Credit Crisis Roundtable - Why the current downturn may be much worse than most expect
Credit Today: Jerry, you've read every book ever written about financial "bubbles." Can you share some of your perspective on what we might be looking at here?
Jerry Flum, CreditRiskMonitor: I think this is a different game we're in. It's very, very different (compared to previous economic downturns). I look at Japan and in 1989. Their stock market was at 40,000, and it's now, in 2008, eighteen years later, it's down to 8,000. It's still down 80% after 19 years. To combat their stagnation over the last 20 years Japan - which is not Italy - has ramped up debt as a percentage of GDP to extraordinary levels. It is now one of the highest in the world at roughly 300% of GDP. They have done everything that you could have ever done as a Keynesian deficit financing country, and they still can't turn the engine on. Their economy and stock market are still ugly after all of that.
Jerry Flum, CreditRiskMonitor, Doug Collins, Atradius, Mike Rodgers, FINACITY
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Ken Moyle, Coface: At their peak, people were living in the equivalent of million dollar homes, but they had 100-year amortization schedules on the homes. The idea that either appreciation or magic in Japan is going to take care of the problem is divorcing responsibility from realty. I say to my wife all of the time, "What ever happened to shame?" Nobody has shame anymore. There is no shame in being a deadbeat. There is no shame in living above your means and then having it all crash. Doug Collins, Atradius: There is one thing that didn't happen in Japan which is interesting and speaks to the debate in Washington. They didn't allow companies and banks to fail. The government spent a lot of that debt to effectively bail out the banking sector to force mergers, to prop up companies, and to spend a lot on infrastructure. The only bright side, and is to Jerry's point is that apparently on the U.S. debt, the GDP ratio, we have a lot of headroom. We can try to end up where Japan is now, but that's not necessarily a good thing. Flum: Yes. But it didn't work in Japan. And we don't have as much headroom, since our debt is now 3 1/2 times our GDP, and it was 2 times our GDP in 1929. For immediate access at our special discounted rate to the entire Credit Crisis Roundtable transcripts, click here to get started! Collins: Exactly. Flum: The point is that the Japanese did this and the bottom line is - as we sit in this room today - it hasn't worked. Collins: But what if they hadn't done anything? Flum: There is a great school of economic thought that if you do nothing, you're going to end up in the exact same place. In fact, this real school of economics is called classical economics, or Austrian economics, and it says, "Get the government out of the way on." You won't have excessive government intervention policies to extend an economic expansion beyond where it should go. Therefore, the contraction when it finally contracts, will be less severe.
 I say to my wife all of the time, 'What ever happened to shame?' Nobody has shame anymore. There is no shame in being a deadbeat. 
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-- Ken Moyle, Coface
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Business cycles will be around for a long time. So what is happening now, because of the government intervention, is that the contraction will be deeper because it went up much further than it should have. If you're an Austrian economist, the question is, "When does the government get out of the way and let whatever is going to happen, happen?" The contractions in economies, or the down part of an economical cycle, is part of the total economic cycle and is a cleansing factor. This allows us to clean out the bad investments made in the expansion. And there are going to be bad investments made in every expansion. Not every business guy is Warren Buffett. If you have some bad investments, an apportionment of capital, then it gets cleaned up in the contraction, which is the normal thing. I think that's a pretty good economic policy. I think that's what we're stuck in today. CT: I wanted to comment to Jerry's comments, talking about the Austrian School versus the Keynesians. The problem is that the Keynesian's were just elected. Chris Hobson, Cortera: Doug, I just want to clarify; the Austrian school of economics is creative destruction, which means let the weak fail. Collins: Right. Hobson: You're absolutely correct. The Keynesian economics is spend, spend, and spend to soften the business cycle. CT: So for all of the talk about our deficit and how out of control it is, we're not anywhere near where Japan is right now, even though Japan is known as a nation of savers? Flum: I'm talking about all debt as a percentage of Gross Domestic Product. We're in a tight race. We are passing the Japanese. CT: Does anyone know the overall figures? Participant: Large. Flum: Large, and that's without counting the derivatives of $400 or $600 trillion. So depending on which number you pick, and you recognize, that's only one part of the problem. It happens to represent eight or ten times the entire Gross National Product in the world. It's not like we're alone with the Japanese in the plane flying into the mountain. There are a lot of other countries in the plane with us.
The fact of the matter is when you see derivatives at $400 or $600 trillion, depending on which number you pick, and you recognize, that's only one part of the problem. It happens to represent eight or ten times the entire Gross National Product in the world. It's not like we're alone with the Japanese in the plane flying into the mountain. There are a lot of other countries in the plane with us.
