Bailout Backfire and the Ticking Debt Time Bomb

by: Matt Blackman October 05, 2008    

Matt Blackman

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Friday's $700 billion bailout was the latest in a string of attempts to address credit constipation. So what impact have it and past efforts had on markets? We compiled a chart showing when the bailouts were initiated and what happened to the Dow Jones Industrial Average afterward.

As we see from Figure 1, the first time the Fed and government intervened was when Bear Stearns got into serious trouble in the second week of March. The Fed intervened and provided guarantees to JP Morgan (JPM) so a quick deal could be done after close of markets on March 14 - 15, thereby averting what many felt could have caused a financial meltdown. As we see from the chart, it helped the Dow mount a two-month rally that ended in the third week of May.

click to enlarge

Figure 1 – Daily chart of the Dow Jones Industrial Average showing the impact of each successive attempt to rescue beleagured companies or stop the carnage on Wall Street, culminating with the approval of the latest $700 billion bailout Friday. Chart by Metastock.com

Next, the Indy Mac takeover was announced July 11, followed by the SEC naked short ban announcement July 15 and action July 21. That intervention triple play had the effect of buoying the Dow until the end of August.

Right after Labor Day, we learned that Fannie Mae (FNM) and Freddie Mac (FRE) needed a federal bailout. Obviously the short ban hadn't helped them but immediately instead of rallying, stocks dropped. Then the Fed had to step in to rescue (AIG) September 16, which caused markets to drop again.

After the SEC decision to stop naked short selling did little to stop the drop in stocks, it announced a short selling ban for 799 financial companies September 17. A few days later that was extended to include companies like General Electric (GE). As we see from the chart, that caused a two day blip, then the carnage resumed.

The collapse of Washington Mutual and subsequent bailout caused a smaller blip that lasted just two days. Finally, we see the impact of the passage of the $700 billion bailout Friday which caused the Dow to drop by 157 points after rallying more than 300 points earlier in the day.

As we pointed out last week, the ban on naked shorting was long overdue if only because it allowed some players to effectively counterfeit shares. Why it has been allowed for so long is beyond comprehension. But the outright ban on short selling of any kind on more than 800 companies is ludicrous.

And bailouts, while seemingly well-intentioned, appear to be having a diminishing impact with the latest bailout actually having the opposite of the desired effect, at least on stocks. Question is, will it be any more effective than past bailouts for the economy?

U.S. stocks lost more than $1 trillion this week and homeowners have lost roughly $3 trillion this year (according to the Case-Shiller Index), exposing the insignificance of recent government and Fed bailouts.

Here is another chart that shows just how bad our debt situation has grown in the last two decades. This next chart shows the ratio of total credit market debt (debt at all levels from household and corporate to government) to GDP. Since 2000 it has grown 25% faster than our economy. This ratio has doubled since 1982.

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Figure 2 – Total credit market debt to GDP percentage, showing that we hit nearly 350% in Q12008. This rate of debt increase is clearly unsustainable but more alarming is what will happen when we have a significant economic slowdown.

As of the first quarter 2008, U.S. debt was nearly 350% of GDP but that's not the scary part. Look what happened the last time we had a really serious slowdown in the early 1930s. GDP fell by 45% but debt only grew bigger, jumping from 155% in 1929 to 260% by 1932 as the economy worsened – a 67% increase in just three years.

A similar economic meltdown again, which is now looking increasingly likely, would push our total debt to GDP ratio to nearly 600%!

Now go back and take a look at our chart in our Sept 19 newsletter showing U.S. Treasury Income Flows, see http://tradesystemguru.com/content/view/214/58/#TIC. As you can see, Treasury is having a hard time selling enough now to pay the $33 billion each month our current $400 billion debt costs. Now add the cost of a host of bailouts combined with falling revenues a recession would cause. Imagine what that combination would do to interest rates… and at the worst possible time.

I don't mean to scare anyone but forewarned is forearmed. Better to hope for the best but plan for the worst than get broadsided without warning.

Disclosure: none.

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This article has 23 comments:

  •  
    Oct 05 10:06 AM
    Matt has written an excellent article.

