BAC and WFC Have No Equity After Accounting For Bad Loans

I have always had the suspicion that Wells Fargo's (WFC) loan values were inflated and wrote as much in January.  Wells sits at ground zero of the housing implosion and the fact that their numbers held up so well was a mystery…unless they were very slow to take write downs for bad loans.   The company's own 10-K reveals that my suspicion was correct.  Numerous banks are equity deficient which explains the continued weakness in the stocks.   

According to Jonathan Weil at Bloomberg "Perhaps never before have so many banks’ balance sheets been so patently full of hot air. Bank of America Corp. last week disclosed that its loans at the end of 2008 were worth $44.6 billion less than what its balance sheet said." 

Investors may be placing too much faith in bank's capital ratios.  If the bank's own estimates of fair value were applied to the company's balance sheet the banks would be technically insolvent.  Weil continues:

Bank of America, for instance, had $35.8 billion of tangible common equity as of Dec. 31, before it completed its government-aided acquisition of Merrill Lynch & Co. That figure falls to negative $1.7 billion once it’s adjusted so that all financial assets and liabilities are measured at fair value, using the numbers BofA disclosed in its footnote. The fair-value version shows BofA needs lots more common equity — badly.

Wells Fargo’s tangible common equity was $13.5 billion as of Dec. 31. On a fair-value basis, it was negative $133 million. That makes the bank’s $40.9 billion stock-market capitalization look awfully rich.

In total, eight of the 24 banks in the KBW Bank Index had negative tangible common equity on a fair-value basis, including SunTrust, KeyCorp, Fifth Third Bancorp, Huntington Bancshares Inc., Marshall & Ilsley Corp. and Regions Financial Corp.

This indicates to me that these companies will soon be back at the government's teat to get more capital injections, further diluting current shareholders.   

If You’re Bearish: Time Has Run Out For A Rally Edition

The time has run out for a rally on the S&P 500, according to James Flanagan, head of Gann Global Financial.  Flanagan uses a historical database of stock and commodity prices to analyze current moves in prices.  His knowledge of market history is unsurpassed and he has been superb in calling the decline in all market since 2007. 

His current database indicates the only historical precedent for the current stock market decline is the 1930 – 1932 time period.  And according to all five legs down during that time period, the current market has run out of time and is due for the next leg down.  Based on a similar analogy, the S&P 500 could decline to between 420 – 700.  The following chart shows the various scenarios from that time period. 

According to Flanagan, "If we are to replicate the velocity of the leg down which occurred into the November 21st low, an the 6 legs down during the "great Depression", there is a high probability we are at a breakaway point where the market can move down very quickly."

"If the Stock Market moves higher from here, it will divorce itself from the market geometry of the declines during the Great Depression.  As you are aware, I do not expect this to happen although for the sake of America I hope it does," adds Flanagan.  

Yes, lets hope it does. 

Gann Global 021709  

Source: Gann Global Financial

If You’re Bullish: Time For A 70’s Party Edition

Many traders have been following the 1974 analogy to the current market.  The Dow Industrials have traded in a remarkably similar pattern to the Dow in the 1973 – 1974 time period. 


According to the analogy, the market is now due for a major advance of 50% – 70%.  In the chart below, the current Dow Jones Industrial Average is pictured in blue, while the 1973 – 1974 Dow is a black line.


Dow today vs 1974  


 Source: Bloomberg


The following chart is a closeup of the current market versus the market in 1974.  The comparison basically shows that the market should not make a new low.  In fact, it should begin a rather strong advance within the next several days, otherwise the overlay will disengage.  


Dow today vs 1974 closeup


 Source: Bloomberg

Credit Thaw Foreshadows Equity Rally

So the bottom line is we're making loans. We want everybody to know it. I mean, we even have banners hanging on the outside of our branches, saying we're making loans. And so if you see somebody that says, they can't get a loan, give them my number.

— Kelly King, CEO of BB&T

Thawing Despite the horrendous news on employment and corporate profits there is some good news from the markets.  Overall, the credit markets have unfrozen for all but the worst credits.  I pointed some of these indicators out in September of last year after Lehman Brothers went bankrupt.  At that time, the indicators correctly warned of the vicious beat down that stocks were about to receive.  Right now, they are showing the exact opposite.  Things are generally returning to normal in the credit markets.  Five months after the Lehman debacle, trust is slowly being restored.  Stocks should be beneficiaries of this improvement in the credit markets.  

