Banks and the Avalanche of Deflation
Let's examine how we arrived at asset deflation, the impacts of deleveraging, future banking trends, and the impact of massive stimulus.
Although we've previously provided an in-depth diagnosis of the root causes behind the slide, in this article we elaborate on our previous diagnosis, discuss the impact of delevering thus far, outline the evolving banking and regulatory landscape, peer at the mess from the corporate banking suite, and finally lay out likely scenarios that might result from the massive twin stimulus currently being applied to the economy.
Diagnosis of the Setup for the Slide
As anyone who has seen an avalanche in person or on the big screen knows, it seems to come out of nowhere, gain downhill momentum in a flash, and inevitably run its course. Just as in the Rocky Mountain high country, many of the agents in our global economy--financial intermediaries as well as overleveraged individuals and institutions--had come to resemble a thick unstable slab of new snow resting atop an eroded base, ready to sheer off with the slightest adverse rumble.
The underlying dynamic is quite simple and resembles so many similar sad stories from history. Not just in U.S. housing, but in many real estate and financial markets around the world, we are now watching the unhappy outcome as a rigid pile of leverage rapidly crumbles, hideously exposing overvaluation across various asset classes. It is a classic bubble and bust.
It's our contention that asymmetric monetary policy, applied over decades in a facile attempt to reproach the unpleasant side effects of a typical recession, produced quite the opposite in the end. By heading off typical recessions--with monetary stimulus and inflating asset prices--before allowing the normal storing up of future economic activity that derives from deferred investment and asset replacement, investors became overly confident in "the great moderation." Long ago, Hyman Minsky clearly identified that this fosters only a relentless increase in the amount of financial leverage in the system, as those who make levered bets on reflation turn up aces over and over again, attracting new followers. This behavior reflects extreme risk tolerance compared with that displayed by the generation scalded by the hardships associated with the Great Depression, from which we are now one or two generations removed.
Serial bouts of asset inflation and steady increases in leverage employed eventually led to the dot-com bubble, which was a real doozie as it burst. When the Fed applied even more massive monetary stimulus in an attempt to thwart the deflation risk that threatened an already overleveraged society, it merely inflated an even bigger bubble, quite notably in the housing market. The key actors that took the easy money and ran were the investment banks, so-called "shadow banks," and improperly adventurous traditional banks.
Regardless of whether a loan was originated in a branch or by a broker in a low-rent strip mall, many nonconforming loans ultimately found their way to Wall Street, where they were aggregated into ill-conceived and poorly executed mortgage securities. Without the multitrillion-dollar government-sponsored enterprises (GSEs) known as Fannie Mae (FNM) and Freddie Mac (FRE) serving as a backstop, Wall Streeters likely would have been less aggressive in their calculus as they took advantage of these easy marks by layering increasingly risky loans against a wobbly but quickly appreciating pile of collateral. As the GSEs lost more and more market share, Wall Street knew they would have no practical choice but to chase the exotic mortgage trend and underlying collateral growth, ratifying the "soundness" of prior private-label mortgage securities, no matter how poorly underwritten.
While the housing market underlies the most conspicuous bubble now bursting, overleveraging of rapidly appreciating assets also took place in the commercial real estate realm and with financial assets at investment shops such as levered credit hedge funds, mortgage REITS, and especially at Wall Street investment banks. Even as many hedge funds and investment banks failed spectacularly quite early and other investment banks were merged away or found shelter with the Fed as newly initiated bank holding companies, business and commercial real estate loans/securities represent an accelerating source of pain that will be splashing the headlines for the foreseeable future due to the worsening economy. While the residential housing bust started the slide and consumer deleveraging quickly ensued, the next shoe to drop relates to businesses built on the premise that consumers would always find new ways to part with their paycheck and/or borrowed funds. Sadly, business layoffs complete the feedback loop by further depressing the housing market as foreclosures add to the glut of inventory.
The Great Unwind
The unwind of all this debt and coincident asset price deflation is ugly to say the least. The first victims were among the most levered, those holding the dodgiest assets, those with the shortest-dated liabilities, and the least diversified. While highly levered holders of subprime CDOs met their fate rather quickly as investment bank lenders called in loans, the process takes much longer for homeowners that don't face a margin call when home price declines put them underwater on what's often the largest and most levered holding in a family's portfolio.
For levered financial intermediaries stuck with questionable loans and securities, lenders and counterparties began to back away upon the realization of mounting risks, which led to a quickening pace of failures. For institutions regarded as too big to fail, this is where the government began to step in, first with the Federal Reserve backing the sale of Bear Stearns and then later with the Treasury and FDIC saving a variety of other institutions. Along the way, it was decided to let Lehman Brothers and Washington Mutual fail, leading to massive losses for many lenders to these institutions. This dramatic realization of an existing fear heightened concern into sheer panic among lenders to competing financial intermediaries.
The pace of dominoes tumbling would have hastened without the ensuing TARP program and the apparent realization by government officials that they were faced with a drastic decision: Either let the dominoes continue to fall and attempt to clean up after the fact; effectively or explicitly guarantee that bondholders would be protected going forward; or step in and nationalize the next dominoes in line. Since then and to this point, the government seems to have decided to protect lenders and has taken partial ownership of the vast majority of banks via preferred equity purchases, one step short of outright nationalization. The government also brokered or approved a variety of mega-deals among financial intermediaries deemed too big to fail.
