What does depression mean? Where are we at the economic cycle? Are the banks in bad shape? Why? Will we see a bank run or is what we are having a “bank walk” ? How likely for the banks to get a hit from the real estate loans they had extended? Will the downtown office spaces never be in high demand again? What happens when we don’t let banks fail? How is the fight against inflation going? Are we seeing declines in prices? Is something more insidious than the Great Depression ahead?
“When we are no longer able to change a situation, we are challenged to change ourselves.” Viktor Frankl
This week two events came across my radar that made me wax sentimental. The first was the passing of NFL running back Jim Brown. Brown is widely regarded as the finest football player to ever play in the NFL. He led the league in rushing 8 of his 9 seasons playing in the era before the Super Bowl. He retired at just 30 years of age and at the top of his game.
We also marked the 25 year anniversary of the end of the greatest sitcom of all time Seinfeld. It is widely available in syndication and its sayings have permeated our culture, but a unique feature was that Seinfeld like Brown left at the top of its game. It was the number 1 ranked show on television when it ended its run and despite Jerry Seinfeld being offered 9 figures to create another season, he turned it down. Getting to the top of a chosen profession is very rare, but getting there and choosing to walk away is even harder to do. Age, changing preferences, changing priorities are all part of the ever-changing cycles of life. Getting the timing right on the ascent and leaving before the descent is admirable.
Economies also go in cycles and unfortunately, we can’t just walk away on top. I’m sorry China, we have had 7 decades as the largest economy on earth, and we know you are catching us but today we have decided to walk away and retire. That’s not how life and economies work so we have to be aware of where we are in the cycle and act accordingly. When the economic cycle is in a depression like we have discussed here in detail,1840s or 1890s, the single most important thing to help turn the cycle back to expansion from contraction is a credit stimulus. Banks need to lend, businesses need to hire, people need to go back to work, and this creates recoveries. The flip side of that coin is true as well. When banks are lending profusely, businesses are hiring at max capacity, and people are working all they want, that is often when stimulus needs to be removed. It creates over production, there are too many products, too much money has been lent into the system and inflation becomes a threat. That is when there can be depression.
Depression can mean many things but comes from the Latin word meaning pressing down. It can mean gloom, sadness and dejection and it results in a financial depression. It can mean a sunken place or part lower than the surrounding surface and it does in regard to financial markets. It can mean a dullness or inactivity as of trade and it does that as well. The Great Depression of the 1930’s fit all three categories to a tee. I’m attaching a link to a Documentary about the great crash of 1929 but I found it fascinating hearing how similar the mentalities were compared to today. American consumerism hit an all time high, Americans thought it was their birth right to be rich, and what allowed this façade was easy easy credit, instalment payments, and buy now pay later. What you thought was invented by Affirm Financial in 2012 in San Francisco?
The Great Depression followed the greatest credit boom and expansion that the world had ever seen. America after World War I was a place of mechanical innovation and due to the sluggishness of Europe’s economies, capital poured into projects and companies in the United States. Inventions were created and marketed for the general use of the public. Cars, radios, electrification, and with-it appliances were produced and marketed to the general public and the standard of living in the United States became the highest in history. What enabled this was the expansion of credit.
In World War I, the government had sold bonds and people had gotten used to buying these instruments and getting back their principal with interest. After the war, banks seized on this new familiarity, and they started selling stock in companies. There was very little regulation, so people bought on margin, enabling them to control large lots of stock with little down payment, just like their auto purchase. Banks helped companies expand by selling stock and raising working capital just like our white-hot IPO and SPAC market from a few years ago.
This was the glamour era of F. Scott Fitzgerald and The Great Gatsby and the roaring 20s were a party for all. People got rich on speculation, they got rich without working, even shoeshine boys were famously playing the market. Joseph Kennedy, the patriarch of the Kennedy family, famously got out of the market when his shoeshine boy started giving him stock tips. One of the great fortunes in American history was preserved by acting ahead of the crash.
What allowed Kennedy to get out on top like Brown and Seinfeld? Insider trading? Perhaps, there were rumours that many financiers were running a pump and dump scheme just like crypto has been doing to investors today. Perhaps it was something else though. The market crashed in October 1929, and it came quietly with little warning. A few bankers warned of trouble ahead, but the markets charged full steam ahead like the Titanic through the northern Atlantic. A key differentiator this time was the involvement of the Federal Reserve and the US government. In past depressions, there were fingerprints of the government at the scene of the crime, but now the government had gotten so big that it was pulling levers trying to save the economy and making it worse.
