Stephen’s Posterous

View From the Top: Wilbur Ross, founder of WL Ross & Co.
By Deborah Brewster and Chrystia Freeland, FT.com 

Wilbur Ross, the 71-year-old peripatetic billionaire investor, is probably the best-known turnround financier in the US. WL Ross & Co, the firm he formed in 2000, has restructured $200bn in failed companies' assets around the world.

In 2002, Mr Ross began merging several steel companies, including Bethlehem and International Steel Group into one, forming the largest steel group in North America, and then sold it to India's Mittal. His interests have mostly been in distress situations in unloved industrial sectors such as textiles, cars, real estate and coal.

He sold his firm in 2006 to Invesco, the money management company, but remains at the helm. They are leading a consortium that is bidding to manage toxic assets under the US government's Public-Private Investment Programme.

If approved, WL Ross will manage the investment and also invest $1bn in it. The plan represents a departure from Mr Ross's usual role in taking over failed companies and restructuring them back to profitability. In an interview with FT.com this week, he said he sees it as an enormous opportunity.

You've announced this week that you and your firm intend to participate in the Public-Private Investment Programme [PPIP]. Why do you think that's a good idea?

It's a good idea for several reasons - most of all, the non-recourse, low interest rate, high leverage that the government is making available for the buyers of the programme.

Some other potential investors have said they're staying away because they're worried that there could be government strings attached, possibly after the fact. Does that concern you?

I don't think it's a big risk because I think it's very different from the Tarp situation. In Tarp, government is bailing out failed institutions, or failing institutions; here, we're doing government a favour helping them get uniquely high bid prices for assets that they want to get off the books of the banks.

Do you think the government will have any trouble getting the banks to disgorge their assets into the programme?

That's harder to answer. My own guess is it'll take a lot of encouragement by the government, probably through some combination of the stress test, more Tarp money and a little bit of jaw-boning.

With regard to the US economy specifically, do you judge that now is the time for you to really jump in or are you really still mostly keeping your powder dry?

We're only about 30 per cent invested in our most recent fund, not counting what we've committed to the PPIP. So we're quite dry in terms of powder. But you can never really pick the exact bottom. We think it's getting close enough that it's time to start putting things to work, but the real question isn't just timing, it's timing and pricing.

Will the PPIP programme have a broader effect in terms of helping the market to find a price more generally?

I think it will, in that a lot of the way that the open market traders look at securitisations is "one size fits all" - so a so-called AAA tranche of subprime from the '07 vintage tends to trade at pretty much the same absolute of par, even though they have very different characteristics. So to the degree that this sets a new higher price there may very well be a reflection in the open market prices.

What's your view of where the economy is right now more generally, and maybe specifically the housing sector?

There's been a tremendous amount of refinancing because, with the decline in the cost of the mortgages, many homeowners are finding they can cut their monthly payments quite significantly by refinancing. The programmes by and large do not let them take extra cash out, but it will provide the consumer with more disposable income . . .

What about Detroit? Are we going to see General Motors go into bankruptcy?

I think the real question is, will GM go through a comfortable bankruptcy or a contentious one? If it's a comfortable one, and by that I mean one where pretty much all the pieces are together - maybe you just have the bondholders as outliers, but everybody else is together - that I think could work pretty well. Especially since the government has recognised that you must keep the suppliers intact.

What about the bondholders?

Well, I don't think there was [much hope] to begin with. GM had way too much debt. If you take principle and interest payments over some reasonable time period they would have needed, 10 per cent of the selling price of the car was going for debt service . . .

I hate to see anybody take a loss, but the bondholders at this point are mostly speculators so they presumably had a pretty good idea of the risk. Also, if GM really does turn around and Chrysler does turn around, they could recoup a lot.

And what about Fiat and Sergio Marchionne? Can he and his team be the salvation of Chrysler?

He's done a very good job with Fiat. A lot of people had written Fiat off for dead and Fiat needs a big presence in America. So I think it's a very sensible transaction from the Fiat point of view.

And what's your broader economic outlook? When do you think we'll see a recovery in the United States?

It won't be until housing gets itself on a better footing. I don't see any kind of miraculous V-shaped recovery in the back half of '09. I'll be very happy if it's recovering by the end of the first quarter of '10.

Source.

Citigroup shares were up 25% on March 19, 2009, in late-morning trading amid a big short squeeze in the stock tied in part to an upcoming massive exchange offer for the company's preferred stock that will result in a huge increase in the number of Citi shares outstanding.

