Thursday, April 29, 2010

More on Crybabies: No One is Responsible!

I am moving more and more to the belief that we will see some substantial inflation in the Western world in the next few years.

Being an optimist, I keep hoping that the leaders at the Federal Reserve can bring off the Fed’s “Great Undoing” and succeed in reducing the excess reserves in the banking system before these reserves turn into loans and spending.

I keep hoping that the federal government will honestly address the issue of its budget deficits which I see increasing the federal debt outstanding by $15 trillion in the next ten years.

I keep hoping that businesses will reduce how much they are leveraged and concentrate more on the production of goods and services rather than on their trading activities.

I keep hoping that consumers will get their balance sheets back in order and begin to live within their means.

I keep hoping…

But, for these things to take place, someone must take responsibility for their actions.

I am not seeing this happening!

All I am seeing are the crybabies that place the blame for their problems on the backs of someone else.

Alan Greenspan and Ben Bernanke did not see (or, they did see, depending upon which speech you listen to) the looming financial crisis, for no one could (or, they could but could do nothing about it) have recognized the future.

Paul O’Neill, Jack Snow, and Hank Paulson had no idea that such huge deficits would be created during the 2000s and contribute to a decline in the value of the United States dollar of over 40% against other major currencies, for they were all in favor of a ‘strong’ U. S. dollar (whatever that is).

And, the leaders of European nations were not responsible for the current financial disorder in the market for sovereign debt. It is obvious in recent remarks (among others):

Sure, the rating agencies are not to be believed and they always move ‘after-the-fact’, but where there is smoke, there must be fire.

And, what about those people that sell securities short and those that deal in Credit Default Swaps. They are nothing but trouble makers taking advantage of the bad press put out by the sensationalist world media. Greedy bastards!

And, bank managements are not really responsible for any of the trials and tribulations of the past several years. That was obvious in testimony given in Congress this week. All of the emphasis on trading rather than financial intermediation, leverage ratios of 40-to-1, increased assumption of risky assets, and the mis-matching of maturities was just ‘business as usual.’

Families and homeowners were not responsible either.

And, this attitude has existed for the last fifty years.

Moral hazard reigns!

If no one is responsible for what took place over the last fifty years or so, then the way people behaved over the past fifty years or so will be repeated. Why? Because, if no one is responsible then we all have to ‘ante up’ so that those who are hurt by a financial collapse can get bailed out. And, since the music continues to play, the dancing must go on.

This ultimately means that the national government budget deficits will not be reduced. It means that the Fed’s “Great Undoing” will not take place. It means the foundation for price inflation will be in place. It means that consumers, businesses, and other governmental bodies will continue to borrow and leverage up. And, it means that financial innovation will continue to permeate the economy.

The Debt Deflation will be prevented. Another round of Credit Inflation, therefore, seems in store.

There is no indication that attitudes or behavior has changed. “Watch the hips, not the lips!”

Why concentrate on Western countries?

Because, over time, those countries that are disciplined will be the ones that benefit relative to those that do not discipline themselves. In this we see several of the emerging nations becoming relatively stronger as they focus more on the future political alignment of the world rather than on short-run outcomes.

These nations understand that power does not like a vacuum. When a powerful country gives up some of its position, others immediately move in to replace what is lost. And, some of these countries understand that slow and steady win the race and proceed in a disciplined way.

Yesterday, there was a very revealing opinion piece by Gerard Lyons of Standard Chartered Bank in the Financial Times titled “When ‘Made in China’ becomes ‘Paid in renminbi’” ( Perhaps the most important line in this piece is the statement that “Gradualism dictates the Chinese approach to most policy measures.” China thinks in decades and not in years I have been told. And, other emerging nations are learning this rule as well.

In the United States and other western countries, economic policy has been focused on the short run. And, by focusing on the short run, outcomes can seem to be the result of random or uncontrollable events. Hence, no one needs to claim responsibility.

However, we are responsible for our actions; for the short run does become the long run and in the longer run success depends upon the acceptance of responsibility and acting with discipline. This is one of the problems that Greece and Portugal and others are having at this time. They are being compared on these terms with other nations, like Germany, and are found wanting. And, they don’t like the implication that they have acted in an irresponsible and undisciplined fashion.

So, cry foul!

Wednesday, April 28, 2010

Is Greece the "Surprise" that Breaks the Camel's Back?

As people move through a financial crisis, the hope is that future ‘surprises’ will be avoided. In making things better and getting the system operating once again, efforts are made to identify problems and then set out to resolve the problems. Problems are not solved over night, but being aware of the problems and then honestly working them out is the way to put things right.

The fear is the unknown...a surprise!

Last Thursday the financial markets got a surprise. Greece’s budget deficit was worse than had previously been reported.

Was this incompetence or lying?

That is not the matter now, the fact is that Greece’s budget deficit is worse than had been expected.

The market sold off and the Wall Street Journal reported in “Traders Bet On a Default From Greece” ( the following:

“Greek bond prices posted a drastic decline Thursday as traders began betting a debt default is inevitable, even if the country receives a massive bailout.

The Greek bond market is now priced for a "catastrophic event," says Sebastien Galy, senior foreign-exchange strategist at BNP Paribas.

Greece's woes helped sink the euro to an 11-month low before the common currency recovered some of its losses.”

Thursday, Moody's Investors Service downgraded Greece's debt rating and warned that additional cuts could be on the way. Tuesday, Standard & Poor’s lowered their rating of Greek debt to “Junk” and at the same time reduced the rating on Portugal’s bonds two levels.

The question plaguing the financial markets now has to be the reality of the ratings on other sovereign debt. This always happens when the market gets a shock! If the figures on the deficit of Greece were wrong, what about Portugal? What about Spain? What about Italy? What about Great Britain? What about the United States?

How far this uncertainty travels depends upon the time and the state of the market. European stock markets sold off yesterday. The Dow-Jones index closed down by 213 points. The Dow stock futures had been down by 30 to 60 points. Markets hate uncertainty!

How can we make the world more transparent?

Eventually the numbers all come out. As Warren Buffet has said, once the tide goes out one discovers who is not wearing a bathing suit.

And, this is an argument for short selling and Credit Default Swaps! Yes, those that cut corners and those that cheat and those that don’t reveal the full extent of budget deficits hate short sellers and the CDS. They hate them because they reveal that the “Emperor is not wearing any clothes” let alone a bathing suit.

The response? Point the finger at the “other guy”, the greedy trader! Divert attention! It is people like those “greedy traders” that give capitalism a bad name! Ban short selling! Eliminate Credit Default Swaps! Those greedy bastards!

Well, the surprise is out! Now we have to see how far the contagion spreads.

The press is having a ball with the title, the PIIGS!

Portugal, Italy, Ireland, Greece, and Spain ate from the trough till they were fat and happy and then they were too bloated to deal with the consequences. So the focus is on them.

This is great for the United States because we now get another “run to quality” boost. Monday, we saw the headline in the Wall Street Journal, “All Signs Point to a Costly Auction”: ( The lead statement: “The U.S. Treasury market faces a challenging week, as investors deal with hefty debt auctions, the uncertainty of a Federal Reserve meeting and key economic data that will likely show the economy continued to grow in the first quarter.

That combination likely means the government may have to pay to sell the $129 billion securities.”

This morning we read in “European Jitters Give Two-Year Auction a Boost” (

“Treasury prices rose Tuesday as investors sought safety in low-risk securities after S&P cut its ratings on Portugal and Greece, sending Greek sovereign debt to ‘junk.’

The reach for safer securities helped to buoy the $44 billion two-year auction, which attracted good demand and helped keep Treasury prices higher.

The auction, the first of several note sales this week, was more than three times oversubscribed.”

The Euro has dropped below $1.32, a level it had not been at since April 28, 2009.

Unfortunately for Goldman Sachs this news is not yet eclipsing the headlines that it is receiving concerning the government’s case against them. But, at least, there is another “finance” story on the front pages of the major newspapers. Good for Goldman, bad for finance!

Still, the issue is about disclosure, transparency, and openness. There are many in finance who do not like “day light”! If anything comes out of the efforts to reform the financial system it should relate to disclosure. If people want to be in the ‘ballgame’ they must fully disclose. If they don’t want to disclose, then they must be excluded and pay the penalty.

And, full disclosure includes “mark-to-market” requirements. People who place bets by mis-matching maturities must also “fess-up.”

Anyway, we have been surprised! Now, the system must re-evaluate everyone so as to identify any other surprises that might exist. In the process, everyone else pays!

Tuesday, April 27, 2010

Is the United States on the Right Track?

The debate rages on: is the economic policy of the United States on the right track? On one side of the argument we hear that not enough has been done by the government to get the economy going again and to reduce unemployment. On the other side we hear that the government is creating too much debt and that most attention needs to be given to the reduction of the looming federal deficits.

Which argument is correct?

