Read My Lips! Too Much Debt!

People and businesses leverage when an economy expands over an extended period of time.  The last major period of leveraging in the United States occurred over the past fifty years beginning in the early 1960s.  This was a period of sustained credit inflation that resulted in an 85% decline in the purchasing power of the dollar. 

People and businesses de-leverage when the economy reaches an unsustainable level of debt and that de-leveraging can take a substantial period of time. 

Research by Carmen Reinhart of the Peterson Institute and her husband Vincent Reinhart of the American Enterprise Institute has suggested that “excessive debt could be corrected only by a long period of deleveraging.” (See the article “Running Out of Road” in the June 18, 2011 copy of The Economist, pages 77-78.)

De-leveraging also means, in aggregate, that increases in lending (debt creation) will not become too buoyant during the restructuring of balance sheets. 

Consequently, de-leveraging will tend to reduce the multiplier effect of any fiscal stimulus program and the creation of more debt through fiscal stimulus will only add an additional burden on the economy that is trying to get its balance sheet back under control.

The desperate hope to counter this de-leveraging is to flood the financial markets with liquidity and pray that the printing of money will somehow stop the de-leveraging and make debt acceptable once again. Hence, QE2!

A caveat here: there are a number of large companies that came out of the Great Recession with their balance sheets well in hand.  For example, Microsoft was one of these companies.  Many of these companies have issued debt over the past year or so to build up cash reserves to acquire other companies that have been overleveraged and are not in such good financial shape. This generally represents a separation in the market between large organizations and all others.

Thus, the only way this de-leveraging will be overcome is by reducing the real value of the debt through a period of credit inflation like the one experienced over the past fifty years.  Otherwise, the debt levels are not sustainable.  Efforts to bail out the people, businesses, and governments that have issued too much debt will only postpone the problem.  The debt levels will have to be reduced sometime…now or in the future. 

The debt loads that people, businesses, and governments are carrying seem to be un-sustainable, even with the very, very loose monetary policy.  For example, household liabilities have declined by a little more than $600 billion since the recession began in December 2007, but the total amount of household debt still totals a little more than appeared on the household balance sheets in the second quarter of 2007. 

Household debt at the start of 2011 is almost double the amount of household debt that existed at the start of the year 2000.  This represents a compound rate of increase of more than 8 percent per year.  One could argue that this rate of increase is not sustainable given that over the long haul the real economy grows only slightly more than 3 percent per year.

Total business debt shows roughly the same pattern.  This debt has declined by a little more than $160 billion from the start of the recession to the first quarter of 2011.  However, the current total is around the same level it was in the third quarter of 2008 indicating that in total, businesses have not accomplished a great deal of de-leveraging to this point. 

And, the debt problem is also entangled with the ability of people and businesses to unravel their situations through foreclosure and bankruptcy proceedings.  Foreclosures take time.  If people or businesses are in foreclosure but these foreclosure proceedings take longer and longer to work out, the economic units involved in the proceedings will be more or less relegated to the sidelines in terms of any additional borrowing or spending. 

An instructive article appeared on the front page of the New York Times yesterday. (“Backlog of Cases Gives a Reprieve on Foreclosures,” http://www.nytimes.com/2011/06/19/business/19foreclosure.html?_r=1&scp=2&sq=foreclosure&st=cse.) “In New York State, it would take lenders 62 years at their current pace, the longest time frame in the nation, to repossess the 213,000 houses now in severe default or foreclosure, according to calculations by LPS Applied Analytics, a prominent real estate data firm.
Clearing the pipeline in New Jersey, which like New York handles foreclosures through the courts, would take 49 years. In Florida, Massachusetts and Illinois, it would take a decade.“
And, this problem is not easing.  In May 2011, total foreclosures in the United States totaled 1,736,724.  Six months earlier the total was 1,682,499.  And the number of sales has declined reflecting the back up in the whole foreclosure process. 
Personal bankruptcies are down but are still running near record rates of 1,450,000 to 1,500,000 per year.  In 2010 there were only 56,425 business bankruptcies, down from 60,851 in 2009.  For the first three months of 2011, business bankruptcies are running around a 50,000 annual rate, far above the figures for the rest of the 2000s.
And, this doesn’t even get into the problems connected with the debt of state and local governments. 
Debt loads must be reduced sometime…in one way or another.  People, businesses, and governments are still carrying too much debt.  And, more and more federal government debt does not really help the situation.  A good portion of the debt must be repaid.
This is the drag on the economy.  And, until a lot of this load is worked off…in one way or another…economic growth will remain weak. 
Why hasn’t this gotten the notice it should in all the discussions going on? 
Because almost all of the economic models used to predict economic activity do not contain information on debt levels and leverage.  The reason is that debt levels and leverage levels are quite subjective over time and depend upon what governments are doing and what people believe to be acceptable.  These decisions vary from cycle to cycle and are extremely hard to model.  Furthermore, as the Reinhart’s have argued, there has not been a sufficient amount of data available to adequately study the influence of debt on economic activity.
My conclusion from this information is that the major problem facing the western countries now is that there is too much debt outstanding.
And, when I look at how the system is working off this debt I can only conclude that there is still a long way to go before people, businesses, and government get to levels of debt that are sustainable.  Even QE2 does not seem to be shaking these economic units from their desire to rebalance their balance sheets.  There is just too much debt still in the system and it doesn’t need more.

Bank Re-regulation Forgot to Consider Google and Twitter

One of the clearest comments I have heard recently about the financial reform actions of Congress and the regulators is that those passing the new laws and establishing the new regulations completely ignored the fact that something like Google and Twitter had been created.

In other words, times have changed and those in Congress and in the regulatory bodies have kept their focus just on the past.

Financial regulation, however, is not the only thing that is falling victim to a backward looking focus.

We are seeing a concentration on the past in dealing with state and local government problems, problems with pensions, bargaining power, and employment. The law just passed in Michigan giving the state government broader powers to intervene in the finances and governance of struggling municipalities and school districts…” has been fought by those that argue that the law “undermines collective bargaining and threatens to subvert elected local governments.” (http://professional.wsj.com/article/SB10001424052748704360404576206603444375580.html?mod=ITP_pageone_1&mg=reno-wsj.)

Times have changed.

The years of inflation which began in the early 1960s has reached a tipping point in many areas. The days of inflated state and local government budgets, of passing on the fiscal impacts of lucrative union bargaining agreements in the form of higher property taxes, and of using the accounting gimmicks that postponed dealing with pension obligations is over. Adjustments must be made

But, that is not how people deal with the unpleasantness of current dislocations.

The inflation benefit for labor unions in manufacturing industries gave out years ago.
Manufacturers of cars and steel and so forth could neither pass on lush labor agreements to the public nor hide the increasing labor costs is limited technological advancements in their products or the production of their products.

And, the labor unions that still exist in these areas of manufacturing have shrunk, both in numbers and in terms of bargaining power.

State and local governments are now having to deal with this phenomenon.

And, what about debt?

The taking on of debt thrives in periods of credit inflation and Americans have had at least fifty years to get on this bandwagon.

And, now people have not really been borrowing. The real question is, should they start borrowing again? I have addressed this in my post “Does Getting Out of Debt Mean that People Should Start Spending More?” (See http://seekingalpha.com/article/257772-does-getting-out-of-debt-mean-people-should-start-spending-more.)

What has this debt done for people? If the number of foreclosures and bankruptcies over the last few years and the number of foreclosures and bankruptcies pending or near the edge are any indication, many people may not want to jump right into the “debt circus” again any time soon.

What accounts for the popularity of the finance guru Dave Ramsey? Take a peek at his new book, “The Total Money Makeover: A Proven Plan for Financial Fitness.” And, what is his recipe for financial fitness and greater happiness?

GET OUT OF DEBT! ALL OF IT!

This advice doesn’t apply to just families. It applies to small businesses, and medium-sized businesses, and others.

GET OUT OF DEBT!

Pass that message on to Chairman Bernanke.

And, what is the solution of Chairman Bernanke and other leaders in Washington, D. C.?

Let the presses role! Start the credit inflation once again!

The question is, will this new round of credit inflation succeed. It seems as if over the past fifty years that every time we entered a new round of credit inflation, some things got worse.

For example, capacity utilization in manufacturing continued to drop since the 1960s. That is, every subsequent peak in capacity utilization during this time period was lower than the previous peak. Furthermore, after almost two years of economic recovery, capacity utilization still remains just a little over 75%.

Underemployment has continually risen over the last fifty years and now about one out of every five individuals of working age in the United States is underemployed.

