Wednesday, August 26, 2009

The Bernanke Re-Appointment

At first I was not going to comment on the re-appointment of Ben Bernanke to the position of Chairman of the Board of Governors of the Federal Reserve System. I thought I had had my say. See my post “Exit Strategy: An Argument Against Bernanke's Reappointment” of July 27, 2009. Guess this was not to be. Since this post was re-posted on several sites yesterday and people have asked me to comment on the news, I decided to provide a current comment on the situation.

There are seemingly two reasons given for the re-appointment of Ben Bernanke to another term as the Chairman of the Board of Governors. The first is that he was calm throughout the crisis. The second is that his appointment, since he is a “known”, will calm the financial markets.

Calm is “good”! I have just been writing about it: see Banking Sector Stays Quiet on August 10 and The Deleveraging Continues: What This Means on August 24. It is good that the financial markets are calm and everyone is on vacation this last week in August: a great time to make a very important appointment.

But, is “calm” what we need. The financial markets do get over changes in leadership. For example, we change Presidents and the markets get over the change! In fact, changing leadership in a time of calm is the best time to change leadership!

And, what does it mean that Bernanke was “calm” during the financial crisis. Why do I keep remembering management team after management team taking their banks public during the Savings and Loan crisis that kept telling us: “Yes, we got the bank into this mess but we learned our lesson. Now, all you have to do is give us another $100 million in new capital and we will change our ways!” And, that was the last the investors saw of their $100 million. But, these managements were calm as their institutions crumbled.

Bernanke was one of the leaders that got us into this mess. He got us through the crisis? I have over my desk the cartoon from the Financial Times showing Bernanke in front of the Federal Reserve building with two revolvers in his hands shooting off lots and lots of currency. The title of the cartoon: “A Fistful of Dollars”. He is not known as “Helicopter Ben” for nothing.

His policy for the crisis: throw as much money into the market as possible. It is way better to have too much money out there than to not have enough. A good, coherent, concise policy!

And, he did this very calmly!

Or did he? See my post of November 16, 2008: The Bailout Plan: Did Bernanke Panic?

My final concern over this re-appointment is my disappointment with President Obama. I had hopes that he would bring a whole new quality of leadership to Washington, D. C. He has been President for over six months now and I must say that hope has not been fulfilled.

Monday, August 24, 2009

The Deleveraging Continues

There are three major factors that will contribute to the timing and the strength of the economic recovery. First, there is the ability and speed at which individuals and businesses are able to get their balance sheets in order by reducing the amount of debt they have on them. Second, there are supply side questions about the restructuring of the economy. This has to do with the large number of people that have left the labor force and may not return in the near term and the secular decline in the capacity utilization of industry. (See my post of June 22, 2009, “Structural Shift in the U. S. Economy is Really in Supply”: Third, there is the tremendous amount of debt the federal government is issuing and the fear that this re-leveraging will create a credit inflation that may go right into prices rather than output and employment.

In this post, I am primarily focusing on the first of these factors. I will discuss the progress of the second two issues in future posts. There is more immediate information on the first and it is vitally important that this deleveraging takes place in an orderly fashion or the near term concern over the latter two will be misplaced.

Perhaps the two most highly publicized methods of deleveraging continue to speed along at a rapid pace. The American Bankruptcy Institute has reported that the total number of bankruptcies in the United States filed during the first six months of 2009 increased by 36 percent over the same period of time in 2008. The only time bankruptcies have been so large is right before the bankruptcy law change earlier in this decade. Business filings during the first six months were up 64 percent over the first six months in 2008 and individual or household filings were up 35 percent.

Bank closings reached 81 for the year with four new banks added to the list on Friday, one of them being the 10th largest bank failure in United States history. Talk now is that there will be 300 or more bank closures in the near future. The FDIC is scrambling to find ways to increase its financial resources to handle the upcoming deluge of failures and is also easing restrictions on those that can bring private equity into the mix to carry some of the financial burden in taking over these failed institutions.

Getting less publicity is the effort that individuals and businesses are making to bring their own financial situation under control. Cutting expenses is, of course, one of the immediate ways that people can work toward their own best interest. Another way of saying this is that people and businesses are increasing their savings. Every week, more and more articles are appearing informing people how this saving might be accomplished and presenting stories of how households and companies are successfully meeting this challenge.

Furthermore, there are a growing number of stories of people and businesses getting in touch with those they owe money to and working with the lenders to set up terms and conditions that will increase the probability that debt will be repaid in a timely manner. My experience in banking supports the contention that financial institutions and other lenders really would prefer to work something out with those they have lent money to, but depend on those borrowers that perceive that they are going to face some difficulties in the future to get with them and initiate discussions about how things might be worked out. Postponing discussions only puts more pressure on both parties and tends to make things harder to resolve.

Refinancing is another problem looming on the horizon. There seems to be dark clouds hovering over the commercial real estate industry and less credit worthy corporate debt issuers. A lot of debt is going to come due over the next 18 months or so. The big concern is whether or not this debt will be able to be re-financed since very little of it will be able to be re-paid. The bits and pieces of news coming out of this area is that discussions are being held and although there may be failures coming out of these situations that the problems are recognized and will be absorbed in a relatively smooth fashion as time passes.

The areas of the bond market that contain firms with higher credit ratings are performing remarkably well. Volumes of new issues are up and the financial markets have absorbed these rather smoothly. If anything, corporations have turned to the bond market for funding since the commercial banking system is actually shrinking its base of commercial and industrial loans. This is an interesting thing happening to substitute bond credit for the credit extended by the banking sector at this point, but, as they say, whatever works.

Another method for de-leveraging that seems to be picking up steam is that corporations are buying back their own debt off the open market. In some cases it is reported that these companies can buy back their existing debt at 50 cents on the dollar which is a pretty good exchange for the company going forward. Look to see this pick up this fall.

