Economics

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Our Trade Problem

Today’s trade release by the Commerce Department is interesting from a number of angles. Let’s get the hard data out of the way first: the US trade deficit widened in March, which is the month for which we have the latest information. The gap between exports and imports rose to $27.6 billion, up from $26.1 billion in February. The short term significance of this change is that the February number had been the smallest trade deficit for nine years and was the last of eight consecutive months during which the gap narrowed. The dramatic shrinkage in the trade gap since the middle of last year has been a fairly important factor in holding GDP higher than it would have been otherwise: net exports are counted as a component of GDP with exports adding and imports subtracting from the total. So the steady drop in imports implied that a higher percentage of our demand was being met from domestic production.

Or at least that’s the way it appears under normal circumstances.

In reality the drop had more to do with the collapse of world trade, the drop in US consumption, and the equally dramatic fall in world commodity prices. The fall in US domestic demand, which is the root problem we are trying to deal with, obviously resulted in less demand for imported goods. At the same time the worldwide recession caused prices of things such as oil to fall from their peaks and so imports cost less. So not only were we importing fewer things, they were costing less as well. That should have been a boost to our well being except that a large part of the gain was offset by the loss of export markets as foreign consumers cut back on their purchases of American made goods and services.

So not only was the gain in net trade smaller than it might have been, it was somewhat of an illusion. I have no doubt that once our economy regains momentum the trade deficit will start to widen again.

And therein lies the rub.

As we re-engineer our economy so it relies less on debt fueled consumption, which will be one of greatest challenges over the next decade, we will be faced with a conundrum: what will replace consumption as the engine of the economy?

I am not suggesting that consumption will ever be replaced as the major driver of growth. My point is that as we shift away from debt towards a more balanced approach to spending, and as savings chew up a larger portion of incomes, consumption will have to back away from being closer to 70% of GDP which is what is has been recently. I expect it will settle somewhere lower and contribute between 60% and 65% of GDP each year. That decline from 70% to 60% will need filling if we are to see GDP grow.

And that’s the dilemma policy makers must face.

Where will that needed addition to the economy come from?

Countries that have previously experienced the kind of severe downturns we going through have typically turned to trade as a primary source of that addition. Japan, whose experience in the late 1990’s we have all talked about so much recently, was able to mitigate its drop in domestic demand by boosting its exports with its Asian trade partners in particular. The boom in China nicely coincided with Japan’s need to find a way to support itself and so exports to China helped mask Japan’s population from their dramatic drop in consumption. Without the trade boom Japan saw at that time its economic woes would have been far more severe and had much more impact on its consumers.

I doubt we will be so lucky.

The recession is worldwide. America plunged down first, so it is likely it will re-emerge first also. That means most, if not all, our trade partners will be still battling the downturn just as we are looking for trade opportunities.

So just when we need trade the most to help offset our own lost demand, and to assist us restructure our economy, the chance of opening up trade will be severely limited.

This is why I think growth is likely to be well below historical averages for quite some time, even after the recovery is well established. In fact I think the adjustment period of slow growth could easily be as long as five years.

People who expect us to rebound back to a typical growth rate either underestimate the difficulty represented by this trade dilemma, or are expecting Americans to go back to their bad debt habits.

My own view is that ‘de-leveraging’ – the cutting back on debt – by both households and businesses will be a dominant theme for years to come. In fact I think the government too will be engaged in debt reduction.

Eventually the Chinese and other emerging markets represent our best hope of re-establishing a more healthy and balanced economy here in the US. Their drive towards higher living standards offers us the chance to export and meet some of their demand. But until those economies get back on track ours will be held back as well.

So trade is another cause of caution concerning the future.

Those trade gains we have seen since the middle of last year need to be made permanent.

Only this time for the right reasons.

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The New Reality

The conclusion of the banking stress tests continued to dominate the economic news through the weekend. For many casual observers it was a conclusion that could not come fast enough. For months we have been told that the banks need fixing; we have lavished vast sums of taxpayer money on them; we have suffered through what seems like endless stories about bonuses; and then we had to twiddle our fingers while the stress tests took place. Now we can assess the new landscape and ask the crucial question: are the banks fixed?

