MUST READ: It's Going to Get Worse Before it Gets Worse!
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"It's going to get worse before it gets worse."
- Doug Roberts, chief investment strategist for Channel Capital Research.com.
Let’s not kid ourselves any longer about the economy, because ‘facts’ as John Adams was fond of saying ‘are stubborn things.’ And the facts are fairly plain that this is no run-of-the-mill recession, not your common economic cold that comes round once every season. No, this is a full blown outbreak of killer flu that is spreading rapidly to pandemic proportions, and we have yet to come up with any vaccine. The Tamiflu TARP program rolled out by Bush, Paulson, and Bernanke had little effect. It prolonged the lives of a few banks and insurance companies, and allowed some of our larger institutions to absorb the first phase of the collapse. JP Morgan Chase picked up Bear Stearns and WaMu, Wells Fargo took on Wachovia, BofA rescued Countrywide and Merrill Lynch. Now these banks, once thought healthy enough to give blood transfusions to their failing brethren, are suddenly swept up with the same mortal fever. Stock in Citigroup and BofA is withering away day by day as the market continues it’s vote of no confidence.
The problem has been dissected, injected, and bandaged up with bailout money, but the basic illness of the banks has never been addressed—they are carrying trillions of toxic securities that no one knows how to value. The solution to that is simple: just offer them for sale. The market will tell you what the value is in a heartbeat, for a thing is only worth what someone else is willing to pay you for it. The banks, however, don’t want to hear the voice of the market, preferring instead their own foolish dream that the securities they hold are still worth something close to their nominal values. With housing values down over 40% in California, and defaults and foreclosures still rising, how can a bank think their mortgage backed securities still retain their nominal values? That’s like a stubborn homeowner in Lee County Florida refusing to lower the price on his home because he paid $250,000 for it in 2005, even though it would still have trouble selling at $50,000 today. Here’s another stubborn fact. Because of the incredible leveraging the banks foolishly engaged in, even a modest decline in the value of these “securities” wipes out their capital. The result is insolvency. The banks are effectively dead men walking, financial zombies.
With the urgency of a CDC strike team, President Obama and his new team of economic advisors have been urging congress to take quick action on yet another rescue plan. The market greeted Geithner’s Tarp II announcement on February 10 with a 380 point skid, for it seemed nothing more than the same medicine that has done nothing to break the fever thus far. Will it be enough to save the banking system and revitalize the economy? Many astute economists have grave doubts. For those stubborn facts begin to mount up day by day, until they form what seems to be an insurmountable truth.
Even the International Monetary Fund (IMF) is finally waking up to the severity of the pandemic. Bloomberg reported: “Advanced economies are already in a depression and the financial crisis may deepen unless the banking system is fixed, International Monetary Fund Managing Director Dominique Strauss-Kahn said. “The worst cannot be ruled out.” Reuters chimed in reporting: “The dynamics of the financial markets as well as the global nature of the current downturn both have similarities to the depression of the 1930s, said Janet Yellen, president of the San Francisco Federal Reserve Bank.” Ambrose Evans-Pritchard was even more direct in his assessment of Europe. Moneynews.com reported: “th international business editor for the Daily Telegraph in London, says debating the risk of a full-blown depression is pointless. "There’s no risk," Evans-Pritchard told Moneynews.com in a wide-ranging interview. "We’re in it. It’s begun." ..He pointed out that, during the past six months, the world’s major economies contracted at rates more severe than those of the 1930s.” Yes, even the financial gurus are starting to get the picture.
The pundits in the mainstream press did not even have the intelligence to call our current situation a “recession” until a full year had elapsed. I have little doubt that they will also not see what appears obvious to me, and increasingly many others as well that, while we are not there yet in terms of certain key benchmarks, we are well on our way to a full blown “depression.” Some have played the game right down the middle, calling our present situation a “Great Recession.” The truth of the matter remains—it’s the 11th hour now, and a make or break effort is being mounted by the new administration to try to stop the economy from sliding further.
