The following post is an article I just finished for the Wescorp web site, but I decided to post it here as well.
In last month’s Longer-term Commentary I discussed the difference between reality and perception, reality being the world regular people like us actually live in and perception being Wall Street’s fantasy land. That disconnect shows no signs of letting up. Over the past month, stocks have continued to push higher (with a minor setback last week) while more and more people continue to join the unemployment lines and incomes shrink.
No Longer “Less Bad”; Just “Not Worse”
The only thing positive about the latest Nonfarm Payroll number was the headline which read “August Nonfarm Payrolls decline less than in July.” Beyond that headline, the details of the report were a bust. First, the Bureau of Labor Statistics (BLS) increased the jobs lost in prior months by 49k. Effectively, that made August payrolls a decline of 265k instead of 216k. Second, the Unemployment Rate rose from 9.4% to 9.7%. A rise in the Unemployment Rate can actually be a good thing at the end of a recession if the increase is the result of a bigger labor pool. As job conditions improve, people are encouraged to at least re-enter the job hunting market and this temporarily increases the Unemployment rate. But this rise in the Unemployment Rate was not due to labor pool adjustments by the BLS. The jump to a 26-year high in the Unemployment Rate was the result of true job losses, not a labor pool adjustment.
The two leading indicators in the report that are important to watch also disappointed. The workweek, which finally rose by .1% for the first time in July, failed to budge further in August from the post-WW II low. Even the separately reported factory workweek failed to rise, despite the assumption that industrial production is rising on re-building of inventories. The second leading indicator, temporary workers, was expected to finally turn positive after a string of declines stretching back eighteen months. Unfortunately, that string grew to nineteen months as another decline was recorded.
We’ve now hit an extraordinary string of twenty months of job losses totaling almost seven million workers. Roughly six million workers that want or need full-time work are only employed part-time. The workweek remains down by .9 hours since 2007, which is equivalent income of roughly 3.5 million workers. The Unemployment Rate of 9.7% is now up a huge 5.1% since December 2007. The average post-Depression recessions resulted in an unemployment rate increase of 2.3%, with the worst coming in 1980-1981 with a 3.1% jump in the rate. Despite the money from the fiscal stimulus package going to states, we’re now finding that states are just beginning to be forced to cut back as state revenues are falling faster than anticipated. Most states, like California, are trying to limit job cuts. But in doing so, they are reducing the incomes of workers by 15% through the use of furloughs. In a recent Los Angeles Times article, the writer interviewed a number of state workers that have job stability but are living paycheck to paycheck, and now those 15% smaller paychecks don’t cover all of the mortgage payment and monthly bills.
As I said last month, yes, the recession is almost certainly over “technically.” We’ll have one or two quarters of positive growth as the result some inventory re-building (cars and more) and a smaller trade gap. What seems to be lost on Wall Street is that the “technical” end of the recession might very well result in no job gains at all. If consumer spending continues to contract, production levels will merely retreat to past lows. Only if consumers begin to spend again will this recession end in more than just “technical” terms.
But in this current economic and financial environment less income to spend is almost secondary to the importance of less income to pay mortgages and other consumer debts.
Bank Worries Behind or Ahead?
With the rally in financial stocks, it’s assumed on Wall Street that the financial sector is in the clear. Oh sure, the FDIC closes an average of four banks every weekend, but at least the big boys are okay. But the danger is very real that, even if we don’t have to worry as much about the top ten, we have to worry more about the rest of the banking industry. The FDIC admitted as much by announcing their list of “problem banks” has jumped from just over 200 to over 400 in the last quarter, and these aren’t just small banks. There are a number of larger regional banks. In fact the last two big failures, Colonial and Guaranty Bank, had assets totaling $40 billion! As in all recent bank failures, the event didn’t cause a ripple as the FDIC smoothly transitioned the good assets to other institutions while retaining the bad assets. But what happens to the other good institutional buyers as these failures escalate. At some point in time, the quality banks will run out of capital to take over the failures. This might be why the FDIC has recently lowered the capital requirements for private buyers to buy failed banks.
