The Crash of 2008:
I.) Versus the crash of 1929
Mark Twain apparently once said something like, “History doesn’t always repeat itself, but sometimes it does rhyme”. Global stock markets have had another absolutely horrendous month, adding significant more downside to their prior “waterfall” decline as the technicians so aptly are wont to frame it. We have been thinking much of markets and recent global developments, and in the process surveying the opinions of those more capable than us at discerning future potentialities from the entrails of past movements. At first glance, it certainly would be hard to argue that we are in the throes of another market crash the likes of which we have not seen since 1929. In fact, just for kicks, we charted the course of the Dow Jones Industrial Average movements from their high in 1929 to their nadir in 1933, and then took today’s’ numbers starting from the (adjusted to 1929 prices) to obtain the following chart:
The red line represents the Dow Jones Industrial Average from its peak of 14,165 (as adjusted to 1929 prices) on October 9, 2007 to now, as compared against the peak of the Dow in 1929 and then quarterly thereafter. To put the crash of 1929 in perspective, the poor souls in the 30’s witnessed a decline in values very similar to what we have just gone through in the last year, and then from that point on, witnessed another further 74% decline over the next three years on top of what we have already experienced. Not exactly the most heartening thought. It begs the question, “could the same thing happen to us in this day and age?”.
II. 1929 vs. 2008
Not an easy question, however the answer must be of more than passing interest to most. Before we embark upon the dangerous job of forecasting the future, let us first begin with a forensic analysis of the past, specifically with what exactly happened in 1929-1930. As we said in last month’s letter: “...The crashes of 1929, 1907, 1873, 1869 and 1837 were all eerily alike in many respects. Common to all crashes is the first step of easy and available credit, which then enables sub-optimal resource allocations, which then fosters the asset bubbles which finally go “pop” with a big bang and frightening rapidity. As the panic spreads, the credit markets inevitably freeze up, credit of any kind disappears, making cash unavailable at any price, which massacres the weaker, most leveraged institutions, with the resultant bankruptcy and major losses which spread like unwanted ripples slowly throughout the rest of the entire system. A painful and usually protracted deleveraging cycle occurs, earnings and profits are hard to come by and the economy slowly claws its way back to normalcy until the cycle begins anew; with the advent of a new generation of unsuspecting and as yet unscathed market newbies representing fearless legions for future fodder.”
To vastly oversimplify, in the interest of keeping this within the bounds of a monthly update and not a text book, we summarize the easy and available credit story of the 1920’s as follows: the easy credit in the 20’s appeared in the “call market”. Brokers in the early 20’s financed margin buying for their customers off their own balance sheets or from bank relationships. As the speculative fever of their customers for stocks on margin progressively grew hotter, appetite for margin loans grew apace. This began to attract non-traditional lenders such as corporates into the space. Due to exploding demand, broker call loan rates rose steadily to over 20% in early 1929, which caused an additional massive diversion of corporate assets out of investment into new plant and equipment and into the short term call market. Corporates who had no business lending in the short term money markets at the time included:
Electric Bond and Share $ 157.5
Bethlehem Steel $ 157.4
Standard Oil of New Jersey $ 97.8
Tri-Continental Corp $ 62.2
Chrysler Corp $ 60.1 (1)
In essence, instead of investing in plant and equipment, corporates started putting their capital to work into the short-term bond market in order to earn returns in excess of 20% per annum. This cash was then cycled into the stock market to further support buying long beyond the time that the fundamentals of the economy warranted it. This classic misallocation of capital at the top is very typical in the standard boom/bust cycles of all stock market manias followed by crashes. There were other glaring misallocations of resources, such as investment trusts, which were highly levered closed-end funds which used the securities they purchased as collateral to borrow more money to purchase more securities on leverage ad infinitum in the precursor to the classic “Ponzi” scheme. Many of these ended up trading either completely bankrupt or best case at something like 5 cents on the dollar post crash. In any case, the bubble ended in tears and stocks along with the real economy completely collapsed in 1929.
The Governments response to the stock market crash:
In 1930, the Republican Hoover administration made a concerted effort to try to minimize the ongoing effects of the stock market crash on the real economy. Hoover proposed a 1% income tax cut, which congress passed before the end of the year. He jawboned the business community and the unions into agreeing to not change wages either up or down. He pushed the utilities, railroads and the construction industry to increase their spending on construction programs, and he got the Federal Government to expand its own public works programs by an additional 250 million. Some further excerpts from “The Crash and Its Aftermath” by Barrie Wigmore (see footnote 2):
“The Hoover policy was to exhort people to think positively, to work harder and to accept personal and local responsibility to expand in order to offset the effects of the crash. He tried to carry the message to the nation that business was sound and that he intended to provide a framework in which the nation could continue to prosper. Besides the 1% tax cut, Hoover’s annual message to Congress in early December promised a new tariff law to clarify the opportunities open for domestic business, promised intensified enforcement of prohibition to upgrade the health and productivity of workers, and promised new railroad mergers to provide a basis for further expansion in that industry...”
“...The policy appeared to work. Utilities, railroads, the steel industry, and major cities, especially New York, made large public commitments for 1930 investment spending in response to Hoover’s requests...” “...President Hoover’s leadership in a combined business and government attack on the impending Depression, and the effects of easy money, were generally expected to produce an economic upswing by mid-1930. Politicians, Businessmen, financiers, and independent economists were close to unanimity in this respect...” “These predictions bore little fruit, however. Doubts about the economy, and suggestions that what we would now call a recession might be ahead, began to develop in May and June (1930). The concern was sufficient to prompt Hoover to try further measures to aid the economy, and he pushed for a conclusion on the tariff considerations which had been before Congress for over a year and were inhibiting business expansion plans. The Senate and House passed the Smoot Hawley Tariff bill in mid-June, raising U.S. Tariffs by 20% on average, to 44% of the dutiable value of imports, thereby making U.S. tariffs the highest in the world. Hoover immediately announced he would sign the bill out of fear that there would be a stock market reaction if he prolonged the uncertainty...”
