Systemic Risk Factor #1: Jobs

On June 19, 2009, the premiere economic consulting firm (not to be named) forecasted a job loss of 275,000 in June.

To me, this seemed odd. The May drop of "only" 345,000 jobs (unrevised) seemed like noisy data. There was no substantial change in Initial Claims for unemployment insurance. Initial claims were running more than 600,000. The ADP also remained at an elevated level. The May ADP number showed a job loss of 532,000. Why should a lower reading be repeated in June?

We are in the mode of seizing any piece of good news as evidence of the turning point. So what, if the May Non-Farm Payroll number was inconsistent with Initial Claims and the ADP? A green shoot is a green shoot.

Throughout June, nothing really changed on the employment front. People viewed it as good news that initial claims were running in the 610,000 range rather than the 640,000. We were going to see a much better number for June. As I said, as of June 19, the Non-Farm Payroll loss was pegged at 275,000.

But 610,000 Initial Claims while better than 640,000 is still terrible news. The ADP on Wednesday completely deflated the unrealistic expectation of a substantial turnaround. The ADP came in at a job loss of 473,000. Economists quickly revised their expectations.

The job loss today of 467,000 was no surprise to me (and to readers of my blog). This is consistent with the forecast made by CFOs in the latest Duke-CFO survey. The CFO survey, conducted in May 2009, suggested that private sector jobs would be scaled back by a staggering 5.6% over the next 12 months. Given the addition of public sector jobs, I estimated the net job loss over the next 12 months to be 4 million (this assumes 2 million public sector jobs are created). We are 1/5th of the way there (May+June losses divided by 4 million).

Perspective

• We have lost 6.46 million jobs in this recession
• We have lost more jobs in this recession than double the sum of the previous two recessions!
• We are 400,000 job losses away from the worst job loss situation since WWII. Technically, the recession of 1948 is still worse. However, it is a weird recession with one amazingly bad month. The percentage loss of jobs in October 1949 would have caused a print of -2.5 million losses today (in a single month).
• This ain't over yet.

The Main Systemic Risk Factor

My main worry is that policy makers and risk managers at financial institutions have greatly underestimated the impact of unemployment on prime mortgages. Given that housing prices are falling at a 19% annual rate and given that many people with prime mortgages are losing their jobs, it makes sense that more and more people will choose to default on their prime mortgages. Note that 20% of U.S. homeowners with mortgages are underwater -- what they owe on their mortgages exceeds the value of their houses. The assumption of a 2-4% loss on prime mortgages in the Treasury's adverse stress test scenario seems unrealistic to me.

Increased defaults on prime mortgages could easily cause a second credit crisis.

Remember when the sub-prime crisis started? People initially said it was no big deal because the size of the market was small. Well, it was a very big deal and, yes, the size of the market was small. The prime market is gigantic and a surge in defaults in that market could quickly wipe out the capital of our financial institutions.

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The Fundamentals are Fundamentally Troubling

The Duke-CFO Survey was released today and the news is grim.

One of the big challenges is to reconcile the growth in confidence against the hard data. Consumers as well as CFOs are more confident. However, our survey shows that this confidence is not influencing business plans. CFOs are playing a cautious, wait and see game, before pulling the trigger on new capital spending and employment growth.

Reconciling Hard vs. Soft Data

In examining the data, consider three factors:

1. Bottomming Out? CFO confidence graph shows that optimism is up but still lower than any other point historically (except the last quarter). It is like saying that housing sales increased by 10% - that is good but a 10% increase on a very low level doesn't do much for economic growth.
2. Sustained vs. fleeting. I think people are grasping for some good news. There is talk of green shoots. However, there is very little fundamental data to support a recovery at this point. It is somewhat easy to feel a little more optimistic. It is a different matter to translate that into corporate plans. That is why I emphasize the idea of "sustained" optimism. Optimism will only translate into corporate action after CFOs are confident that the recent news is not fleeting. They will not change their corporate plans until there is evidence of a sustained recovery. Of course, there is a chicken and egg problem that results from this!
3. This crisis is different. I think CFOs are feeling more optimistic but given the gravity of the crisis - it is dangerous to extrapolate from previous recessions/recoveries. This is another reason to be cautious.

