By John Bougearel, author of Riding the Storm Out and Director of Financial and Equity Research for Structural Logic
Policymakers managed to extinguish a financial panic in 2008-09 by March 2009. This rescue operation allowed the broad U.S. stock market as measured by the SP500 to rally nearly 70%. Extinguishing the panic was to be expected. What I have questioned throughout the year are the measures that policymakers took to extinguish the panic and effect a stock market rescue. In particular, I wonder if the measures taken are only masking over serious unresolved issues within our financial atmosphere.
U.S. Treasury Secretary Timothy Geithner in a December 22, 2009, All Things Considered interview with Michele Norris claimed that 2009 is ending on the road to recovery.
The economy’s growing again. The policies the president put in place are helping lay the foundation for growth and job creation…American’s “can be more confident about their financial future, financial security. Growth looks like its accelerating in the 4th quarter.
NPR queried Timothy about a second wave of systemic crisis coming from commercial real estate or some other seen or unforeseen or unintended time bomb. Many experts remain quite concerned this credit crisis will be back-end loaded with second-round effects and positive feedback loops that spirals us further into the rabbit hole the economy entered in 2008-09. Geithner adamantly replied,
We’re not going to have a second wave of financial crisis. We will do what is necessary to prevent that. We can not afford to let the country live again with the risks of another series of events like we had last year. That’s not something that is acceptable and we will prevent that. And that is something completely within our capacity to prevent… When you have the will to act we have substantial ability to prevent that and we will do what is necessary.
Much of the Treasury Secretary’s positive forecast for 2010 and beyond is predicated on the political will to act and anecdotal signs of Q4 GDP growth, incremental increases in business confidence and consumer spending, and the stabilization of the housing and jobs markets. Never again will America be plunged into the 2008-09 rabbit hole because the Treasury Secretary asserts “that is something completely within our capacity to prevent,” and they have the political “will to act.” Throughout the crisis, we saw policymakers displaying the political will to act in a manner that best served the interests of financial lobbyists, not that of the American public. That was transparent enough. Less apparent was how well policymakers served the short and long term interests of their constituents, the highest authority to which politicians’ should have been appealing.
I do not share Treasury Secretary Geithner’s confidence in the policies the Obama administration “put in place” to effect this recovery, and I will not champion them. In fact, many of the policies put in place only mask unresolved issues. So, I am quite concerned about the secondary effects resulting from this global financial meltdown. There are significant unrealized losses still in the pipeline. The full effects of this global financial meltdown have not been felt yet.
Nor do I share Mr. Geithner’s peculiar brand of optimism which is seemingly reminiscent of Chance the Gardener played by Peter Sellers in Being There “As long as the roots are not severed, all is well, and will be well, in the garden.” Policy measures and legislation passed to date to stabilize the financial crisis in 2008-09 have primarily been aimed at saving the dysfunctional big banks and preserving the OTC Debt and Derivatives markets. In short, the aim has been to restore the tentacled and tightly coupled roots in the big banks Financial Garden of Eden. The fact that lawmakers on Capitol Hill helped big banks preserve their Financial Garden of Eden in 2008-009 as much as possible should come as no surprise, because these same lawmakers had previously played such a large role helping banks create their garden in the first place which made possible the big banks fall and subsequent global financial meltdown.
I do have a great deal of reservations and skepticism about America’s financial future and more specifically about American’s financial security. As 2009 comes to a close, we are in the eye of the hurricane. We have yet to be hit by the backside of this financial storm. This credit-collapse is not your typical Post WWII recovery from recession as economist David Rosenberg and others like Paul Volker so often and thankfully remind us. Paul Volcker in a December 2009 Der Spiegel Interview titled America Must Reassert Stability and Leadership:
What complicates this [crisis] as compared to the ordinary garden variety recession is that we have this financial collapse on top of an economic disequilibrium…We have not been on a sustainable track and that has to be changed….those changes don’t come…in a quarter [or] in a year. If we don’t make that adjustment and if we pump up consumption, we will just walk into another crisis. We have not yet achieved self-reinforcing recovery. We are heavily dependent upon government support so far…both in the financial markets and in the economy.
The Room For Policy Error is Enormous
Thus, the room for error in Mr. Geithner’s optimistic forecast is enormous. His outlook ignores the fact that an incredible, wide array of uncertainties can blind-side both domestic and global policymakers in a post credit-bubble collapse environment. In particular, I will add, the room for downside risks to the Treasury Secretary’s optimism is significantly heightened by the policy measures implemented to stabilize the big banks, precisely because these policies masked the effects of so many underlying issues. If the stabilization of the big banks and the financial system becomes unhinged again, in spite of what Mr. Geithner insists must be and can be prevented from ever happening again, we will walk right back into crisis and Irving Fisher’s debt-deflation spiral will resume.
