Sunday, March 27, 2005

Limits, triggers, and jeremiads

Over the last several years, I’ve contributed to the jeremiads on the woes that will befall us due to excessive government and consumer debt. So far, these jeremiads have been wrong – or more precisely, they have laid out a gloomy future without specifying the timing or the triggers that would unleash this cascade of gloom.

Over the last couple of decades, there have been many localized burst bubbles, including these four:

  • S&Ls. In 1988, the US government bailed out the Savings and Loan (S&L) industry at an ultimate cost of $600 billion. The S&L collapse resulted from 1980 to 1982 deregulation which raised the size of individual deposits insured by the US, lowered S&L capital requirements, reduced the number of S&L regulatory staff, and permitted S&Ls to diversify into new businesses such as real estate investment. Small S&Ls expanded by taking brokered deposits which paid high interest rates and were insured under the new regulations. S&Ls invested these deposits in real estate and other risky financial assets whose yields exceeded the deposit interest rates. In order to maintain their “hot money” deposits, S&Ls reached for ever higher loan rates until the borrowers defaulted – causing the deposit rates to exceed the loan yields. The trigger for the S&L collapse was the cumulative impact of 1987 losses at Texas S&Ls which comprised more than 50% of all S&L losses nationwide – of the 20 largest losses, 14 were in Texas. The Texas economy was in a major recession: crude oil prices fell by 50%, office vacancy exceeded 30%, and real estate prices collapsed.
  • Japan. Japan. Between 1975 and 1989, Japan’s Nikkei average rose 700% from 5,000 to 40,000 only to lose 75% of its value over the subsequent decade. The value of the Nikkei climbed fastest during the 1980’s, as the world feared that Japan’s economic productivity would cause it to take over the world economy. Japan became the world’s largest creditor and had the highest GDP per capita. Japanese corporations built skyscrapers in Tokyo and Osaka. Between 1986 and 1988, the price of commercial land in greater Tokyo doubled. Real estate prices soared so much that Tokyo alone was worth more than the United States. To cool the inflated economy, the Japanese government raised rates. Within months, the Nikkei stock index lost 30,000 points because so many people had borrowed to invest in the Nikkei using Japanese land as loan collateral. Japanese housing prices plummeted for 14 straight years. The Japanese government and corporations are still suffering under unwieldy debt loads taken on since the late 1980’s. This debt was used for stock speculation and buying overpriced land. Even today, the Japanese economy remains in the doldrums.
  • Long-Term Capital Management. In September 1998, Greenwich, CT-based hedge fund Long-Term Capital Management (LTCM) ran out of money and was rescued in a $3.75 billion bailout by lenders such as Deutsche Bank, Barclays, Chase Manhattan and JP Morgan. LTCM borrowed massively so when Russia effectively defaulted on its short-term GKO bonds in August 1998, LTCM’s capital dropped from $4.6 billion to $250 million as lenders tried to get their money back from LTCM. LTCM’s use of borrowing expanded its exposure to $80 billion, 17 times its capital. If the New York Federal Reserve had not stepped in to organize a bail out, LTCM’s collapse would have a more wide-ranging economic impact.
  • Dot-com. In March 2000, the NASDAQ peaked at 5,048 only to plunge 3,000 points in the subsequent year leaving NASDAQ 60% below its peak in March 2005. Venture capital flowed into the Internet sector after 1995’s successful IPO of Web-browser vendor, Netscape. By January 2000, things were looking toppy when internet service provider America Online proposed to buy Time Warner for $166 billion in AOL stock, 350 times the combined company’s net income. But the dot-com collapse was probably triggered by Burning Up, a March 18, 2000 Barron’s article by Jack Willoughby, which detailed how 200 publicly traded dot-com companies would run out of cash within a year. The stampede for the exits, magnified by massive amounts of margin-driven selling of dot-com stocks, wiped out trillions in market value, hundreds of thousands of jobs, and millions of employees’ retirement funds.

What can these examples teach us?

  • Economic bubbles generally start with the germ of a good business idea, but high initial returns attract so much capital that the amount of money invested exceeds the number of worthy places to invest it;
  • Signs of an impending collapse are widely known before the event that triggers the collapse. What is scarce is the willingness of investors to act on the early warning signals;
  • The event that triggers the collapse is always unexpected but not incongruous – particularly when looking at the collapse with the benefit of hindsight; and
  • Lenders generally pull the bubble-popping triggers. When a collapse in collateral values spurs a margin call, the waves of panic selling reverberate loud and long.

What are the implications for our current state of economic affairs?

  • Real estate and the US Federal Government could be candidates for bubble bursting
  • Early warnings on real estate include a March 25th New York Times article on real estate as the new dot-coms;
  • Ominous comments abound on the current account deficit exceeding 6% of US GDP; the record $413 billion US Federal budget deficit; the declining dollar; the lifting of the debt ceiling to a record $7.84 trillion; and 50% dependence on Asia and other foreign countries to finance this debt; and
  • Last week’s Fed comment about inflation could be the first warning shot of rapidly rising interest rates which could trigger a collapse since Real Estate and the Federal Government’s ability to carry so much debt depend on low interest rates which could vanish quickly if the Fed decides it needs to fight inflation more fiercely.

I still don’t know what might trigger the next collapse or when it might happen. But it won’t be different this time.


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