$1.6 Trillion in Losses and Counting
by John Mauldin
In this issue:
$1.6 Trillion in Losses and Counting
Banks Start to Reduce Their Lending
Take Freddie Mac. Please.
The Ugly Muddle Through
Once Again the BLS Numbers Paint a False Picture
It seems that with each passing month the estimates for
losses in the international banking system keep rising. This time last summer
the largest estimates (from credible sources), if memory serves me correct,
were around $400 billion, give or take a few months. By the end of the year it
was in the neighborhood of twice that. Then last quarter we saw estimates
approaching $1 trillion. Last week, the number being broached was $1.6
trillion, by Bridgewater Associates, one of the top, and more credible,
analytical firms in the world. In this week's letter we look at the implications
of that projection, analyze recent lending patterns by banks, briefly touch on
the implications of the recent unemployment numbers, and end with a few
comments on the bear market. It will make for an interesting letter. Warning:
remove sharp objects from your vicinity before reading.
But first, I need your help, and in return I would
like to give you a link to a recent speech I gave, where I speak about what I
think is the development of an important new asset class, one which will come
about precisely because of the problems I am writing abut today. I have not yet
written about this topic in public, and the speech has been well-received. I
think you will like it. Now, as to how you can help me ...
I get to travel a lot with my daughter and business partner
Tiffani (actually she runs the business) and meet new people. Over the years,
she has become as fascinated as I have with their individual stories. Everyone
has a story to tell or a lesson to teach. We have decided to write a book about
those stories, looking at the differences in perspective between old and young,
retired and working, those who are wealthy and those who aspire to wealth. What
are the differences in attitudes, in work habits, in how you manage money, in
how you look at the future, and a score of other items? How do all of these
things correlate?
We have created a totally anonymous online survey seeking
answers to these questions and more. We hope to get at least 10,000 people to
fill out the survey; and we are eager to see what we find as we pore over the
resulting data and engage in a lot of in-depth analysis. Are the rich really
different? Is there a difference in people from
It will take about ten minutes to complete, and I think that
going through the questions will make you think about your own situation. Some
have told us the survey is quite thought-provoking. If you have attempted to
take the survey and had problems, we think we have worked out the bugs.
At the end of the survey, you will be sent to a page with
the speech. If you cannot listen to it immediately, then simply save the page
or the address. And of course, you can just take the survey to help us.
Also, Tiffani and I want to do live (mostly by phone)
interviews with 200 millionaires, of all shapes and sizes and locales. We will
interview you for about 30 minutes, and then you can have equal time asking me
anything you want. Since I will have learned a lot about you, those questions
can be as detailed or as general as you like. We want at least 20% of the
interviews to come from outside the
I am really excited about this project and even more so
about working with Tiffani. We will report back to you on what we find. Thanks
for your help. And if you have any questions, please feel free to reply to this
email.
$1.6 Trillion in Losses and Counting
One of the great privileges I have is getting to read a wide
variety of economic research. While I get a lot of material direct from the
source, I also have a wide network of people who read other sources and send me
what they think is important. When Ambrose Evans-Pritchard wrote this week
about a report done by Bridgewater Associates, it got my attention, and
fortunately this report was sent to me by a few friends. In my book,
First, let's look at what Evans-Pritchard wrote in the
"Bridgewater Associates has issued an apocalyptic
warning to clients that bank losses from the worldwide credit crisis may reach
$1,600bn [$1.6 trillion], four times official estimates and enough to pose a
grave risk to the financial system.
"The giant
" 'We are facing an avalanche of bad assets. We have big doubts
as to whether financial institutions will be able to obtain enough new capital
to cover their losses. The credit crisis is going to get worse,' said the group
in a confidential report, leaked to the Swiss newspaper Sonntags Zeitung.
"Bank losses on this scale would have far-reaching
effects. Lenders would have to curtail loans by roughly 10-to-one to preserve
their capital ratios. This would imply a further contraction of credit by up to
$12,000bn [$12 trillion] worldwide unless banks could raise fresh
capital."
Let's look at some of the details in the report. First,
these losses are not all sub-prime. In fact, more than half of it is from
corporate liabilities, around $800 billion. About $550 billion of the corporate
losses have yet to be written off. As an example,
Better than 90% of the losses from sub-prime assets that are
on the books, have already been written off. That is good. But
"The
I could go on, but the details are not important. The bottom
line is that they estimate there is at least another $1.1 trillion of losses
that will have to be written off by institutions all over the developed world,
including very large potential write-offs from insurance companies.