“...The spirit of optimism following Hoover’s initial positive actions began to fade rapidly in the summer of 1930 when the tariff bill was passed, and especially as the off-year elections approached, the Administration began to display a more acute awareness of the economic crisis at hand...” “...The Democrats swept Congress in the November elections, reflecting the public discontent with the economic conditions, The Republicans lost a 17-seat majority in the Senate, which returned with 48 Republicans, 47 Democrats, and 1 Independent. The Democrats gained over 50 seats in the House, erasing a previous Republican majority of 100...”
“...As the realization developed that Hoover’s policy of exhortation and easy money had not produced recovery, rigid principles began to dominate the Administration’s reactions and policies...” “...The Presidents’ policies remained essentially exhortation and setting an environment conducive to local initiative, even though these policies were failing to produce results. He no longer had the initiative in economic policies. Direct intervention in the economy or for relief was taken grudgingly, usually to forestall proponents of more radical measures.
The principle binding Hoover from acting was a balanced budget, and it is easy to see how it limited his action in the second half of 1930. Every fiscal year in the 1920’s there was a budget surplus of ordinary revenues over ordinary expenditures averaging $ 763 million. The surplus was $ 738 million for the fiscal year ending June 30, 1930, during which Hoover cut taxes, increased public works spending, and expanded the government’s apparatus in order to deal with the Depression. Hoover planned a fiscal 1931 budget surplus, but the likelihood of a surplus diminished as 1930 progressed. In the fiscal year ending June 1931 there was a budget deficit of $ 463 million because of a $ 1 Billion decline in federal receipts. The Federal Gross Debt rose by $ 616 million during the year for the first time since 1919.
Hoover’s budget attitude was reinforced by Treasury Secretary Mellon, whose perception of the tragedies of the Depression rarely rose above abstraction. At this stage Mellon advocated a liquidation of labor, stocks, farmers, and real estate to end the Depression and to form a foundation for renewed expansion...” “...The budget focus was extreme and debilitating. It prevented effective action which, although it would have required deficit financing, would have caused deficits far short of problematical levels...”
“..The Federal Reserve Bank of New York worked actively to bring down short term interest rates in the first half of 1930... ...The Federal Reserve Banks had eased credit conditions in the Crash in order to position the major commercial banks to act as lenders of last resort to borrowers in the call loan market when lenders outside the banking system withdrew their funds, but the subsequent credit easing in 1930 was more a matter of policy. The New York Federal Reserve Bank reduced its buying rate for bankers acceptances 21 times in 1930 from 4% in January to 1.875% by June 30th and to 1.75% by year end, and its discount rate was cut five times during the year from 4.5% in January to a record low of 2.5% on June 20th, and subsequently to 2%...” “...The Federal Reserve’s policy of steadily reducing rates was paired with an open market policy which maintained total Federal Reserve credit (bills discounted, plus bills bought, plus U. S. Government securities bought, plus small other holdings) at a stable level of approximately $ 1 billion from March through November 1930. Federal Reserve holdings of U.S. Governments expanded rapidly following the Crash until March 1930; but as call loan requirements declined and the stock market became more orderly, the Federal Reserve allowed its bill holdings to run down, offsetting its prior U. S. government purchases. The directors of the New York bank and its professional staff wanted to buy up to $ 200 million long U.S. government bonds to prevent the decline in Federal Reserve credit resulting from the decline in the Federal Reserve’s bill holdings and to stimulate the bond market. The New York bank felt, as did the Hoover Administration, that a strong bond market was a precondition for economic recovery. However, the Federal Reserve Board in Washington adamantly opposed the New York banks requests for permission to buy long-term bonds, out of fear that bond purchases were difficult to reverse and therefore might bring about overly stimulative monetary conditions re-creating the “inflationary” credit conditions of 1929, which meant unsound bank loans, stock market speculation, and overexpansion of business...”
“...Whether 1930 should be considered a period of “monetary ease” is a matter of debate. Interest rates declined, but since wholesale prices declined 14.7% and farm prices 29.3% the real burden of interest rates greatly increased for both existing and prospective debtors. Money supply also declined 3.8% to 9.9%, under its various definitions, which seems in contrast to monetary ease...” “...It is unarguable, despite this debate over easy money that throughout the year there were few constraints on the Federal Reserve System had it wished to pursue a more vigorous open market policy. The Federal Budget was still in surplus through most of calendar 1930, which relieved the Federal Reserve System of responsibility for a major financing program, and U. S. Gold reserves of $ 4 Billion were rising rapidly, even in November and December of 1930, when banking problems increased.”
“...The Federal Reserve displayed no leadership effort beyond open market purchases of securities to reduce bank closings. The New York Federal Reserve Bank was the leader of the Federal Reserve System, and its attention was focused principally on the international currency markets and interest rates.... ...The Federal Reserve never suggested that it had any responsibility to preserve the credit of the banking system, and there was no indication that the commercial bankers expected it to exercise such responsibility. Its lender of last resort role appeared to have been reserved for the call money market and the U.S. Government market, which is to say that this responsibility was interpreted by all in its narrowest sense...”
