More Evidence of a Balance Sheet Recession
by Charles Lemos, Sat Jan 17, 2009 at 09:50:42 PM EST
"Make more loans? We're not going to change our business model or our credit policies to accommodate the needs of the public sector as they see it to have us make more loans." -- John C. Hope III, the chairman of Whitney National Bank in New Orleans
Back in early December, I highlighted a warning from UCLA Anderson Forecast Senior Economist David Shulman that the US economy, indeed perhaps much of the world economy, faced what is known as a "balance sheet recession."
To refresh your memories, a balance sheet recessions are highly uncommon and happen following the bursting of a nation-wide asset price bubble such as the one we face now in the housing and commercial real estate markets. Nomura Securities Chief Economist Richard Koo first described the phenomenon, where the vast majority of companies in an economy devote most of their resources to paying off their debts even when interest rates are near zero.
Balance sheet recessions are as rare as a nation-wide asset price bubble which happens perhaps once every two generations. This type of recession is unlike other recessions in that the inventory cycle is not the key driver. The key driver in this recession is the corporate effort to repair their balance sheets by postponing investments and instead, paying down debt. When a large number of companies move away from the usual goal of profit maximization to debt minimization all at the same time in their effort to regain their financial health, the balance sheet recession starts.
A snowballing debt burden may freeze any recovery, since companies and consumers care mostly about paying off debt, choking consumption and investment sentiment. This leads to another round of asset deflation further deepening the economic slump. This vicious cycle is dubbed a balance sheet recession. In effect, companies are looking to wipe under-performing assets off their balance sheets. Japan's experience from 1991 through 2005 is the main and best known example of a balance sheet recession.
Right now, liquidity both in the US and abroad remains tight as lending institutions look to repair their troubled balance sheets. Rather than assume risk, banks are refraining from making loans even to their best customers. From the New York Times:
As the incoming Obama administration decides how to fix the economy, the troubles of the banking system have become particularly vexing.
Congress approved the $700 billion rescue plan with the idea that banks would help struggling borrowers and increase lending to stimulate the economy, and many lawmakers want to know how the first half of that money has been spent before approving the second half. But many banks that have received bailout money so far are reluctant to lend, worrying that if new loans go bad, they will be in worse shape if the economy deteriorates.
Indeed, as mounting losses at major banks like Citigroup and Bank of America in the last week have underscored, regulators are still searching for ways to stabilize the banking system. The Obama administration could be forced early on to come up with a systemic solution, getting bad loans off balance sheets as a way to encourage banks to begin lending, which most economists say is essential to get businesses and consumers spending again.
Well if President-elect Obama is looking for a model, he need only look across the pond to Gordon Brown who is fast becoming one of my political heroes with his renewed and vigorous readiness to tackle the economic crisis head on. From the UK Guardian:
Gordon Brown is preparing an unprecedented multi-billion pound plan to insure British banks against future losses from so-called toxic assets, creating a safety net under the financial system which could unblock lending to homeowners and businesses.
The scheme would force out any bombshells still hidden in the system, but risks exposing taxpayers to huge losses if the bad loans decline more sharply than expected. However, ministers hope it could restore confidence by setting a floor beneath which banks know they will not fall, and could be less of a gamble than proposals to create a "bad bank" into which lenders simply dump unwanted debt.
Ministers are also considering investing £10bn in the state-owned Northern Rock, turning it into a "good bank" lending freely to plug current gaps in mortgages and commercial lending. Since it was nationalised, Northern Rock has wound down its lending, but MPs want the government to exploit its holding.
The prime minister yesterday hinted at the plans, which will require lengthy negotiations but could be sketched out as soon as tomorrow, when he demanded banks disclose the true scale of losses they are harbouring. He told the Financial Times that "where we have got clearly bad assets, I expect them to be dealt with".
