It is unfortunately a recurring pattern.
As I write in December 2008, a build-out period has clearly come to an end. What did we build-out? Most pundits seem to believe that the build-out was in housing. My analysis (from Real Clear Analysis #5) indicates that the housing build-out was too small by itself to have killed the economy. Perhaps housing didn’t act alone. Could it be that, as in 1929, the recent housing boom coincided with another, larger build-out?
As with earlier periods, data on New Security Issues provides critical clues. Issues of new securities are the gateway through which savings become new investments. In the pre-1873 period, Railroads raised billions of dollars by issuing securities (stocks and bonds), far more money than Americans had in liquid assets. In the pre-1929 period, Electric Utilities, Telephone Service Providers, Automotive Manufacturers and Construction projects also raised and invested capital in excess of national resources.
What money was raised in the pre-2008 period? It is clear that the security of choice in recent years has been the bond. Between 2000 and 2007, $10.6 trillion of bonds were issued. That was certainly a lot, but was it “unnatural”?
“Natural” growth of bond issuance has been high in the post-war period (about 10%, well above the rate of inflation). The chart below illustrates the issuance of Corporate Bonds between 1947 and 1999. With the exception of “Junk Bond Mania” in the late-1980s and the telecom-driven spike in 1993, Bond issuance remained near the long-term trendline:
Beginning in 2003, United States Corporations began a four-year run of bond issuance sharply above the trendline. Over four years, the “excess borrowing” amounted to more than $1.5 trillion (of the $10.6 trillion issued, about 14% “excess”).
Unlike earlier periods, however, the capital raised in the 2003-2007 period did not go to Railroads, Utilities or other industries directly. The bulk of the capital went to Financial Companies. The chart below illustrates that Non-Financial Corporation issuance of bonds has been relatively flat since 1990 (the green line) and that virtually 100% of the growth in bond issuance has been by Financial Corporations (the pink line). As recently as 1992, nearly half of bond issuance had been by Non-Financial Corporations. In contrast, between 2003 and 2007, 85% of bond issuance was by Financial Corporations -- $9 trillion in total.
Where did the money go? The specific facts require further analysis, but it is safe to assume that some went to mortgages, some to Private Equity and a fair chunk of it was loaned to Hedge Funds. Because Financial Corporations raised the capital, it is also safe to assume that virtually all of it was entrusted to a Financial Institution and re-loaned to others with the hope of earning a profit margin (or “spread”).
These financial assets, in their own way, are like the steel rails or copper wires of previous generations: they were installed on the expectation that they would generate a profit for the investors. When the expectation of profit is replaced by the fear of loss, a Panic ensues as investors clamor to get their money back. In 1873 it was the failure of the Northern Pacific that initiated the selling, in 1929 it was the rate ruling against Boston Edison and in 2008 it was probably the failure of Lehman Brothers.
The parallels are pretty clear. For the Railroads of 1873, the amount of debt (or “leverage ratios”) of Financial Corporations ballooned to 27/1. At the time of its demise, Bear Stearns’ leverage ratio had reached 35.5/1. Following the crash of 1929, the shares of build-out-related industries such as Electric Utilities dropped by more than two-thirds, Financial stocks have dropped by a similar amount in 2008.
The good news is that, on an economy of $13 trillion, $1.5 trillion of “excess” over four years is nowhere near 1873 or 1929 levels. Indeed, in the second quarter of 2008, the time deposits of Americans exceeded $7.4 trillion and total financial assets totaled $44.3 trillion. Historically speaking, $1.5 trillion is a drop in the bucket.
That is why the chart below is frightening: it paints a different picture. By adding the activity in 2008 to the graph, we can see that bond issuance by Financial Corporations has come to an abrupt near-halt. In a historical heartbeat, Financial Corporations have gone from raising $2-2.2 trillion per year to a run-rate of $700 billion per year.
Is this an overreaction destined to clean up four years of excess in short order – or does this imply that, like the Railroads and Electric Utilities of the past, the build-out of the Financial Sector is somehow “finished”. Were that to be the case the “hole” in the economy would not be a relatively manageable $375 billion per year (about 3% of the economy – “recession-sized”), but rather about $1.5 trillion per year (more than 10% of the economy) -- big enough to cause a depression.
It is a big question, perhaps the big question.
To be continued
