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 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 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.
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.