Citi shares, which were recently trading at $3.14 a share, now have more than tripled from a low of $1 reached on March 5.

Arbitragers say that Citi shares are virtually impossible to short now because of heavy demand from those who had set up an arbitrage in which they bought Citi preferred and shorted the stock after the banking giant announced the exchange offer on Feb. 27.

Traders say that Citi shares could fall once the exchange offer is complete, which is expected in about a month. That's because of the dilution created by the additional common shares.

Citi is expected to file information on the exchange offer with the Securities and Exchange Commission in the next few days.

In a bid to boost its depleted tangible common equity, Citi announced an exchange offer involving some $25 billion of preferred held by the government under the TARP program, some $12.5 billion of preferred held by a group of private investors, including Saudi Prince Alaweed, and $14.9 billion of publicly held preferred.

Citi shares fell sharply in the wake of that announcement, dropping to under $1 from $2.50 as investors banked on massive dilution of existing common holders. Citi's shares outstanding are expected to rise to about 22 billion from 5.5 billion once the roughly $52 billion of preferred is converted into common shares.

The preferred exchange offer is voluntary but the vast majority of public holders are expected to participate. The Treasury Department also is planning to participate.

Arbs who initially bought Citi preferred and shorted Citi common banking on earning a roughly 10% spread until the deal closed now are facing huge losses with one arb calling the situation "a death march."

Citi's actively traded series P preferred now trades around $13.50, way below the exchange value of the preferred of about $20. Holders of the series P preferred will get 7.31 shares of Citi common for each preferred share, which has a face value of $25.

Right after the exchange offer was announced, the series P preferred traded around $8, roughly $1 below the value of the common shares offered in the exchange. That spread has widened to $6.50, badly stinging any arbs who are long the preferred and short Citi.

The talk is that JPMorgan yesterday urged investors interested in owning Citi to buy the preferred, not the common, given the big discount on the preferred. A buyer of the series P preferred can effectively create Citi shares below $2 a share, indicating that Citi may trade lower once the exchange offer is done.

Some wonder why a stock in which there are 5.5 billion outstanding shares is tough to borrow. For starters, many firms are reluctant to lend shares that trade below $5 a share. And many institutional investors are unwilling to lend out their securities in the wake of the collapse of Lehman Brothers amid fears of counterparty risk.

The bottom line is that a massive short squeeze in Citi appears to be a major factor behind the sharp rise in the stock. It's true that financials have rallied recently, but the gain in Citi has been outsized relative to its peers. For those bullish on beleaguered Citi, its preferred, including the series P issue and three other issues, looks like the best bet.

Source.

Facing the worse year for stock dividends since World War II, Judith Saryan holds firm to her mantra, "Dividend-paying stocks are good, but dividend-growing stocks are even better."

Finding them, however, means digging into a lot of balance sheets and debt covenants, says the 54-year-old co-manager of the Eaton Vance Dividend Income Fund (EDIAX).

Saryan says fewer companies will increase cash payments to shareholders in this year, choosing to conserve cash. In fact, Standard & Poor's predicts that dividends paid by companies in the S&P 500 index will plunge 22% in 2009.

Already this year, Pfizer (PFE), General Electric (GE), Dow Chemical (DOW), U.S. Bancorp (USB) and other venerable dividend payers have announced dividend cuts totaling $35.9 billion.

Still, income-hungry investors can find "good dividend plays in every sector," Saryan says.

Founded in 2005, Saryan's fund has fallen 20% in value so far this year. Still, its annualized performance has beaten the S&P 500 index for each of the last three years.

Here are some excerpts from our recent conversation with Saryan:

Barrons.com: Given all the turmoil over the last year, are dividend-paying stocks still good investments?

Saryan: Traditionally, a dividend strategy lowers the variance and the volatility in any portfolio, and provides investors with a consistent income. That's a nice feature in this sort of environment. But while dividend-paying stocks are good, dividend-growing stocks are even better. Companies that hike their dividends send out a strong signal about their financial health.

Q: Many high-profile companies have cut or eliminated their dividend. What do you expect in the coming year?

A: The environment remains a tough one, especially in the financial sector. Companies will trim dividends because they need cash and want to avoid the capital markets. Even companies with lots of cash, and the ability and wherewithal to increase their dividend will take their time before making a decision. Plenty of companies will continue paying dividends, and some will hike them, though fewer than we've seen in past years. Finding these names requires looking at income statements, and balance sheets.