No.

The principal economic policy objective from the beginning of the banking crisis has been to get the banks re-capitalized sufficiently that they can resume their role as engines supplying credit to consumers and businesses. That flow of credit will be essential if we are to establish a strong recovery.

Policy as pursued until now has failed to accomplish that goal. The amounts of capital the government has now instructed the banks to raise is insufficient to return them to robust health. Instead it merely moves them from the critical to the guarded list.

Under both Presidents Bush and Obama there has been an unfortunate bias towards avoiding the ‘heavy’ lifting necessary to clean the banks out of their rubbish and to get capital ratios up to ‘slump proof’ levels. Instead we have suffered through all sorts of ingenious and bureaucratically well crafted schemes that seek to avoid pressing too hard against the delicate fabric of finance in case it falls down. As if it hasn’t already.

Those of us who are disappointed at this policy record have to face the new reality: America will almost certainly have to go through another stimulus and bailout round before it gets a long term solution. Everything that has gone before has been an attempt to stall long enough for the economy to heal and thereby to heal the banks.

So the administration, if we judge it by its deeds rather than its words, has committed us to the long road. I suspect this is a very ‘Summers’ strategy. In essence the new reality is to accept the power of the banks; to accept the theories and worldview of the recent past; to avoid strong action that may have unforeseen consequences; and to attempt to spend as little as possible on the repairs. In short we are temporizing or buying time.

The belief in the administration is that the banks can ‘earn they way to health’ as long as the economy doesn’t fade away altogether. They have studied some of the lessons we learnt back during the S&L crisis of a couple of decades ago and concluded that a combination of lax accounting, steep yield curves, government guarantees, and minimally invasive surgery are all that is needed. That combination will provide that backdrop against which banks can expand profits and thus rebuild capital without any further government intrusion.

It is a very passive policy, born, I suspect, from a pessimistic reading of the political landscape.

“It is a very passive policy, born, I suspect, from a pessimistic reading of the political landscape.”

It is the new reality so we must accept it.

For those of you who disagree with my interpretation, here is the evidence I am going on:

  1. The stress tests were, from the start, skewed in the bank’s favor. They were not really stressful enough. The most severe assumptions used on the most important variables in the test models – such things as unemployment rates – turn out to be pretty much where we are now. By implication then the tests assume things will not get much worse. That’s hardly stressful. The whole point of a stress test is to go to extreme limits and watch for the reactions of the person or company being tested. Their performance on the extreme is a guide to what will happen under much less severe circumstances. And it those less severe circumstances that we ‘expect’ to occur. But our tests didn’t do that. The banks were not pressed to the limit. We have no idea what would happen under a continued decline in the economy. Our forecasts were too benign. Why? Because we really didn’t want to know the ‘outlier’ problems. There was no need since we were committed a priori to only modest findings. The test were bogus. Bernanke himself has hinted at this: he has said he wanted to go down the ‘middle route’.
  2. The banks negotiated the results. It has emerged that even the weak tests suggested that Bank of America needed to raise over $50 billion in capital. An outraged management succeeded in getting that lowered to about $34 billion. Was the test wrong? Or did they just bully the government? We don’t know. But the shift isn’t comforting.
  3. The banks have already let investors know that the government has tacitly agreed to back off any coercion later this year if it turns out the banks have not raised the suggested amounts. That is if the banks have had good earnings this year. This confirms the notion that public policy is to allow then banks to earn their way to health.
  4. The tests were based on bank generated rather than regulator generated risk models. These are the models that caused the crash, but apparently we are happy still to use them. That’s a bit like giving the kids who just crashed the family car the keys to its replacement without making sure they can drive any better.
  5. Finally the Treasury Department has been slipping and sliding on the exact definition of capital it wants to use. It abandoned Tier 1 capital, the old ratio used since 1988, a long time ago to focus on plain old equity. This was supposed to be a ‘quality’ issue: Tier 1 includes all sorts of non-equity stuff like preferred stock that earns interest and so is a bit more of a burden than plain equity. It also is a bit sneaky: the banks can convert the government’s preferred stock and look like they’ve raised capital. Which in a Tier 1 world they haven’t. Now we find out that the Treasury is using something called ‘Tier 1 Common’, not the more restrictive ‘Tangible Common Equity’. Why? Who knows? Not even the Financial Times. The betting seems to be, though, that it gives the banks an edge up. Given the administration’s attitude, that seems like reason enough.

