Lessons Not Learned?
Where We Stand A Year After the
Biggest Policy Mistakes Since the
Bluford H. Putnam
Where We Stand A Year After the Biggest Policy
Mistakes Since the Great Depression
• The Great Banking Panic of 2007‐2009 will be viewed along
side the Great Depression and the Banking Panic of 1907 as a
turning point event in economic history.
• The recession of 2007‐2009 probably was going to happen
sooner or later, but the sequence of policy errors, investor
over‐confidence, and Wall Street excess turned a recession
into a depression and a full‐blown banking panic.
• So many lessons from the past were ignored, and it is not at
all clear what will be learned from this catastrophic financial
We Have Been Changed
• One thing is very clear, though. In the
aftermath of the Great Banking Panic of 2007‐
2009, governments, investors, and financial
markets will never be as they were before.
• We are not going back to the “old” normal,
although eventually we will probably invent a
• We have been changed, and probably for a
• What have the Regulators Learned?
• What have investors learned?
• How have investors been changed?
• How have Governments and Central Banks been changed?
• Where are we now and where are we going?
What Regulators Should Have Known
• Systematic problems require systematic solutions. It seems simple and
• It was not obvious to US Federal Reserve Chairman Ben Bernanke in
August‐September 2007 as the Fed downplayed the sub‐prime mortgage
debacle and all it systematic implications.
• It was not obvious to US Treasury Secretary Henry Paulson as he let
Freddie Mac and Fannie may slide for months upon months, then
obtained the authority to act, but did not act in timely fashion.
• It was not obvious to then New York Federal Reserve Bank President
Timothy Giethner who along with Treasury Secretary Paulson orchestrated
to saving of AIG and very messy take‐down of Lehman Brothers during the
two days in mid‐September 2008 that arguably were the catalyst that
turned the recession into an all‐out banking panic and depression.
• At every step, from July 2007 through September 2008, US policy makers
failed to understand they had a systematic problem on their hands, not an
independent set of mismanaged financial institutions.
What Happened Immediately After
16 September 2008?
• When the global banking system froze with the intentional
and very messy take‐down of Lehman Brothers, a massive
chain reaction was set‐off.
• Consumers stopped spending, dead in their tracks.
• Investors bailed‐out of everything risky, from equities, to
credit, to commodities, to hedge funds, etc.
• Investors bought flight‐to‐quality assets, namely Treasury
securities and some gold.
• The Federal Reserve became a convert to Quantitative
Easing, as did many other central banks.
• The new US President orchestrated an effort to throw
trillions upon trillions of dollars at the problem, and many
other Governments followed suit to varying degrees.
Year over Year Percent Change in Retail Sales
US Retail Sales Hit a Brick Wall in September 2008
Change in Jobs Per Month, 1000s
When Did You Know the US Was in a Recession?
USD Millions, Total Credit Provided by the
Federal Reserve (H.4.1 Report)
the Week Ending 24 September 2008
Quantitative Easing by the US Federal Reserve Started
Quantitative Easing as Practiced by the Federal
Reserve Meant a Sharp Drop in the Percentage of US
Treasury Securities and Corresponding Rise in the
Percent of US Treasury Securities Held in the Fed's
Percent of "Toxic Waste" Assets Held
Asset Portfolio (H.4.1 Report)
What Investors Should Have Known (Part 1)
• Off‐Balance Sheet Leverage and Corporate Transparency
• Embedded, hidden, or off‐balance sheet leverage implies a
lack of transparency that is dangerous to the financial
system. Was nothing learned from Enron or Long‐Term
Capital Management, to name just two events?
• Embedded or Hidden Options
• Embedded or hidden options can lead to massive
underestimation of risks. Did we learn nothing from the
S&L high yield bond crisis of 1990‐92 or the Equity Crash of
1987 and the portfolio insurance debacle?
What Investors Should Have Known (Part 2)
• Correlations Rise in a Crisis
• Correlations between pairs of risky securities rise in a financial crisis,
regardless of source of potential returns. We seemed to have learned
nothing about risk management and portfolio theory from the
recessions of 1990‐1992, the bond sell‐off of spring 1994, or the LTCM
debacle of 1998, among other events.
• Volatility Measurement is not Risk Management
• Have we not learned that volatility measurement is not risk
management? LTCM, Equity Crash of 1987, Bond Crash of 1994, Tech
Wreck of 2000, and on and on. If the trade is put on before portfolio
volatility is measured, then this is NOT risk management. If portfolios
are not viewed in terms of scenario tests, liquidity tests, for possible
disruptive environments, then this is not risk management.
How We Have Changed
How Governments Changed
• Governments will be more interventionist in the market place than
• Fiscal budget deficits have exploded, and over the coming years,
after growth returns, a combination of tax rises and expenditure
cuts (less likely) becomes highly probable.
• Financial markets will be more highly regulated and, therefore, less
• Central banks, having discovered the power embodied in
Quantitative Easing will never be able to go back to simple interest
• As growth returns, though, when central banks raise rates they will
naturally shed many of their assets bought in the QE phase.
How Investors Have Changed
• Investors will be more risk averse. They will still make risky
investments, just less of them and expect even higher returns
when they do make risky investments.
• Investors will pay more for liquidity and transparency. This
will have the effect of steeping yield curves on average over
the long run.
• Absolute return strategies using regular and inverse Exchange
Traded Funds will challenge Hedge Funds in terms of pricing,
liquidity, transparency for the High Net Worth Investor.
• Consumers will raise their savings rates, even in the US,
meaning consumption growth will be slower but on a more
Where Do We Stand Now?
