Archive for February 2009
The Fed et al published their guidelines for the Supervisory Capital Assessment Program today, defining the parameters for the base case and adverse scenarios to be used in the bank stress tests. As Paul Krugman points out the stress test scenarios are somewhat of a letdown. The summary table below show the base case and adverse scenario assumptions for GDP growth, unemployment and home price appreciation over the next two years. The original can be found here.
I was under the impression that a stress test should be designed to take a look at possible outcomes under extreme scenarios. To me, the above hardly seems extreme – especially when comparing the HPA and unemployment numbers to what some of the MBS hedge fund managers I talk to on a regular basis tell me they are using as their “conservative” assumptions: -35% for home prices, unemployment in the mid teens. Is the government putting the banks through a useless exercise?
Two days ago President Obama signed the 2009 stimulus package into law, committing an additional $787 billion to supporting the American economy. A number of banks – JPMorgan, Citigroup, Bank of America and Wells Fargo among them – have agreed on temporary moratoriums on foreclosures. Weekly mortgage applications jumped 46% last week, and (as noted in my last post) a variety of indexes seem to be slowing their decline. Credit Suisse recently suggested that the much-bemoaned US debt to GDP ratio might not be in as bad a shape as commonly assumed. Yet the S&P500 lost -4.6% the day President Obama signed the American Recovery and Reinvestment Act, and the Dow Jones gave up -3.8%. As of February 18, the Dow Jones has lost roughly 14% for the year. I have no idea when equities are going to see a bottom or when the economy is going to reach a turning point. I do believe, though, that there are certain prerequisites to be met before a lasting recovery can begin:
1) We need some signs that the stimulus package is working.
In their January meeting, the minutes of which were published yesterday, the Federal Open Market Committee once again reduced their 2009 growth projections. The consumer confidence index stood at 37.7 in January, its all-time low since inception of the index in 1967. I think that consumer and investor confidence will only tick up again as the tax cuts and spending programs of the $787 billion stimulus package (hopefully) prove their effectiveness over time – per the Congressional Budget Office’s estimates the stimulus will add somewhere between 1.1 and 3.8 percentage points to real GDP in 2009, and have an effect of similar magnitude in 2010.
Take a look at the charts below for a breakdown of the stimulus package, and an estimate from JPMorgan showing the sizing of tax breaks and spending quarter by quarter. Please note that the JPMorgan graph dates to the first week of February and is thus not a fully accurate reflection of the stimulus package that was passed on February 13.
2) Systemic threats on both the national and international level need to be resolved.
Temporary calm returned to the US markets in December of 2008 after the government committed to “doing all that it takes” to thaw credit markets, stabilize the financial system and revive the economy. Talk of an impending collapse of the US financial system subsided as it became clear that the government would do everything possible to prevent another Lehman disaster. I believe that we need a similar commitment from the EU regarding the escalating situation in Eastern Europe, and from the US government and banks regarding the prevention of potential systemic shocks such as a large-scale municipal default (think California which just managed to corral the last vote needed to resolve the budget impasse) or a spike in mortgage defaults triggered by a wave of simultaneous interest rate resets.
3) We need to recalibrate our expectations regarding homeownership, leverage and GDP growth.
It seems that by now both Wall Street and Washington and have understood that we can’t go back to “business as usual” – i.e. our pre-crisis reality. For a while to come, banks and hedge funds won’t be as leveraged as they were over the last decade. American automakers need to revamp their business models. I personally don’t believe that almost 70% of households in the US can afford owning a home (stay tuned for a post outlining why). I don’t think that a personal savings rate in the zero to three percent range is sustainable. And I don’t see how increasing reliance on debt – both private and public – can continue to drive GDP growth going forward.
The charts below show the US debt to GDP ratio (the revised version from Credit Suisse) over the last 100 years, the growth of GDP compared to the increase of productivity in the US since 1965, and the development of homeownership over the same period. Looking at these long-term trends, I believe that we’re in for a prolonged period of pain – after all, the stimulus package addresses the symptoms of the crisis and not its causes: leverage is shifted from private to public, instead of being reduced; homeowners who can’t afford their homes are receiving support to avoid foreclosure.