Financial Blog “Whisky & Gunpowder” comments: “It will be called a “depression” if today’s economic tempest slips out of the government’s control. From a financial point of view, a depression is a period when the distortions of an inflationary boom are liquidated — a mass die-off of the economically misbegotten. From an economic point of view, it’s a period when the general standard of living decreases significantly.” And that’s an understatement.
A close advisor to UK Prime Minister Gordon Brown was rather blunt in his assessment of the situation there. The UK Independent reported: “Britain is facing its worst financial crisis for more than a century, surpassing even the Great Depression of the 1930s, one of Gordon Brown's most senior ministers and confidants has admitted. In an extraordinary admission about the severity of the economic downturn, Ed Balls even predicted that its effects would still be felt 15 years from now. … He warned that events worldwide were moving at a "speed, pace and ferocity which none of us have seen before" and banks were losing cash on a “scale that nobody believed possible.”
R Word vs D Word – What’s the Difference?
At one time all periods of economic declines were called “depressions,” but after the big events of 1929-1938 the word “recession” was coined to distinguish less severe downturns from that crisis. Ray Dalio of Bridgewater Associates explains the difference between recession and depression this way: “You can describe a recession as an economic retraction which occurs when the Federal Reserve tightens monetary policy normally to fight inflation. The cycle continues until the economy weakens enough to bring down the inflation rate, at which time the Federal Reserve eases monetary policy and produces an expansion.”
Notice that both the onset and abatement of a recession is linked, at least in Dalio’s mind, to deliberate actions taken by the Fed involving monetary policy. What we saw this time, however, was a sudden downturn after 9/11 that the Fed battled with the usual monetary controls, by lowering interest rates, which stimulates borrowing and lending, but they left the valve open too long. The result was the housing boom. Typically, when the economy overheats we see inflation, and we certainly saw that on a grand scale when housing prices skyrocketed during the boom due to speculation.(The government doesn’t include housing in its core inflation index, however, even though it makes up the greatest monthly expense.) Inflation is fought by raising interest rates to slow the velocity and supply of credit and money and cool off an overheated economy. But did the Fed raise rates to cool off the wild speculation that characterized the big lending and spending surge of 2002 to 2006? Quite the opposite. The Fed reacted again by further lowering rates and easing! This immediately told me that something was seriously wrong. It was not inflation that the Fed feared, but the massive buildup of debt that would force deleveraging, and create deflation. Look at our debt relative to the time of the Great Depression:
Debt-Service
When the highly leveraged real estate loan base that makes up a significant portion of this debt began to fail, it created a real crisis in the securities and money markets. Banks and investment firms that were leveraged at 30-1, 40-1, 80-1, could suddenly see their capital base wiped out by even a modest decline in the “assets” their securities bets were riding on. This is, in fact, what happened. The Fed knew this when these securities were suddenly “exposed” to great risk and their perceived value was no longer certain. Things once thought to be sure bets, with AAA ratings, were suddenly suspect, perhaps even worthless! Here’s how the banks set up the game:
securities
The Fed also knew there would have to be a massive de-leveraging, a shedding of these bad securities, which would cause tremendous deflation. It therefore reacted by lowering rates and pouring on liquidity to try and keep the banks from collapsing while it planned a way to manage the de-leveraging process “in an orderly fashion.” While they have prevented a complete collapse, the core problem has not been fixed because the monetary policy is now trying to correct for amounts of accrued debt that are simply too massive. There are over $6.6 trillion in mortgage backed securities out there. That’s the easy one. The game got more and more interesting. Banks and brokers began to make bets against the success or failure of these securities. That game got way out of hand, and we now have $50 trillion in these so called “Credit Default Swaps,” a sum nearly equal to the world GDP. These morphed further into the massive “derivatives” positions that now total $600 trillion! Derivatives were essentially insurance policies on the other securities, (like swaps), and they were placed by thousands of hedge funds the world over. Did it ever occur to these geniuses that the cumulative total of their derivative insurance bets exceeded the total GDP of the world by ten times!
