seems that with each passing month the estimates for losses in the
international banking system keep rising. This time last summer the
largest estimates (from credible sources), if memory serves me correct,
were around $400 billion, give or take a few months. By the end of the
year it was in the neighborhood of twice that. Then last quarter we saw
estimates approaching $1 trillion. Last week, the number being broached
was $1.6 trillion, by Bridgewater Associates, one of the top, and more
credible, analytical firms in the world. In this week's letter we look
at the implications of that projection, analyze recent lending patterns
by banks, briefly touch on the implications of the recent unemployment
numbers, and end with a few comments on the bear market. It will make
for an interesting letter. Warning: remove sharp objects from your
vicinity before reading.
But first, I need your help, and
in return I would like to give you a link to a recent speech I gave,
where I speak about what I think is the development of an important new
asset class, one which will come about precisely because of the
problems I am writing abut today. I have not yet written about this
topic in public, and the speech has been well-received. I think you
will like it. Now, as to how you can help me ...
I get to
travel a lot with my daughter and business partner Tiffani (actually
she runs the business) and meet new people. Over the years, she has
become as fascinated as I have with their individual stories. Everyone
has a story to tell or a lesson to teach. We have decided to write a
book about those stories, looking at the differences in perspective
between old and young, retired and working, those who are wealthy and
those who aspire to wealth. What are the differences in attitudes, in
work habits, in how you manage money, in how you look at the future,
and a score of other items? How do all of these things correlate?
have created a totally anonymous online survey seeking answers to these
questions and more. We hope to get at least 10,000 people to fill out
the survey; and we are eager to see what we find as we pore over the
resulting data and engage in a lot of in-depth analysis. Are the rich
really different? Is there a difference in people from Europe, Asia,
Latin America, Africa, and the US? I think we will find some very
interesting information. Please note: this is not just a survey for
millionaires. We want everyone, of all income levels and ages, to take
the survey, so we can get a true representative sample.
You can get to the survey page by clicking here.
It will take about ten minutes to complete, and I think that going
through the questions will make you think about your own situation.
Some have told us the survey is quite thought-provoking. If you have
attempted to take the survey and had problems, we think we have worked
out the bugs.
At the end of the survey, you will be sent to a
page with the speech. If you cannot listen to it immediately, then
simply save the page or the address. And of course, you can just take
the survey to help us.
Also, Tiffani and I want to do live
(mostly by phone) interviews with 200 millionaires, of all shapes and
sizes and locales. We will interview you for about 30 minutes, and then
you can have equal time asking me anything you want. Since I will have
learned a lot about you, those questions can be as detailed or as
general as you like. We want at least 20% of the interviews to come
from outside the US. We will use those interviews in the book, but will
attach no identifying items or real names. If we use something from
your interview in the book, we will let you see it first. If you are
interested in being one of the interviewees, just drop Tiffani a note
at firstname.lastname@example.org and she will get back to you and work out the details.
am really excited about this project and even more so about working
with Tiffani. We will report back to you on what we find. Thanks for
$1.6 Trillion in Losses and Counting
of the great privileges I have is getting to read a wide variety of
economic research. While I get a lot of material direct from the
source, I also have a wide network of people who read other sources and
send me what they think is important. When Ambrose Evans-Pritchard
wrote this week about a report done by Bridgewater Associates, it got
my attention, and fortunately this report was sent to me by a few
friends. In my book, Bridgewater is one of the top analytical groups in
the world. I pay attention and give strong credence to what they write.
And this report is quite sobering.
First, let's look at what Evans-Pritchard wrote in the London Telegraph:
Associates has issued an apocalyptic warning to clients that bank
losses from the worldwide credit crisis may reach $1,600bn [$1.6
trillion], four times official estimates and enough to pose a grave
risk to the financial system.
"The giant US hedge fund said that
it doubted whether lenders would be able to shoulder the full losses,
disguised until now by 'mark-to-model' methods of valuing structured
" 'We are facing an avalanche of bad assets. We have big
doubts as to whether financial institutions will be able to obtain
enough new capital to cover their losses. The credit crisis is going to
get worse,' said the group in a confidential report, leaked to the
Swiss newspaper Sonntags Zeitung.
"Bank losses on this
scale would have far-reaching effects. Lenders would have to curtail
loans by roughly 10-to-one to preserve their capital ratios. This would
imply a further contraction of credit by up to $12,000bn [$12 trillion]
worldwide unless banks could raise fresh capital."
