Economic Crisis: Ready for Round Two?

This is not 1975, and Joe Frazier and Muhammad Ali are not in the ring.

But the economic crisis which began in December 2007 has only finished the first round.

Recap of Round One

The economic events last year bordered on catastrophe – many believing there was a chance of a Great Depression 2.

The epicenter or proximate cause of the crisis was over valued real estate asset values, and the bubble burst. The real estate devaluation exposed a myriad of other economic weaknesses.

The financial system took a standing 8 count, and the Federal Reserve responded with all the constitutional and non-constitutional power they could muster. Money rained from the sky (or helicopters).

Now, 20 months later, the economic decline appears to have stopped. Even Dr. Doom’s RGE Monitor now opines:

In H2 2009, as the economy bottoms out from a record contraction (the worst in the last 60 years), adjustments, such as slower inventory destocking, will occur, while policy measures such as “cash for clunkers” will boost auto production and induce continued spending brought on by the stimulus. According to RGE Monitor, these factors will likely bring U.S. real GDP growth back to positive territory in Q3 2009.

Round one was won by the Federal Reserve. The Great Recession tried to become the Great Depression 2 and failed.

Round two is beginning now but will begin in earnest 4Q 2009. The Fed after winning round one handily does not believe there will be much of a fight in Round Two. They have raised their economic forecasts.

Round Two Defined

The FOMC defined round two in their June 2009 meeting.

Nonetheless, most participants saw the economy as still quite weak and vulnerable to further adverse shocks……. Still, participants generally noted that the improvement in market conditions was in part due to ongoing support from various government programs and that underlying financial conditions remained fragile. Credit was tight, with some banks quite reluctant to lend. Worsening credit quality, especially for consumer and commercial real estate loans, was seen as an important reason for reduced lending and tighter terms, and banks could face substantial losses in their loan portfolios in coming quarters. Many participants noted that obtaining financing for commercial real estate projects remained extremely difficult amid worsening fundamentals in the sector.

We are watching the between rounds activity right now. I am concerned over the FDIC bank closures. Earlier this year, most of the FDIC closures were simply a matter of changing signs on existing banks. Now they are being boarded up with the accounts being moved to other banks.

This will add to the commercial real estate oversupply.

That will even put more stress on the Commercial & Industrial (C&I) real estate market – and put this market into a deepening death spiral. There are already too many C&I properties due to:

• New Normal being a paradigm shift from brick and mortar to internet store fronts.
• A shift in consumer patterns from spending to savings. Lower volume of spending means less demand for brick and mortar properties.
• Recessions always kill the weak businesses so the real estate becomes vacant.

So what is the big deal? Too much supply, prices will fall. C&I real estate values are set by REVENUE of the property. If there are 100 properties and only 70 tenants, 30 properties will end up with zero revenue while the remaining properties will substantially cut the lease rates.

And revenue determines C&I real estate valuations.

Quantifying Round Two

C&I real estate loans are a sizeable minority of the credit which has been extended in America.

But in terms of projected losses earlier this year, C&I real estate loans were the biggest source of defaults.

Unlike residential real estate, C&I real estate loans are on shorter fuses – only 5 or 10 years with little pay down of principal. Underwater loans (loans which are larger than the current value of the property) must face the reality of market conditions as borrowers must refinance periodically.

The above graph understates the losses. These were based on historical losses in a bad recession. We have the additional New Normal resets of lower consumer spending and a trend away from brick and mortar businesses.

This week the Federal Reserve announced an extension in time to the TALF (Term Asset-Backed Securities Loan Facility) program from 31 Dec 2009 to 30 Jun 2010. This program loans banks cash against high rated non-recourse loans (auto, boat, plane, etc) and Commercial Mortgage Backed Securities (CMBS) for a fixed period of time (usually three to five years). Under normal economic conditions, banks securitize these loans and sell them off. This market is still not functioning correctly according to the Federal Reserve statement.

A CMBS is a bundle of commercial real estate loans. There is a reason the CMBS market is not working. 60% to 70% of commercial properties in these portfolios are expected to default. You might remember that CMBS is just another member of the Collaterized Debt Obligation (CDO) family which helped make the Great Recession so bad.

TALF does not really remove these assets from the bank’s books. The banks are using the Fed like a pawn shop for their assets – and they must give the money back in three to five years. As usual, the TALF program is a solution designed around the concept of pushing off problems to tomorrow.

