The Perfect Storm: Three Forces to Undo the Recovery

Beyond the immediate, investment in building productive capacity must occur if the U.S. is to prosper and if higher national debt levels are to be serviced. Three forces that have built up in recent months and that will interact ferociously now make this almost impossible.

Let's be optimistic and assume that any new debt default problems (e.g. from commercial real estate) can be absorbed by the reformed and refinanced financial sector. Yet, the cards are now stacked against sustained recovery.

First, the rule of law has been abandoned for swathes of financial contracts. International research has found that successful economies are those that have well established property rights and law. This gives investors confidence to invest and, if things go wrong, they know the path to follow in seeking redress or unwinding positions. This is what distinguishes the U.S. from Venezuela and Russia. Or used to.

With the crisis, the U.S. rule of law has eroded for investors. Because of the housing loan crisis, there were various proposals for mortgage cram-downs and the like. Whilst the need was and is to help stranded homeowners, and force lenders to ease off or contribute, the effect is also to undermine confidence in the basic mortgage contract. The legal deal between lender and borrower, with the property as security, is now subject to third party intervention by the government with the lender having uncertain recourse to the property. Perhaps all this is just for a short time for certain mortgages, or perhaps not. The sanctity of the contract is gone.

Similarly, the Chrysler deal saw bond holders’ legal position in the queue of claimants overturned. Bond holders were forced by the government to give up part of their entitlements to the union, and castigated by Obama for resisting. So, now in the U.S. bond holders cannot rely on their legal position in the queue in the event of default or bankruptcy. This makes loans to large unionised firms much riskier than hitherto.

Of course, there were good reasons in these cases. Maybe it won't happen again. But at the end of the day, lenders’ legal entitlements have effectively been cancelled by the government in an ad hoc fashion.

Of course, it all depends who you are. As I've commented before, the very protective treatment that bond holders in the big banks have received may be connected to the large bond holdings in the banks by some major overseas sovereign wealth funds. By contrast, the hedge funds lambasted by Obama over Chrysler will predominantly have been representing domestic savers and pension funds.

This first factor interacts ferociously with a second, moral hazard. There's been much discussion over the zombie banks and their recovery. Being too big to fail, they have received both directly and via AIG large sums of public money. They have been allowed to renegotiate their stress test results and now can deduct any profits they make (e.g. from AIG handouts) from the stress test requirements.

In a May 7 interview with Charlie Rose, Geithner speaking of the stress tests on the big banks said:

all Americans should be confident that these institutions are going to be viable institutions going forward…. So it's like precautionary insurance against the risk of a deeper recession. That'll help make recovery more likely, because then banks won't have to keep behaving against the possibility that they have to protect themselves against things getting worse.

So, Secretary Geithner wants to assure all Americans that the big banks are safe. Which means they are. Ordinary financial institutions – banks or otherwise – might have to worry about mortgage lending or buying corporate bonds. But not the big banks because they have a total government guarantee.

Smaller but sound financial institutions will face risks from the government regardless of their legal protections. But the big banks, funded by taxpayers will receive only protections from the government. The inevitable result will be that the big banks gain market share not because of any superiority of performance but because of who they know. Returns on investment will necessarily be secondary to nurturing the relationship with the government.

The third force contributing to the perfect storm is government borrowing and spending. Set aside worries (well founded in my view) about the future of the $ and inflation. Again, let’s be optimistic and assume all that can be handled.

Government debt and government spend as a share of GDP will rise. The compensatory savings proposed by the administration were so small as to be derisory – the government is scarcely even concerned to appear to be looking to save money. And if you believe in the mega savings promised from health try and get your doctor or hospital to undertake to reduce or freeze the real costs of your health care in the future.

There will be massive Treasury bond issues by governments worldwide and a likely reducing Chinese trade surplus and taste for U.S. $. Hence, domestic purchases of bonds will be far more important to fund rising U.S. government debt.

