Financial 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 added nearly one million lost jobs a month when calculated accurately. Jobless numbers thereafter continued to rise by 400,000 a month or more. Today, total jobless levels are well over 20 million and the true unemployment rate more than 17 percent.

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 say about the alleged recovery of the financial system in the U.S.?

In October 2008, 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.

In the preceding weeks a series of big banks had gone bust or collapsed into competitors—including Lehman Brothers, Washington Mutual, Merrill Lynch, Wachovia, and the insurance giant, AIG. The stock market plummeted by several thousand points. Credit markets froze. 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 the lending pipeline. Buying the bad assets 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 this plan TARP (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 because the banks didn't want to sell these assets at their collapsed market prices, in many cases 90 percent less than what they were originally worth. If they did, 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 the banks might be able to manipulate their market value and claim 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 and told them to take the money whether they wanted to or not. He followed this disbursement by another (roughly) $125 billion to scores of regional and smaller banks. Another $80 billion or so went to AIG in several installments. Tens of billions more went to Citigroup and Bank of America in November. Nearly $20 billion went to auto companies. By February 2009 less than $190 billion of the $700 billion remained. None of it was used to purchase bad assets. Throwing the $510 billion at the banks and other big businesses only temporarily plugged an ever-growing black hole in their balance sheets, a hole being driven ever wider by the collapse of housing values caused by 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 were still on their books. Once again, we were told that this was the key to bank stabilization and economic recovery. As Obama said, the first task was "to get credit flowing again."

Geithner created a new program to buy the bad assets called PIPP (Public-Private Investment Program). A better term would have been TARP II. This time, if the banks didn't want to sell the bad assets to the government, the idea was for the banks to sell them to each other and the government would pay both the sellers and the buyers a subsidy to encourage them to make the sale. Or so Geithner thought. However, once again, the banks did not want to sell their bad assets for anything less than what they originally paid for them.

So, once again, the bad assets were not sold. 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 is the total amount of bad assets, 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 the conservative International Monetary Fund (IMF), banks have only been able to recoup half of those losses. About half 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' total remaining bad assets will be somewhere around $1.5 trillion by 2010. This led the British 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.... [T]here 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."

 
Bank Lending Still Declining

Not surprisingly, Paulson's and Geithner's failure to buy up or otherwise clean up the bad assets has resulted in 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: "Demand for loans continued to weaken across all major categories except for prime residential mortgage." Particularly tight were the commercial and industrial loans crucial 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 their report, consumer loans fell 1 percent in June, commercial and industrial loans 2 percent, and commercial real estate by 1 percent. These monthly declines may not seem like much, but when annualized, it means loans are declining at double digit rates.

Another sign of still collapsed credit and lending is the current state of the so-called securitized credit markets where most auto loans, student loans, credit card debt, commercial property, and even home mortgages are resold in order for non-bank businesses to raise money. In 2007, these markets represented $6.7 trillion of total credit issued in the U.S., about 13 percent 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 2007 financial collapse. In 2007 these markets issued more than $1.8 trillion in credit. In 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 securitized markets with the second banking rescue program launched last February, called TALF (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 TALF for all except the commercial property markets.

The commercial property market is an indicator that there are still serious problems in the U.S. financial system. Commercial property sales have fallen 90 percent 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, losses 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 financing. Meanwhile, delinquencies on commercial property loans rose from barely 10 percent in 2006 to 34 percent 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 percent of all such mortgages earlier in 2009. But now the fastest rate of increase in delinquencies is for prime mortgage buyers. Prime mortgages represent 80 percent of all mortgages and now more are becoming delinquent than subprimes, according to the Mortgage Bankers Association. Driving the rapid rise in prime mortgage delinquencies are 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.

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, a major lender to thousands of small and medium-sized businesses. With $30 billion in debt and another $52 billion in credit default swaps derivatives at risk, if CIT goes bankrupt, it would represent the fifth largest bankruptcy in U.S. History and thousands of small businesses would be 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 their bank goes broke. The FDIC technically ran out of funds in the second week of October 2009. After bailing out more than 100 banks to date and reimbursing depositors, the FDIC's insurance fund has been exhausted. With hundreds more 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 8,400 banks in the U.S. The 19 largest own nearly two-thirds of total bank assets. The Obama administration's policy is clearly that these are too big to fail and that it will spend whatever is necessary to keep them afloat. To date, except perhaps for Goldman Sachs and a few others, the big 19 are mostly technically insolvent. But the other 8,381—primarily smaller regional and community banks—will be allowed to fold and it is the FDIC's responsibility to fund depositor bailouts. The FDIC uses an internal method to determine if a bank is in danger of failing called the CAMELS rating system: C stands for capital adequacy; A for asset quality; M for management quality; E for earnings; L for liquidity; S for sensitivity to market risk. According to this system, 54 percent of all California banks are unprofitable (as of October 2009) and another 100 banks will require closing in the last 3 months of 2009. That's 100 in 3 months compared to the 100 in the previous 2 years. There are also more than 800 banks on its watch list as possible candidates for failure. Of these, this writer has predicted more than 500 will fail in this economic cycle and require bailout. The cost will be hundreds of billions of dollars, some of which will almost certainly have to be borrowed from the Treasury.

