Perfect Storms

Recently my very good friend and InsideMoney editor, Dick Wagner, shared with me a posting he had received describing the views of Professor Nouriel Roubini of New York University’s Stern School of Business and founder of RGE Monitor. It highlighted aspects of current events that portended upcoming economic disaster.

Essentially, it listed eleven different qualities of the current US economy that, combined, constituted his view of the quintessential “perfect storm.”

I proceeded with alarm. Yet, as I read, I noticed those familiar sensations I often get when I encounter familiar territory. My subconscious whispered, “We have been here before.” I remembered the pain but I also remembered that the US economy did not go down on its knees! What is more, we survived and lived to write yet again about how the sky, once more, is falling! Perhaps it is also a good time to remind ourselves that healthy economies must go through these periods if only to cleanse their excesses. Not unlike various purification techniques, at the end of the day, these help us to maintain a healthy economic system, even if it can get a bit messy during the cleansing phase.

To do my own bit to buttress the celestial and keep our skies from falling, I think it is helpful to review Professor Roubini’s descriptions of these tempests comprising his “perfect storm.” In so doing, we can consider how we have experienced such problems before. (Please note: I have set forth Professor Roubini’s steps in an indented green “Verdano” font in order to distinguish his thoughts from mine.)

Step one is the worst housing recession in US history. House prices will, he says, fall by 20 to 30 per cent from their peak, which would wipe out between $4,000bn and $6,000bn in household wealth. Ten million households will end up with negative equity and so have a huge incentive to put the house keys in the post and depart for greener fields. Many more home-builders will be bankrupted.

“Step one” observation: So? It won’t be the first time. Remember the 80’s? According to the MIT Center for Real Estate, we had a 10 percent housing drop nationwide in the period between 1987 – 1991. Moreover, these national numbers were deceptively skewed. The coasts had it worse. New York City and California especially had declines in excess of 35% from their 1986 peak. If you remember, in 1984 when the Texas oil bubble burst along with the Hunt Brother’s attempt to corner the Silver Market entire subdivisions in Houston were foreclosed. 5,000 homes were empty and up for sale. Prices were as low as $5,000 per home or better, representing a 90% decline in prices. It got worse with the housing collapse of 1987.

Per a New York Times article, better than 10 percent of the homes in the Tri-State areas suffered foreclosure during the 4 year period. At the time, this was a record. To make matters worse, more than 10 percent of the homes had negative equities. Many home builders went bankrupt and per the US Census bureau 3,000,000 construction jobs evaporated during this time.

Frankly, this all sounds pretty bad to me! The actual numbers continue to elude me, but I recall that the equivalent of $4 to $6 trillion in household wealth was lost during this housing collapse of 1987-1991. Yet the world did not come to an end-- even though some heavy weights declared bankruptcy during this period like John Connolly, former governor of Texas and the two Hunt brothers

Step two would be further losses, beyond the $250bn-$300bn now estimated, for subprime mortgages. About 60 per cent of all mortgage origination between 2005 and 2007 had "reckless or toxic features", argues Prof Roubini. Goldman Sachs estimates mortgage losses at $400bn. But if home prices fell by more than 20 per cent, losses would be bigger. That would further impair the banks' ability to offer credit.

Well, that’s not all. During this same period, we had the Savings & Loan crisis. Per the FDIC’s web site over 205 Savings & Loans became insolvent and the federal government took on over $101 billion debt in 1987 dollars. Then to make matters worse, the banking situation further deteriorated as housing prices sank further. By 1989 President George Herbert Walker Bush created the Resolution Trust Company (RTC) because many of the Savings & Loans had borrowed money from money center banks. Many of them such as Shawmut, The Bank of New England became engaged in the funding crisis. In 1989 and 1990 RTC took over 531 financial institutions and assets in excess of $265 billion dollars. Over $153 billion evaporated; US taxpayers were stuck with a tab over $124 billion –paid for in taxpayer money. Per the inflation calculator this $124 billion in 1989 represents 2008 equivalent buying power of $736 billion. This fits the step 2 scenario outlined by Professor Roubini. Per the FDIC between 1980 and 1994, a total of 1,617 banks and 1,295 thrifts failed and were resolved. I don’t know about you, but 3,612 financial institutions going bust sounds pretty close to financial Armageddon. Yet we survived it!

Step three would be big losses on unsecured consumer debt: credit cards, auto loans, student loans and so forth. The "credit crunch" would then spread from mortgages to a wide range of consumer credit.

