[R-G] [BillTottenWeblog] The US Financial System is Effectively Insolvent

[Bill Totten]

by Nouriel Roubini

Forbes.com (March 05 2009)


For those who argue that the rate of growth of economic activity is turning
positive - that economies are contracting but at a slower rate than in the
fourth quarter of 2008 - the latest data don't confirm this relative optimism.
In 2008's fourth quarter, gross domestic product fell by about six percent in
the US, six percent in the euro zone, eight percent in Germany, twelve percent
in Japan, sixteen percent in Singapore and twenty percent in South Korea. So
things are even more awful in Europe and Asia than in the US.

There is, in fact, a rising risk of a global L-shaped depression that would be
even worse than the current, painful U-shaped global recession. Here's why:

First, note that most indicators suggest that the second derivative of economic
activity is still sharply negative in Europe and Japan and close to negative in
the US and China. Some signals that the second derivative was turning positive
for the US and China turned out to be fake starts. For the US, the Empire State
and Philly Fed indexes of manufacturing are still in free fall; initial claims
for unemployment benefits are up to scary levels, suggesting accelerating job
losses; and January's sales increase is a fluke - more of a rebound from a very
depressed December, after aggressive post-holiday sales, than a sustainable
recovery.

For China, the growth of credit is only driven by firms borrowing cheap to
invest in higher-returning deposits, not to invest, and steel prices in China
have resumed their sharp fall. The more scary data are those for trade flows in
Asia, with exports falling by about forty to fifty percent in Japan, Taiwan and
Korea.

Even correcting for the effect of the Chinese New Year, exports and imports are
sharply down in China, with imports falling (minus forty percent) more than
exports. This is a scary signal, as Chinese imports are mostly raw materials and
intermediate inputs. So while Chinese exports have fallen so far less than in
the rest of Asia, they may fall much more sharply in the months ahead, as
signaled by the free fall in
imports.

With economic activity contracting in 2009's first quarter at the same rate as
in 2008's fourth quarter, a nasty U-shaped recession could turn into a more
severe L-shaped near-depression (or stag-deflation). The scale and speed of
synchronized global economic contraction is really unprecedented (at least since
the Great Depression), with a free fall of GDP, income, consumption, industrial
production, employment, exports, imports, residential investment and, more
ominously, capital expenditures around the world. And now many emerging-market
economies are on the verge of a fully fledged financial crisis, starting with
emerging Europe.

Fiscal and monetary stimulus is becoming more aggressive in the US and China,
and less so in the euro zone and Japan, where policymakers are frozen and behind
the curve. But such stimulus is unlikely to lead to a sustained economic
recovery. Monetary easing - even unorthodox - is like pushing on a string when
(1) the problems of the economy are of insolvency/credit rather than just
illiquidity; (2) there is a global glut of capacity (housing, autos and consumer
durables and massive excess capacity, because of years of overinvestment by
China, Asia and other emerging markets), while strapped firms and households
don't react to lower interest rates, as it takes years to work out this glut;
(3) deflation keeps real policy rates high and rising while nominal policy rates
are close to zero; and (4) high yield spreads are still 2,000 basis points
relative to safe Treasuries in spite of zero policy rates.

Fiscal policy in the US and China also has its limits. Of the $800 billion of
the US fiscal stimulus, only $200 billion will be spent in 2009, with most of it
being backloaded to 2010 and later. And of this $200 billion, half is tax cuts
that will be mostly saved rather than spent, as households are worried about
jobs and paying their credit card and mortgage bills. (Of last year's $100
billion tax cut, only thirty percent was spent and the rest saved.)

Thus, given the collapse of five out of six components of aggregate demand
(consumption, residential investment, capital expenditure in the corporate
sector, business inventories and exports), the stimulus from government spending
will be puny this year.

Chinese fiscal stimulus will also provide much less bang for the headline buck
($480 billion). For one thing, you have an economy radically dependent on trade:
a trade surplus of twelve percent of GDP, exports above forty percent of GDP,
and most investment (that is almost fifty percent of GDP) going to the
production of more capacity/machinery to produce more exportable goods. The rest
of investment is in residential construction (now falling sharply following the
bursting of the Chinese housing bubble) and infrastructure investment (the only
component of investment that is rising).

With massive excess capacity in the industrial/manufacturing sector and
thousands of firms shutting down, why would private and state-owned firms invest
more, even if interest rates are lower and credit is cheaper? Forcing
state-owned banks and firms to, respectively, lend and spend/invest more will
only increase the size of nonperforming loans and the amount of excess capacity.
And with most economic activity and fiscal stimulus being capital- rather than
labor-intensive, the drag on job creation will continue.

So without a recovery in the US and global economy, there cannot be a
sustainable recovery of Chinese growth. And with the US recovery requiring lower
consumption, higher private savings and lower trade deficits, a US recovery
requires China's and other surplus countries' (Japan, Germany, et cetera) growth
to depend more on domestic demand and less on net exports. But domestic-demand
growth is anemic in surplus countries for cyclical and structural reasons. So a
recovery of the global economy cannot occur without a rapid and orderly
adjustment of global current account imbalances.

Meanwhile, the adjustment of US consumption and savings is continuing. The
January personal spending numbers were up for one month (a temporary fluke
driven by transient factors), and personal savings were up to five percent. But
that increase in savings is only illusory. There is a difference between the
national income account (NIA) definition of household savings (disposable income
minus consumption spending) and the economic definitions of savings as the
change in wealth/net worth: savings as the change in wealth is equal to the NIA
definition of savings plus capital gains/losses on the value of existing wealth
(financial assets and real assets such as housing wealth).

