CIT is an example of the kind of problems still facing the economy. CIT has taken on legal counsel in order to determine whether or not it should go into bankruptcy. The problem, the company has $2.7 billion in debt coming due through year end and its credit-rating has been cut “deep into ‘junk’ territory.” (See http://online.wsj.com/article/SB124744080839729811.html#mod=testMod.) It has been seeking liquidity help from the Federal Government but has not received approval yet.
Debt is the problem and it currently continues to haunt most businesses, governments, and individuals in the economy. It is a problem because this debt load has to work itself out. But, in working out the debt problem, the economy suffers and will continue to suffer.
The current debt crisis is so severe because of the credit inflation created by the U. S. Government over the last eight years of so. During expansions, credit inflations take place. This is what happens as the economy is stimulated and confidence in the private sector builds and things appear to be good and getting better. Credit inflations don’t have to directly result in general price inflation, although they can end up with this result.
In the 1990s as well as the 2000s we have had credit inflations where price increases have been relatively mild. In the 1990s we saw the stock market bubble and the credit inflation with respect to new ventures. However, during that decade we saw the federal government turn a deficit budget into a surplus budget by the end of the century. In the 2000s, we saw the housing bubble and the general credit inflation, but we also experienced a huge increase in government debt on top of everything else. Debt was good and most partook of it!
If the credit inflation during a period of economic expansion is not too excessive then the following correction that must take place can be relatively mild and reasonable and the government can come in and re-flate the economy so that the financial dislocation can be righted in a reasonable amount of time without too much “hurt” in the economy in general. Moral hazard is created, but what’s the problem with a little moral hazard? Right?
This is what happens in most minor recessions.
An exception occurred in the credit inflation of the 1970s. President Nixon was so paranoid about getting re-elected that he set about inflating the economy and connected this with taking the United States off the gold standard, floating the dollar, and freezing wages and prices. This philosophy was not abandoned by President Ford. Jimmy Carter just inflated, period. And, by the end of the decade, serious work had to be done to bring general inflation under control.
What happened in the decade of the 2000s was of a totally different nature. The debt structure that was created through this decade’s credit inflation could not be sustained. Debt was growing way more rapidly than the economy could support and the resulting imbalance was greater than at any time since the Second World War. Almost everyone was excessively over leveraged. The headlines focused first upon the subprime market and then upon Structured Investment Vehicles (SIVs) and the Collateralized Debt Obligations (CDOs). And, then it became apparent that this excessive leveraging had been going on everywhere in the economy. And, the federal government was right up there with everyone else.
There is too much debt out there! Yes, there is deficient aggregate demand, but that is not going to be corrected until the debt situation is corrected...no matter how much Paul Krugman and the Keynesian wing of the world cry out! People and businesses are going to have to get their balance sheets in order before private spending will really pick up. Unless, of course, the government is able to get a hyper inflation going again which is the classic solution for an economy with too much debt.
There are three ways for economic units to reduce debt. The first is to sell assets and pay off the debt. However, if people are uncertain about asset values this solution to the debt problem is not going to work. Second, economic units can save out of income and revenues and pay down their debt. This, of course, is the soundest way to de-leverage, but it is also the slowest way to reduce the debt on a balance sheet. The third way to reduce debt is to renounce the debt: that is, declare bankruptcy. This solution does have repercussions, however, on the value of the assets of other people and other businesses.
A firm with too much debt can face another problem. Debt matures and sometimes has to be refinanced. The problem here is that a company may not be able to refinance the debt that is coming due. In such cases, these firms will either be forced into the first way of reducing debt, selling assets and perhaps taking a loss on the sale of the assets, or it will have to renounce the debt by declaring bankruptcy.
One sees CIT examining its resources to decide what is its best option. The second option does not seem to be a viable option because CIT doesn’t have sufficient time to generate enough revenues so that it can pay down its debt. So, it is looking at a situation where it has a substantial amount of debt maturing in the next six months or so. Refinancing is an option, but with its bond ratings reduced to the ‘junk’ category, this could be quite expensive and could produce negative cash flows so that earnings could not provide revenues to pay down debt. Thus, CIT could reduce sell off assets to generate cash to pay off the maturing debt. But, how much does CIT stand to lose if it sells off assets?
If these are the scenarios, then it is good that CIT is getting advice on declaring bankruptcy. This still presents a problem. As people see this possibility facing the company, why should short term lenders continue to help finance the company and why should borrowers continue to borrow from CIT, a company that may not be there tomorrow. Also, on Monday morning investors dumped the company’s stock.
The fact of the matter is that there are many companies, governments, and individuals (and their families) that face this situation right now. And it is very, very scary.
The question is, given these problems, why should these economic units spend? They have a debt problem. And, with rising unemployment and more and more debt coming due in various sectors of the economy, like commercial real estate, why should we expect people to pick up their spending in the near term. There are other, more pressing issues to deal with. This is why the economy is not going to start to pick up much speed soon.
Almost every week there is a new “CIT” that we read about. These companies are too big to ignore. And, that is what is so worrisome. How many more of them are there?
Something else that is worrisome as well. When banks are closed by the FDIC, the general operating procedure is to place the deposits and good assets of the closed bank with a healthy bank. Word is that there are not that many healthy banks around. Thus, the deposits and good assets of banks that are closed are not being placed with healthy banks (See “FDIC’s Challenge with Busted Banks,” http://online.wsj.com/article/SB124744606526030587.html#mod=todays_us_money_and_investing.) So, we now have more banks that have been focused on their own problems taking on the problem of integrating the deposits and good assets of closed banks which can’t help but divert their attention from their own problems. As of last Friday, 53 banks have been closed this year and the expected total of bank closings for the year is over 100. If we don’t have a lot of healthy banks around now to take care of the current crop of banks that are closing, what are we going to do for the rest of the year?
Monday, July 13, 2009
Thursday, July 9, 2009
Explaining the Drop in the Weekly Money Stock Measures
Thursday afternoon the Wall Street Journal came out with a startling headline: “US M1 Fell $16.2 B In June 29 Week; M2 Fell $36.2 B.” (See http://online.wsj.com/article/BT-CO-20090709-714875.html#mod=rss_Bonds.)
Looking at the H.6 release that comes out at 4:30 PM on Thursday afternoon the Journal reported correctly. The H.6 release is titled Money Stock Measures. The seasonally adjusted M1 money stock measure averaged $1,669.1 billion in the week ending June 22, 2009 and averaged $1,652.9 billion in the week ending June 29, 2009, a drop of $16.2 billion. Please note that in the two weeks previous to June 22, the M1 Money Stock measured $1,630.9 billion and $1,656.5 billion, respectively.
Thus, M1 rose by $7.0 billion in the week ending June 15 and by $26.5 billion in the week ending June 22.
In terms of the seasonally adjusted M2 series, the weekly average for the week ending June 22 was $8,385.4 billion and for the week ending June 29 the M2 Money Stock averaged $8,349.2 billion, indicating a $36.2 billion drop. We can note that for the two previous weeks M2 averaged $8370.0 billion and $8,385.2 billion, respectively.
M2 rose by $15.2 billion in the week ending June 15 and by $0.2 billion in the week ending June 22.
Now let’s see what happened to the non-seasonally adjusted data. The M1 money stock rose $29.5 billion in the week ending June 15, by $52.0 billion in the week ending June 22 and rose another $47.9 billion in the week ending June 29. These figures are significantly different than the seasonally adjusted series.
In terms of M2, this series rose by $16.4 billion in the week ending June 15 but it dropped by $74.4 billion in the week ended June 22 and dropped again by $49.0 billion in the week ending June 29. Again there are serious differences.
There are two points to make here. Formerly the Fed did not put out weekly data on the Money Stock Measures because they jumped around so much. Such volatility can be unnerving to people watching the money stock. Obviously, people at the Wall Street Journal reacted very strongly to the weekly release.
Second, trying to seasonally adjust weekly data is only for the foolhardy or for the very brave. The only conclusion I can draw from the behavior of both the seasonally adjusted series and the non-seasonally adjusted series is that a lot of “stuff” is going on and the seasonal adjustment process is doing very little to capture what is going on. That is, what we are seeing here is white noise!
Is there any clue to what might be happening to banking accounts?
The answer to this is yes, there have been things happening that might help to account for some of the swings and because of the uncertainty of exactly when these things happen from year-to-year their movements can “screw up” the seasonal adjustment of the raw series.
To see what might be happening in the banking system, I go to the Federal Reserve release H.4.1, “Factors Affecting Reserve Balances.” This release also comes out at 4:40 PM on Thursdays. The account I am particularly interested in on the Fed statement is the line item called U. S. Treasury General Account. This is the account that the Treasury Department pulls in tax money from the private sector and then pays it out to the private sector. It is the “transaction” account of the Treasury Department, the one in which the Treasury deposits tax money and the one which the Treasury Department writes checks against.
This account is a “Factor that is absorbing reserves.” That is, when the Treasury draws funds in from the private sector it removes reserves from the banking system. When the Treasury writes checks to the private sector and these balances at the Fed decline, reserves are put back into the banking system.
