Markets Getting Severity Right, But Not Duration

Posted by urbandigs

Mon Apr 6th, 2009 12:56 PM

A: This latest equity rally is bringing with it the normal amounts of hope and euphoria that the 'bottom is in' and 'the depression is over'. First off, we had a depression only once in the last 100 years and that equity bear lasted 3 years (14 months for us so far) and the economic side effects another 5-6 years after that. If this is a depression, no way its over now. Second, lets stop trying to declare that whatever we are in is over when we do not know how unhealthy the banks are, how gov't programs will work, how many good assets will eventually start going bad, and how corporate America/consumer will handle the very weak jobs market, higher savings and personal deleveraging to shore up balance sheets. Let us at least admit that there are simply too many uncertainties to declare anything with certainty right now. Mayo's note out of Calyon Securities, reminds us that while the bad assets are taking all the headlines recently, their is a growing trend of deterioration in the good assets - and the jumbo good stuff too! This has never been a subprime-only crisis, rather a broad overall debt crisis that encompasses higher quality debt classes too.

I think the stock market got the severity of this crisis priced in correctly, but I'm not sure they have the length of the problem right. Why? Well, while the PPIP program works to cleanse the troubled banks balance sheets of legacy whole loans & securities, what happens about the good stuff ("...spreading of toxicity to higher quality debt classes as more performing loans deteriorate") held? What if that starts to go bad? I mean, after all we have been through, are people still out there keeping their head in the sand that higher quality debt classes are unaffected by this slowdown?

Bloomberg states, "Mayo Says Loan Losses Will Exceed Depression Levels":

“While certain mortgage problems are farther along, other areas are likely to accelerate, reflecting a rolling recession by asset class,” Mayo wrote. “New government actions might not help as much as expected, especially given that loans have been marked down to only 98 cents on the dollar, on average.”
Not sure how he confirmed that the whole loans were only marked down to an average of 98 cents on the dollar, but from what I am hearing many of these loans are marked down more and sitting on 'accrual (hold) books', which are marked on the spot based on loan defaults and overall book performance - you are not selling, so mark-to-market is meaningless. By the nature of being a hold book this is nothing new, illegal or other - just how it is. Loan loss provisions are done on a quarterly basis, not as assets stop performing.

If the total loans in the book deteriorated 5%, well then the entire book is remarked down 5% from the previous mark or par. It's backward looking. In this regard, Mike Mayo is correct to assume future adjustments because only the eternal optimist would think that higher quality debt classes are completely unaffected by this slowdown; heck the low bids for these loans are telling you that there is downside risk not priced in properly. So it is fairly safe to say that whole loan books considered good with no plans to be resold in PPIP, are behind the curve in terms of their current market value and present a valid concern for the future. In addition, if banks are allowed to suspend mark to market accounting on these loans and carry them at par or close to it then PPIP will have no influence since there will be no upside for the banks to take something off the books.

Moving on to the point, while one toxic area of the banks books gets cleansed by PPIP we should expect another area to start increasing in toxicity due to the nature of this crisis. Bankruptcies are rising, unemployment is rising, consumers are cutting back, banks are rolling back credit, everything is tighter, and for many, borrowing costs are rising (or at the very least, not falling as much as you would think given all fed's actions) due to the deterioration of credit quality as a result of the current environment. The core of the crisis is causing a loop whereby one stage feeds from another.

To get through this crisis we need good old fashioned withdrawal from the drugs that caused this whole mess (using debt to solve a debt problem seems very stupid to me) - unfortunately, its not politically correct to 'bring on' the symptoms of withdrawal to the very people that elected you into office. Last I checked, for most people their job security has deteriorated, incomes were pressured or lost, and yet the debt obligations remain. So we need to let the bankruptcies and restructurings occur so that the banks have sounder entities (consumers & corporations alike) to lend to - and occur it will! As it does, the banks need to take the writedowns, stop hiding the bad stuff, stop refusing to mark down the good stuff, then recapitalize and restructure to the new world. By hindering one of the steps in this 'cleansing' process, you increase the likelihood of having zombie banks infected for years - prolonging the duration of the economic slowdown because of the adverse feedback loop created when banks cut back on credit, instead of expanding it. Its a lose-lose sure, but one scenario gets it over & done with at a sharper pace, and the other strings the process out for many years.

Its not that equities mis-priced the severity of this cycle, rather, I think they have not correctly accounted for the length of the crisis for the above noted reasons.

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