posted December 27, 2009
Financial Instability and Fragility–One Year Later

A year ago, October 2008, the U.S. economy was confronted with a classic banking panic. The panic led to an overnight crash of the credit system, followed by a collapse of business investment, consumer spending falling off a cliff, and mass layoffs beginning in November 2008 that for six months added nearly one million lost jobs a month when accurately calculated. Jobless numbers thereafter continued to rise, properly calculated, by 400,000 a month or more. Today total jobless levels are well over 20 million and the true unemployment rate more than 17%.

With bank stock prices having risen in recent months, and a flood of media and business pundits crowing that the banks have recovered, what do the facts and evidence say about the alleged recovery of the financial system in the U.S.? Are the banks now stable? Have they recovered? Indeed, has the economy itself now ‘recovered’ and the recession now coming to an end?

The Case of Reappearing ‘Bad Assets’

A year ago, then Treasury Secretary Henry Paulson handed Congress a blank check with his name on it for $700 billion and warned them to sign or else a total collapse of the banking system was imminent. He said he needed it to buy up the banks’ bad assets that were clogging their balance sheets and preventing them from lending. That would get the economy going again, Paulson said.

In the preceding weeks of September 2008 a series of big banks went bust or were collapsed into competitors, including Lehman Brothers, Washington Mutual, Merrill Lynch, Wachovia, and the Insurance giant, AIG. The stock market plummeted by several thousands of points. Credit markets one after the other froze up. Banks of all types and sizes were writing down and writing off hundreds of billions of dollars in losses due to collapsing housing markets and other strange assets like CDOs, CLOs, CDSs, and the like. The losses were bottling up their lending pipeline. Buying the bad assets that had collapsed in value was the answer to the crisis, proclaimed Paulson. So he was given the $700 billion to buy up the bad assets and clean up the housing markets. They called the plan to do so the TARP, for Troubled Asset Relief Program.

But Paulson didn’t buy the bad assets. Or clean up the housing markets. Or get the banks to start lending again. He didn’t buy the bad assets—because the banks didn’t want to sell them. At least not at their collapsed market prices, in many cases now 90% less than what they were originally worth. If they did sell them at their true collapsed market values, they would have had to write down even more losses on their balance sheets. Better to keep the bad assets there. At least that way they, the banks, might be able to manipulate their market value and indicate the assets were worth more than in fact they were.

Unable to buy the assets and clean up the banks’ balance sheets—which both banks and government agreed was the necessary first step to get ‘credit flowing—Paulson instead threw $125 billion at the nine biggest banks. He called their CEOs to his office and told they had to take the money whether they wanted to or not. He followed the disbursement by another roughly $125 billion to scores of regional and smaller banks. None of the $250 billion was used to purchase bad assets. Another $80 billion or so went to AIG in several installments. Tens of billions more to Citigroup and Bank of America in November. Nearly $20 billion to auto companies. By February 2009 less than $190 billion of the $700 remained. Once again, none of it expended to purchase ‘bad assets’. Throwing the $510 billion at the banks and other big businesses only served to temporarily plug an ever-growing black hole in their balance sheets, a hole being driven ever wider by the collapse of housing values caused by rapidly rising home foreclosures—the root of the problem which, of course, was never addressed.

When Barack Obama assumed office his new Treasury Secretary, Tim Geithner, former head of the New York Federal Reserve, attempted to repeat Paulson’s effort to buy up the banks’ bad assets, which of course were still on their books. Once again, we all were told that was the key to bank stabilization and economic recovery. As Obama himself said, the first task was ‘to get credit flowing again’. A kind of ‘financial trickle down’ approach.

Geithner created a new program to buy the bad assets, called the PIPP for short, or ‘Public-Private Investment Program’. A better term was ‘son of TARP’ or ‘TARP II’, for the program was little different from Paulson’s. This time, if the banks didn’t want to sell the bad assets to the government, the idea was to get them to sell them to each other and the government would pay both the sellers (the banks) and buyers (investors) a subsidy to encourage them to make the sale—a kind of ‘offer they couldn’t refuse’. Or so Geithner thought. However, once again, the banks simply did not want to sell their bad assets at anything less than what they originally paid for them. Kind of like someone refusing to sell one’s old junk car for anything less than what one bought it for originally.

