The Fake Recovery

I last posted on Thursday before the Easter Holidays in two posts very much at odds with one another.  The overall thrust of the first post was that the financial services industry in the United States was due to gain from some very advantageous circumstances in 2009.  Meanwhile, the later re-post pointed out the continued fragility of the U.S.  economy and banking system and focused on liquidity and solvency as unresolved issues.  I would like to bring these two posts together here because I believe the concept behind the dichotomy is best described as the Fake Recovery.

Why ‘Fake’?  This is a fake recovery because the underlying systemic issues in the financial sector are being papered over through various mechanisms designed to surreptitiously recapitalize banks while monetary and fiscal stimulus induces a rebound before many banks’ inherent insolvency becomes a problem.  This means the banking system will remain weak even after recovery takes hold.  The likely result of the weak system will be a relapse into a depression-like circumstances once the temporary salve of stimulus has worn off.  Note that this does not preclude stocks from large rallies or a new bull market from forming because as unsustainable as the recovery may be, it will be a recovery nonetheless.

The real situation

In truth, the U.S. banking system as a whole is probably insolvent. By that I mean the likely future losses of loans and assets already on balance sheets at U.S. financial institutions, if incurred today, would reveal the system as a whole to lack the necessary regulatory capital to continue functioning under current guidelines. In fact, some prognosticators believe these losses far exceed the entire capital of the U.S. financial system. Witness a recent post by Nouriel Roubini:

The RGE Monitor new estimate in January 2009 of peak credit losses (available in a paper for our RGE clients) suggested that total losses on loans made by U.S. financial firms and the fall in the market value of the assets they are holding would be at their peak about $3.6 trillion ($1.6 trillion for loans and $2 trillion for securities). The U.S. banks and broker dealers are exposed to half of this figure, or $1.8 trillion; the rest is borne by other financial institutions in the US and abroad. The capital backing the banks’ assets was last fall only $1.4 trillion, leaving the U.S. banking system some $400 billion in the hole, or close to zero even after the government and private sector recapitalization of such banks and after banks’ provisioning for losses. Thus, another $1.4 trillion would be needed to bring back the capital of banks to the level they had before the crisis; and such massive additional recapitalization is needed to resolve the credit crunch and restore lending to the private sector.

Now, obviously, if we were to face up to this situation, there would be no chance of recovery as the capital required to recapitalize the banking system would mean a long and deep downturn well into 2010 and perhaps beyond. This is not politically acceptable as 2010 is an election year. Nor is the nationalization of large financial institutions acceptable to the Obama Administration. Moreover, bailing out banks to the tune of trillions of dollars while the economy is in depression is equally unacceptable to the American electorate. The Obama Administration is keenly aware of this fact.

These constraints, some artificial and others very real, leave the Administration with limited options.

Engineer recovery

With the preceding constraints in mind, we should remember that the first priority of elected officials in Washington is not necessarily to make the best long-term choices for the American people, but rather to get re-elected in order to have the opportunity to make those choices.  It should be patently obvious that a downturn which began in December 2007 would be fatal to many politicians if allowed to continue well into 2010. This is why recovery of some sort must take place before that time – irrespective of whether it is sustainable.

How to engineer recovery is another question altogether.  Here again there are a set of political constraints which make things more challenging.  First, there are large swathes of the population that are uncomfortable with the huge debt load and deficit spending that a stimulus-induced recovery creates.  Moreover, a government-sponsored nationalisation or recapitalisation plan would only increase this deficit spending and these debts.

As a result, the Obama Administration has crafted a plan to circumvent these obstacles.

1. Moderate fiscal stimulus.  The Obama Administration decided not to seek massive stimulus earlier this year because they deemed it non-viable politically.This clears the first obstacle: deficit hawks. Most economists understand that the output gap that has opened up in the American economy is $2 trillion or more whereas the Obama stimulus package was only $800 billion.  That leaves a massive hole in output in the U.S.  Moreover, the immediate effective stimulus is less. Much of this ‘stimulus’ will be saved or will not come into play until months from now. Obviously, this is not going to meet the grade (See my comments on this from February).
2. Quasi-fiscal role for the Fed. Having partially assuaged deficit hawks, Obama still needed to close the output gap.  Enter the Federal Reserve.  You will have noticed that the Federal Reserve has added legacy assets as eligible for the TALF program. In effect, this allows banks to slip tens or even hundreds of billions of dollars in so-called toxic assets off their balance sheets. Mind you, these are assets already on the books impairing banks’ ability to loan money.  Under normal circumstances, one would expect the Federal Government to take these  assets out of the system (bad bank, good bank, nationalization) after being given legislative approval to do so.  However, as I have previously stated this approval is not going to be forthcoming.  This is why the Federal Reserve is taking these assets on.  In so doing, the Federal Reserve is taking on a quasi-fiscal role that re-capitalizes the banking system in order to stimulate the economy by increasing credit availability.
3. Quasi-fiscal role for the FDIC. The new PPIP is a similar end-run around Congress.  After all, the role of the FDIC is that it "maintains the stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions, and managing receiverships."  Meanwhile, the PPIP has the FDIC guaranteeing dodgy assets in a massive transfer of wealth from taxpayers to banks and select investors. (See my previous comments on this issue).
4. End of mark-to-market as we knew it.  You should have noticed that most of the assets written down in the past two years have been marked-to-market. Securities traded in the open market are marked to market. Loans held to maturity are not.  This is one reason that large international institutions which participate in the securitisation markets have taken the lion’s share of writedowns, despite the low percentage that marked-to-market assets represent on bank balance sheets.  But, this should end because of new guidelines in marked-to-market accounting.  However, the new guidelines do have two major implications.  First,there are still many distressed loans on the books of U.S. banks that if marked to market would reveal devastating losses.  Second, there will also now be many distressed securities on bank balance sheets that if marked-to-market would reveal yet more losses.  In essence, the new guidelines are helpful only to the degree that it prevents assets being marked down due to temporary impairment.  If much of the impairment is real, as I believe it is, we are storing up problems for later.
5. Interest rate reductions. One reason often given for a large increase in writedowns at financial institutions had been the coming reset of Alt-A adjustable-rate mortgages in 2009.  With the subprime writedowns mostly accounted for, a souring of the much larger pool of Alt-A and Prime residential mortgage loans is the real Armageddon scenario. Well, part of this problem has been temporarily relieved because the Federal Reserve has reduced short-term interest rates to near zero and has begun trying to manipulate long-term interest rates lower by buying long-dated treasury securities.
6. Bank margin increases.  Key to the whole program is banks’ ability to earn massive amounts of money and re-capitalize themselves through retained earnings as opposed to shedding assets or receiving additional paid-in capital (see post from last April on these three methods of recapitalising). The market for bank assets is distressed and few banks can get enough capital from private sources or investors.  Therefore, Obama’s plan hinges on the ability to allow these banks to earn shed loads of money as quickly as possible.  If the banks cannot do this, we are going to have a big problem very quickly (Of course, I think they can).