Finally, the Federal Reserve does not look like it is going to pull the rug out from the banking system and the financial markets going forward. Yes, there is a lot of concern about all the reserves the Fed has put into the banking system and whether or not it is going to be able to “exit” the banking system in an orderly fashion. However, the Fed does not want a replay of the 1937-38 experience when it caused a collapse in the banking system by trying to withdraw excess reserves from the banks by raising reserve requirements. (See my post of August 21, “Federal Reserve: Exit Watch”: The best guess here is that the Fed will continue to keep the banking system very liquid in order to help underwrite the de-leveraging now underway.

The important thing to remember at this time is that “quiet is good”! The de-leveraging is taking place. However, the de-leveraging will take time. We just can’t become too impatient for we must let the system do its work and restructure its balance sheets. We just don’t want any more shocks! There still is a long way to go toward a full economic recovery and the other two issues I mentioned in the first paragraph are of great concern. But, we move forward by just putting one foot in front of the other.

Friday, August 21, 2009

The Federal Reserve Exit Watch--Number One

There is great concern about the “Exit Strategy” the Federal Reserve might follow to reduce its balance sheet back to the levels that existed before the “Big Explosion” in the Fall of 2008. I plan to keep an eye on the Fed’s balance sheet over the next 12 months or so to try and keep abreast of what the Fed is doing to return to a more normal operating procedure. I discussed the prospects for a reduction in the Fed’s balance sheet in three posts on June 25, June 29, and July 2. This is just a checkup to see how things have progressed.

Over the past 13 weeks (a calendar quarter) from May 20, 2009 to August 19, 2009, the Federal Reserve allowed the total factors supplying reserve funds to decline by $128 billion. This helped to account for the major part in the decline of Reserve Balances with Federal Reserve Banks which fell by $146 billion. These are the deposits commercial banks maintain at the central bank. Other factors absorbing reserves accounted for the small difference ($18 billion) between these two figures.

The crucial contributors to this decline were all new programs that the Federal Reserve had instituted going back to December 2007 when the first innovations were introduced to relieve the liquidity crisis that was occurring in both the United States and in financial institutions all over the world. For example the amount of funds outstanding connected with the Term Auction Facility (TAF) declined by $208 billion in the May 20 to August 19 quarter. This account reached a peak amount of $493 billion in early March 2009. Currently it stands at $221 billion. This innovation was put into place to get reserves to the banks that needed them as quickly as possible. It looks as if this facility is winding down as the financial markets seem to be operating in a more normal fashion.

Another innovative response to the crisis was the Central Bank liquidity swaps in which the Federal Reserve was able to get dollars out to the rest of the world so as to avoid the problems of resolving pressures that were being felt around the world in converting financial assets into dollars. Over the past 13 weeks, the accounts related to foreign central banks and currency holdings dropped by $166 billion, another massive movement. These accounts had gotten up to around $390 billion in February of this year and on Wednesday August 19 totaled around $70 billion: another facility that seems to be winding down.

Another line item that seems to be going out of business is the Commercial Paper Funding Facility. This account dropped by $103 billion in the last quarter. This facility supported the commercial paper market and its dealers.

So, these three line items, created under the pressure of the financial crisis beginning in December 2007, have accounted for a reduction of about $477 billion of assets on the Federal Reserve’s balance sheet in the last 13 weeks. And, the declines were still continuing in the past 4 weeks so the runoff has not stopped. The figures here show that the TAF declined about $17 billion in the last 4 weeks while the Commercial Paper Funding Facility dropped $56 billion and the Central Bank facility dropped about $29 billion during the same period.

What has changed because the Total Factors Supplying Reserves only fell by $128 billion?

Well, the Federal Reserve is conducting open market operations again, seemingly to keep longer term interest rates from rising and to provide liquidity support to the mortgage backed securities markets. Securities held outright by the Federal Reserve rose $366 billion in the 13 weeks ending August 19! The biggest increase came in the Fed’s holdings of Mortgage Backed Securities, an increase that totaled $178 billion. The Fed also added $153 billion to its holdings of U. S. Treasury securities and $35 billion to its holdings of Federal Agency securities.

Over the last four weeks the Fed increased its holdings of Mortgage Backed securities by $64 billion, its holdings of U. S. Treasury’s by $43 billion and its holdings of Federal Agency securities by $9 billion.

The bottom line is that the Federal Reserve is allowing the special facilities created during the height of the financial crisis to run off but is substituting purchases of open market securities to keep bank reserves at high levels. Reserve balances with Federal Reserve Banks stood at $805 billion on Wednesday August 19, the vast majority of the reserves being just “Excess Reserves” in the banking system.

The philosophy behind this? The Federal Reserve is “exiting” the special facilities it has created to get the financial system through the crisis. However, it cannot “exit” the banking system by allowing those reserves to leave the banks.

An error was made in 1937. Commercial banks were maintaining large amounts of excess reserves at that time. As at the present time, banks were attempting to get their balance sheets in order, were not lending, and were trying to work off bad loans. The Federal Reserve, seeing all of the excess reserves, RAISED reserve requirements. This resulted in another collapse of the banking system, a collapse in the money stock, and a second period of economic disaster for the U. S. economy to follow the 1929-1933 depression.

The Federal Reserve does not want to create another crisis as it did in the 1937-1938 period. My guess is that the Fed will continue to support the large quantity of excess reserves that exists within the banking system until the commercial banks to start lending again.

Thus, it appears that the concern about an “exit” strategy is not going to be about the shrinking of all the innovative lending facilities that the Fed created to combat the liquidity crisis of the recent financial collapse. It appears as if the Fed is going to substitute open market operations to replace the decline in reserves resulting from the working off of these facilities in order to maintain the high level of excess reserves that currently exist in the banking system. Therefore, the concern about “exit” strategy is going to be connected with the removal of bank reserves from the banking system when the commercial banks begin lending again.

