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The following article appeared in Left Business Observer #56, December 1992. It was written by Doug Henwood, editor and publisher. It retains its copyright and may not be reprinted or redistributed in any form - print, electronic, facsimile, anything - without the permission of LBO.
Going into the recent recession, the U.S. financial structure was the most strained it had been in sixty years. Measures of indebtedness were at record levels, and the interest bite was by far the sharpest ever. As the recession began, it looked like all hell could have broken loose.
It hasn't -- so far. Of course, respected opinion has come to accept an enormous amount of financial and social distress as normal; if a thousand bank failures, record levels of personal and corporate bankruptcy, and the return of tuberculosis to New York City don't count as some sort of crisis, what does? But the crisis has largely been managed or contained. An economic system that delivers 20 years of declining real wages should be in the midst of a serious legitimation crisis, but it isn't, at least not now. Should Clinton fail then it could be, but that's for 1993 or 1994.
The ideological non-crisis is a topic in itself; let's concentrate for now on why the financial crisis never got as bad as it could have. Before speculating on what never happened, however, it's fair to review why expectations were high for financial melodrama. For simplicity's sake, we'll focus mainly on nonfinancial corporations (NFCs), holders of most of the productive wealth of the United States. When the recession began in 1990, debts of NFCs were almost 15 times pretax profits, compared with under 11 times in 1929. Interest payments ate up 39% of pretax profits, compared with 14% in 1929.
(Interest here is measured against EBIT -- or earnings [profits] before interest and taxes; a firm with $100 in pretax profits, and $50 in interest payments, has an interest burden of 33% of EBIT.)
Mid- and late-1980s research by Ben Bernanke, John Campbell, and Toni Whited (BCW) discovered that corporate debt was concentrated among a small number of firms, but the debt-heavy were in a hideous bind. The median firm -- at the 50th percentile -- in the BCW sample of about 1,200 publicly traded firms (which excludes small business) devoted 20% of its cash flow to interest payments in 1980, up from 13% in 1969, not much below the 1988 level of 22%. At the 90th percentile, however, firms devoted 186% of their cash flow to interest, up from 34% in 1969, and 56% in 1980. Firms at the 95th percentile lost money, so the calculation is meaningless -- a situation that had persisted since 1982; in 1969, these firms paid 44% of cash flow in interest. Though BCW don't say, it's safe to assume that firms at the 70th and 80th percentile were barely earning their interest payments, if that.
In a study published in 1988, using financial data like profits, stock prices, and interest rates running through 1986, Bernanke and Campbell simulated recessions as severe as those of 1973-75 and 1980-82; they projected that 10% of U.S. corporations could face bankruptcy in a comparable downturn. Updating their work in 1990, incorporating data from the debt-mad years 1987 and 1988, Bernanke and Campbell, joined by Whited, estimated that 20-25% would face insolvency in a deep recession. The authors emphasize that these were measures of financial stress, not literal predictions. Needless to say, if anything like 10% of U.S. firms went under, that would qualify as a depression.
We've had a nasty recession, but no depression. While thousands of firms -- 60,746 in 1990, 87,266 in 1991, and some 90,000 in 1992 -- went bust, each year's failures represent fewer than 1% of all U.S. businesses. Liabilities of firms that failed in 1991 totaled $108.8 billion, a lot of money, but less than 2% of business debts.
The charts below help explain why things never got worse. They show the course of some important financial variables over three recessions, 1973-75, 1980-82, and 1990-92. To be sure, the timing of the three slumps isn't perfectly matched; their official lifespans are November 1973-March 1975, January 1980-July 1980 and again from July 1981-November 1982 (two back-to-back downdrafts that felt like one long one), and July 1990-?. But all three show peaks in the first year, and two of them show troughs in the third, so this is close enough.
Scrutiny of the graphs shows: in the 1990-92 slump, interest rates fell, but in the others they rose; profits were flat, unlike 1980-82, when they fell 40%; and stock prices rose 20%, instead of falling, as they did in the two prior recessions. Consequently, the average business was able to meet its interest payments, and the value of its equity (stock) stayed above the value of its debt, keeping it out of technical insolvency.
These charts measure changes, not absolute levels. The interest rate on bonds rated as Baa -- those issued by corporations lying between junk and blue-chip status -- was 8.2% in 1973, 13.7% in 1980, and 10.4% in 1990. Interest took 19% of EBIT in 1973, 23% in 1980, and 39% in 1992. In 1992, stocks are much more highly valued relative to corporate profits and underlying assets than they were in 1982 or 1975. But the point is that in the recent recession, financial pressure on nonfinancial business eased dramatically, unlike earlier recessions, when it increased sharply.
Had this recession been more like the earlier two, average debt/equity ratios would have been around 100% (meaning that above-average firms would be under deep water) instead of 60%, and interest would have taken a bigger bite of profits -- in the range of 42-55%, close to the levels of 1933-34 (though still below those of 1931 and 1932). Baa bond rates would be 12-13%, not 9%. BCW haven't updated their work, but it's likely that firms at their 95th percentile went to the wall, but those at the 70th got by, or something like that.