The Fed and the Treasury work hard to coordinate their actions because they don’t want to incur large swings in the bank reserves. So, what happens is that tax payments and such are kept in the banking system until the Treasury is about to write some checks. When it draws funds from the banks, private deposits go down and the Treasury balances at the Fed go up. When the Treasury turns around and sends out checks to the private sector, bank deposits go up and the Treasury balances at the Fed go down. The Fed then manages bank reserves so that there are few if any dislocations caused in the banking system due to these transaction.
What we have here in June is a buildup in balances at the U. S. Treasury General Account and then a draw down as the Treasury writes out checks. What the Wall Street Journal caught was the building up deposits in the Treasury account. This comes out in the releases up to June 29.
However, we have not yet see the affect of the Treasury checks going out because we don’t have more current data on the Money Stock measures. We do have data for the Treasury’s General Account for the banking weeks ending July 1 and July 8.
And what do we see?
In the banking week ending June 10, the Treasury account averaged $31.4 billion. The next week the account averaged on $42.3 billion, but the account AT THE CLOSE OF BUSINESS on June 17 was a whopping $132.8 billion. Most of the money was drawn from the banking system at the end of the banking week so that the average did not move much.
But, for the banking week ending June 24, the Treasury General Account balance averaged $118.7 billion reflecting the growth in deposits, but the account AT THE CLOSE OF BUSINESS on June 24 stood at $78.8 billion. A lot of money passed though this account in a very few days.
The U. S. Treasury General Account then continued its decline. The average balance for the banking week ending July 1 was $72.0 billion and the average balance for the banking week ended July 8 was $34.2. This latter figure was right at the level of the average balances in the account in the first two weeks of June.
So, as the Wall Street Journal reported, we saw a massive decline in both measures of the Money Stock in the week ending June 29. However, the swings were caused by operational transactions within the government and should be reversed out in the data that are released for the weeks ending July 6 and July 13. But we won’t see those data for another two weeks.
Bottom line: the money stock is not collapsing! Whew!
Looking at the H.6 release that comes out at 4:30 PM on Thursday afternoon the Journal reported correctly. The H.6 release is titled Money Stock Measures. The seasonally adjusted M1 money stock measure averaged $1,669.1 billion in the week ending June 22, 2009 and averaged $1,652.9 billion in the week ending June 29, 2009, a drop of $16.2 billion. Please note that in the two weeks previous to June 22, the M1 Money Stock measured $1,630.9 billion and $1,656.5 billion, respectively.
Thus, M1 rose by $7.0 billion in the week ending June 15 and by $26.5 billion in the week ending June 22.
In terms of the seasonally adjusted M2 series, the weekly average for the week ending June 22 was $8,385.4 billion and for the week ending June 29 the M2 Money Stock averaged $8,349.2 billion, indicating a $36.2 billion drop. We can note that for the two previous weeks M2 averaged $8370.0 billion and $8,385.2 billion, respectively.
M2 rose by $15.2 billion in the week ending June 15 and by $0.2 billion in the week ending June 22.
Now let’s see what happened to the non-seasonally adjusted data. The M1 money stock rose $29.5 billion in the week ending June 15, by $52.0 billion in the week ending June 22 and rose another $47.9 billion in the week ending June 29. These figures are significantly different than the seasonally adjusted series.
In terms of M2, this series rose by $16.4 billion in the week ending June 15 but it dropped by $74.4 billion in the week ended June 22 and dropped again by $49.0 billion in the week ending June 29. Again there are serious differences.
There are two points to make here. Formerly the Fed did not put out weekly data on the Money Stock Measures because they jumped around so much. Such volatility can be unnerving to people watching the money stock. Obviously, people at the Wall Street Journal reacted very strongly to the weekly release.
Second, trying to seasonally adjust weekly data is only for the foolhardy or for the very brave. The only conclusion I can draw from the behavior of both the seasonally adjusted series and the non-seasonally adjusted series is that a lot of “stuff” is going on and the seasonal adjustment process is doing very little to capture what is going on. That is, what we are seeing here is white noise!
Is there any clue to what might be happening to banking accounts?
The answer to this is yes, there have been things happening that might help to account for some of the swings and because of the uncertainty of exactly when these things happen from year-to-year their movements can “screw up” the seasonal adjustment of the raw series.
To see what might be happening in the banking system, I go to the Federal Reserve release H.4.1, “Factors Affecting Reserve Balances.” This release also comes out at 4:40 PM on Thursdays. The account I am particularly interested in on the Fed statement is the line item called U. S. Treasury General Account. This is the account that the Treasury Department pulls in tax money from the private sector and then pays it out to the private sector. It is the “transaction” account of the Treasury Department, the one in which the Treasury deposits tax money and the one which the Treasury Department writes checks against.
This account is a “Factor that is absorbing reserves.” That is, when the Treasury draws funds in from the private sector it removes reserves from the banking system. When the Treasury writes checks to the private sector and these balances at the Fed decline, reserves are put back into the banking system.
The Fed and the Treasury work hard to coordinate their actions because they don’t want to incur large swings in the bank reserves. So, what happens is that tax payments and such are kept in the banking system until the Treasury is about to write some checks. When it draws funds from the banks, private deposits go down and the Treasury balances at the Fed go up. When the Treasury turns around and sends out checks to the private sector, bank deposits go up and the Treasury balances at the Fed go down. The Fed then manages bank reserves so that there are few if any dislocations caused in the banking system due to these transaction.
What we have here in June is a buildup in balances at the U. S. Treasury General Account and then a draw down as the Treasury writes out checks. What the Wall Street Journal caught was the building up deposits in the Treasury account. This comes out in the releases up to June 29.
However, we have not yet see the affect of the Treasury checks going out because we don’t have more current data on the Money Stock measures. We do have data for the Treasury’s General Account for the banking weeks ending July 1 and July 8.
And what do we see?
In the banking week ending June 10, the Treasury account averaged $31.4 billion. The next week the account averaged on $42.3 billion, but the account AT THE CLOSE OF BUSINESS on June 17 was a whopping $132.8 billion. Most of the money was drawn from the banking system at the end of the banking week so that the average did not move much.
But, for the banking week ending June 24, the Treasury General Account balance averaged $118.7 billion reflecting the growth in deposits, but the account AT THE CLOSE OF BUSINESS on June 24 stood at $78.8 billion. A lot of money passed though this account in a very few days.
The U. S. Treasury General Account then continued its decline. The average balance for the banking week ending July 1 was $72.0 billion and the average balance for the banking week ended July 8 was $34.2. This latter figure was right at the level of the average balances in the account in the first two weeks of June.
So, as the Wall Street Journal reported, we saw a massive decline in both measures of the Money Stock in the week ending June 29. However, the swings were caused by operational transactions within the government and should be reversed out in the data that are released for the weeks ending July 6 and July 13. But we won’t see those data for another two weeks.
Bottom line: the money stock is not collapsing! Whew!
Uncertainty: The King of the Market and what to do about it
This is a time that is particularly conducive to impulsive or instinctive behavior. It is a time that behavioral economists love because it proves their case about irrational human behavior. People react and they react on the basis of a gut feeling or a snap judgment.
These researchers tell us that this type of behavior is what has helped the human species survive. However, it is not necessarily the kind of behavior that leads to decisions or actions that are in our best interest when investing. “Relying only on intuition in finance can lead to very bad outcomes, not only for individuals but also for markets.” (This quote comes from David Adler’s new book “Snap Judgment”: see my post that reviews this book, http://seekingalpha.com/article/145660-book-review-snap-judgment-by-david-e-adler.) Yet we humans, individually and collectively continue to perform in this way.
Right now, the concern is whether or not the economy is bottoming out and starting to recover. We get “green shoots” here, but then some other indicator of economic activity comes in worse than expected. Alcoa puts up better than expected loss numbers but retail sales come in lower than expected. Sales of existing homes improve yet we get wind of another wave of subprime mortgage problems. (See “Subprime Returns as Housing Woe,” http://online.wsj.com/article/SB124709571378614945.html#mod=todays_us_money_and_investing.) And, what about the problems in commercial real estate, credit cards, and Alt A mortgages?
Then there is the question about whether or not there should be a second round stimulus bill. Paul Krugman has argued for a long time that the first stimulus bill was not enough. Yesterday Laura Tyson indicated that she thought that there needed to be a second round. Now the debate is all over the place. But, wouldn’t another stimulus bill add more to the government budget deficit going forward? And, there are questions about the possibility that the government has already committed to too much debt.
So the Dow Jones average goes up from 6500 and looks very strong approaching 9000 and then goes into a swoon. The price of crude oil was approaching $40 a barrel in February and then shot up to above $70 but now has returned to the $60 range. The yield on the 10-year treasury issue was nearing 2.00% in December 2008, jumped up to around 3.90% in the middle of June and traded at 3.30% yesterday. An index relating the value of the dollar against major currencies was around 70 in July 2008, popped up to the mid-80s in March 2009 and has since declined to about 77.
