You have heard me use the phrase “liquidity is seeking return” to describe the increase in the price of riskier assets due to monetary stimulus. The Bloomberg News video clip below points to an increase in lending for buyers of riskier loans like high yield and mortgage bonds.

The blurb below from the associated article at Bloomberg’s website makes a more complete picture. Afterward, I have a few comments.

Banks are increasing lending to buyers of high-yield company loans and mortgage bonds at what may be the fastest pace since the credit-market debacle began in 2007.

Credit Suisse Group AG and Scotia Capital, a unit of Canada’s third-largest bank, said they’re offering credit to investors who want to purchase loans. SunTrust Banks Inc., which left the business last year, is “reaching out to clients” to provide financing, said Michael McCoy, a spokesman for the Atlanta-based bank. JPMorgan Chase & Co. and Citigroup Inc. are doing the same for loans and mortgage-backed securities, said people familiar with the situation.

“I am surprised by how quickly the market has become receptive to leverage again,” said Bob Franz, the co-head of syndicated loans in New York at Credit Suisse. The Swiss bank has seen increasing investor demand for financing to buy loans in the past two months, he said.

Federal Reserve data show the 18 primary dealers required to bid at Treasury auctions held $27.6 billion of securities as collateral for financings lasting more than one day as of Aug. 12, up 75 percent from May 6.

The increase suggests money is being used for riskier home- loan, corporate and asset-backed securities because it excludes Treasuries, agency debt and mortgage bonds guaranteed by Washington-based Fannie Mae and Freddie Mac of McLean, Virginia or Ginnie Mae in Washington. Broader data on loans for investments isn’t available.

How could investors return to shades of irrational exuberance so quickly?

Liquidity.

James Montier, now at Jeremy Grantham’s GMO, wrote a research paper at the beginning of June when he was at SocGen called “Forever blowing bubbles: moral hazard and melt-up.” Using research from Vernon Smith, he demonstrated that while experienced investors resist the temptation to reflate a bubble, excess liquidity can fool investors into jumping in nonetheless.

At present, monetary policy is extremely loose globally. So, the excess liquidity of which Montier speaks is at play right now. Nevertheless, consumers in much of the world are overly indebted and are loath to spend more as a result of this money. We may be in a liquidity trap.  Nevertheless, this liquidity being pumped into the system has landed on bank’s balance sheets and is looking for a home.

Hence the phrase “liquidity is seeking return,” which Stephen Roach first used a few months ago.

From an Austrian School economics perspective, this is what would commonly be known as malinvestment.  The excess liquidity being pumped into the system by the world’s central banks is inflation, pure and simple.  This inflation is now manifest in the extraordinary rise of asset prices, particularly assets of lower quality and higher risk.  However, eventually the fundamentals will re-assert themselves once the malinvestment is discovered. Let’s hope the economy is on sounder footing when this occurs.

One last thought: this policy response does seem very much like the 2001-2003 deflation-fighting campaign by the Federal Reserve which brought us the housing bubble – only on a grander scale. Are we forever blowing bubbles?

Related posts:

• The ECB is making good on Wellink’s statements
• Covered bonds are not the answer
• Connecting Fed cuts with credit writedowns and quantitative easing
• Will banks exiting TARP take back their toxic waste now?
• Are covered bonds really the solution?

This entry from Gary Shilling comes via John Mauldin’s site InvestorInsight.com where he highlights commentary from some of the best economic thinkers. Shilling, who correctly predicted problems in residential real estate in the US, is in the deflation camp.  He thinks the US will be a slow growing economy prone to recession and high unemployment over the next decade. A major factor in this is the anticipated increase in savings due to withdrawal from the asset-based economy and the beginning of a balance-sheet recession.

As I indicated in my last post, it is this prospect which should keep policy makers up at night because it will mean the US government is going to continue as a major economic actor for years to come.  I should point out that the Great Depression, while much more severe than what we have experienced thus far, had significant periods of high growth, but was largely characterized by short business cycles and a general deleveraging – the D-process, now my short-hand for depression.  Just sayin’.

(excerpted from the August 2009 edition of A. Gary Shilling’s INSIGHT)

Beyond the current recession, the worst since the 1930s, lies years of slow growth, as we’ve discussed in past Insights. The next economic recovery, which will probably start around mid-2010, will likely be so subdued that it may not feel like the recession has ended. And economic growth in the bulk of the next decade will probably be slow — so slow that it will force the federal government to take continuing actions to prevent high and chronically rising unemployment.

Six Causes of Slow Long-Term Growth

As explored in detail in past Insights, six forces will promote slow long-term growth in the U.S. and, indeed, on a global basis — U.S. consumer retrenchment, financial sector deleveraging, weak commodity prices, increased government regulation and involvement in the economy, protectionism and deflation.

Consumer Retrenchment. First and foremost is the dramatic switch by American consumers from a 25-year borrowing and spending binge to a saving spree that should extend a decade or more. As we pointed out last month, in the 1980s and 1990s, U.S. consumers regarded their soaring stock portfolios as continually filling piggybanks that would fund their kids’ education, early retirements and a few round-the-world cruises in between. So they slashed their saving rate and pushed up their borrowing to fund spending growth that consistently exceeded the rise in after-tax income. When stocks nosedived with the collapse in the dot com bubble in 2000-2002, leaping house prices seamlessly took over to finance oversized consumer spending growth.

But now stock and house prices — the vast majority of most Americans’ net worth — are not only depressed but also unlikely to revive to their former glory days for many, many years. Furthermore, our earlier research found no other major consumer assets that could be borrowed against. So consumers are being forced to embark on the saving spree we have been predicting for some years.

For the next decade, we’re forecasting an average one percentage point rise in the saving rate annually, raising it to 10% in 10 years. That still would not return the saving rate to the early 1980s level of 12% even though the demographics for saving have gone from the worst to the best in the interim. And even a decade of vigorous saving will probably not return household net worth even close to its former peaks or eliminate completely the three decades of ever-increasing household financial leverage.

Financial Deleveraging. Financial deleveraging will also reduce long-term economic growth. As we’ve discussed in many past Insights, the recession really started in early 2007 in the financial arena with the collapse of subprime residential mortgages. Then it spread to Wall Street in mid-2007 with the complete mistrust among financial institutions and their assets, too many of which were linked to troubled mortgages. A huge gap opened up back then between the 3-month LIBOR and Treasury bill yields, and that panicked Washington into opening the money floodgates. The Fed started its interest rate-cutting campaign that ultimately drove its federal funds rate target to the zero-to-0.25% range (Chart 1 ).

But the central bank soon found the banks were too scared to lend and creditworthy borrowers didn’t want to borrow when Bear Stearns and Lehman collapsed and other large banks and Wall Street houses were on the brink. So the Fed embarked on quantitative easing that exploded its balance sheet. And Congress and the Administration joined in with the $700 billion TARP, the $787 billion fiscal bailout and many other programs, as witnessed by the exploding federal deficit.

The Bank for International Settlements recently said only limited progress has been made in clearing up the global financial system, and any economic recovery will be short-lived and followed by a long period of stagnation unless bank balance sheets are corrected.

Except for hotels, commercial real estate woes aren’t so much the result of overbuilding, as is the case with residential. Rather, the problems are due to aggressive refinancing and pricing in earlier years as well as current slumping demand. As retailers close stores or fold completely, mall space becomes vacant. Warehouses are empty as consumer retrenchment curtails goods imported from Asia and elsewhere. Excess space and weak business and leisure travel is axing hotel room rates and occupancy. Layoffs result in sublease office space competing with landlords for tenants.

Furthermore, a great deal of real estate debt must be refinanced soon amidst falling occupancy, rents and sales prices as well as tight credit markets. Estimates are that $155 billion in securitizations are coming due by 2012 and two-thirds won’t qualify for refinancing as prices drop 35% to 45% from their 2007 peaks. Meanwhile, $525 billion of commercial mortgages held by banks and thrifts will come due by 2012. About 50% won’t qualify for refinancing since they exceed 90% of the underlying property value. Lenders prefer loans of no more than 65%.

Deleveraging of the financial sector will obviously have negative ramifications for the real economy it finances. We’ve already seen plenty of effects. Many small businesses that depend on outside financing are starving as banks tighten lending standards. In a sense, many derivatives were financial cobwebs spun among bank and other speculators, but they did finance much of the housing boom.

Commodity Crisis. The earlier collapse of the commodity bubble (Chart 2) will also subdue global economic growth in future years. Sure, commodity consumers benefit from lower prices by the same amount that producers lose. But the share of total spending on commodity imports by consumers, especially in developed lands, is tiny while they account for the bulk of exports for producers, many of them developing countries such as Middle East oil producers.

Furthermore, security losses last year devastated sovereign wealth funds, many of them in oil-rich countries as well as Asian exporters. A year ago, they were estimated to hold $3 trillion in assets on their way to $10 trillion. Now the estimate is $1.8 trillion and optimistically forecast to rise to only $5 to $6 trillion by 2012. Lower oil prices have a lot to do with the downward revisions. Singapore’s huge Temasek Holdings fell more than $28 billion, or 22%, at the end of March from a year earlier.

More Government Regulation. So, U.S. consumer retrenchment, global financial deleveraging and weak commodity prices will keep worldwide economic growth subdued for many years. So, too, will vastly increased regulation here and abroad, the normal reaction to financial and economic crises, as noted in our earlier reports. When a lot of people lose a lot of money, there is a cosmic need for scapegoats and increased regulation. Sure, many embarrassed financial wizards have sworn off their wayward ways and will be cautious for years, probably the balance of their careers. But that won’t stop witch hunts.

The Administration has proposed a substantial overhaul of financial regulation. It doesn’t plan to combine regulators to eliminate overlaps and gaps, as originally discussed. Still, it would empower the Fed to monitor financial risks to avoid systemwide instability; create a Consumer Financial Protection Agency with control of mortgages, credit cards, savings accounts and annuities; push public companies to give shareholders say on pay; bring hedge funds under federal regulation; require firms to hold some of mortgage securitizations they create and sell; force derivatives to be traded on exchanges; beef up oversight of insurance; force industrial loan companies to obtain bank holding company charters; urge the SEC to stem runs on money market funds and to strengthen regulation of credit rating firms; create a mechanism for government to takeover large, failing financial institutions; and amends the Fed’s lending powers to require the Treasury Secretary’s approval.

The first Obama federal budget also points clearly to more government regulation and involvement in the economy, in health, education and the environment. Beyond the financial sector, the bailout of U.S. auto producers led to considerable government control of that industry, almost day-to-day management by Washington.

Rising Protectionism. Without question, protectionism will slow or even eliminate global economic growth as international trade slumps. As noted in earlier Insights, recessions spawn economic nationalism and protectionism, and the deeper the slump, the stronger are those tendencies. It’s ever so easy to blame foreigners for domestic woes and take actions to protect the home turf while repelling the offshore invaders. The beneficial effects of free trade are considerable but diffuse while the loss of one’s job to imports is very specific. And politicians find protectionism to be a convenient vote-getter since foreigners don’t vote in domestic elections.

As noted earlier, initially this recession was in the financial arena — the collapse in the residential mortgage market led by the Subprime Slime that started in early 2007, and the follow-on Wall Street woes that commenced in the middle of that year when two big Bear Stearns hedge funds imploded. So it’s not surprising that protectionism began in the financial arena and took the form of competing to safeguard a country’s financial institutions. But at least that competition was positive for financial systems and economies, even if expensive for taxpayers.

Now, however, protection has spread to its more classical import-export arena with the advent late last year of massive U.S. consumer retrenchment and globalization of the downturn. Both forces are severely depressing the goods and services sectors as U.S. consumer spending falls the most since the 1930s and unemployment here and abroad leaps.

Since the early 1980s, world trade has functioned in a smooth but unsustainable fashion. The rest of the world produced and America consumed. In many foreign lands, households were weak consumers and big savers, so production exceeded domestic consumption. Their production surpluses were exported, directly or indirectly, to the U.S. where consumers were saving less and less and spending more and more. With their growing trade surpluses, foreign nations had growing piles of dollars that they recycled into Treasurys and other American investments, helping to hold down interest rates and making it cheaper for spendthrift American consumers to borrow easily and cheaply to fund their leaping debts.

Now, with American consumers embarking on a saving spree, the U.S. will no longer be the buyer of first and last resort for the globe’s excess goods and services. Furthermore, with slower global growth for years ahead, virtually every country will be promoting exports to spur domestic activity. When every country wants to export and none want to import, the pressure for protectionism leaps.

Deflation. Chronic deflation is the sixth reason we forecast slow economic growth in the next decade or so. Chronic deflation spawns self-fulfilling deflationary expectations. Today, who would have the guts to tell a friend he paid the full sticker price for a vehicle? Years of rebates have trained car buyers to expect continuing and even bigger rebates. So they wait to buy. That leads to excess inventories that require even larger price concessions. Buyer suspicions are confirmed so they wait longer, promoting more inventory buildup, more price cuts, etc. in a self-feeding cycle. A key effect, of course, is to retard spending and slow economic growth.

Long-time Insight readers know that we have been forecasting chronic deflation to start with the next major global recession. Well, that recession is here. We earlier forecast chronic good deflation of excess supply because of today’s convergence of many significant productivity-soaked technologies such as semiconductors, computers, the Internet, telecom and biotech that should hype output and depress prices. As a result of rapid productivity growth, fewer and fewer man-hours are needed to produce goods and services. Big output growth also results from the globalization of production and the other deflationary forces we discussed in and since we wrote our two Deflation books a decade ago. With U.S. consumer retrenchment and a shrinking pool of global imports, export-dependent lands will be competing even more fiercely for the remaining markets.

In contrast to good deflation, bad deflation reigned in the 1930s as the Great Depression pushed demand well below supply. Japan also suffered bad deflation over the last two decades after the collapse of her 1980s housing and stock market bubbles. But in Japan, the lack of demand wasn’t caused by a dearth of employment and income as in the U.S. in the 1930s, but because the government delayed cleaning up her financial institutions while consumers refused to spend their incomes.

We’ve consistently predicted the good deflation of excess supply, but we’ve also said clearly that the bad deflation of deficient demand could occur — due to severe and widespread financial crises or due to global protectionism. Both are obvious threats, as explained earlier.

Few agree with our forecast of chronic deflation. They’ve never seen anything but inflation in their business careers or lifetimes, so they think that’s the way God made the world. Few can remember much about the 1930s, the last time deflation reigned. Excessive monetary and fiscal stimuli are also key reasons why most observers forecast chronic and severe inflation in future years. They may concede that deflation is more likely in the balance of the recession (Chart 3) for the reasons we’ve cited in past Insights. Past weakness in commodity prices is still working its way through the production and distribution system. Surplus inventories (Chart 4) — the result of producers, wholesalers and retailers being caught unaware when consumers suddenly retrenched last fall — are still being worked off and depressing prices in the process.

Wage cuts and mandatory furloughs for the first time since the 1930s, as well as layoffs are obviously deflationary as they depress purchasing power. In addition, the excess of supply over demand has clear implications for deflation.

Nevertheless, the vast majority still maintain that inflation is inevitable in the long run. All the money being pumped out by the Fed and the Treasury deficits is sure to stimulate too much demand in relation to supply, they believe. But before money can promote excess demand, it’s got to get into circulation, and scared lenders and creditworthy borrowers are unlikely to convert massive bank reserves into money until rapid economic growth resumes. And that, we believe, is unlikely for many years. Furthermore, if economic growth and loans mushroom, contrary to our forecast, major central bankers, with their congenital fear of inflation, will no doubt withdraw much of that liquidity.

Slow And Weak Recovery

We continue to forecast that the recession will extend into early 2010. Only by then is enough fiscal stimulus likely to be pumped out to stabilize consumer retrenchment. By then, most of the global financial woes should be at least stabilized. And by then, enough excess house inventories may be absorbed to end the downward pressure on prices.

Excess house inventories were built up in the 1996-2005 boom and still number about 1.5 million new and existing houses above normal working levels despite the collapse in housing starts and recent stabilization in sales. Excess inventories are the mortal enemy of prices in any goods-producing industry, especially housing. We continue to believe it will take at least until the end of next year before excess house inventories are reduced to levels that no longer depress prices. Meanwhile, prices — already down 32% from their second quarter 2006 peak — are likely to fall to reach a total 37% decline we’ve forecast for the last two years.

The decline in house prices is evaporating home equity. In the early 1980s, those with mortgages had almost 50% equity in their houses on average, after subtracting all mortgage borrowing from the market price of their homes (Chart 5). Due to increasing mortgage leverage and, more recently, collapsing house prices, that equity was only 20% in the first quarter and continuing to fall.

If house prices drop about 37% from their peak to their final bottom, that equity will be down to about the 15% range. At that point, over 25 million homeowners, or half those with mortgages, will be under water, compared to about 25% today.

After the recession ends as the economy stops falling, a weak recovery is likely to follow, one so tepid and with such high unemployment that you may not know it has arrived. The two normal forces that generate economic recoveries are missing this time. As usual, the Fed eased monetary policy once it saw that the economy was headed for recession.

But unlike the past, Fed action is not reviving housing (Chart 5), given the overhang of excess house inventories. And the normal pop in production when the liquidation of overall inventories ends (Chart 6 ) will be muted and overshadowed by the unusually large slashing of consumer spending. It’s hard for businesses to cut inventories fast enough to keep up with dropping consumer demand.

2.0% GDP Growth

A chronic 1 percentage point annual rise in the consumer saving rate for the next decade or so will knock around 1 percentage point off real GDP growth after its effects work their way through the economy. That’s a big contrast with 0.5 annual percentage point declines in the saving rate over the previous quarter century that added around 0.5 percentage points to growth. That total swing of 1.5 percentage points will reduce real GDP growth from 3.6% per year in the 1982-2000 salad days (Chart 7 ) to 2.1%.

So with the five other inhibitors to growth in coming years — financial deleveraging, weak commodity prices that will retard spending by producing countries, more government regulation and involvement in the economy, rising protectionism and deflation — our forecast of 2.0% real GDP growth is probably even optimistic.

With 2% to 3% deflation, nominal GDP might not gain at all. And with slower growth in the years ahead, economic expansions are likely to be shorter and less robust while recessions will probably be deeper and more frequent.

Consumer Spending Growth

We’re also forecasting real consumer spending growth of 1.4% per year in the next decade. That, too, may be optimistic as consumers retrench and slash real debt which far outran real housing wealth even before it collapsed, outran real annual growth in real stock wealth before it nosedived, and bested real disposable income growth. Much of the explosion in debt was residential mortgage-related borrowing in the mid-1990s – mid-2000s housing bubble, fueled by low borrowing costs, weak lending standards, exotic mortgages and securitization, which distributed toxic mortgage loans to unsuspecting investors.

The deleveraging of consumers that we expect to continue for years is a reversal of the same long run phenomenon of past decades that was measured in different ways — the decline in the saving rate, the rise in debt and debt service rates and the rise in consumption’s share of GDP, reflecting what consumers did with the money they didn’t save and did borrow.

Consumption vs. GDP

With real consumer spending forecast to grow 1.4% annually over the next decade and real GDP 2.0%, real consumption’s share of GDP falls from 71.0% last year to 66.5% in 2018 (Chart 7). That would bring it back to the level of the early 1980s when the consumer spending binge began (Chart 8 ). It may seem inconsistent that we’re forecasting a rise in the household saving rate of 10 percentage points but a decline in real consumption’s share of real GDP of only 4.5 percentage points from 71% to 66.5%. But note that the reverse occurred in the last 25 years — the saving rate fell from 12% to zero, or 12 percentage points while consumption’s share of real GDP rose from 67.5% to 71%.

These differences are in part because household saving is being measured as a percentage of disposable (after-tax) income, which is less than GDP, so the effects of the change in the saving rate on GDP are muted. In the earlier 1980s, real disposable income was about 78% of GDP. Furthermore, the rise in consumption’s share of real GDP in the 1982-2000 boom years (Chart 8) was actually held back by the drop in the real DPI/real GDP ratio. That in turn was largely the result of employee compensation’s share of national income falling while corporate profits’ share leaped during those years.

In the years ahead, however, it’s unlikely that DPI will decline as a share of GDP. As we discussed in earlier years when profits’ share was at its zenith, a big decline in corporate earnings’ piece if the pie was probably in the cards. In a democracy, we noted, neither capital nor labor can continually increase its share indefinitely while the other one’s share chronically shrinks. We also suggested that the recession and financial mess we were forecasting, the worst since the Great Depression, would depress profits. We also opined that Obama Administration and Democratic-controlled Congress would be adverse to shareholders while smiling on their labor constituents.

Where’s The Growth?

If consumer spending grows slower than GDP in the next decade, other GDP components must grow faster. Which ones? As shown in our forecast table (Chart 7), it’s unlikely to be residential construction, which we see growing 1.0% per year in real terms compared with 5.2% in the 1982-2000 years. Housing should remain weak even after the huge excess inventory is worked off. Earlier, homeowners were convinced that house prices never declined — and they hadn’t on a nationwide basis since the 1930s.

But the recent collapse in house prices and the prospect that they will move with overall prices in the future — which means chronic declines with chronic deflation — are shattering the scales that blinded homeowners. So they’re beginning to separate places to live from investments. That means they’ll want smaller quarters, and the new houses that are built will be smaller and less expensive.

Capital Spending

Real spending on nonresidential structures grew only 0.6% per year in the 1982-2000 era as overexpansion in the earlier years curtailed spending later on. With slow economic growth in the years ahead, demand for warehouse, factory, office and hotel space is likely to be subdued. Ongoing consumer retrenchment will keep retail vacancies high and new building low. On balance, we project about the same growth rate for real nonresidential construction, 0.5% per year, in the next decade.

Equipment and software real spending advanced briskly in the 1982-2000 years, 8.2% annually as new technologies such as computers, semiconductors, the Internet, biotech and telecom absorbed tremendous amounts of spending. Furthermore, inflation and interest rates were declining (Chart 9 ) to the benefit of the corporate sector, and operating rates were generally high while profits growth was robust. Those new technologies will continue to attract heavy spending in the next decade, but their initial huge bursts of spending are probably over. Furthermore, although the interest costs to finance capital investment will probably remain low, especially with deflation, profits will probably remain under pressure in an era of slow revenue growth and deflation. And most important, capacity utilization rates are likely to remain low.

A statistical model that we’ve run many times over the years and just updated shows that year-over-year changes in corporate profits, interest costs and capacity utilization in the post-World War II era are all statistically significant in explaining year-over-year growth in both the equipment and software component of GDP and equipment and software plus nonresidential construction. But in either case, capacity utilization is much more important with coefficients almost three times as large as those for interest costs and even bigger relative to those for profits in both models (Charts 10 and 11).

We forecast annual real growth in equipment and software investment of 3.0% per year in the next decade, faster than the 2.0% we foresee for real GDP but much less than the 8.2% in the 1982-2000 golden years.

Imports and Exports

With weak consumer spending growth and overall muted economic advance, real imports are likely to rise only 2.8% annually in the next decade, much less than the 9.0% growth in 1982-2000 when U.S. consumer spending was booming and free trade ruled the world. This forecast is even lower than suggested by our 1.4% annual growth in real consumption. Historically, a 1% rise in consumer spending results in a 2.8% rise in imports, but rising protectionism is likely to dampen that relationship.

This weakness in U.S. imports will leave profound effects on the many foreign economies that have depended for growth on American consumers buying the excess goods and services for which they have no other ready markets. The net effect of subdued growth in U.S. imports will be sluggish economic growth abroad, perhaps even slower in other developed lands than in the U.S. That should limit the growth in U.S. exports to 3.0% per year compared with 7.4% in the 1982-2000 years (Chart 7). Still, government policies in Asia and elsewhere that promote consumer spending are likely to result in U.S. exports growing slightly faster than American imports, the reverse of earlier years. Severe protectionism, however, may stymie even these low growth forecasts for foreign trade.

State and Local Government Spending

Real state and local government spending, as recorded in the GDP accounts, rose slower than real GDP in the 1982-2000 years, 3.2% vs. 3.6%, and no doubt would in the years ahead — except for federal government stimuli that’s spent by municipalities, as discussed later. State governments are in terrible financial shape and likely to continue so in the years ahead. In the first four months of this year, state income taxes plunged 26%. In the economic climate we foresee, corporate, sales and individual income taxes will all remain depressed.