In addition, the inflationary environment of the last fifty years has benefitted the wealthy who can either take advantage of the inflation or protect themselves against it and has been exceedingly costly for the less wealthy, who cannot protect themselves. As a consequence, we have the worst skewing of the income distribution toward the wealthy in United States history.

And, there is more!

But, this is not the point.

The point is: the times have changed!

If we do not accept this fact in financial regulation, in the management of state and local governments, in our own finances, and in the federal governments budgetary policy, we will all be the sorrier for it.

Who has the credit inflation of the last fifty years really helped? The financial industry. And, I have asked the question, who is the “Bernanke Credit Inflation” going to help? This time, will the financial industry just dance alone? (See http://seekingalpha.com/article/255748-will-the-financial-industry-dance-alone.)

Known Unknowns: Debt Refinancings in 2011

When does a financial institution write down an asset?

To those in the banking industry the answer has always been, “Not until I am not responsible for that portfolio anymore.”

My experience with lenders is that when making a loan they tend to be pessimistic and, in addition, require collateral. Unless, of course, they are securitizing the asset created and selling it off.

However, when overseeing a loan portfolio, lenders tend to be very optimistic. “Well, the borrower is just experiencing a slight setback, but things will get better.” “The economy is going to improve soon and then the loan will be alright.” “Yes, the borrower made a mistake, but he has learned from the mistake and is getting his act in order.”

Lenders (bankers) are reluctant to write down anything if they don’t have to. And, this applies to all aspects of their asset portfolios.

But, a big cloud is hanging over the financial industry going into 2011 in the United States, and also in Europe. The big cloud relates to number of bank assets that will need to be refinanced during the year. These numbers are staggering.

My guess is that this is one of the major reasons why commercial banks are not lending now. (See “Little or No Life in the Banking Sector,” http://seekingalpha.com/article/241507-little-or-no-life-in-the-banking-sector.) Banks do not want to write off any more assets now and are reluctant to add any more funds than they have to in order to build up their loan loss reserves. They add to these reserves as little as possible, as little as the regulators will let them get away with, so that they can build up their equity capital positions. If they then let the loans that are maturing run off without replacing them, their capital positions improve. The debt/equity ratio can fall as debt can be reduced while capital is being increased.

Making new loans does not fit into this strategy because the new loans will have to be financed and that will tend to raise the debt/equity ratio. So commercial banks are not lending now.

So what is this cloud and why is it so scary?

There are two specific areas that are being highlighted these days that stand out as potential problems for the banks: the first is the commercial real estate sector; and the second is governments, local, state, and nation.

In all cases a lot of loans or securities are going to mature in 2011 and the bet is that a large number of these assets that are found on bank balance sheets will either not be sufficiently credit worthy to be able to refinance or will not be able to handle the interest rates they will have to pay on the new debt to be issued..

In November 2010, commercial real estate loans made up almost 40 percent of the loan portfolios of the banks not among the largest 25 commercial banks in the United States and over 25 percent of their total assets. If these “smaller” banks had to write down 10 percent of their commercial real estate loans that would amount to about 3 percent of their assets: a substantial blow to their capital positions.

The problem is not so great in the largest 25 banks in the country as commercial real estate loans make up only 14 percent of their loan portfolios and about 8 percent of total assets.
This situation is the one pointed to by Elizabeth Warren in congressional testimony when she stated that 3,000 commercial banks, primarily the smaller ones, faced substantial problems ahead in this part of their loan portfolio.

The other problem mentioned has to do with government securities. More and more concern is being expressed about the condition of the finances of state and city governments in the United States. Layoffs are taking place all over the place, with many of the layoffs threatening health and safety. Yet, there is still substantial concern that the unfunded commitments of these state and city governments embedded in their pension funds have not really fully been addressed.
They may have to be addressed in 2011.

And so we get articles like “Bankrupt City, USA” (http://www.ft.com/cms/s/3/07eabcdc-06c8-11e0-86d6-00144feabdc0.html#axzz185wrM18g) which carry statements like this, “A Congressional Budget Office report reaches a conclusion to terrify investors in America’s $2.8 trillion municipal bond market. Municipal bankruptcy, permitted in 26 states, should be considered by city leaders to restructure labor contracts and debts.”

And the yields on municipal securities are the highest they have been in over a year. (http://online.wsj.com/article/SB10001424052748704681804576018022360684088.html?mod=ITP_moneyandinvesting_0) The situation related to state-issued securities is not too different.

The smaller banks, as defined above, have around 25 percent of their securities portfolio in state and local political issues. This makes up about 5 percent of the total assets of these banks. Again, a write down in this area could cause substantial damage to bank capital positions.
But, this problem relating to government debt is not constrained to United States banks. “Eurozone countries will have to refinance more debt next year than at any time since the launch of the euro amid investors’ warnings that the debt crisis in the region will intensify in the new year….Eurozone nations will have to refinance or repay €560 billion ($740 billion) in 2011, €45 billion more than 2010 and the highest amount since the launch of the single currency in January 1999.” (http://www.ft.com/cms/s/0/f9d781f6-0619-11e0-976b-00144feabdc0.html#axzz1860QqksJ) Much of this debt is held by banks.

What would you do if you were running a bank and were facing the possibility that a substantial portion of your portfolio would have to refinance in 2011? Oh, by-the-way, you also have foreclosures and business bankruptcies running at a relatively high rate as well.

You probably would stop lending, try to shrink you balance sheet as much as you could without damaging profitability and build up as much capital as you could before the time of refinancing arrived.

The question that we don’t have an answer for at the moment relates to whether or not the bankers, themselves, have a good handle on which assets will present the biggest refinancing problems and just how much will have to be written off due to these refinancings. Are they still just “hoping for the best.”

In addition, a rising interest rate environment would be one of the worst scenarios possible given all the refinancings that are going to have to take place.

Happy New Year!

The Current Performance of Commercial Banks

Commercial bank profits are OK. Commercial bank lending is practically nil.

The prognosis for the future?

If commercial bank lending does not pick up, commercial bank profits will fall.

When will commercial bank lending pick up?

Good question, but the answer is not an easy one. Also, to get an answer, it seems as if we need to go to both sides of the desk: to those that are demanding loans and to those that are supplying loans.

There seems to be four factors that are keeping loan demand from growing. First, of course, is that a lot of people and companies are still trying to climb out of the economic hole in which they have found themselves over the past three years. We still have foreclosures and bankruptcies continuing at a very rapid pace even though below record levels. We still have massive amounts of unemployment as well as underemployment. And, we still have large numbers of the American families and businesses with extremely poor credit records.

Second, there is a great amount of uncertainty about the future of business. And, confidence is not built when the Chairman of the Board of Governors of the Federal Reserve System announces before Congress…and the whole world… that the business outlook is “unusually uncertain.” If Mr. Bernanke believes this to be true, what are the people “in the trenches” expected to believe?

Third, there are a large number of companies, mostly big companies, that are sitting on a large amount of cash. These companies are not ready to commit at the present time, but they are poised to put these funds into play, either in an expansion off-shore, or in purchasing other companies. These big companies have been profitable, much like the big banks, but they are not yet ready to put these funds to a business use. As far as wanting bank loans, that will depend upon the strategies these companies want to pursue and the cheapest way to finance them.

Fourth, consumers that have the income flow or wealth continue to pay down their debt in an effort to re-balance their balance sheets. At a time like this with all the evidence around that too much financial leverage is not “the place to be”, individuals and families are not seeking credit and are even reducing the amount of credit that they do have outstanding.

From the demand side we see the reality that the people that have the income and the cash assets are not real anxious to borrow and the only ones that really want to borrow have neither the cash flow nor the cash assets to get a loan.

This gets us to the supply side. Commercial banks, in recent months, across the board, say that they have not changed their credit standards. I take them at their word. Yet, if one compares current bank lending standards with those that were in place one, two, or three years ago, the bar is set much higher than it was. This tightening of standards was to be expected as credit standards are always raised during an economic down turn. They were raised to current levels due to the severity of the 2008-2009 financial crises and to the pressures that were brought on the banks by the regulatory agencies. Although these standards will not get tougher, they will not be eased appreciably any time soon.

The commercial banks are also hit by the uncertainty of the current economic situation and by the coming imposition of new financial reform legislation. In terms of the economic situation, loan officers have to be skeptical of business projections of future cash flows. Since the economic outlook is “unusually uncertain” banks have to be extremely careful about basing the extension of money to a borrower upon “optimistic” forecasts. Even “prudent” forecasts are suspicious because of the uncertain nature of the business environment right now.

