Feature Stories | Mar 19 2008
By Greg Peel
“This financial crisis started with the mortgage lenders (who had been careless in their lending practices), moved on to the commercial banks, then on to insurance companies, and thereafter to the investment banks which then turned around and squeezed their own clients (namely hedge funds and private equity funds). From there, it is easy to imagine that large pension funds and endowments started to worry and raise their precautionary cash levels – and hence the situation we are in today: a corporate bond market which is announcing a disaster of biblical proportions and economic data which, by and large confirms that the OECD is going through a slowdown, and perhaps even a mild recession, while the rest of the world is still encountering very decent economic growth.
“Popular belief argues that money is the blood of the capitalist system and that commercial banks are its heart. And thus, without the commercial banks, the blood/money stops flowing throughout the financial system. What we are thus experiencing would thus be akin to a massive heart attack - and the central banks are busy attempting to wake up the corpses with defibrillators.”
The above neat summation was published by GaveKal’s Louis-Vincent Gave and Ahmad Abdallah last Thursday – a point at which Bear Stearns was bleeding, but still with us. GaveKal has been one research firm awaiting “the whale”, and the analysts have noted this week that the crisis engulfing Bear moved from one of a liquidity crisis to one of solvency crisis. Solvency concerns brought Bear down, or so it would seem. Either way, a venerable Wall Street firm was Chinese-whispered to death.
GaveKal is still not prepared to suggest Bear is the ultimate whale, but it does believe the market perception that brought down Bear was flawed. “Although we have no more idea than anyone else whether an even bigger monster [than Bear] may surface behind it,” say the analysts, “we do think the market is dangerously confused in one respect”. The confusion lies in the difference between a liquidity crisis and a solvency crisis.
Consider an individual who pays rent and also owns a car. If that individual is flying close to the wind, the annual rego payment on the car can put a big dent in the cash balance and possibly render the next rental payment unachievable. However, if a pay-cheque is coming in shortly that can cover the problem then with a bit of purse-string tightening and an appeal to the real estate agent that individual can pull through. It was a liquidity crisis, but it was resolved.
But if that individual knows that while the next pay-cheque will cover the rent already owing, but that the problem will only be revisited the following fortnight, at which point the quarterly electricity bill is overdue, which would put the individual further into arrears, then that individual is in a solvency crisis. Without help, such as a loan from a friend, eviction would soon result.
Bear Stearns first hit liquidity problems back in July when the market for subprime mortgage securities disappeared. It was only a liquidity problem, and not a solvency problem, so Bear kept going. But in the ensuing period, and culminating in recent weeks, liquidity has dried up in even the safest of mortgage securities – those containing only AAA prime mortgages and, even more astoundingly, the AAA-rated mortgage bonds issued by the government sponsored entities (GSEs) Fannie Mae and Freddie Mac, which are supposedly as good as exchangeable for US Treasuries, and whose default risk is as good as zero. When banks began refusing even these ultra-safe securities as collateral on short-term loan rollovers, except at much higher premiums, pretty soon security firms were rapidly exhausting what little actual capital they had.
Carlyle Capital was a highly leveraged investor in GSE bonds. When it could no longer rollover its loans last week it became insolvent. Bear Stearns was also an investor in the same securities and an investor in Carlyle Capital. Carlyle’s demise sent tongues wagging, and although Bear’s CEO claimed on the Wednesday the firm was still liquid, the panicked withdrawals of cash from the firm meant that by Friday it was insolvent. The commercial banks had cut off blood to the heart, and before the Fed could grease the paddles and yell “Clear!”, Bear was gone. In the end, the Fed let Bear go but began ensuring no one else would go with it.
The Fed has been cutting the cash rate, reducing the discount rate premium, and step-by-step accepting more and more asset-backed securities at longer and longer durations ever since the credit crisis began, to no avail. Bear was the casualty. While organising JP Morgan to deal with Bear’s corpse, the Fed then took the extraordinary step of arranging the Primary Dealer Credit Facility. For the first time since 1932 investment banks could “go to the window” and exchange securities for Treasuries. The 2008 version of the PDCF has become effective immediately and allows firms to swap investment grade paper – which includes BBB- or better corporate paper, munis, mortgage-backed and other asset-backed securities for which there is some price available. No subprime, but then the subprime chapter in the credit closed last year when banks wrote down all of their exposures. The PDCF will be available for a full six months – enough time, the Fed is presuming, to allow sanity to return.
