Why don’t we just admit that the current financial and regulatory system is dysfunctional?

We face two fundamental problems.

First, we need to clean the financial system — close weak banks more aggressively, encourage bankruptcies/foreclosures, and free good assets held by poorly financed owners. Small and medium sized businesses with quality projects are not getting loans. This problem will not be solved by tax breaks or targeting some incentives. We need structural change.

Second, the current regulatory system failed us. It needs to change. Our system is comprised of three federal agencies: the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Federal Reserve, as well as 50 state banking departments! I am not even including the Office of Thrift Supervision and all of the Savings and Loan Institutions nor the National Credit Union Administration which supervises all the credit unions.

There are state chartered banks as well as national chartered banks. As a result of the historical maze of changing regulations, we have over 7,000 banks. There is no economic reason for 7,000 banks. It is inefficient both for the bank in providing the lowest cost and highest quality services to their customers. It is a nightmare to regulate.

What is most alarming is that none of our leaders have stepped up with bold proposals to revamp our financial and regulatory system.

Read the rest of this entry »

There are two key questions: (1) is the improvement in the job picture sustainable and (2) if it is, how long will it take get back where we started in December 2007? While there is considerable disagreement in terms of general economic policies, most agree that jobs are the key to the economic recovery.

Summary of the release

In November, the Establishment Survey showed that only 11,000 jobs were lost. There were some favorable revisions to October and September data.

The BLS also reports Household Data and there can be big differences between the Household and Establishment Surveys. For example, October, the Establishment Survey showed a decrease in nonfarm payrolls of (revised) 111,000. However, the Household data suggested a staggering increase of 558,000 to the ranks of the unemployed. In November, the news was much better on the Household Survey. The Household Survey showed that unemployment decreased by 325,000.

To get the unemployment rate, you take the Household Survey unemployment (15.375 million) and divide by the civilian labor force (153.877 million) and you get 10.0% (actually, 9.9992% — so we technically lost the ten-handle!)

There was other good news. The all-in unemployment rate (U-6) dropped from 17.5% to 17.2%. Temporary hiring (a good leading indictator continued to increase (adding 52,400 to the rolls). Finally, the average work week increased by 0.2. This means more money in the pockets of consumers.

All of this is good. However, there are some issues (which I am sure you expect from me). Read the rest of this entry »

Amazing the difference one day makes in the employment outlook. Yesterday, the market shot up because “only” 512,000 applied for initial claims — down from 532,000 the previous week. We saw banners: “Employment Situation Improvement,” “We Have Turned the Corner”, and “Jobs Fuel Market Rally”.

Today we learn that 190,000 jobs were lost in October. That’s about 40,000 worse than widely expected. The unemployment rate rose to a 26 year high, 10.2%.

Understanding the numbers

For those of you that subscribe to my twitter, you know that I was critical of the analysis of the Initial Claims release on November 5. The media noted two pieces of good news. First, the level of claims decreased by 20,000. It is true that is good news. Second, Continuing Claims decreased by 68,000. It is not clear that is good news.

The reason is simple. Many people drop off the regular program not because they get a job — but because the program expires for them. These job-seekers then have a chance to apply for extended benefits or emergency benefits. Hence, you need to look a little deeper.

While the reporting of Extended Benefits and the Emergency program (EUC) is delayed, the recent numbers show an increase of 25,000 in Extended Benefits and a surprising 90,000 in the EUC.

The bottom line is that people are not getting jobs.

Let me give you some perspective on how serious this is. We have lost 7.3 million jobs in this recession. The last really bad recession began in 1981. Many don’t remember this was a time of considerable turmoil with some short term interest rates going above 20%! On a population adjusted basis, the jobs lost in the recession that began in 1981 was 4.3 million. At the time, that was really bad.

In addition, it is not over.

Yes, it is true that the rate of job loss is slowing. That is good news. However, we really need to get at least +100,000 in non-farm payrolls to stop the rate of unemployment from rising. We need about +200,000 to start recovering jobs. That is hugely different from where we are today.

Now, you are used to me saying negative things. I did see three pieces of good news in the employment report. First, temporary employment rose by 33,000. That is often a leading indictor of employment bottoming out. Second, the amount of overtime slightly increased. Again, this is a leading indictor. Finally, the revisions of the previous two months were also good news.

My guess is that the temp employment and the overtime are completely overlooked by market observers. Read the rest of this entry »

Do you remember that iconic banner? Yes, we had 3.5% real GDP growth last quarter. However, it is premature to declare “Mission Accomplished”. We are facing the specter of double digit unemployment lingering throughout 2010.

Short-term versus Long-term

The growth that we have seen is largely a result of government moving economic activity from the future to the present. The most visible example of this was the cash for clunkers program. Consumers could get up to $4,500 for trading their car in before the deadline. This attracted a lot of people that probably would have bought new cars anyways in the future (and now they won’t).

Indeed, 1.7% of the 3.5% GDP growth was vehicle related. Would we see the headlines, “Economic Growth in Third Quarter Heralds End of Recession“, if the GDP print was 1.8% [actual 3.5% minus auto contribution 1.7%=1.8%]?

This is but one example of the short-term stimulus spending. Another example which has been in the press recently is the phase out of the homebuyer tax credit which has likely accounted for some of the action in the housing market. “Existing home sales have largest percentage jump since 1983“. Again, we are just shifting consumption from the future to the present. Oh, by the way, even though was saw one piece of good news, 8.3% increase in existing sales, let me remind you that new and existing sales are still way below their peak. More seriously if you track housing starts, permits and mortgage applications, they all spell even worse news.

I have mentioned this before. There appears to be a bias in the news to report good news and sweep the less favorable news under the carpet. Let’s look at “New Privately Owned Housing Units Authorized by Building Permits” seasonally adjusted. In September 2009, the number was 575,000. The peak was September 2005 with 2,263,000 units. So we have dropped a staggering 75%!

Some more perspective. The last time we were below one million units was the 1991 recession where we hit a low of 786,000 units in January 1991. The low in the double dip recession of the early 1980s was 731,000 units. In the oil recession of 1975, we dropped to 726,000 in January 1975. Remember, the population has grown. Note that the data begins in 1960. The numbers we are experiencing are historic lows.

If we population adjust these numbers, today’s permits look even worse. The graph below shows “population-scaled” building permits. This is an apples to apples comparison. Essentially, it allows us to look at the permit activity in 1960 and ask, what would permits be in January 1960 if we had the population of September 2009?

There are three points here.

1. The government programs may be able to shift some activity from the longer term to the shorter term. However, this will not necessary “jump start” the housing market. This market has a long way to go before recovering.

2. The housing market will provide a continued drag on economic growth both directly (less construction and associated activity) and indirectly (negative wealth effect, i.e. people will not spend as much if their wealth decreases).

3. The depth of the housing crisis will likely cause a second wave of financial crisis as more an more people default on their “prime” mortgages. I have mentioned this before. If there is a significant housing recovery, this could mitigate the second wave. However, I just don’t see the data to make the case for a strong recovery in the housing market.

Read the rest of this entry »

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 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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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.