Endings and the World economy

by | Sep 22, 2000 | Archives

Economic history repeats itself and I want to share how the West's aversion to endings could lead us into a really dangerous economic mess.

If we look back a decade for example we can see how many factors in the economic crash in Japan is similar to many of today's financial events. Many aspects of the dot.com and high tech industries are similar to economic conditions back then. These industries led the world to greater global productivity (as Japanese companies did in the 70s) which gave their shares great growth potential. But as is always the case the shares became way overvalued.

The overvalued shares led to an overvalued real estate market all heavily leveraged. Then the house of cards collapsed and the overhang has taken over a decade to work itself out. This meant that the shares in Japan were overvalued by at least ten years of their potential profits and growth!

U.S. markets have been weak and jittery for two years yet many investors remain heavily invested in these markets that history suggests will drop.

Yet investors hate to walk away from markets that have not topped. They hate the end of the good times and because we can't tell exactly when major shifts will come, we remain over invested in markets that are at risk.

There are other factors now similar to Japan's crash and to the U.S. market crash of the 70s. For example the U.S. dollar is set to fall again. We have been in an era of a very strong U.S. dollar despite a huge U.S. trade deficit (just as in the 70s). There has been a great effort on the part of European, Japanese and U.S. governments to keep the dollar strong. Yet the main factor in the dollar's strength has been that the U.S. stock market has absorbed all the dollar's that foreign businesses have earned selling their goods to the U.S.

The second factor is that we are at a downturn in the U.S. economic cycle. This is normal and natural but because we hate endings we resist this economic cleansing process. This distorts the economy so when the fall comes it is harder and further. This happened in the seventies as well.

Third in the 70s and now there was and is a growing U.S. bank risk. This time events are complicated by a weak federally backed-home loan system. U.S. bank risk has grown because during the economic boom banks have become loose. This looseness has grown to such an extent the Federal Reserve Bank openly admitted the problem in the May 2000 issue of “Monetary Trends”. An article entitled “Are Banks Making Riskier Loans?” points out that bank supervisors have been expressing concern about the risk assumed by U.S banks, especially the large banks with assets over $10 billion. The article concludes by saying, “The increases in problem loan rates at large banks during recent years of rapid economic growth provide emperical support for the concerns expressed by supervisors.” The article included two charts, one on the rise of non performing loans, the other on the percentage of loans being charged off as losses. Each chart showed a dramatic increase in bank problems.

The problem runs deeper than just banks. There is a huge distortion that could create a scandal worse than the U.S. Savings and Loan disaster of the early 90s. America's booming housing market has swayed the government backed home loan agencies Fannie Mae and Freddie Mac to take greater and greater risks. U.S. house pricing is notoriously cyclical. The drop in Wall Street can push housing prices down. A recent article in The Economist magazine (April 15-page 79) tells how the agencies have increased lending at a 20% per annum rate. They have 1.4 trillion of debt and at current expansion will bear risk on more than half of U.S. residences within three years. These agencies are listed on Wall Street and should be private companies. Yet they gain benefits from quasi official state and have $32.00 of debt for only one dollar of capital whereas large banks have $11.50 of debt per dollar of capital.

Their implicit government guarantee allows them to borrow cheaply, yet they are making the same mistakes savings and loans made in the 80s. They pay officials and staff way above public and most private sector rates. Even worse they are moving into “sub-prime” lending.

A dangerous house of cards has been built because these agencies are exempt from rules which limit banks from holding too much exposure in any one company. Banks can hold all they want of this stuff. Today, one third of total bank capital in the U.S. is this federal agency debt and equity, a highly concentrated risk!

During the 80s housing bust, Fannie Mae became technically insolvent, though regulators allowed it to keep operating. Now the risk of a future default has grown and this risk filters through the entire U.S. financial and banking system and is still growing. The U.S. Treasury expects these agencies to soon issue more debt than the U.S. government. A crash of the agencies can affect the U.S. dollar, U.S. debt, U.S. budget, taxation, U.S. banks and Wall Street in a very negative way.

Congressman Richard Baker argued that this debacle may cost the U.S. taxpayer an amount that dwarfs the savings and loan cleanup.

So what happens if all these events come together at the same time, a falling U.S. dollar, a crash Wall on Street and bank failures, plus a U.S. recession and housing bust? this will be an economic mess.

All the world needs is a catalyst to spark off the crash. How about rising oil prices?

The last era of stock market doldrums in the 70s and 80s was accompanied by inflation, high interest rates and a falling U.S. dollar. This same pattern is being reinforced now by the rising U.S. interest rate and the rising price of oil.

In the 80s the Middle east held the Western worlds at ransom. Now it is happening again? How can this happen? We hate endings and refused to let go of an oil based economy. Instead of sticking to the energy savings programs implemented in the 80s, we abandoned them and return to our energy consuming ways. This puts us in the position that the current oil crisis could lead to a global economic mess.

What to Do?

First move into safer investment positions. Diversify out of the U.S. dollar and U.S. banking system. Reduce equities and long bonds. Increase holdings in short term (up to three years) bonds and cash. Upgrade the quality of your investments. Use banks in more than one country.

Be smart about the higher risk investments you make. Aim for safety and take only smart risks. Look for high-potential deals that are at low ebbs. Then wait for them to rise. Avoid hot deals that have peaked and are likely to fall.

None of us can predict the future and if the global economy once again re ignites, our caution will have been in vain. However it is easy to invest once more, if our money is in safe and sane investments. If markets do crash and our portfolios are full of overvalued, leveraged shares, we may not have anything to enjoy when the next good times, which will also assuredly begin, begin.

Respect the ends and beware so you can have good but safe investing!