Thursday, April 30, 2009

Long Term Bond Yields and the Fed

The Federal Reserve is trying to hold down long term interest rates. The reason? To stimulate economic activity and encourage credit flow and especially mortgage lending. But, we have a problem. The Financial Times puts out headlines stating that “Rising bond yields present fresh challenge for the Fed.”

Long term bond rates have been rising lately. Yesterday, the 10-year Treasury hit 3.096%, a territory not breached since November 24, 2008. Last time I looked today, this yield was at 3.134%. The same was true for 20-year Treasuries topping 4.00% yesterday and today.

The Fed has been engaged in an effort to purchase longer term United States Treasury issues on a continuous basis as well as Federal Agency issues and mortgage-backed securities. It has made purchases in sizable amounts weekly. Now, the Fed seems to be losing its grip on yields in the long term end of the market.

The rationale given for this slippage? The record amounts of debt the United States government has to sell.

It is true that there are and will continue to be record amounts of debt issued by the United States government coming to the market now and for as far as we can see in the future. The supply issue may have some effect in the short run, but let me provide another possibility for the rise in rates in the longer term end of the yield curve.

The argument about whether or not the central bank can significantly impact yields in the longer term end of the yield curve has been going on for almost the entire length of my professional career. First, people think that the central bank can, and should, conduct open market operations so as to lower long term interest rates in order to spur on the economy. Then, research is produced that indicates that the Fed cannot achieve a significant reduction in long term yields through open market operations. A little later, some others think that it would be a good idea for the central bank to conduct open market operations to reduce long term interest rates. This is followed by another round of research indicating that the central bank cannot achieve this goal. Now, we are back at the point where policy makers believe that the Fed should attempt to keep long term interest rates low.

My reading of history is that the Federal Reserve cannot control, for any length of time, yields on long-term Treasury issues!

My reading of history also causes me to believe that the supply of Treasury securities cannot impact, for any length of time, the yields on long-term Treasury issues!

I am one that believes that long-term Treasury yields are determined by the appropriate expected real rate of interest and the expected rate of inflation. Since the expected real rate of interest does not change over short periods of time, the general movement in longer-terms interest rates will be determined by changes in expected inflation. And, expected inflation is dependent upon what the financial markets believe the Federal Reserve will be doing with respect to the monetization of the federal debt.

This, of course, has been a big fear in the financial markets. With all of the projected government debt coming down the road, many market participants believe that the Federal Reserve will have no choice but to monetize large portions of this debt. As more and more of the debt is monetized the probability that inflation will rise increases. And, this expectation gets built into long term interest rates.

If this is true, then the central bank faces a real dilemma. When the Federal Reserve attempts to keep long term interest rates low, it can cause a rise in inflationary expectations and this will create upward pressure on long term interest rates. If the Fed monetizes more of the debt to keep interest rates at the lower level, inflationary expectations will become even greater, putting even more upward pressure on long term interest rates. And, as long as the central bank continues to keep these long term yields below where the market wants them, the more damaging will be the consequences in the future.

In all my experience, I have not seen the Federal Reserve succeed in keeping long term interest rates below where the market wants them to be. I don’t expect them to succeed in their present efforts.

And, what about inflationary expectations? I believe that we can provide evidence from other markets that confirm this recent sensitivity to the increasing pressure on the monetary authorities to monetize the government debt. I am not concerned with the absolute levels of expected inflation, just the direction in which the spread has moved.

The spread between the 10-year government bond yield and the rate on 10-year inflation indexed government bonds is often used as an indicator of movements in inflationary expectations. The spread remained relatively constant from January 2009 through March. However, in April the spread has increased by 2 ½ times the January figure. This spread now is at a level we have not seen since early October 2008, right after the fall crisis hit. Market participants seem to be increasingly worried about what the Fed is going to have to do.

Furthermore, every time we see this spread increasing we tend to see a decline in the value of the United States dollar against the Euro and against other major currencies. Relative currency valuations are highly dependent upon changes in what central banks are expected to do because their actions can affect relative rates of inflation. If investors believe that the central bank in your country is going to monetize its government’s debt more rapidly than that of another country, the value of your currency will decline relative to that of the other country.

In this respect, the value of the United States dollar has declined over the past two days and tends to drop every time there is a rise in yields on longer term Treasury bonds. This would indicate that some of the same things affecting the yields on long term bonds are also affecting the value of the currency.

A final piece of evidence in support of this idea is that the market also responded to the minutes released yesterday by the Federal Reserve’s Open Market Committee. In those minutes the Fed stated that “the economic outlook has improved modestly since the March meeting…” It also noted that household spending “has shown signs of stabilizing while businesses have cut inventories, investments and staffing” implying that if consumer spending does stabilize or even increase, businesses will have to restock their shelves in order to support this spending which would be positive for economic recovery. Both of these statements foresee a stronger economy in the future, reinforcing the earlier fears of the market.

Long term Treasury yields were low because there was a flight to quality and because inflationary expectations were low. Unless there is another major shock to the system, I believe that the flight to quality is over and is in the process of being reversed. In addition, I believe that the Fed will continue to monetize the debt in increasing amounts for the Fed also emphasized in the minutes released yesterday that they will “stay the course” in the fight against an economic collapse. For both of these reasons, I feel that pressure will continue for long term Treasury yields to rise and for the value of the dollar to fall.

Tuesday, April 28, 2009

Renouncing the Debt

There are three ways to get out of a debt crisis. First, you can work off the debt, but this takes a long time. An impatient public and an impatient government will not have the stomach the wait that would be necessary for individuals, families, and businesses to get their balance sheets in order so that a recovery can get started.

The second method is to inflate or reflate yourself out of the nominal debt burden you have created. The Federal Reserve is doing its best to create an inflationary environment so that the real value of the debt will be reduced and individuals, families, and businesses will feel comfortable enough to begin borrowing and spending once again.

The third way to reduce the burden of your debt is to repudiate the debt. That is, declare that you will not pay the debt and that those that issued the credit to you will have to take only a partial payment on the amount of funds that they advanced to you. The partial payment, of course, can be zero.

The latter two methods have an “honorable” history that goes back centuries. (Read almost anything by Niall Ferguson.) Usually, it is the government that can get away with either or both of these efforts, but in the 20th century, the private sector got much better in following the lead established by governments, especially repudiating the debt. Individuals, families, and businesses learned the ropes of debt repudiation and are now taking this knowledge to new extremes.

The case that is before everyone’s eyes these days is that of the automobile industry. Both General Motors and Chrysler argue that bondholders must take a huge cut in the amount of money they are owed by these companies so that the companies can survive and thousands and thousands of jobs can be saved. The bondholders, remarkably, have some reluctance to consent to this offer. As of this date, the aimed for restructuring of these two companies depend upon what is worked out between the companies and the bondholders.

Best guess is that the bondholders will lose. And, who will own the auto companies? Not the existing shareholders. The figure I have heard for General Motors is that existing shareholders will end up with about 1% of the ownership of the company after the restructuring takes place. And, not the existing bondholders. The biggest shareholders? The federal government and the labor unions.

The important thing, however, is that the debt problem being experienced by these automobile companies will be resolved. That is, the companies can move forward, leaner and meaner, without the terrible burden of having to honor the debts they had contracted for.

Furthermore, this is what has been proposed for the banking industry. In the plan to sell off bad assets, aren’t the banks being asked to repudiate a large portion of the debt they have on their balance sheets? The assets will be sold to investors and private equity firms to “manage” and this will get the banks out from under the burden of the “toxic assets” they have accumulated.

And, who will bear the risk of this buyout? The federal government, with the real possibility that it may, depending upon the way things work out, end up owning large portions of some of the larger banks. (An important critique of this program is presented by the economist Joseph Stiglitz in “Obama’s Ersatz Capitalism,”

Might this plan work? Well, the people that the federal government wanted to get interested in the plan seemingly smell blood. We read this morning that Wilbur Ross and his firm’s parent company, Invesco, are leading a consortium that is going to bid on some of the assets in the government’s P-PIP. He is joining some other prominent money, like BlackRock, Pimco and Bank of New York Mellon, interested in getting involved in the program.

Do these people think that they might make some money out of this program? Do they believe that the risk-reward tradeoff is skewed in their direction? Damn betcha’.

Here is another case of “watch where the big money players put their money.” My guess for the future is that the evolving banking system is going to be somehow connected with the hedge funds and the private equity funds and will not have the same old “bank on the corner” feel to it that we experience now. And, somehow, this new banking system will be even harder to regulate than the current one. Otherwise, this money will not flow there. (Something to think about for the future.)

With these funds flowing into the P-PIP, one of the things the federal government is going to have to face is the huge profits that these companies will make out of the program. On the one hand, if P-PIP is successful in this way and these funds make huge profits, the banks will be freed up of their “toxic assets” and the tax payer will not be burdened with more taxes. On the other hand, the federal government will have to explain how it catered to all these “Wall Street Interests” and left the poor Main Streeter in his or her poverty.

The essence of the plan, getting back to the story here, is that the banks will have to take the “haircut”, the write down on the value of their assets. This is just another way of repudiating the debt, with the federal government standing behind the banks. Is it fair? Of course not!

A fund that made the wrong bet was Cerberus Capital Management. In a real sense, it hoped to do with Chrysler Corp. what Invesco, BlackRock, Pimco, and others, are hoping to do with the bank assets. It just got in too early when Chrysler was not in bad enough shape for the federal government to attach a “put” to the investment Cerberus made in the company. Too bad for Cerberus.

But, what about all the other debt out there? Mortgages on homes, debt on commercial real estate, consumer credit and credit cards, and small business loans? Why shouldn’t the people that accumulated all this debt get some relief as well? This is, of course, the big question and the big issue in terms of fairness. The basic answer to this is, as usual, size. The banks and the auto companies and others are big, their failures could case systemic problems for the system, and they have expensive lawyers and lobbyists working for them. Is it fair? Of course not!

The fundamental problem that is being faced around the world is a debt problem. There is just too much debt outstanding. And, actually, the amount of debt outstanding in the world is really not shrinking. Especially, as governments increase their debt to cover the debt that has been built up in the private sector. The debt problem is going to be with us for a while and will continue to get in the way, one way or another, of any kind of a robust recovery. How we get through it is going to set the stage for the type of world we have to deal with in the future.

Thursday, April 23, 2009

Bank of America dot Gov

It is becoming clearer and clearer what it means to have government involved in the affairs of banks and businesses. Where all the initial talk was about the “moral hazard” presented by government bailing out the private sector and how this just means that in the future banks, and other organizations, will just take on more and more risk because they know that if things go bad, the government will be there with a rescue net to save the institution.

