Things have been bad in the bond market of late, but many amazing things happened in the bond market yesterday.  I printed out a number of screens from my Bloomberg terminal near 4PM yesterday:


And this blast from the past:

It is hard to convey the depth of the panic gripping the bond market of late, but when t-bills are priced at less than 10 bp of yield, and the 30-year bond rallies almost 9 bucks (46 bp) in one day, that says a lot.  The last graphic above is from Black Monday, when the stock market crashed in 1987.  The move in T-bonds was even greater than that day in spread terms, which is pretty astounding, because ther was a lot more spread to grab in 1987.  In dollar terms, that was a $3+ move, so the move today was unprecedented.

Also consider that 30-year TIPS fell at the same time as the large move up in nominal bonds.  Inflation protection is being given away for free in some cases (zero for 10 years), at very nominal fees in other cases (0.7% for 30 years), and being paid in other cases (-0.5% for 5 years).  The forward inflation curve looks pretty bizarre.  If I can find time, perhaps I can put up a graph.

Away from that, 30-year swap spreads closed near -60 basis points.  Swap rates are supposed to be similar  to where AA banks borrow/lend, so something is broken here.  My suspicion is that long duration managers (pension plans, life insurers) have for some reason felt forced to buy fixed-rate  promises through the swap market, rather than buying zero coupon bonds, the longest of which yield more than 3.5%, considerably more than swap rates.  Anyone holding a position to receive 30-yr fixed, pay floating saw it appreciate by 9-10%, which is pretty amazing.

Many of the rates on the Treasury curve are record low yields as far as I can tell. This contrasts against all of the other bond markets, including agencies, where rates are significantly above Treasuries.  Investment grade and high yield bond spreads are at record levels.  My view is that they should be bought selectively, realizing that purchasing power in this market is supreme, and not give it up easily.

Read Across the Curve for how investment grade corporate spreads are moving out.  CMBS spreads have gotten destroyed.  If I were running life insurance money, and my client felt his liabilities could not run, I would be buying AAA CMBS hand over fist, carefully selecting older deals with better credit quality.  That said, you can see the effects of the carnage in the shares of life insurers, which are the biggest providers of long-term credit.  (ouch with tears)

There are still more oddities to the current bond market, most of which involve parties that can’t take certain risks any more.  We can expand that to banks, and toss in Citi.  Citi is trading like it is going out of business.  Now, Citi is one of the “too big to fail” [TBTF] banks, along with JP Morgan, Bank of America, and Wells Fargo.  If they are in trouble, I’m not sure who can buy them; they would probably be too much for even a coalition of the other TBTF banks to handle.  Is there a foreign bank that wants them?  I doubt it.  This would be another area where a new TBTF chapter of the bankruptcy code would be useful.

I’ll have a more detailed response to my piece, It’s Called a Depression later.  I would say that I found the commentary interesting, particularly the places where some suggested that:

  • I focused too much on financials.
  • Negativity itself is the problem.
  • Why don’t you focus on what’s going right?

Aside from the Great Depression, every other recession since that time, the banks, insurers, etc., may have had a large subset under stress, but not to this degree.  Our economy is credit-based, and the amount of credit is a record multiple of GDP.  That credit in the past greased the gears of non-financial companies.  The troubles in financials is affecting the whole economy.  There will be a sustained decline in demand, because much of the prior demand relied on the ability to borrow.

I have long felt that this is no “crisis of confidence” as many in the government will say.  Rather, it is a realization that when one marks many positions to their market clearing levels (at a lower degree of leverage for the financial system as a whole), that many financial institutions are insolvent.  The government can try to reflate the bubble but it is too small to do so.  Reflating bubbles is not generally achievable, anyway, because the negative dynamics around the old deflating bubble preclude it.  Typically we blow a new bubble instead.

Now, I try not to be controversial.  I don’t like trotting out words like Depression or Stagflation for their shock value.  I bring them out when I think they can be useful in clarifying the situation at hand.  I am not a doom-and-gloomer  by nature.  I would much rather be running my “long only” equity portfolio during a bull market.  Relative performance, at which I have done well, is nice, but nothing beats absolute performance.

Ask yourself, though.  If you were at the start of a new depression, what would it look like?  My list yesterday is an example of what I think it would look like.  Given the freeze-up in lending where the government has not intervened, such as A2/P2 commercial paper and corporate bonds, this is a situation where problems in financials are spilling over to nonfinancials.

Now, as for what is going right, I invite readers to offer their ideas.  Please comment.  I will offer four:

  • Residential mortgage rates are declining a little (though rates are above the levels when Bernanke and Paulson introduced their “scare tactics.”)
  • The dollar is performing well.
  • The US government can borrow at amazing rates. (That no one else can touch, unless you are a long term swap counterparty…)
  • Commodity prices are falling, hard.

These are all consistent with a depression scenario.  Demand for safety, and lack of global demand for the basics.  That said, it is a lot more pleasant filling up my tank.