The Press Release

The press release is found here. Here is an excerpt from the draft release:

For the second consecutive quarter, there has been an increase in optimism. In the latest survey, 54% of respondents are more optimistic about US economic prospects. However, these numbers need to be tempered because the overall level of optimism is still low.

"Our survey carries an important message: don’t put too much weight on the ‘soft’ data like consumer confidence, which has been overemphasized in the news. Recovery requires sustained confidence, and such confidence is forged by stronger economic fundamentals," said Campbell Harvey, founding director of the survey. "The economic fundamentals are still fundamentally troubling. There is no thaw yet in this winter of hardship."

One example of hard data is the surveyed companies’ employment plans. Employment is projected to decrease by 5.6% over the next 12 months. This is essentially unchanged from last quarter’s projection of a 5.7% reduction.

"Approximately 109 million people are employed in the private sector. A drop of 5.6% means the loss of 6.1 million jobs. Presumably, government programs will offset some of these losses, but even the most optimistic government forecasts would reduce the losses by only two million. We’re facing a staggering four million additional job losses," said Harvey.

Since the recession began, 5.7 million jobs have been lost and the unemployment rate is 8.9%. The Congressional Budget Office assumes an unemployment rate of 8.8% in 2009 and 9% in 2010. "CFOs know their companies’ employment plans. Slashing employment by 5.6% means unemployment in the 11-12% range. Our survey evidence renders the CBO projections completely unrealistic," said Harvey.

Full results of the survey.

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Moral Hazard Everywhere

Here are my talking points for my Fox Business News interview.

Watch my interview.

1. Why should all the bailout money be focused on financial institutions? It is seems a matter of fact but no one has really challenged the logic.
2. We must act now to prevent the second wave of the credit crisis. The first wave was partially caused by people with jobs buying houses well beyond their means. The second wave will be people with prime mortgages who have lost their jobs. They are paying out of savings right now (and that accounts for the lull) -- but savings will run out.
3. Fed stress test had unrealistic 2-4% assumption for loan losses in prime mortgages.
4. Prime is by far the biggest market. Close to $9T. Hence, every percent mistake in the Fed assumption is worth $90B. So a small error in prime loan losses could make many financial institutions insolvent.
5. We can't afford any more spending - hence, we should redirect some funds.
6. Will be moral hazard problem (people want to be bailed out that don't need to be bailed out). But not a valid critique of mortgage loan restructuing. The current policy has an even more extreme moral hazard problem. Financial institutions faced with coin flips where "head I win., tails you lose" -- you being the American tax payer.
7. Target: 1) responsible borrowers - those that put at least 25% down on their houses; 2) simple means test based on 2008 tax filing + investment portfolio information; 3) priority in the process to recently unemployed. Reckless borrowers should be foreclosed.
8. Restructuring should be handled by bank or service provider -- not the government or the courts. Not much has happened because little capital has been directed to the individual mortgages.
9. Proactive action to head off second wave. All of this could have been done two years ago and muted the impact of the sub-prime problem.

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Reflecting on the Stress Tests

Most of the reporting on the stress test focused on the number of banks passing the test and the doable amount of capital the failing banks needed to raise. The tough question was not asked: if the stress test wasn't really that stressful, why did a majority of the banks fail?