Now, we are seeing the other side of the bailout business. In the AIG case executives and others were angry because the government interfered with bonuses and other executive decisions. And, we have the government putting lids on executive pay. And, we have government wanting to rewrite mortgages, and cap interest rates on credit card debt, and so on and so on.

This is the other side of the coin.

And, now we learn from testimony given by Ken Lewis, the CEO of Bank of America, that Hank Paulson and Ben Bernanke put a “sock” in his mouth and strongly advised him that he say nothing to the shareholders or anybody else about the implications of the merger between Bank of America and Merrill Lynch.

Furthermore, we hear from New York’s Attorney General Cuomo that Paulson threatened to fire Lewis and remove the entire Board of Directors it Bank of America did not go through with the merger with Merrill Lynch! The reward—money from the Government to help BOA through the process.

The shareholders? Well, they lost on the value of their stock. And, they also will have higher taxes or an inflation tax that they will have to pay in the future.

In addition, why should any company, financial or non-financial even think of an acquisition in the future because the government may force the management to swallow hard, take on something that is not necessarily desirable for the company, and, of course, not inform investors as to the implications of the merger transaction?

And, why should the stockholders of any company approve any acquisition that is at all questionable? The precedent has been set that they might be approving something that will cost them considerable wealth as the stock of their company tanks, and they are given no information to give them any confidence that the transaction might be a worthy one.

What if the shareholders balk? What if they fail to approve such a merger? Will the government step in and force through the merger anyway?

Talk about a mess!

Two thoughts come to mind that I must express.

First, the combination of Paulson and Bernanke was a disaster as far as I can see. I have written about how Bernanke seemed to panic last fall and the result was the TARP. (See my post “The Bailout Plan: Did Bernanke Panic”,

Paulson didn’t do much better in his handling of the crisis and the creation and oversight of the TARP. I always thought that Paulson found the whole bailout idea not to his taste and had hoped that he would be able to get out of Washington before the collapse. Unfortunately for him—and for us—he didn’t make it. As a consequence here was a man doing something that he despised, and his heart, and mind, was really not in the effort. He has left us a very unhappy legacy!

When I reflect on the events of the last fall I keep coming up with the feeling that we would be hard pressed to have found two people less capable of handling the situation than the two that were then in charge. And, then there was the “Decider”, but he was AWOL!

The second thing has to do with the fact that the bankers, and other business leaders, are getting pelted with all the blame for the financial collapse and crisis that we have experienced. Thus we have the “bad guys” in our sights. Thus, they should pay.

But, what if the conditions that existed were created by the government and these bankers and other business leaders were just responding to the incentives initiated by the government? We had a credit bubble connected with the stock market in the 1990s. The credit bubble resulted in negative real rates of interest and consumers stopped saving. The saving rate fell from 7.7% of disposable income in 1992 to about 2.0% by the end of the decade. Then there was the huge deficits that resulted from the 2001 tax cuts and the “war on terror”. This was accompanied by negative real interest rates gain which resulted in the credit bubble in the 2000s and the housing boom. The consumer savings rate remained around two or below, even becoming negative for a short period of time.

The foreign exchange market in the 2000s indicated a fear of a renewal of inflation as the value of the dollar fell by more than 40% against major currencies. What were financial managers to do in such an environment? Generally, because spreads narrow in such times and arbitrage opportunities are based on smaller differences, you tend to leverage up and mismatch maturities. This response is a normal one to gain the needed returns on equity to keep money from leaving your fund or institution.

Is this greed? Yes, but it is also just the natural response of competitive people to the incentives that are created, in this case, by the government. The Bush 43 administration may have been composed of “Free Market Capitalists” but this “gang that couldn’t shoot straight” did more to harm capitalism than most other administrations in the history of the United States.

So, government gets it both ways. It can create the crisis. And, then it can impose itself on the economy to right the system after the crisis occurs. And, best of all, the blame can all be put on “greedy” bankers and the lack of regulation.

I am sure that before this is over we will hear many more horror stories.

Monday, April 20, 2009

The Banking System and Bank Lending

The headlines in the Wall Street Journal shout out at us this morning, “Bank Lending Keeps Dropping” (See The bank lending they are referring to is the lending at “the nation’s biggest banks”, the banks that were the biggest recipients of government money. The results: the biggest recipients of taxpayer money “made or refinanced” 23% less in new loans in February than in October, the month the Treasury kicked off the Troubled Asset Relief Program (TARP).

This is just one more piece of information that the banking system still has major problems.

This is the case even though banks are posting first quarter profits. The latest, Bank of America posted a $4.25 billion net income figure for the quarter. (See But don’t get overjoyed: Apparently, excluding merger costs, Merrill Lynch contributed $3.7 billion to the posted number which included a $2.2 billion gain related to mark-to-market adjustments on certain Merrill Lynch structured notes. The results also included a $1.9 billion pretax gain on the sale of China Construction Bank shares. What does this mean? I don’t know. Who has any trust in the financial reporting of banks anymore!

What information do we have that indicates that the banks still have massive problems? Let me suggest several bits of information that add up to an exceedingly weak banking system.

First, let it be noted, again, that the Monetary Base, the aggregate money figure that is defined as all bank reserves and anything that can become bank reserves (currency in circulation) has doubled in the past year (97.5% increase year-over-year using non-seasonally adjusted data). This measure was increasing at a 2.0% annual rate in August 2008.

