Outside The Box - Geithner, China, and the Specter of Technical Insolvency by David Kotok, Nouriel Roubini and Elisa Parisi-Capone
This week I bring you two different articles as an offering for Outside the Box. As a way to introduce the first, let me give you the quote from Merrill Lynch economist David Rosenberg about the rising threat of global trade protectionism:
“The Financial Times weighs in on the rising threat of global trade protectionism in today’s Lex Column on page 14 (”Economic Patriotism”). The FT points out that the stimulus packages of many countries include “buy local” provisions. At home, there is a proposed inclusion of a ‘Buy American’ provision in the economic recovery package and this could set off trade retaliation from importers of US goods. Here is what the FT had to say, ‘It was trade protectionism that made the 1930s Depression “Great”. Congress would do well to understand that it is in everyone’s interest to keep trade open today.’”
I have long written that the one thing that could derail my Muddle Through (at least eventually) view point is a return to trade protectionism. Nothing could be more devastating to the hopes of a recovery. Nothing could more surely turn a recession into a depression, and a global one at that.
David Kotok of Cumberland Advisors notes the very real problem with Tim Geithner’s written testimony, threatening China and calling the manipulators, clearly making the point that this is Obama’s policy. I did not have time to touch last Friday on the dangerous policy if it is that and not just rhetoric, but David says everything I would want to say and does it shortly and eloquently.
Second, several people requested a chance to look at the actual paper I cited in last week’s Thoughts from the Frontline by Nouriel Roubini and Elisa Parisi-Capone of RGE Monitor (www.rgemonitor.com) on how they come up with an estimated potential loss of $3.6 trillion dollars in the US financial system. It makes for rather grim reading, but they go sector by sector to show where the losses are coming from.
Tomorrow I will hold my first “conversation” with Ed Easterling and Dr. Lacy Hunt. To find out more about how to listen in and still get the half price discount for the rest of this week at https://www.johnmauldin.com/newsletters2.html. Just enter the code JM33 when asked. Have a great week.
John Mauldin, Editor
Outside the Box
Outside the Box
Geithner, Obama and China
By David Kotok
By David Kotok
Following Treasury Secretary designee Tim Geithner’s public confirmation hearing, an extensive Q & A occurred in writing. We have posted a copy of the US Senate Finance Committee’s 100-page text on our website. See: http://www.cumber.com/special/geithnerquestions2009.pdf. This is must reading for any serious investor, economist, strategist, analyst, or observer. In this text you will find what is on the minds of the Senators, and you will gain insight into the policies that will be forthcoming from the Obama administration.
One telling example is found in the following quote that has already created international consternation. Geithner twice answered questions about currency and China. In so doing he has placed the Obama administration squarely in the middle of the tension between the United States and the largest international buyer and holder of US debt: China. This happened as the same Obama administration is unveiling a package that will add to the TARP financing needs and the cyclical deficit financing needs and cause the United States to borrow about $2 trillion this year. Two trillion dollars of newly issued Treasury debt — and this is how the question was answered. Not once but twice.
Geithner (on page 81 and again on page 95) answered: “President Obama — backed by the conclusions of a broad range of economists — believes that China is manipulating its currency. President Obama has pledged as President to use aggressively all the diplomatic avenues open to him to seek change in China’s currency practices.”
“Manipulation?” “Aggressively?” This is strong language. Geithner did not do this on his own authority. These are prepared answers. He is citing the new President, not once but twice.
China’s response was fast and direct. China’s commerce ministry said in Beijing that China “has never used so-called currency manipulation to gain benefits in its international trade. Directing unsubstantiated criticism at China on the exchange-rate issue will only help US protectionism and will not help towards a real solution to the issue.”
Are we seeing the world’s largest and third largest economies calling each other names in the middle of a global economic and financial meltdown?
Are we seeing the world’s largest and third largest economies calling each other names in the middle of a global economic and financial meltdown?
The world is in recession. The economic growth rates in the major and mature economies are now negative numbers. In China the growth rate is at least 4 and maybe as much as 8 points below last year. All the governments of the world that are running deficits are enlarging them in order to finance stimulus packages. Their central banks are bringing the policy interest rates toward zero. Trillions will need to be borrowed by those governments. Either they will be financed by the outright massive printing of money through the central bank mechanism, or they will be financed by those in the world who have savings. China is the largest single holder of financial savings in the world. Japan is next.