When the economic indicators seem strong the price of oil goes up as does the stock market and the price of bonds and the value of the dollar decline. When the economy seems weaker we get just the opposite movements. And, my bet is that it is going to continue this way for a while. So, uncertainty, and hence volatility, rule the marketplace.
This is the short run. Recently, however, I have been writing more upon the long run, what deficits do to long term interest rates and to the value of the dollar. Over the longer run, historically, some patterns repeat themselves over and over again. This, of course, brings to mind the statement made by John Maynard Keynes, “In the long run we are all dead!” Still, we need to take the long run into account.
This is where we need to take heed of what the behavioral economists advise. We, as investors, must not rely on intuition or gut reactions. We must not over react to the environment we now find ourselves in. Research has shown that acting in this way is not necessarily in our best interest.
The research also indicates that investing based on fundamental economic reasoning does work. Therefore, it seems as if now is a time for discipline and hard work. And, it is a time for patience.
But, this does not mean that one needs to totally ignore the short run. It is perhaps impossible to expect that most people will just sit out this stage of the economic cycle and invest their funds in safe, low-yielding assets. So, what kind of strategy might work here? My suggestion is that one needs to segment one’s portfolio, allocating some money to playing in the current market volatility, but allocating a larger share of the funds to potential future fundamental investment choices.
The smaller part of the portfolio can be allocated to playing both sides of various markets. Obviously, getting into the market near a “bottom” would be very profitable, but selling short near a “top” would also work. But, by all means consider any investments here as short term in nature because it is highly likely that the “bottom” may not turn out to be a “bottom” at all. Likewise for a “top.” So, one must be very agile in investing this way. Don’t hang onto losses, but let gains ride. Behavioral finance tells us that people tend to operate in the opposite way hanging onto losses hoping for the best and quickly selling gains to have something to show for their efforts. This is where discipline and focus are crucial.
Furthermore, remember that, on average, the expected returns on trading are zero: and there are still fees that need to be paid. But, using part of your funds in this way keeps you “playing the game” while still keeping the major part of your portfolio available for “value” investing to take advantage of longer run opportunities.
As research has shown, the fundamentals do apply over longer periods of time. Perhaps, however, it is not quite time to commit to some of these “value” propositions. People are worried about the potential inflation that may come about due to the large government budget deficits and the possibility that the Federal Reserve will have to monetize a substantial amount of the debt created. But, there are many people who think that deflation is going to be more of an issue in the near term. Hence, it is perhaps a little premature to put funds into investments that will prosper from a future period of high inflation. This part of the portfolio should be kept safe, but also should be able to be accessed when the time is right to commit to the longer run fundamentals. Research, however, has shown that it is alright to be a little early on these types of investments because the possible returns on such a commitment to fundamentals are substantial enough that being a little early is not harmful.
It is also important that an investor should stay in the areas of the market that they know best. If your skills lend themselves to the technology sector of the stock market then stay there. If your skills are in the government bond market then stay there. If your skills are in the foreign exchange market then stay there. Again, discipline and focus are all important.
Uncertainty is going to remain with us for quite some time in financial markets and commodity markets. The behavioral economists have warned us that this is a dangerous time to act in just an impulsive or instinctive manner. So, if being methodical is not your “cup of tea” then beware for the statistics are not with you. Chasing every “green shoot” or market reaction is not going to produce happy results. Acting in a focused and disciplined way may be very difficult for us to achieve but we need to try. That is what humans have learned they must do in activities like investing in financial or commodity markets.
These researchers tell us that this type of behavior is what has helped the human species survive. However, it is not necessarily the kind of behavior that leads to decisions or actions that are in our best interest when investing. “Relying only on intuition in finance can lead to very bad outcomes, not only for individuals but also for markets.” (This quote comes from David Adler’s new book “Snap Judgment”: see my post that reviews this book, http://seekingalpha.com/article/145660-book-review-snap-judgment-by-david-e-adler.) Yet we humans, individually and collectively continue to perform in this way.
Right now, the concern is whether or not the economy is bottoming out and starting to recover. We get “green shoots” here, but then some other indicator of economic activity comes in worse than expected. Alcoa puts up better than expected loss numbers but retail sales come in lower than expected. Sales of existing homes improve yet we get wind of another wave of subprime mortgage problems. (See “Subprime Returns as Housing Woe,” http://online.wsj.com/article/SB124709571378614945.html#mod=todays_us_money_and_investing.) And, what about the problems in commercial real estate, credit cards, and Alt A mortgages?
Then there is the question about whether or not there should be a second round stimulus bill. Paul Krugman has argued for a long time that the first stimulus bill was not enough. Yesterday Laura Tyson indicated that she thought that there needed to be a second round. Now the debate is all over the place. But, wouldn’t another stimulus bill add more to the government budget deficit going forward? And, there are questions about the possibility that the government has already committed to too much debt.
So the Dow Jones average goes up from 6500 and looks very strong approaching 9000 and then goes into a swoon. The price of crude oil was approaching $40 a barrel in February and then shot up to above $70 but now has returned to the $60 range. The yield on the 10-year treasury issue was nearing 2.00% in December 2008, jumped up to around 3.90% in the middle of June and traded at 3.30% yesterday. An index relating the value of the dollar against major currencies was around 70 in July 2008, popped up to the mid-80s in March 2009 and has since declined to about 77.
When the economic indicators seem strong the price of oil goes up as does the stock market and the price of bonds and the value of the dollar decline. When the economy seems weaker we get just the opposite movements. And, my bet is that it is going to continue this way for a while. So, uncertainty, and hence volatility, rule the marketplace.
This is the short run. Recently, however, I have been writing more upon the long run, what deficits do to long term interest rates and to the value of the dollar. Over the longer run, historically, some patterns repeat themselves over and over again. This, of course, brings to mind the statement made by John Maynard Keynes, “In the long run we are all dead!” Still, we need to take the long run into account.
This is where we need to take heed of what the behavioral economists advise. We, as investors, must not rely on intuition or gut reactions. We must not over react to the environment we now find ourselves in. Research has shown that acting in this way is not necessarily in our best interest.
The research also indicates that investing based on fundamental economic reasoning does work. Therefore, it seems as if now is a time for discipline and hard work. And, it is a time for patience.
But, this does not mean that one needs to totally ignore the short run. It is perhaps impossible to expect that most people will just sit out this stage of the economic cycle and invest their funds in safe, low-yielding assets. So, what kind of strategy might work here? My suggestion is that one needs to segment one’s portfolio, allocating some money to playing in the current market volatility, but allocating a larger share of the funds to potential future fundamental investment choices.
The smaller part of the portfolio can be allocated to playing both sides of various markets. Obviously, getting into the market near a “bottom” would be very profitable, but selling short near a “top” would also work. But, by all means consider any investments here as short term in nature because it is highly likely that the “bottom” may not turn out to be a “bottom” at all. Likewise for a “top.” So, one must be very agile in investing this way. Don’t hang onto losses, but let gains ride. Behavioral finance tells us that people tend to operate in the opposite way hanging onto losses hoping for the best and quickly selling gains to have something to show for their efforts. This is where discipline and focus are crucial.
Furthermore, remember that, on average, the expected returns on trading are zero: and there are still fees that need to be paid. But, using part of your funds in this way keeps you “playing the game” while still keeping the major part of your portfolio available for “value” investing to take advantage of longer run opportunities.
As research has shown, the fundamentals do apply over longer periods of time. Perhaps, however, it is not quite time to commit to some of these “value” propositions. People are worried about the potential inflation that may come about due to the large government budget deficits and the possibility that the Federal Reserve will have to monetize a substantial amount of the debt created. But, there are many people who think that deflation is going to be more of an issue in the near term. Hence, it is perhaps a little premature to put funds into investments that will prosper from a future period of high inflation. This part of the portfolio should be kept safe, but also should be able to be accessed when the time is right to commit to the longer run fundamentals. Research, however, has shown that it is alright to be a little early on these types of investments because the possible returns on such a commitment to fundamentals are substantial enough that being a little early is not harmful.
It is also important that an investor should stay in the areas of the market that they know best. If your skills lend themselves to the technology sector of the stock market then stay there. If your skills are in the government bond market then stay there. If your skills are in the foreign exchange market then stay there. Again, discipline and focus are all important.
Uncertainty is going to remain with us for quite some time in financial markets and commodity markets. The behavioral economists have warned us that this is a dangerous time to act in just an impulsive or instinctive manner. So, if being methodical is not your “cup of tea” then beware for the statistics are not with you. Chasing every “green shoot” or market reaction is not going to produce happy results. Acting in a focused and disciplined way may be very difficult for us to achieve but we need to try. That is what humans have learned they must do in activities like investing in financial or commodity markets.
Sunday, July 5, 2009
Deficits and the Declining Value of the Dollar
One of the questions that has arisen from the posts I have put up over the last several months has to do with my statement that the international financial community doesn’t like government deficits and tends to believe that a lack of fiscal discipline will result in an increased monetization of the debt. The feeling that the central bank of such a country cannot, in the longer run, overcome the fiscal imprudence of its national government and act independently of that government has resulted, time and again, in a decline in the value of the currency of the country being examined. The dollar is no exception.
