The End of the Fake Recovery

This is going to be a relatively long post. But I think it’s important. I have been meaning to update my thinking about what I heralded in early 2009 as the “Fake Recovery” as the economy in the US began to turn. My view is that without policy support this recovery is now on its last legs.

Here, I want to review how we got here in the context of the banking system and what that means about the banking crisis right now.

Engineering Recovery

In early April 2009, I remarked:

financial services companies shedding troubled assets, not marking other assets to market and having an enormous margin spread due to ridiculously low interest rates. To me, this is a huge buy signal.

–Wells profit forecast is a clear bullish sign

The end of mark-to-market accounting in the spring of 2009 was a huge filup for banks that meant a technical recovery could begin. At the time I said that

It should be patently obvious that a downturn which began in December 2007 would be fatal to many politicians if allowed to continue well into 2010. This is why recovery of some sort must take place before that time – irrespective of whether it is sustainable.

The idea was to engineer a Fake Recovery based on the following elements:

• Moderate fiscal stimulus
• Quasi-fiscal role for the Fed
• Quasi-fiscal role for the FDIC
• End of mark-to-market as we knew it
• Interest rate reductions
• Bank margin increases

Concentrating on the role that accounting played in this recovery and what the broader implications were down the line, I wrote at the time:

You should have noticed that most of the assets written down in the past two years have been marked-to-market. Securities traded in the open market are marked to market. Loans held to maturity are not. This is one reason that large international institutions which participate in the securitisation markets have taken the lion’s share of writedowns, despite the low percentage that marked-to-market assets represent on bank balance sheets. But, this should end because of new guidelines in marked-to-market accounting. However, the new guidelines do have two major implications. First,there are still many distressed loans on the books of U.S. banks that if marked to market would reveal devastating losses. Second, there will also now be many distressed securities on bank balance sheets that if marked-to-market would reveal yet more losses. In essence, the new guidelines are helpful only to the degree that it prevents assets being marked down due to temporary impairment. If much of the impairment is real, as I believe it is, we are storing up problems for later.

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You should be under no illusion that the coming rebound is permanent. Much of it is not. What we are seeing is the makings of a cyclical recovery that might begin as early as Q4 2009 or Q1 2010. How long or robust that recovery is remains to be seen. Moreover, it is still questionable whether we will get any meaningful recovery at all in spite of the ‘green shoots’ because the banking system in the United States is severely undercapitalised and more asset writedowns are coming due. This is a fake recovery underneath which many problems remain.

Nevertheless, banks are going to earn a lot of money and that is bullish for their shares – at least in the medium-term. Yes, the stock market is overbought right now. However, if banks put together some decent earnings reports over the next few quarters, their shares will rise.

Furthermore, if the banks can earn enough, this cyclical recovery will have legs as banks will then have enough capital to resume lending and that is supportive of the broader market as well. It is still too early to tell how this will play out over the longer-term. For now, I am much more positive on financials, and somewhat positive on the broader market as well.

TARP exit was a mistake

The exact opposite is now true. The cyclical recovery’s legs are tired and almost all of the policies that led to recovery are exhausted. Fiscal stimulus is dead, the Fed has wound down most of its liquidity programs, the PPIP was a bust, and permanent zero is going to erode bank margins. Only the mark-to-market accounting dodge and the Fed’s interest rate policy remain – and the zero rate interest policy is just not effective in inducing lending. This has exposed the banks to the nagging doubts that resulted from the mistake of allowing them to exit the TARP program without greater capital.

As I wrote at the time in late 2009:

Just re-capping here, Citigroup, Bank of America, and Wells Fargo were the last three big banks allowed to leave the TARP program.  They were allowed to do so because Treasury says TARP was a success and the banks are well-capitalized institutions. Meanwhile, the FDIC will not allow new accounting rules to come into affect that would make the banks look less well-capitalized.

If you sensed subterfuge here, you and I would be on the same page.

–On releasing Citi from TARP and banking by accounting subterfuge

Citigroup was the sickest patient; it nearly failed. But Citi has escaped more scrutiny than the other two this go round largely because as I suspected in late 2009 it was forced by the government to sell assets. It is Bank of America which has had the greatest problems with capital during the panic now. But Citigroup and Wells Fargo are also in the spotlight. BofA and Wells have been downgraded by Moody’s.

