Apple Days Are Here Again

“The Wall Street of 1932 was a dismal ghost town. Securities firms declared “apple days” – unpaid vacation days each month that enabled destitute brokers to go out and supplement their income by selling apples on the sidewalk. Apple vendors appeared at the Corner. Downtown real estate was so depressed that building companies defaulted; astute investors who bought their bonds became the future owners of Wall Street. The misery extended everywhere. Riverside Park was lined with Hoovervilles, and sylvan retreats in Central Park looked like ragged hillbilly hollows. On Park Avenue, ten-room apartments that had been occupied by financiers of the twenties now lacked tenants. The new, half-occupied Empire State Building was mocked as the “Empty State Building”.”

-      Ron Chernow, ‘The House of Morgan’  (with thanks to Stratton Street’s Andrew Clark).

This writer can state from personal experience that the perception of time spooling out in slow motion, with all the details of one’s surroundings given a sharper focus, really does occur just before the impact of a car crash. According to scientists, as the brain area called the amygdala becomes more active, it lays down a dense second set of memories; because these memories are more intense and extensive than normal, they make it appear after the fact that the incident lasted much longer than it actually did.

So time seems to slow down in a crisis, even as we speed to that impending collision. Such has been the case in debt markets for some six months now. The inevitable bust in credit markets (call it subprime if you will, though the problem is altogether more systemic) first started revealing its cracks in late 2006 – with a sharp rise in US home foreclosures – but it took another half year before investors woke up to the brave new reality, or managed to join the dots. Some commentators have resolutely clung to their half-full glasses by suggesting that the US will avoid the recession it’s probably already in because economic expansion is always killed by the Fed – which is now busily lowering short rates. But the debate is more than usually academic: it was higher rates that put the sword to the credit bubble – so traditional boom and bust dynamics still apply – but those rates were hiked by the Fed back in early 2006 (when the Fed Funds target rate was raised from 4% in November 2005 to 5.25% in June 2006). Not, perhaps, a dramatic tightening – but enough to kill off a sufficient number of overborrowed home owners barely able to finance their original teaser rates let alone the refixes, and to trigger in turn the defaults that started, effectively, a run on CDOs and MBS, and then on interbank liquidity, Northern Rock et al.

So far, so history. The fact that the ‘originate and distribute’ model has perversely left banks still holding a largely unpriceable nursery of toxic babies – and that, more than a little awkwardly, the Anglo-Saxon housing markets are simultaneously in retreat – now means that a forced deleveraging by the financial community will lead to ongoing risk aversion by the banking sector and punitive borrowing rates for those entities and individuals able to secure credit of any kind. This is what the start of a recession looks like – whether in slow motion, or not. Unfortunately, the UK boomsters now occupying investment banking dealing rooms have been reared on 60+ consecutive quarters of growth. Most of them have never seen an economic contraction, much less a severe one. That may partially account for the air of unreality and denial pervading stock markets, even as banks, homebuilders and now retailers get selectively taken out and shot.

While equity markets are experiencing a slow motion crash as the dead hand of reverse leverage slowly but inexorably does its work on the consumer economy, it is a marvel to see history repeating itself so precisely from previous debacles. In his account of ‘The Great Crash’, J.K. Galbraith wrote that

“As reverse leverage did its work, investment trust managements were much more concerned over the collapse in the value of their own stock than over the adverse movements in the stock list as a whole. The investment trusts had invested heavily in each other. As a result the fall in Blue Ridge hit Shenandoah, and the resulting collapse in Shenandoah was even more horrible for the Goldman Sachs Trading Corporation..”

