Age of Deflation?
Stocks slid within striking distance of the November bear-market low on Tuesday, as grim manufacturing data signaled the recession is worsening and warnings on risks facing European banks underscored the continuing toll of the financial crisis:
Financial stocks sank to 14-year lows after Moody's Investors Service said banks could be hit by the recession in Eastern Europe, pulling the S&P Financial index down 8 percent.
Data showing a sharp contraction in Japan's economy set the tone early in the day and helped yank oil prices down nearly 7 percent to below $35 a barrel. Chevron and Exxon Mobil were the Dow's biggest drags, sliding more than 4 percent.
"As we retest these November lows, the reality that sets in is that we may have another leg to go down in the economy and the market," said Bucky Hellwig, senior vice president at Morgan Asset Management in Birmingham, Alabama.
U.S. banks, already beaten down by the failure of efforts to save the financial system to take hold yet, slid. Dow component JPMorgan was down 12.3 percent at $21.65 and Wells Fargo dropped 13.1 percent to $13.69.
[U.S. banks are also under pressure from forensic hit-teams.]
The Dow Jones industrial average fell 297.81 points, or 3.79 percent, to 7,552.60. The Standard & Poor's 500 Index gave up 37.67 points, or 4.56 percent, at 789.17. The Nasdaq Composite Index lost 63.70 points, or 4.15 percent, to 1,470.66.
Wall Street's slide pulled the S&P 500 and Dow to their lowest levels since November 20, when stocks hit 11-year lows. Just before the end of the session, the Dow briefly broke through its bear market closing low that was hit on November 20.
The day's losses brought the Dow down 13.9 percent since the start of the year, while the S&P 500 is down 12.6 percent and the Nasdaq has fallen 6.7 percent.
A report showing that manufacturing production in New York state fell to a record low in February stirred worries about the deepening recession and added to fears that the new U.S. economic stimulus package won't be a quick fix.
No, there are no "quick fixes" for the U.S. economy, just like there are no quick fixes for the pension crisis. The deepening recession spells trouble for the Pension Benefit Guaranty Corp., the U.S. government corporation that insures the pensions of 44 million workers and retirees:
The deepening recession spells trouble for a little-known government corporation that insures the pensions of 44 million workers and retirees.
The Pension Benefit Guaranty Corp. already has an $11 billion deficit that seems sure to grow larger as Corporate America suffers through the worst economic crisis since the Great Depression.
With companies reporting shortfalls in their pension funds, it’s all but certain that the PBGC will be forced to take over the pension plans of a rising number of bankrupt businesses.
That means more red ink at the corporation before things possibly can improve.
The future financial health of the agency is hard to forecast. It is hinged on interest rates, the length of the recession and the PBGC’s own luck in playing the market, where it has billions invested.
The agency has $63 billion in assets. But it is obligated to spend $74 billion on pension benefits in the coming years. The PBGC might have time to rebound, but over the long term it might become insolvent and require a bailout.
“Someday — probably more than 20 years from now — there’s a significant chance that somebody is going to have to pay the piper,” said former PBGC Director Charles E.F. Millard, a Bush administration appointee who stepped down on Jan. 20 when Barack Obama became president. “In the near- to medium-term, there will be no need for a bailout of PBGC.”
The PBGC quietly operates in a
brick office building a few blocks from the White House. Its fate is important to the workers covered by the more than 29,000 employer-sponsored benefit pension plans it insures, and to all taxpayers who could be asked to foot the bill if its financial picture worsens down the road.
Congress created the PBGC in 1974 to guarantee the retirement security of workers covered by defined-benefit pension plans. These traditional plans, which pay a specified monthly benefit at retirement, are being phased out as companies turn to 401(k)-style programs that require workers to make contributions and shoulder investment risks. The PBGC, which receives no tax dollars, gets its money from premiums paid by companies that sponsor the pension plans, along with revenue from its investments.
The corporation’s balance sheet has taken heavy hits in recent years. Nine of the 10 largest pension plan terminations in PBGC’s history, including United Airlines, Bethlehem Steel and Kaiser Aluminum, have occurred since 2001.
When a plan is terminated, the PGBC takes over and pays benefits to the retired workers. But they might not get the full amount that their employer promised. The maximum guaranteed amount currently is $54,000 a year for a person retiring at age 65.
