Bill Gross of Pimco on The Markets

I guess he has been writing these for a while, but I've only recently started reading Bill Gross's monthly investment outlook at pimco.com.

In this month's post, Bill spoke about a few issues near and dear to my heart, the first one being the gap between rich and poor, which I have written about before. He rails against this gap, saying that he's firmly in Warren Buffett's camp and thinks it's a travesty for the richest people in America to be paying 15% tax rates on average, while the middle class (their secretaries and assistants) end up paying almost 30%. He says this is one of the prime reasons why there is such a huge gap between the rich and the poor, where 5% of the national income goes to .01% of the families in the US. You read that right, "point zero-one" or "one basis point" take in 5% of the national income.

That whole discussion was spurred by a recent issue that has gotten a lot of attention in the financial press. Basically, the rich managers of private equity funds, whose annual income is measured in hundred millions or billions, have their income treated as capital gains, so it gets taxed at the much lower 15% rate instead of the 35% rate us mortals pay. This New York Times article does a good job of summing up the issue.

I agree with Buffett and Gross. If you made $100 million last year, you should be paying $35 million in taxes, not $15 million. This leaves you with $65 million for yourself. Meanwhile, your secretary (lets assume she's an executive secretary) made $100 thousand last year, and paid her full $35 thousand share. This left her with $65 thousand for herself. Why should she be paying a higher rate than you? If anything, she should be the one paying the lower rate. In fact, it could potentially change her life to have $15k extra in her pocket every year. What's an extra $15 million to someone who already has a billion in the bank?

Gross also spoke about the markets some more, in particular, talking about increasing credit spreads. He basically repeated the theme that easy money is drying up for the LBO funds and PE folks who have been using it for buyouts. In particular, he pointed to a financing that's in the works right now that may not be going so well...

"Those that assert that this is merely an isolated subprime crisis should observe very closely the price and terms that lenders are willing to accept with Chrysler finance this week. That more than anything else may wake them, shake them, and tell them that their world has suddenly changed."

Well according to some press coverage I've been reading, it turns out the lenders haven't been able to accept ANY terms to lend money to Chrysler finance, and the banks and the companies involved are going to fund the buyout themselves.

For those of you who don't follow the credit markets very closely, I'll try to sum up what has been going on (in my opinion). Over the past few years, buyout funds have been able to borrow large sums of money at very low rates and use that money to acquire companies. The lower the price they paid on the borrowed funds, the more money they could make off of these companies they bought. Think of it this way: if you can borrow a million dollars at 3%, you are paying $30,000 a year in interest to use that million dollars. If you use the million to buy a business that returns you 12%, the business will be throwing you $120,000 a year. Subtract out your interest payments, and you're getting $90,000 a year in profit for yourself. Not bad! You'll easily be able to make your interest payments, and in fact you'll probably go out looking for more of these great deals. That's exactly what buyout funds have been trying to do, except they have been buying businesses for much more than $1 million.

The credit markets were giddy with all of these deals. Lenders were willing to charge lower and lower interest rates, somehow believing that there was not much risk involved, even with companies on the shaky end of the spectrum. Credit spreads (basically the additional amount lenders charge for people with shakier credit, just as banks charge people with lower credit scores higher mortgage interest rates because they are more risky) got very narrow. This meant that even a shaky business (one with a low credit rating) could get a loan and pay a rate not much higher than an extremely solid business (one with a high credit rating). There was a small "spread" between the interest rates they were charged. This is referred to as "tight credit spreads" or "narrow credit spreads."

What Gross is saying is that this is now changing. With subprime borrowers defaulting on their mortgages in large numbers, the market got sort of a slap in the face that said "wake up! you've been ignoring some risks here! you need to charge higher interest rates, especially for buyout firms that are using money to buy companies with low credit ratings because these loans are a lot riskier than you used to think! In addition, the credit rating agencies (Standard and Poor's and Moody's, primarily) have been asleep at the wheel too and they aren't giving low ratings to companies that deserve them!"

In the past few weeks, companies with low credit ratings have had to pay higher interest rates to borrow money than they have in the recent past. Things are getting back to normal, but as they make their way back there, there could be a whole lot of pain for the lenders.