The FDIC under-estimated.
In May of this year the FDIC projected $70 billion in losses associated with the failure of closed banks. This was an increase of $5 billion from earlier in the year. Now the figure has been revised upwards to $100 billion.
And, the FDIC is broke!
According to the New York Times: “Officials said that as of this week, the fund, which began the year at more than $30 billion and had about $10 billion over the summer, would have a negative net worth.”
The plan is to have banks “lend” money to the insurance fund in the form of a prepayment of annual assessments for the next three years. This “lending” would show up as an asset on the balance sheets of banks.
Four things are on my mind this morning.
First, the pace of bank failures has been orderly. That is, the problems are basically “known unknowns.” And, the FDIC is resolving the cases step-by-step.
Second, the concern arises about the pace of actual resolutions: has it been slowed because the FDIC knew that it was running out of money and was hoping that the situation would get better. If so, then the FDIC gets an F for this behavior.
We have had almost 100 bank failures this year and there are over 400 more banks on the problem list. Unemployment is rising, people are dropping out of the job market, there are lots of mortgages still to re-price in the next 18 months or so, foreclosures are still rising, and there still is the overhang of commercial real estate loans that are tenuous, at best. The potential number of problem banks could be even larger.
Has the FDIC under-estimated again?
Third, “it’s not over until it’s over!” The failure of financial institutions is a “lagging indicator”. The economy could be bottoming out, yet we can still experience a rising number of bank failures for another year or so due to the lag effect of the failures. But, the government is going to have to eventually “foot-the-bill”.
Accelerating annual assessments is a gimic! It is estimated that this will wipe out bank earnings for the year. So, with bad assets and zero earnings who believes that banks will begin lending again anytime soon?
And, if the banking system doesn’t get back into the lending game, how will the economy recover?
The only ones doing anything in the banking system seem to be the large bank holding companies and they seem to be putting their funds into “nonbank” subsidiaries. (See my post: http://seekingalpha.com/article/163983-credit-market-debt-a-return-to-pre-crash-practices.)
Fourth, what does this tell us about our leaders in government?
My personal view about the last election is that the public viewed the contest, not as a race between Democrats and Republicans, nor as a race between the liberals and conservatives. The public saw the election as a contest between incompetence and “possible” competence.
As of this date, the polls seem to indicate a rising concern that what seemed to be “possible” is fading away. People, at this time, don’t seem to want to move “left”. Look at Europe. Failing economies generally bring on a move for governments that can be labeled more toward the socialist end of the spectrum. Yet, what has been seen is the election of center-right governments.
I think people, in general, are still of a “centrist” mode. That is one reason the health care bill and other legislation is having trouble.
People want competence and they don’t seem to be getting it! Both the FDIC failure and the weak-kneed response to the situation does not raise my confidence level in those in charge.
I had thought Bair was doing a fair job. Now, she seems right up there with Geithner, Bernanke, and others who are not coming through for us.
Needless to say, I am not comforted by this mornings’ news concerning the FDIC!
Wednesday, September 30, 2009
Tuesday, September 29, 2009
Credit Market Debt: Why Is So Much Going to Bank Holding Companies?
Credit market debt increased by only 3% from the end of the second quarter of 2008 to the end of the quarter of 2009, a total of roughly $1.5 trillion. Of course, the primary story concerns the shifts in borrowing that took place during this time. The data used in this analysis is from the Flow of Funds accounts from the Federal Reserve.
One should note that the only two really substantial increases in credit market debt during this time period were the Federal Government and bank holding companies. Bank holding companies?
The Federal Government is easily identified as one of the primary borrowers during this time period as the debt of the government rose 36% or a total of $1.9 trillion. This is the largest year-over-year increase, dollar-wise, in history! But, this is not a surprise for we knew this was coming.
Note, that this increase does not include other sources of government debt extension in what are called “Funding Corporations” that include the creations of the Federal Reserve System to fund AIG and so on. This source of government funding reached a maximum of $445 billion in the fourth quarter of 2008 and dropped off to only $224 billion by the end of the second quarter of 2009.
One thing that has interested me is the performance of the commercial banking industry. The commercial banking industry, as a whole, has increased its use of credit market debt by a little more than 23%, although U. S. chartered commercial banks have actually reduced its reliance on this source of funds by about 6%. Note, too, that the credit market debt of the whole financial sector declined by about 1%.
The difference has come in the dramatic increase in the use of credit market debt by bank holding companies. Bank holding companies increased their use of this source of funds by 50%, an increase of $365 billion. In the process, the bank holding companies reduced their reliance on commercial paper by $78 billion and raised a net of $443 billion in corporate bonds. Thus there was not only a substantial increase in the funds bank holding companies raised during this time period, there was also a lengthening of the liabilities of these institutions.
One should call attention to the fact that Goldman, Sachs and Morgan Stanley became bank holding companies during this time period. How much of an impact this fact had on these aggregate numbers is hard to tell, but one should be aware of this movement. These two organizations became bank holding companies on September 22, 2008 and the bank holding numbers did not really increase appreciably during the third or fourth quarters of the year. Although total financial assets in bank holding companies rose modestly from the end of the second quarter to the end of the fourth quarter, actual credit market liabilities decreased. The numbers really began to jump upwards at the end of the first quarter of 2009.
Another factor influencing bank holding company debt during this time is the guarantee on bank bonds provided by the federal government. This gave bank holding companies the ability to raise funds relatively more cheaply than they could have raised them otherwise: a good reason to raise funds.
The interesting thing is that the raising of these funds did little or nothing to spur on bank lending or commercial bank growth. Investment in bank subsidiaries by bank holding companies went up by about $112 billion but this certainly doesn’t seem to have gone into bank loans since most of the increase in U. S. chartered commercial bank assets has been in the form of a rise in cash assets and government securities.
Total financial assets at banks rose by about $950 billion from the end of the second quarter of 2008 until the end of the second quarter of 2009. However, cash assets and reserves at the Federal Reserve rose by $430 and Government, Agency and GSE-backed securities rose by $185 billion. The only lending category to show much of a rise was the mortgage category, $233 billion, and this was primarily in commercial real estate. Commercial loans actually declined by about $100 billion. Something called Miscellaneous Assets rose by about $160 billion. Not a lot of lending going on in the banking sector.
However, investment by bank holding companies in nonbank subsidiaries actually rose by about $630 billion and investment in Other Miscellaneous assets rose by about $150 billion!
Thus, bank holding companies invested almost $800 billion in funding nonbank assets.
It seems as if big financial institutions are continuing to behave in the same way that they did before the financial markets started to unravel toward the end of 2007. That is, they put their money into non-bank operations, areas that the regulators did not have a lot of insight into or control over. That is, the banking system is still not relying on the fundamentals of banking to make money these days! They are returning to the areas that proved to be so profitable to them before the crash. And, once again, we seem to be in the dark as to what exactly they are doing.
Even through the credit crisis of 2008 and 2009, the credit markets provided some issuers of debt a substantial amount of funds. However, it seems as if these funds are going into hands that were very similar to the ones that were obtaining funds right before the crisis took place.
One should note that the only two really substantial increases in credit market debt during this time period were the Federal Government and bank holding companies. Bank holding companies?
The Federal Government is easily identified as one of the primary borrowers during this time period as the debt of the government rose 36% or a total of $1.9 trillion. This is the largest year-over-year increase, dollar-wise, in history! But, this is not a surprise for we knew this was coming.
Note, that this increase does not include other sources of government debt extension in what are called “Funding Corporations” that include the creations of the Federal Reserve System to fund AIG and so on. This source of government funding reached a maximum of $445 billion in the fourth quarter of 2008 and dropped off to only $224 billion by the end of the second quarter of 2009.
One thing that has interested me is the performance of the commercial banking industry. The commercial banking industry, as a whole, has increased its use of credit market debt by a little more than 23%, although U. S. chartered commercial banks have actually reduced its reliance on this source of funds by about 6%. Note, too, that the credit market debt of the whole financial sector declined by about 1%.
The difference has come in the dramatic increase in the use of credit market debt by bank holding companies. Bank holding companies increased their use of this source of funds by 50%, an increase of $365 billion. In the process, the bank holding companies reduced their reliance on commercial paper by $78 billion and raised a net of $443 billion in corporate bonds. Thus there was not only a substantial increase in the funds bank holding companies raised during this time period, there was also a lengthening of the liabilities of these institutions.
One should call attention to the fact that Goldman, Sachs and Morgan Stanley became bank holding companies during this time period. How much of an impact this fact had on these aggregate numbers is hard to tell, but one should be aware of this movement. These two organizations became bank holding companies on September 22, 2008 and the bank holding numbers did not really increase appreciably during the third or fourth quarters of the year. Although total financial assets in bank holding companies rose modestly from the end of the second quarter to the end of the fourth quarter, actual credit market liabilities decreased. The numbers really began to jump upwards at the end of the first quarter of 2009.
Another factor influencing bank holding company debt during this time is the guarantee on bank bonds provided by the federal government. This gave bank holding companies the ability to raise funds relatively more cheaply than they could have raised them otherwise: a good reason to raise funds.
The interesting thing is that the raising of these funds did little or nothing to spur on bank lending or commercial bank growth. Investment in bank subsidiaries by bank holding companies went up by about $112 billion but this certainly doesn’t seem to have gone into bank loans since most of the increase in U. S. chartered commercial bank assets has been in the form of a rise in cash assets and government securities.
Total financial assets at banks rose by about $950 billion from the end of the second quarter of 2008 until the end of the second quarter of 2009. However, cash assets and reserves at the Federal Reserve rose by $430 and Government, Agency and GSE-backed securities rose by $185 billion. The only lending category to show much of a rise was the mortgage category, $233 billion, and this was primarily in commercial real estate. Commercial loans actually declined by about $100 billion. Something called Miscellaneous Assets rose by about $160 billion. Not a lot of lending going on in the banking sector.
However, investment by bank holding companies in nonbank subsidiaries actually rose by about $630 billion and investment in Other Miscellaneous assets rose by about $150 billion!
Thus, bank holding companies invested almost $800 billion in funding nonbank assets.
It seems as if big financial institutions are continuing to behave in the same way that they did before the financial markets started to unravel toward the end of 2007. That is, they put their money into non-bank operations, areas that the regulators did not have a lot of insight into or control over. That is, the banking system is still not relying on the fundamentals of banking to make money these days! They are returning to the areas that proved to be so profitable to them before the crash. And, once again, we seem to be in the dark as to what exactly they are doing.
Even through the credit crisis of 2008 and 2009, the credit markets provided some issuers of debt a substantial amount of funds. However, it seems as if these funds are going into hands that were very similar to the ones that were obtaining funds right before the crisis took place.
Friday, September 25, 2009
Reasons for the slowdown in M2 growth: A Thrift Industry Crisis?
A surprisingly large amount of attention has recently been given to the slowdown in the growth rate of the M2 measure of the money stock. Around the first of the year, the year-over-year rate of growth of the M2 money stock was around 10%, a healthy rate of increase given the recession and the stance of quantitative easing on the part of the Federal Reserve.
Now, the year-over-year rate of growth in the M2 money stock measure has dropped below 8% and concern has been raised about the weakness in this particular indicator of the effectiveness of monetary policy. The question this weakness raises concerns the ability of the Federal Reserve to influence the real economy and the fact that the economy remains very, very weak.
The reason for this weakness, I believe, has less to do with the effectiveness of the Fed’s monetary policy and more to do with the shift in funds within the financial system. For one, the year-over-year rate of increase in the M1 money stock continues to be quite high, averaging more than 18% in the past month or two.
Whereas the M1 money stock increased about $260 billion over the past year, the M2 measure rose by $600 billion. Thus, the increase in the non-M1 part of the M2 measure was approximately $340 billion. The difference in growth rates for the aggregate measure obviously comes because the base for the M2 growth is much larger than the base for the M1 growth.
But, another interesting shift has occurred within these figures. Some deposit levels within the
non-M1 part of the M2 measure have actually declined over the past year. Note where the declines came: they came in time and savings deposits at thrift institutions and in retail money funds.
People are taking their money out of thrift institutions and money funds and putting them into deposits at commercial banks!
Time and savings deposits at thrift institutions fell about $130 billion over the past year and retail money funds dropped by almost $160 billion.
Note that time and savings deposits at commercial banks rose by $625 billion during the same time period.
This movement is reinforced by the shift in “other checkable deposits” over the past year. Other checkable deposits at commercial banks rose by about $50 billion whereas the same type of accounts at thrift institutions remained roughly the same. (Demand deposits at commercial banks increased by about $125 billion over the same time period.)
If one looks at the flow-of-funds accounts, the total financial assets at savings institutions dropped by about $420 billion from the second quarter in 2008 to the second quarter in 2009. Deposits at these institutions dropped by almost $200 billion and credit market instruments (supplying funds to these institutions) fell by about $280 billion.
What we seem to be observing is a massive withdrawal of funds from the thrift sector! This, I would suggest, is not a result of the monetary stance of the Federal Reserve System.
Very little attention has been given to the thrift industry over the past year. Maybe some more attention should be directed to the problems being faced by this industry.
Now, the year-over-year rate of growth in the M2 money stock measure has dropped below 8% and concern has been raised about the weakness in this particular indicator of the effectiveness of monetary policy. The question this weakness raises concerns the ability of the Federal Reserve to influence the real economy and the fact that the economy remains very, very weak.
The reason for this weakness, I believe, has less to do with the effectiveness of the Fed’s monetary policy and more to do with the shift in funds within the financial system. For one, the year-over-year rate of increase in the M1 money stock continues to be quite high, averaging more than 18% in the past month or two.
Whereas the M1 money stock increased about $260 billion over the past year, the M2 measure rose by $600 billion. Thus, the increase in the non-M1 part of the M2 measure was approximately $340 billion. The difference in growth rates for the aggregate measure obviously comes because the base for the M2 growth is much larger than the base for the M1 growth.
But, another interesting shift has occurred within these figures. Some deposit levels within the
non-M1 part of the M2 measure have actually declined over the past year. Note where the declines came: they came in time and savings deposits at thrift institutions and in retail money funds.
People are taking their money out of thrift institutions and money funds and putting them into deposits at commercial banks!
Time and savings deposits at thrift institutions fell about $130 billion over the past year and retail money funds dropped by almost $160 billion.
Note that time and savings deposits at commercial banks rose by $625 billion during the same time period.
This movement is reinforced by the shift in “other checkable deposits” over the past year. Other checkable deposits at commercial banks rose by about $50 billion whereas the same type of accounts at thrift institutions remained roughly the same. (Demand deposits at commercial banks increased by about $125 billion over the same time period.)
If one looks at the flow-of-funds accounts, the total financial assets at savings institutions dropped by about $420 billion from the second quarter in 2008 to the second quarter in 2009. Deposits at these institutions dropped by almost $200 billion and credit market instruments (supplying funds to these institutions) fell by about $280 billion.
What we seem to be observing is a massive withdrawal of funds from the thrift sector! This, I would suggest, is not a result of the monetary stance of the Federal Reserve System.
Very little attention has been given to the thrift industry over the past year. Maybe some more attention should be directed to the problems being faced by this industry.
Friday, September 18, 2009
The Federal Reserve Exit Watch--Number Two
Due to the great concern over how the Federal Reserve plans to reduce its balance sheet from $2.2 trillion to something comparable to the level it was at in August 2008, something around $900 billion, I will be posting on a regular basis my analysis of how the Fed is withdrawing funds from the banking system and the financial markets.
The concern about having put too many funds into the banking system is one about future inflation. The argument here is that it takes a while for inflation to build up. But, as the credit bubble earlier created by the Fed earlier this decade ended up in the financial collapse of 2008-2009, the fear is that if all the reserves the Federal Reserve has put into the banking system remain there, inflation will become a factor in 2010 and beyond.
The concern about removing the funds from the banking system too quickly comes from the 1937-1938 experience where commercial banks had a large quantity of excess reserves on their balance sheets. The Federal Reserve, at that time, raised reserve requirements to establish “tighter control” over the bank activity. However, the large amount of excess reserves on hand was consistent with the conservative behavior of the banks. The increase in reserve requirement caused banks to be even more conservative resulting in a substantial decline in the money stock. The result was the depression of 1937-1938.
For the two weeks ending September 9, 2009, depository institutions held $823 billion of excess reserves. Cash assets in the commercial banking system totaled slightly less than $1.0 trillion. In August 2008 these figures totaled less than $2.0 billion for excess reserves and around $300 billion for cash assets. Reserve balances with the Federal Reserve totaled about $860 billion on September 16, 2009; and this figure was about $50 billion on September 17, 2008.
It is an understatement to say that a lot of liquidity has been injected into the banking system!
Over the past 13 weeks ending on Wednesday September 16, 2009, reserve balances with Federal Reserve Banks increased by almost $120 billion. This increase alone represented a jump of about 13% of the Fed’s balance sheet one year earlier, so one cannot deny that the rise in reserve balances is not insignificant. The Federal Reserve is still acting in BIG NUMBERS, the size of which would have been incomprehensible 18 months ago!
Dissecting what took place during this time, however, is crucial to an understanding of how the Fed is trying to extricate itself from the situation it now finds itself in without setting off another panic in the financial markets. There were three basic changes in the Fed’s balance sheet over this time. The first change was operational in a seasonal sense and hence not crucial to the reduction in the Fed’s balance sheet. The second change is important because it relates to what is happening to all the special assets and facilities that the Fed set up to combat the financial crisis. These accounts appear to be phasing out. The third change relates to how the Fed is replacing the reserves draining out of the banking system because of the second change. Here the Federal Reserve is getting back into open market operations, something it abandoned in December 2007 as it created the Term Auction Facility (TAF).
The first major change in the balance sheet over the last 13 weeks was the swing in the general deposits the U. S. Treasury holds with the Fed. The movements here were seasonal and therefore solely of an operational nature. This swing has to do with tax receipts and the Treasury writing checks. The Treasury and the Fed have worked out operations so that tax collections and government expenditures do not disrupt the banking system any more than necessary. As a consequence you can get some pretty large swings in the balances that the Treasury holds at the Fed in this account without these movements causing large swings in the reserves that are in the banking system. Over the 13 weeks ending September 16, 2009, Treasury deposits declined by over $60 billion: however, in the last 4 weeks ending on the same date these balances increased by $32 billion. All this was handled smoothly.
It is the second of these factors that is vitally important for the exit strategy of the Fed. Accounts that can be associated with the “unusual” activities engaged in by the Fed over the last 21 months declined by over $300 billion over the last 13 weeks. The amount of funds supplied through the TAF dropped by over $140 billion. The net portfolio holdings of Commercial Paper Funding Facility LLC fell by almost $90 billion. Funding supplied through central bank liquidity swaps declined by more than $87 billion. The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility fell by about $19 billion.
In other words, the Federal Reserve is letting these facilities decline at their own pace as the need for them recedes. Even with all these reductions, however, one can still account for almost $600 billion of the Fed balance sheet being associated with assets created for the specific needs that officials perceived were necessary to keep the banking and financial system from collapsing. So there is still a ways to go to return to normalcy.
The Fed is replacing these assets that are running off with the purchases of various kinds of open market securities. Over the past 13 weeks, the Fed has increased its portfolio of securities held by about $385 billion. (One should note that in the first week of September 2008 the Fed held “total” less than $800 billion in securities. Again the magnitudes are staggering!) Of this increase, $121 billion was in Treasury securities, $35 billion was in Federal Agency securities, and $229 billion were in Mortgage Backed securities. (Note that on September 16, 2009, the Federal Reserve held $685 billion in Mortgage Backed securities, about 88% of the “total” securities held by the Federal Reserve in the first week of September 2008.)
My best guess about how the Fed will reduce its balance sheet is as follows. (Note that I am not including in this analysis any effort on the part of the Fed to support the massive amounts of debt that will be created through the deficits of the federal government in the future.) The portfolio of Treasury securities and Federal Agency securities will not be an active part of the Federal Reserve exit strategy. In my mind, what the Fed would like to see happen is that the roughly $600 billion is “special” assets would “run off” over time without major difficulty. Then, as the market for Mortgage Backed securities stabilizes and then returns to a more normal pattern of activity, the Fed will either allow its portfolio of Mortgage Backed securities to run off or will sell them into a strengthening market and significantly reduce the size of its holdings of these securities. As mentioned above, the Fed’s portfolio of Mortgage Backed securities totaled $685 billion on September 16.
Thus, assuming the best of all worlds, if these two items on the Fed’s balance sheet were eliminated, this would account for almost $1.3 trillion. Take away $1.3 trillion from the $2.2 trillion of assets on the Federal Reserve balance sheet September 16 and you get roughly $900 billion. On September 10, 2008 the Federal Reserve balance sheet totaled a little more than $900 billion in assets!
Can the Fed do it? We’ll just have to wait and see. It is important for us to see that there is a logical path out of the dilemma the Federal Reserve is facing. However, there are many potential bumps along the path. The health of the economy is one. The ever increasing federal debt is another. Recovery around that world is also a factor. And so on and so on. We will continue to watch!
The concern about having put too many funds into the banking system is one about future inflation. The argument here is that it takes a while for inflation to build up. But, as the credit bubble earlier created by the Fed earlier this decade ended up in the financial collapse of 2008-2009, the fear is that if all the reserves the Federal Reserve has put into the banking system remain there, inflation will become a factor in 2010 and beyond.
The concern about removing the funds from the banking system too quickly comes from the 1937-1938 experience where commercial banks had a large quantity of excess reserves on their balance sheets. The Federal Reserve, at that time, raised reserve requirements to establish “tighter control” over the bank activity. However, the large amount of excess reserves on hand was consistent with the conservative behavior of the banks. The increase in reserve requirement caused banks to be even more conservative resulting in a substantial decline in the money stock. The result was the depression of 1937-1938.
For the two weeks ending September 9, 2009, depository institutions held $823 billion of excess reserves. Cash assets in the commercial banking system totaled slightly less than $1.0 trillion. In August 2008 these figures totaled less than $2.0 billion for excess reserves and around $300 billion for cash assets. Reserve balances with the Federal Reserve totaled about $860 billion on September 16, 2009; and this figure was about $50 billion on September 17, 2008.
It is an understatement to say that a lot of liquidity has been injected into the banking system!
Over the past 13 weeks ending on Wednesday September 16, 2009, reserve balances with Federal Reserve Banks increased by almost $120 billion. This increase alone represented a jump of about 13% of the Fed’s balance sheet one year earlier, so one cannot deny that the rise in reserve balances is not insignificant. The Federal Reserve is still acting in BIG NUMBERS, the size of which would have been incomprehensible 18 months ago!
Dissecting what took place during this time, however, is crucial to an understanding of how the Fed is trying to extricate itself from the situation it now finds itself in without setting off another panic in the financial markets. There were three basic changes in the Fed’s balance sheet over this time. The first change was operational in a seasonal sense and hence not crucial to the reduction in the Fed’s balance sheet. The second change is important because it relates to what is happening to all the special assets and facilities that the Fed set up to combat the financial crisis. These accounts appear to be phasing out. The third change relates to how the Fed is replacing the reserves draining out of the banking system because of the second change. Here the Federal Reserve is getting back into open market operations, something it abandoned in December 2007 as it created the Term Auction Facility (TAF).
The first major change in the balance sheet over the last 13 weeks was the swing in the general deposits the U. S. Treasury holds with the Fed. The movements here were seasonal and therefore solely of an operational nature. This swing has to do with tax receipts and the Treasury writing checks. The Treasury and the Fed have worked out operations so that tax collections and government expenditures do not disrupt the banking system any more than necessary. As a consequence you can get some pretty large swings in the balances that the Treasury holds at the Fed in this account without these movements causing large swings in the reserves that are in the banking system. Over the 13 weeks ending September 16, 2009, Treasury deposits declined by over $60 billion: however, in the last 4 weeks ending on the same date these balances increased by $32 billion. All this was handled smoothly.
It is the second of these factors that is vitally important for the exit strategy of the Fed. Accounts that can be associated with the “unusual” activities engaged in by the Fed over the last 21 months declined by over $300 billion over the last 13 weeks. The amount of funds supplied through the TAF dropped by over $140 billion. The net portfolio holdings of Commercial Paper Funding Facility LLC fell by almost $90 billion. Funding supplied through central bank liquidity swaps declined by more than $87 billion. The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility fell by about $19 billion.
In other words, the Federal Reserve is letting these facilities decline at their own pace as the need for them recedes. Even with all these reductions, however, one can still account for almost $600 billion of the Fed balance sheet being associated with assets created for the specific needs that officials perceived were necessary to keep the banking and financial system from collapsing. So there is still a ways to go to return to normalcy.
The Fed is replacing these assets that are running off with the purchases of various kinds of open market securities. Over the past 13 weeks, the Fed has increased its portfolio of securities held by about $385 billion. (One should note that in the first week of September 2008 the Fed held “total” less than $800 billion in securities. Again the magnitudes are staggering!) Of this increase, $121 billion was in Treasury securities, $35 billion was in Federal Agency securities, and $229 billion were in Mortgage Backed securities. (Note that on September 16, 2009, the Federal Reserve held $685 billion in Mortgage Backed securities, about 88% of the “total” securities held by the Federal Reserve in the first week of September 2008.)
My best guess about how the Fed will reduce its balance sheet is as follows. (Note that I am not including in this analysis any effort on the part of the Fed to support the massive amounts of debt that will be created through the deficits of the federal government in the future.) The portfolio of Treasury securities and Federal Agency securities will not be an active part of the Federal Reserve exit strategy. In my mind, what the Fed would like to see happen is that the roughly $600 billion is “special” assets would “run off” over time without major difficulty. Then, as the market for Mortgage Backed securities stabilizes and then returns to a more normal pattern of activity, the Fed will either allow its portfolio of Mortgage Backed securities to run off or will sell them into a strengthening market and significantly reduce the size of its holdings of these securities. As mentioned above, the Fed’s portfolio of Mortgage Backed securities totaled $685 billion on September 16.
Thus, assuming the best of all worlds, if these two items on the Fed’s balance sheet were eliminated, this would account for almost $1.3 trillion. Take away $1.3 trillion from the $2.2 trillion of assets on the Federal Reserve balance sheet September 16 and you get roughly $900 billion. On September 10, 2008 the Federal Reserve balance sheet totaled a little more than $900 billion in assets!
Can the Fed do it? We’ll just have to wait and see. It is important for us to see that there is a logical path out of the dilemma the Federal Reserve is facing. However, there are many potential bumps along the path. The health of the economy is one. The ever increasing federal debt is another. Recovery around that world is also a factor. And so on and so on. We will continue to watch!
Thursday, September 17, 2009
It's the Dollar, Stupid!
“A nation’s exchange rate is the single most important price in its economy.” Paul Volcker
The value of the United States dollar is heading to the lows it reached in the summer of 2008. My belief is that the value of the dollar will reach these lows in the fall and then proceed to even lower levels in 2010.
The reason given for the current decline? The U. S. economy is getting stronger and the recession (Bernanke) is “very likely over.” In other words, uncertainty and, consequently, the financial market’s perception of risk are declining. A simple measure of the risk the financial market perceives is the interest rate spread between Baa-rated bonds and Aaa-rated bonds. The near term peak, 338 basis points, in this spread occurred in November 2008, a time when all hell was breaking lose in the financial markets. In recent weeks this spread has narrowed to about 120 basis points, a level that has not been seen since January 2008, one month after the current recession is said to have begun.
Financial markets are relatively calm and so market participants can direct their attention to some of the longer term issues that still have to be addressed in the world.
Of particular interest is the economic policy stance of the United States and not just the recent reprieve from economic collapse. The crucial elements? First, there is the massive amount of government debt that is projected to accumulate over the next ten years: maybe $10 trillion in additional debt; maybe $15 trillion; maybe more. Second, there is the Federal Reserve balance sheet that currently shows over $2 trillion in assets, substantially more than the $840 billion in asset the Fed held as late as August 2008.
This is a tremendous cloud hanging over the financial markets!
We know that the value of the United States dollar rose in late 2008 because of the crisis in world financial markets. Almost everyone concerned contends that this move came about as financial market participants moved to what they considered to be less risky assets, and that move brought them to U. S. Treasury securities and the U. S. dollar. This concern over risk was exhibited in the Baa-Aaa spread.
But, now with the strengthening of the U. S. economy and other economies around the world and with the calming of the financial markets, investors are moving their money out of dollar denominated assets. And, they are once again focusing upon the fundamentals of the economic policy of the United States government.
And what are the fundamentals? Just looking at the numbers one would have a difficult time telling the difference between what the Bush 43 administration did and what the Obama administration is doing. During the Bush 43 administration, there were massive increases in the federal debt and the Federal Reserve kept interest rates extremely low for an extended period of time. Now in the Obama administration we are seeing massive increases in the federal debt and the Federal Reserve is keeping interest rates extremely low for an extended period of time.
This is not a financial mix that participants in international financial markets like.
Let’s take a look at the historical record. We start during the Nixon administration because until August 1971 the value of the dollar was fixed in value relative to other currencies. But, once the value of the dollar began to fluctuate we saw some very consistent behavior in the currency markets. During the Nixon administration the gross federal debt increased at an 8.5% annual rate. The value of the dollar declined by 12.7% during this time period.
In the period between 1978 and 1992, the gross federal debt rose at a 12.6% annual rate. The value of the dollar only declined by 4.6%, but we must remember that during this time there was the period that Paul Volcker was the chairman of the Board of Governors of the Federal Reserve System and short term interest rates were pushed above 20%. As a consequence, the value of the dollar actually rose during the early part of the period even though the federal debt was continuing to increase. However, it was all downhill for the value of the dollar after 1985.
The exception to the other periods of time examined here was the 1992 to 2000 period. During that time the gross federal debt rose at a miserly annual rate of 3.6% and the value of the dollar actually rose by 16% during this period. By the end of the Clinton administration, the federal budget was actually showing a surplus.
Now we get back to Bush 43. During the 2001 to 2009 period the gross federal debt rose at an 8.5% annual rate. From January 2001 through to January 2009, the value of the dollar declined by 23.0%! (Through one stretch, the value of the dollar actually declined by more than 40%.)
With substantial budget deficits forecast into the foreseeable future, the Obama administration is causing the gross federal debt to continue to increase at annual rates that are relatively high by historical standards. The result? Since January 20, 2009, the value of the dollar against major currencies has declined by about 10.5%; the value of the dollar against the Euro has declined by more than 12%
I don’t believe that the current declines in the value of the dollar are just a result of the strengthening of the United States economy. To me, the fall in the value of the dollar is just a continuation of the market’s response to the general economic and fiscal policies of the latter part of the 20th century. Since at least 1971, the United States government has consistently deflated the value of the dollar.
In 1971, President Richard Nixon, as he embraced deficit spending, said that we had all become Keynesians. Unfortunately, he was right then and I fear that he is still right about the policy makers now in charge in Washington! Because of this I cannot see any long term relief in sight for the dollar. The debt of the federal government will continue to increase at a very rapid pace and the value of the dollar will continue to decline.
The value of the United States dollar is heading to the lows it reached in the summer of 2008. My belief is that the value of the dollar will reach these lows in the fall and then proceed to even lower levels in 2010.
The reason given for the current decline? The U. S. economy is getting stronger and the recession (Bernanke) is “very likely over.” In other words, uncertainty and, consequently, the financial market’s perception of risk are declining. A simple measure of the risk the financial market perceives is the interest rate spread between Baa-rated bonds and Aaa-rated bonds. The near term peak, 338 basis points, in this spread occurred in November 2008, a time when all hell was breaking lose in the financial markets. In recent weeks this spread has narrowed to about 120 basis points, a level that has not been seen since January 2008, one month after the current recession is said to have begun.
Financial markets are relatively calm and so market participants can direct their attention to some of the longer term issues that still have to be addressed in the world.
Of particular interest is the economic policy stance of the United States and not just the recent reprieve from economic collapse. The crucial elements? First, there is the massive amount of government debt that is projected to accumulate over the next ten years: maybe $10 trillion in additional debt; maybe $15 trillion; maybe more. Second, there is the Federal Reserve balance sheet that currently shows over $2 trillion in assets, substantially more than the $840 billion in asset the Fed held as late as August 2008.
This is a tremendous cloud hanging over the financial markets!
We know that the value of the United States dollar rose in late 2008 because of the crisis in world financial markets. Almost everyone concerned contends that this move came about as financial market participants moved to what they considered to be less risky assets, and that move brought them to U. S. Treasury securities and the U. S. dollar. This concern over risk was exhibited in the Baa-Aaa spread.
But, now with the strengthening of the U. S. economy and other economies around the world and with the calming of the financial markets, investors are moving their money out of dollar denominated assets. And, they are once again focusing upon the fundamentals of the economic policy of the United States government.
And what are the fundamentals? Just looking at the numbers one would have a difficult time telling the difference between what the Bush 43 administration did and what the Obama administration is doing. During the Bush 43 administration, there were massive increases in the federal debt and the Federal Reserve kept interest rates extremely low for an extended period of time. Now in the Obama administration we are seeing massive increases in the federal debt and the Federal Reserve is keeping interest rates extremely low for an extended period of time.
This is not a financial mix that participants in international financial markets like.
Let’s take a look at the historical record. We start during the Nixon administration because until August 1971 the value of the dollar was fixed in value relative to other currencies. But, once the value of the dollar began to fluctuate we saw some very consistent behavior in the currency markets. During the Nixon administration the gross federal debt increased at an 8.5% annual rate. The value of the dollar declined by 12.7% during this time period.
In the period between 1978 and 1992, the gross federal debt rose at a 12.6% annual rate. The value of the dollar only declined by 4.6%, but we must remember that during this time there was the period that Paul Volcker was the chairman of the Board of Governors of the Federal Reserve System and short term interest rates were pushed above 20%. As a consequence, the value of the dollar actually rose during the early part of the period even though the federal debt was continuing to increase. However, it was all downhill for the value of the dollar after 1985.
The exception to the other periods of time examined here was the 1992 to 2000 period. During that time the gross federal debt rose at a miserly annual rate of 3.6% and the value of the dollar actually rose by 16% during this period. By the end of the Clinton administration, the federal budget was actually showing a surplus.
Now we get back to Bush 43. During the 2001 to 2009 period the gross federal debt rose at an 8.5% annual rate. From January 2001 through to January 2009, the value of the dollar declined by 23.0%! (Through one stretch, the value of the dollar actually declined by more than 40%.)