Some pension experts shrug their shoulders at the PBGC’s $11 billion deficit, noting that the 35-year-old corporation has been operating at a deficit for most of its existence. They say the PBGC has many years to recoup its losses and fulfill its obligations to pensioners.
“Every time the economy bounces around, everybody acts like everything is going to collapse and that they should worry about the PBGC, and then things come back,” says Dallas Salisbury, president of the Employee Benefit Research Institute in
Others who pore over the PBGC annual reports predict a bailout is inevitable.
“Barring some absolutely phenomenal gains in the market or what PBGC’s new or future investment strategy comes up with, the PBGC will need taxpayer money at some point in time,” said David John, a pensions expert at the conservative Heritage Foundation.
For now, the PBGC, which is awaiting a new boss, will remain on the Government Accountability Office’s “high risk” watch list for the seventh consecutive year because of worries that the economic crisis could mean more pension plan terminations and swell the PBGC’s deficit.
Taking over the pension plan of General Motors Corp., which just announced it will cut 10,000 salaried jobs, would more than double the PBGC’s current $11 billion deficit. But the PBGC also would inherit substantial assets from the automaker’s pension fund.
Companies that have underfunded pension plans, but are otherwise on solid financial footing, pose little risk for the PBGC. It’s the companies in danger of going under that present the biggest threat. But declines in the market have left corporate pension plans severely underfunded — to the tune of $409 billion, according to Mercer, a global consulting firm.
The underfunding trend is likely to continue. Even though Congress passed a law in 2006 requiring companies to meet target dates to eventually fund 100 percent of their pension obligations, those restrictions were relaxed in December to help them weather the bad economic times.
The business community is lobbying to further waive the rules during the current economic slump. Because of plummeting asset values, companies this year are faced with having to contribute to their pension funds two to three times what they had expected, said Aliya Wong, director of pension policy at the U.S. Chamber of Commerce.
“Because this is coming out of the bottom line, companies are making decisions not just about freezing their pension plans but whether they can even continue in business,” Wong said.
The PBGC successfully shaved nearly $3 billion off its deficit in the 2008 budget year, which ended Sept. 30, primarily because 13 auto parts makers reorganized and didn’t dump their pension liabilities on the institution.
Those gains were recorded before the market tanked. Still, Millard insists that a new investment strategy, which allows the PBGC in invest more aggressively in stocks and alternative investments, makes it less likely that it will need a multibillion-dollar congressional bailout.
However, according to a report released by the U.S. Government Accountability Office (GAO), the PBGC’s single-employer and multiemployer benefit insurance programs continue to make the list of “high-risk” federal programs:
Although the combined net financial condition of PBGC’s single-and multiemployer insurance programs has recently improved, the programs and the agency are designated high risk by the GAO because of the “ongoing threat of losses from the termination of underfunded plans.”
As of fiscal year-end 2008, the PBGC’s accumulated deficit totaled $11.2 billion, down from $14.1 billion in 2007. However, the GAO report noted, the recent financial crisis has likely eroded the funding of many large plans and lowered the credit rating of many sponsors, developments that the most recent estimates may not reflect.
In 2008, the PBGC also decided to change its investment policy to increase its allocation of assets invested in equities and other, new asset classes, while decreasing its fixed-income investment allocation. The PBGC believes this change will help it meet its long-term financial obligations, but the GAO noted that it also increases the risk of large investment losses. In addition, the PBGC’s assets may currently be much lower than reported, given the significant stock market decline since the end of the 2008 fiscal year.
According to the GAO, the long-term decline of the defined benefit plan system continues to erode the PBGC’s premium base, with the PBGC insuring about 65% fewer plans than it did 15 years ago. In addition, the PBGC’s insurance programs remain exposed to the threat of terminations of large underfunded plans sponsored by financially weak firms, such as the automakers.
Congress may need to “carefully monitor” the financial health of the PBGC’s programs, the GAO report concluded, and may need to take additional action to safeguard the private pension system’s role in national retirement security.
The PBGC is flirting with disaster and the reality is that if deflation develops and corporate insolvencies soar, the PBGC will surely require a bailout.
So why talk about deflation? Won't the stimulus plan work? Aren't the current measures of aggressive monetary and fiscal policies and aggressive quantitative easing going to lead to inflation?
