Tuesday, August 31, 2010

The World Continues to Move to Smaller and Faster

Given all the headlines about double-dip recessions, consumer and business de-leveraging, and unemployment it is good to get back to some basic trends that, in my mind, are not going to change.

On the front page of the New York Times we read “Advances Offer Path to Shrink Computer Chips Again” (http://www.nytimes.com/2010/08/31/science/31compute.html?ref=todayspaper). “Scientists at Rice University and Hewlett-Packard are reporting this week that they can overcome a fundamental barrier to the continued rapid miniaturization of computer memory that has been the basis for the consumer electronics revolution.” And to the revolution in the waging of war and keeping of secrets, on advances in finance and business technology and so on and so on.

The problem had been that “the limits of physics and finance faced by chip makers had loomed so large that experts feared a slowdown in the pace of miniaturization that would act like a brake on the ability to pack ever more power into ever smaller devices…”

The new method, discovered at Rice University “involves filaments as thin as five nanometers in width…”

“Separately, H. P. is to announce on Tuesday that it will enter into a commercial partnership with a major semiconductor company to produce a related technology that also has the potential of pushing computer data storage to astronomical densities in the next decade.”

These discoveries, if they prove successful, will help to maintain Moore’s Law, the idea that industry can roughly double the computing power of chips every 18 months, and the Storage Law, the idea that industry can roughly double the amount of data that can be stored every two years. These capabilities have been the back-bone of computing power for the past fifty years or so.

Trends like these are going to continue because there is too much to be lost if they do not. For one, governments cannot allow their countries to fall behind in the development of computing power. There are two reasons for this: first, governments need to keep secrets and so must be able to keep others from breaking codes; second, powerful governments must continue to be able to kill people better than other governments in order to maintain their position in the world. Thus the United States government must continue to finance the development of these capabilities. This is why one can continue to expect the development of a fully operational quantum computer in the next decade.

As with the Eniac computer that was developed in the 1940s to improve the accuracy of firing
shells into the enemy, military needs come first, business benefits follow.

It is my belief in the continuation of such trends that lead me to suggest such things as the ineffectiveness of the newly minted financial regulations even before they become operational. Finance is information. This became apparent in the 1960s when the new computer technology produced faster and faster computers and also produced computers that had the ability to store massive amounts of data from the stock markets. This led to a new industry…quantitative finance. The boom in finance Ph. D.’s got its start with the portfolio theory and CAP-M models developed in these years as it became evident that lots and lots of dissertations could be written given all the data that were now available to researchers.

This industry only grew as computers got faster and data storage capacities continued to increase. And, since we were only dealing in information and the manipulation of information, it became apparent that people in this field really did not need to know much finance because the crucial talent became mathematical model building and data mining. Consequently, backgrounds in physics and mathematics became very useful and the application of Information Theory to data streams provided a source for understanding signals that otherwise appeared to be “white noise.” (A readable source for all these developments can be found in the book “The Quants”: http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson.)

This financial engineering continues. This is why I believe that the financial reform package has been legacy from the start. The organizations that the financial reform package are supposed to regulate are, in many cases, already beyond the current legislation, and if they are not yet beyond it, the technology is such that they will be soon.

Is financial innovation going to continue to take place? Yes, and, in fact the pace at which it occurs will accelerate. And, this financial innovation is serving as a model for other markets, even for goods and services. This development is related to what is called “Information Markets” and, with the growth in computing power and the expansion of data bases, these markets are going to become more and more a part of how people transact in the future. (Note for example the new commodity ETF called U. S. Commodity Index Fund (trading symbol USCI). http://professional.wsj.com/article/SB10001424052748703418004575456221354231844.html.The economist Robert Shiller (author of Irrational Exuberance) has written path-breaking work in this area.)

Such developments have led to a boom in employment in the finance industry over the last forty years. This relative shift in employment will continue well into the future because it is information based and the use of information technology is going to spread and prosper.

This is why one person, Andy Kessler, a former hedge fund manager, has suggested (tongue-in-cheek) that one way turn the economy around is to import people that would buy homes. He writes: “I would wager there is a backlog of high-paying jobs for educated foreigners well beyond what H1-B visas allow to trickle in. In the name of financial stability, create a million visas for qualified immigrants, say, those with a masters or Ph. D., and watch home prices start to rise.” (http://professional.wsj.com/article/SB10001424052748704147804575455951017059416.html?mod=WSJ_Opinion_LEFTTopOpinion&mg=reno-wsj)

The important distinction here is that Kessler is writing about “educated foreigners” and not unemployed Americans. This seems to be an issue that many analysts are bringing up these days. The jobs that are available for workers are not the jobs that many of the unemployed or underemployed in the United States are able to fill. And, I don’t perceive that there will be a slowdown in the advancement of computing power and other technologies in the future which leads one to conclude that unless something is done about education and training, the United States workforce is going to bifurcate even further between those that can work productively in the 21st century and those that cannot perform at this level. Programs of fiscal stimulus that puts people back into the jobs they formerly held will not succeed only attempt to re-create the past.

Technology will evolve to produce “things” that are smaller and faster and these “things” will be used more and more in the creation and production of “information goods”. Furthermore, the speed at which these advancements take place will continue to accelerate. Organizations set up to operate within the past, like labor unions, are going to have to change and adapt to this environment. Otherwise, they are more of a dis-service to their constituents than a help. But, that is the future.

Monday, August 30, 2010

National Discipline or the Lack Thereof

I read with dismay an editorial piece in the Financial Times this morning entitled “Germany’s rebound is no cause for cheer,” (http://www.ft.com/cms/s/0/2becafc4-b398-11df-81aa-00144feabdc0.html) by Wolfgang Mϋnchau. The conclusion of the piece: “Germany’s economic strength is likely to be persistent, toxic and quite possibly self-defeating in the long-run.

Germany’s economic strength is likely to be persistent because it is more disciplined than other countries in the Eurozone. The German fiscal budget is more under control than is that of other Eurozone countries, especially those on the periphery like Belgium, Italy, Greece, Spain, and Portugal and German wage moderation is significantly different from these other areas. This discipline is likely “to be persistent.”

Germany’s economic strength is likely to be toxic because the adjustment mechanisms do not seem to be in place within the European Union because it seems that “it remains surprisingly hard to shop cross-border in Europe and “the European labour market remains almost perfectly fragmented.” Furthermore these “peripheral” nations seem to lack the fiscal discipline of the Germans and they seem to be more dependent upon labor unions and those receiving “social benefits” than do the Germans. After years of giving out substantial “social benefits” to their people and after years of credit inflation to stimulate local economies and “keep the dance going” the politicians of these nations are not going to back off what has kept them in office in the past. Without changing their path, the peripheral nations will continue to suffer relative to the Germans and will continue to identify the Germans as the real problem-maker.

And, according to Mr. Mϋnchau, Germany’s economic strength is likely to be “quite possibly self-defeating in the long-run” because the European Union cannot allow these imbalances to continue and still keep the Union together. That is, Germany must become like these other countries or the political union will fall apart. Thus, by continuing to maintain its self-discipline, Germany could cause the dissolution of the European Union which would not be beneficial to it in the long-run.

I am very uncomfortable with this argument.

This argument, to me, says that in playing golf I should not work several hours every day on the practice range hitting ball-after-ball-after-ball, and I should not play several rounds of golf every week against very competitive golfers, and I should not practice my putting for each day for a lengthy period of time, and I should not train in the gym or run 35 miles every week to develop my physical conditioning, and I should not watch my diet and weight. Such discipline gives me an unfair advantage relative to those that are not willing to maintain this kind of discipline. My efforts will cause the resulting inequality in performance “to be persistent, toxic, and quite possibly self-defeating in the long-run.” Thus, I should not practice, etc..

Discipline, in the longer-run, conquers lack of discipline.

Now, I am not advocating the making of discipline into an idol. It is just that in order to achieve other goals and objectives, hopefully good goals and objectives, discipline is an important factor helping one to accomplish these other things.

One problem that arises when one fails to maintain self-discipline is that other problems often arise making it even more difficult to re-establish discipline when you try to get your life back in order. That is, a lack of discipline can make it just that much harder and painful to become competitive when one finally reaches the stage that getting back in the game is a vitally important goal.

The United States, to me, is an example of a nation that has lost its self-discipline. But, this loss is not just a recent problem. The movement in this direction began in the early 1960s and has been going on for about fifty years. Beginning in January 1961, the Gross Federal Debt has increased at a compound rate of more than 7 percent every year up to the current time. Inflation became such a problem that wages and prices were frozen in August 1971 and an extremely restrictive monetary policy had to be enforced in the late 1970s.

Economic leadership of the United States currently rests in the hands of individuals that were an instrumental part in the excessive credit inflation of the 2000s. Ben Bernanke was a member of the Board of Governors of the Federal Reserve System and a vocal supporter of Alan Greenspan’s move to keep the Federal Funds target rate around one percent in 2003 and beyond, having joined the Board in 2002. Timothy Geithner became President of the Federal Reserve Bank of New York in 2003. This position has a permanent vote on the Open Market Committee, so that Geithner was in on all votes during this time as was Bernanke. After a short stint as the Chairman of the President’s Council of Economic Advisors in 2005-2006, Bernanke became Chairman of the Board of Governors of the Federal Reserve System in February 2006. Geithner moved from the New York Fed to become Treasury Secretary in January 2009.