But that may be OK as U.S. households are expected to save more. Setting aside, the consequent drag on consumption, consider the dynamic created.

Financial institutions outside the big banks are subject to extra risk from government confiscation of their loans if the debtor is in difficulty. This curtails their lending. The big banks have no such problem as they are supported by the government. They will respond to government preferences in their lending. And the government soaks up household savings into Treasury bonds which can then be used to fund or partner with the big banks’ lending.

In short, a corporatist approach. So much for the markets and Anglo-Saxon type capitalism. Some might say good riddance, but this removes the strengths of the U.S. economy and hence its growth potential. And consider who will benefit from the change.

Comments

[CautiousInv...:]

Nice article.

But as I have pointed out before the recovery from this recession is by no mean a slam dunk.........meaning I believe improvement in employment will be painfully slow as employers have adopted leaner organizations and consumers will be spending less of what they earn. Thus, recovery is still not at hand.

As to the cozy relationship between heads of large banks and Treasury and the Fed, I would not be surprised......after this economic tsunami blows by.........to see the Fed invested with broad authority to manage systemic risk. Should this be the case and in the interest of avoiding what we have just been through, the Fed could actually increase the reserve requirements of these larger institutions to both contain their growth and make them stronger, safer institutions.

May 12 09:25 AM

[robert.b.fe...:]

In discussing the abrogation of contracts by government interference the author asserts that there was good reason for it in these cases. In reality there wasn't a single good reason for it. This was strictly pay back for the friends of Barak and nothing more. As for the zombie banks, they are now robot banks, that exist to do the bidding of this administration. However there are always consequences for actions. In this case the very bondholders that were ripped off in the Chrysler take over are the ones needed for the public private partnership Tim the tax cheat needed. It would appear that plan is dead on arrival as there is no trust that the government will keep it's end of the bargain. GM will go the way of Chrysler soon but the bond holders will be better prepared this time around.

May 12 09:25 AM

[Larry House:]

Good points all. It is hard to get excited about participating in a game in which the rules change while the game is in progress. We haven't yet seen the costs of health care, the tax structure on corporations, the impact of credit card problems and commercial real estate--too much unknown to put much at stake right now.

May 12 09:59 AM

[user396040:]

You make some very good points - on the other hand, if the government takes a completely hands off approach it could lead to a depression and the kind of political reaction in the direction of statism that Europe experienced in the 1930's. It is very difficult for the government to take steps which save the system but do not undermine its strengths. As in medicine, the first rule should be to "do no harm." In this regard, I think that the worst example of contract abrogration and manipulation was the WAMU debacle . Bondholders got stiffed in a situation in which the assets might have supported some recovery. The next week the Libor skyrocketed and bank bonds plummeted in value.

May 12 12:43 PM

[donzelion:]

" The legal deal between lender and borrower, with the property as security, is now subject to third party intervention by the government with the lender having uncertain recourse to the property."

The legal deal between lender and borrower was only valuable in the market because both parties expect the government to enforce the contract. That's a fundamental assumption for the rule of law. The problem is, enforcement has its price, and the government has its quite evident limitations. When a creditor implements millions of contracts on the expectation of exploiting limited enforcement capacity, then sells the risks to still other parties on the expectation that once again, enforcement limitations will protect them, they effectively take a free ride while shifting risks to all other contracting parties.

Yep, it's a complex issue. So are all the financial products that made this mess possible.

May 12 01:21 PM

[Steve Hamlin:]

"Keep in mind that enforcing regulation of leverage, lending, and derivatives will have unintended negative consequences for the US economy, and stock market."

And you please keep in mind that 'enforcing sensible regulation of leverage, lending, and derivatives' will also have intended, positive consequences for the US economy.

Might the benefits of such regulation outweigh the potential costs? Why do you automatically assume that any regulation is bad regulation, and that any regulation is a net drag on the overall system?

