It’s the writedowns, stupid

This is a post I wrote yesterday at naked capitalism.

Today, I want to make the case for seeing writedowns as central to this global downturn. To do so, we need to rewind and compare what is going on today with what we have experienced in the past. Drawing on this comparison, I can demonstrate that traditional policy tools are likely to be ineffective today. Moreover, the present course of action will also prove inadequate. Other more aggressive means must be applied in order to ensure a more stable banking system and a path to recovery. Likely remedies will include a reorganization of large swathes of the U.S. banking system.

Now, looking back, if one hearkens back to 1992 and the election that took Bill Clinton to the White House, ‘it’s the Economy, stupid’ was the phrase that symbolized Clinton’s victory and George H. W. Bush’s defeat. Today, as we are mired in a deep economic downturn, we should be tempted to bring back that phrase.

But, 2008 was not 1992. This is no garden variety downturn. It is something altogether different. We are not witness to a case of over-production and overheating as is usually the case. It is a case of over-leverage and over-indebtedness. As a result, the key to the outlook for the American economy is fairly simple and it hinges on a single word: credit.

My view of credit
The way I see it, our economic system is not built on work today for money today to consume today. Rather, we work in order to consume today and into the future. The mechanism through which we make this inter-temporal transfer is credit.

Think about any particular year in which you have worked. Certainly, you bought goods and services to consume straight away. But you also purchased homes, cars, television sets, shoes, washer/dryers, and tennis rackets, all to be ‘consumed’ today and into the future. In effect, you were using money in the present in order to consume later.

Now, here’s the thing. Irrespective of whether you saved money from past earnings to buy those goods and services or bought those goods on credit, it was credit that was always behind the transaction. Had you saved, ninety-percent of your savings was loaned out as credit by your bank as soon as you deposited the funds. And if you bought on credit, you were the recipient of a credit loan yourself. No inter-temporal transactions could ever occur without credit. So, in a very real sense, credit is at the core of our system (a longer explanation is here).

Garden-variety recession
In a normal recession, credit becomes tight, but it is not central to the downturn. In fact, 80% of the decline in GDP is due to a de-stocking of inventory. Basically, businesses get ahead of themselves and forecast future demand that turns out not to exist. They are forced to ratchet back production and sell off inventories. In this case, policy makers can step in with fiscal and monetary stimulus and re-kindle domestic demand with a bit of a lag. Bing, presto, we are off to the races again. That’s why recessions are over in 12-18 months tops.

Depression
That’s not what happens in a depression – and this is a depression. In a depression, what happens is macro disequilibria build up so much and become so unsustainable that when the break in demand happens, there is no bing, presto from traditional policy responses. The leverage and debt in the system is just too large. The debt cannot be worked off without de-leveraging (See my post “De-leveraging“).

Ray Dalio of Bridgewater Associates did a fantastic job of explaining this process in a Barron’s interview last month.

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…

Barron’s: 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?

Dalio: 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.

For more on this, see my post “A conversation with Bridgewater Associates’ Ray Dalio“

Increasing credit
This is what is happening now. The problem is that while all this is ongoing, the institutions that issue credit, financial institutions, are hemorrhaging losses. After all, de-leveraging means institutions are selling out of necessity, not out of opportunity. And when everyone’s a seller and few are buyers, asset prices fall and massive losses are the order of the day. When banks lose money, they have less capital and when their capital gets low enough they can’t lend. Less lending = less credit = less growth. So, if we want to get the economy back on its feet, we need to increase lending.

And that is certainly what the alphabet soup of government programs are about: the TALF, the TARP and the TLGP. That’s what the bailouts have been about too. All of this has been done in an effort to recapitalize our banks so that they can start lending again.

It’s the writedowns, stupid
The problem is the writedowns. You see, if you get $30 billion in capital from the government, but lose another $40 billion because of credit writedowns and loan losses, you aren’t going to be lending any money. To me, that says the downturn will only end when the massive writedowns end, not before.

