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My best and worst calls of 2008: a credit crisis retrospective

By Edward Harrison

This is the time of year when everyone tends to look back and sum up the year in one way or another. I have been doing much of the same.

In keeping with that theme, I have taken a good look through my nearly 1400 posts to get a better sense of what I got right and what I got wrong and how knowing that can help me going forward. Call it an exercise in intellectual honesty. This exercise has given me a good understanding of where things went wrong in the past year and why.

It may also give me some thoughts as to where we need to go in 2009. Let me share a little of what I learned with you. This is a long but thoughtful post, so take a few minutes. It should be worth it.

On the whole my predictive powers were working pretty well this year. But, I made a few lousy calls and some controversial ones along the way. Below is my view of how the year went, on some of those calls and links to the relevant posts. At the end, I’ll wrap it up with a few thoughts about where that leaves my thinking for 2009.

Recession in 2008

I started the year (actually it was March when I began) blogging about recession. It was my belief at the time that we were already in a recession that would prove much deeper than widely acknowledged. I tagged this recession as having begun in December 2007 or January 2008. This has turned out to be right on the money. Relevant posts:

Easy Money as the problem, not the solution

My thinking at the time was that a recession,while deep, did not have to lead to deflation and depression if policy makers made the right calls. That meant following an Austrian prescription of appropriately high interest rates in conjunction with liquidity at penalty rates if needed and liquidating excess capacity where appropriate.

Until Lehman’s collapse, I stuck with the basic Austrian school belief: easy money is the problem and not the solution. I felt the Federal Reserve was a bubble blowing, easy money central bank that created the housing bubble because they did not have the regulatory wherewithal to stop the madness. I lay much of the blame for this malaise at the feet of the Federal Reserve. Relevant posts:

The Fed creates a commodities bubble and inflation

As the Spring progressed my worry was easy money. My logic was that an easy Fed was stoking a commodities bubble which, by seeping through into consumer price inflation, was going to cause a much harder landing when the bubble popped. My view was that inflation needed to be kept in check because it would set off demand destruction and create a hard landing that all but guaranteed deflation.

Ultimately, I believe this to be the correct interpretation of events but it is controversial because many see the Fed as having made the right calls in gearing up for deflation from the word go. You decide. Relevant posts:

Credit writedowns will be much worse than expected

Meanwhile the financial services sector was imploding. I was very concerned that policy makers were underestimating the severity of the writedown and loan loss problem about to come ashore. No one was chronicling the writedown problem comprehensively.

So I started the Credit Crisis Timeline on April 15th as a modest post called Global Bank write-offs and failures. Later that same day it later morphed into a post called Articles: Bank Writedowns & Failures before becoming the Credit Crisis Timeline in May.

As April hit us, I saw the credit crisis fanning out far beyond the U.S. and big bank exposure to subprime. This was NOT a subprime crisis and it was a global in nature. The U.S., U.K., Ireland, Spain and Denmark all suffered popped housing bubbles that weakened their banking system. Global banks like UBS were writing off tens of billions in exposure to mortgage backed securities. The U.S. regional banks were starting to look weak. So I started to write a lot about anticipated European bank writedowns and regional bank exposure.

My best call here was in predicting that many more writedowns to come and that the financial sector and its credit writedowns would be at the center of this downturn. My favorite call was on HBOS and its exposure to loan losses. My worst call was on Santander, which I thought was going to take down a lot of writedowns. I got that 100% wrong.

All in all, this was the most sickening time throughout this crisis in my view. The problems were mounting and the Bush Administration, The UK Government, The Federal Reserve, all of them, they were asleep at the wheel. Relevant posts:

Oh no, debt deflation is the problem now

Then, in about June I made a controversial switch to a deflation-only perspective. Most everyone else was concerned about inflation at this point. Yes, I worried about the Fed’s easy money, but I figured the damage was done and now we were going to have to live with the consequences of easy money in the form of crushingly high food and oil prices. That meant a major, major recession. Meanwhile, it was very obvious that the banking sector was getting sicker by the minute Debt deflation became my main only concern starting about June. This was starting to look a lot like Japan.

This inflection period between having to worry about inflation to having to worry about deflation was perhaps the crucial moment for monetary authorities. You can see my angst in the post “What’s a central bank to do?” From where I sit, my seminal piece in all this was the post “The ECB is right and the Fed is wrong,” which I wrote on July 4th. Basically, I still felt that the inflation genie could be put back into the bottle before we suffered an extra-hard deflationary landing. The ECB was looking to do this, but the Federal Reserve was not. In my view, the Fed had been easy all along and it was this easy money that created the oil and food inflation monster.

In retrospect, it was probably too late by July. The extremely hard landing was baked in the cake. So, I was wrong here. I was still worrying about inflation as late as July 18th (post: Has the inflation damage already been done?). By July I should have realized deflation, or at least unwanted disinflation, had already begun. Relevant posts:

Things fall apart

So that gets us to the IndyMac blowup. And we later get to the nationalization of Fannie Mae and Fredie Mac which I correctly predicted in April ( post: Question: How is Fannie Mae a AAA company?). Honestly, I didn’t see IndyMac coming. I knew that things had gone beyond subprime into Alt-A already but I was blindsided by IndyMac like most everyone else.

