[Pen-l] The US Financial System is Effectively Insolvent

[Charles Brown <cdb1003@xxxxxxxxxxx>]

 Meaning , what ? Its firms can't pay their debts ?

depression = stag-deflation


CB

The US Financial System is Effectively Insolvent 
  
by Nouriel Roubini

Forbes.com (March 05 2009)


For those who argue that the rate of growth of 
economic activity is turning
positive - that economies are contracting but at
 a slower rate than in the
fourth quarter of 2008 - the latest data don't
 confirm this relative optimism.
In 2008's fourth quarter, gross domestic 
product fell by about six percent in
the US, six percent in the euro zone, eight
 percent in Germany, twelve percent
in Japan, sixteen percent in Singapore 
and twenty percent in South Korea. So
things are even more awful in Europe and 
Asia than in the US.

There is, in fact, a rising risk of a global
 L-shaped depression that would be
even worse than the current, painful U-shaped
 global recession. Here's why:

First, note that most indicators suggest that
 the second derivative of economic
activity is still sharply negative in Europe and 
Japan and close to negative in
the US and China. Some signals that the 

second derivative was turning positive
for the US and China turned out to be fake starts. 
For the US, the Empire State
and Philly Fed indexes of manufacturing are 
still in free fall; initial claims
for unemployment benefits are up to scary levels,
 suggesting accelerating job
losses; and January's sales increase is a 
fluke - more of a rebound from a very
depressed December, after aggressive 
post-holiday sales, than a sustainable
recovery.

For China, the growth of credit is only 
driven by firms borrowing cheap to
invest in higher-returning deposits, not 
to invest, and steel prices in China
have resumed their sharp fall. The 
more scary
 data are those for trade flows in
Asia, with exports falling by about forty
 to fifty percent in Japan, Taiwan and
Korea.

Even correcting for the effect of the Chinese 
New Year, exports and imports are
sharply down in China, with imports falling
 (minus forty percent) more than
exports. This is a scary signal, as Chinese 
imports are mostly raw materials and
intermediate inputs. So while Chinese exports
 have fallen so far less than in
the rest of Asia, they may fall much more 
sharply in the months ahead, as
signaled by the free fall in
imports.

With economic activity contracting in 2009's
 first quarter at the same rate as
in 2008's fourth quarter, a nasty U-shaped recession 
could turn into a more
severe L-shaped near-depression (or stag-deflation).
 The scale and speed of
synchronized global economic contraction is
 really unprecedented (at least since
the Great Depression), with a free fall of GDP, 
income, consumption, industrial
production, employment, exports, imports,
 residential investment and, more
ominously, capital expenditures around the world.
 And now many emerging-market
economies are on the verge of a fully
 fledged financial crisis, starting with
emerging Europe.

Fiscal and monetary stimulus is becoming 
more aggressive in the US and China,
and less so in the euro zone and Japan, 
where policymakers are frozen and behind
the curve. But such stimulus is unlikely 
to lead to a sustained economic
recovery. Monetary easing - even unorthodox - 
is like pushing on a string when
(1) the problems of the economy are of 
insolvency/credit rather than just
illiquidity; (2) there is a global glut of 
capacity (housing, autos and consumer
durables and massive excess capacity, 
because of years of overinvestment by
China, Asia and other emerging markets), 
while strapped firms and households
don't react to lower interest rates, as it
 takes years to work out this glut;
(3) deflation keeps real policy rates high and 
rising while nominal policy rates
are close to zero; and (4) high yield spreads
 are still 2,000 basis points
relative to safe Treasuries in spite of zero 
policy rates.

Fiscal policy in the US and China also 
has its limits. Of the $800 billion of
the US fiscal stimulus, only $200 billion will be 
spent in 2009, with most of it
being backloaded to 2010 and later.
 And of this $200 billion, half is tax cuts
that will be mostly saved rather than spent, 
as households are worried about
jobs and paying their credit card and 
mortgage bills. (Of last year's $100
billion tax cut, only thirty percent was spent 
and the rest saved.)