The in-bank component of the Monetary Base, Total Reserves in the banking system, in March, was increasing at a 1,722% annual rate (again, year-over-year using non-seasonally adjusted data). We have never seen figures like this before!
In August 2008, the annual rate of increase was -1.0. Yes that is a negative one percent year-over-year rate of increase.

And, what are the banks doing with these funds?

They are holding onto them!

Excess reserves in the banking system (non-seasonally adjusted) were right at $2.0 billion in August 2008. These are funds in the banking system that are just sitting idle on the balance sheets of banks in the banking system—not earning interest or anything. In the banking week ending April 8, 2009, excess reserves totaled $724.6 billion.

Let me put this in perspective. On September 4, 2008, the assets of the Federal Reserve System totaled about $945 billion. So, in the first week of April 2009, the banking system was keeping, in cash, a little less than the total amount of funds that the Federal Reserve had put into the banking system in the first week of September 2008!

If I look at the Federal Reserve Release H.8, I see that commercial banks in the United States, non-seasonally adjusted, had Cash Assets on their balance sheets in March of $915 billion, again quite close to Federal Reserve assets in early September. One year earlier these banks had Cash Assets of only $300 billion, so Cash Assets rose by 205% in the past year.

Now, the total banking system, in aggregate, is lending some. Total bank credit outstanding rose at an annual rate of 3.2% from March 2008 to March 2009. Within this category, Commercial and Industrial loans rose by 4.3% and real estate loans rose by 4.7%. Consumer credit rose by about 9.0%, of which credit card debt rose by 13.0%. So lending in these categories were increasing, but not by major amounts.

The interesting thing to note, security lending—Federal Funds lending and Repurchase Agreements with brokers—dropped by a third, -33.0% and Interbank loans remained basically flat. Banks reduced their lending to other financial institutions, including other banks, during this time period. Talk about risk averse.

The major story that these data tell is that commercial banks are afraid to lend, especially to their own kind. Delinquencies continue to rise, write-offs continue to rise, and banks continue to increase the provision they set aside for future charge-offs. The banks have gone back to lending only to those that don’t need to borrow, the way banking used to be. They are afraid to lend to anyone else and they are still uncertain about the value of the assets that they already have on their books.

This situation is not going to change overnight. There is not much that the Federal Reserve can do if banks won’t even lend to banks!

We see that “U. S. May Convert Banks’ Bailouts to Equity Share.” (See the New York Times article, Still the question remains, “How deep is the hole in bank balance sheets?” We cannot provide the answer to this. Ultimately, the bankers, themselves, will have to provide that answer, and my guess is that bank lending will not start to pick up again until these bankers have that answer.

Thursday, April 16, 2009

Be Careful What Bandwagon You Jump Onto

The Financial Times printed excerpts of an interview with Duncan Niederauer, the Chief Executive of NYSE Euronext. (See “NYSE chief cautious over March rally”, In the interview he stated that the recent rally in the stock market was being driven by short-term traders trying to take advantage of the high volatility that currently existed in the financial markets. He continued that the high trading volumes achieved where concentrated in a “handful of stocks.”

The high volatility in the financial markets has resulted from the high degree of uncertainty that plagues the market with regards to what is going to happen to the economy, the financial system and whether or not the programs initiated by the Obama administration will work. The stocks that have been moving the most have been those that have gotten a lot of publicity over the last six months or so and in which there is a lot of uncertainty connected with the unknown future of the companies they are associated with.

Niederauer goes on to say “large institutions and other long-term investors” have basically sat on the sidelines during this little run-up. The short-term traders do not need to take an extended view of prospects and therefore attempt to make money on the ups and downs of the market. Thus, it is hard to use the recent uptick in the stock market as a longer-term indicator of the economy with a lot of confidence at this point. He adds that when the large institutions and other long-term investors come back into the market the trading volumes will become larger and will be more consistently there.

And, why should the longer-term investors come back into the market at the present time. A piece of evidence against jumping in right now is the bankruptcy of mall owner General Growth Properties, Inc., which is recorded as one of the largest real-estate failures in the history of the United States. The cloud over the commercial real estate sector of the economy has been approaching for some time now and this news seems to be just the first of many that will follow.

Also, Capital One Financial, one of the largest issuers of credit cards in the United States, just announced writedowns that have exceeded the unemployment rate, an interesting relationship if you ask me. It seems like this is an indicator of how bad things are when credit card charge offs exceed the unemployment rate but I don’t see any necessary correlation between the two. Anyhow, the expectation is for credit charge write offs to continue to rise as home foreclosures and personal bankruptcies continue to rise indicating more pain in the future. Personal bankruptcies have risen almost to the pre-2005 level, the time when the bankruptcy laws changed.

In addition, although people keep contending that the housing market is getting firmer, housing starts continue to show a substantial weakness. Housing construction in March fell to an annual rate of 510,000 units, the second lowest level on record. This total was almost 50% below the level of starts attained in the same month last year.

Building permits also fell 9 percent from February to an annual rate of 513,000, which is down from 932,000 last year. This number provides some indication of the amount of future construction that will take place.

And, the amount of foreclosures on personal property continues to rise. It has been reported that foreclosure filings increased 9 percent in the first quarter of the year with filings rising 17 percent from February to March. The area of personal finance continues to be unsettled. And, this is not even considering the rising level of small business foreclosures that seem to be rising monthly.

