Kass: Conversations With Nick and Toni - TheStreet

This blog post originally appeared on RealMoney Silver on July 14 at 7:38 a.m. EDT.

It seems appropriate to christen the inaugural column of "Conversations with Nick and Toni" in East Hampton, Long Island on a beautiful sunny Sunday. After all,

Nick and Toni's

restaurant is the place to be in the tony Hamptons on any Friday or Saturday night. The restaurant is usually inhabited by the movers and shakers in the real estate, media/entertainment and hedge fund industries.

On almost any evening at Nick and Toni's, one can routinely see Donny Deutsch (I think he lives there as he dines at the restaurant so often!), Sarah Jessica Parker, Nathan Lane, Lorne Michaels, Chevy Chase, real estate titans (Trump, Macklowe and Roth), and numerous hedge hoggers (Jim Chanos, Byron Wien and Ron Baron). Even

CNBC

got into the act last week as, while Nick and I were eating there on Thursday night with the Divine Ms. T,

CNBC

was filming its "

High Net Worth

" show with Tyler Matheson.

As to Nick (his pseudonym), he is a friend who has a reservoir of knowledge on the investment business, having first run a significant hedge fund and now, as the chief cook and bottle washer of a thriving media enterprise. Of course, I am Toni. Nick just ended a weeklong stay with me in East Hampton, and, as such, we have had our share of dialogues, disagreements and debates regarding the economy and Mr. Market over the past seven days.

So, without further ado, I give you the premiere "Conversations with Nick and Toni," which I hope to continue on a weekly basis throughout the remainder of the summer.

Toni:

How 'bout those Yankees? Quiet week in the market, huh, Nick?

Nick:

The tape? It comes down to containment vs. contagion. While government officials assured us of the former since last spring, we've watched the latter matter in a big, bad way. From subprime to level 3 assets to dilutive offerings by the financials to fed up sovereign wealth funds, the bloom is clearly off the credit rose.

Now, after a full year of pain, we've finally arrived at the center of the mess, Aunt

Fannie

(FNM)

and Uncle

Freddie

(FRE)

. This is, in many ways, ground zero -- the whole megillah -- the ability to maintain their credit worthiness will dictate the next leg of this market.

Toni:

Pithy words for a slacker, like yourself, who spent the week contemplating his navel on Georgica Beach! You summed it up well, but, as always, the key to the market's riddle is not what happened but rather what is about to happen

Quite frankly, it is hard for me to be convicted as the solutions have been obvious for months -- in housing and credit -- but the Three Blind Mice (Administration, Congress and Treasury) lack creativity and are all characterized by policy inertia.

Nick:

I'm not sure there are solutions outside of time and price. Remember, the grand experiment of financial engineering began after the tech bubble and manifested through 9/11, Iraq, the elections. There is a big difference between a legitimate economic recovery and credit-fueled growth.

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The DNA of this market is vastly different than during any other time in history. Debt destruction, while painful, will ultimately allow for a sustainable foundation for future growth. Unfortunately, it could take up to five years for that to fully flush though the system.

Toni:

I agree that in magnitude the current mess is unlike anything in the past -- after all, the you-know-what is really hitting the Fannie. We are currently at writedowns of $400 billion and counting, and one of the most credible credit analysts extant, Bridgewater Associates, issued an apocalyptic report last week that the aggregate losses in our world's financial institutions might exceed $1.5 trillion.

The investment and economic worlds are today characterized by either Cassandra or Pollyanna -- though I am a skeptical short seller, I lie somewhere in between. Rarely does an automobile experience four blowouts at the same time on the Long Island Expressway -- maybe two but never four! Similarly, hard-hitting solutions, even within the context of the massive credit mess, seem possible if not probable.

Indeed, the Treasury

announced

plans on Sunday to inject $15 billion into Fannie Mae and Freddie Mac in an attempt to assuage fears. Whether or not you agree with it, the perception of a government backstop might shift perception.

Nick:

I agree that perception is reality in the marketplace -- in fact, while I foresee risk to

S&P

1,050 and understand the sharpest selloffs occur in an oversold condition, the trader in me is looking to buy into further weakness, particularly select financials. Downside tail-risk, by definition, is a low-probability affair. That's my short-term sense, and it is offered with the understanding that I have been steadfastly bearish for the last year.

Through a larger lens, however, we must remember that we've shifted from a manufacturing to service to finance-based economy, and that has ominous implications at the beginning of a multiyear deleveraging process. While you'll surely hear choruses of "the coast is clear" on the other side of the if-and-when rally, we would be wise to remember this conversation after it arrives. Trades, as they say, are made to be taken.

Toni:

Well,

Carnac

, my crystal ball is apparently more murky than yours. I would prefer, at this point, to play the role of Ed McMahon (rather than Johnny Carson) and to be less anticipatory than I normally am.

With so many moving parts of the credit problem and solution, I have grown less convicted and more reactive in my investing. I want to let the market dictate more than usual to the process of creating my investment strategy in the months ahead.

As to trading, it's another story, as the volatility is providing facile traders with one of the greatest backdrops I can remember. But most investors and traders should probably err on the side of conservatism by keeping positions at levels that are far smaller than they are accustomed to. It's funny (well, not so funny!) that neither of us has even addressed the headwind of higher crude oil -- as if credit alone is not enough!

Nick:

I agree that this is one of the most difficult investing junctures ever, and, for investors, capital preservation, debt reduction and financial intelligence are core components of any investment strategy.

While I understand your thinking in adapting to the market, I would be careful being too reactive as the market is a forward-looking discounting mechanism. I'm hearing war stories on the hedge fund front and that's causing forced flows. The ability to wait for your pitch and take a proactive (and disciplined) cut will differentiate returns. Not many people are currently in that position.

As for crude, it's the other side of the double-edged sword (with credit). While geopolitical risk (Iran) remains, I will offer once again that this bubble will follow the path of dot.com, real estate and China. It's always different until it isn't. What will be different, I believe, is the equity reaction when precipitously lower prices arrive. My sense is that, after a knee-jerk rally, it will be more endemic of slowing global demand.

Toni:

That's probably a good stopping off place as the sun is shining and Georgica Beach beckons us. Until next week, Nick. Our dialogue as well as your week's stay in my home has been really fun!

Doug Kass writes daily for

RealMoney Silver

, a premium bundle service from TheStreet.com. For a free trial to

RealMoney Silver

and exclusive access to Mr. Kass' daily trading diary, please click here.

At the time of publication, Kass and/or his funds were short Fannie Mae and Freddie Mac, although holdings can change at any time.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd.