The age of financial repression and the shattered American Dream

One year one, QE2, the wealth effect experience, induced by Ben Bernanke has been nothing but a failure.

With interest rates at zero since 2008, income from US Treasuries and Certificate of Desposits have been nothing but short of miserable for pensioners.
And not only did the 401K, took a recent beating, but the house, previously used as an ATM, in the build up to the financial crisis, is no longer an instrument for pensioners to extract additional income and even help out the younger generation facing up with an increasing burden of student loans.

As per CalculatedRish recent post, here is "The New Retirement Plan: No Retirement"

http://www.transamericacenter.org/resources/TCRS12thAnnual%20WorkerNewRetirementFINAL05162011.pdf

What we learn from the survey mentioned is fairly dramatic:

39% of workers plan to work past age 70 or do not plan to retire.
54% of workers expect to plan to continue working when they retire.
40% now expect to work longer and retire at an older age since the recession.

"Fewer than one third (30%) have currently saved more than 100,000 USD in all household retirement accounts.
Most workers regarless of age or household income, agree that they could work until the age of 65 and still not have enough money saved to meet their retirement needs."

But it gets worse
"31% anticipate that they will need to provide financial support to family members."

As I indicated in "The end of the American Dream, the call for trade barriers and the rise in populism...", "There are 70 million Americans born between 1945-1960. One-third have zero retirement savings. The oldest are 64. The only money they have is equity in a house, so they must sell. This will add yet another flood of houses to the market, driving prices down even more."

In relation to the survey mentioned above they conclude with the following recommendation to the policymakers:
"From a public policy perspective, with so many workers planning to work past age 65, policymakers should consider tax incentives for employers to hire older workers along with job training / retraining programs for older workers -- to help keep them in the workforce."

But the issue is not only in the retirement space, there is a steady build up in the student loans space and given the house is no longer there to provide equity withdrawal to support younger generations, it is a growing concern, because rising education costs is also affecting consumption levels to some extent.

I also wrote the following in September 2010
"Even young graduates have become disillusioned, will they be able to therefore repay their student loans?"
"Student loan amount has exceeded the total credit card debts for the first time in the American history.":
"The total outstanding student loan is worth 850 billion USD and the most worrying factor is that some students do not even know on how much they owe and to whom..."

Now student loans are close to 931 billions USD, eclipsing 798 billions in credit card debt. Some experts estimate we could hit one trillion this year alone. Total student debt was 72 billions USD 15 years ago according to Mark Kantrowitz, who provides financial assistance for college students via financial aid website www.finaid.org.


Defaults on student loans nationwide have doubled in the past five years and are on the increase:

Only credit cards have a higher rate of delinquency at 12.2%, but  as indicated  in the below graph from St Louis Fed, overall, delinquencies are falling.
The unemployment rate for workers between 20 and 24 years old is 14.6% compared to 9.1% for the national average. According to Moody's the defaults on securitized private student loans rose to 5.4% in the second quarter. The annualized default rate widened from 5% in the first quarter and 4.5% a year ago, most coming from loans securitized in 2010, containing more delinquencies. The default rate peaked at 7.6% in the third quarter of 2009.

The deleveraging of US Households is still the most important story relating to the ongoing balance sheet recession:


The end of the American Dream of Home Ownership has been dented and its slowely but surely reversing back to the mean:


A concern is the rising trend in consumer loans at all commercial banks for our struggling US Household:


There is a stronger demand for consumer loans:

The good news it seems so far is that delinquencies on all loans and leases, to consumers, all commercial banks, is trending down, but again, there is what we see and what we don't see and if we end up moving back into recession, which looks like almost certain now, the picture could change rapidly:

Stay tuned!

 

Macro and Markets update - from SNAFU to FUBAR?

While the happy ending everyone was expected seems to be playing out with the debt ceiling debate, the ISM came out very ugly today, and I was afraid it would. It was a big miss at 50.9 from 55.3 in June ( a print below 50 would equate to recession). The confirmation of a double dip is more and more evident, and the NFP figures next Friday with the US unemployment rate will be key. It was another big miss for the Wall Street economists expecting 54.5 on average. The weakening data in between the two ISM from June and July was ominous. I really don't understand how these economists got it so wrong this time around (estimates were ranging from 51 to 56).