Some market observers might miss this improvement. Most of the measures of short term liquidity in the credit markets use short term Treasury securities to measure the "spread."  The spread is the difference between the debt instrument, such as corporate bonds, and the "risk-free" rate, or US Government T-Bills.  T-Bill rates are trading at, what I believe, are unsustainably low interest rates because of the flight to safety.  In January, short term treasuries actually had a negative yield when you account for transaction costs because investors were so scared, they were happy to lock in a guaranteed loss rather than risk money in other credit instruments.  The point being, if you look at any debt instrument versus Treasuries, the spread will still be indicating financial stress.  But that's only because treasury securities are trading at unsustainable levels.  With that in mind, let's look at some of the indicators of credit market health.

TED Spread 

The TED spread is a money market spread that measures the difference between the three month T-bill interest rate and three month LIBOR (the interest rate at which banks lend money to each other without posting collateral). The TED spread is a measure of liquidity and shows the degree to which banks are willing to lend money to one another. 

The TED spread has returned to 1.0 or 100 basis points, which is the level at which it was trading before Lehman Brothers went bankrupt.  Yet this level is still higher than pre-credit crisis, when the TED spread (the blue line in the chart below) routinely hovered at 50 basis points or below.  However, it you look at the actual yield of LIBOR (the brown line in the chart below), it has returned to 2002 and 2003 levels, indicating that banks are not charging an outrageous premium to lend to one another. 

TED 020609

Click To Enlarge Image

Source: Bloomberg

Commercial Paper

The commercial paper market shows a similar development.  The commercial paper to US treasury bill spread has returned to pre-Leman Brothers levels.  However, corporations that access the commercial paper market are now paying the same low interest rate as they did in 2002 and 2003.  While the spread is still elevated, the yield on commercial paper has returned to all time lows.  That indicates investors are willing to accept a "normal" interest rate for the risk they are taking on.  Granted, only the highest quality companies are accessing the commercial paper market but the trends are still encouraging.

Commercial Paper T Bill Spread_1020609

Click To Enlarge Image

Source: Bloomberg

Industrial Corporate Bonds

The corporate bond market finally perked up last week with several large deals that were well received.  You can see a similar trend as in the commercial paper market.  While the spread is still elevated, the interest rates for AAA corporate bonds is hovering near all time lows.  Investors are willing to accept a relatively low yield for the highest quality paper.  This indicates that investors are willing to pay up for high quality corporate bonds to earn a higher yield. 

Corporate A Yield 020609

Click To Enlarge Image

Source: Bloomberg

Single A corporate bonds show a similar trend although as you might expect, the yields have not dropped as sharply as with AAA rated bonds.  Investors are sill willing to pay a premium for safety.

Corporate A Yield 020609

Click To Enlarge Image

Source: Bloomberg

The most interesting chart in corporate bonds is the yield of the lowest quality credits.  While interest rates have dropped for both AAA and A rated bonds since the beginning of the year, the rates for BBB rated bonds have actually continued to increase.  So while investors are flocking back to high quality credits, they are still shunning lower quality bonds.  That would be normal investor behavior in a recession. 

B Corp Yield 020609

Click To Enlarge Image

Source: Bloomberg

If you believe that the collapse in the credit markets last September lead to the carnage in the stock market, then the current improvement in the credit markets has to make you bullish.  The trends from the credit markets indicate that trust is returning and credit is flowing for all but the worst credits.  The damage from the credit markets has obviously done serious collateral damage to the real economy, which might well continue to weigh on corporate earnings.  However, the environment has improved which should provide a support for stocks.  A rally back to October highs of 1,000 in the S&P 500 and of S&P 1,000 and 9,500 on the Dow seem achievable.  

GDP Deflator Actually Deflates

After a brief bout of enthusiasm this morning, when GDP came in at -3.8% vs estimates of -5.5%, investors quickly realized that the majority of the "beat" came because of an inventory adjustment.  Inventories grew $6 bil vs. a decline of $28 bil last quarter.  That artificially "lifted" GDP by 1.2%.  In essence, companies were stuck with more inventories than the end market demanded.  In a quirk of GDP reporting, this inventory build gets counted as growth.   