In closing, as some of my older friends who have passed on once said to me, “If the locusts eat your crop, at least you don’t have to harvest.”  This is true, but cold comfort.  I would be happier with the economy that I argued was unsustainable for so long.

PS — As an aside, the government, by protecting some sectors of lending, has intensified the crisis in theareas it did not protect.  The rally in nominal Treasuries is a grab for safety at any price.  The crash in corporate bonds is the opposite.  Money runs (so to speak) from unprotected to protected sectors in a crisis, and so, the government helps create crises, and diminishes liquidity by protecting some favored sectors of fixed income.

I’m going out on a limb here, and I’m going to suggest that we have already entered a depression.  The concept of a depression is even less objective than that of a recession,  but some suggest that a decline in real GDP of 10% or more is the criterion, which we have not attained yet.

I don’t think a 10% decline in GDP is the right threshold.  Depressions are different because of their widespread nature, often coming through financial systems that are in danger.

As it is now, many things are happening that are depression-like.  Here we go:

  • Record high levels of total debt to GDP
  • Many go hat in hand to the government.
  • The spreads of the bond market are at record levels since the last depression, and maybe comparable.
  • There is policy paralysis and confusion.  No one knows what to do (or leave alone), they act blindly or cower in fear.
  • Ultrasafe investments have record low yields.
  • Banks don’t trust each other.
  • GDP is shrinking, and unemployment is increasing at a rapid rate.
  • Financial businesses are failing and shrinking at high rates.
  • The government comes in to “help” the markets, and ends up replacing the markets.
  • The security of banks and other financial entities is open to question.

Will we get a 10% decline in real GDP?  I think so, but I am nowhere near certain on that.  What I am certain of is that the gears of finance are jammed.  The bond market is a shadow of its former self, and few are willing to take seemingly prudent risks.  I’m not sure the government can do much to affect this; it will work out over time, as debts are paid off and forgiven, as the last depression did.

I won’t be your host through this depression, should I live so long.  But knowing what things will be like if we are in a depression is a real advantage for those who invest or run businesses.  Be careful.

From 2003 to 2007, we went through a period where the balance sheets of financial entities went through a systemic downgrade.  They became:

  • More leveraged
  • Less transparent via derivatives
  • More reliant of floating rate finance
  • Reliant on debt structures with shorter maturities
  • More sensitive to calls on cash via ratings-sensitive collateral agreements

That is what has set us up for the problems that we have today.  In the bond markets, those conditions have led to the failures of many large market makers, straining the remaining system.  The remaining market makers in bonds are offering little liquidity amid the panic.  It doesn’t matter what sub-segment of the bond market I point at, every part faces a lack of risk-bearing capacity as parties hoard cash.

Part of this is the fault of the Treasury and Fed, as they proffered their TARP and pulled it back.  The greater the uncertainty from large parties, the more that small parties run and hide.

Away from that, many parties with capital have decided (seemingly) as a group to seek safety all at once, leading to a general malaise in all things risky.  Part of that could be related to the original TARP, as many parties decided to wait on selling until the TARP came along.  With no TARP (as originally conceived), those inclined to sell made offers, and the markets balked.

What can I say? Compared to 2002, there are fewer entities willing to bear credit risk during the crisis, even for short amounts of time.  This allows for arbitrage situations that don’t immediately get resolved, because no one has the balance sheet necessary to do it.

Eventually we will get to a point where those with unencumbered cash will make an effort to close those arbitrage gaps, and lend to worthy businesses at exorbitant rates, but it may take some time.  Until then, the market will flounder in the volatile way that it does.

I have been of two minds on bailouts.  First, I would prefer we did not do them because bailouts beget more bailouts.  Free money brings out the worst in humanity.  Where is the logical end?  How do we choose what is critical, and what is not?

Second, if we’re going to do bailouts, they should be a last resort to the companies receiving them.  Unlike the relatively sweet terms of the capital offered to the banks, bailout capital should be something that a management says, “Ugh, time to fall on our swords, guys, but at least the business and much of the rank-and-file will survive.”

So, when I look at hopeless cases like the “big” 3 automakers, I think that we need a new chapter in the bankruptcy code for businesses that are “too big to fail.” [TBTF]  The rules would be a little different here:

  • Failure of a TBTF institution usually occurs during a major economic crisis.  Other institutions would be stretched too thin, so the US Treasury (together with the Fed) would serve as the Debtor-in-Possession [DIP] lender.
  • In addition to being senior to the existing debt, the Treasury would receive some stock in the reorganized entity.
  • There would be a special court to deal with the competing claims, with a goal of speedy resolution.  Marginal claims would get thrown out early.  Claims without a lot of variability would get little attention.
  • The Court would have the power to throw out contracts, including union and management contracts.
  • The idea is to preserve the business while finding who really owns the new equity, and quickly, so that real life can resume with a balance sheet that has little debt.
  • The court would choose who puts together the first restructuring plan, aiming for the party that has the most at stake, skipping the current nominal equity, in favor of the parties that practically are the equity.
  • A Chapter 11 case could be moved into this chapter if no DIP lender is found, at the option of the Secretary of the Treasury.