The stimulus to come from these measures is still in the pipeline and, by the end of this year, will probably add a big kick to the economy. You should note that only the fiscal stimulus required legislative approval. All of the other ‘stimulus’ has been done without Congressional approval and largely without Congressional oversight. These activities have been specifically designed to be opaque. The government’s claims of wanting to increase transparency ring hollow (see my post on Bloomberg’s suit against the Fed as an example of what is really happening).

I should also mention that the Federal Reserve has been a large factor here. It is acting in concert with the executive branch in a non-arms length fashion which I believe will have consequences regarding Fed independence down the line.

Other positive economic factors

There are a number of so-called green shoots (a phrase coined by Norman Lamont)  of note.

• Jobless claims have plateaued and comparisons to last year are actually declining (see post).
• The U.S. trade deficit is declining significantly as U.S. import demand has fallen off a cliff.
• Inventory liquidation will put U.S. manufacturers in a better position by Q4 and help make quarterly and yearly comparisons favourable.

I linked to the first two bullets of these other factors.  And I wanted to spend a little time on factor number three because I think it is important.  Niels Jensen of Absolute Capital Partners has a very solid write-up on this in his most recent newsletter: (do sign up for his free newsletter because it is quite informative.  Click here to see the newsletters and sign up.)

Turning my attention to the global economy, after a rather muted beginning, manufacturers around the world have now begun to react aggressively to the economic downturn and inventories are falling aggressively. Chart 5 below depicts US manufacturing inventories as published recently by the Census Bureau. Inventory changes can have a meaningful impact on GDP. There is one example from the 1981-82 recession where the inventory correction subtracted 5% (annualised) from GDP in just one quarter. The current inventory correction is very negative for GDP in Q1 and possibly also in Q2, but it is very difficult to quantify the effect it is going to have. We will have to wait and see.

However, as we must remind ourselves, the stock market is not trading on what is going to happen in Q1 and Q2 of this year. Projecting at least 6-9 months ahead, the stock market is probably already looking ahead to Q4 and possibly even Q1 of next year. And the inventory adjustment currently underway is very bullish for GDP growth later this year and into next. The reason is simple. Manufacturers always overreact. Come Q3 or Q4, they will suddenly sit up and realise that inventories have fallen too much and that they need to produce more. There is no reason to believe that this recession will be any different.

Obviously, this means that U.S. Q1 and perhaps even Q2 GDP will be very low due to the subtraction of inventories now being purged. However, when we get to Q3 and Q4, this effect will be gone and quarterly and yearly comparisons will look favourable. So the inventory purge may mean a huge upside surprise to GDP in the second half of the year and early 2010 – potentially enough to see positive GDP numbers.

A brief reminder of what lurks beneath

Despite the positives from the previous section, there are significant headwinds which may even preclude a positive GDP number. They include:

• Rising joblessness
• Increased savings as households rebuild balance sheets
• Spending cuts by local and state governments
• Decreased capital spending by companies
• A calamitous GM bankruptcy

Moreover, credit availability –and hence GDP will be constrained by numerous factors including the following:

• Declining home values
• Increasing foreclosures
• Commercial property writedowns
• Credit card-related writeoffs
• Junk bond defaults

All of this means that a cyclical rebound is not a foregone conclusion at all.

Tying the threads together

You should be under no illusion that the coming rebound is permanent. Much of it is not. What we are seeing is the makings of a cyclical recovery that might begin as early as Q4 2009 or Q1 2010. How long or robust that recovery is remains to be seen. Moreover, it is still questionable whether we will get any meaningful recovery at all in spite of the ‘green shoots’ because the banking system in the United States is severely undercapitalised and more asset writedowns are coming due. This is a fake recovery underneath which many problems remain.

Nevertheless, banks are going to earn a lot of money and that is bullish for their shares – at least in the medium-term. Yes, the stock market is overbought right now.  However, if banks put together some decent earnings reports over the next few quarters, their shares will rise.

Furthermore, if the banks can earn enough, this cyclical recovery will have legs as banks will then have enough capital to resume lending and that is supportive of the broader market as well.  It is still too early to tell how this will play out over the longer-term.  For now, I am much more positive on financials, and somewhat positive on the broader market as well.