Q: What specifically do you look for?

A: The easiest thing to find on a balance sheet is cash. Also important is the amount of cash generated by the business, or cash flow. But we also look at the amount of debt, and then drill down into the debt covenants to see when the bonds are due to mature. If a lot of debt is maturing soon, the company may choose to hoard cash.

Q: Do you prefer high yields?

A: Don't look for the high yields because they can be the most distressed companies. We prefer names with lower yields and good prospects for hiking dividend payments. We try to avoid cyclical companies with yields of 6% or higher, though we will look at companies with steady, recurring revenue streams, such as utilities, that yield over 6%.

Q: Should a company raise its dividend if profits aren't growing?

A: It can be a reasonable decision if the company has hit a temporary pothole caused by the economy, if there's lots of cash on the balance sheet and management has reason to remain confident in its future. Rewarding shareholders in tough times is a particularly good idea because it may be the only return an investor gets. One note of caution: If a company borrows money to pay a dividend, it's a red flag.

Q: How has your portfolio changed in the current environment?

A: We reduced our exposure to financials in the last year. We do hold financial stocks, primarily insurance companies with business models that have gained our confidence. But our exposure to banks is limited due to worries about the earnings and cash flow, the balance sheet and assets on the balance sheet.

Northern Trust (NTRS) is our biggest bank holding, and it has a very defensible business model. It doesn't lend money or invest in questionable mortgage securities. Instead, it receives fees for managing investment portfolios, and thus has managed to circumvent the balance-sheet problems facing many banks.

Northern's decision last month to return $1.6 billion in TARP funding is a good sign because it means that they don't need the capital. The company hasn't raised its quarterly dividend since October of 2007. But the payment has remained steady at 28 cents a share and given time Northern will be in a position to hike it.

[Editor's Note: On Feb. 27, Northern Trust announced that it would repay a $1.6 billion federal bailout loan as quickly as possible, responding to lawmakers who criticized the company for sponsorship of parties and concerts at a professional golf tournament last month. Company officials said the bank acted within government guidelines by sponsoring the tournament and insisted no Troubled Asset Relief Program money was used to fund the event.]

Q: What financial stocks should investors avoid?

A: Be careful with European banks. Many have too much debt. In fact, looking across Europe, I don't think any banks have balance sheets that leave me feeling comfortable.

Q: Once, financials were a place to go for decent dividend stocks. What sector has taken their place?

A: Telecom has strong dividend potential thanks to strong balance sheets and a consistent revenue stream fueled by consumers who pay them monthly for their services. AT&T (T) and Verizon Communications (VZ) are two of the best names, generating consistent cash flow. AT&T hiked its dividend in January, while Verizon should hike its payment as much as 7% this year.

Vodafone Group (VOD) has an even better dividend-growth profile. We expect the company to raise its dividend 10% in June.

Q: What other names do you find attractive?

A: Wal-Mart Stores (WMT) is increasing sales in a very tough environment by luring shoppers with its low prices and a wide assortment of merchandise. The company just raised its dividend 15%, which is ahead of our expectations for operating earnings growth this year.

Q: What other sectors or stocks should dividend investors fear?

A: Aflac (AFL) worries our analysts. It's been a good dividend name. However, its balance sheet includes a lot of hybrid securities from European banks, which are fixed-income securities similar to preferred stock. We worry that many European banks will not be able to pay the dividend on these securities, and the securities will lose value.

Q: The fund has a high yield. Why?

A: In part, because we employ a "dividend capture strategy," which means we use a small percentage of the fund to purchase positions in companies that are about to pay their dividend and then we move on. It's a way to enhance the fund's yield. We have done it very judiciously, and will keep using the strategy. But I don't recommend it for ordinary retail investors. Success depends on properly timing the purchase and sale.

Q: Can you find good dividend-growing stocks anywhere?

A: I think every sector has a good dividend play, though the information-technology sector can be tough. The sector doesn't traditionally pay as much in dividends as other sectors. But we do like IBM (IBM). The company will raise its dividend about 20% this year.

Q: Thank you for your time.

Source. Subscribe to Barron's. Eaton Vance Dividend Income Fund.

The story of our economic crisis mirrors every great market bubble in history. Clearly, banks were key participants, but they were not alone. Mortgage lenders, borrowers, regulators, policy makers, appraisers, rating agencies, investors and investment bankers all played a role in pushing economic excesses forward.

