One MASSIVE Margin Call
Posted by Larry Doyle on February 10, 2009 3:46 PM |
In light of the serious economic crisis facing our country and the world today, there is understandably heightened interest and anticipation towards both the proposed Stimulus Plan and the newly designated Financial Stability Plan. Clearly every individual in our country is impacted by this turmoil and we are hopeful that our leaders in both the private and public sectors can display the real leadership necessary to “right the ship.” Let’s provide a concise review of the newly designated Financial Stability Plan proposed today by Secretary Geithner. I’ll then move toward a further review of our economy and what it means for us going forward.
Financial Stability Plan
Secretary Geithner prefaced his remarks by highlighting that this process will “take time to resolve.” He offered that there is plenty of blame to go around to the public and private sectors, including the regulatory and rating agencies. He acknowledged that public distrust has heightened in the process. While he believes the government is being appropriately aggressive with this plan, I do not share that opinion. I commend him for emphatically stating that there will be total transparency in the process, along with strong contingencies for any entities that borrow public funds. All details will be posted on www.financialstability.gov.
While Geithner did lay out the overview of the plan, he did not extensively provide details. The market has sold off 3% in the process. I believe the market also sold off given the realization that this plan is going to take a LONG time to make a real impact. Let’s get to the meat of the plan:
1. Banks will undergo a comprehensive stress test. What does that mean? The government will provide further capital injections as necessary. Loans provided will be tied to lending. What was the alternative here? The formal nationalization of certain institutions and immediately writing off debts.
2. Public-Private Investment Fund along with TALF (Term Asset Backed Lending Facility). The market is disappointed at the lack of details provided on this piece of the plan. I believe this component will incorporate an “insurance program” in which the government provides both a lending facility and a loss mitigation vehicle in an attempt to incent private capital to purchase Asset Backed Securities (securities backed by auto loans, credit cards, et al). This sector of the market has effectively closed because so many of the current loans in the banking system were not properly underwritten and have either already defaulted or are at risk of defaulting. Will this work? It’s all about pricing. Risks here truly center on making sure that the sellers of these positions do not collude with the buyers knowing that the government is backstopping a large percentage of the losses. It may help banks to sell some positions, but will it lead to increased lending? In order to lend, banks need qualified borrowers who WANT to borrow. Certainly there are plenty of qualified borrowers right now who are having problems getting credit but IMO there is not and will not be sufficient loan demand to turn our economy. Why? Many borrowers are already too indebted.
3. Comprehensive Housing Program. The government will likely implement a “mortgage cram down” that lowers the principal and interest payments on behalf of homeowners who are at risk of foreclosure. Certainly commendable but the unintended consequence here is that mortgage rates will likely move higher as a result. Why? Investors will not buy a mortgage-backed security in which the underlying loans can be unilaterally modified. There is too much risk for an investor with that product. In the face of higher mortgage rates, real estate values around the country will likely not soon rebound.
Geithner indicated there needs to be broad regulatory reforms, a substantial and sustained commitment of public resources, and significant cooperation from all parties. At times of crisis we are all Americans. Nobody should expect a quick improvement in the economy or the markets. The markets are actually selling off even further as I write this piece. Ultimately, the best this plan can do is “slowly” take the air out of the balloon that was our massively overlevered economy. My concern is that we spell s-l-o-w-l-y as J-a-p-a-n i-n t-h-e 9-0-s!!!
Why?? Our economy is so massively overlevered that until the economy delevers (unwinding of debt), we can’t truly grow again. Our collective U.S. debt as a percentage of GDP is almost 350%!!!!! While a large percentage of that are the entitlement programs, our Federal government’s debt has doubled in the last eight years (golfer’s clap tip to Larry Johnson for highlighting this) and will soon approach 100% of GDP!! Consumer debt is currently approximately $2.6 trillion or 20% of GDP.
Although any proposed economic policies are always important, the fact remains that the global economy, led by the United Sates, is experiencing one MASSIVE margin call in which borrowers can either put up more collateral or have their assets sold. I read an outstanding interview in Barron’s with Ray Dalio of Bridgewater Associates, one of the world’s largest hedge funds that highlights this very point. It is a MUST read: Recession? No, it’s a D-process and It Will be Long. I will offer a few highlights:
–our incomes are increasingly unable to service our debts (private, public, personal).
–debts must either be restructured (part of Geithner’s plan), extinguished (bankruptcy or nationalization), or devalued (via inflation!!). –assets will decline in value in an attempt to sell them and retire debt.
–government plans to increase lending will not work because borrowers are already too indebted. –the only entity that will take on debt is the government, but while that may provide a temporary salve it may actually exacerbate the problem by driving interest rates up and “crowding out” qualified borrowers.
–while nationalization of banks or other entites may currently be off the table, do not discount the fact that we will likely revisit this idea.
–the government will print money in an attempt to reflate the economy, but this will only lead to inflation. Note from LD: while Dalio does not believe we will have hyperinflation, I have greater concerns on this front.
–China, our largest creditor, will not likely want to “continue to double down” in buying dollar denominated debt; thus our government interest rates will likely head higher.
–in regard to stocks, “buying equities and taking those risks in late 2009 or more likely 2010 will be a great move because equities will be MUCH CHEAPER than now.”
While Dalio uses the D-word for Depression, that to me conveys an unnecessary fear and anxiety. I use the D-word for delevering, and that is the simple reality of what is and will continue to occur regardless of the details in the Stimulus Plan and the Financial Stability Plan. Certainly each of those plans can provide a degree of cushion, but they can also add to the debt burden and prolong the period of extended economic underperfomance if not outright pain!!
Wish I was writing something differently, but this is how I see it.