Let's look at
some of the details in the report. First, these losses are not all
subprime. In fact, more than half of it is from corporate liabilities,
around $800 billion. About $550 billion of the corporate losses have
yet to be written off. As an example, Bridgewater estimates losses on
commercial loans to be as much as $149 billion, none of which has been
Better than 90% of the losses from subprime assets
that are on the books have already been written off. That is good. But
Bridgewater estimates that there are losses lurking in the prime and
Alt-A loan portfolios that could be much bigger than the subprime
problems, as those loan books are more than six times the size of the
"The US commercial banks are in a position to
suffer the greatest losses, because the core of their portfolio is
risky US debt assets. In order to get a sense of their expected losses
we examine both their loan book and their securities portfolio and
price each type of asset out based upon a reference market. If we use
this current market pricing as a guide, there is a long way to go, as
these institutions have only acknowledged about 1/6 of the expected
losses that they will incur as a result of the credit crisis."
could go on, but the details are not important. The bottom line is that
they estimate there is at least another $1.1 trillion of losses that
will have to be written off by institutions all over the developed
world, including very large potential write-offs from insurance
Banks and investment institutions worldwide may need
another $400 billion in capital infusions. But where they are going to
get it is the problem. They have burned through the usual suspects, and
burned is the correct word. Any sovereign wealth fund or large investor
who has put money into an investment or commercial bank has watched
their investment take large losses in a very short time. How likely are
they to be willing to belly back up to the bar with more money, on
anything except very dilutive terms to current shareholders? The answer
And let me be clear. There are some very large
commercial and investment banks which are simply going to be absorbed,
as regulators move to keep the entire system working. Bear Stearns is
not a one-off deal. I think it is likely we will see at least one
European bank nationalized. Losses the size that Bridgewater describes
are beyond ugly. They are life-threatening for more than one major
institution. More on this later.
Banks Start to Reduce Their Lending
let's revisit a theme I have written about on several occasions over
the past year. As banks incur losses, they either have to find new
capital or reduce their lending in order to maintain their capital
ratios, or some combination of both. And what we are seeing is that
lending is starting to actually decrease.
Earlier this year
lending rose as normal, even though anecdotal reports told of
tightening lending standards and reduced loan lines. The tightening of
standards did not seem to be affecting actual loans being made, which
was odd. But this was partly illusion, as banks were taking back loans
they had spun off in SIVs, taking capital away from their traditional
loan business. This gave the appearance of expanding loan capacity.
Evidently, this bringing back of off-book loans is now being worked
through, as evidenced by this analysis by good friend and analyst par
excellence Greg Weldon, who slices and dices the data to give us this
at the chart below] ... FOR SURE, the recent decline strongly suggests
that the risk of a US recession has intensified CONSIDERABLY, as
defined by what amounts to one of the largest nominal credit
contractions in DECADES, at (-) $154.3 billion, and a clear-cut
violation of the uptrend in place since at least 2001."
goes on to suggest that bank credit could contract a further $6-700
billion over the next nine months, which is a contraction of about 8%.
Healthy economies have a rising rate of bank credit, which is one
source of expansion. When banks have to reduce their lending, it
reduces the growth of the economy or can put it into outright recession.
if the Bridgewater report is anything close to right, Greg is being an
optimist, which is not his normal milieu. Now, do I think worldwide
credit will shrink $12 trillion, as Evans-Pritchard suggests? (Note,
that was not a suggestion or conclusion by Bridgewater.) Not in my
worst nightmares. Capital will be raised, and the various central banks
of the world will do what is necessary to give banks the time to work
through their problems.
But in the meantime, the trend toward
lower lending is likely to continue. And lower lending is going to be a
huge headwind for an economy that is already struggling.
week Ben Bernanke suggested that the "temporary" Term Auction Facility
might be extended into 2009. Let me suggest that it will be extended
into at least 2010 before it is no longer needed. Banks are going to
need to be able to take their illiquid paper and convert it into liquid
Treasuries against which they can make loans and continue to function.
I have written for a long time, it is all about buying time. In 1980,
every major bank in the US was technically bankrupt, as they all had
large amounts of Latin American bonds in their portfolios, at a size
far larger than their capitalization. When the Latin American countries
started to default, if the Fed had made the banks mark their portfolios
to market, it would have been a disaster of biblical proportions. There
would have been no American banks left standing. The US economy would
have gone into a deep depression.