A method like this tries to respect the taxpayer, making it unlikely that bailout funds would be tapped, while still allowing for situations where TBTF institutions could be reorganized in an emergency where the banks can’t lend, rather than a quick liquidation.  It’s a tough balancing act, but one that has to be done for the good of the nation as a whole.  Formalizing methods like this could have value for future crises, such that businesses end up saying that they don’t want to go down the TBTF Bankruptcy Chapter, which would be good for the nation.

That’s my reasoning.  I am open to other ideas, and improvements to the concept.

When is a stock safe enough to buy when it becomes difficult for corporations to find financing?  We can answer the question two ways: 1) Why should we buy stocks when the financial markets are choking?  Better to sit on cash.  2) We can’t tell when the turn is coming, so if we buy companies that are cheap with strong balance sheets and free cash flow, we should do okay over the intermediate-to-long run.

I’m going to illustrate this with a single stock tonight: General Electric.  Why GE?  Here’s something I haven’t mentioned recently about how I source stock ideas.  I read widely, and when some one tells me a stock is cheap, I write it down for later analysis.  My initial cursory analysis during this time of credit stress looks like this:

Let’s look at earnings estimates:

Yeah, is does look cheap.  How has it done recently relative to expectations?

Mmmm…. not so good.  Looks like they are still working off all of the bad accruals from the Jack Welch era.

Now, let’s look at the balance sheet:

Mmmm… there are a lot of intangibles on the balance sheet.  Taqngible book value is light.  Perhaps the intangibles have real economic value.  If so, I would expect to see additional earnings over operating cash flow, and the is not there. Let’s look at debt maturities, could there be a call on cash?


That doesn’t look good.  What if we look at only the holding company?

Okay, not so bad.  Most of the debt is from the finance subsidiary that I have argued for years should spun off.  In a pinch, what are the odds that they would send GE Capital into insolvency?  Very low, so I worry about the refinance risk.  Will GE Capital get attractive financing terms over the next several years?

On to cash flows.  Here are the cash flow screens:

Okay, free cash flow is positive, and congruent with earnings over the last five years.  That’s a good sign.  What else is there to look at?


Okay, Price-to-sales indicates that GE could be cheap versus their long history, but it could get cheaper.

Let’s look at summary statistics:

From all of the above, as I look at GE, there is a refinancing problem.  Many debts come due over the next 5-10 years, probably matched by debt repaqyments over the same horizon.  The effect of default from these repayments could be significant.  I doubt that GE would be willing to send its finance subsidiary into insolvency.

In conclusion, even at the low levels that GE stock price has reached, I’m not comfortable with it.  GE will have to refinance a lot of its debt over the next five years, unless they sell or default on GE Capital.  The debt load outweighs the seeming cheapness.

Full disclosure: no position

I want to return to this topic to deal with some comments that I received.  Before I start, I want to repeat a comment that I made at Barry’s blog:

Barry, I’m going to toss out a third possible cause for the end of the Great Depression. The first two are FDR’s programs and WWII, both of which I don’t find compelling.

I grew up in this business as a risk manager, and a bit of a innovator there. I had experience with nonlinear dynamic modeling which most actuaries and financial analysts, even most quants, don’t get or use. The economy, and most industries are nonlinear dynamic systems, which means there will be cyclical behavior, and that behavior will be more volatile the greater the level of fixed commitments in the system that must be satisfied.

Economies that primarily use equity finance are more stable than those that primarily use debt finance. It becomes easier to have a cascade of failure the greater the overall debt burden is on the system. So, the total debt level has a major impact on the behavior of the economy. In 1929, total debt to GDP was 280%. By 1941, that level was 160% or so, where it stayed (more or less) until 1985.

After that, debt to GDP moved up parabolically to 360% by 2007, and now we find ourselves in the soup in two ways: 1) total level of debt, 2) complexity of debt because of securitization and to a lesser extent, derivatives.

Why did the depression end around 1941? Reason 3 (my reason): enough debt had been paid down or written off, and loans could be made to good borrowers, but only enough that financial sector would grow slowly (not faster than GDP).

The answer today, in my opinion, is that we need expedited procedures for bankruptcy to reset the system, getting lenders to compromise with borrowers, and bring down the debt to GDP ratio. I don’t think the present programs will work, and they may actually prolong the crisis, a la Japan. In my opinion, we won’t see significant economic growth until the debt to GDP ratio falls into the 150-200% range.

That is my opinion in a nutshell.  Or, as I commented regarding Hank Paulson here:

He could have tried a more modest solution of expediting bankruptcy processes, because the most pressing need for the economy is to turn bad debts into lesser equity stakes, so that the debt overhang can clear.

This probably includes streamlining personal bankruptcy such that lenders receive back loans with smaller principal balances, plus property appreciation rights.

Total debt levels must be reduced below 180% of GDP, and then the Fed must add a new constraint to their policy. Tighten when Debt/GDP rises above 180%, and raise bank capital thresholds in response to the overall indebtedness of the economy.