Let’s look at the following information.
Average Yearly Increase in Gross Federal Debt (in billions of dollars)
Nixon/Ford $49.5
Carter $90.2
Reagan $258.6
Bush 41 $359.3
Clinton $232.1
Bush 43 $541.1
Now let’s look at the decline in the value of the dollar from the start of an administration to the end of that administration. I will use the trade weighted index of the United States dollar versus major currencies. The series begins in January 1973. Up until August 1971 the United States had a fixed exchange rate. At that time President Nixon announced that he was allowing the dollar to float in foreign exchange markets and was taking the United States off of the gold standard.
He also announced that “We are all Keynesians now!” meaning that he was going to stimulate the economy with budget deficits (so that he could get re-elected) and to protect against inflation he was freezing wages and prices. He created the Cost of Living Council and the Committee on Interest and Dividends to administer these controls as well as controls on interest rates. As can be seen from the above figures, the Gross Federal Debt increased by an average of almost $50 billion every year during the Nixon/Ford years. This compares with those spendthrifts John Kennedy and Lyndon Johnson who introduced Keynesian economic policies to the United States and who only increased the Gross Federal Debt by an average of less than $10 billion per year.
Change in the value of the dollar (as measured against major foreign currencies).
Nixon/Ford - 1.0 %
Carter - 10.4 %
Reagan - 5.7%
Bush 41 - 1.9 %
Clinton + 16.6%
Bush 41 - 21.6%
Note that the only administration to see a rise in the value of the dollar over the past forty years was the Clinton administration. Note, too, that the only break in the continued increase in the Gross Federal Debt outstanding was during the Clinton administration. As you may recall, the last four years it was in office, the Clinton administration ran budget surpluses.
Also, one can remember the accolades received by Paul Volcker, when he was the Chairman of the Board of Governors of the Federal Reserve System, for bringing inflation under control. Volcker was Chairman from August 1979 until August 1987. Volcker did bring inflation under control and early on this effort was reflected in a rise in the value of the United States dollar. The value of the dollar reached a short term bottom in July 1980 and then, accompanying the decline of inflation in the United States, the dollar rose in value by 55 percent to peak out on March 1985. However, even Volcker could not hold out against the massive deficits that the Reagan administration was piling up and the value of the dollar fell from that peak by 31 percent through the month at Volcker left his position at the Fed. Even someone as strong as Paul Volcker could not fight against the increasing deficits that were being posted by the Reagan administration. The value of the dollar closed lower at the end of the Reagan years than it was at the start.
The only conclusion one can draw from these data is that participants in international financial markets do not like the currency of countries that lack discipline over their fiscal affairs. This, of course, has very strong implications for the Obama administration. With the possibility that the Gross Federal Debt is on a trajectory in which the debt will increase in the $1.0 trillion range per year, at least for the near term, the implications seem clear. There will be continued pressure on the value of the United States dollar in the upcoming years.
The specific argument for this relationship is that increased federal deficits will result in increased monetization of the debt. Increased monetization of the debt will result in an increased rate of inflation. An increased rate of inflation will cause the value of the currency to decline. So, the question being posed by skeptics right now is “where is the inflation?” The time seems more right for deflation rather than inflation.
In the short run it is hard to argue against this logic. The only thing one can fall back on to answer this question is the fact that when budget deficits increase and there is no relief from substantial increases in the debt of the country, participants in international markets tend to sell the currency. What we have seen in the past is that any inflation that results from the massive increase in the debt outstanding can come in many forms that are not all registered in the computed price indices like the Consumer Price Index. Something like the CPI is an estimate, a guess at what is happening to prices. The important thing to remember about massive increases in debt is that they have to go somewhere and where ever they go they will have large consequences. We hope that we can measure these consequences and measure them in a timely manner. However, that does not always happen.
And, where else are we seeing action? India has now joined China and Russia and Brazil in calling for a discussion at the upcoming G-8 conference of the place of the United States dollar in the world’s monetary system. China is tired of continuing to support its currency against the United States dollar. Given the likelihood of a further decline in the value of the dollar, China faces the need to buy more and more dollars and invest in more and more securities from the United States. This, in the longer run, is not in China’s best interest. Nations, other than England and those from the Eurozone, are getting tired of the United States abusing its privilege of having the only reserve currency in the world. Although nothing is going to be done to change the monetary system at this time, this talk is going to get stronger and stronger. And, if the value of the dollar continues to decline in the future, the arguments are going to resonate more and more with others in the world. The basic approach to fiscal policy in the United States over the past 50 years has not been the most productive one in terms of maintaining a sound dollar currency.
Let’s look at the following information.
Average Yearly Increase in Gross Federal Debt (in billions of dollars)
Nixon/Ford $49.5
Carter $90.2
Reagan $258.6
Bush 41 $359.3
Clinton $232.1
Bush 43 $541.1
Now let’s look at the decline in the value of the dollar from the start of an administration to the end of that administration. I will use the trade weighted index of the United States dollar versus major currencies. The series begins in January 1973. Up until August 1971 the United States had a fixed exchange rate. At that time President Nixon announced that he was allowing the dollar to float in foreign exchange markets and was taking the United States off of the gold standard.
He also announced that “We are all Keynesians now!” meaning that he was going to stimulate the economy with budget deficits (so that he could get re-elected) and to protect against inflation he was freezing wages and prices. He created the Cost of Living Council and the Committee on Interest and Dividends to administer these controls as well as controls on interest rates. As can be seen from the above figures, the Gross Federal Debt increased by an average of almost $50 billion every year during the Nixon/Ford years. This compares with those spendthrifts John Kennedy and Lyndon Johnson who introduced Keynesian economic policies to the United States and who only increased the Gross Federal Debt by an average of less than $10 billion per year.
Change in the value of the dollar (as measured against major foreign currencies).
Nixon/Ford - 1.0 %
Carter - 10.4 %
Reagan - 5.7%
Bush 41 - 1.9 %
Clinton + 16.6%
Bush 41 - 21.6%
Note that the only administration to see a rise in the value of the dollar over the past forty years was the Clinton administration. Note, too, that the only break in the continued increase in the Gross Federal Debt outstanding was during the Clinton administration. As you may recall, the last four years it was in office, the Clinton administration ran budget surpluses.
Also, one can remember the accolades received by Paul Volcker, when he was the Chairman of the Board of Governors of the Federal Reserve System, for bringing inflation under control. Volcker was Chairman from August 1979 until August 1987. Volcker did bring inflation under control and early on this effort was reflected in a rise in the value of the United States dollar. The value of the dollar reached a short term bottom in July 1980 and then, accompanying the decline of inflation in the United States, the dollar rose in value by 55 percent to peak out on March 1985. However, even Volcker could not hold out against the massive deficits that the Reagan administration was piling up and the value of the dollar fell from that peak by 31 percent through the month at Volcker left his position at the Fed. Even someone as strong as Paul Volcker could not fight against the increasing deficits that were being posted by the Reagan administration. The value of the dollar closed lower at the end of the Reagan years than it was at the start.
The only conclusion one can draw from these data is that participants in international financial markets do not like the currency of countries that lack discipline over their fiscal affairs. This, of course, has very strong implications for the Obama administration. With the possibility that the Gross Federal Debt is on a trajectory in which the debt will increase in the $1.0 trillion range per year, at least for the near term, the implications seem clear. There will be continued pressure on the value of the United States dollar in the upcoming years.
The specific argument for this relationship is that increased federal deficits will result in increased monetization of the debt. Increased monetization of the debt will result in an increased rate of inflation. An increased rate of inflation will cause the value of the currency to decline. So, the question being posed by skeptics right now is “where is the inflation?” The time seems more right for deflation rather than inflation.
In the short run it is hard to argue against this logic. The only thing one can fall back on to answer this question is the fact that when budget deficits increase and there is no relief from substantial increases in the debt of the country, participants in international markets tend to sell the currency. What we have seen in the past is that any inflation that results from the massive increase in the debt outstanding can come in many forms that are not all registered in the computed price indices like the Consumer Price Index. Something like the CPI is an estimate, a guess at what is happening to prices. The important thing to remember about massive increases in debt is that they have to go somewhere and where ever they go they will have large consequences. We hope that we can measure these consequences and measure them in a timely manner. However, that does not always happen.
And, where else are we seeing action? India has now joined China and Russia and Brazil in calling for a discussion at the upcoming G-8 conference of the place of the United States dollar in the world’s monetary system. China is tired of continuing to support its currency against the United States dollar. Given the likelihood of a further decline in the value of the dollar, China faces the need to buy more and more dollars and invest in more and more securities from the United States. This, in the longer run, is not in China’s best interest. Nations, other than England and those from the Eurozone, are getting tired of the United States abusing its privilege of having the only reserve currency in the world. Although nothing is going to be done to change the monetary system at this time, this talk is going to get stronger and stronger. And, if the value of the dollar continues to decline in the future, the arguments are going to resonate more and more with others in the world. The basic approach to fiscal policy in the United States over the past 50 years has not been the most productive one in terms of maintaining a sound dollar currency.
