Rickards: Why The Panic Is Just Beginning

 Authored by James Rickards via DailyReckoning.com,

Let’s step back from today’s banking financial crisis and look at the bigger picture. That will help us to understand the system dynamics, and estimate how long the crisis might last, and how destructive it might be.

Rickards: Why The Panic Is Just Beginning

As a preliminary matter, let’s distinguish between a recession (even a bad one) and a financial crisis. They’re different.

A recession is a part of the business cycle. It involves some combination of tighter monetary conditions, higher unemployment, business failures, inventory dumping, declines in industrial output and declining GDP.

In recent decades, we’ve had recessions in 1973, 1980, 1981, 1990, 2000, 2007 and 2020. That’s a tempo of one recession about every seven years, although the recessions of 1980 and 1981 show that back-to-back recessions are possible.

Of those, the 2007 recession lasted the longest (one year and six months). The 2020 recession produced the most severe decline in GDP (down 19.2%).

The U.S. is likely in another recession right now, but we won’t have confirmation of that until more first-half data is revealed.

Over the same 50-year period, we’ve had a succession of financial crises.

These included the Latin American debt crisis (1982–1987), the Savings & Loan Crisis (1986–1989), the Black Monday crash (Oct. 19, 1987), the Nikkei collapse (1990), the Mexican Tequila Crisis  (1994), The Asia-Russia-LTCM crisis (1997–1998), the dot-com crash (2000) and the subprime mortgage crisis (2007–2008).

That’s eight crises in 50 years or a tempo of one crisis about every six years.

So much for the “Black Swan” theory, and the idea of 5-sigma events that occur once every 14,000 years. That’s junk science. These things happen all the time.

What’s interesting about financial crises is that they are rarely the same. Some produce large losses but there’s no acute stage where the financial system is hanging by a thread. The Latin American debt crisis, the S&L crisis, and the Nikkei collapse fit into that category.

They lasted for years, but they were manageable in a cash and accounting sense. In some ways, the Nikkei collapse is still going on thirty-five years after it happened because the Nikkei stock index has never recovered the 40,000 level it hit in late 1989.

Other crises were acute but came and went without threatening the banking system. The 1987 flash crash was a good example. It happened, but not much else happened. Two days after the crash turned out to be a great time to buy stocks!

A similar analysis applies to the Mexican Tequila Crisis and the Dot.com collapse. They were over quickly, the banking system as a whole was never threatened, and astute investors with cash could buy in at the low and ride the next wave up.

The only two crises that did come close to destroying the global financial system were the Asia-Russia-LTCM crisis in 1998, and the Subprime Mortgage Crisis in 2007 – 2008.

Even those crises had important differences.

The Asia-Russia-LTCM crisis was acute but there was no recession. Economic growth and the stock market bubble didn’t peak until 2000.

What sets the 2007 – 2008 crisis apart is that it was an existential financial crisis and a severe recession. (The 2020 recession was the most severe, but there was no financial crisis).

If we set the clock at 1973 and count 1998 and 2008 as the only existential crises, then the tempo is once every twenty-five years. That’s a small sample. The last acute crisis was fifteen years ago.

We can draw several conclusions from this data.

  • The first is that recessions and financial crises are different.

  • The second is that recessions have much in common but financial crises tend to be idiosyncratic and unpredictable.

  • The third is that existential financial crises really are rare; only two in the past fifty years.

  • The fourth and most important conclusion is that the combination of a recession and an existential financial crisis is extremely rare.

The events of 2007 – 2008 are the only such combined case in our timeline.

You have to go back to the Great Depression of 1929 – 1940 to find a similar case. That period involved two recessions (1929-1933 and 1937-1938), a massive wave of bank failures (1931-1933), continual currency devaluations, and a collapse of world trade.

Now for the all-important question: Is history repeating itself?

Read on for the answer.

Is History Ready to Repeat Itself?

For our purposes, this history shines a light on the combined crises of 2008. Is history now repeating in its own curvilinear way?

The evidence that we are in a recession is powerful. Low unemployment is almost irrelevant because labor force participation is also low. World trade is contracting. Industrial output is declining. Wholesale inventories are high, which means markdowns and lower profit margins are on the way. Interest rates are still going up and inflation is still sapping real wages.

Much of Europe and Japan are already in recession. The China “reopening” is a flop. The stock market has been volatile but the trend is not your friend. Treasury yield curves are steeply inverted, a condition last seen in 2007. The recession part of the Recession+Crisis condition is already here.