Under the scheme, banks would reveal their toxic assets - mostly a legacy of the American sub-prime lending scandal, in which mortgages which could never be repaid were bundled up into complex debt instruments and sold around the world - to a new state-backed insurer. For a fee, the insurer would guarantee them against further losses below a certain level from their bad investments.
Uncertainty about the impact of an estimated £200bn in toxic loans is blamed for banks' reluctance to lend, which is starving businesses of cash and increasing the risk of job losses.
The news came as it emerged that millions of homeowners could be excluded from government plans for mortgage "holidays" to prevent repossessions among people made redundant in the recession. The Council of Mortgage Lenders has warned the offer may be restricted to low-risk borrowers with over 20-25% equity in their home unless the Treasury puts more public money behind the scheme.
That could exclude up to two million people forecast to be in negative equity by 2010, plus others hit by plummeting house prices - a far cry from last November's proposals to let struggling homeowners defer all but a nominal mortgage interest payment for two years, with the government underwriting payments.
The priority now is tackling banks' toxic debts, after last week's rout in bank shares which wiped £27bn off the value of Barclays in one hour's trading. Brown, his close colleague Shriti Vadera, chancellor Alistair Darling, and business secretary Peter Mandelson spent the weekend in frantic negotiations.
The government may seek a bigger stake in the Royal Bank of Scotland and Lloyds TSB-HBOS, as well as actively using Northern Rock. "They haven't dotted the i's and crossed the t's, but the idea of Northern Rock becoming the 'good bank' is a very strong possibility," said one industry insider.
Downing Street sources confirmed the insurance plan was a leading option, but difficulties remain over calculating the value of toxic assets, and over how it interacts with international banking systems. Brown said that he was discussing an "international solution to the crisis" with other leaders: "We will do everything we can so that families can feel secure about their savings, so that mortgages can continue to be provided."
It is at this point downright criminal for banks to hoard capital for it simply defeats the purpose of the TARP. Again from the New York Times:
Individually, banks that received some of the first $350 billion from the Treasury's Troubled Asset Relief Program, or TARP, have offered few public details about how they plan to spend the money, and they are not required to disclose what they do with it. But in conversations behind closed doors with investment analysts, some bankers have been candid about their intentions.
Most of the banks that received the money are far smaller than behemoths like Citigroup or Bank of America. A review of investor presentations and conference calls by executives of some two dozen banks around the country found that few cited lending as a priority. An overwhelming majority saw the bailout program as a no-strings-attached windfall that could be used to pay down debt, acquire other businesses or invest for the future.
Speaking at the FBR Capital Markets conference in New York in December, Walter M. Pressey, president of Boston Private Wealth Management, a healthy bank with a mostly affluent clientele, said there were no immediate plans to do much with the $154 million it received from the Treasury.
"With that capital in hand, not only do we feel comfortable that we can ride out the recession," he said, "but we also feel that we'll be in a position to take advantage of opportunities that present themselves once this recession is sorted out."
The bankers' comments, while representing only a random sampling of the more than 200 financial institutions that have received TARP money so far, underscore a growing gulf between public expectations for how the $700 billion should be used and the decisions being made by many of the institutions that have taken part. The program does not dictate what banks should do with the money.
The loose requirements in the original plan have contributed to confusion over what the Treasury intended when it abruptly shelved its first proposal -- to buy up bad mortgages -- in favor of making direct investments in individual banks in return for preferred shares of stock.
The Treasury secretary, Henry M. Paulson Jr., said in October that banks should "deploy, not hoard" the money to build confidence and increase lending. He added: "We expect all participating banks to continue to strengthen their efforts to help struggling homeowners who can afford their homes avoid foreclosure."
Bank executives may yet realize that the system is at stake. Perhaps it is to much to expect that they won't let their own greed get in the way of the national interest. Former Federal Reserve Alan Greenspan was dismayed and shocked that the banking sector didn't act in the interests of its shareholders. When might he say something about how the deregulated banking sector has sunk economies from Iceland to Latvia to Hungary to Britain to the US? The national interest seems a foreign concept to many in the banking sector.