Let's face the facts, the US is in a "stagflationay light" environment. While inflation is clearly not a huge concern as it was in the 70s, the inflationary pressures coming from higher fuel prices and food prices are taking their toll on the US consumers (still 70% of GDP).
Housing is still depressed and corporations in the US, while presenting so far much better earnings than they counterparts in Europe, thanks to a weaker US dollar, are not hiring in the face of all uncertainties and sitting on a pile of cash, sitting idle, for the moment.

Manufacturing from Asia to Europe fell last month, how could it had been different for the US?

Demand has weakened on a global scale.

In the US, the production index fell from 54.5 in June to 52.3. New orders dropped to 49.2, the first contraction since June 2009.
The measure of orders waiting to be filled dropped to 45, the lowest level since April 2009.
A jobless recovery means a sluggish demand (household spending rose at 0.1%).

So what's the driving force behind some solid corporate earnings? Very simple, emerging markets strong growth and the expansion of the middle class in emerging markets. Manufacturers, in Europe and in the US have to rely on overseas demand, and the weak US dollar is helping more US exporters than European exporters.

So what happened today, is yet another session of flight to quality in Europe, while equities got pounced, the 10 year German government bond yield dropped to 2.47%. Two weeks ago roughly, it stood at 2.94%. Swiss Franc against both the US dollar and the Euro reached another record.

EUR/CHF intraday move, 1.14 to 1.10...

USD/JPY as well moving to a new high for JPY against dollar:

Bloomberg chart of the day:

Yep, running for the hills, and by the way 2 year Swiss bonds yields are at 0.17%.


2 year Swiss Yield falling fast from May' top (source Bloomberg).

And VIX index, surging still but not yet at March highs:

European peripherals? Well Greece touched 25% yield on the two year, following the new European plan and there was a furious short tightening squeeze on the 22nd of July, but it looks more and more like a distant memory:

Greek two bonds at 31% again.

And it is only Monday...

Now, back to the bunker.

Credit Complacency - HELOCs issues and market update.

In addition to last week post about complacency in the market place, it is important to look at the economic figures which were published this week in the US.

They were not great.

Consumer spending in April in the US at 0.4%, against a revised 0.5% in March. Higher grocery bills and gas prices are taking their toll on the US consumer, that's what Wal-Mart has been telling us. Lower gas prices and strong NFP (Non Farm Payroll) could help for higher consumer spending but the deleveraging is strong. We are not there yet. Disposable income is still flat. Saving rates are at 4.9%, lowest since October 2008, meaning US consumers are in fact dipping into their savings, facing higher bills.

Core inflation rose 1% in April, the most since September.

So, the US consumer needs commodity prices to cool down and lower unemployment numbers. We got on the 25th of May the revised Q1 GDP figures, everyone expected 2.2% from 1.8% and we got the small print at 1.8%.
Also, you need to take into account the following fact, millions of Americans who are delinquent on their mortgages are staying in their homes for free about a year and a half on average. This is helping them buying time to restructure their finances. This is currently providing an unexpected support for consumer spending, which still makes up about 70 percent of the US economy. This is the effect of what is called now "squatter's rent". This equates to increase income from withheld mortgage payments for US households.

According to JP Morgan's chief US economist Michael Feroli, the extra cash could represent a boost to spending that is equal to about half the estimated savings generated by cuts to payroll withholding in December's bipartisan tax plan.

27 percent of single-family homeowners with mortgages are in negative equity, this represents according to CoreLogic USD 744 billion of total negative equity. The strategic defaults and the non payment of mortgages is helping to maintain current level of US consumption. More than a third of mortgage defaults were strategic, according to a June 2010 survey by finance professors Paola Sapienza of the Kellogg School.
For more on strategic defaults:

Strategic defaults could get very ugly - Keith Jurow

How to reverse the tide which ultimately will affect the value of mortages still sitting on US banks balanced sheet?
You can find the proposals made by Lewis Ranieri, the pioneer of mortgage securitization in the following link to a Bloomberg article:

Banks Can Fix Crisis by Easing U.S. Homeowner Debt, Ranieri Says


Ranieri's plan urge "banks to reduce debt for qualified borrowers and recognize losses on second mortgages and home-equity lines of credit."
Good intentions, but recognizing losses on home equity lines of credit for some US banks would have for some, a very significant impact. There are roughly 13 million HELOCs outstanding.