There is little good news to encourage the large or longer-term investor coming from other areas in the financial sector. We still have to see the results of the “stress test” on the banking system. It seems that Secretary of the Treasury Tim Geithner has messed up another public relations opportunity, this time over the announcement of the results of the stress test or the fact that there will be no announcement of the results or that there will be a limited release of information. For an administration that supposedly was going to see to it that the government operated with more transparency and openness, the Treasury Department and its leader have certainly not contributed to the confidence that it is on top of the situation.

Then there is the concern that the banks have not reported accurately the value of their assets in order to obtain TARP funds. (See my post There is seemingly no reason why we, or anybody, should take seriously the financial reports coming out of the banking system, including the quarterly reports being released this week by major financial institutions!

We further read that “Fitch Ratings is warning investors in complex loan investment funds about the practice by their managers of accounting for loans at par, regardless of market value of the loan.” (See “Fitch alert on accounting for CLOs”, Fitch is concerned that managers are attempting to get around rules on how they account for collateralized loan obligations (CLOs) by encouraging investors to consent on having certain restrictions removed so that they can mark assets up to par. In early March, Moody’s warned the market that there would be a review of ratings in response to changes in its rating assumption, including an increase in expectations of the default rate among leveraged loans. In February, Standard & Poor’s warned investors that the debt issued by CLOs could be at greater risk of losses than they realize if only a few companies default.

And, there is more!

The problem is that there is too much debt around. Debt loads have to be worked off and in some way reduced. Of course, one way to reduce debt loads is to inflate away the real value of the debt which is what Bernanke and the Obama administration are trying to do. Otherwise, debt has to either be paid down or written down as Capital One is doing.

A helpful suggestion for government action is to provide money to write down the principal of mortgage loans rather than help troubled mortgagees to get interest rates on the loans reduced. This would have a more stunning effect on home owner performance than would trying to put people to work or to reduce interest rates or to inflate away the debt. It would also probably be cheaper. Pouring money into the banks has not worked! Why not try something else to reduce the debt problem?

Whatever is done, time is going to have to pass. Large investors and longer-term investors will not come back into the stock market until they see that the debt issue is passing and that people, consumers, have their balance sheets more in control. Until then, the stock market will just be a traders’ market. So don’t trust market swings one way or another. Focus on what the real problem is.

Monday, April 13, 2009

Are Banks Telling the Truth?

On the front page of the Financial Times this morning we read the disconcerting headlines, “’Tarp cop’ to investigate whether banks have ‘cooked their books.’” (See Neil Barofsky, special investigator-general for the Troubled Asset Relief Program (TARP), is “seeking evidence of wrongdoing on the part of banks receiving help from the fund.”

The game—“institutions applying for TARP money had to show they were fundamentally sound, potentially prompting them to misstate assets and liabilities.” Barofsky is quoted as saying, “I hope we don’t find a single bank that’s cooked its books to try to get money but I don’t think that’s going to be the case.”

Mr. Barofsky also said the Treasury’s expanded Term Asset-Backed Securities Loan Facility (TALF) was ripe for fraud.

The potential—fraudsters would be receiving indictments!

Two thoughts cross my mind when reading this. First, bankers in deteriorating situations tend to hide their heads in the sand when it comes to bad assets because they keep hoping that things will get better and the assets will recover their value. Having (successfully) completed several bank turnarounds I have found that this is one of the first things that becomes obvious when you initially investigate the loans and other assets of a troubled institution. Bankers, lenders, or portfolio managers continually think that ‘the economy will turn around’ or that ‘the company is getting its act in order’ or that some other event will come along that will result in the ‘asset gone bad’ becoming the ‘asset has become good again.’ And, so the asset is carried along but never comes back to life.

The problem with this is that these bad assets continually undermine the ability of the financial institution to right itself and become profitable again. The example is always there on the books of the banks and whether the executives or officers admit the fact, internally they know that things are not right and this drains efforts to instill a healthy culture to “do the right thing.” Managements that allow this unhealthy culture to continue are just perpetrating a bad situation, one that very rarely ever turns itself around.

The managements that participate in such a charade tend to be desperate and susceptible to moving to the next step when they are thrown a life boat like many financial institutions received in the past nine months or so.

Before following up on this point, let me just say that, historically, the bank either brings in someone to turn the institution around, or, a regulatory agency steps in and dissolves the organization. The American banking system has worked very well in the past with respect to “sick” banks. Contagion has been avoided through quick action connected with the swift resolution of problem assets. Financial institutions that were in trouble were taken care of—period!

But, that is not the case in the current situation. We have had a bailout. The banks have been tossed a life boat. However, financial institutions were supposed to be “fundamentally sound” in order to obtain TARP money. Here we get into the muddy waters of conducting a “general” bailout.

Let me just say that I have been suspicious from the start when government officials claimed that the need for the TARP funds was because the banks were facing “a liquidity problem” with respect to their troubled assets.
Again, my experience in doing bank turnaround’s is that the officers of the bank that claimed their assets were in trouble because of liquidity problems were attempting to cover up the real difficulties connected with the assets which were almost always associated with the issue of solvency.

It would not be much of a surprise to me to hear that the banks justified to the government that they were “fundamentally sound” because their asset problems were associated with liquidity issues rather than ones of solvency. This assessment could perhaps be supported if government officials only took a cursory glance at the assets. But, one could argue that this is the conclusion that government officials wanted to hear at that time.

Is this fraud? That is what Mr. Barofsky is going to have to find out.