Banks and investment institutions worldwide may need another
$400 billion in capital infusions. But where they are going to get it is the
problem. They have burned through the usual suspects, and burned is the correct
word. Any sovereign wealth fund or large investor who has put money into an
investment or commercial bank has watched their investment take large losses in
a very short time. How likely are they to be willing to belly back up to the
bar with more money, on anything except very dilutive terms to current
shareholders? The answer is obvious.
And let me be clear. There are some very large commercial
and investment banks which are simply going to be absorbed, as regulators move
to keep the entire system working. Bear Stearns is not a one-off deal. I think
it is likely we will see at least one European bank nationalized. Losses the
size that
Banks Start to Reduce Their Lending
Further, let's revisit a theme I have written about on
several occasions over the past year. As banks incur losses, they either have
to find new capital or reduce their lending in order to maintain their capital
ratios, or some combination of both. And what we are seeing is that lending is
starting to actually decrease.
Earlier this year lending rose as normal even though
anecdotal reports told of tightening lending standards and reduced loan lines.
The tightening of standards did not seem to be affecting actual loans being
made, which was odd. But this was partly illusion, as banks were taking back
loans they had spun off in SIVs, taking capital away from their traditional
loan business. This gave the appearance of expanding loan capacity. Evidently,
this bringing back of off-book loans is now being worked through, as evidenced
by this analysis by good friend and analyst par excellence Greg Weldon, who
slices and dices the data to give us this view (www.weldononline.com):
"[looking at the chart below] ... FOR SURE, the recent
decline strongly suggests that the risk of a US recession has intensified
CONSIDERABLY, as defined by what amounts to one of the largest nominal credit
contractions in DECADES, at (-) $154.3 billion, and a clear-cut violation of
the uptrend in place since at least 2001."
Greg goes on to suggest that bank credit could contract a
further $6-700 billion over the next nine months, which is a contraction of
about 8%. Healthy economies have a rising rate of bank credit, which is one
source of expansion. When banks have to reduce their lending, it reduces the
growth of the economy or can put it into outright recession.
And if the
But in the meantime, the trend toward lower lending is
likely to continue. And lower lending is going to be a huge headwind for an
economy that is already struggling.
This week Ben Bernanke suggested that the
"temporary" Term Auction Facility might be extended into 2009. Let me
suggest that it will be extended into at least 2010 before it is no longer
needed. Banks are going to need to be able to take their illiquid paper and
convert it into liquid Treasuries against which they can make loans and
continue to function.
As I have written for a long time, it is all about buying
time. In 1980, every major bank in the
Instead, with a wink and nod, they let them keep the bad
bonds on their books at face value, which they all did. Then in the latter part
of the decade, starting with Citibank in 1986 (cue the irony), they began one
by one to write off the bad loans, but only when they had enough capital to do
so. It took six years (or more) of profits and capital raising
to get to where they could deal with the problems without imploding themselves
and the economy of the same time.
Today is only different in the details. The Fed and central
banks around the world are allowing banks to buy time to work through their
problems. There really is no other option. That extra $1.1 trillion that the
research by
Treasury Secretary Paulson said Thursday that no bank is too
big to fail. That is for public consumption. The fact is that there are any
numbers of banks that are too big to fail, depending upon (and borrowing from
my favorite linguist, Bill Clinton) what your definition of fail is. If by fail
you mean that shareholders are wiped out, than he is correct, there is no
institution too big to fail. If by fail you mean that the operations and debt
obligations will be allowed to collapse, then there are institutions whose
collapse would pose major systemic risk to the world markets. They cannot be
allowed to collapse.
Take Freddie Mac. Please.
(Cue Henny Youngman) Take Freddie Mac. Please. Its shares
are down almost 90%. "Freddie Mac owed $5.2 billion more than its assets
were worth in the first quarter, making it insolvent under fair-value
accounting rules. The fair value of Fannie Mae [down 78%] assets fell 66
percent to $12.2 billion, data provided by the Washington-based company show,
and may be negative next quarter, former St. Louis Federal Reserve President
William Poole said." (Bloomberg)
But in the same story, Senators Schumer and McCain both said
Freddie and Fannie would not be allowed to fail. Even curmudgeonly former Fed
Vice-Chairman Wayne Angell (someone whom I sincerely respect), said on CNBC
yesterday that the government regulator of the GSEs (Government Sponsored
Enterprises) ought to get some money from Congress to buy preferred stock and
then get even larger amounts from the public through an offering of preferred
stock. He said that Congress ought to learn about its responsibilities with
regard to a GSE; and the public ought to realize that we are in for a long,
tough fight. (He also expects the second half of 2008 to be no better than the
first half, and he sees 1% growth in 2009.)
