John Hussman had a piece out yesterday that dissects the current economic environment in two parts. In part one, Hussman puts a spotlight on quantitative easing (QE) and why it is unlikely to have the intentioned effect on the U.S. economy. And in part two, Hussman explains how the current technical recovery has been what I call a “fake recovery,” predicated on government backstops, accounting subterfuge, regulatory forbearance and banks’ raising capital. To date, this has worked in buoying both the real economy and financial markets. However, longer-term Hussman remains sceptical both regarding the efficacy of QE and of exit strategies from QE.
Let’s look at part two first because it is an important pre-condition of part one. Here’s how I initially described the fake recovery:
Why ‘Fake’? This is a fake recovery because the underlying systemic issues in the financial sector are being papered over through various mechanisms designed to surreptitiously recapitalize banks while monetary and fiscal stimulus induces a rebound before many banks’ inherent insolvency becomes a problem. This means the banking system will remain weak even after recovery takes hold. The likely result of the weak system will be a relapse into a depression-like circumstances once the temporary salve of stimulus has worn off. Note that this does not preclude stocks from large rallies or a new bull market from forming because as unsustainable as the recovery may be, it will be a recovery nonetheless.
The real situation
In truth, the U.S. banking system as a whole is probably insolvent. By that I mean the likely future losses of loans and assets already on balance sheets at U.S. financial institutions, if incurred today, would reveal the system as a whole to lack the necessary regulatory capital to continue functioning under current guidelines. In fact, some prognosticators believe these losses far exceed the entire capital of the U.S. financial system.
The critical bit about this recovery has been the recapitalization of the banks – which has been real. They are not flush with capital on a mark to market basis but their capital growth and earnings on the accounting basis now in use has been first-rate – hence the pop in shares in 2009. For his part, Hussman says:
In early 2009, many major U.S. banks were faced with clear capital shortfalls that effectively rendered them insolvent – their liabilities exceeded their assets. Instead of restructuring this debt, or dealing with the problem in a sustainable way, the Financial Accounting Standards Board, responding to Congressional pressure, suspended “mark to market rules” and allowed major U.S. financials to use “substantial discretion” in valuing their assets. Since it was neither possible nor credible for banks to immediately write up those assets overnight, loans from the Troubled Asset Relief Program (TARP) were critical in bridging the immediate shortfall. Over the following quarters, banks substantially wrote up their assets, and they issued a large volume of additional stock. The new issuance created a moderate but legitimate improvement in the financial position of these banks, but the asset writeups appear to be inconsistent with the growing volume of delinquent and unforeclosed homes, and the deteriorating debt-service performance of commercial mortgage-backed securities. Presently, the U.S. financial sector is essentially opacity masquerading as solvency.
As Meredith Whitney has observed, the “recovery” of the U.S. financial sector has been a two stage process – massive writeups of troubled assets on balance sheets, followed by large reductions in loan loss reserves on income statements. This activity has not only driven the improvement in operating earnings reported by banks, but has been one of the primary contributors to the recovery in the aggregate earnings of the S&P 500 Index. It is not a process that should be extrapolated.
Notice the part about asset writeups instead of writedowns in an environment of record foreclosures. Why are loan loss reserves falling instead of rising?
That’s the banks. What about Fannie (FNMA.OB) and Freddie (FMCC.OB)? Remember Fannie and Freddie – now part of the government – own the mortgage market right now. Any new losses will accrue to them and not to the banks. Hussman says that the housing market has stabilized, not because of QE, but because the mortgage mess has been nationalized via the government’s now explicit backstop of the GSEs.
As for Fed purchases of U.S. agency securities, there is little doubt that these actions allowed the U.S. housing market to function, albeit at a weak level, over the past 18 months. But this cannot be credited to anything inherent in quantitative easing. Rather, the Fed did something that neither the American public, nor the U.S. Congress were willing to do democratically: it essentially guaranteed Fannie Mae and Freddie Mac debt by taking massive amounts onto its own balance sheet. This was later followed up by more explicit 3-year guarantee by the Treasury (through the end of 2012).