Other than outright “cooking of the books”, in many cases the distinction between liquidity and solvency may fall back on an argument about “judgment”, about the “eye of the beholder.” Thus, Mr. Barofsky is going to have his problems proving his case.

In my opinion, many of the banks that received bailout relief had and still have a solvency problem and until the situation is handled that way the dislocations associated with the banking industry and the financial markets are going to continue. Consequently, I believe that Mr. Barofsky and others are going to find evidence that all along the issue has been solvency and not liquidity. If so, then there is a real issue of whether or not that these institutions that received TARP money were “fundamentally sound.”

My second thought on this issue is a very simple one. If people inside the banks covered up the real issues related to solvency heads should roll. Those that committed fraud should be indicted! Those that knowingly misled should be dismissed!

And, top executives, even though they were not directly involved in fraud or in a cover up, should be removed from their positions as well. They have proven that they cannot manage their institutions with sufficient control to justify their ability to move those institutions on into the future. The “buck stops with the top position” and the argument that they didn’t know what was going on is insufficient. It was their responsibility to know what was going on!

Risk management, the other “bug-in-the-coffee”, and financial control are not glamorous pursuits, especially when compared with the “jet pilots” of finance that were tossing around all sorts of money chasing narrow spreads with lots and lots of leverage. Performance over time, however, is closely related to an institution’s ability to successfully exert risk management and financial control.

We have to know what is going on in the banks and other financial institutions. The pressure needs to be stepped up to find out where things are. And, the sooner this pressure is exerted the sooner we will be able to find ways out of the mess we are in.

And this brings me to one final point. The Financial Times also had another headline on its front page that I found disturbing. The article cried out “AIG in derivatives spotlight.” (See “The unit that all but destroyed AIG has failed to sign up for the overhaul of the global derivatives market, which was given added impetus by the troubles at the US insurance group.” The government is involved with AIG—the government owns most of AIG. It is mind boggling to me that a government that supposedly wants to bring greater openness and transparency to the financial markets allowed this to happen!

Thursday, April 9, 2009

The State of the Recession--a long way to go

Going into this holiday weekend, we need to take a little time to reflect on the state of the economy and the financial markets. I certainly don’t want what I write below to sound like a “rosy scenario” but I would like to try and put some perspective on where I think we are and what is ahead of us.

First, as I have written many times, the liquidity problem is behind us. Liquidity problems are of short term nature and require immediate action. The difficulties we now face are related to solvency and the ability to work things through. This takes time and it takes persistence, things that Americans are often impatient with.

My argument here is that many of the problems we face are known. In the words of the world famous philosopher Donald Rumsfeld, in dealing with a “solvency problem” we are dealing with “known unknowns.” (To clarify my argument, I would argue that a “liquidity crisis” is related to “unknown unknowns.”) Banks and other financial institutions, along with non-financial organizations, unless they are just blinding themselves to the truth of the situation, know what they need to watch out for. That is one reason why banks are not lending much these days. (See my post “The Clogged Banking System”

The “solvency problems” has to do with assets whose value is less than that recorded on the balance sheet of an organization. This “solvency problem” has been exacerbated by the large amounts of debt financial institutions and others have used to acquire these assets thereby leaving the problem of whether or not the equity base of the company exceeds the “hole” that exists between the “real” value of the assets and the value recorded on the financial statements.

The “unknown” here is exactly how much the organizations will eventually get from the “known” questionable assets. The answer to this hinges upon the issue of whether or not the value of the asset will improve if these organizations work with the asset, especially if the asset is a loan that the borrower has some chance of repaying in large part. The alternative, of course is that the value of the asset will never increase and needs to be “charged off” right now.

There is no question that banks and other financial institutions tend to be overly optimistic about their ability to “work things out”, but this is a time when they need to be as realistic as possible about the condition their assets are in. This is a turnaround environment and having led three (successful) bank turnarounds I know how important it is to be realistic about asset values at a time like this. Good leaders, good executives, are ones that face the problem head on and do not try and postpone the inevitable.

But, there is a second issue here. The government help that has been provided to the private sector has not always been helpful. If fact, some of the actions of our leaders have created an environment of greater uncertainty, something that an uncertain economy and financial system does not really need. For example, those of you that have read my posts over time know that I am very skeptical of the actions taken last fall by the Chairman of the Federal Reserve System. (See my post on “The Bailout Plan: Did Bernanke Panic?”

The follow up to this was the execution of the bailout plan, fondly labeled TARP. It was obvious that our leaders were making up the plan as they administered it which led to several changes in direction that totally confused participants and the market. Plus there was never any oversight administered to the program so the money went out and no one knew where it went.

Now we have a “recovery package” that has been approved by Congress. Again, there is great uncertainty about what the “package” is and what will it do. (See my posts and

Then, following this package we had the “summary” of a bank toxic asset program presented by Secretary Geithner that bombed and then the presentation of the P-PIP (See my post which Nobel prize-winning economist Joe Stiglitz and others have torn into as providing a fantastic “real option” that provides tremendous upside for private investors and horrendous potential downsides for tax payers. Furthermore, in response to criticisms that this opportunity was just for “big” players, the Treasury responded that, well, smaller organizations would be let into the game—and, well, we may let the individual investor get into the scheme just like the patriotic program that allowed individuals to buy Treasury bonds during World War II.

