How Much Delevering is Coming?

The below is from an email back and forth that a bunch of my family members were on sent March 2nd, 2009. After having read this article from Thursday March 26th's WSJ, I'm more confident than before that my numbers below are reasonable.

I organized the emails such that the earlier emails are at the top followed by a response and then my response to the response. Don't worry, my conclusion is everything's better. I mean, the stock market's up 25%, doesn't that constitute a new bull market? Happy days are here again - yippee!

I most recently discussed this topic last December here on The Investment Linebacker.

Lightly edited, the emails begin below:

Going back to [my cousin's] first email about thinking about all the system participants in aggregate, I've read slightly different numbers. Jeremy Grantham at GMO basically said that privately held assets in the US (stocks, resi real estate and comm. real estate) totaled to about $50 billion before the "crisis" began. I'll exclude government assets and liabilities for the moment. That Private Asset Base (as he phrased it) was supported by about $25 billion of private borrowings. If you assume the private asset base is now worth about $30 trillion (down 40%, which is probably right, but you can pick a different number if you want), assuming some further deterioration in housing and CRE prices, then the $30 trillion is now supported by $25 trillion of borrowings. This is an incredibly precarious position If we believe that the original 50% debt to equity ratio is the right one, then debt needs to decline by about $10 billion or three fourths of a year of GDP. That's the definition of pain. And that pain is going to be shouldered by the private market, barring further socialization of our private obligations. Even if socialized, it's still born by private individuals, but the burden is shared by people that did not actually borrow the money rather than merely by those that did borrow the money. Adding a new, substantial tax burden will further reduce the value of the assets - since the cash flow off them will be less - merely compounding the problem.

The basic thesis behind taxes is that at virtually every mix of tax rates above a very low level, federal taxes end up fluctuating around 18.5% of GDP. An increase in taxes will cause a quick pop in tax receipts before the resulting drag on productivity brings it back down toward 18.5%. The same thing happens with tax cuts: in years one or two, tax receipts relative to GDP fall before the increased productivity in the economy accelerates capital through the system bringing tax receipts back up toward the 18.5% long term average.

Given that, from the government's perspective of maximizing receipts, tax policy needs to be geared not toward progressive, regressive or flat, but toward whatever solution drives sustainable, long-term growth in GDP since tax receipts will basically be 18.5% of that. We know for a fact that higher taxes reduce productivity, reduce positive private incentives, and manipulate behaviors in ugly ways. Lower taxes do the opposite. For some reason, even though cutting tax rates increases tax receipts over time, certain people get pissed about this fact even though the government's take is bigger because of it.

-TTB

My cousin's reply (he's a smart, great guy for anyone wondering):

I agree with the $50T and $25T numbers, they are within my $90T and $45T, the difference being assets and liabilities carried by other than private entities [referencing a prior email]. I think your 40% number may be a little brutal in the aggregate since it is off a base that includes cash and some safer investments.

Almost as brutal as the asset shrinkage though is the liability shrinkage. Of the $25T give or take $10-12T was in some kind of a securitization. If 25% of this naturally rolls over every year and there is no replacement than $2T or so is going to go away. There is no good way for this to happen.

I generally agree with your basic tax math but would look for other ways to help close the over all quality of life gap. That and other bad fiscal decisions and foreign policy mishaps by Republicans are what put me as the sole defender on this email chain of the esteemed [Uncle of TTB]. [This comment was referencing his bias toward left-leaning politics vs. my different tilt].

TTB's Cousin

My reply back that basically you can pick a less painful hit to the Private Asset Base, but it doesn't change the overall thesis that deleveraging is going to be enormous and painful because you cannot rationally pick a number high enough to avoid the problem. As I mentioned at the beginning of this post, I'm more and more convinced the 40% is reasonable.

