Monday, April 6, 2009

Unsustainability of the Decline of the Global Economy Is Not Cause for Jubilation

Here is where we have been:

April 1 - Bloomberg (Simone Meier):  “German plant and machinery orders extended a record decline in February… Orders dropped 49% from a year earlier after declining an annual 42% in January…

March 31 - Bloomberg (Chris Kirkham):  “Ukraine’s economy shrank between 25% and 30% in the first two months of the year, President Viktor Yushchenko said…”

Here is where we may be going:

April 6 (Bloomberg) -- About 53 percent of U.S. companies that issued high-risk, high-yield bonds will default over the next five years, according to Jim Reid at Deutsche Bank AG.

APRIL 6:  Soros told Reuters Financial Television that rescuing U.S. banks could turn them into "zombies" that suck the lifeblood of the economy, prolonging the economic slowdown. . .

The recovery will look like "an inverted square root sign," Soros said: "You hit bottom and you automatically rebound some, but then you don't come out of it in a V-shape recovery or anything like that. You settle down -- step down."

Much digital and newsprint ink has been spilled over the strong stock rally and some hopeful signs of economic rebound, and the strong chance that given the enormity of the stock and economic selloffs, more upside surprises remain for both the above.  However, please consider this (from RGE Monitor, subscription required):

    Overview: Stress test results are expected by the end of April. Banks then have six months to raise private capital if found to be undercapitalized. Meanwhile, Treasury plans to have the PPIP for toxic assets in place in order to facilitate the quest for private shareholder capital (application deadline extended to April 24). Critics of the stress tests say that the Treasury's stress scenario looks more like the unfolding baseline scenario. Moreover, as details about the current legacy loan valuations on banks' books emerge, doubts increase about the viability of matching buyer and seller interest without a huge subsidy--> Sifting Through Past FDIC Troubled Asset Auctions: Average 56 Cents on Dollar Value Implies Additional $1 Trillion Writedowns. The public and Congress are increasingly concerned about too many incentives to private investors, whereas Treasury has only $50bn in TARP money left after PPIP and TALF to make it work without resorting to Congress or nationalization--> see Are Banks To Buy Toxic Assets From Each Other?
  • April 6, Mike Mayo (via Bloomberg): Loan losses may exceed Great Depression levels and the government may be forced to take over large lenders. “New government actions might not help as much as expected, especially given that loans have been marked down to only 98 cents on the dollar, on average.”--> FASB Eases Mark-To-Market Rules For Toxic Assets: Will Banks Prefer To Keep Them?
  • cont.: Mayo said he expects loan losses to increase to 3.5 percent, and as high as 5.5 percent in a stress scenario, by the end of 2010. The highest level of loan losses in the Great Depression was 3.4 percent in 1934, according to the report. In the 3.5% loss rate scenario, Mr. Mayo said banks will lose between $600 billion and $1 trillion over the next three years, more than the roughly $400 billion in write-downs they've taken on risky investments.
  • cont.: Mortgage-related losses are about halfway to their peak, while credit-card and consumer losses are only a third of the way to their expected highest levels, according to Mayo
  • Among the banks Mr. Mayo rates "underperform" are: Bank of America Corp., Citigroup Inc., Comerica Inc., J.P. Morgan Chase & Co., PNC Financial Services Inc. and Wells Fargo & Co. An "underperform" rating means the stock is expected to perform up to 10% worse than the broader market over the next year. 
  • cont.: The U.S. government cannot provide much relief because its actions will lead to either banks having to raise new capital or toxic assets remaining on banks’ balance sheets. Solutions to the banking crisis will take time, as the increase in risk happened over a decade or more.
  • cont.: "Nationalization of banks remains a possibility because government policy remains unclear." 
  • cont.: The "seven deadly sins" of banking include greedy loan growth, gluttony of real estate, lust for high yields, sloth-like risk management, pride of low capital, envy of exotic fees, and anger of regulators.
  • April 6, Meredith Whitney: Banks will continue to write down their mortgage assets as home prices decline further than lenders expected. The unemployment rate also has exceeded banks’ projections and could lead to further loan losses
The above is cautionary.  In addition, Ms. Whitney now expects a total of 50% peak to trough declines in housing prices, something which is nowhere close to expected by financial companies (CNBC interview today).  She also believes that the ongoing shrinkage of credit lines is an underappreciated headwind for consumer spending.

What strikes one in the above writeup is that financial companies have 6 months to find capital if they fail a stress test.  In other words, the administration is slow-walking things, hoping for better times.

No matter some hopeful signs and potentially some positive spin during the upcoming quarterly earnings reports about the future (no one is being prosecuted under Sarbox no matter how flagrantly they exaggerate), several recent forward-looking indicators continue to deteriorate, including the Conference Board's Employment Trend Index, which reported today that all 8 of its components declined in March, of which several have clear forward-looking predictive value.

Putting all the above together, a coherent story from the best of the best is that short-term market fluctuations are beyond predicting, but many headwinds remain for the economy and government policy remains weighted toward far too much favoritism toward Big Finance with far too little consideration for the Little Guy or the Medium Guy.

Governments need to stop such insanity as New York State passing a budget that increases spending 9%; they need to recognize that matters are opposite in many ways to the 1930s in that Keynes has been misused to justify overpromising and overspending for over 70 years; and they need to encourage the public to save.  We cannot attain a balanced prosperity by the hair-of-the-dog strategy of money printing and piling more and more debt upon all the existing debt.  The best time for an alcoholic to stop drinking is always the time:  NOW.

Until the U. S. and its followers such as the U. K. cure their debt addictions and return to a culture of saving, all the jigs and jags of the economy and good months or quarters for stocks will be irrelevant, as the fundamental problem of unsound financial practices will remain and, if the Obama administration gets its way, these practices will be rewarded.

Copyright (C) Long Lake LLC 2009

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