Watch The Indicators Not the Policy Makers
• For the most part, investors spent 2008 and early 2009
watching to see what policy makers would do. Well, they
have now done almost all they can do with rates near zero,
quantitative easing in action, and fiscal budget deficits
• Investors have shifted gears, the panic is over, and the period
of reassessment is here.
• To figure out where we go from here, investors are now
watching the indicators.
Where Do We Stand Now?
• Worst of the recession is over, yet we are still in a recession.
– US monthly payroll job losses have peaked,
– Weekly new unemployment claims are not as high as their
– But the unemployment rate will keep rising into 2010, to
• Year over year price changes are still negative.
• Consumption is still weak, if bouncing off the bottom.
Productivity Data – Be Careful
• Typically when workers are laid off, the remaining workers
take up some of the slack and productivity data can even
show a rise some times.
• Pay little attention to productivity data.
• Of note, however, is that recessions often wash‐out inefficient
companies and practices, so the level of productivity in the
next economic expansion may set all‐time records. This
means corporate profits will rise much faster than top‐line
revenues. Do not let slow growth in consumer spending lull
you into thinking companies cannot post excellent year‐on‐
year earnings comparisons.
Watch Yield Curves
• A steep yield curve, can be a very healthy sign.
• Some analysts will interpret higher bond yields interpret as a
signal of rising inflation expectations, but they might be
wrong, at least in the underlying concept.
• Right now, real returns in the economy are negative or very
low. A more optimistic view of future corporate profits will
lead to more equity buying, a higher expected real return on
all long‐term assets, and higher bond yields. This is a good
thing, and it signals a real turning point toward an economic
Watch Retail Sales, Cars, and Housing
• First, watch retail sales, around the world. There should be a
bounce, since consumers stopped dead in their tracks. More
importantly, after the bounce, one needs to see consistent growth.
This could happen in the US in the second half of 2009.
• Second, focus on cars. Cars are a durable good, and purchases are
easy to postpone. When car sales turn upward and post several
months of growth, this will be a hugely positive sign. Sure the
clunker program messed up the timing, but car sales are moving up.
• Finally, watch the housing sector. House prices around the world
need to find a bottom to signal the end of the recession; they do
not need to rise and probably will not. As house prices establish a
bottom, pent‐up supply will re‐enter the market as will more
bottom‐fishers on the demand side.
Asset Allocation in the Post‐Panic Era
• Retail and institutional investors will think hard about
acceptable levels of volatility and the liquidity risk with
which they are comfortable.
• Long‐term percentage allocations to risky asset classes,
such as equities or hedge funds, will be lower than in the
1993‐2006 period, but investors will expect superior
returns for the risky investments they choose to make.
• Credit risk will regain some favor, as equities stabilize or rise
and investors become increasingly uncomfortable with
their allocations to longer‐term Government bonds and
their potentially higher yields and lower prices.
• Moderate volatility and truly diversifying products will gain
favor with investors, but these may be hard to find.
And What About The US Dollar
• As the crisis worsened in late 2008, the global deleveraging
meant that the world’s funding currencies, the US dollar and
Japanese yen were the strong currencies versus the Euro and
other currencies. As risky trades and leverage was unwound,
investors had to payback yen and dollars.
• In the current stage, where new policies are in place and yet
economic data remains highly depressed around the world,
currencies investors will focus on (1) which countries will
recover first, and (2) as the recovery becomes clearly in
evidence, which Government will keep policies lax and which
ones will try to rein in the expansive policies.
US Federal Reserve Will be the Last to Tighten
• While solid evidence of a sustainable economic recovery
probably awaits 2010, the US Federal Reserve will be much
too nervous to tighten policy early in the recovery.
• There were false starts in the 1930s, and the Fed will not want
to be blamed for choking off any recovery. They will err to
side of caution, and rates will probably be kept near zero, all
through the first year of the economic recovery.
• This suggests some bias toward a weaker US dollar in the
middle stages of the economic recovery.
Demographics Will Be Important in
• Europe, especially northern and eastern Europe,
are old. Jobs are not the issue. Social safety nets
are typically more robust. The political issue is
long‐term asset preservation, including the
international purchasing power of the currency.
• The European Central Bank (ECB) is well aware of
this political reality, as well as the relative
strength of France and Germany, and thus, this
gives the Euro a moderate upward bias once the
global recovery begins.
China Has Multiple Objectives
• China is providing tremendous domestic stimulus to soften
the impact of declining exports.
• China is also flexing its political muscle in the global arena,
and pointedly challenging the role of the US dollar.
• China cannot be assumed to be a stable buyer of US
Treasury securities, regardless of whatever the diplomatic
• A shrinking trade surplus will make less funds available for
buying US Treasuries, and political ambitions may make
diversification of Chinese foreign reserve a Government
priority. These tendencies favor the Euro over the US
dollar, as well as bode poorly for US Treasuries as the
economic recovery takes hold.
The Fate of the US Treasury Market Depends in part
on Continued Buying by Governments and Central
Banks, such as China
by Foreign Governments in Cuostody at the Federal
USD Millions, 4‐Week Change in US Treasuires Held
Reserve (H.4.1 report)
• We must respect our elders and lessons they have taught
us. Yet, financial markets do not abide by those rules and
seem to have short memories.
• Our Grandfathers’ generation brought us the Great
Depression of the 1930s, and our Fathers’ generation
worked hard to make sure it did not happen again on their
watch. It did not.
• Instead, our Fathers’ generation brought us the inflationary
1970s, and our generation has made sure it did not re‐
occur, even risking deflation.
• Can the next generation learn to respect both it fathers,
grandfathers, and great grandfathers, or are we destined to
have to re‐learn the lessons we did not learn before?
Bluford H. Putnam
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