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.

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:

http://mpettis.com/

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?

(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:

http:/www/alephblog.com/wp-content/uploads/2008/11/

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.

Links:

• CIT Looks to Transform Into Bank
• So far, Washington is on the hook for $5 trillion
• Bailout Lacks Oversight Despite Billions Pledged
• Don’t Just Do Something. Stand There.
• Fed to Banks: Lend!
• Why Bailouts Attract Handout Seekers
• Nuclear Winter
• Depression Economics Returns

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. none

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
		Gradualism
		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:

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.

1) General Growth Properties — another case of too much leverage, illiquid assets, and liquid liabilities.  I live near Columbia and Baltimore, so I know of a lot of property owned by General Growth that was bought when they acquired the Rouse Corp.  I can hear the Rouses in the distance congratulating themselves on a good sale.

For those that haven’t read me much, the deadly trio of too much leverage, illiquid assets, and liquid liabilities is what causes most corporate defaults of financial companies, not lesser issues like mark-to-market accounting.

2) The government thinks it is doing something good, and then it realizes that it is in over its head.  Consider AIG and Fannie Mae.  Where does the bailout end?  The government does not have a team of financial analysts competent to dig into murky balance sheets, and they have the mistaken notion that they must act fast.  Having worked on several takeovers of large financial firms, I can tell you that work done quickly destroys value.  Either there is an underestimate that leads to losing the bid, or an overestimate that leads to overpaying, and an eventual writeoff of part of the investment.

With Fannie Mae and AIG, (and probably Freddie also) the government clearly did not know what it was doing.  What were the main drivers of the loss, and how much worse could they get?  Is this scenario self-reinforcing?  The cursory work led to a bad result that is getting worse.

3) Amazing that we are almost to the end of the first $350 billion of bailout capital.  The government is behaving like a person that just won the lottery, and is profligate with spending, because they’ve never had that much money to throw around with complete discretion until now. As it says in Proverbs 13:11, “Wealth gained by dishonesty will be diminished, but he who gathers by labor will increase. [NKJV]“  Easy come, easy go.  I am not surprised in the slightest that the US Government has mis-estimated the loss exposures.  They don’t have anyone with a concentrated interest (a profit motive) in the result.

4) Here’s another angle in the Fed refusing to disclose what assets they are financing.  If we knew who they were buying from, and what they were buying, the markets would ask the question, “How much more firepower are they willing to expend?”  If the judgment is “little”, market players would sell what the Treasury/Fed was buying, and if the judgment is “a lot”, market players would buy what the Treasury/Fed was buying.

That leads me to believe that the Treasury/Fed doesn’t want to commit a lot more resources to this fight.  If they felt they had a lot more firepower, they would happily disclose their actions, because the private markets would aid their actions.

5) I’ve been talking about it for over a decade, so pardon me if I point at the great pensions disaster.  We have had a lost decade where DB pension money needed to earn 8-9%/yr, and earned around 1%/year.  That gap of 7-8%/yr over 10 years is enough to destroy most well-funded plans at the beginning of the period.  The problem exists for DC plans as well, because as people age, they lose time to compound their money.  Hey, think of this — the dumb guys that put all their money in the stable value fund did much better than those that put their money at risk.  So much for the equity premium in hindsight, but now it’s time to begin committing funds to riskier assets.  (Don’t do it all at once.)

6) At least Mr. Obama can make one market go up — muni bonds.  Wait, that’s not good?!  At least healthy municipalitiestheir borrowing rates improve as higher taxes lead the wealthy to shelter income from taxation.

7) Maybe Obama’s tax poicy could have more bite.  Close down tax havens.  This is something I can get behind.  I like low tax rates, but I don’t like the ability for some to lower their tax rates, and not others.  Let there be a level playing field in the tax code, such that there is no advantage to moving profits offshore.

Now, could Obama enact real tax reform that would be fair, and cause Buffett (and others) to pay taxes on his unrealized capital gains?  He could, but he won’t, because he is a slave of Democratic special interests.