It is going to be interesting to see how the Fed will reduce its securities portfolio by $700 to $800 billion at that time!

Thursday, August 20, 2009

Bank Asset Values are a Lingering Problem

Is the recession over? Has the economic recovery begun? Will there be a double-dip recession?
The picture is fuzzy and one reason the picture is fuzzy is because so many banks and other financial institutions, investors, and regulators either don’t seem to have a good grasp of the value of many of the assets on the balance sheets of these banks and other financial institutions or because they are unwilling to confess what the asset values are.

Look at some of the recent articles that have been in the news this week. “Insurers’ Biggest Writedowns May be yet to Come” by Jonathan Weil, “Disclose the Fair Value of Complex Securities” by Robert Kaplan, Robert Merton and Scott Richard, “Citigroup’s Asset Guarantees to be Audited by TARP” by Bradley Keoun and Mark Pittman, “We Need Daily Data to Get Credit Markets Working Again” by Richard Field,

All of these articles have to do with financial institutions knowing and reporting, as well as possible and as often as possible, the current value of their assets. The managements of financial institutions claim that this will inhibit their actions and force them into decisions that are not in the best interest of their institutions or the financial markets. These managements are wrong!

We are hung up right now because we don’t know the value of those assets either because the banks don’t know what the value of those assets are or the banks are not revealing what the value of those assets are.

I believe that we would face less uncertainty now and may have even avoided a good deal of the financial collapse of the last two years if these financial institutions would have been required to regularly report the fair value of their assets and responded more rapidly to changing market conditions.

Even better, it would have been a sign of outstanding management and real leadership if the banks themselves had been more open and transparent with the financial community, rather than require regulation to force them to release this information.

Alas, this didn’t happen.

This whole dilemma, to me, comes under the “No Free Lunch” argument.

Bankers mismatch the maturities of their assets and liabilities and take advantage of the positive slope to the yield curve. But, in doing so they take on more interest rate risk. Financial markets move against them and the price of the longer term assets decline. Whoops! The benefit the bank got by taking on the extra interest rate risk has backfired. Well, nothing comes for free!

Bankers add riskier loans to their loan portfolio or buy riskier securities to increase their yield. But, in so doing they take on more credit risk. The economy slows down and now these loans or securities face a larger default rate than the bankers had anticipated. Whoops! The benefit the bank got by taking on the extra credit risk has backfired. Well, nothing comes for free!

Financial institutions leverage up their balance sheets in order to squeeze out additional return on their equity position. But, in so doing they take on more financial risk. As assets prices go down the increased leverage backfires and their solvency comes into question. Whoops!

Bankers can’t get something for nothing. And, they can’t hide behind accounting rules in an effort to wait things out until times get better. As Kaplan, Merton, and Richard argue, banks typically fail to act when markets move against the risky positions they have taken and chalk the situation up to “unusual market conditions” or to “just a bump in the road”. And, if economic declines are relatively short and relatively shallow maybe they can get away with waiting the problem assets out. But, in deeper and longer periods of economic and financial dislocation they get trapped in their own failure to act. The asset values do not return to previous levels and the longer they wait to act on the existing problems the worse the situation on their balance sheet becomes.

Richard Field argues, in the article cited above, that banking and credit markets are having problems, not because the loans and securities on the books of the financial institutions are complex, but because they are opaque. This lack of clarity has helped to get us into the current crises and will continue to plague the recovery if it is not corrected. This lack of clarity allows bankers to continue to postpone action, it prevents investors from knowing the value of their investments, and it hinders regulators from in their efforts to understand the true condition of the financial institutions they are regulating.

As I have mentioned in previous posts, I have been involved in several successful bank turnarounds. One of the first things you have to do in turning around a bank is determine the value of your assets and you have to be brutally honest about what the values are. And, in going through this process, in every turnaround I was involved in, it becomes clear that the previous management failed to accept the fact that the value of their assets had declined, they continued to hope that the “unusual market conditions” would pass, and, consequently, by failing to act, the condition of the assets got worse and worse.

Good managements are not afraid of the truth and they are not afraid of releasing that information to the public!

Unfortunately, it is likely that the opaqueness with regard to the value of bank assets will continue.

Saturday, August 15, 2009

Bank Failures Are Up: Way Up!

On Friday, bank failures for the year reached 77. In January or March of this year people started projecting that we may make 100 by the end of the year. I think that is as sure a bet as you can get these days. Now, we are seeing forecasts of over 200 more bank failures in the next 18 months.

The headlines over the past several days have been eye-catching. On, we saw “Toxic Loans Topping 5% May Push 150 Banks to Point of No Return.” On Reuters Blogs, we saw ”Citi’s Dirty Pool of Assets,” which reported that Citigroup had identified $39.5 billion that represented deep problems on its pool of subprime mortgages, of which it has only incurred $5.3 in looses leaving another $34 billion to go. Citi also faces problems in it CDO portfolio some of which it has hedged its exposure with credit default swaps. And, Jonathan Weil, in an article titled “Next Bubble to Burst Is Banks’ Big Loan Values” on, argues that the change in mark to market accounting early this year has covered up huge losses on the books of the biggest banks that were reported in the fourth quarter of 2008 but have since disappeared.

The good news in all this is that most of the troubled assets in banks have been identified and the regulatory bodies, particularly the FDIC, are fully aware of the most troubled banks. These individual insolvency cases are being worked out on a case-by-case basis. We got headlines in the newspapers this week because of the sell-off of Colonial BancGroup Inc. which was the largest bank to fail in 2009 and one of the most costly bank failures ever. But, this bank had been identified a long time ago and it has been systematically handled. The other four that failed this week did not claim headlines. This is good because the banking sector is staying relatively quiet. (See my post of August 10 on this Most bank failures over the next year or so will not get major headlines. (Our most optimistic wish is that none of the bank failures coming in the next year or so will warrant headlines.)