I might like to trade a bit of alpha for a lower beta, when we're talking about the U.S. and global economy. [an economy that is less volatile = lower beta, lower potential GDP growth rate = lower alpha, vis-a-vis a hypothetical base-case of an economy ex-US regulatory reform]

It all depends, of course, on the broadness and market effects of the regulatory framework enacted. I posit that based on the 'costs' of the last 12 months, a move towards more financial markets oversight would be a net benefit to society. Yes, we might lose 0.5% of annual GDP growth, but what was the last 5 years of GDP growth based upon? (Hint: unsustainable credit expansion, and without Mortgage Equity Withdrawals, the U.S. had virtually ZERO organic GDP growth - it was all fiction, bought on credit that is becoming worth less, or worthless).

While I don't want to go all the way to a European-style economy, some reigning is required of 'highly-levered money center banks', of 'too-big-to-fail', of 'use depositors money to increase IB's capital to borrow S-T so they can do prop. trades on CDO^2s, and ask for a bailout if it doesn't work'. The massive gearing, and mixing of should-be-protected (depositors/FDIC) and should-not-be-protected (non-bank parts of C,BAC,WFC; IBs with minimal depository exposure; credit investors) - that has got to go.

Please explain why it shouldn't.

--- --- ---

"Once we start restricting the free market we descend the slippery slope to socialism." (non sequitur fallacy - see below)

The U.S. financial system was NEVER a free market to begin with. Treasury, Fed, OCC, OTS, SEC, FINRA - they all exist to regulate, which is to say, restrict how people act. Capitalism depends on a WELL-REGULATED free market, of the kind that doesn't allow banks to borrow the savings of citizens in order to lever up and chase hot-money yields around the globe.

Is limiting leverage for gov't-chartered banks socialism? Is requiring an exchange settlement process for CDS and similar derivatives 'restricting the free market'? Is not allowing fully-hedged creditors to submarine a bankruptcy workout 'restricting the free market'?

Conspiracy theorists and the Republican Party aside, no one is suggesting that the U.S. permanently move to state-ownership of capital. The only argument is: within a fairly tight range, how much regulation should there be? That is not quite socialism, in my view.


(and BTW - please define 'free market' and socialism' as you are using those terms - I don't agree with that statement. One term has to do with who owns the means of capital, the other has to do with how you require markets participants to interact with each other. Related, perhaps, but certainly not on a single-axis continuum.)


--- --- --- ---
On May 12 11:14 AM Cetin Hakimoglu wrote:

> Keep in mind that enforcing regulation of leverage, lending,
> derivatives will have unintended negative consequences for
> the US economy, and stock market. Once we start restricting
> the free market we descend the slippery slope to socialism.

May 12 05:00 PM

[nuclear stocks:]

The unions did not steal Chrysler from the bondholders. The bondholders purchased bad bonds. Have you ever heard of a bankruptcy hearing where the very first motion was to protect the employees? If the employees walk, the bondholders get nothing because the company is worth nothing. Obama did the same thing that the bankruptcy court would have done at the bondholder’s insistence. This guy is clueless about the corporate bankruptcy process.

What were those bondholders thinking when they bought the Chrysler bonds, Chrysler has bee essentially bankrupt for ten years.

May 12 09:09 PM

[dybydx:]

nuclear stocks,

It appear you do not know Chrysler well. Those bonds were senior debts which were legally secured by hard assets of Chrysler (ie factory, equipment etc, similar to your mortage is secured by your home). In the event that Chrysler fails to make interest payments, these bond holders are legally entitled to take posession of the assets. Of course, selling these assets may only pay back pennies on the dollar (hence the bonds were bought at discount).

Obama overrode that and said "your right to seize assets of Chrysler in the event of a bankruptcy is now null and void, instead those assets will now be given to UAW."

May 12 10:43 PM

[dybydx:]

in case I havn't make that clear, currently the law says, in the event of bankruptcy, secured (or senior) debt holders gets their claims paid BEFORE the employees. It is entirely possible, legal, moral and ethical that secured debt holders get paid 100 cents on the dollar and employees get 0.

