The Second Horseman of the Apocalypse

 

The credit crisis unfolding in the U.S. is not over, nor have we seen the worst of what may be to come. Indeed, I would argue that we have seen two of the four Horsemen of the (financial) Apocalypse, and should keep our eyes peeled for the other two. 

The two that we’ve witnessed to date are, first, the credit crisis that finally came to light in August of 2007, and, more recently, the run on a major U.S. bank, Bear Sterns. Bear Sterns is not a retail, deposit-taking, commercial or consumer bank, but was the fifth largest investment bank in America. It was not a towering giant in the financial industry, as measured by its own assets, and, under other circumstances, might well have been allowed to go bankrupt pour encourager les autres. However, it was in the middle of $10 trillion worth of financial deals. The concern by the U.S. Federal Reserve Bank (the “Fed”) was that Bear’s fall might well trigger the collapse of several other investment banks – and other banks and corporations as well, who have some part of a transactions facilitated by Bear Sterns. 

In my headlining January blog for “Signs & Portents for 2008,” I listed my worst nightmare as being a run on a major bank. Bear Sterns would not have qualified in my opinion at that time. However, the ramifications of the phony credits and securitized garbage authored by Wall Street and others range farther than I (and many others) had expected, with the result that I’ve been forced to re-evaluate downwards my already negative assessment of the situation. Indeed, the Fed has been forced to do so as well, and my hat’s off to them for being proactive in shoring-up the financial system. If they had stuck to their traditional mandate, Bear Sterns would have gone bankrupt, and we might now be in one a hell of a mess. Instead, they re-wrote their rules on the fly, and forestalled a potential financial collapse of mammoth proportions. Their willingness to do so is extreme good news, as I’ll describe later.

 

But that brings me to the two remaining horsemen. I don’t know what might happen next, and I am actually quite hopeful that the Fed, and the markets themselves with their traditional resilience, might well get through this hazardous period. My concern is what happens if they don’t, and that’s the theme and cautionary tale of this blog.

 

The Third Horseman would be as I described in January, if a (relatively) innocent bystander gets sideswiped by the credit crisis. For example, consider what would happen if a major public company that was neither in nor of the financial markets had parked some of their excess cash in what we know in hindsight to be suspect financial assets, in order to earn a slightly higher rate of return. If, when they needed the funds, they found that they could not access the money, and could not pay their bills as a result, then a healthy, profitable company could go bankrupt apparently out of the blue, without warning. If that were to happen, it would shake the confidence of the entire economy, and especially of the financial system. Suddenly, banks and other lenders would look at all the healthy, profitable companies they were financing, and wonder if any of them were truly creditworthy. In that environment, all lending might cease, no one would be able to obtain financing, the financial markets would become frozen solid, and the economy would go into free-fall. If that were to happen, then it would precipitate a financial and economic crash of mammoth proportions. The key would be whether the Fed, working in concert with other central banks, could flush enough liquidity and confidence into the financial markets to prevent this from happening, as they did with Bear Sterns.

 

The other nightmare alternative that I painted in January would be if there was a run on a retail, consumer bank, where depositors decided they’d better get their money out while they could. At the wholesale level, this is what happened to Bear Sterns: corporations that had made short-term loans to Bear, as was normal, and that normally financed Bear Sterns’ operations, suddenly refused to reinvest. The result was that Bear’s ability to raise cash evaporated, which would have led to their insolvency, had the Fed not intervened. Instead, they were bought out for a (comparative) song by their commercial bank, J.P. Morgan, one of the few banks that had stuck to its knitting, and was financially sound enough to bail out Bear. This takeover was orchestrated by the Fed, which also provided with a huge assist in making the deal happen. 

 

Now, the classic prescription for stopping a run on a commercial bank is to literally throw money at it. Armored cars roll conspicuously up to the branches where consumers are anxiously lined up, waiting to get their money, and armed guards drag in large sacks of cash to satisfy consumer demand. Eventually consumers start to worry about carrying all this cash around, and, feeling slightly sheepish, start re-depositing the money back into the bank, which ends the run. 

 

But banks have never had enough cash to pay out all their depositors in a short period of time. And if there were a sufficiently widespread run on not one but several banks, and that run began to spread, then we would reach the ultimate test: can central banks throw enough cash at enough people to restore confidence?

 

So the Fourth Horseman would appear if the Fed, in conjunction with all the rest of the world’s central banks, did everything they could to keep lenders lending, depositors from panicking, and the system solvent, in order to keep the system operating – and it wasn’t enough. That would signal a 19^th Century-style bust, and the beginning of a depression, not a recession. How quickly we could recover from such a bust is impossible to know, because the question becomes: how soon are people willing to risk their money to invest in something, or to buy something? When do bargain hunters with cash start to swoop in to pick up the remains? And how soon is confidence restored?

 

This kind of financial risk exists at the depths of every financial cycle, and panics have often occurred. There was the Penn Central bankruptcy that panicked the financial markets in 1970; the New York City bankruptcy in 1974; the savings & loan disaster of 1982; the run on the Continental Illinois Bank in 1984; the “Asian flu” and panic run on Asian currencies in 1997; the run on the Mexican peso in 1999; and the tech bubble collapse in 2001. All of these precipitated short-lived panics, yet in all of them the central banks intervened, and the system recovered. Why might it be different this time?

 

What’s different this time is scale: how big the markets have grown, and how (comparatively) small the Fed and the central banks are today. The financial markets have exploded in the last 30 years, mushrooming in size, and dwarfing the central banks. Today central banks, including the Fed, cannot stop a run on a currency, or, I fear, a run on the banks because they haven’t grown anywhere near as quickly. They can influence events, they can sometimes booby-trap marauding traders seeking to exploit the situation, but they can no longer control events. Markets are now too big, and could become unstoppable if they panic and run in one direction.

 

So the financial system has put us in a terribly dangerous position by playing fast and loose with credit. Blame the clever folks on Wall Street who thought they could substitute theory for experience. Blame all the bankers who wrote bad loans, knowing that someone would have to deal with them, but didn’t care as long as it wasn’t them, and they could make a fast buck on the way through. Their shoddy ways have put us all in jeopardy. I don’t believe a collapse is likely – as I said, I’m much impressed with how well the Fed is playing this, and the level of international cooperation – but this is the period of every economic cycle where we can be caught off-guard by nasty surprises. And, as readers of my articles know, I’m a firm believer in scenario planning and having contingency plans in your back pocket. This is the time for such planning, for such contingencies.

 

So, what’s your “Plan B”? What’s your best strategy for getting through this hazardous period? In my opinion, you should be both cautious and forward-looking. Be cautious by not overextending yourself, minimizing your debts, and making sure you have liquid money available in the most secure of places, even if that means minimal rates of return in the short run. And be forward-looking, for even though there are risks out there right now, by far the biggest probability is that we will come through this period, as we have before. Then, when the situation looks as if it’s stabilizing, start spooning investment money into depressed blue chip stocks of solid companies, especially those with significant dividends. Or, if you’re running an corporation, there will come a time when you can buy up less thoughtful competitors for a comparative song, or scoop up market share cheap. When the economy comes back, people are going to look back at this period, and wonder why they didn’t grab all the great bargains waiting to be had. We are approaching a major buying opportunity, the kind that comes once in a decade, or perhaps once in a lifetime. Don’t miss it.

 

Now is the time to be prepared, as any good Boy Scout will tell you.