We are in the part of the credit or debt cycle where things are relatively calm: we are way past the phase of the cycle where liquidity was the primary issue. The problem now is not that financial institutions need to and want to get rid of assets as quickly as they can. We are in the “work out” phase of the cycle. Historically, the time it takes to “work things out” depends upon the depth of the collapse in asset values. The betting now seems to be that this time around, the “work out” phase of the cycle will be a relatively long one.

If we still have to go through 125 to 150 more bank failures in the next 18 months or so, the banking system as a whole is not going to be too aggressive in putting new loans on its books. And this will not result in a strong economic rebound going forward.

In addition, the amount of debt that is still outstanding in the economic system will remain a major drag on the banking system. The uncertainty pertaining to the future repayment of loans to the banking system, in the areas of commercial real estate loans, of credit cards, and because of another wave of residential loans that will be repricing over the next 12 months or so, is still a concern. This uncertainty will further restrain banks from being too aggressive in making new loans. (See my post of August 12, “The Debt Problem Poses a Two-Sided Threat to the Fed,” at

And, those who have borrowed will be reluctant to spend giving the uncertainties about the state of the economy, unemployment, foreclosures, and other economic dislocations. Even Paul Krugman has recognized the role that debt plays in spending. In a recent lecture Krugman discussed why the Great Depression did not re-start after World War II when almost all economists expected it to do so. He argued in this talk that by the end of World War II the private sector of the economy, households and businesses, had worked off most of the debt that it had taken on in the 1920s, but had not been able to eliminate in the 1930s. The private sector had deleveraged by the 1950s and was now ready to spend. Krugman contends that the private sector will not begin to spend again coming out of the current recession until it has deleveraged itself from the current buildup of debt.

The financial system and the economic system are working themselves out of their recent problems. Let us hope that things stay quiet. That means, we need to avoid any more surprises. If we don’t have surprises, there is a good chance that the recovery will start and will continue. This doesn’t mean that it won’t take a long time for the banks, households, and businesses to work through their current problems. It will. And, it doesn’t mean that other problems with respect to long term interest rates and the value of the United States dollar may not worsen because of the huge and increasing load of federal debt.

This “quiet” does give us some hope that we are moving in the right direction. There will continue to be bank failures, and foreclosures, and bankruptcies, and more. But, they can be worked through if we don’t get too impatient.

Wednesday, August 12, 2009

The Debt Problem Poses a Two-Sided Threat to the Fed

There are two numbers I can’t get out of my head. The numbers are $1.84 trillion and $1.26 trillion. These are estimates of what the deficit of the United States government is going to be for the fiscal year ending in September 30, 2009 and the fiscal year ending in September 30, 2010. (Note that revised estimates for the fiscal year were supposed to be put out in July, but the Obama administration postponed their release until sometime in August.)

It was announced today that the budget deficit in July reached an all time record of $180.7 billion and this brought the year-to-date deficit to $1.27 trillion.

Some simple calculations show that if the estimated number for fiscal year 2009 is to be hit, the budget deficits for August and September will have to average $285 billion per month.

This would mean that the deficits would be $100 billion more a month than the record deficit that was posted in July! This is not a good trend.

Some analysts are predicting that the current year deficit will actually top $2.0 trillion while the 2010 deficit will reach $1.5 trillion. With the deficit for next year at $1.5 trillion, the monthly deficits would only average $125 billion, a figure that would look pretty good given the July, August, and September figures presented above. But, is this realistic given all of the proposals and programs that are in the federal pipeline.

Gross federal debt held by the public increased by more than 28 percent, year-over-year, at the end of the second quarter of this year. That is up from 24 percent at the end of the fourth quarter of 2008 and 15 percent at the end of the third quarter of 2008. With the forecast figures for the deficit, these numbers are going to continue to be at relatively high rates in the near term.

According to the Congressional Budget Office’s alternative fiscal projections, the public debt of the United States could rise from 44 percent of GDP in 2008 to 87 percent of GDP in 2020.
Adding this much debt to the world is going to place a tremendous burden on financial markets!

The Federal Reserve announced today that it was going to continue on its path to purchase the $300 billion in Treasury securities that it had already committed to, but would extend the program through October rather than ending it in September. The Fed will also retain its plan to buy as much as $1.45 trillion of housing debt by the end of the calendar year. By August 5, 2009 the Fed had purchased $543 billion in mortgage-backed securities.

Numbers like these only cloud the picture of what an “exit” strategy might look like for the Fed. In fact, it does not look like an exit strategy at all.

But, this is just one side of the coin. The other side has to do with existing bad assets. Elizabeth Warren, the chair of the Congressional Oversight Panel that is monitoring the bank bailout effort appeared on Joe Scarborough’s “Morning Joe” program today and stated that the “toxic assets” on bank balance sheets that got us into this financial mess are still there. And, they are going to have to be dealt with at some time in the future. For the near term she warned of a looming commercial mortgage crisis, one that will require more federal money, especially for smaller banks.

Oh, and about commercial mortgages, what about the problem the Fed faces with the commercial mortgages that it already has on its balance sheet. This morning in the Wall Street Journal there was an article about how the Fed has to deal with some debt it inherited from the Bear Stearns failure. (See “Fed Grapples with Extended Stay,” On the balance sheet of the Fed there is a line item dealing labeled Maiden Lane related to the Bear Stearns sale to JPMorgan Chase. Included in this line item is a $900 million debt that the Extended Stay Inc. chain of hotels owes to the Federal Reserve among others. Extended Stay is in bankruptcy now and the issue is how the Fed is treated among other debtors and the deals that have been made between Extended Stay and some of the lenders. It is messy. But, this comes with doing the deals that the Fed has been doing.