Wikipedia has it correct when it states: “Derivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real economy to service its debt obligations and curtailing real economic activity, which can cause a recession or even depression.” It was the bad derivatives that basically killed Bear Stearns and Lehman Brothers to start the great unraveling. The balloon has popped. The process underway now is an equally massive de-leveraging and debt deflation. Can it be controlled?
Dalio explains: “Basically what happens is that after a period of time, economies go through a long-term debt cycle... At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren't adequate to service the debt. The incomes aren't adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring.”
Another word for this debt restructuring is “bankruptcy.” It’s as if you simply had so many credit cards that you could not even make your minimum payments any longer. Now more and more former “consumers” and companies are facing bankruptcy as they realize their debts are simply to large to carry or service any longer. Economist Martin Wolf is correct when he says “ somebody is going to have to bear these losses, and we can’t get anywhere unless we first recognize and admit the losses.” This is what that well massaged word “transparency” is all about. In layman’s terms we call it “telling the truth.”
Preserving The Status Quo
Pandit-smIt’s tough being a CEO of a major bank or corporation these days. You get people talking about your salary. You can’t use the private jet any more. Congressmen ask embarrassing questions. Hell, you can’t even pick out the rugs and office furniture you like! The NY Times had the audacity to write an article asserting that it was impossible to expect anyone in New York to try and live on a paltry half million, the $500,000 salary cap Obama wants for CEO salaries. The Times wrote: “Private school: $32,000 a year per student. Mortgage: $96,000 a year. Co-op maintenance fee: $96,000 a year. Nanny: $45,000 a year. We are already at $269,000, and we haven’t even gotten to taxes yet.” Gawd! Try walking away from your bloated mortgage like millions of other Americans were forced to do, and rent a modest home. Put your kids in public school. Fire the Nanny and learn to clean your own mess! To this the Times retorts: “Sure, the solution may seem simple: move to Brooklyn or Hoboken, put the children in public schools and buy a MetroCard. But more than a few of the New York-based financial executives who would have their pay limited are men (and they are almost invariably men) whose identities are entwined with living a certain way in a certain neighborhood west of Third Avenue: a life of private schools, summer houses and charity galas that only a seven-figure income can stretch to cover.”
Forgive me if I get a bit indelicate here, but to that I simply say: Get over it! This sense of entitlement the wealthy have, with their precious “identities” entwined with their big spending habits is a sham. It’s disgusting. There are 37.5 million Americans now living below the poverty line. Do these executives know what that is? For a single person, the US Department of Health & Human Services defines the poverty line in the lower 48 states to be an annual income of $10,400. Someone with a half million dollar income makes that amount every week! For a family of five, the official poverty line is $24,800. Millions of Americans live this way, with annual incomes half the size of executive Nanny salaries. Forgive me if I waste no tears over these whining, fat-cat executives, wringing their hands over the prospect of getting paid only $500,000. They largely created the mess that the rest of us will live with for the next ten years….Poor little Rich Dads.
