Chapter 16
The Gap
Normally, in the real world of markets and economics, things don't go straight down. There are usually rallies which produce a zigzag pattern. But if you examine price charts closely, you occasionally find what technicians call a "gap" � a hole in the chart between the point where one line ends and another begins.The gap implies that no trading took place during that time, that the price suddenly jumped from one point to another on the chart. That is essentially what happened to the global economy when the Fed cancelled its plan to rescue Metrobank. One moment, we hung in midair over the edge of a cliff. The next moment, we were well on our way to a rocky bottom.
In earlier stages of the crisis, every critical crisis seemed to be distinctly separate from the next one. The economies of Brazil and Argentina first fell in the mid-1980s. The US stock market crashed in 1987. The Asia crisis struck in 1997. Russia went under in 1998. Tech stocks got battered in 2000. Business investments and corporate profits plunged in 2001. The entire nation temporarily shock into silence and inaction after the coordinated attacks from vile fanatics.
Each crisis was distinct and separate, and each market was sucked down the vortex in single-file fashion.
During the Great Stock Panic, however, all the shorts of crises past seemed to return simultaneously: The stock market was crashing again. Derivatives were blowing up. The dollar was falling. A second Asia crisis had burst onto the scene � in Hong Kong, Tokyo and Seoul. Argentina, Brazil, and Mexico turned south again. Business and bank failures continued to spread. Tech stocks were getting clobbered for a third time. And the war on terrorism was dragging out, spurring the fear of still more attacks on America.
An energy crisis appeared, disappeared, and then reappeared. Fannie Mae, the largest corporation in the world, shocked everyone by filing for protection under Chapter 11 of the Federal Bankruptcy Act. Municipal bonds were defaulting. Casualty insurance companies, commercial banks, and other big buyers of municipal bonds, suffered sudden and violent bouts of cash hemorrhaging, became heavy net sellers. HMOs, life insurance companies, credit unions, brokerage firms, and entire governments were going under.
The "Gap" of the early 21st century was a sudden "implosion" of the financial system. To this day, twenty years later, it is still a phenomenon that no one fully understands. The changes came so swiftly, and the participants were so busy salvaging their own assets, few took the time to record the events.
Some say that the acceleration of change was so great that there actually occurred a reversal in the normal sequence of cause and effect � a "time warp" in which reactions preceded actions. Banks in trouble were hit with massive withdrawals before any word of that trouble was known. Specific stocks were dumped even before many so-called "insiders" got wind of the impending bankruptcy. Was it some mystical reversal of time? Or was it merely due to a hyperactive Internet rumor mill in which information was passed along as quickly as the "love bug" virus? Regardless of the cause, one thing was certain: During the Gap, the economy was undergoing a rapid structural transformation.
Economists were not ready for this. They never asked what would happen if consumers became sellers, if major institutions went belly-up, or if certain pivotal markets suffered Chernobyl-type meltdowns. Yet it was precisely these kinds of changes that took place during the Gap.
Since we really don't know what happened during the Gap, the best we can do is speculate. By drawing on diaries and publications, we can see some of the rapid shifts in people's psyches that were precipitated by economic events. One young analyst, formerly a dot-com specialist, described his feelings:
" I was trapped by an unrelenting feeling of helplessness. It seemed that, no matter what I did and no matter what I said, I had lost control over the events in my life. At one point, I even believed my innermost thoughts had been written in some master blueprint of my destiny.
"My feeling of fatalism was reinforced by a stream of eerie coincidences. Names of people and places. Words. Sights. Sounds. The name of the stock which brought the downfall of my portfolio. The name of the street where I lived."
Of course, there was no master plan. But there were strong undercurrents, invisible to the naked eye, tying together events which, in other periods, might be unrelated.
One was mass communication. Media and Internet advertising shifted rapidly to get into synch. Network news anchors, intuitively sensing the new environment, changed their pitch. Everyone lowered their voices and toned down their words in a subconscious effort to compensate for the turmoil.
Another undercurrent was the real cost of money � an economic force that transcended all industry sectors, national borders, and socio-economic classes. At the time, this was a big mystery to most people. But looking back to the 1930s or to Britain in the late 1800s, we can see that it was not an uncommon event in history. Real interest rates � the difference between interest rates and inflation � surged.
Of course, a direct comparison with previous depressions had many pitfalls. History did repeat itself, but it always threw in a new twist, a new wrinkle, or a new footnote to trip up historians. But the astute analyst can see the underlying pattern with a methodology called "structural-functional analysis." Although it was developed originally for cross-cultural comparisons, I have applied it to the comparison of equivalent points in history.
Essentially, one matches institutions, behavior patterns, and economic functions which, although quite different in outward appearance, fit into similar slots in the puzzle. Here are two examples:
(1) The "stock pools" of the 1920s were blamed for sudden selling frenzies that drove down prices. There were no stock pools during the Great Stock Panic. But Internet trading and program trading, which moved large blocks of stocks in unison, filled the same functional role in the overall scheme of things.