With substantial budget deficits forecast into the foreseeable future, the Obama administration is causing the gross federal debt to continue to increase at annual rates that are relatively high by historical standards. The result? Since January 20, 2009, the value of the dollar against major currencies has declined by about 10.5%; the value of the dollar against the Euro has declined by more than 12%
I don’t believe that the current declines in the value of the dollar are just a result of the strengthening of the United States economy. To me, the fall in the value of the dollar is just a continuation of the market’s response to the general economic and fiscal policies of the latter part of the 20th century. Since at least 1971, the United States government has consistently deflated the value of the dollar.
In 1971, President Richard Nixon, as he embraced deficit spending, said that we had all become Keynesians. Unfortunately, he was right then and I fear that he is still right about the policy makers now in charge in Washington! Because of this I cannot see any long term relief in sight for the dollar. The debt of the federal government will continue to increase at a very rapid pace and the value of the dollar will continue to decline.
Tuesday, September 15, 2009
Too much power to too few people: the Lehman debacle.
It is so easy to blame the private sector. And, the government can hide behind “good intentions” and “the public interest.”
For a different view, read the article by John Cochrane and Luigi Zingales who write on “Lehman and the Financial Crisis” in the Wall Street Journal, http://online.wsj.com/article/SB10001424052970203440104574403144004792338.html#mod=todays_us_opinion. The argument is presented here that it was not the failure of Lehman Brothers that set off the financial crisis. It was the panic move by Ben Bernanke and Hank Paulson that resulted in the financial crisis. This mirrors something I wrote last fall on November 16 titled “The Bailout Plan: Did Bernanke Panic?”: http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.
As Cochrane and Zingales write, Fannie Mae and Freddie Mac were taken over on September 7, 2008. Lehman Brothers filed for bankruptcy on September 15. AIG was bailed out on September 16. I believe, as I say in the post above, that everything changed that Tuesday evening when the bailout of AIG was announced.
Bernanke called Paulson on Wednesday September 17. As reported later in the Wall Street Journal, and I quote from my post: The Wall Street Journal article reports that by Wednesday afternoon “Bernanke reached the end of his rope.” He called Paulson and “with an occasional quaver in his voice” he spoke “unusually bluntly” to the Treasury Secretary. Paulson did not move immediately. He had to sleep on it, and on Thursday morning, he committed.
Friday evening Bernanke and Paulson met with Congressional leaders and again I quote from the earlier post: Paulson called the leadership in Congress and asked them to have a meeting with himself and Bernanke on Friday evening. The few members of Congress that talked with the press after that meeting said that Bernanke did most of the talking and “scared the daylights out of everyone.” Bernanke knew his history of the Great Depression and he knew currents events. He was very logical and very articulate. The leaders were told that they had to act and they had to act fast. The plan was to have a bill before Congress on Monday seeking Congressional approval (of both houses) by the following Friday. The Treasury Department had a bill ready (three pages long) by midnight Saturday evening. The price tag - $700 billion. Why $700 billion? Because it was a big number!
But, Cochrane and Zingales state that on Monday September 22, “bank credit-default swap (CDS) spreads were at the same level as on September 12…The Libor-OIS spread—which captures the perceived riskiness of short-term interbank lending—rose only 18 points the day of Lehman’s collapse, while it shot up more than 60 points from September 23 to September 25, after the TARP testimony.” That is Bernanke and Paulson appeared in front of Congress on September 23 and 24 and gave speeches on the need for the TARP funding.
The reason for the subsequent market activity? Cochrane and Zingales claim that “In effect, these speeches amounted to ‘The financial system is about to collapse. We can’t tell you why. We need $700 billion. We can’t tell you what we’re going to do with it.” The authors conclude with “That’s a pretty good way to start a financial crisis.”
The conclusion: putting all the blame on the Lehman failure takes the focus off the main story. The main story is not that there was just one policy failure at this time. The main story is that the government continued to screw up after creating the financial environment and credit inflation that resulted in the asset bubble of earlier in the decade. It continued to screw up in the series of band aids that the Fed and the Treasury imposed on the economy and financial system beginning in December 2007. And, in doing so, the government continued to build up the moral hazard in existence in the system and continued to expand the federal debt outstanding to met ever larger needs for financial bailouts.
By not focusing on the main story, we risk an even larger series of policy failures in the future. That is, the federal government now is doing pretty much what the federal government did last year and the year before and is creating even more massive amounts of debt in the process.
For a different view, read the article by John Cochrane and Luigi Zingales who write on “Lehman and the Financial Crisis” in the Wall Street Journal, http://online.wsj.com/article/SB10001424052970203440104574403144004792338.html#mod=todays_us_opinion. The argument is presented here that it was not the failure of Lehman Brothers that set off the financial crisis. It was the panic move by Ben Bernanke and Hank Paulson that resulted in the financial crisis. This mirrors something I wrote last fall on November 16 titled “The Bailout Plan: Did Bernanke Panic?”: http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.
As Cochrane and Zingales write, Fannie Mae and Freddie Mac were taken over on September 7, 2008. Lehman Brothers filed for bankruptcy on September 15. AIG was bailed out on September 16. I believe, as I say in the post above, that everything changed that Tuesday evening when the bailout of AIG was announced.
Bernanke called Paulson on Wednesday September 17. As reported later in the Wall Street Journal, and I quote from my post: The Wall Street Journal article reports that by Wednesday afternoon “Bernanke reached the end of his rope.” He called Paulson and “with an occasional quaver in his voice” he spoke “unusually bluntly” to the Treasury Secretary. Paulson did not move immediately. He had to sleep on it, and on Thursday morning, he committed.
Friday evening Bernanke and Paulson met with Congressional leaders and again I quote from the earlier post: Paulson called the leadership in Congress and asked them to have a meeting with himself and Bernanke on Friday evening. The few members of Congress that talked with the press after that meeting said that Bernanke did most of the talking and “scared the daylights out of everyone.” Bernanke knew his history of the Great Depression and he knew currents events. He was very logical and very articulate. The leaders were told that they had to act and they had to act fast. The plan was to have a bill before Congress on Monday seeking Congressional approval (of both houses) by the following Friday. The Treasury Department had a bill ready (three pages long) by midnight Saturday evening. The price tag - $700 billion. Why $700 billion? Because it was a big number!
But, Cochrane and Zingales state that on Monday September 22, “bank credit-default swap (CDS) spreads were at the same level as on September 12…The Libor-OIS spread—which captures the perceived riskiness of short-term interbank lending—rose only 18 points the day of Lehman’s collapse, while it shot up more than 60 points from September 23 to September 25, after the TARP testimony.” That is Bernanke and Paulson appeared in front of Congress on September 23 and 24 and gave speeches on the need for the TARP funding.
The reason for the subsequent market activity? Cochrane and Zingales claim that “In effect, these speeches amounted to ‘The financial system is about to collapse. We can’t tell you why. We need $700 billion. We can’t tell you what we’re going to do with it.” The authors conclude with “That’s a pretty good way to start a financial crisis.”
The conclusion: putting all the blame on the Lehman failure takes the focus off the main story. The main story is not that there was just one policy failure at this time. The main story is that the government continued to screw up after creating the financial environment and credit inflation that resulted in the asset bubble of earlier in the decade. It continued to screw up in the series of band aids that the Fed and the Treasury imposed on the economy and financial system beginning in December 2007. And, in doing so, the government continued to build up the moral hazard in existence in the system and continued to expand the federal debt outstanding to met ever larger needs for financial bailouts.
By not focusing on the main story, we risk an even larger series of policy failures in the future. That is, the federal government now is doing pretty much what the federal government did last year and the year before and is creating even more massive amounts of debt in the process.
Monday, September 14, 2009
The Regulation of Banks and Financial Markets: One Year Later
The papers and the news broadcasts over the last week have been filled with stories about the failure of Lehman Brothers and the need to re-regulate the financial system. The second-guessing has been enormous on the failure of the federal government to come to the aid of the troubled investment banking firm, especially when put into the context of the bailout of AIG and the help given to other investment banks and commercial banks.
Furthermore, the report card on the government’s effort to re-regulate the financial system seems to be hovering between D and F! The consensus review of what has happened over the past year is: nothing!
In terms of letting Lehman Brothers go, let me just say that the second-guessing is a fun game and provides a diversion for journalists and makes good reading but is not very productive. This is the problem with decision making under very stressful conditions with very little information on what the potential outcomes of actions might be.
For one thing, very few people in the summer of 2008 even considered that the financial might be on the verge of collapse. That is what makes situations risky, the lack of knowledge of what might happen in the future. Yes, we can talk about Black Swans and so forth, but the probability of a severe financial crises occurring is a very unlikely event and business is not conducted on a “what-if-the-worst-happens” scenario. Second, no one has “experience” in dealing with a very serious financial crisis. It is entirely different studying previous examples of financial crisis, but to have to deal with one face-to-face is an entirely different matter. Third, the biases and prejudices and world views of the individuals in charge of making these decisions play a role in how people respond to a crises and no one, before-the-fact, can make an adequate prediction of how leaders will perform in a “once-in-a-lifetime” situation.