8 ) I understand why the Treasury did it.  They wanted an opaque way of encouraging the purchase of weak banks by stronger banks.  So, they let them absorb tax losses of the acquired bank.  Too bad it is not legal, but legality doesn’t affect our government much these days.

9) Give Spain a hand — they managed to increase capital requirements on their banks during the good times.  Things aren’t perfect now, but Spanish  banks are in decent shape given all of the credit stress.

10) Why is the Fed funds rate so low?  The 75 basis fee point forces the effective Fed funds rate from 1.00% to 0.25%.  Though some see the Fed hemmed in here, I think that as they reduce the Fed funds rate, they will also reduce the 75 bp fee.

“Don’t just stand there.  Do something!”

“Don’t just do something.  Stand there!”

The first statement above is quintessentially American.  We are biased to action.  Terrorist attack?  Reaction: Go kill people who were tangentially related to the event, making everyone wary of attacking us again others think that we act with unreasonable blind rage.

Major companies on the rocks?  Act now to prevent certain disaster!  I don’t know — there are administrative remedies in the short-run that can be used to stave off insolvency, without immediately throwing money at the problem — appoint a conservator to get maximum value out of the company for senior bondholders while you wind it down (liquidate).

That’s the way I feel about AIG, GM, Ford, etc., companies that I have had a consistently negative view on well before the crisis began.  Why are we rewarding companies that took on way too much debt to finance their operations?  To save jobs?  Uh, nice thought, maybe, but you could do a cramdown in bankruptcy where everyone gets hit.  The senior debtholders would convert their claims to a reduced amount of new equity, and wiping everyone else out.

So when I read about AIG getting new loans from the US government, and reducing the interest rate on all of the debt, I go back to my initial statements regarding the bailouts.  When you make policy rapidly, you make mistakes.  This has been proven true with AIG.  Now, with the automakers, will we compound the mistake?

Let the automakers fail.  It is one of the few things that will might bring the unions to their senses.  The senior debtholders will bring in new management, and the unions, if they survive, will have to reduce their unreasonable demands that are out of sync with what other auto workers make in a competitive market.  Many auto workers would be able to keep their jobs, but at wages more congruent with the value produced.

The Humility of Realism

The above title is a play on a book title from a politician who deserves to be obscure, but has hit it big, much like Jimmy Carter.  But as Woody Allen said, half of life is just showing up.  By the humility of realism, I am trying to get across the idea that our government should slow down, take a step back, and think hard before acting.  Bring in the same old players experts who are disconnected from the “crisis” and let them consider with seriousness the depths of the problem that we are in.  We are probably facing a second depression.

From my perspective, depressions end when enough of the debt of the nation is paid off or liquidated, so that the financial system can once again issue moderate amounts of credit to high quality borrowers.  But the US Government is presently compounding failure with interest, adding to the total debt of the US by borrowing more, and giving the proceeds to companies that not only are special interests, but have proven that they cannot use it well.

The humility of realism would recognize that the US government cannot borrow its way to prosperity, but must act to conserve, admitting the faults of the past, recognizing that past policy has erred significantly.  I am not holding my breath here, waiting for that to happen.  I expect that the US government will proceed further down its present path, playing favorites with special interests, and continue to apply irrelevant “cures” in the hope that action will end the crisis.

As for me, I am puzzling over what would preserve value for me, and those that I care for in this environment.  That’s not a easy puzzle; in a depression, everything gets whacked.  But as I get more clarity, I will write more.

Links:

• Auto Makers Force Bailout Issue
• U.S. Throws New Lifeline to AIG, Scrapping Original Rescue Deal
• Time to pull the plug on AIG?
• (And, what will we do about the collapse that is coming in much of commercial real estate?  Not a happy scenario for the banks, and ultimately the taxpayers and others who get milked by the US government.)

Capital structure is relevant.  Promises are significant.  Contracts are definitive.

This will be short (it better be, I’m tired and want to sleep), but I have no end of friends asking me how bad it is out there.  First I tell them my opinion is a minority opinion.  Second, I tell them that debt-laden economies are inherently inflexible.  Third, I tell them that when the banks are compromised, ordinary monetary policy is useless, because there is no way to make a bank that is worried about its solvency lend more.  Fourth, even extraordinary monetary policy may not work, as the Fed tries to target lending markets, and finds that they can absorb bad assets, but can’t readily recycle them.

