Early Exuberance: Are We Getting Ahead of Ourselves?

Jun.21.09 | About: SPDR S&P (SPY)

It's surprising that merely two months after PPIP was announced, with foul play cries from critics on 'too much government/tax payer support', there are already indications of a lack of interest in the program from larger banks. The treasury secretary himself referred to this in a recent interview. This is primarily due to a rapid 30-45 day surge in stock market indicators, with early talks of the recession slowing down.

It's indeed good to see early-stage trend changes in unemployment, housing stats (new & existing), consumer spending, industrial spending - a possible early signal that the steepness of the downturn has been arrested. But that's just about it at this point - the economy as a whole is still showing negative growth, housing prices are still showing no signs of any significant bounce, and overall consumer sentiment is still negative. Given this background, it would be surprising if banks bask in the short term uptick in stock market indicators and show lax interest in participation in the PPIP program. None of the basic drivers - house prices, unemployment rate - have shown a marked movement towards positive territory, and hence its too early to expect quick reduction in credit card delinquencies, loan write-offs or foreclosures. Also, the credit market as a whole has been next-to-inaccessible for a larger part of the population due to extremely stringent lending norms and a sudden uptick in lending (especially mortgage) rates. This is dangerous - it increases the risk of at-the-brink consumers stepping in to delinquency due to insufficient means for availing short-term increases in credit, and thus flexibly manage their debt.

Another reason for the early exuberance, and hence perceived lack of interest in PPIP, might be the result of the bank stress tests that was announced in early May. However, one needs to understand that the 'stress' parameter values used were pretty mild by current standards - looks at this:

The stress test’s “more adverse” scenario, factored in ONLY the following worst case scenarios for GDP, unemployment and housing prices (as described in detail in The Supervisory Capital Assessment Program, Design and Implementation released by the Fed on April 24, 2009):


  • a decline of -3.3% in 2009
  • increase of 0.5% in 2010


  • civilian unemployment of 8.9% in 2009
  • civilian unemployment of 10.3% in 2010

House prices:

  • declines of -22% during 2009
  • 7% in 2010

Given the nature of the downturn and the depth of the crisis, the worst case values used for GDP are pretty mild - especially 2010 numbers. Also, unemployment numbers assumed in worst case are way too mild - we are already close to 8.5% in Q2 2009! House price decline numbers are probably realistic even in worst case scenario considering the decline that this parameter has already seen over the past 30 months! On top of this, only a 2-year stress scenario was used as opposed to a more stringent 5 or 10 year scenario - we are talking 'stress testing' and hence scenarios need to assume worst case numbers/assumptions.

The fact that the Fed/Treasury allowed many large TARP recipients to repay the money in light of the above stress test results does create a serious concern. I agree that some of these institutions are fundamentally sound even in this environment, but not all are. Allowing banks with pass marks after a mild stress test and to ease out of regulatory control (especially on executive compensation) by allowing TARP money repayments shows serious laxness by regulators.

Just to sum it up, we should all be happy to see an uptick in indicators and see the economy reviving. I also believe in the government needing to support this economy and market in ways that are mandated by the current environment. But its not common sense to let go of this opportunity to clean up bank/financial company balance sheets and forge a stronger culture of risk management. This can only lead to future peril and a possible relapse of recessionary trends. The current situation was clearly caused by lax risk management and poor regulatory and governance framework - and unless this fundamental issue is corrected, we are never going to come out of the rut clean.

Also, the situation has to be seen in an even larger context - treasury funding itself might be constrained due to a drastic increase in federal debt. Several of the large sovereign investors in treasuries (notably the BRIC countries) have already expressed serious concerns of the high-level of treasury debt floated these days, lack of focus on reigning in deficits longer term, and hence the risk posed due to an over-reliance on the US dollar as the reserve currency! This limits future treasury/governmant ability to fund and support the market, and hence it is all the more imperative to do it right this time!

Disclosure: None