Better to go back to a gold standard, I say, but if you’re going to have fiat money, at least do it intelligently, so that debt does not get out of control, as it did in the 20s, and 1985-2007.

In essence this would give a third mandate to the Fed.  When total debt to GDP levels get above 180%, tighten, and make bank exams tougher.  Below 120%, flip it (sending a nickel to my pal Cody).

Now, I received a number of responses to my original article.  I’d like to mention a few of them here, and respond.

From Ray Taylor — ….hmmm — “I say Big Bang…”…so you’re a financial analyst with a wife and eight children and you don’t mind being unemployed for a few years…or, alternatively, bagging groceries at Kroger (if it’s still in business)…you might want to ask the rest of your family for their opinion.

Good point.  I have a decent amount of safe assets laid away, but I am an equity manager, so I am not in a great spot.  I am more than willing to bag groceries, though, or work at other more mundane tasks if things get really bad.  My father taught me the value of hard work.  I am not worried for my family if our nation survives.  I am concerned over whether our nation survives.  Present policies are lowering the odds of survival.

Also, I have many friends in my church that will help me if things get bad.  I helped in the good times; they will help in the bad.

From Michael M. — First, I have a deep suspicion that people who advocate we take our medicine sharply, are generally in positions where the pain will not happen to fall sharply on them, but on other people. I suspect the author is one of these. I am pretty appalled at the indifference such people show to the enormous suffering real depression would bring to huge numbers of people.
Second, I do not know of strong agreement that the Great Depression cured itself; most seem to think the fortuitous enormous spending of World War II finished it off, not an automatic self-regulating process.

Michael, I am 65% exposed to equities relative to my net worth.  Part of that is a promise that I made to my long only investors that I would always have a minimum amount of my net worth exposed to what they are investing in.  I speak what I think is the truth because that is what I am supposed to do ethically, whether it hurts me or not.

Also, I believe my proposals would cause the most people the least pain.  The present proposals of our government point in the direction of FDR and Japan, prolonging the pain.

You are right that there is no consensus saying the Great Depression healed itself.  As I said to Barry above, what I am saying is that the consensus is wrong, and that the Austrian School and those that understand nonlinear systems theory are right.  We can’t establish prosperity by government actions (leaving aside infrastructure); prosperity comes through private actions.

From Mike in NOLa — With respect to protectionism, Michael Pettis has pointed out that China today is much like the US was in the late 1920’s, with huge foreign currency reserves and manufacturing overcapacity. As such, China may be the one to go protectionist, either explicitly, or by monetary manipulation. See his last two posts:

I read everything Michael Pettis writes.  I agree totally.

From JVDeLong:— David – a question for you. I cannot claim a good grasp of macro, but my intuitive sense is that the key is your comment about the ratio of debt to GDP. Some of these claims must be wiped out by default – but the chief political characteristic of the system is an utter inability to inflict losses. Everyone must be bailed out.

So if we cannot allow piecemeal bankruptcies to clear the system, then what is the alternative except national bankruptcy — which takes the form of meeting all the claims in nominal terms and then hyper-inflating?

I have stayed with stock market investments on the theory that either the crisis will be brought under control and the stocks will recover, or that the efforts will fail and national bankruptcy will ensue, which means that money-equivalents are not a conservative investment. I do not think the Fed/Treasury will repeat the deflation scenario of the 1930s.

BTW – I heard James Grant speak last week, and he is bearish on money and bullish on high yielding corporate bonds, but I dunno — that looks like threading a needle.

Your thoughts (and I would be happy to be told that I am crazy)?

With respect to Mr. Grant and high yield, I would agree with him.  I am also bearish on the dollar, and would consider oil, gold, or yen as alternatives at present.

National bankruptcy, or significant inflation, is a possibility that everyone should consider.  I agree with you, the Fed and the Government do not want to repeat the 30s, which is why I think inflation is more likely, unless pressure from international interests makes the US government soak its own populace to pay foreigners.

Kevin Murphy says — David: Would a reverse ETF such as the Proshares Ultrashort treasury funds be a good hedge against inflation or a failure of the Government to finance it’s obligations at current interest rates?

Though I don’t like levered ETFs because they usually underperform their targets, yes, that would be a good strategy.

Ben Says: — Has anyone tried to estimate what the economic situation would have been in the US had we not won the war? I know it sounds stupid, but I’m very dubious about this ‘WWII ended the depression theory’. Winning WWII was such a profound positive shock to the US economy that attempts to draw economic analogies and quantify an equivalent amount of peacetime stimulus seem stretched at best.

In terms of the question of how much stimulus we need, there must be many more examples of countries applying economic stimulus to study than the few people are bantering about at the moment. OK, so modern day Japan, Britain in the 70’s and the total experience of the New Deal are not encouraging for Keynesians. Where are the happy endings?

Good points, the Keynesian remedies have not generally worked. Policymakers follow those remedies not because they work, but because they maximize their own power.

VennData Says:– The claim that “this will give a chance to see who was truly correct about what to do then versus now…” is an exaggeration of the benefit of ex post outcomes of economic cause and effect.