The institutions that gave in completely to the frenzy are no longer with us. Those that balanced the need to compete with the need to lend prudently survive today and are helping to stabilize the system.

Amid the turmoil, it has become clear that banks need to make changes in the way they run their business, from risk management to expense control to compensation practices. Most banks are making these changes in a good-faith effort to adjust to new economic realities.

And what role should government play in this? Speculation is rife about whether banks need more capital assistance from the government or whether they need to be nationalized. Unfortunately, our current debate has been riddled with misinformation that will not help us understand our current reality, or help us decide on a sensible path forward.

I would like to provide some clarity on a few key claims that have been repeated so often they are now taken to be fact. They are not.

The banks aren't lending. This claim is simply not true. Yes, banks have tightened lending standards after a period in which standards were too lax. But, according to Federal Reserve data, bank credit has actually increased over the course of this recession, and business lending is trending up modestly so far in 2009.

Also, mortgage finance volume is booming as a result of low interest rates. What's gone from the system is the easy credit that got us into this mess, as unregulated nonbank lenders have disappeared, and the market for many asset-backed securities has all but dried up. Most banks are making as many loans as we responsibly can, given the recessionary environment.

The banks are insolvent. In the past 18 months, we've seen fewer than 50 bank failures. That compares to about 2,000 failures or closings of commercial banks or savings institutions between 1986 and 1991. There may be more to come, but the vast majority of banks will weather this economic storm.

The Troubled Asset Relief Program (TARP) hasn't worked. Not true. Last October, when the TARP was enacted, systemic risk threatened our entire financial system and economy. The point of the program was to stabilize surviving banks, prevent a total meltdown, and enable banks to lend more. The TARP and other government programs have worked, and banks are making more loans as a result.

Taxpayers have given the banks billions and won't get their money back. TARP funds are not charity. Banks that received TARP funds will make about $13 billion in dividend payments to the U.S. Treasury this year. TARP funds are loans yielding anywhere from 5% to 8% interest. This is a win-win: Banks are getting the capital they need, and taxpayers are getting a strong return on their investment.

The banks that caused this mess must be held accountable. In fact, while all banks participated in the bubble economy to some degree, the companies that did the most to cause this mess are gone. The managers and shareholders of those institutions have been held accountable by the toughest, most unforgiving master of all: the free market.

The only way to fix the banks is to nationalize them. This is a misguided premise. The announcement of nationalization would undermine confidence in the financial system and send shudders through the investment community.

Politicizing lending decisions and the credit allocation process would be destructive for the economy. Nationalization also would give the false impression that all banks are insolvent. We agree with Federal Reserve Chairman Ben Bernanke's statement that nationalization of banks is not necessary to stabilize the banking system.

Getting our facts straight as we debate the important issues will help us rebuild a healthy financial services sector that can better support economic growth. I have two thoughts to help us get started.

First, our industry must continue to work in partnership with the government to solve our toughest problems. Congress and the administration have already taken several very positive steps. The Fed is providing sufficient liquidity and has helped lower mortgage rates. The $787 billion stimulus package will help boost economic activity. \

The Term Asset-Backed Securities Loan Facility (TALF) will help liquefy the credit markets. And the administration's housing and foreclosure relief plan will be very helpful to both homeowners and banks as we work to stabilize housing markets across the country.

Second, one of our greatest challenges is balancing the need to extend credit with the need of households to pay down excessive debt. In an economy that became too dependent on debt-driven consumption to create growth, the prospect of household deleveraging is sobering. The answer, in my view, is to let competitive forces lead us back to responsible lending practices, not the type of indiscriminate lending that has created so many problems.

Source.

Ken Lewis, Chief Executive of Bank of America, has grown accustomed to public scrutiny in recent months. Initially lauded as a Wall Street hero for his high-stakes acquisition of Merrill Lynch in September 2008, he was later lambasted for overpaying for the investment bank and for allowing Merrill to pay staff bonuses amid mounting multibillion-dollar losses.

Mr Lewis, 61, who became BofA's chief executive in 2001, has faced criticism for his acquisitions before. When he led BofA's acquisition of Fleet National Bank in 2004, many analysts expressed scepticism over the price of the deal and the bank's ability to wring value out of the combination.