These two leaders, arguably the most important leaders in economics and finance in the United States government, have held top positions and been voting members of policy boards during one of the most un-disciplined times in United States history. And, their lack of discipline continues, as is evident by the speech given by Bernanke last Friday at Jackson Hole, Wyoming. The only policy that these two people follow is one of throwing everything they can at a problem and seeing what works.

The problem is that their interest rate efforts in the 2003 to 2005 period led to a housing bubble and stock market bubble which resulted in the collapse of the sub-prime market in 2006 and 2007. Their response to this break-down resulted in the financial disaster of the 2008 to 2009 period when the government threw just about everything it could at the disaster in order to try and avoid worse. We are now in 2010 and the evidence of the lack of discipline is still around us. Consumers are plagued with debt fostering record numbers of foreclosures and personal bankruptcies. Businesses are overwhelmed with debt, not only with high-yield bond debt but also with commercial real estate loans and foreclosures and bankruptcies are also high in this area. State and local governments are piled high with debt and we find that states and cities are cutting back on the most basic of services including the release of fire fighters and police. And, the federal government faces budget deficits that some estimate will result in $15 trillion or more in additional debt over the next ten years.

The United States has lived off of its position as Number One economic and military power for years and this has allowed it to be so profligate. Only China, in my lifetime, really seems as if it might be a potential threat to this position.

This lack of discipline has shown up in one spot, however. Since the United States dollar was floated in August 1971, it has declined by about 40 percent in value. There were three periods within this time frame when this general trend was challenged. First, was during the time that Paul Volcker headed the Fed and caused interest rates to reach post-World War II highs. Second, during the Clinton administration as the federal budget moved into surplus territory. Third, during the financial crises when the world seemed to be falling apart and there was a “flight to strength.”

In my book, history shows that discipline wins over the longer run. The United States is struggling because it lost its self-discipline. The criticism of Germany presented above shows the mentality in the west that is indicative of this undisciplined approach to living in the world today.

Friday, August 27, 2010

Bernanke in the Hole

"Regardless of the risks of deflation, the FOMC
will do all that it can to ensure continuation of the economic recovery."

Ben Bernanke, Chairman of the Board of Governor of the Federal Reserve System at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming, August 27, 2010.

Translation: Over the past three years or so, I have led the Federal Reserve in throwing everything it can against the wall to see what would stick. I will continue to do so in the future!

May I quote my post of August 12 (http://seekingalpha.com/article/220224-does-the-fed-even-know-what-it-s-doing-anymore).

"The Federal Reserve has two basic problems right now. First, those running the Fed don’t seem to know what they are doing. Second, they are doing a terrible job explaining this to the world.

Never have I seen such confusion in such an important institution. Never have I seen such inadequate leadership.

We have experienced the end of the Fed’s exit strategy, the effort undertaken by the Fed to reduce the size of the Fed’s balance sheet. The exit strategy was designed to reduce the massive amounts of reserves pumped into the financial system by the Fed so that a period of hyper-inflation would not result. That exit strategy saw the Fed’s balance sheet grow by $331 billion over the twelve-month period the “exit” strategy was in place. Excess reserves held by the banking system rose by 38% during the same time period. (Details here.)"

I see nothing from the current speech to clarify the situation!

Thrift Industry News--Down Again

The Office of Thrift Supervision (OTS) released statistics on the state of the thrift industry for the second quarter of 2010 on August 25. The industry is limping along, but the signs of a disappearing industry are all over the report.

The cloud over the whole industry is that the OTS will be merged into the Office of the Comptroller of the Currency (OCC) in the upcoming year. (See my post “So Long to the Savings and Loan Industry”, http://seekingalpha.com/article/214460-so-long-to-the-savings-and-loan-industry.) This, of course, is impacting decisions and affecting performance.

Two major figures stand out.

First, industry assets decreased by 15 percent from the second quarter of 2009 to the second quarter of 2010 to $931 billion from $1.1 trillion. From the second quarter of 2008 to the second quarter of 2009, industry assets fell by 27 percent from $1.51 trillion to $1.1 trillion.

Second, the number of supervised institutions declined from 792 thrifts at the end of the second quarter of 2009 to 753 at the end of the second quarter of 2010, just about a 5 percent decline. Yes, there have been thrift failures, but there has also been the constant drop in the number of thrift institutions in existence due to thrift conversions into commercial banks. This latter trend is expected to accelerate as the merger with the OCC proceeds.

One other interesting structural fact concerning the thrift industry I would like to mention. Of the 753 thrift institutions that exist, 402 of these thrifts are owned by 441 thrift holding company enterprises. These 402 thrifts have assets totaling $714 billion which represents 77 percent of all thrift assets. But, one should also note that these thrift holding companies control approximately $4.1 trillion in United States domiciled consolidated assets.

Note that at the end of the second quarter of 2009, there were 459 thrift holding companies supervised by the OTS and these institutions control $5.5 trillion in U. S. domiciled consolidated assets. The decline from this figure to the second quarter 2010 figure is over 25 percent.

Just in comparison, according to the National Credit Union Association, there are close to 7,500 credit unions in the United States, down about 250 from the same time in 2009. However, assets at these credit unions totaled almost $900 billion at the end of the first quarter of 2010, up just about 5 percent from the end of the same quarter in 2009. Total shares and deposits at credit unions rose by 6.7 percent, year-over-year, to a little over $773 billion. The credit union industry continues to grow and in many areas of the country, Philadelphia for one, major expanded credit unions are becoming a force in the local banking markets.

Overall, in the aggregate data released by the Federal Reserve, deposits at all thrift institutions, including credit unions, rose by 0.5 percent from July 2009 to July 2010. The conclusion one can draw for these numbers is that funds are leaving the OTS regulated thrift institutions to go to commercial banks and credit unions.

It is going to be very interesting to watch the credit union sector over the next several years. The interesting question here is whether or not the larger, expanding credit unions can pick up the consumer funds that are leaving savings and loans, savings banks, and commercial banks. Could the banking industry bifurcate into primarily “business” banks and “consumer” banks?

Given all the other factors that are impacting depository institutions one can safely say that the whole landscape of banking and finance is going to change dramatically over the next five to ten years.

Thursday, August 26, 2010

The Drag Caused by American Household Debt

Today I would like to reference an article by William Galston on the website of the New Republic (http://www.tnr.com/blog/77215/getting-out-the-recession-stimulus-spending-debt-banks).

Galston’s point is this: the value of assets on the balance sheets of households in the United States has declined relative to the amount of money owed by these same households.

To quote Galston: “As the value of assets used as collateral collapses, so does borrowing. This depresses consumption (because the real net worth of households has declined), and the real economy dips, making it much harder for businesses and households to service the debts incurred during boom times. Household consumption remains sluggish until debt is reduced to a level that can comfortably be serviced out of current income, a process that cannot proceed without an increase in the household savings rate. The larger the debt overhang, the longer it will take to work off the excess.”

The figures Galston quotes: in late 2007, household debt was $12.5 trillion which was 133 percent of disposable income. In the first quarter of 2010, total household debt had declined to $11.7 trillion around 122 percent of disposable income.

The Federal Reserve Bank of San Francisco has suggested, in a May 2009 analysis, that this ratio will need to fall to around 100 percent for households to feel more comfortable and begin to loosen up their pocketbooks a little bit more.

For this ratio to decline to 100 percent, the study argues, it would take up to a decade, even if the household savings rate were to rise to 10 percent. The household savings rate is now a little above 6 percent.

Government stimulus programs are not going to counteract this de-leveraging unless they were to create sufficient new inflation to get the value of assets rising rapidly once again!

It is not surprising that small- and medium-sized businesses are in a similar situation. Many of the smaller businesses in the United States used debt much as households did during the buildup of financial leverage because…they were the same people!

And, small- to medium-sized banks are having solvency problems (http://seekingalpha.com/article/222005-where-is-banking-headed-not-up).

Foreclosures, bankruptcies, and bank failures are a common part of such an environment (http://seekingalpha.com/article/222238-why-52-is-not-a-pretty-number).

Regulators and the courts are trying to work out the difficulties connected with such problems as efficiently and smoothly as possible. Galston is just pointing up the fact that correcting such a situation is not going to be accomplished over night. Even the program Galston suggests as a way out of this malaise, a “national infrastructure bank”, would not shorten the time span needed to once again achieve a robust economy with substantially lower unemployment.

Wednesday, August 25, 2010

52 is Not a Pretty Number!

Reading an article in the Wall Street Journal this morning I was hit twice by the number 52. (For those that are looking for signs it can be noted that you can reverse today’s date and get 52 as well!)

The first sighting, Robert Taubman, chief executive of Taubman Centers, Inc. decided earlier this year to stop covering interest payments on it $135 million mortgage on the Pier Shops at Caesars in Atlantic City, N. J. “Taubman, which estimates the mall is now worth only $52 million, gave it back to its mortgage holder. (See http://professional.wsj.com/article/SB10001424052748703447004575449803607666216.html?mod=wsjproe_hps_TopMiddleNews.)

The second sighting: “Of the $1.4 trillion of commercial-real-estate debt coming due by the end of 2014, roughly 52% is attached to properties that are underwater, according to debt-analysis company Trepp LLC.”