Plus, bankers, in general, and lending officers, in particular, are “debt guys”. (Please excuse the gender specificity here, “guys” refers to all bankers and lending personnel.) “Debt guys” are taught that forecasting just on cash flows is a tricky business and so it is wise, extremely wise, to require a borrower to put up collateral behind the loan. And, if cash flows projections become even more uncertain than in the past, more collateral should be required.

But, in a very uncertain economic environment, another problem rises to the surface. This problem has to do with the “value” of the collateral. In a very uncertain economic climate and uncertain secondary markets, how can you get a good estimate of what the value of “physical” capital might be? Hence, commercial banks extend their requirements for the collateral backing of loans, now requiring financial instruments, bank deposits like CDs, compensating balances, or other cash demands. Banks are getting back to the “good old days” when to qualify for a loan, a potential borrower had to prove to the bank that they did not need the loan in order for the bank to extend the money to them.

There is another uncertainty now in play. The passage of the financial regulation reform bill introduces more unknowns into the banks’ decision making. Just the concern over higher capital requirements causes the commercial banks to become more conservative in their lending practices. Furthermore, it is unclear how other rules and regulations, some of them not even written yet (the regulators have several months to write up some of the new provisions), will affect bank policies and procedures. How can commercial banks be aggressive in their lending practices it they don’t know what the “playing field” is going to look like in the future?

Finally, there are still many commercial banks that have solvency problems. As I continually quote, about one in eight commercial banks is on the list of problem banks put out by the FDIC. This list was as of March 31, 2010. Soon there will be a new list out relating to June 30, 2010. It is anticipated that the number of commercial banks on this new problem list will be greater than was the case at the earlier date.

My estimate that another two or three commercial banks out of eight still have problems pertaining to capital requirements, or, pertaining to major credit problems in the areas of consumer or commercial real estate loans. To me, this latter problem is one of the major reasons why the Federal Reserve is keeping short-term interest rates so low and will continue to do so, as Bernanke reiterated in his testimony yesterday, for “an extended period”. Market estimates for when the Federal Reserve might increase its target rate of interest now go until at least the third quarter of 2011. This says to me that there are still many, many problems in the commercial banking industry and these problems are not going to be resolved for “an extended period.”

This situation can only result in a large consolidation in the commercial banking industry in this country. Right now there are about 8,000 domestically chartered commercial banks in the United States. I remember when this number was 14,000 and this did not include an extensive Savings and Loan industry. One could see a drop by one-half or more in the number of banks in the country. And, this doesn’t even take into account the effects information technology is going to have on the banking industry in the next five to ten years.

This does not bode well for the supply of bank loans. With the changing financial regulations, the uncertain economic environment, and the changing structure of the banking industry itself, commercial banks are going to concentrate on “high quality” loans. And, if the big banks cannot find them in existing markets they will invade the local or regional markets of other banks. In fact, many banks are now talking about how the big banks are becoming more aggressive in their markets. This will not result in an increase in loan supply, but it will contribute to the consolidation in the commercial banking industry.

In short, there doesn’t seem to be much reason to expect a pickup in bank loan volume in the near future.

No Housing Recovery In Sight

Households, as a group, are gaining ground financially, but are still far below where they were in 2007. This, along with other weaknesses in the economy, is going to continue to contribute to the weakness in the economic recovery now taking place.

One place this weakness is particularly evident is in the housing sector. The recovery of the housing market helped to lead the economy out of every previous recession in the post-World War II period. In the recent experience, this has not been the case, even with special incentive programs created by the federal government to spur along a rebound.

The figure on housing starts in May 2010, an annual rate of 593,000, confirmed this continued weakness.

The recession ended in July 2009, yet housing starts have hovered around a 600,000 unit annual rate ever since. The highest figure recorded during this time period was an annual rate of 659,000 in April of this year, but the pace dropped off once again in May.

At this time, Americans are just not in a position to acquire housing. If we look at the financial position of United States households since the year 2007, according to the Flow of Funds accounts released by the Federal Reserve, the net worth of households has decline by slightly less than $10 trillion. Year-over-year, from the first quarter of 2009 through the first quarter of 2010, household net worth has risen by a little more than $6 trillion, but almost all of this increase has been in the value of equity shares, something that is not a part of the balance sheets of Main Street America. The value of tangible assets, including the value of homes, has fallen by $5 trillion since 2007 and increased only modestly year-over-year. Again, the beneficiary of any gain here has not been Main Street America.

The plight of the American household is captured in the percentage of households owning their own home and who actually have no equity in the home they are living in. David Wessel captures this dilemma in his Wall Street Journal article this morning, “Rethinking Part of the American Dream,” http://online.wsj.com/article/SB10001424052748703513604575310383542102668.html?mod=WSJ_hps_RIGHTTopCarousel_1. He cites data from the Federal Reserve Bank of New York: for example, in San Diego, 55% of households owned their own home, but the fraction of these households that had equity in their homes was between 35% and 39%; in Las Vegas, only 15% to 19% of households had equity in their homes, even though 59% of those households owned their own home. In the cities reported, Boston, Chicago, and Atlanta scored the highest in owners having equity in their own home.

And, with one out of every four or five working age people being under-employed, it is highly unlikely that there will be a stronger recovery in the housing market in the near future.

Ethan Harris of Bank of America Merrill Lynch is quoted as saying “We’re not going to see a real recovery in the housing market until the foreclosure process gets worked out. That’s…a 2012 event.” (http://online.wsj.com/article/SB10001424052748704009804575309692681916212.html?mod=WSJ_WSJ_US_News_5)

Delinquencies on mortgages seem to have leveled out but they still remain at a high level. Also, foreclosures remain at a high level.

The performance of loans that have been restructured remain dismal: see my post “Eventually Debt Must Be Repaid, http://seekingalpha.com/article/210365-eventually-debt-must-be-repaid. Sixty-five to seventy-five percent of the loans restructured in the Treasury’s loan restructuring plan “re-default.”

And, banks continue to stay on the sidelines in terms of making new loans, especially mortgage loans. With one out of every eight commercial banks on the FDIC list of problem banks and many more on the edge, housing is just not going to show much bounce in upcoming months.

Households, according to the Federal Reserve data, are reducing the amount of debt outstanding, but at a relatively slow pace. This is where, I think, it is important to think about how the country is dividing along two lines, between those that are doing quite well, thank you, and those that are really struggling.

As I mentioned, the value of the financial assets of U. S. Households rose by about $5.5 billion last year, most of the increase coming in the market value of equity shares. However, those benefitting from the rise in the value of equities are generally not the ones that own a home with no equity in it. They are generally the people that are still employed and have a sufficient income. Also, they are not the ones that are in debt in a major way.

In my post on debt repayment, I quoted a report by Fitch Ratings Ltd. indicating that the individuals that were in the mortgage re-structuring program were also heavily in debt on credit cards, car loans, and other obligations. People in this second group are the ones that are excessively in debt and have neither the accumulated wealth nor the current income to pay down their debt.

It is this debt that still must be worked off before the recovery can have any bounce to it. Resolving this debt burden will also go a long way to helping the banking system regain its legs.

Consumer spending may increase modestly, housing starts may gain some, but the Americans that are in this second group will not be the ones contributing to these increases until they get their finances back in order and that may take a long time. To see this in another way, check out what is actually being purchased by consumers. Much of it is up-scale, not ordinary “stuff.”

Unfortunately, Debt Must Be Repaid

Fitch Ratings Ltd. is releasing a report today that points up the problems of having too much debt. Restructuring the debt of a person or a family (or a business), even when government programs help to formalize and regularize loan modifications, is not a “magic wand” that resolves the issue of debt overload.

Using data from the Obama administration’s Home Affordable Modification Program, Fitch reports that “the redefault rate within a year”, of the loans that are modified, “is likely to be 65% to 75%”. This information comes from the Wall Street Journal article, “High Default Rate Seen for Modified Mortgages,” http://online.wsj.com/article/SB10001424052748703280004575308992258809442.html?KEYWORDS=james+hagerty. “Almost all of those who got loan modifications have already defaulted once.”

The failure rate is likely to be high because “most of these borrowers were mired in credit-card debt, car loans and other obligations.” That is, when a person or family (or business) goes into debt they go into debt “across the board” and do not just limit themselves to one kind of debt or one type of lender.

And, the Treasury Department says, that those given loan modifications under this program have a “median ratio of total debt payments to pretax income” that is around 64%. “That often means little money is left over for food, clothing or such emergency expenses as medical care and car repairs.”

The good news is that the results of the program indicate that around one-third of the loan modifications make it through the first year. This is looked on as “good” by the Treasury Department and by a Fitch representative.