The Good News

1. This is a move towards being more transparent. This is a good start.
2. I was very concerned about the assumptions of the stress test. The news that leaked out before the release suggested the loss impairment assumptions were far from realistic. However, it turns out that all of the loss assumptions are for only a two year horizon. This is an important point. For instance, suppose you think that the total impairment over a four year horizon is 8%. You read in the WSJ that the government is using 4%. You think that is way too low. However, it is not as low if the horizon is only two years.
3. The fact this is in the news is serves an educational function. People are getting a forced lesson in risk management. Whether they like it or not, this learning should decrease the chance of a systemic episode in the future. More people know the right questions to ask.

The Bad News

1. As I have said before, the economic assumptions are problematic. The adverse scenario has 8.9% unemployment in 2009 (average). Today we learned that the unemployment rate rose to 8.9% in April. The adverse scenario has a rate of 10.3% in 2010. It is likely we will reach that rate by the end of the summer of 2009.
2. The two year horizon essentially assumes that good times return by 2011. That is not obvious to me. We have not seen unemployment like this since 1948 and I project that we will blow by 1948 (adjusting for the size of the workforce) by the end of the summer. Employment lags the business cycle. This means there will be loan losses in 2011 and 2012. So rather than $599.2, given the assumptions on loss rates but simply extending out to 2012, a more realistic number is $1 trillion.
3. I think the assumption on Prime mortgage losses is particularly problematic. The more adverse scenario assumes Prime losses of 3-4%. First lien mortgage category includes three components: Prime, Alt-A, and Subprime. Putting all these together the adverse scenario only assumes an 8.8% loss over two years. This includes 9.5-13% losses on Alt-A and 21-28% losses on Subprime. I focus on the Prime assumption because the market is so big. In the overall economy (not the 19 banks), we are talking about $6 trillion. So, for every extra 1.5% in losses we drop $100 billion in value.
4. What about the other 8,000 banks? The two-year losses for the 19 are projected to be $599.2 billion in the stress test. These 19 have 2/3s of the assets and half of the loans.
5. I reject the idea that nobody should fail. When anyone takes on risk, you reflect on the upside and the downside. You temper amount of risk you take because of the downside. But if you are always bailed out, there is no downside and you will (continue to) take excessive risk. In addition, it creates a double standard: financial institutions are bailed out but other industries or individuals are not (yes, there are some exceptions like the autos). There is also another double standard based on size: if you are big you are bailed out but if you are small you are allowed to fail. The only word to describe this is "unfair" This bailout mentality did not happen with the Savings and Loan Crisis in the early 1980s.

Resources

The Fed white paper on the stress test results is worth a read.

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See below my monthly employment graph that standardizes the job losses (based on the sized of the labor force) across different recessions.

Four interviews

Obama scorecard

President Obama means well and is doing a great job in many areas. However, I fear that we are perpetuating the same policies of the previous administration when it comes to the financial sector. It is simply not fair that each of the 19 big banks are bailed out. If you take risk, then there must be some consequence. Right now it is a blanket insurance policy that will lead to similar problems down the road.

See BNN interview.

Stress testing the banks

The so-called stress test is a sham. They delayed the release of the test because it is really hard to explain why so many of the banks (including the very largest ones) are offside when the adverse scenario is looking like an optimistic scenario. Note the adverse scenario has 8.9% unemployment in 2009. We could be there next week. It has 10.3% in 2010 and we could be there by the end of the summer. The whole idea of a stress test is to see what happens in a scenario that is worse that what we expect. The test fails on that dimension. It is misleading, increases uncertainty, and decreases confidence.

See BNN interview.

Professor Harvey interviews Len Blum of Westport Capital

See BNN interview.

Westport Capital conducted a stress test based on leaked information. They estimate a further impairment of $200 billion. I question why they would use the government rosey assumptions. I specifically ask for their assumptions on the prime mortgage impairment. It is rumored that the U.S. Treasury is using an assumption of 5% impairment which, in my opinion, is way too low given the surging unemployment.

Are we seeing the end of the recession

While the stock market is up and consumer confidence is up, it is hard to see any economic fundamentals that point to a trough. In particular, the surging unemployment will likely cause a second wave of mortgage defaults. We don't see the defaults right now because people are drawing down their savings. We will see it soon.