Well, if we look at the value of the dollar for an answer to this question, it seems as if investors are leaning a little more on the side of the latter.
This chart shows the value of the United States dollar against other major currencies in the world. The grade that is being given the economic policies of the United States government is not a good one. It should be noted that this index includes the Euro and the British Pound, two currencies that have been quite weak against the United States dollar recently.

Since January 2001, the value of the United States dollar has declined by about 26% against these major currencies. At one time, in 2008, the value was about 32% lower than in January 2001, but the ‘flight to quality’ during the Great Recession allowed the dollar to recover somewhat, but it then declined again to its current level as confidence rebounded.

Even with the situation in Greece (and Portugal and Spain and Ireland and…) investors in international markets still seem to believe that the United States government is on the wrong path with respect to its fiscal and monetary policies. Federal deficits totaling at least $15 trillion over the next ten years connected with a monetary policy that is keeping its target interest rate close to zero for an unknown length of time is not a combination that builds much confidence.

It could be argued that these international investors are giving the Obama Administration about the same grade it gave the Bush (43) Administration. If it were not for events going on in other countries, the value of the dollar could be even lower.

In fact, the recent performance of the dollar indicates that the international financial community sees little difference between the performance of the current administration and that of the administrations that preceded it over the past forty-five years of so, going back to 1961. Yes, different administrations pursued different specific policies that represented what they thought was best for the country, but in terms of aggregate policies, there has been little difference overall. The general thrust has been more federal debt and more private credit. The result: an almost constant increase in credit inflation.

Now, there is the threat of a debt deflation as a consequence of the Great Recession, but world currency markets don’t seem to think that a debt deflation is the most likely prospect.

With a government whose gross debt doubled since January 2001 and is projected to double again within the next decade and with a Federal Reserve that has injected $1.1 trillion of excess reserves into the banking system, little confidence exists among international investors that the United States government can “exit” this situation without losing control.

You can say all you want to about the policy differences of the different administrations over the last fifty years, but if you look at the aggregate economic data, very little separates the performance of the Republican and Democratic Presidents. President Nixon, perhaps, spoke for all Presidents of the past fifty years: “We are all Keynesians”.

One could argue that the Clinton Administration was the exception in terms of fiscal policy. And, Paul Volcker had to overcome the fiscal prodigals, Carter and Reagan, to achieve some credibility for the United States in international financial markets.

This relatively steady performance has weakened the United States internationally and the continued weakness in the dollar indicates that investors think that the current direction of policy will weaken the United States further going forward. This decline, connected with the ascension of the BRICS and other emerging areas in the world, is shifting power relationships all over the globe. The move from the G8 to the G20 captures this change.

The thing is, power cannot stand a vacuum. If the United States is wobbling a little, China, Brazil and others are there to fill in the spaces. Other nations will not stand still so as to allow the United States to dig itself out of the hole that Bush (43) put it in. In fact, by pursuing the same kind of aggregate economic policies that were followed by the Bush (43) Administration, large deficits and extremely loose monetary policy, the Obama Administration, in many ways, just seems to be digging the hole deeper.

Ben Bernanke is even calling for the Obama Administration to produce an “exit” strategy to reduce future federal deficits. But this just highlights the problems that this administration faces. The government must “exit” both an excessively loose monetary policy as well as an excessively prodigal fiscal policy stance. It will be a truly exceptional performance if this administration can pull it off.

Right now, I believe that world markets think that they cannot pull it off. The place to watch is the foreign currency markets: keep your eye on the value of the dollar!

Monday, April 26, 2010

E-Mails, Investment Banking, and the Rating Agencies

Thank goodness for emails! Now we know what was really going on at Goldman Sachs and Moody’s and Standard & Poor’s. How about Congress including in their bill on financial reform the requirement that all financial institutions and rating agencies and all other organizations having to do with finance (say the Federal Reserve and the Treasury and Fannie Mae and Freddie Mac…and Congress…and the White House) release all of their e-mails a week after they were written.

This would really provide the financial markets with transparency!

The thing that strikes me so much about the release of these e-mails over the past week or so is their humanity. These Wall Street villains talk like human beings, like you and me.

Gillian Tett, in my mind, has a terrific opinion piece in the Financial Times this morning titled “E-Mails throw light on murky world of credit” ( Her reflection on the e-mails is captured in the following sentence: “It is fascinating, almost touching, stuff.”

But, even more important she states that “Reading these e-mails with the benefit of hindsight, there is little suggestion that rating officials were engaged in any deliberate malfeasance. Many appear conscientious and hard-working.” These people are just human beings trying to do their job.

The same can be said of those people that wrote the e-mails at Goldman. This is captured in an article by Kate Kelly in the Wall Street Journal titled “Goldman’s Take-No-Prisoners Attitude” (
Kelly speaks of a world, which Tett describes as “so detached and rarefied”, in which betting applied to almost anything. The scene she presents in her article is one in which mortgage traders from Goldman Sachs “cast bets on a White Castle hamburger-eating contest” in December 2007. (Note that the problems in the subprime mortgage market were so severe at this time that the Federal Reserve announced the creation of a Term Auction Facility (TAF) on December 12, 2007 with the first auction being held on December 17, 2007.)

This behavior, Kelly reminisces, “resembled a scene out of ‘Liar’s Poker,’ a book (by Michael Lewis of the book ‘The Big Short’) depicting bawdy antics of (mortgage) bond traders at Salomon Brothers in the 1980s.” She argues that “It was a lower-stakes version of what went on ever day in the group: aggressive, take-no-prisoners trading.”

To Kelly, the world apparently didn’t change much between the 1980s and the 2000s!

Tett draws some conclusions from the picture present in the e-mails. She writes “by 2007 they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control. Their world was also a strange, geeky silo, into which few non-bankers ever peered.”

And, Tett goes on, “Indeed, this world was so detached and rarefied it is, perhaps, little wonder that S&P struggled to deal with the press, or that Goldman traders felt free to celebrate the mortgage market collapse.”

“Few expected external scrutiny or imagined their e-mails would ever be read.” They were just being human.

But, something was wrong! Something bigger than the traders or the raters had taken control and was driving the system.

And, this leads Tett to the first of two lessons she draws from the information in the e-mails: “what went wrong in finance was fundamentally structural, as an entire system spun out of control! It might seem tempting to lash out at a few colorful traders but that is a sideshow…”

She concludes: “what is needed is systemic reform that removes conflicts of interest.”

This is the only point on which I disagree with her. To me this whole “spinning out of control” was a result of the credit inflation that had been prevalent in the financial system for the past fifty years or so. The whole effort to inflate the American economy had resulted in the excessive creation of credit during this time period, the almost fanatical drive toward financial innovation (led by the federal government), and the assumption of more and more risk by the private sector in a search to sustain its returns.

The reference to the book “Liar’s Poker” is particularly relevant because the main story in that book is about the trading going on in mortgage-backed securities, something that did not exist until the early 1970s when the federal government created the instrument. Please note that the first mortgage-backed security was issued by the Government National Mortgage Association (Ginny Mae) in 1970. Before then mortgage-related issues were not traded on capital markets. By the time of the writing of “Liar’s Poker”, government-related mortgage-backed securities had become the largest component of capital markets.

As I have stated many times, the purchasing power of the United States dollar declined by roughly 85% between January 1961 and the present time. Although consumer price inflation was kept relatively low over the past decade or so, credit inflation permeated the asset markets as bubbles appeared in stocks and housing. House prices got so out of line with rental prices during this time that the collapse of the housing bubble became inevitable.

So, I agree with Tett in her statement that “what went wrong in finance was fundamentally structural, as an entire system spun out of control!”

But, human beings acted like human beings during this time. Again, to quote Tett: “they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control.”

And, as Chuck Prince, former CEO of Citigroup, called it: as long as the music is playing, people must keep on dancing. This doesn’t excuse them, but it puts, I think, the behavior in perspective. This was not the well-thought-out plot of evil people.

Lesson: inflation creates incentives that can get out of hand. If the government wants to conduct economic policies with an inflationary bias then they must deal with the consequences at a later time.

I do agree with Tett on her second lesson learned: “the whole murky credit business must be taken out of the shadows. So few people spotted that finance was spinning out of control because the financial system was so separated into silos that its practitioners lost any common sense.”

Tett “welcomes the publication of these emails” but warns us to “keep braced for the next installment.” She “suspects that US regulators and politicians have not finished publishing all those damning e-mails yet.” I look forward to these revelations, as well.

Friday, April 23, 2010

The Changing Banking System

I remember when there were more than 14,000 banks in the United States. I also remember when there were 12,000 banks in the banking system. Even in those days, the financial industry only accounted for no more than about one-sixth of total domestic profits in America.

Now there are about 8,000 banks in the United States and about one in eight of these banks is either on the problem bank list of the FDIC or in rather serious trouble. The FDIC is closing three to four banks a week and it is expected to continue on this pace for another twelve to eighteen months.