The financial system is still functioning and the economy seems to be working its way out of a deep recession. Could things have been done better? Yes. Could things have turned out worse? Of course. But, we seem to have muddled through the real crisis period. Hopefully, we will not have a second shock wave that sends us back into another panic mode.
In terms of re-regulating the financial system, I have several opinions I would like to share. First, to try and re-regulate a financial system immediately after a financial crisis occurs is, in my mind, not the thing to do. For one thing, you don’t really know what happened or what caused the crisis and to rush to judgment is often to rush into folly. Furthermore, villains are usually identified that may or may not really be the “bad guys” that need punishment or controlling. Powerful politicians or government officials impose their own biases and prejudices into the discussion and they are not always the best forces to design a new regulatory system. Also, new regulatory systems that are quickly put into place following a debacle are often designed to “fight the last war” and are not really appropriate for the environment the world is moving into.
The problem with not moving to re-regulate relatively quickly is that the movement to re-regulate loses its urgency.
My second concern has to do with the causes of the financial crisis. Since the financial collapse has to do with financial institutions and financial instruments, people look first at the individuals running these organizations or dealing in these instruments for the culprits of the crisis. The problem I have with this is that the leaders and practitioners of finance are responding to the economic and financial environment that they work within. The macro-incentives that exist within an economy are oftentimes created by others with very little insight into the incentives that they are actually setting up. The “others” I am talking about are, of course, our governmental leaders. Who created the macro-environment that produced the incentives for individuals to act in the way they did? What about Mr. Greenspan and Mr. Bernanke and the credit inflation that they spawned in the early part of this decade? What about the Bush 43 administration that created the huge fiscal deficits that resulted in a more than 40% decline in the value of the dollar?
The federal government represents more than 25% of GDP in the United States and with this impact on economic activity as well as through the rules and regulations it creates, the government has a very pervasive influence on the incentives that individuals and businesses have to respond to and operate within. The leaders in the federal government go free of blame while the people that have to live within the environment these leaders created must bear the burden of shame and guilt for the financial crisis that resulted.
My concern here is that maybe the re-regulation of the financial system is not the entire problem. My concern here is that people do not really understand who created the environment in which a financial meltdown could occur. Maybe better government policy making is in order, but maybe that is too much to ask for.
Finally, I would like to argue that financial types, human beings, are going to continue to innovate in the future and there is ultimately very little that governments or regulators can do to prevent financial innovation from taking place. (Human beings, by their very nature are problem-solvers and innovators.) Financial innovation has existed throughout history. Finance, really, is nothing more than information. That is one reason why financial innovation was able to explode beginning in the 1990s with the advancements in computer technology. The computer just allowed people to “slice and dice” massive amounts of information flows more efficiently and more quickly. (Even one of the staunchest proponents of behavioral finance, Robert Shiller, proposes using computer assisted financial innovation to take contribute to the evolution of new financial markets and instruments: see his books “Macro Markets” and “The New Financial Order.”) The whole idea of “information markets” builds upon models of financial innovation and how these models can be extended to other markets using massive new data base systems and the advanced computing power that is available in the ever-evolving world of information technology.
There must be oversight of the financial system and this oversight must be accompanied by increases in the openness and transparency of financial transactions and financial reporting. The innovation, in my mind, cannot be controlled. Therefore, we (business leaders, investors, and regulators) must also have more and more information available to us on a more timely basis in order to try and understand what is happening and to react to it. This, to me, is the world of the future.
It is this world of the future that must be considered in any effort to re-regulate the financial system. Fighting the last war is not going to produce the regulatory system we need. Ignoring the incentives that government creates is not going to produce the regulatory system we need. Regulations to produce specific “results” will not work. To my mind, it is not all bad that the rush to re-regulate or to develop a new regulatory system has stalled or been put on the bad burner.
Furthermore, the report card on the government’s effort to re-regulate the financial system seems to be hovering between D and F! The consensus review of what has happened over the past year is: nothing!
In terms of letting Lehman Brothers go, let me just say that the second-guessing is a fun game and provides a diversion for journalists and makes good reading but is not very productive. This is the problem with decision making under very stressful conditions with very little information on what the potential outcomes of actions might be.
For one thing, very few people in the summer of 2008 even considered that the financial might be on the verge of collapse. That is what makes situations risky, the lack of knowledge of what might happen in the future. Yes, we can talk about Black Swans and so forth, but the probability of a severe financial crises occurring is a very unlikely event and business is not conducted on a “what-if-the-worst-happens” scenario. Second, no one has “experience” in dealing with a very serious financial crisis. It is entirely different studying previous examples of financial crisis, but to have to deal with one face-to-face is an entirely different matter. Third, the biases and prejudices and world views of the individuals in charge of making these decisions play a role in how people respond to a crises and no one, before-the-fact, can make an adequate prediction of how leaders will perform in a “once-in-a-lifetime” situation.
The financial system is still functioning and the economy seems to be working its way out of a deep recession. Could things have been done better? Yes. Could things have turned out worse? Of course. But, we seem to have muddled through the real crisis period. Hopefully, we will not have a second shock wave that sends us back into another panic mode.
In terms of re-regulating the financial system, I have several opinions I would like to share. First, to try and re-regulate a financial system immediately after a financial crisis occurs is, in my mind, not the thing to do. For one thing, you don’t really know what happened or what caused the crisis and to rush to judgment is often to rush into folly. Furthermore, villains are usually identified that may or may not really be the “bad guys” that need punishment or controlling. Powerful politicians or government officials impose their own biases and prejudices into the discussion and they are not always the best forces to design a new regulatory system. Also, new regulatory systems that are quickly put into place following a debacle are often designed to “fight the last war” and are not really appropriate for the environment the world is moving into.
The problem with not moving to re-regulate relatively quickly is that the movement to re-regulate loses its urgency.
My second concern has to do with the causes of the financial crisis. Since the financial collapse has to do with financial institutions and financial instruments, people look first at the individuals running these organizations or dealing in these instruments for the culprits of the crisis. The problem I have with this is that the leaders and practitioners of finance are responding to the economic and financial environment that they work within. The macro-incentives that exist within an economy are oftentimes created by others with very little insight into the incentives that they are actually setting up. The “others” I am talking about are, of course, our governmental leaders. Who created the macro-environment that produced the incentives for individuals to act in the way they did? What about Mr. Greenspan and Mr. Bernanke and the credit inflation that they spawned in the early part of this decade? What about the Bush 43 administration that created the huge fiscal deficits that resulted in a more than 40% decline in the value of the dollar?
The federal government represents more than 25% of GDP in the United States and with this impact on economic activity as well as through the rules and regulations it creates, the government has a very pervasive influence on the incentives that individuals and businesses have to respond to and operate within. The leaders in the federal government go free of blame while the people that have to live within the environment these leaders created must bear the burden of shame and guilt for the financial crisis that resulted.
My concern here is that maybe the re-regulation of the financial system is not the entire problem. My concern here is that people do not really understand who created the environment in which a financial meltdown could occur. Maybe better government policy making is in order, but maybe that is too much to ask for.
Finally, I would like to argue that financial types, human beings, are going to continue to innovate in the future and there is ultimately very little that governments or regulators can do to prevent financial innovation from taking place. (Human beings, by their very nature are problem-solvers and innovators.) Financial innovation has existed throughout history. Finance, really, is nothing more than information. That is one reason why financial innovation was able to explode beginning in the 1990s with the advancements in computer technology. The computer just allowed people to “slice and dice” massive amounts of information flows more efficiently and more quickly. (Even one of the staunchest proponents of behavioral finance, Robert Shiller, proposes using computer assisted financial innovation to take contribute to the evolution of new financial markets and instruments: see his books “Macro Markets” and “The New Financial Order.”) The whole idea of “information markets” builds upon models of financial innovation and how these models can be extended to other markets using massive new data base systems and the advanced computing power that is available in the ever-evolving world of information technology.
There must be oversight of the financial system and this oversight must be accompanied by increases in the openness and transparency of financial transactions and financial reporting. The innovation, in my mind, cannot be controlled. Therefore, we (business leaders, investors, and regulators) must also have more and more information available to us on a more timely basis in order to try and understand what is happening and to react to it. This, to me, is the world of the future.
It is this world of the future that must be considered in any effort to re-regulate the financial system. Fighting the last war is not going to produce the regulatory system we need. Ignoring the incentives that government creates is not going to produce the regulatory system we need. Regulations to produce specific “results” will not work. To my mind, it is not all bad that the rush to re-regulate or to develop a new regulatory system has stalled or been put on the bad burner.
