Sorry to be gloomy, but this downturn will get worse: Kohler

A dangerous, rather idiotic idea is beginning sprout, or perhaps re-sprout – that we have nothing to fear but fear itself.

Franklin D Roosevelt said it first in his 1933 inaugural address: “First of all, let me assert my firm belief that the only thing we have to fear is fear itself – nameless, unreasoning, unjustified terror which paralyses needed efforts to convert retreat into advance.”

This is the proposition currently resurfacing – that we are talking ourselves into recession, or perhaps talking recession into depression, and that if only we weren’t gloomy there’d be nothing to be gloomy about. It sounds appealingly hopeful – but it was wrong in 1933, and it’s wrong again.

Here are two real things to be fearful of, and for political leaders to do something about, rather than simply encouraging us to whistle a happy tune; the great and continuing credit derivatives overhang and the problem of China.

As Paul Krugman pointed out in his New York Times blog recently, the view is starting to take hold that the appalling valuations of “toxic assets” in bank balance sheets, which is leading to their near-insolvency, are due to “irrational despondency”.

As we we’ve written before, the problem is credit derivatives, specifically collateralised debt obligations, but it’s true that most of the CDO losses that have ruined bank balance sheets are based on theoretical pricing models rather than real valuations.

But as Warren Buffett wrote in his shareholders’ letter published at the weekend, “derivatives are dangerous”.

And analysts at JPMorgan in New York have now shown just how dangerous. They have sifted through the data to find out what has actually been happening to these CDOs, and the result of their work was published a few days ago in the Financial Times.

Between 2005 and 2007, about $US450 billion of CDOs of asset backed securities were issued. Of those, $US305 billion are in a formal state of default, with those underwritten by Merrill Lynch accounting for the largest proportion, followed by UBS and Citigroup.

The real problem is what has happened after the default. JPMorgan estimates that $US102 billion of the CDOs have been liquidated; the average recovery rate for the super senior tranches – rated AAA – has been 32%. For the “mezzanine” AAA tranches – created from mortgage-backed bonds – the recovery rate is just 5%.

A 95% real loss rate on AAA debt CDOs is not what I would call irrational despondency.

The issue is specifically relevant to the bank stress tests that the Obama Administration is now conducting. Will the credit derivatives on their balance sheets be valued according to theoretical models based on the ABX indices, or will Treasury officials conduct auctions of the CDOs to get real price discovery?

And why should we fear China? Isn’t it going to save us with its colossal fiscal stimulus?

Actually, output in China is collapsing so quickly that it is in danger of falling into an actual recession, not just the so-called Chinese version (sub-7% growth).

But in any case, as Michael Pettis of Beijing University points out, most of China’s stimulus is aimed at increasing production, not consumption – actions such as “more credit access for firms in the petrochemical sector”, “tax rebates for electronics and information product exports”, and “increased credit support for shipbuilders”, to list just three of dozens of measures designed to assist exporters.

This might sound good for Australia, since more manufacturing production equals more demand for raw materials and higher commodity prices.

However, Pettis equates it with the Smoot-Hawley Tariff of June 1930, which was the genuine thing to be feared in the Great Depression (as opposed to fear itself).

“The stupid and destructive Smoot-Hawley act, which was terrible not because it was passed by the US but because it was passed by the country with the largest export of overcapacity in the world at the time, is perceived by some as something that can only happen in the US, and not in China.

“On the contrary – US policies can be extremely unhelpful, of course, and it would come as no surprise to me that many of their policies turn out to be harmful to US and global interests, but the US cannot possibly engineer a repeat of Smoot-Hawley’s disastrous impact on global trade and the US economy. As the largest trade deficit country in the world, anything that results in a contraction in net US demand is not only not bad, it is a necessary part of any adjustment.”

Only China, says Pettis, can bring about a repeat of Smoot-Hawley, not by putting a tariff on imports, but through policies that expand their massive export of overcapacity. Instead China must increase its contribution to net demand to help reduce global overcapacity.

“The point is, the reason Smoot-Hawley was such a disaster is because it involved an attempt by the largest trade surplus country in the world (the US) to increase its trade surplus in spite of collapsing world demand, and the 2009 equivalent must necessarily be Chinese or German moves that have the same effect.”

The global employment collapse is only just getting started. The trouble began with a credit crisis caused by the evaporation of trillions of dollars in bank capital that has now exposed massive production overcapacity as demand slumps as a result of the shocking wealth destruction.

The two things I have highlighted this morning – actual CDO values and the true impact of China’s stimulus – are operating on both ends of the feedback loop between the financial and real economies. And they are genuinely scary.

This article first appeared on Business Spectator



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