Think of it this way. If Fannie and Freddie had already been explicitly protected by the full faith and credit of the U.S. government, their securities would have been indistinguishable from U.S. Treasury securities, and housing activity through Fannie and Freddie would have proceeded without any action by the Fed. It wasn’t quantitative easing that helped the housing market. It was the Fed’s willingness to put the U.S. public on the line for any losses sustained by these two insolvent financial institutions.
By purchasing $1.5 trillion in Fannie Mae and Freddie Mac obligations, the Federal Reserve has placed U.S. taxpayers in the position of absorbing whatever additional losses will come on two-thirds of the nation’s mortgages. Prior to the Fed’s actions, the bondholders of these institutions had no right to the full faith and credit of the U.S. government, but the Fed’s massive purchases of this debt are now effectively irreversible without such a guarantee. There appears to be no way for the Fed to extricate itself from this position without provoking massive economic dislocations, except through continued Treasury guarantees to make this agency debt whole so that private market participants will buy it back. By making that “monetary policy” decision, the Fed has actually forced an act of fiscal policy.
So, that’s where we are. The financial sector has been stabilised via government backstops, accounting subterfuge, regulatory forbearance and banks’ raising capital.
Question: If QE wasn’t the major market force the first time, why should we expect it to be this time around? Quantitative easing is not a helicopter drop. Actually, a helicopter drop is a lot more effective than quantitative easing. Quantitative easing is the Fed buying existing financial assets with printed money. While the Fed is increasing the monetary base, they are not actually increasing net financial assets. This is an asset swap of the Fed’s money for bonds. Unless the demand for credit increases, that extra money sits in vaults and no new financial assets are created. In fact, we have just destroyed tens of billions in interest income by paying cash for interest-bearing assets.
In a helicopter drop, people get the money directly, and, thus, they are liable to spend some of it. While both involve money printing, the former (QE) is banker friendly, the latter is more geared to consumption.
And Hussman demonstrates that QE2 isn’t going to increase demand for credit because it’s concentrated on supply. He writes:
Economics is essentially the study of how scarce resources are allocated. To that end, one of the main analytical tools used by economists is “constrained optimization” – we study how consumers maximize their welfare subject to budget constraints, how investors maximize their expected returns subject to a various levels of risk, how companies minimize their costs at various levels of output, and so forth. To assess whether QE is likely to achieve its intended objectives, it would be helpful for the Fed’s governors to remember the first rule of constrained optimization – relaxing a constraint only improves an outcome if the constraint is binding. In other words, removing a barrier allows you to move forward only if that particular barrier is the one that is holding you back.
On the demand side, it is apparent that the U.S. is presently in something of a liquidity trap. Interest rates are already low enough that variations in their level are not the primary drivers of loan demand. Loans are desirable when businesses see opportunities to make profitable investments that will allow the repayment of the loan, without too much uncertainty. Similarly, loans are desirable when consumers see opportunities to shift part of their lifetime consumption stream toward the present (or to acquire durable items such as autos or homes which provide an ongoing stream of benefits), and where they also believe that their future income will be sufficient to service the debt…
Instead, businesses and consumers now see their debt burdens as too high in relation to their prospective income. The result is a continuing effort to deleverage, in order to improve their long-term financial stability. This is rational behavior. Does the Fed actually believe that the act of reducing interest rates from already low levels, or driving real interest rates to negative levels, will provoke consumers and businesses from acting in their best interests to improve their balance sheets?
Bottom Line: QE will be a failure. It is not going to employ people. It is not going to increase wages. It is not going to increase credit supply growth since interest rates are already at zero percent. It will not increase credit demand growth since consumers are still overleveraged. And it certainly will not make this foreclosure issue go away. Anticipation of more money printing and a Bernanke Put has boosted asset prices in US dollar terms temporarily but I say buy the rumour, sell the news.