In this interview, Mr Lewis reiterated his belief in the long-term value of BofA's acquisition of Merrill Lynch, but allowed that the size of the government aid to support the deal had been a "tactical mistake" because it put the bank at risk of appearing weak.

He also expressed concern that limits on executive compensation for the 20 most highly paid executives could lead to a loss of revenue-generating talent.

Do you regret your acquisition of Merrill Lynch?

I'd be less than honest to say that I haven't had my moments, but I always try to step back and say don't judge it by this time and look forward. I still think it's a compelling, strategic acquisition and we're going to be awfully happy to have done it over time.

You have been accused of overpaying when you could have picked Merrill up for almost nothing two days later. What was your motivation?

We knew they had another offer to buy about 9.9 per cent of the company from Goldman [Sachs]. We also heard that there was some discussion with Morgan Stanley as well. So we thought rather than getting into a bidding contest later on we should just go ahead and get it done because the strategic reasons for doing it were so compelling.

Was there a moment when you would have preferred to pull out of the deal?

We did in fact think about doing that . . . and consulted with the government about filling the hole [in Merrill's balance sheet] if we didn't get out. We were strongly advised that the best thing to do was to go forward with the deal on time. While we made the final decision, we relied heavily on that advice because we respected the opinions of the various agencies.

Was taking additional Tarp money to support the deal the right thing to do?

I wish we had not taken as much as we did because it put us in a league too far out of some of the others who had not taken as much. Clearly we were doing that in an abundance of caution. So if I had to admit a tactical mistake I would have taken less than we took . . . probably $10bn less.

Have you been surprised by the strings attached to the Tarp money?

I've been surprised at the reaction of the public for those that have taken the Tarp money when we were doing what we thought was in the best interest of the country.

Were you adequately consulted on Merrill's plans to pay bonuses?

We knew of the bonuses and the process and we had input into it. The issue was that we could advise, but not make the final decision. There was disagreement on a number of things, but we're in the middle of litigation on that issue so I should stop there.

Has public scrutiny of the uses of Tarp money changed how you operate?

We're very focused on the cosmetics of trips and things of that nature, where meetings are held, personal use of the aircraft. We've changed some policies, but not really in the way we operate the business fundamentally.

Are the limits applied to executive compensation reasonable?

I think it's reasonable for the top five, let's say. There's no push back on me not getting an incentive, but when you start talking about the top 20 you're getting into some revenue producers that can really hurt your company if they leave. There are foreign banks hiring and there are boutique investment banks hiring. So there is a place for the top revenue producers to go and we've got to find a way to be able to pay them and keep them.

Are you confident that Bank of America will pass the stress test?

I think we'll pass the stress test. I don't know anything now to cause me to think that we wouldn't pass.

If a bank fails the stress test, do you think nationalisation is a legitimate government response?

No - I think some rehabilitation will have to take place, but I don't think nationalisation would be the answer. The banks do have six months to remedy whatever the issue would be. So that seems reasonable.

What's your view of this proposed public/private partnership to buy up some of the toxic debt?

Most people like the concept but the devil's in the details. Conceptually, it sounds good.

Is there a way round the problem that banks don't want to sell at too great a loss, but private investors don't want to buy at too high a price?

I don't know how you resolve it. There's a pretty big gap of profit that could be used to strike the right chord between the investor and the seller. Then you've got obviously cheap financing through the government that should make a deal possible. I have optimism that something could be worked out.

Source.

Long before the Hollywood set started using energy-saving lightbulbs, Jack Robinson was investing in environmentally friendly companies.

He founded Winslow Management in 1983 to test his theory that an environmentally friendly investing strategy could produce market-beating returns, as well as contribute to a healthier earth. In 2001, he founded the Winslow Green Growth Fund (ticker: WGGFX), which regularly beat the market, until last year, when, according to Morningstar, it trailed the Standard & Poor's 500 by 24 percentage points. To Robinson, however, the future looks promising.

He talked to Barrons.com last week about the future of green investing.

Barrons.com: Given the sorry state of the stock market, are people more likely to shun their environmental principles for the stocks they think are most likely to go up, whether they're green or not?

Jack Robinson: People are definitely investing. We are net cash positive year-to-date and [investors put money in the fund] very significantly last year even at the end. There is just a lot of interest in the green space, and that is now being driven by the government taking a proactive position on climate change and energy security, and tying it into green jobs. Our investors generally have some level of green personal commitment. But what they also all share in common is what I call "G-squared" -- the other green is making money.