The idea that a “Bling Standard” is somehow realistic, desirable, is wrong, Even the Swiss have dumped theirs. It makes you vulnerable to whomever buys up “all the” gold: SWFs, foreign central banks, Private equity, Hedge funds etc… The Fed may have had a hand in too much leverage, but the system self-corrects. The biggest problem after Reagan’s appointment of Greenspan was Bush’s administrative fiat: the 2004 leverage ruling and Congress’s post-Clinton budget busting.

One change we need is addressed correctly above: government policies need to be counter cyclical during boom times – no nation wants to be hamstrung by the pro-cyclical “Bling Standard” – government systems should be counter-cyclical.

At a minimum, the Fed needs to be allowed into VIP lounge where the punch bowl resides.

VennData, I agree with you that policy needs to be countercyclical under a fiat money or gold standard.  In general, governments are averse to doing so, because it reduces their power.  For that reason, I believe that the government should not be in the money business; it gives them power that they have not managed well, and don’t deserve.

But, you misunderstand my comment that you quoted.  I expect the government to interfere massively, and that the malaise will be prolonged as a result.  Bernanke’s methods, and those of the Treasury, will be ineffective, showing that we really did not learn the right lesson from the Great Depression.  The right lesson would be that in fiat money environment, the central bank must limit the creation of leverage.

Russ Wood Says: JVDeLong wrote — So if we cannot allow piecemeal bankruptcies to clear the system, then what is the alternative except national bankruptcy — which takes the form of meeting all the claims in nominal terms and then hyper-inflating?

The alternative lies in the denominator of the Debt/GDP ratio. We have to grow GDP as fast as possible. Unfortunately, no one wants to talk about creating incentives for growth. The only discussion is how to cushion everyone from slower growth.

Russ, I sympathize with your views, but growing GDP rapidly is impossible in a credit-based economy when the banks are compromised.  Debt reduction is the main way out, intially.


So, my views remain unchanged, and perhaps affirmed.  Depressions, like popped bubbles, are primarily phenomena of finance.  They happen when cash flows from assets are insuffiicient to cover liability cash flows.

Would that our government would wake up and realize that the right policy is the one that feels wrong in the short run.  Aside from that, does anyone care about the implications regarding individual freedom?  Or, that group freedoms are affected as well?

The Audacity of Hope

All we need to do is restore the confidence of investors, and everything will be fine.

We must take measures to make sure that the nominal value of assets that have been borrowed against do not fall further.

There is nothing to fear except fear itself.

There is nothing to fear except an aggressive government with idealists who think they know how to prevent a second depression, but really don’t.

Okay, the last one is what I think.  I have new sympathy for the liquidationist philosophies of Andrew Mellon, Secretary of the Treasury for Harding, Coolidge and Hoover.  Depressions occur because of economy-wide debt levels being too high, which leads to a self-reinforcing negative cycle when asset prices can no longer be supported by debt, because the cash flows from the assets become less than the cash flows needed to finance the debts.

There are two choices in such a situation.  The government can interfere and cause a Japan-style malaise, not all that much different from the last depression, or we can liquidate, which is really, really hard.  Think of what Poland went through with their “Big Bang” post-communism.

Most Americans, particularly Baby Boomers, do not like hard things (I would have loved to have written that article).  Well, who does?  But pain is a normal part of life, and mature people embrace it when it unavoidably comes their way.

In a depression, everything fights against the one trying to restrain it.  Ask the Japanese how successful they have been in restoring normality to their financial system.  Or, how good the economy was when the measures our government is applying today were tried during the last depression.  Then consider:

Confidence exists because there is enough transparency and lack of overall leverage that people can have assurance that marginal institutions will not get pulled down in a self-reinforcing cycle of failure.  We are nowhere near that now — if we can get the Debt/GDP down from 3.6x to 1.5x, we would have a chance.  Until then, regardless of the confidence building measures attempted by the Treasury/Fed, we will not get to that level of transparency.

There are a few things different now versus the Great Depression.  The US went into the Great Depression with a clean balance sheet.  We come into this situation with a lot of debt, explicit and implicit (entitlement promises). On the other hand, we don’t have protectionism yet.  We have an aggressive monetary policy, but one designed to stimulate hurting areas, and not the economy as a whole.  The same is true of fiscal policy.  It’s happening a lot faster than the government response during the Great Depression, so this will give a chance to see who was truly correct about what to do then versus now.

Are depressions caused by panics leading to a loss of confidence in the system because a few key areas have failed, and if we patch those up using government/central bank help, everything will go back to normal?  That’s the view of the political powers that be, both now and before the Great Depression.  Or, are they caused by Debt/GDP levels being too high, such that asset values get pushed significantly above their market clearing levels, and incremental new debt is not capable of financing those asset prices anymore?  That’s my view, the view of Mellon, many pre-Great Depression economists, and a number of others today that argue that the problem is not that the markets have failed.  Yes, the markets have failed because we let the credit creation inherent in a fiat money system run out of control.  For the last 20 years, the Fed would never let a recession be severe enough that it would bring debt levels down, as the Fed did from the forties to the mid-eighties.  So the debt levels grew and grew without bounds, because no discipline was imposed in the interests of permanent prosperity.  Congress and the Presidency went along with it happily.  Who wants to get in the way of a perma-boom?

