Gundlach: Excessive Debt Still the Culprit

Jason Stipp: I'm Jason Stipp with Morningstar. One year after the Lehman collapse marked a credit market crisis that was reaching a full tilt, the equity and credit markets seemed to say to us that we have stepped back from the abyss, but there still maybe some issues out there that are concerning investors and we're wondering just what the outlook may be from here. Joining us today is TCW's Chief Investment Officer, Jeffrey Gundlach. He is also Manager of TCW Total Return Bond. Thanks so much for joining us Jeffrey.

Jeffrey Gundlach: Sure, I'm happy to be here with you today.

Stipp: So, a couple of things that I wanted to touch on. First, looking back briefly, but then also looking forward.

Looking back, the crisis that we saw from Lehman Brothers and the collapse of some of the other investment banks and how that spread through the market. In your perspective, has that really changed the way that investors are investing today or are we just seeing sort of a blip and a moment of volatility and then we are just going to sort of go back to business as usual? Is there a different story today than there was a year ago?

Gundlach: I don't think so. I think if we survey what the markets are saying today and what the behavior is now, just one short year after those very scary moments of September of 2008, the markets have pretty much fully recovered in terms of people's attitudes to the norm. We see lots of fear that was in the market back in year-end and certainly a year ago and in March, has largely dissipated. We see a market where bullish sentiment, which was extremely low back in the first quarter of this year is extremely high in sentiment surveys that shows that attitudes of risk have largely normalized.

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It is amazing how short investor memories really are. One would have thought that the type of freefall that was experienced in September-October and then again with less velocity the downside earlier this year would have made a lasting impression, but most analysts have basically gone back to business as usual, and we are starting to see people talk about normalization of earnings growth and normalization of the economy again.

So, risk tends to bubble up from time to time, and it happens once every several years and this last episode was one of the more extreme cases, but the memories are short and the investors' behavior have normalized to a great degree since then.

Stipp: Now, a lot of market-watchers credit this stabilization to some of the unprecedented government actions that we saw and how they may have caused that stability to come back into the market and maybe investors feel they are on a firmer footing now, but it could also lead to some issues down the road. So, how do you see the government's policy response and its effectiveness? And what do you see are some of the problems from that policy response going forward that we really need to keep on our radar?

Gundlach: The government's response has been effective as you would expect it would be with this type of magnitude. Over the short term, there would have been an awful lot of short-term pain that would have been greater than what we experienced had there not been these government programs. However, the government's programs do not address the long-term problems or the structural problems. In fact I am of the opinion that the government's actions in the last 12 months have added to the structural problems and the long-term problems, which is really all about excessive debt.

The excessive debt underneath the markets is the reason why we went into this recession and have remained in the recession on a perceived basis. I know that we will probably get a positive quarter or two, maybe even three of economic growth, so officially in a statistical sense, it is end of the recession, but when you are losing hundreds of thousands of jobs per month and you look at surveys of consumers and citizens, people still feel like we are in a recession.

The cause of that recession was acceleration of consumption based upon auto leases and home equity takeout and multiple credit card usage and all the like on the individual basis. And the debt to GDP ratio based upon consumer borrowing exploded to the upside. As of the first quarter of '09, which is the most recent data point, there will be a new data point out just next week, but the most recent data point is first quarter of '09, debt to GDP was 375%; that's the highest of the century, much higher than what we had in the Great Depression even though economic growth collapsed at that time.

So, we had acceleration of consumption thereby the accumulation of individual choices of increasing individual debt levels. That hit the wall because of the lack of largesse on the part of lenders once default started to build up when the wherewithal to pay back the debt became problematic relative to national income.

So now what has happened is the government has taken on the burden of the debt, so we have seen an explosion in Federal promises to pay, governmental promises to pay of $7 trillion in the past year. The total bill of forward-looking promises to pay is now roughly $65 trillion by the federal government and fully 50% of this year's budget is being borrowed.

So, there is a tremendous amount of debt at the government level that is supporting the current upswing in the economy or at least the mitigation of downside momentum in the economy. And I don't believe that that can continue because the debt to GDP ratio in the government's borrowing has its own limits. In this case, it is not the largesse of creditors because we can ultimately print the money, but without printing the money we would have to borrow more and more and more to keep this debt basis scheme going, and I think the markets ultimately won't be able to support that.

So, I think we are still having the same central problem of excessive debt, but it is being pushed forward and the government's programs stop the pain from getting excessive in the short term, but the long term stretching out of the pain is the likely aftermath of those policies.