Awareness about the environment by investors in this country has never been as high as it is today. And why is that? Well we have just gone through a great deal of volatility in oil. We've had a lot of discussions about energy security. I mean we've got Boone Pickens saying we are sending billions every day to the Mideast and Barack Obama saying the same thing. So, we've got the left and the right pretty much on the same wavelength.

Q: A lot of these stocks, solar stocks for instance, have been very volatile. Why invest in them if they could flame out because of either technological or political reasons?

A: It has already become slightly less volatile. As the companies continue to put up good numbers and the consolidation in this particular industry goes on, I know you will see less volatility in the space by the winter...No. 1, people investing in the space know that it is new. No. 2, it is volatile because most of the most compelling "green companies" in the space are small-cap growth companies and by design are volatile. And No. 3, we try to tell them every which way we can that our portfolio is concentrated, and that you should not be looking to trade it, because you need to stay in it over a longer time period.

Q: In some ways, green investing has become more mainstream. The industries have matured somewhat. Does that change how you invest in this space?

A: Historically a lot of the green companies have been run by what you might call tree huggers, or types of people who are committed to the environmental side but not necessarily to the money-making side. And what we see happening as in the example of Energy Conversion Devices (ENER) with Mark Morelli who is the new CEO, you are seeing proven management teams come in, CEOs, CFOs joining up with these companies because they see the opportunity. These are not stupid people and they are not doing it just out of passion, because they see this as part of the solution and an opportunity to do extremely well financially.

In the case of First Solar (FSLR), you have a management team that is second to none. And all you have to do is look at the financial record of [Toronto-traded] WaterFurnace Renewable Energy (WFI.TO), for example, over the last five years and you'll be pleasantly surprised. It looks a whole lot better than many, many larger U.S. companies that have been touted to be the best-managed companies in the world when in fact they've blown up. This "too big to fail" doesn't cut the mustard anymore, and the nice thing about these companies is that they are continuing to grow in an economic downturn.

Q: Are there any other reasons green stocks are attractive?

A: The technologies are now much lower cost. Wind has been around a long time, as has geothermal and solar. Wind and geothermal today are a compelling investment because of the new tax offsets that have been introduced at the state level for a number of states. And also now at the federal level through the $18 billion footnote on the TARP [Troubled Asset Relief Program] bill gave major extensions of tax credits for renewable energy and the [American Recovery and Reinvestment Act] that was just approved had another $60 billion going into green stuff directly that we know of -- that doesn't include what's flowing into the states.

Q: What affect will the stimulus and other new government policies have on environmental stocks specifically?

A: The most recent bill that was passed which was part of the stimulus act took the cap off the amount you can spend for a green building project. For example, there used to be a $2,000 cap for a home or a small business. The $2,000 cap has now been eliminated, and so you get a 30% tax credit for an infinite amount of improvements. In theory you could set up a $10 million system and get $3 million back. That is just one of a whole series of things that has been going on.

Q: There have been some studies that looked at vice stocks versus more environmentally friendly or "morally upright" sort of stocks and found that vice stocks did better. How do you deal with that reality?

A: I think [vice stocks] tend to be defensive kinds of investments that do quite well in difficult times. But they are a target, I mean the cigarette tax is being increased everywhere in this country. Not to mention the problems we are having with cancer caused by primary and secondary smoke. The only reason the tobacco companies are growing is that they are selling a lot more to the developing world that doesn't really know any better. I think that if you make a product or have a service that kills people, has a toxic element to it, you are asking for trouble.

Source. Subscribe to Barron's. Winslow Management Company.

Robert Albertson doesn't see a quick end to the financial crisis, and believes it could drag on another two or three years.

The seeds of this crisis -- most notably, too much liquidity, in his view -- were sown earlier in the decade. Albertson sounded several warnings: "We conclude that denial is growing," he wrote in a November 2006 note. "The markets are hearing what they want."

The 62-year-old chief strategist for Sandler O'Neill & Partners has had a long career on Wall Street, including an extended stint as director of bank research at Goldman Sachs (1987 to 1999). Albertson joined Sandler O'Neill, an investment bank focusing on the financial sector, in 2002. Barron's caught up with him last week in his midtown office.

Barron's: In 2006, you wrote that the consensus economic view was way too optimistic. What concerned you?

Albertson: There were three key trends that had been growing over the years. The first was that there was a complete reversal of global monetary flows. We had never had the emerging markets running the show on liquidity, and it became huge.