And, apparently the Maiden Lane fund holds about $4 billion in debt backed by Hilton Hotels. Messy, messy, messy.

But, the Fed has also extended money to AIG, and to money market funds, and to commercial paper dealers, and has $543 billion of assets tied up into mortgage-backed securities. The Financial Times reported this last week that the Federal Reserve Bank of New York is hiring like crazy attempting to add positions to its staff as fast as it can, positions that will deal with all the future issues arising from all the new programs that the Federal Reserve System has gotten into over the last year or so. The administrative headaches of these actions are now being felt. (Question: if the Fed exits all of these programs, does the Federal Reserve Bank of New York need to create an exit plan to have a reduction in staff when these programs go away?)

And, the National Association of Realtors released information today that home price declines accelerated in the second quarter and Realty Trac said that foreclosure filings reached a level at which 1 in every 84 U. S. households had received a filing. ForeclosureRadar warned that California was on the verge of a new wave of foreclosure sales as notices of default, the first step in the foreclosure process, rose 12% in July from one year ago. Prime borrowers that were behind on their mortgage payments rose 13.8% between March and June.

On top of this household debt remains at about 130 percent of disposable income and household net worth continues to decline.

Business defaults are above 11 percent and are heading toward 13 percent according to some experts.

As we have reached a relatively calm period in economic and financial markets, more and more people are demanding that the Fed present them with a picture of how it, the Fed, might get out of the position it is in. With all the debt that currently exists and all the debt that is going to be created, the Fed seems to be at a loss about what an exit strategy might look like. In fact, with the growth of federal debt projected to stay in the double digit range for several more years, the realistic answer to the request for the Fed to devise an exit strategy is that there seems to be nothing to exit from.

If we accept this conclusion then we must argue that the problem is not with the Federal Reserve, the problem is with the federal government. The problem is with the Treasury department and with Mr. Geithner. The problem is that there is too much debt outstanding, and the creation of more and more debt by the federal government is not helping the problem, it is only exacerbating it. And, Mr. Geithner only strains his credibility, and that of the administration, when he argues that there is already a plan to reduce the future deficits.

Sunday, August 9, 2009

Banking Sector Still Remains Silent

There is good news and bad news from the banking sector. The good news is that all is quiet. The bad news is that all is quiet.

In terms of the goods news, “quiet is good” because there have been no new “discoveries” of bad loans or bad assets that will shock the financial system. We continue to hope for silence here even with the continued growth in the unemployed, in bankruptcies, in delinquencies, and in loans coming due that need to be re-priced or re-financed.

In terms of the bad news, there is still no life in bank lending. If we are going to see a pick-up in the economy and a return to growth the banking sector is going to have to start lending again, especially in the commercial sector. Commercial and industrial loans were down by 3.3%, year-over-year in June, and in the last five weeks, all in July, these loans have fallen by another $24 billion.

Real estate loans peaked in May 2009 and have declined ever since, dropping approximately $60 billion through the end of July. Even the amount of home equity loans has declined steadily since reaching a peak in May. Consumer loans continue to drop, with credit card debt falling for the fifth consecutive month.

Total bank assets are still up on a year-over-year basis by 7.5%, but the main balance sheet increases are in cash assets, primarily deposit balances at Federal Reserve Banks, and in Treasury and agency securities.

Banks are still not doing any lending to speak of and are staying very, very liquid.

On the liability side of commercial bank’s balance sheets, demand deposits are still rising at a very rapid pace, about 38% on a year-over-year basis. Other checkable deposits at commercial banks are rising at a relatively rapid pace, 19.3%, but a surprising bit of information is that other checkable deposits at thrift institutions have only increased by a modest amount, by 2.9%, year-over-year.

Checking into the thrift institution situation a little further we find that savings deposits at thrift institutions have actually declined year-over-year at a 7.9% rate and small-denomination time deposits at thrift institutions have fallen at a 14.3% rate over the same time period. These balances at commercial banks have increased at a 16.3% rate and a 15.3% rate respectively.

Two shifts seem to be taking place in depository institutions. First, there seems to be a major movement of funds from thrift institutions to commercial banks. Second, individuals are holding more and more of their funds at commercial banks in demand or other checking accounts relative to time and savings accounts. One additional note to this: retail money funds have dropped by about 11.6% on a year-over-year basis indicating another shift taking place from non-banks to commercial banks.

Another trend continues to hold and that is in terms of currency holdings outside of the banking system. Year-over-year, the currency component of the money stock continues to rise in excess of 10%. Like the banks, the public wants to remain as liquid as possible in order to be able to meet the contingencies people experience in uncertain times.

This movement of assets is reflected in the aggregate money stock figures. The Fed publishes money stock growth figures using 13-week averages. On a year-over-year basis using the thirteen weeks ending July 27, 2009, the narrow measure of the money stock, M1, has increased at a 17.0% annual rate whereas the broad measure of the money stock, M2, has increased at an 8.7% annual rate. It is obvious that the growth rate of both measures is dominated by the huge annual rate of increase in demand deposits as people have re-allocated their funds from time and savings accounts to checkable deposits in commercial banks.

This shift is even more obvious if one looks at the relative rates of growth over the past three months. M1 growth is 15.4% while M2 growth is 3.1%, indicating that much of the re-allocation of funds has come in the past three months.

In terms of the Fed’s assets, there continues to be a runoff of dealers using the Commercial Paper funding facility indicating some easing of liquidity in the commercial paper market. This decline was expected to occur as the commercial paper market improved and this is a hopeful sign. Central bank liquidity swaps also continued to decline indicating an additional strengthening of foreign exchange markets around the world, another hopeful sign.

Both of these declines in the Fed’s balance sheet resulted in reserves leaving the banking system. All it means, however, is that excess reserves in the banking system declined. These excess reserves still remain well above $725 billion, while required reserves total around some $65 billion.