The question raised in this article: is it a smart economic decision for commercial real estate firms to just stop making mortgage payments on properties whose values have fallen FAR BELOW the mortgage amounts?

This discussion parallels the discussions that took place many months ago about whether or not it was a smart economic decision for homeowners to just walk away from mortgages on properties whose values have fallen FAR BELOW the mortgage amounts.

The burning issue is between morality and economic incentives. And, what does the economist say about this? Well, everyone has a price. One of the rules I frequently hear is “Don’t say that you wouldn’t sell out for a particular price until you have actually been faced with the decision in real life and actually decided that you wouldn’t sell out for that price.” It’s easy NOT to walk away from a property if you have never been faced with the temptation!

This situation raises concerns relating to two major interpretations of the current economic situation.

First, debates are raging about whether or not we are in a deflationary period. For the last nine months the Consumer Price Index has shown a positive year-over-year rate of increase reaching about 3.0% during this time. For July the year-over-year growth rate was 1.3%.

Yet, the value of real properties seems to be going down and down.

But, isn’t this the same problem that existed in the early 2000s only on the other side of the coin? Then the Consumer Price Index was showing very little inflation, yet the value of real properties was increasing in the 10% to 15% range.

The problem was that the Consumer Price Index measured the price of “flow” goods and services and not the value of the “stock”, the value of the asset. Rent is what is measured in the Consumer Price Index and this is an “imputed” figure. Much concern was raised at the time about the validity of the estimates for rental prices used in the index. Perhaps the same issue should be raised now.

Second, this brings up the issue about whether or not we are in a period of debt deflation. This is the other side of the problem of the early 2000s when we had a credit inflation. In a period of credit inflation the problem is that there is too much credit chasing too few goods and services around. The credit keeps “the music playing” and as long as the music is playing, according to Chuck Prince, Chairman and CEO of Citigroup at the time, you have to keep dancing. A credit inflation is cumulative.

The problem with a debt deflation is that there is too much debt around. When there is too much debt around people have to de-leverage. And, de-leveraging takes a long time and is very, very painful.

One remedy to a debt deflation is for the government to re-flate the economy. This is what many economists, politicians, and pundits would like to see happen. If the government can cause prices to rise again the real value of the debt will go down and guess what? The music starts playing again.

The problem with this solution is that there are historical periods when the amount of debt outstanding becomes unsustainable. People have to accept the fact that “credit bubble” they lived in for so long, no longer exists. And, when this happens, people have to get their balance sheets back in order and live more practically within their means. In times like these, governments and others find it more and more difficult to push them back into profligate habits of spend, spend, spend.

The realization of this hit Europe earlier this year and the pain is evident.

Yet the fundamentalist ministers of “inflationary finance” like Paul Krugman, like many fundamentalist ministers when they are not being listened to, cry out that those who do not respond to their teachings are just members of a cult. These people that oppose them have been misled to a false teaching and are heretics.

The United States (and Europe and some other areas in the world) has a debt problem. And, a great deal of this debt is connected with real estate. And, a great deal of this debt rests on the balance sheets of depository institutions. (See my “Where is Banking Headed? Not up! http://seekingalpha.com/article/222005-where-is-banking-headed-not-up.)

What does a financial institution do when it is holding a mortgage for $135 million and the underlying property is given to them and the value of this underlying property is only $52 million? What does the banking system do knowing that 52% of the $1.4 trillion in commercial real estate debt coming due by the end of 2014 is underwater, and, by all we know, a lot of it is substantially underwater? What does the Federal Reserve and the FDIC and the Treasury Department do when they know that a very large number of the depository institutions in the United States have assets on their balance sheets that are substantially underwater?

This is what happens in a debt deflation. The economy, in a sense, implodes. But, it takes time for everything to happen because it is cumulative. First, there is the panic phase which we have gone through. Now, we are in the un-winding phase because a large number of people know what is happening, they are not surprised anymore, and are trying to work out the problems as smoothly as they can.

The best evidence I can give to support the idea that this implosion is happening is what I presented in the post cited above: on December 31, 2002 there were more than 7,888 commercial banks in the United States. As of March 31, 2010 there were only 6,772 commercial banks. In the next three to five years, many analysts expect this number to drop to 4,000 or so. Note that if the number of banks fell to 4,102 banks, this would be 52% of the number of banks that existed at the end of 2002.

Tuesday, August 24, 2010

Where is Banking Headed? Not Up!

The biggest problem in the economy, I believe, is the banking system. The government recognizes this and that is why the various agencies within the government are following such bizarre policies. The Federal Reserve has kept its target interest rate below 20 basis points for over twenty months now and it appears as if it will maintain this target for at least six to twelve more months. The FDIC, as of March 31, 2010, had 775 banks on its list of problem banks and Elizabeth Warren claims that at least 3,000 banks are facing severe problems relative to commercial real estate loans. The United States Treasury Department is tip-toeing around banking issues and especially around the government agencies called Fannie Mae and Freddie Mac.

I sure would NOT want to be a bank regulator now. The workloads must be enormous and the pressure must never ease. And, in my view, this situation is not going to change for another three years or so.

For one, the industry is bifurcating. The big institutions are winning. The smaller institutions are going down the drain. One figure I am fond of quoting is that the largest 25 commercial banks in the United States control two-thirds of the assets in the industry. (This is from Federal Reserve statistics.) On March 31, 2010 there were 6,772 commercial banks in the industry (according to the FDIC) so that about 6,750 banks control only one-third of the assets in the industry.

Note this, however. On December 31, 2002 there were 7,888 commercial banks in the United States and on December 31, 1992 there were 11,463. So the number of banks in the US declined by more than 40% in the past 18 years.

But, commercial banks with more than $1.0 billion in assets increased from 380 at the 1992 date to 405 at the 2002 date to 523 this year.

Banks that had less than $100 million in assets fell dramatically during this time period: in 1992 there were 8,292 banks; in 2002 there were 4,168; and in 2010 there were 2,469.

Banks between $100 million and $1.0 billion in asset size rose from 2,791 in 1992 to 3,315 in 2002 and to 3,780 in 2010.

However, check this out. In terms of full time equivalent employees, banks with less than $100 million in assets averaged 24 employees in 1992, 20 employees in 2002, and 17 employees in 2010. The middle size of banks averaged 121 employees in 1992, 90 employees in 2002, and 72 employees in 2010.

It appears as if the part of the banking system that controls less than one-third of the banking assets in the United States has gotten smaller and smaller in terms of size of institution and employment. Yet, during the last fifty years, the people in these institutions have been asked to do more and more in terms of the environment they are working within and the pressures they feel. Banks, throughout this time period, have not been able to just live off the interest rate spread they earn between loans and deposits.

Furthermore, the thrift industry has also shrunk. The Savings and Loan industry is dead! (http://seekingalpha.com/article/214460-so-long-to-the-savings-and-loan-industry) The numbers support this demise. On December 31, 1992 there were 2,390 savings institutions in the United States. This number dropped to 1,466 at the end of 2002 and fell to 1,160 at the end of March 2010. The Office of Thrift Supervision (which was a part of the Treasury Department) is to merge into the Office of the Comptroller of the Currency (which is a bureau of the Treasury). Thrift institutions will become more and more like commercial banks and the idea of the thrift industry will fade into memory. Most of these are very small institutions, not unlike the smaller commercial banks listed above with very few employees.

I go through this list because many of the problems that now exist within the banking system are concentrated in these smaller institutions, formerly the heart-beat of Main Street America. In the last fifty years the financial environment changed substantially and a large number of these depository institutions were just not able to make the transition. We are going through the final stages of the current restructuring of the banking industry. What we will see in the next five to seven years will be difficult to compare with what existed in the last half of the twentieth century.

What changed? Well, the inflation of the 1960s and 1970s brought about higher and higher short term interest rates. For many institutions, the comfortable interest rate spreads the banks and thrifts worked with disappeared and even went negative in some instances. The government’s response was to open up the balance sheets and allow these institutions to diversify and create more services that could earn fee income. Also, new financial instruments were created to allow these depository institutions to get into more exotic types of investments.

A typical situation was one in which a depository institution had only 15 people or less with most of them being tellers or clerks and only two or possibly three that had executive authority. Most of these employees had been with the institutions for a decade or more. These institutions were flooded with investment bankers and others with all kinds of sophisticated ideas about how a $50 million organization could get into high-yielding assets or buy cheap deposits or do many other very innovative things so as to regain profitability. The late 1970s and 1980s are full of stories about how the managements of small institutions were “educated” in the ways of Wall Street. The thrift crisis resulted.

In the 1990s and 2000s even more sophisticated instruments and opportunities were brought to the smaller institutions that thought they were getting good advice to help them operate in the twenty-first century. Part of what the managements got into was commercial real estate deals. This is what Elizabeth Warren has alerted us to. But, there are many, many other institutions that have securities or other assets on their balance sheets that are not performing or are damaged in one way or another.

What is Ms. Warren talking about when it comes to the magnitude of the problem? Is she talking about a 20% write down of some assets? A 25% write down? Do these “small” banks have sufficient capital to take such a write down? Can these small banks raise sufficient new capital to cover such a write down?

Can the banking industry handle another 40% decline in the number of banks in the system? Can the banking industry absorb this contraction in the next three to five years not in 18 years? This would mean a loss of more than three thousand commercial banks and savings institutions in this time period.

