Daily Economics Update 23/03/2009

I am putting this link (here) to today's WSJ interview with Gary S Becker in red, bold and at the top of this post (and on the front of my blog page) not only because he is the greatest economist alive today (which he is), and not only because he taught me microeconomics (how poor of a student I was is attested to by my self-deception of believing in being right on more occasions than being wrong), but because this interview is a must read for anyone concerned about the state of our world today.

Ireland

A new invitation is out - from Brian Cowen to the social partners - to enter talks on a new National Agreement. Yes, folks, you've heard it right. The Government that can't do anything worth talking about on the crisis is back to talking about doing something on the crisis. Dust out that Excellence in Services medal for Brian. Instead of facing down the unions in their militant stance on the economy, Brian Cowen has done another one of his 'courageous' and 'decisive' flip-flops that our official media got so accustomed to calling upon him to perform. Expect: more blame for private sector, higher taxes, more pay for public servants, rampant price inflation in state-controlled sectors and... well, just expect more of what we had in Autumn 2008.

This time around, the markets will be searching for what to hit next. Given that Brian's first round of 'dealing with the crisis' has spectacularly collapsed into issuing blanket guarantees to the banks, nationalising one bank, handing taxpayers cash to two other banks, passing no meaningful measures on stimulating economy, hammering consumers and taxpayers, slaughtering retail sector and seeing public debt soar, they will be hard pressed to find a new target still standing.

Revolting, is how I can describe this latest move at best.

Just how senile our policy making has become as of late? Think Nationwide scandal. Mr Fingleton is walking away with millions and the Government and the politicos are issuing salvos of outrage. But they can do nothing - he owns the money. How? The truth is that Fingelton gets to keep his millions only because in September 2008, the Exchequer has underwritten the Nationwide. Would they have said then: "Sorry, buddy, but there is no way Nationwide is a systemic bank and so no guarantee", the bank would have gone into a receivership and Mr Fingleton would have received what he deserves after all these years of running his own 'lille piggy bank' - zilch, nada, zero.

So don't blame the bankers - blame the politicos. And let's ask Brian^2+Mary to see that assessment of the Irish banking system that managed to recognize the likes of the Nationwide as a significant enough institution to have caused a systemic risk to the entire financial system were it allowed to fail.


US:
Forbes is now on the inflation case (here): "On a year-over-year basis, the CPI will turn negative this month and stay negative for many more months. As a result, many believe inflation is a distant memory and those who fear deflation will have data to hang their hats on for much of 2009. But, these deflation-istas will be looking in the rear-view mirror. On a month-to-month basis, inflation is already starting to claw its way back. In the first two months of 2009, consumer prices are up at a 4.1% annual rate, while producer prices are up at a 5.8% rate."

Worth a read. I have warned about this threat of inflation a week ago (here), so we are ahead of the curve...


More on the Geithner 'Trillion-dollar Rescue' Plan (GP): let's do some math

1. The Feds buy $1 trillion worth of banks assets, in partnership with private buyers (95-97% financed by the Treasury - 85% in the form of a non-recourse loans and remaining in the form of equity). Suppose that 5% comes from private investors. Taxpayers liability is $950bn.
2. Now, assume that the average price paid for assets is $0.80-0.85 on the dollar - an assumption consistent with 'clean' assets TARP financing. Banks get an effective disposal of $1tr/0.8=$1.25tr worth of assets. This is the implied value of assets on banks balance sheets. But the banks have marked these assets down already. Suppose the original markdowns were ca 10% impairment. The original, pre-writedown value of the assets that is being purchased under the GP is, therefore $1.25tr/0.9=$1.39tr.
3. Current market price for distressed assets is roughly equal to the recovery rate on such assets - ca $0.40-0.55 per dollar value, so the mark to market value of these assets is now $1.39tr*0.45=$625bn.

Recall that 95-97% is going to be financed by the Feds, and the Government share will be roughly 20% of the entire value. So under GP, taxpayers are getting $125bn in assets in exchange for $950bn in payment... Ahem, that is a rotten deal, indeed.

But what does this deal buy in the end? Combine that with the fact that

• ca 40% of all banks balance sheet assets in the US are in residential mortgages,
  
• ca 24% - in Commercial mortgages,
• of the remaining stuff, 55% is in corporate and industrial loans,
  
• of which good 1/5th is again linked to property.
  

Thus, total balance sheet exposure to property in the case of the US banks is somewhere in the region of 68%. Of these, at least 40% is toxic, so that we can assume that 25% of the entire banks' balancesheets is of reasonably nasty quality. Suppose banks sell (via GP) these assets at $0.80 on the dollar. The required post-sale writedown on the loans will be 25%(1-0.8)=5% of the entire asset base. Per latest statement (December 31, 2008) by the Bank of America, this venerable (if vulnerable) institution has tangible equity to total assets ratio of 5.0% and Tier 1 ratio of 9.2%. This is excluding the toxic stuff it inherited from Merrill Lynch. Thus, in effect, participating in GP will wipe out all of the bank's tangible equity and more than 1/2 of its Tier 1 capital, pushing it well below the 6% Tier 1 ratio required of reasonably sound banks.

So this implies that very few banks will be willing to sell at $0.80 on the dollar. A more acceptable price for banks would be $0.95 to a dollar, but at that price, the US taxpayers will fall some $833mln short on the deal.