The hidden truth in the situation described above is this—the effort now is to try, by any means possible, to preserve the status quo. We hear talk of unfreezing the credit markets, getting consumers spending again, getting the economy back on track for continued growth. To do this, the same institutions that speculated so wildly, the same men who leveraged their assets 40-1, are simply being reinforced and bailed out with public money. Their resistance to living on “only” half a million per year is but a sideshow. What they really want is to get the good old game started again—but every con game depends upon the gullibility of the mark, the sucker out there who believes enough in the potential fairness of the game to want to play. That confidence has been so severely damaged by men like Bernie Madoff and so many others. Nobody trusts the value of the misnamed “securities” that were once so wildly traded. Investors have fled to cash positions, or to gold and treasury bonds. The stock market has suffered a severe crash, and the Great Game has been exposed for what it was—a fraud. No more slicing and dicing of securities into tranches to sell the risk of a loan off to some other mark in the game. It’s over. Look how the activity has trickled off to nothing…
BadSecuritiesGovernment policy has been to try and simply save and restore the old financial system that has proved itself bankrupt, and taken the whole country down with it. Yet no one in government seems willing to admit the stubborn facts about our situation. Charles Hugh Smith (Of Two Minds.com) wrote: “Despite the current gloom, the U.S. is firmly entrenched in a complacent faith that traditional methods like Keynsian borrowing/spending will "repair" the U.S. economy. The basic complacency is this: Everything will bounce back in a quarter or two; all we need to do is patch things over until 2010, when everything will return to endless prosperity… As we examine the "solutions" being offered—borrow and spend, borrow and spend, we see the same old tired script being played out… Where is the recognition that any economy fundamentally dependent on cheap, abundant oil and ever-rising debt, tax revenues and consumer spending is mortally wounded?”
Geithner’s Plan
GeithnerWhen Geithner announced the next phase of the government rescue plan the markets quickly reacted by dropping 380 points on the day, almost 5% of their net worth. Many believed the reaction was due to a lack of details revealed in the plan, or perhaps to an inability to see how it was different than the Paulson TARP fiasco. But popular news blog “The Big Picture” had this to say: “Wall street was hoping for another multi-billion, no strings attached, taxpayer funded giveaway. Instead, they got something much tougher than they expected.” This was perhaps in reference to tougher regulation and a “stress test” before public funds would be committed to an ailing bank. Then we learn that the results of government audits of the big banks would not be made public. They’ll take your money, but you can’t see their books.
On the other side of this argument, Andy Kessler of “Seeking Alpha” had this explanation for the market reaction: “The Treasury secretary seems stuck on keeping the banks we have in place. But we don't need zombie banks overstuffed with nonperforming loans—ask the Japanese. Mr. Geithner wants to "stress test" banks to see which are worth saving. The market already has. Despite over a trillion in assets, Citigroup is worth a meager $18 billion, Bank of America only $28 billion. The market has already figured out that the banks and their accountants haven't fessed up to bad loans and that their shareholders are toast.” It remains to be seen just how tough the new Obama Administration is going to be on the Good Old Boyz, and just how much more punishment the market itself is going to deal out in the trading pits. I’ll suspend judgment until I see what actually happens as this plan goes forward.
The big names in the banking industry were up on the hill in mid-February to explain what they did with the first $350 billion train load of free money they were given at taxpayer expense—and perhaps why no one can get an auto loan these days.
The NT times was gracious in quoting a rival LA Times op-ed columnist who expressed what so many feel now about our Alpha Plus banking elite with their $87 ,000 area rugs: “I want show-trial sweating and stammering. I want their nine-figure bonus checks endorsed over to the rest of us. I want my 401(k) money back. I want blood; I’m a vegetarian, but I’d make an exception for a smoking plate of C.E.O. en brochette.”
Yet when asked by Rep. Jackie Speier of California whether the banks presently receiving taxpayer money at 5% interest would be willing to lower the rates they charge the borrowers (taxpayers all) on credit cards, the CEOs all quietly stated, unequivocally: “No.” No, Mr. Taxpayer. We squandered your deposits in disastrous securities schemes, driving our banks to insolvency. We took your tax dollars, but hell no, you’ll pay us that 30% interest on your credit cards, come hell or high water. Well, Mr. Banker, hell, if you have been noticing lately, is well on the way. Because of the greed, incompetence, and fraud of this trusted crop of financial gurus, a generation of Americans is about to be tested as never before in this crisis. How will we fare? At the moment the promise of hope that Obama brought to the White House has most of us waiting for a turnaround that may never come.
