Page 2 of 2 Truth is too hard to handle
By Chan Akya
Then there are the two large credit card issuers, American Express and Capital
One, which have been given the all-clear as well. I find their assessments
ridiculously overoptimistic for exactly the reasons laid out in the previous
part of this article - namely the apparent catch-22 situation prevailing
between cutting credit card limits (leading to lower earnings in future
quarters) or retaining those limits (leading to losses from credit card
defaults).
Capital One recently revealed that their credit card losses were now in excess
of the amounts expected for the given level of US unemployment, this is that
the straightforward link that is a cornerstone of pricing credit card
asset-backed security transactions has now fallen on the wayside. This is a
classic
response to the underemployment that I described: as people are barely
employed, there is no chance of repaying existing loans and credit card debt on
those salaries.
Effectively, anyone lending money to the American consumer will have to think
long and hard about how to get that money back faster than the economy crumbles
from under their feet.
Then there are the banks that failed the test. Bank of America was deemed to
have a need for $35 billion in new capital, which led the company's stock
prices 18% higher on the day. This raises an obvious question: if the
government had revealed that the bank needed over $50 billion in new capital
(as the initial estimate was before the bank reportedly haggled the figure down
by $15 billion), would stock prices have jumped 30%?
Wells Fargo was another bank that failed the test, which is even more
interesting when you remember that the bank's pre-announcement of its
first-quarter earnings was the proximate cause of the market rally that ended
up doubling the price of financial stocks in following weeks. In its 8K
filings, the bank showed the following "interesting" aberrations: a) Increased commercial mortgages as well as "other" mortgages to the
tune of almost double the same period last year (due to the acquisition of
Wachovia meanwhile); b) The bank showed a big jump in second-lien mortgages: these are the
worst performing of all categories of lending; c) Trading assets have risen by 600% from the same period last year: so
here is a bank that is actually increasing its leverage rather than
reducing it during a period of financial distress; d) Then there is the matter of some $20 billion in goodwill that the
bank holds on its books: given that these pertain to purchases like Wachovia
that haven't quite panned out (now there is understatement), don't
equity investors and the government not have to worry about possible
write-offs?
Once again, it isn't only the US financials that fail my basic evaluation of
system integrity. In the UK, we have RBS announcing losses of around 850
million pounds for the first quarter of this year, as bad loan charges of over
2 billion pounds more than wiped out any organic increase in revenues from its
corporate banking department. Similarly, the French bank Societe Generale
posted losses of 414 million euros against a profit of 140 million euros last
year, once again due to rising provisions for bad debts.
Financial markets have been misled by the rise in profits of banks with strong
fixed income dealing desks, which pertains to trading rather than organic
interest income. Even with all the help being given by the government, there is
no reason to believe that banks can sustain this trading performance.
Corporate earnings recovery
By far the most ridiculous of all the market assumptions is the one about a
recovery in corporate earnings. Non-bank earnings of the sort shown by
multinationals (MNCs), technology companies, aircraft companies and so on
depend more than any other on the progress of the consumer. This is highly
doubtful around the world.
The main reason for that would be the effects of balance sheet recession on the
average consumer around the developed world. Take the example of the US
economy: some $10 trillion of asset values have been wiped out in the housing
bust; compared to debt write-offs of "only" $1 trillion. Remaining debt will
have to be serviced by borrowers (see above paragraphs on how difficult that
would be); inevitably that process entails significant cuts in consumption.
That is the core problem confronting the corporate landscape globally: when
people no longer buy new cars, washing machines and whatever else have you,
where would new earnings come from?
Japan's experience since the beginning of the 1990s highlights the impact of
balance sheet recessions on corporate earnings. While Japan itself benefited
from growing demand for its exports in the US and other economies, the same
cannot be true this time around as economic decline is broad-based and global.
Then there are the new moves to tax the MNCs being initiated by the Obama
administration but very likely to be followed up by others including the UK and
France. These taxes will mean that the benefits of overseas growth no longer
accrue to the companies, but rather to the heavy hand of government yet again.
Costs are being held in check, but the problems associated with supply chain
disruptions aren't minimal. As companies teeter on the edge of bankruptcy,
their typical buyers will have to stock higher amounts of inventory to hedge
such disruptions; that is even worse than the impact of falling demand as such
higher working capital spend inevitably cuts into capital expenditure. To
complete the cycle, cuts in capital expenditure then eat into future economic
growth further undercutting the first argument about the nascent economic
recovery.
European companies have it worse; their export dependence has caused
first-round losses in output that soon translate to second-round consumption
effects (as workers are laid off or made temporarily redundant), which further
depress the output of other companies that sell to these consumers. With
government taxes already excessive in these countries, there isn't the prospect
of US or Chinese-style infrastructure binges; which removes important circuit
breakers to the downturn.
All this isn't even the most bearish bit. If there are still some bullish
readers at this point, perhaps now would be a good time to highlight that none
of the above constitutes the most bearish of my arguments. Rather, some other
details could make the bearish argument more foolproof in coming months:
1) It isn't clear to me, or apparently anyone else in debt markets, how
and where the $6 trillion of new debt being issued by governments will be
absorbed in an era where organic surpluses of countries such as China and those
in the Middle East have been declining. Indeed, by most measures the stock of
foreign assets of these countries will likely begin declining by the end of
this year; in effect adding rather to the supply against market expectations of
rising demand. Supply of debt without adequate demand is a recipe for higher
interest rates: imagine the carnage to my scenarios above from rising interest
rates; 2) Destroying the rule of law has always been a pastime of the left but
in wiping out the rights of secured lenders of Chrysler Corporation, the US
government has created unprecedented doubts about the entire loan market in the
country. Similar gaps in the rights of creditors in countries such as Germany
(witness the shenanigans around Hypo Real Estate) make credit markets far too
risky for ordinary (and even well-connected) investors. Needless to say, a lack
of private capital flowing back into credit inevitably causes damage to
prospects of new bouts of risk taking that will be needed to advance economic
recovery; 3 Higher rates of homeowner defaults in the US, UK, Spain and Ireland
could further imperil banks operating in these countries. Changes to bankruptcy
laws have made such defaults easier, not to mention more acceptable socially; 4) The rising chances of global pandemics such as the H1N1 I wrote about
two weeks ago also highlight potential risks to economic growth in coming weeks
and months.
Health warning: Commenting on financial indices I am not acting as your
adviser per se; readers must always perform their own research and never
believe everything they read or see on television for that matter. In any
event, unlike my colleagues on Asia Times Online such as David Goldman and
Julian Delasantellis, I remain a pseudonymous contributor to these pages,
thereby making the act of following my advice in this article all the more
treacherous for the average reader.
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