The biggest banks in the banking system are doing well, profit wise. The reported earnings this week of JPMorgan Chase, Goldman Sachs, Morgan Stanley, Bank of America, Citigroup, and so on just re-confirmed the recovery of these giant institutions. Of course it is not the banking side of the business that is producing these results, although their loan problems seem to be diminishing. It is the trading side of the business that is creating such significant gains subsidized by the Federal Reserve zero interest rate policy. This is the “quiet” bailout of these banks because it does not require Treasury funds to support the effort and it helps bank assets improve so that insolvency becomes less and less of a problem.

Furthermore, regional banks appear to be recovering. PNC and BB&T have been doing well, but those lagging behind, Fifth Third Bancorp, KeyCorp, SunTrust Banks, and Huntington Bancshares all seem to be showing improvements which respect to their problem loans. PNC and BB&T actually reported profits for the first quarter, $671 million for PNC and $194 million for BB&T. So, the improvements continue down the supply chain (
We are still waiting for the small- to medium-sized banks to start perking up. But, this is where more of the problem or troubled banks lie and where most of the bank closures or acquisitions are going to be.

This fact points to one of the major changes taking place in the banking system. We are going through another period where the number of banks in the banking system is declining. I would not be surprised at all if the number of banks dropped to the 5,000 to 6,000 range over the next few years.

This movement will continue the consolidation of the banking industry in the United States. Right now, $2 out of every $3 in domestic banking assets resides in the largest 25 banks in the country. These are the huge banks mentioned above and the large regional banks mentioned above.

How high might this concentration go? I believe that regardless of what Congress does with respect to financial reform and trying to limit the size of banks that the total amount of domestic assets residing in the largest 25 banks in the country will go to about $4 out of every $5 in the relatively near future. This means that there will be at least 5,000 banks competing for that other $1!

Another change that is taking place in the United States banking system is the presence of more and more foreign banks. This seems to be a perfect time for foreign owned banks to pick up acquisitions in the United States and not only gain size but also gain presence in different regional markets. In this respect, note the article “Foreign Firms Scoop Up Failed U. S. Banks” in the Wall Street Journal, Canadian banks are especially taking advantage of the banking situation in the United States, but banks in Japan and other countries are seizing the opportunity as well.

In March, foreign-related institutions controlled over 11% of the assets in the United States banking system. This is up substantially from thirty years ago and is expected to climb further in the near future. My guess is that this number will be in the 15% to 20% range over the next five years or so. And, these assets will not be owned by small- or medium-sized financial organizations.

This is the problem now faced by President Obama and the Congress in terms of financial reform. I just don’t see these trends reversing themselves. And, as banks get bigger they will also be controlling more and more of the banking assets in the United States. And, as the banks get bigger they will continue to move into more and more areas of the financial market and they will continue to create more and more financial innovations.

And, if they are not done in the United States they will be done somewhere else in the world for commercial banking is, in fact, worldwide and not just the playing field of Americans. Big foreign banks are becoming a bigger part of the United States banking scene just as big United States banks are becoming a bigger part of the banking scene in other countries.

The difficulty in writing regulations that try to control what these banks can do is, in the words of economists Oliver Hart of Harvard and Luigi Zingales of the University of Chicago, “doomed to fail because such regulations are extremely easy to bypass. It takes no time for a clever financier to design a contract that gets around most restrictions.” Finance is just information and information can be restructured in almost any way that someone wants it to be structured.

The evolution of the financial system is going to continue to be fought by those constrained to the old Keynesian fundamentalism. The current financial environment has been created by fifty years of government policy conforming to a dogma that considers an inflationary bias to the economy an necessary pre-requisite for sustaining high levels of economic growth and low levels of unemployment.

Well, this inflationary environment has fostered the undisciplined expansion of credit, the excessive leveraging of financial capital, and the creation of more and more financial innovation to underwrite both the expansion of the debt and the aggressive financial leveraging. It has also resulted in the relative growth of the financial industry.

Many of these same commentators have remarked about how the financial sector has grown relative to the rest of the economy. For example, Paul Krugman in “Don’t Cry for Wall Street”, has written: “In the years leading up to the 2008 crisis, the financial industry accounted for a third of total domestic profits — about twice its share two decades earlier.” He then makes the value judgment that “the fact is that we’ve been devoting far too large a share of our wealth, far too much of the nation’s talent, to the business of devising and peddling complex financial schemes — schemes that have a tendency to blow up the economy. Ending this state of affairs will hurt the financial industry. So?” (See

Well, this is the financial industry that a government following the Keynesian economic philosophy has created. Two final comments: first, care needs to be taken in creating economic policies because the long run effect of the policies may not be what you want even though the short run effects are what you want; and second, once the size and structure of an industry has been created, it does not go away until the industry becomes technologically obsolete. The financial industry is thriving using information technology, a field that is just in its infancy. Finance and information technology have a long way to go.

Thursday, April 22, 2010

Washington Still Doesn't Get It!

The President and Congress just don’t get it!

Financial reform is in the air! The bad guys did it and they need to be brought to account! Protect Main Street and go after those that are on Wall Street!

Unfortunately, this is not going to produce the results that the President and Congress want.

Unfortunately, we are not going to get helpful results until the President and Congress develop an understanding about finance and what their current philosophies about economic policy are doing.

Unfortunately, I don’t see this happening in the near term.

Just two points this morning, but points that I have made before.

The first point pertains to the understanding…or misunderstanding…of what finance is all about. This misunderstanding is captured in the lead editorial in the New York Times this morning titled “After Goldman” ( In this editorial we read: “The Goldman deal was nothing more than a bet on the mortgage market…WITHOUT ‘INVESTING’ ANYTHING IN THE REAL ECONOMY.”

Guess what? That is what finance ultimately is. Finance is nothing more than information and millions and millions of people operate with this kind of information every day.

What is your dollar bill? A piece of paper…a piece of information.

Well, but it is legal tender!

Right, according to the government you have to accept a dollar bill in payment for debt. What has this got to do with THE REAL ECONOMY?

And, what about the demand deposit account you have at your commercial bank? It is just 0s and 1s in some computer. What has this got to do with THE REAL ECONOMY?

By the way, you are betting that you will be able to access that money when you need it? Is it safe?

Well, you say, the deposit account has insurance on it, doesn’t it? The Federal Government has guaranteed that you will not lose these funds and will not be inconvenienced by a delay in access to them. You have a promise! But, what has that got to do with THE REAL ECONOMY?

What are loans? Well, they are cash flows. Say, an initial cash outflow to the borrower and then a series of cash inflows back to the lender. Just 0s and 1s through bank accounts.

But, I put up a house to back the loan, didn’t I? The house is a real asset.

Yes, but the loan agreement is in terms of cash flows and the house is there for security in case you don’t pay the returning cash flow. Furthermore, that house is 25% underwater now, another piece of information, so how does this impact the cash flows?

Furthermore, it was the government that showed us how to “slice and dice” cash flows in order to tailor cash flows so that potential purchasers would find those “new” cash flows more attractive and purchase them. The first mortgage-backed security was issued by the Federal Government in 1970. The mortgage market went from playing a zero role in world capital markets to becoming, by the middle of the 1980s, the largest component of world capital markets. (See Michael Lewis’ “Liar’s Poker”.)

Thank you Washington for teaching us that cash flows are just bits of information! No real world

Now Washington wants to bring the herd of cats it has unleashed under control. Good luck!

The second point has to do with government policy and how it creates the environment for all else that goes on in the economy. Some of this discussion can be related to the David Wessel’s column in the Wall Street Journal this morning, “Mapping Fault Lines of Crises,” ( Wessel, in his column, discusses the work of Raghuram Rajan, a professor at the University of Chicago and former chief economist at the International Monetary Fund.

Rajan argues that “The U. S. approach to recession-fighting and its social safety net are geared for fast recoveries of the past, not jobless recoveries now the norm. That puts pressure on Washington to do something: tax cuts, spending increases and very low interest rates. This leads big finance to assume that the government will keep money flowing and will step in if catastrophe occurs.”

This philosophy of government was first incorporated into government policymaking in the early sixties and has continued as the foundation for economic policy ever since. A consequence of this has been that the purchasing power of the dollar has gone from $1.00 in January 1961 to $0.15 in 2010. And, as we know, a sustained inflationary environment is one that produces massive debt creation and increasing financial leverage along with extensive amounts of financial innovation.

This leads us to another part of Rajan’s argument: “As incomes at the top soared (in the last half of the 20th century), politicians responded to middle-class angst about stagnant wages and insecurity over jobs and health insurance. Since they couldn’t easily raise incomes, politicians of both parties gave constituents more to spend by fostering an explosion of credit, especially for housing.” And, Wessel states, Rajan goes back in history to support the fact that this is not an atypical reaction.

The latter move not only contributed to general inflation, but eventually led to asset price bubbles in specific sectors of the market which could not be sustained. Hence the financial crisis!

Finance has never really been connected to THE REAL ECONOMY. Take a look at Niall Ferguson’s book “The Ascent of Money.” (See my review, This is especially true since the growth in finance and financial innovation, historically, has been connected with government’s financing of wars and, in the 20th century, the social system.

