NEW LOW OBSERVER

Economic events never occur in a vacuum.  Usually there is a string of events that leads from one event to another. One big event can lead to an even bigger event that overshadows the prior calamities that triggered “The Big” event.  The February 9, 1983 issue of Richard Russell’s Dow Theory Letters covers  one market event that led to two major crises that happened at different periods in time.  The two events are joined at the hip based on the decline of oil prices.  This led two separate major bailouts that resulted in the structural shift in the way our brand of capitalism works.

The first event resulted in the Savings and Loan Crisis (S&L Crisis) and is thought to have begun in 1986 due to the Tax Reform Act of 1986 culminating in the bailout of many banks and the eventual bankruptcy of the Federal Savings and Loan Insurance Corporation (FSLIC).

The second event resulted in the Mexican Peso Crisis with the outcome that major banking institutions like Citibank and Goldman Sachs needed to be bailed out.  It is important to note that the Peso Crisis is considered to be as a result of the peso devaluation in 1994.

The true roots of both the S&L Crisis and the Peso Crisis is the decline of oil prices after the inflationary peak in 1980-1981.  Richard Russell’s Dow Theory Letter Issue 854 highlights the seeds of destruction that were going to be much larger than even Russell could have imagined. However, if anyone wishes to understand how the snowball got rolling then this issue highlights the beginning.

The very first quote is an amazing insight of the American dependence of the high price of oil, Richard Russell says the following:

“We’re facing a situation (ironically) where the US is all for holding oil prices at a high level. The banks have lent huge sums of money both to private corporations and to oil producing nations-loans based on rising oil prices. If the oil price cracks badly,  the banks are going to have major problems. On top of that, the US depends on oil taxes (so called “excess profits” tax) for huge chunks of tax income. If oil prices crack then the profits for the oil companies will dive (which they are already doing) and the tax short-fall will be horrendous. (page 1)”

This commentary is staggering in the fact that it was so prescient.  The cracks in the armor of the American oil industry began in Texas when the easy money stopped raining down on oil dependent cities like Houston and Dallas.  In a 1988 issue of Dow Theory Letters, Russell had the following to say:

“With oil prices caving in, Texas now has more people leaving the state than coming in.( Dow Theory Letters. March 9, 1988. page 6.)”

The decline in oil prices led to a decline of jobs for that industry which resulted in a decline in real estate prices as people left the state of Texas.  Loans made by savings and loan institutions in the southwest U.S., to businesses and real estate investors, all went bad at the same time leading to the Savings and Loan Crisis (S&L Crisis).  The S&L Crisis cost several hundreds of billions of dollars and still exist as an off-budget item as part of our national debt.

The decline in the price of oil also crushed foreign economies dependent on the commodity.  The Mexican Peso Crisis, although officially listed as beginning in 1994, had its roots in the early 1980’s.  The natural outcome of this crisis was the bailout of large banking institutions like Citibank and Goldman Sachs when the government stepped in and bought the bad debt held by the bank’s all in gamble.

Likewise, the current boom in commodity rich countries (although somewhat cooler at present) like Australia, Brazil, Russia, China and India could experience significant shocks to their system depending on the level of loans made as “investments” by foreign banking institutions based on the potential of future growth.

Few understood or believed the impact and importance of high oil prices to the American economy at the time.  Even fewer understood the direct reliance of the U.S. government to high oil prices.  Investors should watch for the potential fallout that may arise from the recent precipitous decline in the price of oil.  The troubles afflicting Russia and Brazil’s Petrobras may be early indications of where the pain may be felt.