The big US banks have USD 147 billion in exposure to >100% CLTV HE Loans (source CreditSights):
Bank of America - USD 47 billion
JP Morgan - USD 41 billion
Wells Fargo - USD 39 billion
Citigroup - USD 20 billion

CreditSights estimate that cost related to a potential mortgage servicer settlement, mortgage repurchases, and second lien home equity write downs could lead to almost USD 95 billion in pre-tax losses for the big banks (USD 33.8 billion for Bank of America, 26.3 for JP Morgan, 24 for Wells Fargo, 10.3 for Citigroup USD). Aggregate earnings impact would be of around USD 62 billion according to CreditSights.

EPS Earnings impact:
Bank of America - USD 2.18
JP Morgan - USD 4.37
Wells Fargo - USD 2.96
Citigroup - USD 0.27

59 billion would be linked to write downs of HELOCS according to CreditSights, assuming 40% writedowns for Helocs with a CLTV above 100%. Given junior position of second liens, CreditSights is assuming 100% severity.

Impact on BASEL III Tier 1 common ratio would be:
146 bps down for Wells Fargo
113 bps down for JP Morgan
106 bps down for Bank of America
56 bps down for Citigroup

Conclusion:
I would stay clear of US Bank stocks for the moment, which follows last week post relating to loan growth issues for banks. There is no doubt in my mind that current underprovisioning by US Banks are artificially boosting earnings.

In Ireland, loss recognition has been dramatic even for Foreign-owned banks according to the Irish Time:
Just looking at the cumulative loan losses for Irish banks relating to the property bust, gives me the shivers: Irish Nationwide, total losses amounted to nearly 60% of its book, BoSI 32% and the Rabobank-owned ACC Bank 28%.

Foreign-owned banks count cost of carnage caused at their Irish branches


Pending home sales this month got absolutely whacked: -11.6% down, consensus was for -1%.
What's happening there? It means people are waiting for lower prices, which means than it will take even longer to clear the existing huge inventory I mentioned in last week post.
As a reminder, Short sales and Foreclosures accounted for 40% of existing home transactions in March, up by a third from last year.

New Homes Sales printed at 323000, consensus was for 305000. Nothing great, still in the abyss.

Initial jobless claims at 424K, consensus was for 400K.

University of Michigan consumer sentiment index increased a little to 74.3 from the preliminary reading of 72.4, possibly due to a small drop in gas prices. Please note the consumer sentiment index reading is still in a low area.

Update on bank failures this year: 44 so far. We were at 25, as I posted on the 25th of March 2011. We had 157 banks failures in 2010 according to FDIC.

Meanwhile in the European space, on the CDS sovereign space, spreads are still widening to new records for the peripherals:


Ireland and Portugal Sovereign CDS are now trading at the same levels, above 600 bps for the 5 year.

The full Greek CDS curve as quoted in the market on the 20-05-11:

That's how a fully inverted CDS curve look like...

Update on peripheral government bonds:
10 Year Greek Governmnent bonds are now yielding 16.57%, up 2.75% this month and 8.79% for the year.
10 Year Irish Government bonds are now yeilding 10.54%, up 0.83% on the month and up 5.89% this year.
10 Year Portugal Government bonds are now yielding 9.9%, up 0.39% on the month and 4.77% for the year.

German Bund 10 Year yield dipped this week below 3%, probably a sign of some sort of flight to quality. Here is an update on the 2-10 year curve for German debt:

We can see a nice ongoing flattening of the 2-10 spread on German government bonds.

Spanish Banks 5 year CDS have widened a bit for the weaker ones but haven't come back to their February levels, Santander and BBVA are still trading in the same range:


Itraxx Senior Financial 5 Year index is 60bps wider than Itraxx Main Europe 5 year CDS, 159 bps versus 97 bps. Financials have been widening again since the beginning of the year and single names CDS for banks as well, the worst offenders have been Irish banks CDS so far this year: Bank of Ireland CDS 1425 bps at the beginning of the year, 2415 bps now. Allied Irish, from 3019 bps to 4736 bps.