So once again, this time under Obama, the bad assets were not sold and remained on banks’ balance sheets, clogging them up, and preventing banks from lending. As the New York Times reported on June 4, 2009, “many banks have refused to sell their loans, in part because doing so would force them to mark down the value of those loans and book big losses. Even though the government was prepared to prop up prices…the prices that banks were demanding have remained far higher than the prices investors were willing to pay?. Established in March 2009, the PIPP legacy loan program was dismantled in June.

And what are we talking about in terms of amount of bad assets they wouldn’t sell, one might ask? According to one reputable source, New York University economist, Nouriel Roubini, the amount of bank losses from bad assets at the time was approximately $1.8 trillion. According to that conservative institution, the International Monetary Fund, the IMF, banks have only been able to recoup half of those losses. About half the bad assets are still on their books, close to $1 trillion. Moreover, the IMF now predicts another $1.5 trillion in losses worldwide by 2010. So U.S. banks’ share and total of remaining bad assets will be somewhere around $1.5 trillion by 2010. This led the British business daily, the Financial Times, to remark on October 1, 2009 that “the financial sector’s dire state is essentially unchanged since the IMF’s previous report a half a year ago…there is still a huge hole in the world’s financial system almost as gaping as before…Notwithstanding a flurry of capital raisings, private markets cannot fill this gap.?
U.S. banks in other words still need to raise nearly $1 trillion in order to cover all the losses on their assets to date. And that doesn’t count losses that still may come.

Bank Lending Still Declining

Not surprisingly, the result of Paulson and Geithner having failed to buy up or otherwise clean up the bad assets on banks’ balance sheets has been a continuing decline in bank lending to non-bank businesses and consumers.

For example, in July 2009 a senior loan officer survey conducted by the Federal Reserve showed that lending terms and standards continued to tighten on all major loans to businesses and households compared to a previous April survey. “Demand for loans continued to weaken across all major categories except for prime residential mortgage.? Particularly tight were commercial and industrial loans important to most small and medium businesses, home equity lines of credit, and commercial real estate. This survey was corroborated by the U.S. Treasury’s monthly bank lending survey this past August. According to this second view, consumer loans fell 1% in June, Commercial and Industrial loans 2% for the month, and Commercial Real Estate by 1%. Declines of 1%-2% per month may not seem like much, until it is annualized. It means loans declining at annual double digit rates.

Another sign of still collapsed credit and lending is the current state of the so-called ‘securitized credit’ markets. These are markets where most auto loans, student loans, credit card debt, commercial property and even home mortgages are resold enabling non-bank businesses to raise money. In 2007 these markets represented $6.7 trillion of total credit issued in the U.S., about 13% of total U.S. gross domestic product. As much as $3.4 trillion in loans to commercial property—i.e. to build malls, office buildings, hotels, and industrial structures—were issued through these markets in the years preceding the financial collapse of 2007. In 2007 these markets issued more than $1.8 trillion in credit. In the past year, 2008, they issued less than $100 billion. And there is little sign of their revival. Without recovery, credit will remain relatively tight for auto loans, student loans, credit cards, and commercial property loans in particular.

The Obama administration and the Federal Reserve had proposed to resurrect the securtized markets with the second banking rescue program it launched last February, called the TALF or ‘Term Auction Lending Facility’. The hoopla at the time promised up to $1 trillion from the Fed to get them going. By mid-August 2009, however, only $29 billion of the potential $1 trillion had been spent and the Fed has already begun scaling back the TALF for all except for the commercial property markets.

The commercial property market itself is an indicator of still very serious problems in the financial system in the U.S. Commercial property sales have fallen 90% from pre-2007 levels, and prices for commercial properties have fallen by at least one third from peak levels in 2007. This has meant major write downs and losses for banks; those losses are projected to continue to rise sharply. Delinquency rates on securitized commercial property mortgages have been doubling and tripling every three to six months. Currently hundreds of billions of dollars in commercial property loan renewals are coming due without a market in which to obtain finance. Meanwhile, delinquencies on commercial property loans rose from barely 10% in 2006 to 34% by July 2009. Commercial property may well represent another ‘subprime’ explosion in the making.

Concerning the residential mortgage market, things are a little better but not much. Subprime mortgage delinquencies peaked at 25% of all such mortgages earlier in 2009. But now the fastest rate of increase in delinquencies is for ‘prime’ mortgage buyers. The prime mortgages represent 80% of all mortgages and now more are becoming delinquent than subprimes, according to the Mortgage Bankers Association. The total market impact could be far worse than subprimes eventually. Driving the rapid rise in prime mortgage delinquencies is the escalating jobless numbers, which so far show no sign of abating. There is a direct correlation between joblessness and delinquent prime mortgages. The 20 plus million unemployed and more to come may provoke still another residential mortgage market bust.

