We are clearly in the beginning phase of a classic credit crunch

The German bank IKB has been the recipient of an $11 billion bailout. $64 billion of leveraged buyout financings have been withdrawn in the last month. Standard and Poors have talked of down-rating Bear Stearns, two of whose funds have collapsed. We are clearly in the beginning phase of a classic credit crunch, and it’s therefore worth looking at how these have played out in the past, and where and how holes in the fabric of the world’s financial system are most likely to appear.



Credit crunches are relatively rare, rarer than stock market downturns. There was no credit crunch in 2000-02, though the stock market downturn was substantial. In 1989-92 there was a mild credit crunch in junk bonds and New England real estate, but relatively little spillover to other areas of the credit market. In 1982, there was a credit crunch in emerging market debt, which was eventually solved by a mass debt forgiveness and bailout of the New York banks which were most heavily exposed. Even during that period, there was no great credit crunch in the domestic U.S. market.



The last true credit crunch was thus that of 1973-74, which was particularly severe in Britain but spread throughout the international debt markets. That’s before the working lifetime of most market participants today. Sam Molinaro, chief financial officer of Bear Stearns said Friday that conditions in the fixed income market were “as bad as I have seen in 22 years” – since he is 49 he was presumably referring to his period of participation in the market rather than some hitherto obscure crisis in 1985, from memory a placid and bullish year. One can pause for a moment to mourn the length of institutional memory of 1950s London, where Morgan Grenfell’s chairman Lord Bicester served until his death in office at 89, thus being able to give his junior colleagues a first hand account not only of the 1929 crash but of its predecessors in 1890 and 1907.



It’s worth looking at how the credit crunch of 1973-4 developed.



Like the last few years, the early 1970s was a period in both Britain and the United States of rapidly rising money supply and asset prices, but with stocks still mostly below the level of a record-setting bull market a few years earlier. In the U.S., Federal Reserve Chairman Arthur Burns inflated the money supply by over 10% per annum during the years 1971-73, in order to lift the United States from recession and allegedly assist President Richard Nixon’s 1972 re-election.



In Britain, the Bank of England in 1971 ended quantitative credit controls and moved to a free market system, while prime minister Edward Heath abandoned control of both the money supply and public expenditure and embarked on a “dash for growth.” This quickly produced a real estate bubble, both in housing but particularly in office property, the supply of which was still somewhat restricted by the aftermath of World War II and the lengthy period of building restrictions that followed. Since the period was one of worldwide economic boom, commodity prices also soared, in many cases reaching levels they were not to touch again until after 2000; the first oil crisis, in which oil prices rose from $2 to $10 a barrel, occurred in October 1973.



The main difference between 1973 and now was inflation, which ran in the US at 6.2% and in Britain at 9.2% in that year. That reflected the worldwide increase in commodity prices, which was not offset by worldwide deflation through outsourcing. Interest rates in nominal terms were correspondingly higher than today and Britain in particular was running a tighter monetary policy, with Minimum Lending Rate rising from 11.5% to 13% as the crisis began in October 1973. However longer term rates were around zero in real terms, as today.



The credit crunch appeared through the London secondary banks, fairly similar institutions to today’s sub-prime mortgage lenders, albeit with their portfolios concentrated on commercial rather than residential loans. Rumblings appeared from this sector in the spring of 1973, and international bond market conditions became very difficult after June, but it was not until November 30 that the first secondary bank, London and County Securities, went into insolvency. However the cascade of bankruptcies that followed was rapid and very severe. By December 19 the Bank of England was organizing a “lifeboat” support package to preserve liquidity in the market and allow orderly liquidation of the fringe banks’ portfolios. At its peak the “lifeboat” had loans outstanding to no fewer than 30 banks, and there was fear at one stage that the gigantic National Westminster Bank would go under.



The British economy had two dreadful years in 1974 and 1975, with a miners’ strike, a 3-day workweek and a hard-left Labour government. The Financial Times share index dropped from its 1969 and 1972 peaks of over 500, and around 400 in late 1973 to a low of 150, a drop of 70% in nominal terms and a lower level in real terms than its nadir of 40.4 after the 1940 evacuation of Dunkirk. The credit crunch persisted until the end of 1975, lasting for around 2½ years in all, and bankrupted most of the entrepreneurial financial institutions in the City of London, including notably Jessel Securities, a major fund manager, and Slater Walker, which until 1973 had been the pre-eminent financial innovator of its day.



Internationally, the British secondary banking crisis had initially only a moderate effect. The Eurobond market closed almost completely in December 1973, one of its last issues being the only Euro-financing ever done in Lebanese pounds – by the time the market reopened for such exotica in 1977 or so, Lebanon was engulfed in civil war. The syndicated loan market however remained open during the first quarter of 1974, since loans by this stage were made on a floating interest rate basis based on the London Interbank Offered Rate (LIBOR) -- thus higher inflation did not automatically destroy their value. There was indeed a large amount of both supply and demand in the banking system, since the oil exporting countries of the Middle East for the first time built up multi-billion dollar balances, mostly held in US and British banks, while countries such as Japan found themselves with a huge oil-related hole in the balance of payments and a consequent need to borrow heavily.