The reason it would be wrong to assume we no longer have to worry about bank losses is that credit quality has deteriorated at an alarming pace – in the prime borrower category. Subprime mortgage delinquencies seems to have leveled out at something over 25%. Horrific to be sure, but “not worse.” What is worse is that prime borrowers are now delinquent on mortgages at a record level in excess of 9%, and the numbers are escalating at a rapid pace. What makes this more alarming than the subprime numbers is the fact that 80% of all mortgages were considered “prime” at issue, and financial institutions typically kept more of those on their books. This is especially true in second mortgages. Many banks, especially regionals, sold off prime first mortgages in order to hold more seconds at higher rates. Prime defaults will not reach the level of subprime but, given that prime mortgages constitute more that four times the volume of subprime, it’s a huge concern. At the same time, all forms of prime consumer debts, including credit cards, are exhibiting deteriorating performance.
Why? See the section above on jobs and income. The job losses started mostly with lower income workers but have clearly stretched into all income levels. Even medical workers, teachers, state workers, etc. are no longer immune. When workers with “prime” credit scores lose their jobs, this category of workers typically will have some resources to continue to pay bills until new employment is found. The problem now is that they are using up all of those resources because the time between jobs is at the worst (most time) level since the Depression. You’ve read the stories. They are agonizing to read but no longer uncommon, nor do they represent rare, isolated cases.
So let’s say you lost your job one year ago when businesses began the major blood-letting of jobs. You weren’t too worried at first but now, not only are you running through your savings, but you’re faced with perhaps dipping into your 401k. Looming ahead is the end to your unemployment benefits. What do you do? You look at your mortgage payment – the biggest bang for the buck. You look at the real estate section and see that you’re roughly 125-150% LTV. Why keep paying? You know from your neighbor’s experience you won’t lose your house for six months or longer. I think you can see where this is going. This is happening all across the U.S. with ten states showing Unemployment Rates of over 10% and another fifteen just below that level. It seems almost inevitable that we will see another wave of big mortgage-related losses over the next twelve months.
Want more reasons to worry about banks? How about the fact they haven’t even begun to recognize future losses on commercial real estate lending. This lending sector is especially important to regional banks. It’s not even a secret any longer that loan loss reserves on commercial real estate loans are well short of any reasonable projections; it’s a common topic in most business journals. But the concerns are being dismissed because “it’s a small part of the market.” Where have you heard that before? The $3 trillion commercial market is smaller than residential but hardly insignificant. The apologists continue that recovery experience is higher in commercial real estate (arguable), and that banks can easily handle the losses. I might give that some credence if commercial real estate was the only problem area. Unfortunately, commercial real estate is merely joining its ugly siblings, residential mortgages and consumer debt.
There is a lot of talk about banks not lending. But banks are lending – just not to you or small businesses. It seems banks have decided to start lending again to hedge funds and private equity funds against “distressed assets.” Yes, those are the same assets that were “prime” in 2007, the last time banks loaned against them. A well-respected bank analyst recently reported that banks are not only loaning against these assets, they are also loaning to allow the level of leverage that existed just after the collapse in 2007. Banks counter by saying that more leverage is reasonable because market values have already been market down so drastically. In other words, there is little risk in the low-valued assets. Unless these assets are priced at $0.00, there is still risk.
Finally, I’ll end my ranting about financial worries with this forgotten fact. Think way back, say three or four months ago. Remember the government’s vaunted “stress tests?” Those were the tests that told us we didn’t have to worry about our biggest banks. The base case showed “only” another $599 billion in losses was at risk. Remember what the base case was based on? I didn’t either. The base case forecast for the Unemployment Rate, which drives the loss assumptions for obvious reasons, was 8.4% in 2009 and 8.8% in 2010. Those were rates that produced the $599 billion loss. We’re at 9.7% and climbing. Yet, we’re not hearing anything about how that might impact the losses ahead for banks. That story is buried by reporting on the happy events in Wall Street World.
The Real Danger of InflationI still think it’s too early to spend a lot of time arguing about inflation – in the traditional sense of rising prices for goods and services. We’ll start that argument sometime in the next six months or so. But there is an inflation concern emerging in something else – asset prices. From 2002 onward, there was concern in the economic community that leaving rates so low for such a long time would result in inflation. Of course that didn’t happen in the traditional sense. But leaving rates so low for so long did result serious inflation in asset prices of houses and stocks. Let’s also not forget that the low rates allowed for what was effectively inflation in the value of less quality debt.
