Leigh Skene is a Canadian who has been involved in financial markets ever since he first purchased equities when he was a teenager. He became involved in debt analysis and trading at the Sun Life Assurance Company of Canada. He moved to the sell side and became Head of Fixed Income Trading at investment bank Burns, Fry and Company (now BMO Nesbitt Burns), then became Chief Economist. In 1980, he left Burns Fry and established himself as an independent economic consultant specializing in financial markets and wrote articles for several publications. He has been a director of Lombard Street Associates since 2004, and wrote three key reports in 2007; The ABC of 21st Century Risk; The Sub-prime Mortgage Fiasco—The Start of Something Big; and Credit and Credibility which pointed out the dangers of the new financial system, warned of the impending credit crunch and forecast the ensuing financial turmoil. His fifth book, The Impoverishment of Nations, was published in the autumn of 2009.
Comparisons with the Great Depression
People have compared recent problems to the 1930s, but they’re considerably smaller. The Great Depression was the biggest economic event in US history. Ameritrust has calculated the deviation from trend for the American economy since 1790. The Great Depression held the economy below trend for 10¾ consecutive years with a maximum deviation of 51% from trend. There is no danger of experiencing anything like the Great Depression in the United States or in Europe in the foreseeable future because the monetary system is different.
The modern fiat money system, with flexible exchange rates, guarantees the destruction of debt and money that occurred in the 1930s will not occur in the next few years, so the economic repercussions of the credit difficulties will be far less than in the 1930s. Nevertheless, an extended period of weakness will occur—largely because economies are structurally weak. For example, US GDP growth has averaged 3.4% growth a year since 1947, but only 2% so far this century because recoveries have become weaker and shorter. The fastest rate of growth in the recovery now ending was barely above average, even though a falling savings rate greatly enhanced growth (see Figure 1).
The reasons for slower growth were:
The aging population is slowing the growth rate of the labor force and increasing the burden of taxes, especially for pensions.
Capital productivity has fallen sharply due to a gross misallocation of capital (see Figure 2).
These two factors plus the long overdue rise of savings rates to more normal levels will hinder growth for a long time.
The Three Stages of the Credit Cycle
Debt is the main counterpart to money. Debt and money grew at about the same rate until the early 1980s, when the biggest disintermediation of lending in history started (see Figure 3). Efficient capital allocation would have returned debt to its historical relationship to money after the bank correction had been completed, and debt would be about 35% to 50% lower than it is today. Disintermediation misallocated capital into a huge credit bubble because fiat money has bestowed unlimited ability to create credit. However, creditworthiness falls if debt outstanding rises faster than nominal GDP. In the 1970s, the American economist Hyman Minsky described the credit cycle created by debt rising faster than GDP.
In the first stage of the credit cycle, most borrowers can meet both interest and principal repayments from cash flow. Borrowers intend to repay their debts in full, so moral hazard and the default rate are inconsequential. The first stage of the current credit cycle lasted from the end of the depression until over borrowing began in the 1960s, which ultimately caused the credit crunch in the early 1980s. The second stage began in the aftermath of that credit crunch.
In the second stage of the credit cycle, most borrowers can service only interest payments from cash flow. They assume liquid capital markets will let them refinance the principal amount of their debts. Assuming debt will never be reduced turns debt into cheap equity, so borrowers worry only about how much more they can borrow, never about their ability to repay existing debts. Thus, a drop in liquidity causes an explosion of defaults, as occurred in 2001–2002. Defaults panic officialdom into excessive ease and bailouts, which creates moral hazard. Lenders learn they can make ever more risky loans that pay handsomely when investments turn out well, and get bailed out of the losses if they turn out badly. Moral hazard caused the third stage.
In the third stage of the credit cycle, many borrowers can service neither interest nor principal payments from cash flows. The prices of the assets they invested in must rise to enable them to keep refinancing their debts. Negative amortization mortgages and covenant-light private equity buyouts are textbook examples. The need for rising asset prices to service debts is a pyramid scheme, making the third stage a bubble that must deflate. Rising house prices supported the pyramid debt in the third stage. The subprime mortgage fiasco began soon after house prices began to fall, exposing the thorough trashing of household balance sheets. Also, private equity had over levered a meaningful part of corporate net worth.
The End of the Credit Cycle Means Today’s Credit Problems Are Structural—Not Cyclical
Household net worth is 70% of the total and so is the foundation of the credit structure. It began falling in the second quarter of 2007, which immediately initiated big problems in financial markets. The spread between the three-month Eurodollar rate and the three-month Treasury bill rate is the most reliable single indicator of the health of credit markets. This spread soared to a record high in October, in spite of US$6 trillion of government bailouts, indicating the current credit problems are the most serious since the 1930s (see Figure 4).