As reported before, the banking system seems to be coming out of the big financial bust in typical fashion. This is why the claim that things are quiet in the banking system is a good thing. We can only hope that this peace and quiet will continue.

There will continue to be bank failures. We reached 72 for the year this last week, but there were no surprises in the increase, they had already been identified. One concern arising from the figures presented above is the health of the thrift industry. With funds leaving the thrift industry as reported, what pressure is this putting on thrift institutions in terms of their assets and solvency?

The big question remains: “When are the commercial banks going to start lending to businesses again?” To answer this, we need to keep a close eye on the information coming out of the banking sector. My guess is that banks will not be too quick to start lending to businesses again. There are questions about how brisk the “back-to-school” season will be and there may not be much increase in lending during this time. The next really big test after that will be the holiday season that begins in October and early November. It will be interesting to see how lending activity behaves at this time.

The Fed continues to keep funds going into the capital markets in terms of acquiring Treasury securities and mortgage-backed securities while letting some of the other facilities that were created to support liquidity in different specific areas of the financial markets run off as it was hoped that they would do. As long as the banking sector remains relatively peaceful, this seems to be the way the Fed wants to act. Then as liquidity picks up in the stressed areas of the capital market, the Fed plan is to sell these other securities back to the private sector and reduce the size of its balance sheet.

The good news in the banking sector is that things are relatively quiet. May they stay that way. In my view we will have to wait a while before we see the banks beginning to refuel businesses and the real estate sectors.

Thursday, August 6, 2009

Bank of America and the Appointment of Sallie Krawcheck

This continues to be a trying time for the finance industry. Articles like the one that appeared this morning in the Wall Street Journal just do no good for the stature of those who admit to working in finance in one way or another. The article I am referring to is “Behind BofA’s Silence on Merrill,”

The problem is one similar to that described by John Plender, the Chairman of Quintain PLC, in the Financial Times yesterday, “Ditch Theory and Take Away the Punchbowl,” Plender presents the folksy strategy for central banking ascribed to William McChesney Martin, former Chairman of the Board of Governors of the Federal Reserve System. Martin is reported to have said that the task of a central banker was to take away the punchbowl before the party got out of hand.

To me, the role a financial officer, especially a Chief Financial Officer, is similar. A financial officer ultimately must be the naysayer in an organization. If the financial officer does not act out this role in an organization then the Chief Executive Officer is not going to be well served by the finance function and the organization is going to be exposed as it grows and considers alternative business options!

No one else in the organization performs this function. A “good” Chief Executive Officer wants a strong person in this position because without someone there to say “no” from time-to-time, the CEO will be like the emperor that is wearing no clothes. A “good” CEO knows this. One thing I look for in evaluating a management team is the strength of the people a CEO surrounds him- or herself with, especially the strength of the CFO.

A strong Chief Financial Officer knows that there is no such thing as a free lunch. That is, when it comes to finance, you never get something for nothing. If you want a greater return on your assets, you can take on riskier assets, or you can increase you financial leverage which, of course, increases risk, or you can mismatch the maturities of your assets and liabilities which, of course, increases risk. Of course, we can extend the idea of “no free lunch” to proposals coming from marketing, or information processing, or purchasing as well, but I am sticking with financial issues because that is where the concern is today.

In the euphoria of the credit bubbles that took place in the 1990s and the 2000s, CFOs and other finance people that believed that there was “no fee lunch” and acted upon this belief seem to have fallen out of favor with CEOs seeking to make bundles of money in the bubbles. Of course, not everyone acted in this way but a significant number did and we are all paying the price for this today.

When one sees articles like the one in the Wall Street Journal mentioned above, you can understand why people on Main Street and why Senators and Representatives in Congress can pick on bankers and others who are in the finance profession. It certainly seems as if a trust was broken and greed ruled the kingdom.

The hiring of Sallie Krawcheck by BofA is, therefore, a hint that maybe BofA understands that it needs to build up its credibility. Krawcheck has a reputation for openness and integrity that has stayed with her throughout her career. The argument is that this trait got her in trouble with the CEO of Citigroup, Vikram Pandit, and cost her the position of CFO which she held at Citi. Taking over responsibility for BofAs global wealth and investment management business in not the same as becoming CFO of the institution, but it indicates that BofA is pulling in someone that is not only talented and capable in finance, but also will add some credibility to the organization in terms of honesty and transparency.

One can learn a lot about leaders and the organizations they lead by observing how they respond to people that possess these qualities, especially in times of trouble. Citigroup seems to have a history of releasing top people that question how financial affairs are being handled. Richard Bookstaber comments on how Citi operated in the area of risk management in his book “A Demon of Our Own Design”. We also see that Jamie Dimon was asked to leave Citi when he began to clash with the leadership of that organization on issues of risk and management. (See my review of a book about Dimon: It seems as if Citigroup worked hard and long to get itself into the position it is now in.

Of course, BOA and Citi are not isolated cases. One can name any number of organizations from Bear Sterns to Lehman Brothers to AIG to Wachovia to Countrywide to so and so and on and on. The depth and breadth of the problem just indicates how far the finance profession has lost credibility.

That is why I would advise at this time that investors look even more closely at the people, especially the finance people, that the leadership of an organization brings on board. Strong financial leadership is needed within an organization, leadership that stresses telling the truth, reporting asset values at realistic levels, and leadership that rejects accounting rules that only muddle if not mislead investors and regulators.

In this regard I would argue that we have to get back to mark-to-market accounting. To me, people only kid themselves when they finance long term assets with short term liabilities in order to capture additional return and cry and whine when they have to mark down the values of their longer term assets if the market goes against them. They are brave enough to gamble on this mismatch of maturities. They also need to be brave enough to accept the consequences of their actions. There is no free lunch!

