Toward a More Complex and Difficult Depression

The current liquidity crisis can be paralleled to events leading up to the Great Depression. Specifically, the departure from fundamental valuation principles and extension of credit in the subprime market is consistent with mistakes made by speculators in the late 1920s.

After World War I, the U.S. economy experienced a brief recession from 1920 until 1921 and then experienced robust growth until 1926. The economy grew because new retail markets and credit instruments were introduced to the public. Consumers were bombarded with notions of "buying now and paying later" from retail stores like Macy's (who recently posted a loss in profits). For the first time people could have things they really wanted without having to wait until they saved enough money to pay for it. This included the purchase of securities , and bank loans leveraged on them. Thus, the volume of credit transactions increased the volume of sales and loans, i.e. demand for goods and services. In short, people borrowed and spent like crazy not worrying about the debt they were incurring.

In response to the spending frenzy, firms increased investment to meet the demand for new goods and services. The markets that boomed most were new homes and automobile sales. However, these spending habits and increased production levels could not be sustained forever. The accumulating debt had to catch up with consumers at some point. That time came at the end of 1926, where gross investment peaked and market saturation took toll. Households fell into an unfavorable liquidity positions because of debt burdens and, therefore, demanded fewer goods. In effect, producer inventories increased and gross investment declined from 1927 until 1935.

Does this sound familiar?

We experienced a brief recession after the dot-com bubble and terrorist attacks of 2001. Shortly thereafter we underwent a period of prolonged and "exuberant" growth in the real property and credit markets. Like the 1920s, people (even those with bad credit) could make large purchases with no money down and production levels increased to meet consumer demands for more goods and services, see the trade imbalance with China. Recent uncertainties in the derivatives market have caused some companies to freeze their funds from rightful redemptions by investors. These events have placed households and speculators in unfavorable liquidity positions.

Fortunately the Federal Reserve Bank and the European Central Bank injected capital into the markets last week. If they would have continued to remain idle or foolishly implemented contractionary monetary policies things could have been much worse.

The sooner we return our focus to fundamental valuation practices and think mechanically about the current liquidity issues, we will see the light. We should stop denying the glut in the real estate market and accept the fact that the bottom is falling out, especially in the Midwest where 110,000 people were recently laid off by GM, Ford and Chrysler. We should expect a structured bailout of businesses (located in swing states and) exposed to subprime woes by government sponsored enterprises. As for those not rescued by GSE White Knights, expect them to fall prey to private equity at deep discounts. In terms of credit, do not bank on the Fed to continue to inject capital into the markets -- the U.S. cannot afford to print more money. Instead, look for rate cuts.

Although there are significant opportunities to "Bottom Fish" deals, we should be very mindful of the relationships behind bankruptcy or distressed portfolio purchases. It is more than likely that assets will be sold to indirect affiliates to create a "win win" situation for the loser and winner. In this case, the loser would deduct the loss and the winner obtains an undervalued asset. Think about the feeling you would get if your divorcee sold their assets to a friend prior to your filing of a liz pendens! (It's not a good feeling.)

To avoid contempt, let's hope that these transactions are conducted at arm's length and scrutinized for transparency. If not, the cycle of mismanagement will continue and lead us toward a more complex and difficult depression riddled with unknown unknowns.

What to worry about going forward:

China selling U.S. Treasuries to abandon the dollar like the Britain did the gold standard

Canada arming itself to defend the North Pole from the Russians

U.S. branding elite Iran guards as terrorists and inching toward a military conflict with Iran

Oil prices creeping up to $100 per barrel as a result of market fears and OPEC incentives

China increasing its presence in and defining development in Africa

Keep an eye on:

Commodity prices particularly wheat, sugar and metals

Consumer confidence and inventory levels

Countrywide and U.S. foreclosure rates -- NYC is not looking as good as most purport

Remarks by St. Louis Fed President William Poole -- he is all about understanding uncertainty