Could someone please tell me why we are talking about GP as some sort of a market-turning deal? Unless, that is, we are buying into the plan because it is the first, and so far the only plan that a new Democratic Party White House has contrived?


US Personal Income data: "US personal income growth slowed to 3.9 percent in 2008 from 6.0 percent in 2007 with all states except Alaska sharing in the slowdown," according to the data released by the US Bureau of Economic Analysis. The U.S. growth was the slowest since 2003. Inflation, as measured by the national price index for personal consumption expenditures, rose to 3.3 percent in 2008 up from 2.6 percent in 2007. Here is a nice map of heaviest (and lightest) hit states:
Can you see the pattern? Well, here is another map:

House Prices (US): Home prices rose 1.7% in January relative to December 2008, says Federal Housing Finance Agency - the first monthly increase in 12 months. This leaves home prices down 6.3% in the past 12 months and -9.6% off from their peak in April 2006. In December, the year-on-year decline was 8.8%. One note of caution - this is the preliminary estimate subject to at least two future revisions. For example, December 2008 preliminary estimate was showing 0.1% fall in prices, but this was revised today to -0.2% decline. Overall, in January, home prices rose in 8 out of 9 regions (only Pacific states registered a decline -0.9%), with strongest gains in East North Central (+3.9%) and South Atlantic (+3.6%) regions.

Daily Economics Update 22/03/2009

So we are in a rally, at least in the US.
Financials are again in the lead, as chart below showing.10-year treasuries rise, dollar falls
What can one expect from a relatively rational(ized) market when it is faced with a renewed $1trillion push of cash into draining the toxic pool of mortgages-linked securities.

The DJIA ended gaining 6.84% to close at 7,775.86, the S&P 500 closed at 822.92 (+7.08%), the Nasdaq Comp ended the day at 1,555.77 (op 6.76%).

A friend - high up in international finance - asked me again if this is a sign of a thaw. I again said, it is not - just a rational reaction to a massive push on the dollar. Real values are not changing much, but what is happening is the wholesale repricing for the dollar to reach 1.45-1.50 to euro once again. Here is an illustration of why I am still not buying the permanent rebound hypothesis (courtesy of dshort.com):
What about the Geithner Plan (GP)? Well, whatever one can say about it, words 'original' or 'innovative' are not something that comes to mind. It falls short of a nationalization and nationalization is what will probably be needed. Not a wholesale take over, but certainly not a 20% equity take by the Feds in exchange for a 97% capitalization, as the GP envisions.

Financial services lap-dog economists loves the thing, though. For example, one senior economist from Wells Fargo claimed that the plan "will go a long way toward getting banks... to lend more aggressively and break the deleveraging feedback loop" now in place. This is the lunatic asylum stuff, for it assumes, without even stating so much, that there are hordes of willing borrowers gathering just outside the banks doors. And it further assumes that deleveraging is bad. Given that the whole mess was brought upon us by the excessive leveraging in the first place, either I am losing my mind, or the entire world is now rushing head on to create a new bubble in place of the old one.

The main problem with GP is that it comes on top of the TARP and a host of other asset-purchasing arrangements. Now, all were offering lenders some set of prices for distressed assets. These prices were set arbitrarily high to incentivize the banks to unload their troubled loans. But clearly, TARP was not sufficient, so the GP will have to set prices even higher - at some premium to TARP to further induce the loan holders to part with their distressed paper. And here is a catch. Since inception of TARP, the quality of the loans still on the books in banks have fallen - steadily and rather rapidly. Will this imply that investors are now being incentivized to bid for loans at a price above their true market value? Of course it will and this is precisely why the Feds are offering the bidders a 97% financing package in return for 80% equity in the loans purchased, with Federal financing done on the back of non-recourse loans (loans that are collateralized against the value of the securities purchased alone).

The GP will in effect act as a subsidy to the banks. Hence that nice climb in banks shares in recent days. Geithner's idea is to have a free lunch served to the banks today, for which the taxpayers will pay tomorrow and the restaurant staff (the investors) will get paid a day later. It is, as the Calculated Risk blog puts it, "a European style put option - it can only be exercised at expiration. The taxpayers will pay the price of the option in the future, the investors receive any future benefit, and the banks receive the current value of the option in cash. Geithner apparently believes the future value will be zero, and that is a possibility. If so, this is a great plan - if not, the taxpayers will pay that future value (and it could be significant)."

Note to the Derivatives students: this could have made a good question for exam...

On a somewhat more positive note: sales of existent homes were up 5.1% in February. Although this figure - the largest percentage gain since July 2003 - (a) comes after a 4.6% contraction in yearly sales and (b) was the result of deep price discounts (especially due to rising tide of foreclosures and short sales that accounted for 45% of all transactions), sales rose in all regions. Full 65% of the potential buyers expect the market to bottom out within the next 12 months.

Inventories of unsold homes - once again a sign of deepening foreclosure pools - on the market rose by 5.2% to 3.80 million, equating to a 9.7-month supply at the February sales pace. Although seasonally inventories usually rise ca 5% in February, this time around the increase came after a prolonged period of stalled construction activity. In other words, there is little reason for rising new inventories other than an acceleration in forced sales and foreclosures.

In fact, just as the subprime tsunami recedes by May-June 2009, the next wave of homeowners defaults is about to start hitting the US markets, as the following two charts (sourced here and here) illustrate: