Ben Bernanke’s Initiation: Flashback to 1987

The New York Times ran an article in the Sunday paper that pushed me to share publicly what I have been sharing with clients and friends: we are in for extremely trying times in the financial markets.

Alex Berenson, the author, reminded me that both Greenspan and Volcker had to deal with crises very early in their terms as Federal Reserve chairmen. Bernanke’s relatively recent promotion is just one more commonality that I see between the environment today and the one 20 years ago.

Before I go on, let me confess that I am well aware that it is extremely dangerous to make simplistic analogies between different periods of time. It is never the same, and we humans who like to think that we can predict the future, cling to short-cuts like drawing parallels (though it sure helped me in 2002 when I was evaluating 73-74). With that said, though, the similarities are quite eerie.

Besides the aforementioned new Fed Chairmen phenomenon, consider some of these other “coincidences.” 1987 and 2007 both precede presidential elections (1987 too had a lame-duck president). M&A activity ruled the day right before everything came crashing to a halt in 1987. Remember Ivan Boesky, Mike Milliken? KKR ruled the day then (and isn’t doing so badly today!). Like the wicked drop in April of 1987 followed by a sharp rebound, we had quite a scare in late February. My next point is controversial. Many bull market defenders suggest that interest rates were “very high” back then, but they are “low” today. My response is that it depends how one looks at interest rates, which are the cost to borrow money. In a vacuum, yes, they were higher back then, but so was inflation and so was nominal GDP growth. In any event, the Fed has raised rates by 425 bps over the past two years and long-term rates have risen. In the chart below, you can see that while short-term Fed Funds rates were 7.5% before the 1987 Crash compared to 5.25% today, the economy was growing more rapidly. Inflation, too, was running higher then. The middle panel adjusts short-term Treasury rates for inflation and indicates that the real yield in 1987 was almost exactly the same as today (about 2.5%). The point is that current interest rates aren’t stimulative today and weren’t then either.

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Despite the high level of M&A activity and the increasing leverage, credit spreads were pretty low in 1987 as measured by the spread between Baa bonds and Treasuries. The data doesn’t go back for junk bonds, but clearly they were at very low levels recently, especially compared to earlier this decade.

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Many might take comfort from the high level of Consumer Confidence (especially when the consumer represents such a large part of our economy). In 1987, confidence was soaring as it is today. Back then, the confidence was also reflected in the amount of debt consumers were willing to take on relative to income. Curiously, it had started to roll over before the market decline in 1987 as it is today too.

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And why not be confident? Back then, and now, everyone was working!

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Curiously, though, Housing back then was almost as big a bummer as it is today. I suppose that people were too busy buying stocks! Actually, it may have had something to do with the tax-law change in 1986.

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The next two parallels are much less controversial. Clearly, we are in the 5th year of a bull market today as we were back then:

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The last chart is the one that worries the most. The dollar today, as it was then, has been steadily eroding in value. In my opinion, this ties the hands of Bernanke to some degree should he feel the need to ease. In any event, like 1987, any sort of easing will probably be short-lived. As you can also see in the chart below, commodity prices were surging in 1987 as they are today as well.

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As you can see, there are many parallels. We all know what happened in 1987. I was working as a bond-trader at Kidder, Peabody, so I certainly remember where I was on October 19th. Will this happen again? The short answer is that no one knows. While many of the circumstances may be similar, there are many differences as well. In some ways, I am more worried today. I believe that the excesses in our economy are greater. 1987 ended up being a blip, though it didn’t feel like it at the time. There wasn’t any real economic distortion. In some ways, we are in an environment like 1998, when LTCB blew up after taking on too much leverage and when the emerging economies were seeing their currency values shrink faster than George Costanza in a swimming pool. Again, the implications to the economy proved to be quite insignificant.

In both of these cases, the Recession didn’t come for another three years (and neither did the Iraqi war). How the Fed and other policy makers react will contribute to the outcome should the markets seize up further in the coming weeks. My fear is that our world is so much more economically and financially integrated than it has ever been that the policy-maker responses from our leaders bear less significance. Further, as I look at the perpetually low savings rate here in the context of a clearly stretched average consumer AFTER a huge run in equities and real estate (from which a lot of the mark-to-market gains have been extracted thanks to the home-equity lenders), in the immortal words of Fred Sanford, this could be the “big one.”

