Jim Welsh Investment letter – February 2009
Jim Welsh of Welsh Money Management has been publishing his monthly investment letter, “The Financial Commentator”, since 1985. His analysis focuses on Federal Reserve monetary policy, and how policy affects the economy and the financial markets.
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Investment letter – February 17, 2009
ECONOMY
On Friday, February 13, Congress passed the $787 billion stimulus plan. I’ll bet every member in Congress stayed up until the wee hours of Friday morning reading every one of the 1,434 pages needed to express the vision of the 110th Congress. About 40% of the total will be discretionary spending on education and job training, highway and bridge construction, modernization of the electricity grid, health and science research, housing programs and extending food stamp benefits. About 24% of the total will be spent in direct aid to states to supplement Medicaid costs, extend unemployment benefits, and expand health care programs for the needy. And almost 30% of the total goes for tax breaks for individuals and families, a temporary alternative minimum tax patch, state tax credit bonds to finance public education facilities, renewable energy incentives, and a $3 billion tax break for General Motors.
This legislation has ignited a contentious debate on whether it is too big or not big enough, or whether it contains too little or too much in tax cuts, at the expense of those who have lost their job or home in this crisis. Even more remarkable, not a single defender or detractor noted the inauspicious date it was passed – Friday the 13th! Yikes! Those who have consistently underestimated the magnitude and scope of the credit crisis, and its impact on the economy, seem impressed and hopeful about the plan’s effectiveness. They believe it is the right medicine to not only arrest the deep economic contraction and serious wave of deflation we’re experiencing, but also believe it will have enough muscle to launch a sustainable recovery. This is stimulus on steroids.
My concern is that this plan is being cheered by those who still don’t appreciate the structural nature of the problems we’re facing. It’s like a doctor who prescribes aspirin for a patient with a fever. Hours later, the fever is down, but the patient is admitted to the hospital with acute appendicitis. The doctor treated the symptom successfully, but not the cause of the fever. The Federal Reserve initially misdiagnosed the problem, thinking it was just a sub-prime mortgage problem that would run its course by the end of 2007. The collapse of Bear Stearns in March 2008 was certainly a wake up call. But over the next few months, two Fed members were more worried about inflation and voted against additional easing. It really wasn’t until the demise of Fannie Mae, Freddie Mac, AIG, Merrill Lynch, Washington Mutual, Wachovia, and of course Lehman Brothers that the Federal Reserve and Treasury Department realized how far behind the curve they were. Unfortunately, they are still behind the curve, and now the patient has more than just a fever. In fact, an emergency room doctor might describe it as multiple organ failure. Large segments of the U.S. banking system are effectively insolvent. The securitization markets remain inoperable. The consumer is still in shock, and the global economy has pneumonia. The triage needed to save and revive the patient goes well beyond the scope of the stimulus plan. Remarkably, the majority of economists and investment professionals still believe all that’s needed is aspirin.
In my September 2007 letter I used the metaphor of a tsunami to describe the convulsion that swept through the credit markets in August 2007. Seismologists usually know within hours whether a 100 foot tsunami traveling 500 miles per hour, or a 2 foot wading wave was created by an underwater earth quake. I noted then we wouldn’t know for a number of months the full economic impact, but the displacement in the financial markets left no doubt that a significant seismic event had occurred. The majority of economists and investment professionals saw it as nothing more than a speed bump. There is the perception that a tsunami is a single giant wave of water that sweeps away everything in its path once it reaches land. As financial market participants have painfully learned since August 2007, a tsunami is actually a series of giant waves, each one causing more destruction. After the first wave hits, survivors feel a sense of relief, as the sea water retreats. But that respite is brief, as the second, third and fourth tsunami waves crash on shore. They seem to arrive without warning.
After the first wave in August 2007, the second wave took Bear Stearns down in March 2008. The third and fourth waves hit in July and September 2008 and brought the financial system to its knees. The fifth wave has pushed every developed economy into recession, creating the deepest synchronized global economic contraction since the 1930’s. Although not yet visible, there is a sixth wave coming, as the global recession creates more losses for banks, prolonging this period of weakness and increasing the risk of a much deeper contraction.