Furthermore, finance, in the future, is going to be even more connected with the idea of information and the exchange of information. For example, see the book “The Quants” ( And, this concept is spreading beyond financial markets. An amazing amount of research efforts and publications are connected with “Information Markets” which are not related to financial markets. Bob Shiller of “Irrational Exuberance” has produced a lot in this area: see his books “Macro Markets” and “The New Financial Order.”

The point is, again, that the President and Congress are fighting the last war. But, the last war is history!

Monday, April 19, 2010

The New Way for the Fed to "Exit"?

Has the Federal Reserve begun its exit strategy? Has the Fed already started the “Great Undoing”? It has, but the new exit movement is not taking place in open market operations…or in repurchase agreements. It is occurring with the help of the Treasury Department. Let’s look at the line item on the Fed’s balance sheet titled “U. S. Treasury, supplementary financing account”.

The Federal Reserve defines the U. S. Treasury, supplementary financing account in this way:

“U.S. Treasury, supplementary financing account: With the dramatic expansion of the Federal Reserve's liquidity facilities, the Treasury agreed to establish the Supplementary Financing Program with the Federal Reserve. Under the Supplementary Financing Program, the Treasury issues debt and places the proceeds in the Supplementary Financing Account. The effect of the account is to drain balances from the deposits of depository institutions, helping to offset, somewhat, the rapid rise in balances that resulted from the various Federal Reserve liquidity facilities.”

Thus, this account is a deposit facility of the Federal Reserve similar to the U. S. Treasury, general account, the account that the Treasury conducts its general business from. Thus, it is a factor “absorbing reserve funds”, or, in other words, placing funds in this account removes reserves from the banking system. Hence, it contributes to the “exit” of the Fed from its inflated balance sheet.

I posted a note on this account on February 24, 2010 titled “The Treasury’s Latest Maneuver With the Fed”: In that note I described what was going on in the following way: “On September 17, 2008, the Treasury Department announced something called the ‘Supplementary Financing Program.’ Under this program the Treasury was to issue marketable debt and deposit the proceeds in an account that would be separate from the General Account of the Treasury at the Fed.

In September 2008, this account averaged almost $80 billion. In November 2008 it was above $500 billion. The account dropped to just below $200 billion in January 2009 and remained around that level into September 2009. The figure drops precipitously from there as the issue about the debt limit of the Federal Government had to be dealt with. In January and February 2010, the account averaged just $5 billion.

Now that the Congress has raised the debt limit on the government, the plan has been revived.

The original purpose of the Supplemental Financing Account was to get cash into the hands of those that needed funds and not have to go through the market system which would take more time and, perhaps, a greater amount of trading, to meet the peak liquidity demands in the financial crisis. That is, the Treasury had cash to spend out of this account that could go directly to those that needed the stimulus spending. This program allowed the Treasury to issue securities without going directly to the market and perhaps keeping interest rates from falling.

In the present case, the Treasury says that it is going to keep the cash proceeds from the borrowing on deposit at the Federal Reserve. If this is true, then it seems that what the arrangement is providing is more Treasury securities to the Fed to be used as the central bank reduces the amount of excess reserves in the banking system.”

In recent weeks a lot of activity has taken place in this account. As stated in the post on February 24, 2010, there were $5 billion on deposit in this account.

On March 3, this balance was just under $25 billion. The balance rose to about $50 billion on March 10, around $75 billion on March 17, and near $100 billion on March 24. Again it rose to about $125 billion on April 1, $150 billion on April 8, and $175 billion on April 15.

Obviously, the plan is for this account to increase by $25 billion every week until the Treasury reaches its stated goal of $200 billion in this supplemental financing account.

What impact has this had on bank reserves?

Well, on February 24, factors, other than reserve balances, absorbing reserve funds totaled $1.082 trillion. On April 14, this total was $1.320 trillion, an increase of $238 billion. Reserve balances at Federal Reserve banks declined from $1.246 trillion on February 24 to $1.061 trillion on April 14, a fall of $185 billion.

The latest information we have on excess reserves in the banking system indicates that for the two banking weeks ending April 7, excess reserves averaged about $1.094 trillion, a decline of about $100 billion from the average that existed for the two banking weeks ending February 24 of $1.092 trillion.

Thus, this “maneuver” accomplishes two things. First, it is connected with the issuance of Treasury debt to finance the huge budget deficits of the government. Second, the proceeds of the debt issuance do not stay in the banking system, but are withdrawn and put on deposit at the Federal Reserve so that excess reserves are drained from the banking system.

Therefore, the Federal Reserve, with the help of the Treasury Department, has begun to exit!

One could argue that these reserves are coming out of the banking system willingly. That is, the big concern associated with the “Great Undoing” is that the Fed would take reserves out of the banking system that the commercial banks really wanted to “hang onto.” If this were to take place we might get a replay of the 1937 actions of the Federal Reserve when it took excess reserves out of the banking system that the banks wanted to hold onto which resulted in the contraction of bank lending contributing to the 1937-38 depression.

Removing reserves in this way, with the help of the Treasury, might be a benign way to begin the “undoing” which can then be followed up by more traditional central bank operations using repurchase agreements and outright sales of securities. Also, it takes pressure off the Fed in that open market operations could just focus on the Fed’s holdings of U. S. Treasury securities leaving the Fed’s portfolio of mortgage-backed securities and Federal Agency securities free to just decline by attrition. The Fed has only about $777 billion in Treasury securities in its portfolio and, depending upon how much it needs to reduce the excess reserves in the banking system, would probably not want to be forced to use other other parts of its portfolio in removing these reserves.

So, we observe another financial innovation on the part of the government. Niall Ferguson has argued that, historically, governments have been the biggest innovator when it comes to finance. The reason? Governments have been the largest issuers of debt and have had to be very creative in finding new ways to place debt and to manage debt. Certainly in the last fifty years, governments have shown themselves very adept at coming up with new ways to spend money…and to finance this spending.

Friday, April 16, 2010

The Plight of Consumers

The “consumer” is spending. Retail sales jumped 1.6% in March led by auto sales, clothing and furniture. "There's a growing risk that we're underestimating the strength of the recovery," said Stephen Stanley, chief economist at Pierpont Securities, noting that deep recessions tend to be followed by steeper recoveries. "If the economy pops, it's going to be faster than anyone is forecasting." (From Thursday’s Wall Street Journal article “Evidence Mounts of Strong Recovery,”
The only reason I can give for this spending growth is that with interest rates being so low, some consumers just don’t want to hold onto financial assets. They would rather be spending their funds than keeping them in banks or other financial institutions earning practically nothing on their savings.

For sure, the consumer is not borrowing. Total consumer loans are down: according to the Federal Reserve, they declined by 4.4% in 2009. Total consumer loans are down, year-over-year, for the first quarter of 2010.

To keep up their spending, consumers are drawing on their accumulated wealth by reducing the funds they hold in time accounts at financial institutions, retail money funds, and institutional money funds. Again, according to Federal Reserve statistics, small-denomination time deposits at financial institutions are down by more than 22%, year-over-year, in March 2010. Retail money funds are down by over 27% in that same time period and institutional money funds have fallen by more than 19%. (Also see this article in the Wall Street Journal “Money Funds Decline Anew”:

We can track these declines in the non-M1 component of the M2 measure of the money stock.
Although the savings deposit total of the non-M1 component of M2 has increased by 13% year-over-year in March, all non-M1 M2 is showing a negative year-over-year rate of growth.

These funds are going into demand deposits at commercial banks and other checkable deposits at financial institutions. These are increasing, year-over-year, at a 14% and 20% rate, respectively.

Consumers are seriously moving their assets into transactions accounts as opposed to interest earning uses. The interest rates are just too low on these latter items to be attractive.

The consumers have used some of these funds to pay down consumer loans at banks and to reduce credit card balances. There is some indication that delinquencies are starting to moderate or even decline in this area. (See “Rocked by Bad Loans, Card Issuers Stabilize”:
Still, consumers are facing huge problems going forward with respect to the ownership of their homes. Estimates are that one out of five home owners are “underwater” now on their mortgages. Foreclosures continue to rise: in the first quarter of this year, 930,000 foreclosures were recorded, up 7% from the fourth quarter of 2009 and 16% above the first quarter of 2009. Records indicate that 6.0 million borrowers are more than 60 days delinquent on their loans.

This is putting tremendous pressure on the small- to medium-sized banks in this country. (See “Small Banks See Recovery A Bit Further Down Road”: The current practice seems to be: If you don’t make a loan, it can’t turn bad on you! It is hard to see consumer credit picking up soon.

I find it hard to be enthused by the numbers on retail sales, so I must be out-of-sync with these other economists that take away so much optimism from the March numbers.

One piece of information we don’t have with respect to these numbers. It is hard for me to imagine that a person out-of-work or under employed would take the liquid assets they have and spend it on cars, or clothes, or furniture, or restaurants. We still have close to 10% of the work force unemployed and close to 18% of the working age population under-utilized. And, some believe that under-employment could be closer to 25% because of reporting problems. I can’t imagine that these people are going in for “big ticket, discretionary items.”

