Repetitive Consequences

“We hope that the weight of evidence in this book will give future policy makers and investors a bit more pause before next they declare, “This time is different.” It almost never is.”

-          Reinhart and Rogoff

We recently finished reading “This Time Is Different”, by Carmen Reinhart and Kenneth Rogoff, which provides “a quantitative history of financial crises in their various guises.”  We obviously found the book interesting on a number of levels. 

Firstly, both Keith and I worked at major private equity firms when the world was purportedly “awash” with liquidity.  Many of the world’s “great” financiers theorized that things were different that go around and were modeling company cash flows with no business cycles imbedded therein.   If we need any more evidence of this, it comes from Tishman Speyer Properties handing over Peter Cooper Village and Stuyvesant Town to their lenders this morning.  After closing the most expensive real estate purchase in history at the top of the real estate market, Tishman walked away today with its equity investment marked-to-market at zero.

Secondly, the book is an incredible resource for studying financial crises, particularly related to sovereign debt defaults.  Sovereign debt is a particular focus of our macro analysis this year given the massive amount of sovereign debt issuance piling up globally.  This is both an issue in the domestic United States, but around the globe as nations continue to issue debt to offset the budgetary issues related to the “Second Great Contraction”, as Reinhart and Rogoff refer to the global recession of 2008 / 2009.

The premise of the book is to look at historical financial crises and to attempt to quantify both what a crises is and what exogenous factors led to the crises.  If there is any lesson from the historical studies from the book, it is that crises are more normal than most market operators believe.  In fact, while we have been in a period of low sovereign debt defaults, over history this has not been the norm.  Typically a period of limited debt defaults is followed by a resurgence of default.   As Rogoff and Reinhart note in the preface to the book:

“If there is common theme to the vast range of crises we consider in this book, it is that excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom.  Infusions of cash can make a government look like it is providing greater growth to its economy than it is.”

Historical analysis is valuable because it can provide a range of outcomes for the future.   One of our Q1 Macro Themes is Chinese Ox in a Box, which refers to our belief that China will slow in Q1 of 2010.  Obviously, the most recent data from China already supports this thesis.  A key longer term question relates to the health of the Chinese banking system.  The bears are quite concerned, while the bulls continue to buy Chinese growth with little concern. 

The history of the Chinese banking system is less than stellar.  In fact, the last major crisis in Chinese banking occurred in the late 1990s.  As Reinhart and Rogoff write:

“China’s four large state owned banks, with 68% of banking system assets, were deemed insolvent.  Banking system nonperforming loans were estimated at 50%.” 

Another banking crisis of that magnitude may be solidly out on the TAIL in terms of probability, but we are pretty sure most China bulls aren’t even considering this in their scenario analysis for the Chinese stock market.  And certainly, this scenario is definitely not priced into Chinese stocks.  If Rogoff and Reinhart’s historical studies tell us anything, it is that history tends to repeat itself.  According to George Santayana:

“Those who cannot remember the past are condemned to repeat it.”

Indeed.

Daryl G. Jones
Managing Director