At the local level, collapsed real estate prices will hold down property tax collections in the years ahead while reductions in aid and revenue-sharing from state governments will persist. In a recent survey, 18 states reported cuts in local aid. California Gov. Schwarzenegger proposed that low-level crimes like auto theft and drug possession be considered only misdemeanors so those convicted would do time in county jails. That would reduce state prison expenses and save the state $1.1 billion in the next three years, but raise local government costs. Furthermore, California’s latest budget stopgap will take, temporarily, $4 billion from local government funds.

We’re forecasting 5.0% annual growth in state and local government spending in the next decade, but the majority of it will probably come from Washington, which will be forced to spend heavily to prevent high and chronically rising unemployment.

Rescued By Slow Productivity

Some suggest that slower economic growth will bring slower growth in production. That would reduce the upward pressure on unemployment since more people would be needed for work than with faster productivity growth. But there’s no evidence that productivity growth necessarily slows with a chronically weak economy. In the depressed 1930s, productivity grew 2.39% annually, among the highest decades since 1900. In that decade, much of the new technologies of the 1920s — electrification of homes and factories and mass-produced automobiles — was being implemented, despite the Great Depression and its slow growth aftermath.

Similarly, the new tech burst of the last decade or so in computers, the Internet, biotech, telecom and semiconductors will no doubt promote rapid productivity growth in coming years.

Finally, the mindset of American business will probably promote robust productivity growth in future years. Throughout this decade, the emphasis has been on producing more with fewer people. Note (Chart 12) that even at the top of the expansion in 2007, job openings were fewer than in 2000 at the peak of the previous expansion, despite the growth in the economy in the meanwhile. And since 2007, job openings have collapsed.

Unemployment will also remain high since many of the people who have lost jobs were in construction and finance, two areas that will probably do little net hiring for many years. Normally, a 2 percentage point drop in real GDP causes a 1 percentage point rise in the unemployment rate. But June’s 9.5% rate is 1.5 percentage points higher than this rule of thumb would predict, given the drop so far in real GDP.

Big Federal Spending

If we’re right, then, on our forecast of slow economic growth in the next decade, unemployment will be high and chronically rising — absent huge federal intervention. And that intervention is assured since no government — left, right or center — can withstand high and rising joblessness for long. And don’t forget current as well as future increased federal immersion in the economy builds constituencies that fight fiercely to preserve their government goodies.

Some of this federal intervention will probably take the form of more federal employees and direct purchases of goods and services, which show up in the GDP breakdown (Chart 7). But most of it won’t be recorded as the federal spending GDP component since it will be transferred to individuals as federal unemployment benefits, extra Social Security checks, etc. and to state and local governments to fund leaf-raking and other make-work projects.

Notice that in 2018, we project real federal spending to account for only 7.2% of real GDP, up from 5.9% in 2008. Of course, nobody but economists look at these measures of federal spending, but instead concentrate on the ratio of total federal budget spending to GDP. This ratio mixed apples and oranges since budget spending includes transfers that GDP does not, but it does measure federal involvement in the economy.

In 2008, federal spending equaled 21% of GDP, outdistancing the 17.7% from revenues. This gap is likely to widen even after the current extraordinary spending to combat the recession and financial mess is over. Anti-unemployment spending will jump to higher levels while federal revenues languish. How will the resulting large deficit be financed?

Savers To The Rescue

In the past, federal deficits were financed by foreigners as they recycled back to the U.S. the dollars gained from their trade surpluses, as noted earlier. The growing U.S. current account deficit measures the increasing gap between domestic saving and investment, or, in effect, and the need for foreigners to not only finance government deficits but also make up for declining U.S. consumer saving.

But now, the current account and trade deficits are shrinking as American consumers retrench and slash imports. Further declines will accrue in future years if exports grow faster than imports (Chart 7), so foreigners will have smaller American current account deficits to finance. At the same time, much more of federal deficits will probably be financed by rising U.S. consumer saving.

Household saving is basically what’s left from wages, salaries, rent, interest, dividends and transfers like pension benefits after subtracting spending on durables like autos and appliances, non-durables such as food and clothing and services like recreation and medical services. That amount, divided by the after-tax income in the period in question, is saving rate. Saving can be used to either reduce debt or increase assets.

Debt Reduction

Although the stock bulls may salivate over the prospect that increased saving will mean more equity purchases, we believe that most of the money will go to debt repayment — the flip side of a saving spree. The 6.9% saving rate in May, mentioned earlier, was a result of consumers saving their tax cuts and extra Social Security payments, and is unsustainable. Still, since after-tax income was about $11 trillion at annual rates in May, this saving rate produced annual rate saving of $769 billion. That money was basically used for debt reduction and since money is fungible, it ended up financing a major part of the mushrooming federal deficit. As consumer saving grows in future years, it will increasingly finance the federal deficit, indirectly.

Repaying debt will be attractive to many Americans in future years as they shun many investments after their huge losses in stocks throughout this decade and their shocking setbacks in real estate. A number will want to be less leveraged as slower economic growth makes employment less stable and unemployment more likely. Chastened lenders, pressed by regulators, will be pushing individuals to lower their leverage by repaying debt.

So will the deflation we foresee. Incomes may grow on average in real or inflation-adjusted terms, but shrink in current dollars. Still, debts are denominated in current dollars and therefore will grow in relation to current dollar incomes and the ability to service them. This will be the reverse of inflation, which reduced the value of debts in real terms and makes it easier to service them as incomes rise with inflation.

Future Insights

In future Insights, we’ll update our 2006 study that showed that over 50% of Americans depend in a meaningful way on government spending. The number will probably be much higher in the coming decade of likely slow growth and greater government involvement in the economy. We also plan to discuss our investment themes for an era of slow growth and deflation.

Meanwhile, don’t expect the burst of federal government spending and immersion in the economy to disappear with economic recovery. It’s likely to persist, not only because it spawns self-perpetuating constituencies, but also because the slow economic growth in the years ahead and threats of high and chronically rising unemployment will force continuing high levels of government involvement.

Source

Slow Long-Term Growth, And Government’s Response – Gary Shilling

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OK, I lied.  I am forced to used that dreaded phrase – one last time.  What did a commenter just call it: “Photosynthetically capable new plant growth?”  The reason the dreaded phrase is making a comeback is due to the excellent analysis of Niels Jensen, Senior Partner over at Absolute Return Partners in London. Visit www.arpllp.com to learn more about them.  You can reach them by email at info@arpllp.com.

Scott, this post is for you.

Asset bubbles are strange animals. Ideally, you would like to punch the air out of them relatively early before they become a real danger but, in practice, it is not quite so simple. Ben Bernanke and Alan Greenspan have actually both argued that asset bubbles cannot be detected and monetary policy should therefore not in any way be used to offset suspected bubbles.

I am not sure I agree with the two gentlemen, but that is less relevant for now. What is important to understand is what happens once the asset bubble bursts. In my experience, almost all post-bursting bubbles share two characteristics:

1. At the very least, asset prices revert to the mean, although many actually overshoot on the downside.
2. A long (and often painful) period ensues, where asset prices gradually claw back lost value. History suggests that this period is measured in years and sometimes in decades; never have asset prices recovered from a deflated bubble in just a matter of months.

The recent collapse of residential property prices – at this point still more advanced in the US than in Europe – is a classic asset bubble which is now deflating. The reason I have decided to write about it this month is because the ‘green shoot’ campaigners are missing a hugely important point about the effect that falling US property prices are going to have – not just on the US but also on the global economy.

Recovery will prove temporary Make no mistake. I always expected and continue to expect an economic revival later this year, which unfortunately will prove temporary. There are many good reasons to expect such a short-term recovery, as I discussed in detail in the April issue of this letter. However, it is what happens afterwards that I worry about. The economic uplift is likely to last no more than one or two quarters after which we will have to face more gloom and doom.

There are at least two reasons property prices are so important to the overall economy. The first reason has to do with leverage. There has been a lot of talk about de-leveraging in recent months, and the consensus seems to be that most of it is now behind us. Perhaps, in the narrowest possible sense, that is correct. But leverage is not confined to hedge funds and banks. Many private households run heavily levered balance sheets as a result of their home ownership and it is this leverage that is rapidly growing at the moment. Why is that? Because leverage is a function of both the numerator and the denominator and, as American home owners are about to find out for the first time, falling property prices can have a devastating effect on your balance sheet.

Secondly, property wealth has become an important part of many people’s lives. In both the US and the UK (and in numerous other countries as well) many people have directed their savings towards property in recent years, and no small part of the profits have been recycled into the economy through equity withdrawal schemes. This has created a level of consumption which cannot be sustained if property prices do not continue to rise.

Property prices are down 32% So let’s take a closer look at US residential property prices which have been falling steadily for almost two years now. One of the better measures of that market is the Case-Shiller index. The index peaked in July 2006 and has since dropped by 32%. Now, in order to revert to the mean, US property prices must fall by about 40% or so in total. Therefore, with a bit of luck, those long suffering US home owners are about 75% of the way through the bear market.

But that is not the point I want to make. In December 2006, only a few months after the peak of the housing bull market, the total value of US residential property stood at $21.9 trillion. Prices have dropped by 31% since the end of 2006, so the estimated value today is about $15 trillion; however, the mortgage debt remains more or less unchanged and stands at $10.6 trillion. In other words, whereas debt-to-equity in the US housing market was 48% as recently as in December 2006, it is now 70% and will rise to 80% once house prices have mean-reverted.

Wealth is extremely skewed Although painful, a rise in debt-to-equity of that magnitude would actually be manageable if it weren’t for the fact that income and wealth in the US is extremely skewed. The top 1% of income earners in the US account for a whopping 23% of national income while the median household has seen no improvement in income for the past ten years (see chart 1). Wealth is even more unevenly distributed. Almost 34% of all wealth in the US is held by the wealthiest 1% of the US population.

Chart 1: US Income Distribution

Source: BCA Research

The same picture emerges when you look at home ownership. Almost one-third of all US households have no mortgage. If you adjust for that, the 70-80% debt-to-equity ratio suddenly becomes a major challenge because it means that the two-thirds who do have a mortgage already face a debt-to-equity ratio in excess of 100%. Even worse, once the mean reversion has run its course, two-thirds of US households will be facing a debt-to-equity ratio of 120-125% on average.

US consumers are broke That is a shocking number and it blows a huge hole through the heart of the green shoots campaign so valiantly promoted by most of the mainstream media in recent weeks. The poorest two-thirds of US households are effectively broke, whether they realise it or not.

Obviously, households have assets and liabilities other than property and mortgages. Deutsche Bank has created a measure of liquid assets to liabilities which is illustrated in chart 2 below. As you can see, there has been significant damage done to households’ balance sheets in recent years. The first wave (2000-03) was mostly a function of the collapse of the dot com bubble. The second wave (2007- ) has come about as a result of the more recent collapse in property and share prices. It is probably fair to say that US households are more financially stressed than at any time since the Great Depression.

Chart 2: US Households’ Balance Sheets

Source: Deutsche Bank Global Markets Research

As DB points out in its report, households’ ability to spend is a function of three factors – cash flow (which again is driven mainly by income, mortgage rates and tax), credit (bank lending) and homeowner equity (property prices). Now, with negative equity against their main asset, with even more pressure on income as a result of the recession and with virtually no savings to cushion the pain, the majority of US households have no choice but to cut back drastically on their consumption. And with the US consumer being forced to pull back, the global recovery story turns very pale indeed.

Tax hikes on the agenda The wealthiest one third of US households may be in for a bit of a shock as well. The tax cuts implemented by President Bush are due to expire in 2010 and neither President Obama nor the Congress have shown any desire to extend the current scheme. In fact, tax hikes are already being discussed, and those Americans who think of European tax regimes as evil creatures should prepare for the beast to show up on their own door step. You only have to go back to the 1950s and early 1960s to find marginal tax rates of 90% in the US (President Roosevelt’s so-called ‘New Deal’). My guess is that before Obama’s first term is over the US will endure marginal tax rates of at least 60%.

So how is it possible for an economy to recover if two-thirds of its people are bankrupt and the remaining one-third will be taxed to death? It isn’t!!!

