Injection, Rejection, Disection, Reflection

The following is a guest post by someone who wishes to remain anonymous (I only WISH I could take credit). I will only say that he is an exceedingly bright (perhaps more than that) PhD type with a background in Economics, Mathematics, and Computer Science.

Credit Contraction, US Economy, Markets

The markets and the economy are dependent on government action, as without it the banking system would already have effectively stopped functioning. In addition to numerous measures by the Fed, the Congress has approved a $700B rescue plan. So far $250B has been approved for release, of which $125B is agreed upon on is being released to banks this week. However the $250B will not adequately address the banks’ problems.

If the US government puts only $250B in banking system, US banks would have to shrink their credit outstanding by over 50% . This would result in a decrease of at least 25% of total credit in the economy, as bank lending makes up about half of total credit. Given the relation of credit growth to economic growth, and to the markets, we could see the following :

- Economic contraction of 20%
- Stock market fair value would be down 60%
- Move from previous market top to new bottom: 70%

But given political realities, there will likely be delay in expansion beyond the initial $250B. So the credit crisis will continue causing significant GDP contraction, downward pressure on equity and commodity prices, and upward pressure on USD. Eventually Congress (perhaps the new Congress) will authorize additional bank funds, some likely “earmarked” for specific purposes (e.g. auto loans, home loans, consumer lending). At this point banks may receive another $250B, bringing their total to $500B.

If the US government puts a total of $500B in banking system, commercial banks would be able to maintain their existing credit levels, exclusive of the former investment banks. The effect of eliminating the former investment banks would shrink total credit by about $2.6T, which represents about 10% of the total credit in the economy. The net effects of this credit reduction could be as much as

- Economic contraction of 8%
- Stock market fair value down 24%
- Move from previous market top to new bottom: 42%

But given that the markets are already down close to 40% from their highs, moves below this level may not be sustainable and would be reversed after the second $250B to banks. However stock market values will also be affected by economic growth prospects and potential additional investor risk perception and aversion.


In addition to the bank rescue plans, the US government will likely also greatly increase spending programs to counteract the economic slowdown. The combined effects of Fed and Treasury moves and government spending plans will be that USD money supply contraction will be arrested and USD and commodity prices will stabilize. Of course US government debt will increase substantially.

At this point policy makers may recognize that inflation is a way to reduce the real burden of the debt.

And they may also recognize a need, or at least a benefit, to re-inflate the markets, given

- Private pension funds had $3.1T of equities as of 3Q07
- State and local government pension funds had $2.1T of equities as of 3Q07
- Life insurance companies had $1.5T of equities as of 3Q07

And all of these are likely far below where they need to be to meet projected requirements.


That leaves us with a couple of big questions:

- Will increased government borrowing and spending re-ignite USD inflation, or will economic malaise result in the Japanese model of ongoing deflation

o If inflation:
§ Rates for treasuries will increase
§ USD will lose value in real terms
o If deflation
§ Rates for treasuries will stay low
§ USD may still lose value vs other currencies as potential carry trade currency

- Will China and other big buyers of US treasuries invest more in their own economies rather than support US borrowing?

o If local investment over US treasury debt
§ USD will lose value
§ US rates will have upward pressure
o If continued buying of US treasury debt
§ USD will be supported
§ US rates will have downward pressure

To both of these big questions, the first answer is the more likely.

Appendix 1: US Bank data

- Mortgage-related writedowns likely to be in $1.4T to $1.7T range (10% to 12% of total)

o Using 2005 and 2006 data, with 2004 adjustment: $1.35T to $1.725T
o Using total non-prime market estimates: $1.6T
- Less than $600B has been written down through 2008 3rd quarter, primarily by
investment banks marking to market

- According to Federal Reserve statistics, as of June 2008, US Commercial
banks have the following:

o Assets: $11,694B
§ Mortgage assets: $3,662B (31%)
§ Bank Loans: $2,108B (18%)
§ Consumer credit: $813B (7%)
o Liabilities: $11,362B
o Total Equity (assets – liabilities): $332B
o Applying 10% writedown to mortgage assets, 5% to Bank Loans and Consumer
Credit, assets are reduced by over $500B (~4.5%), completely erasing total
equity
o US Commercial banking system is insolvent as a whole

