Well the economy has finally gotten everyone’s attention. It has the attention of consumers, regulators, investment banks, and government officials in industrial, emerging, and developing countries. You can’t go ANYWHERE and not hear people discussing it. I find it tragically ironic that people don’t even BEGIN to care about investments, economics and banking until we’re sliding straight down the chute into a recession. It seems like there are more opportune times to get educated on this stuff…at any rate…let’s review where we are right now. I’ll start off with an apology today…this update got to be a lot bigger than I expected (especially for a long weekend) but I wanted to provide as much color as I could as we are entering a new phase in the business cycle, and quite possibly a new era in global finance.
A brief history of the last year
Last summer (2007) we saw the beginning of the problems with two Bear Stearns hedge funds hitting the skids. Bear halted redemptions in order to buy time for an orderly liquidation. If memory serves me this was the first in this cycle that we heard the terms “need to buy time” and “orderly liquidation” in the same sentence.
This is about the time everyone began questioning the “mark to model” methodology of pricing complex structured investment vehicles that were based on suspect loans, sliced up, re-packaged, branded with a AAA rating, and then sold to/bought by, investors that didn’t understand any of it. The problem is that by the time anyone stopped to question it the horse was out of the barn. And in this case the horse must have been related to Sea Biscuit because it was off to the races and couldn’t be stopped.
If there is no market to mark against, firms can use a model to evaluate their assets. The first problem was the very nature of the products. These are very complex structured products that contain a wide range of risks. Under the best of circumstances they are difficult to model and require significant assumptions be made. Well now that some firms are having to actually sell assets…there IS a market against which you can mark. So we now have actual trades getting done and prices being pushed lower. All of the firms that carried these instruments on their books at highly optimistic prices are now having to book some major league write-downs.
Beginning in late 2007 we saw wave after wave of giant write-downs which as of August 2008 had passed the $500 Billion mark (most estimates put the ultimate total between $1 and $2 Trillion). These losses forced firms to raise capital to the tune of $352 Billion over the same time period. These firms are destroying capital faster than an industrial sized paper shredder chews through junk mail. I’ve attached a list that Bloomberg compiled through August of 2008. The top 5 companies by size of write-down are listed below to give you a feel for what’s on the list:
(I APOLOGIZE FOR THE FORMAT OF THIS CHART! This blog site seems to have zero compatibility with either Microsoft Word or Excel)
Write-down & loss Capital Raised
Citigroup 55.1 49.1
Merrill Lynch 51.8 29.9
UBS 44.2 28.3
HSBC 27.4 3.9
Wachovia 22.5 11
One immediately has to ask how the smartest guys in the room get themselves into such a mess. The answer appears to be as simple as good ol’ fashioned greed. Richard Bookstaber wrote about this phenomenon in his book “A Demon of Our Own Design”. I’ll paraphrase and hope to do him justice. Essentially the trading desk at these big street firms is the profit center. It’s where all of the money is made. Risk Management is a great title and people pay lip service to it but risk management generally means doing less of the things that make money. When risk managers at these firms point out activities that might lead to adverse consequences they are shouted down by the trading desk. It’s essentially a “we MAKE money and you don’t” type argument and the firm ultimately goes with the folks that make the money. Risk managers at these firms are analogous to a kicker on a football team…you have to have one on the payroll but nobody wants him in the game.
The fact that some of these institutions took their first ever quarterly loss only to be completely wiped off the map of Wall Street shortly thereafter will serve as a lasting testimony to the type of risk management programs these firms were employing. If the first loss you ever take balloons into the loss that kills you, then you were clearly taking far too much risk for far too little reward. The fact that everybody was doing it will be of little comfort to the shareholders that you drove into the dirt.
The situation we face today
So that set the stage for what we’re seeing now. The write-downs led to failures which led to heightened awareness of counter-party exposure, which led to a lack of lending, which began the liquidity crunch. After JP Morgan was given a loan from the government to execute an orderly takeover of Bear Stearns many people cried foul. After the government provided funding to rescue AIG people began screaming that this is “the end of capitalism” and that the feds won’t allow anyone to fail. When Lehman got in trouble the government did allow them to fail…and that failure sparked a global wildfire. Money Market funds holding short Lehman paper now had losses that prevented them from repaying depositors. When the first money market fund broke the buck it shook the entire foundation upon which our financial system is built. A massive wave of redemption orders from money market funds forced the Treasury Department and the Fed to begin taking drastic measures to keep the engine of our economy from seizing up.
If you picture the flow of capital through our financial system as the oil in our economic engine you’ll get a pretty good idea of what will happen if the $4 Trillion money market system dries up. When nobody has faith in anyone else people hoard cash. Banks hoard it and won’t lend to each other, consumers hoard it and pull it out of the bank, and it all goes downhill from there.
