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Thursday, 13 November 2008

Hubris and more of it?

The credit crunch and recession is blamed by all and sundry on "hubris", the self-preening, overweening pride, self-confidence, superciliousness of bankers apparently believing that asset values cannot collapse and house prices can only going up. But from the hubris of nothing can go wrong we now get daily a similat hubris of 'experts' everything is going wrong? Former Goldman Sachs chairman octogenarian John Whitehead, said at the Reuters Global Finance Summit on Wednesday, the economy faces a slump deeper than the Great Depression and a growing deficit threatens the credit of the United States itself ...worsening consumer credit woes combined with an overtaxed federal government... I think it would be worse than the depression... We're talking about reducing the credit of the United States of America, which is the backbone of the economic system... the country's financial strength is at risk due to the sweeping demand for tax relief and a long list of major government spending plans... I see nothing but large increases in the deficit, all of which are serving to decrease the credit standing of America... the country's record deficit is poised to balloon as the public calls on government for more support. Before I go to sleep at night, I wonder if tomorrow is the day Moody's and S&P will announce a downgrade of U.S. government bonds... Eventually U.S. government bonds would no longer be the triple-A credit that they've always been. Disaster indeed?
The FT reported also on Wednesday with some shock-horror("Financial groups' losses near $1,000bn", 12 November) that losses from the credit crisis are approaching $1 trillion after a recent further drop in the value of mortgage-backed securities and other debt securities.
But all this panic-stations is not news. The Bank of England Stability Review last month calmly put the figure for US financial institutions's losses at $1.3 trillion and this does not include mortgages and other debts on balance sheet, which add another $700bn in current, or soon to be, impaired and defaulted loans.
We know and expect this; at least I do thanks to my capital risk models, which should be what every bank has. The simple story is that US banks have $1 trillion in capital. This will be wiped out nearly twice from credit cycle trough to recovery. The US Government is in various ways effectively providing $1 trillion in capital and debt protection to replenish US banks' capital once. That capital will be wiped out again by corporate and consumer defaults and non-mortgage asset losses. The general recovery out of discounted collateral including foreclosures will be 55% of the losses, approximately $1 trillion. This will take 1-3 years. A further $1 trillion has to be found by the banks hemselves from cost savings, sales of assets and business units so that Government support may be redeemed.
By cutting in half banks' losses early the Government's intention is to maintain bank capital and lending sufficiently so that banks can help in economic recovery. The exact same story is the case for the UK. Not all banks get the message however, and some are too willing to dispense with Government help. They may be under-estimating how much their capital is at risk over the coming year. It is not hard to forecast that this will be double what can be expected in less severe recessions. US corporations have over $20 trillions in financial debt and households have over $14 trillions, which put some reassuring perspective on the US Federal Debt of only £10 trillions about which there is also much anxiety.
Actual Federal Debt is really only $6 trillions since over $4 trillions is internal to Government. It is debt between Government agencies. Similarly, in the UK about one quarter of the National Debt is internal and therefore only about one third that of UK Corporations and households. Of course, this is not to say there will not be real losses and millions losing their jobs and others lifetime savings. That's the awesome beauty of capitalism, it's ability to survive such earth-shaking tremors. The US banking sector will experience about 15% defaults in aggregate worth $5 trillions of which nearly half will turn into losses resulting in a final economic loss of about $1.2 trillion after debt recoveries achieved over the next 1-3 years. That is the scale the US authorities are reckoning with. The sooner everyone recognises these proportions and ceases to panic about such numbers, the better for all.
Whitehead, possibly like many oblivious to private debts and over-anxious about government debt (our tax money after all, though why anyone thinks private debts are potentially a far worse tax risk I'm not sure?) said there are at least ten trillion dollar problems facing the United States, including social security, expanding health insurance, rebuilding infrastructure and increased spending on green energy. At the same time, the public does not want to pay for it. The public is not prepared to increase taxes. Both parties were for reducing taxes, reducing income to government, and both parties favored a number of new programs -- all very costly and all done by the government. Large deficits can weaken the country's credit and increase its borrowing costs, which already constitute a significant part of funding to cover expenses. It could take several years for the current problems to be resolved. I can only imagine that in an era when now $trillions trip of the tongue as leadenly as $billions did only 30 years ago that it is easy to worry.
Whitehead said he was speaking out on this topic because he is concerned no lawmakers are against these new spending programs and none will stand up and call for higher taxes. I just want to get people thinking about this, and to realize this is a road to disaster...I've always been a positive person and optimistic, but I don't see a solution here.
Of course it will take several years. Average economic trough to cycle peak is six years. But, the fear about taxation and Government debt is I firmly believe unfounded. One has to take the macro-economic view, see the bigger picture. When Government weighs in its spending is automatically 30-40% cheaper than private alternatives and if it invests in ways that are more beneficial for everyone, for the whole economy, then the effect is not to borrow at the expense of future taxpayers (another political urban myth) but to our and their benefit. That's how I see things. I'm not panicking.

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