It increasingly looks like these measures will do little to stave off the deflationary headwinds hitting the global economy. Ready or not, we have entered the the age of deflation:
Figures released this week in the UK and the US are likely to confirm that the annual rate of inflation is decelerating. On some measures, inflation might even turn negative. Lower prices - not just weaker inflation - will sound like good news to households where incomes have been squeezed by tax rises and higher bills. But a sustained period of falling prices (deflation) would have huge economic costs.
While the risk that deflation will take hold of the Western economies is small, it is not trivial. The prospect is powerfully exercising the minds of central bankers and explains the urgency with which the Bank of England and the US Federal Reserve have cut interest rates. Their apprehension is justified: deflation would be the worst of outcomes for the global economy.
In Europe and America, the possibility of deflation goes against all postwar experience. During the Second World War, policymakers worried that the postwar economy would suffer prolonged falls in prices as troops were demobilised and capacity constraints were eased. Yet the enduring problem proved instead to be inflation. J.M. Keynes was the great intellectual influence on Western policy till the mid-1970s, yet his writings contained little on countering inflation beyond the view that expansionary policies should be relaxed before full employment had been achieved.
In practice, full employment, upward pressure on wages and earnings, and the willingness of governments to engage in deficit financing caused a build-up in inflationary pressures. Only with punishingly high interest rates and recession did central banks manage to tame inflation in the early 1980s. Since then, and especially since the mid-1990s, inflationary conditions have been broadly benign. Cheap imports from China helped to dampen inflation and allowed central banks to keep interest rates low.
Unfortunately, easy monetary policy also stimulated an unsustainable boom in asset prices and an irresponsible expansion of credit. The collapse of the housing market bubble and the credit crunch are now pulling the global economy down into recession. Inflation is decelerating sharply, helped by falls in commodity prices.
In the UK, the annual rate of consumer price inflation - the measure that the Government targets - declined a full point to 3.1 per cent in December. The Bank of England expects the figure to fall below 1 per cent this year. Annual inflation as measured by the retail price index, which includes mortgage repayments, has been falling even more rapidly and is approaching its lowest level since 1960.
A short period of falling prices would do little damage. Consumers are used to seeing the prices of some items fall consistently - particularly in electronic goods, as computing power has become much cheaper.
But a long period of general price falls, as happened in Japan in the 1990s, would be damaging. Consumers would postpone purchases, as they would be able to buy goods more cheaply in a year or two. Employment and investment would collapse. Stock prices would fall as corporate earnings would contract. Most damaging, households with debt - either mortgage debt or unsecured loans - would suffer intense hardship. Adjusted for inflation, the value of their debt burden would rise. Deflation would cause hardship, eviction and widespread corporate and personal bankruptcy.
This is the risk, if not yet prospect, that central banks now contend with. Previous deflations are almost beyond living memory. The Great Depression was marked by hardship and hunger. The Long Depression of 1873-96 generated international friction, trade warfare and financial panic. These precedents are uniformly terrible; the stakes are extremely high.
Nowhere is deflation more problematic than in the housing market where the risks of deflation are high:
Consumer spending declined in December for a record sixth consecutive month and rose 3.6 percent for the year, its lowest annual gain since 1961. The economy lost 3.6 million jobs since the recession started in December 2007.
Yet experts debate whether all this indicates that the economy will slide into full-blown deflation, a prolonged period of falling prices.
Skeptics say the federal government will inject enough money into the economy to prevent it. They say deflation has largely been relegated to apparel and energy prices. Therefore, it's not widespread enough to raise great concern.
"It's a serious situation, but we're a long way from that," said Christopher Rupkey, an economist at Bank of Tokyo-Mitsubishi in New York. "Seeing reduction in wages is good anecdotal evidence, but everyone would have to experience reduction in wages before we're in deflation."
But others argue that today's declines could spread—and stay with us.
"Deflation will become more pervasive as we make our way through the year," said Mark Zandi, chief economist at Moody's Economy.com. "The downturn is intensifying, and businesses are under increasing pressure to cut prices to maintain some sales."
The fear about this recession rests on the severity of the real estate crash and credit crunch, which translates into pain for any homeowner who sank savings into a house only to see property values plummet. Those people are facing a cash crunch of their own.
