Reasons to be Skeptical About Long-Term Recovery Soon

If you want positive signs in the economy here’s a list: bank stocks are up (JP Morgan Chase has more than doubled its March 9 low), banks have been able to raise capital quickly in wake of the stress tests, banks have been successful in starting to clean their balance sheets, the low cost of funding is helping banks make money again, and we’re looking at a steep yield curve. In particular, banks starting to clear their balance sheets is a great sign. They are showing a willingness to dump toxic assets at prices they’d probably rather not sell at, but need to do in order to be healthy again. This is how the financial sector is supposed to heal itself in a recession.

But. (There is always a “but”.)

Despite all this, I see a couple of significant problems. First is Geithner’s Senate testimony earlier this week about maintaining the government rescue programs, and not wanting to discuss an “exit strategy.” I can understand Geithner not wanting to send the banking sector back into a free fall by pulling out the support beams too soon if they were really being helpful. But I ask, could the support beams be maintaining the recession longer than necessary?

If banks needed to be cleaning up their balance sheets. Then why did they wait until now? One reason is they were waiting for a better deal from the government. It started with Paulson saying he was going to buy the toxic assets, and the market froze because Uncle Sam has deeper pockets than the private sector (that whole printing money thing). Then TARP money gave banks enough capital in the short term that they didn’t have to dump assets. And finally the announcement of PPIP put off the sale of assets for months and months. Even though banks are starting to clean up, it’s not a massive clearing house yet. That will supposedly come later when investors buy up pools of “legacy assets” with taxpayer support.

The government has been prolonging the inevitable with the banks, leaving the economy stagnating in the mean time. Historical evidence appears to be supporting this theory. Looking at yield curve indicators from the last six recessions compared to ours, the inverted yield curve–when short-term treasuries rise, a sign that a recession is coming–was relatively short compared to other periods. But it has led to the longest recession. Here is a chart from the Federal Reserve Bank of Cleveland:

Durations of Yield Curve Inversions and Recessions

Duration (months)
Recession Yield curve inversion
(before and during recession)
(through April 2009)

Source: Federal Reserve Bank of Cleveland, May 21, 2009
Though we’re at a length of recession equal to 1982 and 1975 we are sure to have the current one continue. So what is different about this recession? That it stems from a mortgage bubble is a key part, but the unprecedented government rescue spending is also a significant factor. This is far from hard evidence, and the creators of this chart (and related paper) correctly warn, “the bottom line is that yield curves contain important information for business cycle analysis, but, like other indicators should be interpreted with caution.” Nevertheless, while not undeniable, it is damning as there is a lot that points to the government as a key factor for our continued malaise. (Avoiding the inevitable seems to be a pattern for the government, considering that the White House finally sent Chrysler into bankruptcy and looks to be taking GM down the same road we all knew was necessary months ago.)

So, if the support programs are at least a factor in the prolonged recession, then at a minimum we should be discussing and exit strategy for those programs if not actually backing out.

A second concern I have related to recovery is what the Wall Street Journal called “back door nationalization.” The 10 “weak” stress tested banks were told they had six months to raise capital in the private markets or accept more money from the Treasury. This public capital infusion would come in the form of stock and warrant conversions giving the Fed a significant ownership and controlling interest stake. The bank won’t go into FDIC receivership, but for all practical purposes it would be run by Washington. While banks have done well at raising private funds to avoid that, the government didn’t even give the private sector a chance with GMAC, sending them $7.5 billion and taking a 34.5% stake in the auto financier. And though banks have raised $57 billion of the $75 billion needed thus far (see chart below), it’s not a foregone conclusion they will all be successful.

But even if they are, and back door nationalization is no longer a threat, the power the Washington is holding over Wall Street is very real even now. Consider the recent cramdown debate where banks that once stood adamantly opposed to letting bankruptcy judges change mortgage contract terms suddenly supported the move. A little arm twisting from the rescuer wanting a favor from the rescued? Or how about the auto industry suddenly backing increased CAFE fuel standards when they had fought the proposed rules for years. Think the government didn’t pull a mafioso-like move with them? And let’s not forget Paulson forcing the major banks to take money to ensure no one looked weaker than another. The government has not backed away from using “force” to do what it thinks is necessary “to save the market” and that power, the fear that banks and others must have, even if nothing is said directly, is and will continue to skew competitive practice. And I believe until that is gone, it will be difficult to have real recovery.

The other concern I have related to indicators on recovery are unemployment projections. The CBO is estimating we’ll hit 10% unemployment in the later half of 2010. That would mean over a year of more job struggles. It means an increasing number of people out of work long-term. That will mean a drain on social programs (read taxpayers spending lots more money). That will mean more families unable to make mortgage payments due to lack of income, not irresponsible borrowing. Which means more problems in the housing sector. Which doesn’t help banks at all.

This leaves me very worried about a “W” shaped recession. Given the amount of fiscal stimulus poured into the economy (or rather, attempted to be poured, the money is moving slow) coupled with debt guarantees, loans and capital injections, and interest rates on the floor, its possible we could see growth in the 3rd and 4th quarters of 2009. But it’s built on a faux-foundation. And with job losses continuing into 2010, the economy will likely dip back down.

Perhaps that’s why Geithner doesn’t want to remove government rescue programs. Which would imply these programs will around for a while, and that is deeply troubling.

I also wrote about having a realistic outlook on recovery earlier this week.

Capital for Stress Test

Source: Wall Street Journal, May 21, 2009