Page1 of 2 THE
BEAR'S LAIR Spirals of
death By Martin Hutchinson
Close observers of the US housing finance
disaster in recent months will have noted a
curious phenomenon. Companies such as Countrywide
that were in late August regarded as rock solid
have recently passed clearly into the danger zone
while those like Fannie Mae and Freddie Mac that
were regarded as potential market saviors have
come under a cloud.
In Britain, Northern
Rock, whose September bailout was said to
be
modest, involving little risk to the taxpayer, has
now turned into an immense 25 billion pound
($51 billion) potential black hole - real money
even in the US economy let alone in the much
smaller British one. This illustrates a deeply
troubling quality of the largest downturns: the
tendency for the free market to turn into a death
spiral, in which even sound, well-run institutions
are engulfed.
Death spirals are fairly
rare in financial history. The Wall Street Crash
of 1929 was perhaps the most virulent example.
After the first downturn, the market recovered for
several months. Then the collapse of the Bank of
the United States in December 1930, together with
the further economic damage from the Smoot-Hawley
Tariff caused a further collapse in confidence and
activity that was concentrated in the banking
sector, as relatively solid institutions followed
the Bank of the United States into bankruptcy. The
Federal Reserve failed to correct for the money
supply contraction caused by the bank
bankruptcies, leading the US economy further into
the pit. The additional shove given by president
Herbert Hoover’s 1932 tax increase was almost
unnecessary; only the confidence brought by a new
president (albeit with equally counterproductive
economic policies) brought recovery from 1933. By
the time the spiral was over, more than one fourth
of the banks in the United States had gone
bankrupt and the stock market had bottomed out at
one tenth of its peak.
A second death
spiral, with somewhat less dire economic
consequences, occurred in Britain in 1973-74.
Edward Heath’s government had removed the
quantitative controls on bank lending in 1971,
which resulted in an orgy of high-risk lending
against real estate, very similar to the recent
episode in the US except that most of the loans
were made against commercial real estate rather
than housing. When the first major real estate
lender, London and County Bank, collapsed in
November 1973, another, more conservative, house,
First National Finance (FNFC), was used as the
epicenter of the "lifeboat" rescue organized by
the Bank of England. However, the decline in
confidence and real estate values quickly sucked
FNFC into the maelstrom.
The lifeboat
rescue fund grew larger and larger for more than a
year as the stock market declined to record low
levels, 70% below its 1972 high. Homebuilders such
as Northern Developments, in no way involved in
the original crash but dependent on bank lending,
were dragged down. So were the two most important
entrepreneurial finance houses, both
internationally diversified and neither
significantly involved in commercial real estate
lending - Jessel Securities, founded by Oliver
Jessel, and Slater Walker, founded by Jim Slater.
Neither Jessel nor Slater had been
aggressively run - indeed Jim Slater had begun
de-leveraging a year before the crash, as he saw
trouble coming - and no wrongdoing was proved
against the head of either organization, yet by
the end of 1975 both very substantial companies
had gone bankrupt and neither founder played a
significant further role in the British financial
sector. This was a great pity: in losing Jessel
and Slater Britain had lost not only their very
able founders but the most aggressive
entrepreneurial teams in the City of London, who
might have been best able to compete against the
foreign invasion when Britain deregulated the
financial services sector in 1986.
The
British experience of 1973-74 seems more like the
current position in the United States. National
policy is currently reasonably neutral, so far
avoiding the twin dangers of protectionism and tax
increases which caused the medium-sized downturn
of 1929-30 to turn into the Great Depression. The
problem is concentrated in the property sector.
However there are already worrying signs that the
magic alchemy of modern finance, through such
mechanisms as securitization vehicles whose
funding falls apart and complex derivative
securities that prove to be unsalable in a crisis,
is causing the problem to metastasize. In the
consumer sector, GMAC has reported problems with
its automobile loan portfolio, while it appears
that credit card debt quality is rapidly
deteriorating. In the corporate loan sector, loans
to aggressive leveraged buyouts have got in
trouble, and loans to hedge funds and private
equity funds have been sharply cut back. (The
latter effect can be seen in the movement of the
yen/dollar exchange rate from 120 to 108, as the
hedge funds’ "carry trade" positions have been
de-leveraged.)
The "death spiral"
characteristics of the current market are pretty
clear. If Fed chairman Ben Bernanke’s original
estimate of subprime loan losses of $50-100
billion had been anywhere close to accurate, there
would have been no problem. The market deals with
difficulties of that size all the time, without
significant effect on surrounding sectors. A few
fringe operators go bankrupt, a few large houses
show unexpected losses, and the overall market
continues without a tremor. The collapse of the
Amaranth hedge fund in September 2006 or that of
Refco a year earlier were substantial events,
causing losses to a number of those institutions’
business partners, but there was no question of
any general market disturbance.
When the
subprime problem first emerged in February, it
appeared that it would also be limited. A number
of subprime
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