This is the environment that the Fed, the FDIC, and the Treasury Department is currently working within. They have not really let us know how serious the problem is. Elizabeth Warren has perhaps given us more information than others within the government would like us to have. Maybe this straight talking is why many people are reluctant to put her in charge of a government agency. She might tell us what is really going on.

Whatever, it just looks as if the banking system has a long way to go in order to regain its health.

Sunday, August 22, 2010

Dynamic Portfolio Management and the Buildup of Cash

I am responding to a comment I received about one of my recent posts. The post related to the buildup of cash on the balance sheets of large commercial banks, large non-financial companies, and investment funds. The comment was:

“This giant 'pile of cash' is a myth. Check the other side of the balance sheet and you will see even more debt.”

In this post I will present the situation as I see it. I will use some of the concepts and arguments presented in the book “Financial Darwinism” by Leo Tilman which I just reviewed for Seeking Alpha. (http://seekingalpha.com/article/221607-making-money-in-the-21st-century-financial-darwinism-create-value-or-self-destruct-in-a-world-of-risk-by-leo-tilman)

To begin with I argue that the managements of the large organizations mentioned in the first paragraph have adapted to the new world in which finance is looked on as a dynamic exercise rather than the static one that existed in the “Golden Age” of banking. In the dynamic world of finance, senior managements are constantly assessing and re-assessing the economic environment and adjusting their tactics and risk-taking strategies to match the financial environment as it changes due to variations in economic policy on the part of governments or economic shocks that can alter the trajectory of the business cycle.

About twenty months ago, the Federal Reserve decided that it needed to establish its target rate of interest in a range between zero and twenty-five basis points. And, the Fed decided that it needed to re-enforce this strategy by adding that it would continue to maintain this target range for “an extended time.” That was twenty months ago.

At the time, the yield on the ten-year Treasury bond was around 3.5%

Looking at this situation, senior managements could see that the financial terrain had changed. There was a real opportunity in the “carry trade” where they could borrow in the commercial paper market or in some other short term market for around 50 basis points and then buy Treasury securities that would yield them 350 basis points.

This meant that senior management could change its incremental business strategy, given the new circumstances, and earn a net spread of 300 basis points, RISK FREE. There was no credit risk because they would be investing in Treasury securities. And, there would be no interest rate risk because the Federal Reserve had promised that their interest rate policy would stay in effect for an “extended time.”

Tilman, in his book, refers to this kind of activity as “Balance Sheet Arbitrage” which is defined as “the ability of an institution to borrow at submarket levels.” This used to be the primary business of banks in the static world of banking, but had become less important in recent years as financial markets have changed and financial institutions have become more “intertwined.”

Certainly, however, there was an opportunity for senior managements to benefit from “Balance Sheet Arbitrage” within this new dynamic environment created by the monetary policy of the Federal Reserve. This was not a permanent change because the policy would only stay in effect for an “extended time”. Once the Fed allowed short term interest rates to rise again, interest rate risk would become a problem once again and the senior managements would have to re-assess and re-adjust their tactics in response to this changing environment.

While this Federal Reserve policy remained in place, commercial banks could do the following. On the liability side of its balance sheet, a bank could issue $1.0 billion in short term debt. The bank would then take the $1.0 billion and invest in 10-year Treasury securities. This investment, if my calculations are correct, would provide the bank with $30.0 million in profits, given the 300 basis point spread they could earn. The marginal costs of such a transaction would be miniscule so that we can basically ignore these expenses. But, now the bank has $30.0 million in “cash” which is covered on the other side of the balance sheet by an increase in net worth.

Instead of doing this the bank could write off $20.0 million in bad loans which would be taken against net worth, but the $30.0 in cash would still remain on the balance sheet. The $20.0 million write-off would not only improve the balance sheet of the bank but it would also reduce the taxes the bank would have to pay. This whole transaction would result in the bank earning a one percent return on its assets after taxes, something that most banks would not object to.

The ”giant pile of cash”, however, is not a myth. You can look on the other side of the balance sheet and “you will see even more debt.” However, in the “carry trade” you have investments that match up with this debt. This is how the “carry trade” works. The cash is “real”!

The important thing here, as Tilman argues, is that senior managements must change their strategies once the environment changes. The investments that resulted from the activity describe above were not obtained to “buy and hold” as banks did in the static world of banking. Once the environment changes, senior management must change as well.

What are we looking for here? We are looking for any indication that the Fed is going to change its monetary stance and allow short term interest rates to rise. Rising short term interest rates will also result in rising long term interest rates but the long term rates will generally not rise as rapidly as will the short term interest rates. The spread on the “carry” will lessen and could even turn negative. Senior managements will not want to continue this investment activity given a shift in the monetary policy of the Federal Reserve.

One other point that Tilman makes that I should mention. In such an environment where senior managements continually re-assess and re-position their organizations, “mark-to-market” or fair market accounting is a must. In the static world of finance where institutions bought and held investments, mark-to-market accounting was not as much of an issue as it is in the modern, dynamic world of finance.

In using the “carry trade” within the current policy regime of the Federal Reserve, these large organizations are taking advantage of the opportunities that exist within the “real time” financial markets. When the policy situation changes, they, too, must change their efforts: and this will mean selling off the assets.

If these organizations insist in accounting for these assets at purchase price they are deceiving themselves and deceiving their stakeholders. The risk that the Federal Reserve will change its policy stance exists. The senior managements of these organizations must accept the reality of this risk and reflect this in the changing market value of its assets. There is no way they can justify maintaining the accounting value of the assets as if they were in a “buy and hold” mode.

Furthermore, in a dynamic environment where the senior managements of banks are constantly re-assessing and re-adjusting their portfolios it is very difficult to justify some portion as assets that have been obtained to hold to maturity. This is another fall-out of moving to the dynamic world of finance. The lines between categories blur and it becomes harder and harder to make distinctions between what is something and what is something else. Since environments change, assets that were “honestly” purchased to hold to maturity may have to be sold. The risk of selling assets at a loss must be recognized by banks and presented to stakeholders in mark-to-market accounting.

Conclusion: large quantities of cash have been amassed on the balance sheets of big banks, big non-financial organizations, and big investment funds. This build up is not a “myth”. The buildup of cash has been subsidized by Mr. Bernanke and the Federal Reserve System. If would seem as if these large organizations owe Mr. Bernanke a big “thank you” for all he has done for them.

Friday, August 20, 2010

Is the Dam Starting to Break?

Over the past six months or so, I have commented on the buildup of cash at many of the major banks and manufacturing firms in the United States. My bet has been that at some point in the future, these cash hoards would be used by the large, healthy organizations amassing them to buy up other firms in a period of consolidation that would rival any other in United States history.

The growth of these cash hoards has been subsidized by the Federal Reserve System as it has kept its target interest rate near zero for twenty months and promises to continue to do so for an “extended time.” This has allowed large banks, non-bank companies, and investment funds to engage in the “carry trade”, regain their health and profitability, and build up their cash positions to historic levels. In so doing the Fed has underwritten a bubble in the bond market. (http://seekingalpha.com/article/221151-a-bubble-in-the-bond-market)

Behind this policy stance is the concern of the Federal Reserve for the solvency of large numbers of smaller commercial banks. On May 20, 2010, the FDIC claimed that there were 775 banks on its list of problem banks as of March 31, 2010. (The new list should be out any day.) As of last Friday, the FDIC had seen 110 banks close this year a rate of about 3.5 banks per week. Elizabeth Warren has stated in front of Congress that around 3,000 smaller banks face serious problems in the near future, especially in terms of commercial real estate. (http://seekingalpha.com/article/215958-elizabeth-warren-on-the-troubled-smaller-banks) For the problems of these smaller banks to be worked out in an orderly fashion, the Federal Reserve needs to keep interest very low well into 2011.

The consequence of this policy has been a bifurcation of American finance…and American industry. The bigger and better off companies have profited from the extraordinarily low borrowing costs and the promise that the huge, risk-free spreads that could be earned in the bond market would not go away soon. The smaller and less-well-off companies just held on, hoping that they would survive.

So, the bigger and better off companies built up their cash pools. The banks didn’t use the funds to make loans. The non-financial firms didn’t spend them to invest in new plant and equipment. The investment funds kept the perpetual money machines going. The question was, when would these organizations use these cash pools to begin the consolidation frenzy?

Now the Friday newspapers are full of the “deals” that have taken place this week. BHP has a $40 billion offer on the table for Potash Corporation. Intel is spending almost $8 billion for McAfee. Rank group has put out about $5 billion to acquire Pactiv and Dell has obtained 3PAR for a little over $1 billion.

And, in the banking area, First Niagara has paid $1.5 billion to acquire NewAlliance Bancshares. This latter deal seems to be particularly significant because both financial organizations are healthy. There have been many bank acquisitions over the past several years in which only one of the combining institutions have been healthy, but none where both have been in good shape.

This move by First Niagara is seen as something new in the current environment from both the company side, but also from the regulatory side. Regulators have been so pre-occupied in the past several years with problems in the banking space that little time has been available to give any attention to healthy combinations, if they existed. The announcement of this deal raises the question about whether or not more regulatory time will be given to healthy deals in the near future.

