By Paul Zipkin

Here we are in early fall, 2009. It was a fairly calm summer. There were no major financial disasters. The stock market revived somewhat. The economy is still troubled, but compared to the unremittingly awful news during the previous year, it’s been a good time. I believe some credit for this happy turn of events is due to the bank stress tests conducted by the government during the spring.

The tests calculated what would happen over the next couple of years under two scenarios, a base-case scenario and a bad scenario reflecting worse economic conditions. They considered each bank’s entire position, not just standard deposits and loans but also fancy mortgage-backed securities and swaps. The question was, how much capital would each bank need to continue operating normally under the bad scenario?

The method itself is not at all novel. Many businesses, military forces and other organizations do this sort of scenario planning all the time. No one knows exactly what will happen in the future, so it makes sense to simulate several possible futures, to estimate whether the organization’s plans are robust.

But, amazingly, this was the first time the government conducted such a test of our financial system. We do have elaborate financial regulations, but those specify procedures and check whether they have been followed. In other words, they look backwards, not forwards. To look ahead at several plausible scenarios, the exact same ones for all banks, and to include all the banks’ exposures – that was unprecedented. Of course, the inspiration for the stress tests was the sequence of ugly surprises in 2008. Nobody knew how dire the situation was at Lehman and the others until it was too late.

Banks are supposed to do this sort of thing for themselves, of course, but it’s not clear how seriously they take these “risk management” exercises. Anyway, they are not required to use the same methods and certainly not to make the results public.

Before the results were revealed, many observers criticized the tests. The tests were not rigorous enough, the bad scenario was too tame, they said. (The Treasury invited some of this carping by calling the bad scenario the “worst-case” scenario. It was not that.) But the criticism largely fell silent once the tests were complete and the results announced on May 7.
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Is anybody listening out there? Those ‘in the know’ expected 180,000 job losses. Some thought 150,000. Optimists thought job gains. In the end, we bled 283,000 jobs.

It was no surprise to me. The message has been clear in the past two Duke-CFO quarterly surveys. Companies are still in cutting mode. Employment is not going to significantly improve when we have 551,000 new claims for unemployment insurance. So what if the four-week moving average of claims has decreased by 6,250 to 548,000. We need some three handles to stabilize employment and we are way far from that territory.

What to Watch For

The following are very important for those of us that carefully track employment:

• Forget continuing claims. They are misleading. Any headline like “Good News, Continuing Claims for Unemployment are Down” is likely written by someone who doesn’t really understand the data and the Federal programs. Continuing claims might be lower because people roll off the standard unemployment program and hit extended benefits and the emergency program (EUC). You need to count correctly. Notice that the extended benefits and EUC are reported with a two week lag. The most recent data showed that the number of people on emergency programs increased by 99,832 to 3,275,213.
• Extended benefits and EUC are important to watch because we have a problem with the duration of unemployment. It is taking longer to find jobs and this is another sign that the economy is not coming around.
• Watch the average number of hours worked in a week. The number of hours worked has been decreasing. People are sometimes voluntarily working fewer hours to save their jobs (or fellow workers’ jobs). Working fewer hours is a “shadow” unemployment that is not counted in the official numbers.
• I like the Bureau of Labor Statistics measure “U6″. This measure looks at total unemployment by considering unemployed, “marginally attached” workers as well as people working part-time that really want to work full time. This rate is a staggering 17%. It has never been this high.
• Initial claims as mentioned above need to be in the 300,000 range to stabilize employment. We are nowhere near that.
• The scale of the unemployment problem is important because we are approaching no-man’s land. What I mean is all the data to analyze the impact of unemployment comes after 1947. We are already in a recession situation worse than any other since WWII. Yes, this is not the Great Depression – but we don’t really have good data on the Great Depression. It is a challenge to quantitatively analyze some problems (I have an example below). To be clear here, we have lost 7.2 million jobs during this recession. We will lose more. How about this comparison? If we lose an additional 1.7 million jobs, i.e. go to 8.9 million losses from 7.2 million, the loss of jobs on a population adjusted basis will equal the losses in the past four recessions — and that includes the nasty double dip of the early 1980s.