Mortgage rates under pressure Having said that, mortgage rates will be crucial to keeping the US consumer from suffocating completely, and there can be no doubt that the Fed will do everything in its power to keep a lid on them. But, lo and behold, interest rates are playing further havoc. Contrary to what most investors expected, long-dated government bond yields have actually crept up in recent weeks to the point where they may start to inflict some real damage on mortgage rates.

The situation is quite serious but, as far as I can tell, the average US house owner hasn’t really woken up to the fact yet. At the very least, this will slow down the US (and hence the global) recovery to a trickle. At worst, Americans in their millions will walk away from their homes and post the keys to the mortgage provider as many US states allow, further undermining an already fragile financial sector. The US government, desperately trying to avoid nationalisation of large parts of the banking sector, may have no choice in the end.

Over the years I have learned never to underestimate the determination of the US consumer. He has always been prepared to spend his last dollar. Even when the tank was empty, he re-mortgaged his house so that the spending spree could continue a little longer. 70% of the US economy is accounted for by the consumer. That is more than 10% higher than the EU average (see table 1). Within the EU, only the UK comes close. But his options are running out. There can be no doubt that the party is well and truly over.

Table 1: Private Consumption/GDP

Source: Eurostat. All data from 4Q08.

We need the US consumer! There is plenty of schadenfreude to detect here in Europe. Yet most of those people who argue that the American consumer has dug his own grave by acting so “irresponsibly” fail to understand that it is precisely the over-consumption in America which has driven the global economy to the lofty levels we have all come to like and enjoy. Without Americans being prepared to spend their last dime, there would have been no BRIC fairy tale and there would have been no German export boom, masking the fact that the domestic German economy has been on life support for a number of years now.

It is therefore an inescapable fact that with two of the largest consumer-driven economies in the world heading for a protracted slowdown, the global economy will take much longer to recover than most people realise, unless other countries such as Germany wake up and realise that their high savings ratio is as much part of the problem as the American and British über-spending. However, to persuade Mr. and Mrs. Schmidt to adopt Anglo-Saxon spending habits is a tall order – in particular when the problem is not recognised by supposedly intelligent people such as Angela Merkel, the German Chancellor. I could hardly believe my eyes and ears when, during the recent G20 summit in London, she declared that the German growth model would continue to be based on exports. To whom may I ask?

Niels C. Jensen

---

See for example http://www.federalreserve.gov/boarddocs/speeches/2002/20021015/default.htm

I have chosen to ignore the fact that property prices are now falling quite rapidly in many other countries as well. That only strengthens my case.

Related posts:

• Fitch: Prime RMBS loss estimates way too low
• Tapping the 401K and unrealized gains
• What’s different about 2008?
• Americans are not increasing savings
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Citigroup is looking to raise capital and shed assets in order to deleverage and prevent a worst-case outcome for the financial institution. Case and point is the fact that the company is putting its Brazilian subsidiary Redecard on the block for sale:

Citigroup Inc., the New York-based bank bailed out by the U.S. for $52 billion, plans to sell its stake in Brazilian credit card processor Redecard SA through a public offering, according to a securities filing.

Citigroup registered with Brazil’s securities to sell shares of the Sao Paulo-based company, without setting a price for the offering, according to the filing from Redecard. Citigroup owns 17 percent of Redecard, a stake worth 2.94 billion reais ($1.24 billion) based on today’s closing price.

Chief Executive Officer Vikram Pandit is shedding Citigroup’s businesses to free up capital after the bank posted a record $18.7 billion loss in 2008. Last month he said he planned to sell the bank’s CitiFinancial consumer-finance and Primerica life-insurance units as soon as the market permits, and struck a deal to sell majority control of the bank’s Smith Barney brokerage to Morgan Stanley.

Redecard, the Brazilian processor of payments for Mastercard Inc., is down 6.5 percent in the past 12 months, compared with a 41 percent drop in Brazil’s Bovespa index. The stock climbed 3.89 reais today to 25.66 reais. Citigroup shares, which have plunged 90 percent in the past year, dropped 3 percent today to $2.52.

Citigroup spokesman Mike Hanretta in New York didn’t immediately return a call for comment.

A few days ago, I noted that Citi had stopped lending in Denmark and had cut credit lines in the UK. This is all part of a push by Citigroup to shed non-core assets. Reports that Citi is to get rid of Nikko Citigroup in Japan are hitting the headlines as well.

What remains unclear is whether Citi is making these moves just to stave off a worst-case outcome (i.e. bank failure). These sales certainly make the company easier to sell or nationalize.

Souirce
Citi to Sell Redecard Stake in Brazil Public Offer – Bloomberg.com

Related posts:

• Rubin resigns from Citigroup
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Yesterday was a regular Depression-o-rama here because many of the articles I wrote were very much centered around the Depression theme. I would like to move away from this subject. But before I do, I feel compelled to relay a news piece that came out at the weekend (Hat tip Scott).

Bridgewater Associates founder Ray Dalio gave an interview to U.S. investment publications Barron’s in which he said that we are in a deleveraging deflationary depression. He labeled this the ‘D-Process.’ Now, you may remember Bridgewater Associates is the company which correctly predicted enormous writedowns in this downturn back in July. While many were incredulous, their predictions have turned out to actually understate the likely eventual losses.

Fast forward 7 months and we get a sense of what this influential financial firm is thinking via the Barron’s interview with Ray Dalio. I have highlighted the most noteworthy points.

Barron’s: I can’t think of anyone who was earlier in describing the deleveraging and deflationary process that has been happening around the world.

Dalio: Let’s call it a “D-process,” which is different than a recession, and the only reason that people really don’t understand this process is because it happens rarely. Everybody should, at this point, try to understand the depression process by reading about the Great Depression or the Latin American debt crisis or the Japanese experience so that it becomes part of their frame of reference. Most people didn’t live through any of those experiences, and what they have gotten used to is the recession dynamic, and so they are quick to presume the recession dynamic. It is very clear to me that we are in a D-process.

Why are you hesitant to emphasize either the words depression or deflation? Why call it a D-process?

Both of those words have connotations associated with them that can confuse the fact that it is a process that people should try to understand.

You can describe a recession as an economic retraction which occurs when the Federal Reserve tightens monetary policy normally to fight inflation. The cycle continues until the economy weakens enough to bring down the inflation rate, at which time the Federal Reserve eases monetary policy and produces an expansion. We can make it more complicated, but that is a basic simple description of what recessions are and what we have experienced through the post-World War II period. What you also need is a comparable understanding of what a D-process is and why it is different.

You have made the point that only by understanding the process can you combat the problem. Are you confident that we are doing what’s essential to combat deflation and a depression?
The D-process is a disease of sorts that is going to run its course.

When I first started seeing the D-process and describing it, it was before it actually started to play out this way. But now you can ask yourself, OK, when was the last time bank stocks went down so much? When was the last time the balance sheet of the Federal Reserve, or any central bank, exploded like it has? When was the last time interest rates went to zero, essentially, making monetary policy as we know it ineffective? When was the last time we had deflation?

The answers to those questions all point to times other than the U.S. post-World War II experience. This was the dynamic that occurred in Japan in the ’90s, that occurred in Latin America in the ’80s, and that occurred in the Great Depression in the ’30s.

Basically what happens is that after a period of time, economies go through a long-term debt cycle — a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren’t adequate to service the debt. The incomes aren’t adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring. General Motors is a metaphor for the United States.

As goes GM, so goes the nation?

The process of bankruptcy or restructuring is necessary to its viability. One way or another, General Motors has to be restructured so that it is a self-sustaining, economically viable entity that people want to lend to again.

This has happened in Latin America regularly. Emerging countries default, and then restructure. It is an essential process to get them economically healthy.

We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes — the cash flows that are being produced to service them — or we are going to have to raise incomes by printing a lot of money.
It isn’t complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue.

Isn’t the process of restructuring under way in households and at corporations?
They are cutting costs to service the debt. But they haven’t yet done much restructuring. Last year, 2008, was the year of price declines; 2009 and 2010 will be the years of bankruptcies and restructurings. Loans will be written down and assets will be sold. It will be a very difficult time. It is going to surprise a lot of people because many people figure it is bad but still expect, as in all past post-World War II periods, we will come out of it OK. A lot of difficult questions will be asked of policy makers. The government decision-making mechanism is going to be tested, because different people will have different points of view about what should be done.
What are you suggesting?

An example is the Federal Reserve, which has always been an autonomous institution with the freedom to act as it sees fit. Rep. Barney Frank [a Massachusetts Democrat and chairman of the House Financial Services Committee] is talking about examining the authority of the Federal Reserve, and that raises the specter of the government and Congress trying to run the Federal Reserve. Everybody will be second-guessing everybody else.

So where do things stand in the process of restructuring?

What the Federal Reserve has done and what the Treasury has done, by and large, is to take an existing debt and say they will own it or lend against it. But they haven’t said they are going to write down the debt and cut debt payments each month. There has been little in the way of debt relief yet. Very, very few actual mortgages have been restructured. Very little corporate debt has been restructured.

The Federal Reserve, in particular, has done a number of successful things. The Federal Reserve went out and bought or lent against a lot of the debt. That has had the effect of reducing the risk of that debt defaulting, so that is good in a sense. And because the risk of default has gone down, it has forced the interest rate on the debt to go down, and that is good, too.

However, the reason it hasn’t actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth. There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece — banks and investment banks and whatever is left of the financial sector — that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.

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Dalio is essentially saying that we will not see renewed lending until the bad debt is cleared away – until we see the credit writedowns taken for all of the existing debts. Basically, debtors cannot take on any more loans. The corollary of what he is saying is that the approach taken to date by Paulson and Bernanke and likely to be followed by Geithner will be a failure.

What is interesting about Dalio’s analysis is that he focuses on the debtors. He sees debtors as incapable of taking on more debt given the decline in asset prices and income. All of this was possible as asset prices rose.  But no longer. I have come to similar conclusions by focusing on the lenders i.e. that no increase in lending will get done until the lenders get a handle on their bad debt and feel they can write everything down without going bankrupt.

You should also notice that he is inferring that the United States is a banana republic (i.e. a country that is overly indebted to foreigners) when he makes the comparison to Latin America, much as Willem Buiter has done regarding the U.S. and the U.K. One must use the term ‘banana republic’ because there is a pride, an arrogance if you will, that the United States is better than the countries in Latin America like Argentina and Mexico which have had similar problems in the past. It is not, and to deal with this problem, Americans need to get rid of that notion.

A few other points:

• He also takes a view on Treasuries that I share:  the Fed will eventually have to come in and start buying Treasuries.  He says: “The Federal Reserve is going to have to print money. The deficits will be greater than the savings. So you will see the Federal Reserve buy long-term Treasury bonds, as it did in the Great Depression. We are in a position where that will eventually create a problem for currencies and drive assets to gold.”
• So Dalio sees quantitative easing i.e. printing money as an attractive solution for a country which is indebted in its own currency.  In Latin America, the problem was that the debt was in foreign currency.  Here, the U.S. has a relief valve — it’s called devaluation.  That makes gold attractive.
• Nationalization is inevitable.  The U.S. banking system is effectively bankrupt.  That means that the bad debts are greater than the capital in the system.  Many institutions are solvent. However, today, so many large ones are not that nationalization must happen.  Eventually.  In my view, the sooner, the better.  But, we know that politicians will only do this as a last resort.
• To the question of whether we need to get more credit to good businesses because they ae credit starved, he says: “Those examples exist, but they aren’t, by and large, the big picture. There are too many nonviable entities. Big pieces of the economy have to become somehow more viable. This isn’t primarily about a lack of liquidity. There are certainly elements of that, but this is basically a structural issue. The ’30s were very similar to this.”

Dalio has a lot more to say about China, the Chinese currency, inflation and more. It is a very good piece and I believe it is accessible to those without a subscription. See the link below.

Source
Recession? No, It’s a D-process, and It Will Be Long – Barron’s

Related posts:

• It’s the writedowns, stupid
• We are in depression
• Central banks will face a Scylla and Charybdis flation challenge for years
• A brief philosophical argument about the role of government, stimulus and recession
• Some tidbits about stimulus, recovery, and the Great Depression

David Rosenberg has been one of the voices of reason warning of excesses during the recent boom and predicting the unraveling to which we are now witness.  I have quoted him liberally here.  There is a very good piece on Rosenberg in the Canada’s National Post (Rosenberg is a Canadian) from Dec 30th.  Below is a snippet form that article.

