More Evidence of a Balance Sheet Recession

"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.

Tags: Balance Sheet Recession, Gordon Brown, TARP, US Credit Market (all tags)



Re: More Evidence of a Balance Sheet Recession

"Bank executives may yet realize that the system is at stake. "

This assumption is the chief problem with the U.S. version of capitalism as practiced in the last 30 years.  We can certainly hope for best, but it is unlikely.

There is nothing systemic about our capitalism at all. Our system ensures individual short-term rationalism from quarter to quarter. It does not promote long-term systemic rationalism in within organizations, much less outside of them.

by bruh3 2009-01-17 10:00PM | 0 recs
Re: More Evidence of a Balance Sheet Recession

There's a piece of this that people really seem to miss - the alternative to banks "hoarding" money (I'd call it "straightening out their balance sheets," but never mind) is banks, well, lending. Car loans, mortgages, credit card debt.. or in other words, the stuff that got us into this mess to begin with.

I don't think people entirely get that the era of free, easy credit is over. OVER. Finished. Gone with the wind.  Banks aren't lenidng because mostly there's no one to lend to. Individuals? Who needs a mortgage? Or a car loan? And who should get one?  Businesses? Lending to a flailing business in the teeth of a recession? Does that really make sense?

I think this post is at cross purposes: if we have a "balance sheet recession" then lending, again, won't solve it; what needs to happen is to figure out how to get bad, toxic debt off of those balance sheets and that will take time. And in this, we are complicated by the fact that fixing the mortgage mess means either refinancing bad loans - which in many cases were for overvalued homes that should have their principles lowered - or actually lowering the principles... which cascades into surrounding homes and neighborhoods and undermines the whole system.

TARP isn't the problem - it's much more fundamental, and I think much harder for people to face up to - we can't have the easy banking and cheap lending we used to have... now what? 09/01/carp.html

by nycweboy1 2009-01-18 05:01AM | 0 recs
Mark to Market vs Value to Maturity

A CDS (Consolidated Debt Security) with an estimated value at maturity of $10 billion can be sold in the current market for perhaps $1 billion on a good day.  Why is that?

It turned out that many institutions based their Value to Maturity on erroneous estimates.  They began to learn that those values at maturity were 9%-20% too high.  This amounts to hundreds of millions of dollars in each CDS.  Because these instruments are so huge, and no rubric exists to revalue them, nobody knows which ones have what value.  In March and April of 2007 the markets for CDSs ground to a virtual halt due to this lack of information.

Enter Mark-to-Market in November 2007.  The SEC implemented this rule stating that all institutions are required to revalue their holdings based on their current market values.  CDSs turned out to have somewhere in the range of 10-20 percent less Value to Maturity, but under Mark to Market, they lost 80% of their value.  The assets themselves are not toxic.  The income expectations for those holding them have not dropped.

It is 100% a balance sheet recession.  Virtually all the "losses" we see are because we, as a society, decided it would be best to require that tens of trillions of dollars in assets be written down on the order of 80 to 90 percent.

I congratulate Bank of America and JP Morgan Chase.  They have been buying up all these "toxic assets" for dirt cheap.  They will take hundreds of billions of dollars in income out of them for the next 30 years.  At the same time, for doing what is smart business anyway, they are getting billions in bailout funds and five times as much in tax breaks for doing it.

There's a sucker born every minute.  We're the suckers.

by SuperCameron 2009-01-18 07:28AM | 0 recs
Re: Mark to Market vs Value to Maturity

Cameron - There's just no way to say that the bonds have value when the assets underlying them (the mortgages) don't. If B of A or JP Morgan was making the vast amounts of money on CDS that you suggest, there wouldn't be the crisis hat we have now. There's no market for the bonds, because their value is unclear, and the debt securing them is going bad.

In any case, the lesson here is that banks will not be able to sell mortgage backed securities in the way they had been, which changes the way we finance mortgages (and, hopefully, reduces the markets overall dependence on vehicles like Fannie and Freddie to prop up the mortgage market). That in turn changes the economics of buying and selling houses. And that's the crisis we really haven't solved - how to unwind all the bad mortgages, and overvalued properties secured with them, and return to a calmer market for buying and selling homes. Until we get that figured out, I'm convinced we can't really fix the overall economy.

by nycweboy1 2009-01-18 10:58AM | 0 recs
Re: Mark to Market vs Value to Maturity

93% of subprime mortgages are performing, i.e. they are being paid on time.  Therefore the securities they back can be expected to decline in value by....90%???

Of course not.

The problem is that they are worth much more to a holder than they are to a potential buyer.  There is no way for the buyer to guess whether the CDS is worth it's value to maturity or less.  Therefore, the buyer is forced to offer the lowest bid.  The holder would never accept such a price.  Therefore there is no market.  The mark-to-market value plummets.

JP Morgan-Chase bought Bear Stearns.  B of A bought Merrill Lynch.  In so doing, both banks acquired hundreds of billions of dollars worth of CDSs.  Both expect to take all the payments--93% of which are still performing--as income over the next three decades.  On top of that, the US government is letting them off the hook on their reserve requirements, AND handing them several billion dollars in cash.  Essentially, they have bought trillions of dollars in future income at no cost to themselves.