In retrospect, I see IndyMac as the unexpected event which changed psychology toward fear. No longer were Sovereign Wealth Funds ponying up billions into the financial services sinkhole. Investors started to flee the financials in droves and that spelt the end for Fannie and Freddie and later Lehman about whom chatter had already begun even befre IndyMac went bankrupt. Just my opinion.

Below are my warnings in April and May that buying financial services stocks was like catching a falling knife followed by investor revulsion in June and the blowups of IndyMac and the GSEs. I also said the true bloodletting would not begin until people stopped throwing money at the financials which were clearly headed down. One thing you might notice is that I was way too early on commercial real estate. Back in May, I was saying that Commercial Real Estate was the next leg down. It was not.

The missed opportunity for a comprehensive solution

In jumping forward to Fannie’s bankruptcy, I am skipping July and August. I do that in part because I think the GSE bankruptcies were pretty much guaranteed post-Indy Mac. This was a lull where policy makers should have been looking for a comprehensive solution. We saw what happened in Japan and Scandinavia in the early 1990s. Why not use these as test cases? Instead what we saw were policy makers asleep at the wheel yet again. Did they not see the severity of the problem?

Commodities tailspin means hard landing

Meanwhile, I predicted commodity prices would collapse and we would have a brutal downturn. I never envisaged $35 oil. I thought $70 was reasonable and gave $100 as a bogey, but $35 is frightening. It speaks to the depth of deflationary forces.

Below are my posts on predictions about commodities, which would lead to deflation and recession.

The Lehman debacle: completely mishandled

I have been very critical of US economic policy makers and their handling of many aspects of the present financial crisis. But, the Lehman Brothers bankruptcy was the critical event in the whole daisy chain. It unleashed a tidal wave of panic and crushed the global financial system. Before Lehman Brothers went bankrupt, there was considerable wiggle room for the global economy. Yes, there would have been a sharp downturn, but recession is a necessary part of the business cycle. After, Lehman, it was game over.

I wrote this the day after Lehman’s bankruptcy and i think it is the most relevant post I wrote all year:

Deflation is going to happen. Stimulus is needed

Before Lehman was allowed to go bankrupt, the right medicine would have been liquidating bankrupt institutions – financial and otherwise- before their zombie corpses pulled down good companies with them, whilst the central bank remained a ready lender of last resort in the event of market turbulence. That is the Austrian prescription.

But Lehman’s bankruptcy and the attendant market dislocations brought with them the absolute certainty of debt deflation, a downward deflationary spiral, and a deep recession. (For what it’s worse, I was blindsided by the depth f AIG’s fall, while I foresaw WaMu and Wachovia). After Lehman, Depression became more probable than not. This will be the worst economic event 95 of humans on the face of the earth will ever experience. Now suddenly, Keynes has become the man of the hour.

I have felt pretty conflicted by my about face. If you read any of my posts before Lehman Brothers’ bankruptcy, you’ll see that I take a hard Austrian line toward easy money and the solution to crisis. Granted, I have always had a soft spot for Galbraith, but I do not believe in fine tuning the economy, fiat money, or any of that.

In reading through my posts, I have tacked hard to the Keynesian side since about October. Why? In a word: Depression. Economic hardship of the magnitude we are about to face is the bedfellow to famine, war, disease, dictatorship, and economic nationalism. It is the breeding ground for fear and we have never experienced the type of hardship and fear that we are about to experience while in the possession of weapons of mass destruction. There are very bad scenarios to be avoided here. And there are no good choices. To ‘let them eat cake’ is not the way forward. I summed up my thoughts in four posts in mid-December.

The Outlook for 2009 and beyond

So where does that leave us going into 2009? In my view it leaves us in a semi-depressionary state. There are many ills to overcome: commercial real estate, Alt-A mortgages, the unwinds of the banking sectors in the UK and Ireland, and the Eastern European debt crisis, a potential dollar crisis. Most of these things have yet to fully materialize but they are coming. Below are my predictions as made in posts in October and November following the market panic.

Make no bones about it, we are in a very tough economic climate. It will get much worse before it get better.

The key, however, is the policy response. Are we going to stick our heads in he sand and act like these things will never happen or are we going to face the challenges head on? I say we forge ahead and take on the difficult decisions, work our way through this mess and make sure we reform the system so that it never happens again. It will be a long road to the kind of place we really want to be in – perhaps a decade – but we have done it many times before. All we need is the courage to do it again.

I am ever hopeful.

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Edward Harrison 7783 posts 575 comments

Edward Harrison is a senior Editor at Bloomberg. He is also the founder of Credit Writedowns newsletter, a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.

