I just read an interesting article on how the current crisis developed from a historical perspective. Its “Wall Street Lays Another Egg”, Niall Ferguson, 11/17/2008 at vanityfair.com. Here’s my summary:
1. Prior to the 1930’s, only a small minority of American’s owned their homes.
2. FDR decided that home-ownership was a national goal. He created Fannie Mae in 1938, which would issue bonds to buy home-loans from S&L’s (Savings and Loans). Savings and Loans were highly regulated on what they could charge for loans and pay for deposits and could not lend to borrowers more than 50 miles from their offices. Loans of up to 80% of the home’s value for terms as long as 15 years were suddenly available. Home-ownership increased from 43% to 62% from 1940-1960.
3. In 1968, Ginnie Mae was spun off of Fannie Mae to cater to poor borrowers. Fannie Mae was privitized as a GSE and in 1970 Freddie Mac was created to compete with it. In 1977, the community reinvestment act pressured banks to lend to poor, minority communities.
4. High inflation in the 70’s caused Savings & Loans big trouble, they were in danger of going under. Both the Carter (1976-80) and Reagan (1980-88) administrations tried to salvage the S&L’s through tax breaks and deregulation.
5. In the early 80’s, almost all restrictions on lending for the S&L’s were gone – stocks, junk bonds, private equity and real estate projects were all fair game. The FDIC protection of deposits was increased to $100k and S&L’s were now allowed to raise money through brokered deposits from middlemen with higher yields – essentially a government guaranteed loan. The race for risky bets on the government’s dime created a big credit bubble, which burst by 1989 causing 1,047 S&Ls to go bankrupt or be reorganized through a government program.
6. In 1983, Saloman Bros. created the first CDO – bundling mortgages, traunching them & selling to investors. This helped lead to the new model following the S&L crisis, with a combination of big banks holding mortgages, selling mortgages to Fannie and Freddie, and the growing use of mortgage-backed CDO’s as an asset class.
7. In the 1990’s, the use of derivatives was growing strong and the Black-Scholes equations for option pricing led to the hedge fund LTCM, the first of the quants. LTCM had spectacular gains, but only lasted 4 years before their model started to fall apart, following the 1997 Asian financial crisis and 1998 Russian debt default. The protection from the model was supposed to lie in diversification, with the idea that the not all assets could correlate and go down at once. Despite the apparent weakness of the assumptions, the tech boom and computing power combined with LTCM’s performance during operation led to a much more widespread use of quants and mathematical models for investing.
8. The tech bubble burst in 2000, followed by low fed rates for an extended period. in 2003, Bush signed the American Dream Downpayment Act to subsidize low-income first-time homebuyers and reaffirmed that it is our national interest that more people own their own home. Subprime loans were pushed and collateralized into CDO’s. Alt-A loans were expanding as well and mortgage standards were going out the window, with zero-down morgages to people without checking income or assets, loans with floating or teaser rates, and so on. These were bundled into CDO’s and sold like everything else.
9. From 2000-2006, the share of undocumented subprime contracts went from 17% to 44%. Credit-Default Swaps (insurance against the CDO’s failing) and other derivatives were expanding as well, creating an enormous financial bubble. In 2006, with a world-wide GDP of $48.6 trillion, we had $50.6 trillion in stocks, $67.9 trillion in bonds, and a notional value of $400 trillion in financial derivatives. Note that many financial derivatives can be offsetting so the effective size is likely smaller than $400 trillion, but it is still an enormous amount.
10. Home prices stabilize in 2006, then start to decline. Negative equity makes it a downward spiral as foreclosures increase. Banks fail and recession hits. Higher unemployment makes things worse.
11. The article ends in November 2008, right about here, with a question: Is there another credit bubble that can build onto the last one and lever up consumer balance sheets further, or are we going to have to endure a sharper downturn and let these balance sheets shrink? Household debt to disposable income was 40% in 1952, 90% in 1997, and 133% in 2007. Similar stories for bank leverage.
Here’s the continuing story from my own account:
TARP and TALF were created and used to bail out financial institutions in an ad-hoc manner. HAMP did very little besides build up piles of applications from distressed mortgage borrowers. Some businesses are effectively nationalized like Citibank, AIG, and General Motors. In March 2009, a big reform changes the mark-to-market accounting rule to mark-to-model, allowing banks to stop writing down losses and thus meet capital requirements. The Fed triples the size of its balance sheet in 2009, buying a lot of mortgage-backed securities huge amounts of general debt of Fannie Mae and Freddie Mac, and a range of US government bonds. Fed rates are set to remain near zero for an extended period.
Easy money and massive government stimulus leads to a slight recovery. Stock prices soar, but mainly through hedge-fund buying as individual investors switch more and more to bonds (likely a deliberate asset-class shift as the boomers near retirement and nurse their losses in stocks and real estate). Big regulatory (Dodd–Frank Wall Street Reform and Consumer Protection Act) and tax (Patient Protection and Affordable Care Act or Obamacare) bills are passed creating uncertainty for business investment and hiring.
Government debt becomes a big issue in 2010, causing major problems in Europe. Some of the peripheral Eurozone countries experience outright deflation. A huge bailout package for indebted countries is created, and the European Central bank begins buying bonds. Japan is still having problems with deflation, and their central bank recently purchased US government bonds to halt the Yen’s rise, hinting at further purchases if the Yen’s strength continues. Many European governments are turning to contractionary economic policy (higher taxes and lower spending). The US is likely to follow suit as the deficits are seen as a big issue to voters.
I still believe that after all these decades of consumer, financial and government balance sheet expansion that we’ll have to suffer through a slow period while much of this debt is liquidated through a combination of paydowns and default. This will be a strong deflationary pressure (good for bonds), which the Fed will fight with balance-sheet expansion (good for gold, as it acts more like a currency). There is likely further balance-sheet expansion from the central banks for the Euro, Yen and Pound which will also be very good for gold.
I also believe that many institutions are still incorrectly basing this recession (recovery? depression?) on mathematical models of post-WW2 recessions which don’t have the same root causes and won’t follow the same path (they predict speedier recoveries). This means we are likely to see GDP estimates from many firms come down in 2011 just as they did in 2010, along with earnings estimates and stock prices. Note that Bernanke in his speech also gave additional signs of concern about conditions slowing. Don’t buy puts or short based on macroeconomic analysis though – I made that mistake in late 2009, and I have to admit I felt better seeing how many big investment firms lost money betting on the recent stock crash in 2006 or betting on the tech bubble bursting in 1997 and 1998.
Commodities such as oil will have upward pressure from fed actions with the dollar, but downward pressure from a situation of oversupply and weak demand, and I’m thinking big gains are unlikely for a few years. Oil does have potential game-changers, like an Asian economic miracle or middle-east turmoil and supply concerns, but they are difficult to predict. Silver is popular, but it is less liquid and more volatile than gold – and it’s really better suited for traders than investors. Best to stick with the combination of gold and diversified bonds with decent yields (not AAA and treasuries, but not junk bonds either) for the next few years.