Depression comparisons unwarranted

Despite repeated comparisons to the Great Depression, the current financial crisis is unlikely to result in anything so dramatic, according to one senior ratings agency executive.

The coordinated action taken by central banks and stimulus packages offered by governments should help to guide the world economy into a period more similar to the banking panic of 1907 — better than the Depression but still not a pretty picture.

“I continue to be very pessimistic about the environment that we are in,” said Peter Bethlenfalvy, group managing director, global corporate, DBRS, in a speech in Toronto on Monday.

The panic of 1907 began with the infamous run on the Knickerbocker Trust in New York. The insolvency of this deposit-taker destroyed public confidence in the financial system. The knock-on effects included a 21% drop in commodity prices, a spike in unemployment from 2.8% to 8% and a 47% increase in bankruptcies.

At this time, the U.S. had not had a central bank since 1836. The panic was soothed by the actions of a group of financiers led by J.P. Morgan, which “acted as the Fed by injecting cash into the system, buying up liquid and illiquid assets, (and) managing the failure of the weak banks,” according to Bethlenfalvy.

The Federal Reserve, which was created in reaction to the 1907 panic, has followed this same model in today’s financial crisis. This is one of the key differences between the current environment and that of the Great Depression. In 1929, both the Federal Reserve and the Treasury Department stood back and allowed the crisis to unfold.

“They let the market choose, and in fact they let the fourth largest New York–based deposit institution, a bank I bet none of you have ever heard of called the New York Bank of the United States, fail on December 11, 1930,” he said. “The Fed did not view itself as the lender of last resort, so it did not buy or monetize illiquid or even safe securities on the balance sheets of banks such as U.S. Treasury bonds.”

While the U.S. Treasury now carries a debt of more than $10 trillion, government debt is far from being the problem today.

Bethlenfalvy pointed to the “massive explosion” outside of the government sector as the culprit in the credit crisis. Financial sector debt has risen to over 100% of nominal GDP, while household debt is nearing the 100% mark. Fortunately, public sector debt, as a percentage of GDP, has risen only marginally over the same period.

He pointed out that deregulation of the U.S. financial services industry began in the 1970s under the presidency of Jimmy Carter and was then ramped up by Ronald Reagan.

“This led to an environment where significant growth in leverage occurred without a single U.S. or European regulatory body monitoring or policing this growth,” he said. “We saw exponential growth in securitization, credit default swaps and the hedge fund assets without a similar growth in supervision, transparency and regulatory oversight.”

The opacity of the derivatives market made it virtually impossible for regulators or market participants to get an accurate measure of the size of the market. At the beginning of 2001, the credit default swap market had a notional value of less than $1 billion. By the end of 2007, the notional value had soared to $65 trillion.

“Evidence and history now shows that Ronald Reagan, Alan Greenspan and others who let free markets reign were wrong, and we must now address oversight and supervision if we are to restore confidence in the financial markets again.”

Greenspan has already received his allotment of blame, but Bethlenfalvy contends that the former Federal Reserve chairman is wrongly accused of having held interest rates “too low for too long” in the period between 2001 and 2005.

“The reality is that markets drove interest rates to a low level based on a globe awash in U.S. dollars,” he said. “Greenspan was virtually irrelevant in a world awash in cash. The world was searching for yield, and the premium for risk was all but forgotten.”

The world is now a very different place, as investors continue to distrust debt issuance from “even the highest-quality banks and sovereigns,” he said. The securitization market is now effectively in hibernation. So what happens when the market re-awakens?

“Securitization technology, when effectively used to transfer ownership of a well-understood pool of quality assets, such as Canadian mortgages, auto loans and credit cards, can produce a valuable, predictable stream of cash flow to which investors will return in less troubled times,” he said. “We see a return to vanilla assets with perhaps only two tranches, with high transparency and an emphasis on sponsor quality.”

Bethlenfalvy is well aware of the blame that has been assigned to DBRS in the freezing of the third-party asset-backed commercial paper market. The firm has tightened its transparency criteria on the category, declining to rate structures that do not meet these requirements.

DBRS has also split out the sovereign-supported deposits from the non-supported deposits in its global bank ratings, which he said enhances transparency for investors.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(11/18/08)