This is the reality of debt creation during a period that can be referred to as a period of credit inflation. At times like these, more and more people, families, businesses, and governments take on more and more debt until it gets to the point that the debt loads become unsustainable in some sectors of the economy.

Thus, to the first point, people and families take on mortgages, as well as “credit-card debt, car loans and other obligations” until, the second point, their “ratio of total debt payments to pretax income” becomes too large. Then, any increase in total debt payments, like a re-setting of the interest rate on a mortgage, or a reduction in pretax income, due to being laid off a job, puts the borrower into a situation in which debt payments cannot be made. Defaults occur, and a foreclosure…followed by a bankruptcy…may follow.

The “macro” government response is to provide fiscal and monetary stimulus to make sure people stay employed and to inflate incomes so that debt loads (debt payments relative to pretax income) decline. This is the Keynesian prescription!

The problem with this solution is that in a period of credit inflation, as incomes and prices continue to increase, debt loads continue to increase. If the government buys people out of their debt burdens by fiscal stimulus and monetary inflation, people (and families and businesses) don’t adjust their behavior to become more financially prudent. They just keep on, keeping on. This is another case of moral hazard.

Even worse, given the belief that government will continue to “bail out” those who have taken on too much debt, we find that those that have taken on too much debt generally go even further into debt. Take a look at what has happened over the last fifty years of credit inflation and this type of behavior is observed everywhere.

The Keynesian prescription of fiscal and monetary stimulus to keep unemployment low and debt burdens manageable only exacerbates the problem over time. That is, governmental efforts to sustain prosperity over time just postpone the consequences of dealing with the debt loads that are built up during these time periods.

Keynesian economic models, with the exception of the maverick Keynesians like Hy Minsky, don’t include the credit or debt aspects of economic activity. As a consequence, they ignore how people (and families and businesses) manage their balance sheets over time. In essence, these models ignore the very real fact that ultimately, debt must be repaid and cannot just increase without limit!

Over the past fifty years we have seen people and families and businesses and banks and governments take on more and more debt. Inflation has risen at an average compound rate of about 4% from 1961 through 2008 so that it has paid people to increase financial leverage, take on more risky assets, and finance long term assets with short term debt. And the federal government has underwritten this inflation by increasing its gross debt by around 7.7% per year for this period of time and the Federal Reserve has caused the base money in the economy to rise by 6.2% per year. The M2 money stock measure rose at a compound rate of 7.0% per year. All roughly in line with one another.

The Fitch report is presenting us with a picture of what happens when debt loads get “out-of-hand”…when there is just too much debt around.

The current response of the Federal government? Official federal government forecasts of the cumulative fiscal deficits for the next ten years runs around $9 to $10 trillion. Some of us believe that the deficits will run more in the neighborhood of $15 trillion. In terms of monetary policy, the Federal Reserve has placed $1.1 trillion in excess reserves in the commercial banking system. The leadership of the Federal Reserve expects us to believe that they will be able to reduce the amount of these excess reserves to more normal levels without the reserves being turned into loans that will expand the money stock measures by excessive amounts. (Just a reminder: excess reserves totaled less than $2 billion…note, billion and not trillion…in August 2008 before the big injection of reserves into the banking system took place.)

For one more time, the federal government is betting that by stimulating the economy and putting people back to work in the “legacy jobs” they were laid off from and by re-inflating prices and incomes that debt burdens will be reduced and we can get back to “spending as usual”. If the federal government is successful, the day in which debt loads are reduced will be postponed…once again!

However, the credit inflation causes other things to change. Over the last fifty years we have seen that in every employment cycle, fewer and fewer people are re-hired in the “legacy jobs” from which they were released. Under-employment, not just un-employment, rises and this puts more and more pressure on incomes. The ratio of debt payments to pretax incomes rise for these people. Right now, I estimate that roughly one out of every four or five potential works is under-employed, the highest level since the early 1950s.

Second, the steady inflation of the past fifty years has resulted in a larger proportion of the capital stock being un-productive. As a consequence, capacity utilization in industry has fallen to post-World War II lows. As we have seen in each business cycle during this last fifty years, less and less of this capacity is used in each recovery. This results in a drag on employment and income.

Eventually, debt must be repaid and debt loads must be reduced. The Fitch report highlights this problem. It is something that all of us should keep in mind in the upcoming months. If the situation with respect to under-employment and capacity utilization don’t change the debt loads will get even heavier.

The Fed is "Pushing on a String"?

During economic times like these, economists say that the Federal Reserve is “pushing on a string”. That is, the central bank has pumped a large amount of reserves into the banking system, yet banks are not lending, and the money stock is not growing.

Excess reserves in the banking system total more than $1.0 billion. Bank loans on a year-over-year basis show a negative growth rate. And, the M2 measure of the money stock, year-over-year, is growing at a 1.6% annual rate.

The Fed’s actions are not getting transferred through the banking system to the real economy!

As a consequence, economic growth does not seem to be accelerating at the speed economists and governmental policy makers would like.

Yet, if one compares the Great Recession which we have just passed through with the second worst recession in the post-World War II period the recovery does not really look that bad.

What seems to be different is the rate of growth at which the economy was growing in 1978, between 5% and 7%, and the speed it was growing before 2008, around 3%. In addition, the economy rose out of the 1981-1982 recession accelerating into the 8% range. No one seems to be predicting that the United States economy will move into this latter range in the near future. Recovery is occurring, it is just not very robust.

Fed Chairman, Ben Bernanke, testifying before the House Budget Committee yesterday spoke of the economy growing at a 3.5% rate “in the months ahead.” Economists surveyed by the Wall Street Journal expect the economy to grow about 3% in the second half of 2010 and continue that pace into 2011. (See http://online.wsj.com/article/SB20001424052748703890904575296403144025366.html#mod=todays_us_front_section.)
No one seems to believe that economic growth in 2010-2011 will match the recovery achieved in 1983-1984. The difference? Banks aren’t lending. Underemployment seems to be hanging at post-World War II highs, near 20%, and industry is operating at a capacity near post-World War II lows. On this see my post, http://seekingalpha.com/article/207148-breaking-down-the-u-s-economic-recovery. The economy was expanding before the Great Recession, but substantially below the post-World War II average of about 3.4%, year-over-year.

Real growth in the period 2005 to 2010.

The American economy has been showing some substantial dislocations and these are expected to persist as the recovery continues! These dislocations are not going to be corrected with short-term fiscal stimulus packages. And, so the economy will just scrape along.

Along with the factors already mentioned as reasons for why the economy has grown so slowly in the 2000s and why it might be expected to continue to grow slowly is the perception that the economy is bifurcating. That is, one side of America seems to be doing very well and another side is not doing so well at all. This may be due to the restructuring of the United States economy and the slow transition that is occurring getting us there.

For example, big banks seem to be doing very well, thank you, while banks smaller than the 25 largest banks seem to be struggling. (See http://seekingalpha.com/article/209229-federal-reserve-exit-watch-part-11.) Foreclosures remain high and are expected to remain high as unemployment (and underemployment) remains high. Personal and small business bankruptcies have not dropped off. Legacy industries are still in the process of restructuring and are only modestly turning around while younger industries are growing very nicely. The economy of the early 2000s is different from that of the 1990s and before and we cannot go back. And, government shouldn’t force us to go back.

This restructuring is taking place in balance sheets as well as in the structure of the economy. People and businesses that have built up relatively large debt-burdens are restructuring their balance sheets. Consequently, debt liquidation is exceeding debt creation within the financial system and this is resulting in a contraction of bank loans. This is also contributing to the slow growth in money stock measures. This is why it seems as if the Federal Reserve is pushing on a string in terms of stimulating credit expansion.

Economic recovery is occurring, but it seems as if it will be modest and uneven throughout the economy. It also appears as if the economy is transitioning into something else, the Information Economy and not the Industrial Economy, and this will take time and patience. And, maybe we don’t want the banks to expand their lending too rapidly…given the $1.0 trillion in excess reserves in the banking system. Maybe.

Households Continue to Suffer

I’m trying to make sense out of the economic recovery. According to a growing number of people the Great Recession ended in July 2009 or, at least, somewhere in the third quarter. There continue to be “green shoots” that are popping up here and there.

Still, I am uncomfortable. I’m usually a pretty optimistic guy and I don’t like being considered as a “gloomy Gus”. But, some things in the economy continue to nag at me.

Households, at least how we used to know them, are having a difficult time. The major issue remains employment…or unemployment. However, another issue that can’t be ignored and that will impact employment patterns over the next five to ten years is the restructuring of industry and commerce. Restructuring often requires changes in skill sets and changes in geographic location.