“...Old hands in the securities business remember vividly the optimism that prevailed in the early months of 1930, because many investors were enticed back into the stock market only to be wiped out in the drawn out market decline which followed. The smart money was lost in this aftermath. At the time, the optimism appeared justified. A business recession similar to those following stock market panics in 1907, 1914 and 1920 was expected, but it was expected to be limited to trade in luxury items. All the Federal Reserve districts predicted an upturn in the economy in the second half of 1930. The commercial banks also forecast an upturn. The Guaranty Trust Co., a perennial optimist, predicted a quick recovery in building construction because of easy money. The Hoover Administration vociferously expressed its confidence in a business recovery, and industry supported the projections...
...There was good cause for optimism at the beginning of the year. In Washington a businesslike administration ran a balanced budget and had acted quickly and decisively to shore up confidence and promote expansion. The United States was the business leader of the world; its business leaders were grasping their responsibility and expanding to offset any momentary decline in business. Business itself was conservatively financed and had not over expanded, as had the stock market. The commercial banks were sound. The dollar was strong and the nations’s gold supply was large. The price level was declining slightly, as it had through most of the 1920’s, but only enough to raise real wages without creating a problem of inventories bought at earlier, higher prices...”
“...Stock prices boomed in the first quarter of 1930 amid the confidence, many stocks doubling and tripling from their 1929 lows. Trading volume on the New York Stock Exchange recovered to the level of 5-6 million shares a day. Banks and brokers scrambled to rehire the experienced staffs laid off in December 1929...” “...Wall Street continued to expand as if nothing had happened. There was an office-building boom in the first half of 1930... ...Outside Wall Street, industry looked strong. Most companies reported record 1929 earnings during the first quarter of 1930, and February dividend payments were $ 436 million versus $ 387 million in February 1929.After a two month hiatus, acquisitions and mergers carried on at a high rate, reflecting business optimism...”
“...Hoover’s efforts and the widespread optimism might have sustained a business recovery if the decline had been milder. It became clear by mid-year, however, allowing for the time lag in substantiating economic conditions, that the economy was in trouble and its problems were deepening.
Increasing unemployment was the most visible sign of the trend of economic conditions... ...The Federal Reserve index of employment dropped to 93.9 in June from a peak of 108.4 in August 1929 and fell further to 83.8 in December 1930. Employment declines were worst in the durable goods, lumber, rubber products, and transportation equipment industries, in all of which employment declined over 20% during 1930. The most visible declines, however, were in larger industries, such as iron and steel, in which employment dropped by 125,000 jobs; or automobiles, in which employment dropped by 130,000 jobs from less than half the base employment of the iron and steel industry. Railroad employment dropped by almost 200,000 jobs.
There were also job losses in widely diffused small enterprises beyond the more prominent industries. Farms dropped 135,000 workers, textile mills dropped 165,000 workers, and private households dropped 150,000 servants. Almost every industry showed some reduction in employment... ...In aggregate, there was the equivalent of over 2,250,000 fewer employees at work in the United States at the end of 1930 than at the end of 1929. The total number of unemployed was greater than this, of course for to those thrown out of work we must add those previously out of work and new or would be entrants into the labor force who could not find jobs. The unemployed became painfully visible in 1930, particularly in the large cities.
The most visible indication to businessmen of the trend of economic conditions was the railroad industry, which declined sharply during 1930. Railroad freight revenues were 483.3 million in October 1929, which was close to their peak for that month in October 1928, but in November and December 1929 freight revenues were $ 60-70 million below the comparable months in 1928. As 1930 progressed, the comparison with prior year’s freight revenues grew progressively worse. By October 1930, freight revenues were down 20% from October 1929, to 385.5 million...”
“...Contemporaries did not have the detailed sector statistics now available on the period, which helps account for why business conditions were as bad as they were amid the optimism which prevailed in the early months of 1930. But the inconsistency is not surprising because the expectation was that the nation would quickly recover from the effects of the Crash. Eventually, the facts eroded that confidence, as data on the economy became available during the course of the year. At first, there was also a willingness to emphasize the optimistic side of divergent indicators or small improvements, but as the Depression forced itself on people’s daily lives, there was no need for sophisticated data to interpret its increasing impact. There were still many who expected a recovery imminently, by the end of 1930 the balance had swung to the more pessimistic souls...”
“...Commodities price declines during 1930 from the 1929 highs were 45% for wheat, which was the most prominent commodity, 30% for corn, 50% for cotton, 67% for rubber, 44% for raw sugar, 55% for silk, 59% for copper, and 35% for scrap steel... ...At the end of the year the index of prices for 47 farm products was down 29.3% from pre-Crash prices, and publicly traded industrial commodities averaged a price decline of approximately 35%... ...The decline in farm and industrial commodities prices naturally carried over into other products. The Labor Departments Wholesale Price Index declined steadily all year from 93.3 at the end of 1929 to 79.6 in December 1930, a decline of 14.7% mirrored by a 12.9% decline in retail food prices from December to December. Finished product prices, which naturally adjusted more slowly, declined 9.3%. All these price declines are in sharp contrast to the 2.6% decline in the implicit price deflator for Gross National Product in 1930, which appears modest and manageable, whereas the business impact at the time was of continually deeply declining prices which disrupted profits, investment, and creditworthiness...”
