-- Jim Bianco on Bloomberg Television, 1/5/08
I have written extensively since October about how the collapse of the bond market in general would have a paralytic effect on the U.S. economy. In postings such as this one, I have argued that we now have a new kind of financial system that behaves differently than the textbooks say. Combining my own knowledge of how markets work and theories from people such as George Soros, I have suggested that we face something very similar to the Great Depression. While I have yet to find anyone agree with my bigger thesis, I find lots of quotes that validate parts of it. Bianco's above it one of them.
Last week, I had another one from a respected economist who is frequently quoted in the financial press. Because he didn't know I would cite him on this blog, I will not identify him by name, but he works for a major bank and is well known:
"Policy makers globally have lost control of the money supply. Money is no longer just the bills. It's the credit and the leverage. We're seeing a structural shift, and this implosion of the money supply isn’t something that's going to be reversed anytime soon."
Before going any further, let's look at what happened:
This chart shows how the financial system has stopped packaging up different kinds of loans into bonds which are sold to investors -- the process known as securization. My basic argument is that the banking system has grown dependent on securization as the underlying source of credit, and the ultimate arbiter of value. Levels in the bond market are used to set rates on ordinary loans. Extra money in the bond market caused reckless lending. Now that the bubble has broken, the market has swung in the opposite direction and lending is shutting down throughout the entire economy. (I discuss in this posting and this one how all the extra money wound up in the bond market in the first place.)
As a result of this collapse, mortgage lending has ground to a halt:
(Two quick notes: Issuance can be negative because bonds are paid off when they come due, and because they're counted as a negative number when borrowers default. Secondly, I use estimates for 2008 because I do not yet have the numbers for 2008 from the investment banks. Instead I used the average for the first three quarters according to the Fed. All numbers are net, in billions of dollars.)
"You have a market that has been so shut down by the shutdown in the securitization market... What you haven't seen yet digested yet by the market is banks pulling lines from consumers... You're going to see the consumer start to get really strained on their credit card lines ..."
--Meredith Whitney, Oppenheimer & Co. on CNBC 12/1/08.
Whitney estimates consumers will lose $1.5-$2 trillion of borrowing capacity by mid-2010, which dwarfs Obama's planned $300bln tax cut/stimulus plan.
So far, most economists predict things will gradually improve as the banks return to more of their established role as ordinary lenders. I am more skeptical of this because our financial system has spent the last 5-10 years building itself around the securitization model. While I do not fully understand the reasons why this happened, I am sure they make sense. This process is not going to just reverse itself. (For some hard facts on how much things have changed, see this posting.)
When you're dealing with large numbers of people and big institutions, it's best to change as little as possible. This is why the political process is often "conservative", and why some companies keep using technology that is decades old. It's also true in the military, where some procedures and rules persist for decades longer than you might expect. In general, the bigger the group of people, the more robotic and conservative behavior is.
To understand why, think about the English language.. no one thinks it makes sense that we have hundreds of irregular verbs like think/thought, go/went, run/ran. But it's never possible to get millions of speakers in one place at one time to tell them the words have changed.
Markets and industries work the same way. Now that securitization has become established, it's the language people speak. Expecting them to just go back to the old bank-lending model could be unrealistic, especially when the industry is facing huge layoffs, writedowns and scrambling to figure out who owns what now that everything has been packaged up and sold to investors from Bangalore to Bakersfield.
This is why I say the government needs to focus on getting bond issuance moving again. They have nibbled around the edges of this issue by doing things like trying to force mortgage rates lower and guaranteeing bank bonds. This has improved the market for some high-quality corporate bond issuers, and is expected to cause a surge of mortgage refinancing. But like all socialist measures, it tends to help those who are already privileged and does nothing for those "most in need." Just like public schools, if you're rich enough to live in a good town, you get access to a good education... If you don't really need the money, you can get it.
Of course, this will do little to prevent lots of small and weaker companies from going bankrupt and laying off their workers. Even if the government forces mortgage rates lower, I have yet to hear anyone claim it will prevent foreclosures or support home prices.
This is why I think that when Bernanke of Obama/Geithner try to do liquidity injections, it will be like an intern giving someone a shot for the first time and missing the vein.
I want to end with three final charts I made from data in the Fed's H.8 report, a mega-breakdown off all the banks' assets and liabilities. I notice some worrying patterns.
1) Bank asset quality looks poor. Riskless investments like Treasury bonds and Agency bonds are plotted in the top chart (I accidentally labeled it only as Treasuries). They are now below 13% of total bank credit, close to the lowest level since the data started in 1973. If you look back to the early 1990s, you see that banks accumulated huge piles of Treasuries in the wake of the S+L crisis. (This was Greenspan's "brilliant" way to let them rebuild their balance sheets.)
