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Guest Post: It’s the writedowns, stupid

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Submitted by Edward Harrison of the site Credit Writedowns

Edward Harrison here.  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, 2009 is 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 prosed 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.

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward

25 comments

  1. Anonymous

    It’s like trying to deodorize with perfume–you need to out the original odor. Likewise with overleveraging. The solution is ever greater overleveraging.

    Well, at some point the smell is too great. You can try to mask the odor but it just makes the perfume smell seem disgusting.

  2. Anonymous

    Edward, you make good points. I don’t think Washington has the guts to nationalize or liquidate the major players. Where do you suggest individuals park their money in that case?

  3. killben

    “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”

    This presumes 3 things:

    paying a higher price for the asset
    you can buy all the assets that are imploding
    Screw the tax-payers

  4. Anonymous

    You mention beggar-thy-neighbour policies as a (not very good) back up plan. The UK is facing similar problems to the US, and has been much less hesitant to engage in such policies. Even though they have learned the hard way that outright intervention in currency markets does not work, they have relentlessly talked down sterling. Whenever the pound goes up, another statement comes out of the BoE or the government regarding their intentions to print money or the weakness of the UK economy. It will be interesting to see how long it will take for other countries to retaliate. At least the barrier to beggar-thy-neighbour policies might not be as high as you suggest.

  5. Anonymous

    No doubt the fundamentals of credit finance are important but if you look over the woop and warf of the past century and a half you also see that there some technological drivers for the economy.

    Railroads, chemicals, electricity, cars, cars, cars, vacuum tube electronics, transitor electronics etc. all had their day and created opportunities for enormous profits.
    Lately it has been silicon based industry.

    The 1930′s seem to have been as much a time of technological stagnation as economic, at least as compared to the 1920′s when radio, cars, movies all came of age. Then the war and a burst of technological innovation and we had TV, jets, automatic transmissions and transistors to fuel the 1950′s and 1960′s.

    Then the 1970′s. Moon shot, been there done that. Cars? The Mustang
    gave way to the Pinto as gas shocks
    made the muscle cars obsolete. Not much innovation in that decade not much economic growth either. Then the 80′s and the next big thing PC’s, cellphones, CD’s we got moving again.

    My point is that we have reached a 1930′s, 1970′s style turning point or dead end. We await the next big
    thing. I had thought it might be biotech but progress here is painfully slow. Maybe solar energy will be it. Apparently Japan now thinks so.

  6. Anonymous

    Yet another grand theory of credit:

    “No inter-temporal transactions could ever occur without credit.”

    Patently false.

    Savings could fund investment 100 per cent with equity claims.

    Equity claims also facilitate inter-temporal transactions.

  7. jmk

    not so sure wrt Anonymous’ posting re equity claims

    are you sure the market would facilitate inter-temporal transactions purely funded thru savings+ equity claims in the case of a flawed investment which lead to a complete loss? what about that same transaction being requested after a loss within its predecessors (and thus the memory of this loss)?

    credit provides the buffer between those risks where default is ‘manageable’ or understandable

    i would argue equity claims are more relevant for a much higher risk tolerance, and a much more optimistic landscape

    for example: if forced to invest for your 401k between the following, would you buy Goldman stock today or GS senior debt yielding 16%?

  8. Anonymous

    jmk,

    Your points are valid but don’t contradict mine. I didn’t contend that a 100 per cent equity financed system was likely; just that equity finance also allows inter-temporal transactions.

    E.g. I consume 100 per cent of my income this year. I then sell my equity investment to consume an additional 10 per cent. Somebody else by definition must buy that equity investment, and somebody else by definition must forgo consumption from some part of their income.

    The author has made a sweeping statement about the theory of credit which isn’t true.

  9. lineup32

    credit creation has become the hammer used by government and the financial sector to fuel GDP growth and profits for the insiders. Another dead end for the economic growth mob has been reached. What now?

  10. Anonymous

    the downturn will only end when credit (especially consumer credit) is at a reasonable % of GDP again

  11. Terry

    This article, including the Barron’s interview excerpts, is the best analysis I’ve seen of the desperate situation our banking system faces and the wholly inadequate and wrongheaded policy response by both the Bush and Obama administrations.