Not as widely discussed were the import/export component of GDP.  Net exports added to the GDP calculation, which is good.  However, that's only because imports fell even more drastically than exports fell.  And that's not particularly good for world growth.  Demand all over the world is falling off a cliff.  Therefore, statistically, Q4 may NOT be the low for the economy, as some are hoping. 

However, that's not the most alarming and significant part of the GDP report.  The headline numbers that are reported are typically "Real" GDP numbers, which are adjusted for inflation.  Normally, inflation reduces "Nominal" GDP (GDP not including the inflation adjustment) yielding a lower Real GDP number.  This adjustment is known as the GDP Deflator.  However, nominal GDP declined significantly for the first time since 1960 and at a larger rate since 1958.  In fact, this report was the first since 1952 when deflation actually added to the "real" GDP number.  In other words, this is the first time the GDP Deflator has actually deflated in 60 years.  This is deflation showing up in official government statistics for the first time.  

GDP Deflator 013009

Source: Bloomberg

Click Image to Enlarge

It's no wonder that companies can't cut expenses fast enough.  Corporate profits are shrinking even if management does a great job on costs because sales are falling even faster.   

Deflation is taking a wicked hold of the United States economy.  So even though the Treasury is pumping money into the system like mad, they aren't pumping fast enough. 

The Communists Lecture Us

French TauntingI don't want to talk to you, no more, you empty-headed animal, food trough wiper. I fart in your general direction. You mother was a hamster and your father smelt of elderberries.

French Guard, Monty Python and the Holy Grail

So it's come down to this.  The United States is being lectured by Communists about economic policy.  From the Financial Times:

Wen Jiabao, the Chinese premier, and Vladimir Putin, Russia’s prime minister, used the World Economic Forum in Davos to argue that the two rising powers must play a bigger role in a new economic order.

Mr Wen made scathing comments about the “inappropriate macroeconomic policies” of some unnamed countries and the “unsustainable model of development characterised by prolonged low savings and high consumption”.

He attacked financial institutions’ “blind pursuit of profit” and their “lack of self-discipline”.

The two men’s self-confident speeches contrasted with the gloomy mood hanging over the annual gathering of the world’s political, financial and social leaders. “This is Davos under the Russian flag,” Dmitry Peskov, Mr Putin’s spokesman, told reporters on Tuesday.

Their speeches came as a senior adviser to Dmitry Medvedev, Russian president, criticised the scale of the new US administration’s economic rescue package and projected budget deficit, saying it would suck liquidity from other global markets.

“What is discouraging is [Barack] Obama’s statement that he is going to run a $1 trillion deficit for years to come. For us, that means that all the free liquidity in the world will run into American Treasury bills,” said Igor Yurgens, who heads a think tank advising Mr Medvedev.

Mr Yurgens likened the policy to the “beggar thy neighbour” protectionist policies of the 1930s. “Of course, [Mr Obama] expects the Chinese or Russians to buy US Treasury bills. That is pretty selfish and philosophically it is protectionism,” he said.

Mr Wen also voiced concern about protectionism as he called for the establishment of “a new world economic order that is just, equitable, sound and stable”.

The Russian and Chinese leaders are pretty brazen, given the fact that their own economies are facing very difficult circumstances.  It's becoming fairly clear that unless the world economy miraculously turns around, the Chinese government will have a difficult time finding a purpose for the myriad of workers now returning home after their factories closed.  You can get a sense of it from the poignant article on the "reverse migration" of Chinese workers in Der Spiegel

At least Xiaoju's boss did not simply abandon the factory, escaping at night, like the owners of other bankrupt factories in the neighborhood. Xiaoju heard how angry workers seized the machines in those factories. And in some factories, she says, the workers even organized gangs of thugs to collect their outstanding wages.

But these have been isolated cases so far. Most of the laid-off workers take the crisis personally, not politically. For "Little Chrysanthemum," too, the government in Beijing is far away. She has few expectations of the country's leaders, nor does she blame them for anything. "No one can be held responsible for the crisis," she says, as if she were talking about a natural disaster. "It strikes everyone in the same way."

Yet Steven Keen on his blog, Debtwatch, indicates that this might be too benign a view.  China's Providences have a history of rebellion when the Central Government's dictates go awry at the local level.  

But its current serious decline is sending probably millions of once-were-peasants back from their coastal manufacturing jobs to the countryside, where they are likely to be unemployed and seriously disaffected.