In the years when stock markets and home values were going up, the apologists
for the sharp rise in consumption and measured fall in savings were arguing that
the measured savings were distorted downward by failing to account for the
change in net worth due to the rise in home prices and the stock markets.

But now with stock prices down over fifty percent from peak and home prices down
25% from peak (and still to fall another twenty percent), the destruction of
household net worth has become dramatic. Thus, correcting for the fall in net
worth, personal savings is not five percent, as the official NIA definition
suggests, but rather sharply negative.

In other terms, given the massive destruction of household wealth/net worth
since 2006-07, the NIA measure of savings will have to increase much more
sharply than has currently occurred to restore households' severely damaged
balance sheets. Thus, the contraction of real consumption will have to continue
for years to come before the adjustment is completed.

In the meanwhile the Dow Jones industrial average is down today below 7,000, and
US equity indexes are twentyb percent down from the beginning of the year. I
argued in early January that the 25% stock market rally from late November to
the year's end was another bear market suckers' rally that would fizzle out
completely once an onslaught of worse than expected macro and earnings news, and
worse than expected financial shocks, occurs. And the same factors will put
further downward pressures on US and global equities for the rest of the year,
as the recession will continue into 2010, if not longer (a rising risk of an
L-shaped near-depression).

Of course, you cannot rule out another bear market suckers' rally in 2009, most
likely in the second or third quarters. The drivers of this rally will be the
improvement in second derivatives of economic growth and activity in the US and
China that the policy stimulus will provide on a temporary basis. But after the
effects of a tax cut fizzle out in late summer, and after the shovel-ready
infrastructure projects are done, the policy stimulus will slacken by the fourth
quarter, as most infrastructure projects take years to be started, let alone
finished.

Similarly in China, the fiscal stimulus will provide a fake boost to
non-tradable productive activities while the traded sector and manufacturing
continue to contract. But given the severity of macro, household, financial-firm
and corporate imbalances in the US and around the world, this second- or
third-quarter suckers' market rally will fizzle out later in the year, like the
previous five ones in the last twelve months.

In the meantime, the massacre in financial markets and among financial firms is
continuing. The debate on "bank nationalization" is borderline surreal, with the
US government having already committed - between guarantees, investment,
recapitalization and liquidity provision - about $9 trillion of government
financial resources to the financial system (and having already spent $2
trillion of this staggering $9 trillion figure).

Thus, the US financial system is de facto nationalized, as the Federal Reserve
has become the lender of first and only resort rather than the lender of last
resort, and the US Treasury is the spender and guarantor of first and only
resort. The only issue is whether banks and financial institutions should also
be nationalized de jure.

But even in this case, the distinction is only between partial nationalization
and full nationalization: With 36% (and soon to be larger) ownership of Citi,
the US government is already the largest shareholder there. So what is the
non-sense about not nationalizing banks? Citi is already effectively partially
nationalized; the only issue is whether it should be fully nationalized.

Ditto for AIG, which lost $62 billion in the fourth quarter and $99 billion in
all of 2008 and is already eighty percent government-owned. With such staggering
losses, it should be formally 100% government-owned. And now the Fed and
Treasury commitments of public resources to the bailout of the shareholders and
creditors of AIG have gone from $80 billion to $162 billion.

Given that common shareholders of AIG are already effectively wiped out (the
stock has become a penny stock), the bailout of AIG is a bailout of the
creditors of AIG that would now be insolvent without such a bailout. AIG sold
over $500 billion of toxic credit default swap protection, and the
counter-parties of this toxic insurance are major US broker-dealers and banks.

News and banks analysts' reports suggested that Goldman Sachs got about $25
billion of the government bailout of AIG and that Merrill Lynch was the second
largest benefactor of the government largesse. These are educated guesses, as
the government is hiding the counter-party benefactors of the AIG bailout.
(Maybe Bloomberg should sue the Fed and Treasury again to have them disclose
this information.)

But some things are known: Goldman's Lloyd Blankfein was the only CEO of a Wall
Street firm who was present at the New York Fed meeting when the AIG bailout was
discussed. So let us not kid each other: The $162 billion bailout of AIG is a
nontransparent, opaque and shady bailout of the AIG counter-parties: Goldman
Sachs, Merrill Lynch and other domestic and foreign financial institutions.

So for the Treasury to hide behind the "systemic risk" excuse to fork out
another $30 billion to AIG is a polite way to say that without such a bailout
(and another half-dozen government bailout programs such as TAF, TSLF, PDCF,
TARP, TALF and a program that allowed $170 billion of additional debt borrowing
by banks and other broker-dealers, with a full government guarantee), Goldman
Sachs and every other broker-dealer and major US bank would already be fully
insolvent today.

And even with the $2 trillion of government support, most of these financial
institutions are insolvent, as delinquency and charge-off rates are now rising
at a rate - given the macro outlook - that means expected credit losses for US
financial firms will peak at $3.6 trillion. So, in simple words, the US
financial system is effectively insolvent.

_____

Nouriel Roubini, a professor at the Stern Business School at New York University
and chairman of Roubini Global Economics, is a weekly columnist for Forbes.com.

http://www.forbes.com/2009/03/04/global-recession-insolvent-opinions-columnists-roubini-economy.html


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