Given these snippets of evidence I stand by my conclusion: the new reality is to stand back and let the banks go back to whatever they were doing before so they can earn enough to generate or attract capital to plug the holes in their balance sheets.

The economy has to power the banks, not the other way round.

The implications?

  • Slower growth. While the banks repair themselves they will not be very concerned in getting back to expansion. So new loans will be hard to come by and expensive.
  • A renewed call for stimulus. Without healthy banks it is not clear where growth will come from, so it is likely unemployment will rise some more and peak above where it would have done had we fixed the banks more quickly. So by the end of this year the economy could still be languishing and in need of further stimulus.
  • Banking will be less competitive. The crisis eliminated some players and hobbled others. Those that emerge strongly will be able to concentrate power even more than before. We will have even larger banks to contend with in the future, with an even greater fear of their size and ability to harm the economy.
  • We will end up with some sick banks lingering well into next year, maybe beyond. That raises the chance that we may need fresh bailout money, and that the consequent expense will be higher than that had we taken more radical short term action.

Ultimately the administration’s unwillingness to confront the banks dictated this course of action. We have socialized losses and privatized gains relentlessly. There has been a huge transfer of wealth from taxpayers to shareholders and employees of banks. We have put at risk larger parts of the agenda many of us hoped the Obama would enact.

But that is the new reality. We must adapt. Let’s hope it all works out well.

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The Results Are In!

And the winner is? Well that depends on your point of view. The early winners seem to be Goldman Sachs and JP Morgan Chase who flew through the tests with flying colors. The losers include Bank of America and Wells Fargo, the latter of whom must be particularly peeved having been lauded by no less an authority than Warren Buffet just a few days ago. Following up the rear is GMAC who seems to be the only tested bank who pulled the equivalent of an ‘F’.

So. Now what?

The banks that have been told to get capital have until June 8th to present a plan showing how they intend to do so. They then have until November 9th to raise the cash.

What if they don’t? We’ll see about that later.

Now that the whole charade is over and the dust settles what have we learned?

The tests indicate that the Treasury Department expects this group of banks to suffer a further $600 billion in loan losses through the rest of this credit cycle. Those losses are expected to stem from such things as the effects of rising unemployment and the ‘normal’ cycle in commercial real estate. This estimate is on the low side. Other organizations, most notably the IMF have forecast losses much worse than this.

In part the difference between the IMF and the Treasury may flow from the fact that the Treasury allowed the banks to do the predicting by using the banks own risk assessment models. This involvement of the banks would naturally skew the expected losses down. After all these are the same risk models that helped create the mess in the first place.

As you know I have been highly critical and skeptical of the entire testing process. I find it odd that the banks were involved so deeply in the process – it sounds more like a self-assessment than a rigorous audit. And the fact that they were negotiating the results seems just absurd. These two factors fed my naturally cynical nature, and resulted in my conclusion that the tests were run as a ‘misdirection’ play to make it seem as if we were facing the banking crisis rather than actually doing anything about it.

Be that as it may.

The tests are now done and we must all face the new reality.

So the discussion now shifts to the next few months and the consequences of the testing process.

Are the banks safer?

