“I never give them hell. I just tell the truth and they think it’s hell.” – Harry S Truman.
The nature of the figures certainly concentrates the mind. At some point during 2007 / 2008, US federal government borrowing will break the $10 trillion barrier. Debt, of course, is not merely a sovereign issue – individuals are implicated too. The ratio of total debt to US GDP rose to more than 300% in 2005, beating the record of 290% just prior to the 1929 stock market crash. Also by 2005, over 13% of outstanding US mortgages were classified as subprime, compared to just 2.1% in 1999. Just as ominously, by 2005, mortgage-related activities accounted for a record 62% of US commercial banks’ earnings, compared to 33% in 1987 (another iconic year for the markets). Take demographics. In 1942, there were 42 workers for every beneficiary. By 2002, that ratio was down to 3.3. By 2030 it is expected to fall to 2.2. Or take the concentration of risk within ever-expanding derivatives markets. According to the US Comptroller of the Currency, as of Q4 2005 just five institutions (JP Morgan Chase, Bank of America, Citibank, Wachovia and HSBC) accounted for 96% of the more than $100 trillion of derivatives contracts outstanding among some 836 US banks.
These are just some of the figures cited by Michael Panzner in his recent ‘Financial Armageddon: Protecting your future from four impending catastrophes’ (Kaplan Publishing, 2007). In terms of timing, while one feels almost obligated to challenge some of the forecasts therein, the publication of ‘Financial Armageddon’ could hardly have come at a more relevant period during the evolution and possible dislocation of modern capital markets. Of the four bigger picture threats to the stability of the (US) economy to which Panzner refers, at least two – debt, and derivatives – are now the stuff of front page headlines, in the form of the ongoing malaise in the US mortgage market and the possible contagion risk represented by deterioration in subprime lending and CDOs. But it often seems as if one’s forecasts as to the severity of the crisis are straightforwardly dependent on one’s emotional bias: optimists can point to the widespread transformation and dispersal of derivative risks, for example, while pessimists can, erm, point to the widespread transformation and dispersal of derivative risks..
While one can take issue with Panzner’s conclusions (as Ben Graham said, markets in the short-term are essentially voting machines), one can barely fault the cogency and clarity of his argument. With all respect due to Wall Street professionals (i.e. none whatsoever), one need not be one of them to find Panzner an easy and engaging read. (Happily, there is not one chart, nor one use of ‘the greeks’, in the entire publication.) For Panzner, as for others in the financial community, the writing was on the wall during the post-2001 ‘recovery’:
“The personal savings rate had fallen below its lowest levels since the 1930s, indicating that Americans were not socking away anything for a rainy day. Even if they wanted to save, the data suggested it would have been a challenge. Between 2001 and 2004, inflation-adjusted average family income fell by 2%, lagging far behind the prior 3-year period’s 17% increase.. Family income also trailed a double-digit gain in gross domestic product.”
It is now recognised that over recent years labour has increasingly lost out to capital in the global economy. Panzner takes pains to point out that there may be real social tension ahead, particularly if policy makers revert to type and behave according to the dictates of political expediency rather than urgent social need.
Ronald Reagan famously remarked that the nine most dangerous words in the English language were: “I’m from the government and I’m here to help”. If Panzner’s market and economic dislocations come to pass, future historians will spend some time debating the role played by the Greenspan Fed and particularly the first George W. Bush administration in deferring the inevitable by means of overly easy monetary policy and questionable tax cuts. Regardless, the US housing market seems likely to be the precursor of less auspicious times ahead:
“Those struggling on the lowest rungs of the ladder will almost certainly bear the brunt of the early economic carnage. With an average of $3,800 in the bank, $2,200 in credit card debt, a $95,000 mortgage securing a $160,000 home (soon to be worth far less), and household earnings of approximately $43,000, the typical American family, as described in the Fed’s 2004 consumer finance survey, won’t have a lot of room to manoeuvre. For those in more difficult circumstances, like the 10% of owners with zero-to-negative equity in their homes, or the almost 30% of buyers whose mortgages either equal or exceed the value of what they own, the situation will be especially precarious.”
Panzner rounds off his fifth chapter with a summary of ‘Economic Malaise’: property prices are severely pressured by rising defaults; credit markets seize up (shades of 1998); with rising volatility across stock, bond and derivative markets, “the financial system will seem under siege”, with an uncontrolled rush of speculators and banks scrambling to sell variously illiquid and risky holdings. And then in Chapter 6, ‘Systemic Crisis’ – it gets worse. Panzner cites the long queues that formed at American gas stations in the summer of 1979. Many believed they were caused by a shortage of fuel. The reality is that queues (and panic) begat more queues, more panic. The total inventory of petrol in the system remained almost constant. But the actions of nervous drivers moved it from below-ground tanks at gas stations to vehicles’ fuel tanks.
A more potent image might be of the citizens of Bedford Falls besieging the Bailey Building and Loan in a desperate attempt to get their money out - before everybody else. By the time modern markets remotely approach the level of ‘Systemic Crisis’, we will have seen the essential weakness of fractional reserve banking and the ubiquitous spread of (un-stress tested) complex derivatives. Modern finance, not to mention fiat currency, is dependent on a fundamental platform of confidence. When confidence in the system goes, all bets are off.
In Panzner’s dystopian future, having been unwilling or unable to act forcefully earlier on, and with an orgy of credit expansion fast unravelling, the Federal Reserve gives up any pretence of restraint and moves “wholeheartedly into money-creation mode”. Which brings hyperinflation and then economic, financial and social chaos. European and Asian readers can speculate (not necessarily the right word) as to just how localised massive US financial problems might remain in a global economy. And the proposed palliatives will also require fleetness of foot: while hoarding cash and portfolio diversification might serve in a disinflationary bust, spending cash like a drunken sailor on real assets is about the only sensible answer to a hyperinflationary crisis. How likely are these outcomes ? Nobody working in modern financial services could claim to give a truly objective or unself-interested answer. But forewarned surely helps to be forearmed – and ‘Financial Armageddon’ makes for a refreshing change from the complacent happy-talk that passes for much conventional commentary.