For a local perspective on the unfolding crisis and how it may play out, I spoke to a group of astute market thinkers on Friday, before Congress passed the emergency package.

ALAN KOHLER, PRESENTER: For a local perspective on the unfolding crisis and how it may play out, I spoke to a group of astute market thinkers on Friday, before Congress passed the emergency package.

Joining me is Morgan Stanley's chief strategist Gerard Minack, who's been warning for several years about what has actually come to pass, Peter Morgan, one of the nation's foremost investors and founder of the fund manager 452 Capital, and Tom Murphy, former director of private wealth management at Deutsche Bank, who's now started his own advisory business called Family Office Research and Management.

(to Gerard Minack) Well Gerard if I could start with you. You talked this week about the three phases of the process we are in, could you talk about what those phases are and what the third one involves?

GERARD MINACK, CHIEF STRATEGIST, MORGAN STANLEY: Sure, sure. I mean look the first point I always make is this is a global problem. It was a global credit boom. It's going to be a global credit bust. The first phase was when we thought it was predominantly a liquidity story and the initial response of policymakers therefore was to provide all these weird and wonderful liquidity facilities. Now we are starting to...

ALAN KOHLER: Which they are still doing.

GERARD MINACK: Which they are still doing. But now we are starting to realise it is more than just liquidity. It's a solvency issue and that when you've got leveraged institutions that are taking a hit on their asset base, some of them are wobbling, some of them are falling over and what we effectively need to achieve is a recapitalisation of some of the institutions, indeed, I would argue the entire banking system, and that's what we are in the process of doing now.

ALAN KOHLER: And that's phase two?

GERARD MINACK: That's phase two. Now, the third phase is let's assume we don't have a general systemic crisis and we do manage to recapitalise a lot of these banks, the third phase is when we realise we have got the most leveraged banking system in a long time. If you look at US commercial banks, are leveraged 20 times and I think the third phase will be when the bankers sit there and go, "That's not so smart, we've got to reduce our leverage."

Now, if the commercial banks in the US, as an example, decide to reduce their leveraged from 20 times to 18 times, they've got an $8 trillion balance sheet, that means pulling it back by about $800 billion. That will take some time but what it means is we can have very tight credit conditions I think for some time. We are talking about years, not months or quarters as we get the western financial world leveraged back in to order.

ALAN KOHLER: Well Tom, if I can turn to you now, what do you think the underlying causes of this all are? Give us some perspective on how you see that.

TOM MURPHY, FAMILY OFFICE RESEARCH AND MANAGEMENT: As Gerard said, most market collapses do in fact have a preceding period of excess leverage. In past collapses we have had traditional borrowing. This time we've had synthetic leverage through derivatives and swaps but the effect is the same. Money has been too plentiful and the cost of credit has been too easy. I don't think it would be an exaggeration to say that there has been a massive fraud perpetrated on the American people by the investment banking world. I think that the....

ALAN KOHLER: That's a big call.

TOM MURPHY: Well, what's happened with the mortgages is very, very serious because I came from America and I know that there are Americans, like Australians, whose dream is to own a family home and is quite interesting to look at what's happening now because people have been, people have been cheated by the system in the sense that they've been led to believe they can afford mortgages, they cannot, and I'm really talking about the subprime component of the mortgage market which is small, but admittedly, the middle part, what we call the low doc segment is a lot bigger and this part of the market has been populated by people, many of colour, people whose parents did not have the ability to achieve the dream of owning a home.

So it's a very, very serious thing and I would argue that the problem is as much social as economic because what we are seeing now is a class struggle between the haves and the have-nots and it's the kind of struggle we've not seen in America previously.

ALAN KOHLER: Now Peter, the way that Australians are mostly exposed to this mess is through their equity portfolios, and superannuation. We've seen the market fall 33 per cent since last November. How do you feel about it now, are you on the sidelines?

PETER MORGAN, 452 CAPITAL: I'm going to provide a little bit of a background to that Alan. Firstly Australia's financial system, the finance industry's the fourth biggest in the world. God knows what it is per capita so it's a very large industry. Super is very important to it. Now, when you look at the Australian share market the two massive sectors are finance and commodities, and when you've got an exposure to those two sectors, most superannuation funds are heavily exposed and despite that, we are running against that ourselves but when you look at that and look at it in detail there are significant risks to those two sectors. As an example, the BHP at the end of August was trading $41, today it will be $30. Rio was $125, today it will probably be $85 and that is all getting around the fact that the world is slowing, look at the copper price, it's a very good indicator as to what's going on in the world.

