Waiting for the Big Reboot

A review of Contagion: The Financial Epidemic That Is Sweeping the Global Economy…And How To Protect Yourself From It, by John R. Talbott

John Talbott has established a well-deserved reputation as a financial soothsayer, enjoying an incredible run of spot-on predictions. He called the imminent bust of the dot-com bubble in 1999, and in 2003 he authored the best-selling book The Coming Crash in the US Housing Market, which he followed up with Sell Now! The End of the Housing Bubble. If you read and heeded that book’s advice when it came out in 2006, you’re probably pretty thankful right about now. But if Talbott is in fact an economic Nostradamus of sorts, we all have reason to be alarmed.

In Contagion, Talbott paints a bleak picture of America’s economic outlook, predicting that the current recession will be long and severe. He does an excellent job chronicling how we got into this mess, how bad the current situation truly is, and how much worse it is going to get (he says housing has another 50% to decline and has only started to affect the wealthier markets). He also does a fine job of breaking down complex subjects into laymen’s terms (his explanation of a CDO is one of the better explanations I’ve read. Some writers get this so wrong it’s laughable).

Readers interested in Talbott’s views on how to protect themselves from the “financial epidemic” can fast-forward to Chapter 13, where he outlines his investment advice for weathering the storm: Stay as liquid as possible; cash really is king, and just about every asset type will suffer severe price declines. Talbott further advises investors to avoid the temptation to go “yield shopping,” especially when it comes to Muni bonds. Many municipalities across the U.S. are already in dire economic straits caused by the credit crisis and Auction Rate Securities debacle. Talbott warns that their financial conditions will only get worse due to budget shortfalls caused by a steady decline in tax revenues combined with massive losses on mortgage-backed securities and derivative instruments (in which they invested heavily despite lacking a full understanding of what these instruments were, how they worked, and what risks they entailed). The municipalities offering the higher yields are also going to be the municipalities facing the greatest risk of default. If you want to invest in U.S. Treasuries, buy TIPS, he says. Go long on gold but avoid other commodities such as copper, where prices will be too unpredictable. Common stock is also to be avoided, even the sectors that are traditionally defensive plays such as health care and food… they’re going to suffer as well, while the world delevers and reduces its consumption, even for basic necessities. If you must invest in equities, only China may have some upside, he tells us.

But if you do fast-forward to Chapter 13, you’ll miss what the rest of the book is really about. At the end of the day, Contagion is more a vehicle for Talbott’s commentary on the sorry state of the U.S. financial and political systems. In his view, there is no $700b stimulus package that can help the system because the system itself is fundamentally broken. Call the Help Desk (Obama?)… the system is down and needs a reboot!

Capitalism is based on trust. When contracts are not honored and financial institutions are allowed to mask losses using off-balance-sheet SIVs and creative accounting tricks, then trust is lost. When investors are sold securities they were told are AAA, then suffer massive losses on them, trust is lost. (At the same time, Talbott suggests that investors should have read prospectuses and conducted some of their own due diligence and credit risk analysis instead of relying solely on a third party paid millions in fees by the issuers.) Without trust, all economic activity will eventually evaporate (as it slowly has been doing). Talbott laments how the current regulatory environment makes it far too easy for “five guys and a couple of computers” to set up shop and start collecting premiums on CDS. Hedge Funds of this variety should simply not be allowed to issue insurance without demonstrating they have enough capital to meet their obligations under the worst-case scenario. Yet, Hedge Funds such as these are created (and destroyed) on a regular basis.

Talbott uses the collapse of the Japanese banking system to remind us of the damage a lack of trust can do. Depositors and investors could not tell which Banks were solvent and which ones were not. Confidence in the system was so shaken that Japan ended up in a recession for almost two decades. In Contagion, Talbott warns that the U.S., and by extension, the world, is heading into the same prolonged deep recession unless major reforms are made soon.

The prospect ahead doesn’t have to be so bleak, however. The securitization market can be resurrected — but not without significant government involvement. The technology to provide greater transparency and the necessary level of reporting exists today. Governments at the Fed and local level can apply this technology to help restore the trust sorely needed to recreate a healthy financial system where credit flows once again… and then maybe Talbott will finally be wrong.

— William Cohee

William Cohee is a Director of IT at Clayton Holdings. He has a BA in Computer Science from Manhattanville and a MS in Systems Engineering from Polytechnic University, and is a former student of R&R Consulting’s Structured Finance program.