That doesn't mean that all's cool. Profits remained stable because firms have gotten skilled at cost-cutting -- closing plants, hiring only temporary workers, and the rest. In only 5 years since 1934 -- all after 1982 -- did interest exceed 35% of EBIT. Even if firms with big interest bites don't die quickly, they can waste away, pinching investment and R&D, which contributes to long-term financial weakness, which creates a need for borrowed funds, and so on.
Alan Greenspan and the Federal Reserve no doubt knew all this when they began driving interest rates down a year before the recession began; though liberals and supply siders often blast the Fed for having been too slow to ease, the central bank has in fact been quite indulgent. It has essentially validated threatened financial practices (in Hyman Minsky's phrase), as have the various financial bailouts of recent years. Though there's lots of pious talk about how both creditors and debtors have been born again into prudence, the last three years weren't anything like the drubbing of 1929-45, which formed the stodgy credit culture of the 1950s and early 1960s.
But if the rumors of prudence turn out to be true, the real economy could suffer. Fortune 500 companies finance all their new investments out of old profits; quite a few have more cash than they know what to do with. They have also been shedding employees. All new private sector jobs, boosters always remind us, come from small and mid-sized businesses. Unlike the Fortune 500, they are usually under financial constraint -- in good times, they would invest more money than they have access to. Big firms, who don't need much external funding, enjoy easy access to capital markets; small ones, who crave access to other people's money, generally find a chilly reception on Wall Street.
Of course maybe that choice between the new prudence and the old recklessness is moot. Maybe we've entered a new era of balanced, self-sustaining growth. That would be news indeed.
Readers unnerved by the optimistic turn of this page may console themselves with a look at "Recent Developments in International Interbank Relations," a study published in October by the Bank for International Settlements (BIS). [Thanks to Grant's Interest Rate Observer for rescuing the pamphlet from obscurity.] In sober prose, the authors, a committee of central bank technocrats, speculate -- responsibly -- on the financial crises of tomorrow. Their major concern is the rapid growth in global bank claims, which tie the financial world together like never before. Cross-border and foreign currency-denominated claims among banks totaled $7.5 trillion at the end of 1991, nearly twice the 1986 figure. A disruption in one node of the system could spread almost instantaneously to the other side of the globe.
Most interesting is the explosive growth in "derivatives" -- not only relatively familiar things like futures and options, but also complex synthetic products with names like swaps, collars, floors, and swaptions (an option on a swap). Essentially, derivatives involve the exchange of money and promises; nothing as semi-substantial as a stock or bond is involved. For example, a Swiss bank with an asset denominated in yen might swap it for a dollar-denominated one held by a British bank. Or a bank with a floating (adjustable) rate asset can swap it for a fixed-rate asset. More precisely, the parties exchange the payment streams associated with each asset (interest, for example, not the underlying loan or bond) -- that is, each agrees to make specified payments on specified dates. If that sounds incomprehensible, that's OK; many senior bank execs and regulators don't fully understand either. In many cases, the terms of such deals can be parsed only by math whizzes using complex software. At the end of 1991, there were $3.87 trillion in currency and interest rate swaps outstanding, up 347% since 1987; 40% of them had banks on both sides of the trade, with the balance involving nonbank customers.
Banks and other swap-makers say their instruments limit, rather than increase, risk. For example, a currency swap supposedly lowers the risk of losses from changes in exchange rates. But these arguments hold only when everything works normally: sellers can find buyers, and prices change only in modest increments. In a panic, however, these conditions don't prevail. Similarly complex strategies like portfolio insurance not only failed to work in the stock market crash of 1987, they helped cause it. Players who thought they'd hedged themselves against serious losses found out that reality failed to behave the way the computers said it should; their snazzy playthings failed them when they most were needed. And there's little doubt that the illusion of safety lulled plungers into taking much more reckless positions than they would have in an unhedged world.
It was only vigorous support work by the Federal Reserve and its colleagues that kept the 1987 crash from turning into a systemic crisis. Surely the central banks will repeat the treatment should the swap market go sour, right?
Maybe not. By bailing out the system, central bankers only encourage a more casual attitude towards risk. The BIS and the IMF have lately been talking lots about the virtues of "market-based financial discipline" -- i.e., letting punters take big hits to teach them a lesson. Or, as the BIS report put it:[T]here seems to be a certain degree of complacency with respect to systemic risk. This appears to be fostered by a more or less firmly held belief that central banks or public authorities would act to prevent any disruptions from reaching systemic proportions.... However, some [market participants surveyed by the authors] said that they were fully aware that the policy response of central banks or other public authorities to financial disturbances may not necessarily be homogenous.
In other words, you may be on your own, Mr./Ms. Asset Swapper. Nice in theory, perhaps, but will innocent bystanders get crushed when some house of cards collapses?
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