Have they generated positive revenue yet?  Of course not.  Give it three years.  After that, it's all cake.

As for going into the future, many real estate markets have plummetted.  I have purchased two homes in the last six months--60% off their build price, and not in bad shape either.  A nice correction.  I'm not profiting from them--yet.  Give me three years.  After that, it's all cake.

As to a national housing policy, you and I probably agree on much.  Our current policy has been to promote unsustainable building practices and unaffordable homes.  Here's to a drastic change in '09!


by SuperCameron 2009-01-18 05:50PM | 0 recs
Re: Mark to Market vs Value to Maturity

Cake in three years... well, get me some of that; we shall see, but I suspect both for the banks, and for speculative home buyers... that may be optimistic. That large numbers of mortgages are still, just now, performing... doesn't tell us that they will continue to, over time. Part of the reason the bonds have been hard to value is the deterioration of loans over time is not what was expected. Over time, that's not likely to improve (especially over a time like the next year, when job losses and business reversals will make hash of even the most well meaning mortgage holder's finances). And again, if B of A was so happy about the paper it got from Merrill... it's a funny way to show it by announcing near bankruptcy level losses.

Look, I'm happy to believe that this is all a dark plan to benefit the secret cabal of wealthy capitalists whose secret knowledge of the CDS paper will carry them through... that all the tales of battered credit markets and massive financial sector problems are just noise meant to hide the truth... but it seems a bit, well, tinfoil hattish on one end, and a bit of denial on the other. I still think what we have is a lot worse than most people realize and every bit as bad as what's been forecast... that things will get much darker before they brighten... and three years from now won't be cake. For much of anyone. Just my hunch. I'd be happy to be proven wrong... but so far, you're not convincing me.

by nycweboy1 2009-01-18 06:38PM | 0 recs
Re: Mark to Market vs Value to Maturity

You're putting words into my mouth.

B of A's loss this last quarter was 1.39 billion.  B of A has hundreds of billions in assets.  The ultimate purchase price they paid for Merrill was 19 billion.  The treasury department gave B of A 25 billion already to begin to make this deal.  They will be giving B of A another 25 billion for carrying it out.  In addition all these write-downs required by mark-to-market will give B of A all the tax write off's they could want for the next ten years.

There's nothing secretive, conspiratorial, or tin-foil hattish about it.  The effects of mark to market on our financial system were predicted 12 months out.  Just do a google search on the subject.

My three year prediction is based on my belief that the Federal, State, County, and Municipal governments in this country will pursue the same housing policy they've run for the last 75 years--to inflate home values whenever and wherever they can.  They just don't know any other way.  I have seen no indication from the Congress, the incoming administration, or the Fed to indicate a change in that policy.  I believe home values will inflate by at least 30% by the end of 2012.

If not, that's good, too.  Lower housing prices are good for 75% of all Americans.  Additionally, state and county governments will have to make hard decisions about where to spend their dwindling funds.  Will it be schools or prisons?  I won't miss the War on Drugs even a little bit.

So either way, we win.

by SuperCameron 2009-01-19 07:00AM | 0 recs
Re: Mark to Market vs Value to Maturity

Can someone please explain why these securities cannot be valued?  I get that each security has about 1,000 mortgages in it but mortgage administrators know how to get the payments to the bond holders.  

Considering the mess being unable to value these securities is causing, wouldn't it be worth everyone's while to actually hire some people to assess and value them?  I get this is not a small task but in an age of computerization it is not impossible either.  If you compelled the mortgage administrators to provide a compellation of performing and non-perfomring mortgages and the securities to which they belonged and placed into a series of databases we could probably get a handle on this in a few months.  I just don't get why this hasn't been done other than some belief that the market will "reasonably" determine the price.

by jmnyc 2009-01-18 06:38PM | 0 recs
I left a comment on your older blog by mistake

But, could you provide some links on the topic. I googled balance sheet recession, and came up blank except for the Japan example and blog posts by you.

Any links that you found informative would be highly appreciated.

by Ravi Verma 2009-01-18 08:56AM | 0 recs
Re: I left a comment on your older blog by mistake

David Schulman of UCLA has an article out in the UCLA Anderson Forecast released last month. A link to the Forecast is in the post from December. Dr. Richard Koo wrote the definitive book on the topic. It's titled "Balance Sheet Recession: Japan's Struggle with Uncharted Economics and Its Global Implications".

Here's a review from Japan Review.

The other point that might be made is that 'balance sheet recessions' being rare are not easily understood. We are in uncharted waters so to speak.

The other model that might be relevant is the Swedish banking crisis of 1990-1994. But even there, this crisis is deeper and wider. Off the top of my head, I'd say Swedish GDP fell by 10% to 13% somewhere in that range. The cause was an asset bubble in the housing market that then affected the banking sector. Norway also had a banking crisis in that period, albeit much smaller, somewhere around 3% of GDP. This crisis just feels different. Though it's clear that the crisis began in the US residential market, it has spread far beyond affecting asset prices worldwide. Look at energy prices, look at raw materials. Off the top of my head, the only commodity that I can think of that is rising in prices is cocoa and that's largely due to supply problems in the Cote d'Ivoire.

by Charles Lemos 2009-01-18 12:40PM | 0 recs


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