J.Christopher Flowers says there are market values out there, but he expects recession for 2-3 years.
Since mid-September, we've have seen extraordinary measures enacted by governments and extraordinary volatility as markets attempt to adjust to the new rules. We are reinventing the financial world amid cries of the death of capitalism, the rise of socialism, and the promise of a global recession. What will it all mean to investors? Warren Buffett says he’s now buying American stocks. Private equity investor J. Christopher Flowers sees opportunities but also risks.
Flowers created his first private equity fund in 2002 and today the JC Flowers II Fund has $7 billion under management. Chris himself can often seem to be in the room – or to have just left it – in some of the most publicized financial services transactions, notably bidding for Sallie Mae and then withdrawing when changes in the law reduced its projected value, and most recently seeing his due diligence used by Bank of America in its Merrill Lynch acquisition. Few people have a clearer understanding of international financial services firms and the challenges facing distressed financial companies. He sat down in the past week for a discussion on the financial crisis.
We’ve typically not had major financial institutions be a source of instability. That makes this crisis much more profound.
The current financial crisis means that there are vastly more distressed financial firms out there. As someone who has been successful turning around troubled firms, does the current crisis present more opportunities, and where are you looking to invest? Certainly no one has seen markets like this in our lifetime. The times are extraordinary, and when it’s over, there will have been extraordinary opportunities to invest. It’s an outstanding market, but also a dangerous one. The number of firms and ideas seeking capital is significant. The ratio of demand to available capital is very good. But it is hard to assess value. As a result we’re looking to invest where we’re not in harm’s way, either because there are no harmful assets, where we have guarantees on the debt or credit side, or where prices are very cheap.
People have cited deregulation, ineffective regulation, and bad regulation. What do you think brought on the crisis.
This catastrophe has many authors, and if a fair history is written it will include a lot of factors. But the role of regulation for the most part is relatively minor. When’s the last meltdown that regulation stopped? Regulation is typically a lagging indicator of what’s going on. That said, a lot of ridiculous mortgage loans were made. They were the fault of the lender, the borrower, and the regulator. The responsibility is shared. But something that you didn’t mention is the rating agencies. We built a system where we took a lot of securities and stuck them in a box and the rating agencies said it was triple A. But they didn’t really understand what was in the box. Then people used those ratings to make investment decisions. But the box wasn’t triple A. Many businesses have been affected by the rating agencies’ loss of credibility.
Another factor, of course, has been a housing price decline of extraordinary magnitude. It wasn’t just in Texas; it wasn’t just in New England. It was the United States in general. A big and significant housing price decline delivered a major shock to the system. At the same time, the typical buffer protecting the system from this decline was reduced. Most of the loans were in securitized form and didn’t have a big enough buffer against trouble. How is this situation different from past recession, and why do people seem to fear this recession so much more than recessions that have come before? This isn’t the first one that any of us have lived through.
There is a reason to have more fear this time. This is very serious. The financial system has been shaken to its foundation, which is not usually the case. Lending and credit in the best scenario are going to be dramatically curtailed around the world, from the North Pole to the South Pole, from Brazil to Europe to Vietnam. This is of a completely global nature. Also in the past, we’ve typically not had major financial institutions be a source of instability. That makes this crisis much more profound.
This situation is unusual. What people do in government now is going to do a lot to determine how we deal with it. We came as close to a systemic collapse as I ever want to come, a financial situation comparable to the Cuban Missile Crisis.
Has government action helped, or did government exacerbate the crisis by seeming to chase events?
The cheapest thing that government can do is to get the liquidity crisis over, to get companies lending. Everything else is more expensive.
How do we get out of this?
First we have to stop the liquidity crisis from killing the system. That’s on its way I hope. Second, we have to get people lending. And third, we have to get liquidity to the asset side of the world. This can be accomplished by the government buying assets directly, which is in the TARP program and can help. One consequence you alluded to is that the uncertainty surrounding government involvement. What are your thoughts on that?If you look at this as a fixed income investor, if you were in Bear Stearns, AIG, or Wachovia, you got paid. If you were in Lehman or WaMu, you did not. So you can look at this and say you don’t understand. This has freaked out investors. Number one, they don’t know who is the next to go, and their tolerance to wait around to find out is very low. Next, you don’t know who will be too big to fail, and who is not. People who have money are therefore keeping it in their own pockets, which has hurt liquidity. The psychology has suffered a lot of damage, and it is going to take a while to recover. I think there will be a recession of 2-3 years myself. There are not many investors willing to risk capital right now. How do you feel about the government now being in the position of anointing certain institutions as the ones who will survive, and others not?It’s an important question and I don’t have the answer. It’s a problem in a couple of ways. Investors don’t know who is going to be saved. It’s disturbing for government to say we’re going to shoot this one, and rescue another. And the choices made by the government may not be too hot. But we have to say at some point that we’re going to save as many companies and possible, and sometimes we’re going to have to say that this company can’t be saved. In that case the government is going to have to, as they say for cancer patients, help the company have a peaceful exit from this world. At some point we have to hope that skillful, well meaning people will do a good job.
J. Christopher Flowers is the principal of J.C Flowers & Co., a New York based private equity company. He began at Goldman Sachs in 1979, became a partner at the age of 30 and worked on Goldman’s Initial Public Offering in 1998 before leaving the firm. Instead, he would lead his own deals, most strikingly leading the 2000 acquisition of the Long-Term Credit Bank of Japan, the first purchase of a Japanese bank by a foreign owner. The bank, renamed Shinsei, returned huge gains to investors in its 2004 IPO and qualified as the most successful deal in private equity’s history.