Posted on 02/05/2003 11:10:57 AM PST by sourcery
Richard Benson is president of Specialty Finance Group, LLC , offering diversified investment banking services. This article was originally published Oct. 15, 2002 on his website. The recent AOL writedown appears to provide an example of the vaporizing "Fictional Equity" mentioned below.
Simple arithmetic, knowledge of how the world works, and common sense, are all that are needed to see that a long Real Recession lies ahead. The pillars of the U.S. economy: Business, Real Estate, Financial Markets, the Consumer, and, the Government, are still pointing down. In order to meet demand, businesses still have too many workers, too many plants, and too much capital. The $8 Trillion drop in equity values will force companies to write off at least another Trillion in corporate “Goodwill” from their balance sheets. Companies that acquired other companies for stock during the bubble, clearly overpaid. That “Fiction” was booked as Equity in the form of Goodwill. Now that the “Fictional Equity is vaporizing, it is leaving companies with new problems meeting debt to equity covenants with their banks and bond holders. In addition, the drop in equity values has “ripped up” company pension funds. The S&P 500 pension funds alone are suddenly $280 billion under-funded, and major corporations that keep an assumption of an annual 9 - 10% return on their investments are long past the “Laugh Test” for credibility. Corporate revenues are not “Snapping Back”. Indeed, corporations have far too much debt to service, and corporate credit spreads are at record levels. The junk bond market is rapidly expanding because of “Fallen Angles”, and in the next year or two we will certainly see many “household” names of major firms go bankrupt like United Air, Household, and Ford. United Can’t afford to pay its airline pilots up to $300,000 a year; Household can’t keep making credit card loans to people who will lose their job; Ford can’t fund its pension fund and sell cars to people with bad credit, at no profit and at zero interest. The Federal Reserve has tried adding massive amounts of liquidity, and the credit markets are finally waking up to the reality that liquidity doesn’t make “Bad Loans Good”, it makes “Bad Loans Bigger”. Companies can no longer borrow their way to meeting cash-flow needs. Companies are forced to cut new investment and slash employment. If there is any need for new investment, it will certainly be in China, where labor cost 10% of what it does in the U.S. When history is re-written in order to match the actual acts, much of the recent U.S. “Productivity Boom” is nothing more than a strong dollar, importing parts made with “cheap Asian labor”, and final assembly in the U.S. Business is going to continue to be a big negative for the economy and the job market.
Commercial Real Estate is already rotting, and single family real estate has peaked and started a very long slide. Commercial buildings are still being finished for tenants that no longer exist. Commercial vacancy rates are way up, but do not reflect the large amount of “sub-lease” space that is on the market.
The owners of commercial properties with mortgages on the buildings don’t want to look at what will happen when primary leases come up for renewal, and the major tenant decides to reduce the space they are willing to pay for back to what they actually need. The smart property owners are selling now while there is still an impression that Real Estate is better than the stock market. Major corporations, like Citicorp, are selling their corporate headquarters because they need the money. More firms like K-Mart will file bankruptcy and significantly cut the number of locations they lease. New construction for commercial properties has to collapse. Who needs them? Single Family housing foreclosures just hit a 30-year high. This fact undermines the durability of the “Housing Price Bubble” and record cash-out mortgage re-financings.
Housing has helped to hold up the economy but winter is coming. The re-financing binge is running its course and will be ending by the first quarter of next year. The real damage to the housing market has yet to come. New housing construction and record low interest rates have pulled consumers out of multi-family rental units, pushing rents and commercial property prices down. This has encouraged the consumers to greatly overpay for their homes. When this individual loses their job, they will lose their house to the bank. Their new home will become the old apartment they used to rent.
Banks and the GSEs are acting as if housing prices can only go up, and have lent to very marginal borrowers. The good news is that home ownership is at record levels for the population. The bad news is that the records for homeownership will be replaced by new records for housing foreclosures. Look forward to a very long winter for housing and commercial real estate.
The financial markets are still signaling “Major Bubbles”. While the stock markets have started to correct, and have wiped out $8 Trillion in the U.S and at least $20 Trillion worldwide, the major bubble in the debt and credit markets is just stating to unwind. The Federal Reserve created the bubbles and has been desperately trying to protect them with massive injections of liquidity, and encouragement of credit creation. However, the credit markets are beginning to catch on: adding liquidity to markets doesn’t make “Bad Credits Good”; it makes “Bad Loans Bigger”. Too many credits are already too big. Argentina has defaulted. Brazil will default. Turkey will default. United Airlines and Conseco will file bankruptcy. There is a huge list of companies and countries that cannot pay back what they have already borrowed. Lending them more money will change the date of default and increase the amount. The credit markets are saying that you just can’t find anybody that wants to be the “New Lender” to help “Bailout the old Lender.” The problem for the financial markets is that one firm’s debt is a financial institution’s asset. As loans default, they destroy real equity capital in banks, insurance companies, hedge funds, CDO’s, etc.
The capital markets and financial institutions depend on leverage. As equity is destroyed, their ability to leverage and lend is destroyed. Downgrades of a bank like JP Morgan Chase make it harder for them to take on risk. They already have over $20 trillion of derivative exposure. If JP Morgan Chase’s derivative book for interest rate swaps, credit derivatives, structured equity notes and other market bets were put back on balance sheet, they would make the balance sheet of Long Term Capital look quite conservative.
In the financial system there are over $100 Trillion of derivatives. Most of these were booked based on pricing models that assumed that markets do not move more than three standard deviations from long-term trends or averages. We now live in a world where many markets have easily moved four or five standard deviations from the norm. Major financial institutions have tremendous losses that have not jet been realized. The only steady source of earnings for the financial sector is funding long term Treasury notes and mortgage assets with short term CP or Fed Funds. If you think an economy is healthy if it offers a return on a 10-Year Treasury Note of 3.60%, it means you don’t think.