The aggregate capital structure of the economy is not a matter of indifference.  If there are many debt claims, and firms with debt finance other firms via debt, who finance other firms via debt, etc., then we set up a bunch of financial dominoes, where a disturbance can knock one down and carry others with it.

This is why the total debt to GDP ratio matters so much.  Economies stop functioning when they have high levels of embedded debt and a slowdown hits.  That is where we are now, at levels of Debt to GDP that exceed those of the Great Depression.  Until we get that ratio down from 350% down to 150%, normalcy will not return.  Air is leaking out of the debt bubble, and the ability to reflate is not there, because the market value of the assets have sagged to such a level that even a zero Fed funds rate will not raise the market value to the levels where the assets are booked.

People are not reliable; they sin; they default.  Economic systems that are primarily equity financed are better able to deal with the nature of man, because they have more flexibility.  Economic systems that are more heavily debt financed face more problems when someone cannot live up to his promises, because it means that others relying on the performance may not be able to live up to their promises also.

Things are different now.  In past economic cycles, there were sectors of the economy that could be stimulated by the Fed lowering the Fed funds rate.  But now, because of too many fixed committments, there is no sector of the American economy that can absorb more debt, and stimulate everyone else.

Thus the task of levering up falls to the Federal government.  But will they be able to honor all the promises that they have made?  Given that they control the printing press, the answer is yes in nominal terms, but no if in inflation-adjusted terms.

I’ve been beating the avoid the US automakers drum for six years now.  When I was a corporate bond manager, one of the first things that I did was sell 90% of my Ford and GM bonds that I inherited from the prior manager.  When I began writing for RealMoney, I wrote pieces like this:

David Merkel Open Letter to General Motors’ CFO By David Merkel RealMoney.com Contributor 12/9/2004 11:11 AM EST URL: http://www.thestreet.com/p/rmoney/davidmerkel/10198313.html

General Motors (GM:NYSE) BEARISH Price: $38.14  |  52-Week Range: $36.90-$55.55 GM should refinance at least half its 2005 and 2006 maturities while rates remain low. The company’s future is threatened by any increase in bond yields. Position: None

Sir: Though I am not as bearish as my friend Peter Eavis on the prospects for your company, I do want to give you some friendly, if unsolicited, advice: Refinance at least half of your 2005 and 2006 maturities while rates remain low.

With over $50 billion of principal coming due in the next two years, the future of GM (GM:NYSE) is threatened by any increase in bond yields. With the likely weakness in the dollar, yields on Treasury obligations are unlikely to remain this low, in my opinion. Further, though spreads for GM and GMAC are not at historically tight levels, spreads in the corporate bond market are at levels not seen since 1997. Take advantage of the demand (both domestic and international) for yieldy paper while you can. For that matter, do another convert deal. It may put a ceiling over your stock price (but, hey, isn’t there one there now?), but the convertible arbs will give you cheap financing while you figure out how to make your auto operations profitable (and design cars that people crave).

Though your ratings are stable from Moody’s and Standard & Poor’s at present, who can tell how long that will last? GM and GMAC debt are only one notch above junk at S&P, and I can tell you that you will have a hard time selling debt if you ever do get downgraded by S&P. Even if Moody’s leaves you an investment-grade rating, I will tell you that there is not enough buying capacity in the bond market for crossover credits of your size. Your yields would have to rise to the point where equity investors find your bonds an interesting speculation, as was true of auto bonds in mid-2002.

Further, do you want to be subject to the vicissitudes of your cousin Ford (F:NYSE) ? If they catch cold, you may too, at least in the eyes of the ratings agencies. But I digress.

It is always better to seek financing when it is offered, rather than when you need it. Your spreads are not going to get materially tighter, in my opinion, absent a partial refinancing that gives the bond market more confidence in how you will meet your short-term obligations.

