Debt

I wrote the below in a recent letter to partners.. (sorry about the formatting... I can't figure out why it does this.)


In order to counteract the massive contraction in consumption and business investment around
the world, governments and central banks are increasing their participation in asset markets and economies in a dramatic fashion. Here in the U.S., if one adds up all the aid and bailout money committed, both directly or through guarantees, the figure is well above our annual GDP!
All of this intervention and spending has slowed the rate of decline that global economies were
locked in, but it has done nothing to address the real structural problems many developed
economies face. Also, increased government participation throughout history has brought
inefficiency and lowered productivity.

We seem to be taking these extraordinary steps, in large part, to protect bank bondholders.
Maybe this is why in one of Bill Gross’ latest letters he advises the Obama Administration,
“Policy makers should not focus entirely one off bailouts of large estate developers,
municipalities, or even credit card issuers like they have with Citi, BofA, and AIG. Rather they
should recognize that supporting critical asset prices such as municipal bonds, CMBS, and even
investment grade corporate bonds is a necessary step towards eventual economic revival.” Really Bill? Would that work for you and your business?

All we have done so far is shift bad debt from private balance sheets to public balance sheets (and the balance sheets of our children). The debt is still bad and it is still mis-marked, if it is marked at all. (Recently, Wells Fargo reportedly sold $600 million of mostly non-performing sub prime loans to a hedge fund for 35 cents on the dollar. That mark does not bode well for taxpayers getting their money back…)

As I hammered on last quarter, we have a debt problem. So far we have done nothing to even
address that fundamental problem let alone come close to solving it. As Her Munchau so
eloquently points out, the authorities keep kicking the can down the road hoping for a recovery
to help make the loans payers again. The problem is, asset values have declined precipitously,
but debt levels remain the same.

Total credit market debt as a percentage of GDP in this country is at all time highs of close to
370%. (in the U.k. its even worse at 519% GDP!) Domestic non-financial debt as a percent of GDP is 240% of GDP and at an all time high. Financial debt outstanding remains at 120% of GDP.

Many of these debts are not performing. In January, Goldman Sachs estimates that banks would
see just over $2 trillion in losses on its book. Roubini projected over $3.5 trillion. T2 Partners
projected just over $3.7 trillion in March, while the IMF came out in April with a $2.6 trillion loss
for big banks. So far banks have taken $1.3 trillion in writedowns. (Glance back up at that recent
35 cent trade on some loans out of Wells Fargo.)

As I mentioned in last quarters letter, we are currently facing a giant wave of option arm recasts
starting in the second half of this year, that increases into late 2010. Indeed, the WSJ recently
reported that for a third straight month, option adjustable rate mortgages are generating
proportionally more delinquencies and foreclosures than subprime mortgages. According to
CoreLogic, 36.9% of option arms were at least 60 days past due with 19% in foreclosure; while
33.9% of subprime loans were delinquent with 14.5 in foreclosure.

T2 Partners broke down the problem of negative equity in a recent report. The report shows 73% of option arm loans are underwater, 50% of subprime loans, 45% of AltA, and 25% of prime
mortgages were underwater. Historical delinquency rates were around 1% for prime mortgages;
they are now at 4.5%. Almost 10% of all mortgages are in some stage of delinquency or default….
And the unemployment rate keeps climbing putting more and more pressure on these numbers.
Commercial Real Estate is really starting to roll over now. Vacancy rates are climbing; rents are
declining. Moody’s recently estimated CRE prices have fallen about 16% in two months!
Sadly (or is it terrifyingly) European banks are in worse shape than ours. They are, arguably,
more levered than even our investment banks were (think Lehman or Bear Stearns). John
Mauldin writes, “Eurozone banks are already reeling from losses from US subprime-related
problems. They are now getting ready to deal with even deeper losses from their own lending
portfolios. If the losses were just 5% of the portfolio (an optimistic assumption), it would be 20%
of Eurozone GDP. But each country is responsible for its own banks. While it is thought Germany
will be able to handle its problems, the prognostication for Austria and Italy is not so sanguine.
Italy is already running a massive deficit, and has no central bank to monetize its debt. The same goes for Portugal, Spain, Greece, and Ireland. 5% loan losses in Ireland would be 40% of GDP, the equivalent for my fellow US citizens of about $5 trillion. Where does Europe find a few trillion dollars?

U.K. banks responded to a recent CBI survey, showing that the value of nonperforming loans, or
bad debt, increased at the fastest rate since the survey began in 1989. The respondents projected a similar rise for the next quarter.

Toxic assets are still a problem. I believe banks are going to see another wave of big writedowns
and will need to raise more capital. I am not sure they will be able to get it this time.
We also face many years of private sector deleveraging , which will not bring about a return to
recent consumption patterns.

Consumer credit as a percentage of disposable income is starting to roll over (which corresponds
with the recent savings rate data which has shown a solid increase), but remains at around 23%
of income versus its average from 1959 to 1994 of 17.5%. Interestingly, consumer credit’s rate of
growth on an annual basis has been negative for three months now. This has only occurred 3
other times in the history of the series. It will be interesting to see if it remains in a contracting
mode. If it does, it may be a good signal that we have indeed made a secular change in this
country as far as consumption and savings go. One data point that suggests we may have made a
secular change is nominal retail sales. On a year over year basis, it has never gone negative…
until this recession. Does this suggest that the consumer may see a permanent adjustment?