Zero Hedge has time lined the C&I real estate loan refinances.

Zero Hedge believes the losses will exceed $1 Trillion, as 68% of all loans will not qualify for refinancing. Deutsche Bank thinks the default rates of C&I real estate loans will be between 60% to 70%.

This puts $600 to $700 billion of losses inside of the banks just for C&I real estate using Zero Hedge’s data. Other data indicates the losses inside the banks could be well into the trillions.

Round Two Strategy

The government and the Fed will rope-a-dope. They cannot defeat this C&I real estate crisis. The plan is to keep the C&I real estate crisis in check by covering enough of the losses to keep the financial system operating.

Round Two strategy for the government and the Fed will play like Round One except that this time the Fed has weapons ready. Congress will fund the hell out of FDIC and any other program to keep the wheels on the economic cart. This will include higher and higher levels of TALF loans against Commercial Mortgage Backed Securities (CMBS) like those underway this week.

The systemically important stress tested big banks will continue to be supported. More and more medium and smaller sized banks will be biting the dust and be boarded up. The TALF program is only a stop gap – at the end of the day if the economy does not return to significant growth this whole TALF program’s losses will be reimbursed by the taxpayer.

All that Fed and government injected liquidity will continue to be offset by wealth destruction inside of the banks, retirement funds and the insurance companies who own the commercial mortgage-backed securities as commercial real estate spirals down.

The Fed so far has not addressed the primary problem of how to deal with refinancing the C&I real estate market to try to head off the defaults. There are no options for the C&I property owners but default. Why would lenders want to loan against underwater properties? Why would C&I property owners want to borrow against an underwater property?

Round Two will be fought to a draw. The government and the Fed will mitigate the damage of the C&I real estate collapse, and will be willing to spend what is necessary to prevent the C&I real estate crisis from winning. Government debt will continue to rise but Armageddon was avoided, and payback of debt will be mañana.

Round Two – Behind the Scene

Remember the toxic assets in the banks? Where did it go? Right, the toxic assets are still in the banks.

We hear the big economists argue whether another stimulus is necessary to prevent an “L” shaped recession. Here is what Nouriel Roubini said in April 2009:

…..could the US experience an L-shaped recession, i.e. a protracted period of economic stagnation like the one experienced by Japan in the 1990s after the bursting of its housing and equity bubble? My view is that a protracted economic stagnation – bordering on an economic depression – is unlikely in the case of the US as the policy response of the US is already more aggressive than the one of Japan. Japan waited almost two years after the bursting of its bubble to ease monetary policy; and it waited two years before providing fiscal stimulus. In the US, instead, both monetary and fiscal stimulus have started in earnest early on. Also Japanese postponed the necessary corporate and banking restructuring for years keeping alive zombie firms and zombie banks via inappropriate forms of forbearance. In the US both private and especially public efforts to restructure the impaired assets and firms will start faster and more aggressively. Thus the risk of a decade-long economic stagnation is quite limited so far.

Not only will the C&I real estate loans be rotting in the bank’s cooked books, but they have an alphabet soup of unmarked-to-market crap they cannot cleanse as it will force immediate write-downs.

Why are those writedowns so important? We are not recognizing existing wealth destruction. The banks have to rope-a-dope too. Instead of banks being a driver of recovery as they were in the 2001 recession, they now will act passively using their operating profits to cover the losses in consumer and commercial loans.

It has been pointed out that banks can always write and then securitize / sell the loan – make their profit and move on. Newsflash….. this securitization market is not working well and that is the reason for TALF. The banks have to make damn sure the loans they make today are high quality.

And it takes two to tango – where is the demand for loans? Demand for loans has fallen off a cliff.

The point is today’s banks cannot front run a recovery. Banks can only support a recovery as it is occurring.

Ask yourself where the economic driver is for recovery. We have none yet. And without a driver whatever little real growth we have must be diverted to continue to cover up the non-recognized wealth destruction which has already occurred.

This is a big force working against real recovery. We can look to Japan to see what the outcome could be.

Round Three Preview

Round three is the debt, the growing tax load, and the inability of the government to foster growth in private sector jobs. This round will be a marathon.

It will be a miracle if there is not a Round Three. It would require a TKO at the end of Round Two delivered by the economy returning to its past growth pattern. I would also have to be wrong that we are entering a New Normal of lower spending and less debt.

