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Let History Guide Us


A cautionary tale of debt and deflation.

A good example of a somewhat broad nationalization occurring in the U.S. was Texas, Arkansas, and Oklahoma in 1984 (another smaller, less clear one occurred in the savings and loan crisis).

Large regional banks like Interfirst (eighth largest in assets in 1982), Republic, and Texas Commerce were making many loans to oil and gas exploration companies, refiners, and energy production companies. The banks became extremely levered and were taking land, rigs, and oil production as collateral. All was chugging along until oil prices collapsed after the Iran oil embargo ended. What made business sense (positive cash flow and asset values supporting high leverage) with oil at $32 did not make any sense with oil at $14 a barrel. Cash flow dried up and asset values plunged.

The heavy leverage at the banks left them trying to collect collateral as all these companies stopped paying loans. But with no use for the collateral their value fell as well. The banks found out quickly they had no real capital and they all went bankrupt.

This process took about a year as they fought and fought. But eventually the government had to come in and nationalize: they essentially took over the banks and paid off all deposits with taxpayer money. Of course all equity value at the banks, and equity values for regional companies went basically to zero: A stock is an option on profits, not ownership in the assets of a company. When profits go to zero, stocks go to zero. The assets of what is left over is split up by bondholders. Learn that lesson well, for many people do not understand that dynamic.

What happened next is what will happen now except the much broader nature of this deflation will cause it to take much longer. Essentially everything just sat and sat. The economy slowly began to recover as oil prices recovered. But the important point is that it only recovered because debt was destroyed and the level of debt became supportable by the amount of economic activity basic to the region: economic activity produces income which services debt.

The U.S. economy will recover after a process of debt destruction where balance is restored and the level of income generated by economic activity can support that level of debt. Savings will grow and eventually supply the liquidity needed for new lending. We arrived at these imbalances after years of central bank fiddling where debt just grew way way too big. But the magnitude of this is hard to describe. Once Wall-Street realized the Fed was never going to let things slow down they invented all sorts of new ways to create debt. Securitization and derivatives now represents an astounding 80% of total global liquidity. Central banks can only affect a very small part of this liquidity pool.

That is why the Fed is so desperate as it illustrated today by taking on credit risk like never before. The amount of debt stuffed into areas they cannot control relative to the size of the U.S. economy will take years to unwind.

- Mr. P
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