If they emulate their parents, they may well rise up against the local Party officials; the demure acquiescence to Party authority will go out the window when the Party’s policy fails them.

When it does, there will be a political shift in China at the top as well–not necessarily an overthrow of the Western, development orientation, but certainly a strengthening of those who believe, for example, that the provinces should be developed rather than throwing all the resources at the coastal manufacturing cities.

Likewise, Vladimir Putin seems unaware of the political problems that arise in Russia when commodity prices fall.  In my view, the sustained low price of oil did as much to bankrupt Russia in the 1980s and cause the fall of Communism as did President Ronald Reagan's Cold War military buildup.  The political ramifications of an economic recession are not always so severe.  However, Putin is tempting fate by lecturing the United States at a time when his own country will be facing a severe economic downturn.

China's and Russia's lectures show that the move to protectionism is starting.  The retoric is being turned up and it will only shortly follow with actual policy.  Enacting protectionist policies will do more to extend this economic contraction than any bank failure could ever do. 

 

The Devil Is In The Details

Bank stocks are rallying sharply this morning on the news that the administration and Treasury are developing a "good bank/bad bank" concept.  However, whether this rally is justified is all in the details of the plan, which no one knows yet.  For many banks, the concept of a good bank/bad bank scenario involves a binary outcome.  Either the shareholders get screwed or the tax payers get screwed. 
 
For instance, if the government just buys the assets from the banks and leave existing management in place, then the shareholders win. The government will essentially be buying toxic assets at an above market value and putting the burden on working out the problems and taking the losses on the government.
 
However, if the government takes over Citigroup because the company management teams have been incompetent, then the shareholders get nothing.  It would be a repeat of Fannie Mae and Freddie Mac.  The banks get put into conservatorship until all the assets get worked out.  Bill Siedman, CNBC commentator who ran the original Resolution Trust Company, explained the concept in a recent interview on Fast Money

Seidman said he basically nationalized many banks.  He even states that the RTC would have nationalized Citigroup if the company hadn't gotten "saved" by Prince Al-Waleed.   Siedman nationalized insolvent banks, fired and replaced management, sold off the bad assets and returned a "good" bank to the market.  The problem with this method is that it takes guts, resolve and toughness.  The government is basically taking the bank away from the shareholders and current management.  Those parties will scream bloody murder. 
 
In one scenario many bank stocks go to zero.  In the other scenario, many bank stocks double.  However, in either scenario, the overall tone of the market should improve as a huge overhand gets dealt with one way or the other.   
 
I would guess that with the current administration the tax payers won't be the ones that will bear the brunt of the cost.  President Obama doesn't seem to have the shareholder's or management's interest at heart.  However, many Taft Hartley (union) and state pension plans have big exposure large cap bank stocks.  Those plans would be badly hurt if shareholders were wiped out.   In addition, buying the toxic assets gives the Administration a way to help homeowners and banks, but not look as much like they are coddling Wall Street.  At this point, I think it is still a toss up which way the Administration will eventually lean.  

Eight Mistakes That Caused The Financial Crisis

Former Federal Reserve Vice Chairman Alan Blinder notes that six major human errors, all of which were highlighted and criticized at the time, caused the financial crisis.  Blinder makes an important point and one that I hope the new administration takes to heart.  The problems the US is experiencing right now didn't come about because capitalism isn't a good system.  They came about because of misjudgment, stupidity, greed and a lack of studying financial history.  You will never be able to legislate these basic human traits, but you can certainly develop a better framework and better enforce existing regulations to make sure you avoid the current disaster. 

The following are Blinder's six mistakes that could have been avoided as published in the International Herald Tribune:

WILD DERIVATIVESIn 1998, when Brooksley Born, then chairwoman of the Commodity Futures Trading Commission, sought to extend its regulatory reach into the derivatives world, top U.S. officials of the Treasury Department, the Federal Reserve and the Securities and Exchange Commission squelched the idea. While her specific plan may not have been ideal, does anyone doubt that the financial turmoil would have been less severe if derivatives trading had acquired a zookeeper a decade ago?

SKY-HIGH LEVERAGE The second error came in 2004, when the SEC let securities firms raise their leverage sharply. Before then, leverage of 12 to 1 was typical; afterward, it shot up to more like 33 to 1. What were the SEC and the heads of the firms thinking? Remember, under 33-to-1 leverage, a mere 3 percent decline in asset values wipes out a company. Had leverage stayed at 12 to 1, these firms wouldn't have grown as big or been as fragile.