The “Bond Bubble”, based on low and lower short term interest rates, is a catastrophe waiting for the first time the Fed raises interest rates. If the Fed is true to form, it will cut short term interest rates to make this Bond and Agency Security Bubble as big as possible. The financial markets do not offer a quick fix or a long term solution to our current economic problems. Indeed, the financial markets are the problem. Only “de-levering” the financial markets will restore them to health. However, de-levering means less debt, less borrowing, more saving, and much less spending. Less spending means less economic activity.
Will the consumer spend us back to prosperity? The answer is with what? The consumer has been conditioned by the stock market bubble. Since the stock market would take care of his retirement, there was no need to save. Indeed, the consumer could spend every dollar he earned and every dollar he could borrow. This leads us to a world where 1.6 million consumers are now filing for bankruptcy every year. This year the U.S. Treasury will collect $180 billion less in taxes from individuals than last year. That means that $600 billion of income and capital gains has gone missing. This year single family mortgage debt will be up $600 Billion. Borrowing helps keep spending alive. But at some point, decreasing incomes and increased borrowing just don’t add up, particularly when pension funds and 401K’s have been nuked by the Bear Market. Borrowing to spend means that you are spending other people’s money. It’s wonderful; it's fun; Unless, of course, you are the lender. With low incomes, no bonus, job loss, no new jobs, record bankruptcies, and record home foreclosures, we are starting to see consumer spending sag, and slowed down lending to people who can’t pay. The consumer pull-back will trigger the Long Economic Winter.
With Congress approving going to war, you would think that the boost in Federal spending needed for the war effort would boost the economy. The government is not doing enough. While the Federal budget is going into deficit, more of the deficit is coming from a drop in tax revenue than new spending. Moreover, state and local governments are headed for $80 Billion in deficits; except, these governmental entities are not supposed to run deficits. While state and local borrowing is rising, so will taxes and cuts in programs and employment. Because of the November elections, needed fiscal policy will be postponed until next year.
Without massive, immediate fiscal stimulus to offset the major negative forces from business, real estate, the consumer, and financial markets, common sense and arithmetic add up to a very Long Economic Winter.
Billy_bob is an as yet undiscovered talent.
Richard W.
Had they had faxes, phones and interstate highways I have no doubt their tenure would more closely resemble our own.
No, those two circumstances are mutually exclusive.
INFLATION is the devaluation of your currency (ie. it takes more of your currency to buy the same thing).
DEFLATION is the enhancement of your currency (ie., things cost less).
You can have one or none, but not both at the same time.
You must have a different set of bureaucrats than I do. Mine still think that if you bust your butt and try to get ahead, you've won life's lottery.
I'm afraid not. You're ignoring how credit originates and is distributed in our financial system.
The scope of the terms "inflation" and "deflation" is too narrow to capture our current situation. The credit bubble collapse is deflationary, the Central bank's response is inflationary. Unfortunately, the two will not neatly cancel out.
A credit bubble collapse may throw a deflationary tendency into an economy, but it by no means insures that one gets deflation per se.
Likewise, pumping money into an economy may throw inflationary trends into an economy, but it alone by no means insures that one gets inflation.
Moreover, one can not have both inflation and deflation (on any broad scale) simultaneously.
Inflation means that things cost more.
Deflation means that things cost less.
Inflation means that your currency is worth less.
Deflation means that your currency is worth more.
You can have one of those two things (or neither), but it would be quite a feat to have your currency worth both MORE and LESS at the same time!
It all depends on what "things" you are talking about. If a dollar buys more housing,less gold,more equities,less energy,more automobiles but less skilled labor, then what are you going to call it?
Minor peturbations, yes, not the major dislocations that result from the moronic misallocation of resources that is the halmark of Democratic Socialism.
On a side note, I learned the middle name of the President of Fannie Mae today. Delano. Fannie is run by Franklin Delano Raines i.e. FDR
The irony is killing me.
You'll know when resources are grossly mismanaged because you'll see Productivity decline.
Look at Zimbabwe today, for instance, a nation that once was so productive that it exported food now must import emergency rations just to survive yet another day of its self-imposed famine. Now look at Zimbabwe's resources; they've been confiscated from the most productive group and given to the least productive (i.e. the "war veterans" who don't want to do any work, they just want free land and fancy titles).
Now there's a gross misallocation of resources as well as the loss of Productivity to show for it.
Look for Productivity declines to find areas where resources have been misallocated.
My point is that there is now some traction on dividend, estate and capital gains taxes - cuts in any of these diminish the relative tax advantages of borrowing.
America is not the economy, however misconceived.
I do share many of the notions of "prudent bears"-I think the "information economy" was a (mostly) Clintonian shell game, I think outsourcing production is a disaster, and I think the credit bubble is going to pop.
Where I part company with these folks, is to say, "So what?"
This is America. We'll fix it. And it will be better, afterwards.
And Bush has the great fortune of being a contemporary of Gates, Grove, and Greenspan, too!
One big difference between Clinton and Bush is that Bush seeks his inspiration from Kenny Boy of Enron fame, Tyco, and Worldcom. Bush made his fortune from inside trading in Harken Energy stock, didn't he?
Jerry Pournelle discusses the issue of Republic and Empire regularly on his site. As he is a true Modern Renaissance Man, his commentary is interesting and worthy of review and consideration. My summary of his take - we are long past returning to Republic, and seem to be sliding into incompetent empire, where we have the worst of both worlds. If we're going have empire, it should at least be run for the benefit of the citizens of the empire.
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