Well not yet. Some like Goldman and JP Morgan Chase are already chaffing at the bit to repay TARP money so that they can get on with their business without government interference. I don’t blame them. We should all recall that the banking landscape has been re-written over the past few months. There are far fewer major players and some of those left standing are ineffective players at the moment. I can imagine the guys at the healthy banks want to get stuck into the game: they will make hay over the near tern while their weak competitors do lazy eights as they raise capital. Expect profits to rise sharply among the healthy. Not only is the competitive landscape ripe for profit making, but loan spreads are high, the yield curve has been twisted in favor of lenders, and cheap government bailout money is lowering the cost of doing business. In short if you are a ‘healthy’ bank things are truly looking up. The government is doing all it can to give those banks a leg up.

Meanwhile: the weak banks will wallow around. Their spreads and so on will also improve. So their profits will be better. Loan losses will cripple any efforts to expand lending, but that has become secondary. Public policy, which at the start of this crisis was focused on getting lending going again, is now more focused on keeping the weak banks alive long enough that they can thrive on their own. The second objective is to keep the out of pocket cost to taxpayers as low as possible.

An interesting problem may emerge later in the year when, and if, one of the weak banks fails to raise the capital the government has ordered it to. Right now the Treasury Department is indicating that it will forcibly inject more capital at that point. I doubt it. One of the administration’s goals in the test process was to punt the problem forward. By November with banking conditions slightly improved and the economy gradually rising from recession, both of which are certainly possible, the politically smart move would be to punt again. Since the administration seems to have been driven by politics rather than economics so far I would bet on another punt.

Plus I expect lost of discussion to surround that part of a bank’s capital called Tangible Common Equity [‘TCE’]. As I have said here many times that ratio can be fixed more easily than broader measures of capital such as Tier 1 Capital. Geithner has been hugely successful in switching our attention to TCE so there is no reason to change now.

One of my yardsticks for the testing process would have been the level of howls from the industry. Normally a strict audit will elicit predictions of dire consequences and imminent disaster. So far the reaction has been more one of confusion. The stock market has bid up then bid down the stocks of the weak banks, largely due to the flood of rumors we have suffered through. Now that the facts are before us the market should settle down. I would expect banks that are deemed healthy to attract investors, while those who are weak will have a harder time raising private funds: who would want to invest in an organization that the government has on life support? So an outcome of the testing is that the weaker banks, who need to find capital, may find it harder to do just that. The best avenue for capital growth will then be from the sale of subsidiaries and lines of business. Look for hedge funds and private equity funds as well as the healthy banks to attempt to bulk up by acquiring bits of their weaker competitors.

This really is a case of the rich getting richer and the poor getting poorer.

In the end I am glad the process is over. I am sure you are too, given all my venting over it.

But the concerns remain. We should be leery of declarations of success. The second wave of losses is coming, and the structure of banking remains the same. If anything there are some too big to fail banks that will now be much bigger.

Saving banks is one thing. Fixing them so they can’t screw us all up again is another.

So I will leave you with this:

My concern has always been with the structure of the industry: it needs to be reined in so that we are not exposed to its excesses again. As I watched the administration deal with the immediate issue of saving the weaker banks I used it as an acid test of their ability or desire to take what I perceive to be tough action to downsize or limit the power of the industry. The stress test process leaves me highly skeptical. The government seems to be unable or unwilling to face the banks down. Whether that results from hard nosed political calculation or from simple cowardice I don’t care. The result remains the same. Until the banking industry is severely restricted and its major players reduced so that they can fail without destroying everything around them our economy remains at risk: from the undue influence of financiers and from the very high prospect of another asset bubble resulting from easy credit.

So my confidence is high that the banks will be saved. And it is low that they will be fixed.

Too bad.

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The Creditor’s Story: Just What is ‘Fair’?

There is a sub-text in the current storm of bankruptcy activity. In the interests of fair play I should bring it to your attention. It is the fate of creditors. These are the people who go on search of less risky investments and so lend to companies in the form of bonds or other debt, rather than equity. The Chrysler bankruptcy case has become something of a cause celebre for such people.

The essential point is this: American contract law has always been very specific about the rights of creditors during a bankruptcy proceeding. When a company cannot fulfill its contractual obligations it seeks the protection of the court while it tries to renegotiate with its creditors. That’s what Chrysler is doing right now. The normal sequence is that creditors can expect better treatment than equity holders, and within the range of creditors those with ‘security’ can expect the best treatment of all. Unsecured creditors rank lowest on the totem pole, just above the shareholders.

So the Chrysler bond holders argue, how is it that the UAW, an unsecured creditor, seems to have ended up with a better deal than they did?

The Chrysler re-organization plan, the one the government endorsed and the judge has to decide whether to allow to go forward, produces a post-bankruptcy ‘New Chrysler’ in which the UAW would own 55%, with the US government and Fiat owning the rest. In the meantime the bondholders would get about 28 cents on the dollar for their debt. Some of them think they would get more than that were the government’s heavy hand not involved in the deal.

As a result companies and investors are beginning to rumble that the government is wrecking the ‘time honored’ order of things in American bankruptcy proceedings.

The Financial Times has an excellent discussion of the problem in today’s edition.

My first reaction is not to cry too much for the bondholders. They invested in Chrysler. Many of them specialize in ‘distressed debt’ which means that they know full well the risks they are facing. They probably even knew that the company was headed to bankruptcy. What they forgot was that Chrysler is also a very important employer and has significance as a major component in the US auto industry, which is in need of overhaul. The bondholders played no part in encouraging change, indeed they appear, some of them, to be expecting to profit from the company’s failure. Hedge funds that buy ‘distressed debt’ are not active participants in constructing healthy businesses, they are engaged in rummaging through the carrion for profit.

Not that such activity is wrong. We need folks to pick over our corporate corpses. But we shouldn’t get misty eyed about them. They seek to exploit the contract law for profit rather than use the contract law as protection.

That might sound too nuanced, but I think is an important point: creditors who provide vital financing so that companies can grow need to know that their investments should be treated appropriately. Being treated preferentially in bankruptcy is the inducement that gets them to invest: bondholders are a risk averse bunch. Distressed debt buyers are a different group. They are seeking the bonds precisely because the return on the bonds has been driven higher as the company in question fell into crisis. So they knew what they were getting into. This a priori understanding of the heightened risk sets them apart, in my opinion, from ordinary bondholders. They were buying junk and then want to be treated as if they bought the good stuff.

How that gets resolved I don’t know. As ever in America the lawyers will parse it all out and make a fortune along the way.

My take is that we need to treat the original bondholders carefully: they provided the original cash that the company is responsible for repaying. But bottom feeding hedge funds designed to get high returns from ‘distressed debt’ are high risk takers. They are useful in that they provide a market for bad debt. That I acknowledge. They now own the rights that the original bondholders were given. That I also acknowledge. But don’t try to tell me that they didn’t know what they were getting into.

Look at it this way: Chrysler has been tottering along the edge of bankruptcy for years. Buying its debt was always a risky proposition. Buying it when it was distressed is even more risky. Getting 28 cents on the dollar seems like a decent payoff. Why? I doubt that they bought the debt at par. If the debt was distressed it was selling well below par. Maybe not to far from 28 cents on the dollar. Maybe even lower. Meanwhile the interest payments have been extraordinarily high when expressed as a percentage of the cost of the debt.

Here’s an example:

I buy $100 of debt that pays 8% per year interest at par, i.e. $100. I get $8 in interest each year so my annual interest rate earned is 8%. Now the company gets into trouble and I can only sell my bonds for $50. But the new owner still gets $8 in interest on those bonds. So now the new owner’s annual interest rate earned is 8/50 or 16%.

It is this high rate of interest that attracts the ‘distressed debt’ investors.

And notice one more thing. In my example the new bondholders paid $50 for a bond that is worth $100. So were they paid 60 cents on the dollar in bankruptcy they would actually be making a profit of $10. The loss on the bonds has already been suffered by the original holders who sold the debt.

This is a simplified version of what’s going on with Chrysler. Which is why its hard to get worked up on the side of the current bondholders.

Nonetheless their story needs to be told.

