'L' Shaped Recovery and Bank Bailouts

by: Larry MacDonald

You would think the massive fiscal and monetary stimulus released by policymakers over the past year assures a recovery in the world economy. Sharp rallies in world stock markets since March suggest as much.

I hate to post another downbeat entry after Wednesday's post but I just came across some publications from the Bank for International Settlements, an organization that serves as a bank to central banks. I assume they have a little more substance than the usual lot of permabears and professional doomsters, so when their staff issue documents (Annual Report and working papers) with a tone that reminds one of the bearish sentiments of David Rosenberg, it seems worth noting for active investors (less so for passive).

What concerns BIS? They worry that the bank bailouts have left behind some unfinished business, and a failure to deal with it endangers the economic recovery. As the Annual Report notes:

The policy response did succeed in averting the collapse of the financial system and in calming the markets. It was less successful, however, in convincingly addressing the impaired assets on banks’ balance sheets …. A significant risk is therefore that the current stimulus will lead only to a temporary pickup in growth, followed by protracted stagnation.

The BIS says banks around the world were bailed out with no rigorous conditions for booking losses, disposing of bad assets, and eliminating excess capacity. As a result, “doubts about the long-term health of major global banks remain, with uncertainty about the potential losses from loan books and other credit exposures” adversely affecting the banks’ ability to raise capital.

Asset purchase plans were announced but little action seems to have been taken in most countries. One exception was the Swiss National Bank, which bought mortgage-related assets from UBS and placed them in a special investment vehicle. In the U.S. and Germany, things are on the quiet side.

The lack of progress on removing troubled assets from the banks’ balance sheets and recognizing the associated losses is illustrated by the US experience. Rather than buy impaired assets directly, the US Treasury outlined a plan in March, the Public-Private Investment Program (PPIP), to value these assets and to remove them through an auction mechanism …. Despite the favourable terms … the outlook for the PPIP [remains] uncertain [recent Chinese interest notwithstanding]”

According to BIS:

The steps taken so far have focused largely on providing guarantees and subsidized capital. At the same time, government guarantees and asset insurance have exposed taxpayers to potentially large losses. Progress on problem assets has been slowed by the complexity of the securities affected, legal constraints and, above all, the limited political will to commit public funds to the clean-up effort. The lack of progress threatens to prolong the crisis and delay the recovery because a dysfunctional financial system reduces the ability of monetary and fiscal actions to stimulate the economy.

Continues BIS:

What seems clear is that the deterioration in credit quality will generate more losses on banks’ loan books and other credit exposures. Banks may therefore have an incentive to delay recognizing losses, aided by accounting rules that provide management more discretion over when to write down assets. Taxpayers will not want to be exposed to greater potential losses, but key financial institutions are likely to require more government support in order to facilitate the required adjustments, to restore confidence in the financial system and to restart lending on a sustainable basis.

Governments could have made a timely clean-up of balance sheets a condition of injecting funds but they lost some of their leverage when most decided to purchase hybrid securities such as preferred shares instead of common shares. Preferred shares limit the risk of loss to the taxpayer while providing a more attractive dividend stream than common shares. These benefits come at a cost because preferred shareholders typically cannot vote at shareholder meetings, which constrain their ability to influence management.

As a consequence, BIS worries that the massive fiscal stimulus packages may lead only to a transitory uptick. “Short-term actions that delay adjustment and prop up aggregate demand may not be compatible with the medium-term need for banks to de-leverage their balance sheets so as to lay the basis for a healthy financial system and a self-sustaining recovery.”

Two other things about the bank bailouts are disconcerting to BIS. First, the rescue of banks deemed too big to fail has heightened the moral hazard problem, i.e. aggressive risk taking is encouraged because bankers assume the government will always step in to save them. Second, “the rescue packages and government-directed sales of failed banks may unwittingly increase systemic risk by creating larger financial institutions.”