I wish you nothing but the best, if for no other reason than as a U.S. taxpayer, I don’t want to bail GM or Ford out.

Sincerely,

David J. Merkel

P.S. To the CFO of Ford: This goes for you as well. The numbers differ, your spreads are currently tighter than those of GM, but you lack one thing that GM has. GM could sell the non-auto financing assets of GMAC in a pinch, which is presently a very valuable franchise that you don’t possess. Refinance while the bond market is friendly.

I also wrote pieces like this:

		David Merkel
		GM on “Death Ground”
		11/17/2005 5:15 PM EST

The last time I used the phrase “death ground” it was with respect to Fannie Mae. It engendered some confusion then so let me explain the term. “Death Ground” is a term from Sun Tzu’s The Art of War. It is when a General faces a situation where an army unit is in nearly hopeless shape, and the General manuevers the unit into a place where flight is impossible, so that the unit will fight to the death, because they have nothing to lose. Soldiers that motivated sometimes win; it is a last-ditch strategy.

That describes GM today. The CEO announced that in a letter posted on the Financial Times website, “I’d like to just set the record straight here and now: there is absolutely no plan, strategy or intention for GM to file for bankruptcy” GM faces a host of issues, revolving around legacy liabilities, poor design, poor marketing (reliance on sales, rather than everyday low pricing), high production costs, low flexibility, and high debt. Almost everything has to go right for GM to survive against much stronger competition; to me, that’s death ground.

That’s not an exhaustive list. Add into that the possible sale of GMAC, which is the crown jewel of GM, and you can sense the desperation. This is not a company to be playing around with on the long side; truth is, the world doesn’t need GM when it has Toyota. Maybe the US government will bail out GM the way they did Chrysler, but I really wouldn’t expect that.

Long GM debt was trading in the mid-60s this morning for a 12%-ish yield. It improved after the CEO’s statements this afternoon; the longs got a gift. I would take the opportunity to lighten up on long positions in GM stock, and any bonds dated past 2010. Take the $10-15 buck haircut off par, lest you have to settle for a recovery in the $30s five years out. (The 2036 7.75% zero-to-fulls are trading in the low $20s. Assuming an interest rate of about 7-9%, and a default 5 years out, that discounts a recovery in the mid-$30s.)

Position: short FNM, long TM

And this:

GM: Less Has Changed Than Meets the Eye, by David Merkel

6/30/2006 8:24 AM EDT

The story of GM over the past few decades has been to sell off desirable assets to fund the core auto operations, close factories and reduce jobs in North America. Its recent round of adjustments is only different because of the desperateness of the situation. Even with the labor concessions being discussed, GM’s cost structure will remain higher than most of its competition.

Consider the ratings agencies that are “inside the wall” and possess more information than other market participants. Even after the changes made, GM’s debt is rated Caa1 (negative outlook) by Moody’s and B (negative watch) by S&P. The ratings on GM’s debt reflect a highly speculative company with an uncertain future. The debt of GM, though the price is up from its lows still reflects significant uncertainty of full payment. Long debt trades in the mid-$70s.

We still don’t know whether the Pension Benefit Guaranty Corporation will go for the sale of 51% of GMAC. GM has only made a dent in the total liabilities that it faces in pension and health care (active and retiree). Does the PBGC want to lose a claim on one of the more valuable aspects of the firm should it go under?

Finally, sales have been disappointing, and discounting must be resorted to in order to “move the metal.” GM’s offerings have improved of late, but that might only be enough to get someone to buy a GM instead of a Ford. The improvements at GM don’t place the company on the same footing as Toyota or Honda from either a cost or marketability basis.

GM may be able to eke out a small GAAP operating profit in the short run from the changes made. It is still in a lousy competitive position against firms with stronger balance sheets and lower cost structures. My estimate of the long-run outcome has not changed. Avoid the stock and unsecured debt of GM.

P.S. At least GM is showing a little vigor relative to Ford (F:NYSE) , but that’s not saying much. Ford’s situation, if judged by the asset markets (stock, bond and credit-default swaps), has worsened relative to GM. Credit-default swaps now show Ford as more likely to default over the next five years than GM. What a mess.