Do you mean in terms of emerging-market governments buying Treasuries and basically funding a lot of borrowing in the U.S?

That is right, essentially. So it dawned on me that the Fed[eral Reserve] no longer really had control. But more importantly, the money flows were distorting interest rates to the low side -- ridiculously so. Then, starting in 2003, the Fed compounded the problems by driving rates even lower.

What were the other themes that alarmed you?

The assumptions on home prices in the United States and elsewhere were clearly decoupling from any kind of reality. And third -- and I didn't notice this until about 2004 -- the consumer in America didn't go through a recession in 2000; we had a half-recession, if you will. So [consumers] continued to spend. I looked at those three themes together, and I thought there was too much liquidity in the system, and that it was going to come back to haunt us.

Talking about subprime mortgages seems almost quaint these days, considering all of the other things that have happened in this financial crisis.

Everyone was noticing how much subprime delinquencies were going up, and by 2006 it was evident that [they were] unraveling. But then I looked at prime-mortgage delinquencies, and found out they were deteriorating at exactly the same time and pace. So this said to me it wasn't a subprime problem. When I looked beyond just mortgages, I began to see the same unraveling in all consumer credits in 2006. So the conclusion had to be that we were going through a credit-loss cycle to end all credit-loss cycles.

What is your biggest surprise about how this crisis has unfolded?

Instead of recognizing the damage in a controlled fashion and trying to deal with it, everything has gone to the other extreme. In other words, stress tests back in 2005 or 2006 were useless; they were silly and assumed things were going to continue to go to the moon. Now you hear about nothing but toxic assets and their worthlessness and the impending disaster, and I have to believe the reality is probably somewhere in between.

What is your sense of how far along we are in trying to work this out?

You have to look at this from the economic side, and then from the financial-sector side. On the economic side, all consumer debt is at 130% of income. Go back to 2000, and it was at 100%; 10 years earlier it was at 80% or 90%. It has to come down. So the first step is that we have to deleverage, probably by 10 to 20 percentage points, to repair the consumer's balance sheet.

Also, the savings rate used to be 10% to 12% of income, but it went to zero, and it is back up to 3%. It probably has to go back to somewhere near 10%. So, let us just say we got a 25% correction in consumer income, which is about $10.5 trillion. That is a $2.5 trillion headwind of income that has to go toward debt reduction and savings, as opposed to spending. But no government-stimulus program is going to offset that effectively. To me, it is a two- or three-year process.

Where do you think we are in terms of stabilizing the economy?

We are certainly in a recession, and it is probably a depression, if you define it as a long recession. We may have some false starts, but it is going to take two or three years to come out of this. In terms of the financial system, we have to recognize the damage to the balance sheets -- and there are various estimates. I have done a very granular-level look at bank loans, just in the banking system by category, and when I tally it up, it is close to $1 trillion of embedded losses.

The banking system earns money, so it can pay down some of that on its own. The banking system got $200 billion in the original TARP [Troubled Asset Relief Program], excluding the big investment banks, and that is helpful. But we probably then have another $200 billion to $300 billion of additional capital just to fill the remaining hole there. That is going to take a couple of years, if we want to get it from the private sector, as we should. Getting it from the government is wrong.

How effectively has the government responded to this crisis?

I'm seeing very odd interpretations from the government, in particular about what we need. The government isn't thinking about deleveraging. The government is talking about jump-starting consumer credit. I hear the word jump-start all the time. It is such a bad word. Jump-start consumer credit for what? So we can be more indebted?

So what has to be done?

We need to reduce the debt. If you jumpstart credit, you are just going to prolong the problem and deepen it. What we need now is the patience to de-lever. We don't need the stimulus package. We need a savings package, but that couldn't be further from the goals at the moment. The mistake is that the government believes credit drives the economy, instead of the economy driving credit. They have got that backward, and this is a very dangerous time to be misfiring.

What is your advice to the government?

The first thing you need to realize is that all that capital flow from emerging markets, which is now plateauing and likely to decline, will put enormous pressure on our government's borrowing costs.

Presumably if emerging markets curtail their buying of Treasuries, the demand for those securities lessens, pushing up rates. Then what?

The U.S. government is thinking in terms of adding trillions to our debt that is going to cost 5%, 6%, 7% or 8% eventually -- not 2% or 3%. If [officials] really understood that, I don't think they would be so ready to put the taxpayer at risk. Secondly, the consumer has gone through an artificially prolonged period of spending based on too much debt, house prices and home-equity lending, and that has to come out of the financial system.

