The World Debt Crisis Lingers

The Federal Reserve, the European Central Bank, the Bank of England, and others, are all desperate to keep interest rates from rising. The debt overhang in the developed world is humongous and any substantial rise in interest rates would just exacerbate the financial crisis that hangs over Europe and America.

We observe the debt crisis all around us. Gretchen Morgenson writes in the Sunday New York Times about the need of commercial banks to write off billions of dollars of mortgage loans sold to Fannie Mae and Freddie Mac. The article is “$2.6 Billion to Cover Bad Loans: It’s a Start,” (http://www.nytimes.com/2011/01/09/business/09gret.html?_r=1&ref=fairgame). She writes, “Analysts in JPMorgan Chase’s own research unit published a report last fall stating that possible mortgage repurchase liabilities for the overall banking industry ranged from a best case of $20 bill to a worst case of $90 billion.”

The Financial Times reports that “US Regional Banks Set for Consolidation,” (http://www.ft.com/cms/s/0/2388dd24-1c27-11e0-9b56-00144feab49a.html#axzz1AjUYZy6X). The gist of this article is that commercial banks have about $1,500 billion in commercial real estate loans coming due over the next four years. People have been watching these loans for about 18 months now, but they have been kept “evergreen” as bank lenders have continually renewed these loans to keep them on the books till “something good happens.” The article list 15 regional banks that have loan portfolios consisting of, at least 38% of their loans in commercial real estate loans. Seven of these banks have more than 50% of their loans in commercial real estate. The smallest of these banks is $4.2 billion in asset size.

Many corporations in the United States and Europe still have massive debt loads that continue to increase. Several times a week there is more news about corporations facing bankruptcy. Yesterday, Sbarro announced that it was hiring bankruptcy lawyers (http://professional.wsj.com/article/SB10001424052748704458204576074214100579944.html?mod=ITP_marketplace_0&mg=reno-wsj). Last week, the Philadelphia company Tastykake indicated that it was looking for someone to buy it because of the debt problems it was having.

Another article in the New York Times on Sunday reported on “The Crisis That Isn’t Going Away,” (http://www.nytimes.com/2011/01/08/business/global/08euro.html?scp=1&sq=the%20crisis%20that%20isn't%20going%20away&st=cse). This article was about a report produced by Willem Buiter, Chief Economist at Citigroup, who claims that debt restructuring in Greece, Ireland, and Spain is inevitable: “All bank and sovereign debt is now at risk…” European debt levels, he argues, are unsustainable.

This argument is re-enforced by the information contained in another article in the Financial Times, “Europe’s Woes Put Debt Restructuring Back on the Agenda,” (http://www.ft.com/cms/s/0/c25cc3e6-1cec-11e0-8c86-00144feab49a.html#axzz1AjUYZy6X).

Not only is the sovereign debt of Portugal currently under attack but Belgian bonds came under attack yesterday.

The debt estimates for 2013 are downright scary: Greece is expected to have its debt at 144% of GDP in 2013; Italy at 120%; Belgium at 106%; Ireland at 105%; Portugal at 92%; France at 90%; the UK at 86%; and Spain at 79%.

And, what about European banks? Check out the article “Fears Mount Over European Debt, Banks,” (http://www.ft.com/cms/s/0/c25cc3e6-1cec-11e0-8c86-00144feab49a.html#axzz1AjUYZy6X). European banks are expected to go through a new “stress” test this year, one that will be much tougher than the “joke” that was administered last year. There is great concern about how these European banks will fare in the new test.

And what about government debt in America? New governors are taking a tough stance on the budgets for the upcoming year. Jerry Brown is seeking $12.5 billion in spending cuts for the upcoming California budget. And, Andrew Cuomo in New York is asking for salary cuts of 10% and is seeking even more cuts elsewhere. The governor of Illinois is (seriously) hoping that the lame-duck legislature will pass a substantial tax increase on corporations before they leave. Still many states are in dire straits, hoping to avoid bankruptcy. And, there are dozens of municipal governments on the edge of declaring bankruptcy.

Oh, and what about the federal government: Have you seen the projections for interest expense going forward given the deficits that are expected in the future?

Now, what if long term interest rates were to rise by another 100 basis points? 150% basis points?

Just how much longer can the central bankers of the world keep long term interest rates below where the market believe they should be?

Research indicates that central bank actions can keep long term interest rates lower than market conditions warrant for a short period of time. However, to maintain the rates at below market levels, central banks must inject increasing amounts of money.

QE2 was announced as a policy decision to get the economy growing faster so that the unemployment rate would be brought down.

Yet, now we see what a farce the Fed has been playing on us. Chairman Bernanke, himself, just told Congress that the unemployment rate was not going to improve much at all, even if the economy picks up speed, and that it would take five to six years for the unemployment rate to even show much of a decline.

So, one can conclude from this that QE2 is not really aimed at getting the unemployment rate down.

I have argued for a long time that the reason the Fed was providing the financial markets with so much liquidity was because of all the insolvent banks “out there”. The Fed was helping to keep banks “open” so that the FDIC could close all the banks that needed closing in an orderly fashion.