What about another global financial crisis? We know that a banking crisis has already begun. Here’s the casualty list from just this month:

  • Silvergate Bank – Announced its bankruptcy on March 8

  • Silicon Valley Bank – Taken over by the FDIC on March 10

  • Signature Bank – Taken over by the FDIC on March 12

  • First Republic Bank – $30 billion liquidity rescue by 11 banks on March 16

  • Credit Suisse – Swiss government shotgun wedding with UBS on March 19

That’s five bank failures or rescues in eleven days including Credit Suisse, one of the largest banks in the world and the second largest in Switzerland. Combined losses of stockholders and creditors of these institutions exceed $200 billion. Market losses in the banking sector are much greater.

These failures and rescues were accompanied by extraordinary regulatory actions. The FDIC abandoned its $250,000 deposit insurance limit and effectively guaranteed all the depositors in Silicon Valley Bank and Signature Bank, a guarantee of over $200 billion in deposits. This will deplete the FDIC insurance fund and require higher insurance premiums from solvent banks, the cost of which will ultimately be borne by consumers.

The Federal Reserve went further and offered to lend money at par for any government securities tendered as collateral by member banks even if the collateral was worth only 80% or 90% of par. These collateralized loans will be financed with newly printed money, which might exceed $1 trillion.

These actions have thrown the U.S. banking system and bank depositors into utter confusion. Are all bank deposits now insured or just the ones Janet Yellen decides are “systemically important?” What’s the basis for that decision? What about the fact that unrealized losses on U.S. bank portfolios of government securities now exceed $700 billion?

If those losses are realized to provide cash to fleeing depositors, it could wipe out much of the capital of the banking system.

The most important question is: Is the crisis over? Has the Fed done enough to reassure depositors that the system is sound? Has the panic subsided?

The answer is, no. The panic is just getting started.

We base that answer on the history of the two acute financial crises in recent decades — 1998 and 2008. The 1998 crisis reached the acute stage on September 28, 1998, just before the rescue of LTCM. We were hours away from the sequential shutdown of every stock and bond exchange in the world.

But that crisis began in June 1997 with the devaluation of the Thai Baht and massive capital flight from Asia and then Russia. It took fifteen months to go from a serious crisis to an existential threat.

Likewise, the 2008 crisis reached the acute stage on September 15, 2008, with the bankruptcy filing of Lehman Brothers. But that crisis began in the spring of 2007 when HSBC surprised markets with an announcement that mortgage losses had exceeded expectations.

It then continued through the summer of 2007 with the failures of two Bear Stearns high-yield mortgage funds, and the closure of a Société Générale money market fund. The panic then caused the failures of Bear Stearns (March 2008), Fannie Mae and Freddie Mac (June 2008), and other institutions before reaching Lehman Brothers.

For that matter, the panic continued after Lehman to include AIG, General Electric, the commercial paper market, and General Motors before finally subsiding on March 9, 2009. Starting with the HSBC announcement, the subprime mortgage panic and domino effects lasted twenty-four months from March 2007 to March 2009.

Averaging our two examples (1998, 2008) the average duration of these financial crises is about twenty months. This new crisis is one-month old. It could have a long way to run.

On the other hand, this crisis could reach the acute stage faster. That’s because of technology that makes a bank run move at the speed of light. With an iPhone you can initiate a $1 billion wire transfer from a failing bank while you’re waiting in line at McDonald’s. No need to line up around the block in the rain waiting your turn.

In addition, the regulatory response is faster because they’ve seen this movie before. That begs the question of whether regulators are out of bullets because they’ve already guaranteed almost everything so they don’t have more rabbits to pull out of the hat.

This could be the crisis where the panic moves from the banks to the dollar itself. If savers lose confidence in the Fed (we’re almost there) not only will the banks collapse, but the dollar will collapse also. At that point, the only solution is gold bullion.

Further evidence comes from the fact that no sooner was the Credit Suisse shotgun wedding completed than investors aimed their sights at Deutsche Bank, another perennial weak link in the chain. Who’s next? Barclays? Santander? We don’t know. Neither do regulators or investors. But we do know more failures are coming.

By the way, this is not really a banking crisis even though it plays out in the form of bank failures. What’s going on is a crisis caused by a shortage of Treasury bill collateral to support derivatives positions and shrinking balance sheets as a consequence of the collateral shortage.

Why doesn’t the Treasury just issue, say, $2 trillion of new T-bills and let the primary dealers and Fed underwrite them with as much printed money as needed? One reason is that neither Jay Powell nor Janet Yellen understands what we just described.

The other reason is that we’re up against the X-Date when the Treasury runs out of cash and can’t borrow more because of the debt ceiling. Is Congress ready to raise the debt ceiling? Nope. It’s the usual Democrat versus Republican game of chicken with no resolution in sight.

So, we go from bank runs to a Treasury bill shortage to a debt ceiling standoff in no time. Do regulators and financial journalists understand this? No, they don’t know how to connect the dots. But you get it.

We may not be able to prevent the crisis, but we can see it coming and prepare accordingly to preserve wealth. Step one is to get gold. That will see you through the storm.

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