Bottom line: the cash is around in the coffers of many banks and non-financial companies. These organizations do not seem to be intent upon using these funds in a way that will speed up the economic recovery. The strategy seems to be to take part in a substantial consolidation and re-structuring of American finance and industry. The companies I would focus on at this time are those that are profitable, that have a large accumulation of cash, and that have the management team and will to lead this effort. As we saw in the buyout mania that took place in the late 1970s and 1980s, the best performers were the ones that moved first before higher and higher premiums were required to pull off deals. I believe that this will be the case in the present situation. Who said that the world was worried about companies that were “too big to fail”? They ain’t seen nothin’ yet!

Wednesday, August 18, 2010

The Bubble in the Bond Market

There is an op-ed piece in the Wall Street Journal that I believe everyone should read. It is written by Jeremy Siegel and Jeremy Schwartz and is titled “The Great American Bond Bubble.” (http://professional.wsj.com/article/SB10001424052748704407804575425384002846058.html?mod=WSJ_Opinion_LEADTop&mg=reno-wsj) I believe this article is important enough and should be read even if you don’t exactly agree with the argument, which I don’t.

Siegel and Schwartz contend that the current “bubble” in the bond market is comparable to the bubble that occurred in the United States stock market in the 1990s. The reason for this bubble: “Just as investors were too enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic.” In effect, they argue, investors are too concerned about the possibility of slow economic growth and price deflation.

In order to make these “bets” investors have moved money from the stock market into the bond market. “The Investment Company Institute reports that from January 2008 through June 2010, outflows from equity funds totaled $232 billion while bond funds have seen a massive $559 billion of inflows.”

My argument is slightly different. The Federal Reserve has held its target interest rate, the Federal Funds rate, in a range from zero percent to 0.25% since December 16, 2008 to the present. The yield on the 10-year constant maturity, United States Treasury issue has ranged over this time from about 4.00% to about 2.75% where it now stands at. The 3-year constant maturity has stayed in the 2.00% to 0.80% range.

Thus, investors could (and can) borrow money at close to zero interest and invest at a substantial spread...and THIS IS A RISK FREE TRANSACTION!

This is called the “carry trade”! Duh!

What about interest rate risk, the risk that interest rates will rise?

Well, the Federal Reserve, in its infinite wisdom, has taken care of that by promising the financial markets that it will maintain its low target interest rate for “an extended time.” Well, the “extended time” has lasted for twenty months so far and given the news coming out of the Open Market Committee meeting last week, it sounds like the “extended time” will last well into 2011.

The carry trade seems like it has a pretty safe bet for “an extended period of time.”

The Fed seems to be accomplishing two things in following such a policy. First, it is helping the Federal Deposit Insurance Corporation, the FDIC, resolve the problem of dealing with a massive amount of insolvent “smaller” banks in an orderly fashion. This work-out still has a long way to go by all accounts.

Second, the Fed is helping the federal government place massive amounts of debt. Never before has so much government debt been placed in the open market. And, given projections that the federal government will have to place $15 trillion or more of its debt in the next ten years, the Fed faces a daunting task of accommodating such a huge supply of Treasury securities.

The Federal Reserve has certainly accomplished some major things in helping the FDIC and the Treasury Department and in doing so has subsidized the large banks, major corporations, and other investment funds who could partake of the “carry trade” opportunities it created. Too bad if you are a smaller organization or don’t have the wealth to partake.

The Fed subsidy is lining the vaults of the large banks, the large corporations, and the large
investment pools. They are awash in cash!

And, we have a bubble in the bond markets!

This is the third financial market bubble in the last 15 years or so: the stock market bubble in the late 1990s; the bubble in the housing market in the 2000s; and now the bond market bubble. All of these are a product of the Federal Reserve.

I don’t disagree with Siegel and Schwartz in terms of the possible consequences of the current bubble.

“Those who are now crowding into bonds and bond funds are courting disaster.”

“Furthermore, the possibility of substantial capital losses on bonds looms large.”

“One hundred times earnings was the tipping point for the tech market a decade ago. We believe that the same is now true for government bonds.” (Siegel and Schwartz contend, for example, that “The interest rate on standard noninflation-adjusted Treasury bonds due in four years has fallen to 1% or 100 times its payout.”)

However, given my argument, these consequent outcomes and the timing of them depends upon the Fed. The “extended time” will end at some point in the future and the Fed will have to let rates rise. When it does there will be a whole bunch of new problems it will have to face.

The Fed seems to be careening from one serious problem to another and appears to be “out-of-control”. (http://seekingalpha.com/article/220224-does-the-fed-even-know-what-it-s-doing-anymore) Over the past 15 years or so, the Fed has created one bubble after another, one problem after another, and now finds itself in an almost untenable position. It has pumped an excessive amount of reserves into the banking system. It is subsidizing the cash pools of large banks, large corporations, and large money interests. It has been overly accommodative to the financing of the debt of the federal government. And, now its risks bankrupting a large number of people, as Siegel and Schwartz suggest, when it ever raises its interest rate target. What next?

Tuesday, August 17, 2010

Fannie Mae, Freddie Mac and the Future

Earlier this year a friend of mine and his wife got a mortgage on their new home. (As of today, they have only been married three hundred and fifty-three days.) Let me just say that the price of their home is well into the six figures. They borrowed twenty percent of the purchase price. Both of them have established, on their own, a credit rating of at least A and they pay off all of their revolving credit every month.

About two months after signing the mortgage my friend came to see me. He could not believe that his mortgage was now owned by Fannie Mae! Never in his lifetime did he expect to have a mortgage of his owned by this organization!

But, this is a part of modern America. It is a part of the whole effort by government for people to own “things.” Owning “things” in America is good! Monarchs and other royalty owned “things”. The evolution of the wealthy capitalist included owning “things.” It became the right of every American to own “things.”

And, this desire to own “things” played right into the hands of greedy politicians because politicians could promise to deliver “things” to the people that elected them and thereby get elected and re-elected. In the twentieth century, the “thing” of most importance was a home of one’s own. After all, the number one job of a politician is to stay in office! (http://seekingalpha.com/article/219804-wall-street-greed-vs-washington-greed)

Talk about financial innovations. The United States government is one of the most prolific financial innovators the world has ever seen. Just look at the last one hundred years: savings and loan associations, the Federal Home Loan Bank Board, the Federal Savings and Loan Insurance Corporation, the Office of Thrift Supervision, the Federal National Mortgage Association, the Federal Housing Authority, the Department of Housing and Urban Development, the Federal National Mortgage Association, the Government National Mortgage Association, the Mortgage-backed security, and so on and so on.

The surprise is that Fannie Mae and Freddie Mac don’t own more mortgages than they do!

Government programs based on achieving outcomes generally fail. There are two reasons why they fail. First, the goals and objectives of programs focused upon outcomes are generally not based on economics but are based upon achieving desired social consequences. Second, if a program seems to contribute in any way to politicians getting re-elected, more and more resources will be put into that program going forward.

“Popular” programs based on outcomes seem to grow exponentially as each party seeks to “out-do” the other in promising even more to more people. The underlying economics of the situation do not seem to play any role in the cumulative expansion of such programs.

How can people improve things when they tend to hold onto the “old” assumptions? This is a very difficult problem. We see the tip of the iceberg in the column by Andrew Ross Sorkin, “2 Zombies to Tolerate for a While,” in the New York Times (http://www.nytimes.com/2010/08/17/business/17sorkin.html?_r=1&ref=business) where Sorkin discusses what Congress should do about Fannie Mae and Freddie Mac with Congressman Barney Frank. To Frank, Congress has acted as it should have, well maybe a little later than it should have, but things are under control now. The point being: “money is not being lost by anything they (the agencies) are doing now.” The Congressional Budget Office says that taxpayers could absorb almost $400 billion in losses over the next decade, but, to Barney Frank, this is a result of what has happened in the past. Therefore, the agencies just need to be put on a working basis to go forward.

Yet, this doesn’t get at the fundamental issue which has to do with Americans owning “things”. As long as the focus of the government doesn’t change, the problems will not be resolved.

Again, Congress seems to be fighting the last war. As with the financial reform bill that has just been passed by the Congress (http://seekingalpha.com/article/213263-financial-reform-ho-hum), efforts to reform the housing agencies just aim at preventing what has happened over the past ten years or so. It does not deal with the fundamental issue of what it is trying to achieve (the goal itself) and whether or not this goal can be achieved.

However, the world has already changed and will continue to change.

For one, the world is changing at a much faster pace than it did a decade or two ago. Technology, for one, is changing at an ever increasing pace. People do not stay in the same place as long as they did in the past. Families are more divided geographically than ever before and one out of every two marriages ends up in divorce. Small- and mid-sized businesses rise and fall, grow and are sold, and expand and contract. Many people argue that owning “things”, especially “things” that cost a lot of money, will not be as attractive in the future as they have been in the past. The spending (leasing and renting) habits of Americans are changing.

In finance, the environment has also changed over the past fifty years. The whole idea behind the mortgage-backed security was to generate more cash going into the housing market by creating an instrument that pension funds and insurance companies would hold to match their liabilities thereby getting mortgages off the balance sheets of depository institutions, the originators of the mortgages. The idea was that these latter organizations could then create more mortgages.

This effort was based upon a “static” model of how financial intermediaries worked. With the inflation of the 1960s and 1970s, the model for financial intermediaries changed and became more “dynamic” in nature. By the second half of the 1980s, mortgage instruments became the largest component of the capital markets and the volume of trading in this sector was huge. Trading in mortgages became the most spectacular and volatile part of the capital markets.

