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PrudentBear.com, published by
David W. Tice & Associate, LLC, investment adviser to the Prudent Bear
mutual funds. is one of my favorite
sources of information about what is really going on nowadays.
Along with a comprehensive
assortment of links to articles about the economy, the financial system,
individual companies, and international developments, the site also includes
a great deal of interesting commentary by staff members and guest writers.
One knowledgeable
individual whose work is regularly featured at PrudentBear.com and who is
always worth reading is Martin Hutchinson. Mr. Hutchinson is an author and the Business and Economics Editor at
United Press International, and he writes a weekly column called "The
Bear's Lair."
In this week's edition, "Spirals of
Death," Mr. Hutchinson discusses a rare and unfamiliar
phenomenon that is becoming increasingly commonplace.
Close observers of the US
housing finance disaster in recent months will have noted a curious
phenomenon. Companies such as Countrywide that were in late August regarded
as rock solid have recently passed clearly into the danger zone while those
like Fannie Mae and Freddie Mac that were regarded as potential market saviors have come under a cloud. In Britain Northern
Rock, whose September bailout was said to be modest, involving little risk to
the taxpayer has now turned into an immense 25 billion pound ($51 billion)
potential black hole – real money even in the US economy
let alone in the much smaller British one. This illustrates a deeply
troubling quality of the largest downturns: the tendency for the free market
to turn into a death spiral, in which even sound well-run institutions are
engulfed.
Death spirals are fairly
rare in financial history. The Wall Street Crash of 1929 was perhaps the most
virulent example. After the first downturn, the market recovered for several
months. Then the collapse of the Bank of the United
States in December 1930, together with the further
economic damage from the Smoot-Hawley Tariff caused
a further collapse in confidence and activity that was concentrated in the
banking sector, as relatively solid institutions followed the Bank of the United States
into bankruptcy. The Federal Reserve failed to correct for the money supply
contraction caused by the bank
bankruptcies, leading the US
economy further into the pit. The additional shove given by President Herbert
Hoover’s 1932 tax increase was almost unnecessary; only the confidence
brought by a new president (albeit with equally counterproductive economic
policies) brought recovery from 1933. By the time the spiral was over, more
than one fourth of the banks in the United States had gone bankrupt
and the stock market had bottomed out at one tenth of its peak.
A second death spiral, with
somewhat less dire economic consequences, occurred in Britain in 1973-74. Edward
Heath’s government had removed the quantitative controls on bank
lending in 1971, which resulted in an orgy of high risk lending against real
estate, very similar to the recent episode in the US except that most of the loans
were made against commercial real estate rather than housing. When the first
major real estate lender, London
and County Bank, collapsed in November 1973 another more conservative house,
First National Finance (FNFC), was used as the epicenter
of the “lifeboat” rescue organized by the Bank of England. However,
the decline in confidence and real estate values quickly sucked FNFC into the
maelstrom.
The lifeboat rescue fund
grew larger and larger for more than a year as the stock market declined to
record low levels, 70% below its 1972 high. Homebuilders such as Northern
Developments, in no way involved in the original crash but dependent on bank
lending, were dragged down. So were the two most important entrepreneurial
finance houses, both internationally diversified and neither significantly
involved in commercial real estate lending – Jessel
Securities, founded by Oliver Jessel and Slater
Walker, founded by Jim Slater.
Neither Jessel
nor Slater had been aggressively run – indeed Jim Slater had begun
de-leveraging a year before the crash, as he saw trouble coming – and
no wrongdoing was proved against the head of either organization, yet by the
end of 1975 both very substantial companies had gone bankrupt and neither
founder played a significant further role in the British financial sector. This
was a great pity: in losing Jessel and Slater
Britain had lost not only their very able founders but the most aggressive
entrepreneurial teams in the City of London,
who might have been best able to compete against the foreign invasion when Britain
deregulated the financial services sector in 1986.
The British experience of
1973-74 seems more like the current position in the United States. National policy is
currently reasonably neutral, so far avoiding the twin dangers of
protectionism and tax increases which caused
the medium sized downturn of 1929-30 to turn into the Great Depression. The
problem is concentrated in the property sector. However there are already
worrying signs that the magic alchemy of modern finance, though such
mechanisms as securitization vehicles whose funding falls apart and complex
derivative securities that prove to be unsalable in
a crisis, is causing the problem
to metastasize. In the consumer sector, GMAC has reported problems with its automobile loan portfolio, while it appears that
credit card debt quality is rapidly deteriorating. In the corporate loan
sector, loans to aggressive leveraged buyouts have got in trouble, and loans
to hedge funds and private equity funds have been sharply cut back. (The
latter effect can be seen in the movement of the yen/dollar exchange rate
from 120 to 108, as the hedge funds’ ”carry trade”
positions have been de-leveraged.)