Thursday, July 2, 2009
Is Treasury's TARP Debt Already Monetized? Part III
The discussion continues for one more post. I ended the last post with these words:
“The hope is that as the banking system works through its problems, TARP funds will be returned and the mortgage-backed securities will mature or be sold back into the market allowing the balance sheet of the Federal Reserve to contract back to where it was in the summer of 2008. The banking system is apparently holding onto reserves to protect itself and that is why they are really not lending. The idea is that if they don’t need these excess reserves they will return them. This is what the Federal Reserve is planning to happen. Let’s hope that they are correct!”
On this issue, let me point out the post by Jonathan Weil on Bloomberg this morning, “Crisis Won’t End Until Balance Sheets Get Real” (http://www.bloomberg.com/apps/news?pid=20601039&sid=azsX7o.atu7U). After presenting interesting data on the state of commercial bank balance sheets he argues the following:
“Banks and insurers got Congress to browbeat the Financial Accounting Standards Board into making rule changes that will let them plump earnings and regulatory capital. There also was Fed Chairman Ben Bernanke’s line in March about “green shoots,” which sparked a media epidemic of alleged sightings.
For all this, we still have hundreds of financial companies trading as though the worst of their losses are still to come. Just imagine what their prognosis might be if the government hadn’t pulled out all the stops.”
And, then Weil closes:
“Truth is, there’s no way to know if the economy has turned the corner, or if last quarter’s market rally will prove sustainable. Yet when this many banks still have balance sheets that defy belief, it means the industry probably hasn’t re- established trust with the investing public.
Trust, you may recall, is the financial system’s most precious asset. On that score, we still have a long way to go before we can say this banking crisis is over.”
This is the short run problem and it is the one that is going to determine whether or not the Federal Reserve is going to be able to shrink its balance sheet. This has been the point of my last two posts. And why are we facing such uncertainty at this point? Because the Mark-to-Market rule was pulled and because there is not enough openness and transparency in the public financial reporting of financial institutions. If there are going to be regulatory changes in the future, a lot is going to have to be changed as far as the reporting requirements for financial institutions is concerned.
But, this is just the short run problem.
The longer run problem is the projected budget deficits of the Federal government. Even if things work out as the Federal Reserve has planned as far as bank reserves are concerned and Federal Reserve credit retreats back to where it was in August 2008, there is the massive problem facing the country about how prospective government deficits are going to be financed. The bet is that the Fed will finance a substantial portion of the deficits to come. Let the printing presses roll!
The fear? Inflation.
But many say, we are in a severe economic contraction now. The fear should be deflation and not inflation.
The only response to this counter argument is that in the latter half of the 20th century, any nation that has run substantial deficits has, sooner or later, run into problems related to inflation. Monetary authorities are never so independent of their central governments that imprudent fiscal policies are not in one way or another underwritten through some form of monetization. And, since this happens time after time, how can the international investing community sit on the sidelines and do nothing? Yes, the United States is in a severe recession right now, but what are your odds for the monetization of a lot of the Federal debt over the next three years? Over the next five years? Over the next ten years?
Where do you look for such for an indication of market sentiment on this? Look at the value of the United States dollar. The dollar fell by about 15% against major currencies in the latter part of the 1970s as the Carter budget deficits seemed to get out-of-hand. As we know, Paul Volker played the savior there by conducting a very restrictive monetary policy to bring the value of the dollar back in line. However, the Reagan budgets became so severe by 1985 that the value of the dollar began to plummet. In the face of continuing deficits and the realization that this would continue to result in a weak dollar, Volker gave up the reins of the Federal Reserve in August 1987. The dollar did not pick up strength again until fiscal restraint was returned to Washington with the Clinton administration as the value of the dollar rose over 25% from April 1995 until the end of 2000. The massive budget deficits of Bush 43 were translated into another precipitous decline in the value of the dollar which fell by almost 40% between the middle of 2002 to March 2008.
The fiscal policy of a nation does matter to the international investment community!
But, you say, look at all the other major countries having economic problems and their budgets are out of balance as well. Look at England, Germany, Italy, France, and others.
The response to this? This is not the case for many of the major emerging countries of the world, specifically the BRIC countries. Perhaps one leaves Russia out of this, but China, India, and Brazil are going to emerge from this period much stronger relative to the United States than could have been thought even a year ago or so. So is Canada and several other important countries. This world crisis is going to shift world economic power in a way that has not been seen since the shifts in world power that took place in the 1920s and 1930s. And, international investors are realizing this!
Yes, the dollar will still be used as the reserve currency of the world…for a while longer. The Chinese, and the Russians, and the Brazilians, and the Indians all realize this. And, even though they keep talking about establishing a new reserve currency, they seem to back off and say that the dollar cannot be replaced right now. Yet, the Chinese have called for the Group of 8 to talk about a new reserve currency at its upcoming meeting. The issue IS on the table and my guess is that it is not going to go away.
Which brings me back to the deficits. In my mind, the budget deficits of the United States government are out-of-control right now and there is great concern that this administration will not be able to regain control of them in the near future. There is no “reversal” mechanism that is built into these budgets as the Fed has attempted to build in a “reversal” mechanism in its efforts. As a consequence, great pressure will be put on the monetary authorities over the next several years to monetize a substantial portion of the debt that will be created. The history of the past fifty years or so is that the Fed will not be able to avoid the pressure. This is perception that the international investing community will be bringing to the market when it place its bets. This can be translated into higher long term interest rates in the United States and a continuation in the decline in the value of the United States dollar.
“The hope is that as the banking system works through its problems, TARP funds will be returned and the mortgage-backed securities will mature or be sold back into the market allowing the balance sheet of the Federal Reserve to contract back to where it was in the summer of 2008. The banking system is apparently holding onto reserves to protect itself and that is why they are really not lending. The idea is that if they don’t need these excess reserves they will return them. This is what the Federal Reserve is planning to happen. Let’s hope that they are correct!”
On this issue, let me point out the post by Jonathan Weil on Bloomberg this morning, “Crisis Won’t End Until Balance Sheets Get Real” (http://www.bloomberg.com/apps/news?pid=20601039&sid=azsX7o.atu7U). After presenting interesting data on the state of commercial bank balance sheets he argues the following:
“Banks and insurers got Congress to browbeat the Financial Accounting Standards Board into making rule changes that will let them plump earnings and regulatory capital. There also was Fed Chairman Ben Bernanke’s line in March about “green shoots,” which sparked a media epidemic of alleged sightings.
For all this, we still have hundreds of financial companies trading as though the worst of their losses are still to come. Just imagine what their prognosis might be if the government hadn’t pulled out all the stops.”
And, then Weil closes:
“Truth is, there’s no way to know if the economy has turned the corner, or if last quarter’s market rally will prove sustainable. Yet when this many banks still have balance sheets that defy belief, it means the industry probably hasn’t re- established trust with the investing public.
Trust, you may recall, is the financial system’s most precious asset. On that score, we still have a long way to go before we can say this banking crisis is over.”
This is the short run problem and it is the one that is going to determine whether or not the Federal Reserve is going to be able to shrink its balance sheet. This has been the point of my last two posts. And why are we facing such uncertainty at this point? Because the Mark-to-Market rule was pulled and because there is not enough openness and transparency in the public financial reporting of financial institutions. If there are going to be regulatory changes in the future, a lot is going to have to be changed as far as the reporting requirements for financial institutions is concerned.
But, this is just the short run problem.
The longer run problem is the projected budget deficits of the Federal government. Even if things work out as the Federal Reserve has planned as far as bank reserves are concerned and Federal Reserve credit retreats back to where it was in August 2008, there is the massive problem facing the country about how prospective government deficits are going to be financed. The bet is that the Fed will finance a substantial portion of the deficits to come. Let the printing presses roll!
The fear? Inflation.
But many say, we are in a severe economic contraction now. The fear should be deflation and not inflation.
The only response to this counter argument is that in the latter half of the 20th century, any nation that has run substantial deficits has, sooner or later, run into problems related to inflation. Monetary authorities are never so independent of their central governments that imprudent fiscal policies are not in one way or another underwritten through some form of monetization. And, since this happens time after time, how can the international investing community sit on the sidelines and do nothing? Yes, the United States is in a severe recession right now, but what are your odds for the monetization of a lot of the Federal debt over the next three years? Over the next five years? Over the next ten years?
Where do you look for such for an indication of market sentiment on this? Look at the value of the United States dollar. The dollar fell by about 15% against major currencies in the latter part of the 1970s as the Carter budget deficits seemed to get out-of-hand. As we know, Paul Volker played the savior there by conducting a very restrictive monetary policy to bring the value of the dollar back in line. However, the Reagan budgets became so severe by 1985 that the value of the dollar began to plummet. In the face of continuing deficits and the realization that this would continue to result in a weak dollar, Volker gave up the reins of the Federal Reserve in August 1987. The dollar did not pick up strength again until fiscal restraint was returned to Washington with the Clinton administration as the value of the dollar rose over 25% from April 1995 until the end of 2000. The massive budget deficits of Bush 43 were translated into another precipitous decline in the value of the dollar which fell by almost 40% between the middle of 2002 to March 2008.