In terms of employment we have just learned that companies in the United States cut an estimated 22,000 jobs in January, according to ADP Employer Services, the smallest decline in two years, and much lower than the recorded 61,000 decrease in December. The January result showed that 60,000 jobs were lost in the goods-producing area but in service industries 38,000 jobs were added to payrolls, the second consecutive increase. This was not a bad result, but employment is still declining. (http://www.bloomberg.com/apps/news?pid=20601087&sid=a01taizONkz8&pos=3.)

Most estimates for the unemployment rate in January remain in the 10% range. Very little improvement is expected in this measure in the first six months of this year. Furthermore, the projections of the unemployment rate used by the Obama administration in the budget proposals released this week are anything but encouraging.

These figures do not include numbers on discouraged workers who have left the labor force or those individuals that are working part-time but would like full-time employment. The rate of underemployment in the United States is in the neighborhood of 17% and is expected to remain around this level for the foreseeable future.

One of the reasons for underemployment to remain this high is the restructuring of industry and commerce that is going on in this country. As I have reported, capacity utilization in the manufacturing industries remains quite low and has not even come close to returning to 1960s levels in the past 40 years. (http://seekingalpha.com/article/185801-hearts-minds-and-recovery.)

The trend in United States manufacturing has been downward for a long time as industry has shifted from the heavy sectors to areas that produce higher-tech products. Some industries, like the auto makers, have had to decline due to diminished demand in the United States. Other industries, like chemicals, are relocating labor-intensive operations to other countries.

From December 2008 to December 2009 there have been large declines in capacity in the United States in areas such as textiles, printing, furniture, and plastics and rubber products. Industries where substantial increases in capacity have taken place are the producers of semiconductors, of communication equipment, and of computers. Shifts like these have major impacts on labor skills and the location of employees. (http://online.wsj.com/article/SB10001424052748703338504575041510998445620.html?mod=WSJ_hps_LEFTWhatsNews.)

It is important that these shifts take place. One of the problems with job stimulus packages sponsored by the federal government is that they tend to ‘force’ people back into the jobs that these unemployed have lost. This is not good because it reduces the incentives for industries to change even though it generates revenues for producers, like car manufacturers, and income for workers, like autoworkers. However, industries that need to change must change some time and postponing the change only exacerbates the magnitude and pain of adjustment. Need I mention the United States auto industry again?

This change is being reflected elsewhere and it has an influence on how political power is distributed in a country. The number of American workers that are in labor unions has been experiencing a downward trend that mirrors the decline in United States manufacturing. What is additionally interesting is the shift that has taken place within the overall union workforce: in 2009, public employees that are members of a union rose to more than 50% of total of all union workers. The decline in union membership connected to the manufacturing sector has been hidden because of the rapid growth in those connected with government employment. This is just another indication of the restructuring of the labor force. (http://online.wsj.com/article/SB10001424052748703837004575013424060649464.html.)

Added to this is the large shift that has taken place in home ownership in the United States. Home ownership peaked in the United States in 2004 when 69% of all Americans owned their own home. This peak was reached through the emphasis placed on home ownership in the United States, government programs to get people into their own homes, and low interest rates.
However, this rate has fallen to 67% at the end of 2009 and is expected to continue to decline as people lose their homes through foreclosure or bankruptcy. The rate of home ownership could fall into a range of 62% to 64% that was the case in the early 1990s. This represents a massive shift in the asset holdings of United States households for homes are still, by far, the largest asset held by households in America. (http://online.wsj.com/article/SB20001424052748704022804575041083721893188.html#mod=todays_us_page_one.)

This continued decline does not seem unreasonable given the hard facts facing many homeowners in the United States. In the third quarter of 2009, 4.5 million homeowners had seen the value of their homes drop below 75% of their mortgage balance. This figure is projected to hit 5.1 million, or 10% of all homeowners, by June. Research has indicated that this 75% figure is the level at which people really consider walking away from their home. (http://www.nytimes.com/2010/02/03/business/03walk.html?hp.)

These numbers make me feel uneasy…and that is an understatement. The basic reason for feeling uneasy is that I don’t see a “normal” economic recovery reversing these trends. The United States is restructuring from the excesses of the past, of “forcing” industry to not modernize, of “forcing” people to become homeowners, and so forth and so on. It is always the case that restructuring takes place: sooner or later. Now, seems to be OUR time!

The problem is that this restructuring has ramifications for other areas of the economy. Small- and medium-sized banks have lent money to these home owners and they are the ones that these households will walk away from if they leave. Commercial real estate developers will also walk away from the banks, maybe more easily, as we have seen, than the households themselves. Many businesses that are restructuring or downsizing will not be borrowing from the banks so business loan demand will stay low. And, one can think of many other areas in which repercussions may be felt.

I like to be optimistic about things, but I can’t get these “less-than-happy” conditions out of my mind.

Obama and Leadership

Where do I stand on the Obama Presidency?

I stand at about the same place I did last year at this time.

President Obama has put too many projects into his “top priority” list. After a year in office with not a whole lot to point to, he still insists that he will stay the course and continue to pursue the things he has been pursuing.

My experience in leadership cautions me that a leader cannot have too many top priorities. This is true if things are running pretty smoothly and it is especially true if one is in a turnaround situation.

To me, Obama’s job was to execute the turnaround of a pretty sick patient!

Leadership is to bring focus to a situation, identifying what is immediately important and what can be put off for awhile. Leadership is about communicating this focus to others so that they know what they are to concentrate on and they can get on board with the leader. Then the leader needs to bring sufficient resources to bear on the problem so that the goals and objectives of the organization can be met.

There will be diversions along the way. That is just the way the world is. Because the leader knows that she or he will face these other, unknown bumps along the road, having a disciplined agenda will allow the leader to take care of these “diversions” while still pursuing the major goals and objectives.

President Obama put too many projects on his “top priority” list. He did not focus. He had the “Audacity of Hope” driving him on. And, while that may be very appealing and good speech material, everything would have had to go “just right” for the president to achieve all the goals he set for himself.

Someone once was elected to office by focusing on the claim, “It’s the economy, stupid!”

But, this tunnel vision never seemed to be a part of the Obama persona.

Looking back one year, however, it is easy for us to now say, “It was the economy, stupid!”

Last year at this time we were tottering on the brink of another “Great Depression.” There was a lot of fear in the country. America’s biggest banks were on the edge, the economy was in the tank, and unemployment was growing. Foreclosures were rising as were bankruptcies. And, most of the rest of the world was in at least as bad shape as was the United States.

The Obama administration, along with Congress, produced a stimulus plan. There was the interjection of the government into the auto industry and one or two other efforts to head off problems. The Federal Reserve pursued “quantitative easing” keeping its target interest rate around zero.

Things did get better. Analysts are claiming that the “Great Recession” ended somewhere in the second half of 2009. But, unemployment still remains high. Foreclosures and bankruptcies are still taking place at near record rates. There remain over 550 banks on the problem bank list of the FDIC. And, the economy seems lethargic. Our consumer advocate, Elizabeth Warren, is raising concerns over the demise of the middle class. There is the criticism that the focus of the recovery was on Wall Street and not Main Street. Some prominent economists, Stiglitz, Krugman, and Roubini, are worried about a double-dip in the economy.

News about the President’s efforts on the economy were quickly displaced by trips around the world, about health care reform, about global warming, about energy policy and a myriad of other initiatives.

Of particular concern here was the Obama health care effort. I will just make three points here. First, President Obama turned the development of the legislation over to the Reid/Pelosi leadership in the Congress to craft the bill. Obama disappeared. Questions about where the president stood or what he was for received vague, disconnected answers because he was not leading the charge.

The story I heard for this tactic was that the health care bill presented by President Clinton failed because it was crafted in the White House and did not include sufficient Congressional participation in the process. Obama was not going to make this mistake. President Clinton, of course, denies this reason for the failure of the 1993 effort at health care reform.

Second, the emphasis that was placed on obtaining 60 votes in the Senate to pass the legislation put several self-seeking Senators in the driver’s seat. (Who says ‘moral bankruptcy’ is just centered in the Wall Street banks?) Rather than focusing on the health care bill itself, the nation was appalled by the behavior of a few of America’s elite holding everyone else hostage in order to get their special interests taken care of.

Third, the size of the effort was overwhelming. All people heard was universal coverage, coverage of pre-existing conditions, public option, and so forth and so on. The picture that came through to ordinary people was “huge plan” must be connected with “huge cost.” This was the way the government worked. All the efforts and machinations of the politicians to build a plan that would not cost the American people “one dime” just did not resonate with the public. Universal efforts were expensive and always cost more than expected. And, this would just add to the huge deficits predicted for the next ten years or so.