“... The year 1930 was schizophrenic in that the optimistic side prevailed for most of the first half, while the pessimistic side, always looking on and growing in prominence as the months passed, slowly came to the fore. In December 1929, when the stock market first showed strong recovery signs, investors’ attitudes were shaded by the memories of what prices and earnings had been. Stocks looked cheap. Many had been sold under duress as investors became overextended, and the extent of the liquidation had been unreasonable. For those who still had money, 1930 held the opportunity for a killing. The rebounds in stock prices after panics had always been profitable, and this one was no exception. There had also been a series of sell-offs in the last several years from which recoveries had been rapid and from which stocks had risen to new high prices. Investors talked themselves into a similar prospect for 1930, especially the new coterie of brokers and portfolio managers at the investment trusts, casualty insurance companies, and brokerage houses.
The stock market fulfilled these expectations by rising strongly in the first four months of 1930. The Dow Jones indices rose steadily until April. The Dow Jones Industrial Index was up 48% from its low in the Crash by April 17, 1930, when it hit a high for the year of 294, although it was still down 22.8% from its September 1929 high of 381. The market declined for the rest of the year until all the Dow Jones indices hit their lowest levels for 1930 on December 15th. The DJII then was 157, down 46.4% form the April high and 58.7% from the 1929 high. The same index was below the low in the Crash by 10.7%. It had made little difference whether an investor had bought his stock in the speculative exuberance of 1929 or as a cool headed opportunist following the panic. The result was the same—a shocking loss of value...”3
To summarize the take-aways from 1929-1930 experience:
1.) The theology of free markets and lack of direct government intervention in the markets were deeply ingrained fundamentals of the Republican Hoover Administration . Hoover’s first plan of attack to the Crash was to exhort verbally businesses and individuals to accept personal responsibility to expand in order to forestall further economic collapse. He did push through a tax cut of 1%, but almost all of his subsequent “assistance” came through jawboning participants and not direct action and intervention.
2.) The Smoot-Hawley Tariff bill, passed in June 1930, raised U.S. Tariffs by 20%, to 44% of the dutiable value of imports, thereby making U.S. tariffs the highest in the world. This led to reciprocal tariffs and in essence shut down world trade at the most inappropriate time.
3.) When Hoover’s policies of verbal exhortation and easy money did not produce the intended results, the administration became increasingly rigid and inflexible, and hid behind the dogma of free markets. Direct intervention by the government was used as a last resort, and usually only to forestall more radical measures from elsewhere. The Hoover administration remained steadfastly committed to maintaining a balanced budget into the teeth of the crisis, even though hindsight tells us this was precisely the wrong approach at the time.
4.) Treasury Secretary Mellon consistently advocated the total liquidation of labor, stocks, farmers and real estate, to reset the economy and start over. He re-inforced Hoover’s emphasis on maintaining a balanced budget regardless of the cost to the real economy.
5.) The Federal Reserve Board resisted increasing the money supply through open market operations as it feared bringing about “overly stimulative” monetary conditions again and a repeat of the past bubble. The money supply shrank during this period by some 3.8% to 9.9% (depending upon how you measure it). This added extreme pressure to commodity prices and business inventories.
6.) The Federal Reserve displayed no pro-active leadership during this period, and clearly felt that preserving the credit of the overall banking system was beyond the purview of its mandate. The “lender of last resort” was considered to be the bond markets, not the Fed.
7.) Unemployment soared with over 2,250,000 jobs lost between 1929 and 1930. This was the canary in the coal mine that the Administration should have paid more attention to.
8.) Massive declines in commodity prices of 50% or more for many commodity prices between 1929-1930 should have sounded another clarion call for more pro-active action on the part of the Administration.
9.) Investor’s attitudes were still bullish in the first half of 1930, and they were all sucked back into the market just in time for its next wrenching decline. They were all caught up with backward focused memories of what prices and earnings had been. Earnings that came out in the first half of 1930 still looked pretty good on their face, mostly because they incorporated a large part of 1929 in them.
III. 2008 versus 1929
Let us now examine in brief the events of 2008. The following excerpt comes from an article by George Soros which appeared in the Financial Times on January 23, 2008 and he captures the essence of the 2008 crisis as follows:
“The current financial crisis was precipitated by a bubble in the US housing market. In some ways it resembles other crises that have occurred since the end of the Second World War at intervals ranging from four to 10 years. However, there is a profound difference: the current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process. The current crisis is the culmination of a super-boom that has lasted for more than 60 years”... “...Every time the credit expansion ran into trouble, the financial authorities intervened, injecting liquidity and finding other ways to stimulate the economy...That......encouraged ever greater credit expansion...””...Globalization allowed the US to suck up the savings of the rest of the world and consume more than it produced. The US current account deficit reached 6.2 per cent of gross national product in 2006. The financial markets encouraged consumers to borrow by introducing ever more sophisticated instruments and more generous terms. The authorities aided and abetted the process by intervening whenever the global financial system was at risk. Since 1980, regulations have been progressively relaxed until they have practically disappeared. The super-boom got out of hand when the new products became so complicated that the authorities could no longer calculate the risks and started relying on the risk management methods of the banks themselves. Similarly, the rating agencies relied on the information provided by the originators of synthetic products. It was a shocking abdication of responsibility.
Everything that could go wrong did. What started with subprime mortgages spread to all collateralized debt obligations, endangered municipal and mortgage insurance and reinsurance companies and threatened to unravel the multi-trillion dollar credit default swap market. Investment banks’ commitments to leveraged buyouts became liabilities. Market neutral hedge funds turned out not to be market neutral and had to be unwound. The asset backed commercial paper market came to a standstill and the special investment vehicles set up by banks to get mortgages off their balance sheets could no longer get outside financing. The final blow came when interbank lending, which is at the heart of the financial system, was disrupted because banks had to husband their resources and could not trust their counterparties. The central banks had to inject an unprecedented amount of money and extend credit on an unprecedented range of securities to a broader range of institutions than ever before. That made the crisis more severe than any since the Second World War. Credit expansion must now be followed by a period of contraction , because some of the new credit instruments and practices are unsound and unsustainable...” “...Although a recession in the developed world is now more or less inevitable, China, India and some of the oil-producing countries are in a very strong countertrend. So, the current financial crisis is less likely to cause a global recession than a radical realignment of the global economy, with a relative decline in the US and the rise of China and other countries in the developing world...”
