Predictable...and Predicted

Edward Chancellor, author of Devil Take the Hindmost, one of the best books ever written about the history of financial bubbles, and a member of global money manager GMO's asset allocation team, had some nice things to say about my last book and my most recent book in a column for breakingviews entitled "Inefficient Market: The Doomsayer Who Got It Right."

The least useful investment books are those which describe either extremely bright or very dark outcomes for the markets. The quality of predictions from both types tends to be so awful that they generally provide reliable contrarian indicators. If the author says buy, you should sell and vice versa.

Michael Panzner’s Financial Armageddon, which was published in early 2007, is an exception to this rule. The book’s deeply gloomy predictions have proved so accurate that, if the text were changed from the future to the past tense, Financial Armageddon would read like a financial history of the past year and a half. There’s more bad news to come, says Panzner. Given his extraordinary track record, investors are bound to pay attention.

One seldom profits from following the advice of a doom-monger. In September 1981, The Coming Currency Collapse by Jerome Smith was published. Over the next year, the dollar appreciated by roughly a third against the yen. Richard Zambell’s Hyperinflation or Deflation appeared in 1984. This book ushered in more than two decades of stable consumer prices. James Dales’s The Plague of the Black Debt: How to Survive the Coming Depression went to press in 1993, just as the US economy was about to embark on a decade and a half of credit-fuelled expansion. The optimists haven’t much to crow about. Far from tripling in value, as the authors of Dow 36,000 predicted back in the summer of 1999, US stocks are currently worth a third less than a decade ago.

The style of Michael Panzner’s Financial Armageddon, completed in 2006 and published early the following year, is typical of the doom-and-gloom genre. The forecasts are grim, they are presented with deep conviction, and the crisis deepens melodramatically with each successive chapter. What separates Panzner from his fellow doomsayers is that his predictions came true.

More than two years ago, Panzner warned that the collapse in the housing market would "drag the United States – and ultimately the rest of the world – into a deep and dark abyss, the likes of which we haven’t seen for decades". He anticipated that the hardest-hit countries would be those emerging markets which depended most on the bloated American consumer and which had "accumulated massive reserves of dollars and holdings of US assets in an expensive yet ultimately failed strategy to maintain an export market for their rapidly expanding output".

Panzner’s analysis of the flaws in the credit system has been vindicated by events. Banks no longer knew their customers. Instead, they depended on credit scores and risk modeling. But the risk models were flawed: they understated risk during the good times but would force financial players to make fire-sale disposals after a crisis appeared. Panzner pointed out the dangers of subprime and negative amortization mortgage loans long before this credit detritus became common knowledge.

He describes banks originating loans for a fee and parking them in off-balance funds, which in turn issued commercial paper to investors. In time, it would become clear that "allegedly sophisticated investors had struck something of a Faustian bargain during the good times, by exchanging immense quantities of borrowed money for unsaleable assets". Panzner excoriated the securitisation of loans, which had "created an overflowing mess that will contaminate the financial groundwater for years".

This analysis wasn’t wholly original. However, by synthesizing a knowledge of economic history with a deep understanding of recent financial developments, Panzner boldly imagined where the dominoes would fall. His description of how the credit system would unravel was specific and, as things turned out, accurate. "The trigger for a fully-fledged systemic crisis will likely be the abrupt and unexpected failure of an aggressive operator". Banks and prime brokers would scramble to call in loans.

By this time, "there will almost certainly have been a domino-like collapse of more than a few large intermediaries and allegedly sophisticated global financial firms, including hedge funds, insurers, and brokers". Concerns about counterparty risk, Panzner predicted, would reach a "fever pitch". In the early stages of the panic, the dollar would climb in the foreign exchanges as leveraged financial players would require the US currency to unwind dollar-denominated positions.

A number of financial institutions would fail, including Fannie Mae and Freddie Mac, Panzner predicted. As commercial paper soured, several money market funds were set to "break the buck". The collapse of the bond insurers would lead municipal bond spreads to blow out. By then many near-bankrupt states and municipalities would be forced to raise taxes, cut costs, and turn to Washington for a handout. Highly-rated securitised bonds were likely to suffer steep and instantaneous downgrades. Large banks would provide no safe haven: "a long overdue economic slowdown or turn in the credit cycle will almost certainly decimate the financial position of America’s largest banks".

It wouldn’t be long before "bogus appraisals and valuations" would come to light. "The newfound transparency in the wake of the unfolding financial crisis", wrote Panzner, "will expose a scale of fraud, corruption, and self-dealing that many will find almost impossible to comprehend. Day in, day out, reports will surface about hidden losses, false accounting, inflated appraisals, sizable off-balance sheets obligations, valuation discrepancies, unregulated offshore entities, phantom profits, insider trading, and businesses bled dry to enrich a few individuals at the expenses of employees, investors, bankers, and bond holders".

The authorities would be caught off-guard by the severity and speed of the crisis, according to Panzner. Initially, the Fed would be slow to respond. But as deflationary fears spread, the central bank would respond by cutting rates to zero and adopting a policy of quantitative easing. As the crisis spreads around the world, protectionism would resurface. The public’s mood would turn increasingly nasty, as people looked with incredulity at the mismanagement and looting of the financiers. But one shouldn’t expect much from politicians, who would bicker and "try to gain at least a short-term advantage at the others’ expense".

It turns out that this crisis wasn’t just perfectly predictable, it was perfectly predicted. And what of those anticipated events which have yet to occur? Panzner elaborates them in a new book, When Giants Fall (Wiley). The crisis will provoke a backlash against globalisation, he predicts. Nationalism will resurface as faith in multilateral institutions, such as the European Union and the WTO, diminishes. The euro is at risk of collapsing. Unions will grab more power for themselves and state capitalism will make a comeback.

The long-term outlook for the dollar is bleak, claims Panzner. There are too many "unnatural holders" who only own the dollar because of its status as a reserve currency. But in the dark times ahead, as capital is repatriated around the world, dollars will be sold. More worryingly, Panzner fears a general loss of confidence in fiat currencies, as central bankers around the world turn to the electronic printing press as a palliative. A deflationary psychology could suddenly give way to concerns about hyperinflation. At that moment, money would become a hot potato, passed from hand to hand as quickly as possible.

Investors must judge for themselves the likelihood of this scenario. However, they shouldn't ignore it. The biggest losses over the last year and a half have been suffered by those wishful-thinkers who refused ever to consider the worst-case scenario.

Comments

[dukeb]

I read Financial Armageddon the day it was released in hard cover. People seem to think the turmoil began around September 2008. But I know it was early 2007. Because not long after reading Financial Armageddon, I recognized those initial Bear Sterns hedge funds that were having problems (which got scant media attention) as possibly being the start of the nasty sequence described in the book. And I've got the saved-my-butt paper trail to prove it. I hope you got a big cut of the cover price I paid, Mike. (But in the end, I bet I got a better "book deal" out of it than you!)

[rbm411]

You were right. However, Obama's budget has led us to a new place. The printing presses can't run fast enough. Sort health care with impunity, it's dead. Short energy with impunity, it's dead. Short financials with impunity it's dead. Short America with impunity it IS DEAD. Go long guns, RGR, SWHC.

[Maximus]

Congratulations on the recognition -- it is much deserved, although I don't see any mention of Civil Unrest. I have already recognized your blog entries among my "best" on my blog, now I need to read your books....

Maximus
http://4best4worst.wordpress.com/

[Steve]

Great review. I'll be picking up the new book next time I'm shopping.

[Willydog]

Well done sir!

[Marion Shaw]

I read this blog daily and often find the comments to
be very reasonable and knowledgable.
I understand little about money beyond the fact if you
continue to spend more than you have, you will sink
in due time to penury.
What I do not understand,is in the midst of this widely talked about crisis, why is my grocery store still full of imported wines and cheeses; fresh dairy and fruit products; fresh vegetables, crab,shrimp and high quality cuts of beef; infinite varieties of condiments, etc; over the counter drug products, etc. I live in an area of very high unemployment in addition to many well to do retired
types that come to enjoy the scenery and the golf.
Admittedly these readily available products are very
expensive and the food banks are begging for help, but there is no visible evidence of a breakdown in the daily flow of abundance and good living from the supermarkets. When will this change?

[Joe M.]

"there is no visible evidence of a breakdown in the daily flow of abundance and good living from the supermarkets. When will this change?"

It could change overnight! If we had another Arab Oil embargo or some derivative blows-up and starts a chain reaction that shuts down the markets. We truly are teetering on the edge and it's a good idea to have back-up food/cash at home right now.

[Rocky]

The US may be going to hell in a hand basket, but it seems that other countries will get there first. As I recall, the C$ was worth about $1.10 US in September 2007; now it won't even buy $0.80 US. The GBP has dropped significantly as well, and London is even more dependent than New York on financial services. The British banks seem in as bad a shape as the US ones. Mexico has been referred to as a near failed state because of its drug wars. The Gaza Strip depends on foreign charity to make it from day to day and Israel is also no slouch when it comes to the foreign aid department. How long will it last when Uncle Sugar finally cuts off its multi-billion dollar annual grants to that schnnorer (Yiddish for beggar).

[JohnRDC]

Well-deserved praise. I bought the book in 2007 and it contributed to my decision to bail from the stock market.