People that have jobs, that have accumulated wealth, and that manage their assets well see that keeping money in assets that pay less than 2% annually is not very attractive relative to taking out a car loan which, according to Federal Reserve statistics, costs around 5%. In fact, it doesn’t appear that this type of person is very interested in keeping their money in financial assets that pay this little interest at all.

So, this would indicate that we are observing another way in which the American society is bi-furcating. Those that have the wealth and the jobs are continuing to spend, especially in the current interest rate regime that is being pursued by the Federal Reserve. Those that lack these supports are continuing to withdraw as they face the myriad financial difficulties the previous credit-inflation imposed upon them.

The big banks are booming relative to their smaller counterparts due to the interest rate policy followed by the Fed. Those with the wealth and jobs are also prospering relative to their counterparts due to the same policy.

Tuesday, April 13, 2010

The Recession Isn't Over Until It's Over

Yesterday, the members of the National Bureau of Economic Research’s Business Cycle Dating Committee refused to make a decision.

The questions: Is the Great Recession over or not?

The Answer: Too soon to call.

“The committee is very careful to guard against surprises,” the chairman of the committee Robert Hall stated. Since the designation of the end of a recession is important for historical reasons, the committee wants to make sure data revisions don’t result in the need to revise it’s claim that the recession is over.

To me, the crucial part of the comment here is the emphasis on “surprises.” We get into a liquidity crises because we are surprised. Something happens in the market, something that was not expected, like the financial difficulty of a firm that, say, had highly rated commercial paper which was now going to be down-graded. This down-grading then results in investors pulling back from the market because of a concern that the commercial paper of other highly rated firms will be down-graded. Buyers in the market take a vacation until confidence is re-gained in the information pertaining to these other highly rated firms.

A credit crises occurs when investors get concerned about the value of the assets on the books of a financial institution, something that had not been questioned before. This “surprise” is connected with the fact that the financial institution either did not recognize that the value of their assets had changed and so had not reported it to the market, or, the executives in the financial institution did not want to recognize that the value of their assets had changed and were attempting to keep this information to themselves hoping that this value would revert to earlier, healthier, levels.

“Surprises” generally occur when events, which had been heading in one direction, change direction. Like, when housing prices that had been rising decade after decade begin to fall. Or, when the Federal Reserve reverses monetary policy without notice after continually following a different path. Or, when the overly optimistic expectations given an industry, like the startups, are recognized as too optimistic.

“Surprises” hurt because people, investors, have to revise expectations and markets have to absorb the new information, dig for additional information relevant to current valuations, and then adjust as fully as possible to all of the new information.

That is why, at this stage of the economic drama, we hope that the problem areas where future surprises might arise have been identified and that people and institutions are working to resolve the difficulties in as orderly a fashion as possible. “Quiet is good!”

For example, we know that states and local governments are having problems with their finances. No apparent surprises here. People are working to resolve these situations, both locally and nationally. For example, we hear that Felix Rohatyn is back at Lazard Ltd., working on the problems related to state and local government finance. He has proposed “an IMF” to help American cities and states “stave off budget crises.” (
Greece is obtaining help. But, the problems of Spain, Italy, and Portugal are well known and efforts are underway to resolve the issues being faced by these countries.

The banking system does not seem to be out-of-the-woods yet, but banks have seemingly identified their problem areas and are working to resolve them. The FDIC continues to move in an orderly fashion to close those commercial banks that are insolvent. Again, quiet is good!
Here, the Federal Reserve seems to be playing an important role in helping the commercial banking industry to get back on its feet. Having injected a huge amount of reserves into the banking system and seeing these reserves hoarded by commercial banks to the tune of $1.1 trillion excess reserves, the Fed is being very careful not to “jerk” these reserves out of the banking system at too swift of a pace. The effort on the part of the Fed is not to “surprise” the banking system by removing the excess reserves too quickly in a fashion similar to the “surprise” 1937 Federal Reserve decision to raise reserve requirements to reduce the unused reserves in the banking system just sitting idly on the balance sheets of the banks.

And, other areas in the economy are seemingly being handled in a calm, orderly manner.

The Business Cycle Dating Committee does not want surprises. Well, I don’t want any surprises either! I want a dull, ordinary, business-as-usual environment for dealing with all we have to deal with.

My guess is that the recession is over. Markets, in general, seem to be reflecting this fact. Certainly there are areas of concern here and there and new data releases are not always positive. But, financial markets seem to be reflecting that the economy is improving, even if at a very slow pace.

My first inclination is to trust the markets. It doesn’t mean that markets are always correct, but one should look first to see what the markets are trying to tell us and then, only after sufficient study, should we claim that the markets might be wrong if we can justify this latter conclusion. Yes, I still believe in markets. But, like many other people, I am more cognizant of the existence of Black Swans in the world than I was at an earlier date. We can still be hit by “surprises” but, for now, things are moving in the right direction.

There are still longer run problems in the economy that need dealing with. I will not get into those now but interested people can go to two of my recent posts to pick up my thinking on this point: See and The existence of these longer run issues do not negate the belief that the Great Recession seems to be over.

The real question of this blog post is, does it matter whether this committee makes a decision or not? Robert Gordon, a member of the committee, has stated that delaying the decision “raises unnecessary questions about the health of the economy—that the whole committee wouldn’t think the recovery is strong enough to be able to say that it’s a recovery.”

Personally, I don’t think the committee’s decision is that important! It certainly is not going to impact my business and investment decisions.

Note: the Federal Reserve Bank of St. Louis has apparently already declared the end of the Great Recession. Check out all their charts. The grey area on the charts depicting the start of the recession begins in December 2007. The grey area on the chart, signaling the end of the recession, stops before the beginning of the third quarter of 2009. So much for that!

Monday, April 12, 2010

Financial Reform Is No Silver Bullet

These days I find it very hard to be on the same side of arguments with Paul Krugman. I must admit that today I am mostly in agreement with what Krugman has written in the New York Times. (“Georgia on My Mind”,

To begin with, Krugman asks the question: “What’s the matter with Georgia?” He raises this question because that Georgia has recorded 37 bank failures since the beginning of 2008 against 206 for the nation as a whole.

Why is Georgia different?

Georgia, he contends, was not a part of the housing bubble that saw home prices soar to the point that upon the collapse of prices, many home owners found themselves in a position of negative equity. Unlike many other states, Georgia had lots of land and few limits on expansion into empty spaces. As a consequence, Georgia, and especially Atlanta, did not see much of a rise in housing prices.

Still Georgia managed to create its own housing problem. Krugman states that “the share of mortgages with delinquent payments is higher in Georgia than in California” and “the percentage of Georgia homeowners with negative equity is well above the national average.”

The problem? “Georgia suffered from a proliferation of small banks.” And, these small banks were anything but conservative. “Actually, the worst offenders in the lending spree tended to be relatively small start-ups…”

These banks did not develop local deposit bases but relied on “hot money” from out-of-area investors. Their lending practices? New mortgage loans, subprime loans, and home-equity loans. Anything they could put on the books to generate fees and cash flows.

The prices of houses did not rise by as much in Georgia as they did in other states, yet the equity that people had in homes fell, and fell, and fell.

Krugman contends that the reason for this was the absence of consumer-protection regulation so that people could use their homes as “piggybanks” and almost continuously extract cash by increasing the size of their mortgages. He contrasts this behavior with Texas that also had lots of land and few limits on the expansion into empty spaces. Texas avoided the mess that Georgia found itself in because, according to Krugman, Texas had consumer-protection regulation.

This is where I differ slightly from Krugman in interpretation. To me the problem is that “Georgia suffered from a proliferation of small banks.” Too many banks were chartered to serve too limited a geographic area. The competition for loans was too great for the area. Real estate construction was expanding because it could get financed. People could continue to borrow because banks needed to push out money. The government was happy because more Americans were owning their own homes.

This was all a part of the general credit inflation of the past twenty years as more and more debt was created to support the movement of into housing. It came from an unlikely place: commercial banks.

If you would go back in history and ask bankers from the 1960s whether or not commercial
banks should hold more than 60% of their loan portfolios in real estate loans, you would have gotten an overwhelming vote of “NO!”

If one looks back at the 1960s, one finds that, for example, all domestically chartered banks held only 25% of their loan portfolios in mortgages or other real estate loans. Looking at the same figures for 2009 we find that all domestically chartered banks held 61% of their portfolio of loans and leases in mortgages or other real estate loans.

Commercial banks used to lend primarily to businesses. That is why they were called “commercial” banks.

Now domestically chartered commercial banks hold three-quarters of their loan portfolios in real estate loans and consumer loans.

We get a split according to size as well. Small commercial banks now hold almost 70% of their loans and leases in mortgages and real estate loans. The largest 25 domestically chartered commercial banks in the United States hold roughly 55%.