- In 3rd quarter 2008 investment banking system has been largely incorporated
into the commercial banking system with Merrill Lynch purchased by Bank of
America, and both Morgan Stanley and Goldman Sachs reclassified as bank
holding companies
o At end of 2nd quarter securities brokers and dealers had:
§ Assets $2882B (including “miscellaneous assets” of $1603B; mortgage related
assets are not broken out separately)
§ Liabilities $2875B

- Investment banks assets will likely need significant writedowns; 10% of
miscellaneous assets, the category containing mortgage assets, would be $160B
- Former investment banks will have to adhere to commercial bank capital
adequacy standards, meaning reduction in credit from $2.9T to under $0.3T or
increase in capital from $7B to $87B
- Fed injection of $160B would get them back to barely solvent, but would
require credit reduction of $2.6T
- Fed injection of another $80B would allow them to keep outstanding credit
and stay within commercial bank capital adequacy standards

- A total of $740B would be required to get the US banking system back to
where it was in the 3rd quarter of 2007 in terms of ability to support
credit in the economy. This amount does not include rescue packages for
insurers, pension funds, or other industries.

Appendix 2: Bank balance sheets; capital, assets and credit

- The vast majority of bank assets reflect credit they've extended to others
in the economy. These include mortgage debt, consumer and business loans,
as well as corporate and government bonds.
- Banks' balance sheets are identical to standard corporate balance sheets
with Assets = Liabilities plus Equities. When assets are "written down",
such as recognizing that the mortgages outstanding may not be repaid in
full, those writedowns directly impact banks' equity. This is because
banks' equity is essentially the difference between their assets and their
liabilities, and now the assets have decreased while the liabilities of
course are still the same.
- Banks' equity is also called Bank Capital. Banks' capacity to lend is based
on their capital, due to reserve and capital adequacy requirements.
- Total US commercial bank assets are approx 30 times equity (as of 2Q08),
meaning equity is just about 3% of total assets. So a writedown of 5% of
assets would completely wipe out bank capital.

Capital infusion of $250B from government to banks

- With current assets written down by $500B (see Appendix 1), infusion of $250
B reduces capital from $332 to $82B, requiring massive reduction in
commercial bank assets and the complete elimination of former investment
bank assets.
- To avoid this, the Fed, the Treasury, the FDIC, and other bank regulators
will make numerous concessionary changes:
o Capital adequacy rules will be temporarily relaxed to allow increased
leverage
o Accounting rules will be changed to allow the banks to postpone writedowns
o the Fed will pay interest on bank reserves
o the Fed will cut rates
- If capital adequacy standards are halved
o $82B capital would dictate 50% reduction in outstanding credit, in addition
to elimination of former investment bank credit, bringing total reduction to
60%
- If accounting rule changes allow banks to postpone writedowns
o Banks will remain technically solvent but will likely curb all but the
safest lending, and will take writedowns gradually over years as capital
permits.
- If favorable Fed policies increase banks' average return on assets from 1%
to 1.5% and banks cut dividends to preserve cash
o An additional ½ to 1% of total asset value may be added to bank equity
annually.
o It would take 3 to 6 years at this rate to get to former capital levels and
ratios
- Banks are likely to get additional CD deposits due to increased risk
aversion, which would speed the bank repair process, but not help equities





Capital infusion of $500B from government to banks

- $500B will largely offset writedowns on commercial bank assets, exclusive of
former investment banks. These former investment banks were responsible
for approx 20% of bank credit outstanding as of the end of the second
quarter 2008.



Appendix 3: The impact of bank credit on the economy and the markets

- Commercial banks and investment banks are responsible for approx half of non-
governmental debt outstanding in the economy ($13.9T of approx $27T).
Every 10% reduction in commercial bank credit would constitute an overall
credit reduction of 5%.
- Since 2001, US GDP growth has been correlated to business credit growth with
GDP increasing at ~80% of the rate of business credit increase. At this
ratio, every 10% bank credit reduction would cause GDP to contract by 4%
(excluding government moves)
- Market returns average approx 3 times GDP growth.

- At these ratios, every 10% bank credit reduction drops the market value 12%.
- Then consider markets’ well-documented propensity for momentum and
overshooting
- S&P 500 standard deviation is 13% to 16%. So to estimate total move from
top to bottom, start 1 standard deviation over initial fair value and
calculate move to 1 standard deviation under new fair value.