It had come as a surprise to all that even the most valuable of securities could find themselves frozen out of the market. Bear did not become insolvent because of credit quality but because no one had anticipated just how illiquid the market for safe securities could become. But now that the Fed has stepped in with its actions specifically designed to address this problem, allowing investment banks with decent assets to swap them for Treasuries in the meantime, solvency among those who remain should no longer be an issue, as GaveKal suggests. It is no longer a solvency crisis, it is back to being just a run-of-the-mill liquidity crisis. This is a relief.
GaveKal has also being saying for some time that the US financial market would pull itself out of its abyss if either the capital markets were able to resolve the problem itself with a bit of nudging from the Fed (Plan A, and the Fed’s approach in 2007 and early 2008), or if the Fed was forced to step in to save the day (Plan B). Plan B has now been implemented, and GaveKal believes it is going to work.
The University of Western Sydney’s Dr Steve Keen hopes Plan B will work, but he’s not convinced the US is out of the mire just yet.
For starters, all the securities which will be swapped with the Fed will need to be swapped back again down the track. These are, after all, just short term prop-up measures. And have no doubt there will be no stigma attached this time about “going to the window”. Whereas once this meant the kiss of death, now the market expects a rush. Last night Lehman Bros CFO told CNBC the firm was busy assembling a portfolio of assets and would hit the window as soon as possible. Instead of this being seen as Lehman admitting a liquidity crisis, it was seen as Lehman averting a solvency crisis. Everyone’s suffering a liquidity crisis, so even though approaches to the window are made under cover of darkness with no disclosure, Lehman was prepared to shout it from the rooftops.
Dr Keen suggests, in his latest Debtwatch report, that “the real fun on the markets will begin in three months time”. His report was published before the introduction of the PDCF, so you can now make that six months. But the point remains the same – “The world in its history has never carried the same level of debt that it is carrying today, ” Dr Keen notes.
When the US stock market crashed in 1929, the US was carrying a debt to GDP ratio of 150%. That ratio did not peak until 1932, at 215%, when the Great Depression was in full swing. The reason the debt burden kept growing was because real output fell by as much as 13% in 1932, but also because prices fell by over 10% between 1930-32. This deflation, brought on by diminished spending in the economic downturn, meant that even as Americans rushed to pay down debt their debt burden as a ratio to GDP was still advancing.
The US debt burden reached that peak of 215% for the first time again in 2005. It didn’t blink, and is now at 278%. US housing prices began to turn in 2006.
One thing about our Dr Keen is he always manages to pull out the most frightening of charts.
But the question he is thus posing is, to use some licence, can a solvency crisis be averted given such an extraordinary level of debt? Dr Keen has long argued that central banks are wrong to be trying to fight price inflation at this juncture. What is more of an immediate risk is inflated asset values, which have been inflated due to unprecedented levels of leverage. While the price of oil and food may be inflating as the US dollar crumbles, the price of US housing is deflating rapidly. The prices of related securities have collapsed. The prices of equities have now fallen over several months as much as they did in the Crash of ’29. The implication here is thus that the Fed is at least doing the right thing in cutting rates in the face of price inflation. The question is, does the above graph signal we are about to hit another deflationary bust?
GaveKal notes there have been three major busts in the last hundred years – the Depression, the 1970s, and tech-wreck. You might be wondering why the ’87 crash and subsequent recession of the early nineties isn’t counted. The following graph will explain:
In the run from 1982 to 2000, the nineties appear as but a blip.
The 1930s represented a massive deflationary bust. In 2000-03 there was a mild deflationary bust. In the 1970s the world experienced a long and painful inflationary bust. What are we looking at, if anything, in 2008? GaveKal notes that today the cry is that the current crisis “is different from any other”. Yet GaveKal also points out, rather wryly, that the top of every bull market is always preceded by a call, in response to fears the bubble could burst, that “this time it’s different”. So has the credit crisis really broken the long term bull market trend?
The 2000-03 bear market was an unusual one, as it revolved around one very over-inflated market sector – one for which there was little precedent. Stock analysts just weren’t quite sure what to do with internet stocks. But they knew what to do with the large cap stocks that got dragged along in the euphoria, and it was their fall which really made the tech-wreck hurt.
In the 1930s all stocks were sold off heavily (after the crash) as economic activity plummeted. It wasn’t until decades later that the world learnt the Fed’s response at the time was to tighten monetary policy to try to avoid another disaster, and the government’s to impose tariffs as protection. This is now recognised as a fatal error.
The 1970s saw a similar mistake made in monetary policy, in that inflation was allowed to run rampant while rates were cut to overcome the economic shackles of the oil shocks.
Given the Fed is now cutting rates and the US government is not imposing tariffs (at least unless Clinton gets in), and given the government is actually mailing out emergency tax rebate cheques, GaveKal cannot see another deflationary bust like that of the 1930s. Nor can it see a bust like that of 2000-03, given stock valuations prior to the credit crunch had reached nothing like the fantasy land levels of 2000.