Continuing sovereign uncertainty means continued volatility for the financial sector, so watch closely the CDS space for banks for both senior and sub CDS 5 year CDS levels.

Honey, I Shrunk the Balance Sheet...

This crisis is very acute because it is a Balance Sheet Recession and the implications will be severe for many years to come, given the extent of the repairs that needs to be achieved following the catastrophic damages inflicted by the cheap credit fuelled bubble we have been victims of.

The Balance Sheet Recession:

http://www.ft.com/cms/s/0/3d89a930-220d-11de-8380-00144feabdc0.html

In an article published by Roger Altman (chairman and CEO of Evercore Partners and former deputy Treasury secretary in the Clinton Administration) in the Financial Times, we have a very good summary of the damages inflicted to Households and the implications for the recovery.

"What is unusual is that this is a balance-sheet driven recession, centred on the damaged financial condition of both households and banks. These weaknesses mandate sub-normal levels of consumer spending and overall lending for about three years.

In contrast, most postwar recessions had a different sequence – rising inflationary pressures, a monetary tightening to counter them and, then, a slowdown in response to higher interest rates. This was the pattern of the sharp 1980-81 slowdown.

None of that happened here. Instead, we saw a housing and credit market collapse that caused enormous losses among households and banks. The result was a steep drop in discretionary consumer spending and a halt to lending. To see why recovery will be slow, we can look at the balance sheet damage. For households, net worth peaked in mid-2007 at $64,400bn (€47,750, £43,449bn) but fell to $51,500bn at the end of 2008, a swift 20 per cent fall. With average family income at $50,000, and falling in real terms since 2000, a 20 per cent drop in net worth is big – especially when household debt reached 130 per cent of income in 2008."

You can clearly see in the graph below the severity of the damages inflicted to US households in the current recessions compared to previous ones:



Furthermore on Balance Sheet Recession:

http://www.adamsmithesq.com/archives/2009/04/the_balance_sheet_recessi.html

"Recessions as described or dissected by Econ 101 are income-shock driven, not balance-sheet shock driven. Typically, rising inflation compels the Fed to tighten money and raise interest rates and the predictable slowdown follows as (a) business investment contracts because of higher funding costs (b) causing all the industries and suppliers associated with that investment to contract (c) laying off their workers and cutting their orders to their own suppliers (d) leading to further employment contraction (e) decreased consumer spending (f) decreased demand for business products and services, and so on until inflation is tamed and the Fed can ease off the brake and back onto the gas.

Alternatively, of course, a single sector can become a bubble unto itself (the dot-com boom or the S&L crash of the 1980's) or an exogenous shock (the OPEC price spike of the early 1970's) can prompt a recession, but the single-sector bubbles are typically self-contained and parochial in scope and the exogenous shock bring forth a plethora of innovation and plain old readjustments (turn down the thermostat and stock up on sweaters?) that hasten recovery.

This time is different.

This time everyone--households, small businesses, big busineses, banks, investment banks, and yes, law firms--has seen their net worth hosed. The problem with recovering wealth is that it takes so much longer than it does to recover income."

The fall in networth implies that everyone is working hard to repair balance sheets.
This produces weak demand for funds and credit. It will take years to go through the deleveraging process.
Households and Companies are moving from profit maximization to debt minimization.
Everyone is hoarding cash. Cash is king. According to the Federal Reserve, businesses are hoarding about 1.8 trillion USD in cash.





Consumer Credit Collapsing and Banks Hoarding Cash as well:



David Rosenberg in his Breakfast with Dave article on the 16th of August, analyses the cash hoarding situation and implications:

https://ems.gluskinsheff.net/Articles/Breakfast_with_Dave_081610.pdf

"BANKS LENDING ALL RIGHT ... TO UNCLE SAM!"