Today in Business with Reuters ING Group to cut 7,000 jobs Philips to shed 6,000 jobs after quarterly lossAt Davos, crisis culls the guest listA SUBPRIME SURGE The next error came in stages, from 2004 to 2007, as subprime lending grew from a small corner of the mortgage market into a large, dangerous one. Lending standards fell disgracefully, and dubious transactions became common.

Why wasn't this insanity stopped? There are two answers, and each holds a lesson. One is that bank regulators were asleep at the switch. Entranced by laissez faire-y tales, they ignored warnings from those like Edward Gramlich, then a Fed governor, who saw the problem brewing years before the fall.

The other answer is that many of the worst subprime mortgages originated outside the banking system, beyond the reach of any federal regulator. That regulatory hole needs to be plugged.

FIDDLING ON FORECLOSURESThe government's continuing failure to do anything large and serious to limit foreclosures is tragic. The broad contours of the foreclosure tsunami were clear more than a year ago — and people like Representative Barney Frank, Democrat of Massachusetts, and Sheila Bair, chairwoman of the Federal Deposit Insurance Corporation, were sounding alarms.

Yet the Treasury and Congress fiddled while homes burned. Why? Free-market ideology, denial and an unwillingness to commit taxpayer funds all played roles. Sadly, the problem should now be much smaller than it is.

LETTING LEHMAN GO The next whopper came in September, when Lehman Brothers, unlike Bear Stearns before it, was allowed to fail. Perhaps it was a case of misjudgment by officials who deemed Lehman neither too big nor too entangled — with other financial institutions — to fail. Or perhaps they wanted to make an offering to the moral-hazard gods. Regardless, everything fell apart after Lehman.

People in the market often say they can make money under any set of rules, as long as they know what they are. Coming just six months after Bear's rescue, the Lehman decision tossed the presumed rule book out the window. If Bear was too big to fail, how could Lehman, at twice its size, not be? If Bear was too entangled to fail, why was Lehman not?

After Lehman went over the cliff, no financial institution seemed safe. So lending froze, and the economy sank like a stone. It was a colossal error, and many people said so at the time.

TARP'S DETOUR The final major error is mismanagement of the Troubled Asset Relief Program, the $700 billion bailout fund. As I wrote here last month, decisions of Henry Paulson Jr., the former Treasury secretary, about using the TARP's first $350 billion were an inconsistent mess. Instead of pursuing the TARP's intended purposes, he used most of the funds to inject capital into banks — which he did poorly.

To illustrate what might have been, consider Fed programs to buy commercial paper and mortgage-backed securities. These facilities do roughly what TARP was supposed to do: buy troubled assets. And they have breathed some life into those moribund markets. The lesson for the new Treasury secretary is clear: use TARP money to buy troubled assets and to mitigate foreclosures. 

I would add to Blinder's list 1) Alan Greenspan's desire to manage the economy to maintain his political popularity and 2) the mismanagement at the SEC in terms of eliminating the uptick rule. 

Greenspan and BushAlan Greenspan needs to take blame for lowering interest rates to irrationally low levels during the 2002 and 2003 recession.  The artificially low interest rates allowed homeowners to flood into Adjustable Rate Mortgages that were signifcintaly cheaper than long term mortgages.  It also allowed housing speculators to leverage up on cheap money.  This spurred on an already strong housing market into bubble status.  The fact that Greenspan was blind to the consequences despite repeated warnings that a housing bubble was forming, is inexcusable.  Greenspand blatently ignored the central banker's job to "take away the punch bowl just when the party starts getting interesting." Instead, he added fuel to the fire by keeping rates low even as an economic recovery was taking hold in order to appease politicians and the President.  Greenpan will go down in history as the worst and most politically influenced Fed Chairman in history.          

In addition to allowing bank leverage to go unchecked, the SEC also added to the crisis by repealing the uptick rule and allowing markets to operate unchecked.  The uptick rule was enacted in 1933, after regulators witnessed the destruction that short raids could have on investor confidence.  The regulators seemed to think these rules, enacted during the most horrific economic collapse in our history, were "quaint" and difficult to enforce.  However, they served a very important purpose – to slow down the market so investors and regulators could adjust to rapidly changing conditions.  