As everyone realizes, all of the government’s and the Fed’s economic punches to date has had the effect of moving the timeline for the day of reckoning into the future. This strategy is based on two concepts.

1. The economy will grow and will diminish the effects of the growing debt.
2. The corporate and personal balance sheets will heal over time. Therefore if we continue to throw the balls into the air, at some point we can catch them and easily put the problems to bed.

This Is Not Manila and It Is Not 1975

Most economists think this boxing match with the Great Recession is essentially over.

The government and the Fed came out swinging in Round One using all their power. They believed it was a one round match, and were expecting a knock out. The underlying issues of the Great Recession have not been resolved, and their destructive power is still growing.

As the government and Fed’s game plan was for a one round match, they are not in fiscal condition for a marathon fight.

The Thrilla in Manila went 14 rounds.

Hat tip to Steve at MEMETICS & MARKETING for editing support.

Disclosures: None

Comments

[Dave Wrixon:]

The biggest problem is from an International Investor/Speculator perspective the US economy is only one horse in a field. To want to back such a severely handicapped horse the punter would need very long odds indeed, and that means very high interest rates which by themselves will cripple any prospect of a recovery. No, what the intelligent punter will do is take his money off the US horse and put it a horse in good form that is not carrying a lot a of rocks in his saddle bags. The problem is without investment capital the US economy is pretty much doomed, and the only way to attract it back it put its financial house in order and show that it is commercially competitive. Even if the political will were there to do this it would take more than a decade, by which time the questions over who is the World's biggest economy and whose currency take precedence will have long since been resolved in China's favor, with two and three going to India and Russia.

Aug 23 06:07 AM

[Dave Wrixon:]

Well actually of course if you count the Eurozone, then that would probably come in second pushing Russia out the Frame. The US will be a Faller at the Third.


On Aug 23 06:07 AM Dave Wrixon wrote:

> The biggest problem is from an International Investor/Speculator
> perspective the US economy is only one horse in a field. To want
> to back such a severely handicapped horse the punter would need very
> long odds indeed, and that means very high interest rates which by
> themselves will cripple any prospect of a recovery. No, what the
> intelligent punter will do is take his money off the US horse and
> put it a horse in good form that is not carrying a lot a of rocks
> in his saddle bags. The problem is without investment capital the
> US economy is pretty much doomed, and the only way to attract it
> back it put its financial house in order and show that it is commercially
> competitive. Even if the political will were there to do this it
> would take more than a decade, by which time the questions over who
> is the World's biggest economy and whose currency take precedence
> will have long since been resolved in China's favor, with two and
> three going to India and Russia.

Aug 23 06:11 AM

[Michael Clark:]

Excellent article.

Aug 23 06:16 AM

[markfl:]

I like the phrase “slower inventory destocking,” because I think it correctly anticipates the strength of recovery. On the one hand, automakers were induced to restock vehicle inventories based upon the government rebate program. On the other hand, no sooner have some ramped up production than the program is ending. It’s not clear to me that demand is sustained, nor is it apparent that retail goods are exactly flying off the shelf. It is more a deceleration of downward or contraction momentum in the economy than a growth momentum. The panic retrenchment by businesses has subsided, and this has lessened the contraction momentum. That’s about it.

Aug 23 06:18 AM

[Roger Knights:]

"This will add to the commercial real estate oversupply."

So will closing 500 to 1000 post offices.

Aug 23 06:58 AM

[perceptions...:]

"This Is Not Manila and It Is Not 1975
Most economists think this boxing match with the Great Recession is essentially over.

The government and the Fed came out swinging in Round One using all their power. They believed it was a one round match, and were expecting a knock out. The underlying issues of the Great Recession have not been resolved, and their destructive power is still growing."

Steven,
You are right, this isn't Manila 1975 and the economists, the FED & the government have some unresolved issues!

However, we are indeed fortunate that the grand meeting of Central Bankers, has just ocurred, at Jackson Hole in Wyoming.
Link -
business.timesonline.c...

Why is that fortunate, I hear some say?
The answer is simple, it's because all rainbows end at this meeting of central bankers.

Why? So they can again divide up the massive pot of gold, which,
as everyone knows, resides at the end of every rainbow.

Not only that, but this gold is continually replenished by "the exponential economic growth fairy", who also resides, at the end of the rainbow.

Yes, it is a place where all fairytales come true. Where the growth fairy & friends, Dorothy & Toto walk down the Yellow (Gold) BRIC road and where Alice & the Mad Hatter peer thru the looking glass, looking for, somebody or nobody?