Enjoy.

David Rosenberg drew on inspiration from market-rules theorist Robert Farrell and asset-bubble historian Charles Kindleberger to predict the economy’s demise this year.

Rosenberg, the chief North American economist at Merrill Lynch & Co. in New York, by January had already called the recession that this month was officially declared to have started in December 2007. He also said the Federal Reserve would lower its main interest rate to 1% by year-end, one-third of the median estimate of economists surveyed by Bloomberg News; by October, policy makers brought the rate to that level.

Rosenberg, 48, refused to trust his computer models, sensing that the end of the credit and housing-market booms would cause a deeper rout than most analysts thought. Now, he predicts the carnage will cause a 2.5% contraction in gross domestic product in 2009, and sees historians calling the current era “GDII,” a reference to the Great Depression.

“We came off a prolonged period of prosperity that was fueled by excessive leverage and an asset bubble of historical proportions,” Rosenberg said in an interview. “Either you believed that this was sustainable or you didn’t. I came to the conclusion that this was going to end very badly.”

Please read the rest of this article at the link below. It has some good commentary on Robert Farrell, the now deceased Charles Kindelberger, and Jeremy Grantham.

I should note that Rosenberg works at Merrill Lynch, and works in a brilliant  research team that includes Kathleen Bostjancic and Richard Bernstein who have been equally cautious about the economy and the markets over this business cycle.  Why weren’t the Merrill bosses like Stan O’Neal listening to their advice?  Similar questions should be asked about Jim O’Neill at Goldman or Stephen Roach at Morgan Stanley.  The chief economists at these firms were very cautious while their firms were risking everything.

I wonder if Rosenberg and his group are staying on at Bank of America now that the Merrill take over is complete.

Source
How David Rosenberg foresaw the crash – National Post

Related posts:

• David Rosenberg and Richard Bernstein to leave BOA
• One on One with David Rosenberg, Chief North American Economist at Merrill Lynch
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This is a thought experiment.

Imagine it’s the year 2003 and I am a senior credit card company executive. I have grown bored with my job and want to venture out on my own and start up a new company. With my industry connections, I am able to raise 400 million in capital. I soon start ABCD Card Financial and we are ready to start issuing cards.

Now, it just so happens, I am a fairly prudent fellow and I lend cautiously to creditworthy borrowers. But, unbeknownst to me, ABCD’s CFO invests our hard earned capital in Credit Card Asset-Backed Securities. Mind you, this is AAA-rated stuff, so to most observers, this looks like a prudent use of money.

Anyway, business goes well and we take the company public in 2006, raising $1.4 billion for 65% of the company. That’s a nice return for three years work. We are now flush with capital, $2 billion worth including retained earnings. We leverage this up 20 times committing to $40 billion in loans. Much of the capital is invested in more Asset Backed Securities.

Fast forward to 2009. We are now experiencing a deep recession and people are defaulting left and right on their credit cards. Suddenly, those AAA Asset-Backed Securities aren’t looking like a good call after all. ABCD is forced to announce credit writedowns of $300 million. But, luckily for us, our overall lending has been prudent and while charge-offs are high we will survive.

Now, think about it for a second. We just wrote off $300 million of capital. That means we have $6 billion less to lend. So everything else being equal, this credit writedown just vaporized $6 billion. Poof, gone.

What’s my point? Well, globally, financial institutions have written down almost $1 trillion. That is an enormous amount of credit that vanished in the stroke of a pen. Do you think that lowering interest rates 75 basis points more to 0.25% as the Federal Reserve did today is going to get ABCD to lend as much as it did before the writedowns? Maybe, if only we can leverage to 30 times capital and lend to riskier borrowers and that is not in our best interest.

When the Fed lowered interest rates to 0.25% today, the lowest since record keeping began in 1954, it influenced the price of credit lower, but not necessarily the quantity of credit. Low interest rates — what I call easy money — are not going to get the job done. What financial institutions need is more reserves and more capital.

So, what if the Fed came to my CFO and said we’ll trade you some of the Treasurys you own in your short-term investments for dollars? For the right price, we would say yes. Where do the dollars come from? Out of thin air of course. The Fed creates them in order to buy my assets. This is called quantitative easing. It’s basically inflating the money supply plain and simple. The difference between quantitative easing and low interest rates is that easing actually increases my reserves, giving me more money to lend. Whether I choose to lend is another question.

To my mind, lowering interest rates in the aftermath of an enormous credit bubble where institutions have just destroyed $1 trillion in capital is wrong. It distorts lending decisions such that yet more money will eventually be lent out imprudently. The only way to increase credit availability is by getting reserves into the system. And normally you do that by making a profit. However, profits are hard to come by for financial institutions right now. So the Fed can step into the breach adding reserves by purchasing assets with money that the central banks creates. Mind you, this is inflation. Even so, this money inflation won’t necessarily get financial institutions to increase lending.

On the other hand, lowering interest rates just won’t work.

Related posts:

• Is quantitative easing really inflationary?
• Quantitative easing: printing money like mad to ward off deflation
• Quantitative easing everywhere?
• What’s different about 2008?
• Chart of the day: Excess Reserves

The Tribune was simply over-leveraged with a balance sheet made for this age of debt, leverage and bubbles.

Note the lack of equity and the enormous debt load. Why would anyone, especially someone as savvy as Sam Zell load up a declining business with this much debt? Was it greed, hubris? It seems inexplicable to me.

The Tribune bankruptcy was an entirely avoidable event. Yes, newspapers are declining businesses. Yes, we are in a deep recession and ad revenue is getting killed. But, this is a worthy franchise with lots of brand equity and other assets to sell. The owners got caught up in the credit/debt mania and soon they and their employees will be paying the price.  Expect more of the same later in this downturn.

The publisher of the Chicago Tribune and the Los Angeles Times declared bankruptcy on Monday as the U.S. newspaper industry’s unrelenting loss of readers and advertisers claimed its biggest victim yet.

Tribune Co, which owns eight major daily newspapers and several television stations, filed for Chapter 11 bankruptcy protection after collapsing under a heavy debt load just a year after real estate mogul Sam Zell took it private.

Like other big U.S. newspapers, Tribune is under pressure from declining advertising revenue and circulation as more people get news online and as companies cut their marketing budgets because of the economy.

“The Tribune Co’s financial condition is symptomatic of the ills that plague the newspaper industry,” said Jerome Reisman, a bankruptcy attorney with Reisman, Pierez & Reisman.

Tribune’s bankruptcy filing is the latest chapter in the unraveling of the leveraged buyout boom which saw many companies bought by private equity firms and other investors ending up with massive debt loads.

Zell loaded up the privately held publisher with about $8 billion in additional debt when he took the company private in a transaction largely financed by company contributions to an employee stock option plan.

Like other big companies which took on heavy debt burdens during the private equity boom, Tribune is now being forced to find a way to cut its borrowings to an amount it can handle.

“This process of deleveraging America, whether financial institutions or Tribune, will be a long, slow and painful process,” said Duke University Law School Professor James Cox. “That’s what’s going to prolong this recession.”

Sources
Tribune Company 10-Q, Q3 2008
Tribune files for bankruptcy protection – Reuters
What Went Wrong for Tribune Co. – WSJ

Related posts:

• Chicago Tribune near bankruptcy
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In a shocking news story, the Wall Street Journal reports that the media company Tribune Company, which publishes the Chicago Tribune, is exploring bankruptcy.  While advertising revenue has contracted significantly, impacting all major media companies, it was not expected that this would lead to bankruptcy.  Below is a snippet of the Journal story.

Tribune Co. is preparing for a possible filing for bankruptcy-court protection as soon as this week, according to people familiar with the matter, in another sign of trouble for the newspaper industry.

In recent days, as Tribune continued talks with lenders to restructure its debt, the newspaper-and-television concern hired Lazard Ltd. as its financial adviser, as well as legal counsel for a possible trip through bankruptcy court, according to people familiar with the matter.

A Tribune spokesman said the company doesn’t comment on rumors or speculation. Tribune owns eight major daily newspapers, including the Los Angeles Times, Chicago Tribune and Baltimore Sun, and a string of local TV stations.

A spokesman for investment bank Lazard didn’t respond to a request for comment.

Tribune’s latest actions underscore the deepening distress enveloping Tribune and other newspaper publishers. Their businesses are being battered by dwindling advertising sales, and they are carrying debt loads that are unmanageable under current market conditions. Insider insiders expect some papers will need to fold or seek protection from creditors to reorganize in coming months.

Tribune has been on wobbly footing since last December, when real-estate mogul Samuel Zell led a debt-backed deal to take the company private. Tribune so far has stayed ahead of its $12 billion in borrowings with the help of asset sales. Now, however, dwindling profits are tightening the noose.

The company’s cash flow may not be enough to cover nearly $1 billion in interest payments due this year, and Tribune owes a $512 million debt payment in June.

A toxic mix of debt and a monumental downturn may well be enough to take down one of America’s most prestigious media empires. This turn of events was not entirely unexpected as the over-leveraged company had a very poor debt credit rating. It’s most recent 10-Q filing with the SEC from 10 Nov 2008 said the following:

As of Nov. 7, 2008, the Company’s corporate credit ratings were as follows: “B-” with negative outlook by Standard & Poor’s Rating Services, “Caa2” with negative outlook by Moody’s Investor Service and “CCC” with negative outlook by Fitch Ratings.

However, this will not be the last such announcement of a major U.S. company before we hit bottom.

UPDATE:  The Tribune has now filed for bankruptcy. See story here.

Source
Tribune Co. Taps Lazard,Weighs Filing for Chapter 11 – WSJ
Tribune Company 10-Q, Q3 2008
Tribune files for bankruptcy protection – Reuters

Related posts:

• The Tribune files for bankruptcy
• Obama ready to put Chrysler into bankruptcy
• GM Board: Bankruptcy is an option we will consider
• Tribune bondholders will lose 98.5 percent
• Opel and Fiat spells bankruptcy for Chrysler and GM

I have been tied up with other activities all day today. But, I just had to send this post on Peter Schiff. My brother-in-law sent me this video a second ago of Schiff predicting doom and gloom on YouTube. And it’s actually kind of funny to look back and see what he was saying in 2006 and 2007 and how he was pilloried. His calls were uncannily right on the money.

It is definitely no fun going against the grain, though. Take a look.

Related posts:

• Peter Schiff: “Government is a burden on the economy”
• Barron’s: an interview with Peter Schiff
• Wall Street Journal: Right Forecast by Schiff, Wrong Plan?
• New Writedown Risk: Alt-A
• Fitch: Prime RMBS loss estimates way too low

By now, you are familiar with the carry trade, where one borrows in one’s own currency in order to invest in higher yielding foreign assets, often times with significant leverage. The Japanese were famous for making this trade in Australian Dollars, U.S. Dollars, you name it.

What a lot of people don’t realize that everyone and his brother was doing the reverse carry trade as well. This is a trade where one borrows abroad in a currency where interest rate are low and then invests that money at home.

Both trades can make one a lot of money, especially using leverage. And indeed, for quite some time, many have made a killing simply by performing this trade. However, both trades carry some risks. The normal carry trade carries currency risk — i.e. the currency in which you invest your funds falls more than you collect in excess returns before you can repatriate your funds. The reverse carry trade is a problem if your credit comes due and you are unable to rollover this foreign currency debt — i.e. you essentially default because no one will lend to you in the foreign currency.

Of the two trades I find the reverse currency trade much riskier than the carry trade. Let me give you a few examples why.

First, there’s Iceland. This small country of 300,0000 turned itself into a financial services powerhouse, leading to unsustainable spending growth. In order to get there, its banks needed to g abroad to increase their asset base. However, along the way, these companies started to do the reverse carry trade. When Iceland, the country, and its banks ran into difficulties, no one wanted to lend to the Icelandic banks. As a result, result, Kaupthing became the first European issuer to default on Japanese Yen denominated bonds.

Kaupthing Bank hf today became the first European borrower to default in Japan’s samurai bond market after the state-controlled bank missed its last chance to make a 450 million yen ($4.8 million) coupon payment.