(2) The gold standard in the 1930s imposed a strict discipline on monetary policy. In fact, it was due to the fear of a flight to gold that the Fed temporarily tightened money in 1933. By the time of the Great Stock Panic, the gold standard was long gone. So many analysts concluded that things would be vastly different. Not so. This time it was the dollar and the fear of a flight of foreign capital that imposed a similar discipline and prevented the Fed from taking stronger action to rescue the economy.
(3) The Internet mania of the late 1990s seemed brand new. But there had been a similar mania in the Roaring '20s � also in new, up-and-coming communications technologies.
But nowhere, however, was there more confusion than in the realm of interest rates.
Three Interest Rate Moves
Had economists only looked back to the big interest rate swings of the 1930s, they would have found some of the answers. As in the 1930s, there were three interest rate phases that devastated the financial markets and whipsawed even the most astute traders of the Western World.Phase #1 was a sharp decline as the Fed pushed rates down to avert a collapse in the economy and a worldwide derivatives nightmare.
Phase #2 was an upward surge, a volcanic eruption in rates which no one expected. This was called "the Spike." Indeed the "Gap" and the "Spike" were essentially two words for the same phenomenon. The Gap began when the Spike occurred, and the Gap was over when the Spike ended.
The interest rate spike was uncontrollable and unstoppable regardless of the Fed's actions. Its cause is now clear: When the major players withdrew from the derivatives arena, when foreign investors dumped their US dollar investments, and when big banks went into hibernation or failed, it choked off the flow of cash to corporations and other borrowers, producing a "cash drought" that forced the cost of money � real interest rates � skyward.
Phase #3 brought another interest rate decline back to "normal levels." But it didn't occur until a substantial proportion of the derivatives and related debts were liquidated primarily through bankruptcies. It was not until this stage that the panic subsided and the nation embarked on the long road to recovery.
Some Tough Questions
What indicator could be used for getting a better grasp of the timing? What about corporate bonds? Were high-yielding corporates a good investment during the Great Stock Panic? If not, when would they become attractive and safe? As before, the best (albeit imperfect) guide could be found in the patterns of the past. If you were among the few that took the time to study them, here's what you would have found:Treasury bill rate. Roughly six decades earlier, in 1929 and 1930, the rates on T-bills fell sharply. That was Phase #1. However, in 1931, the panic caused T-bill rates to soar temporarily (Phase #2). Finally, in the third and final phase of the 1930s, they fell back down again to new lows.
The experience of the early 21st century was similar with a few notable differences: Due to the derivatives collapse and the acute cash shortages, the fall was not as steep as in 1929-30; and the intermediate spike was greater.
If you were a saver in the 1980s and '90s, T-bills were the best medium for safety and liquidity, but they were not always the best vehicle for high yields.
| When Dad was a young man on Wall Street, he used to think, like everyone else, that interest rates always go down in a crash or depression. He was in for a big surprise. In the first phase of the Crash (phase 1 on these graphs), interest rates did decline, just as expected. But then, in the early 1930s, interest rates abruptly turned around and exploded. T-bill rates jumped by over six-fold — from about a half percent to 3%. Yields on the 20-year Treasury bonds and on high-grade corporate bonds surged beyond their pre-Crash peaks. And the yield on low-grade corporate bonds literally went through the roof, hitting 11%. This experience — of rates surging despite no inflation — provided a lesson he vowed never to forget. |
By watching the T-bill yield, however, you could glean some valuable clues regarding the best time to move into T-bonds: It was when the T-bill rate temporarily rose well above the T-bond yield and when most people shunned the T-bonds for that very reason.
Long-term Treasury bond yields. Back in 1929-1930 (Phase #1), they declined throughout the stock market crash. But in Phase #2, they easily eclipsed their 1929 highs.
For anyone living in the early twentieth-first century, the lessons to be learned from this experience were clear: First, it proved that the stock market could go through a long decline despite a slide in T-bond yields. Second, it showed that the interest rate spike could easily reverse much of the decline once a dollar crash or banking panic started. Third, although yields skyrocketed, it would be difficult for the average person to catch the peak and lock them in.
High-grade corporate bonds. Back in the '30s, their yields declined during Phase #1 and then surged to new highs during Phase #2. And in the Great Stock Panic, they did the same. The trouble is, fewer corporate bonds were able to retain their high rating.
Reason: Bond ratings agencies of the early 20th century were very tough; in the early 21st century, they were very lax. In fact, most A-rated bonds of 2001 had similar balance sheets to the B-rated bonds of 1929.
Many investors couldn't understand why the price of an "average triple-A bond" was holding up relatively well on their charts while their own "triple-A" was sinking so rapidly. The reason was that as soon as their bond was downgraded, it was no longer included in the average depicted in the charts! Instead, it was relegated to the averages shown in the bottom graph � the yield on low-grade bonds.
This is why it was not a very good idea to buy corporate bonds with money you wanted to keep safe. Rather, during the Great Stock Panic, you had to treat most corporate bonds in virtually the same manner as you treated common stocks � as a speculative investment.