Instead, with a wink and nod,
they let them keep the bad bonds on their books at face value, which
they all did. Then in the latter part of the decade, starting with
Citibank in 1986 (cue the irony), they began one by one to write off
the bad loans, but only when they had enough capital to do so. It took
six years (or more) of profits and capital raising to get to where they
could deal with the problems without imploding themselves and the
economy of the US at the same time.
Today is only different in
the details. The Fed and central banks around the world are allowing
banks to buy time to work through their problems. There really is no
other option. That extra $1.1 trillion that the research by Bridgewater
says will have to be written off? You can take it to the bank, pardon
the pun, that it will not be written off this quarter. This is going to
be an ongoing process that will take several years at a minimum. Just
like in 1980, the regulators are going to allow banks to write down
their losses as they can, except in the most egregious of
circumstances, in which case those banks will be "absorbed," a la Bear
Treasury Secretary Paulson said Thursday that no bank is
too big to fail. That is for public consumption. The fact is that there
are any number of banks that are too big to fail, depending upon (and
borrowing from my favorite linguist, Bill Clinton) what your definition
of fail is. If by fail you mean that shareholders are wiped out, then
he is correct, there is no institution too big to fail. If by fail you
mean that the operations and debt obligations will be allowed to
collapse, then there are institutions whose collapse would pose major
systemic risk to the world markets. They cannot be allowed to collapse.
Take Freddie Mac. Please.
Henny Youngman) Take Freddie Mac. Please. Its shares are down almost
90%. "Freddie Mac owed $5.2 billion more than its assets were worth in
the first quarter, making it insolvent under fair-value accounting
rules. The fair value of Fannie Mae [down 78%] assets fell 66 percent
to $12.2 billion, data provided by the Washington-based company show,
and may be negative next quarter, former St. Louis Federal Reserve
President William Poole said." (Bloomberg) Poole asserted that these
institutions are essentially on a short path to insolvency.
in the same story, Senators Schumer and McCain both said Freddie and
Fannie would not be allowed to fail. Even curmudgeonly former Fed
Vice-Chairman Wayne Angell (someone whom I sincerely respect), said on
CNBC yesterday that the government regulator of the GSEs (Government
Sponsored Enterprises) ought to get some money from Congress to buy
preferred stock and then get even larger amounts from the public
through an offering of preferred stock. He said that Congress ought to
learn about its responsibilities with regard to a GSE; and the public
ought to realize that we are in for a long, tough fight. (He also
expects the second half of 2008 to be no better than the first half,
and he sees 1% growth in 2009.)
I wrote the above paragraph, and
a few I deleted below, on Thursday, as I am on a plane to Las Vegas and
need to finish the letter in order to attend a conference. I wrote with
suggestions about how a collapse of the two Government Sponsored
Enterprises might be handled. Last night, the New York Times
broke a story that government officials are looking at how to go about
taking over operations at Freddie and Fannie, should worse come to
worst. Then this morning, the Wall Street Journal in its lead story elaborated on this theme.
basic problem is that both Fannie and Freddie need more capital, and
perhaps far more than their current market capitalization. Where to
find it? What investor wants to try and catch this falling safe,
without government guarantees? The Journal article quotes numerous people with various ideas about what to do. Most of their ideas will potentially cost US taxpayers.
make no mistake. The problems with Fannie and Freddie have to be
solved. They are now doing 80% of the mortgages in the US. Without them
the housing market would grind to a halt quickly and housing prices
would drop even beyond Gary Shilling's pessimistic views.
mention that the world has assumed the implicit backing of the
government in buying the paper of Freddie and Fannie. How easy would it
be to finance US debt if this paper was allowed to default? The
implications are serious. I understand the arguments for allowing them
to fail, and I think shareholders should bear the risk they take on
when buying equity.