Charles Kindleberger tells us financial crises are “hardy perennials.” That is true, but traditional remedies for extinguishing panics in the financial system over the past two hundred years have more or less always followed Walter Bagehot’s prescript that you “lend freely and early, to solvent firms, against good collateral, and at high rates.” This is what the bank of England did to avert the Panic of 1825. It is exactly what JP Morgan did to avert the Rich Man’s Panic of 1907 ~ he liquidated the bad banks and recapped the good ones. This is roughly what FDR did in 1933 and what Sweden did in the 1990s. They all separated the good banks and good collateral from the bad banks and bad collateral, letting the bad banks fail, and backstopping the still solvent banks. The broader aim was always the same, to save the financial system rather than the bad banks and their shaky collateral. To do this, they let the under-collateralized banks fail, and lent freely to solvent banks against good collateral at a high rate.
The financial panic of 2008-09 stands in stark contrast to the extinguishing of previous financial panics. The most outstanding features to the financial panic of 2008-09 was that the policies set in place were to save the bad banks loaded with toxic collateral on and off its balance sheets rather than to save the financial system itself. Lawmakers effected this change in March 2009 when they eliminated the fair value accounting rule to allow insolvent banks to mark their toxic assets at full value rather than at market value. Effectively, they swept the toxic asset under the rug. They masked their toxic effect, but unresolved issues remain. These toxic assets are now being stored on the Federal Reserves and other off-balance sheets, loaded with unrealized losses. The Basel Committee and FASB are now allowing banks until 2012-2013 to put these assets back onto their balance sheets. This explosive timetable has been reset to 2012, the end of the Mayan Calendar. For those with an eschatological bent, this date with destiny might be the End Days of our financial system as we knew it.
This is a first-ever occurrence in 200 years of banking history that losses stemming from bad collateral were not realized early on. They are time bombs with delayed fuses. To partially offset this day of reckoning in 2012, the Federal Reserve adopted a Zero Interest Rate Policy (ZIRP) to help the very same insolvent banks lever up the yield curve borrowing short and lending long to earn their way out of insolvency. But rather than letting these profits restore the banks impaired balance sheets, bank executives are redistributing these profits in the form of bonuses. Worse yet, ZIRP is a financial hardship that hurts millions of saving Americans plowing their hard earned dollars into CDs and money market funds. In this way, a zero interest rate policy serves to undermine the financial security of millions of Americans. And still, the unanswered question is whether insolvent banks can successfully recap themselves before these Bouncing-Betty’s detonate. In a race against the clock, policymakers are simply buying banks time, hoping they can avoid mutually assured destruction when their eschatological date with destiny arrives.
Global Warming Trends Serve as a Model for the Global Financial Meltdown
Financial innovation over the past thirty years led to a huge growth spurt in the OTC Debt and Derivatives markets. One could say that innovation led to a revolution within the financial industry. This revolution has created vast sums of toxic assets now being stored on the Federal Reserves and other off-balance sheet vehicles. By way of analogy, these man-made toxic assets can be likened to man-made greenhouse gases being created by the industrial revolution and fossil-fuel industries which are now contributing to accelerating global-warming trends. The meltdown in the global financial markets has many dangerous parallels to global-warming trends to consider.
Man-made greenhouse gases like carbon dioxide that have been released into the earth’s atmosphere are being partially absorbed by the ocean and then stored there. However, the carbon dioxides that have been absorbed into the ocean are not passively sitting there; they are actively destroying the ocean’s corral reefs and shellfish. These gases being stored in the ocean have yet to be re-released into the earth’s atmosphere. The ocean creates a lagged effect on global warming trends. When they are re-released into the earth’s atmosphere, this will create negative second-round effects thereby accelerating global-warming trends in the decades ahead.
Today, the Federal Reserve acts much like the ocean for greenhouse gases, absorbing and storing the toxic assets and shaky collateral [OTC Debt and Derivative products] created and released by the big banks. These financial carbon dioxides being stored on and eating away at the Fed’s balance sheets have yet to be re-released into the global financial system. When these financial carbon dioxides are re-released into the global financial system, this will create negative second-round effects that will broaden the reach of the global financial meltdown in the immediate years ahead [2011-2013]. Do you see where I am going now?
Jim Hansen, a leading global warming scientist has shown us that global warming trends in the earth’s atmosphere do not respond instantaneously to increases in greenhouse gases. There is a “substantial amount of what Jim calls ‘unrealized warming’ or warming that was still ‘in the pipeline’ – we hadn’t felt it yet.” What Jim Hansen is describing are the feedback loops and secondary effects that are still in the pipeline. “And feedbacks are inherently slow to unfold.” One of the most important examples of feedback is the melting of permafrost in Alaska, northern Canada and Siberia. “Plants that have been frozen for thousands of years are now supplementing the greenhouse effect as they decompose and send prodigious quantities of carbon dioxide and methane into the air.” The artic tundra stores more than 500 billion tons of carbon which is twice that of all the rainforests on the planet and 20 times the amount of fossil fuels emitted in a year. The secondary and lag effects with respect to global warming, Jim Hansen notes “obviously complicates the tasks of decision-makers.”