I basically agree with my cousin that it would be nice to close the quality of life gap, but more important than the gap is the absolute level of quality of life. While the gap may be wider today than it was forty years ago (I have no idea), the absolute quality of life for everyone is much much higher. In any case, here's my reply:

Cash is a minor percentage of private assets in the US. Anyway, pick your number. -30%? I mean, the S&P’s down 55% from peak [today closer to -45%], so we have some cushion on the other asset side to play with. If it’s a 30% decline, then private assets are $35 Trillion and debt needs to decline by $7-8 Trillion which is a bit over half a year’s GDP. Point is, you can’t just wipe out 6-12 months of total economic activity in any way other than huge pain and we have barely started. All of this assumes that we do not over correct or land at a level of yet lower leverage.

The ideal is to absorb that pain over a big number of years, but it’s possible we eat it over call it a four year period which means GDP falls 10% a year for a couple of years before we’ve delevered merely to the leverage ratio we had at the beginning of this “crisis”. If we go to a more conservative position, which wouldn’t be shocking, the pain is worse.

During The Great Depression, nominal GDP declined 46% peak to trough. People don’t remember that fact, but just think about what that means for a minute. Lord willing that won’t happen again. But believe it or not, we have a lot more leverage relative to our asset base this time around, so I won’t say that it can’t happen, but I am hopeful it won't happen.

-TTB

Sorry for the sour posts, but I do not see any other way. The government can print money until the cows come home with a hope of supporting asset values, but the resulting inflation will likely end us in a worse place than if we just let the correction happen naturally.

-TTB

The TTB PA Hit a New High Today

Go team.

Tax the Hell out of these Bailout Thieves!

Before I get into why I support this tax, let me just state that Congress's behavior makes me sick. The fact that the government is trying to target specific kinds of employees for a tax is disgusting and, it seems to me, unconstitutional.

However, I'm still hopeful the most punitive version of this bill becomes law. Trap as many companies as possible and jack the tax as high as possible. I feel awful for writing that as the vast, vast majority of the people that received eligible bonuses don't deserve this punishment.

Nobody is more anti-tax than me, but the beauty of this is that it will have precisely the wrong outcome. It will serve to massively undermine the government's ability to convince companies to volunteer to receive bailout financing until things become drastic. This will cause a talent exodus from bailed out banks the likes of which the Pharoahs could hardly conceive. TARP money and other forms of bailout financing are increasingly going to serve as a scarlet letter and companies will avoid these capital injections until the last possible moment. This will improve the likelihood that capitalism's natural course will play out as it limits government's effectiveness.

Frankly, who on Earth will want to participate in the TALF or in the Public Private Investment Partnership? You just might find out after the fact that the government isn't so fond of your profiting with taxpayer support.

By the way, isn't the intellectually honest thing to do to make sure that these taxes also apply to all the income of government employees that make more than $250,000?

As a final aside, the dumbest aspect of this whole thing is that it only applies to bonus compensation. What? Why? What a crazy stupid incentive system that set-up creates.

The depth of the stupidity of our elected officials borders on the unfathomable.

Anyway, cheers to unintended consequences canceling out the intended consequences of prior governmental interference and thusly voiding their even worse unintended consequences.

Prediction: President Obama vetos this idiocy and he and most Senate Republicans end up on the same side of an issue for once. The problem for President Obama is it will only take a small minority of those Senate Republicans to override the veto and Chuck Grassley, who really bats more lefty than righty anyway, is clearly in favor of this. Should make for great theater.

-TTB

PS: Short NYC-metro area housing. No brainer. This is just going to add to the pummeling that market is already receiving.

The Bank "Not Too Much" Stress Test Plan

The following is an email I thumbed on my Blackberry while on an airplane to Asia (very light editing to clean up some Blackberry typos):

Reading the NY Times cover story on Citi and govenment mandated bank stress testing from today (Monday the 22nd) and in it the author talks about how banks' balance sheets will be stress tested by the Fed and Treasury under Geithner's plan. The testing will include scenarios that assess how banks would perform under a variety of "Depression-like [literally with a capital D] conditions, with unemployment surging to 10 or 12 percent [from 7.6 at last report], for example, or home prices dropping 20 percent further [officials said]".