The Panic of 1930 was when failures of agricultural banks caused many banks to fail and the response by the federal government was to contract the money supply while economic growth was falling. The Federal Reserve Bank of Atlanta and St. Louis reacted quite differently. Atlanta opened the discount window and served as a lender of last resort and therefore had less failures than the St Louis branch leading many to believe that it was a matter of liquidity rather than solvency. This serves as the bedrock of the Federal Reserve’s actions today and we just saw them open the discount window to regional banks and offer a lending solution to banks. Some banks like Silicon Valley Bank were too financialized and insolvent but many needed liquidity.
What happens when we don’t let banks fail? We don’t get the cleansing effect of a true business cycle. It is like a crash diet for two weeks where someone loses a little weight and then goes back to eating and gets bigger than before. The lessons of proper financial dieting aren’t learned, and business goes back to normal shortly thereafter. Banks aren’t in a good place today because they are sitting on a bunch of bad loans. Commercial real estate loans are a cancer to banks’ balance sheets because they have not been adjusted to show the market value of the underlying properties. Empty office buildings are starting to hit the market like 350 California Street in downtown San Francisco which was valued at $300 million and is being sold for 80% less today at close to $60M.
We discussed how banks had a mismatch of assets to liabilities with regard to long term bonds with Silicon Valley Bank’s failure. Customers withdrew their money and the banks were behind on a bond at market prices and had to sell to create liquidity to meet customer deposits. The key difference is that those bonds were US treasuries and the bank would have been made whole at the end of that term. The commercial real estate loan portfolios offer a much more toxic scenario.
But no one will step in and buy those office buildings because no one will be made whole. I’d argue that the long-term top in office building real estate was reached pre-pandemic and we will never go back. Our inner cities are not compatible with where businesses want to be right now. Crime, taxes, and work from home has pushed business to the sunshine states and suburban offices and away from the traditional money center cities.
In the Great Depression, people borrowed too much money to buy new consumer goods and stocks. Today, the credit structures dwarf the 1920s in their complexity and efficiency on how to extract money from a consumer. Home equity lines, credit lines, credit cards, swaps, derivatives, debt financing, equity financing, investment banking and shadow banking, consumer lending, bank lending, and finally at the top of the shaky structure government lending. We have financed a house of cards from poorest to the surest. The surest instrument meaning the US Treasury bond which is backed by the full faith and what is that? credit, of the United States of America.
Many things will keep us from another depression. Right now the economy is slowing, in fact quarters 1 and 2 of 2022 showed negative growth, the traditional definition of recession, but the government just changed the definition of that and we moved on, but right now and more concerning is the money supply. We are currently undergoing the largest money contraction since the Great Depression. That’s right. Have you noticed commodity prices coming down, grocery prices too, and even home prices in some of the high destinations are starting to fall. This is a good thing in the fight against inflation. Our jedi Jerome Powell is starting to see results, however the Great Depression showed us that declining money supply leads to bank runs as people are nervous about their money. Well, the government came out and bailed out the Silicon Valley depositors who had more than $250k in their accounts so like Jim Biancho has said we are now in a bank walk.
Depositors are pulling their money in search of a better rate in either money market funds or bonds, but banks are still seeing money walk which creates financial stress for them. Banks have toxic commercial real estate loans on their balance sheets, they have real estate loans in which the properties are starting to decline, eroding their margin of safety, and they have depositor flight. Then we have the debt ceiling and by this time next week the Republicans will have probably gotten their pound of flesh from the Democrats and we will have a deal. Hooray, the crisis averted. Not so fast, the Treasury Owl Janet Yellen now needs to refill the Treasury General Account and that means selling bonds into the market further sucking up liquidity that might have gone into stocks or other investments. Be careful what you wish for because you just might get it.
We saw that banks and lending are the lifeblood of economic expansion and the contraction or depression of that leads to what exactly? It led to a depression in the 1930s, but I’d argue that after what we saw in 2007 something more insidious could be ahead than the Great Depression. People love to say that history doesn’t repeat but it rhymes, and you know I hate that saying so I have a new one. History doesn’t repeat but it rhymes, but 4 nickels still equal 2 dimes. They are different, sure, but in finance they are the same. To be continued…
Sincerely Yours,
C Thomas Printer
Financial tip of the week
In 2022, the price of eating out was 21% higher than eating at home, but in 2023 that number jumped to 30%. With labor shortages the service has dropped even more than the price has increased. Try eating at home, and if you can’t cook go on YouTube and you can watch someone cook a great tasting meal that you can copy for a much smaller fraction of the price of eating out.
On this date in history
140 years ago to be exact, the Brooklyn bridge opened, connecting Manhattan to Brooklyn.
Also born on this date
The inventor of the mercury in glass thermometer, Daniel Gabriel Fahrenheit.
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