In my experience there is one thing that financial integrity does: it causes people to act earlier than they would otherwise. The situation I saw over and over again in doing bank turnarounds was that people postponed doing anything about a bad position because they were not forced to recognize a problem early on. As a consequence they put off doing something about the bad situation and put it off until the problem grew into a much larger problem where they could not postpone action any longer. Good management recognizes problems and deals with them early on.

Hopefully, the hiring of Sallie Krawcheck is a sign that organizations are recognizing the need for strong financial leadership. Then, in hiring more people like her, maybe emperors won’t have to go out into crowds to discover that they don’t have any clothes on. The absence of clothes will have been discovered long before then and the situation will have been corrected.

Wednesday, August 5, 2009

A Market Grade for the Obama Economic Policy

There is a brutal way to grade administrations on their economic policies: look at what foreign exchange traders do to the currency of a country. This has been a test of political administrations around the world since the world removed itself from the gold standard in August 1971.

If we use the movement of the value of a country’s currency as a grading mechanism then this is how the Obama administration stacks up since it took office on January 20, 2009. The value of the dollar against the Euro from January 20 through July 31, 2009 has dropped 9.3%. Using early morning figures registered today, the drop has been 10.1%. The value of the dollar against Major Currencies has dropped 9.5%.

These are not very good grades!

What are the underlying factors behind this decline? First, the administration is proposing a huge deficit for this year, $2.0 trillion, a deficit that dwarfs all other deficits in United States history! And, some experts are projecting deficits that will continue to average around $1.0 trillion per year for the next ten years or so. Second, a monetary policy that is keeping short term interest rates extremely low, and it has been stated that these rates will be kept that low until possibly 2011.

Any comparisons?

The Bush administration saw the value of the dollar peak in March 2002 and then decline about 40% into 2008.

What were the underlying factors behind this decline? First, the administration created huge deficits by historical standards, deficits that continued throughout the entire Bush administration. Second, there was a monetary policy that kept short term interest rates extremely low, and it kept them at an extremely low level for two years or so.

Let me quote Paul Volcker once again. He has written that “a nation’s exchange rate is the single most important price in its economy.” This is from the book “Changing Fortunes: The World’s Money and the Threat to American Leadership,” by Paul Volcker and Toyoo Gyohten (Times Books: New York), page 232.

When are we going to learn?

Monday, August 3, 2009

Long Term Treasury Yields and the U. S. Dollar

I still feel that the yields on long term Treasury issues and the value of the United States dollar are tied together. I have believed for some time now that long term interest rates will trend upwards over the next 12 months and that the value of the dollar will decline during the same time period. The strong rise in the 10-year Treasury and strong drop in the value of the dollar on August 3 just reinforce this belief.

In looking back at the 2002-2004 period there are too many similarities to feel comfortable. The Federal government is presenting us with large and growing deficits. Monetary policy is ridiculously easy. And, the dollar is under pressure.

What about long term Treasury yields? Well, in that earlier period the United States had the Chinese to pick up large amounts of the exploding Treasury debt so that long term interest rates did not have to rise significantly and the Federal Reserve did not have to monetize the debt.

The reason for the Federal Reserve behavior at that time? Chairman Greenspan was concerned that we might experience a period of deflation!

There are two theories why long term interest rates have not risen further than they have this year. First, there is still a concern among major investors about investment risk and as long as this concern lingers, funds from these investors will remain in long term Treasuries.

Now, there is a second reason given for long term interest rates remaining low and that is the enormous amount of liquidity in the commercial banking system. In recent weeks, commercial banks have started to expand their holdings of U. S. Government securities and this has put funds into the Treasury market with some of it spilling over into the longer end.

Why are commercial banks expanding their holdings of U. S. Government securities? Because the Federal Reserve has given out signals that it may keep short term interest rates low for an extended period of time: even into 2011. If this is to occur, then the reserves that the Fed has put into the banking system will have to stay for a while. That is, there will be no quick exit on the part of the Fed. Since the banks don’t want to lend to businesses or consumers they might as well get a higher yield than they do on reserves at the Fed by investing in market issues.

The reason for the Federal Reserve behavior at this time? Chairman Bernanke is concerned that we might experience a period of deflation!

As a consequence of the specific conditions of the present time, long term Treasury interest rates may not rise appreciably in the near term. However, I still believe that they will show a significant rise in the next 12 months.

I feel more certain about the decline in the value of the United States dollar. Participants in international markets are very reluctant to stick with the currency of a country that runs huge deficits with the strong likelihood that these large deficits will not go away for a long time.

Can you imagine a $2.0 trillion deficit this fiscal year and a Federal deficit of around $1.0 trillion a year for up to ten years! This is unsustainable, even for the United States.

And, what is going to fuel the further decline in the value of the United States dollar?

Oil prices. And, copper prices. And, gold prices. And, stock prices, And, housing prices. All these are rising now. As these asset prices continue to show strength, the value of the dollar will continue to decline. On August 2 I wrote a post called “Looking for Signs of a Recovery” (see In that post I laid out some things to look for in determining whether or not the economic recovery is taking place. Rising asset prices is an important factor.

The trouble with rising asset prices at this time is that these increases are being underwritten by the extremely loose monetary policy. It is entirely possible that these asset prices may continue to rise while real economic growth remains dismal at best. And, in such a situation, consumer prices may not rise appreciably. Again, this is consistent with what we saw in the 2002-2004 period—asset bubbles and only moderate consumer price inflation.

Of course, a scenario that contains a continuing decline in the value of the United States dollar is not a good one for the Obama administration. It raises serious questions about the ability of the Federal government to finance such huge deficits as the ones that are forecast and still maintain relatively low long term interest rates without a major monetization of the debt. This whole scene seems like a replay of the first term of the Bush administration. There is just too much debt in existence. And, like the Bush administration, the Obama administration is experiencing a reduction in any “good” policy options that are available to it.