Stress tests mandated TARP exit

Allowing the sickest patients to exit the TARP program was absolutely foreseeable because of the way the stress tests were sold. When the best-capitalised institutions left the TARP program in June 2009 I remarked that:

this repayment makes clear who really is in trouble and who is not.  Do you see Citigroup’s name anywhere?  How about Bank of America?  Wells Fargo anyone?  I anticipate every bank that is still receiving TARP funds will struggle to get off the government breast as soon as possible because we are likely to see a divergence in stock/preferred share performance between those who get off TARP and those who do not.

We were told the exact amounts that banks needed to meet the right capital levels in order to withstand economic weakness. And once they got to those levels, they had to be released. Eventually, all of the banks got out of TARP, Fifth Third and Wells Fargo being the last big banks. I should point out that Wells was the last and that tells you that Warren Buffett’s comments that Wells Fargo passed Buffet’s ‘own stress test’ were not very serious; he always talks his own book.

The Propaganda Machine

Let’s remember that we have been spun a completely different story here. I have remarked on this many times and I have a list of these kinds of stories in the Credit Writedowns reading list. The one called “Imagine the Bailouts Are Working“ is one of my favourites.

Writing ahead of elections last year about the pro-bailout narrative, I said this:

I don’t know what immediate purpose this kind of revisionism serves because it is not likely to be helpful in the mid-terms given how mad Americans are about the bailouts. Moreover, I do think it is too early to label TARP a success because, despite regulatory forbearance, another downturn would expose the banks to serious losses.

In the end, I am left with the sense that this is how history is made. It pays to fashion a history early. The simplification of all historical narratives means whitewashing events of the intricacies of competing contemporary accounts. Thus, if the US economy recovers, I expect historians will look back on TARP as an unmitigated success – largely due to simplified contemporary accounts…; Opportunity costs will become irrelevant. If we double dip on the other hand, this narrative will be for nought anyway.

–Despite the propaganda machine’s attempts to label TARP a success, it was not

European Stress Tests

Europe never had a TARP to play up. But they have had two sets of stress tests. I saw an article on the European Bank Run and stress tests in the Guardian today that reminded me of what I wrote about the value of stress tests when they were being conducted in Europe last year.

The Guardian asks “How did Europe’s bank stress tests give Dexia a clean bill of health?”:

It may seem like a lifetime away, but it is only in July that the European Banking Authority published the result of "stress tests" on 90 banks across 21 countries in the EU, covering around 65% of the banking industry.

Eight failed. Sixteen were border line with core tier one capital ratios – a key measure of financial strength – of between 5% and 6%.

So presumably, Dexia, the Franco-Belgian bank on which markets are currently fixated, was in one of the danger-zone categories?

Well no. Its statement issued on the day proclaimed "no need for Dexia to raise additional capital".

Why? Well under the "shocks" imposed by the EBA its core tier one capital ratio would fall to 10.4% by 2012 from 12.1%, its actual ratio at the end of 2010. An easy pass.

Yet, barely three months later, Dexia is regarded as being in deep trouble, unable to raise the cash it needs on the financial markets – largely because the market is concerned about its ability to withstand losses on its €3.4bn (£2.9bn) of exposure to Greece.

France and Belgium have been forced to make statements promising to stand behind it – which in turn is raising questions about Belgium’s ability to cope with the financial strain.

The tests have proved to be meaningless even quicker than they were in 2010 when Ireland’s banks were given a clean bill of health, only to be bailed out four months later. In July, 2011 the EBA had been reckoning that the capital shortfall of the banks that failed was just €2.5bn. Now the markets reckon that the hole is more like €300bn.

This is the problem. Stress tests don’t have a lot of value beyond the confidence building they are supposed to engender from the enhanced disclosure they give investors. That allows the banks to then go out and recapitalise. However, if everyone believes the banks really need €200 billion instead of €2.5 billion, the stress tests will end up looking like a sham.

This is what I had to say about the stress tests in June of last year as they were being conducted in Europe:

Undercapitalised Europe

The Eurozone banks are less well-capitalised than US banks. If you recall, last year I went through this exercise (see The top 25 European banks by assets) because of an article in the Telegraph which indicated that European banks were sitting on 16.3 trillion in toxic assets. I expect that many of the toxic assets that were on European bank balance sheets in February 2009 are still on their balance sheets at cost i.e. without having been written down. This is why I think the European banks are undercapitalized and why the stress tests are happening.

In alarmist early 2009 posts like Switzerland threatened with bankruptcy, German banks loaded with 816 billion in toxic paper or The European problem, the genesis of my alarm was the interconnectedness and undercapitalisation of the European banking system. I first wrote about this before Lehman and the panic of 2008 (see my June 2008 post European banks: still undercapitalised). So, it’s not as if the undercapitalisation meme appeared on the scene due to the panic and drop in asset values. And these are the same issues today, two years later. We are talking solvency – not liquidity – in Europe as we are in the US.