Why are we picking a fight with China? The implied question is why are we alluding to one with Japan, whose currency is currently the strongest of the G4 majors? In a world where global finance is mostly in US dollars, British pounds, Euros, and yen, this is engaging in a dangerous sport.
The pound has lost one third of its value against the dollar since the crisis began. It is destined to weaken more. The euro struggles because of the structural issue of having to conduct monetary policy in the sovereign debt of the various euro zone member countries. The gap between those sovereign interest rates has reached nearly 3% between the weakest and strongest. This is an extremely difficult task for the European Central Bank to manage.
And Japan is getting killed by the flight to the strong yen. Japan will intervene soon to weaken the yen; they have as much as said so. The yen is strengthening against the Chinese Yuan; that is Japan’s largest trading partner. The yen is 1.5 standard deviations above the JPY/USD exchange rate. It is nearly 3 standard deviations above the JPY/EUR cross rate that has been established during the ten years the euro existed. And it is over 3 standard deviations above the JPY/GBP cross rate.
So that leaves the dollar likely to get stronger. Right now it is the default choice of the world. We have currency strength not because we are so desirable but because we are currently better than the others. All bad; we’re not as bad as they are. Or all bad and the others are even worse.
So what do we do within 72 hours of launching the Obama administration that says it is seeking “change?” We fire the first public salvo in what could easily become a trade war or a threat to global financial integration.
What makes us so credible? Is it our proven record of regulatory oversight of our financial markets, as demonstrated by the Madoff scandal and the SEC? Is it the way our rating agencies work so diligently to place a coveted “AAA” on paper that was peddled to the rest of the world and was found out to be highly toxic? Is it the way we honor the promises of federal agencies by having tier-one-eligible Fannie and Freddie preferred held in the US and abroad by institutions, and then essentially cause a structural default on that preferred (actually, dividend suspension)? Or is it the way the actions of Treasury and the Federal Reserve allowed a primary dealer (Lehman) to fail, thus triggering a global contagion?
C’mon? Where is the plan to restore confidence and credibility and transparency and consistent policy for the United States? And how does the Obama administration believe that launching a fight with China is beneficial?
In the 1930s the severe recession of 1929-1931 was turned into the depression of 1931-1933 because of protectionism. Every historian knows that. Every economist learns it in school. This is well-known by Geithner and even better-known by Larry Summers and Paul Volcker. They are the three members of the Obama economic troika.
The statement Geithner repeated twice was certainly known to them in advance. Why did they not temper it? What is the plan? Do they want to threaten and see if China backs down? This, too, is dangerous. Do they intend to pursue the Schumer tariff scheme? There are more questions than answers.
Lastly, Larry Summers was going to attend the World Economic Forum in Davos, Switzerland. He has cancelled. Why? Was it because he did not want to have to face the private conversations that would follow such statements as have been made by Geithner in the name of the President?
Watch Davos closely. And remember that the absence of statements is as revealing, if not more so, than the presence of them. Not one mention of trade openness appears in our reading of the 100 pages of answers to the Senate. Maybe someone else can find an affirmation of free and open trade. I cannot.
We fear protectionism. It starts with rhetoric. We now have that threat. If it is pursued, it ends badly for everyone. No one wins.
Geithner’s answers are sobering. We are now in the realm of fiscal policy and national policy. This is not in the realm of the central bank; the Federal Reserve is not the player here. The Fed is doing all it can to unfreeze the financial system and restore it to functionality. If permitted to complete its task, that policy will work. If stymied or corrupted by conflicting policy in trade or federal finance, the recession will worsen and the pain will become more severe.
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Specter of Technical Insolvency for the Banking System Calls for Comprehensive Solution
By Nouriel Roubini and Elisa Parisi-Capone
Back in February 2008, we at RGE Monitor warned that that the credit losses of this financial crisis would amount to at least $1 trillion and most likely closer to $2 trillion.
At that time such estimates were derided as being exaggerated as the market consensus at that time was around $200-300 billion of subprime mortgage related losses. But we pointed out that losses were not limited to subprime mortgages and would rapidly mount — following a severe US and global recession — to near prime and prime mortgages, commercial real estate loans, credit card loans, auto loans, student loans, leveraged loans, muni bonds, industrial and commercial loans, loans to real estate developers and contractors, corporate bonds, CDS and the securities (MBS, CDOs, CMOs, CPDOs, and the entire alphabet soup of derivative instruments) that — via securitization — represented claims on these underlying loans.