Consider this: the $9.5 trillion already committed to the banking industry is more than the cost of all wars America has ever fought. It was reported to be enough to pay off virtually every mortgage in the nation, which would have stopped all the defaults, foreclosures and subsequent pain cold. Sharon Astyk adds: “It could have paid for free health care for every American, cradle to grave for a century. It was enough to build renewable energy infrastructure that could have softened the crisis, to re-insulate our houses, to provide basic food and health care to the world’s poor. The same trillions we were told we didn’t have when it was needed by those who wanted educations, basic medical care, decent shelter, a home, hope, a decent life, but we had a plenty for the banks and the wealthiest people in the world.”
Ilargi of “Automatic Earth” put it this way in his Feb 12th post: “We just hope for things to get better, and prepare for a year or two at most of doing with a little less, while our governments turn our economies around and the party can start anew. We simply refuse to ask ourselves what happens if the turnaround never comes, just as we refuse to act as if that were even possible. So we sit around and wait while our money is wasted on doomed rescue attempts for long since lost institutions that have hurt us all our lives to begin with, and we can't get ourselves to rise up and do what must be done to minimize the suffering of our children and friends and mitigate the disasters looming on the horizons of our lives.”
That’s a fairly severe, yet frank, assessment. Recession, Great Recession or Depression—call it what you will, we are all in the maelstrom now and I have seen no clear path to a solution. My own thinking is to simply let the existing system fail, and then start over. But God only knows what level of pain and dislocation that would cause. One thing is certain—our lives are going to get leaner and much more difficult for the foreseeable future. Things are not going to return to the old “normal” way of life we are accustomed to. Now we are pressed to discover a new normal, and one at a decidedly lower level than our old life styles.
There is no question that the banks are in deep trouble, a quagmire of their own making. I went in to make a deposit at one of the big national banks recently, noticing that each teller window had been newly decked out with placards advertising a new savings account plan. It reminded me of the mailed advertisement I received from WaMu on a similar plan just a week before that bank failed. The banks are desperate for new capital. They’ll take our dollars any way they can--by direct deposit through the front door, or by Fed delivered taxpayer funds by the back door. Another prominent sign was labeled “INVESTMENTS” and it touted them as some kind of savings to grace a rosy future in stocks and mutual funds. I smiled, realizing that these markets have been an elevator with but one button of late--Down.
This is the one great aspect that the media continues to miss. The new “stimulus” plan is just treating the Main Street symptoms of the crisis--the lost jobs, the frozen credit, the foreclosures. The massive debt at the deep core of our insolvent banking system is not being faced or addressed. As Bill Clinton might put it: “It’s the securities, stupid!” That’s where the real crisis lies.
The dark heart of the crisis we face is the huge exposure of our financial institutions to securities of “questionable value.” Banks have only written down some $350 billion in announced losses to date. But there are those trillions and trillions in securities out there, and they have not been dealt with yet. They have notional values that are held “off” the balance sheet. If given a fair market value and moved “on” the balance sheet, the banks would be wiped out many times over.
In my thinking, the whole effort to prop up the system to date has been merely buying time. How to deal with this massive deleveraging? We cannot resolve this crisis with tax money, because there isn’t even enough of that to run the government. We already run on a $1.3 trillion deficit. How long can we continue to raise money through treasury bond offerings? There are rumblings that the very credit rating of Uncle Sam himself is suspect.
Watch the bond markets... The next point of crisis will be there. Any sudden movement of investor funds out of treasuries will be a very bad sign. A “flight from treasuries” will signal that we are indeed at the 11th hour of this crisis, and that the powers that be may have run out of control rods. If this happens they will have only one solution left--the printing press--and the end of that road leads to sudden and rapid inflation.
In the next article I will take a look over our shoulder at the last Great Depression, review some more stubborn facts about our situation today, and surmise what our prospects may be from here on out, and how we can evolve in response to the crisis.
John Schettler
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