What makes a Great Depression a Depression and not a recession?

You’ve heard me throw the ‘D’ word around on a couple of occasions – sometimes to signal policy makers are trying to avoid that outcome, but other times to signal this is looking like one. So, which is it? We don’t know yet. But let me use this post to explain how I’m looking at it – and where policy choices matter as a result.

Length and severity

When we think of Depressions, we think of economic suffering that is both long and deep. There’s the Great Depression, which began in 1929, and, by most accounts, fed bellicose populist voices that began World War 2. It wasn’t over until the War ended. That’s sixteen years.

Then there’s the Long Depression that began after the Panic of 1873 and lasted 23 years in the United States, ushering in Jim Crow as the Compromise of 1876 ended post-Civil War Reconstruction and plunged the South into 90 years of segregation and disenfranchisement.

In the US, there was the Panic of 1837 and the resulting Great Depression, often considered worse than the Great Depression that began in 1929. It only really ended with the California Gold Rush in 1848. In fact, all the early American panics, like the Panic of 1819, led to Depressions. The one in 1819 caused the first Great Depression in the US.

Greece had a Great Depression from 2009. Is it over now? It’s hard to say. If you look at the numbers, they show very poor growth punctuated by fits of contraction even after the sovereign debt crisis ended. And the unemployment rate today is still 16%, whereas it was no more than 11 or 12% at its worst in the 2000s.

So, Depressions are extreme events economically. And they generally last a long time. So, while this downturn has been severe, it hasn’t lasted long…yet. It’s hard to say yet whether it’s a Depression then.

Credit Writedowns

For me, though, Depressions are made in the banking sector. The reason this site is named Credit Writedowns owes to that. Time and again, it’s a financial panic and crisis that takes down the financial system that has ensured a Depression.

It is the fact that banks take losses on their loans and other assets on their balance sheet and must write those assets down that causes distress. When banks write down assets, it’s a direct hit to capital. And that constrains lending. And it’s that lack of lending which causes the economy to slow. When bank capital is so impaired that financial institutions fail, it starts a daisy chain of contagion that ends in generalized financial distress that then causes the economy to contract violently. A Depression sets in.

Deeply unpopular and deeply hard to understand

What policy makers did in 2009 is prop up the financial system, bail out the banks to prevent that outcome. The optics were bad – really bad, given that it was the those very same institutions whose employees’ reckless behavior caused the crisis. But policy makers, the Tim Geithners of the world, felt this was the least bad option. As Geithner himself put it in 2009, he felt forced to do “deeply unpopular, deeply hard to understand” things.

So, what did policy makers (think they) learn(ed) from the Great Financial Crisis? I would say the first lesson is that bailouts work. The optics may be poor but they work by preventing the financial system from collapsing. The second lesson is that the Federal Reserve and other central banks have unlimited resources. They can never run out of bullets. We saw this when the Fed waded into junk last week, telling us it was going to buy the debt of ‘Fallen Angels’ and high yield exchange traded funds. 

For institutions, the first important lesson is that size matters. If you are small, the chances of bankruptcy are exponentially greater. Get too big to fail and you’ll get a bailout. It’s not just banks either. In this downturn we see Boeing getting earmarked for a bailout from the US Treasury for national security reasons. And the only reason Boeing is a ‘national security’ interest is because Boeing bought defense contractor McDonnell Douglas in 1997.

For investors, the big lesson is that the Fed put exists. Why? A big part of how the Fed operates is in gauging the transmission of monetary policy via financial conditions. And the way they do that is by looking at credit spreads, market volatility, debt issuance and other signs of buoyancy in credit markets. So, if markets sell off violently, by definition financial conditions have tightened aggressively and the Fed has to react. That’s where the concept of a Fed put comes into play. 

In defense of the Fed?

So, the piece I wrote on Friday was a recognition of all of the what I just wrote. I wasn’t defending Fed policy because I thought it was the right policy. I was outlining why it made sense; all policy makers want to avoid a great depression. And the Fed plays a key role, since it safeguards the financial system in the US.

Forced into a corner due to the severity and pervasiveness of the financial crisis after coronavirus hit, the Fed has simply decided to provide blanket support because it fears, otherwise, the financial crisis would metastasize into a Depression. The problem is that the Fed and other policy makers, by buying everything in sight are, in effect, taking chunks of the private sector onto their balance sheet – creating a giant moral hazard by privatizing gains and socializing loss.