Soon enough, market estimates of loan and securities losses mounted: by April 2008 the IMF estimated them to be $945 billion; then Goldman Sachs came with an estimate of $1.1 trillion; the hedge fund manager John Paulson estimated them at $1.3 trillion; then in the fall of 2008 the IMF increased its estimate to $1.4 trillion; Bridgewater Associates came with an estimate of $1.6 trillion; and most recently, in December 2008, Goldman Sachs cites some estimates close to $2 trillion (and argues that loan losses alone may be as high as $1.6 trillion and expects a further $1.1 trillion of loan losses ahead).
In mid-November 2008, the threshold of $1 trillion in global financial write-down was finally reached. Thus, as we argued throughout 2008, our $1 trillion estimate was only a floor - not a ceiling - for eventual losses and our upper range of $2 trillion would become more likely.
We have now revised our estimates and we now expect that total loan losses for loans originated by U.S. financial institutions will peak at up to $1.6 trillion out of $12.37 trillion loans. Our estimates assume that national house prices will fall another 20% before they bottom out some-time in 2010 and that the unemployment rate will peak at 9%. If we include then around $2 trillion mark-to-market losses of securitized assets based on market prices as of December 2008 (out of $10.84 trillion in securities), total losses on the loans and securities originated by the U.S. financial system amount to a figure close to $3.6 trillion.
U.S. banks and broker dealers are estimated to incur about half of these losses, or $1.8 trillion ($1 -1.1 trillion loan losses and $600-700bn in securities write-down) as 40% of securitizations are assumed to be held abroad. The $1.8 trillion figure compares to banks and broker dealers capital of $1.4 trillion as of Q3 of 2008, leaving the banking system borderline insolvent even if write-down on securitizations are excluded.
Arguably, mark-to-market losses on private sector securitizations have so far been largely compensated for by increased activity in the government-sponsored sectors, but mark-to-market write-down may become a more important factor going forward for bank capitalizations and credit provision to the private sector (see discussion in Hatzius (2008))
Moreover, even assuming that securitized assets may have fallen in value excessively because of a liquidity premium — rather than credit risk alone — we still get very large losses. Assume — generously — that securities are now underpriced because of illiquidity and that market losses will be eventually 20% lower than we currently estimate because of such temporary factors. Then write-down on market securities would be $1.6 trillion rather than $2 trillion and total credit losses would be $3.2 trillion rather than $3.6 trillion.
Moreover, even assuming that securitized assets may have fallen in value excessively because of a liquidity premium — rather than credit risk alone — we still get very large losses. Assume — generously — that securities are now underpriced because of illiquidity and that market losses will be eventually 20% lower than we currently estimate because of such temporary factors. Then write-down on market securities would be $1.6 trillion rather than $2 trillion and total credit losses would be $3.2 trillion rather than $3.6 trillion.
In this paper we argue that, in order to restore safe credit growth, the U.S. banking system thus needs an additional $1 — 1.4 trillion in private and/or public capital. These magnitudes call for a comprehensive solution along the lines of a ‘bad bank’, or preferably a restructuring of the financial system through an RTC or our through our HOME proposal.
Loss Estimates
Our data on outstanding loan and securities amounts are as in IMF Global Financial Stability Report, Table 1.1, as well as the weights in assigning loss shares to banks and non-bank (see data in Appendix 1).Different from the IMF which focuses on charge-offs only, we look at both charge-off and delinquency rates as we assume a high proportion of delinquent loans will turn bad in this cycle, especially as financial institutions have thin capital bases inadequate to deal with unexpected losses.
Compared to the IMF we estimate for loan losses based not on current default/ delinquencies rates but rather what those losses will be when such default and delinquencies will reach their peak some time in 2010. Our calculations are assume a further 20% fall in house prices (Case/Shiller) and unemployment peaking at 9% during this cycle as discussed in the RGE 2009 Global Economic Outlook.