As always, in our humble opinion, Mr Soros hits the nail on the head. We had our bubble in 2008, starting in the sub-prime housing market and spilling over to take no prisoners in most of the rest of the credit markets. He calls the crash of 2008 “the culmination of a super-boom that has lasted more than 60 years” from which one is to presumably infer much more downside from here. Offsetting this unquestionably gloomy and dreary sentiment is his more upbeat assertion “...China, India and some of the oil-producing countries are in a very strong countertrend. So, the current financial crisis is less likely to cause a global recession than a radical realignment of the global economy...” There is, at least, some light glowing faintly at the end of the tunnel.
The U.S. housing market was ground zero, and became the asset class which ascended to bubble valuations as a result of the easy credit conditions fostered by Wall St financial innovation and the regulators. Subprime loans accounted for 15% of the U.S. mortgage market in 2006, vs. 3% in 2002. So called “Ninja” loans, (no income, no job, no assets) became readily available. To compete with private lenders, Fannie Mae and Freddie Mac lowered lending standards and provided mortgage loans to subprime borrowers. Housing prices predictably rose to unsustainable levels. Trillions of dollars of Asset Backed Securities and Collateralized Debt Obligations (CDO’s) were created, using a good chunk of these subprime mortgages as underlying collateral. Investment banks, hedge funds and even commercial banks used borrowed money to invest in these structured financial products. The rating agencies contributed to the mix, by giving investment grade ratings to complex structures that even their creators often did not fully understand. As a result, total debt outstanding in the U.S. steadily rose to all time highs versus the U.S. GDP.
The U.S. economy thus became more levered than at any other time in history. This was due in part to unwise financial engineering and in part due to the secular decline in interest rates which started in 1981.
Corporations also took advantage of the lower interest rate environment prevailing over the last 20 years, and issued enormous amounts of new debt and retired enormous amounts of equity, which added fuel to the stock market rise, and more systemic debt.
This mountain of debt now represents a huge problem for the U.S. Economy. When measured against current GDP, it stands at an all time high of over 3.5 x, and that’s based upon trailing 12 months GDP. When measured against prospective GDP, that ratio will only continue to rise inexorably higher. It grew to be so large because of the perfect storm of easy credit, ever declining interest rates, financial innovation, financial engineering, speculation and just plain old fashioned greed. The “perfect storm” is over now and the world has changed forever. We are left with a rapidly contracting economy, rising unemployment and an emerging “depression” type mentality. Individuals no longer feel “flush”, home prices have fallen in some cases as much as 30% and many face situations where the mortgage is now worth more than the value of the home it was used to buy.
So as we have seen, eventually, as with all bubbles, the wheels came off. Defaults on subprime loans in 2006 started to rise precipitously, reaching over 20% currently, according to Freddie Mac statistics. This rapid and sudden decline in values in ABS and CDO’s caused some leveraged hedge funds to implode in 2007, which lead to forced liquidation of their portfolios and further massive write downs in the ABS, CDO and SIV (Structured Investment Vehicle) markets. This immediately pressured many financial institutions which held large positions in these synthetic securities, and bids dried up so they became totally illiquid. This forced massive write downs in book value and caused them to violate debt covenants, forcing further liquidation at firesale prices which then spiraled downwards in a domino effect into further write downs. Eventually, a list of long standing blue chip financial services titans were felled, including such former luminaries as Bear Stearns, Lehman Brothers, AIG, Washington Mutual, and Wachovia.
The U.S. Government reacted in a diametrically different way to the Crash of 2008 than their counterparts did in 1930. With the benefit of hindsight, the Secretary of the Treasury and the Chairman of the Federal Reserve were able to respond to the current crisis with speed, strategy, creativity, flexibility and most importantly lots of incremental money and federal guarantees.
Congress passed the Troubled Asset Relief Plan (TARP) which enables the government to purchase up to $ 250 billion in equity stakes in US Financial institutions, as well as up to $ 700 billion of financial sector assets. In addition, the Federal Deposit Insurance Corporation (FDIC) has expanded federal deposit insurance protection from $ 100,000 to $ 250,000. The Fed has also taken other major innovative concrete steps such as allowing banks to post unconventional assets as collateral for repurchase agreements, setting up a commercial paper facility bypassing the banking system altogether which allows corporates to fund directly with the Fed; extended a $ 50 billion credit line to money market funds and paying interest on bank reserves. Some accounting standards have been revised to allow financial institutions to carry some assets at higher values than current market so their book capital is not impaired and their existing loan covenants are not violated.
Whether this bailout program will be effective in altering the course of the Crash of 2008 remains to be seen. Certainly, the Fed has been most accommodative, and has been pumping into the system as much “high powered” money as it can:
Source: Ned Davis Research
As you can see from the chart, systemic monetary growth has exploded as the government struggles to reliquify the system. Efforts to date seem to have had some effect, however until we see some narrowing of credit spreads from current blowout levels we are by no means out of the danger zone.
The Fed can only go so far in its efforts to reliquify the system. They can provide money to the banks, however they cannot force the banks to relend to the participants in the broader economy. Lending standards continue to tighten globally, and banks so far do not seem to be cooperating in pushing out the additional reserves in the form of new loans, which would help ease current liquidity constraints. This shows up as corporates are forced to pay ever higher rates to obtain loans, and credit spreads versus treasuries continue to widen.
