My past three Observations have been devoted to counterbalancing the financial Pollyanna folly that the worst is behind us; this will be the fourth. Foolish commentary abounds in the financial media that continues to fail to see the bigger picture as they are ever catching the proverbial falling knife in their bottom calling, such as the commentary below from a favorite on Larry Kudlow’s show on CNBC (emphasis added).
It is hard to imagine any time in history when such rampant pessimism about the economy has existed with so little evidence of serious trouble…
Because all debt rests on a foundation of real economic activity, and the real economy is still resilient, the current red alert about a crashing house of cards looks like another false alarm. Warren Buffett, Wilbur Ross and Bank of America are buying, and there is still $1.1 trillion in corporate cash on the books. The bench of potential buyers on the sidelines is deep and strong. Dow 15,000 looks much more likely than Dow 10,000. Keep the faith and stay invested. It's a wonderful buying opportunity.
Brian Wesbury, Chief Economist for First Trust Portfolios, L.P.
Wall Street Journal, 01/28/2008
However, there are voices that grasped the true magnitude of the situation and were laughed at and scoffed at their dire predictions. One of those voices is Nouriel Roubini, an economics professor at NYU. His recent comments are provided below (emphasis added).
But at that time (1990-1991) the housing bust and the ensuing decline in home prices was much smaller than today: during that recession home prices – as measured by the Case-Shiller/S&P index – fell less than 5% from their peak. This time around instead such an index has already fallen 18% from its peak and it will most likely fall by a cumulative 30% before it bottoms sometime in 2010. If a 5% fall in home prices was enough to make Citti effectively insolvent in 1991 what will a 30% fall in home prices – and massive defaults on many other forms of credit (commercial real estate loans, credit cards, auto loans, student loans, home equity loans, leveraged loans, muni bonds, industrial and commercial loans, corporate bonds, CDS) - do to these financial institutions? It challenges the credulity of even spin masters to argue that financial firms are not in worse shape today than they were in 1990-91 when a significant number of major banks were technically insolvent. So, not only hundreds of small banks and a significant fraction of regional banks but also some major money center banks will become effectively insolvent during this crisis…
Also the FDIC has done a mediocre job at identifying which banks are at risk. So far there are only about 90 banks on its watch list; and IndyMac was not put on that list until last month! So if the FDIC did not even identify IndyMac as in trouble until it was too late, how many other IndyMacs are out there that that the FDIC has not identified yet?
Nouriel Roubini's Global EconoMonitor, Jul 20, 2008
Along with Mr. Roubini is Barry Ritholtz at The Big Picture blog, who helps balance the views of the guests on Larry Kudlow’s show. Mr. Ritholtz has done an excellent job in chronicling the ridiculous bottom calls by the financial media and pointed out the most recent one by Barron’s last Saturday (It’s Unanimous: Banks Have Bottomed!). An excerpt from Barron’s cover article over the weekend is provided below (emphasis added).
What to Bank On
Barron’s Cover Story, 07/19/2008
After a record-setting rally last Wednesday, the brutal selloff in financial stocks — the worst for any major industry group since the technology bubble burst in 2000 — could be over…
"This is a once-in-a-generation opportunity in the financials," says Mark Boyar, head of the New York investment firm bearing his name. Boyar is partial to such stocks as JPMorgan Chase (JPM), Lehman Brothers (LEH), Travelers (TRV) and Bank of New York Mellon (BK). The last time financial stocks were hit so badly was in 1990, when the group fell 24%. That was followed by a 43% gain in 1991 (re read Mr. Roubini’s comments above on the comparison of financials to 1990-1991 episode).
Mr. Ritholtz also pointed out in his blog that this is Barron’s second attempt in calling for a bottom in the banks this year.