Now the payment for this folly has come due, and the question sits before us: do we take it short and sharp, a Big Bang?  Or, do we eat the elephant one bite at a time, a la Japan, which is still not quite out of its bubble woes after almost 20 years?  I say Big Bang, but that’s not the nature of our culture, so be humble, be realistic, and be ready for a long slump or series of slumps as we enter the not-so-great depression.

(Alternate Title: Be a Bank; Or, Just Look Like One.)

There has been a significant shift in bailout psychology over the last week or two.  The grand shift has been to make the cost of receiving money from the US government smaller, which gets “banks” to line up for cheap money, and non-banks like CIT and American Express to become banks.  Insurers with Thrift arms can be “banks” as well.  The hurdle for help is low.

This is the wrong philosophy.  Bailouts have to be the best of a bunch of bad solutions, rather than something financial companies like.  Common and Preferred Equity need to get whacked hard, and subordinated debt needs to take a haircut.

The present situation has the Treasury coming back to Congress for the second $350 billion quite rapidly, with little accountability for what they have done already.  How can we tell that what the Treasury has done is right?  How can we tell that it is fair?  Answer: we can’t.

In giving and forcing money into healthy institutions, the Treasury has wasted money, in my opinion.  Far better to give it to marginal institutions that need a little to get by in exchange for a large stake in the institution.  But what they have done so far resembles giving aid to the largest politically connected firms, whether they need it or not.

Going back to Walter Bagehot, Central Banks should lend without limit at a penalty rate during a crisis.  That rate should hurt, but it is better than no access to credit.  To do otherwise is to shortchange taxpayers, and place the value of the Dollar at risk.  That is what we are doing now.

Consider these graphs:


Or, the oversimplified version:

The Federal Reserve was once a simple institution. Bloated with too many people for the task at hand, but simple all the same.  But now, the Fed no longer controls its destiny.  What high-quality securities that Fed holds belong to the US Treasury.  And, if you look at the top graph, you will see a gap in the Northeast corner.  That represents the degree that the Fed is short high quality Treasury assets.  Not pretty.  In a real crisis, where the Fed would face a call on cash, the result would either be inflation or severe recession.

Our government is rhyming with what it did during the Great Depression; they aren’t finding ways to reduce overall debt levels.  They are moving deck chairs around on the Titanic.  Our economy will not be healthy until we reduce debt relative to GDP.  That’s not on the agenda now, which means we might imitate Japan for the next few decades, assuming our entitlements crisis doesn’t do us in.


Insurance is complex by nature.  Anytime one brings in a third party to be a protector/guarantor against adverse events, it creates some weird dynamics.  Now, a few of the states, including the best of them, New York, have been regulating insurance for a long time.  But the Feds have not dealt with insurance in any significant way, because that role has been ceded to the states.

With the failure of AIG, and it getting acquired by the Feds, the questions of regulation have taken on new significance.  I have written before about the Federalization of insurance regulaton, indicating some indifference about who regulates it, but pointing out the difficulties — what an effective insurance regulator needs to learn.

The following is personal to me in four ways:

  • I used to work for AIG (’89-’92)
  • My main local paper is the Baltimore Sun (though I don’t subscribe, because of lack of value)
  • Elijah Cummings is my Congressman, at least since the last gerrymander. (Hey, give him credit, he voted against the bailout.)
  • I have interacted with many insurance regulators of varying abilities over the last 20+ years.

Elijah Cummings and some other congressmen have gotten offended over seemingly extravagant expenses over conferences, particularly for agents/representatives of the company.  Now, as a young actuary, I would sometimes say, “Why do the agents get to go to all of the fun conferences?”  Not true — only the top agents went to those conferences, and it was a reward that would stimulate extra performance (and the real reward was bragging rights — the companies often made money off of conference-type rewards).  Actuaries are nice, and all that, but the ability to sell product, particularly in life insurance and annuities, is rare.

When the government gets involved in industry, the incentives become messy:

A1) We need to do a lot of mortgage workouts for the good of mortgage payors and those in residential real estate.

A2) We need to minimize the cost of the mortgage bailout to the taxpayer.  Or, we can’t borrow that much.

B1) We must reduce tobacco smoking in our state; it is harming our dumbest citizens.

B2) But we issued tobacco bonds against the recent settlement with the tobacco companies.  We can’t afford to lose revenue.

C1) We’ve got to crack down on shady life insurance sales practices.  Too many people are getting cheated.

C2) That insurance company employs a lot of people in our state, and they are located in the district of the head of the commerce committee.

D1) Gambling has introduced new forms of addiction to our state, and perhaps organized crime as well.

D2) We can’t afford to give up the tax proceeds from gambling — the schools depend on it.