Other than the crisis of 2007/8 being a debt rather than an equity debacle, there are few real distinctions. Same circus, different clowns. This time round, as apparent self-preservation wins out over maintaining orderly markets (the interests of clients having long been discarded), the complexity of the products and the inherent interdependency of Wall Street means that supposedly self-interested firms have been shooting their own feet off as they struggle to stay upright. As Bloomberg’s Yalman Onaran reports, Merrill Lynch (for example) sold hundreds of millions of dollars of CDOs to Bear Stearns hedge funds. Merrill Lynch also loaned some 90% of the face value of the CDOs to Bear Stearns. (This sort of vendor financing was also well deployed during the TMT boom and it didn’t end much better then.) When the prices of those CDOs started to fall, Merrill Lynch demanded more collateral in the form of margin calls (payback, some suggest, for Bear Stearns’ non-participation in the bailout syndicate for LTCM in 1998 that included Merrill Lynch). Bear Stearns responded that a fire sale of their CDOs would push down the prices of everybody else’s. Intransigence reigned. The resultant fire sale subsequently detonated beneath the $23 billion of CDOs that Merrill Lynch itself owned. In the financial markets equivalent of Mutually Assured Destruction, Bear Stearns’ hedge funds run by Ralph Cioffi, goaded there partly by Merrill Lynch, declared bankruptcy, but at the price of triggering a $7.9 billion writedown (so far) and a CEO departure for Merrill. At the risk of stretching a metaphor, one assumes that unlike investment banks, international arms dealers at least try and sell down their inventory before seeking new victims. In this playground of the Wild West, Sovereign Wealth Funds have ridden to the rescue – according to conventional wisdom – but are in no position to magic functional markets back into being. Few tears should be shed for Wall Streeters facing the 2008 equivalent of “Apple Days” – this is a market for grown-ups who have tended to be well paid even as their employers haemorrhage capital – but whether politicians will be charitable to investment bankers facing accusations of ‘breaking’ the real economy, not least due to a wholesale abandonment of ethical principles, is another question. Two questions for those investors scooping up “cheap” banking stocks: assuming that current dividends are maintained, when do you expect future revenues from debt structuring and mortgage-related issuance, say, to return to 2007 (or 2006) levels ? In your lifetime ? Does your assessment of current valuations take any account of a conceivable wider deterioration in related credit businesses ? And does the reputational damage to investment banking brands inflicted by the various facets of the credit boom and bust make the swift return of 2007 (or 2006) revenues more or less likely ? If you answer anything other than “less likely”, do you think you deserve to have any customers ? (This is a game staff at credit ratings agencies can also play.)

We now know that retailers are falling off the ugly tree and, as a whole, hitting every branch on the way down. Patrick Perret-Green of Citigroup separately points to the growing risk of non-residential property to the broader economy: “With credit no longer easily available and a large construction pipeline set to hit an increasingly vulnerable market, activity is set to cool rapidly.” Leverage in reverse still has a few more victims to strike down. All of this is in plain sight, as it were, but the outcome will likely take months if not longer to play out.

Other potential outcomes ? In a severe Anglo-Saxon economic contraction (which bond markets have been pricing in for a while but which would still come as new news to equities), western government bond yields could yet decline close to Japanese levels. (10 year JGBs currently yield less than 1.5%. Now that’s deflation.) But as central banks finally and belatedly realise that the financial sector is undergoing a crisis of solvency rather than just liquidity, all bets are off when the pumps finally get primed – and the deflation / inflation cycle finally swings round, explosively, to the latter. A Japan-style “lost decade” is a remote likelihood, as western finance lacks the baroque cross-shareholdings of the zaibatsu; but banking shareholders (SRM and RAB take note) will likely have to learn to take their lumps along with everybody else. And given the 1930s experience, one shouldn’t ignore the potential in a severe crisis for politicians to do extraordinary things (renationalisation ? state appropriation ?) to save their hides. It would be ironic if, just when capitalism seemed to have won the global battle for consumer hearts and minds, its venal banking sector had sown the seeds for its own destruction and replacement by a newly resurgent spirit of socialism and protectionism. Financial assets – in a world of fractional reserve banking and fiat currencies – are ultimately only as strong as the confidence of the environment that nurtures and tolerates them. Having long behaved as if untethered by any moral or social accountability, Wall Street and City interests can be forgiven for looking wistfully on as investors vote – as they have already started to – in favour of the supreme fiscal independence of gold and of hard assets more generally.

The song “Happy Days Are Here Again” was played during Franklin D. Roosevelt’s successful presidential campaign as a Democrat in 1932, in the aftermath of a stock market collapse - exacerbated by too much leverage - and in the midst of an economic depression. To what extent could history repeat itself in the months ahead ? It would be nice to think that we avoid the worst case scenario hinted at above. But capital preservation and absolute return investing is primarily about preparing for the worst case even as one anticipates ultimately more favourable outcomes. In any event, investors will not be well served by portfolio managers blithely pursuing the same old equity / bonds / cash paradigm or committing to a long-only investment style contingent on continued economic expansion. The game has profoundly changed. Portfolio managers would do well to recognize that fact.

Comments

[Andy G]

An enjoyable post, thank you :o)

[Teri Pittman]

The only question I have is why do you refer to it as an Anglo-Saxon crisis? The Spanish real estate market is tanking. There are housing bubbles in Eastern Europe. It's possible that their bankers are playing games too.

[tim price]

Quite possibly - but the reason I view this as primarily an Anglo-Saxon crisis is that the US and UK economies are at the epicentre of softening residential / commercial property prices and financial services / investment banking, and there seems to be greater evidence of sudden consumer reversals there than elsewhere.

[Charles Butler]

Teri,

I think the distinction is valid. The boom and bust aspect of cycles, in my experience, is more pronounced in the Anglo economies. Something about a cultural insistence that the future be demonstrably better than the present would be my first guess...