Beware The Day Of the Bear

By RICHARD HORNIK and James Grant

Q. Have the crisis in the Middle East and the resulting oil shock finally launched the bear market you forecast in September 1984?

A. The Middle East, I think, has remarkably little to do with the slump in world equity markets, which was under way long before Iraq barged into Kuwait. For the most significant international financial event of the year, I nominate the collapse of the Japanese stock market.

Q. Now that the economy has begun to slide, meaning that you're finally right, don't you feel like gloating?

A. If you have kids, how glad can you be that the economy is not supporting the parents of their friends, or indeed of oneself? What gives me satisfaction is to see financial events move in a logic that I understand and advocate. I am frustrated not so much by being wrong as by seeing the Bakers and the Bradys and the Greenspans try to manipulate and buy orthodoxy on the cheap. So they are going to do something clever with the G-7, or they are going to pass a constitutional amendment to balance the budget. When I get the numbers wrong on a stock or on a credit situation, that is one thing, but to see the authorities with a wink and a nudge just sparring for more time, that's another.

Q. Were you ever worried that the financial excesses of the 1980s might go on forever?

A. Yes and no. My publication, Grant's Interest Rate Observer, is about interest rates and especially about credit. On that score my views have basically worked. The junk-bond market did come apart starting in 1989. And there is a credit contraction. Bank stocks have been good to sell short. And real estate, which is another big editorial topic, has been going down, taking with it such people as Donald Trump.

What has not come to pass and does give me a lot of worry is that these problems seem to have had so little impact on financial markets generally. So there is both gratification in the run of the news and frustration at a seeming lack of overall significance.

Q. Do you ever gloat?

A. I would have to say that I do in the case of Donald Trump. Just to have him shut up is such a wonderful gift, if only temporarily, a great improvement in the quality of life. And so debt isn't all bad.

Q. When did Donald Trump first come on your screen?

A. In December 1987 we wrote a long piece about Trump, and I had long thought he was emblematic of the times. For that reason he was interesting to watch. Instead of declaiming on the universe, we try to pick out people or companies that more or less represent trends. I thought that Trump was a fine exemplar of financial leverage and gall, both of which were in oversupply and now are becoming scarcer.

Q. What role has real estate investment played in the financial turmoil of the 1980s?

A. Real estate is one of the most revealing features of the credit travails. It was the original taboo. Citibank existed from 1812 to 1960 without making real estate loans. There was this cultural resistance as well as regulatory and legal resistance to making real estate loans because when the depositors wanted their money it was not the time to rely on a piece of land.

Then lo and behold, we had inflation; we had deregulation of interest rates. And we had banks that were losing their best corporate customers to the commercial paper market. We had banks that needed fee income and needed to do something clever lest they go out of business the slow way, which is by starving to death. And so real estate lending became the favored commercial- bank asset. And as with any asset favored by bankers, it suffered a depreciation because they lent so much that they helped create a glut.

Q. How responsible is the Reagan Administration for the savings and loan disaster and the banking industry's problems?

A. Certainly there was a great failing of the Washington apparatus in the 1980s. But I think, paradoxically, a lot of what happened in the '80s can be blamed on the politicians of the 1930s. When deposit insurance was written into law in '33, it was almost a free ticket. The banking system had been purged of bad loans the old-fashioned way, the weakest banks had long since failed, and the strong banks were barely making a go of it.

The reflexive psychology of bankers was that of -- well, bankers were starting at the sight of their own shadows. So deposit insurance could be done painlessly for decades because bankers were too terrified to do anything resembling making a bad loan. It was not until a generational shift occurred in the '70s that bankers prepared to entertain really rank loans. The government had this free ride for a long time. There were hardly any failures because bankers were not lending in such a way as to fail. And now, paradoxically, when the talk is of cutting back on deposit insurance, the banking system is a mirror image of the system in '33.

Q. Is it a passing of generations in the financial world that leads it to periodic busts?

A. The generation that was caught up in the great debt liquidation of the '30s never got over it. If you had started work in the '50s on Wall Street, you would have heard a lot of talk about the Crash. Even 20 years later, it would have defied, never mind financial common sense, it would have defied known laws of physics to the bankers in the late '70s had anyone presented to them the proposition that an airline should be leveraged. "What? You are talking about a labor-intensive, highly unionized, highly cyclical commodity-driven business being leveraged?" Yet by the time the cycle matured, people were not only proposing but actually undertaking to leverage airlines.

That is the way great ideas end, not with a bang, not with a whimper, but through reductio ad absurdum. You know investment bankers are not satisfied until every good idea is driven into the ground like a tomato stake.

Q. Where does this preoccupation with debt lead?

A. I certainly think there is a severe business slump in our future, and I think what is so different this time is the recklessness of financial practices. That recklessness, if this does not sound too Calvinistic, will come to bear in the downturn, making it deeper than it otherwise would be. And the medium of that will be a shrinkage in the availability of credit. Just as the advent of ever longer maturities in car loans, for example, helped prolong and deepen the expansion, so will shrinkage in the terms of credit -- whether they be in car loans or mortgages or corporate lending -- deepen the recession. I am not at all sure this is going to be a Grapes of Wrath. At least, I hope not. But I think by the time it is all over, people will be refusing to make good loans, just as they had been overzealous in making bad ones.

Q. So what should we do? Buy gold bars and bury them in the backyard?

A. Well, we had a co-op in Brooklyn Heights, which we sold last summer. We are now renting because I think that it is a good time to rent. I think short- dated Treasuries are a nice way to ride things out. You are being paid what is historically a good rate of interest, and you are going to get your money back. I think you ought to be very aware of the credit condition of your insurance company. There are outfits that rate the claims-paying ability of insurance companies, and people ought to ask their financial planners or someone whom they trust to make sure that their insurance company's claims- paying ability is the top.