Great Depression vs. 'Great Deleveraging' - Can You Tell the Difference?

The longest downturn of the 20^th century began in August 1929 and did not end until March 1933, three and one-half years later. During this Great Depression:

• GDP contracted by 30%;
• Unemployment rose from 3% to 25%;
• Consumer prices fell 27%; and
• Bank insolvencies created waves of financial crises.

The current financial crisis is the most severe since 1929, and it could easily become the longest since (what Milton Friedman and Anna Schwartz called) the “Great Contraction.”

To isolate a few of the similarities and differences between our current predicament and that of 1929 – 1933, I’ve put together a little test.

For each of the four topics listed below, I’ve provided two summaries. One refers to the 20^th century’s Great Depression. The other refers to what I’m calling the 21^st century’s Great Deleveraging. Your job is to figure out which is which.

If you want to brush up on your economic history before taking the test, read DanskeBank’s Lessons from the Great Depression (.pdf), by Allan von Mehren. Answers are at the bottom. Enjoy.

1: CREDIT EXPANSION

• An expansion of consumer and mortgage credit fueled the purchase of consumer durables. In the decade prior to The Decline, outstanding mortgage loans rose by 145% and corporate dept increased by 80%. The economy became too dependent upon credit, and too many “bad borrowers” were granted loans. When things turned sour, a substantial number of these “bad borrowers” went bankrupt.

• An expansion of mortgage credit to less-than-creditworthy borrowers fueled the expansion of home ownership. In the decade prior to The Decline, outstanding mortgage loans rose by 180% and corporate dept increased by 95%. Home ownership expanded in response to financial innovation and governmental policy goals despite the lack of any real income growth. Too many “subprime borrowers” were granted loans and when home prices declined, this created a surge in foreclosures and REO property sales.

This created huge losses for their bank lenders.

2: BREAKDOWN OF FINANCIAL INTERMEDIATION

• Widespread bankruptcies and bank runs produced numerous bank failures. Banks’ assets (i.e., loans) were very illiquid while their liabilities (demand deposits) were not. Deposit withdrawals forced banks to dispose of their illiquid assets at low prices, creating losses that produced bank failures.

• The takeover of government-sponsored mortgage entities wiped out the investments of preferred stock investors as the government-sanctioned bankruptcy of a major investment bank produced a run on uninsured money market funds. Commercial paper markets froze up. The government was forced to create a series of special purpose funding facilities to replace the markets that it had destroyed.

Banks became cautious, tightened their lending standards, and increased their holding of liquid government bonds. This produced a very wide spread between the yields on corporate and US government bonds.

3: CENTRAL BANK & TREASURY REACTION

• The Federal Reserve remained passive and did NOT put more cash into circulation to ease the crisis, producing a contractionary monetary policy. The Treasury Secretary argued that cleaning out “weak” banks had to occur before the banking system could recover.

• The Federal Reserve actively intervened in the financial markets to provide liquidity to, and recapitalize, the banking system. Regulators forced the acquisition of several weak banks by stronger institutions by arbitrarily denying the weak firms access to special purpose government lending facilities. The Treasury Secretary did not articulate a coherent strategy for the treatment of “weak” banks but the Fed rolled out a new website touting its successes.

4: FISCAL POLICY

• Taxes were increased during the downturn in an attempt to run balanced budgets. Income taxes on top earners were raised from 25% to 63%, the estate tax was doubled, and corporate tax rates were raised by 15%. Emergency relief measures were aimed at corporations, state and local governments.

• Taxes were temporarily cut and a large fiscal package was passed that included immediate tax cuts and the gradual phase-in of a variety of public works projects.

Special agencies or programs were established to lower the cost of home ownership and reduce foreclosures.

ANSWERS

The first item in each section refers to the Great Depression of the 20^th century. The second item in each section refers to the Great Deleveraging of the 21^st century.

REFERENCES

Federal Reserve - Flow of Funds 2008Q3, 11 Dec 2008.

DISCLOSURES: No Positions

Comments

[Mad Hedge F...:]

Here is a novel plan put forth by a hedge fund in Florida, Derivatives Bridge, LLC. Securities backing performing mortgages worth 100% are being sold for 20% because there is no market for these securities. Have the government buy these securities for 60%, rescuing the banks, and then sell them back to the original homeowner. The homeowner then is able to refinance his home, see his mortgage principal drop by 40%, restoring his net worth, and purchasing power. The cost to the taxpayer is zero. This is already possible in some countries like Denmark. If someone offered me a deal like this I’d take it in a heartbeat, even if I had to clean out the sofa cushions and raid my kids’ piggy banks. They say necessity is the mother of invention.

Feb 26 08:25 AM

[User 143167:]

Today, the Fed may provide some short term liquidity to the banks, but not increased currency in circulation by a large amount. I think the Fed is trying to pursuade the market they are printing a lot, but they didn't actually, at least not close to the level in the 1934-1944 period.

Feb 26 09:02 AM

[Aristophanes:]

The hiccups that stop this are:

1) The original homeowner is who? By now a significant chunk of these mortgages are foreclosed. In many cases the original owner cannot pay due to unemployment, or never could pay. Large numbers of these properties are vacant. Even auction buyers from back in December are acknowledging they bought non-performing, no-sell deeds. Ouch.