I believe that investors are coming to realize that the Fed is not trying to keep rates down in order to spur on the economy. To me, this realization contributed to the fact that the yield on 10-year Treasury securities rose by about 100 basis points after the Fed laid out its plans for QE2. The financial markets just rebounded to levels that more closely approximated where the market should be if the Fed were not “messing” with it.

Bottom line: the debt problem is still real. There is a lot of debt “out there” and the value of this debt is not really the economic value of the debt. The central banks of the world are just trying to keep long term interest rates low in order to push off the day when the debt will have to be written down to a more realistic value. The problem is that more and more attention is being paid to the fact that this debt needs to be written down. And, until this write-down takes place, we cannot really recover, economically.

Housing Still in Cumulative Downward Cycle?

Why would financial institutions want to put home mortgages on their balance sheets right now?

Answer: they really don’t want to add mortgages to their balance sheets.

The consequence is that very tight credit standards exist for mortgages at the present time, a time when credit standards have usually been increasing as the economy comes out of a recession. A Federal Reserve report covering the third quarter of 2010 showed that 13 percent of bank loan officers stated that they were working with tighter requirements. Only 4 percent stated that they were working with easier ones.

Banks, of course, are not issuing non-governmental mortgage-backed securities. In fact, the amount of mortgage-backed securities outstanding has plummeted beginning in 2008. Federal Reserve statistics indicate that privately issued pools of home mortgages fell by $310 billion in 2008, by almost $340 billion in 2009 and have fallen by about $230 billion in 2010.

Agency- and GSE-backed mortgage pools are increasing but at a rate way below previous levels.
In 2008, home mortgages totaled over $11.1 trillion; at the end of the third quarter of 2010, there was only about $10.6 trillion in home mortgages outstanding in the United States, a 4.5 percent drop.

It is apparent that financial institutions do not want to hold mortgages on their own balance sheets and if they cannot securitize them and sell them then they just don’t originate them.

There appears to be two reasons contributing to this behavior. First, delinquencies and foreclosures are still increasing at near record rates. Trying to work out loans that are delinquent and carrying out the process of foreclosure takes time and human resources, resources that could be used to originate mortgages. Second, home owners do not seem to be borrowing if they don’t have to. Mortgage applications have fallen by more than a third from the levels reached in late 2008 and show an almost continuous decline in 2010. Why should home people move if they don’t have to and home prices continue to decline?

Furthermore, Fannie Mae and Freddie Mac have gotten very aggressive demanding that commercial banks buy back defaulted loans if it can be shown that the mortgages Fannie and Freddie acquired were not originated under stated underwriting guidelines. Financial institutions are scared due to the fact that if they have to buy back defaulted loans…it may put them out of business.

Why should the affected banks make any more loans if they might go out of business? Making loans under these circumstances is just a waste of time.

In terms of home prices, Zillow.com has reported that home prices will have dropped by about 7 percent in 2010. In 2011, Fitch Ratings has projected a further 10 percent decline in home prices.

The dynamics of the housing market, therefore, is that falling employment and incomes are still a problem in many sectors of the economy. Banks are not very willing to originate new home mortgages and have tightened requirements to obtain loans. Housing prices fall because the demand for homes has dropped and there is a large inventory of foreclosed properties on the market. This puts more homeowners “under water” with respect to the outstanding loan values they have. And the cycle continues…downward.

Given such a cycle, there is very little incentive for financial institutions to put home mortgages
on their balance sheets.

But, there is another possibility threatening the value of the home mortgages already on the balance sheets of commercial banks.

Fannie Mae and Freddie Mac are reported to be in discussions with people from the Obama administration seeking support for a program to write down loan balances on home mortgages where the borrowers mortgage is greater than the current market price of their homes.

Doing so would help these home owners by “forgiving” the amount of the loan that is underwater. This would reduce the probability of more foreclosures due to a mortgage being underwater and it would also have the effect of reducing loan payments. The “write down” would cost the American taxpayer as the government would have to pay for the amount written down.

Even more scary is the fact that if Fannie Mae and Freddie Mac start to reduce loan amounts to levels that are more consistent with current prices, what pressure would be put upon commercial banks to do exactly the same thing? And, this pressure would seemingly grow as the next Presidential election came nearer.

Commercial banks, both the largest 25 banks in the country and those smaller than these 25 banks, have slightly more than 14 percent of their assets in home mortgages. How much of a hit could these banks absorb and still remain solvent?

Even a little more “write down” in the face of all the other problems that reside on the balance sheets of the banking system would seem to be very troublesome. (See, for example, http://seekingalpha.com/article/241787-the-pending-2011-debt-refinancing-for-commercial-banks.)

The banking industry is fighting such a write down.

The problems existing banks are facing just seem to go on-and-on. Is it any wonder that the banking system, as a whole, is shrinking its loan portfolio? Is it any wonder that federal regulators are continuing to “prop up” the banking system so that these difficulties can be worked out as smoothly as possible? Is it any wonder that the banking system is not contributing to the economic recovery?

Even with some economic recovery taking place, there are still areas of the economy…housing and commercial real estate…that seem to be in on a cumulative downward cycle.