Those who recognized this reality and took the necessary precautions when buying them, were able to pick them up for 40 or 50 cents on the dollar, earn high yields and make substantial profits. Unlike Treasury bonds, however, which were best bought before the end of the Gap, the ideal time to buy corporate bonds was after the Gap, when you could sort out the wheat from the chaff. You had to know, with a reasonable degree of certainty, that the bad news on the company was already out, and that there were no more big surprises on the horizon.
Low-grade bonds. The contrast between this graph and the three previous ones is obvious. The yield decline (Phase #1) was much more shallow, and the spike (Phase #2) was much steeper. The same held true in the early 21st century: After the initial decline, these rates later turned around and easily eclipsed their all-time highs, decimating the equity of investors as their market value collapsed.
Thus, the interest-rate spike became the epicenter of the Gap, turning off the money spigots to nearly all sectors of the economy. Hopes for material well-being were replaced by a struggle for economic survival. Rapid reversals occurred in values, attitudes, feelings, beliefs, and actions.
Cries For Relief
Most economic institutions now faced their day of reckoning. Which ones were solvent, which were insolvent? These questions had been asked initially about dot-com companies ... then about other tech companies ... then about blue-chip companies. Now, they were also being asked about individuals, retailers, manufacturers, utilities, banks, universities, foundations, cities, states, and even entire nations.The answers had little to do with size or power. Instead, survival usually depended primarily upon the degree of liquidity during the final stage of the boom and the swiftness of protective action taken in the early stage of the panic. No matter what, the world economy needed a rest, a time for reflection and relief, a cease-fire from the bombardment of events.
The first to feel this need were Internet companies ... then California's electric utilities ... then officials of the banking and S&L industry.
A few months earlier, while the stock market was plunging through its previous lows, many homeowners could no longer pay their credit cards and mortgages.
As a result, the delinquency rate soared past what was later called the "absurdity threshold," the level at which it became impossible to live up to written contracts, orders, and promises of all kinds.
Who could answer all the complaints? How could they handle the legal proceedings against all those who resisted? What criteria would the banks and S&Ls; use for choosing the cases to prosecute and the cases to write off as losses? The credit card statements, mortgages, repossession notices, and all the other "paperwork" became just that � a lot of paper and a lot of work. It was an "absurd situation."
A grassroots movement took hold. Out of closed-door meetings held in the bank branch offices throughout the country came the word "moratorium." At first, it was only whispered. But it soon was shouted � as one of the most virulent public demands of the twenty-first century. Moratorium implied some form of global relief � a major dissolution of the debts. But precisely how this would be accomplished no one knew.
In Silicon Valley in California, Silicon Alley in New York, and other high-tech capitals of the world, leading Web companies called for a special "tech support" legislation, hailing back to support for the R&D; provided by the Japanese Ministry of Industry and Technology (MITI) in the 1970s and 1980s. Meanwhile, they wanted debt relief � government loans or government-guaranteed bank loans.
In Hartford, Connecticut, and other insurance centers of the world, large insurers petitioned their state commissioners for a "policy loan freeze" to prevent the "disintegration" of their liquidity. In California, S&Ls; cried out for relief from withdrawals as the only way to keep their doors open.
Within a few weeks, the strongest demands for a moratorium came from some of the giant corporations. They used the term "debt freeze" with the argument that, if only something could be done to stop the cash drain of debt payments, business would improve. They also hoped this would be linked to a postponement of payments on trade credit and interest so they wouldn't have to file for bankruptcy and further clutter the courts.
The Federal Reserve again responded with vehement opposition. "Rather than face the reality of their own insolvency, what these firms are asking for is a kind of 'collective bankruptcy' with another name. They want us to somehow abolish or postpone � as if by magic � all the debts they owe to their suppliers and dealers. They forget, as usual, about the other side of the ledger: The creditors. For every firm that's granted relief, another � the one owed the money � is driven further into the hole. Since each has borrowed from Peter to pay Paul, any collective defaults will spread from one sector to the next in a chain reaction of bankruptcies."
According to one senior executive, "The bottom didn't fall out of our market. It was the market that fell out of our bottom! And we're still trying to find it. We have a fleet of ships floundering at sea. We ran out of cash-fuel weeks ago, and now, we're throwing the deck furniture into big furnaces called 'interest costs.' And there's still no sign of land." The fleet he was referring to was the electric power industry.
California power companies � besieged by a lopsided deregulation and an acute energy crisis in 2001 � weren't the only ones. And the nature of the crisis was also changing: Many of the power companies' big corporate customers were canceling or reducing their accounts. Some were going bankrupt. Almost all were cutting corners and delaying payments.
Meanwhile, smaller accounts, the same families who were delinquent on home mortgage payments, also defaulted on their electric bills. The electric company, along with other utilities, found themselves in much the same position as banks and the insurance companies � with a "run" on their cash resources.
The bank failure rate, which had declined to nearly zero in the late 1990s, surged again toward new, all-time highs. Interest rates, which had been declining for months, again spiked upward. All eyes turned once again to Washington for some solution to the crisis.
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