Future Regulatory and Banking Trends
With the big banks only getting bigger during this period of rapid consolidation, it begs the question: How are we to deal with the (now amplified) too-big-to-fail problem in the future? In our view, its a near impossibility that too-big-to-fail institutions will ever be dosed with appropriate market discipline from their lenders--given recent precedent showing providers of wholesale funds to banks will likely be bailed out--to head off future risk of systemic failure. While the U.S. is merely catching up with many other countries that are already dominated by banking oligopolies, one might ask why not follow the same path? Perhaps an oligopolistic banking environment is inherently more stable as competition eases a bit. Recent evidence from the United Kingdom, Ireland, and Iceland would suggest otherwise, as these banking oligopolies disintegrated even more quickly than in the U.S.
Barring market discipline from lenders and depositors (who are also increasingly insured), improved regulation seems to be the likely answer. That's fine since there has been an amazing lack of regulation and enforcement, which suggests that considerable improvement should be an attainable goal. Although this is a necessary step, we don't see it as a sufficient long-term solution. As the memory of recent events fades and regulatory arbitrage once again rears its ugly head, it seems likely that any new and improved regulatory scheme could ultimately fail somewhere down the road.
Others argue that the most simple and elegant answer to the too-big-to-fail problem is to reduce the size of these institutions. Although we acknowledge that this line of thinking has legitimate appeal, we don't view it as likely because it would be an outright rejection and remediation of recently encouraged deals. This about-face would also be very complicated to implement, especially if attempted before the avalanche debris is cleared, and would be an affront against recent white knights that rode to the rescue.
Because regulation requires constant vigilance and evolution to keep pace with private profit seekers and we seem to be cursed with the too-big-to-fail problem for the foreseeable future, it seems that the best way to manage the cycles inherent to capitalism and human nature is to allow typical recessions to play out, inflict some pain, and sow the seeds for the ensuing recovery. Instead of blowing up asset/lending bubbles as a short-term fix, they should be leaned against as they form through some combination of higher rates, tighter lending oversight, and countercyclical capital requirements and provisioning.
Running a Bank in a Highly Uncertain World
The press is filled with complaints aired by Congress and others about a "lack of lending" from banks that are TARP fund recipients, which yields a good sound bite for the constituent-minded. Quite simply put, what would you do if faced with managing a bank caught up in an avalanche of deleveraging and asset deflation? My bet is most would swim for safety before the swirling mess of debris turns to concrete muck at the bottom of the slope.
Obviously this metaphor is an oversimplification, although the most troubled banks are doing just that. They are trying to work their way out from under problem assets, aiming for survival. We are seeing a variety of banks make the strategic decision to run off poorly chosen loans, customers, partners, exotic product offerings, and nonstrategic geographies. Many troubled banks such as Citigroup (C), First Horizon (FHN), and Morgan Stanley (MS) are shrinking and deleveraging as the securitization markets are largely shut and wholesale funding has proved unreliable.
The boldest of the bold among strong banks like J.P. Morgan (JPM), Well Fargo (WFC), PNC Financial (PNC), US Bancorp (USB), and BB&T (BBT) are attempting to profit from the massive dislocation, either by stealing long-term customer relationships from troubled peers (and the dysfunctional bond market) or by acquiring distressed assets or institutions. While the worst-off banks are in survival mode even with a government lifeline, it's the stronger banks that are forced to consider the appropriate risk tolerance at this critical juncture--a choice that will look wise or foolish depending on how bad the economy gets and how far collateral values ultimately slide. It's not lost on any bank executives that Lehman bought (additional) distressed Alt-A mortgage loans shortly before failing, or that Fannie and Freddie both regret stepping into the void that developed in the Alt-A mortgage market in the back half of 2007. Alt-A loans are contributing roughly half of the sizable and rapidly growing credit losses at the government-sponsored housing giants of late.
The Grand Fiscal and Monetary Experiment
To switch metaphors for a minute, consider the world's largest particle accelerator called the Large Hadron Collider (LHC) built on Swiss soil by the European Organization for Nuclear Research, which is expected to be fired up later this year. The LHC is a 27-kilometer underground circular vacuum track that will be used to accelerate subatomic particles (nearly to the speed of light) in opposite directions in order to create a collision that is analogous to the moments just after the big bang.
This grand experiment is also analogous to the unique nature and scale of the monetary and fiscal stimulus that the Federal Reserve and U.S. government are applying to the economy in an attempt to arrest the massive deleveraging and asset bubble burst taking place in the housing and financial markets.
We see three possible outcomes that might result from this massive collision, only envisioned in the classroom heretofore. The first is simply that the government's efforts work and deflation yields to reflation, with the key risk being overheated inflation after the initial success due to the difficulty associated with weaning the markets from the steady drip of government funds.
The second possibility is a depressionlike scenario as the dual stimulus fails to arrest the self-reinforcing slide of deflation, delevering, and clipped risk-taking that currently dominates the nation's psychology. Perhaps it could even exacerbate the situation as foreign investors lose faith in the U.S. financial markets, economy, and currency. What would you think if you were an overseas lender earning a pittance return on U.S. Treasury bonds while the Federal Reserve relentlessly printed new currency?
The third and most likely scenario--at least based on an admittedly rudimentary grasp of physics--is that we end up somewhere between these two extremes, much like Japan and its lost decade. In this scenario, the stimulus blunts the immediate magnitude of the current deflationary event, but since subsidized "teaser rates" prevent the housing market from clearing at true bargain levels, the pain is simply dulled and elongated. Each time the economy begins to emerge from its slump, the resulting higher rates pressure the housing and financial markets lower again.
Switching back to the original metaphor, let's hope that we're already far enough down the slope regarding asset price declines that the stimulus is akin to a friendly Saint Bernard pawing the snow away after a rough ride. But with more than 4 million homes for sale and widely ranging estimates of coming foreclosures easily matching this already large figure, it's hard to picture the slide settling down just yet.
Matthew Warren does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.