Thus, given the collapse of five out of six 
components of aggregate demand
(consumption, residential investment, capital
 expenditure in the corporate
sector, business inventories and exports),
 the stimulus from government spending
will be puny this year.

Chinese fiscal stimulus will also provide 
much less bang for the headline buck
($480 billion). For one thing, you have an 
economy radically dependent on trade:
a trade surplus of twelve percent of GDP, 
exports above forty percent of GDP,
and most investment (that is almost fifty percent of GDP) 
going to the
production of more capacity/machinery 
to produce more exportable goods. The rest
of investment is in residential construction
 (now falling sharply following the
bursting of the Chinese housing bubble) 
and infrastructure investment (the only
component of investment that is rising).

With massive excess capacity in the
 industrial/manufacturing sector and
thousands of firms shutting down, why would
 private and state-owned firms invest
more, even if interest rates are lower and credit
 is cheaper? Forcing
state-owned banks and firms to, respectively, 
lend and spend/invest more will
only increase the size of nonperforming loans 
and the amount of excess capacity.
And with most economic activity and fiscal 
stimulus being capital- rather than
labor-intensive, the drag on job creation will continue.

So without a recovery in the US and global economy, 
there cannot be a
sustainable recovery of Chinese growth. And with
 the US recovery requiring lower
consumption, higher private savings and lower 
trade deficits, a US recovery
requires China's and other surplus countries' 
(Japan, Germany, et cetera) growth
to depend more on domestic demand and less
 on net exports. But domestic-demand
growth is anemic in surplus countries for 
cyclical and structural reasons. So a
recovery of the global economy cannot occur 
without a rapid and orderly
adjustment of global current account imbalances.

Meanwhile, the adjustment of US consumption
 and savings is continuing. The
January personal spending numbers were up 
for one month (a temporary fluke
driven by transient factors), and personal savings
 were up to five percent. But
that increase in savings is only illusory. 
There is a difference between the
national income account (NIA) definition of 
household savings (disposable income
minus consumption spending) and the economic 
definitions of savings as the
change in wealth/net worth: savings as the change in wealth is equal to the NIA
definition of savings plus capital gains/losses 
on the value of existing wealth
(financial assets and real assets such as housing wealth).

In the years when stock markets and home values 
were going up, the apologists
for the sharp rise in consumption and 
measured fall in savings were arguing that
the measured savings were distorted downward 
by failing to account for the
change in net worth due to the rise in home prices 
and the stock markets.

But now with stock prices down over fifty percent
 from peak and home prices down
25% from peak (and still to fall another twenty percent), 
the destruction of
household net worth has become dramatic. 
Thus, correcting for the fall in net
worth, personal savings is not five percent, as 
the official NIA definition
suggests, but rather sharply negative.

In other terms, given the massive destruction 
of household wealth/net worth
since 2006-07, the NIA measure of savings will 
have to increase much more
sharply than has currently occurred to restore 
households' severely damaged
balance sheets. Thus, the contraction of real 
consumption will have to continue
for years to come before the adjustment is completed.

In the meanwhile the Dow Jones industrial average
 is down today below 7,000, and
US equity indexes are twentyb percent down from
 the beginning of the year. I
argued in early January that the 25% stock market 
rally from late November to
the year's end was another bear market suckers'
 rally that would fizzle out
completely once an onslaught of worse than 
expected macro and earnings news, and
worse than expected financial shocks, occurs. 
And the same factors will put
further downward pressures on US and global 
equities for the rest of the year,
as the recession will continue into 2010,
 if not longer (a rising risk of an
L-shaped near-depression).

Of course, you cannot rule out another bear 
market suckers' rally in 2009, most
likely in the second or third quarters. The drivers 
of this rally will be the
improvement in second derivatives of economic 
growth and activity in the US and
China that the policy stimulus will provide on a 
temporary basis. But after the
effects of a tax cut fizzle out in late summer,
 and after the shovel-ready
infrastructure projects are done, the policy 
stimulus will slacken by the fourth
quarter, as most infrastructure projects take
 years to be started, let alone
finished.