"The banks are still sitting on an unprecedented cash hoard and doing nothing with it. Consider that on a 13-week rate change of basis:
•
C&I loans are down at a 1.2% annual rate.
•
Home equity lines of credit are down at a 4.1% annual rate.
•
Residential mortgages are down at a 2.9% annual rate.
•
Commercial real estate loans are down at a 9.2% annual rate.
•
Credit card loan balances are down at a 6.7% annual rate.
Meanwhile, cash on bank balance sheets have expanded at a 10% annual rate over this time frame and purchases of government securities have ballooned at a 21.3% annual rate. In fact, since the end of June, the banks have bought a huge $83 billion of government/agency bonds, the third most over such a short time frame. Just in case you were wondering who has been the culprit behind this phenomenal rally in the Treasury market."


Households in the US are deleveraging big time:



And they are deleveraging at an incredible fast rate:



How far will debt to income fall?



We can see a big surge in the amounts in personal savings in the US:





At the same time the government is trying to make up for the big drop in consumer spending by running a huge deficit!



What are the implications of a Balance Sheet Recession and why Japan is a very bad exemple to follow in a Balance Sheet Recession:

In his latest weekly letter, John Mauldin quotes Charles Gave, writer as well as founder of the excellent Macro Research house Gavekal:

http://www.2000wave.com/article.asp?id=mwo091010

"The only way that one can expect Keynesian policies to break the 'paradox of thrift' is to make the bet that people are foolish, and that they will disregard the deterioration in their balance sheets and simply look at the improvements in their income statements.

"This seems unlikely. Worse yet, even if individuals are foolish enough to disregard their balance sheets, banks surely won't; policies that push asset prices lower are bound to lead to further contractions in bank lending. This is why 'stimulating consumption' in the middle of a balance sheet recession (as Japan has tried to do for two decades) is worse than useless, it is detrimental to a recovery.


TPC from the excellent website "The Pragmatic Capitalist" does a great job as well in analysing the deleveraging process induced by this acute Balance Sheet Recession:

http://pragcap.com/the-deteriorating-macro-picture

Businesses and consumer are using their surpluses to pay down their debts and increases their savings due to the damages they have suffered in the dowturn as well as increased uncertainties instead of spending or investing.





Keynes argued that in a liquidity trap, consumers and businesses are so fearful to spend or invest that they hoard cash, this is excactly what is happening right now. And because the Federal Reserve cannot lower interest rates below zero, it runs out of room to force more money into the economy.

What could be a solution to reverse the course?

How could the Balance Sheet be rapidly repaired?

Tax cuts stimulate the economy when they involve reductions in tax rates!

Permanent cuts in marginal rates of the payroll tax, capital gains tax and double taxation of dividends could be positive to stimulate investment as well as employment.
The negative dynamics such as anticipated future tax increases are the main reason why consumers and companies are hoarding cash.

Instead of having an already inefficient stimulus, how about 1 trillion USD in tax cuts? Would we need more? Would that restore confidence? Entice people to invest and recruit? Would that help small businesses to drag us out of the recession given they have always pulled the economy out of a recession when they thrive?

Tax cut would be appropriate given it would increase consumer's credit lines. The consumer would either consume more or save more (and maybe buy Goverment bonds in the process...).

Economic 101 reminder:
GNP = C + I + G + NX

where:

C = consumption spending by individuals
I = investment spending (business spending on machinery, etc.),
G = government purchases
NX = net exports

Consumer spending typically equals two-thirds of GNP.

Reducing taxes, pushes out the aggregate demand curve as consumers demand more goods and services with their higher disposable incomes. Supply side tax cuts are aimed to stimulate capital formation. If successful, the cuts will shift both aggregate demand and aggregate supply because the price level for a supply of goods will be reduced, which often leads to an increase in demand for those goods.

How about cutting corporate taxes?

Here is what Peter Ferrara in Forbes, thinks about it:

http://www.forbes.com/2009/02/04/tax-cut-stimulus-opinions-contributors_0204_peter_ferrara.html

"Here are the components of a plan that would work to restore economic growth precisely because they do focus on governing economic incentives. America's corporations suffer from a federal corporate tax rate of 35%, close to 40% with state taxes. This is the second-highest rate in the industrialized world, just a bit behind Japan, which may cut its rate soon. The European Union cut its average corporate tax rate from 38% in 1996 to 24% in 2007. Germany and Canada each recently adopted a top corporate rate of 19%, with Canada's slated to fall further to 15%. India and China have lower corporate rates as well.