    One chart is worth more than a thousand words, particularly the clear chart of total credit debt [households, corporate and government] as a percent of GDP. Importantly, data from the 1920s has been displayed for comparison. It is scary [ for added effect we might quote Lee Iacocca of Chrysler fame and say "if this does not scare the hell out of you I don't know what will!"]. If you look carefully, this single total debt to gdp ratio says it all, it is never so high, it is even higher than that during the Great Depression, it has risen in the last 2 decades, accelerated in the last decade, it has risen exponentially in the last decade. Matt has said this high ratio may yet double! before it subsides again as it must.

    No wonder Matt cautioned that "I don't mean to scare anyone but to be forewarned is to be forearmed". Timely advise indeed, even now in the midst of the economic storm. It pays to ponder over this?

    Someone wrote in Seekingalpha that "The die is cast". It would appear that that we have to assume that the economic storm will take its course [because whatever governments do cannot alter the laws of economics and reverse the inordinately high credit built up over 2 decades]. Out of creative destruction there will emerge a new, brighter future much like after the Great Depression.
    Reply | Link to Comment
  •  
    Oct 05 10:08 AM
    It is a sad reflection on the leadership of this country to be in such a predicament. I only hope the next president can do something to balance the budget and get the economy headed in the right direction.
    Reply | Link to Comment
  •  
    Oct 05 10:44 AM
    I don't disagree with the fundamental points this author is making. However, I wonder about two points. First, how much of the credit debt is a reflection that are society buys a lot more via credit cards and while some of those balances get paid off monthly, the monthly amount is shown as "outstanding"... Second, if our government is having trouble issuing its debt - as the author asserts - that doesn't seem to be showing up in the interest rates (even before the crisis)? I don't disagree that it eventually will get more costly as our creditworthiness deteriorates.
    Reply | Link to Comment
  •  
    Oct 05 10:45 AM
    Okay, now that I'm forewarned what do I do?
    Reply | Link to Comment
  •  
    Oct 05 10:47 AM
    Oops, I hit the "publish" button before editing. On the credit cards, what I was trying to say is that we use cards for a lot more types of transactions (anybody remember when it wasn't allowed to use cards to buy food at the supermarket)? So I'm wondering how much of the credit growth on this chart is "statement balance" that actually gets paid off?
    Reply | Link to Comment
  •  
    Oct 05 11:38 AM
    Notice the debt mushroomed under Reagan and Bush Jr. At least Reagan had the excuse (a weak excuse) that he had to beef up the military to fight the USSR. What is Bush's excuse?

    Got gold?
    Reply | Link to Comment
  •  
    Oct 05 12:09 PM
    The growth during the Reagan and Bush Jr periods are staggering. Not to inject politics into a serious discussion, but clearly there's a lesson here.
    Reply | Link to Comment
  •  
    Oct 05 12:49 PM
    The covering acting will be difficult. The are confronting the possible rejection of the US$ by major creditor nations. That means that commerce is hurt badly for all. The EU fiance meeting this weekend came up with a "do Little" plan mostly because they want to wait and see of the dollar survives. I support some gold, and some hard assets are required. In the end , however, we will need a new currency back by PMs in part, and debt repayment plan something like Argentina is attempting to work out. Worse than most know!
    Reply | Link to Comment
  •  
    Oct 05 01:58 PM
    I am surprised that many are blaming "lack of regulation" and few are blaming "the maestro" for encouraging reckless expansion of credit by absurdly low interest rates. A free market, even wihout regulation, would lend out is capital carefully if the interest rates were high enough, since those borrowing the capital would have to be able to use it more effectively than those who have accumulated it and are now lending it out to them. Simply having the Fed impose unnatural interest rates on the economy, in violation of this basic fact, and for extended periods, is the principal reason of this crisis.
    Reply | Link to Comment
  •  
    Oct 05 03:26 PM
    I totally agree with what prudentinvestor commented. A free market should be "free" and the forces of supply and demand should dictate the interest rate and not the stimulus from the government.

    Government is made "for" the people "by" the people. "By" the people is what I am afraid of. One cannot rule out the "interest" of these higher ups in the government who have the complete authority to take decision which will help a select few.

    I am of the opinion that let the market adjust itself. There will be a lot of pain and suffering but at least we all will learn from the excess that we did in the last few years.
    Reply | Link to Comment
  •  
    Oct 05 03:26 PM
    I totally agree with what prudentinvestor commented. A free market should be "free" and the forces of supply and demand should dictate the interest rate and not the stimulus from the government.

    Government is made "for" the people "by" the people. "By" the people is what I am afraid of. One cannot rule out the "interest" of these higher ups in the government who have the complete authority to take decision which will help a select few.

    I am of the opinion that let the market adjust itself. There will be a lot of pain and suffering but at least we all will learn from the excess that we did in the last few years.
    Reply | Link to Comment
  •  
    Oct 05 05:48 PM
    prudentinventor said: "Simply having the Fed impose unnatural interest rates on the economy, in violation of this basic fact, ***and for extended periods***(!!!), is the principal reason of this crisis." [my emphasis added!!!]- only a die hard monetarist or an inflexible Keynesian economist would make this statement. Over the LONG run, the Fed cannot influence the natural (long term) interest rate--most economists would agree (see Greg Mankiw's Econ 101 textbook). Over the SHORT run, it can. So make up your mind--was the bubble a short run phenomena, in which case your statement makes sense, or was it long run, in which it does not? My personal view is that this bubble was a classic case of greedy overexpansion, not Fed easy money. Recall savers (via banks) freely gave hedge funds money during the bubble to make a little extra income. Now they regret it. See my other post here at SeekingAlpha as to why the last 30 days are not unprecedented, historically, from what's occurred in recent history in both the drop in commercial paper outstanding and the rise of LIBOR/TED. Paulson and Bernanke simply panicked in a relatively routine (albeit severe) credit contraction; a contraction which typically precedes many recessions. History will be their judge: they overreacted. God save us if we turn socialist because of this blunder. I feel the US public is falling for this panic and the "official" response and rationale in the same way they fell for Bush's WMD argument in Iraq. A piecemeal response, of the kind Europe is doing at the moment (which has similar rotten banks, if not more so than the USA), would have been more prudent.
    Reply | Link to Comment
  •  
    Oct 06 12:46 AM
    Does anyone want bailout to help $2T hedge funds? Totally unregulated - you know why. So they can all be bankrupt; but will find out at a pro forma mark to market once a year maybe. Hedge funds might cleverly unload any toxic holdings such as mortgage backed bonds etc. to another more open firm, which then can unload such holdings to the gov, which are marked to market once a year maybe. Another possibility, introduce dual currencies such as eurodollar for currency and accounting. Not so different from American firms in the City in London? Hence competition, wherein we trust the stability of eurodollar more than what politicians have done to our currency (-30%), which results in a 30% premium on our number one import, oil. We must have less government spending, in order to restore confidence (to foreign creditors) in our currency and bonds, for our debtor nation.
    Reply | Link to Comment
  •  
    Oct 06 10:40 AM
    It is not safe to allow anyone to read this unless they are sitting down. Make that lying down.A recession is unavoidable. A deep recession looks likely. A Depression looks very possible.
    Reply | Link to Comment
  •  
    Oct 06 11:54 AM
    Looking at those charts, no wonder congress has a single digit approval rating.
    Reply | Link to Comment
  •  
    Oct 06 01:35 PM
    It would seem that somewhere, somehow, if total net debt (not just Federal Debt) keeps rising faster than production (Real-GDP), the burden of interest charges at some point now indefinite and unknown, but nevertheless real, will become too great to carry.
    Reply | Link to Comment
  •  
    Oct 06 01:36 PM
    Any deficit, by definition, creates a demand for loan-funds. The larger the deficit, the higher interest rates will be, or the less they will fall.
    Any given deficit should be evaluated in terms of: (1) the size of the deficit in the context of the size of future deficits, and the accumulated debt relative to the means and costs of financing the whole: (2) how the deficit is financed: (a) from savings or (b) commercial bank credit, i.e., newly created money; and (3) the purpose for which the deficits are incurred.

    Prorating the federal deficits over the entire spectrum of federal expenditures, it can be said that virtually all of the current deficits are attributable to defense spending, military and civil service pensions, interest on the debt, and welfare and unemployment benefits. Social security for now is not include in the above list since only a very small proportion of social security benefits are financed from non-social security taxes. From an economic standpoint, only interest is “untouchable”.

    If current projections of Federal Deficits materialize in this, and the next few years, interest rates (both long and short-term) will be driven up sharply by the increased demand for loan funds. I.e., any recovery in the economy will present a “Catch 22” situation. An upturn in the economy will add increased private demand for loan funds to the insatiable demands of the Federal Government. The consequent rise in interest rates will effectively abort any recovery.

    Raising taxes to accomplish a reduction in the deficit would be counter-productive. Most of this debt is short-term. Combine this with the factor with the constant roll-over of some of the long-term debt and it becomes obvious that the burden of higher interest rates will be compounded.

    The burden becomes a function of the major portion of the debt, not just the current deficits. The burden, in fact, becomes exponential. In other words, if the trend is not stopped, the debt inevitably has to be repudiated.

    Reply | Link to Comment
  •  
    Oct 06 01:37 PM
    Those who are wont to minimize the ill effects of the deficit are prone to compare the size of the deficit with nominal GDP, as if the volume of nominal GDP were independent of the size of the deficit.

    Unprecedentedly large deficits “absorb” a disproportinoately large share of nominal GDP

    Present deficits are unprecedented no matter how measured, and the past gives us no reliable guide to the future effects of deficit financing, beneficial or otherwise.

    To appraise the effect of the federal budget deficit on interest rates, it is necessary to compare the deficit, not to GDP, but to the volume of CURRENT SAVINGS made available to the credit markets. The current deficit is absorbing about 24% of gross savings.

    The more alarming aspect of the deficits is not the effect on interest rates but the effect of high interest rates on the level of taxable income and the volume of taxes required to serve a cumulative debt now exceeding $10+ trillion. Both high interest rates and high taxes induce stagflation, thus eroding the tax base and increasing the volume of futures deficits.

    Reply | Link to Comment
  •  
    Oct 06 01:37 PM
    It should be recalled that the charges on debt are related to a cumulative figure; and since the multiplier effects of debt expansion on income, the ingredient from which the charges must inevitably be paid, is a non-cumulative figure, it would seem that the time will inevitably arrive when further debt expansion is no longer a practical or possible expedient, either to provide full employment or to keep debt charges with tolerable limits.
    Reply | Link to Comment
  •  
    Oct 06 01:38 PM
    The significant economic purposes for which a debt was contracted, or the manner in which it was financed, is of inestimatable value in evaluating it's impact.

    For example if the debt was acquired to finance the acquisition of a (new-security), the proceeds of which are used to finance plant and equipment expansion, rather than the purchase of an (existing-security) to finance the construction of a new house, rather than to finance the purchase of an existing one (as will Paulson's planned $700 bill bailout), or to finance (inventory-expansion), rather than refinance (existing-inventories)...

    The former types of investment are designated as "real" as contrasted to the latter, which constitute "financial" investment (existing homes). Financial investment provides a relatively insignificant demand for labor and materials and in some instances the over-all effects may actually be retarding to the economy. Compared to real investment,it is rather inconsequential as a contributor to employment and production. Only debt growing out of real investment or consumption makes an actual direct demand for labor and materials.
    Reply | Link to Comment
  •  
    Oct 06 01:42 PM
    Ray Lopez:

    THE MONEY SUPPLY CAN NEVER BE MANAGED BY ANY ATTEMPT TO CONTROL THE COST OF CREDIT.
    Reply | Link to Comment
  •  
    Oct 06 09:26 PM
    Excellent chart, a picture worht a thousand words! Seems LEH is omittied, that would be the big drop preceding the AIG event? The market keeps going down whether the government do or doesn't do anything! credit lock up, business failures, loss of jobs, dropping home prices, foreclosures, repeat at credit lock up, etc how to stop this vicious cycle ???
    Reply | Link to Comment
  •  
    Oct 09 01:49 AM
    Interesting point about LEH Ed but then that wasn't a bailout in the traditional sense of the term - it was basically let go and got very little federal or Fed help...
    Reply | Link to Comment
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