My advice (take it for what it is worth): Steer clear of banks and brokers, Fannie (FNM) and Freddie (FRE) any company that needs to access capital (many REITS). Yes, these things are down a lot, but they can go down a lot more as this credit crunch evolves. I am not sure how it will end, but, like the infamous Chrysler bail-out that culminated the failed presidency of Jimmy Carter, I expect that President Bush will have to deal with the government take-over of Fannie Mae (FNM) and Freddie Mac (FRE).

Comments

[Solution:]

In 1987, GDP was rising at yearly rate of 6%. Inflation around 3.6%. Interest rate was heading 9-10% to curb the over heated economy.
Today, we have GDP less then 3%, inflation 2.5%, 5-5.5% intrest rate is about right.
The two situations are very different.

2007 Aug 06 04:41 PM

[Alan Brochs...:]

I thought that I addressed this in the article. First of all, use apples to apples. Nominal GDP over the past 4 quarters has been 4.6%, while you are correct that it was 6% in 1987 (both the year ending 6/30). Real GDP was a bit stronger then at 3.26, while it has run 1.8% over the past year (our economy is much more mature today than it was then - China gets the juice today). That gets you inflation then of about 2.75% back then and 2.8% now. Interestingly, though, there was a strikingly different relationship betweeh CPI and Core CPI back then. Today, CPI runs about 1% ABOVE Core CPI, while in 1987, the reported CPI was 2% BELOW the Core CPI. The short-term rate back then (90-day bills) was about 7% right before the crash. Today it is 5.25%. I don't really see much of a difference. Back then, the economy, growing at about 6%, saw short-term rates 1% higher and the Fed-funds 1.5% higher. Inflation (Core) was about 4%. Today, we are about flat on the 90-day bills and .65% higher on the Funds rate. Inflation (Core) is about 2.3%. My point is that the general relationship of short-term rates to the growth in the economy is pretty simlar (not exactly the same). In both periods, the Fed has moved from easy to tight. Right now, Fed Funds is CORE CPI + 300, back then, it was +350. Same ballpark.

When you say rates were "headed to 10", I am not sure what you were talking about. I assume that you are referring to longer-rates, which were indeed at 10% compared to under 5% today. The Fed doesn't really control long rates, and we were much closer to the very inflationary period of the early 1980s than we are today. Investors demanded a huge premium for longer maturities back then. I am not sure that it is really relevant. Most inventories are financed at short-term rates. I have done a lot of work going back over various cycles to determine which rates are most correlated to recessions, and my conclusion has been short-rates (for the reason I mentioned I would suspect). If you are a business man, and your borrowing costs are going up, you carry less inventory. If you are an trying to earn a good return in a business over the next year and you can make a really low return in short-term rates, you invest in the business. If you were referring to the rise in short-term rates AFTER the post-crash decline, that has no relevance at all.

2007 Aug 06 06:43 PM

[Solution:]

Thanks for the reply. As you point out, today Fed fund is CPI plus 3%. It was CPI plus 3.5% in 1987.
The big difference is the GDP. Higher growth means higher inflation. It need higher fed fund rate to slow down the growth. Today GDP at 3%, it is exactly the difference between Fed fund rate and CPI.
Back then, the difference of Fed fund and CPI was only 3.5%. Comparing it with 6% GDP, fed fund needs to be raised for another 2.5% to 3%. I would be very scared under that environment.

2007 Aug 06 08:53 PM

[Jim Glazen:]

Fannie and Freddie were up huge today..... [Edited by SA]

2007 Aug 06 09:47 PM

[flow5:]

Black Monday Oct 19 1987.

“Will this happen again? The short answer is that no one knows.”

This is of course - absolute tripe.

On Sept. 4 the Fed raised (1) the discount rate 1/2 percent to 6, and (2) the federal funds rate 1/2 percent to 7.25 (up from 5.875 percent in Jan). On Sept. 30 fed funds spiked at 8.38; fell to 7.30 by Oct. 7; then rose to a peak of 7.61 Oct 19 (Black Monday).

At the same time, (Sept. & Oct 87), the decline in the proxy for real-gdp (its rate of change) plummeted (a record since its inception in 1918). The quantity of legal reserves bottomed in the bi-weekly period ending 10/21/87. This was the trigger.

At the time, the 30 year conventional mortgage yielded 11.26 percent, up from 8.49 percent in Jan. 87, and moody's 30 year AAA corporate bonds yielded 11.06 percent on 10/19/87, up from 9.37 in Jan. 87.

