Bernanke’s fighting Depression and he’s not using Zoloft.
As we’ve moved from the summer of 2007 to December of 2008 we’ve seen a shift from “all is well” to “Katie, bar the door”. We have seen a long string of increasingly aggressive and relentless shots fired by the Treasury and the Fed…but what are they shooting at? To the casual observer it could easily appear that they are in full bore “reactionary” mode just hopping from one problem to the next and trying to rescue everyone they see along the way. Up until November of 2008 when the National Bureau of Economic Research made the official declaration that we are in recession, there was still a good bit of talk about whether we’d actually post the two consecutive quarters of negative GDP growth required to hit the technical definition of recession. The NBER came out and said it matters not…things stink so bad we’re calling it before we get the two negative quarters.
We’ve all seen the drastic measures being taken by everyone from the Fed and Treasury, to Congress, the White House and beyond. We’ve seen a 40% drop in the stock markets, a 70% drop in commodities prices, and as of September’s Case Shiller National Composite Index a 21% drop in home prices on a year over year basis. We’ve seen federally insured money market accounts, federally insured corporate bonds, increases in federally insured bank deposits…at times it seems like the only thing not insured by the federal government is my truck. We’ve seen massive capital injections at banks around the country, we got a look at the list of “too big to fail” companies and it turned out to be much larger than I suspect anyone thought it could possibly be.
The question becomes “Why?”
Do governments do ALL of THIS to avoid two puny quarters of negative GDP growth? I would say no…they don’t do all of this to avoid a mere recession. Why turn so many laws of finance and economics on their heads? Why use such vast amounts of government intervention in the free markets? You do it because you are trying to avoid something much more sinister than two quarters of negative GDP.
If we jump in the time machine and go back to 1933 we can listen to a highly regarded and widely studied economist by the name if Irving Fisher. Mr. Fisher lived through the Great Depression and to this day his work on the Debt-Deflation Spiral forms the basis of many reports on the period. In today’s market update I’m going to speed through Mr. Fisher’s work then move on to some of Bernanke’s analysis on the Great Depression and the lessons learned from that event. I’m going to move quickly taking large strides; providing references for anyone that wants to move through the material in smaller steps.
Rather than write at length on Fisher’s work I’ll provide insight by quoting material from his paper “The Debt Deflation Theory of Great Depressions”. I think some quotes from this work will be immediately relevant to our current situation.
Why was the Great Depression so great?
Fisher’s work centers on the interaction of over-indebtedness and deflation. In isolation the ill effects of either deflation or over-indebtedness produce less damaging outcomes…but the two in combination form a potent brew that kills economies. In 1933 he recognized that over-indebtedness generally occurs when there are “new opportunities to invest at a big prospective profit, as compared with ordinary profits and interest…easy money is the greatest cause of over-borrowing. When an investor thinks he can make over 100 per cent per anum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or speculate with borrowed money. This was a prime cause leading to the over-indebtedness of 1929.”
“Just as a bad cold leads to pneumonia, so over-indebtedness leads to deflation. And, vice versa, deflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debts cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed. Then, the very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed. Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depressions: the more the debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing.”
Fisher goes on to say that “if the over-indebtedness is not sufficiently great to make liquidation thus defeat itself” then it’s not that big of a deal and we’ll have a more normal run through the business cycle.
With regard to the deflation portion he writes “unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-1933 (when the more you pay the more you 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 get smaller. “This is the so-called natural way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.”
He concludes that had there been no massive government intervention the Great Depression “we would soon have seen general bankruptcies of the mortgage guarantee companies, savings banks, life insurance companies, railways, municipalities, and states.”
Hmmm…anybody know of any problems in the financial guaranty companies, banks, insurance companies or municipalities?
What’s the fix?
So Fisher warns of over-indebtedness and deflation being a bad combo. What does he propose as the answer to this dilemma?
“ On the other hand, if the foregoing analysis is correct, it is always economically possible to stop or prevent such a depression simply by re-flating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged.”
That is a heck of a quote in a month where we’ve seen Fannie and Freddie suggest that we can use the OLD APPRAISAL value for the house when doing a refi. Fannie and Freddie have essentially floated a plan in which the assumed value for the home being refinanced will be the one at which it was initially contracted…bingo…right out of Fisher’s playbook for avoiding a great depression.
