Stephen’s Posterous

From Roberto Barr, Professor of Economics at Harvard and a Fellow at Stanford University's Hoover Institution

Central questions these days are how severe will the U.S. economic downturn be and how long will it last?

The most serious concern is that the downturn will become something worse than the largest recession of the post-World War II period,1982, when real per capita GDP fell by 3% and the unemployment rate peaked at nearly 11%. Could we even experience a depression, defined as a decline in per-person GDP or consumption by 10% or more?

The U.S. macroeconomy has been so tame for so long that it's impossible to get an accurate reading about depression odds just from the U.S. data. My approach uses long-term data for many countries and takes into account the historical linkages between depressions and stock-market crashes. The research is described in "Stock-Market Crashes and Depressions," a working paper Jose Ursua and I wrote for the National Bureau of Economic Research last month.

The bottom line is that there is ample reason to worry about slipping into a depression. There is a roughly one-in-five chance that U.S. GDP and consumption will fall by 10% or more, something not seen since the early 1930s.

Our research classifies just two such U.S. events since 1870: the Great Depression from 1929 to 1933, with a macroeconomic decline by 25%, and the post-World War I years from 1917 to 1921, with a fall by 16%. We also assembled long-term data on GDP, consumption and stock-market returns for 33 other countries, sometimes going back as far as 1870.

Our conjecture was that depressions would be closely connected to stock-market crashes at least in the sense that a crash would signal a substantially increased chance of a depression.

This idea seems to conflict with the oft-repeated 1966 quip from Paul Samuelson that "The stock market has predicted nine of the last five recessions." The line is clever, but it unfairly denigrates the predictive power of stock markets. In fact, knowing that a stock-market crash has occurred sharply raises the odds of depression. And, in reverse, knowing that there is no stock-market crash makes a depression less likely.

Our data reveal 251 stock-market crashes defined as cumulative real returns of -25% or less and 97 depressions. In 71 cases, the timing of a market crash matched up to a depression. For example, the U.S. had a stock-market crash of 55% between 1929-31 and a macroeconomic decline of 25% for 1929-33.

Likewise, Finland had a stock-market crash of 47% for 1989-91 and a macroeconomic fall of 13% for 1989-93. We found that 30 cases where there were both crashes and depressions were also associated with wars. In fact, World War II is the worst macroeconomic event of the period, with strong U.S. wartime economic growth as an outlier.

In the post-World War II period, the Organisation for Economic Co-operation and Development (OECD) countries were strikingly tranquil up to 2008. The worst macroeconomic event in that period came in Finland in the early 1990s. Sweden also faced a financial crisis in the early 1990s, though it reacted quickly and is now being touted as a possible guide for leading the U.S. out of its current economic crisis.

Outside of the OECD, there have been many linked stock-market crashes and depressions since World War II -- including the Latin American debt crisis of the 1980s, Mexico's financial crisis in the mid-1990s, the Asian financial crisis of the late 1990s, and Argentina's financial turbulence that lasted until 2002.

Looking at all of the events from our 34-country history, we find that there is a 28% probability that a "minor depression," macroeconomic decline of 10% or more will occur when there is a stock-market crash.

There is a 9% chance that a "major depression," a fall of 25% or more will occur when there is a stock-market crash. In reverse, the chance that a minor depression will also feature a stock-market crash is 73%. And major depressions are almost sure to have stock-market crashes, our data show the probability is 92%.

In applying our results to the current environment, we should consider that the U.S. and most other countries are not involved in a major war. The Iraq and Afghanistan conflicts are not comparable to World War I or World War II. Thus, we get better information about today's prospects by consulting the history of nonwar events -- for which our sample contains 209 stock-market crashes and 59 depressions, with 41 matched by timing.

In this context, the probability of a minor depression, contingent on seeing a stock-market crash, is 20%, and the corresponding chance of a major depression is only 2%. However, it is still the case that depressions are very likely to feature stock-market crashes, 69% for minor depressions and 83% for major ones.

In the end, we learned two things. Periods without stock-market crashes are very safe, in the sense that depressions are extremely unlikely. However, periods experiencing stock-market crashes, such as 2008-09 in the U.S., represent a serious threat. The odds are roughly one-in-five that the current recession will snowball into the macroeconomic decline of 10% or more that is the hallmark of a depression.

