Nov. 22, 2022

When The Tide Goes Out, You Find Out Who's Swimming Naked

Our economy is based on credit, to a larger extent than many realize. For the last 30 years, financial empires are built during times of loose credit, and many fail during times of tightening credit, like we're going through today. This is because many of these multi-billion dollar financial firms operate on extremely thin margins, and rising interest rates can quickly turn their incomes statements red.


I learned this bitter lesson back in the 1980s. It was when the walls between investment banks and commercial banks were falling. Old laws and regulations, particularly the Glass-Steagall Act, were on their last legs. Within a decade, President Clinton would sign the Act that allowed all banks to have a broker division.

But in the 80s several West Coast Savings and Loans were already operating their stock broker division. And I worked for a firm that provided the back office services for these new S&L Brokerage Divisions.

One day the head of Gibraltar Savings And Loans invited me out for lunch. It was not uncommon for us to get together, so I thought nothing of it. As we sat down, he told me he had some bad news; the firm was going out of business. Not just his brokerage division but the entire Savings and Loan, a company in California for a century, was now in a position where failure was inevitable.

His announcement was a real shock! I had never expected this. And we went through just how it happened for the next hour or more. And let me give you the highlights.

Starting in 1987, around the time of the Stock Market Crash, the Federal Reserve began raising interest rates. They pushed rates from slightly over 6% to just under 10%, only about a 3% rise in rates but enough to drive up Gibraltar's cost of funds. And it only took a minimal move before Gibraltar was underwater. What was worse, this drama would take months to play out, although we saw the inevitable during our lunch. Six months after our meeting, Gibraltar filed for bankruptcy, and hundreds of workers, in both the bank and brokerage were laid off. A historic California financial institution was no more.

Interestingly no bail-out was provided from Washington, unlike some East Coast banks that would find themselves in the same position a decade later. Remember, S&Ls were not members of the Federal Reserve.

But here is the takeaway, when the Fed decides to tighten monetary conditions by raising interest rates and various other strategies, they will inevitably put some financial companies out of business. Firm failures are all part of that "demand destruction" that we're hearing much about today.

I would have the same experience months later when the same interest rate cycle caught the nation's most significant Savings and Loan, Home Savings. However, they would be forced to merge instead of closing their doors. Ironically their merger partner would be another client, Washington Mutual, which would later combine with JP Morgan Chase. By this time, the regulators had become more efficient at merging troubled banks instead of just closing them. Mergers provided savers and investors with a readily available alternative.

During the 21st Century, we've experienced two periods of Fed Tightening. During each period, major bankruptcies have occurred, although sometimes with a lag time of up to a year.

The first period of tightening was from 1999 until 2000, which brought on the 2001 Recession, during which we saw three significant bankruptcies, Enron, World Com, and Conseco. These ranged in size from $61 billion for Conseco to the $103 billion loss for World Com.

Reacting to the 2001 Recession, the Federal Reserve once again lowered interest rates and provided loose credit conditions. By 2004 rates were back down to just 1%. Then, again, the Fed began to tighten, raising interest rates, until, by July 2006, fundamental interest was at 5 1/4%. That's a significant jump, a 500% increase in just a couple of years.

The results were predictable. Already skating on thin ice, some major financial firms went out of business. During this credit tightening, Chrysler and General Motors both declared bankruptcy. It was also the time when CIT Group and MF Global also fell. And topping the list was Washington Mutual, a record-smashing $327 billion bankruptcy. A record that didn't last. Shortly after, Lehman Brothers were insolvent, at $691 billion, the largest, most significant bankruptcy in American history.

It had been more than two years since the Fed reached its terminal interest rate of 5 1/4% before these last two firms fell. It can take months for significant firms to unwind.

Today, less than a year since the Fed began raising interest rates, we've already seen the first to fall, FTX Exchange. Higher interest rates and tightening monetary conditions always eliminate the weak and the crooked. I expect to see many more in the next couple of years.

As Warren Buffett says:

"When the Tide Goes Out, You Find Out Who Is Swimming Naked."


Econ Briefs



Interesting Treasury Auction yesterday. The US Treasury auctioned off the three and 6-month bills and the two and 5-year Notes. The yields are already inverted at the auction, which you rarely see.

The highest yield was for the 6-month T Bill, with an interest rate greater than 4 1/2%. And as investors went to longer maturities, their returns became progressively lower—precisely the opposite of what you would expect in a regular market. The lowest yield was for the far-out maturity, the 5-year Notes, the return on the 5-years, less than 4%, 50 basis points less than the 6-month Bill.

So, here's what the Treasury market is telling us. First that the economy is slowing dramatically. The higher interest rates we're experiencing today are not sustainable. In Five year's this economy will only support much lower interest rates.

And as night follows day, Treasuries also tell us that inflation will be much lower. If we use the rule of thumb that investors expect to receive the rate of inflation plus 3% from their Treasury investments, then the 5-year Note predicts inflation will be at less than 1% in 5 years.

Exciting news from the world's largest financial market, US Treasuries.

On the calendar is the weekly Redbook report on Retail Sales. This season is the critical time of the year for Retailers, as most profits come from holiday sales. So the Street will be scrutinizing this Redbook report. This report has been lower than last year's sales for three weeks. Let's hope the retailers can turn this around.