Credit spreads still moving in the wrong direction, signaling that the systemic gridlock in the credit system is far from over, indicating that the Fed’s reliquification efforts still need more thoughtful attention.
LIBOR spreads have started to narrow, offering some offsetting hope that the system (or at least the inter-bank market) has begun to reliquify.
Mirroring the experience of 1929-1930, commodity prices have collapsed in 2008.
(The chart below was done earlier in 2008 before the September/October implosions)
This collapse most likely presages the demand destruction that has been working its way through the system as the consumer and corporate segments retrench and begin the long overdue deleveraging process. This now continuous deleveraging cycle we have entered bodes ill for coming corporate earnings.
The NACM Credit Manager’s Index has also collapsed in recent months. October’s decline was the largest monthly drop ever recorded since this Index was created.
Both the manufacturing and services sectors appear to be in credit freefall:
” The Credit Manager’s Index (CMI) is created from a monthly survey of credit and collection professionals. The CMI survey asks NACM members to rate favorable and unfavorable factors in their monthly business cycle. Favorable factors include sales, new credit applications, dollar collections, and amount of credit extended. Unfavorable factors include rejections of credit applications, accounts placed for collections, dollar amounts of receivables beyond terms, and filings for bankruptcies. The results provide a benchmarking and forecasting tool that looks at the entire cycle of commercial business transactions. The CMI has gained rapid acceptance among the business and financial community as an economic indicator to both watch and report on.” (Source: NACM website)
The services industry is also contracting rapidly, and recently had its largest ever one month contraction in October 2008 as shown by the red line in the chart above.
The economy looks really bad, no matter how you slice it. Deleveraging, credit implosion, declining consumer spending, rising defaults and delinquencies, and rising borrowing costs all lead to a self-reinforcing ( or reflexive, as Soros would say) downward spiral in economic activity. This was very much the pattern in 1929 and is very much the pattern right now.
The Baltic Dry Index (BDI) measures the demand for shipping capacity versus the supply of dry bulk carriers. The demand for shipping varies with the amount of cargo that is being traded or moved in various markets. The supply of ships is much less elastic than the demand for them, so the index indirectly measures global supply and demand for the commodities shipped aboard dry bulk carriers, such as building materials, coal, crude oil, metallic ores, and grains. Because dry bulk primarily consists of materials that function as raw material inputs to the production of finished goods, the index is also seen as a relatively accurate leading barometer of the coming volume of global trade. The chart speaks for itself.
Adding insult to injury, in the final blow-off stages of the bubble, financial engineering really kicked into high gear, starting about 2002. The period from 2002-2007 added a notional overlay of derivative instruments some TEN times larger than the actual cash markets they were created to hedge against. This came right on top of the already staggering amounts of systemic ordinary debt that have been issued.
Credit default swaps went from almost nothing in 2002 to over 50 trillion as of June 2008, a period of less than six years. This astounding number is all the more astonishing when one considers that the entire size of the US debt market is about 50 trillion, and the size of the US GDP is estimated at about 14 trillion (as of June 30, 2008). Credit-default swaps pay the buyer face value in exchange for the underlying securities should the borrower fail to adhere to its debt agreements. They are private contracts between two parties, don't trade on any exchange and aren't processed through a central clearinghouse, making it virtually impossible for the public to assess the amount wagered on the debt.
Credit default swaps are the reason AIG went down the tubes. They are really just another form of insurance, and AIG minions armed with “proprietary” computer risk management software priced and sold lots and lots of swaps, which at the time were quite profitable and immediately additive to earnings. It was not clear until much later that the software adequately identified only one of the three types of risk endemic in these contracts, and by the time the flaws were discovered it was far too late in the game for AIG to offload its unhedged risk.
According to a recent article on Bloomberg, credit-default swaps totaling $33.6 trillion are currently outstanding (as of November 2008) on government debt, corporate bonds and asset-backed securities worldwide as reported by the Depository Trust & Clearing Corp, (DTCC) (which estimates it sees about 90 percent of all trades). While that is down from its June peak, it is still an incredibly large number, and nobody knows if the risk tails offset each other, or pose additional systemic risk.
Trading exploded 10-fold in the past decade in the CDS market as the market went from being largely a tool for banks to hedge loans to a place where hedge funds, insurance companies and asset managers could speculate on the creditworthiness of companies, governments and other borrowers, including homeowners. No one understands the total amount of systemic risk that is outstanding today as a result of these “derivatives” and this poses just one more exceedingly difficult problem for the regulators to deal with in the current unwinding period.
IV) 2008 versus 1929 Conclusions:
S&P 500 1/02/02 – 11/04/08
Now that’s a “textbook” waterfall decline!!
There are many similarities between the course of events in 1929 and today, with some important differences.
1.) The first difference is the level and nature of regulatory and governmental response. In 1929, the regulators did not have the benefit of all of the academic literature and hindsight and post-mortem analysis of what went wrong and why that we have freely available today. When the crisis hit in 1929, the Hoover administration was caught like a deer in the headlights, and after a few weak attempts to verbally exhort the private sector to increase investment to be “confident” in the future, the Regulators (meaning the Federal Reserve, the Treasury Secretary and Hoover himself) recused themselves from much pro-active involvement in the snowballing problems of the private sector, and hid behind the dogma of “free markets” and lack of direct government intervention.