Ireland adopted a 12.5% corporate rate in 1988, when it had the second-lowest per capita income in Europe. Today, Ireland enjoys the second-highest incomes in Europe, and it raises more in corporate taxes as a percent of gross domestic product than the U.S. does with a tax rate three times higher.

For the U.S. economy to remain internationally competitive, the federal corporate rate should be slashed to 20%. The heavily burdensome federal corporate capital gains rate should also be cut from 35% to the current individual rate of 15%, and that individual rate and the dividends tax rate of 15% should be made permanent. The capital gains tax is a second level of taxation on capital, not a loophole providing lower rates for capital income."

We need to do whatever we can to boost the private sector:

"The reduction in rates improves incentives for savings, investment, business creation and expansion, job creation, entrepreneurship and work by allowing people to keep a greater percentage of the reward produced by these activities."

Also Peter Ferrara makes a very important point:

"In addition, America needs deregulation to unleash the private sector to produce more oil and natural gas, from offshore and onshore, and to build more nuclear power plants. This would build a powerful energy industry, adding to GDP and creating jobs."

Why America needs urgent deregulation and massive investment from the private sector in the Energy sector?

John Mauldin told us why in his latest letter:

http://www.2000wave.com/article.asp?id=mwo091010

"If the US is going to really attempt to balance the budget over time, reduce our personal leverage, and save more, then we have to address the glaring fact that we import $300 billion in oil (give or take, depending on the price of oil).

This can only partially be done by offshore drilling. The real key is to reduce the need for oil. Nuclear power, renewables, and a shift to electric cars will be most helpful. Let us suggest something a little more radical. When the price of oil approached $4 a few years ago, Americans changed their driving and car-buying habits.Perhaps we need to see the price of oil rise. What if we increased the price of oil with an increase in gas taxes by 2 cents a gallon each and every month until the demand for oil dropped to the point where we did not need foreign oil? If we had European gas-mileage standards, that would be the case now.

And take that 2 cents a month and dedicate it to fixing our infrastructure, which is badly in need of repair. In fact, the US Infrastructure Report Card (www.infrastructurereportcard.org), by the American Society of Civil Engineers, which grades the US on a variety of factors (the link has a very informative short video), gave our infrastructure the following grades in 2009: Aviation (D), Bridges (C), Dams (D), Drinking Water (D-), Energy (D+), Hazardous Waste (D), Inland Waterways (D-), Levees (D-), Public Parks and Recreation (C-), Rail (C-), Roads (D-), Schools (D), Solid Waste (C+), Transit (D), and Wastewater (D-).

Overall, America's Infrastructure GPA was graded a "D." To get to an "A" would requires a 5-year infrastructure investment of 2.2 trillion dollars.

That infrastructure has to be paid for. And we need to buy less oil. And we know price makes a difference. The majority of that 2 cents would need to stay in the states where it was taxed, and forbidden to be used on anything other than infrastructure.

(And while we are at it, why not build 50 thorium nuclear plants now? No fissionable material, no waste-storage problem, and an unlimited supply (at least for the next 1,000 years) of thorium in the US. The reason we chose uranium was to be able to produce nuclear bombs, among other reasons.) We'll get into this and more when we get to the chapter on the way back for the US."

Why not try something else rather than pointless Government spending, which is no substitute for real growth coming from a repaired private sector.

As a conclusion let me quote Brian S. Wesbury and Robert Stein in an article published in Forbes:

http://www.forbes.com/2008/12/08/friedman-cut-taxes-oped-cx_bw_rs_1209wesburystein.html

"There are many positive alternatives that are not being formally discussed. This is a mistake. And more to the point, the last time the government tried to bail out the economy with drastic action, we ended up in the Great Depression. If we really want to "change" the way government and the private sector interact, why is the U.S. government still trying the same old policies that failed in the past? Tax cuts have worked before, so if deficits don't matter, why not try a different kind of surge--a private-sector, incentive-creating one?"