The next leg of the 1973-74 credit crunch came with the bankruptcy of the medium sized German bank I.D. Herstatt, which took place on June 26, 1974. This would normally have caused only a modest ripple internationally, but the foolish German authorities closed the bank in mid-afternoon, while New York was still trading. A number of banks, including my own employers the merchant bank Hill Samuel, had entered into spot foreign exchange transactions, and had paid deutschemarks into Herstatt, expecting to receive dollars from Chase Manhattan, Herstatt’s New York correspondent. The dollars were never paid. This proved to be utterly destructive of international banking confidence; a period of illiquidity followed which was similar only to that after the Creditanstalt failure of 1931. Japanese trust banks, a highly solid and well behaved bunch, were forced to borrow at 2% above LIBOR for around a year, making their funding cost 2% higher than the best U.S. and European banks. The U.S. banking system also got into difficulties, with the Franklin National Bank, a major institution which had invented the bank credit card in 1952, being declared insolvent on October 8, 1974.



The U.S. and British economies went into recession in late 1973, dragged down by the combined effect of the credit crunch and the oil price spike, but the recession was fairly short-lived, ending in late 1974. Politicians were throughout unaware of the true position, as evidenced by the Gerald Ford administration’s switch from distributing “Whip Inflation Now” buttons to proposing a recession-fighting public spending package within the space of six weeks in late 1974, after the economy had already been in recession for a year. Indeed, the final major effects of the credit crunch, the bankruptcy of Slater Walker and the near-bankruptcy of New York City, did not occur until the autumn of 1975, while Cleveland’s default did not occur until 1978.



There are a number of lessons we can learn from this history about the credit crunch we appear to be entering:



· Credit crunches very often occur after periods of excessive monetary expansion which appear to produce halcyon economic conditions of rapid worldwide growth, albeit with rising commodity prices. Check!



· “Foreshocks” occur for some considerable period before the credit crunch, generally concentrated in areas where lending has been most vigorous. In the Latin American credit crunch of 1981-2, the market more or less closed for new lending at the end of 1981, but default did not occur until August 1982. Check – the sub-prime mortgage market went into severe difficulties in February.



· Once a credit crunch hits, it inevitably spreads to other areas where lending has been aggressive, although it may take some months to do so. The international bond markets closed around the same time as the 1973 secondary banking crisis, but the loan markets did not close until several months later. The current crunch appears now to have spread to the LBO market; the emerging market debt market surely cannot be far behind.



· The principal effect of a credit crunch is to dry up lending in general. Bank balance sheets and bond investors’ portfolios become constipated, with no room for new deals and an urgent need for repayment of outstanding loans and cancellation of commitments. In 1974, it became very difficult to get a “backstop” credit line for commercial paper issues, so even though the commercial paper market remained open (there being no real equivalent of the Penn Central collapse of 4 years earlier) issuance became impossible for all but the most liquid companies.



Sub-prime mortgages didn’t cause this to happen this time around, because they had mostly been packaged and sold to outsiders such as the unfortunate IKB. However the drying up of the LBO market is causing illiquidity at the heart of the system. In just a few weeks, the major LBO market lenders have provided transaction bridge financing (short term lending) totaling around $12 billion for the Chrysler LBO, $20 billion for Boots and $35 billion for Texas Utilities, to name only 3 deals. Long term takeout financing for all three transactions appears now to be unobtainable; hence major bank and investment bank balance sheets have suddenly become highly illiquid and concentrated in a few unattractive credit risks.


Assets become almost impossible to sell during a credit crunch, and trading books become ossified, with remnants of deals attempted years earlier remaining on them and clogging up liquidity. Bargain-hunters attempt to pick up equity and loan assets involved in the crunch at prices far below those of a year earlier, but the “bargains” are chimerical; most such assets end in bankruptcy as confidence never returns.

Credit crunches don’t typically end quickly; their effects drag on for at least a couple of years. During that period, credit is very difficult to obtain and even well-run solvent companies can find themselves in sudden difficulties. It is impossible to predict which companies will be forced to declare bankruptcy, but major bankruptcies there will undoubtedly be. One difference from the 1970s is the increased importance of trial lawyers and aggressiveness of prosecutors; if 2001-05 is anything to go by, bankruptcies will be followed by prosecutions of the managements involved, sequestrations of their assets and generally lengthy prison terms. Jeff Skilling’s fate in the U.S. has not been all that different to Mikhail Khodorkovsky’s in Russia, although his prison is probably somewhat warmer than the latter’s Siberian incarceration.

Stock markets and real estate markets will go into a lengthy period of illiquidity and quiescence, with price drops far in excess of those currently expected. In a period when credit is almost impossible to obtain, valuation metrics that depend on the use of credit quickly become worthless. US business is far more leveraged than in 1973; its decline in value will thus be correspondingly more intense. Only liquid companies in the liquid countries of East Asia, particularly Japan, and maybe the Arabian Gulf states are likely to be fortified by the experience.



Joyful prospect, isn’t it? But that’s what happens after a decade of fiat money run mad.