    May God save us from these fools!

  12. Dave Schuler


    Caution dictates an aggressive response — one which should include nationalization or liquidation of a significant number of banking institutions.

    The number of institutions isn’t relevant. What’s important is how much in the way of writedowns is involved, just how insolvent they are. That’s just why nationalizing or liquidating a few institutions, e.g. Citibank and Bank of America, would be a good start.

    However, that’s unlikely to be what happens. What’s likely to happen is that we’ll weaken the banks that aren’t in trouble in order to preserve the biggest, least solvent banks.

  13. Moopheus

    “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.”

    I somewhat disagree with this in that I favor bank runs. Because I would agree with everything else you say. But I also think the government will have to pushed into doing what needs to be done, and that pushing will have to come from citizen action. The Fed, Treasury, and FDIC are clearly intent on propping up at least the big banks UNTIL there is a sign of a bank run. No matter what else happens. So anyone who has money in one of the big banks should withdraw it as soon as possible.

  14. ben

    equity won’t work for all intemporal transactions. you won’t find many buyers for equity in someones car purchase or fridge purchase and even equity transactions for buying houses are rare. i’ve seen like 50% equity/50% loan deals…

  15. El Bobo

    If you look at the Fed’s Z1 report, through the end of Q4 2008, total credit has increased to a new record of 370% of GDP and the financial sector has also continued to increase, to a new high of 121% of GDP.

    The cries about the ‘great credit contraction’ are at odds with reality, if the Fed’s numbers are correct.

  16. CTMM

    Hohoho…

    Just nationalize the banks, eh?

    So what to do with entities like AIG that have massive CDS exposure to foreign banks and investors?

    Let them take a bath? Sounds good, until they stop selling you oil, and buying your treasuries.

    Tiger be the tail…

  17. Eric L. Prentis

    Piling on more and more debt to resuscitate the previous and now discredited securitized global financial system is a no-win strategy. What is required is debt forgiveness/reorganization as part of receivership, starting with zombie financial institution such as Citi, BofA and AIG. A piecemeal approach to propping up failed institutions, hoping that the market will revive and asset values will return to full valuations, is a policy of desperation that is only good for the insolvent banks’ directors, executives, stockholders and bondholders but terrible for the US. The credit crisis bank bailout policy of Obama/Geithner/Summers/Bernanke will put the US into a no/slow growth economy for 20 years, like the Japanese (1989-2009), and result in an S&P 500 Index value of 321 in the year 2029, like the Japanese (Nikkei Index ’89 top of 38,916; ’09 currently at 7,972: down 80%).

  18. Juan

    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. …

    Edward,

    Have you considered that ‘over-leverage and over-indebtedness’ may have developed in reaction to prolonged crisis of overproduction, understanding that term to be substantially more than a simple glut of product but to include at least the overproduction of plant and equipment [and not only on a national scale]?

    From this perspective today’s financial crisis [and 'yesterday's' bubble] can be seen as a symptom which arrived at its limits which, last instance, reside with the real economy.

  19. Juan

    should say:

    From this perspective ‘yesterday’s’ bubble [and today's financial crisis] can be seen as symptomatic of contradiction between the real and financial, and limits to the latter as well as ‘permanent crisis management’.

  20. Anonymous

    Interesting post and comments. But I wonder, when the real problem is too much debt, and today we observe the Government printing another $300B for credit markets, plus $750B for mortgage backed securities, common sense says this financial hole is only getting deeper. Are we raising the ante and going for broke? This will not end well.

  21. john c. halasz

    The time-preference theory of interest is Austrian hooey. For the rest, what Juan said. It’s noteworthy that corporate cap-ex with cycle was poor to mediocre, even as reported corporate profits were at near record levels as % of GDP. As for that “global savings glut”, in fact, aggregate global savings and investment declined during this cycle compared to others. There was not such “glut”, rather just a trade imbalance at the behest of corporate labor arbitrage.

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