What Worries Me the Most

Suppose you statistically examine the relationship between unemployment and mortgage defaults. There is a moderate positive association as you might expect (higher unemployment leads to higher defaults). Indeed, this moderate positive association forms the basis for the stress tests that banks have (finally) done.

What if this model is flawed? What if the financial institutions have underestimated the number of defaults? Here are the reasons why the models could be wrong:

• The estimates are largely based on mild recessions. This is not a mild recession. We have not seen anything like it in all of the available data. Essentially, we are extrapolating outside of historical experience. Usually when this occurs, we explicitly account for the extra uncertainty by being more conservative. I have my doubts that the financial institutions have factored in this extra uncertainty.
• While first point is important, the second one is more important. There is a critical omitted variable in the analysis. People statistically analyze default versus unemployment — but you must take housing values into account. If your house is worth less than what is owed on the mortgage, you are far more likely to default than if your house is worth more than the mortgage. In most of the data used in the standard analysis, houses are worth more than the loans. In other words, the fact that potentially 50% of houses with mortgages are under water, greatly increases the sensitivity of default to unemployment. This suggests that there is much more downside than financial institutions have prepared for. It suggests a second wave of credit crisis.
• Even the financial institutions know that defaults have not peaked yet. People are still holding on. Expect a surge in defaults, foreclosures and bankruptcies to happen next year.
• The social stigma attached to defaulting on your mortgage is gone. Keeping up the Jones’ means you get to default too. Anyways, those banks took all that government money making it easier for them to be the bad guys.

Other Tidbits

• As predicted, the Cash for Clunkers simply shifted car purchases. GM sales down 42%. In the end, the problems in the auto industry remain. Any bets on Chapter 22?
• There is a lot of push back on basic financial regulatory initiatives – like the requirement to offer vanilla mortgages. A lot of the push back is from small financial institutions who cannot compete in such a market against the likes of BAC and Citi. The real issue here is why do we need 7,000 banks in the U.S.? It would be far better for both customers and the economy to have a massive shakeout. In addition, it is completely dysfunctional to have different banking regulations depending upon the state that the bank resides in.
• The FDIC is bankrupt. For the last year, I have said that there are 1,000 banks that need to go down. Now we are in the odd situation where the FDIC cannot close down so many banks because they simply don’t have the funds.

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See below my monthly employment graph that standardizes the job losses (based on the size of the labor force) across different recessions.

There is a lot of finger pointing going on one year after Lehman declared bankruptcy. Most of those fingers are pointing to Lehman and the way the bankruptcy was handled. However, that is a very simplistic view of what happened a year ago. The crisis was transformed into a panic — not because of the Lehman filing, but largely because of the bungling policy known as TARP.

Setting the Record Straight on Lehman

Lehman deserved to fail.

Here is the real story.

Then Treasury Secretary Paulson was getting a lot of pressure to help Lehman. Paulson wisely asks for the following information. He wants to know how they are valuing a list of illiquid assets. He requests the same valuations from Goldman and J.P. Morgan. The data come back quickly. The values that Goldman and J.P. Morgan are carrying on their balance sheet are deeply discounted and quite close to each other. The values that Lehman has on their balance sheet aren’t even close. Angry, Paulson is determined that the firm will go down. Why bail them out? It would be a colossal waste of taxpayer money.

This was the correct thing to do. Any bailout would have probably taken many rounds of taxpayer help.

Of course, the execution of the bankruptcy was a problem. Surely, arrangements could have been made for a more orderly transition. This would have given counterparties more time to unwind Lehman linked positions.

It is ironic that the disorderly bankruptcy of Lehman poisoned the possibility of the government letting other large firms file. As a result, the government adopted the terrible policy of “too big to fail.”

Trashing TARP

Let’s summarize the events:

• Paulson comes to Congress with a three-page term sheet asking for close to $800 billion
• The American people (rightfully) assume that the Treasury Secretary and Fed Chairman have inside information on the gravity of the financial crisis.
• They stoke uncertainty by their vague reasons for needing the $800B the apparent lack of strategy.
• They cause outrage on Main Street when it is revealed that toxic assets will be purchased at premium prices — essentially bailing out bad trades with tax payer money.
• TARP fails on first vote.
• TARP eventually passes.
• TARP is never TARP. That is, the money was not used for Trouble Assets. Instead, money was used to inject equity into big banks.
• Essentially, no questions were asked before the banks got the TARP money — remember the famous “Stress Test” came after the money was given to the banks.
• Government guarantees the big 19 banks.
• Good TARP money went to many firms that were essentially in Lehman’s situation. The TARP money was used to reduce risk rather than create new loans to pull us out of recession.
• Banks realize that they can’t pay bonuses at the same rate with TARP. As a result, they begin to give money bank. This results in even less money for lending – completely defeating the purpose of the original equity injection.