Have the Banks Finally HIT BOTTOM
Barron’s Cover Story, 03/24/2008
The financial sector's strongest players probably don't have further to sink, even with the ongoing pressure of negative news. Here are several banks and brokerages ready to pop up for air…
At last, we may be there. After months of turmoil capped by a run on a leading Wall Street house, banks and brokerage firms may finally have hit bottom. You can thank the multi-pronged regulatory response to the near-collapse of Bear Stearns. Those measures may well prevent the deeply depressed stocks of many financial outfits from sinking further. The shares may even start to recover, with encouraging implications for the entire market. Yes, after being down on financial stocks for more than a year, we find ourselves unable to resist some real springtime optimism…
One of the main problems with the financial media is selective reporting of information where the ugly details of economic and company data are blatantly ignored while their emphasis is primarily, if not entirely, on the positive details. This is exactly what we saw last Wednesday (07/16/08) with the earnings release by Wells Fargo that propelled the stock northward by 33% at one point and also boosted the financial sector to see one of their biggest daily rallies in more than a decade. The media emphasized two points on the Wells Fargo earnings report, which were an earnings surprise and a 10% dividend increase while ignoring two glaringly negative tidbits.
The financial media reported that Wells beat earnings but they did not say HOW the company beat analyst estimates. Wells Fargo earned $1.8 billion in the last quarter beating analysts polled by Thomson Financial who expected earnings of $1.6 billion. The media conveniently left out that the company changed their policy of writing off home equity loans where payments were more than 180 days late, rather than 120, thus deferring $265 million in charge-offs. Subtracting the $265 million from the company’s earnings would have led to earnings of $1.535 billion, or 4.1% BELOW analyst estimates. Second, the company quadrupled its provision for loan losses, another tidbit that was conveniently left out on many CNBC segments commenting on the company’s earnings.
Make no mistake, things are not improving for either the economy or financial markets as the credit crisis and housing depression move up the food chain as evidenced by American Express’ earnings report this week (emphasis added).
American Express reports 38% drop in net income
Market Watch, 07/21/08
American Express reported a 38% drop in second-quarter earnings Monday and warned that it won't be able to meet long-term financial targets until the economy improves.
The credit card company said that even its most creditworthy, long-standing customers felt the effects of the economic slowdown that's currently sweeping the U.S…
"With bad debt occurring even in the superprime card segment, AmEx's earnings clearly show that the credit crisis is going upscale, which does not bode well for the U.S. economy," Red Gillen, a senior analyst at consulting firm Celent, commented via an email exchange…
The environment has weakened significantly since then, particularly during the month of June," Chenault (CEO) added…
Further signs of economic weakness and a retrenchment by the U.S. consumer came from Mervyn’s who is on the verge of bankruptcy and closing its stores.
Mervyn's Fights to Keep Its Store Doors Open
Mervyn's LLC, the long-struggling California department-store chain, is fighting for survival as some of its vendors have halted shipments to the company and key lenders have pulled financing, according to people familiar with the situation.
In recent days, Mervyn's executives have been trying to persuade vendors to ship merchandise to the retailer for the crucial back-to-school season. If that effort fails, the company could be forced to file for bankruptcy protection as soon as this month and shut down, according to these people. Mervyn's operates 177 stores in seven states, mostly in California.
A Mervyn's spokesman couldn't be reached to comment.
A Mervyn's liquidation would deliver another blow to the nation's mall owners, which are suffering through a torrent of store closings. Linens 'n Things, Goody's Discount Clothing and Sharper Image are just some of the chains that are closing stores or shutting down for good this year.
Problems first surface in the economy and then later in the financial markets, as housing peaked in 2005 though losses in residential mortgage-backed securities (RMBS) did not really start to mount until last year. As consumers began to retrench last year with picking up the pace this year, losses on commercial mortgage-backed securities are just starting to mount and are adding to the strain in the financial markets reeling under RMBS losses. A recent report by Fitch shows an acceleration in retail loan delinquencies. The report points out that overall delinquency rates have only risen slightly, though the concern is over the marked acceleration in delinquency rates that illustrates things are getting worse, not better in the retail sector.
Fitch: U.S. CMBS Delinquencies Rise Slightly on Office & Retail Weakness
Centre Daily Times, 07/21/08
Retail loan delinquencies increased 25.7% month-over-month, due to the addition of 15 newly delinquent loans located across 12 different states. Loans secured by retail properties represent 28.1% of the Fitch rated universe, and 13.2% of the overall loan delinquency index. Isolating the delinquent retail loans and comparing them to all retail loans in the Fitch-rated universe, the sector's delinquency index has ticked up slightly to 0.21%, from 0.17% in May. Despite relatively stable performance to date, Fitch remains concerned about the retail sector.