Also, bank finances are deteriorating rapidly. The Texas ratio successfully identified banks likely to fail in the oil bust in Texas in the 1980s by comparing the ratio of bad loans to their ability to absorb bad loans. Banks are likely to fail if the ratio exceeds 100%. In the second quarter of 2008, the Texas ratio for US commercial banks was 26%, more than double the figure two years previously (see Figure 5).
The irresponsibility of lending and borrowing in the third stage of the credit cycle ended an expansion in leverage that had lasted for over 60 years. Lender liquidity went from lavish to almost nonexistent, lending from cautious to irresponsible, and leverage from almost nonexistent to grotesquely excessive. The losses from the irresponsible lending and excessive leverage, plus low growth, will ultimately return us to the first stage of the next credit cycle. The current credit crunch is a 1-in-50-year event because credit cycles tend to last at least 50 years.
The big disintermediation weakened the credit structure by:
Dubious to fraudulent lending practices;
Creating opaque securities of unknown value;
Grossly excessive leverage.
Lending standards are being tightened, but that’s the only abuse that is being addressed so far. Opaque securities of unknown value abound and their embedded losses must be identified and excised before credit conditions can return to normal. Governments and Wall Street don’t want to know, so this process hasn’t started yet. Also, statements about massive deleveraging are somewhat misleading.
The acceleration of gearing up from 2000 to the second quarter of 2007 created the illusion of unlimited liquidity. The deceleration of gearing up thereafter reduced the excess liquidity in a financial system accustomed to excess liquidity always rising. This created the illusion that liquidity had suddenly vanished. It hadn’t. Short-term sovereign yields fell far below policy rates for some time, showing excess liquidity, not lack of liquidity. Also, banks are still lending to creditworthy borrowers. The trouble is creditworthy borrowers are hard to find.
Leverage dropped to zero in the second quarter of 2008. The painful process of gearing down started in the third quarter, even though the authorities are doing everything they can to prevent it. Gearing down is not a problem; it is the solution. Excess debt must be purged from balance sheets before the credit structure can function normally. Disintermediation created US debt US$17 trillion above optimal. Financial debt, which created the excessive leverage, was US$16.5 trillion. The similarity of these numbers is no coincidence.
Financial institutions with the biggest portfolios of bad assets have lent mostly to fund derivatives and other nonproductive purposes. Their shrinkage is having minimal impact on GDP growth. Lending in the interbank market is having an equally minimal impact. An individual bank can obtain funding in this market, but the interbank market can’t be a source of funds for the whole banking system.
The credit bubble affected asset prices far more than GDP growth. The equity and housing booms had created illusions of strength in weak recoveries. Similarly, the credit bubble bursting is affecting asset prices far more than GDP growth. All asset classes are well below their 2007–2008 highs.
The Problem Is Solvency, Not Liquidity
Recessions are rarely perceived until after they have begun, but the end of the housing boom created a perception of recession before it even started. Soft asset prices will continue to worsen perceptions of economic weakness for a considerable time. The exaggerated public perceptions of weakness panicked governments. The Fed began slashing policy rates too soon and cut them far too much, causing an unwarranted rise in inflation. Authorities worldwide have pledged more than US$15 trillion to combat the credit crunch—most of it to increase liquidity. However, there’s no liquidity problem, so most of the increase was used to acquire the sovereign bonds that funded the liquidity. This merry-go-round drove sovereign yields far too low, but did little to free up other financial markets.
The problem is solvency. Defaults and credit spreads usually peak a year or two after the recession ends. However, balance sheets have been weakened so badly that most credit spreads have risen to the widest levels since the Great Depression before the recession. The wide spreads probably herald record high default rates. The Alt A, jumbo, and prime mortgage problems are just starting. They constitute the vast majority of residential mortgages and their total losses will exceed subprime losses. Also, the rises in losses from commercial mortgages, consumer finance, and junk bonds and loans have just begun and will accelerate in the recession, putting even more pressure on bank capital.
Off-balance-sheet vehicles to avoid capital regulations, severe downgrading, and mark-to-market losses have drained vast amounts of bank capital. The most recent World Bank Global Financial Stability Report estimates total bank losses of $3.4 trillion. US banks have written off 60% of their losses and Europe 40% of theirs. In total, less than one half of the losses have been taken and more than US$1 trillion of bank losses must be recapitalized—even if total losses don’t rise further.