At the time of publication, Merkel and/or his fund was short GM and Ford, though positions may change at any time.

FInally there is this piece four months ago, where I said: As I have said many times before GM common is an eventual zero.  Same for Ford.  All the errors in labor relations over the years, compounded with interest, are coming back to bite, hard.

Why throw good money after bad?  Why reward exceedingly lousy managers, and unions that have sucked the carcasses of the auto companies dry? Throw in $25 billion.  It won’t be enough.  Toyota and Honda are so much better managed, that they will win anyway.

In 2002, we let 20+ steel companies die.  The valuable assets were bought up, union contracts were torn up, and the industry regained sanity.  The industry is in much better shape today, and able to compete against the rest of the world.

We should do the same with the autos.  Let GM, Ford and Chrysler die.  Let Toyota, Honda, Daimler, Renault, Hyundai, Magna, Kirk Kerkorian (dreamer), etc., bid for the assets in bankruptcy.  Many jobs will be retained, though at fairer levels of compensation.  Remember my piece Rethinking Comparable Worth?  We are facing international comparable worth issues in labor in the auto sector now.

Before there were the possibilities with government bailouts, GM and Ford said they had more than enough cash.  But when the carrot of cheap financing is in front of them, they tell their tales of woe.  Examples from the media:

• GM, Ford May Step Up Pleas for Help as Obama Wins
• GMAC Posts Loss, Says ResCap Mortgage Unit May Fail
• The Cost of Saving GM and Chrysler
• GM’s `Time Is Very Short’ for U.S. Aid, Altman Says
• Auto-Industry Crisis Tests Obama
• Why GM Says Bankruptcy Is an Impossibility

I could add to the examples in other sectors — MBIA and Ambac seem to be  headed to zero as well.  Another set of examples of too much debt and too little transparency.

But to close on the automakers, I highlight the well-written article at the Curious Capitalist.  The companies are not as critical as their assets, which will be bought by others, and many of the jobs will be retained.  Any bailout will throw good money after bad, and will not preserve the auto industry here in the long run.

Full disclosure: long HMC MGA

There is a common error with contrarian investing.  It is not a question of identifying things that people believe that are wrong, but finding things that people rely on that are wrong.  Reliance is the critical component.  I don’t care about what people think if they don’t have any skin in the game.  When someone relies on a certain result happening (or not happening), then there will be series of behaviors that happen as what he believes in fails, from intensifying the bet in the early phases, to throwing in the towel in disgust at the end.

I’m going to take this idea and twist it a different way tonight.  One thing that the Democrats and Republicans (except Ron Paul) agree and rely on is that they know how to avoid a repeat of the Great Depression.  The textbook answer is:

• Easy Money
• Fiscal Stimulus
• Don’t Raise Trade Barriers

Ben Bernanke learned this as a young college student, and built it up in his Ph. D. dissertation.  He has the same moral certainty about this that George Bush, Jr. does about fighting terrorism.  And, I’m going suggest that Bernanke, and most of the political establishment (which hasn’t really changed in the last few days) are wrong.

What is a bubble?  My definition: a bubble is a self-reinforcing cycle where monies invested obtain a negative return in aggregate over the long haul.  It is characterized by significant borrowing at low rates to invest in already appreciated assets in order to profit from a momentum-driven market.  When cash flow is insufficient to pay the interest to finance the bubble, the bubble pops, and a self-reinforcing bear market ensues.  When that bear market encompasses most of the financial system, we call it a depression.

What is a depression?  A severe recession where the banks are impaired.  In an ordinary recession, lowering the Fed funds rate can stimulate the banks to lend.  Not so now; the banks are licking their wounds, and letting profits grow by financing at lower rates, and sucking in bailout cash to shore up their balance sheets against future real estate lending losses.

The Great Depression ended when the Debt to GDP ratio dropped below 150%.  When enough debts were extinguished by payoff or default, the system could once again be normal.  Virtually none of the efforts of FDR focused on eliminating debts; in my opinion, he lengthened and intensified the Depression by not encouraging the liquidation of bad debts.  And now we do the same thing.  We perpetuate the misallocation of resources by trying to keep house prices high, by bailing out institutions that should go through the bankruptcy process.  This fails to convert bad debts into equity in newly solvent businesses.