We saw that in 2009 because the Fed’s actions to save the system ended up with companies leveraging up and making themselves more vulnerable to economic shock. The reason the Fed is buying junk bonds is exactly this – companies are leveraged. And, with an economic shock, the Fed feels essentially forced to go further down the credit easing spectrum and take the private sector’s losses on its balance sheet to make punters whole for fear of another Great Depression.

If we get out of this without the Depression, the lesson will be the same as it ever was: size matters. Get big. Get leveraged. Enjoy the profits from that and expect the Fed to save the day if things go pear shaped.

A pro-active or reactive Fed?

If credit writedowns are the problem in any financial crisis, a proactive Fed would be prohibiting dividend payments by financial institutions right now. But they aren’t yet. So, clearly they aren’t yet being proactive on that score.

Look at this article from 2019: “10 Banks With Soaring Dividend Payouts“.

Until recently, regulators had forced banks to keep their dividend payout ratios at 30% or lower… With the sector returning to health, and regulators approving massive returns of capital to shareholders, these ratios are rising. By 2019, the median payout ratio for the 10 banks listed above will be about 40%, per JPMorgan Chase’s projections.

Why isn’t the Fed stopping this? Because it’s reactive, not proactive. Once the credit writedowns begin en masse due to the downturn, the Fed will stop these payouts. But, until then, it’s business as usual. If any of these banks are in your portfolio, expect the dividends to get cut – either by the Fed in reaction to credit writedowns, or by the companies themselves for fear of their balance sheet and finding market access.

The Fed’s reactive junk response

Then there’s the junk bond buying by the Fed. I told you there was a problem in that space in January. Here’s how I put it:

…A downgrade of GE, AT&T or Ford, for example, would bring in an issuer so large that high yield bond indices could not – under size allocation rules – absorb. Put simply, no issuer in a HY index can be above a certain percentage of the index. And GE, Ford or AT&T would violate that principle.

Completely beside the investment grade selling issue, this is a big problem in terms of demand for those bonds in the high yield space. What you would then have is a fallen angel with a lack of both high yield and investment grade investor demand. In a worst case scenario, this could cause selling of that specific issue to leak into funds selling other issues in order to meet redemption demand, adding a significant amount of contagion to the bond market.

And to make matters even worse, high yield bond funds like HYG give investors the false sense of security that they can sell on demand, even though the underlying high yield investment universe is relatively illiquid. The reality is that bonds are much less liquid than stocks. Long-term investors often buy and hold to maturity. And single name companies release a multiplicity of bond issues, whereas they generally have only one publicly-traded stock issue. That further decreases liquidity. For bond ETFs that’s a big problem when there is heavy selling.

So my view here is that we have a disaster waiting for a trigger. And the disaster is a selling wave of high yield bonds and bond ETFs. Ostensibly, to the degree this is merely a liquidity problem, this could present a buying opportunity for investors. But, to the degree the trigger is a downgrade to fallen angel status caused by a recession, you have the makings of a rout in high yield that could lead to refinancing risk, especially in the CCC space.

Personally, I think when the music stops, there will be a lot of defaults at the lower end of the credit spectrum. And the dynamics of fallen angels and high yield ETFs will only exacerbate the fundamental issues by heightening the loss of liquidity.

In my view, regulators need to fix the bond ETF liquidity mismatch issue before investors get hurt. Right now, it’s a question of when, not if.

Regulators didn’t do anything. So when the market seized up, they felt compelled to take it onto their balance sheet to provide ‘liquidity’.

But, remember, CCCs are in a world of hurt – as are energy bonds. The Fed’s actions won’t change that. As I predicted in January, liquidity has dried up for these names. All the Fed has done is move the Fed security blanket down from BBB- to BB-. B and CCC companies will default. And companies that were BB before the crisis will also be vulnerable to default to.

My View

We are still in the throes of a situation which has the hallmarks of Depression written all over it. To stop the rot, policy makers are effectively taken private sector losses onto their balance sheet, at least temporarily, and likely for a long time to come. Think of it as the equivalent of the British nationalization of Royal Bank of Scotland writ large for the entire economy.

But, the larger the security blanket becomes, the greater the moral hazard is regarding socializing losses that are potentially associated with previous privatized gains. The Fed is aware of this problem but feels obligated to intercede because the situation is dire; if they don’t intercede we will have a Depression for sure.

Even so, large portions of the economy remain in freefall. And eventually that will infect both corporate earnings and bank balance sheets via credit writedowns. It’s only a matter of time