Governments have finally begun to address the need for bank recapitalization more than a year after it became obvious solvency was a major factor in the credit crunch. Bank capital could become a financial black hole and the recapitalizations will decimate the equity of current shareholders in weak banks.
The end of the credit cycle is deflationary in spite of more than US$6 trillion in government bailouts. Global equity market losses have been estimated at US$16 trillion, housing losses at about half that, and untold more trillions have been lost in structured finance and derivatives. Japan has shown a rising money supply doesn’t prevent deflation (see Figure 6). A mild deflation, as occurred in Japan, is likely in the US and Europe.
The bailing out of financial institutions and deposit guarantees are multiplying the direct and contingent liabilities of many nations. Government debt to GDP ratios are likely to double and some smaller nations lack the resources required to honor the liabilities they’ve assumed. Iceland has already reneged on its guarantees, and others may follow. Many sovereign credits will be downgraded and rising interest costs will transfer wealth out of taxpayer pockets, impeding growth in GDP and living standards for many years.
Investment and Economic Consequences
Most credit spreads increased to the widest levels since the Great Depression even though creditworthy borrowers have been able to borrow throughout and the rest shouldn’t borrow. Bargains abounded in investment-grade corporate bonds and they remain good value at today’s lower yields. Junk bonds and loans are a different kettle of fish. The Finra junk bond average yielded about 20%. This high cost closed financial markets to below-investment-grade companies as few would buy equity in a company with a 20% cost of borrowing. Distressed debt gave a better rate of return than equity, but the subsequent drop in yields to below 10% was a triumph of hope over experience. The default rate on junk bonds has risen to 15% and will rise higher due to slow growth and the threat of deflation. In addition, equities are far above their long term trends and fair value relative to earnings.
Shareholder returns come from reported earnings, not the higher operating earnings numbers analysts like to use, and executive stock options often further reduce shareholder returns. Estimated reported earnings for the S&P 500 for 2009 total US$46.51 for a current price–earnings ratio of 23 times, well above the long-term average. Earnings forecasts assume a V-shaped recovery, which is very unlikely after the bursting of a credit bubble, so equities are expensive. At first glance the S&P 500 appears expensive relative to European indexes, but adjusting for differing accounting methods, industry compositions and earnings outlooks would make price–earnings ratios similar.
Housing is also expensive. Professor Robert Shiller calculated an index of real prices for existing housing from 1890 to 2006. A house costing 100 in 1890 reached a 25% premium only twice up to 2000, in 1894 and 1989. However, the premium was 99% in 2006, double “fair value.” Real house prices must fall by 50% from that peak to return to “fair value.” They have fallen 35% so far, so the correction may be about 70% over, but overshoot is likely. Housing in the United Kingdom, Ireland, and Spain is similarly expensive.
This isn’t a cyclical adjustment; it’s a period of structural change. Credit conditions won’t return to normal until the following five truths have been learned.
Deleverage and falling asset prices are two sides of the same coin and so offset each other, making balance sheet repair difficult. Only increased saving and debt write-offs can repair balance sheets without inflation. Weak economies make saving difficult, so write-offs will do the heavy lifting and credit problems will last a long time.
The banking system is not fit for purpose. IBM has found a big difference between what banks think their customers want and what the customers actually want. Bank regulation is high on the agenda, but most regulations are counter-productive. Canada has strong banks because it regulates bank leverage, something few other nations have even considered. Hopefully, others will follow Canada’s lead.
Aging populations exposed the pyramid-scheme nature of the welfare state. The welfare state needs labor forces to expand fast enough to be able to produce the output needed to satisfy their needs, plus those of the growing number of beneficiaries. Recent labor-force growth hasn’t been fast enough to do this, so taxes are rising and benefits falling. As a result, the rise in living standards has reversed for some people.
Bailouts are aggravating the fall in living standards. The transfer of wealth from taxpayers due to the big rises in government interest costs from the bailouts and guarantees will reverse the rise in living standards for most people. The days of big government are numbered.
Last and most important, the attitudes of the borrow-and-spend nations must be converted to save-and-invest. Only saving and investment can create growth. America and Europe are condemned to stagnation until the majority put saving and investment at the top of their list of priorities.
"It's not what you don't know that hurts you, its what you know that ain't so." Will Rogers
"If you torture numbers long enough they will confess to anything." Amity Shlaes
"The only statistics you can trust are those you have falsified yourself." Winston Churchill
"Paper money always returns to its intrinsic value - zero." Voltaire