Two weeks ago, the Commerce Department reported that fourth quarter GDP fell at an annual rate of 3.8%, which was the largest drop since 1982. Though bad, that figure grossly understates the degree of actual weakness. Since sales were weaker than production, inventories grew. If sales and production had been in balance, GDP would have been lowered by 1.32%. Instead, the unwanted inventories will cause companies to reduce production in the first quarter. The GDP report measures domestic output, so the Commerce Department subtracts imports to determine domestic production. In the fourth quarter, imports plunged and boosted GDP by 2.93%. The collapse in domestic demand for imports is hardly a sign of economic strength. Without the misleading additions from inventories and imports, GDP would have been down 8.0% in the fourth quarter.
In last month’s letter, I discussed how the slowdown would create excess capacity, forcing companies to reduce investments in new plants, equipment and software. In the fourth quarter, business investment dropped at a 28% annual rate. This is significant since business investment is a key driver of growth, representing up to 15% of GDP, and a big contributor to gains in productivity. The decline in sales volume and increase in excess capacity is forcing companies to aggressively cut costs. In the last five months, almost 2.5 million jobs have been eliminated and the average work week is at a record low of 33.3 hours. Personal income fell .2% in December for the third consecutive month. Personal spending has declined for five consecutive months, after plunging 1% in December.
In the last twelve months, the unemployment rate has soared from 4.9% to 7.6%, and could exceed 9% by the end of 2009. The surge in unemployment will result in higher default rates on every type of consumer credit and lead to more losses for banks. A 1% increase in unemployment leads to a 1% increase in the credit card charge-off rate. The huge jump in unemployment over the last year, and especially the past five months, means banks are facing a big increase in credit card losses. As the unemployment climbs further, more prime borrowers, who tend to have larger loan balances, will be affected. This suggests bank losses could accelerate, as the unemployment rate rises in coming months.
From 2002 to 2006, banks originated an average of $557 billion a year in jumbo mortgage loans, according to Inside Mortgage Finance, and a total of $750 billion of option adjustable-rate mortgages. As of December, the percent of jumbo loans that are at least 90 days delinquent has surged to 6.9% from 2.6% in December 2007. Moody’s Investor’s Service has downgraded 75% of all prime jumbo loans originated in 2006 and 2007 that previously carried the top rating of triple-A. According to LPS Applied Analytics, 28% of option ARM mortgages are delinquent or in foreclosure. More than 55% of borrowers with option ARMs owe more than the value of their home, which means these borrowers have no option to refinance.
A year ago, I noted that it was not a good sign for the banking system or the economy that the Federal Deposit Insurance Corp. was hiring. Although FDIC bank examiners have increased the frequency of examinations for at-risk banks, many are falling into trouble faster than in previous downturns. Of the 25 banks that failed in 2008, 9 collapsed before regulators could respond, including Washington Mutual and IndyMac, two of the largest failures in history.
In recent weeks, the International Monetary Fund increased its estimate of total global banking losses from $1.4 trillion to $2.2 trillion. The IMF said the world’s advanced economies – the U.S., European Union countries, Britain, and Japan – are “already in depression.” The IMF estimates that United States banks have a capital shortage of $500 billion, and that’s if things aren’t worse than expected. Keep in mind that future lending will be reduced $10 for every $1 of capital shortage. A reduction of $5 trillion or more in future lending will dampen economic growth for at least two years.
Prior to August 2007, more credit was created by the securitization markets than through bank lending. Unfortunately, the securitization markets are in worse shape than the banking system, with the volume of securitization down 70% over the last year. In November, the Federal Reserve announced a plan to resuscitate the securitization of auto loans, student loans, and credit card debt. Almost 3 months have passed since the Fed announced its plan, but nothing has been done. Obviously, the complexity and size of the task has proven more daunting than expected. It took years for the securitization markets to develop, and central to that growth was the trust buyers of securitized debt placed in the rating agencies. That trust was destroyed, when investors were told their ‘AAA’ holdings were really junk, virtually overnight.
The collapse of the banking system and almost complete breakdown of the securitization markets represent a structural fissure in the credit creation process. What many economists and investment professionals have failed to understand is that there is no easy or quick fix. By their nature, structural problems take years to repair, not just a few quarters. Unfortunately these are not the only structural problems challenging policy makers.
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