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Wednesday, July 15, 2009

"Brown manure, not green shoots."

Economist Nouriel (Dr. Doom) Roubini explains why the economy isn't in recovery mode. Indeed, there are thunderheads on the horizon, starting with an accounting fudge (ah, transparency) which is concealing weakness in (where else?) the financial sector:

The other important aspect of the labor market is that if the unemployment rate is going to peak around 11% next year, the expected losses for banks on their loans and securities are going to be much higher than the ones estimated in the recent stress tests. You plug an unemployment rate of 11% in any model of loan losses and recovery rates and you get very ugly losses for subprime, near-prime, prime, home equity loan lines, credit cards, auto loans, student loans, leverage loans and commercial loans--much bigger numbers than what the stress tests projected.

In the stress tests, the average unemployment rate next year was assumed to be 10.3% in the most adverse scenario. We'll be already at 10.3% by the fall or the winter of this year, and certainly well above that and close to 11% at some point next year.

So these very weak conditions in the labor market suggest problems for the U.S. consumer, but also increasing problems for the banking system as these sharp increases in job losses lead to further delinquencies on loans and securities and lower than expected recovery rates.

The latest figures on mortgage delinquencies and foreclosures suggest a spike not only in subprime and near-prime delinquencies, but now also on prime mortgages. So the problems of the economy are significantly affecting the banking system. Even if for a couple of other quarters banks are going to use the new Financial Accounting Standards Board (FASB) rules and under-provisioning for loan losses to report better-than-expected results, by Q4, with unemployment rates above 10%, that short-term accounting fudge will have a significant impact on reported earnings. And this will show the underlying weakness in the economy. So banks may fudge it for a couple of other quarters, but eventually the effects of very sharp unemployment rates and still sharply falling home prices are going to drag down earnings and have a sharp effect on losses and capital needs of the banks and the entire financial system.

I remember reading about the too-optimistic stress tests months ago. Buckle up.

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