Why Deleveraging Is Necessary For Economic Recovery

From The Daily Capitalist

A Plan For Recovery

While bank closures and high foreclosure and mortgage default rates are universally seen as negative impacts on the economy, it is closures and foreclosures that we need for a recovery. The bearers of such news are usually ignored as doom-sayers, bears, or Cassandras: no one wants to hear bad news. A fear of "bad news" is what has been driving the government's recovery policies and that is why this recession is not over. In fact those same policies may be leading us to a renewed period of decline.

It is of course unfortunate and sad to see banks close and people lose their homes. But when put in the context of the boom years when personal, corporate, bank, and government debt went off the charts, deleveraging has the effect of creating the conditions needed for a recovery.

We have not recovered. We see people still saddled by high personal debt. We see most banks weighed down by bad loans from commercial real estate, residential development, and consumer loans. We see deflation continue to drive residential real estate and commercial real estate down, further magnifying the the impact. As a consequence, credit is still largely frozen for most individual and business borrowers, money supply continues to shrink, the economy appears to be headed to stagnation, and unemployment remains disturbingly high.

While very large corporations and perhaps the ten largest money center banks have access to credit, it hasn't helped most Americans or the majority of businesses. In fact, last quarter's profits for those large financial institutions were at impossible record levels based on the lucrative carry trade/arbitrage opportunity provided them by the Fed.

The answer to this conundrum is to withdraw government programs that support lenders and borrowers who are essentially bankrupt. It would be nice to see individual borrowers pay off their loans, but since most of the debt created in the boom phase originated from home equity, the continuing decline of home prices makes that a moot point.

Likewise, while it would be nice to see banks raise more capital, sell off bad loans and assets, and clear their balance sheets, they have been reluctant to do that, waiting as it were for more government bailouts. However, the amount of problem loans related to commercial real estate  and residential real estate development is huge and much of what they lent on is fundamentally unsound because of overbuilding.

In an attempt to keep this debt rolling forward in the hope that the next cycle or inflation would bail lenders and borrowers out, policies such as TARP, HAMP, HARP, HAFA, extend and pretend, delay and pray, mark-to-make-believe, bailouts of Fannie and Freddie, lowered lending requirements, massive Fed purchases of mortgage backed securities known as "toxic assets," and many others have tried to keep the debt barge afloat. It hasn't worked.

If it had worked, as the Fed and the government believes it should have, then we would see credit expanding, money supply growing, asset prices rising, consumer consumption increasing, and jobs going up and unemployment going down.

Presently the FDIC has 775 banks listed as "problem institutions." Bank closings are at 73 this year, and at 238 since 2008. Lending declined for the seventh straight month (accounting changes created an anomaly that falsely indicated an increase last month).

The combined percentage of residential loans in foreclosure or at least one payment past due was 14.01% last quarter. Morgan Stanley just reported that this "shadow inventory" could be as high as 8 million homes and take 47 months to liquidate, assuming current rates experienced by REO departments. Morgan Stanley's is the highest estimate I have seen. Others are 3.5 million. 4.7 million. and 5.5 million. Whichever number you pick, it still high.

CRE debt is getting critical for most banks. This is the main reason credit is frozen, excess reserves are high, and money supply is shrinking. Between 2010 and 2014, about $1.4 trillion in commercial real estate loans are expected to reach the end of their terms. CRE asset values are still falling.

Studies by McKinsey Global Institute and research by Romer and Reinhardt show that history is not kind in cycles with resulting high debt: on the average it can take six to seven years to deleverage, and can take as much as 25% off the top of GDP. It is painful and unavoidable, but understandable. This cycle is the biggest cycle in history and debt reached historic proportions, worldwide. Understand that mortgage backed securities, both residential and commercial, were distributed worldwide to banks, pension funds, insurance companies, hedge funds, and endowment funds.

How we could we fix this problem:

1. Require banks to mark-to-market the assets securing their loans, and raise more capital or go out of business.

2. Remove federally funded or guaranteed residential mortgage lending. This would include Fannie Mae, Freddie Mac, and the FHA.

3. End all Fed lending programs created at the beginning of the crisis, such as TARP.

4. End all programs to help home mortgage borrowers, such as HAMP and HAFA.

5. Require the Fed to auction its portfolio of mortgage backed securities.

6. Establish a program similar to the Resolution Trust Corporation (RTC) to quickly dispose of the assets of failed banks.

7. End tax policies that require borrowers to incur phantom income as a result of real estate debt relief.

8. End taxes on interest and dividend income to encourage savings.

9. Immediately raise the Fed Funds rate.

Many of these solutions seem counter-intuitive, but one must question the path our government has taken to stimulate a recovery. We need to look at this crisis in an entirely different way: the boom was the real problem and the bust is the cure. The harm was done in the boom phase as a Fed induced credit expansion and various government programs misdirected capital to businesses that, but for this government action, would not have been otherwise profitable. In economic terms this is called "malinvestment."

As in all booms, reality, usually in the form of a tightening of money supply by the Fed, brings asset value back to the ground, and even under the ground as we find these malinvestments unprofitable. That is what we are seeing now. The bust phase is a process of redirecting capital from these failed investments back into more profitable ventures. It is obvious that large amounts of capital will be lost. But by liquidating these bad assets, banks eventually go back to normal, credit loosens, people save more money because of financial uncertainty and to reduce their debt, thus creating the new capital needed for a true economic expansion.

If this liquidation phase is thwarted, as we have seen, we get stagnation and zombie banks. This is what Japan has experienced for the past 20 years.

Take the bitter pill, endure the inevitable pain, and we will recover quicker.

Comments

[Anton LaVey]

An interesting article, Econophile, but one that glosses over an important point: deleveraging is going to create Deflation, the destruction of money. And Deflation is a death spiral, one that

Let's take a quick example, you propose:

5. Require the Fed to auction its portfolio of mortgage backed securities.

And that is fine and good, except for these nagging questions: (a) what makes you think you will find a sucker to buy that kind of junk? and (b) what makes you think these buyers will be ready to buy that junk for more than a penny to the dollar (at best)?

In other words, applying this idea of yours would result in massive deleveraging, true, but also in a massive deflation. And deflation itself is a vicious circle: if money disappears into a black hole, people have a tendency to hoard it, and not spend it. And it is this "hoarding rather than spending" mentality that feeds upon itself and prevents an exit from the crisis.

This being said, I agree with your conclusion: deleveraging will happen, and it will probably set us on the path to recovery. But I happen to believe that this deleveraging will take the form of massive default (including sovereign default), either through debt restructuring or through inflation.

[Econophile]

Anton,

We are already in a deflation. Most of the debt is related to real estate and you know what's happening there. Perhaps I was not clear enough in defining what I meant by "deleveraging." Deleveraging as it is with reference to the current crisis means not just paying off debt, but wiping it out which means these assets aren't worth the value of the debt they secure.

Spending won't get us out of this crisis. This is the Keynesian "demand gap" solution that doesn't work. They tried to stoke spending in Japan and it didn't work there. Saving isn't hoarding: it's saving. Saving has an economic purpose. Saving is a proper response by citizens to financial uncertainty. It sends a message throughout the economy that they don't want to spend and manufacturers should heed the message.

If you want recovery, adding more debt to an already bankrupt economy won't help.

Thanks for the comment.

[Sudden Debt]

"Require the Fed to auction its portfolio of mortgage backed securities."

ehe... did you see how the morgage companies are performing? 1 word about it, and they all go belly up making things worse.

I'm pretty fond of these blue pills. Can't get enoug of them.

[Joe Shmoe]

Super interesting article.  It is counterintuitive though.  It assumes that citizens would be willing to undergo severe economic hardship while things reset (and that they'd remember why they were undergoing such hardship).  On the other hand, ultimately, what other choice do we have than to eventually face the music.

Your quote that " the boom was the real problem and the bust is the cure" is a great one.  Nice work.

[anony]

How can Capital EVER be lost?  Is it burned in some cosmic furnace?