So with that, I propose eight human errors led to the current crisis.  All of them could have been avoided had the powers in charge understood economic history and followed the strong precedents set before them.  Theses errors can be fixed without enacting major socialist legislation, imposing trade barriers or placing undue burden on a very fragile economy.     

Digging Into The Layers Of Domestic Debt

Most economists and stock market analysts are finally coming to the conclusion that the United States is in too much debt to jump start a quick economic recovery.   Yet most of the analysis of the US debt levels is still simplistic and misleading.  Digging into the layers of debt within various sectors of the economy is very similar to excavating archaeological layers of the earth.  While some sector debt levels will have to be reduced drastically, others can still be expanded. 


The following chart has been widely distributed now thanks to Henry Blodget at Yahoo Finance, nakedcapitalism and Nouriel Roubini, among many others. It shows the ratio of domestic debt to total US Gross Domestic Product – comparing the total amount of debt outstanding to the gross economic output.  Right now, the amount of debt outstanding is staggering relative to our nation’s economic output.


USDebtload-0_97x0_97


Source: Ned Davis Research


Click To Enlarge Chart


But the chart is a bit misleading and simplistic.  First, the government didn’t keep official debt figures until the mid 1950s.  You’ll see at the bottom of the chart that data prior to 1946 was “interpolated”.   While I’m sure Ned Davis did their best to make sure the data was accurate, it’s far from clean data.  Second, a large part of the increase in the Credit Market Debt ratio in the early 1930s was caused by the implosion of the numerator – i.e. Gross Domestic Product (GDP) growth fell off a cliff by 40% in the early 1930s.  That accounts for much of the spike in the ratio.  So while the overall idea of the chart is correct – there’s a lot of debt outstanding – the numbers are a bit questionable.


The other problem with simply looking at the total debt is that it doesn’t take into account the other side of the balance sheet – the assets.  Over the past two decades, the level of assets for US Households has increased significantly as a percent of total GDP.  So while Household debt has grown rapidly, so have household assets.  However, that trend is now reversing and if it continues as is likely, it will become an issue.   The absolute level of assets still far outweighs the level of debt as is shown in the chart below. 


Household Net Worth Relative To Household Debt 012109  


Source: Bloomberg


Click To Enlarge Chart


Debt is definitely a problem.  The overall level of debt has increased dramatically in all economic sectors which is now weighing on the potential for an economic recovery.  Let’s take a look at the official government data since the 1950s and the various components of that debt to get a better understanding of what we’re up against.  The following chart comes from Bloomberg and shows the total debt levels by sector of the economy as measured by the Federal Reserve.   Remember, the debt levels are shown as a ratio – Debt/GDP.  Therefore, an increasing line means that debt is rising faster than GDP growth and a declining line means debt is declining versus GDP growth.  This data is compiled quarterly and published in the Federal Reserve’s Flow of Funds Report.



  Debt as a percent of GDP By Sector   


Source: Bloomberg


Click To Enlarge Chart


The Federal Reserve breaks down debt levels into two broad categories – 1) Domestic Non-Financial sectors and 2) Domestic Financial sectors.  The Domestic Non-Financial sector is further broken down into the following economic sectors – 1) Household 2) Business 3) State and Local Governments, and 4) Federal Government.   The Household debt includes both secured Mortgage Debt and unsecured Consumer Credit, neither of which I have shown on the chart. 


Domestic Financial Debt


Let’s examine the debt levels by category.  First, the largest and most rapidly growing sector has been Domestic Financial sector debt.  As we now know, the absurd increase in leverage by Investment and Money Center banks caused the huge increase in the Domestic Financial sector.    The deleveraging of this sector is currently weighing on the overall market.  As you can see, there’s a long way to go before the debt levels in this sector return to more normalized levels.  


The total amount of Domestic Financial sector debt currently stands at $16.9 trillion.   As of the fourth quarter of 2008, US financial companies have written off approximately $729 billion in debt, according to Bloomberg.   I would estimate that the Domestic Financial sector would have to continue to deleverage either through write-downs, write-offs, asset sales or simply paying down until debt returns to $10 to $12 trillion or 70% to 80% of GDP.   That implies another $3 to $4 trillion in debt deleveraging.  Mind you, I’m not predicting $3 – $4 trillion in write-offs – much of the debt will be eliminated through asset sales, paying down debt and portfolio run-offs.