Which leaves us the with the 1970s – a period which many a commentator is quick to point out is the era most disturbingly similar to the present. Indeed, GaveKal suggests the market has been preparing itself for another inflationary bust, as the Fed cuts rates while letting the oil price race to new highs.
There are four key drivers to economic growth, GaveKal suggests: consumer spending, capital spending (ie business spending), exports, and government spending. Capital spending is usually the most volatile, followed by exports and consumer spending. Government spending should always be “contra-cyclical”, in that governments should increase spending in a slow economy to provide stimulus and decrease it in a strong economy to provide a brake.
The 2000 lead-up was one where capital spending ran rampant while profits waned. Money was poured into the internet when revenues were still a pipedream. Credit spreads thus rose, as lenders were not keen to throw good money after science fiction, and so when capital spending expired so did the economy. It is interesting to compare the 2007-08 rapid blow-out of credit spreads with the peaks reached after 2000.
This time, capital spending has been lagging, except in the emerging markets. We would not have seen anything like the commodity price boom we have seen if capital spending had been a bit more ambitious in the producing world last decade. Yet companies have been producing record profits and cashflows in the lead up to the credit crunch, and many, outside certain sectors, still are. The US government has been handing out money in tax cuts, not spending it, and exports have surged with the fall of the US dollar.
That only leaves the US consumer as the possible candidate to cause a bust. And it is thus no surprise it is the US consumer everyone is worried about, particularly as consumers represent 70% of the economy and have been hit right in the hip pocket by falling house prices and rising oil and food prices. The US consumer failed to grow in each of 1974, 1982 and 1991, and in each case a recession followed. This last run of increasing consumer spending has lasted for a record sixteen years. It could be time for something to pop.
The latest data suggest the US consumer has begun to waver. It’s hardly surprising, given falling house prices and rising prices of everything else. But at the same time, unemployment is at record lows and disposable income has been growing impressively for the last few years. There have been jobs lost in finance and building, but there is yet to be a broad turn in employment. It is going to take quite a loss of confidence in the consumer to see the year 2008 turn out to be one of net negative growth. This particular crisis is one contained to a large extent in the financial sector. If you were going to have a banking crisis, notes GaveKal, well now is probably the best time to have one.
GaveKal suggests a bust is unlikely, given policymakers are not repeating past mistakes. “Instead of monetary policy tightening, protectionism and tax increases, we are currently seeing more global integration than ever before, massive monetary policy loosening and fiscal easing. This is bound to bear some fruit”.
Ah, but the question of inflation remains, doesn’t it. The Fed failed to combat inflation in the 70s, and a bust resulted. It is currently acting despite inflation as well.
GaveKal notes that in today’s world of emerging markets and global integration, most prices are falling most of the time, unless shortages emerge. An inflation rate of 3% last century would imply that the price of everything is rising between about 2% and 4%. But in this century, it’s been the case that some prices are rising by 25% (commodities) while some are falling by 20% (cars, telecoms). Inflation is discontinuous. (Note the ongoing reduction in inflation volatility in Dr Keen’s graph earlier in this article).
Hence while it would seem to the average Joe that everything is ridiculously more expensive, only some things are. That is why inflation still appears to be low and why, as GaveKal suggests, it would be foolish to try to cap the growth in prices of only those which are rising, only to push the whole equation over into de-flation.
Yet commodity prices have truly exploded to the upside in 2008, making policymakers very nervous. However there is still a counterweight, and this time it’s housing prices. There is thus a risk that if the US government does dive in to support house prices (by buying mortgages), it would kill the deflation side of the equation and leave only inflation.
There is also a risk that emerging markets are setting themselves up for an inflationary bust as well. Asia, for one, has seen much higher levels of headline inflation growth than the West. This is encouraging a build up of inventories along the supply chain of manufacturing, as each link in the chain tries to avoid even further margin erosion through cost inflation by loading up on product to sell at a higher price down the track. If the music stops, and Asia does see even a slight pullback from its lofty heights of economic growth, suddenly a lot of manufacturers are going to be sitting on a lot of unwanted goods.
Yet this is still not enough to sway the analysts at GaveKal, who are prepared to make the bet against an inflationary bust. History shows such busts are very few and far between. This time GaveKal believes the Fed is doing the right thing, and the market has loaded itself up with positions which are betting on an inflationary bust. This is not a good time to join the party.
Last night we saw a renewed bout of euphoria in stock markets. Could it be that the end of this correction is beginning to appear on the horizon? It is still not yet a time for heroes.