With respect to credit losses on unsecuritized loans, recent research by the Federal Reserve Board (Sherlund (2008)) using comparable house price assumptions (but assuming high oil prices) concludes that over half of 2006-2007 subprime mortgage originations are set to default (i.e. $150bn out of $300bn in our data). The loss trajectories for Alt-A loans are similar, resulting in a 25% default rate ($150bn out of $600bn). Even prime mortgage delinquencies display a very high correlation with subprime loan delinquencies (Doms/Furlong/Krainer (2008), implying an approximate 7% default rate when the potential for ‘jingle mail’ is taken into account ($266bn out of $3,800bn). Our dollar losses for the subprime and Alt-A categories (incl. RMBS) are broadly in line with similar estimates in the literature.
The cycle has also turned in the commercial real estate (CRE) area with the traditional lag of around 2 years. Current serious delinquency plus default rates of 5.9% of CRE loans (Fed data) are projected to increase to up to 17% by industry experts cited in a Fitch study referring to CMBS data and assuming a 25% fall in prices ($408bn out of $2.4 trillion.) This compares with a 1991 peak charge-off plus delinquency rate of 14.5%.
The cycle has also turned in the commercial real estate (CRE) area with the traditional lag of around 2 years. Current serious delinquency plus default rates of 5.9% of CRE loans (Fed data) are projected to increase to up to 17% by industry experts cited in a Fitch study referring to CMBS data and assuming a 25% fall in prices ($408bn out of $2.4 trillion.) This compares with a 1991 peak charge-off plus delinquency rate of 14.5%.
In the consumer loan area, we estimate credit card charge-off rates could increase to 13% in the worst case scenario. Adding a typical 4% delinquency rate during recessions, the total loan losses on unsecuritized consumer loans are projected to increase to $238bn out of $1.4 trillion.
The IMF warned that commercial and industrial loans (C&I) losses are likely to climb to historical peaks and potentially beyond in this cycle. Compared to past C&I loan loss rates, we project charge-off and delinquencies to reach 10% or $370bn out of $3.7 trillion of unsecuritized C&I loans. With regard to leveraged loans, the latest research by Boston Consulting/IESE Business School based on the 100 largest PE firms engaged in LBOs calculates an expected book loss from default of about 30%. This translates into $51bn in losses out of $170bn unsecuritized leverage loans.
Based on these calculations, RGE now expects total loan losses to the financial system to reach about $1.6 trillion out of $12.37 trillion of unsecuritized loans alone, implying an aggregate default rate of over 13%. Applying IMF weights, the U.S. banking system (commercial banks and broker dealers) carries about 60-70% of unsecuritized loan losses, or around $1.1 trillion.
Based on these calculations, RGE now expects total loan losses to the financial system to reach about $1.6 trillion out of $12.37 trillion of unsecuritized loans alone, implying an aggregate default rate of over 13%. Applying IMF weights, the U.S. banking system (commercial banks and broker dealers) carries about 60-70% of unsecuritized loan losses, or around $1.1 trillion.
Total mark-to-market (mtm) write-down on a further $10.8 trillion of U.S. originated securities outstanding reached about $2 trillion by the end 2008 based on cash bond and derivatives prices. In particular, applying Markit ABX prices to $1.1 trillion of outstanding subprime RMBS results in a mtm loss rate of 50%, or $550bn. Markit TABX prices also show that $400 billion ABS CDOs consisting of mostly junior subprime RMBS tranches are all but worthless by now and expected to remain that way (95% or 380bn month-to-month loss.)
Write-down in the prime MBS universe are primarily driven by jumbo mortgages which we assume to trade at 97% based on the record 3% spread between the 30-year jumbo mortgage and the 10-year Treasury yield with comparable average maturity. Mtm losses on prime MBS are therefore assumed to be $114bn out of $3.8 trillion outstanding. CMBX spreads spiked up implying a month-to-month write down of about $282bn out of $940bn outstanding.
The aggregate consumer debt ABS price index across all ratings trades at 80% thus implying $130bn in month-to-month write-down out of $650bn outstanding. The high-yield corporate debt index traded at 75% (month-to-month $150bn out of $600bn), whereas high-grade corporate debt traded at 95% before moving back to 100%: we assume a write-down of $190bn out of $3.8 trillion. Derivatives indices for securitized leveraged loans implied a month-to-month loss of 123bn by the end of 2008 out of $350bn in CLOs outstanding. Flow of funds data show that 40% of U.S. originated securitizations are held abroad, leaving U.S. institutions with 60% of m-t-m write-down, and U.S. banks in particular with a share of 50-60% thereof, i.e. $600 –700bn, when applying IMF weights.