All the US government is doing is creating a bigger bubble.  What will happen when the Treasury auctions fail, or, stretch the yield curve so wide that there is panic.  We don’t want our financial institutions to fail, so we are willing to wager the creditworthiness of the nation in order to save them.  I don’t like that bet.  Many empires have died choking on debt.  Is the US to be next?

When I wrote articles opposing the bailout, I did so because I did not think it would work, and that one-off conservations/liquidations would be preferable, but not optimal.  Optimal to me would be using the bankruptcy code on a expedited basis, wiping out junior capital, and making senior capital take haircuts.

But in the present, we contemplate borrowing to bail out all manner of problems — bail out homeowners, automakers, banks, insurers, guarantors, etc.  The end to this phase will come when the creditors of the US write off their prior lending, and decide not to throw good money after bad.  I have no idea when that time will come, but the dreamy schemes of politicians aiming to solve every financial hurt will help to force such a time to happen.

I enjoyed the pieces by Felix Salmon and James Surowiecki, and Eddy Elfenbein on how stocks work.  I have reproduced their arguments here, together with my thoughts.

Felix Salmon: What’s the relationship, in theory, between a company’s return on equity, on the one hand, and its stock price, on the other? Does a high return on equity mean a rising stock price, or is it a rising return on equity which means a rising stock price? Or, to put it another way: if one company has an ROE which is (expected to be) flat at 4%, and another company has an ROE which is (expected to be) flat at 14%, would you expect the latter to rise more than the former, or indeed either of them to rise at all?

Jim Surowiecki: Your first question, unfortunately, can’t really be answered in the abstract. It’s perfectly possible for a business with high returns on capital to still be overvalued - that is, for its stock price to overestimate the cash flows it will generate over time. In that case, the fact that a company is generating high returns on capital won’t translate into an increase in its stock price. Microsoft’s average return on invested capital, for instance, is consistently good - above 25% — but its stock is just about where it was a decade ago.

This speaks to your second question, which is really about expectations. If the market is accurately forecasting the returns on capital of the low-ROIC company and the high-ROIC company, you wouldn’t expect the latter’s stock price to dramatically outperform the former. But assuming both are fairly valued, the high-ROIC company will have a much higher valuation, meaning it will generate more income for shareholders going forward (in the form of dividends, buybacks, etc.)

That’s why, all things being equal, you want to own shares of companies that generate high returns on capital rather than those of companies that don’t. This is, in a way, self-evident. If you put money into a company, you want it to use that money to generate high returns, higher than you could get elsewhere. That’s what companies that have high returns on capital do: Microsoft earns an additional twenty-five cents for every dollar it invests. By contrast, companies with low returns on capital create less value, and companies that earn returns that are lower than their cost of capital (as was true of Japanese companies between 1990 and the early part of this century) actually destroy value for their shareholders.

Eddy Elfenbein: A company’s share price is the net present value of all future cash flows. A company’s return-on-equity is a measure of profits for the next year relative to present equity, so the two are connected. However, a high ROE does not translate to a rising share price, but a rising ROE should. Regarding your question, I would assume that the market has discounted both stocks’ net present value which incorporates ROE. Therefore, I would only expect the stocks to rise at the pace of the risk-free rate plus the equity risk premium.

This may help: ROE can be broken down into three parts; profit margin, asset turnover and leverage. It goes like this:

Profit margin is earnings divided by sales. Asset turnover is sales divided by assets. Leverage is assets divided by equity.

Earnings……….Sales…………..Assets
—————X—————-X————–
Sales…………….Assets………..Equity

Note that the sales and assets cancel each other out to give you Earnings divided by Equity.

David Merkel: The question can be answered in the abstract, with some noise.  With a few assumptions/limitations as disclosed in this article, Quantitative Analysis is not Trivial — The Case of PB-ROE.  In most mature industries where capital constrains growth, there is a linear relationship between price-to-book and and ROE.    This is a result of the dividend discount model, given the assumptions of the article that I cited.