Still another indicator of the general depressed state of the financial markets in the U.S. today is the pending bankruptcy of a financial services firm called CIT Group. CIT Group’s importance is that it is a major lender to thousands of small and medium businesses. With $30 billion in debt and another $52 billion in credit default swaps derivatives at risk, should CIT go bankrupt it would represent the fifth largest bankruptcy in U.S. history. Thousands of small businesses would find themselves without credit. Moreover, unknown repercussions would occur with regard to other financial institutions holding its debt and credit default swaps.

Breaking the ‘CAMELS’s Back

The Federal Deposit Insurance Company, FDIC, is broke! This is the federal agency responsible for reimbursing average depositors when the bank in which they put their money goes broke. But the FDIC itself technically ran out of funds in the second week of October 2009. After bailing out more than a hundred banks to date and reimbursing depositors the FDIC’s insurance fund has been exhausted. Its choices are to have banks pay larger fees into the fund or to get the Treasury to give it a loan. But with hundreds more of bank failures on the horizon, it will need far more than a mere increase in member banks’ premium payments to its insurance fund. It will have to ‘borrow’ hundreds of billions from the Treasury before the current cycle of bank failures runs its course.

There are 8400 banks in the U.S. The big 19 largest own nearly two-thirds of total bank assets. The Obama administration’s policy is clearly that the big 19 are ‘too big to fail’. It will spend whatever is necessary to keep the big 19 from failing. To date, except perhaps for Goldman Sachs and a few others, the big 19 are mostly technically insolvent. But the other 8381 smaller regional and community banks are another story. They will be allowed to fold. And it is the FDIC’s responsibility to fund the depositor bailouts. Thus far about 100 of the banks under its jurisdiction have failed. The FDIC uses an internal rating method to determine if a bank is in danger of failing. It is called the ‘CAMEL’ system. C stands for capital. A for assets. M for management. E for equity. L for liquidity. And S for securities at risk. According to the CAMELS’ system used by the FDIC, for example, 54% of all California banks are unprofitable as of October 2009. Using this system the FDIC internally has determined that another 100 banks will require closing in the last three months of 2009. That’s 100 in three months compared to the 100 in the previous two years. There are also more than 800 banks on its ‘watch list’ as possible candidates for failure. Many of these are deeply exposed to local commercial property markets and their problems. As their problems deepen, so too will the number of bank failures. This writer has predicted more than 500 will fail in this cycle and require bailout. The number could run appreciably higher. The cost will be hundreds of billions of dollars. It will almost certainly have to borrow from the Treasury.

Phony Stress Tests and Phonier Accounting

The hype and spin prevailing the past several months nonetheless claims that the banks have been recovering. Just look at their new profits and the rise in their stock prices. But much of this is not real.

Back in March-April 2009 the Obama administration launched an effort to ‘stress test’ the big 19 banks. This testing was designed from the outset to show the banks were not insolvent, which of course they were. The government and banks negotiated the final results between them several times before the government released the results. The assumptions employed were exceedingly optimistic. The outcome was the banks were led to appear more profitable than they in fact were. The desired result of the entire project was to create an atmosphere in which bank stocks would rise. That in fact happened. Rising equity values means the banks can add these values to their otherwise depressed balance sheet. It appears as if they raised capital. It appears as if they have fewer losses. But appearances are deceptive and so was the entire process. Even the finance minister of Germany publicly dubbed them as phony tests where the results were predetermined.

One of the most important changes this past spring was the suspension of the ‘mark to market’ accounting rule. Instead of valuing their bad assets on their books at their true market value, the administration and Congress allowed them to suspend ‘mark to market’ accounting and assign values otherwise. This change, along with the Fed pumping trillions of $ into the banks since October, including allowing them to ‘borrow’ from the Fed at absurd 0.25% interest rates, combined to raise banks apparent profits. In turn their stock prices also rose. But it should be clear that banks’, even in the best of cases, have recovered less than half their original stock prices before the August 2007 bust. The same holds true for the stock market in general. It fell more than 50%, from a high of 14,400 to only 6,600. It has ‘recovered’ to only 9,300. That’s less than half the original decline recovered. Much of the stock market’s partial recovery to 9,300 was driven by the banks’ even faster stock price rise. So the rise in the stock market to 9,300 is itself partly built on phony bank stock engineered increases in profitability due to phony accounting and Fed subsidized loans to banks at 0.25%.