Two investors in the Reykjavik-based bank’s 50 billion yen in 1.8 percent notes, who declined to be identified, said they hadn’t received funds that were originally due on Oct. 20. Kaupthing had a one-week grace period to make its payment, according to the terms of the sale prospectus.

Yields on the bonds have risen as high as 45,000 basis points over the one-year yen swap rate to nearly 451 percent as investors hurried to unload the securities in recent days.

A basis point is 0.01 percentage point.
-Bloomberg

Then, there are the stories behind the Fed’s need to extend swap lines to every Tom, Dick, and Harry central bank around the world. You were probably wondering where all the money Alan Greenspan printed went. Well, some of it went to our own mortgage bubble in the good ol’ U.S. of A. But, some of it also went to foreign banks that proceeded to finance their own speculative binges abroad. Houston, we have a problem — these banks can’t roll over their dollar-denominated. The credit markets have come unstuck and everyone is in a panic. What to do?

Enter the Fed. Basically, the Fed is acting as a global lender of last resort by offering virtually unlimited dollars to the ECB, the Swiss central bank, the BoE, the South Korean central bank, as well as the Mexican and Brazilian central banks. Needles to say, this is not good for the U.S. dollar’s value over the long-term. But, who else is going to step in here?

All of these central banks need the money for their domestic financial institutions. So rather than leave these banks at the mercy of the global credit markets, Ben Bernanke and company have stepped in and given the money to the local central banks who then help these companies by loaning them the dollars to roll over their debt or by helping them get out of dollars and into their own currency. Again, swapping out of dollars means less demand for the Greenback and a lower U.S. Dollar.

Finally, there’s this little story I caught at Bloomberg today.

Imre Apostagi says the hospital upgrade he’s overseeing has stalled because his employer in Budapest can’t get a foreign-currency loan.

The company borrows in foreign currencies to avoid domestic interest rates as much as double those linked to dollars, euros and Swiss francs. Now banks are curtailing the loans as investors pull money out of eastern Europe’s developing markets and local currencies plunge.

“There’s no money out there,” said Apostagi, a project manager who asked that the medical-equipment seller he works for not be identified to avoid alarming international backers. “We won’t collapse, but everything’s slowing to a crawl. The whole world is scared and everyone’s going a bit mad.”

Foreign-denominated loans helped fuel eastern European economies including Poland, Romania and Ukraine, funding home purchases and entrepreneurship after the region emerged from communism. The elimination of such lending is magnifying the global credit crunch and threatening to stall the expansion of some of Europe’s fastest-growing economies.

“What has been a factor of strength in recent years has now become a social weakness,” said Tom Fallon, emerging-markets head in Paris at La Francaise des Placements, which manages $11 billion.
-Bloomberg

It makes you want to cry — this is a hospital for Pete’s sake. And they are getting caught up in this global currency and credit crisis. But, that’s the carry trade for you.

From where I am sitting, a lot of the recent turmoil in emerging markets is a direct result of the reverse currency trade — borrowing at low rates in foreign currency in order to invest at home. Argentina, Brazil and half of Asia blew up less than 10 years ago for just these reasons.

When will they learn? Do people have that short a memory.

Related posts
Currency crisis is gathering storm
The carry trade unwinds and it’s not pretty
Currency crisis is gathering storm
A shift to Eastern Europe and emerging markets too
Asia is next
Japan’s easy money policy was the trigger for the tech wreck

Sources
Iceland Kaupthing Defaults on Samurai Bonds as Yields Hit 450% – Bloomberg
`Panic’ Strikes East Europe Borrowers as Banks Cut Franc Loans – Bloomberg

Related posts:

• Is the U.S. dollar carry trade replacing the one in Japanese yen?
• U.S. Bailout: the mother of all carry trades?
• Swiss Franc at Dollar parity?
• The carry trade unwinds and it’s not pretty
• Chart of the day: Aussie – Yen cross

I ran across a very disturbing news item today that is getting a lot of press in Germany. Apparently, the leveraged finance community is getting routed at the German Automaker VW. The crux of the situation is that Porsche, which controls VW, upped its stake in the company causing shares to rise.

For whatever reason, a number of hedge funds were actually short VW – meaning they were betting against the shares. A short squeeze ensued and the shares rose a massive 50% – making VW the world’s largest company – at least temporarily.

The result: losses in excess of 20 billion euros. And I have heard that the rise in VW alone made the DAX (Germany’s equivalent of the Dow Jones Industrial Average) rise 7%. Truly amazing.

Volkswagen briefly became the world’s largest company by market capitalisation on Tuesday as panic-buying by hedge funds desperate to cover losses caused its value to shoot up by up to €150bn.

Shares in Europe’s largest carmaker soared as high as €1,005 in early trading, having closed at about €210 on Friday. That gave it a market capitalisation of around €296bn ($369bn), higher than that of ExxonMobil, the oil company that closed on Monday with a value of $343bn……

“I have hedge fund managers literally in tears on the phone,” said one London-based auto analyst. Hedge funds had bet that VW’s share price would fall but after Porsche disclosed it held 74 per cent of the carmaker rather than the previously assumed 35 per cent there was a huge scramble to cover positions.

Analysts and investors said some hedge fund failures were likely because of the size of the losses, which reached about €20bn-€30bn on Tuesday. They also called for a full investigation by Bafin, Germany’s financial regulator, into whether there was market manipulation.
-Financial Times

See the video at the FT article.

I still think much of the recent market turmoil – especially in currencies – has a lot to do with forced selling by hedge funds. These hedge fund managers on the phone crying deserve zero sympathy.

I am a fan of short sellers and the transparency they bring to the market. But, these leveraged players were simply playing with fire and they got burnt.

This is further reason we need to regulate these funds.

Related posts
Random musing: forced liquidation

Related posts:

• Is the short covering rally over?
• Hedge funds collapsing
• Reflation watch hedge fund edition
• Australia bans short selling too
• Jim Chanos: short sellers are heroes

The recent movement in global markets has me scratching my head a bit. You have people dumping gold and the Swiss Franc in order to invest in the U.S. dollar and Treasury securities. Everyone says it is a flight to quality. I do not agree. Logic has it that the U.S., as a debtor nation which is spending hundreds of billions to prop up an ailing financial sector, is not quality. It is anti-quality. So what gives?

My take is that this is a flight to liquidity. The U.S. Dollar and U.S Treasury securities are liquid markets that one can reasonably expect to invest in without worrying about liquidity concerns. To my mind, what has precipitated this flight to liquidity is the need by hedge funds to liquidate holdings as redemptions come due.

People are taking their money and going home, so the leveraged financial community is being forced to sell everything in all markets. They are unwinding all of their leveraged bets: Australian Dollar over Japanese Yen. Brazilian and South Korean bonds over Treasuries. Puts on the U.S. Dollar. Everything.

Fight to quality? Hardly. This is deleveraging. This is a forced liquidation.

Related posts
Dollar strength is an illusion
De-leveraging redux
De-leveraging

Related posts:

• TALF: ‘the great liquidation’ begins for hedge funds and shadow banks
• Massive short covering at VW and massive losses for hedgies
• Reverse carry trade borrowing is deadly
• Markets are looking very good
• Hedge funds collapsing

I have felt for sometime that dollar strength is a counter-trend that has a sell-by date written all over it. You see, the Federal Reserve is ballooning its balance sheet like nobody’s business as it tries to be the global lender of last resort. This is very inflationary. Apparently, the Fed wants to trash the Dollar. And, despite recent events, I believe it will eventually get its wish.

The United States is the world’s biggest debtor nation, dependent upon foreign governments to buy treasury and agency debt in order to maintain itself. However, two articles I read today have convinced me that this situation is about to change in a nasty way and Asian countries are about to let the dollar go (very big hat tip Scott).

The first article concerns Taiwan and their apparent desire to stop buying agency debt for fear of throwing good money after bad.

Taiwan’s financial regulators reportedly have ordered that nation’s insurance companies to pare their holdings of the debt and mortgage-backed securities of Fannie Mae (ticker: FNM), Freddie Mac (FRE) and Ginnie Mae securities, according to a report on the Internet site of Asian Investor magazine.
 
Such an order would be a stunning rebuke to Washington, coming a little more than a month after the federal government effectively nationalized the mortgage giants. Fannie and Freddie last month were placed into conservatorships with the Treasury standing ready to inject up to $100 billion through purchases of preferred shares in the government sponsored enterprises.

As a result, Fannie and Freddie debt has the “effective guarantee” of the U.S. government, a spokeswoman for the Federal Housing Finance agency, the regulator for the GSEs, said Thursday. (That was a “clarification” of FHFA director James Lockhart’s earlier declaration to the Senate Finance Committee that Fannie and Freddie debt had the “explicit” guarantee of the U.S. Treasury, Dow Jones Newswires reports.)

Moreover, Ginnie Mae securities have always been backed with the same full faith and credit guarantee as the U.S. Treasury.

In either case, the Taiwanese action is a blow to the reeling U.S. mortgage market, which has been supported by the Republic of China’s purchases of agency securities. According to U.S. Treasury data, Taiwan owned a very substantial $55 billion of U.S. agencies along with $43 billion of Treasuries as of June 30, 2007, the most recent date for which these data are available.
-Randall Forsyth, Barron’s

This certainly is bad news for U.S. interest rates, mortgage rates and the U.S. Dollar. However, more worrying s that mainland China seems to be following its Taiwanese brothers in rejecting the U.S.

The United States has plundered global wealth by exploiting the dollar’s dominance, and the world urgently needs other currencies to take its place, a leading Chinese state newspaper said on Friday.

The front-page commentary in the overseas edition of the People’s Daily said that Asian and European countries should banish the U.S. dollar from their direct trade relations for a start, relying only on their own currencies.
A meeting between Asian and European leaders, starting on Friday in Beijing, presented the perfect opportunity to begin building a new international financial order, the newspaper said.

The People’s Daily is the official newspaper of China’s ruling Communist Party. The Chinese-language overseas edition is a small circulation offshoot of the main paper.
Its pronouncements do not necessarily directly voice leadership views. But the commentary, as well as recent comments, amount to a growing chorus of Chinese disdain for Washington’s economic policies and global financial dominance in the wake of the credit crisis.
-Reuters

China is the largest holder of U.S. government and agency debt. If they go on strike, the consequences for the U.S. would be catastrophic.

It is hard to believe we are asking this, but events are pointing in an ominous direction: Is the U.S. Government even solvent?

Related posts:

• Quote of the day: China hopping mad about GSEs
• Question: How is Fannie Mae a AAA company?
• Conservatorship of GSEs is bad for the dollar and inflation
• How much longer for dollar strength?
• Quote of the day: Gordon Brown, get your bazooka

CNBC and other media sources are reporting that a number of hedge funds are collapsing under the weight of poor performance and massive fund redemption. Given the market volatility in credit, sick, bond and currency markets, it was only a matter of time before we started to see this occurrence.

CNBC reported the following today:

Citadel confirmed to CNBC that its flagship Kensington and Wellington funds, which hold around $15 billion in assets, are down between 26 percent and 30 percent so far this year.

But Chicago-based Citadel denied rumors that it’s having difficulty meeting margin calls and is facing mass redemptions. The firm also denied that it’s unwinding any positions.

Highland, on the other hand, is unwinding positions, according to traders with knowledge of the activity of the big hedge fund company, which has $14 billion under management.

-CNBC News

Look through the related posts below to see my warnings that this was going to eventually occur. I particularly saw the whipsawing in currency markets as a major event. But, losses on convertible bonds and corporate bonds due to the recent market panic were also contributing factors.

Hedge Funds have provided out-sized returns in part duew to high leverage. However, leverage cuts both ways and we are now seeing it cut to the downside.

Related posts
Hedge Funds
Dollar weakness
The dollar rally spells trouble for some investors
Quote of the day: 10 Aug 2008 – trickier than LTCM
Corporate defaults mean more hedge fund blow-ups

Source
Hedge Fund Woes: Troubles at Citadel, Highland – CNBC

Related posts:

• Hedge Funds: the bell tolls for Ospraie
• Hedge Funds
• Hedge Fund Panic
• RAB looks to halt redemptions for three years
• Massive short covering at VW and massive losses for hedgies

With Goldman Sachs and Morgan Stanley becoming bank holding companies, the traditional U.S. investment banking model has come to an end.