The hype and spin prevailing in 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. Much of this is not real. In March-April 2009, the Obama administration launched an effort to "stress test" the big 19 banks. The government and banks negotiated the final results between them several times before the government released the results, which showed the banks as 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 meant the banks could add these values to their otherwise depressed balance sheet so it appeared as if they had raised capital and had fewer losses. But appearances are deceptive and so was the entire process. Even the finance minister of Germany dubbed them as phony tests with predetermined results.

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 banks to suspend mark to market accounting and assign values otherwise. This change, along with the Fed pumping trillions of dollars into the banks—including allowing them to borrow from the Fed at an absurd 0.25 percent interest rate—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 value since before the August 2007 bust. The same holds true for the stock market in general. It fell more than 50 percent, 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. Also, much of the stock market's partial recovery was partly built on engineered increases in profitability due to phony accounting and Fed subsidized loans.

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

Standard and Poors, the corporate rating agency, has estimated that company defaults from junk grade bonds will rise to a postwar high of 15 to 16 percent 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 is now being built into the system.

The largest companies are able to weather financial crises 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 consumers must turn to banks for loans.

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, 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 percent. Today, it is 127 percent, which is hardly a dent. This 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 worked off.

 
Is There A Recovery Underway?

Accompanying the general misrepresentation that the financial system in the U.S. has now recovered is the no less erroneous conclusion that the non-financial economy has also recovered. It is difficult to see how the current situation represents a recovery in any sustained long-term sense.

The $787 billion 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 are 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.

In terms of the real economy, the current situation at very best represents a 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 and there is no sustained economic stimulus on the horizon.

The U.S. economy, at best, and only in select segments, is moving sideways. 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, 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 dollars of bad assets to remain on bank balance sheets may prove the single most serious strategic error of the Obama administration. 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 is resolved.

 
Obama's Basic Strategy

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

The strategy is similar for the non-financial side of the economy. The Administration has not focused seriously on creating jobs to offset the 20 to 25 million that have been lost. The Obama stimulus is not a jobs bill or is one likely to be passed even as the jobless numbers continue to rise. Nor has the Administration proposed to do anything about the eight million home foreclosures, apart from token measures addressing a very small fraction of the problem. Rather, the Obama stimulus bill focuses on restoring parts of the previously shredded safety net for the unemployed: more unemployment benefits, health insurance subsidies, and the like. That is, to try to put a floor under the massive consumption collapse now being driven by jobless numbers not seen since the opening years (1929-30) of the Great Depression. It is a holding strategy. Wait for the markets to return to health and they'll return the economy to healthy lending, job creation, housing sales.

But the fragility of the financial system continues to deteriorate while the consumer situation worsens. As banks don't lend, businesses stave off default by adding more debt. More debt means greater fragility and potential defaults in the future. It will not take much of a shock event to set off a subsequent financial crisis and/or further consumption collapse.

The rising deficits are increasingly threatening the stability of the U.S. currency in global markets. The value of the dollar will undergo a freefall should deficits rise appreciably higher. This would mean 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 made the decision—as was clearly signaled by Bernanke and Geithner—to protect its ability to borrow and its currency in international markets.

The overriding important strategic shift at mid-year 2009 is that the Obama team is now willing to accept a slower domestic economic recovery, perhaps even a renewed downturn, to protect the dollar. International considerations now prevail over domestic. This was the same dilemma that occurred in 1932, when the U.S. Federal Reserve decided to protect the currency by raising interest rates. This in turn contributed to descent and to transition from epic recession in the summer of 1932 into a full blown depression in the fall. This is truly ironic, since this is precisely what Fed Chair Bernanke, and many monetarists like him, maintained 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. 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 and would not allow the Fed to make the same error again. But it has. And it is.

Z