Turning to Junk

With bank lending still declining and the securitized credit markets still moribund, non-financial businesses have had to turn to the junk bond market in order to raise funds. To do so they have had to pay junk bond rates for such debt, often approaching 20%. The term of the debt has also become increasingly short term. Non-bank companies are thus taking on greater risk and larger debt payments to remain in businesses. This will result eventually in even greater financial instability and potential defaults for them.

Standard and Poors, the corporate rating agency, as estimated that company defaults from junk grade bonds will rise to a postwar high of 15%-16% by the end of 2010. More defaults will mean more bank write-downs and write-offs of declining assets later in 2010 and beyond. In short, another source of long term financial instability that is now being built into the system.

The largest companies are able to weather financial crises as have recently occurred much better than smaller or medium sized companies and better than consumers. They can obtain the highest grade bond credit, or sell commercial paper easily, or finance expansion out of their typical huge retained earnings funds. But smaller and medium sized companies and consumer must turn to banks for loans. And loan availability has been falling, for businesses and consumers alike. Businesses and at times even consumers can alternatively turn to finance companies. Or to junk bonds, as was described. But these sources come with a major cost of interest. In the longer run it results in greater debt levels, and greater debt servicing of principle and interest payments. That all builds toward greater financial fragility and instability over the longer run.

Consumers have been experiencing a similar ‘consumption fragility’ parallel to the continuing financial fragility on the banking side. Just as banks have not been able to rid themselves of much of their ‘bad debt’ as yet, so too have consumers not been able to unwind (or ‘deleverage’ as they say in financial circles) their bad debt overhang. At the beginning of 2009, consumer debt measured as a ratio to their disposable income was 133%. Today it has fallen to a mere 127%. Hardly a dent. That means that, like banks, consumers will not renew spending to any significant extent, just as banks are not lending to any significant extent, until more debt is first worked off.
Beyond the spin and hype of the moment, the scenario is not one that describes a healthy financial system that is able to generate a sustained longer term recovery.

Is There a ‘Recovery’ Underway?

Accompanying the general misrepresentation that the banks and financial system in the U.S. have now recovered and are on the way to growth once again is the no less erroneous conclusion that the non-financial economy has also now recovered from recession. However, it is difficult to see how the current situation represents a recovery in any sustained long term sense.

The $787 stimulus package has been a profound failure in terms of jobs creation. Efforts to loosen up credit availability to consumers have been repeatedly thwarted by bank and credit card lobbyists in Congress. Stock equity and retirement plan values have recovered less than a third of their initial collapse after August 2007. Consumption is still in decline, as is real earnings of the 90 million or so working-middle class. Industrial production decline has leveled off and select other indicators are no longer in freefall. But the absence of continued decline does not constituted ‘recovery’, despite media and government spin to the contrary. By late summer 2009 it appears the stock market recovery is stalling once again, and jobless numbers—even official and not fully accurate—show hundreds of thousands of new job loss every month with no end in sight. Well over 20 million are now unemployed and rising. The true jobless rate is somewhere between 17%-19%.

In terms of the real economy, the current situation at very best represents a possible ‘pause’ on the way down. What temporary and tepid recovery has occurred is due largely to the $200 billion or so in extra payments to social security recipients and the unemployed, neither of which will generate long term jobs and sustained recovery. Other temporary stimuli about to expire include the ‘cash for clunkers’ auto rebates, which have bought some time for that industry, and the first time homebuyer subsidy. Both have or are now coming to an end. In short, there is no sustained economic stimulus on the horizon.

The U.S economy at best, and only in select segments, is moving sideways. What there is of recovery is slight and will not be long-lived. The longer term scenario is more likely another downturn, or a ‘double dip’ or ‘W-shaped’ decline that is typical of Epic Recessions.

On the bank and financial side, financial fragility continues as a very real problem, just as consumption fragility continues to deteriorate on the real side of the economy. The banks have not come close to fully recapitalizing. New capital has among the most stable of banks increased less than a third of the total bad assets still on their books. Allowing those $ trillions of bad assets to remain on bank balance sheets may prove the single, most serious strategic error of the Obama administration in terms of financial instability. It is furthermore highly likely that the volume of ‘bad assets’ will continue to rise, as commercial property and other losses multiply in the months immediately ahead.

The banks simply can’t voluntarily recapitalize their way out of the crisis. And the administration has refused to take more aggressive action to ensure the problem of remaining bad assets is resolved, which is quite unlike what was done in the 1930s and even the late 1980s.

