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Monday, April 12, 2010 1:05 PM


"Banking System Still Quietly Insolvent" ; Larry Summers' Imagination Reaches Escape Velocity


Inquiring minds are reading an excellent post by John Hussman about Stock Market Valuations, Extend and Pretend Banking, Public Policy on Housing Bailouts, and Solvency of the Banking System. Here are a few snips from Extend and Pretend.

Over the past 12 years or so, I've been repeatedly astonished at the tendency of investors to do things that they should have known to avoid simply with the use of a calculator and basic arithmetic. We've used numerous metrics during this period to show that the estimation of long-term market returns (7-10 years and beyond) doesn't require calculus or statistics, but fairly direct methods to normalize earnings, plus a bit of arithmetic. Rich valuations are predictably followed by sub-par returns. As a result, investors have earned an average annual total return of just 2.4% in the S&P 500 over the past 12 years, while enduring two separate instances where they have lost about half of their money as part of the ride. Essentially, we have gone nowhere in an interesting way. At present, investors have priced the market at a level that makes a continuation of this experience likely for several years to come.

As of last week, the S&P 500 remained strenuously overvalued on the basis of normalized fundamentals. From that perspective, even if the trough we observed in March 2009 was the ultimate price low of the secular bear market since 2000, it's not likely to represent the ultimate valuation trough. Given the current state of valuations, and the likelihood of several years of additional credit deleveraging, it seems that economic conditions, valuations, and the typical duration of secular bear markets converge on the likelihood of several more years of interesting but unrewarding market volatility. Secular bull market periods tend to begin with quite low multiples to normalized earnings (historically, on the order of 7), which is what provides the platform for a very long period of subsequent gains.

Extend and Pretend

With regard to credit conditions, the U.S. financial system continues to pursue a strategy of "extend and pretend." ... The impact of "extend and pretend" is to create a gap between the reported value of assets and the value they would have on the basis of the cash flows that those assets can reasonably be expected to generate over their maturity.

Moreover, regulatory changes over the past year have affected what actually gets reported as "troubled." As the New York Times recently observed, " A bank owed, say, $4 million on a property now worth $3 million would previously have had to classify the entire loan as troubled. Now it can do that to the $1 million difference only."

As for policy efforts to reduce delinquencies, I've long argued that it is a bad idea for policy makers to announce delinquency prevention plans that have, as their centerpiece, publicly subsidized reductions in mortgage principal. It's one thing to extend the loan in a way that preserves its present value, by swapping a claim on future appreciation in return for principal reduction, but it's quite another to offer to cut the principal outright. The reason is that instead of confining the assistance to presently troubled borrowers, you create a whole new set of borrowers who then choose to be troubled in order to get the assistance. According to a University of Chicago study, "strategic defaults" - where people choose to default on their mortgages even though they can afford to pay - accounted for 35% of all residential defaults in December 2009, up from 23% in March 2009. Offering public subsidies for this behavior, when too many homeowners are already legitimately struggling, does not smack of a bright idea.

The real concern from my perspective remains the potential for a second wave of delinquencies beginning in data as of the first quarter of 2010 and extending well into 2011. ...

In short, my impression is that investors are deluding themselves about the solvency of the banking system. People learned in the 1930's that when you don't require the reported value of assets to have a clear and tangible link to the value that the assets would have in liquidation, bad things happen. Yet this is what regulatory and accounting rules are allowing for the banking system at present. While I do believe that bank depositors are safe to the extent of FDIC guarantees, my impression is that the banking system is still quietly insolvent.
There is much more in the article including a series of charts on bank loans, real estate loans, and credit card loans.

Global Banking System Extend and Pretend Insolvency

I happen to agree with John Hussman on all points mentioned. Moreover, it is not just the U.S. banking system that is insolvent, the global banking system is nothing but a giant extend and pretend operation including the PIIGS (Portugal, Ireland, Italy, Greece, Spain), China, the UK, and even Canada as soon Canada's gigantic housing bubble crashes.

Just as U.S. housing policy encourages more walk-aways, the EU's subsidized loans to Greece (See Grecian Formula 16 Now On Sale) practically guarantees the EU will need to offer the same deal to Spain and Portugal at a minimum.

Note too, that European banks have their own extend and pretend game going in regards to loans based in Euros to the Baltic states. Those loans cannot possibly be paid back.

George Soros is talking about a pound devaluation for the U.K. Please see Former Fed Gov. Poole Blasts Fed's Favoritism; Soros Bought More Gold, Says Pound Devaluation is Option for details.

Canada did not avoid a crisis because their banks were better or smarter or used less leverage. Canada avoided a crisis because for whatever reason, their housing bubble did not yet blow sky high. However it will, and Canada's banking crisis is yet to come.

To understand why, please see California USA vs. Ontario Canada - Which State (Province) Is In Worse Shape? Canadian Banks vs. US Banks Comparison.

There are so many reports on bubbles in China that I hardly know where to begin. Here are a couple of them. GMO has a white paper on 10 Signs of Speculative Mania in China. In response to that paper, please consider an Email from a Chinese on China's Real Estate Bubble.

Finally, in the US, please consider an interactive map of the $3+ trillion public pension plan deficit, state by state: Interactive Map of Public Pension Plans; How Badly Underfunded are the Plans in Your State?

In short, consumer and bank debt simply cannot be paid back in a global wage arbitrage economy, with massive consumer and corporate debt and no source of jobs.

Escape Velocity

Amazingly, Larry Summers says that problems with healthcare, education, and even long term fiscal deficits are being addressed. That is proof economists are starting to believe their own nonsense on extend and pretend.

"I think the economy appears to be moving towards escape velocity." said Summers.

One thing that has reached escape velocity is Larry Summers' imagination.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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