Fred Feldkamp gave us permission to share this exceptional history lesson, which includes work on credit spreads, markets, war, and the defining characteristics of our country’s national durability. Fred is a retired lawyer with skills in the securities and financial services business and a scholar of history. A retired partner of Foley & Lardner LLP, he has worked on developing mortgage and asset-backed securities since 1973.
Here’s Fred’s masterful essay below with links to the documents he references.
David R. Kotok
Chairman & Chief Investment Officer
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War looms and the world’s financial markets are in upheaval. What can and should be done?
Nobody said it would be easy to lead a fractured world in the aftermath of several centuries of the most deadly wars in history. On the attached list of the 12 most deadly wars, the first five are most important, I believe, for understanding what the world faces today. But understanding the US role in today’s world affairs requires us to look back 275 years.
America arose in the wake of the first truly “global” war. That war, primarily among the UK, France, Spain, Austria, Germany and Russia, lasted seven years, from 1756 to 1763. It triggered a process that, 20 years later, caused the US to declare and win independence from the UK. Debate over that war and its economic implications, particularly in the UK among colleagues of Adam Smith and Ben Franklin (the most famous American colonist, who resided in England during that time), produced the seeds of today’s world financial order.
Political implications of that war and the resulting economic debate continue to reverberate. World Wars I and II finally brought peace among five of the six main combatants, but Russia (the last European nation to end serfdom) refused to participate in the US-led resolution after WW II. Moreover, China (which suffered centuries of foreign domination until the end of WW II) only began to emerge as a modern-day international force during the 1970s. World peace must include Russia and China.
The “Seven Years War” began under British King George II and ended during the calamitous 60-year reign of George III. Ironically, George Washington’s 1754 defeat of French troops at Fort Duquesne (now Pittsburgh) may have encouraged the British to follow a plan led by Charles Cornwallis to seize French holdings in what is now Canada and south of the Great Lakes.
The war plan succeeded in limiting North American ambitions of France and Spain but ended with US independence. The British course to victory in 1763 backfired in 1781.
British efforts to tax North American colonists for the “security” gained by victory in the Seven Years War combined with events of 1772 in the UK (outlined in the attached article, “Above the Law”) and led to the US Revolutionary War. For more than a century, responsive struggles for independence followed among nations of Europe. The emergence of long-suppressed radical political and religious groups periodically combined with the quest for freedom to generate the most deadly period of war in history.
It is generally true of all wars that “victory” is short-lived. In 1781, angry residents of Havana, having suffered a British invasion in 1762 (that led to the UK victory of 1763), resupplied a French fleet that proceeded to blockade the entrance of Chesapeake Bay as Washington moved colonial soldiers south from New Jersey and Pennsylvania. Their combined forces trapped Cornwallis at Yorktown, where he surrendered to Washington on October 19, 1781.
Similarly, the demands of “victors” in WW I led to the emergence of Hitler’s Nazis and WW II.
With the notable exception of the Marshall Plan after WW II, war and its aftermath have proven universally harmful. It is the predictable and unpredictable financial implications of war, therefore, that we must now understand and resolve.
The world is now trampled by “Four Horsemen of the Apocalypse.”
Genocide, conquest, pestilence and starvation threaten human existence today. We must respond to each situation, and we must do so responsibly. If the world acquires and destroys goods to conduct war, spends too little or too much to combat pestilence and starvation, or loses essential workers to heartless genocide, we can easily “inflate” or “deflate” the whole world into an economic recession or a depression.
At present, the US Fed is forced to raise short-term interest rates because it is mandated by the US Congress to achieve maximum employment with stable prices. The US faces inflation generated over the past six years and must bring that under control.
In 2017 the US stimulated “growth” by reducing taxes after eight years of responsible stability had eliminated the need for stimulative policies. Next, the US cut off productivity growth generated by migrants who accept low-paying US jobs while others move to higher wage jobs. Then the US taxed and restricted importation of inflation-reducing goods produced by other nations. Finally, as 2019 ended, the US disastrously blundered at the control of importation and interstate transmission of a deadly pathogen. We then decided to “throw” about $15 trillion at what appears (in hindsight) to have been about a $7 trillion problem that blunder created.
All of these blunders were led by a former commercial real estate developer whose father made a fortune by inflation, from the late 1940s to the 1980s.
His father thrived on the need to house returning WWII soldiers and their “baby boom” children. As elimination of wartime wage and price controls permitted inflation in housing values, it forced creditors of Fred Trump’s entities to accept reductions in the net value of loans to his enterprise. The same effect resulted when Germany used inflation in the 1920s to reduce the burden of Versailles Treaty “reparations” obligations.