But it bears remembering that investment banks are highly leveraged institutions. Both Goldman Sachs and Morgan Stanley will have to either deleverage significantly or merge with an existing depositary institution with less leverage in order to meet the stricter regulatory requirements bans face.

That brings me to the quote of the day, which comes from Niels Jensen and Jan Wilhelmsen of Absolute Return Partners via John Mauldin.

For the past couple of decades investment banks have been operating like mega hedge funds. An ever larger part of profits has been derived from proprietary activities. I remember once, not that many years ago, when I worked for one of the largest investment banks, it was explained to me that the bank’s gearing was around 40-45 times during the month. Then, every month, as we approached month-end, the gearing would be brought down to below 30 in order to satisfy the regulator. I would be surprised if this practice was not widespread, but I would be even more startled if this sort of activity has not been seriously curtailed in the current environment. As markets have frozen, investment banks have had to reconsider their business model.
-Observations on a Crisis, Investors Insights

That this went on in the shadows of the U.S. financial system is further evidence of why we are where we are today.

Related posts:

• Goldman and Morgan Stanley are now banks
• Morgan Stanley’s writedowns bring us to a cool $1 trillion
• Deflation in action
• Goldman looking to buy a bank
• Financial Alchemy at Morgan Stanley: Greywolf A3 CDOs now Aaa bonds

UBS reported a loss of 358 million Swiss Francs ($332 million) after writing down a further $5.1 billion in debt.

In my post yesterday, I said the market expected as much. But, more importantly UBS has confirmed plans also mentioned in yesterday’s post of splitting the bank up into three autonomous units – effectively ending the universal banking model. Citigroup, another big loser in this credit crunch will be under increasing pressure to follow suit, as Sandy Weill’s ‘financial supermarket’ concept has performed abysmally.

The Financial Times also notes that UBS is quite downbeat about turnaround prospects for the second half of 2008. If one takes this to mean that the same environment which caused these writedowns is likely to hold, I believe it means we should see significant writedowns in Q3 and Q4 earnings cycles — and not only from UBS.

However, investors have developed a severe case of heartburn when it comes to financial services share offerings. Share sales at this point in the year will likely be met with little investor appetite and risk failing. If writedowns continue unabated into the third and fourth quarter as UBS management has suggested, a weaker global player will likely go to the wall because of limited capital raising opportunities.

These are very nervous times.

Sources
UBS shakes up board amid further losses – FT
UBS to Separate Businesses After Second-Quarter Loss – Reuters/NY Times
UBS to reorganise in three units – BBC News

Related posts:

• JPMorgan: Beats expectations despite writedowns
• Goldman loses $2.1 in the third quarter
• Merrill and Citi are the big losers this season
• $467 billion in writedowns and counting
• Writedown news: 13 Aug 2008

I wish it were not so, but it is increasingly obvious that every part of the financial sector in the United States is infected by this menacing plague of credit losses and writedowns. Now it comes to light that the five biggest U.S. credit unions have lost so much on residential mortgage-backed securities that it has wiped out their entire equity base.

The Wall Street Journal has issued a damning report today which suggests that losses at credit unions are large.

Five of the nation’s largest credit unions are reporting big paper losses on mortgage-related securities, a sign that housing-market distress is spreading even to the most risk-averse financial sectors.

The federal regulator overseeing credit unions says the losses are likely to be reversed when mortgage markets stabilize, and that the institutions are sound and adequately capitalized. But some outside observers are concerned that the credit unions are underestimating the depth of their mortgage-market problems.

“This is a serious situation,” says Gerald Hanweck, a finance professor at George Mason University, who studies the banking industry and is a visiting scholar at the Federal Deposit Insurance Corp. Mr. Hanweck believes the five firms have sufficient access to funding to handle a deeper downturn, but he worries that perceptions of added risk could lead to a run on one or more of them.

Credit unions are not-for-profit, member-owned cooperatives that take deposits and lend money like banks. The mortgage problems are focused on so-called corporate credit unions, which are key players in the industry. They don’t deal directly with consumers, but provide investment services and financing to regular credit unions, which do.

The five corporates showing big mortgage-related losses, according to federal regulatory filings, are U.S. Central Federal Credit Union; Western Corporate Federal Credit Union; Members United Corporate Federal Credit Union; Southwest Corporate Federal Credit Union; and Constitution Corporate Federal Credit Union. Together, they reported about $5.7 billion in “unrealized” losses as of the end of May, the filings indicate. Unrealized losses happen when the market value of a security falls, even if it hasn’t been sold.

Credit unions in general are among the most conservatively run financial institutions in the U.S. That some are showing strains indicates that almost no financial sector is immune from the mortgage meltdown that has caused widespread carnage among commercial banks and on Wall Street. Financial-services firms have already taken writedowns of more than $300 billion in connection with the mortgage mess.

-WSJ, 11 Aug 2008

The Wall Street Journal doesn’t take off the kid gloves here because $5.7 billion wipes these credit unions out. Housing Wire gets more to the point, also suggesting that some are trying to hide these losses.

Corporate credit unions aren’t consumer facing, but provide investment services and financing to more regular credit unions nationwide.

The $5.7 billion in losses on paper are enough to wipe out the net worth of each of the five credit unions, the Journal said; aggregate negative equity after accounting for so-called “unrealized” losses on the RMBS securities is $2.9 billion, although that total doesn’t account for membership capital, or the float of funds tied to regular credit unions.

A shell game?
The most explosive allegations in the Journal’s story, however, are that the two credit unions absorbing the biggest RMBS hits — U.S. Central FCU and Western Corporate FCU — are using accounting tricks to potentially hide further losses. The games being played here aren’t all that different from what’s being observed in other sectors, but take on new significance because credit unions don’t have ready access to new capital, a la Merrill Lynch & Co. and others.

Both credit unions earlier this year reclassified a huge chunk of their assets as “held for investment,” moving them out of the more traditional “available for sale” accounting category; it’s a shift that the federal regulator overseeing credit unions said had never been done in the industry’s past. It’s also a shift that means any valuation changes that are deemed temporary in nature don’t have to be recorded against income.

By June, U.S. Central had placed $10.9 billion of its $35.3 billion in investments into the “held for investment” category, according to the Journal, while Western Corporate has moved one-third of its total investments — $9.6 billion — into the same category. Both moves came as the secondary markets locked up and the companies say they decided it would be better to hold the assets until maturity (or they realized they’d never be able to sell an illiquid asset, take your pick).

But how much of the current depressed valuations of subprime and Alt-A — even the AAA-grade stuff — can honestly be considered “temporary?” At what point is an other-than-temporary permanent impairment charge warranted?

In our view, the two credit unions in question might be the last holdouts on Earth at this point still adamantly saying their securities will recover in value at some point, or that they’ll be able to hold them to maturity. More than a few commercial and investment banks strutted the same point out roughly two quarters ago, and have since abandoned the line of thought as the mess has come into clearer view.

-Housing Wire, 11 Aug 2008

Read these stories again. What we have here are financial institutions that are effectively bankrupt. Were they to sell these assets and take the loss, they would have to be declared insolvent. The NCUA (the Credit Union’s equivalent of the FDIC) would have to step in. For some, this may come as no surprise. However, this event only represents the tip of the iceberg of what is lurking out there in hidden losses, not just at financial institutions, but at Pension Funds and Mutual Funds as well.

The regulators are nonplussed about the whole affair. The Wall Street Journal says:

Kent Buckham, director of the office of corporate credit unions for the National Credit Union Administration, the federal regulator, says the mortgage investments held by corporate credit unions are safer than many that are causing havoc on Wall Street, and are very likely to rebound in value. In his view, the paper losses reported by the corporate credit unions reflect unrealistically low market values for mortgage investments, in part due to investor nervousness about the sector. He says he doesn’t expect the firms will have to sell those assets at “fire-sale prices.”

I thought credit unions were supposed to be conservative institutions — apparently not. In my view, This is just the type of wishful thinking and loss aversion I wrote about a couple of days ago. It’s only a matter of time before the Grim Reaper comes calling for some of these financial institutions. Uninsured depositors should rightly start to become worried at this state of affairs.

The U.S. Government needs to hive off these bad debts into a Resolution Trust Corporation-
like entity NOW before we see more bank runs and systemic risk. The longer Bush & co. dither, the greater the likelihood for an disorderly unwind.

Related posts:

• Bank consolidation and getting positive about the credit crisis
• Credit Unions aren’t immune
• Two largest wholesale credit unions seized
• AMEX credit card trouble deepens bank worries
• The global credit crunch hits New Zealand institutions

Let’s hope the UBS earnings report is not as bad as Merrill. If you recall, Citi, Merrills and UBS are the three worst offenders when it comes to writedowns. Given the recent asset sales by RBS and Merrill, one would expect to see some real ugliness at UBS tomorrow. Stay tuned.

The pressure is growing to make some radical moves, after a series of challenges:

• The bank’s writedowns on bad credit investments are expected to reach $43 billion.
• A settlement was announced Friday with U.S. regulators to buy back as much as $19 billion in auction-rate securities.
• The bank’s private-banking business is fighting to keep lucrative clients amid a tax-evasion investigation.

Among the options being aired: the sale of a UBS money-management unit in the U.S., formerly known as PaineWebber, and the separation of its troubled investment bank into an independent unit.

-WSJ, 11 Aug 2008

Related posts:

• Citi close to selling German unit
• UBS woes with IRS have Swiss worried
• Mortgage insurers will trigger further writedowns
• UBS writes down another $5 billion
• Didn’t Merrill just write down over $9 billion?

I’m getting a lot of mail about the Rosenberg post and my mea culpa on inflation. To be blunt, a lot of you think I’m out to lunch and Rosenberg is too — after all inflation is over 5% and that’s just the bogus CPI measure our governments release.

But, alas, there is method to my madness on inflation. Here’s my thinking:

My baseline argument is that the world’s central banks were way too easy with monetary policy after the recession of 2001 and 9/11. Basically, they saw a deflationary threat and panicked. The result has been inflation.

To be sure, there was plenty of inflation before 2001 — it was just channeled toward asset prices instead of consumer prices because the deflationary forces of China, India and the collapse of the Soviet Union brought a lot of workers into the global capitalist world. So, before the so-called deflationary threat, all of that excess money bid up only asset prices because global wage arbitrage kept it from hitting consumer prices (think DVDs, LCD screens, toys, clothes and so forth — all made in China).

However, once the global housing bubble collapsed, the asset class of choice became commodities and those same inflationary forces started to work their magic in the commodities sector. Unfortunately for central banks, commodities are an asset class that feed right into consumer price inflation. So the central banks have not had the same ability to reflate after the housing bubble because inflation is now popping up in consumer prices. As an inflation hawk, I was pretty vocal in calling out against the Fed’s easy money policy (I still think it’s wrong because it’s basically surreptitiously stealing money from citizens through devaluing the currency).

Funny thing is though — inflation has a way of killing consumer demand; it’s called demand destruction. So, the rise in food and oil prices has cratered demand for oil and really undercut consumption to the point where the global economy is in recession. Spain, Denmark, Germany, Italy, the U.S. and Canada have all recently posted negative or near zero GDP numbers. Japan looks to be in recession as well. There is no way inflation will continue to rise in this environment unless oil prices go back up due to some exogenous shock.

So, barring an Israeli-Iranian war or the like, we should expect oil to deflate to $100 a barrel and inflation to recede. Remember, core inflation (ex. food and energy) has yet to become too worrying. What does this mean for the global economy?

1. Expect inflation to push up for a few months due to unfavorable year-to-year comparisons, but then to recede starting near the end of this year.
2. The rise in oil has already done its damage: the global economy is in recession and this means jobs will be lost and companies will go bankrupt.
3. Writedowns from the housing bust will continue unabated because of the faltering real economy. This means stress for the financial sector.

And ultimately this confluence of events means credit availability will be in short supply. No credit = no growth = no inflation. In fact, financial services companies will be deleveraging i.e. cutting lines of credit to companies and individuals in order to shrink their balance sheets.

For example, if you were Morgan Stanley and the U.S. economy was headed for a protracted downturn would you

a. increase credit lines to homeowners, hoping it would single-handedly pull the economy out of recession?

b. restrict credit to bad companies and those with poor credit as you need to be prudent? or

c. Panic and reduce credit all around, especially HELOCs (Home Equity Lines of Credit)?