And, this was going on while the president spoke, always eloquently, about his other concerns.

Then, there was Iran, and Iraq, and Afghanistan, and the Christmas terrorist bomber, and Massachusetts (and Virginia and New Jersey) and other detours.

The consequence? Confusion, uncertainty, frustration, anger, you name it, on the part of the people. What are the priorities? Where does the president stand? What does the president want us to do? What are the rules? Who is in charge, Congress or the President? What is important?

And, the economy? I don’t know when I have seen a situation in which such uncertainty exists. First, the big banks are helped. (Yesterday we heard that the crucial thing was that the economy did not collapse, not how much money Goldman or the French or whoever got.) Then the big banks became the big bad guys. Now we need to re-regulate them. But, how are they going to be regulated? What about foreclosures? Can anything be done about them? And, then the small- and medium-sized banks aren’t lending. How can we get credit flowing again? And, so on and so on.

People and businesses can’t follow if they don’t know where their leaders are heading, what their main priorities are. People and businesses can’t plan if they don’t know what the rules and regulations are going to be. People and businesses can’t commit if they are plagued with uncertainty.

The State of the Union address last evening did not resolve any of these issues for me or lessen my concerns. To me the issue is leadership and the respect for a leader is earned. This is a question of the rubber hitting the road and no speech, no matter how eloquent it might be is going to change this fact. I am still waiting for the focus of intention and the focus of effort.

Something is Wrong!

A headline in the New York Times, “Walk Away From Your Mortgage!”

Why not?

The best remedy for the current economic malaise?

Since there is too much debt, let’s all just walk away from our debt.

And, if the New York Times is printing such material, then it must be OK! Right?

As we “recover” from the Great Recession we see pockets of problems all over the place. Things just don’t fit together the way they used to. And, what we are doing to combat these problems doesn’t seem to be relieving the suffering. The whole world seems to be dislocated.

There is too much debt outstanding. No one disagrees with that, but how do you get people and businesses and governments to start spending again when they are desperate to reduce their outstanding debt?

Other headlines this morning point to the problems in commercial real estate. In “Delinquency Rate Rises for Mortgages” we read that “More than 6% of commercial-mortgage borrowers in the U. S. have fallen behind in their payments, a sign of potential troubles ahead as nearly $40 billion of commercial-mortgage-backed bonds come due this year.” (See http://online.wsj.com/article/SB20001424052748704130904574644042950937878.html#mod=todays_us_money_and_investing.) Also, “Further Slide Seen in N. Y. Commercial Real Estate” points to the fact that 180 buildings totaling $12.5 billion in value, are in trouble in Manhattan. (See http://www.nytimes.com/2010/01/08/nyregion/08commercial.html?hp.)

But, the problems don’t seem to be just in commercial real estate. The New York Times article cited above states that at least one quarter of all residential mortgages in the United States are underwater and that 10% of the mortgages outstanding are delinquent. Another round of foreclosures and bankruptcies seem to be on the way.

Which brings us to the banking system: here the difficulties bifurcate depending upon size. If you are really big you seem to be doing very, very well these days. In fact, it seems as if the “good ole daze” have returned for these bankers. Risk-taking and speculation in the carry trade abound. Simon Johnson, an economist at MIT issued a warning on CNBC yesterday morning that the next phase of the financial crisis could be just beginning and this gets back to the risk-taking of the six major banks in the US whose combined balance sheets exceed 60% of United States GDP.

If you are smaller, however, your problems are immense. The smaller banks are carrying the burden of the commercial real estate problems and consumer debt and mortgages still present these banks with problems because these loans represented “Main Street” and were not all packaged and sold to investors in Finland. Remember there are 552 banks, all small- and medium-sized banks that are on the FDICs list of problem banks and this is expected to grow this year before declining, generally do to actual failures.

There are more dislocations throughout the economy that point to persisting problems. For example, in manufacturing, since the 1960s the unused capacity of United States industry has continually declined from peak usage to peak usage of that capacity The latest peak utilization of capacity still saw that about 20% of the industrial capacity of the United States remained unused. Unused capacity for the past thirty years seems to average around 23% to 24%.

We see unused capacity in the labor force as well. Since the 1970s under-employment of labor has grown quite consistently. Attention is focused upon the unemployment rate, but this measure does not include those individuals that have left the labor force because they are discouraged and those that are only working part time but would like to work more. We have seen estimates that 17% to 20% of the employable people in the United States are under-employed. Another dislocation that is not comforting.

Then we hear about the problems in state and local governments. Reports indicate that there are more than 30 states that are currently experiencing fiscal difficulties. We hear most about California and New York, but there are many other states particularly in the west and southwest that are having real problems. One estimate is that the states will have a combined budget shortfall of at least $350 billion in the fiscal years of 2010 and 2011. And, this doesn’t even get to the difficulties that are being faced by local governmental bodies.

And, there are the dislocations being created by the federal government. Budget deficits for the next ten years have been placed in the range of $15 trillion. The United States is fighting in three wars throughout the world. The government is passing health care legislation that has been justified fiscally by postponing start dates of programs from three to five years. There is climate control efforts being considered along with regulations, like anti-pollution controls, that will just exacerbate the economic and fiscal problems of the country. Then there are other changes in the rules and regulations that apply to industry that will further change the playing field and create greater uncertainty about what management’s should do.

There is the problem of unemployment, the number one issue among the American voter. (And, you thought the number one issue was health care or pollution or terrorism or the war in Afghanistan.) But, there is a dislocation problem relating to federal government stimulus programs.

For fifty years or so, the federal government has attempted to stimulate the economy to put people back to work in the same jobs that they were released from. The government has sought to put unemployed people back to work in the steel industry, in the auto industry, and in other jobs that are the backbone of American industry (according to the labor unions and others). As a consequence, the steel industry lost competitiveness, the auto industry lost competitiveness, and so do many other industries.

This effort to stimulate the economy and put people back into the jobs that they had lost has contributed greatly to the increase in the unused industrial capacity and to the increase in the under-employed in this country. The effort to constantly maintain a low unemployment rate by putting people back into the jobs they have lost has resulted in a massive slide in the competitive position of the United States.

The point of this discussion is my concern with the huge dislocations that now exist within the country. Things are out-of-whack and it is going to take us quite a while for us to get things back together again. Yes, we can try and “force” the economy back into a position of higher employment and greater capacity utilization, of lower debt burdens and greater solvency. But, this would just postpone, once again, the need to realign the country to deal with the pressures of the 21st century.

Something has changed, however. The United States is now facing a more competitive and hostile world economy. The government may not be able to “force” the economy back into its old mold.

Has the Fed (and other central banks) Made a Mistake?

The Federal Reserve, the Bank of England, and the European Central Bank are all keeping interest rates exceedingly low and are continuing to engage in “quantitative easing.” The central banks have claimed that they are caught in a “liquidity trap” and cannot force interest rates to go any lower, especially below zero. Their solution is to continue to force liquidity into the banking system in order to keep the financial system functioning and to encourage commercial banks to start lending again.

I have a problem with this interpretation and have been writing about it since the events of the fall of 2008. The liquidity problem the central banks have focused upon is one connected with the liquidity of bank assets and security holdings that are hard to price. The central banks, as well as the United States Treasury, has seen this problem as a liquidity problem.

I see the basic problem as a solvency problem and argue that there is a significant difference between a “liquidity problem” and a “solvency problem.” Furthermore, commercial banks will respond in an entirely differently way to a “solvency problem” than will to a “liquidity problem.” If the situation has been mis-interpreted, then this, perhaps, accounts for the lack of understanding on the part of the Chairman of the Federal Reserve System and the Treasury Secretary concerning what is happening “out there” in the banking system. It also explains their feeble recent attempts to coax banks into lending more of the liquidity that has been given them.
Right from the start of the financial upheaval last fall, beginning in the week of September 15, 2008, the Fed Chairman and the Treasury Secretary (Paulson this time) saw the financial crisis as a liquidity problem. This is what the original package, the TARP package, was designed for. It was designed to provide funds to buy troubled assets off the books of the financial institutions. It was believed that these institutions could not dispose of these “troubled” assets because the assets could not be priced and hence the banks could not find a buyer for them.
The plan was for the government to provide a buyer for these assets and hence loosen up the balance sheets of these financial institutions. The plan did not really get off the ground from the first day and the funds became the source of bailout bounty that was distributed around the system to those in need.

