My best and worst calls of 2008: a credit crisis retrospective
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:
- The Economy Is Definitely In Recession (Mar 2008)
- Recession: How Long and How Deep? (Mar 2008)
- Last week’s GDP numbers (May 2008)
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:
- Has anyone noticed the Dollar has gone into freefall? (Mar 2008)
- Is the Fed reckless? (Mar 2008)
- The US Economy 2008 (Mar 2008)
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:
- Liquidity trap of a different sort (Apr 2008)
- Oil price rise is accelerating May 2008
- The Fed is on the easy money trip (May 2008)
- George Soros warns UK on economy, oil and inflation May 2008
- What is Inflation? (Jun 2008)
- Peak oil: are we there yet? (Jun 2008)
- Bernanke is responsible for the market meltdown (June 2008)
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:
- Finding a bottom (Apr 2008)
- RBS takes an enormous hit (Apr 2008)
- Where’s HBOS? (Apr 2008)
- Santander: US, Spanish and UK mortgage exposure (Apr 2008)
- HBOS to raise new capital (Apr 2008)
- The UK is ground zero in the credit crisis (May 2008)
- British Banks are underestimating losses (May 2008)
- Regionals are exposed to credit crisis (May 2008)
- Bradford & Bingley to issue profit warning (May 2008)
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:
- De-leveraging (Jun 2008)
- De-leveraging redux (Jun 2008)
- Forget Inflation, debt deflation is the real threat (Jun 2008)
- The Japanese Problem is now ours (Jun 2008)
- Credit deflation and the Japanese problem (Jun 2008)
- Is the Fed going to raise rates? (Jun 2008)
- Deflation has already arrived (Jun 2008)
- BIS warns of worsening credit crisis and deflation (Jun 2008)
- Inflation or deflation? (Jun 2008)
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.
- Finding a bottom (Apr 2008)
- Carlyle: Expect protracted credit crisis (May 2008)
- What’s different about 2008? (May 2008)
- UBS warns on non-US property losses (May 2008)
- Regionals are exposed to credit crisis (May 2008)
- Regionals have CRE and Construction exposure (May 2008)
- Investors in Financials lose $10 billion (Jun 2008)
- Investors finally balk at giving banks more capital (Jun 2008)
- Financials: catching a falling knife (Jul 2008)
- IndyMac: Another Banking Bankruptcy (Jul 2008)
- Freddie and Fannie taken over by US government (Sep 2008)
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?
- Lessons from Japan’s Bank Crisis (Aug 2008)
- The Swedish banking crisis response – a model for the future? (Aug 2008)
- A cautionary tale: story from 1994 Japan (Aug 2008)
- Japan circa 1996 – forgotten already? (Jul 2008)
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.
- Oil to sink to $100 (Jul 2008)
- Have commodity prices peaked?
- Ten predictions for 2008 (Jul 2008)
- Refiners as a canary in the coalmine (Jul 2008)
- Commodity prices are dropping across the board (Jul 2008)
- The inflation – deflation debate redux (Aug 2008)
- What happened to peak oil? (Aug 2008)
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.
- Confessions of an Austrian economist
- What does Mises say about trying to stimulate the economy out of recession
- Nouriel Roubini: Will massive stimulus ward off stag-deflation?
- A brief philosophical argument about the role of government, stimulus and recession
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.
- The U.S. banking crisis: where are we?
- History shows US bank lending will be soft for years
- Europe is in for a rude awakening
- The Europeanisation of the Credit Crisis
- Where is the global economy headed?
- A shift to Eastern Europe and emerging markets too
- Dollar strength is an illusion
- Currency crisis is gathering storm
- Subprime good, prime bad
- The emerging markets crisis
- Iceland: a cautionary tale for small nations
- Is Ireland the next Iceland?
- Why I am bearish on the U.S. Dollar
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.