The regulators of 2008 have reacted in a totally different manner to our current crisis, bringing ideas, money and speed to forestall the complete meltdown that occurred in 1929. So far, they have been successful, and while there have been some widely publicized bankruptcies no one whose bankruptcy could pose systemic risk through some domino effect of defaults has been allowed as yet to go under. The Fed and the Treasury have cooperated closely together with private industry to pump liquidity far and wide wherever it is needed.
2.) The second major difference between 1929 and 2008 is in the overall health of the financial systems. In 1930, as we have seen, the administration ran a balanced budget, the United States was the business leader of the world, business itself was conservatively financed and had not over expanded, as had the stock market. The dollar was strong and the nations’s gold supply was large. In 2008, in contrast, we face instead a veritable mountain of debt, much of it of the “toxic variety” across all sectors of the economy, from government to corporate to the consumer. On top of that, we have a mountain of freshly minted “derivatives” which are impossible to handicap from a systemic risk perspective until they actually unwind. Throw in the rapidly burgeoning deficits, and you have a lot of questions without much clarity on the answers. In our humble opinion, the only way out will be to reflate by printing money, and paying off this debt with devalued dollars. Our currency short term continues to benefit hugely because there is no global substitute, however our debt problem will force over time alternatives to emerge which will likely not favor the U.S., resulting in a general and widespread decline in our standard of living vis a vis the rest of the world.
3.) The third difference is that even though we have a new Democrat in the Whitehouse, it is unlikely that there will be new tariffs and taxes on imports such as Smoot Hawley in 1930. It is now very clear that the import duties enacted in the 1930’s effectively put the nail in the coffin of the economy at that time, and it is hopefully unlikely for that specific mistake to be repeated. As a result of the U.S. Smoot-Hawley tariff, European governments retaliated with their own additional tariffs and international trade virtually ground to a halt. Germany was struggling to pay off its WWI war debts and its economy was too weak for it to keep current on payments. Forced banking holidays in Germany and Austria followed shortly thereafter in 1931, and the British system became illiquid because many of its banking assets became trapped and illiquid as a result of the German meltdown. The collapse of global trade as a direct result of these tariffs dealt a lethal blow to an already reeling U.S. economy. In the 2008 crisis, however, there still exists many relatively healthy international trading partners, particularly in Asia, and the continued growth in their economies should enable the U.S. to recover a lot sooner than in 1929. Unless, of course, the U.S. government does something really stupid vis a vis current tariff and trade policy.
4.) Fourth, global markets are now very intertwined and interrelated, as can be seen from the chart below, but we believe that they will begin to decouple and trade more independently as a direct result of the crash of 2008. A look at the chart below shows how tightly global stock markets are correlated at present. We appear to be all part of one global, mega economy, and returns on asset classes, such as stocks, commodities and bonds are inextricably and inexplicably interlinked in many complex ways that are impossible for even the most sophisticated professionals to discern. There is no good reason based upon fundamentals for the China stock market and the India stock market to collapse just because the U.S. market did, and yet that is exactly what happened in the current crash.
World Equity Indices percent total returns 1/1/08-11/4/08
While global markets are all highly and incestuously interlinked now, it is probable that there will be a gradual decoupling and disintegration of this direct interlinkage over time. Most economies in Asia do not have exposure to the “toxic debt” problem that has come to plague the U.S. and European markets. Their banking systems are sound, leverage as a percentage of GDP is generally below 1x, and they have enough foreign reserves accumulated to both start and increase domestic infrastructure spending to keep their economies growing rapidly. It is highly likely that during the unwind and deleveraging phase we are entering now, the U.S. will contract while some Asian economies will continue to grow positively at rates ranging from 6%-9%.
In spite of the crash, the investment thesis for India and China today remains intact. They both continue to offer a once in a generation investment opportunity to participate in their rapid technological convergence with the more developed west. Today’s telecommunications, the internet, ease of travel, global trade pacts such as WTO and population dynamics are still working together to create the perfect storm for hyper-development in these countries. The crash may slow things down at the margin, however both economies should still enjoy sustained real growth rates for the next 5+ years in the range of 6-9% per annum; as opposed to the probable negative growth rates now projected for the U.S. and Europe. China and India are now following the same hyper growth trajectories as previously experienced in Japan, Taiwan and Korea. If the past is any guide, their current high growth rates could last for decades.
The Indian stock market has been decimated during this last global crash, with the Sensex falling by over 60% in the last 9 months from over 22,000 to 8,500. Valuations have reached absurd levels, with some listed companies trading at 1x current annualized cashflow. There is no toxic debt problem in India, the country was far too socialistic for anyone to loan money via debt because it was impossible to collect (up until recent revisions in the law). The economy in India is not export oriented, it grows now mainly as a result of domestic consumption growth, and it will continue to grow rapidly even if the U.S. economy goes to zero.
China, on the other hand, while more export oriented than India, has accumulated over $ 1 Trillion in foreign currency reserves, and the Government has strongly indicated it will use some of these funds on domestic public infrastructure projects to ensure topline GDP growth of at least 9%. It has been our experience that when the Government in China makes a public pronouncement like that, you can take it to the bank, it will happen. Global markets will decouple, and we believe the way to play the markets at this juncture is to be long of Asia and short of the U.S. and Europe.
By Geoff Dyer in Beijing November 9 2008 19:14
China announced on Sunday a “massive infrastructure spending programme” as part of a new fiscal stimulus plan aimed at boosting the country’s rapidly slowing economy.
The State Council, China’s cabinet, authorised Rmb4,000bn ($586bn) of investment on infrastructure and social welfare over the next two years, although it did not say how much of the spending would be on new projects not already in the budget.