In the U.K., prices are 10% lower than a year ago, further deepening the economic gloom. In the U.S., home foreclosure notices hit 274,000 in January, a 10% decrease from December but still up 18% from January 2008, and it could get a lot worse as America's new housing problem is unemployment:
The U.S. government is gearing up to spend $50.0 billion of its dwindling Troubled Asset Relief Program funds to resolve part of America's housing crisis by renegotiating mortgages that borrowers can't afford. Nice try, but that's not going to deal with 2009's housing issue: rising unemployment.
All the mortgage rejiggerings in the world won't do much to help homeowners whose major source of income disappears, and that is a growing threat to the American real estate market as the country's economy endures a second year of recession.
While Congress doesn't address this issue at all except in the long-term way of trying to stimulate economic growth, the Federal Reserve Bank of Boston has hatched a plan to deal with the risk of joblessness in the U.S. housing market.
Under the Boston Fed plan, taxpayers would cover between a quarter and a half of mortgages for homeowners who lose their jobs. The aid would last up to two years or until new employment was secured, whichever comes first. This ad hoc national unemployment insurance would cost $50.0 billion, assuming that 3.5 million homeowners got in on it.
The strengths in the Boston Fed plan lies in its simplicity. There are no modifications to the terms of the loans, so you don’t need to get mortgage services and lenders on board. There is no taxpayer liability down the road. Borrowers aren't forced to share any upside action, a murky concept that has been the death of other loan-modification programs, and while it’s only temporary help, it would have a significant impact on a borrower's ability to pay.
Other programs aimed at helping distressed borrowers permanently reduce monthly payments, as with the Federal Deposit Insurance Corp.’s affordability-focused IndyMac model which cuts payments by about a fourth on average. But when borrowers lose their jobs, whether they had an old-fashioned 30-year or a buy-now, pay later deal, they probably can’t come with most of their mortgage payments.
Earlier versions of the proposal had beneficiaries paying back the funds, but working out the details became too tricky.
The New England-based researchers addressed the issue of moral hazard and offered a few ideas to keep it to a minimum. Those considered too rich are shouldered out by caps on income and the amount the government might contribute. Modestly paid borrowers are discouraged from taking a paid two-year vacation through a provison requiring that lost earnings must have comprised at least 25.0% of total household income.
They also wrote in defense of adjustable-rate mortgages that there is no data to support the idea that resets increase defaults. They added that mortgages with introductory teaser rates, which were popular toward the end of the American subprime housing bubble, were made at relatively high interest charges and that the reset to permanent rates was not "explosive." The situation was eased by the Federal Reserve's reduction of U.S. overnight interest rates to levels near zero, which means that many variable-rate mortgages did not see much increase.
"There is plenty of evidence that the major factor in this cycle has been declining home prices and adverse life events, and not rate resets," said Thomas Lawler, a former Fannie Mae chief economist. "I wouldn't say that for ARMs where rates reset upward didn't create problems. It's just that it hasn't been the major problem."
But if interest rates aren't the problem, then why are so many borrowers likely to mail in their keys during this economic cycle? One reason is that some borrowers haven't been building any equity in their homes as prices fall, so they have no skin the game. Another is that they don't see any upside paying their mortgage; that their homes will never be worth the value of the loan.
Still, at this juncture, unemployment or other cash-flow crises -- divorce or illness chief among them -- are likely to be the drivers of coming defaults. With prices falling and savings limited, homeowners have little to fall back on. While home prices were on the upswing, an unemployed borrower could sell the property or refinance, raising cash, but now, with property depreciating, each month that owners stay digs them deeper into their financial holes.
Credit Suisse estimates that there will be 8.1 million foreclosures over the next four years representing 16.0% of all mortgages assuming "timid" loan modifying efforts continue and a now conservative 8.0% rate of unemployment. They also estimate that nearly two-thirds of homeowners that lose their primary sources of income will also lose their homes.
While the mechanics of any national foreclosure policy to address the mortgage crisis has yet to be revealed, $50.0 billion in taxpayer funds has already been set aside to help delinquent borrowers keep their homes. (See "Geithner Does Little To Create Confidence")
If the plan does not bolster confidence, it will accelerate the deflationary psychology which is already wreaking havoc on the global financial system.