The fiscal policy of a nation does matter to the international investment community!
But, you say, look at all the other major countries having economic problems and their budgets are out of balance as well. Look at England, Germany, Italy, France, and others.
The response to this? This is not the case for many of the major emerging countries of the world, specifically the BRIC countries. Perhaps one leaves Russia out of this, but China, India, and Brazil are going to emerge from this period much stronger relative to the United States than could have been thought even a year ago or so. So is Canada and several other important countries. This world crisis is going to shift world economic power in a way that has not been seen since the shifts in world power that took place in the 1920s and 1930s. And, international investors are realizing this!
Yes, the dollar will still be used as the reserve currency of the world…for a while longer. The Chinese, and the Russians, and the Brazilians, and the Indians all realize this. And, even though they keep talking about establishing a new reserve currency, they seem to back off and say that the dollar cannot be replaced right now. Yet, the Chinese have called for the Group of 8 to talk about a new reserve currency at its upcoming meeting. The issue IS on the table and my guess is that it is not going to go away.
Which brings me back to the deficits. In my mind, the budget deficits of the United States government are out-of-control right now and there is great concern that this administration will not be able to regain control of them in the near future. There is no “reversal” mechanism that is built into these budgets as the Fed has attempted to build in a “reversal” mechanism in its efforts. As a consequence, great pressure will be put on the monetary authorities over the next several years to monetize a substantial portion of the debt that will be created. The history of the past fifty years or so is that the Fed will not be able to avoid the pressure. This is perception that the international investing community will be bringing to the market when it place its bets. This can be translated into higher long term interest rates in the United States and a continuation in the decline in the value of the United States dollar.
Sunday, June 28, 2009
Is Treasury's TARP Debt Already Monetized?--Part Two
My post from Friday June 26 contained the first part of this discussion. Today I would like to continue the discussion and there are two reasons for doing so. The first reason is to understand just what the Federal Reserve has been doing over these last nine months. The second is to understand how likely it might be for the Federal Reserve to “unwind” what it has done over the past nine months and reduce a part of the fear of future inflation. Note, I am not including any discussion of future government deficits and the probability that they will be “monetized.”
There is no doubt in my mind that the Federal Reserve has “printed” a lot of money since early September 2008, most of it before January 2009. The Monetary Base (Non-seasonally adjusted, NSA) rose from $847 billion in August 2008 to $1,712 billion in January 2009, an increase of $865 billion. Between January and May 2009, the Monetary Base only rose $63 billion.
Total Reserves (NSA) in the banking system increased by $817 billion from September 2008 to January 2009, but only increased by $42 billion since January. The most interesting thing is that Excess Reserves (NSA) in the banking system rose by almost $800 billion in the earlier period and increased by $46 billion in the January to May period.
The Federal Reserve put a lot on money into the banking system over the last nine months and the VAST MAJORITY of the funds went into Excess Reserves. The Fed “printed” a lot of money (or, created a lot of deposits at the Fed) but these monies did not find their way into the economy!
These two periods need to be separated in order to get a better picture of what the Fed has done and for some implications about what might occur in the future. My basic argument is that the Fed has put a tremendous amount of money into the world banking system and has ultimately underwritten the Treasury’s TARP program and provided much more money to the banking system than Congress authorized.
The underlying effort has two goals: first, to keep financial markets liquid; and second, to protect against the insolvency of the banking system. The first goal has basically been accomplished. The second is still playing itself out. The crucial thing to understand is that the way the Fed has acted has given the system a chance to get healthy and yet provide a net to catch insolvent banks so as to avoid a precipitous collapse of the banking system.
In the September 2008 to January 2009, the crisis period, the Fed basically ceased using the normal tools of monetary policy: open market operations consisting of outright purchases of government securities and repurchase agreements. In the fall, the Federal Reserve basically picked and choose what parts of the financial markets needed liquidity and created facilities to support these ill-liquid sub-markets. The major ways that it supplied funds or saw funds withdrawn in the September 2008 through January 2009 period and in the January 2009 through May 2009 period.
Change (billions) from Sept/08 to Jan/09: Term Auction Credit $257; Other Loans $166; Commercial Paper LLC $334; Other Fed Reserve Assets $506; for a total of $1,263. The change (billions) from Jan/09 through May 2009: Term Auction Credit (-$124); Other Loans (-$62); Commercial Paper LLC (-$206); Other Fed Reserve Assets (-$411); for a total of minus $803.
The Term Auction Credit Facility (TAF) helped to get reserves to the commercial banks that needed reserves, an effort the Fed believed was more efficient than open market operations. TAF peaked at $300 billion increase on 12/31/08. Other loans include increased borrowings from the Fed’s discount window, a facility for asset-backed commercial paper (which reached a peak increase of $152 billion on 10/8/08), a facility for primary government security dealers (which reached a peak increase of $147 billion on 10/1/08), and a facility for AIG. The commercial paper LLC was a limited liability facility that bought 3-month paper from eligible issuers (which reached its peak of $334 billion on 12/31/08). The increase in Other Fed Reserve assets was primarily Central Bank Liquidity swaps (which reached a peak of $682 billion on 12/17/08).
However, the Fed’s efforts reported here resulted in almost a $1.3 trillion increase in its assets and an $865 billion increase in the Monetary Base. Thus, almost the entire monetization ended up as excess reserves held at Federal Reserve Banks. Bank reserves at Federal Reserve Banks increased steadily throughout the fall, peaking at $856 million on December 31, 2008. Whew! The Federal Reserve had made it through this period of financial market illiquidity which accompanied the entire Thanksgiving/Christmas seasonal need for cash.
What happened in 2009? As mentioned above, the needs of specific market makers retreated, but now the solvency of the banking system came to the fore. In terms of the special facilities, as can be seen from the figures given above, a total of $803 billion was removed during the first five months of the year. Then the Fed began to conduct open market operations again. Throughout this time, securities bought outright by the Fed increased by $712 bullion. This included a program to buy government securities on a regular basis which contributed $177 billion to the Fed’s portfolio. It also added $70 billion of Federal Agency issues. Furthermore, the Fed initiated a very important program in 2009 and bought $465 billion of Mortgage-backed securities.
In essence, Total Federal Reserve Bank credit declined by about $200 billion during the first five months of the year but, as was reported earlier, the monetary base increased by $63 billion and total reserves and excess reserves in the banking system increase by more than $40 billion. In essence, the Fed operated in 2009 to keep the banking system very liquid and replaced the reserves that had been supplied to different parts of the financial markets in 2008 by interjecting funds directly into the banking system. The new twist? Directly helping banks sell their mortgage-backed securities, thereby reducing pressure on the banks to clean up their balance sheets. This was the original purpose of the Treasury’s TARP program.
The banking system faces three problems going forward: existing bad assets; bad assets that will appear over the next 18 months or so; and refinancing needs as the banks may not always be able to roll over existing liabilities.(See my post of June 15, “What Banks Aren’t Telling Us”, http://seekingalpha.com/article/143276-what-aren-t-banks-telling-us, for more on these factors.) The huge amount of excess reserves will help the banks face these problems. In terms of financing needs, the banks have the cash to pay off maturing liabilities without needing to roll the debt over. In terms of bad debts, this is where the TARP program comes in because the Treasury has provided preferred stock to banks with warrants attached. Charge offs can go against existing capital and the preferred stock and warrants can be transformed into new capital owned by the government to keep these banks afloat until something can be done with them.
Some banks have repaid the TARP funds that they had received. Several well-known large banks returned $68.25 billion this month to reduce Federal Government oversight. Still there have been 633 banks that have directly received about $200 billion in TARP funds and a total of 32 banks have now repaid about $70 billion. (On this see “Small Banks Not Shying From TARP” in June 27 Wall Street Journal, http://online.wsj.com/article/SB124606040026463617.html.) So, of the roughly $800 billion that banks are now holding in excess reserves, one could argue that approximately $130 billion of them have been supplied through the Treasury program and are held, mostly, by smaller banks and $670 billion of them has been supplied by the Federal Reserve, the total of the two being the money “printed “ to get us out of the current financial crisis.
The hope is that as the banking system works through its problems, TARP funds will be returned and the mortgage-backed securities will mature or be sold back into the market allowing the balance sheet of the Federal Reserve to contract back to where it was in the summer of 2008. The banking system is apparently holding onto reserves to protect itself and that is why they are really not lending. The idea is that if they don’t need these excess reserves they will return them. This is what the Federal Reserve is planning to happen. Let’s hope that they are correct!
There is no doubt in my mind that the Federal Reserve has “printed” a lot of money since early September 2008, most of it before January 2009. The Monetary Base (Non-seasonally adjusted, NSA) rose from $847 billion in August 2008 to $1,712 billion in January 2009, an increase of $865 billion. Between January and May 2009, the Monetary Base only rose $63 billion.
