Another Recession Ahead? - Analyst Blog

Are we heading into another financial meltdown? That is what the data released by the U.S. government last Friday seems to suggest. Statistics revealed by the Bureau of Economic Analysis shows economic growth that is stalling and may even flatten out over the rest of the year, raising specters of another recession ahead.

While the expected economic growth of 2.4% in the second quarter of 2010 was viewed as feeble, only about 1.6% was actually achieved. A slower build-up of stocks by companies and largest import surge in 26 years were primarily responsible. Compare this to a GDP growth rate of 3.7% in the first-quarter of 2010 and 5% in the fourth quarter of 2009, and we are looking at a potential crisis.

However, the growth rate has surpassed the 1.3% that many economists had forecasted. Though this marks the fourth straight quarter of economic growth, the annualized growth rate averaged only 2.9%. In the second quarter, investment in new machinery, computers and software increased nearly 25%, driving most of the growth. According to the economists, the economic growth needs to be about 3% just to stop the unemployment rate rising above the current rate of 9.5%.

Following the last recession, consumers are now saving more than they spend. Also, the CARD Act has ensured that card issuers clip the credit they provide to borrowers. This is forcing card holders to tighten their purse strings; consequently, businesses are experiencing lower volumes. Considering these trends, economists forecast the GDP growth for the current quarter to less than or equal to 1%. Also, with a sharp dip in new home sales, moderate manufacturing and an unpleasant unemployment rate, the economic growth rate may even reverse and re-enter the red.

Soaring Imports

The Commerce Department figures show that imports increased 32.4%, the most since 1984, after rising 11.2% in the first quarter. However, exports increased only 9.1%, compared with 11.4% in the first quarter. This trade imbalance has significantly threatened the economic growth rate. Without the trade deficit, the economy would have grown at 5%, in line with the healthy growth rate during the recovery phase in the fourth quarter of 2009.

Is the Federal Reserve Prepared?

Shortly after the grim report, in a speech to central bankers, Fed Reserve Chairman Ben Bernanke reassured investors by saying that if the situation were to worsen significantly, the Federal Reserve was ready to inject more money into the economy to keep the recovery on track and prevent a further recession.

However, the question that lingers is the extent that the Federal Reserve can intensify its efforts to protect the economy. Even with near-zero interest rates, banks have failed to encourage investment. On the other hand, Congress remains reluctant to provide more bailout funds to the banks as the government’s deficit is significantly increasing.

Nevertheless, Bernanke laid out several possible measures, including the Federal Reserve buying more securities such as government debt and mortgage investments. These actions are expected to lower the interest rates on debt, enhancing private-sector spending. With increased consumer savings and the willingness of healthier bank loans, consumer spending should increase, leading to a stronger growth in 2011.

Where Have All the TARP Funds Gone?

Criticizing the structure of the U.S. Treasury’s Troubled Asset Relief Program (TARP) that was created to rescue the nation’s financial industry, the Congressional Oversight Panel said in a report earlier this month that foreign companies got greater benefit from the U.S. bailout program than U.S. companies realized from other countries’ bailout programs.

Following the collapse of Lehman Brothers in September 2008, which was acquired by Barclays (BCS), the U.S. government injected billions of dollars into several national financial institutions including giants like American International Group (AIG), Morgan Stanley (MS), Bank of America (BAC), JPMorgan Chase & Co. (JPM), Wells Fargo (WFC), Goldman Sachs (GS) and Citigroup (C) to stabilize the financial system. The government took this step to alleviate the sector, as financial institutions are the lifeblood of an economy.

Many of these financial institutions have substantial overseas operations. As a result, the rescue funds indirectly helped financial institutions based in France, Germany, Canada, Great Britain and Switzerland.

The Banking Sector’s Skewed Profit

The overall banking industry’s profit improved during the first half of 2010. However, this was primarily led by big banks, while small banks remained strained due to deteriorating credit conditions.

The improved profit of the industry was primarily driven by a dwindling of reserves that banks hold for anticipated loan losses. However, most of the diminution was confined to the largest banks.

The government should set policies to help all the industry participants contribute to the overall profitability. Otherwise, we will see only a few large banks survive, exposing the industry to an oligopolistic market, which is not desirable.

Bank Failures Continue

While the bigger banks benefited greatly from the various programs launched by the government, many smaller banks are still weak, and the Federal Deposit Insurance Corporation’s (FDIC) list of problem banks continues to grow.

Despite the government’s strong efforts, we continue to see bank failures. Tumbling home prices, soaring loan defaults and a high unemployment rate continue to take their toll on small banks. As the industry absorbs bad loans made during the credit explosion, the trouble in the banking system goes even deeper, increasing the possibility of more bank failures.

There have been 118 bank failures already this year, compared to 140 in 2009, 25 in 2008 and just 3 in 2007. Increasing loan losses on commercial real estate are expected to cause hundreds more bank failures in the next few years.

Government efforts in restoring the lending activity at the banks have not succeeded either. Lower lending will continue to hurt margins and the overall economy, though the low interest rate environment should be beneficial to banks with a liability-sensitive balance sheet.

Impact of Financial Reform Law

In July 2010, President Obama signed a law to overhaul the banking system and Wall Street in an effort to reduce many of the practices that led the U.S. economy into its worst state since the 1930s.

Though the law — the most sweeping financial reform since the Great Depression — gives the government more power to tighten regulations for companies that threaten the economy, this may become a significant threat to profitability for the country’s biggest banks in the near to mid term.

This law would partially restrict proprietary trading of commercial banks. Also, derivatives trading would be restricted, which are used to hedge risk or speculate the future value of assets. Also, banks will be banned from proprietary trading and will be able to invest only up to 3% of their Tier 1 capital in private equity and hedge funds. As a result, a significant impact on profitability is expected for the big commercial banks.

A Catch-22 Situation

If the government withdraws the monetary and fiscal stimulus too soon, there is the risk of regressing into another recession. Then again, fiscal strictness is very much necessary in the country to deal with the large deficits and debt. Raising taxes and cutting government spending could perhaps be a better option to evade the chance of a further recession.

On the other hand, if the government continues the stimulus for a long period, the rising fiscal deficits may lead to a sovereign debt crisis. This could again threaten the economic recovery.

Another Recession Ahead? – Analyst Blog

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