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Mark's Market Blog

1-6-09: Banking Crises

By Mark Lawrence

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The stock market continues its bear market run-up, with impressive gains over the first few trading days of 2009. It does this in the face of auto sales collapsing world-wide. In the US, every major manufacturer is reporting deep losses, with Chrysler shutting down their factories for an entire month and even Toyota shutting down for a couple weeks. It's getting harder every week to see Chrysler surviving as an independent company; I think they will have no choice but to merge with GM or evaporate.

CompanyDecember Sales Decrease

Obama is working hard on a $800B stimulus package. He's included an estimated $35B in tax cuts for businesses, much of which looks to me to go to the housing industry and Wall Street. He's also including an estimated $75B in tax cuts for people making less than $200k per year. These are said to be included to attract Republican votes - Obama considers it important to pass this legislation quickly with bi-partisan approval. In any case, right now the market is loving it.

Two university economists, Carmen M. Reinhart U.Maryland and Kenneth S. Rogoff Harvard have published a very interesting pair of papers; I'm going to be talking about these papers now. The papers are Banking Crises: An Equal Opportunity Menace and The Aftermath of Financial Crises. All of the charts below are taken from these papers. The central questions they have attempted to ask are "Is the current world financial crisis historically unusual," and "What is this crisis likely to look like as it unfolds." Their basic answer is that banking and financial crises happen with rather disturbing regularity, there's nothing really unusual about this one; and this crisis is likely to last much longer and be significantly deeper than most people are currently projecting. Our experience in the last 50 years with various recessions is not likely to be a good guide to what will happen next: this crisis is qualitatively different than a more typical six to twelve month downturn in the business cycle.

First, we ask "is this banking crisis unusual?" Before WWII, governments had few supervisory departments watching the money supply or the various markets, so after 1945 we might think that banking crises were substantially prevented or at least better managed. We've heard a lot of talk in the last decade about the "new economy" which is immune to profits, downturns, risk. . . it's all managed by the Internet, a bunch of 20-something computer wiz kids, and Wall Street's new discovery, Rocket Scientists and managed tranches of risk. In the table below we see a summary of banking crises in various regions. The crises are averaged from 1800 to the present, and separately from 1945 to the present. A quick look will assure you that while we have perhaps gotten a bit better at managing our banks since WWII, it's a only a bit better at best.

Frequency of Banking Crises 1800 to 2008
Region % years in a banking
crisis since 1800
% years in a banking
crisis since 1945
# crises per country
since 1800
# crises per country
since 1945
Africa 12.5 12.3 1.7 1.3
Asia 11.2 12.4 3.6 1.8
Europe  6.3  7.1 5.9 1.4
Latin America 4.4  9.7 3.6 2.0
North America 11.2 8.6 10.51.5
Oceania  4.8  7.0 2.0 1.5
Advanced  8.3  7.0 7.2 1.4
Emerging 10.8 10.8 2.8 1.7

In a typical banking crises, there is a bubble in stock shares and housing prices. This bubble is significantly fueled by a large inflow of money from foreign countries: foreign investors are looking for the hot investment. When the bubble bursts, that money inflow not only dries up, but is pulled out of the economy by foreigners. The banks run out of capital and stop lending money. Businesses slow and lay off workers, who take a triple hit as unemployment raises, the value of their houses and investments drops, and credit becomes extremely tight. This describes most of the 200 banking crises investigated by Reinhart and Rogoff. It also paints a pretty compelling picture of the US in 2007 and 2008. There was a huge inflow of capital due to the trade deficit, where foreigners traded manufactured goods for US treasury bonds, US stocks, and US properties.

Historically countries in a banking crises have property values drop. It's my opinion, shared by many, that our current financial crises started with sub-prime mortgage failures and is deeply related to housing prices. In the graph below, we see the total house price decline in 21 banking crises, six of the 21 current and not yet complete. The average of these crises is a 35% decline in housing prices over a period of six years. I think the peak of the housing market was in roughly June of 2006, so we're likely not quite half way into our price decline. We should expect that housing prices will not bottom out for another two to four years. The US average so far is about a 27% decline, so country wide we're about three-quarters of the way there. Historically house prices decline to those established roughly four years before the peak, so we should expect the bottom to be at prices established in the summer of 2002.

Banking crises are also reflected in stock market prices. Below we see a chart of the stock markets in the aforementioned 21 crises, 7 of them current and ongoing. You can see that poor Iceland is really taking it on the nose. At this instant, the only positive thing about living in Iceland is that no one is going to travel there to kick you out of your house. The average loss in the market is 56%, the bottom coming 3.4 years after the top. The top of our market was a Dow of 14,164 set on Oct 9 2007. A 3.4 year long decline of 56% would have our market bottoming out in March of 2011 at a value of 6230. A 65% decline would not be astounding, and this would mean that our low would be a Dow of 5000. Those who think that the bottom set on Nov.20 2008 of 7550 is an actual bottom and we're now at the start of a long slow recovery, well, I can only say that your optimism is most charming, and ask how that's working out for you. Only three of the 15 crises studied hit their bottom in two years, none hit their bottom in one year, which is where we were on Nov.20 2008. No one can know the future, but it seems clear we have a longer road ahead of us.

Unemployment in a banking crises is somewhat more variable. Before our bubble burst, in the summer of 2007, our unemployment rate was about 4.5%. A typical banking crises historically has lead to unemployment topping out in three to six years, and increasing by 5% to 12%. So, we expect our unemployment to be at its worst somewhere between summer 2010 and summer 2013, and our peak unemployment to be somewhere between 9.5% and 16.5%. The average would have us hitting our peak in the spring of 2012 with unemployment of 11.5%. There is a lot of pain and suffering ahead of us.

As our government tries to deal with this crisis, they will find themselves spending more in their role as the Keynesian spender of last resort, and also they will find that as employment drops tax revenues will decline dramatically. In this country we live on the income tax; if there's no income, there's no tax. Between Obama's planned stimulus of $800B and the projected decline in tax revenues, we can expect to nearly double our national debt. Currently our national debt is about $10 trillion. We can expect that in the next three years, our national debt will climb to roughly $18 trillion. This is not at all hard to believe - in my blog of 12-5-08 I showed that we had already loaned or spent about $7.4 trillion on this crises, with another $1.5 trillion planned as of today. It's easy to believe that we're not done loaning / spending money, and that some of this money will never come back.

Finally, although we've been having some fun thinking only about us, this is a world-wide banking crises. Few countries have escaped, and none of the rich countries have. All of us pretty much everywhere are going to see our national debts increase. Some countries aren't going to be able to repay this debt - we can pretty easily foresee a debt crises on the horizon about ten years from now or so when the bills come due and the money isn't there. Historically it's completely unsurprising to find that there is a pretty decent correlation between banking crises and later debt crises, shown below.

In summary, Obama is hearing from many of his advisers that this could be a replay of the great depression if we misstep, and I think now we've all seen how one can get to this perspective. I personally am not glum - I think we'll muddle through this somehow, doing, as Churchill said of Americans, "the right thing - after they've tried everything else." However, it seems unlikely in the extreme that we will be coming out of our little recession in the Summer of 2009, with the stock market anticipating this recovery by six months or so, meaning now. My opinion is that it's time to batten down the hatches and get ready to ride out a big storm.

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