The bright side of a 20% depression probability is the 80% chance of avoiding a depression. The U.S. had stock-market crashes in 2000-02 by 42% and 1973-74 by 49% and, in each case, experienced only mild recessions. Hence, if we are lucky, the current downturn will also be moderate, though likely worse than the other U.S. post-World War II recessions, including 1982.

In this relatively favorable scenario, we may follow the path recently sketched by Federal Reserve Chairman Ben Bernanke, with the economy recovering by 2010. On the other hand, the 59 nonwar depressions in our sample have an average duration of nearly four years, which, if we have one here, means that it is likely recovery would not be substantial until 2012.

Given our situation, it is right that radical government policies should be considered if they promise to lower the probability and likely size of a depression. However, many governmental actions -- including several pursued by Franklin Roosevelt during the Great Depression -- can make things worse.

I wish I could be confident that the array of U.S. policies already in place and those likely forthcoming will be helpful. But I think it more likely that the economy will eventually recover despite these policies, rather than because of them.

Source.

It's always dangerous to think that we know more than the market. One doesn't have to be a fanatical believer in the markets' efficiency to nevertheless recognize that markets reflect a lot more information than any one of us can possibly incorporate into our analysis. The graveyards on Wall Street are filled with those who had the arrogance to believe otherwise.

So it is with no small dose of trepidation that I explore the possibility that U.S. Treasuries are incredibly overpriced, which of course is just another way of saying that their yields are way too low. But if they are, then investors should run, not walk, away from placing any long-term bets in U.S. Treasuries. Instead, consider the alternative investments that I describe below.

Right now the yield on the 10-year Treasury note stands at 2.89%. On an after-tax basis for an investor in the highest tax bracket, that translates into an effective yield of 1.88%. In order for such an investor to show any real (after-inflation) return over the next 10 years, inflation therefore would have to average less than 1.88% for the next decade.

What are the chances of that? Even if you are investing in a tax-free account, what are the odds that inflation for the next decade will average less than 2.89%?

While you're mulling over your answer to these questions, consider the following: In July 2007, the 10-year Treasury note was yielding 5.2%. In other words, despite the federal government injecting trillions of new dollars into the financial system over the last 18 months, in a textbook illustration of the monetary inflation for which Federal Reserve Chairman Ben Bernanke earned his nickname of "Helicopter Ben," the markets are nevertheless discounting a much lower inflation rate today than then.

Or consider this mathematical truth about the power of compounding. Let's assume that the inflation is negative for the next two years, at a rate of (negative) 2% a year. That's deflation, in other words. That's a big assumption, since Helicopter Ben has dedicated himself to never allow the economy to slip into deflation.

But let's nevertheless assume that we get a 2% deflation for each of the next two years. Let's further assume that for the eight years thereafter that consumer prices actually grow and the inflation rate is 5% a year. That seems reasonable given how much money would be injected into the economy if we actually get a sustained deflation -- money that presumably will eventually translate into higher inflation.

Given these assumptions, the inflation rate over the next 10 years will still average 3.6% a year. That's more or less twice the 1.88% after-tax current yield of the 10-year Treasury note. To be sure, we can endlessly play around with these assumptions. But the general idea is clear: Locking in Treasuries' current yields provides a long-term real return only if inflation is a whole lot lower than what it seems quite clear it will be.

How did the markets get into this situation? The obvious answer: panicked investors' flight to quality over the last 18 months. Investors have been so concerned about the credit quality of any borrower other than Uncle Sam that they have been willing to forfeit much, if not all, of their yield. It's not that investors during this flight to quality reduced their expectations of future inflation. It's instead that in their panic they became preoccupied with the safety of their principal.

Unless the world comes to an end, however, this credit and liquidity crisis won't last forever. And when it does dissipate, Treasury yields will once again reflect investors' expectations of future inflation. You don't have to be a market timer and try to predict when this will begin to happen to know that -- absent the end of the world -- it will take place eventually.

In many ways, the current situation is just the inverse of what prevailed in 1981, when the yield on the 10-year Treasury climbed above the 15% level. That meant that investors were betting that average inflation for the subsequent decade would be close to double digits. That in effect meant that investors were betting on the financial equivalent of the end of the world, since double-digit inflation for 10 years in a row would have been nothing short of devastating.