'High energy and commodity prices, rising unemployment, housing market weakness, and lower credit availability continue to negatively impact retail sales and are expected to dampen retail sector growth going forward', said Merrick. 'Recent store closings, including continued bankruptcy filings of tenants such as specialty retailer Linens 'n Things and discount-apparel retailer Steve & Barry's, will impact retail performance.'
The uptick in delinquencies within the office sector represents a 32% increase over May's total of $222.3 million. However, the sector continues to perform relatively well, with only 0.19% of all office loans in the Fitch rated universe delinquent.
Weakness in the consumer sector first hit housing-related home furnishings but has now spread to consumer electronics and apparel. A listing of chapter 11 filings by retailers as of the end of the first quarter is provided below from a report from Fitch Ratings (The Retail Register report, Spring 2008). The report also shows the deteriorating financial condition in the retail sector that is leading to bankruptcies and store closings as cash positions are falling while debt levels are rising.
Recent Chapter 11 Petitions
Source: Fitch Ratings
Sources of Cash
Source: Fitch Ratings
Economic weakness from the housing depression first showed up in housing-related sectors of the retail industry and then spread to other areas of retail. The same trend is seen on a national level with economic weakness spreading from housing boom-to-bust states like California and Florida to the rest of the nation. The Federal Reserve Bank of Philadelphia's state coincident index is showing a domino effect with more and more states in economic decline. The number of states showing increasing activity is currently at recessionary territory as seen in the figure below.
Only seven out of the 50 states showed increasing economic activity in May of this year, tying the all-time low set in December of 1981 when the U.S. was in a deep recession. How any financial pundit can call for a mid-cycle slowdown or Goldilocks landing is utterly beyond me as the current reading is way below the levels seen in the middle 1980s and middle 1990s economic slowdowns that averted a recession. Readings for the last four recessions and two mid-cycle slowdowns are listed below, with recessionary periods in bold.
Supporting the widespread economic weakness seen in the Philly Fed state coincident index comes from an article in The Wall Street Journal.
A new report is projecting that the cumulative fiscal-year 2009 budget shortfall for U.S. states will more than triple to $40.3 billion as the economic slump makes it more difficult for states to collect revenues.
"Lackluster" revenue collections already took a toll on states' fiscal 2008 budgets, leaving states with a cumulative budget shortfall of almost $13 billion, the National Conference of State Legislatures said in a report released Wednesday…
The report noted that the fiscal year 2008 and fiscal year 2009 budget data stand in stark contrast to fiscal year 2007, "when nearly every state" reported stable financial conditions.
"You can see the picture beginning to worsen now," said NCSL Executive Director William Pound on a conference call with reporters. "We got through '08 fairly well. We have a very mixed picture here in '09."
Mr. Pound said state officials are concerned about the stability of their 2009 budgets and have also already voiced concern about fiscal year 2010.
Further underscoring widespread economic weakness comes from a commentary by Mark Zandi, Chief Economist and co-founder of Moody’s Economy.com. Excerpts from his most recent commentary on the state of the economy and its forward outlook are presented below (emphasis added).
Debt, the Financial Crisis, and Policy
The erosion in household credit is evident across all loan types and in nearly every corner of the country. Mortgage loans are under the most pressure. The rate of delinquency—loans 30 to 120 days past due—on first mortgages is set to surpass delinquencies on unsecured credit cards for the first time in history. First mortgage loan defaults, the first step in the lengthy foreclosure process, are surging. At the end of June, 2.72 million loans were in default at an annualized rate. For all of 2008, defaults could very well hit 3 million, up from approximately 1.5 million in 2007 and 1 million in 2006.
Although mortgage delinquencies and defaults are expected to moderate early in the next decade, they will remain elevated by historical standards. Many subprime and Alt-A mortgage loans that are avoiding large payment resets today because of low interest rates will face much higher payments when rates normalize. Indeed, many alt-A loans that originated at the peak of the housing boom in 2005 and 2006 are "5-25" loans, due to hit their first rate resets in 2010 and 2011 when interest rates are likely to be measurably higher. First mortgage loan defaults are expected to remain near 2.5 million in 2009, falling to 1.6 million in 2010 and 1.1 million in 2011.