Now let’s speculate about some future events in 2010:

• Toxic assets still remain on the balance sheets.
• TARPless banks return to paying big bonuses.
• Defaults peak some time in 2010.
• Banks and policy makers are not surprised by the large number of defaults in Commercial Real Estate.
• Banks and policy makers are surprised by the large number of prime mortgage defaults.
• 1,000 banks are in trouble in 2010.
• Banks go back to the trough, err, TARP.

Already the FDIC is out of money — and they will need a lot more. 92 banks have failed this year and there are hundreds more to go. I made the 1,000 forecast last year. I noticed today that John Mauldin (who I high recommend reading) quoted some unpublished analysis from Institutional Risk Analytics that grades 2,256 banks in the “F” range. If less than half go under, you are at the 1,000 number.

There is more pain to come. Again, the decrease in new claims for unemployment insurance was spun as “good” news. Claims dropped by 12,000 to 545,000. However, to get the unemployment rate to meaningfully decrease, we need to reduce claims by about 300,000 — not 12,000. We are not even close to that. As I have written, the continued high umemployment will be the prime driver of prime defaults.

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See my appearance about 4 minutes into this BNN story.

Courtesy of AI Roofing Company, LLC Houston

 Given the decrease job losses and other favorable (or less bad) news, it appears as if the economic storm is abating — or is it the calm that you feel when the eye of the hurricane passes over?

There is unambiguous information that the rate of job losses is decelerating. “Only” 216,000 jobs were lost in August. The unemployment rate increased due to three reasons: (a) the job losses in August; (b) a revision upwards in the job losses in July; (c) and new people entering the labor force – perhaps reentering after a prolonged period of unemployment.

However, in my opinion, there is very little to call “good news” here.

Let’s summarize:

• We have lost 5.02% of the labor force to unemployment during this recession, over 6.9 million jobs
• This is now the worst episode in the post WWII period (this month it became worse than 1948).
• This is not the end. Remember the government stress test has the “worst case scenario” of 10.3% in 2010. We are getting close to that now.
• This is the time of maximum government spending. Just as the clunkers program has ended, the amount of government spending will begin to decrease.
• We have yet to see the peak in foreclosures and defaults in both residential and commercial real estate. That should happen sometime in 2010.
• We will see surprisingly positive growth in Q3 and people will declare the recession over.
• Even if such declarations are true, we are not out of the woods. The combination of three economic forces will slow growth in 2010.
  • A new wave of stress on the financial system due to surging defaults on prime mortgages and commercial real estate.
  • The continued constraints that small and medium sized businesses face in getting credit. These businesses drive employment growth.
  • Little or no action from consumer spending – which represents 70% of GDP. Consumers need to protect themselves by saving. No job is safe right now.

The Consumer’s Problem

Let me comment a bit on the consumer. The consumer has taken multiple body blows.

• A dramatic wealth hit due to degradation in the value of their main asset — housing. Indeed, for most homeowners with mortgages, their equity has been wiped out (or negative).
• A wealth hit due to a drop in the value of other holdings (like 401Ks).
• Unemployment and fear of potential future unemployment.
• Unease over future obligations as the government racks up record deficits and debt.

You put this altogether and it seems unlikely that the consumer is going to be the engine of the recovery. Savings rates were driven to very low levels during good times. This recession is shockingly bad and it caught most consumers by surprise. Indeed, we really haven’t had a deep recession in almost 30 years — people forget.

The result is caution. Consumers will build their savings for three reasons. First, many fear losing their jobs — or being paid less in the future. Second, the savings were close to zero to start with. Third, they want some insurance for the future.

All of this spells slow growth.

I am not sure when they will officially date the end of the recession. I had originally forecast the end of 2009. However, the more important issue has to do with growth prospects going forward.