Bernanke 1983
That is as brief a summary of Fisher’s work as I can provide without diluting it. THAT leads us to a paper that Ben Bernanke wrote in 1983 titled “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression.” I think the alternate title was “Bens take on the Big One” but it didn’t have an Ivy League ring to it.
Bernanke’s paper starts off with a summary of the causes of the great depression. Of special interest is the following quote from Ben “The disruptions of 1930-1933 reduced the effectiveness of the financial sector as a whole in performing these services (intermediation). As the real costs of intermediation increased, some borrowers (especially households, farmers, and small firms) found credit to be expensive and difficult to obtain. The effects of this credit squeeze on aggregate demand helped convert the severe but not unprecedented downturn of 1929-1930 into a protracted depression”.
If that doesn’t sound familiar, you must not be listening. With that statement from Bernanke in 1983 as a backdrop it becomes startlingly clear why he is moving heaven and earth to unfreeze the credit markets. He fears that the inability of households and small firms to get access to credit is a primary driver that can cause a recession to become a full blown depression.
Bernanke goes on to point out the two primary components of the financial collapse in 1930-1933 were “the loss of confidence in financial institutions, primarily commercial banks, and the widespread insolvency of debtors.”
I think Bernanke got a good scare when Leman brothers failed and the money markets ran for the door. He has been fighting a crisis of confidence at every turn since then. They’ve insured just about everything under the sun since Lehman failed in an effort to restore confidence in the financials. Given his statement above one can see why he attaches such importance to this.
The paper goes on to point out the many differences in the structure of the banking system between 1933 and today. It is true that there are many important differences, but it is equally true that if you end up at a point where you have over-indebtedness plus lack of confidence in the financials and then you add deflation…it really doesn’t matter HOW you got to that point…what matters is that you are there, and according to Fisher, Bernanke, and others…you are in deep trouble.
What is Bernanke’s conclusion?
After providing page upon page of math and the assumptions used in all of the statistical models and all of the other stuff you have to include in a paper to keep the academics happy, Bernanke gets around to providing his insight on what helped to end the Great Depression. Here again we see his words from 1983 in action in 2008.
“March 1933 was a watershed month in several ways: It marked not only the beginning of economic and financial recovery but also the introduction of truly extensive government involvement in all aspects of the financial system. It might be argued that the federally directed financial rehabilitation- which took strong measures against the problems of both creditors and debtors – was the only major New Deal program that successfully promoted economic recovery.”
Knowing that statement above was written by Bernanke provides a good bit of color into what is going on inside the Fed. The Chairman sees government intervention in the markets and strong action against the problems faced by both debtors and creditors as very important pieces of the solution…perhaps THE most important pieces of the solution. Now we can look at the plans for loan modifications from a new angle. The new Hubbard-Meyer plan calls for the government to get right in the middle of the refi business by asking the bank to take a write-down that will be shared with the government so the homeowner can refi a lower balance and reduce his monthly payment…at the same time the homeowner sacrifices appreciation potential up to the amount of the write-down.
Bernanke on how it worked:
“The Government’s actions set the financial system on its way back to health; recovery was neither rapid nor complete.” We all read the verbiage of the FOMC statement this week where they told us rates were likely to remain exceptionally low for “some time”. Sounds a bit like the concept in the quote above.
“Deposits did not flow back into banks in great quantities until 1934 and the government had to pump large sums into banks and other intermediaries.” Clearly there have been many steps taken to reduce the chance of these deposits ever flowing out of the banks in the first place…two new tools created to combat this particular problem have been the new $250,000 insurance limit on interest bearing deposits and insurance on unlimited amounts of non-interest bearing transaction accounts.
Bernanke on mortgages after the Great Depression:
“Home mortgage lending was another important area of credit activity. In this sphere, private lenders were even more cautious after 1933 than in business lending.”
“To the extent that the home mortgage market did function in the years immediately following 1933, it was largely due to the direct involvement of the federal government. Besides establishing some important new institutions (such as the FSLIC and the system of federally chartered savings and loans), the government “readjusted” existing debts, made investments in the shares of thrift institutions, and substituted for recalcitrant private institutions in the provision of direct credit. In 1934, the government sponsored Home Owners Loan Corporation made 71% of all mortgage loans extended.”
Bernanke spends a good bit of time in his analysis addressing the difficulty for home owners and small businesses to get access to credit. He also assigns a great deal of credit to government intervention for alleviating that pressure. We see many signs of this today as the TARP money is deployed and the government is pushing for banks to lend, plans are being pondered to allow the government to split losses with banks and provide loans to homeowners to help refinance, and there are potential plans allowing Fannie and Freddie to use the “old” appraised value for a home that is doing a refinance. There are a lot of tools being brought to bear on the problems we have. Most of these tools have their roots in lessons learned from the Great Depression.
