Green Shoots and Agent Orange

Agent Orange

At best, we have seen a pause in the economic decline. It is too early to call a trough.

Surging unemployment will act like Agent Orange on those “green shoots”. While we have every reason to be worried about a swine flu pandemic, the recovery was at risk well before the first reported cases. That is, the economic fundamentals suggest a second wave of hardship.

The Past

The first quarter of 2009 is behind us and it was a disaster with GDP plunging at a 6.3% annual rate. While consumption stabilized, investment was slashed by 16.7%. That’s not an annual rate! The annualized change in private domestic investment was an astonishing -66.7%. We thought that the previous quarter was bad at -24.2%. The freefall in investment has more than doubled.

The Future

The IMF recently revised their estimates of losses in the U.S. to a staggering $2.7 trillion. The report can be viewed here. These are deeper losses than one would be led to expect by statements from our government.

But I think we are missing something.

We are bleeding jobs to the tune of 600,000 per month. In addition, we know that even after a trough in economic activity, job losses continue. We are not factoring into the economic equation the impact of the job losses.

To be more clear, the first wave of subprime losses were caused by loans being made to people that had jobs but their income was insufficient to pay their mortgage payments. Banks made these loans assuming either their incomes would increase by the time the reverse amortization ended (for example, the end of the low teaser rate) or their house would appreciate by enough so that a mortgage equity withdrawal could be made to pay the interest on the original loan (in true Ponzi fashion). Note, in both cases, the homeowner has a job.

The situation is different today. We have a wave of people that will not be able to pay their mortgages because they are unemployed. It is not critical right now because these homeowners are drawing down what little savings they have. However, time is running out as these saving are depleated.

The market is seizing whatever little piece of good news. However, it will soon be reckonning time for the second wave.

The Trouble

There are three other troubling developments.

1. The Stress Test is Bogus

On Monday we will get the first official results of the stress test.

The so-called “adverse” scenario assumes an unemployment rate of 8.9% in 2009. That is a sham. We will likely have that rate for April! It effectively assumes a dramatic end to job losses in May 2009. Who believes that?

Equally bogus is the fact that we are relying on the bank’s own models to run the stress test. These are precisely the failed risk management models that got us into this mess.

To make things even worse, the Treasury secretary has said that anybody who fails will get recapitalized. Whatever happened to the idea that if you take a bad bet, you lose. If you are reckless, you go out of business. All of that is gone. You get bailed no matter what you do. We reward incompetence with hard earned taxpayer money.

2. No Transparency

There is no transparency. I have no idea what these bank “earnings” announcements mean. Accounting “earnings” depend on the loan loss reserve assumptions as well as the valuations of their assets. I have no way to assess the quality of the bank assumptions – but I have strong suspicion of low quality.

FASB has recently said that banks don’t need to use market prices. What does this mean? It means that if you don’t like the market price (i.e. too low), then you can use your model price (which is likely too high). If you think about it, you could easily argue that the so-called fire-sale price is too high. You observe a price but that’s before you need to sell your asset. When you put your asset on the market, that will likely cause the price to fall even more. All of this makes the financial statements impossible to interpret. Right now, I have little idea of who is solvent and who is insolvement. However, I have a strong suspicion that there are many insolvement banks.

3. Too Big to Fail

Pass the barf bag. I don’t think I am the only one. This policy encourgages reckless risk taking on the part of large banks. They know they will be bailed out so there is no risk for them – it is the American taxpayer that bears the cost of their mistakes.

We need to end this policy. There are two ways. First, you let some big players fail – but do it in an orderly way (i.e. no repeat of the Lehman fiasco). The alternative is to break up these firms. Either way, we put our financial institutions and our economy in a stronger position for the future.

Weird Zombie Game

Yes, it is true that some credit spreads have improved. Consumer confidence has also increased. But these are fleeting. A recovery must be sustainable. On the financial side, there are two prerequisties to the proper functioning of financial markets and a sustainable recovery: transparency and purging. Right now, we have neither. The stress test will provide little or worse — potentially misleading information. The losers are rewarded with bailouts, guarantees — and bonuses. The taxpayer is shafted. The economy is sloshing around is a sea of Zombies.

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2 Responses to Green Shoots and Agent Orange

  1. Pingback: Green Shoots and Agent Orange - Town-cryers

  2. David Gagnon says:

    Cam,
    I think you are on the mark. The policymakers actions are too reminiscent of what I saw in Japan in the 1990s – more bailing out the bad bank managers who got us into the trouble, resulting in choking of credit for small and medium size companies.

    I agree that jobs – or the lack of – are going to be problem for many months. In fact, with the shift in the mix of jobs (service jobs account for 85% of private sector jobs up form 60% in the 1960s) the pace of job loss is much worse than the headline numbers make them appear. Nonfarm payrolls are off about -4% y/y similar to the early 1980s and the V-shaped recessions of the 1950s. However, when one looks at the manufacturing and services separately, the picture is grim. We have lost manufacturing jobs at a “normal” -10% as seen in the 1950s, 70s, and 80s, but service jobs, which rarely turn significantly negative are shrinking by a record -2.2% versus the 1949 record of -1.4%. Correct me if I am wrong, but lost service jobs are difficult to replace because much of the knowledge walks out the door when the employee leaves. It would seem like potential GDP is ratcheting down and that there may not be as much “spare” capacity as the statistics indicate.

    Also, it seems that real wages and benefits are probably weaker and more broadly weaker than the numbers indicate – at least anecdotally it seems like employees are feeling pinched by company-wide salary cuts and benefit cuts (lower 401k matching, high medical insurance costs, reduced wages and/or work hours). Intuitively isn’t it worse (for the economy) to cut everyone’s salary by 10% rather than just cut the lowest 10% of performers? Or perhaps companies want to do that but they can only lay-off people so fast and are being forced to retain workers at lower wages/benefits until they “can” fire them later.

    Finally, 1Q Consumption seems a bit odd – about a quarter of the 2.2% bounce came from durable goods purchases, but the auto manufactures reported that unit sales of vehicles contracted by 8% in 1Q? Also another quarter of the bounce in consumption came from a rise in electricity and medical care consumption – probably signs of people staying at home and running to the doctor before they lose their medical benefits (or the costs go up). Those do not seem like signs of strength.

    Anyhow, those are my rays of sunshine.

    Thanks,
    David Gagnon

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