Sunday, August 2, 2009

Looking For Signs of a Recovery

Amid everything else going on, we still continue to look for signs of a recovery. This weekend I spent some time looking at the investment side of the economy to see if I could pick up any sign of life on the capital spending front. At the end of the weekend, I gave up looking for encouraging information, either in terms of business investment or investment in real estate.

Let’s look at the supply side first, the companies and businesses that supply physical capital, either in terms of real estate or in terms of business equipment. In order to summarize the information on the supply side of the market there seems to be one favorable factor that would encourage the production of investment goods and two that are not encouraging concerning the production of capital goods or real estate.

The positive factor is short term interest rates. The supply of capital goods in the past has been dependent upon the cost of short term funds and right now, of course, short term interest rates are as low as we can ever expect them. If these rates stay at these levels and other factors encouraging investment production improve, we should start to see the economy recover. The word out of the Federal Reserve is that short term interest rates are going to be kept low for an extended period of time and this weekend we heard that these rates may stay low into the year 2011.

The two negative factors relate to the internal cash flow of firms and the terms on which lenders are willing to lend. In terms of internal cash flow, potential suppliers of investment goods are still in a position in which they are trying to de-leverage and actually reduce the amount of debt they have outstanding relative to their internal sources of funds. Thus, there is not much effort to expand production from the suppliers of goods because they have not yet got their balance sheets back in order as of this time.

Lenders, of course, are not lending. If anything, most lenders are still risk adverse and continuing to tighten up on the maturities and terms of any lending they do. As a consequence, we see very little willingness on the side of lenders to encourage the supply of funds to expand.

Therefore, whereas the Federal Reserve is consciously keeping short term interest very low and intends to keep them low for a long period of time, potential suppliers of capital have not seemingly restructured their balance sheets sufficiently to begin to produce again and lenders seem far from willing to take any chance on who they lend to. We are back in the position where bankers, and others, will not lend to someone unless the potential borrower does not need the money.

In terms of the demand side of the market the factors that tend to support investment expenditures all seem to be in the negative range. Long term corporate interest rates have fallen some over the summer and this is encouraging. Moody’s AAA corporate bond rate was at a yearly high in June averaging 5.61% for the month. This rate moderately bounced downward in July but seemed to be rising into the 5.50s toward the end of the month. Moody’s BAA corporate bond rate has declined significantly from March 2009 when it averaged around 8.40% and has fallen to the 7.10% range toward the close of July.

The decline in corporate rates has been encouraging and indicates that the financial market’s taste for risk has improved at the expense of longer term Treasury issues whose yields have been rising since March. The question here is whether there will be a continued rise in Treasury bond rates over the next 12 months or so. If Treasury interest rates continue to rise, as I believe they will, this will put a floor under corporate rates, one that will tend to rise as longer term rates rise in general. And, with the spread between AAA and BAA securities around 150-160 basis points one cannot see this spread getting much narrower as long term interest rates rise over the next year or so.

Less favorable trends appear to be the lack of growth in cash flows This means that those that want to acquire capital goods or real property still face the need to continue to de-leverage their balance sheets. This concern can be combined with the fear that many economic units have about the possibility that they could face default or foreclosure in the upcoming twelve month period. There are still a lot of financial issues that must be resolved and this attitude does not produce a lot of optimism on the part of businesses or individuals to extend their own resources into risky investments in the near future.

This attitude coupled with the economic forecasts that the recovery will be tepid at best for the next 12 to 18 months does not do much to create optimism about future profit expectations. Profits have increased but the general consensus is that a large portion of these profits have been achieved either through cost cutting or through trading operations. Neither one of these can be expected to contribute to a general increase in profit expectations for the future since cost cutting can only do so much and trading profits are sporadic and cannot be counted on on a regular basis. The prospect for growing profit expectations is not strong presently. Confidence can change rapidly, but it appears that it will remain relatively low for the near term.

There are some firms and some industries that are producing solid profits and can be expected to generate profits going forward. How much they will stimulate the sectors that are not performing well and how much they will contribute to a growing optimism concerning the future performance of the economy is anybody’s guess right now. These companies continue to look for an uptick in their business in the coming months as well. It is possible that these companies could lead the economy out of the recession, but they don’t seem to be in a mood to over extend themselves or to take on too much more than they are doing at the present time. They are happy to be making profits and intend to do so in the future: but, in a controlled and conservative manner.

The needed conditions for coming out of a recession are not really present at the current time. The Federal Reserve has, of course, have kept interest rates quite low and there has been the favorable movement in longer term, non-Treasury yields which have declined in recent months as financial markets have moved back into securities that are riskier than U. S. Treasuries. In respect to the cost of money, everything is in place for the recovery. The problem of achieving a sustained increase in real investment, either in plant or equipment or in real estate, rests upon the potential borrowers and the possible lenders. Neither seems to be in any shape to begin borrowing or lending in the near term and this shows both on balance sheets and in the market place.

We have observed in the past that “animal spirits” can be revived and they can be revived relatively quickly. Question marks are always present relating to the issues of what is going to set off the animal spirits and when are they going to be set off. We can only keep looking at the major factors that are related to the psychology of economic units and attempt to determine when the direction of the economy is going to change.

At present, there are indications that a recovery is possibly starting to mount. For example, the index of leading economic indicators rose recently for the third month in a row. Still, the dark clouds fail to go away. Unemployment is, of course, still a big concern. And, with unemployment benefits increasingly running out while unemployment continues to grow and with the further prospect of additional credit difficulties in the banking system while bank failures continue to rise, care still must be exercised before one extends ones self by taking on more debt and by committing ones self to the purchase of expensive capital goods. I don’t believe that animal spirits will be on the rise anytime soon.