Given all their problems with bad assets now and climbing corporate defaults, it seems probable that banks will continue to stock pile Treasuries rather than making loans.
2) Keeping with the theme point #1, loans appear to have actually peaked at around 74% of bank credit and now are declining.
3) The bottom chart shows that banks have a huge amount of "Other Securities" on their balance sheets. These probably include lots of "toxic assets," which gives banks even more incentive to buy only Treasuries going forward.
Ordinary people have recently been piling money into bank accounts as they swing from being compulsive spenders to savers. The only problem with this phenomenon is that the same banks are not lending the money back into the economy, but to the government!! Treasuries climbed from 15% of bank credit in 1989 to 23% in 1993, and averaged 16% in the post 1973 era. Given that it's now less than 13%, banks are destined to buy tons of government debt going forward -- especially when you consider the trillions of dollars in Treasury bonds we're going to sell in coming years to "stimulate" the economy. Meredith Whitney's words about less access to credit cards resonate in my thoughts... The government is going to crowd American businesses and consumers out of their own economy!
You might counter: "So what?" Once banks rebuilt their balance sheets in 1995, the financial system was stronger than ever and produced the greatest bull market for stocks in history. That is true, but at that time, there were many other positive secular forces at work on their own that are gone today. For instance, productivity was rising thanks to new technology. Consumer debt and home prices were still rising. Demographics were still favorable as the baby boomers entered their highest earning years.
These things have all reversed now, or at least slowed (I am less sure about productivity gains, but that doesn't even matter during a recession.)
The thing we need to start thinking about is that our established paradigms for making money are coming under seige... Since the 1920s, we have relied on the integrated industrial company to generate wealth and innovation -- the IBM, GE, GM, etc. I believe this model as an overall concept is now coming under increasing secular pressure. (When I say secular, I mean a long-term mega-trend, as opposed to a business cycle trend that improves when the economy bounces back. For instance, typewriters suffered a secular trend in the 1990s -- even as the economy grew, they declined in relevance.)
According to Pullitzer prize winning business historian Alfed Chandler, the modern industrial corporation is more a center of knowledge than of production. This started with the railroads, which amassed armies of clerks to manage time tables, and progressed for decades as the "white collar" or "pink collar" revolution took off. This is why during the 1920s, even as the agricultural economy was already in depression and parts of the industrial economy were already in recession, a new consuming middle class of office workers was emerging.
The corporation centralized knowledge and coordinated production. By owning brands and knowing customers, they were able to ensure a steady revenue stream. Once the cash was reliable flowing in the door, they were able to invest in cost-saving mass-production. This is how companies like Kraft, Anhueser-Busch, Proctor & Gamble and so many others enjoyed an upper hand in the economy for years.
I see this shifting now due to revolutions in information technology. Companies are going to see their comparative advantages shrink going forward. Already consumer-product companies are facing growing threats from generic-brand competition. My sister, for one, has used the Internet to buy shares in a live cow rather than buy meat at the store. All of this is anecdotal, but there is a new secular trend emerging, which I actually discussed in this blog entry over the summer.
So, in the early 1990s, we also had a banking crisis. But, we had a whole bunch of great companies and industries, all blasting off on their own massive growth cycles: computers, biotech, Wal-Mart, Fannie Mae, etc. The stock market was already in an uptrend from the 1980s, and slowly ground higher for a few years before taking off again. Plus, the consumer at that point was still on solid footing.
This is very different. Not only is our financial crisis much bigger, this time we have few industries that are enjoying real positive growth. (That's why companies spent the last 5 years buying back their own shares rather than investing in their own businesses.) Alternate energy looked promising for a while, but even that is now going to be in question with oil so much cheaper. One final shoe to drop is will be the education industry, which is going to get slammed by losses in their endowments and tighter credit. (I think STRA is getting ready to be a huge short-selling opportunity.)In one final chart, I plot the debt of non-financial corporations relative to GDP from 1952 to the present. One important thing is that corporate profits have risen faster than GDP in recent years, so companies' ability to service this debt has done better than this chart suggests. But now corporate profits are contracting and returning to more historically normal levels. (From 10-11% of GDP probably back to 7-8% of GDP.)
That means that leverage ratios will be going up and overall creditworthiness will fall. This is worrisome because it is a general sign of decline: Companies almost always move down in credit quality as they mature. They start as growth dynamos and then gradually accumulate debt on their balance sheets like old people building up plaque in their arteries. (For instance, during my time covering credit, I saw most of the entire hospital industry borrow itself into the poorhouse and witnessed willful balance-sheet hari-kari of once strong AA and A credits like Home Depot and Target.)
Debt is a sign of decadence and decline. You saw it in GM, and you see it in our own national government. This time is different. Hard times lay ahead. The post-WWII party when everything always went right for the USA is over. There's no "going back to normal" this time.
Going forward, we're going to learn just how unusual normal was.