And deflation will wreak havoc on pension funds too as assets deflate and interest rates plummet, increasing future liabilities.
Importantly, Geithner’s financial stability plan may come too late to rescue the commercial property market, which is following housing into a slump.
According to Environmental Data Resources, Inc. (EDR) trend data published this week, an already struggling commercial real estate industry took a sharp turn for the worse in the fourth quarter of 2008:
EDR's ScoreKeeper(TM) index of environmental site assessment volume fell nearly 20 points from 81.3 at the close of the third quarter to only 62.7 by year end, reflecting the weakest quarterly performance of the year. On a monthly basis, the index hit a three-year low in November at 51.7, a drop of 70 points compared to the
March 2006peak of 121.7.
Because Phase I environmental site assessments are a standard pre-closing activity for many commercial real estate transactions, this data is a leading indicator of the overall health of the commercial real estate market in areas across the country.
The fourth quarter ScoreKeeper results are consistent with a commercial real estate market that has held up better than the housing market, but began to struggle late last year as banks were forced to write down the value of their real estate assets. Recent data reflect the hit that the real estate market took in late September when powerhouses like Lehman Brothers, AIG and Merrill Lynch toppled, and a new level of fear took hold as investors and lenders pulled in their horns.
"In the fourth quarter of 2008, an already skittish market worsened," observed
Dianne Crocker, EDR's senior economist. "In fact, the decline in environmental site assessments, while steep, was not as dramatic as the drop in commercial real estate transactions. Demand for environmental assessments is being sustained to some extent by a significant increase in the number of foreclosures from loan defaults and workouts as regulators sort through the real estate assets of the growing number of failed banks."
During the quarter, environmental site assessment activity declined in virtually all of the 100 metros modeled in ScoreKeeper. "No geographic area has been immune to the impacts of tighter credit conditions and the weakening economy," noted Crocker. Declines ranged from a moderate 1% in
Boston, Mass.and Indianapolis, Ind., to a much more significant contraction of 56% and 60% in Sacramento, Cal., and Melbourne, Fla., respectively.
"Recovery in commercial real estate will eventually take hold," Crocker added, "and when it does, it will be interesting to see which metros recover faster than others so that environmental firms, developers and investors can position themselves in the areas where activity is the strongest.
The first quarter of 2009, which is already off to a slow start, will be very telling, particularly as details of the Obama administration's strategy for jumpstarting commercial real estate lending and dealing with toxic real estate assets on banks' balance sheets begin to emerge."
The full 4Q08 report is available at: www.edrnet.com/scorekeeper.
And private equity firms are becoming drivers of merger deals as the economic downturn is hurting many of their own companies, forcing them into uneasy cooperation with their rivals:
The groups, which are sitting on $1 trillion (700 billion pounds) of unspent investor cash raised during the boom, are mulling mergers of companies they own, and injecting scarce cash into other firms as they look for novel ways to make returns.
Private equity firms whose funds are exhausted may also resort to cash injections from rival houses.
However, the deals have obstacles to overcome as the industry adjusts to the idea of forging closer ties with erstwhile rivals.
"With fewer healthy deals being done, the focus is really on the distressed side," said Scott Dunfrund, co-head of European corporate finance at Houlihan Lokey.
"And with the constrained financing, if I am a private equity principal or partner and I'm looking for ways to grow my portfolio ... this is one of the areas I am going to take a look at."
Houlihan Lokey is currently advising on a potential merger in the auto parts industry, in which one of the parties is in distress and the other is relatively healthy, Dunfrund said, declining to name the companies involved.
Nick Jones, a partner at corporate finance house Clearwater, said he is also advising on potential mergers, and is currently pitching one in the financial services sector to a private equity firm.
Such deals could take place between two companies owned by separate private equity houses, or between a private equity-owned firm and a publicly-listed company or its subsidiary.
"But both would (need to) be sub-optimal, both would need strengthening and the corporate could be strapped for funding," in order for the deal to make sense, Jones said.
Private equity firms with dedicated funds to invest in distressed assets may come to the rescue of troubled companies held by their rivals, offering them the chance to take control for a relatively small outlay.
"If somebody has a fund that's exhausted and a company that needs 50 million pounds to sort out its banking, there may be a deal to be done," said Jon Moulton, a managing partner at Alchemy Partners.
