Morningstar Advisor - April/May 2009 - 43

Hey, wait a minute! That sounds a lot like a Ponzi scheme, doesn’t it? That the people who are in the pool right now have a good outcome only if other people come into the pool to take them out at a profit. That’s what bank debt is. Jeffrey Gundlach most recent stimulus plan. I’m working with the assumption that the stimulus plan will have minimal impact upon the U.S. economy in this year and next. It would not surprise me to see them have to do another plan. As such, the optimism that occurred toward the end of last year, be it in the equity market with the rally or in the high-yield market and some other areas, was premature. It was predicated upon a second-half economic recovery and earnings recovery, neither of which will occur. This, then, sets the stage for considerable disappointment in 2009 going into 2010. Finally, the pandemic breakdown in underwriting standards is still unfolding. The next area that will hit will be in the commercial real estate market, beginning right now, throughout this year, and into next year. Jeffrey Gundlach: I agree. I certainly am very there are decent buying opportunities from time to time in the credit markets, but it’s my view that the corporate credit market will end 2009 at a lower price than it began the year. There’s also a misplaced belief in the bank debt market. I’ve done more traveling in the last four months than I’ve done in years, because I’m interested in taking the temperature of what’s going on out there. Almost without exception, everywhere I go, the bank debt market is viewed as a compelling opportunity. I think it’s being priced to the dream. People quote a high discount margin of the price of the bank debt market at about 75, even pushing 80 on the good days. People think that’s a great buy. They point out that it’s a high yield spread. What they’re missing, though—and I would also make this point for CMBS (commercial mortgage-backed securities), which share the same problem—is that those are yield spreads to refinance or to par payback, and those par paybacks are based upon a balloon payment or, in the case of bank debt, somebody else rolling over the financing, so that the existing investors can be paid out. Hey, wait a minute! That sounds a lot like a Ponzi scheme, doesn’t it? That the people who are in the pool right now have a good outcome only if other people come into the pool to take them out at a profit. That’s what bank debt is. In these balloon markets, you’re not going to get a check on maturity date; you’re going to get a meeting to discuss how much less than par you’re going to be willing to accept. Rodriguez: On the commercial side, if you look at the total commercial and multifamily debt outstanding for ’05, ’06, ’07, and ’08, you had almost $1.2 trillion in new issuance on a base of $2.3 trillion. What was so amazing in this process was to see cap rates go down to 3%. I was watching it in California and several other areas. We’re just now starting to see the break in the fourth quarter of ’08. So with rents coming down and cap rates now up into the 8% to 9% range, you’re looking at price declines on commercial properties in the neighborhood of 40% to 50%. Thus, using a rough calculation, when you look at CMBS outstanding—it’s at $758 billion as of Q3 ‘08, up from around $410 billion—and then you take the balance as other commercial and multi, it would not surprise me to see a hole from that area in the neighborhood of $400 billion to $600 billion. Again, we keep going back to the banking system and shadow banking system. As I commented more than two years ago, the holes are so big that effectively the U.S. banking system is insolvent. Gundlach: The banking system’s been insolvent negative on commercial mortgage-backed securities and commercial real estate. I don’t think you could possibly paint a worse fundamental underpinning than is in place. There are a lot of bond managers parading around the world saying—to use a hackneyed phrase, but it’s one that they’re using— that this is a “buying opportunity of a lifetime” in many fixed-income sectors. Frankly, I think they’re saying this because it’s the only way they can explain why they shouldn’t be fired for all of the bad decisions they made in the past. They’re taking a global dart-throwing approach. They’ve wrapped a too-cheap-to-sell argument in a more-forward-looking viewpoint. Certainly, there are cheaper markets today than there were some time ago, and I would say for a long time. Bob, you call it the shadow banking system. I’ve coined another phrase: the “bogadollar” system. Rodriguez: I call it “hope springs eternal.” Gundlach: I call it bogadollar for bogus money, from auto leases to home equity takeout to derivative market value growing by $15 trillion. What is the loss in the banking system? If you take the number of bogadollars, which is in the tens of trillions, and you realize that the loss on most asset classes already is, let’s be conservative about it and say 25%—50% might be more of the number—you’re talking MorningstarAdvisor.com 43

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Morningstar Advisor - April/May 2009

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