Debt Outstanding Financial Institutions 012109  


Source: Bloomberg


Click To Enlarge Chart


Household Debt


The second largest sector is Household debt which consists of Mortgage Debt and Consumer Credit.   Household debt currently stands at $13.9 billion or 97% of GDP.  Debt growth in this sector began increasing at an accelerating rate in 1999 and 2000 as the housing bubble began to inflate and as households turned to credit to maintain their lifestyle during the 2001 – 2002 recession.  It’s interesting to note this is the only sector which has begun turning down.  Obviously, the housing bust is largely responsible for the reduction in mortgage debt.   However, after the horrendous holiday retail sales season, I believe even consumer credit has turned down as well.  This is perfectly rational behavior on the part of the consumer.  The economy has slowed, the housing market has turned down and consumers are retrenching.  I venture that until Household debt declines to the mid 1990s level of 70% of GDP, the consumer will continue to pull back.  That implies consumer debt will have to decline $3.9 trillion from current levels.


Debt Outstanding Household 012109


Source: Bloomberg


Click To Enlarge Chart


Business Debt


The remaining sectors of business and government debt are actually in relatively good shape.   Business debt stands at approximately $11 trillion or 75% of GDP.   While this is high, it’s not much higher than debt levels in the mid 1980s or early 2000s when Business debt averaged around 70% of GDP.    I estimate that over the next several years, Business sector debt will decrease by $1 trillion as companies go bankrupt or decide to pay down debt with cash flows rather than increase dividends. 


Debt Outstanding Business 012109  


Source: Bloomberg


Click To Enlarge Chart


Federal Debt


The deleveraging from the private sector is being offset by the leveraging up of public debt.   Luckily for President Obama, Fed Chairman Bernanke and Treasury Head Timothy Geithner, Federal government debt as a percent of GDP is actually relatively low.   Current Federal Government debt as a percent of GDP stands at 40% or $5.8 trillion.  Be aware that this figure is not the $9.4 trillion figure widely quoted as “public debt.”  The $5.8 trillion number does not include State and Local Debt, not does it include debt owed to the government itself, such as in the Social Security Trust Fund.  The amount of Federal Debt actually compares favorably to other developed countries.  For instance, Germany’s debt relative to GDP stands at 60% and other European countries stand at over 100%.  Most amazingly, Japan’s two decade long fight against deflation has increased its level of Federal Debt to GDP to over 160%. 


Debt as a percent of GDP Japan


Source: Bloomberg


Click To Enlarge Chart


The fact that Federal Debt is actually a relatively low percent of GDP partially explains why the US government debt is still considered a “safe haven.”   The US government actually has the ability to continue leveraging up.   If it were to expand its balance sheet to the level of Japan’s, it could borrow over $17 trillion more.    This level of borrowing seems unrealistic but it does go to show that the Federal government does have room to maneuver.   It also explains why, despite the huge deficits projected by the Obama administration, the dollar has remained relatively strong. 


State and Local Debt


The final layer of debt measured by the Federal Reserve is State and Local Debt.  At $16.9 billion, this also seems well under control relative to GDP.  Most states are not allowed to run budget deficits and many governments were aided by the housing boom in expanding revenues.  That spending will have to contract to keep the ratio in line relative to GDP. 


Based on my back of the envelope calculations, I believe Financial, Household and Business debt will be reduced by $8 – $9 trillion over the next decade.   This level of deleveraging would bring debt to GDP levels back in line with the early 1990s.  However, the deleveraging of the private sector will be met by the leveraging up of the public sector.  Lawrence Summers, director of the White House’s National Economic Council, confirmed this week that the government will run deficits as far as the eye can see in order to combat the deleveraging going on in the real economy.  


The implications for stock market investors are rather obvious.  While the consumer retrenches, retail spending will remain weak.  The domestic financial sector will also remain weak as those companies continue to deleverage, impairing profitability and reducing growth.  And while businesses will also see some retrenchment, the balance sheets of many US corporations remain strong.   Companies with strong balance sheets should come out on the other side of this downturn in better shape than ever.  Finally, while unchecked government spending is abhorrent to most every taxpayer, the Federal Government actually has the balance sheet to leverage up.  That should avoid a major crisis of confidence in the solvency of the United States, at least in the upcoming four years.