Friday, September 11, 2009
Accountants Misled Us Into Crisis
This headline is the headline of an article I would recommend everyone read about the financial crisis. This article, by Floyd Norris, can be found in the Friday morning New York Times (see http://www.nytimes.com/2009/09/11/business/economy/11norris.html?ref=business). As readers of this blog know, I have been a strong advocate of more transparent and open reporting from all organizations, but especially from financial institutions. Mark-to-market and the determination of fair values of financial assets, I believe, is a must going forward!
The bankers cry only after-the-fact, that is, once their bets on mismatched maturities on their balance sheets or on the assumption of riskier assets has gone sour. They can’t have it both ways, which is how little children want it. If you are going to take risks, Mr. Banker, then accept the responsibility for the risks that you take. Don’t cry about unfair accounting standards once the milk is spilt.
To me there are two major reasons why shareholders and regulators should be alerted to the bets that bankers have placed. The first has to do with achieving a more appropriate valuation of the stock of the bank or financial institution. Owners should know what bets have been placed so that they can incorporate risk into the valuations they are placing on the stock of the company they are interested in investing in. Regulators need to know as truly as possible the potential danger a bank faces and the treat the bank poses to the bank insurance fund.
The second reason has to do with management, itself. I have led the successful turnaround of three financial institutions. In each case, a major reason the banks got themselves in trouble was that managements repeatedly postponed, and then postponed again, dealing with problems because they could hide the problems from both the investment community and the regulatory bodies. This is also the case in the vast majority of troubled or failed institutions.
Successful managements must own up to the problems that they have created and act to correct those problems as soon as they can. The openness and transparency created by good accounting standards are important tools to create an environment in which managements do identify problems early and then act on them.
In a real sense, however, accounting standards are a crutch. Good executives require full disclosure of asset values and report this information to shareholders and regulators. They also act to resolve problems in a timely manner, as the problems are identified. Good executives create a culture in which they learn about problems as soon as possible because they don’t want surprises. I was taught that this is what good management is all about.
Perhaps we should post a list of all banks and bankers that are in favor of easing these reporting rules and discount the price of their common stock by 30% to 40% from current levels.
The reason?
To me, any banker that wants to ease up the rules on reporting the fair value of assets is, by definition, a poor manager and a poor leader. And, I do not want to invest in any organization that has poor management or poor leadership.
The bankers cry only after-the-fact, that is, once their bets on mismatched maturities on their balance sheets or on the assumption of riskier assets has gone sour. They can’t have it both ways, which is how little children want it. If you are going to take risks, Mr. Banker, then accept the responsibility for the risks that you take. Don’t cry about unfair accounting standards once the milk is spilt.
To me there are two major reasons why shareholders and regulators should be alerted to the bets that bankers have placed. The first has to do with achieving a more appropriate valuation of the stock of the bank or financial institution. Owners should know what bets have been placed so that they can incorporate risk into the valuations they are placing on the stock of the company they are interested in investing in. Regulators need to know as truly as possible the potential danger a bank faces and the treat the bank poses to the bank insurance fund.
The second reason has to do with management, itself. I have led the successful turnaround of three financial institutions. In each case, a major reason the banks got themselves in trouble was that managements repeatedly postponed, and then postponed again, dealing with problems because they could hide the problems from both the investment community and the regulatory bodies. This is also the case in the vast majority of troubled or failed institutions.
Successful managements must own up to the problems that they have created and act to correct those problems as soon as they can. The openness and transparency created by good accounting standards are important tools to create an environment in which managements do identify problems early and then act on them.
In a real sense, however, accounting standards are a crutch. Good executives require full disclosure of asset values and report this information to shareholders and regulators. They also act to resolve problems in a timely manner, as the problems are identified. Good executives create a culture in which they learn about problems as soon as possible because they don’t want surprises. I was taught that this is what good management is all about.
Perhaps we should post a list of all banks and bankers that are in favor of easing these reporting rules and discount the price of their common stock by 30% to 40% from current levels.
The reason?
To me, any banker that wants to ease up the rules on reporting the fair value of assets is, by definition, a poor manager and a poor leader. And, I do not want to invest in any organization that has poor management or poor leadership.
Thursday, September 10, 2009
Banks Remain on the Sidelines
The commercial banking system is still holding onto cash rather than lending or investing. Over the thirteen weeks ending August 26, 2009 the assets of the banking system dropped by $246 billion, but the cash assets of the banking system rose by $87 billion. In the most recent four week period bank assets did rise by $85 billion, but cash assets at the banks rose by $183 billion during the same time span.
Overall, banks, during the last 13-week period, have reduced, at a more rapid pace, their holdings of loans and investments as write-offs have increased, as there has been little incentive to make new loans, and as the banks have gotten out of securities that are not issued or guaranteed by the U. S. government. This is evidence that the banks are de-leveraging and are attempting to clean up their balance sheets. More detail of this behavior is presented below.
The total amount of cash assets in the banking system was $1.1 trillion in the banking week of August 26. This amounted to 9.3% of the total assets in the banking system as total assets averaged $11.8 trillion for the week. Note that banks were required to hold an average of only $62 billion ($0.06 trillion) in reserves behind their deposits during the two week period ending August 26. The excess reserves in the banking system averaged around a whopping $0.8 trillion during this same two week period. (The peak level of excess reserves in the banking system was about $0.85 trillion in the month of May.) Also, note that bank reserve balances with Federal Reserve Banks averaged around $0.83 trillion in the banking week ending August 26.
Beginning in December 2008, the banking system has held an average of $0.76 trillion in excess reserves every succeeding month. Before September 2008, the banking system held, on average, $0.002 trillion in excess reserves. To put these figures in context, bank assets in the banking week of August 26, 2009 were only $0.8 trillion larger than they were in the banking week of August 27, 2008. Thus, the entire increase in bank assets over the previous 52-week period was in cash assets!
The banks certainly have not been lending or investing. Over the past 13 weeks, commercial banks reduced their holdings of securities by $335 billion and they also reduced their holdings of loans or leases by $237 billion.
The interesting shift in the investment portfolio is in government guaranteed mortgage-backed securities. These have been increasing over the past 13 weeks. (See the Wall Street Journal article “Banks Load Up on Mortgages, in New Way,” http://online.wsj.com/article/SB125253192129897239.html#mod=todays_us_money_and_investing.) The banks have also been purchasing U. S. Treasury and Agency (non-MBS securities) issues over the same time period.
The big decline in security holdings has been in Mortgage-backed securities that were not guaranteed by the federal government or a government agency. Here it is important to note that the banking system still holds more than $200 billion in non-government guaranteed mortgage-backed securities and over $700 billion in assets that include other asset-backed securities, other domestic and foreign debt securities, and investments in mutual funds and other equity securities with “readily determinable fair values.” The banks were obviously chasing yield by investing in these securities. Over 75% of these holdings are in large commercial banks with small banks primarily investing in this category in state and local government securities, although this may not be comforting.
The decline in loans and leases spans the board. Commercial and industrial loans are down by $57 billion in the last 13 weeks whereas these loans are down by only $68 billion over the past 52 weeks. This decline seems to be speeding up as the decline over the last four weeks totaled about $34 billion.
Real estate loans are actually higher now than they were a year ago, but the volume of these loans is now decreasing. Home equity loans are down by $9 billion over the previous 13 weeks, residential loans are down $40 billion over the same time period, and commercial real estate loans have fallen by $29 billion.
Consumer loans are about the same as a year ago, as is credit card debt and other revolving credit. However, these figures have shown weakness over the past three months with total consumer credit declining by about $39 billion and the credit card and revolving credit debt falling by about $26 billion.
The commercial banking system continues to restructure. It is maintaining high levels of cash and is moving into less risky interest earning assets. The banking system, net, is not lending. We continue to hope that the restructuring will continue to occur without further surprises. Strong economic recovery, however, will not occur with bankruptcies and foreclosures remaining at high levels and with unemployment continuing to increase. Banks are not going to lend into this environment.
The bottom line from this analysis: the economy is recovering but economic growth will be anemic. Economic growth will remain anemic as long as the banking system stays on the sidelines.
Overall, banks, during the last 13-week period, have reduced, at a more rapid pace, their holdings of loans and investments as write-offs have increased, as there has been little incentive to make new loans, and as the banks have gotten out of securities that are not issued or guaranteed by the U. S. government. This is evidence that the banks are de-leveraging and are attempting to clean up their balance sheets. More detail of this behavior is presented below.
The total amount of cash assets in the banking system was $1.1 trillion in the banking week of August 26. This amounted to 9.3% of the total assets in the banking system as total assets averaged $11.8 trillion for the week. Note that banks were required to hold an average of only $62 billion ($0.06 trillion) in reserves behind their deposits during the two week period ending August 26. The excess reserves in the banking system averaged around a whopping $0.8 trillion during this same two week period. (The peak level of excess reserves in the banking system was about $0.85 trillion in the month of May.) Also, note that bank reserve balances with Federal Reserve Banks averaged around $0.83 trillion in the banking week ending August 26.