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-- Jerry Flum, CreditRiskMonitor
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CT: What about the idea that those contracts lay off multiple times on the same contract, so you're really counting the same derivative several times over? Flum: Absolutely. CT: So what do you think that will wash out as? How Hedging Derivatives Work Flum: This is my reading of the derivatives that I see. What happens is that now they appear to have netted them out. Part of the real problem with derivatives is that 80% of this number is an over-the-counter derivative. Let me give you a couple of things which I think are really critical with over-the-counter derivatives. First, you don't have a standardized contract. If you want to hedge something, it's not like the old put-call where you walk in and there is a put-call broker with a standarized contract. You go into Goldman or Bear - it isn't Bear anymore - whoever is around and you say, "I want to hedge something." They would then write a special contract for you. You want to hedge gold and they might say, "The best way to hedge gold is to go short timber because the correlation is X." They'll go through all of this BS so they can get a huge amount of dough out of you to hedge it. Derivatives Contracts: Incomprehensible Those contracts terms and conditions become so complicated that nobody could put them on an exchange where standarized terms are needed. How do people assess what the risk is, so that all of the members of the exchange can in effect, insure that you will be there if the contract gets called? One of the classic cases of this extraordinarily complicated dealing and terminology occurred about six years ago. I don't remember the exact names, so you'll forgive me. I don't know who these people are, but I'm going to use names. I think the seller was Bankers Trust, one of the big banks - I think the buyer was Procter and Gamble. Seventeen guys from Bankers Trust; some with PhDs go down to the offices at Procter and Gamble. You can imagine, 47 MBAs sitting there all lined up and they negotiate this deal over months and months. A year later Procter and Gamble loses $100 million or some large amount. Their first reaction is, "How the hell did this happen?" Of course, they say, "It can't be us!" For immediate access at our special discounted rate to the entire Credit Crisis Roundtable transcripts, click here to get started! Hobson: They pulled out this chart. [Laughter] Flum: Yeah. They pulled out this chart. I'm not making this up! This is not a Hollywood movie. This is real life. They come in and now P&G says, "We didn't understand the contract. We couldn't have lost that much money. We're too smart. You guys must have lied or misconstrued it." The bottom line is that Bankers Trust settled for roughly 30 or 50 cents on the dollar. Now this is Procter and Gamble coming out and saying, "We were too stupid to understand this derivative." Can you imagine an over-the-counter derivative that gets pushed out, pushed out, resold, and resold, and now it ends up with some guy in a bank in South America? Somebody walks in and puts the contract down, and the banker says, "We don't do business that way here. I don't understand the contract. I'm not going to do it, I'm bankrupt."
Former Federal Reserve Board Chairman Alan Greenspan
Thanks to Cortera
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So now, that contract starts to collapse inward since somebody was relying might be relying on that contract for the other side of their hedge. Now, with one part of the hedge evaporating, they're naked long or short. That's the problem here. By the way, the exact same thing happened five or six years ago in another American bank. They sold some derivatives to a bank in Korea, I believe, and the bank said, "We don't care what the contract is, we're not honoring the contract. This is insane. We can't be losing that much money, let's settle." Finally, as I remember the story, I think the U.S. Government had to get involved and say, "Look, you need to get on the Korean government to lean on the bank." And say, "Look, guys, this is a real heavy game. You have to honor your contracts. The whole financial system is based on this." That's the real problem here. You have counter party risk on a huge scale and nobody knows where the domino will fall. Markets, the stock and bond markets, start to contract and go down. This, in turn, destroys the ability of consumers so spend because their wealth has contracted dramatically. The engine of everything out there is that everybody in the world is supposed to have four cars and seven television sets. That will not happen now. For immediate access at our special discounted rate to the entire Credit Crisis Roundtable transcripts, click here to get started!
Slide 4: Household Delinquencies Skyrocketing
Source: Moody's Economy.com; Thanks to Cortera
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Dan Meder, Experian: I have a quick question. Chris, where did you get that picture of Alan Greenspan?Flum: That is a great picture. Meder: That's a great picture. Hobson: The quote was more recent than the picture. Participant: Whose caption is it? Meder: Yeah. Right. That's a better question. Hobson: I just want to say that the regulators, regimes, or GSEs were wrong, conflicted, or asleep at the switch. Greenspan has been lionized as the savior of the economy through Long Term Capital Management, the Asian crisis, etcetera through the late 1990s. After arguing for years that this derivative market that Jerry was just talking about shouldn't be regulated and we should let the market regulate itself, he came out in September or October and said, "I was wrong."
Slide 5: Treasury Secretary Hank Paulson
Thanks to Cortera
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For immediate access at our special discounted rate to the entire Credit Crisis Roundtable transcripts, click here to get started! "Everyone Asleep at the Switch;" Day of Reckoning is Here For me, that epitomizes all of those four boxes that were wrong, conflicted, or asleep at the switch. We've talked about this next slide, slide 4; The Day of Reckoning is Here. Look at the aggregate amount of household debt in delinquency or default; it's close to a trillion dollars of household debt, which is crazy. You have house prices plummeting, and as we talked before, as that works its way through the financial system you end up with banks writing it down and/or having to raise a ton of capital, or merging. You end up with this picture of Hank Paulson. What the hell is going on, right? To try to pull all of this back to what it means for credit and collection professionals, it's a triple whammy. It might even be a quadruple or quintuple whammy; there might be more of it. At the very least, you have consumer confidence plummeting. You have a recession happening, which is going to drive bad debt.
Slide 6: Percent Over 30: Dramatic Rise in 5 Months
Source: Cortera
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Basically, as a leading indicator, a year later, that debt expense roughly doubles from a half of a percent to one or more percent. The banks aren't in a position to extend more working capital loans. Companies are slow in paying their suppliers to shore up their own source of capital. Again, CRF (Credit Research Foundation) is showing that 90% of respondents are reporting that customers are relying on them for working capital needs. Two-thirds are seeing a slow down in payments. If you look at the Z.1 statistics from the Federal Reserve, they show that trade receivables are continuing to grow even as the economy is slowing. It's all pointing in the same direction. The reckoning is here. Editor's Note: This is part 3 of 12. Next up in part 4:
The lowdown on derivatives and how they impact trade credit; Tripling (or more) in default rates in 2009? ... Economic policy from Mars? ... Top management's in denial: the implications for credit execs... For immediate access at our special discounted rate to the entire Credit Crisis Roundtable transcripts, click here to get started!
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