Obama’s Basic Strategy

After nine months the Obama administration’s basic strategy for addressing the banking crisis is becoming increasingly clear. That strategy is simply to stem the decline and hold the line, i.e prevent further collapse, and thereafter rely on the market to do the rest. It is essentially a market strategy, for the reliance ultimately is on the financial markets to correct themselves. The strategy is not to clean up the banks by whatever means necessary—i.e. get rid of the bad assets. The strategy is to offset bank losses with taxpayer funding until such time the banks can raise private capital sufficiently to offset losses themselves and return to lending once again. The first presumption is they can raise all the necessary capital (which is doubtful). The second presumption is that once they have, they will then return to lending to non-financial businesses and consumers (which they still may not).

The strategy is similar for the real, non-financial side of the economy. The administration has not focused seriously on creating jobs to offset the 20-25 million that have been lost. The Obama stimulus was not a jobs bill. Nor is one likely to be passed as the jobless numbers continue to rise. Nor has the administration proposed to do anything about the 8 million home foreclosures, apart from token measures addressing a very small fraction of the probem. The Obama stimulus bill focuses on restoring parts of the previously shredded ‘safety net’ for the unemployed. More unemployment benefits, health insurance subsidies for the unemployed, and the like. That is, the strategy is to try to pub a floor under the massive consumption collapse now being driven by jobless numbers not seen since the opening years of the 1929-30 of the great depression. It too is a ‘holding strategy’, buying time to wait for the market to turn around on their own and restore jobs.

In other words, don’t clean up the bad assets, just plug the gaping black holes on banks balance sheets at taxpayer expense. Don’t launch a major jobs creation program, just spend some money to ease the consumption collapse and pain of the unemployed. Don’t stop the foreclosures, just help builders and lenders get new owners into the properties being foreclosed. Do this and wait for the markets to return to health and they’ll return the economy to healthy lending, jobs creation, housing sales.

But while this ‘hold and wait for the markets to revive’ strategy remains, the fragility of the financial system continues to deteriorate while the fragility of the consumer continues to worsen as well. As banks don’t lend, businesses stave off default by adding more debt. More debt means greater fragility and potential defaults in the future. Consumer fragility rises as well, as incomes fall and prevent consumers from working off previously record debt levels. Fragility is a function of both rising debt and falling incomes. While the administration, Fed, the press, and business pundits trumpet their best to assure us that the recession is ending, beneath the surface the fragility is growing—i.e. the economic rot is still deepening. It will not take much of a ‘shock’ event for a system in which fragility is worsening to set off a subsequent financial crisis and/or further consumption collapse.

The huge magnitude of the bad assets still remaining on bank balance sheets is no doubt a major constraint for the administration. So is the now apparent refusal of the administration, the Fed, and the Congress to incur more fiscal stimulus to create more jobs or fund more bank bailouts should either of these mean the U.S. incurring an even greater deficits. The rising deficits are increasingly threatening the stability of the U.S. currency, the U.S. dollar, in global markets. The value of the dollar will undergo a freefall should deficits rise appreciably higher, the administration has determined. In this case, they are probably right. Should deficits accelerate further, the U.S. will not be able to continue to borrow from China, the petro-economies, or elsewhere to finance its escalating budget deficit. The Obama administration has therefore made the decision—as was clearly signaled by Bernanke and Geithner—to protect its ability to borrow to cover deficits and thereby to protect its currency in international markets over ensuring a more rapid domestic recovery.

The over-riding important strategic shift at mid-year 2009 is that the Obama team is now willing to accept a slower domestic economic recovery, or perhaps even a renewed downturn, to protect the dollar. International considerations now prevail over domestic.

And that is truly ironic. This was the same dilemma that occurred in 1932, when the U.S. federal reserve decided to protect the currency by raising interest rates, which in turn contributed in a major way to descent and transition from Epic Recession in the summer of 1932 into a full blown depression in the fall of 1932. Ironic all the more, since this is precisely what Fed chairman Bernanke, and many monetarists like him, maintain was the primary cause of the depression—i.e. the Fed deciding to support the dollar and the gold standard at the expense of the domestic economy. It is pure historic irony that Bernanke’s policies have led to this precipice once more, despite his having pledged in 2002 to Milton Friedman, the prince of monetarists, that we now knew how to prevent depression; we will not allow the Fed to make the same error again, in other words. But it has. And it is.

Jack Rasmus
October 4, 2009

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