With the growth in the number of other mortgage instruments, securitization, and derivative instruments, the mortgage finance industry became one of the hottest things around. This was not something the creators of mortgage-backed securities in the late 1960s expected. And, as with other areas experiencing financial innovation, new and more wonderful instruments can still be expected.

Congress continues to work with a “static” model of financial institutions and a perception that people will continue to focus on “things”. Both are wrong!

As a consequence, whatever Congress creates out of Fannie Mae and Freddie Mac, financial incentives will be set up so that people can “game” the system and take advantage of the efforts Congress makes to attain its social goals.

Maybe one day the government will own all the mortgages on all the homes in America. Some people may think that this would be a good thing. On the contrary, it would be just another story of the less well-to-do paying for the pleasures of the more well-to-do.

Who do you think is going to bear the burden of the almost $400 billion cost of Fannie Mae and Freddie Mac the Congressional Budget Office projects? Certainly not the wealthy. Why is it so hard for the people in government to see that the wealthy have enormous resources available to them to protect their incomes and wealth. The less-well-off do not have those resources. Consequently, over time, the burden falls upon the latter even on the programs designed to help them.

Monday, August 16, 2010

Some Sustained Lending Activity at Smaller Banks

In reviewing the banking data put out by the Federal Reserve System last month, I titled my post “Grasping at Straws” because there was some indication of an increase in lending at the smaller banks. (See http://seekingalpha.com/article/215058-grasping-at-straws-in-the-banking-data.) In that post I made the following statement: “An interesting pattern is showing up in the data, however, and gives us something to look for going forward. The smaller, domestically chartered banks in the United States increased their loan balances a little bit over the four-week period ending in the week of July 7, 2010.”

In these releases the “smaller banks” are defined as all domestically chartered commercial banks in the United States with assets less than the largest 25 domestically chartered commercial banks in the United States. The largest 25 domestically chartered commercial banks in the United States hold roughly 67% of the banking assets in the United State while the other roughly 8,000 banks in the United States make up approximately 33% of the banking assets.

Focus is placed upon the smaller banks because this is where the vast majority of “troubled” banks in the United States reside and the concern about these troubled banks is significant enough that Elizabeth Warren has stated in Congressional testimony that there are serious problems which still persist in the smaller banks in the country and the Federal Reserve continues to keep its target interest rate low in order to help the process of bank consolidation flow smoothly. (See http://seekingalpha.com/article/215958-elizabeth-warren-on-the-troubled-smaller-banks.)

The increase in bank lending at the smaller banks seems to have continued through July according to the latest data released by the Federal Reserve. Loans at small domestically chartered commercial banks in the United States rose in the four weeks ending August 4, 2010, by about $16 billion or roughly 0.7%. Loans at these banks are still down, year-over-year, by about 3%, but we are looking for “green shoots” and this represents the second consecutive four-week period in which we have seen an increase in small bank lending.

The gains are concentrated in the consumer area as residential loans rose by over $13 billion in the last four-week period, consumer loans added about $10 billion over the same period, and home equity loans increased by a little more than $1 billion during the time.

Business lending continued to fall as commercial and industrial loans dropped by about $8 billion and commercial real estate loans fell by $3 billion. Furthermore, these latter loans are down by more than $16 billion over the last 13-week period. It is in the area of commercial real estate that Elizabeth Warren and others believe continued problems will plague the smaller banks in the United States.

One can draw the tentative conclusion from these data that some of the smaller banks are beginning to lend, but primarily to consumers and mainly in areas where real estate can serve as collateral. But, this is good news.

Still, in the aggregate, the smaller commercial banks are managing their balance sheets in a very conservative manner. Cash assets at these institutions rose by more than $23 billion or by about 8.5% over the past four weeks, and by almost $30 billion over the past 13 weeks. Total assets at these institutions increased by $46 billion and $70 billion, respectively, over the same time periods.

Overall, however, commercial banking shows very little life in the lending area. Year-over-year, the total assets of all commercial banks in the United States rose by less than one percent and total loans at these institutions fell by a little more than one percent. Commercial and industrial loans were the hardest hit category, falling by almost 15%, followed by commercial real estate loans, which dropped by more than 8%. Shorter periods of time do not present a much different picture.

In my post “No Banks, No Recovery” (http://seekingalpha.com/article/218027-no-banks-no-recovery) I presented the following argument: “It is very difficult to see the United States economic recovery accelerating if the banking system is sitting on the sidelines. The part of the banking system to worry about is the 8,000 banks that do not make the list of the 25 largest domestically chartered banks in the country.”

This is why I am giving so much attention at this time to the smaller banks. We have looked for “Green Shoots” before in this economic recovery and have been disappointed. We continue to look for positive signs that are not just of a passing nature. Hopefully, the data on the commercial banking system contain some positive signs that will continue to show indications that the economic recovery is, in fact, progressing.

Thursday, August 12, 2010

"We don't know what we are doing"--the Fed

The Federal Reserve has two basic problems right now. First, those running the Fed don’t know what they are doing. Second, they are doing a terrible job explaining this to the world.

Never have I seen such confusion in such an important institution. Never have I seen such inadequate leadership.

We have experienced the end of the Fed’s exit strategy, the effort undertaken by the Fed to reduce the size of the Fed’s balance sheet. The exit strategy was designed to reduce the massive amounts of reserves pumped into the financial system by the Fed so that a period of hyper-inflation would not result. That exit strategy saw the Fed’s balance sheet grow by $331 billion over the twelve-month period the “exit” strategy was in place. Excess reserves held by the banking system rose by 38% during the same time period.

One can only imagine what the end to the "exit strategy” will mean for bank reserves.

So, the Fed is now not going to let its balance sheet decline. As securities mature it will replace those securities with newly purchased securities. Impact is “net zero” on the balance sheet. If the economic recovery does not pick up steam or if it stalls or even declines, the Fed will purchase even more securities resulting in a further increase in bank reserves.

The reason for this change in focus? Well, the Fed has observed that the economy is moving more slowly than previously thought.

This is the Fed and the Fed leadership that continued to fight inflation as the housing market tanked and financial institutions balanced on the edge of collapse. The Fed seems to have totally missed the August 2007 meltdown of hedge funds failing to act until September 2008. Then, in the fall of 2008, Bernanke panicked and we got the infamous TARP legislation and an inconsistent mish-mash of bailouts that “saved the financial system.” (http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic)

The Fed continues to frame its statements in terms of the weakness of the economy. However, in the statement released after the last meeting of the Open Market Committee the Fed admits that “Bank lending has continued to contract.”

This is all the attention the Fed gives to the banking system; the industry which the Fed supposedly knows intimately? And, this banking system has over $1.0 in excess reserves and is not lending? This banking system that has 775 banks on the FDIC’s list of problem banks? This banking system that Elizabeth Warren claims has 3,000 banks facing severe solvency problems? This banking system that has one out of every 2 banks in it in trouble?

The statements of the Fed just don’t coincide with what people and the financial markets see out in the real world.

There seems to be a significant disconnect between what is going on in the Federal Reserve and what is going on in the world. Damn those econometric models!!!

We got where we are because the Fed didn’t understand what was happening and then threw everything it could against the wall to see what would stick. I fear that we are experiencing déjà vu all over again!

Tuesday, August 10, 2010

Those Greedy B*****ds in Washington

I have not heard one elected official or government bureaucrat in Washington, D. C. apologize to the American public for all the problems they have caused the American people over the past fifty years. All I have heard from this august bunch is “Get the Greedy Bastards from Wall Street”!

Yet, it is the “Greedy Bastards” from Washington, D. C. that put into place the incentives that everyone else in the country had to respond to and that created the environment that resulted in the mess the country has been going through over the last four years. These “Greedy Bastards from Washington” were greedy for power and for the benefits and rewards of being elected and re-elected over and over again. So they developed the incentives for the rest of the country that would allow them to get re-elected over and over again.

I could go into a long list of “incentives” that the White House and Congress created over the past fifty years, but I thought that today I would work from my list of personal experiences that, to me, show how Washington can impact the private sector and put in place “incentives” that end up causing more trouble for people than they do benefits, even though the programs are put into place to “make things better for people”…and to get elected people re-elected.

In the public sector I was a spectator to the build-up of the securitized mortgage. All this “stuff” we are hearing so much about really began in the late 1960s. Fannie Mae (FNMA) was split in two in 1968, the new wing became Ginnie Mae (GNMA), the Government National Mortgage Association. In 1968, GNMA guaranteed the first mortgage pass-through security. In 1970 FNMA was authorized to purchase private mortgages. Also in 1970, Freddie Mac was created to do the same thing as FNMA. I was able to see the early years of the operation of these institutions as a liaison between the Secretary of HUD and these agencies. I also experienced the effort to create more viable mortgage backed securities so that longer term funds from insurance companies and pension funds could flow into the housing market and provide more money to help “American citizens” own their own home. (By the time Michael Lewis wrote “Liar’s Poker” in the late 1980s, the market for mortgage backed securities was the largest part of the capital markets in the world! This is up from almost zero in the 1960s.)

From where I sat there was only one reason why so much effort was put into these “financial innovations” and that was to help the people in the White House and in Congress get re-elected. The stated goal of these programs was to put Americans their own homes. Okay!