NO EXCUSES THIS TIME
As things now stand, a few more major financial failures could quickly overwhelm the government’s ability to cope with them. The FDIC’s resources are limited, and the failure of just a couple large depository institutions could quickly deplete them. This would frighten already-edgy depositors, exacerbating the problem. It is also unclear how the government would deal with the failure of another major broker-dealer or even a monoline insurer. While such possibilities still seem remote, so too did many of the things that have already happened during this crisis. It is understandable that policymakers were surprised by the Bear Stearns collapse, and it is passable that they didn’t see Fannie and Freddie’s problems coming, but it will be difficult to explain why they weren’t prepared for the next major financial shock. The resulting crisis of confidence could further unravel the financial system, resulting in a full-blown, and economically debilitating, credit crunch.
Although many are calling for a second stimulus package and a massive housing bailout, these will not come without consequences. The dollar has been in an utter free fall ever since the Fed started slashing interest rates last summer and further news of government bailouts will concern jittery foreign investors holding U.S. investments who are already shifting away from the dollar as Jim Jubak from MSN Money points out.
Creditworthiness of the Country at Stake
It's their very size (Fannie Mae and Freddie Mac) that has turned the current financial crisis into something affecting much more than the mortgage market or even the U.S. banking sector. What's at stake now is the credit of the United States itself.
Because of Fannie Mae and Freddie Mac, the overseas investors who hold $9 trillion in U.S. government debt and trillions more in U.S. dollars are weeks away from losing faith in the government's creditworthiness.
In the days since the crisis at Fannie and Freddie turned red-hot, the council that advises Saudi Arabia's king has recommended revaluing the Saudi currency, the riyal, which is pegged to the U.S. dollar, by up to 30%. That could be a first step toward switching the riyal from a price pegged to the dollar to one pegged to a basket of world currencies.
A similar advisory body in Abu Dhabi has suggested abandoning that country's dollar peg for its currency. A third oil-rich Middle Eastern country, Kuwait, ended its currency link to the dollar last year.
More ominously, because the threat is more immediate, some of the world's largest sovereign wealth funds, including that of China, are edging away from the U.S. dollar at an increasing speed. China's State Administration of Foreign Exchange, which holds the majority of China's $1.6 trillion in foreign currency reserves (mostly in dollars), has been holding talks with European private-equity companies about investing in their latest round of funds. That would shift dollars into euros.
The huge threat to the US economy, 07/22/2008
The loss of faith in the U.S. government’s creditworthiness is already beginning to be seen as evidenced by the price of 10-year U.S. government debt, which has doubled since in the last two months as commented upon by Michael Panzner below.
Over the past three days, the price of a credit default swap (or CDS, a form of "insurance" on creditworthiness) on 10-year U.S. government debt has risen by 8.3 basis points (one-hundreths of a percentage point), or 61 percent, to 21.8 basis points, and is now almost 80% higher than the median value of this CDS since it was first quoted on April 2.
There is no doubt that talk of a bailout of Fannie Mae and Freddie Mac has spurred what could be a short-lived spike. Still, it makes you wonder if the market is starting to price in what many say is inevitable after years of profligacy and failed policies: a credit downgrade for the United States.
Source: Michael Panzner, Financial Armageddon
The information presented above should clearly put to rest that the worst is not behind us by any stretch of the imagination. So far this year every market bounce has been a bear trap with prices putting in lower lows as the economic and financial carnage plays out. Every market bounce will prove to be an opportunity to increase defensive positions until the economy begins to show some stabilization.
In terms of monitoring an economic recovery, employment will be crucial as employment levels play a major role in consumer spending which accounts for more than 70% of GDP. In terms of leading indicators for overall employment, housing-related employment levels bottom first followed by temporary service help before overall employment levels bottom. Currently, the rate of decline in housing-related employment appears to have bottomed, which is encouraging though temporary service help employment has not. A bottoming in the employment rate of change often marks the end of a recession and with employment still contracting we are not out of the woods, despite media pundits assertions.
To close I’d like to end with some sound advice from Mohamed A. El-Erian, co-CEO and co-CIO of PIMCO from a recent interview (Advisor Perspectives: Our Interview with Mohamed El-Erian).
Unless banks get a new balance sheet (through a sovereign wealth fund, the US government, etc), this is a lengthy and disorderly process.
I don’t believe it will end quickly. A number of steps have to take place. Any attempt to declare an early end to this crisis is premature. It will play out over a long time. Fasten your seat belt and don’t put yourself in a position where you have to be a forced seller.