S. GDP growth has decelerated from over 3% to 1.8%;
- The U.S. housing market is not only not improving, it is declining at an accelerating rate;
- The increase in commodity prices caused by QE2 has reduced disposable personal income for U.S. consumers and retirees;
- As the Federal Reserve unwinds QE2, interest rates are likely to increase. If GDP growth and housing prices are declining when rates are at or near 0%, what is going to happen to GDP and housing prices when rates start increasing?
- The bottom line was that most participants believe Bernanke has lost his credibility with the market. It will be important to watch what happens when QE2 ends.
As I said at the beginning of this blog, the material above was intended for informational and educational purposes only; however, I thought it was important for my current and prospective students to read what leading CEOs and CIOs believe are today's important topics. I am hopeful that over the summer the students in the AIM program will follow these events since they are likely to be market movers. I’ll continue to post updates and articles such as these as I receive them. Enjoy summer and work hard at your internships!