It took courage at that time to follow the contrarian conclusion and buy Treasuries. But there were at least some who did: The editor of one of the investment newsletters I monitor, who asked that I not use his name, told me that he put his daughter through Yale on the profits he earned from buying Treasuries at that time. And, it's probably needless to say, Yale's tuition is not cheap.

What would the corresponding contrarian strategy be in today's yield environment? The particularly risky bet would be to sell Treasuries short. If you want to be that aggressive, the preferred vehicle for doing so would be an exchange-traded fund, such as the iShares Barclays 10-20 Year Treasury Bond Fund (ticker: TLH). Be aware that, even if you eventually turn a big profit on this trade -- which I believe is likely, of course -- you still will have a not-insignificant carrying cost during the trade, in the form of the dividends that the ETF pays along the way.

A conservative way of making the contrarian bet today is simply to invest in TIPS, the Treasury securities that are indexed against the consumer-price index and which therefore provide a guaranteed return above and beyond inflation. An ETF that invests in TIPS is the iShares Barclays TIPS Bond Fund (TIP).

A contrarian trade whose riskiness is in-between the conservative TIPS strategy and the aggressive short-sale would be to create a hedge that buys TIPS and sells short an equivalent dollar amount of regular (nominal) Treasuries. Such a hedge will show a profit so long as nominal Treasury yields rise faster than do TIPS yields -- or fall less than TIPS yields do if yields unexpectedly continue to fall.

Source.

Kenneth Lewis is getting a hard lesson in the new balance of power between Washington and Wall Street.

The Bank of America Corp. chairman and chief executive had agreed to buy brokerage giant Merrill Lynch & Co. in September, possibly saving it from collapse. But by early December, Merrill's losses were spiraling out of control. Internal calculations showed Merrill had a horrifying pretax loss of $13.3 billion for the previous two months, and December was looking even worse.

Mr. Lewis had had enough. On Wednesday, Dec. 17, he flew to Washington, ready to declare that he was through with Merrill, people close to the executive say.

"I need you to know how bad the picture looks," Mr. Lewis told then-Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke, according to accounts of the conversation by people inside the government. Mr. Lewis said Bank of America had a legal basis to abandon the deal.

Messrs. Paulson and Bernanke forcefully urged Mr. Lewis not to walk away, praising the bank's earlier cooperation -- but warning that abandoning the deal would be a death sentence for Merrill. They said the move also could undercut confidence in Bank of America, both in the markets and among government officials. Despite the blunt talk, Bank of America executives interpreted the comments as a signal that the government was willing to work out a compromise.

Two days later, in a follow-up conference call, federal officials struck a harder tone. Mr. Bernanke said Bank of America had no justification for ditching Merrill, according to people who heard the remarks. A Federal Reserve official warned that if Mr. Lewis did so and needed more government money down the road, Bank of America could expect regulators to think hard about their confidence in management.

Mr. Lewis was told that the government would consider ousting executives and directors, people close to the bank say. The threats left no doubt: The federal government saw itself as firmly in charge of U.S. financial institutions propped up since October by infusions of taxpayer-funded capital.

During the four weeks that followed Mr. Lewis's conference call, federal officials and Bank of America hashed out a deal to salvage the Merrill takeover. The government agreed to provide $20 billion in additional aid for the Charlotte, N.C., bank, and to provide protection against losses on $118 billion in troubled assets.

The money is coming at a price. Six months into the great bailout of U.S. finance, Washington's rescue attempt has helped shore up the system. But that emergency effort, planned on the fly, has taken the government on a risky journey deep into the heart of American capitalism.

Bureaucrats are calling the shots behind the scenes at some of the nation's largest enterprises. Critics of the bailout program say its rules are opaque and its execution ad hoc, leading to a lingering lack of confidence in the the financial system. Some lawmakers are scrambling to steer funds to favored lenders.

Federal officials have said little publicly about their oversight of the institutions that received capital from the Troubled Asset Relief Program. Initially, the government seemed reluctant to use the ownership stakes it got in banks ranging from J.P. Morgan Chase & Co. to Saigon National Bank as leverage over bank executives.