The government said the spending plan reflected a decision to adopt an “active” fiscal policy to deal with the global financial crisis, while monetary policy would be “moderately active”...
...Beijing has also been under growing international pressure to take fiscal measures to boost its economy in the hope that continued strong growth can provide some counter-balance to recession in the developed world.
The government has already cut interest rates three times, scrapped quotas for bank lending and unveiled measures to help housebuyers and some exporters. However, economists said those measures had not been enough to overcome growing gloominess among companies and consumers.
According to the official Xinhua news agency, the State Council decided on Friday to “map out more forceful measures to expand domestic demand”, which would include “massive” infrastructure spending....
5.) Fifth, commodity prices have collapsed just like they did in 1929, with almost identical percentage declines this far into the crash. The markets are rapidly discounting the implosion of corporate activity and the likely outlook for future earnings and profits. The difference between now and 1929 is that there are still economies that are growing globally, such as India and China, and while demand for commodities may cool for some time, the reflation-commodity scarcity theme will come back in spades. It has to.
The emergence of China as a global manufacturing powerhouse will continue to be one of the main drivers. China accounted for only about 4% of world GDP in 2005 but experts estimate it consumed roughly 9% of the world’s crude oil, 20% of aluminum, 30% of steel, 30% iron ore, and an incredible 45% of all the cement in the world. Chinese economic growth is centered around the commodity-intensive activities of infrastructure build-outs, urbanization and manufacturing and is likely to continue for the foreseeable future.
India and China together represent 2.4 billion people, 40% of the population of the entire planet, which currently are only producing 7% of the worlds nominal GDP. The US and the EU together with 13% of the world’s population at present produce 59% of the world’s nominal GDP. Longer term, the U.S. and the EU are in trouble, but China and India are not. They will become the new growth engines of the twenty first century, and will continue growing regardless of the domestic problems faced by the U.S. and Europe.
The Chandrayaan 1 spacecraft is launched
India has successfully launched its first mission to the Moon.
The unmanned Chandrayaan 1 spacecraft blasted off smoothly from a launch pad in southern Andhra Pradesh to embark on a two-year mission of exploration. The robotic probe will orbit the Moon, compiling a 3-D atlas of the lunar surface and mapping the distribution of elements and minerals. The launch is regarded as a major step for India as it seeks to keep pace with other space-faring nations in Asia. Indian PM Manmohan Singh hailed the launch as the "first step" in a historic milestone in the country's space programme…”
Story from BBC News:
Published: 2008/10/22 09:54:42 GMT
6.) Sixth, there is a strong likelihood of a “sucker rally” in the US market just like there was in the first four months of 1930. People now still remember the heady days of double and triple digit returns, and all that lovely free flowing money and compensation and profits. Many people definitely feel like they got juked out at the bottom, that stocks are super cheap now and that most of them will be easy doubles in twelve months. Negative sentiment is now at the extremes one expects to see at bear market bottoms, so it is likely in any case that we will have a pretty good trading rally sometime in the next several months. People felt the same way in 1930, but what they failed to consider was the coming weakness in the real economy, which cut the ‘E” in the P/E ratios and made stocks still look expensive later even at 30-40% of the prior year’s prices.
Clearly, one needs to be wary of “muscle memory” and to resist the temptation to be lured back in too quickly. One needs to better understand what the world is going to look like going forward, and there is not enough data available yet on how bad the rot is in the current environment to make any intelligent decisions. The world has certainly changed forever in the last three months, and up until then we have been in a bull market in stocks pretty much since 1982 when the long bond yield started to fall, and kept falling all the way until now. (The dot-com crash of 2002 aside!)
Unemployment statistics over the next few months will be a key indicator as to how bad things could get. These numbers soared in late 1929-early 1930, and if the astute observer had paid close attention then to the magnitude of the numbers he could have avoided the sucker rally completely.
7.) Sensible trading themes for now are therefore:
Deflation first, then reflation.....
Stock markets re-test lows....then, sucker rally begins....
The dollar strengthens....but the US loses clout....
India and China become the new engines of global growth....long Asia, short U.S. and Europe...
World stock market capitalization at the end of May 2008 was estimated by the World Federation of Exchanges at about $ 50 trillion, at the end of September at about $ 40 trillion and at the end of October one can infer something like $ 30 trillion and change. That means $20 trillion of wealth, or buying power, or leverageable assets, however one wishes to frame it, has evaporated off the planet into the ether in the last five months. It has vanished into thin air, poof, and it leads me to believe that in the short run, things could get quite deflationary across the globe. However, when looking at the mountain of debt we have accumulated in the last 25 years in the U.S., I become a bit more sanguine about that problem---deflation. It is increasingly clear the only way out of the current predicament we all find ourselves in is to reflate longer term. They do that by spending money, which first they print. No one has to vote for it, no one has to go on record supporting it; all they have to do is spend the money, which both political parties have demonstrated over time they are very good at. A nice roaring inflation, ala 1970’s vintage with a stagnant economy on top of it, would seem to me where we will end up. Our big mountain of debt will be paid back with nominal dollars whose real value will have been greatly eroded, and our children will happily make hay until the crash of 2037......
Your comments, suggestions and flame-mail are always welcome, All Best Regards,
1 “The Big Board” by Robert Sobel, Copyright 1965, The Free Press p. 257
2 “The Crash and Its Aftermath” by Barrie Wigmore Copyright 1985, Greenwood Press p. 114
3 “The Crash and Its Aftermath” by Barrie Wigmore Copyright 1985, Greenwood Press various pp 114-145
4 Source: The Financial Times Online Edition 11/09/2008