Obama is saying employees deserve 75 cents, senior debt holders get 25 cents.

May 12 10:49 PM

[oldfolkdancer:]

The present administration is changing existing rules to suit itself. I'm surprised it hasn't said "we have to be flexible" or "extraordinary times demand extraordinary methods" or "our desired end DOES justify our means" More and more our situation reminds me of George Orwell's "Animal Farm"

May 13 09:30 AM

[johnmorrison9:]

The collective must obey. Blame George.

May 13 10:09 AM

[robert.b.fe...:]

Regardless of when or why they purchased the bonds by definition they bought secured debt. They should have been first in line to recover thier money. By pushing them to the back of the line this administration has nullified over one hundred years of bankruptcy case law. If Chrysler could not pay them back they had every right to demand liquidation of company assets to satisfy thier claims.


On May 12 09:09 PM nuclear stocks wrote:

> The unions did not steal Chrysler from the bondholders. The bondholders
> purchased bad bonds. Have you ever heard of a bankruptcy hearing
> where the very first motion was to protect the employees? If the
> employees walk, the bondholders get nothing because the company is
> worth nothing. Obama did the same thing that the bankruptcy court
> would have done at the bondholder’s insistence. This guy is clueless
> about the corporate bankruptcy process.
>
> What were those bondholders thinking when they bought the Chrysler
> bonds, Chrysler has bee essentially bankrupt for ten years.

May 13 11:33 AM

[reluctantQuant:]

So what country are all you guys moving to?

--rq

May 13 12:58 PM

[Jan Baker:]

But the infidelity to contracts was so predictable--the first time the public took infidelity to the marriage contract, and divorce, as an acceptable option. They go together. They were always linked. Both contribute to social stability, and growth, and prosperity. They both took so many thousand years to establish. And so few, just a few generations, to trash. But there's a certain justice in the current situation. Those abandoned stockholders can perhaps now look with somewhat more sympathy at the plight of abandoned wives, and perhaps feel their pain as all their friends now tell them, regarding their crushed retirement funds, 'Let it go, move on, think of it as a new opportunity.' Yeah, uh-huh . . .we'll all love working until we die. Just like abandoned wives. Oh the joy of no-fault.

May 13 03:37 PM

[norom:]

It will happen again. The productive capacity of the United States and its capacity to consume has never been more distant. Thats the Achillies heel of every great civilization, dependance on imports which can only be afforded by an ability to make transfer and interest payments. The supply of goods and services can only go down, which leads to inflation and turmoil. Our primary industries do not produce anything of tangible value and those that do have no incentive to use time and resources effectively. Instead of building the economy by ensuring a competitive marketplace our government has allocated the time and resources of the United States to furthering X-inefficiency, the virus that caused this collapse in the first place. I.e. too much money chasing money.

May 13 04:25 PM

[norom:]

The Unions did. There is now, at Chrysler, an incentive to take on projects with negative net-present-value because shareholders get all the upside. The Unions got a cheap date and stand to profit hugely while the money they subsited on from debt-holders dry out. Its like buying your own credit-card debt and forgiving yourself of that debt.


On May 12 09:09 PM nuclear stocks wrote:

> The unions did not steal Chrysler from the bondholders. The bondholders
> purchased bad bonds. Have you ever heard of a bankruptcy hearing
> where the very first motion was to protect the employees? If the
> employees walk, the bondholders get nothing because the company is
> worth nothing. Obama did the same thing that the bankruptcy court
> would have done at the bondholder’s insistence. This guy is clueless
> about the corporate bankruptcy process.
>
> What were those bondholders thinking when they bought the Chrysler
> bonds, Chrysler has bee essentially bankrupt for ten years.

May 13 04:30 PM

[Simon Smelt:]

I live in New Zealand


On May 13 12:58 PM reluctantQuant wrote:

> So what country are all you guys moving to?
>
> --rq

May 14 07:35 PM