It’s the leverage, stupid. Why the kool aid gang visualizes a ‘V’ in spite of this fact is beyond me. Yes, GDP accounting can associate with an upward trajectory based upon positive second derivatives and modest first derivatives. I understand that. That is not sustainable, strong growth. The reality is we face modest growth at best and a possible ‘W’. The following is a review of where we are and what could happen.
First, the household sector overleveraged. The process of adding leverage to the household balance sheet has been ongoing for decades, but there is little question this process accelerated in the past decade as financial engineering made more credit available to a wider range of individuals and per individual. While this became most noticeable in the housing sector, it was pervasive as auto loans became increasingly longer and credit cards limits expanded. I have yet to see a persuasive argument as to where the debt service to income ratio will eventually settle in. Yet significantly lower seems a safe bet. The debt service ratio was last reported at 129%, down from 135% and Equifax recently reported consumer debt has been reduce to $11T. However, income has also declined and does not seem destined to accelerate sharply higher anytime soon. EVEN IF YOU BELIEVE the consumer wants to restart the borrowing binge, it is highly unlikely they will have access to the necessary credit in the foreseeable future. Perforce, reduced spending via reduced credit growth implies a lower trajectory of consumer spending going forward unless you are forecasting a compensating increased growth in income. This seems improbable at least in the near term.
Second, the CRE sector is overlevered. Two years ago, the CRE mavens were unconcerned because, unlike prior partytime eras, they had not ‘overbuilt.’ That assumed constant or growing demand. Demand for space is obviously seriously curtailed and a supply glut now exists. Furthermore, underwriting standards were as nonexistent in this space as in much of the residential market. Cash flows do not remotely support the debt load and there is almost no capacity to refinance this debt. Examples abound such as Morgan Stanley recently turning over several large projects to lenders who hold debt amounting to less than 40% of the properties’ purchase price. This is a problem that is still mostly prospective in nature and current policy for dealing with it is generally described as “extend and pretend.”
The leveraged buyout market also overlevered. Deals were done with zero covenants and coverage ratios of 10 or 11 to one. What has saved this market has again been, extend and pretend, not growing cash flows or, in most cases, reduced debt.
The financial sector in general became overlevered. Part of this problem has been fixed. The 40:1 leverage ratios in the dealer community of two years ago are gone and many banks have raised meaningful equity capital. Having stipulated that, many of the factors that affect actual leverage or otherwise impact the sector have not been rectified. When Congressional threats forced the cessation of “mark-to-market” accounting, the true extent of losses became unknown and probably understated. Furthermore, much of the leverage contained in derivative form, e.g., SIVs, still exists. The result is a reduced willingness and capacity of the banks to lend. Exacerbating this factor is the massive reduction in “shadow banking” capacity. While an auto loan ABS deal can be marketed, we have yet to see a return in any size of whole loan residential deals, CMBS deals, etc. For an economy built on credit as the fuel, it remains difficult to envision a return to ‘normal’ growth much less fast growth when the fuel tank remains almost empty.
Barrons contained an interesting interview last week of Richard Koo, formerly of the NY Fed and currently senior economist for Nomura Research. He drew parallels to Japan of the past two decades and called what we are experiencing a “balance sheet” recession. In his mind we are approaching our ailment with the prescription for a cold when in reality we have pneumonia. In a balance sheet recession monetary policy does not work as expected as people want to reduce debt. He does not use the expression, but in essence he suggests the Fed is “pushing on a string.” In his opinion the only solution is a massive fiscal stimulus, combined with a program to allow banks to slowly write off toxic assets over ten years, and essentially forcing rating agencies to lay off downgrading sovereign debt.
While I do not subscribe to his prescription, I do think he highlights the key points that deleveraging is different than an inventory cycle and that monetary policy may not induce the expected results. I do not believe these financial imbalances necessitate another leg down in the economy, but they do place at least a significant brake on potential growth.
What can still go wrong?
First, a very possible reduction in asset values which could damage the psychology of consumers, businesses, and investors. It could arise from any number of sources. Housing may have bottomed in the sense of existing home sales (ex special tax credits) and new starts, but I doubt valuations have. In another Barrons piece last week, Barrons reviewed a company called Loan Processing Services which counts 80% of the largest banks as clients and, among other things, acts as a special servicer. It sees a 6 million unit overhang of “shadow inventory,” i.e., potential foreclosures. Laurie Goodman of Amherst Securities recently raised her estimate from 7 million (last Sept.) to a range of 9 to 10 million. Various mitigation efforts delayed the day of reckoning, but have to a large degree been failures. The problem has definitely spread well outside the original hotspots and could accelerate if homeowner psychology further morphs to the point that walking away from an underwater property is a smart idea. Conservatively, 25% of homeowners are currently “under water,” and that is at current prices. CRE also has significant potential to continue declining. I will leave it to the equity mavens to assess what happens to stock valuations if a very slow growth environment, ala Japan of the past two decades, becomes accepted as the best potential outcome.
Second, policy mistakes. Many have already occurred and it is difficult to know when and how Murphy’s Law will grab hold of one of them and run with it. That said, think prospectively in terms of what happens when the economy and markets finally confront the fact that taxes or other government imposed fees (think healthcare) are not only going up, but have a form and size that can be assessed rather than speculated about. It may spring from a VAT, the health care bill, states and municipalities, etc., but it is coming. Another obvious potential source is the withdrawal of monetary ease. Pick your poison: too soon or fast and the carry trade bubbles burst while too long or slow risks larger bubbles and inflation concerns. And when the bubbles do burst, they may not be domestic, yet still have economic reverberations here. And of course, this list would not be complete without identifying regulatory risk. Interestingly, I think this is mitigated by the recognition that policy which may be good and/or necessary in the long run (think financial regulation or some cap-and-trade variant) becomes problematic when the economy is very fragile. Still, it could happen.
Third, sovereign risk. As Thailand taught us a dozen years ago, seemingly innocuous, minor countries can be the snow ball which starts the avalanche. Whether it originates in one of the numerous Eastern European basket cases, the PIIGS, the UAE, or China’s bubble is impossible to say. BUT THERE ARE SO MANY POSSIBILITIES that it does not seem to be the ordinary ‘how can you pick an exogenous risk’ as it seems to be a question of assigning a probability far greater than 1%, like about 50-50 in 2010.
The workout to the leverage problem requires time for debt to be extinguished. Progress has been made, but more is required. We probably would have been better served if the fiscal stimulus had gone entirely toward retiring private debt, but that mostly did not happen. Furthermore, it would have created untold future problems anyway from the moral hazard perspective. The best case I can see is a modest sine wave pattern for economic growth: periods of slow growth interspersed with no growth or modest contraction. At best further government policy initiatives produce a temporal switch in growth as the Keynesian multiplier is less than one.
Disclosure: No Positions