As you probably know from reading the news, the answer has been and will continue to be

c. it’s panic time on Wall Street, Bay Street and in the City of London.

Conclusion
The only conclusion I can draw from this is that the lifeblood of our capitalist system, credit, will be contracting and this means deflation is a real threat going forward. While I have been concerned about inflation up until now, the evidence coming out in the last few weeks suggests the global economy is in recession and that deflation is really what we need to be thinking about from here on.

Related posts:

• Quote of the day: William White and inflation
• The inflation-deflation debate
• Inflation or deflation?
• What is Inflation?
• Ireland gets deflation

Lloyds TSB announced first half results, a 70% fall in pre-tax profits. Yet, Lloyds’ management was confident enough to raise the dividend 2p a share to 11. 4p. This strikes me as completely out of touch with market conditions. In the midst of a credit crisis and on the back of a 70% fall in pre-tax profits and a prediction of more economic volatility to come, one does not raise dividends. Now is the time for banks to husband their cash.

A few weeks ago, Wells Fargo did exactly the same in releasing their earnings in the US. Perhaps Lloyds and Wells Fargo are looking to signal a lack of financial distress to the marketplace in order to reap some short term rewards in terms of security or to take over a more distressed rival. There are plenty of better ways to do that.

All that said, Lloyds looks to be amongst the best performing banks in Europe along with Santander, BBVA, and Credit Suisse. Note, however, that Lloyds took more than $1 billion in writedowns associated with losses due to the credit crunch.

Shares in Lloyds TSB fell 4 per cent in early trading on Wednesday after the group kicked off the UK banking interim results with a warning that “we expect a lower level of growth in the UK economy which will impact our business”.

The bank announced a 70 per cent fall in reported pre-tax profits to £599m, as asset writedowns and volatility in its insurance business hit the figures. However, underlying profits were up 11 per cent to £2.158bn and the interim dividend rises by 2 per cent to 11.4p.

Eric Daniels, chief executive, said the dividend increase was “a very positive signal” at a time when other banks were asking shareholders for extra capital or paying dividends in shares rather than cash.

He said there were “no guarantees” that the final dividend would also be increased, but suggested the interim rise was a “good indication”.

Some analysts have been expecting Lloyds to cut its dividend – perhaps at the year-end – because of its heavy exposure to a slowing UK economy, which they expect will lead to higher impairment charges on both its retail and commercial lending.

But Sandy Chen, at Panmure Gordon, said the dividend rise “signals Lloyds’ intention to trade through this credit crunch”.

-FT, 30 Jul 2008

Related posts:

• Nils Pratley: A tale of two banks at RBS and Lloyds
• Lloyds to raise 21 billion pounds in biggest rights issue ever
• Irish banks have unreported bad debt
• Quality financials are out there
• Bank of America cuts its dividend

Last week, we heard that Australia’s NAB had to take a massive writedown due to American CDO exposure (apparently triggered by Merrill Lynch). Yesterday, we heard about Australia’s ANZ Bank taking it on the chin to the tune of $1.2 million Australian.

Now, it’s New Zealand’s turn with the problems at the New Zealand Guardian Trust Company. The credit crunch continues to claim more victims globally. This is a truly international crisis.

The New Zealand Guardian Trust Company said it was suspending withdrawals and new investments in its Guardian Mortgage Fund which holds nearly $NZ250 million ($A195 million) for 3,700 investors.

“Due to current liquidity difficulties in the market, the fund is currently operating below its target liquidity rate of 5 per cent,” the company said.

“In such conditions this is not considered appropriate by the directors. In the interest of fairness among unit holders, the directors feel a cautious approach is necessary.”

- Sydney Morning Herad, 29 Jul 2008

Related posts:

• How Goldman profits from the credit crunch
• New Zealand in recession: who’s next in Asia?
• Recession nears in New Zealand
• Credit crunch hits autos, students and homes
• Bankrupt global financial institutions

I fully anticipate this will happen, so the question becomes: what will the Fed do?

The FDIC stepped in at two banks over the weekend, 1st National Bank of Nevada and First Heritage Bank. These banks failed as a result of construction loans in real estate bust regions of the US. No, surprise there. This is to be expected in a downturn and the FDIC was prepared.

But, the regional banks have been absolutely crushed over the past few months. Judging by their stock prices, equity investors expect some of them to go bankrupt. Fifth Third, Washington Mutual, National City, Huntington Bancshares, and KeyCorp are all down over 80% to mention a few names. The group as a whole is in deep trouble.

What’s more is the full brunt of the downturn has yet to be felt. In particular, souring commercial real estate and construction loans are going to be a theme oft-heard in the coming weeks and months. One other theme barely broached is land prices. Home builders have bought massive parcels of land in anticipation of an ever-increasing demand for housing. With house prices dropping dramatically, those purchases have devalued considerably, sometimes as much as 60-70%. Who do you think loaned the home builders money for these purchases? Regional banks.

So the stage is set for a major failure in the regional banking cohort — which brings us to the question of policy response. None of the major regionals has an explicit or implicit backstop from the U.S. Federal Reserve like the golden list of 19 do. Therefore, should a major regional bank go to the wall, it cannot expect a government guarantee like Freddie and Fannie. It should not expect the kid gloves treatment of Bear Stearns because systemic risk is less of a question. The best it could expect is an FDIC asset seizure, wiping out shareholders, but protecting insured deposits.

On the other hand, uninsured bank deposits are still at risk. Recent share weakness has been precipitated by rumors that Washington Mutual’s uninsured creditors are quietly pulling money from the company, weakening its liquidity position. Were WaMu to fail as a result of these liquidity concerns, a large chunk of the FDIC capital base would need to be used to fund the bank’s seizure as this would be the largest FDIC seizure by an order of magnitude. Therefore, it is likely that the FDIC would ask for more funds from taxpayers in order to shore up its own balance sheet. I fully anticipate that the FDIC will lack adequate capital to take over the banks which will fail over the next few years.

So, a regional bank will not get an explicit or even implicit backstop from the government and taxpayers. However, the magnitude of the problem is such that eventually the taxman must come calling for more money. Those individuals still under the impression that banking writedowns will not be nationalized in some form have a long overdue date with reality coming. Despite its free-market bluster and rhetoric, America is not so different from Japan.

Related posts:

• Michael Panzner: regional banks in trouble
• Regional banks: examples of risk from SoCal
• WaMu on the brink of disaster: has agreement with regulators
• Fifth Third takes on assets of Freedom Bank
• More warnings on regional banks

1st National Bank of Nevada and First Heritage Bank, operating in Nevada, Arizona and California were taken over by the FDIC on Friday. They always wait until Friday night to do their business. This marks the first FDIC closure action since the FDIC closed the much bigger IndyMac.

Bad loans to developers and home builders in Arizona and Nevada led to the failure Friday of an Arizona company’s two banks, including First Heritage Bank in Newport Beach.

The Federal Deposit Insurance Corp. seized the banks late in the day and turned over operations to Mutual of Omaha Bank, part of the large Mutual of Omaha insurance company.

All depositors, including those with deposits in excess of the FDIC’s insurance limits, will have their accounts switched to Mutual of Omaha Bank and will be covered for all their funds, the federal agency said.

“Customers should just think of it as two banks merging,” said FDIC spokesman David Barr.

Ten banks and thrifts have failed in the last 18 months, mostly because of the collapse of real estate markets inflated by years of easy-money lending by mortgage originators. The largest specialist in so-called alt-A loans — made to borrowers whose risk profile fell between prime and subprime — was IndyMac Bank, which collapsed this month and is being operated by the FDIC.

First Heritage and First National of Nevada were owned by First National Bank Holding Co. of Scottsdale, Ariz.

First Heritage, established in 2005, was mainly a deposit-taking franchise, specializing in homeowners associations, property managers such as condominium companies and similar enterprises.

-LA Times, 26 Jul 2008

This sort of thing is going to make people a bit more panicked about where they put their money. At least the FDIC has a ready made solution here.

The last three bank failures demonstrate that hot regions like Arizona, Nevada and California should expect to see a lot of failed banks associated with construction loans.

I’ve added them to my list of Bankrupt Global Financial Institutions.

Update: 509 EDT 26 Jul 2008 – Past FDIC closures of this ilk demonstrate that insured depositors do not have to worry about losing money. Whether taxpayers have to eventually top up the FDIC’s resources is another question altogether. But, some previous articles from TheStreet.com point out the pitfalls and benefits. For instance, ING acquired NetBank’s assets when it failed. But it did NOT acquire the uninsured deposits.

NetBank’s Failure Is Proof That Ratings Matter, The Street.com, 1 Oct 2007
Losing Half a Million on NetBank’s Fall, TheStreet.com, 3 Oct 2007
Ohio Bank Fails, TheStreet.com, 4 Oct 2007
Bad Management Sinks Bank, TheStreet.com, 28 Jan 2008

When a merger partner is found, that’s the best case scenario. But, as the NetBank case shows, that’s not always a happy solution if yo have more than $100,000 tied up in a bank. When an IndyMac-style closure happens, uninsured depositors should be frightened as well. This link shows you who is protected and who isn’t.

Related articles
Two More Banks Fail, WSJ
Mutual of Omaha Bank to Acquire Deposits of Failed First National Bank, Market Watch
Regulators Close Two More National Banks, Washington Post

Related posts:

• FDIC moves in at Great Basin Bank
• Two more FDIC Friday Night Specials brings total to 55 failed banks
• Banks seized by FDIC in Nevada and Illinois
• Silver State Bankruptcy: Another FDIC Friday Night Special
• FDIC closes banks in Michigan and California

The day is almost over for the market (thank goodness) and it seems that financal service investors are in panic mode again. The market is down over 250 points and some shares in financial services are down over 15%. What gives?

As we may soon find out, non-market based economic solutions, like the infamous SEC list of 19, always have unintended consequences. After a great rally in financial shares of more than 50% to the upside, we are having another bruising day — and for no apparent reason. It seems likely we have just seen the end of a terrific short-covering rally.

Since the SEC has scared the shorts out of financials in order to prop the sector up, fewer investors are willing to buy bank shares when they fall. This means we could see some gapping down in financials on minimal signs of stress in the sector. That leaves the weaker financials exposed to bankruptcy.

Certainly, the awful home sales data has a lot to do with the selling as homebuilders like Lennar are off over 20% on the day. But, one month’s housing data does not a trend make. Another possible reason for today’s market selloff in financials in particular is rumors about Washington Mutual’s solvency.

Washington Mutual Inc. tumbled more than 20 percent for a second day as Gimme Credit LLC said unsecured creditors were “pulling funds” from the biggest U.S. savings and loan.

Gimme Credit analyst Kathleen Shanley cited the decline in federal funds purchased and commercial paper to $75 million from $2 billion at year-end, which Washington Mutual reported this week in its second-quarter results. Securities sold under agreements to repurchase dropped to $214 million from $4.1 billion at the end of 2007, she wrote.

Washington Mutual, known as WaMu, reported a $3.3 billion second-quarter loss on July 23. Rising delinquencies forced the Seattle-based company to boost provisions for bad loans. While WaMu said it has enough capital after raising more than $7 billion earlier this year, Shanley said liquidity remains a concern.

“We won’t use the phrase `run on the bank,’ but we would be remiss if we did not observe that many creditors have quietly been pulling funds,” wrote Shanley, based in Chicago. Their actions are “presenting an increasing funding challenge,” she wrote. Gimme Credit is an independent research firm serving corporate bond investors.

-Bloomberg, 24 Jul 2008

Rumors don’t cause banks to implode. Inherent distrust and financial institution weakness do. Is anyone spreading rumor about Goldman or Credit Suisse? The ironic thing about this particularly ugly day is that Fannie and Freddie are both down over 15% when the government’s actions were suposed to stop selling pressure.

When selling pressure begins again in earnest, the weakest financial institutions will be exposed to downside pressure like never before — with no shorts to buy when their shares fall. A major financial sector bankruptcy will then be in the offing. And some home builders are sure to go down as well. These are some unintended consequences that are sure to anger taxpayers when the GSE and FDIC bills comes due.

Related posts:

• Market turmoil confirms FDIC’s tough position
• Brace yourself!
• Massive short covering at VW and massive losses for hedgies
• Financials: catching a falling knife
• Quality financials are out there