At first blush, this seems like a good idea to me. We should want to know the answers to those implied questions.

However, the article goes on to say, "Fed officials emphasized that these hypothetical events were 'highly unlikely' to occur." The article actually goes on to call these "nightmarish economic conditions." Does anyone [reading this blog] think those conditions aren't reasonably likely?

Let me state unequivocally that 10%+ unemployment is not "highly unlikely". While it certainly may not occur, at best it is a "reasonably likely" scenario at this point. Also, home prices down another 20% also seems reasonably likely given that's about what it takes to return back to long run affordability averages (see Clay's email from Sunday). I'm not saying better than 50% odds but probably better than 25%, so certainly not "highly unlikely." Do policy makers really believe this and if so...

Nothing is certain, but these are anything but "highly unlikely" scenarios. They may not be "highly likely" either but frankly they should be in people's middle to slightly-worse-than-hoped-for case at this point.

Further, the article states the stresses will be an "or" scenario not an "and" scenario. For example, 10% unemployment OR housing prices declining a further 20%. However, if one of these happens I'd say it's "highly likely" both will happen. These stresses need to be applied under "and" scenarios. Obviously the outcome will be much worse under "and" scenarios, but that's the only sensible way to apply the stresses. They almost certainly will happen together so we need to assess their cumulative effects.

My guess is the answer results in bad outcomes. I think it was BB&T that said a month or so ago (when measured unemployment was closer to 7.0%) that their modeling got ugly at unemployment of 8.0-8.5%. The next unemployment report will have us on the doorstep of 8% (if not over the threshold). Further, the shadow unemployment of reduced pay/shortened work weeks won't be reflected in the stats but is also impactful.

Food for thought.

The culprit in all this, I believe, is in the government's past "mandate" of high leverage. By having the Fed's support of low-reserve fractional reserve banking, it basically ensures that asset spreads (eg, lending margins) on bank owned assets would decline and leverage would increase to compensate. In order to maintain a reasonable ROE, you absolutely had to partake in the leverage orgy. This basically means that the government mandated both high leverage and low spread (risk both ways - high leverage and higher prices for assets funded with the leverage) that caused this crisis. While everyone from borrowers to lenders is to blame, the government (esp the Fed) deserve a double or triple dollop.

As an aside, everything I stated above is compounded by a foolhardy belief or semi-belief in the efficient market hypothesis - how else could someone possibly justify or dispassionately observe (as the Fed did) the massive leverage coursing through and ultimately building up in the system? You have to believe asset prices are fairly valued at all times to operate at 15x-20x levered (or more for investment banks). If a 5-6% general overestimation of asset values can lead to complete wipeout, how can you conceivably not think this is possible (much less likely) without a core belief in market value efficiency?

Don't be fooled by statements that this is a breakdown in free market behavior. Free markets are by definition imperfect and they generally structure and price to account for imperfection. Banks and insurers do not and did not operate in a free market (frankly nobody does given the government controls the printing press and thus manipulates demand signals by changing the pace and volume of printing as well as the accessibility of freshly minted dollars all the time). Banks and insurers are the most highly regulated and government manipulated private market in the U.S. outside of utilities. Free markets would NEVER allow the broad market of banks to lever like this because they'd be at constant risk of bankruptcy (much less lever more and more to fund increasingly risky assets). Rather than interbank lending supported by the Fed, banks would force settlement of assets received backed by other banks (eg, customer checks) which would immediately limit the pyramiding of leverage on bank equity.

Anyway, regardless of who deserves the aim of our damningly directed finger, we should at least demand that the "stress" test actually hypothesize a stressful AND unlikely set of scenarios. I only want to have my money on loan to an institution prepared to weather the highly unlikely not merely the somewhat unlikely.

If anyone identifies said institution, let me know. Your feedback is always welcome.

-TTB