We are indeed fortunate, that our central bankers have access to such a wonderous, never ending treasure of Gold and to have the assistance of economists such as, Dorothy, Toto, Alice & the Mad Hatter, to enable them to magically solve all of our economic problems.

I can now, rest tonight, happy that the world is in safe hands?

PS - Personally, I think Jekyll Island would be THE most appropriately named place, for Central Bankers to meet!

Aug 23 08:15 AM

[User 353732:]

So now we have the Govt of the abettors of Bad Debt for the holders of Bad Debt by the issuers of Bad Debt?
1. In addition to CRE defaults, there will be parallel waves of rolling debaults of credit card debt, auto loans, student loans( many young people and recent graduates have no jobs or are underemployed and their families cannot underwrite their past due student loans while also trying to put other young people thru college and financially look after aged relatives whose net worths and retirement incomes have fallen by 50 to 60% in the past 12 months), medical bills,and utility bills: these will strike simulataneously in 2010
2. At the same time, in the second and third quarters of 2010 we may see rolling waves of minui debt default of increasing severity(falling tax/fee revenues at the local level and rising fixed costs esp. legacy obligations coupled with no more opportunities for new accounting fraud) which will lead to many vendors and investors being hurt and scores or even hundreds of thousands more muni employee layoffs
3. Moreover, the credit and public policy environment for small and medium businesses is now so malignant in the US that hundreds of thouands of solo, small and medium businesses will need to shed employees or reduce working hours or cut compensation merely to survive; as all cash is diverted to survival, investment spending by these businesses will decline to almost nothing: there will be substantail second order consequences for large companies from this collapse in investment spending
4. The Great Bubbles of the East in China( real estate, stocks, unneeded infrastructure, inventory building far in excess of actual final sales )will likely deflate first gradually then quickly perhaps starting in Q4 2009 and roiling the Chinese and hence Asian economies deep into 2010. As a reaction, Asian stock markets will see a flight of capital and the fall in the inflated stock markets of Asia will, of course, substantially compress equity markets in the result of the world.
5. As a result of the developments noted above consumer confidence may well collapse in the US and EU resulting in the concommitant collapse in business confidence while at the same time egregiously bad public policy in the US will severly discourage genuine risk capital, useful innovation and true talent from creating new businesses and jobs.
It seems to me that multiple adverse economic and financial , sequential and simultaneous, forces are gathering strength across the world and their cumulative effect will to be overwhelm , with contemptuous ease, the serial bubble making , resource misallocation and fiat dollar policies of the US Govt. and its fellow travellers, the UK and Chinese Govts.
In my view, what we have seen so far was merely a prolog: the main chapters in this tremendous tragedy of how the venomously corrupt, self aggrandizing and monumentally avaricious elites of the US, UK, China and Russia(among others, of course) brought gratuitous misery to billions of people across the planet have yet to be revealed.

Aug 23 08:40 AM

[j-dub:]

You must be a hoot at cocktail parties. A real 'life of the party' type of guy.

Let me guess your vocation of choice...................
GOT IT!!!

motivational speaker
Am I right? :)



On Aug 23 08:40 AM User 353732 wrote:

> So now we have the Govt of the abettors of Bad Debt for the holders
> of Bad Debt by the issuers of Bad Debt?
> 1. In addition to CRE defaults, there will be parallel waves of rolling
> debaults of credit card debt, auto loans, student loans( many young
> people and recent graduates have no jobs or are underemployed and
> their families cannot underwrite their past due student loans while
> also trying to put other young people thru college and financially
> look after aged relatives whose net worths and retirement incomes
> have fallen by 50 to 60% in the past 12 months), medical bills,and
> utility bills: these will strike simulataneously in 2010
> 2. At the same time, in the second and third quarters of 2010 we
> may see rolling waves of minui debt default of increasing severity(falling
> tax/fee revenues at the local level and rising fixed costs esp. legacy
> obligations coupled with no more opportunities for new accounting
> fraud) which will lead to many vendors and investors being hurt and
> scores or even hundreds of thousands more muni employee layoffs<br/>3.
> Moreover, the credit and public policy environment for small and
> medium businesses is now so malignant in the US that hundreds of
> thouands of solo, small and medium businesses will need to shed employees
> or reduce working hours or cut compensation merely to survive; as
> all cash is diverted to survival, investment spending by these businesses
> will decline to almost nothing: there will be substantail second
> order consequences for large companies from this collapse in investment
> spending
> 4. The Great Bubbles of the East in China( real estate, stocks, unneeded
> infrastructure, inventory building far in excess of actual final
> sales )will likely deflate first gradually then quickly perhaps starting
> in Q4 2009 and roiling the Chinese and hence Asian economies deep
> into 2010. As a reaction, Asian stock markets will see a flight of
> capital and the fall in the inflated stock markets of Asia will,
> of course, substantially compress equity markets in the result of
> the world.
> 5. As a result of the developments noted above consumer confidence
> may well collapse in the US and EU resulting in the concommitant
> collapse in business confidence while at the same time egregiously
> bad public policy in the US will severly discourage genuine risk
> capital, useful innovation and true talent from creating new businesses
> and jobs.
> It seems to me that multiple adverse economic and financial , sequential
> and simultaneous, forces are gathering strength across the world
> and their cumulative effect will to be overwhelm , with contemptuous
> ease, the serial bubble making , resource misallocation and fiat
> dollar policies of the US Govt. and its fellow travellers, the UK
> and Chinese Govts.
> In my view, what we have seen so far was merely a prolog: the main
> chapters in this tremendous tragedy of how the venomously corrupt,
> self aggrandizing and monumentally avaricious elites of the US, UK,
> China and Russia(among others, of course) brought gratuitous misery
> to billions of people across the planet have yet to be revealed.

Aug 23 09:22 AM

[Outofchips:]

Steve,

With your excellent awareness & insight of what's really going on I wish you would write a modern, readable version of Atlas Shrugged. It is happening.

Aug 23 09:49 AM

[T.Stamps:]

Good article. When the govt spends 800 billion on a stimulus
and only 10% is actually a stimulant and the rest goes to
helping the party in power get re-elected, this doesnt bring
much confidence.

Aug 23 11:10 AM

[Spartacuss:]

You just can't help but ponder: what if they had just let it crash?

As Bill Bonner of Agora publishing is fond of saying, "the cure for high prices is high prices". Perhaps the cure then for low prices is low prices. And arising out of the ashes of failed past policies and laws as designed by our past congress' might be the a) no more new laws from congress and b) let the thing crash and prices will eventually hit bottom and we can wiggle the way back out of the swamp like we Americans have a long history of doing well.

But, alas, we are doomed to go in the direction of George Orwells world...socialist oligarchy...and we, the prol's will be ground to dust under the heels of the all knowing messiahs of the new left.

Aug 23 12:09 PM

[Gregman2:]

Excellent post. FYI: this isn't Haiti either where Baby Docs wife was throwing money from her limousine. Problems are being addressed really through monetarist mechanisms, and the bottomline is...the technologies of capitalism are ultimately so efficient that it makes many workers unnecessary. We need a way to bottom-up this recovery, to restore buying power in a way that gives people steady pay checks.

Aug 23 02:17 PM

[derryl:]

Another hard hitting factual analysis from Steve.

perceptions wrote, "However, we are indeed fortunate that the grand meeting of Central Bankers, has just ocurred, at Jackson Hole in Wyoming.
Link -
business.timesonline.c...

Why is that fortunate, I hear some say?
The answer is simple, it's because all rainbows end at this meeting of central bankers."

Actually, this meeting is hosted by Kansas City Fed President Thomas Hoenig who recently wrote, "Too Big has Failed",

www.kc.frb.org/speechb...

in which he advocates an orderly unwinding of the bubble valuations and unpayable debts, firing the management of all insolvent financial institutions, and starting over on financially solid ground. I haven't read anything about what was actually concluded at Jackson Hole but it would be interesting to see if Mr. Hoenig was received any better than former BIS chief economist William White who consistently warned central bankers about the bubbles while they were forming.

Aug 23 05:40 PM

[TinyTim:]

Nice article.

Round two should be a KO for the banks if the refs will allow them to fall over. The banks will go for the ropes and clinches with the Fed. A TKO will drag out this round to the bell but is unlikely.

Round three will be a split decision. The megabanks and the proletariat will still be standing. The middle class and the dollar will be down for the count.

Aug 23 06:18 PM

[Blair Dehuff:]

One of your best, Steve, and it really should be an editor's pick. I hope it's ok I linked your article to some message boards at Yahoo Finance.

Aug 28 11:28 AM