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7 Comments
  1. Glen says

    Some good calls here. The biggest challenge going forward is reform but those in charge are the ones who have benefited the most in the past so real reform is not likely and will be opaque at best. It's intersting that on other sites, bloggers have argued that regulations should be lifted! Hell, if this is the mess they can do while regulated, imagine what could be done when no one is watching! Unfortunately I don't believe that the next president will make much of a difference. $750 b and 3 million new jobs – that's $250k per job, not really economical is it. I honestly don't think that there is anyone in any position of authority who has the ability or independence to tackle what needs to be done. There's just too much money and too many recalcitrant people in powerful positions to make the right decisions – one just has to look at BB, HP and their links to Wall Street. While Rome burns, Nero sits on the roof. My predictions for 09; much bumbling by politicians and central bankers will only exacerbate any recovery while China will come clean by mid year about it's true state of affairs and it won't be pretty. Recovery for end 09 – forget it. Try 2011.

  2. Edward Harrison says

    Glen, many of us are suspicious about the reform bona fides of Obama's economic team. Geithner at Treasury is very much involved in the Lehman debacle I just wrote about. Summers was originally a Reagan administration operative whose historical perspective was not exactly pro-New Deal. These men will need to show that they want true change. Right now, it is looking like more of the same with a Democratic varnish on it. I am still hopeful.

  3. smoody says

    ". . .the Federal Reserve was a bubble blowing, easy money central bank. . ."
    The Fed actually began raising rates in 2004 in part, presumably, to deflate the housing bubble. Short rates rose some 400 basis points, but long rates drifted lower. Greenspan dilemma, remember?
    In a paper in Feb 2005, Brad Setser and Nouriel Roubini pointed out that foreign central banks (primarily China, of course) began buying long-dated Treasuries as early as 2003. Overall, between 2000 and 2007, foreign central bank reserves grew by some USD 4.4 trillion while US Treasury debt increased only 1.5 trillion. In his book, Greenspan says the Fed's 2004 monetary policy was defeated by "global forces," which I suppose translates to Chinese central bank purchases of Treasuries overall and long-dated Treasuries in particular. So I suggest that the cause of the current crisis is the defeat (or failure) of Federal Reserve monetary policy from 2004 on.

    1. Edward Harrison says

      Happy New Year, smoody. The Fed would agree with your argument, especially Alan Greenspan. However, I would say that the bubble took form while Greenspan was lowering rates. To my mind, this is a repeat of the Internet bubble policy action. If you recall, Greenspan made "Irrational Exuberance" speech in 1996, yet he lowered rates in 1998 after the LTCM blow-up and flooded the market with liquidity in 1999. These actions only increased the magnitude of the bubble.

      Fast forward to 2001 and it was much the same with Greenspan lowering rates even though house price appreciation had already outstripped inflation by a large amount over the preceding 6 years. You can see some Dean Baker analyses from 2002 for that. It was obvious that a bubble was building as far back as 2000-2001. My problem with Greenspan was that he lowered rates even in the face of this growing evidence.

      Your 2004 time frame came after it was too late and the bubble had already formed.

  4. smoody says

    Happy New Year!
    No argument. The Fed clearly aided and abetted development of the US Housing Bubble. Had the Fed's policy succeeded in 2004, there still would have been a bubble, though prices probably wouldn't have gone as high and the
    worst vintages of subprime and Alt-A mortgages might not have been written. But the current crisis goes beyond the US Housing Bubble. It's global. It's a globalization crisis because, globalized, the world economy is too big for the Fed to manage. This is a systemic crisis, not unlike the collapse of the Bretton Woods system in '71. The system doesn't work if foreign central banks can't buy Treasuries without disrupting the Fed's conduct of monetary policy. In 2004, FCB purchases of US Treasuries defeated Fed policy; globalization of liquidity pulled the plug on the Fed.
    Scary picture, don't think? The world's largest economy unable to conduct monetary policy. Actually, the worlds's two largest economies–the US and Japan–were without effective monetary policy from 2004 until October 2008. No wonder the world's financial markets ran amok.

    1. Edward Harrison says

      smoody, a smart guy by the name of Davidson, who is a professor of Economics at the New School has some good stuff on how to reform the so-called Bretton Woods II system that I need to post. The long-and-short of what he says is that you are correct, this is a systemic crisis and we need to reform the entire system.

      The post-1971 world is one where there are no checks and balances and this leads to excess and eventually crisis. We have seen this tme and again in a way that we never saw pre-1971. In my view, it is the lack of a currency anchor like gold that makes the system of fiat currencies rotten to the core and is the ultimate 'reason' for excess.

      So, I agree 00% that this goes beyond the Fed, in part because capital controls don't exist and this means someone's excess doesn't necessarily lead to a bubble only in their economy. Often times, excess spills out to other economies without inflating the domestic economy (Japan is a perfect example). If we had a check on this as we did pre-1971, things would never have developed the extreme that they did.

  5. smoody says

    Ed, please post Davidson's stuff. No one else is actively pursuing this argument.

Comments are closed.

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