The trade or the freight is slowing quite markedly and whereas everyone was talking about China as being the saviour, it's now being well and truly questioned. So commodities are under pressure. In addition to that, we have got a lot of concerns with the Australian banks, not systematically but just coming from a position where the bad debts have never really been lower. If one looks at the bad debts charged the last half it's averaging 30 cents out of every hundred dollars.

ALAN KOHLER: You can't get any better that.

PETER MORGAN: Well it can't really get any better than that. From this point it won't get better.

ALAN KOHLER: Do you see it in two phases, that the first part of the bear market was the financials, and are you saying that we are actually entering now a resources or commodities bear?

PETER MORGAN: Well I think those two sectors you can't, there is no way the market can go forward if those two sectors are struggling, if I'm right on that and they are showing every sign of struggling. Just to take the banks a step further the other thing is that funding side. The Australian banks are big reliers on the wholesale market globally. They have got to raise something like $120 billion next year and I think there is a lot, I don't think there's any coincidence that the Australian dollar is quite weak at the moment. I think that's partly a reflection of Australia's reliance on the rest of the world in terms of that funding.

So the big question mark for all superannuation holders is how exposed are you to those sectors and what effect that's going to have. Now, let's also put that in context that going into the downturn from June 2007 we had four years when the market was up 20 per cent, 20 per cent, 20 per cent, so it's not a total disaster in those terms but it's going to be very, very difficult over the next 18 months to two years.

ALAN KOHLER: You've always been a bit of a pessimist. At some point you are going to have to turn into an optimist in this process. When is that going to happen?

PETER MORGAN: I am fighting that every day, and there is some value emerging. You know, I don't know if this is good or bad but I was around in 1987, I was around in '91, '92 but I have never seen anything like this Alan, and I challenge anyone in the market to actually say they have seen anything like it.

It's something new, it's global as Gerard said and it will take time and there will be periods of volatility and as I said we haven't really seen the effect of - you know, superannuation trustees have never seen a downturn. Super came in to the early '90s. They haven't gone through this period. The last thing we want is them to be panicking at the wrong time. That may occur. On the other side, you know, superannuation is maybe a saviour to the system itself.

ALAN KOHLER: Gerard, the official stats don't show yet that the US is in recession. Do you think it is?

GERARD MINACK: Yes, to every intent and purpose absolutely in recession, and that means we can look at past recessions and we can be very confident of a few things happening. Whenever you have a recession you get rate cuts and that's not a 9 out of 10 storey or 7 out of 10. It's 10 out of 10. It always happens so we can expect some rate cuts from central banks throughout the world including the US.

ALAN KOHLER: They haven't got very far to cut, though.

GERARD MINACK: They haven't got very far to cut that's true. That is true but you may as well used what you've got. The second thing is we know inflation is going to fall. We have a bit of an inflation scare earlier in the year. There is a lag when growth slows and inflation follows but it always follows.

The third thing is earnings always fall and corporates have operational leverage. We have got a finance sector that is still bloated and I would argue that particularly in Australia. Analysts though, the consensus forecast are still I think in lala-land. They are still going for double-digit earnings growth. In the US, if you pull out the financial sector there is a massive earnings miss coming in the US and of course equities never do well in a recession and that's ahead of us.

ALAN KOHLER: Do you agree with that Peter?

PETER MORGAN: I think there is one additional point there - the focus on inflation. I think there is a real risk here that we're running into a deflationary environment very quickly and I think Bernanke and a few of the central bankers around the world are really scared of that and if you've got a lot of debt going into deflation much the same as the Japanese did, it's going to be extraordinarily tough for anyone that's got debt because asset prices are falling.

We can see that they are falling pretty quickly and you know I would throw that into the ring that it's going to be a battle to try and stabilise things so you can get inflation back into the system.

ALAN KOHLER: What about the earnings forecast, when the reports come in to you, what do you think?