If the problem had been a liquidity problem right from the start, this program would have helped to combat the difficulties by creating a “floor” under prices and the market could have continued on its merry way.

But, the financial institutions did not respond to the availability of these funds. And, they held onto their assets. Something else was happening.

Let me just add, a “liquidity crisis” is a relatively short term phenomenon. A shock hits the system; say it is found that the credit rating on an issuer of commercial paper is lowered, as in the case of the Penn Central. The immediate reaction in the market is for buyers to leave the market…go play golf or tennis. The reason for this is asymmetric information, the sellers are anxious to sell because they don’t know whether or not more ratings will be lowered, but the buyers don’t know what the price level should be. The buyers will stay away from the market until they get some idea that the market is stabilizing.

The classic central bank response to a “liquidity crisis” is to throw open the lending window and to engage in repurchase agreements to provide liquidity for the market in order to help it stabilize. A “liquidity crisis” is usually over in a matter of days, if not weeks. A “liquidity crisis” is resolved without recourse to massive amounts of government support as a substitute for buyers who have left the market.

A “solvency problem” is an entirely different matter. Here borrowers have problems repaying loans and, as a consequence, the solvency of the financial institution is brought into question. However, the “solvency problem” is not just a short run problem as is the “liquidity problem”.

First, the troubled borrowers have to be discovered. In many cases, it takes a longer period of time to identify the borrowers that are having problems. Then begins the process of working with the borrower in order to see if a plan can be devised to make the bank whole or to rescue at least as much of the funds as possible. After that, it takes more time to see if the borrower can actually deliver on the restructured loan.

And, if the economy is sinking and people are losing their jobs and asset values are declining the bank is faced with the possibility that there will be a whole other wave (or two) of problem loans that they will have to deal with. The “solvency problem” to a commercial bank, and to other financial institutions, is a long term affair. Yes, some banks fail right away, but the majority of the banks face an extended period of one, two, or more years before the problem is completely under control.

The best scenario that the central bank can hope for is that the liquidity crisis will occur and be resolved. Then the solvency problem will come to the fore and will have to be dealt with. The solvency problem takes a long time to work itself out and the best that can be hoped for is that there will be few surprises, that bank failures will precede in an orderly and controlled way.

To me, this has been the evolving picture of the economy, both in the United States and in the world, for the past year. We had our liquidity crisis and then we moved into the solvency problems phase. The system is working things out in an orderly and controlled way.

Yet, the Federal Reserve (and the Treasury) has stayed with the interpretation that the problem continues to be a liquidity one. That is why all the innovative facilities were created by the Fed. That is why the Fed supports the mortgage-backed securities market and the federal agency market. Their “Fed speak” is couched in the terms of the “liquidity needs” of the system.

Isn’t $1.0 trillion in excess reserves in the banking system sufficient for the liquidity needs of the commercial banks? Isn’t the purchase of $800 billion in mortgage-backed securities and $150 billion in federal agency securities enough liquidity for the financial markets?

And, yet banks are not lending. Just as you would expect in a “solvency crisis”. Historically, bankers have always held onto funds and stopped lending when there is a “solvency crisis”. They will not commit funds to any extent while they are fearful that they might be going out of business in the next 12 to 18 months. And, as has just been reported this week, default rates continue to rise, and foreclosures continue to rise, and personal bankruptcies continue to rise, the commercial banks will continue to sit on their hands.

To me, the Chairman of the Board of Governors of the Federal Reserve System and the United States Treasury Secretary have interpreted the situation all wrong! The problem in solvency and not liquidity. The evidence of this is the behavior of the banking and financial system. This mis-interpretation has caused the central bank to act in a totally inappropriate way and, as a consequence, exposes the banking system to massive operating problems over the next year or two if the Fed actually does try and remove all the reserves that it has pumped into the banking system.

One could argue that putting the Federal Reserve in the position it is now in is Ben Bernanke’s THIRD MJOR MISTAKE! Some argue that it is really his FOURTH MAJOR MISTAKE!

Bank Asset Values are a Lingering Problem

Is the recession over? Has the economic recovery begun? Will there be a double-dip recession?
The picture is fuzzy and one reason the picture is fuzzy is because so many banks and other financial institutions, investors, and regulators either don’t seem to have a good grasp of the value of many of the assets on the balance sheets of these banks and other financial institutions or because they are unwilling to confess what the asset values are.

Look at some of the recent articles that have been in the news this week. “Insurers’ Biggest Writedowns May be yet to Come” by Jonathan Weil, http://www.bloomberg.com/apps/news?pid=20601039&sid=a8itsmbfm9qc. “Disclose the Fair Value of Complex Securities” by Robert Kaplan, Robert Merton and Scott Richard, http://www.ft.com/cms/s/0/7eb082d6-8b8e-11de-9f50-00144feabdc0.html. “Citigroup’s Asset Guarantees to be Audited by TARP” by Bradley Keoun and Mark Pittman, http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aiWZXE5RKSCc. “We Need Daily Data to Get Credit Markets Working Again” by Richard Field, http://www.ft.com/cms/s/0/8a9f2906-8d20-11de-a540-00144feabdc0.html.

All of these articles have to do with financial institutions knowing and reporting, as well as possible and as often as possible, the current value of their assets. The managements of financial institutions claim that this will inhibit their actions and force them into decisions that are not in the best interest of their institutions or the financial markets. These managements are wrong!

We are hung up right now because we don’t know the value of those assets either because the banks don’t know what the value of those assets are or the banks are not revealing what the value of those assets are.

I believe that we would face less uncertainty now and may have even avoided a good deal of the financial collapse of the last two years if these financial institutions would have been required to regularly report the fair value of their assets and responded more rapidly to changing market conditions.

Even better, it would have been a sign of outstanding management and real leadership if the banks themselves had been more open and transparent with the financial community, rather than require regulation to force them to release this information.

Alas, this didn’t happen.

This whole dilemma, to me, comes under the “No Free Lunch” argument.

Bankers mismatch the maturities of their assets and liabilities and take advantage of the positive slope to the yield curve. But, in doing so they take on more interest rate risk. Financial markets move against them and the price of the longer term assets decline. Whoops! The benefit the bank got by taking on the extra interest rate risk has backfired. Well, nothing comes for free!

Bankers add riskier loans to their loan portfolio or buy riskier securities to increase their yield. But, in so doing they take on more credit risk. The economy slows down and now these loans or securities face a larger default rate than the bankers had anticipated. Whoops! The benefit the bank got by taking on the extra credit risk has backfired. Well, nothing comes for free!

Financial institutions leverage up their balance sheets in order to squeeze out additional return on their equity position. But, in so doing they take on more financial risk. As assets prices go down the increased leverage backfires and their solvency comes into question. Whoops!

Bankers can’t get something for nothing. And, they can’t hide behind accounting rules in an effort to wait things out until times get better. As Kaplan, Merton, and Richard argue, banks typically fail to act when markets move against the risky positions they have taken and chalk the situation up to “unusual market conditions” or to “just a bump in the road”. And, if economic declines are relatively short and relatively shallow maybe they can get away with waiting the problem assets out. But, in deeper and longer periods of economic and financial dislocation they get trapped in their own failure to act. The asset values do not return to previous levels and the longer they wait to act on the existing problems the worse the situation on their balance sheet becomes.

Richard Field argues, in the article cited above, that banking and credit markets are having problems, not because the loans and securities on the books of the financial institutions are complex, but because they are opaque. This lack of clarity has helped to get us into the current crises and will continue to plague the recovery if it is not corrected. This lack of clarity allows bankers to continue to postpone action, it prevents investors from knowing the value of their investments, and it hinders regulators from in their efforts to understand the true condition of the financial institutions they are regulating.

As I have mentioned in previous posts, I have been involved in several successful bank turnarounds. One of the first things you have to do in turning around a bank is determine the value of your assets and you have to be brutally honest about what the values are. And, in going through this process, in every turnaround I was involved in, it becomes clear that the previous management failed to accept the fact that the value of their assets had declined, they continued to hope that the “unusual market conditions” would pass, and, consequently, by failing to act, the condition of the assets got worse and worse.

Good managements are not afraid of the truth and they are not afraid of releasing that information to the public!

Unfortunately, it is likely that the opaqueness with regard to the value of bank assets will continue.

What Banks Aren't Telling Us?

I am still worried about what banks aren’t telling us.

Why?

Total Reserves in the banking system have increased by $857.8 billion over the twelve month period ending in May 2009. Excess reserves in the banking system have increased by $842.1 billion in the same time period.