Have I made it clear?  Politicians want political results, and they want tax revenues, which are often opposed to each other.  They aren’t typically businessmen, so they don’t understand the tradeoff.  Rather, they swing from one to the other, as political convenience dictates.

And so in this situation, I would say that the amounts in question are rather nominal.  Why fuss over the conferences?  Rewarding top performers is important, and if you don’t do that, you will lose business, and the government will lose on its “investment” (what a word 😉 ) in AIG.  Most companies have conferences like AIG, and I can tell you, they wil think twice about coming under the government’s umbrella for that reason, as well as many other reasons that have political significance, but harm corporate performance.

State legislatures took time to build up expertise in insurance regulation.  Some more so like New York (we should move the NY regulators to DC if we federalize), and some less so.  Congress doesn’t have the vaguest idea on what to do with insurance and AIG.  The ignorant statements of Rep. Cummings are a great example.  Ed Liddy has only been on the job for less than two months.  Why call for his head?  Insurance companies are complex organizations where most significant things are planned a year in advance or so.

Now, so I like the AIG bailout?  No, perhaps we should have let the holding company fail, and the underlying insurance subsidiaries would have been fine.  Some CDO holders would have been hurt, but what are you doing dabbling in CDOs, anyway?  And why didn’t you question why so much of your CDO exposure was AIG guaranteed?  When only one company guarantees much of the business, that is a bad sign (underpricing).

But seeing the ruckus here, this is why it is bad for the government to own an insurance company.  All of the incentives are confused, which will lead to a greater failure, and more expense to the taxpayers.


UPDATE 1PM 11/13/08  Adam corrects me below.  Cummings voted against the initial bailout bill, and for the final bailout bill.  Thanks for the correction, Adam.

Before I try to explain what a Depression is, let me explain what a bubble is.  A bubble is a self-reinforcing boom in the price of an asset class, typically caused by cheap financing,  with the term of liabilities usually shorter than the lifespan of the asset class.

But, before I go any further, consider what I wrote in this vintage CC post:

David Merkel
Bubbling Over
1/21/05 4:38 PM ET
In light of Jim Altucher’s and Cody Willard’s pieces on bubbles, I would like to offer up my own definition of a bubble, for what it is worth.A bubble is a large increase in investment in a new industry that eventually produces a negative internal rate of return for the sector as a whole by the time the new industry hits maturity. By investment I mean the creation of new companies, and new capital-raising by established companies in a new industry.This is a hard calculation to run, with the following problems:

1) Lack of data on private transactions.
2) Lack of divisional data in corporations with multiple divisions.
3) Lack of data on the soft investment done by stakeholders who accept equity in lieu of wages, supplies, rents, etc.
4) Lack of data on corporations as they get dissolved or merged into other operations.
5) Survivorship bias.
6) Benefits to complementary industries can get blurred in a conglomerate. I.e., melding “media content” with “media delivery systems.” Assuming there is any synergy, how does it get divided?

This makes it difficult to come to an answer on “bubbles,” unless the boundaries are well-defined. With the South Sea Bubble, The Great Crash, and the Nikkei in the 90s, we can get a reasonably sharp answer — bubbles. But with industries like railroads, canals, electronics, the Internet it’s harder to come to an answer because it isn’t easy to get the data together. It is also difficult to separate out the benefits between related industries. Even if there has been a bubble, there is still likely to be profitable industries left over after the bubble has popped, but they will be smaller than what the aggregate investment in the industry would have justified.

To give a small example of this, Priceline is a profitable business. But it is worth considerably less today than all the capital that was pumped into it from the public equity markets, not even counting the private capital they employed. This would fit my bubble description well.

Personally, I lean toward the ideas embedded in Manias, Panics, and Crashes by Charles Kindleberger, and Devil take the Hindmost by Edward Chancellor. From that, I would argue that if you see a lot of capital chasing an industry at a price that makes it compelling to start businesses, there is a good probability of it being a bubble. Also, the behavior of people during speculative periods can be another clue.

It leaves me for now on the side that though the Internet boom created some valuable businesses, but in aggregate, the Internet era was a bubble. Most of the benefits seem to have gone to users of the internet, rather than the creators of the internet, which is similar to what happened with the railroads and canals. Users benefited, but builders/operators did not always benefit.


Bubbles are primarily financing phenomena.  The financing is cheap, and often reprices or requires refinancing before the lifespan of the asset.  What’s the life span of an asset?  Usually quite long:

  • Stocks: forever
  • Preferred stocks: maturity date, if there is one.
  • Bonds: maturity date, unless there is an extension provision.
  • Private equity: forever — one must look to the underlying business, rather than when the sponsor thinks he can make an exit.
  • Real Estate: practically forever, with maintenance.
  • Commodities: storage life — look to the underlying, because you can’t tell what financing will be like at the expiry of futures.

Financing terms are typically not locked in for a long amount of time, and if they are, they are more expensive than financing short via short maturity or floating rate debt.  The temptation is to choose short-dated financing, in order to make more profits due to the cheap rates, and momentum in asset prices.