The third issue centers on the amount of debt outstanding in the world. We write about the plight of the United States consumer and all the debt that he/she accumulated during the credit bubble of the early 2000s. This is a problem and will take a long time to work itself out with layoffs and unemployment increasing and bankruptcies, both individual and small business, on the upswing, along with rising delinquencies on credit cards and other consumer loans and with the overhang of large amounts of residential mortgages repricing over the next 15 months or so. This will be a drag on the United States economy for a while.

Real investment in the economy will not begin to rise until consumers get their balance sheets in order and feel confident enough to spend once again. However, many analysts are arguing that the economy is in for a structural shift, returning the United States consumer to a more fiscally conservative balance sheet with more of their disposable incomes going toward saving. This will require businesses to be smaller and more conservative in their operations. Both will retard recovery.

In addition, there is the problem of debt in the world. There are huge amounts of debt outstanding in the world that are going to have to be dealt with over then next three years of so. (An example of this looming problem is discussed in the Financial Times this morning, “Eastern Eggshells,” This just points to the fact that this recession is world wide in nature and the fate of the United States is going to be tied up with what goes on in Eastern Europe, in Japan, in China, in Russia, in Western Europe, and so on and so on.

This is why a growing number of people, like Niall Ferguson, author of “The Ascent of Money” is concerned that the United States—and others—are trying to resolve the problems created by too much debt and financial leverage by increasing the amount of debt and financial leverage that is in the world. These people are contending that we are all in this together and we must fight extreme national self-interest and protectionism.

The state of the nation is precarious—there is no doubt about that. However, I believe that we have progressed to the point that we are dealing with “known unknowns” rather than “unknown unknowns”. There is still much uncertainty in the economy, in the world, and people are attempting to work through the problems they face. But, because there are many people feeling a lot of pain right now and there will be more joining their ranks in the near future, there is a great deal of pressure to do a lot of “something” about it. And, in the minds of many, the effort must err on the side of doing too much rather than in doing too little. The potential downside to all these efforts is that much of what will be done may actually create more difficulties than they solve. Impatience is not always a virtue.

Sunday, April 5, 2009

The Clogged Banking System

The Federal Reserve is doing almost everything it can to get commercial banks to start lending again. Just a quick look at the data reveals what is happening in the banking system where the rubber hits the road. Let’s take a look.

Looking at the figure Total Reserves which is defined as bank reserve balances held at Federal Reserve Banks and vault cash at banks used to satisfy reserve requirements. The year-over-year rate of increase in this figure for February 2009 was 1,538 %. Yes, that’s right, one thousand, five hundred and thirty-eight percent, rounded off! But, this rate of growth is down from the December 2008 year-over-year figure which was 1,823%. Yes, one thousand, eight hundred and twenty-three percent!

In August 2008, before the financial tsunami hit, the year-over-year rate of increase in Total Reserves was – 1%. Yes, that is a negative one percent! And the rate of increase throughout 2008 up to August was modest, at best.

Let’s move up to a larger measure, the Monetary Base, defined primarily as Total Reserves and Clearing Balances at Banks plus the currency component of the Money Stock measures. In February 2009, the year-over-year rate of increase in the Monetary Base was 88%, rounded off. That is, the Monetary Base increased by a little less than two times over the twelve month period ending February 2009. In December 2008, the year-over-year rate of increase was 99%, rounded off.

Going back to August 2008, the year-over-year increase in the Monetary Base was about 2%. Again, the rate of increase in this measure throughout 2008 up to this time was around this magnitude, give or take a percentage point or two.

How did this increase in reserve measures get translated into the Money Stock figures? Well, in the case of the narrow measure of the Money Stock, M1, the year-over-year rate of increase for February 2009 was 13.5%, down from 17.2% in December. In August 2008, the year-over-year growth in the M1 Money Stock was a little less that 2%. The rate of growth of this measure for the earlier part of 2008 was slightly negative to slightly positive.

In terms of the components of the M1 Money Stock, what contributed to this increase in growth? First of all, the Demand Deposit component rose by about 35% on a year-over-year basis in February, but this was down from a little over 59% in December. The interesting thing is that the year-over-year rate of growth of the currency component of the M1 Money Stock was relatively constant through the end of 2008 into February of 2009. For example, the currency component grew at around a 7% rate of growth in December 2008 but grew at a 10% rate in February.

The conclusion one can draw from this is that people and businesses are holding more of their wealth in currency and in demand deposits! That is, the funds that the Federal Reserve is pumping into the banking system are staying in the banking system or going into cash or very liquid transactions balance in the banking system.

One could argue that the public is not spending these cash and transactions balance accounts any more than they have to and are keeping them on hand to meet their uncertain needs for living and conducting business. That is, these holdings are for security in treacherous times.

Just one additional note on Demand Deposit growth and Currency growth: in August 2008, the year-over-year rate of growth in Demand Deposits was essentially zero and the year-over-year rate of growth of currency was slightly over 2%. That is, in August 2008 almost all the growth in the M1 Money Stock measure was coming from the growth in the currency component.

Now, what about the rate of increase in the M2 Money Stock measure? In February 2009 the growth over February 2008 was just less than 10%. This growth rate was exactly the same as the growth in this measure in December 2008. In August, the year-over-year growth rate in the M2 Money Stock was approximately 6%.

The conclusion that one can draw from this is that individuals, families, and businesses are keeping funds in very safe and easily accessible form. Growth in deposit measures or credit measures beyond cash and demand deposits is almost non-existent. People and businesses are attempting to protect themselves, they are not borrowing more than necessary, and they are not spending more than necessary. One guesses that this is not going to change much in the near future.