PETER MORGAN: In a lot of ways, given the environment we've been in, the bullshit environment we've been in, we've taken the earnings forecasts as a little bit of a grain of salt. We are quite counter cyclical to a cycle. You know if something is at the top of the cycle will generally be well away from it so to that end we are not - but you know, you are going into an AGM season in the next month or so there has to be some downgrades there.

You are starting to see some coming through but the big issue also is the balance sheet and you know any company that is handicapped by a large amount of debt, first they have got to be lucky to get through it, and secondly, it's going to be a handicap going forward and I would add to it, the cost of debt is rising. We are going to get capital raisings not only here in Australia. We're also going to get them around the world and the call on capital is going to be there for a reasonable period of time.

ALAN KOHLER: You were going to say Gerard?

GERARD MINACK: I was going to say - I mean one of the things I've yet to meet an investor who believes those consensus earnings numbers but it's a bit like the apocryphal story about the CEO who says, "I know I am wasting half by advertising budget, I just don't know which half." There's general unease about the earnings numbers but we don't know which specific companies are going to warn and what we are still seeing in the market today is when a company put its hand up and says, "I am missing", they get smashed. So even though there is this unease about earnings numbers I think when the downgrades come through it will have an impact.

ALAN KOHLER: How do you see the thing unfolding in... you were going to say something else, Tom?

TOM MURPHY: Looking forward, I think we have to recognize that in the past half century the stock market is typically bottom somewhere three or five calendar quarters before the actual economy turns upward, so we could be coming into a period of profit downgrades even though the stock markets will tell us well in advance that we are nearing the end and in relation to the American market, I would say we had a couple of instances in the past few decades. We had Ronald Reagan and at the opposite end of the political spectrum we had Bill Clinton, who brought in an air of optimism to the US economy and they made people feel good about themselves and about the future of America.

If that were to happen with the new President in January, we could see in the first quarter a turn in markets well before the economies turn. Foreclosures will still be under way and it will still look terrible but people might feel a sense of optimism and it's about leadership now.

ALAN KOHLER: You get the sense that there's also going to be a big phase of re-regulation going on, possibly even equivalent to Roosevelt's New Deal?

TOM MURPHY: And it is inevitable and we will even see bans on short selling and limitations on short selling in some of the Asian markets who have stood back and said, "We are not going to do this." So we are going to see radical change and if there has ever been a time for regulation it is now.

ALAN KOHLER: Speaking of short selling, has the ban on short selling had much impact on the market as far as you can see?

PETER MORGAN: I think it has had a massive impact in terms of it being there and not being there and I think it's one of the great untold stories and it's going to sound that being a buyer of shares that I am against it but I firstly cannot rationalise shorting as an investment.

ALAN KOHLER: Is there realistically going to be a permanent ban on short selling?

PETER MORGAN: I think there needs to be something done pretty damn quickly about it and I think the trustees of superannuation funds should be looking at themselves in the face and say, "Is this proper?" I don't think they are getting the right amount of money for it. I think point two or whatever they are getting for it and sharing it with the custodian. It's totally unregulated. Alan, it is one of the great cock-ups, for want of a better word, of all time, what's gone on in the last six months with regard to shorting. Opes prime related to it. So much for regulation.

ALAN KOHLER: Just to conclude, Gerard. What's the event that would cause you to start to get optimistic, to believe that it's turned?

GERARD MINACK: There are three things I am looking for. The first absolutely necessary precondition is we get some rate cuts. I can't think of a bear market that's ended before policymakers have taken the foot off the break and put it on the accelerator and all we've seen really globally is a few Anglo banks cut but most other banks have still been tightening. So I want to see that.

The second thing I want to see is I want to see some of those downgrades come through. Now I absolutely agree with Tom, the markets look ahead, so we don't wait for the end of the downgrades because of the market will have raced ahead but we are right at the start of the downgrade process and if you look, for example, at our resource sector here, last month was the first month of downgrades. The market has started to sell off before that but it's very unusual that after one month of downgrades all the subsequent downgrades are in the price.

The third thing I would like to see is more attractive valuations. I keep on thinking my mind that this has been an earnings bubble. We've seen margins, ROEs, profit shares and GDP at all-time highs. I think the big trap for investors is when an earnings bubble drops is value traps. So I think we need to see more attractive valuations and a straightforward PE is not going to do it for me. I would rather look at ROEs or margins and see them get back to more sustainable levels.

ALAN KOHLER: Thanks, gentlemen