To the extent that the policy measures put in place in 2009 to “mask” “store” and “freeze” the financial dioxides embedded in the financial system rather than having them purged them from the system, most American’s financial futures and their financial security will be at risk for several years to come. I see no room for complacency. Moreover, American’s financial security will be further compromised in the coming decades as and when Social Security and Medicare pass their tipping points as well. Will the U.S. government default on their social obligations to meet their financial obligations in the years to come?
So what happens as and when the frozen and unrealized losses still in the pipeline and being stored on off-balance sheets are allowed to decompose over the course of the next three years? What will be the cost to millions of American’s financial security once the full effect of this financial meltdown is felt? And I speak as if this were only an American problem. But in point of fact, this is a global problem, particularly in those countries running large deficits. The financial security and well being of hundreds of millions of global citizens remain vulnerable.
Mr. Geithner’s reassurances to Americans aside, the lagged consequences of the global financial meltdown remain considerable. While some of these risks are transparent, many of the risks are opaque and remain hidden. Final outcomes are imaginable yet highly uncertain and largely unquantifiable. No one person can possibly get their arms around all of the risks. Below I attempt to highlight some of the foreseeable uncertainties, risks, and challenge that lie ahead between 2010 and 2013. The list is by no means comprehensive.
Domestic Risks and Uncertainties
1. The Bulk of the Option Arm resets trigger in 2010-2011 – “The reality is that these loans were never meant to survive the reset. Unless an alternative is created, the human pain and loss will be massive.” Institutional Risk Analyst Chris Whalen
2. The Black Holes at FNM and FRE and other GSEs continue to grow
3. Bank hoarding in 2009, with no end in sight until those option arm resets trigger and all toxic assets have been brought back onto their balance sheets by 2013
4. State and local governments defaulting on financial obligations. To meet financial obligations, austerity measures will be required, social obligations will suffer, meaning more unemployment and less teachers, firemen, and policemen. This burden will be another source of drag on the U.S. economy.
5. Credibility of the Fed and U.S. Treasury and White House Administration will be on the forefront on Investors minds in 2010 and beyond. If their credibility suffers, there will be negative ramifications in the financial markets
6. Stock Market Rescue Operations like the one that got underway in March 2009 tend to last roughly two years, and are followed by bear market resumptions. My models indicate the 2009 bear market rally may end sometime in 2H 2010 followed by a resumption of the secular bear market into 2012-2013.
7. My models also indicate the 2009 bear market rally in the Dow Jones may peak at 11,750-to 12,000, near the bull market crest in 2000. That leaves maybe 12% further upside in 2010 and implies that most of the gains from this bear market rally are already in place. As David Rosenberg pointed out throughout 2009, this is a rally for investors to ‘rent.’ What reallocations can they make as and when the rally ends?
8. Advanced Economies in America and Europe all face Pension liability nightmares with shrinking workforces to support the retiring population, recent examples are GM and YRC pension nightmares. Are taxpayers going to be obligated to fund all private and public pensions of bankrupt companies and state governments?
9. Risk Aversion, saving more versus spending more will be a drag on the economy
10. U.S. government mandate requiring 30 million uninsured Americans to buy health insurance will curb consumer spending and act as a tax on the economy. It will also curb hiring plans amongst U.S. employers further prolonging Americans sidelined from employment opportunities and exacerbating the unemployment rate issues.
11. Will the kindness of foreigners continue to fund the U.S. deficit spending? Eric Sprott and David Franklin noted in their December 2009 missive titled “Is it all just a Ponzi Scheme?” that the “household sector” bought $528 billion of the $1.88 trillion of U.S. debt that was issued to them. This sector only bought $15 billion of treasuries in 2008, where would this group find the wherewithal to buy 35 times more than then bought in the previous year. Sprott concludes that makes no sense with accelerating unemployment and foreclosures, so the household sector must be a “phantom. They don’t exist. They merely serve to balance the ledger in the Federal Reserve’s Flow of Funds report.”
Global Risks and Uncertainties
12. Sovereign Risks of Default are increasing as is their fiscal credibility in countries with large debts
13. Asymmetries within the EMU could precipitate a possible breakup of the EMU. The solidification of the countries in the EMU may break-up like ice sheets in the Artic tundra as the global financial meltdown puts further stress on the EMU. Incentives to remain in the EMU, for many EU countries it might be better to leave the EMU than stick around for its constraints and austerity measures
14. The One-size fits-all monetary policy in the EMU may be derailed by this crisis
15. Germany may not want to subsidize weaker countries in the EMU if their exports to those weaker euro countries are falling off a cliff as the crisis rolls on
16. The ECB may not be able to accept sovereign collateral and assets from countries in the EMU that have a negative credit outlook and are later hit with further downgrades. That could have spillover effects into the banks-at-large, including the ones the U.S. government sought so frantically to save.
17. The PIIGS (Portugal, Ireland, Italy, Greece, and Spain) debt ratios are all expected to exceed the 3% GDP 1992 Maastricht Treaty requirement.
18. PIIGs negative 2009 GDP resulting from global export decline leaves them with little incentive to stay strapped to an expensive Euro.
19. Italy is expected to be the first country that will first kiss the EMU good riddance. Greece and Spain might not be far behind as a domino-effect takes hold.