When US inflation ended in the 1980s, the change of policy forced Donald Trump into bankruptcy, a result that the inflation of today, left unchecked, could have reversed.
The most obvious impacts of the current change in US financial policy are being felt internationally. Since the US Fed has changed focus to the reduction of inflation expectations that have built since 2017, the US dollar has risen more than 17% in value. By insisting on repeating the blunders of the US since 2017, the UK has seen the value of its currency plummet to record lows.
While rates on long-term US government debt have risen roughly 80–100 bps, a far more combative Russia has seen its long-term debt cost rise about 300 bps (so much for the “wisdom” of war in the modern world).
The US, therefore, now risks a recession, mainly because its vibrant secondary markets now price (1) the “High Yield” debt of “growth” firms and (2) long-term fixed-rate “conforming” mortgages at an increase in rate that is more than 100 bps higher than when the Fed shifted policy to the reduction of inflation expectations.
What appears to be a “cold” for US investors, however, looks like the flu for our allies and pneumonia for Russia and other free world “enemies.” The US can help its allies by allowing or facilitating access to US financial markets. That cannot be said for those that choose to be US enemies.
Since ONLY the US has secondary markets capable of liquefying worldwide financial systems through this period of adjustment, the current situation is rather frightening. There is no alternative to what the US can offer because the markets developed here cannot operate without compliance with the rule of law US investors have demanded for the low rates offered in US markets.
“Control” cannot produce the freedom investors demand in exchange for the lower rates that US markets produce. Other systems, therefore, cannot compete with what the US has created.
Today’s situation was well described yesterday morning in the NY Times:
“Despite the pain a strong dollar is causing, most economists say that the global outcome would be worse if the Fed failed to halt inflation in the United States.
“At the same time, the sweep of rising interest rates around the globe is causing concerns that central bankers might move too far, too fast. The World Bank warned this month that simultaneous interest rate increases are pushing the world toward a recession and developing nations toward a string of financial crises that would inflict ‘lasting harm.’
“Clearly, the Fed’s mandate is to look after the American economy, but some economists and foreign policymakers argue it should pay more attention to the fallout its decisions have on the rest of the world.
“In 1998, Alan Greenspan, a five-term Fed chair, argued that ‘it is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress.’
“The United States is now facing a slowing economy, but the essential dilemma is the same.
“‘Central banks have purely domestic mandates,’ said Mr. Obstfeld, the U.C. Berkeley economist, but financial and trade globalization have made economies more interdependent than they have ever been and so closer cooperation is needed. ‘I don’t think central banks can have the luxury of not thinking about what’s happening abroad.’”
(“The Dollar Is Strong. That Is Good for the U.S. but Bad for the World,” https://www.nytimes.com/2022/09/26/business/economy/us-dollar-global-impact.html)
What’s the cost?
The last attachment is an updated version of the “Appendix of Charts and Explanations” that is attached to “Above the Law.” The first page cross-references the charts to pages in the article. The first chart shows the cycles of residential mortgage rates before the US developed secondary markets for long-term fixed-rate residential mortgages. Each “plunge” on that chart is when rising relative mortgage rates caused a crisis in the US housing industry. Abiding by the Fed’s mandate is causing a new plunge today.
The second chart uses 12 rate and relative credit cost examples to show the impact of raising (a) long-term US Treasury rates and (b) the premium paid by private sector borrowers compared to the US Treasury. Between 2017 and 2021, the US made all the mistakes that force rising credit costs on that chart. The trends of US rates shown on the last three charts after the 12-box chart confirm what the 12-box chart says.
Rising rates alone can reduce stock market values by as much as 80%, but that impact can be reduced as firms adjust their capital structures to reduce reliance on debt. Rising relative costs for private sector firms, standing alone, cause a 50% reduction of stock values, but that cannot be corrected without reorganizations. When BOTH rates and relative costs rise and are not contained, the chart shows a 93% reduction of stock values (a depression by all analyses).
The US has experienced and resolved all of the troubles summarized on that 12-box chart. What is required is an ability to change course.
For most people, however, “change” is a four-letter word, and that is particularly true for autocrats.
Fred Feldkamp
September 28, 2022
Here, again, are Fred’s attachments:
https://www.cumber.com/sites/default/files/2022-10/Fred-Feldkamp-Commentary-Twelve-Deadliest-Wars.pdf
https://www.cumber.com/sites/default/files/2022-10/Fred-Feldkamp-Commentary-Above-the-Law.pdf
https://www.cumber.com/sites/default/files/2022-10/Fred-Feldkamp-Commentary-Appendix-of-Charts-and-Explanations.pdf
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