Beginning in December 2008, the banking system has held an average of $0.76 trillion in excess reserves every succeeding month. Before September 2008, the banking system held, on average, $0.002 trillion in excess reserves. To put these figures in context, bank assets in the banking week of August 26, 2009 were only $0.8 trillion larger than they were in the banking week of August 27, 2008. Thus, the entire increase in bank assets over the previous 52-week period was in cash assets!
The banks certainly have not been lending or investing. Over the past 13 weeks, commercial banks reduced their holdings of securities by $335 billion and they also reduced their holdings of loans or leases by $237 billion.
The interesting shift in the investment portfolio is in government guaranteed mortgage-backed securities. These have been increasing over the past 13 weeks. (See the Wall Street Journal article “Banks Load Up on Mortgages, in New Way,” http://online.wsj.com/article/SB125253192129897239.html#mod=todays_us_money_and_investing.) The banks have also been purchasing U. S. Treasury and Agency (non-MBS securities) issues over the same time period.
The big decline in security holdings has been in Mortgage-backed securities that were not guaranteed by the federal government or a government agency. Here it is important to note that the banking system still holds more than $200 billion in non-government guaranteed mortgage-backed securities and over $700 billion in assets that include other asset-backed securities, other domestic and foreign debt securities, and investments in mutual funds and other equity securities with “readily determinable fair values.” The banks were obviously chasing yield by investing in these securities. Over 75% of these holdings are in large commercial banks with small banks primarily investing in this category in state and local government securities, although this may not be comforting.
The decline in loans and leases spans the board. Commercial and industrial loans are down by $57 billion in the last 13 weeks whereas these loans are down by only $68 billion over the past 52 weeks. This decline seems to be speeding up as the decline over the last four weeks totaled about $34 billion.
Real estate loans are actually higher now than they were a year ago, but the volume of these loans is now decreasing. Home equity loans are down by $9 billion over the previous 13 weeks, residential loans are down $40 billion over the same time period, and commercial real estate loans have fallen by $29 billion.
Consumer loans are about the same as a year ago, as is credit card debt and other revolving credit. However, these figures have shown weakness over the past three months with total consumer credit declining by about $39 billion and the credit card and revolving credit debt falling by about $26 billion.
The commercial banking system continues to restructure. It is maintaining high levels of cash and is moving into less risky interest earning assets. The banking system, net, is not lending. We continue to hope that the restructuring will continue to occur without further surprises. Strong economic recovery, however, will not occur with bankruptcies and foreclosures remaining at high levels and with unemployment continuing to increase. Banks are not going to lend into this environment.
The bottom line from this analysis: the economy is recovering but economic growth will be anemic. Economic growth will remain anemic as long as the banking system stays on the sidelines.
Wednesday, September 9, 2009
Returning to the Real World
Over the past two weeks, I have done the best I can to help re-stimulate the economy. I got married, I closed on a new house, I hired contractors, and I spent as much as I could. Well maybe I could have spent more.
This morning I returned to the real world. And, what did I see? Gold is right around $1,000 an ounce. The dollar sank to its lowest level in nearly a year. The Chinese, through their sovereign-wealth fund, are looking at investing big bucks in United States real estate, a better longer term investment than putting them in United States Treasury securities.
In this vein, the Wall Street Journal contains a “tongue-in-cheek” letter from the Ministry of Finance in Beijing to “Dear Esteemed Chairman and Savior of the World Economy” in its editorial “Dear Chairman Bernanke” congratulating Chairman Bernanke on his re-appointment at the Chairman of the Board of Governors of the Federal Reserve System (http://online.wsj.com/article/SB10001424052970203440104574401212809493056.html#mod=todays_us_opinion).
And, what about the quantity of United States Treasury securities?
Martin Feldstein has presented a sobering opinion about the future of federal deficits resulting from the proposed health care proposals. (See his “ObamaCare’s Crippling Deficits” in the Wall Street Journal, http://online.wsj.com/article/SB20001424052970203585004574393110640864526.html#mod=todays_us_opinion.) Feldstein quotes the Congressional Budget Office report of March 2009 which estimates that federal deficits “will average 5.2% of GDP over the next decade and will be 5.5% of GDP in 2019.” He adds that “Without the president’s proposals, the budget office forecasts a 2019 deficit of only 2% of GDP.” However, Feldstein argues, “More realistic assumptions would imply a 2019 deficit of more than 8% of GDP and a government debt of more than 100% of GDP.”
And what news do I see about economic activity?
I guess my stimulus efforts are not having much of an effect. Consumers aren’t borrowing, banks aren’t lending, commercial real estate is showing higher and higher levels of vacancies and unemployment has reached 9.7% of Americans looking for a job. Of course, this does not include the discouraged workers that are not seeking a job which indicates that the people without jobs is above 15%. And, today, there was an article in the New York Times about all the fancy mortgage loans granted over the past four or five years that are going to be re-pricing in the next 12 to 36 months, re-pricing at substantially higher payments that individuals and families will not be able to cover given their current income levels.
Americans seem to be de-leveraging. However, the net worth of American households is declining. But, America, the nation, seems to be leveraging up. The dollar is declining and this makes American physical assets cheaper and cheaper to those in the world that possess wealth, that hold United States Treasury securities.
As the dramatic events of the financial crisis recede we return to the story that was developing in 2007 and early 2008. This story evolved out of the massive federal deficits created by the Bush 43 administration and the more than 40% decline in the value of the United States dollar. Earlier in this decade, before the financial collapse, the wealth of the world was being shifted to China, India, and the Middle East. These countries and their sovereign wealth funds were buying more and more physical assets in the United States as their wealth increased and the value of the dollar declined.
On returning to the real world, it seems as if this latent story is still alive and well and will continue into the future as more and more wealth is transferred out of the United States and into the rest of the world.
This morning I returned to the real world. And, what did I see? Gold is right around $1,000 an ounce. The dollar sank to its lowest level in nearly a year. The Chinese, through their sovereign-wealth fund, are looking at investing big bucks in United States real estate, a better longer term investment than putting them in United States Treasury securities.
In this vein, the Wall Street Journal contains a “tongue-in-cheek” letter from the Ministry of Finance in Beijing to “Dear Esteemed Chairman and Savior of the World Economy” in its editorial “Dear Chairman Bernanke” congratulating Chairman Bernanke on his re-appointment at the Chairman of the Board of Governors of the Federal Reserve System (http://online.wsj.com/article/SB10001424052970203440104574401212809493056.html#mod=todays_us_opinion).
And, what about the quantity of United States Treasury securities?
Martin Feldstein has presented a sobering opinion about the future of federal deficits resulting from the proposed health care proposals. (See his “ObamaCare’s Crippling Deficits” in the Wall Street Journal, http://online.wsj.com/article/SB20001424052970203585004574393110640864526.html#mod=todays_us_opinion.) Feldstein quotes the Congressional Budget Office report of March 2009 which estimates that federal deficits “will average 5.2% of GDP over the next decade and will be 5.5% of GDP in 2019.” He adds that “Without the president’s proposals, the budget office forecasts a 2019 deficit of only 2% of GDP.” However, Feldstein argues, “More realistic assumptions would imply a 2019 deficit of more than 8% of GDP and a government debt of more than 100% of GDP.”
And what news do I see about economic activity?
I guess my stimulus efforts are not having much of an effect. Consumers aren’t borrowing, banks aren’t lending, commercial real estate is showing higher and higher levels of vacancies and unemployment has reached 9.7% of Americans looking for a job. Of course, this does not include the discouraged workers that are not seeking a job which indicates that the people without jobs is above 15%. And, today, there was an article in the New York Times about all the fancy mortgage loans granted over the past four or five years that are going to be re-pricing in the next 12 to 36 months, re-pricing at substantially higher payments that individuals and families will not be able to cover given their current income levels.
Americans seem to be de-leveraging. However, the net worth of American households is declining. But, America, the nation, seems to be leveraging up. The dollar is declining and this makes American physical assets cheaper and cheaper to those in the world that possess wealth, that hold United States Treasury securities.
As the dramatic events of the financial crisis recede we return to the story that was developing in 2007 and early 2008. This story evolved out of the massive federal deficits created by the Bush 43 administration and the more than 40% decline in the value of the United States dollar. Earlier in this decade, before the financial collapse, the wealth of the world was being shifted to China, India, and the Middle East. These countries and their sovereign wealth funds were buying more and more physical assets in the United States as their wealth increased and the value of the dollar declined.
On returning to the real world, it seems as if this latent story is still alive and well and will continue into the future as more and more wealth is transferred out of the United States and into the rest of the world.
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