A very reasonable idea was broached by Steve
Forbes on a BizRadio program this afternoon, which Dan Frishberg
graciously allowed me to co-host. He suggests breaking Fannie and
Freddie into eight smaller companies, giving them whatever backing they
need in the form of public financing to start business, and then cut
them off to sink or swim on their own, with much tighter capitalization
controls. Remember, this is one of the more free-market conservative
The authorities are slowly losing control. All they
can do is crisis manage. There are no good solutions, only expedient
ones. And we must all hope they choose the best among a handful of not
particularly pleasing options. Allowing the system to devolve into
chaos is not an option. The Fed and whatever administration comes in
will do the same as the current group, which is to buy time so that the
wounds can heal, and hopefully put in place rules to prevent another
(Sidebar: I will go into greater detail in a
later letter, but regulators need to move NOW to create a Credit
Default Swaps Exchange. A problem/crisis in that unregulated market is
actually a far bigger problem than the current subprime crisis. Why do
you think Bear Stearns was not allowed to go into bankruptcy? There are
banks that are too big to fail, despite what Paulson says for public
There are a lot of conflicting opinions, which you can read at www.bloomberg.com
if you care. Some say Fannie and Freddie will have to lose $70 billion
before the regulators step in. Poole says they are insolvent now, using
fair market accounting methods. I don't know, and neither do 99.9 % of
the shareholders. At this point Fannie and Freddie are not an
investment, they are a gamble. Sitting here at Caesar's in Vegas, and
reading the opinions, makes me think I have better odds at the tables
I hope that when (not if!) taxpayer money is used, it
is at market rates and means that shareholders are last in line, if at
all, to recoup any money. For those of us who for years have called for
tighter regulation and increased capitalization of the GSEs, as well as
a clear removal of any government backing, implicit or explicit, being
able to say "I told you so" does not feel all that good. Freddie and
Fannie cannot be allowed to go out of existence. They are too tightly
wound into the core and fiber of the US economy.
What can and
should happen is that shareholders bear their losses, taxpayers pick up
the bill, and when they are healthy again, as they will be at some
point, another public offering should be done to hopefully recoup the
losses to taxpayers. Or perhaps an auction with some guarantees to a
potential buyer, but a complete removal of implicit government
guarantees on future loans, and higher capitalization requirements.
There are any numbers of ways to lessen the ultimate cost to the
What I fear is that politicians will use the
opportunity to prop up the mortgage markets with taxpayer guarantees
and create much larger losses, which could quickly mount into the
hundreds of billions if not properly dealt with. A new
populist-oriented administration could find this problem on their desk
as they take office.
I would not want to own any stock in the
financial sector. There is going to be a continual stream of write-offs
over the coming year, at a minimum. Yes, some banks are better managed
and will avoid the real life-threatening problems. Some will be like JP
Morgan and end up with solid assets backed by government guarantees.
which ones? Do you want to trust the analysts that have been telling
you there is value in the financials at each step, all the way down?
The management who insists they are in good shape, then raises capital
at dilutive prices? The very people who did not see the problems to
begin with, telling you that they are now solved?
that analysts optimistically see in various financial stocks is
evaporating with each quarter, as they slowly write down ever more
losses. With another potential $1 trillion to be written off or
absorbed through earnings from profitable parts of the business, there
is more pain to come. Investing in financials today is like trying to
catch a falling safe.
The Ugly Muddle Through
Sachs published a report Thursday in which they suggest the most
probable scenario for the next 12 months is GDP growth between -0.25%
and 0.25%, or basically zero. Wayne Angell, mentioned above, expects
the second half of '08 to be no better than the first half and for GDP
growth to be 1%.
In the Bridgewater report mentioned above, they
estimate that the net worth of US-based assets is down about 13% since
January 2007, a total loss of almost $8 trillion. This is hitting
pension plans, corporations, and consumers, making them think twice
about planned investments and expenditures.
are being cut with each passing month. The P/E ratio for the S&P
500 is currently at a sporty 23. Historically, in times of rising
inflation, the stock market goes through "multiple compression." That
means P/E ratios fall more than earnings. If multiples fell just 20%,
back to 18, which is still above long-term trends, the market would see
another 20% drop from here. Even with earnings growth, the market is
going to have a challenge rising in the current environment.
A number of you have written questioning my source for the P/E ratio,
as you read or hear different numbers from what I write. You can indeed
find estimates of forward P/E ratios as low as 12 a year from now. That
is a lot different than the 23 I cited above.
There are two basic
types of earnings that are reported. One is "operating earnings," or
what I call EBBS, or Earnings Before Bad Stuff. Then there is "reported
earnings," which is what the corporations report on their tax forms.
Not all that long ago, in the mid-'90s, operating earnings and reported
earnings were generally in line with each other. Companies would deduct
genuine one-time, unusual losses from their reported earnings to give
us operating earnings. And such a system has a valid basis for
existence. If something is truly one-time, maybe an investor should
overlook it when evaluating the company's potential.