The largest banks hold 17% of their loan portfolio in consumer loans whereas the loan portfolios of smaller banks only contain about 9%. Adding the two numbers together results in both the big banks and the smaller banks holding around 75% of their loans in these categories.

Commercial banking has changed!

Since the 1960s, the mortgage market has become the place where commercial banks play. This is even more so for the smaller banks! And, Georgia represents our extreme example of this.

How did we get to where we are? A picture of this transition from the 1960s to now is presented by Michael Lewis in his book “Liar’s Poker”. The first mortgage pass-through security was issued in 1970. By the middle of the 1980s the mortgage market was the largest component of the capital markets worldwide. Lewis describes this part of the capital markets in his book.

I do agree with Krugman that some consumer-protection regulation is important in this world. But, it is not a panacea. And, along with other regulation of financial institutions it is not a “silver bullet” that will keep the United States from another financial crisis in the future.

We are hearing almost daily the things that the larger commercial banks are doing to avoid future regulation. Plus, it is my contention that these banks have moved well beyond what Congress is now working on to resolve financial crises. Furthermore, we are constantly bombarded by headlines like the one that appeared in the Financial Times this morning, “Banks seek to exploit new rules,”

And, as Krugman argues, “The case of Georgia shows that bad behavior by many small banks can do as much damage as misbehavior by a few financial giants.” Of the 8,000 small- to medium-sized banks in United States, about one in eight is seriously in trouble. This certainly is not the major part of the pie as these 8,000 or so banks make-up only about a third of the assets of domestically chartered commercial banks in the United States. The largest 25 banks control two-thirds of the banking assets in the country.

Conventional regulation is not going to do the job in this information age. (See my comments on this beginning with I have found a regulatory scheme I believe will work better than the ones currently being proposed. I will write on this scheme later this week.

Sunday, April 11, 2010

Bank Lending and the Banking System Remain Weak

Bank lending remained weak during March and the assets of the banking system, on average, continued to follow a downward path, resuming their decline from the November total after bouncing around for a month or two. Banking assets were down 5.8% in 2009 from 2008.

The commercial banking figures for the banking week ending March 31, 2010 were impacted by changes in accounts that were related to the adoption of FASB’s Financial Accounting Statements No. 166, Accounting for Transfers of Financial Assets and No. 167, Amendments for FASB Interpretation No. 46(R).

The first statement “improves financial reporting by eliminating (1) the exceptions for qualifying special-purpose entities from the consolidation guidance and (2) the exception that permitted sale accounting for certain mortgage securitizations when a transferor has not surrendered control over the transferred financial assets. In addition, comparability and consistency in accounting for transferred financial assets will be improved through clarifications of the requirements for isolation and limitations on portions of financial assets that are eligible for sale accounting.”

The second was aimed to bring FASB and IASB treatments together and “addresses the potential impacts on the provisions and application of Interpretation 46(R) as a result of the elimination of the qualifying special-purpose entity concept in Statement 166.” Ultimately, FASB and IASB will seek to issue a converged standard that addresses consolidation of all entities.

The overall affect: assets and liabilities that banks were holding “off-balance sheet” were brought back onto the balance sheets of banks.

The impact of the adoption of these rules is to increase certain asset and liability classes of commercial banks. In aggregate, domestically chartered commercial banks saw a net increase in assets and liabilities of $378 billion. The major asset items increased were consumer loans, credit cards and other revolving credit, an adjustment of $324 billion, and other consumer loans, an adjustment of $41 billion. The major memoranda items affected were securitized credit cards and other revolving plans which were reduced by $351 billion.

As one might imagine, these changes occurred primarily in the large domestically chartered banks which are defined as “the top 25 domestically chartered commercial banks, ranked by domestic assets.”

In the banking week ended March 31, total consumer loans increased by $321 billion and were up $364 billion from four weeks earlier. Small domestically chartered banks recorded an increase in total consumer loans by $46 billion in the banking week ended March 31 but increased by only $28 billion from four weeks earlier. The primary source of these adjustments came from how securitized credit card debt was treated on the balance sheets of commercial banks.

The result of this change was a $26 billion decrease in the residual (assets minus liabilities) of domestically chartered commercial bank, with most of the decline found in the large banks and not the smaller ones. That is, the capital of the banking system declined.

Taking these changes into account leads one to the conclusion that there was still little or no increase in consumer lending during this time period.

In other lending areas, the trends were still mostly down, especially in business loans. Commercial and Industrial loans were down by almost $26 billion over the last four weeks and were down $71 billion in the past 13-week period. Most of the former decline ($23 billion) was registered at the large commercial banks.

Real estate loans were roughly constant over the latest four week period although the smaller banks increased their portfolio of real estate loans by about $31 billion with $19 billion of the increase coming in commercial real estate loans. Home equity loans and residential mortgages both increased in the neighborhood of $6 billion.

Interestingly, real estate loans at large commercial banks declined by $32 billion with about $26 billion of the decline coming in commercial real estate loans.

One item we have been watching pretty closely has been the cash assets of the commercial banks. Over the last four weeks, commercial banks decreased their cash holdings by almost $180 billion. Only about $60 billion of this came in the large banks. A $30 billion decline occurred in the smaller banks, but foreign-related institutions in the United States reduced their cash balances by $90 billion. It appears that a large part of the latter decline came as these foreign-related banks reduced their borrowings from institutions other than banks.

In conclusion, if appears that lending was roughly the same as in past months. Commercial banks, as a system, are not lending much, if at all. Thus, the banking system is still not playing the role of underwriter of the economic recovery. We continue to wait for banks to become more open to making loans, especially to businesses. However, given our concerns about the solvency of the smaller banks, this may not occur any time soon.

The movement on the part of FASB to bring memorandum items onto balance sheets is a healthy move and long overdue. Efforts like this may still be an inhibiting factor as far as bank lending is concerned, but it is still vital for us to understand the financial condition of the banking system. Off-balance sheet items need to been brought into the light, just as the book value of assets needs to reflect the real market value of the underlying assets. The sad thing is that many banks (not all) have abused the trust of the public by manipulating their balance sheets. Until these abuses get cleaned up, we will not fully understand the state of the banking system and the decisions that are being made by these bank executives.

The more we learn about what bank managements have done…or, what they haven’t done…the more we fear that the real reason the Federal Reserve is not anxious to end its period of quantitative easing is to maintain the solvency of the banking system itself. Does the Federal Reserve need to maintain this policy of quantitative easy for as long as the FDIC needs to reduce the number of insolvent banks in an orderly fashion.

As I projected, the FDIC continues to close 3 to 4 commercial banks every week. I have argued that this pace may be kept up for at least 12 months if not more. Is the banking system really that weak?

Friday, April 9, 2010

Economic Recovery?

The front page of the New York Times reads, “Why So Glum? Numbers Point to a Recovery.” ( The economic recovery is at hand, yet, to many, even to many economists, something seems to be missing.

Unemployment remains high, but it is a lagging indicator. Consumer debt remains high and home foreclosures and personal bankruptcies continue to stay near record levels, but these tend to be lagging indicators. State and Local governments are on the edge, apparently faced with becoming the “next Greece.” (For example, this morning see “Los Angeles Faces Threat of Insolvency”,, and “Next ‘Big Crisis’ Is Unfolding in Muni-Bond Market”, But, these problems are related to the condition of the consumer and hence will not recover until the consumer recovers. Commercial banks are not lending, small businesses are not getting bank loans, and there are still concerns about the value of bank assets and the impending loan problems.

Floyd Norris, in his New York Times article, speaks about slow economic recoveries and attempts to put the current situation within the context of other post-World War II recessions. Within this context, he argues, the prospects for the current recovery are not that bad. When the economy is turning around, current data tend to be revised as more information becomes available and the recoveries, historically, appear to be “less slow” than they were during the time they were actually being experienced.

I believe that Norris is correct in his interpretation of where the United States economy is at the present time and how the data we are now receiving compares with the data relating to previous

What this misses, as I have tried to present over the past six-to-nine months, is that there are other factors at play in the economic developments of the past fifty years and this has created a situation that is not favorable to a strong economic performance in upcoming years…unless some things change.

One of those changes that are necessary relates to the inflationary bias of our government’s monetary and fiscal policies. As I have mentioned many, many times before, inflation is not helpful over the longer run and, in fact, over the longer run tend to hurt the very people the inflationary bias is aimed to help. The fact that the purchasing power of a dollar has declined by over 80% in the last fifty years has left the American economy is a very weak position. Long-term inflation has had an impact on the economy.

For one, inflation is supposed to help existing manufacturing industries. Yet, we have seen that over the past fifty years, the capacity utilization of United States industry has continuously declined with each peak reached in a subsequent period of economic recovery lying below the level of the previous peak. (See my post “The Trouble with Recovery,”

Inflation is supposed to help labor, yet the level of the under-employed has risen almost constantly during the last fifty years. As capacity utilization has declined, the “mainstream” laborer has found him- or her-self less and less trained to do something outside “mainstream” industry. Hence, the growing number of those that don’t “fit” into the twenty-first century industrial structure. It will be very difficult to put these people back-to-work on a full time basis.