So now we’ve seen all of the theatrics that are modern politics with the Treasury Secretary and the Chairman of the Federal Reserve appearing before Congress, the G7 countries meeting at the White House, etc. We’ve heard all of the questions and complaints, and the one unanswered question that frustrates the politicians so greatly is “what if the plan doesn’t work?”
I can’t tell you how many times I’ve heard a politician ask this question in one form or another. I don’t think I’ve heard anyone associated with the plan provide an answer to the question, although I’m confident they have some ideas of what failure would mean. Failing to restore confidence in the financial system will at the least mean a deep recession, and clearly concerns are mounting about a global depression. With a potential depression looming what do you do? If you are a central banker do you sit idle and watch the train-wreck? Do you attempt to intervene? Will intervention help, or will intervention just prolong the agony or push it further out to a future date?
I continue to hear the comment that the government should do nothing. This stems from concern about Main Street vs. Wall Street. It is important to understand that if the money markets freeze up there won’t be much of a Main Street anymore. If a $4 Trillion market of short term deposits just walks away, business financing in this country will come to a sudden and screeching halt.
For instance, the average American today pays his bills, buys a house he can afford, goes to work and pays his taxes. Likewise his employer can be financially sound, running an honest set of books, and providing stable employment for dozens or hundreds of citizens in his community. But…due to things far outside of his control his company might not be able to fund inventory purchases due to a seizure in the money markets. If they can’t fund inventory they have nothing to sell, if they have nothing to sell they can’t pay the bills and they go under. Now our hard working Main Street American is out of a job, and likely out of a home due to events he had nothing to do with. Now multiply this scenario across every city in the country and you begin to get an idea of how important that $4 Trillion money market is to the economy as a whole…not just to Wall Street fat cats with golden parachutes.
What happens if the plan doesn’t work?
With all of these questions being currently pondered by everyone in America I thought it would be useful to review some depression era economics.
We are at the point where central banks around the world are clearly trying to avoid not a shallow recession…but a global depression.
Irving Fisher lived through the Great Depression and wrote some very influential material on the subject. Here is a very brief summary of Irving Fishers theory of the Debt Deflation Spiral that causes depressions. You can be quite certain that Bernanke and Paulson are familiar with the work of Irving Fisher…you can actually get a copy of Fishers work on the Debt Deflation Spiral from the St. Louis Fed’s website.
Fisher’s words, written in 1933 have an eerily familiar ring to them today. Below is a summary of Fishers work on the Debt Deflation Spiral written by Giovanni Pavanneli:
The explosive dynamic process typical of “great depressions” had its origins, rather, in the fact that the initial over-indebtedness was progressively aggravated by deflation. In brief, the model considered firstly a system burdened with debt, but otherwise in equilibrium, albeit an unstable one; in this situation, a minor shock (“bad news” or a fall in share prices) was enough to undermine the confidence of “either debtors, creditors or both” and to lead to a first wave of liquidation of debts.
The rush to “liquidate” led to “distress selling” and the consequent sharp fall in share prices and a contraction of bank deposits. This triggered deflation, which in turn increased the stock of debt in real terms.
In essence, the attempt by individuals and banks to reduce their debt touched off a perverse dynamic process that worsened their situation in real terms, dragging them towards financial collapse. The immediate consequence was a wave of bankruptcies that drove prices still further down.
The generalised reduction in prices also damaged the entrepreneurs who were not in debt: their sales prices fell faster than costs, squeezing profits. Now, in a capitalistic system, Fisher writes, “it is the profit taker who usually makes the decision as to the rate at which his enterprise is to be run”.
A fall in profits was thus bound to bring a general reduction in output and employment. Taken together, these factors produced a lack of confidence and pessimism that translated into a general rush towards money: phenomena of hoarding thus multiplied, further reducing the velocity of circulation of money and lowering price levels; consumption contracted even further.
Again in this case, therefore, the effort by each agent to improve his own position led to a worsening of the overall situation: “Every man who hoards does it for his own protection; yet by hoarding he aggravates the very condition that started his fear”..
In essence, if not adequately countered by the monetary authorities, the deflationary process will set in motion a perverse, self-fueling spiral bound to cause “almost universal bankruptcy”.
I find that this picture painted by Fisher helps to provide some context to what central banks are doing right now. Monetary authorities are trying their level best to avoid a depression and they are absolutely committed to not allowing a depression to run its natural course. I’ve read some scary things in my life but Fishers ultimate conclusion of “universal bankruptcy” is difficult to come to terms with. Clearly it scares world financial leaders as well.
Fisher’s insight on doing nothing in the face of depression is summed up below:
“Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-1933 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized. Ultimately, of course, but only after almost universal bankruptcy, the indebtedness must cease to grow greater and begin to grow less. Then comes recovery and a tendency for a new boom-depression sequence. This is the so called “natural” way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation”
You couldn’t hire Stephen King to write something that scary…that’s worse than Cujo and Carrie combined!