The housing sector was “bankrolled” by the United States government, to get government officials re-elected. Both parties took advantage of this effort and both parties added to the incentives available to all those participating in the “give-away.” And, today we face the reality that over half the residential mortgages in this country are held by either Fannie Mae or Freddie Mac and that each of these institutions is losing so much money that it will eventually cost the taxpayer an estimated $350 billion. Little is being done about this, and, no one in Congress or the White House is apologizing for this loss. Shame on them!

Back in the private sector I joined the Senior Management of a mutual savings bank in late 1983 with assets of about $1.0 billion. In January 1984 I became the Chief Financial Officer of the organization. There were some pretty severe restrictions on the balance sheet of a savings bank at that time. Sixty percent of the assets of the bank, and no more, could be placed in residential mortgages. The other forty percent could be placed in a limited list of marketable securities, primarily Treasury securities. The organization I joined had about 60% of its assets in residential mortgages, 30% in longer-term U. S. Treasury securities, and 10% in very liquid assets.

The bank was in trouble! Not from the mortgages. The residential mortgages were performing well. The problem was in the portfolio of longer-term U. S. Treasury securities. They were deeply “underwater” and this threatened the life of the institution which had been in existence since the 1830s.

United States Treasury issues with a maturity of 10 years traded around 7.5% in 1975. In the 1983-1984 period these securities traded in the 11.5% to 12.5% range. Needless to say, the 30% of the assets the institution held was not in good shape.

Notice, however, this bank was not in trouble because of “bad” assets. The quality of the assets on the books of the bank was of the highest level. This was an institution that was very prudently managed.

The problem came from the inflationary expectations that were built into longer term interest rates, an inflation that came about due to the inflationary policies of the United States government in the 1960s and 1970s. Remember, a small amount of inflation was good at that time because it put people back to work and that was good for the politicians. The tradeoff between inflation and unemployment was called the “Phillips Curve.” Too bad about the highly restricted thrift industry!

Let me just mention two responses that were made to this situation. The first was to convert the mutual institution into a stock institution. This was done successfully and $42 million in new capital was injected into the bank. But, the nature of the bank had changed forever. We were in a new era where “maximizing shareholder returns” became the dominant goal of the organization.

Second, we examined a new financial innovation, a “risk controlled” interest rate arbitrage of $100 million, one-tenth in size of the whole organization, to “off-set” the low interest rates that were being earned on the Treasury portfolio. The justification for the arbitrage transaction was pages and pages of computer printouts that showed how the transaction would perform in dozens of interest rate environments similar to the ones that had existed in history…the last twenty years. Ah, the benefits of computer-based quantitative simulations. Financial innovation was grand!

What happened to the bank? Well, interest rates fell back into the 7.0% to 7.5% range in 1986 (thank you Paul Volcker) and the Treasuries were sold and the olvency problem was resolved. The bank is still in existence today.

The second turn-around I was involved in was a sleepy old savings and loan association that was run by the same old man and old board of directors that had been around for years. The portfolio was solid residential real estate mortgages. This institution did not have to convert and go public, but the environment was such that in 1986 they went public and raised $18 million dollars for an institution that had less than $300 million in assets. They didn’t know what to do with the money but now they had to maximize shareholder value. So they started up a commercial real estate development subsidiary and began to explore getting into more and more commercial activities and also acquisitions. This S&L was run by a “pillar” of the community who had done nothing more than make residential mortgages and manage a large number of women tellers for forty years or so. With the “new” money, the bank grew to about $1.0 billion with many problem areas because the “old guy” just didn’t get it! I was with this institution from 1987 through 1991.

The CEO was finally forced out of his position in 1991 along with many board members. This came about because the financial community substantially discounted the stock because of the “old guy” and the regulators finally forced some board members into doing something. The bank was finally sold to what is now one of the twenty-five largest banks in the country. A board member of the acquiring institution who I knew well told me later that this acquisition was so cheap it was the only acquisition he was familiar with that was accretive in the first year after the acquisition. The regulators did not know what to do with all the problem banks they had on their hands during this time period and so forced many “good” institutions into situations they were totally unprepared for.

I then moved into a commercial bank turnaround. This bank had been one of dozens of “startup” banks which took place in the late 1980s and early 1990s. When I was brought into the bank I was amazed that the bank had policies and procedures that were well suited for a multi-billion dollar bank, but not for a startup institution that never got above $100 million in assets. The management of the bank had grandiose ideas about what they could do and a board of directors that knew almost nothing about banking. But, Washington wanted more and more banks to keep money flowing into the community. The bank had severe problems but we succeeded to the extent that we were the only “boutique” bank in Philadelphia that was not either closed or forced to merge with another institution. So much for providing funds to the local community.

I have worked in both the public sector and the private sector in my career. I have seen how the incentives set up by government have distorted markets as the incentives played to the “greed” of many in the private sector. In the short run, these “incentives” seemed to work for the good of the society. In the longer run as people found out how to “play” the system, the greed of the private sector came to dominate the news angering the people from “Main Street” and making it easy for politicians to point their fingers at the “Greedy Bastards on Wall Street” and walk away as if they had nothing to do with all the problems that they had created. Those “Greedy Bastards from Washington”! Beware of what these “Greedy Bastards” do because they only have one incentive…to get re-elected.

Monday, August 9, 2010

Federal Reserve Exit Watch: Part 13

In the summer of 2009, a great deal of concern was expressed about the Federal Reserve and the excessive amounts of Reserve Bank credit that had been pumped into the banking system. The Federal Reserve stated that it had an “exit” plan to withdraw these reserves from the banking system so as not to create an inflationary or hyper-inflationary environment once the economic recovery began to pick up speed.

Here we are 13 months into the “exit watch” and there has been “no exit” of reserves from the banking system. In fact, Reserve Bank credit is now $331 billion GREATER than it was one year ago; it has grown over the past 365 days by 16.7%, as of August 4, 2010.
The stated reason for this “no exit” performance: the economy has remained stagnant and as long as the economy stays very weak the Federal Reserve will keep its low target interest rates which means that the target Federal Funds rate will remain close to zero for an “extended period”.

As I have reported in my blog posts, my belief is that the Federal Reserve is excessively concerned about the solvency difficulties being experienced by the small banks in this county, a concern that I have recently summarized in my post of August 2, titled “No Banks, No Recovery,” http://seekingalpha.com/article/218027-no-banks-no-recovery. There are many small banks experiencing extreme problems and the Federal Reserve is not going to begin withdrawing reserves from the banking system until there is some indication that this solvency problem is over.

Commercial bank Reserve Balances with Federal Reserve Banks has risen by $334 billion over the past year, an increase of 46.6% since August 5, 2009. Note that Excess Reserves at depository institutions rose from a monthly average of $750 billion in June 2009 to $1,035 billion in June 2010, an increase of 38%.

This is a strange “exit.”

And, as the Federal Reserve has pumped these additional reserves into the banking system, the total assets of the commercial banks in the United States fell by 1.7% from almost $12.0 trillion to about $11.8 trillion from June 2009 through June 2010. Loans and leases at these commercial banks declined by 2.6%. Banks got out of a substantial amount of business loans during this time period, as commercial and industrial loans fell by 16.7%, June-over-June, and commercial real estate loans declined by 7.8%, year-over-year.

The reserves the Fed is pumping into the banking system are not going into “pumping up” the economy. The reserves the Fed is pumping into the banking system are just going into excess reserves!

Looking at a shorter period of time, over the past 13 weeks, the last quarter, Reserve balances with Federal Reserve banks rose by $8.0 billion. The primary swings in the Fed’s balance sheet over this time period were operational in nature. There was a $26 billion decrease in the General Account of the U. S. Treasury, a seasonal increase in currency in circulation of about $9 billion and a $7 billion rise in Foreign Reverse Repos. The offsetting transactions of the Fed to neutralize these changes was an increase in Securities Held Outright by the Fed of about $12 billion, the primary increase coming in the Fed’s purchase of Mortgage-backed securities.

In the past 4 weeks, the U. S. Treasury balance reversed itself, increasing by almost $28 billion and there were modest declines in currency in circulation and Foreign Reverse Repos. The Fed offset a portion of these by letting it holdings of Federal Agencies decline by a little more than $5 billion. The net effect of these operating transactions was a $19 billion decline in Reserve balances held at Federal Reserve banks.

Thus, over the past 4 weeks and over the past 13 weeks, Reserve Bank Credit barely changed. Both periods were dominated by operating transactions within the banking system offset by Federal Reserve balancing transactions.

As a consequence, excess reserves in the banking system stayed relatively constant over the last quarter of the year.

Loans and leases at commercial banks continued to decline over the last 4-week and 13 week periods as did commercial and industrial loans and commercial real estate loans.

In summary, the Exit Watch in the thirteenth month of its existence can report little or no action on the exit front over the past month or the past three months. “Exit” is still on hold until either the general condition of the small banks improves or the economic recovery really becomes an economic recovery…or both.

Wednesday, August 4, 2010

Interpreting the Recent Behavior of the Monetary Aggregates

All research seems to indicate that, over time and everywhere, inflation is a monetary phenomenon. If this is true then we need to take some account of monetary aggregates in the short run so as to better understand what is taking place and what the current situation implies for the future. Also, it seems as if interest in the monetary aggregates might be surfacing once again. (See my post, http://seekingalpha.com/article/217598-monetary-targets-a-fresh-take.)