Interpreting the Data Going Forward

The data will be difficult to interpret. We will see strong Q3 growth which is really due to government spending (which cannot be indefinitely maintained) and some inventory adjustment (firms have let inventories run so low that there needs to be some production to restock). Neither of these positive forces is sustainable.

While I am more pessimistic than most, let me say something optimistic. The Unites States is in far better shape than European countries or Japan. So, while this might seem for the U.S. to be a painful period of slow growth, we will gain ground globally with respect to other developed countries.

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See below my monthly employment graph that standardizes the job losses (based on the size of the labor force) across different recessions.

Courtesy of flickr/Jeff Turner

Just because the unemployment rate dropped from 9.5% to 9.4% does not mean we are out of danger. This is how I think the economy will unfold. The scenario is consistent with what I have been posting for the last six months:

• Many people want to believe the recession is over. Any piece of less bad news is considered good news.
• Yes, we will see perhaps +3% real growth in Q3 and positive growth in Q4. That does not mean the recession is over.
• The pop in growth is largely due to government intervention. The maximum stimulus impact will occur between now and the end of the year.
• Much of this government spending is simply “shifting” consumption expenditures. Cash for clunkers is a great example. People buy a subsidized car right now rather than next year or the year after. While we get some economic action today, it takes away from what would have happened in the future.
• Unemployment will continue its climb (but at a slower rate). We will likely hit 11% early next year. I have referred to this as the major risk the economy faces.
• What is not well understood is that loan defaults are beginning to surge now and will continue for a number of years.
• This surge in defaults (during and after severe recession with high unemployment) will cause a greater than expected impairment in the value of prime mortgages.
• The prime defaults (along with other loan defaults – I pick on prime because it is the largest category) will cause a second wave of trouble for financial institutions.
• Risk aversion increases in the face of new economic uncertainty. Growth falls again. The double dip. Read the rest of this entry »

On June 19, 2009, a premiere economic consulting firm (not to be named) forecasted a job loss of 275,000 in June.

To me, this seemed odd. The May drop of “only” 345,000 jobs (unrevised) seemed like noisy data. There was no substantial change in Initial Claims for unemployment insurance. Initial claims were running more than 600,000. The ADP also remained at an elevated level. The May ADP number showed a job loss of 532,000. Why should a lower reading be repeated in June?

We are in the mode of seizing any piece of good news as evidence of the turning point. So what, if the May Non-Farm Payroll number was inconsistent with Initial Claims and the ADP? A green shoot is a green shoot.

Throughout June, nothing really changed on the employment front. People viewed it as good news that initial claims were running in the 610,000 range rather than the 640,000. We were going to see a much better number for June. As I said, as of June 19, the Non-Farm Payroll loss was pegged at 275,000.

But 610,000 Initial Claims, while better than 640,000, is still terrible news. The ADP on Wednesday completely deflated the unrealistic expectation of a substantial turnaround. The ADP came in at a job loss of 473,000. Economists quickly revised their expectations.

The job loss today of 467,000 was no surprise to me (and to readers of my blog). This is consistent with the forecast made by CFOs in the latest Duke-CFO survey. The CFO survey, conducted in May 2009, suggested that private sector jobs would be scaled back by a staggering 5.6% over the next 12 months. Given the addition of public sector jobs, I estimated the net job loss over the next 12 months to be 4 million (this assumes 2 million public sector jobs are created). We are 1/5th of the way there (May+June losses divided by 4 million).

Perspective

• We have lost 6.46 million jobs in this recession
• We have lost more jobs in this recession than double the sum of the previous two recessions!
• We are 400,000 job losses away from the worst job loss situation since WWII. Technically, the recession of 1948 is still worse. However, it is a weird recession with one amazingly bad month. The percentage loss of jobs in October 1949 would have caused a print of -2.5 million losses today (in a single month).
• This ain’t over yet.

The Main Systemic Risk Factor

My main worry is that policy makers and risk managers at financial institutions have greatly underestimated the impact of unemployment on prime mortgages. Given that housing prices are falling at a 19% annual rate and given that many people with prime mortgages are losing their jobs, it makes sense that more and more people will choose to default on their prime mortgages. Note that 20% of homeowners with mortgages are underwater — what they owe on their mortgages exceeds the value of their houses. The assumption of a 2-4% loss on prime mortgages in the Treasury’s adverse stress test scenario seems unrealistic to me.