The Federal Reserve System has overseen a 1,900% increase in total reserve in the banking system, year-over-year, for the year ending May 2009, and banks have chosen to sit on the injection almost dollar-for-dollar!

These figures come from the Federal Reserve statistical release H.3 “Aggregate Reserves of Depository Institutions and the Monetary Base.” I have used the “not seasonally adjusted” data.

This is unheard of! In May 2008, excess reserves were $2.0 billion and stood at 4.5% of the total reserves in the banking system. In May 2009, excess reserves totaled 93.7% of the total reserves in the banking system.

Unless someone can convince me otherwise there are, in my mind, only three reasons for this behavior. The first is the volume of bad assets currently on the balance sheets of banks that have not been recognized. The second is the volume of bad assets that banks anticipate will be forthcoming over the next year or so. The third has to do with how the banks have funded themselves in the past several years.

If these assumptions are correct, the recession cannot be called over yet and any economic recovery that might be forthcoming is going to be relatively tepid or postponed for some time. I obviously hope that I am wrong but something just does not “foot” with the data that I have reported above.

In the first category, current bad assets on the balance sheet, one would think that we know a fair amount about them. Their volume was sufficiently large so that the government put into place the TARP program and then followed that up with the idea of the P-PIP. Several banks feel sufficiently strong that they are returning their TARP money and it appears as if the P-PIP will never be actually implemented.

Financial markets have responded favorably to these events. Yet, we know that there still remain a large number of bad assets in the banking system. The current confidence has allowed some banks to return the TARP funds wanting to get the “Feds” out of their buildings and out of their compensation committees. In addition, with the relative calm in both financial and economic markets, confidence has risen within the banking system that maybe they can ride out the rest of the way to recovery, hoping that many of the remaining bad assets will turnaround or be refinanced or be worked with.

In my experience working in the banking sector, “hope seems to spring eternal” when it comes to believing that bad assets will eventually become good assets. The attitude is that “with time” the borrowers will come through.

But, what kind of confidence is it that sits on $844.1 billion in excess reserves, funds that are earning no return to the banks? Required reserves in the banking system in May only totaled $58.8 billion. What am I missing?

Let’s look at the second category, that about debt coming due or repricing in the future. We have seen more and more reports in recent weeks about the Option Mortgages that are coming due over the next 18 months or so; we read about all the commercial mortgage debt that is on the edge and this was accentuated this week with the bankruptcy filing of Six Flags; and we know that credit card delinquencies are still rising. What we don’t know is the extent of the fallout from the bankruptcies in the auto industry and how this will impact those industries and regions that have depended upon a healthy car business. In addition, personal bankruptcies and small business bankruptcies continue to rise and there is really no firm information about when the increase in these will moderate and what the effect on the banking system will be.

Finally, there is the problem of financing the banking system itself. I recommend that you take a look at the article by Gretchen Morgenson in the June 14 New York Times, “Debts Coming Due at Just the Wrong Time.” (http://www.nytimes.com/2009/06/14/business/14gret.html?ref=business.) Morgenson writes about the debt of the banking system and the need for bank balance sheets to shrink. The banking system, itself, needs to de-leverage and may have to do so unwillingly.

In this article, Morgenson refers to a study by Barclays Capital that discusses the amount of debt of financial companies coming due over the next year or two. The figures, roughly $172 billion of debt will mature in the rest of 2009 and $245 billion will mature in 2010. This means that financial institutions will have to refinance about $25 billion a month for the next 18 months or so. Part of the problem in refinancing this debt is that “many of the entities that bought this debt when it was issued aren’t around any more.” Furthermore, in general, “few buyers of short-term bank debt are around now.”

Raising equity capital is fine, but, over then next few years, the banks may have a larger hole to finance in terms of the debt that it must try to roll over. This, of course, will put more pressure on the policy makers. The policy makers have gone out on a limb in attempting to protect the need to write down bad assets. The policy makers have provided capital for some of the banks that were in the worst financial shape. The next issue has to do with the need for the purchase of bank liabilities. This may be a very tough balancing act to complete successfully.

But, maybe the government has already provided the funds to meet these emergencies. Maybe that is why banks are holding such large amounts of excess reserves. They know that over the next 18 months that they are going to have a severe funding problem. Excess reserves are the perfect answer to paying off the debt as it runs off, leaving the banks with a lot of funds that still can buy them time to “work out” the bad assets that remain on their balance sheets.

P-PIP, R. I. P.?

Shall we say, Rest In Peace to the P-PIP? Considered from its beginning as an ill-conceived program of the Treasury Department, the Federal Deposit Insurance Corporation has delayed a test auction for the placement of toxic assets which seems to unofficially declare P-PIP DOA. The sooner this effort is totally put to bed the better off we will all be.


P-PIP was always conceived as a program to deal with the illiquidity of bank loans and securities. The difficulty with this is that the real problem was one of solvency. That is, the problem was not about the sale-ability of the loans or assets. The problem was that the banks would need to take such a large write-down of asset values if the solvency of the loans and securities were truly accounted for that the banks, themselves, would face the threat of insolvency.

The P-PIP was an attempt to limit the write-down in asset values so that the banks would not have to directly face the insolvency issue. The Federal Government would use tax-payer dollars to provide the floor for the write-downs. This would avoid, in the minds of government officials, an alternative to “nationalization” of the banks.

The environment has changed. Now that emotions have settled down a little bit, banks (and regulators) are dealing with the loan and securities problems a little more calmly. They are attempting to “work things out” and not “run for the doors.” The ability of banks to raise more capital has also contributed to this new, calmer atmosphere.

In a credit bubble, like the one created by the Federal Reserve earlier this decade, the economic system becomes more and more fragile as institutions seek to achieve adequate returns by manipulating their financial structure. As spreads narrow, management efforts to earn competitive returns focus more and more on financial engineering such as taking on more and more risky assets, and, financing these assets with more and more leverage and by shorter and shorter term liabilities.

The real crisis occurs when the bubble pops and everyone runs for the door at the same time. The Federal Reserve created the incentives that resulted in the financial engineering and since the engineered structures, at some point, become unsustainable the following collapse becomes systemic!

Financial innovation and the creation of derivatives and other financial instruments over the past forty years or so has made the financial markets more efficient--except when everyone tries to leave the game at the same time. The real problem is that financial innovation cannot make up for bad government policy, especially if the central bank is not independent of the government of a country.

When the bubble bursts there is at first fear, as everyone realizes that they are highly exposed. Then, things settle down a bit, but still there is a high level of emotion as people look for short-cuts to get out of their positions. Then people begin to look at their portfolios more realistically and start to work through the problems they identify.

The one real crucial element in moving to this last position is fully understanding and accepting how bad the problems are. Having worked in three bank turnarounds I understand how important it is for the managements of these organizations to face their situation realistically. One can only work one’s way out of a difficult situation if one is completely honest about what needs to be done.

It appears that in the last month or so, more bank managements have moved toward a realistic approach to working out their asset problems. Things are not rosy yet, but things have calmed sufficiently so that banks have raised additional capital where they can and they have weighed the trade-off between selling assets into a P-PIP like program and decided that they are better off relying on their own efforts than those of the government. A good choice in my mind!

There are still going to be bank failures. In fact the number of bank failures projected for this year has ranged from 100 to 1,000. In order to help work through these failures, the FDIC has presented a program to deal with the troubled assets of failed banks that is modeled upon the Resolution Trust Corporation. This program will provide debt guarantees to organizations issuing debt used to buy the troubled assets of failed banks. This seems like a more legitimate way to work with private interests in settling the affairs of banks that have already gone into receivership.

Good riddance to the P-PIP if, in fact, the idea of the P-PIP is expiring. We need to move on and we need to move on where ever possible without the government playing an excessive role in the solution. The problems are not over, but the problems of financial institutions need to be handled by the financial institutions themselves. But, if everyone is not running to the door at the same time the financial system should be able to work through their difficulties.

In no way does this mean that things will be easy. Information released yesterday indicates that bankruptcies, both personal and commercial, continue to increase. Personal bankruptcies in May ran in excess of 6,000 per day, up about 150 per day over April, and commercial bankruptcies rose to 376 per day, up about 125 per day over April. Continuing at this pace, bankruptcy filings could reach 1.5 million this year. And, the full impact of the collapse of the auto industry is still to be felt.

P-PIP may be going away, but the financial crisis has not yet expired. The good news is that financial institutions are now going about their business in a more orderly manner. The bad news is that the bad news with respect to financial institutions is not going to go away.

Furthermore, the bad news is that working through these problems is going to take a long time. The good news is—that they can be worked through.