Total Reserves (NSA) in the banking system increased by $817 billion from September 2008 to January 2009, but only increased by $42 billion since January. The most interesting thing is that Excess Reserves (NSA) in the banking system rose by almost $800 billion in the earlier period and increased by $46 billion in the January to May period.
The Federal Reserve put a lot on money into the banking system over the last nine months and the VAST MAJORITY of the funds went into Excess Reserves. The Fed “printed” a lot of money (or, created a lot of deposits at the Fed) but these monies did not find their way into the economy!
These two periods need to be separated in order to get a better picture of what the Fed has done and for some implications about what might occur in the future. My basic argument is that the Fed has put a tremendous amount of money into the world banking system and has ultimately underwritten the Treasury’s TARP program and provided much more money to the banking system than Congress authorized.
The underlying effort has two goals: first, to keep financial markets liquid; and second, to protect against the insolvency of the banking system. The first goal has basically been accomplished. The second is still playing itself out. The crucial thing to understand is that the way the Fed has acted has given the system a chance to get healthy and yet provide a net to catch insolvent banks so as to avoid a precipitous collapse of the banking system.
In the September 2008 to January 2009, the crisis period, the Fed basically ceased using the normal tools of monetary policy: open market operations consisting of outright purchases of government securities and repurchase agreements. In the fall, the Federal Reserve basically picked and choose what parts of the financial markets needed liquidity and created facilities to support these ill-liquid sub-markets. The major ways that it supplied funds or saw funds withdrawn in the September 2008 through January 2009 period and in the January 2009 through May 2009 period.
Change (billions) from Sept/08 to Jan/09: Term Auction Credit $257; Other Loans $166; Commercial Paper LLC $334; Other Fed Reserve Assets $506; for a total of $1,263. The change (billions) from Jan/09 through May 2009: Term Auction Credit (-$124); Other Loans (-$62); Commercial Paper LLC (-$206); Other Fed Reserve Assets (-$411); for a total of minus $803.
The Term Auction Credit Facility (TAF) helped to get reserves to the commercial banks that needed reserves, an effort the Fed believed was more efficient than open market operations. TAF peaked at $300 billion increase on 12/31/08. Other loans include increased borrowings from the Fed’s discount window, a facility for asset-backed commercial paper (which reached a peak increase of $152 billion on 10/8/08), a facility for primary government security dealers (which reached a peak increase of $147 billion on 10/1/08), and a facility for AIG. The commercial paper LLC was a limited liability facility that bought 3-month paper from eligible issuers (which reached its peak of $334 billion on 12/31/08). The increase in Other Fed Reserve assets was primarily Central Bank Liquidity swaps (which reached a peak of $682 billion on 12/17/08).
However, the Fed’s efforts reported here resulted in almost a $1.3 trillion increase in its assets and an $865 billion increase in the Monetary Base. Thus, almost the entire monetization ended up as excess reserves held at Federal Reserve Banks. Bank reserves at Federal Reserve Banks increased steadily throughout the fall, peaking at $856 million on December 31, 2008. Whew! The Federal Reserve had made it through this period of financial market illiquidity which accompanied the entire Thanksgiving/Christmas seasonal need for cash.
What happened in 2009? As mentioned above, the needs of specific market makers retreated, but now the solvency of the banking system came to the fore. In terms of the special facilities, as can be seen from the figures given above, a total of $803 billion was removed during the first five months of the year. Then the Fed began to conduct open market operations again. Throughout this time, securities bought outright by the Fed increased by $712 bullion. This included a program to buy government securities on a regular basis which contributed $177 billion to the Fed’s portfolio. It also added $70 billion of Federal Agency issues. Furthermore, the Fed initiated a very important program in 2009 and bought $465 billion of Mortgage-backed securities.
In essence, Total Federal Reserve Bank credit declined by about $200 billion during the first five months of the year but, as was reported earlier, the monetary base increased by $63 billion and total reserves and excess reserves in the banking system increase by more than $40 billion. In essence, the Fed operated in 2009 to keep the banking system very liquid and replaced the reserves that had been supplied to different parts of the financial markets in 2008 by interjecting funds directly into the banking system. The new twist? Directly helping banks sell their mortgage-backed securities, thereby reducing pressure on the banks to clean up their balance sheets. This was the original purpose of the Treasury’s TARP program.
The banking system faces three problems going forward: existing bad assets; bad assets that will appear over the next 18 months or so; and refinancing needs as the banks may not always be able to roll over existing liabilities.(See my post of June 15, “What Banks Aren’t Telling Us”, http://seekingalpha.com/article/143276-what-aren-t-banks-telling-us, for more on these factors.) The huge amount of excess reserves will help the banks face these problems. In terms of financing needs, the banks have the cash to pay off maturing liabilities without needing to roll the debt over. In terms of bad debts, this is where the TARP program comes in because the Treasury has provided preferred stock to banks with warrants attached. Charge offs can go against existing capital and the preferred stock and warrants can be transformed into new capital owned by the government to keep these banks afloat until something can be done with them.
Some banks have repaid the TARP funds that they had received. Several well-known large banks returned $68.25 billion this month to reduce Federal Government oversight. Still there have been 633 banks that have directly received about $200 billion in TARP funds and a total of 32 banks have now repaid about $70 billion. (On this see “Small Banks Not Shying From TARP” in June 27 Wall Street Journal, http://online.wsj.com/article/SB124606040026463617.html.) So, of the roughly $800 billion that banks are now holding in excess reserves, one could argue that approximately $130 billion of them have been supplied through the Treasury program and are held, mostly, by smaller banks and $670 billion of them has been supplied by the Federal Reserve, the total of the two being the money “printed “ to get us out of the current financial crisis.
The hope is that as the banking system works through its problems, TARP funds will be returned and the mortgage-backed securities will mature or be sold back into the market allowing the balance sheet of the Federal Reserve to contract back to where it was in the summer of 2008. The banking system is apparently holding onto reserves to protect itself and that is why they are really not lending. The idea is that if they don’t need these excess reserves they will return them. This is what the Federal Reserve is planning to happen. Let’s hope that they are correct!
Thursday, June 25, 2009
Treasury's TARP Debt Already Monetized?
Where does all the TARP money show up? TARP, of course, stands for the Troubled Asset Relief Program that became law on October 3, 2008, a program aimed at providing support for the banking system. The program was initially intended to provide liquidity-help for the troubled assets that were on the balance sheets of banks but it soon morphed into a program to support troubled banks in their capital needs as funds were made available to purchase senior preferred stock and warrants from commercial banks and other troubled financial institutions.
The first $350 billion of funds was authorized to be released on October 3, 2008 and Congress approved the release of the next $350 billion on January 15, 2009. Part of the concern with the program was that the government deficit would have to increase by $700 billion in order to create the funds. Concerns arose about how the Treasury Department would finance these payments?
One quick answer was “let the Federal Reserve monetize the debt?”
What if the Federal Reserve has already monetized the debt related to TARP? If this is the case, then two questions that have been puzzling me have answers to them. The first question relates to the increase in excess reserves in the banking system. The second question relates to the concern about how the Federal Reserve will reverse out all of the reserves that it pumped into the banking system last fall. Let’s look at both in turn.
Federal Reserve Bank Credit has increased by $1.2 trillion since just before the financial meltdown in September 2008. What has increased the most in the banking system? Excess reserves in the commercial banking system have risen by about $800 billion. Excess reserves in the WHOLE banking system had run about $2 billion before September 2008. Something unprecedented obviously took place!
In terms of policy making the creation of TARP and the response of the Federal Reserve are closely tied together. (See my post of November 16, 2008, “The Bailout Plan: Did Bernanke Panic?: http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.) As mentioned above, the first round of TARP was released in October. But, the Federal Reserve could not wait. It began pumping reserves into the banking system in the latter part of September increasing Reserve Bank Credit outstanding from about $890 billion on September 10, 2008 to $1.5 trillion on October 8, $1.9 trillion on October 29, and $2.2 trillion on November 19.
In all this action, what happened to reserve balances at the Federal Reserve? They went from around $8 billion on September 10, to $175 billion, to $420 billion, to $624 billion, respectively, on the same dates as above. Excess reserves in the banking system averaged $2 billion in August, $60 billion in September, $268 billion in October, $559 billion in November, and $767 billion in December.
Excess reserves in the banking system averaged $844 billion in May and are averaging around $800 in June. Clearly a lot of money!
The question is “Why are the banks sitting on such large amounts of basically idle cash?”
My response is that they are sitting on this cash because it is connected with the receipt of TARP monies and the banks are hoping, as some of the larger and stronger institutions have done, to repay the funds as soon as possible.
Let’s look a little closer at the data. I am using information from the H.8 release put out by the Federal Reserve System on assets and liabilities of all commercial banks in the United States. Year-over-year, through May 2009, total assets in the banking system increased by 9.7% or about $1.1 trillion. Cash assets in the banking system increased a whopping $731 billion or at a year-over-year rate of 236%. This is comparable to the year-over-year increase in excess reserves observed on the H.3 release of the Federal Reserve providing data on bank reserves.