There is the inherent assumption that net worth is the limiting factor in doing new business.  If that is not the case, then the model does not work.  If sales is the limiting factors the equation becomes price-to-sales as a function of profit margins.

FS: What’s the relationship between stock price, ROE, and risk-free rate of return? Would one expect ROEs in a country with a zero risk-free rate to be lower than ROEs in a country with a higher risk-free rate? How does that feed in to stock prices, if at all?

JS: You would expect returns on invested capital to be lower in countries with lower risk-free rates (like Japan). Two reasons suggest themselves for this: first, the low risk-free rate may be indicative of lower growth prospects for the economy as a whole. But also, when the risk-free rate is low, the hurdle rate for corporate investments is also lower (because investors’ expectations of what counts as a reasonable return are also lower.) That may make companies more likely to invest in low-return projects. Both factors have something to do with why Japanese firms have underperformed over the last twenty years (and in particular in that 1990-2002 stretch). But I think the most important factors explaining the low ROIC of Japanese firms were their indifference to shareholder value and their willingness to invest in value-destroying projects.

EE: Again, a company’s share price is the net present value of all future cash flows. ROE is the best measure of the growth of future cash flows. How do we discount that? We discount it by the cost of capital which is risk-free rate plus an equity-risk premium. That’s why a lower risk-free rate tends to boost equity prices.

According to the Gordon Model, it should look something like this:

Price = Earnings/(Risk Free Rate + Equity Risk Premium - ROE)

DM: The risk free rate often has little to do with where corporations can source funds.  Eddy talks about the equity risk premium, but that varies over time.  At present that risk premium is high.  If the country in question is in a liquidity trap, like Japan, equity risk premiums are high.  In general, equity risk premiums are a free market, and disconnected from the “risk free rate” represented by short government bonds

FS: How can a company with a positive ROE destroy economic value for shareholders?

JS: The key to understanding how a company with a positive ROE can nonetheless destroy economic value is simply recognizing that equity is not free. It has a cost, just like debt does, a cost that reflects the return that investors demand as compensation for the risks and opportunity costs that owning equities entail. We can debate how to calculate that cost of equity (risk-free rate + market risk premium is a simple solution). But the basic principle is, as I said above, that a company is only creating economic value for its shareholders if it’s earning more than its cost of capital. Again, this is intuitive: if you were the part owner of a company that, on a risk-adjusted basis, was earning less than the yield you could get on a 30-year T-bill, you probably wouldn’t keep your money in that company, because you would effectively be losing money with every day that passed. Shareholders feel the same way, so the share prices of companies that earn less than their cost of capital are unlikely to rise over time. According to a study by the Japanese government, Japanese companies’ return on capital was below their cost of capital for roughly the entire decade of the 1990s through 2002. If you want to know why Japanese stock prices fell precipitously during that period, that’s the biggest reason why: the companies weren’t creating any value for shareholders. And what made it worse was that, as a result of the bubble, expectations were already inordinately high.

One thing I should say, though: Japanese companies have significantly improved their performance in the past five years, and there’s a strong case to be made that, as in the U.S., the recent sell-off of the Nikkei has been massively overdone. In fact, if you think that the transformation of Japanese firms in recent years will be long-lasting (I’m agnostic on the question), then the Nikkei looks very undervalued right now - or at least it did before it rose something like 15% in the last week and a half.

EE: All companies in all industries are in phantom competition with the cost of equity capital. Even though you can’t see it, you’re struggling against it every day. So even if a company manages to squeak out positive ROE, capital will not flow your way if you keep losing to everybody else.

DM: No disagreement here.  Companies must earn more than their cost of capital in order to add value.  This helps explain why low positive ROEs trade at a discount to book value.

=-=-=–==-=-=-=-=-=-=-=-=-=-

That’s all, and spite of all the discussion here, I own shares of  Honda Motors and the SPDR Russell/Nomura Small Cap Japan ETF,

Full disclosure: long JSC HMC