The current deleveraging in the market is bad. Worse though, is the inevitable household deleveraging yet to come.
In his latest research, George Magnus, senior adviser at UBS, argues that unfortunately all of the above is unavoidable. Policy should, as a result, focus on containment rather than reversal. He explains:
The US economy could be contracting now at close to a 3-4% annualised rate, and if household deleveraging (where the change in the household financial balance moves from a modest deficit back to, say, +4% or 5% of GDP) in the US and some other low savers like the UK were to happen rapidly, the economic contraction would become much larger. It probably won’t — these deleveragings tend to span three to four years — but that is exactly why policy needs to ensure that the process is extended rather than chaotic
While Magnus applauds some of the efforts already taken by international central banks and treasuries, he says more must still be done to assure banks have the capital to cope with the continuing deleveraging spiral. A primary objective for further government rescues should therefore be over-capitalising the banks. The Tarp, in particular, should be used in this way.
Breaking the sums down, Magnus estimates the world can expect full market-to-market losses of both securitised and non-securitised loans of about $3tn. He bases that sum on a loss rate for the US economy of 7 per cent, just over twice the average of post-1945 downturns – in an economy with $48tn worth of debt.
If the loss recovery rate were 50%, and US financial entities have raised about US$500bn of capital so far, the implied capital shortfall is about US$1,000bn.
As a result, the $250bn of capital received by the banks under the Tarp so far can be considered ‘lite’ by about $100-150bn.
The new administration – if not Paulson – must seek to use its remaining $350bn Tarp funds for a second-round capital injection. The current Tier 1 situation certainly points that way. He explains:
UBS banking analysts have estimated that the major US and European banks they cover have risk-weighted assets of about US$19,300bn, Tier 1 capital of US$1.5bn, and an end-2008 Tier 1 ratio of 8%. Assuming that ’10%’ is the new ’8%’ by the end of 2009, the change in capital ratios could come about through US$400bn of new capital, a 20% fall in total assets, but not by a total freeze on dividends, which would only release about US$90bn. In all probability, banks will go down all three routes. So, assuming a partial dividend reduction and a 5% fall in assets, banks could realise 10% Tier 1 ratios by the end of 2009 only by raising about US$210bn of new capital. Though these numbers comprise a different universe from all financial entities, and include both US and European banks, the ‘order of magnitude’ numbers point in the same direction, namely that US banks still need a big slug of capital, and several European banks also.
What’s more, Magnus says it’s not irrational to assume that required Tier 1 ratios will eventually rise beyond the current 10 per cent being demanded by the market.
Back to how all this translates to household deleveraging. Magnus says nothing short of 100 per cent public ownership of the banks would definitively pump credit to where it’s really needed – that being the SME sector. As that is not an ideal outcome, a rise in bankruptcies and failures is simply unavoidable. Simple tax cuts, however, are not the answer:
Cutting taxes in particular may have some economic and much political merit, but will do little, if anything, to spur credit growth — and will certainly not be a substitute in any way for the household balance sheet correction that is underway. It would be far better to supplement such cuts, or utilise such funds, for the purposes of household borrower relief programmes so as to ease or speed up the process of balance sheet repair.
The answer is instead a wide-ranging and timely fiscal stimulus package that features, most importantly, household and mortgage relief programmes. On this front several European packages come up short, says Magnus, although he does have high hopes for Obama.
While some assets will be sold cheaply to new owners, and write-offs will continue, debt restructuring on the scale required will have to take the form of renegotiated debt agreements, debt relief programmes (for example, for eligible homeowners), and possibly under some circumstances, debt forgiveness. Ultimately, though, it must mean a sharp rise in defaults. What we must be careful to avoid is such a spate of bankruptcies and deleveraging that it takes us straight towards a debt deflation. This is one of the most recent scares swirling around the financial markets, and soliciting a new debate about what the authorities should do about deflation if it became more likely.
As described above, the inevitable consequences of all this are rising defaults and an increased risk of deflation. Not to worry though, this is exactly where a quantitative easing programme comes in. In fact, Magnus expects that an official announcement will be made quite shortly:
Suffice to say that the US looks to be very near to the point where a formal announcement about a change in the operating guidelines of monetary policy may have to be made. While the ECB, Bank of England and other central banks in Europe may be further away, none should imagine that they might not be faced with a comparable situation in the next 12 months.
Related links:
Wanted $1000,000,000,000 to bailout the financial system – FT Alphaville
Terpology – FT Alphaville
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