Increased defaults on prime mortgages could easily cause a second credit crisis.

Remember when the sub-prime crisis started? People initially said it was no big deal because the size of the market was small. Well, it was a very big deal and, yes, the size of the market was small. The prime market is gigantic and a surge in defaults in that market could quickly wipe out the capital of our financial institutions.

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The Duke-CFO Survey was released today and the news is grim.

One of the big challenges is to reconcile the growth in confidence against the hard data. Consumers as well as CFOs are more confident. However, our survey shows that this confidence is not influencing business plans. CFOs are playing a cautious, wait and see game, before pulling the trigger on new capital spending and employment growth.

Reconciling Hard vs. Soft Data

In examining the data, consider three factors:

1. Bottomming Out? CFO confidence graph shows that optimism is up but still lower than any other point historically (except the last quarter). It is like saying that housing sales increased by 10% – that is good but a 10% increase on a very low level doesn’t do much for economic growth.
2. Sustained vs. fleeting. I think people are grasping for some good news. There is talk of green shoots. However, there is very little fundamental data to support a recovery at this point. It is somewhat easy to feel a little more optimistic. It is a different matter to translate that into corporate plans. That is why I emphasize the idea of “sustained” optimism. Optimism will only translate into corporate action after CFOs are confident that the recent news is not fleeting. They will not change their corporate plans until there is evidence of a sustained recovery. Of course, there is a chicken and egg problem that results from this!
3. This crisis is different. I think CFOs are feeling more optimistic but given the gravity of the crisis – it is dangerous to extrapolate from previous recessions/recoveries. This is another reason to be cautious.

The Press Release

The press release is found here. Here is an excerpt from the draft release:

For the second consecutive quarter, there has been an increase in optimism. In the latest survey, 54% of respondents are more optimistic about US economic prospects. However, these numbers need to be tempered because the overall level of optimism is still low.

"Our survey carries an important message: don’t put too much weight on the ‘soft’ data like consumer confidence, which has been overemphasized in the news. Recovery requires sustained confidence, and such confidence is forged by stronger economic fundamentals," said Campbell Harvey, founding director of the survey. "The economic fundamentals are still fundamentally troubling. There is no thaw yet in this winter of hardship."

One example of hard data is the surveyed companies’ employment plans. Employment is projected to decrease by 5.6% over the next 12 months. This is essentially unchanged from last quarter’s projection of a 5.7% reduction.

"Approximately 109 million people are employed in the private sector. A drop of 5.6% means the loss of 6.1 million jobs. Presumably, government programs will offset some of these losses, but even the most optimistic government forecasts would reduce the losses by only two million. We’re facing a staggering four million additional job losses," said Harvey.

Since the recession began, 5.7 million jobs have been lost and the unemployment rate is 8.9%. The Congressional Budget Office assumes an unemployment rate of 8.8% in 2009 and 9% in 2010. "CFOs know their companies’ employment plans. Slashing employment by 5.6% means unemployment in the 11-12% range. Our survey evidence renders the CBO projections completely unrealistic," said Harvey.

Full results of the survey.

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Here are my talking points for my Fox Business News interview.

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1. Why should all the bailout money be focused on financial institutions? It is seems a matter of fact but no one has really challenged the logic.
2. We must act now to prevent the second wave of the credit crisis. The first wave was partially caused by people with jobs buying houses well beyond their means. The second wave will be people with prime mortgages who have lost their jobs. They are paying out of savings right now (and that accounts for the lull) — but savings will run out.
3. Fed stress test had unrealistic 2-4% assumption for loan losses in prime mortgages.
4. Prime is by far the biggest market. Close to $9T. Hence, every percent mistake in the Fed assumption is worth $90B. So a small error in prime loan losses could make many financial institutions insolvent.
5. We can’t afford any more spending – hence, we should redirect some funds.
6. Will be moral hazard problem (people want to be bailed out that don’t need to be bailed out). But not a valid critique of mortgage loan restructuing. The current policy has an even more extreme moral hazard problem. Financial institutions faced with coin flips where “head I win., tails you lose” — you being the American tax payer.
7. Target: 1) responsible borrowers – those that put at least 25% down on their houses; 2) simple means test based on 2008 tax filing + investment portfolio information; 3) priority in the process to recently unemployed. Reckless borrowers should be foreclosed.
8. Restructuring should be handled by bank or service provider — not the government or the courts. Not much has happened because little capital has been directed to the individual mortgages.
9. Proactive action to head off second wave. All of this could have been done two years ago and muted the impact of the sub-prime problem.