But assume that consumers repair their balance sheets. Doesn't that make it harder for gross domestic product to recover?

There is no choice; that is where we are. We should have had this decline in consumer spending in 2000, along with the corporate sector decline that should have been the recession that reset the economy. We have a cyclical economy; that is normal. We had an 18-year expansion, which had never happened before.

What is the biggest danger of the stimulus plan?

That it will be a false start. It will be priming a pump that still has an empty well underneath. It will stop again even harder, and we will be further in debt and have further problems in the financial system from that debt.

What else concerns you?

Just as we ignored the absurdity of home prices before, we are now taking that absurd calculation to the negative in terms of bank balance sheets.

There are many securities in banks that are perfectly current and likely to pay over time that are now being marked down to 30 or 40 cents on the dollar -- because the accountants think they aren't going to work out. We aren't giving it a chance. So we are now absorbing problems that don't exist in the future. We are truncating them into the present, and we are making the hole that much deeper and the inability to fill that hole becomes that much more shocking and it scares the private investor away.

It looks like the stimulus package, whatever form it finally takes, will include some tax cuts along with a lot spending.

As I said, there is at least $2.5 trillion that has to come out of consumer spending in order to pay down debt and build savings. If you want to replace that $2.5 trillion with the government, they are only at around $800 billion. No. 2, going back to the economic stimulus of early 2008, we now recognize that the bulk of it wasn't spent; it was saved. So you can split this package any way you want. It isn't going to give the desired effect. It is going to give a false small blip, although it could give us a spike.

You noted recently that bank lending is a small fraction of consumer borrowing. Could you elaborate?

I'm fearful that the government doesn't understand how consumer credit is generated. If savings decline and deposit growth stalls, which it did, how did we have an expansion in the mortgage, auto, and student loans over the last five to seven years? We got it from Wall Street via the secondary market.

Wall Street went out and found investors willing to take a package of securities. When you go get a car and you do it on credit, you don't want to go to the bank. At the showroom someone helps you fill out the form for what is, in essence, a loan that is going to be funded by Wall Street, which then finds the investor. For all consumer debt, Wall Street has provided $3 out of $4 of the credit. That is what has collapsed, and that is what needs to be rebuilt.

What needs to be done to fix the secondary loan market?

No. 1, we have to have price discovery, so we all understand how toxic the toxic assets are. The second thing we need to do is literally rebuild what has been destroyed, somewhat unnecessarily, on Wall Street in terms of generating credit from investment pools and other liquidity pools – not from deposits. The final thing we need to do is to stock the banks with deposits, and we can't do that until people save.

Is it time to start nibbling at the financials?

The opportunity is coming, and it could come as early as later this year -- if it is clear the government understands the problem and does no more harm. This could be a massively great opportunity to invest, but it could also be a kiss of death, and you can't tell which one it is from the information we now have.

What is your advice to investors?

Keep your powder dry; focus on sectors outside the financials, and remember how we got here -- which was the enormous strength of the emerging markets getting the model right and building their own domestic infrastructures and their own domestic demand.

We make a big mistake when we think that we are still leading the world and that all those emerging markets rely on us and other industrialized countries for export demand. It is still critical. It is still important, but most of these countries, most notably Brazil and China, now have huge domestic markets, and no one has noticed that they are increasingly independent.

Your outlook is very cautious, but are there any sectors that look attractive to you?

My fear is that the recession is multiyear, and completely different from what we have seen before. It seems to me that the consumer is down for the count. The government can only go so far, and the corporate sector can revive eventually. If you want to focus on areas that are going to benefit from infrastructure improvement, that certainly makes sense. If you want to focus on agriculture, commodities and raw materials, and bet on the emerging-market demand driving those prices up, that makes sense as well.

Any parting thoughts?

Don't make the same mistake twice. Don't make an assumption that makes no sense. Everyone assumed home prices wouldn't go down, but don't assume they can't bottom and go up. No one would ever have guessed interest rates would have been this low. Don't assume that is a normal state; assume they are going back up again.

Everyone recognizes that recessions only last 18 months -- but that is wrong, some last longer. We are in a test now for what could be something longer. Don't be in a rush to commit funds. Do it very gradually and wait for conviction, as opposed to the fear of missing the bottom.

Thanks very much, Robert.

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