See BNN interview.

Green Shoots and Agent Orange

At best, we have seen a pause in the economic decline. It is too early to call a trough.

Surging unemployment will act like Agent Orange on those "green shoots". While we have every reason to be worried about a swine flu pandemic, the recovery was at risk well before the first reported cases. That is, the economic fundamentals suggest a second wave of hardship.

The Past

The first quarter of 2009 is behind us and it was a disaster with U.S. GDP plunging at a 6.3% annual rate. While consumption stabilized, investment was slashed by 16.7%. That's not an annual rate! The annualized change in private domestic investment was an astonishing -66.7%. We thought that the previous quarter was bad at -24.2%. The freefall in investment has more than doubled.

The Future

The IMF recently revised their estimates of losses in the U.S. to a staggering $2.7 trillion. The report can be viewed here. These are deeper losses than one would be led to expect by statements from our government.

But I think we are missing something.

The U.S. is bleeding jobs to the tune of 600,000 per month. In addition, we know that even after a trough in economic activity, job losses continue. We are not factoring into the economic equation the impact of the job losses.

To be more clear, the first wave of subprime losses were caused by loans being made to people that had jobs but their income was insufficient to pay their mortgage payments. Banks made these loans assuming either their incomes would increase by the time the reverse amortization ended (for example, the end of the low teaser rate) or their house would appreciate by enough so that a mortgage equity withdrawal could be made to pay the interest on the original loan (in true Ponzi fashion). Note, in both cases, the homeowner has a job.

The situation is different today. We have a wave of people that will not be able to pay their mortgages because they are unemployed. It is not critical right now because these homeowners are drawing down what little savings they have. However, time is running out as these saving are depleated.

The market is seizing whatever little piece of good news. However, it will soon be reckonning time for the second wave.

The Trouble

There are three other troubling developments.

1. The Stress Test is Bogus

On Monday we will get the first official results of the stress test.

The so-called "adverse" scenario assumes an unemployment rate of 8.9% in 2009. That is a sham. We will likely have that rate for April! It effectively assumes a dramatic end to job losses in May 2009. Who believes that?

Equally bogus is the fact that we are relying on the bank's own models to run the stress test. These are precisely the failed risk management models that got us into this mess.

To make things even worse, the U.S. Treasury secretary has said that anybody who fails will get recapitalized. Whatever happened to the idea that if you take a bad bet, you lose. If you are reckless, you go out of business. All of that is gone. You get bailed no matter what you do. We reward incompetence with hard earned taxpayer money.

2. No Transparency

There is no transparency. I have no idea what these bank "earnings" announcements mean. Accounting "earnings" depend on the loan loss reserve assumptions as well as the valuations of their assets. I have no way to assess the quality of the bank assumptions - but I have a strong suspicion of low quality.

FASB has recently said that banks don't need to use market prices. What does this mean? It means that if you don't like the market price (i.e. too low), then you can use your model price (which is likely too high). If you think about it, you could easily argue that the so-called fire-sale price is too high. You observe a price but that's before you need to sell your asset. When you put your asset on the market, that will likely cause the price to fall even more. All of this makes the financial statements impossible to interpret. Right now, I have little idea of who is solvent and who is insolvement. However, I have a strong suspicion that there are many insolvement banks.

3. Too Big to Fail

Pass the barf bag. I don't think I am the only one. This policy encourgages reckless risk taking on the part of large banks. They know they will be bailed out so there is no risk for them - it is the American taxpayer that bears the cost of their mistakes.

We need to end this policy. There are two ways. First, you let some big players fail - but do it in an orderly way (i.e. no repeat of the Lehman fiasco). The alternative is to break up these firms. Either way, we put our financial institutions and our economy in a stronger position for the future.

Weird Zombie Game

Yes, it is true that some credit spreads have improved. Consumer confidence has also increased. But these are fleeting. A recovery must be sustainable. On the financial side, there are two prerequisties to the proper functioning of financial markets and a sustainable recovery: transparency and purging. Right now, we have neither. The stress test will provide little or worse -- potentially misleading information. The losers are rewarded with bailouts, guarantees -- and bonuses. The U.S. taxpayer is shafted. The economy is sloshing around is a sea of Zombies.

The Public-Private Investment Voodoo

Each of the three programs announced by the Secretary of the Treasury today has the same theme: the private investor has a limited downside and a huge upside – the American taxpayer bears almost all the downside and gets shafted on the upside.

Read my preliminary analysis of the three programs.

AIG and Faux Transparency

AIG disclosed some of the firms that benefited from the U.S. government bailout. Essentially, the government money was largely used to pay off other firms. I have a few comments.

1. AIG's customers were either using AIG for hedging positions or speculative positions. This was mainly done through Credit Default Swaps. These CDS essentially "insure" risky corporate debt - if the CDS is used along with a position in corporate debt. For example, you could buy Ford bonds and simultaneously protect against a default by purchasing CDS from someone like AIG. You are hedged but (and this is a big but) only fully hedged if AIG stays in business.

2. For the hedgers, they failed to properly take the risk of the insurer into account. Parties on the other side of these contracts need to share some of the responsibility. Goldman, for example, was not doing business with the U.S. government - they were doing business with a corporation. This is not the same thing as Goldman having a savings account where the FDIC is covering $250,000 - yet that is how we are treating it. The U.S. taxpayer should not be obligated to make whole all these counterparties who miscalculated the risk of AIG. We are bailing out bad risk management and it is not fair to the American taxpayer. As for the speculators, why should they be bailed out? It's like bailing out someone who lost at the craps table.

3. It is not surprising that many of the counterparties are foreign. I don't think the foreign firms should be treated differently. Domestic firms, foreign firms, municipalities, all failed in their risk management. They all should bear some of the cost. BMO is listed getting $1.1 billion for their positions.

4. From the AIG press release:
American International Group, Inc. (AIG) recognizes the importance of upholding a high degree of transparency with respect to the use of public funds. As a result, after close consultation with the Federal Reserve, AIG is disclosing information identifying certain credit default swap counterparties, municipal counterparties and securities lending counterparties.
What does "certain" mean? Does it mean "a select number"? Does it mean ""all"? If it was "all", why didn't they say "all". How can they call this a "high degree of transparency"?

5. The real story here is for someone to figure out how much more the American taxpayer is potentially on the hook for. AIG has been to the trough four times and now has $180 billion of hard-earned money, roughly $1,200 for every working (and seeking work) American. It seems like there was little or no due diligence done on the original government dole out. Transparency to me implies a level of disclosure such that we can figure out the future obligations. How much more will they likely need? $50b, $100b, $300b? We have no way of determining this. This type of forward looking analysis needs to be done as a prerequisite for any future taxpayer money.

6. The other sub-story here is size. AIG has many good business units. However, because they were a conglomerate, the good businesses are being punished for the incompetence of a small number of their business units. With smaller specialized units, we would not be in this situation. AIG could not make the "systemic risk" AKA "too big to fail" argument (as they do on their website).

7. The final sub-story is the following. The U.S. taxpayer is "the" stakeholder in AIG. It is not clear to me that the corporate governance in AIG has shifted from maximize shareholder value to 'do what's best for the American economy'. For example, full transparency is necessary. Uncertainty about the future health of AIG and the size of future government obligations, works against the recovery of the U.S. economy.

Read the AIG release here.

See my interview on this topic on BNN.

Hemorrhaging Jobs

The losses are staggering. If the pace of January and February continued through the year, the U.S. would lose 8.4 million jobs in 2009.

That is unlikely, but it will be ugly. Consider the following facts.

The percentage job losses have now exceeded the deep 1981 recession. Since December 2007, the U.S. has lost 3.17% of nonfarm jobs. In 1981, the loss 3.07%. But we are not done yet.

The recent survey by Duke University and CFO Magazine had CFOs cutting 5.7% of their workforce in 2009. Further, they see the recession lasting another 14 months.

Let's do some calculations. There are 111 million private sector jobs. 5.7% layoffs means 6.3 million jobs lost in the private sector.

Currently, the labor force is 154 million and there are 12.5 million unemployed, implying an unemployment rate of 8.1%.

Now suppose the CFOs are correct and we lose another 6.3 million jobs and the unemployed rise to 18.8 million (12.5+6.3). That implies an unemployment rate of 12.2%.

So you think the CFOs are pessimistic? Well, maybe they are. But we are forgetting something. We are measuring "planned" workforce reductions. This number does not include the layoffs that result from firms going out of business. Hence, there is reason to believe the number could be greater than 6.3 million.

Wait, we have forgotton the "stimulus" plan. In the most optimistic (and unrealistic) projection, 3 million jobs are created. This means (only) 15.8 million unemployed and a rate of 10.2%. In my opinion, it is more realistic to think that 1.5 million new jobs are created by the plan. This leaves us with 11.2% unemployment.

There is a serious disconnect here.

The Obama economic team's analysis of the stimulus plan had unemployment capping out at 8% (with the plan). We have already blown through 8%.

More seriously, the so called "stress test" assumes a worst case scenario of average 8.9% unemployment in 2009. That is not a worst case. That is not even a realistic projection. We could hit 8.9% in the next two months! Oddly, the "baseline" scenario, also has 8.9% unemployment in 2009. What kind of scenario analysis has identical projections for "baseline" and "severe"?

Unfortunately, the news gets worse. Unemployment lags the business cycle. This means that even if there is a recovery in the economy in 2010 unemployment will likely continue to increase. The stress test worst case had unemployment increasing 1.4 points in 2010.

The recent data suggest: (1) the situation is much more severe than the policy makers are letting on and (2) the stress test exercise for the U.S. financial institutions will have little value because of the unrealistic assumptions about the economy in 2009.

Given the trillions that the American taxpayers are shelling out, I think they deserve transparency and straight talk. It is better to tell them how bad it really is than to sugar-coat some economic projections that will surely lead to future disappointments -- and decreased confidence.

That Sinking Feeling

AIG is back to the trough for another $30 billion. The U.S. already gave them $150 billion.

AIG -- supposedly a firm in the insurance business -- got into trouble taking an astounding $450B unhedged bet in the Credit Default Swap (CDS) markets. They insured the holders of mortgage debt and other asset backed securities.

I have no idea how you can consider yourself an insurance company and take the largest unhedged bet in the history of business.

Folklore suggests that the original $150B deal was made quickly over the telephone with former Treasury Secretary Paulson. A default by AIG would sent many firms instantly into bankruptcy -- including UBS and Goldman Sachs (need I say more?). These banks were technically hedged - but their hedges assumed no counterparty risk (i.e. their hedges would only work if AIG was solvent). FYI, a hedge with counterparty risk is not a real hedge. So these banks share some blame too. In addition, our regulators were asleep at the wheel. Essentially, there was no oversight - even though the U.S. taxpayer is covering the downside.

At the time, the deal seemed like a good one. The U.S. taxpayer (in contrast to a number of other deals) got equity worth 79.9% of the firm. The taxpayer had the upside!

However, we now know that there was no attempt to value the firm. If the most basic valuation was done, it would be evident that the firm had a huge negative net worth - probably -$250B!

Valuation? --You gotta be kidding. Knowing the value of what you are buying? -- Not required! This is the legacy of our government's actions during the financial crisis.

Each working American has written a check to AIG for $1,200 because of the reckless bets they took.