Interestingly the IMF currently reports that the Global Financial Crisis could lead to famine in developing countries in Africa and Central America (that forecast follows Fishers roadmap on depression). The IMF also forecasts Global growth at only 3% in 2009 with growth in the G7 countries (US, France, Canada, Germany , Japan, Italy, and the UK) barely scraping by with just over 0% growth for the year.
JP Morgan just revised its forecasts for US growth to include recession, and most major firms have included downward revisions.
Views from around the world of finance:
The quotes below are taken from the attached Bloomberg article:
``It's certainly going to be the worst since the 1980s,'' says Bradford DeLong, an economics professor at the University of California at Berkeley who worked at the U.S. Treasury Department from 1993 to 1995. ``The hope is that it won't become the worst unemployment business cycle since the Great Depression.''
``This is the worst crisis I've seen in my 50-year career,'' William Rhodes, senior vice chairman of Citigroup Inc. in New York, told fellow bankers in Washington yesterday. ``We still have to deal with the effects on the real economy here and elsewhere.''
``We're heading into a global recession,'' Simon Johnson, also a former IMF chief economist and now a senior fellow at the Peterson Institute for International Economics in Washington, said last month.
``It's hard to imagine it not being the worst recession in at least 25 years,'' says Kenneth Rogoff, who is now a professor at Harvard University in Cambridge, Massachusetts. ``You can take most of the official forecasts for 2009 and knock two'' percentage points off of them, he adds. That would make it the worst slump since 1982, when the world economy grew 0.9 percent.
``Time is of crucial importance,'' JPMorgan Chase's Kasman says. ``The longer we wait to implement the strategies, the more damage we can do to the world economy.''
Looking forward
So where do we go from here? It’s tempting to throw our hands up in the air and say “who knows?” but prudence demands a more thoughtful analysis.
he first step is to unlock the credit markets. We’ve seen the disruption in this market impact things ranging from a lack of financing for company inventories, to securities dealers shutting off their purchase activities and leaving institutional buyers from Wall Street firms to community banks being unable to generate liquidity through selling investments.
Getting Libor in line with central bank rates is a first step. This has been a very difficult task to date, but the hope is that with coordinated policy action from central banks around the world it can be done.
There are measures being put forth to guarantee that solvent banks survive. Such guarantees will clearly help reduce perceived counter-party risk. Such guarantees may not even have to be funded. A rational investor will loan you money at a market rate if they know for certain that you won’t go bankrupt before the term of the loan is up. Since the banks being guaranteed are solvent banks to begin with the likelihood of actually having to step in with money is remote. The guarantee itself should be enough to restore confidence and efficiency.
Once banks begin lending to each other again we’ll see the return of credit lines. In the world of securities dealers your credit line is your life line. If that line gets cut you are living on borrowed time. One doesn’t have to look far back in history to get an example. A few days before Merrill Lynch sought out Bank of America to buy them they had their credit line cut…by Bank of America. I have no idea if that was B-of-A playing hardball and forcing Merrill to their knees in a period of known weakness, or if B-of-A simply did an impartial review of a counter-party’s creditworthiness and acted objectively. Either way it points out the vulnerability of financial firms to having credit lines cut. Within three days Merrill was history. Once the interbank lending market un-freezes we should see a more regular flow of credit here as well.
Once that credit flow returns to normal we should begin to see trading desks re-enter the market as buyers. Institutional trading desks are the main engine of efficiency in these markets. They know how to price securities and they put their own capital at risk to maintain efficient markets. If something is mispriced they immediately pounce on the opportunity, capturing the excess return offered by the inefficiently priced security and pushing that securities market price back in line at the same time. I would imagine that the return of efficiency here will be gradual rather than instantaneously. It’s a bit like stepping back into the batter’s box after being drilled with a fastball on your last at bat. You’re going to get back in there but you’ll be hesitant in your approach.
Depositors need to be assured that their money is safe. Despite decades of protection by the FDIC, fear still causes depositors to do stupid things. Like taking all of their savings out of an FDIC insured bank account and keeping it at home. I have a friend that sells safes for a living…he says business is booming. He also tells me that he has seen hundreds of thousands of dollars in people’s homes locked up in safes that would take him 15 minutes with a screwdriver to compromise. When depositors are assured of their safety the threat of bank runs will diminish.
These first steps of restoring calm to the money markets, unlocking the interbank lending market, and calming depositors’ fears should go a long way toward the end goal of steadying the markets.
Once that is done we can begin digesting the economic data that is being released. Will there be a recession? How long will it be? How deep? How will the employment situation develop? These are all questions that time will shed light on soon enough. I’ll keep you posted as things develop.
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