Let’s look at the current situation beginning with the quarter that followed the start of the Great Recession, the first quarter of 2008. If one looks at the year-over-year growth rate of the M2 measure of the money stock, things look relatively benign. Growth remained modestly above 6% through the first nine months of
the recession, but rose to over 10% by early 2009. However, this did not signal that monetary policy was working even though the end of the recession has been dated as July 2009. In fact, in looking at all the other monetary measures one could discern some troubling behavior that might indicate a deeper recession and a very slow recovery.

For example, the behavior of this measure certainly did not track the performance of bank reserves or the monetary base. Through the first nine months of 2008, total reserves in the banking system averaged a little under 5%, year-over-year. In the second quarter of 2009, the rate of increase was over 1,800%! The monetary base performed in a similar fashion. For the first nine months of 2008, the monetary base grew around 2.5% year-over-year. This increased to more than 100% in the beginning of 2009.

Of course, we know the reason why these reserve aggregates grew so rapidly while the money stock measure picked up only modestly. Excess reserves in the banking system went from less than $2 billion in the second quarter of 2008 to over $800 billion in the first quarter of 2009. The Federal Reserve was supplying funds to the banking system. However, the banking system was just holding onto them!

There was another movement within the monetary aggregates that was also of interest during this time period. The growth of required reserves, the reserves the banks had to hold behind their deposits, rose throughout 2008 but not nearly at the pace of total reserves or the monetary base. Note, however, that the growth rate of the non-M1 component of M2 remained relatively constant throughout 2008 and 2009 which indicated that a lot must be happening within the M1 measure of the money stock.
Here we see that through the first six months of 2008, the M1 money stock hardly grew at all. However, starting in September 2008 which marked the beginning of the financial crisis, this measure took off and was growing by almost 17% in early 2009. Growth was mainly in the demand deposit component of M1.

Two things were happening here. First, interest rates fell dramatically in 2009; keeping money in interest bearing accounts at banks and thrift institutions did not make much sense. Second, as people lost jobs and the economic environment became more and more uncertain, people and businesses moved assets from less liquid vehicles to transaction balances (demand deposits and other checkable deposits) so as to be able to buy necessities and to pay bills.

It is very important to identify this behavior because it explains a lot about how people were using their wealth at this time and what kinds of pressures they were feeling. This information helps us understand why the economy is performing the way it is and what implications this kind of behavior has for the future.

Taking this analysis into 2010 we see that the growth rate of M2 drops off drastically to less than 2%, yet M1 continued to incease at rates in excess of 5%. This is because people continued to transfer funds from interest-bearing accounts into transaction accounts. This is supported by the information on the growth rate in required reserves which was still above 10%. Note, that because of this the Federal Reserve has needed to continue to supply more reserves into the banking system to handle this increase in required reserves yet maintain the extraordinarly high levels of excess reserves in the banking system, reaching more than $1.0 trillion in the fourth quarter of 2009.

What this indicates to me is that the behavior of people and of the business community has not changed much over the past two and one-half years. People are still scared. Because of the tepid economy, high unemployment, and the uncertainty about the future, economic units still prefer to put their funds into transaction accounts so that they can facilitate their needed expenditures. This kind of information does not give one much confidence.

Furthermore, this kind of behavior is not what is seen before economic recoveries pick up steam. And, with the M2 measure of the money stock growing below 2%, year-over-year, one can only conclude that money is not entering the economy in a way that will stimulate future business expansion. Only when bank loans begin to increase and, consequently, M2 begins to expand more rapidly, then, maybe, confidence in the recovery will grow.

To me, monetary information is very valuable in trying to understand what is happening in the economy and where the economy might be going. However, the analysis of monetary aggregates must not be the kind of “cookie-cutter” analysis done in the 1970s and 1980s. Good analysis of the monetary aggregates is very complex and must include some historical analysis with it.

Tuesday, August 3, 2010

High Taxes and Tax Avoidance

The most profound comment in the news yesterday was, in my mind, this quote:

“The highest tax bracket income earners, when compared with those people in lower tax brackets, are far more capable of changing their taxable income by hiring lawyers, accountants, deferred income specialists and the like. They can change the location, timing, composition and volume of income to avoid taxation.”

This comes from the keyboard of Arthur Laffer of Supply-side economics fame. (See, http://professional.wsj.com/article/SB10001424052748703977004575393882112674598.html.) Laffer then gives several examples of such avoidance behavior: Senator John Kerry of Massachusetts, former Senator Howard Metzenbaum, and former Chairman of the House Ways and Means Chairman Charles Rangel.

I totally agree with Laffer on his major point.

This avoidance behavior also exists in the presence of an “inflation” tax. Whereas inflation has been touted as benefitting the “less well-to-do”, this is just a short-run help. Over the longer run, the “less well-to-do” cannot protect themselves very well against rising prices and so end up with lower real wages, real wealth, and fewer job opportunities.

As in the case of government assessed taxes, those individuals in the highest tax brackets or who have accumulated the greatest amounts of wealth are more capable of protecting their real income and real assets from an inflationary depreciation “by hiring lawyers, accountants, deferred income specialists and the like.” They can find many ways to avoid inflation that are not available to the “less well-to-do.”

There are three points that I would like to make relative to the above comments. First, many policies that attempt to help one class of people in a democratic society at the expense of another class of people may succeed in the short run. However, in the longer run, these policies tend to rebound on the former class of people, making them worse off, while achieving little or nothing in terms of the latter class.

In some cases these efforts produce a “negative-sum game” result in which everyone loses something. And, this leads me to the second point. By facing off “one class” of society versus “another class” of society, antagonisms are created, suspicions are raised, and society tends to be worse off. This is not what is supposed to happen in a liberal, democratic nation.

A liberal society works where people cooperate with one another and build community. To quote Ludwig von Mises on a liberal society: “It is important to remember that everything that is done, everything that man has done, everything that society does, is the result of such voluntary cooperation and agreements.”

I am not arguing in this post for or against renewing the “Bush tax cuts”. What I am arguing for
is a change in the rhetoric surrounding discussions about the federal budget, the rhetoric surrounding discussion about the financial reform bill, and the rhetoric surrounding many other issues in front of the American public these days.

Yes, arguing for one class against another may seem like good politics, but in America this really doesn’t win elections. Arguing for one class against another is a form of populism and the very politically astute Bill and Hilary Clinton have stated that elections cannot be won on a populist platform. (One reference on this point to Hilary Clinton can be found in Robert Rubin’s book “In An Uncertain World”.) I still remember watching Al Gore, in the 2000 election campaign, speaking in Mark Twain’s home town on the Mississippi River, Hannibal, Missouri, re-framing his campaign in populist terms. My immediate reaction was…Gore has just lost the election! And, he was well ahead of dubya in the polls at the time.

My third point is that very often people (and especially politicians) get caught up in the consequences of actions, which are current, and fail to see the causes of the these outcomes. This is a big problem in economics: many economic causes occur long before the consequences of the cause are recorded. For example, rent controls on apartments may lower housing costs for renters in the short run. However, if the owners of the apartments fail to maintain the units over time because of the reduced cash flows from the lower rental revenues, many will blame the “owner” and not the rent controls, for the now shoddy apartments .

An important example of this is the government caused inflation over the past fifty years or so. The gross federal debt increased by a compound rate of more than 7% per year from 1961 through 2008. A lot of this debt was monetized so that inflation increased at a compound rate of more than 4% per year during this time period accompanied by numerous asset bubbles which resulted from the excessive creation of credit. Financial innovation prospered in such an environment leading to greater and greater use of financial leverage, the taking on of greater amounts of risk, and the growth of “creative” accounting practices. Ponzi schemes also thrived in such an environment.

Why did businesses succumb to the taking on of excessive risk? The answer: in an inflationary environment, that is where the incentives are. If a company is out-performing its competitor by ten basis points then the competitor may assume more risk or take on greater financial leverage to pump up returns to match the competitor. The environment is cumulative in that more risk begets even more: or, as Chuck Prince, the CEO of Citigroup stated, “If the music keeps on playing, you have to keep on dancing.”

And who gets blamed? The greedy bankers…and not the government that created the inflationary environment. This point was made by the economist Irving Fisher in 1933: “If it is inflation and the one who profits is the business man, the workman calls the profiter a ‘profiteer.’ The underdog reasons as follows: ‘How did I get poor while you got rich? You did it, you dirty thief. I don’t know just how you did it; your ways are too subtle, sinister, dark and underground for simple me; but you did it all the same’

But, none of us—neither the farmer, nor the workman, nor the bondholder, nor the stockholder—thinks of blaming the dollar. So the real culprit stands on the curbstone watching us poor mortals as we beat out each other’s brains, and has the last laugh.”

Working together can result in a “positive-sum game”. The wealthy and those earning high incomes, at least most of them, believe that they should pay taxes. Maybe a new approach needs to be tried rather than attacking them and then trying to penalize them by enacting highly restrictive rules or excessive tax structures which they will spend great amounts of money to avoid.

The old methods don’t seem to work. Maybe we need to work to balance the tax laws so as to maximize tax revenues rather than punish one group of people over another. Maybe we need to think about creating a more open and transparent financial system that allows the economic process to work rather than saddle the economy with rules that dictate “outcomes”.

However, the old methods are built into the political system and will not change before this November. Guess we will just keep on shooting ourselves in the foot!