On September 15, 2008, Lehman Brothers failed and its collapse triggered a financial panic. This was the first true panic since the Great Depression or even perhaps since 1907. A financial panic is very different from a regular stock market decline such as we saw in 2000-02 or 1973-74. A falling stock market may be scary, but falling stocks alone do not constitute a financial panic. During a panic, stocks plummet, but there has to be a second factor, which is a widespread loss of faith in the entire financial system. That happened in 1907, which led to the formation of the Federal Reserve Bank. It also happened in the Great Depression as banks failed, unemployment soared, trade barriers increased and global economic output fell.
Having just experienced a financial panic, is it likely that we will go through another? From a historical perspective the answer would have to be no. Financial panics are very rare events that occur once or twice per century, not every couple of years. Also, financial panics typically arise from unforeseen problems. Though the problems we face today — potential failure of the EU, tumbling real estate values, excessive debt of excessive deb — are thorny and difficult — no one could say they are unforeseen.
Q: So, is another financial panic coming?
By panic, I mean a stock market crash of 30% or more in the next 12 months, plus legitimate fear of a systemic collapse of the international financial system. First, here is a chart of the S&P 500 to give you a sense of what a 30% or more decline looks like. Click to enlarge:
The stock market peaked in October 2007 and then began falling. However, the ‘over the waterfall’ decline did not happen until the Lehman bankruptcy triggered fears of a systemic collapse. At that point, stocks entered a free fall period lasting about six months. These two factors together create a financial panic.
Had our leaders reacted better in the aftermath of 2008, the likelihood of another panic happening would be very low or even nil. Unfortunately, we really did not fix the financial system, but rather we just papered over the cracks caused by excessive debt.
The Fed saves big banks, not savers
Right now, the central bankers of the world such as the Federal Reserve and the European Central Bank are pumping liquidity into near-dead or financial institutions that are, essentially zombie banks. The goal of the liquidity injections is to get normal credit market conditions back on track. Those efforts are likely to be in vain because banks all over the world are trying to hold on to their cash and get rid of toxic assets. Why are they holding on to cash?
- They have billions in bad debt on the books and they are desperately trying to stave off insolvency.
- There are very few borrowers who want new bank loans and actually have a high likelihood of repaying the loan on time.
I believe that attempts to kick start the economy by shoring up zombie banks will fail. The central bankers may be able to avert a bank credit contagion leading to a financial panic. However, I do not think the central bankers can avert the deflationary impact of contracting credit, falling sovereign debt values and weak real estate prices. Therefore, I foresee very weak economic growth and high unemployment ahead.
The debt hangover
In a recent speech, Federal Reserve Chairman Ben Bernanke acknowledged that the recession, which ended in June 2009, was different from previous ones. It was caused by the bubble in real estate and the resulting financial panic. Therefore, the usual remedies for a normal business cycle recession have not been effective. What could we have done that would have had a higher probability of success?
The Swedish solution and the S&L crisis
Sweden went through a nasty financial crisis in the early 1990s and it dealt with the problem by taking over failing banks and wiping out shareholders and even bondholders in many cases. We did the right thing during the Savings & Loan crisis in the 1980s and early 1990s. Our government dealt with that problem quite well by letting banks and savings & loan go under with hideous losses to shareholders of those institutions. So we knew what to do back in the 1980s. Unfortunately, this time around we have forgotten what we learned from the S&L crisis. We now are letting smaller banks fail, but we have allowed big banks to dictate policy such that they have evolved into a new breed of zombie institutions considered to be too big to fail. This is a mistake that both Europe and the U.S. are making.
The problems in European countries such as Greece and Portugal are visible reminders of the fragility of the international financial system, but there are other problem areas too. Normally, the problem we can see — Greece for example — is not likely to cause a panic, but we live in interesting times. So, is another financial panic coming?
A: In terms of another financial panic in the next year, I believe there is a 20% or lower probability
In other words, I think we are likely to avoid a full-blown financial panic, but I cannot completely rule out the possibility. Given that we just came through a panic, a 20% probability is actually very high because panics are very rare events. A higher probability is that we muddle along with weak economic growth or even slide back into another recession.
What should you do to prepare for this possibility? From an investment perspective, the possibility of a panic leads me to be more cautious than I might otherwise be. That is, I believe it is useful to have some ‘dry powder’ in your portfolio. By dry powder I mean assets in a low risk bond fund that you could redeploy if the stock market falls.
For example, you could have some assets in a low risk, income vehicle such as short-term bond fund such as Pimco Low Duration Bond Fund (PTLDX) or Vanguard Short-Term Investment Grade Bond Fund (VFSTX). These types of holding have three virtues: First, they have a solid yield of 2.3% in the case of PIMCO and 2.9% in the case of Vanguard. Second, these fund have a low average maturity which keeps the risk of loss due to higher interest rates quite low. Finally, these are liquid funds so you can move assets out whenever you want to do so if the stock market falls and presents you with an opportunity.