Stress Tests

As for stress tests, I think they are of dubious value. However, in a November post I presented both sides of the argument on the US Treasury’s handling of the credit crisis – with the stress test and liquidity/solvency issues front and centre:

• The wildly optimistic view of Treasury’s handling of the crisis
• The less optimistic view of Treasury’s handling of the crisis

Note the following about the US tests:

Of course the stress tests were a sham. They were a confidence trick to raise more capital and buy time for the banks to earn yet more still. The point was to allow the banks to ease into their losses. And that’s exactly what’s been happening for the past year.

–The fake stress tests and the coming wave of second mortgage writedowns

So, if the European stress tests are equally ‘successful,’ the European bank liquidity crisis will fade and we will see banks raising much needed debt and equity capital in the market instead of having the government inject capital.

The view of the stress tests I presented in March is still operative:

If I had to summarize these thoughts I would say the stress tests were a mock exercise to instil confidence in the capital markets. This was important first and foremost because it would induce private investors to pay for bank recapitalization instead of taxpayers. But it was also important for the economy as a whole as the sick banking sector was dragging the whole economy down. The key, however, is that the tests were a mock exercise. Despite the additional capital, banks are still hiding hundreds of billions of dollars in losses in level three, hold to maturity, and off balance sheet asset pools. If asset prices fall and/or the economy weakens, all of this subterfuge would be for nought.

–Geithner: jusqu’ici tout va bien

The same issues are at play in Europe. If recovery continues, I fully expect the biggest and best capitalized to escape trouble and be home free. This is important as many of them are too big to bail. However, if recovery fades and asset prices fall again, we are in big trouble across the board. And you should expect bankruptcies and bailouts all around – just a warning.

Expect more failures and bailouts

The recent Dexia rescue tells us that this view is now being validated by markets. What’s more is that it’s not just the Euro banks, although they are the ones most imperilled and under capitalised; the American banks are on the line too because of the interconnectedness of our financial system.

Robert Reich wrote yesterday:

The Street has lent only about $7 billion to Greece, as of the end of last year, according to the Bank for International Settlements. That’s no big deal.

But a default by Greece or any other of Europe’s debt-burdened nations could easily pummel German and French banks, which have lent Greece (and the other wobbly European countries) far more.

That’s where Wall Street comes in. Big Wall Street banks have lent German and French banks a bundle.

The Street’s total exposure to the euro zone totals about $2.7 trillion. Its exposure to to France and Germany accounts for nearly half the total.

And it’s not just Wall Street’s loans to German and French banks that are worrisome. Wall Street has also insured or bet on all sorts of derivatives emanating from Europe – on energy, currency, interest rates, and foreign exchange swaps. If a German or French bank goes down, the ripple effects are incalculable.

Get it? Follow the money: If Greece goes down, investors start fleeing Ireland, Spain, Italy, and Portugal as well. All of this sends big French and German banks reeling. If one of these banks collapses, or show signs of major strain, Wall Street is in big trouble. Possibly even bigger trouble than it was in after Lehman Brothers went down.

This is what Felix Zulauf meant when he said we should expect more market turmoil than in 2008.

Let’s bring this full circle back to the root of the Fake Recovery, accounting. I think Barry Ritholtz made some good comments on this score. He called it Banking’s Self Inflicted Wounds and wrote:

Morgan Stanley in a free fall. Goldman Sachs at multi-year lows. Citigroup looking Ugly. Bank of America off 50% from recent highs.

You may be wondering what is going on with the major firms in the financial sector. While each of these firms have different problems — vampire squids to Countrywide acquisitions — they all have something in common: Their balance sheets are opaque.

This is no accident. Indeed, it was by design that execs in the banking sector, and their outside accountants, hatched a scheme in 2008 to hide their balance sheets from public view. The bankers had been lobbying the Financial Accounting Standards Board to change the rules that governed “Fair Value Measurements” also known as FAS157 (September 2006).

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The bottom line is this: Investors do not really have a clear idea of how healthy any of these banks truly are. We do not know the state of their balance sheets. We do not know what their exposures are to mortgages, to Europe, to Greece, etc. They could all be technically insolvent, as far as any investor can tell.

That’s it exactly. And it’s this doubt that is creating panic. With the stimulative measures that supported recovery over, the end of the fake recovery is at hand. You need to get rid of any sense that banks are undercapitalised. Until the banks take substantially more credit writedowns and recapitalise, this crisis will continue and get worse.