Similarly in China, the fiscal stimulus will 
provide a fake boost to
non-tradable productive activities while the 
traded sector and manufacturing
continue to contract. But given the severity 
of macro, household, financial-firm
and corporate imbalances in the US and 
around the world, this second- or
third-quarter suckers' market rally will fizzle
 out later in the year, like the
previous five ones in the last twelve months.

In the meantime, the massacre in financial 
markets and among financial firms is
continuing. The debate on "bank nationalization"
 is borderline surreal, with the
US government having already committed - 
between guarantees, investment,
recapitalization and liquidity provision - 
about $9 trillion of government
financial resources to the financial system 
(and having already spent $2
trillion of this staggering $9 trillion figure).

Thus, the US financial system is de facto 
nationalized, as the Federal Reserve
has become the lender of first and only resort 
rather than the lender of last
resort, and the US Treasury is the spender
 and guarantor of first and only
resort. The only issue is whether banks and
 financial institutions should also
be nationalized de jure.

But even in this case, the distinction is only
 between partial nationalization
and full nationalization: With 36% (and soon to be larger) 
ownership of Citi,
the US government is already the largest 
shareholder there. So what is the
non-sense about not nationalizing banks? 
Citi is already effectively partially
nationalized; the only issue is whether it should 
be fully nationalized.

Ditto for AIG, which lost $62 billion in the
 fourth quarter and $99 billion in
all of 2008 and is already eighty percent 
government-owned. With such staggering
losses, it should be formally 100% government-owned. 
And now the Fed and
Treasury commitments of public resources to 
the bailout of the shareholders and
creditors of AIG have gone from $80 billion
 to $162 billion.

Given that common shareholders of AIG are 
already effectively wiped out (the
stock has become a penny stock), the bailout 
of AIG is a bailout of the
creditors of AIG that would now be insolvent 
without such a bailout. AIG sold
over $500 billion of toxic credit default swap 
protection, and the
counter-parties of this toxic insurance are
 major US broker-dealers and banks.

News and banks analysts' reports suggested 
that Goldman Sachs got about $25
billion of the government bailout of AIG and that 
Merrill Lynch was the second
largest benefactor of the government largesse. 
These are educated guesses, as
the government is hiding the counter-party 
benefactors of the AIG bailout.
(Maybe Bloomberg should sue the Fed and 
Treasury again to have them disclose
this information.)

But some things are known: Goldman's 
Lloyd Blankfein was the only CEO of a Wall
Street firm who was present at the New York Fed
 meeting when the AIG bailout was
discussed. So let us not kid each other: 
The $162 billion bailout of AIG is a
nontransparent, opaque and shady bailout of 
the AIG counter-parties: Goldman
Sachs, Merrill Lynch and other domestic and
 foreign financial institutions.

So for the Treasury to hide behind the 
"systemic risk" excuse to fork out
another $30 billion to AIG is a polite way to say 
that without such a bailout
(and another half-dozen government bailout programs 
such as TAF, TSLF, PDCF,
TARP, TALF and a program that allowed $170 billion 
of additional debt borrowing
by banks and other broker-dealers, with a full
 government guarantee), Goldman
Sachs and every other broker-dealer and major 
US bank would already be fully
insolvent today.

And even with the $2 trillion of government support,
 most of these financial
institutions are insolvent, as delinquency and 
charge-off rates are now rising
at a rate - given the macro outlook - that means 
expected credit losses for US
financial firms will peak at $3.6 trillion.
 So, in simple words, the US
financial system is effectively insolvent.

_____

Nouriel Roubini, a professor at the Stern Business School at New York University
and chairman of Roubini Global Economics, is a weekly columnist for Forbes.com.

http://www.forbes.com/2009/03/04/global-recession-insolvent-opinions-columnists-roubini-economy.html
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