Sometimes economics and economies need to take into account things like ‘fairness’, and not simply stick rigidly to the laws. After all laws are often written to benefit certain groups within society rather than society as a whole. What is ‘fair’ and what is the law are often two distinct things as we all know.

The Chrysler bankruptcy has served to highlight the conflict between the rights of the workers whose lives depend upon the company; the bondholders whose profits depend upon the legal process; and the taxpayers at large whose rights are represented by the government.

I am sure everyone thinking this through has an opinion about what is ‘fair’.

I also think that restoring an element of more socially acceptable fairness is one of the primary goals we must undertake during the next few years. I, like many others, perceive a great ‘unfairness’ in the way our economy distributes its wealth. The rules and laws seem to be bent against the regular folks and in favor of those who have the skills and cash to game the system.

Bond traders and distressed debt hedge funds: both taking risks. Both acting in their self interest. Both ‘just trying to make a buck’. And both reviled by the public. If we think their roles in the economy are worth protecting then we have to find a way to make them look more fair. Hem them in a little perhaps. Make them pay appropriate taxes – hedge funds I am looking at you. And soften the edge they have acquired of being just leeches on the ‘real economy’.

In any case, it is only ‘fair’ to tell their side of the story.

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Auto Industry News

It is a sure sign of the times that the best news about the auto industry comes from a bankruptcy judge. Are we really that low? Unfortunately, yes. Both GM and Chrysler are doing their part to take attention away from the ludicrous spectacle the Treasury Department has put on during ‘stress test season’. More about that later, but first the auto industry.

The good news is that the judge presiding over Chrysler’s bankruptcy hearing stomped on a motion by the dissident creditors that would have prevented the sale of assets to Fiat. So it appears as if the message that we need a quick resolution to the company’s re-organization has been heard. The quibbling by the dissidents has been overridden at every turn so far. From the perspective of an interested party – you and I are now unwilling investors in the shambles that was Chrysler – it can only be good news when the judge orders the company’s plan to move ahead. The sooner it emerges from bankruptcy the sooner we find someone to take our shares off our hands.

And, frankly we need the money.

Why?

Because the real struggle in the auto industry will be fixing GM, and that lovable old elephant is lumbering right towards us.

Well, maybe not lumbering. Staggering might me a better description after this morning’s first quarter earnings release. Our erstwhile largest auto maker announced that it managed to lose $6 billion in the first quarter. As Oscar Wilde would say: that’s downright careless. At the same time it burned through over $10 billion in cash. There is no way it can keep this up. So buckle up. GM will certainly be bankrupt by the end of the month.

As seems to be the case with all our various crises the epicenter of the storm is a group of creditors who hold about $27 billion of unsecured bonds. GM has proposed swapping those bonds for equity, which would give the bondholders approximately a 10% ownership stake. So far they have resisted. Presumably because they feel they could get more through a bankruptcy or even a liquidation process. I don’t see how that could be, but there again I’m not sure I would have bought GM debt: it’s been a dying company for years.

Meanwhile the company’s management is aggressively pursuing its re-organization plan. It has put Saab, Saturn, and Hummer up for sale and will close Pontiac by year end. It speaks volumes about the state of GM when those brand names elicit not much but a yawn. The company had collected some dogs along the way, and ridding itself of them will be an uphill battle. Approximately $800 million of the first quarter loss comes from Saab’s effort to enter bankruptcy in Sweden.

It is also trying to eliminate over a third of its dealerships. This latter exercise will be difficult. The nature of American politics is the cause of that difficulty. Dealerships are very often significant local businesses. Most towns have one. The owner of a dealership is often a big player in local commerce and thus in local politics. So much so that most states now have laws preventing the arbitrary closing of dealerships by the car makers. So GM finds itself entangled in a morass of local and state level negotiations, which absorb management effort and take time. And, as the first quarter earnings report shows very clearly: time is something GM does not have much of.

So to sum up our auto industry report:

We have one company speeding through bankruptcy, so far at least. With another speeding towards bankruptcy. We have absolutely nothing to say about Ford at the moment. That’s a good thing.

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