I wrote the above paragraph, and a few I deleted below, on
Thursday, as I am on a plane to
The basic problem is that both Fannie and Freddie need more
capital, and perhaps far more than their current market capitalization. Where
to find it? What investor wants to try and catch this falling safe, without
government guarantees? The Journal article quotes numerous people with
various ideas about what to do. Most of their ideas will potentially cost US
taxpayers.
And make no mistake. The problems with Fannie and Freddie
have to be solved. They are now doing 80% of the mortgages in the
Not to mention that the world has assumed the implicit
backing of the government in buying the paper of Freddie and Fannie. How easy
would it be to finance
A very reasonable idea was broached by Steve Forbes on a
BizRadio program this afternoon, which Dan Frishberg graciously allowed me to
co-host. He suggests breaking Fannie and Freddie into eight smaller companies,
giving them whatever backing they need in the form of public financing to start
business, and then cut them off to sink or swim on their own, with much tighter
capitalization controls. Remember, this is one of the more free-market
conservative thinkers.
The authorities are slowly losing control. All they can do
is crisis manage. There are no good solutions, only expedient ones. And we must
all hope they choose the best among a handful of not particularly pleasing
options. Allowing the system to devolve into chaos is not an option. The Fed
and whatever administration comes in will do the same as the current group,
which is to buy time so that the wounds can heal, and hopefully put in place
rules to prevent another such occurrence.
(Sidebar: I will go into greater detail in a later letter,
but regulators need to move NOW to create a Credit Default Swaps Exchange. A
problem/crisis in that unregulated market is actually a far bigger problem than
the current subprime crisis. Why do you think Bear Stearns was not allowed to
go into bankruptcy? There are banks that are too big to fail, despite what
Paulson says for public consumption.)
There are a lot of conflicting opinions, which you can read
at www.bloomberg.com if
you care. Some say Fannie and Freddie will have to lose $70 billion before the
regulators step in.
I hope that when (not if!) taxpayer money is used it is at
market rates and means that shareholders are last in line, if at all, to recoup
any money. For those of us who for years have called for tighter regulation and
increased capitalization of the GSE’s, as well as a clear removal of any
government backing, implicit or explicit, being able to say "I told you
so" does not feel all that good. Freddie and Fannie cannot be allowed to
go out of existence. They are too tightly wound into the core and fiber of the
What can and should happen is that shareholders bear their
losses, taxpayers pick up the bill, and when they are healthy again, as they
will be at some point, another public offering should be done to hopefully
recoup the losses to taxpayers. Or perhaps an auction with some guarantees to a
potential buyer, but a complete removal of implicit government guarantees on
future loans and higher capitalization requirements. There are any numbers of
ways to lessen the ultimate cost to the taxpayer.
What I fear is that politicians will use the opportunity to
prop up the mortgage markets with taxpayer guarantees and create much larger
losses, which could quickly mount into the hundreds of billions if not properly
dealt with. A new populist-oriented administration could find this problem on
their desk as they take office.
I would not want to own any stock in the financial sector.
There is going to be a continual stream of write-offs over the coming year, at
a minimum. Yes, some banks are better managed and will avoid the real
life-threatening problems. Some will be like JP Morgan and end up with solid
assets backed by government guarantees.
But which ones? Do you want to trust the analysts that have been telling
you there is value in the financials at each step, all the way down? The
management who insists they are in good shape, then raises capital at dilutive
prices? The very people who did not see the problems to begin with, telling you
that they are now solved?
The "value" that analysts optimistically see in
various financial stocks is evaporating with each quarter, as they slowly write
down ever more losses. With another potential $1 trillion to be written off or
absorbed through earnings from profitable parts of the business, there is more
pain to come. Investing in financials today is like trying to catch a falling
safe.
The Ugly Muddle Through
Goldman Sachs published a report Thursday in which they
suggest the most probable scenario for the next 12 months is GDP growth between
-0.25% and 0.25%, or basically zero. Wayne Angell, mentioned above, expects the
second half of '08 to be no better than the first half and for GDP growth to be
1%.
In the
Earnings estimates are being cut with each passing month.
The P/E ratio for the S&P 500 is currently at a sporty 23. Historically, in
times of rising inflation, the stock market goes through "multiple
compression." That means P/E ratios fall more than earnings. If multiples
fell just 20%, back to 18, which is still above long-term trends, the market
would see another 20% drop from here. Even with earnings growth, the market is
going to have a challenge rising in the current environment.
Sidebar: A number of you have written questioning my source
for the P/E ratio, as you read or hear different numbers from what I write. You
can indeed find estimates of forward P/E ratios as low as 12 a year from now.
That is a lot different than the 23 I cited above.
