Is a Depression Coming?

We know how we got into this mess, but where are we going? One potential route has been described by Hayman Adivors. The firm's managing partner J. Kyle Bass wrote a scary letter (below) in mid October. He says we're "experiencing the global deflationary bust of all time."

Some of his points are:

• Don't trust financial stocks' book values. They're making it up. They are incredibly over-leveraged. For example, if we look at assets to tangible equity, Bank of America's leverage ratio is 134x!
  
• It's not that banks are scared to lend. They just don't have any money left to lend.
• Losses (from mortgages, credit cards, personal loans, auto loans, credit default swaps, corporate bonds, etc) will total in the trillions of dollars by the time we get through this.
• The total credit market debt as percentage of Gross Domestic Product is the highest it has ever been. As of the end of June 2008, total debt was 356.5% of GDP. Heading into the Great Depression, this figure spiked at 260%. This percentage will come down, whether we like it or not. The government, meanwhile, is trying to re-lever the economy.
  
• Home prices will bottom around 34% off their highs, and the economy will decline for at least two and a half more years.
• Unemployment will hit as high as 12%.
• Stocks will potentially decline 70% from their highs, or more. That's around 4,200 on the DJIA and 470 on the S&P 500. Warren Buffett is not infallible, says Bass.

In anticipation, Hayman's equity portfolio is only 20% long, and 50% short. Their bond portfolio is all short. They are also shorting currencies that they think will decline most against the dollar.

I don't know how they fared this past week, when the markets soared and the dollar weakened, but they've been bearish at least as far back as 2007. I've been unsuccessful in finding any kind of track record for Hayman Advisors. All I found was that they owned stakes in Express Jet (XJT) and Genesco (GCO) (I'm pretty sure they're losing money on these).

So far, LIBOR rates have been falling, a sign that the interbank lending freeze is thawing. This puts into doubt the "it's not fear, they have no money to lend" point. While mortgage rates have been on the rise (according to Bankrate.com, rates are once again at the highest levels they've been this year), a counter indication of sorts, it could be fear rather than having no money to lend.

These are tough times for investors. If you believe Bass, cash is the safest place to be. But the possibility of inflation is here too, in which case, as Warren Buffett wrote, cash is a sure loser.

Perhaps the best way to go is to buy shares of good companies and hedge them with puts?

Here's the Hayman Advisors letter:

Hayman Advisors Oct 14 - Upload a Document to Scribd

Disclosure: At the time of writing, I had no position in any securities mentioned above.

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