What do you think needs to happen in order for things to get better?
The S&P500 is currently hovering around 800, almost -50% off of its October 2007 high. And while the first optimistic pieces are starting to pop up in main street media, a number of sources – including some of Wall Street’s powerhouses – suggest that the S&P500 will bottom in the 650-700 area. That’s another -12% to -19% from where we are today. If you take a look at the below flurry of indicators (courtesy of JPM/Bloomberg/OECD) you get a sense for what these predictions are based on: bad news across the board.
What do you think – are we anywhere close to a bottom?
Over the last few days there has been plenty of press about how and why Geithner’s annoucement of the rescue plan on Tuesday spooked the markets. The Dow ended the day down -4.6%, financials were down somewhere around -10%.
That’s the equity side of things. Corporate bonds suffered, too, on Tuesday as money flowed back to the perceived safety of Treasuries – but at least CDS showed no knee-jerk reaction to the Geithner plan: they did widen, but not materially. A silver lining?
CDS on Select Banks (US & Intl) through February 13, 2009
This is a visual addendum to my earlier post about inflation vs. deflation and the quantity theory of money. As a reminder, Friedman postulates that inflation is caused by an increase in the money supply; the quantity theory of money in its simple form states that the amount of money in an economy multiplied by its velocity equals the real value of goods in the economy times the price level, or M*V = P*Q. So an increase in the money supply, ceteris paribus, should result in an increase in price levels.
As I noted last month, the US monetary base has recently seen drastic increases. We haven’t seen rising inflation, though, because all the additional money that the Fed has been printing is getting soaked up by banks upping their reserves. FT Alphaville’s Stacey-Marie Ishmael posted an impressive chart yesterday showing this decrease in the velocity of money.
You can find the original here. And if you’re sifting through the FT Alphaville archives, also take a look at the hyperinflation scenario that Morgan Stanley sees as a (not highly likely, but realistic) possibility.
The government is adding to the bailout tab almost daily, and no slowdown is in sight. The total cost of equity infusions for financial institutions, guarantees and lending facilities to date is estimated anywhere between $4 and $8 trillion, depending on which programs are included in the count. The following chart shows some of the biggest ticket items in the US budget over the last 200 years, adjusted for inflation (i.e. in today’s dollars).
Below is the same chart, this time including the 2008 / 2009 bailout package (using the most conservative end of the range with an estimated total cost to date of $4.3 trillion). For reference, the total cost of World War II to the US was roughly $3.6 trillion.
Remind me why people are still talking about “deleveraging”?
A week ago, Standard & Poor’s published the November results for its Case-Shiller home price indexes. The seasonally adjusted 20 cities aggregate index is now down -25.1% since its peak in July 2006. Common sentiment on the Street is that home prices have further to fall, and the numbers cited range anywhere from an additional -10% to -40% of declines before we see a bottom. No surprise there.
It’s also no surprise that delinquencies and default rates are rising as more and more borrowers are under water on their mortgages and can’t afford the monthly payments anymore because of rate resets and rising unemployment. What is surprising, though, is the historical connection between home price appreciation (HPA) and loss severity, i.e. the actual loss incurred by a lender after foreclosure. In times of rising home prices, a lender will barely lose money even if a borrower defaults: the delinquent borrower is forced out of the house, the property is put back on the market and the lender recovers most of the unpaid loan balance through the sale of the foreclosed property in an auction. Now take a look at this chart which I found in a recent presentation by T2 Partners:
The chart shows a scary connection between home price appreciation and loss severity. With 10% HPA per annum, a lender gets 95% of his money back if the borrower defaults. With a more modest increase in house prices of 3% per year, severity is at 60% – i.e. the lender gets only 40% of his money back. The above chart should be taken with a grain of salt since it is based on only five years of data and I have not been able to confirm the loan type, but it is powerful. Based on this picture, what will the loss severity be in an environment of rapidly falling home prices?