The preceding tight monetary policy and the sharp reduction in legal reserves, had forced all interest rates up in the short run (when inflation and real-gdp were subsiding).

And the banks scrambled for reserves at the end of their maintenance period - to support their loans-deposits (contemporaneous reserve requirements were in effect exacerbating the shortfall and response time). Apparently a significant number of banks, or large banks with large reserve deficiencies, tried to settle their obligations at the last moment.

Black Monday's trigger was obscured because the decline in monetary flows (MVt) overlapped Qtr3 & Qtr4 GDP (quarterly reports are used by the Bureau of Economic Analysis to measure gross domestic product – not monthly - which is another problem).

The Fed quickly reversed their policy when the markets panicked, i.e., they brought the volume legal reserves back into alignment.

The United States has the largest national economy in the world, with a GDP for 2006 of 13.21 trillion dollars. Fed 27, 2007 didn't start in China, it started here. That's why the Shanghai market dropped 6.5% May 30 2007 without affecting other world markets.

Interest rates have already peaked in July along with nominal gdp. Real-gdp & inflation both bottom in Oct. this year 2007. It should be a period of market weakness. Even so, 4qtr economic activity sharply rebounds.

There will absolutely not be a repeat of 87. Monetary Flows (MVt) are inviolate & sacrosanct.

2007 Aug 06 10:42 PM

[Alan Brochs...:]

Thanks for your comments. I didn't mean to imply that we will necessarily have a large sell-off in a short period of time like we did 20 years ago, but I see the contagion spreading. The U.S. consumer has been immune from a lot of attacks over the past few years - rising rates, rising gasoline and electricity/heating costs, an on-going war of futility that might typically depress the average person. Yet, confidence abounds and spending has certainly held up. I think that we have a large risk of this housing finance/housing crisis dampening consumption. Not only the folks who will struggle to refinance their IO/Arms, but also anyone who wants to try to sell a house and has to compete with foreclosures, struggling builders and wiped out speculators. My biggest concern, though, is that consumer lenders (i.e. the same banks that are getting nailed on other aspects of their lending) will tighten standards on the credit card front. Credit Card debt is huge, and many of the borrowers have been able to jump from teaser rate to teaser rate. To the extent that ends, it could be quite onerous (default rates run from 20-30% from what I understand - they can jack the rates that high for no reason).

So, if I understand your argument, you are saying that we can all be comfortable that the evolving crisis is going to disappear because money supply is growing at an adequate rate? Sorry, I don't buy it. What is your outlook for the dollar, then. If rates have peaked and the economy is slowing, all those foreigners who have been buying our stocks (and bonds) will not be happy. The dollar will weaken further. This is the two-edged sword that the Fed faces now. Global economic strength (and rising rates across the world). Something in your argument isn't adding up. Feel free to shoot me an email if you would like.

2007 Aug 06 11:18 PM

[Jim Glazen:]

It's a common misconception that the dollar will weaken vs. other currencies if we go into a recession.

Looking back at history, currency values fluctuate mainly on relative growth rates in their respective money supplies.

A recession would indicate credit growth has faltered and money supply growth rates have reduced or even gone negative. I would expect the dollar to strengthen under this scenario just like it did during the last recession in 2000-2002.

2007 Aug 07 12:14 AM

[Ross:]

Rather than using interest rates (either nominal or real) it might be more appropriate to look at the total interest cost (in $s) as a percentage of income. In Australia at the moment people are coming to the quick (ok, so not that quickly) realisation that although rates are about 1/3rd of what they were back in the late eighties (6% v 18%, rough numbers) their interest cost as a percentage of income is now double what it was then. Therefore people are now suffering cash-flow problems at these much lower rates. This, to me anyway, is far more meaningful than looking at the rates in isolation.

2007 Aug 08 12:23 AM

[phdinsuntan...:]

The list of big creditors likely to be hit in HomeBanc's collapse includes JP Morgan Chase Bank (JPM), KeyBank, Commerzbank Aktiengesellschaft New York (CRZBY), US Bank NA, BNP Paribas (BNPQY), DB Structured Products Inc. (DB). Fortis Capital Corp., Bank Hapoalim (POLI.TV), Fannie Mae (FNM) and Freddie Mac (FRE), court documents say, and FNM is going up like crazy! a few puts are available...

2007 Aug 10 11:03 AM