Leverage borrowing exploded as low short-term rates vs. returns in other markets resulted in huge gains. The huge gains in asset prices made everyone (especially lenders) feel there was no risk, which in turn led to more leverage and less concern about credit quality or much of anything else for that matter. We know how that story ended.
It’s entirely possible that the stock market could continue to run ahead. So far at least, mediocre economic improvement from near-depression like lows has not been a deterrent, nor has lack of revenue growth. (Earnings have grown, but that is due to slashing costs and people not growing revenues.) As long as analysts and pundits keep the expectations bar on the ground, it’s easy to hop over. And make no mistake about it; low interest rates this time is what is attracting risk capital and leverage. It’s not a sudden surge in confidence by big time players in the economy, real estate market, or anything else. It’s cheap money. Even for non-leveraged investors, low rates provide an incentive to move toward greater risk. The problem is this can go too far, as we all well know. And don’t count on recent experience to necessarily deter anyone. Remember, “it’s different this time” is a phrase that always seems to work on Wall Street. It’s easy to imagine a runaway stock market and collapsing credit spreads as investors interpret the stock market’s upward movement as reflecting the underlying fundamentals of the future of the real world. In fact though, we’re a long way from correcting our debt problems. But risk concerns could once again become a casualty of asset-inflation.
Unfortunately, this runaway asset-inflation scenario is not too farfetched. The Fed is almost powerless to raise the cost of money to pop a burgeoning asset bubble, given an Unemployment Rate of around 10%. That would only happen if Ben Bernanke is replaced by Paul Volker. More importantly, while there has been a lot of talk about the regulatory changes for all financial institutions, there have been no meaningful regulatory changes adopted and implemented. Perhaps even more important is the fact there has been no adoption of any changes about compensation at financial institutions. There has been a lot of talk, and in this case talk is not cheap. As long as it remains in the “talking” stage, financial institutions are free to do what they will – and they have, as evidenced by bonuses disclosed at Morgan Stanley and Goldman just to name two. So those running major institutions are looking at a landscape where the appetite for risk is ramping up again, higher stock prices has muted all discussions of concerns and open challenges to management decisions, and a window to rack up another round of huge bonuses. If you asked me a few months ago if it was possible to return so quickly to an era of big leveraged risk taking and big Wall Street bonuses, I would have said “absolutely no way.” But I have underestimated Wall Street again. Maybe that’s why I’m on Overland Court instead.
There are two points to take away from this. First, the stock market is not the economy. Just as the stock market and the home prices did not reflect reality at the peak in 2007 (and we all paid the price), we are at risk of repeating the error. I know you’re tempted to want to recover all your lost 401k value in a short period of time, but this could be just setting us up for an even greater fall. Let’s hope the stock market stays grounded until the economy eventually catches up. Second, if another asset bubble does in fact form, we’ll need to use that window to prepare for the next meltdown.
Knowing My Place
Over the past few months, I’ve often felt remorse when I’ve written about what I’ve viewed as negative developments. In fact, if you look back at previous articles, I’ve tried to present potential positive outcomes as well just the negative, though you always knew where I stood. In the last couple of months, I’ve felt even worse about it because it seems that everyone is so upbeat these days. It’s happy talk all the time on CNBC, The Wall Street Journal and business magazines are full of positive articles on everything but the government, the economists’ consensus has swung completely around to a very bullish economic outlook, and investor sentiment is back to the most bullish since 2007. The Nonfarm Payroll number gave us a classic example of the psychology. Stocks ended the day higher by 100 points as the consensus viewpoint gelled around the belief that the number was probably the last bad number – given that the economy was really taking off. CNBC also resorted to bringing on one guest economist who expressed concern about the report only to be shouted down by three who weren’t bothered. That was the programming game played so often in 2006 and 2007 should anyone dare to question the housing market’s invincibility.
But this from this month on, I’ve determined to stop feeling guilty. The relentless message from Wall Street is nothing but the positive. I can see the potential positive outcome as well, but I still view the risks to a more negative outcome as far greater. So, I know you’re well covered on getting happy news, and I’ll unashamedly continue to try to fairly present the risks ahead. No more apologies.
Dwight Johnston