There are two basic types of earnings that are reported. One
is "operating earnings," or what I call EBBS, or Earnings Before Bad Stuff. Then there is "reported
earnings," which is what the corporations report on their tax forms. Not
all that long ago, in the mid-'90s, operating earnings and reported earnings
were generally in line with each other. Companies would deduct genuine
one-time, unusual losses from their reported earnings to give us operating
earnings. And such a system has a valid basis for existence. If something is
truly one-time, maybe an investor should overlook it when evaluating the
company's potential.
But then the media and analysts started using the operating
earnings as the primary number, and companies began to game the system. More
and more items were considered one-time. One of the more egregious examples was
when Waste Management Systems declared that painting the garbage trucks was a
one-time extraordinary expenditure and should be accounted as such. Today the
difference between as-reported and operating earnings can be 20-40% or more! It
seems there are many losses that management assures us are just one Standard
and Poor's has a web page where you can see a spreadsheet of historical data
and projections for both types of earnings. That is the source of my data. It
is at http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS?GXHC_gx_session_id_=5350992f205e73e4&
.
Analysts' estimates do tend to get brighter the further out
one looks on the table. But if the growth scenarios mentioned above come about,
and banks have to curtail all sorts of lending, the earnings projections are
going to be way too high, as they have been for the last 12 months. That is
going to mean more pain for the stock market.
I think it is quite likely we see the Dow slip below 11,000.
(Ok, I wrote that Thursday!) As I said on Kudlow the other night, another 10%
drop in the market would take us only to the average bear market. A "9
handle" on the Dow seems quite possible, if not likely. (Note: when
someone says "a 9 handle," they mean that the first number in the
index or stock price is a 9. The first number is the handle.) The risk is to
the downside, given the tepid potential growth of the economy.
Once Again, the BLS Numbers Paint a
False Picture
I almost get tired of writing this each month, but it is
important, and I will do it quickly. The unemployment number from the BLS last
week showed a loss of 62,000 jobs. Private sector jobs were off by 91,000, with
the government showing growth of 29,000.
But once again, the birth/death ratio of estimated new jobs
was 177,000. As The Liscio Report noted: "...
without the b/d's contribution, private employment would have been down by
something like 268,000. It added 29,000 [new jobs] to construction,
22,000 to professional and business services, and 86,000 to leisure and
hospitality. Given the weakness of the economy and the crunchiness of credit,
we doubt that there are enough startups around to match these
imputations."
Revisions to the prior two months were a negative 52,000.
When they do the final numbers a few years from now, we will find that the
revisions will be in the hundreds of thousands for the first half of the year.
We have now had five consecutive months of downward revisions, which is typical
of recessions.
Unemployment held steady at 5.5%, but that masks an
underlying and growing problem. There has been a huge increase in the number of
people working "part-time for economic reasons" and a large number of
people who are discouraged and not looking for a job but would like one. These
two categories are not counted as unemployed. If you add them into the
equation, the unemployment or underemployment number goes to 10.3%! (per Greg Weldon)
As I warned above, this has not made for pleasant reading.
But it is reality, and we need to deal with it.
And let me say that even given the above, I am a long-term
(and even mid-term) optimist. We have to work through some serious problems,
but we will. Valuations are going to be low once again, and it will be time to
become bullish. And researching and writing my book on how the world will
change in 20 years makes me very optimistic. No one in 20 years will think of
today as the "good old days." The changes that are in front of us
will be amazing. So, simply take a deep breath, be conservative today, and get
ready for a really wild and fun ride.
And speaking of investment banks, I need an introduction to
someone who is deeply involved in the Exchange-Traded Notes. Drop me a line.
Las
Vegas , Maine
I am at Freedom Fest in Las Vegas, and want to hit the send
button so I can attend the sessions and see a lot of old friends. I really
think it will be good fun. I have dinner with Frank Holmes of US Global
tonight, and look forward to it. Frank is the consummate gentleman and always
very interesting.
And speaking of dinner, I was with Barry Ritholtz (of Big
Picture fame) last week, and we agreed we are psyched about going to
Daughter Tiffani's wedding is getting closer. 08-08-08. Less than a month, and a lot of coordination to be done. It
is at the point where I am sitting in on meetings. Flowers cost what? Fireworks? Credit lines are being squeezed. But it is going
to be so much fun!
Remember, the markets are not where you live. If your
investments keep you up at night, sell until you can sleep. Life is to be
enjoyed, and I am doing my part. So have fun this week! And call some friends
and share a few laughs.
Your wishing he could be a bull analyst,
John Mauldin
John@FrontLineThoughts.com
Copyright 2008 John Mauldin. All Rights
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