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An analysis of social networks and minute-by-minute customer transactions during a run on an Indian bank has found that bank runs can spread through a community like a contagion.

Duke University finance professor Manju Puri and co-author Rajkamal Iyer of the University of Amsterdam assembled a unique data set on the bank run and then employed epidemiological techniques to determine connections between bank depositors, using Google Earth to map the locations of their home addresses.

Following the failure of a larger, neighboring bank, the customers of a bank that was fundamentally sound were withdrawing funds out of fear that they might not be able to access them in the future.

“Using these tools, we were able to track the ‘transmission’ of running from one customer to another, just as you would see with the spread of a disease,” said Puri, the J.B. Fuqua Professor of Finance at Duke’s Fuqua School of Business. “We found that an individual customer’s decision to run or not was highly correlated with whether or not their neighbors had already run from the bank. We found clusters of customers running who all lived in the same building or on the same street. If one person ran, many did, but in other places no one ran at all.”
See video.

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Most of the reporting on the stress test focused on the number of banks passing the test and the doable amount of capital the failing banks needed to raise. The tough question was not asked: if the stress test wasn’t really that stressful, why did a majority of the banks fail?

The Good News

1. This is a move towards being more transparent. This is a good start.
2. I was very concerned about the assumptions of the stress test. The news that leaked out before the release suggested the loss impairment assumptions were far from realistic. However, it turns out that all of the loss assumptions are for only a two year horizon. This is an important point. For instance, suppose you think that the total impairment over a four year horizon is 8%. You read in the WSJ that the government is using 4%. You think that is way too low. However, it is not as low if the horizon is only two years.
3. The fact this is in the news is serves an educational function. People are getting a forced lesson in risk management. Whether they like it or not, this learning should decrease the chance of a systemic episode in the future. More people know the right questions to ask.

The Bad News

1. As I have said before, the economic assumptions are problematic. The adverse scenario has 8.9% unemployment in 2009 (average). Today we learned that the unemployment rate rose to 8.9% in April. The adverse scenario has a rate of 10.3% in 2010. It is likely we will reach that rate by the end of the summer of 2009.
2. The two year horizon essentially assumes that good times return by 2011. That is not obvious to me. We have not seen unemployment like this since 1948 and I project that we will blow by 1948 (adjusting for the size of the workforce) by the end of the summer. Employment lags the business cycle. This means there will be loan losses in 2011 and 2012. So rather than $599.2, given the assumptions on loss rates but simply extending out to 2012, a more realistic number is $1 trillion.
3. I think the assumption on Prime mortgage losses is particularly problematic. The more adverse scenario assumes Prime losses of 3-4%. First lien mortgage category includes three components: Prime, Alt-A, and Subprime. Putting all these together the adverse scenario only assumes an 8.8% loss over two years. This includes 9.5-13% losses on Alt-A and 21-28% losses on Subprime. I focus on the Prime assumption because the market is so big. In the overall economy (not the 19 banks), we are talking about $6 trillion. So, for every extra 1.5% in losses we drop $100 billion in value.
4. What about the other 8,000 banks? The two-year losses for the 19 are projected to be $599.2 billion in the stress test. These 19 have 2/3s of the assets and half of the loans.
5. I reject the idea that nobody should fail. When anyone takes on risk, you reflect on the upside and the downside. You temper amount of risk you take because of the downside. But if you are always bailed out, there is no downside and you will (continue to) take excessive risk. In addition, it creates a double standard: financial institutions are bailed out but other industries or individuals are not (yes, there are some exceptions like the autos). There is also another double standard based on size: if you are big you are bailed out but if you are small you are allowed to fail. The only word to describe this is "unfair" This bailout mentality did not happen with the Savings and Loan Crisis in the early 1980s.

Resources

The Fed white paper on the stress test results is worth a read.

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See below my monthly employment graph that standardizes the job losses (based on the sized of the labor force) across different recessions.