Moulton said he was working on a number of deals that could be completed in days and others that would take months, and he expected more such activity ahead.
These types of mergers and bailouts present obstacles.
One problem is that if a change of control clause is triggered, it could set off an expensive debt renegotiation that could wipe out any potential merger synergies.
"If your financing package is very attractive on terms that were agreed 18 months or two years ago, you don't want to have to refinance that as a result of the merger," said Florus Plantenga at Houlihan Lokey.
Moulton of Alchemy Partners said that such terms are often absent in deals that were done later in the private-equity bubble, which lasted until the middle of 2007.
However, if there are changes to control clauses, Andrew Roberts, a private equity partner at law firm Travers Smith, said that rolling the two companies into a new company and splitting the equity between the two parties might provide a way out.
Potential clashes between the private equity partners involved in a deal could be another problem.
While large buyout firms, such as Permira and Apax, have a history of doing club deals, smaller firms often dislike sharing decision-making.
"When you come down to the mid-market, it's absolutely not common at all. Most houses stay away from each other," said Clearwater's Jones.
These testing times will require firms to be more flexible, particularly as the deteriorating environment can rapidly push a company into bankruptcy.
Paul Canning, managing director at H.I.G. Europe, which does distressed and plain buy-out deals, believes there will be restructurings in which all parties will be able to reach an agreement quickly.
"If that means that some of the parties that were historically involved keep some involvement, then fine, if that helps speed up the restructuring," Canning said.
In hedge funds, net returns of structured credit hedge funds fell around 40 percent in a disastrous 2008 as many went out of business, a leading sector index showed on Monday:
So deflation is hitting all asset classes, especially alternative investments that were highly levered. But is deflation a foregone conclusion? Not necessarily. The recent surge in the shipping index might signal that the global economic recovery is beginning.
The Palomar Structured Credit Hedge Fund Index ended the year with 19 constituents, down from 30 at the end of 2007. Its net value fell to 559.55 at end-2008 from 924.63 at end-2007.
Structured credit assets such as asset-backed securities and collateralised debt obligations (CDOs) have been at the centre of the financial crisis, accounting for billions of dollars of writedowns at banks and hedge funds.
"Structured credit got terribly hit; liquidity was virtually non-existent," said Markus Kroll, a partner in Palomar Financial Services Group, a Zurich-based financial advisory firm and fund of funds manager with more than 1 billion Swiss francs ($855.4 million) under management.
Among members of the index, however, there was a big divergence in returns between the funds that lost everything and a few others that reported gains of more than 15 percent or even 20 percent for the year, he said.
"There are a few funds that have done really well," he said, adding that names of index constituents are confidential.
The index kicked off in early 2005 with a starting value of 1,000 and peaked at 1,133.94 at end-April 2007, before the credit crisis started to hit returns.The number of constituents peaked at 40 funds in July 2007.
In late 2008, many hedge funds across asset classes suffered heavy redemptions as mounting losses led investors to withdraw and banks cut back leverage limits.
The structured credit fund index showed monthly declines of 6.16 percent in September, 4.25 percent in October, 5.99 percent in November and 0.74 percent in December.
Leverage was one of the key reasons for casualties in structured credit last year, but some of the funds that had gains for the year had leverage and managed it well, Kroll said.
The worst month was February 2008, with a drop of 17.15 percent in net returns mostly due to the collapse of what was then the largest index member, an asset-backed fund managed by the UK's Peloton Partners LLP.
Palomar has recently been approached by a number of managers who are trying to create new structured credit funds, Kroll said. "At least that's a sign that the market is not dead."
A lot of distressed funds also have started to focus on structured credit, but they do not qualify for the index because they have strict limitations on redemptions and do not provide performance data, he said.
Palomar's is an investable index, meaning that it includes only funds that are open to new subscriptions and allow investors to redeem within 180 days.
However, I warn you, any surge from depressed levels should be treated with caution and developments in China, Japan and elsewhere will only intensify the global deflationary headwinds.
Perhaps this is why gold rose to its highest in almost seven months in London as investors bought the precious metal to preserve their wealth on speculation the global economy will deteriorate.
Only time will tell if Treasury Secretary Geithner's plan will help stave off a prolonged downtrun, but from my vantage point, the age deflation has already arrived.