Given my post of last June 15, 2009, “What Aren’t Banks Telling Us?”, (http://seekingalpha.com/article/143276-what-aren-t-banks-telling-us) I was interested in looking a little deeper into this information to see how these excess reserves were distributed within the banking system. Roughly the division is this. The increase in cash assets at large commercial banks was $371billion, at small banks the increase was $143 billion, and at Foreign-related Institutions in the United States, $217 billion. The increase at the larger institutions, the large banks and the foreign-related institutions, was $588 billion and this represented the immediate problem to the policy makers. The problems of the smaller banks could be dealt with later.
The reason I am interested in looking into this distribution is the claim made in the above-mentioned post that commercial banks had not been fully open with the public on the problems they were still facing. In that post I mentioned three areas of concern: the bad assets now on the books of the banks; the anticipated increase in the bad assets in the upcoming months; and finally, the needs of the banks to be able to fund themselves in the future in the face of liabilities that were maturing and would not be rolled over. The build up in cash assets, it was argued, was a precaution the banks were taking to handle the uncertainty they faced as either asset values fell or a run off of liabilities forced the banks to dispose of assets.
Here is where the TARP money comes into play. If TARP money went into preferred stock and warrants, then these monies could be used to provide capital to the banks as the banks needed to write off bad loans and securities. The stock could even be converted into capital if the funds were needed to keep the banks solvent. Otherwise the banks could use the TARP funds to pay off maturing debt that could not be rolled over in the financial markets. (See Gretchen Morgenson, “Debts Coming Due At The Wrong Time,”
http://www.nytimes.com/2009/06/14/business/14gret.html?_r=1&scp=1&sq=gretchen%20morgenson/June%2014,%202009&st=cse.) Thus, monetizing the TARP debt makes a lot of sense in that it helps to protect the banking system from either bad assets that have to be written off or from financing problems resulting from the inability of the banks to roll over maturing liabilities.
What does this have to do with the Federal Reserve being able to unwind all the Reserve Bank Credit that it has pumped into the system? Well, when the banking system gets its act in order and charges off the loans and securities that it needs to and when its refinancing needs are satisfied, banks can then repay the TARP money to the Treasury as have the large financial institutions that have already repaid the TARP funds that they received. And, as the TARP monies are repaid, Reserve Bank Credit will decline so as to reduce the concern over the Fed monetizing the federal deficit.
Nice trick! The policy makers have provided a net under the banking system if the situation gets too bad in order to protect it against things falling apart and parallelizing the financial system. And, they have built into the system the means of reducing reserves as the financial system strengthens so as to avoid concerns over possible future inflation.
One final question: have the actions of the Federal Reserve had any impact on bank lending? The answer is “Not Really!” Year-over-year, loans and leases at all commercial banks increased by a tepid $182 billion or at a 2.6% annual rate. And, where were these increases located? Generally in home equity loans, consumer loans, and other residential loans (primarily mortgages) satisfying consumers needs for ready cash through consumer credit or the refinancing of homes. And, these loans were pretty evenly spread throughout the banking system.
Bottom line, however, is that the banks aren’t lending! Especially in the areas of commercial and industrial loans and commercial mortgages. Does that tell you something?
The first $350 billion of funds was authorized to be released on October 3, 2008 and Congress approved the release of the next $350 billion on January 15, 2009. Part of the concern with the program was that the government deficit would have to increase by $700 billion in order to create the funds. Concerns arose about how the Treasury Department would finance these payments?
One quick answer was “let the Federal Reserve monetize the debt?”
What if the Federal Reserve has already monetized the debt related to TARP? If this is the case, then two questions that have been puzzling me have answers to them. The first question relates to the increase in excess reserves in the banking system. The second question relates to the concern about how the Federal Reserve will reverse out all of the reserves that it pumped into the banking system last fall. Let’s look at both in turn.
Federal Reserve Bank Credit has increased by $1.2 trillion since just before the financial meltdown in September 2008. What has increased the most in the banking system? Excess reserves in the commercial banking system have risen by about $800 billion. Excess reserves in the WHOLE banking system had run about $2 billion before September 2008. Something unprecedented obviously took place!
In terms of policy making the creation of TARP and the response of the Federal Reserve are closely tied together. (See my post of November 16, 2008, “The Bailout Plan: Did Bernanke Panic?: http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.) As mentioned above, the first round of TARP was released in October. But, the Federal Reserve could not wait. It began pumping reserves into the banking system in the latter part of September increasing Reserve Bank Credit outstanding from about $890 billion on September 10, 2008 to $1.5 trillion on October 8, $1.9 trillion on October 29, and $2.2 trillion on November 19.
In all this action, what happened to reserve balances at the Federal Reserve? They went from around $8 billion on September 10, to $175 billion, to $420 billion, to $624 billion, respectively, on the same dates as above. Excess reserves in the banking system averaged $2 billion in August, $60 billion in September, $268 billion in October, $559 billion in November, and $767 billion in December.
Excess reserves in the banking system averaged $844 billion in May and are averaging around $800 in June. Clearly a lot of money!
The question is “Why are the banks sitting on such large amounts of basically idle cash?”
My response is that they are sitting on this cash because it is connected with the receipt of TARP monies and the banks are hoping, as some of the larger and stronger institutions have done, to repay the funds as soon as possible.
Let’s look a little closer at the data. I am using information from the H.8 release put out by the Federal Reserve System on assets and liabilities of all commercial banks in the United States. Year-over-year, through May 2009, total assets in the banking system increased by 9.7% or about $1.1 trillion. Cash assets in the banking system increased a whopping $731 billion or at a year-over-year rate of 236%. This is comparable to the year-over-year increase in excess reserves observed on the H.3 release of the Federal Reserve providing data on bank reserves.
Given my post of last June 15, 2009, “What Aren’t Banks Telling Us?”, (http://seekingalpha.com/article/143276-what-aren-t-banks-telling-us) I was interested in looking a little deeper into this information to see how these excess reserves were distributed within the banking system. Roughly the division is this. The increase in cash assets at large commercial banks was $371billion, at small banks the increase was $143 billion, and at Foreign-related Institutions in the United States, $217 billion. The increase at the larger institutions, the large banks and the foreign-related institutions, was $588 billion and this represented the immediate problem to the policy makers. The problems of the smaller banks could be dealt with later.
The reason I am interested in looking into this distribution is the claim made in the above-mentioned post that commercial banks had not been fully open with the public on the problems they were still facing. In that post I mentioned three areas of concern: the bad assets now on the books of the banks; the anticipated increase in the bad assets in the upcoming months; and finally, the needs of the banks to be able to fund themselves in the future in the face of liabilities that were maturing and would not be rolled over. The build up in cash assets, it was argued, was a precaution the banks were taking to handle the uncertainty they faced as either asset values fell or a run off of liabilities forced the banks to dispose of assets.
Here is where the TARP money comes into play. If TARP money went into preferred stock and warrants, then these monies could be used to provide capital to the banks as the banks needed to write off bad loans and securities. The stock could even be converted into capital if the funds were needed to keep the banks solvent. Otherwise the banks could use the TARP funds to pay off maturing debt that could not be rolled over in the financial markets. (See Gretchen Morgenson, “Debts Coming Due At The Wrong Time,”
http://www.nytimes.com/2009/06/14/business/14gret.html?_r=1&scp=1&sq=gretchen%20morgenson/June%2014,%202009&st=cse.) Thus, monetizing the TARP debt makes a lot of sense in that it helps to protect the banking system from either bad assets that have to be written off or from financing problems resulting from the inability of the banks to roll over maturing liabilities.
What does this have to do with the Federal Reserve being able to unwind all the Reserve Bank Credit that it has pumped into the system? Well, when the banking system gets its act in order and charges off the loans and securities that it needs to and when its refinancing needs are satisfied, banks can then repay the TARP money to the Treasury as have the large financial institutions that have already repaid the TARP funds that they received. And, as the TARP monies are repaid, Reserve Bank Credit will decline so as to reduce the concern over the Fed monetizing the federal deficit.
Nice trick! The policy makers have provided a net under the banking system if the situation gets too bad in order to protect it against things falling apart and parallelizing the financial system. And, they have built into the system the means of reducing reserves as the financial system strengthens so as to avoid concerns over possible future inflation.
One final question: have the actions of the Federal Reserve had any impact on bank lending? The answer is “Not Really!” Year-over-year, loans and leases at all commercial banks increased by a tepid $182 billion or at a 2.6% annual rate. And, where were these increases located? Generally in home equity loans, consumer loans, and other residential loans (primarily mortgages) satisfying consumers needs for ready cash through consumer credit or the refinancing of homes. And, these loans were pretty evenly spread throughout the banking system.
Bottom line, however, is that the banks aren’t lending! Especially in the areas of commercial and industrial loans and commercial mortgages. Does that tell you something?
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