Bernanke’s Summary:
“Summarizing the reading of all of the evidence by economists and by other students of the period, it seems safe to say that the return of the private financial system to normal conditions after March 1933 was not rapid; and that the financial recovery would have been more difficult without extensive government intervention and assistance. A moderate estimate is that the U.S. financial system operated under handicap for about five years (beg of 1931 to end of 1935)…this is consistent with the claim that the effects of financial crisis can help explain the persistence of the depression.”
My summary:
If I see a man with a fire hose I have to assume he’s going to fight a fire. As I consider the totality of the government’s actions to date, I see that they are using all of the tools recommended for fighting a depression. The only rational conclusion I can draw is that the fear behind closed doors at the highest levels is that this recession gets away from us and we slip right on into another great depression. We clearly started out with the classic over-indebtedness of consumers, we then got our dose of lack of confidence in the financials, we then moved to consumers and small businesses having their access to credit restricted, we’ve seen deflation in asset prices and are beginning to see some small signs of deflation in general prices as well.
With that in mind I would expect to see the government do exactly what Bernanke says helped in 1933…they will be heavily involved in every aspect of this economy, especially when it comes to maintaining faith in the financial system and helping homeowners and small business maintain access to credit.
I’ve had a regional Fed president tell me recently that a depression isn’t what they’re worried about but at this point I’d have to ask “if you’re not worried about a fire…what’s with the hose?”
What does all of this tell us?
How does this information impact my investment activities today? We know that Bernanke is not going to tolerate a crisis of confidence in the financials. We know from reading his work on the subject of the great depression and from watching his activities over the last year that he is committed to doing everything possible to keep that problem from developing.
Most importantly from the perspective of investing, is that many of the big financials (firms with names such as JP Morgan, GE, and Bank of America to name a few) have been given the backing to issue Full Faith and Credit paper through the TLGP program. What better way to restore confidence in financials than to magically make them the same credit quality as the US Treasury?
Short corporate bonds from these issuers appear to have exceptional value. The issuers have the ability under the TLGP to refinance 125% of their existing debt on a full faith and credit basis. This drastically lowers the firms cost of debt which puts them all on a much more solid foundation (as Bernanke would like), at the same time they are receiving capital injections from the government to support them on a wider scale. These are the biggest names in an industry that Bernanke says MUST be protected.
They aren’t going to refinance all of the debt at one time. There is plenty of paper trading in the secondary market that does NOT carry the full faith and credit guaranty, but this paper obviously benefits from the issuers ability to issue full faith and credit TLGP paper.
This non-guaranteed paper is trading at huge spreads to the TLGP issued full faith and credit paper. This leads us to ask “is it realistic that the government would be guaranteeing billions of dollars of debt for companies in the TLGP only to let them go out of business 4, 5, or 6 months or 2 years later?”
It is our opinion that the government will not allow large firms in critical industries that they are actively supporting, and to whom they are providing debt guarantees, to fail.
Later this week and early next week I’ll be putting out a more detailed analysis of opportunities available in this sector. To provide you with a glimpse of the value consider JP Morgan paper that is being issued under the TLGP program.
3 year bullets from JP Morgan issued under the TLGP traded yesterday at a 1.27% yield level.
1.5 year bullets in the secondary market (the non-insured bonds) from the same issuer were at a 4.55%.
If you think the government is going to let JP Morgan (or any of the big financials) go under despite everything they’ve said and done to the contrary, then clearly the corporate bond is not a good option for you. However, if you think the support of the US Government will allow JP Morgan to be with us in 1.5 years, then you have a huge opportunity to pick up product at much more attractive levels than are available in other sectors. If you are of this opinion then short corporate bonds from these issuers should play some part in your investment plan over the near term.
As a final note I’ll mention that Treasury Secretary Paulson said earlier this week that he expects no more of the large financials to fail this cycle. He believes that the combined efforts of the Fed, the Treasury and central banks around the world will enable all firms with systemic risk to remain viable.
Short corporate bonds from these issuers offer a great shelter from the storm of low yields we are experiencing currently. If you need to see levels on these today just shoot me an e-mail, otherwise look for further analysis to be forthcoming shortly.
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