The “death
spiral” characteristics of the current market are pretty clear. If Fed
Chairman Ben Bernanke’s original estimate of subprime loan losses of $50-100 billion had been anywhere
close to accurate, there would have been no problem. The market deals with
difficulties of that size all the time, without significant effect on
surrounding sectors. A few fringe operators go bankrupt, a few large houses
show unexpected losses, and the overall market continues without a tremor. The
collapse of the Amaranth hedge fund in September 2006 or that
of Refco a year earlier were substantial
events, causing losses to a number
of those institutions’ business partners, but there was no question of
any general market disturbance.
When the subprime problem first emerged in February, it appeared
that it would also be limited. A number of subprime
lenders, relatively insignificant institutions, were forced to shut down. However
the general market appeared unaffected; its view appeared to be that the
problem was localized and should have no effect on the real economy, nor even
any great effect on the broader housing finance market.
August’s widening in
Libor spreads, at which banks lend money to each other, should have told us
that this problem would be different, and altogether more important. If
leading banks were unable to assess each other’s credit quality for
short term transactions then something much more serious was wrong than the
collapse of a modest fringe sector of the housing finance market. The
Fed’s chosen solution, dropping interest rates and pumping more money
into the system, did not address the real problem and was thus useless, as it
has since proved. It has only postponed the denouement for a few months and
stored up further trouble with inflation.
Two factors are at play
here. The first is sheer size. If as now appears likely the eventual losses
in the home mortgage market do not total only $100 billion, but a figure much
closer to $1 trillion, then the subprime debacle
becomes something much more than a localized meltdown. $1 trillion of losses
is 7% of US Gross Domestic Product. The market cannot absorb losses of that
size without some major institutional bankruptcies or a lengthy recession. The
closest equivalent problem is the savings and loan collapse of 1989-92; that
caused a major housing downturn
but only a minor recession. However its cost (mostly borne by the US
taxpayer) of $176 billion was about 3% of 1990 US GDP, only half the size of
the likely current losses on mortgage loans.
The second is lack of
transparency, and the blow to confidence that comes from the dawning
suspicion that a large portion of the derivatives and securitization
mechanisms designed in the last quarter century are faulty.
The unluckily timed implementation for years beginning after November 15 of
FAS Rule 157, requiring banks to divide their assets into three levels
according to their degree of marketability, has thrown an unwelcome spotlight
on the problem. If Level 3 assets can be valued only by reference to an
internal valuation model, and have been allowed to accrue value in
banks’ financial statements for a decade or more (enabling hefty
bonuses to their progenitors) then how do we know they are really worth
anything close to what the model says, and how do we go about realizing them,
in a market where confidence has vanished?
To ask those questions is
to answer them. Since every incentive led bank mathematicians to devise
models that maximized the reported value of the bank’s holdings, and
since little or no market existed by which those values could be checked, it
is likely that today those assets’ book values are highly overstated. Moreover,
even in banks where the mathematicians and their bosses were scrupulously,
even impossibly disinterested and intelligent, there still remains the
problem that those assets are worth far less in a downturn, because their illiquidity makes them intrinsically
unattractive in a market where liquidity has become once more important. Anyone
who has attempted to sell venture capital positions in a bear market can
attest to how rapidly and completely the value of such assets can disappear. It
is thus perfectly possible that the true realizable value of “Level 3” holdings in a
bear market is no more than 10% of their book value.
This immediately
demonstrates the problem. Goldman Sachs, generally regarded as insulated from
the subprime mortgage problem, has $72 billion of
Level 3 assets; its capital is only $36 billion. If anything like 90% of the
Level 3 assets’ value has to be written off, Goldman Sachs is
insolvent. They do not have the option of acting like Nomura Securities did
recently, selling everything possible and writing the remainder down to zero,
because they would be without
capital. Instead they are likely to be dragged kicking and screaming, quarter
by quarter, to a gradual writedown and sale of
their Level 3 assets, with their true position remaining undisclosed and
obfuscated by meaninglessly optimistic statements by top management. Only the
bonuses will survive, paid in cash and draining liquidity from the struggling
company.
That’s what a death
spiral looks like. The US
survived the Great Depression, eventually, and Britain survived the 1973-74 debacle. However the market recovered only after it had
plumbed depths previously thought impossible, at which even the soundest
investments were trading far below their true value. After normality returned,
the financial services landscape was very different, with many large and
apparently solid houses having disappeared, a generation of participants
reduced to driving taxis or selling apples and a generation of investors
scarred by their losses and unwilling to return to the market. Emergency
infusions of money, from the Fed or the taxpayers, generally do no good, only
postponing the denouement and delaying the arrival of truly bargain price
levels.
Such spirals of death
represent the final definitive triumph of the Bears.
By :
Michael J. Panzner
Editor, Financial Armageddon
financialarmageddon.com
Michael
J. Panzner is a
25-year veteran of the global stock, bond, and currency markets and the author of Financial Armageddon: Protecting Your Future from Four Impending
Catastrophes, published by Kaplan
Publishing.
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