But the tough negotiations with Bank of America, along with other recent moves by federal officials related to executive compensation and other issues, suggest that the government's attitude toward the troubled banking industry has changed, as financial markets have deteriorated further and political ire has risen.

When Citigroup Inc. took $25 billion in TARP funds in October, the executive-pay section of its pact with Treasury was just two sentences long and vaguely worded. A second rescue, for $20 billion in December, limits Citigroup's executive bonus pool for 2008 and 2009, requiring that a majority of 2008 bonuses be paid on a deferred basis.

Tough talk by President Barack Obama and other officials about bonuses and perks is making bank executives uncomfortable. Last week, under pressure from Treasury officials, Citigroup canceled its order for a corporate jet. The bank now is exploring its options for modifying the terms of a nearly $400 million marketing deal with the New York Mets. On Wednesday, Mr. Obama unveiled a series of executive pay curbs, including a strict limit on executive salaries for companies that receive an "exceptional" level of government assistance.

The story of Merrill Lynch's troubles and subsequent rescue negotiations, pieced together from interviews with people who participated in the process, suggests that the government's extension of control over the U.S. banking system is evolving on an makeshift basis. Despite agreeing to pump $25 billion into Bank of America and Merrill in October, the government had no idea the securities firm was hemorrhaging money until it was too late to avoid a second bailout.

By the end of November, two months into the fourth quarter, Merrill had accumulated $13.34 billion in pretax quarterly losses, according to an internal document reviewed by The Wall Street Journal. Some Bank of America executives expressed concern about proceeding with the takeover, people close to the bank say. On the advice of their lawyers, the bank decided to go ahead with Dec. 5 shareholder votes on the deal. Shareholders of both Merrill and Bank of America gave their approval.

After less than 48 hours of due diligence, Bank of America struck an agreement to buy the battered securities firm for $50 billion in stock, or $29 a share. The value of the deal has since declined along with Bank of America's share price. "I look forward to a great partnership with Merrill Lynch," Mr. Lewis said, toasting the deal with a glass of champagne.

A month later, Mr. Lewis was at the Treasury Department along with eight other chief executives of large U.S. financial institutions, summoned there by Mr. Paulson. The Treasury secretary wanted the executives to accept a round of government capital totaling $125 billion as a way of shoring up confidence in the banking system. Mr. Paulson explained that saying no wasn't an option, according to a person who attended the meeting.

"We are going to do this," Mr. Lewis replied, urging the other CEOs to call their boards if they needed approval. After persuading the nine financial institutions to take taxpayer money, the government, at first, refrained from flexing its muscles.

Bank of America executives remained confident about the deal. Doubts began to creep in shortly before Thanksgiving. With more than a month to go until the end of the fourth quarter, the pretax quarterly losses at Merrill were approaching $9 billion, according to people familiar with the figures. By month's end, the figure had exceeded $13 billion, or $9.29 billion after taxes.

Most of the losses were coming from the securities firm's sales and trading department. But business was even suffering in Merrill's lucrative wealth-management unit, which saw its revenue drop to $797 million in December, from $1.08 billion in October. Still, not all the losses, which included expected asset write-downs on assets such as Merrill's investment in rental-car company Hertz Global Holdings Inc., should have come as a surprise to Bank of America.

In meetings with Merrill managers, Mr. Thain acknowledged big losses, but said they weren't any worse than those of the firm's Wall Street rivals, noting that November had been a horrible month for everyone, say people who heard his remarks. At Bank of America, executives debated whether Merrill's losses were so severe that the bank could walk away from the deal, citing the "material adverse effect" clause in its merger agreement. Merger agreements typically specify certain "adverse" conditions that give an acquirer the right to abandon a deal.

But lawyers from inside and outside the bank concluded that the losses likely were in line with other firms, and recommended that Bank of America move forward with the purchase, according to people familiar with the discussions.

The deliberations continued up until a few days before shareholders of Merrill and Bank of America were scheduled to vote, one of these people says. Senior Bank of America executives had "mixed emotions," this person says, but "everyone wanted to see the deal go through."