But was this always so?  Let’s go back through history:

2003-2006: Housing bubble, Investment Bank bubble, Hedge fund bubble.  There was a tendency for more homeowners to finance short.  Investment banks rely on short dated “repo” finance.  Hedge funds typically finance short through their brokers.

1998-2000: Tech/Internet bubble.  Where’s the financing?  Vendor terms were typically short.  Those who took equity in place of rent, wages, goods or services typically did so without long dated financing to make up for the loss of cash flow.  Also, equity capital was very easy to obtain for speculative ventures.

1998: Emerging Asia/Russia/LTCM.  LTCM financed through brokers, which is short-dated.  Emerging markets usually can’t float a lot of long term debt, particularly not in their own currencies.  Debts in US Dollars, or other hard currencies are as bad as floating rate debt,  because in a crisis, it is costly to source hard currencies.

1994: Residential mortgages/Mexico: Mexico financed using Cetes (t-bills paying interest in dollars).  Mortgages?  As the Fed funds rates screamed higher, leveraged players were forced to bolt.  Self-reinforcing negative cycle ensues.

I could add in the early 80s, 1984, 1987, and 1989, where rising short rates cratered LDC debt, Continental Illinois, the bond and stock markets, and banks and commerical real estate, respectively. That’s how the Fed bursts bubbles by raising short rates.  Consider this piece from the CC:

David Merkel
1/31/2006 1:38 PM EST

One more note: I believe gradualism is almost required in Fed tightening cycles in the present environment — a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:

  • 2000 — Nasdaq
  • 1997-98 — Asia/Russia/LTCM, though that was a small move for the Fed
  • 1994 — Mortgages/Mexico
  • 1989 — Banks/Commercial Real Estate
  • 1987 — Stock Market
  • 1984 — Continental Illinois
  • Early ’80s — LDC debt crisis
  • So it moves in baby steps, wondering if the next straw will break some camel’s back where lending has been going on terms that were too favorable. The odds of this 1/4% move creating such a nonlinear change is small, but not zero.

    But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can’t afford it.

    Position: None

    Bubbles end when the costs of financing are too high to continue to prop up the inflated value of the assets.  Then a negative self-reinforcing cycle ensues, in which many things are tried in order to reflate the assets, but none succeed, because financing terms change.  Yield spreads widen dramatically, and often financing cannot be obtained at all.  If a bubble is a type of “boom phase,” then its demise is a type of bust phase.

    Often a bubble becomes a dominant part of economic activity for an economy, so the “bust phase” may involve the Central bank loosening rates to aid the economy as a whole.  As I have explained before, the Fed loosening monetary policy only stimulates parts of the economy that can absorb more debt.  Those parts with high yield spreads because of the bust do not get any benefit.

    But what if there are few or no areas of the economy that can absorb more debt, including the financial sector?  That is a depression.  At such a point, conventional monetary policy of lowering the central rate (in the US, the Fed funds rate) will do nothing.  It is like providing electrical shocks to a dead person, or trying to wake someone who is in a coma. In short: A depression is the negative self-reinforcing cycle that follows a economy-wide bubble.

    Because of the importance of residential and commercial real estate to the economy as a whole, and our financial system in particular, the busts there are so big, that the second-order effects on the financial system eliminate financing for almost everyone.

    How does this end?

    It ends when we get total debt as a fraction of GDP down to 150% or so.  World War II did not end the Great Depression, and most of the things that Hoover and FDR did made the Depression longer and worse.  It ended because enough debts were paid off or forgiven.  At that point, normal lending could resume.

    We face a challenge as great, or greater than that at the Great Depression, because the level of debt is higher, and our government has a much higher debt load as a fraction of GDP than back in 1929.  It is harder today for the Federal government to absorb private sector debts, because we are closer to the 150% of GDP ratio of government debts relative to GDP, which is where foreigners typically stop financing governments. (We are at 80-90% of GDP now.)

    We also have hidden liabilities through entitlement programs that are not reflected in the overall debt levels.  If I reflected those, the Debt to GDP ratio would be somewhere in the 6-7x GDP area. (With Government Debt to GDP in the 4x region.)

    We are in uncharted waters, held together only because the US Dollar is the global reserve currency, and there is nothing that can replace it for now.  In the short run, as carry trades collapse, there is additional demand for Yen and US Dollar obligations, particularly T-bills.

    But eventually this will pass, and foreign creditors will find something that is a better store of value than US Dollars.  The proper investment actions here depend on what Government policy will be.  Will they inflate away  the problem?  Raise taxes dramatically?  Default internally?  Externally?  Both?

    I don’t see a good way out, and that may mean that a good asset allocation contains both inflation sensitive and deflation sensitive assets.  One asset that has a little of both would be long-dated TIPS — with deflation, you get your money back, and inflation drives additional accretion of the bond’s principal.  But maybe gold and long nominal T-bonds is better.  Hard for me to say.  We are in uncharted waters, and most strategies do badly there.

    Last note: if you invest in stocks, emphasize the ability to self-finance.  Don’t buy companies that will need to raise capital for the next three years.