Expected U.S. banks loan losses of about $1.1 trillion out of a total $1.6 trillion, plus bank month-to-month write-down of $600 - $700bn on securities based on December 2008 prices amount to about $1.8 trillion. Compared with a total bank capitalization of $1.4 trillion (incl. FDIC insured plus investment banks as of Q3), the estimated capital shortfall amounts to around $400bn in the worst case scenario before recapitalization.
(Our colleague Christopher Whalen of Institutional Risk Analytics — one of the leading experts of U.S. banking - has long predicted that peak charge-offs for the US banking industry will reach 2x 1990 levels during 2009, which would mean 4% charge-offs against total loans and leases for all FDIC insured banks or some $800 billion in realized losses. In reviewing a draft of our paper, Chris noted that the Q4 2008 results from Citi, JPMorgan, Bank of America show that charge-offs were running at a rate roughly double 2007 levels and that he expects charge-offs for these larger banks to double again by Q2 2009 and to continue rising through the second half of 2009. He thinks that our “$1.1t loss estimate is very reasonable for the financials in terms of charge-offs”. The total accumulated loss for all FDIC insured banks will depend upon how long the industry remains at this peak level of loss experience; thus, our loss estimates for U.S. banks losses could be conservative and losses may end up being much larger than we predict.
Even including the TARP 1 injection of capital of $230 billion into the banking system and the further $200 billion of capital injected by private investors and sovereign wealth funds since the start of the crisis, the overall banking system would still be borderline insolvent.
Moreover, in order to restore the capital of the banking system to the previous level of $1.4 trillion (a level close to the 8% capital requirement of Basel II) an additional $1.4 trillion of private and public/government capital would have to be injected in the banking system to restore safe credit growth. If a reform of the regime of regulation of banking institutions were to argue that banks and broker dealers need more than the Basel II 8% criteria to operate safely even more than $1.4 trillion of new capital will have to be injected in the banking system.
Thus, even the release of TARP 2 (another $350 billion) and its use to recapitalize banks only would not be sufficient to restore the capital of banks and broker dealers to internationally accepted capital ratios. A TARP 3 and 4 of up to $1.05 trillion (assuming generously that all of TARP 2 goes to banks and broker dealers) may be needed to restore capital ratios to adequate levels.
Even assuming that private and foreign capital would contribute to 50% of this additional required recapitalization an additional TARP 3-4 of $560 billion may be needed in the form of public capital injections in banks and broker dealers alone. This would leave out the insurance companies, finance companies and other financial institutions (the GMAC, GE Capital, etc.) which may also need further public capital. Our estimates may turn out to be too pessimistic as the current illiquidity premium in prices of securities may disappear over time and a faster than expected growth recovery may reduce the expected losses on loans. But even in that case the current shortfall of capital in the banking system would be close to a staggering $1 trillion rather than an even bigger $1.4 trillion.
Conversely, credit losses may turn out to be even larger than we estimate: if instead of a U-shaped recession that is over by the end of 2009, the US recession were to last well into 2010 and turn out to be a Japanese style L-shaped recession, total loan and especially securities losses would end up being much larger than our benchmark of $3.6 trillion, potentially as high as $5 trillion.
Thus, the release of TARP 2 is welcome news for the banking sector but the prospect of further month-to-month losses and feedback loops that are not yet priced in calls for a more comprehensive solution for toxic assets along the lines of the proposed ‘aggregator bank’ or preferably an outright restructuring of the banking system a la RTC. Moreover, in order to address the root causes of the financial crisis in the mortgage and the household sectors, we proposed recently the “HOME (Home Owners’ Mortgage Enterprise): A 10 Step Plan to Resolve the Financial Crisis” that includes an RTC to deal with toxic assets, a HOLC to reduce homeowner mortgage debt, and an RFC to refinance viable banking institutions.
The US banking system is borderline insolvent in the aggregate and it will take a huge amount of public financial resources and complex and time-consuming work-out of insolvent institutions to restore its financial health and allow it to lend again in ways that support sustained economic growth.
John F. Mauldin
johnmauldin@investorsinsight.com
johnmauldin@investorsinsight.com
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