A Plan For Recovery
While bank closures and high foreclosure and mortgage default rates are universally seen as negative impacts on the economy, it is closures and foreclosures that we need for a recovery. The bearers of such news are usually ignored as doom-sayers, bears, or Cassandras: no one wants to hear bad news. A fear of "bad news" is what has been driving the government's recovery policies and that is why this recession is not over. In fact those same policies may be leading us to a renewed period of decline.
It is of course unfortunate and sad to see banks close and people lose their homes. But when put in the context of the boom years when personal, corporate, bank, and government debt went off the charts, deleveraging has the effect of creating the conditions needed for a recovery.
We have not recovered. We see people still saddled by high personal debt. We see most banks weighed down by bad loans from commercial real estate, residential development, and consumer loans. We see deflation continue to drive residential real estate and commercial real estate down, further magnifying the impact. As a consequence, credit is still largely frozen for most individual and business borrowers, money supply continues to shrink, the economy appears to be headed to stagnation, and unemployment remains disturbingly high.
While very large corporations and perhaps the ten largest money center banks have access to credit, it hasn't helped most Americans or the majority of businesses. In fact, last quarter's profits for those large financial institutions were at impossible record levels based on the lucrative carry trade/arbitrage opportunity provided them by the Fed.
The answer to this conundrum is to withdraw government programs that support lenders and borrowers who are essentially bankrupt. It would be nice to see individual borrowers pay off their loans, but since most of the debt created in the boom phase originated from home equity, the continuing decline of home prices makes that a moot point.
Likewise, while it would be nice to see banks raise more capital, sell off bad loans and assets, and clear their balance sheets, they have been reluctant to do that, waiting as it were for more government bailouts. However, the amount of problem loans related to commercial real estate and residential real estate development is huge and much of what they lent on is fundamentally unsound because of overbuilding.
In an attempt to keep this debt rolling forward in the hope that the next cycle or inflation would bail lenders and borrowers out, policies such as TARP, HAMP, HARP, HAFA, extend and pretend, delay and pray, mark-to-make-believe, bailouts of Fannie (FNM) and Freddie (FRE), lowered lending requirements, massive Fed purchases of mortgage backed securities known as "toxic assets," and many others have tried to keep the debt barge afloat. It hasn't worked.
If it had worked, as the Fed and the government believes it should have, then we would see credit expanding, money supply growing, asset prices rising, consumer consumption increasing, and jobs going up and unemployment going down.
Presently the FDIC has 775 banks listed as "problem institutions." Bank closings are at 73 this year, and at 238 since 2008. Lending declined for the seventh straight month (accounting changes created an anomaly that falsely indicated an increase last month).
The combined percentage of residential loans in foreclosure or at least one payment past due was 14.01% last quarter. Morgan Stanley just reported that this "shadow inventory" could be as high as 8 million homes and take 47 months to liquidate, assuming current rates experienced by REO departments. Morgan Stanley's is the highest estimate I have seen. Others are 3.5 million. 4.7 million. and 5.5 million. Whichever number you pick, it still high.
CRE debt is getting critical for most banks. This is the main reason credit is frozen, excess reserves are high, and money supply is shrinking. Between 2010 and 2014, about $1.4 trillion in commercial real estate loans are expected to reach the end of their terms. CRE asset values are still falling.
Studies by McKinsey Global Institute and research by Romer and Reinhardt show that history is not kind in cycles with resulting high debt: on the average it can take six to seven years to deleverage, and can take as much as 25% off the top of GDP. It is painful and unavoidable, but understandable. This cycle is the biggest cycle in history and debt reached historic proportions, worldwide. Understand that mortgage backed securities, both residential and commercial, were distributed worldwide to banks, pension funds, insurance companies, hedge funds, and endowment funds.
How we could we fix this problem:
1. Require banks to mark-to-market the assets securing their loans, and raise more capital or go out of business.
2. Remove federally funded or guaranteed residential mortgage lending. This would include Fannie Mae, Freddie Mac, and the FHA.
3. End all Fed lending programs created at the beginning of the crisis, such as TARP.
4. End all programs to help home mortgage borrowers, such as HAMP and HAFA.
5. Require the Fed to auction its portfolio of mortgage backed securities.
6. Establish a program similar to the Resolution Trust Corporation (RTC) to quickly dispose of the assets of failed banks.
7. End tax policies that require borrowers to incur phantom income as a result of real estate debt relief.
8. End taxes on interest and dividend income to encourage savings.
9. Immediately raise the Fed Funds rate.
Many of these solutions seem counter-intuitive, but one must question the path our government has taken to stimulate a recovery. We need to look at this crisis in an entirely different way: the boom was the real problem and the bust is the cure. The harm was done in the boom phase as a Fed induced credit expansion and various government programs misdirected capital to businesses that, but for this government action, would not have been otherwise profitable. In economic terms this is called "malinvestment."
As in all booms, reality, usually in the form of a tightening of money supply by the Fed, brings asset value back to the ground, and even under the ground as we find these malinvestments unprofitable. That is what we are seeing now. The bust phase is a process of redirecting capital from these failed investments back into more profitable ventures. It is obvious that large amounts of capital will be lost. But by liquidating these bad assets, banks eventually go back to normal, credit loosens, people save more money because of financial uncertainty and to reduce their debt, thus creating the new capital needed for a true economic expansion.
If this liquidation phase is thwarted, as we have seen, we get stagnation and zombie banks. This is what Japan has experienced for the past 20 years.
Take the bitter pill, endure the inevitable pain, and we will recover quicker.
Disclosure: No positions