Capital is peripatetic. It moves. A lot. But lost?   What self-respecting economist would ever say that?

Bank loans a trillion dollars to build some space station that blows up in a solar flare.   Is the capital lost in space? The materials, men, and machinery may be lost, but the capital that built it, is still somewhere on earth. In someone's pockets.

[Econophile]

Capital is not like the Law of Thermodynamics. If you bought stock at 50 and it's now worth 10, you are poorer. Because someone else has your 50 doesn't mean you haven't lost something.

[mikla]

+1 !!!!

So sick, so sad, so perversely true.

This is why economists are morons, mercifully spared the ravages of intelligence, logic, and reality.

[Tic tock]

Just a handful of these policies would be sufficient to return a market economy. Yet the question of whether the TBTF and the US system is a market economy is not itself clear. New York is global financial hub and the US economy is the engine for global growth. Hence, for several years, US economic policy has been about living off wealth generated abroad and repatriated as wealth through New York -much like the city's fraction of UK GDP. With the world in recession, there is little evidence to show buying pressure on financial instruments- outside of newly created central bank issuance. So, an auction of FED-held collateral would net little use.

Raising the discount rate would be a poor sister to reforming the banking system to fit-for-purpose: this is the other hand of current US economic policy:..profits-for-banks-so-the-world-will-not-end -- if we were going forward, instead of back 1800 yrs, a low discount rate would be useful. The FEd and the banks are currently two sies of the same coin, removing liquidity measures would invalidate both of them, is that what you want? 

Housing assistance, is not perfect, but it stops some of the bleeding. A generation of financially illiterate were suckered- real estate is always a trivial expense- if you don't invest in real estate on those terms, you aren't doing it right- trust me on that. Taking away support from that would be extremely counter-productive. 

[BlackBeard]

Dylan Ratigan hosting the YoungTurks tonight.  Nice to see him get more exposure.  Keep beating the truth drum Dylan:

http://www.youtube.com/watch?v=0ECYmqIODxM&playnext_from=TL&videos=byfyDsGe2f0&feature=sub

Glenn Beck followers feel free to chime in.  Inclusiveness is required to solve the problems we face today.

[anony]

Thanks for just wasting 6 minutes of my life listening to utter nonsense.

[Matto]

Great oversight piece.

My little opinions

- What happened in Japan is not possible this time round, even though the west would probably prefer it over the alternative. The japanese managed to prolong the inevitable due to their high domestic savings and external global growth supporting their exports. This time we're all slowing, aging and drowning in unison.

- Whether the powers that be like it or not, the western world is just on the cusp of loosing the babyboomers from the productivity pool. The movement of the baby boomers from high productivity/high spending in the 90's to high productivity low spending (and attempted high asset accumulation) in the 00's fed the economic boom times and the financial engineering boom times of both decades respectively. Right now baby boomers are set to: stop adding productively to western economies, limit their spending patterns as they enter retirement and re-rationalise and access their retirement assets (crimping the asset base the financials have been feeding off for the last decade).  

These factors will work to delverage western economies and the financial systems, who operate within a model contingent upon (and leveraged upon) uninterupted expansion, whether the fed/gov like it or not. The only question is when will these forces reassert themselves over the extend and pretend practices and how cataclysmic will be the results by then?

[bob resurrected]

Could we be seeing the unpoken fed policy of a controlled deflation to avoid a cataclysmic deflation? An ABS controlled stop rather than a crash?

[Econophile]

How could they do that?

[bob resurrected]

I don't know that they can. But if the Fed provides just enough liquidity to not reflate, but slow the deflation... Couldn't it allow forelosures, bankruptcies and liquidations to proceed orderly until we reach a bottom over time instead of a full on collapse tomorrow?

[Lighty]

Good points, you stole my comment!

With no savings, big account deficit, at best stagnant global economy (on average) and bad demographics, the US can cannot be kicked down the road for too long.

[mikla]

[mikla]

+1, good article, good comment, good follow-up.

These are very basic "moving parts".  Feel free to cry out against the night if you want, but the future is assured.