On Dec. 5, the deal was approved at separate shareholder meetings in Charlotte and New York. Nothing was said about Merrill's problems. "It puts us in a completely different league," Mr. Lewis said about the deal's completion. On Dec. 8, Merrill's board gathered in Manhattan for their last meeting. Mr. Thain said the firm faced continuing losses, but they weren't unusual, given upheaval in the markets, directors recall.

The next day, Bank of America Chief Financial Officer Joe Price gave a detailed presentation to the bank's directors about its financial situation and Merrill's fourth-quarter woes, according to a person familiar with the meeting. Within a few days, Merrill's quarterly net losses had swelled to about $14 billion. People close to Bank of America say the losses ticked higher due to trading losses, as well as further asset write-downs.

The trading losses stem largely from legacy positions Merrill Lynch took in previous years. Mr. Lewis told Bank of America directors in a conference call that the bank might abandon the acquisition, which was supposed to close in two weeks. In mid-December, Edward Herlihy, a partner at law firm Wachtell, Lipton, Rosen & Katz who had helped set the merger talks in motion, reached out to Ken Wilson, a former Goldman Sachs Group banker and a top deputy of Mr. Paulson.

By then, Merrill's losses had reached almost $21 billion on a pretax basis, roughly equivalent to about $15 billion in net losses, and some of Bank of America's lawyers felt there was sufficient grounds to invoke the legal clause to torpedo the deal.

Mr. Herlihy, a longtime adviser to Bank of America, expressed concern to Mr. Wilson about the size of the losses, according to people familiar with the matter. Mr. Wilson was stunned by the news. Get Mr. Lewis to call Mr. Paulson, Mr. Wilson said, according to people familiar with the conversation.

At the meeting the next day, Dec. 17, Messrs. Paulson and Bernanke asked Mr. Lewis to give government officials time to think through their options, according to people with knowledge of the discussions. Mr. Lewis agreed and returned to Charlotte.

People close to Mr. Thain say he was unaware of Bank of America's concerns. On Dec. 19, he hopped a plane to Vail, Colo., with his family, people familiar with the matter said.

That same day, about 20 people in Charlotte and Washington dialed into a conference call that included Mr. Lewis, other Bank of America executives, Messrs. Paulson and Bernanke, and other Treasury and Fed officials. Mr. Bernanke told Mr. Lewis that Fed staff members had concluded there was no way for the bank to invoke the material-adverse-change clause in the takeover agreement that would allow it to abandon the deal.

Government officials also warned Mr. Lewis that withdrawing from the deal would frazzle the markets, spark a flurry of lawsuits against Bank of America and tarnish the bank for years. A senior Fed official ratcheted up the pressure, telling Mr. Lewis that any future requests for government assistance would cause officials to consider taking a heavier hand in Bank of America's operations.

The government's tone wasn't hostile. But the implication was obvious, people close to Bank of America say. As the bank's primary regulator, the Fed can force out executives if the agency concludes they are behaving irresponsibly. Mr. Lewis responded matter-of-factly that that government should do what it had to do, and Bank of America would do the same.

Asked what he needed to move ahead with the deal, Mr. Lewis responded that Bank of America wanted additional capital and protection against future losses on Merrill's assets -- something akin to the protection J.P. Morgan Chase & Co. received from the government when it agreed to take over Bear Stearns Cos. last March. Messrs. Paulson and Bernanke agreed to keep talking.

Over the next several days, government officials sifted through the books at Bank of America and Merrill, wrangling over which toxic assets to guarantee and how to value them, people close to the bank say. It became increasingly clear that Bank of America's balance sheet also was packed with assets that faced bruising write-downs, these people say.

Later, talks slowed because bank executives were concerned about the 8% interest rate the government wanted on new preferred shares it would take in Bank of America, these people say. Executives also complained that executive-compensation restrictions were being forced on it, despite government assurances that officials didn't want to punish the bank. The bank wound up agreeing to limit total compensation, including bonuses, to a fraction of the amounts awarded in recent years.

On Jan. 16, Bank of America announced the new bailout. At the same time, it disclosed Merrill's fourth-quarter net loss of $15.31 billion. Shareholders were floored. Bank of America reported a net quarterly loss of $1.79 billion. Asked by an analyst about his decision to go ahead with the Merrill deal, Mr. Lewis responded: "We did think we were doing the right thing for the country."

Source.