From the non-bank side of the equation, why should people and businesses be borrowing if they can avoid it? Unemployment jumped to 8.5% in March, and this weekend economists were talking that this number would reach at least 10% before this economic downturn is over.

Furthermore, bankruptcies were up, almost 4% in March and up almost 40% over a year earlier. This measure, too, is expected to rise throughout 2009 and into 2010. And then, housing prices continue to fall. One measure used to judge where housing prices are relative to (estimated) rental payments was reported by John Authers in the Financial Times on last Thursday. He wrote that the ratio of housing prices to rents which had risen by 44% from 2002 to its peak through the credit bubble has returned to about its 2002 level. However, Authers argues that even though it returned to the 2002 level this ratio could still fall another 20% to reach levels of a decade or so earlier.

And, why should the banks lend? For one, they still have a ton of questionable assets on their balance sheets. And, if these banks are worried about their solvency, they need to work these assets out and not add more and more new assets to their balance sheet. Their focus needs to be on regaining financial health now, not expanding their balance sheet and reducing capital ratios further.

And, we still have the commercial real estate problems to go through, as well as the problem implied in the credit card area due to the rising delinquencies in that sector. Furthermore, there are two kinds of mortgage loans that are going to reprice over the next 15 months or so. Analysts are afraid of what this might do to foreclosures and bankruptcies given the rise in unemployment and the decline in household incomes. Also, there are the surfacing problems connected with state and local government finance. This has not really gathered much attention to date.

The Federal Reserve has been pushing about as hard as it can. Yet, the monetary stimulus is not working its way through the banking system. This is obviously a problem. But, banks in the condition described above don’t really want to lend, and consumers and businesses are in the process of consolidating and strengthening their balance sheets and have little incentive to re-leverage themselves at this point.

The Keynesian solution to this dilemma is, of course, government spending, the more the better. The intent of this spending is to get the banking system unclogged. Whether or not this government spending can actually accomplish this is still to be determined? So, we still are faced with enormous amounts of uncertainty. And, this uncertainty, in my mind, is not going to go away soon.

Thursday, April 2, 2009

FASB and the Mark-to-Market Rules

The Financial Accounting Standards Board (FASB) should have released their easier guidelines on ‘mark-to-market’ accounting on April Fool’s day because that date would have been much more appropriate for what they have done.

Once again the accounting profession has shown that accounting is an “art” rather than a professional practice and art, as we well know, like pornography, is in the eye of the beholder.

FASB has “revised the rules to allow companies to use their judgment to a greater extent in determining the ‘fair value’ of their assets. In other words, there are no rules!

Arguing for the change is, of course, the banks. The banks “have contended that during the current financial crisis, when many markets are frozen or not functioning smoothly, the rules have unfairly pushed those valuations lower and forced them to take big losses on the basis of market fluctuations that are temporary.”

There are three points I would like to emphasize here. First, an appropriate accounting for the financial condition of a firm is a prerequisite for understanding the state that the company is in. Without this knowledge, the customers of the banks, lenders as well as depositors, are at a loss about the financial condition of the bank, investors are at a loss about the condition of the bank, and regulators are at a loss about the condition of the bank.

Second, if the revised rules “allow companies to use their judgment” then there are no unbiased standards or relatively objective criteria by which to judge the condition of the bank. What good are financial statements if people can put whatever they want on their balance sheet?

Third, the explanation for the change includes the assumption that the problems being faced by the affected financial institutions are ones of liquidity and not ones of solvency. We are told that “when markets are frozen or not functioning smoothly” it will be hard to price the assets. We are being told that this is what the banks face today, the problem that for some bank assets, the markets in which they trade are illiquid.

What if the problem is, as some of us believe, that a few (or more) of these banks are insolvent and it is not just a problem of the liquidity, or illiquidity, of their assets?

The administration and the congress keep giving us solutions to the financial chaos around us that are intended to relieve the problem of liquidity. They seem to keep their head in the sand when it is suggested that maybe the problem is one of solvency.

And, what is the real underlying situation here? Banks and other financial institutions, in an effort to squeeze out a few extra basis points in terms of their return on equity, not only added assets to their balance sheets that exhibited a greater amount of credit risk, they also increased their leverage ratios to extraordinary lengths, and, in addition, added further interest rate risk to their balance sheets by increasing the mis-match of the maturities of their assets and liabilities.

They knew what they were doing! And, they knew what the consequences would be if things went against them!

Now, these same people are crying false tears because events did not go their way and they got caught!

Congress and others got mad at the executives of AIG for attempting to live up to the contracts that were given to employees in terms of the bonuses they were to receive. In the current situation, Congress and others are up-in-arms because they want to change the rules under which the banks and other financial institutions were to be held accountable for.

And Rick Wagoner can be forced out of GM, but the same bank leaders that got the banks where they are remain in their executive lofts.

Go figur’.

The financial performance of the banks will now improve. There are a dozen or so articles in the financial press contending that the new P-PIP will suffer because of the change in the accounting rules. Just what we need—another government program, like TARP, in which the nature of the program changes once the program has been presented to the public.

In truth, the condition of banks and other financial institutions has not changed! Those that are insolvent are still insolvent. Those that are not insolvent are still not insolvent. But, the public, the lenders, the depositors, the investment community, and the regulators are worse off.

The change in the accounting rules is another bailout for the bankers!

Happy April Fool’s day!