But then the
media and analysts started using the operating earnings as the primary
number, and companies began to game the system. More and more items
were considered one-time. One of the more egregious examples was when
Waste Management Systems declared that painting the garbage trucks was
a one-time extraordinary expenditure and should be accounted as such.
Today the difference between as-reported and operating earnings can be
20-40% or more! It seems there are many losses that management assures
us are just one-time items.
Standard and Poor's has a web page
where you can see a spreadsheet of historical data and projections for
both types of earnings. That is the source of my data. It is at http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS?GXHC_gx_session_id_=5350992f205e73e4& .
estimates do tend to get brighter the further out one looks on the
table. But if the growth scenarios mentioned above come about, and
banks have to curtail all sorts of lending, the earnings projections
are going to be way too high, as they have been for the last 12 months.
That is going to mean more pain for the stock market.
I think it
is quite likely we see the Dow slip below 11,000. (Ok, I wrote that
Thursday!) As I said on Kudlow the other night, another 10% drop in the
market would take us only to the average bear market. A "9 handle" on
the Dow seems quite possible, if not likely. (Note: when someone says
"a 9 handle," they mean that the first number in the index or stock
price is a 9. The first number is the handle.) The risk is to the
downside, given the tepid potential growth of the economy.
Once Again, the BLS Numbers Paint a False Picture
almost get tired of writing this each month, but it is important, and I
will do it quickly. The unemployment number from the BLS last week
showed a loss of 62,000 jobs. Private sector jobs were off by 91,000,
with the government showing growth of 29,000.
But once again, the birth/death ratio of estimated new jobs was 177,000. As The Liscio Report
noted: "... without the b/d's contribution, private employment would
have been down by something like 268,000. It added 29,000 [new jobs] to
construction, 22,000 to professional and business services, and 86,000
to leisure and hospitality. Given the weakness of the economy and the
crunchiness of credit, we doubt that there are enough startups around
to match these imputations."
Revisions to the prior two months
were a negative 52,000. When they do the final numbers a few years from
now, we will find that the revisions will be in the hundreds of
thousands for the first half of the year. We have now had five
consecutive months of downward revisions, which is typical of
Unemployment held steady at 5.5%, but that masks an
underlying and growing problem. There has been a huge increase in the
number of people working "part-time for economic reasons" and a large
number of people who are discouraged and not looking for a job but
would like one. These two categories are not counted as unemployed. If
you add them into the equation, the unemployment or underemployment
number goes to 10.3%! (per Greg Weldon)
As I warned above, this has not made for pleasant reading. But it is reality, and we need to deal with it.
let me say that even given the above, I am a long-term (and even
mid-term) optimist. We have to work through some serious problems, but
we will. Valuations are going to be low once again, and it will be time
to become bullish. And researching and writing my book on how the world
will change in 20 years makes me very optimistic. No one in 20 years
will think of today as the "good old days." The changes that are in
front of us will be amazing. So, simply take a deep breath, be
conservative today, and get ready for a really wild and fun ride.
speaking of investment banks, I need an introduction to someone who is
deeply involved in the creation of Exchange-Traded Notes. Drop me a
Las Vegas, Maine, and a Wedding
at Freedom Fest in Las Vegas, and want to hit the send button so I can
attend the sessions and see a lot of old friends. I really think it
will be good fun. I have dinner with Frank Holmes of US Global tonight,
and look forward to it. Frank is the consummate gentleman and always
And speaking of dinner, I was with Barry Ritholtz (of Big Picture
fame) last week, and we agreed we are psyched about going to Maine at
the end of the month for David Kotok's annual fishing extravaganza.
Lots of good friends, wine, and conversation - and I will get to
collect on at least one of the group bets we made last year predicting
markets, etc. And I was way wrong, but everyone else was even more
wrong. Go figure. I will tell you all the details after the trip.
Tiffani's wedding is getting closer. 08-08-08. Less than a month, and a
lot of coordination to be done. It is at the point where I am sitting
in on meetings. Flowers cost what? Fireworks? Credit lines are being
squeezed. But it is going to be so much fun!
markets are not where you live. If your investments keep you up at
night, sell until you can sleep. Life is to be enjoyed, and I am doing
my part. So have fun this week! And call some friends and share a few
Your wishing he could be a bull analyst,
Copyright 2008 John Mauldin. All Rights Reserved
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