The economy of the past fifty years has also relied on the strength of construction, especially the construction of houses. This area has received special attention in that the government has created many, many financially innovative ways to support this industry which has led to an inflation in real estate prices that has out-stripped those in other areas of the economy.

A consequence of this has been that most personal saving over the past fifty years was tied up in the value of a person’s home. People saved by investing in a home and then watching the value of the house continue to appreciate. This appreciation of home prices also allowed their owners the opportunity to borrow against the increased value of the house to maintain higher and higher living standards. Now much of this “wealth” has been destroyed.

And, the inflationary bias has led to a hurricane of financial innovation. The creation of debt and financial innovation thrive in an inflationary environment. The last fifty years has been a treasure-trove for those in the financial industry and the financial innovation that has resulted exceeds that of any period in the history of human-kind. The economy may seem unbalanced with the growth of the finance industries relative to the manufacturing industries, but that is what you get when you have fifty years of consumer and asset price inflation.

The theoretical underpinnings of the policies that have resulted in the inflationary bias of the last fifty years were built on two primary assumptions. The first is that the labor force must be kept employed in order to avoid revolutionary unrest. The second assumption is that foreign exchange rates would be fixed in value. (See my book review:

The model derived from these assumptions is “short-run” in nature. (Remember Keynes is quoted as saying “In the long run we are all dead.”) Policy making within this paradigm, therefore, focuses upon achieving short-run goals even if the long run consequences, as presented above, are detrimental to the people that are, hopefully being helped. Since the world is a series of short-runs, the problems resulting from previous “short-run solutions” will be offset at a later date. As we have seen, this does not happen.

In addition, since 1971 most of the world has been operating within a regime of floating foreign exchange rates. A country cannot isolate itself from other countries, in terms of the fiscal and monetary policies it follows, without repercussions. In the case of the United States, we have seen during this period of inflationary bias the value of the United States dollar has declined. The two periods in which this was not the case were those of the late 1970s-early 1980s, when Paul Volcker was the Chairman of the Board of Governors of the Federal Reserve System, and the 1990s, when Robert Rubin was an influential member of the Clinton Administration. Overall, however, the value of the United States dollar has declined during this period and is currently substantially lower, relative to other major currencies, than it was in the 1970s.

The policy focus of the United States government must change. To me, Paul Volcker had it right when he argued that “a nation’s exchange rate is the single most important price in its economy.” Consequently, he argued that a government cannot ignore large swings in its exchange rate. A country’s exchange rate reflects how international markets interpret the inflationary stance of the monetary and fiscal policy of a government. In the future, more emphasis must be placed upon this price in making policy decisions for the United States no longer dominates the world the way it did in the past.

Second, the policy focus of the United States government must move away from employment in legacy industries. A recent research paper by Dane Stangler and Robert Litan, “Where Will the Jobs Come From?”, published by the Kauffman Foundation, emphasizes that “nearly all” of the jobs created in the United States from 1980-2005 were created in firms less than five years old. By focusing on legacy industries in determining its economic policy, the federal government is just fostering an environment in which under-employment is going to continue to grow. This is not healthy for the future of the American economy, especially as emerging nations around the world are focusing on the future and not the past.

Wednesday, April 7, 2010

Mr. Geithner Goes to China

Treasury Secretary Tim Geithner will meet Thursday with Wang Qishan, the Chinese Vice-Premier responsible for economic affairs. The agenda of the meeting is unknown. At least one probable subject of discussion is the exchange rate policy that has been followed by China in recent years.

The word of the street is that China may widen the daily trading band for their currency and allow the renminbi to trade over a wider range. This could allow the currency to gradually appreciate against the dollar, present China as a cooperative partner in global trade, and help to build for more open world trade going forward.

It is reported that “The Chinese foreign ministry would adhere to three principles on currency policy: any change must be controlled, it must be Beijing’s own initiative and any shift must be gradual.” (See “Geithner heads to Beijing for talks”:

This points to the fact that the major issue here is a political one, not an economic one. China is on the upswing in the world and is playing out its options “close to the vest.” It is bargaining for the long run, and those that see the world only as a series of “short-runs” fail to understand the Chinese mind.

In a recent post, “Why should China Change,”, I wrote: “One piece of advice some people gave me several years ago about the Chinese has proven to be very perceptive. They said that whereas people in the West have very short time horizons, generally in the three to five year range or less, the Chinese have a much long perspective of history. They think in decades rather than years.”

As a consequence of this the Chinese do not want to rush into anything, any new arrangement, without a full consideration of the implications of what they are about to do. Again, from my earlier post, “My guess is that China does not plan to overdo it for they have more to gain in the future if trade is more open than not. I believe that the Chinese know that they will be better off over the longer run if world trade is more open rather than more restricted. Hence, they will not go far so as to create a trade war that will be detrimental to achieving a more open world trade. China’s investments in natural resources and companies throughout the world underscore this bet.”

And, the United States? “The United States is in a weakened position. Thus, the Chinese can achieve more now by taking advantage of this weak position and still achieve the longer-term goal of more open trade. The United States is in no position to resist this and will not be in a position to resist this for some time. And, it would hurt us more to act aggressively at this time to introduce more trade protection than it would China. Hence, advantage China.”

Yet, China does not want to “overplay” its hand.

The meeting this Thursday is a positive sign. The word is that “The secretary and the vice-premier have been working together to find an opportunity for some time,” according to a spokesperson for Secretary Geithner. Geithner, being right next door in India, found it very convenient to arrange a side trip for such a meeting.

As stated above, no agenda was reported for the meeting and there is no expectation that a statement will be issued when the meeting ends.

Still, leaders at this level don’t just agree to meet unless there is something going on. Furthermore, in recent months “conciliatory gestures” have been made by both sides. And, there was the April 2 telephone conversation between the presidents of China and the United States, a conversation that “reached an important new consensus” between the two parties according to the Chinese minister for foreign affairs.

Stephen Green, an economist with Standard Charter in Shanghai, was reported by the Financial Times to have said that “Some grand bargain between the US and Beijing appears to be in the works, if it hasn’t already been struck.”

As a prelude to the meeting, Geithner stated on television on Tuesday that the decision to revalue the renminbi was “China’s choice”. He also added that he believed that China would see that it was in their long run interest to work with a more flexible exchange rate policy in the future.

So, it seems that the pieces are in place and the meeting is at hand.

The bottom line is that it is in the interest of the United States to take a longer run view of things. For the past fifty years or so, the emphasis of the United States economic policy has been on the short run. As a consequence, the United States has focused undue attention on current levels of unemployment, short-run growth projections, and temporary fixes to markets and industries and, in the process, has established an inflationary-bias to monetary and fiscal policies that has produced more than an 80% decline in the purchasing power of the dollar. Individuals and families found that in such an environment the best way they could save was to buy a home and watch the value of the house appreciate. They didn’t need savings because their net worth was rising with the price of their home.

This short-run focus produced mounting deficits that had to be financed off-shore since Americans, themselves, were not producing the savings necessary to fund them. Thus, the rest of the world helped to finance the inflationary binge and now we in the United States have to bear the burden of this myopia.

We can see now that a nation with a longer-term focus can trump a nation that just focuses on the short-run. If the United States is going to match up with China, and with other rapidly emerging nations in the world, then it, too, will have to lengthen its perspectives to the longer-run. Perhaps we are seeing this change in the progress that has been made leading up to this meeting.

And, maybe this gives us another picture of the underlying operating process of the Obama administration. In the current issue of Time magazine, Jon Meacham comments on “The New Book on Barack Obama,” titled “The Bridge” by David Remnick, the editor of the New Yorker. Meacham writes that Obama has a recognition that “politics (and life) is in the end more about the journey than the destination, since no destination is ever really permanent.” And, he argues, the president is “a patient man because journeys require patience” and this “helps explain his understated doggedness.”

If this administration is truly working from a longer-run perspective, maybe this is one reason that many of his critics, who have just a short-term myopia relating to policy and achievements, are so unhappy with him. We shall see.

Tuesday, April 6, 2010

Future Long Term Treasury Rates

The ten year Treasury yield hit 4.00% yesterday, a level not hit since June 6, 2009. Then one has to go back to October 31, 2008 for the next time this yield hit the 4.00% level. The big question is, of course, where is the rate going to go from here?

Many experts claim that the outlook for longer term interest rates depends upon what is going to happen to inflationary expectations in the financial markets. With the Consumer Price Index for All Items hovering around the 2.0%-2.5% range, year-over-year, and the CPI less Food and Energy at the 1.0%-1.5% range, year-over-year, actual inflation is extremely low given the experience of the past 50 years or so.

So, what is the market anticipating in terms of inflationary expectations for the next ten years?