Again, we endured this same phenomenon during the 1980’s. Indeed, it was among the reasons for RTC’s creation. In 1980 the average credit card debt was $512 and by 1990 it had soared five fold to $2,500. With more than 200 financial institutions failing annually during this period, together with bankruptcies and general economic contraction, a credit card crisis occurred. The debt situation was so bad that General Motors, Ford and Chrysler’s consumer credit division were losing hundreds of millions of dollars. In fact, Chrysler, under the renowned Lee Iacocca, was technically insolvent. Corporate, government and private groups combined to save the company and thousands of jobs.

Step four would be the downgrading of the monoline insurers, which do not deserve the AAA rating on which their business depends. A further $150bn write down of asset-backed securities would then ensue.

Remember, these times? This was when an industry stalwart, Executive Life, went under. Moreover, you might also recall that Transamerica was basically insolvent at that time. The Japanese were telling us to get our house together and one of the “Back to the Future” movies showed Japanese companies controlling America. Federal Reserve backed the mono line insurers at that time to fix the problem quietly. Yet, we had these insurance companies failing at a rate not seen since the Great Depression.

Step five would be the meltdown of the commercial property market, while step six would be bankruptcy of a large regional or national bank.

During the same recession, many of us used such terms as “cellophane” or “see through” buildings to describe commercial properties that had almost no tenants. Remember Executive Life bought hundreds of millions of junk bonds financed through Michael Milliken and Drexel Burnham. Milliken ended up in prison while Drexel Burnham collapsed in 1989. These two factors caused many lenders to contract. Consequently, many other companies lost a major financing source. Not to put too fine a point on it, I suggest these were on the same scale, if not worse, than the current credit crisis.

Step seven would be big losses on reckless leveraged buy-outs. Hundreds of billions of dollars of such loans are now stuck on the balance sheets of financial institutions.

We saw that occur in the same period. Money center banks lent money to South American countries by the billions at usurious interest rates. By the late 1980s these countries were defaulting. The US banks then had to call in lines of credits of good American companies because their abilities to lend had contracted. As you might imagine, there was harm to the good as well as to the bad.

Step eight would be a wave of corporate defaults. On average, US companies are in decent shape, but a "fat tail" of companies has low profitability and heavy debt. Such defaults would spread losses in "credit default swaps", which insure such debt. The losses could be $250bn. Some insurers might go bankrupt.

We had that happen during the late 1980s early 1990s as well. Corporate balance sheets looked like garbage and many of the big companies were technically under water. Remember Chrysler under Lee Iacocca? He had the suppliers and the federal government shores up the company because it was insolvent and the economy supposedly could not tolerate the loss in jobs and the ripple effect of it going through bankruptcy. We had the railroads bankrupt and the oil companies consolidating because they could not turn a profit with the collapse in oil prices. Transamerica and many other insurance companies were technically insolvent. Executive Life did go under. Thousands of manufacturing jobs evaporated. US Steel and other rust belt companies went under, their pension plans requiring rescue.

Step nine would be a meltdown in the "shadow financial system". Dealing with the distress of hedge funds, special investment vehicles and so forth will be made more difficult by the fact that they have no direct access to lending from central banks.

In 1987 we had worse. The stock market basically imploded. Losses were so great the market was closed until the country could come up with a system. There were ferocious margin calls; shorting did lead to problems. In response, the government stopped the game and changed the rules. I think the same thing would happen again. Most likely, this would lead to strict hedge funds regulation. Remember also, we had companies with fancy derivative insurance programs that exacerbated the problems of the meltdown in October of 1987.

Step 10 would be a further collapse in stock prices. Failures of hedge funds, margin calls and shorting could lead to cascading falls in prices. Step 11 would be a drying-up of liquidity in a range of financial markets, including interbank and money markets. Behind this would be a jump in concerns about solvency. Step 12 would be "a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices".

All of us who survived that time remember how difficult it was to get a mortgage, start a business or receive a business bank loan because of the damage to the financial system and yet almost twenty years later the economy has grown many times further and we are again hearing the same fear mongering from the same fear mongers. We survived that contraction. I suspect that we shall survive this contraction as well.

So far, in comparison to the late 1980s, the problems we are facing today do not seem as dire. Now, make no mistake, I am not belittling the problems that beset us. Yet, as tough as these times are, I caution against panic. We will get through this and those of us who don’t lose our heads might even make a great deal of money at it! For example, I almost bought a house on Nantucket in 1991 for $250,000, if I had and kept it until today, I could have sold the same house for $2 million in 2008 despite the collapse in housing markets. We all know there are thousands of stories like that.

Money and the money markets are complex but they tend to resolve their own excesses. While we all enjoy times of irrational exuberance we know they are finite and fleeting. There are no free lunches. When we think there are, the markets remind us of this reality: We have been here before.

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