2) The refinancing part might work if there was enough capital available from the government to underwrite a new mortgage system, but that would mean risk taken on by the taxpayer via Fannie & Freddie, who are already bleeding on their prime portfolios. As with point #1 the number of homeowners able to refinance at all is declining. So the government could be stuck with the actual property. (That may not be all bad. Some of these tracts in the Sunbelt should never have been built in the first place. Removing surplus housing supply is a necessity to rebalance the market.)

3) It still doesn't help the banks because of the credit default swap liabilities. They are the yin to the CDO yang. Unwinding these is proving a horror for AIG and Lehman. The taxpayer would need to cover these losses through the backdoor as that 40% on already depleted capital would have to funnel back into the banks to keep them solvent.

Overall, the market is starting to come to the realization that a cramdown of some sort is necessary to keep the revenue stream from deteriorating, and that is what this plan is—a cramdown. Moral hazard out the door. So many buyers are leaving the system that the downward pressure is self-reinforcing.


On Feb 26 08:25 AM The Mad Hedge Fund Trader wrote:

> Here is a novel plan put forth by a hedge fund in Florida, Derivatives
> Bridge, LLC. Securities backing performing mortgages worth 100% are
> being sold for 20% because there is no market for these securities.
> Have the government buy these securities for 60%, rescuing the banks,
> and then sell them back to the original homeowner. The homeowner
> then is able to refinance his home, see his mortgage principal drop
> by 40%, restoring his net worth, and purchasing power. The cost to
> the taxpayer is zero. This is already possible in some countries
> like Denmark. If someone offered me a deal like this I’d take it
> in a heartbeat, even if I had to clean out the sofa cushions and
> raid my kids’ piggy banks. They say necessity is the mother of invention.

Feb 26 09:32 AM

[Heaven, Hel...:]

Good article which provides valuable context to the now ubiquitous comparisons of the current crisis with the Great Depression (when in addition to the above figures, default rates hit 30%).

While the Fed undoubtedly has reacted in a much different manner than during the '29-'32 timeframe, expanding its balance sheet exponentially since the crisis began, especially in the post-Lehman world, the trend since the end of 2008 has been towards shrinkage. Why has that happened in the face of the "lessons learned" from the Great Depression?

Specifically, while the balance sheet peaked at $2.25 tn around the end of December, from there it shrunk consistently through mid-February to $1.8 tn, a six week period of steady decline.

Since then, it has ticked up to $1.9 tn based on the most recent data available and probably will continue to do so with the announced expansion of the TALF facility, but if the level of support lent by the Fed to the economy (pun intended) is critical for financial stabilization and eventual recovery, why it was allowed to shrink for this period of time?

Feb 26 10:59 AM

[Socialism c...:]

Bullshit!! Moral hazard is MORE relevant than ever before! Let foreclosures happen, and the pricing will follow naturally. Gotta quit trying to prop them up.

> Overall, the market is starting to come to the realization that a
> cramdown of some sort is necessary to keep the revenue stream from
> deteriorating, and that is what this plan is—a cramdown. Moral hazard
> out the door. So many buyers are leaving the system that the downward
> pressure is self-reinforcing.

Feb 26 05:59 PM

[Aristophanes:]

You don't get it. The number of buyers is declining faster than the supply of properties (which is actually still increasing faster than workers are added to the labour force, likely because municipalities see sales of residential zoning as a revenue tool). Foreclosure as a method to right a market only works if there are enough buyers to stanch the red ink on that particular property. Foreclosure can lead to a write-down all the way to zero on the price, but the property then still competes with its neighbours.

The moral hazard line was crossed when the houses were built that could only ever be sold to those who could not afford or were not qualified for a prime loan. That's close to 9 million homes, most of them in the Sunbelt. If you build millions of homes for sub-prime, and you turf the sub-prime residents, guess what? There is no pool of prime purchasers waiting to buy up those units.

The central lesson of the Great Depression was that an economy can lose so much buying power that prices do not recover for over 2 decades. People fall off the property ladder and stay off, even if they have incomes and jobs. Houses become a multi-decade depreciating asset run by rental companies or standing desolate driving everyone's value down. A market cannot rebalance until those with cash get back in. But why buy in when you can rent and in doing so drive your costs down further every year?

"Dear Landlord, I see the property values declined again for the third year i a row. I am therefore informing you I want a rent reduction or I will move somewhere else. There is plenty of choice. Oh, and I would like you to pay for the electricity now as well. Thank-you. Your Tenant."

Try paying down a mortgage on that as a rental income property. It's already happening. There was a fellow in Florida bought 6 properties dirt cheap at from a bankrupt developer under a year ago, but his tenants now all want huge rent reductions that would be less income than the property taxes! He's losing his shirt. He cannot find other tenants.

Look around in many parts of Las Vegas, Phoenix and California and Florida. Foreclosures go to auction and only a fraction of the properties get sold. Pricing that follows "naturally"? Deflation destroy price discovery and value, year after year. Look at Japan where the property price decline is now in its 19th year! And they had far less oversupply than the US. Sometimes normative classic economic theory cannot break a deflationary cycle.


On Feb 26 05:59 PM Socialism cannot compete! wrote:

> Bullshit!! Moral hazard is MORE relevant than ever before! Let
> foreclosures happen, and the pricing will follow naturally. Gotta
> quit trying to prop them up.

Feb 26 09:47 PM

[MGA_1:]

Awful so say, but if the mortgages arent properly written down, then somebody will have to pay a premium for that - that somebody will probably be the govt and eventually, well, all of the tax payers. It sounds callous I guess but I think it's best to let the market function on this one.

Feb 27 09:30 AM