The U.S. government has finally realized this and is now moving to stem the tide. Their efforts point in four directions:

1. Increase asset prices. If the assets on the balance sheets of banks are falling, then why not buy them at higher prices and stop the bloodletting? This is the purpose of the TALF, Obama’s mortgage relief program and the original purpose of the TARP.
2. Increase asset prices. If assets on the balance sheet are falling, why not eliminate the accounting rules that are making them fall? Get rid of marking-to-market. This is the purpose of the newly proposed FASB accounting rule change.
3. Increase asset prices. If asset prices on the balance sheet are falling, why not reduce interest rates so that the debt payments which are crushing debtors ability to finance those assets are reduced? This is why short-term interest rates are near zero.
4. Increase asset prices. If asset prices on the balance sheet are falling, why not create Public-Private partnerships to buy up those assets at prices which reflect their longer-term value? This is what Geithner’s Capital Assistance Program is designed to do.

So I lied, there is only one direction the government is headed: increase asset prices (or, at least keep them from falling). Read White House Economic Advisor Larry Summers’ recent prepared remarks to see what I mean. (Summers on How to Deal With a ‘Rarer Kind of Recession’ – WSJ)

Sure, there is always quantitative easing a.k.a. printing money. But, this is inflation pure and simple. It is the effective equivalent of a partial default on payments in that the value of money erodes the real burden of debt. This is also known as beggar-thy-neighbour and leads to nasty protectionist retaliation or competitive currency devaluations — not a very good backup plan.

Better is an increase in real incomes for ordinary Americans, something Summers does discuss in his speech from a few days ago when he discussed President Obama’s stimulus package.

These plans are not going to work
As aggressive as this campaign by the U.S. government is, it will have limited effectiveness because the extent of the writedowns of assets already on the books is going to be too massive.In fact, there are four asset classes where we should expect significant further deterioration in quality (see my post “Top ten predictions for the 2009 global economy” for a longer version of this section):

1. Residential Property. There is significant evidence that residential property distress has moved well into the Alt-A and Prime classes of borrowers.
2. Commercial Property. There is equally ample evidence that the commercial real estate market is imploding (see posts here and here). There will be huge writedowns in this asset class in 2009.
3. Leveraged Loans and High Yield. In February downgrades were outpacing upgrades 49 to 6. Heavy losses are likely to occur due to defaults. (see the FT analysis here).
4. Credit Cards, Auto Loans, and Student Loans. Credit card default rates were at the highest in 20 years in February. Meredith Whitney has been beating the drum about this. She sees credit cards losses taking on tsunami proportions.

The U.S. banking system is effectively insolvent
So, it should be pretty clear that we have some serious losses still left to work through in the financial sector. I reckon the U.S. banking system is effectively insolvent. This is what Nouriel Roubini means when he says there will be $3.6 trillion in writedowns before this is all over. This means that banks do not have adequate capital to absorb the likely losses facing them later this year.

To date we have addressed this problem by throwing more money at it — bailing out the banks and attempting to prevent asset prices from falling. I predict this solution will lead to another panic if continued indefinitely. (Remember, between now and the summer or fall, the unemployment rate could reach 9-10%, while home prices would still be falling and default rates rising.) American citizens would realize the system is insolvent and would cease to trust that a reasonable solution was in the offing.

Confidence in America’s banking system is already lacking, especially in the large banks and large regional banks. This confidence can only be restored if banks are adequately capitalized now and in the future. Were we to suffer another round of major writedowns and capital injections into major institutions, I expect all confidence would be lost and bank runs would begin in earnest. This must be avoided at all costs.

Given the lack of capital the banking system now has and the likely level of writedowns, many institutions are fundamentally insolvent. They must, therefore, be liquidated or nationalized BEFORE confidence in the system is lost and bank runs occur.

Buying up assets at inflated prices, halting mark-to-market, and reducing interest rates to zero will not reduce the problem assets on bank balance sheets enough to avoid further massive writedowns.

Conclusion
In sum, most available evidence suggests bank writedowns will be massive — perhaps larger than the present capital base of the U.S. banking system. While, present measures of recapitalizing and bailing out faltering institutions and buying up toxic assets may prove adequate to prevent further writedowns and capital erosion, I would rather err on the side of caution.

Caution dictates an aggressive response — one which should include nationalization or liquidation of a significant number of banking institutions. Anything less is wishful thinking, the consequences of which could be very dire indeed.