If one uses inflation-indexed government bonds as an estimate for the real rate of interest, then for a ten-year Treasury security the market seems to be estimating that the real rate of interest is now around 1.50%. If so, then with the nominal 10-year Treasury security around 4.00%, one could say that the market expects inflation, over the next ten year period to run about 2.5% or approximately at the upper end of the current range for the CPI for all items.

However, one could argue that the Treasury market has been the beneficiary over the past 15 months or so of two unusual forces, both connected with the financial collapse that began in the fall of 2008 and continue to this day. The first of these forces is the huge amount of funds that have flown to the United States and to Treasury securities connected with the “flight to quality” from the rest-of-the world. This “flight-to-quality” began in late 2008 and continued throughout most of 2009 with lapses here and there.

The second factor is the quantitative easing on the part of the Federal Reserve. This has helped to sustain very low market interest rates, long-term as well as short-term. The quantitative easing has also been accompanied by the Fed’s huge purchase program of mortgage-backed securities and Federal Agency securities that have provided a substantial amount of liquidity to the financial markets.

Both forces have resulted in Treasury yields that are substantially below what I would consider to be normal on a historical basis. And, these forces have impacted the inflation-indexed securities as well as the nominal-yield securities. Expected real rates of interest just do not drop to the level that the inflation-indexed securities have fallen to.

Historically, for the last fifty years, the estimate I have used for the real rate of interest tends to be around 3.0%. I won’t argue with 2.8% or with 3.2% because that is not the crucial issue. Before the 1960s, the real rate of interest seemed to be about 2.5% due to the slow growth period of the 1950s and this helps to account for nominal interest rates being so low throughout most of that period of time. Beginning in the sixties, however, the higher, 3.0% rate, seems to provide a relatively better estimate for the “expected” real rate of interest.

If one assumes that the “expected” real rate of interest for the next ten years is 3.0%, then one could argue that the current “realized” real rate of interest from the inflation-indexed securities resulting from the international “flight-to-quality” and the quantitative easing of the Federal Reserve is 150 basis points below what it otherwise would be.

Carrying this argument further, one could argue that the nominal 10-year Treasury security should be around 4.50% once the influence of the foreign “risk-averse” money and the Federal Reserve easing is accounted for. This would imply that the inflationary expectations built into the Treasury yield by the financial markets was about 1.5%, a figure that is at the high end of the current rate of inflation indicated by the CPI less food and energy costs.

But, you could go further than this. The Fed and Ben Bernanke have stated that the “informal” inflation target of the Federal Reserve is about 2.0%. If it is assumed that the Fed is able to contain inflation at this 2.0% level for the next decade, then one would assume that the 10-year Treasury yield should be around 5.0% to reflect an expectation of inflation of about 2.0%.
If the market believes that in the long run, the costs of food and energy should be accounted for in inflation, then, assuming that the upper bound of the current rate of CPI inflation for All Items, 2.5% is achieved over the next 10-years, then inflationary expectations should be at this level and the nominal 10-year Treasury yield should be around 5.5%

Of course, there is another body of thought that looks at the $1.1 trillion of excess reserves in the United States banking system and contends that there is no way the Fed will be able to remove these excess reserves from the banking system before bank loans expand excessively, money stock growth becomes extremely rapid, and inflation becomes a major problem again. To these investors, the assumption of inflationary expectations of 2.5% is ridiculous. Consequently, even a 5.5% 10-year bond rate seems excessively low.

One can argue that, as in the decade of the 2000s, many foreign countries have helped to finance the United States deficit and, as a consequence, and this has also kept United States interest rates lower than perhaps they would have been otherwise. Some analysts believe that this will continue. One can argue from many different sides of this argument for a specific level of interest rates relative to expected real rates plus inflationary expectations. I don’t really find this “supply of funds” argument convincing.

I believe that long term interest rates are headed up. How far they will go depends upon a lot of things, some of which I have tried to present in this post. If the economy continues to strengthen, I feel that the 10-year yield on Treasury securities should, over the next two years, be closer to the 6.00% level than the 4.5% level. There, I am on the record.

Friday, April 2, 2010

Federal Reserve Exit Watch: Part 9

The operating statement of the Federal Reserve is getting downright boring these days. Thank goodness! It brings back memories of the good old days when nobody really cared much about the Fed’s balance sheet or what the Fed was really doing operationally.

I remember calling a friend of mine at the Fed in February 2008. I had a question. There was a new thing called “Central Bank Liquidity Swaps” and I was trying to locate where it was on the Fed’s H.4.1 release, the “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.” At that time, because it was brand new, it didn’t have a separate line item to indicate what the Fed was doing with currency swaps with other central banks. I presumed that the numbers were added into the account “Other Federal Reserve Assets” which had changed substantially in recent weeks and was, formerly, just a miscellaneous collection of a number of different unimportant accounts.

After confirming that the “Other Federal Reserve Assets” contained the information on “Central Bank Liquidity Swaps”, my friend asked me why I was interested in writing about this in my new blog. “Nobody is interested in the Federal Reserve statement. You are just wasting your time!” he said.

Obviously, over the next 24 months or so, a lot of people got interested in the Federal Reserve statement. If we want to talk about financial innovation in the last twenty or thirty years, what happened inside the Fed during this period of time certainly represents some of most important “financial innovation” that took place. To not watch what the Fed was doing with its balance sheet was to miss a large part of the show.

Now, that show is coming to a dull close. Again, we can be very thankful for this. In the banking sector, “DULL IS GOOD!”

First, the Fed had supplied approximated $2.349 trillion in funds to the commercial banking system on March 31, 2010. I estimate that at most $200 billion of these funds are related to the special programs that were created over the past two and one-half years, only about 8.5%. These $200 billion in assets will slowly trickle off the Fed’s statement and will cause very little impact, if any, on the banking system or on financial markets. Good riddance!

Of course, the other $2.1 trillion in funds that the Fed has supplied to the banking system still looms over the financial markets and the economy because almost $1.1 trillion of those funds are residing in commercial bank reserve balances at Federal Reserve banks. In other words, the commercial banking system possesses about $1.1 trillion in excess reserves.

But, the situation is “boring” now because on March 31, 2010, the securities portfolio of the Federal Reserve amounted to slightly more than $2.0 trillion: $777 billion in U. S. Treasury securities; $169 billion in Federal Agency debt securities; and $1,069 billion in Mortgage-backed securities. The removal of funds from the banking system in the Federal Reserve exit strategy, we are told, will come from selling these securities through outright sales or, initially, through repurchase agreements. This is where most of the action will be in the future.

There is another vehicle that the Federal Reserve has cooked up with the U. S. Treasury Department to drain some reserves from the banking system using an account of the Treasury’s at the Fed. This is the “U. S. Treasury, supplementary financing account” and it appears as a liability of the Federal Reserve. (See my post of February which describes this facility: An increase in this account absorbs funds from the banking system so it can be used to remove reserves along with the Fed operations in its securities portfolio.

At the end of 2009, this supplementary financing account was at $5.0 billion. The Treasury Department had to wait until Congress raised the United States debt limit before it could again rebuild this account. The account has risen by $120 billion since December 30, 2009 and by $100 billion since March 3, 2010. This has helped to keep reserve balances at the Fed relatively constant since the end of the year while the Fed was, at the same time, supplying reserves to the financial markets during this time by buying mortgage-backed securities.

So, in the last 13-week period, the financial markets were relatively calm, the commercial banking system was peaceful, and the Fed did practically nothing except buy $160 billion more mortgage backed securities. The question is, “Is this the calm before the storm?”

No one knows how the “Great Undoing” is going to proceed. The Fed has stopped buying mortgage-backed securities as it promised it would do. There has been some reaction in the financial markets (See “Mortgage Risk Premiums Widen”: Mortgage rates have also risen. We are told that “A lot of people are observing what’s going to happen now that the Fed is actually out.”

Now the waiting begins. The Fed has confirmed that it will continue to keep its target interest rate range at current levels for the near term. There are still many uncertainties in the economy that are keeping the Fed from removing the reserves from the banking system and raising its target interest rate range. One of these, of course, is the state of the economy. Economic growth continues to remain anemic, although it seems to be picking up, and the unemployment rate continues to hover around 10.0%.

Furthermore, the health of the banking system, itself, remains questionable as about one in eight banks remain on the problem bank list or near to it. Bankruptcies continue to rise ( as do foreclosures on homes. We are still waiting to see how the commercial real estate industry works through the next 12 months or so. The Federal Reserve does not want to remove reserves from the banking system if the banking system “wants” to keep those reserves to protect itself during the continuing financial workout period.

The Fed is now as ready as it ever will be to execute its “Great Undoing”. We continue to need to watch the Fed’s balance sheet to observe what the Fed is actually doing with its portfolio of securities and how the Treasury Department is contributing to the removal of reserves through the manipulation of its supplementary financing account.

As with the banking system itself, the thing to hope over the next year or so is for in the actual execution of the Fed’s exit strategy to be accomplished in an orderly fashion. Keep your fingers crossed!