Lawrence McDonald had a front row seat of the Financial Crisis that began on 15 September 2008 with the collapse of Lehman Brothers. As a VP in the trading division of Lehman, he warned about what was coming but reckons few within the organisation – or elsewhere – paid any attention. McDonald is once again acting as a canary in the financial coal mine, travelling the world to warn conference audiences the next Crisis is brewing, right now, in China. He was in Cape Town last week. We caught up with him on our CNBC Africa Power Lunch show. – AH
ALEC HOGG: Financial services firm Lehman Brothers – a name that goes down in infamy in the world’s financial circles – filed for bankruptcy protection on the 15th of September 2008. It became the largest bankruptcy filing in the United States history and as a consequence we had what was known as the Great Recession. Someone right inside during all of this is Larry McDonald. He was a Vice-president there at Lehman and wrote a book called ‘The colossal failure of common sense’, one of the best-sellers on the New York Times Bestselling list – not surprisingly – because we all wanted to find out what happened. Larry, you must have spoken a thousand times about your book, what happened at Lehman’s, your thoughts and what we should be doing to make sure that it isn’t going to happen again. I guess the obvious question is what have we learned that is now being applied. In fact, are we applying any of it?
LAWRENCE MCDONALD: The way I see it, the global epicentre of risk has transferred from the West in 2007/2008 in Lehman…2011/2012 it was in Europe, and now the global epicentre of risk…the next crisis it’s coming out of, is definitely Asia.
ALEC HOGG: How significant could that be? Is it possible that we’ll have a similar kind of meltdown that we saw after the 2008 crisis?
LAWRENCE MCDONALD: Unfortunately we haven’t learned a lot. There’s a tremendous amount of leverage in the Chinese housing and commercial business sector in terms of corporate finance, and that deleveraging process will impact… I think it’s already impacting all of the Emerging Markets. A good chunk of why the Emerging Markets have had such a rough time is the China slowdown, and I commend Barclays and Absa. We had a conference this week and they’re doing a wonderful job of getting out in front of clients with risk management strategies to improve alpha and improve returns for the clients.
GUGULETHU MFUPHI: Are those risk management strategies enough, Larry?
LAWRENCE MCDONALD: Well, I think the way Barclays and Absa are looking at it is very important. If you think…since Lehman, many of the returns have been generated by avoiding risk, whereas you can do the best analysis on specific companies or bonds to create alpha, but if you don’t have the risk quotient right, your returns are going to be sub-par. I think the Barclay’s/Absa team is doing a very good job at helping clients avoid those things, and I think that’s important going forward around the world. We have to look at risk in a totally different way.
ALEC HOGG: Larry, I was in Cape Town – where you are right now – a week ago. Michael Pettis, whom you no doubt are aware of, was over there giving a similar kind of warning. He lives in Beijing. He’s a Professor at the Peking University. Why is it that his view and your view is still a minority view, if it is so obvious?
LAWRENCE MCDONALD: This is the same thing we saw in 2007 in the United States. We were on the trading desk, shorting sub-prime. We were calling our warnings. People in our building at Lehman were avoiding our warnings and ignoring us, and people in the street were ignoring it. People look at China and they say ‘okay, they have $1.3 trillion of Treasuries. They have a lot of firepower to put out fires, and many risk controls in terms of throwing cash at problems’ but at the end of the day, if they keep throwing cash at problems and they keep bailing out these trusts that are going bankrupt… I think you’ll see a credit contraction similar to what happened in Japan ten years ago where, if they’re doing these bailouts, there will be less lending in the system and therefore less credit and that leads to GDP contraction. People just aren’t seeing it right now. It’s coming at us and they’re looking at the Chinese government and everything they’ve done.
ALEC HOGG: But what happens if the Chinese start selling those treasuries – if they start selling US bonds?
LAWRENCE MCDONALD: Well, that would be a real wild card. We don’t see that happening. I guess at some point to raise cash – if it got really ugly – that would happen, but if they did sell a portion of their Treasury holdings you would see a global crisis because they would probably take US rates. Right now, US rates are about 2.64%. If China sold even five percent of their holdings, you could see rates go up half a percentage point or even a percentage.
ALEC HOGG: So you’ve been through this before – you were in the sharp end, and it’s all about risk. How high would you rate the risk of a recurrence of what you’re talking about, or warning about?
LAWRENCE MCDONALD: I think most of all the Emerging Markets are very cheap. They’re trading at 30 percent discount to the MSCI global stocks. I think what’s going to happen is it won’t be as severe as Lehman – the next crisis – because there’s less overall leverage in this part of the world than there was in the United States. There is also less interconnectivity. In other words, the banks and the financial institutions over here are a lot like the United States was back in the eighties. The risks/the dominoes are further apart whereas in the United States and in Europe in 2008 and 2012, the banks were just way too interconnected. I think that what’s going to happen is…the real value is buying Emerging Market stocks because they’ve already been priced in many of these risks. The developed markets are what are really going to get hurt, because the Chinese economy is very important in the world today. About 15 percent of S&P 500 earnings come out of the Emerging Markets now.
GUGULETHU MFUPHI: Larry, you’ve raised the red flags on Asia. Is anyone responding to them?
LAWRENCE MCDONALD: What is interesting is that in the United States, I spoke at a number of conferences over the last couple of months and I’ve listened to Mr Paulson, John Paulson said that China has had its maximum limit of credit expansion. John Paulson, who warned us about the housing crisis in the United States; he’s out there now, publicly – in the last three weeks – saying some of the things I’m saying. In the last three weeks, George Soros also said about China’s credit expansion and its ability to expand from here. George Soros thinks they’re at the end of their credit expansion as well, so there are a few people pointing out these warning signs coming at us.
ALEC HOGG: But both Soros and Paulson are long on gold; that doesn’t help them too much, lately. Do you think they’ll be proven right?
LAWRENCE MCDONALD: I was on CNBC – I’m a contributor in New York. I was very bullish on gold in December and we’ve lightened up on some of our holdings with our clients. I think absolutely, over the next year…year-and-a-half, gold is going to have some rocky times, but I think gold will move higher.
ALEC HOGG: Well, that is going to be music to many people in South Africa’s ears. How do you position yourself though, for the possibility of the risk you’ve articulated, actually coming through?
LAWRENCE MCDONALD: From an equity perspective, I think you want to be long Emerging Markets and short developing markets’. Think of the money in Europe. Look at Europe right now. Twenty-five billion dollars are ploughed into European stocks and today, those stocks are at 22 times earnings – European stocks. The Emerging Market stocks are trading anywhere between…down in Russia at seven times earnings, maybe overall emerging markets are trading at 12 times earnings, so I think what you do is you go long Emerging Markets and short developed markets because any crisis over here will hurt the global economy. Think about global GDP. This is very important. According to the IMF, they’re looking from the emerging markets at five-point-seven percent – global GDP, a little around two percent, so a huge chunk of the global growth is coming out of the Emerging Markets. If that slows down, it will hurt the developed markets. Those markets are priced really rich. Those are the markets that are going to fall the most.
GUGULETHU MFUPHI: Larry before you go, in a nutshell is there a good-news story for emerging markets like South Africa in the long term?
LAWRENCE MCDONALD: Of course, this is one of the most sophisticated in the world, so it’s just right now trading at a premium. If you think on a priced-to-book basis, Emerging Markets right now are at 1.3 times book. South Africa is up at 2.2, 2.3, so people know that the market here is a better market overall, and that’s why there’s been a premium.
